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724533_1993.txt	724533_1993	1993	724533	ITEM 1. BUSINESS Development and Description of Business --------------------------------------- Information concerning the business of American Insured Mortgage Investors (the Partnership) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and in Notes 1, 4, 5, and 6 of the notes to the financial statements of the Partnership contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Also see Schedule XII- Mortgage Loans on Real Estate, contained in Item 14, for the table of the Insured Mortgages (as defined below) invested in by the Partnership as of December 31, 1993. Employees --------- The business of the Partnership is managed by CRIIMI, Inc. (the General Partner), while its portfolio of mortgages is managed by AIM Acquisition Partners, L.P. (the Advisor) and CRI/AIM Management, Inc. (the Sub-advisor). CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). CRI is also an affiliate of the Sub-advisor. The Partnership has no employees. Competition ----------- In disposing of Insured Mortgages, the Partnership competes with private investors, mortgage banking companies, mortgage brokers, state and local government agencies, lending insti- tutions, trust funds, pension funds, and other entities, some with similar objectives to those of the Partnership and some of which are or may be affiliates of the Partnership, its General Partner, the Advisor or their respective affiliates. Some of these entities may have substantially greater capital resources and experience in disposing of FHA insured mortgages than the Partnership. Pursuant to the Sub-advisory Agreements, the Advisor retained the Sub-advisor to perform the services required of the Advisor under the Advisory Agreements. CRI also serves as a general partner of the advisers to CRIIMI MAE and CRI Liquidating REIT, Inc., which have investment objectives similar to those of American Insured Mortgage Investors-Series 85, L.P. (AIM 85), American Insured Mortgage Investors L.P. - Series 86 (AIM 86) and American Insured Mortgage Investors L.P. - Series 88 (AIM 88) as well as the Partnership (collectively, the AIM Partnerships). CRI and its affiliates are also general partners of a number of other real estate limited partnerships. CRI and its affiliates also may serve as general partners, sponsors or managers of real estate limited partnerships, real estate investment trusts (REITs) or other entities in the future. The Partnership may attempt to dispose of mortgages at or about the same time that one or more of the other AIM Partnerships and/or other entities sponsored or managed by CRI, including CRIIMI MAE and CRI Liquidating REIT, Inc., are attempting to dispose of mortgages. As a result of market conditions that could limit dispositions, the Sub-advisor and its affiliates could be faced with conflicts of interest in determining which mortgages would be disposed of. Both CRI and CRIIMI, Inc., however, are subject to their fiduciary duties in evaluating the appropriate action to be taken when faced with such conflicts. ITEM 2. ITEM 2. PROPERTIES Although the Partnership does not own the related real estate, the Insured Mortgages in which the Partnership has invested are first liens on the respective multifamily residential developments or retirement homes. PART I ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings to which the Partnership is a party. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the security holders to be voted on during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS Principal Market and Market Price for Units and Distributions ------------------------------------------------------------- From November 5, 1985 through July 6, 1989, the Units were included in the NASDAQ National Market System. From July 7, 1989 through April 7, 1992, the Units were traded in the over-the-counter market and quoted on the NASDAQ quotation system under the symbol "AIMAZ." Since April 8, 1992, the Units have traded on the American Stock Exchange with a trading symbol of AIA. The high and low bid prices for the Units as reported in AMEX or the NASDAQ Quotation System and distributions, as applicable, for each quarterly period in 1993 and 1992 were as follows: Amount of 1993 Distribution Quarter Ended High Low Per Unit ------------------- ------- ------- ------------ March 31, $4 7/8 $4 5/16 $ .095 June 30, 4 3/4 4 5/16 .090 September 30, 4 13/16 4 7/16 .090 December 31, 5 1/8 4 1/4 .370(1) --------- $ .645 ========= Amount of 1992 Distribution Quarter Ended High Low Per Unit ------------------- ------- ------- ------------ March 31, $4 5/8 $4 1/2 $ 1.53(2) June 30, 5 5/8 3 7/8 .10 September 30, 4 3/4 3 7/8 .09 December 31, 4 5/8 4 1/8 .10 -------- $ 1.82 ======== (1) This includes a special distribution of $.28 per Unit comprised of: (i) $.21 per Unit return of capital from the disposition of the mortgages on Chapelgate Apartments and Cumberland Village and (ii) $.07 per Unit capital gain from these dispositions plus additional sales proceeds from the sale of the mortgage on Clark and Elm Apartments. (2) This includes a $1.34 per Unit special distribution due to the disposition of the mortgage on Clark and Elm Apartments and the receipt of the remaining 9% of assignment proceeds from the mortgage on Foxfire West Apartments. The United States Congress recently repealed portions of the federal tax code which had an adverse impact on tax-exempt investors in "publicly traded partnerships." In an effort to allow pension funds and other tax-exempt organizations to invest in publicly-traded partnerships, the Revenue Reconciliation Act of 1993 repealed the rule that automatically treated income from publicly-traded partnerships as gross income that is derived from an unrelated trade or business. As a result, investments in publicly-traded partnerships such as AIM 84 are now treated the same as investments in other partnerships for purposes of the unrelated business taxable income rules. PART II ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS - Continued There are no material legal restrictions upon the Partnership's present or future ability to make distributions in accordance with the provisions of the Partnership Agreement. The Partnership's Dividend Reinvestment Plan was amended effective April 10, 1992 to exclude the amount of any special distributions from reinvestment under the Plan. The regular distributions will continue to be automatically reinvested in additional Units as in the past. Approximate Number of Unitholders as of Title of Class December 31, 1993 --------------------------- ---------------------- Depository Units of Limited Partnership Interest 11,000 PART II ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per Unit amounts) PART II ITEM 6. SELECTED FINANCIAL DATA - Continued The selected statements of operations data presented above for the years ended December 31, 1993, 1992 and 1991, and the balance sheet data as of December 31, 1993 and 1992, are derived from and are qualified by reference to the Partnership's financial statements which have been included elsewhere in this Form 10-K. The statements of operations data for the years ended December 31, 1990 and 1989 and the balance sheet data as of December 31, 1991, 1990 and 1989 are derived from audited financial statements not included in this Form 10-K. This data should be read in conjunction with the financial statements and the notes thereto. PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General ------- American Insured Mortgage Investors (the Partnership) was formed under the Uniform Limited Partnership Act in the state of California on July 12, 1983. During the period from March 1, 1984 (the initial closing date of the Partnership's public offering) through December 31, 1984, the Partnership, pursuant to its public offering of 10,000,000 depositary units of limited partnership interest (Units), raised a total of $200,000,000 in gross proceeds. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 limited partnership interests in exchange therefor. At a special meeting of the limited partners and Unitholders of the Partnership held on August 16, 1991, a majority of these interests approved, among other items, the assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership, as described below, and the adoption of provisions which prohibit a "Reorganization Transaction" (including transactions commonly known as "roll-ups") for a period of five years unless approved by a super-majority. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded AIM Capital Management Corp. (the former managing general partner with a partnership interest of 2.8%) and IRI Properties Capital Corp. (the former corporate general partner with a partnership interest of 0.1%) as the sole general partner of the Partnership. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE) formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is CRI. In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. The former managing general partner, former corporate general partner and former associate general partner are sometimes collectively referred to as former general partners. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (Integrated Funding) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and disposes of the Partnership's mortgages. Prior to the expiration of the Partnership's reinvestment period in November 1988, the Partnership was engaged in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages and together with Originated Insured Mortgages, referred to herein as Insured Mortgages). The Partnership purchased the Acquired Insured Mortgages from unaffiliated third parties at a discount from the outstanding principal balance. With respect to the two remaining Originated Insured Mortgages, the Partnership is entitled to receive, in addition to base interest payments, additional interest (commonly termed Participations) based on a percentage of the net cash flow from the development and of the net proceeds from the refinancing, sale or other disposition of the development. No payments were PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued received in 1993, 1992 or 1991 as a result of the Participations. Through November 1988, the former managing general partner had the right to reinvest the proceeds from any sale or prepayment of an Insured Mortgage or any insurance proceeds received from the assignment of an Insured Mortgage (subject to the conditions set forth in the Partnership Agreement). After the expiration of the reinvestment period, the Partnership is required (subject to the conditions set forth in the Partnership Agreement) to distribute such proceeds to its Unitholders. The Partnership Agreement states that the Partnership will terminate on December 31, 2008, unless previously terminated under the provisions of the Partnership Agreement. As of December 31, 1993, the Partnership had remaining investments in 16 Insured Mortgages, including one Originated Insured Mortgage classified as Mortgage Held for Disposition, with an aggregate carrying value and face value of $43,342,199 and $49,225,550, respectively, all of which were originated or acquired by the former managing general partner. All of the Partnership's Insured Mortgages are insured by the United States Department of Housing and Urban Development (HUD) for 100% of their current face value, less a 1% assignment fee, and are nonrecourse first liens on multifamily residential developments or retirement homes owned by entities unaffiliated with the Partnership, its General Partner, or their affiliates and are insured under Section 221(d)(4) of the National Housing Act. As of December 31, 1993, all of the Partnership's Insured Mortgages are current with respect to the payment of principal and interest. Mortgage Dispositions --------------------- A summary of dispositions that are included in the statements of operations for the years ended December 31, 1993, 1992 and 1991 are as follows: PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Results of Operations --------------------- 1993 versus 1992 ---------------- Net earnings for 1993 increased compared to 1992 primarily due to the recognition of gains from mortgage dispositions in September and November 1993 as shown in the above chart. Mortgage investment income decreased during 1993 compared to 1992 primarily due to the decrease in the mortgage base resulting from mortgage dispositions during 1993 and 1992. Interest and other income decreased during 1993 compared to 1992 due to the temporary investment of proceeds received during January 1992 from the sale of the defaulted mortgage on Clark and Elm Apartments pending the distribution to Unitholders in May 1992. General and administrative expenses decreased for 1993 as compared to 1992. This decrease was due primarily to the payment in 1992 of non-recurring professional fees in connection with the transfer of the title of the Partnership's mortgages necessitated by the change in general partner, as well as the payment in 1992 of a one-time American Stock Exchange listing fee. This decrease was also attributable to a decrease in professional fees and reimbursable wages due to the decrease in the mortgage base. 1992 versus 1991 ---------------- Net earnings for 1992 decreased compared to 1991 primarily due to the impact on the mortgage base of the disposition of the mortgage on Clark and Elm Apartments during January 1992. During the first quarter of 1992, the Partnership recognized a financial statement loss on the disposition of this mortgage in the amount of $21,103. In addition, the net earnings for 1991 included the gain recognized from the assignment of the mortgage on Foxfire West Apartments in the amount of $340,677. Mortgage investment income decreased during 1992 compared to 1991 primarily due to the decrease in the mortgage base, as previously discussed. Interest and other income increased during 1992 as compared to 1991 primarily due to the short-term investment of the disposition proceeds received during January 1992 pending the distribution to Unitholders in May 1992. The asset management fee decreased during 1992 compared to 1991 as a result of a reduction in the mortgage base in 1992 and a reduction in the asset management fee percentage, effective October 1, 1991. At the special meeting held on August 16, 1991, the limited partners and Unitholders of the Partnership consented to, among other things, a reduction in the asset management fee payable by the Partnership to the Advisor from the previous level of 1.75% to .95%, effective October 1, 1991, and a reduction in the asset management fee payable after January 1, 1999 from the previous level of 1.00% to .95%. The limited partners and Unitholders also consented to the elimination of the subordinated fees. During 1992, general and administrative expenses decreased compared to 1991 primarily due to cost savings in investor services expenses resulting primarily from a reduction in mailing costs. This decrease was partially offset by an increase in non- recurring professional fees incurred in 1992 in connection with the transfer of the title of the Partnership's mortgages as discussed above. Also offsetting the decrease in general and administrative expenses for 1992 compared to 1991 was the payment of the American Stock Exchange listing fee for the Partnership's PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Units, coupled with an increase in mortgage servicing fees. During the first quarter of 1992, a servicer detected that it had neglected to charge service fees in the last quarter of 1991, which resulted in the recognition of higher than expected service fees in the first quarter of 1992. Liquidity and Capital Resources ------------------------------- The Partnership's operating cash receipts, derived from payments of principal and interest on Insured Mortgages, plus cash receipts from interest on short-term investments, were sufficient during 1993 to meet operating requirements. The basis for paying distributions to Unitholders is net proceeds from mortgage dispositions and cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each year due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and (4) changes in the Partnership's operating expenses. Since the Partnership is obligated to distribute the Proceeds of Mortgage Prepayments, Sales and Insurance of Insured Mortgages (as defined in the Partnership Agreement) to its Unitholders, the size of the Partnership's portfolio will continue to decrease. The magnitude of the decrease will depend upon the size of the Insured Mortgages which are prepaid, sold or assigned for insurance proceeds as reflected in the preceding table. If necessary, the Partnership has the right to establish reserves either from the Proceeds of Mortgage Prepayments, Sales and Insurance of Insured Mortgages or from Cash Flow (as defined in the Partnership Agreement). It should be noted, however, that to the extent reserves are not established, the Partnership is required to distribute the Proceeds of Mortgage Prepayments, Sales and Insurance of Insured Mortgages, and generally intends to distribute substantially all of its Cash Flow from operations. If any reserves are deemed to be necessary by the Partnership, they will be invested in short-term, interest-bearing investments. The Partnership anticipates that reserves generally would only be necessary in the event the Partnership elected to foreclose on an Originated Insured Mortgage insured by the Federal Housing Administration (FHA) and take over the operations of the underlying development. In such case, there may be a need for additional capital. Since foreclosure proceedings can be expensive and time-consuming, the Partnership expects that it will generally assign these Originated Insured Mortgages to HUD for insurance proceeds rather than foreclose. The determination of whether to assign the mortgage to HUD or institute foreclosure proceedings or whether to set aside any reserves will be made on a case-by-case basis by the General Partner, the Advisor and the Sub-advisor. As of December 31, 1993 and 1992, the Partnership had not set aside any reserves. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Cash flow - 1993 versus 1992 ---------------------------- Net cash provided by operating activities decreased during 1993 as compared to 1992 principally due to the receipt of accrued interest, in 1992, on the mortgage on Clark and Elm Apartments which defaulted in 1991 and was sold in 1992. This decrease was also attributable to a decrease in interest and other income and mortgage investment income, as previously discussed. Net cash provided by investing activities decreased during 1993 compared to 1992 principally due to the receipt of proceeds of $13,652,589 from the January 1992 sale of the mortgage on Clark and Elm Apartments compared to proceeds of $2,965,249 received during September and November 1993 from an adjustment to the sale price for the 1992 sale of the mortgage on the Clark and Elm Apartments, as well as proceeds from the sale of the mortgages on Chapelgate Apartments and Cumberland Village. The decrease in cash used in financing activities during 1993 as compared to 1992 was principally due to the distribution to Unitholders in 1992 of net proceeds received from the sale of the mortgage on Clark and Elm Apartments. Cash flow - 1992 versus 1991 ---------------------------- Net cash provided by operating activities increased during 1992 as compared to 1991 principally due to the receipt of accrued interest on the mortgage on Clark and Elm Apartments which defaulted in 1991 and was sold in 1992. This increase was partially offset by a decrease in mortgage investment income during 1992 due to the reduced mortgage base. Net cash provided by investing activities increased during 1992 compared to 1991 principally due to the receipt of proceeds of $13,652,589 from the disposition of the mortgage on Clark and Elm Apartments compared to proceeds of $1,714,086 received during 1991 representing a portion of the disposition proceeds from the assignment of the mortgage on Foxfire West Apartments and the remaining amount due from the disposition of the mortgage on Wellington Apartments. The increase in cash used in financing activities during 1992 as compared to 1991 was principally due to the distribution to Unitholders in 1992 of net proceeds received from the sale of the mortgage on Clark and Elm Apartments. This compares to the distribution to Unitholders in 1991 of net proceeds received from the assignment of the mortgage on Foxfire West Apartments. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is contained in Part IV. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a), (b), (c) and (e) The Partnership has no officers or directors. The affairs of the Partnership are generally managed by the General Partner, which is wholly owned by CRIIMI MAE, a company whose shares are listed on the New York Stock Exchange. CRIIMI MAE is managed by an adviser whose general partner is CRI. At a special meeting of the limited partners and Unitholders of the Partnership held on August 16, 1991, a majority of these interests approved, among other items, the assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, the General Partner succeeded AIM Capital Management Corp. (the former managing general partner with a partnership interest of 2.8%) and IRI Properties Capital Corp. (the former corporate general partner with a partnership interest of 0.1%) as the sole general partner of the Partnership. In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, the Advisor succeeded Integrated Funding as the adviser of the Partnership. AIM Acquisition is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and disposes of the Partnership's mortgages. The General Partner is also the general partner of AIM 85, AIM 86 and AIM 88, limited partnerships with investment objectives similar to those of the Partnership. (d) There is no family relationship between any of the officers and directors of the General Partner. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. (h) Based solely on its review of Forms 3 and 4 and amendments thereto furnished to the Partnership, and written representations from certain reporting persons that no Form 5s were required for those persons, the Partnership believes that all reporting persons have filed on a timely basis Forms 3, 4, and 5 as required in the fiscal year ended December 31, 1993. PART III ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to Note 3 of the notes to the financial statements of the Partnership contained in Part IV. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of December 31, 1993, no person was known by the Partner- ship to be the beneficial owner of more than five percent (5%) of the outstanding Units of the Partnership. As of December 31, 1993, neither the officers and directors, as a group, of the General Partner nor any individual director of the General Partner, are known to own more than 1% of the out- standing Units of the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. Note 3 of the notes to the Partnership's financial statements contained in Part IV of this report contains a discussion of the amounts, fees and other compensation paid or accrued by the Partnership to the directors and executive officers of the General Partner and their affiliates, and is incorporated herein by reference. (b) Certain business relationships. Other than as set forth in Item 11 of this report which is incorporated herein by reference, the Partnership has no business relationship with entities of which the former general partners or the current General Partner of the Partnership are officers, directors or equity owners. (c) Indebtedness of management. None. (d) Transactions with promoters. Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements: See Item 8. "Financial Statements and Supplementary Data." (a)(2) Financial Statement Schedules: XII - Mortgage Loans on Real Estate All other schedules have been omitted because they are inapplicable, not required, or the information is included in the Financial Statements or Notes thereto. (a)(3) Exhibits: 3. Amended and Restated Certificates of Limited Partnership are incorporated by reference to Exhibit 4(a) to the Registration Statement on Form S-11 (No. 33-6747) dated June 25, 1986 (such Registration Statement, as amended, is referred to herein as the "Registration Statement"). 4. Agreement of Limited Partnership, incorporated by reference to Exhibit 3 to the Registration Statement. 4.(b) Form of Depository Receipt, incorporated by reference to Exhibit 4(b) to the Registration Statement. 4.(c) Amendment to the Amended and Restated Agreement of Limited Partnership of the Partnership dated February 12, 1990, incorporated by reference to Exhibit 4(c) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1989. 10.(b) Origination and Acquisition Services Agreement, dated September 1, 1983, between the Partnership and IFI, incorporated by reference to Exhibit 10(b) to the registration statement on Form S-11 (No. 2-85476) dated November 30, 1983 (such registration statement, as amended, is referred to herein as the "Initial Registration Statement"). (c) Management Services Agreement, dated November 30, 1983, between the Partnership and IFI, incorporated by reference to Exhibit 10(c) to the Initial Registration Statement. (d) Disposition Services Agreement, dated November 30, 1983, between the Partnership and IFI, incorporated by reference to Exhibit 10(d) to the Initial Registration Statement. (e) Agreement, dated November 30, 1983, among the former managing general partner, the former associate general partner and Integrated, incorporated by reference to Exhibit 10(e) to the Initial Registration Statement. (f) Reinvestment Plan, incorporated by reference to the Prospectus contained in the Registration Statement. (l) Mortgage Note dated March 26, 1986 between Mastic Associates and IFI, incorporated by reference to Exhibit 10(l) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1986. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - Continued (m) Mortgage dated March 26, 1986 between Mastic Associates and IFI, incorporated by reference to Exhibit 10(m) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1986. (n) Mortgagor/Mortgagee Agreement dated March 26, 1986 between Mastic Associates and IFI, incorporated by reference to Exhibit 10(n) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1986. (o) Lease Agreement dated as of December 10, 1984 between NHP Land Associates, as Landlord and Mastic Associates, as Tenant, incorporated by reference to Exhibit 10(o) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1986. 28. Pages A-1 - A-4 of the Partnership Agreement of Registrant. 28.(a) Purchase Agreement among AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 1, 1990, as amended January 9, 1991. 28.(b) Purchase Agreement among CRIIMI, AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 13, 1990 and executed as of September 6, 1991. 28.(c) Amendments to Partnership Agreement dated August 16, 1991. Incorporated by reference to Exhibit 28.(a), above. 28.(d) Sub-Management Agreement by and between AIM Acquisition and CRI/AIM Management, Inc. dated as of March 1, 1991. (b) Reports on Form 8-K filed during the last quarter of the fiscal year: None All other items are not applicable. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN INSURED MORTGAGE INVESTORS (Registrant) By: CRIIMI, Inc. General Partner March 2, 1994 /s/H. William Willoughby --------------------------- ------------------------- DATE H. William Willoughby President and Principal Financial Officer and Board Member March 2, 1994 /s/William B. Dockser --------------------------- ----------------------- DATE William B. Dockser Chairman of the Board and Principal Executive Officer March 8, 1994 /s/Garrett G. Carlson --------------------------- ------------------------- DATE Garrett G. Carlson Director March 3, 1994 /s/G. Richard Dunnells --------------------------- ------------------------- DATE G. Richard Dunnells Director March 4, 1994 /s/Robert F. Tardio --------------------------- ------------------------- DATE Robert F. Tardio Director AMERICAN INSURED MORTGAGE INVESTORS Financial Statements as of December 31, 1993 and 1992 and for the Years Ended December 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of American Insured Mortgage Investors: We have audited the accompanying balance sheets of American Insured Mortgage Investors (the Partnership) as of December 31, 1993 and 1992, and the related statements of operations, changes in partners' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements and the schedule referred to below are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Partnership as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the years ended December 31, 1993, 1992 and 1991, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule XII-Mortgage Loans on Real Estate as of December 31, 1993 and for the year then ended is presented for purposes of complying with the Securities and Exchange Commission's rules and regulations and is not a required part of the basic financial statements. The information in this schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. Washington, D.C. February 28, 1994 AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION American Insured Mortgage Investors (the Partnership) was formed under the Uniform Limited Partnership Act in the state of California on July 12, 1983. From inception through September 6, 1991, AIM Capital Management Corp. served as managing general partner (with a partnership interest of 2.8%), IRI Properties Capital Corp. served as corporate general partner (with a partnership interest of 0.1%) and Z Square G Partners II served as the associate general partner (with a partnership interest of 0.1%). All of the foregoing general partners are sometimes collectively referred to as former general partners. At a special meeting of the limited partners and Unitholders of the Partnership held on August 16, 1991, a majority of these interests approved, among other items, the assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. The Partnership purchased the interest of the former associate general partner. CRIIMI, Inc. is a wholly- owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc. CRIIMI MAE is managed by an adviser whose general partner is C.R.I., Inc. (CRI). Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (Integrated Funding) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and disposes of the Partnership's mortgages. Prior to the expiration of the Partnership's reinvestment period in November 1988, the Partnership was engaged in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages and, together with Originated Insured Mortgages referred to herein as Insured Mortgages). In accordance with the terms of the Partnership Agreement, the Partnership is no longer authorized to originate or acquire Insured Mortgages and, consequently, its primary objective is to manage its portfolio of Insured Mortgages, all of which constitute nonrecourse first liens on multifamily residential developments and are insured under Section 221(d)(4) of the National Housing Act. The Partnership Agreement states that the Partnership will terminate on December 31, 2008, unless previously terminated under the provisions of the Partnership Agreement. During the first quarter of 1992, the General Partner applied to list the Units on the American Stock Exchange (AMEX) and the application was approved by AMEX. Trading commenced on April 8, 1992 with a trading symbol of AIA. AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES Method of Accounting -------------------- The financial statements of the Partnership are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Investment in Mortgages ----------------------- As of December 31, 1993 and 1992, the Partnership accounted for its investment in mortgages at amortized cost. The difference between the cost and the unpaid principal balance at the time of purchase is carried as a discount or premium and amortized over the remaining contractual life of the mortgage using the effective interest method. The effective interest method provides a constant yield of income over the term of the mortgage. Mortgage investment income is comprised of amortization of the discount plus the stated mortgage interest payments received or accrued less amortization of the premium. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), effective for fiscal years beginning after December 15, 1993. This statement requires that investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. The General Partner believes that the majority of securities held by the Partnership will fall into either the Held to Maturity or Available for Sale categories. However, the General Partner has not yet determined the ultimate impact of the implementation of this statement on the Partnership's financial statements. Mortgage Held for Disposition ----------------------------- At any point in time, the Partnership may be aware of certain mortgages which have been assigned to the United States Department of Housing and Urban Development (HUD) or for which the servicer has received proceeds from a prepayment. In addition, at certain times the Partnership may have entered into a contract to sell certain mortgages. In these cases, the Partnership will classify these mortgages as Mortgages Held for Disposition. Gains from dispositions of mortgages are recognized upon the receipt of cash or debentures. AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES - Continued Losses on dispositions of mortgages are recognized when it becomes probable that a mortgage will be disposed of and that the disposition will result in a loss. In the case of Originated Insured Mortgages fully insured by HUD, the Partnership's maximum exposure for purposes of determining the loan losses would generally be an assignment fee charged by HUD representing approximately 1% of the unpaid principal balance of the Originated Insured Mortgage at the date of default, plus the unamortized balance of acquisition fees and closing costs paid in connection with the acquisition of the Originated Insured Mortgage and the loss of 30-days accrued interest. In the case of Acquired Insured Mortgages, since they were purchased at a discount from the unpaid principal balance of the mortgage, the Partnership's investment in the Acquired Insured Mortgage is less than the amount that would be recovered from HUD in the event of a default under the Acquired Insured Mortgage. Therefore, the Partnership should experience no loan losses on discounted Acquired Insured Mortgages in the case of a default. Cash and Cash Equivalents ------------------------- Cash and cash equivalents consist of time and demand deposits with original maturities of three months or less. Income Taxes ------------ No provision has been made for Federal, state or local income taxes since they are the personal responsibility of the Unitholders. Per Unit Amount --------------- Net earnings per Limited Partnership Unit are computed based upon the weighted average number of Units outstanding of 10,000,125 for each of the years ended December 31, 1993, 1992 and 1991. 3. TRANSACTIONS WITH RELATED PARTIES The principal officers of the General Partner for the period September 7, 1991 through December 31, 1993 did not receive fees for serving as officers of the General Partner, nor are any fees expected to be paid to the officers in the future. The General Partner, former general partners and certain affiliated entities have, during the Partnership's years ended December 31, 1993, 1992 and 1991, earned or received compensation or payments for services from the Partnership as follows: AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 3. TRANSACTIONS WITH RELATED PARTIES - Continued AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 3. TRANSACTIONS WITH RELATED PARTIES - Continued (1) The General Partner, pursuant to amendments to the Partnership Agreement effective September 6, 1991, is entitled to receive 2.9% of the Partnership's income, loss, capital and distributions including, without limitation, the Partnership's Adjusted Cash from Operations and Proceeds of Mortgage Prepayments, Sales or Insurance (both as defined in the Partnership Agreement). (2) The Advisor, pursuant to the Purchase Agreement and amendments to the Partnership Agreement, is entitled to an Asset Management Fee equal to .95% of Total Invested Assets (as defined in the Partnership Agreement), effective October 1, 1991. The Asset Management Fee was based on 1.75% of Total Invested Assets from September 7, 1991 through September 30, 1991. Of the amounts paid to the Advisor, the Sub-advisor, CRI/AIM Management, Inc., earned a fee equal to $129,429, $133,160 and $53,358, or .28% of Total Invested Assets, for the years ended December 31, 1993 and 1992 and the period September 7, 1991 through December 31, 1991, respectively. (3) The former general partners were entitled to receive 3% of the Partnership's income, loss, capital and distributions through September 6, 1991 (2.8% to the former managing general partner, 0.1% to the former corporate general partner and 0.1% to the former associate general partner). (4) Asset Management Fees for managing the Partnership's mortgage portfolio for the period January 1, 1990 through September 6, 1991 were based on 1.75% of Total Invested Assets. (5) These amounts are paid to CRI as reimbursement for expenses incurred on behalf of the General Partner and the Partnership. (6) These amounts include special distributions resulting from mortgage dispositions, as discussed in Note 6. 4. INVESTMENT IN MORTGAGES As of December 31, 1993, the Partnership had remaining investments in 16 Insured Mortgages, including one Originated Insured Mortgage classified as Mortgage Held for Disposition, with an aggregate carrying value and face value of $43,342,199 and $49,225,550, respectively, all of which were originated or acquired by the former managing general partner. All of the Partnership's Insured Mortgages are insured under Section 221(d)(4) of the National Housing Act, by HUD for 100% of their current face value, less a 1% assignment fee, and are nonrecourse first liens on multifamily residential developments or retirement homes owned by entities unaffiliated with the Partnership, its General Partner, or their affiliates. As of December 31, 1993, all of the Partnership's Insured Mortgages are current with respect to the payment of principal and interest. A summary of dispositions that are included in the statements of operations for the years ended December 31, 1993, 1992 and 1991 are as follows: AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 5. MORTGAGE HELD FOR DISPOSITION As of December 31, 1993, the following Originated Insured Mortgage was classified as Mortgage Held for Disposition: AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 6. DISTRIBUTIONS TO UNITHOLDERS The distributions paid or accrued to Unitholders on a per Unit basis for the years ended December 31, 1993, 1992 and 1991 are as follows: Quarter Ended 1993 1992 1991 ------------- -------- -------- -------- March 31, $ .095 $ 1.53(2) $ .135 June 30, .090 .10 .085 September 30, .090 .09 .235(3) December 31, .370(1) .10 .094 -------- -------- -------- $ .645 $ 1.82 $ .549 ======== ======== ======== (1) This includes a special distribution of $.28 per Unit comprised of: (i) $.21 per Unit return of capital from the disposition of the mortgages on Chapelgate Apartments and Cumberland Village and (ii) $.07 per Unit capital gain from these dispositions plus additional sales proceeds from the sale of the mortgage on Clark and Elm Apartments. (2) This includes a $1.34 per Unit special distribution due to the disposition of the mortgage on Clark and Elm Apartments and the receipt of the remaining 9% of assignment proceeds from the mortgage on Foxfire West Apartments. (3) This amount includes a special distribution of $.153 per Unit due to the assignment of 90% of the mortgage on Foxfire West Apartments. The basis for paying distributions to Unitholders is net proceeds from mortgage dispositions and cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each year due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and (4) changes in the Partnership's operating expenses. During 1993 and 1992, the distributions to Unitholders were paid approximately 30 days after the end of the calendar quarter versus 10 days after the end of the calendar quarter in previous years. 7. PARTNERS' EQUITY Depositary Units representing economic rights in limited partnership interests were issued at a stated value of $20. A total of 10,000,000 depositary Units of limited partnership interest were issued for an aggregate capital contribution of $200,000,000. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 Units of limited partnership interest in exchange therefor, and the former general partners contributed a total of $1,000 to the Partnership. AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 8. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (In Thousands, Except Per Unit Data) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993, 1992 and 1991: AMERICAN INSURED MORTGAGE INVESTORS NOTES TO FINANCIAL STATEMENTS 8. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (In Thousands, Except Per Unit Data) AMERICAN INSURED MORTGAGE INVESTORS NOTES TO SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE (1) Under the Section 221 program of the National Housing Act of 1937, as amended, a mortgagee has the right to assign a mortgage ("put") to the FHA at the expiration of 20 years from the date of final endorsement, if the mortgage is not in default at such time. Any mortgagee electing to assign an FHA insured mortgage to FHA will receive in exchange therefor HUD debentures having a total face value equal to the then outstanding principal balance of the FHA insured mortgage plus accrued interest to the date of assignment. These HUD debentures will mature 10 years from the date of assignment and will bear interest at the "going Federal rate" at such date. This assignment procedure is applicable to a mortgage which had a firm or conditional FHA commitment for insurance on or before November 30, 1983 and, in the case of mortgages sold in Government National Mortgage Association (GNMA) auctions, prior to February of 1984. The Partnership anticipates that each eligible mortgage for which a prepayment has not occurred and which has not been sold will be assigned to FHA at the expiration of 20 years from the date of final endorsement. The Partnership, therefore, does not anticipate holding any eligible mortgage beyond the expiration of 20 years from final endorsement of that mortgage. (2) Inclusive of closing costs and acquisition fees. (3) Prepayment of these mortgages would be based upon the unpaid principal balance at the time of prepayment. (4) These amounts represent the Partnership's 50% interest in these mortgages. The remaining 50% interest was acquired by AIM 85. (5) In addition, the servicer of the mortgages, an unaffiliated third party, is entitled to receive compensation for certain services rendered in an amount up to ten basis points (.10%) of the unpaid principal balance of the mortgages. (6) This represents the base interest rate during the permanent phase of these mortgage loans. Additional interest, (referred to as Participations) measured as a percentage of surplus cash and a percentage of the proceeds from sale or refinancing of the development (as defined in the Participation Agreements), will also be due. No payments were received for the years ended December 31, 1993, 1992 or 1991 as a result of the Participations. (7) The Partnership's mortgages are nonrecourse first liens on multifamily residential developments or retirement homes. (8) Principal and interest are payable at level amounts over the life of the mortgages. (9) A reconciliation of the carrying value of Insured Mortgages, including a Mortgage Held for Disposition, for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Beginning balance $ 45,760,878 $ 59,629,849 Net gain (loss) on mortgage dispositions 762,250 (21,103) Disposition of Insured Mortgages (2,965,249) (13,652,589) Principal receipts on mortgages (215,680) (195,279) ------------ ------------ Ending balance $ 43,342,199 $ 45,760,878 ============ ============ (10) The tax basis of the Insured Mortgages was approximately $43.1 and $45.6 million as of December 31, 1993 and 1992, respectively.	8,225	53,788
9626_1993.txt	9626_1993	1993	9626	ITEM 1. BUSINESS - ----------------- The business of The Bank of New York Company, Inc. (the "Company") and its subsidiaries is described in the "Business Review" section of the Company's 1993 Annual Report to Shareholders which description is included in Exhibit 13 to this report and incorporated herein by reference. Also, the "Management's Discussion and Analysis" section included in Exhibit 13 contains financial and statistical information on the operations of the Company. Such information is herein incorporated by reference. COMPETITION The retail and commercial businesses in which the Company operates are strongly competitive. Competition is provided by both unregulated and regulated financial services organizations, whose products and services span the local, national, and global markets in which the Company conducts operations. Savings banks, savings and loan associations, and credit unions actively compete for deposits, and money market funds and brokerage houses offer deposit-like services. These institutions, as well as consumer and commercial finance companies, national retail chains, factors, insurance companies and pension trusts, are important competitors for various types of loans. Issuers of commercial paper compete actively for funds and reduce demand for bank loans. For personal and corporate trust services and investment counseling services, insurance companies, investment counseling firms, and other business firms and individuals offer active competition. CERTAIN REGULATORY CONSIDERATIONS General As a bank holding company, the Company is subject to the regulation and supervision of the Federal Reserve Board under the Bank Holding Company Act ("BHC Act"). The Company is also subject to regulation by the New York State Department of Banking. Under the BHC Act, bank holding companies may not directly or indirectly acquire the ownership or control of more than 5% of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. In addition, bank holding companies are generally prohibited under the BHC Act from engaging in nonbanking activities, subject to certain exceptions. The Company's subsidiary banks are subject to supervision and examination by applicable federal and state banking agencies. The Bank of New York ("BNY") is a state-chartered New York banking corporation and a member of the Federal Reserve System and is subject to regulation and supervision principally by the Federal Reserve Board. The Bank of New York (Delaware) ("BNY Del.") is a Delaware chartered FDIC insured non-member bank and therefore is subject to regulation and supervision principally by the FDIC. The Bank of New York National Association ("BNYNA") is organized as a national association under the laws of the United States and therefore is subject to regulation and supervision principally by the Comptroller of the Currency ("Comptroller"). 3. Capital Adequacy Bank regulators have adopted risk-based capital guidelines for bank holding companies and banks. The minimum ratio of qualifying total capital to risk-weighted assets (including certain off-balance sheet items) is 8%. At least half of the total capital is to be comprised of common stock, retained earnings, noncumulative perpetual preferred stocks, minority interests and for bank holding companies, a limited amount of qualifying cumulative perpetual preferred stock, less certain intangibles including goodwill ("Tier I capital"). The remainder ("Tier II capital") may consist of other preferred stock, certain other instruments, and limited amounts of subordinated debt and the loan and lease loss allowance. In addition, the Federal Reserve Board has established minimum Leverage Ratio (Tier I capital to average total assets) guidelines for bank holding companies and banks. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies and banks that meet certain specified criteria, including that they have the highest regulatory rating. All other banking organizations will be required to maintain a leverage ratio of 3% plus an additional cushion of at least 100 to 200 basis points. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "Tangible Tier I Leverage Ratio" in evaluating proposals for expansion or new activities. The Tangible Tier I Leverage Ratio is the ratio of Tier I capital, less intangibles not deducted from Tier I capital, to average total assets. The Federal Reserve Board has not advised the Company of any specific minimum leverage ratio applicable to it. Federal banking agencies have proposed regulations that would modify existing rules related to risk-based and leverage capital ratios. The Company does not believe that the aggregate impact of these modifications would have a significant impact on its capital position. Bank regulators continue to indicate their desire to raise capital requirements applicable to banking organizations beyond their current levels. However, management is unable to predict whether and when higher capital requirements would be imposed and, if so, at what level and on what schedule. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was enacted in December 1991, substantially revised the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act ("FDIA") and made revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under applicable regulations, an FDIC-insured bank is defined to be well capitalized if it maintains a Leverage Ratio of at least 5%, a risk-adjusted Tier I Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. A bank is generally considered to be adequately capitalized if it is not defined to be well capitalized but meets all of its minimum capital requirements, i.e., if it has a total risk-based Capital Ratio of 8% or greater, a Tier I risk-based Capital Ratio of 4% or greater and a Leverage Ratio of 4% or greater. A bank will be considered undercapitalized if it fails to meet any minimum required measure, significantly undercapitalized if it is significantly below such measure and critically undercapitalized if it maintains a level of tangible equity capital equal to or less than 2% of total assets. A bank may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. 4. FDICIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. For an undercapitalized depository institution's capital restoration plan to be acceptable, its holding company must guarantee the capital plan up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan. In the event of the parent holding company's bankruptcy, such guarantee would take priority over the parent's general unsecured creditors. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator. The Company's significant banking subsidiaries are well capitalized. The table below indicates capital ratios of the Company and its significant banking subsidiaries at December 31, 1993 and 1992 and the respective guidelines for well capitalized institutions under FDICIA. At December 31, 1993, the amounts of capital by which the Company and its significant banking subsidiaries exceed the guidelines are as follows: Well Capitalized BNY Company BNY Del. BNYNA (in millions) ------- --- ---- ----- Tier I $1,215 $753 $ 79 $167 Total Capital 1,545 960 52 110 Leverage 1,404 861 149 66 5. The following table presents the components of the Company's risk-based capital at December 31, 1993 and 1992: (in millions) 1993 1992 ---- ---- Common Stock $3,778 $3,302 Preferred Stock 294 369 Less: Intangibles 317 345 ----- ------ Tier 1 Capital 3,755 3,326 Convertible Preferred Stock - 59 Qualifying Long-term Debt 1,489 1,452 Qualifying Allowance for Loan Losses 534 554 ------ ------ Tier 2 Capital 2,023 2,065 ------ ------ Total Risk-based Capital $5,778 $5,391 ====== ====== The following table presents the components of the Company's risk adjusted assets at December 31, 1993 and 1992: 6. Subsequent to December 31, 1993, the Company redeemed $173 million of preferred stock and BNY acquired the domestic factoring business of the Bank of Boston. After giving pro forma effect to these actions, the Company's and BNY's captial ratios at December 31, 1993 were as follows: Company BNY ------- ---- Tier 1 8.33% 7.82% Total Capital 13.08 12.41 Leverage 7.51 6.89 Tangible Common Equity 6.88 7.58 A discussion of the Company's capital position is incorporated by reference from the caption "Capital Resources" in the "Management's Discussion and Analysis" section of Exhibit 13. Brokered Deposits The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits. Under the regulations, a bank cannot accept, rollover or renew brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer "pass-through" insurance on certain employee benefit accounts. Whether or not it has obtained such a waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized. Because BNY and BNY Del. are well capitalized, the Company believes the brokered deposits regulation will have no material effect on the funding or liquidity of BNY and BNY Del. BNYNA is well capitalized, but has no brokered deposits. FDIC Insurance Assessments BNY, BNY Del., and BNYNA are subject to FDIC deposit insurance assessments. As required by FDICIA, the FDIC has adopted a risk-based premium schedule which has increased the assessment rates for most FDIC- insured depository institutions. Under the schedule, the premiums initially range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital groups --- well capitalized, adequately capitalized, or undercapitalized --- and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and other information relevant to the institution's financial condition and the risk posed to the applicable insurance fund. The actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. The FDIC is authorized to raise insurance premiums in certain circumstances. Any increase in premiums would have an adverse effect on the Company's earnings. Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by a bank's federal regulatory agency. Depositor Preference The Omnibus Budget Reconciliation Act of 1993 provides for a national depositor preference on amounts realized from the liquidation or other resolution of any depository institution insured by the FDIC. That act requires claims to be paid in the following order of priority: the receiver's administrative expenses; deposits; other general or senior liabilities of the institution; obligations subordinated to depositors or general creditors; and obligations to shareholders. Under an FDIC interim rule, which became effective August 13, 1993, "administrative expenses of the receiver" are defined as those incurred by the receiver in liquidating or resolving the affairs of a failed insured depository institution. 7. Acquisitions The BHC Act generally limits acquisitions by the Company to commercial banks and companies engaged in activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. The Company's direct activities are generally limited to furnishing to its subsidiaries services that qualify under the "closely related" and "proper incident" tests. Prior Federal Reserve Board approval is required under the BHC Act for new activities and acquisitions of most nonbanking companies. The BHC Act, the Federal Bank Merger Act, and the New York Banking Law regulate the acquisition of commercial banks. The BHC Act requires the prior approval of the Federal Reserve Board for the direct or indirect acquisition of more than 5% of the voting shares of a commercial bank. The BHC Act generally prohibits the acquisition of a domestic bank located outside the Company's state of principal operations, New York State, unless authorized by the law of the state of the target bank. Most states have enacted interstate banking laws that permit the Company to acquire banks located in their states, but some states (particularly in the Southeast) presently do not permit entry by New York bank holding companies. The New York Banking Law requires state regulatory approval before the Company can acquire more than 5% of the voting shares of a commercial bank in New York. The merger of BNY with another bank would require the approval of the Federal Reserve Board or other federal bank regulatory authority and, if the surviving bank is a state bank, the New York Superintendent of Banks. With respect to BNYNA, the approval of the Comptroller is required for branching of national banks, purchasing the assets of other banks and for bank mergers in which the continuing bank is a national bank. In reviewing bank acquisition and merger applications, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, and the applicant's record under the Community Reinvestment Act. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to its banks and to commit resources to support such banks in circumstances where it might not do so absent such policy. In addition, any loans by the Company to its banks would be subordinate in right of payment to deposits and to certain other indebtedness of its banks. Regulated Banking Subsidiaries As a New York State chartered bank and a member of the Federal Reserve System, BNY is subject to the supervision of, and is regularly examined by, the New York State Banking Department and the Federal Reserve Board. As a bank insured by the FDIC, BNY is also subject to examination by that agency. BNY Del. is subject to the supervision of, and is regularly examined by, the FDIC and the Office of State Bank Commissioner of the State of Delaware. BNYNA is a national bank subject to the regulation and supervision of, and regular examination by, the Comptroller and subject to regulations of the FDIC and Federal Reserve Board. Both federal and state laws extensively regulate various aspects of the banking business, such as permissible types and amounts of loans and investments, permissible activities, and reserve requirements. These regulations are intended primarily for the protection of depositors rather than the Company's stockholders. Restrictions on Transfer of Funds Restrictions on the transfer of funds to the Company are discussed in Note 12 to the Consolidated Financial Statements included in Exhibit 13. Such discussion is incorporated herein by reference. 8. FIRREA A depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled institution or (ii) any assistance provided by the FDIC to a commonly controlled, FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver, and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. GOVERNMENT MONETARY POLICIES The Federal Reserve Board has the primary responsibility for monetary policy; accordingly, its actions have an important influence on the demand for credit and investments and the level of interest rates. 9. Continued on page 10 10. 11. 12. Interest-Rate Sensitivity - ------------------------- The Company actively manages interest-rate sensitivity (the exposure of net interest income to interest rate movements). The relationship of interest-earning assets and interest-bearing liabilities between repricing dates is monitored, and is flexible enough to capitalize on profit opportunities, while minimizing adverse effects on earnings when changes in short-term and long-term interest rates occur. The Company uses complex simulation models to adjust the structure of its assets and liabilities in response to interest rate changes. The following table reflects the year-end position of the Company's interest-earning assets and interest-bearing liabilities that either reprice or mature within the designated time periods. A positive interest sensitivity gap, for a particular time period, is one in which more interest- earning assets reprice or mature than interest-bearing liabilities. A negative interest sensitivity gap results from a greater amount of liabilities repricing or maturing. Further, within the time periods shown below, assets and liabilities reprice on different dates and at different levels. Interest sensitivity gaps change daily. A negative gap will result in an increase in net interest income in periods of declining rates and a decrease in net interest income in periods of rising rates. The opposite is true for positive gaps. 13. PROVISION AND ALLOWANCE FOR LOAN LOSSES - --------------------------------------- Risk factors other than less developed country (LDC) loans and highly leveraged transaction (HLT) loans are discussed below. LDC and HLT loans are discussed under the captions "Provision and Allowance for Loan Losses" and "Highly Leveraged Transactions" in the "Management's Discussion and Analysis" section included in Exhibit 13, which discussion is incorporated herein by reference. At December 31, 1993, the domestic commercial real estate portfolio had approximately 74% of its loans in New York and New Jersey, 6% in California, 5% in Pennsylvania, 3% in New England, and 2% in Florida; no other state accounts for more than 2% of the portfolio. This portfolio consists of the following types of properties: Business loans secured by real estate 47% Offices 24 Retail 7 Hotels 5 Mixed-Used 4 Condominiums and cooperatives 3 Land 2 Industrial/Warehouse 1 Other 7 ---- 100% ==== At December 31, 1993 and 1992, the Company's nonperforming real estate loans and real estate acquired in satisfaction of loans aggregated $171 million and $411 million, respectively. Net charge-offs of real estate loans were $69 million in 1993 and $90 million in 1992. In addition, other real estate charges were $53 million and $106 million in 1993 and 1992. A discussion of other real estate charges under "Noninterest Expense and Income Taxes" in the "Management's Discussion and Analysis" section included in Exhibit 13 is incorporated herein by reference. The Company's consumer loan portfolio is comprised principally of credit card, other installment, and residential loans. Residential and auto loans are collateralized, thereby reducing the risk. Credit card net charge-offs were $121 million in 1993 compared to $118 million in 1992. The 1993 and 1992 amounts exclude $56 million and $57 million in net charge-offs related to the portion of the portfolio that is securitized. As a percentage of average credit card outstandings, net charge-offs decreased to 2.88% in 1993 from 3.74% in 1992. On a managed receivables basis, net charge-offs as a percentage of average outstandings were 3.19% in 1993 compared to 3.89% in 1992. Other consumer net charge-offs were $23 million in 1993 and $37 million in 1992. Lending to the utility industry is concentrated in investor-owned electric utilities. The Company also makes loans to gas and telephone utilities. Nonperforming loans in this industry amounted to $2 million at year-end 1993 compared to $3 million in 1992. Charge-offs of loans to the utility industry were $14 million in 1992. There were no charge-offs in 1993. 14. The Company's loans to the communications, entertainment, and publishing industries primarily consist of credits with cable television operators, broadcasters, magazine and newspaper publishers and motion picture theaters. There were no nonperforming communications loans at December 31, 1993. Nonperforming communication loans amounted to $8 million at December 31, 1992. Charge-offs of communications loans were $1 million and $23 million in 1993 and 1992. None of these amounts represent HLTs. The Company's portfolio of loans for purchasing or carrying securities is comprised largely of overnight loans which are fully collateralized, with appropriate margins, by marketable securities. Throughout its many years of experience in this area, the Company has rarely experienced a loss. The Company makes short-term, collateralized loans to mortgage bankers to fund mortgages sold to investors. Nonperforming loans and charge-offs have not been significant. Based on an evaluation of individual credits, historical loan losses, and global economic factors, the Company has allocated its allowance for loan losses as follows: Such an allocation is inherently judgmental, and the entire allowance for loan losses is available to absorb loan losses regardless of the nature of the loan. 15. The following table details changes in the Company's allowance for loan losses for the last five years. 16. Nonperforming Assets - -------------------- A summary of nonperforming assets is presented in the following table. 17. Securities - ---------- The following table shows the maturity distribution by carrying amount and yield (not on a taxable equivalent basis) of the Company's securities portfolio at December 31, 1993. Loans - ----- The following table shows the maturity structure of the Company's commercial loan portfolio at December 31, 1993. 18. Deposits - -------- The aggregate amount of deposits by foreign customers in domestic offices was $739 million, $789 million, and $664 million at December 31, 1993, 1992, and 1991, respectively. The following table shows the maturity breakdown of domestic time deposits of $100,000 or more at December 31, 1993. The majority of deposits in foreign offices are time deposits in denominations of $100,000 or more. Other Borrowed Funds - --------------------- Information related to other borrowed funds in 1993, 1992, and 1991 is presented in the table below. Foreign Assets - -------------- The only foreign country in which the Company's assets exceed .75% of year end total assets was the United Kingdom ($351 million in 1993 and $393 million in 1991). 19. ITEM 2. ITEM 2. PROPERTIES - ------------------- In New York City, the Company owns the thirty story building housing its executive headquarters at 48 Wall Street, a forty-nine story office building at One Wall Street, and an operations center at 101 Barclay Street. In addition, the Company owns and/or leases administrative and operations facilities in New York City; various locations in New Jersey; Harrison, New York; Newark, Delaware; London, England; and Utica, New York. Other real properties owned or leased by the Company, when considered in the aggregate, are not material to its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- Litigation regarding Northeast Bancorp., Inc. is described in Note 14 to the Consolidated Financial Statements included in Exhibit 13, and such description is incorporated herein by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ There were no matters submitted to a vote of security holders of the registrant during the fourth quarter of 1993. PART II - ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND - -------------------------------------------------- RELATED STOCKHOLDER MATTERS --------------------------- Information with respect to the market for the Company's common equity and related stockholder matters is incorporated herein by reference from the "Quarterly Data" section included in Exhibit 13. The Company's securities that are listed on the New York Stock Exchange (NYSE), are indicated as such on the front cover of this report. The NYSE symbol for the Company's Common Stock is BK. The Warrants (to purchase the Company's Common Stock) are traded over the counter. All of the Company's other securities are not currently listed. The Company had 26,900 common shareholders of record at February 28, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- Selected financial data are incorporated herein by reference from the "Financial Highlights" section included in Exhibit 13. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - ---------------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS ----------------------------------- Management's discussion and analysis of financial condition and results of operations is incorporated herein by reference from the corresponding section of the Company's 1993 Annual Report to Shareholders the relevant portions of which are filed as Exhibit 13 of this report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- Consolidated financial statements and notes and the independent auditors' report are incorporated herein by reference from the Company's 1993 Annual Report to Shareholders the relevant portions of which are filed as Exhibit 13 to this report. Supplementary financial information is incorporated herein by reference from the "Quarterly Data" section included in Exhibit 13. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ----------------------------------------------------------------------------- There have been no events which require disclosure under Item 304 of Regulation S-K. 20. PART III - -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ The directors of the registrant are identified on pages 25 and 26 of this report. Additional material responsive to this item is contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders, which information is incorporated herein by reference. EXECUTIVE OFFICERS OF THE REGISTRANT AND BUSINESS EXPERIENCE DURING THE PAST FIVE YEARS - ----------------------------------------------------------------------------- Company Officer Name Office and Experience Age Since ---- --------------------- --- ----- J. Carter Bacot 1989-1994 Chairman and Chief 61 1975 Executive Officer of the Company and the Bank Thomas A. Renyi 1992-1994 President of the Company and 48 1992 Vice Chairman of the Bank 1989-1993 Senior Executive Vice President and Chief Credit Officer of the Bank Alan R. Griffith 1990-1994 Senior Executive Vice 52 1990 President of the Company, and President and Chief Operating Officer of the Bank 1989-1990 Senior Executive Vice President of the Bank Samuel F. Chevalier 1989-1994 Vice Chairman of the Company 60 1989 and the Bank 1989-1990 Chief Operating Officer and President of Irving Bank Corporation 1989 Vice Chairman and Chief Operating Officer of Irving Trust Company Deno D. Papageorge 1989-1994 Senior Executive Vice 55 1980 President of the Company 1989-1994 Senior Executive Vice President and Chief Financial Officer of the Bank Richard D. Field 1989-1994 Executive Vice President 53 1987 of the Company 1989-1992 Senior Executive Vice President of the Bank Robert E. Keilman 1989-1994 Comptroller of the 48 1984 Company and the Bank, Senior Vice President of the Bank Charles E. Rappold 1989-1994 Secretary and Chief Legal 41 1986 Officer of the Company, Senior Vice President and Chief Legal Officer of the Bank Robert J. Goebert 1989-1994 Auditor of the Company, 52 1982 Senior Vice President of the Bank 21. Officers of BNY who perform major policy making functions: Bank Executive Officer Name Office and Experience Age Since ---- --------------------- --- ------ Richard A. Pace 1990-1994 Executive Vice President and Chief 48 1989 Technologist 1989-1990 Senior Vice President 1989 Senior Vice President of Irving Trust Company Robert J. Mueller 1992-1994 Senior Executive Vice President - 52 1989 Chief Credit Policy Officer 1989-1994 Executive Vice President - Mortgage & Construction Lending There are no family relationships between the executive officers of the Company. The terms of office of the executive officers of the Company extend until the annual organizational meeting of the Board of Directors. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - -------------------------------- The material responsive to such item in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders is incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------ The material responsive to such item in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders is incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- The material responsive to such item in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders is incorporated by reference. PART IV - ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------- (a) 1 Financial Statements: See Item 8. (a) 2 Financial Statement Schedules: Financial statement schedules are omitted since the required information is either not applicable, not deemed material, or is shown in the respective financial statements or in the notes thereto. 22. (a) 3 Listing of Exhibits: Exhibit No. Per Regulation S-K Description - -------------- ----------- 3 (a) The By-Laws of The Bank of New York Company, Inc. as amended through October 13, 1987. (Filed as Exhibit 3(a) to the Company's 1987 Annual Report on Form 10- K and incorporated herein by reference.) (b) Certificate of Incorporation of The Bank of New York Company, Inc. as amended through July 14, 1993. (Filed as Exhibit 3 to Current Report on Form 8-K filed by the Company on July 14, 1993.) 4 (a) None of the outstanding instruments defining the rights of holders of long-term debt of the Company represent long-term debt in excess of 10% of the total assets of the Company. The Company hereby agrees to furnish to the Commission, upon request, a copy of any of such instruments. (b) Amended and Restated Rights Agreement dated March 8, 1994. (Filed as Exhibit 4(a) to Current Report on Form 8-K filed by the Company on March 23, 1994.) 10 (a) 1984 Stock Option Plan of The Bank of New York Company, Inc. as amended through February 23, 1988. (Filed as Exhibit 10(a) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference.) (b) The Bank of New York Company, Inc. Excess Contribution Plan as amended through July 10, 1990. (Filed as Exhibit 10(b) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference.) (c) Amendments to The Bank of New York Company, Inc. Excess Contribution Plan dated February 23, 1994 and November 9, 1993. (d) The Bank of New York Company, Inc. Excess Benefit Plan as amended through December 8, 1992. (Filed as Exhibit 10(d) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (e) Amendments to The Bank of New York Company, Inc. Excess Benefit Plan dated February 23, 1994 and November 9, 1993. (f) Management Incentive Compensation Plan of The Bank of New York Company, Inc. (Filed as Exhibit 10(d) to the Company's 1986 Annual Report on Form 10-K and incorporated herein by reference.) (g) 1994 Management Incentive Compensation Plan of The Bank of New York Company, Inc. (h) 1988 Long-Term Incentive Plan as amended through December 8, 1992. (Filed as Exhibit 10(f) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (i) The Bank of New York Company, Inc. 1993 Long Term Incentive Plan. (Filed as Exhibit 10(m) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) 23. Exhibit No. Per Regulation S-K Description - --------------- ----------- 10 (j) The Bank of New York Company, Inc. Supplemental Executive Retirement Plan. (Filed as Exhibit 10(n) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (k) Amendment to The Bank of New York Company, Inc. Supplemental Executive Retirement Plan dated March 9, 1993. (l) Trust Agreement dated April 19, 1988 related to deferred compensation plans. (Filed as Exhibit 10(h) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference.) (m) Trust Agreement dated November 16, 1993 related to deferred compensation plans. (n) Form of Remuneration Agreement between the Company and two of the five most highly compensated executive officers of the Company. (Filed as Exhibit 10 to the Company's 1982 Annual Report on Form 10-K and incorporated herein by reference.) (o) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(h) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) (p) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(i) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) (q) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(j) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (r) The Bank of New York Company, Inc. Retirement Plan for Non- Employee Directors. (s) Deferred Compensation Plan for Non-Employee Directors of The Bank of New York Company, Inc. 11 Statement - Re: Computation of Per Common Share Earnings 12 Statement - Re: Computation of Earnings to Fixed Charges Ratios 13 Portions of the 1993 Annual Report to Shareholders 21 Subsidiaries of the Registrant 23.1 Consent of Deloitte & Touche 23.2 Consent of Arthur Andersen & Co. 24. (b) Reports on Form 8-K: October 18, 1993: Unaudited interim financial information and accompanying discussion for the third quarter of 1993. December 7, 1993: An Underwriting Agreement, a Form of Note, an Officers' Certificate, and a Legal Opinion filed in connection with the Company's Registration Statement on Form S-3 (File No. 33-51984 and No. 33-50333) with the Securities and Exchange Commission covering the Company's 6.50% Subordinated Notes due 2003. January 13, 1994: Unaudited interim financial information and accompanying discussion for the fourth quarter of 1993. March 23, 1994: Amended and Restated Rights Agreement dated March 8, 1994 (c) Exhibits: Submitted as a separate section of this report. (d) Financial Statements Schedules: None 25. SIGNATURES - ---------- Pursuant to the requirements of Section 13 or 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 in New York, New York, on the 8th day of March, 1994. THE BANK OF NEW YORK COMPANY, INC. By: \s\ J. Carter Bacot ------------------------------------- (J. Carter Bacot, Chairman) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been duly signed below by the following persons on behalf of the registrant and in the capacities indicated on the 8th day of March, 1994. Signature Title --------- ----- \s\J. Carter Bacot Chairman and - ----------------------------------- Chief Executive Officer (J. Carter Bacot) (principal executive officer) \s\ Deno D. Papageorge Senior Executive Vice President - ----------------------------------- (principal financial officer) (Deno D. Papageorge) \s\ Robert E. Keilman Comptroller (principal - ------------------------------------ accounting officer) (Robert E. Keilman) \s\ Richard Barth Director - ------------------------------------ (Richard Barth) \s\ William R. Chaney Director - ------------------------------------ (William R. Chaney) \s\ Samuel F. Chevalier Vice Chairman and Director - ------------------------------------ (Samuel F. Chevalier) \s\ Anthony S. D'Amato Director - ------------------------------------ (Anthony S. D'Amato) \s\ Anthony P. Gammie Director - ------------------------------------ (Anthony P. Gammie) 26. \s\ Ralph E. Gomory Director - ------------------------------------ (Ralph E. Gomory) \s\ Alan R. Griffith Senior Executive Vice President - ----------------------------------- and Director (Alan R. Griffith) \s\ Edward L. Hennessy, Jr. Director - ------------------------------------ (Edward L. Hennessy, Jr.) \s\ John C. Malone Director - ------------------------------------ (John C. Malone) \s\ Donald L. Miller Director - ------------------------------------ (Donald L. Miller) \s\ H. Barclay Morley Director - ------------------------------------ (H. Barclay Morley) \s\ Martha T. Muse Director - ------------------------------------ (Martha T. Muse) \s\ Catherine A. Rein Director - ------------------------------------ (Catherine A. Rein) \s\ Thomas A. Renyi President and Director - ------------------------------------ (Thomas A. Renyi) \s\ Harold E. Sells Director - ------------------------------------ (Harold E. Sells) \s\ Delbert C. Staley Director - ------------------------------------ (Delbert C. Staley) \s\ W. S. White, Jr. Director - ------------------------------------ (W. S. White, Jr.) \s\ Samuel H. Woolley Director - ------------------------------------ (Samuel H. Woolley) 27. INDEX TO EXHIBITS Exhibit No. - ------------ 3 (a) The By-Laws of The Bank of New York Company, Inc. as amended through October 13, 1987. (Filed as Exhibit 3(a) to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference. (b) Certificate of Incorporation of The Bank of New York Company, Inc. as amended through July 14, 1993. (Filed as Exhibit 3 to Current Report on Form 8-K filed by the Company on July 14, 1993.) 4 (a) None of the outstanding instruments defining the rights of holders of long-term debt of the Company represent long-term debt in excess of 10% of the total assets of the Company. The Company hereby agrees to furnish to the Commission, upon request, a copy of any of such instruments. (b) Amended and Restated Rights Agreement dated March 8, 1994. (Filed as Exhibit 4 (a) to Current Report on Form 8-K filed by the Company on March 23, 1994.) 10 (a) 1984 Stock Option Plan of The Bank of New York Company, Inc. as amended through February 23, 1988. (Filed as Exhibit 10(a) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference.) (b) The Bank of New York Company, Inc. Excess Contribution Plan as amended through July 10, 1990. (Filed as Exhibit 10(b) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference.) (c) Amendments to The Bank of New York Company, Inc. Excess Contribution Plan dated February 23, 1994 and November 9, 1993. (d) The Bank of New York Company, Inc. Excess Benefit Plan as amended through December 8, 1992. (Filed as Exhibit 10(d) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (e) Amendments to The Bank of New York Company, Inc. Excess Benefit Plan dated February 23, 1994 and November 9, 1993. (f) Management Incentive Compensation Plan of The Bank of New York Company, Inc. (Filed as Exhibit 10(d) to the Company's 1986 Annual Report on Form 10-K and incorporated herein by reference.) (g) 1994 Management Incentive Compensation Plan of The Bank of New York Company, Inc. (h) 1988 Long-Term Incentive Plan as amended through December 8, 1992. (Filed as Exhibit 10(f) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (i) The Bank of New York Company, Inc. 1993 Long Term Incentive Plan. (Filed as Exhibit 10(m) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) 28. INDEX TO EXHIBITS Exhibit No. - ------------ 10 (j) The Bank of New York Company, Inc. Supplemental Executive Retirement Plan. (Filed as Exhibit 10(n) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (k) Amendment to The Bank of New York Company, Inc. Supplemental Executive Retirement Plan dated March 9, 1993. (l) Trust Agreement dated April 19, 1988 related to deferred compensation plans. (Filed as Exhibit 10(h) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference.) (m) Trust Agreement dated November 16, 1993 related to deferred compensation plans. (n) Form of Remuneration Agreement between the Company and two of the five most highly compensated executive officers of the Company. (Filed as Exhibit 10 to the Company's 1982 Annual Report on Form 10-K and incorporated herein by reference.) (o) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(h) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) (p) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(i) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) (q) Remuneration Agreement between the Company and an executive officer of the Company. (Filed as Exhibit 10(j) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference.) (r) The Bank of New York Company, Inc. Retirement Plan for Non-Employee Directors. (s) Deferred Compensation Plan for Non-Employee Directors of The Bank of New York Company, Inc. 11 Statement - Re: Computation of Per Common Share Earnings 12 Statement - Re: Computation of Earnings to Fixed Charges Ratios 13 Portions of the 1993 Annual Report to Shareholders 21 Subsidiaries of the Registrant 23.1 Consent of Deloitte & Touche 23.2 Consent of Arthur Andersen & Co.	6,776	44,907
51200_1993.txt	51200_1993	1993	51200	ITEM 1. BUSINESS -------- A. OVERVIEW. International Controls Corp. ("ICC, Registrant or the Company") is a holding company and its business is conducted by its operating subsidiaries. Through its subsidiaries, the Company is engaged in four major lines of business. Through Great Dane Trailers, Inc. ("Great Dane"), the Company manufactures a full line of truck trailers for the over-the-road tractor trailer long and short haul market and containers and chassis for intermodal shipping. Checker Motors Corporation ("Checker") and its subsidiary, South Charleston Stamping & Manufacturing Company ("SCSM"), are major manufacturers of sheet metal stampings for automotive and light truck and van components and subassemblies, primarily for General Motors Corporation ("GM"). The Company, through its Yellow Cab Company division ("Yellow Cab"), is currently the largest owner of taxicabs and provider of taxi-related services in Chicago, Illinois. American Country Insurance Company ("Country") underwrites property and casualty insurance, including taxicab insurance, workers' compensation and other commercial and personal lines. The Company was incorporated in 1959 under the laws of the State of Florida. On January 1, 1989, the Company's continuing operations consisted solely of Great Dane's truck trailer manufacturing operations. On January 11, 1989, the Company acquired all of the outstanding capital stock of Checker. Immediately following the acquisition of Checker by the Company, Checker Holding Corp. ("Holding"), a privately-held company owned by substantially all of the former shareholders of Checker, acquired all of the outstanding capital stock of the Company (the "Holding Buyout"). Subsequently, Holding was merged into the Company. The Holding Buyout has been accounted for as if Checker acquired the Company (a "reverse acquisition"), since there was no significant change in control of Checker. B. INFORMATION CONCERNING INDUSTRY SEGMENTS. Certain financial data with respect to Registrant's industry segments appear in Note N of Notes to Consolidated Financial Statements and are incorporated herein by reference. As of December 31, 1993, the Company employed a total of 5,055 people. The chart below details the number of persons employed as of that date in each of the Company's industry segments: C. NARRATIVE DESCRIPTION OF BUSINESS. TRUCK TRAILER MANUFACTURING. Great Dane designs, manufactures and distributes a full line of truck trailers and containers and chassis. In 1993, Great Dane, the largest truck trailer manufacturer in the United States, accounted for approximately 12.7% of the new truck trailer market, 11.7% of the new van market, 11.9% of the new platform trailer market, 38.0% of the new refrigerated van ("reefer") market and 23.4% of the market for intermodal containers and chassis. Great Dane sells its trailers primarily through a nationwide network of branches and independent dealers to gain access to smaller, less price sensitive customers. The Company believes it offers the largest line of trailers in the industry and works closely with customers to customize products to their specific needs. Great Dane strives to stay at the forefront of the industry in the design and development of new and improved products. In addition to manufacturing, Great Dane's business includes a parts sales operation, sales of used trailers acquired mainly in trade-in transactions, and retail services (including repair and maintenance) which enable it to be a full service provider. The parts and service operations are less sensitive to the economic environment mitigating the impact of the cyclical product lines. Late in 1991, Great Dane hired new operating management to implement several important strategies designed to position Great Dane to take advantage of both expected industry growth in the trailer market and the expansion of the intermodal container and chassis market. As part of this strategy, Great Dane adapted certain of its manufacturing facilities to enable it to fill orders for high-volume purchasers without sacrificing its ability to cater to the special needs of its many smaller customers. In addition, Great Dane broadened its network of distributors and branches, initially focused on the Southeast, to develop a nationwide presence and to expand Great Dane's businesses into Canada and Mexico, thereby increasing its access to trailer customers, as well as providing new outlets for its parts and services business, which is less vulnerable to economic downturns and produces higher margins. Great Dane believes it currently has the largest marketing organization in the trailer industry. Furthermore, during 1992, Great Dane's engineering department, working in conjunction with J.B. Hunt Transport, one of the largest truckload carriers in the United States ("J. B. Hunt"), developed a unique line of intermodal containers and matching ultra lightweight chassis, which allows Great Dane's customers to take advantage of new double stack intermodal shipping methods, the most economical method of hauling freight over long and intermediate distances. Great Dane's intermodal containers are designed for use on rail but may also be transported over the road on chassis to and from rail yards. In connection with an approximately $125 million initial purchase order from J. B. Hunt for these new intermodal products, Great Dane installed new assembly lines within three existing factories and initiated production for the order in early 1993. Great Dane has, subsequently, received an additional order of approximately $48 million from J. B. Hunt. Although J. B. Hunt's requirements for these containers and chassis will level off, Great Dane believes that intermodal transportation will provide growth opportunities as other carriers replace some or all of their trailers with containers and chassis. The Company believes that Great Dane, which has also manufactured refrigerated containers for others, is well-positioned to maintain a substantial share of the new and growing intermodal market. Great Dane's headquarters are located in Savannah, Georgia, and its manufacturing is performed in Savannah, Georgia; Brazil, Indiana; Memphis, Tennessee; and Wayne, Nebraska. These plants include assembly lines for the various types of trailers and containers and fabricating departments which produce from raw or semi-finished material the components used in the assembly of its products other than those items requiring machine shop or foundry work and except for certain components, such as brakes, tires, wheels, rims, axles, landing gear and springs, which are purchased as finished items. The national truck trailer market is fragmented and competitive due to the relative ease of entrance (with the exception of the higher technology refrigerated trailers). There are approximately 180 companies in the truck trailer manufacturing industry. In 1993, the two largest companies, Great Dane and Wabash National Corporation, accounted for approximately 24% of the market and the ten largest companies accounted for approximately 65% of sales. The basis of competition in the truck trailer industry is quality, durability, price, warranties, service and relationships. Due in large part to the quality of its products and its strong distribution system, the Company believes that Great Dane has built sustainable competitive advantages in each of these important areas. Management believes its "Great Dane" trademark, which identifies all of its products, to be of value and to contribute significantly to the wide acceptance of its products. Truck trailer and container backlog was approximately $365 million at December 31, 1993, and $259 million at December 31, 1992. The increase in backlog is attributed to the previously discussed dry freight containers and chassis order and increased orders for truck trailers. AUTOMOTIVE PRODUCTS OPERATIONS. Through SCSM and the Partnership, the Company is currently engaged in the fabrication of various sheet metal components and subassemblies, including automotive doors, roofs and hoods, primarily for light trucks and vans, which tend to have longer model lives and less frequent design changes than passenger cars. Through the purchase of SCSM in 1989 and the expansion of that facility's press lines, the Company acquired a modernized stamping facility covering an area of more than 900,000 square feet. SCSM presently has the capability to produce virtually any automotive stamping product, carrying out substantially all phases of the project under one roof. SCSM holds GM's "Mark of Excellence" award and The Chrysler Corporation's "Quality of Excellence" designation. The automotive operations' primary customer is GM, which has, historically, accounted for more than 95% of this segment's revenues. Management is, however, increasing its efforts to broaden its customer base. The effect of that effort is evidenced by the expansion of the customer base to include Freightliner Corp. ("Freightliner"), Ford Motor Company ("Ford"), and the Chrysler Corporation ("Chrysler"). In addition, the automotive segment recently received a letter of intent from Mercedes-Benz for products which, subject to the execution of final documentation, are currently scheduled for shipment commencing in 1997. Shipments of customers' orders are made on a daily or weekly basis as required by the customers. GM provides an estimated 13 week forecast for material and fabrication planning purposes. Nevertheless, changes in production by the customer may be reflected in increases or decreases in these forecasts. The fabrication business is highly competitive and SCSM and the Partnership compete with numerous other industrial manufacturers, as well as with the in-house capabilities of its customers (i.e., GM). The failure to obtain future orders from GM could have a material adverse impact on SCSM and/or the Partnership despite the fact that the Company is expanding its customer base. The automotive products industry is experiencing increased pricing pressure from GM which is continuing its aggressive measures to reduce its operating costs, including obtaining significant price reductions from suppliers. Although opportunities for new business may arise as a result of GM's pressure on other suppliers and, while the Company believes that it has adequately provided for any price reductions which may result from discussions with GM in near-term financial plans, future earnings of the automotive products operations may be materially adversely affected by additional price reductions requested or required by GM. VEHICULAR OPERATIONS. Yellow Cab is the largest taxicab fleet owner in the City of Chicago and, as of February 1, 1994, owned approximately 2,370 of the roughly 5,400 taxicab licenses ("medallions") available in Chicago. Yellow Cab leases its medallions and its owned vehicles to independent, non- employee taxi operators pursuant to two programs; the owner-operator program and the daily-lease program. The owner-operator program relieves Yellow Cab of vehicle maintenance and repair costs, as well as the cost of housing and storing a large fleet. The Partnership and affiliated entities also provide a variety of other services to taxi drivers and non-affiliated medallion holders, including insurance coverage and repair and maintenance services. Pursuant to a 1988 agreement with the City of Chicago to settle various lawsuits, Yellow Cab is required to relinquish to the City of Chicago and not renew 100 taxicab licenses on January 1 of each year through 1997 (the "Agreement"). In addition, the Agreement limits to 100 per year the number of new licenses that the City of Chicago may add to the total medallions outstanding through 1997, bringing the total number of available licenses to a maximum of 5,700 on December 31, 1997. At the required surrender rates, assuming no additional medallions are sold by Yellow Cab, Yellow Cab would hold approximately 2,070 medallions after January 1, 1997, or approximately 36% of the maximum total then-to-be outstanding. The scheduled decline in the number of licenses allowed to be held by Yellow Cab pursuant to the Agreement has had, and will continue to have, a negative effect on the revenue-generating capability of the taxi leasing operations. Yellow Cab has been able to offset these declines to some extent through increases in the average lease rates charged to its customers. At the same time, as the number of medallions held by Yellow Cab declines, Yellow Cab will require fewer new vehicles to support its taxi leasing operations and, consequently, a lower level of capital spending. The Agreement has also had the effect of allowing the Company to purchase and sell licenses in the open market for the first time since 1982. In 1993, sales of these licenses have been recorded at prices of approximately $38,000 per medallion, and the prices realized by Yellow Cab have been consistent with the prices realized in license sales by other, non- affiliated, medallion holders. Although the value of Yellow Cab's fleet of vehicles is reflected on the Company's balance sheet, the significant value of its medallions is not. Although Yellow Cab is the largest provider of taxicab related services in Chicago, it faces competition from a number of other medallion owners who lease medallions and vehicles to independent operators. The most significant of these competitors are Flash Cab Company, American United and Abernathy. Yellow Cab management believes that each of these competitors owns approximately 150 to 200 medallions, although each competitor operates under a variety of individual cab service names and logos. Yellow Cab currently maintains liability insurance coverage for losses of up to $350,000 per occurrence, as well as an "excess layer" of coverage for losses over $600,000 and up to $29,000,000. The initial $350,000 layer of insurance is issued by Country. See "Business--Insurance Operations." During several periods in the past, Yellow Cab did not maintain the level of coverage that Yellow Cab currently maintains for any losses over $350,000 per occurrence. As a result, there are currently nine outstanding claims against Yellow Cab for which it is not fully covered by third-party insurance. Yellow Cab maintains balance sheet reserves totalling $3 million for these claims. Management believes that these reserves will be sufficient to cover its outstanding claims. Yellow Cab's operations are regulated extensively by the Department of Consumer Services of the City of Chicago which regulates Chicago taxicab operations with regard to certain requirements including vehicle maintenance, insurance and inspections, among others. The City Council of Chicago has authority for setting taxicab rates of fare. Effective January 18, 1994, rates of fare increased by 10%. However, lessors may increase the rates paid by lessee drivers by not more than 2.8% until April 1, 1994, and thereafter may not raise such rates at all without the consent of the City of Chicago. The City of Chicago is required to establish rules before April 1, 1994, pursuant to which they will hold hearings on any proposed rate increase. INSURANCE OPERATIONS. Country, a wholly-owned subsidiary of the Partnership, historically concentrated solely on underwriting affiliated taxi liability, collision and workers' compensation insurance. During the past seven years, however, Country has expanded its operating focus to include underwriting non-affiliated personal and commercial property/casualty lines. During 1993 and 1992, 67% of Country's total premium revenue was attributable to nonaffiliated property and casualty lines. Country is one of the few voluntary providers of taxi liability insurance in the industry. Most insurers which have previously written taxi insurance coverage on a voluntary basis experienced poor underwriting results and have withdrawn from the business. Management believes that Country's longstanding relationship with Yellow has provided it with a stable market for this type of coverage and has enabled it to develop a comprehensive understanding of the business and to assess more properly the associated risk. The taxicab liability coverage which Country writes carries a $350,000 limit of liability for each driver. In addition, Country makes collision insurance available to licensees and owner-operators at premium rates which are favorable relative to the rates charged by competitors for equivalent coverage. Country also writes full lines of commercial and personal property and casualty insurance for risks located in the City of Chicago and the surrounding metropolitan area. With the exception of a specialty public transportation program, which program policies are reinsured for amounts above $350,000, all non-affiliate policies are reinsured for amounts above $150,000. Country is domiciled in the State of Illinois and is a licensed carrier in Michigan, as well as being admitted as an excess and surplus lines carrier in 36 other states. To the best of management's knowledge, Country is in compliance with all applicable statutory requirements and regulations. Country is currently rated "A" by A. M. Best Company. LABOR RELATIONS. Approximately 286 employees in the Company's automotive products operations, 295 in the Company's truck trailer manufacturing operations and 63 in the Company's vehicular operations are covered by collective bargaining agreements. The Partnership entered into a new contract with the Allied Industrial Workers of America, AFL-CIO, Local 682 in Kalamazoo--currently known as Local Union No. 7682 of the United Paperworkers International Union, AFL-CIO--which expires in May 1996. The Partnership is party to a contract with D.U.O.C. Local 777, a division of National Production Workers of Chicago and Vicinity, Local 777 which expires in November 1995. During February 1993, Great Dane Trailers, Tennessee, Inc., a subsidiary of Great Dane, negotiated a new contract (expiring in January 1996) with Talbot Lodge No. 61 of the International Association of Machinists and Aerospace Workers. In general, the Company believes its relationship with its employees to be satisfactory. COMPLIANCE WITH ENVIRONMENTAL PROTECTION PROVISIONS. The Company believes that future compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will have no material effect upon the capital expenditures, earnings and competitive position of the Company. ITEM 2. ITEM 2. PROPERTIES ---------- The Company's principal executive offices are located at the Partnership's facility at 2016 North Pitcher Street, Kalamazoo, Michigan 49007. The location and general description of the principal properties owned or leased by the Company are as follows: The principal facilities owned by the Company and its subsidiaries are considered by the Company to be well maintained, in good condition and suitable for their intended use. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- EXECUTIVE LIFE LITIGATION. By order of the Superior Court of Los Angeles County on April 11, 1991 (the "California order"), the California State Insurance Commissioner was appointed conservator (the "Conservator") for Executive Life Insurance Company ("ELIC"), a limited partner in the Partnership. By letter dated May 20, 1991, Checker and the Partnership advised ELIC and the Conservator that the appointment of the Conservator pursuant to the California Order constituted an "Event of Default" under the Amended and Restated Agreement of Limited Partnership of the Partnership (the "Agreement"), and that, therefore, ELIC's rights under the Agreement and interest in the Partnership were altered. More specifically, Checker and the Partnership asserted that ELIC's rights, as of April 11, 1991, were limited to the right to receive a payout of its capital account, calculated as of that date, in quarterly installments over approximately a 23-year period. By letter dated June 28, 1991, the Conservator notified Checker and the Partnership that he did not accept the position set forth in the May 20 letter. On July 8, 1991, Checker and the Partnership filed suit against ELIC and the Conservator in the Delaware Chancery Court for New Castle County. In that action, Checker and the Partnership sought a declaratory judgment that they had properly invoked the provisions of the Agreement relating to an Event of Default and that they are not in violation of the California Order. In addition, they sought an order declaring that ELIC has no further interest in the Partnership or any rights under the Agreement, except the right to receive its capital account, with interest, as provided in the Agreement, and that Checker and the Partnership have no additional liability or obligation to ELIC. Checker and the Partnership sought to enjoin ELIC from taking a position inconsistent with their interpretation of the Agreement. On September 10, 1991, ELIC and the Conservator moved to stay or dismiss the complaint in the Delaware action. On February 13, 1992, the judge granted the motion to dismiss on the basis that Checker's action constituted a "claim" under the Uniform Insurers Liquidation Act, as adopted in Delaware, which could not be brought in the absence of an ancillary receiver for ELIC having been appointed in Delaware. On September 14, 1992, the portion of this opinion which would have required Checker and the Partnership to bring their action in California because no ancillary receiver had been appointed for ELIC in Delaware was modified. The Delaware Supreme Court held that a resident of an ancillary state could file "claims" with either the ancillary receiver of such state or with the domiciliary receiver, thereby allowing Checker and the Partnership to pursue their claim in a jurisdiction in which they are resident and in which an ancillary receiver was appointed in October 1991. Checker and the Partnership have now filed a claim against ELIC in Michigan. On March 4, 1992, the Company received a copy of the Conservator's filing in California of an Amendment to its Application for Order of Conservation adding Checker, the Partnership and Checker Holding Corp. III as parties (the Checker Entities") to its original order and seeking (a) damages in an unspecified amount for their alleged "forfeiture" or ELIC's partnership interest, their breach of fiduciary duties, and their interference with the conservatorship proceedings and waste of conservatorship assets and (b) a declaration of ELIC's rights under the Agreement. The Company made a limited appearance in California to dispute the jurisdiction of the court over the Checker Entities. On June 10, 1992, the California court ruled that the Checker Entities are subject to jurisdiction in California. The Checker Entities filed a Petition for Writ of Mandate and Request for Temporary Stay of Proceedings in the Court of Appeal of the State of California, Second Appellate district, and a hearing on the Petition was held on November 5, 1992. On February 24, 1993, the court denied the writ. On March 11, 1993, the Checker Entities filed a Petition for Rehearing based on their belief that the Appellate Court's opinion was predicated upon omissions of material facts and misstatements of material facts, which Petition for Rehearing was denied by the court. The Company has offered to redeem ELIC's interest in the Partnership and South Charleston Stamping & Manufacturing Company for $32 million. The Conservator has not yet responded to the offer. BOEING LITIGATION. On February 8, 1989, the Boeing Company ("Boeing") filed a lawsuit naming the Company, together with three prior subsidiaries of the Company, as defendants in Case No. CV89-119MA, United States District Court for the District of Oregon. In that lawsuit, Boeing sought damages and declaratory relief for past and future costs resulting from alleged groundwater contamination at a location in Gresham, Oregon, where the three prior subsidiaries of the Company formerly conducted business operations. On December 22, 1993, the Company entered into a settlement with Boeing, settling all claims asserted by Boeing in the lawsuit. Pursuant to the settlement terms, the Company will pay Boeing $12.5 million over the course of five years, $5 million of which has been committed by certain insurance companies in the form of cash or irrevocable letters of credit. In accordance with the settlement agreement, Boeing will move to dismiss its claims against the Company and the three former subsidiaries and will release and indemnify the Company with respect to certain claims. CERTAIN ENVIRONMENTAL MATTERS. Within the past five years, Great Dane and Checker have entered into certain consent decrees with federal and state governments relating to the cleanup of waste materials. The aggregate obligations of Great Dane and Checker pursuant to these consent decrees are not material. In May 1988, the Company sold all of the stock of its subsidiaries, Datron Systems, Inc. ("Datron") and All American Industries, Inc., and in connection therewith agreed to indemnify the purchaser for, among other things, certain potential environmental liabilities. The purchaser asserted various claims for indemnification and had commenced litigation in Connecticut with respect to alleged contamination at a manufacturing facility owned by a former second-tier subsidiary. The court denied one of the purchaser's claims and another was dismissed. The balance of the claims for reimbursement of monitoring and clean up costs were dismissed without prejudice and the Company is discussing with the purchaser the resolution of approximately $625,000 in claims previously submitted by the purchaser for cleanup and monitoring costs at the facility, as well as its responsibility for future costs. The Company does not believe that its obligations will be material. The purchaser has also put the Company on notice of certain other alleged environmental and other matters for which it intends to seek indemnification as costs are incurred. The Company does not believe that its obligations, if any, to pay these claims will be material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS There is no market for Registrant's common stock; all issued and outstanding common stock is owned of record by David R. Markin, Martin L. Solomon, Allan R. Tessler and Wilmer J. Thomas, Jr. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Summarized below is selected financial data for the years 1989 through 1993. The extraordinary items in all years relate to the gain or loss on the repurchase of indebtedness (see Note L of the Notes to Consolidated Financial Statements). The accounting changes represent the cumulative effect of changes in accounting principles as a result of adopting, as of January 1, 1993, the provisions of Statement of Financial Accounting Standard ("SFAS") No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes" (see Notes I and K of the Notes to Consolidated Financial Statements). Per share amounts for all of the years are based on 9,036,700 shares. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL. From the time that present management assumed control of the Company in January 1989, it has been continually reassessing the Company's financial condition and prospects. During March 1990, Great Dane obtained a loan commitment of $80 million. A substantial portion of the loan proceeds was utilized to repurchase, in the open market, a portion of the Company's outstanding 12-3/4% Senior Debentures due 2001 (the "12-3/4% Debentures") and Subordinated Discount Debentures due January 1, 2006 (the 14-1/2% Debentures"). During September 1992, Checker Motors Co., L.P. (the "Partnership") entered into a Loan and Security Agreement with a bank pursuant to which the bank provided a $30 million term loan. Approximately $18 million of the proceeds from the loan was used to repay certain indebtedness of a subsidiary of Checker, which debt had been guaranteed by the Partnership, and to pay certain costs associated with the financing and repayments. The Company was hampered in its efforts to achieve a refinancing of its debt in recent years, in part because of certain litigation arising out of alleged groundwater contamination at a location where three prior subsidiaries of the Company formerly conducted business. That lawsuit has now been settled. See "Business--Legal Proceedings--Boeing Litigation." The Company has also been engaged in litigation with the Conservator of ELIC, a limited partner in the Partnership, seeking, among other things, a declaratory judgment regarding ELIC's rights in the Partnership. See "Business--Legal Proceedings--Executive Life Litigation." With the settlement of the Boeing litigation and negotiations in progress to settle the Executive Life Litigation, the ability of the Company to achieve a successful refinancing has been enhanced. Accordingly, in February 1994, the Company filed a Registration Statement on Form S-1 with the Securities and Exchange Commission in connection with an overall refinancing of the Company's outstanding indebtedness. The proposed refinancing, as described in the registration statement, involves the Company entering into a credit facility consisting of a $60 million term loan and a revolving credit facility which would provide up to $115 million, subject to the Company's ability to meet certain financial tests (the term loan and the revolving credit facility being known as the "New Credit Facility"). Additionally, the Company is proposing to offer $265 million (adjusted from $225 million) of new Senior Secured Notes (the "Senior Notes"). If the refinancing is successfully completed, the proceeds from the new Credit Facility would be utilized to redeem substantially all of the currently outstanding indebtedness of the Company's subsidiaries and the proceeds from the offering of the Senior Notes would be used to redeem parent company indebtedness and to redeem the Minority Interest held by ELIC, in each case together with any accrued interest and transaction fees and expenses. A successful completion of the refinancing, the terms of which are still subject to change, is expected to help the Company achieve increased liquidity from reduced principal debt amortization requirements, the removal of certain restrictions on the use of cash from the Company's subsidiaries and more flexible and efficient cash management at the holding company level. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES. Available cash and cash equivalents, cash flow generated from operations ($30.7 million, $25.2 million and $37.8 million for the years ended December 31, 1993, 1992 and 1991, respectively), proceeds from borrowings and proceeds from disposal of assets have provided sufficient liquidity and capital resources for the Company to conduct its operations. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The impact of adopting SFAS No. 106 was a charge to net income of $29.7 million (net of taxes of $16.5 million) which was recorded as a cumulative effect adjustment in the quarter ended March 31, 1993. The Company also adopted the provisions of SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. The impact of adopting SFAS No. 109 was a charge to net income of $16.9 million which was recorded as a cumulative effect adjustment in the quarter ended March 31, 1993. During the quarter ended March 31, 1993, the Company adopted the provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short Duration and Long Duration Contracts." Because of the type of insurance contract Country provides, the adoption of this statement had no impact on earnings; however, it requires the disaggregation of various balance sheet accounts. For financial reporting purposes, the 1992 balance sheet and 1992 and 1991 statements of cash flows have been restated as if SFAS No. 113 were adopted as of the beginning of the earliest period presented. While the adoption of the above SFAS's has a significant effect on the Company's financial position, it does not adversely affect liquidity and capital resources. The Company is a holding company and is, therefore, dependent on cash flow from its subsidiaries in order to meet its obligations. Purchases of property, plant and equipment have averaged approximately $18.0 million per year over the past three years and have been funded principally by cash flow generated from operations as well as proceeds from disposal of assets. Purchases of property, plant and equipment for 1994 are anticipated to be approximately $26.0 million and are expected to be funded principally by cash flow generated from operations. During the fourth quarter of 1993, the Company entered into a settlement of the Boeing litigation (see "Business--Legal Proceedings--Boeing Litigation"). It is anticipated that the settlement ($12.5 million over five years) will be paid by the Company through recoveries from insurance carriers, the sale of assets of certain of the subsidiaries, cash currently on hand and cash flow generated from operations. GM, a major customer of the Company's automotive products segment, is resorting to many measures, including obtaining significant price reductions from its suppliers, in an effort to reduce its operating costs. Management of the Company's automotive products segment is currently engaged in discussions with GM concerning future pricing of parts presently being manufactured. Automotive products segment management believes that it has adequately provided in its near-term financial plans for any price reductions which may result from its current discussions with GM. However, price reductions in excess of those anticipated could have a material adverse effect on the automotive products operations. IMPACT OF INFLATION. Recently, due to competitive market conditions, the Company has been unable to factor all cost increases into selling prices for its products and services. The Company does not believe, however, that the impact of inflation affects the Company any more than it affects the Company's competitors. RESULTS OF OPERATIONS. 1993 COMPARED TO 1992: During 1993, revenues increased $192.6 million and gross profit increased $24.7 million as compared to 1992. The Truck Trailer Manufacturing and the Automotive Products segment operations benefited from increased demand for their products. Truck Trailer Manufacturing revenues increased by $175.5 million as compared to 1992, primarily due to the sale of containers and chassis which were introduced in late 1992 and sold principally to one customer, and a higher volume of truck trailer sales. Automotive Products revenues increased $15.3 million as compared to 1992. Increased production of the General Motors Blazer and Suburban models and crew cab products and other general increases in volumes to accommodate automotive customers' demands are the principle reasons for the increase. Vehicular Operations revenues increased $1.5 million in 1993 as compared to 1992. The increase was attributed to lease rate increases obtained in 1993 to cover certain Vehicular Operations cost increases. The revenue increase was somewhat offset by the impact of tendering medallions to the City of Chicago. The factors impacting sales, as discussed previously, had the effect of increasing the Company's 1993 operating profit (gross profit less selling, general and administrative expenses) by $18.4 million as compared to 1992. Truck Trailer Manufacturing operating profit increased by $14.8 million as compared to 1992. This increase is principally due to higher volumes, partly offset by higher selling, general and administrative expenses ("S G & A"). Higher volumes were also the principal reason for an increase of $3.7 million of Automotive Products operating profits as compared to 1992. S G & A expenses were $6.3 million higher in 1993 as compared to 1992, but as a percentage of sales, S G & A expense is 1.7 percentage points lower in 1993 as compared to 1992. Other expenses decreased $5.5 million in 1993 as compared to 1992. The decrease in expense resulted primarily from $1.4 million income from the settlement of a dispute in 1993 and $2.8 million income from sales of taxi medallions in 1993. On February 8, 1989, the Boeing Company ("Boeing") filed a lawsuit naming the Company, together with three prior subsidiaries of the Company, as defendants in Case No. CV89-199MA, United States District Court for the District of Oregon. In that lawsuit, Boeing sought damages and declaratory relief for past and future costs resulting from alleged groundwater contamination at a location in Gresham, Oregon, where the three prior subsidiaries of the Company formerly conducted business operations. On December 22, 1993, the Company entered into a settlement with Boeing, settling all claims asserted by Boeing in the lawsuit. Pursuant to the settlement terms, the Company will pay Boeing $12.5 million over the course of five years, $5 million of which has been committed by certain insurance carriers in the form of cash or irrevocable letters of credit. Accordingly, the Company recorded a $7.5 million special charge during 1993 to provide for the cost associated with this legal proceeding. In accordance with the settlement agreement, Boeing will move to dismiss its claims against the Company and the three former subsidiaries and will release and indemnify the Company with respect to certain claims. 1992 COMPARED TO 1991: During 1992, revenues increased $161.5 million and gross profit increased $31.1 million as compared to 1991. The Truck Trailer Manufacturing and the Automotive Products segment operations were positively impacted by increased demand for their products. Truck Trailer Manufacturing revenues increased by $136.1 million as compared to 1991, primarily resulting from a higher volume of truck trailer sales. Automotive Products revenues increased $28.2 million as compared to 1991. Increased production of the General Motors Blazer and Suburban models and crew cab products for the 1993 model year and other general increases in volumes to accommodate automotive customers' demands were partly offset by a $6.1 million decrease in revenues associated with the coordination of tooling programs for General Motors. Vehicular Operations revenues decreased $2.5 million as compared to 1991. The decrease in revenues is principally attributed to a continuing downturn in taxicab leasing in the City of Chicago, as well as a decrease in the number of cabs available for lease from Yellow Cab as a result of the settlement agreement reached with the City of Chicago in 1988. The negative trend to revenue changes for this segment could continue if the economic environment does not improve and if the segment is not successful in continuing to develop new sources of revenue as the settlement agreement requires the tendering of 100 additional licenses to the City of Chicago in each of the next five years. The factors impacting sales, as discussed previously, had the effect of increasing the Company's 1992 operating profit (gross profit less selling, general and administrative expenses) by $26.3 million as compared to 1991. Truck Trailer Manufacturing operating profit increased by $10.5 million as compared to 1991. This increase is principally due to higher volumes, partly offset by higher selling, general and administrative expenses ("S G & A"). Higher volumes were also the principal reason for an increase of $15.9 million of Automotive Products operating profits as compared to 1991. Automotive Products Operations' S G & A expenses were only slightly higher in 1992 as compared to 1991. Vehicular Operations operating profits decreased $1.4 million in 1992 compared to 1991 due to lower revenues. While efforts were made to reduce Vehicular Operations' operating costs through the combination of the two taxicab operations in late 1991, the decrease in revenues previously discussed was not fully offset by decreased operating and sales, general and administrative costs. S G & A expenses were $4.9 million higher in 1992 as compared to 1991, but as a percentage of sales, S G & A expense is 2.2 percentage points lower in 1992 as compared to 1991. Other expenses increased $0.9 million in 1992 as compared to 1991. Higher gains realized on investment transactions during 1992 compared to 1991 were offset by lower gains on sale of assets in 1992 as compared to 1991. Interest expense was $4.7 million lower in 1992 than in 1991. The decrease can be attributed to lower interest rates during 1992 compared to 1991 as well as lower levels of debt outstanding during 1992 compared to 1991. There is no minority equity expense in 1992 because ELIC was placed into conservatorship in 1991 and, as a result, its interest in the Partnership and rights under the Partnership Agreement became limited to the right to receive the balance of its capital account as of April 11, 1991. (See "Business-- Legal Proceedings--Executive Life Litigation.") ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Registrant's response to this item is incorporated herein by reference to the consolidated financial statements and consolidated financial statement schedules, and the report thereon of independent auditors, listed in Item 14(a)1 and (2) and appearing after the signature page to this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT David R. Markin, age 63, President and Chief Executive Officer of the Company since January 11, 1989, has been President and Chief Executive Officer of Checker since 1970. Mr. Markin serves on the Boards of Directors of Jackpot Enterprises, Inc., an operator of gaming machines, Enhance Financial Services Group Inc., a reinsurance company, and Data Broadcasting Corporation, a provider of market data services to the investment community. Allan R. Tessler, age 57, Chairman of the Board of the Company since January 11, 1989, is also Chairman of the Boards of Directors of International Financial Group, Inc., a merchant banking firm ("IFG"), Enhance Financial Services Group Inc., a reinsurance company, and Allis-Chalmers Corporation, a manufacturer of miscellaneous fabricated textile products ("Allis-Chalmers"), and is Chief Executive Officer of IFG (since 1987) and Allis-Chalmers (beginning in 1994). Mr. Tessler serves on the Boards of Directors of Jackpot Enterprises, Inc., an operator of gaming machines, and The Limited, Inc., a manufacturer and retailer of apparel. Mr. Tessler is also an attorney and from 1976 through 1988, he was a member of the Executive Committee of the law firm of Shea & Gould; from 1989 through March 1, 1993, he was of counsel to that firm. Beginning in 1990, Mr. Tessler and another person were retained by Infotechnology, Inc., and Financial News Network Inc. as a restructuring team and to serve as Co-Chief Executive Officers during the restructuring of those companies. As part of the plan implemented by the restructuring team, those companies were placed in bankruptcy, from which they emerged in 1992 as Data Broadcasting Corporation, a provider of market data services to the investment community. Mr. Tessler continues to serve as Co-Chairman of the Board and Co-Chief Executive Officer of the restructured company. Martin L. Solomon, age 57, Vice Chairman and Secretary of the Company since January 11, 1989, is a private investor. Mr. Solomon was employed as a securities and portfolio analyst at Steinhardt Partners, an investment firm, from 1985 through 1987. From 1988 through September 1990, he was the Managing Partner and Director at Value Equity Associates I, Limited Partnership, an investment firm. Mr. Solomon serves on the Board of Directors of Xtra Corporation, a truck leasing company. Wilmer J. Thomas, Jr., age 67, Vice Chairman of the Company since January 11, 1989, is a private investor. Mr. Thomas served as Treasurer of the Company from January 1989 to January 1994. Mr. Thomas serves on the Boards of Directors of Moore Medical Corp., a pharmaceutical and surgical supply company, and Oak Hills Sportswear Corp., a clothing company, and RCL Capital Corp. a development-stage company whose business objective is to acquire an operating company. The executive officers of the Registrant, in addition to Messrs. Markin, Tessler, Solomon and Thomas, are: Jay H. Harris, age 57, who has been Executive Vice President and Chief Operating Officer of the Company for more than the past five years and a Vice President of Checker since 1991. Mr. Harris was a director of the Company from 1978 until January 11, 1989. Marlan R. Smith, age 50, who has been Treasurer of the Company since January 1994 and Vice President and Treasurer of Checker since March 1988. Prior to being elected Treasurer of the Company, he served as Assistant Treasurer since January 1989. Kevin J. Hanley, age 38, who has been Controller of the Company since January 1994 and Secretary and Controller of Checker since December 1989 and for more than 5 years prior thereto served as a senior manager with Ernst & Young. Willard R. Hildebrand, age 54, who was elected as President and Chief Executive Officer of Great Dane effective January 1, 1992. Mr. Hildebrand had served as President and Chief Operating Officer of Fiatallis North America, Inc., a manufacturer of heavy construction and agricultural equipment, for more than five years prior thereto. Larry D. Temple, age 47, who has been Group Vice President of Checker since September 1989. Mr. Temple served as Vice President of Manufacturing from 1988 to 1989 and, prior thereto, as Assistant Vice President of Manufacturing. Jeffrey M. Feldman, age 43, nephew of David R. Markin, who has been President of Yellow Cab since 1983. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION COMPENSATION The following table sets forth the 1993 annual compensation for the Company's Chief Executive Officer and the five highest paid executive officers, as well as the total compensation paid to each individual for the Company's two previous fiscal years: COMPENSATION PURSUANT TO PLANS GREAT DANE PENSION PLAN Great Dane has in effect a defined benefit employee pension plan entitled Retirement Plan For Great Dane Trailers, Inc. (the "Retirement Plan") covering substantially all of its employees. Pension benefits are subject to limitations imposed by the Internal Revenue Code of 1986, as amended, and the Employee Retirement Income Security Act of 1974, as amended, with respect to the annual amount of benefits provided by employer contributions. Effective as of July 1, 1988, the assets and the liabilities attributable to active and former employees under the Amended and Restated International Controls Corp. Pension Plan as of June 30, 1988 were transferred to the Retirement Plan and the Company adopted the Retirement Plan for the benefit of its employees. With respect to benefits accruing after June 30, 1984, to a participant who was a participant under the Amended and Restated International Controls Corp. Pension Plan as of June 30, 1988, the following table shows the estimated annual benefits payable upon retirement at age 65 under the plan to specified average annual compensation and years of benefit service classifications. The following amounts would be reduced by a Social Security offset: Mr. Harris has an aggregate of 24 years of benefit service under the Retirement Plan (8 years) and the Amended and Restated International Controls Corp. Pension Plan (16 years) and will receive benefits of approximately $74,000 per year at age 65. PARTNERSHIP PENSION AND EXCESS BENEFIT PLANS The Partnership maintains a defined benefit employee pension plan entitled Checker Motors Pension Plan (the "Pension Plan") covering substantially all of its non-union employees, and, effective January 1, 1992, the employees of the Company. The Partnership also maintains the Checker Motors Co., L.P. Excess Benefit Retirement Plan (the "Excess Benefit Plan"). An employee of the Partnership will become a participant in the Excess Benefit Plan if the benefits which would be payable under the Pension Plan are not fully provided thereunder because of the annual maximum benefit limitations of Section 415 of the Internal Revenue Code of 1986, as amended. The amount that the participant is entitled to receive under the Excess Benefit Plan is an amount equal to the amount that would have been payable under the Pension Plan if Section 415 did not apply, minus the amount that is actually payable under the Pension Plan. At the present time, David R. Markin and Jeffrey M. Feldman are the only individuals named above who would receive benefits under the Excess Benefit Plan. Considered compensation under the Excess Benefit Plan is limited to $300,000. Set forth below are the estimated annual benefits for participants in the Pension Plan (including benefits payable under the Excess Benefit Plan) who have been employed by the Partnership and its predecessors for the indicated number of years prior to retirement, assuming retirement at age 65 in 1993: The above benefit projections were prepared on the assumption that the participant made participant contributions to the Pension Plan for all years in which he was eligible to contribute. The benefit projection would be reduced by a Social Security offset. For those executive officers named above, the following are credited years of service under the Pension Plan and Excess Benefit Plans and 1993 salary covered by the Pension Plan: SALARY CONTINUATION PLAN Checker entered into Stated Benefit Salary Continuation Agreements (the "Agreements") with certain officers and employees (the "Salary Plan") pursuant to which such participants will receive benefits upon attaining age 65 (or their beneficiaries will receive benefits upon their death prior to or within 120 months after such executives or employees attain age 65). Checker's obligations pursuant to the Salary Plan were assumed by the Partnership in 1986. For those executive officers named above, the following table sets forth the benefits payable pursuant to the Salary Plan: COMPENSATION OF DIRECTORS The directors did not receive any fees for their services as directors in 1993. See "Compensation Committee Interlocks and Insider Participation." EMPLOYMENT AGREEMENTS The Partnership, as the assignee of Checker, is party to an Amended and Restated Employment Agreement dated as of November 1, 1985, as further amended, with David R. Markin pursuant to which Mr. Markin is to serve as President, Chief Executive Officer and Chief Operating Officer of the Partnership until March 31, 1996, subject to extension (the "Termination Date"), at a minimum salary of $600,000 per annum, together with the payment of certain insurance premiums, the value of which have been included in the Summary Compensation Table above, and the beneficiaries of which have been designated by Mr. Markin. Mr. Markin continues to be eligible to participate in profit sharing, pension or other bonus plans of the Partnership. Pursuant to the Amended and Restated Employment Agreement, in the event of Mr. Markin's death, the Company shall pay Mr. Markin's estate the compensation which would otherwise be payable to him for the period ending on the last day of the month in which death occurs. In addition, the Company shall pay to Mr. Markin's beneficiaries deferred compensation from the date of his death through the Termination Date in an annual amount equal to one-third of his base salary at the date of his death. In the event of termination of the Amended and Restated Employment Agreement for any reason other than cause, disability or death, Mr. Markin shall continue to serve as a consultant to the Company for a period of five years, for which he shall receive additional compensation in the amount of $50,000 per annum. The Partnership has agreed to indemnify Mr. Markin from certain liabilities arising out of his service to the Partnership, except for liabilities resulting from his gross negligence or willful misconduct. Effective January 1, 1994, Mr. Markin and the Company memorialized in writing their agreement, pursuant to which Mr. Markin has been compensated by the Company since January 11, 1989, on substantially the same terms as are set forth above. The Company entered into an employment agreement as of July 1, 1992, with Jay H. Harris pursuant to which Mr. Harris serves as Executive Vice President and Chief Operating Officer of the Company until June 30, 1994, subject to extension, at a minimum salary of $350,000 per annum, an incentive bonus to be determined by the Board of Directors, and such other fringe benefits and plans as are available to other executives of the Company. Upon the happening of certain events, including a change in control (as defined therein) of ICC or retirement after June 30, 1994, Mr. Harris is entitled to compensation in an amount equal to the greater of (a) five percent of the increase in the Company's retained earnings, subject to certain adjustments, during the period commencing on March 31, 1992, and ending on the last day of the month preceding the event which triggers the payment (the "Termination Payment") and (b) 2.99 times the then base. If Mr. Harris were to leave the Company before July 1, 1994, or if he were to die or become disabled, he or his estate would receive the greater of (a) one year's base compensation or (b) the Termination Payment. Payments in either case would be made over a period of time, the length of which would be dependent on the amount due to Mr. Harris. Mr. Harris has agreed to serve as a consultant to the Company during the first year after termination for no compensation beyond his expenses incurred in connection with rendering such services. The Company has agreed to indemnify Mr. Harris to the full extent allowed by law. Checker has guaranteed the Company's obligations. The Partnership is party to an Amended and Restated Employment Agreement dated as of June 1, 1992, with Jeffrey Feldman pursuant to which Mr. Feldman serves as President of the Partnership's Vehicular Operations division until February 1, 1996, subject to extension (the "Termination Date"), at a minimum salary of $200,000 per annum, together with certain insurance premiums, the value of which have been included in the Summary Compensation Table above, and the beneficiaries of which have been designated by Mr. Feldman. Mr. Feldman is eligible to participate in profit sharing, pension or other bonus plans implemented by the Vehicular Operations division of the Partnership. Pursuant to the Amended and Restated Employment Agreement, in the event of Mr. Feldman's death, the Partnership shall pay Mr. Feldman's estate the amount of compensation which would otherwise be payable to him for the period ending on the last day of the month in which death occurs. In addition, the Partnership shall pay to Mr. Feldman's estate deferred compensation from the date of his death to the Termination Date in an annual amount equal to one- third of his base salary at the date of his death. In the event of the termination of the Amended and Restated Employment Agreement for any reason other than cause, disability or death, Mr. Feldman shall continue to serve as a consultant to the Partnership for a period of five years (if terminated by Mr. Feldman) or seven years if terminated by the Partnership, for which he shall receive compensation in the amount of $75,000 per annum. The Partnership has agreed to indemnify Mr. Feldman from certain liabilities arising out of his service to the Partnership, except for liabilities resulting from his gross negligence or willful misconduct. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Each of Messrs. Markin, Solomon, Tessler and Thomas is an executive officer of the Company and participates, as a director, in the deliberations concerning executive officer compensation. During 1993, Mr. Markin served on the compensation committee of Enhance Financial Services Group Inc., Ameriscribe Corp. and Data Broadcasting Corporation and Mr. Tessler served as an executive officer of each of these companies. As of December 31, 1993, Country holds $0.9 million principal amount of Enhance Financial Services Group, Inc., 7% Senior Notes due December 1, 1996. During 1993, the Company used, on a month-to-month basis, an airplane owned by a corporation of which Mr. Tessler is the sole shareholder. The Company pays $60,000 per month for such use. Each of Messrs. Markin, Solomon, Tessler and Thomas provides consulting services to Yellow Cab and each receives for such services (commencing in January 1988) $10,000 per month. Messrs. Solomon, Thomas and Tessler also provide consulting services (a) to Checker for which they each receive monthly fees of $5,000 (commencing in January 1988) and (b) to Country for which they each receive monthly fees of approximately $18,300. Mr. Markin serves as a consultant to Chicago AutoWerks, a division of the Partnership, for which he receives monthly fees of approximately $1,200 (commencing in January 1988), and to Country, for which he receives monthly fees of approximately $4,600. Until March 1, 1993, Mr. Tessler was of counsel to Shea & Gould, a law firm retained by the Company for certain matters. Frances Tessler, the wife of Allan R. Tessler, is employed by Smith Barney Shearson which executes trades for Country's investment portfolio. During 1993, Mrs. Tessler received for her services approximately $78,000 of the commissions paid to Smith Barney Shearson. On September 24, 1992, American Country Financial Services Corp. ("AFSC"), a subsidiary of Country, purchased from The Mid City National Bank of Chicago the promissory note dated July 30, 1992, made by King Cars, Inc. ("King Cars") in the principal amount of $381,500 plus accrued interest in the amount of $3,560. On September 24, 1992, the King Cars note purchased by AFSC was paid and a new note dated September 24, 1992 and payable on January 30, 1993, in the principal amount of $398,482 bearing interest at the rate of 6.5% per annum was executed and delivered by King Cars to AFSC. On January 30, 1993, the note was renewed in the principal amount of $407,691 with a maturity date of May 30, 1993. On November 30, 1993, the note, then in the principal amount of $416,524, was once again renewed, with a maturity date of December 31, 1994. King Cars is owned by Messrs. Markin, Tessler, Solomon, Thomas and Feldman. King Cars is a party to an agreement dated December 15, 1992, with Yellow Cab pursuant to which Yellow Cab purchases from King Cars display frames for installation in its taxicabs and King Cars furnishes Yellow Cab advertising copy for insertion into the frames. King Cars receives such advertising copy as an agent in Chicago for an unrelated company which is in the business of selling and arranging for local and national advertising. Of the revenues generated from such advertising, 30% will be retained by King Cars and the balance will be delivered to Yellow Cab until such time as Yellow Cab has recovered costs advanced by it for the installation of advertising frames in 500 of its taxicabs (approximately $78,000). The terms to Yellow Cab are the same or more favorable than those offered by King Cars to unrelated third parties. Each of Messrs. Markin, Solomon, Tessler and Thomas received interest payments of $704,795 in 1993 pursuant to the terms of the Company's senior notes held by them (See Note G of the Notes to Consolidated Financial Statements--December 31, 1993). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Common Stock, which is the only class of stock of the Company, is owned as follows: The address of each of the shareholders is c/o International Controls Corp., 2016 North Pitcher Street, Kalamazoo, Michigan 49007. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Jeffrey M. Feldman is the nephew of David R. Markin. The Company received revenues of approximately $4.4 million in 1993 from Checker Taxi Association, an independent affiliation of medallion owners including approximately 1,100 independent owners, which amount includes reimbursement of certain management, general and administrative costs. Checker has guaranteed certain of Checker Taxi Association's obligations. The outstanding principal balance of these obligations was approximately $0.7 million, as of December 31, 1993. The Partnership has borrowed $2.5 million from Country, which loan is secured by certain of the Partnership's property. See also "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1 and 2. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES: The following consolidated financial statements and consolidated financial statement schedules of International Controls Corp. and subsidiaries and the report thereon of independent auditors are filed as part of this Annual Report on Form 10-K and are incorporated by reference in Item 8: A. Report of Independent Auditors. B. Consolidated Financial Statements. Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Shareholders' Deficit for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements - December 31, 1993. C. Consolidated Financial Statement Schedules. Schedule I - Marketable Securities - Other Investments Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Schedule III - Condensed Financial Information of Registrant Schedule IV - Indebtedness of and to Related Parties - Not Current Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings Schedule X - Supplemental Income Statement Information Schedule XIV - Supplemental Information Concerning Property- Casualty Insurance Operations See the accompanying Index to Financial Statements and Financial Statement Schedules Covered by Report of Independent Auditors appearing after the signature page to this Annual Report on Form 10-K. 3. See the accompanying Index to Exhibits which precedes the Exhibits filed with this Annual Report on Form 10-K. (b) REPORTS ON FORM 8-K: None (c) EXHIBITS: See the accompanying Index to Exhibits which precedes the Exhibits filed with this Annual Report on Form 10-K. (d) FINANCIAL STATEMENT SCHEDULES REQUIRED BY REGULATION S-X: See the accompanying Index to Financial Statements and Financial Statement Schedules Covered by Report of Independent Auditors which appears after the signature page to this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 10, 1994 INTERNATIONAL CONTROLS CORP. By: /s/ David R. Markin ------------------------------------------ David R. Markin President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, including at least a majority of the members of its Board of Directors, on behalf of Registrant and in the capacities and on the dates indicated. /s/ Allan R. Tessler Chairman of the Board March 10, 1994 - -------------------------- Allan R. Tessler /s/ David R. Markin President, Chief Executive March 10, 1994 - -------------------------- Officer and Director David R. Markin /s/ Jay H. Harris Executive Vice President and March 10, 1994 - -------------------------- Chief Operating Officer Jay H. Harris /s/ Marlan R. Smith Treasurer (Principal March 10, 1994 - -------------------------- Financial Officer and Marlan R. Smith Principal Accounting Officer) /s/ Martin L. Solomon Vice Chairman of the Board March 10, 1994 - -------------------------- and Secretary Martin L. Solomon /s/ Wilmer J. Thomas, Jr. Vice Chairman of the Board March 10, 1994 - -------------------------- Wilmer J. Thomas, Jr. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS The following consolidated financial statements of International Controls Corp. and subsidiaries are submitted herewith in response to Item 8: Page ---- - - Report of Independent Auditors - - Consolidated Balance Sheets as of December 31, 1993 and 1992 - - Consolidated Statements of Shareholders' Deficit for the Years Ended December 31, 1993, 1992 and 1991 - - Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 - - Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 - - Notes to Consolidated Financial Statements--December 31, 1993 The following consolidated financial statement schedules of International Controls Corp. and subsidiaries are submitted herewith in response to Item 14(d): Schedule I - Marketable Securities - Other Investments S-1 Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties S-8 Schedule III - Condensed Financial Information of Registrant S-9 Schedule IV - Indebtedness of and to Related Parties - Not Current S-12 Schedule VIII - Valuation and Qualifying Accounts S-13 Schedule IX - Short-Term Borrowings S-15 Schedule X - Supplementary Income Statement Information S-16 Schedule XIV - Supplemental Information Concerning Property-Casualty Insurance Operations S-17 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. REPORT OF INDEPENDENT AUDITORS Board of Directors International Controls Corp. We have audited the accompanying consolidated balance sheets of International Controls Corp. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' deficit and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of International Controls Corp. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes I and K to the consolidated financial statements, the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes in the year ended December 31, 1993. /s/ Ernst & Young Kalamazoo, Michigan March 1, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES December 31, 1993 NOTE A--ORGANIZATION The Company has two operating subsidiaries, Great Dane Trailers, Inc. ("Great Dane") and Checker Motors Corporation ("Checker"). During 1989, the Company purchased all of the common stock of Checker, the general partner of Checker Motors Co., L.P. (the "Partnership), a Delaware limited partnership (the "Checker acquisition"). Immediately after the Checker acquisition, substantially all of Checker's former shareholders purchased, through Checker Holding Corp. ("Holding"), all of the outstanding common stock of the Company (the "Holding buyout"). Holding was created solely for the purpose of acquiring the stock of the Company and was subsequently merged into the Company. The Holding buyout has been accounted for as if Checker acquired the Company (a "reverse acquisition"), since there was no significant change in control of Checker. Under generally accepted accounting principles for reverse acquisitions, the net assets of Checker acquired in the Checker acquisition cannot be revalued to estimated fair value. Accordingly, the $127.7 million excess of the amount paid over the historical book value of Checker's net assets has been accounted for as a separate component reducing shareholders' equity and is not subject to amortization. The fair value of Checker's net assets, as estimated by management, is significantly greater than historical book value, but no appraisal of fair value is available. NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of International Controls Corp. and its subsidiaries, including a wholly-owned trailer leasing company, other greater than 50% owned companies, the Partnership and the Partnership's wholly-owned subsidiaries, including American Country Insurance Company ("Insurance Subsidiary"). All significant intercompany accounts and transactions have been eliminated. CASH EQUIVALENTS: The Company considers all highly liquid investments, other than Insurance Subsidiary investments, with a maturity of three months or less when purchased to be cash equivalents. INVENTORIES: Inventories are stated at the lower of cost or market. The cost of inventories is determined principally on the last-in, first-out ("LIFO") method. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment are stated at cost. Depreciation is provided based on the assets' estimated useful lives, principally by the straight-line method. Estimated depreciable lives are as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--Continued. . . INTANGIBLE ASSETS: Intangible assets, principally cost in excess of net assets acquired, noncompete agreements and a trademark, are being amortized on the straight-line basis over periods of 4 to 40 years. MINORITY INTEREST: Minority interest represents the limited partner's allocable share of the Partnership's net assets (see Notes H and J) and the limited partner's allocable share of net assets of South Charleston Stamping & Manufacturing Company ("SCSM"). REVENUE RECOGNITION: Revenues from sales of trailers that are manufactured in response to customers' orders are recorded when such products are completed and invoiced. Finance income is recognized as other income over the term of the finance leases by applying the simple interest method to scheduled monthly collections. Rental income from vehicle leases is recognized as earned. Vehicles are generally leased on a daily or weekly basis to unaffiliated operators. Insurance Subsidiary premiums are recognized as income ratably over the period covered by the policies. Unearned premium reserves are calculated on the monthly pro-rata basis. Realized gains and losses on investments are determined on a specific identification basis and are included in the determination of net income. DEBT ISSUE EXPENSE: Expenses incurred in connection with the issuance of debt are capitalized and amortized as interest expense over the life of the debt. LOSSES AND LOSS ADJUSTMENT EXPENSES: The Insurance Subsidiary's liability for unpaid losses and loss adjustment expenses represents an estimate of the ultimate net costs of all losses which are unpaid at the balance sheet dates, and is determined using case-basis evaluations and statistical analysis. These estimates are continually reviewed and any adjustments which become necessary are included in current operations. Since the liability is based on estimates, the ultimate settlement of losses and the related loss adjustment expenses may vary from the amounts included in the consolidated financial statements. INSURANCE SUBSIDIARY REINSURANCE: During 1993, the Company adopted the provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short Duration and Long Duration Contracts" ("SFAS No. 113"). Because of the type of insurance contracts the Company's Insurance Subsidiary provides, the adoption of this statement had no impact on earnings; however, it requires the disaggregation of various balance sheet accounts. For financial reporting purposes, the 1992 balance sheet and the 1992 and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--Continued. . . 1991 statements of cash flows have been restated as if this statement were adopted as of the beginning of the earliest period presented. RECLASSIFICATION: Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 presentation. NOTE C--TRAILER LEASING OPERATIONS Great Dane, through a wholly-owned leasing subsidiary, leases trailers under operating and sales-type leases ("finance lease receivables"). The following is a summary of the components of the subsidiary's net investment in finance lease receivables (dollars in thousands): Minimum lease payments are receivable as follows: $1.0 million in 1994, $0.3 million in 1995 and $0.4 million in 1996. Trailers subject to operating leases are included in transportation equipment in the accompanying consolidated balance sheets. The cost and accumulated depreciation of such trailers were $0.5 million and $0.2 million, respectively, at December 31, 1993, and $1.5 million and $0.6 million, respectively, at December 31, 1992. NOTE D--INVENTORIES Inventories are summarized below (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE D--INVENTORIES--Continued. . . Inventories would not differ materially if the first-in, first-out costing method were used for inventories costed by the LIFO method. NOTE E--PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are summarized below (dollars in thousands): NOTE F--INVESTMENTS Insurance Subsidiary investments, which are generally reserved for Insurance Subsidiary operations, are as follows (dollars in thousands): The amortized cost, gross unrealized gains and losses and estimated market values of fixed-maturity investments held by the Insurance Subsidiary as of December 31, 1993, are as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE F--INVESTMENTS--Continued. . . The amortized cost and estimated market value of fixed-maturity investments at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds from sales of fixed-maturity investments were $57.2 million for 1993 and $21.7 million for 1992. Gross gains of $1.2 million and gross losses of $0.2 million were realized during 1993 and gross gains of $0.6 million and no gross losses were realized on those sales during 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE F--INVESTMENTS--Continued. . . Bonds with an amortized cost of $2.2 million at December 31, 1993, were on deposit to meet certain regulatory requirements. Realized gains (losses) for 1993, 1992 and 1991, including other than temporary declines in market value and unrealized appreciation (depreciation) on fixed maturities and equity security investments of the Insurance Subsidiary, are summarized as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE G--BORROWINGS Long-term debt is summarized below (dollars in thousands): Interest on the $132 million face value of 12-3/4% Senior Subordinated Debentures is payable semiannually at the stated rate. The recorded debt discount is being amortized as interest expense over the expected life of the debentures using an imputed interest rate of approximately 15% compounded semiannually. Under the terms of the debentures, the Company's payment of dividends is limited to, among other things, 50% of consolidated net income subsequent to June 30, 1986, plus $12 million. At December 31, 1993, the Company was restricted from paying a dividend. The debentures are redeemable at the option of the Company in whole or in part at a decreasing premium. The debentures are subject to redemptions through a sinking fund whereby the Company is required to make five annual sinking fund payments of $18 million commencing August 1, 1996, with the final payment due August 1, 2001. Interest on the $61 million face value of 14-1/2% Subordinated Discount Debentures is payable semiannually at the stated rate. The recorded debt discount is being amortized as interest expense over the expected life of the debentures using an imputed interest rate of approximately 16.7% compounded semiannually. The 14-1/2% debentures are subject to redemption through a sinking fund whereby the Company is required to redeem, at their face value, on January 1 in each of the years 1997 through 2005, 7-1/2% of the principal amount of the debentures outstanding on January 1, 1997. The balance of debentures are due January 1, 2006. The debentures are callable NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE G--BORROWINGS--Continued. . . any time at their face value and are subordinated to all present or future indebtedness of the Company not expressly subordinated to, or on a parity with, the debentures. The notes payable to shareholders are due September 30, 1997, or upon the earlier payment in full of obligations under both the 1992 Partnership Loan and Guaranty Agreement and the 1990 Great Dane loan and security agreement and bear interest payable quarterly in arrears at an annual rate equal to the prime rate of a New York bank (5.5% at December 31, 1993) plus 3-1/2%. In March 1990, Great Dane entered into a five year loan and security agreement ("Agreement") with certain banks. The Agreement made available to Great Dane a $33 million five-year term loan and a $47 million revolving credit line. In 1993, the maximum revolving credit line was increased to $65 million. The amount available under the revolving credit line is based upon the amount of Great Dane's eligible trade accounts receivable and inventory as defined in the Agreement. The additional amount available under the revolving credit line under the borrowing base terms of the Agreement totaled $32.3 million at December 31, 1993. The term loan is payable in equal monthly installments of $0.34 million plus interest at the bank's prime interest rate (6% at December 31, 1993) plus 1-1/2%, with the balance due in March 1995. The revolving credit line is due in 1995 and requires interest payments at the bank's prime rate (6% at December 31, 1993) plus 1-1/2%. All borrowings under the Agreement are fully secured by substantially all of the Great Dane assets not pledged elsewhere. The Agreement requires Great Dane to, among other things, comply with certain financial covenants, and limits additional loans to the Company, limits additions to and sales of Great Dane's fixed assets and limits additional Great Dane borrowings. Under the most restrictive covenant, no additional transfers of funds to the Company are available until after December 31, 1993. During 1992, the Partnership entered into a Loan and Guaranty Agreement with a bank pursuant to which the bank provided a $30 million term loan to the Partnership. The term loan requires twenty quarterly principal payments of $1.5 million, plus interest at the bank's prime rate (6% at December 31, 1993) plus 1-1/4%, which payments commenced December 31, 1992. The term loan is secured by substantially all of the Partnership's assets, excluding the stock of the Insurance Subsidiary. The term loan agreement, which is guaranteed by Checker, requires Checker to, among other things, comply with certain financial covenants and limits additional loans to Checker. The equipment term loan requires quarterly payments of $0.5 million plus interest at the bank's prime rate (6% at December 31, 1993) plus 1-1/4%. The obligation is secured by certain machinery and equipment with a net carrying amount of $6.5 million at December 31, 1993. In connection with the Partnership term loan and the equipment term loan, Checker is required to comply with certain financial covenants. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE G--BORROWINGS--Continued. . . The economic development term loan, which is guaranteed by Checker, is payable by SCSM to the West Virginia Economic Development Authority, and requires monthly payments of $0.1 million, including interest at 5% with the unpaid balance due 2008. The interest rate will be adjusted in April 1998 and 2003, so as to remain equal to 75% of the base rate, as defined, plus 1/2%. The loan is secured by certain machinery and equipment with a net carrying amount of $25.1 million at December 31, 1993. The installment notes are secured by the Company's finance lease receivables and by the Company's rights under certain operating leases. The notes bear interest at various fixed rates averaging approximately 10.9% and are payable in varying monthly installments through 1995. Maturities of long-term debt for the four years subsequent to 1994 are as follows: $44.4 million in 1995, $9.1 million in 1996, $54.1 million in 1997 and $19.6 million in 1998. Interest paid totaled $39.8 million in 1993, $42.4 million in 1992 and $43.3 million in 1991. SCSM has a line of credit with a bank totaling $7.5 million at December 31, 1993. Borrowing under the line ($5.0 million at December 31, 1993) bears interest at the bank's prime rate (6% at December 31, 1993) plus 1%. The Partnership has a $5.0 million line of credit with a bank. Borrowings under the line ($0 at December 31, 1993) bear interest at the bank's prime rate (6% at December 31, 1993) plus 1%. In February 1994, the Company filed a Registration Statement on Form S-1 with the Securities and Exchange Commission in connection with an overall refinancing of the Company's outstanding indebtedness. The proposed refinancing, as described in the registration statement, involves the Company entering into a credit facility consisting of a $60 million term loan and a revolving credit facility which would provide up to $115 million, subject to the Company's ability to meet certain financial tests (the term loan and the revolving credit facility being known as the "New Credit Facility"). Additionally, the Company is proposing to offer $265 million (adjusted from $225 million) of new Senior Secured Notes (the "Senior Notes"). If the refinancing is successfully completed, the proceeds from the new Credit Facility would be utilized to redeem substantially all of the currently outstanding indebtedness of the Company's subsidiaries and the proceeds from the offering of the Senior Notes would be used to redeem parent company indebtedness and to redeem the Minority Interest held by ELIC, in each case together with any accrued interest and transaction fees and expenses. A successful completion of the refinancing, the terms of which are still subject to change, is expected to help the Company achieve increased liquidity from reduced principal debt amortization requirements, the removal of certain restrictions on the use of cash from the Company's subsidiaries and more flexible and efficient cash management at the holding company level. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE H--COMMITMENTS AND CONTINGENCIES On February 8, 1989, the Boeing Company ("Boeing") filed a lawsuit naming the Company, together with three prior subsidiaries of the Company, as defendants in Case No. CV89-119MA, United States District Court for the District of Oregon. In that lawsuit, Boeing sought damages and declaratory relief for past and future costs resulting from alleged groundwater contamination at a location in Gresham, Oregon, where the three prior subsidiaries of the Company formerly conducted business operations. On December 22, 1993, the Company entered into a settlement with Boeing, settling all claims asserted by Boeing in the lawsuit. Pursuant to the settlement terms, the Company will pay Boeing $12.5 million over the course of five years, $5 million of which has been committed by certain insurance companies in the form of cash or irrevocable letters of credit. Accordingly, no further adjustment is necessary to the $7.5 million special charge which was recorded in the quarter ended June 30, 1993, to provide for the cost associated with this legal proceeding. In accordance with the settlement agreement, Boeing will move to dismiss its claims against the Company and the three former subsidiaries and will release and indemnify the Company with respect to certain claims. On March 4, 1992, Checker received notice that the Insurance Commissioner of the State of California, as Conservator and Rehabilitator of ELIC, a limited partner of the Partnership, had filed an Amendment to the Application for Order of Conservation filed in Superior Court of the State of California for the County of Los Angeles. The amendment seeks to add to the Order, dated April 11, 1991, Checker, the Partnership and Checker Holding Corp. III, a limited partner of the Partnership. The amendment alleges that the action by Checker invoking provisions of the Partnership Agreement that alter ELIC's rights in the Partnership upon the occurrence of certain events is improper and constitutes an impermissible forfeiture of ELIC's interest in the Partnership and a breach of fiduciary duty to ELIC. The amendment seeks (a) a declaration of the rights of the parties in the Partnership and (b) damages in an unspecified amount. The Partnership believes that it has meritorious defenses to the claims of ELIC. The Partnership has been in litigation on these issues for almost three years with each party seeking, among other things, a declaration of its rights under the Partnership Agreement. The Company has offered to redeem ELIC's minority interest in the Partnership and SCSM for $32 million. If ELIC's rights under the Partnership Agreement had not been altered, net income for 1993, 1992 and 1991 would have been reported at $0.6 million, $0.7 million and $3.3 million less, respectively, than the amounts reported (see Note J). In 1988, Great Dane entered into an operating agreement with the purchaser of a previously wholly-owned finance company ("Finance"). Under the terms of the agreement, the purchaser is given the opportunity to finance certain sales of Great Dane. The 1988 operating agreement requires that Great Dane, among other things, (i) not finance the sale of its products for the first eight years and (ii) maintain a minimum net worth as defined in the agreement. In addition, under this operating agreement, Great Dane is liable to the purchaser for 50% of losses incurred in connection with the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE H--COMMITMENTS AND CONTINGENCIES--Continued. . . realization of certain new receivables financed by the purchaser subsequent to the sale of Finance subject to certain maximums. Failure to comply with these requirements of the agreement would result in Great Dane having to repay the purchaser varying amounts reducing to $5 million during the year ending September 8, 1996. At December 31, 1993, Great Dane was in compliance with the provisions of the operating agreement. In addition, the Company's installment notes are payable to Finance. At December 31, 1993, the Company was directly liable for the installment notes and has guaranteed the realization of receivables of approximately $4.8 million in connection with the sale of Finance and is partially responsible for the realization of new receivables of approximately $121.3 million financed by the purchaser under the operating agreement subject to certain maximums. In addition to Great Dane's guarantee, these receivables are also collateralized by a security interest in the respective trailers originally sold by Great Dane. A loss reserve of $3.1 million, for potential losses that may be incurred on the ultimate realization of these receivables, is included in other accrued liabilities in the December 31, 1993, consolidated balance sheet. To secure certain obligations, the Company and its subsidiaries had outstanding letters of credit aggregating approximately $3.4 million at December 31, 1993, and $9.3 million at December 31, 1992, which letters of credit were fully secured by cash deposits included in other assets in the consolidated balance sheets. In addition, Great Dane has standby letters of credit aggregating approximately $7.5 million outstanding at December 31, 1993. The Company and its subsidiaries lease real estate and equipment. Certain leases are renewable and provide for monthly rentals, real estate taxes and other operating expenses. The Company believes that, in the normal course of business, leases that expire will be renewed or replaced by other leases. Rental expense under operating leases was approximately $4.8 million in 1993, $3.8 million in 1992 and $3.6 million in 1991. Minimum rental obligations for all noncancelable operating leases at December 31, 1993 are as follows: $2.9 million in 1994, $2.7 million in 1995, $2.6 million in 1996, $2.5 million in 1997, $2.4 million in 1998 and $16.5 million thereafter. Management believes that none of the above legal actions, guarantees or commitments will have a material adverse effect on the Company's consolidated financial position. NOTE I--RETIREMENT PLANS The Company and its subsidiaries have defined benefit pension plans applicable to substantially all employees. The contributions to these plans are based on computations by independent actuarial consultants. The Company's general funding policy is to contribute amounts required to maintain funding standards in accordance with the Employee Retirement NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE I--RETIREMENT PLANS--Continued. . . Income Security Act. Employees' benefits are based on years of service and the employees' final average earnings, as defined by the plans. Net periodic pension cost includes the following components (dollars in thousands): During 1991, as a result of the effect of the continued economic recession on the automotive industry, the number of active pension plan participants in one of the subsidiaries' defined benefit plans was substantially reduced during 1991, resulting in a $0.5 million curtailment loss. Gains and losses and prior service cost are amortized over periods ranging from seven to fifteen years. Other assumptions used in the calculation of the actuarial present value of the projected benefit obligation were as follows: The following table sets forth the plans' funded status and amounts recognized in the Company's consolidated balance sheets (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE I--RETIREMENT PLANS--Continued. . . Relative positions and undertakings in multiemployer pension plans covering certain of the Partnership's employees are not presently determinable. Expense related to defined contribution plans, which is based on a stipulated contribution for hours worked or employee contributions, approximated $0.7 million in 1993, $0.5 million in 1992 and $0.4 million in 1991. The Company and its subsidiaries provide postretirement health care and life insurance benefits to eligible retired employees. The Company's policy is to fund the cost of medical benefits as paid. Prior to 1993, the Company recognized expense in the year the benefits were provided. The amount charged to expense for these benefits was approximately $2.5 million in 1992 and $2.0 million in 1991. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions." This statement requires the accrual of the cost of providing postretirement benefits, including medical and life insurance coverage, during the active service period of the employee. The Company recorded a charge of $29.7 million (net of taxes of $16.5 million), or NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE I--RETIREMENT PLANS--Continued. . . $3.29 per share, during 1993 to reflect the cumulative effect of this change in accounting principle. The following table sets forth the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheet at December 31, 1993 (in thousands): Net periodic postretirement benefit cost for the year ended December 31, 1993, includes the following components (in thousands): The health care cost trend rate ranges from 13.6% down to 5.0% over the next 14 years and remains level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $4.0 million. The weighted- average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% at December 31, 1993. The effect of adopting SFAS No. 106 decreased 1993 pre-tax income by $2.0 million as compared to 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE J--MINORITY EQUITY On April 11, 1991, ELIC was placed in conservatorship. In accordance with the provisions of the Partnership Agreement, the Partnership continues, but ELIC's interest in the Partnership and rights under the Partnership Agreement are limited to the right to receive the balance of its capital account as calculated and on the terms set forth in the Partnership Agreement. For financial reporting purposes, partnership earnings had previously been allocated to ELIC's capital account based on book income and the minority equity amount was calculated accordingly (the "GAAP Capital Account Amount"). The Partnership Agreement, however, provides for allocations of the partnership earnings to ELIC's capital account on a basis that differs from book income and calculation of the minority equity amount thereunder is to be made accordingly (the "Partnership Agreement Capital Account Amount"). Because the provisions of the Partnership Agreement require that ELIC's capital account be fixed and calculated as of April 11, 1991, minority equity for the year ended December 31, 1991, includes a $2.3 million credit representing the adjustment of ELIC's capital account from the GAAP Capital Account Amount as of April 11, 1991, to the Partnership Agreement Capital Account Amount as of the same date (the "Final Capital Account"). The Final Capital Account, which totaled $40.1 million at December 31, 1993, is being paid out in level quarterly installments of $0.9 million, including interest at 7% per annum, through the year 2013. NOTE K--INCOME TAXES Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years financial statements have not been restated. The Company recorded a charge of $16.9 million, or $1.87 per share, during 1993 to reflect the cumulative effect of this change in accounting principle. Application of FAS 109 decreased 1993 pre-tax income by approximately $1.5 million primarily because of FAS 109's requirement to record assets acquired in prior business combinations at pre-tax amounts. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1993 are as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE K--INCOME TAXES--Continued. . . The components of income tax benefit (expense) before extraordinary items are as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE K--INCOME TAXES--Continued. . . The components of the deferred tax benefit (expense) are as follows (dollars in thousands): Income tax benefit (expense) differs from the amount computed by applying the statutory federal income tax rate to income (loss) before income taxes and extraordinary items. The reasons for these differences are as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE K--INCOME TAXES--Continued. . . Income taxes paid totaled $13.4 million in 1993, $3.9 million in 1992 and $8.6 million in 1991. NOTE L--EXTRAORDINARY ITEMS During 1991, the Company repurchased $66.2 million face value ($58.7 million net carrying value) of the 14-1/2% Subordinated Discount Debentures at an average cost of 36% of face value. Additionally, the Company repurchased $7.6 million face value ($6.8 million net carrying value) of the 12-3/4% Senior Subordinated Debentures at an average cost of 40% of face value. The resulting gain of $23.2 million on these repurchases, net of taxes of $14.8 million, has been classified as an extraordinary item. Upon the completion of the Corporation's 1990 federal income tax return, management elected to treat certain extraordinary gains under an alternative election available under the Internal Revenue Code, which resulted in these gains, on which deferred income taxes had been provided in prior periods, not being subject to tax. This change in estimate had the effect of increasing the extraordinary gain and net income by $8 million in the year ended December 31, 1991 resulting in a total gain of $31.2 million. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE M--RELATED PARTY TRANSACTIONS An officer of Checker is the owner of a taxicab association established in 1988 in the City of Chicago to which both Company affiliated and independent taxi drivers may belong for a fee, and through which the members may obtain automobile liability insurance from the Insurance Subsidiary and other maintenance and rental services. The association purchases services from various Checker operations and reimburses the operations for certain management, general and administrative costs. Amounts received from the association totaled $4.4 million in 1993, $3.3 million in 1992 and $2.6 million in 1991. At December 31, 1993, Checker has guaranteed certain of the association's obligations totaling $0.7 million. The Company leases an airplane owned by a corporation of which a director is the sole shareholder. Lease expenses totaled $0.7 million each year in 1993, 1992 and 1991. Each of the Company's directors provides consulting services. Annual expenses incurred relating to these consulting services totaled $1.4 million each year in 1993, 1992 and 1991. NOTE N--INDUSTRY SEGMENT INFORMATION The Company operates in four principal segments: TRAILER MANUFACTURING SEGMENT--Manufacturing and distribution of highway truck trailers. AUTOMOTIVE PRODUCTS SEGMENT--Manufacturing metal stampings and assemblies and coordination of related tooling production for motor vehicle manufacturers. VEHICULAR OPERATIONS SEGMENT--Leasing taxicabs. INSURANCE OPERATIONS SEGMENT--Providing property and casualty insurance coverage to the Partnership and to outside parties. Trailer Manufacturing segment sales to J. B. Hunt totaled approximately $92.3 million in 1993, $50.0 million in 1992 and $1.2 million in 1991. Automotive product net sales to General Motors Corporation totaled approximately $121.5 million in 1993, $109.1 million in 1992 and $80.3 million in 1991 (includes accounts receivable and unbilled tooling charges of $8.9 million, $8.9 million and $5.7 million at December 31, 1993, 1992 and 1991, respectively). Industry segment data is summarized as follows (dollars in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--CONTINUED INTERNATIONAL CONTROLS CORP. AND SUBSIDIARIES NOTE O--FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating the fair value of financial instruments: CASH AND CASH EQUIVALENTS: The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. FINANCE LEASE RECEIVABLES: The fair values of the Company's finance lease receivables are estimated using discounted cash flow analyses based on current market rates for similar types of financing. INDEBTEDNESS: The carrying amounts of the Company's notes payable to shareholders, Great Dane term loan payable, Great Dane revolving credit line, Partnership term loan payable, equipment term loan, economic development term loan and line of credit approximate their fair value. The fair values of the Company's 12-3/4% Senior Subordinated Debentures and 14- 1/2% Subordinated Discount Debentures are based on quoted market prices. The fair values of the Company's other indebtedness is estimated using discounted cash flow analyses based on current market rates. The carrying amounts and fair values of the Company's finance lease receivables and indebtedness at December 31, 1993, are as follows (dollars in thousands): S-1 S-2 S-3 S-4 S-5 S-6 S-7 S-8 S-9 S-10 S-11 The Registrant's subsidiaries declared dividends totaling $22 million in 1993, $120.9 million in 1992 and $13.1 million in 1991. These dividends were declared to offset certain intercompany account balances at the respective dates. S-12 S-13 S-14 S-15 S-16 S-17 E-1 INDEX TO EXHIBITS The following Exhibits required by Item 601 of Regulation S-K (and numbered in conformity therewith) are filed herewith or incorporated by reference herein: 3.1 - Restated Articles of Incorporation of Registrant (incorporated herein by reference to Exhibit 3.1 to Registration Statement No. 033-52255 filed with the Securities and Exchange Commission on February 14, 1994 (the "1994 S-1")). 3.2 - Bylaws of Registrant as effective May 13, 1991 (incorporated herein by reference to Exhibit 3.3 to the 1992 10-K). 4.1 - Form of Indenture between Registrant and First Fidelity Bank, National Association, New Jersey, as trustee, relating to the 12- 3/4% Senior Subordinated Debentures due August 1, 2001 of Registrant (incorporated herein by reference to Exhibit 4.1 to Registration Statement No. 33-7212 filed with the Securities and Exchange Commission on July 15, 1986). 4.2 - Form of Indenture between Registrant and Midlantic National Bank, as trustee, relating to the 14-1/2% Subordinated Discount Debentures due January 1, 2006 of Registrant (incorporated herein by reference to Exhibit 4.1 to Registration Statement No. 33-1788 filed with the Securities and Exchange Commission on November 26, 1985). 4.3 - Agreement to furnish additional documents upon request by the Securities and Exchange Commission (incorporated herein by reference to Exhibit 4.3 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 (the "1989 10-K")). 10.1 - Amended and Restated Agreement of Limited Partnership of the Partnership (incorporated herein by reference to Exhibit 10.17 to the 1989 10-K). 10.2 - Amendment, dated July 28, 1989, to Amended and Restated Agreement of Limited Partnership of the Partnership (incorporated herein by reference to Exhibit 19.1 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 10-K")). 10.3 - Amendment, dated June 25, 1991, to Amended and Restated Agreement of Limited Partnership of the Partnership (incorporated herein by reference to Exhibit 19.2 to the 1991 10-K). 10.4 - Amended and Restated Employment Agreement, dated as of November 1, 1985, between Checker and David R. Markin ("Markin Employment Agreement") (incorporated herein by reference to Exhibit 10.17 to the 1989 10-K). 10.5 - Amendment, dated as of March 4, 1992, to Markin Employment Agreement (incorporated herein by reference to Exhibit 10.3 to the 1991 10-K). E-2 10.6 - Extension, dated July 12, 1993, of Amended and Restated Employment Agreement between Checker and David R. Markin* 10.7 - Amended and Restated Employment Agreement, dated as of June 1, 1992, between Yellow Cab and Jeffrey Feldman (incorporated herein by reference to Exhibit 28.2 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992 (the "June 1992 10-Q"). 10.8 - Form of Stated Benefit Salary Continuation Agreement (incorporated herein by reference to Exhibit 10.17 to the 1989 10-K). 10.9 - Employment Agreement, dated as of July 1, 1992, between Registrant and Jay H. Harris (incorporated herein by reference to Exhibit 28.1 to the June 1992 10-Q). 10.10 - Loan and Guaranty Agreement, dated September 17, 1992, by and among the Partnership, Checker, SCSM and NBD Bank, N.A. (the "Loan and Guaranty Agreement") (incorporated herein by reference to Exhibit 28.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (the "September 1992 10-Q"). 10.11 - First Amendment dated as of November 1, 1993, to the Loan and Guaranty Agreement (incorporated herein by reference to Exhibit 10.11 of the 1994 S-1). 10.12 - Credit and Guaranty Agreement, dated as of August 1, 1989, by and among SCSM, Checker, the Partnership and NBD Bank, N.A. (the "Credit Agreement") (incorporated herein by reference to Exhibit 10.10 to the 1992 10-K). 10.13 - First Amendment, dated as of June 1, 1990, to the Credit Agreement (incorporated herein by reference to Exhibit 10.11 to the 1992 10-K). 10.14 - Second Amendment, dated as of January 2, 1991, to the Credit Agreement (incorporated herein by reference to Exhibit 10.12 to the 1992 10-K). 10.15 - Third Amendment, dated as of November 1, 1993, to the Credit Agreement (incorporated herein by reference to Exhibit 10.15 to the 1994 S-1). 10.16 - Supplemental Agreement, dated as of April 20, 1992, among SCSM, Checker, the Partnership and NBD Bank, N.A. (incorporated herein by reference to Exhibit 10.13 to the 1992 10-K). 10.17 - Second Supplemental Agreement, dated as of September 17, 1992, among SCSM, Checker, the Partnership and NBD Bank, N.A. (incorporated herein by reference to Exhibit 28.2 of the September 1992 10-Q). 10.18 - Lease dated December 1, 1988, between SCSM and Park Corporation (incorporated herein by reference to Exhibit 10.17 to the 1989 10-K). E-3 10.19 - Loan and Security Agreement dated as of March 21, 1990, by and among Great Dane, Great Dane Trailers Indiana, Inc., Great Dane Trailers Nebraska, Inc., Great Dane Trailers Tennessee, Inc., certain lending institutions and Security Pacific Business Credit Inc., as Agent (the "Security Pacific Agreement") (incorporated herein by reference to Exhibit 10.17 to the 1989 10-K). 10.20 - First Amendment, dated as of March 30, 1990, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 19.3 to the 1991 10-K). 10.21 - Second Amendment, dated as of April 30, 1990, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 19.4 to the 1991 10-K). 10.22 - Third Amendment, dated as of August 14, 1990, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 19.5 to the 1991 10-K). 10.23 - Fourth Amendment, dated as of February 28, 1991, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 19.6 to the 1991 10-K). 10.24 - Waiver and Fifth Amendment, dated as of September 3, 1991, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 19.7 to the 1991 10-K). 10.25 - Waiver, Consent and Sixth Amendment, dated April 30, 1992, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 28 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992). 10.26 - Seventh Amendment, dated as of July 10, 1992, to the Security Pacific Agreement (incorporated herein by reference to the June 1992 10-Q). 10.27 - Eighth Amendment, dated as of February 19, 1993, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 10.24 to the 1992 10-K). 10.28 - Waiver, Consent and Ninth Amendment, dated March 26, 1993, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 10.29 to the 1992 10-K). 10.29 - Tenth Amendment, dated as of November 1, 1993, to the Security Pacific Agreement (incorporated herein by reference to Exhibit 10.29 of the 1994 S-1). 10.30 - Assumption Agreement dated as of August 1, 1989, by and between Checker and the West Virginia Economic Development Authority (incorporated herein by reference to Exhibit 10.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10.31 - Agreement, dated as of September 1, 1991, between the Partnership and Jerry E. Feldman (incorporated herein by reference to Exhibit 10.12 to the 1991 10-K). E-4 10.32 - Form of Checker Motors Corporation Excess Benefit Retirement Plan, effective January 1, 1983 (incorporated herein by reference to Exhibit 19.9 to the 1991 10-K). 10.33 - Amended and Restated License Agreement, dated December 30, 1992, between Checker Motors Corporation and Checker Taxi Association, Inc. (incorporated herein by reference to Exhibit 10.28 to the 1992 10-K). 10.34 - Employment Agreement, dated as of January 1, 1994 between Registrant and David R. Markin (incorporated herein by reference to Exhibit 10.34 to the 1994 S-1). 21.1 - Subsidiaries of Registrant.* - ---------------- [FN] *Filed herewith.	17,177	112,381
837486_1993.txt	837486_1993	1993	837486	ITEM 1. BUSINESS THE COMPANY Eagle Industries, Inc. ("Eagle" or the "Company") is a Delaware corporation, its principal executive offices are located at Two North Riverside Plaza, Suite 1100, Chicago, Illinois 60606 and its telephone number is (312) 906-8700. Eagle has grown from revenues of approximately $250 million in 1987 to $1.1 billion for the year ended December 31, 1993. This growth has been generated primarily through acquisitions. Eagle is currently comprised of 16 businesses operating in five segments. These businesses generally are low and medium technology industrial companies in niche markets. They primarily service the residential and commercial construction, electric utility, chemical and pharmaceutical, commercial aviation, automotive aftermarket, consumer yarn and commercial refrigeration markets. From its inception, much of the Company's growth has come from acquisitions. The Company's acquisition philosophy has been to acquire "underperforming" manufacturing companies that have the potential to become market leaders and low cost producers through the application of Eagle's cost reduction and quality improvement strategies. Eagle generally has sought companies that serve basic industrial niche markets. To enhance its position within these market niches, the Company has pursued and completed over 21 "add-on" acquisitions to profitably expand product lines and geographical scope. Eagle has also divested 16 businesses for total proceeds of over $500 million. A substantial portion of these proceeds were used to reduce debt levels. HISTORY In February 1987, Great American Management and Investment, Inc. ("GAMI") consolidated its basic manufacturing businesses by capitalizing Eagle with Lapp Insulator Company ("Lapp") and various businesses which were previously a part of Clevepak Corporation ("Clevepak"). In April 1987, Eagle purchased The Pfaudler Companies, Inc. ("Pfaudler") and in February of 1988, Eagle purchased The DeVilbiss Company ("DeVilbiss"). In September 1989, Eagle purchased Amerace Corporation ("Amerace"), and certain indirect subsidiaries of GAMI acquired The Jepson Corporation ("Jepson"). In January 1991, GAMI, through its subsidiaries, contributed Jepson to Eagle and concurrent with becoming a subsidiary of Eagle, Jepson changed its name to Falcon Manufacturing, Inc. ("Falcon"). Effective as of September 25, 1992 GAMI, and its subsidiaries consummated a restructuring (the "Restructuring"). Pursuant to the Restructuring, among other things, (i) Eagle sold the net assets of Equality Specialties, Inc. ("Equality") to GAMI for approximately $17 million; (ii) GAMI contributed, through certain subsidiaries, all of the outstanding stock owned by it in North Riverside Holdings, Inc. ("North Riverside") to Eagle; (iii) Eagle declared a stock dividend to facilitate the Distribution, as defined below (the effect of which was negated by a reverse stock split in December 1993); and (iv) Great American Financial Group, Inc. (formerly Great American Industrial Group, Inc.) ("GAFG") distributed all of the outstanding Eagle common stock owned by it to GAMI. For a discussion of the accounting treatment of the foregoing transactions, see Note 1 and Note 12 to the Eagle Industries, Inc. and Subsidiaries Consolidated Financial Statements ("Eagle Consolidated Financial Statements"). On September 25, 1992, the Board of Directors of GAMI authorized the distribution of all of the outstanding shares of Eagle common stock, $.01 par value per share (the "Eagle Common Stock"), to holders of GAMI common stock (the "Distribution"). On October 29, 1992, the GAMI Board of Directors delayed the consummation of and on October 13, 1993 decided not to complete the Distribution. BUSINESS Eagle is currently comprised of 16 businesses operating in five business segments. The five business segments are: the Building Products Group, the Electrical Products Group, the Industrial Products Group, the Automotive Products Group and the Specialty Products Group. These businesses generally are low and medium technology, industrial companies in niche markets. They primarily service the residential and commercial construction, electric utility, commercial aviation, chemical and pharmaceutical, automotive aftermarket, craft and consumer yarn and commercial refrigeration markets. See Note 16 to the Eagle Consolidated Financial Statements for financial information regarding industry segments and geographic data. BUILDING PRODUCTS GROUP The Building Products Group consists of three businesses which manufacture and distribute building products primarily for the residential and commercial construction and home improvement markets. Products manufactured by this group include air distribution and handling equipment, bathroom plumbing fixtures and light-duty air compressors. The building products industry relies primarily on the residential and commercial construction markets. The residential construction market is largely dependent on housing starts and remodeling/do-it-yourself ("DIY") projects. Housing starts and remodeling/DIY projects are generally a function of new household formation, mortgage rates, inflation, unemployment and gross national product growth. Since fiscal 1990, the decline in residential housing starts resulted in excess manufacturing capacity and pricing pressures in this industry. More recently, this trend has started to reverse as a result of lower mortgage rates and improved consumer confidence. The Company believes that future growth in revenue and earnings for companies operating in this industry is dependent upon the housing and construction markets in North America, increased international business, quality and customer service, and further market penetration with new products and within niches. Air Distribution and Handling Equipment Hart & Cooley is a manufacturer of residential and commercial air distribution and air handling products in the North American market. Hart & Cooley manufactures more than 6,000 items primarily for the residential and, to a lesser extent, commercial heating ventilating and air conditioning ("HVAC") markets, including metal grilles, registers and diffusers, metal and plastic chimney vent systems, flexible ducts, terminal units and electric duct heaters. Products are generally produced on a high-volume, low cost basis, however, the standard product line is supplemented with custom-engineered products designed to meet specific size or performance requirements. Residential and commercial products are marketed to HVAC contractors primarily through wholesale distributors. In order to provide high quality service and convenience to HVAC contractors, the Company services its distribution network through a direct field sales staff which is supported by a customer service group located at Hart & Cooley's headquarters. These products are marketed under the Hart & Cooley(R), Metlvent(R) and Ultravent(R) trade names. Commercial/industrial registers, grilles, diffusers, terminal units, louvers and electric duct heaters are marketed primarily to HVAC contractors through manufacturers' representatives under the Tuttle & Bailey(R) trade name. Key competitive considerations in the HVAC market are delivery time, quality and proximity to distributors. Bathroom Plumbing Fixtures Mansfield is a manufacturer of ceramic, vitreous china and enameled steel bathroom plumbing fixtures, including lavatories, toilet bowls and tanks and brass and plastic fittings. These products are sold primarily to the residential construction markets and, to a lesser extent, to commercial markets. Mansfield competes primarily with regional manufacturers, and to a lesser extent with national manufacturers. Management believes that there are approximately eight other regional competitors. Mansfield's emphasis on quality control and customer service has enabled it to charge slightly higher prices for its products. As part of the Energy Policy Act of 1992, the manufacture of 3.5 gallon per flush toilets for residential use is prohibited after January 1, 1994. In the past three years, Mansfield has introduced four new models of ceramic toilet bowls which use 1.6 gallons per flush, approximately 55% less than the average water volume used per flush in existing toilet bowls, while still preserving the simplicity of conventional plumbing fixtures. Ceramic bathroom fixtures and brass and plastic fittings are marketed through manufacturers' representatives to plumbing wholesalers and plumbing fixture manufacturers, and to the retail hardware and DIY markets through wholesalers, packagers, and mass merchants. The market is divided into: manufacturers that distribute nationally, service all market segments and have broad product lines; and regional manufacturers that distribute regionally, tend to emphasize marketing at the wholesale level and have narrower product lines. Air Products DeVilbiss Air Power is a North American supplier of light-duty air compressors for the commercial and consumer, building and construction markets. DeVilbiss Air Power manufactures a broad line of portable and stationary air compressors in the 3/4 to 6 horsepower range and also sells a variety of accessories such as paint spray guns, air hoses, pneumatic tools and other related items. DeVilbiss Air Power's products are primarily used for painting, stapling and nailing applications for home improvement and building. DeVilbiss Air Power was the first company to introduce oil-free technology to light-duty air compressors, and since 1979 has been the primary supplier of Craftsman(R) air compressors to Sears Roebuck & Company ("Sears"). Sales to Sears account for a significant amount of the sales of the Building Products Group. Eagle restructured DeVilbiss Air Power in 1989 by constructing a new manufacturing facility in Jackson, Tennessee. In fiscal 1991, DeVilbiss Air Power acquired the Energair division ("Energair") of the Ingersoll-Rand Company, whose strong market position in the home center and warehouse club outlets, has strengthened DeVilbiss Air Power's position in the DIY and refurbishing markets under such trade names as Charge Air Pro(R), Air America(R) and Pro Air II(R). DeVilbiss Air Power also manufactures air compressors under private-label programs, which has further expanded its customer and distribution base. ELECTRICAL PRODUCTS GROUP The Electrical Products Group consists of two broad groups of businesses, those providing electrical power distribution products for the electric utility market and those supplying electrical control products for electrical equipment manufacturers. The principal products manufactured by these businesses include medium voltage electric cable, underground cable accessories, and interconnect and timing devices. The electrical products industry is largely dependent on utility transmission and distribution expenditures, new construction and spending levels of those manufacturers who supply electrical equipment to the utility industry. Spending for utility transmission equipment has been at historically low levels for the last several years and has not yet begun to improve. This has resulted in excess industry capacity and continued pricing pressures. Eagle believes that future growth in revenue and earnings in this industry is largely dependent on increased electric utility capital spending from the currently depressed levels and further recovery of the residential and commercial construction markets in North America. Electrical Power Distribution Products Major products manufactured by these businesses for the electrical power distribution market include: Elastimold's pre-molded terminators, separable connectors, cable joints and surge arrestors for underground power distribution systems; and Hendrix's residential power distribution cables, aerial cable systems and medium voltage accessory products. Elastimold is a designer, manufacturer and marketer of underground medium and high voltage cable accessories for the electric utility industry in North America. The majority of Elastimold's products are used for power distribution systems and are related to housing starts. Elastimold has established joint ventures and partnerships in Europe and Asia to increase Elastimold's distribution base. These businesses market their products through a number of distribution channels, including manufacturers' representatives, original equipment manufacturers and authorized distributors, as well as through a direct sales staff. Elastimold's electrical products are marketed directly to North American, Canadian and European electric utilities through a direct sales staff, manufacturers' representatives and authorized distributors. Elastimold also maintains a world-wide presence through joint ventures in western Europe, Japan and Taiwan. Hendrix markets its products primarily to electric utilities and electrical equipment manufacturers through a network of manufacturers and distributors. Since the electrical power distribution products are used primarily in the transmission and distribution of electricity, their operating performance depends in part on the demand for residential and commercial construction. Although not heavily dependent upon the construction of new power plants, these companies' business prospects are closely tied to the electric utility industry. Industrial Electrical Products Eagle's Industrial Electrical Products Group consists of four businesses, hereinafter referred to as IEP. These businesses provide products that serve a wide variety of markets with a number of recognized names such as: Agastat(R) timers and protective relays; Buchanan(R) electrical terminal blocks and electronic connectors; Russellstoll(R) medium to high amperage electrical connectors; pin and sleeve plug and receptacle connector devices for the world-wide refrigerated container industry. In addition, these businesses manufacture and distribute airfield transformers, connector kits and cable assemblies. The product lines are sold through an extensive distributor network, supplemented with direct sales to original equipment manufacturers and to end users in the United States, Canada, the United Kingdom and Europe. Eagle has undertaken an extensive cost reduction program since acquiring the IEP companies in 1989. As a major part of that plan, Eagle relocated one of IEP's principal manufacturing facilities from New Jersey to Florida in the first quarter of 1993 in order to improve productivity and quality control, enhance manufacturing efficiencies and increase labor flexibility. INDUSTRIAL PRODUCTS GROUP The Industrial Products Group consists of three businesses that manufacture and distribute products for the chemical/pharmaceutical, process industries and commercial aviation markets. Products manufactured and distributed include reactor and storage vessels, fluid mixing and agitation equipment and commercial airline seating. The chemical process industry is largely dependent on capital expenditures by chemical and pharmaceutical producers. Domestically, capital spending over the past few years has been less than anticipated by published industry forecasts. However, the pharmaceutical segment of the chemical process industry has shown continued growth. Both domestically and in Europe, Eagle's business is focused on the pharmaceutical segment. Eagle's operations in Europe continue to be negatively affected by the depressed economy in Germany. The financial difficulties experienced by the domestic airline industry have resulted in a reduction in capital spending for commercial aircraft and associated equipment. However, Burns Aerospace ("Burns") derives approximately 65% of its aviation business from the foreign aviation market, which has not been as adversely affected as the domestic industry. Eagle believes that future revenue and earnings growth for the Industrial Products Group is largely dependent on worldwide capital spending in the chemical and aviation industries. Process Industries Products Major products manufactured for the process industries markets include: lined and coated reactor and storage vessels, heat exchangers, mixers and evaporators, columns and accessories, and agitators and static mixers. Pfaudler is a producer of glass-lined reactor and storage vessels, which are custom-ordered and designed for use in the chemical and pharmaceutical industries. Pfaudler's sales exceed those of its major competitor. Pfaudler's products are manufactured in six facilities operating in the United States, the United Kingdom, Germany, Mexico, Brazil and a joint venture interest in India. This arrangement allows Pfaudler to respond quickly to market demands for both sales and service. Replacement parts and service represent a significant portion of revenues. Pfaudler's products are available in a broad range of construction materials, such as glass-lined steel fluoropolymers, exotic metals and alloys. These vessels, together with accessories such as agitators and baffles, are marketed under the trade name Glasteel(R). In pharmaceutical applications, Glasteel(R) protects the color and purity of the products being processed. Chemineer is a designer, manufacturer and distributor of agitators and static mixers for fluid processing applications, which range from sophisticated polymerization and fermentation processes to simple storage operations. Chemineer's products include its line of HT Series turbine agitators, which use rotary action to produce motion in a fluid; side-entering agitators; static mixers, which are continuous mixing and processing devices with no moving parts; and small portable agitators. Competition is based primarily on application engineering and customer service. Replacement parts and service account for a significant portion of revenues. Chemineer's products are used in the chemical, pharmaceutical, paint, coatings, petrochemical, food processing and water treatment industries. Chemineer's products are marketed worldwide to a diverse customer base, with products being sold primarily through manufacturers' representatives and sales representative organizations. Chemineer also maintains direct sales offices in Houston, Texas, the United Kingdom and the Netherlands. Chemineer established a research and development facility to focus on the development of new products and on applied research. Chemineer recently has introduced computer technology to perform on-site customized application engineering. Commercial Aviation Products Burns manufactures and refurbishes commercial airline seating, including passenger, observer and flight attendant seating. In addition, Burns manufactures various spare parts, including seat cushions and covers for aftermarket sale in the commercial aircraft markets. Burns sells its Innovator(R), Airest(R) 5, Airest(R) 202 and Airest(R) Commuter seating products primarily to the major air carriers in the United States and Europe. Over the past four years, Burns has been able to successfully diversify its customer base from a domestic regional orientation to an international mix. Burns derives approximately 65% of its new seat revenues from foreign carriers. AUTOMOTIVE PRODUCTS GROUP Eagle has three primary businesses which serve various sectors of the automotive aftermarket: Mighty Distributing System of America ("Mighty"), The Parts House ("Parts House") and Denman Tire ("Denman"). Major products produced and/or distributed to the automotive markets include: automotive parts and accessories and specialty pneumatic tires. Clevaflex manufactures and distributes multi-ply flexible tubing for carburetor air ducts to original equipment manufacturers in the automotive market. Mighty and Parts House distribute automotive parts and accessories principally throughout the United States. Mighty is an owner and operator of automotive parts franchise operations and has over 150 franchises nationwide and one distribution center that sell automotive parts in the aftermarket to professional dealers and installers. Mighty also markets new territories and re-markets existing territories to generate franchise fee revenues. Mighty repackages and distributes Mighty private label auto parts to franchisees and other company locations, and owns and operates nine locations directly. Parts House, headquartered in Jacksonville, Florida, is a wholesale distributor of nationally branded automotive parts and accessories serving primarily the Southeast region of the United States and operates through three principal distribution centers. Denman manufactures and distributes over 1,000 different types of specialty pneumatic tires, including tires for classic and racing automobiles, all-terrain vehicles, motorcycles, light and medium duty trucks and farm, mining and other industrial vehicles. Denman's products are marketed nationally under both the Denman brand name and the private label names of certain Denman customers. Denman distributes its tires primarily through five major wholesale distributors, and services its customers through a direct sales force. Substantially all of Denman's sales are to the replacement tire market. Clevaflex manufactures and distributes multi-ply, flexible tubing for carburetor air ducts used in automobile emission systems and other automotive-engine compartment applications. Clevaflex has a direct sales force which distributes its products to original equipment manufacturers in the automotive markets. Approximately 80% of Clevaflex's sales are made directly to domestic automobile manufacturers, including General Motors Corporation, Ford Motor Company and Chrysler Corporation, with additional sales to certain foreign automobile manufacturers for use in models produced in the United States. SPECIALTY PRODUCTS GROUP The Specialty Products Group consists of businesses which manufacture and distribute commercial refrigeration equipment and consumer products. Businesses within the group manufacture refrigerated display cases and hand knitting and craft yarns. In addition, the group includes a designer and distributor of ski and rugged outerwear. The Specialty Products Group is largely dependent on trends in consumer spending and overall consumer confidence. The Company believes that future growth in revenue and earnings for the Specialty Products Group is dependent on consumer spending. Commercial Refrigeration Equipment Hill Refrigeration ("Hill") manufactures commercial refrigeration equipment, including refrigeration and non-refrigeration display cabinets, condensing units and refrigeration systems, and related equipment for sale to food retailers. Principal products in this market include refrigerated display cases that merchandise and protect perishables such as meat, deli products, frozen foods, dairy products and produce. To enhance manufacturing efficiencies, cases are configured to use common design parts and are produced in two basic lengths. However, to meet specific needs of the customer, Hill offers many options and special accessories. In addition, because energy efficiency is a significant consideration in case purchases, Hill offers sophisticated controls and patented features to reduce operating costs for its customers. Hill equipment is sold through a direct sales force to leading supermarket chains, food wholesalers and government commissaries. Smaller food chains are serviced through a network of independent distributors who buy and re-sell equipment. In 1993, the Company closed Hill's Canadian facility and consolidated those operations with its Trenton, New Jersey facility. In an effort to reduce manufacturing costs and to simplify manufacturing processes, Hill initiated a project to redesign its commercial refrigeration cases in 1993. This redesign has led to a decision to restructure Hill's Trenton, New Jersey manufacturing facility. Accordingly, in 1993, the Company reduced the book value of its Trenton, New Jersey plant by approximately $20 million as it reviews relocation options. Consumer Products Eagle has two businesses which serve various consumer markets: Gerry Sportswear ("Gerry") and Caron International ("Caron"). Gerry designs and markets ski and rugged outerwear. Caron is a manufacturer and distributor of acrylic hand knitting and craft yarns and a producer of craft kits. The yarn products include a broad line of acrylic fibers in a wide assortment of weights and colors with varying textures. Craft kits are sold under the Wonder Art(R) name and include latch hook, stamped goods, craft dolls and yarn kits. Caron markets its yarn products and craft kits directly to major retailers through its own sales force. Caron's customer base includes all major distribution channels, including mass merchants, chain stores, fabric stores and craft and specialty stores. As part of a cost reduction program which the Company undertook in 1993, Caron closed its London, Kentucky manufacturing facility, consolidating the London operation into its other locations. COMPETITION Eagle faces competition in each of the various product lines from numerous firms within the United States and internationally. Businesses within the Building Products Group, the Electrical Products Group, Automotive Products Group and the Specialty Products Group compete primarily with several domestic competitors in their various markets. Pfaudler competes primarily with one major competitor on a world-wide basis. The other businesses within the Industrial Products Group compete primarily with several domestic competitors in their various markets. Eagle strives to position its businesses as market leaders, desiring to achieve a position as one of the top three suppliers in each of the individual markets which its businesses serve. Eagle's businesses compete with other companies on the basis of price, service, product quality, availability and delivery. Certain of Eagle's competitors are larger and have greater financial resources than Eagle. SEASONALITY, WORKING CAPITAL AND CYCLICALITY Sales of certain of Eagle's products are subject to seasonal variation. Seasonal factors historically have not had a significant affect on working capital requirements as Eagle has been able to adjust its production to meet these seasonal demands. Sales of products manufactured within the Building Products Group are primarily dependent on residential and commercial construction markets and home improvement. Sales of certain products manufactured within the Electrical Products Group are also dependent on the construction industry. Due to seasonal factors associated with the construction industry, sales of these products are higher during the spring and summer building seasons than at other times of the year. Most of the industries in which the Company competes are particularly sensitive to changes in the economy. The nation's most recent recession had an adverse impact on the Company's sales and profitability. Future downturns in the economy would negatively affect the Company's operating results. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." RAW MATERIALS, SUPPLIERS AND CUSTOMERS Eagle purchases raw materials, principally steel, aluminum, alloy metals, clay and other supplies from numerous domestic and foreign suppliers. These raw materials and other supplies are generally available. Eagle's businesses market their products to numerous domestic and foreign customers. As previously discussed, Sears accounts for a significant amount of sales in the Building Products Group, however, this amount is not significant to Eagle's consolidated net sales. See "Business" above. RESEARCH AND DEVELOPMENT Eagle and its subsidiaries invest in research and development of new products. See Note 2 to the Eagle Consolidated Financial Statements for information regarding research and development expenses. PATENTS, TRADEMARKS, LICENSES AND FRANCHISES There are several registered patents and trademarks used by businesses within the Building Products Group, the Electrical Products Group, the Industrial Products Group, the Automotive Products Group and the Specialty Products Group, none of which are individually significant to the consolidated operations of Eagle. Eagle's businesses do not materially rely on any single patent, license or franchise. BACKLOG The following table indicates the approximate backlog for each of Eagle's business groups as of the dates indicated. Approximately $44 million of the backlog at December 31, 1993 is expected to be shipped in 1995 or after, substantially all of which relates to Burns. OTHER MATTERS ENVIRONMENTAL MATTERS Eagle's subsidiaries, as manufacturing companies, are subject to various environmental laws concerning, for example, emissions to the air, discharges into water and the generation, handling, storage, transportation, treatment and disposal of waste and other materials. In addition to costs associated with regulatory compliance, companies such as those within Eagle, which in prior years have disposed of hazardous material at various sites, may be liable under various federal and state laws for the costs of the clean-up of such sites. It is impossible to predict accurately Eagle's future expenditures for environmental matters; however, Eagle anticipates that future environmental requirements will become more stringent, which may result in increased expenditures. It is Eagle's policy to take all reasonable measures to control and eliminate pollution resulting from its operations. Eagle believes that as a general matter its policies, practices and procedures in the areas of pollution control, product safety, occupational health, medical services and safety and loss prevention are adequate to prevent unreasonable risk of environmental and other damage, and the resulting financial liability. Eagle believes, based on consultations with legal counsel and environmental consultants and its own reviews of the nature and extent of potential liabilities, that compliance with existing environmental protection laws, including those requiring clean-up of hazardous waste, will not have a material adverse effect on Eagle's financial position, results of operations or competitive position. The Company believes that it has adequate reserves. The amounts spent by Eagle on environmental expenditures were not material to Eagle's results of operations and financial position in the year ended December 31, 1993, the five months ended December 31, 1992 or in fiscal 1992 or 1991. It is impossible, however, to predict with certainty the level of expenditures with respect to any such obligations, in part because a substantial portion of any expenditure is a function of unsettled and evolving enforcement and regulatory policies in states where Eagle conducts its business. EMPLOYEES Eagle's continuing operations employed approximately 9,400 employees as of December 31, 1993. Approximately 3,800 employees are represented by 24 unions. Collective bargaining is conducted on a subsidiary-by-subsidiary basis with local unions belonging to various national and international unions. Management believes that labor relations are satisfactory at all subsidiaries. ITEM 2. ITEM 2. PROPERTIES Eagle believes its manufacturing, warehouse and office facilities are adequate for its current and foreseeable requirements. Eagle's principal facilities consist of the following: - ------------------------- (a) Substantially all domestic properties owned by Eagle and its subsidiaries are subject to mortgages granted to financial institutions under its credit facilities. See Note 5 to the Eagle Consolidated Financial Statements for additional information regarding indebtedness of Eagle and its subsidiaries. (b) Eagle leases this property from affiliates of GAMI. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Eagle and its subsidiaries are defendants in several lawsuits arising in the ordinary course of business. Management does not believe, based on the advice of counsel, that any of these lawsuits, individually or in the aggregate, will have a material adverse effect on Eagle's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As a result of the Restructuring, Eagle became a wholly owned subsidiary of GAMI, and as such, had one stockholder subsequent to September 25, 1992. Pursuant to the Restructuring, Eagle declared a stock dividend, resulting in 11,077,261 shares of common stock issued and outstanding. In December, 1993, Eagle declared a reverse stock split of 1/11,077 per share of common stock resulting in the Company having 1,000 shares of common stock issued and outstanding. At March 15, 1994, Eagle had 1,000 shares of common stock authorized, issued and outstanding, all of which was held by GAMI. Eagle paid a $30.0 million cash dividend to its corporate parent out of earnings in February 1991. Eagle does not currently intend to pay dividends to its stockholder. Eagle's dividend policy will be reviewed from time to time by its Board of Directors in light of Eagle's earnings, financial position and other factors deemed relevant by the Board of Directors. In addition, the amount of cash dividends, if any, which may be paid on the Eagle Common Stock is restricted by debt agreements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources," "Certain Relationships and Related Transactions -- Disaffiliation Agreement" and Note 5 to the Eagle Consolidated Financial Statements for a discussion of restrictions on the ability of Eagle to pay dividends. As discussed in Note 17 to the Eagle Consolidated Financial Statements, in January 1994 the Company received $50 million from GAMI in the form of a capital contribution. ITEM 6. ITEM 6. SELECTED FINANCIAL INFORMATION The selected financial information presented below has been derived from the audited Eagle Consolidated Financial Statements for the year ended December 31, 1993, the five months ended December 31, 1992 and for the fiscal years ended July 31, 1989 through 1992 and should be read in conjunction with such financial statements and the notes thereto. The five month period ended December 31, 1991 is unaudited and is presented only for comparative purposes. This information has been restated to give retroactive effect to businesses accounted for as discontinued operations. - ------------------------- (A) Eagle adopted the new accounting standard "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112") effective December 31, 1993, "Accounting for Income Taxes" ("SFAS No. 109") in the first quarter of calendar 1993 and "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") in the first quarter of fiscal 1992. Refer to Notes 2, 6 and 7 to the Eagle Consolidated Financial Statements for additional information regarding the adoption of these accounting pronouncements. (B) See Note 3 to the Eagle Consolidated Financial Statements for information regarding acquisitions. (C) See Note 12 to the Eagle Financial Statements for information regarding certain adjustments to stockholder's equity. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following should be read in conjunction with the Consolidated Financial Statements included herein. GENERAL Effective December 16, 1992, Eagle changed its year end from July 31 to December 31. Information for the year ended December 31, 1992 and for the five months ended December 31, 1991 is unaudited and has been presented for comparative purposes only. As disclosed in Notes 2 and 7 to the Eagle Consolidated Financial Statements, Eagle adopted the provisions of SFAS No. 109 effective January 1, 1993. By adopting this standard, Eagle reduced its net deferred tax assets by $3.5 million and recorded a corresponding charge of $3.5 million. As disclosed in Note 2 to the Eagle Consolidated Financial Statements, Eagle adopted the provisions of SFAS No. 112 effective December 31, 1993. By adopting this standard, Eagle increased its accrued expenses by $3.0 million and recorded a corresponding pretax charge of $3.0 million. As disclosed in Note 6 to the Eagle Consolidated Financial Statements, Eagle adopted the provisions of SFAS No. 106 in the first quarter of fiscal 1992. By adopting this standard, Eagle recorded a cumulative adjustment of $24.2 million by reducing its then recorded postretirement benefits liability to the discounted present value of expected future benefits attributed to employees' service rendered prior to August 1, 1991, and recorded a corresponding $24.2 million non-cash pretax benefit. In 1993, the Company redefined its industry segments to add an Automotive Products Group and realign its Building Products and Specialty Products Groups. Prior periods' results of operations have been restated to reflect the reclassifications. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 AS COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net Sales Following are net sales by business group: Excluding the effects of acquisitions, consolidated net sales for the year ended December 31, 1993 were $16.3 or 1.5% higher than net sales for the year ended December 31, 1992. This increase was primarily due to increased volume at the Company's automotive parts distribution businesses, Denman, Hart & Cooley, Mansfield and Hill partially offset by declines at Burns, Pfaudler and Caron. Net sales of $372.3 million for the year ended December 31, 1993 for the Building Products Group were $27.1 million or 7.9% higher than in the 1992 period. This increase was primarily due to increased volume at Mansfield and increased volume and to a lesser extent improved pricing at Hart & Cooley. These increases were primarily the result of improvement in the residential construction market. Net sales of $176.8 million for the year ended December 31, 1993 for the Electrical Products Group were $8.1 million or 4.8% higher than in the 1992 period. Approximately $2.4 million of the increase was due to a product line acquisition made by Elastimold. The remainder of the increase was primarily due to increased volume and improved pricing at Hendrix and increased international volume at Elastimold. Net sales of $241.4 million for the year ended December 31, 1993 for the Industrial Products Group were $38.8 million or 13.9% lower than in the 1992 period. This decrease was due to lower volume at Pfaudler due to a decline in European sales and lower volume at Burns due to decreased expenditures in the aviation industry and a large order in the 1992 period, which was not repeated in 1993. These decreases were partially offset by an increase in volume at Chemineer, which was partially offset by reduced pricing. Net sales of $164.2 million for the year ended December 31, 1993 for the Automotive Products Group were $24.4 million or 17.5% higher than in the 1992 period. This increase was primarily due to increased volume at Denman and as a result of an increase in the customer base at the automotive parts distribution businesses. Net sales of $187.6 million for the year ended December 31, 1993 for the Specialty Products Group were $2.1 million or 1.1% lower than in the 1992 period. This decrease was primarily due to a decrease in volume at Caron related to the sale of its industrial yarn product line in 1992, which accounted for $6.5 million of the decrease, as well as continued softness in consumer discretionary spending. This decrease was partially offset by increased volume at Hill, partially offset by reduced pricing. Gross Earnings Consolidated gross earnings of $224.5 million for the year ended December 31, 1993 were $2.2 million lower than in the 1992 period. This decrease was primarily due to lower sales volume and to a lesser extent competitive pricing in the Industrial Products Group, a write-down of inventory at Burns and a decrease in volume at Caron. Consolidated gross margin of 19.7% in 1993 was down from 20.2% in the comparable 1992 period. Operating Income Following is operating income by business group: Consolidated operating loss for the year ended December 31, 1993 was $12.9 million compared to operating income of $62.8 million in 1992. This decrease was primarily due to the recording of $71.8 million of restructuring charges in the third and fourth quarter of 1993. Excluding these restructuring charges and $1.7 million of restructuring charges recorded in 1992, operating income decreased $5.7 million or 8.8%. This decrease was primarily due to lower sales volume at Pfaudler, Burns and Caron, and a write-down of certain inventory and receivables at Burns of $6.7 million. The decline was partially offset by increased sales volume at Denman and the Company's automotive parts distribution businesses and an increase in price and volume at Hendrix and Hart & Cooley. Several of the Company's businesses recorded restructuring charges totaling $71.8 million in the third and fourth quarter of 1993. Elastimold recorded charges of $0.6 million related to an early retirement program. IEP recorded charges of $2.0 million for additional costs associated with the relocation of one of its manufacturing facilities from New Jersey to Florida. Pfaudler recorded charges of $2.0 million, principally for the downsizing of certain of its foreign operations. Caron recorded charges of $6.2 million for the shut down of its London, Kentucky facility. Hill recorded charges of $8.8 million for the shut down of its Canadian facility. Hill also recorded charges of $52.2 million for the write-down of certain assets including property, plant and equipment of $19.4 million and goodwill of $25.8 million associated with its studies regarding the reconfiguration and/or relocation of its Trenton, New Jersey plant. See Note 8 to the Eagle Consolidated Financial Statements for a more detailed description of the restructuring charges. Operating income for the year ended December 31, 1993 for the Building Products Group was $3.4 million or 7.7% higher than in 1992. This increase was primarily due to improved pricing and increased volume at Hart & Cooley, partially offset by decreases at Mansfield due to decreased pricing and higher operating costs. Operating margin for the group was 12.8% for the years ended December 31, 1993 and 1992. Excluding the effects of restructuring charges, income for the year ended December 31, 1993 for the Electrical Products Group was $0.4 million or 2.6% higher than in 1992. Improved pricing at Hendrix and reduced manufacturing costs at IEP were offset by declines at Elastimold caused by decreased earnings at its European joint venture. Excluding the effects of restructuring charges, operating margins were 9.9% and 10.0% for the years ended December 31, 1993 and 1992, respectively, due to the above mentioned factors. Excluding restructuring charges of $2.0 million in 1993 and $1.7 million in 1992, the operating loss for the year ended December 31, 1993 for the Industrial Products Group was $0.9 million compared to operating income of $13.4 million in 1992. The decrease was due primarily to decreased pricing at Chemineer, lower volume and prices at Burns, the write-down of certain receivables and inventory at Burns and lower volume at Pfaudler. Excluding the effects of restructuring charges and the write-down of accounts receivables and inventory in 1993 and restructuring charges in 1992, operating margins were 2.4% and 4.8% for the years ended December 31, 1993 and 1992, respectively, due to the above mentioned factors. Operating income for the year ended December 31, 1993 for the Automotive Products Group was $2.6 million or 72.5% higher than in 1992. This increase was primarily due to increased sales volume at Denman and the automotive parts distribution businesses. Operating margins were 3.8% and 2.6% for the years ended December 31, 1993 and 1992, respectively, due to the above mentioned factors. Excluding restructuring charges, operating loss for the year ended December 31, 1993 for the Specialty Products Group was $0.4 million compared to an operating loss of $0.9 million in 1992. The improvement was primarily due to increased volume at Hill partially offset by decreased volume at Caron. Excluding the effects of restructuring charges, operating margins were (0.2)% and (0.5)% for the years ended December 31, 1993 and 1992, respectively, due to the above mentioned factors. Corporate expenses for the year ended December 31, 1993 were $1.7 million or 13.1% lower than in the 1992 period. This decrease was primarily due to a one time curtailment gain of $1.3 million associated with a pension plan. Interest Expense Net interest expense related to continuing operations was $67.1 million for the year ended December 31, 1993 compared to $63.8 million for the comparable 1992 period. This increase is primarily attributable to a decrease in interest income (see Note 12 to the Eagle Consolidated Financial Statements). Loss From Continuing Operations (Before Income Taxes) The loss from continuing operations before income taxes for the year ended December 31, 1993 was $80.0 million. This was due to restructuring charges and the write-down of certain accounts receivables and inventory totaling $78.5 million. In addition, as discussed in Liquidity and Capital Resources below, the Refinancing is expected to generate annual savings of at least $20 million in interest expense. Income Tax Provision The Company's tax benefit for continuing operations for the year ended December 31, 1993 reflected the significant amount of non-deductible expenses including the write-down of goodwill balances and goodwill amortization. See Note 7 to the Eagle Consolidated Financial Statements for a further analysis of the effective tax rate. FIVE MONTHS ENDED DECEMBER 31, 1992 AS COMPARED TO FIVE MONTHS ENDED DECEMBER 31, 1991 Net Sales Following are net sales by business group: Excluding the effects of acquisitions, consolidated net sales for the five months ended December 31, 1992 were $20.5 million or 4.7% higher than net sales for the five months ended December 31, 1991. The increase was primarily due to increased volume at Hart & Cooley, Mansfield, Elastimold, Denman and DeVilbiss Air Power, partially offset by declines at Chemineer and Caron. Net sales increased $4.3 million due to the effect of an acquisition within the Company's Automotive Products Group during the five months ended December 31, 1991. Net sales of $150.1 million for the Building Products Group were $21.4 million or 16.6% higher than net sales for the five months ended December 31, 1991. This was primarily due to increased volume attained by all businesses within this group. Contributing to this increase were increased sales to customers in Mexico by Mansfield of $1.7 million and increased sales to Sears by DeVilbiss Air Power of $6.5 million. Net sales of $66.2 million for the Electrical Products Group were $4.0 million or 6.4% higher than net sales for the five months ended December 31, 1991. This was primarily due to increased international volume at Elastimold. Net sales of $100.5 million for the Industrial Products Group were $0.2 million or 0.2% lower than net sales for the five months ended December 31, 1991. This decrease was primarily due to a $3.7 million decline in sales at Chemineer, partially offset by an increase of $3.0 million at Burns. Net sales of $58.9 in the Automotive Products Group were $11.9 million or 25.3% higher than the net sales for five months ended December 31, 1991. Approximately $4.3 million of the increase reflects the effect of an acquisition within the Company's automotive parts distribution businesses. Sales also increased at Denman and Eagle's automotive parts distribution businesses. Net sales in the Specialty Products Group were $12.3 million or 12.9% lower than the net sales for five months ended December 31, 1991. This decrease was primarily due to declines at Caron and Gerry caused by continued softness in consumer discretionary spending and, to a lesser extent, the sale of Caron's industrial yarn product line. Gross Earnings Consolidated gross earnings of $90.2 million for the five months ended December 31, 1992 were virtually unchanged from gross earnings of $89.8 million for the five months ended December 31, 1991. The consolidated gross margin declined to 19.7% for the five months ended December 31, 1992 from 20.7% for the five months ended December 31, 1991 due primarily to competitive pricing pressures and changes in product mix in many of Eagle's businesses. Many of the Company's businesses reduced sales prices in order to remain competitive and/or to gain market share. Partially offsetting these price discounts were cost reduction programs, which included reduced staffing levels and other cost containment measures. Operating Income Following is operating income by business group: Consolidated operating income of $19.6 million for the five months ended December 31, 1992 was $4.8 million, or 19.7% lower than operating income for the five months ended December 31, 1991. Operating income declined primarily due to unfavorable product mix and a restructuring charge of $1.7 million in certain businesses in the Industrial Products Group and reduced sales volumes for certain businesses in the Specialty Products Group. Consolidated operating margin, before restructuring charges, was 4.6% for the five months ended December 31, 1992 as compared to 5.7% for the five months ended December 31, 1991. The decline is due to the above mentioned factors. Consolidated selling and administrative expenses increased $4.5 million for the five months ended December 31, 1992 compared to the five months ended December 31, 1991 as a result of the higher sales levels, however, selling and administrative expenses as a percentage of net sales remained at 14.3% during both periods. Operating income for the Building Products Group of $18.6 million for the five months ended December 31, 1992 was $2.7 million, or 17.4% higher than operating income for the same period in 1991. This increase was due primarily to increased sales volume at all of the businesses within this group. Operating margin was essentially flat at 12.4% and 12.3% for the five months ended December 31, 1992 and 1991, respectively. Operating income for the Electrical Products Group of $4.4 million for the five months ended December 31, 1992 was $0.6 million or 14.4% higher than operating income for the same period in 1991. This increase was due primarily to increased volume at Elastimold and cost reduction programs at certain units. Operating margin was 6.6% and 6.1% for the five months ended December 31, 1992 and 1991, respectively, due to the above mentioned factors. Operating income for the Industrial Products Group of $0.5 million for the five months ended December 31, 1992 was $2.1 million lower than operating income for the same period in 1991. This decrease was attributable to unfavorable product mix at Burns and lower sales volume at Chemineer. Savings at Pfaudler from cost reduction programs partially offset the decline, despite restructuring charges of $1.7 million at Pfaudler and Burns. Operating margin, before restructuring charges, was 2.1% and 2.6% for the five months ended December 31, 1992 and 1991, respectively, due to the reasons discussed above. Operating income for the Automotive Products Group of $0.5 million for the five months ended December 31, 1992, was $0.6 million lower than operating income for the same period in 1991. The decline is primarily due to lower sales volume at Clevaflex and increased operating expenses at Denman. Operating margins were 1.3% and 2.9% for the five months ended December 31, 1992 and 1991, respectively, due to the above mentioned factors. Operating income for the Specialty Products Group of $1.4 million for the five months ended December 31, 1992 was $4.3 million lower than operating income for the same period in 1991. This decline was due primarily to decreases in volume at Caron and Gerry, as well as lower absorption and costs associated with a new product line at Hill. Operating margins were 1.7% and 6.0% for the five months ended December 31, 1992 and 1991, respectively, due to the above mentioned factors. Corporate expenses for the five months ended December 31, 1992 increased $1.1 million compared to the five months ended December 31, 1991. The increased corporate expense was due to costs associated with the year end change and the Restructuring consummated on September 25, 1992. Interest Expense Net interest expense related to continuing operations was $27.2 million for the five months ended December 31, 1992 compared to $27.7 for the corresponding period of 1991. This decrease is due primarily to the overall decline in interest rates. Loss from Continuing Operations (Before Income Taxes) The loss from continuing operations before income taxes was $7.6 million for the five months ended December 31, 1992 compared to a loss of $3.3 million for the five months ended December 31, 1991. The loss reflected the general economic environment in which Eagle was operating and the performance of certain of its businesses. Eagle has taken actions throughout all of its businesses to reduce operating expenses and manufacturing costs. The cost reduction efforts did not offset the lower sales prices in many of these businesses. Income Tax Provision Eagle's tax benefit for continuing operations for the five months ended December 31, 1992 reflected the significant amount of nondeductible expenses, including goodwill amortization and depreciation, which are included in the current operating loss. See Note 7 to the Eagle Consolidated Financial Statements for a further analysis of the effective tax rate. FISCAL YEAR ENDED JULY 31, 1992 AS COMPARED TO FISCAL YEAR ENDED JULY 31, 1991 Net Sales Following are net sales by business group: Despite the adverse impact of the recession on many of the Company's businesses, consolidated net sales for fiscal 1992 were $64.9 million or 6.3% higher than fiscal 1991. Net sales increased $27.8 million in fiscal 1992 due to the full year impact of the fiscal 1991 acquisitions, which included Norris (acquired September 1990) and Energair (acquired April 1991). Excluding the effects of the Norris and Energair acquisitions, consolidated net sales increased by $37.1 million in fiscal 1992 compared to fiscal 1991. Net sales of $323.9 million for the Building Products Group increased $65.6 million in fiscal 1992 compared to fiscal 1991. The acquisition of Norris and Energair contributed $27.8 million to the sales increase in fiscal 1992. Excluding net sales of Norris and Energair, net sales improved by $37.8 million, $5.9 million of the increase was attributable to Mansfield due primarily to increased sales volume of vitreous china products, while DeVilbiss Air Power contributed $23.7 million. Hart & Cooley's sales increased $8.2 million of which $5.1 million was due to increased flexible duct system volume. Net sales of $164.7 million for the Electrical Products Group declined $17.5 million in fiscal 1992 compared to fiscal 1991. The recession had a negative impact on this group, primarily during the first six months of fiscal 1992, as both electric utility capital spending levels and construction levels were below fiscal 1991 levels. Additionally, $5.5 million of this decline related to a division which was sold by Eagle in January 1991. Net sales of $280.4 million for the Industrial Product Group increased $10.1 million in fiscal 1992 compared to fiscal 1991. This increase was attributable to an increase at Burns of $18.0 million, due to several large contracts for commercial aircraft seating, partially offset by decreases at Pfaudler and Chemineer of $6.2 million and $1.6 million, respectively. Capital spending by the chemical processing industry in the United States and Europe, which affects sales volumes of Pfaudler and Chemineer, continued to remain flat compared to levels experienced in fiscal 1991. Shipments in the last half of fiscal 1992 improved over fiscal 1991 levels. Net sales of $127.9 million for the Automotive Products Group were $12.8 million higher in fiscal 1992 compared to fiscal 1991. This increase was primarily due to increased sales at Eagle's automotive distribution businesses of $13.3 million. Net sales of $201.9 million for the Specialty Products Group were $6.1 million lower in fiscal 1992 compared to fiscal 1991. This decrease was primarily due to lower sales at Caron and Gerry of $2.4 million and $1.9 million, respectively, due to softness in consumer discretionary spending and decreases at Hill of $1.8 million. Gross Earnings Despite the adverse impact of the recession on many of the Company's businesses, consolidated gross earnings of $226.2 million for fiscal 1992 were $3.1 million higher than gross earnings of $223.1 million in fiscal 1991. Gross earnings improved for businesses in the Building Products Group and Automotive Products Group by $15.8 million and $3.6 million, respectively, primarily as a result of increased sales volume resulting from improved market conditions and acquisitions. Certain businesses within the Electrical Products Group, Industrial Products Group and, to a lesser extent, the Specialty Products Group, experienced price pressure. For these segments, gross earnings declined $6.2 million, $6.3 million and $3.9 million, respectively. Consolidated gross margin was 20.6% for fiscal 1992 compared to 21.6% in fiscal 1991. The reduced level of gross margin was due primarily to the above-mentioned factors. Operating Income Following is operating income by business group: Consolidated operating income for fiscal 1992 was $2.0 million or 3.0% higher than operating income in fiscal 1991. Consolidated operating margin was 6.2% and 6.4% for fiscal 1992 and 1991, respectively, and declined primarily due to reduced sales volumes and continued price declines experienced by certain businesses within the Electrical Products Group and reduced sales volumes and manufacturing inefficiencies for certain businesses within the Industrial Products Group. These decreases were partially offset by increases in the Building Products Group and the Specialty Products Group due to increases in sales volume and more substantial improvements in operating margin. Operating income for the Building Products Group increased $13.8 million during fiscal 1992 compared to fiscal 1991. This increase was due primarily to increased sales volume and effective cost reduction programs previously implemented by the businesses within this group, as well as to the earnings contribution of Norris and Energair, which contributed $2.4 million to operating income in fiscal 1992. Operating margin was 12.8% and 10.7% for fiscal 1992 and fiscal 1991, respectively, with the improvement being due to the above mentioned factors. Operating income for the Electrical Products Group declined $2.1 million during fiscal 1992 compared to fiscal 1991. Operating margin was relatively flat at 10.0% and 10.2% for fiscal 1992 and 1991, respectively. The decline in operating income was due to the reduced sales volumes and price declines experienced by certain businesses within this group during fiscal 1992. Operating income for the Industrial Products Group declined $9.7 million during fiscal 1992 compared to fiscal 1991 due primarily to the reduced sales volumes at Pfaudler and to manufacturing inefficiencies at Burns which resulted in higher labor costs. Operating margin was 5.1% and 8.8% for fiscal 1992 and 1991, respectively, and declined due to the above mentioned factors. Operating income for the Automotive Products Group increased $0.4 million during fiscal 1992 compared to fiscal 1991, primarily due to increased volume at the Company's automotive parts distribution businesses. Operating margin was 3.3% for both fiscal 1992 and fiscal 1991. Operating income for the Specialty Products Group decreased by $0.8 million during fiscal 1992 compared to fiscal 1991. This decrease was primarily due to continued softness in consumer discretionary spending. In addition, operating income in fiscal 1991 included increased costs at Hill, offset by improved product mix and lower operating expenses at Caron. Operating margin was 1.6% and 2.0% in fiscal 1992 and 1991, respectively, due to the above mentioned factors. Corporate expenses for fiscal 1992 declined $0.4 million compared to fiscal 1991. This decline reflected efforts to reduce administrative costs at all levels. Interest Expense Net interest expense related to continuing operations was $64.9 million for fiscal 1992 compared to $68.7 million in fiscal 1991. The decline in net interest expense was due primarily to the reduction in indebtedness as proceeds from fiscal 1991 business dispositions (totaling approximately $250.2 million through January 1991) were applied to outstanding debt balances. Accordingly, the average outstanding debt balance for fiscal 1992 was approximately $7.0 million less than for fiscal 1991. In addition, Eagle realized savings in fiscal 1992 interest expense due to the overall decline in interest rates from levels seen in fiscal 1991. Income From Continuing Operations (Before Income Taxes) Income from continuing operations before income taxes was $2.8 million for fiscal 1992 compared to a loss of $3.0 million for fiscal 1991. The improvement is a result of actions taken by Eagle throughout all of its businesses to reduce operating expenses and manufacturing costs, which included headcount reductions, renegotiating vendor contracts and reducing general corporate and administrative expenses to offset lower volume and sales prices in many of its businesses. Income Tax Provision Eagle's tax provision for continuing operations for fiscal 1992 reflected the significant amount of nondeductible expenses, including goodwill amortization and depreciation, which are included in the current operating loss. See Note 7 to the Eagle Consolidated Financial Statements for a further analysis of the effective tax rate. DISCONTINUED OPERATIONS In the third quarter of 1993, the Company classified Lapp Insulator Company ("Lapp"), Underground Technologies, Inc. ("Underground Technologies") and Power Structures, Inc. ("Power Structures") as discontinued operations. The Company is currently pursuing options for the sale of Lapp. The Company sold Power Structures and certain assets of Underground Technologies in the fourth quarter of 1993 for total proceeds of $3.5 million. The Company made a provision of $24.0 million, net of applicable tax benefit of $8.2 million, for estimated losses from operations and from the ultimate disposition of these businesses. These charges are reflected as "Loss on disposal" in the Company's Consolidated Financial Statements. Included in the provision for disposition was the write-off of approximately $10 million of goodwill related to Lapp and Underground Technologies. The $10 million goodwill represented all of the goodwill assigned to these businesses. In February, 1993, Eagle sold, through an indirect wholly owned subsidiary, a 60% interest in Signet Armorlite, Inc. ("Signet") to Galileo Industrie Ottiche, S.p.A. ("Galileo"). Signet manufactures and distributes ophthalmic lenses used for eyeglasses and also distributes supplies used in ophthalmic lens processing. The Company received cash proceeds of approximately $23 million from the sale, which were used to reduce outstanding debt. The Company recorded a pretax loss of $5.0 million with a corresponding tax benefit of $2.0 in December 1992. See Note 4 to the Eagle Consolidated Financial Statements for a further discussion of the sale agreement and resulting accounting treatment. During fiscal 1992, Eagle and its subsidiaries completed the sale of its process pump business, Pulsafeeder, Inc. and subsidiaries ("Pulsafeeder"), for total cash and other consideration of $69.0 million, as a result of which a net gain of approximately $10.6 million was recorded during the fourth quarter of fiscal 1992. In addition, in conjunction with the Restructuring, Eagle sold the net assets of Equality to GAMI for approximately $17.0 million. Eagle did not record any gain on the sale of Equality. During fiscal 1991, Eagle and its subsidiaries completed the sale of seven business units for cash consideration of $250.2 million. A net gain of $35.8 million was recorded as a result of these dispositions. Interest expense allocated to these discontinued businesses primarily represented interest expense associated with debt assumed by the buyer or debt related to the discontinued businesses that will no longer be incurred by Eagle or its subsidiaries. In addition, certain interest expense related to Eagle and its subsidiaries' revolving lines of credit has also been allocated to discontinued operations based on the percentage of net assets sold to total consolidated net assets plus indebtedness of Eagle. Interest expense related to Eagle's subordinated notes has not been allocated to these discontinued operations. Eagle believes the method used to allocate interest expense to discontinued businesses is reasonable. The provision for income taxes reflected for the operations of these discontinued businesses in Eagle's Consolidated Statement of Income for the year ended December 31, 1993, the five months ended December 31, 1992 and 1991 and for fiscal 1992 and 1991, recognizes the tax effects related specifically to the discontinued businesses. An income tax benefit of $8.2 million was recorded in connection with the ultimate disposition of companies recorded as discontinued operations in 1993. The tax benefit recorded differs from that computed by utilizing the U.S. federal tax rate due to certain non-deductible losses, principally the writedown of goodwill. Income tax expense of $18.7 million and $37.6 million were provided against the net gains on disposal of businesses in fiscal 1992 and 1991, respectively. The tax recorded on the gains recorded in fiscal 1992 and 1991 differ from that computed by utilizing the U.S. federal tax rate due to state taxes, certain non-deductible losses, the effect of net-of-tax accounting, the effect of foreign tax credits and excess tax gain over the book gain attributable to differences between the book and tax basis of assets related to businesses sold. LIQUIDITY AND CAPITAL RESOURCES Eagle has historically met its debt service, capital expenditure requirements and operating needs through a combination of operating cash flow and external financing. Operating Cash Flow Cash flow from continuing operating activities was $12.5 million for the year ended December 31, 1993. The Company recorded a loss from continuing operations of $68.1 million of which $71.8 million was related to restructuring charges. An increase in accounts receivable, as well as the recording of income tax benefits and expenditures due to the relocation of IEP's manufacturing facility from New Jersey to Florida represented the primary uses of cash in 1993. Credit Facilities As further described in Note 5 to the Eagle Consolidated Financial Statements, in July 1993, the Company completed a tender offer for $151 million of its 13% Senior Subordinated Notes ("13% Notes"). The tender of the $151 million of the 13% Notes was funded through a concurrent sale of Senior Deferred Coupon Notes due 2003 ("Notes"). The issue price of the Notes was $598.97 per $1,000 principal amount at maturity, which represents a yield to July 15, 1998 of 10.5% per annum. The aggregate principal amount of Notes issued was $315 million. Cash interest will be payable on January 15 and July 15 of each year at a rate of 10.5% per annum commencing on January 15, 1999 until maturity on July 15, 2003. The net proceeds, after deducting the tender premium, consent payments, interest on the 13% Notes tendered and other fees and expenses, amounted to approximately $167 million. In connection with the tender of the 13% Notes, the Company recognized an extraordinary charge of $8.4 million net of applicable tax benefit of $5.8 million for call premiums and expenses. In January 1994, the Company consummated a Refinancing (the "Refinancing"), the proceeds of which were utilized to repay and redeem all of its subsidiaries senior bank credit facilities, the remaining $149 million of its 13% Notes and the 13.75% Senior Subordinated Notes ("13.75% Notes"). A portion of the proceeds from the Refinancing were derived from a new senior bank credit facility ("Credit Facility") made available to Eagle Industrial Products Corporation, ("Eagle Industrial"), a newly formed wholly owned subsidiary of the Company which owns all of the operating subsidiaries of the Company. The Company also entered into an asset securitization program whereby it sold certain of its accounts receivable for approximately $110 million. In addition, the Company received a capital contribution from GAMI of $50 million in connection with the Refinancing. The Refinancing of the Company's debt is expected to generate a reduction of interest expense in excess of $20 million. In connection with the Refinancing, the Company will record a pretax extraordinary charge of approximately $26 million in the first quarter of 1994. See Note 17 to the Eagle Consolidated Financial Statements for a further discussion of the Refinancing. The Eagle Industrial Credit Facility consists of: (1) a $225 million term loan due in quarterly installments increasing from $4.9 million per quarter during 1994 to $15 million in 1999; (2) a $65 million term loan due in equal quarterly installments aggregating $0.5 million per year in 1994 and 1995, $1 million per year in 1996 through 1999 and $60 million in 2000; and (3) a $135 million revolving Credit Facility (subject to borrowing base availability) that expires in 1999, which may be extended through 2000. Borrowings under the Credit Facility bear interest at alternative floating rate structures, at management's option (4.9% at January 31, 1994), and are secured by substantially all domestic property, plant, equipment, inventory and certain receivables of Eagle Industrial and its subsidiaries. At January 31, 1994, $35 million and $290 million were outstanding under the revolving credit portion and term loan portion of the Credit Facility, respectively. Additionally, the Credit Facility provides for a letter of credit facility of up to $50 million. Borrowing availability under the revolving portion of the Credit Facility is reduced by the outstanding amount of letters of credit. At January 31, 1994, an additional $28 million was available to borrow under the Credit Facility. The Eagle Industrial Credit Facility contains various financial covenants, the more restrictive requirements being: the maintenance of minimum levels of net worth; limitations on incurring additional indebtedness; restrictions on the payment of dividends or the making of loans to the Company; maintenance of certain ratios of cash flow to interest expense and indebtedness; maintenance of a minimum level of cash flow to fixed charges; and a prohibition on payments to the Company for management services in excess of $3 million per year. The Company has provided a guarantee as to the repayment of amounts outstanding under this Credit Facility. Additionally, the Credit Facility requires that the Zell interests (as defined) directly or indirectly maintain at least 30% of the voting power to elect members of the board of directors of the Company and that the Company directly own 100% of Eagle Industrial. Prior to the Refinancing, the Company had four senior credit facilities which were available to four subsidiary groups of the Company (the "Senior Bank Credit Facilities"). A portion of the proceeds of the Refinancing were utilized to fully repay the Senior Bank Credit Facilities in January 1994. The aggregate amount available under the revolving portion of the Senior Bank Credit Facilities (subject to borrowing base availability) amounted to $350.0 million at December 31, 1993, of which $156.9 million was outstanding. Additionally, the Senior Bank Credit Facilities at December 31, 1993 included $69.6 million in outstanding term loans. Borrowings under the Senior Bank Credit Facilities bore interest at alternative floating rate structures, at management's option (5.6% and 6.1% at December 31, 1993 and 1992, respectively), and were secured by substantially all domestic property, plant, equipment, inventory and receivables of the Company's subsidiaries. Three of these senior credit facilities were guaranteed by the Company. Additionally, these credit facilities provided for letter of credit facilities within each credit facility. At December 31, 1993, $33.5 million of letters of credit were issued and outstanding under the aforementioned credit facilities. The Senior Bank Credit Facilities contained various financial covenants, the more restrictive requirements being the maintenance of minimum levels of net worth; limitations on the incurrence of additional indebtedness, as defined; maintenance of certain ratios of profitability to interest expense; maintenance of certain asset to liability ratios; requirements that the Zell interests (as defined) directly or indirectly maintain at least 51% of the voting power to elect members of the board of directors of certain subsidiary groups; and maintenance of minimum levels of earnings to fixed charges, as defined. Capital Expenditures Capital expenditures were $27.7 million and $31.8 million for the years ended December 31, 1993 and 1992, respectively. Expenditures during 1992 included the construction of a new facility for IEP. Capital expenditures were $13.6 million for the five months ended December 31, 1992, $27.5 million in fiscal 1992 and $26.3 million in fiscal 1991. In addition to normal maintenance expenditures, Eagle also expects to incur additional capital expenditures to develop new products and improve product quality. Capital expenditures will be funded through operating cash flow and through availability under the Credit Facility. Eagle had no material commitments for capital expenditures at December 31, 1993. The Company expects that its capital expenditures in 1994 will increase to approximately $45 million. Acquisitions and Divestitures Although the Company has historically made a number of acquisitions, it has not made any material acquisitions since fiscal 1990. While certain preliminary discussions are at varying stages at this time, Eagle currently does not have any contract or arrangement with respect to a material acquisition. Eagle has historically sold a number of businesses, realizing cash proceeds of $25.9 million in 1993 and $17.0 million in the five months ended December 31, 1992. Proceeds were $67.4 million, $250.2 million and $162.5 million in fiscal 1992, 1991 and 1990, respectively. Eagle has considered, and in the future will consider, proposals for the sale of some or all of its interests in its businesses. However, it has, at this time, no agreements or arrangements for the sale of any of its businesses. Other Liquidity Considerations Eagle is structured as a holding company and the operations of Eagle are conducted principally through its subsidiaries. As a result of the Refinancing, Eagle has no debt service requirements and no cash interest payments due until January 1999. Eagle Industrial owns all the operating subsidiaries of the Company. Eagle Industrial will rely almost exclusively on income and cash flow from its operating subsidiaries to generate the funds necessary to meet its debt service obligations as defined in "Credit Facilities" above. Claims of creditors (including trade creditors), if any, of Eagle's subsidiaries, even though such claims do not constitute indebtedness of Eagle, will have priority as to the assets and earnings of such subsidiaries over claims of Eagle and the holders of Eagle's indebtedness. In addition, the Credit Facility and agreements to which Eagle or its subsidiaries are a party, restrict the ability of Eagle or its subsidiaries to incur further indebtedness. See Note 5. Management believes that cash flow from continuing operations along with availability under the Credit Facility will be sufficient to pay interest on outstanding debt, meet current debt maturities, pay income taxes and fund anticipated capital expenditures. IMPACT OF INFLATION Eagle believes that inflation has not had a significant impact on operations during the period August 1, 1990 through December 31, 1993 in any of the countries or industries in which Eagle competes. Inflationary increases to operating income in Brazil and Mexico are substantially offset by translation losses included in operating income. Brazilian and Mexican monetary assets, net of monetary liabilities, are not material to Eagle. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Eagle Industries, Inc.: We have audited the accompanying consolidated balance sheets of Eagle Industries, Inc. (a Delaware corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholder's equity and cash flows for the year ended December 31, 1993, the five months ended December 31, 1992 and each of the two years in the period ended July 31, 1992. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Eagle Industries, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the year ended December 31, 1993, the five months ended December 31, 1992 and each of the two years in the period ended July 31, 1992, in conformity with generally accepted accounting principles. As explained in Note 2 and Note 7 to the consolidated financial statements, effective January 1, 1993, the Company adopted the requirements of Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes". As explained in Note 2 to the consolidated financial statements, effective December 31, 1993, the Company adopted the requirements of Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits". As explained in Note 7 to the consolidated financial statements, effective August 1, 1991, the Company adopted the requirements of Statement of Financial Accounting Standards No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions". ARTHUR ANDERSEN & CO. Chicago, Illinois March 10, 1994 EAGLE INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes to consolidated financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY The accompanying notes to consolidated financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED) The accompanying notes to consolidated financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) BASIS OF PRESENTATION Eagle Industries, Inc. (the "Company" or "Eagle") commenced operations on February 1, 1987, when GAMI transferred certain stock and net assets of Clevepak Corporation and Lapp Insulator Company to the Company. On January 9, 1991, Great American Management and Investment, Inc. ("GAMI"), through its subsidiaries, contributed all of the outstanding capital stock of The Jepson Corporation ("Jepson"), an indirect wholly owned subsidiary of GAMI, to the Company. The contribution of the capital stock of Jepson to the Company was accounted for as an exchange between companies under common control and in a manner similar to that utilized in pooling-of-interest accounting. The historical financial statements of the Company have been restated to give effect to the September 1989 acquisition of Jepson by a subsidiary of GAMI, as if the acquisition of Jepson had been consummated by Eagle. Prior to the Restructuring, as hereinafter defined, Great American Financial Group, Inc. (formerly Great American Industrial Group, Inc.) ("GAFG") directly and indirectly owned 100% of the common stock of the Company and GAMI owned 100% of the common stock of GAFG. Eagle is currently 100% owned by GAMI. Effective as of September 25, 1992, GAMI and its subsidiaries consummated a restructuring (the "Restructuring"). Pursuant to the Restructuring, among other things, (i) Eagle sold the net assets of its business, Equality Specialties, Inc. ("Equality") to GAMI for approximately $17 million; (ii) GAFG contributed all of the outstanding stock owned by it in North Riverside Holdings, Inc. ("North Riverside") to Eagle; (iii) Eagle declared a stock dividend to facilitate the distribution of Eagle's common stock (the effect of which was negated by a reverse stock split in December 1993); and (iv) GAFG distributed all of the outstanding Eagle common stock owned by it to GAMI. Effective December 16, 1992, Eagle changed its year end from July 31 to December 31. (2) SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION: The accompanying Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS: For purposes of the Consolidated Statements of Cash Flows, all highly liquid investment instruments with original maturities of three months or less are considered to be cash equivalents. INVENTORIES: Inventories are stated at the lower of cost or market. Cost includes raw materials, labor and manufacturing overhead. The last-in, first-out ("LIFO") method of inventory valuation is used for 45.5% and 49.8% of inventory at December 31, 1993 and 1992, respectively. The first-in first-out ("FIFO") method of inventory valuation is used for the remaining inventory. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment is stated at cost. Cost is based on appraised fair market values when allocating the purchase price for acquisitions. The straight-line method is generally used to provide for depreciation over the estimated useful lives of the assets. Property, plant and equipment held for sale is written down to net realizable value and classified in other assets. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 GOODWILL: Goodwill represents the purchase price associated with acquired businesses in excess of the fair value of the net assets acquired. Goodwill is amortized on a straight-line basis primarily over forty years. Accumulated amortization was $43.4 million and $32.9 million at December 31, 1993 and 1992, respectively. The Company assesses the recoverability of unamortized goodwill allocated to each of its individual acquired businesses as follows: A) continuing operations -- whenever current operating income is not sufficient to recover current amortization of goodwill or when events and circumstances indicate that future operating income and cash flow may be negatively affected, the recoverability is evaluated based upon the estimated future operating income and undiscounted cash flow of the related entity during the remaining period of goodwill amortization, and; B) entities to be divested -- the carrying value of the net assets of each entity, including the amount of goodwill assigned thereto, is compared to the expected divestiture proceeds. If a loss is indicated, it is recorded when known; gains are recorded when the divestiture occurs. FOREIGN CURRENCIES: The effects of foreign currency translation adjustments are recorded as a separate component of stockholder's equity. Translation adjustments of non-U.S. subsidiaries with highly inflationary economies (Brazil and Mexico) are charged to operations. REVENUE RECOGNITION: The Company recognizes revenues as products are shipped. POSTEMPLOYMENT BENEFITS: The Company adopted the provisions of "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112") effective December 31, 1993. By adopting this standard, the Company increased its accrued expenses by $3.0 million and recorded a corresponding pretax charge of $3.0 million reflected as a "Cumulative effect of change in accounting principle". RESEARCH AND DEVELOPMENT: Research, product development and engineering facilities are maintained at various subsidiary locations. Research and development efforts center on developing improved materials and designs for existing products and the creation of new products and equipment. Research and development costs are expensed as incurred. Research and development costs were $3.1 million for the year ended December 31, 1993, $1.6 million for the five months ended December 31, 1992, $3.4 million in fiscal 1992 and $3.5 million in fiscal 1991. INCOME TAXES: The Company is included in GAMI's consolidated U.S. federal income tax return. Under the terms of a tax sharing arrangement with GAMI, the Company computes and pays to GAMI its liability for U.S. federal income taxes as if the Company filed a separate U.S. federal income tax return. The Company files separate U.S. state and non-U.S. income tax returns. The Company does not provide for U.S. income taxes on the undistributed earnings of its non-U.S. subsidiaries. Management intends to indefinitely reinvest non-U.S. subsidiaries' earnings. Undistributed earnings of non-U.S. subsidiaries were $9.3 million at December 31, 1993. If these earnings were distributed, foreign tax credits would substantially offset the related U.S. income tax liability. The Company adopted the provisions of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS. No. 109") effective January 1, 1993. This new standard changes the Company's method of accounting for income taxes from the deferred method required under APB No. 11 to the asset and EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 liability method. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized. (See Note 7.) INTEREST EXPENSE RELATED TO DISCONTINUED OPERATIONS: Interest expense allocated to the discontinued businesses principally represents interest expense related to debt assumed by the buyer or debt related to the discontinued businesses that will no longer be incurred by the Company or its subsidiaries. In addition, certain interest expense related to the Company and its subsidiaries' revolving lines of credit has also been allocated to discontinued operations based on the percentage of net assets sold or to be sold to total consolidated net assets plus indebtedness of the Company. Interest expense related to the Company's subordinated notes has not been allocated to the discontinued businesses. The Company believes the method used to allocate interest to discontinued businesses is reasonable. (3) ACQUISITIONS As described in Note 1, as part of the Restructuring GAMI contributed all of the outstanding capital stock of North Riverside to Eagle. Substantially all of North Riverside's operations are conducted through two automotive aftermarket parts distributors. The contribution of North Riverside to the Company has been accounted for in a manner similar to a pooling-of-interests under the provisions of APB No. 16. In April 1991, the Company, purchased all of the assets and assumed certain liabilities of the Energair division ("Energair") for total cash consideration of $8.4 million. Energair manufactures and distributes air compressors in the United States. In September 1990, the Company purchased all of the assets and assumed certain liabilities of Norris Plumbing Products ("Norris") for total cash consideration of $12.3 million. Norris manufactures and distributes ceramic and enameled steel bathroom fixtures for use in the residential and commercial construction industry. The aforementioned acquisitions have been accounted for under the purchase method of accounting in accordance with Accounting Principles Board Opinion No. 16 ("APB No. 16") and, accordingly, the assets acquired and liabilities assumed have been recorded at their fair values as of their respective dates of acquisition. (4) DISCONTINUED OPERATIONS In the third quarter of 1993, the Company reflected Lapp Insulator Company ("Lapp"), Underground Technologies, Inc. ("Underground Technologies") and Power Structures, Inc. ("Power Structures") as discontinued operations. The Company is currently pursuing options for the sale of Lapp. The Company sold Power Structures and certain assets of Underground Technologies in the fourth quarter of 1993 for total proceeds of $3.5 million. The Company made a provision of $24.0 million, net of applicable tax benefit of $8.2 million, for estimated losses from operations and from the ultimate disposition of these businesses. Included in the provision for disposition was the write-off of approximately $10 million of goodwill related to Lapp and Underground Technologies. In February, 1993, the Company sold a 60% interest in Signet Armorlite, Inc. ("Signet") to Galileo Industrie Ottiche, S.p.A. ("Galileo"). Signet manufactures and distributes ophthalmic lenses used for eyeglasses and also distributes supplies used in ophthalmic lens processing. The Company received cash proceeds of approximately $23 million, which were used to reduce outstanding debt. Under the terms of the sale agreement, the Company has the right to put (the "Put") its remaining 40% interest in Signet to Galileo on February 26, 1998. Galileo has the right to acquire the remaining 40% interest (the "Call") held by the Company any time prior to February 26, 1998. While the Company retains a 40% interest; it has no obligation EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 to fund future losses or make additional investments; it has a less than majority board representation; it has given up substantially all of its rights to future earnings or appreciation related to its 40% interest; and it intends to exercise its Put in the event that Galileo does not exercise its Call. The price under either the Put or Call is $14.9 million. The Company recorded a pretax loss of $5.0 million with a corresponding tax benefit of $2.0 million in December 1992. Under the terms of the sale agreement, Galileo also has the right to put certain of Signet's plant and equipment (the "Real Estate Put") to the Company from February 26, 1997 through February 26, 1998 for $10.0 million. No gain or loss has been recognized with respect to the Real Estate Put. As disclosed in Note 1, Eagle sold Equality to GAMI as part of the Restructuring. The total consideration received by the Company was approximately $17 million in cash. No gain or loss was recorded as a result of the sale of Equality. In May, 1992, the Company sold substantially all of the assets of Pulsafeeder, Inc. and its wholly owned subsidiaries ("Pulsafeeder"). Total consideration received by the Company was $69.0 million. The Company recorded a pretax gain of $29.3 million with a corresponding tax provision of $18.7 million during the fourth quarter of fiscal 1992. During the first quarter of fiscal 1991, the Company, through a wholly owned subsidiary, sold all of the issued and outstanding shares of capital stock of DeVilbiss Health Care, Inc. and its subsidiaries ("DeVilbiss Health Care") for total cash consideration of $84.5 million. The July 31, 1991 Consolidated Financial Statements reflect a pretax gain of $44.7 million from the sale of DeVilbiss Health Care with a corresponding tax provision of $15.8 million. In addition, during fiscal 1991, the Company sold its Stimsonite, Air Maze and Atlantic businesses for total cash consideration of $45.0 million, $8.3 million and $38.8 million, respectively. Since the consideration received for these businesses approximated the fair value allocated to the net identifiable assets of these businesses in purchase accounting, no net gain or loss was recorded as a result of their sales. However, due to net-of-tax purchase accounting, other income of $17.8 million with a corresponding tax provision of $17.8 million has been recorded as a result of these divestitures. This income, net of the related tax provision, has been included in net gain on disposal of businesses in the Consolidated Statement of Income. During the second quarter of fiscal 1991, the Company sold two of its businesses, Hedstrom and Emerson. Certain net assets of Emerson were sold for total cash consideration of $56.1 million. Since the consideration received for Emerson approximated the fair value allocated to the net identifiable assets of this division in purchase accounting, no net gain or loss was recorded as a result of this divestiture. Certain net assets of Hedstrom were sold to New Hedstrom Corp. ("Buyer"), an affiliate of GAI Partners Limited Partnership ("GAI Partners"), which was organized to purchase, own and operate the business constituted by such assets (the "Business"), for total consideration of $34.5 million. The $34.5 million of consideration received by the Company consisted of a $32.5 million note receivable, which bears interest at 9.0% payable quarterly, with principal payments due in varying installments through January 1998 (the "Hedstrom Note"), and 9.0% cumulative preferred stock of Hedstrom Holdings, Inc., which owns 100% of the stock of Buyer, having a redemption value of $2.0 million. Payment of interest on the Hedstrom Note may be deferred at the option of GAI Partners until maturity, with interest accruing at 9.0% on any amount of unpaid principal and interest. The Hedstrom Note is secured by a pledge of the non-voting preferred stock GAI Partners holds in GAFG. In the event of default on the GAFG non-voting preferred stock, GAMI has agreed to issue GAMI non-voting preferred stock with similar rights and designations. Through January 1996, any acceleration resulting from a default under the Hedstrom Note may, at the option of GAI Partners, be satisfied solely by the transfer of the aforementioned preferred stock (see Note 12) to the holder of such note. Since the consideration received for the Business approximated the fair value allocated to the net identifiable assets of Hedstrom in purchase accounting, no net gain or loss was recorded as a result of this divestiture. In connection EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 with the sales of Emerson and Hedstrom, while no net gain or loss was recognized due to net-of-tax purchase accounting, other income of $3.8 million with a corresponding tax provision of $3.8 million has been recorded as a result of these divestitures. This income, net of the related tax provision, has been included in net gain on disposal of businesses in the Consolidated Statement of Income. In fiscal 1991, the Company recorded an additional gain on disposal of $6.9 million relating to the fiscal 1990 divestiture of a business. There was no corresponding tax provision related to this additional gain due to net-of-tax accounting. The following table summarizes key financial data related to the discontinued operations of Lapp, Power Structures, Underground Technologies, Signet, Pulsafeeder, Equality, DeVilbiss Health Care, Air Maze, Atlantic, Emerson and Hedstrom. The net current assets of discontinued operations included in the Consolidated Balance Sheet at December 31, 1993 amounted to $38.9 million, and consisted primarily of receivables, inventories and property, plant and equipment, net of accounts payable, accrued liabilities, debt and accrued employee benefit obligations. These amounts have all been classified as current based on the intent to dispose of them within one year. The net current assets of discontinued operations at December 31, 1992 amounted to $65.3 million and consisted primarily of receivables, goodwill and inventories net of accounts payable and accrued liabilities. The net long-term assets of discontinued operations at December 31, 1992 amounted to $21.6 million and consisted primarily of property, plant and equipment and goodwill, net of debt and accrued employee benefit obligations. (5) DEBT SENIOR SUBORDINATED NOTES: Amounts outstanding at December 31, 1993 under the Company's Senior Subordinated Notes are as follows: EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 Senior Deferred Coupon Notes: The Company's $315 million principal amount of Senior Deferred Coupon Notes (the "Notes") issued pursuant to an Indenture, dated July 1, 1993, (the "Indenture") mature on July 15, 2003. The issue price of each Note was $598.97 per $1,000 principal amount at maturity, which represents a yield to July 15, 1998 of 10.5% per annum. Cash interest will not accrue on the Notes prior to July 15, 1998. Cash interest will be payable on January 15 and July 15 of each year at a rate of 10.5% per annum commencing January 15, 1999 until maturity. The Notes are general unsecured obligations of the Company and rank pari pasu in right of payment with all senior indebtedness of the Company. The Notes are redeemable at the Company's option on or after July 15, 1998 at par value, plus accrued interest. In addition, prior to July 15, 1996, up to 35% of the Notes may be redeemed out of the proceeds of certain equity offerings at 110% of accreted amount to July 15, 1994 and decreasing by 1% per annum each July 14 thereafter, until July 14, 1996. Upon a Change of Control (as defined below) each holder of the Notes may require the Company to repurchase such holders' Notes at 101% of the accreted amount plus accrued interest, if any. A Change of Control is primarily defined to mean such time as any person or group, [other than GAMI, Equity Holding Limited, Hellman & Friedman Capital Partners and any affiliate thereof (the "Original Investors")], become the beneficial owner of more than 40% of the voting power of stock of the Company and such ownership level exceeds that of the Original Investors as a group. The Notes contain restrictive covenants, the more significant requirements being: a limitation on dividend payments and distributions on capital stock; restrictions on distributions from subsidiaries; limitations on sales of assets and subsidiary stock; and limitations on the creation of additional indebtedness (excluding certain refinancings of indebtedness, certain amounts to finance capital expenditures, indebtedness under bank credit agreements not to exceed $440 million, and other indebtedness of $50 million) unless consolidated EBITDA to Consolidated Net Interest Expense (as defined in the Indenture) is equal to or exceeds 1.75 to 1 for periods through July 1995 and 2.00 to 1 for periods after July 1995. 13% Senior Subordinated Notes: The Company's $300 million 13% Senior Subordinated Notes ("13% Notes") issued pursuant to an indenture dated October 1, 1988 (the "Eagle Indenture") were due in October 1998. The 13% Notes became redeemable by the Company on October 15, 1993 at 104% of the principal amount of these notes with the redemption price reducing to 100% in 2% increments each October 15 thereafter. The 13% Notes were subordinated to all existing Senior Debt of the Company. In April 1993, the Company commenced a tender offer for $151 million aggregate principal amount of the 13% Notes at a price as subsequently amended of $1,049 per $1,000 principal amount. The Company also solicited consents, at a price of $15 for each $1,000 principal amount of 13% Notes purchased, from tendering holders for proposed amendments to the Eagle Indenture to allow the Company and its subsidiaries to incur certain amounts of additional indebtedness. The Company received sufficient consents to adopt the proposed amendments to the Eagle Indenture and consummated the tender offer on July 12, 1993, concurrent with the offering of the Notes. As further discussed in Note 17, Subsequent Events -- Refinancing, in January 1994, the Company called for redemption on February 27, 1994, the remaining $149 million of 13% Notes at 104% of their principal amount plus accrued interest. Proceeds for the redemption were derived from the Refinancing. 13.75% Notes: The $75 million 13.75% Senior Subordinated Notes ("13.75% Notes") issued pursuant to an indenture dated March 15, 1988 were due in March 1998. The 13.75% Notes were redeemable at 108.25% of the EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 principal amount of these notes in March 1992 decreasing to 100% in 1.375% increments each March 15 thereafter. As further described in Note 17, Subsequent Events -- Refinancing, in January 1994, all of the 13.75% Notes were called for redemption on March 15, 1994 at 105.5% of their principal amount plus accrued interest. Proceeds for the redemption were derived from the Refinancing. OTHER LONG-TERM DEBT: Eagle Industrial Credit Facility: As further described in Note 17, in January 1994 the Company consummated a refinancing (the "Refinancing"), the proceeds of which were utilized to repay and redeem of all of its subsidiaries senior bank credit facilities, its 13% Notes and the 13.75% Notes. Thus, in January 1994 the Senior Bank Credit Facilities (defined below) were fully repaid and the agreements terminated. A portion of the proceeds to consummate the Refinancing were derived from a new senior bank credit facility made available to Eagle Industrial Products Corporation, ("Eagle Industrial") a newly formed wholly owned subsidiary of the Company which owns all of the operating subsidiaries of the Company. On January 31, 1994, Eagle Industrial entered into a new $425 million senior credit facility with a group of banks (the "Credit Facility"). The Credit Facility consists of: (1) a $225 million term loan due in quarterly installments increasing from $4.9 million per quarter during 1994 to $15 million in 1999; (2) a $65 million term loan due in equal quarterly installments aggregating $0.5 million per year in 1994 and 1995, $1 million per year in 1996 through 1999 and $60 million in 2000; and (3) a $135 million revolving credit facility (subject to borrowing base availability) that expires in 1999, which may be extended through 2000. Borrowings under the Credit Facility bear interest at alternative floating rate structures, at management's option (4.9% at January 31, 1994), and are secured by substantially all domestic property, plant, equipment, inventory and certain receivables of Eagle Industrial and its subsidiaries. The Credit Facility requires an annual commitment fee of 0.5% on the average daily unused amount of the revolving portion of the Credit Facility. At January 31, 1994, $35 million and $290 million were outstanding under the revolving credit portion and term loan portion of the Credit Facility, respectively. Additionally, the Credit Facility provides for a letter of credit facility of up to $50 million. Borrowing availability under the revolving portion of the Credit Facility is reduced by the outstanding amount of letters of credit. At January 31, 1994, an additional $28.0 million was available to borrow under the Credit Facility. The Credit Facility contains various financial covenants, the more restrictive requirements being: the maintenance of minimum levels of net worth; limitations on incurring additional indebtedness; restrictions on the payment of dividends or the making of loans to the Company; maintenance of certain ratios of cash flow to EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 interest expense and indebtedness; maintenance of a minimum level of cash flow to fixed charges; and a prohibition on payments to the Company for management services in excess of $3 million per year. The Company has provided a guarantee as to the repayment of amounts outstanding under this credit facility. Additionally, the Credit Facility requires that the Zell interests (as defined) directly or indirectly maintain at least 30% of the voting power to elect members of the board of directors of the Company and that the Company directly own 100% of Eagle Industrial. The proforma aggregate long-term debt maturities over the next five years (including amounts that will be due under the Credit Facility and excluding amounts repaid in connection with the Refinancing) are as follows: 1994 -- $23.2 million; 1995 -- $27.0 million; 1996 -- $36.8; 1997 -- $40.3 million and 1998 -- $51.3 million. Senior Bank Credit Facilities: The Company had four senior credit facilities which were available to four subsidiary groups of the Company prior to the Refinancing (the "Senior Bank Credit Facilities") (see Note 17). A portion of the proceeds of the Refinancing were utilized to fully repay the Senior Bank Credit Facilities in January 1994. The aggregate amount available under the revolving portion of the Senior Bank Credit Facilities (subject to borrowing base availability) amounted to $350.0 million at December 31, 1993, of which $156.9 million was outstanding. Additionally, the Senior Bank Credit Facilities at December 31, 1993 included $69.6 million in outstanding term loans, which were due in quarterly installments increasing from $3.9 million per quarter in 1994 to $7.5 million in 1997. Borrowings under the Senior Bank Credit Facilities bore interest at alternative floating rate structures, at management's option (5.6% and 6.1% at December 31, 1993 and 1992, respectively), and were secured by substantially all domestic property, plant, equipment, inventory and receivables of the Company's subsidiaries. Annual commitment fees ranging from 0.375% to 0.60% were payable on the average daily unused amount of the revolving portion of these credit agreements. Three of these senior credit facilities were guaranteed by the Company. Additionally, these credit facilities provided for letter of credit facilities within each credit facility. At December 31, 1993, $33.5 million of letters of credit were issued and outstanding under the aforementioned credit facilities. The Senior Bank Credit Facilities contained various financial covenants, the more restrictive requirements being: the maintenance of minimum levels of net worth; limitations on the incurrence of additional indebtedness, as defined; maintenance of certain ratios of profitability to interest expense; maintenance of certain asset to liability ratios; requirements that the Zell interests (as defined) directly or indirectly maintain at least 51% of the voting power to elect members of the board of directors of certain subsidiary groups; and maintenance of minimum levels of earnings to fixed charges, as defined. The Company and its subsidiaries were in compliance with all covenants of their respective debt agreements at December 31, 1993. (6) EMPLOYEE RETIREMENT AND BENEFIT PLANS: PENSION: U.S. Plans: Substantially all employees are covered by Company or union sponsored defined benefit pension plans. Plans covering salaried and management employees provide pension benefits that are based on the employee's years of service with the Company and average compensation during the five years before retirement. For other employees, pension benefits are provided based on a stated amount for each year of service. The Company's funding policy for all plans is to make no less than the minimum annual contributions required by applicable governmental regulations. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The following table sets forth the funded status for all U.S. defined benefit pension plans and related amounts recognized in the Company's Consolidated Financial Statements: Plan assets generally consist of common stocks and fixed income instruments. The unrecognized liability at August 1, 1987 is being amortized on a straight-line basis over 15 years. In accordance with SFAS No. 87, the Company has recorded an additional minimum pension liability for underfunded plans of $10.1 million and $3.2 million at December 31, 1993 and 1992, respectively, representing the excess of unfunded accumulated benefit obligations over previously recorded pension cost liabilities. A corresponding amount is recognized as an intangible asset except to the extent that these additional liabilities exceed related unrecognized prior service costs and net transition obligations, in which case the increase in liabilities is charged directly to stockholder's equity. At December 1993, the excess minimum pension liability resulted in a net charge to equity of $4.6 million. Net periodic pension cost for defined benefit pension plans reporting under the provisions of SFAS No. 87 included in the above table was: EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The following assumptions were used in determining the actuarial present value of the projected benefit obligation for the Company's U.S. defined benefit plans: weighted-average discount rate of 7.5% for the year ended December 31, 1993 and 9.0% for the five months ended December 31, 1992; rate of increase in future compensation levels of 4.0% for the year ended December 31, 1993 and 6.0% for the five months ended December 31, 1992; and expected long-term rate of return on assets of 9.0% for both periods. The Company and its subsidiaries also have several defined contribution plans for certain U.S. employees. Employer contributions to these plans were $4.8 million in the year ended December 31, 1993, $1.2 million in the five months ended December 31, 1992, $4.4 million in fiscal 1992 and $3.2 million in fiscal 1991. Contributions to these plans by the Company are determined under a variety of methods including those based on the number of years employed or a percentage of the contribution made by the employee. Non-U.S. Plan: The following table sets forth amounts recognized in the Company's Consolidated Financial Statements related to its non-U.S. unfunded pension plan: Net periodic pension cost for this non-U.S. defined benefit pension plan included in the above table was: The Company used the following assumptions in determining the actuarial present value of the projected benefit obligation for this non-U.S. pension plan: weighted average discount rate of 7.25% for the year ended December 31, 1993 and 8.25% for the five months ended December 31, 1992 and fiscal 1992, and rate of increase in future compensation levels of 4.0 % for all periods presented. Pension payments are paid by this subsidiary from funds generated by operations. OTHER POSTRETIREMENT BENEFITS: The Company provides certain postretirement life and health-care benefits to certain of its employees. For most business units providing these benefits, employees retiring from the Company on or after attaining EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 age 55 who have rendered at least 15 years of active service to the Company are entitled to postretirement benefits coverage. Most of these plans are non-contributory, while there are a few in which employees and retirees contribute towards their coverage. The Company has not funded any of this postretirement benefits liability. Contributions to the postretirement plans are made by the Company as claims are incurred. The Company adopted the provisions of SFAS No. 106 in the first quarter of fiscal 1992 by adjusting its postretirement benefits liability recognized as of August 1, 1991 to the discounted present value of expected future benefits attributed to employees' service rendered prior to August 1, 1991. The accumulated postretirement benefit obligation was determined using an assumed discount rate of 7.5% for the year ended December 31, 1993, 9% for the five months ended December 31, 1992 and 9.5% for fiscal 1992, and a health care cost trend rate of 12% for the year ended December 31, 1993, with the assumption that the health care cost trend rate would decrease ratably to 6.0% by the year 1997. The health care cost trend rate was 13.0% for the five months ended December 31, 1992, with the assumption that the health care cost trend rate would decrease gradually to 7.0% by the year 2000. The trend rate used for the year ended July 31, 1992 was 15% with the assumption that the rate would gradually decrease to 7.5% by the year 2000. The effect of a one percent increase in the health care cost trend rate assumption would be to increase the accumulated postretirement benefit obligation, the annual service cost and interest expense components by approximately $3.2 million, $0.2 million and $0.4 million, respectively. In adopting the provisions of SFAS No. 106, the Company evaluated the assumptions used previously in estimating its postretirement benefits obligation under the unfunded accrual method. Based on its experience and the results of this evaluation, the Company revised certain of these previous assumptions when adopting SFAS No. 106. Trend rates used in adopting SFAS No. 106 reflect the Company's prior experience and expectation that future rates will trend downward. Additionally, the August 1, 1991 valuation of the Company's postretirement benefit obligation included the effects of announced future cost sharing programs and benefit plan changes. In conjunction with the adoption of SFAS No. 106, the Company recorded a reduction of its postretirement benefit obligation of $24.2 million and recognized a corresponding $24.2 million pretax benefit as a "Cumulative effect of change in accounting principle", with a related tax provision of $7.3 million. In the fourth quarter of 1993, the Company curtailed certain of its postretirement benefits for its non-bargaining employees. In general, the curtailment affects employees who retire after December 1994 with exception for certain employees who meet certain age plus years of service requirements. The curtailment resulted in a reduction of the postretirement benefit liability of $4.2 million. The effect of the curtailment was offset by a charge in the fourth quarter of 1993 of $4.2 million related to the Company s self-insurance costs. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The following table sets forth postretirement benefits recognized in the Company's Consolidated Financial Statements: Net postretirement benefit cost included the following components: (7) INCOME TAXES The Company adopted the provisions of SFAS No. 109 effective January 1, 1993. The December 31, 1993 Consolidated Financial Statements reflect a decrease in the net deferred tax assets of $3.5 million and a corresponding charge of $3.5 million, reflected as a "Cumulative effect of change in accounting principle". As part of the adoption of SFAS No. 109, various "gross" up adjustments were made to the balance sheet in order to adjust amounts which were originally recorded on a net of tax basis as part of purchase accounting. These adjustments resulted in increases to net property, plant and equipment, accrued liabilities, accrued employee benefit obligations and other long-term liabilities of approximately $21.4 million, $1.9 million, $19.3 million and $12.2 million, respectively. These increases were offset by a corresponding increase to deferred taxes of approximately $12.0 million. As a result of the adoption of SFAS No. 109, the Company's loss from continuing operations before income taxes for the year ended December 31, 1993 was increased by approximately $2.0 million due to increased depreciation expense. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The Company's Consolidated Financial Statements reflect the following deferred tax assets and liabilities (in millions): The U.S. and non-U.S. components of income from continuing operations before income taxes and the components of the provision for income taxes is as follows: EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 Deferred tax provisions/(benefits) for the five months ended December 31, 1992 and for the fiscal years ended July 31, 1992 and 1991, resulted principally from expenditures related to divestitures, non-cash accrued employee benefits and depreciation. Reconciliation of income taxes computed at the U.S. federal statutory rate to the consolidated provision (benefit) for income taxes from continuing operations: (8) RESTRUCTURING CHARGES During 1993, the Company recorded restructuring charges of $71.8 million related principally to the closure of Hill's Canadian manufacturing facility, the write down of certain assets of Hill Refrigeration, the closure of Caron's London, Kentucky manufacturing facility, the downsizing of certain of Pfaudler's foreign operations and costs associated with the relocation of one of IEP's manufacturing facilities. In 1993, the Company decided to close Hill's Canadian manufacturing facility. Accordingly, a charge of $8.8 million was recorded in the third quarter of 1993 to reflect the write down of property, plant and equipment and to accrue for related shut down expenses. The shut down was substantially complete at December 31, 1993. In addition, in late 1993, the Company performed an in-depth analysis of Hill's products, competitive position, market share and manufacturing cost base. A decision was made to reduce its manufacturing costs and simplify its manufacturing processes for its commercial refrigeration cases which were being redesigned. To implement this decision, a review of reconfiguration and/or relocation options was initiated. A decision was made to relocate the manufacturing of the redesigned cases. Accordingly, a review was made of the fair market value of the Trenton manufacturing facility which resulted in a write down of $19.4 million in the fourth quarter of 1993. Employee related costs of $7.0 million associated with the relocation/reconfiguration decision were also recorded in the fourth quarter of 1993. In evaluating the goodwill related to Hill, a write-down of $25.8 million was made in the fourth quarter of 1993 in accordance with the Company's accounting policy for goodwill. In the third quarter of 1993, the Company decided to consolidate Caron's London, Kentucky manufacturing facility into Caron's other manufacturing facilities. Accordingly, the Company provided $6.2 million of EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 restructuring charges including $3.0 million for the write down of property, plant and equipment and $3.2 million for shut down related expenses. The shut down was substantially complete at December 31, 1993. In the third quarter of 1993, the Company initiated a restructuring of its work force in Pfaudler's German manufacturing unit. Costs for severance payments in accordance with German legal requirements were accrued in the third quarter of 1993. This severance program has been substantially completed in early 1994. In conjunction with the relocation of one of IEP's manufacturing facilities in the first quarter of 1993, costs were incurred which exceeded previously established reserves. Accordingly, the Company recorded $2.0 million in charges in the fourth quarter of 1993. The cash and non-cash components of these charges are as follows (in millions): EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 (9) BALANCE SHEET DETAIL (10) INCOME STATEMENT DETAIL Repair and maintenance expense was $14.1 million in the year ended December 31, 1993, $6.6 million for the five months ended December 31, 1992, $19.3 million in fiscal 1992 and $16.0 million in fiscal 1991. Advertising expense was $6.3 million in the year ended December 31, 1993, $3.5 million for the five months ended December 31, 1992, $7.9 million in fiscal 1992 and $7.0 million in fiscal 1991. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 (11) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash, cash equivalents and long-term investments The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those instruments. Long-term investments are stated at the lower of cost or market. Subordinated Notes The fair value of the Company's Notes is based on the Call Price at January 31, 1994, for the 13% Notes and the 13.75% Notes and quoted market prices for the Notes at December 31, 1993. The fair value was determined using quoted market prices for all the subordinated notes at December 31, 1992. Senior Bank Credit Facilities The carrying amount approximates fair value as the rates are tied to the prime rate and LIBOR which fluctuate based on current market conditions. Other Debt The carrying amount approximates fair value as rates approximate borrowing rates currently available to the Company for similar loans. The estimated fair values of the Company s financial instruments are as follows: (12) STOCKHOLDER'S EQUITY PREFERRED STOCK: The Company amended its Restated Certificate of Incorporation in December 1993 to eliminate the authority to issue preferred stock. COMMON STOCK: In connection with the Restructuring, and in order to facilitate the distribution of Eagle's common stock in September 1992, the Company distributed, as a stock dividend, approximately 11,077 shares of its common stock for each share outstanding. As the GAMI Board of Directors decided not to complete the Distribution, the Company declared a reverse stock split of 1/11,077 per share of common stock in December 1993, resulting in the Company having 1,000 shares of common stock issued and outstanding. The accompanying financial statements and related footnotes have been restated to give retroactive effect to this reverse stock split. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 ADDITIONAL PAID IN CAPITAL: Restructuring In connection with the sale of certain net assets of Hedstrom to an affiliate of GAI Partners in January 1991, a portion of the consideration received included the Hedstrom Note. Through January 16, 1996, any acceleration resulting from a default under the Hedstrom Note may, at the option of GAI Partners, be satisfied solely by the preferred stock GAI Partners holds in GAFG (the "Class C Preferred Stock"). See Note 4. The terms of the Class C Preferred Stock include, among other things, (i) that the holder of the Class C Preferred Stock may on January 15 of 1999, 2000 and 2001, require GAFG to redeem any or all of the Class C Preferred Stock at a redemption price equal to $1,000 per share plus a redemption premium equal to 8% of the amount redeemed if redeemed in 1999, 11% if redeemed in 2000 and 13% if redeemed in 2001, plus accrued but unpaid dividends through the date of redemption, (ii) that upon liquidation of GAFG, the Class C Preferred Stock is entitled to a liquidation preference of $1,000 per share, and (iii) in the event of default on the GAFG non-voting preferred stock, GAMI has agreed to issue GAMI non-voting preferred stock with similar rights and designations. See Note 4. To relieve GAFG (to the extent Eagle or any of its subsidiaries acquires such rights and is permitted to do so under the Eagle Indenture and one of the Senior Bank Credit Facilities) of its obligation to redeem, or pay a liquidation preference with respect to the Class C Preferred Stock, Eagle declared and paid to GAFG, its sole shareholder at the time, a non-cash dividend consisting of the benefits conferred by Eagle's execution of a Disaffiliation Agreement (the "Disaffiliation Agreement"), effective as of September 25, 1992. Although the dividend was paid by the execution of the Disaffiliation Agreement, the economic benefit of the dividend will be received, if at all, only upon the satisfaction of certain conditions including that no default under the Indenture exists or is caused by the transfer of said benefits. Pursuant to the Disaffiliation Agreement, among other things: - Eagle agreed that if it or any of its subsidiaries becomes the owner of any Class C Preferred Stock, it will transfer or cause to be transferred (the "Transfer") such Class C Preferred Stock to GAFG without the payment of any amount by GAFG, provided that certain conditions are satisfied including that no default under the Indenture exists or is caused by the Transfer; - Eagle agreed that if the Transfer is made by one of its subsidiaries, it will pay the transferor the redemption price or, if applicable, the liquidation preference related to such Class C Preferred Stock, that the transferor would have received from GAFG had the Transfer not been made, such payment to be made at the time that GAFG would have been obligated to pay such redemption price or liquidation preference; - Eagle agreed to reimburse GAFG if GAFG pays any amount, to Eagle or its subsidiaries (or any transferee of Eagle or its subsidiaries), for redemption of, or as a liquidation preference in respect of, any Class C Preferred Stock, provided that certain conditions are satisfied including that no default under the Indenture exists or is caused by the reimbursement; and - To induce GAI Partners, as the owner of the Class C Preferred Stock, to consent to the Restructuring and the Distribution, GAMI guaranteed GAFG's obligation to pay the redemption price or the liquidation preference, provided such guaranty will terminate if a default occurs and is continuing under the Hedstrom Note or GAI Partners transfers ownership of the Class C Preferred Stock to the holder of the Hedstrom Note. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The Disaffiliation Agreement conferred no benefits on Eagle, but Eagle's execution thereof is a condition of the Distribution. To account for the reorganization and the above transactions, Eagle reduced paid in capital at July 31, 1992 by the amount of the Hedstrom Note and related accrued interest thereon, pursuant to the dividend of the benefits conferred on GAFG through execution of the Disaffiliation Agreement. Other Transactions In January 1991, GAFG issued 35,650 shares of its non-voting preferred stock having a redemption value of $1,000 per share to GAI Partners, in exchange for the 20% of GAFG common stock held by GAI Partners. GAFG has accounted for the exchange of the aforementioned securities as an acquisition of its minority interest, in accordance with APB No. 16, and has "pushed down" this additional purchase price to subsidiaries of GAFG, pursuant to Securities and Exchange Commission regulations. The effect on the Consolidated Financial Statements, as a result of this transaction, was an increase in both paid in capital and goodwill of approximately $35.6 million. In January 1991, prior to the contribution of the capital stock of Jepson to the Company, Jepson returned $5.0 million of original contributed capital to subsidiaries of GAMI. In March 1991, prior to the contribution of the capital stock of North Riverside to the Company, GAMI converted $0.6 million of contributed capital of North Riverside to intercompany indebtedness. PENSION LIABILITY ADJUSTMENT: In December 1993, the Company recorded a charge to equity related to its underfunded pension plans. See Note 6. DIVIDENDS: In February 1991, the Company paid a $30.0 million cash dividend to its shareholders. (13) RELATED PARTY TRANSACTIONS The Company has in the past entered into agreements or arrangements with affiliates of directors or officers relating to acquisition and divestiture services, financing services, legal services and consulting arrangements which are described below. In addition, the Company has entered into arrangements for certain administrative services in which the amount involved did not exceed $60,000 for any one agreement. The Company believes that the terms and resulting costs of all related party transactions and agreements are no more or less favorable than those which could have been obtained from non-affiliated parties. The Company leases office space from an affiliate of GAMI. The Company incurred expenses of $0.3 million in the year ended December 31, 1993, $0.2 million in the five months ended December 31, 1992 and $0.4 million in each of fiscal 1992 and 1991 for this office space and related expenses. Affiliates of GAMI provided management services to the Company for which the Company paid $0.5 million in fiscal 1991. Affiliates of GAMI provide general corporate computer and printing services to the Company for which the Company paid these affiliates $0.2 million in the year ended December 31, 1993, the five months ended December 31, 1992 and in each of fiscal 1992 and 1991. GAMI's internal audit department provides certain audit services to the Company for which GAMI was paid $0.2 million in the year ended December 31, 1993, $0.1 million in the five months ended December 31, 1992, $0.7 million in fiscal 1992 and $0.5 million in fiscal 1991. An affiliate of GAMI was paid $1.1 million in fiscal 1991 for services rendered in connection with the divestitures of certain business. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The law firm of Rosenberg & Liebentritt P.C., of which a Company Director and former Officer is a member, has rendered legal services to the Company. The Company paid this law firm $0.6 million in the year ended December 31, 1993, $0.3 million in the five months ended December 31, 1992, $1.0 million in fiscal 1992 and $1.5 million in fiscal 1991. The fees paid to Rosenberg & Liebentritt P.C. in the year ended December 31, 1993 included: $0.3 million for services related to divestiture activity, $0.1 million for services related to financing agreements and $0.2 million for other general expenses. The Company and North Riverside historically entered into revolving credit facilities with GAMI. All amounts were repaid prior to December 31, 1992. GAMI provided management and accounting services to North Riverside for which North Riverside paid $0.1 million in each of fiscal 1992 and 1991. Also see Notes 1, 3, 4 and 12 for other information regarding related party transactions. (14) COMMITMENTS AND CONTINGENCIES The Company conducts manufacturing operations at various leased facilities and also leases warehouses, office space, computers and office equipment. Most of the realty leases contain renewal options and escalation clauses. Total rent expense, including related real estate taxes, amounted to $13.4 million in the year ended December 31, 1993, $5.7 in the five months ended December 31, 1992, $12.1 million in fiscal 1992 and $11.6 million in fiscal 1991. Future minimum lease payments required as of December 31, 1993 (in millions): The Company and certain of its subsidiaries are involved in several lawsuits arising in the ordinary course of business. However, it is the opinion of the Company's management, based upon the advice of counsel, that these lawsuits are either without merit, are covered by insurance, or are adequately reserved for in the Consolidated Financial Statements, and that the ultimate disposition of pending litigation will not be material in relation to the Company's consolidated financial position. (15) OTHER ACQUISITIONS/DIVESTITURES Management continues to evaluate the acquisition of businesses that complement the existing portfolio of companies. While certain negotiations are at varying stages at this time, Eagle currently has no contract or arrangement with respect to any material acquisition. Management also continuously monitors and evaluates the businesses within the Company's portfolio. While certain businesses may not necessarily meet certain of the Company's long-term objectives, there currently are no definitive sales agreements or formal plans to discontinue any businesses except Lapp as disclosed in Note 4. (16) SEGMENT AND GEOGRAPHIC DATA Eagle is organized into five business segments: the Building Products Group, the Electrical Products Group, the Industrial Products Group, the Automotive Products Group, and the Specialty Products Group. In EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 1993, the Company redefined its industry segments to add an Automotive Products Group and realign its Building Products and Specialty Products Groups. Segment information for prior periods has been restated to reflect the reclassifications. The Building Products Group consists of three businesses which manufacture and distribute building fixtures for the residential and commercial construction and home improvement markets. Products manufactured by this group include air distribution and handling equipment, bathroom plumbing fixtures and air compressors. The Electrical Products Group consists of two broad groups of businesses, those providing electrical power distribution products for the electric utility market and those supplying industrial electrical products for electrical equipment manufacturers. The principal products manufactured by this group include medium voltage electric cable, underground cable accessories, and interconnect and timing devices. The Industrial Products Group consists of three businesses which manufacture and distribute products for the process industries and commercial aviation markets. Products manufactured by this group include chemical and pharmaceutical reactor vessels, fluid mixing and agitation equipment and commercial airline seating. The Automotive Products Group consists of four businesses which manufacture and distribute products primarily to the automotive aftermarket. Major products include automotive aftermarket parts and accessories. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 The Specialty Products Group consists of three businesses which manufacture and distribute products to the consumer market and the commercial refrigeration market. Major products include knitting yarns, skiwear and commercial refrigeration equipment. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 Corporate depreciation and amortization is principally amortization of debt issuance costs. Corporate assets are principally cash and cash equivalents, debt issuance costs, taxes receivable from affiliate and in fiscal 1991, notes receivable. The following table shows certain financial information relating to the Company's operations in various geographic areas: Export sales from the United States to other geographic areas were $17.4 million in the year ended December 31, 1993, $8.0 million for the five months ended December 31, 1992, $60.0 million in fiscal 1992 and $68.5 million in fiscal 1991. (17) SUBSEQUENT EVENTS -- REFINANCING On January 31, 1994, Eagle completed a refinancing (the "Refinancing") of substantially all of its outstanding debt except for its Senior Deferred Coupon Notes. Through a newly formed subsidiary, Eagle Industrial, the Company entered into the Credit Facility with a group of banks. The Company also entered into an asset securitization program (the "Securitization") whereby it sold certain of its accounts receivable for EAGLE INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1993 approximately $110 million. In addition, the Company received $50 million from GAMI in the form of a capital contribution. Total proceeds from the Refinancing were $485 million. Proceeds from the Refinancing were used to retire the Senior Bank Credit Facilities. In addition, proceeds will be used to retire the Company's 13.75% Notes and the 13.0% Senior Subordinated Notes, both of which were called for redemption on January 28, 1994. The call price for the 13.75% and 13.0% Senior Subordinated Notes was $1,055 and $1,040 per $1,000 principal amount, respectively. Eagle will record an extraordinary pretax charge of approximately $26 million in the first quarter of 1994 in connection with the Refinancing. In connection with the Securitization, the Company entered into a receivables sale agreement whereby it will sell on a continuous basis, an undivided interest in a pool of customer account receivables. Under the agreement, which expires in June 1999, the maximum amount of proceeds which may be accessed through this agreement is $145 million and is subject to change based on the level of eligible receivables and restrictions on concentrations of receivables. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL DATA (UNAUDITED) QUARTERLY FINANCIAL DATA The following is a summary of the unaudited interim results of operations for the years ended December 31, 1993 and 1992. Quarterly data has been restated to reflect discontinued operations. Refer to Note 4 in the Company's Consolidated Financial Statements. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT DIRECTORS OF EAGLE The chart below sets forth the name of each director of Eagle as of March 15, 1994 and, for each, the year during which each director was first elected, information relating to the director's principal occupation and business experience during the last five years, and any other directorships held by the director in publicly held companies, and certain other information. Eagle's Amended and Restated By-Laws (the "Eagle Bylaws") provide that the number of directors shall not be less than one nor more than eleven, with the precise number to be determined by resolution of the Board of Directors or the stockholders from time to time. The Board of Directors has fixed the number of directors at four. Each director is elected to serve until the next annual meeting or until his successor is duly elected and qualified. EXECUTIVE OFFICERS OF EAGLE The chart below sets forth the age and position of each executive officer of Eagle at March 15, 1994: Mr. Hall has served as President of Eagle since August 1988, as a Director of GAMI since March 1994, and as Chief Executive Officer of Eagle since July 1990. From August 1988 until September 1992, Mr. Hall also served as Chief Operating Officer and Treasurer of Eagle. Mr. Hall is a Director of Huffy Corporation, a manufacturer of bicycles and recreational products, and A.M. Castle & Co., a metals distribution company. Mr. Athas has served as Senior Vice President, General Counsel and Secretary of the Company since May 1993. From September 1992 to May 1993, Mr. Athas was Vice President, General Counsel and Secretary. From November 1987 to September 1992, Mr. Athas served as Vice President, General Counsel and Assistant Secretary. Mr. Cottone has served as Senior Vice President -- Finance, Chief Financial Officer and Treasurer of the Company since March 1994. From May 1993 to March 1994, Mr. Cottone served as Senior Vice President -- Finance and Chief Financial Officer. For more than five years prior thereto, Mr. Cottone was a partner with Arthur Andersen & Co. Mr. Koulogeorge has served as Vice President -- Corporate Development since September 1992. From October 1990 to September 1992, Mr. Koulogeorge served as Director -- Corporate Development. From August 1989 until September 1990, Mr. Koulogeorge was a mergers and acquisitions associate with Equity Group. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS EAGLE/GAMI TAX AGREEMENT Eagle and its U.S. subsidiaries are included with GAMI in its consolidated U.S. federal income tax returns for the taxable periods during which, pursuant to applicable U.S. federal income tax laws, they qualify as members of GAMI's affiliated group (the "Affiliation Years"). GAMI has entered into tax sharing agreements with Eagle and each of its U.S. subsidiaries. Collectively, these tax sharing agreements (i) provide for the manner of determining the allocation and payment of U.S. federal, state and foreign income tax liabilities and benefits among members of each subsidiary group for the Affiliation Years, (ii) detail the procedure for determining the allocation of payments by, or refunds to, members of each subsidiary group as a result of adjustments to the U.S. federal or state income tax liabilities of any or all members of such subsidiary group with respect to any Affiliation Year and (iii) define the post-affiliation obligations of GAMI and any member that becomes disaffiliated with any of the subsidiary groups (a "Former Member") with respect to post-affiliation years in which the tax liability of GAMI, such Former Member or subsidiaries of such Former Member may be affected by the former affiliation. Under the tax sharing agreements, each member is to benefit fully from any loss, deduction or credit attributable to such member. DISAFFILIATION AGREEMENT Prior to January 9, 1991, Ditri Associates, Inc., a Delaware corporation, through its affiliate, GAI Partners Limited Partnership ("GAI Partners"), a Connecticut limited partnership not affiliated with GAMI or Eagle, owned 20% of the common equity of GAFG. On January 9, 1991, GAI Partners exchanged its 20% common equity interest in GAFG for 35,650 shares of GAFG Class C Preferred Stock (the "Class C Preferred Stock"), and Falcon Manufacturing, Inc. caused its subsidiary, Hedstrom Corporation ("Hedstrom") to sell certain of Hedstrom's net assets to New Hedstrom Corp. ("Buyer"), an affiliate of GAI Partners for total consideration of $34.5 million. Such consideration consisted of a $32.5 million promissory note made by GAI Partners, which bears interest at 9.0% payable quarterly, with principal payments due in varying installments through January 1998 (the "Hedstrom Note"), and 9.0% cumulative preferred stock of Hedstrom Holdings, Inc., which owns 100% of the stock of Buyer, having a redemption value of $2.0 million. Payment of interest on the Hedstrom Note may be deferred at the option of GAI Partners until maturity, with interest accruing at 9.0% on any amount of unpaid principal and interest. To date, GAI Partners has exercised this option and deferred payment of such interest. The Hedstrom Note is held by a subsidiary of Eagle and is secured by a pledge of the Class C Preferred Stock. The terms of the Class C Preferred Stock provide, among other things, that (i) the holder of the Class C Preferred Stock may on January 15 of 1999, 2000 and 2001, require GAFG to redeem any or all of the Class C Preferred Stock at a redemption price equal to $1,000 per share plus a redemption premium equal to 8% of the amount redeemed if redeemed in 1999, 11% if redeemed in 2000 and 13% if redeemed in 2001, plus accrued but unpaid dividends through the date of redemption, (ii) upon liquidation of GAFG, the Class C Preferred Stock is entitled to a liquidation preference of $1,000 per share, and (iii) in the event of default on the GAFG non-voting preferred stock, GAMI has agreed to issue GAMI non-voting preferred stock with similar rights and designations. GAI Partners is the current owner of all outstanding Class C Preferred Stock. Through January 16, 1996, upon acceleration, the Hedstrom Note may, at the option of GAI Partners, be satisfied by transferring ownership of the Class C Preferred Stock to the holder of such note. In such event, the holder of the Hedstrom Note would become the owner of the Class C Preferred Stock. In the event of a default on the Hedstrom Note, Eagle may indirectly become the owner of the Class C Preferred Stock. In this event, Eagle's subsidiary would have the rights of a holder of such Preferred Stock, including the right to require GAFG to redeem it. To relieve GAFG of its obligation to redeem, or pay a liquidation preference with respect to, the Class C Preferred Stock, Eagle declared and paid to GAFG, its sole stockholder at the time, a non-cash dividend consisting of the benefits conferred by Eagle's execution of a Disaffiliation Agreement (the "Disaffiliation Agreement"), effective as of September 25, 1992. Although the dividend was paid by the execution of the Disaffiliation Agreement, the economic benefit of the dividend will be received, if at all, only upon the satisfaction of certain conditions. Pursuant to the Disaffiliation Agreement, among other things: - Eagle agreed that if it or any of its subsidiaries becomes the owner of any Class C Preferred Stock, it will transfer or cause to be transferred (the "Transfer") such Class C Preferred Stock to GAFG without the payment of any amount by GAFG, provided that certain conditions are satisfied; - Eagle agreed to reimburse GAFG if GAFG pays any amount to Eagle or its subsidiaries (or any transferee of Eagle or its subsidiaries) for redemption of, or as a liquidation preference in respect of, any Class C Preferred Stock, provided that certain conditions are satisfied; and - To induce GAI Partners, as the owner of the Class C Preferred Stock, to consent to the Restructuring and the Distribution GAMI guaranteed GAFG's obligation to pay the redemption price or the liquidation preference, provided such guaranty will terminate if a default occurs and is continuing under the Hedstrom Note or GAI Partners transfers ownership of the Class C Preferred Stock to the holder of the Hedstrom Note. Eagle's execution of the Disaffiliation Agreement was a condition of the Distribution and the granting of the indemnity discussed below. INDEMNITY AGREEMENTS In connection with the Restructuring, GAMI and Eagle entered into an indemnity and hold harmless agreement pursuant to which GAMI agreed to indemnify and hold Eagle and its subsidiaries harmless from and against any and all claims, settlements, judgments or expenses (including reasonable attorneys' fees) relating to, affecting or arising out of claims filed against Madison, an unconsolidated affiliate of GAMI, in connection with its November 1991 petition under Chapter 11 (subsequently converted to Chapter 7) of the Bankruptcy Code. Eagle believes that any potential claim against Eagle arising out of the bankruptcy proceeding will not have a material effect on Eagle's operating results or financial condition, since (i) GAMI has indemnified Eagle as discussed above and (ii) GAMI has represented to Eagle that it has substantial meritorious defenses against actions brought by the trustee. In addition, GAMI and Eagle entered into an agreement (the "Indemnity Agreement") pursuant to which, among other things, GAMI agreed to indemnify Eagle, its subsidiaries and their respective officers and directors against any losses, liabilities, claims and damages arising out of or based upon any untrue statement of a material fact contained in, or the failure to state a material fact required to be stated in, the Information Statement which GAMI mailed on October 16, 1992 relating to the Distribution, other than in Appendix A to such Information Statement. Correspondingly, Eagle agreed to indemnify GAMI, its subsidiaries and their respective officers and directors against any losses, liabilities, claims and damages arising out of or based upon any untrue statement of a material fact contained in, or the failure to state a material fact required to be stated in Appendix A to such Information Statement. GAMI and Eagle each agreed to provide the other party to the Indemnity Agreement access to certain information in possession of the other party. ONGOING TRANSACTIONS WITH GAMI AFFILIATES Eagle has in the past entered into agreements or arrangements with affiliates of directors or officers of Eagle relating to acquisition and divestiture services, financing services, and consulting arrangements which are described below. In addition, Eagle has entered into arrangements for certain administrative services in which the amount involved did not exceed $60,000 for any one agreement. Eagle may enter into similar agreements or arrangements from time to time in the future. Eagle believes that the terms of the transactions described below are no less favorable than those which could have been obtained from non-affiliated parties. LEASES WITH AFFILIATES Eagle currently leases corporate office space at the rate of $28,000 per month from an affiliate of GAMI. The Company incurred expenses of $0.3 million in the year ended December 31, 1993. MANAGEMENT SERVICES Affiliates of GAMI provide general corporate computer and printing services to Eagle for which Eagle paid $0.2 million in the year ended December 31, 1993. Eagle will continue to utilize such services from time to time in the future. INTERNAL AUDIT SERVICES GAMI's internal audit department has provided Eagle with various audit services in the past, including review of operational and financial controls and assistance to outside auditors during Eagle's annual audit. These services have been provided to Eagle and its subsidiaries during the year ended December 31, 1993 at a cost of $0.2 million. Eagle will continue to utilize such services from time to time in the future. LEGAL SERVICES The law firm of Rosenberg & Liebentritt, P.C., of which Mrs. Rosenberg is a member, has rendered legal services to Eagle and its subsidiaries. Eagle paid this law firm $0.6 million in the year ended December 31, 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES, AND REPORTS ON FORM 8-K (A) Financial Statements and Schedules All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions, or are inapplicable, or the information called for therein is included elsewhere in the financial statements or the notes thereto. Accordingly, such schedules have been omitted. (B) Reports on Form 8-K None (C) Exhibits Exhibits required by Item 601 of Regulation S-K are listed in the Index to Exhibits, which is incorporated herein by reference. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To the Board of Directors of Eagle Industries, Inc. We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Eagle Industries, Inc. and Subsidiaries included in this Annual Report on Form 10-K, and have issued our report thereon dated March 10, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the adoption of Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 112, "Employer's Accounting for Postemployment Benefits", and No. 109, "Accounting for Income Taxes", as discussed in Note 2, Note 6 and Note 7 to the consolidated financial statements. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. Supplemental Schedule III is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the consolidated financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois March 10, 1994 EAGLE INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT EAGLE INDUSTRIES, INC. (PARENT COMPANY) BALANCE SHEETS The accompanying notes to these financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT EAGLE INDUSTRIES, INC. (PARENT COMPANY) INCOME STATEMENTS The accompanying notes to these financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT EAGLE INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF CASH FLOWS The accompanying notes to these financial statements are an integral part of these statements. EAGLE INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT EAGLE INDUSTRIES, INC. (PARENT COMPANY) NOTES TO FINANCIAL STATEMENTS (1) BASIS OF PRESENTATION In the parent company only financial statements for Eagle Industries, Inc., (the "Company"), the Company's investment in subsidiaries is stated at cost plus equity in undistributed earnings of subsidiaries since the date of acquisition. The Company's share of net income of its unconsolidated subsidiaries is included in consolidated income using the equity method. Pursuant to the Restructuring in September 1992, Clevaflex, Inc., formerly a subsidiary of Eagle, was merged into and became an operating division of Eagle. Parent company only financial statements should be read in conjunction with the Company's consolidated financial statements. (2) DEBT As further discussed in Note 5 to the Company's Consolidated Financial Statements, in July 1993, the Company issued $315 million principal amount of Senior Deferred Coupon Notes due 2003 (the "Notes"). The issue price of each Note was $598.97 per $1,000 principal amount at maturity, which represents a yield to July 15, 1998 of 10.5% per annum. Cash interest will not accrue on the Notes prior to July 15, 1998. The proceeds from the issuance of the Notes were used to redeem $151 million principal amount of the Company's 13% Senior Subordinated Notes ("13% Notes"). The 13% Notes were redeemed pursuant to a tender offer at a price of $1,049 per $1,000 principal amount. As further discussed in Note 17 to the Company's Consolidated Financial Statements, the Company called for redemption on February 27, 1994, the remaining $149 million of 13% Notes at 104% of their principal amount, plus accrued interest. Proceeds for the redemption were derived from a new senior bank credit facility made available to Eagle Industrial Products Corporation, a newly formed wholly owned subsidiary of the Company and a $50 million capital contribution from GAMI. (3) COMMITMENTS AND CONTINGENCIES See Note 14 to the Company's Consolidated Financial Statements. SIGNATURES Pursuant to the requirements of Section 13 or 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. EAGLE INDUSTRIES, INC. By: /s/ WILLIAM K. HALL ---------------------------------- William K. Hall President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated. INDEX TO EXHIBITS	23,853	157,957
43960_1993.txt	43960_1993	1993	43960	ITEM 1. BUSINESS. INTRODUCTION The following discussion relates to Greyhound Financial Corporation ("GFC" or the "Company"), a wholly owned subsidiary of GFC Financial Corporation ("GFC Financial"). On March 3, 1992, The Dial Corp's ("Dial") shareholders approved the spin-off to its shareholders of GFC Financial, a newly-formed Delaware corporation, which comprised Dial's former commercial lending and mortgage insurance subsidiaries. In connection with the spin-off, the holders of common stock of Dial received a distribution of one share of common stock of GFC Financial for every two shares of Dial common stock (the "Distribution"). Prior to the Distribution, Dial contributed its 100% ownership interest in companies constituting the Greyhound European Financial Group ("GEFG") and Greyhound BID Holding Corp. to GFC and contributed all of the common stock of GFC to GFC Financial. Certain contractual arrangements continue between Dial and GFC Financial or its subsidiaries for a limited period of time following the Distribution. GFC Financial and Dial entered into certain agreements providing for (i) the orderly separation of GFC Financial from Dial and the making of the Distribution; (ii) the provision by Dial of certain interim services to GFC Financial; (iii) the assignment of the "Greyhound" and "Image of the Running Dog" trademarks for use in all of GFC Financial's business activities; (iv) a sublease of certain office space currently used by GFC Financial; and (v) the administration of tax returns and allocation of certain tax liabilities and benefits. GENERAL GFC was incorporated in 1965 in Delaware and is the successor to a California corporation that commenced operations in 1954. GFC has conducted business continuously since that time. Foreign financial services are provided primarily in the United Kingdom, where GEFG has provided such services since 1964. Domestic and foreign financial operations, prior to the Distribution, had been conducted independently of each other for many years. Following the Distribution, they have been conducted as a consolidated enterprise; however, during the second quarter of 1992, GFC announced its intention to phase out the London based financing operations of GEFG. This phase out is expected to be substantially completed within a two to three year period. FINANCIAL SERVICES The Company engages in the business of providing collateralized financing of selected commercial and real estate activities in the United States and intermediate-term lending on a secured basis in foreign countries. The Company accomplishes this through secured loans and leases. The Company generates interest and other income through charges assessed on outstanding loans, loan servicing, leasing and other fees. The Company's primary expenses are the costs of funding its loan business (including interest paid on debt), provisions for possible credit losses, marketing expenses, salaries and employee benefits, servicing and other operating expenses and income taxes. The Company's current emphasis is on secured lending to businesses in specific industry niches, where the group's expertise in evaluating the needs and creditworthiness of prospective customers enables it to provide specialized financing services. The Company's strategy has been to seek to maintain a high-quality portfolio using clearly defined underwriting standards in an effort to minimize the level of nonearning assets and write- offs. Lines of Business The Company's activities now include the following lines of business: - Corporate Finance. The Corporate Finance group provides financing, generally in the range of $2 million to $25 million, focusing on middle market businesses nationally, including distribution, wholesale, retail, manufacturing and services industries. The group's lending is primarily in the form of term loans secured by the assets of the borrower, with significant emphasis on cash flow as the source of repayment of the secured loan. - Transportation Finance. Through the Transportation Finance group, the Company structures secured financings for specialized areas of the transportation industry, principally involving domestic and foreign used aircraft, as well as domestic short-line railroads and used rail equipment. Typical transactions involve financing up to 80% of the fair market value of used equipment in the $3 million to $30 million range. Traditionally focused on the domestic marketplace, Transportation Finance established a London, England office in 1992, broadening its product line to include international aircraft loans. - Communications Finance. The Communications Finance group specializes in radio and television. Other markets include cable television, print and outdoor media services in the United States. The Company extends secured loans to communications businesses requiring funds for recapitalization, refinancing or acquisition. Loan sizes generally are from $3 million to $35 million. - Commercial Real Estate Finance. The Commercial Real Estate group provides cash-flow-based financing primarily for acquisitions and refinancings to experienced real estate developers and owner tenants of income-producing properties in the United States and the United Kingdom. The Company concentrates on secured financing opportunities, generally between $3 million and $30 million, involving senior mortgage term loans on owner-occupied commercial real estate. The Company's portfolio of real estate leveraged leases is also managed as part of the commercial real estate portfolio. - Resort Finance. The Resort Finance group focuses on successful, experienced resort developers, primarily of timeshare resorts, second home resort communities, golf resorts and resort hotels. Extending funds through a variety of lending options, the Resort Finance group provides loans and lines of credit ranging from $3 million to $30 million for construction, acquisitions, receivables financing and purchases and other uses. Through its subsidiary, GFC Portfolio Services, Inc. ("GPSI"), the Resort Finance group offers expanded convenience and service to its customers. Professional receivables collections and cash management gives developers the ability of having loan-related administrative functions performed for them by GFC. - Asset Based Finance. Acquired in early 1993, the Asset Based Finance group ("ABF") offers a full range of nationwide collateral-oriented lending programs to middle-market businesses including manufacturers, wholesalers and distributors. GFC's ABF group mainly provides revolving lines of credit ranging between $2 million and $25 million, often partnering with the Corporate Finance group to offer convenient "one-stop" financing to businesses. - Consumer Rediscount Group. The Consumer Rediscount Group ("CRG") offers $2 million to $25 million revolving credit lines to regional consumer finance companies, which in turn extend credit to consumers. GFC's customers provide credit to consumers to finance home improvements, automobile purchases, insurance premiums and for a variety of other financial needs. - Ambassador Factors. On February 14, 1994, GFC purchased Fleet Factors Corp, better known as Ambassador Factors Corporation ("Ambassador") from Fleet Financial Group, Inc. Ambassador provides accounts receivable factoring and asset- based lending principally to small and medium-sized textile and apparel manufacturers and importers. See Note N of Notes to Consolidated Financial Statements included in Annex A. - TriCon Capital Corporation. On March 4, 1994, GFC Financial announced the signing of a definitive purchase agreement under which GFC will acquire all the stock of TriCon Capital Corporation ("TriCon"), an indirect wholly-owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), in an all cash transaction. This transaction is subject to regulatory approvals and certain other conditions. TriCon is a $1.8 billion niche-oriented provider of commercial and equipment leasing services. TriCon's marketing orientation fits well with GFC's emphasis on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. See Pending Acquisition of TriCon Capital Corporation under Optional Items in Part I and Note N of Notes to Consolidated Financial Statements included in Annex A. In conjunction with the liquidation of the GEFG portfolio, GEFG surrendered the banking license of its United Kingdom bank, Greyhound Bank PLC, and renamed the company Greyhound Guaranty Limited ("GGL"). GGL operates a finance group that was primarily involved in lending to individuals in the United Kingdom secured by second mortgages on residential real estate. The group ceased writing new consumer finance business in the first quarter of 1991 but continues to administer and collect loans previously made. The Company's operations are conducted primarily in the United States and Europe. For a description of its assets owned, interest earned from financing transactions, interest margins earned and income before income taxes for domestic and European operations, see Note L of Notes to Consolidated Financial Statements included in Annex A. Investment in Financing Transactions At December 31, 1993, 1992, 1991, 1990 and 1989, the Company's investment in financing transactions (before reserve for possible credit losses) was $2,846,571,000, $2,485,844,000, $2,281,872,000, $2,198,441,000 and $1,950,372,000, respectively, and consisted of the following: An analysis of nonaccruing contracts and repossessed assets at December 31 of each year shown is as follows: 1993 1992 1991 1990 1989 ------------------------------------------------ (dollars in thousands) Nonaccruing contracts: Domestic $ 13,263 $ 24,031 $ 39,276 $ 41,201 $ 38,040 Foreign 12,320 22,400 43,875 39,777 19,231 -------- -------- -------- -------- -------- 25,583 46,431 83,151 80,978 57,271 -------- -------- -------- -------- -------- Latin America: Brazil 22,775 22,998 Ecuador 40,487 42,195 Other 3,380 7,187 -------- -------- -------- -------- -------- 66,642 72,380 -------- -------- -------- -------- -------- Total nonaccruing contracts 25,583 46,431 83,151 147,620 129,651 -------- -------- -------- -------- -------- Repossessed assets: Domestic 77,001 53,931 27,319 13,288 12,288 Foreign 23 60 826 2,611 Latin America 99 -------- -------- -------- -------- -------- Total repossessed assets 77,024 53,991 28,145 15,899 12,387 -------- -------- -------- -------- -------- Total nonaccruing contracts and repossessed assets $102,607 $100,422 $111,296 $163,519 $142,038 ======== ======== ======== ======== ======== Nonaccruing contracts and repossessed assets as a percentage of investment in financing transactions 3.6% 4.0% 4.9% 7.4% 7.3% ======== ======== ======== ======== ======== In addition to the repossessed assets in the above table, GFC had repossessed assets, with a total carrying amount of $49.0 million and $21.5 million at December 31, 1993 and 1992, respectively, which earned income of $2.7 million and $1.9 million during 1993 and 1992, respectively. The following is an analysis of the reserve for possible credit losses for the years ended December 31: 1993 1992 1991 1990 1989 ----------------------------------------------- (dollars in thousands) Balance, beginning of year: Domestic $65,100 $72,387 $67,363 $62,158 $44,938 Foreign 4,191 15,213 9,735 10,478 32,668 ------- ------- ------- ------- ------- 69,291 87,600 77,098 72,636 77,606 ------- ------- ------- ------- ------- Provision for possible credit losses (Note 1): Domestic 5,206 144 57,210 10,094 25,252 Foreign 500 6,596 20,477 435 (17,301) ------- ------- ------- ------- ------- 5,706 6,740 77,687 10,529 7,951 ------- ------- ------- ------- ------- Write-offs (Note 1): Domestic (7,548) (7,823) (52,753) (6,114) (8,764) Foreign (5,027) (15,838) (15,593) (1,748) (20,675) ------- ------- ------- ------- ------- (12,575) (23,661) (68,346) (7,862) (29,439) ------- ------- ------- ------- ------- Recoveries: Domestic 221 392 567 1,225 732 Foreign (Note 2) 496 357 96 22 16,014 ------- ------- ------- ------- ------- 717 749 663 1,247 16,746 ------- ------- ------- ------- ------- Other: Domestic 1,286 Foreign (145) (2,137) 498 548 (228) ------- ------- ------- ------- ------- 1,141 (2,137) 498 548 (228) ------- ------- ------- ------- ------- Balance, end of year: Domestic 64,265 65,100 72,387 67,363 62,158 Foreign 15 4,191 15,213 9,735 10,478 ------- ------- ------- ------- ------- $64,280 $69,291 $87,600 $77,098 $72,636 ======= ======= ======= ======= ======= NOTES: (1) In 1991, the Company recorded a special provision for possible credit losses of $65 million and recorded a $47.8 million write-down of Latin American assets (included in the domestic portfolio) and recorded write-offs of $15 million in the foreign operations (GEFG) portfolio. (2) In 1989, the foreign operations (GEFG) made recoveries of $16.0 million related to its shipping (maritime) portfolio. The Company does not allocate a dollar amount of its reserve for possible credit losses to specific categories of loans and financing contracts. It does, however, allocate reserves between domestic and foreign portfolios. Write-offs by major loan and collateral types, experienced by the Company during the years ended December 31, are as follows: A further breakdown of the portfolio by collateral type can be found in Note C of Notes to Consolidated Financial Statements in Annex A. Cost and Utilization of Borrowed Funds The Company relies on borrowed funds as well as internal cash flow to finance its operations. The Company follows a policy of relating provisions under its loans and leases to the terms on which it obtains funds so that, to the extent feasible, floating-rate assets are funded with floating-rate borrowings and fixed-rate assets are funded with fixed-rate borrowings. The following table reflects the approximate average pre-tax effective cost of borrowed funds and pre-tax equivalent rate earned on accruing assets for the Company for each of the periods listed: Year Ended December 31, --------------------------------- 1993 1992 1991 1990 1989 --------------------------------- Domestic: Short-term debt and variable rate long-term debt (1) 4.6% 5.0% 6.9% 8.8% 9.9% Fixed-rate long-term debt (1) 11.4% 10.6% 10.9% 11.4% 12.3% Aggregate borrowed funds (1) 6.4% 7.2% 8.8% 10.1% 11.2% Rate earned on accruing assets (2) (3) 10.1% 10.7% 12.2% 12.7% 13.6% Spread percentage (4) 4.8% 4.4% 4.6% 4.2% 3.9% Foreign: Short-term debt and variable rate long-term debt 5.6% 9.3% 12.3% 15.5% 13.0% Customer deposits 6.2% 10.2% 14.2% 15.4% 14.4% Rate earned on accruing assets (3) 15.1% 17.6% 16.7% 20.1% 16.0% Spread percentage (4) 10.4% 9.8% 6.2% 8.2% 6.6% _____________________ NOTES: (1) Includes the effect of interest rate conversion agreements. (2) Accruing assets are net of deferred taxes applicable to leveraged leases. (3) Earnings include gains on sale of assets. (4) Spread percentages represent interest margins earned as a percentage of earning assets, net of deferred taxes applicable to leveraged leases. _____________________________________ The effective costs presented above include costs of commitment fees and related borrowing costs and do not purport to predict the costs of funds in the future. For further information on the Company's cost of funds, refer to Note D of the Notes to Consolidated Financial Statements included in Annex A. Following are the ratios of income to combined fixed charges and preferred stock dividends ("ratio") for each of the past five years: Year Ended December 31, --------------------------------- 1993 1992 1991 1990 1989 --------------------------------- 1.47 1.35 ---- 1.24 1.23 ===== ===== ===== ===== ===== Variations in interest rates generally do not have a substantial impact on the ratio because fixed-rate and floating-rate assets are generally matched with liabilities of similar rate and term. Income available for fixed charges, for purposes of the computation of the ratio of income to combined fixed charges and preferred stock dividends, consists of the sum of income before income taxes (adjusted for the effect of reduced tax rates on income from leveraged leases) and fixed charges. Combined fixed charges include interest and related debt expense and a portion of rental expense determined to be representative of interest and preferred stock dividends grossed up to a pre-tax basis. For the year ended December 31, 1991, earnings were inadequate to cover combined fixed charges by $35.3 million. The decline in the ratio in 1991 was due to restructuring and other charges and transaction costs recorded in the fourth quarter of 1991. Those charges and costs were recorded in connection with the spin-off of the Company from Dial. Credit Ratings GFC currently has investment-grade credit ratings from the following rating agencies. Commercial Senior Subordinated Paper Debt Debt ------------------------------------- Duff & Phelps D1- A- BBB+ Fitch Investors Services, Inc. A A- Moody's Investors Service P2 Baa2 Ba1 Standard & Poor's Corp. A2 BBB BBB- There can be no assurance that GFC's ratings will be maintained. None of the Company's other subsidiaries have received credit ratings. Duff & Phelps Credit Rating Company ("Duff & Phelps") has placed GFC's senior and senior subordinated debt ratings on Rating Watch with negative implications. Duff & Phelps indicated that its action follows GFC Financial's announcement on March 4, 1994 indicating that it has signed a definitive purchase agreement to acquire TriCon from Bell Atlantic Corporation. Fitch Investors Services, Inc. ("Fitch") announced that it has placed GFC's senior debt, subordinated debt and commercial paper ratings on Fitch Alert with negative implications. This action also follows GFC Financial's announcement of the proposed acquisition of TriCon. Both Duff & Phelps and Fitch indicated that their actions resulted from their need to observe GFC management's ability to successfully integrate the new businesses and maintain appropriate controls in light of the significant increase in the size of GFC. Moody's Investors Services and Standard & Poor's Corp. affirmed GFC's current ratings. Interest and Other Core Income The Company has pursued a strategy of focusing on lending activities producing a predictable stream of revenues, as opposed to the less predictable gains on asset sales associated with leasing activities. For the year ended December 31, 1993, core income (i.e., net income before a $4.9 million adjustment to deferred income taxes made in 1993, restructuring and other charges recorded in 1991 and gains on sale of assets (after-tax) realized in each of the years) was $38.0 million, $34.6 million and $24.8 million for the years 1993, 1992 and 1991, respectively. Core income represented 92% of net income (before the adjustment to deferred income taxes) in 1993, up from 50% in 1987. Residual Realization Experience In each of the last 38 years, the Company has realized, in the aggregate, proceeds from the sale of assets upon lease terminations (other than foreclosures) in excess of carrying amounts; however, there can be no assurance that such results will be realized in future years. Sales proceeds upon lease terminations in excess of carrying amounts are reported as income when the assets are sold. Income from leasing activities is significantly affected by gains from asset sales upon lease termination and, hence, can be less predictable than income from non-leasing activities. During the five years ended December 31, 1993, the proceeds to the Company from sales of assets upon early termination of leases and at the expiration of leases have exceeded the respective carrying amounts and estimated residual values as follows: Terminations at End of Lease Early Terminations Term (Note 3) (Notes 1, 2 and 4) ------------------------------ ------------------------------------ Proceeds Proceeds Carrying as a % Estimated as a % of Amount of Residual Estimated Sales of Carrying Sales Value of Residual Year Proceeds Assets Amount Proceeds Assets Value ------------------------------------ ------------------------------ (dollars in thousands) (dollars in thousands) 1993 $ --- $ --- --- $ 486 $ 248 196% 1992 20,493 17,527 117% 2,164 1,768 122% 1991 25,027 21,904 114% 10,114 6,553 154% 1990 10,854 7,127 152% 20,210 11,719 172% 1989 30,894 16,616 186% 14,559 11,305 129% NOTES: (1) Excludes foreclosures for credit reasons which are immaterial to the above amounts. (2) Excludes proceeds of $3,201,000 in 1993 on assets held for sale. (3) Excludes proceeds of $2,000,000 in 1993 received on guarantees. (4) Excludes proceeds of $460,000 in 1990 from the disposal of warrants. __________________________________ The estimated residual value of leased assets in the accounts of the Company at December 31, 1993 aggregated 39.0% of the original cost of such assets (21.9% excluding the original costs of the assets and residuals applicable to real estate leveraged leases, which typically have higher residuals than other leases). The financing contracts and leases outstanding at that date had initial terms ranging generally from one to 25 years. The average initial term weighted by carrying amount at inception and the weighted average remaining term of financing contracts at December 31, 1993 for financing contracts excluding leveraged leases were 7.3 and 3.7 years, respectively, and for leveraged leases were approximately 20 and 12 years, respectively. The comparable average initial term and remaining term at December 31, 1992 for financing contracts excluding leveraged leases were 7.7 and 3.7 years, respectively, and for leveraged leases were approximately 20 and 13 years, respectively. The Company utilizes either employed or outside appraisers to determine the collateral value of assets to be leased or financed and the estimated residual or collateral value thereof at the expiration of each lease. For a discussion of accounting for lease transactions, refer to Notes A and B of Notes to Consolidated Financial Statements included in Annex A. Business Development and Competition The Company develops business primarily through direct solicitation by its own sales force. Customers are also introduced by independent brokers and referred by other financial institutions. At December 31, 1993, the Company had 912 financing contracts with 604 customers (excluding 2,886 contracts with consumer finance customers), compared to 874 financing contracts with 570 customers (excluding 3,481 contracts with consumer finance customers) at December 31, 1992. The Company is engaged in an extremely competitive activity. It competes with banks, insurance companies, leasing companies, the credit units of equipment manufacturers and other finance companies. Some of these competitors have substantially greater financial resources and are able to borrow at costs below those of the Company. The Company's principal means of competition is through a combination of service and the interest rate charged for money. The interest rate is a function of borrowing costs, operating costs and other factors. While many of the Company's larger competitors are able to offer lower interest rates based upon their lower borrowing costs, the Company seeks to maintain the competitiveness of the interest rates it offers by emphasizing strict control of its operating costs. Credit Quality As a result of the use of clearly defined underwriting standards, portfolio management techniques, monitoring of covenant breaches and active collections and workout departments, the Company believes it maintains a high-quality customer base. Risk Management The Company generally conducts investigations of its prospective customers through a review of historical financial statements, published credit reports, credit references, discussions with management, analysis of location feasibility, personal visits and property inspections. In many cases, depending upon the results of its credit investigations and the nature and type of property involved, the Company obtains additional collateral or guarantees from others. As part of its underwriting process, the Company gives close attention to the management, industry, financial position and level of collateral of any proposed borrower. The purpose, term, amortization and amount of any proposed transaction must be clearly defined and within established corporate policy. In addition, underwriters attempt to avoid undue concentrations in any one credit, industry or regional location. - Management. The Company considers the reputation, experience and depth of management; quality of product or service; adaptability to changing markets and demand; and prior banking, finance and trade relationships. - Industry. The Company evaluates critical aspects of each industry to which it lends, including the seasonality and cyclicality of the industry; governmental regulation; the effects of taxes; the economic value of goods or services provided; and potential environmental liability. - Financial. The Company's review of a prospective borrower includes a comparison of certain financial ratios among periods and among other industry participants. Items considered include net worth; composition of assets and liabilities; debt coverage and servicing requirements; liquidity; sales growth and earning power; and cash flow needs and generation. - Collateral. The Company regards collateral as an important factor in a credit evaluation and has established maximum loan to value ratios, normally ranging from 60% - 95%, for each of its lines of business. However, collateral is only one of the many factors considered. The underwriting process includes, in addition to the analysis of the factors set forth above, the design and implementation of transaction structures and strategies to mitigate identified risks; a review of transaction pricing relative to product-specific return requirements and acknowledged risk elements; a multi-step, interdepartmental review and approval process, with varying levels of authority based on the size of the transaction; and periodic, interdepartmental reviews and revision of underwriting guidelines. The Company also monitors loan portfolio concentrations in the areas of aggregate exposure to a single borrower and related entities, within a given geographical area and with respect to an industry and/or product type within an industry. The Company has established concentration guidelines for each line of business it conducts for the various product types it may entertain within that line of business. Geographical concentrations are reviewed periodically and evaluated based on historical loan experience and prevailing market and economic conditions. The Company's financing contracts and leases generally require the customer to pay taxes, license fees and insurance premiums and to perform maintenance and repairs at the customer's expense. Contract payment rates are based on several factors, including the cost of borrowed funds, term of contract, creditworthiness of the prospective customer, type and nature of collateral and other security and, in leasing transactions, the timing of tax effects and estimated residual values. In leasing transactions, lessees generally are granted an option to purchase the equipment at the end of the lease term at its then fair market value or, in some cases, are granted an option to renew the lease at its then fair rental value. The extent to which lessees exercise their options to purchase leased equipment varies from year to year, depending on, among other factors, the status of the economy, the financial condition of the lessee, interest rates and technological developments. Portfolio Management In addition to the review at the time of original underwriting, the Company attempts to preserve and enhance the earnings quality of its portfolio through proactive management of its financing relationships with its clients and its underlying collateral. This process includes the periodic appraisal or verification of the collateral to determine loan exposure and residual values; sales of residual and warrant positions to generate supplemental income; and review and management of covenant compliance. The Portfolio Management department regularly reviews financial statements to assess customer cash flow performance and trends; periodically confirms operations of the customer; conducts periodic reappraisals of the underlying collateral; seeks to identify issues concerning the vulnerability of debt service capabilities of the customer; disseminates such information to relevant members of the Company's staff; resolves outstanding issues with the borrower; and prepares quarterly summaries of the aggregate portfolio quality for management review. To facilitate the monitoring of a client's account, each client is assigned to a customer service representative who is responsible for all follow-up with that client. Delinquencies and Workouts The Company monitors timely payment of all accounts. Generally, when an invoice is 10 days past due, the customer is contacted, and a determination is made as to the extent of the problem, if any. A commitment for immediate payment is pursued and the account is observed closely. If payment is not received after this contact, all guarantors of the account are contacted within the next 20 days. If an invoice becomes 31 days past due, it is reported as delinquent. A notice of default is sent prior to an invoice becoming 45 days past due and, between 60 and 90 days past the due date, if satisfactory negotiations are not underway, outside counsel is generally retained to help protect the Company's rights and to pursue its remedies. When accounts become more than 90 days past due (or in the case of consumer finance accounts, 180 days past due), income recognition is suspended, and the Company vigorously pursues its legal remedies. Foreclosed or repossessed assets are considered to be nonperforming, and are reported as such unless such assets generate sufficient cash to result in a reasonable rate of return. Such accounts are continually reviewed, and write-downs are taken as deemed necessary. While pursuing collateral and obligors, the Company generally continues to negotiate the restructuring or other settlement of the debt, as appropriate. Management believes that collateral values significantly reduce loss exposure and that the reserve for possible credit losses is adequate. For additional information regarding the reserve for possible credit losses, see Note C of Notes to Consolidated Financial Statements included in Annex A. Governmental Regulation The Company's domestic activities, including the financing of its operations, are subject to a variety of federal and state regulations such as those imposed by the Federal Trade Commission, the Securities and Exchange Commission, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and the Interstate Land Sales Full Disclosure Act. Additionally, a majority of states have ceilings on interest rates chargeable to customers in financing transactions. The Company's international activities are also subject to a variety of laws and regulations promulgated by the governments and various agencies of the countries in which the business is conducted. EMPLOYEES At December 31, 1993, the Company and its subsidiaries had 261 employees, consisting of 230 and 31 employees in GFC and GEFG, respectively. None of such employees were covered by collective bargaining agreements. The Company believes its employee relations are satisfactory. ITEM 2. ITEM 2. PROPERTIES The principal executive offices of the Company are located in premises leased from Dial in Phoenix, Arizona. The Company operates five additional offices in the United States and one office in Europe. All such properties are leased. Alternative office space could be obtained without difficulty in the event leases are not renewed. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and certain of its subsidiaries are parties either as plaintiffs or defendants to various actions, proceedings and pending claims, including legal actions, which involve claims for compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against the Company. Although the ultimate amount for which the Company or its subsidiaries may be held liable with respect to matters where the Company is defendant is not ascertainable, the Company believes that any resulting liability should not materially affect the Company's financial position or results of operations. Through a Report on Form 8-K, dated January 5, 1993, the Company reported litigation titled Cabana Limited Partnership, a South Carolina Partnership v. Greyhound Real Estate Finance Company, et al., and related litigation (collectively, the "Litigation"). On January 31, 1994, the court in the above-named case granted summary judgment in favor of the Company and the other defendants on all counts. On motion of defendants, the court dismissed the plaintiffs' claims without prejudice. The parties subsequently entered into a global settlement agreement whereby all rights to appeal and to pursue the related litigation have been waived by Plaintiffs. The terms of the settlement agreement are confidential but involve the payment by the defendants to plaintiffs' counsel of a relatively nominal amount, to secure finality, which the Company believes will cover a portion of plaintiffs' counsels' litigation costs and expenses. The summary judgment in the Company's and related defendants' favor remains unchanged. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted. OPTIONAL ITEMS. 1. PENDING ACQUISITION OF TRICON CAPITAL CORPORATION. The acquisition of TriCon, combined with the acquisition of Ambassador, would increase GFC's total assets on a pro forma basis to $5 billion with pro forma 1993 income from continuing operations on a combined basis of approximately $72 million before the $4.9 million adjustment to deferred taxes applicable to leveraged leases. This acquisition of TriCon is expected to give the Company significant critical mass and important economies of scale. Management believes it puts the Company among the largest independent commercial finance companies in the United States and allows it to compete over a greater range of services. TriCon's marketing orientation fits well with GFC's emphasis on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. Following is a brief description of TriCon and the various business activities in which it engages. GENERAL TriCon is a niche oriented provider of commercial finance and equipment leasing services to a highly segmented group of borrowers and lessees throughout the United States. TriCon conducts its operations through seven specialized business groups which provide financial products and services to three specific market sectors of the finance and leasing industry. End-User Sector The customers in the end-user sector use the assets which TriCon finances or leases for the ongoing operation of their businesses. The equipment which TriCon leases to its customers is typically purchased from an equipment manufacturer, vendor or dealer selected by the customer. The three specialized business groups associated with this market sector and the services provided by TriCon to customers of each business group include: - Medical Finance Group. Equipment and real estate financing and asset management services targeting the top 2,400 health care providers in the United States. - Commercial Equipment Finance Group. Direct finance leasing of, and lending for, general business equipment to quality commercial business enterprises which lack ready access to public finance markets. - Government Finance Group. Primarily tax-exempt financing to state and local governments. Program Finance Sector TriCon's business groups in the Program Finance Sector provide financing programs to help manufacturers, distributors, vendors and franchisors facilitate the sale of their products or services. The three specialized business groups associated with this market sector and the services provided by TriCon to customers of each business group include: - Vendor Service Group. Point-of-sale financing programs and support services for regional and national manufacturers, distributors and vendors of equipment classified as "small ticket" in transaction size (generally transactions with an equipment cost of less than $250,000). The equipment which TriCon leases to the ultimate end-user is typically sold to TriCon by the vendor participating in the financing program. - Franchise Finance Group. Equipment and total facility financing programs for the franchise-based food service industry. The equipment which TriCon leases to the ultimate end-user is typically purchased by TriCon from the equipment manufacturer, vendor or dealer selected by the end-user. - Commercial Credit Services Group. Accounts receivable and inventory lending for manufacturers and major distributors, manufacturer-sponsored inventory financing for office equipment dealers, and telecommunications receivables financing for the regional providers of long distance operator services. Capital Services Sector The Capital Services Sector has one business group which focuses on the management and origination of highly structured financing of "large ticket" commercial equipment (generally transactions involving the sale or lease of equipment with a cost in excess of $15 million) primarily leveraged leases for major corporations. The equipment which TriCon leases to its customers is typically purchased from an equipment manufacturer, vendor or dealer selected by the customer. The commercial finance and equipment leasing industry is highly competitive. While price is an important consideration, many customers value a high level of service which is the primary basis on which TriCon competes. Although TriCon has only a small share of the total commercial leasing market, the "Asset Finance and Leasing Digest" ranked TriCon Leasing Corporation as one of the top 50 leasing companies in the world for 1992 based on volume and total assets. Portfolio Composition The total assets under the management of TriCon consist of the TriCon portfolio of owned lease and loan assets (the "Portfolio Assets") plus certain assets that are owned by others but managed by TriCon and are not reflected on TriCon's balance sheet. At December 31, 1993, the Portfolio Assets were approximately $1.8 billion. At that date, the assets of others managed by TriCon were approximately $1.3 billion, consisting of approximately $344 million of securitized assets (the "Securitizations") and approximately $976 million of net lease receivables relating to the leveraged lease and project finance portfolio of Bell Atlantic. TriCon's primary financing products are finance leases, operating leases, collateralized loans and inventory and receivable financing. The Portfolio Assets are diversified across types of financed equipment with the largest equipment concentrations being data processing equipment, health care equipment, communications equipment, furniture and fixtures, office machines and diversified commercial use equipment. The Portfolio Assets also include real estate-related assets, consisting primarily of real estate held as collateral in conjunction with its health care and franchise-based food service equipment financings and, to a lesser extent, a portfolio of general commercial real estate mortgages currently being managed for liquidation. TriCon's investment exposure to both the aircraft-related and energy-related sectors is less than 1% of the Portfolio Assets. TriCon's current customer base includes approximately 70,000 customer accounts; its largest exposure to any single customer is approximately $33 million or approximately 2% of the Portfolio Assets and Securitizations. Approximately 80% of the Portfolio Assets and Securitizations are located in 20 states with the five largest concentrations being California (15.8%), Texas (10.5%), New Jersey (5.7%), Florida (5.5%) and Pennsylvania (5.3%). 2. TRICON CAPITAL CORPORATION AUDITED FINANCIAL STATEMENTS. The following financial statements contain references to a proposed public offering of stock of TriCon and certain restructuring of the business. The acquisition by GFC supersedes that public offering and the purchase agreement makes certain changes to the proposed restructuring. Page TRICON CAPITAL CORPORATION - PREDECESSOR BUSINESS Report of Independent Accountants 22 Consolidated Balance Sheets as of December 31, 1993 and 1992 23 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 24 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 25 Notes to Consolidated Financial Statements 26 Exhibit 12 - Computation of Ratio of Earnings to Fixed Charges 39 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholder and Board of Directors of Bell Atlantic TriCon Leasing Corporation: We have audited the consolidated balance sheets of TriCon Capital Corporation--Predecessor Business (see Note 1 to the Consolidated Financial Statements) at December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TriCon Capital Corporation--Predecessor Business at December 31, 1993 and 1992, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 2 and 9 to the Consolidated Financial Statements, in 1993 the Company adopted the method of accounting for income taxes prescribed by Statement of Financial Accounting Standards No. 109 and the method of accounting for postemployment benefits prescribed by Statement of Financial Accounting Standards No. 112, and in 1991 adopted the method of accounting for postretirement benefits other than pensions prescribed by Statement of Financial Accounting Standards No. 106. COOPERS & LYBRAND New York, New York February 7, 1994 TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) DECEMBER 31, ------------------------- 1993 1992 ----------- ---------- ASSETS Cash . . . . . . . . . . . . . . . . . . . . . $ 4,483 $ 4,503 Notes receivable and finance leases: Investment in notes receivable . . . . . . . . 912,964 833,487 Investment in finance leases . . . . . . . . . 647,055 639,592 ----------- ---------- Total notes receivable and finance leases 1,560,019 1,473,079 Less: Allowance for credit losses . . . . . . . . . . 43,191 48,279 ----------- ---------- Net investment in notes receivable and finance leases . . . . . . . . . . . . . . 1,516,828 1,424,800 Investment in operating leases, net of accumulated depreciation . . . . . . . 240,057 230,721 Other assets . . . . . . . . . . . . . . . . . 27,091 32,222 ----------- ---------- Total Assets . . . . . . . . . . . . . . . $ 1,788,459 $1,692,246 =========== ========== LIABILITIES AND EQUITY Liabilities: Notes payable . . . . . . . . . . . . . . . . . $ 709,508 $ 919,642 Accounts payable and accrued expenses . . . . . 75,302 71,951 Due to affiliates . . . . . . . . . . . . . . . 611,194 349,842 Deferred income taxes . . . . . . . . . . . . . 81,100 93,908 ----------- ---------- Total Liabilities . . . . . . . . . . . . . . . 1,477,104 1,435,343 ----------- ---------- Total Equity . . . . . . . . . . . . . . . . . 311,355 256,903 ----------- ---------- Total Liabilities and Equity . . . . . . . $ 1,788,459 $1,692,246 =========== ========== The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 1993 1992 1991 -------- -------- -------- REVENUE Interest income . . . . . . . . . . . . $ 80,477 $ 77,170 $ 90,788 Finance lease revenue . . . . . . . . . 65,835 77,009 94,503 Operating lease revenue . . . . . . . . 63,806 46,337 34,679 Other . . . . . . . . . . . . . . . . . 35,182 41,751 33,879 -------- -------- -------- Total Revenue . . . . . . . . . . 245,300 242,267 253,849 -------- -------- -------- EXPENSES Interest . . . . . . . . . . . . . . . 80,211 90,298 115,190 Selling, general and administrative . . 48,128 49,638 46,533 Provision for credit losses . . . . . . 21,634 28,057 29,876 Depreciation . . . . . . . . . . . . . 41,582 31,496 23,881 -------- -------- -------- Total Expenses . . . . . . . . . . 191,555 199,489 215,480 -------- -------- -------- Income before provision for income taxes and cumulative effect of changes in accounting principles . . . 53,745 42,778 38,369 Provision for income taxes . . . . . . 22,164 15,414 15,014 -------- -------- -------- Income before cumulative effect of changes in accounting principles . . 31,581 27,364 23,355 Cumulative effect of changes in accounting principles . . . . . . . . 5,530 -- (1,471) -------- -------- -------- NET INCOME . . . . . . . . . . . . $ 37,111 $ 27,364 $ 21,884 ======== ======== ======== Pro forma earnings per share before cumulative effect of changes in accounting principles (unaudited). . . . . . . . . . . . . . $ 2.20 The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) FOR THE YEARS ENDED DECEMBER 31, ----------------------------------------- 1993 1992 1991 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income . . . . . . . . . $ 37,111 $ 27,364 $ 21,884 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 43,538 33,436 25,329 Provision for credit losses 21,634 28,057 29,876 Amortization of initial direct costs . . . . . . . 8,946 10,417 12,081 Foreign currency transaction gain . . . . -- -- (2,857) Valuation adjustment . . . -- (6,000) -- Cumulative effect of changes in accounting principles . (5,530) -- 1,471 Gain on sale of equipment and real estate held under operating leases . . (2,548) (72) (29) Gain on transfer of receivables . . . . . . . . (11,290) (13,065) (11,745) Deferred income taxes . . . (6,893) 593 (41) Changes in certain assets and liabilities: (Increase) decrease in other assets . . . . . . . (628) 2,491 28,404 Increase (decrease) in accounts payable and accrued expenses . . . . . 7,461 (8,320) (4,171) ----------- ----------- ----------- Net cash provided by operating activities . . . . . 91,801 74,901 100,202 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to notes receivable and finance leases . . . . . . (1,844,466) (1,355,261) (1,198,591) Principal payments received on notes receivable and finance leases . . . . . . 1,553,092 1,053,913 969,786 Additions to equipment and real estate held under operating leases . . (60,270) (57,686) (63,420) Proceeds from sale of equipment and real estate under operating leases . . 8,236 4,166 461 Proceeds from transfer of receivables . . . . . . 183,242 275,049 291,053 ----------- ----------- ----------- Net cash used in investing activities . . . . . . . . . . (160,166) (79,819) (711) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings . . 128,529 204,223 283,067 Principal repayments of borrowings . . . . . . . (338,663) (254,155) (458,595) Increase in amounts due to affiliates . . . . . . . 261,352 32,703 73,579 Capital contributions . . . 21,438 40,416 6,073 Capital distributions . . . (3,932) (17,932) (3,677) Other . . . . . . . . . . . (395) -- (42) ----------- ----------- ----------- Net cash provided by (used in) financing activities . . . . . 68,329 5,255 (99,595) ----------- ----------- ----------- EFFECTS OF EXCHANGE RATE CHANGES ON CASH . . . . . . . 16 (31) (164) ----------- ----------- ----------- (DECREASE) INCREASE IN CASH . . (20) 306 (268) CASH, BEGINNING OF YEAR . . . . 4,503 4,197 4,465 ----------- ----------- ----------- CASH, END OF YEAR . . . . . . . $ 4,483 $ 4,503 $ 4,197 =========== =========== =========== The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS) 1. BACKGROUND AND BASIS OF PRESENTATION BACKGROUND: TriCon Capital Corporation, a wholly-owned subsidiary of Bell Atlantic Investments, Inc. and, ultimately, Bell Atlantic Corporation ("Bell Atlantic"), was incorporated on December 3, 1993 and will be the successor entity to certain businesses of Bell Atlantic TriCon Leasing Corporation ("Old TriCon") which is wholly owned by Bell Atlantic Capital Corporation. Prior to a planned restructuring (the "Restructuring") in contemplation of a public offering of the Company's common stock, the Company will be capitalized with amounts sufficient to acquire from Old TriCon certain assets which comprise the Predecessor Business (described below). Pursuant to the Restructuring, the Company will acquire substantially all of the assets and assume certain liabilities of Old TriCon, other than its leveraged lease portfolio, project finance portfolio and certain other assets to be retained by Old TriCon (the "Transferred Assets" and "Excluded Assets," respectively). The purchase price will be equivalent to the net book value of the Transferred Assets, subject to certain adjustments, and will be paid in part by the issuance of notes payable to Old TriCon. Pursuant to the Restructuring, the Company will also, among other things, assume the rights and obligations of Old TriCon under its securitization agreements and enter into a five-year agreement to manage, for a fee, the leveraged lease and project finance portfolios retained by Old TriCon. BASIS OF PRESENTATION: The consolidated financial statements reflect the financial position, results of operations and cash flows of TriCon Capital Corporation--Predecessor Business, which consists of the assets and liabilities to be acquired or assumed by the Company in the contemplated Restructuring described above. Use of "the Company" in these financial statements refers to the Predecessor Business, unless the context indicates reference to TriCon Capital Corporation. The consolidated financial statements include the accounts of a Canadian division and all wholly owned subsidiaries which are included in the Predecessor Business. All significant intercompany balances are eliminated. The consolidated financial statements include allocations of certain liabilities and expenses relating to the Predecessor Business to be transferred to the Company in the Restructuring. Debt and related interest expense were allocated between the Transferred Assets and the Excluded Assets based upon the internal "match funding" and debt-to-equity ratio policies of Old TriCon in place during such periods. Common expenses were allocated on a proportional basis between the Transferred Assets and the Excluded Assets. Management believes that these allocation methods are reasonable. Pro Forma Earnings Per Share (unaudited) Pro forma earnings per share is calculated based on pro forma net income divided by the number of shares of common stock of TriCon Capital Corporation to be outstanding after the proposed offering of approximately 13,500,000 shares of common stock and grants of 11,972 shares to non-management employees in connection therewith. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Investment in Finance Leases Investment in finance leases consists of the minimum lease payments receivable, estimated residual value of the equipment and initial direct costs less unearned income and security deposits. The unearned income represents the excess of the gross lease payments receivable plus the estimated residual value over the cost of the equipment leased. Unearned income is amortized to income so as to provide an approximate level rate of return on the net outstanding investment. The original lease terms of the direct finance leases are generally from 36 to 84 months. Investment in Operating Leases Investment in operating leases consist predominantly of medical equipment and health care facilities. The Company recognizes operating lease revenue on a straight-line basis over the term of the lease. The cost of equipment and facilities held under operating leases is depreciated to the estimated residual value, on a straight-line basis, over the shorter of the estimated economic life or the period specified under the lease term. Initial direct costs are deferred and amortized over the lease term on a straight-line basis. Residual Values Residual values are reviewed by the Company at least annually. Declines in residual values for finance leases are recognized as charges to income. Declines in residual values for operating leases are recognized as adjustments to depreciation on operating leases over the shorter of the useful life of the asset or the remaining term of the lease. Allowance for Credit Losses In connection with the financing of leases and other receivables, the Company records an allowance for credit losses to provide for estimated losses in the portfolio. The allowance for credit losses is based on a detailed analysis of delinquencies, an assessment of overall risks, management's review of historical loss experience and evaluation of probable losses in the portfolio as a whole given its diversification. An account is fully reserved for or written off when analysis indicates that the probability of collection of the account is remote. Income Taxes For federal income tax purposes, the results of the Company's operations are included in Bell Atlantic's consolidated tax return. In accordance with the Bell Atlantic Consolidated Federal Income Tax Allocation Policy, the Company is allocated federal income tax, or benefit, to the extent it contributes taxable income or loss, and credits, which are utilized in consolidation. The Company and each of its subsidiaries file separate state tax returns in the jurisdictions in which they conduct business. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), which the Company adopted effective January 1, 1993. SFAS 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes must be provided on all book and tax basis differences and deferred tax balances must be adjusted to reflect enacted changes in income tax rates. The cumulative impact of adopting SFAS 109 on the earnings of the Company is a tax benefit of $5,763. Prior to January 1, 1993, deferred taxes were provided for differences in the measurement of revenue and expenses for financial accounting and income tax purposes using the deferral method under Accounting Principles Board Opinion No. 11 (APB 11), "Accounting for Income Taxes." Interest Rate Swaps Interest rate swaps are contracts between two parties to exchange interest payments without the exchange of the underlying notional principal amounts. The Company enters into interest rate swap agreements primarily to hedge interest rate risks. The Company records a net receivable or payable related to the interest to be paid or received as an adjustment to interest expense. In the event of an early termination of an interest rate swap contract, the gain or loss would be amortized over the remaining life of the swap. Foreign Currency Translation Adjustments The financial statements of foreign operations are translated in accordance with the provisions of Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation." Under the provisions of the statement, assets and liabilities are translated at year-end exchange rates, and revenues and expenses are translated at average exchange rates prevailing during the year. The related translation adjustments are recorded as a separate component of Total Equity. Transactions denominated in foreign currencies are translated at rates in effect at the time of the transaction. Gains or losses resulting from foreign currency transactions are included in results of operations. 3. INVESTMENT IN NOTES RECEIVABLE AND FINANCE LEASES Investment in notes receivable consists primarily of amounts due the Company relating to commercial inventory and accounts receivable financing and first mortgage notes which are collateralized by the underlying commercial real estate. The notes bear interest at rates ranging from 5.1% to 15.4% and mature between the years 1994 and 2015. The components of investment in notes receivable as of December 31 are as follows: 1993 1992 -------- -------- Notes receivable . . . . . . . . . . . . . . .. $883,122 $803,009 Initial direct costs . . . . . . . . . . . . . 5,002 4,272 Non-accrual accounts . . . . . . . . . . . . . 24,840 26,206 -------- -------- Investment in notes receivable . . . . . . . . $912,964 $833,487 ======== ======== Investment in finance leases consists of various types of equipment including diversified commercial use equipment, health care equipment and data processing equipment. The original lease terms are generally from 36 to 84 months. The components of investment in finance leases as of December 31 are as follows: 1993 1992 -------- -------- Minimum lease payments . . . . . . . . . . . . $685,578 $659,097 Estimated residual value . . . . . . . . . . . 64,004 75,834 Less: Unearned income . . . . . . . . . . . . . . . . 133,991 134,364 Security deposits . . . . . . . . . . . . . . . 20,737 20,171 Plus: Initial direct costs . . . . . . . . . . . . . 15,259 13,426 Net investment in non-accrual accounts . . . . 36,942 45,770 -------- -------- Investment in finance leases . . . . . . . . . . $647,055 $639,592 ======== ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 3. INVESTMENT IN NOTES RECEIVABLE AND FINANCE LEASES(Continued) At December 31, 1993, estimated minimum annual receipts from notes receivable and finance leases based upon contractual terms are as follows: NOTES FINANCE YEAR ENDING DECEMBER 31 RECEIVABLE LEASES ----------------------- ---------- --------- 1994 . . . . . . . . . . . . . . . . . . . . $338,390 $ 223,413 1995 . . . . . . . . . . . . . . . . . . . . 113,977 177,670 1996 . . . . . . . . . . . . . . . . . . . . . 95,010 130,487 1997 . . . . . . . . . . . . . . . . . . . . 81,733 82,128 1998 . . . . . . . . . . . . . . . . . . . . . 51,897 38,629 Thereafter . . . . . . . . . . . . . . . . . . 202,115 33,251 -------- --------- $883,122 $ 685,578 ======== ========= 4. INVESTMENT IN OPERATING LEASES Operating leases have original terms from 12 to 120 months. Investment in operating leases consists of the following at December 31: 1993 1992 -------- -------- Medical equipment, at cost . . . . . . . . . . $215,951 $193,828 Commercial real estate, at cost . . . . . . . . 99,943 95,926 Other, at cost . . . . . . . . . . . . . . . . 6,466 6,466 -------- -------- Total cost . . . . . . . . . . . . . . . . . . 322,360 296,220 Less accumulated depreciation . . . . . . . . . (82,303) (65,499) -------- -------- Net investment in operating leases . . . . . . $240,057 $230,721 ======== ======== Depreciation expense relating to equipment and real estate held under operating leases was $39,012, $28,645 and $21,191 in 1993, 1992 and 1991, respectively. Estimated minimum annual lease receipts from noncancelable operating leases as of December 31, 1993 are as follows: YEAR ENDING DECEMBER 31, - ---------------------------------------------------------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,934 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,454 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,273 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,989 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 61,893 -------- $250,543 ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 5. NOTES PAYABLE Notes payable at December 31 consist of the following: 1993 1992 -------- -------- Recourse notes payable with interest rates from 3.31% to 11.0% and maturity dates through 2005 . . . . . . . . . . . . . . . . . $709,508 $918,617 Nonrecourse notes payable with fixed interest rates from 8.5% to 9.3% and retired in 1993 . -- 1,025 -------- -------- Total notes payable . . . . . . . . . . . . $709,508 $919,642 ======== ======== At December 31, 1992, all nonrecourse notes were collateralized by specific lease receivables and the underlying equipment. During 1993, 1992 and 1991, the Company paid $82,656, $91,434 and $113,925, respectively, in interest. The above recourse note amounts are allocated from aggregate recourse notes of Old TriCon of $847,917 and $1,066,193 at December 31, 1993 and 1992, respectively (see Note 1). Under the terms of various recourse notes and receivable transfer agreements, Old TriCon was subject to certain restrictive covenants. The most restrictive of these covenants require Old TriCon to maintain a minimum net worth of $150,000; an interest coverage ratio of at least 1.2:1; and a ratio of indebtedness (as defined in the various agreements) to net worth not to exceed 8:1. Old TriCon was in compliance with all covenants as of the balance sheet dates. In addition, certain affiliates have agreed to maintain Old TriCon's compliance with certain financial covenants pursuant to agreements covering the majority of recourse borrowings at December 31, 1993. During 1993 and 1992, Old TriCon participated with an affiliate in the issuance of medium-term notes. Old TriCon's share of the issuance was $184,567 and $60,750 in 1993 and 1992, respectively, which is included in recourse notes payable above. The notes bear interest at varying rates from 4.33% to 6.625% and have maturity dates through December 1999. The Company recognized interest expense on these medium-term notes of $8,054 and $217 in 1993 and 1992, respectively. Maturities of notes payable are as follows: YEAR ENDING DECEMBER 31, - ---------------------------------------------------------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $218,627 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,072 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,824 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,011 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,045 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 56,929 -------- $709,508 ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 6. TOTAL EQUITY The following are transactions affecting total equity: 1993 1992 1991 -------- -------- -------- Balance at beginning of year . . . . $256,903 $206,674 $185,069 Capital contributions . . . . . . . . 21,438 40,416 6,073 Net income . . . . . . . . . . . . . 37,111 27,364 21,884 Capital distributions . . . . . . . . (3,932) (17,932) (3,677) Foreign currency translation adjustments . . . . . . . . . . . . . 230 381 (2,633) Other . . . . . . . . . . . . . . . . (395) -- (42) -------- -------- -------- Total Equity at end of year . . . $311,355 $256,903 $206,674 ======== ======== ======== 7. INCOME TAXES In 1990, Bell Atlantic was subject to the alternative minimum tax (AMT) provisions of the 1986 Tax Reform Act on a tax return basis. The Company has provided for its share of Bell Atlantic's consolidated current AMT liability and for the deferred benefit relating to the corresponding AMT credit carryforward.Bell Atlantic was able to utilize all AMT carryforwards in 1991 and 1992. The Company's income tax expense for the years 1993, 1992 and 1991 would not have differed materially from that reported had the Company filed tax returns on a stand alone basis. The provision for income taxes (exclusive of the tax effect of the cumulative effect of changes in accounting principles in 1993 and 1991) for the years ended December 31 consists of the following: 1993 1992 1991 -------- ------- ------- Current: Federal . . . . . . . . . . . . . . . $ 28,912 $14,065 $15,045 State and local . . . . . . . . . . . 145 756 10 -------- ------- ------- 29,057 14,821 15,055 -------- ------- ------- Deferred: Federal . . . . . . . . . . . . . . . (11,365) (3,071) (4,012) State and local . . . . . . . . . . . 4,472 3,664 3,971 -------- ------- ------- (6,893) 593 (41) -------- ------- ------- Provision for income taxes . . . $ 22,164 $15,414 $15,014 ======== ======= ======= TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 7. INCOME TAXES (Continued) Deferred tax liabilities (assets) are comprised of the following: -------- Gross deferred tax liabilities: Lease related differences . . . . . . . . . . . . . . . . $ 75,263 Other . . . . . . . . . . . . . . . . . . . . . . . . . . 57,704 -------- Gross deferred tax liabilities . . . . . . . . . . . . . . 132,967 -------- Gross deferred tax assets: Allowance for credit losses and accrued liabilities for securitizations . . . . . . . . . . . . . . . . . . . (23,031) Other . . . . . . . . . . . . . . . . . . . . . . . . . . (28,836) -------- Gross deferred tax assets . . . . . . . . . . . . . . . . . (51,867) -------- Net deferred taxes . . . . . . . . . . . . . . . $ 81,100 ======== Under APB 11, deferred taxes resulted from timing differences in the recognition of revenue and expenses for federal and state tax and for financial statement purposes. The tax effects of the timing differences that resulted in the provision for deferred income taxes are summarized as follows: 1992 1991 -------- -------- Accelerated depreciation . . . . . . . . . . . $ (407) $ 3,151 Direct finance and operating leases . . . . . . (23,681) (10,653) State taxes . . . . . . . . . . . . . . . . . 2,418 2,621 Deferred AMT credits . . . . . . . . . . . . . 7,937 6,597 Asset backed securitizations . . . . . . . . 7,834 103 Provision for credit losses . . . . . . . . . . 3,227 (9,195) Other, net . . . . . . . . . . . . . . . . . . 3,265 7,335 -------- -------- Total . . . . . . . . . . . . . . . . $ 593 $ (41) ======== ======== During 1993, 1992 and 1991 the Company paid $24,989, $23,415 and $8,322, respectively, in income taxes. The provision for income taxes recorded for financial reporting purposes differs from the expense computed at the statutory federal income tax rate as follows: 1993 1992 1991 ---- ---- ---- Federal income tax provision at the statutory rate . . . . . . . . . . . . . . 35.0% 34.0% 34.0% State income tax provision, net of federal tax benefit . . . . . . . . . . . 5.6 6.8 6.8 Adjust prior years' tax provision . . . . . (.1) (1.1) -- Income tax expense related to acquisition of business . . . . . . . . . .5 1.4 2.1 Income tax benefit related to tax exempt income . . . . . . . . . . . . (4.3) (3.8) (3.9) Impact of 1% rate change . . . . . . . . . 4.4 -- -- Other . . . . . . . . . . . . . . . . . . . .1 (1.3) .1 ---- ---- ---- Provision for income taxes . . . . . . . 41.2% 36.0% 39.1% ==== ==== ==== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 8. TRANSACTIONS WITH AFFILIATES The Company purchased equipment from affiliates of Bell Atlantic totaling $4,574, $7,793 and $10,923 in 1993, 1992 and 1991, respectively, which is being leased to third parties under financing lease arrangements. In 1990, the Company purchased $11,800 of equipment from an affiliate in return for a non-interest bearing note payable due in 1991. During 1991, the Company returned such equipment to the affiliate in full payment of the note. During 1993, 1992 and 1991, the Company leased various equipment to affiliates under direct finance and operating leases and recognized earned income of $1,540, $1,143 and $1,481, respectively. During 1993, 1992 and 1991, the Company earned $100, $1,174 and $234, respectively, of management fees from an affiliate. The Company has entered into a short-term borrowing arrangement with an affiliate that bears interest at a rate which approximates the affiliate's average daily cost of funds (weighted average effective rates of 3.28%, 3.83% and 6.04% for the years ended December 31, 1993, 1992 and 1991, respectively). The Company recognized interest expense of $13,844, $13,910 and $19,727 in 1993, 1992 and 1991, respectively, under these arrangements. Due to Affiliates consists of the following at December 31: 1993 1992 1991 -------- -------- -------- Advances under short-term borrowing arrangements . . . . . $603,501 $347,260 $311,029 Payables to affiliates . . . . . 4,437 3,855 4,723 Receivables from affiliates . . . (2,148) (2,825) (2,846) Income tax payable. . . . . . . . 5,404 1,552 4,235 -------- -------- -------- $611,194 $349,842 $317,141 ======== ======== ======== 9. EMPLOYEE BENEFITS Pension Plans Substantially all of the Company's employees are covered under a noncontributory defined benefit pension plan sponsored by Bell Atlantic Capital Corporation and its subsidiaries. The pension benefit formula used is based on a stated percentage of adjusted career average income. The funding objective of the plan is to accumulate funds at a relatively stable rate over participants' working lives so that benefits are fully funded at retirement. Amounts contributed to the plan are determined actuarially, principally under the aggregate cost method, and are subject to applicable federal income tax regulations. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. Government and corporate debt securities, and real estate. In addition, the Company participates in the Executive Management Retirement Plan, a non-qualified pension plan, sponsored by Bell Atlantic and its subsidiaries. Aggregate pension costs are as follows: YEAR ENDED DECEMBER 31, ---------------------------- 1993 1992 1991 ------- ------- ------- Current year cost . . . . . . . . . $1,306 $1,417 $1,464 Percentage of salaries and wages . 3.7% 4.0% 4.6% The decrease in pension cost from 1991 to 1993 is the net result of changes in plan provisions and other actuarial assumptions, and amortization of actuarial gains and losses relating to demographic and investment experience. Statement of Financial Accounting Standards No. 87, "Employers Accounting for Pensions" requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. Such disclosures are not presented for the Company because the structure of the plan does not allow for the determination of this information on an individual company basis. The assumed discount rate used to measure the projected benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992 and 1991. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993, 1992 and 1991. The expected long-term rate of return on plan assets was 8.25% for December 31, 1993 and 1992 and, 7.5% for December 31, 1991. Postretirement Benefits Other than Pensions Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106) which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. Prior to this adoption, the Company charged costs relating to such benefits to expense as paid. In conjunction with the 1991 adoption of SFAS 106, the Company elected to immediately recognize the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of any plan assets, and recognized accrued postretirement benefit cost (transition obligation) in the amount of $1,471, net of a deferred income tax benefit of $758. Substantially all of the Company's employees are covered under postretirement health benefit plans sponsored by Bell Atlantic Capital Corporation and its subsidiaries. The determination of benefit cost for the postretirement health benefit plan is based on comprehensive hospital, medical and surgical benefit provisions. Aggregate postretirement benefit cost for the year ended December 31, 1993, 1992 and 1991 was $571, $394 and $332, respectfully. There were no amounts paid for postretirement health benefits in 1990. SFAS 106 requires a comparison of the actuarial present value of the accumulated postretirement benefit obligation with the fair value of the plan assets, the disclosure of the components of net periodic postretirement benefit cost, and a reconciliation of the funded status of the plan with the amount recorded on the balance sheet. Such disclosures are not presented for the Company because the structure of the Bell Atlantic plan does not allow for the determination of this information on an individual company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992 and 1991. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.50% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in year 2003 of approximately 5.0%. Employee Stock Ownership Plans The Company maintains savings plans which cover substantially all of its employees. Under these plans, the Company matches a certain percentage of eligible contributions made by the employees. In 1989, Bell Atlantic established two leveraged employee stock ownership plans (ESOPs) within two existing employee savings plans. Under the ESOP provisions, which began January 1, 1990, a substantial portion of Company matching contributions are allocated to the employees in the form of Bell Atlantic stock from the ESOP trusts. Bell Atlantic stock allocated by the ESOP trusts to the participating employees is based on the proportion that principal and interest paid in a year bears to remaining principal and interest due over the life of the notes. Leveraged ESOP expense for the years ended December 31, 1993, 1992 and 1991 is $786, $912 and $803, respectively. Employers' Accounting for Postemployment Benefits Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standard No. 112 "Employers' Accounting for Postemployment Benefits" (SFAS 112) which requires employers who provide benefits to former or inactive employees to recognize the obligation relative to such future benefits on an accrual basis. This change principally affects the Company's accounting for long-term disability benefits which were previously charged to expenses as benefits were paid. The cumulative impact at January 1, 1993 of adopting SFAS 112 was a reduction of net income of $232, net of a deferred income tax benefit of $151. 10. COMMITMENTS At December 31, 1993, the Company's commitments under noncancelable operating leases having remaining terms in excess of one year, primarily for office space are as follows: YEAR ENDING DECEMBER 31, - ------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,803 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,543 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,488 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,251 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,741 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 3,739 ------- $15,565 ======= Such leases generally include escalation and renewal clauses and require that the Company pay for utilities, taxes, insurance and maintenance. Rent expense under operating lease agreements was $2,972, $2,985 and $2,952 in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company has outstanding commitments to finance notes receivable of $171,985. The anticipated expirations of such commitments are $167,487 in 1994, $0 in 1995, $0 in 1996, and $4,498 in 1997. 11. FINANCIAL INSTRUMENTS Concentrations of Credit Risk Concentrations of credit risk exist when changes in economic, industry or geographic factors similarly affect groups of customers whose aggregate credit exposure is material in relation to the Company's total credit exposure. Although the Company's portfolio is broadly diversified along industry, customer, equipment and geographic lines, there does exist a concentration of transactions within the health care industry (approximately 22% of total assets plus transferred receivables at December 31, 1993 and 1992). The Company's exposure to credit risk in these and other industries is mitigated by the diversity of customers in the customer base and in many cases by the quality of the underlying collateral. Receivable Transfer Agreements (Securitizations) During 1993, 1992 and 1991, the Company transferred its interests in approximately $179,206, $248,048 and $246,721, respectively, of its direct finance lease portfolio for $200,447, $275,049 and $270,621, respectively. These transfers provide limited recourse for credit losses to the Company and certain of its assets. As of December 31, 1993, $60,153 of finance lease receivables are the sole collateral for certain limited recourse provisions. In addition to such finance lease receivables, the Company has recourse exposure at December 31, 1993 limited to $106,429. At December 31, 1993 and 1992, an outstanding allowance for estimated losses under these recourse provisions of $14,146 and $17,360, respectively, is included in Accounts Payable and Accrued Expenses. The outstanding gross receivable balance of transferred receivables was $495,906 and $541,834 at December 31, 1993 and 1992, respectively. The Company will service these lease contracts for the transferee, and a portion of the proceeds on the transfer has been deferred representing service fees to be earned over the term of the agreements. Interest Rate Swaps The Company has entered into a number of interest rate swap agreements which have effectively fixed interest rates on $424,432 of floating rate instruments including debt and receivable transfer agreements. Under these interest rate swap agreements, the Company will pay the counterparties interest at a fixed rate and the counterparties will pay the Company interest at a variable rate based on the London Interbank Offered Rate (LIBOR), the A1/P1 commercial paper rate or a money market yield. The fixed rates payable under these agreements range from 4.08% to 7.96% with terms expiring at various dates from February 1994 to August 1996. Cash flows resulting from the above are classified with the transactions being hedged. The Company would be exposed to increased interest costs in the event of non-performance by the counterparties for the fixed to floating interest rate swap agreements. However, because of the stature of the counterparties, the Company does not anticipate non-performance. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), requires the disclosure of the fair value of financial instruments, both recognized and unrecognized on the consolidated balance sheet, for which it is practicable to estimate fair value. Leases are not considered financial instruments under SFAS 107 and are accordingly excluded from the fair value disclosures. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange nor can they be substantiated by comparison to independent markets. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash, Accounts Payable, Accrued Expenses, Other Amounts Due to Affiliates and Recourse Provisions under Receivable Transfer Agreements The carrying amount approximates fair value. Notes Receivable Fair values of notes receivable are based principally on the net present value of the future expected cash flows using current interest rates. Notes Payable and Advances under Short-term Borrowing Arrangements with Affiliates The fair values of notes payable and advances under short-term borrowing arrangements with affiliates is estimated based on the quoted market prices for the same or similar issues, where available or is based on the net present value of the future expected cash flows using current interest rates. Interest Rate Swap Agreements The fair value of interest rate swap agreements is the estimated amount that the Company would have to pay to terminate the swap agreements at December 31, 1993, taking into account current interest rates and the creditworthiness of the swap counterparties. Loan Commitments The fair value of loan commitments is estimated using the fees currently charged to enter into similar commitments. The carrying amounts and estimated fair values of the Company's financial instruments are as follows: DECEMBER 31, 1993 DECEMBER 31, 1992 --------------------- --------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE --------- --------- --------- --------- FINANCIAL INSTRUMENTS ON THE BALANCE SHEETS Notes Receivable net of Allowance for Credit Losses . . . . $ 894,486 $ 896,051 $ 818,216 $ 827,264 Notes Payable . . . . . (709,508) (740,970) (919,642) (973,021) Advances under Short-term Borrowing Arrangements with Affiliates . . . . . (603,501) (603,793) (347,260) (348,897) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Interest Rate Swap Agreements . . . . . -- $ (1,160) -- $ 1,321 Loan Commitments . . . -- 6,516 -- 4,383 12. SUPPLEMENTAL CASH FLOW ACTIVITIES During 1992 and 1991 the Company transferred $5,859 and $57,050, respectively, of investment in notes receivable to other assets. In addition, during 1992 the Company transferred $41,585 of property foreclosed in 1991 and included in other assets to investment in operating leases, following the determination to hold such property for operating purposes. The resultant valuation adjustment of $6,000 is reflected in other revenues in 1992. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 13. QUARTERLY INFORMATION (Unaudited) FIRST SECOND THIRD FOURTH TOTAL ------- ------- ------- ------- -------- Total revenue . . . . $57,258 $58,629 $62,253 $67,160 $245,300 Interest expense . . 20,795 20,956 19,564 18,896 80,211 Provision for credit losses . . . 7,384 7,606 2,966 3,678 21,634 Depreciation . . . . 10,416 9,902 10,138 11,126 41,582 Cumulative effect of changes in accounting principles . . . . . 5,763 -- -- (233) 5,530 Net income . . . . . 9,815 5,368 8,111 13,817 37,111 Total revenue . . . . $53,980 $54,217 $59,137 $74,933 $242,267 Interest expense . . 23,736 22,804 22,012 21,746 90,298 Provision for credit losses . . . 5,606 6,671 9,355 6,425 28,057 Depreciation . . . . 6,960 7,193 8,049 9,294 31,496 Net income . . . . . 2,706 4,892 4,859 14,907 7,364 Net income in the fourth quarter of 1993 and 1992 was increased by certain securitization transactions (see Note 11). EXHIBIT 12 TRICON CAPITAL CORPORATION - PREDECESSOR BUSINESS COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES At or for the Year Ended December 31, ------------------------------------------------ 1993 1992 1991 1990 1989 ------------------------------------------------ (Dollars in Thousands) Income before income taxes and cumulative effect of changes in accounting principles $ 53,745 $ 42,778 $ 38,369 $ 39,380 $ 30,391 Add: Fixed charges 81,201 91,293 116,174 121,039 97,424 -------- -------- -------- -------- -------- Income as adjusted $134,946 $134,071 $154,543 $160,419 $127,815 Fixed Charges: Interest or indebtedness $ 80,211 $ 90,298 $115,190 $119,965 $ 96,347 Interest factor of annual rentals (1) 990 995 984 1,074 1,077 -------- -------- -------- -------- -------- Fixed Charges $ 81,201 $ 91,293 $116,174 $121,039 $ 97,424 -------- -------- -------- -------- -------- Ratio of earnings to fixed charges 1.66x 1.47x 1.33x 1.33x 1.31x ======== ======== ======== ======== ======== ____________ (1) The interest portion of annual rentals is estimated to be one- third of such rentals. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS. There is no market for the Company's common stock or redeemable preferred stock as the Company is wholly owned by GFC Financial. The preferred stock is subject to mandatory redemption on July 1, 1997. Dividends paid on the common stock for the first through fourth quarters of 1993 were $3,200,000, $3,200,000, $3,600,000 and $3,600,000, respectively. Dividends paid on the common stock for the first through fourth quarters of 1992 were $3,000,000, $3,000,000, $2,900,000 and $2,900,000, respectively. See Note D of Notes to Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in Annex A for a discussion of restrictions on the ability of GFC to pay dividends and Note E thereof for a discussion on dividends relating to the preferred stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Omitted. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See pages 1 - 7 of Annex A. ITEM 8. ITEM 8. FINANCIAL STATEMENTS & SUPPLEMENTARY DATA. 1. Financial Statements - See Item 14 hereof. 2. Supplementary Data - See Condensed Quarterly Results included in Note M of Notes to Consolidated Financial Statements included in Annex A. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING & FINANCIAL DISCLOSURE. NONE. PART III ITEM 10. ITEM 10. DIRECTORS & EXECUTIVE OFFICERS OF THE REGISTRANT. Omitted. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Omitted. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS & MANAGEMENT. Omitted. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS & RELATED TRANSACTIONS. Omitted. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed. 1. Financial Statements. (i) The following financial statements of Greyhound Financial Corporation are included in Annex A: Annex Page ------- Management's Discussion and Analysis of Financial Condition and Results of Operations 1 - 7 Report of Management and Independent Auditors' Report 8 Consolidated Balance Sheet 9 - 10 Statement of Consolidated Operations 11 Statement of Consolidated Stockholder's Equity 12 Statement of Consolidated Cash Flows 13 Notes to Consolidated Financial Statements 14 - 45 (ii) The Financial Statements of TriCon Capital Corporation are included in Part I, Optional Item 2. 2. All Schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits. Exhibit No. ----------- (3-A) The Company's Certificate of Incorporation, as amended through the date of this filing (incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 10-K"), Exhibit 3-A). (3-B) The Company's By-Laws, as amended through the date of this filing (incorporated by reference from the Company's 1991 10- K, Exhibit 3-B). (4.A) Instruments with respect to issues of long-term debt have not been filed as exhibits to this Annual Report on Form 10-K if the authorized principal amount of any one of such issues does not exceed 10% of total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request. (4-B-1) Form of Common Stock Certificate of the Company from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K"), Exhibit 4-B-1. (4-B-2) Form of the Company's Series A Redeemable Preferred Stock Certificate from the 1992 10-K, Exhibit 4-B-2. (4-C) Certificate of Designations of Series A Redeemable Preferred Stock of the Company (incorporated by reference from the 1992 GFC Financial Annual Report on Form 10-K for the year ended December 31, 1992 (the "GFC Financial 1992 10-K", Exhibit 10- MM)). (4-D) Relevant portions of the Company's Certificate of Incorporation and Bylaws are included in Exhibits 3-A and 3-B above, respectively. (4-E) Indenture dated as of November 1, 1990 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-37743, Exhibit 4). (4-F) Fourth Supplemental Indenture dated as of April 17, 1992 between the Company and the Trustee named therein, supplementing the Indenture referenced in Exhibit 4-E above, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-F. (4-G) Prospectus and Prospectus Supplement dated April 17, 1992, relating to $350,000,000 principal amount of the Company's Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-G. (4-H) Form of Floating-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the 1992 GFC Financial 10-K, Exhibit 4-H. (4-I) Form of Fixed-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-I. (4-J) Form of Indenture dated as of September 1, 1992 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, Exhibit 4). (4-K) Prospectus and Prospectus Supplement dated September 25, 1992 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-K. (4-L) Form of Floating-rate Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-L. (4-M) Form of Fixed-rate Medium-term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-M. (4-N) Indenture dated as of June 1, 1985 between the Company and the trustee named therein is hereby incorporated by reference from the 1992 10-K, Exhibit 4-N. (4-O) Prospectus and Prospectus Supplement dated February 16, 1994 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (4-P) Prospectus, dated February 16, 1994, and Prospectus Supplement dated February 17, 1994 regarding $100,000,000 principal amount of the Company's Floating-Rate Notes, is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33- 51216, as amended on that date. (9) Form of Distribution Agreement among the Company, GFC Financial Corporation, The Dial Corp and certain other parties named therein, dated as of January 28, 1992 (incorporated by reference from GFC Financial's Registration Statement on Form S-1, Registration No. 33-45452, Annex II to the Prospectus and Exhibit 2.1) (containing section 2.08(b), regarding the voting of the Greyhound Financial Corporation preferred stock). (10-A) Fifth Amendment and Restatement dated as of May 18, 1993 of the Credit Agreement dated as of May 31, 1976 among the Company and the banking institutions listed on the signature pages thereto, and Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents (incorporated by reference from the Corporation's Current Report on Form 8-K dated February 14, 1994, Exhibit 7(c)). (10.A1) Amendment dated as of January 31, 1994, to the Fifth Amendment and Restatement, noted in 10-A above incorporated by reference from the GFC Financial 1992 10-K, Exhibit 10. A1.* (10-C) Sublease dated as of April 1, 1991 among the Company, GFC Financial, Dial and others, relating to the Company principal office space is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-NN. (10-D) Interim Service Agreement dated January 28, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-JJ. (10-E) Tax Sharing Agreement dated February 19, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-KK. (10.F) Stock Purchase Agreement between the Company and Bell Atlantic TriCon Leasing Corporation dated as of March 4, 1994.* (10.G) Form of Assets Purchase Agreement between Bell Atlantic TriCon Leasing Corporation and TriCon Capital Corporation.* (12) Computation of Ratio of Income to Combined Fixed Charges and Preferred Stock Dividends.* (23) Consent of Independent Accountants - Deloitte & Touche.* (23.A) Consent of Independent Accountants - Coopers & Lybrand.* (23.B) Consent of Independent Accountants - Coopers & Lybrand.* (23.C) Consent of Independent Accountants - KPMG Peat Marwick.* * Filed herewith. (b) Reports on Form 8-K: A Report on Form 8-K dated January 18, 1994 was filed by Registrant, which reported under Item 5 the revenues, net income and selected financial data and ratios for the fourth quarter and twelve months ended 1993 (unaudited). Reports on Form 8-K dated January 21, 1994 were filed by Registrant, which reported under Item 5 the settlement of the litigation between Cabana Limited Partnership, a South Carolina Limited Partnership v. Greyhound Real Estate Finance Company, et al, a subsidiary of Greyhound Financial Corporation, the principal operating subsidiary of the Registrant. Reports on Form 8-K, 8-K/A and 8-K-A-1, dated February 14, 1994 were filed by Registrant, which reported under Items 2 and 7 the signing of an agreement by the registrant to purchase Ambassador Factors from Fleet Financial Group, Inc. and the Fifth Amendment and Restatement, dated as of May 18, 1993, of Credit Agreement dated as of May 31, 1976 among Greyhound Financial Corporation, Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents, and the financial institutions listed. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the capacities indicated, in Phoenix, Arizona on the 10th day of March, 1994. Greyhound Financial Corporation By: /s/ Samuel L. Eichenfield _________________________________________ Samuel L. Eichenfield President and Chief Executive Officer (Chief Executive Officer) By: /s/ Robert J. Fitzsimmons _________________________________________ Robert J. Fitzsimmons Vice President - Treasurer (Chief Financial Officer) By: /s/ Bruno A. Marszowski _________________________________________ Bruno A. Marszowski Vice President - Controller (Chief Accounting Officer) Pursuant to the requirements of the Securities 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: _________________________________ ________________________________ W. Carroll Bumpers (Director) Samuel L. Eichenfield (Chairman) March 10, 1994 March 10, 1994 _________________________________ ________________________________ Robert J. Fitzsimmons (Director) Bruno A. Marszowski (Director) March 10, 1994 March 10, 1994 ANNEX A Page Management's Discussion and Analysis of Financial Condition and Results of Operations 1 - 6 Report of Management and Independent Auditors' Report 7 Consolidated Balance Sheet at December 31, 1993 and 1992 8 - 9 Statement of Consolidated Operations for the Years Ended December 31, 1993, 1992 and 1991 10 Statement of Consolidated Stockholder's Equity for the Years Ended December 31, 1993, 1992 and 1991 11 Statement of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 12 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991 13 - 37 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion relates to Greyhound Financial Corporation ("GFC" or the "Company"), including the European Financial Group ("GEFG") and Greyhound BID Holding Corporation ("BID"), the subsidiaries contributed to GFC prior to the Distribution as discussed in Note A of Notes to the Consolidated Financial Statements. The following comments and information should be read in conjunction with the Annual Report as a whole. GFC is a wholly owned subsidiary of GFC Financial Corporation ("GFC Financial"). GFC Financial is a holding company, the principal subsidiaries of which are GFC and Verex Corporation ("Verex"), a mortgage insurance company that was sold on July 16, 1993. Results of Operations 1993 Compared to 1992 Net income for 1993 was $36.4 million compared to $36.8 million in 1992. The 1993 results included a $4.9 million adjustment in the third quarter for deferred taxes applicable to leveraged leases and $1.6 million (pre-tax) of expenses that can no longer be allocated to Verex. Excluding these amounts, net income for 1993 was $42.3 million, an increase of 15% over 1992. The $4.9 million adjustment in 1993 represented the effects of the recent increases in federal and state income tax rates as they applied to deferred income taxes generated by the Company's leveraged lease portfolio. Financial Services. Interest Margins Earned. Interest margins earned, which represent the difference between interest earned from financing transactions and interest expense, increased by 17% in 1993 compared to 1992. These margins were improved significantly by more favorable debt costs in 1993 when compared to 1992 (approximately a 1% reduction in the aggregate cost of debt). Also contributing to the improved margins was the growth of the domestic portfolio and higher prepayment fees, partially offset by the effects of larger foreign exchange gains reported by GEFG in 1992 and the continued winding down of the GEFG portfolio. The $10.0 million reduction in interest expense primarily is attributable to more favorable debt costs in 1993. The more favorable debt costs, in comparison to 1992, primarily relate to the Company's ability to consistently maintain a matched position throughout 1993 relative to financing its floating-rate assets with floating-rate debt. During the second and third quarters of 1992, GFC, because of the significant refinancing done in connection with the spin-off, had to finance a major portion of its floating-rate assets with fixed-rate debt. That fixed-rate debt was subsequently converted to floating-rate debt through interest rate conversion agreements. However, the timing between the issuance of fixed- rate debt and the execution of the interest rate conversion agreements caused interest margins to shrink by approximately $2.8 million in 1992. Non-Interest Expense. Although the provision for possible credit losses was lower in 1993, in the opinion of management, such provision was adequate to cover the growth and risk in the portfolio. The reserve for possible credit losses, which is increased by the loss provisions and reduced by write-offs, was 2.3% of funds employed at December 31, 1993. Details of the write-offs by collateral type can be found in Note C of Notes to Consolidated Financial Statements. Selling, administrative and other operating expenses increased during 1993 due to the addition of the Asset Based Finance ("ABF") operations acquired from U.S. Bancorp Financial, Inc. (see "Recent Developments and Business Outlook"), expenses that are no longer allocated to discontinued operations and legal expenses incurred in connection with certain problem accounts. See Note K of Notes to Consolidated Financial Statements. Gains on Sale of Assets. Gains on sale of assets were higher in 1993 than in 1992 due to the amount and type of assets sold. Income Taxes. Income taxes, excluding the $4.9 million adjustment applicable to deferred taxes, were higher in 1993 and more in the range of an ongoing effective tax rate (approximately 36% of income before income taxes) for the Company. The higher income taxes were attributable to the effects of a 1% increase in both federal and state income tax rates, which increased the provision for taxes by approximately $1 million, and to higher income before income taxes. Additionally, in 1992, income taxes were reduced by $3.1 million representing tax adjustments related to the refinancing of the Company's debt. See Note F of Notes to Consolidated Financial Statements. Cash Flow. Net cash provided by operating activities in 1993 was $42.7 million, an increase of $10.0 million when compared to 1992. This increase was principally due to the increase in deferred income taxes, partially offset by a decline in customer deposits in GEFG's subsidiary bank, Greyhound Bank, PLC ("GBL") and a decrease in interest payable. Net cash used by investing activities was $369.4 million in 1993, up by $107.2 million from 1992. The major reasons for the increase in 1993 were the record amount of expenditures for new business and the purchase of ABF, partially offset by the collection of advances made to Verex. Also offsetting the increase was higher principal collections on financing transactions (which included a significant amount of prepayments in 1993). Net cash provided by financing activities was $310.5 million, an increase of $99.7 million from 1992. The increase primarily consisted of higher advances from GFC Financial representing the proceeds received on the sale of its discontinued mortgage insurance operations (Verex) and higher net borrowings primarily used to finance new business. 1992 Compared to 1991 Net income for 1992 was $36.8 million compared to a loss of $38.7 million in 1991. The 1991 results include $69 million (after-tax) of restructuring and other charges as part of the spin-off from The Dial Corp ("Dial"). Excluding the effects of the restructuring and other charges made in 1991, net income in 1992 increased by 21% over 1991 ($36.8 million compared to $30.3 million). The following discussion of results of operations excludes the $69 million (after-tax) of restructuring and other charges recorded in 1991. Interest Margins Earned. Interest margins earned increased by 11% in 1992 compared to 1991. This increase is attributable primarily to higher margins in the domestic portfolio ($83.4 million in 1992 compared to $73.6 million in 1991) due to the growth of $334.9 million in the domestic portfolio in 1992. GEFG's interest margins earned increased by $1.0 million in 1992 as a result of the $47.2 million of additional capital infused by Dial in December 1991 as part of the spin-off. The effect of this capital infusion helped to offset the reduction in margins caused by the continued liquidation of the GEFG portfolio. During the second and third quarters of 1992, GFC, because of the significant refinancing done in connection with the spin-off, had to finance a major portion of its floating-rate assets with fixed-rate funds. Those fixed-rate funds were subsequently converted to floating-rate funds through interest rate conversion agreements. The timing between the issuance of fixed-rate funds and the execution of interest rate conversion agreements resulted in a decrease in margins of approximately $2.8 million. GFC was able to liquidate a substantial portion of its Latin American assets for gains of $3.1 million, which offset the adverse effect of the temporary imbalance of rate-sensitive assets and liabilities. Also contributing to the improved interest margins were the effects of lower nonaccruals, which averaged $114 million in 1992 compared to $185 million in 1991, higher prepayment fees and interest expense reductions related to the refinancing of high cost fixed-rate debt during 1991 and 1992. These increases were partially offset by the effect of recognizing $6.3 million of additional income in 1991, related to the leveraged lease portfolio, with no comparable amount being recognized in 1992. Non-Interest Expense. Provisions for possible credit losses were lower in 1992 but, nevertheless, were adequate to cover the growth and risk in the portfolio. A breakdown of the write-offs by collateral type can be found in Note C of Notes to Consolidated Financial Statements. Selling, administrative and other operating expenses increased during 1992 due to additional costs associated with being a subsidiary of a public company, the liquidation of GEFG (which included $1.3 million of after-tax employee termination costs) and normal cost increases. See Note K of Notes to Consolidated Financial Statements. Gains on Sale of Assets. Gains on sale of assets were lower in 1992 than in 1991 due to reduced quantities and values of assets coming off lease. This reduction was the result of the gradual liquidation of the Company's lease portfolio and is in line with the Company's strategy of improving core income (i.e., net income excluding after-tax gains on sale of assets). Income Taxes. The effective income tax rate for 1992 is lower than the statutory rate primarily because of a $3.1 million reduction in taxes for tax benefits related to the expenses of refinancing the Company's debt. See Note F of Notes to Consolidated Financial Statements. Cash Flow. Cash provided by operating activities was $32.7 million in 1992, an improvement of $101.8 million over 1991. The improvement was due to higher earnings and reduced uses of cash in 1992. The lower uses of cash, when compared to 1991, primarily related to withdrawals of customer deposits in GBL, reductions in deferred income taxes and lower interest paid resulting from lower effective interest rates in 1992. Partially offsetting these increases in cash was the payment in 1992 of restructuring and other charges and transaction costs related to the spin-off. Net cash used by investing activities was $262.3 million in 1992, up $105.0 million from 1991. The major reasons for the higher use of cash were the increases in expenditures for financing transactions, net advances of $57.3 million made to Verex in 1992 to refinance its debt obligations and lower proceeds from the sale of assets, partially offsetting these items was an increase in principal collections from financing transactions in the domestic portfolio, increased prepayments and the principal and interest recovered from the sale of certain Latin American assets. Net cash provided by financing activities was $210.8 million during 1992, a decline of $28.1 million from 1991. The decline was due primarily to lower net borrowings, partially reduced by amounts received from a subsidiary of Dial in connection with the spin-off to purchase GFC preferred stock and settle intercompany balances. Liquidity and Capital Resources Funds employed (i.e., investment in financing transactions before the reserve for possible credit losses) increased by $361 million, or approximately 15%, to $2,847 million at December 31, 1993 from $2,486 million at December 31, 1992. This increase was due to approximately $1 billion of new business being added during 1993 and the acquisition of $63 million of ABF assets, partially offset by $702 million of portfolio runoff, early terminations, translation adjustments, write-offs and collections on net advances made to Verex ($57 million). The primary focus of ABF, which was acquired on February 1, 1993, is financing through revolving lines of credit secured by accounts receivable and inventories. This acquisition extends the financial services the Company can provide. The GEFG portfolio continued to wind down in 1993 reflecting a reduction of $58.6 million to $124.3 million at December 31, 1993 from $182.9 million at December 31, 1992. In conjunction with the winding down of the GEFG portfolio, GEFG, in December 1993, surrendered the banking license of the United Kingdom bank and, therefore, will not be taking in any more customer deposits. Additional geographic information can be found in Note L of Notes to Consolidated Financial Statements. The reserve for possible credit losses ("reserve") declined in 1993 by $5.0 million to $64.3 million at December 31, 1993 from $69.3 million at December 31, 1992. The decline was principally attributable to write-offs of $12.6 million ($5.0 million of which were in GEFG), partially offset by provisions for possible credit losses made in connection with the growth in funds employed. The reserve is believed to be adequate at December 31, 1993 at 2.3% of funds employed and 62.6% of nonaccruing assets. Nonaccruing contracts and repossessed assets were $102.6 million at December 31, 1993 compared to $100.4 million at December 31, 1992. This increase is comprised of a $12.3 million increase in the domestic portfolio (to $90.3 million at December 31, 1993) partially offset by a decrease of $10.1 million in GEFG's portfolio (to $12.3 million at December 31, 1993). Nonaccruing contracts and repossessed assets as a percent of funds employed declined to 3.6% at December 31, 1993 from 4.0% at December 31, 1992. For more information on write-offs and nonaccruing assets see Note C of Notes to Consolidated Financial Statements. The Company's outstanding debt of approximately $2,107 million (including $25 million of redeemable preferred stock) was 6.1 times its equity base of $345 million at December 31, 1993. The Company also had deferred taxes of $198 million at that date to help finance its lending activities. Growth in funds employed is typically financed by internally generated cash flow and additional borrowings. During 1993, GFC issued $200 million of new senior debt, which, together with general corporate funds and net borrowings through the issuance of commercial paper, was used to finance new business and redeem or retire $200 million of maturing debt. GFC satisfies a significant portion of its cash requirements from a diversified group of worldwide funding sources and is not dependent upon any one lender. Additionally, GFC relies on the issuance of commercial paper as a major funding source. During 1993, GFC issued $3.3 billion of commercial paper (with an average of $294 million outstanding during the year) and raised $200 million through new long-term senior notes of two to ten year durations. Commercial paper and short-term borrowings are supported by a $700 million unused long-term revolving bank credit agreement. Debt repayments in 1993 included the prepayment ($145 million) of six term loans due February 1994 to August 1996. GFC generally mitigates the volatility of interest rate changes by matching the terms of its investments in new and existing transactions with approximate similar terms and duration applicable to its funding sources. Generally, fixed-rate assets are financed with fixed-rate debt and floating- rate assets are financed with floating-rate debt. GFC also balances the maturities of its investments so that sufficient cash flow is available to service anticipated debt requirements. In the third quarter of 1993, GFC entered into four three-year interest rate hedge agreements on $750 million of floating-rate borrowings to effectively guarantee a spread of approximately 2.3% between its borrowing rate (LIBOR) and the Prime interest rate. GFC had outstanding 31 interest rate conversion agreements with notional principal amounts totaling $1.3 billion. Six agreements with notional principal amounts of $180 million were arranged to effectively convert certain floating interest rate obligations into fixed interest rate obligations and require interest payments on the stated principal amount at rates ranging from 8.3% to 9.8% (remaining terms of three months to five years) in return for receipts calculated on the same notional amounts at floating interest rates. In addition, 25 agreements with notional principal amounts of $1.1 billion were arranged to effectively convert certain fixed interest rate obligations into floating interest rate obligations and require interest payments on the stated principal amount at the three month or six month LIBOR (remaining terms of five months to nine years) in return for receipts calculated on the same notional amounts at fixed interest rates of 4.9% to 7.6%. The agreements have been entered into with major financial institutions which are expected to fully perform under the terms of the agreements, thereby mitigating the credit risk from the transactions. GFC's aggregate cost of funds has declined to 6.3% for 1993 from 7.2% in 1992. GFC's cost of and access to capital resources is significantly influenced by its debt ratings. Recent Developments and Business Outlook On February 1, 1993, GFC purchased the Asset Based Lending Division of U.S. Bancorp Financial, Inc., a wholly owned subsidiary of U.S. Bancorp, for approximately $70 million in cash. The primary focus of the Asset Based Finance group, which is based in Los Angeles and recently opened an office in Chicago, is to offer revolving lines of credit and term loans secured by accounts receivable and inventories on a national basis. GFC established a new line of business (in August 1993), the Consumer Rediscount Group, which provides senior financing to independent consumer finance companies. Based in Dallas, Texas, this type of secured lending, known as rediscounting, represents another niche-business for GFC. On February 14, 1994, GFC acquired Fleet Financial Group, Inc.'s factoring and asset-based lending subsidiary, Fleet Factors Corp, operating under the trade name Ambassador Factors ("Ambassador"). As of November 30, 1993, Ambassador had a $336 million loan portfolio and generated $810 million of factoring volume in 1993. Its customer base primarily consists of small to medium-sized textile and apparel manufacturers in the factoring operation and similar sized manufacturers, distributors and wholesalers in the asset-based lending business. See Note N of Notes to Consolidated Financial Statements. On March 4, 1994, GFC Financial announced the signing of a definitive purchase agreement under which it will acquire all of the stock of TriCon Capital Corporation ("TriCon"), an indirect wholly-owned subsidiary of Bell Atlantic Corporation, in an all cash transaction. The transaction is subject to regulatory approvals and certain other conditions. TriCon is a $1.8 billion niche-oriented provider of commercial and equipment leasing services. TriCon's marketing orientation fits well with GFC's focus on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. See Note N to Notes to Consolidated Financial Statements. The expanding and improving U.S. and United Kingdom economies, are predicted to stimulate business investment and pave the way for stronger growth. Signs of these changes are becoming evident to the Company by the improved liquidity in its domestic Commercial Real Estate and Communication Finance businesses, as well as reduced nonaccruals in the European Consumer Finance portfolio. Strategies implemented during 1993 position the Company to take advantage of the improving domestic economy and to expand its financial services operations into three new niche businesses. New Accounting Standards In November 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postemployment Benefits". Analogous to SFAS No. 106 for postretirement benefits, this standard requires companies to accrue for estimated future postemployement benefit expenses during the periods when employees are working. Postemployment benefits are any benefits other than retirement benefits that are provided after employment is discontinued. This standard must be adopted for fiscal years beginning after December 15, 1993, which for the Company would be 1994. Based on management's review, the adoption of the new standard will not have a material impact on the Company's financial position or results of operations. The FASB has issued a new accounting standard, SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). This standard requires that impaired loans that are within the scope of this statement generally be measured based on the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral, if the loan is collateral dependent. Under SFAS 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due. Presently, the reserve for possible credit losses represents management's estimate of the amount necessary to cover potential losses in the portfolio considering delinquencies, loss experience and collateral. The impact of the new standard, which is effective for fiscal years beginning after December 15, 1994, has not yet been determined. New accounting standards adopted by GFC in 1993 included SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB"). The disclosure required by this statement is included in Note G of Notes to Consolidated Financial Statements. MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Greyhound Financial Corporation is responsible for the preparation, integrity and objectivity of the financial statements and other financial information included in this Annual Report. The financial statements are presented in accordance with generally accepted accounting principles reflecting, where applicable, management's best estimates and judgments. Management of the Company has established and maintains a system of internal controls to reasonably assure the fair presentation of the financial statements, the safeguarding of the Company's assets and the prevention or detection of fraudulent financial reporting. The internal control structure is supported by careful selection and training of personnel, documented policies and procedures and regular review by both internal auditors and the independent auditors. The Board of Directors, through its Audit Committee, also oversees the financial reporting of the Company and its adherence to established procedures and controls. Periodically, the Audit Committee meets, jointly and separately, with management, the internal auditors and the independent auditors to review auditing, accounting and financial reporting matters. The Company's financial statements have been audited by Deloitte & Touche, independent auditors. Management has made available to Deloitte & Touche all of the Company's financial records and related data, and has made valid and complete written and oral representations and disclosures in connection with the audit. Management believes it is essential to conduct its business in accordance with the highest ethical standards, which are characterized and set forth in the Company's written Code of Conduct. These standards are communicated to all of the Company's employees. Samuel L. Eichenfield Chairman, President & Chief Executive Officer Bruno A. Marszowski Vice President - Controller Derek C. Bruns Director - Internal Audit GFC Financial Corporation INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Greyhound Financial Corporation We have audited the accompanying consolidated balance sheet of Greyhound Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Greyhound Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Deloitte & Touche Phoenix, Arizona March 4, 1994 CONSOLIDATED BALANCE SHEET (Dollars in Thousands) ASSETS - ---------------------------------------------------------------------------- December 31, 1993 1992 - ---------------------------------------------------------------------------- Cash and cash equivalents $ 2,859 $ 19,120 Investment in financing transactions: Loans and other financing contracts, less unearned income of $72,747 and $122,381, respectively 2,343,755 1,919,371 Leveraged leases 283,782 269,370 Operating and direct financing leases 219,034 239,782 Related party advances 57,321 - ---------------------------------------------------------------------------- 2,846,571 2,485,844 Less reserve for possible credit losses (64,280) (69,291) - ---------------------------------------------------------------------------- Investment in financing transactions - net 2,782,291 2,416,553 Other assets and deferred charges 49,747 44,653 - ---------------------------------------------------------------------------- $ 2,834,897 $ 2,480,326 ============================================================================ See notes to consolidated financial statements. LIABILITIES AND STOCKHOLDER'S EQUITY - ---------------------------------------------------------------------------- December 31, 1993 1992 - ---------------------------------------------------------------------------- Liabilities: Accounts payable and accrued expenses $ 30,158 $ 27,613 Due to Parent 130,760 Customer deposits 3,064 15,064 Interest payable 23,633 29,062 Short-term debt 510 1,360 Senior debt 1,991,986 1,806,433 Subordinated debt 86,790 75,916 Deferred income taxes 197,705 174,090 - ---------------------------------------------------------------------------- 2,464,606 2,129,538 - ---------------------------------------------------------------------------- Redeemable preferred stock 25,000 25,000 - ---------------------------------------------------------------------------- Stockholder's equity: Common stock, $1 par value, 100,000 shares authorized, 25,000 shares outstanding 25 25 Additional capital 298,665 298,665 Retained income 54,374 33,783 Cumulative translation adjustments (7,773) (6,685) - ---------------------------------------------------------------------------- 345,291 325,788 - ---------------------------------------------------------------------------- $ 2,834,897 $ 2,480,326 ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED OPERATIONS (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- Interest and other income $218,171 $210,873 $212,706 Lease income 30,529 29,933 38,766 - ---------------------------------------------------------------------------- Interest earned from financing 248,700 240,806 251,472 transactions Interest expense 126,152 136,107 157,560 - ---------------------------------------------------------------------------- Interest margins earned 122,548 104,699 93,912 - ---------------------------------------------------------------------------- Provision for possible credit losses 5,706 6,740 12,687 Restructuring and other charges 65,000 - ---------------------------------------------------------------------------- 5,706 6,740 77,687 - ---------------------------------------------------------------------------- Net interest margins earned 116,842 97,959 16,225 Gains on sale of assets 5,439 3,362 6,684 - ---------------------------------------------------------------------------- 122,281 101,321 22,909 - ---------------------------------------------------------------------------- Selling, administrative and other 58,158 50,728 46,923 operating expenses Transaction costs of the Distribution 13,000 - ---------------------------------------------------------------------------- 58,158 50,728 59,923 - ---------------------------------------------------------------------------- Income (loss) before income taxes 64,123 50,593 (37,014) Income taxes: Current and deferred 22,825 13,843 1,728 Adjustment to deferred taxes 4,857 - ---------------------------------------------------------------------------- 27,682 13,843 1,728 - ---------------------------------------------------------------------------- NET INCOME (LOSS) $36,441 $36,750 $(38,742) ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED STOCKHOLDER'S EQUITY (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- COMMON STOCK: Balance, beginning and end of year $25 $25 $25 - ---------------------------------------------------------------------------- ADDITIONAL CAPITAL: Balance, beginning of year 298,665 270,680 272,355 Contributions from (distribution to) The Dial Corp 27,985 (1,675) - ---------------------------------------------------------------------------- Balance, end of year 298,665 298,665 270,680 - ---------------------------------------------------------------------------- RETAINED INCOME: Balance, beginning of year 33,783 10,605 64,382 Net income (loss) 36,441 36,750 (38,742) Dividends (15,850) (13,572) (15,035) - ---------------------------------------------------------------------------- Balance, end of year 54,374 33,783 10,605 - ---------------------------------------------------------------------------- CUMULATIVE TRANSLATION ADJUSTMENTS: Balance, beginning of year (6,685) (1,639) 351 Unrealized translation loss (1,088) (5,046) (1,990) - ---------------------------------------------------------------------------- Balance, end of year (7,773) (6,685) (1,639) - ---------------------------------------------------------------------------- STOCKHOLDER'S EQUITY $345,291 $325,788 $279,671 ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED CASH FLOWS (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- OPERATING ACTIVITIES: Net income (loss) $36,441 $36,750 $(38,742) Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Provision for possible credit losses 5,706 6,740 77,687 Gains on sale of assets (5,439) (3,362) (6,684) Deferred income taxes 21,608 (4,837) (17,760) Increase in accounts payable and accrued expenses 2,545 4,418 19,275 Decrease in customer deposits (12,287) (577) (126,979) (Decrease) increase in interest payable (5,429) 3,576 (4,906) Other (475) (10,019) 29,035 - ---------------------------------------------------------------------------- Net cash provided (used) by operating activities 42,670 32,689 (69,074) - ---------------------------------------------------------------------------- INVESTING ACTIVITIES: Proceeds from sale of assets 5,681 22,657 35,141 Principal collections on financing transactions 644,939 454,390 338,451 Expenditures for financing transactions (1,007,794) (682,369) (525,659) Purchase of subsidiary (69,808) Net related party advances 57,321 (57,321) Other 221 392 (5,213) - ---------------------------------------------------------------------------- Net cash used by investing activities (369,440) (262,251) (157,280) - ---------------------------------------------------------------------------- FINANCING ACTIVITIES: Borrowings 646,701 974,232 760,947 Repayment of borrowings (451,102) (829,212) (539,609) Issuance of preferred stock 25,000 Advances and contributions from The Dial Corp 54,331 32,575 Net advances from Parent 130,760 Dividends (15,850) (13,572) (15,035) - ---------------------------------------------------------------------------- Net cash provided by financing 310,509 210,779 238,878 activities - ---------------------------------------------------------------------------- (Decrease) increase in cash and cash equivalents (16,261) (18,783) 12,524 Cash and cash equivalents, beginning of year 19,120 37,903 25,379 - ---------------------------------------------------------------------------- Cash and cash equivalents, end of year $2,859 $19,120 $37,903 ============================================================================ See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands in Tables) NOTE A SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Principles of Consolidation--On March 3, 1992, The Dial Corp's ("Dial") shareholders approved the spin-off to its shareholders of GFC Financial Corporation ("GFC Financial"), a newly-formed Delaware corporation, which comprised Dial's former commercial lending and mortgage insurance subsidiaries. In connection with the spin-off, the holders of common stock of Dial received a distribution of one share of common stock of GFC Financial for every two shares of Dial common stock (the "Distribution"). Prior to the Distribution, Dial contributed its 100% ownership interest in companies constituting the Greyhound European Financial Group ("GEFG") and Greyhound BID Holding Corp. ("BID") to Greyhound Financial Corporation ("GFC") and contributed all of the common stock of GFC (collectively the "Company") to GFC Financial. The historical consolidated financial statements of GFC and subsidiaries have been retroactively restated to include the accounts and results of operations of GFC, GEFG and BID for all periods presented as if a pooling of interests of companies under common control. All intercompany accounts and transactions have been eliminated from the consolidated financial statements. These consolidated financial statements are prepared in accordance with generally accepted accounting principles. Described below are those accounting policies particularly significant to GFC, including those selected from acceptable alternatives. Financing Transactions--For loans and other financing contracts earned income is recognized over the life of the contract, using the interest method. Leases that are financed by nonrecourse borrowings and meet certain other criteria are classified as leveraged leases. For leveraged leases, aggregate rentals receivable are reduced by the related nonrecourse debt service obligation including interest ("net rentals receivable"). The difference between (a) the net rentals receivable and (b) the cost of the asset less estimated residual value at the end of the lease term is recorded as unearned income. Earned income is recognized over the life of the lease at a constant rate of return on the positive net investment, which includes the effects of deferred income taxes. For operating leases, earned income is recognized on a straight-line basis over the lease term and depreciation is taken on a straight-line basis over the estimated useful life. Operating lease income is net of depreciation and related expenses. For leases classified as direct financing leases, the difference between (a) aggregate lease rentals and (b) the cost of the related assets less estimated residual value at the end of the lease term is recorded as unearned income. Earned income is recognized over the life of the contracts using the interest method. Income recognition is generally suspended for leases, loans and other financing contracts at the earlier of the date at which payments become 90 days past due (other than consumer finance accounts of GEFG, which are considered nonaccruing when 180 days past due) or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. The reserve for possible credit losses is available to absorb credit losses. The provision for possible credit losses is the charge to income to increase the reserve for possible credit losses to the level that management estimates to be adequate considering delinquencies, loss experience and collateral. Other factors include changes in geographic and product diversification, size of the portfolio and current economic conditions. Accounts are either written-off or written-down when the probability of loss has been established in amounts determined to cover such losses after giving consideration to the customer's financial condition, the value of the underlying collateral and any guarantees. Any deficiency between the carrying amount of an asset and the ultimate sales price of repossessed collateral is charged to the reserve for possible credit losses. Recoveries of amounts previously written-off as uncollectible are credited to the reserve for possible credit losses. Repossessed assets are carried at the lower of cost or fair value. Loans classified as in-substance foreclosures are included in repossessed assets. Loans are classified as in-substance foreclosed assets, even though legal foreclosure has not occurred, when (i) the borrower has little or no equity in the collateral at its current fair value, (ii) proceeds for repayment are expected to come only from the operation or sale of the collateral and (iii) it is doubtful that the borrower will rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. The Financial Accounting Standards Board ("FASB") has issued a new accounting standard, SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). This standard requires that impaired loans that are within the scope of this statement generally be measured based on the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral, if the loan is collateral dependent. Under SFAS 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due. Presently, the reserve for possible credit losses represents management's estimate of the amount necessary to cover potential losses in the portfolio considering delinquencies, loss experience and collateral. The impact of the new standard, which is effective for fiscal years beginning after December 15, 1994, has not yet been determined. Pension and Other Benefits--Trusteed, noncontributory pension plans cover substantially all employees. Benefits are based primarily on final average salary and years of service. Net periodic pension cost for GFC is based on the provisions of SFAS No. 87, "Employers' Accounting for Pensions". Funding policies provide that payments to pension trusts shall be at least equal to the minimum funding required by applicable regulations. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires accrual of such benefits during the years the employees provide services. Prior to 1993, the costs of such benefits were expensed as incurred. See Note G of Notes to Consolidated Financial Statements for further information. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits". Analogous to SFAS No. 106 for postretirement benefits, this standard requires companies to accrue for estimated future postemployement benefits during the periods when employees are working. Postemployment benefits are any benefits other than retirement benefits that are provided after employment is discontinued. This standard must be adopted for fiscal years beginning after December 15, 1993, which for the Company would be 1994. Based on management's review, the adoption of the new standard will not have a material impact on the Company's financial position or results of operations. Income Taxes--Income taxes are provided based upon the provisions of SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under SFAS 109, deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax law. Cash Equivalents--For purposes of the Statement of Consolidated Cash Flows, the Company has classified highly liquid investments with original maturities of three months or less from date of purchase as cash equivalents. Reclassifications--Certain reclassifications have been made to the 1992 financial statements to conform to the 1993 presentation. NOTE B INVESTMENT IN FINANCING TRANSACTIONS The Company provides secured financing to commercial and real estate enterprises principally under financing contracts (such as loans and other financing contracts, leveraged leases, operating leases and direct financing leases). At December 31, 1993 and 1992, the carrying amount of the investment in financing transactions, including the estimated residual value of leased assets upon lease termination, was $2,846,571,000 and $2,485,844,000 (before reserve for possible credit losses), respectively, and consisted of the following types of loans and collateral: - ---------------------------------------------------------------------------- Percent of Total Carrying Amount - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Resort receivables 19.8% 18.3% Aircraft and related equipment 19.6 19.1 Communications finance 17.8 16.2 Commercial real estate 12.4 18.1 Real estate leveraged leases 6.9 7.3 Asset based finance 6.2 Production and processing equipment 4.7 5.8 Land receivables 2.6 3.7 Railroad equipment 2.6 2.5 Consumer finance (GEFG) 1.6 2.3 Commercial vehicles 0.4 1.4 Other (1) 5.4 5.3 - ---------------------------------------------------------------------------- 100.0% 100.0% ============================================================================ (1) The category "Other" includes different classes of commercial and industrial contract receivables, none of which accounted for more than 1% of the aggregate carrying amount of the net investment in financing transactions. The Company's investment in financing transactions outside of the United States at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Europe, primarily United Kingdom $ 196,499 $ 206,893 Mexico 30,952 33,827 Other countries 17,740 38,168 - ---------------------------------------------------------------------------- $ 245,191 $ 278,888 ============================================================================ The Company's investment in financing transactions is primarily settled in U.S. dollars, except for approximately $100,000,000 and $128,000,000 at December 31, 1993 and 1992, respectively, which is primarily due in British pounds. The exchange rate of British pounds to dollars at December 31, 1993 and 1992 was 1.48:1 and 1.52:1, respectively. Aggregate installments on loans and other financing contracts, leveraged leases, operating leases and direct financing leases at December 31, 1993 (excluding repossessed assets of $77,024,000 and estimated residual values) are due during each of the years ending December 31, 1994 to 1998 and thereafter as follows: - ---------------------------------------------------------------------------- There- 1994 1995 1996 1997 1998 after - ---------------------------------------------------------------------------- Domestic: Loans and other financing contracts: Commercial: Fixed interest rate $ 80,796 $ 77,294 $ 72,707 $ 45,984 $ 31,600 $ 81,838 Floating interest rate 179,164 211,921 218,987 141,294 126,221 75,418 Real Estate: Fixed interest rate 61,416 43,634 39,777 27,935 18,702 46,941 Floating interest rate 147,101 167,375 147,507 92,831 53,461 39,204 Leveraged leases 4,834 5,385 7,282 13,862 8,395 171,883 Operating and direct financing leases, primarily at fixed interest rates 21,120 20,389 29,295 17,907 16,873 115,737 - ---------------------------------------------------------------------------- 494,431 525,998 515,555 339,813 255,252 531,021 - ---------------------------------------------------------------------------- Foreign, primarily at floating interest rates: Loans and other financing contracts 10,078 6,429 8,915 16,007 23,700 Consumer Finance 14,122 7,858 7,212 9,617 5,255 1,200 Operating and direct financing leases 4,284 3,038 4,343 2,496 2,870 - ---------------------------------------------------------------------------- 28,484 17,325 20,470 28,120 31,825 1,200 - ---------------------------------------------------------------------------- $522,915 $543,323 $536,025 $367,933 $287,077 $532,221 ============================================================================ The net investment in leveraged leases at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Rentals receivable $1,377,107 $1,451,925 Less principal and interest payable on nonrecourse debt (1,165,466) (1,237,776) - ---------------------------------------------------------------------------- Net rentals receivable 211,641 214,149 Estimated residual values 306,894 306,691 Less unearned income (234,753) (251,470) - ---------------------------------------------------------------------------- Investment in leveraged leases 283,782 269,370 Less deferred taxes arising from leveraged leases (223,006) (206,342) - ---------------------------------------------------------------------------- Net investment in leveraged leases $60,776 $63,028 ============================================================================ The components of income from leveraged leases, before the effects of interest on nonrecourse debt and other related expenses, for the years ended December 31 were as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Lease and other income $11,376 $ 9,172 $16,421 Income tax expense 8,363 2,757 4,903 - ---------------------------------------------------------------------------- The investment in operating and direct financing leases at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Operating leases $147,222 $100,911 Direct financing leases: Rentals receivable 91,153 154,463 Estimated residual values 23,121 42,158 Unearned income (42,462) (57,750) - ---------------------------------------------------------------------------- 71,812 138,871 - ---------------------------------------------------------------------------- Investment in operating and direct financing leases $219,034 $239,782 ============================================================================ The investment in operating leases is net of accumulated depreciation of $10,601,000 and $4,110,000 as of December 31, 1993 and 1992, respectively. Depreciation expense relating to equipment held under operating leases was $6,491,000, $2,531,000 and $1,685,000 in 1993, 1992 and 1991, respectively. The Company has a substantial number of loans and leases with payments that fluctuate with changes in index rates, primarily Prime interest rates and the London Interbank Offered Rate ("LIBOR"). The investment in loans and leases with floating interest rates (excluding nonaccruing contracts and repossessed assets) at December 31 was as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Receivables due on financing transactions $1,661,602 $1,368,412 Estimated residual values 8,162 Less unearned income (25,928) (34,899) - ---------------------------------------------------------------------------- Investment in loans and leases $1,635,674 $1,341,675 ============================================================================ Interest earned from financing transactions with floating interest rates was approximately $154,000,000 in 1993, $127,000,000 in 1992 and $128,000,000 in 1991. The adjustments, which arise from changes in index rates, can have a significant effect on interest earned from financing transactions; however, the effects on interest margins earned and net income are substantially offset by related interest expense changes on debt obligations with floating interest rates. At December 31, 1993, the Company had a committed backlog of new business of approximately $420,000,000 compared to $317,000,000 at December 31, 1992. NOTE C RESERVE FOR POSSIBLE CREDIT LOSSES The following is an analysis of the reserve for possible credit losses for the years ended December 31: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Balance, beginning of year $69,291 $87,600 $77,098 Provision for possible credit losses (1) 5,706 6,740 77,687 Write-offs (1) (12,575) (23,661) (68,346) Recoveries 717 749 663 Other 1,141 (2,137) 498 - ---------------------------------------------------------------------------- Balance, end of year $64,280 $69,291 $87,600 ============================================================================ (1) In the fourth quarter of 1991, the Company recorded a special provision for possible credit losses of $65,000,000 and recorded write-offs of $15,000,000 related to nonearning assets in the GEFG portfolio and a $47,759,000 write-down to reduce Latin American assets to current market value. Write-offs by major loan and collateral types experienced by the Company during the years ended December 31 are as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Consumer finance (GEFG) $ 4,071 $ 10,176 $ 13,687 Commercial real estate 3,082 8,904 2,894 Manufacturing and processing equipment 2,242 1,908 604 Commercial vehicles 1,579 67 Communications finance 1,488 1,500 1,200 Maritime 906 Latin America 47,759 Other 113 267 2,135 - ---------------------------------------------------------------------------- $ 12,575 $ 23,661 $ 68,346 ============================================================================ Write-offs as a percentage of investment in financing transactions 0.44% 0.95% 3.00% ============================================================================ An analysis of nonaccruing contracts and repossessed assets at December 31 is as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Nonaccruing contracts: Domestic $ 13,263 $ 24,031 Foreign 12,320 22,400 - ---------------------------------------------------------------------------- Total nonaccruing contracts 25,583 46,431 - ---------------------------------------------------------------------------- Repossessed assets: Domestic 77,001 53,931 Foreign 23 60 - ---------------------------------------------------------------------------- Total repossessed assets 77,024 53,991 - ---------------------------------------------------------------------------- Total nonaccruing contracts and repossessed assets $ 102,607 $ 100,422 ============================================================================ Nonaccruing contracts and repossessed assets as a percentage of investment in financing transactions 3.6% 4.0% ============================================================================ In addition to the repossessed assets included in the above table, the Company had repossessed assets, with a total carrying amount of $48,956,000 and $21,509,000 at December 31, 1993 and 1992 which earned income of $2,700,000 and $1,900,000 during 1993 and 1992, respectively. In the normal course of business, the Company has renegotiated and modified certain contracts with respect to rates and other terms. At December 31, 1993 and 1992, the Company had approximately $47,000,000 and $68,000,000, respectively, of these rewritten contracts requiring disclosure under the provisions of SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings". These contracts are yielding, on a weighted average basis, a return of approximately 9.3%. Had all contracts placed in a nonaccrual status outstanding at December 31, 1993, 1992 and 1991, respectively, remained accruing, interest earned would have been increased by approximately $6,000,000, $7,500,000 and $11,300,000, respectively, for domestic contracts and $5,000,000, $5,100,000 and $9,100,000, respectively, for foreign contracts. Income recognized on these accounts was approximately $1,732,000, $589,000 and $1,100,000 for domestic contracts during the years 1993, 1992 and 1991, respectively. NOTE D DEBT The Company satisfies its short-term financing requirements from bank lines of credit, other bank loans, public medium-term notes and the issuance of commercial paper. In conjunction with the winding down of the GEFG portfolio, GEFG, in December 1993, surrendered the banking license of the United Kingdom bank and, therefore, will not be taking in any more customer deposits. At December 31, 1993, short-term bank loans and commercial paper of $515,876,000 (net of unamortized discount) are considered to be long-term debt because they are supported by an unused long-term revolving bank credit agreement of $700,000,000. The following information pertains to all short-term financing, including bank loans and commercial paper (considered to be long-term debt), for the years ended December 31: - --------------------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------------------- Maximum amount of short-term debt outstanding during year $ 516,386 $ 504,829 $ 533,446 Average short-term debt outstanding during year 336,672 322,176 448,174 Weighted average short-term interest rates at end of year: Short-term borrowings 3.5% 4.1% 8.1% Commercial paper* 3.6% 4.2% 5.6% Weighted average interest rate on short- term debt outstanding during year* 3.5% 4.3% 6.9% - ---------------------------------------------------------------------------- * Exclusive of the cost of maintaining bank lines in support of outstanding commercial paper and the effects of interest rate conversion agreements. Senior and subordinated debt at December 31 was as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Senior debt: Commercial paper and short-term bank loans supported by unused long-term bank revolving credit agreements, less unamortized discount $515,876 $330,141 Medium-term notes due to 2003, 4.6% to 12.5% 751,500 591,433 Term loans payable to banks due to 1996, 4.2% 150,000 310,000 Senior notes due to 2002, 8.3% to 16.0%, less unamortized discount 555,666 555,147 Nonrecourse installment notes due to 2002, 10.6% (assets of $25,613 and $25,579, respectively, pledged as collateral) 18,944 19,712 - ---------------------------------------------------------------------------- Total senior debt 1,991,986 1,806,433 - ---------------------------------------------------------------------------- Subordinated debt: Senior subordinated loans, due 1994, 14.1% 92,270 92,270 Less unamortized discount (5,480) (16,354) - ---------------------------------------------------------------------------- Total subordinated debt 86,790 75,916 - ---------------------------------------------------------------------------- TOTAL $2,078,776 $1,882,349 ============================================================================ Aggregate commitments under the Company's domestic revolving credit agreement availability was $700,000,000 at December 31, 1993. Under the terms of this agreement, the Company has the option to periodically select either domestic dollars or Eurodollars as the basis of borrowings. Interest is based on the banks' Prime rate for domestic dollar advances or LIBOR for Eurodollar advances. The agreements also provide for a commitment fee on the unused credit. The Company, in the event it becomes advisable, intends to exercise its right under this agreement to borrow for the purpose of refinancing commercial paper and short-term bank loans. The credit agreement for $700,000,000, described in the preceding paragraph, will be subject to renewal in May 1996. If the credit facility with any or all of the participating banks is not renewed, the Company may, at its option, repay the non-renewing banks' outstanding participation, if any, immediately or in equal quarterly installments over a four year period. As of December 31, 1993, the Company had outstanding 31 interest rate conversion agreements with notional principal amounts totaling $1,320,000,000. Six agreements with notional principal amounts of $180,000,000 were arranged to effectively convert certain floating interest rate obligations into fixed interest rate obligations and require interest payments on the stated principal amount at rates ranging from 8.3% to 9.8% (remaining terms of three months to five years) in return for receipts calculated on the same notional amounts at floating interest rates. In addition, 25 agreements with notional principal amounts of $1,140,000,000 were arranged to effectively convert certain fixed interest rate obligations into floating interest rate obligations and require interest payments on the stated principal amount at the three month or six month LIBOR (remaining terms of five months to nine years) in return for receipts calculated on the same notional amounts at fixed interest rates of 4.9% to 7.6%. In the third quarter of 1993, GFC entered into four three-year interest rate hedge agreements on $750 million of floating-rate borrowings to effectively guarantee a spread of approximately 2.3% between its borrowing rate (LIBOR) and the Prime interest rate. The agreements have been entered into with major financial institutions, which are expected to fully perform under the terms of the agreements, thereby mitigating the credit risk from the transactions. Annual maturities of long-term debt outstanding at December 31, 1993 due through June 2003 (excluding the amount supported by the revolving credit agreements expected to be renewed) will approximate $179,392,000 (1994), $192,135,000 (1995), $163,030,000 (1996), $198,747,000 (1997), $204,072,000 (1998) and $625,524,000 (thereafter). The agreements pertaining to long-term debt of GFC include various restrictive covenants and require the maintenance of certain defined financial ratios with which GFC has complied. Under one of these covenants, dividend payments are limited to 50 percent of accumulated earnings after December 31, 1991. As of December 31, 1993, GFC had $7,174,000 of excess accumulated earnings available for distribution. Total interest paid is not significantly different from interest expense. NOTE E REDEEMABLE PREFERRED STOCK On July 30, 1993, GFC Financial acquired 2,500 shares of GFC's Series A Redeemable Preferred Stock ("GFC Preferred Stock") from a subsidiary of Dial. The GFC Preferred Stock was issued in connection with the Distribution for a purchase price of $25 million in cash. The GFC Preferred Stock, par value of $10,000 per share, entitles the holder thereof to receive cash dividends at the annual rate of 9%, payable quarterly, but only, when, as and if declared by the Board of Directors of GFC, and such dividends shall be cumulative (provided that such rate shall increase to 15% per annum in the event that GFC fails to redeem such shares on July 1, 1997). The GFC Preferred Stock has a liquidation preference of $10,000 per share, and ranks prior to the common stock, par value $1 per share, of GFC (the "GFC Common Stock"), both as to payment of dividends and as to distribution of assets upon liquidation, dissolution or winding up of GFC. The GFC Preferred Stock is redeemable, in whole or in part, at the option of GFC, at $10,000 in cash per share plus accrued and unpaid dividends, and must be redeemed, on July 1, 1997, for $10,000 per share. In addition, the GFC Preferred Stock must be redeemed if, prior to July 1, 1997, GFC receives at least $25 million of proceeds from the issuance of additional preferred or common stock or other contributions to its capital. With the consent of the holders of at least two thirds of the GFC Preferred Stock, GFC may defer the mandatory redemption beyond July 1, 1997, for a specified period of time. Each share of GFC Preferred Stock has one vote and votes together with the GFC Common Stock on all matters submitted to a vote of the shareholders of GFC. There are 25,000 shares of GFC Common Stock issued and outstanding, all of which are owned by GFC Financial. Thus, the GFC Preferred Stock represents approximately 9% of the voting securities of GFC. NOTE F INCOME TAXES Prior to the Distribution, Dial credited or charged the Company an amount equal to the tax reductions realized or tax payments made by Dial as a result of including the Company's tax results and credits in Dial's consolidated federal and other applicable income tax returns. In all other respects, the Company's tax provisions have been computed on a separate return basis. The consolidated provision (benefit) for income taxes consist of the following for the years ended December 31: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Current: United States: Federal $4,976 $16,265 $20,087 State 1,254 2,069 1,364 Foreign (156) 346 (1,963) - ---------------------------------------------------------------------------- 6,074 18,680 19,488 - ---------------------------------------------------------------------------- Deferred: United States 21,608 (2,377) (17,760) Foreign (2,460) - ---------------------------------------------------------------------------- 21,608 (4,837) (17,760) - ---------------------------------------------------------------------------- Provision for income taxes $27,682 $13,843 $1,728 ============================================================================ Deferred income taxes relate to the following principal temporary differences: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Lease and other contract income and related depreciation $13,791 $3,882 $6,244 Gains on sale of assets (1,377) 1,726 (16,732) Provision for possible credit losses (277) 1,551 (8,175) Recognition of deferred intercompany gain (7,531) Adjustment to deferred taxes related to the increase in the U.S. federal statutory income tax rate 4,857 Operating expense deferrals 2,365 Recognition of tax benefit on refinancing charges accrued in 1991 (3,153) Minimum tax credit carryforward 1,456 Other 793 1,148 903 - ---------------------------------------------------------------------------- Provision (benefit) for deferred income taxes $21,608 $(2,377) $(17,760) ============================================================================ The benefit for foreign deferred income taxes for the year ended December 31, 1992 relates to operating losses of GEFG. Income taxes paid in 1993, 1992 and 1991 amounted to $10,511,000, $19,096,000 and $16,769,000, respectively. The federal statutory income tax rate is reconciled to the effective income tax rate as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Federal statutory income tax rate 35.0% 34.0% (34.0%) State income tax 3.4% 2.7% 2.3% Foreign tax effects (2.1%) (2.4%) 11.7% Tax provision on intercompany gains resulting from the Distribution 21.6% Recognition of tax benefits on refinancing charges accrued in 1991 (6.2%) Permanent differences on transaction costs 12.0% Other (0.7%) (0.7%) (8.9%) - ---------------------------------------------------------------------------- Current provision for income tax 35.6% 27.4% 4.7% Adjustment to deferred taxes 7.6% - ---------------------------------------------------------------------------- Provision for income taxes 43.2% 27.4% 4.7% ============================================================================ NOTE G PENSION AND OTHER BENEFITS Pension Benefits Net periodic pension (income) cost for the years ended December 31, included the following components: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Service cost benefits earned during period $603 $493 $215 $341 Interest cost on projected benefit obligation 638 499 293 345 Actual return on plan assets (1,504) (1,071) (736) (382) Net amortization and deferral 625 303 459 79 - ---------------------------------------------------------------------------- Periodic pension cost 362 224 231 383 Curtailment gain (777) - ---------------------------------------------------------------------------- Net periodic pension (income) cost $(415) $224 $231 $383 ============================================================================ Assumptions regarding the determination of net periodic pension (income) costs were: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Discount rate for obligation 8.5% 9.0% 9.0% 9.0% Rate of increase in compensation levels 5.5% 6.0% 8.0% 8.0% Long-term rate of return on assets 9.5% 9.5% 9.0% 9.0% - ---------------------------------------------------------------------------- GFC participated in a Dial pension plan and was allocated pension credits of $21,000 for 1991. The following table indicates the plans' funded status and amounts recognized in the Company's consolidated balance sheet at December 31, 1993 and 1992: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligations $12,000 $3,195 $3,440 $3,088 ============================================================================ Accumulated benefit obligations $12,600 $3,835 $3,440 $3,088 ============================================================================ Projected benefit obligation $14,400 $6,724 $3,755 $3,548 Market value of plan assets, primarily equity and fixed income securities 17,606 9,625 3,781 3,319 - ---------------------------------------------------------------------------- Plan asset over (under) projected benefit obligation 3,206 2,901 26 (229) Unrecognized transition asset (451) (285) (109) (123) Unrecognized prior service cost reduction 404 450 72 96 Unrecognized net loss 1,804 539 101 254 - ---------------------------------------------------------------------------- Prepaid (accrued) pension costs $4,963 $3,605 $90 $(2) ============================================================================ Assumptions regarding the funded status of pension plans are: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Discount rate for obligation 7.75% 8.50% 8.00% 9.00% Rate of increase in compensation levels 4.25% 5.50% 6.00% 8.00% Long-term rate of return on assets 9.50% 9.50% 9.00% 9.00% - ---------------------------------------------------------------------------- There are restrictions on the use of excess pension plan assets in the event of a defined change in control of the Company. Postretirement Benefits Other Than Pensions Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB"), which requires the accrual of retiree benefits during the years the employees provide services. OPEB requires the recognition of a transition obligation that represents the aggregate amount that would have accrued in the years prior to adoption of OPEB had the standard been in effect for those years. The Company elected to accrue the transition obligation over 20 years. The adoption of SFAS No. 106 has no cash impact because the plans are not funded and the pattern of benefit payments did not change. Net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components: - ---------------------------------------------------------------------------- Service cost benefits earned during period $ 55 Interest cost on accumulated postretirement benefit obligation 143 Net amortization and deferral 85 - ---------------------------------------------------------------------------- Net periodic postretirement benefit cost $ 283 ============================================================================ Assumptions regarding the determination of net periodic postretirement benefit costs were: - ---------------------------------------------------------------------------- Discount rate for obligation 8.5% Rate of increase in compensation levels 5.5% Rate of increase in health care costs (1) 14.0% ============================================================================ (1) Rate of increase in health care costs was 14.0% in 1993, graded to 7.0% in 2000 and thereafter. OPEB benefit costs for 1993 are $223,000 higher than postretirement benefits paid and expensed in 1992 due to the adoption of SFAS No. 106. Amounts paid for postretirement benefits in 1992 and 1991 were approximately $60,000 and $38,000, respectively. The following table indicates the amounts recognized in the Company's consolidated balance sheet at December 31, 1993: - --------------------------------------------------------------------------- Accumulated postretirement benefit obligation: Retirees $ 1,680 Actives eligible for full benefits 230 Other actives 370 - --------------------------------------------------------------------------- Total accumulated postretirement benefit obligation 2,280 Unrecognized transition obligation 1,607 Unrecognized net loss 437 - --------------------------------------------------------------------------- Accrued postretirement benefit cost $ 236 =========================================================================== Assumptions regrading the accrued postretirement benefit at December 31, 1993 were: - ---------------------------------------------------------------------------- Discount rate for obligation 7.75% Rate of increase in compensation levels 4.25% Rate of increase in health care costs (1) 13.25% - ---------------------------------------------------------------------------- (1) Rate of increase in health care costs was 13.25% in 1993, graded to 6.25% in 2000 and thereafter. A one percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately 7% and the ongoing annual expense by approximately 5%. NOTE H TRANSACTIONS WITH DIAL Pursuant to the Distribution, the Company and Dial entered into several agreements, including the Distribution Agreement, Tax Sharing Agreement, Sublease Agreement, Interim Services Agreement and Trademark Assignment and Agreement. These agreements do not result in significant additional expenses. The Company leases its corporate office facilities from Dial under an agreement which expires March 31, 2001. Annual rentals under the lease are approximately $1,616,000 to 1996 and $1,806,000 thereafter. NOTE I LITIGATION AND CLAIMS The Company and certain of its subsidiaries are parties either as plaintiffs or defendants to various actions, proceedings and pending claims, including legal actions, certain of which involve claims for compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against the Company. Although the ultimate amount for which the Company or its subsidiaries may be held liable is not ascertainable, the Company believes that any resulting liability should not materially affect the Company's financial position or results of operations. NOTE J SFAS NO. 107 - "DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS" The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments". The estimated fair value amounts have been determined by the Company using available market information and valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying amounts and estimated fair values of the Company's financial instruments are as follows for the years ended December 31: - --------------------------------------------------------------------------- 1993 1992 - --------------------------------------------------------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value - --------------------------------------------------------------------------- Balance Sheet - Financial Instruments: Assets: Loans and other financing contracts $ 2,192,192 $ 2,172,154 $ 1,854,761 $ 1,812,864 Liabilities: Senior debt 1,991,986 2,149,387 1,806,433 1,847,875 Subordinated debt 86,790 88,390 75,916 83,915 Off-Balance Sheet - Financial Instruments: Interest rate conversion agreements --- 36,361 ---- 4,536 - ---------------------------------------------------------------------------- The carrying values of cash and cash equivalents, accounts payable and accrued expenses, customer deposits, interest payable and short-term debt approximate fair values due to the short-term maturities of these instruments. The methods and assumptions used to estimate the fair values of other financial instruments are summarized as follows: Loans and other financing contracts: The fair value of loans and other financing contracts was estimated by discounting expected cash flows using the current rates at which loans of similar credit quality, size and remaining maturity would be made as of December 31, 1993 and 1992. Management believes that the risk factor embedded in the entry-value interest rates applicable to performing loans for which there are no known credit concerns results in a fair valuation of such loans on an entry value basis. As of December 31, 1993 and 1992, the fair value of nonaccruing contracts with a carrying amount of $25,583,000 and $46,431,000, respectively, was not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the market place for such loans. As of December 31, 1993 and 1992, the carrying amount of loans and other financing contracts excludes repossessed assets with a total carrying amount of $125,980,000 and $75,500,000, respectively. Senior and subordinated debt: The fair value of senior and subordinated debt was estimated by discounting future cash flows using rates currently available for debt of similar terms and remaining maturities. The carrying values of commercial paper and borrowings under revolving credit facilities were assumed to approximate fair values due to their short maturities. Interest rate conversion agreements: The fair values of interest conversion agreements is based on quoted market prices obtained from participating banks and dealers. The fair value estimates presented herein were based on information available as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair values, such values have not been updated since December 31, 1993 and 1992; therefore, current estimates of fair value may differ significantly from the amounts presented herein. NOTE K SELLING, ADMINISTRATIVE AND OTHER OPERATING EXPENSES: The following represents a summary of the major components of selling, administrative and other operating expenses for the three years ended December 31: - -------------------------------------------------------------------------- 1993 1992 1991 - -------------------------------------------------------------------------- Salaries and employee benefits $ 29,502 $ 27,247 $ 24,362 Problem account costs 11,822 7,642 5,790 Occupancy expense 4,160 4,494 3,444 Depreciation and amortization 2,803 1,970 1,502 Other 9,871 9,375 11,825 - -------------------------------------------------------------------------- $ 58,158 $ 50,728 $ 46,923 ========================================================================== NOTE L GEOGRAPHIC INFORMATION The Company operates primarily in the United States and Europe. Geographic information for the three years ended December 31, 1993 is shown below: - ---------------------------------------------------------------------------- Domestic Europe Consolidated - ---------------------------------------------------------------------------- Assets at year end: 1993 $ 2,699,030 $ 135,867 $ 2,834,897 1992 2,272,036 208,290 2,480,326 1991 1,960,520 351,332 2,311,852 - ---------------------------------------------------------------------------- Interest earned from financing transactions: 1993 225,688 23,012 248,700 1992 202,472 38,334 240,806 1991 197,080 54,392 251,472 - ---------------------------------------------------------------------------- Interest margins earned: 1993 106,651 15,897 122,548 1992 83,390 21,309 104,699 1991 73,647 20,265 93,912 - ---------------------------------------------------------------------------- Income (loss) before income taxes: 1993 62,822 1,301 64,123 1992 54,937 (4,344) 50,593 1991 (19,076) (17,938) (37,014) - ---------------------------------------------------------------------------- NOTE M CONDENSED QUARTERLY RESULTS (UNAUDITED) - ---------------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ---------------------------------------------------------------------------- Interest earned from financing transactions: 1993 $ 58,262 $ 62,356 $ 63,450 $ 64,632 1992 57,842 60,219 63,100 59,645 - ---------------------------------------------------------------------------- Interest expense: 1993 30,568 31,423 30,788 33,373 1992 35,263 33,896 34,580 32,368 - ---------------------------------------------------------------------------- Gains on sale of assets: 1993 2,061 179 --- 3,199 1992 --- 1,617 196 1,549 - ---------------------------------------------------------------------------- Non-interest expenses (includes provision for possible credit losses): 1993 16,339 15,022 14,389 18,114 1992 11,860 14,934 12,760 17,914 - ---------------------------------------------------------------------------- Net income: 1993 8,545 10,323 6,750 (1) 10,823 1992 7,185 8,969 10,087 10,509 - ---------------------------------------------------------------------------- (1) Income from continuing operations and net income for the third quarter of 1993 include an adjustment of $4,857,000 representing the effect of recent federal and state income tax increases applicable to deferred income taxes generated by the Company's leveraged lease portfolio. NOTE N SUBSEQUENT EVENT (Unaudited) - PURCHASE OF AMBASSADOR FACTORS AND TRICON CAPITAL CORPORATION On February 14, 1994, GFC acquired Fleet Financial Group, Inc.'s ("Fleet") factoring and asset based lending subsidiary, Fleet Factors Corporation, which operates under the trade name Ambassador Factors ("Ambassador"). The cash purchase price of the acquisition was $248,285,000 and represented Ambassador's stockholder's equity, including a premium ($76,285,000), and repayment of the intercompany balance due from Ambassador to Fleet ($172,000,000). In addition, GFC assumed $111,526,000 due to to factored clients, $4,843,000 of accrued liabilities and $8,800,000 of additional liabilities and transaction costs. The acquisition will be accounted for as a purchase and will create approximately $30,400,000 of goodwill, which will be amortized on a straight line basis over 20 years. The acquisition was financed with proceeds received from the sale of GFC Financial's discontinued mortgage insurance subsidiary and cash generated from operations. GFC Financial, simultaneously with the acquisition, increased its investment in GFC by contributing $40,000,000 of intercompany loans as additional paid in capital of GFC. On March 4, 1994, GFC signed a definitive purchase agreement under which it will acquire all of the stock of TriCon Capital Corporation ("TriCon") from Bell Atlantic Corporation ("Bell Atlantic"), in an all-cash transaction. This transaction is subject to regulatory approvals and certain other conditions. Accordingly, there can be no assurance that the acquisition will be consummated. The cash purchase price of the acquisition is $344,250,000. In addition, GFC will assume outstanding indebtedness and liabilities of TriCon totaling $1,453,201,000 and additional accrued liabilities and acquisition costs of $7,500,000. The acquisition is expected to be accounted for as a purchase and will create approximately $69,817,000 of goodwill, which will be amortized on a straight line basis over 20 years. The cash purchase price is expected to be financed initially with the proceeds of interim debt and internally generated funds. A portion of the interim debt is expected to be replaced with additional equity to be raised in the near future by GFC Financial in public or private offerings which, together with the remaining intercompany loans from GFC Financial to GFC and other assets, will be contributed as additional paid in capital of GFC. It is not expected that such equity securities of GFC Financial will be issued prior to the consummation of the acquisition of TriCon by GFC. There can be no assurance that such an offering or the raising of the interim debt will occur. The Company's obligation to consummate the acquisition of TriCon is conditioned upon the receipt of waivers or consents from lenders under certain of the Company's credit and loan agreements with respect to certain financial covenants contained therein. The Company is in the process of obtaining such consents and waivers, believes they will be obtained and will not complete the acquisition until they are obtained. Upon receipt, such waivers and consents will be conditioned upon the receipt by the Company, not later than 120 days following the consummation of the acquisition of TriCon, of the equity investment from GFC Financial referred to above. The failure of GFC Financial to complete the equity offering or offerings and invest the required proceeds in the Company by such date would constitute a default under such credit and loan agreements, unless the Company could obtain additional waivers, consents or amendments to such credit and loan agreements. The Company's inability to obtain additional waivers, consents or amendments to such credit and loan agreements would allow GFC's lenders to declare an event of default and could result in the acceleration of the indebtedness due thereunder. Such default and/or acceleration would constitute a default under other borrowing arrangements and could result in the acceleration of substantially all of the Company's outstanding indebtedness, which would have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that GFC Financial will complete such equity offering or offerings and make the required investment in the Company by the required date or at any other date. The following Pro Forma Consolidated Balance Sheet (unaudited) of GFC as of December 31, 1993 and Pro Forma Statement of Consolidated Income From Continuing Operations (unaudited) for the year ended December 31, 1993 have been prepared to reflect the historical financial position and income from continuing operations as adjusted to reflect the acquisition of Ambassador and the pending acquisition of TriCon by GFC. The Pro Forma Consolidated Balance Sheet has been prepared as if such acquisitions occurred on December 31, 1993 and the Pro Forma Statement of Consolidated Income From Continuing Operations has been prepared as if such acquisitions occurred on January 1, 1993. The pro forma consolidated financial information is unaudited and is not necessarily indicative of the results that would have occurred if the acquisitions had been consummated as of December 31, 1993 or January 1, 1993. Total assets on a pro forma basis increased to $5,010,959,000 at December 31, 1993. Pro forma income from continuing operations would have been $66,693,000 after a $4,857,000 adjustment for deferred taxes applicable to leveraged leases. Excluding the $4,857,000 charge, pro forma income from continuing operations would be approximately $72 million. NOTES TO PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS (1) The Pro Forma Consolidated Balance Sheet, as of December 31, 1993 and the Pro Forma Statement of Consolidated Income From Continuing Operations for the year ended December 31, 1993 include the historical balance sheet of Ambassador, incorporated herein by reference from the Company's Current Report on Form 8-K, dated February 14, 1994, as amended, as of November 30, 1993 and the historical statement of income of Ambassador for the eleven months ended November 30, 1993. ACQUISITION OF AMBASSADOR (2) To record the purchase of Ambassador, including the accrual of various liabilities and the resulting goodwill, using the proceeds advanced to GFC upon the sale of GFCFC's discontinued mortgage insurance subsidiary and cash generated from operations. (3) To record repayment of Ambassador's intercompany payable to Fleet using the proceeds advanced to GFC upon the sale of GFCFC's discontinued mortgage insurance subsidiary and cash generated from operations. (4) To record the contribution by GFCFC of $40,000,000 of intercompany loans from GFCFC to GFC as additional paid in capital of GFC. (5) Adjustments to reflect interest expense of debt repaid in 1993 with proceeds received from the sale of GFCFC's discontinued mortgage insurance operation and cash generated from operations. Such debt is assumed to be outstanding for the entire pro forma period. The adjustment is partially offset by interest saved as a result of the $40,000,000 equity contribution in item (4). (6) To record amortization of goodwill based on an amortization period of twenty years and amortization of the covenant not to compete over one year (see item (20)). (7) To record additional administrative expenses for additional employees and general overhead. (8) To record the income tax effect of items (5), (6) and (7) at GFC's effective incremental income tax rate of 40%. (9) To adjust income taxes for the lower state income tax rate applicable to GFC. ACQUISITION OF TRICON (10) To record the original capital contribution by Bell Atlantic as part of the incorporation of TriCon. (11) To transfer assets and the related debt of TriCon, not purchased by GFC, to Bell Atlantic and reduce interest earned from financing transactions for the income recorded on such assets in 1993. (12) To record issuance of notes payable to fund the deferred tax payment to Bell Atlantic for an amount equal to the deferred taxes of TriCon, exclusive of deferred tax assets. (13) To record a dividend from TriCon to Bell Atlantic and the issuance of a note payable to Bell Atlantic for the remaining principal amount of the short-term borrowings from affiliates of TriCon. (14) To record the purchase of TriCon. The acquisition of TriCon is expected to be financed initially with interim debt, the assumption of outstanding indebtedness of TriCon to Bell Atlantic, the assumption of TriCon's third party debt and liabilities and internally generated funds. A portion of the interim debt is assumed to be replaced with equity raised by GFCFC and, such equity, together with the outstanding preferred stock of GFC held by GFCFC, the remaining intercompany loans due to GFCFC from GFC and other assets will be contributed to GFC as additional paid in capital of GFC. The pro forma adjustment assumes the equity contributions were made at the beginning of the pro forma period. The interest expense related to the debt that is being replaced with equity and, therefore, nonrecurring and excluded from the pro forma consolidated statement of income from continuing operations is approximately $2,000,000. Including new debt, the debt assumed, the accrual of various additional liabilities and acquisition costs, the total purchase price of the acquisition is estimated to be $1,804,951,000 resulting in $69,817,000 of goodwill. The purchase will result in a new tax basis for TriCon's assets, eliminating the remaining deferred tax asset. (15) To reflect base fees and incremental costs related to an agreement to manage leveraged leases for Bell Atlantic. (16) To record additional interest expense resulting from additional debt to Bell Atlantic and interim debt not replaced with the proceeds from the GFCFC equity issuance in item (14). The adjustment is partially offset by the interest saved on the debt transferred to Bell Atlantic and interest saved as a result of equity contribution of the intercompany loans in item (14). (17) To record amortization of goodwill based on an amortization period of twenty years (see item (20)). (18) To reduce TriCon's income taxes for the effect of increases in income tax rates for 1993 (principally the increase in the federal tax rate) due to the deferred tax payment and new tax basis in assets at the beginning of the pro forma period. (19) To record the income tax effect of adjustments (11) and (15) through (17) at GFC's effective incremental income tax rate of 40%. (20) Goodwill may be adjusted as the final allocation of the values of the purchased assets and liabilities is established. GREYHOUND FINANCIAL CORPORATION COMMISSION FILE NUMBER 1-7543 EXHIBIT INDEX DECEMBER 31, 1993 FORM 10-K Page No. in Sequentially Numbered Form 10-K No. Title Report - --------- ------------------------------------------------------ ---------- (3-A) The Company's Certificate of Incorporation, as amended through the date of this filing (incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 10-K"), Exhibit 3-A. (3-B) The Company's By-Laws, as amended through the date of this filing, (incorporated by reference from the Company's 1991 10-K, Exhibit 3-B. (4-A) Instruments with respect to issues of long-term debt have not been filed as exhibits to this Annual Report on Form 10-K if the authorized principal amount of any one of such issues does not exceed 10% of total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request. (4-B-1) Form of Common Stock Certificate of the Company from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K", Exhibit 4-B-1. (4-B-2) Form of the Company's Series A Redeemable Preferred Stock Certificate from the 1993 10-K, Exhibit 4-B-2. (4-C) Certificate of Designations of Series A Redeemable Preferred Stock of the Company (incorporated by reference from the 1992 GFC Financial Annual Report on Form 10-K for the year ended December 31, 1992 (the "GFC Financial 1992 10-K", Exhibit 10-MM). (4-D) Relevant portions of the Company's Certificate of Incorporation and Bylaws are included in Exhibits 3- A and 3-B above, respectively. (4-E) Indenture dated as of November 1, 1990 between the ompany and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-37743, Exhibit 4). (4-F) Fourth Supplemental Indenture dated as of April 17, 1992 between the Company and the Trustee named therein, supplementing the Indenture referenced in Exhibit 4-E above, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-F. (4-G) Prospectus and Prospectus Supplement dated April 17, 1992, relating to $350,000,000 principal amount of the Company's Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-G. (4-H) Form of Floating-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the 1992 GFC Financial 10-K, Exhibit 4-H. (4-I) Form of Fixed-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-I. (4-J) Form of Indenture dated as of September 1, 1992 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, Exhibit 4). (4-K) Prospectus and Prospectus Supplement dated September 25, 1992 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-K. (4-L) Form of Floating-rate Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-L. (4-M) Form of Fixed-rate Medium-term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-M. (4-N) Indenture dated as of June 1, 1985 between the Company and the trustee named therein is hereby incorporated by reference from the 1992 10-K, Exhibit 4-N. (4-O) Prospectus and Prospectus Supplement dated February 16, 1994 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (4-P) Prospectus, dated February 16, 1994, and Prospectus Supplement dated February 17, 1994 regarding $100,000,000 principal amount of the Company's Floating-Rate Notes, is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (9) Form of Distribution Agreement among the Company, GFC Financial Corporation, The Dial Corp and certain other parties named therein, dated as of January 28, 1992 (incorporated by reference from GFC Financial's Registration Statement on Form S-1, Registration No. 33-45452, Annex II to the Prospectus and Exhibit 2.1) (containing section 2.08(b), regarding the voting of the Greyhound Financial Corporation preferred stock). (10-A) Fifth Amendment and Restatement dated as of May 18, 1993 of the Credit Agreement dated as of May 31, 1976 among the Company and the banking institutions listed on the signature pages thereto, and Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents (incorporated by reference from the Corporation's Current Report on Form 8-K dated February 14, 1994, Exhibit 7(c)). (10.A1) Amendment dated as of January 31, 1994, to the Fifth Amendment and Restatement, noted in 10-A above incorporated by reference from the GFC Financial 1992 10-K, Exhibit 10-A1.* (10-C) Sublease dated as of April 1, 1991 among the Company, GFC Financial, Dial and others, relating to the Company's principal office space is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-NN. (10-D) Interim Service Agreement dated January 28, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-JJ. (10-E) Tax Sharing Agreement dated February 19, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-KK. (10.F) Stock Purchase Agreement between the Company and Bell Atlantic TriCon Leasing Corporation dated as of March 4, 1994.* (10.G) Form of Assets Purchase Agreement between Bell Atlantic TriCon Leasing Corporation and TriCon Capital Corporation.* (12) Computation of Ratio of Income to Combined Fixed Charges and Preferred Stock Dividends.* (23) Consent of Independent Accountants - Deloitte & Touche.* (23.A) Consent of Independent Accountants - Coopers & Lybrand.* (23.B) Consent of Independent Accountants - Coopers & Lybrand.* (23.C) Consent of Independent Accountants - KPMG Peat Marwick.*	28,902	198,135
3721_1993.txt	3721_1993	1993	3721	ITEM 1 - BUSINESS ----------------- GENERAL - ------- The Allen Group Inc. ("Allen", the "Company" or the "Registrant") was incorporated under the laws of the State of Delaware on February 3, 1969. Its predecessor was Allen Electric and Equipment Company, incorporated under the laws of the State of Michigan on January 13, 1928, which merged into the Delaware corporation on May 1, 1969. On May 5, 1972, the name of the Company was changed to The Allen Group Inc. The business of Allen and its subsidiaries includes Mobile Communications Products, Automotive Test and Service and Truck Products. On June 11, 1993, Allen sold its Allen Testproducts division and related wholly owned leasing subsidiary, The Allen Group Leasing Corp. ("Leasing"), to SPX Corporation ("SPX"). Allen Testproducts manufactured and sold automotive engine diagnostic and emission test equipment for the automotive service industry and provided product financing through Leasing. At the closing, Allen received $21,000,000 in cash and an 8% subordinated note of SPX, dated June 11, 1993, in the amount of $19,737,000. Additional information regarding this divestiture is incorporated herein by reference to "Acquisitions and Dispositions" in Note 10 of the Notes to Consolidated Financial Statements on page 26 of Allen's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. There have been no other significant changes in the business, kinds of products produced or services rendered or in the markets or methods of distribution since the beginning of the last fiscal year. MOBILE COMMUNICATIONS PRODUCTS - ------------------------------ Allen's Mobile Communications Products segment is principally comprised of Allen Telecom Group ("ATG") and Comsearch. In early 1993, Allen's Antenna Specialists, Decibel Products, Grayson Electronics Company and db Mobile business units were reorganized to form ATG in order to better serve ATG's customers and to develop broader name recognition in the industry. ATG's principal product lines are systems products, including Extend-A-Cells trademark, microcells, paging repeaters and power amplifiers; site management and base station products, including filters, combiners, duplexers, isolators and cable; and mobile and base station antennas. The demand for equipment supplied by ATG is primarily a function of the development of wireless communications systems throughout the world, and ATG's ability to develop new products and technology related to system coverage and capacity. Comsearch is a leading provider of transmission planning services for microwave, satellite, cellular, SMR and PCS communications. Over the last two years, Comsearch has become a leading provider of engineering services and software to the cellular and PCS markets. During 1993, the Company increased its investment in other wireless communication technologies in the form of loans, advances and/or direct minority equity investments in order to broaden its expertise in this industry. ATG acquired substantially all of the assets of TSR Technologies, Inc., which supplies test equipment and measuring systems in cellular and paging markets, and designs proprietary software to monitor cellular and paging activity. Allen also has invested $1.0 million in Alven Capital Corporation, which is engineering rural telephony systems, and over $1 million in Encompass, Inc., which is a PCS consulting company. Allen also maintains a 14% equity ownership interest in RF Micro Devices Inc., which manufactures radio frequency integrated circuits for various communications products. In 1993, sales of the Mobile Communications Products segment increased nearly $55 million, or 43%, over 1992, primarily due to the full year effect of the acquisition of Alliance Telecommunications Corporation in July 1992, and sustained growth of existing telecommunication products. Mobile communication products are manufactured or assembled by the Company, and are sold directly or through distributors and sales representatives to original equipment manufacturers, common carriers and other large users of telecommunication products. In 1993, 11% of sales in the Mobile Communications Products segment were made to Motorola, Inc. AUTOMOTIVE TEST AND SERVICE - --------------------------- Allen's Automotive Test and Service segment now consists solely of its wholly owned subsidiary, MARTA Technologies, Inc. ("MARTA"), which is engaged in the centralized automotive emissions testing business. The Company's former Allen Testproducts division, which manufactured, sold and leased automotive diagnostic and emissions testing equipment, was divested during 1993. MARTA designs, builds and operates centralized automotive emissions testing programs under long-term contracts with state governments, and is one of only five major companies that has the necessary capabilities and experience for such programs. Due to more stringent air quality standards mandated by the 1990 Amendments to the Federal Clean Air Act, it is expected that approximately 100 million cars will be subjected to biennial emissions testing. Generally, each of these emissions testing programs is structured so that once awarded, the company awarded the program (such as MARTA) is responsible for purchasing the land, constructing the testing facilities, equipping the sites with analytical and computer equipment, hiring and training personnel and eventually operating the program. It is not until a program begins to operate (typically under a multi-year sole source contract) that revenue (generally on a fixed fee, cash per test basis, except for the State of Maryland program which is an annual fixed fee received monthly from the State) begins to be generated. During 1993, MARTA was awarded two programs: the El Paso region of Texas and the State of Maryland. These two programs are scheduled to begin operations on January 1, 1995. In addition, MARTA currently has five bids outstanding and anticipates bidding on other programs in 1994. The timing and number of new centralized emissions testing programs placed for bid are dependent upon the enactment of state legislation and resultant issuance of a request for proposal. Any delay in legislation or the issuance of proposals will necessarily delay the start-up of the operating phase of such programs. MARTA also operates an emissions inspection program in Jacksonville, Florida, which currently accounts for 100% of its revenue. The State of Maryland program requires a capital commitment of approximately $48 million ($3.6 million expended in 1993); however, under the terms of the contract, the State will purchase the capital assets from the Company for cash on or before the January 1, 1995 start-up date. The El Paso region of Texas program requires a capital investment of approximately $8.0 million ($0.6 million expended in 1993). The Company anticipates significant opportunity for MARTA as it bids additional programs throughout 1994. The Company intends to finance such programs through MARTA but still may make considerable equity investments or guarantees on behalf of MARTA. TRUCK PRODUCTS - -------------- Allen manufactures and sells heavy-duty radiators and specialty heat exchangers for trucks and off-highway equipment through its G & O Manufacturing Company division. Allen also produces steel parts manufactured primarily to customers' specifications, such as truck fenders, cabs and battery boxes, specialized interiors installed in utility trucks and vans, and custom sheet metal fabrications, through its Crown divisions. These products are sold by Allen's own sales employees and commissioned sales representatives to major automotive, truck and off-road equipment manufacturers, major delivery services and others. During 1993, Allen's Crown division relocated production of its four-door pickup truck cabs and dual rear wheel conversions from Canada to a new facility located near Louisville, Kentucky. During 1993, the Company manufactured certain truck products in Canada, which accounted for 27% of sales in this industry segment and 9% of Allen's total sales in 1993. Ford Motor Company and PACCAR Inc. accounted for 37% and 13%, respectively, of sales in the Truck Products segment in 1993. JOINT VENTURE OPERATIONS - ------------------------ The Company, along with Handy & Harman, participates in a 50/50 joint venture partnership, GO/DAN Industries, which is accounted for under the equity method. GO/DAN Industries is engaged in the manufacture and sale of automotive replacement radiators and other heat transfer products. GO/DAN Industries was organized on June 1, 1990, at which time Allen and Handy & Harman each transferred to the joint venture certain assets, net of related liabilities, relating to such business. WORKING CAPITAL - --------------- The working capital requirements of the Company vary with its particular product lines. Truck Products are generally manufactured on an "as ordered" basis; therefore, large inventories are generally not maintained nor is the amount of product returned significant. The remaining manufacturing product lines of the Company consist of standard manufactured products for which inventory levels are generally based on product demand. The most significant capital requirement for the Company will be for the expansion of MARTA. As previously noted, MARTA was awarded two programs in 1993. The Maryland program requires a capital commitment of approximately $48.0 million ($3.6 million expended in 1993); however, under the terms of the contract between the State of Maryland and MARTA, the State will purchase the capital assets from the Company, for cash, on or before the January 1, 1995 start-up date. Interim construction financing has been established by MARTA through two banking institutions. The El Paso region of Texas program requires a capital investment of approximately $8.0 million ($.6 million expended in 1993), and the Company anticipates arranging project supported financing prior to its January 1, 1995 start-up date. The Company continues to see significant opportunity for MARTA as it bids additional programs throughout 1994. The Company anticipates financing such programs through MARTA, but still may make considerable equity investments or guarantees on behalf of MARTA. MARTA has available credit lines with three banks, each in the amount of $20.0 million, and such lines expire in September 1994. Additional capital requirements will depend upon any new emissions programs being awarded to MARTA. COMPETITION - ----------- In each of Allen's industry segments, competition is vigorous. In its centralized emissions testing inspection program product line, the Company presently has four principal competitors. The primary means of competition and the selection of a contractor by the governmental agency are experience, technological capability, financial resources and price. The Company believes that it has established a major market position in the United States for mobile cellular telephone antennas, where competition is distributed among many manufacturers. In its other product lines, the Company believes that it is among the major manufacturers and that competition is widely distributed. Allen's principal methods of competition include price, service, warranty, market availability and product research and development, innovation and performance. In certain of its product lines, the Company has augmented its own resources through licensing agreements with companies possessing complementary resources and technologies. MAJOR CUSTOMERS - --------------- Except as noted in the preceding industry segment descriptions, there is no single customer or group of a few customers for which the loss of any one or more would have a material adverse effect on any industry segment or on the Company. The remainder of Allen's sales is widely distributed among many customers. The increase in the Automotive Test and Service backlog represents the award of two emission testing contracts to MARTA (the El Paso region of Texas and the State of Maryland) in 1993. The increase in backlog for Mobile Communications Products represents increased orders for systems and site management products. With the exception of Automotive Test and Service, all 1993 backlog is expected to be completely filled within the 1994 fiscal year. PRODUCTION, RAW MATERIALS AND SUPPLIES - -------------------------------------- In addition to manufacturing certain products, Allen also assembles at its facilities certain components manufactured for it by non-affiliated companies. The principal materials used in the production of Allen's products are steel, copper, brass, zinc, aluminum, plastics, rubber, nickel and electronic components. These materials are purchased regularly from several domestic and foreign producers and have been generally available in sufficient quantities to meet Allen's requirements, although occasionally shortages have occurred. A significant portion of the copper and brass used by the Company in the manufacture of truck radiators is sourced from a foreign manufacturer; the Company believes that the risk, if any, inherent in this arrangement is no greater than in any of its other raw material sources. The Company believes that the supplies of materials through the end of 1994 will be adequate. PATENTS, LICENSES AND FRANCHISES - -------------------------------- The Company owns a number of patents, trademarks and copyrights and conducts certain operations under licenses granted by others. Although the Company does not believe that the expiration or loss of any one of these would materially affect its business considered as a whole or the operations of any industry segment, it does consider certain of them to be important to the conduct of its business in certain product lines. In 1991, a United States Federal Court found that an overseas manufacturer had willfully infringed the Company's patent on its On-Glass registered trademark cellular telephone antennas. The Company believes that the court affirmation of the validity of its patent has slowed the entrance of infringing foreign-manufactured products into the United States. Business franchises and concessions are not of material importance to Allen's industry segments. RESEARCH AND DEVELOPMENT - ------------------------ The Company is engaged in research and development activities (substantially all of which are Company-sponsored) as part of its ongoing business. The Company is continuing to emphasize the development of specialty products and accessories to serve the cellular telephone and mobile communications markets. Currently, these are not at a stage that would require a material investment in assets. For additional information, see "Research and Development Expenses" in Note 1 of Notes to Consolidated Financial Statements on page 17 of Allen's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ENVIRONMENTAL CONTROLS - ---------------------- The Company is subject to federal, state and local laws designed to protect the environment and believes that, as a general matter, its policies, practices and procedures are properly designed to prevent unreasonable risk of environmental damage and financial liability to the Company. Additional information regarding environmental issues is incorporated herein by reference to the last paragraph of Note 6, "Commitments and Contingencies", of the Notes to Consolidated Financial Statements on page 22 of Allen's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. EMPLOYEES - --------- As of December 31, 1993, Allen had approximately 2,500 employees. SEASONAL TRENDS - --------------- Generally, the Company's sales are not subject to significant seasonal variations; however, sales and earnings for ATG tend to be lower in the first fiscal quarter due to lower base station antenna installations. In addition, earnings typically tend to be lower during the first half of the year due to the seasonality of the Company's GO/DAN Industries joint venture. INDUSTRY SEGMENTS, CLASSES OF PRODUCTS, FOREIGN OPERATIONS AND EXPORT SALES - --------------------------------------------------------------------------- Information relating to the Company's industry segments, classes of similar products or services, foreign and domestic operations and export sales is incorporated herein by reference to "Segment Sales and Income" on page 12, "Industry Segment and Geographic Data" in Note 9 of the Notes to Consolidated Financial Statements on page 26, and the information presented in the charts on pages 30 to 33, of the Company's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. With the transfer of its manufacturing operations from Canada to the United States as set forth under "BUSINESS - Truck Products" on pages 4 to 5 of this Report, and except with respect to ATG's Mexican operations which supplies mobile antennas to ATG, Allen engages in no material manufacturing operations in foreign countries, and no material portion of Allen's sales currently is derived from such operations. In addition, the Company's 50/50 joint venture, GO/DAN Industries, has a manufacturing facility located in Mexico. With the opportunities represented by the rapid deployment of cellular telephony systems throughout the world, the Company has seen extensive growth in international markets and export sales have increased from $33 million in 1992 to over $57 million in 1993. This growth has encouraged the Company to continue to expand the size and number of its international sales and service offices. In the opinion of management, any risks inherent in Allen's existing foreign operations and sales are not substantially different than the risks inherent in its domestic operations and sales. ITEM 2 ITEM 2 - PROPERTIES ------------------- At December 31, 1993, Allen's continuing operations were conducted in 31 facilities in 13 states, Canada (the Company exited its principal Canadian manufacturing facility in 1994) and Mexico. In addition, ATG maintains sales offices in Australia, Germany, the United Kingdom and Singapore. Allen occupies approximately 1,463,000 square feet of space for manufacturing, fabrication, assembly, centralized automotive emissions testing, warehousing, research and development and administrative offices. Approximately 440,000 square feet are rented under operating leases, and the remainder is owned. Principal domestic facilities are located in Ohio, Connecticut, Florida, Kentucky, Mississippi, Texas, and Virginia. In Ontario, Canada, Allen formerly occupied approximately 96,000 square feet; in Reynosa, Mexico, Allen owns approximately 59,000 square feet. Allen's machinery, plants, warehouses and offices are in good condition, reasonably suited and adequate for the purposes for which they are presently used and generally are fully utilized. In addition to the above, Allen owns four manufacturing facilities that had been utilized by its former discontinued operations and automotive replacement radiator businesses. Three of these facilities (totalling 185,000 square feet) are currently under short-term leases, including a facility leased to the purchaser of the automated manufacturing product line, a facility leased to GO/DAN Industries (an affiliated joint venture) and a facility leased (with an option to purchase) to an independent third party. The fourth facility, with an aggregate of 48,000 square feet, is currently vacant and being held for sale. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS -------------------------- The information required by this Item is incorporated herein by reference to the fourth paragraph of Note 6, "Commitments and Contingencies", of the Notes to Consolidated Financial Statements on page 22 of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The following list sets forth the names of the executive officers (as defined under rules promulgated by the Securities and Exchange Commission) of Allen, their ages and business experience during at least the last five years. ROBERT G. PAUL - President and Chief Executive Officer; age 52. Mr. Paul has been President and Chief Executive Officer of the Company since February 1991. He was President and Chief Operating Officer of the Company from December 1989 to February 1991, Senior Vice President-Finance from April 1987 to December 1989, Vice President-Finance from January 1987 to April 1987 and a Vice President from 1974 to January 1987. He also was President of the Antenna Specialists Company division of the Company from 1978 to June 1990. Mr. Paul joined the Company in 1970 as an Assistant to the President and also served as Assistant Treasurer from 1970 to 1972. He was elected Treasurer in 1972 and Vice President and Treasurer of Allen in 1974. Mr. Paul was appointed Vice President-Finance and Administration of the Antenna Specialists Company division of Allen's subsidiary, Orion Industries, Inc. (a predecessor of ATG), in 1976, its Vice President-Operations in 1977 and its President in 1978, while continuing as a Vice President of Allen. ROBERT A. YOUDELMAN - Senior Vice President-Finance and Chief Financial Officer; age 52. Mr. Youdelman joined the Company in 1977 as Director of Taxes. In February 1980 he was elected Vice President-Taxation, and in December 1989 was elected Senior Vice President-Finance and Chief Financial Officer. Mr. Youdelman is an attorney. FRANK J. HYSON - Vice President; age 61. Mr. Hyson joined Allen in 1973 as Vice President-Finance of the Company's Crown Divisions and was appointed President of Crown in 1976. He was elected a Vice President of Allen in September 1987. ERIK H. VAN DER KAAY - Vice President; age 53. Mr. van der Kaay joined the Company in 1990 as President of the Antenna Specialists Company division of Allen's subsidiary, Orion Industries, Inc. He was elected Vice President of Allen in February 1993. Prior to joining Allen, Mr. van der Kaay was the Chief Executive Officer of Millitech Corporation, a developer and manufacturer of milliliter communication components and systems, South Deerfield, Massachusetts, from 1988 to 1990, and Group Vice President of Telecommunications at Avantek Inc., a developer and manufacturer of microwave radios and CATV systems, Santa Clara, California, from 1984 to 1988. JAMES L. LEPORTE, III - Vice President and Controller; age 39. Mr. LePorte joined the Company in 1981 as Senior Financial Analyst. In 1983, he was appointed Manager of Financial Analysis, and, in 1984, was named Assistant Controller. In April 1988, Mr. LePorte was elected Controller of the Company and in December 1990 was elected a Vice President. JOHN C. MARTIN, III - Vice President and Treasurer; age 41. Mr. Martin joined the Company in 1979 as a Senior Business Analyst and was appointed Manager, International Business Development in 1984 and Director, Corporate Development in 1987. He was elected Treasurer in April 1988 and a Vice President in September 1991. MCDARA P. FOLAN, III - Secretary and General Counsel; age 35. Mr. Folan joined the Company in August 1992 as Corporate Counsel and was elected Secretary and General Counsel in September 1992. Prior to joining Allen, Mr. Folan was affiliated with the law firm of Jones, Day, Reavis and Pogue, Cleveland, Ohio, from September 1987 to August 1992. Mr. Folan is an attorney. There is no family relationship between any of the foregoing officers. All officers of Allen hold office until the first meeting of directors following the annual meeting of stockholders and until their successors have been elected and qualified. PART II ------- ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ------------------------------------------------------------------------------ The information required by this Item is incorporated herein by reference to the eighth paragraph of Note 2 of the Notes to Consolidated Financial Statements on page 19, and to "Exchange Listings", "Market Price Range of Common Stock", "Dividends Declared on Common Stock" and "Stockholders" on page 36, of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA -------------------------------- The information required by this Item is incorporated herein by reference to "Ten Year Summary of Operations" on pages 34 to 35 of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------------------------------ RESULTS OF OPERATIONS --------------------- The information required by this Item is incorporated herein by reference to pages 30 to 33 of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ---------------------------------------------------- The information required by this Item is incorporated herein by reference to the Consolidated Statements of Income, Consolidated Balance Sheets, Consolidated Statements of Cash Flows and Consolidated Statements of Stockholders' Equity on pages 13 to 16, to the Notes to Consolidated Financial Statements on pages 17 to 28, and to the "Report of Independent Accountants" on page 29, of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON --------------------------------------------------------- ACCOUNTING AND FINANCIAL DISCLOSURE ----------------------------------- Not applicable. PART III -------- ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT -------------------------------------------------------- The information required by this Item relating to the Company's executive officers is included on page 9 hereof under "EXECUTIVE OFFICERS OF ALLEN" and is incorporated herein by reference to "EXECUTIVE COMPENSATION AND TRANSACTIONS WITH MANAGEMENT -- Employment, Termination of Employment and Change of Control Arrangements" on pages 16 to 18 of the Registrant's definitive proxy statement dated March 17, 1994 filed with the Securities and Exchange Commission pursuant to Section 14(a) of the Securities Exchange Act of 1934. The other information required by this Item is incorporated herein by reference to "ELECTION OF DIRECTORS -- Information Regarding Nominees" on pages 1 to 3 of the Registrant's definitive proxy statement dated March 17, 1994 filed with the Securities and Exchange Commission pursuant to Section 14(a) of the Securities Exchange Act of 1934. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION -------------------------------- The information required by this Item is incorporated herein by reference to "ELECTION OF DIRECTORS -- Compensation Committee Interlocks and Insider Participation" on page 4, to "ELECTION OF DIRECTORS -- Compensation of Directors" on pages 4 to 6 and to "EXECUTIVE COMPENSATION AND TRANSACTIONS WITH MANAGEMENT -- Transactions with Executive Officers and Directors" on page 20 of the Registrant's definitive proxy statement dated March 17, 1994 filed with the Securities and Exchange Commission pursuant to Section 14(a) of the Securities Exchange Act of 1934. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ------------------------------------------------------------------------ The information required by this Item is incorporated herein by reference to "STOCK OWNERSHIP" on pages 21 to 23 of the Registrant's definitive proxy statement dated March 17, 1994 filed with the Securities and Exchange Commission pursuant to Section 14(a) of the Securities Exchange Act of 1934. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------------------------------------------------------- The information required by this Item is incorporated herein by reference to "EXECUTIVE COMPENSATION AND TRANSACTIONS WITH MANAGEMENT -- Transactions with Executive Officers and Directors" on page 20, and to "STOCK OWNERSHIP -- Principal Stockholders" on page 21 of the Registrant's definitive proxy statement dated March 17, 1994 filed with the Securities and Exchange Commission pursuant to Section 14(a) of the Securities Exchange Act of 1934. PART IV ------- ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K -------------------------------------------------------------------------- (a)(1) FINANCIAL STATEMENTS OF THE REGISTRANT -------------------------------------- The Consolidated Financial Statements of the Registrant listed below, together with the Report of Independent Accountants, dated February 16, 1994, are incorporated herein by reference to pages 13 to 29 of the Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants (2) FINANCIAL STATEMENT SCHEDULES ----------------------------- The following additional information should be read in conjunction with the Consolidated Financial Statements of the Registrant described in Item 14(a)(1) above: FINANCIAL STATEMENT SCHEDULES OF THE REGISTRANT ----------------------------------------------- Report of Independent Accountants on page 13 of this Report relating to the financial statement schedules Schedule VIII - Valuation and Qualifying Accounts and Reserves, on page 14 of this Report Schedule X - Supplementary Income Statement Information, of page 15 of this Report Schedules other than that listed above are omitted because they are not required or are not applicable, or because the information is furnished elsewhere in the financial statements or the notes thereto. (3) EXHIBITS* -------- The information required by this Item relating to Exhibits to this Report is included in the Exhibit Index on pages 18 to 23 hereof. (b) REPORTS ON FORM 8-K ------------------- None. ______________ A copy of any of the Exhibits to this Report will be furnished to persons who request a copy upon the payment of a fee of $.25 per page to cover the Company's duplication and handling expenses. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Stockholders of The Allen Group Inc.: Our report on the consolidated financial statements of The Allen Group Inc. has been incorporated by reference in this Annual Report on Form 10-K from page 29 of the 1993 Annual Report to Stockholders of The Allen Group Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the Index on page 12 of this Form 10-K Annual Report. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand COOPERS & LYBRAND Cleveland, Ohio February 16, 1994 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 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. THE ALLEN GROUP INC. -------------------- (Registrant) By /s/ Robert A. Youdelman ---------------------------- Robert A. Youdelman Senior Vice President-Finance Date: March 30, 1994 ------------------- 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. /s/ Robert G. Paul March 30, 1994 -------------------------------------------- Robert G. Paul, President, Chief Executive Officer and Director (Principal Executive Officer) /s/ Robert A. Youdelman March 30, 1994 -------------------------------------------- Robert A. Youdelman, Senior Vice President- Finance (Principal Financial Officer) /s/ James L. LePorte March 30, 1994 -------------------------------------------- James L. LePorte, Vice President and Controller (Principal Accounting Officer) /s/ Wade A. Allen March 30, 1994 -------------------------------------------- Wade W. Allen, Director March , 1994 -------------------------------------------- George A. Chandler, Director /s/ Philip Wm. Colburn March 30, 1994 -------------------------------------------- Philip Wm. Colburn, Chairman of the Board and Director /s/ Jill K. Conway March 30, 1994 -------------------------------------------- Jill K. Conway, Director /s/ Albert H. Gordon March 30, 1994 -------------------------------------------- Albert H. Gordon, Director /s/ William O. Hunt March 30, 1994 ------------------------------------------ William O. Hunt, Director /s/ J. Chisholm Lyons March 30, 1994 ------------------------------------------ J. Chisholm Lyons, Director /s/ Charles W. Robinson March 30, 1994 ------------------------------------------ Charles W. Robinson, Director /s/ Richard S. Vokey March 30, 1994 ------------------------------------------ Richard S. Vokey, Director /s/ William M. Weaver, Jr. March 30, 1994 ------------------------------------------ William M. Weaver, Jr., Director EXHIBIT INDEX ------------- EXHIBIT NUMBERS PAGES - --------------- ----- (3) Certificate of Incorporation and By Laws - (a) Restated Certificate of Incorporation (filed as Exhibit Number 3(a) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1984 (Commission file number 1-6016) and incorporated herein by reference)............... - (b) Certificate of Designations, Powers, Preferences and Rights of the $1.75 Convertible Exchangeable Preferred Stock, Series A (filed as Exhibit Number 3(b) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986 (Commission file number 1-6016) and incorporated herein by reference) ........................... - (c) Certificate of Amendment of Restated Certificate of Incorporation (filed as Exhibit Number 3(c) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference) .. - (d) Certificate of Designations, Powers, Preferences and Rights of the Variable Rate Preferred Stock, Series A (filed as Exhibit Number 3(d) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference) .. - (e) Certificate of Designation, Preferences and Rights of Series B Junior Participating Preferred Stock (filed as Exhibit Number 3(e) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference) .. - (f) Certificate Eliminating Variable Rate Preferred Stock, Series A (filed as Exhibit Number 3(f) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1989 (Commission file number 1-6016) and incorporated herein by reference) ..................................... - (g) Certificate of Amendment of Restated Certificate of Incorporation................................ 24 (h) Certificate Eliminating $1.75 Convertible Exchangeable Preferred Stock, Series A.......... 26 (i) By-Laws, as amended through September 10, 1992 (filed as Exhibit Number 3(g) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)............................ - (4) Instruments defining the rights of security holders - (a) Rights Agreement, dated as of January 7, 1988, between the Registrant and Manufacturers Hanover Trust Company (filed as Exhibit Number 4 to Registrant's Form 8-K Current Report dated January 7, 1988 (Commission file number 1-6016) and incorporated herein by reference) .......... - (b) Credit Agreement, dated as of February 17, 1994, among the Registrant, the Banks signatory thereto, and Bank of Montreal, as agent........................... 29 Additional information concerning Registrant's long- term debt is set forth in Note 2 of the Notes to Consolidated Financial Statements on pages 18 to 19 of Registrant's 1993 Annual Report to Stockholders, a copy of which is filed as Exhibit 13 to this Report. Other than the Credit Agreement referred to above, no instrument defining the rights of holders of such long-term debt relates to securities having an aggregate principal amount in excess of 10% of the consolidated assets of Registrant and its subsidiaries; therefore, in accordance with paragraph (iii) of Item 4 of Item 601(b) of Regulation S-K, the other instruments defining the rights of holders of long-term debt are not filed herewith. Registrant hereby agrees to furnish a copy of any such other instrument to the Securities and Exchange Commission upon request. (10) Material contracts (All of the exhibits listed as material contracts hereunder are management contracts or compensatory plans or arrangements required to be filed as exhibits to this Report pursuant to Item 14(c) of this Report.) - (a) The Allen Group Inc. 1970 Non-Qualified Stock Option Plan, as amended April 25, 1978, June 23, 1981 and February 19, 1985 (revised) (filed as Exhibit Number 10(a) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1985 (Commission file number 1-6016) and incorporated herein by reference)............................................... - (b) Amendment, dated November 3, 1987, to 1970 Non-Qualified Stock Option Plan (filed as Exhibit Number 10(b) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commis- sion file number 1-6016) and incorporated herein by reference) .............................................. - (c) The Allen Group Inc. 1982 Stock Plan, as amended through November 3, 1987 (filed as Exhibit Number 10(c) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference)............ - (d) Amendment, dated as of December 4, 1990, to 1982 Stock Plan, as amended (filed as Exhibit No. 10(d) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......... - (e) Form of Restricted Stock Agreement pursuant to 1982 Stock Plan, as amended (filed as Exhibit No. 10(e) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......... - (f) The Allen Group Inc. 1992 Stock Plan (filed as Exhibit No. 10(f) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)..... - (g) Form of Restricted Stock Agreement pursuant to 1992 Stock Plan (Salary Increase Deferral), dated November 30, 1993, entered into by the Registrant with certain executive officers, officers and division presidents...................................... 111 (h) Form of Restricted Stock Agreement pursuant to 1992 Stock Plan (Salary Increase Deferral), dated April 28, 1992, entered into by the Registrant with certain executive officers, officers and division presidents (filed as Exhibit No. 10(g) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)................................................ - (i) Form of Non-Qualified Option to Purchase Stock granted to certain directors of the Registrant on September 12, 1989 (filed as Exhibit Number 10(e) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1989 (Commission file number 1-6016) and incorporated herein by reference) ................................... - (j) The Allen Group Inc. 1994 Non-Employee Directors Stock Option Plan (filed as Exhibit A to Registrant's Proxy Statement dated March 17, 1994 (Commission file number 1-6016) and incorporated herein by reference)...... 119 (k) The Allen Group Inc. Amended and Restated Key Management Deferred Bonus Plan (incorporating all amendments through February 27, 1992) (filed as Exhibit No. 10(i) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)..................................... - (l) Form of Restricted Stock Agreement pursuant to 1992 Stock Plan and Key Management Deferred Bonus Plan (filed as Exhibit No. 10(j) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference).................... - (m) Form of Severance Agreement, dated as of November 3, 1987, entered into by the Registrant with certain executive officers, officers and division presidents (filed as Exhibit Number 10(g) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference) ............................................. - (n) Form of Amendment, dated December 5, 1989, to Severance Agreement entered into by the Registrant with certain executive officers, officers and division presidents (filed as Exhibit Number 10(j) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1989 (Commission file number 1-6016) and incorporated herein by reference) .......... - (o) Key Employee Severance Policy adopted by the Registrant on November 3, 1987 (filed as Exhibit Number 10(h) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 6-6016) and incorporated herein by reference) ................................... - (p) Amendment, dated May 14, 1991, to Key Employee Severance Policy adopted by the Registrant on November 3, 1987 (filed as Exhibit No. 10(n) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)............................................. - (q) Employment Agreement, dated June 28, 1988, between the Registrant and Philip Wm. Colburn (filed as Exhibit Number 10(m) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988 (Commission file number 1-6016) and incorporated herein by reference) ................................... - (r) Amendment, dated as of February 27, 1992, of Employment Agreement, dated June 28, 1988, between the Registrant and Philip Wm. Colburn (filed as Exhibit No. 10(p) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference)............ - (s) Amendment, dated as of February 26, 1991, of Employment Agreement, dated June 28, 1988, between the Registrant and Philip Wm. Colburn (filed as Exhibit Number 10(n) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......................................... - (t) Amended and Restated Post Employment Consulting Agreement, dated as of December 20, 1990, between the Registrant and Philip Wm. Colburn (filed as Exhibit Number 10(o) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......................................... - (u) Amended and Restated Supplemental Pension Benefit Agreement, dated as of December 20, 1990, between the Registrant and Philip Wm. Colburn (filed as Exhibit Number 10(p) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......................................... - (v) Insured Supplemental Retirement Benefit Agreement, dated as of September 4, 1985, between the Registrant and Philip Wm. Colburn (filed as Exhibit Number 10(l) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1987 (Commission file number 1-6016) and incorporated herein by reference) .......... - (w) Split Dollar Insurance Agreement, dated as of July 1, 1991, between the Registrant and Philip Wm. Colburn (filed as Exhibit No. 10(u) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference...................................... - (x) Supplemental Pension Benefit Agreement, dated as of December 6, 1983, between the Registrant and J. Chisholm Lyons (filed as Exhibit Number 10(r) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1983 (Commission file number 1-6016) and incorporated herein by reference) ... - (y) Amendment, dated as of December 20, 1990, of Supplemental Pension Benefit Agreement, dated as of December 6, 1983, between the Registrant and J. Chisholm Lyons (filed as Exhibit Number 10(s) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) ... - (z) Post Employment Consulting Agreement, dated as of September 12, 1989, between the Registrant and J. Chisholm Lyons (filed as Exhibit Number 10(s) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1989 (Commission file number 1-6016) and incorporated herein by reference) .......... - (aa) Amendment, dated as of December 20, 1990, of Post Employment Consulting Agreement, dated as of September 12, 1989, between the Registrant and J. Chisholm Lyons (filed as Exhibit No. 10(u) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990 (Commission file number 1-6016) and incorporated herein by reference) .......... - (bb) Employment Agreement, dated June 25, 1991, between the Registrant and Robert G. Paul (filed as Exhibit Number 10(x) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (Commission file number 1-6016) and incorporated herein by reference)..................................... - (cc) Supplemental Pension Benefit Agreement, dated as of June 25, 1991, between the Registrant and Robert G. Paul (filed as Exhibit Number 10(y) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (Commission file number 1-6016) and incorporated herein by reference).................... - (dd) Form of Split Dollar Insurance Agreement, dated as of November 1, 1991, entered into by the Registrant with certain executive officers, officers and division presidents (filed as Exhibit No. 10(bb) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference......................... - (ee) Form of Supplemental Pension Benefit Agreement, dated as of February 27, 1992, entered into by the Registrant with certain executive officers, officers and division presidents (filed as Exhibit No. 10(cc) to Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (Commission file number 1-6016) and incorporated herein by reference......................... - (11) Statement re Computation of Earnings (Loss) Per Common Share ........................................... 123 (13) 1993 Annual Report to Stockholders .................... 124 (21) Subsidiaries of the Registrant ......................... 164 (23) Consent of Independent Accountants ..................... 166 ___________________________ * Furnished for the information of the Securities and Exchange Commission and not to be deemed "filed" as part of this Report except for the Consolidated Financial Statements of the Registrant and the Accountants' Report on pages 11 to 29 of said Annual Report to Stockholders and the other information incorporated by reference in Items 1 and 3 of Part I hereof and Items 5 to 8 of Part II hereof. A copy of any of these Exhibits will be furnished to persons who request a copy upon the payment of a fee of $.25 per page to cover the Company's duplication and handling expenses.	7,183	49,166
14930_1993.txt	14930_1993	1993	14930	Item 1. Business Brunswick Corporation (the "Company") is organized into seven divisions with operations in two industry segments: Marine and Recreation. Segment information is contained in Note 8 on page 32. Marine The Marine industry segment consists of the Mercury Marine Division, which manufactures and sells marine propulsion systems, and the US Marine, Sea Ray and Fishing Boat Divisions, which manufacture and sell pleasure and fishing boats. The Company believes it has the largest dollar volume of sales of recreational marine engines and pleasure boats in the world. The Mercury Marine Division manufactures and sells Mercury, Mariner and Force outboard motors, MerCruiser gasoline and diesel inboard and stern drive engines, and the Sport-Jet 90 water-jet system. Outboard motors are sold through marine dealers for pleasure craft and commercial use and to the Company's US Marine, Sea Ray and Fishing Boat Divisions. The MerCruiser engines and the water-jet systems are sold principally to boatbuilders, including the Company's US Marine, Sea Ray and Fishing Boat Divisions. The Mercury Marine Division also manufactures and sells replacement parts for engines and outboard motors and marine accessories, including steering systems, instruments, controls, propellers, service aids and marine lubricants. These products are marketed through marinas, dealers and boatbuilders under the Quicksilver brand name. Mercury Marine products are manufactured in North America and Europe for global distribution. International assembly facilities are located in Belgium and Mexico, and offshore distribution centers are in Belgium, Japan and Australia. Trademarks for Mercury Marine products include MerCruiser, Mercury, Mariner, Force and Quicksilver. The US Marine Division builds and sells several brands of fiberglass pleasure and fishing boats, ranging in size from 14 to 47 feet. Bayliner is the Division's oldest and most well known brand, with offerings that include jet powered boats, family runabouts, cabin cruisers, sport fishing boats and luxury motor yachts. Other brands include Maxum (runabouts and cabin cruisers) and Robalo (sport fishing boats). The US Marine Division is vertically integrated, producing many of the parts and accessories which make up the boats. Escort boat trailers are also produced by the Division and sold with smaller boats as part of boat-motor-trailer packages. Outboard motors and stern drive and inboard engines are purchased from the Mercury Marine Division. The US Marine Division's boats, Escort boat trailers, and parts and accessories are sold through dealers. Trademarks for US Marine products include Bayliner, Maxum, Cobra, Quantum, Robalo, Ciera, Trophy, Jazz, Escort and US Marine. The Sea Ray Division builds and sells Sea Ray fiberglass boats from 13 to 65 feet in length, including luxury motor yachts, cabin cruisers, sport fishing boats, sport boats, runabouts, water skiing boats, and jet powered boats. Sea Ray boats use and are sold with outboard motors, stern drive engines and gasoline or diesel inboard engines. The Division purchases its outboard motors and most of its stern drive and gasoline inboard engines from the Mercury Marine Division. Sea Ray boats are sold through dealers under the Sea Ray, Laguna, Ski Ray and Sea Rayder trademarks. The Fishing Boat Division manufactures and sells fiberglass and aluminum boats for the sport fishing and recreational boating markets. Some of these boats are equipped with Mercury, Mariner or Force outboard motors at the factory and are sold in boat-motor-trailer packages by marine dealers. The Fishing Boat Division's boats are sold through dealers under the Astro, Fisher, MonArk, Procraft, Starcraft, and Spectrum trademarks. The Company has an interest in Tracker Marine, L.P., a limited partnership, which manufactures and markets boats, motors, trailers and accessories. The Company has various agreements with Tracker Marine, L.P., including contracts to supply outboard motors, trolling motors and various other Brunswick products for Tracker Marine boats. The Company's Marine segment sales to unaffiliated customers include sales of the following principal products for the three years ended December 31, 1993, 1992, and 1991: Boat sales include the value of engines when such engines are sold as a component of a finished boat. Engine sales include sales to boat manufacturers which are not Company-owned, marine dealers and others, when the engine is not sold with a Company-manufactured boat. Recreation There are three divisions in the Recreation industry segment: Zebco, Brunswick, and Brunswick Recreation Centers. The Zebco Division manufactures, assembles, purchases and sells fishing reels, rods, reel/rod combinations, and accessories. The Division also manufactures and sells electric trolling motors for fishermen and for use by boat manufacturers, including Marine segment operations. The Brunswick Division manufactures and sells products for the bowling industry, including bowling lanes, automatic pinsetters, ball returns, computerized scoring equipment and business systems, and BowlerVision, a computer software bowling system which allows pins to be set up in a variety of configurations, creating new games for bowlers to play. BowlerVision also is able to analyze and display ball path, ball speed and entry angle. In addition, the Division manufactures and sells seating and locker units for bowling centers; bowling pins, lane finishes and supplies; and bowling balls and bags. The Brunswick Division also manufactures and sells golf club shafts and golf bags and sells billiards tables which are manufactured for the Company to its specifications. The Brunswick Division has a 50% interest in Nippon Brunswick K. K., which sells bowling equipment and operates bowling centers in Japan. In 1993, the Division entered into a joint venture to build, own and operate bowling centers in Brazil and a joint venture to build, own and operate bowling centers and to sell bowling equipment in Thailand. The Division also entered into a joint venture to build, own and operate recreation centers containing the Q-Zar laser tag game and to sell Q-Zar laser tag equipment in Brazil and Mexico. The Division also has the rights to sell Q-Zar laser game equipment in Korea. The Brunswick Recreation Centers Division operates 126 recreation centers worldwide. Recreation centers are bowling centers which offer, in varying degrees depending on size and location, the following additional activities and services: billiards and other family games, children's playrooms, restaurants and cocktail lounges. The Company owns most of its recreation centers. In 1993, the Division also opened three Circus World Pizza facilities which contain children's play and entertainment areas and restaurants which serve pizza. The Company intends to open seven Circus World Pizza facilities in 1994. Among the Company's trademarks in the recreation field are Zebco, Quantum, Pro Staff, Classic and Martin fishing equipment, MotorGuide, Stealth and Thruster electric trolling motors, Brunswick Recreation Centers, Circus World Pizza, Leiserv, Brunswick, AS-90, Armor Plate 3000, Anvilane, BallWall, Guardian, Perry-Austen, Rhino, GS-10, Systems 2000, BowlerVision and Colorvision bowling equipment, and Brunswick Golf and Precision FM golf club shafts. Browning S.A. has licensed the Zebco Division to manufacture and sell Browning fishing equipment. Recreation products are distributed, mainly under these trademarks, to mass merchants, distributors, dealers, bowling centers, and retailers by the Company's salesmen and manufacturers' representatives and to the recreation centers operated by the Company. Recreation products are distributed worldwide from regional warehouses, sales offices and factory stocks of merchandise. Discontinued operations The Company has announced its intention to divest its Technical Group, and the businesses in the Technical Group are considered and have been accounted for as discontinued operations. The Technical Group manufactures and sells composite structures for aircraft, helicopters, spacecraft, propulsion systems, missiles, ships, automobiles, trucks, buses, oil and gas wells and offshore platforms; radomes; space qualified products including fire detection systems, filters and extendable robotic arms; camouflage; infrared optical surveillance systems; tactical weapons; flight decoys and target training systems; relocatable and mobile shelter systems; and chemical protective detectors/alarms. These products are sold to the U.S. Department of Defense; major defense prime contractors; electronics, aerospace and commercial aircraft manufacturers; and machinery, automotive and oil and gas manufacturers and distributors. Raw materials Many different raw materials are purchased from various sources. At the present time, no critical raw material shortages are anticipated in either of the Company's industry segments. General Motors Corporation is a significant supplier of the gasoline engines used to manufacture the Company's gasoline stern drives. Patents, trademarks and licenses The Company has and continues to obtain patent rights, consisting of patents and patent licenses, covering certain features of the Company's products and processes. The Company's patents, by law, have a limited life, and rights expire periodically. In the Marine segment, patent rights principally relate to boats and features of outboard motors and inboard-outboard drives including die-cast powerheads, cooling and exhaust systems, drive train, clutch and gearshift mechanisms, boat/engine mountings, shock absorbing tilt mechanisms, ignition systems, propellers, spark plugs, and fuel and oil injection systems. In the Recreation segment, patent rights principally relate to computerized bowling scorers and business systems, bowling lanes and related equipment, lightweight golf club shafts, game tables, fishing reels and electric trolling motors. Although the Company has important patent and patent license positions, the Company believes that its performance is mainly dependent upon its engineering, manufacturing, and marketing capabilities. The Company has many trademarks associated with its various divisions and applied to its products. Many of these trademarks are well known to the public and are considered valuable assets of the Company. Significant trademarks are listed on pages 1-4 herein. Seasonality of business The Company's overall business is not seasonal. Demand in the marine business is typically strongest in the first half of the year, when for the past several years between 50 and 60 percent of that segment's annual sales have been recorded. In the recreation segment, slightly more than 50 percent of the segment's annual sales are recorded in the second half of the year. Order backlog Order backlog is not considered to be a significant factor in the businesses of the Company, except for bowling capital equipment. The backlog of bowling capital equipment at December 31, 1993 was $47 million, and the Company expects to fill all of such orders during 1994. The backlog of bowling capital equipment at December 31, 1992 was $61 million. Competitive conditions and position The Company believes that it has a reputation for quality in its highly competitive lines of business. The Company competes in its various markets by utilizing efficient production techniques and innovative marketing, advertising and sales efforts, and by providing high quality products at competitive prices. Strong competition exists with respect to each of the Company's product groups, but no single manufacturer competes with the Company in all product groups. In each product area, competitors range in size from large, highly diversified companies to small producers. The following paragraphs summarize what the Company believes its position is in each area. Marine. The Company believes it has the largest dollar volume of sales of recreational marine engines and of pleasure boats in the world. The domestic marine engine market includes relatively few major competitors. There are 10-12 competitors in outboard engine markets worldwide, and foreign competition continues in the domestic marine engine market. The marine engine markets are experiencing pricing pressures. The marine accessories business is highly competitive. There are many manufacturers of pleasure and fishing boats, and consequently, this business is highly competitive. The Company competes on the basis of quality, value, performance, durability, styling and price. Demand for pleasure and fishing boats and marine engines is dependent on a number of factors, including economic conditions, the availability of fuel and marine dockage and, to some extent, prevailing interest rates and consumer confidence in spending discretionary dollars. Recreation. The Company competes directly with many manufacturers of recreation products. In view of the diversity of its recreation products, the Company cannot identify the number of its competitors. The Company believes, however, that in the United States, it is one of the largest manufacturers of bowling equipment and fishing reels. Certain bowling equipment, such as BowlerVision, automatic scorers and computerized management systems, represents innovative developments in the market. For other recreation products, competitive emphasis is placed on pricing and the ability to meet delivery and performance requirements. The Company maintains a number of specialized sales forces that sell equipment to distributors and dealers and also, in some cases, to retail outlets. The Company operates 126 recreation centers worldwide. Each center competes directly with centers owned by other parties in its immediate geographic area; so, competitive emphasis is placed on customer service, quality facilities and personnel, prices and promotional programs. Research and development Company-sponsored research activities, relating to the development of new products or to the improvement of existing products, are shown below: Number of employees The number of employees at December 31, 1993 is shown below by industry segment: Marine 11,300 Recreation 6,500 Corporate 200 18,000 There are approximately 800 employees in the Recreation segment and 2,200 employees in the Marine segment who are represented by labor unions. The Company believes that relations with the labor unions are good. Environmental requirements The Company is involved in certain legal and administrative proceedings under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 and other federal and state legislation governing the generation and disposition of certain hazardous wastes. These proceedings, which involve both on and off site waste disposal, in many instances seek compensation from the Company as a waste generator under Superfund legislation which authorizes action regardless of fault, legality of original disposition or ownership of a disposal site. The Company believes that it has established adequate reserves to cover all known claims. Item 2. Item 2. Properties The Company's headquarters are located in Lake Forest, Illinois. The Company has numerous manufacturing plants, distribution warehouses, sales offices and test sites. Research and development facilities are division-related, and most are located at individual manufacturing sites. The Company's plants are deemed to be suitable and adequate for the Company's present needs. The Company believes that all of its properties are well maintained and in good operating condition. Most plants and warehouses are of modern, single-story construction, providing efficient manufacturing and distribution operations. The Company's plants currently are operating at approximately 65% of capacity, excluding the 15 closed plants in the Marine segment. Twelve of these closed plants are being offered for sale. The other three closed plants are not being offered for sale, but the Company has no plans to reopen them in the near future. The Company's headquarters and all of its principal plants are owned by the Company. Some bowling recreation centers, three small plants, two test facilities and an overseas distribution center are leased. The Company's primary facilities are in the following locations: Mercury Marine Division Fond du Lac, Oshkosh and Milwaukee, Wisconsin; Stillwater, Oklahoma; St. Cloud, Florida; Juarez, Mexico; and Petit Rechain, Belgium. US Marine Division Arlington and Spokane, Washington; Roseburg, Oregon; Miami and Claremore, Oklahoma; Pipestone, Minnesota; Cumberland and Salisbury, Maryland; Dandridge, Tennessee; Valdosta, Georgia; Tallahassee, Florida; and Lincoln, Alabama. Sea Ray Division Knoxville and Vonore, Tennessee; Merritt Island, Sykes Creek and Palm Coast, Florida; Phoenix, Arizona; and Cork, Ireland. Fishing Boat Division Topeka and Nappanee, Indiana; West Point, Mississippi; and Murfreesboro, Tennessee. Zebco Division Tulsa, Oklahoma; and Starkville, Mississippi. Brunswick Recreation Centers Deerfield, Illinois headquarters; 126 bowling centers in the United States, Canada and Europe; and Circus World Pizza theme restaurants in the United States. Brunswick Division Muskegon, Michigan; Eminence, Kentucky; Bristol, Wisconsin; Torrington, Connecticut; Des Moines, Iowa; Stockach, Germany; and Kettering, England. Item 3. Item 3. Legal Proceedings Genmar Industries, Inc. v. Brunswick Corporation, et al. Genmar Industries brought an action against the Company and certain of its subsidiaries in the United States District Court for the District of Minnesota on June 23, 1992, alleging that the Company (i) has monopolized or attempted to monopolize the sale of recreational marine engines and boats through its acquisition of Bayliner Marine Corporation and Ray Industries, Inc. in 1986; its acquisition of four smaller fishing boat builders in 1988; its 1990 acquisition of Kiekhaefer Aeromarine, Inc., a supplier of high performance propulsion units to the marine engine industry and the owner of certain patents for recreational marine engine components; and its agreement in 1992 to form a partnership with Tracker Marine Corporation for the manufacture and marketing of recreational marine engines and power boats; (ii) has unlawfully coerced purchasers to buy the Company's boats by charging higher prices for its engines sold separately than for its engines sold with its boats, thereby inducing purchasers to buy its boats in addition to its engines; (iii) has breached its agreement to offer Genmar the lowest possible price made available to other recreational marine engine purchasers for the same quantity of engines purchased; (iv) has not dealt in good faith with Genmar by, among other things, communicating to Genmar dealers that Genmar is experiencing purported financial difficulties; and, (v) by virtue of the foregoing, has interfered with Genmar's existing and prospective business relationships. Genmar has asked that the Company be required to divest its boat manufacturing business, be enjoined from continuing its partnership with Tracker Marine, and pay damages, including treble damages under the antitrust laws. The Company believes, based upon its assessment of the complaint and in consultation with counsel, that this litigation is without merit and intends to defend itself vigorously. Parties to this suit have exchanged written discovery and have begun depositions. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Company The Company's executive officers are listed in the following table: Officer Present Position Age J. F. Reichert Chairman of the Board 63 and Chief Executive Officer J. P. Reilly President and Chief 50 Operating Officer J. M. Charvat Executive Vice President 63 J. W. Dawson Vice President and Zebco 59 Division President F. J. Florjancic, Jr. Vice President and Brunswick 47 Division President W. R. McManaman Vice President-Finance 46 D. M. Yaconetti Vice President Adminis- 47 tration and Secretary T. K. Erwin Controller 44 R. T. McNaney General Counsel 59 R. S. O'Brien Treasurer 44 W. J. Barrington Sea Ray Division President 43 A. D. Fogel BRC Division President 58 J. W. Hoag US Marine Division 54 President D. D. Jones Mercury Marine Division 50 President J. A. Schenk Corporate Director of 51 Planning and Development R. C. Sigrist Technical Group President 60 There are no family relationships among these officers. The term of office of all elected officers expires April 27, 1994. The Division Presidents are appointed from time to time at the discretion of the Chief Executive Officer. Jack F. Reichert has been Chairman of the Board since 1983 and Chief Executive Officer since 1982. He was President from 1977 to 1993. John P. Reilly has been President and Chief Operating Officer since 1993. From 1984 to 1993 he was President of Tenneco Inc.'s Automotive Division, a manufacturer of automotive mufflers, shocks and brake components. John M. Charvat has been Executive Vice President of the Company since 1989. He was Vice President of the Company from 1986 to 1989 and Zebco Division President from 1977 to 1989. Jim W. Dawson has been Vice President of the Company since 1994 and Zebco Division President since 1989. From 1981 to 1989 he was Senior Vice President of Zebco/Motor Guide Technical Operations, responsible for manufacturing, research and development, distribution, and consumer service. Frederick J. Florjancic, Jr. has been Vice President of the Company and President of the Brunswick Division since 1988. William R. McManaman has been Vice President-Finance since 1988. Dianne M. Yaconetti has been Vice President-Administration since 1988, Corporate Secretary since 1986 and Manager of the Office of the Chairman since 1985. Thomas K. Erwin has been Controller since 1988. Robert T. McNaney has been General Counsel since 1985. Richard S. O'Brien has been Treasurer since 1988. William J. Barrington has been Sea Ray Division President and President of Ray Industries, Inc. ("Ray") since 1989. From 1985 to 1989 he was Vice President-Finance and Treasurer of Ray. Arnold D. Fogel has been Brunswick Recreation Centers Division President since 1984. James W. Hoag has been US Marine Division President since 1989. From 1988 to 1989 he was Executive Vice President of the US Marine Division. David D. Jones has been Mercury Marine Division President since 1989. From 1985 to 1989 he was General Manager of US Marine Power. James A. Schenk has been Corporate Director of Planning and Development since 1988. Robert C. Sigrist has been President of the Technical Group (known as the Defense Division prior to 1991) since 1988. Part II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The Company's common stock is traded on the New York, Chicago, Pacific, London, and Tokyo Stock Exchanges. Quarterly information with respect to the high and low sales prices for the common stock and the dividends declared on the common stock is set forth in Note 21 on page 54. As of December 31, 1993, there were approximately 27,900 shareholders of record of the Company's common stock. Item 6. Item 6. Selected Financial Data Net sales, net earnings, earnings per common share, cash dividends declared per common share, total assets, and long-term debt are shown in the Five Year Financial Summary on page 57. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis is presented on pages 19 to 23. Item 8. Item 8. Financial Statements and Supplementary Data The Company's Consolidated Financial Statements are set forth on pages 24 to 26 and are listed in the index on page 18. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant Information with respect to the directors of the Company is set forth on pages 2 and 3 of the Company's definitive Proxy Statement dated March 25, 1994 (the "Proxy Statement") for the Annual Meeting of Stockholders to be held on April 27, 1994, and is hereby incorporated by reference. The Company's executive officers are listed herein on pages 10-11. Item 11. Item 11. Executive Compensation Information with respect to executive compensation is set forth on pages 5, 13-15 and 17-20 of the Proxy Statement and is hereby incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information with respect to the securities of the Company owned by the directors and certain officers of the Company, by the directors and officers of the Company as a group and by the only persons known to the Company to own beneficially more than 5% of the outstanding voting securities of the Company is set forth on pages 6 and 7 of the Proxy Statement, and such information is hereby incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions None. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K a) Financial Statements and Exhibits Financial Statements Financial statements and schedules are incorporated in this Annual Report on Form 10-K, as indicated in the index on page 18. Exhibits 3.1 Restated Certificate of Incorporation of the Company filed as Exhibit 19.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987, and hereby incorporated by reference. 3.2 By-Laws of the Company. 4.1 Indenture dated as of March 15, 1987, between the Company and Continental Illinois National Bank and Trust Company of Chicago filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987, and hereby incorporated by reference. 4.2 Form of 8-1/8% Notes of the Company Due April 1, 1997, filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987, and hereby incorporated by reference. 4.3 Officers' Certificate setting forth terms of the Company's $125,000,000 principal amount 7-3/8% Debentures due September 1, 2023. 4.4 The Company's Agreement to furnish additional debt instruments upon request by the Securities and Exchange Commission filed as Exhibit 4.10 to the Company's Annual Report on Form 10-K for 1980, and hereby incorporated by reference. 4.5 Rights Agreement dated as of March 15, 1986, between the Company and Harris Trust and Savings Bank filed as Exhibit 4.14 to the Company's Annual Report on Form 10-K for 1985, and hereby incorporated by reference. 4.6 Amendment dated April 3, 1989, to Rights Agreement between the Company and Harris Trust and Savings Bank filed as Exhibit 2 to the Company's Current Report on Form 8-K dated April 10, 1989, and hereby incorporated by reference. 10.1* Third Amended and Restated Employment Agreement entered as of December 30, 1986, between the Company and Jack F. Reichert filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for 1986 and hereby incorporated by reference. 10.2* Amendment dated October 24, 1989, to Employment Agreement by and between the Company and Jack F. Reichert filed as Exhibit 19.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989 and hereby incorporated by reference. 10.3* Supplemental Agreement to Employment Agreement dated December 30, 1986, by and between the Company and Jack F. Reichert filed as Exhibit 19.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, and hereby incorporated by reference. 10.4* Amendment dated February 12, 1991 to Employment Agreement by and between the Company and Jack F. Reichert filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for 1990 and hereby incorporated by reference. 10.5* Amendment dated March 20, 1992 to Employment Agreement by and between the Company and Jack F. Reichert filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for 1992 and hereby incorporated by reference. 10.6* Amendment dated December 15, 1992 to Employment Agreement by and between the Company and Jack F. Reichert filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for 1992 and hereby incorporated by reference. 10.7* Employment Agreement dated as of June 1, 1989 by and between the Company and John M. Charvat filed as Exhibit 19.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, and hereby incorporated by reference. 10.8* Amendment dated as of December 15, 1992 to Employment Agreement by and between the Company and John M. Charvat filed as Exhibit 10.8 to the Company's Annual Report on Form 10-K for 1992 and hereby incorporated by reference. 10.9* Supplemental Pension Plan filed as Exhibit 19.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and hereby incorporated by reference. 10.10* Form of Employment Agreement by and between the Company and each of T. K. Erwin, W. R. McManaman, R. T. McNaney, R. S. O'Brien, J. A. Schenk, D. M. Yaconetti, W. J. Barrington, J. W. Dawson, F. J. Florjancic, Jr., A. D. Fogel, J. W. Hoag, D. D. Jones, and R. C. Sigrist filed as Exhibit 19.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and hereby incorporated by reference. 10.11* Amendment to Form of Employment Agreement filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for 1992 and hereby incorporated by reference. 10.12* Form of Insurance Policy issued for the life of each of the Company's officers, together with the specifications for each of these policies, filed as Exhibit 10.21 to the Company's Annual Report on Form 10-K for l980 and hereby incorporated by reference. The Company pays the premiums for these policies and will recover these premiums, with some exceptions, from the policy proceeds. 10.13* Insurance policy issued by The Prudential Insurance Company of America insuring all of the Company's officers and certain other senior management employees for medical expenses filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for 1980 and hereby incorporated by reference. 10.14* Form of Indemnification Agreement by and between the Company and each of M. J. Callahan, J. P. Diesel, D. E. Guinn, L. Herzel, G. D. Kennedy, B. K. Koken, J. W. Lorsch, B. M. Musham, R. N. Rasmus, and R. W. Schipke filed as Exhibit 19.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, and hereby incorporated by reference. 10.15* Indemnification Agreement dated September 16, 1986, by and between the Company and J. F. Reichert filed as Exhibit 19.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, and hereby incorporated by reference. 10.16* Form of Indemnification Agreement by and between the Company and each of J. M. Charvat, T. K. Erwin, F. J. Florjancic, Jr., W. R. McManaman, R. T. McNaney, R. S. O'Brien, J. A. Schenk, and D. M. Yaconetti filed as Exhibit 19.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, and hereby incorporated by reference. 10.17* Employment Agreement dated October 1, 1993 by and between the Company and John P. Reilly. 10.18* Indemnification Agreement dated October 26, 1993 by and between the Company and John P. Reilly. 10.19* 1991 Stock Plan filed as Exhibit A to the Company's definitive Proxy Statement dated March 21, 1991 for the Annual Meeting of Stockholders on April 24, 1991 and hereby incorporated by reference. 10.20* Change In Control Severance Plan filed as Exhibit 10.22 to the Company's Annual Report on Form 10-K for 1989 and hereby incorporated by reference. 10.21* Brunswick Performance Plan for 1993 filed as Exhibit 10.21 to the Company's Annual Report on Form 10-K for 1992 and hereby incorporated by reference. 10.22* Brunswick Performance Plan for 1994. 10.23* Brunswick Strategic Incentive Plan. 10.24* 1988 Stock Plan for Non-Employee Directors filed as Exhibit B to the Company's definitive Proxy Statement dated March 10, 1988 for the Annual Meeting of Stockholders on April 27, 1988 and hereby incorporated by reference. 10.25* 1994 Stock Option Plan for Non-Employee Directors filed as Exhibit A to the Company's definitive Proxy Statement dated March 25, 1994 for the Annual Meeting of Stockholders on April 27, 1994 and hereby incorporated by reference. 22.1 Subsidiaries of the Company. 25.1 Powers of Attorney. b) Reports on Form 8-K The Company filed no reports on Form 8-K during the three months ended December 31, 1993. *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 14(c) of this Report. Signatures Pursuant to the requirements of Section 13 or 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. Brunswick Corporation March 28, 1994 By /s/ Thomas K. Erwin Thomas K. Erwin, Controller 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. Name Title Jack F. Reichert Chairman of the Board, Chief Executive Officer (Principal Executive Officer) and Director John P. Reilly President, Chief Operating Officer and Director William R. McManaman Vice President-Finance (Principal Financial Officer) Thomas K. Erwin Controller (Principal Accounting Officer) Michael J. Callahan Director John P. Diesel Director Donald E. Guinn Director Leo Herzel Director George D. Kennedy Director Bernd K. Koken Director Jay W. Lorsch Director Bettye Martin Musham Director Robert N. Rasmus Director Roger W. Schipke Director Thomas K. Erwin, pursuant to a Power of Attorney (executed by each of the officers and directors listed above and filed with the Securities and Exchange Commission, Washington, D.C.), by signing his name hereto does hereby sign and execute this report of Brunswick Corporation on behalf of each of the officers and directors named above in the capacities in which the names of each appear above. March 28, 1994 /s/ Thomas K. Erwin Thomas K. Erwin Brunswick Corporation Index to Financial Statements and Schedules Page Consolidated Financial Statements Management's Discussion and Analysis 19 to 23 Statements of Results of Operations 1993, 1992 and 1991 24 Balance Sheets December 31, 1993 and 1992 25 Statements of Cash Flows 1993, 1992 and 1991 26 Notes to Financial Statements 1993, 1992 and 1991 27 to 54 Report of Management 55 Report of Independent Public Accountants 55,56 Five Year Financial Summary 57 Schedules Consent of Independent Public Accountants 58 I- Marketable Securities 1993 59 V- Property 1993, 1992 and 1991 60 VI- Accumulated Depreciation 1993, 1992 and 1991 61 VIII- Valuation and Qualifying Accounts 1993, 1992 and 1991 62 X- Supplementary Income Statement Information 1993, 1992 and 1991 62 All other schedules are not submitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or in the notes thereto. These notes should be read in conjunction with these schedules. The separate financial statements of Brunswick Corporation (the parent company Registrant) are omitted because consolidated financial statements of Brunswick Corporation and its subsidiaries are included. The parent company is primarily an operating company, and all consolidated subsidiaries are wholly owned and do not have any indebtedness (which is not guaranteed by the parent company) to any person other than the parent or the consolidated subsidiaries in an amount that is material in relation to consolidated assets. Brunswick Corporation Management's Discussion and Analysis Cash Flow, Liquidity and Capital Resources Net cash provided by operating activities increased $19.9 million in 1993 to $188.9 million from the $169.0 million reported in 1992. The increase resulted primarily from a $14.8 million improvement in earnings from continuing operations. Income taxes payable increased and deferred items, primarily income taxes, decreased as a result of the Company's January 1994 agreement with the U.S. Internal Revenue Service regarding the IRS examination of the Company for the years 1985 and 1986, as discussed in Note 15 to the consolidated financial statements. Charges in both years for the cumulative effect of changes in accounting principles and estimated losses on the divestiture of the Company's Technical Group did not involve cash expenditures. The net cash used for investing activities decreased $39.8 million to $97.1 million in 1993 from the $136.9 million in 1992. The primary reason for the decrease was reduced payments for businesses acquired. Net cash used for financing activities was $38.5 million in 1993 compared to net cash provided by financing activities of $61.3 million in 1992. The 1993 financing activities included payment of long-term debt of $117.3 million, primarily for the redemption of the Company's 9.875% sinking fund debentures, as well as net proceeds of $122.9 million from the issuance of 7.375% debentures due in 2023. The 1992 financing activities included net proceeds of $104.5 million received from the sale of 6.5 million shares of common stock. Working capital at December 31, 1993, was $347.8 million compared to $362.0 million at December 31, 1992. The Company's current ratio was 1.6 to 1 at December 31, 1993, and 1.7 to 1 at December 31, 1992. The Company's long-term financing was primarily comprised of 30-year debentures, 10-year unsecured notes, loans secured by mortgages on property and the guarantee of $78.0 million of debt of the Brunswick Employee Stock Ownership Plan (ESOP). The form and timing of all financing is determined by the prevailing securities markets, the Company's capital requirements and its financial position. At December 31, 1993, the Company had unused short-term and long-term credit agreements totaling $400 million with a group of banks. The Company's debt-to-capitalization ratio increased to 29.5% at December 31, 1993, from 28.0% at the end of 1992. Total debt increased $15.9 million to $336.4 million at December 31, 1993, from the $320.5 million at December 31, 1992. Capital expenditures, excluding acquisitions, were $95.8 million, $88.6 million and $74.7 million in 1993, 1992 and 1991, respectively. The Company continues to make capital expenditures which offer increased production efficiencies and improved product quality. The Company believes that existing cash balances and future operating results, supplemented when necessary with short and/or long-term borrowings, will continue to provide the financial resources necessary for capital expenditures and working capital requirements. Results of Operations - 1993 vs 1992 Net Sales The Company's consolidated net sales for 1993 increased 7% to $2.21 billion from the $2.06 billion reported for 1992. Increases in both the Marine and Recreation segments contributed to this improvement. The Marine segment's 1993 net sales increased 4% to $1.57 billion from $1.52 billion in 1992. Domestic sales of engines and boats increased 14% over the prior year, while international sales declined approximately 20% as major European and Asian markets continue to experience recessions. Price increases accounted for 2.5% of the 4% increase with the other 1.5% attributable to increased volume and mix changes. Unit sales of boats to dealers were slightly lower than dealers' retail sales in 1993 and, therefore, dealer inventories continue to remain at relatively low levels. The Recreation segment's 1993 net sales increased 17% to $635.6 million from $543.3 million in 1992. The Brunswick Division sales increased 29% as international demand for capital equipment continued to increase, as did domestic demand for consumer products, supplies and parts. Zebco Division sales increased 15% due to domestic volume increases and the full year effect of a 1992 fourth quarter acquisition. The Brunswick Recreation Centers (BRC) Division sales were flat in 1993 compared to 1992 as price increases, which were limited by competitive pressures, offset slight lineage declines. Operating Earnings The consolidated operating earnings increased $20.0 million to $99.8 million in 1993 from the $79.8 million reported for 1992. Both the Marine and Recreation segments contributed to this increase. The Marine segment's operating earnings for 1993 rose 25% to $53.7 million from the $43.0 million in 1992. The previously discussed sales increase and the continuation of cost reduction programs begun four years ago, when the marine industry downturn began, contributed to the operating results improvement. The Recreation segment's operating earnings were $80.0 million for 1993 compared to $65.2 million in 1992. The Brunswick Division benefited from the previously discussed sales increases which were partly offset by start-up costs associated with manufacturing its new composite golf shaft and plant rearrangement expenses in the golf unit. The Zebco Division operating earnings increased in line with the Division's sales increase. The BRC Division's operating earnings for 1993 declined from 1992 levels largely due to start-up costs for its Circus World Pizza operations. Interest and Other Items, Net Interest expense declined to $27.2 million in 1993 from $29.9 million in 1992. The decline resulted primarily from lower levels of ESOP and other debt and the net reduction in interest expense from the redemption of the 9.875% sinking fund debentures on August 9, 1993, and the sale of 7.375% debentures on August 25, 1993. Interest income and other items, net increased to $13.9 million in 1993 from $12.1 million in 1992, primarily due to increased equity in earnings of unconsolidated affiliates. Income Taxes In 1993, the Company recorded a tax provision of $32.0 million compared with a tax provision of $22.3 million in 1992. The effective tax rate for 1993 of 37% compares to 36% for 1992. The increase in the effective tax rate results primarily from an increase in the effective foreign tax rate which was offset by a net benefit from a change in the Federal statutory income tax rate. In January 1994, the Company reached an agreement with the U.S. Internal Revenue Service regarding its examination of the Company for the years 1985 and 1986. See Note 15 for additional discussion. Results of Operations - 1992 vs. 1991 Net Sales The Company's consolidated net sales for 1992 increased 12% to $2.06 billion from the $1.84 billion reported for 1991. Increases in both the Marine and Recreation segments accounted for this improvement. The Marine segment's 1992 net sales of $1.52 billion were 11% above the $1.37 billion reported in 1991. Increased domestic demand for engines and boats resulted in the first year-to-year improvement since the marine industry downturn began in 1988, but the recession that affected domestic markets has spread to major European and Asian markets. Unit sales improved more than the sales increase in dollars as the strongest improvements were in the areas of fishing boats and outboard motors, which are typically in the lower price range of the products in the segment. Sales of boats to dealers were approximately even with retail sales in 1992, so dealer inventories remained at relatively low levels. In anticipation of a stronger spring selling season in 1993, dealers increased their engine inventories, primarily outboards, over the levels of the prior year. The Recreation segment's 1992 net sales increased 15% to $543.3 million from $472.7 million in 1991. Each of the three Divisions in the segment reported increases. The Zebco Division experienced an increase of 29% as a result of increased volume to major retailers. The Brunswick Recreation Centers (BRC) Division increase of 3% resulted primarily from higher demand by value conscious consumers. The Brunswick Division net sales increased 14% on continued increases in international demand for capital equipment. Operating Earnings The consolidated operating earnings of $79.8 million in 1992 compares to an operating loss of $18.4 million in 1991. The 1991 operating results include a $38.0 million provision for litigation matters, of which $30.0 million is included in the Marine segment. The Marine segment's operating earnings for 1992 of $43.0 million compared to an operating loss of $30.5 million in 1991 which included the $30.0 million litigation provision. The previously discussed sales increases and the benefits of cost reduction programs, which included production consolidations and plant closings, begun three years ago when the marine industry downturn began, contributed to the operating results improvement. The Recreation segment's operating earnings were $65.2 million for 1992 compared to $52.5 million in 1991. This increase resulted from higher operating earnings at the Zebco and Brunswick Divisions because of their sales increases and lower warranty costs in the Brunswick Division. The BRC Division's operating earnings were flat with the prior year, despite the small sales increase, because of pricing pressures on open (non-league) bowling. Interest and Other Items, Net Interest expense declined to $29.9 million in 1992 from $32.0 million in 1991. The Company utilized no commercial paper borrowings in 1992, resulting in a reduction of interest expense of $3.0 million. This reduction was partially offset by interest expense of $0.9 million on a foreign borrowing made in the fourth quarter of 1991. Interest income and other items, net increased to $12.1 million in 1992 from $9.9 million in 1991 primarily due to increased equity in earnings of unconsolidated affiliates. Income Taxes In 1992, the Company recorded a tax provision of $22.3 million compared with a tax benefit of $5.5 million in 1991. The effective tax rate in 1992 of 36% compares to a benefit rate of 13.6% in 1991. The 1991 benefit rate of 13.6% is below the statutory rate primarily due to the inability to utilize $9.3 million of foreign tax credits in the calculation of the consolidated tax provision. Brunswick Corporation Consolidated Statements of Results Of Operations For the Years Ended December 31, (in millions, except per share data) Brunswick Corporation Consolidated Balance Sheets As of December 31, (in millions, except per share data) Consolidated Statements Of Cash Flows For the Years ended December 31, (in millions) Brunswick Corporation Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991 1. Significant Accounting Policies Restatement. The Company's consolidated financial statements have been restated to segregate the results of operations and net assets of the Company's discontinued Technical segment. In addition, certain previously reported amounts have been reclassified to conform with year-end 1993 presentations. Principles of consolidation. The Company's consolidated financial statements include the accounts of its significant domestic and foreign subsidiaries, after eliminating transactions between Brunswick Corporation and such subsidiaries. Investments in certain affiliates, including some majority-owned subsidiaries which are immaterial, are reported using the equity method. Cash and cash equivalents. For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments with a maturity of three months or less from the time of purchase to be cash equivalents. Inventories. Approximately fifty percent of the Company's inventories are valued at the lower of first-in, first-out (FIFO) cost or market (replacement cost or net realizable value). All other inventories are valued at last-in, first-out (LIFO) cost, which is not in excess of market. Inventory cost includes material, labor and manufacturing overhead. Property. Property, including major improvements, is recorded at cost. The costs of maintenance and repairs are charged against results of operations as incurred. Depreciation is charged against results of operations over the estimated service lives of the related assets. Improvements to leased property are amortized over the life of the lease or the life of the improvement, whichever is shorter. For financial reporting purposes, the Company principally uses the straight-line method of depreciation. For tax purposes, the Company generally uses accelerated methods where permitted. Sales and retirements of depreciable property are recorded by removing the related cost and accumulated depreciation from the accounts. Gains or losses on sales and retirements of property are reflected in results of operations. Intangibles. The costs of dealer networks, trademarks and other intangible assets are amortized over their expected useful lives using the straight-line method. Accumulated amortization was $253.2 million and $278.3 million at December 31, 1993 and 1992, respectively. The decline resulted primarily from fully amortized intangible assets of $60.6 million being written off. The excess of cost over net assets of businesses acquired is being amortized using the straight-line method, principally over 40 years. Accumulated amortization was $25.2 million and $21.7 million at December 31, 1993 and 1992, respectively. Subsequent to acquisition, the Company continually evaluates whether later events and circumstances have occurred that indicate the remaining estimated useful life of its intangible assets may warrant revision or that the remaining balance of such assets may not be recoverable. When factors indicate that such assets should be evaluated for possible impairment, the Company uses an estimate of the related business segment's undiscounted cash flows or, in the case of goodwill, undiscounted operating earnings, over the remaining life of the asset in measuring whether the asset is recoverable. Income taxes. Statement of Financial Accounting Standards No. 109 (SFAS No. 109), "Accounting for Income Taxes", was issued by the Financial Accounting Standards Board (FASB) in February 1992, effective for fiscal years beginning after December 15, 1992, with earlier adoption encouraged. The Company elected to adopt SFAS No. 109 as of January 1, 1992. The adoption of SFAS No. 109 changed the Company's method of accounting for income taxes from the deferred method (under APB No. 11) to an asset and liability approach. Previously, the Company deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax bases of assets and liabilities. Retirement plans. The Company accrues the cost of pension and retirement plans which cover substantially all employees. Pension costs, which are primarily computed using the projected unit credit method, are generally funded based on the minimum required contribution under the Employee Retirement Income Security Act of 1974 for the Company's domestic pension plans and in accordance with local laws and income tax regulations for foreign plans. During 1993, the Company contributed $19.0 million in excess of the required minimum funding for its domestic pension plans. 2. Earnings (loss) Per Common Share Earnings (loss) per common share are based on the weighted average number of common and common equivalent shares outstanding during each period. Such average shares were 95.3 million, 92.7 million and 88.4 million for 1993, 1992 and 1991, respectively. 3. Inventories At December 31, 1993 and 1992, $133.7 million and $111.1 million, respectively, of inventories were valued using the LIFO method. If the FIFO method of inventory accounting had been used by the Company for inventories valued at LIFO, inventories at December 31 would have been $73.9 million and $71.2 million higher than reported for 1993 and 1992, respectively. The FIFO cost of inventories at these dates approximated replacement cost or net realizable value. Inventories at December 31 consisted of the following: 4. Investments On April 14, 1992, the Company acquired a significant minority interest in Tracker Marine, L.P., a limited partnership, which manufactures and markets boats, trailers and accessories. The Company also entered into various other agreements, including contracts to supply outboard motors, trolling motors and various other Brunswick products for Tracker boats. The Company's total payments relating to these transactions were $25 million. 5. Discontinued Operations In February 1993, the Company's Board of Directors approved plans to divest the Technical Group, the only remaining business in the Company's Technical segment. A $26.0 million estimated loss ($42.0 million pretax) on the divestiture of the Technical Group and for certain other expenses of the previously divested Technical businesses was recorded in 1992. In 1993, the Company recorded an additional $12.2 million estimated loss ($20.0 million pretax) on the divestiture of the Technical Group which reflects the offers for that operation which the Company is reviewing. The net sales and earnings from discontinued operations for each of the three years in the period ended December 31, 1993, were as follows: Operating losses of discontinued operations for 1993 have been charged against the reserve established in 1992. 6. Acquisitions In 1993, the Company purchased the assets of three companies. The consideration for these acquisitions totaled $2.1 million in cash. In October 1992, the Company purchased certain assets of three companies in the United States and Europe, which comprised the Fishing Division of Browning, a line of fishing rods and reels. The consideration for these assets consisted of cash of $17.9 million and assumed liabilities of $2.1 million. The Company also purchased certain assets of another company for $1.9 million in cash in 1992. In 1991, the Company purchased the assets of four companies. The consideration for these acquisitions totaled $1.8 million in cash. The effect of the aforementioned acquisitions, which were accounted for as purchases, was not significant to the Company's consolidated results of operations in the year of acquisition. 7. Commitments and Contingent Liabilities It is customary within the marine industry for manufacturers to enter into product repurchase agreements with financial institutions that provide financing to marine dealers. The Company has entered into agreements which provide for the repurchase of its products from a financial institution in the event of repossession upon a dealer's default. Most of these agreements contain provisions which limit the Company's annual repurchase obligation. The Company accrues for the cost and losses that are anticipated in connection with expected repurchases. Such losses are mitigated by the Company's resale of repurchased products. Repurchases and losses incurred under these agreements have not and are not expected to have a significant impact on the Company's results of operations. The maximum potential repurchase commitments at December 31, 1993 and 1992, were approximately $124.0 million and $136.0 million, respectively. The Company also has various agreements with financial institutions that provide limited recourse on marine and bowling capital equipment sales. The maximum potential recourse liabilities outstanding under these programs were approximately $45.0 million and $40.0 million at December 31, 1993 and 1992, respectively. Recourse losses have not and are not expected to have a significant impact on the Company's results of operations. The Company had outstanding standby letters of credit and financial guarantees of approximately $19.0 million and $34.0 million at December 31, 1993 and 1992, respectively, representing conditional commitments whereby the Company guarantees performance to a third party. The majority of these commitments are standby letters of credit which guarantee premium payment under certain of the Company's insurance programs. The Company enters into interest rate swap agreements in connection with the management of its assets and liabilities and interest rate exposure. The differential to be paid or received is recognized over the lives of the agreements. These agreements are entered into to reduce the impact of changes in interest rates on the Company's investments and borrowings. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements. The Company regularly monitors its positions and the credit ratings of these counterparties and considers the risk of default to be remote. At December 31, 1993 and 1992, the Company had an outstanding floating-to-floating interest rate swap agreement with a notional principal amount of $260.0 million that terminates in September 2003. The interest rate on this agreement is set on a semi-annual basis in arrears, the first such setting took place in March 1992. The Company also has entered into fixed-to-floating interest rate swap agreements through October 1996 on $200.0 million of its fixed-rate debt. The floating interest rates are set on a semi-annual basis. The first such setting took place in October 1993. The cost exposure of the interest rate swaps, which represents the net cost to terminate these agreements, is not material to the Company. The Company also enters into forward exchange contracts to hedge the U.S. dollar exposure of its foreign operations. Realized and unrealized gains and losses on contracts are recognized and included in net income. At December 31, 1993, the Company had contracted to exchange 1,057.2 million Belgian francs for $29.2 million during 1994. Had this contract been entered into on December 31, 1993, the Company would have to exchange 1,057.2 million Belgian francs for $29.8 million. A loss of $0.6 million has been included in net income. At December 31, 1992, the Company had contracted to exchange 46.8 million Deutsche marks for $29.2 million during 1993. Had this contract been entered into on December 31, 1992, the Company would have to exchange 46.8 million Deutsche marks for $28.4 million. 8. Segment Information Net sales to customers include immaterial amounts sold to unconsolidated affiliates. Sales between domestic and foreign operations generally are priced with reference to prevailing market prices. Operating earnings of segments do not include the expenses of corporate administration, other expenses and income of a nonoperating nature, and provisions for income taxes. The 1991 operating loss of the Marine segment includes litigation charges of $30.0 million. The 1991 Corporate expenses include litigation charges of $8.0 million. Corporate assets consist primarily of cash and marketable securities, prepaid income taxes and investments in unconsolidated affiliates. The Company's export sales to unaffiliated customers for the three years ended December 31, 1993, 1992 and 1991 were $181.4 million, $218.2 million and $256.2 million, respectively. 9. Accrued Expenses Accrued expenses at December 31 were as follows: 10. Debt Short-term debt at December 31 consisted of the following: Long-term debt at December 31 consisted of the following: Scheduled maturities 1995 $ 25.8 1996 6.1 1997 106.3 1998 10.8 Thereafter 175.5 $ 324.5 On November 8, 1993, the Company and seventeen banks entered into a short-term credit agreement for $100 million and a long-term credit agreement for $300 million with termination dates of November 7, 1994, and December 31, 1996, respectively. With mutual agreement between the Company and the banks, the Company may extend both agreements. The short-term credit agreement may be extended each 364 day anniversary, but not beyond December 31, 1996. The long-term credit agreement contains two one-year extension options with the extension requests permitted on the first and second anniversaries. Under terms of the new agreements, the Company has multiple borrowing options, including borrowing at a corporate base rate, as announced by The First National Bank of Chicago, or a rate tied to the Eurodollar rate. Currently, the Company must pay a facility fee of 0.1875% per annum on the short-term agreement and 0.25% per annum on the long-term agreement. Under the agreements, the Company is subject to interest coverage, net worth and leverage tests, as well as a restriction on secured debt, as defined. On the interest coverage test, the Company is required to maintain a ratio of consolidated income before interest and taxes, as defined, to consolidated interest expense of not less than 2.0 to 1.0 on a cumulative twelve-month basis. This ratio, on a cumulative twelve-month basis, was 3.7 to 1.0 at December 31, 1993. The leverage ratio of consolidated total debt to capitalization, as defined, may not exceed 0.55 to 1.00, and at December 31, 1993, this ratio was 0.30 to 1.00. The Company also is required to maintain shareholders' equity of at least $711.6 million at December 31, 1993. The required level of shareholders' equity at December 31 of each subsequent year is increased by 50% of net earnings for that year. The Company has complied with this limitation and the secured debt limitation as of December 31, 1993. There were no borrowings under the credit agreements at December 31, 1993. On August 9, 1993, the $100 million 9.875% sinking fund debentures were redeemed by the Company at 105.704% of the principal amount of the debentures plus accrued interest to the redemption date. Proceeds of the Company's common stock offering in May 1992 of $104.5 million, and cash from operations were used to redeem the debentures. The Company recorded an after-tax extraordinary loss of $4.6 million ($7.4 million pretax) relating to this transaction during the third quarter of 1993. On August 25, 1993, the Company sold $125 million of 7.375% debentures maturing on September 1, 2023. The proceeds will be used for general corporate purposes. On February 27, 1990, the Brunswick Employee Stock Ownership Plan (ESOP) sold $96.7 million principal amount of notes bearing interest at the rate of 8.2% per annum, which were guaranteed by the Company and are payable in semi-annual installments of interest and principal ending in 2004. The interest rate on these notes was reduced to 8.13% per annum, effective as of January 1, 1993, as a result of the change in tax law passed by the U.S. Congress in August 1993. Company contributions to the ESOP along with dividends paid on shares purchased with ESOP debt proceeds are used to service the ESOP debt. Under the terms of the ESOP debt agreement, future changes in tax law could cause the interest rate on the debt to vary within the range of 6.8% to 10.3%. The carrying amounts for the short-term debt and current maturities of long-term debt approximate their fair value because of the short maturity of these instruments. The fair value of the long-term debt is $318.2 million and $316.3 million, respectively, versus carrying amounts of $324.5 million and $304.5 million, respectively, at December 31, 1993 and 1992. The fair value is based on quoted market prices where available or discounted cash flows using market rates available for similar debt of the same remaining maturities. 11. Consolidated Common Shareholders' Equity (in millions, except per share data) 12. Litigation The Company is subject to certain legal proceedings and claims which have arisen in the ordinary course of its business and have not been finally adjudicated. In 1993, 1992 and 1991, the Company recorded pretax provisions of $18.2 million, $4.8 million and $38.0 million ($11.2 million, $3.1 million and $23.6 million after-tax), respectively, for litigation matters. In light of existing reserves, the Company's litigation and environmental claims, including those discussed below, when finally resolved, will not, in the opinion of management, have a material adverse effect on the Company's consolidated financial position and results of operations. The Company is involved in certain legal and administrative proceedings under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 and other federal and state legislation governing the generation and disposition of certain hazardous wastes. These proceedings, which involve both on and off site waste disposal, in many instances seek compensation from the Company as a waste generator under Superfund legislation which authorizes action regardless of fault, legality of original disposition or ownership of a disposal site. In June 1992, Genmar Industries brought an action against the Company and certain of its subsidiaries in the United States District Court for the District of Minnesota, alleging that the Company (i) has monopolized or attempted to monopolize the sale of recreational marine engines and boats, (ii) has unlawfully coerced engine purchasers to buy the Company's boats, (iii) has breached its contract with Genmar, (iv) has not dealt in good faith with Genmar, and (v) has interfered with Genmar's existing and prospective business relationships. Genmar has asked that the Company be required to divest its boat manufacturing business, be enjoined from continuing its partnership with Tracker Marine, and pay damages, including treble damages under the antitrust laws. The Company believes, based upon its assessment of the complaint and in consultation with counsel, that this litigation is without merit and intends to defend itself vigorously. Parties to this suit have exchanged written discovery and have begun depositions. The Federal Trade Commission is conducting an investigation of whether the formation or operations of Tracker Marine, L.P. and the Company's contracts with Tracker Marine, L.P. violate antitrust laws. The Company has received and responded to a subpoena seeking information relating to the Company's outboard motor sales. The Company understands that other marine companies have received similar subpoenas from the Federal Trade Commission. In August 1988, certain plaintiffs brought an action against the Company in the United States District Court in Los Angeles, California alleging violations of the federal antitrust laws arising out of their planned construction of a bowling center and asserting three claims under state law principles. On May 3, 1991, a jury returned a verdict against the Company in the amount of $5.1 million in actual damages and in the amount of one dollar in punitive damages. Pursuant to federal antitrust laws, plaintiffs' antitrust damages were trebled to $15.3 million. The plaintiff was also entitled to legal fees and costs totalling $1.4 million plus interest at the rate of 6.04% per annum on both the damage award and the attorney fees and costs. On October 13, 1993, the United States Court of Appeals reversed the District Court's judgment and directed that judgment be entered in favor of the Company. 13. Stock Plans and Management Compensation On April 24, 1991, shareholders of the Company approved the 1991 Stock Plan (Plan) to succeed the 1984 Restricted Stock Plan and the 1971 Stock Plan. Under this Plan, the Company may grant non-qualified stock options, incentive stock options, stock appreciation rights and restricted stock and other various types of awards to executives and other management employees of the Company. The Plan provides for the issuance of a maximum of 5,000,000 shares of common stock of the Company which may be authorized but unissued shares or treasury shares. No grants or awards were made under this Plan during 1991. During 1993 and 1992, non-qualified stock options were awarded to 413 and 420, respectively, executives and management employees of the Company. Under the terms of the Plan, the option price per share may not be less than 100% of the fair market value on the date of grant. The stock options are exercisable over a period of time determined by the Compensation Committee of the Board of Directors. In the event of a change in control as defined below, the option holder may exercise all unexercised options until the earlier of the stated expiration date or two years following termination of employment. At December 31, 1993, 263,110 shares were exercisable under outstanding options at a weighted average option price of $14.0077 per share. In addition to stock options, restricted shares were also awarded during 1993 and 1992 to seventeen and sixteen senior executives of the Company, respectively. Restrictions will lapse on a portion of these shares four years from the date of grant and after five years on the remaining shares. As the restrictions lapse, the shares awarded are transferred to the employees. According to the terms of this grant, a participant may elect within 90 days of a change in control to terminate the restricted period for all shares awarded to him. Charges against earnings from continuing operations for the compensation element of the Plan were $0.3 million and $0.2 million for 1993 and 1992, respectively. Stock option and restricted stock activities including discontinued operations are as follows: Selected management employees, including employees of its discontinued operations, have received shares of the Company's common stock under the 1984 Restricted Stock Plan (1984 Plan). Under the 1984 Plan, 1,367,232 shares, net of canceled shares, have been awarded. No award has been made since 1991 and no further awards will be made under the 1984 Plan. After a restricted period of one to three years, the shares awarded are transferred to the employees. At that time, the employees may also receive a cash award if certain performance standards, as established by the Compensation Committee of the Board of Directors, have been met. The 1984 Plan provides that, within 90 days after a change in control of the Company, a participant may elect to terminate the restricted period on shares of common stock awarded under the 1984 Plan. A "change in control of the Company" occurs when 1) any person is or becomes a beneficial owner directly or indirectly of 30% or more of the combined voting power of the Company, 2) individuals nominated by the Board of Directors for election as directors do not constitute a majority of the Board of Directors after such election, or 3) a tender offer is made for the Company's stock, involving a control block, which is not negotiated and approved by the Board of Directors. The 1984 Plan also provides that the Compensation Committee may at any time reduce the restricted period for restricted stock of any participant or group of participants to a minimum of one year. Charges against earnings (loss) from continuing operations for the compensation element of the 1984 Plan were $0.7 million, $1.4 million, and $1.9 million for 1993, 1992 and 1991, respectively. Under the 1971 Stock Plan (1971 Plan), certain other management employees were granted shares of the Company's common stock at no cost during 1988 through 1991. There have been no grants since 1991 and there will be no further grants under the 1971 Plan. The shares awarded or purchased under the 1971 Plan are subject to restrictions which lapse ratably over a period of one to five years. The shares will be released at the time of a change in control of the Company or on a date selected by the Compensation Committee. Charges against earnings (loss) from continuing operations for the compensation element of the 1971 Plan were $0.4 million in 1993, $0.6 million in 1992 and $1.0 million in 1991. The Company has employment agreements with certain executive officers that become operative only upon a change in control of the Company, as defined above. In 1989, the Company established a severance plan for all other salaried employees of the Company which also only becomes operative upon a change in control of the Company. Compensation which might be payable under these agreements and the severance plan has not been accrued in the consolidated financial statements as a change in control has not occurred. Under the Brunswick Employee Stock Ownership Plan (ESOP), the Company may make annual contributions to a trust for the benefit of eligible domestic employees in the form of either cash or common shares of the Company. In April 1989, the Company's Board of Directors approved an amendment to the ESOP that permits the ESOP to borrow funds to acquire the Company's common shares. Subsequent to that amendment, the ESOP obtained a bridge loan of $100 million and purchased from the Company 5,095,542 shares (ESOP Shares) of the Company's common stock at a price of $19.625 per share. The bridge loan was repaid with notes sold on February 27, 1990. The debt of the ESOP is guaranteed by the Company and is recorded in the Company's consolidated financial statements. The ESOP Shares are maintained in a Suspense Account until released and allocated to participants' accounts. The release of shares from the Suspense Account is determined by multiplying the number of shares in the Suspense Account by the ratio of debt service payments (principal plus interest) made by the ESOP during the year to the sum of the debt service payments made by the ESOP in the current year plus the debt service payments to be made by the ESOP in future years. Allocation of released shares to participants' accounts is done at the discretion of the Compensation Committee of the Board of Directors. The shares released from the Suspense Account were 327,900 in 1993 and 1992 and 327,899 in 1991 leaving 3,442,948 shares in the Suspense Account at December 31, 1993. The expense recorded by the Company since 1989 is based on cash contributed or committed to be contributed by the Company to the ESOP during the year. Unamortized ESOP expense is reduced as the Company recognizes compensation expense (excluding the impact of dividends on ESOP Shares). In 1993, 1992 and 1991, the ESOP made debt service payments totaling $11.2 million which were funded by Company contributions of $9.0 million and dividends received on ESOP shares of $2.2 million in each of the three years. The Company, including discontinued operations, recognized expense of $9.0 million in 1993, 1992 and 1991 ($5.5 million, $5.9 million and $5.6 million after-tax) of which $6.6 million, $7.0 million and $7.3 million, respectively, were recorded as interest expense and $2.4 million, $2.0 million and $1.7 million, respectively, were recorded as compensation expense. 14. Retirement and Employee Benefit Costs The Company has pension and retirement plans covering substantially all of its employees, including certain employees in foreign countries. Pension cost of continuing operations for all plans was $7.3 million, $3.6 million and $6.2 million in 1993, 1992 and 1991, respectively. Plan benefits are based on years of service, and for some plans, the average compensation prior to retirement. Plan assets generally consist of debt and equity securities, real estate and investments in insurance contracts. Pension costs for 1993, 1992 and 1991, determined in accordance with the Financial Accounting Standards Board Statement No. 87, "Employers' Accounting for Pensions" (SFAS No. 87), included the following components: The funded status of the plans accounted for in accordance with SFAS No. 87 and the amounts recognized in the Company's balance sheets at December 31 were as follows: The projected benefit obligations were determined primarily using assumed weighted average discount rates of 7.5% in 1993 and 8.5% in 1992, and an assumed compensation increase of 5.5% in 1993 and 1992. The assumed weighted average long-term rate of return on plan assets was primarily 9% in 1993 and 1992. The unrecognized asset or liability at the initial adoption of SFAS No. 87 is being amortized on a straight-line basis over 10 years for the Company's domestic plans and over the average remaining service period of plan participants for the Company's foreign plans. The unrecognized prior service cost is being amortized on a straight-line basis over the average remaining service period of plan participants. Two of the Company's salaried pension plans provide that in the event of a termination, merger or transfer of assets of the plans during the five years following a change in control of the Company occurring on or before March 1, 1996, benefits would be increased so that there would be no excess net assets. The Company's supplemental pension plan provides for a lump sum payout to plan participants of the present value of accumulated benefits upon a change in control of the Company. For a definition of "change in control of the Company" refer to Note 13. The Company has an unfunded retirement plan which provides for payments to retired directors. This plan is accounted for as a deferred compensation arrangement and resulted in charges to net earnings (loss) of $0.2 million in 1993 and 1992 and $0.1 million in 1991. Sea Ray employees participate in a noncontributory employee stock ownership and profit sharing plan, under which the Company makes annual cash contributions to a trust for the benefit of eligible employees. The charges to net earnings (loss) for this plan were $1.3 million, $1.4 million and $1.2 million in 1993, 1992 and 1991, respectively. Certain employees participate in a profit sharing plan to which the Company makes cash contributions. Participants become vested in the contributions after they are employed for a specified period. This plan resulted in charges to net earnings (loss) of $2.2 million, $2.1 million and $1.5 million in 1993, 1992 and 1991, respectively. The Brunswick Retirement Savings Plan for salaried and certain hourly employees, including discontinued operations, allows participants to make contributions via payroll deductions pursuant to section 401(k) of the Internal Revenue Code. Effective January 1, 1991, the Company makes a minimum matching contribution of 5% of a participant's pretax contributions limited to 6%of their salary. The Company may increase the matching percentage to 30% of the participant's pretax contributions. The Company made 10% matching contributions in 1993 and 1992, and the minimum 5% matching contribution in 1991. The Company's contribution is made in common stock of the Company. In 1993 and 1992, the net charge to continuing operations for matching contributions was $0.5 million and $0.4 million in 1991. In addition to providing benefits to present employees, the Company currently provides certain health care and life insurance benefits for eligible retired employees. Employees may become eligible for those benefits if they have fulfilled specific age and service requirements. The Company monitors the cost of these plans, and has, from time to time, changed the benefits provided under these plans. The plans contain requirements for retiree contributions generally based on years of service as well as other cost sharing features such as deductibles and copayments. The Company reserves the right to make additional changes or terminate these benefits in the future. The Company's plans are not funded; claims are paid as incurred. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), for its domestic unfunded postretirement health care and life insurance programs. SFAS No. 106 requires the cost of postretirement benefits to be accrued during the service lives of employees. As 1991 costs were recognized as expense when the claims were paid by the Company, postretirement benefit cost is not comparable with 1993 and 1992. The cumulative effect on years prior to 1992 of adopting SFAS No. 106 on an immediate recognition basis, including discontinued operations, was to decrease net earnings by $38.3 million. The Company had previously recognized approximately $9.6 million of its accumulated postretirement benefit obligation primarily in conjunction with the disposition of the non-Defense businesses of the Technical segment. Postretirement benefit cost was $6.4 million, $6.7 million and $1.4 million in 1993, 1992, and 1991, respectively. Net periodic postretirement benefit cost of continuing operations for 1993 and 1992 included the following components: The amounts recognized in the Company's balance sheets at December 31 were as follows: The accumulated postretirement benefit obligation was determined using weighted average discount rates of 7.5% in 1993 and 8.5% in 1992, and an assumed compensation increase of 5.5% in 1993 and 1992. The health care cost trend rates were assumed to be 12% and 10% in 1994 for pre-65 and post-65 benefits, respectively, gradually declining to 5% after eight years and four years, respectively, and remaining at that level thereafter. The health care cost trend rates were assumed to be 15%, and 10% in 1993 for pre-65 and post-65 benefits, respectively, gradually declining to 6% after ten years and seven years, respectively, and remaining at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, a 1% increase in the health care trend rate would increase the accumulated postretirement benefit obligation by $7.9 million at December 31, 1993 and the net periodic cost by $1.0 million for the year. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112), for employees' disability benefits. SFAS No. 112 requires the accrual method for recognizing the cost of postemployment benefits. The cumulative effect on prior years of adopting SFAS No. 112, including discontinued operations, was to decrease net earnings by $14.6 million. The effect of this change on 1993 consolidated results of operations was not material. 15. Income Taxes The sources of earnings (loss) before income taxes are presented as follows: The income tax provision (benefit) consisted of the following: Temporary differences and carryforwards which give rise to deferred tax assets and liabilities at December 31 are as follows: The valuation allowance relates to deferred tax assets established under SFAS No. 109 for capital loss carryforwards of $3.1 million, and foreign tax credit carryforwards of $2.7 million. These unutilized loss and credit carryforwards, which will expire in 1996, will be carried forward to future years for possible utilization. No benefit for these carryforwards has been recognized in the financial statements. No other valuation allowances were deemed necessary, as all deductible temporary differences will be utilized either by carryback to prior years' taxable income, charges against reversals of future taxable temporary differences, or charges against expected future taxable income other than reversals. The change in the valuation allowance from 1992 to 1993 is primarily due to the utilization of foreign tax credit carryforwards which reduced income tax expense for the current year. During 1991, deferred income taxes were provided for timing differences in the recognition of revenue and expenses for tax and financial statement purposes. The deferred tax provision (benefit) consisted of the following: (in millions) U.S. Federal Litigation and claims $ (11.8) Restructuring charge 4.9 Employee benefits (1.8) Bad debts (0.1) Product warranty (0.5) Dealer allowances and discounts (2.0) Inventory 0.8 State and local taxes 2.5 Sales of businesses 2.2 Insurance (2.3) Depreciation and amortization (0.6) Other 0.5 (8.2) Foreign 0.4 Total deferred tax (benefit) $ (7.8) Deferred taxes have been provided, as required, on the undistributed earnings of foreign subsidiaries and unconsolidated affiliates. The difference between the actual income tax provision and the tax provision (benefit) computed by applying the statutory Federal income tax rate to earnings (loss) before taxes is attributable to the following: In January 1994, the Company reached an agreement with the U.S. Internal Revenue Service regarding its examination of the Company for the years 1985 and 1986. The issues of this examination dealt primarily with the deductibility of approximately $500 million of acquired intangible assets, which the IRS proposed to reclassify to non-deductible intangible assets. Under the terms of the agreement, the IRS has agreed to allow amortization deductions for virtually all of the acquired intangible assets, and the Company has agreed to increase the amortizable lives of most of the acquired intangible assets. The revised lives create a temporary difference which results in an initial obligation by the Company to pay the IRS approximately $55 million, representing taxes and interest net of taxes for the years 1986 through 1993. This initial $55 million obligation will subsequently be reduced by the future tax benefits of the temporary difference created by the agreement. Since the interest will be charged to existing reserves and the taxes paid represent temporary differences which create, and have been recorded as, deferred tax assets, this agreement will have no impact on the Company's consolidated results of operations. 16. Translation of Foreign Currencies Most of the Company's foreign entities use the local currency as the functional currency and translate all assets and liabilities at year-end exchange rates, all income and expense accounts at average rates and record adjustments resulting from the translation in a separate component of common shareholders' equity. The following is an analysis of the cumulative translation adjustments reflected in common shareholders' equity: The remaining foreign entities translate monetary assets and liabilities at year-end exchange rates and inventories, property and nonmonetary assets and liabilities at historical rates. Income and expense accounts are translated at the average rates in effect during the year, except that depreciation and cost of sales are translated at historical rates. Adjustments resulting from the translation of these entities are included in the results of operations. Gains and losses resulting from transactions of the Company and its subsidiaries which are made in currencies different from their own are included in income as they occur. Currency losses of $1.0 million and $5.1 million were recorded in 1993 and 1992, respectively, and a gain of $3.2 million was recorded in 1991. 17. Leases The Company has various lease agreements for offices, branches, factories, distribution and service facilities, certain Company-operated bowling centers, and certain personal property. These obligations extend through 2032. Most leases contain renewal options and some contain purchase options. Many leases for Company-operated bowling centers contain escalation clauses, and many provide for contingent rentals based on percentages of gross revenue. No leases contain restrictions on the Company's activities concerning dividends, additional debt or further leasing. Rent expense consisted of the following: Future minimum rental payments at December 31, 1993, under agreements classified as operating leases with noncancelable terms in excess of one year, are as follows: (in millions) 1994 $ 3.2 1995 2.5 1996 1.7 1997 1.6 1998 1.3 Thereafter 2.7 Future minimum operating lease rental payments (not reduced by minimum sublease rentals of $1.3 million) $ 13.0 18. Technological Expenditures Technological expenditures consisted of the following: 19. Preferred Share Purchase Rights In March 1986, the Company's Board of Directors declared a dividend of one Preferred Share Purchase Right (Right) on each outstanding share of the Company's common stock. After the two-for-one stock split distributed on June 9, 1987, under certain conditions, each holder of Rights may purchase one one-hundredth share of a new series of junior participating preferred stock at an exercise price of $100 for each two Rights held. The Preferred Share Purchase Rights become exercisable at the earlier of (1) a public announcement that a person or group acquired or obtained the right to acquire 15% or more of the Company's common stock or (2) ten days after commencement or public announcement of an offer for more than 15% of the Company's common stock. After a person or group acquires 15% or more of the common stock of the Company, other shareholders may purchase additional shares of the Company at fifty percent of the current market price. These Rights may cause substantial ownership dilution to a person or group who attempts to acquire the Company without approval of the Company's Board of Directors. The Rights, which do not have any voting rights, expire on March 31, 1996, and may be redeemed by the Company at a price of $.025 per Right at any time prior to a person's or group's acquisition of 15% or more of the Company's common stock. The new series of preferred stock that may be purchased upon exercise of the Rights may not be redeemed and may be subordinate to other series of the Company's preferred stock designated in the future. A Right also will be issued with each share of the Company's common stock that becomes outstanding prior to the time the Rights become exercisable or expire. In the event that the Company is acquired in a merger or other business combination transaction, provision will be made so that each holder of Rights will be entitled to buy the number of shares of common stock of the surviving company, which at the time of such transaction would have a market value of two times the exercise price of the Rights. 20. Unconsolidated Affiliates and Subsidiaries The Company has certain unconsolidated foreign and domestic affiliates that are accounted for on the equity method. Summary financial information of the unconsolidated affiliates is presented below: 21. Quarterly Data (unaudited) Report of Management The Company maintains accounting and related internal control systems which are intended to provide reasonable assurance that assets are safeguarded from loss or unauthorized use and to produce records necessary for the preparation of financial information. There are limits inherent in all systems of internal control, and the cost of the systems should not exceed the expected benefits. Through the use of a program of internal audits and through discussions with and recommendations from its independent public accountants, the Company periodically reviews these systems and controls and compliance therewith. The Audit Committee of the Board of Directors, comprised entirely of nonemployee directors, meets regularly with management, the internal auditors, and the independent public accountants to review the results of their work and to satisfy itself that their responsibilities are being properly discharged. The internal auditors and independent public accountants have full and free access to the Audit Committee and have discussions regarding appropriate matters, with and without management present. The primary responsibility for the integrity of financial information rests with management. Certain valuations contained herein result, of necessity, from estimates and judgments of management. The accompanying consolidated financial statements, notes thereto, and other related information were prepared in conformity with generally accepted accounting principles applied on a consistent basis. Report of Independent Public Accountants To the Shareholders of Brunswick Corporation: We have audited the accompanying consolidated balance sheets of Brunswick Corporation(a Delaware Corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of results of operations, and cash flows for each of three years ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Brunswick Corporation and Subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 14 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postemployment benefits, and effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules listed in the preceding index are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. Chicago, Illinois, February 6, 1994 Brunswick Corporation Five Year Financial Summary Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation of our report dated February 6, 1994, included in this Form 10-K, into the Company's previously filed registration statements on Form S-8 (File No. 33-4683), Form S-3 (File No. 33-61512) and Form S-8 (File No. 33-55022). Arthur Andersen & Co. Chicago, Illinois, March 28, 1994 Brunswick Corporation Schedule I - Marketable Securities and Other Investments Brunswick Corporation Schedule V - Property Brunswick Corporation Schedule VI - Accumulated Depreciation Brunswick Corporation Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information	14,618	95,275
55785_1993.txt	55785_1993	1993	55785	ITEM 1. BUSINESS Kimberly-Clark Corporation was incorporated in Delaware in 1928. As used in Items 1, 2 and 7 of this Form 10-K Annual Report, the term "Corporation" refers to Kimberly-Clark Corporation and its consolidated subsidiaries. In the remainder of this Form 10-K Annual Report, the terms "Kimberly- Clark" or "Corporation" refer to Kimberly-Clark Corporation. Financial information about product classes and results, and foreign and domestic operations, and information about principal products and markets of the Corporation, contained under the caption "Management's Discussion and Analysis" and in Note 12 to the Financial Statements contained in the 1993 Annual Report to Stockholders, are incorporated in this Item 1 by reference. Description of the Corporation. Kimberly-Clark is principally engaged in the manufacturing and marketing throughout the world of a wide range of products for personal, business and industrial uses. Most of these products are made from natural and synthetic fibers using advanced technologies in absorbency, fibers and nonwovens. The Corporation's products and services are segmented into three classes. Class I includes tissue products for household, commercial, institutional and industrial uses; infant, child, feminine and incontinence care products; industrial and commercial wipers; health care products; and related products. Class I products are sold under a variety of well-known brand names, including Kleenex, Huggies, Pull-Ups, Kotex, New Freedom, Lightdays, Depend, Poise, Hi-Dri, Delsey, Spenco, Kimguard and Kimwipes. Products for home use are sold through supermarkets, mass merchandisers, drugstores, warehouse clubs, home health care stores, variety stores, department stores and other retail outlets, as well as to wholesalers. Other products in this class are sold to distributors, converters and end-users. Pulp produced by the Corporation, including amounts sold to other companies, is included in Class I, except for pulp manufactured for newsprint and certain specialty papers which is included in Class II. Class II includes newsprint, printing papers, premium business and correspondence papers, tobacco industry papers and products, technical papers, and related products. Newsprint and groundwood printing papers are sold directly to newspaper publishers and commercial printers. Other papers and specialty products in this class are sold directly to users, converters, manufacturers, publishers and printers, and through paper merchants, brokers, sales agents and other resale agencies. PART I (Continued) ITEM 1. BUSINESS (Continued) Class III includes aircraft services, commercial air transportation and other products and services. The Corporation owns various patents and trademarks registered domestically and in certain foreign countries. The Corporation considers the patents and trademarks which it owns and the trademarks under which it sells certain of its products, in each instance in the aggregate, to be material to its business. Consequently, the Corporation seeks patent and trademark protection by all available means, including registration. A partial list of the Corporation's trademarks is included under the caption "Trademarks" contained in the 1993 Annual Report to Stockholders and is incorporated herein by reference. EMPLOYEES. In its worldwide consolidated operations, the Corporation had 42,131 employees as of December 31, 1993. RAW MATERIALS. Cellulose fibers in the form of wood pulp are the primary raw material for the Corporation's paper and tissue products and are important components in disposable diapers, training pants, feminine pads and incontinence care products. Certain specialty papers are manufactured with other cellulose fibers such as flax straw and cotton. Large amounts of secondary and recycled fibers are also consumed, primarily in tissue products. Superabsorbent materials are important components in disposable diapers, training pants and incontinence care products. Polypropylene and other synthetics are primary raw materials for manufacturing nonwoven fabrics which are used in disposable diapers, training pants, feminine pads, incontinence and health care products and industrial wipers. Most secondary fibers and all synthetics are purchased. Wood pulp and nonwood cellulose fibers are produced by the Corporation and purchased from others. The Corporation considers the supply of such raw materials to be adequate to meet the needs of its businesses. For its worldwide consolidated operations, the Corporation's pulp mills at Coosa Pines, Alabama, and Terrace Bay, Ontario, had the capacity to supply about two-thirds of the 1993 wood pulp requirements for products other than newsprint. The Corporation's newsprint mill at Coosa Pines produces substantially all of its own pulp requirements. The Corporation owns or controls 5.1 million acres of forestland in North America, primarily as a source of fiber for pulp production. Approximately .4 million acres are owned and 4.7 million acres, principally in Canada, are held under long-term Crown rights or leases. Certain states have adopted laws and entered into agreements with publishers requiring newspapers sold in such states to contain specified amounts of recycled paper. The Corporation provides certain newspaper publishers with newsprint containing specified amounts of recycled paper. COMPETITION. The Corporation competes in numerous domestic and foreign markets. The number of competitors and the Corpora- tion's competitive positions in those markets vary. In general, in the sale of its principal products, the Corporation faces strong competition from other manufacturers, some of which are larger and more diversified than the Corporation. The Corporation has one major competitor, and several regional competitors, in its disposable diaper business and several major competitors in its household and other tissue-based products, and feminine and incontinence care products businesses. During 1993, in the U.S., private label and economy branded competitors continued to expand distribution of their disposable training pants nationally in competition with the Corporation's training pants business, and, in the fourth quarter, a major competitor initiated regional introductions of a branded training pant. In foreign markets, the Corporation has encountered increased competition and expects to encounter significant competition in connection with its introduction of training pants and diapers in Europe. Depending on the characteristics of the market involved, the Corporation com- petes on the basis of product quality and performance, price, service, packaging, distribution, advertising and promotion. RESEARCH AND DEVELOPMENT. At year-end 1993, approximately 1,200 of the Corporation's employees were engaged in research and development activities and were located in Neenah, Wisconsin; Roswell, Georgia; Coosa Pines, Alabama; Troy, Ohio; Munising, Michigan; Waco, Texas; the United Kingdom; and France. A major portion of total research and development expenditures is directed toward new or improved personal care, health care, household products, and nonwoven materials. Consolidated research and development expenditures were $158.5 million in 1993, $156.1 million in 1992 and $148.8 million in 1991. ENVIRONMENTAL MATTERS. Capital expenditures for environmental controls to meet legal requirements and otherwise relating to the protection of the environment at the Corporation's facilities in the United States are estimated to be $54 million in 1994 and $15 million in 1995. Such expenditures are not expected to have a material effect on the Corporation's total capital expenditures, consolidated earnings or competitive position; however, these estimates could be modified as a result of changes in the Corporation's plans, changes in legal requirements or other factors. RISKS FOR FOREIGN OPERATIONS. The products of the Corporation and its equity companies are made in 21 countries outside the U.S. Consumer products made abroad or in the U.S. are marketed in approximately 150 countries. Because these countries are so numerous, it is not feasible to generally characterize the risks involved. Such risks vary from country to country and include such factors as tariffs, trade restrictions, changes in currency value, economic conditions and international relations. INSURANCE. The Corporation maintains coverage consistent with industry practice for most risks that are incident to its operations. ITEM 2. ITEM 2. PROPERTIES Management believes that the Corporation's production facilities are suitable for their purpose and adequate to support its businesses. The extent of utilization of individual facilities varies, but generally they operate at or near capacity. New facilities of the Corporation are under construction and others are being expanded. Principal facilities and products or groups of products made at these facilities are listed on the following pages. In addition, the principal facilities of the Corporation's equity companies and the products or groups of products made at such facilities are included on the following pages. Products described as consumer, service and/or nonwoven products include tissue products for household, commercial, institutional and industrial uses; infant, child, feminine and incontinence care products; industrial and commercial wipers; health care products; and related products. PART I (Continued) ITEM 2. PROPERTIES (Continued) Headquarters Locations Dallas, Texas Roswell, Georgia Neenah, Wisconsin Administrative Center Knoxville, Tennessee Production and Service Facilities United States Alabama Ashville - Wood chips Coosa Pines - Newsprint, groundwood printing papers, pulp, seedling nursery Goodwater - Lumber Nixburg - Wood chips Roanoke - Wood chips Westover - Lumber Arizona Tucson - Nonwoven products Arkansas Conway - Consumer products Maumelle - Consumer products California Fullerton - Consumer products Connecticut New Milford - Consumer products Georgia LaGrange - Nonwoven materials and products Massachusetts Lee - Tobacco industry papers, thin papers, service products Westfield - Aviation services Michigan Munising - Printing and base papers Mississippi Corinth - Nonwoven materials, service products New Jersey Montvale - Aviation services Spotswood - Tobacco industry papers and products New York Ancram - Tobacco industry papers and products North Carolina Hendersonville - Nonwoven materials and products Lexington - Nonwoven materials and products Ohio Troy - Adhesive-coated products Oklahoma Jenks - Consumer products South Carolina Beech Island - Consumer and service products Tennessee Loudon - Service products Memphis - Consumer and service products Texas Dallas - Aviation services Paris - Consumer products Waco - Consumer and service products Utah Ogden - Consumer products Wisconsin Appleton - Aviation services Milwaukee - Commercial airline service Neenah - Consumer and service products, nonwoven materials, business and correspondence papers Whiting - Business and correspondence papers Outside the United States Australia Albury - Nonwoven materials and products Ingleburn (near Sydney) - Consumer products Lonsdale (near Adelaide) - Consumer products Millicent - Consumer and service products Seven Hills (near Sydney) - Consumer and service products Tantanoola - Pulp Warwick Farm (near Sydney) - Consumer and service products Brazil Mogi das Cruzes (near Sao Paulo) - Consumer and service products Canada Huntsville, Ontario - Consumer and service products Rexdale, Ontario (near Toronto) - Consumer and service products St. Catharines, Ontario - Consumer and service products, base papers St. Hyacinthe, Quebec - Consumer products Terrace Bay, Ontario - Pulp Winkler, Manitoba (mobile operations) - Flax tow Colombia Barbosa (near Medellin) - Tobacco industry papers, service products Guarne (near Medellin) - Consumer and service products Pereira - Consumer and service products, nonwoven materials Costa Rica Cartago - Consumer products El Salvador Sitio del Nino (near San Salvador) - Consumer and service products France Le Mans - Tobacco industry products Malaucene - Tobacco industry papers Quimperle - Tobacco industry papers Rouen - Consumer products Villey-Saint-Etienne - Consumer products Germany Koblenz - Consumer and service products Equity company production facility PART I (Continued) ITEM 2. PROPERTIES (Continued) Honduras Cortes - Nonwoven products Indonesia Medan - Tobacco industry papers Korea Anyang (near Seoul) - Consumer and service products Kimcheon (near Taegu) - Consumer and service products Taejon - Consumer products Malaysia Petaling Jaya (near Kuala Lumpur) - Consumer and service products Mexico Bajio (near San Juan del Rio) - Consumer and service products; business, printing and school papers Cuautitlan (near Mexico City) - Consumer and service products Empalme - Nonwoven products Hermosillo - Nonwoven products Magdalena - Nonwoven products Naucalpan (near Mexico City) - Consumer and service products; business, printing and school papers; tobacco industry papers; pulp Nogales - Nonwoven products Orizaba - Consumer and service products; business, printing and school papers; pulp Ramos Arizpe - Consumer products Santa Ana - Nonwoven products Netherlands Veenendaal - Consumer and service products Panama Panama City - Consumer and service products Philippines San Pedro, Laguna (near Manila) - Consumer and service products, tobacco industry papers Saudi Arabia Al-Khobar - Consumer and service products Singapore Singapore - Consumer and service products South Africa Cape Town - Consumer and service products Germiston (near Johannesburg) - Consumer and service products Springs (near Johannesburg) - Consumer and service products Thailand Patumthanee (near Bangkok) - Consumer and service products United Kingdom Barton-upon-Humber - Consumer products Flint - Nonwoven materials, service products Larkfield (near Maidstone) - Consumer and service products Prudhoe (near Newcastle-upon-Tyne) - Consumer and service products, recycled fiber Sealand (near Chester) - Consumer products Venezuela Guacara - Consumer products Equity company production facility ** Other companies ITEM 3. ITEM 3. LEGAL PROCEEDINGS The following is a brief description of material pending legal proceedings to which the Corporation or any of its subsidiaries is a party or of which any of their properties is subject: A. On March 11, 1993, a class action lawsuit was filed against the Corporation in the United States District Court, Middle District of Tennessee (the "Tennessee District Court"), on behalf of certain retirees who were formerly represented by the United Paperworkers International Union ("UPIU"). The Corporation's Motion to Transfer this action to the Eastern District of Wisconsin was granted. A similar action was filed in the United States District Court, Central District of California, on behalf of retirees who were formerly represented by the Association of Western Pulp and Paper Workers ("AWPPW") at the Corporation's Fullerton, California facility. This second action was voluntarily dismissed and refiled in the Tennessee District Court on March 25, 1993. The Corporation's Motion to Transfer this action to the Central District of California was granted. The parties to both actions have executed settlement agreements, dated March 15, 1994, providing for the voluntary dismissal of such actions, without prejudice, for a period of one year from the date that such agreements are approved by the respective courts, subject to certain conditions and circumstances allowing for the earlier refiling of such actions. On March 23, 1994, the court for the Eastern District of Wisconsin entered an order approving the settlement agreement with respect to the UPIU action. The settlement agreement with respect to the AWPPW action has been submitted to the court for the Central District of California for its consideration. The actions relate to certain changes made by the Corporation to its retiree medical plans effective January 1, 1993. The allegations in each action are that the Corporation's retiree medical benefits were vested and could not be unilaterally amended by the Corporation, and that, therefore, the retirees are entitled to an unalterable level of medical benefits. In the event that the AWPPW settlement agreement is not approved by the court, or the actions are refiled pursuant to the terms of the settlement agreements, management has determined that under Financial Accounting Standard No. 106, and based on prevailing market interest rates, the estimated cost to the Corporation of not being able to make any amendments to its retiree medical plans with respect to the two putative classes of retirees would result in a maximum pretax charge of approximately $5.7 million per year. B. Since September 28, 1990, about 60 employees of contractors who allegedly worked at the Corporation's mill in Coosa Pines, Alabama at some point in their careers filed separate actions in the United States District Court for the Northern District of Texas against the Corporation and approximately 36 other companies. Most of these cases were transferred to the Federal District Court, Northern District of Alabama and subsequently have been consolidated in the Federal District Court, Eastern District of Pennsylvania where all asbestos cases pending at such time in United States Federal District Courts were consolidated. Approximately 4,713 individuals refiled three of such cases in the District Court of Orange County, Texas. The actions allege, with respect to the Corporation, that the ownership of facilities containing asbestos caused the plaintiffs to suffer physical injury. The actions seek unspecified damages. The Corporation has denied the allegations and has asserted, among other things, that the claims fail to state a claim upon which relief can be granted and that such actions are barred by applicable statutes of limitation. These actions presently are in the discovery phase. PART I (Continued) ITEM 3. LEGAL PROCEEDINGS (Continued) C. On September 28, 1992, the Corporation filed an action against Drypers Corporation, Pope & Talbot, Inc. and Pope & Talbot, Wis., Inc. in the United States District Court, Western District of Washington, alleging patent infringement with respect to the defendants' use of containment flaps in disposable diapers. In June 1993, each of the defendants filed counterclaims against the Corporation alleging that the Corporation misused its patent in violation of the federal antitrust laws. The defendants are seeking invalidation of the patent, treble damages based on the defendants' attorneys fees for defending the patent suit, and the defendants' attorney fees for prosecuting the antitrust counterclaim. The case is currently in discovery. A trial date has been set for June 7, 1994. The Corporation also is subject to routine litigation from time to time which individually or in the aggregate is not expected to have a material adverse effect on the Corporation's business or results of operations. Environmental Matters - --------------------- (See the Corporation's 1993 Annual Report to Stockholders under the "Environmental Matters" section of "Management's Discussion and Analysis.") The Corporation has been named a potentially responsible party ("PRP") under the provisions of the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), or analogous state statute, at 21 waste disposal sites, none of which, in management's opinion, could have a material adverse impact on the Corporation's business or results of operations. Notwithstanding its opinion, management believes it appropriate to disclose the following recent developments concerning three of these sites where the extent of the Corporation's liability cannot yet be established: A. The South 8th Street Landfill Site, located across the Mississippi River from Memphis, Tennessee, in Crittenden County, Arkansas, is a 30-acre site that received municipal and industrial waste from the 1950's to the early 1980's. The site is divided into three separate landfill disposal areas and an oily sludge pit area. A refining company (the "Refiner") apparently used the pit area for the disposal of waste sludge from its oil re-refining process through November 1969. On September 9, 1992, the Environmental Protection Agency (the "EPA") identified Kimberly-Clark's Memphis mill as a PRP at the site. The mill was linked to the site by an affidavit of an employee of the Refiner which alleged that the Refiner picked up waste oil at the mill for re-refining. While Kimberly-Clark did not send hazardous wastes to the site, it did send used oil to the Refiner for reclamation. The EPA recently conducted a Remedial Investigation and Feasibility Study with respect to the site. Based on such study, the EPA's preferred remedial alternative for the landfill area is organic treatment, stabilization and disposal in a licensed, nonhazardous landfill at a cost of $14.8 million to $18.1 million. The EPA's preferred remedial alternative for the oily sludge pit is natural soil cover at a cost of $2.3 million. There are approximately 103 members, including Kimberly-Clark, of the PRP group with respect to the site. The Corporation's estimated share of total site remediation cost, if any, cannot yet be established. B. In August 1992, Kimberly-Clark's Spotswood, New Jersey mill received an information request from the New Jersey Department of Environmental Protection and Energy ("NJDEPE") with respect to the Jones Industrial Service Landfill. Kimberly-Clark currently has no information about the site or the status of the NJDEPE's actions to date. Kimberly- Clark does not have records indicating that the mill used the site. However, the Spotswood mill has used an industrial company for nonhazardous waste disposal services and has received routing sheets from such company which indicate that the company may have sent three loads of Spotswood mill waste to the site in September 1980. Until Kimberly-Clark receives the site information requested from the State of New Jersey, no determination regarding the extent of Kimberly-Clark's liability, if any, can be made. C. On February 6, 1991, the NJDEPE identified the Corporation as a PRP under the provisions of the New Jersey Spill Compensation and Control Act for remediation of the Global Sanitary Landfill waste disposal site located in Old Bridge Township, New Jersey based on the Corporation's disposal of waste at such site. The EPA has designated the disposal site as a state-led site under CERCLA with the NJDEPE acting as lead agency. In May 1991, the Corporation signed a PRP agreement and paid an administrative assessment. In August 1993, a consent decree was executed by the State of New Jersey and the PRPs, pursuant to which the Corporation agreed to pay $575,000 for its share of Phase I cleanup costs. The Corporation's share of Phase II cleanup costs, if any, cannot yet be established. PART I (Continued) ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of the executive officers of the Corporation as of March 1, 1994, together with certain biographical information are as follows: JAMES D. BERND, 60, was elected Executive Vice President effective December 1, 1990. Mr. Bernd joined Kimberly-Clark in 1959 as a trainee at the Niagara Falls, New York, mills. He was appointed Marketing Manager for KLEENEX(R) facial tissue in 1973 and Business Manager for Household Products in 1975. Mr. Bernd was appointed Division Vice President in 1976, President of the Household Products Sector in 1985 and assumed his present position in 1990. He is responsible for the Household Products and Service and Industrial Sectors, U.S. Consumer Sales, Consumer Business Services and Safety and Quality Assurance. Mr. Bernd is a member of the University of Wisconsin School of Business Board of Visitors, the Riverside Medical Center - Waupaca Board of Trustees, and the Associated Bank, National Association Board of Directors. He has been a director of the Corporation since 1990. JOHN W. DONEHOWER, 47, was elected Senior Vice President and Chief Financial Officer in 1993. Mr. Donehower joined Kimberly-Clark in 1974. He was appointed Director of Finance - Europe in 1978, Vice President, Marketing and Sales - Nonwovens in 1981, Vice President, Specialty Papers in 1982, Managing Director, Kimberly-Clark Australia Pty. Limited in 1982, and Vice President, Professional Health Care, Medical and Nonwoven Fabrics in 1985. He was appointed President, Specialty Products - U.S. in 1987, and President - World Support Group in 1990. O. GEORGE EVERBACH, 55, was appointed Senior Vice President - Law and Government Affairs in 1988. Mr. Everbach joined Kimberly-Clark in 1984. His responsibilities within the Corporation have included direction of legal, human resources and administrative functions. He was elected Vice President and General Counsel in 1984, Vice President, Secretary and General Counsel in 1985, and Senior Vice President and General Counsel in 1986. THOMAS J. FALK, 35, was elected Group President - Infant and Child Care in 1993. Mr. Falk joined Kimberly-Clark in 1983. His responsibilities within the Corporation have included internal audit, financial and strategic analysis and operations management. He was appointed Vice President - Operations Analysis and Control in 1990 and Senior Vice President - Analysis and Administration in 1992. JAMES G. GROSKLAUS, 58, was elected Executive Vice President effective December 1, 1990. He is responsible for the Pulp and Newsprint, Paper and Specialty Products Sectors, and also is responsible for various staff functions. Employed by the Corporation since 1957, Mr. Grosklaus was appointed Vice President in 1972 and Divisional Vice President in 1975, and was elected Senior Vice President effective January 1, 1979. He was appointed President, K-C Health Care, Nonwoven and Industrial Group in 1981, Senior Staff Vice President in 1982, Senior Vice President in 1983 and President, Technical Paper and Specialty Products in 1985, and elected Executive Vice President in January 1986. In 1988, he was appointed President - - North American Pulp and Paper Sector. He is a member of the Emory University Board of Visitors and the Woodruff Arts Center Board of Trustees. He has been a director of the Corporation since 1987. EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) TIMOTHY E. HOEKSEMA, 47, was appointed President - Transportation Sector in 1988. Mr. Hoeksema joined Kimberly- Clark in 1969. Prior to 1977, Mr. Hoeksema served as Chief Pilot of Kimberly-Clark. He was elected President of K-C Aviation Inc., a wholly owned subsidiary of Kimberly-Clark, in 1977, and President of Midwest Express Airlines, Inc., a wholly owned subsidiary of K-C Aviation Inc., in 1983. JAMES T. MCCAULEY, 55, was elected Executive Vice President in 1990. Mr. McCauley joined Kimberly-Clark in 1969. He was elected Treasurer in 1980, Vice President and Treasurer in 1980, appointed Vice President - Nonwoven Operations in 1984, Senior Vice President, Kimberly-Clark Newsprint & Pulp and Forest Products in 1984, President, North American Pulp and Newsprint Sector in 1985, President, Health Care and Nonwovens Sector in 1987, and President - Nonwovens and Technical Products Sector in 1988. Mr. McCauley was appointed President - Nonwovens, Medical and Technical Products Sector in 1988 and was appointed President - Nonwovens and Professional Health Care Sector, Far East Operations and World Support Group in 1990. WAYNE R. SANDERS, 46, was elected Chief Executive Officer of the Corporation effective December 19, 1991, and Chairman of the Board effective March 31, 1992. He previously had been elected President and Chief Operating Officer in December 1990. Employed by the Corporation in 1975, Mr. Sanders was appointed Vice President of Kimberly-Clark Canada Inc., a wholly owned subsidiary of the Corporation, in 1981. He held various positions in that company, and was appointed Director and President in 1984. Mr. Sanders was elected Senior Vice President of Kimberly-Clark Corporation in 1985 and was appointed President - Infant Care Sector in 1987, President - Personal Care Sector in 1988 and President - World Consumer, Nonwovens and Service and Industrial Operations in 1990. He is a member of the Lawrence University Board of Trustees and the Marquette University Board of Trustees. He has been a director of the Corporation since 1989. KATHI P. SEIFERT, 44, was elected Group President - Feminine and Adult Care effective January 7, 1994. Ms. Seifert joined Kimberly-Clark in 1978. Her responsibilities in the Corporation have included various marketing positions within the Service and Industrial, Consumer Tissue and Feminine Products business sectors. She was appointed President - Feminine Care Sector, in 1991. JOHN A. VAN STEENBERG, 46, was elected President - European Consumer and Service & Industrial Operations effective January 1, 1994. Mr. Van Steenberg joined Kimberly-Clark in 1978. His previous responsibilities have included operations and major project management. He was appointed Managing Director of Kimberly-Clark Australia Pty. Limited in 1990. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The dividend and market price data included in Note 11 to the Financial Statements, and the information covered by the captions "Dividends and Dividend Reinvestment Plan" and "Stock Exchanges" contained in the 1993 Annual Report to Stockholders are incorporated in this Item 5 by reference. As of March 18, 1994, the Corporation had 25,121 stockholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA PART II (Continued) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information under the caption "Management's Discussion and Analysis" contained in the 1993 Annual Report to Stockholders is incorporated in this Item 7 by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of the Corporation and its subsidiaries and independent auditors' report contained in the 1993 Annual Report to Stockholders are incorporated in this Item 8 by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The section of the 1994 Proxy Statement captioned "Certain Information Regarding Directors and Nominees" under "Proposal 1. Election of Directors" identifies members of the board of directors of the Corporation and nominees, and is incorporated in this Item 10 by reference. See also "EXECUTIVE OFFICERS OF THE REGISTRANT" appearing in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information in the section of the 1994 Proxy Statement captioned "Executive Compensation" under "Proposal 1. Election of Directors" is incorporated in this Item 11 by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the sections of the 1994 Proxy Statement captioned "Security Ownership of Management" and "Other Principal Holder of Voting Securities" under "Proposal 1. Election of Directors" is incorporated in this Item 12 by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the sections captioned "Certain Transactions and Business Relationships" and "Executive Compensation -- Compensation Committee Interlocks and Insider Participation" under "Proposal 1. Election of Directors" of the 1994 Proxy Statement is incorporated in this Item 13 by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS REPORT. 1. Financial statements: The Consolidated Balance Sheet as of December 31, 1993 and 1992, and the related Consolidated Income Statement and Consolidated Cash Flow Statement for the years ended December 31, 1993, 1992 and 1991, and the related Notes thereto, and the Independent Auditors' Report are incorporated in Part II, Item 8 of this Form 10-K by reference to the Financial Statements contained in the 1993 Annual Report to Stockholders. 2. Financial statement schedules: The following information is filed as part of this Form 10-K and should be read in conjunction with the consolidated financial statements in the 1993 Annual Report to Stockholders. Independent Auditors' Report Schedules for Kimberly-Clark Corporation and Subsidiaries: V Property, Plant and Equipment VI Accumulated Depreciation of Property, Plant and Equipment VIII Valuation and Qualifying Accounts IX Short-Term Borrowings All other schedules have been omitted because they were not applicable or because the required information has been included in the financial statements or notes thereto. 3. Exhibits: Exhibit No.(3)a. Restated Certificate of Incorporation of Kimberly-Clark Corporation, dated April 16, 1987, incorporated by reference to Exhibit No. 4e. of the Kimberly-Clark Corporation Form S-8 filed on February 16, 1993 (File No. 33-58402). Exhibit No.(3)b. By-Laws of Kimberly-Clark Corporation, as amended April 22, 1993, incorporated by reference to Exhibit No.(3) of the Kimberly-Clark Corporation Form 10-Q for the quarterly period ended June 30, 1993. Exhibit No.(4). Copies of instruments defining the rights of holders of long-term debt will be furnished to the Securities and Exchange Commission on request. PART IV (Continued) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Exhibit No.(10)a. Kimberly-Clark Corporation 1976 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)b. Kimberly-Clark Corporation Management Achievement Award Program, incorporated by reference to Exhibit No. (10)b of the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1990. Exhibit No.(10)c. Kimberly-Clark Corporation Executive Severance Plan, incorporated by reference from the Kimberly- Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)d. Second Amended and Restated Deferred Compensation Plan for Directors of Kimberly-Clark Corporation, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)e. Kimberly-Clark Corporation 1986 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No. (10)f. Kimberly-Clark Corporation 1992 Equity Participation Plan, incorporated by reference to Exhibit No. 4A. of the Kimberly-Clark Corporation Form S-8 filed on June 26, 1992 (File No. 33-49050). Exhibit No.(11). The net income per share of common stock computations for each of the periods included in Part II, Item 6. Selected Financial Data, of this Form 10-K are based on average common shares outstanding during each of the respective periods. The only "common stock equivalents" or other poten- tially dilutive securities or agreements (as defined in Accounting Principles Board Opinion No. 15) in Kimberly-Clark Corporation's capital structure during the periods presented were options outstanding under the Corporation's Equity Participation Plans. Computations of "primary" and "fully diluted" net income per share assume the exercise of outstanding stock options under the "treasury stock method." The table below presents the amounts by which the earnings per share amounts presented in Item 6 would be reduced if the "treasury stock method" had been used. Primary Fully Diluted ------- ------------- 1993 $.01 $.01 1992 - - 1991 .02 .02 1990 .01 .01 1989 .01 .02 Exhibit No.(12). Computation of ratio of earnings to fixed charges for the five years ended December 31, 1993. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Exhibit No.(13). Portions of the Kimberly-Clark Corporation 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K. Exhibit No.(21). Consolidated Subsidiaries and Equity Companies of Kimberly-Clark Corporation are identified in the 1993 Annual Report to Stockholders, and such information is incorporated in this Form 10-K by reference. Exhibit No.(23). Independent Auditors' Consent Exhibit No.(24). Powers of Attorney (b) Reports on Form 8-K (i) The Corporation filed a Current Report on Form 8-K dated February 17, 1994, which reported the Corporation's 1993 audited financial statements and management's discussion and analysis. (ii) The Corporation filed a Current Report on Form 8-K dated February 18, 1994 which reported the offering of $100 million principal of debt securities by the Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 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. Kimberly-Clark Corporation March 24, 1994 By: /s/ John W. Donehower ----------------------------------------- John W. Donehower Senior Vice President and Chief 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. /s/ Wayne R. Sanders Chairman of the Board March 24, 1994 - ---------------------------- Wayne R. Sanders and Chief Executive Officer and Director /s/ John W. Donehower Senior Vice President and March 24, 1994 - ---------------------------- John W. Donehower Chief Financial Officer /s/ Randy J. Vest Vice President - March 24, 1994 - ---------------------------- Randy J. Vest Controller (principal accounting officer) Directors John F. Bergstrom Phala A. Helm, M.D. James D. Bernd William E. LaMothe Pastora San Juan Cafferty Louis E. Levy Paul J. Collins Frank A. McPherson Claudio X. Gonzalez H. Blair White James G. Grosklaus By: /s/ O. George Everbach ------------------------------------ O. George Everbach, Attorney-in-Fact March 24, 1994 INDEPENDENT AUDITORS' REPORT Kimberly-Clark Corporation: We have audited the consolidated financial statements of Kimberly-Clark Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 28, 1994, which report includes an explanatory paragraph concerning the Corporation's changes in its methods of accounting for income taxes and postretirement benefits other than pensions to conform with Statements of Financial Accounting Standards No. 109 and No. 106, respectively; such consolidated financial statements and report are included in your 1993 Annual Report and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Kimberly-Clark Corporation, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche - --------------------- DELOITTE & TOUCHE Dallas, Texas January 28, 1994 SCHEDULE V Kimberly-Clark Corporation and Subsidiaries PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 (Millions of dollars) SCHEDULE V Kimberly-Clark Corporation and Subsidiaries PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Millions of dollars) SCHEDULE VI Kimberly-Clark Corporation and Subsidiaries ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) SCHEDULE VIII Kimberly-Clark Corporation and Subsidiaries VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) SCHEDULE IX Kimberly-Clark Corporation and Subsidiaries SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) INDEX TO DOCUMENTS FILED AS A PART OF THIS REPORT Description ----------- Consolidated financial statements, incorporated by reference Independent Auditors' Report, incorporated by reference Independent Auditors' Report Schedules for Kimberly-Clark Corporation and Subsidiaries: V Property, Plant and Equipment VI Accumulated Depreciation of Property, Plant and Equipment VIII Valuation and Qualifying Accounts IX Short-Term Borrowings Exhibit No.(3)a. Restated Certificate of Incorporation of Kimberly-Clark Corporation, dated April 16, 1987, incorporated by reference to Exhibit No. 4e. of the Kimberly-Clark Corporation Form S-8 filed on February 16, 1993 (File No. 33-58402) Exhibit No.(3)b. By-Laws of Kimberly-Clark Corporation, as amended April 22, 1993, incorporated by reference to Exhibit No.(3) of the Kimberly-Clark Corporation Form 10-Q for the quarterly period ended June 30, 1993 Exhibit No.(4). Copies of instruments defining the rights of holders of long-term debt will be furnished to the Securities and Exchange Commission on request Exhibit No.(10)a. Kimberly-Clark Corporation 1976 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No.(10)b. Kimberly-Clark Corporation Management Achievement Award Program, incorporated by reference to Exhibit No.(10)b. of Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1990 Exhibit No.(10)c. Kimberly-Clark Corporation Executive Severance Plan, incorporated by reference from the Kimberly- Clark Corporation Form 10-K for the year ended December 31, Index to Documents Filed as a Part of This Report (Continued) Description ----------- Exhibit No.(10)d. Second Amended and Restated Deferred Compensation Plan for Directors of Kimberly-Clark Corporation, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No.(10)e. Kimberly-Clark Corporation 1986 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No. (10)f. Kimberly-Clark Corporation 1992 Equity Participation Plan, incorporated by reference to Exhibit No. 4A. of the Kimberly-Clark Corporation Form S-8 filed on June 26, 1992 (File No. 33-49050) Exhibit No.(11). Statement re: computation of earnings per share Exhibit No.(12). Computation of ratio of earnings to fixed charges Exhibit No.(13). Portions of the Kimberly-Clark Corporation 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K Exhibit No.(21). Consolidated Subsidiaries and Equity Companies of Kimberly-Clark Corporation are identified in the 1993 Annual Report to Stockholders, and such information is incorporated in this Form 10-K by reference Exhibit No.(23). Independent Auditors' Consent Exhibit No.(24). Powers of Attorney	6,418	43,721
30554_1993.txt	30554_1993	1993	30554	ITEM 1. BUSINESS DuPont was founded in 1802 and was incorporated in Delaware in 1915. The company is the largest United States chemical producer and is one of the leading chemical producers worldwide. The company conducts fully integrated petroleum operations primarily through its wholly owned subsidiary Conoco Inc. and, in 1992, ranked eighth in the worldwide production of petroleum liquids by U.S.-based companies and tenth in the production of natural gas. Conoco Inc. and other subsidiaries and affiliates of DuPont conduct exploration, production, mining, manufacturing or selling activities, and some are distributors of products manufactured by the company. During 1993, the company significantly changed the way it was organized. Large business sectors were eliminated and replaced by approximately twenty strategic business units. Within the strategic business units approximately 85 businesses manufacture and sell a wide range of products to many different markets, including the energy, transportation, textile, construction, automotive, agricultural, printing, health care, packaging and electronics markets. The company and its subsidiaries have operations in about 70 nations worldwide and, as a result, about 45% of consolidated sales are derived from sales outside the United States, based on the location of the corporate unit making the sale. Total worldwide employment at year-end 1993 was about 114,000 people. The company is organized for financial reporting purposes into five principal industry segments--Chemicals, Fibers, Polymers, Petroleum, and Diversified Businesses. The following information describing the businesses of the company can be found on the indicated pages of Exhibit 13: - -------- * Exclude photograph and related caption on page 4. SOURCES OF SUPPLY The company utilizes numerous firms as well as internal sources to supply a wide range of raw materials, energy, supplies, services and equipment. To assure availability, the company maintains multiple sources for most raw materials, including hydrocarbon feedstocks, and for fuels. Large volume purchases are generally procured under competitively priced supply contracts. A majority of sales in the Chemicals, Fibers, and Polymers segments' businesses is dependent on hydrocarbon feedstocks derived from crude oil and natural gas. Current hydrocarbon feedstock requirements are met by Conoco and other major oil companies. A joint venture with OxyChem, a subsidiary of Occidental Petroleum Corporation, manufactures and supplies a significant portion of the company's requirements for ethylene glycol. A joint venture with subsidiaries of RWE AG supplies the company's requirements for coal. A significant portion of the company's caustic/chlorine needs is supplied by a joint venture with Olin Corporation. The major purchased commodities, raw materials, and supplies for the following industry segments in 1993 are listed below: In the Petroleum segment, the major commodities and raw materials purchased are the same as those produced. Approximately 59% of the crude oil processed in the company's U.S. refineries in 1993 came from U.S. sources. In 1993, the company's refineries outside the United States processed principally North Sea and Middle East crude oils. In addition, during 1993, the company consumed substantial amounts of electricity and natural gas. PATENTS AND TRADEMARKS The company owns and is licensed under various patents, which expire from time to time, covering many products, processes and product uses. No individual patent is of material importance to any of the industry segments, although taken as a whole, the rights of the company and the products made and sold under patents and licenses are important to the company's business. During 1993, the company was granted 591 U.S. and 1,828 non-U.S. patents. The company also has about 900 registered trademarks for its products. Ownership rights in trademarks continue indefinitely if the trademarks are continued in use and properly protected. SEASONALITY In general, sales of the company's products are not substantially affected by seasonality. However, the Diversified Businesses segment is impacted by seasonality of sales of agricultural products with highest sales in the first half of the year, particularly the second quarter. Within the Petroleum segment, the mix of refined products, natural gas and natural gas liquids varies because of increased demand for gasoline in the summer months and natural gas, heating oil and propane during the winter months. MAJOR CUSTOMERS The company's sales are not materially dependent on a single customer or small group of customers. The Fibers and Polymers segments, however, have several large customers in their respective industries that are important to these segments' operating results. COMPETITION Principal competitors in the chemical industry include major chemical companies based in the United States, Europe, Japan, the Republic of China and other Asian nations. Competitors offer a comparable range of products from agricultural, commodity and specialty chemicals to plastics, fibers and medical products. The company also competes in certain product markets with smaller, more specialized firms. Principal competitors in the petroleum industry are integrated oil companies, many of which also have substantial petrochemical operations, and a variety of other firms including independent oil and gas producers, pipeline companies, and large and small refiners and marketers. In addition, the company competes with the growing petrochemical operations in oil-producing countries. Businesses in the Chemicals, Fibers, Polymers, and Diversified Businesses segments compete on a variety of factors such as price, product quality or specifications, customer service and breadth of product line, depending on the characteristics of the particular market involved. The Petroleum segment business is highly price-competitive and competes as well on quality and reliability of supply. Further information relating to competition is included in two areas of Exhibit 13 (1) the "Letter to Stockholders" on pages 2, 4, 5, 7 and (2) Industry Segment Reviews on pages 20-28. RESEARCH AND DEVELOPMENT The company's substantial research and development activities are primarily funded with internal resources and conducted at over 60 domestic sites in 21 states at both dedicated research facilities and manufacturing plants. DuPont operates several large research centers near Wilmington, Delaware supporting strategic business units in its Chemicals, Fibers, Polymers and Diversified Businesses segments. Among these, the Experimental Station laboratories engage in fundamental, exploratory and applied research, and the Stine-Haskell Research Center conducts agricultural product research and toxicological research of company products to assure they are safe for manufacture and use. At its facility in Ponca City, Oklahoma, the company conducts research for new products and technologies for petroleum operations as well as other segments of the business. DuPont also operates research facilities at a number of locations outside the United States in Belgium, Canada, France, Germany, Japan, Luxembourg, Mexico, Netherlands, Switzerland and the United Kingdom reflecting the company's growing global business interests. Research and development activities include exploratory studies to advance scientific knowledge in fields of interest to the company; basic and applied work to support and improve existing products and processes; and scouting work to identify and develop new business opportunities in relevant fields. Each strategic business unit of the company funds research and development activities to support its business mission. The corporate laboratories are responsible for assuring that leading-edge science and engineering concepts are identified and diffused throughout the DuPont technical community. All R&D activities are coordinated by senior R&D management to insure that business and corporate technical activities are integrated and that the core technical competencies underlying DuPont's current and future businesses remain healthy and continue to provide competitive advantages. Further information regarding research and development is in Exhibit 13 on page 4 of the "Letter to Stockholders." Annual research and development expense and such expense shown "As Percent of Combined Segment Sales" for the five years 1989 through 1993 are included under the heading "General" of the Five- Year Financial Review on page 65 of Exhibit 13. - -------- Exclude photograph and related caption on page 4. ENVIRONMENTAL MATTERS Information relating to environmental matters is included in two areas of Exhibit 13 (1) the "Letter to Stockholders" on page 5 and (2) "Management's Discussion and Analysis" on pages 33-34. RISKS ATTENDANT TO FOREIGN OPERATIONS The company's petroleum exploration and production operations outside the United States are exposed to risks due to possible actions by host governments such as increases or variations in tax and royalty payments, participation in the company's concessions, limited or embargoed production, mandatory exploration or production controls, nationalization, and export controls. Civil unrest and changes in government are also potential hazards. Under certain circumstances, the company has attempted to minimize its exposure by carrying political risk insurance. The profitability of the company's worldwide exploration and production operations is also exposed to risks due to actions of the United States government through tax legislation, executive order, and commercial restrictions. Actions by both the United States and host governments have affected operations significantly in the past, and may continue to impact operations in the future. ITEM 2. ITEM 2. PROPERTIES The company owns and operates manufacturing, processing, production, refining, marketing, research and development facilities worldwide. In addition, the company owns and leases petroleum properties worldwide. DuPont's corporate headquarters is located in Wilmington, Delaware, and the company's petroleum businesses are headquartered in Houston, Texas. In addition, the company operates sales offices, regional purchasing offices, distribution centers and various other specialized service locations. Further information regarding properties is included in Exhibit 13 in the Industry Segment Reviews on pages 20-28. Information regarding research and development facilities is incorporated by reference to Item 1, Business-- Research and Development on page 5 of this report. Additional information with respect to the company's property, plant and equipment, and leases is incorporated by reference to Schedules V and VI on pages 20-22 of this report, and is contained in Notes 14 and 21 to the company's consolidated financial statements on pages 46 and 50 of Exhibit 13. CHEMICALS, FIBERS, POLYMERS, AND DIVERSIFIED BUSINESSES Approximately 75% of the property, plant and equipment related to operations in the Chemicals, Fibers, Polymers, and Diversified Businesses is located in the United States and Puerto Rico. This investment is located at some 85 sites, principally in Texas, Delaware, Virginia, North Carolina, Tennessee, West Virginia, South Carolina, and New Jersey. The principal locations within these states are as follows: Property, plant and equipment outside the United States and Puerto Rico is located at about 70 sites, principally in Canada, the United Kingdom, Germany, Netherlands, Luxembourg, Singapore, Taiwan, Mexico, France, Japan, Spain, Brazil, Republic of Korea, Argentina and Belgium. Products from more than one business are frequently produced at the same location. The company's plants and equipment are well maintained and in good operating condition. Sales as a percent of capacity were 85% in 1993, 88% in 1992, and 86% in 1991. These properties are directly owned by the company except for some auxiliary facilities and miscellaneous properties, such as certain buildings and transportation equipment, which are leased. Although no title examination of the properties has been made for the purpose of this report, the company knows of no material defects in title to any of these properties. PETROLEUM BUSINESSES The company owns and leases oil and gas properties worldwide. Exploration, production, and natural gas and gas products properties are described generally on pages 24-26 and 58-63 of Exhibit 13. Estimated proved reserves of oil and gas are found on page 58 of Exhibit 13. Information regarding the company's refining, marketing, supply, and transportation properties is also provided on pages 24-26 of Exhibit 13. PETROLEUM PRODUCTION The following tables show the company's interests in petroleum production and natural gas deliveries. Petroleum liquids production comprises crude oil and condensate and natural gas liquids (NGL) removed for the company's account from its natural gas deliveries. Natural gas deliveries represent Conoco's share of deliveries from leases in which the company has an ownership interest. NGL's extracted from purchased natural gas by the company's gas processing plants are discussed under the topic "Natural Gas and Gas Products" on pages 9 and 10. AVERAGE PRODUCTION COSTS AND SALES PRICES The following table presents data as prescribed by the Securities and Exchange Commission (SEC). Accordingly, the unit costs do not include income taxes and exploration, development and general overhead costs. Since these excluded costs are material, the following data should not be interpreted as measures of profitability or relative profitability. See Results of Operations for Oil- and Gas-Producing Activities on page 59 of Exhibit 13 for a more complete disclosure of revenues and expenses. See also the references to crude oil and natural gas prices and volumes in business review of the Petroleum segment on pages 24-26 of Exhibit 13. - -------- (a) Average production costs per barrel of equivalent liquids, with natural gas converted to liquids at a ratio of 6 MCF of gas to one barrel of liquids. (b) Excludes proceeds from sales of interest in oil and gas properties. PRESENT ACTIVITIES - -------- Includes wells being completed. Approximately 186 gross (72 net) oil wells and 602 gross (177 net) gas wells, all in the United States, have multiple completions. DEVELOPED AND UNDEVELOPED PETROLEUM ACREAGE ESTIMATES OF TOTAL PROVED RESERVES FILED WITH OTHER FEDERAL AGENCIES COVERING THE YEAR 1993 The company is not required to file, and has not filed on a recurring basis, estimates of its total proved net oil and gas reserves with any U.S. or non- U.S. governmental regulatory authority or agency other than the Department of Energy (DOE) and the SEC. The estimates furnished to the DOE have been consistent with those furnished to the SEC. They are not necessarily directly comparable, however, due to special DOE reporting requirements such as requirements to report in some instances on a gross, net or total operator basis, and requirements to report in terms of smaller units. In no instance have the estimates for the DOE differed by more than 5% from the corresponding estimates reflected in total reserves reported to the SEC. NATURAL GAS AND GAS PRODUCTS The company has interests in 30 natural gas processing plants in the United States. Natural gas liquids extracted for the company's account from produced and purchased gas averaged 68,631 barrels per day in 1993 and 60,901 barrels per day in 1992. The company operates 16 of the gas plants: 1 in Colorado, 3 in Louisiana, 2 in New Mexico, 4 in Oklahoma, and 6 in Texas. Other natural gas facilities include an 800-mile intrastate natural gas pipeline system in Louisiana, owned by Louisiana Gas System, Inc., a wholly owned subsidiary, and natural gas and natural gas liquids pipelines in several states. C&L Processors Partnership, a 50% owned equity affiliate, has an additional 13 natural gas liquids plants in Oklahoma and Texas, and Conoco's pro rata share of NGL production is 7,885 barrels per day. In May 1993, Conoco acquired a 22.5% interest in Gulf Coast Fractionators, a natural gas fractionator located in Mt. Belvieu, Texas, which is currently expanding from a capacity of 64,000 barrels per day to 104,000 barrels per day. Outside the United States, the company operates a 50% owned gas processing facility at Theddlethorpe, England, and owns a 41% interest in Phoenix Park Gas Processors, whose gas processing facility at Point Lisas, Trinidad, provided a net NGL production of 3,661 barrels per day to Conoco in 1993. REFINING The company currently owns and operates four refineries in the United States located at Lake Charles, Louisiana; Ponca City, Oklahoma; Billings, Montana; and Denver, Colorado. The company also owns and operates the Humber refinery in the United Kingdom and has a 25% interest in a refinery at Karlsruhe in Germany. Capacities at year-end 1993 as well as inputs processed during 1993 are summarized in the following table: - -------- Represents 25% interest in the Karlsruhe refinery. Utilization of refinery capacity depends on the market demand for petroleum products and the availability of crude oil and other feedstocks. MARKETING In the United States, the company sells refined products at retail in 38 states, principally under the "Conoco" brand. In addition, the company markets a wide range of products other than at retail in all 50 states and the District of Columbia. Refined products are also sold in Austria, Germany and the United Kingdom under the "Jet" and "Conoco" brands; in Belgium, France and Luxembourg under the "Seca" brand; and in Switzerland under the "OK Coop" brand. The "Jet" brand is used for marketing in the Czech Republic, Denmark, Finland, Hungary, Ireland, Norway, Poland, Sweden, and Thailand. The company has commenced operations in Spain through a 50% equity affiliate. SUPPLY AND TRANSPORTATION The company has an extensive pipeline system for crude oil and refined products. Information concerning daily pipeline shipments is presented below: Conoco Pipe Line Company (CPL), a wholly owned subsidiary and operator of the company's U.S. petroleum pipeline system, transported approximately 722 thousand barrels per day of crude oil and refined products in 1993. In addition to pipeline facilities, CPL operates, under a management contract, four marine terminals, one coke-exporting facility and 52 product terminals located throughout the United States. These facilities are wholly or jointly owned by the company. Crude oil is gathered in the Rocky Mountain, mid-continent and southern Louisiana areas primarily for delivery to local refiners. Refined products pipelines are located in the Rocky Mountain and mid-continent areas to serve regional demand centers. Other U.S. transportation assets include numerous tank cars, barges, tank trucks and other motor vehicles. The company also operates a fleet of seagoing crude oil tankers. These vessels, principally of Liberian registry, are described as follows: ITEM 3. ITEM 3. LEGAL PROCEEDINGS Because of the size and nature of its business, the company is subject to numerous lawsuits and claims with respect to such matters as product liabilities, governmental regulations and other actions arising out of the normal course of business. While the effect on future financial results is not subject to reasonable estimation because considerable uncertainty exists, in the opinion of company counsel, the ultimate liabilities resulting from such lawsuits and claims will not materially affect the consolidated financial position of the company. To date, DuPont has been served with more than 500 lawsuits in several jurisdictions, principally Florida, Hawaii and Puerto Rico, by growers who allege plant damage from using "Benlate" DF 50 fungicide. Seventy (70) of these suits have been disposed of: 12 by dismissal, 3 by summary judgment, 52 by settlement, 1 by directed verdict in DuPont's favor at trial, and 2 by jury verdict in DuPont's favor. Additionally, DuPont obtained summary judgment in 7 Florida cases, based on the economic loss doctrine which limits damages to breach of warranty. In our most recent trial (2 cases), a Florida jury returned a verdict in DuPont's favor. In 5 other trials, jury verdicts have been returned against DuPont, but for an average of less than a third of the compensatory damages claimed by the plaintiffs. In 4 of these trials, the juries also allocated liability to the plaintiffs. DuPont has appealed these jury verdicts. DuPont also had one jury verdict for the company. DuPont believes that "Benlate" DF 50 fungicide did not cause the alleged damages. DuPont had earlier paid claims based on the belief that, at the time, "Benlate" DF 50 would be found to be a contributor to the reported plant damage. In 1992, after eighteen months of extensive research, DuPont scientists concluded that "Benlate" DF 50 was not responsible for plant damage reports received since March 1991. Concurrent with these research findings, DuPont stopped paying claims relating to those reports. Since 1989, DuPont has been served with approximately fifty-two, lawsuits in several jurisdictions, principally in Texas, Florida, Maryland and Arizona alleging damages as a result of leaks in certain polybutylene plumbing systems. A nationwide class action has been filed in state and federal court in Houston, Texas, but the class has not been certified as of this date. In most cases, DuPont is a codefendant with Shell, Hoechst-Celanese and other parts manufacturers. The polybutylene plumbing systems consist of flexible pipe extruded from polybutylene connected by plastic fittings made from acetal. Shell Chemical is the sole producer of polybutylene; the acetals are provided by Hoechst-Celanese and DuPont. DuPont entered the market in 1983, and it is not known as to the number of commercial or dwelling units that have polybutylene plumbing systems, or the number of commercial or dwelling units that have DuPont's product in their plumbing systems. Presently, DuPont is active in twenty-four suits. There have been twenty-four lawsuits of which the company has disposed of twenty-three by pretrial settlements and one by dismissal. DuPont has not been to trial in any case. On October 24, 1988, the Louisiana Department of Environmental Quality (LDEQ) issued a Compliance Order and Notice of Proposed Penalty to Conoco Inc. for alleged violations of the Louisiana Hazardous Waste Regulations. Following an inspection, LDEQ proposed a penalty of $165,000 for alleged violations related to the handling of by-product caustic and other refinery waste management practices. The company's legal counsel believes that the allegations are generally without factual basis, and that the penalty will be significantly reduced. On April 3, 1991, the Environmental Protection Agency (EPA) assessed a civil penalty of $1.3 million pursuant to a Complaint and Notice of Hearing alleging violations of the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA) in connection with the distribution of a company fungicide. The allegations arise out of the discovery that a herbicide may have been introduced inadvertently into some batches of the fungicide during formulation at contractor sites in 1988 and 1989. The company was made aware of the potential problem by complaints from growers and notified EPA in August 1989 that it was undertaking a voluntary recall of suspect batches. EPA issued a stop sale order in September 1989 accompanied by a formal request for a product recall. The company has reviewed its recall with EPA and they have expressed satisfaction with the company's efforts. The company intends to seek a settlement of the Complaint and expects that the assessed penalty will be reduced. On October 15, 1993, EPA filed a complaint in the U.S. District Court, Eastern District of Texas (Beaumont), against DuPont alleging various violations of the Clean Water Act at the Sabine River Works. Included are alleged unauthorized discharges, effluent limitation violations, and monitoring and reporting violations under the plant's NPDES permit. The government is seeking a civil penalty of $1.4 million. DuPont's legal counsel believes that most of the allegations are legally without merit and that the case will ultimately settle for a significantly smaller amount. DuPont has entered into a voluntary agreement with the EPA to conduct an audit of the U.S. sites under the Toxic Substance Control Act (TSCA). Agreement participation is not an admission of TSCA noncompliance. Maximum stipulated penalties which DuPont could pay under the agreement are capped at $1 million. The first phase of the audit was completed, but no findings have been issued. Subject to EPA's issuance of new reporting criteria, the second phase of its audit is scheduled to begin in mid-1994. On October 18, 1991, EPA issued an Administrative Order under the Resource Conservation and Recovery Act (RCRA) directing Conoco Pipe Line Company (CPLC) to undertake specific remedial measures related to a former oil reprocessing facility in Converse County, Wyoming. CPLC contested the Administrative Order, and has taken voluntary measures at the site together with other interested parties. On February 19, 1993, the U.S. Department of Justice (DOJ) filed a lawsuit against 10 entities, including CPLC, to enforce the Order and collect penalties. The DOJ calculates CPLC's maximum penalties as of April 1, 1993 at approximately $2.6 million. The lawsuit is in the discovery phase, and CPLC intends to vigorously defend this matter. On July 1, 1993, EPA filed an administrative complaint against DuPont. EPA alleged that DuPont violated the premanufacturing notification regulations of the U.S. Toxic Substances Control Act (TSCA) and sought a $158,375 penalty. DuPont and EPA have signed an agreement to settle the complaint. Under the settlement, DuPont paid EPA $80,000, but did not admit that EPA's legal conclusions were true. On December 21, 1993, Conoco's Denver Refinery received a Notice of Violation from EPA, Region VIII, and the Colorado Department of Health requesting a civil penalty of $169,500 in a dispute over proper scope and scheduling of certain RCRA on-site investigation activities. The investigation activities have previously been the subject of a settlement with EPA and the Colorado Department of Health, and the work performed has been in compliance with such agreement in the opinion of company counsel. As such, it is anticipated that the fine will be significantly reduced pursuant to negotiations between the parties. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list, as of March 1, 1994, of the company's executive officers. - -------- (1) Member of the Board of Directors. The Company's executive officers are elected or appointed for the ensuing year or for an indefinite term, and until their successors are elected or appointed. Each officer named above has been an officer or an executive of DuPont or its subsidiaries during the past five years. PART II Information with respect to the following Items can be found on the indicated pages of Exhibit 13 if not otherwise included herein. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock is listed on the New York Stock Exchange, Inc. (symbol DD) and certain non-U.S. exchanges. The number of record holders of common stock was 181,264 at December 31, 1993 and 179,171 at March 1, 1994. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - -------- * Exclude photograph and related caption on page 4. PART III Information with respect to the following Items is incorporated by reference to the pages indicated in the company's 1994 Annual Meeting Proxy Statement dated March 18, 1994, filed in connection with the Annual Meeting of Stockholders to be held April 27, 1994. However, information regarding executive officers is contained in Part I of this report (page 13) pursuant to General Instruction G of this form. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements, Financial Statement Schedules and Exhibits 1. Financial Statements (See listing at Part II, Item 8 of this report regarding financial statements, which are incorporated by reference to Exhibit 13.) 2. Financial Statement Schedules The following should be read in conjunction with the previously referenced Financial Statements: Financial Statement Schedules listed under SEC rules but not included in this report are omitted because: a) they are not applicable; b) they are not required under the provisions of Regulation S-X; or c) the required information is shown in the financial statements or notes thereto incorporated by reference. Condensed financial information of the parent company is omitted because restricted net assets of consolidated subsidiaries do not exceed 25% of consolidated net assets. Footnote disclosure of restrictions on the ability of subsidiaries and affiliates to transfer funds is omitted because the restricted net assets of subsidiaries combined with the company's equity in the undistributed earnings of affiliated companies does not exceed 25% of consolidated net assets at December 31, 1993. Separate financial statements of affiliated companies accounted for by the equity method are omitted because no such affiliate individually constitutes a 20% significant subsidiary. 3. EXHIBITS The following list of exhibits includes both exhibits submitted with this Form 10-K as filed with the SEC and those incorporated by reference to other filings: - -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K. (b) Reports on Form 8-K The following Current Report on Form 8-K was filed during the quarter ended December 31, 1993. (1) On October 27, 1993, a Current Report on Form 8-K was filed in connection with Debt Securities that may be offered on a delayed or continuous basis under its Registration Statements on Form S-3 (No. 33- 39161 and No. 33-48128). Under Item 7, "Financial Statements and Exhibits," the Registrant's Earnings Press Release, dated October 27, 1993 was filed. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED AND IN THE CAPACITIES INDICATED, ON THE 18TH DAY OF MARCH, 1994. E. I. DU PONT DE NEMOURS AND COMPANY (Registrant) C. L. Henry By______________________________________ C. L. HENRY SENIOR VICE PRESIDENT--DUPONT FINANCE (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED ON THE 18TH DAY OF MARCH 1994, BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT IN THE CAPACITIES INDICATED: CHAIRMAN AND DIRECTOR (PRINCIPAL EXECUTIVE OFFICER): E. S. Woolard, Jr. - ------------------------- E. S. WOOLARD, JR. VICE CHAIRMAN AND VICE CHAIRMAN AND DIRECTOR: DIRECTOR: J. A. Krol C. S. Nicandros - ------------------------- ------------------------- J. A. KROL C. S. NICANDROS DIRECTORS: P. N. Barnevik L. C. Duemling M. P. MacKimm - ------------------------- ------------------------- ------------------------- P. N. BARNEVIK L. C. DUEMLING M. P. MACKIMM E. P. Blanchard, Jr. E. B. Du Pont W. K. Reilly - ------------------------- ------------------------- ------------------------- E. P. BLANCHARD, JR. E. B. DU PONT W. K. REILLY A. F. Brimmer C. M. Harper H. R. Sharp, III - ------------------------- ------------------------- ------------------------- A F. BRIMMER C. M. HARPER H. R. SHARP, III C. R. Bronfman R. E. Heckert C. M. Vest - ------------------------- ------------------------- ------------------------- C. R. BRONFMAN R. E. HECKERT C. M. VEST E. M. Bronfman H. W. Johnson J. L. Weinberg - ------------------------- ------------------------- ------------------------- E. M. BRONFMAN H. W. JOHNSON J. L. WEINBERG E. Bronfman, Jr. E. L. Kolber - ------------------------- ------------------------- E. BRONFMAN, JR. E. L. KOLBER REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and the Board of Directors of E. I. du Pont de Nemours and Company Our audits of the consolidated financial statements referred to in our report dated February 17, 1994 appearing on page 36 of the 1993 Annual Report to Stockholders of E. I. du Pont de Nemours and Company, (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 February 17, 1994 E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT(a) FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- See page 22 for footnotes. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT(a) FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- See page 22 for footnotes. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES (DOLLARS IN MILLIONS) SCHEDULE V--FOOTNOTES (a) See Property, Plant and Equipment (PP&E) in Note 1 to the company's Consolidated Financial Statements on page 41 of Exhibit 13 for accounting policy with respect to certain additions and retirements. (b) Principally reflects intersegment transfers. In addition, 1991 reflects restructuring of the coal business described in Note 6 on page 43 of Exhibit 13. SCHEDULE VI--FOOTNOTES (a) See Property, Plant and Equipment in Note 1 to the company's Consolidated Financial Statements on page 41 of Exhibit 13 for accounting policy with respect to the methods and rates used for depreciation, depletion and amortization. (b) The following reconciles the amounts shown herein as Additions Charged to Cost and Expenses and the amounts shown as Depreciation, Depletion and Amortization in the Consolidated Income Statement on page 37 of Exhibit 13. (c) Principally reflects intersegment transfers. In addition, 1991 reflects restructuring the coal business described in Note 6 on page 43 of Exhibit 13. E.I DUPONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993 (DOLLARS IN MILLIONS) - -------- Note: Columns D, E and G have been omitted as the answers thereto were "none." (a) The annual aggregate amount of interest guaranteed is approximately $22. (b) DuPont has received a cross-guarantee for 50% of this amount from another party. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (a) Indicated interest rates exclude the effect of interest rate swap agreements that effectively convert floating rate borrowings to fixed rate borrowings. (b) Based on month-end data, except for commercial paper and master notes which are based on daily data, and certain non-U.S. subsidiary bank borrowings which are based on quarterly data. (c) Unsecured promissory notes with maturities not in excess of 270 days. (d) Includes 1,173 million Norwegian Krone borrowings (U.S. $158) with an average interest rate of 5.9%. (e) Average interest rates include the effect of borrowings in certain currencies where local inflation has resulted in relatively high interest rates. (f) Master notes were issued to U.S. banks and are payable on demand. (g) Includes $157 with a floating money market based interest rate. (h) Includes 200 million Australian dollar borrowings (U.S. $140) with a floating money market based interest rate. (i) Interest rates include the effect of a subsidiary's 0% interest export incentive financing. E. I. DU PONT DE NEMOURS AND COMPANY INDEX OF EXHIBITS - -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K.	5,586	36,794
814135_1993.txt	814135_1993	1993	814135	ITEM 1. BUSINESS. BACKGROUND Viacom International Inc. (the "Company") is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. Viacom Networks operates three advertiser-supported basic cable television program services, MTV: MUSIC TELEVISION(R), including MTV EUROPE(TM) and MTV LATINO(TM), VH-1(R)/VIDEO HITS ONE(R), and NICKELODEON(R)/NICK AT NITE(R), and three premium subscription television program services, SHOWTIME(R), THE MOVIE CHANNEL(TM) and FLIX(TM). The Company, directly and through Viacom Networks, participates as a joint venturer in four additional advertiser- supported basic cable program services: LIFETIME(R), COMEDY CENTRAL(TM), NICKELODEON (TM) (U.K.), and ALL NEWS CHANNEL(TM). On March 29, 1994, the Company agreed to sell its one-third partnership interest in LIFETIME to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. Viacom Entertainment distributes television series, feature films, made-for-television movies, mini-series and specials for television exhibition in domestic and international markets, produces television series and movies for prime time broadcast network television, acquires and distributes television series for initial exhibition on a "first run" basis, and develops, produces, distributes and markets interactive software for the stand-alone and other multimedia marketplaces. Viacom Cable Television owns and operates cable television systems in California, and the Pacific Northwest and Midwest regions of the United States. Viacom Broadcasting owns and operates five network-affiliated television stations and fourteen radio stations. Viacom International Inc. was originally organized in Delaware in August 1970 as a wholly owned subsidiary of CBS Inc., and was reincorporated in Ohio in 1975 (the "Predecessor Company"). On June 9, 1987, the Predecessor Company became an indirect wholly owned subsidiary of Viacom Inc. in a leveraged buyout pursuant to a merger (the "Merger") of a subsidiary of Viacom Inc. into the Predecessor Company, which was the surviving corporation. On April 26, 1990, pursuant to a plan of liquidation, the Predecessor Company merged into a direct wholly owned subsidiary of Viacom Inc., and the surviving Delaware corporation simultaneously changed its name to "Viacom International Inc." All references herein to the term "Company" refer, unless the context otherwise requires, to Viacom International Inc., its consolidated subsidiaries and the Predecessor Company. The Company's principal offices are located at 1515 Broadway, New York, New York 10036 (telephone (212) 258-6000). Viacom Inc. was organized in Delaware in 1986 for the purpose of acquiring the Company. As of December 31, 1993, National Amusements, Inc. ("NAI"), a closely held corporation that owns and operates approximately 850 movie screens in the United States and the United I - 1 Kingdom, owned 45,547,214 shares or 85.2% of the Class A Common Stock ("Class A Common Stock"), and 46,565,414 shares or 69.1% of the Class B Common Stock ("Class B Common Stock") outstanding on such date. NAI is not subject to the informational filing requirements of the Securities Exchange Act of 1934, as amended. Sumner M. Redstone, the controlling shareholder of NAI, is the Chairman of the Board of Viacom Inc. and the Company. As of December 31, 1993, the principal asset of Viacom Inc. (together with its subsidiaries, unless the context otherwise requires, "Viacom Inc.") was the common stock of the Company. Viacom Inc.'s principal executive offices are located at 200 Elm Street, Dedham, Massachusetts 02026. As of December 31, 1993, the Company and its affiliated companies employed approximately 5,000 persons. On March 11, 1994, pursuant to a tender offer (the "Paramount Offer") commenced in the fourth quarter of 1993, Viacom Inc. acquired 61,657,432 shares of Paramount Communications Inc. ("Paramount") common stock constituting a majority of the shares outstanding. The Paramount Offer was made pursuant to an Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. As a result of the Paramount Merger Agreement, a new wholly owned subsidiary of Viacom Inc. will merge with and into Paramount (the "Paramount Merger"), and Paramount will become a wholly owned subsidiary of Viacom Inc. after the effective time of the Paramount Merger, which is expected to occur in the second quarter of 1994. Except where expressly noted, information is given as of December 31, 1993, and does not include information on or with respect to Paramount or its businesses. Information with respect to Paramount in response to Item 1 is incorporated by reference herein from (i) Item 1 of Paramount's Transition Report on Form 10-K for the six-month period ended April 30, 1993, as such report was amended in its entirety by Form 10-K/A No. 1 dated September 28, 1993, as further amended by Form 10-K/A No. 2 dated September 30, 1993 and as further amended by Form 10-K/A No. 3 dated March 21, 1994 and (ii) Paramount's Quarterly Reports on Form 10-Q for the quarters ended July 31, 1993, October 31, 1993 and January 31, 1994 (the documents in clauses (i) and (ii) being hereinafter collectively referred to as the "Paramount Reports"). Information in the Paramount Reports is given as of the date of each such report and is not updated herein. A copy of each of the Paramount Reports is included as an exhibit hereto. Descriptions of all documents incorporated by reference herein or included as exhibits hereto are qualified in their entirety by reference to the full text of such documents so incorporated or included. The businesses of Paramount are entertainment and publishing. Entertainment includes the production, financing and distribution of motion pictures, television programming and prerecorded videocassettes, and the operation of motion picture theaters, independent television stations, regional theme parks and Madison Square Garden. Publishing includes the publication and distribution of hard cover and paperback books for the general public, textbooks for elementary schools, high schools and colleges, and the provision of information services for business and professions. On January 7, 1994, Viacom Inc. and Blockbuster Entertainment I - 2 Corporation ("Blockbuster") entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger"). Blockbuster is an international entertainment company with businesses operating in the home video, music retailing and filmed entertainment industries. Blockbuster also has investments in other entertainment related businesses. The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. holds sufficient shares of Paramount common stock to approve, on behalf of Paramount, the Paramount Merger and intends to vote its shares of Paramount in favor of the merger, and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The contribution to revenues and earnings from operations of each industry segment and the identifiable assets attributable to each industry segment for each of the last three years ending December 31, are set forth in Note 12 ("Business Segments") to the Consolidated Financial Statements of Viacom Inc. and the Company included elsewhere herein. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS Financial information relating to foreign and domestic operations for each of the last three years ending December 31, is set forth in Notes 11 and 12 ("Foreign Operations" and "Business Segments") to the Consolidated Financial Statements of Viacom Inc. and the Company included elsewhere herein. BUSINESS VIACOM NETWORKS Viacom Networks operates three advertiser-supported basic cable television program services, MTV: MUSIC TELEVISION(R) ("MTV"), including MTV EUROPE(TM) and MTV LATINO(TM), VH-1(R)/VIDEO HITS ONE(R) ("VH-1") and NICKELODEON(R)/NICK AT NITE(R), and three premium subscription television program services, SHOWTIME(R), THE MOVIE CHANNEL(TM) and FLIX(TM). The Company, directly and through Viacom Networks, participates as a joint venturer in four additional advertiser-supported basic cable program services: LIFETIME(R) with The Hearst Corporation and Capital Cities/ABC Video Enterprises, Inc., COMEDY CENTRAL(TM) with Home Box Office ("HBO"), a division of Time Warner Entertainment Company, L.P., NICKELODEON(TM)(U.K.) with a subsidiary of British Sky Broadcasting Limited, and ALL NEWS I - 3 CHANNEL(TM) with Conus Communications. On March 29, 1994, the Company agreed to sell its one-third partnership interest in Lifetime to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. MTV Networks launched two new services in 1993, NICKELODEON (U.K.) in September and MTV LATINO in October. Viacom Networks also distributes special events and feature films on a pay-per-view basis through SET(TM) PAY PER VIEW and packages satellite-delivered program services for distribution to home satellite dish owners through SHOWTIME SATELLITE NETWORKS(TM). Viacom Networks, through its operation of the Showtime Entertainment Group, also arranges for the development and production of original programs and motion pictures, including feature films under the Viacom Pictures label. These original programs and motion pictures premiere domestically on SHOWTIME and certain of such programming is exploited in various media worldwide. Basic cable program services derive revenues primarily from two sources: the sale of advertising time to national advertisers and per-subscriber license fees paid by cable operators and other distributors. Basic cable services are generally offered to customers of cable television operators and other distributors as part of a package or packages of services for a periodic subscription fee. Premium subscription television program services derive revenues primarily from subscriber fees paid by cable television operators and other distributors. Subscribers typically pay fees for each premium service to cable television operators and other distributors. MTV NETWORKS. MTV Networks ("MTVN") operates MTV: MUSIC TELEVISION, MTV EUROPE, MTV LATINO, NICKELODEON (including the NICKELODEON and NICK AT NITE program segments, and the U.K. NICKELODEON network) and VH-1 which are transmitted via satellite for distribution by cable television operators and other distributors. The MTV, VH-1, NICKELODEON and NICK AT NITE trademarks are strongly identified with the product lines they represent and are significant assets of their respective businesses. MTV: MUSIC TELEVISION is a 24-hours-a-day, seven-days-a-week program service offering a format which consists primarily of rock music videos, augmented by music and general lifestyle information, promotions, news, interviews, comedy, concert tour information, specials, documentaries and other youth-oriented programming. MTV targets young adult viewers from the ages of 12 to 34. In addition to rock music videos, MTV offers regularly scheduled youth-oriented programming such as the animated BEAVIS & BUTT-HEAD(TM), specials such as the Annual MTV Video Music Awards and the MTV Movie Awards, public affairs campaigns, and series such as UNPLUGGED(TM). MTV successfully merchandised BEAVIS & BUTT-HEAD in 1993, featuring a BEAVIS & BUTT- HEAD album, "THE BEAVIS & BUTT-HEAD EXPERIENCE", released in December 1993 by Geffen Records, and "MTV'S BEAVIS & BUTT-HEAD: THIS BOOK SUCKS", which was the first book of the MTV Books imprint published by Callaway Editions/Pocket Books, a division of Simon & Schuster, in November 1993. Following the conclusion of MTV's 1992 CHOOSE OR LOSE political awareness campaign and continuing its emphasis on public affairs, MTV launched the FREE YOUR MIND campaign in 1993, focusing on issues of diversity and discrimination, which included on-air promotional spots, news reports and specials and contests. I - 4 UNPLUGGED features live acoustical performances by major recording artists such as Eric Clapton, Rod Stewart and 10,000 Maniacs. MTV licenses the distribution of UNPLUGGED home video versions of these performances, and MTV and the applicable record labels release the soundtracks to MTV's UNPLUGGED series. MTV Productions made its first venture into theatrical film-making by agreeing with Geffen Pictures in 1993 to jointly develop JOE'S APARTMENT into a feature-length film for distribution by Warner Bros. JOE'S APARTMENT is the award-winning short film about a young man's efforts to cope with a big dirty city and a tiny apartment full of talking cockroaches. At December 31, 1993, MTV was licensed to approximately 52.2 million domestic cable subscribers (based on subscriber counts provided by each cable system). According to the December 1993 sample reports issued by the A. C. Nielsen Company (the "Nielsen Report"), MTV reached approximately 59 million subscriber households. MTV EUROPE is a 24-hours-a-day, seven-days-a-week video music network distributed via cable systems and direct-to-home satellite transmission throughout Europe, reaching over 58.3 million subscribers as of December 31, 1993 (based on subscriber counts provided by each distributor of the service). During 1993, MTV EUROPE expanded its reach by entering into distribution arrangements in certain countries in Eastern Europe, the former Soviet Union and the Middle East. MTV EUROPE is designed to communicate with Europe's youth in their language by providing approximately 85% European-sourced youth programming, including music videos, fashion, movie shows, MTV NEWS, trends and social issues. In October 1993, MTVN launched MTV LATINO, a 24-hours-a-day, seven-days-a-week music-based program service customized for Spanish- speaking viewers, ages 12 to 34, in Latin America and the United States. MTV LATINO reaches subscribers to cable, multichannel, multidistribution systems ("MMDS"), satellite master antenna television ("SMATV") and direct-to-home viewers in approximately 20 territories in Latin America. MTV LATINO was distributed to approximately 2.4 million subscribers as of December 31, 1993 (based on subscriber counts provided by authorized distributors). MTVN has licensing arrangements covering the distribution of regionally-specific program services called MTV: MUSIC TELEVISION in Asia, Japan and Brazil. MTVN provides creative input and programming, production, marketing and research expertise and support in connection with licenses to each such licensee of the right to package and exhibit a customized MTV program service containing MTV trademarks and logos and a mix of MTV-owned and controlled programming and interstitial material with locally produced programming and interstitial material. Such arrangements include agreements with a subsidiary of HutchVision Limited for a 24-hours-a-day MTV Asia service, which is distributed to 42 million subscriber households via the AsiaSat 1 satellite on the Hong Kong-based Satellite Television Asian Region (STAR) system to 30 countries in Asia and parts of the Middle East; the Abril Group for MTV Brazil, which airs 16-hours-a-day in Brazil, reaching 9.5 million households; and Music Channel Co. Ltd., a joint venture of Pioneer Electronic Corp., TDK Corp. and Tokyu Agency, Inc. for MTV Japan, which launched in December 1992 and is distributed to approximately 810,000 subscriber households in Japan via the Superbird B satellite. I - 5 MTVN licenses, in international markets, the format rights and/or broadcast television exhibition rights to MTVN-owned or controlled programming. MTVN also licenses the exhibition of "MTV Internacional", a Spanish-language MTV-produced one-hour program, to Spanish-language television stations in the U.S. and abroad. MTVN anticipates further worldwide licensing of MTVN networks, programs, merchandise and format rights. NICKELODEON, the first network for kids, is a 24-hours-a-day, seven-days-a-week entertainment program service which combines acquired and originally produced programs in a pro-social, non-violent format, comprising two distinct program segments: NICKELODEON, targeted to audiences ranging from the ages of 2 to 15, and NICK AT NITE, targeted to family audiences including NICKELODEON'S 2 to 15 year old audience and ranging up to age 54. Cable television operators and other distributors typically carry both of the NICKELODEON programming segments. In 1993, NICKELODEON expanded its successful original animated programming block, NICKTOONS(R), with the introduction of ROCKO'S MODERN LIFE(TM). NICKELODEON continues to develop original animation projects such as REAL MONSTERS(TM), in addition to THE REN & STIMPY SHOW(TM), DOUG(TM) and RUGRATS(R). NICKELODEON also exhibits on Saturday nights SNICK(TM), its first prime-time block of original NICKELODEON programming. MTVN, in cooperation with MCA Inc. ("MCA"), operates NICKELODEON STUDIOS FLORIDA at Universal Studios in Orlando, Florida, which combines state-of-the-art television production facilities with interactive features that demonstrate the operation of NICKELODEON's studios from a kid's perspective. NICKELODEON and Sony Music entered into an agreement in April 1993 for Sony to manufacture and distribute NICKELODEON home video and audio products in the U.S. and Canada through its Sony Wonder Children's label. In June 1993, NICKELODEON launched NICKELODEON MAGAZINE, a bi-monthly humor-based children's publication. At December 31, 1993 circulation was approximately 225,000 (based on subscription and newsstand sales); distribution is handled, under agreement with NICKELODEON, by the New York Times' The Family Circle, Inc. (U.S.), and Worldwide Media Service, Inc. (U.K.). At December 31, 1993, NICKELODEON was licensed to approximately 53.4 million cable subscribers (based on subscriber counts provided by each cable system). At December 31, 1993, NICK AT NITE was licensed to approximately 53.1 million cable subscribers (based on subscriber counts provided by each cable system). According to the Nielsen Report, NICKELODEON and NICK AT NITE each reached approximately 60.9 million subscriber households. In December 1992, Nickelodeon Huggings U.K. Limited, a subsidiary of the Company, entered into a joint venture with a subsidiary of British Sky Broadcasting Limited for the launch and operation of NICKELODEON program service in the United Kingdom and Ireland. NICKELODEON in the U.K. is a 12-hours-a-day, seven-days-a-week, satellite-delivered children's programming service which launched in September 1993, and it carries a mix of programming, including original productions from NICKELODEON in the U.S. and programming originally produced by the joint venture for the U.K. market. Pursuant to the joint venture agreement and related parent agreements, the Company guarantees the obligation of its subsidiary and has both the right of first negotiation/last refusal with respect to any sale I - 6 of, and the right to approve any purchaser of, the British Sky Broadcasting subsidiary's interest in NICKELODEON U.K. The Company's subsidiary is obligated to fund loans in an amount equal to 50% of NICKELODEON U.K.'s working capital deficit. The Company funded loans of approximately B.P.3,500,000 in 1993 and expects to fund loans of approximately B.P.7,000,000 in 1994. VH-1/VIDEO HITS ONE is a 24-hours-a-day, seven-days-a-week music program service. VH-1 targets an audience of baby boomers, 25 to 49 years old, rather than the 12 to 34 year-olds targeted by MTV. The format consists primarily of music video clips from the adult contemporary, soft rock, classic oldies, contemporary jazz and country genres, augmented by original animation, music and general lifestyle information and programming, comedy, fashion, nostalgia, interviews and promotions. VH-1 offers programs such as original and acquired comedy programming including STAND-UP SPOTLIGHT and Gallagher specials; FT: FASHION TELEVISION; and the ONE-TO-ONE series which profiles pop artists. At December 31, 1993, VH-1 was licensed to approximately 45.5 million cable subscribers (based on subscriber counts provided by each cable system). According to the Nielsen Report, VH-1 reached approximately 49.5 million subscriber households. Substantially all such subscribers also receive MTV. MTVN has agreements with some U.S. record companies which, in exchange for cash and advertising time, license the availability of such companies' music videos for exhibition on MTV and on MTVN's other basic cable networks; a number of other record companies provide MTVN with music videos in exchange for promotional consideration only. The agreements generally provide that the videos are available for debut by MTVN and, in some cases, that videos are subject to exclusive periods on MTV. These record companies provide a substantial portion of the music videos exhibited on MTV and VH-1. MTVN is currently in negotiations for the renewal and extension of certain of its record company agreements. Although MTVN believes that these agreements will be renewed, there can be no assurance that the terms of such renewals will be as favorable as existing arrangements. MTVN derives revenues principally from two sources: the sale of time on its own networks to advertisers and the license of the services to cable television and other system operators. The sale of MTVN advertising time is affected by viewer demographics, viewer ratings and market conditions for advertising time. Adverse changes in market conditions for advertising may affect MTVN's revenues. MTVN derives revenues from license fees paid by cable operators and other distribution systems which deliver programming by satellite and microwave transmissions. In 1993, MTVN derived approximately 58% of its revenues from music programming and approximately 42% of its revenues from children's and other programming. MTVN also derives revenues from the sale of advertising time within internally produced or co-produced programming distributed to television stations and from the sale of advertising time within such programs produced by third parties. MTVN, through its operation of One World Entertainment, sells barter advertising time in series licensed for distribution to television stations by the Company and third parties, in exchange for a commission. COMEDY CENTRAL. The Company and HBO, through a 50-50 joint venture, operate COMEDY CENTRAL, a 24-hours-a-day, seven-days-a-week program service targeted to audiences ranging from the ages of 18 to I - 7 34. The format consists primarily of comedy programming, including movies, series, situation comedies, stand-up and sketch comedy, commentary, promotions, specials, and other original and acquired comedy programming. Pursuant to the joint venture agreement, the Company is obligated to make capital contributions in an amount equal to 50% of the partnership's working capital deficit (and Viacom Inc. has guaranteed such obligation). The Company's capital contributions for 1993 totaled $13.6 million. For 1994, the Company estimates its contribution obligation to be approximately $9 million. COMEDY CENTRAL reached approximately 30.3 million subscriber households according to the Nielsen Report. LIFETIME. The Company owns a one-third partnership interest in LIFETIME, an advertiser-supported basic cable television network that provides programming directed primarily toward women in the 18 to 54 age group. On March 29, 1994, the Company agreed to sell its one- third partnership interest in LIFETIME to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. SHOWTIME NETWORKS INC. Showtime Networks Inc. ("SNI") operates three 24-hours-a-day, commercial-free, premium subscription services offered to cable television operators and other distributors: SHOWTIME, offering theatrically released feature films, dramatic series, comedy specials, boxing events, family programs and original movies; THE MOVIE CHANNEL, offering feature films and related programming including film festivals; and FLIX, an added value premium subscription service featuring movies primarily from the 1960s, 70s and 80s which was launched on August 1, 1992. SHOWTIME, THE MOVIE CHANNEL and FLIX are offered to cable television operators and other distributors (including the Company) under affiliation agreements which for SHOWTIME and THE MOVIE CHANNEL are generally for a term of three to five years and in each case are distributed to the systems they serve by means of domestic communications satellites. As of December 31, 1993, SHOWTIME, THE MOVIE CHANNEL and FLIX, in the aggregate, had approximately 11,900,000 cable and other subscribers in approximately 8,700 cable systems and other distribution systems in 50 states and certain U.S. territories. SNI also provides special events, such as sports events, and feature films to licensees on a pay-per-view basis through its operation of SET PAY PER VIEW, a division of the Company. Showtime Satellite Networks Inc. ("SSN"), a subsidiary of SNI, packages for distribution to home satellite dish owners (on a direct retail basis) SHOWTIME, THE MOVIE CHANNEL, FLIX, Viacom Networks' basic cable program services, ALL NEWS CHANNEL (a 24-hour satellite- delivered news service which is a joint venture between Viacom Satellite News Inc., a subsidiary of the Company, and Conus Communications Company Limited Partnership, a limited partnership whose managing general partner is Hubbard Broadcasting, Inc.) and certain third-party program services. SHOWTIME, THE MOVIE CHANNEL and FLIX are also offered to third-party licensees for subdistribution to home satellite dish owners. In order to exhibit theatrical motion pictures on premium subscription television, SNI enters into commitments to acquire rights, with an emphasis on acquiring exclusive rights for SHOWTIME and THE MOVIE CHANNEL, from major or independent motion picture I - 8 producers and other distributors (including the Company). SNI's exhibition rights always cover the United States and may on a contract-by-contract basis cover additional territories. Theatrical motion pictures are generally exhibited first on SHOWTIME and THE MOVIE CHANNEL after an initial period for theatrical, home video and pay-per-view exhibition and before the period has commenced for standard broadcast television and basic cable television exhibition. FLIX primarily offers motion pictures from the 1960s, 70s and 80s, most of which have been previously made available for standard broadcast and other exhibitions. The cost of acquiring premium television rights to programming, including exclusive rights, is the principal expense of SNI. At December 31, 1993, in addition to such commitments reflected in Viacom Inc.'s and the Company's financial statements, SNI had commitments to acquire such rights at a cost of approximately $1.8 billion. Most of the $1.8 billion is payable within the next seven years as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. In November 1993, SNI entered into a seven-year agreement with Metro-Goldwyn-Mayer Inc. ("MGM") under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to MGM and United Artists feature films. The agreement includes all qualifying films theatrically released from September 1, 1994 through August 31, 2001, up to a maximum of 150 pictures. This agreement follows a previous agreement between SNI and Pathe Entertainment, Inc., a predecessor-in-interest to MGM. The recent agreement also calls for SNI and MGM to co-finance the production of certain exclusive original movies to be produced for SNI's program services. Also in 1993, SNI and Sony Pictures Entertainment Inc. entered into a five-year agreement under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to TriStar Pictures feature films. A continuation of SNI's previous three-year arrangement with TriStar, this new agreement includes all qualifying TriStar films theatrically released from 1994 through 1998, up to a maximum of 75 pictures. Feature films theatrically released by TriStar include SLEEPLESS IN SEATTLE, CLIFFHANGER and PHILADELPHIA. In February 1994, SNI reached an agreement in principle with Castle Rock Entertainment ("Castle Rock") to acquire the exclusive premium television rights in the licensed territory to additional Castle Rock feature films. This agreement follows SNI's previous output arrangement with Castle Rock, which included such previously theatrically released feature films as A FEW GOOD MEN, CITY SLICKERS, WHEN HARRY MET SALLY, MISERY, MALICE and IN THE LINE OF FIRE. The new agreement includes all qualifying Castle Rock motion pictures theatrically released from 1994 through 1999, up to a maximum of 55 pictures. In March 1994, SNI entered into an agreement with Orion Pictures Corporation ("Orion") under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to up to 30, in the aggregate, motion pictures, including qualifying motion pictures theatrically released from 1994 through 1996 and qualifying original motion pictures. This agreement follows a previous output agreement between SNI and Orion. I - 9 In 1989, SNI agreed with Walt Disney Pictures ("Disney") to acquire exclusive premium television rights in the licensed territory to qualifying feature films (up to a maximum of 125 films) produced and distributed by Disney's major distribution labels (other than the Disney label) and theatrically released during the five-year period commencing January 1, 1991. These films include SISTER ACT 2, TOMBSTONE, THE JOY LUCK CLUB and WHAT'S LOVE GOT TO DO WITH IT. In addition, SNI has agreements with (among other suppliers) New Line Distribution, Inc., Imagine Films Entertainment, Inc., Cannon Pictures, Inc., and Polygram Filmed Entertainment Distribution, Inc. SNI also arranges for the development and production of original programs and motion pictures that premiere on SHOWTIME through its operation of the Showtime Entertainment Group, which was formed in 1992. The Showtime Entertainment Group reflects SNI's increased commitment to the development and production of original programming and includes the operation of Viacom Pictures, a division of the Company. Viacom Pictures arranges for the development and production of motion pictures that are exhibited theatrically in foreign markets and premiere domestically on SHOWTIME. These films are then made available for distribution to various media worldwide, with the exception of the U.S. theatrical market. These feature films are generally budgeted at an average cost of approximately $5 million. During 1993, Viacom Pictures completed principal photography on two films: PAST TENSE, starring Scott Glenn, Anthony LaPaglia and Lara Flynn Boyle, and ROSWELL, starring Kyle MacLachlan, Martin Sheen and Dwight Yoakam. The Showtime Entertainment Group also has entered into commitments to produce, distribute and/or exhibit other original programming, including series, films, documentary programs, comedy specials and boxing events. In 1993, for example, SNI televised comedy specials featuring Tim Allen, Brett Butler and Shelley Long, boxing matches featuring such fighters as Julio Cesar Chavez, and the critically acclaimed dramatic anthology series entitled FALLEN ANGELS, episodes of which were directed by Michael Mann, Steve Soderbergh, Jonathan Kaplan and Tom Cruise and starred Gary Oldman, Laura Dern, Meg Tilly, Gabrielle Anwar, James Woods, Joe Mantegna, Gary Busey and Alan Rickman. In addition to exhibiting these original programs and motion pictures on its premium subscription services, SNI distributes certain of such programming for exploitation in various media worldwide. ADDITIONAL INFORMATION ABOUT VIACOM NETWORKS. The domestic program services of MTVN and SNI are currently transmitted over transponders principally on GE Americom's C-3 and C-4 and the Hughes Galaxy I and V domestic satellites. In 1994, Viacom Networks program services on Galaxy I will move to AT&T's Telstar 302. NICKELODEON (U.K.) program service is transmitted over the Astra 1-C satellite. MTV LATINO is transmitted over PanAmSat-1. MTV EUROPE is transmitted over the Astra 1-A, Astra 1-B and Eutelsat II-F1 satellites. The Company has entered into pre-launch agreements for international satellite coverage on Apstar-1 and Apstar-2, covering a broad Asian area, on PanAmSat-2 (Pacific Rim area), PanAmSat-3 (Latin America) and PanAmSat-4 (India/Middle East and South Africa) and Eutelsat II-F6 (greater Europe), all for service beginning in 1994 and 1995. I - 10 The Company entered into agreements, as of August 27, 1992, with United States Satellite Broadcasting Inc. ("USSB"), a subsidiary of Hubbard Broadcasting, Inc., for the direct broadcast satellite distribution using high-powered Ku-band technology ("DBS") of each of the Company's wholly owned basic cable and premium networks. These networks are expected to be offered by USSB to DBS customers beginning in 1994, and will be delivered directly to dishes located at DBS customers' homes from the first high-powered Ku-band satellite serving the U.S., which was launched in December 1993. DBS delivery utilizes consumer dishes significantly smaller than the C-band consumer dishes currently in use by home satellite dish owners in the U.S. VIACOM ENTERTAINMENT Viacom Entertainment is comprised of (i) Viacom Enterprises, which distributes television series, feature films, made-for- television movies, mini-series and specials for television exhibition in various markets throughout the world and also distributes television series for initial United States television exhibition on a non-network ("first run") basis and for international television exhibition; (ii) Viacom Productions, which produces television series and other television properties independently and in association with others primarily for initial exhibition on U.S. prime time network television; (iii) Viacom New Media, which was established in 1992 to develop, produce, distribute and market interactive software for the stand alone and other multimedia marketplaces; (iv) Viacom World Wide, which explores and develops business opportunities in international markets primarily in cable and premium television; and (v) Viacom MGS Services, which duplicates and distributes television and radio commercials. Viacom Enterprises and Viacom Productions are expected to be consolidated with Paramount's television operations during 1994. VIACOM ENTERPRISES. Viacom Enterprises distributes or syndicates television series, feature films, made-for-television movies, mini- series and specials, and first run series for television exhibition in domestic and/or international broadcast, cable and other markets. Feature film and television properties are acquired from third parties or result from the Company's own production activities, including television properties produced by Viacom Productions and certain television properties produced by or for MTV Networks. Third-party agreements for the acquisition of distribution rights are generally long-term and exclusive in nature; such agreements frequently guarantee a minimum recoupable advance payment to such third parties and generally provide for periodic payment to such third parties based on the amount of revenues derived from distribution activities after deduction of Viacom Enterprises' percentage distribution fee, recoupment of distribution expenses and recoupment of any advance payments. At December 31, 1993, Viacom Enterprises held domestic and/or international television distribution rights to approximately 5,000 half-hour series episodes, 2,000 one-hour series episodes, 1,500 feature films and television movies, and 30 mini-series. At December 31, 1993, Viacom Enterprises distributed television product to, among other outlets, approximately 750 domestic broadcast television stations, including stations in every principal city in the U.S., and to outlets in approximately 120 other countries I - 11 around the world. Viacom Enterprises generally licenses product to exhibitors for periods of one to six years, with license fee payments due over a somewhat shorter period. Episodes of a network television series from the first four seasons on a broadcast network generally become available for exhibition in domestic syndication to broadcast television stations commencing upon the start of the fifth broadcast season on the network; episodes from each subsequent broadcast season generally become available for such domestic syndication at the conclusion of each such subsequent broadcast season. Episodes of network television series are available for exhibition by foreign stations prior to or concurrent with their initial network runs. Generally, a network television series must air for at least three full broadcast seasons before it has value for such domestic syndication. Television programs can be made available to stations and other outlets, such as cable television services, on a first run basis without having been exhibited on any of the networks. The Company has greater control over the availability for exhibition in such domestic syndication of programming developed by and for Viacom's cable networks than of programming developed for network television. The Company has adopted a strategy of internal development of first run programs utilizing in- house creative resources from within Viacom Enterprises and from elsewhere within the Company, such as MTV Networks. Feature films which have been released theatrically generally become available for exhibition in such domestic syndication after their theatrical, home video, pay-per-view, and premium television exhibition periods have expired (which is generally three to four years after domestic theatrical release) and for network or ad hoc network exhibition between the first and second premium television windows. Such feature films generally become available for free television exhibition by foreign stations after the foreign theatrical, home video, pay-per- view (if any) and premium television (if any) exhibition periods have expired (which is generally two to three years after theatrical release in the applicable foreign market). The Company controls the exclusive worldwide broadcast, basic cable, premium, and home video television distribution rights to ROSEANNE, now in its sixth network broadcast season on ABC, and THE COSBY SHOW, which completed its eight-year network run at the end of the 1991/92 network broadcast season. The start of the sixth network season of ROSEANNE automatically triggered the first of three 26-week extensions of individual station licenses for ROSEANNE's initial licensing in domestic syndication, which was made on a cash plus barter basis. The second licensing period in domestic syndication for THE COSBY SHOW commenced in September 1993 (upon expiration of the term for the initial licensing in domestic syndication of THE COSBY SHOW) on an all-cash basis. The Company also controls certain worldwide exclusive distribution rights to classic network series such as I LOVE LUCY, THE ANDY GRIFFITH SHOW, THE BEVERLY HILLBILLIES, HAWAII FIVE-O and THE TWILIGHT ZONE. The Company is also offering VIACOM SEASONAL SPECIALS FEATURING NICKTOONS which brings six one hour seasonally themed specials, drawn from MTV Networks' critically acclaimed NICKTOONS animation block, to broadcast television. In addition, the Company controls the exclusive worldwide distribution rights in all media to various network television movies and series produced by Viacom Productions such as the PERRY MASON I - 12 television movies starring Raymond Burr, the DIAGNOSIS MURDER television movies and series starring Dick Van Dyke and the MATLOCK series starring Andy Griffith. Most episodes of MATLOCK and most of the PERRY MASON television movies are currently available for exhibition in domestic syndication. (See "BUSINESS -- Viacom Entertainment -- Viacom Productions") The Company had accumulated a backlog of unbilled license agreements of approximately $399 million at December 31, 1993. As the entire license fee amount is billed during the term of various licensing contracts, the Company will recognize as revenues that portion of such amount representing its distribution fees. Down payments and other accelerated payments of license fees are included in the backlog and are recognized as revenues in accordance with the billing terms of the license agreements. (See Note 1 to the Consolidated Financial Statements of Viacom Inc. and the Company for an explanation as to how license fees are billed.) Approximately 58% of the Company's backlog is attributable to license fees for ROSEANNE and THE COSBY SHOW. As THE COSBY SHOW becomes a smaller portion of the total backlog, the percentage of the total license fee recognized as revenue by the Company will be reduced. Since the late 1970s, the Company has produced and/or acquired television series for distribution on a first run basis. There is a financial exposure to the Company when it acquires or produces such series to the extent that advertising revenues derived by the Company and/or license fees paid by television stations to the Company are not sufficient to cover production costs. The Company typically offers to license new episodes of a first run series on a broadcast season basis. Generally, a first run series may be canceled by the Company for any reason at any time; in such event, television station licenses for such first run series are subject to termination by the Company, and the Company may have certain financial obligations to the producer notwithstanding cancellation. The Company is currently offering the third season (since its national launch) of THE MONTEL WILLIAMS SHOW, a first run one-hour strip (five times per week) talk show which premiered in Spring 1991 and was nationally launched in September 1992, on a cash plus barter basis, and NICK NEWS, a first run half hour weekly (one time per week) news and information show targeted for audiences 12 years old and under, which was nationally launched in September 1993 on an all-barter basis. The Company licenses certain ancillary rights to third parties, including home video, video disc and merchandising rights. These rights can be acquired concurrently with a program acquisition, derived from programs or characters created in-house, or directly licensed from the holders of such rights. These activities have not been a source of significant revenues to date. For the year ended December 31, 1993, approximately 37% of Viacom Enterprises' revenues were attributable to foreign operations and export business. A substantial portion of such revenues is derived in countries that have import quotas and other restrictions which limit the number of foreign programs and films exhibited in such countries. (See "BUSINESS -- Regulation -- Viacom Entertainment -- European Community Directive") VIACOM PRODUCTIONS. Viacom Productions Inc. ("Viacom Productions") produces programs independently and in association with others primarily for U.S. network prime time television. I - 13 These programs, which include television movies, series and mini- series, are also a source of product for the Company's distribution activities. There is a financial exposure to the Company with respect to such programs to the extent that revenues from distribution or syndication in foreign or domestic broadcast, cable and/or other markets are not sufficient to cover production deficits (i.e., the ---- difference between production costs and network license fees). For the 1993/94 broadcast season, Viacom Productions is producing the eighth network broadcast season of Andy Griffith's MATLOCK series (ABC); three additional PERRY MASON mystery television movies (NBC); the first network broadcast season of Dick Van Dyke's DIAGNOSIS MURDER series (CBS); two television movies starring Louis Gossett, Jr. (NBC); and several two-hour television movies, including THE ANISSA AYALA STORY (NBC); DESPERATE JOURNEY, starring Mel Harris (ABC); and SIN AND REDEMPTION, starring Richard Grieco (CBS). Viacom Productions also produces movies for cable television networks, including THEY, starring Vanessa Redgrave (SHOWTIME) and A FRIENDLY SUIT, starring Melissa Gilbert and Marlee Matlin (LIFETIME). VIACOM NEW MEDIA. Viacom New Media, the Company's interactive publishing division, was formed in 1992 to develop, produce, distribute and market interactive software for the stand-alone and other multimedia marketplaces. ICOM Simulations, Inc., an interactive software development company, was acquired by the Company in May 1993 and has been integrated into Viacom New Media; among other things, ICOM Simulations, Inc. is known for its SHERLOCK HOLMES CONSULTING DETECTIVE series of CD-ROM products. Viacom New Media released an interactive horror movie on CD-ROM entitled DRACULA UNLEASHED in the fourth quarter of 1993. In 1994, Viacom New Media expects to release original video games and CD-ROM products based on certain MTV Networks programs, including ROCKO'S MODERN LIFE (currently scheduled for second quarter 1994 release) and BEAVIS & BUTT-HEAD. Viacom New Media also expects to participate in the development of interactive programming for the Viacom/AT&T Castro Valley cable system project. (See "BUSINESS -- Viacom Cable Television") VIACOM WORLD WIDE LTD. Viacom World Wide Ltd. ("Viacom World Wide") explores and develops international business opportunities in all media, focusing primarily on countries with recently deregulated television industries. Viacom World Wide works closely with the Company's other operating units in identifying international business opportunities. Viacom World Wide also provides consulting services to companies overseas. Over the past year, Viacom World Wide has provided strategic and business planning services to corporations in the Middle East and engineering services in Japan. None of these services has been a source of significant revenues to date nor required significant capital contributions by the Company. VIACOM MGS SERVICES. Viacom MGS Services Inc. ("MGS") distributes, duplicates and stores taped and filmed television commercials, radio commercials, and other programs for advertisers and agencies, production houses and industrial and educational customers. VIACOM CABLE TELEVISION CABLE OPERATIONS. At December 31, 1993, Viacom Cable Television ("Viacom Cable") was approximately the 13th largest multiple cable television system operator in the United States with approximately 1,094,000 subscribers. In January 1993, the Company completed the I - 14 sale of its suburban Milwaukee cable system, serving approximately 47,000 customers, to Warner Communications Inc., a unit of Time Warner Entertainment Co., L.P. as part of the settlement of the Company's antitrust lawsuit against Time Warner Inc. Viacom Cable's systems are operated pursuant to non-exclusive franchises granted by local governing authorities. Viacom Cable offers two tiers of primary (i.e., non-premium) service: "Limited Service", which consists generally of local and distant broadcast stations and all public, educational and governmental channels ("PEG") required by local franchise authorities; and, the "Satellite Value Package", which provides additional channels of satellite-delivered cable networks. Monthly service fees for these two levels of primary service constitute the major source of the systems' revenue. The monthly service fees for Limited Service and the Satellite Value Package are regulated under the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation"). At December 31, 1993, the fixed monthly fees charged to customers for primary services varied by geographic area and ranged from $9.00 to $14.84 per month for Limited Service and from $21.25 to $25.78 for the combination of Limited Service plus the Satellite Value Package, in each case for all of an individual customer's television connections. The Company offers customers the Company's own basic programming services, as well as third-party services such as CNN and ESPN. An installation charge is levied in many cases but does not constitute an important source of revenue. Customers are free to discontinue service at will. None of Viacom Cable's systems is exempt from rate regulation under the 1992 Cable Act. Viacom Cable offers premium cable television programming, including the Company's premium subscription television services, to its customers for an additional monthly fee of up to $12.25 per premium service. As of December 31, 1993, the Company's cable television systems had approximately 718,000 subscriptions to premium cable television program services. Viacom Cable customers who elect to subscribe to Limited Service alone are also able to purchase premium and pay-per-view services offered by the Company without first having to "buy through" the Satellite Value Package. The 1992 Cable Act requires cable operators to implement this practice where no technological limitations exist. (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation") Viacom Cable also derives revenue from sales of available advertising spots on advertiser-supported programming and sharing of revenues from sales of products on home shopping services offered by Viacom Cable to its customers. Cable operators require substantial capital expenditures to construct systems and significant annual expenditures to maintain, rebuild and expand systems. The equipment of each cable system consists principally of receiving apparatus, trunk lines, feeder cable and drop lines connecting the distribution network to the premises of the customers, electronic amplification and distribution equipment, converters located in customers' homes and other components. System construction and operation and quality of equipment used must conform with federal, state and local electrical and safety codes and certain I - 15 regulations of the FCC. Viacom Cable, like many other cable operators, is analyzing potential business applications for its broadband network, including interactive video, video on demand, data services and telephony. These applications, either individually or in combination, may require technological changes such as fiber optics and digital compression. If these applications justify capital spending in excess of current projections, Viacom Cable will revise its capital needs accordingly. Although management believes the equipment used in the cable operations is in good operating condition, except for ordinary wear and tear, Viacom Cable invests significant amounts each year to upgrade, rebuild and expand its cable systems. During the last five years, Viacom Cable's capital expenditures were as follows: 1989: $40 million; 1990: $46 million; 1991: $45 million; 1992: $55 million; and 1993: $79 million. The Company expects that Viacom Cable's capital expenditures in 1994 will be approximately $100 million. Viacom Cable has constructed a fiber optic cable system in Castro Valley, California to provide more channels with significantly better picture quality, and to accommodate testing of new services including an interactive on-screen programming guide known as StarSight (in which a consolidated affiliate of the Company currently has a 21.4% equity interest which it has the right to increase to 35%), other interactive programs with Viacom New Media, video-on-demand premium services, multiplexed premium services, and advanced interactive video and data services. Viacom has entered into an agreement with AT&T to test and further develop such services. As part of Viacom's strategic relationship with NYNEX Corporation ("NYNEX"), Viacom has granted NYNEX a right of first refusal with respect to providing telephony service upgrade expertise to Viacom Cable. I - 16 I - 17 VIACOM BROADCASTING Viacom Broadcasting is engaged in the operation of five television and 14 radio stations. The Company's television and radio stations operate pursuant to the Communications Act of 1934, as amended (the "Communications Act"), and licenses granted by the FCC, which are renewable every five years in the case of television stations and every seven years in the case of radio stations. VIACOM TELEVISION. The Company owns and operates the following five television properties: NETWORK STATION AND AFFILIATION METROPOLITAN AND EXPIRATION YEAR AREA SERVED TYPE DATE OF AGREEMENT ACQUIRED - -------------------------------------------------------------------- KMOV-TV St. Louis, MO VHF CBS/December 31, 1994 1986 WVIT-TV Hartford-New Haven- New Britain-Waterbury, CT UHF NBC/July 2, 1995 1978 WNYT-TV Albany-Troy-Schenectady, NY VHF NBC/September 28, 1980 KSLA-TV Shreveport, LA VHF CBS/June 30, 1995 1983 WHEC-TV Rochester, NY VHF NBC/August 13, 1994 1983 As reflected in the table above, each of the Company's television stations is affiliated with a national television network. Such affiliations can be an advantage, because network programming is often competitively stronger and results in lower programming costs than would otherwise be necessary to obtain programming from other sources. The Company expects that the affiliation agreements which expire in 1994 will be renewed. I - 18 In addition to fees paid by networks to their affiliates, the principal source of revenue for the Company's television stations is the sale of broadcast time that has not been sold by the networks to national, local and regional advertisers. Such sales may involve all or part of a program or spot announcements within or between programs. Broadcast time is sold to national advertisers through national sales representatives who are compensated on a commission basis at normal industry rates. Advertising is sold to local and regional advertisers through a station's own sales force. Local and national spot advertising is generally sold pursuant to contracts which are for short periods and are generally cancelable upon prior notice but which are frequently renewed for additional terms. VIACOM RADIO. The Company owns and operates the 14 radio stations listed below. On June 16, 1993, the Company acquired the assets of KQLZ-FM (now KXEZ-FM), serving Los Angeles, California and on November 1, 1993, the Company acquired the assets of WCXR-FM and WCPT-AM serving Washington, D.C., in exchange for the assets of KIKK-AM/FM serving Houston, Texas and cash. The Company now operates multiple FM and/or multiple AM stations in Seattle, Washington (2 FMs, 1 AM), Los Angeles, California (2 FMs) and Washington, D.C. (2 FMs, 2 AMs) as permitted by the FCC's recently liberalized ownership rules which permit common ownership of two or more AM or two or more FM stations in the same market. Pursuant to the FCC's order on March 4, 1994 consenting to the transfer of control of Paramount's broadcast licenses to Viacom Inc., which licenses include a television station serving Washington, D.C., the Company has undertaken to dispose of one AM and one FM radio station serving Washington, D.C. no later than September 11, 1995. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Ownership Limitations") I - 19 STATION AND METROPOLITAN POWER RADIO YEAR AREA SERVED FREQUENCY WATTS STATION FORMAT ACQUIRED - ----------------------------------------------------------------------- WLTW-FM New York, NY 106.7 MHz 50,000 Adult 1980 Contemporary WLIT-FM Chicago, IL 93.9 MHz 50,000 Adult 1982 Contemporary WLTI-FM Detroit, MI 93.1 MHz 50,000 Adult 1988 Contemporary WMZQ-AM-FM Washington, (AM) 1390 KHz 5,000 Country 1984 D.C. (FM) 98.7 MHz 50,000 1980 WCXR-FM 105.4 MHz 50,000 Classic Rock 1993 WCPT-AM 730 KHz 5,000 D* CNN Headline 1993 Washington, 20 N* News D.C. KBSG-AM-FM Tacoma/Seattle, (FM) 97.3 MHz 100,000 Oldies 1987 WA (AM) 1210 KHz 10,000 D* 1989 1,000 N* KNDD-FM Seattle, WA 107.7 MHz 100,000 New Rock (AOR) 1992 I - 20 STATION AND METROPOLITAN POWER RADIO YEAR AREA SERVED FREQUENCY WATTS STATION FORMAT ACQUIRED - ----------------------------------------------------------------------- KYSR-FM Los Angeles, 98.7 MHz 75,000 Adult 1990 CA Contemporary KXEZ-FM Los Angeles, 100.3 MHz 50,000 Adult 1993 CA Contemporary KSRY-FM San Francisco, 98.9 MHz 50,000 Adult 1990 CA Contemporary KSRI-FM Santa Cruz/San 99.1 MHz 50,000 Adult 1990 Jose, CA Contemporary _________________________ * D/N = Day/Night As indicated in the table above, the radio stations generally have specialized program formats targeted to specific audiences. In addition, the stations' programming includes entertainment, news, religion, sports, education and other topics of general interest. The stations also provide time for public affairs, educational and cultural programs and for discussion of local and national issues. Radio station revenues are derived almost entirely from the sale of advertising time. Only a small amount of such revenues is derived from sponsored programs or non-broadcast sources. As is customary in the industry, national representatives are engaged to obtain advertising from and to sell broadcast time to national advertisers, and are compensated on a commission basis. The stations' own sales forces sell advertising time to local and regional advertisers. Local, regional and national advertising is generally sold pursuant to contracts which are for short periods and generally are cancelable upon prior notice, but frequently are renewed for additional terms. REGULATION The Company's entertainment, cable television and broadcasting businesses are subject to extensive regulation by federal, state and local governmental authorities and its programming businesses are affected thereby. The rules, regulations, policies and procedures affecting these businesses are constantly subject to change. The descriptions which follow are summaries and should be read in conjunction with the texts of the statutes, rules and regulations I - 21 described herein. The descriptions do not purport to describe all present and proposed federal, state and local statutes, rules and regulations affecting the Company's businesses. VIACOM ENTERTAINMENT The Company's first run, network and other production operations and its distribution of off-network, first run and other programs in domestic and foreign syndication are not directly regulated by legislation. However, existing and proposed rules and regulations of the FCC applicable to broadcast networks, individual broadcast stations and cable could affect Viacom Entertainment. FINANCIAL INTEREST AND SYNDICATION RULES. The financial interest and syndication rules ("finsyn rules") were adopted by the FCC in 1970. These rules significantly limited the role of broadcast television networks in broadcast television program syndication. The financial interest rule prohibited a network from acquiring a financial or proprietary right or interest in the exhibition (other than its own broadcast network exhibition), distribution or other commercial use in connection with the broadcasting of any television program of which it is not the sole producer. The syndication rule prohibited a network from syndicating programming domestically to television stations for non-network exhibition and precluded a network from reserving any rights to participate in income derived from domestic broadcast syndication, or from foreign broadcast syndication where the network was not the sole producer. For the purposes of these rules, a broadcast network was defined as any entity which offers an interconnected program service on a regular basis for 15 or more hours per week to at least 25 affiliated television stations in 10 or more states. In 1991 the FCC adopted modified finsyn rules. In 1992, these rules were vacated by the U.S. Court of Appeals for the Seventh Circuit (the "Seventh Circuit Appeals Court"), acting on appeals filed by ABC, CBS, NBC and others. In 1993 the FCC adopted a decision (the "Decision") further modifying the finsyn rules effective as of June 5, 1993, although ABC, CBS, and NBC could not commence operating under the modified finsyn rules until November 10, 1993 when the antitrust consent decrees to which they are subject were modified to eliminate certain restrictions by an order (the "Order") of the U.S. District Court for the Central District of California (the "District Court"). The modified rules will expire in November 1995, absent an affirmative FCC action retaining or further modifying them. The FCC is to initiate a final review of the modified rules six months prior to their November 1995 expiration date and proponents of their continuance have the burden of proving that the public interest requires their continued retention. The Decision has been appealed by the networks and others, and all appeals have been consolidated before the Seventh Circuit Appeals Court. The Company is unable to predict what action the court will take when it reviews the Decision or what effect, if any, the Decision will have on the Company's distribution and production activities. I - 22 The Decision eliminates certain restrictions on network acquisition of financial interests and syndication rights in network programming. With respect to first run programs, networks may not acquire any financial interests or syndication rights except in programs produced solely by the network and in programs distributed only outside the U.S. The networks are also prohibited by the modified rules from directly engaging in syndication in the U.S. of both network prime time entertainment programs and first run programs, but they may syndicate non- prime time network programs and network non-entertainment programs in the U.S. and any programs in foreign markets. Networks must also release prime time entertainment programs in which they hold syndication rights into the syndication market no later than four years after the program's network debut or within six months after the end of the network run, whichever is earlier. In addition, networks are also subject to certain certification and reporting requirements. A network is defined in the modified rules as any entity that provides more than 15 hours of prime time programming per week to affiliates reaching 75% of television households nationwide. Emerging networks not currently meeting the network definition are exempt from the modified rules except for certain reporting requirements which become applicable when they commence providing 16 hours per week of prime time programs to their affiliates. The networks must use an independent syndicator to distribute off- network prime time entertainment programs in which they hold syndication rights, and there must be no contractual or other understandings between the network and the syndicator regarding the subsequent sale or scheduling of the syndicated program that would have the direct or indirect effect of affiliate station favoritism. The FCC will consider complaints if a party can make a showing undermining the credibility of the independence of the syndicator, and it is unclear whether such complaints may be directed only to the network involved or whether independent syndicators may also be subject to such complaints. PRIME TIME ACCESS RULE. The Prime Time Access Rule ("PTAR") prohibits network affiliates in the top 50 markets (designated by the FCC based on survey data) from exhibiting network or off-network programming during more than three out of the four prime time hours, with certain limited exceptions. The Decision provided that first run programming produced by a network will be considered network programming for this purpose. A number of interested parties have raised the issue of whether PTAR should be modified or repealed. Certain programmers are seeking modification of PTAR to permit the exhibition of off-network programming. The licensee of WCPX-TV, Orlando, Florida, has sought elimination of PTAR on First Amendment grounds and certain West Coast network affiliates have obtained PTAR waivers from the FCC that facilitated the commencement of network prime time one hour earlier. If PTAR itself is so modified or is eliminated, the Company is unable to predict the effect, if any, on its first run and other I - 23 distribution activities. The Company is also unable to predict whether earlier commencement of network prime time programming would affect the availability of prime time for the presentation of syndicated programs on network-affiliated stations. EUROPEAN COMMUNITY DIRECTIVE. In October 1989, the European Commission directed each European Community member country to adopt broadcast quota regulations based on its guidelines by October 3, 1991. All member countries other than Spain and the Flemish region of Belgium have enacted legislation aimed at adopting such regulations. Such broadcast quota regulations may limit the amount of U.S. produced programming to be purchased by foreign customers which could have an adverse impact on the Company's foreign syndication operations. Similar rules are contained in a Council of Europe Convention which went into force on May 1, 1993. This has currently been ratified by Cyprus, Italy, Poland, San Marino, Switzerland, the Vatican and the United Kingdom. VIACOM CABLE Federal Regulation 1992 CABLE ACT. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") substantially amending the regulatory framework under which cable television systems have operated since the Communications Act of 1934, as amended (the "Communications Act"), was amended by the Cable Communications Policy Act of 1984 (the "1984 Act"). The FCC through its rules and regulations began implementing the requirements of the 1992 Cable Act in 1993 and is currently engaged in several proceedings in order to adopt additional rules and regulations or to reconsider and/or amend certain of the rules and regulations previously adopted. The extent and materiality of the effects of the 1992 Cable Act on Viacom Cable and Viacom Networks depend to a large degree on the final form of the FCC's implementing regulations and the outcome of judicial challenges to various provisions of the 1992 Cable Act as more fully discussed below. The following is a summary of certain significant issues: Rate Regulation. Rate regulations adopted in April 1993 by the FCC --------------- (the "April 1993 Regulations") govern rates charged to subscribers for regulated tiers of cable service and became effective on September 1, 1993. On February 22, 1994, the FCC adopted additional rules (the "February 22nd Regulations") which have not yet been published in their final form. The "benchmark" formula adopted as part of the April 1993 Regulations establishes an "initial permitted rate" which may be charged by cable operators for specified tiers of cable service. The regulations also establish the prices which may be charged for equipment used to receive these services. Because the text of the February 22nd Regulations has not been released, it is not possible to know the extent or nature of the revisions to the April 1993 Regulations. However, from public statements made during the FCC's February 22 meeting and news releases issued thereafter, it appears that the February 22nd Regulations will contain a new formula for determining permitted rates. The new formula may require up to a I - 24 17% reduction of rates from those charged on September 30, 1992, rather than the 10% reduction required by the April 1993 Regulations. The February 22nd Regulations also adopted interim standards governing "cost-of-service" proceedings pursuant to which a cable operator would be permitted to charge rates in excess of rates which it would otherwise be permitted to charge under such regulations, provided that the operator substantiates that its costs in providing services justify such rates. Based on its implementation of the April 1993 Regulations, the Company estimates that it will recognize a reduction to revenues ranging from $27 million to $32 million on an annualized basis, substantially all of which will be reflected as a reduction in earnings from operations of its cable television division. The Company's estimated reduction does not reflect further reductions to revenue which would result from the lowering of the initial permitted rates pursuant to the February 22nd Regulations. These new and reduced initial permitted rates will apply prospectively from a date to be announced by the FCC when it publishes precise regulations which implement the February 22nd Regulations. Until the February 22nd Regulations are released, it is not possible to predict the effects of the interim standards governing cost-of- service proceedings; however, based on the FCC's public statements, the Company believes it is unlikely that it will be able to utilize such proceedings so as to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations. The Company's ability to mitigate the effects of these new rate regulations by employing techniques such as the pricing and repricing of new or currently offered unregulated program services and ancillary services may also be restricted by the new regulations adopted as part of the February 22nd Regulations. No such mitigating factors are reflected in the estimated reductions to revenues. The stated reduction to revenues may be mitigated by the higher customer growth due to lower primary service rates. The Company also cannot predict the effect, if any, of cable system rate regulation on license fee rates payable by cable systems to program services such as those owned by the Company. Vertical Integration. Certain pricing and other restrictions are -------------------- imposed on vertically integrated cable programmers (such as the Company) with respect to their dealings with multichannel distributors of programming, such as cable systems, SMATV systems, MMDS operators and TVRO and DBS distributors (as defined in "BUSINESS--Competition-- Viacom Cable Television"). The FCC's implementing regulations governing access by multichannel distributors to the programming of vertically integrated cable programmers limit the extent to which a vertically integrated cable programmer can differentiate in pricing or other terms and conditions of carriage between and among multichannel distributors. Because the application of these new regulations is subject to numerous uncertainties, the Company is currently unable to determine their impact, if any, on the Company. The FCC's implementing regulations also limit the number of channels on a cable system which may be used to carry the programming of such system's affiliated (vertically integrated) cable programmers. These regulations provide generally that no more than 40% of such a system's channels can be used to carry the programming of the system's I - 25 affiliated cable programmers. These channel occupancy limits apply only up to 75 channels of a given system. The FCC also considered whether limits should be placed on a multichannel distributor's right to participate in the production or creation of programming, and concluded that no such limits are appropriate at this time. The FCC's implementing regulations governing access by multichannel distributors to the programming of vertically integrated cable programmers and regarding channel occupancy limits are subject to pending petitions for reconsideration at the FCC. Must Carry/Retransmission Consent. Commercial television stations --------------------------------- which are "local" to communities served by a cable system can elect to require either (a) carriage (and with certain restrictions, channel position) on the cable system ("Must Carry"), or (b) payment (monetary or in-kind) in consideration for their consent to the retransmission of their signal by the cable system ("Retransmission Consent"). In addition, a cable system may not carry any commercial non-satellite- delivered television station which is "distant" to communities served by such system or any radio station without obtaining the consent of such station for such retransmission; however, such television and radio stations do not have Must Carry rights. Such stations may require payment in consideration for Retransmission Consent. Viacom Cable has negotiated retransmission rights for a number of commercial stations which it carries. Some of these agreements are on an interim basis and may be canceled by the stations. Viacom Cable carries other stations pursuant to their exercise of their Must Carry rights. Local non-commercial television stations have Must Carry rights, but may not elect Retransmission Consent. The Must Carry rules were challenged by cable program services and cable system operators. In April 1993, a District of Columbia three judge court upheld the rules against a facial First Amendment attack. The U.S. Supreme Court accepted review; oral argument was heard in January 1994 and a decision is expected by July 1994. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Must Carry/Retransmission Consent") Limits on Number of Subscribers. The FCC's implementing ------------------------------- regulations generally impose a 30% horizontal ownership limit on the number of homes passed by cable that any one cable operator can serve nationwide through systems in which it has an attributable interest (the Company serves approximately 2% of "homes passed" nationwide). In view of a recent federal district court decision holding that this imposition of horizontal ownership limits is unconstitutional, the FCC has stayed the effectiveness of this 30% limit until final judicial resolution of the constitutional issue. Buy Through to Premium Services. Pursuant to the 1992 Cable ------------------------------- Act, a cable system may not require subscribers to purchase any tier of service other than the basic service tier in order to obtain services offered by the cable operator on a per channel (e.g., premium services) or pay-per-view basis. A cable system ---- which is not now fully addressable and which cannot utilize other means to facilitate access to all of its programming will have up to 10 years to fully comply with this provision through the implementation of fully addressable technology. The Company's cable systems have already begun to implement compliance. I - 26 Among other things, the 1992 Cable Act and the FCC's implementing regulations also: (i) with certain exceptions, require a three-year holding period before the resale of cable systems; (ii) provide that franchising authorities cannot unreasonably refuse to grant competing franchises (all of the Company's current franchises are non-exclusive); (iii) require that the FCC study the cost and benefits of issuing regulations with respect to compatibility between cable system equipment and consumer electronics such as VCRs and issue such regulations as may be appropriate; and (iv) facilitate the manner in which third parties can lease channel capacity from cable systems and provide that the maximum rates which a cable system can charge for leased channel capacity may be set by the FCC. Pursuant to the 1992 Cable Act, the FCC adopted minimum customer service standards and also determined the circumstances under which local franchising authorities may impose higher standards. Lawsuits have been filed challenging the constitutionality of various provisions of the 1992 Cable Act including the provisions relating to rate regulation, Must Carry, Retransmission Consent, the pricing and other restrictions imposed on vertically integrated cable programmers with respect to their dealings with multichannel programming distributors, and the mandated availability of cable channels for leased access and PEG programming. COMPETITION WITH TELEPHONE COMPANIES. In a recent decision by the U.S. District Court for the Eastern District of Virginia, the Court declared the restrictions contained in the Communications Act on the provision of video programming by a telephone company in its local service area to be unconstitutional and has enjoined enforcement of those restrictions. The Court has held that this decision does not apply to geographic areas outside of its jurisdiction. An appeal of the Court's holding of the unconstitutionality of such restrictions has been filed. Several similar suits have recently been filed in different jurisdictions by regional Bell Operating Companies (including NYNEX) ("BOCs") challenging the very same restrictions. In an interpretation of the current restrictions contained in the Communications Act, the FCC in 1992 established its "Video Dial Tone" policy. The Video Dial Tone policy is being challenged in court by cable interests as violating the Communications Act. It is also being challenged by telephone interests as not being liberal enough. The policy permits in-service-area delivery of video programming by a telephone company (a "telco", as further defined below) and exempts telcos from the Communications Act's franchising requirements so long as their facilities are capable of two-way video and are used for transmission of video programming on a common carrier basis, i.e. use of the facilities must be available to all programmers - ---- and program packagers on a non-discriminatory, first-come first- served basis. Telcos are also permitted to provide to facilities users additional "enhanced" services such as video gateways, video processing services, customer premises equipment and billing and collection. These can be provided on a non-common carrier basis. There are currently pending in Congress four principal bills (in the Senate, S. 1086, the Telecommunications Infrastructure Act of 1993, and S. 1822, the Communications Act of 1994 (which is expected to supersede S. 1086) and in the House, H.R. 3626, the Antitrust Reform Act 1993, and H.R. 3636, the National Communications Competition and Information Infrastructure Act of 1993) which would, among other things, permit a I - 27 BOC or a Regional Holding Company ("RHC"; a BOC or RHC, a "telco") to offer cable service under certain stated conditions including providing safeguards and transition rules designed to protect against anti- competitive activity by the telcos and cross-subsidization of a telco's cable business by the telco's charges to its telephone customers. These bills also generally eliminate state and local entry barriers which currently either prohibit or restrict an entity's (including a cable operator's) capacity to offer telecommunications services (including telephone exchange service) in competition with telcos and to interconnect on a non-discriminatory basis with telcos and utilize certain telco facilities in order to provide service in competition with a telco. The Clinton Administration has indicated its intention to propose reform of federal telecommunications legislation, although such proposal has not been finalized. At present, state and/or local laws do not prohibit cable television companies from engaging in certain kinds of telephony business in most states. Viacom Cable is a general partner in three partnerships providing commercial competitive access services which link business customers to long distance carriers via private networks owned by the cable television company partners and leased to the partnerships. If the pending legislation does not become law, and the various appeals courts uphold the unconstitutionality of the Communications Act's restrictions on telco video programming, the telcos have stated their intent to immediately enter the video programming business. COMPULSORY COPYRIGHT. Cable television systems are subject to the Copyright Act of 1976 which provides a compulsory license for carriage of distant broadcast signals at prescribed rates. No license fee is charged by the copyright holder for retransmission of broadcast signals which are "local" to the communities served by the cable system. The FCC has recommended to Congress that it eliminate the compulsory license for retransmission of both distant and local signals, requiring instead that approval be received from the copyright holders for retransmission. If the compulsory license is repealed, Viacom Cable could incur additional costs for its carriage of programming of certain broadcast stations and if some broadcast stations are not carried, customer satisfaction with cable service may be adversely affected until satisfactory replacement programming is obtained. Pending legislation in the 103rd Congress includes a bill (H.R.759) to affirm the application of the compulsory license to MMDS and other alternative video transmission technologies; a bill (H.R.1103) to eliminate the sunset provision of the Satellite Home Viewer Act and continue the application of the compulsory license to satellite carriers that transmit to home dish owners; and a bill (H.R.12) to provide for payment by television broadcasters to program producers where a broadcaster exercises its Retransmission Consent rights enacted in the 1992 Cable Act and thereby obtains payment from a cable operator for retransmission of the broadcaster's signal. State and Local Regulation. State and local regulation of cable is exercised primarily through the franchising process under which a company enters into a franchise agreement with the appropriate franchising authority and agrees to abide by applicable ordinances. The 1992 Cable Act permits the FCC to I - 28 broaden the regulatory powers of the franchising authorities, particularly in the areas of rate regulation and customer service standards. (See "BUSINESS --- Regulation -- Viacom Cable -- Federal Regulation") Under the 1984 Act, franchising authorities may control only cable- related equipment and facilities requirements and may not require the carriage of specific program services. However, if the Must Carry provisions of the 1992 Cable Act are upheld by the Supreme Court, federal law (as implemented by FCC regulations) will mandate the carriage of both commercial and non-commercial television broadcast stations "local" to the area in which a cable system is located. (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation") The 1984 Act, as amended, guarantees cable operators due process rights in franchise renewal proceedings and provides that franchises will be renewed unless the cable operator fails to meet one or more enumerated statutory criteria. The Company's current franchises expire on various dates through 2017. During the five-year period 1994 through 1998, franchises having an aggregate of approximately 230,081 customers (as of October 31, 1993) will expire unless renewed. The Company expects its franchises to be renewed. VIACOM NETWORKS 1992 CABLE ACT. See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation -- 1992 Cable Act". MODIFICATION OF FINAL JUDGMENT. The Modification of Final Judgment (the "MFJ") is the consent decree pursuant to which AT&T was reorganized and was required to divest its local telephone service monopolies. As a result, seven RHCs were formed (including NYNEX) comprised of operating companies within their regions (the BOCs). In addition, that portion of the continental United States served by the BOCs was divided into geographical areas termed Local Access and Transport Areas ("LATAs"). The MFJ restricts the RHCs, the BOCs and their affiliates from engaging in inter-LATA telecommunications services and from manufacturing telecommunications products. As a result of NYNEX's investment in Viacom Inc., the Company could arguably be considered an affiliate of an RHC for MFJ purposes. As a result, the Company transferred certain of Viacom Networks' and other operations and properties to an affiliated entity which will be consolidated into the Company for financial reporting purposes. Neither the transfer nor the operations of the affiliate as an entity separate from the Company will have a material effect on the financial condition or the results of operations of the Company. However, should the MFJ restrictions be modified or waived, the Company intends to retransfer the assets and operations and any future appreciation in the value of such assets after such retransfer will be for the benefit of the holders of Viacom Common Stock. VIACOM BROADCASTING Television and radio broadcasting are subject to the jurisdiction of the FCC pursuant to the Communications Act. I - 29 THE COMMUNICATIONS ACT. The Communications Act authorizes the FCC: to issue, renew, revoke or modify broadcast licenses; to regulate the radio frequency, operating power and location of stations; to approve the transmitting equipment used by stations; to adopt rules and regulations necessary to carry out the provisions of the Communications Act; and to impose certain penalties for violations of the Communications Act and the FCC's regulations governing the day-to-day operations of television and radio stations. BROADCAST LICENSES. Broadcast station licenses (both television and radio) are ordinarily granted for the maximum allowable period of five years in the case of television and seven years in the case of radio, and are renewable for additional five-year or seven-year periods upon application and approval. Such licenses may be revoked by the FCC for serious violations of its regulations. Petitions to deny renewal of a license or competing applications may be filed for the frequency used by a renewal applicant. If a petition to deny is filed, the FCC will determine whether renewal is in the public interest based upon presentations made by the licensee and the petitioner. If a competing application is filed, a comparative hearing is held to determine which applicant should be granted the license. In the absence of egregious and willful violations of FCC rules, license holders, as a practical matter, can generally expect renewal by the FCC. The licenses for the Company's television stations expire as follows: WVIT-TV on April 1, 1994; each of WNYT-TV and WHEC-TV on June 1, 1994; KSLA-TV on June 1, 1997; and KMOV-TV on February 1, 1998. The Company's licenses for its radio stations expire as follows: WMZQ- AM-FM, WCPT-AM and WCXR-FM on October 1, 1995; WLTI-FM on October 1, 1996; WLIT-FM on December 1, 1996; KSRI-FM and KSRY-FM on August 1, 1997; KYSR-FM and KXEZ-FM on December 1, 1997; each of KBSG-AM-FM and KNDD-FM on February 1, 1998; and WLTW-FM on June 1, 1998. The Company has applied for renewal of and expects that the licenses which expire in 1994 will be renewed. The Communications Act prohibits the assignment of a license or the transfer of control of a license without prior approval of the FCC. The Communications Act also provides that no license may be held by a corporation if (1) any officer or director is an alien, or (2) more than 20% of the voting stock is owned of record or voted by aliens or is subject to control by aliens. In addition, no corporation may hold the voting stock of another corporation owning broadcast licenses if any of the officers or directors of such parent corporation are aliens or more than 25% of the voting stock of such parent corporation is owned of record or voted by aliens or is subject to control by aliens, unless specific FCC authorization is obtained. MUST CARRY/RETRANSMISSION CONSENT. The 1992 Cable Act contains provisions which grant certain Must Carry rights to commercial broadcast television stations that are "local" to communities served by a cable system, including the right to elect either to require a cable operator to carry the station pursuant to the Must Carry provisions of the Act or to require that the cable operator secure the station's Retransmission Consent on a negotiated basis before the station can be carried (i.e., retransmitted) on the cable system. Each of the ---- Company's television stations elected in 1993 to negotiate with their I - 30 local cable systems for the systems' right to retransmit the station's signal. All such negotiations were successfully completed assuring continued carriage of each station on all of their local cable systems at least through December 1996. The Must Carry Rules were challenged by cable program services and cable system operators. In April 1993, a District of Columbia three judge court upheld the rules against a facial First Amendment attack. The U.S. Supreme Court accepted review; oral argument was heard in January 1994 and a decision is expected by July 1994. If the Must Carry Rules are determined to be unconstitutional, the Company's television stations do not expect to be materially affected since they expect to continue to obtain carriage pursuant to Retransmission Consent negotiations. If a station is not carried by a cable system in its area, that station could experience a decline in revenues. The Company's television stations have traditionally been carried prior to the institution of Retransmission Consent and in the absence of Must Carry. (See "BUSINESS -- Regulation - -- Viacom Cable Television -- Must Carry/Retransmission Consent and Compulsory Copyright") RESTRICTIONS ON BROADCAST ADVERTISING. In past Congressional sessions, committees of Congress examined proposals for legislation that would eliminate or severely restrict advertising of beer and wine either through direct restrictions on content or through elimination or reduction of the deductibility of expenses for such advertising under federal tax laws. Such proposals generated substantial opposition, but it is possible that similar proposals will be reintroduced in Congress. The elimination of all beer and wine advertising would have an adverse effect on the revenues of the Company's television and radio stations. Congress may again take up Campaign Finance Reform legislation similar to that which was passed by the 102nd Congress but vetoed by President Bush. Such legislation could reduce revenues of the Company's television and radio stations derived from political advertising by candidates for certain public offices. On April 9, 1991, the FCC adopted regulations to implement the Children's Television Act of 1990 (the "Children's Television Act") which limit the amount of advertising in children's programming, including a prohibition on children's programming which contains characters that are based on products advertised on such programs. The FCC will take into account the efforts made by broadcasters to meet the educational and informational needs of children as part of assessing the broadcaster's record of performance in the public interest before granting renewal of broadcast licenses. The impact, if any, of these regulations on the Company's television stations is not material. The FCC has instituted an inquiry into the manner in which TV stations have been complying with the Children's Television Act. Additionally, the FCC is considering whether to impose limits on the amount of advertising time which a television station can sell during any broadcast hour or part thereof. OWNERSHIP LIMITATIONS. The FCC has placed limits on the number of radio and television stations in which one entity can own an "attributable interest". The Company currently owns radio stations below those ownership limits and, with the transfer of control of licenses held by Paramount, owns the maximum permitted number of I - 31 television stations. The FCC has adopted a number of rules designed to prevent monopoly or undue concentration of control of the media of mass communications. In 1992 the FCC amended its regulations to permit a single entity to have an "attributable" ownership or management interest in up to 18 AM and 18 FM stations nationwide (20 AM and 20 FM beginning in 1994), including multiple AM and/or FM stations licensed to serve the same market. Minority-controlled broadcasters can own an additional three AM and three FM stations. The limit on the number of such multiple stations in a particular market which a single entity may own or control depends upon the total number of AM and/or FM stations in that market, provided that, at the time of purchase, the combined audience share of such multiple stations does not exceed 25%. With respect to television, the FCC's rules limit the maximum number of stations nationwide in which one entity can have an "attributable" ownership or management interest, to that number which serves up to 25% of U.S. television households, provided, however, that (except in limited circumstances) the total number of stations will not exceed 12. Unlike certain of the new radio rules, there is now no allowance for ownership of multiple television stations licensed to serve the same market, although the FCC is examining the issue. The FCC also permits radio stations to broker the programming and sales inventories of their stations to other radio stations within the same area, subject to various restrictions, so long as ultimate operational control and ownership is retained and exercised by the licensee. Such brokerage agreements function, as a practical matter, to effect a consolidation of competitive radio broadcast stations within a market in much the same manner as multiple ownership of radio facilities by one entity. Similar brokerage agreements among television stations are being implemented in a smaller number of markets than in radio and are not now subject to any explicit FCC regulations. The FCC's ownership limitations also prohibit a single entity from owning multiple "same service" (e.g., TV, AM or FM) stations licensed ---- to serve different markets if the broadcast signals of such stations overlap, to a specified measurable degree. The maximum number of commonly owned stations serving neighboring markets whose signals can overlap is the same as that maximum number of commonly owned stations which an entity can own or control in a single market. Additional ownership prohibitions preclude common ownership in the same market of (i) television stations and cable systems; (ii) television or radio stations and newspapers of general circulation; and (iii) radio and television stations. Radio-television cross-ownership prohibitions are subject to waiver by the FCC on a case-by-case basis. The Company operates two AM and two FM stations as well as a television station serving Washington, D.C. Ownership of the television station (WDCA) was obtained when Viacom Inc. acquired majority ownership of Paramount on March 11, 1994. Pursuant to the FCC's order consenting to the transfer of control of the broadcast licenses of Paramount to the Company, the Company has undertaken to dispose of one AM and one FM radio station serving Washington, D.C. no later than September 11, 1995. The FCC's previous prohibition on a national television network's (ABC, CBS, and NBC) owning or operating cable systems has been repealed but with certain limits as to the number of homes which network-owned cable systems can pass on a national and local basis. TERRITORIAL EXCLUSIVITY. The FCC is considering changes to its I - 32 non-network program territorial exclusivity rules which provide that a broadcaster, with certain limited exceptions, cannot obtain exclusivity to syndicated programming as against other broadcast stations beyond a 35-mile radius from its city of license. The proposed rule would permit expansion of the 35-mile exclusivity area thereby increasing the protection given the programming contracted for by a broadcaster. The Company cannot predict the effect, if any, that any change of this rule may have on its broadcast operations. HDTV. The FCC is considering technical standards to be adopted for the transmission of high definition television ("HDTV"), an advanced television system which enhances picture and sound quality, as well as the methods and timetable for implementation of an HDTV transmission standard by broadcasters. A standard has been recommended to the FCC by an advisory committee. The standard which is ultimately adopted for HDTV transmissions and the manner in which that transmission standard will be implemented and the development of technologies such as "digital compression" will have an economic and competitive impact on broadcasting and cable operations. The Company cannot predict the effect of implementation of these technologies on its operations. The FCC has stated its intention not to disadvantage broadcasters and it is expected that any HDTV standard which is ultimately adopted will be fashioned so as to accommodate the needs of broadcasters vis-a-vis competitive video delivery technologies. The FCC has already determined that TV stations will be given up to six years to implement HDTV once a standard has been selected and that stations which do not convert to the HDTV standard will lose their licenses to broadcast at the end of a proposed 15-year period from adoption of the standard. The cost of converting to HDTV will not have a material effect on the Company. COMPETITION VIACOM NETWORKS MTVN COMPETITION. MTVN services are in competition for available channel space on existing cable systems and for fees from cable operators and alternative media distributors, with other cable program services, and nationally distributed and local independent television stations. MTVN also competes for advertising revenue with other cable and broadcast television programmers, and radio and print media. For basic cable television programmers, such as MTVN, advertising revenues derived by each programming service depend on the number of households subscribing to the service through local cable operators and other distributors. A number of record companies have announced plans to launch music-based program services in the U.S. and internationally. For example, Tele-Communications, Inc. and Bertelsmann AG announced plans for a music video/home shopping channel and Sony Corp.'s Sony Music and Time Warner Inc.'s Time Warner Music Group are discussing the formation of a worldwide music video program service with such other major record companies as EMI Music, a unit of Thorn EMI PLC, and PolyGram. As of December 31, 1993, there were 32 principal cable program I - 33 services and superstations under contract with A.C. Nielsen Company, including MTV, VH-1, NICKELODEON (including NICKELODEON and NICK AT NITE program segments), each with over 10,000,000 subscribers. The Nielsen Report ranked NICKELODEON/NICK AT NITE seventh, MTV eleventh, and VH-1 sixteenth, in terms of subscriber households. MTV EUROPE is engaged in a number of related litigations in Europe contesting the legality of certain joint licensing activities by the major worldwide record companies. In 1992, MTV EUROPE initiated a proceeding before the European Commission, seeking the dissolution, under Articles 85 and 86 of the Treaty of Rome, of the record companies' joint licensing organizations -- Video Performance Limited (VPL) and International Federation of Phonogram and Videogram Producers (IFPI) -- through which the record companies exclusively license rights to exhibit music video clips on television in Europe and elsewhere. The EC issued a preliminary letter in 1993 stating its non-binding opinion that the arrangements constituted an unlawful restriction of trade under Article 85, and reserved its right to address abuse of monopoly power under Article 86. MTVN has been informed that the EC has issued a Statement of Objections, which commences formal legal proceedings against VPL and IFPI, and their major record company members. MTV EUROPE has been licensed to continue to exhibit music video clips during the EC proceeding under an EC-assisted interim agreement with VPL and IFPI, which expires in July 1994. In December 1993, MTV EUROPE commenced a separate proceeding before the European Commission, challenging the operation of VIVA, a German language music service owned by four of the five major record companies, as another example of illegal cartel activity. In a separate U.K. high court action, MTV EUROPE is seeking reimbursement of license fees paid to VPL and IFPI, on the grounds that these fees were unlawfully extracted by the record companies' cartel organizations. SNI COMPETITION. The principal means of competition in the provision of premium subscription television program services are: (1) the acquisition and packaging of an adequate number of quality recently released motion pictures; and (2) the offering of prices, marketing and advertising support and other incentives to cable operators and other distributors so as to favorably position and package SNI's premium subscription television program services to subscribers. HBO is the dominant company in the premium subscription television category, offering two premium subscription television program services, the HBO service and Cinemax. SNI is second to HBO with a significantly smaller share of the premium subscription television category. In addition, in February 1994, Encore Media Corp. (an affiliate of Liberty Media Corporation and Tele-Communications, Inc.) launched Starz!, a premium subscription television program service that will exhibit recently released motion pictures. The Company believes that Starz! will directly compete with SNI's premium program services. On November 9, 1993, the Company filed an amended complaint in its antitrust suit against Tele-Communications, Inc., Liberty Media Corporation, Satellite Services, Inc., Encore Media Corp., Netlink USA, Comcast Corporation and QVC Network, Inc., which action is pending in I - 34 the Southern District of New York. (See "Item 3 - Legal Proceedings") VIACOM ENTERTAINMENT Distribution and production of programming for television is a highly competitive business. The Company competes directly with other distributors and producers including major motion picture studios and other companies which produce and/or distribute programs and films. The main competitive factors in the television program distribution business are the availability and quality of product, promotion and marketing, and access to licensees of product. Major studios and distributors with a history of successful programming are better positioned to acquire and/or produce and distribute quality product. These studios and distributors also have greater available resources for promotion and marketing. Brand name identification is an advantage to a distributor in promoting and marketing programs for domestic and first run exhibition. The decline in the demand by licensees for recent off-network series and series produced for first run exhibition (due to renewal of existing series by stations during the past year) and feature films (due primarily to the recent expansion of the Fox network to supply programming to its affiliated stations seven nights a week) has been partly offset by a resurgence in demand by stations for first run hours and an increasing number of programming outlets, particularly cable networks. Distributors are advantageously positioned to obtain clearances from stations they also own. This advantage increases with an increase in the number of stations so owned, the size of the markets served by those stations and the viewership of those stations. Since the successful launch of a program for first run exhibition generally requires securing licenses in New York, Los Angeles and Chicago, distributors owning stations serving these markets are at the greatest advantage among distributors owning stations. Distribution of programming for television in international markets is also a highly competitive business. The Company competes in such markets with both U.S. and non-U.S. producers and distributors. Deregulation by certain foreign countries has given rise to new broadcast stations and cable services which, along with technological advances such as DBS, are continuing to increase the number of potential international customers. However, as a result of a political directive adopted by the European Community in 1989, which became effective in October 1991, most European Community countries have adopted broadcast quota regulations based on the guidelines of the directive. Such broadcast quota regulations may adversely affect the amount of U.S. produced programming to be purchased by foreign customers. (See "BUSINESS -- Regulation -- Viacom Entertainment -- European Community Directive") Program production for network television, which is a source of product for the Company's distribution operations, and program production for first run exhibition on cable and other media are highly competitive businesses. The Company competes with the major studios and other production companies. A company with a program airing on a network, which program the network deems commercially successful, is at an advantage in getting that network and, to a lesser extent, other I - 35 networks, to license additional programs. (See "BUSINESS -- Viacom Entertainment -- Viacom Productions") Subsequent to December 31, 1993, Viacom Inc. acquired Paramount, which is a significantly larger distributor and producer of television programming. It is anticipated that this acquisition and the combination of the Company's television distribution and production businesses with those of Paramount will significantly enhance the Company's competitive position in these businesses. VIACOM NEW MEDIA The emerging market for interactive multimedia software is highly competitive and rapidly evolving. Major competitors include hardware manufacturers who also manufacture and publish cartridge video games, software publishers, and interactive software publishing divisions that have been established by diversified entertainment companies similar to the Company. VIACOM CABLE TELEVISION The Company's cable systems operate pursuant to non-exclusive franchises granted by local governing authorities (either municipal or county) and primarily compete with over-the-air broadcast television. Cable systems also compete with other distribution systems which deliver programming by microwave transmission ("MDS" and "MMDS") and satellite transmission to master antennas ("SMATV") or directly to subscribers via either "TVRO" or "DBS" technology. A new type of distribution system called Multichannel Local Distribution Service ("MLDS"), which is similar to but more advanced than MMDS due to greater channel capacity, could also become competitive with cable. In 1991, the FCC concluded a proceeding aimed at eliminating a number of technological and regulatory limitations applicable to, and thereby supporting the potential growth of, MMDS and SMATV as competitive video delivery technologies. Certain DBS distribution systems are expected to commence their services in the near future, including United States Satellite Broadcasting, Inc., with which the Company has distribution agreements for each of the Company's wholly owned basic cable and premium networks, and Hughes DirecTV The development of these other distribution systems could in the future result in substantial competition for the Company's cable systems, depending upon the marketing plans and programming provided. However, a developing technology called "digital compression" may allow cable systems to significantly increase the number of channels of programming they deliver and thereby help cable systems meet competition from these other distribution systems. The acquisition of new franchises has slowed as an increasingly limited number of franchises and systems are left to be developed. The resulting reduced rate of construction may affect the cable industry's ability to sustain its historical subscriber growth rate. However, cable operators have increasingly sought to expand their subscriber bases through the acquisition of contiguous systems, which provide increased operating efficiencies. The Company's plan to expand in the cable business includes supplying additional services to its customers, I - 36 increasing primary and premium subscriber penetrations, developing existing franchise areas and, to a lesser degree, reviewing possible acquisitions of existing systems, principally contiguous systems, directly or through participation with others in partnerships or joint ventures. Since the Company's cable television systems are franchised on a non-exclusive basis, other cable operators have been franchised and may continue to apply for franchises in certain areas served by the Company's cable systems. In addition, the 1992 Cable Act prohibits a franchiser from granting exclusive franchises and from unreasonably refusing to reward additional competitive franchises. In 1986, the U.S. Supreme Court held that cable system operations implicate First Amendment rights and that local franchising authorities may violate those rights by establishing franchise requirements, unless there is a legitimate government purpose. Since this decision, various federal district and appellate courts have issued contradictory opinions with respect to the enforceability of specific franchise requirements. Depending on the resolution of these cases, competitive entry by other operators into Viacom Cable's franchise areas and Viacom Cable's entry into other franchise areas could be more easily achieved. The entry of telephone companies into the cable television business may adversely affect Viacom Cable. The FCC's Video Dial Tone regulations (See "BUSINESS -- Regulation -- Viacom Cable Television -- Competition with Telephone Companies") are an indication of the FCC's willingness to narrow the cross-ownership prohibitions contained in the Communications Act to the extent that it can do so consistent with its interpretation of the Act. VIACOM BROADCASTING The principal methods of competition in the television and radio broadcasting field are the development of audience interest through programming and promotions. Television and radio stations also compete for advertising revenues with other stations in their respective coverage areas and with all other advertising media. They also compete with various other forms of leisure time activities, such as cable television systems and audio players and video recorders. These competing services, which may provide improved signal reception and offer an increased home entertainment selection, have been in a period of rapid development and expansion. Technological advances and regulatory policies will have an impact, upon the future competitive broadcasting environment. In particular, recent FCC liberalization of its radio station ownership limits will allow for increased group ownership of stations. However, the Company is unable to predict what impact these rule changes will have on its businesses in their markets. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Ownership Limitations") DBS satellite distribution of programs is expected to commence in 1994. Additionally, the FCC has issued rules which may significantly increase the number of multipoint distribution service stations (i.e., ---- video services distributed on microwave frequencies which can only be received by special microwave antennas). The FCC has also authorized I - 37 video uses of certain frequencies which have not traditionally been used or permitted for commercial video services and has issued rules which will increase the number of FM and AM stations. The FCC is also considering authorizing digital audio broadcasts ("DAB"), which could ultimately permit increased radio competition by satellite delivery of audio stations directly to the home (or to cars) and result in an increased spectrum being used for digital delivery of radio signals, and it has authorized and is in the process of licensing low power television stations ("LPTV stations") that may serve various communities with coverage areas smaller than those served by full conventional television stations. Because of their coverage limitations, LPTV stations may be allocated to communities which cannot accommodate a full power television station because of technical requirements. ITEM 2. ITEM 2. PROPERTIES. The Company maintains its worldwide headquarters at 1515 Broadway, New York, New York, where it rents approximately 720,000 square feet for executive offices, including MTVN. The Company also rents approximately 24,000 square feet at the same location for WLTW-FM and Viacom Broadcasting headquarters. The lease runs to 2010, with four renewal options for five years each. The lease also grants the Company options for additional space at the then fair market value, including sufficient space for SNI and Paramount headquarters staff, and a right of first negotiation for other available space in the building. The Company also leases approximately 106,000 square feet at 1775 Broadway, New York, New York. The lease expires in 1998. In 1992, the Company sublet approximately 53,000 square feet of such space to COMEDY CENTRAL. The Company also operates a data processing facility in Rutherford, New Jersey and owns a 30,000 square foot building at 140 West 43rd Street, New York, New York, which supports office and conferencing requirements. Viacom MGS Services leases approximately 25,000 square feet at 619 West 54th Street, New York, New York. During 1993, the Company leased premises in California, Ohio, Oregon, Tennessee and Washington, the locations of Viacom Cable's operations. Viacom Cable's operations require a large investment in physical assets consisting primarily of receiving apparatus, trunk lines, feeder cable and drop lines connecting the distribution network to the premises of the customers, electronic amplification and distribution equipment, converters located in customers' homes and other components. Significant expenditures are also required for replacement of and additions to such system assets as a result of technological advances, ordinary wear and tear and regulatory standards. Approximately 47% of the Company's cable television systems' fixed assets have been installed within the past five years and, except for ordinary wear and tear, the Company believes that this equipment is in good condition. I - 38 In addition to its leased space at 1515 Broadway, Viacom Broadcasting owns office and studio space in Hartford, Connecticut, occupied by television station WVIT-TV; in Menands, New York, occupied by television station WNYT-TV; in Shreveport, Louisiana, occupied by television station KSLA-TV; and in Rochester, New York, occupied by television station WHEC-TV. Television station KMOV-TV, St. Louis, Missouri, leases office and studio space for a term expiring December 31, 2002. WLIT-FM, Chicago, Illinois, leases office and studio space for a term expiring in April 2002. WLTI-FM, Detroit, Michigan, leases office and studio space for a term expiring in August 2002. WMZQ-FM, Washington, D.C., leases office and studio space for a term expiring in December 1998. WMZQ-AM, Arlington, Virginia, leases office and studio space for a term expiring in August 2014. WCPT-AM and WCXR-FM lease office and studio space in Alexandria, Virginia for a term expiring in November 2001. KBSG-AM/FM, Tacoma/Seattle, Washington, lease office and studio space for a term expiring in August 1999. KYSR-FM, and KXEZ-FM, Los Angeles, California, lease office and studio space for a term expiring in October 1999. KSRY-FM, San Francisco, California, leases office and studio space for a term expiring in March 1997. KSRI-FM, Santa Cruz, California, leases office and studio space for a term expiring in July 1995. KNDD-FM, Seattle, Washington, leases office and studio space for a term expiring in February 2001. Viacom Broadcasting owns the broadcasting antenna equipment of its radio and television stations and the main transmission and antenna sites used by its five television stations and radio stations WMZQ-FM, WCPT-AM, KYSR-FM and KNDD-FM. The other radio stations, WLTW-FM, WLIT- FM, WLTI-FM, WCXR-FM, WMZQ-AM, KBSG-AM, KBSG-FM, KSRY-FM, KSRI-FM and KXEZ-FM lease their transmission and antenna sites. The leases expire in August 2005, September 2002, December 1995, February 2000, August 2014, February 2000, December 1997, February 2000, May 1999, and November 2000, respectively. MTVN, by agreement with MCA, leases approximately 75,000 square feet of studio and office space for NICKELODEON STUDIOS FLORIDA, which agreement expires (with extensions at MCA's option) in 2003. MTVN leases approximately 58,600 square feet of other office facilities and studios (i.e., excluding 1515 Broadway, 1775 Broadway, NICKELODEON ---- STUDIOS, Orlando and Universal City, Los Angeles). MTVN also owns the Network Operations Center in Smithtown, New York at which it assembles and uplinks its programming signals. The center consists of a 15,000 square foot building housing television and satellite transmission equipment. In March 1993, a subsidiary of the Company entered into an agreement to purchase approximately 50,000 square feet of office and studio space in London, England. The Company leases the space to MTV EUROPE. SNI's executive offices are located at 1633 Broadway, New York, New York, where it rents approximately 106,000 square feet. SNI leases approximately 58,000 square feet of other office facilities (i.e., ---- excluding 1633 Broadway, 1775 Broadway and Universal City, Los I - 39 Angeles). For a description of the transponders employed by MTVN and SNI, see "BUSINESS -- Viacom Networks -- Additional Information about MTVN and SNI." Other than Brazil, where the office facility is owned, most of the domestic and international television program and feature film sales offices are held under leases aggregating approximately 9,000 square feet. Also, the Company maintains approximately 83,000 square feet of consolidated offices in Universal City, Los Angeles for Viacom Entertainment, MTVN and SNI. The Company also maintains a tape storage and operations service center of approximately 22,500 square feet for Viacom Networks and Viacom Enterprises in New York, New York. The Company believes that all of its facilities are adequate for the activities conducted at such facilities. However, the Company anticipates that it will lease or purchase additional office space both in the New York area as well as in other areas where the Company and its subsidiaries are presently located. Information with respect to Paramount in response to Item 2 is incorporated by reference herein from the Paramount Reports. Information in the Paramount Reports is given as of the date of each such report and is not updated herein. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Stockholder Litigation. Seven putative class action complaints were filed by alleged Blockbuster stockholders in the Delaware Court of Chancery against Blockbuster, the members of its Board of Directors, Viacom Inc. and Sumner M. Redstone. By Order dated January 31, 1994, the seven actions were consolidated under the caption In re Blockbuster Entertainment Corp. Shareholders' Litigation, Consolidated Civil Action No. 13319. On February 18, 1994, plaintiffs filed the Consolidated and Amended Class Action Complaint (the "Complaint"). The Complaint generally alleges that Blockbuster's directors have violated their fiduciary duties of loyalty and fair dealing by allegedly failing to ensure the maximization of stockholder value in the sale of control of Blockbuster, including the alleged failure to authorize and direct that a process designed to secure the best value available for Blockbuster stockholders be undertaken, and by implementing measures such as the Subscription Agreement which allegedly were designed solely to thwart or impede other competing transactions. Among other things, the plaintiffs seek to (i) preliminarily and permanently enjoin the purchase by Blockbuster of shares of Viacom Class B Common Stock pursuant to the Subscription Agreement (see next paragraph); (ii) preliminarily and permanently enjoin the Blockbuster Merger or any anti-takeover devices designed to facilitate the Blockbuster Merger; (iii) require the Blockbuster directors to maximize stockholder value by exploring third party interest; and/or (iv) recover damages from the I - 40 Blockbuster directors for their alleged breaches of fiduciary duty. The defendants believe that plaintiffs' allegations are without merit and intend to defend themselves vigorously. On February 28, 1994, plaintiffs filed motions in the Delaware Chancery Court seeking expedited discovery, a temporary restraining order enjoining consummation of the Subscription Agreement and the scheduling of a preliminary injunction hearing. On March 1, 1994, Vice Chancellor Carolyn Berger issued an order denying plaintiffs' motions. Following issuance of the above-described order, plaintiffs filed a Motion for Clarification or, in the alternative, for Certification on Interlocutory Appeal, requesting that the Chancery Court clarify whether its order also refers to a hearing for a preliminary injunction. Plaintiffs requested that, if the order is limited to a hearing for a temporary restraining order, the Chancery Court schedule a hearing on plaintiffs' motion for a preliminary injunction. On March 2, 1994, plaintiffs informed the Chancery Court that they had decided not to seek an interlocutory appeal and indicated their understanding that the order precluded preliminary injunctive relief as to the Subscription Agreement. On March 7, 1994, the plaintiffs filed a motion for a preliminary injunction, seeking an order preliminarily enjoining the defendants from (i) taking any steps to effectuate or enforce the Blockbuster Merger Agreement, the Subscription Agreement and the Stockholders Stock Option Agreement; (ii) making any payment to Viacom of its fees and expenses pursuant to Section 8.05(b) of the Blockbuster Merger Agreement; and (iii) entering into any competing transaction with a party other than Viacom, which transaction includes a stock component unless adequate price protection for the stockholders of Blockbuster is provided. Plaintiffs have also moved for an injunction requiring the Blockbuster defendants to investigate all bona fide offers to acquire Blockbuster and to provide such bona fide offerors access to information concerning Blockbuster in order to facilitate such offers. No schedule has been set for a hearing on the motion. On March 10, 1994, Defendant Sumner Redstone filed a motion to dismiss the Complaint as to him, on the grounds of lack of personal jurisdiction, insufficiency of process, and insufficiency of service of process. Also, on March 10, 1994, defendant Viacom filed a motion to dismiss the Complaint as to itself, for failure to state a claim against Viacom upon which relief can be granted. No schedule has been set for a hearing on these motions. Antitrust Matters On September 23, 1993, the Company filed an action in the United States District Court for the Southern District of New York styled Viacom International Inc. v. Tele-Communications, Inc., et al., Case No. 93 Civ. 6658, against Tele-Communications, Inc. ("TCI"), Liberty Media Corporation, Satellite Services, Inc. ("SSI"), Encore Media Corp., Netlink USA, and QVC Network, Inc. The complaint alleges violations of Sections 1 and 2 of the Sherman Act, Section 7 of the Clayton Act, Section 12 of the Cable Act, and New York's Donnelly Act, and tortious interference, against all defendants, and a breach of contract claim against defendants TCI and SSI only. In addition to I - 41 other relief, the Company seeks injunctive relief against defendants' anticompetitive conduct and damages in an amount to be determined at trial, including trebled damages and attorneys' fees under the Sherman and Clayton Acts and damages resulting from QVC Network, Inc.'s proposed acquisition of Paramount Communications Inc. The 19 claims for relief in the complaint are based on allegations that defendants exert monopoly power in the U.S. cable industry through their control over approximately one in four of all cable households in the United States. Among other things, the complaint alleges that defendants conspired and attempted to force SNI to enter into a merger with a TCI-controlled pay television service; defendants have attempted to eliminate The Movie Channel from at least 28 of TCI's systems and have plans to eliminate The Movie Channel from another 27 such systems; defendants have conspired with General Instrument Corporation ("GI") to entrench GI's monopoly power in the markets for digital compression and encryption systems and to use such monopoly power to weaken and eliminate the defendants' competitors; and TCI's construction of a central authorization center to illegally control the distribution of programming services through refusals to deal and denial of direct access. On November 9, 1993, the Company amended its complaint in Viacom International Inc. v. Tele-Communications, Inc., et al., Case No. 93 Civ. 6658, to add Comcast Corporation as an additional defendant and to incorporate into the allegations additional anticompetitive activities by the defendants. Each of the defendants has answered and has generally denied the material allegations of the Company's amended complaint. Following the filing of its amended complaint, the Company has agreed to voluntarily dismiss certain of its breach of contract claims against TCI and SSI. Viacom Cable, through a subsidiary of the Company, was one of the original partners ("Original Partners") of Primestar Partners L.P. ("Primestar"). Primestar was launched in 1990 to deliver programming directly to dishes located at subscribers' homes from a mid-powered Ku- band satellite. The Company has withdrawn from Primestar by, among other things, exercising in November 1991 the Company's contractual right not to continue funding its share of Primestar's capital requirements. The Department of Justice ("DOJ") has conducted an inquiry into the structure and business of Primestar to ensure that the Original Partners did not engage in any concerted action prohibited by law. In addition, several state Attorneys General ("AGs") have reviewed the structure and business plan of Primestar as well as certain business practices of the Original Partners which reflect business practices in the cable industry, generally. The AGs' inquiry resulted in a final judgment entered into with the consent of the Original Partners in September of 1993. The DOJ has concluded its inquiry by submitting a similar consent judgment for judicial approval. Both judgments address (i) access by multichannel distributors competitive with cable to programming controlled by any of the Original Partners and (ii) the extent of programming which may be licensed exclusively by the cable operations of the Original Partners. The provisions of the AGs' decree expire in 1997 and 1999. If approved, as expected, the provisions of the DOJ decree will expire in 1999. The terms of the judgments do not materially affect the Company. Information with respect to Paramount in response to Item 3 is I - 42 incorporated by reference herein from the Paramount Reports. Information in the Paramount Reports is given as of the date of each such report and is not updated herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable EXECUTIVE OFFICERS OF VIACOM INC. AND THE COMPANY Set forth below is certain information concerning the current executive officers of Viacom Inc. and the Company, which information is hereby included in Part I of this report. POSITIONS WITH VIACOM INC. NAME AGE AND THE COMPANY - ------------------------------------------------------------------------ Sumner M. Redstone 70 Chairman of the Board of Viacom Inc. and the Company Frank J. Biondi, Jr 49 President, Chief Executive Officer and Director of Viacom Inc. and the Company Raymond A. Boyce 58 Senior Vice President, Corporate Relations of Viacom Inc. and the Company Neil S. Braun 41 Senior Vice President of Viacom Inc. and the Company Vaughn A. Clarke 40 Vice President, Treasurer of Viacom Inc. and the Company Philippe P. Dauman 40 Executive Vice President, General Counsel, Chief Administrative Officer and Secretary and Director of Viacom Inc. and the Company Earl H. Doppelt 40 Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company Thomas E. Dooley 37 Executive Vice President, Finance, Corporate Development and Communications of Viacom Inc. and the Company Michael D. Fricklas 34 Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company I - 43 John W. Goddard 52 Senior Vice President of Viacom Inc. and the Company; President, Chief Executive Officer of Viacom Cable Edward D. Horowitz 46 Senior Vice President, Technology of Viacom Inc. and the Company; Chairman, Chief Executive Officer of New Media and Interactive Television Kevin C. Lavan 41 Vice President, Controller and Chief Accounting Officer of Viacom Inc. and the Company Henry J. Leingang 44 Senior Vice President, Chief Information Officer of Viacom Inc. and the Company William A. Roskin 51 Senior Vice President, Human Resources and Administration of Viacom Inc. and the Company George S. Smith, Jr. 45 Senior Vice President, Chief Financial Officer of Viacom Inc. and the Company Mark M. Weinstein 51 Senior Vice President, Government Affairs of Viacom Inc. and the Company None of the executive officers of Viacom Inc. or the Company is related to any other executive officer or director by blood, marriage or adoption except that Brent D. Redstone, a Director of Viacom Inc. and the Company, is the son of Sumner M. Redstone. Mr. Redstone has been Chairman of the Board and a Director of the Company since the Merger. Mr. Redstone is also Chairman of the Board and a Director of Viacom Inc. Mr. Redstone has served as President, Chief Executive Officer of NAI since July 1967, and continues to serve in such capacity; he has also served as the Chairman of the Board of NAI since 1986. Mr. Redstone became a director of Paramount in March 1994. He served as the first Chairman of the Board of the National Association of Theater Owners, and is currently a member of the Executive Committee of that organization. During the Carter Administration, Mr. Redstone was appointed a member of the Presidential Advisory Committee on the Arts for the John F. Kennedy Center for the Performing Arts and, in 1984, he was appointed a Director of the Kennedy Presidential Library Foundation. Since 1982, Mr. Redstone has been a member of the faculty of Boston University Law School, where he has lectured in entertainment law. In 1944, Mr. Redstone graduated I - 44 from Harvard University and, in 1947, received an L.L.B. from Harvard University School of Law. Upon graduation, he served as Law Secretary with the United States Court of Appeals, and then as a Special Assistant to the United States Attorney General. Mr. Biondi has been President, Chief Executive Officer and a Director of Viacom Inc. and the Company since July 1987. He became a director of Paramount in March 1994. From November 1986 to July 1987, Mr. Biondi was Chairman, Chief Executive Officer of Coca-Cola Television and, from 1985, Executive Vice President of the Entertainment Business Sector of The Coca-Cola Company. Mr. Biondi joined HBO in 1978 and held various positions there until his appointment as President, Chief Executive Officer in 1983. In 1984, he was elected to the additional position of Chairman and continued to serve in such capacities until October 1984. Mr. Boyce has been an executive officer of Viacom Inc. and the Company since January 1988 when he was elected Senior Vice President, Corporate Relations of the Company. In April 1988, he was elected Senior Vice President, Corporate Relations of Viacom Inc. Mr. Boyce served as Vice President, Public Relations of the Entertainment Business Sector of The Coca-Cola Company from 1982 to 1987. In 1979, Mr. Boyce joined Columbia Pictures Industries, Inc. and served first as Director, Corporate Communications and later as Vice President, Corporate Communications until The Coca-Cola Company's acquisition of Columbia Pictures Industries, Inc. in 1982. Mr. Braun has been an executive officer of Viacom Inc. and the Company since November 1987 when he was elected Senior Vice President of each. He served as Chairman, Chief Executive Officer of Viacom Entertainment from July 1992 to March 1994. Prior to that, Mr. Braun served as Senior Vice President, Corporate Development and Administration of Viacom Inc. and the Company from November 1987 to July 1992 and from October 1989 to July 1992, he also served as Chairman of Viacom Pictures. Mr. Braun served as President, Chief Operating Officer of Imagine Films Entertainment from May 1986 until he joined the Company. From 1982 until 1986, Mr. Braun held various positions at HBO including Senior Vice President, Film Programming of HBO and Executive Vice President of HBO Video, Inc. Mr. Clarke was elected Vice President, Treasurer of Viacom and the Company in April 1993. Prior to that, he spent 12 years at Gannett Co., Inc., where he held various management positions, most recently as Assistant Treasurer. Mr. Dauman has been a Director of Viacom Inc. and the Company since the Merger. In March 1994, he was elected Executive Vice President, General Counsel, Chief Administrative Officer and Secretary of Viacom Inc. and the Company. From February 1993 to March 1994, he served as Senior Vice President, General Counsel and Secretary of Viacom Inc. and the Company. Prior to that, Mr. Dauman was a partner in the law firm of Shearman & Sterling in New York, which he joined in 1978. Mr. Dauman became a Director of National Amusements, Inc. in 1992 and Paramount in March 1994. Mr. Dooley has been an executive officer of the Company since I - 45 January 1987. In March 1994, he was elected Executive Vice President, Finance, Corporate Development and Communications of Viacom Inc. and the Company. From July 1992 to March 1994, Mr. Dooley served as Senior Vice President, Corporate Development of Viacom Inc. and the Company. From August 1993 to March 1994, he also served as President, Interactive Television. Prior to that, he served as Vice President, Treasurer of the Company and Viacom Inc. since 1987. In December 1990, he was named Vice President, Finance of Viacom Inc. and the Company. Mr. Dooley joined the Company in 1980 in the corporate finance area and has held various positions in the corporate and divisional finance areas, the most recent of which was Director of Business Analysis from 1985 to 1986. Mr. Doppelt was elected Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company in March 1994. Prior to that, he served as Senior Vice President of Paramount since 1992 and as Deputy General Counsel of Paramount since 1985. He joined Paramount in 1983 as Associate Litigation Counsel, and in 1985 was appointed Assistant Vice President and Deputy General Counsel. In 1986, he became a Vice President of Paramount. From 1977 to 1983, Mr. Doppelt was an attorney in private practice at the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. Mr. Fricklas was elected Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company in March 1994. From June 1993 to March 1994, he served as Vice President, Deputy General Counsel of Viacom Inc. and the Company. He served as Vice President, General Counsel and Secretary of Minorco (U.S.A.) Inc. from 1990 to 1993. Prior to that, Mr. Fricklas was an attorney in private practice at the law firm of Shearman & Sterling. Mr. Goddard has been an executive officer of the Company since August 1980. In November 1987, Mr. Goddard was elected Senior Vice President of Viacom Inc. and in September 1983, Mr. Goddard was elected Senior Vice President of the Company and President, Chief Executive Officer of Viacom Cable and continues to serve in those capacities. In August 1980, Mr. Goddard was appointed President of Viacom Cable and, in September 1980, he was elected Vice President of the Company. From September 1978 through July 1980, Mr. Goddard was Executive Vice President, Viacom Communications. From June 1971 until September 1978, Mr. Goddard was President and General Manager of Tele-Vue Systems, a subsidiary of the Company. Mr. Horowitz has been an executive officer of Viacom Inc. and the Company since April 1989. In March 1994, he was elected Senior Vice President, Technology of Viacom Inc. and the Company and Chairman, Chief Executive Officer of New Media and Interactive Television. Prior to that, he served as Senior Vice President of Viacom Inc. and the Company from April 1989 and as Chairman, Chief Executive Officer of Viacom Broadcasting from July 1992 to March 1994. From 1974 to April 1989, Mr. Horowitz held various positions with HBO, most recently as Senior Vice President, Technology and Operations. Mr. Horowitz held several other management positions with HBO, including Senior Vice President, Network Operations and New Business Development and Vice President, Affiliate Sales. I - 46 Mr. Lavan has been an executive officer of the Company since December 1987. In May 1989, he was elected Vice President of Viacom Inc. and the Company. In December 1990, he assumed the added responsibilities of oversight of Company tax matters. From 1991 to 1992, he also served as Senior Vice President and Chief Financial Officer of Viacom Pictures. Mr. Lavan joined Viacom in 1984 as Assistant Controller and, in December 1987, was elected Controller, Chief Accounting Officer of Viacom Inc. and the Company and he continues to serve in such capacities. Mr. Leingang was elected Senior Vice President, Chief Information Officer in May 1993. Prior to that, he served as Vice President, Chief Information Officer upon joining Viacom in 1990. Mr. Leingang was Vice President, Information Services of the Train Group (formerly Triangle Industries) from 1984 to 1990. From 1982 to 1984, he served as Corporate Director, MIS, and Manager, MIS Planning and Control for Interpace Corporation. Prior to that he held positions with Touche Ross & Company, McGraw-Hill Book Company and General Electric Credit Corp. Mr. Roskin has been an executive officer of Viacom Inc. and the Company since April 1988 when he became Vice President, Human Resources and Administration of each. In July 1992, Mr. Roskin was elected Senior Vice President, Human Resources and Administration of Viacom Inc. and the Company. From May 1986 to April 1988, he was Senior Vice President, Human Resources at Coleco Industries, Inc. From 1976 to 1986, he held various executive positions at Warner Communications, Inc., serving most recently as Vice President, Industrial and Labor Relations. Mr. Smith has been an executive officer of the Company since May 1985. In November 1987, he was elected Senior Vice President, Chief Financial Officer of Viacom Inc. and the Company and he continues to serve in such capacities. In May 1985, Mr. Smith was elected Vice President, Controller of the Company and, in October 1987, he was elected Vice President, Chief Financial Officer of the Company. From 1983 until May 1985, he served as Vice President, Finance and Administration of the Viacom Broadcasting Division and from 1981 until 1983, he served as Controller of Viacom Radio. Mr. Smith joined the Company in 1977 in the Corporate Treasurer's office and until 1981 served in various financial planning capacities. Mr. Weinstein has been an executive officer of the Company since January 1986. In February 1993, he was elected Senior Vice President, Government Affairs of Viacom Inc. and the Company. Prior to that, Mr. Weinstein served as Senior Vice President, General Counsel and Secretary of the Company and of Viacom Inc. since the fall of 1987. In January 1986, Mr. Weinstein was appointed Vice President, General Counsel of the Company. From 1976 through 1985, he was Deputy General Counsel of Warner Communications Inc. and in 1980 became Vice President. Previously, Mr. Weinstein was an attorney in private practice at the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. I - 47 PART II Item 5. Item 5. Market for Viacom Inc.'s Common Equity and Related Security Holder Matters. Viacom Inc. voting Class A Common Stock and Viacom Inc. non-voting Class B Common Stock are listed and traded on the American Stock Exchange ("ASE") under the symbols "VIA" and "VIAB," respectively. The following table sets forth, for the calendar period indicated, the per share range of high and low sales prices for Viacom Inc.'s Class A Common Stock and Class B Common Stock, as reported on the ASE Composite Tape by the National Quotation Bureau Incorporated. As of March 30, 1994 there were approximately 6,912 holders of Viacom Inc. Class A Common Stock, and 6,861 holders of Viacom Inc. Class B Common Stock. Viacom Class A Viacom Class B Common Stock Common Stock --------------- ---------------- High Low High Low ---- --- ---- --- 1st quarter $37 1/4 $32 1/8 $36 1/2 $31 1/4 2nd quarter 38 1/2 32 3/8 36 7/8 30 1/2 3rd quarter 34 7/8 30 7/8 32 7/8 29 4th quarter 44 28 1/8 41 7/8 27 1st quarter $46 1/2 $37 1/2 $44 1/8 $35 1/4 2nd quarter 52 5/8 37 1/8 49 1/2 36 3rd quarter 67 1/2 50 1/2 61 1/4 45 3/4 4th quarter 66 1/2 47 60 1/2 40 3/8 The parent, Viacom Inc., has substantially no source of funds other than dividends paid by the Company on its stock. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes), unless its total leverage ratio is less than a specified amount. II-1 Item 6. Item 6. Selected Financial Data. VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES (Thousands of dollars, except per share amounts) See Notes to Consolidated Financial Statements for information on transactions and accounting classifications which have affected the comparability of the periods presented above. Viacom Inc. has not declared cash dividends for any of the periods presented above. II-2 Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. General ------- Management's discussion and analysis of the combined results of operations and financial condition of Viacom Inc. and the Company should be read in conjunction with the Consolidated Financial Statements and related Notes. Information presented below does not include information with respect to Paramount, which became a subsidiary of Viacom Inc. on March 11, 1994. Information with respect to Paramount's results of operations and financial condition and Paramount's audited and unaudited financial statements, in each case including the notes thereto, are incorporated by reference herein from the Paramount Reports (as defined in Item 1). Information in the Paramount Reports is given as of the date of each such report and is not updated herein. A copy of each of the Paramount Reports is included as an exhibit hereto. Descriptions of all documents incorporated by reference herein or included as exhibits hereto are qualified in their entirety by reference to the full text of such documents so incorporated or included. Viacom Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, "Viacom Inc.") is a holding company whose principal asset is the common stock of Viacom International Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, the "Company"). The Company is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. Viacom Inc. is an approximately 76.3% owned subsidiary of National Amusements, Inc. ("NAI"), a closely held corporation that owns and operates approximately 850 movie screens in the United States and the United Kingdom. In early March 1994, Viacom Inc. acquired a majority interest in Paramount Communications Inc. ("Paramount") pursuant to the terms of its tender offer. Paramount will become a wholly owned subsidiary of Viacom Inc. upon the closing of the merger pursuant to the Paramount merger agreement. Viacom Inc. has also entered into a merger agreement with Blockbuster Entertainment Corporation ("Blockbuster") pursuant to which Blockbuster will merge into Viacom Inc. (See "Paramount Merger, Blockbuster Merger and Related Transactions" for additional information regarding the mergers). The primary differences between Viacom Inc.'s and the Company's financial statements are as follows: a) the capitalization of the two companies -- the Company's shareholders' equity reflects the contribution to capital of Viacom Inc.'s exchangeable preferred stock, which was exchanged for 15.5% Junior Subordinated Exchange Debentures due 2006 (the "Exchange Debentures") on March 31, 1989 which in turn were fully redeemed during 1991; b) during 1993, Viacom Inc. issued $1.8 billion of 5% cumulative convertible preferred stock and declared related preferred stock dividends of $12.8 million, c) certain general and administrative expenses recorded by Viacom Inc. of $5.0 million (1993), $9.0 million (1992) and $12.9 million (1991), which include transactions associated with the long-term deferred incentive compensation plans; and d) Viacom Inc. recorded net interest income of $3.1 million (1993) and net interest expense of $45.2 million (1991). II-3 Business Segment Information ---------------------------- The following tables set forth revenues, earnings from operations, depreciation and amortization by business segment and a reconciliation of total earnings from operations to net earnings (loss) attributable to common stock for the periods indicated: Year Ended December 31, Percentage Change ----------------------------- ----------------- From From 1993 1992 1991 1992 1991 ---- ---- ---- To To 1993 1992 ---- ---- (Thousands of Dollars) Revenues: Networks $1,221,200 $1,058,831 $ 922,157 15% 15% Entertainment 209,110 248,335 273,488 (16) (9) Cable Television 415,953 411,087 378,026 1 9 Broadcasting 181,778 168,847 159,182 8 6 Intercompany elimination (23,092) (22,417) (21,291) (3) (5) ---------- --------- ---------- Total revenues $2,004,949 $1,864,683 $1,711,562 8 9 ========== ========== ========== Earnings from operations: Networks $ 272,087 $ 205,576 $ 172,296 32 19 Entertainment 32,480 59,662 73,214 (46) (19) Cable Television 110,176 122,037 103,954 (10) 17 Broadcasting 42,293 31,956 27,734 32 15 Corporate (72,041) (71,304) (64,964) (1) (10) ---------- --------- ---------- Total earnings from operations $ 384,995 $ 347,927 $ 312,234 11 11 ========== ========== ========== Depreciation and amortization: Networks $ 44,747 $ 41,754 $ 30,123 Entertainment 9,549 6,792 7,160 Cable Television 71,520 68,505 66,604 Broadcasting 23,475 24,509 27,062 Corporate 3,766 3,242 1,915 ---------- --------- ---------- Total depreciation and amortization $ 153,057 $ 144,802 $ 132,864 ========== ========== ========== II-4 Reconciliation to net earnings (loss) attributable to common stock: Total earnings from operations $ 384,995 $ 347,927 $ 312,234 Interest expense, net (144,953) (194,104) (297,451) Other items, net 61,774 1,756 (6,536) ---------- --------- ---------- Earnings before income taxes 301,816 155,579 8,247 Provision for income taxes 129,815 84,848 42,060 Equity in loss of affiliated companies, net of tax (2,520) (4,646) (12,743) ---------- --------- ---------- Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle 169,481 66,085 (46,556) Extraordinary losses, net of tax (8,867) (17,120) (3,101) Cumulative effect of change in accounting principle 10,338 -- -- ---------- --------- ---------- Net earnings (loss) 170,952 48,965 (49,657) Cumulative convertible preferred stock dividend requirement of Viacom Inc. 12,750 -- -- ---------- --------- ---------- Net earnings (loss) attributable to common stock $ 158,202 $ 48,965 $ (49,657) ========== ========== ========== II-5 Results of Operations --------------------- 1993 vs. 1992 ------------- Revenues increased 8% to $2.0 billion in 1993 from $1.9 billion in 1992. Earnings from operations increased 11% to $385.0 million in 1993 from $347.9 million in 1992. Explanations of variances in revenues and earnings from operations for each operating segment follow. Net earnings attributable to common stock of $158.2 million, or $1.31 per share, for the year ended December 31, 1993, reflect net interest expense of $145.0 million, a pre-tax gain aggregating $72.4 million from the sale of the Wisconsin cable television system and sales of a portion of an investment held at cost, and a provision for income taxes of $129.8 million. Net earnings of $49.0 million, or $.41 per share, for the year ended December 31, 1992, reflect net interest expense of $194.1 million and a provision for income taxes of $84.8 million. The comparability of results of operations for 1993 and 1992 has been affected by (1) the sale of the Wisconsin cable television system, effective January 1, 1993 and (2) the change in estimate of copyright royalty revenues during 1992 in the Entertainment segment. (See "Cable Television" and "Entertainment" for additional information concerning the changes noted above.) Networks (Basic cable and premium television networks) The constituents of Networks are MTV Networks ("MTVN") and Showtime Networks Inc. ("SNI"). Networks revenues increased 15% to $1.221 billion in 1993 from $1.059 billion in 1992. Networks earnings from operations increased 32% to $272.1 million in 1993 from $205.6 million in 1992. MTVN revenues increased 27% to $677.9 million in 1993 from $533.4 million in 1992: 70% of the increase was attributable to increased advertising sales; 21% was due to increased affiliate fees; and 9% was due to other sources. The increases in advertising sales and affiliate fees were principally due to rate increases. The increase in other sources was principally due to revenues from new business ventures including licensing and merchandising. Earnings from operations of MTVN increased 39% to $239.7 million in 1993 from $172.9 million in 1992, reflecting the increased revenues, partially offset by increased programming and marketing expenses at each of the networks and other costs of operating the networks, including start up losses of MTV Latino and Nickelodeon Magazine aggregating $6.5 million. The increased programming and marketing expenses at each of the networks (including animated programming on Nickelodeon and MTV) was to a large extent responsible for the Company's ability to increase advertising rates. II-6 SNI revenues increased 3% to $543.3 million in 1993 from $525.7 million in 1992, including Viacom Pictures in each period presented, due to (i) an increase of $13.6 million in revenues of Showtime Satellite Networks ("SSN"), primarily due to a 40% increase in SSN's subscriber base, principally attributable to the use of upgraded scrambling technology, partially offset by a decrease of 8% in average rates, (ii) an increase of $4.4 million in revenues of Showtime and The Movie Channel (excluding revenues generated by SSN), reflecting a 3% increase in the combined subscriber base with a decrease in average rates of 2% and (iii) a $.4 million decrease in other revenue sources. SNI's premium movie services, Showtime, The Movie Channel and FLIX, served approximately 11.9 million subscribers as of December 31, 1993 and 10.7 million subscribers as of December 31, 1992. SNI's overall earnings from operations decreased 1% to $32.3 million in 1993 from $32.7 million in 1992, reflecting increased programming and marketing expenses, partially offset by the increased revenues. Entertainment (Television programming, syndication, production and new media) The Entertainment segment distributes television series, feature films, made-for-television movies and mini-series for television exhibition around the world, produces television series and made-for- television movies, and also distributes television and radio commercials. The Entertainment segment also includes Viacom New Media, which develops, produces, distributes and markets interactive software. Entertainment revenues decreased 16% to $209.1 million in 1993 from $248.3 million in 1992. The revenue variance was principally due to lower syndication revenues, lower copyright revenues resulting from a change in estimate which increased revenue by approximately $10 million in 1992, and decreased network production revenues. Lower sales to the broadcast, cable and other markets reflect lower syndication revenues for The Cosby Show and softness in the syndication marketplace due to a decrease in the number of independent broadcast television stations because of new network affiliations. Revenues from the domestic broadcast syndication of The Cosby Show were approximately 12% and 18% of Entertainment revenues during 1993 and 1992, respectively. The decrease was due to the ending of the first domestic syndication cycle of The Cosby Show during the third quarter of 1993. The second domestic broadcast syndication cycle of The Cosby Show, which began in the third quarter of 1993, will generate significantly lower revenues. Network license fees were lower because fewer shows were produced for network television; however the decrease does not have a significant impact on Entertainment earnings from operations. Earnings from operations decreased 46% to $32.5 million in 1993 from $59.7 million in 1992, reflecting the decreased revenues and $6.1 million of start-up losses associated with Viacom New Media, which anticipates releasing approximately nine interactive video games based II-7 on MTV Networks' programming by the end of 1994. The Company had accumulated a backlog of unbilled syndication license agreements of approximately $399.0 million at December 31, 1993. As the license fees are billed over the term of the various licensing contracts, the Company will recognize as revenues that portion of such license fees representing its distribution fees. Approximately 58% of the Company's backlog was attributable to license fees for Roseanne and The Cosby Show. As The Cosby Show becomes a smaller portion of the total backlog, the percentage of the total license fee recognized as revenue by the Company will be reduced. Cable Television (Cable television systems) Cable Television revenues increased 1% to $416.0 million in 1993 from $411.1 million in 1992. Earnings from operations decreased 10% to $110.2 million in 1993 from $122.0 million in 1992. On a comparable basis with the 1992 results (excluding the Wisconsin cable system, which was sold effective January 1, 1993), Cable Television revenues increased 6% to $416.0 million in 1993 from $393.6 million in 1992: 52% of this increase resulted from increases in rates for basic services; 32% from increased basic customers; 8% from increased pay-per-view revenues; and 8% from increases in other revenue sources. Total revenue per basic customer per month increased 3% to $32.03 in 1993 from $31.04 in 1992. Earnings from operations decreased 6% to $110.2 million in 1993 from $117.6 million in 1992, reflecting increased operating expenses (which included non-recurring costs associated with the implementation of Federal Communication Commission ("FCC") rate regulations discussed below), partially offset by increased revenues. The 1992 Cable Act amended the Communications Act of 1934, as amended (the "Communications Act"). Rate regulations adopted in April 1993 by the FCC govern rates charged to subscribers for regulated tiers of cable service and became effective on September 1, 1993. On February 22, 1994, the FCC adopted additional rules (the "February 22nd Regulations") which have not yet been published in their final form. The "benchmark" formula adopted as part of the regulations in April 1993 establishes an "initial permitted rate" which may be charged by cable operators for tiers of cable service. The regulations also establish the prices which may be charged for equipment used to receive these services. Because the text of the February 22nd Regulations has not been released, it is not possible to know the extent or nature of revisions to the April 1993 regulations. However, from public statements made during the FCC meeting and news releases issued thereafter, it appears that the February 22nd Regulations will contain a new formula for determining permitted rates. The new formula will require up to a 17% reduction of rates from those charged on September 30, 1992, rather than the 10% reduction required by the April 1993 regulations. The February 22nd Regulations also adopted interim standards governing "cost-of-service" proceedings pursuant to which a II-8 cable operator would be permitted to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations, provided that the operator substantiates that its costs in providing services justify such rates. Based on its implementation of the April 1993 rate regulations, the Company estimates that it will recognize a reduction to revenues ranging from $27 million to $32 million on an annualized basis substantially all of which will be reflected as a reduction in earnings from operations of its cable division. The Company's estimated reduction does not reflect further reductions to revenue which would result from the lowering of the initial permitted rates pursuant to the February 22nd Regulations. These new and reduced initial permitted rates will apply prospectively from a date to be announced by the FCC when it publishes precise regulations which implement the February 22nd Regulations. Until the February 22nd Regulations are released, it is not possible to predict the effects of the interim standards governing cost-of-service proceedings; however, based on the public statements, Viacom believes it is unlikely that it will be able to utilize such proceedings so as to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations. The Company's ability to mitigate the effects of these new rate regulations by employing techniques such as the pricing and repricing of new or currently offered unregulated program services and ancillary services may be restricted by the new regulations adopted as part of the February 22nd Regulations. No such mitigating factors are reflected in the estimated reductions to revenues. The stated reduction to revenues may be mitigated by higher customer growth due to lower basic rates. The "must carry" provisions of the 1992 Cable Act are not material to the Company's results of operations. As of December 31, 1993, the Company operated systems in California, Oregon, Washington, Ohio and Tennessee, serving approximately 1,094,000 basic customers subscribing to approximately 718,000 premium units. Basic customers and premium units decreased 2% and 9%, respectively, since December 31, 1992; and, excluding the Wisconsin cable system customers in 1992, basic customers and premium units increased 2% and decreased 5%, respectively. As part of the settlement of the Time Warner antitrust lawsuit, the Company entered into an agreement to sell all the stock of Viacom Cablevision of Wisconsin, Inc. to Warner Communications Inc. ("Warner"), effective January 1, 1993. As consideration for the stock, Warner paid the sum of $46 million, $20 million of which was received during 1992, plus repayment of debt in the amount of $49 million, resulting in a pre-tax gain of approximately $55 million reflected in "Other items, net." As of December 31, 1992, the Wisconsin cable system served approximately 47,000 basic customers subscribing to approximately 34,000 premium units. II-9 Broadcasting (Television and radio stations) As of December 31, 1993, the Broadcasting segment operated five network-affiliated television stations and 14 radio stations. Broadcasting revenues increased 8% to $181.8 million in 1993 from $168.8 million in 1992. Earnings from operations increased 32% to $42.3 million in 1993 from $32.0 million in 1992. Television revenues increased 4% to $90.3 million in 1993 from $87.1 million in 1992, reflecting an increase in national and local advertising revenues. Earnings from operations increased 20% to $20.3 million in 1993 from $16.9 million in 1992, primarily reflecting the increased revenues. Television Stations: STATION LOCATION AFFILIATION MARKET RANK (a) ------- -------- ----------- ------ -------- KMOV-TV St. Louis, MO CBS 18 2 WVIT-TV Hartford/New NBC 25 3 Haven, CT WNYT-TV Albany/Schenectad NBC 52 2 y, NY WHEC-TV Rochester, NY NBC 71 2 KSLA-TV Shreveport, LA CBS 74 1 (a) Source: Nielsen, November 1993. Radio revenues increased 12% to $91.4 million in 1993 from $81.8 million in 1992, reflecting increased national and local advertising revenues. Earnings from operations increased 45% to $26.6 million in 1993 from $18.3 million in 1992, primarily reflecting the increased revenues, partially offset by increased selling costs. Radio Stations: STATION LOCATION FORMAT MARKET RANK (a) ------- -------- ------ ------ ----- WLTW-FM New York, NY Adult 1 1 Contemp KYSR-FM Los Angeles, CA Adult 2 2 Contemp KXEZ-FM (b) Los Angeles, CA Adult 2 2 Contemp WLIT-FM Chicago, IL Adult 3 7 Contemp KSRY-FM San Francisco, Adult 4 24 CA Contemp (Tie) II-10 KSRI-FM Santa Cruz/San Adult 4 24 Jose, CA Contemp (Tie) WLTI-FM Detroit, MI Adult 6 8 Contemp WMZQ-AM/FM Washington, DC Country 8 4 (Tie) WCXR-FM (c) Washington, DC Classic Rock 8 9 (Tie) WCPT-AM (c) Washington, DC Headline 8 NA(d) News KBSG-AM/FM Seattle/Tacoma, Oldies 13 2 WA KNDD-FM (e) Seattle, WA Modern Rock 13 5 (AOR) (a) Source: Arbitron, Fall 1993, based on target demographics. (b) Acquired in June 1993. (c) Acquired in November 1993. (d) Rank not applicable. (e) Acquired in December 1992. See "Acquisition and Ventures" for disclosure of acquisitions and exchanges of radio stations that occurred in 1993 and 1992. Other Income and Expense Information Corporate expenses increased 1% to $72.0 million in 1993 from $71.3 million in 1992, reflecting increased overall expenses offset by decreased compensation expense associated with the Long-Term Incentive Plans (the "Plans"), which consist of the Long-Term Incentive Plan ("LTIP") and the Long-Term Management Incentive Plan ("LTMIP"). The Plans provide for grants of phantom shares and stock options. The value of phantom shares issued under the Plans is determined by reference to the fair market value of Viacom Class A Common Stock and Viacom Class B Common Stock (collectively, "Common Stock"). The Plans also provide for subsequent cash payments with respect to such phantom shares based on appreciated value, subject to certain limits, and vesting requirements. As a result of the fluctuation in the market value of its Common Stock, Viacom Inc. recorded compensation expense associated with the Plans of $3.9 million in 1993 and $8.2 million in 1992. During December 1992, a significant portion of the liability associated with the LTIP was satisfied by the cash payment of $68.6 million and the issuance of 177,897 shares of Viacom Class B Common Stock valued at $6.9 million. The Plans' phantom shares currently have a maximum potential liability of $19.5 million, all of which was accrued as of December 31, 1993. II-11 Net interest expense decreased 25% to $145.0 million in 1993 from $194.1 million in 1992, reflecting improvements made to the capital structure (as described below) and reduced interest rates, including rates associated with the Credit Agreement (as defined in "Capital Structure"). The Company and Viacom Inc. had approximately $2.4 billion principal amount of debt outstanding as of December 31, 1993 and December 31, 1992 at weighted average interest rates of 5.3% and 6.5%, respectively. On July 15, 1993, the Company redeemed all $298 million principal amount outstanding of 11.80% Senior Subordinated Notes. During 1992, the following changes to the capital structure were made: a) on March 4, 1992, the Company issued $150 million principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due 1999; b) on March 10, 1992, the Company redeemed all $193 million of the outstanding 11.5% Senior Subordinated Extendible Reset Notes ("11.5% Reset Notes") due 1998; c) on May 28, 1992, the Company issued $100 million principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due 2001; and d) on June 18, 1992, the Company redeemed all $356.5 million of the outstanding 14.75% Senior Subordinated Discount Debentures ("Discount Debentures") due 2002 (see "Capital Structure"). (See "Liquidity and Capital Resources" for additional information concerning changes in Viacom Inc.'s and the Company's capital structure.) For 1993, "Other items, net" reflects the pre-tax gain of approximately $55 million on the sale of the stock of the Wisconsin cable system (see "Cable Television"), a pre-tax gain of $17.4 million in the aggregate from sales of a portion of an investment held at cost, and an increase of $9.1 million to previously established non-operating litigation reserves and other items. The settlement of the Time Warner antitrust lawsuit resulted in various business arrangements, which have a positive effect on Viacom Inc. currently and are expected to continue to have a favorable effect on a prospective basis. "Other items, net" reflects a gain of $35 million recorded in the third quarter of 1992; this gain represents payments received in the third quarter of 1992 relating to certain aspects of the settlement of the lawsuit, net of Viacom Inc.'s 1992 legal expenses related to this lawsuit. "Other items, net" also reflects a reserve for litigation of $33 million during the second quarter of 1992 related to a summary judgment against Viacom Inc. in a dispute with CBS Inc. arising under the 1970 agreement associated with the spin-off of Viacom International Inc. by CBS Inc. On July 30, 1993, the Company settled all disputes arising under that litigation. "Equity in loss of affiliated companies, net of tax," consists primarily of the Company's share of Lifetime's net earnings, Comedy Central's net losses and Nickelodeon (UK)'s net losses in II-12 1993. "Equity in loss of affiliated companies, net of tax" decreased 46% to $2.5 million in 1993 from $4.6 million in 1992, primarily reflecting improved operating results at Lifetime and Comedy Central, partially offset by net losses on equity investments made in 1993. (See "Acquisitions and Ventures.") The provision for income taxes represents federal, state and foreign income taxes on earnings before income taxes. The annual effective tax rate of 43% for 1993 and 54.5% for 1992 (which continues to be adversely affected by amortization of acquisition costs which are not deductible for tax purposes) is decreased as a result of reductions of certain prior year tax reserves of $22.0 million and $20.0 million in 1993 and 1992, respectively. The reductions relate to management's current opinion on several tax issues based upon the progress of federal, state and local audits. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" on a prospective basis and recognized a cumulative benefit from a change in accounting principle of $10.3 million. In August 1993, the Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act") was signed into law. It is not expected that the Reconciliation Act will have a significant effect on the Company's financial position or results of operations. In 1993, the Company recognized an after-tax extraordinary loss from the early extinguishment of the 11.80% Notes of $8.9 million (net of a tax benefit of $6.1 million). In 1993, Viacom Inc. declared dividends on its Preferred Stock (as defined in "Capital Structure") of $12.8 million. In 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting For Postemployment Benefits" ("SFAS 112"), which the Company will adopt in 1994. SFAS 112 requires that postemployment benefits be accounted for under the accrual method versus the currently used pay-as-you-go method. SFAS 112 is not expected to have a significant effect on the Company's financial position or results of operations. 1992 vs. 1991 ------------- Revenues increased 9% to $1.9 billion in 1992 from $1.7 billion in 1991. Operating expenses increased 8% to $854.0 million in 1992 from $790.8 million in 1991. Earnings from operations increased 11% to $347.9 million in 1992 from $312.2 million in 1991. Explanations of variances in revenues and earnings from II-13 operations for each operating segment follow. Net earnings of $49.0 million, or $.41 per share, for the year ended December 31, 1992, reflect net interest expense of $194.1 million and a provision for income taxes of $84.8 million. The net loss of $49.7 million, or $.44 per share, for the year ended December 31, 1991, reflects net interest expense of $297.5 million and a provision for income taxes of $42.1 million. Networks (Basic cable and premium television networks) Networks revenues increased 15% to $1.058 billion in 1992 from $922.2 million in 1991. Earnings from operations increased 19% to $205.6 million in 1992 from $172.3 million in 1991. MTVN revenues increased 30% to $533.4 million in 1992 from $411.4 million in 1991: 77% of the increase was attributable to increased advertising sales; 19% was due to increased affiliate fees; and 4% was due to other sources. The increases in advertising sales and affiliate fees were principally due to rate increases. The increase in other sources was principally due to revenues from new business ventures including licensing and merchandising. Earnings from operations of MTVN increased 23% to $172.9 million in 1992 from $141.0 million in 1991, reflecting the increased revenues, partially offset by increased programming expenses and other costs of operating the networks. The Company increased programming expenses, particularly for new animated programming on Nickelodeon. This new programming was to a large extent responsible for the Company's ability to increase advertising rates. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. Subsequent to August 30, 1991, the results of operations of MTV EUROPE have been included in MTVN's results of operations. Prior to such date, the investment in MTV EUROPE was accounted for under the equity method; therefore, operating results were included in "Equity in loss of affiliated companies, net of tax." The financial results of MTV EUROPE were not material to the financial results of the Company or the Networks segment; however, as the pan-European marketplace develops for both advertising revenues and affiliate fees, the financial results of MTV EUROPE may become material. In the aggregate, MTV (excluding MTV EUROPE), VH-1 and Nickelodeon/Nick at Nite revenues increased 21%, subscribers increased 3% and earnings from operations increased 18% during 1992 versus 1991. SNI revenues increased 3% to $515.3 million in 1992 from $501.3 million in 1991: 30% of the revenue increase was due to rate increases for SSN; 23% was due to a higher average subscriber II-14 base during the year for SSN principally attributable to the use of upgraded scrambling technology in 1992; 23% was due to a higher average cable subscriber base during the year for Showtime and The Movie Channel; and 24% of this increase was due to other revenue sources. SNI's premium movie services served approximately 10.7 million subscribers as of December 31, 1992 and 10.2 million subscribers as of December 31, 1991. SNI's overall earnings from operations increased 7% to $35.2 million in 1992 from $33.0 million in 1991, reflecting the increase in revenues, partially offset by an increase in programming expenses. Entertainment (Television programming, syndication, production and new media) Entertainment revenues decreased 9% to $248.3 million in 1992 from $273.5 million in 1991. The revenue variance was principally due to lower sales to broadcast, cable and other markets, lower network license fees and lower copyright royalty revenues. Lower sales to the broadcast, cable and other markets reflect softness in the syndication marketplace due to a generally weak economy and due to a decrease in the number of independent broadcast television stations because of new network affiliations. Network license fees were lower because there were fewer shows produced for network television. Copyright royalties were lower due to changes made by cable operators in the tiering of their services, which generated lower copyright royalty liabilities and therefore less income for program producers and syndicators. During the first quarter of 1992, certain legal developments indicated that the percentage of income recognized under certain copyright royalty arrangements should be increased. This change in estimate resulted in an increase in revenues of approximately $10 million. During the first quarter of 1991, the Company began to recognize copyright royalty revenue on an accrual basis rather than a cash basis, as a sufficient pattern had been established to make these revenues estimable; this change resulted in an increase in revenues of approximately $13.0 million. Earnings from operations decreased 19% to $59.7 million in 1992 from $73.2 million in 1991, reflecting the decreased revenues and changes in estimate noted above, and expenses associated with staff changes and the implementation of new systems of approximately $4.0 million. Cable Television (Cable television systems) Cable television revenues increased 9% to $411.1 million in 1992 from $378.0 million in 1991: 68% of this increase resulted from increases in rates for basic services; 26% from increased basic customers; 10% from increased premium customers; partially offset by a negative 4% from decreases in other revenue sources. Total II-15 revenue per basic customer per month increased 5% to $31.06 in 1992 from $29.41 in 1991. Earnings from operations increased 17% to $122.0 million in 1992 from $104.0 million in 1991, reflecting the increased revenues, partially offset by increased operating expenses. As of December 31, 1992, the Company operated systems in California, Oregon, Washington, Wisconsin, Ohio and Tennessee, serving approximately 1,116,000 basic customers subscribing to approximately 786,000 premium units. Basic customers and premium units increased 3% and 1%, respectively, since December 31, 1991. Broadcasting (Television and radio stations) Broadcasting revenues increased 6% to $168.8 million in 1992 from $159.2 million in 1991. Earnings from operations increased 15% to $32.0 million in 1992 from $27.7 million in 1991. Television revenues increased 9% to $87.1 million in 1992 from $80.1 million in 1991, reflecting an increase in national and local advertising revenues at each of the stations, primarily due to higher rates driven by the Olympics and the political campaign. Earnings from operations increased 38% to $16.9 million in 1992 from $12.2 million in 1991, reflecting the increased revenues, partially offset by increased programming and selling expenses. Radio revenues increased 3% to $81.8 million in 1992 from $79.0 million in 1991, reflecting an increase in local advertising revenues, partially offset by a decrease in national advertising revenues. Earnings from operations decreased 7% to $18.3 million in 1992 from $19.6 million in 1991, driven by increased operating, selling and promotion costs, partially offset by the increased revenues. Other Income and Expense Information Corporate expenses increased 10% to $71.3 million in 1992 from $65.0 million in 1991, primarily due to severance costs, partially offset by decreased legal costs and decreased compensation expense associated with the Long-Term Incentive Plans. As a result of the fluctuation in the market value of its Common Stock, Viacom Inc. recorded compensation expense associated with the Plans of $8.2 million and $12.3 million in 1992 and 1991, respectively. Net interest expense decreased 35% to $194.1 million in 1992 from $297.5 million in 1991, reflecting improvements made to the capital structure and reduced interest rates, including rates associated with the Credit Agreement (as defined in "Capital Structure"). The II-16 Company and Viacom Inc. had approximately $2.4 billion and $2.3 billion principal amount of debt outstanding as of December 31, 1992 and December 31, 1991 at weighted average interest rates of 6.5% and 9.2%, respectively. During 1991, Viacom Inc. realized net proceeds of approximately $317.7 million from the issuance of non- voting Class B Common Stock ("Viacom Class B Common Stock"); redeemed all $402 million of its outstanding Exchange Debentures; the Company repurchased $43 million principal amount of the Discount Debentures; and the Company issued $200 million principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due 2001. (See "Liquidity and Capital Resources" for additional information concerning changes in Viacom Inc.'s and the Company's capital structure.) Viacom Inc. and the Company file a separate consolidated federal income tax return and have done so since the period commencing June 11, l991, the date on which NAI's percentage ownership of Viacom was reduced to less than 80% (see "Capital Structure"). Prior to such date, Viacom Inc. and the Company filed a consolidated federal income tax return with NAI, and participated in a tax-sharing agreement with NAI with respect to federal income taxes. The tax-sharing agreement obligated Viacom Inc. and the Company to make payment to NAI to the extent that they would have paid federal income taxes on a separate company basis, and entitled them to receive a payment from NAI to the extent their losses and credits reduced NAI's federal income taxes. "Equity in loss of affiliated companies, net of tax," decreased 64% to a loss of $4.6 million in 1992 from a loss of $12.7 million in 1991, driven by improvements at Lifetime and Comedy Central. In 1992, the Company recognized after-tax extraordinary losses from the early extinguishment of the Discount Debentures of $13.7 million (net of a tax benefit of $8.9 million) and the 11.50% Reset Notes of $3.4 million (net of a tax benefit of $2.4 million). Liquidity and Capital Resources ------------------------------- Paramount Merger, Blockbuster Merger and Related Transactions ------------------------------------------------------------- On March 11, 1994, Viacom Inc. acquired, pursuant to a tender offer (the "Paramount Offer"), 61,657,432 shares of Paramount common stock, constituting a majority of the shares outstanding, at a price of $107 per share in cash. The Paramount Offer was financed by (i) the sale of Preferred Stock (see "Capital Structure"), proceeds of which are reflected as cash and cash equivalents on the balance sheet as of December 31, 1993, (ii) the sale of Viacom Class B Common Stock to Blockbuster and (iii) borrowings under a credit agreement (as described below). The II-17 Paramount Offer was made pursuant to the Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. Paramount will become a wholly owned subsidiary of Viacom Inc. (the "Paramount Merger") at the effective time of a merger between Paramount and a subsidiary of Viacom Inc. (the "Paramount Effective Time") which is expected to occur in the second quarter of 1994. Pursuant to the Paramount Merger Agreement, each share of Paramount common stock outstanding at the time of such merger (other than shares held in the treasury of Paramount or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights) will be converted into the right to receive (i) 0.93065 of a share of Viacom Class B Common Stock, (ii) $17.50 principal amount of 8% exchangeable subordinated debentures of Viacom Inc., (iii) 0.93065 of a contingent value right ("CVR"), (iv) 0.5 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the third anniversary of the Paramount Merger at a price of $60 per share, and (v) 0.3 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the fifth anniversary of the Paramount Merger at a price of $70 per share. If the debentures are issued prior to the completion of the proposed merger of Viacom Inc. and Blockbuster, the debentures will be exchangeable, at the option of Viacom Inc., into 5% exchangeable preferred stock of Viacom Inc. on or after January 1, 1995 if the proposed merger with Blockbuster has not previously been consummated. Each CVR will represent the right to receive the amount, if any, by which the Target Price exceeds the greater of the Current Market Value or the Minimum Price (see defined terms in following paragraph). The CVRs will mature on the first anniversary of the Paramount Effective Time (the "Maturity Date"); provided, however, that Viacom Inc. may, at its option, (i) extend the Maturity Date to the second anniversary of the Paramount Effective Time (the "First Extended Maturity Date") or (ii) extend the First Extended Maturity Date to the third anniversary or the Paramount Effective Time (the "Second Extended Maturity Date"). Viacom Inc., at its option, may pay any amount due under the terms of the CVRs in cash or in the equivalent value of registered securities of Viacom Inc., including without limitation, common stock, preferred stock, notes, or other securities. The "Minimum Price" means (a) at the Maturity Date, $36, (b) at the First Extended Maturity Date, $37 and (c) at the Second Extended Maturity Date, $38. Target Price means (a) at the Maturity Date, $48, (b) at the First Extended Maturity Date, $51, and (c) at the Second Extended Maturity Date, $55. The "Current Market Value" means the average market price of Viacom Class B Common Stock for a specified period. II-18 On January 7, 1994, Viacom Inc. and Blockbuster entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger") subject to shareholder approval. At the effective time of the Blockbuster Merger, each share of Blockbuster common stock outstanding at the time of the Blockbuster Merger (other than shares held in the treasury of Blockbuster or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights, if available) will be converted into the right to receive (i) 0.08 of a share of Viacom Class A Common Stock, (ii) 0.60615 of a share of Viacom Class B Common Stock, and (iii) up to an additional 0.13829 of a share of Viacom Class B Common Stock, with the exact fraction of a share being dependent on the market prices of Viacom Class B Common Stock during the year following the effective time of the Blockbuster Merger, and with the right to receive such additional fraction of a share to be evidenced by one variable common right ("VCR"). The VCRs mature on the first anniversary of the Blockbuster Merger ("VCR Conversion Date"). The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. intends to vote its shares of Paramount in favor of the merger and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. On March 10, 1994, Blockbuster purchased approximately 22.7 million shares of Viacom Class B Common Stock for an aggregate purchase price of $1.25 billion, or $55 per share. If (with certain exceptions) the Blockbuster Merger Agreement is terminated and in the event that Viacom Class B Common Stock trades (for a specified period) at a level below $55 per share during the one year period after such termination, Viacom Inc. may be obligated to make certain payments of up to a maximum of $275 million, at its option, in cash or securities, or to sell certain assets to Blockbuster. The Viacom Class B Common Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On February 15, 1994, Blockbuster entered into a credit agreement with certain financial institutions named therein, pursuant to which such financial institutions have advanced to Blockbuster, on an unsecured basis, an aggregate of $1.0 billion to finance a portion of the purchase of the shares under the Subscription Agreement (the "Blockbuster Facility"). The II-19 Blockbuster Facility contains certain events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness incurred by Blockbuster under the Blockbuster Facility. On March 11, 1994, Viacom Inc. borrowed $3.7 billion under a credit agreement dated as of November 19, 1993, as amended on January 4, 1994 and February 15, 1994, among Viacom Inc., the banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agent (the "Merger Credit Agreement"). The Merger Credit Agreement provides that, in order to pay for the Paramount Offer and related expenses, up to $3.7 billion may be borrowed, repaid and reborrowed until November 18, 1994, at which time all amounts outstanding will become due and payable. The Merger Credit Agreement provides that Viacom Inc. may elect to borrow at either the Base Rate or the Eurodollar Rate (each as defined below), subject to certain limitations. The "Base Rate" will be the higher of (i) the Citibank N.A., Base Rate and (ii) the Federal Funds Rate plus 0.50%. The "Eurodollar Rate" will be the London Interbank Offered Rate plus (i) 0.9375%, until Viacom Inc.'s senior unsecured long-term debt is rated by Standard & Poor's Corporation or Moody's Investors Service, Inc., and (ii) thereafter, a variable rate ranging from 0.25% to 0.9375% dependent on the senior unsecured long-term debt rating assigned to Viacom Inc. The Merger Credit Agreement provides that Viacom Inc. will pay each bank a facility fee on such bank's commitment until November 18, 1994. The Merger Credit Agreement contains certain covenants which, among other things, require Viacom Inc. to meet certain financial ratios. As of December 31, 1993, Viacom Inc. had promissory notes outstanding in the aggregate amount of $26 million, in order to finance expenses associated with the Mergers and expects to obtain additional financing as required to finance such expenses. Viacom Inc. anticipates that, following the Mergers, Viacom Inc., Paramount and Blockbuster, on a pro forma combined basis (the "Combined Company") will have outstanding total indebtedness of approximately $10 billion ($8 billion if the Blockbuster Merger is not consummated) and 5% Preferred Stock (as defined in "Capital Structure") with a liquidation preference of $1.2 billion ($1.8 billion if the Blockbuster Merger is not consummated). Of such $10 billion, $3.7 billion was borrowed under the Merger Credit Agreement and must be repaid by November 18, 1994. In addition, the $1.0 billion II-20 borrowed under the Blockbuster Facility must be repaid by February 14, 1995 and both the Blockbuster Facility and a previous Blockbuster credit agreement contain certain covenants and events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness under such Blockbuster facilities prior to the Blockbuster Merger. Accordingly, assuming consummation of the Blockbuster Merger, the foregoing facilities, together with other current maturities, may require Viacom Inc. to refinance up to $5.7 billion ($4.0 billion if the Blockbuster Merger is not consummated) within the next 12 months. Viacom Inc. also anticipates that, following the Mergers, the Combined Company will fund its anticipated operating, investing and financing activities, including the anticipated cash requirements of its joint ventures, commitments, capital expenditures, preferred stock dividend requirements and principal and interest payments on outstanding indebtedness, through a variety of sources, which may include, but may not be limited to, funds generated internally by Viacom Inc. and its subsidiaries (including following the Mergers funds generated by Blockbuster and Paramount), bank refinancing, and the public or private sale of debt or equity securities. The Blockbuster Merger is subject to shareholder approval. In the event the Blockbuster Merger is not consummated, Viacom Inc. believes that it will still be capable of meeting all of its obligations. Viacom Inc. and the Company - Liquidity and Capital Resources ------------------------------------------------------------- (prior to the Paramount Offer and the Mergers) ---------------------------------------------- The Company's scheduled maturities of long-term debt through December 31, 1998, assuming full utilization of the $1.9 billion commitment under the Credit Agreement and $300 million under the Loan Facility Agreement, are $300 million (1994), $380 million (1995), $380 million (1996) $380 million (1997) and $380 million (1998). On January 4, 1993, Viacom Inc. borrowed $42.2 million from The Bank of New York ("BONY") pursuant to an unsecured credit agreement ("Term Loan Agreement") to satisfy its obligation under the LTIP. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. (See "Capital Structure " for defined terms and additional information). The Company's joint ventures are expected to require estimated cash contributions of approximately $20 million to $40 million in 1994. Capital expenditures are primarily related to additional construction and equipment upgrades for the Company's existing cable franchises, certain transponder payments and information system costs. Planned capital expenditures, II-21 including information systems costs, are approximately $150 million to $170 million in 1994. The Company was in compliance with all covenants and had satisfied all financial ratios and tests as of December 31, 1993 under its Credit Agreement and the Company expects to remain in compliance and satisfy all such financial ratios and tests during 1994. Debt as a percentage of total capitalization of Viacom Inc. was 47% at December 31, 1993 and 76% at December 31, 1992. The decrease in debt as a percentage of total capitalization resulted principally from the issuance of Preferred Stock (as defined in "Capital Structure") during 1993. The commitments of the Company for program license fees which are not reflected in the balance sheet as of December 31, 1993, which are estimated to aggregate approximately $1.9 billion, principally reflect commitments under SNI's exclusive arrangements with several motion picture companies. This estimate is based upon a number of factors. A majority of such fees are payable within the next seven years, as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. During July 1991, the Company received reassessments from 10 California counties of its Cable Division's real and personal property, related to the June 1987 acquisition by NAI, which could result in substantially higher California property tax liabilities. The Company is appealing the reassessments and believes that the reassessments as issued are unreasonable and unsupportable under California law. The Company believes that the final resolution of this matter will not have a material effect on its consolidated financial position or results of operations. Net cash flow from operating activities increased 45% to $147.6 million in 1993 from $102.0 million in 1992, resulting from increased net earnings before extraordinary items and cumulative effect of change in accounting principle, partially offset by increased payments for accrued expenses. Net cash expenditures for investing activities of $128.4 million in 1993 principally reflects capital expenditures, the acquisitions of KXEZ-FM and ICOM Simulations, Inc. and the additional investment in StarSight Telecast Inc. ("StarSight") and advances to Comedy Central, partially offset by proceeds from the sale of the Wisconsin cable system, proceeds related to the radio station swap and proceeds from the sale of an investment held at cost. Net cash expenditures for investing activities of $116.8 million in 1992 principally reflect capital expenditures, advances to II-22 Comedy Central and a deposit received on the sale of Viacom Cablevision of Wisconsin Inc. Financing activities reflect borrowings and repayment of debt under the Credit Agreement during each period presented; the redemption of the 11.80 % Notes and the issuance of the Preferred Stock during 1993, and the redemption of the 11.50% Reset Notes and Discount Debentures, and the issuance of the 9.125% Notes and the 8.75% Reset Notes during 1992. Acquisitions and Ventures ------------------------- On November 1, 1993, the Company exchanged KIKK-AM/FM, Houston, Texas, for Westinghouse Broadcasting Company, Inc.'s WCXR-FM and WCPT-AM, Washington, D.C., and cash. On June 16, 1993, the Company purchased KXEZ-FM (formerly KQLZ- FM), Los Angeles, California from Westwood One Stations Group- LA, Inc. for $40 million in cash and certain other consideration. The Company sold KXEZ-FM to Viacom Inc. in exchange for a $40 million promissory note. On May 5, 1993, the Company completed the purchase of privately held ICOM Simulations, Inc. On March 31, 1993, the Company increased its percentage of ownership in StarSight. On August 5, 1993, StarSight completed an initial public offering of 3,105,000 shares of common stock. On September 16, 1993, the Company exercised a warrant to purchase 833,333 shares of StarSight common stock at a cost of $5.625 per share. In November 1993, the Company transferred its ownership percentage in StarSight to a consolidated affiliate of the Company. As a result of these transactions, the affiliate of the Company's percentage ownership of StarSight is approximately 21%. The investment in StarSight is accounted for under the equity method. In December 1992, the Company entered into a 50-50 joint venture called Nickelodeon (UK) with a subsidiary of British Sky Broadcasting Limited. Nickelodeon (UK) began airing on September 1, 1993. The Company's investment is accounted under the equity method and therefore the results of operations is included in "Equity in loss of affiliated companies, net of tax." The Company exchanged KHOW-AM and FM, Denver, Colorado for Noble Broadcast Group, Inc.'s KNDD-FM, Seattle, Washington effective December 28, 1992. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. The approximate value of the purchase was $65.0 million, which included intangibles of II-23 approximately $61.6 million. As consideration for the sale, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock (see "Capital Structure"). Capital Structure ----------------- The following table and related notes set forth the capitalization of Viacom Inc. and subsidiaries as of December 31, 1993 and December 31, 1992: December 31, December 31, 1993 1992 ----------- ----------- (Thousands of Dollars) Current portion of long-term debt $ 55,004 $ -- =========== ============ Long-term debt: Notes payable to banks (a) $ 1,928,271 1,648,984 11.8% Senior Subordinated Notes due -- 298,000 1998 (b) 9.125% Senior Subordinated Notes due 150,000 150,000 1999 (c) 8.75% Senior Subordinated Reset Notes 100,000 100,000 due 2001 (d) 10.25% Senior Subordinated Notes due 200,000 200,000 2001 (e) 5.75% Convertible Subordinated 15 30 Debentures due 2001 ----------- ------------ Total long-term debt $ 2,378,286 $ 2,397,014 =========== ============ Shareholders' equity (f): Preferred Stock $ 1,800,000 $ -- Common Stock and additional paid-in 922,072 918,671 capital Accumulated deficit (3,958) (162,160) ----------- ------------ Total shareholders' equity $ 2,718,114 $ 756,511 =========== ============ II-24 (a) -- At December 31, 1993, there were aggregate borrowing facilities of $1.9 billion and $300 million under (i) an unsecured credit agreement guaranteed by Viacom Inc. (amended and restated as of January 17, 1992 (as amended, the "Credit Agreement") among the Company, the named banks ("Banks"), Citibank, N.A. ("Citibank") as agent and The Bank of New York ("BONY") as co-agent and (ii) an unsecured credit agreement, dated June 2, 1993, among the Company and the named banks and BONY and Citibank as agents (the "Loan Facility Agreement"). The Loan Facility Agreement has a 364-day term and is identical to the Credit Agreement in all other material terms and conditions. Borrowings of $1.765 billion were outstanding under the Credit Agreement as of December 31, 1993, including $274 million aggregate principal amount assumed by five subsidiaries of the Company ("Subsidiary Obligors"). Borrowings of $150 million were outstanding under the Loan Facility Agreement as of December 31, 1993, $135 million of which were classified as long-term. Subsequent to December 31, 1993, Viacom Inc. borrowed approximately $3.7 billion pursuant to the Merger Credit Agreement in connection with the Paramount Merger (see "Paramount Merger, Blockbuster Merger and Related Transactions"). The following is a summary description of the Credit Agreement. The description does not purport to be complete and should be read in conjunction with the Credit Agreement. The Credit Agreement provides for three facilities: Facility A - $700 million under a term loan having a final maturity of June 30, 1999; Facility B - $926 million under a revolver, which converts on January 1, 1995 into a term loan having a final maturity of June 30, 1999; and Facility B-1 - $274 million under a term loan having a final maturity of June 30, 1999. The interest rate on all loans made under the three facilities is based upon Citibank, N.A.'s base rate, the domestic certificate of deposit rate or the London Interbank Offered Rate and is affected by the Company's leverage ratio. At December 31, 1993, the London Interbank Offered Rates (upon which the Company's borrowing rate was based) for borrowing periods of one month and two months were 3.25% and 3.3125%, respectively. The Company is permitted to issue commercial paper with a maturity at the time of issuance not to exceed nine months, provided that following each issuance of II-25 commercial paper, (i) the aggregate face amount of commercial paper outstanding shall not exceed $500 million less the aggregate amount of competitive bid rate borrowings (described below), outstanding at such time and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company is also permitted to make short- term competitive bid rate borrowings from the Banks until December 1, 1994, provided that following the making of each proposed competitive bid rate borrowing, (i) the aggregate amount of the competitive bid rate loans outstanding shall not exceed $500 million less the aggregate face amount of commercial paper outstanding and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company and Subsidiary Obligors are required to repay the principal outstanding under the Credit Agreement in quarterly payments equal to percentages of the original aggregate principal amount with respect to the Facility A loans and Facility B-1 loans, and of the outstanding principal amount with respect to the Facility B loans, under the Credit Agreement, in the amount of 5% for the period commencing January 2, 1995 through and including January 2, 1999; and 7.5% on April 1, 1999 and on June 30, 1999. The Company may prepay at any time a portion or all of the principal outstanding under the Credit Agreement. Any such optional prepayments shall be applied to the remaining installments of Facility A and Facility B loans in the order that the Company designates. The Company is required to make mandatory prepayments upon receipt of net cash sale proceeds in connection with permitted sales of assets not in the ordinary course of business. All such prepayments shall be applied until December 31, 1994 to reduce the Facility B loans outstanding; provided, however, that any amounts so repaid may be reborrowed prior to December 31, 1994. All such prepayments after December 31, 1994 shall be applied pro rata against the remaining installments of first, the Facility A loans and second, the Facility B loans. In the event of a sale of the stock or substantially all of the assets of any Subsidiary Obligor, the Facility B-1 loan of such Subsidiary Obligor shall be repaid in full; provided, however, that upon such prepayment prior to December 31, 1994, the Facility B commitment of each Facility B Bank shall be increased by an amount equal to the principal amount of such Facility B Bank's Facility B-1 loan prepaid as a result of such prepayment and such amounts may be borrowed by the Company prior to December 31, 1994. The Company is required to prepay principal outstanding under the Credit Agreement with the proceeds of certain issuances of unsecured senior debt in an amount equal to the proceeds so received, together with accrued interest to the date of such prepayment on the principal amount prepaid, with such prepayments applied against remaining installments of first, the II-26 Facility A loans and second, the Facility B loans. The Credit Agreement contains certain covenants which, among other things, require the Company to maintain certain financial ratios and impose on the Company and its subsidiaries certain limitations on (i) the incurrence of indebtedness or the guarantee or assumption of indebtedness of another; (ii) the creation or incurrence of mortgages, pledges or security interests on the property or assets of the Company or any of its subsidiaries in order to secure debt or the sale of assets of the Company or its subsidiaries; (iii) the merger or consolidation of the Company with any person or other entity; (iv) the incurrence of capitalized leases and purchase money indebtedness; (v) the payment of cash dividends or the redemption or repurchase of any capital stock of the Company; and (vi) investments and acquisitions. The Credit Agreement also contains certain customary events of default. The Credit Agreement also provides that it is an event of default if National Amusements, Inc. ("NAI") fails to own at least 51% of the outstanding voting stock of Viacom Inc. or Viacom Inc. fails to own at least 67% of the outstanding voting stock of the Company. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes, including the satisfaction of Viacom Inc.'s obligations under the LTIP), unless its total leverage ratio is less than a specified amount. The Company is required to pay a commitment fee based on the aggregate average daily unborrowed portion of the Facility B commitment, with any amounts outstanding under competitive bid rate loans and commercial paper being deemed unborrowed for the purpose of calculating the commitment fee. The Company also is required to pay certain agency fees to the agent. The Credit Agreement does not require compensating balances. On January 4, 1993, Viacom Inc. borrowed $42.2 million from BONY pursuant to the Term Loan Agreement. The interest rate in the Term Loan Agreement is based upon BONY's prime rate or the London Interbank Offered Rate. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. Viacom Inc. may prepay at any time a portion or all of the principal amount outstanding under the Term Loan Agreement. Any such optional prepayments shall be applied to reduce the principal installment due January 1995 and shall include all accrued interest II-27 on the amount of principal prepaid. Viacom Inc. shall be obligated to prepay the loan in the amount of any dividends received from the Company. The Term Loan Agreement contains certain covenants which impose certain limitations on (i) the incurrence of indebtedness and (ii) payment of cash dividends or the redemption or repurchase of any capital stock of Viacom. The Term Loan Agreement also contains certain customary events of default. The Term Loan Agreement has been amended to allow Viacom Inc. to complete the Paramount Offer and Paramount Merger. The indebtedness under the Credit Agreement, Loan Facility Agreement and Term Loan Agreement bear interest at floating rates, causing the Company to be sensitive to changes in prevailing interest rates. The Company enters into interest rate protection agreements with off-balance sheet risk in order to reduce its exposure to changes in interest rates on its variable rate long- term debt. These interest rate protection agreements include interest rate swaps and interest rate caps. At December 31, 1993, the Company and Viacom Inc. had interest rate protection agreements outstanding with commercial banks, with respect to $1.1 billion of indebtedness under the Credit Agreement and $42.2 million under the Term Loan Agreement. These agreements effectively change the Company's interest exposure under the Credit Agreement to a ceiling of 5.64% on the interest rate caps, and under the Term Loan Agreement to a fixed weighted average rate of 6.65% on interest rate swaps. The interest rate protection agreements are in effect for a fixed period of time. The Company is exposed to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company does not anticipate nonperformance by the counterparties. The Company had commercial paper outstanding of $60.9 million as of December 31, 1993. The Company also has aggregate money market facilities of $40 million, all of which was available at December 31, 1993. (b) -- On July 15, 1993, the Company redeemed all of the $298 million principal amount outstanding of the 11.80% Senior Subordinated Notes ("11.80% Notes") at a redemption price equal to 103.37% of the principal amount plus accrued interest to July 15, 1993. The Company recognized an after-tax extraordinary loss from the early extinguishment of debt of $8.9 million, net of a tax benefit of approximately $6.1 million on the transaction. The Company borrowed the funds necessary for the redemption under its bank credit facilities. (c) -- On March 4, 1992, the Company issued $150 million aggregate principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due August 15, 1999. Interest is payable II-28 semiannually on February 15 and August 15, commencing August 15, 1992. The 9.125% Notes may not be redeemed prior to February 15, 1997. They are redeemable at the option of the Company, in whole or in part, during the 12 month period beginning February 15, 1997 at a redemption price of 102.607% of the principal amount, during the 12 month period beginning February 15, 1998 at 101.304% of the principal amount, and on or after February 15, 1999 at 100% of the principal amount. Any such redemption will include accrued interest to the redemption date. The 9.125% Notes are not subject to any sinking fund requirements. (d) -- On May 28, 1992, the Company issued $100 million aggregate principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due on May 15, 2001. Interest is payable semiannually on May 15 and November 15, commencing November 15, 1992. On May 15, 1995 and May 15, 1998, unless a notice of redemption of the 8.75% Reset Notes on such date has been given by the Company, the interest rate on the 8.75% Reset Notes will, if necessary, be adjusted from the rate then in effect to a rate to be determined on the basis of market rates in effect on May 5, 1995 and on May 5, 1998, respectively, as the rate the 8.75% Reset Notes should bear in order to have a market value of 101% of principal amount immediately after the resetting of the rate. In no event will the interest rate be lower than 8.75% or higher than the average three year treasury rate (as defined in the indenture) multiplied by two. The interest rate reset on May 15, 1995 will remain in effect on the 8.75% Reset Notes through and including May 15, 1998 and the interest rate reset on May 15, 1998 will remain in effect on the 8.75% Reset Notes thereafter. The 8.75% Reset Notes are redeemable at the option of the Company, in whole but not in part, on May 15, 1995 or May 15, 1998, at a redemption price of 101% of principal amount plus accrued interest to, but not including, the date of redemption. The 8.75% Reset Notes are not subject to any sinking fund requirements. (e) -- On September 15, 1991, the Company issued $200 million aggregate principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due September 15, 2001. Interest is payable semiannually on March 15 and September 15, commencing March 15, 1992. The 10.25% Notes are not redeemable by the Company prior to maturity and are not subject to any sinking fund requirements. (f) -- On December 31, 1993, there were 53,449,325 outstanding shares of Viacom Class A Common Stock (100,000,000 shares authorized) and 67,347,131 outstanding shares of Viacom Class B Common Stock (150,000,000 shares authorized). On October 22, 1993, Blockbuster purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series A Preferred Stock") for $600 million. On November 19, 1993, NYNEX Corporation ("NYNEX") purchased 24 million shares of cumulative convertible preferred stock, par value $.01 II-29 per share, of Viacom Inc. ("Series B Preferred Stock," collectively with the Series A Preferred Stock, "Preferred Stock") for $1.2 billion. Series A Preferred Stock and Series B Preferred Stock have liquidation preferences of $25 per share and $50 per share, respectively. The Preferred Stock has an annual dividend rate of 5%, is convertible into shares of Viacom Class B Common Stock at a conversion price of $70 and does not have voting rights other than those required by law. The Preferred Stock is redeemable by Viacom Inc. at declining premiums after five years. The Preferred Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. Both NYNEX and Blockbuster may, under certain limited circumstances, require Viacom Inc. to repurchase their respective preferred shares, but such right does not inure to the benefit of subsequent holders of such preferred shares. NAI holds approximately 76.3% and the public holds approximately 23.7% of outstanding Viacom Inc. Common Stock as of December 31, 1993. NAI's percentage of ownership consists of 85.2% of the outstanding Viacom Class A Common Stock and 69.1% of the outstanding Viacom Class B Common Stock, as of December 31, 1993. Pursuant to a purchase program initiated in August 1987, NAI announced its intention to buy, from time to time, up to an additional 3,000,000 shares of Viacom Class A Common Stock and 2,423,700 shares of Viacom Class B Common Stock. As of December 31, 1993, NAI had acquired an aggregate of 3,374,300 shares of Common Stock, consisting of 1,466,200 shares of Viacom Class A Common Stock and 1,908,100 shares of Viacom Class B Common Stock, pursuant to this buying program. On August 20, 1993, NAI ceased making purchases of Common Stock. _____________________ The Company and Viacom Inc. filed a shelf registration statement with the Securities and Exchange Commission ("SEC") registering $800 million of debt securities (or, if such debt securities are issued at an original issue discount, such greater principal amount as shall result in an aggregate offering price equal to $800 million) guaranteed by Viacom Inc. The registration statement was declared effective by the SEC on March 11, 1993. Some or all of the debt securities may be issued by the Company in one or more offerings. During April 1993, the Company and Viacom Inc. terminated the prior shelf registration statement, under which an aggregate of $300 million principal amount of additional debt securities remained available. NAI, Sumner M. Redstone and the Company each have purchased on the open market and may in the future continue to purchase on the open market or in privately negotiated transactions certain debt securities of the Company. During 1993, there were no purchases of debt securities made by NAI, Sumner M. Redstone or the II-30 Company. During 1992, Sumner M. Redstone purchased directly or beneficially $350,000, $605,000, $15,000 and $200,000 of 11.50% Senior Subordinated Extendible Reset Notes, 9.125% Senior Subordinated Notes, 10.25% Senior Subordinated Notes and 8.75% Senior Subordinated Reset Notes, respectively. During 1991, NAI and Sumner M. Redstone purchased $3,110,000 and $869,000 of 11.80% Senior Subordinated Notes, respectively. During 1991, NAI purchased $311,000 of the 11.50% Senior Subordinated Extendible Reset Notes. During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. II-31 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS - --------------------------------- To the Boards of Directors and Shareholders of Viacom Inc. and Viacom International Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of shareholders' equity present fairly, in all material respects, the financial position of Viacom Inc. and its subsidiaries and of Viacom International Inc., a wholly- owned subsidiary of Viacom Inc., and its subsidiaries, at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the management of Viacom Inc. and Viacom International Inc.; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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 the opinion expressed above. As discussed in Note 7 to the financial statements, Viacom Inc. and Viacom International Inc. adopted Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes" in 1993. PRICE WATERHOUSE 1177 Avenue of the Americas New York, New York 10036 February 4, 1994, except as to Note 2, which is as of March 11, 1994 II-32 MANAGEMENT'S STATEMENT OF RESPONSIBILITY FOR FINANCIAL REPORTING - ---------------------------------------------------------------- Management has prepared and is responsible for the consolidated financial statements and related notes of Viacom Inc. They have been prepared in accordance with generally accepted accounting principles and necessarily include amounts based on judgments and estimates by management. All financial information in this annual report is consistent with the consolidated financial statements. The Company maintains internal accounting control systems and related policies and procedures designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and properly recorded, and that accounting records may be relied upon for the preparation of consolidated financial statements and other financial information. The design, monitoring, and revision of internal accounting control systems involve, among other things, management's judgment with respect to the relative cost and expected benefits of specific control measures. The Company also maintains an internal auditing function which evaluates and reports on the adequacy and effectiveness of internal accounting controls, policies and procedures. Viacom Inc.'s consolidated financial statements have been audited by Price Waterhouse, independent public accountants, who have expressed their opinion with respect to the presentation of these statements. The Audit Committee of the Board of Directors, which is comprised solely of directors who are not employees of the Company, meets periodically with the independent accountants, with our internal auditors, as well as with management, to review accounting, auditing, internal accounting controls and financial reporting matters. The Audit Committee is also responsible for recommending to the Board of Directors the independent accounting firm to be retained for the coming year, subject to stockholder approval. The independent accountants and the internal auditors have full and free access to the Audit Committee with and without management's presence. VIACOM INC. By: /s/Frank J. Biondi, Jr. ----------------------------------------- Frank J. Biondi, Jr. President, Chief Executive Officer By: /s/George S. Smith, Jr. ------------------------------------------ George S. Smith, Jr. Senior Vice President, Chief Financial Officer By: /s/Kevin C. Lavan ------------------------------------------ Kevin C. Lavan Vice President, Controller and Chief Accounting Officer II-33 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- (Thousands of dollars, except per share amounts) Year Ended December 31, ------------------------------ 1993 1992 1991 ---- ---- ---- Revenues $2,004,949 $1,864,683 $1,711,562 Expenses: Operating 877,609 853,977 790,816 Selling, general and administrative 589,288 517,977 475,648 Depreciation and amortization 153,057 144,802 132,864 --------- ---------- ---------- Total expenses 1,619,954 1,516,756 1,399,328 --------- ---------- --------- Earnings from operations 384,995 347,927 312,234 Other income (expense): Interest expense, net (144,953) (194,104) (297,451) Other items, net (See Note 14) 61,774 1,756 (6,536) --------- ---------- --------- Earnings before income taxes 301,816 155,579 8,247 Provision for income taxes 129,815 84,848 42,060 Equity in loss of affiliated companies, net of tax (2,520) (4,646) (12,743) --------- ---------- --------- Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle 169,481 66,085 (46,556) Extraordinary losses, net of tax (See Note 4) (8,867) (17,120) (3,101) Cumulative effect of change in accounting principle 10,338 -- -- --------- ---------- --------- Net earnings (loss) 170,952 48,965 (49,657) Cumulative convertible preferred stock dividend requirement of Viacom Inc. 12,750 -- -- --------- ---------- --------- Net earnings (loss) attributable to common stock $ 158,202 $ 48,965 $ (49,657) ========= ========= ========== Weighted average number of common shares 120,607 120,235 113,789 Net earnings (loss) per common share: Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle $ 1.30 $ .55 $ (.41) Extraordinary losses (.07) (.14) (.03) Cumulative effect of change in accounting principle .08 -- -- --------- ---------- --------- Net earnings (loss) $ 1.31 $ .41 $ (.44) ========= ========= ========= See notes to consolidated financial statements. II-34 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS --------------------------- (Thousands of dollars) December 31, ------------------------- 1993 1992 ---- ---- Assets Current Assets: Cash and cash equivalents $1,882,381 $ 48,428 Receivables, less allowances of $33,889 and $25,779 351,765 319,804 Distribution fees advanced and committed, current 18,620 19,631 Program rights and deferred program costs, current 264,212 215,109 Prepaid distribution costs 73,722 89,723 Other current assets 95,693 65,793 ---------- ---------- Total current assets 2,686,393 758,488 Property and Equipment: Land 16,486 17,869 Buildings 41,627 37,486 Cable television systems 414,918 388,170 Broadcasting facilities 52,100 50,665 Equipment and other 349,332 258,565 Construction in progress 26,982 10,858 ----------- ---------- 901,445 763,613 Less accumulated depreciation 347,243 306,548 ---------- ---------- Net property and equipment 554,202 457,065 ---------- ---------- Distribution fees advanced and committed, non-current 263,281 228,784 Program rights and deferred program costs, non-current 526,247 462,122 Intangibles, at amortized cost 2,180,571 2,195,936 Other assets 206,174 214,699 ---------- ---------- $6,416,868 $4,317,094 ========== ========== See notes to consolidated financial statements. II-35 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS --------------------------- (Thousands of dollars, except per share amounts) December 31, ----------------------- 1993 1992 ---- ---- Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ 96,579 $ 71,199 Accrued interest 20,684 38,229 Deferred income, current 50,930 68,295 Other accrued expenses 264,921 290,937 Income taxes 140,453 96,529 Owners' share of distribution revenue 139,081 158,351 Program rights, current 197,966 187,956 Current portion of long-term debt 55,004 -- ---------- ---------- Total current liabilities 965,618 911,496 ---------- ---------- Long-term debt 2,378,286 2,397,014 Program rights, non-current 86,752 92,886 Other liabilities 268,098 159,187 Commitments and contingencies (See Note 10) Shareholders' Equity of Viacom Inc. (See Notes 1 and 6): Preferred Stock, par value $.01 per share; 100,000,000 shares authorized; 48,000,000 shares issued and outstanding; stated at liquidation value 1,800,000 -- A Common Stock, par value $.01 per share; 100,000,000 shares authorized; 53,449,325 (1993) and 53,380,390 (1992) shares issued and outstanding 535 534 B Common Stock, par value $.01 per share; 150,000,000 shares authorized; 67,347,131 (1993) and 67,069,688 (1992) shares issued and outstanding 673 671 Additional paid-in capital 920,864 917,466 Accumulated deficit (3,958) (162,160) ---------- ---------- Total shareholders' equity 2,718,114 756,511 ---------- ---------- $6,416,868 $4,317,094 ========== ========== See notes to consolidated financial statements. II-36 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- Year Ended December 31, -------------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Net cash flow from operating activities: Net earnings (loss) $170,952 $ 48,965 $ (49,657) Adjustments to reconcile net earnings (loss) to net cash flow from operating activities: Depreciation and amortization 153,057 144,802 132,864 Interest accretion and interest in kind on debentures -- -- 59,196 Reserve for litigation (See Note 14) -- 33,000 -- Equity in loss of affiliated companies, net of tax 2,520 4,646 12,743 Gain on the sale of the cable system, net of tax (45,873) -- -- Gain on the sale of investment held at cost, net of tax (10,882) -- -- Extraordinary losses, net of tax 8,867 17,120 3,101 Deferred compensation . 3,924 8,202 12,328 Provision (benefit) for deferred income taxes 24,364 15,068 (8,756) (Decrease) increase in accounts payable and accrued expenses (17,189) 53,400 6,831 Increase in receivables (31,881) (49,756) (61,929) Increase in programming related assets and liabilities, net (137,549) (138,568) (66,391) Increase in income taxes payable 58,501 7,389 37,732 (Decrease) increase in deferred income (8,999) 22,933 (2,384) (Increase) decrease in unbilled receivables (6,516) 17,749 (27,630) Payment of LTIP liability (3,606) (68,599) -- Other, net (12,080) (14,362) 21,819 ---------- --------- --------- Net cash flow from operating activities 147,610 101,989 69,867 ---------- --------- --------- Investing activities: Capital expenditures (135,011) (110,222) (72,157) Investments in and advances to affiliated companies. (21,618) (23,708) (44,372) Advances from affiliated companies 13,441 9,447 5,546 Proceeds from sale of cable system and radio station 93,739 20,000 -- Proceeds from sale of investment held at cost 18,140 -- -- Proceeds from sale of transponders 51,000 -- -- Acquisitions (82,197) -- -- Deposits on transponders (49,934) (9,723) -- Payment of deferred merger costs (15,382) -- -- Other, net (616) (2,636) (4,120) ---------- --------- --------- Net cash flow from investing activities (128,438) (116,842) (115,103) ---------- --------- --------- Financing activities: Borrowings from banks under credit facilities 334,291 8,343,967 6,695,048 Repayments to banks under credit facilities -- (7,968,466) (6,764,593) Issuance of notes -- 250,000 200,000 Redemption of notes and debentures (298,015) (549,454) (407,580) Issuance of Preferred Stock 1,800,000 -- -- Issuance of B Common Stock -- -- 317,987 Payment of deferred financing costs (18,106) (22,659) (5,869) Payment of premium on redemption of notes (10,054) (19,753) (4,078) Other, net 6,665 924 (18) ---------- --------- --------- Net cash flow from financing activities 1,814,781 34,559 30,897 ---------- --------- --------- Net increase (decrease) in cash and cash equivalents 1,833,953 19,706 (14,339) Cash and cash equivalents at beginning of year 48,428 28,722 43,061 ---------- --------- --------- Cash and cash equivalents at end of year $1,882,381 $ 48,428 $ 28,722 ========== ========= ========= See notes to consolidated financial statements. II-37 -- VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS ----------------------- OF SHAREHOLDERS' EQUITY ----------------------- (Thousands of dollars) See notes to consolidated financial statements. II-38 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1) SUMMARY OF ACCOUNTING POLICIES Basis of Presentation -Viacom Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, "Viacom Inc.") is a holding company whose principal asset is the common stock of Viacom International Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, the "Company"). The Company is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. The primary differences between Viacom Inc.'s and the Company's financial statements include the following factors: a) the capitalization of the two companies -- the Company's shareholders' equity reflects the contribution to capital of Viacom Inc.'s exchangeable preferred stock, which was exchanged for 15.5% Junior Subordinated Exchange Debentures due 2006 (the "Exchange Debentures") on March 31, 1989 which in turn were fully redeemed during 1991; b) during 1993, Viacom Inc. issued $1.8 billion of 5% cumulative convertible preferred stock (see Note 6) and declared related preferred stock dividends of $12.8 million, c) certain general and administrative expenses recorded by Viacom Inc. of $5.0 million (1993), $9.0 million (1992) and $12.9 million (1991), which include transactions associated with the long-term deferred incentive compensation plans; and d) Viacom Inc. recorded net interest income of $3.1 million (1993) and net interest expense of $45.2 million (1991). Certain amounts reported on the balance sheet and statements of cash flows for prior years have been reclassified to conform with the current presentation. Principles of Consolidation - The consolidated financial statements include the accounts of Viacom Inc., the Company and all investments of more than 50% in subsidiaries and other entities. All significant intercompany transactions have been eliminated. Investments in affiliated companies of more than 20% but less than or equal to 50% are accounted for under the equity method. Investments of 20% or less are accounted for under the cost method. In 1993, the fiscal year end for certain foreign operations was changed from October 31 to December 31. Cash Equivalents - Cash equivalents are defined as short-term (3 months or less) highly liquid investments. Program Rights - The Company acquires rights to exhibit programming on its broadcast stations or cable networks, and produces its own programs. The costs incurred in acquiring and producing programs are capitalized and amortized over the license period or over the estimated exhibition life of the program. Costs related to the production of programs are either charged to earnings or capitalized to the extent they are estimated to be recoverable from future revenue. Program rights and the related liabilities are recorded at the gross amount of the liabilities when the license period has begun, the cost of the program is determinable and the program is accepted and available for airing. Program Distribution - Fees for distributing television shows and feature films are recognized upon billing over contractual periods generally ranging from one to five years, except that such fees for internally produced programs are recognized when such programs are delivered and fees for barter advertising revenue are recognized when the programs are available and a noncancellable contract has been executed. Receivables reflect gross billings, which include the owners' share. Amounts due to owners are recorded as liabilities in "Owners' share of distribution revenue" or are deducted from "Distribution fees advanced and committed, current." Minimum guarantees to owners are recorded as liabilities and are liquidated by payments in accordance with contract terms. A corresponding asset is recorded as "Distribution fees advanced and committed" and is reduced by the owners' share of billings until fully recovered or amortized as operating expenses against the Company's share of total estimated billings based on the ratio of total estimated costs to total estimated billings. Prepaid distribution costs incurred on behalf of the owners are recovered from the owners' share of billings or amortized as operating expenses against the Company's share of total estimated billings based on the ratio of total estimated costs to total estimated billings. II-39 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) All amortization estimates are reviewed periodically by management and are adjusted prospectively. Minimum guarantees or other costs estimated not to be recoverable from total estimated billings are expensed in the period any shortfall is determined. Depreciation and Amortization - Depreciation is computed principally by the straight-line method over estimated useful lives ranging principally from 3 to 15 years. Capitalized lease amortization of $5.5 million (1993) and $3.0 million (1992) is included in depreciation expense. Depreciation expense was $92.8 million (1993), $81.5 million (1992) and $70.1 million (1991). Intangibles resulting from business acquisitions are generally amortized over 40 years. Accumulated amortization relating to intangibles at December 31 was $412.5 million (1993) and $361.1 million (1992) . Equity in Loss of Affiliated Companies - Equity in loss of affiliated companies is primarily comprised of the Company's one-third interest in Lifetime, the 50% interest in Comedy Central, the 50% interest in Nickelodeon (UK) during 1993 and the 49.99% interest in MTV EUROPE prior to August 30, 1991. (See Note 3.) Provision for Doubtful Accounts - The provision for doubtful accounts charged to expense was $16.7 million (1993), $9.4 million (1992) and $15.9 million (1991). Net Earnings (Loss) per Common Share - Earnings (loss) per share is calculated based on the weighted average number of shares outstanding during the year. The effect of the assumed exercise of stock options and conversion of convertible debentures is not material for each of the years presented. For 1993, the assumed conversion of the Preferred Stock (as defined in Note 2) would have an antidilutive effect on fully-diluted earnings per common share. Therefore, the effects of such assumption are not reflected in net earnings (loss) per common share. Interest Rate Protection Agreements - The amount to be paid or received is accrued as interest rates change and is recognized over the life of the agreements as an adjustment to interest expense. 2) SUBSEQUENT EVENTS On March 11, 1994, Viacom Inc. acquired, pursuant to a tender offer (the "Paramount Offer"), 61,657,432 shares of Paramount common stock, constituting a majority of the shares outstanding, at a price of $107 per share in cash. The Paramount Offer was financed by (i) the sale of Preferred Stock (see "Note 6"), proceeds of which are reflected as cash and cash equivalents on the balance sheet as of December 31, 1993, (ii) the sale of Viacom Class B Common Stock to Blockbuster and (iii) borrowings under a credit agreement (as described below). The Paramount Offer was made pursuant to the Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. Paramount will become a wholly owned subsidiary of Viacom Inc. (the "Paramount Merger") at the effective time of a merger between Paramount and a subsidiary of Viacom Inc. (the "Paramount Effective Time") which is expected to occur in the second quarter of 1994. Pursuant to the Paramount Merger Agreement, each share of Paramount common stock outstanding at the time of such merger (other than shares held in the treasury of Paramount or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights) will be converted into the right to receive (i) 0.93065 of a share of Viacom Class B Common Stock, (ii) $17.50 principal amount of 8% exchangeable subordinated debentures of Viacom Inc., (iii) 0.93065 of a contingent value right ("CVR"), (iv) 0.5 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the third anniversary of the Paramount Merger at a price of $60 per share, and (v) 0.3 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the fifth anniversary of the Paramount Merger at a price of $70 per share. If the debentures are issued prior to the completion of the purposed merger of Viacom Inc. and Blockbuster, the debentures will be exchangeable, at the option of Viacom Inc., into 5% exchangeable preferred stock of Viacom Inc. on or after January 1, 1995 if the proposed merger with Blockbuster has not previously been consummated. II-40 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Each CVR will represent the right to receive the amount, if any, by which the Target Price exceeds the greater of the Current Market Value and the Minimum Price (see defined terms in following paragraph). The CVRs will mature on the first anniversary of the Paramount Effective Time (the "Maturity Date"); provided, however, that Viacom Inc. may, at its option, (i) extend the Maturity Date to the second anniversary of the Paramount Effective Time (the "First Extended Maturity Date") or (ii) extend the First Extended Maturity Date to the third anniversary or the Paramount Effective Time (the "Second Extended Maturity Date"). Viacom Inc., at its option, may pay any amount due under the terms of the CVRs in cash or in the equivalent value of registered securities of Viacom Inc., including without limitation, common stock, preferred stock, notes, or other securities. The "Minimum Price" means (a) at the Maturity Date, $36, (b) at the First Extended Maturity Date, $37 and (c) at the Second Extended Maturity Date, $38. Target Price means (a) at the Maturity Date, $48, (b) at the First Extended Maturity Date, $51, and (c) at the Second Extended Maturity Date, $55. The "Current Market Value" means the average market price of Viacom Class B Common Stock for a specified period. On January 7, 1994, Viacom Inc. and Blockbuster entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger") subject to approval. At the effective time of the Blockbuster Merger, each share of Blockbuster common stock outstanding at the time of the Blockbuster Merger (other than shares held in the treasury of Blockbuster or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights, if available) will be converted into the right to receive (i) 0.08 of a share of Viacom Class A Common Stock, (ii) 0.60615 of a share of Viacom Class B Common Stock, and (iii) up to an additional 0.13829 of a share of Viacom Class B Common Stock, with the exact fraction of a share being dependent on the market prices of Viacom Class B Common Stock during the year following the effective time of the Blockbuster Merger, and with the right to receive such additional fraction of a share to be evidenced by one variable common right ("VCR"). The VCRs mature on the first anniversary of the Blockbuster Merger ("VCR Conversion Date"). The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. intends to vote its shares of Paramount in favor of the merger and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. The Mergers will be accounted for under the purchase method of accounting. The unaudited condensed pro forma data for the year ended or at December 31, 1993 presented below assumes the Mergers occurred on January 1, 1993 for statement of operations data or at December 31, 1993 for balance sheet data. Intangible assets are expected to be amortized over 40 years on a straight-line basis. The unaudited pro forma information is not necessarily indicative of the combined results of operations or financial position of Viacom Inc., Paramount and Blockbuster (the "Combined Company") following the Mergers that would have occurred if the completion of the Mergers had occurred on the dates previously indicated nor are they necessarily indicative of future operating results of the Combined Company. II-41 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Year Ended or at December 31, 1993 ---------------- (Millions of dollars) (Unaudited) Results of operations data: Revenues $9,624.1 Earnings from operations $ 887.9 Net earnings before extraordinary items, cumulative effect of changes in accounting principles and preferred stock dividends $ 135.6 Net earnings attributable to common stock before extraordinary items and cumulative effect of changes in accounting principles $ 75.6 Primary earnings per common share before extraordinary items and cumulative effect of changes in accounting principles $ .18 Balance sheet data: Total assets $24,377.3 Long-term debt, including current maturities $ 9,998.8 Shareholders' equity: Preferred $ 1,200.0 Common $ 8,844.8 On March 10, 1994, Blockbuster purchased approximately 22.7 million shares of Viacom Class B Common Stock for an aggregate purchase price of $1.25 billion, or $55 per share. If (with certain exceptions) the Blockbuster Merger Agreement is terminated and in the event that Viacom Class B Common Stock trades (for a specified period) at a level below $55 per share during the one year period after such termination, Viacom Inc. may be obligated to make certain payments of up to a maximum of $275 million, at its option, in cash or securities, or to sell certain assets to Blockbuster. The Viacom Class B Common Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On February 15, 1994, Blockbuster entered into a credit agreement with certain financial institutions named therein, pursuant to which such financial institutions have advanced to Blockbuster, on an unsecured basis, an aggregate of $1.0 billion to finance a portion of the purchase of the shares under the Subscription Agreement (the "Blockbuster Facility"). The Blockbuster Facility contains certain events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness incurred by Blockbuster under the Blockbuster Facility. On March 11, 1994, Viacom Inc. borrowed $3.7 billion under a credit agreement dated as of November 19, 1993, as amended on January 4, 1994 and February 15, 1994, among Viacom Inc., the banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agents (the "Merger Credit Agreement"). The Merger Credit Agreement provides that, in order to pay for the Paramount Offer and related expenses, up to $3.7 billion may be borrowed, repaid and reborrowed until November 18, 1994, at which time all amounts outstanding will become due and payable. The Merger Credit Agreement provides that Viacom Inc. may elect to borrow at either the Base Rate or the Eurodollar Rate (each as defined below), subject to certain limitations. The "Base Rate" will be the higher of (i) the Citibank N.A., Base Rate and (ii) the Federal Funds Rate plus 0.50%. The "Eurodollar Rate" will be the London Interbank Offered Rate plus (i) 0.9375%, until Viacom Inc.'s senior unsecured long-term debt is rated by Standard & Poor's Corporation or Moody's Investors Service, Inc., and (ii) thereafter, a variable II-42 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) rate ranging from 0.25% to 0.9375% dependent on the senior unsecured long-term debt rating assigned to Viacom Inc. The Merger Credit Agreement provides that Viacom Inc. will pay each bank a facility fee on such bank's commitment until November 18, 1994. The Merger Credit Agreement contains certain covenants which, among other things require Viacom Inc. to meet certain financial ratios. As of December 31, 1993, Viacom Inc. has promissory notes outstanding in the aggregate amount of $26 million, in order to finance expenses associated with the Mergers and expects to obtain additional financing as required to finance such expenses. 3) ACQUISITIONS AND VENTURES On November 1, 1993, the Company exchanged KIKK-AM/FM, Houston, Texas, for Westinghouse Broadcasting Company, Inc.'s WCXR-FM and WCPT-AM, Washington, D.C., and cash. On June 16, 1993, the Company purchased KXEZ-FM (formerly KQLZ-FM), Los Angeles, California from Westwood One Stations Group-LA, Inc. for $40 million in cash and certain other consideration. The Company sold KXEZ-FM to Viacom Inc. in exchange for a $40 million promissory note. On May 5, 1993, the Company completed the purchase of privately held ICOM Simulations, Inc. On March 31, 1993, the Company increased its percentage of ownership in StarSight Telecast Inc. ("StarSight"). On August 5, 1993, StarSight completed an initial public offering of 3,105,000 shares of common stock. On September 16, 1993, the Company exercised a warrant to purchase 833,333 shares of StarSight common stock at a cost of $5.625 per share. In November 1993, the Company transferred its ownership percentage in StarSight to a consolidated affiliate of the Company. As a result of these transactions, the affiliate's of the Company's percentage ownership of StarSight is approximately 21%. The investment in StarSight is accounted for under the equity method. In December 1992, the Company entered into a 50-50 joint venture called Nickelodeon (UK) with a subsidiary of British Sky Broadcasting Limited. Nickelodeon (UK) began airing on September 1, 1993. The Company's investment is accounted for under the equity method. The Company exchanged KHOW-AM and FM, Denver, Colorado for Noble Broadcast Group, Inc.'s KNDD-FM, Seattle, Washington effective December 28, 1992. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. The approximate value of the purchase was $65.0 million, which included intangibles of approximately $61.6 million. As consideration for the sale, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock (See Note 6). II-43 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4) BANK FINANCING AND DEBT Total debt, which includes short-term and long-term debt, consists of the following: December 31, December 31, 1993 1992 ------------ ------------ (Thousands of dollars) Notes payable to banks (a) $1,983,275 $1,648,984 11.80% Senior Subordinated Notes due 1998 -- 298,000 9.125% Senior Subordinated Notes due 1999 (b) 150,000 150,000 8.75% Senior Subordinated Reset Notesdue 2001 (c) 100,000 100,000 10.25% Senior Subordinated Notes due 2001 (d) 200,000 200,000 5.75% Convertible Subordinated Debentures due 2001 15 30 ---------- ---------- 2,433,290 2,397,014 Less current portion 55,004 -- ---------- ---------- $2,378,286 $2,397,014 ========== ========== (a) -- At December 31, 1993, there were aggregate borrowing facilities of $1.9 billion and $300 million under (i) an unsecured credit agreement guaranteed by Viacom Inc. (amended and restated as of January 17, 1992, (as amended, the "Credit Agreement") among the Company the named banks ("Banks"), Citibank, N.A. ("Citibank") as agent and The Bank of New York ("BONY") as co-agent and (ii) an unsecured credit agreement, dated June 2, 1993, among the Company and the named banks and BONY and Citibank as agents (the "Loan Facility Agreement"). The Loan Facility Agreement has a 364-day term and is identical to the Credit Agreement in all other material terms and conditions. Borrowings of $1.765 billion were outstanding under the Credit Agreement as of December 31, 1993, including $274 million aggregate principal amount assumed by five subsidiaries of the Company ("Subsidiary Obligors"). Borrowings of $150 million were outstanding under the Loan Facility Agreement as of December 31, 1993, $135 million of which were classified as long-term. The following is a summary description of the amended and restated Credit Agreement. The description does not purport to be complete and should be read in conjunction with the Credit Agreement. The Credit Agreement provides for three facilities: Facility A - $700 million under a term loan having a final maturity of June 30, 1999; Facility B - $926 million under a revolver, which converts on January 1, 1995 into a term loan having a final maturity of June 30, 1999; and Facility B-1 - $274 million under a term loan having a final maturity of June 30, 1999. The interest rate on all loans made under the three facilities is based upon Citibank, N.A.'s base rate, the domestic certificate of deposit rate or the London Interbank Offered Rate and is affected by the Company's leverage ratio. At December 31, 1993, the London Interbank Offered Rates (upon which the Company's borrowing rate was based) for borrowing periods of one month and two months were 3.25% and 3.3125%, respectively. The Company is permitted to issue commercial paper with a maturity at the time of issuance not to exceed nine months, provided that following each issuance of commercial paper, (i) the aggregate face amount of commercial paper outstanding shall not exceed $500 million less the aggregate amount of competitive bid rate borrowings (described II-44 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) below), outstanding at such time and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company is also permitted to make short-term competitive bid rate borrowings from the Banks until December 1, 1994, provided that following the making of each proposed competitive bid rate borrowing, (i) the aggregate amount of the competitive bid rate loans outstanding shall not exceed $500 million less the aggregate face amount of commercial paper outstanding and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company and Subsidiary Obligors are required to repay the principal outstanding under the Credit Agreement in quarterly payments equal to percentages of the original aggregate principal amount with respect to the Facility A loans and Facility B-1 loans, and of the outstanding principal amount with respect to the Facility B loans, under the Credit Agreement, in the amount of 5% for the period commencing January 2, 1995 through and including January 2, 1999; and 7.5% on April 1, 1999 and on June 30, 1999. The Company may prepay at any time a portion or all of the principal outstanding under the Credit Agreement. Any such optional prepayments shall be applied to the remaining installments of Facility A and Facility B loans in the order that the Company designates. The Company is required to make mandatory prepayments upon receipt of net cash sale proceeds in connection with permitted sales of assets not in the ordinary course of business. All such prepayments shall be applied until December 31, 1994 to reduce the Facility B loans outstanding; provided, however, that any amounts so repaid may be reborrowed prior to December 31, 1994. All such prepayments after December 31, 1994 shall be applied pro rata against the remaining installments of first, the Facility A loans and second, the Facility B loans. In the event of a sale of the stock or substantially all of the assets of any Subsidiary Obligor, the Facility B-1 loan of such Subsidiary Obligor shall be repaid in full; provided, however, that upon such prepayment prior to December 31, 1994, the Facility B commitment of each Facility B Bank shall be increased by an amount equal to the principal amount of such Facility B Bank's Facility B-1 loan prepaid as a result of such prepayment and such amounts may be borrowed by the Company prior to December 31, 1994. The Company is required to prepay principal outstanding under the Credit Agreement with the proceeds of certain issuances of unsecured senior debt in an amount equal to the proceeds so received, together with accrued interest to the date of such prepayment on the principal amount prepaid, with such prepayments applied against remaining installments of first, the Facility A loans and second, the Facility B loans. The Credit Agreement contains certain covenants which, among other things, require the Company to maintain certain financial ratios and impose on the Company and its subsidiaries certain limitations on (i) the incurrence of indebtedness or the guarantee or assumption of indebtedness of another; (ii) the creation or incurrence of mortgages, pledges or security interests on the property or assets of the Company or any of its subsidiaries in order to secure debt or the sale of assets of the Company or its subsidiaries; (iii) the merger or consolidation of the Company with any person or other entity; (iv) the incurrence of capitalized leases and purchase money indebtedness; (v) the payment of cash dividends or the redemption or repurchase of any capital stock of the Company; and (vi) investments and acquisitions. The Credit Agreement also contains certain customary events of default. The Credit Agreement also provides that it is an event of default if National Amusements, Inc. ("NAI") fails to own at least 51% of the outstanding voting stock of Viacom Inc. or Viacom Inc. fails to own at least 67% of the outstanding voting stock of the Company. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes, including the satisfaction of Viacom Inc.'s obligations under the LTIP), unless its total leverage ratio is less than a specified amount. The Company is required to pay a commitment fee based on the aggregate average daily unborrowed portion of the Facility B commitment, with any amounts outstanding under competitive bid rate loans and commercial paper being deemed unborrowed for the purpose of calculating the commitment fee. The Company also is required to pay certain agency fees to the agent. The Credit Agreement does not require compensating balances. II-45 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) On January 4, 1993, Viacom Inc. borrowed $42.2 million from BONY pursuant to the Term Loan Agreement. The interest rate in the Term Loan Agreement is based upon BONY's prime rate or the London Interbank Offered Rate. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. Viacom Inc. may prepay at any time a portion or all of the principal amount outstanding under the Term Loan Agreement. Any such optional prepayments shall be applied to reduce the principal installment due January 1995 and shall include all accrued interest on the amount of principal prepaid. Viacom Inc. shall be obligated to prepay the loan in the amount of any dividends received from the Company. The Term Loan Agreement contains certain covenants which impose certain limitations on (i) the incurrence of indebtedness and (ii) payment of cash dividends or the redemption or repurchase of any capital stock of Viacom. The Term Loan Agreement also contains certain customary events of default. The Term Loan Agreement has been amended to allow Viacom Inc. to complete the Paramount Offer and the Paramount Merger. The indebtedness under the Credit Agreement, Loan Facility Agreement and Term Loan Agreement bear interest at floating rates, causing the Company to be sensitive to changes in prevailing interest rates. The Company enters into interest rate protection agreements with off-balance sheet risk in order to reduce its exposure to changes in interest rates on its variable rate long-term debt. These interest rate protection agreements include interest rate swaps and interest rate caps. At December 31, 1993, the Company and Viacom Inc. had interest rate protection agreements outstanding with commercial banks, with respect to $1.1 billion of indebtedness under the Credit Agreement and $42.2 million under the Term Loan Agreement. These agreements effectively change the Company's interest exposure under the Credit Agreement to a ceiling of 5.64% on the interest rate caps, and under the Term Loan Agreement to a fixed weighted average rate of 6.65% on interest rate swaps. The interest rate protection agreements are in effect for a fixed period of time. The Company is exposed to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company does not anticipate nonperformance by the counterparties. The Company had commercial paper outstanding of $60.9 million as of December 31, 1993. The Company also has aggregate money market facilities of $40 million, all of which was available at December 31, 1993. (b) -- On March 4, 1992, the Company issued $150 million aggregate principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due August 15, 1999. Interest is payable semiannually on February 15 and August 15, commencing August 15, 1992. The 9.125% Notes may not be redeemed prior to February 15, 1997. They are redeemable at the option of the Company, in whole or in part, during the 12 month period beginning February 15, 1997 at a redemption price of 102.607% of the principal amount, during the 12 month period beginning February 15, 1998 at 101.304% of the principal amount, and on or after February 15, 1999 at 100% of the principal amount. Any such redemption will include accrued interest to the redemption date. The 9.125% Notes are not subject to any sinking fund requirements. (c) -- On May 28, 1992, the Company issued $100 million aggregate principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due on May 15, 2001. Interest is payable semiannually on May 15 and November 15, commencing November 15, 1992. On May 15, 1995 and May 15, 1998, unless a notice of redemption of the 8.75% Reset Notes on such date has been given by the Company, the interest rate on the 8.75% Reset Notes will, if necessary, be adjusted from the rate then in effect to a rate to be determined on the basis of market rates in effect on May 5, 1995 and on May 5, 1998, respectively, as the rate the 8.75% Reset Notes should bear in order to have a market value of 101% of principal amount immediately after the resetting of the rate. In no event will the interest rate be lower than 8.75% or higher than the average three year treasury rate (as defined in the indenture) multiplied by two. The interest rate reset on May 15, 1995 will remain in effect on the 8.75% Reset Notes through and including May 15, 1998 and the interest rate reset on May 15, 1998 will remain in effect on the 8.75% Reset Notes thereafter. The 8.75% Reset Notes are redeemable at the option of the Company, in whole but not in part, on May 15, 1995 or May 15, 1998, at a redemption price of 101% of II-46 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) principal amount plus accrued interest to, but not including, the date of redemption. The 8.75% Reset Notes are not subject to any sinking fund requirements. (d) -- On September 15, 1991, the Company issued $200 million aggregate principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due September 15, 2001. Interest is payable semiannually on March 15 and September 15, commencing March 15, 1992. The 10.25% Notes are not redeemable by the Company prior to maturity and are not subject to any sinking fund requirements. _____________________ II-47 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The extraordinary losses and related tax benefits associated with the extinguishment of certain debt of Viacom Inc. and the Company are summarized as follows: 11.50% 11.80% Reset Discount Exchange Notes Notes Debentures Debentures Total ------ ------ ---------- ---------- ----- (Thousands of dollars) Year ended December 31, 1993: - ---------------------------- Extraordinary loss (a) $14,953 $ -- $ -- $ -- $14,953 Tax benefit 6,086 -- -- -- 6,086 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ 8,867 $ -- $ -- $ -- $ 8,867 ======= ====== ======= ====== ======= Year ended December 31, 1992: - ---------------------------- Extraordinary loss (b) $ -- $5,800 $22,600 $ -- $28,400 Tax benefit -- 2,361 8,919 -- 11,280 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ -- $3,439 $13,681 $ -- $17,120 ======= ====== ======= ====== ======= Year ended December 31, 1991: - ---------------------------- Extraordinary loss (c) $ -- $ -- $ 3,761 $ 947 $ 4,708 Tax benefit -- -- 1,284 323 1,607 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ -- $ -- $ 2,477 $ 624 $ 3,101 ======= ====== ======= ====== ======= (a) On July 15, 1993, the Company redeemed all of the $298 million principal amount outstanding of the 11.80% Senior Subordinated Notes ("11.80% Notes") at a redemption price equal to 103.37% of the principal amount plus accrued interest to July 15,1993. (b) On June 18, 1992, the Company redeemed all of the $356.5 million principal amount outstanding of the 14.75% Senior Subordinated Discount Debentures ("Discount Debentures") at a redemption price equal to 105% of the principal amount plus accrued interest to June 18, 1992. On March 10, 1992, the Company redeemed all of the $193 million principal amount outstanding of its 11.50% Senior Subordinated Extendible Reset Notes ("11.50% Reset Notes") at a redemption price equal to 101% of the principal amount plus accrued interest to the redemption date. (c) During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. On August 30, 1991 and October 31, 1991, Viacom Inc. redeemed $250 million and $152 million, respectively, constituting the entire principal amount of the Exchange Debentures. The Company borrowed the funds necessary for each of these redemptions under its bank credit facilities existing in the respective periods. _____________________ NAI, Sumner M. Redstone and the Company each have purchased on the open market and may in the future continue to purchase on the open market or in privately negotiated transactions certain debt securities of the Company. During 1993, there were no purchases of debt securities made by NAI, Sumner M. Redstone or the Company. During 1992, Sumner M. Redstone purchased directly and beneficially $350,000, $605,000, $15,000 and $200,000 of 11.50% Senior II-48 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Subordinated Extendible Reset Notes, 9.125% Senior Subordinated Notes, 10.25% Senior Subordinated Notes and 8.75% Senior Subordinated Reset Notes, respectively. During 1991, NAI and Sumner M. Redstone purchased $3,110,000 and $869,000 of 11.80% Senior Subordinated Notes, respectively. During 1991, NAI purchased $311,000 of the 11.50% Senior Subordinated Extendible Reset Notes. During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. Interest costs incurred, interest income and capitalized interest are summarized below: Year Ended December 31, -------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Interest Incurred $154,509 $195,725 $298,591 Interest Income $ 9,184 $ 1,119 $ 626 Capitalized Interest $ 372 $ 502 $ 513 Scheduled maturities of long-term debt of the Company through December 31, 1998, assuming full utilization of the $1.9 billion commitment under the Credit Agreement and $300 million commitment under the Loan Facility, are $300 million (1994), $380 million (1995), $380 million (1996), $380 million (1997) and $380 million (1998). Scheduled maturities of debt of Viacom Inc. under the Term Loan Agreement are $13.9 million (repaid on January 15, 1994) and $28.3 million (1995). (See Note 2 regarding Paramount Merger financing and scheduled maturity of debt.) 5) FAIR VALUE OF FINANCIAL INSTRUMENTS The Company's carrying value of the financial instruments approximates fair value, except for differences with respect to the senior subordinated debt and certain differences related to other financial instruments which are not significant. The carrying value of the senior subordinated debt is $450 million and the fair value, which is estimated based on quoted market prices, is $486 million. 6) SHAREHOLDERS' EQUITY On October 22, 1993, Blockbuster purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series A Preferred Stock") for $600 million. On November 19, 1993, NYNEX Corporation ("NYNEX") purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series B Preferred Stock," collectively with the Series A Preferred Stock, "Preferred Stock") for $1.2 billion. Series A Preferred Stock and Series B Preferred Stock have liquidation preferences of $25 per share and $50 per share, respectively. The Preferred Stock has an annual dividend rate of 5%, is convertible into shares of Viacom Class B Common Stock at a conversion price of $70 and does not have voting rights other than those required by law. The Preferred Stock is redeemable by Viacom Inc. at declining premiums after five years. The Preferred Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On August 30, 1991, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock to an affiliate of Mirror Group Newspapers in exchange for the remaining 50.01% interest in MTV EUROPE (See Note 3). On September 17, 1991, all such shares of B Common Stock were sold by Mirror Group Newspapers in an underwritten public offering. II-49 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) On June 11, 1991, Viacom Inc. completed the sale of 10,781,600 shares of Viacom Class B Common Stock in a registered public offering and the private placement of an additional 500,000 shares of Viacom Class B Common Stock with NAI. Viacom Inc. realized proceeds, net of underwriting discounts and other related expenses, of approximately $317.7 million from the sale and private placement. NAI holds approximately 76.3% and the public holds approximately 23.7% of outstanding Viacom Inc. Common Stock as of December 31, 1993. NAI's percentage of ownership consists of 85.2% of the outstanding Viacom Class A Common Stock and 69.1% of the outstanding Viacom Class B Common Stock, as of December 31, 1993. Pursuant to a purchase program initiated in August 1987, NAI announced its intention to buy, from time to time, up to an additional 3,000,000 shares of Viacom Class A Common Stock and 2,423,700 shares of Viacom Class B Common Stock. As of December 31, 1993, NAI had acquired an aggregate of 3,374,300 shares of Common Stock, consisting of 1,466,200 shares of Viacom Class A Common Stock and 1,908,100 shares of Viacom Class B Common Stock, pursuant to this buying program. On August 20, 1993, NAI ceased making purchases of Common Stock. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes), unless its total leverage ratio is less than a specified amount. Long-Term Incentive Plans - The purpose of the Long-Term Incentive Plans (the "Plans"), which consist of the Long-Term Incentive Plan ("LTIP") and the Long- Term Management Incentive Plan ("LTMIP"), is to benefit and advance the interests of Viacom Inc. by rewarding certain key employees for their contributions to the financial success of the Company and thereby motivating them to continue to make such contributions in the future. The Plans provide for grants of equity-based interests pursuant to awards of phantom shares, stock options, stock appreciation rights, restricted shares or other equity- based interests ("Awards"), and for subsequent payments of cash with respect to phantom shares or stock appreciation rights based, subject to certain limits, on their appreciation in value over stated periods of time. During December 1992, a significant portion of the liability associated with the LTIP was satisfied through the cash payment of $68.6 million and the issuance of 177,897 shares of Viacom Class B Common Stock valued at $6.9 million. The LTMIP provides that an aggregate of 7,000,000 Awards may be granted over five years. As of December 31, 1993, there were 1,994,020 Awards available for future grant, and 4,616,155 Awards outstanding consisting of phantom shares for 643,098 shares of common stock at an average grant price of $29 and vesting over three years from the date of grant, and stock options for 3,973,057 shares of common stock with exercise prices ranging from $20.75 to $55.25 and vesting over four years from the date of grant. The stock options expire 10 years after the date of grant. II-50 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) A summary of stock option activity follows: Number of Option Shares Price range ------- ----------- Balance at December 31, 1991 3,148,357 $20.75 to $29.375 Granted 643,740 31.875 Exercised (45,291) 20.75 to 29.00 Canceled (189,215) 20.75 to 29.375 --------- Balance at December 31, 1992 3,557,591 20.75 to 31.875 Granted 856,990 43.25 to 55.25 Exercised (346,378) 20.75 to 31.875 Canceled (95,146) 20.75 to 55.25 --------- Balance at December 31, 1993 3,973,057 $20.75 to $55.25 ========= Available for future grant: December 31, 1993 1,994,020 December 31, 1992 2,752,854 Exercisable: December 31, 1993 1,448,570 December 31, 1992 775,040 Viacom Inc. has reserved 224,410 shares of Viacom Class A Common Stock and 29,462,933 shares of Viacom Class B Common Stock, principally for exercise of stock options and the conversion of the Preferred Stock. 7) INCOME TAXES The provision for income taxes shown below for the years ended December 31, 1993, 1992 and 1991 represents federal, state and foreign income taxes on earnings before income taxes. The tax benefits relating to losses accounted for under the equity method of accounting, which are shown net of tax on the Company's statement of operations, are $.6 million (1993), $2.2 million (1992) and $6.4 million (1991). See Note 4 for tax benefits relating to the Extraordinary Losses. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") on a prospective basis and recognized an increase to earnings of $10.3 million in 1993 as the cumulative effect of a change in accounting principle. SFAS 109 mandates the liability method for computing deferred income taxes. II-51 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Earnings before income taxes are attributable to the following jurisdictions: Year Ended December 31, ------------------------------ 1993 1991 1992 ---- ---- ---- (Thousands of dollars) United States $267,804 $138,215 $ (2,716) Foreign 34,012 17,364 10,963 -------- -------- -------- Total $301,816 $155,579 $ 8,247 ======== ======== ======== Components of the provision for income taxes on earnings before income taxes are as follows: Year Ended December 31, ---------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Current: Federal $89,484 $47,347 $29,039 State and local 10,357 17,851 16,618 Foreign 5,610 4,582 5,159 -------- ------- ------- 105,451 69,780 50,816 Deferred 24,364 15,068 (8,756) -------- ------- ------- $129,815 $84,848 $42,060 ======== ======= ======= II-52 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) A reconciliation of the U.S. Federal statutory tax rate to the Company's effective tax rate on earnings before income taxes is as follows: Year Ended December 31, ----------------------- 1993 1992 1991 ---- ---- ---- Statutory U.S. tax rate 35.0% 34.0% 34.0% State and local taxes, net of federal tax benefit 5.7 4.7 10.8 Foreign taxes, net of federal tax benefit .5 1.9 41.3 Amortization of intangibles 7.1 18.2 405.3 Divestiture gain - nontaxable portion (3.2) -- -- Property and equipment basis difference -- 7.2 150.0 Other purchase accounting adjustments -- -- (46.8) Alternative minimum tax -- (88.7) Income tax reserve adjustment (5.0) (12.9) -- Effect of changes in statutory rate .5 -- -- Other, net 2.4 1.4 4.2 ----- ----- ------- Effective tax rate 43.0% 54.5% 510.1% ===== ===== ====== The annual effective tax rate of 43% for 1993 and 54.5% for 1992 includes a reduction of certain prior year tax reserves in the amount of $22 million and $20 million, respectively. The reduction is based on management's view concerning the outcome of several tax issues based upon the progress of federal, state and local audits. As of December 31, 1993, after having given effect to SFAS 109, the Company had total non-current deferred net tax liabilities of $85.2 million and current deferred net tax assets of $16.3 million. The deferred net tax assets are deemed to be fully realizable and therefore no valuation allowance has been established. At December 31, 1993, the Company had no net operating loss or investment tax credit carryovers. II-53 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following is a summary of the deferred tax accounts in accordance with SFAS 109 for the year ended December 31, 1993. (Thousands of dollars) Current deferred tax assets and (liabilities): Differences between book and tax recognition of revenue $ 17,826 Differences between book and tax expense for program costs (4,127) Other differences between tax and financial statement values 2,591 -------- Gross current deferred net tax assets 16,290 -------- Noncurrent deferred tax assets and (liabilities): Tax depreciation in excess of book depreciation (69,118) Reserves in excess of tax expense 39,336 Tax amortization in excess of book amortization (32,985) Differences between book and tax expense for program costs (18,442) Differences between book and tax recognition of revenue (3,505) Other differences between tax and financial statement values (497) ---------- Gross noncurrent deferred net tax liabilities (85,211) ---------- Total net deferred tax liabilities $ (68,921) ========== The following table identifies the deferred tax items which were part of the Company's tax provision under previously applicable accounting principles for the years ended December 31, 1992 and 1991: Year Ended December 31, ----------------------- 1992 1991 ---- ---- (Thousands of dollars) Deferred compensation $22,682 $(3,044) Depreciation 7,594 4,320 Syndication advance payments 4,118 (771) Alternative minimum tax - (7,821) Litigation accrual (13,324) - Sale of cable system (6,850) - Other, net 848 (1,440) ------- ------ $15,068 $(8,756) ======= ======== II-54 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) There are no significant temporary differences relating to foreign undistributed earnings or investments in foreign subsidiaries for 1993, 1992 or 1991. Thus, no related deferred taxes have been recorded by the Company for these years. Viacom Inc. and its subsidiaries file a consolidated federal income tax return and have done so since the period commencing June 11, 1991, the date on which NAI's percentage of ownership of Viacom Inc. was reduced to less than 80%. Prior to such date, Viacom Inc. and the Company filed a consolidated federal income tax return with NAI, and also participated in a tax-sharing agreement with NAI with respect to federal income taxes. The tax-sharing agreement obligated Viacom Inc. and the Company to make payment to NAI to the extent they would have paid federal income taxes on a separate company basis, and entitled them to receive a payment from NAI to the extent losses and credits reduced NAI's federal income taxes. 8) PENSION PLANS, OTHER POSTRETIREMENT BENEFITS AND POSTEMPLOYMENT BENEFITS The Company and certain of its subsidiaries have non-contributory pension plans covering substantially all employees. The benefits for these plans are based primarily on an employee's years of service and pay near retirement. All employees are vested in the plans after five years of service. The Company's policy for all pension plans is to fund amounts in accordance with the Employee Retirement Income and Security Act of 1974. Plan assets consist principally of common stocks, marketable bonds and United States government securities. Net periodic pension cost for the periods indicated included the following components: Year Ended December 31, ---------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Service cost - benefits earned during the period $5,442 $4,581 $3,919 Interest cost on projected benefit obligation 4,106 3,300 2,761 Return on plan assets: Actual (1,777) (1,421) (4,434) Deferred (gain) loss (1,134) (752) 2,952 Unrecognized prior service cost 480 454 450 -------- ------- ------- Net pension cost $7,117 $6,162 $5,648 ====== ====== ====== II-55 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The funded status of the pension plans for the periods indicated is as follows: Year Ended December 31, ----------------------- 1993 1992 ---- ---- (Thousands of dollars) Actuarial present value of benefit obligations: Accumulated benefit obligation: Vested $34,440 $ 24,095 Non-vested 3,177 1,740 --------- -------- Total $37,617 $ 25,835 ======= ======== Projected benefit obligation $58,845 $ 43,626 Plan assets at fair value 32,649 28,282 --------- -------- Plan assets less than the projected benefit obligation (26,196) (15,344) Unrecognized loss during the year 8,104 476 Unrecognized prior service cost 3,743 4,384 Adjustment to recognize minimum liability (576) (768) --------- -------- Pension liability at year end $(14,925) $(11,252) ========= ======== For purposes of valuing the 1993 and 1992 projected benefit obligation, the discount rate was 7.5% (1993) and 8.25% (1992) and the rate of increase in future compensation was 6% for each of the years. For determining the pension expense for each of the years, the long-term rate of return on plan assets was 9%. In 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting For Postemployment Benefits" ("SFAS 112") which the Company will be required to adopt in 1994. SFAS 112 requires that postemployment benefits be accounted for under the accrual method versus the currently used pay-as-you-go method. The Company is evaluating the impact of SFAS 112 and it is not expected that SFAS 112 will have a significant effect on the Company's consolidated financial position or results of operations. 9) RELATED PARTY TRANSACTIONS The Company, through the normal course of business, is involved in transactions with affiliated companies. The Company sold programming to affiliates amounting to $5.5 million (1993), $3.3 million (1992) and $.9 million (1991) and paid subscriber fees of $6.1 million (1993), $5.4 million (1992) and $2.0 million (1991). In addition, rent and other expenses of $5.8 million, $4.7 million and $4.0 million were charged to affiliated companies during 1993, 1992 and 1991, respectively. Related party accounts receivable and accounts payable were immaterial for each period. The Company received approximately $.9 million (1993) and $1.3 million (1992) under its tax-sharing agreement with NAI and paid approximately $.9 million (1991). II-56 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 10) COMMITMENTS AND CONTINGENCIES The Company has long-term noncancellable lease commitments for office space and equipment, transponders, studio facilities and vehicles. At December 31, 1993, minimum rental payments under noncancellable leases are as follows: Operating Capital Leases Leases ------ ------ (Thousands of dollars) 1994 $ 59,746 $ 9,632 1995 58,946 10,660 1996 56,795 11,689 1997 53,125 12,717 1998 55,373 13,746 1999 and thereafter 390,181 38,764 -------- ------- Total minimum lease payments $674,166 97,208 ======== Less amounts representing interest 34,121 ------- Present value of net minimum payments $63,087 ======= Future minimum capital lease payments and operating lease payments have not been reduced by future minimum sublease rentals of $26.0 million and $.5 million, respectively. Rent expense amounted to $74.2 million (1993), $67.9 million (1992) and $64.6 million (1991). Capital leases represent the financing of transponders of $67.0 million (1993) and $26.2 million (1992), net of accumulated amortization of $7.8 million (1993) and $3.0 million (1992). The commitments of the Company for program license fees which are not reflected in the balance sheet as of December 31, 1993, which are estimated to aggregate approximately $1.9 billion, principally reflect commitments under SNI's exclusive arrangements with several motion picture companies. This estimate is based upon a number of factors. A majority of such fees are payable within the next seven years, as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. During July 1991, the Company received reassessments from 10 California counties of its Cable Division's real and personal property, related to the June 1987 acquisition by NAI, which could result in substantially higher California property tax liabilities. The Company is appealing the reassessments and believes that the reassessments as issued are unreasonable and unsupportable under California law. The Company believes that the final resolution of this matter will not have a material effect on its consolidated financial position or results of operations. There are various lawsuits and claims pending against the Company. Management believes that any ultimate liability resulting from those actions or claims will not have a material adverse effect on the Company's financial position or results of operations (See Note 14). II-57 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 11) FOREIGN OPERATIONS The consolidated financial statements include the following amounts applicable to foreign subsidiaries: Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Revenues $ 122,200 $68,193 $31,786 Earnings before income taxes $ 34,012 $17,364 $10,963 Net earnings $ 33,747 $16,384 $ 9,294 Current assets $ 54,190 $47,769 $38,452 Total assets $ 115,744 $73,817 $40,422 Total liabilities $ 68,728 $57,441 $30,897 Total export revenues were $25.2 million (1993), $34.9 million (1992) and $26.7 million (1991). Foreign currency transaction gains and losses were immaterial in each period presented. II-58 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 12) BUSINESS SEGMENTS Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Revenues: Networks $1,221,200 $1,058,831 $ 922,157 Entertainment 209,110 248,335 273,488 Cable Television 415,953 411,087 378,026 Broadcasting 181,778 168,847 159,182 Intercompany elimination (23,092) (22,417) (21,291) ---------- ---------- ---------- Total revenues $2,004,949 $1,864,683 $1,711,562 ========== ========== ========== Earnings from operations: Networks $ 272,087 $ 205,576 $ 172,296 Entertainment 32,480 59,662 73,214 Cable Television 110,176 122,037 103,954 Broadcasting 42,293 31,956 27,734 Corporate (72,041) (71,304) (64,964) ---------- ---------- ---------- Total earnings from operations $ 384,995 $ 347,927 $ 312,234 ========== ========== ========== Depreciation and amortization: Networks $ 44,747 $ 41,754 $ 30,123 Entertainment 9,549 6,792 7,160 Cable Television 71,520 68,505 66,604 Broadcasting 23,475 24,509 27,062 Corporate 3,766 3,242 1,915 ---------- ---------- ---------- Total depreciation and amortization $ 153,057 $ 144,802 $ 132,864 ========== ========== ========== Identifiable assets at year end: Networks $1,794,418 $1,604,504 $1,453,643 Entertainment 845,620 829,607 855,357 Cable Television 963,047 972,066 979,668 Broadcasting 744,208 722,023 742,650 Corporate 2,069,575 188,894 157,060 ---------- ---------- ---------- Total identifiable assets at year end $6,416,868 $4,317,094 $4,188,378 ========== ========== ========== Capital expenditures: Networks $ 35,786 $ 26,076 $ 6,170 Entertainment 4,933 7,102 916 Cable Television 79,482 54,596 44,967 Broadcasting 4,886 5,102 3,101 Corporate 9,924 17,346 2,275 ---------- ---------- ---------- Total capital expenditures $ 135,011 $ 110,222 $ 57,429 ========== ========== ========== II-59 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 13) QUARTERLY FINANCIAL DATA (unaudited): Summarized quarterly financial data for 1993 and 1992 appears below: First Second Third Fourth Quarter Quarter Quarter Quarter Total Year ------- ------- ------- ------- ---------- (Thousands of dollars, except per share amounts) - ---- Revenues $470,650 $495,799 $508,122 $530,378 $2,004,949 Earnings from operations $ 90,182 $106,562 $110,153 $ 78,098 $ 384,995 Earnings before extraordinary losses and cumulative effect of changes in accounting principle (1) $ 70,626 $ 41,628 $ 30,901 $ 26,326 $ 169,481 Net earnings $ 80,964 $ 41,628 $ 22,034 $ 26,326 $ 170,952 Net earnings attributable to common stock (2) $ 80,964 $ 41,628 $ 22,034 $ 13,576 $ 158,202 Net earnings per common share: Earnings before extraordinary losses and cumulative effect of changes in accounting principle $ .59 $ .35 $ .25 $ .11 $ 1.30 Net earnings $ .67 $ .35 $ .18 $ .11 $ 1.31 Average number of common shares 120,479 120,517 120,645 120,782 120,607 - ---- Revenues $430,568 $451,053 $471,498 $511,564 $1,864,683 Earnings from operations (3) $ 83,399 $ 96,873 $100,010 $ 67,645 $ 347,927 Earnings (loss) before extraordinary losses (4) $ 10,527 $ (1,145) $ 45,049 $ 11,654 $ 66,085 Net earnings (loss) $ 7,088 $(14,826) $ 45,049 $ 11,654 $ 48,965 Net earnings (loss) per common share: Earnings (loss) before extraordinary losses $ .09 $ (.01) $ .37 $ .10 $ .55 Net earnings (loss) $ .06 $ (.12) $ .37 $ .10 $ .41 Average number of common shares 120,228 120,229 120,230 120,250 120,235 (1) The first quarter of 1993 reflects a pre-tax gain of $55 million related to the sale of the stock of Viacom Cablevision of Wisconsin Inc. (See Note 14). (2) The fourth quarter of 1993 reflects Preferred Stock dividends of $12.8 million (See Note 6). (3) The third quarter of 1992 reflects a reversal of compensation expense associated with the Long-Term Incentive Plans. The fourth quarter of 1992 reflects a significant expense associated with the Long-Term Incentive Plans. The fluctuations in compensation expense associated with the Long- Term Incentive Plans for the third and fourth quarter of 1992 resulted primarily from the fluctuations in market value of Viacom Inc.'s Common Stock (See Note 6). (4) The second quarter of 1992 reflects the reserve for litigation of $33 million related to a summary judgment against the Company in a dispute with CBS Inc. The third quarter of 1992 reflects a gain of $35 million related to certain aspects of the settlement of the Time Warner antitrust lawsuit (See Note 14). II-60 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 14) OTHER ITEMS, NET As part of the settlement of the Time Warner antitrust lawsuit, the Company sold all the stock of Viacom Cablevision of Wisconsin, Inc. to Warner Communications Inc. ("Warner"). This transaction was effective on January 1, 1993. As consideration for the stock, Warner paid the sum of $46 million plus repayment of debt under the Credit Agreement in the amount of $49 million, resulting in a pre-tax gain of approximately $55 million reflected in "Other items, net." Also reflected in this line item is the net gain on the sale of a portion of an investment held at cost and adjustments to previously established non-operating litigation reserves, and other items. "Other items, net" reflects a gain of $35 million recorded in the third quarter of 1992; this gain represents payments received in the third quarter relating to certain aspects of the settlement of the Time Warner antitrust lawsuit, net of the Company's 1992 legal expenses related to this lawsuit. "Other items, net" also reflects a reserve for litigation of $33 million during the second quarter of 1992 related to a summary judgment against Viacom in a dispute with CBS Inc. arising under the 1970 agreement associated with the spin-off of Viacom International Inc. by CBS Inc. On July 30, 1993, the Company settled all disputes arising under the above litigation. In September 1991, the Company recorded a reserve for its investment in a start-up joint venture. On August 16, 1991, the Company sold 129,837 shares of Turner Broadcasting System, Inc. Class B Common Stock for approximately $1.9 million. These transactions resulted in a pre-tax loss of approximately $6.5 million, which is reflected in "Other items, net." II-61 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 15) SUPPLEMENTAL CASH FLOW INFORMATION Year Ended December 31, ------------------------ 1993 1992 1991 ---- ----- ---- (Thousands of dollars) Cash payments for interest net of $167,383 $194,879 $233,904 amounts capitalized Cash payments for income taxes 32,675 50,738 24,539 Cash received for income taxes 1,074 1,470 3,301 Supplemental schedule of non-cash financing and investing activities: B Common stock issued as satisfaction for LTIP liability -- 6,894 -- Equipment acquired under capitalized leases 44,381 26,192 -- B Common Stock issued to acquire the remaining 50.01% interest in MTV EUROPE -- -- 65,000 II-62 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. II-63 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES The following consolidated financial statements and schedules of the registrant and its subsidiaries are submitted herewith as part of this report: Reference (Page/s) -------- 1. Report of Independent Accountants.................. II-32 2. Management's Statement of Responsibility for Financial Reporting................................ II-33 3. Consolidated Statements of Operations for the years ended December 31, 1993, 1992, and 1991........... II-34 4. Consolidated Balance Sheets as of December 31, 1993 and 1992........................................... II-35-II-36 5. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991........... II-37 6. Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991... II-38 7. Notes to Consolidated Financial Statements......... II-39-II-62 Report of Independent Accountants on Financial Statement Schedules................................... Financial Statement Schedules: II. Amounts receivable from related parties. VIII. Valuation and qualifying accounts.......... IX. Short-term borrowings...................... X. Supplementary statement of operations information................................ All other Schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Boards of Directors and Shareholders of Viacom Inc. and Viacom International Inc. Our audits of the consolidated financial statements referred to in our report dated February 4, 1994, except as to Note 2, which is as of March 11, 1994, appearing on page II-32 of this annual report on Form 10-K also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE 1177 Avenue of the Americas New York, New York 10036 February 4, 1994 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION (Thousands of Dollars) Col. A Col. B ------ ----------------------------- Charged to Costs and Expenses ----------------------------- Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- ITEM Maintenance and repairs $21,104 $25,649 $20,145 Advertising costs $79,827 $51,124 $68,858 Amortization $60,278 $63,256 $62,795 Taxes, other than payroll and $30,362 $21,000 $19,805 income taxes NOTE: ---- Items not presented above are less than 1% of revenues or are presented elsewhere in the consolidated financial statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Information Concerning Directors and Nominees" is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained in the Viacom Inc. Definitive Proxy Statement under the captions "Directors' Compensation" and "Executive Compensation" is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Related Transactions" is incorporated herein by reference. III - 1 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) and (d) Financial Statements and Schedules (see Index on Page) (b) Reports on Form 8-K Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of October 5, 1993 relating to the agreement dated as of October 4, 1993 between Viacom Inc. and NYNEX Corporation ("NYNEX") pursuant to which NYNEX subscribed for and agreed to purchase from Viacom Inc. 24 million shares of newly issued Series B Cumulative Convertible Preferred Stock of Viacom Inc. for an aggregate purchase price of $1.2 billion. Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of October 27, 1993 relating to the completion of the issuance and sale to Blockbuster Entertainment Corporation ("Blockbuster") by Viacom Inc. of 24 million shares of new issued Series A Cumulative Convertible Preferred Stock and the election of H. Wayne Huizenga, Chairman and Chief Executive Officer of Blockbuster, as a director of Viacom Inc. and Viacom International Inc. Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of November 19, 1993 relating to the completion of the issuance and sale to NYNEX Corporation ("NYNEX") of 24 million shares of newly issued Series B Cumulative Convertible Preferred Stock for an aggregate purchase price of $1.2 billion and the election of William C. Ferguson, Chairman and Chief Executive Officer of NYNEX, as a director of Viacom Inc. and Viacom International Inc. (c) Exhibits (see index on Page E-1) IV-1 SIGNATURES Pursuant to the requirements of Section 13 or 15(D) of the Securities Exchange Act of 1934, Viacom International Inc. has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. VIACOM INTERNATIONAL INC. By /s/Frank J. Biondi, Jr. --------------------------------- Frank J. Biondi, Jr., President, Chief Executive Officer By /s/George S. Smith, Jr. --------------------------------- George S. Smith, Jr., Senior Vice President, Chief Financial Officer By /s/Kevin C. Lavan --------------------------------- Kevin C. Lavan, Vice President, Controller, Chief Accounting Officer Date: March 31, 1994 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of Viacom Inc. and in the capacities and on the dates indicated: By * March 31, 1994 -------------------------------- George S. Abrams, Director By /s/Frank J. Biondi, Jr. March 31, 1994 -------------------------------- Frank J. Biondi, Jr., Director By /s/Philippe P. Dauman March 31, 1994 -------------------------------- Philippe P. Dauman, Director By * March 31, 1994 -------------------------------- William C. Ferguson, Director By * March 31, 1994 -------------------------------- H. Wayne Huizenga, Director By * March 31, 1994 -------------------------------- Ken Miller, Director By * March 31, 1994 -------------------------------- Brent D. Redstone, Director By * March 31, 1994 -------------------------------- Sumner M. Redstone, Director By * March 31, 1994 -------------------------------- Frederic V. Salerno, Director By * March 31, 1994 -------------------------------- William Schwartz, Director * By /s/Philippe P. Dauman March 31, 1994 -------------------------------- Philippe P. Dauman Attorney-in-Fact for the Directors VIACOM INC. AND SUBSIDIARIES INDEX TO EXHIBITS ITEM 14(C) EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (2) Plan of Acquisition (a) Certificate of Ownership and Merger of Viacom International Inc. into Arsenal Holdings II, Inc. as filed with the Office of Secretary of State of Delaware and effective on April 26, 1990 (incorporated by reference to Exhibit 2(1) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (b) Certificate and Agreement of Merger of Viacom International Inc. into Arsenal Holdings II, Inc. filed with the Office of the Secretary of State of Ohio and effective April 26, 1990 (incorporated by reference to Exhibit 2(2) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (c) Agreement and Plan of Merger dated as of January 7, 1994 between Viacom Inc. and Blockbuster Entertainment Corporation (incorporated by reference to Exhibit 99(c)(9) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 20) dated January 7, 1994). (d) Voting Agreement dated as of January 7, 1994 between National Amusements, Inc. and Blockbuster Entertainment Corporation (filed herewith). (e) Amended and Restated Stockholders Stock Option Agreement dated as of January 7, 1994 among Viacom Inc. and each person listed on the signature pages thereto (filed herewith). (f) Amended and Restated Proxy Agreement dated as of January 7, 1994 among Viacom Inc. and each person listed on the signature pages thereto (filed herewith). (g) Voting Agreement dated as of January 21, 1994 between National Amusements, Inc. and Paramount Communications Inc. (incorporated by reference to Exhibit 99(a)(66) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 29) dated January 24, 1994). (h) Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 between Viacom Inc. and Paramount Communications Inc. (incorporated by reference to Exhibit 99(a)(92) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 38) dated February 7, 1994). E-1 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (3) Articles of Incorporation and By-laws (a) Restated Certificate of Incorporation of Viacom Inc. (incorporated by reference to Exhibit 3(a) to the Annual Reports on Form 10- K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554). (b) Certificate of the Designations, Powers, Preferences and Relative, Participating or other Rights, and the Qualifications, Limitations or Restrictions thereof, of Series A Cumulative Convertible Preferred Stock ($0.01 par value) of Viacom Inc. (incorporated by reference to Exhibit 4.1 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended September 30, 1993) (File Nos. 1-9553/1-9554). (c) Certificate of the Designations, Powers, Preferences and Relative, Participating or other Rights, and the Qualifications, Limitations or Restrictions thereof, of Series B Cumulative Convertible Preferred Stock ($0.01 par value) of Viacom Inc. (filed herewith). (d) By-laws of Viacom Inc. (incorporated by reference to Exhibit 3.3 to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33-13812). (e) Certificate of Incorporation of Viacom International Inc. (formerly Arsenal Holdings II, Inc.) (incorporated by reference to Exhibit 3(e) to the Annual Reports on Form 10- K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990, as amended on Form 8, dated June 3, 1991) (File Nos. 1-9553/1-9554). (f) By-laws of Viacom International Inc. (formerly Arsenal Holdings II, Inc.) (incorporated by reference to Exhibit 3(f) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990, as amended on Form 8, dated June 3, 1991) (File Nos. 1-9553/1-9554). E-2 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (4) Instruments defining the rights of security holders, including indentures: (a) Specimen certificate representing the Viacom Inc. Voting Common Stock (currently Class A Common Stock) (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33- 13812). (b) Specimen certificate representing Viacom Inc. Class B Non-Voting Common Stock (incorporated by reference to Exhibit 4(a) to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1990) (File Nos. 1-9553/1-9554). (c) Specimen certificate representing Viacom Inc. Series A Cumulative Convertible Preferred Stock of Viacom Inc. (filed herewith). (d) Specimen certificate representing Viacom Inc. Series B Cumulative Convertible Preferred Stock of Viacom Inc. (filed herewith). (e) Indenture, dated as of September 15, 1991, among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s Guarantied Senior Subordinated Debt Securities (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1-9553/1-9554) as supplemented by the First Supplemental Indenture dated as of September 15, 1991 among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s 10.25% Senior Subordinated Notes due September 15, 2001 (incorporated by reference to Exhibit 4.2 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1-9553/1-9554) as further supplemented by the Second Supplemental Indenture dated as of March 4, 1992 among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s 9.125% Senior Subordinated Notes due August 15, 1999 and relating to Viacom International Inc.'s 8.75% Senior Subordinated Reset Notes due May 15, 2001 (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of March 4, 1992) (File Nos. 1-9553/1-9554). (f) Specimen of Note evidencing the 10.25% Senior Subordinated Notes due September 15, 2001 (incorporated by reference to Exhibit 4.3 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1- 9553/1-9554). (g) Specimen of Note evidencing the 9.125% Senior Subordinated Notes due August 15, 1999 (incorporated by reference to Exhibit 4.2 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of March 4, 1992) (File Nos. 1-9553/1- 9554). E-3 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (h) Specimen of Note evidencing the 8.75% Senior Subordinated Reset Notes due May 15, 2001 (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of May 28, 1992) (File Nos. 1-9553/1- 9554). (i) Indenture, dated as of July 15, 1988, between Viacom International Inc. and Bankers Trust Company, Trustee, relating to Viacom International Inc.'s 11.80% Senior Subordinated Notes due 1998 (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-2 filed by Viacom International Inc.) (File No. 33-21280) and the First Supplement to Indenture dated April 27, 1990 between Viacom International Inc. and Bankers Trust Company, as Trustee (incorporated by reference to Exhibit 4(2) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (j) Form of Note evidencing the 11.80% Senior Subordinated Notes due 1998 (incorporated by reference to Exhibit A to the Indenture filed as Exhibit 4.1 to the Registration Statement on Form S-2 filed by Viacom International Inc.) (File No. 33-21280). (k) Indenture, dated as of June 15, 1986, between Viacom International Inc. and Morgan Guaranty Trust Company of New York, Trustee, relating to Viacom International Inc.'s 5 3/4% Convertible Subordinated Debentures Due 2001 (incorporated by reference to Exhibit 4.5(b) to the Annual Report on Form 10-K of Viacom International Inc. for the fiscal year ended December 31, 1986) (File No. 1-6514), and the First Supplement to Indenture, dated June 9, 1987, among Viacom International Inc., Viacom Inc. and Morgan Guaranty Trust Company of New York, Trustee (incorporated by reference to Exhibit 4.5(b) to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33-13812). (l) Credit Agreement, dated as of September 26, 1989 (the "Credit Agreement"), among Viacom International Inc., the banks listed therein (the "Banks"), and Citibank, N.A. as Agent and The Bank of New York as Co-Agent, as amended and restated as of January 17, 1992 among Viacom Inc., as Guarantor, Viacom International Inc., the Subsidiary Obligors, the Banks, Citibank, N.A. as Agent, and The Bank of New York as Co-Agent (incorporated by reference to Exhibits 10(1) and 10(2) to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of January 22, 1992) as amended by Letter Agreements dated as of May 13, 1993 and April 7, 1993 (incorporated by reference to Exhibits 4.1 and 4.2 to the Current Reports on Form 10- Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993) (File Nos. 1-9553/1-9554) (m) Loan Facility Agreement dated as of June 2, 1993 among the Company and the banks named therein and The Bank of New York as Administrative Managing Agent, and The Bank of New York and Citibank as Managing Agents (incorporated by reference to Exhibit 10.1 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1- 9553/1-9554). E-4 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (n) Credit Agreement dated as of November 19, 1993, as amended as of January 4, 1994 and as further amended as of February 15, 1994, among Viacom Inc., the Banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agents (incorporated by reference to Exhibit 99(a)(11) to Viacom Inc. Schedule 14D- 1 Tender Offer Statement (Amendment No. 46) dated March 3, 1994). (10) Material Contracts (a) Viacom Inc. 1989 Long-Term Management Incentive Plan (as amended and restated through April 23, 1990) (incorporated by reference to Exhibit A to Viacom Inc.'s Definitive Proxy Statement dated April 27, 1990).* (b) Viacom Inc. Long-Term Incentive Plan (incorporated by reference to Exhibit A to Viacom Inc.'s Definitive Proxy Statement dated April 29, 1988), and amendment thereto (incorporated by reference to Exhibit 10(d) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 21, 1991) (File Nos. 1- 9553/1-9554), and as further amended by amendment dated December 17, 1992 (incorporated by reference to Exhibit 10(d) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (c) Viacom Inc. Long-Term Incentive Plan (Divisional) (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554).* (d) Viacom International Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated through December 17, 1992) (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (e) Viacom Inc. and Viacom International Inc. Retirement Income Plan for Non-Employee Directors (incorporated by reference to Exhibit 10(f) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1989) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-5 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ------------------------------------------------------------------- (f) Viacom Inc. Stock Option Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554).* (g) Excess Benefits Investment Plan for Certain Key Employees of Viacom International Inc. (effective April 1, 1984 and amended as of January 1, 1990) (incorporated by reference to Exhibit 10(h) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (h) Excess Pension Plan for Certain Key Employees of Viacom International Inc. (incorporated by reference to Exhibit 10(i) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (i) Employment Agreement, dated as of August 1, 1987, between Viacom International Inc. and Frank J. Biondi, Jr. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (File No. 1-9553/1-9554). Guarantee Agreement, dated as of August 1, 1987, from Viacom Inc. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (Files Nos. 1-9553/1-9554). Agreement under the Viacom Inc. Long-Term Incentive Plan, dated March 7, 1989, between Viacom Inc. and Frank J. Biondi, Jr. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (File Nos. 1- 9553/1-9554).* (j) Agreement, dated as of January 1, 1990, between Viacom International Inc. and Neil S. Braun (incorporated by reference to Exhibit 10(l) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(k) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (k) Amended and Restated Employment Agreement, dated as of October 1, 1987, between Viacom International Inc. and John W. Goddard (incorporated by reference to Exhibit 10(l) to the Annual Reprints on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1991) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-6 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (l) Agreement, dated as of August 1, 1990, between Viacom International Inc. and George S. Smith, Jr. (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (m) Agreement, dated as of August 1, 1990, between Viacom International Inc. and Mark M. Weinstein (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of February 1, 1993 (incorporated by reference to Exhibit 10(n) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (n) Agreement, dated as of August 1, 1992, between Viacom International Inc. and Thomas E. Dooley (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1- 9554).* (o) Agreement, dated as of January 1, 1992, between Viacom International Inc. and Edward Horowitz (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (p) Agreement dated as of February 1, 1993 between Viacom International Inc. and Philippe P. Dauman (incorporated by reference to Exhibit 10(q) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-7 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (q) Partnership Agreement between Viacom HA! Holding Company and The Comedy Channel Corp. dated as of December 17, 1990 (incorporated by reference to Exhibit 10.2 to the Registration Statement on Form S-3 filed by Viacom International Inc.) (File No. 33-40170). (r) Lease Agreement between First Security Bank of Utah, N.A., as owner trustee and Viacom International Inc. dated as of August 12, 1992 (incorporated by reference to Exhibit 10(t) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554). (s) Lease Agreement dated as of June 22, 1993 between Mellon Financial Services Corporation and Viacom International Inc. (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554). (t) Stock Purchase Agreement dated as of October 4, 1993 between Viacom Inc. and NYNEX Corporation, as amended as of November 19, 1993 (filed herewith). (u) Amended and Restated Stock Purchase Agreement dated October 21, 1993 between Viacom Inc. and Blockbuster Entertainment Corporation (filed herewith). (v) Subscription Agreement, dated January 7, 1994 between Viacom Inc. and Blockbuster Entertainment Corporation (incorporated by reference to Exhibit 99(c)(8) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 20) dated January 7, 1994). (12) Statements re Computation of Ratios (a) Computation of Ratio of Earnings to Fixed Changes of Viacom International Inc. (filed herewith). (b) Computation of Ratio of Earnings to Fixed of Viacom Inc. (filed herewith). (21) Subsidiaries of Viacom Inc. and Viacom International Inc. (filed herewith). (23) Consents of Experts and Counsel (a) Consent of Price Waterhouse (filed herewith). (b) Consent of Ernst & Young (filed herewith). (24) Powers of Attorney (filed herewith). (99) Additional Exhibits (a) Item 1, Item 2 and Item 3 of Paramount's Transition Report on Form 10-K for the six- month period ended April 30, 1993, as such report was amended in its entirety by Form 10-K/A No. 1 dated September 28, 1993, as further amended by Form 10-K/A No. 2 dated September 30, 1993 and as further amended by Form 10-K/A No. 3 dated March 21, 1994 (filed herewith). (b) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended July 31, 1993 (filed herewith). (c) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended October 31, 1993 (filed herewith). (d) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended January 31, 1994 (filed herewith). E-8	49,163	324,280
82267_1993.txt	82267_1993	1993	82267	ITEM 1. BUSINESS GENERAL Raytheon is a diversified, international, multi-industry, technology- based company. Its principal business is the design, manufacture and sale of electronic devices, equipment and systems for government and commercial use. Through a diversification program begun in 1964, Raytheon has expanded into aircraft products, energy and environmental services, major appliances and textbook publishing. In recent years, the Company's strategy has been to strengthen its commercial businesses through consolidation, operational improvement and acquisitions and to diversify core defense technologies into commercial markets while remaining a strong defense company. Sales to the United States Government (the "Government"), principally to the Department of Defense, were $4.501 billion in 1993 and $4.666 billion in 1992 representing 48.9% of total sales in 1993 and 51.5% in 1992. Of these sales, $779 million in 1993 and $579 million in 1992 represented purchases made by the Government on behalf of foreign governments. Raytheon's businesses are organized into four segments: Electronics, Aircraft Products, Energy and Environmental and Major Appliances. ELECTRONICS SEGMENT The Electronics segment consists of several business units that work primarily on government contracts: Missile Systems Division, Equipment Division, Electromagnetic Systems Division, Research Division and the Advanced Device Center. The principal contributor to electronic sales and earnings in recent years has been and continues to be sales to the United States and foreign governments of air defense missile systems, subsystems and components. The Patriot Air Defense System, the Company's largest program, had sales of $1.248 billion, $1.209 billion and $1.265 billion, in 1993, 1992 and 1991, respectively. Other products and services sold directly or indirectly to the Government include: ship and land based radar systems for surveillance, target identification, tracking, fire control, navigation, air traffic control and weather observation; sonar systems; communications systems; electronic countermeasures systems and electronic components (see Backlog Discussion, p. 6). Some of the Government's procurement is for non- military use such as air traffic control and weather observation. Raytheon acts as a prime contractor or major subcontractor for many different Government programs including those that involve the development and production of new or improved weapons or other types of electronics systems or major components of such systems. Over its lifetime, a program may be implemented by the award of many different individual contracts and subcontracts. The funding of Government programs is usually subject to congressional appropriations. Although multi-year contracts may be authorized in connection with major procurements, Congress generally appropriates funds on a fiscal year basis even though a program may continue for many years. Consequently, programs are often only partially funded initially, and additional funds are committed only as Congress makes further appropriations. The Government is required to adjust equitably a contract price for additions or reductions in scope or other changes ordered by it. Generally, Government contracts have provisions for audit, price redetermination and other profit and cost controls and limitations and may be terminated, in whole or in part, without prior notice at the Government's convenience upon the payment of compensation only for work done and commitments made at the time of termination. In the event of termination, the contractor may also receive some allowance for profit on the work performed. The right to terminate for convenience has not had any significant effect upon Raytheon's business in light of its total Government business. Raytheon's Government business is performed under both cost reimbursement and fixed price prime contracts and subcontracts. Cost reimbursement contracts provide for the reimbursement of allowable costs plus the payment of a fee. These contracts fall into two basic types: (i) cost plus fixed fee contracts which provide for the payment of a fixed fee irrespective of the final cost of performance, and (ii) cost plus incentive fee contracts which provide for increases or decreases in the fee, within specified limits, based upon actual results as compared to contractual targets relating to such factors as cost, performance and delivery schedule. Under cost reimbursement type contracts, Raytheon is reimbursed periodically for allowable costs and is paid a portion of the fee based on contract progress. Some costs incident to performing contracts have been made partially or wholly unallowable by statute or regulation. Examples are charitable contributions, travel costs in excess of government rates and certain litigation defense costs. Raytheon's fixed price contracts are either firm fixed price contracts or fixed price incentive contracts. Under firm fixed price contracts, Raytheon agrees to perform the contract for a fixed price and as a result benefits from cost savings and carries the burden of cost overruns. Under fixed price incentive contracts, Raytheon shares with the Government savings accrued from contracts performed for less than target costs and costs incurred in excess of targets up to a negotiated ceiling price (which is higher than the target cost) and carries the entire burden of costs exceeding the negotiated ceiling price. Under such incentive contracts, Raytheon's profit may also be adjusted up or down depending upon whether specified performance objectives are met. Under firm fixed price and fixed price incentive type contracts, Raytheon usually receives progress payments monthly from the Government generally in amounts equalling 85% of costs incurred under the contract. For contracts and modifications issued after November 11, 1993, progress payments may not exceed 75% of incurred costs. This rate may be adjusted from time to time on the basis of the Short Term Commercial Borrowing Rate published by the Federal Reserve. The remaining amount, including profits or incentive fees, is billed upon delivery and final acceptance of end items under the contract. Raytheon's Government business is subject to specific procurement regulations and a variety of socio-economic and other requirements. Failure to comply with such regulations and requirements could lead to suspension or debarment, for cause, from Government contracting or subcontracting for a period of time. Among the causes for debarment are violations of various statutes, including those related to employment practices, the protection of the environment, the accuracy of records and the recording of costs. Raytheon has not, at any time, been debarred or suspended. Under many Government contracts, Raytheon is required to maintain facility and personnel security clearances complying with Department of Defense ("DOD") requirements. Companies such as Raytheon, which are engaged in supplying defense- related equipment to the Government, are subject to certain business risks peculiar to that industry. Among these are: the cost of obtaining trained and skilled employees; the uncertainty and instability of prices for raw materials and supplies; the problems associated with advanced designs, which may result in unforeseen technological difficulties and cost overruns; and the intense competition and the constant necessity for improvement in facilities and personnel training. Sales to the Government may be affected by changes in procurement policies, budget considerations, changing concepts of national defense, political developments abroad and other factors. As a result of the 1985 Balanced Budget and Emergency Deficit Reduction Control Act, the federal deficit and changing world order conditions, DOD budgets have been subject to increasing pressure resulting in an uncertainty as to the future effects of DOD budget cuts. Raytheon has, nonetheless, maintained a solid foundation of tactical defense systems which meet the needs of the United States and its allies, as well as serving a broad government program base and wide range of commercial electronics businesses. These factors lead management to believe that there is high probability of continuation of Raytheon's current major tactical defense programs. During the first quarter of 1994 the Company's Board of Directors approved a company-wide restructuring plan designed to help maintain the Company's competitive position in a shrinking defense market and improve productivity in its commercial businesses. The plan will be implemented over a two-year period and will result in a one-time, pre-tax charge of $250 million ($162 million after tax). The major elements of the plan include the costs of employee separations and relocations, facility consolidations and facility and equipment disposals. The Electronics segment's commercial group consists of Raytheon Marine Company, Seiscor Technologies, the Semiconductor Division, Switchcraft, Inc., BSG-Schalttechnik GmbH & Company and REMCO, S.A. In addition, D.C.Heath and Company is part of the group. Electronic products sold to commercial customers include: marine collision avoidance systems; marine radiotelephones, radars, autopilots and "Fathometer " depth sounders; and components such as semiconductor devices, transistors, diodes, integrated circuits, electronic controls for automobiles and appliances, switches, jacks and plugs. Some electronic products are manufactured and assembled for Raytheon outside of the United States. Raytheon's D.C. Heath and Company division publishes school and college textbooks and educational software. AIRCRAFT PRODUCTS SEGMENT Raytheon's Aircraft Products segment consists of Raytheon Corporate Jets, Inc. and Beech Aircraft Corporation. Raytheon Corporate Jets was formed in 1993 to acquire the assets of the Corporate Jets business of British Aerospace plc, and Beech was acquired in 1980. Raytheon Corporate Jets designs, manufactures, services and supports the "Hawker(TM)" 800 and "Hawker(TM)" 1000 medium-sized business jets, which are sold in domestic and international markets. More than 850 Hawker aircraft of various models have been sold throughout the world since the product line was introduced in 1960 as the de Havilland 125. Beech, founded in 1932, designs, manufactures, services and supports piston-powered, jetprop and light jet aircraft for the world's business, military and regional airline markets. The single engine piston-powered Beechcraft Bonanza introduced in 1947 enjoys the distinction of the longest continuous production of any aircraft in history. Beech also produces the twin-engine piston-powered Baron, several models of turbine- powered aircraft in the Starship and King Air jetprop product lines, and the Beechjet light business jet and its military counterpart, the T-1A Jayhawk Trainer sold to the United States Air Force. The Beech 1900D is a stand-up cabin 19-passenger aircraft sold to commuter airlines and corporate customers. Beech also produces two missile target drones for the United States and its allied forces. Beech operates fixed base operations at airports throughout the United States and supports military aircraft throughout the world. ENERGY AND ENVIRONMENTAL SEGMENT The Energy and Environmental segment is comprised of operating subsidiaries of Raytheon Engineers & Constructors International, Inc., including Raytheon Engineers & Constructors, Inc., Raytheon Service Company and Cedarapids, Inc. Raytheon Engineers & Constructors -- formed in 1993 to consolidate the operations of United Engineers & Constructors and The Badger Company -- designs, constructs and maintains petroleum, petrochemical, chemical processing, cogeneration facilities, electrical generating and industrial plants, and infrastructure projects. The former Badger operations, both domestically and through subsidiaries in The Netherlands and elsewhere, specialize in the engineering, design and construction of petroleum refining, lube oil, petrochemical, fertilizer, chemical, plastics, synthetic fuels and environmental treatment plants. Customers include many of the world's largest petroleum, petrochemical and chemical companies. The former United Engineers operations, domestically and internationally, are engaged in the design, construction and maintenance of electricity generating fossil fuel and nuclear plants, electrical substations, metals manufacturing and processing plants and other types of heavy industrial plants. In addition, Raytheon Engineers & Constructors provides engineering services relating to facility and site planning, environmental assessment and design studies. It also designs and constructs specialty process, pharmaceutical and biotechnology plants. Customers include a number of major utility companies, industrial concerns and the Department of Energy. Raytheon Engineers & Constructors undertakes some engineering and construction projects on a firm fixed price basis ("lump sum turnkey"), and as a result benefits from cost savings and carries the burden of cost overruns. During 1993 Raytheon Engineers & Constructors acquired selected assets of Gibbs & Hill, Harbert Construction Company and Ebasco Services, Inc., providing additional resources in power, infrastructure, construction and quality assurance. Cedarapids, Inc. designs and manufactures a wide range of stationary and portable aggregate producing equipment, asphalt paving equipment, mixing plants and soil remediation systems. Raytheon Service Company offers worldwide engineering, construction, installation, operation, maintenance, environmental and training services and supports and maintains other complex military and industrial systems. MAJOR APPLIANCES SEGMENT The Major Appliances segment, which consists of Amana Refrigeration, Inc. and Speed Queen Company, manufactures and sells household and commercial appliances under the Amana, Speed Queen, Caloric, Modern Maid, Sunray and Menumaster brand names. Products include refrigerators, freezers, microwave ovens, gas and electric ranges, washing machines, dryers, and other laundry products as well as other central heating and air conditioning products and home appliances. These products are sold to dealers, distributors and home builders for resale to the customer or for incorporation into new homes and apartments. Financial information about Operations by Business Segments and Operations by Geographic Areas is contained on page 41 of Raytheon's 1993 Annual Report to Stockholders and is incorporated herein by reference. BACKLOG Raytheon's backlog of orders at December 31, 1993 was $7.756 billion compared with $7.273 billion at the end of 1992. The 1993 amount includes funded backlog of $4.519 billion from the Government compared with $5.311 billion at the end of 1992. Normally, the Government funds its major programs only to the dollar level appropriated annually by Congress, even though the total estimated program values are considerably greater. Accordingly, Raytheon's Government funded backlog represents only that amount which has been appropriated and against which Raytheon can be reimbursed for work performed. Approximately $996 million of the overall backlog figure represents the unperformed portion of multi-year direct orders from foreign governments, principally for air defense systems or components thereof and related services. Approximately $713 million of the overall backlog represents non-government foreign backlog, $604 million of which relates to Raytheon Engineers and Constructors' Rayong refinery project. Aircraft Products backlog was to $1.082 billion at the end of 1993 versus $1.028 billion at the end of 1992. Backlog in the Energy and Environmental segment was $1.824 billion at the end of 1993 compared with $906 million at the end of 1992. The increase was due primarily to the Ebasco acquisition. Design and construction contracts in this segment typically take from eighteen months to several years to perform. Approximately $2.292 billion of the $7.756 billion 1993 year-end backlog is not expected to be filled during the following twelve months. RESEARCH AND DEVELOPMENT During 1993, Raytheon derived net sales of $686.2 million ($672.6 million in 1992 and $586.2 million in 1991) pursuant to Government contracts for research and development. In addition, during 1993 Raytheon expended $279.4 million on research and development efforts compared with $289.9 million in 1992 and $278.5 million in 1991. These expenditures principally have been for product development for the Government and for aircraft products. Approximately 10,100 employees (10,400 for 1992), of whom 4,600 (4,800 for 1992) hold engineering or scientific degrees, were actively engaged in research and development at the end of 1993. SUPPLIERS Delivery of raw materials and supplies to Raytheon is generally satisfactory. Raytheon is sometimes dependent, for a variety of reasons, upon sole-source suppliers for procurement requirements. However, Raytheon has experienced no significant difficulties in meeting production and delivery obligations because of delays in delivery or reliance on such suppliers. COMPETITION The military and commercial industries in which Raytheon operates are highly competitive in both military and commercial areas. Raytheon's competitors range from highly resourceful small concerns, which engineer and produce specialized items, to large, diversified firms. Products are subject to an unpredictable and often high degree of obsolescence. The Electronics segment is a direct participant in most major areas of development in the defense, space, information gathering, data reduction and automation fields. Technical superiority and reputation, price, delivery schedules, financing and reliability are principal competitive factors considered by electronics customers. About half of the 50 largest defense contractors in the United States are competitors in the Electronics segment. At the present time, the Office of the Secretary of Defense (the undersecretary of Defense for Acquisition) is reviewing the Army's selection of the ERINT missile to satisfy the requirements of the Patriot Advanced Capability - 3 (PAC-3). If this decision is upheld, it is expected that Patriot's multimode development by the Company would continue as a risk reduction measure for the Army. The Company would continue to produce the Patriot Ground and Support equipment and would remain as Patriot System integrator. Competition in the Aircraft Products segment comes from a number of domestic and foreign jet, turboprop and piston aircraft manufacturers. Principal elements of competition in the industry are price, operating costs, reliability, cabin size and comfort, product quality, speed and service support. In the Energy and Environmental segment it is estimated that about 15 firms compete for major business opportunities worldwide. Competition is based primarily upon technical superiority, project experience and price. The ability to arrange or otherwise provide financing to customers is sometimes significant in attracting or retaining clients. In the Major Appliances segment, quality, warranty, price, advertising and marketing are all competitive factors. Approximately 24 firms compete with Raytheon in the appliance field. Of these, Raytheon considers four firms to be significant competitors. PATENTS AND LICENSES In most of the businesses in which Raytheon is engaged, patents are prevalent. Raytheon and its subsidiaries own a large number of United States and foreign patents and patent applications. In addition, rights under the patents and inventions of others have been acquired through licenses. Raytheon's patent position is deemed adequate for the conduct of its businesses. Should additional rights be desirable, Raytheon believes that in most instances they can be acquired on reasonable terms. It is Raytheon's policy to enforce its own patent rights and to respect the rights of others. Typically there are a number of infringement claims pending or threatened both by and against Raytheon. In the opinion of management, these claims will be disposed of in a satisfactory manner. EMPLOYMENT At December 31, 1993, Raytheon had 63,800 employees compared with 63,900 employees at the end of 1992. During 1993 the employment level declined by 5,800 people and 5,700 people were added as a result of acquisitions. Subsidiaries of Raytheon Engineers & Constructors International, Inc. and certain other subsidiaries have craft employees engaged for individual projects not included in Raytheon's employee count. Raytheon considers its employee relations to be generally satisfactory. Raytheon has, for the most part, successfully negotiated labor agreements without significant work stoppages. Over the past ten years, Raytheon has experienced only one work stoppage: a two-week stoppage at its Amana, Iowa facility. FOREIGN SALES Of total sales, Raytheon's sales to customers outside the United States were 18.4%, 18.7% and 17.7% in 1993, 1992 and 1991, respectively. These sales were principally in the fields of air defense systems, air traffic control systems, sonar systems, aircraft products, petrochemical power and industrial plant design and construction, electronic equipment, computer software and systems, personnel training, equipment maintenance, and microwave communication. Financing, to the extent needed for foreign manufacturing and sales, is generally sought in the countries concerned. Sales and income from international operations are subject to changes in currency values, domestic and foreign government policies (including requirements to expend a portion of program funds in-country) and regulations, embargoes and international hostilities. Exchange restrictions imposed by various countries could restrict the transfer of funds between countries and between Raytheon and its subsidiaries. Raytheon generally has been able to protect itself against most undue risks through insurance, foreign exchange contracts, contract provisions, government guarantees or progress payments. On occasion Raytheon utilizes the services of sales representatives and distributors in connection with foreign sales. Such representatives and distributors normally are paid either commissions or granted resale discounts in return for services rendered in connection with obtaining orders. Licenses are required from Government agencies under the Export Administration Act, the Trading with the Enemy Act of 1917 and the Arms Export Control Act of 1976 (formerly the Foreign Military Sales Act) for export from the United States of many of Raytheon's products. In the case of certain sales of defense equipment and services to foreign governments, the Government's Executive Branch must notify Congress at least 30 days prior to authorizing such sales. During that time, Congress may take action to block the proposed sale. ITEM 2. ITEM 2. PROPERTIES Raytheon and its subsidiaries operate in a number of plants, laboratories and office facilities in the United States and abroad. Raytheon's manufacturing, engineering, research, administrative, sales and storage floor space aggregated approximately 30.2 million square feet at December 31, 1993, more than 90% of which was located in the United States. Of such total, 59% was owned, 30% was held pursuant to long-term leases, 5% was held pursuant to short-term leases and 6% was Government- owned. Raytheon's facilities are suitable and adequate for its current level of business. In connection with a recently announced restructuring plan, certain facilities will be disposed of following consolidation. Raytheon maintains a wide-spread energy conservation effort in cooperation with Federal and state agencies. While Raytheon's businesses generally utilize clean manufacturing processes, such processes at times utilize chemicals, solvents, gases and other materials which could be hazardous. Several states have adopted "right-to-know" legislation entitling employees and, to a lesser extent, the public to information concerning such materials. Discharge of effluents and smoke particles are regulated by Federal and state agencies and frequently require permits. Discharge in excess of permit limitations may result in fines. Enforcement proceedings may be brought by citizen groups as well as government agencies. In the opinion of management, Raytheon complies with these regulations in all material respects. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various stages of investigation and cleanup relative to remediation of various sites. All appropriate costs incurred in connection therewith have been expensed. Due to the complexity of environmental laws and regulations, the varying costs and effectiveness of alternative cleanup methods and technologies, the uncertainty of insurance coverage and the unresolved extent of the Company's responsibility, it is not possible to determine the ultimate outcome of these matters. However, in the opinion of management, any liability will not have a material effect on the Company's financial position or results of operations after giving effect to provisions already recorded. As previously reported, in 1989 Beech was cited by the EPA, Region VII (Kansas City Office) for its failure to comply with a Wastewater Discharge Permit and applicable regulations. Beech has entered into a Consent Decree pursuant to which it will pay a civil penalty of $521,735 and install paint booth centrifuges at its Wichita facility. Accidents involving personal injuries and property damage occur in general aviation travel. When permitted by appropriate government agencies, Beech investigates accidents related to Beech products involving fatalities or serious injuries. Through a relationship with FlightSafety International, Beech provides initial and recurrent pilot and maintenance training services to reduce the frequency of accidents involving its products. Beech is a defendant in a number of product liability lawsuits which allege personal injury and property damage and seek substantial recoveries including, in some cases, punitive and exemplary damages. Beech maintains partial insurance coverage against such claims and maintains a level of uninsured risk determined by management to be prudent. (See Note J to Raytheon's Financial Statements for the years ended December 31, 1993, 1992 and 1991.) The insurance policies for product liability coverage held by Beech do not exclude punitive damages, and it is the position of Beech and its counsel that punitive damage claims are therefore covered. Historically, the defense of punitive damage claims has been undertaken and paid by insurance carriers. Under the law of some states, however, insurers are not required to respond to judgments for punitive damages. Nevertheless, to date there have been no judgments for punitive damages sustained against Beech. Defense contractors are subject to many levels of audit and investigation. Among agencies which oversee contract performance are: the Defense Contract Audit Agency, the Inspector General, the Defense Criminal Investigative Service, the General Accounting Office, and the Department of Justice and Congressional Committees. The Department of Justice from time to time has convened grand juries to investigate possible irregularities by Raytheon in governmental contracting. Various claims and legal proceedings generally incidental to the normal course of business are pending or threatened against the Company. While the Company cannot predict the outcome of any of these matters, in the opinion of management, any liability arising from them will not have a material effect on the Company's financial position, liquidity or results of operations after giving effect to provisions already recorded. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. SUBSTITUTE ITEM 4. EXECUTIVE OFFICERS OF REGISTRANT AS OF MARCH 1, 1994 Max E. Bleck. Director since November 1990 and President since March 1991. Prior to assuming his present position, Mr. Bleck served as President and Chief Executive Officer - Beech Aircraft Corporation from 1987. Age: 66 Philip W. Cheney. Vice President - Engineering since February 1990. Prior to assuming his present position, Dr. Cheney served as Program Manager - AMRAAM, Missile Systems Division from January 1985. Age: 58 Stanley L. Clark. Vice President and Group Executive - Commercial Electronics Group since May 1992. Prior to assuming his present position, Mr. Clark served as Group Executive - Commercial Electronics Group from January 1992 and as President of Raytheon Marine Company from February 1983. Age: 50 Peter R. D'Angelo. Vice President - Corporate Controller since February 1992. Prior to assuming his present position, Mr. D'Angelo served as Controller - Missile Systems Division from 1984. Age: 55 Herbert Deitcher. Senior Vice President - Treasurer since November 1989. Age: 60 David S. Dwelley. Vice President - Strategic Business Development since April 1991. Prior to assuming his present position, Mr. Dwelley served as Vice President - President, Raytheon Europe Limited from 1989. Age: 54 John F. Harding. Vice President - Contracts since October 1988. Age: 55 Christoph L. Hoffmann. Senior Vice President - Law, Human Resources and Corporate Administration, and Secretary since February 1994. Prior to assuming his present position, Mr. Hoffmann served as Vice President, Secretary and General Counsel from July 1991 and as Senior Vice President, General Counsel and Secretary of Pneumo Abex Corporation from 1986. Age: Thomas D. Hyde. Vice President and General Counsel since February 1994. Prior to assuming his present position, Mr. Hyde served as Assistant General Counsel from August 1992, as Senior Vice President, General Counsel and Chief Financial Officer of MNC Financial Inc. Special Assets Bank from 1991, and as Vice President, Finance Manville Sales Corporation from 1988. Age: 45 Charles Q. Miller. Senior Vice President and Group Executive - Chairman and Chief Executive Officer of Raytheon Engineers & Constructors International, Inc. since March 1993. Prior to assuming his present position, Mr. Miller served as President, United Engineers & Constructors, Inc. from 1990 and as Vice President-General Manager of Stearns-Rogers Division from 1989. Age: 48 John R. Pasquariello. Vice President - President and Chief Executive Officer of Cedarapids Inc. since September 1993. Prior to assuming his present position, Mr. Pasquariello served as Vice President - Environmental Quality from 1992, as Vice President-Manufacturing and Environmental Quality from April 1990 and as Vice President-Manufacturing from 1979. Age: 64 Dennis J. Picard. Director since 1989 and Chairman and Chief Executive Officer since March 1991. Prior to assuming his present position, Mr. Picard served as President from 1989. Age: 61 C. Dale Reis. Vice President and General Manager - Equipment Division since September 1993. Prior to assuming his present position, Mr. Reis served as Vice President-General Manager, Submarine Signal Division from October 1990 and Manager-Equipment Development Laboratories, Equipment Division from 1988. Age: 48 Sheldon Rutstein. Senior Vice President - Chief Financial Officer since February 1992. Mr. Rutstein also serves as Chief Accounting Officer. Prior to assuming his present position, Mr. Rutstein served as Senior Vice President-Controller from 1989. Age: 59 Robert A. Skelly. Vice President - Assistant to the Executive Office. Prior to assuming his present position, Mr. Skelly served as Vice President-Administration, Environmental Quality and Procurement since September 1992, as Vice President-Public and Financial Relations from January 1991 and as Assistant to the President from August 1989. Age: 51 Robert L. Swam. Senior Vice President, Group Executive - Appliance Group since January 1992. Prior to assuming his present position, Mr. Swam was an independent consultant from 1989. Age 53 William H. Swanson. Senior Vice President - General Manager, Missile Systems Division since August 1990. Prior to assuming his present position, Mr. Swanson served as Vice President - Assistant General Manager-Operations, Missile Systems Division from 1989. Age: 45 Arthur E. Wegner. Senior Vice President - Chairman and Chief Executive Officer of Beech Aircraft Corporation since July 1993. Prior to assuming his present position, Mr. Wegner served as Executive Vice President and President of the Aerospace/Defense Sector of United Technologies Corporation from 1989. Age: 56 Edmund B. Woollen. Vice President - Government Marketing since December 1992. Prior to assuming his present position, Mr. Woollen served as Vice President-Corporate Marketing from October 1990 and as Director of Marketing, Government Group from 1986. Age: 49 Each executive officer was elected by the Board of Directors to serve for a term of one year and until his successor is elected and qualified or until his earlier removal, resignation or death. PART II Item 5. Item 5. Market For Registrant's Common Equity and Related Stockholder Matters This information is contained in the Annual Report to Stockholders for the year ended December 31, 1993 on page 1, on page 40 under the caption "Quarterly Financial Data" and on the back cover and is incorporated herein by reference. Item 6. Item 6. Selected Financial Data This information is included in the "Ten Year Statistical Summary" contained in the Annual Report to Stockholders for the year ended December 31, 1993 on pages 42 and 43 and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This information is contained in the Annual Report to Stockholders for the year ended December 31, 1993 on pages 35 through 40 and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplemental Data Financial statements and supplementary data of the Registrant are contained in the Annual Report to Stockholders for the year ended December 31, 1993 on pages 44 through 59 and are incorporated herein by reference. Schedules required under Regulation S-X are filed as "Financial Statement Schedules" pursuant to Item 14 hereof. Item 9. Item 9. Changes in and Disagreements with Accountants and Financial Disclosure None. Item 10. Item 10. Directors and Executive Officers of the Registrant Information regarding the directors of the Registrant is contained in the definitive proxy statement of the Registrant for the annual meeting of stockholders to be held May 25, 1994 on pages 2 and 3 under the caption "Election of Directors" and is incorporated herein by reference. See Part I, Substitute Item 4 of this Form 10-K for information regarding the executive officers of the Registrant. Item 11. Item 11. Executive Compensation This information is contained in the definitive proxy statement of the Registrant for the annual meeting of stockholders to be held May 25, 1994 beginning with the caption "Executive Compensation" on pages 6 through 9 and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management This information is contained in the definitive proxy statement of the Registrant for the annual meeting of stockholders to be held May 25, 1994 under the caption "Security Ownership" on pages 4 and 5 and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions This information is contained in the definitive proxy statement of the Registrant for the annual meeting of stockholders to be held May 25, 1994 under the caption "Other Information" on page 15 and is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements and Schedules (1) The following financial statements of Raytheon Company and Subsidiaries Consolidated, as contained in Raytheon's 1993 Annual Report to Stockholders, are hereby incorporated by reference: Balance Sheets at December 31, 1993 and 1992 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 (2) The following schedules are included in this report: Schedule II - Amounts Receivable from Employees for the Three Years Ended December 31, 1993 Schedule V - Property, Plant and Equipment for the Three Years Ended December 31, 1993 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the Three Years Ended December 31, 1993 Schedule VIII - Reserves for the Three Years Ended December 31, 1993 Schedule IX - Short-Term Borrowing for the Three Years Ended December 31, 1993 Schedules I, III, IV, VII, X, XI, XII and XIII are omitted because they are not required, not applicable, or the information is otherwise included. (b) Reports on Form 8-K On June 9, 1993, the Company filed a Form 8-K reporting the acquisition by Raytheon Company of the business of Corporate Jets Inc. (c) Exhibits (3.1) Raytheon Company Certificate of Incorporation, as amended through July 1, 1987, heretofore filed as an Exhibit to Registration Statement No. 33-15396, is hereby incorporated by reference. (3.2) Raytheon Company By-Laws, as amended through August 22, 1990, heretofore filed as an Exhibit to Raytheon's Form 10-K for the year ended December 31, 1990, are hereby incorporated by reference. (4) On July 3, 1986, the Company filed a registration statement on Form 8-A, which form was amended on June 28, 1988, describing certain rights that may accrue to stockholders in the event that a person or group acquires beneficial ownership of 20% or more of the Company's outstanding capital stock or commences a tender or exchange offer that would result in such person or group owning 25% or more of such outstanding capital stock. Said Registration Statement is hereby incorporated by reference. (10.1) Raytheon's 1976 Stock Option Plan, filed as an exhibit to Raytheon's Registration Statement No. 33-23449 on Form S-8, is hereby incorporated by reference. (10.2) Raytheon's 1991 Stock Plan, filed as an exhibit to Raytheon's 1991 Form 10-K, is hereby incorporated by reference. (13) Raytheon's 1993 Annual Report to Stockholders (furnished for the information of the Commission and not to be deemed "filed" as part of this Report except to the extent that portions thereof are expressly incorporated by reference). (22) Subsidiaries of Raytheon Company (24.1) Consent of Independent Accountants (24.2) Report of Independent Accountants (28.1) Annual Report on Form 11-K for the (To be filed at a Raytheon Savings and Investment Plan later date under Form 8) (28.2) Annual Report on Form 11-K for the (To be filed at a Raytheon Savings and Investment Plan later date under for Specified Hourly Payroll Employees Form 8) (28.3) Annual Report on Form 11-K for the (To be filed at a Caloric Savings and Investment Plan later date under Form 8) (28.4) Annual Report on Form 11-K for the (To be filed at a Badger Company, Inc. Savings and later date under Investment Plan Form 8) SIGNATURE Pursuant to the requirements of Section 13 or 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. RAYTHEON COMPANY By: /s/ Thomas D. Hyde Thomas D. Hyde Vice President and General Counsel for the Registrant Dated: March 23, 1994 SIGNATURES 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. SIGNATURES TITLE DATE Chairman of the Board Dennis J. Picard and Director (Principal March 23, 1994 (Dennis J. Picard) Executive Officer) Max E. Bleck President and Director March 23, 1994 (Max E. Bleck) Charles F. Adams Director March 23, 1994 (Charles F. Adams) Francis H. Burr Director March 23, 1994 (Francis H. Burr) Ferdinand Colloredo-Mansfeld Director March 23, 1994 (Ferdinand Colloredo-Mansfeld) Theodore L. Eliot, Jr. Director March 23, 1994 (Theodore L. Eliot, Jr.) Barbara B. Hauptfuhrer Director March 23, 1994 (Barbara B. Hauptfuhrer) Richard D. Hill Director March 23, 1994 (Richard D. Hill) James N. Land, Jr. Director March 23, 1994 (James N. Land, Jr.) Thomas L. Phillips Director March 23, 1994 (Thomas L. Phillips) Warren B. Rudman Director March 23, 1994 (Warren B. Rudman) Joseph J. Sisco Director March 23, 1994 (Joseph J. Sisco) Alfred M. Zeien Director March 23, 1994 (Alfred M. Zeien) Sheldon Rutstein Senior Vice President - March 23, 1994 (Sheldon Rutstein) Chief Financial Officer (Chief Accounting Officer) RAYTHEON COMPANY AND SUBSIDIARIES CONSOLIDATED ----------------------------------------------- SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 --------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Balance at Deductions Balance at close of period beginning Amounts Amounts Name of debtor of period Additions collected written off Current Non-current --------------------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993 Elizabeth H. Allen (4) $ - $475 $475 $ - $ - $ - Max E. Bleck (1) 800 - - - 800 - Tom B. Burgher (2) 23 - 7 - 7 9 Larry R. Capps (3) 31 - 31 - - - Kenneth A. Dickerson (4) 430 - 430 - - - James V. DiLorenzo (5) 155 - 19 - 21 115 Edward C. Douglas (6) 288 - 11 - 12 265 S. Robert Foley (7) 141 - 141 - - - David W. Gerety (9) 64 - 27 - 12 25 Ronald J. Lazarto (10) 5 - 5 - - - Charles Q. Miller (20) - 175 - - 175 - C. Dale Reis (11) 100 - 100 - - - Gerard A. Smith (7) 70 - 70 - - - Robert L. Swam (13) 250 - 30 - 40 180 Frank D. Umanzio (14) 189 - - - 189 - (continued next page) SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES --------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Balance at Deductions Balance at close of period beginning Amounts Name of debtor of period Additions collected written off Current Non-current --------------------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1992 Max E. Bleck (1) $800 $ - $ - $ - $800 $ - Tom B. Burgher (2) 255 - 232 - 8 15 Larry R. Capps (3) - 130 99 - 31 - Kenneth A. Dickerson (4) 430 - - - 430 - James V. DiLorenzo (5) 172 - 17 - 19 136 Edward C. Douglas (6) 299 - 11 - 11 277 S. Robert Foley (7) 175 - 34 - 25 116 Chet E. Foraker (8) 136 - 136 - - - David W. Gerety (9) 150 - 86 - 10 54 Richard B. Johnston (8) - 155 155 - - - Ronald J. Lazarto (10) 150 - 145 - 5 - C. Dale Reis (11) 120 - 20 - 20 80 Richard A. Rom (12) 24 - 24 - - - Gerard A. Smith (7) 102 - 32 - 34 36 Robert L. Swam (13) - 250 - - 30 220 Frank D. Umanzio (14) 189 - - - 189 - (continued next page) SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES ---------------------------------------------- (continued) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Balance at Deductions Balance at close of period beginning Amounts Name of debtor of period Additions collected written off Current Non-current --------------------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1991 Max E. Bleck (1) $ - $ 800 $ - $ - $800 $ - Jay T. Bluestein (15) 120 - - 120 - - Tom B. Burgher (4) - 255 - - 255 - Kenneth A. Dickerson (4) 430 - - - 430 - James V. DiLorenzo (5) 187 - 15 - 17 155 Edward C. Douglas (6) 302 - 3 - 15 284 Richard J. Foley (8) - 400 400 - - - S. Robert Foley (7) - 305 130 - 26 149 Chet E. Foraker (8) - 136 - - 136 - Thomas M. Gallagher (8) 160 - 160 - - - David W. Gerety (9) - 150 - - 38 112 Ronald D. Kalp (16) 178 - 128 50 - - Ronald J. Lazarto (4) 150 - - - 150 - Robert J. Minton (17) 104 - - 104 - - C. Dale Reis (11) 168 287 335 - 20 100 Richard A. Rom (12) 34 - 10 - 11 13 John T. Rowntree (8) 65 - 65 - - - Gerard A. Smith (7) 131 - 29 - 32 70 Frank D. Umanzio (14) - 189 - - 189 - (continued next page) SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES ---------------------------------------------- (continued) 1. Non-interest bearing loan for the purchase of employee's home in Massachusetts, repayable upon the employee selling the home or ending his employment. Raytheon holds a mortgage on the home. 2. Non-interest bearing loan made on a demand note was reduced by a partial principal payment and converted to a non-interest bearing installment term loan commencing in January 1993. Raytheon holds a mortgage on the home of this employee. 3. Non-interest bearing loan made on a demand note was reduced by a partial principal payment. Raytheon holds a mortgage on the home of this employee. 4. Non-interest bearing loan made on a demand note to be paid on the sale of the first home. 5. Non-interest bearing installment loan with annual installments commencing February 15, 1990 and continuing through February 15, 1999. Raytheon Company holds a mortgage on the home of this employee. 6. Interest bearing loan made on a demand note to be paid on the sale of the first home. Raytheon Company holds mortgages on both homes of this employee. Employee pays $2600 per month as partial payment of principal and interest until sale of either home is completed. 7. Non-interest bearing interim loan was reduced by the proceeds from the sale of the employee's home and converted to a non-interest bearing installment loan with annual installments. The balance was prepaid when the employee left the company. 8. Non-interest bearing loan made on a demand note to be paid upon the sale of the first home. Raytheon Company held a mortgage on the homes of these employees. 9. Interest bearing loan made on a demand note was reduced by partial principal payment and converted to a non-interest bearing installment term loan commencing February 1992 and maturing in March 1997 which was modified in 1993 as a result of the prepayment of part of the principal. Raytheon holds a mortgage on the home of this employee. (continued next page) SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES ----------------------------------------------- (continued) 10. Interest bearing loan made on a demand note which was paid on the sale of the first home. Raytheon Company held a mortgage on the home of this employee. 11. Borrowing on a non-interest bearing line of credit enabled relocated employee to build a new home. Upon completion of construction, the loan was converted to an interest free installment term loan with a value of $117,170 and with annual installments commencing in 1992 and continuing through 1996. The loan was liquidated in 1993. 12. Non-interest bearing loan made on a demand note was reduced by partial principal payment and converted to a non-interest bearing installment term loan with monthly payments commencing in September, 1990 and was paid in full in 1992. Raytheon Company held a mortgage on the home of this employee. 13. Non-interest bearing installment term loan maturing in February 1997. Raytheon holds a mortgage on the home of this employee. 14. Relocation loan, part of which is interest bearing, was made to the employee to be repaid in January, 1994, unless either home is sold earlier. Raytheon Company holds mortgages on two homes of this employee. 15. Non-interesting bearing loans made on demand notes and involving employee relocations. Amount was written off in 1991 based upon multiple relocation agreements made with employee. 16. Non-interest bearing 10-year installment loan was partially repaid in July, 1991 with the balance being written off pursuant to a severance agreement with the employee. Raytheon Company held a mortgage on the two homes of this former employee. 17. Interest bearing loan made on a demand note to be paid on the sale of the first home. Raytheon Company held a mortgage on the home in Georgia of this former employee. Amount was charged to a reserve in 1991. 18. Non-interest bearing installment loan with balance due paid in February 1990. Raytheon Company held a mortgage on the home of this employee. 19. Non-interest bearing 8-year installment loan with balance due paid in May 1990. Raytheon Company held a mortgage on the home of this employee. 20. Non-interest bearing loan made on a demand note. In January 1994, the employee's home was sold and the loan reduced to an installment term loan. The remaining installment in the amount of $17,279 is payable in January 1995. RAYTHEON COMPANY AND SUBSIDIARIES CONSOLIDATED ---------------------------------------------- SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 ------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F Balance at Other changes Balance beginning Additions add (deduct) at end Classification of period at cost Retirements Note (1) of period ------------------------------------------------------------------------------------------------------------------------ Year ended December 31, 1993: Land $ 46,254 $ 1,642 $ 350 $ <50> $ 47,496 Building and leasehold improvements 888,039 29,847 12,368 <719> 904,799 Machinery and equipment 2,482,229 256,135 158,203 <1,766> 2,578,395 Equipment leased to others 61,636 22,678 24,671 - 59,643 ---------- -------- -------- --------- ---------- $3,478,158 $310,302(2) $195,592 $ <2,535> $3,590,333 ========== ======== ======== ========= ========== Year ended December 31, 1992: Land $ 47,082 $ 290 $ 674 $ <444> $ 46,254 Building and leasehold improvements 870,458 33,324 9,709 <6,034> 888,039 Machinery and equipment 2,614,297 227,726 337,883 <21,911> 2,482,229 Equipment leased to others 67,518 46,386 52,268 - 61,636 ---------- --------- -------- --------- ---------- $3,599,355 $ 307,726 $400,534 $ <28,389> $3,478,158 ========== ========= ======== ========= ========== Year ended December 31, 1991: Land $ 47,892 $ 184 $ 587 $ <407> $ 47,082 Building and leasehold improvements 877,908 19,796 22,610 <4,636> 870,458 Machinery and equipment 2,512,663 297,347 165,944 <29,769> 2,614,297 Equipment leased to others 46,400 31,209 10,091 - 67,518 ---------- --------- -------- --------- ---------- $3,484,863 $ 348,536 $199,232 $ <34,812> $3,599,355 ========== ========= ======== ========= ========== Note (1) - Includes foreign exchange translation adjustments. Note (2) - Includes additions from acquisitions recorded under the purchase method. See Note Q of Notes to Financial Statements on page 58 of the Company's 1993 Annual Report to Stockholders. RAYTHEON COMPANY AND SUBSIDIARIES CONSOLIDATED ---------------------------------------------- SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 -------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F Additions Balance at charged to Other changes Balance beginning costs and add (deduct) at end Description of period expenses Retirements Note (1) of period ----------------------------------------------------------------------------------------------------------------------- Year ended December 31, 1993: Land $ - $ - $ - $ - $ - Building and leasehold improvements 328,501 38,859 7,866 <1,594> 357,900 Machinery and equipment 1,721,062 243,555 162,311 187 1,802,493 Equipment leased to others 8,550 4,704 5,400 - 7,854 ---------- --------- --------- ----------- ---------- $2,058,113 $ 287,118 $ 175,577 $ <1,407> $2,168,247 ========== ========= ========= =========== ========== Year ended December 31, 1992: Land $ - $ - $ - $ - $ - Building and leasehold improvements 298,205 39,105 6,151 <2,658> 328,501 Machinery and equipment 1,763,159 255,981 281,819 <16,259> 1,721,062 Equipment leased to others 21,473 7,047 19,970 - 8,550 ---------- --------- --------- ----------- ---------- $2,082,837 $ 302,133 $ 307,940 $ <18,917> $2,058,113 ========== ========= ========= =========== ========== Year ended December 31, 1991: Land $ - $ - $ - $ - $ - Building and leasehold improvements 273,776 38,073 12,434 <1,210> 298,205 Machinery and equipment 1,657,644 263,658 136,987 <21,156> 1,763,159 Equipment leased to others 21,362 4,386 4,275 - 21,473 ---------- --------- -------- ---------- ----------- $1,952,782 $ 306,117 $153,696 $ <22,366> $ 2,082,837 ========== ========= ======== ========== =========== Note (1) - Includes foreign exchange translation adjustments. Note (2) - See Note A of Notes to Financial Statements on page 48 of the Company's 1993 Annual Report to Stockholders, which is hereby incorporated by reference, for discussion on method of depreciation and amortization. RAYTHEON COMPANY AND SUBSIDIARIES CONSOLIDATED ---------------------------------------------- SCHEDULE VIII - RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 ------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Additions Balance at Balance at beginning Charged to costs Charged to other Deductions end of Description of period and expenses accounts Note (1) period -------------------------------------------------------------------------------------------------------------------- Year ended December 31, 1993: Allowance for doubtful $20,023 $ 4,586 - $(1,282) $25,891 accounts receivable Year ended December 31, 1992: Allowance for doubtful $19,229 $10,336 - $ 9,542 $20,023 accounts receivable Year ended December 31, 1991: Allowance for doubtful $16,916 $ 7,651 - $ 5,338 $19,229 accounts receivable Note (1) - Uncollectible accounts and adjustments, less recoveries RAYTHEON COMPANY AND SUBSIDIARIES CONSOLIDATED --------------------------------------------- SCHEDULE IX - SHORT TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 ------------------------------------------- (In thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F Category of Maximum month- Average amount Weighted average aggregate Balance Weighted average end amount out- outstanding interest rate short-term at end interest rate at standing during during the during the borrowings of period end of period (2) the period period (3) period (3) ------------------------------------------------------------------------------------------------------------------------ 1993: Notes Payable $ 27,187 (1) 6.01% $ 42,593 $ 25,966 6.77% Commercial Paper 844,990 3.35 1,063,570 851,799 3.09 All categories 872,177 3.43 1,084,252 877,765 3.20 1992: Notes Payable $ 16,492 (1) 8.71% $ 35,527 $ 35,039 8.03% Commercial Paper 688,297 3.42 1,245,025 1,080,670 3.74 All categories 704,789 3.54 1,305,460 1,115,709 3.87 1991: Notes Payable $ 56,493 (1) 10.05% $ 103,135 $ 72,245 10.15% Commercial Paper 1,043,973 4.83 1,453,244 1,356,778 5.96 All categories 1,100,466 5.10 1,567,627 1,429,023 6.17 Note (1) - In addition to this amount, lines of credit with certain commercial banks exist as a standby facility to support the issuance of commercial paper by the company. These lines of credit were $1.108 billion, $1.120 billion, and $1.440 billion as of December 31, 1993, 1992, and 1991, respectively. Through December 31, 1993, there have been no borrowings under these lines of credit. (2) - The weighted average interest rate at the end of each year is calculated by multiplying the actual interest rate times the principal amounts of all short-term debt instruments outstanding at December 31. This total calculated interest amount is then divided by the total outstanding debt to arrive at the weighted average interest rate. (3) - The weighted average interest rate during each year is determined by dividing the interest expense for the year by the average short-term debt during the year. The average short-term bank debt is determined by averaging the outstanding balances at the beginning of the year and at the end of each quarter (a five point weighted average). The average balance in commercial paper is determined based on amounts outstanding at the end of each day. /TABLE	8,480	56,461
74208_1993.txt	74208_1993	1993	74208	Item 1. Business United Dominion Realty Trust, Inc. (the "Trust"), a Virginia corporation, is a self-administered equity real estate investment trust ("REIT"), formed in 1972, whose business is devoted to one industry segment, the ownership of income-producing real estate, primarily apartments. The Trust acquires, upgrades and operates its properties with the goals of maximizing its funds from operations (defined as income before gains(losses) on investments and extraordinary items adjusted for certain non-cash items, primarily real estate depreciation) and quarterly distributions to shareholders, while building equity primarily through real estate appreciation. Prior to 1991, the Trust's investment policy was to emphasize the acquisition of under-leased, under-managed, and/or under-maintained properties that could be physically or otherwise upgraded and could be acquired at significant discounts from replacement costs. At the beginning of 1991, changed economic conditions and the Trust's financial strength enabled it to embark on a major expansion of its apartment portfolio involving (i) the acquisition of more stable apartment properties having high occupancy levels and not requiring substantial renovation, and (ii) entry into new markets, most recently the Baltimore/Washington area, central Florida and Nashville, Tennessee. The properties have been acquired generally at significant discounts from replacement cost and at attractive current yields. The sellers have been primarily financially distressed real estate limited partnerships, the RTC, the FDIC, lenders who had foreclosed and insurance companies seeking to reduce their real estate exposure. Since 1991, the Trust has acquired 38 apartment properties containing 9,885 units at a total cost of approximately $277 million. As of March 28, 1994, the Trust's portfolio of income-producing real estate consisted of ninety-five properties including seventy-six apartment complexes, fifteen shopping centers, and four other properties. (See Item 2. Item 2. Properties The table below sets forth a summary of the Trust's portfolio of rental properties owned at December 31, 1993. See also Notes 1 and 2 to Financial Statements and Schedule XI - Summary of Real Estate Owned. Item 2. Properties (continued) December 31, 1993 (1) Two anchor tenants occupying more than 60,000 square feet at this center filed for bankruptcy during 1991. (2) An anchor tenant occupying 53,000 sqaure feet at this center filed for bankruptcy. (3) An anchor tenant occupying 34,800 square feet vacated its space in May, 1992. This space has been leased as of June 1, 1994. (4) On June 30, 1993 the Trust sold a specialty medical building that had been vacant for the first half of the year. (5) Building was vacated by the anchor tenant. The space was fully leased effective June 15, 1993. Item 3. Item 3. Legal proceedings None Item 4. Item 4. Submission of matters to a vote of security holders No matters were submitted to a vote of the Trust's shareholders during the last quarter of its fiscal year ended December 31, 1993. Executive officers The executive officers of the Trust, listed below, serve in their respective capacities for approximate one year terms and are subject to re-election annually by the Board of Directors, normally in May of each year. Name Age Office Since John P. McCann 49 President and Chief 1974 Executive Officer James Dolphin 44 Senior Vice President 1979 and Chief Financial Officer Barry M. Kornblau 44 Senior Vice President and 1991 Director of Apartment Operations Mr. McCann, a Director, has been the Trust's managing officer since 1974, serving as its President since 1979, its Secretary from 1974 to 1980, and its Treasurer from 1982 to 1985. Mr. Dolphin, a Director, was first employed by the Trust in May, 1979 as Controller and served as Corporate Secretary from 1980 to January, 1993. He was elected Vice President of Finance in 1985 and Senior Vice President in 1987. Prior to joining the Trust, Mr. Dolphin was employed by Arthur Young and Company, Certified Public Accountants. Mr. Kornblau joined the Trust in 1991 as Senior Vice President and Director of Apartment Operations. From 1985 through 1990, he was President and Chief Executive Officer of Summit Realty Group, Inc. which managed the Trust's apartment properties during that period. He is a licensed real estate broker and a C.P.M. Part II Item 5. Item 5. Market for registrant's common equity and related stockholder matters Incorporated herein by reference from the captions "Common Stock Price" and "Shareholders" appearing on the inside back cover of the Trust's 1993 Annual Report to Shareholders, included in Exhibit 13. Information regarding the Trust's dividend policy is included in Item 7. Item 6. Item 6. Selected financial data Incorporated herein by reference from the caption "Selected Financial Information" appearing on page 7 of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 7. Item 7. Management's discussion and analysis of financial condition and results of operations. Incorporated herein by reference from the caption "Management's Discussion of Financial Condition and Operations" appearing on pages 8 through 10 of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 8. Item 8. Financial statements and supplementary data The Trust's financial statements at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, and the independent auditor's report thereon and the Trust's unaudited quarterly financial data for the two-year period ended December 31, 1993 are incorporated herein by reference from pages through of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 9. Item 9. Changes in and disagreements with accountants on accounting and financial disclosure None Part III Item 10. Item 10. Directors and executive officers of the registrant Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Information regarding the executive officers of the Trust is included in Part I. The Trust also employs five other officers who hold the office of vice president or equivalent as follows: Curtis W. Carter, 37, joined the Trust in 1991 as Assistant Vice President in charge of apartment property management and was subsequently elected Vice President. From December 1985 through 1990, he was Vice President of Property Management for Summit Realty Group, Inc. He is a CPM. Richard B. Chess, 40, joined the Trust in October, 1987 as Director of Acquisitions. He was elected Assistant Vice President in 1988 and Vice President in 1989. From 1984 to 1987 he was employed by Manufacturers Life Insurance Company as Senior Analyst - Real Estate Syndications. He previously served in the Pennsylvania General Assembly and is admitted to the practice of law in Virginia and Pennsylvania. Jerry A. Davis, 31, joined the Trust in March, 1989 as Controller and was subsequently elected Assistant Secretary. In 1991 he was elected Vice President and Controller-Corporate Accounting. From 1986 to 1989, he was employed by Crestar Bank, Richmond, Virginia, as an officer and financial analyst. He was previously employed by Arthur Young & Company, Certified Public Accountants, Richmond, Virginia. He is a certified public accountant. Richard A. Giannotti, 38, joined the Trust as Director of Development and Construction in September, 1985. He was elected Assistant Vice President in 1988 and Vice President in 1989. Prior to joining the Trust he was employed as Project Manager by Vaughan Associates, Architects and by Beckstoffer and Associates, Architects, both of Richmond, Virginia. He is a registered architect. Katheryn E. Surface, 35, joined the Trust in 1992 as Assistant Vice President and Legal Counsel and in 1993 was elected General Counsel, Corporate Secretary and Vice President. From 1986 to 1992, she was an attorney with the law firm of Hunton and Williams, the Trust's outside counsel. Item 11. Item 11. Executive compensation Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Item 12. Item 12. Security ownership of certain beneficial owners and management Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Item 13. Item 13. Certain relationships and related transactions Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Part IV Item 14. Item 14. Exhibits, financial statement schedules, and reports on Form 8-K (a) The following documents are filed as a part of this report and are hereby incorporated by reference: Page Numbers (manually signed original) Preliminary Prospectus Dated March 29, 1994, Contained in the Trust's Form S-3 Registration Statement (Registration No. 33-52521) Filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 Form (Exhibit 99(ii)) 10-K 1. Financial Statements: Report of Ernst & Young, Independent Auditors 27 Balance sheets at December 31, 1993 and 1992 28 Statements of operations for each of the three years in the period ended December 31, 1993 29 Statements of shareholders' equity for each of the three years in the period ended December 31, 1993 31 Statements of cash flows for each of the three years in the period ended December 31, 1993 30 Notes to financial statements through 32-39 Supplementary information - Quarterly financial data (unaudited) 39 2. Financial Statement Schedules Schedule II - Amounts Receivable from Directors, Officers, and Employees 41 Schedule VIII - Valuation and Qualifying Accounts 42 Schedule X - Supplementary Earnings Statement Information 43 Schedule XI - Summary of Real Estate Owned 44 - 45 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto. 3. Exhibits The exhibits listed on the accompanying exhibit index are filed as part of this annual report. (b) Reports on Form 8-K (i) A Form 8-K dated December 22, 1993 was filed with the Securities and Exchange Commission on December 22, 1993 and amended by Form 8-K/A dated February 18, 1994. The filing reported the acquisition of certain properties which in the aggregate were deemed to be significant. The financial statements filed as part of this report are statements of rental operations of the Village at Old Tampa Bay Apartments, Peppertree Apartments and Beechwood Apartments. UNITED DOMINION REALTY TRUST, INC. EXHIBIT INDEX Item 14 (a) References to pages under the caption "Location" are to sequentially numbered pages of the manually signed original of this Form 10-K, and references to exhibits, forms, or other filings indicate that the form or other filing has been filed, that the indexed exhibit and the exhibit referred to are the same and that the exhibit referred to is incorporated by reference. Exhibit Description Location 3(a)(i) Restated Articles of Incorporation Exhibit 3 to the Trust's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992 3(a)(ii) Amendment of Restated Articles Exhibit 6(a)(l) to the of Incorporation Trust's Form 8-A Registration Statement 3(b) By-Laws Exhibit 4(c) to the Trust's Form S-3 Registration Statement (Registration No. 33-44743) filed with the Commission on December 31, 1991 4(i) Specimen Common Stock Pages 46 through 47 Certificate 4(ii)(a) Loan Agreement dated as of Exhibit 6(c)(l) to the November 7, l991, between the Trust's Form 8-A Trust and Aid Association for Registration Statement Lutherans 4(ii)(b) Loan Agreement dated as of Exhibit 6(c)(2) November 14, 1991, between the to the Trust's Form 8-A Trust and Signet Bank/Virginia Registration Statement 4(ii)(c) Note Purchase Agreement dated Exhibit 6(c)(3) to as of February 19, 1992, between the Trust's Form 8-A the Trust and Principal Mutual Registration Statement Life Insurance Company 4(ii)(d) Credit Agreement dated as of Exhibit 6(c)(4) to the December 15, 1992, between the Trust's Form 8-A Trust and Signet Bank/Virginia Registration Statement 4(ii)(e) Note Purchase Agreement dated Exhibit 6(c)(5) to the as of January 15, l993, between Trust's Form 8-A the Trust and CIGNA Property Registration Statement and Casualty Insurance Company, Connecticut General Life Insurance Company, Connecticut General Life Insurance Company, on behalf of one or more separate accounts, Insurance Company of North America, Principal Mutual Life Insurance Company and Aid Association for Lutherans The Trust agrees to furnish to the Commission on request a copy of any instrument with respect to long-term debt of the Trust or its subsidiary the total amount of securities authorized under which does not exceed 10% of the total assets of the Trust. 10(i) Employment Agreement between Exhibit 10(v)(i)to the Trust and John P. McCann, Form 10-K for the year dated October 29, l982 ended December 31, 1982. 10(ii) Employment Agreement between Exhibit 10(v)(ii) to the Trust and James Dolphin, Form 10-K for the year dated October 29, l982 ended December 31, 1982. 10(iii) Employment Agreement between Exhibit 10(iii) to the Trust and Barry M. Kornblau, Form 10-K for the year dated January 1, 1991. December 31, 1990. 10(iv) 1985 Stock Option Plan, Exhibit B to the Trust's as amended definitive proxy statement dated April 13, 1992. 10(v) 1991 Stock Purchase and Loan Exhibit 10(v) to Plan Form 10-K for the year ended December 31, 1991. 13 Page of the Trust's 1993 Page 21 Annual Report to Shareholders that includes information incorporated by reference into this Form 10-K. 21 The Trust's only subsidiary is The Commons of Columbia, Inc., a Virginia corporation, which does not do business under any other name. 24 Consent of Independent Page 40 Auditors 99(ii) Pages 7 through 10, Pages 22 through 39 inclusive, and pages through, inclusive of the preliminary prospectus dated March 29, 1994, included in the Trust's Form S-3 Registration Statement (Registration No. 33-52521) filed with the Commission on March 7, 1994 and amended on March 29, 1994. With the exception of the information incorporated by reference into Item 5, the 1993 Annual Report to Shareholders is not deemed filed as part of this report. ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) and (2), (c) and (d) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 UNITED DOMINION REALTY TRUST, INC. RICHMOND, VIRGINIA General information General Offices United Dominion Realty Trust 10 S. Sixth Street, Suite 203 Richmond, Virginia 23219-3802 (804)780-2691 (804)343-1912 FAX General Counsel Hunton & Williams Riverfront Plaza-East Tower 901 E. Byrd Street Richmond, Virginia 23219-4074 Independent Auditors Ernst & Young 901 East Cary Street Richmond, Virginia 23219 Transfer Agent Mellon Securities Trust Company Four Station Square, 3rd Floor Pittsburgh, Pennsylvania 15219-1173 Shareholders On March 1, 1994, the Trust had 4,505 shareholders of record. Employees As of February 20, 1994, the Trust had 556 full and part-time employees. Annual Meeting The Annual Meeting of Shareholders is scheduled for Tuesday, May 10, 1994, at 4:00 p.m., at the Omni Richmond Hotel in Richmond, Virginia. All Shareholders are cordially invited to attend. Member National Association of Real Estate Investment Trusts (NAREIT) National Apartment Association National Multi-Housing Council International Council of Shopping Centers Stock Listing New York Stock Exchange Symbol UDR 10-K Report The Trust offers its shareholders, without charge, copies of its Annual Report on Form 10-K, as reported to the Securities and Exchange Commission. Dividend Reinvestment and Stock Purchase Plan The Trust offers its shareholders the opportunity to purchase additional shares of common stock through the Dividend Reinvestment and Stock Purchase Plan. Information regarding the Plan can be obtained directly from the Trust's office. Requests should be addressed to Shareholder Relations, United Dominion Realty Trust, at the Trust's office. Common Stock Price The table below sets forth the range of the high and low sales prices per share for each quarter of the last two years. Dividend information reflects dividends declared for each calendar quarter and paid at the end of the following month. Information for 1992 and the first quarter of 1993 give retroactive effect to a 2-for-1 stock split in May 1993. Dividend 1992 High Low Declared 1st Quarter $11 1/2 $10 $.165 2nd Quarter 10 13/16 9 3/4 .165 3rd Quarter 12 3/16 10 9/16 .165 4th Quarter 12 11/16 10 7/8 .165 1st Quarter $14 13/16 $11 7/8 $.175 2nd Quarter 14 5/8 12 1/2 .175 3rd Quarter 16 5/8 13 1/2 .175 4th Quarter 16 7/8 12 5/8 .175 (1) In 1991, 1992 and 1993 the Trust entered into stock purchase agreements whereby certain officers purchased shares of common stock at the then current market price. The Trust provides 100% financing for the purchase of the stock with interest payable quarterly at rates escalating from 7% to 8-1/2%. The underlying notes mature beginning in November, 1998. The Trust holds as collateral all stock purchased through this plan. (1) The balance is netted against the cost of real estate owned on the balance sheet SCHEDULE X UNITED DOMINION REALTY TRUST, INC. SUPPLEMENTARY EARNINGS STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) Charged to Expense Description 1993 1992 1991 Advertising $1,078 $731 $652 Rental Promotions 420 650 553 Other items requiring disclosure are not shown as they are less than 1% of rental income. Depreciable Life of Date of Date Building Construction Acquired Component Apartments: 2131 Apartments/Nashville, TN 1972 12/16/92 35 yrs. Azalea/Richmond, VA 1967 12/31/84 35 yrs. Bay Cove/Clearwater, FL 1972 12/16/92 35 yrs. Bayberry Commons/Portsmouth, VA 1973/74 04/07/88 35 yrs. Beechwood/Greensboro, NC 1985 12/22/93 35 yrs. Braeland Commons/Columbia, MD 1983 12/29/92 35 yrs. Bramblewood/Goldsboro, NC 1980/82 12/31/84 35 yrs. Brynn Marr/Jacksonville, NC 1973/77 12/31/84 35 yrs. Canterbury Woods/Charlotte, NC 1968/70 12/18/85 35 yrs. Cedar Point/Raleigh, NC 1972 12/18/85 35 yrs. Cinnamon Ridge/Raleigh, NC 1968/70 12/01/89 35 yrs. Colonial Villa/Columbia, SC 1974 09/16/92 35 yrs. Colony of Stone Mtn/Atlanta, GA 1970/72 06/12/90 35 yrs. Colony Village/New Bern, NC 1972/74 12/31/84 35 yrs. Country Walk/Columbia, SC 1974 12/19/91 35 yrs. Courthouse Green/Richmond, VA 1974/78 12/31/84 35 yrs. Courtney Square/Raleigh, NC 1979/81 07/08/93 35 yrs. The Cove at Lake Lynn/Raleigh, NC 1986 12/01/92 35 yrs. Craig Manor/Salem,VA 1975 11/06/87 35 yrs. The Creek/Wilmington, NC 1973 06/30/92 35 yrs. Crescent Square/Atlanta, GA 1970 03/22/89 35 yrs. Dover Village/Orlando, FL 1981 03/31/93 35 yrs. Eastwind/Virginia Beach, VA 1970 04/04/88 35 yrs. Eden Commons/Columbia, MD 1984 12/29/92 35 yrs. Emerald Bay/Charlotte, NC 1972 02/06/90 35 yrs. English Hills/Richmond, VA 1969/76 12/06/91 35 yrs. Forest Hills/Wilmington, NC 1964/69 06/30/92 35 yrs. Forestbrook/Columbia, SC 1974 07/01/93 35 yrs. Foxcroft/Tampa, FL 1972 01/28/93 35 yrs. Gable Hill/Columbia, SC 1985 12/04/89 35 yrs. Gatewater Landing/Glen Burnie, MD 1970 12/16/92 35 yrs. Grand Oaks/Charlotte, NC 1966/67 05/01/84 35 yrs. Hampton Court/Alexandria, VA 1967 02/19/93 35 yrs. Harbour Town/Nashville, TN 1974 12/10/93 35 yrs. Heather Lake/Hampton, VA 1972/74 03/01/80 35 yrs. Heatherwood/Greenville, SC 1978 09/30/93 35 yrs. Heritage Trace/Newport News, VA 1973 06/30/89 35 yrs. The Highlands/Charlotte, NC 1970 01/17/84 35 yrs. Key Pines/Spartanburg, SC 1974 09/25/92 35 yrs. The Lakes/Nashville, TN 1986 09/15/93 35 yrs. Lake Washington Downs/Melbourne,FL 1984 09/24/93 35 yrs. Laurel Ridge/Roanoke, VA 1970/72 05/17/88 35 yrs. Laurel Village/Richmond, VA 1972 09/06/91 35 yrs. The Ledges/Winston-Salem, NC 1959 08/13/86 35 yrs. Liberty Crossing/Jacksonville, NC 1972/74 11/30/90 35 yrs. Meadow Run/Richmond, VA 1973/74 12/31/84 35 yrs. Meadowdale Lakes/Richmond, VA 1967/71 12/31/84 35 yrs. The Melrose/Dumfries, VA 1951 12/11/85 35 yrs. Mill Creek/Atlanta, GA 1972 11/11/88 35 yrs. Mill Creek/Wilmington, NC 1986 09/30/91 35 yrs. Northview/Salem, VA 1969 09/29/78 35 yrs. Olde West Village/Richmond, VA 1978/82/85/87 12/31/84 & 8/27/91 35 yrs. Orange Orlando/Orlando, FL 1971 01/21/93 35 yrs. Park Green/Raleigh, NC 1987 09/27/91 35 yrs. Parkwood Court/Alexandria, VA 1964 06/30/93 35 yrs. Patriot Place/Florence, SC 1974 10/23/85 35 yrs. Peppertree/Charlotte, NC 1987 12/14/93 35 yrs. Pinebrook/Clearwater,FL 1977 09/28/93 35 yrs. Plum Chase/Columbia, SC 1974 01/04/91 35 yrs. River Road/Ettrick, VA 1973/74 08/31/81 35 yrs. Riverwind/Spartanburg, SC 1987 12/31/93 35 yrs. Rollingwood/Richmond, VA 1974/78 12/31/84 35 yrs. St. Andrews Commons/Columbia, SC 1986 05/20/93 35 yrs. Spring Forest/Raleigh, NC 1978/81 05/21/91 35 yrs. Stanford Village/Atlanta, GA 1985 09/26/89 35 yrs. Summit-on-Park/Charlotte, NC 1963 01/17/84 35 yrs. Summit West/Tampa, FL 1972 12/16/92 35 yrs. Timbercreek/Richmond, VA 1969 08/31/83 35 yrs. Towne Square/Hopewell, VA 1967 08/27/85 35 yrs. Twin Rivers/Hopewell, VA 1972 01/06/82 35 yrs. Village at Old Tampa Bay/Oldsmar,FL 1986 12/08/93 35 yrs. Windsor Harbor/Charlotte, NC 1971 01/13/89 35 yrs. Woodland Hollow/Charlotte, NC 1974/76 11/03/86 35 yrs. Woodscape/Newport News, VA 1974/76 12/29/87 35 yrs. SCHEDULE XI. Summary of Real Estate Owned (continued) Depreciable Life of Date of Date Building Construction Acquired Component Shopping Centers: Circle/Richmond, VA 1956/62/67 11/01/73 25/35 yrs. Cumberland Square/Dunn, NC 1972/78/84 08/28/86 35 yrs. Deerfield Plaza/Myrtle Beach, SC 1979 01/17/84 35 yrs. Glen Lea/Richmond, VA 1964/85 05/25/83 25 yrs. Gloucester Exchange/Gloucester, VA 1974 11/12/87 35 yrs. Hanover Village/Richmond, VA 1971/72 06/30/86 35 yrs. Kroger Sav-On/Waynesboro, VA 1975 03/07/80 35 yrs. Laburnum Park/Richmond, VA 1988/89 09/28/90 35 yrs. Laburnum Square/Richmond, VA 1978/85 02/11/81 40 yrs. Meadowdale/Richmond, VA 1976/82 12/31/84 35 yrs. Rite Aid/Richmond, VA 1974 12/31/84 35 yrs. Rose Manor/Smithfield, NC 1972/75 08/28/86 35 yrs. The Village/Durham, NC 1965 08/28/86 35 yrs. Village Square/Myrtle Beach, SC 1978/79 05/25/88 35 yrs. Willow Oaks/Hampton, VA 1968/74 08/01/84 35 yrs. Office and Industrial Buildings: Franklin St./Richmond, VA 1890 07/01/86 35 yrs. Meadowdale Offices/Richmond, VA 1983 12/31/84 35 yrs. Statesman Park/Roanoke, VA 1974 05/22/75 33 yrs. Tri-County Buildings/Bristol, TN 1976/79 01/21/81 33 yrs. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. United Dominion Realty Trust, Inc. (registrant) By /s/ James Dolphin James Dolphin Senior Vice President, Secretary, and Chief Financial Officer March 15, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 15, 1994 by the following persons on behalf of the registrant and in the capacities indicated. /s/ John P. McCann /s/ R. Toms Dalton,Jr. John P. McCann R. Toms Dalton, Jr. Director, President and Chief Director Executive Officer /s/ James Dolphin /s/ Jeff C. Bane James Dolphin Jeff C. Bane Director, Senior Vice President, Director Secretary and Chief Financial Officer /s/ Jerry A. Davis /s/ John C. Lanford Jerry A. Davis John C. Lanford Vice President, Controller-Corporate Accounting Director and Chief Accounting Officer /s/ C. Harmon Williams, Jr. /s/ H. Franklin Minor C. Harmon Williams, Jr. H. Franklin Minor Chairman of the Board of Directors Director /s/ Barry M. Kornblau /s/ Robert P. Buford Barry M. Kornblau Robert P. Buford Director, Senior Vice President and Director Director of Apartments	3,806	24,899
277158_1993.txt	277158_1993	1993	277158	ITEM 1. BUSINESS THE COMPANY Southeastern Michigan Gas Enterprises, Inc. (the Company) is a holding company formed in 1977 which owns six direct subsidiaries. The Company provides professional and technical services for its subsidiaries in the areas of finance and accounting, taxes, risk management, human resources, legal assistance and information systems. Southeastern Michigan Gas Company (Southeastern), Battle Creek Gas Company (Battle Creek) and Michigan Gas Company (Michigan Gas) (collectively, the utility subsidiaries) generate revenues through the sale and transportation of natural gas. Set forth in the table below is sales and transportation information for the past three years: Residential and commercial gas sales revenues are sensitive to weather as residential and commercial customers use natural gas primarily for space heating purposes. Industrial sales and transportation volumes and margins are primarily dependent upon the comparative cost of alternate fuels, economic conditions and government policies. Southeastern and Michigan Gas are subject to the jurisdiction of the MPSC as to various phases of their operations including rates, accounting, service standards and the issuance of securities. Battle Creek is subject to the jurisdiction of the MPSC as to various phases of its operations including accounting, service standards and issuance of securities, but not as to rates. Battle Creek's rates are subject to the jurisdiction of the City Commissioners of Battle Creek, Michigan. SEMCO Energy Services, Inc. (SEMCO) was formed in 1986 to take advantage of the natural gas marketing opportunities created by deregulation in the natural gas industry. SEMCO also has operations and interests in natural gas transmission and gathering systems, an underground natural gas storage field, a gas processing plant and oil and gas properties. Some of these interests were obtained through equity investments where an unrelated party is the operator. The majority of these activities are regulated by various state regulatory agencies with respect to maximum rates charged to customers. Set forth below are SEMCO's operating revenues, cost of gas marketed, volumes, average number of customers and earnings (loss) from equity investments for the past three years: SEMCO's gas marketing margins and volumes are sensitive to the comparative costs of alternate fuels, seasonal patterns and competition within the gas marketing industry. As FERC Order 636 is implemented, the gas marketing industry will face increasing competition but will also be presented with new opportunities. See "Management's Discussion and Analysis" for further discussion relating to Order 636. Southeastern Development Company's (SEDCO's) principal activities consist of developing a residential real estate project and assisting in the gas supply and transportation procurement for a cogeneration general partnership in which it owns a 50% interest. At this time, SEDCO has no plans to expand its real estate operations. Southeastern Financial Services, Inc. (SFS) leases motor vehicles and data processing equipment primarily to companies of the consolidated group. Gas Supply. The service territories of the utility subsidiaries are served by four major interstate pipelines: Panhandle Eastern Pipe Line Company, Northern Natural Gas Company, Great Lakes Gas Transmission Company and ANR Pipeline Company. In 1993, 10% of the natural gas volumes purchased by the utility subsidiaries were from interstate pipelines. Eighty-nine percent of 1993 gas purchases were from the spot market or from firm suppliers at prices indexed to the spot market. These supplies are transported to the utility subsidiaries' systems under various firm and interruptible transportation arrangements with interstate and intrastate transmission companies. Less than one percent of 1993 gas purchases were from intrastate suppliers. The Company has provided for 80% of its annual gas requirements under long-term firm contracts with prices indexed to market prices. The Company expects to purchase the remaining 20% of annual requirements on the spot market. All of the Company's transportation requirements are covered by firm agreements. The Company utilizes on-system and leased storage capacity of approximately 40% of annual gas sales volumes to reduce its reliance on the interstate pipelines for peak day needs and purchase gas at lower prices. The utility subsidiaries own underground storage facilities with a working capacity of 5.2 Bcf. In addition, the Company leases 6.9 Bcf of storage from Eaton Rapids Gas Storage System and 3.9 Bcf from non-affiliates. SEMCO Gas Storage Company (an affiliated company) is a 50% owner of Eaton Rapids Gas Storage System. SEMCO obtains its gas supply from various production sources, primarily located in Louisiana, Oklahoma and Michigan. SEMCO generally contracts for gas supply on a monthly basis, however, it does enter into some long-term gas purchasing arrangements. See Note 1 of "Notes to the Consolidated Financial Statements" for a further description of SEMCO's gas supply strategy. New Business. Since 1987 the Company has added approximately 5,000 customers per year. Customer additions have been primarily residential and commercial. Clean air legislation and resultant pressures on industry and electric utilities to reduce emissions from their plants continue to support interest in natural gas as an industrial fuel. The use of natural gas as a primary vehicle fuel is also receiving serious attention for the same environmental reasons. Rates and Regulation. Management continually reviews the adequacy of the utility subsidiaries' rates. It is management's intention to file requests for rate increases whenever it is deemed necessary and appropriate. There have been no general rate filings by Southeastern since 1983 or Michigan Gas since 1990. Battle Creek last placed new rates into effect in 1991. In 1992, the MPSC issued a generic order addressing the accounting for the cost of postretirement benefits other than pensions. Pursuant to this order, the utility subsidiaries must file generic rate cases before 1996 in order to recover certain expenses related to this change in accounting treatment. The utility subsidiaries plan to file these cases before 1996 and any relief granted by the MPSC will be based on all elements of cost of service. See Note 7 of "Notes to the Consolidated Financial Statements" for further discussion. Competition. Natural gas competes with other forms of energy available to customers, primarily on the basis of rates. These competitive forms of energy include electricity, coal, propane and fuel oils. Changes in the availability or price of natural gas or other forms of energy, as well as business conditions, conservation, legislation, regulations, capability to convert to alternate fuels and other factors may affect the demand for natural gas in areas served by the Company's subsidiaries. The Company's subsidiaries sell natural gas to and transport natural gas for several large customers who have the ability to use alternate fuels. In addition, the Company's marketing operations compete with other marketing firms on the basis of price, the ability to arrange suitable transportation to the customer's premises and the ability to provide related services such as pipeline nominations and balancing. FERC Order 636 has increased competition in the natural gas industry as pipelines unbundle their services and instead offer separate service for gas transportation, storage and gathering. See "Management's Discussion and Analysis" for a further discussion of Order 636. ITEM 2. ITEM 2. PROPERTIES The total properties of the Company consist of the Common Stock of Southeastern Michigan Gas Company, Michigan Gas Company, Battle Creek Gas Company, SEMCO Energy Services, Inc., Southeastern Development Company, Southeastern Financial Services, Inc., and leasehold improvements and office equipment. SOUTHEASTERN MICHIGAN GAS COMPANY Southeastern owns gas supply systems which, on December 31, 1993, included approximately 112 miles of transmission pipelines and 1,732 miles of distribution pipelines. The pipelines are located in southeastern Michigan (centered in and around the City of Port Huron) and south-central Michigan (centered in and around the City of Albion). Southeastern's distribution system and service lines are, for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Southeastern with permission or consent, except to an inconsequential extent, of the individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities. Southeastern's underground storage system consists of six salt caverns and a depleted gas field, located in St. Clair County, Michigan, together with measuring, compressor and transmission facilities. The aggregate working capacity of the system is approximately 3.5 Bcf, with a capacity to deliver 86 MMcf on a peak day. Southeastern also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. Southeastern leases its computer and transportation equipment. Southeastern's principal plants and properties are held subject to the lien of the Indenture of Mortgage and Deed of Trust securing its First Mortgage Bonds. BATTLE CREEK GAS COMPANY Battle Creek owns gas supply systems which, on December 31, 1993, included approximately 27 miles of transmission pipelines and 612 miles of distribution pipelines. The pipelines are located in southwestern Michigan (centered in and around the City of Battle Creek, Michigan). Battle Creek's distribution system and service lines are, for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Battle Creek with permission or consent, except to an inconsequential extent, of the individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities. Battle Creek owns and operates underground gas storage facilities in a depleted salt cavern and two depleted gas fields. The aggregate working capacity of the storage system is approximately 1.7 Bcf. Battle Creek also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. Battle Creek leases its computer and transportation equipment. MICHIGAN GAS COMPANY Michigan Gas owns gas supply systems located in the southwest portion of Michigan's lower peninsula and the central and western areas of Michigan's upper peninsula. The systems include 1,943 miles of distribution pipeline, meters, service lines, gas regulating and metering stations, garages, warehouses, and other buildings necessary and useful in conducting its business. Michigan Gas leases its computer equipment, transportation equipment, and certain buildings. Michigan Gas's distribution system and service lines are for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Michigan Gas with permission or consent, except to an inconsequential extent, of individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities. SEMCO ENERGY SERVICES, INC. The principal properties of SEMCO and its affiliates include interests and operations in natural gas transmission and gathering systems and an underground gas storage system. Set forth in the following table are the equity investments of SEMCO and its affiliates, the total non-current asset balance of each entity, and SEMCO's ownership percentage and equity investment at December 31, 1993: SEMCO Arkansas Pipeline Company (a wholly-owned subsidiary of SEMCO) is a 32% general partner in the NOARK Pipeline System. The partnership operates a 302-mile pipeline crossing northern Arkansas which completed its first year of service in 1993. The pipeline provides pipeline capacity to producers in the Arkansas section of the Arkoma Basin and access to new natural gas service to communities along the pipeline route. See Note 8 of the "Notes to the Consolidated Financial Statements" for a discussion of commitments made relating to this project. SEMCO Gas Storage Company (a wholly-owned subsidiary of SEMCO) owns a 50% equity interest in the Eaton Rapids Gas Storage System. This system consists of approximately 12 Bcf of underground storage capacity located near Eaton Rapids, Michigan. The system became operational in March 1990. Of the total capacity, 6.5 Bcf has been contracted by Southeastern, Battle Creek, and Michigan Gas (affiliated companies) under long-term contracts. The remainder is leased to non-affiliated companies. SEMCO Pipeline Company (SEMCO Pipeline) (a wholly-owned subsidiary of SEMCO) is an 11% owner of Nimrod Natural Gas Corporation (Nimrod) of Tulsa, Oklahoma. Nimrod engages in the business of installing or purchasing and operating natural gas gathering systems. These systems purchase, collect and re-sell wellhead natural gas by delivering it to major transportation pipelines for redelivery to customers. SEMCO Pipeline also is a 50% owner of the Michigan Intrastate Pipeline System and the Michigan Intrastate Lateral System, whose sole purpose is to own 10% of the Saginaw Bay Pipeline Project. The Saginaw Bay Pipeline Project is a 126-mile pipeline from Michigan's Saginaw Bay area to processing plants in Kalkaska, Michigan. The following table sets forth the operations wholly or partially owned by SEMCO and its affiliates, the total net property of the project, and SEMCO's ownership percentage and net property at December 31, 1993: SEMCO Pipeline is a 33% owner in the Litchfield Lateral, a 31-mile pipeline located in southwest Michigan. The line, which is leased entirely to ANR Pipeline Company, links the Eaton Rapids Gas Storage System with interstate pipeline supplies. The Litchfield Lateral began operations in February 1993. In 1991, SEMCO Pipeline constructed an 18-mile pipeline to serve Detroit Edison's Greenwood power plant located in Michigan's thumb area. SEMCO Pipeline and Detroit Edison have entered into an agreement whereby Detroit Edison has contracted for the entire capacity of the line of 240 MMcf per day. SEMCO Pipeline is a 40% owner of the Iosco County Pipeline and Reno Gas Processing Plant (Iosco-Reno System), which was placed in service in September 1992. The Iosco-Reno System gathers and processes wet gas in the Au Gres and Santiago fields located in mid-Michigan for delivery to the processing plant and ultimate delivery to the gas markets. SEMCO Pipeline completed the 7.1-mile Eaton Rapids Pipeline in 1990, providing direct delivery of gas from the Eaton Rapids Gas Storage System to Battle Creek and Southeastern's Albion division. OTHER The principal properties of SFS consist of vehicles and data processing equipment primarily leased to affiliates. SEDCO's principal properties include real property and related improvements held for resale, office properties leased to affiliates and third parties, and its equity investment in the Dunn/SECO cogeneration venture. The non-affiliate properties of SFS and SEDCO total $5.1 million or 2.4% of consolidated utility plant and other property, net. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Refer to Note 8 of "Notes to the Consolidated Financial Statements" for information regarding a lawsuit against the NOARK Pipeline System. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS COMMON STOCK DATA The common stock of the Company is traded in the over-the-counter market and is quoted on the NASDAQ National Market System under the symbol "SMGS." The table below shows high and low closing bid prices of the Company's common stock in the over-the-counter market as reported by the Detroit Free Press and quoted on NASDAQ/NMS, adjusted to reflect the 5% stock dividends in May 1992 and 1993. These quotations reflect dealer prices, without brokerage commission, and may not necessarily represent actual transactions. See the cover page for a recent stock price and the number of shares outstanding. See "Selected Financial Data" below for the number of shareholders at year end for the past five years. DIVIDENDS See Notes 4 and 10 of "Notes to the Consolidated Financial Statements" and "Selected Financial Data." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Net Income Net income available for common stock before extraordinary item was $9.7 million ($1.02 per share) for the year ended December 31, 1993. This represented an increase of $529,000 over the $9.2 million ($.99 per share) net income available for common stock before extraordinary item for the year ended December 31, 1992. The Company recorded extraordinary charges for 1993 and 1992 of $177,000 ($.02 per share) and $901,000 ($.09 per share), respectively, for the early extinguishment of debt. The improvement in net income before extraordinary items primarily reflects increased earnings from the Company's natural gas distribution operations. Colder weather and customer additions resulted in a 4.4% increase in natural gas volumes sold. Earnings from natural gas marketing, gas transmission and gas gathering operations also increased in 1993 compared to 1992. Natural gas volumes marketed increased 6.3% over the 1992 level along with higher per unit marketing margins. In addition, 1993 earnings reflect the revenues from SEMCO's investment in two recently completed pipeline projects located in Michigan. These earnings offset a loss in 1993 from the Company's investment in the NOARK Pipeline System, which began operations in September 1992, and higher charges related to the Company's remaining oil and gas exploration and production operations. For 1992, net income available for common before extraordinary item increased $1.9 million over 1991 from $7.3 million ($.81 per share) to $9.2 million ($.99 per share). The increase was primarily the result of the impact of colder temperatures and customer additions on natural gas volumes sold by the Company's utility subsidiaries. Operating Revenues and Gross Margin Natural Gas Distribution. The Company's natural gas distribution business involves operations of Southeastern Michigan Gas Company, Battle Creek Gas Company and Michigan Gas Company. These companies generate revenue through the sale and transportation of natural gas. The following table compares sales and transportation information for the last three years: Natural gas sales volumes and gross margin from gas sales increased 1,655 MMcf and $3.3 million for 1993 compared to 1992. Temperatures 2.5% colder than 1992 and 5% colder than normal resulted in increased gas usage by weather-sensitive residential and commercial users in 1993. The addition of an average of 5,683 new gas sales customers in 1993, or 2.8%, generated increased gas sales and service charge revenues. For 1992, compared to 1991, gas sales volumes and margin increased 2,159 MMcf and $2.5 million, respectively. Temperatures during 1992 were 7.6% colder than 1991 and 2.2% colder than normal. In addition, the average number of customers increased in 1992 compared to 1991 by 4,811, or an increase of 2.4%. Transportation volumes decreased 3,073 MMcf in 1993 from 1992 while revenues increased slightly. For 1992, compared to 1991, transportation volumes decreased 210 MMcf while revenues increased $182,000. In 1992 and 1991, the Company transported significant coal-displacement volumes. Coal-displacement volumes are sensitive to natural gas prices relative to coal and are priced at lower margins. Due to the relative prices of coal and natural gas during the year, the Company did not benefit from any coal-displacement volumes in 1993. Natural Gas Marketing. Marketing margins were $3.5 million, $2.2 million and $2.3 million in 1993, 1992 and 1991, respectively. These margins relate to natural gas volumes marketed of 31,501 MMcf, 29,637 MMcf and 28,636 MMcf for the same period. Generally, the price of alternate fuels, seasonal patterns and competition in the industry contribute to the fluctuation in margins per unit of gas marketed and the volumes marketed. In addition, the improvement for 1993 compared to prior years reflects SEMCO's emphasis on expanding its level of marketing-related services coincident with Order 636 and an increase in marketing staff. Other Operating Revenues. Other operating revenues consist of the revenues generated by natural gas transmission and gathering activities, oil and gas exploration and production, natural gas cogeneration, real estate development, equipment leasing and miscellaneous utility revenue. Revenues generated by these operations were $6.4 million, $6.1 million and $5.5 million in 1993, 1992 and 1991, respectively. The increases principally result from SEMCO's interest in the operations of various natural gas transmission and gathering projects placed in service in recent years. The revenues generated by these projects offset the declines in equipment leasing, real estate development and oil and gas activities since 1991. Operating Expenses and Income Deductions Operations expense increased $817,000, or 3.8%, in 1993 compared to 1992. This increase results primarily from operating costs for distribution and underground gas storage systems and expenses associated with additional customers. For 1992 compared to 1991, operations expense decreased $188,000 due to reductions in the level and cost of contracted services partially offset by increases in uncollectible accounts expense related to leasing activities. Depreciation expense increased $124,000, or 1.0%, in 1993 compared to 1992 and $206,000, or 1.7%, in 1992 compared to 1991. The increase over 1992 reflects depreciation expense associated with growth in utility plant and other property, depletion associated with the Company's remaining oil and gas properties, partially offset by reductions in depreciation expense resulting from the reduction of property leased to non-affiliates. The increase in 1992 over 1991 reflects plant growth, partially offset by lower charges to oil and gas properties in 1992 compared to 1991. Income taxes increased $1.6 million in 1993 compared to 1992 and $539,000 in 1992 compared to 1991. Increases in income taxes are principally due to the improvement in earnings and the increase in statutory tax rates from 34% to 35% in 1993. Taxes other than income taxes consist primarily of property taxes. The year-to-year increases in property taxes reflect growth in the Company's gas distribution, transmission and gathering plant. Other interest expense, consisting primarily of interest on short-term borrowings, increased $365,000, or 26%, in 1993 compared to 1992 and decreased slightly in 1992 from 1991. The average balance in short-term borrowings was $42.3 million in 1993, $22.3 million in 1992 and $15.7 million in 1991 at weighted average interest rates of 4.1%, 4.5% and 6.8%, respectively. The increased level of borrowings substantially results from the build-up of permanent capital needs generated by capital expenditure programs and the impact of gas costs on inventory carrying amounts and other working capital requirements. Other Income, Net Other income, net, consists primarily of income from SEMCO's equity investments but also includes miscellaneous nonoperating income and expense items, net of tax. Other income, net, was $41,000, $562,000 and $570,000 in 1993, 1992 and 1991, respectively. Specific items reflected in the year-to-year change are losses from the investment in the NOARK Pipeline System of $834,000 and $233,000 in 1993 and 1992, respectively, and a $665,000 after-tax charge to the Company's real estate development activities in 1991. Partially offsetting the impact of these items on other income, net, were year-to-year improvements in the earnings from the Company's investment in Eaton Rapids Gas Storage System. NOARK completed its first year of operation in September 1993. Through a subsidiary, the Company holds a 31.67% general partnership interest in the $102.6 million pipeline. NOARK has an operating capacity of 141,000 Mcf a day. During 1993, NOARK had firm transportation contracts averaging 78,000 Mcf a day at a demand fee equal to approximately 19.3 cents per Mcf. Actual gas volumes transported by the pipeline during 1993 averaged nearly 79,000 Mcf a day, or 56% of capacity, at both firm and interruptible rates. See Note 8 of Notes to the Consolidated Financial Statements for a discussion of the Company's guarantees related to the pipeline's financing and legal actions involving NOARK. LIQUIDITY AND CAPITAL RESOURCES Cash Flows The Company's net cash provided from operating activities totalled $12.1 million in 1993, $3.2 million in 1992 and $18.1 million in 1991. The change in operating cash flows is significantly influenced by changes in the level and cost of gas in underground storage, accounts receivable and unbilled gas sales, gas cost recoveries and accounts payable. The changes in these accounts are largely the result of the timing of receipts and payments. The Company uses significant amounts of short-term borrowings to finance natural gas purchases for storage during the non-heating season to sell during the heating season. The Company owns and leases natural gas storage facilities with available capacity approximating 40% of annual gas sales. Generally, gas is stored during the months of April through October and withdrawn for sale from November through March. The carrying amount of natural gas stored underground peaked at $45.7 million, $42.1 million and $34.6 million in October 1993, 1992 and 1991, respectively. Net cash from financing activities totalled $12 million in 1993, $26.3 million in 1992 and $11.8 million in 1991. During 1993, $20 million in funds were provided through a term loan, due May 31, 1997 and $5.4 million in proceeds from the Dividend Reinvestment and Common Stock Purchase Plan (DRIP). During 1993, funds were used for the payment of dividends and to repay certain portions of long-term and short-term debt outstanding. In addition to funds provided from the DRIP and short-term lines of credit in 1992, the Company issued $25 million of 8 5/8% debentures due in 2017. Funds in 1992 were used for the payment of dividends and to redeem $14.9 million in 11 1/2% debentures originally due 2000 at 105% of face value. This redemption resulted in an extraordinary charge to income of $901,000 ($.09 per share) in 1992. In 1991, funds provided by proceeds from the DRIP and short-term lines were used to pay dividends and pay down long-term debt. The following table identifies capital expenditures for the three years: Capital expenditures by the Company's natural gas distribution companies amounted to $19.2 million in 1993. In addition to normal plant repair and replacement expenditures of $7.4 million, $11.8 million was spent for new customer additions. Of the $19.9 million spent by the distribution companies in 1992, $14.3 million was for new customer additions. The remainder was primarily for normal repair and replacement projects. In 1991, the distribution companies spent $10.8 million for new customer additions, $1.2 million on an interconnect with the Greenwood Pipeline and the remainder primarily on normal repair and replacement of distribution properties. Capital expenditures for operations other than natural gas distribution were principally to complete the Litchfield Lateral pipeline. Of the natural gas transmission, gathering and storage capital expenditures in 1992, $5.1 million was spent on SEMCO's investment in the NOARK Pipeline System. Another $2.6 million was spent toward completion of the Litchfield Lateral project and $1.1 million toward the Iosco/Reno gas gathering and processing facility. During 1991, the Company spent $8 million to complete the Greenwood Pipeline and $2.6 million on the Eaton Rapids Gas Storage System. Future Capital Expenditures and Liquidity 1994 Capital Expenditures. For 1994, the Company plans to expend $23.2 million on capital additions. Of this amount $19.9 million is planned for natural gas distribution operations, with $11.8 million targeted for new customer additions. Future Financing. Funds needed for the Company's 1994 capital expenditure program and dividend payments will be financed primarily through internally- generated funds and utilization of short-term lines of credit. At year end 1993, the Company had short-term credit facilities totalling $70 million. A significant source of funds has been the level of dividends reinvested and optional payments made by shareholders to the DRIP. In 1993, of the total dividends on common shares of $7.4 million, $2.8 million were reinvested into common stock. This portion of dividends along with optional cash payments of $2.6 million resulted in 246,733 new shares issued to existing shareholders in 1993. In December 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission to offer up to $80 million aggregate principal amount of debentures and up to 750,000 shares of common stock. In January 1994, the Company issued 747,500 shares of common stock pursuant to the shelf. Net proceeds approximating $14.7 million were used to pay down notes payable incurred to finance the Company's ongoing capital expenditure programs and for general corporate purposes. The Company is considering the issuance of debentures primarily to redeem some of its long-term debt outstanding for the purpose of reducing interest expense. If these redemptions take place in 1994, the expensing of the call premiums and unamortized debt expense would result in an extraordinary loss on early extinguishment of debt in 1994 of up to $1.3 million. In February 1994, the Company called the $21.2 million of its 10% debentures due 2007 and the $12.5 million of its 10% debentures due 2008. These debentures were called at 104.5% of face value. Expensing of the portion of the call premium and unamortized debt expense associated with the Company's non-regulated operations resulted in a $177,000 ($.02 per share) extraordinary charge to income in 1993. The Company plans to issue long-term debt securities at a lower interest rate to refinance these debentures, including the call premium, in the near future. The Company will use its available short-term lines of credit to fund the called debt until the new securities are issued. In connection with the redemption of debentures, Southeastern and Michigan Gas filed securities applications in December 1993 with the MPSC requesting authority to redeem corresponding long-term debt owed to the Company. The Company expects these applications will be approved by the MPSC in early 1994. See Note 8 of Notes to the Consolidated Financial Statements for a discussion of the Company's guarantees related to the NOARK Pipeline System's financing. Commodity Futures Contracts. The Company's natural gas marketing subsidiary, SEMCO has entered into various long-term sales agreements with fixed prices that extend through October 1996. Fixed-price sales commitments are hedged with either fixed-price purchase commitments from reliable suppliers or commodity futures contracts purchased on the NYMEX. The futures contracts are subsequently sold when the supply is purchased for delivery under the sales agreements. At December 31, 1993, SEMCO had commitments to sell and deliver approximately 13,200 MMcf, of which approximately 5,000 MMcf was covered by purchase commitments from reliable suppliers and 8,200 MMcf was covered by commodity futures contracts. OTHER AREAS Adoption of New Accounting Standards In the first quarter of 1993, the Company adopted two new standards issued by the FASB. In December 1990, the FASB issued SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS 106 requires the accrual method of accounting for postretirement benefits. In February 1992, the FASB issued SFAS 109, "Accounting for Income Taxes." SFAS 109 requires measurement and restatement of deferred tax assets and liabilities based upon the estimated future tax effects of temporary differences and carryforwards. Although the adoption of these standards did not have a material impact on the Company's result of operations in 1993, adoption of SFAS 106 by the utility subsidiaries has significant regulatory ratemaking implications. See Note 7 and Note 3 of the Notes to the Consolidated Financial Statements for further discussion of SFAS 106 and SFAS 109. Impact of Inflation The cost of gas sold by the three distribution companies is recovered from natural gas distribution customers on a current basis. Although inflation has steadied in recent years, increases in other utility operating costs are recovered through the regulatory process of filing a rate case, and therefore may adversely affect the results of operations in inflationary periods due to the time lag involved in this process. The Company attempts to minimize the impact of inflation by controlling costs, increasing productivity and filing rate cases on a timely basis. It is likely the utilities will be filing rate cases before January 1996 in conjunction with the adoption of SFAS 106. See Note 7 of the Notes to the Consolidated Financial Statements. INDUSTRY TRENDS Competition The market prices of alternate sources of energy such as coal and #6 fuel oil compete directly with the price the utilities charge for industrial sales and transportation of gas. The prices of alternate fuels similarly affect the volumes and margins of the natural gas marketing operations of the Company. In addition, continued deregulation of the natural gas industry has further increased the sources of competition. See "Federal Regulation" discussion below. To lessen the impact of prices on fuel choice by industrial customers, the Company offers additional services, such as gas storage and balancing. However, the competition among fuels is expected to continue to affect volumes sold, transported and marketed and the associated margins. Federal Regulation Interstate pipelines were required to comply with FERC Order 636 by the 1993-1994 heating season. Order 636, intended to increase competition within the gas industry, requires pipelines to unbundle their services and instead offer separate service for gas transportation, storage and gathering. Competition. As a result of this restructuring of the interstate pipeline service, natural gas distribution companies have the ability to select and pay for only those pipeline services they require. In addition, Order 636 allows customers on natural gas distribution systems to purchase the same level of unbundled service directly from the interstate pipelines. Under such circumstances, natural gas distribution companies generally provide transportation services to those customers. It is expected that the availability of unbundled pipeline services to customers will result in pressure on gas distribution companies to offer similar unbundled services in order to compete with the pipelines. The Company anticipates this competition may result in pressure to reduce natural gas transportation margins. Currently, the utility subsidiaries are providing transportation services principally to large industrial customers. In addition to pressure on the transportation margins of the utility subsidiaries, Order 636 will impact the natural gas marketing operations of SEMCO. Access to unbundled pipeline services is expected to attract new competitors to the marketing industry and present opportunities for marketers to offer expanded services to their customers. The Company believes it is well-positioned to compete in the post-Order 636 environment. Through the combination of on-system underground gas storage facilities and leased storage facilities, the utility subsidiaries are able to offer a variety of gas service options to their customers. In addition, the Company has significant experience in the natural gas marketing industry through SEMCO, which began its marketing operations in 1986. Gas Supply. Order 636 has the effect of shifting the risk of securing reliable gas supply and managing pipeline capacity from the interstate pipelines to local gas distribution companies. As a result, gas utilities face more complex gas supply procurement issues. However, the Company does not expect Order 636 to significantly affect the gas supply operations of the utility subsidiaries. For the past several years, the utilities have reduced their dependence on bundled service from the interstate pipelines. In addition, on-system underground gas storage facilities and leased storage of Southeastern, Battle Creek and Michigan Gas will provide the needed flexibility in gas supply planning and balancing between interstate pipeline deliveries and customer use patterns expected to arise from Order 636. The Company's utility subsidiaries are served by four interstate pipelines, Panhandle Eastern Pipe Line Company, ANR Pipeline Company, Great Lakes Gas Transmission Company and Northern Natural Gas Company. These pipelines have received authority from the FERC to substantially implement their restructuring plans effective November 1, 1993. In conjunction with these plans, the FERC has given interstate pipelines authority to directly bill customers for certain transition costs resulting from the restructuring. As former purchasers of bundled interstate pipeline service, the utility subsidiaries are responsible for some of these transition costs. To date, the utility subsidiaries have been billed approximately $2 million in Order 636 transition costs. At this time, no further significant direct-billed transition costs are anticipated. As with previously FERC-mandated billings, the Company believes Order 636 transition costs will be recoverable from ratepayers through gas cost recovery mechanisms. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The accompanying notes to the consolidated financial statements are an integral part of these statements. The accompanying notes to the consolidated financial statements are an integral part of these statements. The accompanying notes to the consolidated financial statements are an integral part of these statements. The accompanying notes to the consolidated financial statements are an integral part of these statements. The accompanying notes to the consolidated financial statements are an integral part of these statements. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation. The consolidated financial statements include the accounts of Southeastern Michigan Gas Enterprises, Inc. (the Company) and its wholly-owned subsidiaries, Southeastern Michigan Gas Company (Southeastern), Battle Creek Gas Company (Battle Creek), Michigan Gas Company (Michigan Gas), SEMCO Energy Services, Inc. (SEMCO), Southeastern Financial Services, Inc. and Southeastern Development Company. Investments in unconsolidated companies at least 20% owned, but not greater than 50% owned, are reported using the equity method of accounting. All significant intercompany transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform with 1993 presentations. Rate Regulation. The Company accounts for the effects of regulation under SFAS 71, "Accounting for the Effects of Certain Types of Regulation." As a result, the actions of regulators affect when revenues, expenses, assets and liabilities are recognized. The rates of the utility subsidiaries, Southeastern, Battle Creek and Michigan Gas, are subject in certain respects to the requirements of state and local regulatory bodies. The MPSC authorizes the rates charged to customers by Southeastern and Michigan Gas. Battle Creek's rates are subject to the jurisdiction of the City Commission of Battle Creek, Michigan. Utility Plant, Other Property and Depreciation. Utility plant in service is recorded at cost. The utility subsidiaries provide for depreciation on a straight-line basis over the estimated useful lives of the related property. Included in other property are the nonutility fixed assets of the Company and its subsidiaries, reduced by the related accumulated depreciation. Generally, these assets are recorded at cost and depreciated on a straight-line basis over their estimated useful lives. The ratio of depreciation to the average balance of property approximated 4.3%, 4.6% and 5.2% for the years 1993, 1992 and 1991, respectively. Certain investments in unconsolidated companies recorded using the equity method are also reported as other property. See Note 9 for further discussion. Receivables, Gas Sales, Transportation and Marketing Revenues. Customer receivables, gas sales and transportation revenues arise from the operations of the utility subsidiaries. These subsidiaries deliver natural gas to a broadly diversified base of residential, commercial and industrial customers located within the state of Michigan. Marketing revenues and receivables arise from SEMCO's marketing operations. SEMCO markets natural gas to industrial customers and gas distribution utilities located in Michigan, Ohio and Illinois. Revenue Recognition. Southeastern, Michigan Gas and Battle Creek bill monthly on a cycle basis and follow the industry practice of recognizing revenue for gas services rendered to their customers but not billed at month end. These amounts are presented as accrued utility revenue in the balance sheet. SEMCO enters into natural gas futures and options contracts to mitigate the effects of gas price fluctuations on its fixed-price marketing contracts. Gains and losses on these transactions, accounted for as hedges, are included in revenues in the same period natural gas is delivered to customers pursuant to the marketing contracts. Futures and options contracts are purchased almost exclusively on the NYMEX. Hedge Accounting. The fair market value of futures and options contracts and any deferred gains or losses are included with related contract deposits in other current assets. At December 31, 1993, the fair market value of SEMCO's 820 futures contracts and 260 option contracts were $934,000 and $135,000, respectively. SEMCO also maintained $2,000,000 in related deposits and recorded $2,387,000 in net deferred futures contract losses. There were immaterial amounts recorded in 1992 related to SEMCO's hedging activities. Gas in Underground Storage. Gas in underground storage for Southeastern, Michigan Gas and SEMCO is reported at average cost. Battle Creek's gas inventory is stated at last-in, first-out (LIFO) cost. At December 31, 1993 and 1992, the balance in this account approximates the replacement value of the gas in storage. In general, commodity costs and variable transportation costs are capitalized as gas in underground storage. Fixed costs, primarily pipeline demand charges and storage charges, are expensed as incurred through cost of gas. Cost of Gas. The utility subsidiaries have gas cost recovery mechanisms which allow for the adjustment of rates charged to customers in response to increases and decreases in the cost of gas purchased. As permitted by the regulatory jurisdiction, increases or decreases in the cost of gas purchased are subsequently recovered from or refunded to customers. Income Taxes. Deferred income taxes are recorded for differences between the book and tax basis of certain assets and liabilities. Income tax expense includes Federal and state taxes currently payable and deferred income tax expenses resulting from adjustments to deferred income tax assets and liabilities. Investment tax credits (ITC) utilized in prior years for income tax purposes are deferred for financial accounting purposes and are amortized through credits to the income tax provision over the lives of the related property. The Company and its subsidiaries file a consolidated Federal income tax return. Income taxes are allocated to each subsidiary based on its separate taxable income. Oil and Gas Properties. The Company accounts for oil and gas properties under the successful efforts method of accounting. Under this method, costs of productive wells, developmental dry holes and productive leases are capitalized and amortized on a unit-of-production basis over the life of remaining related reserves. Cost centers for amortization purposes are determined on a field-by-field basis. The estimated future costs of dismantlement, restoration and abandonment are amortized as part of depreciation, depletion and amortization expense. Oil and gas leasehold costs are capitalized when incurred. Unproved properties are assessed periodically and any impairments in value are charged to depreciation expense. Exploratory expenses, including geological and geophysical expenses and annual delay rentals for oil and gas leases, are charged to expense as incurred. Exploratory drilling costs, including stratigraphic test wells, are initially capitalized, but charged to expense if and when the well is determined to be unsuccessful. Oil and gas properties are reported as other property and expenses related to oil and gas exploration activities are reported as operations expense and depreciation. Statement of Cash Flows. For purposes of the consolidated statement of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash and temporary cash investments. Non-cash investing and financing activities for the years 1993, 1992 and 1991 are as follows (in thousands of dollars): 2. REGULATORY MATTERS Take-or-Pay. The take-or-pay liabilities of the utility subsidiaries arose pursuant to FERC actions involving deregulation of natural gas industry. These costs are substantially recoverable from ratepayers. At December 31, 1993, the Company had a total of $1,475,000 in remaining take-or-pay liabilities. The Company does not anticipate additional take-or-pay assessments. Order 636 Transition Costs. In 1992, the FERC issued Order 636 requiring interstate pipelines to unbundle their services to most customers and instead offer separate services for gas supply, gathering, transportation and storage. Pursuant to the implementation of Order 636 in 1993, the interstate pipelines have incurred transition costs. The FERC has allowed the interstate pipelines to directly bill certain of these transition costs to former sales service customers. As a result, the Company has recorded liabilities of $2,014,000 at December 31, 1993. The Company does not anticipate any significant additional direct billings related to Order 636 transition costs. As with take-or-pay costs, the Company expects Order 636 costs will be recoverable from ratepayers. Securities Applications. In December 1993, Southeastern and Michigan Gas filed applications with the MPSC requesting authority to issue up to $23,000,000 and $31,000,000, respectively, of long-term debt securities to the Company. These applications are in connection with the Company's plans to issue up to $80,000,000 in long-term debt securities to redeem certain outstanding issues. Southeastern and Michigan Gas plan to use the proceeds of this debt to redeem long-term debt and certain short-term debt currently owed to the Company, finance related call premiums and issue costs and, in Southeastern's case, to redeem First Mortgage Bonds outstanding. The Company expects MPSC approval of these securities applications in early 1994. MPSC Orders. In December 1992, the MPSC issued Order U-10040 addressing the adoption of SFAS 106, "Employers' Accounting For Postretirement Benefits Other Than Pensions", by utilities subject to MPSC jurisdiction. In February 1993, the MPSC issued Opinion and Order U-10083 addressing the provisions of the MPSC Uniform System of Accounts for electric and gas utilities related to deferred income tax accounting. Refer to Note 3 for deferred income tax accounting discussion and Note 7 for SFAS 106 discussion. 3. INCOME TAXES SFAS No. 109. In January 1993, the Company prospectively adopted SFAS 109, "Accounting For Income Taxes." Previously, the Company accounted for income taxes under Accounting Principle Board Opinion No. 11. SFAS 109 requires an annual measurement of deferred tax assets and deferred tax liabilities based upon the estimated future tax effects of temporary differences and carryforwards. In general, the total deferred tax expense or benefit for the year equals the difference between the beginning and end of year balances in deferred tax assets and liabilities. In February 1993, the MPSC issued Opinion and Order U-10083 addressing deferred income tax accounting for electric and gas utilities under its jurisdiction. The order granted electric and gas utilities regulated by the MPSC general authorization to use deferred tax accounting and to use specific accounts to comply with SFAS 109. The order also confirmed continued recovery of regulatory assets and refunding of regulatory liabilities arising from deferred tax accounting through current ratemaking practices. Upon adoption, the initial application of SFAS 109 was determined by recomputing the balance sheet deferred tax amounts as of January 1, 1993 using currently enacted tax rates. The most significant adjustments were related to the Company's regulated operations and, since these adjustments are expected to be recovered from or refunded to customers in future rates, were offset on the balance sheet by regulatory assets and regulatory liabilities. As a result, the adoption of SFAS 109 had no material impact on the results of operations. SFAS 109 requires that deferred tax assets and deferred tax liabilities be adjusted for changes in tax rates. During 1993, the Company adjusted these items for a one percent increase in the enacted rate. There was no material impact to operations resulting from this adjustment. Provision for Income Taxes. The components of the provision for income taxes are as follows (in thousands of dollars): Reconciliation of Statutory Rate to Effective Rate. A reconciliation of the difference between the Company's provision for income taxes and income taxes computed at the statutory rate follows (in thousands of dollars): Deferred Taxes. The principal components of the Company's deferred tax assets (liabilities) were as follows (in thousands of dollars): Deferred Tax Expense. In 1992 and 1991, deferred tax expense resulted from timing differences in the recognition of revenue and expense for tax and financial reporting purposes. The sources of these timing differences were as follows (in thousands of dollars): 4. CAPITALIZATION Common Stock Equity. Earnings per share of common stock, cash dividends per share of common stock and average number of common shares outstanding are restated to reflect five percent stock dividends in May 1993, May 1992 and May 1991. The Company has several short-term credit arrangements and long-term debt indentures which contain, among other restrictions, limits on the payment of dividends beyond certain levels of retained earnings. Under the most restrictive of these covenants, all of the Company's retained earnings ($13,691,000) was available for the payment of dividends on any class of stock at December 31, 1993. Under the trust indenture of its First Mortgage Bonds, all of Southeastern's retained earnings ($18,914,000) was available for the payment of dividends on its preferred and common stock at December 31, 1993. In January 1994, the Company issued 747,500 shares of common stock pursuant to a shelf registration. Net proceeds approximating $14,724,000 were used to reduce notes payable to banks incurred to finance the Company's ongoing capital expenditure program and for general corporate purposes. The proceeds are reflected as a reduction in current maturities of long-term debt at December 31, 1993. Cumulative Convertible Preferred Stock. At December 31, 1993 and 1992, 7,605 and 8,791 shares of the Company's $2.3125 cumulative convertible preferred shares were outstanding and each share was convertible at the option of the holder to 4.11 shares of common stock. At December 31, 1993, 31,257 shares of common stock are reserved for issuance upon conversion to holders of the convertible preferred stock. In 1993, 1992 and 1991, preferred shares totalling 1,186, 500 and 706 were converted into 4,873, 2,055 and 2,900 shares of the Company's common stock, respectively. Cumulative Preferred Stock of Subsidiary. The cumulative preferred stock of Southeastern is callable at Southeastern's option at $105 per share. Annually dividends on Southeastern's preferred stock are fully guaranteed by the Company. Long-Term Debt. At December 31, 1993, the aggregate amount of maturities and sinking fund requirements for all issues of long-term debt for each of the next five years are as follows (in thousands of dollars): The $19,138,000 maturing in 1994 includes $33,697,000 of long-term debt called in February 1994, to be refinanced, net of the $14,724,000 proceeds from the common stock offering in January 1994. In February 1994, the Company called, at 104.5% of face value, the $21,169,000 of its 10% debentures due 2007 and the $12,528,000 of its 10% debentures due 2008. This call resulted in an extraordinary charge in 1993 of $177,000, net of tax. The Company plans to issue long-term debt securities at a lower interest rate to refinance these debentures, including the call premium, in the near future. The Company will use its available short-term lines of credit to fund the call until the new securities are issued. Substantially all of Southeastern's utility plant is subject to the lien of the First Mortgage Bonds. 5. SHORT-TERM BORROWINGS The Company maintains unsecured lines of credit at two banks. Interest on all such lines are at variable rates, which do not exceed the banks' prime lending rates. These arrangements are set to expire during 1994 and the Company expects they will be renegotiated at comparable terms. Information regarding these borrowings for each of the last three years is as follows (in thousands of dollars): 6. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each significant class of financial instruments: Cash, temporary cash investments, trade payables and receivables, notes payable to banks, and variable rate long-term debt. The carrying amount approximates fair value. Long-term debt. The fair values of the Company's fixed-rate long-term debt are estimated based on quoted market prices for the same or similar issues or the call price if less. The estimated fair values of the Company's long-term debt as of December 31, 1993 and 1992 are as follows (in thousands of dollars): 7. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS Pension Plans. The Company has non-contributory, defined benefit pension plans, for which the Company is the trustee, covering substantially all employees. Pension plan benefits are generally based upon years of service and compensation during the final years of employment. The Company's funding policy is to contribute amounts annually to the plans based upon actuarial and economic assumptions designed to achieve adequate funding of projected benefit obligations. The Company contributes at least the minimum required by the Employee Retirement Income Security Act of 1974, as amended. At December 31, 1993, plan assets consisted of 48.5% equity investments, 17% guaranteed income insurance contracts, 16.1% fixed income securities and 18.4% cash equivalents. The Company's pension expense was $1,728,000, $1,821,000 and $2,086,000 in the years 1993, 1992 and 1991, respectively. Combined net periodic pension cost for the Company's defined benefit plans consists of the following components (in thousands of dollars): The following table sets forth the funded status of the plans and amounts recognized in the Company's consolidated balance sheet as of December 31, 1993 and 1992 (in thousands of dollars): Significant pension plan assumptions are as follows: Other Postretirement Benefits. In addition to providing pension benefits, the Company provides certain medical and prescription drug benefits to qualified retired employees, their spouses and covered dependents. To qualify, a retiree must have started employment before January 1, 1992 and have had at least ten years of service. Retirees with less than 30 years of service are required to contribute from 5% to 50% of the Company's coverage cost, with the percentage depending on the retiree's age and years of service. Employees hired after January 1, 1992 are not eligible for these benefits under the current plan. In December 1990, the FASB issued SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The new standard requires the Company to change its method of accounting for the cost of postretirement benefits other than pensions that are provided to retirees from a pay-as-you-go (cash) method to a full accrual method. Accrual of such postretirement benefit costs is required during the years that the employee renders service to the Company until the date of full eligibility. The Company adopted SFAS 106 effective January 1, 1993. In December 1992, the MPSC issued a generic order addressing the adoption of SFAS 106 by utilities under their jurisdiction. The order allows Michigan utilities to adopt SFAS 106 for accounting and ratemaking purposes, subject to a final order in a general rate case filed before 1996. The generic order requires external funding for amounts recovered in rates. Pursuant to the order, the Company recorded a liability for the utility subsidiaries' portion of SFAS 106 expense, a corresponding regulatory asset for the anticipated recovery in rates based upon a 20-year amortization period and an expense for the utility subsidiaries' pay-as-you-go costs. The Company plans to file general rate cases in accordance with the order prior to 1996. Any rate relief granted by the MPSC will be based on all elements of cost of service, including this obligation. The combined net postretirement benefit costs consisted of (in thousands of dollars): In 1993, the Company recorded regulatory assets of $4,425,000 for the utility subsidiaries' portion of the SFAS 106 costs and an expense of $153,000 for the nonutility subsidiaries' portion of SFAS 106 costs. Also in 1993, the Company recorded an expense of $688,000 for the utility subsidiaries' portion of postretirement expense incurred under the pay-as-you-go method. In 1992 and 1991, the other postretirement expense incurred under the pay-as-you-go method was $717,000 and $482,000, respectively. The Company funds other postretirement benefits on a discretionary basis through an Internal Revenue Code Section 401(h) account. For the years 1993, 1992 and 1991, the Company made cash contributions to the 401(h) account of $579,000, $314,000 and $318,000, respectively. The funded status of the postretirement benefit plans is reconciled with the liability recorded at December 31, 1993 as follows (in thousands of dollars): Significant plan assumptions are as follows: The 1993 costs were developed based on the substantive health care plan in effect at January 1, 1993. As of December 31, 1993, the actuary assumed that retiree medical cost increases would be 12% in 1993, 11.5% in 1994, and decrease uniformly to 5.8% in 2005 and thereafter and that prescription drug cost increases would be 16% in 1993, 15.2% in 1994, and decrease uniformly to 5.8% in 2005 and thereafter. The health care cost trend rate assumption significantly affects the amounts reported. For example, a one percentage point increase in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $8,268,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit costs for 1993 by $985,000. Employee Stock Ownership Trust. The Company has an employee stock ownership trust (ESOT) which covers substantially all employees. Under the provisions of this trust, the Company may contribute an annual amount at its discretion for the benefit of eligible employees. The contribution, if any, may be made in cash or in common shares of the Company. For the years 1993, 1992 and 1991, the Company's contributions were $600,000, $400,000 and $500,000, respectively. In December 1988, the trust borrowed $4,000,000 under a term loan to purchase 274,348 shares of the Company's common stock. In accordance with applicable accounting rules, the Company has recorded the ESOT indebtedness in long-term debt on its balance sheet with an offsetting charge to common stock equity captioned "Unearned compensation-ESOT." The amount of dividends on ESOT shares used by the trust to pay debt service in 1993, 1992 and 1991 were $185,000, $675,000 and $694,000, respectively. Interest expense incurred by the trust in those years was $5,000, $45,000 and $138,000, respectively. The ESOT term loan was paid in full in 1993. 8. COMMITMENTS AND CONTINGENCIES Construction Program. The Company's plans for expansion and improvement of its distribution and transmission system, as well as other operations, are under a process of continuing review. Aggregate capital expenditures for all segments of the Company's operations for 1994 are projected at $23,200,000. Certain commitments have been made in connection with these expenditures. Guarantees. SEMCO Arkansas Pipeline Company, a wholly-owned subsidiary of SEMCO, has a 31.67% interest in a partnership which operates the NOARK Pipeline System (NOARK). NOARK is a 302-mile intrastate natural gas pipeline, originating in northwest Arkansas and extending northeast across the state. The pipeline became operational during the third quarter of 1992. The Company, SEMCO Arkansas Pipeline Company and SEMCO have guaranteed 40% of the principal and interest payments on up to $93,000,000 of debt used to finance the pipeline. Of the total, $63,000,000 is pursuant to a long-term arrangement requiring annual principal payments of approximately $3,150,000 together with interest on the unpaid balance. This arrangement matures in 2009 and has a fixed interest rate of 9.7375%. The remaining debt of $30,000,000 is pursuant to a credit agreement which currently terminates January 1996. Under the terms of the credit agreement, NOARK may request, on an annual basis, a one year extension of the then-effective terminate date. At December 31, 1993 NOARK had $25,200,000 outstanding under the agreement with interest payments at a variable interest rate. NOARK has entered into an interest rate swap relating to a notional amount of $40,000,000. Pursuant to the swap, NOARK will receive interest payments at 5% per annum on $40,000,000 and make interest payments on $40,000,000 at a rate equal to six-month LIBOR. The Company has guaranteed 40% of the payments due pursuant to this swap. In December 1993, Vesta Energy Corporation (Vesta), a firm shipper on NOARK, filed a complaint in the Federal District Court for the Northern District of Oklahoma against seven defendants, including NOARK. Vesta seeks actual damages on several theories in an aggregate amount exceeding $1,000,000, seeks punitive damages in excess of $1,000,000 and seeks to rescind its contracts with certain defendants, including its contract with NOARK. Neither the Company nor any of its subsidiaries is a party to the suit. Under the terms of Vesta's contract with NOARK, Vesta is obligated to pay a demand fee of approximately 19.3 cents per Mcf on 50,000 Mcf per day and approximately 9.2 cents per Mcf for volumes actually transported on the NOARK system. This contract is set to expire in 1997. On January 1, 1994, Vesta discontinued shipments of gas pursuant to its contract with NOARK and ceased payment of the demand fee. An affiliate of Southwestern Energy Pipeline Company, a NOARK general partner, which was providing approximately 25,000 Mcf per day of the gas transported by Vesta over the NOARK system, has indicated its current intent to continue to ship those volumes over the system, initially at the full firm rate, generating NOARK revenues of approximately $210,000 per month. In February 1994, the defendants, including NOARK, filed a motion for dismissal of Vesta's claim due to lack of Federal jurisdiction in the Oklahoma court. In addition, NOARK and certain other defendants filed separate claims in Arkansas against Vesta for breach of contract. As these circumstances continue, the loss of revenues to NOARK reduces the Company's net income by approximately $35,000 per month and reduces NOARK's cash flows available for debt service. To the extent NOARK's operating cash flows are insufficient to meet debt service, NOARK may draw on its available line of credit, require an equity contribution or a loan from its partners, or do a combination. If the above circumstances continue, the Company estimates these circumstances could result in a related cash outflow of approximately $1,000,000 from the Company in 1994. The Company expects to ultimately recover the remaining cost of its investment in NOARK over the life of the project. 9. INVESTMENTS IN AFFILIATES The equity method of accounting is used for interests the Company holds in affiliates 20% to 50% owned or in which the Company has significant influence over operations. These affiliate companies are generally involved in natural gas transmission, storage, or associated operations. The Company provides income taxes on its share of undistributed earnings of these subsidiaries at the time the earnings are included in consolidated income. Refer to Note 8 for a discussion of the Company's significant guarantees of affiliate debt. At December 31, 1993, the Company held the following interests in these affiliates: Summarized combined financial information for the Company's investments in affiliate companies for the years ended December 31, 1993, 1992 and 1991 is as follows (in thousands of dollars): 10. QUARTERLY FINANCIAL INFORMATION (Unaudited) In the opinion of the Company, the following quarterly information includes all adjustments necessary for a fair statement of the results of operations for such periods. Earnings and dividends per share of common stock are calculated based upon the weighted average number of shares outstanding during each quarter. Due to the seasonal nature of the Company's gas distribution business, the results of operations reported on a quarterly basis show substantial variations. The following amounts are shown in thousands of dollars, except per share amounts: ARTHUR ANDERSEN & CO. Report of Independent Public Accountants To Southeastern Michigan Gas Enterprises, Inc.: We have audited the accompanying consolidated balance sheets and statements of capitalization of SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. (a Michigan corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southeastern Michigan Gas Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 3 and 7 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes and other postretirement benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Detroit, Michigan, February 9, 1994. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing under the captions "Information About Directors and Executive Officers" and "Other Executive Officers" in Registrant's definitive Proxy Statement (filed or to be filed pursuant to Regulation 14A) with respect to Registrant's April 19, 1994 Annual Meeting of Shareholders is incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Compensation of Directors and Executive Officers" in Registrant's definitive Proxy Statement (filed or to be filed pursuant to Regulation 14A) with respect to Registrant's April 19, 1994 Annual Meeting of Shareholders is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the caption "Stock Outstanding, Voting Rights and Votes Required" in the Registrant's definitive Proxy Statement (filed or to be filed pursuant to Regulation 14A) with respect to Registrant's April 19, 1994 Annual Meeting of Shareholders, is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under the caption "Certain Business Relationships of Directors" in the Registrant's definitive Proxy Statement (filed or to be filed pursuant to Regulation 14A) with respect to Registrant's April 19, 1994 Annual Meeting to Shareholders, is incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Consolidated Financial Statements. The following financial statements are included in Part II, item 8 above. (a) 2. Financial Statement Schedules. The following additional data should be read in conjunction with the Consolidated Financial Statements in Part II, item 8 above. Schedules not included herein have been omitted because they are not applicable or the required information is shown in such financial statements or notes thereto. (a) 3. Exhibits, including those incorporated by reference Key to Exhibits Incorporated by Reference (a) Filed with Enterprises' Registration Statement, Form S-2, No. 33-18979, filed December 10, 1987. (b) Filed with Enterprises' Form 10-K for 1987, dated March 28, 1988, File No. 0-8503. (c) Filed with Enterprises' Form 10-K for 1988, dated March 30, 1989, File No. 0-8503. (d) Filed with Enterprises' Form 10-Q for the quarter ended June 30, 1989, File No. 0-8503. (e) Filed with Enterprises' Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (f) Filed with Enterprises' Form 10-Q for the quarter ended September 30, 1990, File No. 0-8503. (g) Filed with Enterprises' Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (h) Filed with Enterprises' Registration Statement, Form S-2, No. 33-46413, filed March 16, 1992. (i) Filed with Enterprises' Form 10-K for 1991, dated March 27, 1992, File No. 0-8503. (j) Filed with Enterprises' Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (k) Filed with Enterprises' Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (l) Filed March 16, 1994, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503. ITEM 14. (Continued) (b) No reports on Form 8-K have been filed during the quarter ended December 31, 1993. On January 11, 1994, the Company filed Form 8-K to report litigation affecting the Company. See Note 8 of "Notes to the Consolidated Financial Statements" for further discussion. (c) The Exhibits, if any, filed herewith are identified on the Exhibit Index. (d) The financial statement schedules filed are listed under Item 14.(a).2. above. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. Date: March 28, 1994 By /s/ Ward N. Kirby ---------------------------------------- President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Rents, royalties, advertising and research and development costs are not significant. SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. Exhibit Index Form 10-K Key to Exhibits Incorporated by Reference (a) Filed with Enterprises' Registration Statement, Form S-2, No. 33-18979, filed December 10, 1987. (b) Filed with Enterprises' Form 10-K for 1987, dated March 28, 1988, File No. 0-8503. (c) Filed with Enterprises' Form 10-K for 1988, dated March 30, 1989, File No. 0-8503. (d) Filed with Enterprises' Form 10-Q for the quarter ended June 30, 1989, File No. 0-8503. (e) Filed with Enterprises' Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (f) Filed with Enterprises' Form 10-Q for the quarter ended September 30, 1990, File No. 0-8503. (g) Filed with Enterprises' Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (h) Filed with Enterprises' Registration Statement, Form S-2, No. 33-46413, filed March 16, 1992. (i) Filed with Enterprises' Form 10-K for 1991, dated March 27, 1992, File No. 0-8503. (j) Filed with Enterprises' Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (k) Filed with Enterprises' Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (l) Filed March 16, 1994, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503.	11,455	75,979
749751_1993.txt	749751_1993	1993	749751	ITEM 1. BUSINESS. GENERAL GUARDIAN BANCORP Guardian Bancorp (the "Company") is a bank holding company which was incorporated in California on December 31, 1981 and registered under the Bank Holding Company Act of 1956, as amended. Guardian Bancorp conducts operations through its sole subsidiary, Guardian Bank. The Company's executive offices are located at 800 South Figueroa Street, Los Angeles, California 90017, and its telephone number is (213) 239-0800. GUARDIAN BANK Guardian Bank (the "Bank") was incorporated under the laws of the State of California on October 22, 1982, was licensed by the California Superintendent of Banks ("Superintendent") and commenced operations as a California state-chartered bank in October 1983. The Bank's deposit accounts are insured by the Federal Deposit Insurance Corporation ("FDIC") up to applicable limits, and the Bank is a member of the Federal Reserve System. The Bank has three regional banking offices at the following locations: 800 South Figueroa Street, Los Angeles, California, which also serves as the Bank's head office; 17330 Brookhurst Street, Fountain Valley, California; and 3401 Centrelake Drive, Ontario, California. Historically, the Bank concentrated on marketing to, and servicing the needs of, the title insurance and escrow industries, labor unions, real estate professionals, small and medium sized businesses and high net worth individuals in the counties of Los Angeles, Orange, Riverside, San Bernardino and Ventura, California. Furthermore, the Bank's historical primary lending focus was on real estate-mortgage and construction lending and, to a lesser extent, on lending to commercial and industrial enterprises. Although the Bank also makes installment loans, it does so primarily as an accommodation to existing customers. Real estate-mortgage loans include individual and multi-family residential mortgages, commercial and industrial mortgage loans and land acquisition loans. Construction loans include individual and multi-family residential construction loans and commercial and industrial construction loans. Commercial loans include loans made primarily to small and medium sized businesses and professionals for working capital and equipment acquisitions as well as trade finance. A substantial portion of these loans are made to borrowers involved in the real estate industry. Installment loans consist primarily of automobile loans and loans made to finance small equipment acquisitions. The Bank has generated a substantial portion of its deposits from large balance depositors by offering various customer services. A significant amount of such deposits are from Southern California-based title insurance companies and escrow companies. Customer services consist primarily of accounting, data processing and courier services. The Bank also offers a variety of other deposit instruments. These include personal and business checking accounts, savings accounts, including interest-bearing negotiable order of withdrawal accounts, money market accounts and time certificates of deposits. The Bank also offers a range of specialized services designed to attract and service the needs of its customers, including wire transfer capability, telephone transfers, same day posting and account research. In response to a changed economic environment, the Company has recently embarked upon a loan portfolio and deposit base diversification effort. The Company's loan portfolio diversification efforts are focused on targeting small and medium sized businesses in its market area and such targets include manufacturers, wholesalers, distributors, retailers, service companies and professionals. Efforts at changing the Company's deposit mix include introducing a wider array of deposit products, including retirement and cash management accounts. GUARDIAN TRUST COMPANY Guardian Trust Company was incorporated under the laws of the State of California on April 16, 1991, was licensed by the Superintendent and commenced operations as a California state-chartered trust company in July 1991. Guardian Trust Company, a wholly-owned subsidiary of the Bank, maintains its offices at 800 South Figueroa Street, Los Angeles, California. Guardian Trust Company offers custodial, securities servicing and cash management services to trusts established by labor unions. Each trust has professional investment managers that direct the investment of the trust funds held by Guardian Trust Company, and Guardian Trust Company does not offer any investment advice to such trusts. Guardian Trust Company, which was capitalized at $5 million by the Bank, subleases approximately 1,500 square feet of office space from the Company and employs eight people. Currently, the financial condition and results of operations of Guardian Trust Company are not material to those of the Company on a consolidated basis. At December 31, 1993, Guardian Trust Company provided services to trust fund clients based primarily in Southern California who control approximately $2.3 billion in assets. PRINCIPAL MARKET AREA The general economy in the Company's market area, and particularly the real estate market, are suffering from the effects of a persistent recession that has negatively impacted the ability of certain borrowers of the Company to perform under the original terms of their obligations to the Company. According to THE UCLA BUSINESS FORECAST FOR THE NATION AND CALIFORNIA, DECEMBER 1993 REPORT (the "UCLA Report"), the current recession in California is expected to continue until at least the second half of 1994, despite the presence of a moderate national economic recovery. The UCLA Report attributes the length and depth of the California recession, which began in 1990, to a number of negative economic factors, including permanent cutbacks in the California defense industries and military base closings, a cyclical downturn in California residential real estate construction, lower rates of international trade growth as a result of the worldwide recession and the effects on employment of an increased global emphasis on cost controls and downsizing. The statewide unemployment rate in November 1993 was 8.6%, compared with a national rate of 6.4%. The UCLA Report notes that while statewide unemployment figures have improved recently, this was due to a decline in the size of the labor force and that total California employment has declined. Nevertheless, the UCLA Report expects a weak job recovery to begin in California during the second half of 1994, approaching a normal growth rate over the next four years. Based on its assessment of recent economic reports and the current economic environment in the Company's market areas, management believes that the California recession may continue beyond the third quarter of 1994. It remains uncertain if the impact of the recent Southern California earthquake and the related aftershocks will have additional negative effect on the Southern California economy and the Company's customers. The financial condition of the Company has been, and is expected to continue to be, dependent upon overall general economic conditions and the real estate market in Southern California. The future success of the Company is dependent, in large part, upon the quality of its assets. Although management of the Company has devoted substantial time and resources to the identification, collection and workout of nonperforming and other potential problem assets, the real estate market and the overall economy in Southern California are likely to continue to significantly effect the quality of the Company's assets in future periods and, accordingly, its financial condition and results of operations. LOAN PORTFOLIO The Company has historically engaged in real estate lending through construction and term mortgage loans, all of which are secured by deeds of trust on underlying real estate. The Company also engages in commercial lending to businesses, and although the Company looks principally to the borrowers' cash flow as the source of payment, many commercial loans are secured by real estate as a secondary source of repayment. The Company's real estate and construction loans are diversified by type of collateral and are concentrated geographically throughout the five counties it serves in Southern California. The Company is currently in the process of diversifying its loan portfolio to include more commercial loans to businesses. In addition to the collateralized position on its lending activities, all lending transactions are subject to the Bank's credit evaluation, underwriting criteria and monitoring standards. The lending activities of the Company are guided by the basic lending policy established by the Company's Board of Directors. Each loan is evaluated based on, among other things, character and leverage capacity of the borrower; capital and investment in a particular property, if applicable; cash flow; collateral; market conditions for the borrower's business or project; and prevailing economic trends and conditions. The Company's lending policy also requires an independent appraisal or an evaluation on each parcel of real estate which will be taken as collateral for a loan. Loan approval is centralized, and no officer has loan approval authority in excess of $100,000 on unsecured loans or $250,000 on secured loans. The following table sets forth the type and amount of loans outstanding as of the dates indicated: Except as otherwise disclosed herein, as of December 31, 1993, the Company did not have any concentration of loans in any particular industry exceeding 10% of total outstanding loans. In light of the current economic environment and the impact it has had and may have on the real estate sector, as well as a regulatory recommendation regarding the size and growth of the Company's real estate related loans prior to 1992, management remains committed to reducing the Company's real estate concentration, particularly construction lending. At the same time, management intends to continue diversifying the loan portfolio by increasing the level of non-real estate credits to the extent such loans satisfy the Bank's underwriting criteria and are available and by limiting the growth of new real estate related loans. REAL ESTATE-MORTGAGE LOANS. Approximately 45.5% of the Company's loan portfolio at December 31, 1993 was comprised of medium term mortgage loans, virtually all of which were secured by first deeds of trust. The following table sets forth the composition of such mortgage loans by broad type of collateral as of the dates indicated. The Company's 1-4 family residential mortgage loans, which averaged approximately $270,000 at December 31, 1993 (with four loans over $1 million), are typically secured by moderate or high-priced single family residences located in the Company's principal market area. These loans generally have a term of five years, are amortized over 20 to 30 years, provide for a balloon payment at the end of the term and generally bear a floating rate of interest either tied to the 11th District cost of funds or the Company's prime rate. These loans generally were underwritten with loan-to-value ratios ranging from approximately 70% to 80%, which decreases progressively for loans in excess of $250,000. The Company's multifamily residential mortgage loans, which averaged approximately $652,000 at December 31, 1993 (with four loans over $1 million), are typically secured by small (8 to 30 unit) apartment projects for which the Company has provided the construction financing (see "Item 1. Business -- Loan Portfolio -- Construction Loans" below). These loans generally have a term of five years, are amortized over 20 to 30 years and bear a floating rate of interest tied to the Company's prime rate. The Company's underwriting standards generally apply a maximum loan-to-value ratio of 75% to these loans. The Company's commercial and industrial mortgage loans, which averaged approximately $696,000 at December 31, 1993 (with 29 loans over $1 million), are primarily secured by small office buildings and multi-use industrial buildings that are either owner-occupied or built for rental purposes and, to a much lesser extent, by small (20 to 50 unit) motels located in the Company's principal market area. These loans generally have a term of three to five years, are amortized over 20 years and bear a floating rate of interest tied to the Company's prime rate. The Company's underwriting standards generally apply a maximum loan-to-value ratio of 70% to these loans. Land acquisition loans, which averaged approximately $403,000 at December 31, 1993 (with four loans over $1 million), are typically secured by raw land acquired for residential, commercial or industrial development within a relatively short period of time after acquisition. Of the amount outstanding at December 31, 1993, 56.2% was for residential development, 42.1% was for commercial projects and 1.7% was for industrial development. These loans generally mature in three years or less, bear a floating rate of interest tied to the Company's prime rate and are all due and payable at maturity. In addition, these loans were generally underwritten between 45% to 60% of the appraised value of the property on an undeveloped basis under the Company's underwriting policy. Although real estate-mortgage loans increased by approximately $8.6 million at the close of 1993 from the amount outstanding at December 31, 1992, this increase is primarily attributable to an increase in mini-permanent loans made by the Company to existing customers. The Company's mini-permanent loans represent loans that have a term of three to five years, are amortized over 20 to 25 years and provide for a balloon payment at the end of the term. Most of these loans provide intermediate term financing for construction loans that were originated by the Company. The Company expects to continue to provide intermediate term financing of this type in the future. CONSTRUCTION LOANS. Approximately 27.2% of the Company's loan portfolio at December 31, 1993 was comprised of construction loans. The following table sets forth the composition of such construction loans by broad type of project as of the dates indicated. During the last two and a half years, the Company's residential construction loans have increased as a percentage of the Company's total construction loan portfolio. This increase is indicative of the Company's preference for entry level housing projects, including detached homes and condominiums, and multifamily rental units, and the demand for such loans by its regular construction customers. These single-family housing and condominium units built for resale typically average approximately 1,600 square feet and sell for $130,000 to $250,000. The multifamily residential units financed by the Company consist of low-rise apartment projects of between eight and 30 units, each ranging in size from 800 square feet to 1,000 square feet, and rent for between $750 and $1,000 per month. As of December 31, 1993, four of the Company's residential construction loans, totalling approximately $2.3 million, or 0.7% of the total loan portfolio, were for projects located outside the State of California. The borrowers on these out-of-state loans are customers with whom the Company has had a long-standing relationship and who previously have demonstrated an ability to complete similar projects successfully. The Company's residential construction loans generally bear a floating rate of interest and mature in one year or less. The Company's residential construction loan underwriting standards generally limit the loan amount to approximately 70% of the completed value of the project. Larger single-family residential projects, including detached homes and/or condominiums, which consist of 15 to 150 units, are usually built by the Company's customers on a phased basis. Construction loans for these projects are generally underwritten on a phase-by-phase basis, such that each phase must qualify for financing separately and only after all or substantially all of the units in the prior phase or phases have been sold. The Company's commercial and industrial construction loans are typically made for the construction of small office, multi-use industrial buildings and, to a lesser extent, retail centers and had an average outstanding balance of $2.0 million at December 31, 1993. The Company's commercial and industrial construction loans generally bear a floating rate of interest and mature in one year or less. The Company's commercial and industrial loan underwriting standards generally limit the loan amount to approximately 70% of the completed value of the project. Since inception, all of the Company's commercial construction projects have been located in Southern California and have been made to customers who have had long-standing relationships with the Company and who generally have had previous success in the commercial construction industry. The Company disburses funds under each construction loan in accordance with a disbursement schedule that is part of the construction loan agreement and details the budgeted project cost. Borrowers are required to submit payment requests with cost breakdowns and invoices that are accompanied by, as appropriate, labor releases, original material releases and payee signatures acknowledging pending payment. Payment requests must also be supported by project inspection reports that include, among other things, line item actual cost amount comparisons to budgeted costs, photographs of the project and a discussion of the project's status. Funds are disbursed only after the request has been reviewed by the Company and a determination has been made that the project is proceeding on budget. Real estate mortgage and construction lending contain potential risks which are not inherent in other types of commercial loans. These potential risks include declines in market values of underlying real property collateral and, with respect to construction lending, delays or cost overruns, which could expose the Company to loss. In addition, risks in commercial real estate lending include declines in commercial real estate values, general economic conditions surrounding the commercial real estate properties, and vacancy rates. A decline in the general economic conditions or real estate values within the Company's market area have had and could have a further negative impact on the performance of the loan portfolio or value of the collateral. During the last three years, the Company has been adversely affected by the actualization of these risks. See "Nonaccrual, Past Due and Modified Loans" and "Management's Discussion and Analysis of Financial Condition and Results of Operations". COMMERCIAL LOANS. As of December 31, 1993, approximately 26.7% of the Company's loan portfolio was comprised of commercial loans. Loans in this category, which averaged approximately $131,000 at December 31, 1993, include loans made primarily to small and medium sized businesses and professionals for working capital and equipment acquisitions, as well as trade finance. In addition, at December 31, 1993, the Company had made available $24.0 million in secured warehouse lines of credit to Southern California mortgage banking companies, of which $14.1 million was outstanding. At December 31, 1993, approximately 70% of the Company's commercial loans were to borrowers involved in the real estate industry, such as real estate brokers, title insurance companies, escrow companies, mortgage banking companies and other real estate professionals. Although the Company typically looks to the borrower's cash flow as the principal source of repayment for such loans, approximately 34.4% of the loans within this category at December 31, 1993 were secured by real estate as a secondary source of repayment. Certain of the Company's commercial loans are secured by buildings for which the Company has provided the construction financing. As indicated above, a significant portion of the Company's loan portfolio, including commercial loans, is secured by real estate. The general economy in the Company's market area, and particularly the real estate market, are suffering from the effects of persistent recessionary conditions. Real estate values have been negatively impacted resulting in increases in the Company's average loan to value ratios in almost all segments of its loan portfolio. The current recession also has negatively impacted the volume of real estate transactions which adversely affected certain commercial borrowers involved in the real estate industry. INSTALLMENT LOANS. Installment loans consist primarily of automobile loans and loans made to finance small equipment acquisitions. These loans are made primarily as an accommodation to existing customers and are not a substantial part of the Company's lending strategy. MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES The following table sets forth the maturity distribution of the Company's loan portfolio (excluding installment loans) at December 31, 1993, which are based on remaining scheduled principal repayments (dollars in thousands). The following table sets forth the sensitivity of the amounts due after one year to changes in interest rates for the Company's loan portfolio (excluding installment loans) at December 31, 1993 (dollars in thousands). NONACCRUAL, PAST DUE AND MODIFIED LOANS The performance of the Company's loan portfolio is evaluated regularly by senior management. Interest on loans is accrued monthly as earned. When, in the opinion of management, a reasonable doubt exists as to the collection of principal or interest, such loans are evaluated individually to determine both the collectibility and the adequacy of collateral. Loans are generally placed on nonaccrual status when principal or interest is past due 90 days or more, or management has reasonable doubt as to the full collection of principal and interest, at which time the accrual of income is discontinued and previously accrued but unpaid interest is reversed against income. Subsequent interest payments are generally credited to income when received, except when the ultimate collectibility of principal is uncertain, in which case all collections are applied as principal reductions. The following table sets forth the amount of the Company's nonperforming loans (nonaccrual loans and loans delinquent 90 days or more) and loans with modified terms as of the dates indicated (dollars in thousands). The following tables set forth the Company's nonperforming loans by type as of the dates indicated (dollars in thousands): The following tables set forth the composition of nonperforming loans by broad collateral type as of the dates indicated (dollars in thousands): The following table sets forth the Company's loans with modified terms by type as of the dates indicated (dollars in thousands): At December 31, 1993, the Company's portfolio of loans with modified terms reflects the original principal amount as amortized by their terms, less a $600,000 charge-off of principal taken against one credit at the time of modification. The weighted average stated yield on these loans for the year ended December 31, 1993 was approximately 5.5%. The Company's average cost of interest-bearing liabilities was 3.3% for the year ended December 31, 1993. The following table sets forth the composition of loans with modified terms by broad collateral type as of the dates indicated (dollars in thousands): Since 1991, the Company has been impacted by the significant slowdown in California's economic activity. One result of the current recessionary environment has been the decrease of real estate values in certain sectors of the Company's target markets which, in turn, has affected certain borrowing customers' financial capabilities and liquidity. The significant increase in amounts reported as nonperforming loans since 1990 is attributable to the existing economic climate, and a substantial portion of the nonperforming loans are real estate mortgage and construction credits. At December 31, 1993, 1992, and 1991, the ratio of the allowance for loan losses to period end nonperforming loans was 52.3%, 38.6% and 31.7%, respectively. The amount of loans with modified terms has increased significantly since 1992. It is the Company's policy to consider a restructured loan a loan with modified terms when a determination has been made that greater economic value may be realized under new terms rather than through foreclosure, liquidation or other disposition. In such circumstances, the Company may grant a concession to the borrower that it would not otherwise grant, including the reduction of interest charged, the forgiveness of certain penalties and, in certain cases, the reduction of the principal balance on a loan. Except for the loans included in the nonperforming and modified loan tables above and approximately $35.3 million in additional credits, which represent loans that have been identified by management as potential problem credits but are not included in the tables above, the Company is not aware of any other loans at December 31, 1993 where known information about possible credit problems of the borrower causes management to have serious doubts as to the ability of such borrowers to comply with their present loan repayment terms and which may result in such loans being included in such tables at some future date. The following table sets forth the composition of potential problem credits by broad collateral type at December 31, 1993 (dollars in thousands): Management cannot predict the extent to which the current recessionary economic environment may persist or worsen or the full impact such environment may have on the Company's loan portfolio. However, if current economic conditions continue for a sustained period of time or worsen, management anticipates that the Bank's borrowers will be adversely effected and underlying collateral values will continue to decline. Furthermore, the Bank's primary regulators review the loan portfolio as an integral part of their periodic examinations of the Bank, and their assessment of specific credits, based upon information available to them at the time of their examinations, may affect the level of the Company's nonperforming loans. Accordingly, there can be no assurance that other loans will not be placed on nonaccrual, become 90 days or more past due or have terms modified in the future. ALLOWANCE FOR LOAN LOSSES A certain degree of risk is inherent in the extension of credit. Management has credit policies in place to monitor and attempt to control the level of loan losses and nonperforming loans. One product of the Company's credit risk management is the maintenance of the allowance for loan losses at a level considered by management to be adequate to absorb estimated known and inherent losses in the existing portfolio, including commitments and standby letters of credit. The allowance for loan losses is established through charges to operations in the form of provisions for loan losses. The allowance is based upon a regular review of current economic conditions, which might affect a borrower's ability to pay, underlying collateral values, risks in and the composition of the loan portfolio, prior loss experience and industry averages. In addition, the Bank's primary regulators, as an integral part of their examination process, periodically review the Company's allowance for loan losses and may recommend additions to the allowance based on their assessment of information available to them at the time of their examination. Loans that are deemed to be uncollectible are charged-off and deducted from the allowance. The provision for loan losses and recoveries on loans previously charged-off are added to the allowance. The following table sets forth the Company's loan loss experience and certain information relating to its allowance for loan losses as of the dates and for the years indicated (dollars in thousands). The increase in net charge-offs during 1993 and in 1992 from those reported in prior periods primarily resulted from losses recognized upon transfer of assets to other real estate owned ("OREO"), losses taken on certain real estate related loans due to economic conditions and other charge-offs related to loans deemed uncollectible by the Company. Management believes that the allowance for loan losses at December 31, 1993 was adequate to absorb the known and inherent losses in the loan portfolio at that time. However, no assurance can be given that continuation of current recessionary factors, future changes in economic conditions that might adversely affect the Company's principal market area, borrowers or collateral values, and other circumstances will not result in increased losses in the Company's loan portfolio in the future. Although the Company does not normally allocate the allowance for loan losses to specific loan categories, an allocation has been made for purpose of this discussion as set forth below. The allocations used in the table are based upon the criteria considered by management in determining the amount of additional provisions for loan losses and the aggregate level of the allowance for loan losses (dollars in thousands). The allocation of the allowance for loan losses should not be interpreted as an indication of future credit trends or that losses will occur in these amounts or proportions. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories, since even on the above basis there is a substantial unallocated portion of the allowance, and the total allowance is a general allowance applicable to the entire portfolio. OTHER REAL ESTATE OWNED Real estate and other assets acquired in satisfaction of loans are recorded at estimated fair value, less estimated costs of disposition, and any difference between fair value and the loan amount is charged to the allowance for loan losses. Gains and losses from the sale of such assets, any subsequent additions to the OREO valuation allowance and net operating expenses are included in noninterest expense. Activity in OREO for the periods indicated is as follows (dollars in thousands): The following sets forth the composition of OREO, net of valuation adjustments, by broad type of collateral at the dates indicated (dollars in thousands): DEPOSITS The Company has generated a substantial portion of its deposits from large balance depositors by offering various customer services. A significant amount of such deposits are from Southern California based title insurance companies and escrow companies. Customer services consist primarily of accounting and courier services. The Company seeks to control its customer service expense by continuously monitoring the earnings performance of its account relationships and, on that basis, limiting the amount of services provided. As of December 31, 1993, title insurance companies and escrow companies accounted for approximately $287.3 million, or 89.0%, of the Company's noninterest-bearing demand deposits which compares to $374.1 million, or 90.3% of the Company's noninterest-bearing demand deposits at the close of 1992. The decline between the close of 1993 and 1992 principally reflects a slow down in real estate transaction activity handled by such depositors, and to a lesser extent, the Company's reduced reliance on such accounts as a funding source. At December 31, 1993, the Company's five largest title insurance company customers accounted for $129.5 million, or 24.6% of total deposits; the two largest of such customers accounted for 8.5% and 6.3% of total deposits. Title insurance company deposits and, to a lesser extent, escrow company deposits are subject to greater fluctuation and can be sensitive to prevailing interest rates and other general economic factors that affect the demand for housing and other real estate than other types of demand deposits. For example, as real estate development and sales activity decline during periods of rising interest rates, the Company might experience a corresponding decline in its demand deposits from such sources. Should the Company experience a decline in the level of such deposits, it would have to obtain funds from other sources, and probably at higher rates, to maintain, or expand, its lending activities. An increase in the cost of funds without a corresponding increase in the yield on interest earning assets would likely decrease the Company's net interest income, which is the primary component of the Company's earnings. During the first quarter of 1994, the Board of Governors of the Federal Reserve System issued a new interpretive release which is applicable to all member banks, such as the Bank, and other entities, which limits the payment of customer service expense to prescribed instances. As a result of this release, it is expected that certain balances of accounts associated with these expenses and customer service expense will decline in 1994. Labor union deposits, which were $91.5 million at December 31, 1993, or 17.4% of total deposits and were $90.9 million at December 31, 1992, or 15.2% of total deposits, generally are not transaction oriented and, thus, are less likely to fluctuate with the general level of interest rates. At December 31, 1993, approximately 64.2% of such deposits were demand deposits. Management believes that labor union deposits are subject to less fluctuation than title insurance company and escrow company deposits and therefore afford a more stable funding source for the Company's lending activities. No individual account represented 10% or more of total deposits. Time certificates of deposit of $100,000 or more, which were $22.2 million at December 31, 1993, or 4.2% of total deposits and were $28.4 million, or 4.7%, of total deposits at December 31, 1992, are generally more sensitive to changes in interest rates than other types or amounts of deposits. The Company's period end deposit balances traditionally reflect increases in noninterest-bearing demand deposits from title insurance company and escrow company customers. These deposits increase at or near each month end as the underlying real estate transactions being handled by such deposit customers are nearing consummation. Accordingly, management considers average deposit balances to be more indicative of the Company's deposit base. The following table sets forth the distribution of average deposits and the rates paid thereon for the years indicated (dollars in thousands): During the year ended December 31, 1993, the mix in the composition of average deposits changed from the prior year as average noninterest-bearing demand deposits decreased, and average time certificates of deposit increased, when expressed as a percentage of average total deposits. Average noninterest-bearing demand deposits comprised 59.3%, 63.6% and 54.9% of average total deposits for the years ended December 31, 1993, 1992 and 1991, respectively. Average time certificates of deposit comprised 21.3%, 17.0% and 25.3% of total average deposits for the years ended December 31, 1993, 1992 and 1991, respectively. Total average interest-bearing demand, savings and money market deposits, when expressed as a percentage of total average deposits, remained comparable over the three years ended December 31, 1993, and were 19.4%, 19.4% and 19.7%, respectively, during 1993, 1992 and 1991. The increase in the Company's average time certificates of deposit during the year ended December 31, 1993 from the prior year's average is, in management's opinion, attributable to efforts devoted toward diversifying the Company's funding sources. The Company's noninterest-bearing deposits declined in 1993 from levels reached in the prior two years reflecting the decreased volume of title insurance company and escrow company deposit activity occurring as a result of recent declines in refinancing activity from levels in the prior two years. During the first quarter of 1994, the Board of Governors of the Federal Reserve System issued a new interpretive release which is applicable to all member banks, such as the Bank, and other entities, which limits the payment of customer service expense to certain prescribed instances. As a result of the issuance of this interpretive release it is expected that certain noninterest-bearing account balances of title insurance company and escrow company depositors will decline in 1994. The following table sets forth the maturities of the Company's time certificates of deposit outstanding at December 31, 1993 (dollars in thousands). COMPETITION The Company faces substantial competition for deposits and loans throughout its market area. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. Competition for deposits comes primarily from other commercial banks, savings institutions, credit unions, thrift and loans, money market funds and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. Competition for loans comes primarily from other commercial banks, savings institutions, thrift and loans, mortgage banking firms, credit unions and other financial intermediaries. The Company faces competition for deposits and loans throughout its market areas not only from local institutions but also from out-of-state financial intermediaries which have opened loan production offices or which solicit deposits in its market areas. Many of the financial intermediaries operating in the Company's market areas offer certain services, such as trust, investment and international banking services, which the Company does not offer directly (other than custodial, cash management and securities servicing provided by Guardian Trust Company). Additionally, banks with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers. The Company has three offices located in Los Angeles, Fountain Valley and Ontario, California. Neither the deposits nor loans of any office of the Company exceed 1% of the aggregate loans or deposits of all financial intermediaries located in the counties in which such offices are located. EMPLOYEES At December 31, 1993, the Company employed 159 people. Management believes that its relations with its employees are satisfactory. EFFECT OF GOVERNMENTAL POLICIES AND RECENT LEGISLATION Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank's portfolio comprise the major portion of the Company's earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Company are subject to the influence of local, domestic and foreign economic conditions, including recession, unemployment and inflation. The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the Federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The likelihood of any major changes and the impact such changes might have on the Company are impossible to predict. Certain of the potentially significant changes which have been enacted and proposals which have been made recently are discussed below. FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") was enacted into law. Set forth below is a brief discussion of certain portions of this law and implementing regulations that have been adopted or proposed by the Federal Reserve Board, the Comptroller of the Currency, the Office of Thrift Supervision and the FDIC (collectively, the "Federal banking agencies"). BIF RECAPITALIZATION. The FDIC Improvement Act provides the FDIC with three additional sources of funds to protect deposits insured by the Bank Insurance Fund (the "BIF") administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the U.S. Treasury; borrow from the Federal Financing Bank up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver; and borrow from financial intermediaries that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. IMPROVED EXAMINATIONS. All insured depository institutions must undergo a full-scope, on-site examination by their appropriate Federal banking agency at least once every 12 months. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate Federal banking agency against each institution or affiliate as it deems necessary or appropriate. STANDARDS FOR SAFETY AND SOUNDNESS. Pursuant to the FDIC Improvement Act, the Federal banking agencies have issued proposed safety and soundness standards on matters such as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. The proposals, among other things, establish the maximum ratio of classified assets to total capital at 1% and the minimum level of earnings sufficient to absorb losses without impairing capital. The proposals provide that a bank's earnings are sufficient to absorb losses without impairing capital if the bank is in compliance with minimum capital requirements and the bank would, if its net income or loss over the last four quarters continued over the next four quarters, remain in compliance with minimum capital requirements. Any institution which fails to comply with these standards must submit a compliance plan. Failure to submit a plan or to comply with an approved plan will subject the institution to further enforcement action. No assurance can be given as to the final form of the proposed regulations or, if adopted, the impact of such regulations on the Company and the Bank. In December 1992, the Federal banking agencies issued final regulations prescribing uniform guidelines for real estate lending. The regulations, which became effective March 19, 1993, require insured depository institutions to adopt written policies establishing standards, consistent with such guidelines, for extensions of credit secured by real estate. The policies must address loan portfolio management, underwriting standards and loan to value limits that do not exceed the supervisory limits prescribed by the regulations. PROMPT CORRECTIVE REGULATORY ACTION. The FDIC Improvement Act requires each Federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions that fall below one or more prescribed minimum capital ratios. The purpose of this law is to resolve the problems of insured depository institutions at the least possible long-term cost to the appropriate deposit insurance fund. The law requires each Federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized (significantly exceeding the required minimum capital requirements), adequately capitalized (meeting the required capital requirements), undercapitalized (failing to meet one or more of the capital requirements), significantly undercapitalized (significantly below one or more capital requirement) and critically undercapitalized (failing to meet all capital requirements). In September 1992, the Federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of the FDIC Improvement Act. Under the regulations, an insured depository institution will be deemed to be: -"well capitalized" if it (i) has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based ratio capital of 6% or greater and a leverage ratio of 5% or greater and (ii) is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure; -"adequately capitalized" if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or a leverage ratio of 3% or greater if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); -"undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier 1 risk-based capital ratio that is less than 4% or a leverage ratio that is less than 4% (or a leverage ratio that is less than 3% if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); -"significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or a leverage ratio that is less than 3%; and -"critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized or undercapitalized may be reclassified to the next lower capital category if the appropriate Federal banking agency, after notice and opportunity for hearing, (i) determines that the institution is in an unsafe or unsound condition or (ii) deems the institution to be engaging in an unsafe or unsound practice and not to have corrected the deficiency. At each successive lower capital category, an insured depository institution is subject to more restrictions and Federal banking agencies are given less flexibility in deciding how to deal with it. The law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if after such transaction the institution would be undercapitalized. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate Federal banking agency, subjected to asset growth restrictions and required to obtain prior regulatory approval for acquisitions, branching and engaging in new lines of business. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate Federal banking agency 45 days after becoming undercapitalized. The appropriate Federal banking agency cannot accept a capital plan unless, among other things, it determines that the plan (i) specifies the steps the institution will take to become adequately capitalized, (ii) is based on realistic assumptions and (iii) is likely to succeed in restoring the depository institution's capital. In addition, each company controlling an undercapitalized depository institution must guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the appropriate Federal banking agency may impose on any undercapitalized depository institution any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the prompt corrective action provisions. An insured depository institution that is significantly undercapitalized, or is undercapitalized and fails to submit, or in a material respect to implement, an acceptable capital restoration plan, is subject to additional restrictions and sanctions. These include, among other things: (i) a forced sale of voting shares to raise capital or, if grounds exist for appointment of a receiver or conservator, a forced merger; (ii) restrictions on transactions with affiliates; (iii) further limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage; (v) modification or termination of specified activities; (vi) replacement of directors or senior executive officers, subject to certain grandfather provisions for those elected prior to enactment of the FDIC Improvement Act; (vii) prohibitions on the receipt of deposits from correspondent institutions; (viii) restrictions on capital distributions by the holding companies of such institutions; (ix) required divestiture of subsidiaries by the institution; or (x) other restrictions as determined by the appropriate Federal banking agency. Although the appropriate Federal banking agency has discretion to determine which of the foregoing restrictions or sanctions it will seek to impose, it is required to force a sale of voting shares or merger, impose restrictions on affiliate transactions and impose restrictions on rates paid on deposits unless it determines that such actions would not further the purpose of the prompt corrective action provisions. In addition, without the prior written approval of the appropriate Federal banking agency, a significantly undercapitalized institution may not pay any bonus to its senior executive officers or provide compensation to any of them at a rate that exceeds such officer's average rate of base compensation during the 12 calendar months preceding the month in which the institution became undercapitalized. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. For example, a critically undercapitalized institution generally would be prohibited from engaging in any material transaction other than in the ordinary course of business without prior regulatory approval and could not, with certain exceptions, make any payment of principal or interest on its subordinated debt beginning 60 days after becoming critically undercapitalized. Most importantly, however, except under limited circumstances, the appropriate federal banking agency, not later than 90 days after an insured depository institution becomes critically undercapitalized, is required to appoint a conservator or receiver for the institution. The board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator or to an acquisition or merger as required by the regulator. As of December 31, 1993, the Bank had a total risk-based capital ratio of 8.33%, a Tier 1 risk-based capital ratio of 7.02% and a leverage ratio of 4.19%. The Bank is subject to a written regulatory agreement that requires it to develop a plan to maintain an adequate capital position. See "Item 1. Business - -- Supervision and Regulation -- Potential and Existing Enforcement Actions." Pursuant to its plan, in January 1994, the Company raised gross proceeds of approximately $19.7 million in new equity capital in a rights offering (offering) which, after deducting capital raising costs, provided $18.0 million in net equity capital. The Company contributed $16.5 million of the net proceeds to the Bank in the form of Tier 1 capital. On a proforma basis, the Bank's total risk-based capital ratio, and Tier 1 risk-based capital ratio and leverage ratio are 11.77%, 13.07% and 6.89%, respectively, at December 31, 1993, assuming that the Bank had received the capital contribution and, in turn, placed the funds in 20% risk-weighted assets at year end. Under the same assumptions, the Company's total risk-based capital ratio, Tier 1 risk-based capital ratio and leverage ratio were 13.08%, 10.95% and 6.68%, respectively. OTHER ITEMS. The FDIC Improvement Act also, among other things, (i) limits the percentage of interest paid on brokered deposits and limits the unrestricted use of such deposits to only those institutions that are well capitalized; (ii) requires the FDIC to charge insurance premiums based on the risk profile of each institution; (iii) eliminates "pass through" deposit insurance for certain employee benefit accounts unless the depository institution is well capitalized or, under certain circumstances, adequately capitalized; (iv) prohibits insured state chartered banks from engaging as principal in any type of activity that is not permissible for a national bank unless the FDIC permits such activity and the bank meets all of its regulatory capital requirements; (v) directs the appropriate Federal banking agency to determine the amount of readily marketable purchased mortgage servicing rights that may be included in calculating such institution's tangible, core and risk-based capital; and (vi) provides that, subject to certain limitations, any Federal savings association may acquire or be acquired by any insured depository institution. The FDIC has adopted final regulations implementing the risk-based premium system mandated by the FDIC Improvement Act. Under the final regulations, which cover the assessment periods commencing on and after January 1, 1994, insured depository institutions are required to pay insurance premiums within a range of 23 cents per $100 of deposits to 31 cents per $100 of deposits depending on their risk classification. To determine the risk-based assessment for each institution, the FDIC will categorize an institution as well capitalized, adequately capitalized or undercapitalized based on its capital ratios. A well capitalized institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio and a 5% leverage capital ratio. An adequately capitalized institution will have at least an 8% total risk-based capital ratio, a 4% Tier 1 risk-based capital ratio and a 4% leverage capital ratio. The FDIC will also assign each institution to one of three subgroups based upon reviews by the institution's primary Federal or state regulator, statistical analyses of financial statements and other information relevant to evaluating the risk posed by the institution. As a result, the assessment rates within each of three capital categories will be as follows (expressed as cents per $100 of deposits): In addition, the FDIC has issued final regulations implementing provisions of the FDIC Improvement Act relating to powers of insured state-chartered banks. The regulations prohibit insured state-chartered banks from making equity investments of a type, or in an amount, that are not permissible for national banks. In general, equity investments include equity securities, partnership interests and equity interests in real estate. Under the final regulations, non-permissible investments must be divested by no later than December 19, 1996. The FDIC has also issued final regulations which prohibit, subject to certain specified exceptions, insured state-chartered banks from engaging as principal in any activity not permissible for a national bank, without FDIC approval. The regulations also provide that, subject to certain specified exceptions, subsidiaries of insured state-chartered banks may not engage as principal in any activity that is not permissible for a subsidiary of a national bank, without FDIC approval. The impact of the FDIC Improvement Act on the Company and the Bank is uncertain, especially since many of the regulations promulgated thereunder have only been recently adopted and certain of the law's provisions still need to be defined through future regulatory action. Certain provisions, such as the recently adopted real estate lending standards and the limitations on investments and powers of state-chartered banks and the rules to be adopted governing compensation, fees and other operating policies, may affect the way in which the Bank conducts its business, and other provisions, such as those relating to the establishment of the risk-based premium system and the limitations on pass-through insurance, may affect the Bank's results of operations. CAPITAL ADEQUACY GUIDELINES The Federal Reserve Board and the FDIC have issued guidelines to implement risk-based capital requirements. The guidelines are intended to establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet items into account in assessing capital adequacy and minimizes disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance sheet items, such as letters of credit and outstanding loan commitments, are assigned to one of several risk categories, which range from 0% for risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregate dollar amount of each category is then multiplied by the risk-weight associated with that category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets. The guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must consist of Tier 1 capital. Higher risk-based ratios are required for an insured depository institution to be considered well capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Improvement Act of 1991 -- Prompt Corrective Regulatory Action." A banking organization's qualifying total capital consists of two components: Tier 1 capital (core capital) and Tier 2 capital (supplementary capital). Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock (plus, for bank holding companies, qualifying cumulative perpetual preferred stock in an amount up to 25% of Tier 1 capital) and minority interests in the equity accounts of consolidated subsidiaries. Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchase credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization's total regulatory capital must consist of Tier 1 capital. Tier 2 capital may consist of (i) the allowance for possible loan and lease losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock and long-term preferred stock (which for bank holding companies must have an original maturity of 20 years or more) and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus, in an amount up to 50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2 capital are subject to certain requirements and limitations of the Federal banking agencies. The Federal Reserve Board and the FDIC have also adopted a minimum leverage ratio of Tier 1 capital to average total assets of 3% for institutions which have been determined to be in the highest of five categories used by regulators to rate financial institutions. This leverage ratio is only a minimum. Institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain capital well above the minimum level. All other institutions are required to maintain leverage ratios of at least 100 to 200 basis points above the 3% minimum. Furthermore, higher leverage ratios are required for an insured depository institution to be considered well capitalized or adequately capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. Business - -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Corporation Improvement Act of 1991 -- Prompt Corrective Regulatory Action." As of December 31, 1993, the Company and the Bank had total risk-based capital ratios of 8.15% and 8.33%, Tier 1 risk-based capital ratios of 6.00% and 7.02% and leverage ratios of 3.74% and 4.19%, respectively. See "Effect of Governmental Policies and Recent Legislation -- Standards for Safety and Soundness." The Federal banking agencies have issued proposed rules, in accordance with the FDIC Improvement Act, seeking public comment on methods for measuring interest rate risk, and two alternative methods for determining what amount of additional capital, if any, a bank may be required to have for interest rate risk. The Company cannot yet determine whether such proposals will be adopted or the impact of such regulations, if adopted, on the Company and the Bank. The Federal banking agencies recently issued a statement advising that, for regulatory purposes, federally supervised banks and savings associations should report deferred tax assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," beginning in 1993. SFAS No. 109 employs an asset and liability approach in accounting for income taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and as measured by the provisions of enacted tax law. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation." However, the Federal banking agencies have advised limiting the amount of deferred tax assets that is allowable in computing an institution's regulatory capital. Deferred tax assets that can be realized from taxes paid in prior carry back years and from the future reversal of taxable temporary differences would generally not be limited. Deferred tax assets that can only be realized through future taxable earnings, including the implementation of a tax planning strategy, would be limited for regulatory capital purposes to the lesser of (i) the amount that can be realized within one year of the quarter-end report date or (ii) 10% of Tier 1 capital. The amount of deferred taxes in excess of this limit, if any, would be deducted from Tier 1 capital and total assets in regulatory capital calculations. CHANGES IN ACCOUNTING PRINCIPLES In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). Under SFAS 114, a loan is impaired when it is "probable" that a creditor will be unable to collect all amounts due (i.e., both principal and interest) according to the contractual terms of the loan agreement. The measurement of impairment may be based on (1) the present value of the expected future cash flows of the impaired loan discounted at the loan's original effective interest rate, (2) the observable market price of the impaired loan or (3) the fair value of the collateral of a collateral-dependent loan. The amount by which the recorded investment of the loan exceeds the measure of the impaired loan is recognized by recording a valuation allowance with a corresponding charge to provision for loan losses. Additionally, SFAS 114 eliminates the requirement that a creditor account for certain loans as foreclosed assets until the creditor has taken possession of the collateral. SFAS 114 is effective for financial statements issued for fiscal years beginning after December 15, 1994. Earlier adoption is permitted. To comply with regulatory requirements regarding SFAS No. 114 effective in 1993, in-substance foreclosed assets are classified as loans in cases where the Company does not have physical possession of the underlying collateral. Although the Company has not yet adopted SFAS 114, management does not expect implementation to have a material impact on the Company's financial position or results of operations. In May 1993, the FASB issued Statement of Financial Standards No. 115 "Accounting For Certain Investments in Debt and Equity Securities" addressing the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments would be classified in three categories and accounted for as follows: (i) debt and equity securities that the entity has the positive intent and ability to hold to maturity would be classified as "held to maturity" and reported at amortized cost; (ii) debt and equity securities that are held for current resale would be classified as trading securities and reported at fair value, with unrealized gains and losses included in operations; and (iii) debt and equity securities not classified as either securities held to maturity or trading securities would be classified as securities available for sale, and reported at fair value, with unrealized gains and losses excluded from operations and reported as a separate component of shareholders' equity. The statement is effective for financial statements for calendar year 1994, but may be applied to an earlier fiscal year for which annual financial statements have not been issued. The Bank has both investment securities classified as "available to maturity" and investment securities classified as "available for sale". Securities classified as available for sale will be reported at their fair value at the end of each fiscal quarter. Accordingly, the value of such securities fluctuates based on changes in interest rates. Generally, an increase in interest rates would result in a decline in the value of investment securities held for sale, while a decline in interest rates would result in an increase in the value of such securities. Therefore, the value of investment securities available for sale and the Bank's shareholders' equity could be subject to fluctuation based on changes in interest rates. As a consequence, the Bank's capital levels for regulatory purposes could change based solely on fluctuations in interest rates and fluctuations in the value of investment securities available for sale. Such change could result in additional regulatory restrictions under the prompt corrective actions provisions of the FDIC Improvement Act of 1991 and various other laws and regulations that are based, in part, on an institution's capital levels, including those dealing with the risk related insurance premium system and brokered deposit restrictions. See "Business -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Corporation Improvement Act of 1991." OMNIBUS BUDGET RECONCILIATION ACT OF 1993 On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act"). Some of the provisions in the Reconciliation Act that may have an effect on the Company include the following: (i) the corporate income tax rate was increased from 34.0% to 35.0% for taxable income in excess of $10.0 million; (ii) mark-to-market rules for tax purposes with regard to securities held for sale by the Company; (iii) beginning in 1994 the amount of business meals and entertainment expenses that will be disallowed will be increased from the current 20.0% disallowance to 50.0% disallowance; (iv) club dues and lobbying expenses will no longer be deductible; and (v) certain intangible assets, including goodwill, will be amortized over a period of 15 years. Considering the Company's current tax situation, the Company does not expect the provisions of the Reconciliation Act to have a material effect on the Company. SUPERVISION AND REGULATION Bank holding companies and banks are extensively regulated under both federal and state law. THE COMPANY The Company, as a registered bank holding company, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Act. The Federal Reserve Board may conduct examinations of the Company and its subsidiaries. The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest certain subsidiaries or affiliates when the Federal Reserve Board believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities. Under the Act and regulations adopted by the Federal Reserve Board, a bank holding company and its nonbanking subsidiaries are prohibited from requiring certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Further, the Company is required by the Federal Reserve Board to maintain certain levels of capital. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation -- Capital Adequacy Guidelines." The Company is required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company. The Company is prohibited by the Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making any such determination, the Federal Reserve Board is required to consider whether the performance of such activities by the Company or an affiliate can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities commenced DE NOVO and activities commenced by acquisition, in whole or in part, of a going concern and is generally prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition is specifically authorized by the laws of such other state. Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve Board's policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both. This doctrine has become known as the "source of strength" doctrine. Although the United States Court of Appeals for the Fifth Circuit found the Federal Reserve Board's source of strength doctrine invalid in 1990, stating that the Federal Reserve Board had no authority to assert the doctrine under the Act, the decision, which was not binding on federal courts outside the Fifth Circuit, was recently reversed by the United States Supreme Court on procedural grounds. The validity of the source of strength doctrine is likely to continue to be the subject of litigation until definitively resolved by the courts or by Congress. The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the California State Banking Department. Finally, the Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, including but not limited to, filing annual, quarterly and other current reports with the Securities and Exchange Commission. THE BANK The Bank, as a California state-chartered bank which is a member of the Federal Reserve System, is subject to primary supervision, periodic examination and regulation by the Federal Reserve Board and the Superintendent. The Bank is insured by the FDIC, which currently insures deposits of each member bank to a maximum of $100,000 per depositor. For this protection, the Bank, as is the case with all insured banks, pays a semi-annual statutory assessment and is subject to the rules and regulations of the FDIC. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation." Various requirements and restrictions under the laws of the State of California and the United States affect the operations of the Bank. State and Federal statutes and regulations relate to many aspects of the Bank's operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation -- Capital Adequacy Guidelines." RESTRICTIONS ON TRANSFERS OF FUNDS TO GUARDIAN BANCORP BY THE BANK Guardian Bancorp is a legal entity separate and distinct from the Bank and its subsidiary. There are statutory and regulatory limitations on the amount of dividends which may be paid to Guardian Bancorp by the Bank. California law restricts the amount available for cash dividends by state-chartered banks to the lesser of retained earnings or the bank's net income for its last three fiscal years (less any distributions to shareholders made during such period). In the event a bank has no retained earnings or net income for its last three fiscal years, cash dividends may be paid in an amount not exceeding the net income for such bank's last preceding fiscal year only after obtaining the prior approval of the Superintendent. The Federal Reserve Board also has authority to prohibit the Bank from engaging in what, in the Federal Reserve Board's opinion, constitutes an unsafe or unsound practice in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the Federal Reserve Board could assert that the payment of dividends or other payments might, under some circumstances, be such an unsafe or unsound practice. Further, the Federal Reserve Board has established guidelines with respect to the maintenance of appropriate levels of capital by banks or bank holding companies under their jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of the FDIC Improvement Act could limit the amount of dividends which the Bank or the Company may pay. See "Item 1. Business -- Federal Deposit Insurance Corporation Improvement Act of 1991 -- Prompt Corrective Regulatory Action and -- Capital Adequacy Guidelines" for a discussion of these additional restrictions on capital distributions. At December 31, 1993, Guardian Bancorp, on an unconsolidated parent company only basis, had cash and cash equivalents available of approximately $402,000. Guardian Bancorp retained approximately $1.2 million of the net proceeds received in its rights offering completed in the first quarter of 1994 for purposes of meeting its general corporate operating needs. Substantially all of Guardian Bancorp's future revenues, on an unconsolidated basis, including funds available for the payment of dividends and other operating expenses, are, and will continue to be, primarily dividends paid by the Bank. However, the Bank has entered into a written agreement with the Federal Reserve Bank of San Francisco (the "Federal Reserve Bank") pursuant to which it has agreed not to pay any cash dividends to Guardian Bancorp without the prior written approval of the Federal Reserve Bank. See "Item 1. Business -- Supervision and Regulation -- Potential and Existing Enforcement Actions." The Bank is subject to certain restrictions imposed by Federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, the Company or other affiliates, the purchase of or investments in stock or other securities thereof, the taking of such securities as collateral for loans and the purchase of assets of the Company or other affiliates. Such restrictions prevent the Company and such other affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in the Company or to or in any other affiliate is limited to 10% of the Bank's capital and surplus (as defined by Federal regulations) and such secured loans and investments are limited, in the aggregate, to 20% of the Bank's capital and surplus (as defined by Federal regulations). California law also imposes certain restrictions with respect to transactions involving Guardian Bancorp and other controlling persons of the Bank. Additional restrictions on transactions with affiliates may be imposed on the Bank under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. Business -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Corporation Improvement Act of 1991 -- Prompt Corrective Regulatory Action." POTENTIAL AND EXISTING ENFORCEMENT ACTIONS Commercial banking organizations, such as the Bank, and their institution-affiliated parties, which include the Company, may be subject to potential enforcement actions by the Federal Reserve Board, the Superintendent and the FDIC for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the Bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDIC Improvement Act. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company. On February 16, 1993, the Bank consented to the payment of $20,000 as settlement of an assessed civil money penalty relating to alleged Call Report filing deficiencies asserted by the Federal Reserve Board. The payment was made solely for the purpose of settlement of the alleged deficiencies and to avoid protracted or extended hearings, testimony or other proceedings, and it did not constitute an admission by the Bank of any allegation made or implied by the Federal Reserve Board. Management believes that the Federal Reserve Board does not contemplate taking any further action in connection with this matter. On October 14, 1992, the Federal Reserve Bank, acting under delegated authority from the Federal Reserve Board, entered into a separate written agreement with each of the Company and the Bank. These agreements require the Company and the Bank to, among other things: (a) develop a plan and take steps to monitor and decrease the level of the Bank's nonperforming or otherwise classified assets; (b) establish policies designed to monitor the type, growth and amounts of credit concentration; (c) develop or update, as necessary, various operating and intercompany plans and procedures; (d) develop formalized strategic operating and capital maintenance plans, including a plan to maintain an adequate capital position; (e) maintain a loan loss reserve that is equal to or greater than 1.7% of the Bank's total loans; (f) assess the duties and remuneration of certain personnel; (g) take steps to correct or eliminate any violations of law and to avoid them in the future; (h) refrain from declaring or paying any cash dividends without the prior approval of the Federal Reserve Bank; (i) refrain from incurring any debt, other than in the ordinary course of business, at the holding company level without the prior approval of the Federal Reserve Bank; (j) refrain from accepting or placing any brokered deposits except in compliance with Sections 29 and 29A of the Federal Deposit Insurance Act; (k) notify the Federal Reserve Bank at least 30 days before adding or replacing a director or senior executive officer; (l) take steps to ensure that all reports required to be filed accurately reflect the financial condition of the Company or the Bank as of the date of such report; and (m) furnish quarterly written progress reports to the Federal Reserve Bank detailing the actions taken to comply with the terms of the agreements. Both before and after entering into these agreements, management of the Company and the Bank have taken various steps, including the recently completed capital raising efforts, that are designed to facilitate compliance with the terms thereof. However, compliance with the terms of the agreements will be determined by the Federal Reserve Bank during subsequent examinations of the Company and the Bank. In the event that the Federal Reserve Bank determines that the Company or the Bank is not in compliance with any of the terms of the agreements, it would have available to it various remedies, including taking one or more of the enforcement actions discussed above. ITEM 2. ITEM 2. PROPERTIES. All of the Company's offices are occupied under leases that expire on various dates through March 2003, and, in the case of the Company's principal executive and the Bank's head office, include options to renew. For the years ended December 31, 1993, 1992 and 1991, rental expense under these leases aggregated approximately $921,000, $1.6 million and $1.4 million, respectively. Guardian Trust subleases its space from the Company. Management believes that its existing facilities are adequate for its present purposes. See Note 13 to the Company's Consolidated Financial Statements of the Registrant's Annual Report to shareholders for the year ended December 31, 1993 (the "1993 Annual Report") and incorporated herein for additional information relating to lease rental expense and commitments. During the first quarter of 1993, the Company renegotiated the lease for the Company's principal executive office and the Bank's head office. The renegotiated lease will reduce the base rent expense for that space over the next nine years by an aggregate amount of approximately $2.3 million. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is a party to routine litigation involving various aspects of its business, none of which, in the opinion of management, will have a material adverse impact on the consolidated financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Inapplicable PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required by this item is set forth under the caption "Common Stock Price Range and Dividend Policy" at page 52 of the Registrant's 1993 Annual Report and incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information required by this item is set forth under the caption "Selected Financial Data" at page 8 of the Registrant's 1993 Annual Report and incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by this item is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" at pages 9 through 27 of the Registrant's 1993 Annual Report and incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Item 14 of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Inapplicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by this item is set forth in the Registrant's Definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year ("Proxy Statement") under the captions entitled "Election of Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" and incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is set forth in the Registrant's Proxy Statement under the caption entitled "Executive Compensation" and incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is set forth in the Registrant's Proxy Statement under the caption entitled "Beneficial Ownership of Common Stock" and incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS. The information required by this item is set forth in the Registrant's Proxy Statement under the caption entitled "Executive Compensation -- Transactions with Management" and incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: 1. Financial Statements and Schedules 2. No financial statement schedules are included in this report on the basis that they are either inapplicable or the information required to be set forth therein is contained in the financial statements filed herewith. 3. Exhibits Executive Compensation Plans and Arrangements The following compensation plans and arrangements are filed as exhibits to this Annual Report on Form 10-K: Guardian Bancorp 1984 Stock Option Plan, as amended and restated and further amended, and the Form of Stock Option Agreements thereunder, Exhibits 4.2, 4.2(a), 4.2(b), 4.3 and 4.4; Guardian Bancorp Employee Stock Ownership Plan, Exhibit 4.7; Guardian Bancorp Employee Stock Ownership Trust, dated May 25, 1988, Exhibit 4.8; Guardian Bancorp Deferred Compensation Plan, Exhibit 4.9; Guardian Bancorp Deferred Compensation Trust Agreement, Exhibit 4.10; Guardian Bancorp 1990 Stock Incentive Plan, as amended and restated and further amended, and the Form of Stock Option Agreements thereunder, Exhibits 4.14, 4.14(a), 4.15 and 4.16; Guardian Bancorp 1990 Deferred Compensation Plan, Exhibit 4.17; Guardian Bancorp 1990 Deferred Compensation Plan Trust Agreement, Exhibit 4.18; Employment Agreement between the Registrant and Paul M. Harris, dated October 20, 1992, Exhibit 10.4; Settlement Agreement and Mutual General Release among the Registrant, Guardian Bank, Guardian Trust Co. and Arthur W. Tate dated November 12, 1993, Exhibit 10.5; Employment Agreement between the Registrant and Vincent A. Bell, dated October 20, 1988, Exhibit 10.6; Settlement Agreement and Mutual General Release among the Registrant, Guardian Bank and Ronald W. Holloway dated November 26, 1993, Exhibit 10.7. (b) Reports on Form 8-K Inapplicable (c) Exhibits Required by Item 601 of Regulation S-K See Item 14(a)(3) above. (d) Additional Financial Statements Inapplicable For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8, Commission File Nos. 2-96894 (filed April 5, 1985 and amended by post-effective amendment dated May 24, 1988), 33-22371 (filed June 8, 1988) and 33-35012 (filed May 30, 1990): 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 foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission 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 Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirement of Section 13 or 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. GUARDIAN BANCORP Date: March 29, 1994 By: /s/ PAUL M. HARRIS -------------------------------------- Paul M. Harris CHIEF EXECUTIVE OFFICER By: /s/ JON D. VAN DEUREN -------------------------------------- Jon D. Van Deuren EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS	14,334	94,268
790051_1993.txt	790051_1993	1993	790051	ITEM 1. BUSINESS. Carlisle Companies Incorporated was incorporated in 1986 in Delaware as a holding company for Carlisle Corporation, whose operations began in 1917, and its wholly-owned subsidiaries. Unless the context of this report otherwise requires, the words "Company" and "registrant" refer to Carlisle Companies Incorporated and its wholly-owned subsidiaries and any divisions or subsidiaries they may have. The Company's diversified manufacturing operations are conducted through its subsidiaries. The Company manufactures and distributes a wide variety of products for industry, primarily of rubber, plastics and metal content. Its products include both components used by other companies in the manufacture of capital and consumer goods and those for the aftermarket. The Company is the leading producer, or among the leading producers, of many of its lines. Sales of the Company's products are reported by distribution to the following three industry segments: Construction Materials, Transportation Products and General Industry. The principal products produced and services rendered in each of the industry segments include: Construction Materials--elastomeric membranes, metal roofing components, adhesives and related products for roofing systems and water barrier applications and outdoor recreation tiles; Transportation Products--custom manufactured rubber and plastic products for the automotive market, brake linings and pads for heavy duty trucks, trailers and off-road vehicles, specialty friction products, brakes and actuation systems for construction equipment and insulated wire products; General Industry--molded plastic foodservice products, small pneumatic tires, stamped and roll-formed wheels, custom molded plastic components, system integration products and insulated wire products. The amount of total revenue contributed by the products or services in each industry segment for each of the last three fiscal years is as follows (in millions): In each industry segment, the Company's products are generally distributed either by Company-employed field sales personnel or manufacturers' representatives. In a few instances distribution is through dealers and independent distributors. Inasmuch as some of the Company's customers are other manufacturers of relatively significant size, marketing methods in certain operations are designed to accommodate the requirements of a small group of high-volume producer-customers. In each industry segment, satisfactory supplies of raw materials and adequate sources of energy essential for operation of the Company's businesses have generally been available to date. Uncertain economic conditions, however, could cause shortages of some basic materials, particularly those which are petroleum derivatives (plastic resins, synthetic rubber, etc.) and used in the construction materials, and transportation products and general industry segments. The Company believes, though, that energy sources are secure and sufficient quantities of raw materials can be obtained through normal sources to avoid interruption of production in 1994. Patents, trademarks and licenses held by the Company generally are not considered significant to the successful conduct of most of the segments' businesses. In each industry segment, the Company is engaged in businesses, and its products serve markets, which generally are highly competitive. Product lines serving most markets tend to be price competitive; all lines compete not only on pricing, but also on service and product performance. No industry segment is dependent upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the segment. Order Backlog, which is believed to be firm, was $86.4 million at December 31, 1993 and $91.5 million at December 31, 1992. Stronger backlog positions at the end of 1993 were evident in the Company's automotive rubber and plastics markets and for operations within the Construction Materials segment. Strong backlog levels continued to be recorded at the Company's specialty tires and wheels and aircraft wire and cable operations at the end of 1993 though below levels of a year ago as manufacturing capacity and productivity have increased. Company sponsored research and development expenses increased to $11.2 million in 1993 from $10.7 million in 1992 and $10.4 million in 1991. Increased research and development activities within the Company's automotive rubber and plastics operations, along with expenses incurred by new operations combined for the higher expense levels in 1993. All other major operations maintained a similar level of research and development projects and costs in 1993 and 1992. The average number of persons employed by the Company during 1993 was 4,440. The businesses of the Construction Materials and Transportation Products industry segments are not seasonal in nature. Within the General Industry segment, distribution of lawn and garden products generally reach peak sales volume during the first two quarters of the year. In 1993, the Company acquired most of the assets of ECI Building Components, Inc., a metal roofing and panel manufacturer, and now operates a business with the assets under the name Carlisle Engineered Metals Incorporated. The Company also acquired the assets of Goodyear Tire & Rubber Company's Roofing Systems Division, and now operates a non-residential roofing systems business under the name Versico Incorporated. During 1993, the Company entered the market for services to the international perishable cargo transportation industry by establishing a partnership with Marubeni Corporation, a large Japanese trading firm, to provide specialty equipment leasing services to shippers of perishable cargo. Carlisle Container Manufacturing Corporation, formed in 1993, will manufacture insulated containers for transportation of perishable cargo. In each industry segment, the Company's compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment is not anticipated to have a material effect upon the capital expenditures, earnings or the competitive position of the Company or its divisions and subsidiaries. Information on the Company's revenues, operating profit or loss and identifiable assets by industry segments for the last three fiscal years, the nature and effect of the restatement of such information as a result of changes made in the way the Company's products or services are grouped into industry segments and the principal products in each segment is as follows: ITEM 2. ITEM 2. PROPERTIES The following table sets forth certain information with respect to the principal properties and plants of the Company as of December 31, 1993: Total plant space of 3,574,140 sq. ft. is used for As of December 31, 1993, the Company owned three additional facilities. One is related to a wire and cable business sold in early 1988, one is a wire and cable operation relocated in 1989, and the other is related to a commercial foodservice business relocated in 1992. These facilities, totaling approximately 500,000 sq. ft., are being held for sale. An additional 523,000 sq. ft. is leased by the Company, under various agreements, principally for warehousing and distribution. All of the manufacturing and most of the office and warehousing space is of masonry and steel construction and most are equipped with automatic sprinkler systems. Approximately one- third of the owned office, manufacturing and warehousing space has been constructed within the last twenty years; the remaining buildings are from twenty to seventy years old and have been maintained in good condition. ITEM 3. ITEM 3. LEGAL PROCEEDINGS As of December 31, 1993, other than ordinary routine litigation incidental to the business, which is being handled in the ordinary course of business, neither the Company nor any of its subsidiaries is a party to, nor are any of their properties subject to any material pending legal proceedings, nor are any such proceedings known to be contemplated by governmental authorities. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. The Company's common stock is traded on the New York Stock Exchange. As of December 31, 1993, there were 2,186 shareholders of record. Quarterly cash dividends paid and the high and low prices of the Company's stock on the New York Stock Exchange in 1993 and 1992 were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The Company's sales increased 16% and net earnings from continuing operations improved 17% in 1993 compared to 1992. Sales in 1993 were $611.3 million versus sales in 1992 of $528.1 million. Net earnings from continuing operations improved to $28.4 million, $1.83 a share, from $24.2 million, $1.58 a share in 1992. In 1992, discontinued operations contributed an additional $0.5 million, $0.03 a share, to net earnings resulting in total earnings of $24.7 million, $1.61 a share. In the second quarter of 1993, prompted by strong growth in the price of the Company's shares, the Company executed a two-for-one stock split. All share information has been adjusted in this report to reflect the split. The Company completed two acquisitions in 1993 to expand and strengthen its operations within its construction materials segment. Acquired in January 1993 were the assets of ECI Building Components, Inc. (now operating as Carlisle Engineered Metals Incorporated), an architectural metal roofing and panel manufacturer. In March 1993, the Company purchased the Roofing Systems division of Goodyear Tire & Rubber Company (now operating as Versico Incorporated), broadening its coverage of the non-residential EPDM roofing market. Sales in 1993 increased over 1992's levels as the result of record performances by operations within the Company's General Industry segment and the performance of the acquisitions made within the Construction Materials segment. A summary of sales by operating segment is presented below. Construction Materials segment sales in 1993 of $247.6 million increased by $48.9 million when compared to 1992, as the acquisitions made in early 1993 recorded revenues of $43.3 million. Non-residential roofing demand was effectively flat in 1993 versus 1992's depressed levels, while pricing levels declined slightly. Continued market share improvements, including increased international shipments, contributed to 1993's record segment sales levels. The segment's sales comparisons were also impacted in 1993 by the decision to discontinue the sales of plenum cable. The elimination of this product line caused a $4.4 million reduction in 1993's sales compared to the prior year. Transportation Products segment sales improved 2% to $177.0 million in 1993 compared to 1992. Aircraft wire product sales in 1993 improved $4.2 million over 1992's levels as the Company's Tufflite wire products gained market acceptance during the year. Demand for the Company's braking system products declined while heavy-duty friction products sold to the original equipment tractor/trailer market were up over 25% in a strong market in 1993. Heavy duty friction aftermarket revenues improved 2% compared to 1992. Custom rubber and plastic sales to automobile equipment manufacturers finished strongly in the latter part of 1993 as automobile and truck production surpassed 1992 levels. This stronger market brought sales volume increases which were partially offset by lower prices throughout 1993 to net a 3% sales increase over 1992. General Industry segment sales were up 19% in 1993 over 1992 as the two primary operations in the segment achieved record high results. In 1993, the Company's specialty tires and wheels operations recorded a 22% sales increase over 1992, after achieving a similar improvement in 1992 over 1991. Increased sales from specialty tires and wheels operations were the result of higher volumes from market share gains, an extended lawn and garden season in 1993, expanded product offerings and successful penetration into new markets. The Company's foodservice plastics operations also achieved record sales levels in 1993 as revenues increased 11% over 1992. Market share gains, particularly in the Company's contract plastic molding operations, combined with expanded foodservice product offerings to achieve the successful 1993 results. Other operations within the general industry segment, including high speed data wire and cable and system integration products also improved their market positions in 1993 to produce higher sales. Net earnings from continuing operations improved 17% in 1993 over 1992 on the strength of performances of operations within the Construction Materials and General Industry segments. Net earnings from continuing operations in 1993 were $28.4 million, $1.83 a share, compared to $24.2 million, $1.58 a share, in 1992. This compares to net earnings from continuing operations of $6.6 million, $0.43 a share, in 1991 after taking an $11.6 million after-tax charge, $0.76 a share, for operational restructuring. In 1991, the Company recorded losses associated with the operations and discontinuance of its operations engaged in the production, sale and maintenance of computer tape products and systems hardware. These operations were sold in 1992. A summary of after-tax results for the last three years is presented below. Earnings by continuing operating segment, before income tax, interest, restructuring charge and corporate expense, are summarized below. Earnings from the Construction Materials segment improved 8% in 1993 versus 1992. Contributing to the earnings improvement was a favorable product mix and lower operating expenses within non-residential roofing systems operations. Partially offsetting these gains were initial year operating expenses absorbed in 1993 associated with the acquisition and establishment of Carlisle Engineered Metals Incorporated. The Company's initial year entry into the metal roofing market brought lower overall margins to this segment in 1993. Transportation Products segment earnings in 1993 were flat compared to 1992. Earnings improved significantly from aircraft wire operations on higher sales and improved operational margins. Heavy duty friction operations earnings were impacted by an unfavorable product mix, as a higher percentage of sales in 1993 originated from its lower margin original equipment business compared to a year ago. Lower sales of braking system products in 1993, particularly in international markets, also negatively impacted segment earnings compared to 1992. Earnings from sales of custom rubber and plastics products to the automotive industry declined as the result of a full year impact of price concessions in 1993, which partially impacted 1992. Lower overall administrative expenses helped offset some of the effect of reduced prices in this segment in 1993. Operations within the General Industry segment recorded earnings in 1993 at a level 49% higher than 1992. Earnings in this segment improved 57% in 1992 over 1991. The increased 1993 sales of specialty tires and wheels operations produced a gain in earnings of 25%. Competitive pricing actions pushed margins downward but lower expenses continued to have a favorable effect upon earnings. Foodservice plastics operations improved earnings by 20% in 1993 versus 1992, again primarily driven by higher revenues. Margin percentages were slightly lower in 1993 as the result of the product mix of foodservice plastics products sold. Administrative expenses in relation to foodservice plastics sales were at lower levels in 1993 contributing to the improved earnings performance over 1992. High speed data wire and cable and system integration operations also improved their profitability in 1993 on the strength of major cost reduction efforts and higher sales levels. Gross margins as a percent of sales were 25.9% in 1993, compared to 26.3% in 1992 and 26.0% in 1991. The reduction in gross margins as a percent of sales in 1993 was caused by unfavorable product mixes and the inability to pass through material cost increases in some markets. The economic conditions in the first half of 1993 produced competitive pricing pressures, particularly within the Transportation Products segment. A higher mix of sales in 1993 to lower margin original equipment manufacturers in proportion to sales into the aftermarket resulted in lower comparative margin ratios within the heavy-duty friction operation. Improved overhead absorption from increased sales and effective cost reduction and expense control programs in each operating segment in 1993 combined to help offset the lower margin levels. Selling and administrative expenses continued to decline as a percent of sales to 16.1% in 1993, from 16.4% in 1992 and 17.2% in 1991. In the Construction Materials segment, excluding 1993 acquisitions, expense levels were reduced by approximately $1.0 million in 1993 compared to 1992. Higher expenses were required, however, in the first year of operations of the segment's 1993 acquisitions, resulting in an unfavorable effect upon the Company's overall expense ratios. Transportation Products segment operations reduced selling and administrative expenses by over $2.2 million in 1993 versus 1992. Higher sales levels and expense containment programs in place at operations within the general industry segment contributed to improved expense ratios for the segment. Research and development expenses increased to $11.2 million in 1993 from $10.7 million in 1992 and $10.4 million in 1991. Increased research and development activities within the Company's automotive rubber and plastics operations, along with expenses incurred by new Company operations combined for the higher expense levels in 1993. All other major operations maintained a similar level of research and development projects and costs in 1993 and 1992. Interest expense was $4.3 million in 1993 compared to $5.2 million in 1992 and $4.4 million in 1991. Two actions taken in 1993 resulted in lowering interest expense for the Company. The Company paid down $12.0 million of its 8% senior notes in March 1993 and refinanced its $8.5 million revenue bond issue to an adjustable rate bond in June 1993. The bond refinancing resulted in the average interest rate paid on the bonds after the refinancing to be 2.6% versus its previous 10.25% fixed rate. Income taxes were computed for financial statement purposes at a rate of 39.5% in 1993 compared to 39% in 1992 and 38% in 1991. The higher rate in 1993 is primarily the result of the increase in the corporate federal tax rate legislated in 1993. An analysis of the provision for income taxes for each of the years is included in the Notes to Consolidated Financial Statements. Order backlog was $86.4 million at December 31, 1993 and $91.5 million at December 31, 1992. Stronger backlog positions at the end of 1993 were evident in the Company's automotive rubber and plastics markets and for operations within the Construction Materials segment. Strong backlog levels continued to be recorded at the Company's specialty tires and wheels and aircraft wire and cable operations at the end of 1993 though below levels of a year ago as manufacturing capacity and productivity have increased. Accounts receivable were $91.2 million at December 31, 1993 compared to $71.8 million at December 31, 1992. The acquisitions made in 1993 account for $6.1 million of the increase. Strong fourth quarter sales performances from the construction materials segment and from automotive rubber and plastics operations resulted in an increased 1993 year-end receivable balance compared to a year ago. Inventories valued primarily by the last-in, first-out (LIFO) method were $65.0 million at December 31, 1993 compared to $50.0 million at December 31, 1992. The acquisitions made in 1993 account for $12.9 million of the inventory increase. Higher inventory levels at year end 1993, after historically low levels at the end of 1992 at the Company's specialty tires and wheels and aircraft wire and cable operations were partially offset by reductions from aggressive inventory management within foodservice plastics and friction operations. Working capital was $144.5 million at December 31, 1993 and $162.1 million at December 31, 1992. In 1993, the Company paid down $12.0 million of long-term debt and increased levels of internal investment through capital spending. These factors along with the effects of the 1993 acquisitions are the primary factors for the change in working capital. Capital expenditures totaled $28.5 million in 1993 and $19.9 million in 1992. Major projects in 1993 included the acquisition of machinery to expand and improve the Company's automotive rubber and plastics operations, add capacity to the specialty tire and wheels operations and provide advanced processing technology into construction material operations. In 1992, the major components of activity included adding capacity in the Company's foodservice plastics operations and purchasing assets to expand non-automotive plastic molding capabilities. Cash flows provided by operating activities were $32.8 million in 1993 compared to $49.8 million in 1992. The lower amount provided in 1993 results from higher levels of working capital employed by operations at year end 1993 versus 1992 and higher tax payments required during the course of 1993. Investing activities absorbed $49.4 million of cash flow in 1993 through capital spending, operational investments and company acquisitions. In 1992, net cash was provided from investing activities of $18.3 million as capital spending was exceeded by cash received from the sale of excess facilities and discontinued operations. Financing activities in 1993 were driven by the pay-down of senior long-term debt and higher dividend payments resulting in reductions in cash of $22.2 million. Financing activities in 1992 provided cash of $8.0 million as net proceeds from long-term debt exceeded dividend payments. The Company's primary liquidity and capital sources are its operations, bank lines of credit and long-term borrowings. The Company continues to have substantial borrowing capacity and financial flexibility. The Company recognizes the importance of its responsibilities toward matters of environmental concern. Programs are in place to monitor and test facilities and surrounding environments, as well as to recycle materials where practical. The Company has not incurred any material charges relating to environmental matters in 1993 or in prior years, and none are anticipated in the foreseeable future. The 1994 outlook for the Company is good. Effective cost control has been an important factor in the earnings improvement of the Company. Continuation of this cost control with improving conditions in our markets should result in better performance as the year evolves. Non-residential roofing markets will continue to be dominated by repair and replacement demand in a slowly improving market. The effects of the 1993 acquisitions of a metal roofing business and a membrane roofing business, included for a full year in 1994, will have a favorable impact upon earnings. The Company's strong competitive position places us favorably to take advantage of opportunities presented by a strengthening market. The optimistic outlook for automobile and truck production will translate into stronger performance in our Transportation Products segment. The results of our custom-molded rubber and plastic products should improve at least as much as the overall market. We will continue the diversification of our customer base. The strength in original equipment markets for friction products is expected to continue. Improved financial performance, however, depends upon a rebound in the aftermarket. A strengthening economy is the primary stimulus to overall freight movement. Strong domestic growth and new products will result in a rebound in performance for the Company's friction business. The 1993 momentum in the high performance aircraft wire and cable business is expected to continue. Excellent acceptance by the major manufacturers in the industry will continue to allow us to overcome the weakness in the overall aviation market. The Company's leading position in specialty tires and wheels is expected to generate further gains in this well performing business. Growing participation in golf car and trailer tires combined with good results from the lawn and garden sector provide for an optimistic outlook. Similarly, the record performance of our foodservice plastics business is expected to continue in 1994. Added product lines, improved internal efficiency and attractive markets should produce another outstanding year. Overall, the outlook for the Company in 1994 and beyond is bright. The order backlog is good, financial resources are in place, domestic markets are improving and our international presence is growing. The Company expects to make further strategic investments that will blend with the positive momentum of our existing businesses to provide consistent and progressive long-term performance improvement that translates to value for our customers and our shareholders. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING POLICIES The consolidated financial statements include the accounts of the Company and its subsidiaries. Investments in less than majority owned affiliates, none of which are significant, are accounted for on the equity method. All material intercompany transactions and accounts have been eliminated. Cash and cash equivalents include all cash balances and highly liquid investments with original maturities of three months or less. Inventories are valued at lower of cost or market. Cost for inventories is determined for a majority of the Company's inventories by the last-in, first- out (LIFO) method with the remainder determined by the first-in, first-out (FIFO) method. Property, plant and equipment are stated at cost. Costs assigned to property, plant and equipment of acquired companies are based on estimated fair value at the date of acquisition. Depreciation is principally computed on the straight line basis over the estimated useful lives of the assets. Asset lives are 20 to 40 years for buildings, 5 to 15 years for machinery and equipment and 3 to 10 years for leasehold improvements. Patents and other intangibles, obtained through acquisitions, are recorded at cost (net of accumulated amortization of $5.4 million and $4.9 million at December 31, 1993 and 1992, respectively) and amortized over their remaining lives averaging six to eight years. Also included is the excess of acquisition cost over the value of assets acquired, $2.3 million and $2.4 million at December 31, 1993 and 1992, respectively, and is being amortized over various periods not exceeding 30 years. Amortization expense is recorded on the straight-line method. The Company maintains product warranties reserves to provide for future claims. Extended periods of coverage are available on certain products for a fee. Deferred tax assets and liabilities are recognized for the future tax consequences of the differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. These balances are measured using enacted tax rates expected to apply to taxable income in the years in which such temporary differences are expected to be recovered or settled. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized. Net earnings per share of common stock are based on the weighted average number of common shares and common equivalent shares outstanding during the period, assuming the exercise of stock options. Certain reclassifications have been made to prior years' information to conform to 1993 presentation. INVENTORIES The components of inventories are: PROPERTY, PLANT & EQUIPMENT The components of property, plant and equipment are: BORROWINGS Long-term debt, all unsecured, includes: In 1993, the Company paid down $12.0 million of its 8% notes and refinanced its previous 10.25% fixed rate revenue bonds to variable rate bonds. Additional variable rate industrial revenue bonds of $2.5 million were also secured in 1993. The interest rate on the revenue bonds at December 31, 1993 was 3.2%. The debt facilities contain various restrictive covenants and limitations, all of which were complied with in 1993 and 1992. Cash payments for interest were $4.9 million in 1993, $3.7 million in 1992, and $4.1 million in 1991. The Company had $10.1 million and $10.7 million of outstanding letters of credit issued against credit lines at December 31, 1993 and 1992, respectively. The aggregate amount of long-term debt maturing in each of the five years subsequent to December 31, 1993 is approximately $0.1 million a year through 1997 and $9.7 in 1998. ACQUISITIONS Acquisitions completed by the Company in the last three years include: 1993- ECI Building Components Incorporated, a metal roofing and panel manufacturer and Goodyear Tire & Rubber Company's Roofing Systems Division, a distributor and seller of non-residential roofing systems; 1991-SiLite Incorporated, a manufacturer of plasticware products for the foodservice industry. These acquisitions were completed for cash and assumption of debt and certain other liabilities of approximately $52.6 million and have been accounted for as purchases. Results of operations, which have been included in the consolidated financial statements since their respective acquisition dates, did not have a material effect on consolidated operating results of the Company in the years of acquisition. OPERATIONAL RESTRUCTURING In the third quarter of 1991, the Company recorded a restructuring charge of $18.7 million for costs associated with the relocation and consolidation of operations and the elimination of product lines. The charge included provisions for personnel severance, relocation and training costs, equipment relocation and related facility costs, the write-down of assets and other costs associated with the repositioning and removal of product lines. The restructuring charge is separately identified in the Consolidated Statement of Earnings for 1991. DISCONTINUED OPERATIONS In September 1991, the Company announced its decision to sell its businesses engaged in the production, sale and maintenance of computer tape products and systems integration hardware. A provision was recorded in 1991 for anticipated disposal costs and the write-down of related assets to estimated realizable value totalling $20.3 million, $12.6 million after-tax. In 1992, the Company sold its quarter-inch tape business, as well as its half-inch tape business, to substantially eliminate the operations which are classified as discontinued operations. The Company recognized earnings in 1992 from discontinued operations of $0.9 million, $0.5 million after-tax, as it adjusted its estimates due to better than anticipated performance. In 1991, net sales from discontinued operations were $88.1 million through September 30, and $117.5 million for the year. Losses from discontinued operations before tax were $3.9 million in 1991. SHAREHOLDERS' EQUITY On April 20, 1993 the Company's Board of Directors authorized a two-for-one stock split which was issued on June 1, 1993, to shareholders of record on May 11, 1993. The split resulted in the issuance of 9,832,656 new shares of common stock and the reissuance of 2,175,479 shares of common stock held in treasury. All references in the financial statements to average number of shares outstanding and related prices, per share amounts, and stock option plan data have been restated to reflect the split. The Company has a Stockholders' Rights Plan which is designed to protect stockholder investment values. A dividend distribution of one Preferred Stock Purchase Right for each outstanding share of the Company's common stock was declared, payable to stockholders of record on March 3, 1989. The rights will become exercisable under certain circumstances, including the acquisition of 25% of the Company's common stock, or 40% of the voting power, in which case all rights holders except the acquiror may purchase the Company's common stock at a 50% discount. If the Company is acquired in a merger or other business combination, and the rights have not been redeemed, rights holders may purchase the acquiror's shares at a 50% discount. Common stockholders of record May 30, 1986 are entitled to five votes per share. Common stock acquired subsequent to that date entitles the holder to one vote per share until held four years, after which time the holder will be entitled to five votes. EMPLOYEE STOCK OPTIONS & INCENTIVE PLAN The Company maintains an Executive Incentive Program for executives and certain other employees of the Company and its operating divisions and subsidiaries. The Program contains a plan, for those who are eligible, to receive cash bonuses and/or shares of restricted stock. The Program also has a stock option plan available to certain employees who are not eligible to receive cash or restricted stock awards. The Program makes available up to 627,099 shares of the Company's common stock for issuance as restricted stock and up to 736,392 shares for stock option grants. In 1993, 23,116 shares of restricted stock were issued and 4,951 shares were surrendered under the terms of the Program. The activity under the stock option plan, as restated, is as follows: RETIREMENT PLANS The Company maintains defined benefit retirement plans for the majority of its employees. Benefits are based primarily on years of service and earnings of the employee. Plan assets consist primarily of publicly-listed common stocks and corporate bonds. Pension expense includes: The funded status of the plans at December 31 was: The projected benefit obligation was determined using an assumed discount rate of 7.75% in 1993 and 8.50% in 1992. The assumed rate of compensation increase was 4.5% in 1993 and 5.5% in 1992. The expected rate of return on plan assets was 8.75% in 1993, 1992 and 1991. In 1992, the sale of discontinued operations and the corresponding reduction in retirement plan participants resulted in a plan curtailment. The effects of the curtailment were to decrease the unamortized balance of unrecognized prior service costs and to decrease the projected benefit obligation of the retirement plan which resulted in a net gain of $1.2 million. This gain is included in the computation of the net loss on the disposal of discontinued operations as reported in the Consolidated Statement of Earnings. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers Accounting for Post- Retirement Benefits Other Than Pensions". The Company has a limited number of post-retirement benefit programs and participants. Accordingly, the Company has elected to record the previously unrecognized obligations arising from the adoption of SFAS No. 106 prospectively as a component of future years expense, amortized over a 20 year period. The annual SFAS No. 106 expense for the Company, inclusive of the components of service costs, interest costs and the amortization of the unrecognized transition obligation, is approximately $0.6 million, $0.4 million after tax. The resulting annual expense in 1993 is not materially different than the Company's post-retirement benefits expense in 1992 and 1991 and is not material to its Consolidated Statement of Earnings. INCOME TAXES The provision for income taxes was as follows: Deferred tax assets (liabilities) are comprised of the following at December 31: A reconciliation of taxes computed at the statutory rate with the tax provision is as follows: The Company adopted SFAS No. 109 "Accounting for Income Taxes", in 1992 and applied its provisions retroactively to 1990. Cash payments for income taxes were $23.6 million, $9.6 million, and $12.3 million in 1993, 1992 and 1991, respectively. SEGMENT INFORMATION The Company's continuing operations are classified into the following business segments: CONSTRUCTION MATERIALS--elastomeric membranes, metal roofing components, adhesives and related products for roofing systems and water barrier applications and outdoor recreation tiles. TRANSPORTATION PRODUCTS--custom manufactured rubber and plastic products for the automotive market, brake linings and pads for heavy-duty trucks, trailers and off-road vehicles, specialty friction products, brakes and actuation systems for construction equipment and insulated wire products. GENERAL INDUSTRY--molded plastic foodservice products, small pneumatic tires, stamped and roll-formed wheels, custom molded plastic components, system integration products and insulated wire products. CORPORATE--includes general corporate and idle property expenses. Corporate assets consist primarily of cash, leasing company assets and excess facilities. Financial information for continuing operations by reportable business segment is included in the following summary: All per share amounts have been restated to reflect the two-for-one stock split on June 1, 1993. INDEPENDENT AUDITORS' REPORT The Board of Directors Carlisle Companies Incorporated: We have audited the accompanying consolidated balance sheet of Carlisle Companies Incorporated and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three-year period ending December 31, 1993. These consolidated financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Carlisle Companies Incorporated and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. KPMG Peat Marwick /s/ KPMG Peat Marwick Syracuse, New York February 2, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The following table sets forth certain information relating to each executive officer of the Company as of December 31, 1993, as furnished to the Company by the executive officers. Except as otherwise indicated each executive officer has had the same principal occupation or employment during the past five years. The officers have been elected to serve at the pleasure of the Board of Directors of the Company. There are no family relationships between any of the above officers, and there is no arrangement or understanding between any officer and any other person pursuant to which he was selected an officer. Information required by Item 10 with respect to directors of the Company is incorporated by reference to the Company's definitive proxy statement filed with the Securities and Exchange Commission on March 9, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required by Item 11 is incorporated by reference to the Company's definitive proxy statement filed with the Securities and Exchange Commission on March 9, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by Item 12 is incorporated by reference to the Company's definitive proxy statement filed with the Securities and Exchange Commission on March 9, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not Applicable PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. Financial statements required by Item 8 are as follows: Consolidated Statement of Earnings, years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Shareholders' Equity, years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheet, December 31, 1993 and 1992 Consolidated Statement of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Financial statement supplementary notes applicable to the filing of this report are as follows: Page 1. Other current liabilities 37 2. Maintenance and repair costs 37 3. Discontinued operations 37 Financial statement schedules applicable to the filing of this report are as follows: Page V - Property, Plant and Equipment 38 VI - Accumulated Depreciation of Property, Plant and Equipment 38 All other schedules are omitted because the required information is inapplicable or the information is presented in the financial statements or related notes. Exhibits applicable to the filing of this report are as follows: (3) By-laws of the Company * (3.1) Restated Certificate of Incorporation as amended April 22, 1991*** (4) Shareholders' Rights Agreement, February 8, 1989.* (10.1) 1988 Executive Long-Term Incentive Program.* (10.2) Representative copy of Executive Severance Agreement, dated December 19, 1990, between the Company and certain individuals, including the five most highly compensated executive officers of the Company. (10.3) Summary Plan Description of Carlisle Companies Incorporated Director Retirement Program, effective November 6, 1991.* (21) Subsidiaries of the Registrant. (23) Consent of Independent Auditors. * Filed as an Exhibit to the Company's annual report on Form 10-K for the year ended December 31, 1988 and incorporated herein by reference. Filed as an Exhibit to the Company's annual report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. * Filed as an Exhibit to the Company's annual report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference. No reports on Form 8-K were filed during the last quarter of the period covered by this report. The Company will furnish to the Commission upon request its long-term debt instruments not listed in this Item. SIGNATURES Pursuant to the requirements of Section 13 or 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. CARLISLE COMPANIES INCORPORATED /s/ Dennis J. Hall By: Dennis J. Hall, Executive Vice President and Treasurer 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 date indicated. /s/ Stephen P. Munn /s/ Magalen O. Bryant Stephen P. Munn, Chairman, Magalen O. Bryant, Director President and Chief Executive Officer and a Director (Principal Executive Officer) /s/ Donald G. Calder /s/ Dennis J. Hall Donald G. Calder, Director Dennis J. Hall, Executive Vice President, Treasurer and Chief Financial Officer /s/ Paul J. Choquette, Jr. (Principal Financial Officer) Paul J. Choquette, Jr., Director /s/ James B. Pineau James B. Pineau, Vice President /s/ Henry J. Forrest and Controller (Principal Accounting Officer) Henry J. Forrest, Director /s/ David G. Thomas David G. Thomas, Director March 28, 1994 INDEPENDENT AUDITORS' REPORT The Board of Directors Carlisle Companies Incorporated Under date of February 2, 1994, we reported on the consolidated balance sheet of Carlisle Companies Incorporated and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in this annual report on Form 10-K for the year ended December 31, 1993. These consolidated financial statements and our report thereon are incorporated by reference to this Form 10-K for the year ended December 31, 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related supplementary notes and financial statement schedules as listed in Item 14 of this Form 10-K. These supplementary notes and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these supplementary notes and financial statement schedules based on our audits. In our opinion, such supplementary notes and financial statement schedules, when considered in relation to the basic consolidated financial statements taken as whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Syracuse, New York /s/ KPMG Peat Marwick February 2, 1994 CARLISLE COMPANIES INCORPORATED AND SUBSIDIARIES SUPPLEMENTARY NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Note 1. Other Current Liabilities - Other current liabilities at December ------------------------- 31 consist of the following: Note 2. Maintenance and Repair Costs ---------------------------- Maintenance and repair costs of $11.2 million, $11.1 million and $8.7 million in 1993, 1992, and 1991 respectively, have been charged to earnings as cost of goods sold or selling and administrative expenses. Note 3. Discontinued Operations ----------------------- Net sales from discontinued operations were $58.4 million and $117.5 million in 1992 and 1991 respectively. Schedules V and VI should be read in conjunction with the Notes to Consolidated Financial Statements. CARLISLE COMPANIES INCORPORATED COMMISSION FILE NUMBER 1-9278 FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 1993 EXHIBIT LIST Page ---- (21) Subsidiaries of the Registrant 40 (23) Consent of Independent Auditors 41	7,082	47,133
859119_1993.txt	859119_1993	1993	859119	Item 1. Business BACKGROUND Illinois Central Corporation (the "Company") was incorporated under the laws of Delaware on January 27, 1989. The Company, through its wholly- owned subsidiary, Illinois Central Railroad Company (the "Railroad"), traces its origin to 1851, when the Railroad was incorporated as the nation's first land grant railroad. Today, the Railroad operates 2,700 miles of main line track between Chicago and the Gulf of Mexico, primarily carrying chemicals, coal and paper north, with coal, grain and milled grain products moving south along its lines. The Railroad has been significantly downsized and restructured from its peak of nearly 10,000 miles of track operated in 13 states, rebuilding its main line and converting to a single-track main line with a centralized traffic control system and divesting major east-west segments. In addition to the Railroad, the Company's other direct subsidiary conducts railroad related financing operations. In 1989, the Company was acquired by The Prospect Group, Inc. ("Prospect") by means of a public tender offer that resulted in the Company becoming highly leveraged. Prospect distributed the stock of the Company to Prospect's stockholders in 1990, and the Company again became publicly owned. Improved operating performance, combined with sales of non-operating assets and proceeds from equity and lower-cost debt financings since 1990 have resulted in a substantial reduction in the Company's leverage. Between December 31, 1989 and December 31, 1993, the Company reduced its debt to capitalization ratio from 89% to approximately 50%. The principal executive office of the Company is located at 455 North Cityfront Plaza Drive, Chicago, Illinois 60611-5504 and its telephone number is (312) 755-7500. GENERAL The Company is in the midst of a four year plan designed to increase its revenues and lower its operating ratio and interest costs. The plan is in sharp contrast to the Company's primary focus for the four years ended December 31, 1992 of significantly reducing costs and improving service offerings. With 1992 as its base, the plan will focus on capitalizing on the Company's leading operating ratio among Class I railroads (operating expenses divided by operating revenues) which was 68.2% at December 31, 1993. The components of the plan are: - increase annual revenues by $100 million by the end of 1996 - reduce the operating ratio by one percentage point per year for a total of four (4) points below the 1992 base - reduce annual interest expense by $10 million To accomplish this plan, revenues must grow at a compounded rate of 4.3% per year while operating expenses must not exceed a compounded annual growth rate of 2.5% per year. Management has identified the sources of planned revenue growth as economic expansion, new and expanded plants on line and market share growth. Economic expansion is the combination of industrial production improvement and freight rate increases. Market share growth is volume gained from competition, (i.e., other railroads, trucklines and barges) facilitated by being a low cost producer. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the progress made in 1993. To foster achievement of these goals, the Railroad reorganized its marketing and sales effort (see below), restructured its safety and claims group into a Risk Management Group and streamlined the operating organization. The latter effectively created teams of engineering, maintenance and transportation experts who share the common goal of moving trains safely and efficiently. As a result of these changes, decision-making authority and accountability are now at lower and more localized levels, in line with the Company's systematic efforts to examine and refine all aspects of its service offering to customers. COMMODITIES AND CUSTOMERS The Railroad's customers are engaged in a wide variety of businesses and ship a number of different products that can be classified into commodity groups: chemicals, coal, grain, paper, grain mill and food products and other commodities. In 1993, two customers accounted for approximately 7% and 6%, respectively, of revenues (no other customer exceeded 5%) and the ten largest customers accounted for approximately 37% of revenues. In order to address more effectively the diversity of the Company's customer base and move toward attainment of the four year growth plan, the Railroad's marketing department was re-organized in 1993 along major commodity groups. The new business units are chemicals and bulk, grain and grain mill, forest products, coal and coke and metals, and intermodal. The formation of separate units enables a fully integrated sales and marketing effort. Specialization allows employees to anticipate and respond to customer needs more quickly, to attract customers who previously used trucks or barges for their service needs, and to establish business relationships with new shippers. These new units work with current and prospective customers to develop customized shipping solutions. Management believes that this commitment to improved customer service has enhanced relations with shippers. The formation of the Intermodal Business Unit underscores the Company's commitment to intermodal through long-term relationships with major participants in this strategic market. By forming a separate business unit, the Railroad has fully integrated its intermodal hub operation with sales and marketing for unmatched control of this highly specialized, customer-oriented service. In 1993, the Railroad invested in 800 new trailers and upgraded facilities to position itself for intermodal growth, dedicated its newest, state- of-the-art terminal, just south of Chicago at the intersections of major expressways, and initiated a major expansion at the Memphis facility with completion anticipated for the first quarter of 1994. To enhance service within its corridor, the Railroad entered into several joint operating agreements in 1992 and 1993 with trucklines and other intermodal carriers. Management anticipates that these relationships will provide better service to customers and seamless transportation of goods for shippers and customers. In 1993, approximately 75% of the Railroad's freight traffic originated on its own lines, of which approximately 29% was forwarded to other carriers. Approximately 20% of the Railroad's freight traffic was received from other carriers for final delivery by the Railroad, and the balance of approximately 5% represented bridge or through traffic. The respective percentage contributions by principal commodity group to the Railroad's freight revenues and revenue ton miles during the past five years are set forth below: CONTRIBUTION TO REVENUE TON MILES BY COMMODITY GROUP(1) COMMODITY GROUP 1993 1992 1991 Chemicals...................... 15.9% 15.1% 16.0% Coal........................... 15.1 18.2 17.0 Grain.......................... 27.9 27.3 27.7 Paper.......................... 9.6 9.0 8.4 Grain mill & food products .... 9.9 9.0 8.3 Intermodal..................... 3.7 3.1 2.9 All other ..................... 17.9 18.3 19.7 ------ ------ ------ Total.......................... 100.0% 100.0% 100.0% ====== ====== ====== - ------------------- (1) A new car tracking system installed in late 1990 affects the comparability of 1993's, 1992's and 1991's ton mile data with that of the prior years, thus prior years are not presented. Some of the elements contained in these commodity groupings are as follows: CHEMICALS ................... A wide variety of chemicals and related products such as chlorine, caustic soda, potash, soda ash, vinyl chloride monomer, carbon dioxide, synthetic resins, alcohols, glycols, styrene monomer, plastics, sulfuric acid, muriatic acid, anhydrous ammonia, phosphates, mixed fertilizer compounds and carbon blacks. COAL......................... Bituminous and metallurgical coal. GRAIN ....................... Corn, wheat, soybeans, sorghum, barley and oats. PAPER........................ Pulpboard, fiberboard, woodpulp, printing paper, newsprint and scrap or waste paper. GRAIN MILL & FOOD PRODUCTS .. Products obtained by processing grain and other farm products such as feed, soybean meal, corn syrup, flour and middlings, animal packinghouse by-products (tallow), canned food, corn oil, soybean oil, vegetable oils, malt liquors, sugar and molasses. INTERMODAL................... A wide variety of products shipped either in containers or trailers on specially designed cars. OTHER........................ Pulpwood and chips, lumber and other wood products; sand, gravel and stone, coke and petroleum products, metallic ores and other bulk commodities; primary and scrap metals, machinery and metal products, appliances, automobiles and parts, transportation equipment and farm machinery; glass and clay products, ordnance and explosives, rubber and plastic products, and general commodities. - ---------------------- (1) Ton mile data for years subsequent to December 31, 1990, are not comparable with prior years because of the installation of a new car tracking system in late 1990. As a result, this information is not meaningful (NM) for 1990 and 1989. (2) Freight train miles equals the total number of miles traveled by the Railroad's trains in the movement of freight. (3) Revenue ton miles of freight traffic equals the product of the weight in tons of freight carried for hire and the distance in miles between origin and destination. (4) Revenue per ton mile equals net freight revenue divided by revenue ton miles of freight traffic. (5) Gallons per ton mile equals the amount of fuel required to move one ton of freight one mile. The following tables summarize operating expense-to-revenue ratios of the Company for each of the past four years, excluding the effect of the $8.9 million pretax special charge in 1992. The ratios for 1989 are not comparable to subsequent years because of the March 17, 1989, change in control and are not presented. The first table analyzes the various components of operating expenses based on the line items appearing on the income statements, whereas the second table is based on functional groupings. - --------------------------- (1) Operating ratio means the ratio of operating expenses before special charge over operating revenues. (2) Transportation ratio means the ratio of transportation expenses (such as expenses of operating, servicing, inspecting, weighing, assembling and switching trains) over operating revenues. (3) Maintenance of way ratio means the ratio of maintenance of way expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring right- of-way and trackage structures, buildings and facilities) over operating revenues. (4) Maintenance of equipment ratio means the ratio of maintenance of equipment expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring transportation and other operating equipment) over operating revenues. EMPLOYEES; LABOR RELATIONS Railroad industry personnel are covered by the Railroad Retirement System instead of Social Security. Employer contribution rates under the Railroad Retirement System are currently more than double those in other industries, and may rise further because of the increasing proportion of retired employees receiving benefits relative to the shrinking number of working employees. Labor relations in the railroad industry are subject to extensive governmental regulation under the Railway Labor Act. Railroad industry personnel are also covered by the Federal Employer's Liability Act ("FELA") rather than by state no- fault workmen's compensation systems. FELA is a fault-based system, with compensation for injuries determined by individual negotiation or litigation. The Railroad is a party to several national collective bargaining agreements which establish the wages and benefits of its union workers -- 90% of all Railroad employees. These agreements are subject to renegotiation beginning November 1, 1994, however, cost of living allowance provisions and other terms in each agreement continue until new agreements are reached. Despite being part of a national bargaining group, the Railroad has expressed a desire to negotiate separate distinct agreements with each of its unions on a local basis. Management has been exploring that position and has held several discussions with representatives from most of its unions. It is too early to determine if separate agreements will be reached. Thus, the Railroad has not taken steps to withdraw formally from the national bargaining group. The following table shows the average annual employment levels of the Railroad: 1993 1992 1991 1990 1989 Total employees.. 3,306 3,421 3,611 3,688 3,942 A significant portion of the decline from the 1992 level is the result of a separate agreement between the Railroad and the United Transportation Union, reached in November 1991. This agreement permits the Railroad to reduce the size of all crews on all trains operated. In accordance with this agreement, 158 crew members were severed at a cost of $9.6 million to date. No further dramatic reductions in the current crew size of approximately 2.75 at December 31, 1993 is anticipated. Management believes that additional jobs in all areas may be eliminated over the next several years primarily through attrition and retirements though additional severances are possible. REGULATORY MATTERS; FREIGHT RATES; ENVIRONMENTAL Considerations The Railroad is subject to significant governmental regulation by the ICC and other federal, state and local regulatory authorities with respect to rates, service, safety and operations. The jurisdiction of the ICC encompasses, among other things, rates charged for certain transportation services, issuance of securities, assumption of certain liabilities by railroads, mergers or the acquisition of control of one carrier by another carrier and extension or abandonment of rail lines or services. The Federal Railroad Administration, the Occupational Safety and Health Administration and certain state transportation agencies have jurisdiction over railroad safety matters. These agencies prescribe and enforce regulations concerning car and locomotive safety equipment, track safety standards, employee work conditions and other operating practices. The amount of coal transported by the Railroad is expected to decline somewhat as the Clean Air Act is fully implemented. Much of the coal from mines currently served by the Railroad will not meet the environmental standards of the Clean Air Act without blending or installation of air scrubbers. On the other hand, the Railroad expects to participate in additional movements of Western coal. Overall, management believes that implementation of the Clean Air Act is unlikely to have a material adverse effect on the results of the Company. The Company is and will continue to be subject to extensive regulation under environmental laws and regulations concerning, among other things, discharges into the environment and the handling, storage, transportation and disposal of waste and hazardous materials. Inherent in the operations and real estate activities of the Railroad and other railroads is the risk of environmental liabilities. As discussed in Item 3. "Legal Proceedings," several properties on which the Railroad currently or formerly conducted operations are subject to governmental action in connection with environmental degradation. Additional expenditures by the Railroad may be required in order to comply with existing and future environmental and health and safety laws and regulations or to address other sites which may be discovered. Environmental regulations and remediation processes are subject to future change and cannot be determined at this time. Based on present information, in the opinion of management, the Company has adequate reserves for the costs of environmental investigation and remediation. However, there can be no assurance that environmental conditions will not be discovered which might individually or in the aggregate have a material adverse effect on the Company's financial condition. COMPETITION The Railroad faces intense competition for freight traffic from motor, water, and pipeline carriers and, to a lesser degree, from other railroads. Competition with other railroads and other modes of transportation is generally based on the quality and reliability of the service provided and the rates charged. Declining fuel prices disproportionately benefit trucking operations over railroad operations. The trucking industry frequently is more cost and transit-time competitive than railroads, particularly for distances of less than 500 miles. While deregulation of freight rates under the Staggers Act has greatly increased the ability of railroads to compete with each other and alternate forms of transportation, changes in governmental regulations (particularly changes to the Staggers Act) could significantly affect the Company's competitive position. To a greater degree than other rail carriers the Railroad is vulnerable to barge competition because its main routes are parallel to the Mississippi River system. The use of barges for some commodities, particularly coal and grain, sometimes represents a lower cost mode of transportation. As a result, the Railroad's revenue per ton-mile has generally been lower than industry averages for these commodities. Barge competition and barge rates are affected by navigational interruptions from ice, floods and droughts. These interruptions cause widely fluctuating rates. The Railroad's ability to maintain its market share of the available freight has traditionally been affected by its response to the navigational conditions on the river. Most of the Railroad's operations are conducted between points served by one or more competing carriers. The consolidation in recent years of major midwestern and eastern rail systems has resulted in strong competition in the service territory of the Railroad. LIENS ON PROPERTIES Most of the locomotives and rail cars owned by the Company's financing/leasing subsidiaries are subject to liens. See Note 8 of Notes to Consolidated Financial Statements. LIABILITY INSURANCE The Company is self-insured for the first $5 million of each loss. The Company carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Company's management to be adequate in light of the Company's safety record and claims experience. ITEM 2. ITEM 2. PROPERTIES - ------------------- PHYSICAL PLANT AND EQUIPMENT System. As of December 31, 1993, the Railroad's total system consisted of approximately 4,700 miles of track comprised of 2,700 miles of main line, 300 miles of secondary main line and 1,700 miles of passing, yard and switching track. The Railroad owns all of the track except for 190 miles operated by agreements over track owned by other railroads. Track Structures. During the five years ended December 31, 1993, the Railroad has spent $305.3 million on track structure to maintain its rail lines, as follows ($ in millions): Capital Expenditures Maintenance Total 1993 ......... $ 50.3 $ 25.1 $ 75.4 1992 ......... 46.4 23.0 69.4 1991 ......... 36.3 20.7 57.0 1990 ......... 34.6 20.0 54.6 1989 ......... 19.1 29.8 48.9 ------ ------ ------ Total......... $186.7 $118.6 $305.3 ====== ====== ====== These expenditures concentrated primarily on track roadway and bridge rehabilitation in 1993 and 1992. Approximately 1,300 miles and 1,400 miles of road were resurfaced in 1993 and 1992, respectively. Over the last two years, a total of $8.4 million was spent to construct new or expanded intermodal facilities in Chicago and Memphis. Expenditures in 1991 and 1990 benefited from the use of reclaimed rail, cross ties, ballast and other track materials from the second main line when the Railroad's double-track mainline was converted to a single-track mainline with centralized traffic control. Most reclaimed material has now been used and future expenditures will reflect the purchase of new materials. The reduced number of miles of track and the general good condition of the track structure should result in future expenditures approximately equal to the average of 1993 and 1992. Fleet. The Railroad's fleet has undergone significant rationalization and upgrading from its peak in 1985 of 862 locomotives and 28,616 freight cars. Over the last two years older, less efficient locomotives were replaced with newer larger horsepower and more efficient equipment. In 1993, the Company implemented a program to increase ownership of freight cars and locomotives and become less dependent on the leasing market as a source of equipment. Over the last three years the Company, through wholly-owned financing/leasing subsidiaries, has acquired a total of sixty-one (61) 15 to 16 year- old SD-40-2 locomotives and 1,522 freight cars. The 61 locomotives are leased to the Railroad for seven and one-half years. Approximately 650 of the cars acquired are leased to the Railroad as well. The remaining cars are leased to other non- affiliated railroads. When those leases expire, the Railroad has first right of refusal to lease the equipment. As these cars are leased to the Railroad other leased equipment will be returned to the independent, third-party lessors or short-term car hire agreements will be terminated. In 1993, the Railroad acquired 4 SD-40-2 locomotives and also upgraded its highway trailer fleet with 800 newly built trailers which replaced 880 older leased trailers. The following is the overall fleet at December 31: Total Units: 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Locomotives(1) 468 449 470 471 516 Freight cars.. 16,634 15,877 16,381 16,526 17,141 Work equipment. 745 902 881 934 1,000 Highway trailers .898 203 124 67 70 (2) - ----------------------- (1) Approximately 100 locomotives need repair before they can be returned to service. This equipment is repaired if needed on an ongoing basis or sold. In 1993 and 1992, the Railroad sold 23 and 66 surplus locomotives, respectively. The active fleet is 322 as of December 31, 1993. (2) Excludes trailers being accumulated for return to lessors. The components of the fleet by subsidiary and in total for 1993 and in total for 1992 are shown below: (1) In addition, approximately 2,735 freight cars and 696 highway trailers were being used by the Railroad under short-term car hire agreements. (2) May be subject to Conditional Sales Agreements. (3) Excludes equipment listed under Leasing Subsidiaries. (4) Excludes trailers being accumulated for return to lessor. Item 3. Item 3. Legal Proceedings - -------------------------- State of Alabama, et al. v. Alabama Wood Treating Corporation, Inc., et al., S.D. Ala. No. 85-0642-C The State of Alabama and Alabama State Docks ("ASD") filed suit in 1985 seeking damages for alleged pollution of land in Mobile, Alabama, stemming from creosoting operations over several decades. Defendants include the Railroad, which owned the land until 1976, Alabama Wood Treating Corporation, Inc., and Reilly Industries, Inc. ("RII"), which leased the land from the Railroad and conducted creosote operations on the site. In December 1976, the Railroad sold the premises to ASD. The complaint sought payment for the clean-up cost together with punitive and other damages. In 1986, ASD, RII and the Railroad agreed to form a joint technical committee to clean the site sharing equally the cost of clean-up, and in October 1986, the court stayed further proceedings in the suit. Under the agreement the joint technical committee has spent approximately $6.6 million and has been authorized to expend up to a total of $6.9 million. The Railroad has contributed $2.2 million and has agreed to increase its contribution to a total of $2.3 million. Further clean-up activities are anticipated. Under the agreement, if any party disagrees with the amount determined by the joint technical committee to be expended or otherwise disagrees with any aspect of the clean-up, such party may decline further participation and recommence legal proceedings. However, amounts already contributed by any party will be credited against that party's eventual liability and may not be recovered from any other party. Iselin Yard, Jackson, Tennessee In 1991, the Iselin Rail Yard in Jackson, Tennessee was placed on the Tennessee Superfund list. In May 1993, the United States Environmental Protection Agency ("EPA") proposed to add a number of sites, including Iselin Rail Yard to the National Priorities List. The Railroad operated a rail yard and locomotive repair facility at the site. The shop facility was sold in 1986 and the rail yard was sold in 1988. Trichloroethylene ("TCE") has been found in several municipal water wells near the site. TCE is a common component of solvents similar to those believed to have been used at the Iselin shop. In addition, concentrations of metals and organic chemicals have been identified on the surface of the site. No order has been issued by any regulatory agency but the State of Tennessee is monitoring work at the site. The Railroad expects to cooperate with the agencies and other Potentially Responsible Parties to conduct any necessary studies and clean-up activities. The Railroad has commenced a remedial investigation and feasibility study of the site. McComb, Mississippi Elevated levels of lead and other soil contamination has been discovered at the Railroad's facility in McComb, Mississippi. The site was used for many years for sandblasting lead-based paint off freight cars. The Railroad has commenced a formal site investigation under the supervision of the Mississippi Department of Environmental Quality. The Remedial Investigation has disclosed the presence of lead in the soil and further testing of the surface and subsurface soil and groundwater is underway to assess the scope of the contamination. No order has been issued by any regulatory agency. The Railroad expects to cooperate with the State of Mississippi to conduct any necessary studies and clean-up activities. Waste Oil Generation The Railroad was notified in September 1992 that it had been identified as a Potentially Responsible Party at a federal superfund site in West Memphis, Arkansas. The Railroad is alleged to have generated waste oil which was collected by a waste oil refiner who in turn disposed of sludge at the West Memphis landfill. In December 1992, the successor to the refiner initiated legal proceedings to preserve testimony in anticipation of a future contribution action against multiple Potentially Responsible Parties including the Railroad. Similar actions have been taken by the EPA or third parties with respect to waste oil allegedly generated by the Railroad and disposed of in landfills at Livingston, LA, Griffith, IN and Nashville, TN. Based on information currently available, the Railroad believes it has substantial defenses to liability for any contamination at these sites, and that any contribution to the contamination by the Railroad was de minimis. Item 4. Item 4. Submission of Matters to a Vote of Security Holders ---------------------------------- No matters were submitted to a vote of security holders during the Company's fourth quarter. Item 4A. Executive Officers of the Registrant - ---------------------------------------------- The executive officers of the Company are identified in the table below. Each executive officer of the Company currently holds an identical position with the Railroad. Executive officers of the Company and the Railroad serve at the pleasure of the respective Boards of Directors. Name Age Position(s) ---- --- ----------- Gilbert H. Lamphere 41 Chairman of the Board of Directors E. Hunter Harrison 49 President and Chief Executive Officer, Director Gerald F. Mohan 53 Senior Vice President - Marketing John D. McPherson 47 Vice President - Operations James M. Harrell 41 Vice President - Human Resources David C. Kelly 49 Vice President - Maintenance Ronald A. Lane 43 Vice President and General Counsel and Secretary Dale W. Phillips 39 Vice President and Chief Financial Officer John V. Mulvaney 43 Controller BIOGRAPHICAL INFORMATION The following sets forth the periods during which the executive officers of the Company and the Railroad have served as such and a brief account of the business experience of such persons during the past five years. Mr. Lamphere was elected Chairman of the Board of Directors of the Company and the Railroad in February 1993. He has been a director of the Company and the Railroad since 1989 and Chairman of the Executive Committee of the Board since July 1990. Mr. Lamphere has been Co-Chairman and Chief Executive Officer of The Noel Group, Inc. ("Noel"), a diversified operating company since 1991, and a director of Noel since March 1990. Mr. Lamphere also is the Chairman, Chief Executive Officer and a director of Prospect, for which he has served in various capacities since becoming a director in 1983. Mr. Harrison was appointed President, Chief Executive Officer and a Director of the Company and the Railroad in February 1993. He joined the Company and the Railroad as Vice President and Chief Transportation Officer in 1989. In November 1991 he was appointed Senior Vice President - Transportation and was named Senior Vice President - - Operations in July 1992. He was employed by Burlington Northern Railway in various vice presidential positions from 1985 to 1989. Mr. Mohan was appointed Senior Vice President - - Marketing of the Railroad in 1986. In April 1993 he was elected a Director of the Railroad. He was appointed to his present position with the Company in December 1989. Mr. McPherson joined the Company and the Railroad in his current position in July 1993. Prior to joining the Company and the Railroad, he held various positions with the Atchison, Topeka and Santa Fe Railway Company from 1966 to 1993, most recently as Assistant Vice President - Safety. Mr. Harrell joined the Company and the Railroad in his current position in 1992. He served as Director of Labor Relations for The Atchison, Topeka and Santa Fe Railway Company from 1989 to 1992. From 1974 to 1989 he held various positions with The Atchison, Topeka and Santa Fe Railway Company. Mr. Kelly joined the Company and the Railroad as Vice President and Chief Engineer in 1989. In January 1994, he was appointed Vice President - Maintenance. He served as Assistant Chief Engineer - - Systems of CSX Transportation from 1987 to 1989. Mr. Lane joined the Company and the Railroad as Vice President and General Counsel and Secretary in 1990. In April 1993 he was elected a Director of the Railroad. He was previously employed by The Atchison, Topeka and Santa Fe Railway Company and Santa Fe Pacific Corporation serving as Assistant Vice President - Personnel and Labor Relations, 1987 to 1990. Mr. Phillips has been employed by the Railroad since February 1988, serving as Director of Taxes & Property Accounting from February to October 1988, as Assistant Controller from October 1988 to April 1989, and Controller from April 1989 to April 1990. He was appointed to his present position in the Company and the Railroad in April 1990. In April 1993 he was elected a Director of the Railroad. Mr. Phillips also serves as a director of Rail Association Insurance, Ltd. Mr. Mulvaney joined the Company and the Railroad as Controller in June 1990. He was previously employed by Navistar International Transportation Corp., serving as Director of Accounting, 1987 to 1990. No family relationship exists among the officers of the Company or the Railroad. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------- The following table sets forth, for the periods indicated, (i) the high and low sale prices of the Common Stock as reported on the New York Stock Exchange Composite Tape, adjusted for the February 1992 3-for-2 stock split, and (ii) the per share amount of dividends paid. STOCK PRICE DIVIDENDS HIGH LOW PER SHARE First Quarter.. $25.500 $21.083 $ - Second Quarter. 24.875 20.250 .10 Third Quarter.. 22.375 16.500 .10 Fourth Quarter. 25.625 18.250 .15 First Quarter.. $27.250 $23.625 $ .15 Second Quarter. 30.125 25.375 .15 Third Quarter.. 32.750 26.625 .17 Fourth Quarter. 36.000 29.250 .17 First Quarter $38.625 $33.500 $ .21 (through March 1) As of March 1, 1994, there were approximately 11,000 stockholders based on estimates of beneficial ownership. The closing price of the Common Stock as reported on the New York Stock Exchange Composite Tape on March 1, 1994 was $35.75 per share. On February 10, 1994, the Board declared a dividend of $.21 per share payable April 7, 1994, to stockholders of record on March 24, 1994. Prior to April 1992, the Company had not previously paid cash dividends on its Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources," for a discussion of the restrictions on the Railroad's ability to transfer funds as dividends to the Company. The Common Stock is listed on the New York Stock Exchange, Inc. under the symbol "IC." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- The following table sets forth selected historical consolidated financial data of the Company for the four years ended December 31, 1993, and for the period January 27, 1989 the date on which the Company was incorporated, through December 31, 1989, and selected historical consolidated financial data of the Railroad as predecessor of the Company for the period January 1, 1989, through March 16, 1989, all derived from the consolidated financial statements of the Company which were audited by Arthur Andersen & Co. This summary should be read in conjunction with the consolidated financial statements included elsewhere in this Report and the schedules and notes thereto. The purchase method of accounting was used to record the assets acquired and liabilities assumed by the Company in 1989. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. 1. THE COMPANY Illinois Central Corporation, a holding company, (hereinafter, the "Company") was incorporated under the laws of Delaware. The Company was formed originally for the purpose of acquiring, through a wholly-owned subsidiary, the outstanding common stock of Illinois Central Transportation Company ("ICTC"). Following a tender offer and several mergers, the Illinois Central Railroad Company ("Railroad") is the surviving corporation and the successor to ICTC and now a wholly-owned subsidiary of the Company. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries. Significant investments in affiliated companies are accounted for by the equity method. Transactions between consolidated companies have been eliminated in the accompanying consolidated financial statements. PROPERTIES Depreciation is computed by the straight-line method and includes depreciation on properties under capital leases. The depreciation rates for the equipment owned by the Company's finance subsidiary are based on estimated useful life and anticipated salvage value. Lives used range from 18 to 20 years. At the Railroad, depreciation for track structure, other road property, and equipment is calculated using the composite method. In the case of routine retirements, removal cost less salvage recovery is charged to accumulated depreciation. Expenditures for maintenance and repairs are charged to operating expense. The Interstate Commerce Commission ("ICC") approves the depreciation rates used by the Railroad. In 1991, the Railroad completed a study which resulted in revised depreciation rates for road properties (excluding track properties) and equipment. The revised rates did not and will not have a significant effect on operating results. The approximate ranges of annual depreciation rates for major property classifications are as follows: Road properties .................1% - 8% Transportation equipment ........1% - 7% In 1989, the Company initiated a program to convert approximately 500 miles of double track main line to a single track main line, with a centralized traffic control system. This program was completed successfully in 1991. REVENUES Revenues are recognized based on services performed and include estimated amounts relating to movements in progress for which the settlement process is not complete. Estimated revenue amounts for movements in progress are not significant. INCOME TAXES Effective January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). Under SFAS No. 109, deferred income taxes are accounted for on the asset and liability method by applying enacted statutory tax rates to differences ("temporary differences") between the financial statement carrying amounts and the tax bases of assets and liabilities. The resulting deferred tax assets and liabilities represent taxes to be collected or paid in the future when the related assets and liabilities are recovered and settled, respectively. See Note 10 for discussion of the 1992 impact of adopting SFAS No. 109. CASH AND TEMPORARY CASH INVESTMENTS Cash in excess of operating requirements is invested in certain funds having original maturities of three months or less. These investments are stated at cost, which approximates market value. INCOME PER SHARE Income per common share of the Company is based on the weighted average number of shares of common stock and common stock equivalents outstanding for the period. Dilution, which could result if all outstanding common stock equivalents were exercised, is not significant. FUTURES, OPTIONS, CAPS, FLOORS AND FORWARD CONTRACTS In March 1990, the FASB issued Statement of Financial Accounting Standards No. 105 "Disclosure of Information about Financial Instruments with Off Balance Sheet Risk and Financial Instruments with Concentration of Credit Risk" ("SFAS 105"). Disclosures required by SFAS 105 are found in various notes where the financial instruments or related risks are discussed. See specifically Notes 6, 7, 8, and 13. CASUALTY AND FREIGHT CLAIMS The Company accrues for injury and damage claims outstanding based on actual claims filed and estimates of claims incurred but not filed. Estimated amounts expected to be settled within one year are classified as current liabilities in the accompanying Consolidated Balance Sheets. EMPLOYEE BENEFIT PLANS All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contribution costs of the plan are funded currently. Mr. E. L. Moyers, former Chairman, President and Chief Executive Officer ("Mr. Moyers") is covered by a supplemental plan which is discussed in Note 9. Effective January 1, 1993, the Company adopted both the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires that future costs associated with providing postretirement benefits be recognized as expense over the employees' requisite service period. The pay-as-you-go method used prior to 1993 recognized the expense on a cash basis. SFAS No. 112 establishes accounting standards for employers who provide postemployment benefits and clarifies when the expense is to be recognized. In accordance with the provisions of these standards, years prior to 1993 have not been restated. See Note 9 for discussion of the impact of adopting SFAS No. 106 and SFAS No. 112. RECLASSIFICATIONS Certain items relating to prior years have been reclassified to conform to the presentation in the current year. 3. EXTRAORDINARY ITEM AND REFINANCING The 1993 extraordinary loss resulted from the retirement of the Railroad's 14-1/8% Senior Subordinated Debentures (the "Debentures") and refinancing the Permanent Facility. The loss was $23.4 million, net of tax benefits of $12.6 million. The loss resulted from the premium paid, the write-off of unamortized financing fees and debt discount and costs associated with the calling of the $10.3 million of Debentures not tendered. The net proceeds of the 6.75% Notes (see Note 8), borrowings under the $180 million Revolving Credit Facility and other available cash were used to fund the retirement of the Debentures. 4. OTHER INCOME, NET Other Income, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Income, net.............. $ 3.9 $ 3.8 $ 3.0 Net gains on real estate sales................... .8 .4 .7 Net gain (loss) on disposal of rolling stock........ (2.3) - - Equity in undistributed earnings of affiliates.. .5 .3 .4 Net gain on Series K..... - - 3.6 Other, net............... (1.2) (2.5) (2.0) ------ ------ ------ Other Income, Net....... $ 1.7 $ 2.0 $ 5.7 5. SUPPLEMENTAL CASH FLOW INFORMATION Cash changes in components of working capital, exclusive of Current Maturities of Long-Term Debt, included in the Consolidated Statements of Cash Flows were as follows ($ in millions): Years Ended December 31, 1993 1992 1991 Receivables, net.... $ (3.9) $ 4.7 $ (2.6) Materials and supplies (1.4) (3.2) (.6) Other current assets.. (1.5) .3 1.0 Accounts payable... 1.1 (5.7) (5.0) Income taxes payable 13.6 .5 (5.4) Accrued redundancy reserves............ (2.6) (11.0) (11.7) Other current liabilities......... (6.1) (1.4) (.4) ------- -------- -------- $ (.8) $ (15.8) $ (24.7) Included in changes in Other Liabilities and Reserves is approximately $6.3 million and $23.4 million for the years ended December 31, 1993 and 1992, respectively, reflecting proceeds from the settlement of casualty claims with numerous insurance carriers. In 1993, the Railroad entered into a capital lease for 200 covered hoppers. The lease expires in 2003. See Note 7 for a recap of the present value of the minimum lease payments. In 1991, the Railroad retired several Long- Term Debt obligations, most significantly its $150 million 15.5% Series K First Mortgage Bonds ("Series K"). These retirements resulted in non- cash reductions of debt balances of $4.6 million. Also, in 1991 the balance of a long term investment was reduced by $2.5 million. 6. MATERIALS AND SUPPLIES Materials and Supplies, valued using the average cost method, consist of track material, switches, car and locomotive parts and fuel. The Railroad entered into various hedge agreements designed to mitigate significant changes in fuel prices. As a result, approximately 93% of the short-term diesel fuel requirements through March 1995 and 46% through June 1995 are protected against significant price changes based on the average near-by contract for Heating Oil #2 traded on the New York Mercantile Exchange. 7. LEASES As of December 31, 1993, the Company leased 6,709 of its cars and 166 of its locomotives. The majority of these leases have original terms of 15 years and expire between 1994 and 2001. Under the terms of the majority of its leases, the Company has the right of first refusal to purchase, at the end of the lease terms, certain cars and locomotives at fair market value. Other leases include office and computer equipment, vehicles and office facilities. Net obligations under capital leases at December 31, 1993 and 1992, included in the Consolidated Balance Sheets are $5.4 million and $.2 million, respectively. At December 31, 1993, minimum rental payments under capital and operating leases that have initial or remaining noncancellable terms in excess of one year were as follows ($ in millions): Capital Operating Leases Leases 1994 ............................$ .9 $ 34.6 1995 ............................ .9 28.4 1996 ............................ .8 19.3 1997 ............................ .8 7.8 1998 ............................ .8 4.2 Thereafter ...................... 3.1 17.4 ---- ------ Total minimum lease payments... 7.3 $111.7 Less: Imputed interest .......... 1.9 Present value of minimum ---- payments..................... $5.4 Total rent expense applicable to noncancellable operating leases amounted to $45.2 million in 1993, $46.2 million for 1992 and $48.5 million for 1991. Most of the leases provide that the Company pay taxes, maintenance, insurance and certain other operating expenses. 8. LONG-TERM DEBT AND INTEREST EXPENSE Long-Term Debt at December 31, consisted of the following ($ in millions): At December 31, 1993, the aggregate annual maturities and sinking fund requirements for debt payments for 1994 through 1999 and thereafter are $24.3 million (includes bridge financing of $21.7 million (see below)), $2.3 million, $80.6 million, $2.7 million, $57.6 million, $61.2 million and $155.9 million, respectively. The weighted- average interest rate for 1993 and 1992 on total debt excluding the effect of discounts, premiums and related amortization was 9.1% and 10.8%, respectively. In November 1993, the Railroad initiated a public commercial paper program. The commercial paper is rated A2 by S&P, by Fitch and P3 by Moody's and is supported by a new $100 million Revolver with the Railroad's bank lending group. The Railroad views this program as a significant long-term funding source and intends to issue replacement notes as maturities occur. Therefore, the $38.1 million outstanding at December 31, 1993 has been classified as long-term. In connection with the commercial paper program, the bank lending group agreed to replace the $180 million Revolving Credit Facility (see below) with (i) a new $100 million Revolver, due 1996 and (ii) a $50 million 364-day facility due October 1994 ("Bank Line"). The new Revolver will be used primarily for backup for the commercial paper but can be used for general corporate purposes. The available amount is reduced by the outstanding amount of commercial paper borrowings and any letters of credit issued on behalf of the Railroad under the facility. No amounts have been drawn under the Revolver. The $100 million was limited to $57.9 million because $38.1 million in commercial paper was outstanding and $4.0 million in letters of credit had been issued. The Bank Line was structured as a 364-day renewable instrument and the Company intends to renew it on an on-going basis. The $40 million outstanding at December 31, 1993, has therefore been classified as long-term. The Company's financing/leasing subsidiaries have approximately $13.0 million in long-term borrowing agreements which were used to acquire a total of 61 locomotives during 1993 and 1991. Such borrowings are secured by equipment which is leased to the Railroad. These agreements mature in 1999 and 2000. One subsidiary used a short- term bridge financing of $21.7 million to acquire 1,522 box cars in December 1993. The bridge financing must be repaid or refinanced prior to March 3, 1994. The Company expects to refinance this debt with either a seven year floating or fixed rate term loan or a combination revolving facility and term loan also with a floating or fixed rate. During April 1993, the Company and the Railroad reached an agreement with its bank lending group and the holders of the privately placed $160 million Senior Secured Notes ("Senior Notes") for a release of all collateral and those instruments are now unsecured. The bank agreed to replace the Permanent Facility with a $180 million Revolving Credit Facility. This was done in connection with the tender offer made by the Railroad for all of the Debentures. The tender offer was funded by issuance of new $100 million 6.75% Notes, due 2003 (the "Notes"), borrowing under a $180 million Revolving Credit Facility negotiated with the banks which replaced the Permanent Facility and cash on hand. See Note 3 for discussion of the extraordinary loss incurred upon tender for the Debentures. The Railroad irrevocably placed $12.6 million on deposit with a trustee to cover principal, a 6% premium and interest through the first call date of October 1, 1994, for the untendered Debentures. The Notes (issued at a slight discount 1.071%) pay interest semiannually in May and November and are covered by an Indenture. Of the Senior Notes, $109.8 million bears interest at a rate of 10.02% and $50 million at 10.4%. Principal payments of $55 million are due in each of 1998 and 1999, and $25 million in each of 2000 and 2001. The Senior Notes are governed by a Note Purchase Agreement. Various borrowings of the Company's subsidiaries are governed by agreements which contain certain affirmative and negative covenants customary for facilities of this nature including restrictions on additional indebtedness, investments, guarantees, liens, distributions, sales and leasebacks, and sales of assets and capital stock. Some also require the Railroad to satisfy certain financial tests, including a leverage ratio, an earnings before interest and taxes to interest charges ratio, debt service coverage, and minimum consolidated tangible net worth requirements. The Railroad may be required to apply 100% of net after-tax proceeds of sales aggregating $2.5 million or greater of certain assets to reduce Revolver commitments. The holders of the Senior Notes can elect to receive a pro-rata share of after-tax proceeds. Interest Expense, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Interest expense........ $35.2 $46.2 $59.7 Less: Interest capitalized..... .8 .6 .4 Interest income..... 1.3 2.0 4.2 ----- ----- ----- Interest Expense, Net... $33.1 $43.6 $55.1 9. EMPLOYEE BENEFIT PLANS Retirement Plans. All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contributions under the plan vest immediately. Expenses relating to the defined contribution plan were $.4 million for each of the years ended December 31, 1993, 1992 and 1991. Mr. Moyers is covered by a non-qualified, unfunded supplemental retirement benefit agreement which provides for a defined benefit payable annually, commencing upon death, permanent disability or retirement (with benefits arising from retirement commencing upon his attaining age 65 and compliance with certain non-competition agreements), in the amount of $250,000 per year for a maximum of 15 years. In accordance with the term of the agreement, no payments will be made while Mr. Moyers is employed by another Class I railroad. The present value of this agreement was included in the 1992 special charge. See Note 15. Postretirement Plans. In addition to the Company's defined contribution plan for management employees, the Company has three benefit plans which provide some postretirement benefits to most former full-time salaried employees and selected former union represented employees. The medical plan for salaried retirees is contributory, with retiree contributions adjusted annually if expected inflation rate exceeds 9.5%, and contains other cost sharing features such as deductibles and co-payments. The Company's contribution will be fixed at the 1999 year end rate for all subsequent years. Salaried retirees are covered by a life insurance plan which provides a nominal death benefit and is non-contributory. The medical plan for locomotive engineers who retired under a special early retirement program in 1987 provides non-contributory coverage until age 65. All benefits under this plan terminate in 1998. There are no plan assets and the Company will continue to fund these benefits as claims are paid as was done in prior years. Postemployment Benefit Plans. The Company provides certain postemployment benefits such as long-term salary continuation and waiver of medical and life insurance co-payments while on long-term disability. SFAS No. 106 and SFAS No.112. As described in Note 2 effective January 1, 1993 the Company adopted SFAS No. 106 and SFAS No. 112. With respect to SFAS No. 106, the Company elected to immediately recognize the transition asset associated with adoption which resulted because the Company had previously recorded an amount under purchase accounting to reflect the estimated liability for such benefits as of the acquisition date of ICTC. As a result of adopting these two standards, the Company recorded a decrease to net income of $84,000 (net of taxes of $46,000) as a cumulative effect of changes in accounting principles ($ in millions): Postretirement Benefits (SFAS No. 106): APBO at January 1, 1993: Medical......................... $36.5 Life............................ 2.3 ----- Total APB................. 38.8 Liability previously recorded..... (40.3) ----- Transition Asset.......... 1.5 Postemployment Benefits Obligation at January 1, 1993 (SFAS 112)..... (1.6) ----- Pre-tax Cumulative Effect of Changes in Accounting Principles.......... (.1) Related tax benefit.................. - ----- Cumulative Effect of Changes in Accounting Principles.......... $ (.1) ===== Per Share Impact..................... $ - ===== In accordance with each standard, years prior to 1993 have not been restated. For 1993, the adoption of these two standards had no significant effect on income before cumulative effect of changes in accounting principles as compared to the Company's prior pay-as-you-go method of accounting for such benefits. The accumulated postretirement benefit obligations ("APBO") of the postretirement plans were as follows ($ in millions): January December 31, 1993 1, 1993 Medical Life Total Total Accumulated post- retirement benefit obligation: Retirees....... $26.4 $ 2.4 $28.8 $33.4 Fully eligible active plan participants.. .7 - .7 .7 Other active plan participants.. 4.7 - 4.7 4.7 ----- ----- ----- ----- Total APBO.... $31.8 $ 2.4 34.2 38.8 Unrecognized net gain.......... 5.0 - Accrued liability for post- retirement benefits....... $39.2 $38.8 ===== ===== The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 8.0% at January 1, 1993. As a result of the Company's improved financial condition and recognizing the overall shift in the financial community, the Company lowered the weighted-average discount rate to 7.25% as of December 31, 1993. The change in rates resulted in approximately $2.0 million actuarial loss. The loss was offset by actual experience gains, primarily fewer claims and lower medical rate inflation, which resulted in a $5.0 million unrecognized net gain as of December 31, 1993. The components of the net periodic postretirement benefits cost for 1993 were as follows ($ in millions): Service costs........................ $ .1 Interest costs....................... 3.0 Net amortization of Corridor excess.. - ----- Net periodic postretirement benefit costs...................... $ 3.1 The weighted-average annual assumed rate of increase in the per capital cost of covered benefits (e.g., health care cost trend rate) for the medical plans is 14.0% for 1993 and is assumed to decrease gradually to 6.25% by 2001 and remain at that level thereafter. The health care cost trend rate assumption normally has a significant effect on the amounts reported; however, as discussed, the plan limits annual inflation for the Company's portion of such costs to 9.5% each year. Therefore, an increase in the assumed health care cost trend rates by one percentage point in each year would have no impact on the Company's accumulated postretirement benefit obligation for the medical plans as of December 31, 1993, or the aggregate of the service and interest cost components of net periodic postretirement benefit expense in future years. 10. PROVISION FOR INCOME TAXES Effective January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). As a result, the Company recorded a $23.4 million ($.55 per share) reduction in its accrued net deferred income tax liability as of January 1, 1992. The gain recorded upon adoption could not be recognized previously in accordance with SFAS No. 96 which the Company had adopted in 1988. The Company elected to report this change as the cumulative effect of a change of accounting principle. Therefore, prior year amounts were not restated. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993, which contains a deficit reduction package, became law. Certain aspects of the Act directly affect the Company. Most significantly, the new law increased the maximum corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. This change required the Company to record additional deferred income tax expense of approximately $3.1 million to reflect the new tax rate's impact on net deferred income tax liability as of January 1, 1993. The higher corporate rate is not anticipated to significantly affect the Company's cash flow. The Provision for Income Taxes for continuing operations consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Current income tax: Federal............. $23.6 $14.4 $ 9.4 State............... .9 1.6 1.0 Deferred income taxes. 31.9 21.4 20.4 ----- ----- ----- Provision for Income Taxes............... $56.4 $37.4 $30.8 The effective income tax rates for the years ended December 31, 1993, 1992 and 1991, were 38%, 34% and 32%, respectively. See Note 3 for the tax benefits associated with the extraordinary loss. The items which gave rise to differences between the income taxes provided for continuing operations in the Consolidated Statements of Income and the income taxes computed at the statutory rate are summarized below ($ in millions): Temporary differences between book and tax income arise because the tax effects of transactions are recorded in the year in which they enter into the determination of taxable income. As a result, the book provisions for taxes differ from the actual taxes reported on the income tax returns. The net results of such differences are included in Deferred Income Taxes in the Consolidated Balance Sheets. The Company has an Alternative Minimum Tax ("AMT") carryforward credit of $.1 million at December 31, 1993. This excess of AMT over regular tax can be carried forward indefinitely to reduce future U.S. Federal income tax liabilities. At December 31, 1993, this credit was used to reduce the recorded deferred tax liability. At December 31, 1993, the Company, for tax or financial statement reporting purposes, had no net operating loss carryovers. Deferred Income Taxes consisted of the following ($ in millions): December 31, ----------------------- 1993 1992 Deferred tax assets... $ 82.2 $ 114.4 Less: Valuation allowance. (2.2) (3.3) Deferred tax assets, net of valuation allowance 80.0 111.1 Deferred tax liabilities. (259.5) (258.2) --------- --------- - - Deferred Income Taxes.... $ (179.5) $ (147.1) The valuation allowance is comprised of the portion of state tax net operating loss carryforwards expected to expire before they are utilized and non-deductible expenses incurred with the previous merger of wholly-owned subsidiaries. Major types of deferred tax assets are: reserves not yet deducted for tax purposes ($64.0 million) and safe harbor leases ($11.8 million). Major types of deferred tax liabilities are: accelerated depreciation ($206.2 million), land basis differences ($10.3 million) and debt marked to market ($2.1 million). The Company and the Railroad have a tax sharing agreement whereby the Railroad's federal tax liability and combined state tax liabilities (if any) are the lesser of (i) the Railroad's separate consolidated liability as if it were not a member of the Company's consolidated group or (ii) the Company's consolidated liability computed without regard to any other subsidiaries of the Company. The Company and its financing/leasing subsidiaries have a tax sharing agreement whereby the subsidiary's federal income tax and state income tax liabilities are determined on a consolidated, or combined state income tax basis as if it were not a member of the Company's consolidated group, with no benefit for prior net operating losses or credit carryovers from prior years. 11. COMMON STOCK AND DIVIDENDS The Company is authorized to issue 65,000,000 shares of Common Stock, par value $.001. At December 31, 1993, there were 42,614,566 shares of Common Stock outstanding. Each holder of Common Stock is entitled to one vote per share in the election of directors and on all matters submitted to a vote of stockholders. Subject to the rights and preferences of redeemable preferred stock, if any, each share of Common Stock is entitled to receive dividends as may be declared by the Board of Directors out of funds legally available and to share ratably in all assets available for distribution to stockholders upon dissolution or liquidation. No holder of Common Stock has any preemptive right to subscribe for any securities of the Company. No shares of preferred stock were outstanding at December 31, 1993 and 1992. On February 4, 1992, the Board of Directors authorized a three-for-two stock split on Common Stock. The split was in the form of a stock dividend and was paid on February 28, 1992. Fractional shares were settled for cash. A total of 14,132,058 shares were issued from authorized but unissued shares. In 1992, the Board of Directors initiated a policy of quarterly dividends on the Common Stock of the Company. Future dividends may be dependent on the ability of the Railroad to pay dividends to the Company. Certain covenants of the Railroad's debt restrict the level of dividends it may pay to the Company. At December 31, 1993, approximately $76 million was free of such restrictions. The Company awarded 25,000 shares and 150,000 shares of restricted stock to eligible employees of the Railroad in 1993 and 1992, respectively. No cash payments are required by the individuals. Shares awarded under the plans may not be sold, transferred, or used as collateral by the holders until the shares awarded become free of the restrictions. Restrictions lapse over a four-year period. All shares still subject to restrictions will be forfeited and returned to the plan if the employee's relationship with the Railroad is terminated. A total of 13,500 shares were forfeited in 1993. If the employee becomes disabled, or dies, or a change in control occurs during the vesting period, the restrictions will lapse at that time. The compensation expense resulting from the award of restricted stock is valued at the closing market price of the Company's Common Stock on the date of the award, recorded as a reduction of Stockholders' Equity, and charged to expense evenly over the service period. Compensation expense was $.8 million and $.5 million in 1993 and 1992, respectively. In 1992, the Company awarded 200,000 shares to Mr. Moyers as well. Of this amount, 133,000 were vested upon his retirement in 1993. The remaining 67,000 were forfeited in 1993 when Mr. Moyers was employed by another Class I railroad. See Note 15. 12. COMPENSATION AND STOCK OPTIONS Stock Purchase Plan. Under the Company's 1990 Stock Purchase Plan (the "Stock Plan"), 736,380 shares (post split) of Common Stock were made available from shares held by Prospect for sale to key employees and officers of the Company other than Mr. Moyers, as determined by the Company's Board of Directors. Shares so awarded were sold at a price of $.10 per share (post split)(which was Prospect's approximate original per share cost for such stock as adjusted for the 3 for 2 stock split in February 1992). In general, shares awarded pursuant to the Stock Purchase Plan are restricted for a period of four years and vest at a rate of 25% per year. At December 31, 1993, only 130,313 shares are restricted. All shares will vest prior to June 30, 1994, with 126,563 vesting on or before April 1, 1994. Unvested shares are subject to repurchase by the Company at a price of $.267 per share upon the termination of the participant's employment, other than as a result of death or permanent disability. The unawarded shares (63,270) and those repurchased in 1991 are now classified as Treasury Stock. Long-Term Incentive Plan. Under the Company's 1990 Long-Term Incentive Plan (the "Long-Term Incentive Plan") shares of Common Stock are available for issuance upon the exercise of incentive options that may be awarded by the Compensation Committee to directors and selected salaried employees of the Company and its affiliates and to certain other individuals who possess the potential to contribute to the future success of the Company. The Compensation Committee also has the authority under the Long- Term Incentive Plan to award stock appreciation rights, restricted stock and restricted stock units, dividend equivalents and other stock-based awards, and to determine the consideration to be paid by the participant for any awards, any limits on transfer of awards, and, within certain limits, other terms of awards. In the case of options (other than options granted to directors who are not full-time employees of the Company ("Outside Directors"), as described below) granted under the Long-Term Incentive Plan, the Committee has the power to determine the exercise price of the option (which cannot be less than 50% of the fair market value on the date of grant of the shares subject to the option), the term of the option, the time and method of exercise and whether the options are intended to qualify as "incentive stock options" pursuant to Section 422A of the Internal Revenue Code. Outside Directors of the Company also participate in the Long-Term Incentive Plan and are granted an option to purchase 15,000 shares of Common Stock upon initial appointment or election. In addition, Outside Directors as of November 1990 were granted options to purchase an additional 10,000 shares, which grants were approved at the 1991 Annual Meeting of Stockholders. Also on the date of each Annual Meeting, each Outside Director of IC who serves immediately prior to such date and who will continue to serve after such date (whether as a result of such director's re- election or by reason of the continuation of such director's term), will be granted an option to purchase 1,500 shares of Common Stock. Options granted to Outside Directors entitle such persons to purchase Common Stock at the fair market value of such Common Stock on the date the option was granted. Options held by Outside Directors expire 10 years from the date of grant, or, if earlier, one year following termination of service as a director for any reason other than death or disability. Such options become exercisable in full six months after their date of grant. At the 1993 Annual Meeting, the stockholders authorized an additional one million shares to be available for issuance under the Long-Term Incentive Plan. The following table summarizes the shares available for award under the Incentive Plan for the year ended December 31, 1993: Reserved shares at beginning of year........... 904,000 Options exercised............ (49,500) Restricted stock awarded..... (25,000) (74,500) -------- -------- Subtotal.................. 829,500 Increase in authorized shares. 1,000,000 Shares of restricted stock forfeited.................... 80,500 Change in options outstanding during year.................. (482,500) --------- Shares available for award at end of year............... 1,427,500 The following table summarizes changes in shares under option for the year ended December 31, 1993: Last Date Exercisable 4-21-2003 11-23-2003 The Compensation Committee awarded stock options to employees under the Long-Term Incentive Plan for the first time in 1993. Awards, all at fair market value, vest ratably over four years and expire 10 years from date of grant. In 1993, Outside Directors exercised 7,500 options at $12.00 per share when the market price was $25.625 per share, 7,500 options at $12.00 per share when the market price was $27.875 per share and a total of 34,500 options at prices ranging from $8.000 per share to $27.750 per share when the market price was approximately $33.00 per share. See Notes 11 and 15 for a discussion of the restricted stock issued under the Long-Term Incentive Plan. 13. CONTINGENCIES, COMMITMENTS AND CONCENTRATION OF RISKS The Company has unconditionally guaranteed its finance subsidiary's $32.1 million obligations. The Company is self-insured for the first $5 million of each loss. The Company carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Company's management to be adequate in light of the Company's safety record and claims experience. As of December 31, 1993, the Company had $4.0 million of letters of credit outstanding as collateral primarily for surety bonds executed on behalf of the Company. Such letters of credit expire in 1994 and are automatically renewable for one year. The letters of credit reduced the maximum amount that could be borrowed under the Revolver (see Note 8). The Company has guaranteed repayment of certain indebtedness of a jointly owned company aggregating $7.8 million. The Company's primary share is $1.0 million; the remainder is a primary obligation of other unrelated owner companies. There are various regulatory proceedings, claims and litigation pending against the Company. While the ultimate amount of liability that may result cannot be determined, in the opinion of the Company's management, based on present information, adequate provisions for liabilities have been recorded. See "Management's Discussion and Analysis - Other" for a discussion of environmental matters. 14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and temporary cash investments. The carrying amount approximates fair value because of the short maturity of those instruments. Investments. The Company has investments of $10.3 million in 1993 and $11.1 million in 1992 for which there are no quoted market prices. These investments are in joint railroad facilities, railroad terminal associations, switching railroads and other transportation companies. For these investments, the carrying amount is a reasonable estimate of fair value. The Company's remaining investments ($5.4 million in 1993 and $3.9 million in 1992) are accounted for by the equity method. Long-term debt. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Fuel hedge agreements. The fair value of fuel hedging agreements is the estimated amount that the Company would receive or pay to terminate the agreements as of year end, taking into account the current credit worthiness of the agreement counterparties. At December 31, 1993 and 1992, the fair value was a liability of $4.6 million and less than $.1 million, respectively. The estimated fair values of the Company's financial instruments at December 31, are as follows ($ in millions): 15. SPECIAL CHARGE In 1992, the Company recorded a pretax special charge of $8.9 million as part of operating expense. The special charge reduced Net Income by $5.9 million or $.13 per share. The special charge consisted of $7 million for various costs associated with the retirement of Mr. Moyers and the related organizational changes. The costs associated with Mr. Moyers' retirement include the present value of his pension, accelerated vesting of a portion of his restricted stock award and certain costs of a non- competition agreement. The remaining $1.9 million was for the disposition costs of railcars and a building and its adjacent land. 16. SELECTED QUARTERLY FINANCIAL DATA - (UNAUDITED)($ IN MILLIONS, EXCEPT SHARES DATA: Per share amounts in 1991 have been restated to reflect the 3-for-2 stock split that occurred in February 1992. - ----------------------- (a) Includes the special charge recorded in the fourth quarter of 1992, see Note 15. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES -------------------- ----------------------------- F O R M 10-K FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES ------------- ------------- I N D E X T O FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) Schedules for the three years ended December 31, 1993: II-Amounts receivable from related parties, and underwriters, promoters and employees other than related parties... III-Condensed financial information........ V-Property, plant and equipment.......... VI-Accumulated depreciation and amortization of property, plant and equipment....... VII-Guarantees of securities of other issuers............................... VIII-Valuation and qualifying accounts...... Pursuant to Rule 5.04 of General Rules of Regulation S-X, all other schedules are omitted because they are not required or because the required information is set forth in the financial statements or related notes thereto. ------------- ------------- ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES ($ in millions) Balance at end of year Balance ----------- at begin- Non- Name of ning of Addi- Deduc- Curr- Curr- Debtor year tions tions ent ent - ------ --------- ----- ------ ---- ----- E. L. Moyers $.7 - - $.2 $.5 - ----------------- Pursuant to a four-year note dated May 15, 1992, bearing interest at the rate of 7.1%, Mr. Moyers became indebted to the Company in the principal amount of $1,000,000. In connection with Mr. Moyers' decision to retire and resign from the Board, Mr. Moyers repaid $238,500 of principal and interest and the Compensation Committee forgave an additional $200,000 principal amount of the loan. The May 15, 1992 note was cancelled in favor of a new note (the "Note") to be repaid in four annual installments of principal and interest, commencing on February 18, 1994. The Note provides that unpaid principal, including any accrued interest thereon, is to be accelerated in the event of a breach of the non-competition covenant contained in Mr. Moyers' consulting and non-competition agreement with the Company. The Note bears interest at a rate of 6.22% per annum and is prepayable in whole or in part at any time. Any unpaid principal, including any accrued interest thereon, is to be forgiven in the event of Mr. Moyers' death or disability. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (a) Reflects 3-for-2 stock split in February 1992. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (a) Reflects 3-for-2 stock split in February 1992. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (1) Reclassification of properties from "Other Assets." (2) Reclassification of properties from "Assets Held For Disposition." ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993, 1992 AND 1991 ($ IN MILLIONS) Column A Column B Column C Column D - -------- -------- -------- -------- Name of Title of Total Amount Nature of Issuer of Issue of Guaranteed Guarantee Securities Class of and Guaranteed Securities Outstanding by Person Guaranteed for Which Statement is Filed - ----------- ---------- ------------ -------- Terminal Refunding $7.8 Principal Railroad and and Association Improvement annual of St. Mortgage 4% interest Louis Bonds, St. Louis Series "C", due 7/1/2019 ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 3.1 Articles of Incorporation of Illinois Central Railroad Company, as amended. (Incorporated by reference to Exhibit 3.1 to the Registration Statement of Illinois Central Railroad Company on Form S-1. (SEC File No. 33-29269)) 3.2 By-Laws of Illinois Central Railroad Company, as amended. (Incorporated by reference to Exhibit 3.2 to the Registration Statement of Illinois Central Railroad Company on Form S-1. (SEC File No. 33-29269)) 3.3 Restated Articles of Incorporation of Illinois Central Corporation. (Incorporated by reference to Exhibit 3.1 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 3.4 By-Laws of Illinois Central Corporation, as amended. (Incorporated by reference to Exhibit 3.4 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1. (SEC File Nos. 33-36321 and 33-36321- 01)) 3.5 Certificate of Retirement of Illinois Central Corporation (Incorporated by reference to Exhibit 3.3 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 40696 and Post-Effective Amendments to Registration Statement Nos. 33-36321 and 33-36321-01)) 3.6 Certificate of Elimination of Illinois Central Corporation. (Incorporated by reference to Exhibit 3.2 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) - -------------------- * Used herein to identify management contracts or compensation plans or arrangements as required by Item 14 of Form 10-K. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.1 Form of 14-1/8% Senior Subordinated Debenture Indenture dated as of September 15, 1989 (the "Senior Subordinated Debenture Indenture") between Illinois Central Railroad Company and United States Trust Company of New York, Trustee (including the form of 14-1/8% Senior Subordinated Debenture included as Exhibit A therein). (Incorporated by reference to Exhibit 4.1 to the Registration Statement of Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 29269)) 4.2 Restated Articles of Incorporation of Illinois Central Corporation (included in Exhibit 3.3) 4.3 Form of the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Restated Revolving Credit Note, the Form of the Restated Term Note, the Form of the Intercreditor Agreement, the Form of the Security Agreement and the Form of the Bond Pledge Agreement included as Exhibits A, B, G, H and I, respectively, therein). (Incorporated by reference to Exhibit 4.1 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.4 Amendment No. 1 dated as of February 28, 1992, to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Railroad Company filed March 12, 1992. (SEC File No. 1-7092)) 4.5 Form of Guaranty dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Corporation and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad Company and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.6 Form of Pledge Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Corporation and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of amended and restated as of July 23, 1991, among the Illinois Central Railroad Company and the Banks named therein and the Senior Note Purchasers that are parties to the Note Purchase Agreement dated as of July 23, 1991. (Incorporated by reference to Exhibit 4.4 to the Quarterly Report of Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.7 Form Supplemental Indenture dated July 23, 1991, between Illinois Central Railroad Company and Morgan Guaranty Trust Company of New York relating to First Mortgage Adjustable Rate Bonds, Series M. (Incorporated by reference to Exhibit 4.2 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.8 Form of Note Purchase Agreement dated as of July 23, 1991, among Illinois Central Railroad Company, as issuer, and Illinois Central Corporation, as guarantor, for 10.02% Guaranteed Senior Secured Series A Notes due 1999 and for 10.4% Guaranteed Senior Secured Series B Notes due 2001 (including the Form of Series A Note and Series B Note included as Exhibits A-1 and A-2, respectively, therein). (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of the Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.9 Form of the Loan and Security Agreement dated as of December 6, 1991, between IC Leasing Corporation I and Hitachi Credit America Corp. (including the Form of the Initial Funding Credit Note, the Form of the Refurbishing Credit Note, the Form of Assignment of Lease and Agreement, the Form of the Pledge Agreement between IC Financial Services Corporation and Hitachi Credit America Corp. and the Form of the Guaranty Agreement between Illinois Central Corporation and Hitachi Credit America Corp. included as Exhibits D, E, F, G and H, respectively, therein). (Incorporated by reference to Exhibit 4.9 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Corporation filed March 12, 1992. (SEC File No. 1-10720)) 4.10 Form of the Trust Agreement dated as of March 30, 1993, between IC Leasing Corporation II and Wilmington Trust Company. (Incorporated by reference to Exhibit 4.10 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.11 Form of the Security Agreement and Mortgage dated as of March 30, 1993, between IC Leasing Trust II and UNUM Life Insurance Company of America (Including the Form of the Promissory Note between IC Leasing Trust II and UNUM Life Insurance Company of America included as Exhibit A, therein). (Incorporated by reference to Exhibit 4.11 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.12 Assignment of Lease and Conveyance dated March 30, 1993, between IC Leasing Corporation II and IC Leasing Trust II. (Incorporated by reference to Exhibit 4.12 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.13 Assignment of Lease and Conveyance dated March 30, 1993, between IC Leasing Trust II and UNUM Life Insurance Company of America. (Incorporated by reference to Exhibit 4.13 to the Current Report of Illinois Central Corporation on Form 8-K dated May 7, 1993. (SEC File No. 1- 10720)) 4.14 Form of the Amended and Restated Demand Promissory Note between IC Leasing Corporation III and The First National Bank of Boston dated December 3, 1993, and amended and restated as of January 3, 1994. 4.15 Form of the Guaranty dated as of December 3, 1993, between Illinois Central Corporation and The First National Bank of Boston. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.16 Security Agreement dated as of December 3, 1993, between IC Leasing Corporation III and The First National Bank of Boston and Amendment No. 1 to the Security Agreement dated as of January 3, 1994. 4.17 Form of the Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). (Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K for the year ended December 31, 1993, for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 4.18 Form of the Amended and Restated Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). (Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K for the year ended December 31, 1993, for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.19 Form of Commercial Paper Dealer Agreement between Illinois Central Railroad Company and Lehman Commercial Paper, Inc. dated as of November 19, 1993. (Incorporated by reference to Exhibit 4.10 to the Annual Report on Form 10-K for the year ended December 31, 1993 for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 4.20 Form of Issuing and Paying Agency Agreement of the Illinois Central Railroad Company related to the Commercial Paper Program between Illinois Central Railroad Company and Bank America National Trust Company dated as of November 19, 1993, (including Exhibit A the Form of Certificated Commercial Paper Note included therein). (Incorporated by reference to Exhibit 4.11 to the Annual Report on Form 10-K for the year ended December 31, 1993 for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 10.1 * Form of supplemental retirement and savings plan. (Incorporated by reference to Exhibit 10C to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.2 * Form of management incentive compensation plan. (Incorporated by reference to Exhibit 10D to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.3 Consolidated Mortgage dated November 1, 1949 between Illinois Central Railroad Company and Guaranty Trust Company of New York, Trustee, as amended. (Incorporated by reference to Exhibit 10.8 to the Registration Statement of Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 29269)) 10.4 Form of indemnification agreement dated as of January 29, 1991, between Illinois Central Corporation and certain officers and directors. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1990, for the Illinois Central Corporation filed on April 1, 1991. (SEC File No. 1-10720)) 10.5 * Form of IC 1990 Stock Purchase Plan. (Incorporated by reference to Exhibit 10.6 to the Registration Statement of Illinois Central Corporation on Form 10 filed on January 5, 1990, as amended. (SEC File No. 1-10720)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.6 * Form of IC Long-Term Incentive Option Plan. (Incorporated by reference to Exhibit 10.17 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1. (SEC File Nos. 33-36321 and 33- 36321-01)) 10.7 * Amendments No. 1 and No. 2 to the IC Long-Term Incentive Plan. (Incorporated by reference to the Proxy Statement of Illinois Central Corporation in connection with its 1992 Annual Meeting of Stockholders. (SEC File No. 1- 10720)) 10.8 Railroad Locomotive Lease Agreement between IC Leasing Corporation I and Illinois Central Railroad Company dated as of September 5, 1991. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1991 for the Illinois Central Railroad Company filed March 12, 1992. (SEC File No. 1- 7092)) 10.9 Railroad Locomotive Lease Agreement between IC Leasing Corporation II and Illinois Central Railroad Company dated as of January 14, 1993. (Incorporated by reference to Exhibit 10.6 to the Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Railroad Company filed March 5, 1993. (SEC File No. 1- 7092)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.10 * Form of Consulting and Non- Competition Agreement between Illinois Central Corporation and Edward L. Moyers dated as of February 18, 1993. (Incorporated by reference to Exhibit 10.10 to Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Corporation filed March 5, 1993. (SEC File No. 1-10720)) 10.11 * Form of the Note Agreement between the Illinois Central Corporation and Edward L. Moyers dated February 18, 1993. (Incorporated by reference to Exhibit 10.11 to Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Corporation filed March 5, 1993. (SEC File No. 1- 10720)) 10.12 * Form of a Supplemental Retirement Benefit Agreement dated as of August 20, 1992 between Illinois Central Corporation and Edward L. Moyers. (Incorporated by reference to Exhibit 10.3 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three month ended September 30, 1992. (SEC File No. 1-10720)) 10.13 The Asset Sale Agreement between Allied Railcar Company and IC Leasing Corporation III dated December 3, 1993, (including the Bill of Sale Agreement and Assumption of Liabilities included as Exhibits C and D, respectively, therein). ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.15 The Purchase Agreement between IC Leasing Corporation III and The First National Bank of Maryland dated December 29, 1993. 11 Computation of Income Per Common Share (Included at E-9) 21 Subsidiaries of Registrant (Included at E-10) 24.1 Consent of Arthur Andersen & Co. (A) --------------------- (A) Included herein but not reproduced. (1) Shares for 1991 restated to reflect February 1992 3 for 2 stock split. (2) Such items are included in primary calculation. Additional shares represent difference between average price of Common Stock for the period and the end of period price.	14,272	92,646
5016_1993.txt	5016_1993	1993	5016	ITEM 1 Business Introduction American Financial Corporation ("AFC") was incorporated as an Ohio Corporation in 1955. Its address is One East Fourth Street, Cincinnati, Ohio, 45202; its phone number is (513) 579-2121. Carl H. Lindner and certain members of the Lindner family own all of the outstanding common stock of AFC. AFC is a holding company operating through wholly-owned and majority-owned subsidiaries and other companies in which it holds significant minority ownership interests. These companies operate in a variety of financial businesses, including property and casualty insurance, annuities, and portfolio investing. In non-financial areas, these companies have substantial operations in the food products industry, television and radio station operations and industrial manufacturing. The following table shows AFC's percentage ownership of voting securities of the significant companies over the past several years: Ownership at December 31, 1993 1992 1991 1990 1989 Great American Insurance Group 100% 100% 100% 100% 100% Great American Life Insurance Company (a) (a) 100% 100% 100% American Annuity Group 80% 82% 39% 32% 32% American Premier Underwriters 41% 51% 50%+ 42% 34% (formerly Penn Central Corporation) Chiquita Brands International 46% 46% 48% 54% 82% Great American Communications 20% 40% 40% 65% 62% General Cable (b) 45% 45% - - - Spelling Entertainment Group (c) 48% 53% 53% 51% (formerly The Charter Company) (a) Sold to American Annuity Group in December 1992. (b) 100%-owned by American Premier prior to spin-off in July 1992. Ownership percentage excludes shares held by American Premier for future distribution aggregating 12%. (c) Sold on March 31, 1993. (d) Generally, companies have been included in AFC's consolidated financial statements when AFC's ownership of voting securities has exceeded 50%; for investments below that level but above 20%, AFC has accounted for the investments as investees. (See Note E to AFC's financial statements.) The following summarizes the more significant changes in ownership percentages shown in the above table. American Annuity Group American Annuity is the successor to STI Group, Inc., formerly known as Sprague Technologies, Inc. ("STI"). Between 1990 and 1992, American Annuity disposed of substantially all of its operations and on December 31, 1992, purchased Great American Life Insurance Company ("GALIC") from Great American Insurance Company ("GAI"). In connection with the acquisition, GAI purchased 5.1 million shares of American Annuity's common stock pursuant to a cash tender offer and 17.1 million additional shares directly from American Annuity. American Premier Underwriters Between 1989 and 1991, American Premier repurchased and retired approximately 26 million shares of its common stock, resulting in AFC's ownership being increased. During 1991, AFC purchased an additional 1.6 million shares of American Premier common. In August 1993, American Financial Enterprises, Inc., an 83%-owned subsidiary of AFC, whose assets consist primarily of investments in American Annuity Group, American Premier and General Cable, sold 4.5 million shares of American Premier common stock in a secondary public offering. Chiquita Brands International In 1988 and 1990, Great American Communications sold 5.25 million and 2.2 million shares of Chiquita to Chiquita and an additional 5 million shares in a secondary public offering in 1990. In 1990 and 1991, Chiquita sold 5.3 million and 5 million shares of its stock in public offerings. Also in 1990, Chiquita issued 1.7 million shares upon conversion of debentures. Great American Communications In 1991, GACC issued 21.6 million shares in connection with debt restructurings. In December 1993, GACC completed a joint prepackaged plan of reorganization. Under the terms of the restructuring, GACC's outstanding stock was reduced in a 1-for-300 reverse split. In the restructuring, AFC's previous holdings of GACC stock and debt were exchanged for 20% of the new common stock. General Cable In July 1992, American Premier distributed to its shareholders approximately 88% of the stock of General Cable Corporation, which was formed to own certain of American Premier's manufacturing businesses. American Premier retained the remaining shares of General Cable for distribution under American Premier's 1978 Plan of Reorganization and to reserve for potential option and convertible preference stock exercises. AFC and its subsidiaries, excluding American Premier, received approximately 45% of General Cable in the spin-off. Spelling Entertainment Group During 1992, The Charter Company issued 5.8 million shares of its common stock in a merger with Spelling Entertainment Inc., resulting in AFC's ownership of Charter being decreased below 50%. Subsequent to the merger, Charter changed its name to Spelling Entertainment Group Inc. ("Spelling") to reflect the nature of its business. In March 1993, AFC sold its common stock investment in Spelling to Blockbuster Entertainment Corporation. General The following discussion concerning AFC's businesses is organized along the lines of the major company investments as shown in the table above. Reference to the table and to AFC's consolidated financial statements is recommended for a better understanding of this section and Item 6 - "Selected Financial Data". Great American Insurance Group AFC's primary insurance business is multi-line property and casualty insurance, headed by Great American Insurance Company ("GAI"). Hereafter, GAI and its property and casualty insurance subsidiaries will be referred to collectively as "Great American". They employ approximately 3,300 persons. According to the most recent ranking published in "Best's Review", Great American was the 42nd largest among all property and casualty insurance groups operating in the United States on the basis of total net premiums written in 1992. GAI is rated "A" (Excellent) by A.M. Best Company, Inc. This rating is given to companies that "have a strong ability to meet their obligations to policyholders over a long period of time." On December 31, 1990, GAI sold its non-standard automobile insurance group ("NSA group") to American Premier. The NSA group accounted for approximately one-fourth of Great American's earned premiums and had a 1990 statutory combined ratio of 95.5%. Data in this section includes the NSA Group for the periods it was owned by GAI. In February 1994, American Premier announced that it was considering a proposal from AFC to purchase GAI's personal lines business (primarily insurance of private passenger automobiles and residential property) for $380 million. These operations had earned premiums of $342 million in 1993 and represented approximately 25% of the premiums earned by all of Great American's insurance operations. GAI has estimated that the accident year statutory combined ratio for the personal lines business was about 99% in each of the last two years. The purchase would include the transfer of a portfolio of principally investment grade securities with a market value of approximately $450 million. GAI has estimated the net book value, based on generally accepted accounting principles ("GAAP"), of the business to be transferred would be approximately $200 million. Unless otherwise indicated, all tables concerning insurance are presented on the statutory basis prescribed by the National Association of Insurance Commis-sioners and each insurer's domiciliary state. In general, this method results in lower capital surplus and net earnings than result from application of GAAP which are utilized in preparing the financial statements found elsewhere herein. These differences include charging policy acquisition costs to expense as incurred rather than spreading the costs over the periods covered by the policies, requiring additional loss reserves, establishing valuation reserves for investments held by life insurance subsidiaries and charging to surplus certain assets, such as furniture and fixtures and agents' balances over 90 days old. The following table shows (in millions) the performance of Great American in various categories. While financial data is reported on a statutory basis for insurance regulatory purposes, it is reported in accordance with GAAP for shareholder and other investment purposes. Underwriting The profitability of a property and casualty insurance company depends on two main areas of operation: underwriting of insurance and investment of assets. Underwriting profitability is measured by the combined ratio which is a sum of the ratio of underwriting expenses to premiums written and the ratio of losses and loss adjustment expenses to premiums earned. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. The following table shows certain underwriting data of Great American (dollars in millions): As shown in the table above, Great American's underwriting results, although not profitable, have been significantly better than the industry's. Great American's results reflect an emphasis on writing commercial lines coverages of specialized niche products where company personnel are experts in particular lines of business. During 1993, approximately half of Great American's premiums were written in these specialized niche product areas. Great American's combined ratio (after policyholder dividends) for 1993 excluding its personal lines business (which may be sold to American Premier) was 104.7%. Certain natural disasters (hurricanes, tornados, forest fires, etc.) and other incidents of major loss (explosions, civil disorder, fires, etc.) are classified as catastrophes by industry associations. Losses from these incidents are usually tracked separately from other business of insurers because of their sizable effects on overall operations. Major catastrophes in recent years included flooding in the Midwest in 1993; Hurricanes Andrew and Iniki, Chicago flooding, and Los Angeles civil disorder in 1992; Oakland fires in 1991; and Hurricane Hugo and the San Francisco earthquake in 1989. Total net losses to AFC's insurance operations from catastrophes were $26 million in 1993; $42 million in 1992; $22 million in 1991; $13 million in 1990; and $32 million in 1989. These amounts are included in the tables herein. Insurance regulations in various states require prior approval of premium rate increases on approximately 85% of Great American's personal lines business. The commercial business generally does not require prior approval, although a number of states impose some degree of review of commercial rates. Information for the major classes of business written by Great American is as follows (dollars in millions). Losses incurred and loss ratios exclude loss adjustment expenses. Combined ratios are stated before policyholders' dividends. 1993 1992 1991 1990 1989 Auto Liability and Physical Damage (A) Premiums Written $424 $397 $364 $820 $687 Premiums Earned 403 389 362 785 670 Losses Incurred 249 259 187 504 423 Loss Ratio 61.8% 66.6% 51.5% 64.1% 63.1% Combined Ratio 103.4% 107.7% 92.2% 102.5% 101.6% Property and Multiple Peril (B) Premiums Written $349 $329 $368 $387 $353 Premiums Earned 337 347 378 374 351 Losses Incurred 189 228 235 203 208 Loss Ratio 56.0% 65.6% 62.3% 54.3% 59.3% Combined Ratio 103.9% 117.3% 110.6% 102.4% 104.4% Workers' Compensation and Other Liability (C) Premiums Written $340 $349 $349 $390 $352 Premiums Earned 338 349 357 369 374 Losses Incurred 216 173 235 267 252 Loss Ratio 64.2% 49.6% 65.7% 72.6% 67.4% Combined Ratio 108.6% 92.7% 109.9% 114.8% 111.6% All Other (D) Premiums Written $174 $149 $121 $115 $ 95 Premiums Earned 165 135 117 107 93 Losses Incurred 75 64 46 47 40 Loss Ratio 45.6% 47.6% 38.8% 43.9% 43.0% Combined Ratio 95.3% 93.1% 82.0% 87.8% 92.6% (A) Includes related bodily injury, property damage and physical damage. Unusually low Combined Ratio in 1991 generally reflects the effects of a program to reduce exposure to certain commercial "bad risk" groups while retaining previous pricing, followed by reductions in pricing in later years. (B) Includes extended coverage, tornado, windstorm, cyclone, hail on growing crops, personal multiple peril, riot and civil commotion, vandalism and malicious mischief, and sprinkler leakage and water damage. Unusually high Combined Ratio in 1992 generally reflects the effects of Hurricanes Andrew and Iniki. (C) Includes other bodily injury, property damage and directors and officers' liability. Unusually low Combined Ratio in 1992 generally reflects reductions in redundant reserves on certain matured lines of commercial liability coverages written in the late 1980s. (D) Includes accident and health, credit, burglary, glass, earthquake, aircraft physical damage and boiler and machinery. Unusually low Combined Ratio in 1991 generally reflects especially good operations for the Inland Marine and Surety operations. The table above includes the results of GAI's personal lines business which AFC has proposed to sell to American Premier. Information for this business for 1993 follows (dollars in millions): Automobile Homeowners Other Total Premiums Written $250 $80 $21 $351 Premiums Earned 242 79 21 342 Losses Incurred 150 51 8 209 Loss Ratio 61.8% 64.7% 38.2% 61.1% Combined Ratio 100.8% 111.3% 74.6% 101.6% The following table shows the ratio of net premiums written to policy-holders' surplus for Great American and the industry on a consolidated basis. Increases in this ratio beyond the informal industry standard of 3:1 may cause insurance commissioners to require companies to reduce underwriting activities or obtain additional capitalization. 1993 1992 1991 1990 1989 Great American 1.45 1.44 1.43 2.49 2.24 Industry (stock companies) () 1.24 1.30 1.33 1.53 1.51 () Source: Conning & Company, Property and Casualty Model and Forecast Service, March 1994. Great American is represented by several thousand agents and brokers who are paid on a commission basis; most also represent other insurance companies. The geographical distribution of direct premiums written in 1993 compared to 1989, before giving effect to reinsurance, was as follows (dollars in millions): 1993 1989 Location Premiums % Premiums % California $ 216 13.6% $ 188 11.4% New York 135 8.5 79 4.8 Connecticut 114 7.2 112 6.8 New Jersey 90 5.7 74 4.5 North Carolina 81 5.1 95 5.8 Pennsylvania 78 4.9 40 2.4 Texas 75 4.7 49 3.0 Florida 68 4.3 103 6.3 Illinois 56 3.5 69 4.2 Ohio 56 3.5 63 3.8 Oklahoma 53 3.3 85 5.2 Massachusetts 52 3.3 37 2.3 Michigan 49 3.1 61 3.7 Maryland 36 2.3 * * Washington 35 2.2 32 2.0 Kentucky 32 2.0 * * Georgia * * 96 5.9 Virginia * * 46 2.8 Tennessee * * 37 2.3 All others, including foreign, each less than 2% 359 22.8 375 22.8 $1,585 100.0% $1,641 100.0% () Less than 2%. In 1988, a California ballot initiative, Proposition 103, was passed by a very small margin of voters. The consumer-sponsored initiative sought to (i) increase rate regulation, (ii) mandate rate rollbacks and freezes for most lines of property and casualty insurance and (iii) make changes in antitrust laws applicable to the insurance industry. The California Supreme Court upheld the validity of most of the major portions of the initiative but permitted insurers to seek exemptions from the rate rollback if such a rollback would not enable them to make a fair and reasonable profit. In 1991, the newly elected Insurance Commissioner of California promulgated a new set of regulations on rate rollbacks and prior approval of rates, replacing those adopted by the former Insurance Commissioner under Proposition 103. Although these regulations are not finalized, there have been some company specific hearings and there are ongoing appellate proceedings challenging the regulations. Great American has not received a notice of the Insurance Department's assessment of its rollback liability or a hearing date, although it is exploring settlement possibilities. Since, at present, there is no finalized regulatory arrangement, Great American cannot determine the actual amount of the liability, if any, for a refund pursuant to the rollback provision of Proposition 103. By its terms, Proposition 103 does not affect workers' compensation insurance. Loss and Loss Adjustment Expense Reserves The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of Great American. This liability represents estimates of the ultimate net cost of all unpaid losses and LAE and is determined by using case-basis evaluations and statistical projections. These estimates are subject to the effects of claim amounts and frequency and are continually reviewed and adjusted as additional information becomes known. In accordance with industry practices, such adjustments are reflected in current year operations. Increases in claim payments are caused by a number of factors that vary with the individual types of policies written. Future costs of claims are projected based on historical trends adjusted for changes in underwriting standards, policy provisions, the anticipated effect of inflation and general economic trends. These anticipated trends are monitored based on actual development and are reflected in estimates of ultimate claim costs. The liability for losses and LAE for certain long-term scheduled payments under workers' compensation, auto liability and other liability insurance has been discounted at rates ranging from 3.5% to 8%. As a result, the total liability for losses and LAE at December 31, 1993, 1992 and 1991 has been reduced by $56 million, $51 million and $51 million, respectively. The limits on risks retained vary by type of policy and risks in excess of certain retention limits are reinsured. Each insurance company within the group establishes its own retention limits based on the individual company's surplus. Generally, reserves for reinsurance and involuntary pools and associations are reflected in Great American's results at the amounts reported by those entities. The following table provides an analysis of changes in the liability for losses and LAE, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions): Major components of the net decrease in the provision for claims occurring in prior years as reflected in the table above were as follows (dollars in millions): The following table presents the development of the liability for losses and LAE, net of reinsurance, on a GAAP basis for the last ten years. The top line of the table shows the estimated liability (in millions) for unpaid losses and LAE recorded at the balance sheet date for the indicated years. The remainder of the table presents development as percentages of the estimated liability. The development results from additional information and experience in subsequent years. The middle line shows a cumulative deficiency (redundancy) which represents the aggregate percentage increase (decrease) in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability. This table does not present accident or policy year development data. Further-more, in evaluating the re-estimated liability and cumulative deficiency (redundancy), it should be noted that each percentage includes the effects of changes in amounts for prior periods. For example, a deficiency related to losses settled in 1993, but incurred in 1983, would be included in the re-estimated liability and cumulative deficiency percentage for each of the years 1983 through 1992. Conditions and trends that have affected development of the liability in the past may not necessarily exist in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. Management believes that Great American's development is similar to that of companies with similar mixes of business. The adverse development in earlier years in the table above was partially caused by the effect of higher than projected inflation on medical, hospitalization, material, repair and replacement costs. Additionally, changes in the legal environment have influenced the development patterns over the past ten years. Two significant changes in the early to mid-1980s were the trend towards an adverse litigious climate and the change from contributory to comparative negligence. The adverse litigious climate is evidenced by an increase in lawsuits and damage awards, changes in judicial interpretation of legal liability and of the scope of policy coverage, and a lengthening of time it takes to settle cases. In addition, a trend has developed in the manner and timeliness of first claim notices. Historically, the first notification of claim came directly from the claimant; in recent years, however, there has been a gradual increase in the number of notifications in the form of direct legal action. Not only has this notification been less timely, it has been more adversarial in nature. The change in rules of negligence governing tort claims has also influenced the loss development trend. During the early to mid-1980s, most states changed from contributory to comparative negligence rules. When contributory negligence rules control, a plaintiff seeking damages is barred from recovering damages for a loss if it can be demonstrated that the plaintiff's own negligence contributed in any way to the cause of the injury. When comparative negligence rules control, a plaintiff's negligence is no longer a bar to recovery. Instead, the degree of plaintiff's negligence is compared to the negligence of any other party. Generally, if the plaintiff's negligence is 50% or less of the cause of the injury, the plaintiff can recover damages, but in an amount reduced by the portion of damage attributable to the plaintiff's own negligence. Many claims which would have been successfully defended under contributory negligence rules now result in an award of damages or a settlement during suit under the comparative negligence rules. The differences between the liability for losses and LAE reported in the annual statements filed with the state insurance departments in accordance with statutory accounting principles ("SAP") and that reported in the accompanying consolidated financial statements in accordance with GAAP at December 31, 1993, are as follows (in millions): Liability reported on a SAP basis $2,144 Additional discounting of GAAP reserves in excess of the statutory limitation for SAP reserves (11) Estimated salvage and subrogation recoveries recorded on a cash basis for SAP and on an accrual basis for GAAP (1) Reinsurance reserve included in other liabilities (19) Reinsurance recoverables 611 Liability reported on a GAAP basis $2,724 Environmental Property and casualty insurers have experienced a significant increase in the number of claims and legal actions related to hazardous products and environmental pollution. Ensuing litigation extends to issues of when the loss occurred and what policies provide coverage, what claims are covered, extent of coverage, whether there is an insured obligation to defend and other policy provisions. To date, court decisions have been inconsistent on several coverage issues; these issues are not likely to be resolved in the near future. Great American's liability for loss and loss adjustment expenses includes amounts for various liability coverages related to environmental and hazardous product claims. Establishing reserves for those types of claims is subject to uncertainties that are greater than those represented by other types of claims. Factors contributing to those uncertainties include a lack of historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure and the extent and timing of any such contractual liability. Management believes that its reserves are adequate to cover the claims reported. Although Great American establishes reserves for reported environmental claims, it does not establish reserves for unreported claims and related litigation expenses because such amounts cannot be reasonably estimated. Although future results may be adversely affected, management does not believe any such effect is likely to be material to AFC's financial condition or results of operations. Following is an analysis (in millions) of net reported environmental pollution and hazardous products claims for those subsidiaries capable of retrieving such data. These companies accounted for over 95% of AFC's insurance claims and reserves at December 31, 1993. 1993 1992 1991 Reserves at beginning of year $51.2 $51.3 $40.0 Incurred losses and LAE 18.5 25.8 28.0 Paid losses and LAE (24.6) (25.9) (16.7) Reserves at end of year $45.1 $51.2 $51.3 Figures above do not include asbestos abatement and underground storage tank coverage written by certain AFC subsidiaries in recent years. The table above includes exposures where Great American has been held liable for coverage on general liability policies written years ago where environmental coverage was not intended. In contrast, asbestos abatement and underground storage tank coverage is written with the intent of covering environmental-related losses. Net loss reserves on this coverage totaled $53 million, $51 million and $42 million at December 31, 1993, 1992 and 1991, respectively. Reinsurance In accordance with industry practice, Great American reinsures a portion of its business with other insurance companies and assumes reinsurance from other insurers. Ceding reinsurance permits diversification of risks and limits maximum loss arising from large or unusually hazardous risks or a localized catastrophe. Although reinsurance does not legally discharge the original insurer from primary liability, risks that are reinsured are, in practice, treated as though they were transferred to the reinsurers. Reinsurance is provided on one of two bases: the facultative basis or the treaty basis. Facultative reinsurance is generally provided on a risk by risk basis. Individual risks are ceded and assumed based on an offer and acceptance of risk by each party to the transaction. Treaty reinsurance provides for risks to be automatically ceded and assumed according to contract provisions. In addition to various facultative reinsurance coverages, GAI has current treaty reinsurance programs which generally provide for retention maximums. For workers' compensation policies, the retention maximum is $5 million per loss occurrence with reinsurance coverage for the next $45 million. For all other casualty policies, the retention maximum is $5 million per loss occurrence with reinsurance coverage for the next $15 million. For property coverages, the retention is $5 million per risk with reinsurance coverage for the next $25 million; for catastrophe coverage on property risks, the retention is $20 million with reinsurance covering 89% of the next $110 million in losses. Contracts relating to reinsurance are subject to periodic renegotiation and no assurance can be given concerning the future terms of such reinsurance. Great American's major reinsurers include American Re-Insurance Company, Employers Reinsurance Corporation, General Reinsurance, Mitsui Marine and Fire Insurance Company, Ltd. and Taisho Marine & Fire Insurance Company. Great American regularly monitors the financial strength of its reinsurers. This process periodically results in the transfer of risks to more financially stable reinsurers. Management believes that its present group of reinsurers is financially sound. However, market conditions over the past few years have forced many reinsurers into financial difficulties or liquidation proceedings. At December 31, 1993, Great American had an allowance of approximately $56 million for doubtful collection of reinsurance recoverables. The collectibility of a reinsurance balance is based upon the financial condition of a reinsurer as well as individual claim considerations. Included in "recoverables from reinsurers and prepaid reinsurance premiums" were $80 million on paid losses and LAE and $611 million on unpaid losses and LAE at December 31, 1993. Premiums written for reinsurance ceded and assumed are presented in the following table (in millions): 1993 1992 1991 1990 1989 Reinsurance ceded $422 $328 $284 $219 $214 Reinsurance assumed: From companies under management contract 63 17 8 8 6 Other, primarily non-voluntary pools and associations 61 71 55 71 54 Investment Results The following table, prepared on a GAAP basis, shows the performance of Great American's investment portfolio, excluding equity investments in affiliates (dollars in millions): 1993 1992 1991 1990 1989 Average Cash and Investments at Cost $2,822 $2,743 $2,538 $2,445 $2,300 Investment Income 205 222 217 236 245 Net Realized Gains (Losses) 77 (56) 14 29 9 Credit (Provision) for Impairment on Investments (2) 32 (33) (69) (22) Percentage Earned: Excluding Realized Gains (Losses) (A) 7.3% 8.1% 8.5% 9.7% 10.7% Including Realized Gains (Losses) (A)10.0% 6.1% 9.1% 10.9% 11.0% Including Realized Gains (Losses) and Credit (Provision) for Impairment on Investments 10.0% 7.3% 7.8% 8.0% 10.1% Increase (Decrease) in Unrealized Gains on Marketable Securities (Net of Realized Gains) $68 $61 ($110) ($41) $103 (A) Excludes provision for losses on investments. American Annuity Group and Great American Life Insurance Company Data in this section relating to the period following the sale of GALIC to STI generally has been taken from the 1993 Form 10-K of American Annuity. General American Annuity is a holding company whose only significant asset is the capital stock of GALIC which it acquired from GAI on December 31, 1992. GALIC is engaged principally in the sale of tax-deferred annuities to employees of qualified not-for-profit organizations. GALIC is currently rated "A" (Excellent) by A.M. Best. American Annuity and GALIC employ approximately 440 persons. The following table (in millions) presents information concerning GALIC on a GAAP basis, unless otherwise noted. Annuity Products Annuities are long-term retirement savings plans that benefit from interest accruing on a tax-deferred basis. Certain employees of educational institutions and other not-for-profit groups are eligible to save for retirement through contributions made on a before-tax basis to purchase annuities. Contributions are made at the discretion of the participants, generally through payroll deductions. Federal income taxes are not payable on contributions or earnings until amounts are withdrawn. GALIC's principal products are Flexible Premium Deferred Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). FPDAs are characterized by premium payments that are flexible in amount and timing as determined by the policyholder. SPDAs require a one-time lump sum premium payment. Since January 1, 1988, approximately three-fourths of GALIC's SPDA receipts have resulted from rollovers of tax-deferred funds previously maintained by policyholders with other insurers. In 1993, FPDAs accounted for approximately two-thirds of GALIC's total annuity receipts, with SPDAs accounting for the remainder. Annuity contracts can be either variable rate or fixed rate. With a variable rate annuity, the rate at which interest is credited to the contract is tied to an underlying securities portfolio or other performance index. With a fixed rate annuity, an interest crediting rate is set by the issuer, periodically reviewed by the issuer, and changed from time to time as determined to be appropriate. GALIC has issued only fixed rate annuities and its products offer minimum interest rate guarantees of 3% to 4%. All of GALIC's annuity policies permit GALIC to change the crediting rate at any time (subject to the minimum guaranteed interest rate). In determining the frequency and extent of changes in the crediting rate, GALIC takes into account the profitability of its annuity business and the relative competitive position of its products. The average rate being credited on funds held by GALIC was approximately 5.3%, 6.2% and 7.2% at December 31, 1993, 1992 and 1991, respectively. GALIC seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits to its policies. GALIC accomplishes this by (i) offering flexible crediting rates, (ii) designing annuity products that encourage persistency and (iii) maintaining an appropriate matching of assets and liabilities. Such incentives typically take the form of "two-tier" annuities which, in general, reward persistency by offering higher effective interest rates or lower "upfront" fees to policyholders who annuitize than are offered on prematurely withdrawn funds. Over the past five years, the annual persistency rate of GALIC's annuity products has averaged 92%. Policyholders maintain access to their funds without incurring penalties through a provision in the contract which allows policy loans. At December 31, 1993, GALIC had approximately 230,000 annuity policies in force, nearly all of which were individual contracts. GALIC's policyholders are employees of over 8,300 institutions nationwide. Of the $4.3 billion in total statutory reserves held by GALIC as of December 31, 1993, approximately 95% were attributable to policies in the accumulation phase. Annuity surrender payments represented 6.9%, 7.8% and 9.4%, of average statutory reserves in 1993, 1992 and 1991, respectively. Marketing and Distribution GALIC markets its annuities principally to employees of educational institutions in the kindergarten through high school segment. GALIC's management believes that this market segment is attractive because of the growth potential and persistency rate it has demonstrated. In 1993, written premiums from this market segment represented 90% of GALIC's total tax-qualified premiums, with sales of annuities to other not-for-profit groups accounting for the balance. GALIC markets its annuity products through approximately 55 managing general agents ("MGAs") who, in turn, direct more than 1,000 actively producing independent agents. GALIC has developed its business since 1980 on the basis of its relationships with MGAs and independent agents primarily through a consistent marketing approach and responsive service. GALIC is licensed to sell its products in all states (except Kansas and New York) and the District of Columbia. The geographical distribution of GALIC's annuity premiums written in 1993 compared to 1989 was as follows (dollars in millions): 1993 1989 Location Premiums % Premiums % California $ 87 21.8% $ 98 26.7% Florida 39 9.8 22 6.0 Michigan 34 8.5 39 10.6 Massachusetts 32 8.0 30 8.2 New Jersey 22 5.5 27 7.4 Ohio 22 5.5 * Connecticut 21 5.2 31 8.4 Illinois 13 3.3 10 2.7 North Carolina 13 3.3 * * Texas 13 3.3 12 3.3 Washington 10 2.4 10 2.7 Rhode Island 9 2.2 12 3.3 All others, each less than 2% 85 21.2 76 20.7 $400 100.0% $367 100.0% () Less than 2%. Sales of annuities are affected by many factors, including: (i) competitive rates and products; (ii) the general level of interest rates; (iii) the favorable tax treatment of annuities; (iv) commissions paid to agents; (v) services offered; (vi) ratings from independent insurance rating agencies; and (vii) general economic conditions. Investment Results GALIC's annuity products are structured to generate a stable flow of investable funds. GALIC earns a spread by investing these funds at an investment earnings rate in excess of the crediting rate payable to its policyholders. Investments comprise approximately 96% of GALIC's assets and are the principal source of its income. The following table shows the performance of GALIC's investment portfolio, excluding equity investments in affiliates (dollars in millions): 1993 1992 1991 1990 1989 Average Cash and Investments at Cost $4,455 $4,078 $3,828 $3,278 $2,796 Investment Income 358 334 340 304 295 Net Realized Gains (Losses) 35 27 4 (32) (13) Credit (Provision) for Impairment on Investments - - 51 (23) (47) Percentage Earned: Excluding Realized Gains (Losses) (A) 8.0% 8.2% 8.9% 9.3% 10.5% Including Realized Gains (Losses) (A) 8.8% 8.9% 9.0% 8.3% 10.1% Including Realized Gains (Losses) and Credit (Provision) for Impairment on Investments 8.8% 8.9% 10.4% 7.6% 8.4% Increase (Decrease) in Unrealized Gains on Marketable Securities (Net of Realized Gains) $58 $51 $22 ($27) $7 (A) Excludes provision for losses on investments. American Premier Data in this section generally has been taken from the 1993 Form 10-K of American Premier. American Premier's principal operations are conducted by a group of insurance subsidiaries which write non-standard automobile insurance and workers' compensation coverage. In March 1994, American Premier changed its name from The Penn Central Corporation to reflect its identity as a property and casualty insurance company. American Premier employs approximately 5,400 persons. Insurance American Premier acquired Republic Indemnity Company of America in March 1989. Republic writes workers' compensation and employers' liability insurance coverage in California. In addition to highly regulating the industry, the State of California establishes minimum premium levels and is a major competitor in providing coverage. Republic successfully competes by emphasizing service to customers and brokers. Management believes that Republic Indemnity's record and reputation for paying relatively high policyholder dividends have enhanced its competitive position. Republic reported a statutory combined ratio (after policyholders' dividends) of 88.1% for 1993. American Premier purchased Great American's non-standard automobile insurance companies on December 31, 1990, and Leader National Insurance Company in May 1993. These companies (collectively the "NSA Group") write auto insurance coverage for physical damage and personal liability for (i) individuals perceived to be higher than normal risks due to factors such as age, prior driving violations, occupation or type of vehicle driven, or (ii) those who have been cancelled or rejected by another insurance company. Because of the risk, such policies are issued at greater than normal premiums. The NSA Group has been successful in profitably underwriting this specialty insurance niche, reporting a statutory combined ratio of 96.9% in 1993. In February 1994, American Premier announced that it was considering a proposal to purchase GAI's personal lines insurance business for $380 million. Refer to Item 1 - "Great American Insurance Group" for a discussion of these operations. Unless otherwise indicated, data in this section is presented on the statutory basis prescribed by the NAIC and each insurer's domiciliary state. The profitability of a property and casualty insurance company depends on both the underwriting of insurance and investment of assets. When the combined ratio is under 100%, underwriting results are generally considered profitable; conversely, a ratio over 100% generally indicates unprofitable underwriting results. The statutory ratios for the major classes of business written by American Premier's Insurance Group are as follows. Republic's favorable loss and expense ratio record has been attributable to strict underwriting standards, loss control services, a disciplined claims philosophy and expense containment. These factors, as well as Republic's favorable reputation with insureds for paying policyholder dividends, have contributed to a high policy renewal rate. From 1991 through 1993, the percentage of Republic's policies renewed increased from 73% to 84% and the percentage of premiums represented by policy renewals increased from 77% to 89% of the premiums eligible for renewal. The NSA Group has achieved underwriting profits over the past several years as a result of refinement of various risk profiles, thereby dividing the consumer market into more defined segments which can either be excluded from coverage or surcharged adequately. Effective cost control measures, both in the underwriting and claims handling areas, have further contributed to the underwriting profitability of the NSA Group. In addition, the NSA Group generally writes policies of short duration, allowing more frequent evaluation of the rates on individual risks. American Premier's Insurance Group writes business throughout the United States. The geographical distribution of gross premiums written in 1993 compared to 1992, was as follows (dollars in millions): 1993 1992 Premiums % Premiums % Workers' Compensation California $469 100.0% $402 100.0% Non-standard Automobile Florida $121 13.3% $132 19.8% Georgia 111 12.2 91 13.7 Texas 96 10.6 37 5.6 California 54 5.9 52 7.9 Arizona 54 5.9 39 5.9 Tennessee 41 4.6 31 4.7 Alabama 34 3.8 27 4.1 Connecticut 33 3.7 23 3.5 Missouri 31 3.4 15 2.2 Indiana 29 3.2 23 3.4 All others 304 33.4 194 29.2 $908 100.0% $664 100.0% The withdrawal from the Southern California market by several large workers' compensation carriers due to continuing underwriting losses contributed to Republic's 1993 premium growth. The NSA Group attributes its premium growth in recent years primarily to the overall growth in the non-standard market, entry into new states, increased market penetration in its existing states and the 1993 purchase of Leader National. The non-standard market has experienced significant growth in recent years as standard insurers have become more restrictive in the types of risks they will write. Loss and Loss Adjustment Expense Reserves The following table provides an analysis of changes in American Premier's liability for losses and LAE, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions): The following table presents the development of American Premier's liability for losses and LAE (in millions), net of reinsurance, on a GAAP basis since 1989 (the year American Premier acquired its first insurance subsidiary). 1989 1990 1991 1992 1993 Liability for Unpaid Losses and Loss Adjustment Expenses$369 $602 $664 $764 $916 Liability Re-estimated as of: One year later 97.0% 96.5% 97.0% 92.4% Two years later 89.7% 93.0% 93.4% Three years later 85.7% 91.0% Four years later 85.5% Cumulative Redundancy (14.5%)( 9.0%)( 6.6%)( 7.6%) N/A Cumulative Paid as of: One year later 19.5% 43.0% 44.1% 40.6% Two years later 49.1% 64.4% 64.5% Three years later 64.6% 75.2% Four years later 71.4% Other In December 1992, American Premier announced its intention to pursue the sale of all of its non-insurance operating businesses. The sale of these businesses is intended to further implement American Premier's strategy of concentrating on its property and casualty businesses. In August 1993, American Premier sold its defense services operations for approximately $94 million in cash, subject to post-closing working capital adjustments. In May and November 1993, American Premier sold securities of investees in public offerings for approximately $178 million in cash. At December 31, 1993, the aggregate book value of businesses remaining to be sold was $36.1 million. Chiquita Brands International Data in this section generally has been taken from the 1993 Form 10-K of Chiquita. Chiquita is a leading international marketer, processor and producer of quality fresh and processed food products. Chiquita employs approximately 45,000 persons in its continuing operations, 39,000 of whom are employed in Central and South America. In recent years, the Company has capitalized on its "Chiquita" and other premium brand names by building on its worldwide leadership position in the marketing, distribution and sourcing of bananas; by expanding its quality fresh fruit and vegetable operations; and by further developing its business in value-added processed foods. Chiquita's fresh foods products include: Bananas, grapefruit, kiwi, mangos and pineapples sold under the "Chiquita" brand name; * Bananas, citrus and other quality fresh fruit including apples, grapes, papaya, peaches, pears, plums, strawberries and tomatoes sold under the "Consul," "Chico," "Amigo," "Frupac" and other brand names; and * A wide variety of fresh vegetables including asparagus, beans, broccoli, carrots, celery, lettuce, onions and potatoes sold under the "Premium" and various other brand names. The core of Chiquita's fresh foods operations is the marketing, distribution and sourcing of bananas. Approximately 60% of Chiquita's consolidated net sales comes from the sale of bananas. Chiquita's sales of bananas in 1993 in its principal markets, as a percent of its total banana revenues, were: Europe, 45%; North America, 34%; and Other (principally the Far East and Middle East), 21%. Chiquita has generally been able to obtain a premium price for its bananas due to its reputation for quality and its innovative marketing techniques. Chiquita has a greater number and geographic diversity of sources of bananas than any of its competitors. During 1993, approximately 30% of all bananas sold by Chiquita were sourced from Panama. Bananas were also sourced from Colombia, Costa Rica, Guatemala, Honduras, Mexico and the Philippines. Approximately two-thirds of the bananas sourced by Chiquita were produced by subsidiaries and the remainder were purchased under arrangements from suppliers. Chiquita's low concentration of sources in individual producing locations reduces its overall risk of business interruption from localized weather conditions and crop disease as well as from political changes. Transportation expenses comprise approximately one-fourth of the total costs incurred by Chiquita in its sale of tropical fruit. Chiquita ships its tropical fruit in vessels it owns or charters. All of Chiquita's tropical fruit shipments into the North American market are delivered using pallets or containers that minimize damage to the product by eliminating the need to handle individual boxes. As a result of a multi-year investment program, now nearly completed, and the elimination of a substantial amount of chartered ship capacity under its restructuring program, Chiquita now owns or controls through long-term lease approximately 60% of its aggregate shipping capacity. Most of the remaining capacity is operated under contractual arrangements having terms of three years or less. Chiquita also operates loading and unloading facilities which it owns or leases in Central and South America and various ports of destination. Chiquita's processed foods products include: * Fruit and vegetable juices and other processed fruits and vegetables, including banana puree, marketed under the "Chiquita," "Friday" and other brands; * Wet and dry salads sold under the "Club Chef" and "Chef Classic" brands; and * Margarine, shortening and other consumer packaged foods sold under the "Numar," "Clover" and various regional brand names. Chiquita's branded juices are available throughout most of the United States and are manufactured by others to the Company's specifications. Chiquita also sells banana puree, sliced bananas and other specialty banana products to producers of baby food, fruit beverages and baked goods and to others. Chiquita manufactures and markets shortening, margarine and vegetable oil products primarily in Costa Rica and Honduras from oil palm grown on the Company's plantations located in these countries. Chiquita owns one of the largest private-label vegetable processors in the U.S. which markets a full line of over twenty-five types of processed vegetables to retail and food service customers throughout the U.S. and other countries. During the fourth quarter of 1992, after evaluation of reorganization plans announced earlier that year and completion of other preparatory actions, Chiquita adopted a plan of disposal for its Meat Division operations. Pursuant to the plan, Chiquita sold a component of its Meat Division in December 1992 and has made significant progress since, including: (i) successful ongoing cost reduction efforts resulting in breakeven operating results for 1993; (ii) progress toward obtaining substantial cost reductions relating to retiree medical costs; (iii) grants of subsidies and concessions from state and local governments; (iv) stand alone working capital financing; and (v) sale of the Division's specialty meat operations in February 1994 for approximately $50 million in cash. Chiquita expects to complete the divestures of these operations by the end of 1994. Chiquita's Meat Division is engaged in the processing and marketing primarily of fresh pork and processed meat products which are sold principally in the U.S. and for export to Japan, Mexico, Canada and other Central American and Pacific Rim countries. The operations of the Meat Division involve supplying a consistent quality product to a broad market, including large food chains. Profit margins in the fresh meat business are low, and the availability of adequate supplies and cost of livestock is significant to the profitability of the Meat Division's fresh meat operations. Great American Communications Data in this section generally has been taken from the 1993 Form 10-K of GACC. GACC is engaged in the ownership and operation of television and radio stations; its operations are conducted through Great American Television and Radio Company, Inc. ("GATR"). At December 31, 1993, GATR and its subsidiaries employed approximately 1,300 full-time employees and 250 part-time employees. Following its acquisition of Taft Broadcasting in 1987, GACC was highly leveraged. In the ensuing years, GACC restructured substantial amounts of its debt and sold assets to meet debt maturities. However, the downturn in the per-formance and values of the TV and radio businesses caused GACC's cash flow from operations to be insufficient to meet all of its obligations as they came due. In December 1993, GACC completed a comprehensive financial restructuring which included a joint prepackaged plan of reorganization under Chapter 11 of the Bankruptcy Code for GACC and two of its non- operating subsidiaries. GACC also negotiated a new credit facility with its bank lenders. Through the reorgani-zation, GACC reduced its total outstanding debt and preferred stock from $910 million to $433 million and lowered its annual fixed charges (interest and preferred stock dividends) from more than $94 million to approximately $41 million. Under GACC's restructuring, AFC exchanged its investment in GACC stock and debt for approximately 2.3 million shares of new GACC common stock. In addition, AFC contributed $7.5 million of new capital to GACC in exchange for additional common stock and 14% notes. At December 31, 1993, AFC owned 20% of GACC's voting common stock; AFC's Chairman owned an additional 12% of the stock. At December 31, 1993, GATR owned and/or operated six network- affiliated television stations, twelve FM radio stations and five AM radio stations. The following tables give the location, network affiliation and market information for these stations. The source of all television stations' market information is the Nielsen Station Index, November 1993. Substantially all of GATR's broadcast revenues come from the sale of advertising time to local and national advertisers. Local advertisements are sold by each station's sales personnel and national spots are sold by independent national sales representatives. GATR's television stations receive a significant portion of their programming from their respective networks; the networks sell commercial advertising time within such programming. The competitive position of the stations is directly affected by viewer acceptance of network programs. In recent years, the national audience shares obtained by the networks have declined as a result of increased competition from cable television networks and other competing program sources. As of 1991, these declines began to diminish and it is expected that significant declines will not occur during the next several years. The non-network programs broadcast by the stations are either produced by the stations or acquired from other sources. Locally originated programs include a wide range of show types such as entertainment, news, sports, public affairs and religious programs. Because most radio programming originates locally, network affiliation has little effect upon the station's competitive position within the market. GATR's AM radio stations offer their listeners a wide range of programs including news, music, discussion, commentary and sports. GATR's FM radio stations offer primarily album oriented rock, classic rock and contemporary hit music programming, designed to appeal to a more youthful audience. Federal Communication Commission ("FCC") rules permitting ownership of two FM and/or two AM radio stations in certain markets (a "duopoly") have created opportunities for GATR to increase advertising revenues and may reduce operating expenses. GATR expects in the near future to purchase, sell or exchange radio stations in order to take advantage of the considerable operating opportunities presented from the duopoly rules. General Cable Data in this section generally has been taken from the 1993 Form 10-K of General Cable. General Cable Corporation was formed in 1992 to hold American Premier's wire and cable and heavy equipment manufacturing businesses. In July 1992, American Premier distributed approximately 88% of all the outstanding shares of General Cable common stock to American Premier shareholders. In February 1994, General Cable sold the equipment manufacturing businesses in order to concentrate on the wire and cable business. General Cable employs approximately 4,600 persons. General Cable is comprised of (i) the Electrical Group which manufactures and sells electrical wire and cable for industrial, commercial and residential uses; (ii) the Telecommunications & Electronics Group which manufacturers and markets telecommunications and electronic wire and cable for a variety of voice and data communications applications; and (iii) the Consumer Products Group which manufactures and sells wire and cable products to consumers and original equipment manufacturers. Spelling Entertainment Group AFC was engaged in the distribution and production of filmed entertainment programming through its subsidiary Spelling Entertainment Group. In March 1993, AFC sold its common stock investment in Spelling to Blockbuster Entertainment Corporation in exchange for 7.6 million shares of Blockbuster common stock and warrants to purchase an additional two million Blockbuster shares at $25 per share. Other Companies Through subsidiaries, AFC is engaged in a variety of other businesses, including The Golf Center at Kings Island (golf and tennis facility) and Provident Travel Agency, both in the Greater Cincinnati area; commercial real estate operations in Cincinnati (offices and hotel), Louisiana (hotel), Florida (resort) and Massachusetts (resort) and apartments in Alabama, Florida, Kentucky, Louisiana, Minnesota, Oklahoma and Texas; and Financial World Magazine. These operations employ approximately 500 full-time employees. In October 1993, AFC sold its insurance brokerage operation, American Business Insurance, Inc., to Acordia, Inc., an Indianapolis-based insurance broker. In the sale, AFC received approximately $50 million in cash, 800,000 shares of Acordia common stock and warrants to purchase an additional 1.5 million Acordia shares at $25 per share. AFC was engaged in the theme park business through its wholly- owned subsidiary, Kings Island, one of the top ten theme parks in the United States based on attendance. In October 1992, AFC sold Kings Island to an unaffiliated party for approximately $210 million in cash. Investment Portfolio General A breakdown of AFC's December 31, 1993, investment portfolio by business segment follows (excluding investment in equity securities of investee corporations) (in millions). The following tables present the percentage distribution and yields of AFC's investment portfolio (excluding investment in equity securities of investee corporations) as reflected in its financial statements. Unlike most insurance groups which have portfolios that are invested heavily in tax-exempt bonds, AFC has historically invested substantial amounts in taxable corporate bonds. In addition, AFC has generally followed a practice of concentrating its investments in a relatively limited number of issues rather than maintaining relatively limited positions in a larger number of issues, although this practice has moderated in recent years. The NAIC assigns quality ratings to publicly traded as well as privately placed securities. These ratings range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows AFC's bonds and redeemable preferred stocks, by NAIC designation (and comparable Standard & Poor's Corporation rating) as of December 31, 1993 (dollars in millions). Risks inherent in connection with fixed income securities include loss upon default and market price volatility. Factors which can affect the market price of securities include: credit worthiness, changes in interest rates and economic growth, fewer market makers and investors, defaults by major issuers of securities and public concern about concentrations in certain types of securities by institutions. AFC's primary investment objective for bonds and redeemable preferred stocks is interest and dividend income rather than realization of capital gains. AFC invests in bonds and redeemable preferred stocks that have primarily short-term and intermediate-term maturities. This practice allows additional flexibility in reacting to fluctuations of interest rates. AFC's practice permits concentration of attention on a relatively limited number of companies in relatively few industries, principally insurance, utilities, financial services, food products, energy and communications. Some of the investments, because of their size, may not be as readily marketable as the typical small investment position. Alternatively, a large equity position may be attractive to persons seeking to control or influence the policies of a company and AFC's concentration in a relatively small number of companies and industries may permit it to identify investments with above average potential to increase in value. This concentration of size is less prominent in fixed income security investments than in equity investments. Seasonality The operations of certain of AFC's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, flooding, hurricanes, tornados, etc.) may be seasonal. The banana portion of the food products segment is affected by variations in consumer demand based on the availability of other fruits. The resulting seasonal pricing generally produces the strongest period during the first six months of the year. Television broadcast revenues tend to be higher in the second and fourth quarters. Competition Most areas of AFC's operations are highly competitive, with competition coming from a variety of sources, many of which are larger and have financial resources greater than AFC or its subsidiaries. The Insurance Groups and GALIC compete with other insurers primarily in service and price. Since they sell policies through independent agents, they must also compete for agents. Such competition is based on service to policyholders and agents, product design, commissions and profit sharing. No single insurer dominates the marketplace. Competitors include individual insurers and insurance groups of varying sizes, some of which are mutual companies possessing competitive advantages in that all their profits inure to their policyholders, and many of which possess financial resources in excess of those available to the Insurance Groups and GALIC. In a broader sense, GALIC competes for retirement savings with a variety of financial institutions offering a full range of financial services. Chiquita's principal competitors consist of a limited number of large international companies. In order to compete successfully, Chiquita must be able to source bananas of uniformly high quality and distribute them in worldwide markets on a timely basis. Chiquita believes that it sells more bananas than any of its competitors, accounting for approximately one- fourth of all bananas imported into its principal markets throughout the world. GACC's television and radio stations compete for revenues with other stations in their respective signal coverage areas as well as with all other advertising media. The broadcast stations also compete for audience with other forms of home entertainment, such as cable television, pay television systems of various types and home video and audio recordings. General Cable's electrical group competes against numerous building wire suppliers. General Cable believes it is one of the three leaders in this market, each of which has at least a 20% market share. Its telecommunications and electronics group is in a highly competitive market which is dominated by AT&T Technologies, Inc. Regulation AFC's insurance subsidiaries are regulated under the insurance and insurance holding company laws of their states of domicile and other states in which they operate. These laws, in general, require approval of the particular insurance regulators prior to certain actions by the insurance companies, such as the payment of dividends in excess of statutory limitations and certain transactions and continuing service arrangements with affiliates. Regulation and supervision of each insurance subsidiary is administered by a state insurance commissioner who has broad statutory powers with respect to the granting and revoking of licenses, approvals of premium rates, forms of insurance contracts and types and amounts of business which may be conducted in light of the policyholders' surplus of the particular company. AFC's largest insurance subsidiaries, GAI and GALIC, are Ohio domiciled insurers. State insurance departments conduct periodic financial examinations of insurance companies, with GAI's and GALIC's most recent such examinations being as of December 31, 1990. Insurance departments also perform market conduct examinations to determine compliance with rate and form filings and to monitor treatment of policyholders and claimants. State insurance laws also regulate the character of each insurance company's investments, reinsurance and security deposits. The statutes of most states provide for the filing of premium rate schedules and other information with the insurance commissioner, either directly or through rating organizations, and the commissioner generally has powers to disapprove such filings or make changes to the rates if they are found to be excessive, inadequate or unfairly discriminatory. The determination of rates is based on various factors, including loss and loss adjustment expense experience. The National Association of Insurance Commissioners ("NAIC") is an organization which is comprised of the chief insurance regulator for each of the 50 states and the District of Columbia. In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over 15 regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 1993, 32 states were accredited, including Ohio. In December 1993, the NAIC adopted the Risk Based Capital For Insurers Model Act which applies to both life and property and casualty companies. The risk-based capital formulas determine the amount of capital that an insurance company needs to ensure that it has an acceptably low expectation of becoming financially impaired. The act provides for increasing levels of regulatory intervention as the ratio of an insurer's total adjusted capital and surplus decreases relative to its risk-based capital, culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called "mandatory control level". The risk-based capital formulas became effective in 1993 for life companies and will become effective with the filing of the 1994 Annual Statement for property and casualty companies. Based on the 1993 results of AFC's insurance companies, all such companies are adequately capitalized. The NAIC's state accreditation criteria require that a state adopt the NAIC model law governing extraordinary dividends or a law substantially similar to the model. The current NAIC model for extraordinary dividends requires prior regulatory approval of any dividend that exceeds the "lesser of" 10% of statutory surplus or 100% of the prior year's net income (net gain from operations for life insurance companies), subject in either case to the existence of sufficient earned statutory surplus from which such dividends may be paid. The NAIC has adopted a variety of alternative provisions which may be considered "substantially similar" to its model, one of which includes the "greater of" rather than "lesser of" standard with other restrictions. In October 1993, Ohio revised its dividend law to adopt one of the alternatives. The maximum amount of dividends which may be paid without (i) prior approval or (ii) expiration of a 30 day waiting period without disapproval is the greater of statutory net income or 10% of policyholders' surplus as of the preceding December 31, but only to the extent of earned surplus as of the preceding December 31. The Ohio Insurance Department has broad discretion to limit the payment of dividends by insurance companies domiciled in Ohio. The NAIC has been considering the adoption of a model investment law for several years. The current projection for adoption of a model law is the end of 1994, at the earliest. It is not yet determined whether the model law would be added to the NAIC accreditation standards so that consideration of the model for adoption in states would be required for the achievement or continuation of any state's accreditation. It is not possible to predict the impact of these activities on AFC's insurance subsidiaries. There can be no assurance that existing insurance-related laws and regulations will not become more restrictive in the future and thereby have a material adverse effect on the operations of AFC's insurance subsidiaries and on their ability to pay dividends. Chiquita is subject to a variety of governmental regulations in certain countries where it sources and markets its products, including import quotas and tariffs, currency exchange controls and taxes. In July 1993, the European Union ("EU") implemented a new quota effectively restricting the volume of Latin American bananas imported into the EU to approximately 80% of prior levels. Challenges to the quota and many matters regarding implementation and administration of the quota remain to be resolved. In May 1993, the principles underlying the new regulation that discriminate against Latin American banana exporting countries were ruled illegal under the General Agreement on Tariffs and Trade ("GATT") by a GATT dispute settlement panel. In January 1994, a GATT dispute settlement panel ruled on a second lawsuit against the current EU regulation in favor of the Latin American countries. GATT rulings in favor of the Latin American countries could result in an increase in the total volume of Latin American bananas, including banana volume of Chiquita, which could be imported under the quota. However, there can be no assurance that the EU will comply, or the manner in which it would comply, with such rulings. GACC's television and radio broadcasting operations are subject to the jurisdiction of the FCC. FCC regulations govern issuance, term, renewal, transfer and cross-ownership of licenses which are necessary for operation of television and radio stations. ITEM 2 ITEM 2 Properties AFC and subsidiaries own several buildings located in downtown Cincinnati, Ohio. These buildings are situated on one block of land owned by AFC and contain approximately 570,000 square feet of commercial and office space, one-half of which is occupied by AFC and affiliates. GAI and its subsidiaries own office and storage facilities in Cincinnati, Dallas, Tulsa and Oklahoma City. In addition, Great American leases approximately 204,000 square feet of space for its home office in a downtown Cincinnati building under leases expiring in 1994 thru 1997. Great American also leases office space in approximately 75 cities throughout the United States for its regional and service offices. In connection with the acquisition of a majority ownership of American Annuity by AFC, American Annuity relocated its corporate offices to Cincinnati where it leases approximately 100,000 square feet. In addition, American Annuity leases office space totaling approximately 60,000 square feet in Los Angeles under a lease which expires in December 1994 and is not expected to be renewed. American Annuity also owns approximately 650,000 square feet and leases approximately 150,000 square feet of manufacturing facilities related to its discontinued operations. American Annuity is actively engaged in efforts to sell these remaining facilities or extend existing leases on the properties. American Premier's insurance subsidiaries lease an aggregate of approximately 360,000 square feet in nine cities under leases with expirations ranging from 1994 to 2001. Chiquita owns about three-fourths of the 178,000 acres (located primarily in Central America) that it uses for its banana and oil palm operations. In addition, Chiquita owns power plants, packing stations, warehouses, irrigation systems and loading and unloading facilities. Chiquita owns, controls under bareboat leases or uses under time-charter agreements over 40 ocean-going refrigerated vessels. GACC owns all of its television station studios and buildings and all but one of its transmission sites. GACC owns three of its radio studios and buildings, four of its FM transmission sites and all but one of its AM transmission sites. General Cable operates 22 manufacturing facilities in the United States. Four-fifths of those facilities, consisting of 4.1 million square feet, are owned. In addition, General Cable owns its Northern Kentucky headquarters building, consisting of 66,000 square feet of office space and 100,000 square feet of warehouse capacity. AFC and its subsidiaries own approximately 600 acres northeast of Cincinnati on which are located The Golf Center at Kings Island and a campground. ITEM 3 ITEM 3 Legal Proceedings AFC and its subsidiaries are involved in various litigation, most of which arose in the ordinary course of business. Except for the following, management believes that none of the litigation meets the threshold for disclosure under this Item. For several years AFC had an ownership interest of less than 50% in Mission Insurance Group, Inc. That company experienced financial difficulties culminating in bankruptcy and receivership proceedings in 1985 and 1986. AFC wrote off its investment in Mission in 1986 and sold its ownership position in 1987. Under the receivership proceedings, the Insurance Commissioner of California sued numerous reinsurers who had done business with Mission's insurance subsidiaries in two suits brought in Superior Court, Los Angeles County, California, styled Insurance Commissioner of the State of California v. Mission Insurance Company and Gillespie v. Abeille-Paix et al. During 1989, AFC, Carl H. Lindner and Ronald F. Walker ("AFC Defendants"), along with other directors of Mission ("Mission Directors"), were added as cross-defendants to that litigation by both the Commissioner and the reinsurance companies. The trials began in late 1991 and continue as of March 1, 1994. The Commissioner's cross-complaint against the AFC Defendants and the Mission Directors alleges breach of fiduciary duty and seeks indemnity in the event the reinsurers are not required to pay as a result of any finding of fraud, negligence or breach of duty. The actions brought by the reinsurers against the AFC Defendants and Mission Directors were dismissed. The Commissioner has entered into a Partial Settlement Agreement (which became final in 1990) with the AFC Defendants and certain of the Mission Directors ("Settling Parties"). The settlement provides that the Commissioner release the Settling Parties from all claims except that the Settling Parties may still be liable in the event that the Commissioner does not recover the full amount sought from the reinsurers and it is determined that such failure to recover resulted from misconduct by one or more Settling Parties. The liability of any Settling Party must be determined on an individual comparative fault basis. The Settling Parties have denied all material allegations. Management believes there is little likelihood that this litigation will have a material impact on AFC's financial statements. PART II ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters Not applicable - Registrant's Common Stock is owned by fewer than 20 share-holders. See the Consolidated Financial Statements for information regarding dividends. ITEM 6 Selected Financial Data The following table sets forth certain data for the periods indicated (dollars in millions). ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AFC's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page. AFC is organized as a holding company with almost all of its operations being conducted by subsidiaries and investees. The parent corporation, however, has continuing expenditures for administrative expenses and corporate services and, most importantly, for the payment of principal and interest on borrowings and redemption of and dividends on AFC Preferred Stock. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since many of its businesses are financial in nature, AFC does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful. LIQUIDITY AND CAPITAL RESOURCES Ratios The following ratios may be considered relevant indicators of AFC's liquidity and are typically presented by AFC in its prospectuses and similar documents. Management believes that balance sheet ratios (debt-to-equity) are more meaningful on a parent only basis. On the other hand, earnings statement ratios (fixed charges) are more meaningful on a total enterprise basis since the parent only ratio is dependent, to a great degree, on the discretionary nature of dividend payments from subsidiaries. Ratios of AFC's (parent only) long-term debt to equity (i) excluding Capital Subject to Mandatory Redemption, or (ii) including it as either (a) debt or (b) equity at December 31, 1993, 1992 and 1991 are shown below. Ratios of earnings to fixed charges, excluding and including preferred dividends, for the three years ended December 31, 1993 are also shown below. 1993 1992 1991 Debt to equity 1.06 1.99 2.13 Debt (plus redeemable capital) to equity 1.16 2.09 2.45 Debt to equity (plus redeemable capital) .98 1.81 1.63 Earnings to fixed charges 2.62 2.15 1.54 Earnings to fixed charges plus preferred dividends 2.26 1.94 1.42 Sources of Funds A wholly-owned subsidiary, Great American Holding Corporation ("GAHC"), has a revolving credit agreement with several banks under which it can borrow up to $300 million. The credit line converts to a four-year term loan with scheduled principal payments to begin in March 1997. Borrowings under the credit line are made by GAHC and are advanced to AFC. The line is guaranteed by AFC and secured by 50% of the stock of Great American Insurance Company ("GAI"). Borrowings, repayments and interest payments on the line are included in "net advances from (to) subsidiaries" in the following table. At December 31, 1993, GAHC had no outstanding borrowings under the agreement. Funds to meet the parent company's expenditures have been provided from a variety of sources within the holding company, from subsidiaries and directly from outside sources, as detailed in the following table (in millions): AFC and certain subsidiaries have arrangements among themselves under which they may borrow from each other from time to time for short-term working capital needs. Certain AFC subsidiaries have revolving credit facilities with banks (including those mentioned herein) which may be used for various corporate purposes. These facilities aggregated approximately $320 million of which $305 million was available at December 31, 1993. Generally, over 90% of the dividends (including non-cash dividends) received from subsidiaries have been from GAI. Payments of dividends by GAI are subject to various laws and regulations which limit the amount of dividends that can be paid without regulatory approval. During 1993, the State of Ohio revised its dividend law for Ohio-domiciled insurers. Under the new law, the maximum amount of dividends which may be paid without (i) prior approval or (ii) expiration of a 30 day waiting period without disapproval is the greater of statutory net income or 10% of policyholders' surplus as of the preceding December 31, but only to the extent of earned surplus as of the preceding December 31. While the new law is generally more restrictive than the prior law regarding the amount of dividends which can be paid without prior approval, management believes GAI will be able to gain such approvals due to its strong surplus position. The maximum amount of dividends payable in 1994 from GAI based on its 1993 earned surplus is approximately $108 million. For statutory accounting purposes, equity securities are generally carried at market value with changes in aggregate market value directly affecting policy-holders' surplus. At December 31, 1993, AFC's insurance group owned publicly traded equity securities of affiliates with a market value of $858 million, including equity securities of AFC subsidiaries of $451 million. Since significant amounts of affiliated investments are concentrated in a relatively small number of companies, volatility in the market prices of these stocks could adversely affect the insurance group's policyholders' surplus, potentially impacting the amount of dividends available or necessitating a capital contribution. Under tax allocation agreements with AFC, 80%-owned U.S. subsidiaries generally compute tax provisions as if filing a separate return based on book taxable income computed in accordance with generally accepted accounting principles. The resulting provision (or credit) is currently payable to (or receivable from) AFC. Management believes AFC has sufficient resources to meet its liquidity requirements through operations in the short-term and long-term future. If funds generated from operations, including dividends from subsidiaries, are insufficient to meet fixed charges in any period, AFC would be required to meet such charges through bank borrowings, sales of securities or other assets, or similar transactions. Uncertainties In exchange for $5 million, AFC has agreed to indemnify Spelling Entertainment Group Inc. for up to $35 million in excess of a threshold amount of $25 million of the costs Spelling may incur in the 12 years beginning April 1, 1993 to resolve Spelling's environmental matters, bankruptcy claims and certain other matters. Additionally, an AFC subsidiary has responsibility for environmental remediation costs, which are estimated to be between $10 million and $15 million, associated with the sales of former manufacturing properties. The subsidiary has reserved $10.6 million at December 31, 1993. AFC's insurance subsidiaries do not establish reserves for unreported environmental claims because such amounts cannot be reasonably estimated. At December 31, 1993, they had recorded $45.1 million (net of reinsurance recoverables) for reported environmental pollution and hazardous products claims on policies written many years ago where, in most cases, coverage was never intended. Due to inconsistent court decisions on many coverage issues and the difficulty in determining standards acceptable for cleaning up pollution sites, significant uncertainties exist which are not likely to be resolved in the near future. While the results of all such uncertainties cannot be predicted, based upon its knowledge of the facts, circumstances and applicable laws, management believes that sufficient reserves have been provided and that the ultimate resolution of these uncertainties will not have a material adverse effect on AFC's financial condition or liquidity. Capital Requirements AFC is not heavily engaged in capital-intensive businesses and therefore does not have substantial capital resource requirements to the same extent that other companies might. Cash expenditures for property, plant and equipment, excluding Chiquita which ceased being a subsidiary in 1991, were $32 million, $53 million and $28 million, in 1993, 1992 and 1991, respectively. Management of AFC has always believed in the use of leverage (borrowing funds at predetermined rates) to increase the return on its equity. Historically, AFC has relied more on the use of fixed-rate debt and preferred stock issuances in its financing activities. AFC borrows from both public and private sources, with parent only debt at December 31, 1993, coming almost entirely from public sources. Whenever possible, AFC tries to do its financing on a long-term basis, even if the current costs associated are slightly higher. At December 31, 1993, the average maturity of AFC's borrowings on a parent only basis was approximately 6-1/2 years; the average interest rate on those borrowings was 11.6%. Comparable figures for three years ago are 9 years maturity and 11.6% stated interest rate (12.8% effective rate). In February 1994, AFC commenced an offer to issue new 9-3/4% Debentures due April 20, 2004 and cash in exchange for its publicly traded debentures. On March 28, 1994, AFC announced that the expiration date had been extended to April 15, and that in excess of $190 million of old debentures had been accepted for exchange. The table below shows (in thousands) total sinking fund and other principal payments on all debt of AFC (parent only) for 1994 and in subsequent periods on an historical basis and on a pro forma basis (a) assuming 50% of each issue of the old debentures are exchanged pursuant to the offer ("50% Accept-ance") and (b) assuming all of the old debentures are tendered ("100% Accept-ance"). The scheduled payments shown below assume that debentures purchased are applied to the earliest scheduled retirements. Pro Forma December 31, 1993 50% 100% Historical Acceptance Acceptance 1994 $ 12,080 $ 3,231 $ 3,231 1995 10,883 261 261 1996 11,843 261 261 1997 17,818 5,493 5,493 1998 19,223 261 261 1999-2002 343,605 184,928 11,469 2003-2004 154,279 375,296 548,755 Total $569,731 $569,731 $569,731 Actual cash outlays will be less than indicated in the above table to the extent that AFC can satisfy scheduled retirements and sinking fund requirements by acquiring its debt at discounts from redemption values. The net annual charge to pretax income for interest expense would decline by approximately $6.8 million based on 50% Acceptance and approximately $13.5 million based on 100% Acceptance. Based on the results of this offer and cash availability, AFC will redeem some or all of the unexchanged debentures. In March 1994, AFC called for redemption its 13-1/2% Debentures and its 13-1/2% Series A Debentures. Holders of either issue may accept the exchange offer. Interest and dividend payments on parent company debt and preferred stock (all issues) for the subsequent five years, assuming all sinking fund and other principal payments are made as scheduled and before effects of the 1994 exchange offers and redemptions, would be approximately (in millions): 1994 1995 1996 1997 1998 Interest $66.0 $64.7 $63.5 $62.3 $60.8 Dividends 26.0 25.5 25.1 25.1 25.1 Payment of preferred dividends and redemption of AFC Preferred Stock is subordinate to AFC's obligations to pay principal and interest on its debt. At December 31, 1993, sinking fund and other scheduled principal payments on debt of subsidiaries for the next five years were as follows: 1994 - $4 million; 1995 - $63 million; 1996 - $1 million; 1997 - $16 million; and 1998 - $159 million. Certain members of the Lindner family have the right to "put" to AFC their shares of AFC Common Stock or options at any time at a price based on AFC's book value per share (as defined). The "put" price is paid one-third in cash and the balance in a five-year installment note bearing interest at a rate equal to the five-year U.S. Treasury Note rate plus 3%. The aggregate purchase price for remaining shares and options covered by the "put" at December 31, 1993, was approximately $40 million. Investments Approximately three-fifths of AFC's consolidated assets are invested in marketable securities (excluding investment in equity securities of investee corporations). AFC's investment philosophy is briefly summarized in the following paragraphs. AFC attempts to optimize investment income while building the value of its portfolio, placing emphasis upon long-term performance. AFC's goal is to maxi-mize return on an ongoing basis rather than focusing on year-by-year performance. Significant portions of equity and, to a lesser extent, fixed income investments are concentrated in a relatively limited number of major positions. This approach allows management to more closely monitor these companies and the industries in which they operate. Some of the investments, because of their size, may not be as readily marketable as the typical small investment position. Alternatively, a large equity position may be attractive to persons seeking to control or influence the policies of a company. While management believes this investment philosophy will produce higher overall returns, such concentrations subject the portfolio to greater risk in the event one of the companies invested in becomes financially distressed. Fixed income investment funds are generally invested in securities with short-term and intermediate-term maturities with an objective of maximizing interest and dividend yields. This practice allows additional flexibility in reacting to market conditions. Approximately 95% of the bonds and redeemable preferred stocks held by AFC were rated "investment grade" (credit rating of AAA to BBB) at December 31, 1993, compared to less than 60% at the end of 1988. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. The realization of capital gains, primarily through sales of equity securities, has been an integral part of AFC's investment program. Individual securities are sold creating gains or losses as market opportunities exist. Pretax capital gains (losses) recognized upon disposition of securities, including investees, during the past five years have been: 1993 - $165 million; 1992 - $104 million; 1991 - $38 million; 1990 - ($89 million) and 1989 - $64 million. At December 31, 1993, AFC had gross unrealized gains and losses on bonds and redeemable preferred stocks and equity securities as follows (in millions): Net Gross Unrealized Unrealized Gains Losses Gain Bonds and redeemable preferred stocks: Held to maturity $189.2 ($18.5) $170.7 Available for sale 133.2 - 133.2 322.4 (18.5) 303.9 Equity securities 137.2 (5.1) 132.1 $459.6 ($23.6) $436.0 When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings and the carrying value of that investment is reduced. At December 31, 1993, collateralized mortgage obligations ("CMOs") represented approximately 30% of AFC's bonds and redeemable preferred stocks. At that date, interest only (I/Os), principal only (P/Os) and other "high risk" CMOs represented approximately four-tenths of one percent of AFC's total CMO portfolio. AFC invests primarily in CMOs which are structured to minimize prepayment risk. In addition, the majority of CMOs held by AFC were purchased at a discount to par value. Management believes that the structure and discounted nature of the CMOs will minimize the effect of prepayments on earnings over the anticipated life of the CMO portfolio. Substantially all of AFC's CMOs are rated "AAA" by Standard & Poor's Corporation and are collateralized by GNMA, FNMA and FHLMC single- family residential pass-through certificates. The market in which these securities trade is highly liquid. Aside from interest rate risk, AFC does not believe a material risk (relative to earnings and liquidity) is inherent in holding such investments. RESULTS OF OPERATIONS - THREE YEARS ENDED DECEMBER 31, 1993 General Due to decreases in ownership percentages, AFC ceased accounting for the following companies as subsidiaries and began accounting for them as investees: American Premier (April 1993), Spelling (July 1992), Chiquita (July 1991) and GACC (June 1991). AFC had accounted for American Premier as a subsidiary from 1992 through the first quarter of 1993 due to AFC's ownership exceeding 50%. As a result of these changes, current year income statement components are not comparable to prior years and are not indicative of future years. AFC's net earnings reached a record high of $220 million in 1993. Major factors contributing to the increase in earnings included $155 million in pretax gains from the sales of AFC's insurance agency operations, Spelling Entertainment Group, 4.5 million shares of American Premier and additional proceeds received on the 1990 sale of the NSA Group in addition to improved contributions to results from American Premier, Chiquita and GACC. Operating difficulties at two major investees caused significant losses for AFC in 1992, partially offset by the benefit from the effect of the accounting change as required by SFAS No. 109 and a gain on the sale of Kings Island. Significant realized gains on securities sales and from the public issuance of stock by an investee contributed to the $72 million of earnings in 1991. Property and Casualty Insurance - Underwriting Underwriting profitability is measured by the combined ratio which is a sum of the ratio of underwriting expenses to premiums written and the ratio of losses and loss adjustment expenses to premiums earned. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. The combined underwriting ratio (statutory basis, after policyholders' dividends) of GAI and its property and casualty insurance subsidiaries ("Great American") was 103.9% in 1993, 105.0% in 1992 and 103.2% in 1991. Total net losses to AFC's insurance operations from catastrophes (natural disasters and other incidents of major loss) were $26 million in 1993, $42 million in 1992 and $22 million in 1991. To understand the overall profitability of particular lines, timing of claims payments and the related impact of investment income must be considered. Certain "short-tail" lines of business (primarily property coverages) have quick loss payouts which reduce the time funds are held, thereby limiting investment income earned thereon. On the other hand, "long-tail" lines of business (primarily liability coverages and workers' compensation) have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received. While Great American desires and seeks to earn an underwriting profit on all of its business, it is not always possible to do so. As a result, the company attempts to expand in the most profitable areas and control growth or even reduce its involvement in the least profitable ones. In recent years, many commercial lines markets have been extremely competitive as predicted premium rate increases have not materialized. Workers' compensation, in particular, has been especially hard hit by competition, rising benefit levels and claims fraud. Many states have begun to address these problems and, in the last couple of years, Great American has focused its efforts toward those markets where improvements are evident. In 1993, Great American's underwriting results significantly outperformed the industry average for the eighth consecutive year. Great American has been able to exceed the industry's results by supplementing its commercial lines coverages with highly specialized niche products and new automobile and homeowner products. Many of the improvements experienced by Great American and the market in general in recent years are expected to continue in 1994. See the discussion of Underwriting and Loss and Loss Adjustment Expense Reserves under Item 1 - "Business - Great American Insurance Group". 1993 compared to 1992 Property and casualty insurance premiums decreased $657 million (31%) in 1993 reflecting the deconsolidation of American Premier's insurance operations beginning in the second quarter of 1993. Premiums for the remainder of AFC's insurance group were virtually unchanged. 1992 compared to 1991 Property and casualty insurance premiums increased $955 million (80%) in 1992 reflecting the consolidation of American Premier's insurance operations beginning in 1992. Premiums for the remainder of AFC's insurance group were virtually unchanged. Investment Income Changes in investment income reflect fluctuations in market rates and changes in average invested assets. 1993 compared to 1992 Investment income decreased $87 million (13%) in 1993 reflecting the deconsolidation of American Premier in 1993, partially offset by an increase in average investments held. 1992 compared to 1991 Investment income increased $120 million (21%) in 1992 reflecting primarily the consolidation of American Premier in 1992, partially offset by lower interest rates available in the marketplace. Investee Corporations Equity in net earnings of investee corporations (companies in which AFC owns a significant portion of the voting stock) represents AFC's proportionate share of the investees' earnings and losses. 1993 compared to 1992 AFC's equity in the net earnings of investees in 1993 was $70 million compared to a loss of $339 million in 1992. The principal items responsible for this improvement were (i) the absence of losses from GACC in 1993 compared to AFC's loss of $187 million from that investment in 1992, (ii) a $108 million improvement from Chiquita's operations and (iii) $92 million in earnings from American Premier which became an investee in the second quarter of 1993 when AFC's ownership declined below 50%. 1992 compared to 1991 The decrease in equity in net earnings of investees in 1992 reflects primarily the results of Chiquita and GACC, both of which became investees in the third quarter of 1991. Chiquita reported a net loss of $284 million in 1992 attributable principally to (i) sharply increased banana costs and expenses and (ii) lower banana prices in the first half of the year. GACC reported a net loss of $597 million in 1992 which includes a $658 million provision to revalue intangible assets to reflect estimated current market values of broadcasting assets at December 31, 1992. In addition, significant debt, depreciation and amortization expenses continued to more than offset broadcasting results. In connection with a proposed financial restructuring of GACC, AFC transferred all securities and loans related to GACC to the investee account and reduced the carrying value of that investment to estimated net realizable value ($35 million). Gains on Sales of Investees The gains on sales of investees in 1993 include (i) a pretax gain of $52 million in the first quarter on the sale of Spelling and (ii) a pretax gain of $28 million in the third quarter on the public sale by AFEI of 4.5 million shares of American Premier common stock. Gains on Sales of Subsidiaries The gains on sales of subsidiaries in 1993 include (i) a pretax gain of $44 million from the sale of American Business Insurance, Inc. and (ii) a pretax gain of $31 million representing an adjustment on the 1990 sale of AFC's non-standard automobile insurance group to American Premier. The gain on sale of subsidiary in 1992 represents a pretax gain from the sale of Kings Island Theme Park. The gains on sales of subsidiaries in 1991 include (i) a pretax gain of $58 million as a result of Chiquita's public issuance of 5 million shares of its common stock; (ii) a pretax gain of $13 million on Charter's sale of its interest in an oil producing concession; and (iii) a $7 million pretax gain on the disposition of 455,000 shares of Chiquita common stock. These items were partially offset by a pretax loss of $12 million realized as a result of GACC's issuance of 16.5 million shares of its common stock. Sales of Other Products and Services Sales shown below (in millions) include those of American Premier (from January 1992 to March 1993), Spelling Entertainment Group (through June 1992), GACC (through May 1991), Spelling Entertainment Inc. (from May 1991 to June 1992), Kings Island Theme Park (through September 1992) and Chiquita (through June 1991). 1993 1992 1991 Federal Systems $ 99.2 $ 414.0 $ - Diversified Products and Services 52.9 255.4 - Petroleum Products - 159.7 424.0 Broadcasting and Entertainment: Broadcasting - - 78.0 Entertainment - 118.8 139.4 Kings Island Theme Park - 83.0 79.2 Food Products: Fresh Foods - - 1,347.5 Prepared Foods - - 1,089.2 $152.1 $1,030.9 $3,157.3 Sales of Federal Systems and Diversified Products and Services represent American Premier's revenues from systems and software engineering services and the manufacture and supply of industrial products and services. Sales of petroleum products reflect Spelling's revenues from petroleum marketing activities. Broadcasting revenues represent GACC's television and radio operations. Entertainment revenues reflect Spelling's television production and distribution operations. Sales of food products represent Chiquita's revenues. 1993 compared to 1992 The deconsolidation of American Premier and Spelling and the sale of Kings Island accounted for the decrease in revenues from sales of other products and services in 1993. 1992 compared to 1991 In July 1992, AFC's ownership of Spelling decreased below 50%; accordingly, Spelling's revenues are included for only the first six months of 1992 compared to the entire year for 1991. The increase in Kings Island revenues in 1992 was due primarily to a 14% increase in attendance over the comparable period in 1991. Revenues from several operating days in October and a "Winterfest" operation during the holiday season were approximately $5 million in the fourth quarter for 1991. In October 1992, AFC sold the theme park to an unaffiliated party. See "Gains on Sales of Subsidiaries". Interest on Annuities For GAAP financial reporting purposes, GALIC's annuity receipts are accounted for as interest-bearing deposits ("annuity policyholders' funds accumulated") rather than as revenues. Under these contracts, policyholders' funds are credited with interest on a tax-deferred basis until withdrawn by the policyholder. The average crediting rate on funds held by GALIC has decreased from 7.2% at December 31, 1991 to 6.2% at December 31, 1992 and 5.3% at December 31, 1993; GALIC's products offer minimum interest rate guarantees of 3% to 4%. The rate at which GALIC credits interest on annuity policyholders' funds is subject to change based on market conditions. Annuity receipts totaled $400 million in 1993, $360 million in 1992 and $460 million in 1991. Receipts in 1993 increased primarily due to the introduction of new single premium products in the second half of 1992. Receipts in 1992 were lower than anticipated due to (i) a reduction in receipts relating to a new product introduced in 1990 which encouraged rollovers of other retirement funds and (ii) unfavorable economic and market conditions, including the impact of the negative publicity associated with a number of highly publicized insolvencies in the life insurance industry. Annuity surrender payments represented 6.9%, 7.8% and 9.4% of average statutory reserves in 1993, 1992 and 1991, respectively. 1993 compared to 1992 Interest on annuity policyholders' funds decreased $13 million (5%) in 1993 due to a reduction in rates being credited to policyholders. The effect of this decrease more than offset an increase of 7% in the average amount of accumulated policyholders' funds held. 1992 compared to 1991 Interest on annuity policyholders' funds decreased by $16.3 million (6%) from 1991 due to a reduction in rates being credited to policyholders, which more than offset an increase of approximately 7% in the average amount of accumulated policyholders' funds held. Interest on Borrowed Money Changes in interest expense result from fluctuations in market rates as well as changes in borrowings. AFC has generally financed its borrowings on a long-term basis which has resulted in higher current costs. Interest expense included in AFC's consolidated statement of operations was comprised of (in millions): 1993 1992 1991 AFC Parent $ 71.1 $ 70.6 $ 73.8 Great American Holding 23.4 34.2 37.8 Great American Insurance 14.0 14.3 14.3 American Premier 17.2 69.2 - American Annuity 21.2 - - Chiquita - - 41.1 GACC - - 49.6 Spelling - 4.7 8.2 Other Companies 10.3 22.9 26.5 $157.2 $215.9 $251.3 GAHC's interest expense has decreased due to repayments of bank borrowings in 1992 and 1993. American Annuity borrowed approximately $230 million in December 1992 to acquire GALIC. The decrease in other companies' interest expense is due primarily to the sale of a subsidiary in 1992 and repayments of borrowings in 1993. Other Operating and General Expenses Operating and general expenses included the following charges (credits) (in millions): 1993 1992 1991 Minority interest $35 $38 $44 Writeoff of debt discount and issue costs 24 - - Allowance for bad debts 10 (3) 26 Relocation expenses 8 - - Book Value Incentive Plan 1 (1) 38 Allowance for bad debts includes charges for possible losses on agents' balances, reinsurance recoverables and other receivables. Relocation expenses represent the estimated costs of moving GALIC's operations from Los Angeles to Cincinnati. Income Taxes Certain subsidiaries have not been able to recognize tax benefits on significant operating losses. Accordingly, AFC's effective tax rates were greater than the normal rate of 34% in 1992 and 1991. See Note L to the Financial Statements for an analysis of other items affecting AFC's effective tax rate. In 1992, AFC implemented SFAS No. 109, "Accounting for Income Taxes". The cumulative effect of implementing this statement resulted in a benefit of $85.4 million to net earnings for the recognition of previously unrecognized tax benefits. The portion of AFC's net deferred tax asset at December 31, 1992, attributable to American Premier was $245.3 million. The 1993 provision for income tax includes a $15 million first quarter benefit due to American Premier's revision of estimated future taxable income likely to be generated during the company's tax loss carryforward period. The analysis of estimated future taxable income will be reviewed and updated periodically, and any required adjustments, which may increase or decrease the net deferred tax asset, will be made in the period in which the developments on which they are based become known. Discontinued Operations Earnings from discontinued operations represent the results of Hunter Savings Association prior to its sale in December 1991. Earnings from continuing operations do not reflect earnings that would have been earned on the sales proceeds had the sale of Hunter taken place at the beginning of 1991. Recent Accounting Standards The following Statements of Financial Accounting Standards ("SFAS") have been implemented by AFC in 1992 or 1993 or will be implemented in 1994. The implementation of these standards is discussed under various subheadings of Note A to the Financial Statements; effects of each are shown in relevant Notes. Implementation of SFAS Nos. 112 and 114 in the first quarter of 1994 and 1995, respectively, is not expected to have a significant effect on AFC. SFAS# Subject of Standard (Year Implemented) Reference 106 Certain Postretirement Benefits(1993) "Benefit Plans" 107 Fair Values (1992) "Fair Value" 109 Income Taxes (1992) "Income Taxes" 112 Certain Employment Benefits (1994) -n/a- 113 Reinsurance (1993) "Reinsurance" 114 Impairment of Loans (1995) -n/a- 115 Investment in Securities (1993) "Investments" Other standards issued in recent years did not apply to AFC or had only negligible effects on AFC. ITEM 8 Financial Statements and Supplementary Data Page Reports of Independent Auditors Consolidated Balance Sheet: December 31, 1993 and 1992 Consolidated Statement of Operations: Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Capital Accounts: Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows: Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements "Selected Quarterly Financial Data" has been included in Note Q to the Consolidated Financial Statements. PART III ITEM 10 Directors and Executive Officers of the Registrant The directors and executive officers of AFC at March 1, 1994, are: Executive Name Age Position Since Carl H. Lindner 74 Chairman of the Board and Chief 1959 Executive Officer Richard E. Lindner 72 Director 1959 Robert D. Lindner 73 Vice Chairman of the Board 1959 Ronald F. Walker 55 Director, President and Chief 1973 Operating Officer Carl H. Lindner III 40 President of GAI and President 1987 and Chief Operating Officer of American Premier S. Craig Lindner 39 President of AAG and Senior Executive Vice President of AMM James E. Evans 48 Vice President and General Counsel Sandra W. Heimann 51 Vice President 1984 Robert C. Lintz 60 Vice President 1979 Thomas E. Mischell 46 Vice President 1985 Fred J. Runk 51 Vice President and Treasurer 1978 Carl H. Lindner has served as Chairman of the Board and Chief Executive Officer of AFC for more than five years. He serves in similar capacities with various AFC subsidiaries. He serves as Chairman of the Board of the following public companies: American Annuity Group, Inc. ("AAG"), American Financial Enterprises, Inc. ("AFEI"), Chiquita, General Cable, Great American Communications Company ("GACC") and American Premier. AFC owns a substantial beneficial interest (over 20%) in all of these companies. Richard E. Lindner is owner, Chairman of the Board of Directors, President and Chief Executive Officer of Thriftway, Inc., a supermarket chain otherwise unaffiliated with AFC, and has been associated with that company for over five years. Robert D. Lindner, for more than five years, has served as Vice Chairman of the Board of Directors of AFC. In addition, he is Chairman of the Board of United Dairy Farmers, Inc. ("UDF") which, among other things, is engaged through subsidiaries in dairy processing and the operation of convenience stores. He is also a director of AFEI. Ronald F. Walker has served as President and Chief Operating Officer of AFC for more than five years. He is also Vice Chairman of the Board of Directors of GAI and holds executive positions in most of AFC's other subsidiaries. He is also a director of AAG, AFEI, Chiquita, General Cable and Tejas Gas Company. Carl H. Lindner III has been President of GAI for more than five years. He holds executive positions in many of GAI's subsidiaries. He has also been President and Chief Operating Officer of American Premier since 1991. S. Craig Lindner has been Senior Executive Vice President of American Money Management Corporation ("AMM"), a subsidiary of AFC which provides investment services to AFC and its subsidiaries, for more than five years. He was elected President of AAG in March 1993. James E. Evans has served as a Vice President and the General Counsel of AFC for more than five years. Sandra W. Heimann has been a Vice President of AFC and an executive officer of AMM for more than five years. Robert C. Lintz has been a Vice President of AFC for more than five years. Thomas E. Mischell has been a Vice President of AFC for more than five years. Fred J. Runk has served as Vice President and Treasurer of AFC for more than five years. Carl H. Lindner, Robert D. Lindner and Richard E. Lindner are brothers. Carl H. Lindner III and S. Craig Lindner are sons of Carl H. Lindner. All of the executive officers of AFC devote substantially all of their time to the affairs of AFC and its subsidiaries. All of the above are United States citizens. The information required by the following Items will be provided within 120 days after end of Registrant's fiscal year. ITEM 11 Executive Compensation ITEM 12 Security Ownership of Certain Beneficial Owners and Management ITEM 13 Certain Relationships and Related Transactions REPORTS OF INDEPENDENT AUDITORS Board of Directors American Financial Corporation We have audited the accompanying consolidated balance sheets of American Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in capital accounts, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements of American Premier Underwriters, Inc. (formerly The Penn Central Corporation), General Cable Corporation and American Annuity Group, Inc. (1991). Those statements were audited by other auditors whose reports have been furnished to us. The reports pertaining to the statements of General Cable Corporation and American Premier Underwriters, Inc. included explanatory paragraphs that described their change in method of accounting for income taxes in 1992. Our opinion on the consolidated financial statements and schedules, insofar as it relates to data included for those corporations as described in Note E, is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, American Financial Corporation and subsidiaries changed their method of accounting in 1993 for certain investments in debt and equity securities and in 1992 for income taxes. ERNST & YOUNG Cincinnati, Ohio March 25, 1994 REPORT OF AMERICAN PREMIER'S INDEPENDENT AUDITORS American Premier Underwriters, Inc. (formerly The Penn Central Corporation): We have audited the financial statements and the financial statement schedules of American Premier Underwriters, Inc. and Consolidated Subsidiaries listed in the Index to Financial Statements and Financial Statement Schedules of American Premier Underwriters, Inc.'s Form 10-K for the year ended December 31, 1993 (included as Exhibit 99 herein). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of American Premier Underwriters, Inc. and Consolidated Subsidiaries at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Note 1 to the financial statements, in 1992 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 16, 1994 (March 25, 1994 with respect to the change of the Company's name as discussed in Note 1 to American Premier's financial statements) REPORT OF GENERAL CABLE'S INDEPENDENT AUDITORS General Cable Corporation: We have audited the consolidated financial statements and related schedules of General Cable Corporation and subsidiaries listed in Item 14(a) of the Annual Report on Form 10-K of General Cable Corporation for the year ended December 31, 1993 (not presented separately herein). These consolidated financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of General Cable Corporation and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 1 and 10 to the consolidated financial statements, in 1992 General Cable Corporation changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 18, 1994 REPORT OF AMERICAN ANNUITY'S INDEPENDENT AUDITORS American Annuity Group, Inc.: We have audited the consolidated balance sheet of American Annuity Group, Inc., formerly Sprague Technologies, Inc., and subsidiaries as of December 31, 1991 and the related consolidated statements of operations, common stockholders' equity and cash flows for the year then ended (before adjustments and reclassifications to conform with the presentation for 1992). Our audit also included the 1991 financial statement schedule listed in the Index at Item 14(a) of American Annuity Group, Inc's. Form 10-K for the year ended December 31, 1993 (not presented separately herein). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements (before adjustments and reclassifications to conform with the presentation for 1992) present fairly, in all material respects, the financial position of American Annuity Group, Inc. and subsidiaries as of December 31, 1991 and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Stamford, Connecticut March 24, 1992 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Thousands) December 31, 1993 1992 Assets Cash and short-term investments $ 167,950 $ 837,429 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,959,400 and $4,705,600) 3,788,732 4,597,544 Available for sale - at market (amortized cost - $2,216,328 and $1,905,814) 2,349,528 1,976,514 Other stocks - principally at market (cost - $207,056 and $182,476) 339,156 230,876 Investment in investee corporations 899,800 568,207 Bonds and receivables from investees 6,783 305,701 Loans receivable 624,149 812,436 Real estate and other investments 139,319 179,152 8,147,467 8,670,430 Recoverables from reinsurers and prepaid reinsurance premiums 756,060 599,204 Trade receivables 298,240 594,834 Other receivables 213,507 318,799 Property, plant and equipment, net 44,950 215,851 Deferred tax asset - 258,300 Prepaid expenses, deferred charges and other assets 275,349 394,319 Cost in excess of net assets acquired 173,965 499,639 $10,077,488 $12,388,805 Liabilities and Capital Insurance claims and reserves $ 3,422,657 $ 4,279,853 Annuity policyholders' funds accumulated 4,256,674 3,973,524 Long-term debt: Parent company 571,874 557,161 American Premier - 657,800 Other subsidiaries 482,132 794,217 Accounts payable, accrued expenses and other liabilities 648,462 1,005,866 Minority interest 109,219 812,707 9,491,018 12,081,128 Capital subject to mandatory redemption 49,232 27,683 Preferred Stock (redemption value - $278,889) 168,588 168,588 Common Stock without par value 904 904 Retained earnings 210,846 42,402 Net unrealized gain on marketable securities, net of deferred income taxes 156,900 68,100 $10,077,488 $12,388,805 See notes to consolidated financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN CAPITAL ACCOUNTS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INDEX TO NOTES A. Accounting Policies B. Acquisitions and Sales of Subsidiaries C. Segments of Operations D. Investments E. Investment in Investee Corporations F. Property, Plant and Equipment G. Cost in Excess of Net Assets Acquired H. Long-Term Debt I. Capital Subject to Mandatory Redemption J. Other Preferred Stock K. Common Stock L. Income Taxes M. Discontinued Operations N. Pending Legal Proceedings O. Benefit Plans P. Transactions With Affiliates Q. Quarterly Operating Results (Unaudited) R. Additional Information S. Restrictions on Transfer of Funds and Assets of Subsidiaries T. Subsequent Event (Unaudited) A. Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of American Financial Corporation ("AFC") and its subsidiaries except for Hunter Savings Association which was sold in the fourth quarter of 1991 and is presented in the financial statements as "discontinued operations". Changes in ownership levels of other subsidiaries and investees have resulted in certain differences in the financial statements and have affected comparability between years. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. AFC's ownership of subsidiaries and significant investees with publicly traded shares at December 31, was as follows: AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED D. Investments Bonds, redeemable preferred stocks and other stocks at December 31, consisted of the following (in millions): The table below sets forth the scheduled maturities of bonds and redeemable preferred stocks based on carrying value as of December 31, 1993. Data based on market value is generally the same. Collateralized mortgage obligations have an average life of approximately 4 years at December 31, 1993. Held to Available Maturity Maturity for Sale One year or less 1% 1% After one year through five years 7 5 After five years through ten years 18 13 After ten years 55 31 81 50 Collateralized mortgage obligations 19 50 100% 100% AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Gross gains of $69.4 million, $85.2 million and $208.8 million and gross losses of $16.5 million, $4.7 million and $236.9 million were realized on sales of fixed maturity investments during 1993, 1992 and 1991, respectively. Realized gains (losses) and changes in unrealized appreciation (depreciation) on fixed maturity and equity security investments are summarized as follows (in thousands): Investment in other stocks at December 31, 1992 consisted of (in thousands): At December 31, 1992, gross unrealized gains on other stocks were $63.7 million and gross unrealized losses were $15.1 million. Carrying values of investments were determined after deducting cumulative provisions for impairment aggregating $47 million and $78 million at December 31, 1993 and 1992, respectively. Fair values for investments are based on prices quoted, when available, in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, fair values of comparable securities, or similar methods. Short-term investments are carried at cost; loans receivable are stated at the aggregate unpaid balance. Carrying amounts of these investments approximate their fair value. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED E. Investment in Investee Corporations Investment in investee corporations represents AFC's ownership of securities of certain companies. All of the companies named in the following table are subject to the rules and regulations of the SEC. Market value of the investments (excluding $50 million in non-public securities at December 31, 1992, for which market values are not available) was approximately $940 million and $700 million at December 31, 1993 and 1992, respectively. AFC's investment (and common stock ownership percentage) and equity in net earnings and losses of investees are stated below (dollars in thousands): American Premier operates businesses primarily in specialty property and casualty insurance. In March 1994, American Premier changed its name from The Penn Central Corporation to reflect the nature of its business. Chiquita is a leading international marketer, processor and producer of quality fresh and processed food products. GACC is engaged in the ownership and operation of television and radio stations. General Cable primarily manufactures and markets electrical and communication wire and cable products. Due to GACC's financial difficulties, AFC transferred all GACC securities and loans to the investee account and reduced the carrying value of that investment to estimated net realizable value ($35 million) at the end of 1992. AFC resumed equity accounting for its investment in GACC following GACC's reorganization at the end of 1993. In July 1992, American Premier distributed to its shareholders approximately 88% of the stock of General Cable. AFC and its subsidiaries, excluding American Premier, received approximately 45% of the shares. The shares retained by American Premier are being held for distribution to creditors and other persons. Accordingly, those shares were included in "Other stocks" at December 31, 1992 and AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED General Cable was not consolidated because control was temporary. The operating results of General Cable for the first six months of 1992 are included in other income. Sprague reported net losses of $29 million in 1992 and $53 million in 1991. Over the past few years, Sprague sold substantially all of its operating businesses and recorded substantial restructuring charges and loss provisions ($25 million in 1992 and $55 million in 1991). Included in AFC's consolidated retained earnings at December 31, 1993, was approximately $145 million applicable to equity in undistributed net losses of investees. The unamortized negative goodwill in investees totaled approximately $62 million at December 31, 1993. Summarized financial information for AFC's major investees at December 31, 1993, is shown below (in millions). See "Investee Corporations" in Management's Discussion and Analysis. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Great American Communications 1993 1992 1991 Contracts, Broadcasting Licenses and Other Intangibles $575 $540 Other Assets 145 174 Long-term Debt 433 635 Minority Interest - Preferred Stock of Subsidiary - 275 Shareholders' Equity (Deficit) 139 (339) Net Revenues of Continuing Operations $205 $211 $202 Operating Income (Loss) 40 (642) 12 Loss from Continuing Operations (67) (613) (33) Discontinued Operations - 11 40 Extraordinary Items 408 5 77 Net Income (Loss) 341 (597) 84 General Cable Corporation Six Year months ended ended 12/31/93 12/31/92 Current Assets $338 $366 Non-current Assets 282 345 Current Liabilities 110 159 Notes Payable to American Premier 287 255 Non-current Liabilities 83 78 Shareholders' Equity 140 219 Net Sales from Continuing Operations $764 $416 Operating Income (Loss) 2 (29) Loss From Continuing Operations (26) (53) Discontinued Operations (32) - Net Loss (58) (53) General Cable's 1993 results included a $34.4 million loss on the disposal of its equipment manufacturing businesses. AFC's share of this loss reduced negative goodwill and was not included in AFC's equity in General Cable's earnings. General Cable's results for the first six months of 1992 (prior to its spin-off from American Premier) are included in American Premier's results. F. Property, Plant and Equipment Property, plant and equipment consisted of the following at December 31, (in thousands): 1993 1992 Land $ 3,654 $ 33,487 Buildings and improvements 21,493 96,523 Machinery, equipment and office furnishings 89,329 278,805 Other - 46,622 114,476 455,437 Less accumulated depreciation (69,526) (239,586) $ 44,950 $215,851 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED G. Cost in Excess of Net Assets Acquired At December 31, 1993 and 1992, accumulated amortization of the excess of cost over net assets of purchased subsidiaries amounted to approximately $94 million and $176 million, respectively. Amortization expense was $15.0 million in 1993, $25.0 million in 1992 and $37.2 million in 1991. H. Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands): AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED At December 31, 1993, sinking fund and other scheduled principal payments on debt for the subsequent five years were as follows (in thousands): Parent Other Company Subsidiaries Total 1994 $12,080 $ 3,669 $ 15,749 1995 10,883 63,050 73,933 1996 11,843 1,064 12,907 1997 17,818 15,667 33,485 1998 19,223 158,821 178,044 In February 1994, AFC commenced an offer to issue new 9-3/4% Debentures due April 20, 2004 and cash in exchange for its publicly traded debentures. In December 1993, AFC wrote off $24.3 million in unamortized original issue discount and debt issue costs related to the debentures covered in the exchange offer. Based on the results of this offer and cash availability, AFC will redeem some or all of the unexchanged debentures. In March 1994, AFC called for redemption its 13-1/2% Debentures and its 13-1/2% Series A Debentures. Holders of either issue may accept the Exchange Offer. Parent company sinking fund and other scheduled principal payments on debt at December 31, 1993, assuming at least 50% of each issue of the old debentures are exchanged, would be as follows (in thousands): 1994 1995 1996 1997 1998 $3,231 $261 $261 $5,493 $261 AFC may, at its option, apply debentures otherwise purchased in excess of scheduled payments to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures purchased are applied to the earliest scheduled retirements. At December 31, 1993, the estimated fair value of all long-term debt of AFC and its subsidiaries exceeded carrying value by approximately $23 million. Fair values of debt instruments were calculated using quoted market prices where available and present values, discounted cash flows, or similar techniques in other cases. During 1993, GAHC entered into a new revolving credit agreement with several banks under which it can borrow up to $300 million. Borrowings bear interest at prime rate or at LIBOR plus 1.375% and are collateralized by a pledge of 50% of the stock of AFC's largest insurance subsidiary. The agreement converts to a four-year term loan in December 1996 and requires annual facility fees and commitment fees based upon the unused portion of the credit line. AFC guarantees amounts borrowed under the credit agreement. In connection with the acquisition of GALIC, AAG borrowed $180 million under a Bank Term Loan Agreement and $50 million under a Bridge Loan. In 1993, AAG sold $225 million principal amount of Notes to the public and used the proceeds to pay off the Bank and Bridge Loan. Unamortized debt issue costs of $4.6 million (net of minority interest) were written off and are included in extraordinary items. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFEI redeemed its 13-7/8% Notes and paid $40 million of bank debt with the proceeds from the sale of shares of American Premier in August 1993. Subsequently, AFEI entered into a new revolving credit agreement which enables it to borrow a maximum of $20 million through December 1997. Cash interest payments of $133 million, $206 million and $221 million were made on long-term debt in 1993, 1992 and 1991, respectively. I. Capital Subject to Mandatory Redemption Capital subject to mandatory redemption includes AFC's Mandatory Redeemable Preferred Stock and capital subject to a put option. Mandatory Redeemable Preferred Stock The outstanding shares of Mandatory Redeemable Preferred Stock are nonvoting, cumulative and consist of the following: Series E, $10.50 par value - authorized 2,725,000 shares; annual dividends per share $1; to be retired at par in 1994 and 1995; 504,711 shares (stated value - $5.3 million) outstanding at December 31, 1993 and 1992. Series I, $.01 par value - authorized 700,000 shares; annual dividends per share $2.66 in 1993; redeemable at $28 per share; 150,212 shares (stated value - $4.2 million) and 225,318 shares (stated value - $6.3 million) outstanding at December 31, 1993 and 1992, respectively. The fair market value of AFC's Mandatory Redeemable Preferred Stock approximates stated value. In February 1994, AFC redeemed the outstanding shares of Series I Preferred Stock. Approximately 45% of the Series E Preferred Stock is scheduled to be retired in December 1994; the balance is to be retired in December 1995. During 1993, AFC purchased 75,106 shares of Series I Preferred Stock for approximately $2.1 million. During 1992, AFC purchased 680,369, 115,500 and 75,105 shares of Series D, Series E and Series I Preferred Stock, respectively, for approximately $10.4 million. During 1991, AFC purchased 679,689 shares of Series D Preferred Stock for approximately $7.1 million. Capital Subject to Put Option Under an agreement entered into in 1983, certain members of the Lindner family (the "Group") who, in the aggregate, owned 1,848,235 shares of AFC Common Stock, were granted options to purchase an additional 1,225,000 shares. The options, which expire two years after the death of Robert D. Lindner, are exercisable at $6.65 per share plus $.40 per share per year from April 1983. Holders have the right to "put" to AFC any shares of AFC Common Stock or options at any time at a price equal to AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFC's book value per share, adjusted to reflect all equity securities (including investees and subsidiaries with publicly traded shares) at market prices. The purchase price is to be paid one-third in cash and the balance in a five-year installment note bearing interest at a rate equal to the five- year U.S. Treasury note rate plus 3%. AFC has the right to "call" any AFC shares owned by the Group after Robert D. Lindner's death at the same price as described under the "put" (but not less than $6.65 per share plus 10% compounded annually from April 1983). Further, AFC has a right of first refusal on shares owned by members of the Group. At December 31, 1993, the Group owned 1,533,767 shares of AFC Common Stock and options to purchase an additional 762,500 shares. The aggregate purchase price for all shares covered by the put is included in "capital subject to mandatory redemption" and amounted to $40 million and $16 million at December 31, 1993 and 1992, respectively. Changes in the aggregate purchase price are charged or credited directly to retained earnings without affecting earnings. J. Other Preferred Stock Under provisions of both the Nonvoting (55,800,000 shares authorized, including the redeemable issues) and Voting (3,500,000 shares authorized, none outstanding) Cumulative Preferred Stock, the Board of Directors is authorized to divide the authorized stock into series and to set specific terms and conditions of each series. The outstanding shares of Nonvoting Cumulative Preferred Stock, excluding those that are mandatorily redeemable, consist of the following: Series F, $1 par value - authorized 15,000,000 shares; annual dividends per share $1.80; 10% annually may be retired at AFC's option at $20 per share from 1994 to 1996; 13,753,254 shares (stated value - $168.0 million) outstanding at December 31, 1993 and 1992. Series G, $1 par value - authorized 2,000,000 shares; annual dividends per share $1.05; may be retired at AFC's option at $10.50 per share; 364,158 shares (stated value - $600,000) outstanding at December 31, 1993 and 1992. In 1992 and 1991, AFC sold 1.0 million and 1.4 million shares of Series F Preferred Stock to its ESORP for $15.0 million and $19.4 million in cash, respectively. K. Common Stock At December 31, 1993, Carl H. Lindner and certain members of the Lindner family owned all of the outstanding Common Stock of AFC (18,971,217 shares, including 1,533,767 shares subject to a put option as described in Note I). Of the 32,300,000 authorized shares of Common Stock at December 31, 1993, 762,500 shares were reserved for issuance upon exercise of options. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED L. Income Taxes The following is a reconciliation of income taxes at the statutory rate of 35% in 1993 and 34% in 1992 and 1991 and income taxes as shown in the Statement of Operations (in thousands): Adjusted earnings (loss) before income taxes consisted of the following (in thousands): 1993 1992 1991 Subject to tax in: United States $255,682($144,854) ($ 45,020) Foreign jurisdictions 1,744 - 187,065 $257,426($144,854) $142,045 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The total income tax provision consists of (in thousands): The 1993 provision for income tax includes a $15 million first quarter benefit due to American Premier's revision of estimated future taxable income likely to be generated during the company's tax loss carryforward period. The components of the provision for deferred income taxes for 1991 were (in millions): Undistributed earnings of subsidiaries and investees $19.6 Losses not utilized 20.5 Insurance underwriting adjustments (16.3) Investment income (16.2) Disposition of assets 35.9 Book value incentive plan (11.9) Other (5.4) $26.2 For income tax purposes, certain members of the AFC consolidated tax group had approximately $180 million of operating loss carryforwards available at December 31, 1993. The carryforwards are scheduled to expire as follows: $23 million in 1994, $9 million in 1995 through 2000 and $148 million in 2001 through 2005. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The cumulative effect of implementing SFAS No. 109 in 1992, which resulted from giving recognition to previously unrecognized tax benefits, was income of $85.4 million. This income consisted of a charge of $40 million related to members of the AFC tax group and a benefit of $125.4 million for AFC's share of American Premier's accounting change. Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities for AFC's tax group included in the Balance Sheet at December 31, were as follows (in millions): The gross deferred tax asset was reduced by a valuation allowance based on an analysis of the likelihood of realization. Factors considered in assessing the need for a valuation allowance include: (i) recent tax returns, which show neither a history of large amounts of taxable income nor cumulative losses in recent years, (ii) opportunities to generate taxable income from sales of appreciated assets, and (iii) the likelihood of generating larger amounts of taxable income in the future. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known. Cash payments for income taxes, net of refunds, were $49.6 million, $9.6 million and $41.2 million for 1993, 1992 and 1991, respectively. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED M. Discontinued Operations In December 1991, AFC sold Hunter Savings Association to Provident Bancorp (an affiliate) for approximately $67.9 million in Provident Bancorp securities and $834,000 in cash. Prior to the sale, Hunter paid AFC a dividend of approximately $26.8 million in cash. Discontinued operations for 1991 consisted of the following (in thousands): Gain Operations on Sale Pretax Earnings $17,683 $5,652 Tax (5,617) (1,922) Net Earnings $12,066 $3,730 N. Pending Legal Proceedings Counsel has advised AFC that there is little likelihood of any substantial liability being incurred from any litigation pending against AFC and subsidiaries. O. Benefit Plans AFC expensed ESORP contributions of $8.9 million in 1993, $7.4 million in 1992 and $7.5 million in 1991. Other operating and general expenses include a charge of $1 million in 1993, a credit of $1 million in 1992 and a charge of $38 million in 1991 for units outstanding under AFC's Book Value Incentive Plan. In 1993, AFC began accruing postretirement benefits over the period the employees qualify for such benefits. Expense for 1993 was $3.1 million. Prior to this change, costs were charged to expense as incurred. P. Transactions With Affiliates Various business has been transacted among AFC and its subsidiaries over the past several years, including rentals, data processing services, accounting services, investment management services, loans, leases, insurance, advertising and sales of assets. Unless otherwise disclosed, none of these transactions had a material effect on the net earnings or equity of AFC. Aggregate charges for these services within AFC and its subsidiaries have been insignificant in relation to consolidated revenues. In addition, AFC and its subsidiaries have had certain of the above types of transactions with certain of AFC's officers and directors and with business entities owned by them. Charges for such services have been less than one percent of consolidated revenues in 1993, 1992 and 1991. In 1993 AFC sold stock of an affiliate to certain of its officers and employees for $1.8 million in cash and $270,000 in 5.25% unsecured notes due in five equal annual installments beginning in 1996. In 1991, The Provident Bank purchased a $5 million loan to an AFC resort real estate subsidiary from an unrelated bank. The loan is secured by the subsidiary's property and is guaranteed by AFC. At December 31, 1993, $452,000 is owed to Provident under the loan. Members of the Lindner family are majority owners of Provident's parent. Except as noted otherwise, all of the above transactions have taken place at approximate market rates or values and, in the opinion of management, all amounts are fully collectible. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Q. Quarterly Operating Results (Unaudited) The operations of certain of AFC's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornados, etc.) may be seasonal. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. The following are quarterly results of consolidated operations for the two years ended December 31, 1993 (in millions). See Note B for changes in ownership of companies whose revenues are included in the consolidated operating results and for the effects of gains on sales of subsidiaries in individual quarters. Following American Premier's announcement in May 1993 that it was committed to sell its Federal Systems segment, AFC classified the operations of this business as "discontinued" for the periods American Premier was accounted for as a subsidiary. These operations have been classified as "continuing" operations below since the amounts were not material ($1.4 million in the first quarter of 1993 and $1.5 million, $1.5 million and $1.4 million in the first three quarters of 1992). In addition, AAG's $5.2 million (pretax before minority interest) writeoff of debt issue costs in the third quarter of 1993 has been reclassified as "extraordinary". Realized gains (losses) on sales of securities and charges for possible losses on investments for the respective quarters amounted to (in millions): New insurance regulations requiring rate rollbacks are being implemented in California as a result of the 1988 ballot initiative, Proposition 103. GAI has not received a rollback assessment and management believes an ultimate liability, if any, cannot be estimated. Since it is not probable that GAI will pay a material premium refund, no provision has been made in the financial statements for a potential liability. In the normal course of business, AFC's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty premium income accounts in connection with reinsurance ceded, (ii) amounts included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses. 1993 1992 1991 Reinsurance ceded $422 $278 $284 Reinsurance assumed: From companies under management contract 63 17 8 Other, primarily non-voluntary pools and associations 61 117 55 Reinsurance recoveries 343 151 109 The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. The aggregate fair value of all annuity liabilities, net of deferred policy acquisition costs, at December 31, 1993, approximates the amounts recorded in the financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, AFC and its subsidiaries enter into financial instrument transactions which may present off-balance-sheet risks, of both credit and market risk nature. These transactions include interest rate swaps and collars, commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. Market risk arises from the possibility that interest and exchange rate movements may make financial instruments less valuable or more onerous. Credit risk arises from the possibility of failure of another party to perform according to the terms of a contract. Appropriate collateral, credit analysis and other control procedures are considered in the light of circumstances of individual situations to minimize risk. Management does not anticipate any material adverse effect on its financial position resulting from involvement in these instruments. At December 31, 1993, AFC and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totalling $35 million at December 31, 1993. S. Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFC's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. The maximum amount of dividends payable in 1994 from GAI based on its 1993 earned surplus is approximately $108 million. Total "restrictions" on intercompany transfers from AFC's subsidiaries cannot be quantified due to the discretionary nature of the restrictions. T. Subsequent Event (Unaudited) In February 1994, American Premier announced that it was considering a proposal from AFC to purchase GAI's personal lines business (primarily insurance of private passenger automobiles and residential property) for $380 million. These operations had earned premiums of $342 million in 1993 and represented approximately 25% of the premiums earned by all of GAI's insurance operations. The purchase would include the transfer of a portfolio of principally investment grade securities with a market value of approximately $450 million. The estimated net book value (GAAP basis) of the business to be transferred would be approximately $200 million. PART IV ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note Q to the Consolidated Financial Statements. B. Schedules filed herewith for 1993, 1992 and 1991: Page II - Amounts Receivable from Related Parties and Under- writers, Promoters, and Employees other than Related Parties S-2 III - Condensed Financial Information of Registrant S-4 XIV - Supplemental Information Concerning Property-Casualty Insurance Operations S-6 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. C. The annual report on Form 10-K of American Premier Underwriters, Inc. (File No. 1-1569) for the period ended December 31, 1993, is hereby incorporated by reference. Copies of this Annual Report on Form 10-K and all subsequent reports filed pursuant to Section 13 of the Securities Exchange Act of 1934 may be obtained from the Commission's principal office at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of the fees prescribed by the rules and regulations of the Commission or may be examined without charge at Room 1024 of the Commission's public reference facilities at the same address. Copies of material filed with the Commission may also be inspected at the following regional offices: 500 West Madison Street, Suite 1400, Chicago, Illinois 60661; and 7 World Trade Center, New York, New York 10048. 3. Exhibits - see Exhibit Index on page E-1. (b) Reports on Form 8-K: Date of Report Items Reported February 23, 1994 1. Exchange Offer for AFC Debentures 2. Proposal to sell personal lines business to American Premier March 17, 1994 1. Amended Exchange Offer terms 2. Call for redemption of 13-1/2% Debentures AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION - PARENT ONLY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE XIV - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS) INDEX TO EXHIBITS AMERICAN FINANCIAL CORPORATION Number Exhibit Description 3 Articles of Incorporation and Code of Regulations, filed as Exhibit 3 to AFC's Form 10-K for 1988. * 4 Instruments defining the The rights of holders of rights of security holders. Registrant's Preferred Stock are defined in the Articles of Incorporation. Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and consolidated subsidiaries. Management Contracts: 10(a) Book Value Incentive Plan, filed as Exhibit 10(a) to AFC's Form 10-K for 1983. * 10(b) Option Agreement, filed as Exhibit 10(b) to AFC's Form 10-K for 1983. * 10(c) Nonqualified ESORP Plan, filed as Exhibit 10(e) to AFC's Form 10-K for 1989. * 12 Computation of ratios of earnings to fixed charges and fixed charges and preferred dividends. 21 Subsidiaries of the Registrant. 28 Information from reports furnished to state insurance regulatory authorities. 99 Form 10-K of American Premier Underwriters, Inc. for 1993. () Incorporated herein by reference. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES EXHIBIT 12 - COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES AND FIXED CHARGES AND PREFERRED DIVIDENDS (Dollars in Thousands) AMERICAN FINANCIAL CORPORATION EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT The following is a list of subsidiaries of AFC at December 31, 1993. All corporations are subsidiaries of AFC and, if indented, subsidiaries of the company under which they are listed. Percentage of State of Common Equity Name of Company Incorporation Ownership American Financial Enterprises, Inc. Connecticut 83% Great American Holding Corporation Ohio 100 Great American Insurance Company Ohio 100 American Annuity Group, Inc. Delaware 80 Great American Life Insurance Company Ohio 100 American Empire Surplus Lines Insurance Company Delaware 100 American National Fire Insurance Company New York 100 Great American Management Services, Inc. Ohio 100 Mid-Continent Casualty Company Oklahoma 100 Stonewall Insurance Company Alabama 100 Transport Insurance Company Ohio 100 The names of certain subsidiaries are omitted, as such subsidiaries in the aggregate would not constitute a significant subsidiary. See Part I, Item 1 of this Report for a description of certain companies in which AFC owns a significant portion and accounts for under the equity method. AMERICAN FINANCIAL CORPORATION EXHIBIT 28 - INFORMATION FROM REPORTS FURNISHED TO STATE INSURANCE REGULATORY AUTHORITIES Schedule P of Annual Statements A. CONSOLIDATED PROPERTY AND CASUALTY ENTITIES - See Attached Schedules Schedule P (prepared in accordance with the rules prescribed by the National Association of Insurance Commissioners) includes the reserves of AFC's consolidated property and casualty subsidiaries. The following is a summary of Schedule P reserves (in millions): GAI Insurance Group Schedule P - Part 1 Summary - col. 33 $1,823 - col. 34 321 Statutory Loss and Loss Adjustment Expense Reserves $2,144 B. UNCONSOLIDATED SUBSIDIARIES None C. 50% OR LESS OWNED PROPERTY AND CASUALTY INVESTEES Not Included Information for American Premier Underwriters, Inc. for 1993 is not included since that company files such information with the Commission as a registrant in its own right. Signatures Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Financial Corporation has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Financial Corporation Signed: March 28, 1994 BY:s/CARL H. LINDNER Carl H. Lindner Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Capacity Date s/CARL H. LINDNER Chairman of the Board March 28, 1994 Carl H. Lindner of Directors s/ROBERT D. LINDNER Director March 28, 1994 Robert D. Lindner s/RONALD F. WALKER Director March 28, 1994 Ronald F. Walker s/FRED J. RUNK Vice President and March 28, 1994 Fred J. Runk Treasurer (principal financial and accounting officer) * Member of the Audit Committee ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters Not applicable - Registrant's Common Stock is owned by fewer than 20 share-holders. See the Consolidated Financial Statements for information regarding dividends. ITEM 6 ITEM 6 Selected Financial Data The following table sets forth certain data for the periods indicated (dollars in millions). ITEM 7 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AFC's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page. AFC is organized as a holding company with almost all of its operations being conducted by subsidiaries and investees. The parent corporation, however, has continuing expenditures for administrative expenses and corporate services and, most importantly, for the payment of principal and interest on borrowings and redemption of and dividends on AFC Preferred Stock. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since many of its businesses are financial in nature, AFC does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful. LIQUIDITY AND CAPITAL RESOURCES Ratios The following ratios may be considered relevant indicators of AFC's liquidity and are typically presented by AFC in its prospectuses and similar documents. Management believes that balance sheet ratios (debt-to-equity) are more meaningful on a parent only basis. On the other hand, earnings statement ratios (fixed charges) are more meaningful on a total enterprise basis since the parent only ratio is dependent, to a great degree, on the discretionary nature of dividend payments from subsidiaries. Ratios of AFC's (parent only) long-term debt to equity (i) excluding Capital Subject to Mandatory Redemption, or (ii) including it as either (a) debt or (b) equity at December 31, 1993, 1992 and 1991 are shown below. Ratios of earnings to fixed charges, excluding and including preferred dividends, for the three years ended December 31, 1993 are also shown below. 1993 1992 1991 Debt to equity 1.06 1.99 2.13 Debt (plus redeemable capital) to equity 1.16 2.09 2.45 Debt to equity (plus redeemable capital) .98 1.81 1.63 Earnings to fixed charges 2.62 2.15 1.54 Earnings to fixed charges plus preferred dividends 2.26 1.94 1.42 Sources of Funds A wholly-owned subsidiary, Great American Holding Corporation ("GAHC"), has a revolving credit agreement with several banks under which it can borrow up to $300 million. The credit line converts to a four-year term loan with scheduled principal payments to begin in March 1997. Borrowings under the credit line are made by GAHC and are advanced to AFC. The line is guaranteed by AFC and secured by 50% of the stock of Great American Insurance Company ("GAI"). Borrowings, repayments and interest payments on the line are included in "net advances from (to) subsidiaries" in the following table. At December 31, 1993, GAHC had no outstanding borrowings under the agreement. Funds to meet the parent company's expenditures have been provided from a variety of sources within the holding company, from subsidiaries and directly from outside sources, as detailed in the following table (in millions): AFC and certain subsidiaries have arrangements among themselves under which they may borrow from each other from time to time for short-term working capital needs. Certain AFC subsidiaries have revolving credit facilities with banks (including those mentioned herein) which may be used for various corporate purposes. These facilities aggregated approximately $320 million of which $305 million was available at December 31, 1993. Generally, over 90% of the dividends (including non-cash dividends) received from subsidiaries have been from GAI. Payments of dividends by GAI are subject to various laws and regulations which limit the amount of dividends that can be paid without regulatory approval. During 1993, the State of Ohio revised its dividend law for Ohio-domiciled insurers. Under the new law, the maximum amount of dividends which may be paid without (i) prior approval or (ii) expiration of a 30 day waiting period without disapproval is the greater of statutory net income or 10% of policyholders' surplus as of the preceding December 31, but only to the extent of earned surplus as of the preceding December 31. While the new law is generally more restrictive than the prior law regarding the amount of dividends which can be paid without prior approval, management believes GAI will be able to gain such approvals due to its strong surplus position. The maximum amount of dividends payable in 1994 from GAI based on its 1993 earned surplus is approximately $108 million. For statutory accounting purposes, equity securities are generally carried at market value with changes in aggregate market value directly affecting policy-holders' surplus. At December 31, 1993, AFC's insurance group owned publicly traded equity securities of affiliates with a market value of $858 million, including equity securities of AFC subsidiaries of $451 million. Since significant amounts of affiliated investments are concentrated in a relatively small number of companies, volatility in the market prices of these stocks could adversely affect the insurance group's policyholders' surplus, potentially impacting the amount of dividends available or necessitating a capital contribution. Under tax allocation agreements with AFC, 80%-owned U.S. subsidiaries generally compute tax provisions as if filing a separate return based on book taxable income computed in accordance with generally accepted accounting principles. The resulting provision (or credit) is currently payable to (or receivable from) AFC. Management believes AFC has sufficient resources to meet its liquidity requirements through operations in the short-term and long-term future. If funds generated from operations, including dividends from subsidiaries, are insufficient to meet fixed charges in any period, AFC would be required to meet such charges through bank borrowings, sales of securities or other assets, or similar transactions. Uncertainties In exchange for $5 million, AFC has agreed to indemnify Spelling Entertainment Group Inc. for up to $35 million in excess of a threshold amount of $25 million of the costs Spelling may incur in the 12 years beginning April 1, 1993 to resolve Spelling's environmental matters, bankruptcy claims and certain other matters. Additionally, an AFC subsidiary has responsibility for environmental remediation costs, which are estimated to be between $10 million and $15 million, associated with the sales of former manufacturing properties. The subsidiary has reserved $10.6 million at December 31, 1993. AFC's insurance subsidiaries do not establish reserves for unreported environmental claims because such amounts cannot be reasonably estimated. At December 31, 1993, they had recorded $45.1 million (net of reinsurance recoverables) for reported environmental pollution and hazardous products claims on policies written many years ago where, in most cases, coverage was never intended. Due to inconsistent court decisions on many coverage issues and the difficulty in determining standards acceptable for cleaning up pollution sites, significant uncertainties exist which are not likely to be resolved in the near future. While the results of all such uncertainties cannot be predicted, based upon its knowledge of the facts, circumstances and applicable laws, management believes that sufficient reserves have been provided and that the ultimate resolution of these uncertainties will not have a material adverse effect on AFC's financial condition or liquidity. Capital Requirements AFC is not heavily engaged in capital-intensive businesses and therefore does not have substantial capital resource requirements to the same extent that other companies might. Cash expenditures for property, plant and equipment, excluding Chiquita which ceased being a subsidiary in 1991, were $32 million, $53 million and $28 million, in 1993, 1992 and 1991, respectively. Management of AFC has always believed in the use of leverage (borrowing funds at predetermined rates) to increase the return on its equity. Historically, AFC has relied more on the use of fixed-rate debt and preferred stock issuances in its financing activities. AFC borrows from both public and private sources, with parent only debt at December 31, 1993, coming almost entirely from public sources. Whenever possible, AFC tries to do its financing on a long-term basis, even if the current costs associated are slightly higher. At December 31, 1993, the average maturity of AFC's borrowings on a parent only basis was approximately 6-1/2 years; the average interest rate on those borrowings was 11.6%. Comparable figures for three years ago are 9 years maturity and 11.6% stated interest rate (12.8% effective rate). In February 1994, AFC commenced an offer to issue new 9-3/4% Debentures due April 20, 2004 and cash in exchange for its publicly traded debentures. On March 28, 1994, AFC announced that the expiration date had been extended to April 15, and that in excess of $190 million of old debentures had been accepted for exchange. The table below shows (in thousands) total sinking fund and other principal payments on all debt of AFC (parent only) for 1994 and in subsequent periods on an historical basis and on a pro forma basis (a) assuming 50% of each issue of the old debentures are exchanged pursuant to the offer ("50% Accept-ance") and (b) assuming all of the old debentures are tendered ("100% Accept-ance"). The scheduled payments shown below assume that debentures purchased are applied to the earliest scheduled retirements. Pro Forma December 31, 1993 50% 100% Historical Acceptance Acceptance 1994 $ 12,080 $ 3,231 $ 3,231 1995 10,883 261 261 1996 11,843 261 261 1997 17,818 5,493 5,493 1998 19,223 261 261 1999-2002 343,605 184,928 11,469 2003-2004 154,279 375,296 548,755 Total $569,731 $569,731 $569,731 Actual cash outlays will be less than indicated in the above table to the extent that AFC can satisfy scheduled retirements and sinking fund requirements by acquiring its debt at discounts from redemption values. The net annual charge to pretax income for interest expense would decline by approximately $6.8 million based on 50% Acceptance and approximately $13.5 million based on 100% Acceptance. Based on the results of this offer and cash availability, AFC will redeem some or all of the unexchanged debentures. In March 1994, AFC called for redemption its 13-1/2% Debentures and its 13-1/2% Series A Debentures. Holders of either issue may accept the exchange offer. Interest and dividend payments on parent company debt and preferred stock (all issues) for the subsequent five years, assuming all sinking fund and other principal payments are made as scheduled and before effects of the 1994 exchange offers and redemptions, would be approximately (in millions): 1994 1995 1996 1997 1998 Interest $66.0 $64.7 $63.5 $62.3 $60.8 Dividends 26.0 25.5 25.1 25.1 25.1 Payment of preferred dividends and redemption of AFC Preferred Stock is subordinate to AFC's obligations to pay principal and interest on its debt. At December 31, 1993, sinking fund and other scheduled principal payments on debt of subsidiaries for the next five years were as follows: 1994 - $4 million; 1995 - $63 million; 1996 - $1 million; 1997 - $16 million; and 1998 - $159 million. Certain members of the Lindner family have the right to "put" to AFC their shares of AFC Common Stock or options at any time at a price based on AFC's book value per share (as defined). The "put" price is paid one-third in cash and the balance in a five-year installment note bearing interest at a rate equal to the five-year U.S. Treasury Note rate plus 3%. The aggregate purchase price for remaining shares and options covered by the "put" at December 31, 1993, was approximately $40 million. Investments Approximately three-fifths of AFC's consolidated assets are invested in marketable securities (excluding investment in equity securities of investee corporations). AFC's investment philosophy is briefly summarized in the following paragraphs. AFC attempts to optimize investment income while building the value of its portfolio, placing emphasis upon long-term performance. AFC's goal is to maxi-mize return on an ongoing basis rather than focusing on year-by-year performance. Significant portions of equity and, to a lesser extent, fixed income investments are concentrated in a relatively limited number of major positions. This approach allows management to more closely monitor these companies and the industries in which they operate. Some of the investments, because of their size, may not be as readily marketable as the typical small investment position. Alternatively, a large equity position may be attractive to persons seeking to control or influence the policies of a company. While management believes this investment philosophy will produce higher overall returns, such concentrations subject the portfolio to greater risk in the event one of the companies invested in becomes financially distressed. Fixed income investment funds are generally invested in securities with short-term and intermediate-term maturities with an objective of maximizing interest and dividend yields. This practice allows additional flexibility in reacting to market conditions. Approximately 95% of the bonds and redeemable preferred stocks held by AFC were rated "investment grade" (credit rating of AAA to BBB) at December 31, 1993, compared to less than 60% at the end of 1988. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. The realization of capital gains, primarily through sales of equity securities, has been an integral part of AFC's investment program. Individual securities are sold creating gains or losses as market opportunities exist. Pretax capital gains (losses) recognized upon disposition of securities, including investees, during the past five years have been: 1993 - $165 million; 1992 - $104 million; 1991 - $38 million; 1990 - ($89 million) and 1989 - $64 million. At December 31, 1993, AFC had gross unrealized gains and losses on bonds and redeemable preferred stocks and equity securities as follows (in millions): Net Gross Unrealized Unrealized Gains Losses Gain Bonds and redeemable preferred stocks: Held to maturity $189.2 ($18.5) $170.7 Available for sale 133.2 - 133.2 322.4 (18.5) 303.9 Equity securities 137.2 (5.1) 132.1 $459.6 ($23.6) $436.0 When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings and the carrying value of that investment is reduced. At December 31, 1993, collateralized mortgage obligations ("CMOs") represented approximately 30% of AFC's bonds and redeemable preferred stocks. At that date, interest only (I/Os), principal only (P/Os) and other "high risk" CMOs represented approximately four-tenths of one percent of AFC's total CMO portfolio. AFC invests primarily in CMOs which are structured to minimize prepayment risk. In addition, the majority of CMOs held by AFC were purchased at a discount to par value. Management believes that the structure and discounted nature of the CMOs will minimize the effect of prepayments on earnings over the anticipated life of the CMO portfolio. Substantially all of AFC's CMOs are rated "AAA" by Standard & Poor's Corporation and are collateralized by GNMA, FNMA and FHLMC single- family residential pass-through certificates. The market in which these securities trade is highly liquid. Aside from interest rate risk, AFC does not believe a material risk (relative to earnings and liquidity) is inherent in holding such investments. RESULTS OF OPERATIONS - THREE YEARS ENDED DECEMBER 31, 1993 General Due to decreases in ownership percentages, AFC ceased accounting for the following companies as subsidiaries and began accounting for them as investees: American Premier (April 1993), Spelling (July 1992), Chiquita (July 1991) and GACC (June 1991). AFC had accounted for American Premier as a subsidiary from 1992 through the first quarter of 1993 due to AFC's ownership exceeding 50%. As a result of these changes, current year income statement components are not comparable to prior years and are not indicative of future years. AFC's net earnings reached a record high of $220 million in 1993. Major factors contributing to the increase in earnings included $155 million in pretax gains from the sales of AFC's insurance agency operations, Spelling Entertainment Group, 4.5 million shares of American Premier and additional proceeds received on the 1990 sale of the NSA Group in addition to improved contributions to results from American Premier, Chiquita and GACC. Operating difficulties at two major investees caused significant losses for AFC in 1992, partially offset by the benefit from the effect of the accounting change as required by SFAS No. 109 and a gain on the sale of Kings Island. Significant realized gains on securities sales and from the public issuance of stock by an investee contributed to the $72 million of earnings in 1991. Property and Casualty Insurance - Underwriting Underwriting profitability is measured by the combined ratio which is a sum of the ratio of underwriting expenses to premiums written and the ratio of losses and loss adjustment expenses to premiums earned. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. The combined underwriting ratio (statutory basis, after policyholders' dividends) of GAI and its property and casualty insurance subsidiaries ("Great American") was 103.9% in 1993, 105.0% in 1992 and 103.2% in 1991. Total net losses to AFC's insurance operations from catastrophes (natural disasters and other incidents of major loss) were $26 million in 1993, $42 million in 1992 and $22 million in 1991. To understand the overall profitability of particular lines, timing of claims payments and the related impact of investment income must be considered. Certain "short-tail" lines of business (primarily property coverages) have quick loss payouts which reduce the time funds are held, thereby limiting investment income earned thereon. On the other hand, "long-tail" lines of business (primarily liability coverages and workers' compensation) have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received. While Great American desires and seeks to earn an underwriting profit on all of its business, it is not always possible to do so. As a result, the company attempts to expand in the most profitable areas and control growth or even reduce its involvement in the least profitable ones. In recent years, many commercial lines markets have been extremely competitive as predicted premium rate increases have not materialized. Workers' compensation, in particular, has been especially hard hit by competition, rising benefit levels and claims fraud. Many states have begun to address these problems and, in the last couple of years, Great American has focused its efforts toward those markets where improvements are evident. In 1993, Great American's underwriting results significantly outperformed the industry average for the eighth consecutive year. Great American has been able to exceed the industry's results by supplementing its commercial lines coverages with highly specialized niche products and new automobile and homeowner products. Many of the improvements experienced by Great American and the market in general in recent years are expected to continue in 1994. See the discussion of Underwriting and Loss and Loss Adjustment Expense Reserves under Item 1 - "Business - Great American Insurance Group". 1993 compared to 1992 Property and casualty insurance premiums decreased $657 million (31%) in 1993 reflecting the deconsolidation of American Premier's insurance operations beginning in the second quarter of 1993. Premiums for the remainder of AFC's insurance group were virtually unchanged. 1992 compared to 1991 Property and casualty insurance premiums increased $955 million (80%) in 1992 reflecting the consolidation of American Premier's insurance operations beginning in 1992. Premiums for the remainder of AFC's insurance group were virtually unchanged. Investment Income Changes in investment income reflect fluctuations in market rates and changes in average invested assets. 1993 compared to 1992 Investment income decreased $87 million (13%) in 1993 reflecting the deconsolidation of American Premier in 1993, partially offset by an increase in average investments held. 1992 compared to 1991 Investment income increased $120 million (21%) in 1992 reflecting primarily the consolidation of American Premier in 1992, partially offset by lower interest rates available in the marketplace. Investee Corporations Equity in net earnings of investee corporations (companies in which AFC owns a significant portion of the voting stock) represents AFC's proportionate share of the investees' earnings and losses. 1993 compared to 1992 AFC's equity in the net earnings of investees in 1993 was $70 million compared to a loss of $339 million in 1992. The principal items responsible for this improvement were (i) the absence of losses from GACC in 1993 compared to AFC's loss of $187 million from that investment in 1992, (ii) a $108 million improvement from Chiquita's operations and (iii) $92 million in earnings from American Premier which became an investee in the second quarter of 1993 when AFC's ownership declined below 50%. 1992 compared to 1991 The decrease in equity in net earnings of investees in 1992 reflects primarily the results of Chiquita and GACC, both of which became investees in the third quarter of 1991. Chiquita reported a net loss of $284 million in 1992 attributable principally to (i) sharply increased banana costs and expenses and (ii) lower banana prices in the first half of the year. GACC reported a net loss of $597 million in 1992 which includes a $658 million provision to revalue intangible assets to reflect estimated current market values of broadcasting assets at December 31, 1992. In addition, significant debt, depreciation and amortization expenses continued to more than offset broadcasting results. In connection with a proposed financial restructuring of GACC, AFC transferred all securities and loans related to GACC to the investee account and reduced the carrying value of that investment to estimated net realizable value ($35 million). Gains on Sales of Investees The gains on sales of investees in 1993 include (i) a pretax gain of $52 million in the first quarter on the sale of Spelling and (ii) a pretax gain of $28 million in the third quarter on the public sale by AFEI of 4.5 million shares of American Premier common stock. Gains on Sales of Subsidiaries The gains on sales of subsidiaries in 1993 include (i) a pretax gain of $44 million from the sale of American Business Insurance, Inc. and (ii) a pretax gain of $31 million representing an adjustment on the 1990 sale of AFC's non-standard automobile insurance group to American Premier. The gain on sale of subsidiary in 1992 represents a pretax gain from the sale of Kings Island Theme Park. The gains on sales of subsidiaries in 1991 include (i) a pretax gain of $58 million as a result of Chiquita's public issuance of 5 million shares of its common stock; (ii) a pretax gain of $13 million on Charter's sale of its interest in an oil producing concession; and (iii) a $7 million pretax gain on the disposition of 455,000 shares of Chiquita common stock. These items were partially offset by a pretax loss of $12 million realized as a result of GACC's issuance of 16.5 million shares of its common stock. Sales of Other Products and Services Sales shown below (in millions) include those of American Premier (from January 1992 to March 1993), Spelling Entertainment Group (through June 1992), GACC (through May 1991), Spelling Entertainment Inc. (from May 1991 to June 1992), Kings Island Theme Park (through September 1992) and Chiquita (through June 1991). 1993 1992 1991 Federal Systems $ 99.2 $ 414.0 $ - Diversified Products and Services 52.9 255.4 - Petroleum Products - 159.7 424.0 Broadcasting and Entertainment: Broadcasting - - 78.0 Entertainment - 118.8 139.4 Kings Island Theme Park - 83.0 79.2 Food Products: Fresh Foods - - 1,347.5 Prepared Foods - - 1,089.2 $152.1 $1,030.9 $3,157.3 Sales of Federal Systems and Diversified Products and Services represent American Premier's revenues from systems and software engineering services and the manufacture and supply of industrial products and services. Sales of petroleum products reflect Spelling's revenues from petroleum marketing activities. Broadcasting revenues represent GACC's television and radio operations. Entertainment revenues reflect Spelling's television production and distribution operations. Sales of food products represent Chiquita's revenues. 1993 compared to 1992 The deconsolidation of American Premier and Spelling and the sale of Kings Island accounted for the decrease in revenues from sales of other products and services in 1993. 1992 compared to 1991 In July 1992, AFC's ownership of Spelling decreased below 50%; accordingly, Spelling's revenues are included for only the first six months of 1992 compared to the entire year for 1991. The increase in Kings Island revenues in 1992 was due primarily to a 14% increase in attendance over the comparable period in 1991. Revenues from several operating days in October and a "Winterfest" operation during the holiday season were approximately $5 million in the fourth quarter for 1991. In October 1992, AFC sold the theme park to an unaffiliated party. See "Gains on Sales of Subsidiaries". Interest on Annuities For GAAP financial reporting purposes, GALIC's annuity receipts are accounted for as interest-bearing deposits ("annuity policyholders' funds accumulated") rather than as revenues. Under these contracts, policyholders' funds are credited with interest on a tax-deferred basis until withdrawn by the policyholder. The average crediting rate on funds held by GALIC has decreased from 7.2% at December 31, 1991 to 6.2% at December 31, 1992 and 5.3% at December 31, 1993; GALIC's products offer minimum interest rate guarantees of 3% to 4%. The rate at which GALIC credits interest on annuity policyholders' funds is subject to change based on market conditions. Annuity receipts totaled $400 million in 1993, $360 million in 1992 and $460 million in 1991. Receipts in 1993 increased primarily due to the introduction of new single premium products in the second half of 1992. Receipts in 1992 were lower than anticipated due to (i) a reduction in receipts relating to a new product introduced in 1990 which encouraged rollovers of other retirement funds and (ii) unfavorable economic and market conditions, including the impact of the negative publicity associated with a number of highly publicized insolvencies in the life insurance industry. Annuity surrender payments represented 6.9%, 7.8% and 9.4% of average statutory reserves in 1993, 1992 and 1991, respectively. 1993 compared to 1992 Interest on annuity policyholders' funds decreased $13 million (5%) in 1993 due to a reduction in rates being credited to policyholders. The effect of this decrease more than offset an increase of 7% in the average amount of accumulated policyholders' funds held. 1992 compared to 1991 Interest on annuity policyholders' funds decreased by $16.3 million (6%) from 1991 due to a reduction in rates being credited to policyholders, which more than offset an increase of approximately 7% in the average amount of accumulated policyholders' funds held. Interest on Borrowed Money Changes in interest expense result from fluctuations in market rates as well as changes in borrowings. AFC has generally financed its borrowings on a long-term basis which has resulted in higher current costs. Interest expense included in AFC's consolidated statement of operations was comprised of (in millions): 1993 1992 1991 AFC Parent $ 71.1 $ 70.6 $ 73.8 Great American Holding 23.4 34.2 37.8 Great American Insurance 14.0 14.3 14.3 American Premier 17.2 69.2 - American Annuity 21.2 - - Chiquita - - 41.1 GACC - - 49.6 Spelling - 4.7 8.2 Other Companies 10.3 22.9 26.5 $157.2 $215.9 $251.3 GAHC's interest expense has decreased due to repayments of bank borrowings in 1992 and 1993. American Annuity borrowed approximately $230 million in December 1992 to acquire GALIC. The decrease in other companies' interest expense is due primarily to the sale of a subsidiary in 1992 and repayments of borrowings in 1993. Other Operating and General Expenses Operating and general expenses included the following charges (credits) (in millions): 1993 1992 1991 Minority interest $35 $38 $44 Writeoff of debt discount and issue costs 24 - - Allowance for bad debts 10 (3) 26 Relocation expenses 8 - - Book Value Incentive Plan 1 (1) 38 Allowance for bad debts includes charges for possible losses on agents' balances, reinsurance recoverables and other receivables. Relocation expenses represent the estimated costs of moving GALIC's operations from Los Angeles to Cincinnati. Income Taxes Certain subsidiaries have not been able to recognize tax benefits on significant operating losses. Accordingly, AFC's effective tax rates were greater than the normal rate of 34% in 1992 and 1991. See Note L to the Financial Statements for an analysis of other items affecting AFC's effective tax rate. In 1992, AFC implemented SFAS No. 109, "Accounting for Income Taxes". The cumulative effect of implementing this statement resulted in a benefit of $85.4 million to net earnings for the recognition of previously unrecognized tax benefits. The portion of AFC's net deferred tax asset at December 31, 1992, attributable to American Premier was $245.3 million. The 1993 provision for income tax includes a $15 million first quarter benefit due to American Premier's revision of estimated future taxable income likely to be generated during the company's tax loss carryforward period. The analysis of estimated future taxable income will be reviewed and updated periodically, and any required adjustments, which may increase or decrease the net deferred tax asset, will be made in the period in which the developments on which they are based become known. Discontinued Operations Earnings from discontinued operations represent the results of Hunter Savings Association prior to its sale in December 1991. Earnings from continuing operations do not reflect earnings that would have been earned on the sales proceeds had the sale of Hunter taken place at the beginning of 1991. Recent Accounting Standards The following Statements of Financial Accounting Standards ("SFAS") have been implemented by AFC in 1992 or 1993 or will be implemented in 1994. The implementation of these standards is discussed under various subheadings of Note A to the Financial Statements; effects of each are shown in relevant Notes. Implementation of SFAS Nos. 112 and 114 in the first quarter of 1994 and 1995, respectively, is not expected to have a significant effect on AFC. SFAS# Subject of Standard (Year Implemented) Reference 106 Certain Postretirement Benefits(1993) "Benefit Plans" 107 Fair Values (1992) "Fair Value" 109 Income Taxes (1992) "Income Taxes" 112 Certain Employment Benefits (1994) -n/a- 113 Reinsurance (1993) "Reinsurance" 114 Impairment of Loans (1995) -n/a- 115 Investment in Securities (1993) "Investments" Other standards issued in recent years did not apply to AFC or had only negligible effects on AFC. ITEM 8 ITEM 8 Financial Statements and Supplementary Data Page Reports of Independent Auditors Consolidated Balance Sheet: December 31, 1993 and 1992 Consolidated Statement of Operations: Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Capital Accounts: Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows: Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements "Selected Quarterly Financial Data" has been included in Note Q to the Consolidated Financial Statements. PART III ITEM 10 Directors and Executive Officers of the Registrant The directors and executive officers of AFC at March 1, 1994, are: Executive Name Age Position Since Carl H. Lindner 74 Chairman of the Board and Chief 1959 Executive Officer Richard E. Lindner 72 Director 1959 Robert D. Lindner 73 Vice Chairman of the Board 1959 Ronald F. Walker 55 Director, President and Chief 1973 Operating Officer Carl H. Lindner III 40 President of GAI and President 1987 and Chief Operating Officer of American Premier S. Craig Lindner 39 President of AAG and Senior Executive Vice President of AMM James E. Evans 48 Vice President and General Counsel Sandra W. Heimann 51 Vice President 1984 Robert C. Lintz 60 Vice President 1979 Thomas E. Mischell 46 Vice President 1985 Fred J. Runk 51 Vice President and Treasurer 1978 Carl H. Lindner has served as Chairman of the Board and Chief Executive Officer of AFC for more than five years. He serves in similar capacities with various AFC subsidiaries. He serves as Chairman of the Board of the following public companies: American Annuity Group, Inc. ("AAG"), American Financial Enterprises, Inc. ("AFEI"), Chiquita, General Cable, Great American Communications Company ("GACC") and American Premier. AFC owns a substantial beneficial interest (over 20%) in all of these companies. Richard E. Lindner is owner, Chairman of the Board of Directors, President and Chief Executive Officer of Thriftway, Inc., a supermarket chain otherwise unaffiliated with AFC, and has been associated with that company for over five years. Robert D. Lindner, for more than five years, has served as Vice Chairman of the Board of Directors of AFC. In addition, he is Chairman of the Board of United Dairy Farmers, Inc. ("UDF") which, among other things, is engaged through subsidiaries in dairy processing and the operation of convenience stores. He is also a director of AFEI. Ronald F. Walker has served as President and Chief Operating Officer of AFC for more than five years. He is also Vice Chairman of the Board of Directors of GAI and holds executive positions in most of AFC's other subsidiaries. He is also a director of AAG, AFEI, Chiquita, General Cable and Tejas Gas Company. Carl H. Lindner III has been President of GAI for more than five years. He holds executive positions in many of GAI's subsidiaries. He has also been President and Chief Operating Officer of American Premier since 1991. S. Craig Lindner has been Senior Executive Vice President of American Money Management Corporation ("AMM"), a subsidiary of AFC which provides investment services to AFC and its subsidiaries, for more than five years. He was elected President of AAG in March 1993. James E. Evans has served as a Vice President and the General Counsel of AFC for more than five years. Sandra W. Heimann has been a Vice President of AFC and an executive officer of AMM for more than five years. Robert C. Lintz has been a Vice President of AFC for more than five years. Thomas E. Mischell has been a Vice President of AFC for more than five years. Fred J. Runk has served as Vice President and Treasurer of AFC for more than five years. Carl H. Lindner, Robert D. Lindner and Richard E. Lindner are brothers. Carl H. Lindner III and S. Craig Lindner are sons of Carl H. Lindner. All of the executive officers of AFC devote substantially all of their time to the affairs of AFC and its subsidiaries. All of the above are United States citizens. The information required by the following Items will be provided within 120 days after end of Registrant's fiscal year. ITEM 11 Executive Compensation ITEM 12 Security Ownership of Certain Beneficial Owners and Management ITEM 13 Certain Relationships and Related Transactions REPORTS OF INDEPENDENT AUDITORS Board of Directors American Financial Corporation We have audited the accompanying consolidated balance sheets of American Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in capital accounts, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements of American Premier Underwriters, Inc. (formerly The Penn Central Corporation), General Cable Corporation and American Annuity Group, Inc. (1991). Those statements were audited by other auditors whose reports have been furnished to us. The reports pertaining to the statements of General Cable Corporation and American Premier Underwriters, Inc. included explanatory paragraphs that described their change in method of accounting for income taxes in 1992. Our opinion on the consolidated financial statements and schedules, insofar as it relates to data included for those corporations as described in Note E, is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, American Financial Corporation and subsidiaries changed their method of accounting in 1993 for certain investments in debt and equity securities and in 1992 for income taxes. ERNST & YOUNG Cincinnati, Ohio March 25, 1994 REPORT OF AMERICAN PREMIER'S INDEPENDENT AUDITORS American Premier Underwriters, Inc. (formerly The Penn Central Corporation): We have audited the financial statements and the financial statement schedules of American Premier Underwriters, Inc. and Consolidated Subsidiaries listed in the Index to Financial Statements and Financial Statement Schedules of American Premier Underwriters, Inc.'s Form 10-K for the year ended December 31, 1993 (included as Exhibit 99 herein). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of American Premier Underwriters, Inc. and Consolidated Subsidiaries at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Note 1 to the financial statements, in 1992 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 16, 1994 (March 25, 1994 with respect to the change of the Company's name as discussed in Note 1 to American Premier's financial statements) REPORT OF GENERAL CABLE'S INDEPENDENT AUDITORS General Cable Corporation: We have audited the consolidated financial statements and related schedules of General Cable Corporation and subsidiaries listed in Item 14(a) of the Annual Report on Form 10-K of General Cable Corporation for the year ended December 31, 1993 (not presented separately herein). These consolidated financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of General Cable Corporation and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 1 and 10 to the consolidated financial statements, in 1992 General Cable Corporation changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 18, 1994 REPORT OF AMERICAN ANNUITY'S INDEPENDENT AUDITORS American Annuity Group, Inc.: We have audited the consolidated balance sheet of American Annuity Group, Inc., formerly Sprague Technologies, Inc., and subsidiaries as of December 31, 1991 and the related consolidated statements of operations, common stockholders' equity and cash flows for the year then ended (before adjustments and reclassifications to conform with the presentation for 1992). Our audit also included the 1991 financial statement schedule listed in the Index at Item 14(a) of American Annuity Group, Inc's. Form 10-K for the year ended December 31, 1993 (not presented separately herein). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements (before adjustments and reclassifications to conform with the presentation for 1992) present fairly, in all material respects, the financial position of American Annuity Group, Inc. and subsidiaries as of December 31, 1991 and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Stamford, Connecticut March 24, 1992 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Thousands) December 31, 1993 1992 Assets Cash and short-term investments $ 167,950 $ 837,429 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,959,400 and $4,705,600) 3,788,732 4,597,544 Available for sale - at market (amortized cost - $2,216,328 and $1,905,814) 2,349,528 1,976,514 Other stocks - principally at market (cost - $207,056 and $182,476) 339,156 230,876 Investment in investee corporations 899,800 568,207 Bonds and receivables from investees 6,783 305,701 Loans receivable 624,149 812,436 Real estate and other investments 139,319 179,152 8,147,467 8,670,430 Recoverables from reinsurers and prepaid reinsurance premiums 756,060 599,204 Trade receivables 298,240 594,834 Other receivables 213,507 318,799 Property, plant and equipment, net 44,950 215,851 Deferred tax asset - 258,300 Prepaid expenses, deferred charges and other assets 275,349 394,319 Cost in excess of net assets acquired 173,965 499,639 $10,077,488 $12,388,805 Liabilities and Capital Insurance claims and reserves $ 3,422,657 $ 4,279,853 Annuity policyholders' funds accumulated 4,256,674 3,973,524 Long-term debt: Parent company 571,874 557,161 American Premier - 657,800 Other subsidiaries 482,132 794,217 Accounts payable, accrued expenses and other liabilities 648,462 1,005,866 Minority interest 109,219 812,707 9,491,018 12,081,128 Capital subject to mandatory redemption 49,232 27,683 Preferred Stock (redemption value - $278,889) 168,588 168,588 Common Stock without par value 904 904 Retained earnings 210,846 42,402 Net unrealized gain on marketable securities, net of deferred income taxes 156,900 68,100 $10,077,488 $12,388,805 See notes to consolidated financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN CAPITAL ACCOUNTS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INDEX TO NOTES A. Accounting Policies B. Acquisitions and Sales of Subsidiaries C. Segments of Operations D. Investments E. Investment in Investee Corporations F. Property, Plant and Equipment G. Cost in Excess of Net Assets Acquired H. Long-Term Debt I. Capital Subject to Mandatory Redemption J. Other Preferred Stock K. Common Stock L. Income Taxes M. Discontinued Operations N. Pending Legal Proceedings O. Benefit Plans P. Transactions With Affiliates Q. Quarterly Operating Results (Unaudited) R. Additional Information S. Restrictions on Transfer of Funds and Assets of Subsidiaries T. Subsequent Event (Unaudited) A. Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of American Financial Corporation ("AFC") and its subsidiaries except for Hunter Savings Association which was sold in the fourth quarter of 1991 and is presented in the financial statements as "discontinued operations". Changes in ownership levels of other subsidiaries and investees have resulted in certain differences in the financial statements and have affected comparability between years. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. AFC's ownership of subsidiaries and significant investees with publicly traded shares at December 31, was as follows: AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED D. Investments Bonds, redeemable preferred stocks and other stocks at December 31, consisted of the following (in millions): The table below sets forth the scheduled maturities of bonds and redeemable preferred stocks based on carrying value as of December 31, 1993. Data based on market value is generally the same. Collateralized mortgage obligations have an average life of approximately 4 years at December 31, 1993. Held to Available Maturity Maturity for Sale One year or less 1% 1% After one year through five years 7 5 After five years through ten years 18 13 After ten years 55 31 81 50 Collateralized mortgage obligations 19 50 100% 100% AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Gross gains of $69.4 million, $85.2 million and $208.8 million and gross losses of $16.5 million, $4.7 million and $236.9 million were realized on sales of fixed maturity investments during 1993, 1992 and 1991, respectively. Realized gains (losses) and changes in unrealized appreciation (depreciation) on fixed maturity and equity security investments are summarized as follows (in thousands): Investment in other stocks at December 31, 1992 consisted of (in thousands): At December 31, 1992, gross unrealized gains on other stocks were $63.7 million and gross unrealized losses were $15.1 million. Carrying values of investments were determined after deducting cumulative provisions for impairment aggregating $47 million and $78 million at December 31, 1993 and 1992, respectively. Fair values for investments are based on prices quoted, when available, in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, fair values of comparable securities, or similar methods. Short-term investments are carried at cost; loans receivable are stated at the aggregate unpaid balance. Carrying amounts of these investments approximate their fair value. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED E. Investment in Investee Corporations Investment in investee corporations represents AFC's ownership of securities of certain companies. All of the companies named in the following table are subject to the rules and regulations of the SEC. Market value of the investments (excluding $50 million in non-public securities at December 31, 1992, for which market values are not available) was approximately $940 million and $700 million at December 31, 1993 and 1992, respectively. AFC's investment (and common stock ownership percentage) and equity in net earnings and losses of investees are stated below (dollars in thousands): American Premier operates businesses primarily in specialty property and casualty insurance. In March 1994, American Premier changed its name from The Penn Central Corporation to reflect the nature of its business. Chiquita is a leading international marketer, processor and producer of quality fresh and processed food products. GACC is engaged in the ownership and operation of television and radio stations. General Cable primarily manufactures and markets electrical and communication wire and cable products. Due to GACC's financial difficulties, AFC transferred all GACC securities and loans to the investee account and reduced the carrying value of that investment to estimated net realizable value ($35 million) at the end of 1992. AFC resumed equity accounting for its investment in GACC following GACC's reorganization at the end of 1993. In July 1992, American Premier distributed to its shareholders approximately 88% of the stock of General Cable. AFC and its subsidiaries, excluding American Premier, received approximately 45% of the shares. The shares retained by American Premier are being held for distribution to creditors and other persons. Accordingly, those shares were included in "Other stocks" at December 31, 1992 and AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED General Cable was not consolidated because control was temporary. The operating results of General Cable for the first six months of 1992 are included in other income. Sprague reported net losses of $29 million in 1992 and $53 million in 1991. Over the past few years, Sprague sold substantially all of its operating businesses and recorded substantial restructuring charges and loss provisions ($25 million in 1992 and $55 million in 1991). Included in AFC's consolidated retained earnings at December 31, 1993, was approximately $145 million applicable to equity in undistributed net losses of investees. The unamortized negative goodwill in investees totaled approximately $62 million at December 31, 1993. Summarized financial information for AFC's major investees at December 31, 1993, is shown below (in millions). See "Investee Corporations" in Management's Discussion and Analysis. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Great American Communications 1993 1992 1991 Contracts, Broadcasting Licenses and Other Intangibles $575 $540 Other Assets 145 174 Long-term Debt 433 635 Minority Interest - Preferred Stock of Subsidiary - 275 Shareholders' Equity (Deficit) 139 (339) Net Revenues of Continuing Operations $205 $211 $202 Operating Income (Loss) 40 (642) 12 Loss from Continuing Operations (67) (613) (33) Discontinued Operations - 11 40 Extraordinary Items 408 5 77 Net Income (Loss) 341 (597) 84 General Cable Corporation Six Year months ended ended 12/31/93 12/31/92 Current Assets $338 $366 Non-current Assets 282 345 Current Liabilities 110 159 Notes Payable to American Premier 287 255 Non-current Liabilities 83 78 Shareholders' Equity 140 219 Net Sales from Continuing Operations $764 $416 Operating Income (Loss) 2 (29) Loss From Continuing Operations (26) (53) Discontinued Operations (32) - Net Loss (58) (53) General Cable's 1993 results included a $34.4 million loss on the disposal of its equipment manufacturing businesses. AFC's share of this loss reduced negative goodwill and was not included in AFC's equity in General Cable's earnings. General Cable's results for the first six months of 1992 (prior to its spin-off from American Premier) are included in American Premier's results. F. Property, Plant and Equipment Property, plant and equipment consisted of the following at December 31, (in thousands): 1993 1992 Land $ 3,654 $ 33,487 Buildings and improvements 21,493 96,523 Machinery, equipment and office furnishings 89,329 278,805 Other - 46,622 114,476 455,437 Less accumulated depreciation (69,526) (239,586) $ 44,950 $215,851 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED G. Cost in Excess of Net Assets Acquired At December 31, 1993 and 1992, accumulated amortization of the excess of cost over net assets of purchased subsidiaries amounted to approximately $94 million and $176 million, respectively. Amortization expense was $15.0 million in 1993, $25.0 million in 1992 and $37.2 million in 1991. H. Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands): AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED At December 31, 1993, sinking fund and other scheduled principal payments on debt for the subsequent five years were as follows (in thousands): Parent Other Company Subsidiaries Total 1994 $12,080 $ 3,669 $ 15,749 1995 10,883 63,050 73,933 1996 11,843 1,064 12,907 1997 17,818 15,667 33,485 1998 19,223 158,821 178,044 In February 1994, AFC commenced an offer to issue new 9-3/4% Debentures due April 20, 2004 and cash in exchange for its publicly traded debentures. In December 1993, AFC wrote off $24.3 million in unamortized original issue discount and debt issue costs related to the debentures covered in the exchange offer. Based on the results of this offer and cash availability, AFC will redeem some or all of the unexchanged debentures. In March 1994, AFC called for redemption its 13-1/2% Debentures and its 13-1/2% Series A Debentures. Holders of either issue may accept the Exchange Offer. Parent company sinking fund and other scheduled principal payments on debt at December 31, 1993, assuming at least 50% of each issue of the old debentures are exchanged, would be as follows (in thousands): 1994 1995 1996 1997 1998 $3,231 $261 $261 $5,493 $261 AFC may, at its option, apply debentures otherwise purchased in excess of scheduled payments to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures purchased are applied to the earliest scheduled retirements. At December 31, 1993, the estimated fair value of all long-term debt of AFC and its subsidiaries exceeded carrying value by approximately $23 million. Fair values of debt instruments were calculated using quoted market prices where available and present values, discounted cash flows, or similar techniques in other cases. During 1993, GAHC entered into a new revolving credit agreement with several banks under which it can borrow up to $300 million. Borrowings bear interest at prime rate or at LIBOR plus 1.375% and are collateralized by a pledge of 50% of the stock of AFC's largest insurance subsidiary. The agreement converts to a four-year term loan in December 1996 and requires annual facility fees and commitment fees based upon the unused portion of the credit line. AFC guarantees amounts borrowed under the credit agreement. In connection with the acquisition of GALIC, AAG borrowed $180 million under a Bank Term Loan Agreement and $50 million under a Bridge Loan. In 1993, AAG sold $225 million principal amount of Notes to the public and used the proceeds to pay off the Bank and Bridge Loan. Unamortized debt issue costs of $4.6 million (net of minority interest) were written off and are included in extraordinary items. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFEI redeemed its 13-7/8% Notes and paid $40 million of bank debt with the proceeds from the sale of shares of American Premier in August 1993. Subsequently, AFEI entered into a new revolving credit agreement which enables it to borrow a maximum of $20 million through December 1997. Cash interest payments of $133 million, $206 million and $221 million were made on long-term debt in 1993, 1992 and 1991, respectively. I. Capital Subject to Mandatory Redemption Capital subject to mandatory redemption includes AFC's Mandatory Redeemable Preferred Stock and capital subject to a put option. Mandatory Redeemable Preferred Stock The outstanding shares of Mandatory Redeemable Preferred Stock are nonvoting, cumulative and consist of the following: Series E, $10.50 par value - authorized 2,725,000 shares; annual dividends per share $1; to be retired at par in 1994 and 1995; 504,711 shares (stated value - $5.3 million) outstanding at December 31, 1993 and 1992. Series I, $.01 par value - authorized 700,000 shares; annual dividends per share $2.66 in 1993; redeemable at $28 per share; 150,212 shares (stated value - $4.2 million) and 225,318 shares (stated value - $6.3 million) outstanding at December 31, 1993 and 1992, respectively. The fair market value of AFC's Mandatory Redeemable Preferred Stock approximates stated value. In February 1994, AFC redeemed the outstanding shares of Series I Preferred Stock. Approximately 45% of the Series E Preferred Stock is scheduled to be retired in December 1994; the balance is to be retired in December 1995. During 1993, AFC purchased 75,106 shares of Series I Preferred Stock for approximately $2.1 million. During 1992, AFC purchased 680,369, 115,500 and 75,105 shares of Series D, Series E and Series I Preferred Stock, respectively, for approximately $10.4 million. During 1991, AFC purchased 679,689 shares of Series D Preferred Stock for approximately $7.1 million. Capital Subject to Put Option Under an agreement entered into in 1983, certain members of the Lindner family (the "Group") who, in the aggregate, owned 1,848,235 shares of AFC Common Stock, were granted options to purchase an additional 1,225,000 shares. The options, which expire two years after the death of Robert D. Lindner, are exercisable at $6.65 per share plus $.40 per share per year from April 1983. Holders have the right to "put" to AFC any shares of AFC Common Stock or options at any time at a price equal to AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFC's book value per share, adjusted to reflect all equity securities (including investees and subsidiaries with publicly traded shares) at market prices. The purchase price is to be paid one-third in cash and the balance in a five-year installment note bearing interest at a rate equal to the five- year U.S. Treasury note rate plus 3%. AFC has the right to "call" any AFC shares owned by the Group after Robert D. Lindner's death at the same price as described under the "put" (but not less than $6.65 per share plus 10% compounded annually from April 1983). Further, AFC has a right of first refusal on shares owned by members of the Group. At December 31, 1993, the Group owned 1,533,767 shares of AFC Common Stock and options to purchase an additional 762,500 shares. The aggregate purchase price for all shares covered by the put is included in "capital subject to mandatory redemption" and amounted to $40 million and $16 million at December 31, 1993 and 1992, respectively. Changes in the aggregate purchase price are charged or credited directly to retained earnings without affecting earnings. J. Other Preferred Stock Under provisions of both the Nonvoting (55,800,000 shares authorized, including the redeemable issues) and Voting (3,500,000 shares authorized, none outstanding) Cumulative Preferred Stock, the Board of Directors is authorized to divide the authorized stock into series and to set specific terms and conditions of each series. The outstanding shares of Nonvoting Cumulative Preferred Stock, excluding those that are mandatorily redeemable, consist of the following: Series F, $1 par value - authorized 15,000,000 shares; annual dividends per share $1.80; 10% annually may be retired at AFC's option at $20 per share from 1994 to 1996; 13,753,254 shares (stated value - $168.0 million) outstanding at December 31, 1993 and 1992. Series G, $1 par value - authorized 2,000,000 shares; annual dividends per share $1.05; may be retired at AFC's option at $10.50 per share; 364,158 shares (stated value - $600,000) outstanding at December 31, 1993 and 1992. In 1992 and 1991, AFC sold 1.0 million and 1.4 million shares of Series F Preferred Stock to its ESORP for $15.0 million and $19.4 million in cash, respectively. K. Common Stock At December 31, 1993, Carl H. Lindner and certain members of the Lindner family owned all of the outstanding Common Stock of AFC (18,971,217 shares, including 1,533,767 shares subject to a put option as described in Note I). Of the 32,300,000 authorized shares of Common Stock at December 31, 1993, 762,500 shares were reserved for issuance upon exercise of options. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED L. Income Taxes The following is a reconciliation of income taxes at the statutory rate of 35% in 1993 and 34% in 1992 and 1991 and income taxes as shown in the Statement of Operations (in thousands): Adjusted earnings (loss) before income taxes consisted of the following (in thousands): 1993 1992 1991 Subject to tax in: United States $255,682($144,854) ($ 45,020) Foreign jurisdictions 1,744 - 187,065 $257,426($144,854) $142,045 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The total income tax provision consists of (in thousands): The 1993 provision for income tax includes a $15 million first quarter benefit due to American Premier's revision of estimated future taxable income likely to be generated during the company's tax loss carryforward period. The components of the provision for deferred income taxes for 1991 were (in millions): Undistributed earnings of subsidiaries and investees $19.6 Losses not utilized 20.5 Insurance underwriting adjustments (16.3) Investment income (16.2) Disposition of assets 35.9 Book value incentive plan (11.9) Other (5.4) $26.2 For income tax purposes, certain members of the AFC consolidated tax group had approximately $180 million of operating loss carryforwards available at December 31, 1993. The carryforwards are scheduled to expire as follows: $23 million in 1994, $9 million in 1995 through 2000 and $148 million in 2001 through 2005. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The cumulative effect of implementing SFAS No. 109 in 1992, which resulted from giving recognition to previously unrecognized tax benefits, was income of $85.4 million. This income consisted of a charge of $40 million related to members of the AFC tax group and a benefit of $125.4 million for AFC's share of American Premier's accounting change. Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities for AFC's tax group included in the Balance Sheet at December 31, were as follows (in millions): The gross deferred tax asset was reduced by a valuation allowance based on an analysis of the likelihood of realization. Factors considered in assessing the need for a valuation allowance include: (i) recent tax returns, which show neither a history of large amounts of taxable income nor cumulative losses in recent years, (ii) opportunities to generate taxable income from sales of appreciated assets, and (iii) the likelihood of generating larger amounts of taxable income in the future. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known. Cash payments for income taxes, net of refunds, were $49.6 million, $9.6 million and $41.2 million for 1993, 1992 and 1991, respectively. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED M. Discontinued Operations In December 1991, AFC sold Hunter Savings Association to Provident Bancorp (an affiliate) for approximately $67.9 million in Provident Bancorp securities and $834,000 in cash. Prior to the sale, Hunter paid AFC a dividend of approximately $26.8 million in cash. Discontinued operations for 1991 consisted of the following (in thousands): Gain Operations on Sale Pretax Earnings $17,683 $5,652 Tax (5,617) (1,922) Net Earnings $12,066 $3,730 N. Pending Legal Proceedings Counsel has advised AFC that there is little likelihood of any substantial liability being incurred from any litigation pending against AFC and subsidiaries. O. Benefit Plans AFC expensed ESORP contributions of $8.9 million in 1993, $7.4 million in 1992 and $7.5 million in 1991. Other operating and general expenses include a charge of $1 million in 1993, a credit of $1 million in 1992 and a charge of $38 million in 1991 for units outstanding under AFC's Book Value Incentive Plan. In 1993, AFC began accruing postretirement benefits over the period the employees qualify for such benefits. Expense for 1993 was $3.1 million. Prior to this change, costs were charged to expense as incurred. P. Transactions With Affiliates Various business has been transacted among AFC and its subsidiaries over the past several years, including rentals, data processing services, accounting services, investment management services, loans, leases, insurance, advertising and sales of assets. Unless otherwise disclosed, none of these transactions had a material effect on the net earnings or equity of AFC. Aggregate charges for these services within AFC and its subsidiaries have been insignificant in relation to consolidated revenues. In addition, AFC and its subsidiaries have had certain of the above types of transactions with certain of AFC's officers and directors and with business entities owned by them. Charges for such services have been less than one percent of consolidated revenues in 1993, 1992 and 1991. In 1993 AFC sold stock of an affiliate to certain of its officers and employees for $1.8 million in cash and $270,000 in 5.25% unsecured notes due in five equal annual installments beginning in 1996. In 1991, The Provident Bank purchased a $5 million loan to an AFC resort real estate subsidiary from an unrelated bank. The loan is secured by the subsidiary's property and is guaranteed by AFC. At December 31, 1993, $452,000 is owed to Provident under the loan. Members of the Lindner family are majority owners of Provident's parent. Except as noted otherwise, all of the above transactions have taken place at approximate market rates or values and, in the opinion of management, all amounts are fully collectible. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Q. Quarterly Operating Results (Unaudited) The operations of certain of AFC's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornados, etc.) may be seasonal. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. The following are quarterly results of consolidated operations for the two years ended December 31, 1993 (in millions). See Note B for changes in ownership of companies whose revenues are included in the consolidated operating results and for the effects of gains on sales of subsidiaries in individual quarters. Following American Premier's announcement in May 1993 that it was committed to sell its Federal Systems segment, AFC classified the operations of this business as "discontinued" for the periods American Premier was accounted for as a subsidiary. These operations have been classified as "continuing" operations below since the amounts were not material ($1.4 million in the first quarter of 1993 and $1.5 million, $1.5 million and $1.4 million in the first three quarters of 1992). In addition, AAG's $5.2 million (pretax before minority interest) writeoff of debt issue costs in the third quarter of 1993 has been reclassified as "extraordinary". Realized gains (losses) on sales of securities and charges for possible losses on investments for the respective quarters amounted to (in millions): New insurance regulations requiring rate rollbacks are being implemented in California as a result of the 1988 ballot initiative, Proposition 103. GAI has not received a rollback assessment and management believes an ultimate liability, if any, cannot be estimated. Since it is not probable that GAI will pay a material premium refund, no provision has been made in the financial statements for a potential liability. In the normal course of business, AFC's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty premium income accounts in connection with reinsurance ceded, (ii) amounts included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses. 1993 1992 1991 Reinsurance ceded $422 $278 $284 Reinsurance assumed: From companies under management contract 63 17 8 Other, primarily non-voluntary pools and associations 61 117 55 Reinsurance recoveries 343 151 109 The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. The aggregate fair value of all annuity liabilities, net of deferred policy acquisition costs, at December 31, 1993, approximates the amounts recorded in the financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, AFC and its subsidiaries enter into financial instrument transactions which may present off-balance-sheet risks, of both credit and market risk nature. These transactions include interest rate swaps and collars, commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. Market risk arises from the possibility that interest and exchange rate movements may make financial instruments less valuable or more onerous. Credit risk arises from the possibility of failure of another party to perform according to the terms of a contract. Appropriate collateral, credit analysis and other control procedures are considered in the light of circumstances of individual situations to minimize risk. Management does not anticipate any material adverse effect on its financial position resulting from involvement in these instruments. At December 31, 1993, AFC and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totalling $35 million at December 31, 1993. S. Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFC's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. The maximum amount of dividends payable in 1994 from GAI based on its 1993 earned surplus is approximately $108 million. Total "restrictions" on intercompany transfers from AFC's subsidiaries cannot be quantified due to the discretionary nature of the restrictions. T. Subsequent Event (Unaudited) In February 1994, American Premier announced that it was considering a proposal from AFC to purchase GAI's personal lines business (primarily insurance of private passenger automobiles and residential property) for $380 million. These operations had earned premiums of $342 million in 1993 and represented approximately 25% of the premiums earned by all of GAI's insurance operations. The purchase would include the transfer of a portfolio of principally investment grade securities with a market value of approximately $450 million. The estimated net book value (GAAP basis) of the business to be transferred would be approximately $200 million. PART IV ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note Q to the Consolidated Financial Statements. B. Schedules filed herewith for 1993, 1992 and 1991: Page II - Amounts Receivable from Related Parties and Under- writers, Promoters, and Employees other than Related Parties S-2 III - Condensed Financial Information of Registrant S-4 XIV - Supplemental Information Concerning Property-Casualty Insurance Operations S-6 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. C. The annual report on Form 10-K of American Premier Underwriters, Inc. (File No. 1-1569) for the period ended December 31, 1993, is hereby incorporated by reference. Copies of this Annual Report on Form 10-K and all subsequent reports filed pursuant to Section 13 of the Securities Exchange Act of 1934 may be obtained from the Commission's principal office at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of the fees prescribed by the rules and regulations of the Commission or may be examined without charge at Room 1024 of the Commission's public reference facilities at the same address. Copies of material filed with the Commission may also be inspected at the following regional offices: 500 West Madison Street, Suite 1400, Chicago, Illinois 60661; and 7 World Trade Center, New York, New York 10048. 3. Exhibits - see Exhibit Index on page E-1. (b) Reports on Form 8-K: Date of Report Items Reported February 23, 1994 1. Exchange Offer for AFC Debentures 2. Proposal to sell personal lines business to American Premier March 17, 1994 1. Amended Exchange Offer terms 2. Call for redemption of 13-1/2% Debentures AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION - PARENT ONLY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE XIV - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS) INDEX TO EXHIBITS AMERICAN FINANCIAL CORPORATION Number Exhibit Description 3 Articles of Incorporation and Code of Regulations, filed as Exhibit 3 to AFC's Form 10-K for 1988. * 4 Instruments defining the The rights of holders of rights of security holders. Registrant's Preferred Stock are defined in the Articles of Incorporation. Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and consolidated subsidiaries. Management Contracts: 10(a) Book Value Incentive Plan, filed as Exhibit 10(a) to AFC's Form 10-K for 1983. * 10(b) Option Agreement, filed as Exhibit 10(b) to AFC's Form 10-K for 1983. * 10(c) Nonqualified ESORP Plan, filed as Exhibit 10(e) to AFC's Form 10-K for 1989. * 12 Computation of ratios of earnings to fixed charges and fixed charges and preferred dividends. 21 Subsidiaries of the Registrant. 28 Information from reports furnished to state insurance regulatory authorities. 99 Form 10-K of American Premier Underwriters, Inc. for 1993. () Incorporated herein by reference. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES EXHIBIT 12 - COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES AND FIXED CHARGES AND PREFERRED DIVIDENDS (Dollars in Thousands) AMERICAN FINANCIAL CORPORATION EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT The following is a list of subsidiaries of AFC at December 31, 1993. All corporations are subsidiaries of AFC and, if indented, subsidiaries of the company under which they are listed. Percentage of State of Common Equity Name of Company Incorporation Ownership American Financial Enterprises, Inc. Connecticut 83% Great American Holding Corporation Ohio 100 Great American Insurance Company Ohio 100 American Annuity Group, Inc. Delaware 80 Great American Life Insurance Company Ohio 100 American Empire Surplus Lines Insurance Company Delaware 100 American National Fire Insurance Company New York 100 Great American Management Services, Inc. Ohio 100 Mid-Continent Casualty Company Oklahoma 100 Stonewall Insurance Company Alabama 100 Transport Insurance Company Ohio 100 The names of certain subsidiaries are omitted, as such subsidiaries in the aggregate would not constitute a significant subsidiary. See Part I, Item 1 of this Report for a description of certain companies in which AFC owns a significant portion and accounts for under the equity method. AMERICAN FINANCIAL CORPORATION EXHIBIT 28 - INFORMATION FROM REPORTS FURNISHED TO STATE INSURANCE REGULATORY AUTHORITIES Schedule P of Annual Statements A. CONSOLIDATED PROPERTY AND CASUALTY ENTITIES - See Attached Schedules Schedule P (prepared in accordance with the rules prescribed by the National Association of Insurance Commissioners) includes the reserves of AFC's consolidated property and casualty subsidiaries. The following is a summary of Schedule P reserves (in millions): GAI Insurance Group Schedule P - Part 1 Summary - col. 33 $1,823 - col. 34 321 Statutory Loss and Loss Adjustment Expense Reserves $2,144 B. UNCONSOLIDATED SUBSIDIARIES None C. 50% OR LESS OWNED PROPERTY AND CASUALTY INVESTEES Not Included Information for American Premier Underwriters, Inc. for 1993 is not included since that company files such information with the Commission as a registrant in its own right. Signatures Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Financial Corporation has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Financial Corporation Signed: March 28, 1994 BY:s/CARL H. LINDNER Carl H. Lindner Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Capacity Date s/CARL H. LINDNER Chairman of the Board March 28, 1994 Carl H. Lindner of Directors s/ROBERT D. LINDNER Director March 28, 1994 Robert D. Lindner s/RONALD F. WALKER Director March 28, 1994 Ronald F. Walker s/FRED J. RUNK Vice President and March 28, 1994 Fred J. Runk Treasurer (principal financial and accounting officer) * Member of the Audit Committee ITEM 10 Directors and Executive Officers of the Registrant The directors and executive officers of AFC at March 1, 1994, are: Executive Name Age Position Since Carl H. Lindner 74 Chairman of the Board and Chief 1959 Executive Officer Richard E. Lindner 72 Director 1959 Robert D. Lindner 73 Vice Chairman of the Board 1959 Ronald F. Walker 55 Director, President and Chief 1973 Operating Officer Carl H. Lindner III 40 President of GAI and President 1987 and Chief Operating Officer of American Premier S. Craig Lindner 39 President of AAG and Senior Executive Vice President of AMM James E. Evans 48 Vice President and General Counsel Sandra W. Heimann 51 Vice President 1984 Robert C. Lintz 60 Vice President 1979 Thomas E. Mischell 46 Vice President 1985 Fred J. Runk 51 Vice President and Treasurer 1978 Carl H. Lindner has served as Chairman of the Board and Chief Executive Officer of AFC for more than five years. He serves in similar capacities with various AFC subsidiaries. He serves as Chairman of the Board of the following public companies: American Annuity Group, Inc. ("AAG"), American Financial Enterprises, Inc. ("AFEI"), Chiquita, General Cable, Great American Communications Company ("GACC") and American Premier. AFC owns a substantial beneficial interest (over 20%) in all of these companies. Richard E. Lindner is owner, Chairman of the Board of Directors, President and Chief Executive Officer of Thriftway, Inc., a supermarket chain otherwise unaffiliated with AFC, and has been associated with that company for over five years. Robert D. Lindner, for more than five years, has served as Vice Chairman of the Board of Directors of AFC. In addition, he is Chairman of the Board of United Dairy Farmers, Inc. ("UDF") which, among other things, is engaged through subsidiaries in dairy processing and the operation of convenience stores. He is also a director of AFEI. Ronald F. Walker has served as President and Chief Operating Officer of AFC for more than five years. He is also Vice Chairman of the Board of Directors of GAI and holds executive positions in most of AFC's other subsidiaries. He is also a director of AAG, AFEI, Chiquita, General Cable and Tejas Gas Company. Carl H. Lindner III has been President of GAI for more than five years. He holds executive positions in many of GAI's subsidiaries. He has also been President and Chief Operating Officer of American Premier since 1991. S. Craig Lindner has been Senior Executive Vice President of American Money Management Corporation ("AMM"), a subsidiary of AFC which provides investment services to AFC and its subsidiaries, for more than five years. He was elected President of AAG in March 1993. James E. Evans has served as a Vice President and the General Counsel of AFC for more than five years. Sandra W. Heimann has been a Vice President of AFC and an executive officer of AMM for more than five years. Robert C. Lintz has been a Vice President of AFC for more than five years. Thomas E. Mischell has been a Vice President of AFC for more than five years. Fred J. Runk has served as Vice President and Treasurer of AFC for more than five years. Carl H. Lindner, Robert D. Lindner and Richard E. Lindner are brothers. Carl H. Lindner III and S. Craig Lindner are sons of Carl H. Lindner. All of the executive officers of AFC devote substantially all of their time to the affairs of AFC and its subsidiaries. All of the above are United States citizens. The information required by the following Items will be provided within 120 days after end of Registrant's fiscal year. ITEM 11 ITEM 11 Executive Compensation ITEM 12 ITEM 12 Security Ownership of Certain Beneficial Owners and Management ITEM 13 ITEM 13 Certain Relationships and Related Transactions REPORTS OF INDEPENDENT AUDITORS Board of Directors American Financial Corporation We have audited the accompanying consolidated balance sheets of American Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in capital accounts, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements of American Premier Underwriters, Inc. (formerly The Penn Central Corporation), General Cable Corporation and American Annuity Group, Inc. (1991). Those statements were audited by other auditors whose reports have been furnished to us. The reports pertaining to the statements of General Cable Corporation and American Premier Underwriters, Inc. included explanatory paragraphs that described their change in method of accounting for income taxes in 1992. Our opinion on the consolidated financial statements and schedules, insofar as it relates to data included for those corporations as described in Note E, is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, American Financial Corporation and subsidiaries changed their method of accounting in 1993 for certain investments in debt and equity securities and in 1992 for income taxes. ERNST & YOUNG Cincinnati, Ohio March 25, 1994 REPORT OF AMERICAN PREMIER'S INDEPENDENT AUDITORS American Premier Underwriters, Inc. (formerly The Penn Central Corporation): We have audited the financial statements and the financial statement schedules of American Premier Underwriters, Inc. and Consolidated Subsidiaries listed in the Index to Financial Statements and Financial Statement Schedules of American Premier Underwriters, Inc.'s Form 10-K for the year ended December 31, 1993 (included as Exhibit 99 herein). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of American Premier Underwriters, Inc. and Consolidated Subsidiaries at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Note 1 to the financial statements, in 1992 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 16, 1994 (March 25, 1994 with respect to the change of the Company's name as discussed in Note 1 to American Premier's financial statements) REPORT OF GENERAL CABLE'S INDEPENDENT AUDITORS General Cable Corporation: We have audited the consolidated financial statements and related schedules of General Cable Corporation and subsidiaries listed in Item 14(a) of the Annual Report on Form 10-K of General Cable Corporation for the year ended December 31, 1993 (not presented separately herein). These consolidated financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of General Cable Corporation and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 1 and 10 to the consolidated financial statements, in 1992 General Cable Corporation changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Cincinnati, Ohio February 18, 1994 REPORT OF AMERICAN ANNUITY'S INDEPENDENT AUDITORS American Annuity Group, Inc.: We have audited the consolidated balance sheet of American Annuity Group, Inc., formerly Sprague Technologies, Inc., and subsidiaries as of December 31, 1991 and the related consolidated statements of operations, common stockholders' equity and cash flows for the year then ended (before adjustments and reclassifications to conform with the presentation for 1992). Our audit also included the 1991 financial statement schedule listed in the Index at Item 14(a) of American Annuity Group, Inc's. Form 10-K for the year ended December 31, 1993 (not presented separately herein). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements (before adjustments and reclassifications to conform with the presentation for 1992) present fairly, in all material respects, the financial position of American Annuity Group, Inc. and subsidiaries as of December 31, 1991 and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Stamford, Connecticut March 24, 1992 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Thousands) December 31, 1993 1992 Assets Cash and short-term investments $ 167,950 $ 837,429 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,959,400 and $4,705,600) 3,788,732 4,597,544 Available for sale - at market (amortized cost - $2,216,328 and $1,905,814) 2,349,528 1,976,514 Other stocks - principally at market (cost - $207,056 and $182,476) 339,156 230,876 Investment in investee corporations 899,800 568,207 Bonds and receivables from investees 6,783 305,701 Loans receivable 624,149 812,436 Real estate and other investments 139,319 179,152 8,147,467 8,670,430 Recoverables from reinsurers and prepaid reinsurance premiums 756,060 599,204 Trade receivables 298,240 594,834 Other receivables 213,507 318,799 Property, plant and equipment, net 44,950 215,851 Deferred tax asset - 258,300 Prepaid expenses, deferred charges and other assets 275,349 394,319 Cost in excess of net assets acquired 173,965 499,639 $10,077,488 $12,388,805 Liabilities and Capital Insurance claims and reserves $ 3,422,657 $ 4,279,853 Annuity policyholders' funds accumulated 4,256,674 3,973,524 Long-term debt: Parent company 571,874 557,161 American Premier - 657,800 Other subsidiaries 482,132 794,217 Accounts payable, accrued expenses and other liabilities 648,462 1,005,866 Minority interest 109,219 812,707 9,491,018 12,081,128 Capital subject to mandatory redemption 49,232 27,683 Preferred Stock (redemption value - $278,889) 168,588 168,588 Common Stock without par value 904 904 Retained earnings 210,846 42,402 Net unrealized gain on marketable securities, net of deferred income taxes 156,900 68,100 $10,077,488 $12,388,805 See notes to consolidated financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN CAPITAL ACCOUNTS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INDEX TO NOTES A. Accounting Policies B. Acquisitions and Sales of Subsidiaries C. Segments of Operations D. Investments E. Investment in Investee Corporations F. Property, Plant and Equipment G. Cost in Excess of Net Assets Acquired H. Long-Term Debt I. Capital Subject to Mandatory Redemption J. Other Preferred Stock K. Common Stock L. Income Taxes M. Discontinued Operations N. Pending Legal Proceedings O. Benefit Plans P. Transactions With Affiliates Q. Quarterly Operating Results (Unaudited) R. Additional Information S. Restrictions on Transfer of Funds and Assets of Subsidiaries T. Subsequent Event (Unaudited) A. Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of American Financial Corporation ("AFC") and its subsidiaries except for Hunter Savings Association which was sold in the fourth quarter of 1991 and is presented in the financial statements as "discontinued operations". Changes in ownership levels of other subsidiaries and investees have resulted in certain differences in the financial statements and have affected comparability between years. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. AFC's ownership of subsidiaries and significant investees with publicly traded shares at December 31, was as follows: AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED D. Investments Bonds, redeemable preferred stocks and other stocks at December 31, consisted of the following (in millions): The table below sets forth the scheduled maturities of bonds and redeemable preferred stocks based on carrying value as of December 31, 1993. Data based on market value is generally the same. Collateralized mortgage obligations have an average life of approximately 4 years at December 31, 1993. Held to Available Maturity Maturity for Sale One year or less 1% 1% After one year through five years 7 5 After five years through ten years 18 13 After ten years 55 31 81 50 Collateralized mortgage obligations 19 50 100% 100% AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Gross gains of $69.4 million, $85.2 million and $208.8 million and gross losses of $16.5 million, $4.7 million and $236.9 million were realized on sales of fixed maturity investments during 1993, 1992 and 1991, respectively. Realized gains (losses) and changes in unrealized appreciation (depreciation) on fixed maturity and equity security investments are summarized as follows (in thousands): Investment in other stocks at December 31, 1992 consisted of (in thousands): At December 31, 1992, gross unrealized gains on other stocks were $63.7 million and gross unrealized losses were $15.1 million. Carrying values of investments were determined after deducting cumulative provisions for impairment aggregating $47 million and $78 million at December 31, 1993 and 1992, respectively. Fair values for investments are based on prices quoted, when available, in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, fair values of comparable securities, or similar methods. Short-term investments are carried at cost; loans receivable are stated at the aggregate unpaid balance. Carrying amounts of these investments approximate their fair value. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED E. Investment in Investee Corporations Investment in investee corporations represents AFC's ownership of securities of certain companies. All of the companies named in the following table are subject to the rules and regulations of the SEC. Market value of the investments (excluding $50 million in non-public securities at December 31, 1992, for which market values are not available) was approximately $940 million and $700 million at December 31, 1993 and 1992, respectively. AFC's investment (and common stock ownership percentage) and equity in net earnings and losses of investees are stated below (dollars in thousands): American Premier operates businesses primarily in specialty property and casualty insurance. In March 1994, American Premier changed its name from The Penn Central Corporation to reflect the nature of its business. Chiquita is a leading international marketer, processor and producer of quality fresh and processed food products. GACC is engaged in the ownership and operation of television and radio stations. General Cable primarily manufactures and markets electrical and communication wire and cable products. Due to GACC's financial difficulties, AFC transferred all GACC securities and loans to the investee account and reduced the carrying value of that investment to estimated net realizable value ($35 million) at the end of 1992. AFC resumed equity accounting for its investment in GACC following GACC's reorganization at the end of 1993. In July 1992, American Premier distributed to its shareholders approximately 88% of the stock of General Cable. AFC and its subsidiaries, excluding American Premier, received approximately 45% of the shares. The shares retained by American Premier are being held for distribution to creditors and other persons. Accordingly, those shares were included in "Other stocks" at December 31, 1992 and AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED General Cable was not consolidated because control was temporary. The operating results of General Cable for the first six months of 1992 are included in other income. Sprague reported net losses of $29 million in 1992 and $53 million in 1991. Over the past few years, Sprague sold substantially all of its operating businesses and recorded substantial restructuring charges and loss provisions ($25 million in 1992 and $55 million in 1991). Included in AFC's consolidated retained earnings at December 31, 1993, was approximately $145 million applicable to equity in undistributed net losses of investees. The unamortized negative goodwill in investees totaled approximately $62 million at December 31, 1993. Summarized financial information for AFC's major investees at December 31, 1993, is shown below (in millions). See "Investee Corporations" in Management's Discussion and Analysis. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Great American Communications 1993 1992 1991 Contracts, Broadcasting Licenses and Other Intangibles $575 $540 Other Assets 145 174 Long-term Debt 433 635 Minority Interest - Preferred Stock of Subsidiary - 275 Shareholders' Equity (Deficit) 139 (339) Net Revenues of Continuing Operations $205 $211 $202 Operating Income (Loss) 40 (642) 12 Loss from Continuing Operations (67) (613) (33) Discontinued Operations - 11 40 Extraordinary Items 408 5 77 Net Income (Loss) 341 (597) 84 General Cable Corporation Six Year months ended ended 12/31/93 12/31/92 Current Assets $338 $366 Non-current Assets 282 345 Current Liabilities 110 159 Notes Payable to American Premier 287 255 Non-current Liabilities 83 78 Shareholders' Equity 140 219 Net Sales from Continuing Operations $764 $416 Operating Income (Loss) 2 (29) Loss From Continuing Operations (26) (53) Discontinued Operations (32) - Net Loss (58) (53) General Cable's 1993 results included a $34.4 million loss on the disposal of its equipment manufacturing businesses. AFC's share of this loss reduced negative goodwill and was not included in AFC's equity in General Cable's earnings. General Cable's results for the first six months of 1992 (prior to its spin-off from American Premier) are included in American Premier's results. F. Property, Plant and Equipment Property, plant and equipment consisted of the following at December 31, (in thousands): 1993 1992 Land $ 3,654 $ 33,487 Buildings and improvements 21,493 96,523 Machinery, equipment and office furnishings 89,329 278,805 Other - 46,622 114,476 455,437 Less accumulated depreciation (69,526) (239,586) $ 44,950 $215,851 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED G. Cost in Excess of Net Assets Acquired At December 31, 1993 and 1992, accumulated amortization of the excess of cost over net assets of purchased subsidiaries amounted to approximately $94 million and $176 million, respectively. Amortization expense was $15.0 million in 1993, $25.0 million in 1992 and $37.2 million in 1991. H. Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands): AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED At December 31, 1993, sinking fund and other scheduled principal payments on debt for the subsequent five years were as follows (in thousands): Parent Other Company Subsidiaries Total 1994 $12,080 $ 3,669 $ 15,749 1995 10,883 63,050 73,933 1996 11,843 1,064 12,907 1997 17,818 15,667 33,485 1998 19,223 158,821 178,044 In February 1994, AFC commenced an offer to issue new 9-3/4% Debentures due April 20, 2004 and cash in exchange for its publicly traded debentures. In December 1993, AFC wrote off $24.3 million in unamortized original issue discount and debt issue costs related to the debentures covered in the exchange offer. Based on the results of this offer and cash availability, AFC will redeem some or all of the unexchanged debentures. In March 1994, AFC called for redemption its 13-1/2% Debentures and its 13-1/2% Series A Debentures. Holders of either issue may accept the Exchange Offer. Parent company sinking fund and other scheduled principal payments on debt at December 31, 1993, assuming at least 50% of each issue of the old debentures are exchanged, would be as follows (in thousands): 1994 1995 1996 1997 1998 $3,231 $261 $261 $5,493 $261 AFC may, at its option, apply debentures otherwise purchased in excess of scheduled payments to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures purchased are applied to the earliest scheduled retirements. At December 31, 1993, the estimated fair value of all long-term debt of AFC and its subsidiaries exceeded carrying value by approximately $23 million. Fair values of debt instruments were calculated using quoted market prices where available and present values, discounted cash flows, or similar techniques in other cases. During 1993, GAHC entered into a new revolving credit agreement with several banks under which it can borrow up to $300 million. Borrowings bear interest at prime rate or at LIBOR plus 1.375% and are collateralized by a pledge of 50% of the stock of AFC's largest insurance subsidiary. The agreement converts to a four-year term loan in December 1996 and requires annual facility fees and commitment fees based upon the unused portion of the credit line. AFC guarantees amounts borrowed under the credit agreement. In connection with the acquisition of GALIC, AAG borrowed $180 million under a Bank Term Loan Agreement and $50 million under a Bridge Loan. In 1993, AAG sold $225 million principal amount of Notes to the public and used the proceeds to pay off the Bank and Bridge Loan. Unamortized debt issue costs of $4.6 million (net of minority interest) were written off and are included in extraordinary items. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFEI redeemed its 13-7/8% Notes and paid $40 million of bank debt with the proceeds from the sale of shares of American Premier in August 1993. Subsequently, AFEI entered into a new revolving credit agreement which enables it to borrow a maximum of $20 million through December 1997. Cash interest payments of $133 million, $206 million and $221 million were made on long-term debt in 1993, 1992 and 1991, respectively. I. Capital Subject to Mandatory Redemption Capital subject to mandatory redemption includes AFC's Mandatory Redeemable Preferred Stock and capital subject to a put option. Mandatory Redeemable Preferred Stock The outstanding shares of Mandatory Redeemable Preferred Stock are nonvoting, cumulative and consist of the following: Series E, $10.50 par value - authorized 2,725,000 shares; annual dividends per share $1; to be retired at par in 1994 and 1995; 504,711 shares (stated value - $5.3 million) outstanding at December 31, 1993 and 1992. Series I, $.01 par value - authorized 700,000 shares; annual dividends per share $2.66 in 1993; redeemable at $28 per share; 150,212 shares (stated value - $4.2 million) and 225,318 shares (stated value - $6.3 million) outstanding at December 31, 1993 and 1992, respectively. The fair market value of AFC's Mandatory Redeemable Preferred Stock approximates stated value. In February 1994, AFC redeemed the outstanding shares of Series I Preferred Stock. Approximately 45% of the Series E Preferred Stock is scheduled to be retired in December 1994; the balance is to be retired in December 1995. During 1993, AFC purchased 75,106 shares of Series I Preferred Stock for approximately $2.1 million. During 1992, AFC purchased 680,369, 115,500 and 75,105 shares of Series D, Series E and Series I Preferred Stock, respectively, for approximately $10.4 million. During 1991, AFC purchased 679,689 shares of Series D Preferred Stock for approximately $7.1 million. Capital Subject to Put Option Under an agreement entered into in 1983, certain members of the Lindner family (the "Group") who, in the aggregate, owned 1,848,235 shares of AFC Common Stock, were granted options to purchase an additional 1,225,000 shares. The options, which expire two years after the death of Robert D. Lindner, are exercisable at $6.65 per share plus $.40 per share per year from April 1983. Holders have the right to "put" to AFC any shares of AFC Common Stock or options at any time at a price equal to AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFC's book value per share, adjusted to reflect all equity securities (including investees and subsidiaries with publicly traded shares) at market prices. The purchase price is to be paid one-third in cash and the balance in a five-year installment note bearing interest at a rate equal to the five- year U.S. Treasury note rate plus 3%. AFC has the right to "call" any AFC shares owned by the Group after Robert D. Lindner's death at the same price as described under the "put" (but not less than $6.65 per share plus 10% compounded annually from April 1983). Further, AFC has a right of first refusal on shares owned by members of the Group. At December 31, 1993, the Group owned 1,533,767 shares of AFC Common Stock and options to purchase an additional 762,500 shares. The aggregate purchase price for all shares covered by the put is included in "capital subject to mandatory redemption" and amounted to $40 million and $16 million at December 31, 1993 and 1992, respectively. Changes in the aggregate purchase price are charged or credited directly to retained earnings without affecting earnings. J. Other Preferred Stock Under provisions of both the Nonvoting (55,800,000 shares authorized, including the redeemable issues) and Voting (3,500,000 shares authorized, none outstanding) Cumulative Preferred Stock, the Board of Directors is authorized to divide the authorized stock into series and to set specific terms and conditions of each series. The outstanding shares of Nonvoting Cumulative Preferred Stock, excluding those that are mandatorily redeemable, consist of the following: Series F, $1 par value - authorized 15,000,000 shares; annual dividends per share $1.80; 10% annually may be retired at AFC's option at $20 per share from 1994 to 1996; 13,753,254 shares (stated value - $168.0 million) outstanding at December 31, 1993 and 1992. Series G, $1 par value - authorized 2,000,000 shares; annual dividends per share $1.05; may be retired at AFC's option at $10.50 per share; 364,158 shares (stated value - $600,000) outstanding at December 31, 1993 and 1992. In 1992 and 1991, AFC sold 1.0 million and 1.4 million shares of Series F Preferred Stock to its ESORP for $15.0 million and $19.4 million in cash, respectively. K. Common Stock At December 31, 1993, Carl H. Lindner and certain members of the Lindner family owned all of the outstanding Common Stock of AFC (18,971,217 shares, including 1,533,767 shares subject to a put option as described in Note I). Of the 32,300,000 authorized shares of Common Stock at December 31, 1993, 762,500 shares were reserved for issuance upon exercise of options. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED L. Income Taxes The following is a reconciliation of income taxes at the statutory rate of 35% in 1993 and 34% in 1992 and 1991 and income taxes as shown in the Statement of Operations (in thousands): Adjusted earnings (loss) before income taxes consisted of the following (in thousands): 1993 1992 1991 Subject to tax in: United States $255,682($144,854) ($ 45,020) Foreign jurisdictions 1,744 - 187,065 $257,426($144,854) $142,045 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The total income tax provision consists of (in thousands): The 1993 provision for income tax includes a $15 million first quarter benefit due to American Premier's revision of estimated future taxable income likely to be generated during the company's tax loss carryforward period. The components of the provision for deferred income taxes for 1991 were (in millions): Undistributed earnings of subsidiaries and investees $19.6 Losses not utilized 20.5 Insurance underwriting adjustments (16.3) Investment income (16.2) Disposition of assets 35.9 Book value incentive plan (11.9) Other (5.4) $26.2 For income tax purposes, certain members of the AFC consolidated tax group had approximately $180 million of operating loss carryforwards available at December 31, 1993. The carryforwards are scheduled to expire as follows: $23 million in 1994, $9 million in 1995 through 2000 and $148 million in 2001 through 2005. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The cumulative effect of implementing SFAS No. 109 in 1992, which resulted from giving recognition to previously unrecognized tax benefits, was income of $85.4 million. This income consisted of a charge of $40 million related to members of the AFC tax group and a benefit of $125.4 million for AFC's share of American Premier's accounting change. Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities for AFC's tax group included in the Balance Sheet at December 31, were as follows (in millions): The gross deferred tax asset was reduced by a valuation allowance based on an analysis of the likelihood of realization. Factors considered in assessing the need for a valuation allowance include: (i) recent tax returns, which show neither a history of large amounts of taxable income nor cumulative losses in recent years, (ii) opportunities to generate taxable income from sales of appreciated assets, and (iii) the likelihood of generating larger amounts of taxable income in the future. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known. Cash payments for income taxes, net of refunds, were $49.6 million, $9.6 million and $41.2 million for 1993, 1992 and 1991, respectively. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED M. Discontinued Operations In December 1991, AFC sold Hunter Savings Association to Provident Bancorp (an affiliate) for approximately $67.9 million in Provident Bancorp securities and $834,000 in cash. Prior to the sale, Hunter paid AFC a dividend of approximately $26.8 million in cash. Discontinued operations for 1991 consisted of the following (in thousands): Gain Operations on Sale Pretax Earnings $17,683 $5,652 Tax (5,617) (1,922) Net Earnings $12,066 $3,730 N. Pending Legal Proceedings Counsel has advised AFC that there is little likelihood of any substantial liability being incurred from any litigation pending against AFC and subsidiaries. O. Benefit Plans AFC expensed ESORP contributions of $8.9 million in 1993, $7.4 million in 1992 and $7.5 million in 1991. Other operating and general expenses include a charge of $1 million in 1993, a credit of $1 million in 1992 and a charge of $38 million in 1991 for units outstanding under AFC's Book Value Incentive Plan. In 1993, AFC began accruing postretirement benefits over the period the employees qualify for such benefits. Expense for 1993 was $3.1 million. Prior to this change, costs were charged to expense as incurred. P. Transactions With Affiliates Various business has been transacted among AFC and its subsidiaries over the past several years, including rentals, data processing services, accounting services, investment management services, loans, leases, insurance, advertising and sales of assets. Unless otherwise disclosed, none of these transactions had a material effect on the net earnings or equity of AFC. Aggregate charges for these services within AFC and its subsidiaries have been insignificant in relation to consolidated revenues. In addition, AFC and its subsidiaries have had certain of the above types of transactions with certain of AFC's officers and directors and with business entities owned by them. Charges for such services have been less than one percent of consolidated revenues in 1993, 1992 and 1991. In 1993 AFC sold stock of an affiliate to certain of its officers and employees for $1.8 million in cash and $270,000 in 5.25% unsecured notes due in five equal annual installments beginning in 1996. In 1991, The Provident Bank purchased a $5 million loan to an AFC resort real estate subsidiary from an unrelated bank. The loan is secured by the subsidiary's property and is guaranteed by AFC. At December 31, 1993, $452,000 is owed to Provident under the loan. Members of the Lindner family are majority owners of Provident's parent. Except as noted otherwise, all of the above transactions have taken place at approximate market rates or values and, in the opinion of management, all amounts are fully collectible. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Q. Quarterly Operating Results (Unaudited) The operations of certain of AFC's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornados, etc.) may be seasonal. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. The following are quarterly results of consolidated operations for the two years ended December 31, 1993 (in millions). See Note B for changes in ownership of companies whose revenues are included in the consolidated operating results and for the effects of gains on sales of subsidiaries in individual quarters. Following American Premier's announcement in May 1993 that it was committed to sell its Federal Systems segment, AFC classified the operations of this business as "discontinued" for the periods American Premier was accounted for as a subsidiary. These operations have been classified as "continuing" operations below since the amounts were not material ($1.4 million in the first quarter of 1993 and $1.5 million, $1.5 million and $1.4 million in the first three quarters of 1992). In addition, AAG's $5.2 million (pretax before minority interest) writeoff of debt issue costs in the third quarter of 1993 has been reclassified as "extraordinary". Realized gains (losses) on sales of securities and charges for possible losses on investments for the respective quarters amounted to (in millions): New insurance regulations requiring rate rollbacks are being implemented in California as a result of the 1988 ballot initiative, Proposition 103. GAI has not received a rollback assessment and management believes an ultimate liability, if any, cannot be estimated. Since it is not probable that GAI will pay a material premium refund, no provision has been made in the financial statements for a potential liability. In the normal course of business, AFC's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty premium income accounts in connection with reinsurance ceded, (ii) amounts included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses. 1993 1992 1991 Reinsurance ceded $422 $278 $284 Reinsurance assumed: From companies under management contract 63 17 8 Other, primarily non-voluntary pools and associations 61 117 55 Reinsurance recoveries 343 151 109 The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. The aggregate fair value of all annuity liabilities, net of deferred policy acquisition costs, at December 31, 1993, approximates the amounts recorded in the financial statements. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, AFC and its subsidiaries enter into financial instrument transactions which may present off-balance-sheet risks, of both credit and market risk nature. These transactions include interest rate swaps and collars, commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. Market risk arises from the possibility that interest and exchange rate movements may make financial instruments less valuable or more onerous. Credit risk arises from the possibility of failure of another party to perform according to the terms of a contract. Appropriate collateral, credit analysis and other control procedures are considered in the light of circumstances of individual situations to minimize risk. Management does not anticipate any material adverse effect on its financial position resulting from involvement in these instruments. At December 31, 1993, AFC and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totalling $35 million at December 31, 1993. S. Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFC's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. The maximum amount of dividends payable in 1994 from GAI based on its 1993 earned surplus is approximately $108 million. Total "restrictions" on intercompany transfers from AFC's subsidiaries cannot be quantified due to the discretionary nature of the restrictions. T. Subsequent Event (Unaudited) In February 1994, American Premier announced that it was considering a proposal from AFC to purchase GAI's personal lines business (primarily insurance of private passenger automobiles and residential property) for $380 million. These operations had earned premiums of $342 million in 1993 and represented approximately 25% of the premiums earned by all of GAI's insurance operations. The purchase would include the transfer of a portfolio of principally investment grade securities with a market value of approximately $450 million. The estimated net book value (GAAP basis) of the business to be transferred would be approximately $200 million. PART IV ITEM 14 ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note Q to the Consolidated Financial Statements. B. Schedules filed herewith for 1993, 1992 and 1991: Page II - Amounts Receivable from Related Parties and Under- writers, Promoters, and Employees other than Related Parties S-2 III - Condensed Financial Information of Registrant S-4 XIV - Supplemental Information Concerning Property-Casualty Insurance Operations S-6 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. C. The annual report on Form 10-K of American Premier Underwriters, Inc. (File No. 1-1569) for the period ended December 31, 1993, is hereby incorporated by reference. Copies of this Annual Report on Form 10-K and all subsequent reports filed pursuant to Section 13 of the Securities Exchange Act of 1934 may be obtained from the Commission's principal office at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of the fees prescribed by the rules and regulations of the Commission or may be examined without charge at Room 1024 of the Commission's public reference facilities at the same address. Copies of material filed with the Commission may also be inspected at the following regional offices: 500 West Madison Street, Suite 1400, Chicago, Illinois 60661; and 7 World Trade Center, New York, New York 10048. 3. Exhibits - see Exhibit Index on page E-1. (b) Reports on Form 8-K: Date of Report Items Reported February 23, 1994 1. Exchange Offer for AFC Debentures 2. Proposal to sell personal lines business to American Premier March 17, 1994 1. Amended Exchange Offer terms 2. Call for redemption of 13-1/2% Debentures AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN FINANCIAL CORPORATION - PARENT ONLY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In Thousands) AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE XIV - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS) INDEX TO EXHIBITS AMERICAN FINANCIAL CORPORATION Number Exhibit Description 3 Articles of Incorporation and Code of Regulations, filed as Exhibit 3 to AFC's Form 10-K for 1988. * 4 Instruments defining the The rights of holders of rights of security holders. Registrant's Preferred Stock are defined in the Articles of Incorporation. Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and consolidated subsidiaries. Management Contracts: 10(a) Book Value Incentive Plan, filed as Exhibit 10(a) to AFC's Form 10-K for 1983. * 10(b) Option Agreement, filed as Exhibit 10(b) to AFC's Form 10-K for 1983. * 10(c) Nonqualified ESORP Plan, filed as Exhibit 10(e) to AFC's Form 10-K for 1989. * 12 Computation of ratios of earnings to fixed charges and fixed charges and preferred dividends. 21 Subsidiaries of the Registrant. 28 Information from reports furnished to state insurance regulatory authorities. 99 Form 10-K of American Premier Underwriters, Inc. for 1993. () Incorporated herein by reference. AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES EXHIBIT 12 - COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES AND FIXED CHARGES AND PREFERRED DIVIDENDS (Dollars in Thousands) AMERICAN FINANCIAL CORPORATION EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT The following is a list of subsidiaries of AFC at December 31, 1993. All corporations are subsidiaries of AFC and, if indented, subsidiaries of the company under which they are listed. Percentage of State of Common Equity Name of Company Incorporation Ownership American Financial Enterprises, Inc. Connecticut 83% Great American Holding Corporation Ohio 100 Great American Insurance Company Ohio 100 American Annuity Group, Inc. Delaware 80 Great American Life Insurance Company Ohio 100 American Empire Surplus Lines Insurance Company Delaware 100 American National Fire Insurance Company New York 100 Great American Management Services, Inc. Ohio 100 Mid-Continent Casualty Company Oklahoma 100 Stonewall Insurance Company Alabama 100 Transport Insurance Company Ohio 100 The names of certain subsidiaries are omitted, as such subsidiaries in the aggregate would not constitute a significant subsidiary. See Part I, Item 1 of this Report for a description of certain companies in which AFC owns a significant portion and accounts for under the equity method. AMERICAN FINANCIAL CORPORATION EXHIBIT 28 - INFORMATION FROM REPORTS FURNISHED TO STATE INSURANCE REGULATORY AUTHORITIES Schedule P of Annual Statements A. CONSOLIDATED PROPERTY AND CASUALTY ENTITIES - See Attached Schedules Schedule P (prepared in accordance with the rules prescribed by the National Association of Insurance Commissioners) includes the reserves of AFC's consolidated property and casualty subsidiaries. The following is a summary of Schedule P reserves (in millions): GAI Insurance Group Schedule P - Part 1 Summary - col. 33 $1,823 - col. 34 321 Statutory Loss and Loss Adjustment Expense Reserves $2,144 B. UNCONSOLIDATED SUBSIDIARIES None C. 50% OR LESS OWNED PROPERTY AND CASUALTY INVESTEES Not Included Information for American Premier Underwriters, Inc. for 1993 is not included since that company files such information with the Commission as a registrant in its own right. Signatures Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Financial Corporation has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Financial Corporation Signed: March 28, 1994 BY:s/CARL H. LINDNER Carl H. Lindner Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Capacity Date s/CARL H. LINDNER Chairman of the Board March 28, 1994 Carl H. Lindner of Directors s/ROBERT D. LINDNER Director March 28, 1994 Robert D. Lindner s/RONALD F. WALKER Director March 28, 1994 Ronald F. Walker s/FRED J. RUNK Vice President and March 28, 1994 Fred J. Runk Treasurer (principal financial and accounting officer) * Member of the Audit Committee	44,582	294,303
60302_1993.txt	60302_1993	1993	60302	ITEM 1. BUSINESS (a) General Development of Business Longview Fibre Company, was incorporated on November 17, 1989 in the State of Washington as a successor to a company of the same name incorporated in the State of Delaware on August 2, 1926. No general development of material importance has occurred during the past fiscal year. (b) Financial Information about Industry Segments This item is completed by reference to Note 12 of Item 8 of this Form 10-K. (c) Narrative Description of Business (1) Business Done and Intended to be Done (i) Principal Products, Markets and Methods of Distribution Logs - The company owns and operates tree farms in Oregon and Washington which produce logs for sale in the domestic and export market. Paper and Paperboard - Its pulp and paper mill at Longview, Washington produces pulp which is manufactured into kraft paper and containerboard. Wrapping paper and converting paper (paper in large rolls for use by manufacturers of bags and other items) are sold by the company's sales force working out of San Francisco, California; Longview, Washington; Milwaukee, Wisconsin; and Atlanta, Georgia or through paper merchants. Sales are made primarily in the domestic market with some grades of paper sold in the export market. Containerboard is sold in the export market and in the Pacific Coast states. Converted Products - The company's fourteen converting plants in ten states produce shipping containers and merchandise and grocery bags. The tonnage of paper and containerboard used in the converting plants equals approximately 66% of the Longview mill production. Bags are sold by the company's sales force working out of San Francisco and Los Angeles, California; Longview, Washington; and Waltham, Massachusetts. Sales are made directly or through paper merchants. Corrugated and solid fibre boxes are sold by the company's offices located at Longview, Seattle and Yakima, Washington; Portland, Oregon; San Francisco and Oakland, California; Twin Falls, Idaho; Spanish Fork, Utah; Milwaukee, Wisconsin; Rockford, Illinois; Cedar Rapids, Iowa; Minneapolis, Minnesota; Amsterdam, New York; and Springfield, Massachusetts. The following table sets forth the contribution to sales by each class of similar products which accounted for more than 10% of sales. 1993 1992 1991 Logs 24% 17% 14% Paper and Paperboard 28% 34% 35% Converted Products 48% 49% 51% (ii) There has been no public announcement, or information which has become public, about a new product or line of business requiring the investment of a material amount of total assets of the company. (iii) Wood Supply and Timberlands - The raw material fibers come primarily from purchased wood chips and sawdust with important contributions from fiber reclaimed from post-consumer and post-industrial waste and augmented by log chipping operations owned by the Company and others. Wood chip costs were about one percent higher than in the prior year. Lockup of federal and state timber for so-called threatened species (spotted owls and marbled murrelets) continues with no relief in sight. This keeps chip costs up, but enhances log revenues. Any adverse effect on our ability to log our private lands due to threatened species is presently estimated at under six percent. The Leavenworth sawmill is improving. Dry kilns are being installed. When these are operative (estimated early 1994), operations should be in the black. The company operates its 529,730 acres of tree farms on a sustained yield basis with rotations between 50 and 70 years; no large inventory of mature trees is maintained. (iv) Patents, trademarks, licenses, franchises and concessions held do not play an important part in the business of the company. (v) No material portion of the business of the company is seasonal. (vi) The practice of the company and the industry does not require an abnormal amount of working capital. (vii) The loss of a single customer, or a few customers, would not have a material effect on the business of the company. (viii) The backlog of orders is not material to an understanding of the business of the company. (ix) There is no material portion of the business subject to renegotiation or termination of contracts at the election of the Government. (x) Practically all merchantable logs produced from the company's timberlands are sold to independent sawmills and plywood plants which purchase a substantial part of their log requirements, to U. S. exporters or direct to foreign importers. The company continues to emphasize quality, service, continuity and design of products to meet customers special needs. Accordingly, the company believes it is in an acceptable competitive posture as to its primary products in spite of high wood fiber costs in the region. As to converted products, the company believes it competes on even terms in highly competitive markets avoiding large accounts which have reached excessive loss levels. (xi) The amount spent on research and development is completed by reference to Note 11 of Item 8 of this Form 10-K. (xii) Estimated capital expenditures for environmental protection are $1,000,000 per year for 1994 and 1995. (xiii) The company has approximately 3,500 employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales Segment information (including amount of export sales) is completed by reference to Note 12 of Item 8 of this Form 10-K. ITEM 2. ITEM 2. PROPERTIES The principal plants and important physical properties of the company are held without any major encumbrances and their respective locations by industry segment are as follows: Logs - As of October 31, 1993 the company owned in fee 529,730 acres of tree farms located in various counties of Washington and Oregon. The company as a matter of policy has consistently acquired and intends to continue to acquire more timberlands whenever purchasable at acceptable prices dependent on the location and quality of the site involved and the species and quality of the merchantable timber and growing stock thereon. The company operates its tree farms on a sustained yield basis with rotations between 50 and 70 years. No large inventory of mature trees is maintained. Paper and Paperboard - At Longview, Washington on a site of approximately 350 acres owned by the company with deep water frontage on the Columbia River and featuring connections with two transcontinental railroads and adequate highway access, there is an integrated operation for producing pulp and delivering it to twelve paper and/or containerboard machines with full supporting facilities. Mill utilization was at 76% during fiscal 1993. Converted Products - On the same site at Longview there is a box factory for production of solid fibre and corrugated boxes. At each of the following twelve locations there are factories for the production of converted products: Oakland, California Corrugated Boxes Only Twin Falls, Idaho " " " Rockford, Illinois " " " Cedar Rapids, Iowa " " " Springfield, Massachusetts " " " Minneapolis, Minnesota " " " Amsterdam, New York " " " Seattle, Washington " " " Yakima, Washington " " " Spanish Fork, Utah Corrugated Boxes, Grocery Bags and Merchandise Bags Milwaukee, Wisconsin Corrugated and Solid Fibre Boxes Waltham, Massachusetts Merchandise Bags The volume of converted products sold decreased during the past fiscal year. Capacity is available for increased sales. Other - The company owns mineral rights on the majority of its tree farm acres. Revenues from minerals are immaterial. Natural gas from company lands in Columbia County, Oregon produce some royalty income. These revenues make land ownership more attractive, but to date have had an immaterial impact on overall corporate results. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Nothing to report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Nothing was submitted during the fourth quarter of the fiscal year to a vote of the Shareholders. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS (a)(1)(ii) Transaction prices per share as reported on the New York Stock Exchange are reported below. Fiscal 1993 1992 Quarter High Low High Low 1st $18.75 $15.88 $16.00 $10.38 2nd 20.25 16.00 18.75 14.75 3rd 18.25 15.75 17.25 14.63 4th 18.25 15.88 17.38 12.88 (b)(1) The company estimates it now has approximately 11,650 shareholders. (c)(1) Dividends per share paid in fiscal 1993, 1992 and 1991: 1993 1992 1991 January $0.10 $0.10 $0.13 April 0.10 0.10 0.13 July 0.10 0.10 0.13 October 0.22 0.22 0.13 $0.52 $0.52 $0.52 The Directors have declared a regular dividend of $0.13 per share to be paid on January 10, 1994, to shareholders of record on December 24, 1993. Restrictions on the company's ability to pay cash dividends are completed by reference to Notes 5, 10 and 13 of Item 8 of this Form 10-K. ITEM 6. ITEM 6. SELECTED FINANCIAL AND OTHER DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS 1993 vs. 1992 1993 was the fifth unsatisfactory year in a row. While earnings improved by 26%, they are 58% below 1988 when shareholders' equity was 11% lower. Log profits increased from $61,006,000 to $101,471,000 in fiscal 1993. The 66% improvement was primarily due to a 49% increase in average price. Footage sold decreased by 2%. Demand and prices remain at good levels in both the export and domestic markets but are below peak 1993 levels. The company operates its 529,730 acres of tree farms on a sustained yield basis with rotations between 50 and 70 years. Based on recent purchases and sales, we now estimate the value of the tree farms to be between six and nine times book value. Substantial new acquisitions completed after the end of the fiscal year are at market value; when they appear in subsequent balance sheets, the multiplier to estimate market value will, of course, be lower. The lockup of federal and state timber for so-called threatened species (spotted owls and marbled murrelets) continues with no relief in sight. The resulting reduced log supply in the marketplace keeps log prices at very good levels. Any adverse effect on our ability to log our private lands is presently estimated at under 6%. For the year, sales of paper and paperboard decreased 19% while operating results declined from $14,398,000 to $(2,181,000). Tonnage sold during the year decreased 25% while the average prices for paper held steady at year ago levels and the average price for paperboard declined 3%. Slow recovery from the recession and intense competitive conditions have kept mill production at about 76%. Chip costs were high and depreciation costs increased. Aggressive recycling of old corrugated containers helped control fiber costs and facilitated product marketing. An additional pulper will shortly be installed which will permit utilization of purchased bleached pulp in lieu of bleaching on-site. This will reduce chip demand and defer a decision on how to replace our old bleach plants, which while they meet current environmental rules could not meet proposed EPA rules to be effective in 1997 or 1998. Labor costs in the Pacific Northwest paper industry were bargained to very high levels when the region had low chip costs and could afford wages substantially above typical manufacturing rates. But with the reduction of government timber sales, chip costs in the region are now around two-thirds higher than those of the South. The premium wage rates are now a severe penalty. Current high chip costs, which are about 1% higher than in the prior year, put the Pacific Northwest mills at a disadvantage in competing with mills in other regions. Over time, one can expect this disadvantage to become less. Supply- demand balance should be helped by reduced chip exports, increased imports, more recycling, pulp mill closures, pulp wood plantations and the reduction in diameter of logs sawn which increases the ratio of chips to lumber. Chip costs in other regions are likely to rise because of increased exports, increased consumption and environmental constraints. Converting results declined from $(4,830,000) in fiscal 1992 to $(14,717,000) in fiscal 1993. Sales declined 3% due to a 4% decrease in tonnage sold. Average price improved by 1%. Operating losses increased due to higher costs of containerboard used to manufacture boxes. Paper, paperboard and corrugated box demand remained below industry capacity. Major competitors continue depressed price levels in the mistaken belief that market share and full operation in weak markets are more desirable than adequate margins. The company continues to emphasize quality, service, continuity and the design of products to meet customers special needs, avoiding large accounts which have reached excessive loss levels. Sale of power continues to make a substantial reduction in net cost of power used. Selling, administrative and general expenses were 7% of sales in fiscal 1993 and fiscal 1992. Interest expensed decreased 7% in fiscal 1993 as compared with fiscal 1992 due to lower borrowing and lower interest rates. A harsh governmental climate for business, especially for forest products and manufacturing industries, plus a weak world economy, make the prospects for recovery appear limited. If a sharp recovery should occur, the company's ability to take full advantage thereof may be limited by raw material availability. Should this happen, the company will move away from its lowest margined sales and will thus materially improve results. A dawdling recovery seem more likely, which would postpone any dramatic restoration of results to the previous peak level. RESULTS OF OPERATIONS 1992 vs. 1991 1992 was the fourth unsatisfactory year in a row. While earnings improved by 93%, they were 67% below 1988 when shareholders' equity was 8% lower. Log profits increased from $45,286,000 in fiscal 1991 to $61,006,000 in fiscal 1992. The 35% improvement was due to an 11% increase in footage sold and a 14% increase in average price. Demand and prices remain strong in both the export and domestic markets. The company operates its 527,800 acres of tree farms on a sustained yield basis with rotations between 50 and 70 years. Based on recent purchases and sales, we now estimate the value of the tree farms to be between five and seven times book value. Lockup of federal and state timber for so-called threatened species (spotted owls and marbled murrelets) continues with no relief in sight. The resulting reduced log supply in the marketplace keeps log prices at very good levels. Any adverse effect on our ability to log our private lands is presently estimated at under 3%. For the year, sales of paper and paperboard improved 5% while operating profits declined from $15,183,000 in fiscal 1991 to $14,398,000 in fiscal 1992. Tonnage sold during the year increased 16% while average prices for paper and paperboard decreased 3% and 6% respectively. Slow recovery from the recession and intense competitive conditions kept mill production at about 85% of capacity. Depreciation and interest costs increased due to the completion of major capital projects such as Number 22 recovery furnace. Labor costs remain high as do chip costs which were about 1% higher than the prior fiscal year. Converting results improved from $(19,535,000) in fiscal 1991 to $(4,830,000) in fiscal 1992. Sales improved 4% due to a 3% increase in average price and modest increase in tonnage sold. Operating losses were reduced due to lower costs of containerboard used to manufacture boxes and a better product mix. Demand for paper, paperboard and corrugated boxes remained below industry capacity. Product markets remain chaotic. Announced price increases are often not implemented. Excessively leveraged competitors continue to dump products in markets they do not customarily serve. Competitive earnings clearly show the futility of such dumping. Any competitor who succeeds in remaining sold out during slow business will inevitably disappoint some customers in a strong market. The company continues to try to earn sales by quality, service, continuity and the design of custom grades and products, not by price cutting. The twelve machines with varied but overlapping capabilities, and with considerable flexibility in switching from paper to board or from liner to corrugating medium, permit excellent response to customer needs. Sale of power continues to make a substantial reduction in net cost of power used. Selling, administrative and general expenses were 7% of sales in fiscal 1992 and fiscal 1991. Interest expensed increased modestly due to increased borrowing and proportionately less interest attributable to uncompleted capital projects. Short-term prospects continue to appear to be mediocre. Industry expansion appears to be modest and if and when strong economic recovery occurs, earnings should improve materially. LIQUIDITY AND CAPITAL RESOURCES Cash provided by operations increased $22,161,000 in 1993 compared with 1992 due primarily to increased earnings and increases in noncash charges to earnings such as depreciation, depletion and deferred taxes. Working capital was $34,308,000 at October 31, 1993 compared to $30,119,000 at October 31, 1992. Long-term debt, current installments of long-term debt and short-term borrowings decreased by $35,596,000 in 1993 due to reduced capital expenditures and increased cash provided by operations. At October 31, 1993, the company had bank lines of credit totaling $247,000,000. Of this amount, $170,000,000 was under a credit agreement with a group of banks expiring February 28, 1995, with renewal provisions beyond that date. The company had outstanding $150,000,000 of notes payable under this agreement at October 31, 1993. Also available was $77,000,000 of bank credit lines for additional borrowing needs. At October 31, 1993, the company had an outstanding balance of $30,000,000 under these credit lines. The unused portion of all bank lines of credit was $67,000,000 as of October 31, 1993, which is adequate for anticipated future needs. Also outstanding at October 31, 1993 were senior notes of $157,500,000 and revenue bonds of $28,900,000. Expenditures for fiscal 1993 for plant and equipment were $53,256,000 and for timberland $4,700,000. Expenditures for fiscal 1992 for plant and equipment were $66,744,000. The backlog of approved capital projects as of October 31, 1993 is $56,000,000. Timberland purchases of $26,000,000 closed after October 31, 1993. Capital projects: Capacity of the old corrugated container (OCC) recycling plant will be increased by 33% in the first quarter of fiscal 1994. The Leavenworth sawmill operation is improving. Dry kilns are being installed. When these are operative (estimated early 1994), operations should be in the black. Engineering is proceeding on a 50,000 average kw cogeneration plant. When all necessary permits are received, the project can proceed. Cost of the plant is included in the capital backlog. Capital investments in plant and equipment are expected to average $45,000,000 per year. During fiscal 1993 the company purchased 17,973 shares of its stock for an average price of $16.62 per share. During fiscal 1992, the company purchased 8,323 shares for an average price of $15.29 per share. Purchases began in 1964; the total number of shares acquired through fiscal 1993 is 21,198,381 shares for $93,518,674 at an average cost of $4.41 per share. Stock purchases increase interest costs and thus reduce corporate earnings. In most years when earnings are good, they increase earnings per share. In a bad year, the interest cost can decrease earnings per share slightly. Dividends of $.52 per share were paid in fiscal 1993 and 1992. Shareholders' equity increased $16,678,000 in fiscal 1993 as compared with an increase of $5,082,000 in fiscal 1992. Due to timberland purchases of $26,000,000, total borrowing will increase during the first fiscal quarter of 1994. It is expected that near-term capital expenditures will be financed from internally generated funds. OTHER The company has in place a process of reviewing any known environmental exposures which includes determining the costs of remediation. At the present time, the company is not aware of any environmental liabilities that would have a material impact on the consolidated financial statements. The company's consolidated financial statements are prepared based on historical costs and do not portray the effects of inflation. The impact of inflation is most noticeable for inventories and capital assete, although most of the inflationary effect of inventories is already portrayed in the consolidated income statement by the use of the LIFO method of inventory valuation. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Financial Statements: Report of Independent Accountants . . . . . . . . . . . . . . . 13 Consolidated Statements of Income for the three years ended October 31, 1993 . . . . . . . . . . . . . . 14 Consolidated Statements of Shareholders' Equity for the three years ended October 31, 1993. . . . . . . 14 Consolidated Balance Sheets at October 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . 15 Consolidated Statements of Cash Flows for the three years ended October 31, 1993 . . . . . . . . . . . . 16 Notes to Consolidated Financial Statements. . . . . . . . . . . 17 Financial Statement Schedules: V - Property, Plant and Equipment. . . . . . . . . . . . . . . 26 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . . . . . . . . . . . . . 28 Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Longview Fibre Company In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Longview Fibre Company and its subsidiaries at October 31, 1993, 1992 and 1991, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audits 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 the opinion expressed above. As discussed in Note 1 to the financial statements, the Company changed its method of accounting for income taxes and for postretirement benefits other than pensions. \s\ Price Waterhouse Price Waterhouse Portland, Oregon December 8, 1993 CONSOLIDATED STATEMENT OF INCOME Years Ended October 31 (thousands except per share) 1993 1992 1991 Net sales. . . . . . . . . . . . . . . . . . . $689,551 $690,998 $644,000 Logs . . . . . . . . . . . . . . . . . . 166,822 114,944 90,785 Paper and paperboard . . . . . . . . . . 189,787 234,119 223,260 Converted products . . . . . . . . . . . 332,942 341,935 329,955 Cost of products sold, including outward freight . . . . . . . . . . . . . . . 554,984 571,453 556,329 Gross profit . . . . . . . . . . . . . . . . . 134,567 119,545 87,671 Selling, administrative and general expenses . 49,994 48,971 46,737 Operating profit . . . . . . . . . . . . . . . 84,573 70,574 40,934 Logs . . . . . . . . . . . . . . . . . . 101,471 61,006 45,286 Paper and paperboard . . . . . . . . . . (2,181) 14,398 15,183 Converted products . . . . . . . . . . . (14,717) (4,830) (19,535) Interest income. . . . . . . . . . . . . . . . 329 357 1,290 Interest expensed. . . . . . . . . . . . . . . (22,772) (24,356) (24,211) Miscellaneous. . . . . . . . . . . . . . . . . 958 812 4,490 Income before income taxes . . . . . . . . . . 63,088 47,387 22,503 Provision for taxes on income (see Note 9) Current. . . . . . . . . . . . . . . . . . . . 13,055 11,603 (633) Deferred . . . . . . . . . . . . . . . . . . . 9,745 3,697 6,493 22,800 15,300 5,860 Net income . . . . . . . . . . . . . . . . . . $ 40,288 $ 32,087 $ 16,643 Per share. . . . . . . . . . . . . . . . $ 0.78 $ 0.62 $ 0.32 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (thousands) 1993 1992 1991 Common stock: Balance at beginning of year . . . . . . $ 77,527 $ 77,540 $ 77,565 Issued . . . . . . . . . . . . . . . . . 323 - - Ascribed value of stock purchased. . . . (27) (13) (25) Balance at end of year . . . . . . . . . $ 77,823 $ 77,527 $ 77,540 Additional paid-in capital: Balance at beginning of year . . . . . . $ - $ - $ - On common stock issued . . . . . . . . . 3,306 - - Balance at end of year . . . . . . . . . $ 3,306 $ - $ - Retained earnings: Balance at beginning of year . . . . . . $304,590 $299,495 $309,913 Net income . . . . . . . . . . . . . . . 40,288 32,087 16,643 Less cash dividends on common stock ($0.52 per share). . . . . . . . . . . (26,940) (26,878) (26,883) Less purchases of common stock . . . . . (272) (114) (178) Balance at end of year . . . . . . . . . $317,666 $304,590 $299,495 Common shares: Balance at beginning of year . . . . . . 51,685 51,693 51,710 Issued . . . . . . . . . . . . . . . . . 215 - - Purchases. . . . . . . . . . . . . . . . (18) (8) (17) Balance at end of year . . . . . . . . . 51,882 51,685 51,693 The accompanying notes are an integral part of these financial statements. CONSOLIDATED BALANCE SHEET October 31 (dollars in thousands except per share) 1993 1992 1991 ASSETS Current assets: Accounts and notes receivable. . . . . . . . $ 82,563 $ 91,671 $ 84,121 Allowance for doubtful accounts. . . . . . (1,000) (750) (750) Taxes on income, refundable. . . . . . . . . - - 3,620 Inventories (see Note 3) . . . . . . . . . . 59,674 55,741 48,390 Other. . . . . . . . . . . . . . . . . . . . 7,081 1,883 2,074 Total current assets . . . . . . 148,318 148,545 137,455 Capital assets: Buildings, machinery and equipment at cost . 1,164,411 1,124,957 1,070,637 Accumulated depreciation . . . . . . . . . 548,538 499,228 452,619 Costs to be depreciated in future years (see Note 2). . . . . . . . . . . 615,873 625,729 618,018 Plant sites at cost. . . . . . . . . . . . . 2,423 2,423 2,318 618,296 628,152 620,336 Timber at cost less depletion. . . . . . . . 129,372 129,206 127,431 Roads at cost less amortization. . . . . . . 9,198 10,628 12,184 Timberland at cost . . . . . . . . . . . . . 10,264 9,669 8,455 148,834 149,503 148,070 Total capital assets . . . . . 767,130 777,655 768,406 Other assets . . . . . . . . . . . . . . . . 28,925 24,568 20,991 $ 944,373 $ 950,768 $ 926,852 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Payable to bank resulting from checks in transit . . . . . . . . . . . . . $ 8,363 $ 7,193 $ 9,022 Accounts payable . . . . . . . . . . . . . . 40,219 42,796 44,049 Short-term borrowings (see Note 4) . . . . . 20,000 35,000 9,000 Payrolls payable . . . . . . . . . . . . . . 8,973 8,431 7,054 Federal income taxes payable . . . . . . . . 1,502 4,057 - Other taxes payable. . . . . . . . . . . . . 15,010 15,324 14,714 Current installments of long-term debt . . . 19,943 5,625 25,825 Total current liabilities . . . 114,010 118,426 109,664 Long-term debt (see Note 5) . . . . . . . . 327,486 362,400 356,025 Deferred taxes - net (see Note 9). . . . . . 97,693 83,266 79,569 Other liabilities. . . . . . . . . . . . . . 6,389 4,559 4,559 Commitments (see Note 10). . . . . . . . . . - - - Shareholders' equity: Preferred stock; authorized 2,000,000 shares - - - Common stock, ascribed value $1.50 per share; authorized 150,000,000 shares; issued 51,881,819, 51,684,792 and 51,693,115 shares respectively (see Note 13) . . . . . 77,823 77,527 77,540 Additional paid-in capital . . . . . . . . . 3,306 - - Retained earnings. . . . . . . . . . . . . . 317,666 304,590 299,495 Total shareholders' equity. . . 398,795 382,117 377,035 $ 944,373 $ 950,768 $ 926,852 The accompanying notes are an integral part of these financial statements. Page 15 CONSOLIDATED STATEMENT OF CASH FLOWS Years Ended October 31 (thousands) 1993 1992 1991 Cash provided by (used for) operations: Net income . . . . . . . . . . . . . . . . . $ 40,288 $ 32,087 $ 16,643 Charges to income not requiring cash - Depreciation . . . . . . . . . . . . . . 60,859 57,371 52,396 Depletion and amortization . . . . . . . 8,166 6,036 5,600 Deferred taxes - net . . . . . . . . . . 9,745 3,697 6,493 (Gain) loss on disposition of capital assets. . . . . . . . . . . . . 1,437 797 (1,285) Change in: Inventories . . . . . . . . . . . . . . . (3,190) (7,351) (353) Taxes on income, refundable . . . . . . . - 3,620 (3,620) Other . . . . . . . . . . . . . . . . . . (516) 191 (299) Accounts and notes receivable . . . . . . 9,358 (7,550) (2,173) Accounts, payrolls and other taxes payable. . . . . . . . . . . . . . (3,049) 6,477 (271) Federal income taxes payable. . . . . . . (2,555) 4,057 (1,769) Other noncurrent assets . . . . . . . . . (4,357) (3,577) (3,321) Other noncurrent liabilities. . . . . . . 1,830 - - Cash provided by operations. . . . . . . . . 118,016 95,855 68,041 Cash provided by (used for) investing: Additions to: Plant and equipment . . . . . (53,256) (66,744) (101,950) Timber and timberlands. . . . (4,700) (7,579) (1,730) Proceeds from sale of capital assets . . . . 905 871 2,878 Cash used for investing. . . . . . . . . . . (57,051) (73,452) (100,802) Cash provided by (used for) financing: Additions to long-term debt. . . . . . . . . 21,029 35,000 100,000 Reduction in long-term debt. . . . . . . . . (41,625) (48,825) (37,655) Short-term borrowings. . . . . . . . . . . . (15,000) 26,000 (14,877) Payable to bank resulting from checks intransit. . . . . . . . . . . . . . 1,170 (1,829) 9,022 Accounts payable for construction. . . . . . 700 (5,744) 2,451 Cash dividends . . . . . . . . . . . . . . . (26,940) (26,878) (26,883) Purchase of common stock . . . . . . . . . . (299) (127) (203) Cash provided by (used for) financing. . . . (60,965) (22,403) 31,855 Decrease in cash position. . . . . . . . . . - - (906) Cash position, beginning of year . . . . . . - - 906 Cash position, end of year . . . . . . . . . $ - $ - $ - Supplemental disclosures of cash flow information: Cash paid during the year for: Interest (net of amount capitalized) . . . . $ 23,231 $ 24,037 $ 23,484 Capitalized interest . . . . . . . . . . . . 548 2,670 4,192 Income taxes . . . . . . . . . . . . . . . . 16,134 9,727 5,061 The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF ACCOUNTING POLICIES: Principles of consolidation The financial statements include the accounts of the company and all subsidiaries after elimination of intercompany balances and transactions. Inventories Inventories are stated at the lower of cost or market. Cost is determined on a last-in, first-out method except for supplies at current averages. Property and depreciation Buildings, machinery and equipment are recorded at cost and include those additions and improvements that add to production capacity or extend useful life. Cost includes interest capitalized during the construction period on all significant asset acquisitions. When properties are sold or otherwise disposed, the cost and the related accumulated depreciation are removed from the respective accounts and the resulting profit or loss is recorded in income. The costs of maintenance and repairs are charged to income when incurred. Depreciation for financial accounting purposes is computed on the straight-line basis over the estimated useful lives of the assets. The estimated useful lives of assets range from 20 to 60 years for buildings and principally from 12 to 16 years for machinery and equipment. Timberlands, depletion and amortization Timber, timberlands and timber roads are stated at cost. Provision for depletion of timber and amortization of logging roads represents charges per unit of production (footage cut) based on the estimated recoverable timber. No gain or loss is recognized on timberland exchanges since the earnings process is not considered complete until timber is harvested and marketed. Earnings per share Net income per common share is computed on the basis of weighted average shares outstanding of 51,785,201, 51,688,336 and 51,697,653 for 1993, 1992 and 1991, respectively. Pension and other benefit plan costs The company's policy is to accrue as cost an amount computed by the actuary and to fund at least the minimum amount required by ERISA. The Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," was adopted during 1993. FAS 106 requires the company to accrue the estimated cost of retiree benefit payments, other than pensions, during the employees' active service period. The company elected to amortize the unrecognized transition obligation over 20 years. The transition obligation is $10 million as of November 1, 1992. The annual pretax costs for postretirement benefits other than pensions are $2 million greater in 1993 under the provisions of FAS 106 than under the company's prior "pay-as-you-go" method of accounting (see Note 7). Income taxes The Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes," was adopted during 1993. FAS 109 requires a change from the deferred method to the asset and liability method of accounting for income taxes. Under FAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, deferred taxes were recognized using the tax rate applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates. The cumulative effect of the change in the method of accounting for income taxes as of the beginning of fiscal 1993 was not material. Financial statements for prior years have not been restated (see Note 9). Revenue recognition The company generally recognizes revenues when goods are shipped. NOTE 2 - BUILDINGS, MACHINERY AND EQUIPMENT: At Cost - net of accumulated depreciation consist of the following: October 31 (thousands) 1993 1992 1991 Buildings - net . . . . . . . . $ 39,644 $ 38,726 $ 39,749 Machinery and equipment - net . 576,229 587,003 578,269 $615,873 $625,729 $618,018 NOTE 3 - INVENTORIES: Inventories consist of the following: October 31 (thousands) 1993 1992 1991 Finished goods. . . . . . . . . $14,977 $12,861 $10,261 Goods in process. . . . . . . . 11,231 11,024 9,043 Raw materials and supplies. . . 33,466 31,856 29,086 $59,674 $55,741 $48,390 The amounts included above for inventories valued by the LIFO method are less than replacement or current cost by approximately $39,306,000, $41,331,000 and $40,683,000 at October 31, 1993, 1992 and 1991, respectively. NOTE 4 - SHORT-TERM BORROWINGS: At October 31, 1993, the company had bank lines of credit totaling $247 million. Of this amount, $170 million was under a credit agreement with a group of banks providing various methods of borrowing. The company can request a "Competitive Bid" specifying dollar amounts and loan duration. The various banks may then bid, specifying rates and amounts, which the company may accept or reject. The agreement also provides for borrowings other than competitive bids, at the Euro Dollar Rate plus 5/8% or the bank's prime rate, whichever the company selects. The credit agreement contains certain financial covenants and provides for a 1/4% facility fee and a 1/8% commitment fee on the unused portion of the commitments. This agreement has an expiration date of February 28, 1995 with renewal provisions beyond that date. At October 31, 1993, the company had loans of $150 million under the credit agreement. The company also has an agreement whereby it can borrow money by issuing notes in the commercial paper market. The $170 million credit agreement above provides credit back-up for commercial paper issued, therefore the combined borrowing under the credit agreement and the commercial paper agreement cannot exceed $170 million. During the year no commercial paper was issued. Also available was $77 million of bank credit lines for additional borrowing needs. Of this amount, two $20 million agreements are committed lines of credit which are subject to a nominal commitment fee and expire March 31, 1995 and November 1, 1996, respectively. The other $37 million is uncommitted. At October 31, 1993, the company had an outstanding balance of $30 million under these credit lines. Short-term borrowings of $160 million, $176 million and $199 million at October 31, 1993, 1992 and 1991, respectively, under the above agreements, have been reclassified as long-term debt because they are to be renewed and replaced with borrowings due beyond one year and into future periods. Short-term borrowing activity including the amount reclassified as long-term is summarized as follows: (thousands) 1993 1992 1991 Notes payable October 31 . . . . $180,000 $211,000 $208,000 Interest rate October 31 . . . . 4.0% 4.3% 6.1% Average daily amount of notes payable outstanding during year . . . . . . . . . . $179,601 $193,573 $186,476 Average* interest rate during year . . . . . . . . . . 4.2% 5.0% 7.2% Maximum amount of notes payable at any month end. . . . $195,000 $211,000 $210,000 Computed by dividing interest incurred by average notes payable outstanding. NOTE 5 - LONG-TERM DEBT: Long-term debt consists of the following: October 31 (thousands) 1993 1992 1991 Senior notes due through 1999 (7.70%-10.13%) - Note (a). . . . $157,500 $163,125 $153,750 Revenue bonds payable through 2015 (floating rates, currently 2.55%-2.75%) - Note (b). . . . . 28,900 28,900 29,100 Other . . . . . . . . . . . . . . 1,029 - - Notes payable - banks - Note 4 above . . . . . . . . . . 160,000 176,000 199,000 347,429 368,025 381,850 Less current installments . . 19,943 5,625 25,825 Net long-term debt. . . . . . . . $327,486 $362,400 $356,025 Scheduled maturities 1995 $205,993 1996 34,119 1997 34,119 1998 14,119 1999-2015 39,136 $327,486 Note (a) Covenants of the senior notes include tests of minimum net worth, short-term borrowing, long-term borrowing, current ratio and restrictions on payments of dividends. Accordingly, at October 31, 1993, approximately $47 million of consolidated retained earnings was unrestricted as to the payment of dividends. Note (b) Primarily incurred upon the purchase of manufacturing equipment. At October 31, 1993 $23,900,000 was secured by liens on the equipment. NOTE 6 - RETIREMENT AND SAVINGS PLANS: The company has two trusteed defined benefit pension programs which cover a majority of employees who have completed one year of continuous service. The plans provide benefits of a stated amount for each year of service with an option for some employees to receive benefits based on an average earnings formula. The weighted-average discount rate and rate of increase in the future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7% and 5.25% for 1993, and 8% and 5.5% for 1992 and 1991, respectively. The expected long-term rate of return on assets was 9%. The following table sets forth the plans' funded status and amounts recognized in the company's consolidated financial statements at October 31: (thousands) 1993 1992 1991 Actuarial present value of benefit obligations: Vested . . . . . . . . . . . . . $132,030 $112,824 $106,879 Vested and nonvested . . . . . . $132,803 $113,429 $107,574 Projected for service rendered . . . . . . . . . . . $147,395 $127,745 $121,149 Plan assets at fair value, primarily listed stocks. . . . . . 235,763 197,524 187,911 Excess plan assets. . . . . . . . . 88,368 69,779 66,762 Items not recognized in earnings: Net (asset) at adoption of FAS No. 87 . . . . . . . . . . . . . (10,164) (11,534) (12,903) Unrecognized prior service cost. . 7,487 8,925 9,847 Net (gain) subsequent to adoption . . . . . . . . . . . . (63,095) (48,438) (47,740) Pension asset recognized in the consolidated balance sheet . . . . $ 22,596 $ 18,732 $ 15,966 Net pension (income) includes the following: Benefits earned during period. . . . . . . . . . . . . $ 3,203 $ 3,258 $ 3,138 Interest cost on projected benefit obligation. . . . . . . 9,770 9,451 8,951 Actual (return) on plan assets. . . . . . . . . . . . . (45,229) (16,098) (60,191) Net amortization and deferral of items not recognized in earnings. . . . . . . . . . . . 28,392 622 45,785 Net pension (income). . . . . . . . $ (3,864) $ (2,767) $ (2,317) Voluntary savings plans are maintained for all employees who have completed one year of continuous service. The plans allow salary deferrals in accordance with IRC section 401(k) provisions. The company contribution as a matching incentive during 1993, 1992 and 1991 was $857,000, $826,000 and $563,000, respectively. NOTE 7 - POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The company provides postretirement health care insurance benefits for all salaried and certain non-salaried employees and their dependents. Individual benefits generally continue until age 65. The company does not pre-fund these benefits. Postretirement benefit expense was $2,274,000, $390,000 and $382,000 in 1993, 1992 and 1991, respectively. The components of expense in 1993 were as follows: (thousands) 1993 Service cost . . . . . . . . . . . . . . . . . . . . . . . . $ 639 Interest cost. . . . . . . . . . . . . . . . . . . . . . . . 1,137 Amortization of unrecognized transition obligation . . . . . 498 Net periodic postretirement benefit cost . . . . . . . . . . $ 2,274 The accumulated postretirement benefit obligation, comprises the following components: (thousands) 1993 Retirees . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,245) Fully eligible active plan participants. . . . . . . . . . . (3,025) Other active plan participants . . . . . . . . . . . . . . . (11,268) Total accumulated postretirement benefit obligation. . . . . (16,538) Unrecognized net loss. . . . . . . . . . . . . . . . . . . . 677 Unrecognized transition obligation . . . . . . . . . . . . . 9,472 Accrued postretirement benefit cost. . . . . . . . . . . . . $ (6,389) Future benefit costs were calculated using a health care cost trend rate of 16% for the indemnity plan and 9% for the HMO plan. The trend rate declines each year until the ultimate health care cost trend rate, 5.5%, is reached in the year 2003 for the indemnity plan and the year 1999 for the HMO plan. A one percent change in the health care cost trend rate assumption has a $2,029,000 effect on the accumulated postretirement benefit obligation as of October 31, 1993 and a $251,000 effect on the net periodic postretirement benefit cost. The weighted-average discount rate used was 8% at November 1, 1992 and 7.5% at October 31, 1993. NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS: Accounts receivable, revenue bonds and notes payable to banks approximate fair value as reported in the balance sheet. The fair value of senior notes is estimated using discounted cash flow analyses, based on the company's incremental borrowing rates for similar types of borrowing arrangements. The fair value of the company's long-term debt at October 31, 1993 is approximately $9 million more than the stated value. NOTE 9 - INCOME TAXES: Provision (credit) for taxes on income is made up of the following components. The 1993 amounts reflect use of the liability method under FAS 109 while the 1992 and 1991 amounts reflect accounting using the deferred method which was required under previous rules. (thousands) 1993 1992 1991 Current: Federal. . . . . . . . . . . . . . $12,601 $10,720 $ (401) State. . . . . . . . . . . . . . . 454 883 (232) 13,055 11,603 (633) Deferred: Federal. . . . . . . . . . . . . . 8,699 2,880 6,101 State. . . . . . . . . . . . . . . 1,046 817 392 9,745 3,697 6,493 $22,800 $15,300 $ 5,860 1992 and 1991 deferred income tax provision: (thousands) 1992 1991 Depreciation . . . . . . . . . . . $13,642 $11,690 Alternative minimum tax. . . . . . (9,600) (5,652) Other. . . . . . . . . . . . . . . (345) 455 $ 3,697 $ 6,493 An analysis of the effective income tax rate as compared to the expected federal income tax rate is as follows: 1993 1992 1991 Expected federal income tax rate . . 35% 34% 34% Foreign Sales Corporation. . . . . . (5) (4) (7) State income taxes less federal income tax benefit . . . . 1 2 1 Enacted rate change impacting deferred taxes . . . . . . . . . . 5 - - Other. . . . . . . . . . . . . . . . - - (2) 36% 32% 26% The deferred income tax liabilities (assets) recorded in the Consolidated Balance Sheet as of October 31, 1993, are as follows: (thousands) Non-Current Current Depreciation . . . . . . . . . . . . $119,667 $ Employee Benefit Plans . . . . . . . 8,363 Alternative Minimum Tax. . . . . . . (24,235) Other. . . . . . . . . . . . . . . . (6,102) Non-deductible accruals. . . . . . . (4,682) Deferred tax liabilities (assets). . $ 97,693 $ (4,682) Federal income tax returns through 1985 have been settled with the Internal Revenue Service. NOTE 10 - COMMITMENTS AND CONTINGENCIES: Estimated costs to complete approved capital projects were approximately $56 million, $18 million and $47 million at October 31, 1993, 1992 and 1991, respectively. NOTE 11 - SUPPLEMENTAL EXPENSE INFORMATION: (thousands) 1993 1992 1991 Maintenance & repairs. . . . . . . . $63,556 $64,527 $70,297 Taxes, other than income taxes: Payroll. . . . . . . . . . . . 10,206 10,156 9,319 Property . . . . . . . . . . . 10,689 10,763 11,295 Sales and use. . . . . . . . . 3,548 3,797 4,246 Other. . . . . . . . . . . . . 7,823 7,561 7,240 Research and development . . . . . . 462 725 788 NOTE 12 - SEGMENT INFORMATION: The company owns and operates tree farms in Oregon and Washington which produce logs for sale. Its pulp and paper mill at Longview, Washington produces pulp which is manufactured into kraft paper and containerboard. The raw material fibers come primarily from purchased wood chips and sawdust with important contributions from fiber reclaimed from post-consumer and post-industrial waste, and augmented by log chipping operations owned by the company and others. The company's fourteen converting plants in ten states produce shipping containers, and merchandise and grocery bags. The tonnage of paper and containerboard used in the converting plants equals approximately 66% of the Longview mill tonnage. Included in sales to customers are export sales, principally to Japan, Hong Kong, Taiwan and Southeast Asia in 1993, 1992 and 1991 of $124,195,000, $123,604,000 and $89,588,000, respectively. All sales are made in U. S. dollars. There are no intersegment sales as all manufacturing operations to produce primary or converted products for sale are considered integrated from the purchased wood to the sale of the finished product. Identifiable assets are segregated or allocated to segments as follows: 1. Assets used wholly within a segment are assigned to that segment. 2. Assets used jointly by two segments are allocated to each segment on a percentage determined by dividing total cost of product into cost of product produced for each segment. Paper and paperboard assets of $275,417,000, $262,105,000 and $266,305,000 have been allocated to converted products at October 31, 1993, 1992 and 1991, respectively. Depreciation, depletion and amortization and additions to capital assets have been segregated and allocated similarly to the method used for identifiable assets. (thousands) 1993 1992 1991 Sales to customers: Logs . . . . . . . . . . . . . . . . $166,822 $114,944 $ 90,785 Paper and paperboard . . . . . . . . 189,787 234,119 223,260 Converted products . . . . . . . . . 332,942 341,935 329,955 Total. . . . . . . . . . . . . . . 689,551 690,998 644,000 (thousands) 1993 1992 1991 Income (loss) on sales: Logs . . . . . . . . . . . . . . . . 101,471 61,006 45,286 Paper and paperboard . . . . . . . . (2,181) 14,398 15,183 Converted products . . . . . . . . . (14,717) (4,830) (19,535) Interest expensed and other. . . . . (21,485) (23,187) (18,431) Income before income taxes . . . . 63,088 47,387 22,503 Identifiable assets at October 31: Logs . . . . . . . . . . . . . . . . 188,450 190,041 180,337 Paper and paperboard . . . . . . . . 278,981 302,855 279,264 Converted products . . . . . . . . . 476,942 457,872 467,251 Total. . . . . . . . . . . . . . . 944,373 950,768 926,852 Depreciation, depletion and amortization: Logs . . . . . . . . . . . . . . . . 11,010 8,114 6,196 Paper and paperboard . . . . . . . . 19,907 20,225 17,533 Converted products . . . . . . . . . 38,108 35,068 34,267 Total. . . . . . . . . . . . . . . 69,025 63,407 57,996 Additions to capital assets: Logs . . . . . . . . . . . . . . . . 5,453 12,797 17,714 Paper and paperboard . . . . . . . . 15,162 27,898 35,922 Converted products . . . . . . . . . 37,341 33,628 50,044 Total. . . . . . . . . . . . . . . $ 57,956 $ 74,323 $103,680 NOTE 13 - SHAREHOLDER RIGHTS PLAN: A Shareholder Rights Plan provides one right for each share of common stock. With certain exceptions, the rights will become exercisable only in the event that an acquiring party accumulates 20% or more of the company's voting stock or a party announces an offer to acquire 30% or more of the voting stock. The rights expire on March 1, 1999, if not previously redeemed or exercised. Each right entitles the holder to purchase one-tenth of one common share at a price of $4.00 ($40 per whole share), subject to adjustment under certain circumstances. In addition, upon the occurrence of certain events, holders of the rights will be entitled to purchase a defined number of shares of an acquiring entity or the company's common shares at half their then current market value. The company will generally be entitled to redeem the rights at $0.01 per right at any time until the tenth day following the acquisition of 20% or more, or an offer to acquire 30% or more, of the company's voting stock. QUARTERLY FINANCIAL DATA (UNAUDITED) Fiscal Year Quarters Total Fiscal (thousands except per share) 1st 2nd 3rd 4th Year Net sales. . . . . . . . . . $155,873 $179,045 $175,826 $178,807 $689,551 Gross profit . . . . . . . . 25,026 37,916 40,380 31,245 134,567 Net income . . . . . . . . . 5,089 13,363 14,625 7,211 40,288 Net income per share (1) . . 0.10 0.26 0.28 0.14 0.78 Net sales . . . . . . . . . $152,696 $172,868 $177,878 $187,556 $690,998 Gross profit . . . . . . . . 23,132 32,040 31,529 32,844 119,545 Net income . . . . . . . . . 3,904 9,679 8,689 9,815 32,087 Net income per share (1) . . 0.08 0.18 0.17 0.19 0.62 Net sales . . . . . . . . . $152,355 $158,106 $161,320 $172,219 $644,000 Gross profit . . . . . . . . 16,770 22,295 22,880 25,726 87,671 Net income . . . . . . . . . 1,458 3,279 4,523 7,383 16,643 Net income per share (1) . . 0.03 0.06 0.09 0.14 0.32 (1) Per share statistics have been computed on the average of number of shares outstanding in the hands of the public. Per share statistics for the first three quarters may vary slightly from amounts reported on an interim basis due to changes in the number of shares outstanding. SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (thousands) Balance at Other Balance beginning Additions changes- at end Description (7) of period at cost Retirements describe of period For the Year Ended October 31, 1993 Buildings. . . $ 63,957 $ 2,504 $ 370 $ $ 66,091 Machinery and equipment. . . 1,061,000 50,752 13,432 1,098,320 1,124,957 53,256 13,802 1,164,411 Plant sites. . 2,423 - - 2,423 1,127,380 53,256 13,802 1,166,834 Timber . . . . 129,206 3,377 718 (5,864) (1) 129,372 3,371 (5) Timber Roads . 10,628 968 12 (2,303) (2) 9,198 (83) (3) Timberland . . 9,669 355 18 258 (5) 10,264 149,503 4,700 748 (4,621) 148,834 $1,276,883 $ 57,956 $14,550 $(4,621) $1,315,668 For the Year Ended October 31, 1992 Buildings. . . $ 63,672 $ 539 $ 254 $ $ 63,957 Machinery and equipment. . . 1,006,965 66,100 12,065 1,061,000 1,070,637 66,639 12,319 1,124,957 Plant sites. . 2,318 105 - 2,423 1,072,955 66,744 12,319 1,127,380 Timber . . . . 127,431 6,487 17 (3,769) (1) 129,206 (926) (4) Timber Roads . 12,184 804 2 (2,267) (2) 10,628 (91) (3) Timberland . . 8,455 288 - 926 (4) 9,669 148,070 7,579 19 (6,127) 149,503 $1,221,025 $ 74,323 $12,338 $(6,127) $1,276,883 SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (thousands) Balance at Other Balance beginning Additions changes- at end Description (7) of period at cost Retirements describe of period For the Year Ended October 31, 1991 Buildings. . . $ 63,568 $ 1,168 $ 1,055 $ (9) (6) $ 63,672 Machinery and equipment. . . 932,167 100,763 24,930 (1,035) 1,006,965 995,735 101,931 25,985 (1,044) 1,070,637 Plant sites. . 2,017 19 - 282 2,318 997,752 101,950 25,985 (762) 1,072,955 Timber . . . . 127,651 1,519 6 (3,346) (1) 127,431 890 (4) 723 (6) Timber Roads . 14,414 145 - (2,254) (2) 12,184 (94) (3) (27) (4) Timberland . . 9,215 66 2 (863) (4) 8,455 39 (6) 151,280 1,730 8 (4,932) 148,070 $1,149,032 $103,680 $25,993 $(5,694) $1,221,025 (1) Depletion of timber and amortization of aerial fertilization, charged to income. (2) Road amortization, charged to income. (3) Depreciation on bridges, culverts, and fire roads, charged to income. (4) Effect of timber trades. (5) Timber and timberland acquired through exchange of Longview Fibre Company common stock. (6) Effect of Los Angeles Box Plant exchange. (7) The methods used in computing the annual provisions are completed by reference to Item 8, Note 1 of this Form 10-K. SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (thousands) Additions Other Balance at charged to changes - add Balance beginning costs and (deduct) - at end Description of period expenses Retirements describe of period For the Year Ended October 31, 1993 Buildings. . . . $ 25,231 $ 1,524 $ 308 $ $ 26,447 Machinery and equipment. . . 473,997 59,252 11,158 522,091 $499,228 $60,776 $11,466 $ $548,538 For the Year Ended October 31, 1992 Buildings. . . . $ 23,923 $ 1,496 $ 188 $ $ 25,231 Machinery and equipment. . . 428,696 55,784 10,483 473,997 $452,619 $57,280 $10,671 $ $499,228 For the Year Ended October 31, 1991 Buildings. . . . $ 23,482 $ 1,492 $ 1,051 $ $ 23,923 Machinery and equipment. . . 401,235 50,810 23,349 428,696 $424,717 $52,302 $24,400 $ $452,619 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change of accountants or disagreements on any matter of accounting principles, practices or financial statement disclosures required to be reported under this item. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Item 10, with the exception of the following information regarding executive officers of the company, is contained in the Notice of Annual Meeting of Shareholders and Proxy Statement which is incorporated as part of this Form 10-K. Executive Officers of the Company Name Age Office and Year First Elected R. P. Wollenberg 78 (1) Chairman of the Board, President and Chief Executive Officer (1953) R. E. Wertheimer 65 (2) Executive Vice President (1960) W. H. Smith 65 (3) Vice President-Production (1992) R. J. Parker 45 (4) Senior Vice President-Production (1994) D. L. Bowden 58 (5) Senior Vice President-Timber (1989) L. J. Holbrook 38 (6) Senior Vice President-Finance, Secretary and Treasurer (1989) D. C. Stibich 62 (7) Senior Vice President-Paper Sales (1981) R. B. Arkell 62 (8) Vice President-Industrial Relations and General Council (1986) (1) R. P. Wollenberg From 1985 Chairman, President and Chief Executive Officer 1978-1985 President and Chief Executive Officer 1969-1978 President 1960-1969 Executive Vice President (2) R. E. Wertheimer From 1985 Executive Vice President 1975-1985 Vice President-Container Division 1974-1975 Vice President-Production 1963-1974 Vice President-Container Sales (3) W. H. Smith From 1992 Vice President-Production 1982-1992 Assistant Mill Manager (4) R. J. Parker From 1994 Senior Vice President-Production 1993-1994 Vice President and Assistant to the President 1992-1993 Pulp Mill Superintendant 1985-1992 Assistant Pulp Mill Superintendant (5) D. L. Bowden From 1992 Senior Vice President-Timber 1989-1992 Vice President-Timber 1980-1989 Assistant Timber Manager (6) L. J. Holbrook From 1992 Senior Vice President-Finance, Secretary and Treasurer 1991-1992 Vice President-Finance, Secretary and Treasurer 1989-1991 Assistant Secretary and Assistant Treasurer (7) D. C. Stibich From 1986 Senior Vice President Paper Sales 1981-1986 Vice President Paper Sales 1968-1981 Manager Paper Sales (8) R. B. Arkell From 1979 Vice President Industrial Relations and General Counsel ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This item is completed by reference to Notice of Annual Meeting of Shareholders and Proxy Statement which is incorporated as part of this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security ownership of certain beneficial owners. This item is completed by reference to Notice of Annual Meeting of Shareholders and Proxy Statement which is incorporated as part of this Form 10-K. (b) Security ownership of management. This item is completed by reference to Notice of Annual Meeting of Shareholders and Proxy Statement which is incorporated as part of this Form 10-K. (c) Changes in control. No known arrangements. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. There have been no known transactions in an amount in excess of $60,000 involving any of the specified persons. (b) Certain business relationships. No director or nominee for director is known to be involved in any of the specified relationships with the company. (c) Indebtedness of management. None of the specified persons is indebted to the company in an amount in excess of $60,000. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following financial statements, schedules and exhibits are filed as part of this Form 10-K. (1) Financial Statements: The 1991, 1992 and 1993 consolidated financial statements are included in Item 8 of this Form 10-K. The individual financial statements of the company have been omitted since the company is primarily an operating company and all subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interest and/or indebtedness to any person other than the company or its consolidated subsidiaries in amounts which together exceed 5% of total consolidated assets at October 31, 1993. (3) Exhibits required to be filed by Item 601 of Regulation S-K: 3.1 Articles of Incorporation of Longview Fibre Company 3.2 Bylaws of Longview Fibre Company * 4.1 Commercial Paper Facility * 4.2 Rights Agreement ** 4.3 $170,000,000 Credit Agreement 4.4 First Amendment to Credit Agreement 4.5 Loan Agreement 4.6 Other long-term debts that do not exceed 10% of the total assets of the company, details of which will be supplied to the Commission upon request: Senior Notes due through 1999 (7.70% - 10.13%) $157,500,000 Revenue Bonds payable through 2015 (floating rates, 2.55% through 2.75% at October 31, 1993) $ 28,900,000 Other $ 1,029,000 23. Consent of Independent Accountants * Incorporated by reference to company's Annual Report on Form 10-K for the year ended October 31, 1988. Incorporated by reference to company's Annual Report on Form 10-K for the year ended October 31, 1989. * Incorporated by reference to company's Annual Report on Form 10-K for the year ended October 31, 1990. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ended October 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LONGVIEW FIBRE COMPANY Registrant \s\ L. J. Holbrook 1-25-94 L. J. Holbrook, Vice President-Finance, Date Secretary and Treasurer Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the company and in the capacities and on the dates indicated. \s\ R. P. Wollenberg 1-25-94 R. P. Wollenberg, Chief Executive Officer Date and Director \s\ L. J. Holbrook 1-25-94 L. J. Holbrook, Chief Financial Officer Date and Director \s\ C. D. Norman 1-25-94 C. D. Norman, Chief Accounting Officer Date \s\ R. B. Arkell 1-25-94 R. B. Arkell, Director Date \s\ D. L. Bowden 1-25-94 D. L. Bowden, Director Date \s\ M. A. Dow 1-25-94 M. A. Dow, Director Date \s\ C. H. Monroe 1-25-94 C. H. Monroe, Director Date \s\ G. E. Schwartz 1-25-94 G. E. Schwartz, Director Date \s\ J. E. Wertheimer 1-25-94 J. E. Wertheimer, Director Date \s\ D. A. Wollenberg 1-25-94 D. A. Wollenberg, Director Date EXHIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS LONGVIEW FIBRE COMPANY LONGVIEW, WASHINGTON We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-14358) and the Registration Statement on Form S-8 (No. 33-37836) and the Registration Statement on Form S-8 (No. 33-56620) of Longview Fibre Company of our report dated December 8, 1993, which appears at Item 8 of Longview Fibre Company's Annual Report on Form 10-K. \s\ Price Waterhouse Price Waterhouse Portland, Oregon January 25, 1994	11,081	62,306
101839_1993.txt	101839_1993	1993	101839	Item 1. Business United Telephone Company of Ohio (Company), a wholly-owned subsidiary of Sprint Corporation (Sprint), was incorporated under the laws of the State of Ohio in 1965 and subsequently succeeded by acquisition or merger to the business of several other telephone operating companies in Ohio. In 1990, the Company combined its administrative offices with United Telephone Company of Indiana, Inc. (United of Indiana), an affiliate. Each company retains a separate legal identity. The Company is engaged in the business of furnishing communications services consisting mainly of local and long-distance services and network access. It provides service to 507,111 access lines in 164 exchange areas. No other company furnishes local telephone service in any of the exchange areas served by the Company. Revenues from telephone and other communications services constitute about 91% of the Company's total operating revenues. The remaining 9% of total operating revenues is, in large part, contributed by directory advertising, billing and collection services, operator services, facility leases, and non- regulated sales. A significant portion of the Company's network access revenues are derived from access charge billings to AT&T Communications, Inc. (AT&T). The Company's operating area includes approximately 8,700 square miles or 21% of the geographical area of the State of Ohio and contains approximately 10% of the State's population. Approximately 34% of the Company's 507,111 access lines in service are located in the five exchange areas of Warren, Mansfield, Lima, Wooster and Mount Vernon. The service areas contain a variety of both large and commercial and agricultural businesses. In addition to furnishing local service, the Company's central offices and long-distance lines are connected with other independent telephone companies and with the nationwide long-distance networks of interexchange carriers, primarily AT&T. Long-distance calls may thus be made to any telephone in the United States and most other countries. Other telecommunications services, for the most part furnished in conjunction with other telephone companies, include facilities for private line service, data transmission, mobile radio telephone and wide area long-distance service. The Company has two wholly-owned subsidiaries. United Telephone Communications Services of Ohio, Inc. offers terminal equipment and inside wire leasing and maintenance services to the residential and business markets. United Telephone Long Distance, Inc. offers one-plus, interLATA long-distance service. (Page 2) United of Ohio Form 10-K,Part I December 31, 1993 Item 1. Business (continued) The PUCO also continued to debate extended area service (EAS) in 1993 regarding the definition of more stringent guidelines for specific EAS requests. A generic docket is before the PUCO but has not been ruled upon. In the meantime, the PUCO has continued to rule in favor of extended local calling (a measured form of EAS), as recommended by the Company (resulting in the cost causer being the cost payer), rather than traditional flat rate EAS. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing LECs to direct coin telephone competition in many states. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier 1 LECs (including the Company) allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the D.C. Circuit. In October 1992, the FCC adopted a new rate structure and new pricing rules for LEC-provided switched transport. It is considered an interim rate structure (approximately two years) while the FCC determines a long-term structure. Rates were developed such that the impact of this new rate structure will be revenue-neutral for the Company. The new rates went into effect on December 30, 1993. The extent and ultimate impact of competition on the Company will continue to depend, to a considerable degree, on FCC and PUCO actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress. Item 2. Item 2. Properties The properties of the Company consist principally of land, structures, facilities and equipment used in providing telephone service and are in good operating condition. Substantially all of the telephone properties are subject to the lien securing the Company's first mortgage bonds. Of the Company's investment in telephone plant in service as of December 31, 1993, central office equipment represented approximately 37%; cable and wire facilities, 45%; telephone instruments and related equipment installed on subscribers' premises, 4%; land and buildings, 6%; and other telephone plant, 8%. The following table shows gross additions to, and retirements of, properties of the Company for each of the years in the five year period ended December 31, 1993 (in thousands of dollars): Gross Property Gross Gross Property at Beginning Property Retirements at End of Year Additions or Sales of Year 1993 $992,555 $74,587 $36,609 $1,030,533 1992 944,646 76,856 28,947 992,555 1991 902,252 76,131 33,737 944,646 1990 850,631 78,706 27,085 902,252 1989 818,228 62,686 30,283 850,631 (Page 4) United of Ohio Form 10-K, Part I December 31, 1993 Item 3. Item 3. Legal Proceedings No material legal proceedings are pending to which the Company or any of its subsidiaries is a party or of which any of their property is the subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted under the provisions of General Instruction J. Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The Registrant is a wholly-owned subsidiary of Sprint, and consequently its common stock is not traded. Item 6. Item 6. Selected Financial Data The table set forth below presents significant financial data for each of the years in the five year period ended December 31, 1993 (in thousands of dollars): 1993 1992 1991 1990 1989 Operating Revenues $398,089 $371,806 $351,973 $343,005 $343,328 Net Income (1) $ 34,741 $ 42,896 $ 41,238 $40,969 $ 41,777 Total Assets $628,839 $596,282 $575,721 $557,214 $552,282 Long-Term Debt $163,705 $167,386 $121,780 $122,876 $130,282 (excludes current maturities) (1) During 1993, nonrecurring charges of $12.8 million were recorded representing the Company's portion of the costs associated with the merger of Sprint and Centel Corporation. Such charges reduced 1993 net income by $8.3 million. Earnings and dividend per share information has been omitted because the Company is a wholly-owned subsidiary of Sprint. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Recent Development - Sprint/Centel Merger Effective March 9, 1993, Sprint consummated its merger with Centel Corporation, a telecommunications company with local exchange and cellular/wireless communications services operations (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in a nonrecurring charge to Sprint during 1993. The portion of such charge attributable to the Company was $12.8 million, which reduced 1993 net income by approximately $8.3 million. (Page 5) United of Ohio Form 10-K, Part I December 31, 1993 Item 7 Management's Discussion (continued) Liquidity and Capital Resources During 1993, cash from operating activities exceeded capital expenditures by $2.8 million, continuing to indicate the Company's strong liquidity and financial position. The Company maintains its commitment to provide its subscribers the most technologically advanced telecommunications equipment. Accordingly, the Company continually replaces and constructs new facilities, and the 1993 construction program continued that emphasis. The actual expenditures for property, plant and equipment were $74.6 million in 1993, $76.9 million in 1992, and $76.1 million in 1991. The planned construction expenditures in 1994 are expected to approximate $77.1 million, as the increasing demand for interexchange access services requires the placement of high-capacity fiber optic facilities. The Company anticipates that the funds for this program will be supplied by operating activities and short-term borrowings. The demand for telephone services is relatively constant and usually generates a non-cyclical cash in-flow. During 1993, operating activities generated cash of $77.4 million, compared to $111.1 million in 1992 and $109.4 million in 1991. The decrease from 1992 to 1993 is attributable to increased accounts receivable, decreased accounts payable, and expenditures related to merger and restructuring costs. Adequate depreciation rates remain critical to the Company due to the large investment in telecommunications plant and equipment. To ensure the timely recovery of capital, the Company has historically sought to obtain higher depreciation rates from the PUCO. Effective January 1, 1989, the PUCO allowed a maximum ten-year period for amortizing a depreciation reserve deficiency of $54.5 million, and gave the Company the option to accelerate the amortization for book purposes. Included in depreciation expense for 1993, 1992 and 1991 is amortization of $5.4 million each year. At December 31, 1993, $26.1 million of the reserve deficiency remains to beamortized at a minimum of $5.4 million annually. Net cash used by financing activities was $4.3 million. The Company issued $40 million of First Mortgage Bonds, Series CC, due January 1, 2000. The proceeds from this issuance were used to repay advances from the parent company of $30 million, which were classified as long-term debt, and to fund capital construction. The Company early retired $76.0 million in long-term debt in 1993 with interest rates ranging from 6.875 percent to 9.0 percent. These retirements were refinanced on a long-term basis with the issuance of Series DD, due June 1, 2000 for $30 million and Series EE, due June 1, 2005 for $35 million at rates of 6.5 percent and 7.25 percent, respectively. No dividends were declared in 1993. At December 31, 1993, the composition of the Company's capital structure was 61.4 percent common equity and 38.6 percent long-term debt. This compares to a year-end capital structure comprised of 57.6 percent common equity and 42.4 percent long-term debt in 1992. (Page 6) United of Ohio Form 10-K, Part I December 31, 1993 Item 7 Management's Discussion (continued) Results of Operations Operating revenues consist of local service, network access, long-distance network and miscellaneous. Local service revenues are derived from providing local telephone exchange services and leasing equipment. Network access revenues are derived from billing other carriers and telephone customers for their use of the local network to complete long-distance calls in those instances where the long-distance service is not provided by the Company. Long- distance revenues are derived principally from providing long-distance services within designated areas. Miscellaneous revenues primarily relate to directory advertising, billing and collection services for interexchange carriers, operator services, network facility leases and sales of telecommunications equipment. Operating revenues in 1993 increased by $26.3 million or 7.1 percent from 1992. This increase in total operating revenues was universal to all revenue categories during the year. Access lines in 1993 grew by 17,785 or 3.6 percent compared to 1992. This growth trend was reflected in a 3.9 percent growth in local service revenue. Basic subscriber line revenue increased $4.6 million or 3.8 percent. Network access revenue increased by $9.7 million or 7.7 percent for the year ended December 31, 1993 compared to 1992. Increased usage, as indicated by a 5.0 percent growth in message volumes and a 7.2 percent growth in minutes of use, accounted for the increase. Long distance network revenue increased $4.8 million or 8.7 percent for the year ended December 31, 1993 compared to 1992. The increase can be attributed to increased volumes of messages and minutes of use in the current year. Other revenues increased $5.6 million or 17.8 percent for the year ended December 31, 1993 compared to 1992. Sales of telecommunication equipment increased $4.1 million due to increased sales of structured wire and PBX systems. Increased revenues from providing operator services also contributed to the increase. Operating expenses (including taxes) increased $34.0 million or 10.7 percent in 1993 compared to 1992. The major components of the current year's increase were increases in plant expense, customer operations, and merger, integration and restructuring costs. Plant expense increased $7.4 million or 6.7 percent. Repairs of buried cable increased $1.4 million due to the implementation of a new preventive cable maintenance program. General purpose computer and generic software expense increased $1.7 million resulting from increased purchases from Northern Telecom for central office switch conversions. Other plant nonspecific expenses increased $1.6 million, including network operations and access expense. Other increases in plant expense occurred in rearrangement and change activity. Customer operations expense increased $8.3 million or 20.6 percent for the year ended December 31, 1993. Sales and advertising expense increased $4.2 million in the current year as the Company continues to intensify its efforts to achieve increased market share in today's competitive environment. Call completion, number services, and business operations expense increased $1.7 million which is directly related to the increase in revenues derived from providing operator services. (Page 7) United of Ohio Form 10-K, Part I December 31, 1993 Item 7 Management's Discussion (continued) Merger, integration and restructuring costs were $12.8 million in 1993 as discussed above. Other operating expense was $4.1 million higher in 1993 when compared to 1992 due to an increase of $4.0 million in cost of equipment sales. In addition to the increases discussed above, plant expense, customer operations expense and corporate operations expense also increased as a result of higher postretirement benefits costs due to the adoption of Statement of Financial Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The incremental cost associated with this change in accounting principle was approximately $6,550,000. Effects of Inflation The effects of inflation on the operations of the Company were not significant during 1993, 1992 or 1991. Recent Accounting Developments Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits" (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Consistent with most local exchange carriers, the Company accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. The Company's management believes that the Company's operations meet the criteria for the continued application of the provisions of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the Company no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, non-cash charge. (Page 8) United of Ohio Form 10-K, Part I December 31, 1993 Item 8. Item 8. Financial Statements and Supplementary Data UNITED TELEPHONE COMPANY OF OHIO INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Pages Report of Independent Auditors 10 Consolidated Balance Sheets at December 31, 1993 and 1992 11-12 Consolidated Statements of Income for each of the three years ended December 31, 1993 13 Consolidated Statements of Retained Earnings for each of the three years ended December 31, 1993 14 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 15 Notes to Consolidated Financial Statements 16-27 (Page 9) United of Ohio Form 10-K, Part I December 31, 1993 REPORT OF INDEPENDENT AUDITORS The Board of Directors United Telephone Company of Ohio We have audited the accompanying consolidated balance sheets of United Telephone Company of Ohio, a wholly-owned subsidiary of Sprint Corporation, as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Telephone Company of Ohio at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, United Telephone Company of Ohio changed its method of accounting for postretirement benefits in 1993. ERNST & YOUNG Kansas City, Missouri January 21, 1994 (Page 10) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. ACCOUNTING POLICIES United Telephone Company of Ohio is engaged in the business of providing communications services, principally local, network access and long distance services in Ohio. The principal industries in its service area include a variety of both large and small industrial, commercial and agricultural businesses. Basis of Presentation The accompanying consolidated financial statements include the accounts of United Telephone Company of Ohio, and its wholly-owned subsidiaries, United Telephone Long Distance, Inc. (UTLD) and United Telephone Communications Services of Ohio, Inc., collectively referred to as the "Company". All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Sprint Corporation (Sprint); accordingly, earnings per share information has been omitted. The Company accounts for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation", which requires the accounting recognition of the rate actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. These reclassifications had no effect on net income in either year. Cash and Equivalents Cash equivalents generally include highly liquid investments with original maturities of three months or less and are stated at cost, which approximates market value. Inventories Inventories consist of materials and supplies, stated at average cost, and equipment held for resale, stated at the lower of average cost or market. The sales inventory balances were $377,000 and $291,000 at December 31, 1993 and 1992, respectively. Property, Plant and Equipment Property, plant and equipment are recorded at cost. Retirements of depreciable property are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. (Page 16) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. ACCOUNTING POLICIES (continued) Depreciation Depreciation expense is generally computed on a straight-line basis over estimated useful lives as prescribed by regulatory commissions. As ordered by the Public Utilities Commission of Ohio (PUCO), the Company recorded an amortization of a reserve deficiency to depreciation expense in the amount of $5,447,000 in 1993, 1992 and 1991, which reduced net income by $3,149,000, $3,122,000 and $3,145,000, respectively. Average annual composite depreciation rates, excluding the nonrecurring charges, were 7.5 percent for 1993, 7.3 percent for 1992 and 7.5 percent for 1991. Income Taxes Operations of the Company are included in the consolidated federal income tax returns of Sprint. Federal income tax is calculated by the Company on the basis of its filing a separate return. Effective January 1, 1992, the Company changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to accounting for income taxes. Under the provisions of SFAS No. 109, the Company adjusted existing deferred income tax amounts, using current tax rates, for the estimated future tax effects attributable to temporary differences between the tax bases of the Company's assets and liabilities and their reported amounts in the financial statements. The Company's principal temporary difference results from using different depreciable lives and methods with respect to its property, plant and equipment for tax and financial reporting purposes. As a result of corporate income tax rate reductions in prior years and the previous income tax accounting standards which did not permit accumulated deferred income tax amounts to be adjusted for subsequent tax rate changes, adoption of SFAS No. 109 resulted in a decrease in the amount of deferred income tax liabilities recorded. However, because this decrease will accrue to the benefit of the Company's customers through future telephone rates established by the Company's regulators, this decrease in deferred income tax liabilities has been reflected as a regulatory liability in the Company's financial statements. Additionally, deferred income taxes were not provided in prior years in those instances where the Company's regulators did not recognize such deferred income taxes for ratemaking purposes. Upon adoption of SFAS No. 109, the Company recognized deferred income tax liabilities for those temporary differences for which deferred income taxes had not previously been provided. Corresponding regulatory assets were also recorded by the Company to reflect the anticipated recovery of such taxes in future telephone rates based on actions of the Company's regulators. Accordingly, the adoption of SFAS No. 109 had no significant effect upon the Company's 1992 net income. As allowed by SFAS No. 109, prior years' consolidated financial statements were not restated. During 1991, in accordance with Accounting Principles Board Opinion (APB) No. 11, deferred income taxes were provided for all differences in timing of reporting income and expenses for financial statement and income tax purposes, except for items that were not allowable by the Federal Communications Commission (FCC) or the PUCO, as an expense for rate-making purposes. (Page 17) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. ACCOUNTING POLICIES (continued) Income Taxes (continued) Investment tax credits (ITC) are deferred and amortized over the useful life of the related property. The Tax Reform Act of 1986 effectively eliminated ITC after December 31, 1985. Postretirement Benefits Effective January 1, 1993, the Company changed its method of accounting for postretirement benefits (principally health care benefits) provided to certain retirees by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits to employees and their dependents or beneficiaries during the years employees earn the benefits. As permitted by SFAS No. 106, the Company elected to recognize the obligation for postretirement benefits already earned by its current retirees and active work force as of January 1, 1993, by amortizing such obligation on a straight-line basis over a period of twenty years. During 1992 and 1991, the Company expensed postretirement benefits as such costs were paid. Postemployment Benefits Effective January 1, 1994, the Company will adopt SFAS No 112, "Employers' Accounting for Postemployment Benefits." Under the new standard, the Company is required to recognize certain previously unrecorded obligations for benefits provided to former or inactive employees and their dependents, after employment but before retirement. Postemployment benefits offered by the Company include severance, workers' compensation and disability benefits, including the continuation of other benefits such as health care and life insurance coverage. As required by the standard, the Company will recognize its obligations for postemployment benefits through a cumulative adjustment in the consolidated income statement. The resulting nonrecurring, non-cash charge will not significantly impact the Company's 1994 net income. Adoption of this standard is not expected to significantly impact future operating expenses. Interest Charged to Construction In accordance with the Uniform System of Accounts, as prescribed by the FCC, interest is capitalized on those telephone plant construction projects for which the estimated construction period exceeds one year. In addition, the PUCO has ordered that the Company also capitalize interest during construction on short-term projects. 2. MERGER AND INTEGRATION COSTS Effective March 9, 1993, Sprint consummated its merger with Centel Corporation (Centel), a telecommunications company with local exchange and cellular/wireless communications services operations. Centel's local exchange telephone businesses operate in six states: Florida, North Carolina, Virginia, Illinois, Texas and Nevada. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock. (Page 18) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 2. MERGER AND INTEGRATION COSTS (continued) The operations of the merged companies are being integrated and restructured to achieve efficiencies which are expected to yield significant operational synergies and cost savings. The transaction costs associated with the merger and the estimated expenses of integrating and restructuring the operations of the two companies resulted in nonrecurring charges to Sprint during 1993. The portion of such charges attributable to the Company was $12,816,000, which reduced 1993 net income by approximately $8,300,000. 3. EMPLOYEE BENEFIT PLANS Defined Benefit Pension Plan Substantially all employees of the Company are covered by a noncontributory defined benefit pension plan. For participants of the plan represented by collective bargaining units, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plan provides pension benefits based upon years of service and participants' compensation. The Company's policy is to make contributions to the plan each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plan's assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. The components of the net pension credits and related assumptions are as follows (in thousands): 1993 1992 1991 Service cost - benefits earned during the period $ 3,222 $ 3,044 $ 2,948 Interest cost on projected benefit obligation 8,972 8,513 7,912 Actual return on plan assets (27,975) (10,400) (44,237) Net amortization and deferral 7,391 (6,914) 27,854 --------- --------- -------- Net pension credit $ (8,390) $ (5,757) $(5,523) ========= ========= ======== Discount rate 8.00% 8.50% 8.50% Expected long-term rate of return on plan assets 9.50% 8.25% 8.25% Anticipated composite rate of future increases in compensation 5.50% 6.33% 7.02% (Page 19) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Defined Benefit Pension Plan (continued) The funded status and amounts recognized in the consolidated balance sheets for the plan, as of December 31, are as follows (in thousands): 1993 1992 Actuarial present value of pension benefit obligations Vested benefit obligation $(112,517) $ (96,112) --------- --------- Accumulated benefit obligation $(126,977) $(106,179) --------- --------- Projected benefit obligation $(135,615) $(114,879) Plan assets at fair value 231,371 209,165 Plan assets in excess of the projected --------- --------- benefit obligation 95,756 94,286 Unrecognized net gains (38,781) (36,062) Unrecognized prior service cost (benefit) 4,956 (2,681) Unamortized portion of transition asset (29,654) (32,949) --------- --------- Prepaid pension cost $ 32,277 $ 22,594 ========= ========= The projected benefit obligations as of December 31, 1993 and 1992, were determined using a discount rate of 7.50% for 1993 and of 8.00% for 1992, and anticipated composite rates of future increases in compensation of 4.50% for 1993 and of 5.50% for 1992. Defined Contribution Plans Sprint sponsors two defined contribution employee savings plans covering substantially all employees of the Company. Participants may contribute portions of their compensation to the plans. Contributions of participants represented by collective bargaining units are matched by the Company based upon defined amounts as negotiated by the respective parties. Contributions of participants not covered by collective bargaining agreements are also matched by the Company. For these participants, the Company provides matching contributions equal to 50 percent of participants' contributions up to 6 percent of their base compensation and may, at the discretion of Sprint's Board of Directors, provide additional matching contributions based upon the performance of Sprint's common stock price in comparison to other telecommunications companies. The Company's contributions to the plans aggregated $2,280,000, $1,612,000 and $1,651,000 in 1993, 1992 and 1991, respectively. Postretirement Benefits The Company provides other postretirement benefits (principally health care benefits) to certain retirees. Substantially all employees who retired from the Company before January 1, 1991, became eligible for these postretirement benefits at no cost to the retirees. Employees retiring after such date, who meet specified age and years of service requirements, are eligible for these benefits on a shared cost basis, with the Company's portion of the cost determined by the retirees' years of credited service at retirement. The Company funds the accrued costs as benefits are paid. (Page 20) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 3. EMPLOYEE BENEFITS PLAN (continued) Postretirement Benefits (continued) For regulatory purposes, the FCC permits recognition of net postretirement benefits costs, including amortization of the transition obligation, in accordance with SFAS No. 106. The components of the 1993 net postretirement benefits cost are as follows (in thousands): Service cost -- benefits earned during the period $ 1,857 Interest on accumulated postretirement benefits obligation 5,325 Amortization of transition obligation 3,395 ------- Net postretirement benefits cost $10,577 ======= For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed trend rate would have increased the 1993 net postretirement benefits cost by approximately $1,721,000. The weighted average discount rate for 1993 was 8 percent. The cost of providing health care benefits to retirees was $2,016,000 and $1,698,000 in 1992 and 1991, respectively. The amount recognized in the consolidated balance sheet as of December 31, 1993, is as follows (in thousands): Accumulated postretirement benefits obligation Retirees $25,224 Active plan participants -- fully eligible 19,382 Active plan participants -- other 26,499 ------- 71,105 Unrecognized net gains 2,005 Unrecognized transition obligation (64,514) Accrued postretirement benefits cost $ 8,596 The accumulated benefits obligation as of December 31, 1993, was determined using a discount rate of 7.5 percent. An annual health care cost trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the accumulated benefits obligations as of December 31, 1993, by approximately $10,239,000. (Page 21) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 4. INCOME TAXES The components of federal and state income tax expense are as follows (in thousands): 1993 1992 1991 ------- ------- ------- Federal income taxes Current $22,418 $23,415 $21,027 Deferred (8,868) (5,764) (2,756) Amortization of deferred ITC (3,298) (3,819) (4,029) ------- ------- ------- 10,252 13,832 14,242 ------- ------- ------- State income taxes Current (341) 118 203 Deferred 123 140 24 ------- ------- ------- (218) 258 227 ------- ------- ------- Total income tax expense $10,034 $14,090 $14,469 ======= ======= ======= The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in thousands): 1993 1992 1991 ------- ------- ------- Federal income tax at the statutory rate $15,671 $19,375 $18,940 Less amortization of deferred ITC (3,298) (3,819) (4,038) Expected federal income tax provision after ------- ------- ------- amortization of deferred ITC 12,373 15,556 14,902 Effect of Differences required to be flowed through by regulatory commissions 457 509 607 Reversal of rate differentials (2,187) (2,725) (2,482) Tax examination adjustments 1,087 Other, net (609) 750 355 ------- ------- ------- Income tax expense, including ITC $10,034 $14,090 $14,469 ======= ======= ======= Effective income tax rate 22.4% 24.7% 26.0% ======= ======= ======= (Page 22) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 4. INCOME TAXES (continued) During 1993 and 1992, in accordance with SFAS No. 109, deferred income taxes were provided for the temporary differences between the carrying amounts of the Company's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, along with the income tax effect of each, are as follows (in thousands): 1993 1992 Deferred Income Tax Deferred Income Tax Assets Liabilities Assets Liabilities ------- ------------ ------- ----------- Property, plant and equipment $44,291 $49,520 Allowance for doubtful accounts 575 234 Expense accruals 6,894 3,937 Deferred ITC 8,206 11,503 Other, net (3,909) (3,485) ------- ------- ------ ------- $56,057 $61,709 On August 10, 1993, the Revenue Reconciliation Act of 1993 (the Act) was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to the beginning of the year. Pursuant to SFAS No. 71, the resulting adjustments to the Company's deferred income tax assets and liabilities to reflect the revised rate have generally been reflected as reductions to the related regulatory liabilities. During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, were as follows (in thousands): Property, plant and equipment $(4,424) Allowance for doubtful accounts (207) Expense accruals 2,585 Other, net (686) ------- $(2,732) ======= (Page 23) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 5. LONG-TERM DEBT Long-term debt as of December 31, excluding current maturities, is as follows (in thousands): 1993 1992 ----------------------- ------- Weighted Average Amount Interest Rate Amount -------- ------------- -------- First mortgage bonds, maturities 2000 to 2005 $165,000 6.85% $137,537 Advances from parent company classified as long-term debt 30,000 Less: Unamortized discount on first mortgage bonds 1,295 151 -------- -------- $163,705 $167,386 ======== ======== Advances from parent company were classified as long-term debt at December 31, 1992, as they were replaced with $40,000,000 of 7.11% series CC seven-year First Mortgage Bonds issued in February 1993. Long-term debt maturities during the next five years consist of $1,587,000 scheduled for repayment in 1994. The first mortgage bonds are secured by substantially all of the Company's property, plant, and equipment. Under the most restricted terms of the Company's first mortgage bond indentures, $56,629,000 of retained earnings were restricted from payment of dividends at December 31, 1993. As of December 31, 1993, the Company had lines of credit with banks totalling $20,000,000, all of which was available at year end. The bank lines, which renew annually on various dates, provide for short-term borrowings at market rates of interest and require annual commitment fees based on the unused portion. Lines of credit may be withdrawn by the banks if there is a material adverse change in the financial condition of the Company. During 1993, the Company redeemed prior to scheduled maturities $75,950,000 of first mortgage bonds with interest rates from 6.875 percent to 9.0 percent. During 1992, the Company redeemed, prior to scheduled maturities, $43,850,000 of first mortgage bonds with interest rates ranging from 8.875 percent to 10.25 percent. The payment penalties related to these early extinguishments of debt were not significant. (Page 24) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 6. COMMITMENTS Gross rental expense aggregated $5,490,000 in 1993, $5,676,000 in 1992 and $5,963,000 in 1991. The Company's planned capital expenditures for the year ending December 31, 1994 are approximately $77,118,000. Normal purchase commitments have been or will be made for these planned expenditures. 7. RELATED PARTY TRANSACTIONS The Company purchases telecommunications equipment, construction and maintenance equipment, and materials and supplies from its affiliate, North Supply Company. Total purchases for 1993, 1992, and 1991 were $25,612,000, $23,207,000 and $20,420,000, respectively. Under an agreement with Sprint, the Company reimburses Sprint for data processing services, other data related costs and certain management costs which are incurred for the Company's benefit. A credit resulting from deferred income taxes on intercompany profits is also allocated by Sprint to affiliated companies. Total charges to the Company aggregated $30,628,000, $27,091,000 and $23,065,000 in 1993, 1992 and 1991, respectively, and the credit relating to deferred income taxes was $596,000, $630,000 and $704,000 in 1993, 1992 and 1991, respectively. The Company enters into cash advance and borrowing transactions with Sprint; generally, interest on such transactions is computed based on the prior month's thirty-day average commercial paper index, as published in the Federal Reserve Statistical Release H.15, plus forty-five basis points. Interest expense on such advances from Sprint was $429,000, $1,256,000 and $1,057,000 in 1993, 1992 and 1991, respectively. Interest income on such advances to Sprint was $162,000, $63,000 and $357,000 in 1993, 1992 and 1991, respectively. Sprint Publishing & Advertising, an affiliate, pays the Company a fee for the right to publish telephone directories in the Company's operating territory, a listing fee, and a fee for billing and collection services performed for Sprint Publishing & Advertising by the Company. For 1993, 1992 and 1991, Sprint Publishing & Advertising paid the Company a total of $8,622,000, $8,549,000 and $8,512,000, respectively. The Company paid Sprint Publishing & Advertising $850,000, $788,000 and $1,572,000 in 1993, 1992 and 1991, respectively, for its costs of publishing the white page portion of the directories. The Company provides various services to Sprint's long distance communications services division, such as network access, operator and billing and collection services, and the lease of network facilities. The Company received $10,094,000, $9,227,000 and $8,454,000 in 1993, 1992 and 1991, respectively, for these services. The Company paid Sprint's long distance communications services division $4,648,000, $4,540,000 and $4,109,000 in 1993, 1992 and 1991, respectively, for interexchange telecommunications services. Beginning in 1991, the Company provided interstate interexchange carrier operator services to nine affiliated local telephone companies. The Company billed the affiliated companies a total of $5,665,000 and $5,301,000 in 1993 and 1992, respectively. The amount billed in 1991 was insignificant. (Page 25) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 7. RELATED PARTY TRANSACTIONS (continued) The Company is reimbursed by United Telephone Company of Indiana, Inc. for certain salaries and other costs which are incurred by the Company for the benefit of the affiliate. Similarly, the Company reimburses the affiliate for certain costs incurred by the affiliate for the Company's benefit. These reimbursements represent the cost of such items as determined by the Company and its affiliates. Such reimbursable charges, net of amounts reimbursed by the Company, totalled $23,955,000, $21,651,000 and $18,584,000 in 1993, 1992 and 1991, respectively. Certain directors and officers of the Company are also directors or officers of banks at which the Company conducts borrowings and related transactions. The terms are comparable with other banks at which the Company has similar transactions. 8. ADDITIONAL FINANCIAL INFORMATION Financial Instruments Information The Company's financial instruments consist of long-term debt, including current maturities, with carrying amounts as of December 31, 1993 and 1992 of $165,292,000 and $167,939,000, respectively, and estimated fair values of $172,977,000 and $168,339,000, respectively. The fair values are estimated based on quoted market prices for publicly-traded issues, and based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved for all other issues. The carrying values of the Company's other financial instruments (principally cash equivalents) approximate fair value as of December 31, 1993 and 1992. Supplemental Cash Flows Information The supplemental disclosures required for the consolidated statements of cash flows for the years ended December 31, are as follows (in thousands): 1993 1992 1991 Cash paid for Interest, net of amounts capitalized $10,166 $11,568 $10,404 Income taxes $24,578 $25,679 $18,119 Major Customer Information Operating revenues from American Telephone & Telegraph resulting primarily from network access, billing and collection services, and the lease of network facilities aggregated approximately $70,090,000, $68,740,000 and $66,842,000 for 1993, 1992 and 1991, respectively. (Page 26) UNITED TELEPHONE COMPANY OF OHIO NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 9. SUPPLEMENTAL QUARTERLY INFORMATION - UNAUDITED (in thousands) 1993 Quarters Ended ------------------------------------------------------- March 31 June 30 September 30 December 31 -------- ------- ------------ ----------- Operating revenues $95,294 $98,522 $101,255 $103,018 Operating income 5,095 13,812 14,803 13,577 Net income 2,123 10,312 11,751 10,555 1992 Quarters Ended ------------------------------------------------------- March 31 June 30 September 30 December 31 -------- ------- ------------ ----------- Operating revenues $90,656 $92,214 $91,409 $97,527 Operating income 13,731 13,858 13,066 14,340 Net income 10,878 10,821 9,697 11,500 In the first and fourth quarters of 1993, the Company recorded merger and integration costs of $10,300,000 and $2,516,000, respectively, as a result of the merger of Sprint and Centel. Such charges reduced net income by approximately $6,700,000 and $1,600,000, respectively. (Page 27) United Telephone of Ohio Form 10-K, Part II/Part III December 31, 1993 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None Item 10. Item 10. Directors and Executive Officers of the Registrant Omitted under the provisions of General Instruction J. Item 11. Item 11. Executive Compensation Omitted under the provisions of General Instruction J. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Omitted under the provisions of General Instruction J. Item 13. Item 13. Certain Relationships and Related Transactions Omitted under the provisions of General Instruction J. (Page 28) United Telephone of Ohio Form 10-K, Part II/Part III December 31, 1993 Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. The consolidated financial statements of the Company filed as part of this report are listed in the Index to Consolidated Financial Statements on page 9. 2. The consolidated financial statement schedules of the Company filed as part of this report are listed in the Index to Consolidated Financial Statement Schedules on page 30. (b) The exhibits filed as part of this report as required by Item 601 of Regulation S-K are listed in the Index to Exhibits on page 39. (Page 29) United of Ohio Form 10-K, Part IV December 31, 1993 UNITED TELEPHONE COMPANY OF OHIO INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES (Item 14(a) 2) Page Reference For the three years ended December 31, 1993, 1992 and 1991 Schedule V - Property, Plant and Equipment. . . . . . . . . . . . . 31-33 Schedule VI - Accumulated Depreciation. . . . . . . . . . . . . . . 34-36 Schedule VIII - Valuation and Qualifying Accounts . . . . . . . . . 37 Schedule X - Supplementary Income Statement Information . . . . . . 38 All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. (Page 31) (Page 32) (Page 33) (Page 34) (Page 35) (Page 36) (Page 37) United Telephone of Ohio Form 10-K, Part IV December 31, 1993 PART IV UNITED TELEPHONE COMPANY OF OHIO SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION-CONSOLIDATED (Thousands of Dollars) [TEXT] Maintenance expense is the primary component of plant expense which is shown separately on the Consolidated Statements of Income. The Company had no significant advertising or royalty expenses during 1993, 1992, and 1991. (Page 38) United of Ohio Form 10-K, Part IV December 31, 1993 UNITED TELEPHONE COMPANY OF OHIO INDEX TO EXHIBITS (Item 14(c)) Exhibit No. (3A) Amended Articles of Incorporation (incorporated herein by reference to Exhibit 3-A to Registration Statement of the Company on Form S-1, No. 2-39684). (3B) Amendment to Amended Articles of Incorporation (incorporated herein by reference to Exhibit 3-B to Registration Statement of the Company on Form S-1, No. 2-52845). (3C) Code of Regulations (incorporated herein by reference to Exhibit 3-C to Registration Statement of the Company on Form S-1, No. 2-34454). (4A) Indenture of Mortgage and Deed of Trust dated as of April 1, 1968 and Supplemental Indentures First through Seventh (filed as Exhibit 4-A to Registration Statement No. 2-45070, Exhibit 2-H to Registration Statement No. 2-62515 and Exhibit 19 to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1982), and the Eighth Supplemental Indenture dated as of October 1, 1982, from Company to the Huntington National Bank, Trustee (filed as Exhibit 4J to the Company's Registration Statement on Form S-3, No. 33-50818), and incorporated herein by reference. (4B) Ninth Supplemental Indenture dated as of October 1, 1992, from the Company to the Huntington National Bank, Trustee, filed with this Annual Report on Form 10-K for the year ended December 31, 1992. (Filed as an exhibit to Company's Registration statement on Form S-3 No. 33-50818 and incorporated herein by reference.) (4C) Tenth Supplemental Indenture dated as of January 1, 1993, from the Company to the Huntington National Bank, Trustee, filed with this Annual Report on Form 10-K for the year ended December 31, 1992. (4D) Eleventh supplemental Indenture dated as of May 15, 1993 from the Company to the Huntington National Bank, Trustee, filed with this Annual Report on Form 10-K for the year ended December 31, 1993. (Filed as an exhibit to the Company's Registration statement on Form S-3 No. 33-61024 and incorporated herein by reference.) 23 Consent of Independent Auditors (Page 39) Exhibit 23 CONSENT OF INDEPENDENT AUDITORS The Board of Directors United Telephone Company of Ohio We consent to the incorporation by reference in the Registration Statement (Form S-3 No. 33-61024) of United Telephone Company of Ohio and in the related Prospectus of our report dated January 21, 1994, with respect to the consolidated financial statements and schedules of United Telephone Company of Ohio included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG Kansas City, Missouri March 30, 1994 (Page 40) SIGNATURES Pursuant to the requirements of Section 13 or 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. UNITED TELEPHONE COMPANY OF OHIO (Registrant) March 3, 1994 ________________________________ I. C. Oberlin Vice President-Finance and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date ____________________________ President and Director March 3, 1994 J. D. Kelley ____________________________ Vice President-Network March 3, 1994 L. V. Sprouse Operations ____________________________ Controller March 3, 1994 P. J. Weitzel ____________________________ Director March 3, 1994 J. O. Basford ____________________________ Director March 3, 1994 J. W. Gillis ____________________________ Director March 3, 1994 J. S. Gorman (Page 41) Signature Title Date ____________________________ Director March 3, 1994 B. L. Laramore ____________________________ Director March 3, 1994 N. E. McCann ____________________________ Director March 3, 1994 D. W. Peterson ____________________________ Director March 3, 1994 R. W. Platt ____________________________ Director March 3, 1994 J. E. Schafstall ____________________________ Director March 3, 1994 J. B. Schomaeker ____________________________ Director March 3, 1994 G. L. White ____________________________ Director March 3, 1994 R. L. Zielsdorf (Page 42)	7,987	54,162
819671_1993.txt	819671_1993	1993	819671	ITEM 1. BUSINESS (Continued) Business Plan (Continued) ship's operating cash flow in excess of anticipated renovation costs, unless the Partnership's Oversight Committee approves alternative uses for such operating cash flow. No excess operating cash flow was available for distributions in 1991 or 1992. On October 7, 1993, the Partnership announced a resumption of regular distributions at the initial rate of $0.20 per unit and on December 10, 1993 paid a distribution totaling $388,000. The Partnership has announced a first quarter distribution of $0.20 per unit payable on March 30, 1994, to the unitholders of record on March 18, 1994. The Settlement Agreement also provides that, if certain annually increasing targets relating to the price of National Realty's units of limited partner interest and distributions (hereafter the "Target") are not met, the Oversight Committee may request the Partnership to use its best efforts to sell a portion of its assets and to distribute resulting net proceeds to unitholders. In May 1991, the first of the annual Targets was not met. The second annual Target was not achieved in May 1992. Since the Target was not met for two successive years, the Settlement Plan requires that the General Partner resign effective upon the election and qualification of its successor and requires the Partnership to purchase the General Partner's interest for its fair value. The Settlement Plan will terminate upon the election and qualification of the successor general partner. See ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement." At the discretion of the General Partner, the Partnership may, from time to time, sell properties or other assets, make improvements to properties, make additional investments or obtain additional or initial financing for its properties. As more fully discussed in ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Liquidity and Capital Resources," cash flow from operations should be sufficient to meet the Partnership's various cash needs only if the Partnership is successful in its attempts to refinance or extend mortgage debt as it becomes due during 1994. If the Partnership's efforts to refinance or extend such mortgage debt are not successful, which the Managing General Partner believes is unlikely, accelerated dispositions of Partnership properties or other assets would be required. The establishment, implementation and modification of the business objectives and policies of the Partnership are the responsibility of the General Partner, and, in general, the limited partners have no voting rights with respect to such matters. With respect to the GCLP properties, such business objectives and policies are the responsibility of GCMI. The Partnership's primary business purpose is the ownership of improved, income-producing real estate, but the Partnership may also conduct any business that may lawfully be conducted under the Delaware Revised Uniform Limited Partnership Act. As long as the Settlement Plan is in effect, Oversight Committee approval would be required for the Partnership to enter into any new line of business. See "Management and Operations" below. ITEM 1. BUSINESS (Continued) Management and Operations Since February 1, 1990, affiliates of the Managing General Partner have provided property management services to the Partnership. Currently, Carmel, Ltd. provides such property management services. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Partnership. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) Syntek West, Inc. ("SWI") of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of nine of the Partnership's commercial properties to Carmel Realty, Inc., which is owned by SWI. Effective November 25, 1992, Carmel, Ltd. ceased providing property management services for the apartment complexes transferred to GCLP. BCM performs administrative functions such as accounting services, mortgage servicing and portfolio review and analysis for the Partnership on a cost reimbursement basis. Affiliates of BCM also perform loan placement services, leasing services and real estate brokerage, and other services, for the Partnership for fees and commissions. GCMI performs similar administrative functions for GCLP, also on a cost reimbursement basis. Pending Withdrawal of General Partner As described in ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement," the Settlement Plan provides that, if certain aggressive, annually increasing Targets relating to the price of National Realty's units of limited partner interest and distributions to unitholders are not met for two successive years of the Settlement Plan or the fifth and final year of the Settlement Plan, the General Partner is required to resign and the Partnership is required to repurchase the General Partner's interest for its fair value. The withdrawal of the General Partner would require the Partnership to acquire the General Partner's interest in the Partnership (the "Redeemable General Partner Interest") at its then fair value, and to pay certain fees and other compensation, as provided in the Partnership Agreement and the Settlement Agreement. The Settlement Agreement provides that any payment for such Redeemable General Partner Interest, fees and other compensation during the pendency of the Settlement Plan may, at the Oversight Committee's option, be made over three years pursuant to a secured promissory note bearing interest at a financial institution's prime rate. The Managing General Partner has calculated the Redeemable General Partner Interest at December 31, 1993 to be $25.8 million and believes that there has been no material change in such value since such date. However, the calculation of such Redeemable General Partner Interest at any particular time depends primarily upon the appraised value of the Partnership's properties at such time. The Partnership would be entitled to offset against any such payment the then-outstanding principal balance ($4.2 million at December 31, 1993) ITEM 1. BUSINESS (Continued) Pending Withdrawal of General Partner (Continued) plus accrued unpaid interest ($3.5 million at December 31, 1993) on the note receivable from SAMLP described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Indebtedness of Management." The Oversight Committee has informed the Partnership that it intends to calculate the amount of such Redeemable General Partner Interest in a materially different manner than has the Managing General Partner which would result in a much lower value of approximately $20.0 million. Upon the withdrawal of SAMLP as general partner, the value of the Redeemable General Partner Interest would depend on the value of the Partnership's assets at the time of calculation and there can be no assurance that the value of the Redeemable General Partner Interest payable on any such withdrawal will not be substantially higher or lower than any current calculation. If at the time of such withdrawal, SAMLP and the Oversight Committee are unable to agree on the value of the Redeemable General Partner Interest, it is expected that such disagreement would be resolved by means of a petition to the Judge appointed pursuant to the Settlement Agreement to supervise its implementation. If Targets are not met for any two successive years of the Settlement Plan or for the final year of the Settlement Plan, SAMLP must withdraw as General Partner effective at the time a successor general partner is selected. The Settlement Plan terminates upon the withdrawal of SAMLP as General Partner and the due election and taking office of a successor. Withdrawal of SAMLP as General Partner pursuant to the Settlement Agreement would be subject to the provisions of the Partnership Agreement, including the right of unitholders to elect a successor general partner by majority vote. Upon the withdrawal or removal of the General Partner without the election of a successor, the Partnership would be dissolved. The Target price for the first anniversary date, May 9, 1991, was $44.00 per unit. The Partnership did not achieve this Target. The second anniversary date was May 9, 1992, and the second annual Target was $57.00 per unit. The Partnership did not achieve this Target and, accordingly, the General Partner expects to resign effective upon the election and qualification of its successor. SAMLP and the Oversight Committee are proceeding with the selection of a nominee for successor general partner. Separation of Messrs. Phillips and Friedman and the Partnership from Southmark Until January 1989, Mr. Phillips, a general partner of SAMLP, and Mr. Friedman, a general partner of SAMLP until March 4, 1994, were officers and directors of Southmark and certain of Southmark's subsidiaries and affiliates, including Southmark Asset Management, Inc., then the managing general partner of SAMLP and a wholly-owned subsidiary of Southmark. Mr. Phillips served as Chairman of the Board and a director (since 1980) and President and Chief Executive Officer (since 1981) of ITEM 1. BUSINESS (Continued) Separation of Messrs. Phillips and Friedman and the Partnership from Southmark (Continued) Southmark, and as a director and Chairman of the Board of Southmark Asset Management, Inc. Mr. Friedman served as Vice Chairman of the Board (since 1982), Secretary (since 1984) and a director (since 1980) of Southmark, and as a director, President and Chief Executive Officer of Southmark Asset Management, Inc. As a result of a deadlock on Southmark's Board of Directors, Messrs. Phillips and Friedman entered into certain agreements with Southmark in January 1989 (the "January Agreements") and resigned their positions with Southmark and various of Southmark's subsidiaries and affiliates, including Southmark Asset Management, Inc. Southmark Asset Management, Inc. exchanged its general partner interest in SAMLP for a limited partner interest representing an equivalent 96% beneficial interest. Following continual disputes, effective June 30, 1989, Messrs. Phillips and Friedman entered into additional agreements with Southmark and its affiliates (collectively, the "June Agreements") under which, among other things, Southmark Asset Management, Inc. transferred its limited partner interest in SAMLP to ART. On February 25, 1992, as part of the settlement of litigation described in ITEM 3. "LEGAL PROCEEDINGS - Southmark Litigation", ART transferred to Southmark a 19.2% limited partner interest in SAMLP. ART has a three year option which expires December 27, 1994, to reacquire such limited partner interest from Southmark for $2.4 million less any distributions received. As an additional component of the January Agreements, National Realty and Southmark agreed to change the maturity date of the $50 million revolving line of credit from Southmark (the "Southmark LOC"). Under the June Agreements, National Realty paid to Southmark $7.5 million in cash as partial payment of the then-outstanding balance of the Southmark LOC. Additionally, National Realty and Southmark agreed to submit their respective claims with respect to reconciliation of the balance out-standing to an arbitrator for final settlement by binding arbitration. In December 1991, Messrs. Phillips and Friedman and the Partnership entered into a settlement with Southmark and its affiliates which concluded all disputes among the parties. See ITEM 3. "LEGAL PROCEEDINGS - Southmark Litigation." Competition The real estate business is highly competitive and the Partnership competes with numerous entities engaged in real estate activities (including certain entities described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - - Certain Business Relationships,") some of which may have greater financial resources than the Partnership. The Partnership believes that success against such competition is dependent upon the geographic location of the property, the performance of property managers in areas such as marketing, collection, and the ability to control operating expenses, the amount of new construction in ITEM 1. BUSINESS (Continued) Competition (Continued) the area, and the maintenance and appearance of the property. Additional competitive factors with respect to commercial properties are the ease of access to the property, the adequacy of related facilities, such as parking, and sensitivity to market conditions in setting rent levels. With respect to apartment properties, competition is also based upon the design and mix of the units and the ability to provide a community atmosphere for the tenants. The Partnership believes that general economic circumstances and trends and the rate at which new properties are developed in the vicinity of each of the Partnership's properties are also competitive factors. As discussed in "Business Plan" above, the Partnership does not anticipate making material property acquisitions at the present time. However, to the extent that the Partnership seeks to sell certain of its properties, the sales price for such properties may be affected by competition from governmental and financial institutions, whose assets are located in areas in which the Partnership's properties are located, and are seeking to liquidate foreclosed properties. As described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Certain Business Relationships," Oscar W. Cashwell, the President and a director of SAMI, the Managing General Partner of SAMLP, and the President of BCM, is also the President or director of certain other entities, each of which has business objectives similar to the Partnership's. Mr. Cashwell owes fiduciary duties to such other entities and the Partnership under applicable law. In addition, the Partnership also competes with other entities which are affiliates of BCM or for which BCM acts as advisor, and which may have investment objectives similar to the Partnership's and that may compete with the Partnership in purchasing, selling, leasing and financing real estate and real estate related investments. In resolving any potential conflicts of interest which may arise, BCM has informed the Partnership that it intends to continue to exercise its best judgment as to what is fair and reasonable under the circumstances in accordance with applicable law. Special Considerations Relating to Investments in Real Estate The Partnership is subject to all of the risks incident to the ownership of real estate and interests therein, many of which relate to the general illiquidity of real estate investments. These risks include, changes in general or local economic conditions, changes in interest rates and the availability of permanent mortgage financing which may render the sale or refinancing of a property difficult or unattractive and which may make debt service burdensome, changes in real estate and zoning laws, increases in real estate taxes, federal or local economic or rent controls, floods, earthquakes and other acts of God and other factors beyond the control of the Partnership. The illiquidity of real estate investments generally impairs the ability of the Partnership to respond promptly to changing circumstances. The Partnership believes ITEM 1. BUSINESS (Continued) Special Considerations Relating to Investments in Real Estate (Continued) that such risks are partially mitigated by the diversification by geographic region and property type of the Partnership's real estate portfolio. The Partnership's limited liquidity is discussed in ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." ITEM 2. ITEM 2. PROPERTIES (Continued) Real Estate (Continued) December 31, 1993. No loss was recorded in 1993 in connection with the insubstance foreclosure as the fair value of the collateral property (minus estimated costs of sale) exceeded the carrying value, net of deferred gain, of the mortgage note receivable. In August 1993, the Partnership refinanced the Regency Pointe Shopping Center in Jacksonville, Florida receiving net cash of $788,000 after the payment of the then existing mortgage debt of $1.6 million, associated closing costs and funding of required repair and maintenance escrows. The new $3.0 million mortgage bears interest at 7.5% per annum for the first year and is adjusted thereafter based on the average yield of United States Treasury Securities with a floor of 7.5% per annum, matures September 2005 and requires monthly principal and interest payments. The Partnership has guaranteed 50% of the mortgage. The Partnership, in accordance with the Partnership Agreement, paid BCM a 1% loan arrangement fee of $30,000 in connection with such refinancing. In September 1993, the $2.3 million second lien mortgage secured by the Marina Playa Office Building in Santa Clara, California was extended nine months from its original maturity of October 19, 1993 to July 20, 1994. All other loan terms remain unchanged. In March 1994, the Partnership completed the refinancing of the Cross County Mall in Mattoon, Illinois. The Partnership received no net cash from its first draw on the loan of $4.7 million with loan proceeds of $3.8 million being used to payoff the existing first mortgage, $475,000 being used to payoff the second mortgage and with the remainder of the proceeds being used to fund required real estate tax escrows and to pay various closing costs associated with the financing. Both mortgages were scheduled to mature in 1994. The Partnership has access to the remaining $2.8 million available under the loan as it completes certain capital and tenant improvements to the mall. The new first mortgage bears interest at prime plus 1.75% per annum and requires monthly payments of principal and interest. Principal and accrued but unpaid interest are due at maturity on March 1, 1997 which may be extended to March 1, 2002. The mortgage debt is recourse to the Partnership. The Partnership, in accordance with the Partnership Agreement, paid BCM a 1% loan arrangement fee of $75,000 in connection with such refinancing. Mortgage Loans In addition to real estate, a portion of the Partnership's assets consist of mortgage notes receivable, principally those originating from the sale of Partnership properties and secured by income-producing properties. The Partnership's mortgage notes consist of first and wraparound mortgage loans and participations in first and junior mortgage loans. First Mortgage Loans. These loans generally provide for level periodic payments of principal and interest sufficient to substantially repay the ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) loan prior to maturity, but may involve interest-only payments or moderate amortization of principal and a "balloon" principal payment at maturity. With respect to first mortgage loans, it is the Partnership's general policy to require that the borrower provide a mortgagee's title policy or an acceptable legal opinion of title as to the validity and the priority of the mortgage lien over all other obligations, except liens arising from unpaid property taxes and other exceptions normally allowed by first mortgage lenders in the relevant area. Wraparound Mortgage Loans. A wraparound mortgage loan, sometimes called an all-inclusive loan, is a mortgage loan having an original principal amount equal to the outstanding balance under the prior existing mortgage loan(s) plus the amount actually advanced under the wraparound mortgage loan. Wraparound mortgage loans may provide for full, partial or no amortization of principal. At December 31, 1993, the Partnership's mortgage notes and participations in mortgage notes had an aggregate face amount of $29.5 million and an aggregate net carrying value of $11.5 million, net of deferred gains ($16.2 million), discounts ($93,000) and allowance for estimated losses ($1.9 million). The following table sets forth the percentage (based on the outstanding mortgage note balance at December 31, 1993), by property type and geographic region, of the properties that serve as collateral for the five mortgage notes receivable, excluding participations, in the Partnership's mortgage notes receivable portfolio at December 31, 1993. See Schedule XII to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for further details of the Partnership's mortgage notes receivable portfolio. Commercial Region Apartments Properties Total - ------ ---------- ---------- ----- Mountain.............. -% 15% 15% Pacific............... 56 - 56 Midwest............... - 29 29 --- --- --- 56% 44% 100% In 1991, the Partnership and an insurance company entered into an Asset Sales Agreement to sell participations in certain of the Partnership's mortgage notes receivable in exchange for participations in other mortgage notes or assets and cash. The Partnership entered into the Asset Sales Agreement in an effort to develop a potential source for future financing and to generate cash from otherwise illiquid assets. The governing documents include put and guaranty provisions. The Partnership sold participations and assigned certain mortgage notes receivable totaling $4.7 million and in exchange received participations and assignments in other notes receivable, a limited partnership interest and $1.0 million in cash. ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) In March 1992, the insurance company was placed in receivership. In June 1992, the Partnership provided notice to the insurance company, under the terms of the put and guaranty provisions, of its desire to divest itself of all the assets received. The Receiver has refused to allow the enforcement of the terms of the Asset Sales Agreement. In September 1992, the Court approved the Receivers' Petition for an Order of Liquidation for the insurance company. The Partnership determined, in 1992, that the fair value of the underlying collateral securing one of the participations received was not sufficient to satisfy the Partnership's participation interest and accordingly, the Partnership recorded a $1.6 million provision for loss to provide for such deficiency. In May 1993, the Partnership foreclosed on an assigned first mortgage note secured by land in Denver, Colorado. In October 1993, the land was sold for $225,000 in cash. The Partnership incurred no loss as a result of the foreclosure or sale other than amounts previously provided. If the Partnership forecloses on the collateral securing the participations and the remaining assets acquired, no additional losses are anticipated as the estimated fair values of the underlying collateral approximates their adjusted carrying values. The Partnership is continuing to evaluate its options with regard to these assets and is also in settlement negotiations with the Receiver. Investment in Marketable Equity Securities of ART At December 31, 1993, the Partnership owned 48,931 shares of common stock of ART, a real estate investment company, representing approximately 2% of ART's outstanding shares. Mr. Phillips is a general partner and Mr. Friedman was a general partner of SAMLP, the General Partner of the Partnership. Messrs. Phillips and Friedman served as executive officers and directors of ART until November 16, 1992, and December 31, 1992, respectively. Mr. Cashwell, the President and a director of SAMI, the Managing General Partner of SAMLP, is a director of ART. See ITEM 12. "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT." At December 31, 1993, the market value of the ART common stock owned by the Partnership was $593,000. ART owns a 76.8% limited partner interest in SAMLP. In addition, as of March 11, 1994 ART owned 942,813 of National Realty's units of limited partner interest, approximately 44% of the units then outstanding. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Moorman Settlement The Partnership is party to a Settlement Agreement, dated as of May 9, 1990, between plaintiffs Joseph B. Moorman, et al. and defendants Robert A. McNeil, National Realty, the Operating Partnership, SAMLP, Gene E. Phillips and William S. Friedman, and Shearson Lehman Hutton Inc., successor-in-interest to defendant E.F. Hutton & Company Inc., relating ITEM 3. LEGAL PROCEEDINGS (Continued) Moorman Settlement (Continued) to the action entitled Moorman, et al. v. Southmark Corporation, et al. Such action was filed on September 2, 1987, in the Superior Court of the State of California, County of San Mateo. On May 9, 1990, the Partnership agreed to settle such action pursuant to the terms of a written agreement (the "Moorman Settlement Agreement"). On June 29, 1990, after a hearing as to its fairness, reasonableness and adequacy, the Moorman Settlement Agreement was granted final court approval. By agreeing to settle the Moorman action, the Partnership, SAMLP, the General Partner of the Partnership, and Messrs. Phillips and Friedman, general partners of SAMLP at the time of the settlement, did not and do not admit any liability whatsoever. The terms of the Moorman Settlement Agreement are complex and the following summary is qualified in its entirety by reference to the text thereof, which was previously included as an exhibit to the Partnership's Form 10-Q for the quarter ended March 31, 1990. The Moorman Settlement Agreement provides for a Settlement Plan (the "Moorman Settlement Plan") that if certain aggressive, annually increasing targets (the "Targets") relating to unit price are not met, may result in, among other things, withdrawal of the General Partner and the resulting required purchase of the General Partner's interest in the Partnership (the "Redeemable General Partner Interest"), required distributions to unitholders, and the Partnership's being required to use its best efforts to sell a portion of its assets and to distribute any resulting net proceeds to unitholders. The effects of some or all of these provisions could adversely affect the Partnership's liquidity. The Target for the first anniversary date of May 9, 1991 was $44.00 per unit. The average market price per unit for the averaging period was $13.30 and therefore, the first Target was not met. The Target for the second anniversary date of May 9, 1992 was $57.00 per unit. The average market price per unit for the averaging period was $20.93 and therefore, the second Target was not met. Since the Target was not met for two successive years, the Moorman Settlement Agreement requires that SAMLP resign as General Partner, effective upon the election and qualification of its successor. On July 8, 1992, SAMLP notified the Oversight Committee of the failure to meet the Target for two successive years. Upon, among other things, the withdrawal of SAMLP as General Partner and the due election and taking office of a successor, the Moorman Settlement Plan will terminate. Withdrawal of SAMLP as General Partner pursuant to the Moorman Settlement Agreement requires unitholders to elect a successor general partner by majority vote. Upon the withdrawal or removal of the General Partner without the selection of a successor, the Partnership would be dissolved. The Moorman Settlement Agreement provides that between the date of the certification causing the General Partner's resignation and the date a successor general partner takes office, the resigning General Partner shall limit its activities, as General Partner, to the conduct of the business of the Partnership in the ordinary course, shall not, without ITEM 3. LEGAL PROCEEDINGS (Continued) Moorman Settlement (Continued) consent of the Oversight Committee, purchase or sell any real estate or other assets of the Partnership not in progress on said date, shall cooperate in the election of a successor general partner and shall cooperate with its successor to facilitate a change in the office of General Partner of the Partnership. The resigning General Partner will continue to receive fees, expenses and distributions, if any, while the solicitation is prepared. The withdrawal of the General Partner will require the Partnership to acquire the Redeemable General Partner Interest at its then fair value, and to pay certain fees and other compensation, as provided in the Partnership Agreement and the Moorman Settlement Agreement. Under the Moorman Settlement Agreement, payment for such Redeemable General Partner Interest, fees and other compensation may, at the Oversight Committee's option, be paid over a three-year period pursuant to a secured promissory note bearing interest at the prime rate and containing commercially reasonable terms and collateral. Under the Moorman Settlement Plan, the purchase price for SAMLP's Redeemable General Partner Interest will be calculated, as of the time it withdraws as General Partner under the Partnership's governing documents. The Managing General Partner has calculated the fair value of the Redeemable General Partner Interest at December 31, 1993 to be $25.8 million, and believes there has been no material change in such value since such date. The Partnership would be entitled to offset against any such payment the then outstanding principal balance ($4.2 million at December 31, 1993) plus all accrued but unpaid interest ($3.5 million at December 31, 1993) on the note receivable from SAMLP for its capital contribution to the Partnership. In the accompanying Consolidated Financial Statements, the Redeemable General Partner Interest is shown as a reduction of Partners' Equity. The note receivable from the General Partner has been offset against the Redeemable General Partner Interest. The Oversight Committee has informed the Partnership that it calculated the amount of such Redeemable General Partner Interest at December 31, 1993, before the note receivable and unpaid interest offset described above, to be approximately $20.0 million. When SAMLP withdraws as General Partner of the Partnership, the value of the Redeemable General Partner Interest would depend on the fair value of the Partnership's assets at the time of calculation and there can be no assurance that the Redeemable General Partner Interest, fees and other compensation payable on any such withdrawal will not be substantially higher or lower than any current estimate or calculation. In October 1993, SAMLP and the Oversight Committee reached an agreement in principle, evidenced by a detailed Term Sheet, to nominate a candidate for successor General Partner and to resolve all related matters under the Moorman Settlement Agreement. The following summary is qualified in its entirety by reference to the text of the Term Sheet filed as an exhibit to the Partnership's Current Report on Form 8-K dated October 6, 1993. The Term Sheet provides that the nominee for successor General Partner will be a newly formed corporation which will be a wholly-owned subsidiary of SAMLP. The Term Sheet also sets forth ITEM 3. LEGAL PROCEEDINGS (Continued) Moorman Settlement (Continued) an agreement in principle to effect a restructuring of National Realty and the spinoff by National Realty to its unitholders of shares of a newly formed subsidiary which would qualify as a Real Estate Investment Trust ("REIT") for federal tax purposes and would be the beneficial owner of 75% of NOLP's partnership interest in GCLP. The Term Sheet also contains proposed amendments to the Partnership Agreement. Pursuant to the Term Sheet, the Partnership will be relieved of any obligation to acquire the Redeemable General Partner Interest or to pay any other fees or compensation to SAMLP upon SAMLP's withdrawal as General Partner. The parties are preparing the agreements and other documents contemplated by the Term Sheet. Upon execution of an agreement embodying the provisions of the Term Sheet, the Oversight Committee and SAMLP will petition the Supervising Judge for his approval of the agreement. The proposed restructuring of National Realty and the formation and spinoff of the REIT, the election of the new general partner and the proposed amendments to the Partnership Agreement require unitholder approval before becoming effective. Southmark Litigation In December 1991, the Partnership and several other parties entered into a comprehensive settlement of litigation with Southmark Corporation ("Southmark") which settled all actions between Southmark and its affiliates and the Partnership. In connection with the settlement, the Partnership is obligated to pay Southmark the net amount which it had recorded as due to Southmark ($1.8 million), on the date the settlement was entered into. To date, the Partnership has made payments totaling $1.5 million. The balance of $265,000 is to be paid by the Partnership on June 27, 1994. To secure its settlement payment obligation to Southmark, in February 1992, the Partnership issued 300,000 new units of limited partner interest to ATN Equity Partnership ("ATN") which pledged such units to Southmark along with securities of ART and Transcontinental Realty Investors, Inc. ("TCI"). As of December 31, 1993, all collateral units had been released from the pledge and returned to the Partnership by ATN and canceled. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. (THIS SPACE INTENTIONALLY LEFT BLANK.) PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S UNITS OF LIMITED PARTNER INTEREST AND RELATED SECURITY HOLDER MATTERS National Realty's units of limited partner interest are traded on the American Stock Exchange ("AMEX") using the symbol "NLP." National Realty does not meet certain of the criteria of the AMEX for continued listing and may continue to fail to meet such criteria. Although National Realty does not anticipate that the AMEX will seek to delist its units, there can be no assurance that the AMEX will not seek to do so. The following table sets forth high and low sale prices of National Realty's units of limited partner interest as reported by the AMEX: QUARTER ENDED HIGH LOW - ------------------ ------------ ------------ March 31, 1994........................... $ 28 1/4 $ 25 (through March 11, 1994) March 31, 1993........................... 22 7/8 18 1/2 June 30, 1993............................ 25 1/4 19 7/8 September 30, 1993....................... 23 19 1/4 December 31, 1993........................ 30 3/4 22 3/4 March 31, 1992........................... 27 1/2 11 3/4 June 30, 1992............................ 24 1/4 17 1/2 September 30, 1992....................... 20 5/8 18 5/8 December 31, 1992........................ 20 1/4 18 3/8 As of March 11, 1994, the closing price of National Realty's units of limited partner interest on the AMEX was $27.75 per unit. As of March 11, 1994, National Realty's units of limited partner interest were held by 9,509 holders of record. Pursuant to the Moorman Settlement Agreement, on February 14, 1992, the Partnership issued 2,692,773 warrants (the "Warrants") to purchase an aggregate of 673,193 of its units of limited partner interest subject to adjustment. Each Warrant initially entitled the holder thereof to purchase one quarter of one unit at the exercise price ($11.00 per Warrant). The initial exercise price was equal to $44.00 per unit and increased to $48.00 per unit on February 14, 1993, subject to adjustment. The Warrants may be exercised for five years from the February 14, 1992 date of issuance, or until earlier redemption. See ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement." Prior to 1989, the Partnership's policy was to distribute operating cash flow in excess of necessary reserves for property improvements and repairs. However, due to liquidity problems, on December 29, 1989 the Partnership announced a suspension of cash distributions. Pursuant to the terms of the Moorman Settlement Agreement, the Partnership has agreed to distribute to unitholders all of the Partnership's operating cash flow in excess of certain renovation costs, unless the Oversight ITEM 5. MARKET FOR THE REGISTRANT'S UNITS OF LIMITED PARTNER INTEREST AND RELATED SECURITY HOLDER MATTERS (Continued) Committee approves alternative uses for such operating cash flow. On October 7, 1993, the Partnership announced a resumption of distributions at the initial rate of $0.20 per unit, and on December 10, 1993 paid a total of $388,000 to unitholders. On March 4, 1994, the Partnership announced a first quarter 1994 distribution of $0.20 per unit payable March 30, 1994. However, no assurance can be given that the Partnership will be able to continue making such distributions. See ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 6. SELECTED FINANCIAL DATA (Continued) Units and per unit data have been restated to give effect to the one-for-four reverse unit split, effected January 1, 1991. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction National Realty, L.P. ("National Realty") is a Delaware limited partnership formed on January 29, 1987, the business of which consists primarily of owning and operating through National Operating, L.P., also a Delaware limited partnership (the "Operating Partnership"), a portfolio of real estate. Most of the Operating Partnership's properties were acquired in transactions consummated on September 18, 1987, pursuant to which National Realty acquired all of the assets, and assumed all of the liabilities, of 35 public and private limited partnerships. National Realty and the Operating Partnership operate as an economic unit and, unless the context otherwise requires, all references herein to the "Partnership" shall constitute references to National Realty and the Operating Partnership as a unit. In November 1992, the Operating Partnership, in conjunction with a refinancing of 52 of its apartment complexes and a wraparound note receivable, transferred such assets to Garden Capital, L.P. ("GCLP"), a Delaware limited partnership in which the Operating Partnership holds a 99.3% limited partner interest. See Note 7. "NOTES PAYABLE." Liquidity and Capital Resources Cash and cash equivalents aggregated $4.0 million at December 31, 1993 as compared with $3.4 million at December 31, 1992. At December 31, 1992, the Partnership had access to certain achievement escrows aggregating $3.0 million. During 1993, achievement escrows totaling $1.0 million were received by the Partnership and the remaining $2.0 million of achievement escrows were applied to reduce the principal balances of the related mortgages, net of $228,000 of prepayment penalties. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) The Managing General Partner has discretion in determining methods of obtaining funds for the Partnership's operations. The Partnership's governing documents place no limitation on the amount of leverage that the Partnership may incur either in the aggregate or with respect to any particular property or other investment. At December 31, 1993, the aggregate loan-to-value ratio of the Partnership's real estate portfolio, computed on the basis of the ratio of total property-related debt to aggregate appraised values, was 52.1% compared to 57.7% at December 31, 1992. Historically, the Partnership's principal sources of cash flow have been and will continue to be from property operations and externally generated funds. Externally generated funds include borrowings, proceeds from the sale of Partnership properties and other assets, proceeds from the issuance of debt secured by Partnership properties or mortgage notes receivable and in the future may include proceeds from the exercise of the Warrants which were issued to the class members included in the Moorman litigation settlement. The Partnership continues to experience liquidity problems and expects that cash from operations together with externally generated funds will be sufficient to meet the Partnership's various cash needs only if the Partnership is able to renew and extend mortgage financings as they mature, obtain mortgage financing on its unencumbered properties, or alternatively, increase the rate of property and other asset sales, in amounts sufficient to provide adequate cash. Currently, all but five of the Partnership's properties are encumbered by mortgage debt. In 1994, mortgage debt totaling $21.6 million comes due. The Partnership has reached a tentative agreement with a lender for the modification and extension of a mortgage, which matured in 1993, with a principal balance of $9.3 million at December 31, 1993. In addition, $4.2 million of scheduled 1994 principal maturities were successfully refinanced in March 1994. The new $7.5 million loan, of which only $4.7 million has been drawn to date, matures March 1, 1997. It is the Partnership's intention to either pay the remaining mortgages that mature in 1994 when due, or seek to extend the due dates one or more years while attempting to obtain long-term financing. The Partnership also intends to seek to refinance certain mortgages not due in 1994, and use excess financing proceeds for working capital purposes. Due to the limited long-term financing available to the Partnership, there can be no assurance that the Partnership will be successful in extending such "balloon" payments or that it will not ultimately lose certain of its properties to foreclosure. The General Partner believes it will continue to be successful in obtaining at least the minimum amount of loan extensions or other proceeds to enable the Partnership to maintain ownership of all properties in which it has equity. As of March 11, 1994, the Partnership had three apartment complexes under contract for sale; Bavarian Woods Apartments in Middletown, Ohio and Brandywine and Raintree Apartments in East Lansing, Michigan. The ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) Oversight Committee has approved the terms of the pending sales and the Partnership anticipates finalizing such transactions during the second quarter of 1994. The assets have been reclassified as real estate held for sale in the Partnership's accompanying Consolidated Balance Sheet. The Partnership, however, can give no assurance that it will successfully complete these property sales. In November 1992, in conjunction with the transfer of the net assets of 52 apartment complexes and a wraparound note receivable to GCLP, such assets were refinanced under a $223 million blanket mortgage loan. The blanket mortgage loan requires that cash flow from the GCLP properties be used to fund various escrow and reserve accounts and limits the payment of distributions to the Partnership. During 1993, the Partnership received distributions from GCLP totaling $1.7 million. A total of $7.5 million of escrow and reserve deposits are required to be funded by GCLP during 1994 in monthly installments. Such escrowed amounts are included in escrow deposits and other assets in the accompanying Consolidated Balance Sheets. GCLP is required to make monthly deposits, from the cash flow of its properties, for (i) a recurring replacement reserve, (ii) a capital replacement reserve, (iii) a credit enhancement reserve and (iv) a tax and insurance reserve. As a result of the restrictions placed on GCLP's use of its cash flow, excess cash of approximately $4.0 million is expected to be remittable to the Partnership during 1994. On October 7, 1993, the Partnership announced a resumption of distributions at the initial rate of $0.20 per unit and on December 10, 1993 paid a total of $388,000 to unitholders. The Partnership has also announced a first quarter of 1994 distribution of $0.20 per unit payable March 30, 1994. The Partnership's rents collected increased from $98.0 million for 1992 to $99.0 million for 1993 due to the Partnership's successful effort of increasing and maintaining higher occupancy levels during 1993 as compared to 1992. Occupancy rates at the Partnership's apartment complexes, which accounts for over 80% of the properties included in the Partnership's portfolio, increased 2.5% as compared to 1992 occupancy levels. In addition, payments for property operating expenses decreased from $62.7 million in 1992 to $57.6 million in 1993. 1992 property operating expense payments included $2.0 million of 1991 real estate taxes that were not paid until 1992, due to the Partnership's constricted 1991 cash flow. Payments of property operating expenses during 1993 include only current year expenses indicative of a stabilization of the Partnership's cash flow. During 1993, the Partnership successfully refinanced mortgage debt totaling $6.7 million. Also in 1993, the Partnership made other scheduled principal paydowns on mortgage debt of $2.9 million. As more fully discussed in NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement," the Moorman litigation settlement agreement (the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) "Moorman Settlement Agreement") set forth certain aggressive, annually increasing targets relating to the price of the Partnership's units of limited partner interest which were not met, resulting in, among other things, the required withdrawal of the Partnership's General Partner upon election of a successor and the resulting required purchase of the Redeemable General Partner Interest, as defined below. The effects of some or all of these provisions could adversely affect the Partnership's already strained liquidity. However, the General Partner and the Oversight Committee have agreed in principle, as discussed below, to possible arrangements which would alleviate the adverse effect of such provisions. The withdrawal of the General Partner requires the Partnership to acquire the General Partner's interest in the Partnership (the "Redeemable General Partner Interest") at its then fair value, and to pay certain fees and other compensation, as provided in the Partnership Agreement and the Moorman Settlement Agreement. The Moorman Settlement Agreement provides that any payment for such Redeemable General Partner Interest, fees and other compensation during the pendency of the Moorman Settlement Agreement may, at the option of the Oversight Committee (also established under the Moorman Settlement Agreement), be made over three years pursuant to a secured promissory note bearing interest at a financial institution's prime rate. The Managing General Partner has calculated the fair value of the Redeemable General Partner Interest at December 31, 1993 to be $25.8 million, and believes that there has been no material change in such value since that date. The Partnership would be entitled to offset against such payment the then outstanding principal balance of the note receivable ($4.2 million at December 31, 1993) plus all accrued and unpaid interest ($3.5 million at December 31, 1993) on the note receivable from the General Partner representing its capital contribution to the Partnership. The Oversight Committee has informed the Partnership that it calculates the amount of such Redeemable General Partner Interest at December 31, 1993, before the note receivable and unpaid interest offset discussed above, to be approximately $20.0 million. When Syntek Asset Management, L.P. ("SAMLP") withdraws as General Partner of the Partnership, the fair value of the Redeemable General Partner Interest would depend on the value of the Partnership's assets at the time of calculation and there can be no assurance that the Redeemable General Partner Interest, fees and other compensation payable on any such withdrawal will not be substantially higher or lower than any current estimate or calculation. In the accompanying Consolidated Financial Statements, the Redeemable General Partner Interest is shown as a reduction of Partners' Equity and the note receivable from the General Partner has been offset against the Redeemable General Partner Interest. In conjunction with the Moorman Settlement Agreement, the Partnership received contributions from certain co-defendants of cash and notes including a promissory note for $2.0 million from Gene E. Phillips and William S. Friedman, at the time general partners of SAMLP, and guaran- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) teed by SAMLP. On May 14, 1993, the third annual payment of $631,000 including accrued interest was made. The final payment of $631,000 is due on May 14, 1994. In October 1993, SAMLP and the Oversight Committee reached an agreement in principle, evidenced by a detailed Term Sheet, to nominate a candidate for successor general partner and to resolve all related matters under the Moorman Settlement Agreement. The Term Sheet provides that the nominee for successor General Partner will be a newly formed corporation which will be a wholly-owned subsidiary of SAMLP. The Term Sheet also sets forth an agreement in principle to effect a restructuring of National Realty and the spinoff by National Realty to its unitholders of shares of a newly formed subsidiary which would qualify as a Real Estate Investment Trust ("REIT") for federal tax purposes and would be the beneficial owner of 75% of NOLP's partnership interest in GCLP. The Term Sheet also contains proposed amendments to Partnership Agreement. Pursuant to the Term Sheet, the Partnership will be relieved of any obligation to acquire the Redeemable General Partner Interest or to pay any other fees or compensation to SAMLP upon SAMLP's withdrawal as General Partner. However, if the spinoff of the to be formed REIT shares occurs, the Partnership will no longer receive 100% of the cash distributions from the GCLP properties which amounted to $1.7 million in 1993. The parties are preparing the agreements and other documents contemplated by the Term Sheet. Upon execution of an agreement embodying the provisions of the Term Sheet, the Oversight Committee and SAMLP will petition the Supervising Judge for his approval of the agreement. The proposed restructuring of National Realty and the formation and spinoff of the REIT, the election of the new general partner and the proposed amendments to the Partnership Agreement require unitholder approval before becoming effective. In November 1987, the Board of Directors of the Managing General Partner approved the Partnership's purchase of up to 10% of National Realty's units of limited partner interest and on December 15, 1992, the Board of Directors of the Managing General Partner approved the repurchase of up to 100,000 additional units in open-market transactions. Through December 31, 1993, the Partnership had purchased a total of 134,320 units at an aggregate cost of $5.1 million. During 1993, the Partnership purchased 2,100 units at a cost of $39,000. The Managing General Partner does not expect the Partnership to purchase additional units during the term of the Moorman Settlement Plan, unless such purchases are approved by the Oversight Committee. Results of Operations 1993 Compared to 1992. The Partnership reported net income of $1.3 million for 1993 as compared to a net loss of $3.2 million for 1992. Included in the Partnership's 1993 net income is an increase in ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) operating income of $3.2 million, as more fully discussed below, and an extraordinary gain of $9.0 million related to the discounted payoff of a mortgage obligation. See NOTE 8. "ACCRUING MORTGAGE." Rental income increased $4.4 million in 1993 as compared to 1992 after reduction of reported 1992 rental income of $3.0 million for four Partnership properties which were either lost to foreclosure or sold during 1992. This increase is attributable to higher rental rates ($2.8 million) and improved occupancy levels ($1.6 million) related to the Partnership's apartment complexes in the Southwest and Southeast regions of the United States. Property operating expenses increased from $56.9 million in 1992 (after reduction of operating expenses of $2.3 million related to four Partnership properties which were either lost to foreclosure or sold during 1992) to $60.4 million in 1993. Of this $3.4 million increase, $2.0 million is related to higher real estate taxes on Partnership apartment complexes in the Midwest, Pacific and Southwest regions of the United States. In addition, utility expenses were $598,000 higher in 1993 than in 1992 due to higher occupancy levels and repairs and maintenance expenses were also higher in 1993 as compared to 1992 by $913,000, as a result of the Partnership's continuing effort to maintain and increase occupancy levels. Apartment occupancy levels increased by 2.5% during 1993 with the largest increases being in the Southwest and Southeast regions of the United States, where approximately 59% of the Partnership's apartment units are located. Interest income decreased from $3.9 million in 1992 to $3.1 million in 1993. This decrease is primarily due to nonperforming mortgage note participations as well as $222,000 related to one of the Partnership's mortgage notes receivable which became nonaccruing in June 1993. In December 1993, the Partnership recorded the insubstance foreclosure of the collateral property securing that note, the Whispering Pines Apartments in Canoga Park, California. The Partnership obtained title to the property in February 1994. Interest expense decreased from $36.0 million in 1992 to $34.7 million in 1993. Interest expense related to the GCLP properties, refinanced in November 1992, increased by $4.0 million as compared to 1992. This increase, however, was more than offset by a decrease in interest expense associated with the Partnership's line of credit with Transcontinental Realty Investors, Inc. ("TCI"), which was paid in full in December 1992 with the refinancing proceeds from the GCLP refinancing. Interest expense also declined as a result of the acquisition at a discount of a mortgage obligation in March 1993 and from Partnership properties sold or lost to foreclosure in 1992. See NOTE 8. "ACCRUING MORTGAGE." Depreciation and amortization in 1993 approximated that in 1992 after reduction of $275,000 related to four Partnership properties which were either lost to foreclosure or sold during 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) General and administrative expenses increased by $221,000 in 1993 as compared to 1992. Legal expenses decreased $144,000 for the year due primarily to 1992 litigation expenses related to the Moorman Settlement which were not incurred in 1993. See NOTE 14. "COMMITMENTS AND CONTINGENCIES." Also, the Partnership's overhead reimbursements to Basic Capital Management, Inc. decreased by $259,000 in 1993. Offsetting these decreases were increased overhead costs associated with GCLP totaling $729,000 in 1993, GCLP's first full year of operation. Overhead costs associated with GCLP in 1992 totaled $108,000. The Partnership made no provision for losses in 1993 compared to $2.0 million in 1992. The 1992 provision includes a $416,000 write down of one of the Partnership's office buildings to the related nonrecourse debt, which property was subsequently lost to foreclosure, and $1.6 million related to the Partnership's mortgage notes receivable. During 1992, the Partnership recorded the receipt of $1.0 million upon the settlement of litigation related to a lender's failure to honor a refinancing commitment for two of the Partnership's apartment complexes. In addition, the Partnership recognized a $375,000 gain on the sale of the Terrace View Apartments in Burlen, Washington. No such gains were recognized in 1993. The Partnership recognized extraordinary gains of $9.0 million in 1993 and $6.4 million in 1992. The 1993 gain resulted from the acquisition at a discount of a mortgage obligation. See NOTE 8. "ACCRUING MORTGAGE." The 1992 gain is attributable to the foreclosure of the Hunters Glen Apartments in Kansas City, Missouri and the Lakes Apartments in Atlanta, Georgia and the forgiveness of the related nonrecourse mortgage debt. 1992 Compared to 1991. The Partnership had a net loss of $3.2 million in 1992 as compared to a net loss of $18.2 million in 1991. In addition to a $11.3 million increase in operating income from 1991 to 1992, as more fully discussed below, in 1991 the Partnership recorded a $13.4 million loss due to the foreclosure of the Hidden Valley Land and an extraordinary gain of $17.9 million on the forgiveness of the related nonrecourse mortgage debt. The Partnership recorded no losses on foreclosure of Partnership properties in 1992 but did recognize extraordinary gains of $7.0 million from the forgiveness of nonrecourse mortgage debt related to two properties which were foreclosed by lenders and a $614,000 extraordinary loss related to the refinancing of the 52 apartment complexes and a wraparound note receivable by GCLP which necessitated the early payoff of existing mortgage debt. See NOTE 7. "NOTES PAYABLE." Rental income increased from $93.0 million in 1991 to $97.8 million in 1992. This increase is primarily attributable to higher occupancy levels reached in 1992 as compared to 1991 which generated additional ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) rental income of $4.1 million. With the exception of a few commercial properties in the Pacific region of the United States, most Partnership properties showed significant increases in occupancy levels: apartment occupancy increased by 4.0% and commercial properties increased their occupancy by 3.1%. Interest expense decreased from $38.7 million in 1991 to $36.0 million in 1992. This decrease is primarily due to lower interest rates on some of the Partnership's mortgage debt which bears interest that fluctuates with the prime interest rate and to a $986,000 reduction in interest expense related to properties lost to foreclosure and a Partnership property sold in 1992. In addition, $447,000 of the decrease is due to the payment of underlying liens on mortgage notes receivable. Depreciation and amortization decreased $796,000 in 1992 as compared to 1991. $290,000 of the decrease relates to properties lost to foreclosure or sold during 1992 and late 1991 and the remainder relates to several property improvements that became fully depreciated during 1991. Other property operation expenses increased from $4.0 million for the year ended December 31, 1991 to $4.8 million for the year ended December 31, 1992. During 1992, the Partnership incurred additional advertising and promotional expenditures in a successful effort to increase occupancy levels in the Partnership's apartment complexes. Apartment occupancy levels increased 4.0%, from 86.5% in 1991 to 90.5% in 1992. General and administrative expenses decreased from $5.9 million in 1991 to $5.4 million in 1992. This decrease is due primarily to lower legal expenditures of $830,000 in connection with the Southmark adversary proceedings that were concluded in 1991. The Partnership recorded a $5.0 provision for losses in 1991 compared to $2.0 million in 1992. The 1992 provision includes a $416,000 writedown of one of the Partnership's office buildings to the nonrecourse debt which was subsequently foreclosed, and provision for losses totaling $1.6 million related to the Partnership mortgage notes receivable, as more fully described in NOTE 5. "ALLOWANCE FOR ESTIMATED LOSSES." The 1991 provision for losses includes a $964,000 write down of the Partnership's investment in the common stock of American Realty Trust, Inc. ("ART"), a $1.1 million permanent write down of one of the Partnership's office buildings, a $525,000 loss recorded as a result of the restructuring of one of the Partnership's mortgage notes receivable and $2.4 million to write off uncollectible property-level receivables. Gains on sales of real estate recorded by the Partnership were $371,000 in 1991 and $375,000 in 1992. During 1992, the Partnership sold the Terrace View Apartments for net cash of $700,000 and recorded a gain on the sale of $375,000. In 1991, a payment on a mortgage note receivable generated from a prior year property sale resulted in the partial recognition of $371,000 of previously deferred gain. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) In 1992, the Partnership recorded the receipt of $1.0 million upon the settlement of litigation related to a lender's failure to honor a refinancing commitment for two of the Partnership's apartment properties. In 1991, the Partnership recorded litigation and settlement expenses of $721,000 related to the settlement of a lawsuit involving a mortgage that was obtained by a predecessor to the Partnership which was subsequently foreclosed, and to unitholder litigation involving Southmark. Environmental Matters Under various federal, state and local environmental laws, ordinances and regulations, the Partnership, may be potentially liable for removal or remediation costs, as well as certain other potential costs relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos- containing materials into the air, and third parties may seek recovery from the Partnership for personal injury associated with such materials. The General Partner is not aware of any environmental liability relating to the above matters that would have a material adverse effect on the Partnership's business, assets or results of operations. Impact of Inflation The effects of inflation on the Partnership's operations are not quantifiable. Revenues from property operations fluctuate proportionately with inflationary increases and decreases in housing costs. Fluctuations in the rate of inflation also affect the sales values of the Partnership's properties and, correspondingly, the ultimate gains to be realized by the Partnership from property sales. Inflation also has an effect on the Partnership's earnings from short-term investments, and on its interest income and interest expense to the extent that such income and expense depend on floating interest rates. Recent Accounting Pronouncement The Financial Accounting Standards Board ("FASB") has recently issued Statement of Financial Accounting Standards ("SFAS") No. 114 - "Accounting by Creditors for Impairment of a Loan" which amends SFAS No. 5 - "Accounting for Contingencies" and SFAS No. 15 - "Accounting by Debtors and Creditors for Troubled Debt Restructurings." The statement requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. SFAS No. 114 is effective for fiscal years beginning after December 15, 1994. The Partnership has not fully evaluated the effects ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Recent Accounting Pronouncement (Continued) of implementing this statement but expects that they will not be material as the statement is applicable to debt restructurings and loan impairments after the earlier of the effective date of the statement or the Partnership's adoption of the statement. At its January 26, 1994 meeting, the FASB directed its staff to prepare an exposure draft, that if approved, would eliminate the provisions of SFAS No. 114 that describe how a creditor should recognize income on an impaired loan and add disclosure requirements on income recognized on impaired loans. The effective date of SFAS No. 114 is not anticipated to change. Current Value Reporting The Partnership believes that the historical cost basis financial statements prepared in accordance with generally accepted accounting principles are not representative of the economic value of the Partnership's real estate assets because most of the properties have appreciated in value over their historical cost basis. Nevertheless, generally accepted accounting principles require periodic depreciation charges. In conjunction with the exchange transaction, by which the Partnership was formed, the Partnership retained independent appraisers to estimate the Current Appraised Value of the Partnership's properties as of March 31, 1987, based in part upon certain financial, lease and other information provided by the general partners of the exchange transaction partnerships. The Current Appraised Value of the Partnership's properties at March 31, 1987 was $758.0 million, and Revaluation Equity was $410.0 million at such date. Revaluation Equity, is defined as the difference between the appraised value of the Partnership's real estate, adjusted to reflect the Partnership's estimate of disposition costs, and the face amount of the mortgage notes payable and accrued interest, if any, encumbering such real estate. The Current Appraised Value of the Partnership's properties at December 31, 1992, was $541.5 million, and Revaluation Equity was $200.5 million at such date. In 1993, the Partnership retained an independent appraiser to determine the Current Appraised Value of the Partnership's properties as of December 31, 1993, in a manner consistent with the methodology used to determine Current Appraised Value as of December 31, 1992 and March 31, 1987. The Current Appraised Value of the Partnership's properties at December 31, 1993 was $607.7 million and Revaluation Equity was $258.4 million at such date. Tax Legislation National Realty is a publicly traded limited partnership and, for federal income tax purposes, all income or loss generated by the Partnership is included in the income tax returns of the individual ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Tax Legislation (Continued) partners. In December 1987, Congress passed legislation requiring certain publicly traded partnerships to be taxed as corporations. National Realty qualifies for "grandfather" treatment and will be treated as a partnership until at least 1997, unless the Partnership adds a substantial new line of business, which would require approval of the Oversight Committee, and will continue to be so treated thereafter if 90% or more of its gross income consists of qualifying income from real estate activities. As presently operated, the Partnership meets these requirements. Under Internal Revenue Service guidelines generally applicable to publicly traded partnerships and thus to the Partnership, a limited partner's use of his or her share of partnership losses is subject to special limitations. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Certified Public Accountants................... 36 Consolidated Balance Sheets - December 31, 1993 and 1992......................................... 38 Consolidated Statements of Operations - Years Ended December 31, 1993, 1992 and 1991...................... 40 Consolidated Statements of in Partners' Equity (Deficit) - Years Ended December 31, 1993, 1992 and 1991....................... 41 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991....................... 42 Notes to Consolidated Financial Statements........................... 44 Schedule X - Supplementary Income Statement Information.............. 69 Schedule XI - Real Estate and Accumulated Depreciation............... 70 Schedule XII - Mortgage Loans on Real Estate......................... 75 All other schedules are omitted because they are not required, are not applicable or the information required is included in the Consolidated Financial Statements or the notes thereto. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Partners National Realty, L.P. We have audited the accompanying consolidated balance sheets of National Realty, L.P., a limited partnership, as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1993. We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Partnership's Managing General Partner. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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 and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Realty, L.P. at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the schedules present fairly, in all material respects, the information set forth therein. As discussed in Note 14, "Moorman Settlement", the Oversight Committee (the committee formed to oversee the implementation of the Moorman Settlement Agreement) has stated that it disputes the Managing General Partner's calculation of the Redeemable General Partner Interest. The outcome of the dispute cannot be presently determined and the consolidated financial statements and schedules do not include any adjustments that might result from the outcome of this dispute. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS (Continued) The accompanying consolidated financial statements have been prepared assuming that the Partnership will continue as a going concern. As described in Note 14, the Moorman Settlement Agreement provides that the Oversight Committee can require the Partnership to repurchase the General Partner's interest for either cash or the issuance of a secured note, payable over three years. As further discussed in Note 14, "Moorman Settlement", a Term Sheet setting forth the general framework for the consummation of the Moorman Settlement was entered into in October 1993. If finalized, the settlement will result in, among other things, the spinoff of common stock in a newly organized real estate investment trust whose sole asset is comprised of a limited partnership investment in Garden Capital, L.P. The Term Sheet also proposes that the Partnership would not be required to purchase the Redeemable General Partner Interest calculated by the Partnership's Managing General Partner at December 31, 1993 to be $25.8 million (before reductions for amounts owed to the Partnership by the General Partner). The Partnership's operating cash flow is not sufficient to repurchase the General Partner's interest without asset sales and further refinancings. Also, the effects of the spinoff and other provisions contained in the Term Sheet, if consummated, could adversely affect the Partnership's liquidity and realization of its assets in the ordinary course of business. These circumstances raise substantial doubt about the Partnership's ability to continue as a going concern. Management's plans in regard to these matters are described in Note 15. The financial statements and schedules do not include any adjustments that might result from the outcome of this uncertainty. BDO Seidman Dallas, Texas March 24, 1994 NATIONAL REALTY, L.P. CONSOLIDATED BALANCE SHEETS December 31, -------------------------- 1993 1992 ---------- ---------- (dollars in thousands) Assets ------ Real estate held for investment Land................................... $ 47,985 $ 47,502 Buildings and improvements............. 362,116 365,100 ----------- ---------- 410,101 412,602 Less - Accumulated depreciation........ (186,059) (182,706) ----------- ---------- 224,042 229,896 Real estate held for sale................ 47,553 34,409 Less - Accumulated depreciation........ (20,061) (13,246) ----------- ---------- 27,492 21,163 Notes and interest receivable, net of deferred gains ($16,198 in 1993 and $20,272 in 1992)....................... 13,379 14,683 Less - allowance for estimated losses.. (1,910) (1,989) ----------- ---------- 11,469 12,694 Cash and cash equivalents................ 4,038 3,387 Accounts receivable...................... 2,005 2,271 Prepaid expenses......................... 1,066 1,156 Escrow deposits and other assets......... 7,815 13,435 Marketable equity securities of affiliate (at market in 1993 and at adjusted cost in 1992)............................... 593 269 Deferred financing costs................. 17,525 18,788 ----------- ---------- $ 296,045 $ 303,059 =========== ========== The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. CONSOLIDATED BALANCE SHEETS (Continued) December 31, ----------------------------- 1993 1992 ---------- ---------- (dollars in thousands) Liabilities and Partners' Equity (Deficit) - ----------------------------------------- Liabilities Notes and interest payable............. $ 335,200 $ 333,642 Accruing mortgage and related interest payable..................... - 9,946 Pension notes and related interest payable, net......................... 9,618 8,590 Accrued property taxes................. 7,138 6,447 Accounts payable and other liabilities. 5,128 5,992 Tenant security deposits............... 2,813 2,683 Amounts due to affiliates.............. 1,450 2,209 ---------- ---------- 361,347 369,509 Commitments and contingencies Redeemable General Partner Interest..... 21,600 14,700 Partners' equity (deficit) General Partner........................ 2,480 2,455 Limited Partners (2,139,607 units in 1993 and 2,316,834 units in 1992).... (63,931) (64,730) Unrealized gain on marketable equity securities........................... 324 - ---------- ---------- (61,127) (62,275) Redeemable General Partner Interest..... (25,775) (18,875) ---------- ---------- (86,902) (81,150) ---------- ---------- $ 296,045 $ 303,059 ========== ========== The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. CONSOLIDATED STATEMENTS OF PARTNERS' EQUITY (DEFICIT) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The accompanying Consolidated Financial Statements of National Realty, L.P. and consolidated entities (the "Partnership") have been prepared in conformity with generally accepted accounting principles, the most significant of which are described in NOTE 2. "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES." These, along with the remainder of the Notes to Consolidated Financial Statements, are an integral part of the Consolidated Financial Statements. The data presented in the Notes to Consolidated Financial Statements are as of December 31 of each year or for the year then ended, unless otherwise indicated. Dollar amounts in tables are in thousands, except per unit amounts. Certain balances for 1992 and 1991 have been reclassified to conform to the 1993 presentation. NOTE 1. ORGANIZATION General. National Realty, L.P. ("National Realty") is a Delaware limited partnership which commenced operations on September 18, 1987 when it acquired through National Operating, L.P. (the "Operating Partnership") all of the assets, and assumed all of the liabilities, of 35 public and private limited partnerships. National Realty is the sole limited partner of the Operating Partnership and owns 99% of the beneficial interest in the Operating Partnership. The general partner of, and owner of 1% of the beneficial interest in each of, National Realty and the Operating Partnership is Syntek Asset Management, L.P. (the "General Partner" or "SAMLP"). Gene E. Phillips is the sole general partner and until March 4, 1994, William S. Friedman was also a general partner of SAMLP, and each owns 1.95% of the beneficial interest in SAMLP. American Realty Trust, Inc. ("ART"), a real estate investment company of which Messrs. Phillips and Friedman served as executive officers and directors until November 16, 1992 and December 31, 1992, respectively, owns a 76.8% limited partner interest in SAMLP. Southmark Corporation ("Southmark") owns a 19.2% limited partner interest in SAMLP. Syntek Asset Management, Inc. ("SAMI"), a corporation of which Messrs. Phillips is an officer and director, and until February 15, 1994, Mr. Friedman served as an officer and director, owns a .10% general partner interest in SAMLP. SAMI is the Managing General Partner of SAMLP. See NOTE 14. "COMMITMENTS AND CONTINGENCIES -Southmark Litigation." SAMI, as Managing General Partner of SAMLP, manages the affairs of the Partnership. In addition, SAMI's corporate parent, Basic Capital Management, Inc. ("BCM"), performs certain administrative functions such as accounting services, mortgage servicing and portfolio review and analysis for the Partnership on a cost reimbursement basis. Mr. Friedman served as President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips. Messrs. Phillips and Friedman served as directors of BCM until December 22, 1989 and Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992. Since February 1, 1990 BCM NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. ORGANIZATION (Continued) or affiliates of BCM have provided property management services for the Partnership. Currently, Carmel Realty Services, Ltd. ("Carmel, Ltd."), an affiliate of BCM, performs such property management services for the Partnership. See NOTE 11. "GENERAL PARTNER FEES AND COMPENSATION." In November 1992, the Partnership refinanced 52 of its apartment complexes and a wraparound note receivable with a financial institution. To facilitate the refinancing, the Operating Partnership transferred these assets to Garden Capital, L.P. ("GCLP"), a Delaware limited partnership. The Operating Partnership is the sole limited partner with a 99.3% limited partnership interest in GCLP. The Operating Partnership received its limited partnership interest in exchange for the transfer of the net assets of the 52 apartment complexes and a wraparound note receivable to GCLP. Garden Capital Management Incorporated ("GCMI"), a Nevada corporation, is the .7% managing general partner of GCLP. See NOTE 8. "ACCRUING MORTGAGE." GCLP transferred the acquired net apartment assets, in exchange for a 99% limited partnership interest to each of 52 single asset limited partnerships which were formed for the purpose of operating, refinancing and holding title to the apartment complexes. The transfer of the 52 apartment complexes and the wraparound note receivable were effective November 25, 1992. Each of the single asset limited partnerships has no significant assets other than an apartment complex encumbered by mortgage debt. Garden Capital Incorporated ("GCI"), a Nevada corporation, is the 1% managing general partner in each of the single asset limited partnerships. Except as described under NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement," all decisions relating to the Partnership, including all decisions with respect to the acquisition, disposition, improvement, financing or refinancing of the Partnership's properties or other investments, are made by the Managing General Partner. However, all decisions with respect to the acquisition, disposition, improvement, financing or refinancing of the GCLP properties are made by GCMI or GCI as managing general partner of GCLP or the single asset partnerships, respectively. BCM performs certain administrative functions for the Partnership, such as accounting services, mortgage servicing and portfolio review and analysis, on a cost reimbursement basis. In addition to property management services discussed above, BCM or affiliates of BCM also perform loan placement services, leasing services and real estate brokerage and acquisition services and other services for the Partnership for fees and commissions. Mr. Friedman served as President of BCM until May 1, 1993, and Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips. GCMI performs administrative functions, similar to those performed for the NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. ORGANIZATION (Continued) Partnership by BCM, for GCLP on a cost reimbursement basis. The common stock of GCI and GCMI is owned by John A. Doyle (20%), Richard A. Green (40%) and Henry W. Simon (40%). Participation in net income, net loss and distributions. The limited partners of National Realty have a 99% interest and the General Partner has an aggregate 1% interest in the net income or net loss and distributions of National Realty. National Realty has a 99% and the General Partner has a 1% interest in the net income or net loss of the Operating Partnership. The 1% General Partner interest in each of National Realty and the Operating Partnership is equal to a 1.99% interest on a combined basis. The Operating Partnership has a 99.3% limited partnership interest and GCMI has a .7% general partnership interest in the net income or net loss and distributions of GCLP. GCLP has a 99% interest and GCI has a 1% interest in the net income or net loss and distributions of the 52 single asset partnerships that hold the apartment complexes. GCMI's .7% general partner interest in GCLP and GCI's 1% general partner interest in the single asset partnerships is equal to a 1.68% interest on a combined basis. For tax purposes limited partners are allocated their proportionate share of net income or net loss commencing with the calendar month subsequent to their entry into the Partnership. During the pendency of the Moorman Settlement Plan (as defined in NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement"), the General Partner's base compensation, equal to 10% of the distributions to unitholders from the Partnership's cash from operations, is waived. General Partner's capital contribution. In return for its 1% interest in National Realty, the General Partner was required to make aggregate capital contributions to the Partnership in an amount equal to 1.01% of the total initial capital contributions to the Partnership. The General Partner contributed $500,000 in cash with the remaining contribution evidenced by a promissory note bearing interest at the rate of 10% per annum compounded semi-annually payable on the earlier of September 18, 2007, liquidation of the Partnership or termination of the General Partner's interest in the Partnership. The principal balance of such promissory note was $4.2 million at December 31, 1993 and 1992. In the accompanying Consolidated Balance Sheets, the note receivable from the General Partner is offset against the Redeemable General Partner Interest as described in NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement." The General Partner received its 1% interest in the Operating Partnership in exchange for its agreement to serve as general partner of the Operating Partnership. If National Realty issues additional units of limited partner interest, the General Partner is entitled to maintain its aggregate 1% interest in each of National Realty and the Operating Partnership without payment of additional consideration. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. ORGANIZATION (Continued) GCMI contributed 100% of its economic interest in an apartment complex in Flagstaff, Arizona, to GCLP as its initial general partner capital contribution. In March 1993, GCMI contributed the Accruing Mortgage as a substitute capital contribution for its .7% general partner interest in GCLP. National Realty subsequently purchased the Accruing Mortgage (as defined in NOTE 8. "ACCRUING MORTGAGE") for a $900,000 note payable. GCI received its 1% general partner interest in the single asset partnerships in exchange for agreeing to manage the property owned by each such partnership. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of consolidation. The Consolidated Financial Statements include the accounts of National Realty, the Operating Partnership, GCLP and consolidated entities. All significant intercompany balances and transactions have been eliminated. Minority interests (which are not significant) are included in other liabilities. Revenue recognition on the sale of real estate. Sales of real estate are recognized when and to the extent permitted by Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("SFAS No. 66"). Until the requirements of SFAS No. 66 for full profit recognition have been met, transactions are accounted for using either the deposit, the installment, the cost recovery or the financing method, whichever is appropriate. Real estate and depreciation. Land, buildings and improvements are stated at the lower of cost or estimated net realizable value, except for foreclosed properties which are initially recorded at the lower of cost or fair value. Properties held for sale are depreciated in accordance with the Partnership's established depreciation policies. The subsequent classification of property previously held for sale to held for investment does not result in a restatement of previously reported revenues, expenses or net income (loss). Depreciation is provided on buildings and improvements using the straight-line method over estimated useful lives of 40 years for buildings and 7 to 25 years for improvements. Expenditures for renewals and betterments are capitalized and repairs and maintenance are charged against operations as incurred. Allowance for estimated losses. A valuation allowance is provided for estimated losses on notes receivable to the extent that the Partnership's investment in the notes exceeds the Partnership's estimate of net realizable value of the collateral of each such note, or fair value of the collateral if foreclosure is probable. In estimating net realizable value, consideration is given to the current estimated collateral value adjusted for costs to complete or improve, hold and dispose. The provision for losses on notes receivable is based on NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) estimates, and actual losses may vary from current estimates. Such estimates are reviewed periodically and any additional provision determined to be necessary is charged against earnings in the period in which it becomes reasonably estimable. Foreclosed real estate held for sale. Foreclosed real estate is recorded at new cost, defined as the lower of original cost or fair value minus estimated costs of sale. Interest recognition on notes receivable. It is the Partnership's policy to cease recognizing interest income on notes receivable that have been delinquent for 60 days or more. In addition, accrued but unpaid interest income is only recognized to the extent that the net realizable value of underlying collateral exceeds the carrying value of the receivable. Deferred financing costs. Deferred financing costs are capitalized and amortized on the interest-rate method over the term of the related loans. Present value discounts. The Partnership provides for present value discounts on notes receivable or payable that have interest rates that differ substantially from prevailing market rates and amortizes such discounts by the interest method over the lives of the related notes. The factors considered in determining a market rate for receivables include the borrower's credit standing, nature of the collateral and payment terms of the note. Marketable equity securities of affiliate. Marketable equity securities are considered to be available-for-sale and are carried at fair value, defined as year end closing market value. Net unrealized holding gains and losses are reported as a separate component of partners' equity until realized. Such securities were carried at adjusted cost in the Partnership's December 31, 1992 Consolidated Balance Sheet. Fair value of financial instruments. The Partnership used the following assumptions in estimating the fair value of its notes receivable, marketable equity securities and notes payable. For performing notes receivable, the fair value was estimated by discounting future cash flows using current interest rates for similar loans. For nonperforming notes receivable, the estimated fair value of the Partnership's interest in the collateral property was used. For marketable equity securities, fair value was the year end closing market price of each security. The estimated fair values presented do not purport to present amounts to be ultimately realized by the Partnership. The amounts ultimately realized may vary significantly from the estimated fair values presented. For notes payable, the fair value was estimated using current rates for mortgages with similar terms and maturities, which, at December 31, 1992 and 1993, approximated carrying value. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Cash equivalents. For purposes of the Consolidated Statements of Cash Flows, the Partnership considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Earnings per unit. Income (loss) per unit of limited partner interest is computed based upon the weighted average number of units outstanding during each year. Accordingly, net income (loss) per unit is derived by dividing 98.01% of the Partnership's net income (loss) by 2,249,330, 2,348,478 and 2,152,605 units for 1993, 1992 and 1991, respectively. NOTE 3. REAL ESTATE AND DEPRECIATION The Partnership has a 75% general partnership interest in Southern Palms Associates, which owns Southern Palms Shopping Center. On August 28, 1992, Southern Palms Associates filed a voluntary petition in bankruptcy seeking to restructure the $9.3 million nonrecourse mortgage secured by the shopping center. On October 26, 1993, the bankruptcy court approved the plan of reorganization and disclosure statement subject to certain conditions, involving the 25% general partner of Southern Palms Associates, to be rectified by the Partnership prior to the confirmation hearing, tentatively scheduled for the second quarter of 1994. The approved plan provides for the lender to extend the maturity date of the mortgage debt by five years to March 1998, and required the Partnership to pay all past due real estate taxes on the property of $1.0 million in December 1993. If the plan of reorganization is not confirmed, and the shopping center is foreclosed, the Partnership will record a loss on foreclosure of $5.9 million equal to the amount by which the carrying value of the property exceeds the mortgage debt. In June 1993, a wholly-owned subsidiary of the Partnership acquired the 2.5% general partner interest in Club Mar Realty Group, Ltd. for $17,500. The Partnership also holds a senior preferred limited partnership interest and receives 100% of the property's cash flow after debt service and is responsible for funding such deficiencies. Club Mar Realty Group, Ltd. is a Florida limited partnership which owns the Club Mar Apartments in Sarasota, Florida. The Partnership recorded the purchase of the general partner interest and the acquisition of the apartments at their fair market value of $6.2 million and the assumption of $6.1 million in first lien mortgage debt. The mortgage debt bears interest at 8.25% per annum, matures July 2023 and requires monthly principal and interest payments of $45,941. Also in June 1993, a wraparound mortgage note receivable with an original principal balance of $5.8 million secured by the Whispering Pines Apartments in Canoga Park, California, became nonperforming. On February 4, 1994, the Partnership, obtained through foreclosure proceedings, title to the collateral property. The Partnership recorded an insubstance foreclosure of the collateral property as of December 31, NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 3. REAL ESTATE AND DEPRECIATION (Continued) 1993. No loss resulted from the foreclosure as the fair market value of the collateral property (minus estimated costs of sale) exceeded the carrying value, net of deferred gains, of the mortgage note receivable. In March 1994, the Partnership completed the refinancing of the Cross County Mall Mattoon, Illinois. The Partnership received no net cash from its first draw on the loan of $4.7 million with loan proceeds of $3.8 million being used to payoff the existing first mortgage, $475,000 being used to payoff the second mortgage and with the remainder of the proceeds being used to fund required real estate tax escrows and to pay various closing costs associated with the financing. Both mortgages were scheduled to mature in 1994. The Partnership has access to the remaining $2.8 million available under the loan as it completes certain capital and tenant improvements to the mall. The new first mortgage bears interest at prime plus 1.75% per annum and requires monthly payments of principal and interest. Principal and accrued but unpaid interest are due at maturity on March 1, 1997 which may be extended to March 1, 2002. The mortgage debt is recourse to the Partnership. The Partnership, in accordance with the Partnership Agreement, paid BCM a 1% loan arrangement fee of $75,000 in connection with such refinancing. As of March 11, 1994, the Partnership had three apartment complexes under contract for sale; Bavarian Woods Apartments in Middletown, Ohio and Brandywine and Raintree Apartments in East Lansing, Michigan. The Oversight Committee has approved the terms of the pending sales and the Partnership anticipates finalizing such transaction during the second quarter of 1994. The assets have been reclassified as real estate held for sale in the Partnership's accompanying Consolidated Balance Sheet. The Partnership, however, can give no assurance that it will successfully complete these property sales. During 1992, the Partnership attempted to restructure $15.6 million of nonrecourse mortgage debt related to three Partnership properties; Plaza One Office Building in Earth City, Missouri, Hunters Glen Apartments in Kansas City, Missouri and the Lakes Apartments located in Atlanta, Georgia. All of the properties were placed in bankruptcy and negotiations with the respective lenders were held in an attempt to restructure each of the mortgages. The negotiations were unsuccessful and the properties were lost to foreclosure. As a result, the Partnership recognized extraordinary gains totaling $7.0 million representing the excess of the nonrecourse mortgage debt over the associated carrying values of the properties. The estimated fair value of each of the properties approximated the related mortgage debt at the respective dates of foreclosure. In July 1992, the Partnership sold the Terrace View Apartments in Burlen, Washington for $700,000 in cash subject to the outstanding mortgage of $2.4 million. The Partnership recognized a $375,000 gain on the sale. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 4. NOTES RECEIVABLE Notes and interest receivable consisted of the following: The Partnership does not recognize interest income on nonperforming notes receivable. Notes receivable are considered to be nonperforming when they become 60 days or more delinquent. For 1993 and 1992, unrecognized interest income on nonperforming notes totaled $924,100 and $325,000, respectively. All notes receivable were performing in 1991. The notes receivable mature from 1994 through 2000 with interest rates ranging from 8.0% to 11.5% with a weighted average interest rate of 6.3%. Discounts were based on interest rates at the time of origination. Notes receivable are nonrecourse and are generally collateralized by real estate. The majority of the notes require monthly payments of interest only with "balloon" principal payments at the end of their one-to-ten-year terms. Scheduled principal maturities of $1.5 million are due in 1994. Deferred gains result from property sales where the buyer has either made an inadequate down payment or has not met the continuing investment test of SFAS No. 66. The Partnership recognized deferred gains of $371,000 in 1991 due to a principal paydown on a wraparound note receivable. As discussed in NOTE 3. "REAL ESTATE AND DEPRECIATION," at December 31, 1993, the Partnership recorded the insubstance foreclosure of the collateral property securing a wraparound mortgage note receivable. In 1991, the Partnership and an insurance company entered into an Asset Sales Agreement to sell participations in certain of its mortgage notes receivable in exchange for participations in other mortgage notes or assets and cash. The Partnership entered into the Asset Sales Agreement in an effort to develop a potential source for future financing and to generate cash from otherwise illiquid assets. The governing documents include put and guaranty provisions whereby, at any time, either party may demand that the seller reacquire any asset it sold pursuant to the NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 4. NOTES RECEIVABLE (Continued) terms of the Asset Sales Agreement. The Asset Sales Agreement guaranteed a 10% per annum rate of return on the participations sold or acquired. The Partnership sold participations and assigned certain mortgage notes receivable totaling $4.7 million and in exchange received participations and assignments in other notes receivable, a limited partnership interest and $1.0 million in cash. In March 1992, the insurance company was placed in receivership. In June 1992, the Partnership provided notice to the insurance company, under the terms of the put and guaranty provisions, of its desire to divest itself of all the assets received. The Receiver has refused to allow the enforcement of the terms of the Asset Sales Agreement. In September 1992, the Court approved the Receivers' Petition for an Order of Liquidation for the insurance company. The Partnership determined, in 1992, that the fair value of the underlying collateral securing one of the participations received was not sufficient to satisfy the Partnership's participation interest and accordingly, the Partnership recorded a $1.6 million provision for loss to provide for such deficiency. In May 1993, the Partnership foreclosed on an assigned first lien secured by land in Denver, Colorado. The Partnership incurred no loss as a result of the foreclosure. In October 1993, this land was sold for its carrying value. If the Partnership forecloses on the collateral securing the participations and the remaining assets acquired, no additional losses are anticipated as the estimated fair values of the underlying collateral approximates their adjusted carrying values. The Partnership is continuing to evaluate its options with regard to these assets and is also in settlement negotiations with the Receiver. NOTE 5. ALLOWANCE FOR ESTIMATED LOSSES Activity in the allowance for estimated losses was as follows: In addition to the provision for losses in 1992, $416,000 was charged against operations to write-down one of the Partnership's office buildings to the balance of the related nonrecourse mortgage debt. The property was subsequently foreclosed. The Partnership's 1991 provision for losses of $5.0 million was comprised of direct charges against operations for the write-down of the Partnership's investment in equity NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 5. ALLOWANCE FOR ESTIMATED LOSSES (Continued) securities of ART of $964,000, a loss recorded on the restructuring of a mortgage note receivable of $525,000, a $1.1 million permanent impairment of value on one of the Partnership's office buildings, and the direct write-off of uncollectible property-level receivables (rents, common area maintenance charges, etc.) of $2.4 million. NOTE 6. INVESTMENTS IN MARKETABLE EQUITY SECURITIES OF AFFILIATE The Partnership owns 48,931 shares of the common stock of ART which the Partnership acquired in open market purchases in 1990. The Partnership has elected to adopt, effective December 31, 1993, Statement of Financial Accounting Standards No. 115 - "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). SFAS No. 115 requires that equity securities be carried at fair value. For trading securities, securities bought and held principally for sale in the near term, any increase or decrease in fair value is included in current earnings. All other equity securities are to be considered as available-for-sale and any increase or decrease in fair value is reported as a separate component of partners' equity until realized. The Partnership's ART equity securities are considered available-for-sale and are carried at fair value (market value) at December 31, 1993 and at adjusted cost at December 31, 1992. The market value of the ART common stock was $306,000 at December 31, 1992 and $593,000 at December 31, 1993. In 1991, the Partnership determined that the decline in the market value of ART common stock was other than temporary and, accordingly, the Partnership recorded a provision for loss of $964,000 for such market value decline. NOTE 7. NOTES PAYABLE Notes payable at December 31, 1993 and 1992 are collateralized by land, buildings and improvements and are generally nonrecourse to the Partnership. The GCLP mortgage debt, as discussed below, is cross-collateralized and cross-defaulted among the apartment complexes and wraparound note receivable that serve as collateral for such debt. The notes payable outstanding at December 31, 1993 bear interest at stated rates ranging from 5.0% to 15.0% with a weighted average rate of 9.1% and such notes have maturities or call dates ranging from one to 31 years. In August 1993, the Partnership refinanced the Regency Pointe Shopping Center in Jacksonville, Florida receiving net cash of $788,000 after the payment of the then existing mortgage debt of $1.6 million, associated closing costs and funding of required repair and maintenance escrows. The new $3.0 million mortgage bears interest at 7.5% per annum for the first year and is adjusted thereafter based on the average yield of United States Treasury Securities with a floor of 7.5% per annum, NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 7. NOTES PAYABLE (Continued) matures September 2005 and requires monthly principal and interest payments. The Partnership has guaranteed 50% of the mortgage. During 1993, achievement escrows totaling 1.8 million were applied against principal balances on three mortgage loans, $524,000 was applied to reduce the mortgage debt secured by the Granada Apartments in Bellevue, Nebraska, net of $66,000 of prepayment penalties, $924,000 was applied against the mortgage debt secured by the Vineyards Apartments in Broadview Heights, Ohio, net of $117,000 of prepayment penalties and $323,000 was applied against the mortgage debt secured by the Brookview Apartments in Smyrna, Georgia, net of $45,000 prepayment penalties. The new principal balance of each loan is to be amortized over their respective remaining terms of 371 months. All other terms remained unchanged. All prepayment penalties are included in interest expense in the accompanying Consolidated Statements of Operations. In September 1993, the $2.3 million second lien mortgage loan secured by the Marina Playa Office Building in Santa Clara, California was extended nine months from its original maturity of October 19, 1993 to July 20, 1994. All other loan terms remain unchanged. In November 1992, the Partnership transferred the net assets of 52 apartment complexes and a wraparound note receivable to GCLP, which then refinanced such assets with a financial institution through the issuance of a $223 million blanket mortgage. GCLP used the refinancing proceeds to pay off the related nonrecourse mortgage debt of the 52 properties and the wraparound note receivable of $175.1 million, after prepayment penalties and discounts, the line of credit with Transcontinental Realty Investors, Inc. ("TCI") of $21.9 million, including accrued but unpaid interest, and make a $8.5 million principal paydown on the Accruing Mortgage. (See NOTE 8. "ACCRUING MORTGAGE.") Refinancing proceeds of $3.8 million were deposited in four escrow accounts, as discussed below. After fees and other closing costs of $12.0 million were paid, net refinancing proceeds of $1.7 million remained. The Partnership recorded an extraordinary loss of $614,000 as a result of prepayment penalties and deferred borrowing costs. In conjunction with the refinancing, four escrow accounts were established and GCLP made an initial deposit totaling $3.8 million from the refinancing proceeds. The recurring replacement escrow requires monthly deposits of $232,000 and such funds will be used for capital repairs, replacements and improvements. The capital replacement escrow requires monthly deposits totaling $1.7 million in 1994 ($800,000 in 1993). These funds will also be used for capital replacement, repair work and environmental compliance as specified in the loan agreement. The credit enhancement escrow requires monthly deposits totaling $3.0 million in 1994 ($3.0 million in 1993), $3.3 million in 1995, $3.5 million in 1996 and $2.0 million for each of 1997, 1998 and 1999 up to NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 7. NOTES PAYABLE (Continued) an aggregate maximum amount of $18.5 million. These funds will be used to fund any operating shortfalls. A tax and insurance escrow was also established which requires monthly payments based on projections of real estate taxes and insurance. Also in conjunction with the GCLP refinancing, a letter of credit was provided by a financial institution for a term of not less than five years and in the amount of $12.5 million. The letter of credit may be drawn upon by GCLP to pay any operating shortfalls, provided such funds are not on deposit in the credit enhancement escrow, described above, which will be used, first, to fund operating shortfalls. The letter of credit will be reduced by the amount of (i) each draw on the letter of credit, (ii) each credit enhancement escrow deposit and (iii) any additional deposits made to the credit enhancement escrow account in excess of the requirement. No amounts have been drawn under the letter of credit. Scheduled notes payable principal payments (including pension notes) are due as follows: 1994............................................ $ 21,629 1995............................................ 9,318 1996............................................ 19,409 1997............................................ 14,682 1998............................................ 6,175 Thereafter...................................... 271,918 ----------- $ 343,131 =========== Included in 1994 maturities is $9.3 million in mortgage debt secured by the Southern Palms Shopping Center in Tempe, Arizona, which is currently in default. The Partnership has reached a tentative agreement to modify and extend the mortgage for five years. Also included in 1994 maturities is $4.2 million in mortgage debt secured by the Cross County Mall in Mattoon, Illinois, which was refinanced in March 1994. See NOTE 3. "REAL ESTATE AND DEPRECIATION." NOTE 8. ACCRUING MORTGAGE In connection with its formation in January 1987, the Partnership restructured $12.7 million of obligations due to Southmark Corporation ("Southmark") or its affiliates (including certain mortgages, payables and accrued interest due to Southmark) into an "Accruing Mortgage". The Accruing Mortgage had a maturity date of September 18, 1994 and was secured by Partnership properties. In November 1992, an affiliate of GCMI, the managing general partner of GCLP, a 99.3% owned limited partnership, acquired the Accruing Mortgage. In connection with the GCLP refinancing $8.5 million was paid against the principal balance and one of the Partnership's collateral apartment properties, the Oak Hollow Apartments in Austin, Texas, was released and the recourse provisions of NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ACCRUING MORTGAGE (Continued) the Accruing Mortgage were canceled. In March 1993, the holder of the Accruing Mortgage merged into GCMI and GCMI contributed such mortgage at an agreed value of $900,000 as a substitute capital contribution for its .7% general partner interest in GCLP. In March 1993, the Partnership acquired from GCLP and canceled the Accruing Mortgage in exchange for a $900,000 noninterest bearing unsecured demand note in full satisfaction of principal and accrued but unpaid interest. The Partnership recognized an extraordinary gain of $9.0 million from the discounted acquisition of the Accruing Mortgage. NOTE 9. PENSION NOTES In connection with its formation, the Partnership issued $4.7 million of 8% subordinated Pension Notes to certain investors in exchange for their interest in the net assets of certain of the "rolled-up" partnerships. The Pension Notes were issued under an Indenture between the Partnership and Security Pacific National Bank as successor Trustee. The Pension Notes are unsecured, subordinated obligations of the Partnership and bear interest at the rate of 8% compounded annually. Principal and interest are to be paid upon maturity on September 18, 1997 or earlier redemption. The Pension Notes are redeemable at the option of the Partnership at any time, in whole or in part, at 100% of the principal amount plus accrued and unpaid interest to the date of redemption. The Pension Notes are also subject to mandatory redemption if the Partnership's current value net worth (as defined in such Indenture) on the last day of each of any two consecutive fiscal quarters is less than 175% of the aggregate redemption price of Pension Notes then outstanding. The 8% stated interest rate on the Pension Notes is different than the assumed market rate at the time of issuance. Such discount is being amortized over the term of the Pension Notes using the interest method. Interest expense of $1,028,000, $918,000 and $936,000 was incurred on the Pension Notes for the years 1993, 1992, 1991, respectively. NOTE 10. WARRANTS Pursuant to the Moorman Settlement Agreement, the Partnership issued on February 14, 1992, 2,692,773 warrants to purchase an aggregate of 673,193 of its units of limited partner interest subject to adjustment. Each warrant initially entitled the holder thereof to purchase one quarter of one unit at the exercise price ($11.00 per warrant). The initial exercise price was equal to $44.00 per unit and increased to $48.00 per unit on February 14, 1993, subject to adjustment. The warrants are exercisable for five years from the February 14, 1992 date of issuance or until earlier redemption. See NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement." NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11. GENERAL PARTNER FEES AND COMPENSATION General. Mr. Phillips is a general partner and until March 4, 1994, Mr. Friedman was a general partner of SAMLP, the Partnership's General Partner. Mr. Phillips serves as an officer and director of SAMI, the Partnership's Managing General Partner. Messrs. Phillips and Friedman are also officers, directors or trustees of various entities engaged in real estate and related activities. These entities may have the same objectives and may be engaged in activities similar to those of the Partnership. Property Management Fees. As compensation for providing property management services to the Partnership's property, as provided in the Partnership Agreement, the General Partner or an affiliate of the General Partner is to receive a reasonable property management fee. Since February 1, 1990, affiliates of the Managing General Partner have provided property management services to the Partnership. Currently, Carmel Realty Services, Ltd. ("Carmel, Ltd.") provides such property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Partnership at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) Syntek West, Inc. ("SWI"), of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of nine of the Partnership's commercial properties to Carmel Realty, Inc. which is owned by SWI. Carmel, Ltd. does not perform property management services for GCLP. Leasing Commissions. As compensation for providing leasing and rent-up services for a Partnership property, as provided in the Partnership Agreement, the General Partner or an affiliate of the General Partner shall be paid a reasonable leasing commission. Reimbursement of Administrative Expenses. To the extent that officers or employees of the general partners or any of their affiliates participate in the operation or administration of the Partnership or GCLP, the general partners and their affiliates are to be reimbursed under the partnership agreements for salaries, travel, rent, depreciation, utilities or general overhead items incurred and properly allocable to such services. Such amounts are included in General and Administrative expense in the accompanying Consolidated Statements of Operations. General Partner Compensation. As base compensation for providing administrative and management services under the Partnership Agreement, the General Partner is entitled to receive from the Partnership an annual partnership management fee equal to 10% of distributions made in each calendar year of Cash from Operations, as defined in the Partnership Agreement, for the calendar year, payable within 90 days NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11. GENERAL PARTNER FEES AND COMPENSATION (Continued) after the end of that calendar year. As additional incentive compensation, the General Partner is entitled to receive in each calendar year an amount equal to 1% of the Average Unit Market Price, as defined in the Partnership Agreement, for that calendar year. Provided, however, that no incentive compensation is payable unless distributions of cash from operations exceed 6% of the Exchange Value of the original assets, also as defined in the Partnership Agreement. The General Partner has waived its base compensation during the pendency of the Moorman Settlement Agreement. Real Estate Brokerage Commissions. The General Partner or an affiliate of the General Partner may, pursuant to the Partnership Agreement, charge a reasonable real estate brokerage commission, payable at the time the Partnership acquires title to, or beneficial ownership in, an acquired property. Upon the sale of any Property by the Partnership, the General Partner or an affiliate of the General Partner may, pursuant to the Partnership Agreement, charge a reasonable real estate brokerage commission, payable at the time the Partnership transfers title to the property. In each case, such commissions are payable only if the General Partner or such affiliate actually performed brokerage services. Incentive Disposition Fee. Under the Partnership Agreement, the General Partner or an affiliate of the General Partner is paid a fee equal to 10% of the amount, if any, by which the Gross Sales Price, as defined in the Partnership Agreement, of any property sold by the Partnership exceeds 110% of the Adjusted Cost, also as defined in the Partnership Agreement, of such property. Acquisition Fees. As compensation under the Partnership Agreement for services rendered in structuring and negotiating the acquisition by the Partnership of any property, other than an Initial Property, as defined in the Partnership Agreement, the General Partner or an affiliate of the General Partner is paid a fee in an amount equal to 1% of the Original Cost, also as defined in the Partnership Agreement, of such property. Fees For Additional Services. Under the Partnership Agreement the General Partner or an affiliate of the General Partner may provide services other than those set out above for the Partnership in return for reasonable compensation. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11. GENERAL PARTNER FEES AND COMPENSATION (Continued) Fees and cost reimbursement to SAMLP, the General Partner of the Partnership and its affiliates: - ---------------------------------- * Net of property management fees paid to subcontractors. Cost reimbursements to GCMI, the general partner of GCLP: Rent. The office building which serves as headquarters for the Partnership, BCM and other entities managed by BCM or Mr. Phillips is located in Dallas, Texas. The office building is owned by Search/Lodges Diversified, L.P., in which BCM is a limited partner. The Partnership leased its office space in October 1989, under a five-year lease which expires in 1994. Total rental expense paid by the Partnership to BCM or its affiliates was $301,000 in 1993, $288,000 in 1992 and $272,000 in 1991. Minimum future rents due under the remaining lease term are as follows: 1994........................................... $ 312 ========== NOTE 12. RENTALS UNDER OPERATING LEASES The Partnership's rental operations include the leasing of office buildings and shopping centers. The leases thereon expire at various dates through 2013. The following is a schedule of minimum future rentals on non-cancelable operating leases as of December 31, 1993: 1994.......................................... $ 8,693 1995.......................................... 7,834 1996.......................................... 6,581 1997.......................................... 4,587 1998.......................................... 3,159 Thereafter.................................... 14,567 ------------ $ 45,421 ============ NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 13. INCOME TAXES The Partnership's partners include their share of partnership income or loss in their respective tax returns and, accordingly, no federal or state income taxes have been provided in the accompanying Consolidated Financial Statements. In December 1987, Congress passed legislation requiring certain publicly traded partnerships to be taxed as corporations. National Realty qualifies for "grandfather" treatment and will be treated as a partnership for federal tax purposes until at least 1997, unless the Partnership adds a substantial new line of business, which would require approval of the Oversight Committee (see NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement") and will continue to be so treated thereafter if 90% or more of its gross income consists of qualifying income from real estate activities. As presently operated, National Realty meets this qualification. Under the legislation, losses are suspended and carried forward to offset future income or gain from the Partnership's operations or gain upon a partner's disposition of all units held. Any remaining income will be taxed as portfolio income. NOTE 14. COMMITMENTS AND CONTINGENCIES Moorman Settlement The Partnership is party to a settlement agreement, dated as of May 9, 1990, between plaintiffs Joseph B. Moorman, et al. and defendants Robert A. McNeil, National Realty, the Operating Partnership, SAMLP, Messrs. Phillips and Friedman, and Shearson Lehman Hutton Inc., successor-in-interest to defendant E.F. Hutton & Company Inc., relating to the action entitled Moorman, et al. v. Southmark Corporation, et al. Such action was filed on September 2, 1987, in the Superior Court of the State of California, County of San Mateo. The plaintiffs' motion for class certification, was granted, for purposes of settlement only, on May 16, 1990. The "Class Members" are those persons who, as of September 17, 1987, were limited partners of one or more of McNeil Real Estate Fund VI, Ltd., McNeil Real Estate Fund VII, Ltd. and McNeil Real Estate Fund VIII, Ltd. (each a California limited partnership that was merged into the Operating Partnership by means of an exchange transaction), exclusive of (i) the defendants in the action and certain affiliates of such defendants and (ii) those persons who elected to be excluded from the plaintiff class. On May 9, 1990, the Partnership agreed to settle such action pursuant to the terms of a written agreement (the "Moorman Settlement Agreement"). On June 29, 1990, after a hearing as to its fairness, reasonableness and adequacy, the Moorman Settlement Agreement was granted final court approval. By agreeing to settle the Moorman action, the Partnership, SAMLP, and Messrs. Phillips and Friedman did not and do not admit any liability whatsoever. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Moorman Settlement (Continued) The terms of the Moorman Settlement Agreement are complex and the following summary is qualified in its entirety by reference to the text thereof, which was previously included as an exhibit to a Partnership filing with the Securities and Exchange Commission. The Moorman Settlement Agreement provides for a plan (the "Moorman Settlement Plan") consisting of, among other things, the following: (i) the appointment and operation of a committee (the "Oversight Committee"), to oversee the implementation of the Moorman Settlement Plan, (ii) the appointment and operation of an audit committee having a majority of members unaffiliated with Messrs. Phillips and Friedman or SAMLP, (iii) the establishment of specified annually increasing targets described below (each a "Target") for each of the next five years, relating to the price of the units of limited partner interest as decreased for certain distributions to unitholders, (iv) an agreement by SAMLP not to seek reimbursement of greater than $500,000 per year for Messrs. Phillips' and Friedman's salaries for serving as general partners of SAMLP, (Mr. Friedman resigned as general partner of SAMLP effective March 4, 1994) and a deferral of such payments until such time as a Target may be met, and, if SAMLP resigns as General Partner, a waiver of any compensation so deferred, (v) a deferral until such time as a Target may be met of certain future annual General Partner compensation payable, pursuant to the Partnership's governing documents, to SAMLP or its affiliates, and, if SAMLP resigns as General Partner, a waiver of any compensation so deferred, (vi) the required distribution to unitholders of all the Partnership's operating cash flow in excess of certain renovation costs, unless the Oversight Committee approves alternative uses for such operating cash flow, (vii) the issuance of Warrants to purchase an aggregate of up to 687,500 units (the "Warrants") to Class Members, (viii) the contribution by certain co-defendants of cash and notes payable to the Partnership aggregating $5.5 million (including $2.5 million to be contributed by SAMLP and its general partners over a four-year period), (ix) the amendment of the Partnership Agreement to reduce the vote required to remove the General Partner from a two-thirds vote to a majority vote of the units, (x) the Partnership's redemption of its unit purchase rights and an agreement not to adopt a similar rights plan without Oversight Committee approval and (xi) the Partnership's payment of certain settlement costs, including plaintiffs' attorneys' fees in the amount of $3.4 million. The Moorman Settlement Plan will remain in effect for a maximum period of five years from the May 9, 1990 announcement of the Moorman Settlement Agreement to the financial press, and the Warrants will remain exercisable for five years from the February 14, 1992 date of issuance or until earlier redemption. In May 1991, 1992 and 1993, SAMLP, on behalf of itself and its general partners, made the first three of its four annual payments of $631,000 (including accrued interest), to the Partnership, as required by the Moorman Settlement Agreement. The final payment of $631,000 is to be paid in May 1994. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Moorman Settlement (Continued) If the Partnership falls short of a Target for any one year of the Moorman Settlement Plan by 10% or more, then the Oversight Committee may request that the Partnership dispose of a portion of its assets and distribute the resulting net proceeds to unitholders. Specifically, (i) if the shortfall equals 10% or more but less than 35% of a Target, then the Oversight Committee may request that the Partnership sell assets having at least 10% of the Partnership's then aggregate Equity Value, as defined in the Moorman Settlement Agreement, in real estate and other assets, and (ii) if the shortfall equals 35% or more of a Target, then the Oversight Committee may request that the Partnership sell assets having at least 20% of the Partnership's then aggregate Equity Value in real estate and other assets. If Targets are not met for any two successive years of the Moorman Settlement Plan or for the final year of the Moorman Settlement Plan, SAMLP will be required to withdraw as General Partner effective at the time a successor general partner is elected. Upon, among other things, the withdrawal of SAMLP as General Partner and the due election and taking office of a successor, the Moorman Settlement Plan would terminate. The first two annual Targets, relating to unit market price were as follows: Anniversary Date Target ---------------- --------- May 9, 1991............................. $ 44.00 May 9, 1992............................. 57.00 Whether a given Target was achieved was determined by reference to the average closing price per unit of National Realty's units of limited partner interest on the American Stock Exchange ("AMEX") for the period beginning 30 days before the corresponding Anniversary Date and ending 30 days thereafter. There shall be added to this average closing price all distributions made after May 9, 1990, compounded at 9% per annum. Thus, achievement of the Targets may be accomplished both through increases in the price of units and by distributions to unitholders. The May 1991 Target of $44.00 per unit was not achieved and the Oversight Committee formally requested that the Partnership sell real property and other assets with an equity value of at least 20% of the aggregate equity value of the real property and other assets owned by the Partnership as of December 31, 1990. The General Partner selected a group of assets which it offered for sale and such assets were classified as real estate held for sale. Five of the assets selected were apartment complexes which were transferred to GCLP and refinanced, and are no being longer offered for sale. Accordingly, these assets were classified as held for investment in the Partnership's Consolidated Balance Sheets at December 31, 1992 and 1993. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Moorman Settlement (Continued) The Target for the second anniversary date of May 9, 1992 was $57.00 per unit. The average market price per unit for the averaging period was $20.93 and therefore, the second Target was not met. Since the Target has not been met for two successive years, the Moorman Settlement Agreement requires that SAMLP resign as General Partner, effective upon the election and qualification of its successor. On July 8, 1992, SAMLP notified the Oversight Committee of the failure to meet the Target for two successive years. Upon, among other things, the withdrawal of SAMLP as General Partner and the due election and taking office of a successor, the Moorman Settlement Plan would terminate. Withdrawal of SAMLP as General Partner pursuant to the Moorman Settlement Agreement requires unitholders to elect a successor general partner by majority vote. Upon the withdrawal or removal of the General Partner without the selection of a successor, the Partnership would be dissolved. The Moorman Settlement Agreement provides that between the date of the certification causing the General Partner's resignation and the date a successor general partner takes office, the resigning General Partner shall limit its activities, as General Partner, to the conduct of the business of the Partnership in the ordinary course, shall not, without consent of the Oversight Committee, purchase or sell any real estate or other assets of the Partnership not in progress on said date, shall cooperate in the election of a successor general partner and shall cooperate with its successor to facilitate a change in the office of General Partner of the Partnership. The resigning General Partner will continue to receive fees, expenses and distributions, if any, while the solicitation is prepared. Any dispute between the General Partner and the Oversight Committee concerning the operation of the Moorman Settlement Agreement is to be resolved by the Judge appointed pursuant to the Moorman Settlement Agreement to supervise its implementation. The withdrawal of the General Partner would require the Partnership to acquire the General Partner's interest in the Partnership (the "Redeemable General Partner Interest") at its then fair value, and to pay certain fees and other compensation, as provided in the Partnership Agreement and the Moorman Settlement Agreement. Under the Moorman Settlement Agreement, payment for such Redeemable General Partner Interest, fees and other compensation may, at the Oversight Committee's option, be paid over a three year period pursuant to a secured promissory note bearing interest at the prime rate and containing commercially reasonable terms and collateral. Under the Moorman Settlement Plan, the purchase price for Redeemable General Partner Interest would be calculated, as of the time SAMLP withdraws as General NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Moorman Settlement (Continued) Partner under the Partnership's governing documents. The Managing General Partner has calculated the Redeemable General Partner Interest at December 31, 1993 to be $25.8 million, and believes there has been no material change in such value since such date. The Partnership would be entitled to offset against any such payment the then outstanding principal balance ($4.2 million at December 31, 1993) plus all accrued but unpaid interest ($3.5 million at December 31, 1993) on the note receivable from SAMLP described in NOTE 1. "ORGANIZATION." In the accompanying Consolidated Financial Statements, the Redeemable General Partner Interest is shown as a reduction of Partners' Equity. The note receivable from the General Partner has been offset against the Redeemable General Partner Interest. The Oversight Committee has informed the Partnership that it calculated the amount of such Redeemable General Partner Interest at December 31, 1993, before the note receivable and unpaid interest offset described above, to be approximately $20.0 million. When SAMLP withdraws as General Partner of the Partnership, the value of the Redeemable General Partner Interest would depend on the fair value of the Partnership's assets at the time of calculation and there can be no assurance that the Redeemable General Partner Interest, fees and other compensation payable on any such withdrawal will not be substantially higher or lower than any current estimate or calculation. In October 1993, SAMLP and the Oversight Committee reached an agreement in principle, evidenced by a detailed Term Sheet, to nominate a candidate for successor General Partner and to resolve all related matters under the Moorman Settlement Agreement. The following summary is qualified in its entirety by reference to the text of the Term Sheet filed as an exhibit to the Partnership's Current Report on Form 8-K dated October 6, 1993. The Term Sheet provides that the nominee for successor General Partner will be a newly formed corporation which will be a wholly-owned subsidiary of SAMLP. The Term Sheet also sets forth an agreement in principle to effect a restructuring of National Realty and the spinoff by National Realty to its unitholders of shares of a newly formed subsidiary which would qualify as a Real Estate Investment Trust ("REIT") for federal tax purposes and would be the beneficial owner of 75% of NOLP's partnership interest in GCLP. The Term Sheet also contains proposed amendments to the National Realty partnership agreement. Pursuant to the Term Sheet, the Partnership will be relieved of any obligation to acquire the Redeemable General Partner Interest or to pay any other fees or compensation to SAMLP upon SAMLP's withdrawal as General Partner. The parties are preparing the agreements and other documents contemplated by the Term Sheet. Upon execution of an agreement embodying the provisions of the Term Sheet, the Oversight Committee and SAMLP will petition the Supervising Judge for his approval of the NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Moorman Settlement (Continued) agreement. The proposed restructuring of National Realty and the formation and spinoff of the REIT, the election of the new general partner and the proposed amendments to the Partnership Agreement require unitholder approval before becoming effective. Southmark Litigation During 1990 and 1991, several adversary proceedings were initiated against the Partnership and others by Southmark and its affiliates. On December 27, 1991, the Partnership and several other parties entered into a comprehensive settlement of litigation with Southmark (the "Southmark Settlement Agreement"). The settlement covered all actions between Southmark and its affiliates and National Realty and its affiliates. Pursuant to the Southmark Settlement Agreement, Southmark is to receive $13.2 million from the various settling parties. As of December 31, 1993, Southmark had received payments totaling $11.9 million. The remaining balance of $1.3 million is to be paid on June 27, 1994. Southmark also received from ART a 19.2% limited partnership interest in SAMLP, the general partner of the Partnership. ART has an option to repurchase the SAMLP partnership interest from Southmark for $2.4 million. Such option expires December 27, 1994. The unpaid balance of the settlement is secured by a pledge of ART securities having a minimum market value of 145% of the unpaid balance and by ART's remaining limited partnership interest in SAMLP not conveyed to Southmark. In addition to the pledge of securities securing the payment to Southmark, Messrs. Phillips and Friedman, ART and SWI each executed and delivered separate, final, nonappealable judgments in favor of Southmark, each in the amount of $25 million. In the event of default, Southmark is entitled to entry of those judgments and to recover from the parties an aggregate of $25 million, subject to reduction for any amounts previously paid. If the settlement obligations are met, the judgments will be returned to the defendants. Of the $13.2 million to be paid to Southmark, the Partnership is to pay $1.8 million, the net amount which it had recorded as due to Southmark as of the date the Southmark Settlement Agreement was entered into. To date, the Partnership has made payments totaling $1.5 million. The remaining balance of $265,000 is to be paid by the Partnership on June 27, 1994. To secure its settlement payment obligation to Southmark, the Partnership issued 300,000 new units of limited partner interest to ATN Equity Partnership ("ATN") which pledged such units to Southmark along with securities of ART and Transcontinental Realty Investors, Inc. As of December 31, 1993, all 300,000 units had been released from the pledge, returned to the Partnership and canceled. NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 14. COMMITMENTS AND CONTINGENCIES (Continued) Other Litigation The Partnership is also involved in various other lawsuits arising in the ordinary course of business. Management of the Partnership is of the opinion that the outcome of these lawsuits will have no material impact on the Partnership's financial condition. NOTE 15. LIQUIDITY The Partnership's principal sources of cash flow have been and will continue to be from property operations and externally generated funds. Externally generated funds include borrowings, proceeds from the sale of Partnership properties and other assets, proceeds from the issuance of debt secured by Partnership properties or mortgage notes receivable. As discussed in NOTE 14. "COMMITMENTS AND CONTINGENCIES - Moorman Settlement," the Managing General Partner is required to resign upon the election and qualification of its successor. The Oversight Committee can require the Partnership to purchase the Redeemable General Partner Interest for either cash or the issuance of a secured note, payable over three years. The Partnership's operating cash flow is not expected to be sufficient to purchase the Redeemable General Partner Interest without asset sales and/or further refinancings. However, the General Partner and the Oversight Committee have reached an agreement in principle whereby the Partnership will be relieved of any obligation to acquire the Redeemable General Partner Interest. However, if the spinoff of the to be formed REIT shares occurs, the Partnership will no longer receive 100% of the cash distributions from the GCLP properties which amounted to $1.7 million in 1993. Currently, all but five of the Partnership's properties are encumbered by mortgage debt. In addition to the possibility of purchasing the Redeemable General Partner Interest, mortgage debt totaling $21.6 million is in default or comes due in 1994. It is the Partnership's intention to either pay the mortgages when due, or seek to extend the due dates one or more years while attempting to obtain long-term financing. The Partnership also intends to seek to refinance certain mortgages not due in 1994 and use the proceeds for working capital purposes. Due to the limited long-term financing available to the Partnership, there can be no assurance that the Partnership will be successful in extending such "balloon" payments or that it will not ultimately lose certain of its properties to foreclosure. However, the General Partner believes it will continue to be successful in obtaining at least the minimum amount of extensions or other proceeds to enable the Partnership to maintain ownership of all properties in which it has equity. The Partnership has reached a tentative agreement with a lender for the modification and extension of a mortgage, which matured in 1993, with a NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 15. LIQUIDITY (Continued) principal balance of $9.3 million at December 31, 1993. In addition, $4.2 million of scheduled 1994 principal maturities were successfully refinanced in March 1994. See NOTE 3. "REAL ESTATE AND DEPRECIATION." As of March 11, 1994, the Partnership had three apartment complexes under contract for sale. The Partnership anticipates finalizing such transactions during the second quarter of 1994. The assets have been reclassed as real estate held for sale in the Partnership's accompanying Consolidated Balance Sheet. The Partnership, however, can give no assurance that it will successfully complete these property sales. See NOTE 3. "REAL ESTATE AND DEPRECIATION." NOTE 16. QUARTERLY DATA The following is a tabulation of the unaudited quarterly results of operations for the years 1993 and 1992. In the first quarter of 1993, the Partnership recorded a $9.0 million extraordinary gain as a result of its acquisition, at a discount, of the Accruing Mortgage. See NOTE 8. "ACCRUING MORTGAGE." (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL REALTY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 16. QUARTERLY DATA (Continued) In the first quarter of 1992, the Partnership recorded a $416,000 provision for loss to write-down the carrying value of one of the Partnership's office buildings to the related nonrecourse debt balance. The office building was foreclosed by the lienholder in June 1992. In the third quarter of 1992 the Partnership recorded a $500,000 provision for loss to reserve against the carrying value of a note participation. The Partnership also recorded extraordinary gains from the forgiveness of nonrecourse mortgage debt related to the foreclosure of three apartment properties. In the fourth quarter of 1992, the Partnership recorded a $1.1 million provision for loss to reserve against a note participation. The Partnership also recorded $557,000 extraordinary loss primarily related to the GCLP refinancing resulting from negotiated discounts net of prepayment penalties and deferred borrowing costs. (THIS SPACE INTENTIONALLY LEFT BLANK.) SCHEDULE X NATIONAL REALTY, L.P. SUPPLEMENTARY INCOME STATEMENT INFORMATION SCHEDULE XI NATIONAL REALTY, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 SCHEDULE XI (Continued) NATIONAL REALTY, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 SCHEDULE XI (Continued) NATIONAL REALTY, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 SCHEDULE XI (Continued) NATIONAL REALTY, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 __________________________________ (1) The aggregate cost for financial statement purposes approximates that for federal tax purposes. (2) Does not include discounts and mortgages payable totaling $16,806 on real estate which has been sold but for which the Partnership remains liable on the underlying mortgage note. (3) Write-down of property to estimated net realizable value. (4) Held for sale. SCHEDULE XI (Continued) NATIONAL REALTY, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION SCHEDULE XII NATIONAL REALTY, L.P. MORTGAGE LOANS ON REAL ESTATE December 31, 1993 - ------------------------- (1) Represents mortgage participations sold. SCHEDULE XII (Continued) NATIONAL REALTY, L.P. MORTGAGE LOANS ON REAL ESTATE ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. _________________________________ PART III ITEM 10. ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER As partnerships, neither National Realty, L.P. ("National Realty" or the "Registrant") nor National Operating, L.P. (the "Operating Partnership") (collectively the "Partnership") has officers or directors. The General Partner of the Partnership is Syntek Asset Management, L.P. ("SAMLP"), whose general partners are Gene E. Phillips and Syntek Asset Management, Inc. ("SAMI"), which also serves as Managing General Partner. Mr. Phillips is associated with a number of entities which have business objectives that are similar in certain respects to those of the Partnership. The Managing General Partner manages the day-to-day affairs of the Partnership which includes all decisions with respect to the acquisition, disposition, improvement, financing or refinancing of the Partnership's properties, subject to the limitations of the Moorman Settlement Agreement. See ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement." In addition, SAMI's corporate parent, Basic Capital Management, Inc. ("BCM"), performs certain administrative functions and other services for the Partnership for cost reimbursements and fees as described in ITEM 1. "BUSINESS - Management and Operations." The individual general partner of SAMLP and the executive officers of SAMI are listed below, together with their ages, terms of service, their principal occupations, business experience, and directorships with other companies during the last five years or more. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) GENE E. PHILLIPS: Age 56, General Partner (since 1987) of SAMLP; and Chairman of the Board, Director and Chief Executive Officer (since March 1989) of SAMI, the Managing General Partner of SAMLP and a corporation owned by BCM. Chief Executive Officer (February 1989 to September 1992) and Chairman of the Board and Director (February 1989 to December 1989) of BCM; Director and President (November 1989 to September 1992) of Carmel Realty Services, Inc. ("CRSI"); Limited Partner (since January 1991) of Carmel Realty Services, Ltd. ("Carmel, Ltd."); Chairman of the Board (1984 to November 1992), Director (1981 to November 1992), Chief Executive Officer (1982 to July 1991) and President (February 1989 to July 1991) of American Realty Trust, Inc. ("ART"); Trustee or Director (January 1989 to December 1992) of Transcontinental Realty Investors, Inc. ("TCI"), Vinland Property Trust ("VPT"), National Income Realty Trust ("NIRT"), Continental Mortgage and Equity Trust ("CMET") and Income Opportunity Realty Trust ("IORT"); Secretary (1982 to 1990) and Chairman of the Board (since 1982) of Syntek Investment Properties, Inc. ("SIPI"), which has invested in, developed and syndicated real estate through its subsidiaries and other related entities since 1973; Director and Secretary (since 1982) and the sole shareholder of Syntek West, Inc. ("SWI"); Chairman of the Board (since 1978) of Hungry Bull, Inc., which owns mortgages on restaurant properties; Trustee (1988 to November 1989) of Wespac Investors Trust ("Wespac"); and Director of Pratt Hotel Corporation (1986 to April 1989). Until January 1989, Mr. Phillips served in the following positions: Chairman of the Board and Director (from 1980) and President and Chief Executive Officer (from 1981) of Southmark Corporation ("Southmark"); Chairman of the Board and Director of Integon Corporation (from 1982), Director of NACO Finance Corporation (from 1982), Pacific Standard Life Insurance Company (from 1984), Servico, Inc. (from 1986), Southmark San Juan, Inc. (from 1987), National Heritage, Inc. (from 1987), J.M. Peters Company, Inc. (1987) and San Jacinto Savings Association (1987); Director and Chairman of the Board of Thousand Trails, Inc. (from 1987) and MGF Oil Corporation (from 1988). (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) OSCAR W. CASHWELL: Age 66, Director and President (since February 1994) of SAMI. President (since February 1994) of CMET, IORT and TCI; President and Director of Property and Asset Management (since January 1994) of BCM; Assistant to the President, Real Estate Operations (July 1989 to December 1993) of BCM; Assistant to the President, Real Estate Operations (March 1982 to June 1989) of Southmark; and Director (since November 1992) of ART. KARL L. BLAHA: Age 45, Executive Vice President and Director of Commercial Management (since April 1992) of SAMI. President (since October 1993) of ART; Executive Vice President and Director of Commercial Management (April 1993 to September 1993) of ART; Executive Vice President and Director of Commercial Management (since April 1992) of BCM, ART, CMET, IORT and TCI; Executive Vice President and Director of Commercial Management (April 1992 to February 1994) of NIRT and VPT; Partner - Director of National Real Estate Operations of First Winthrop Corporation (August 1988 to March 1992); Corporate Vice President of Southmark (April 1984 to August 1988); and President of Southmark Commercial Management (March 1986 to August 1988). HAMILTON P. SCHRAUFF: Age 58, Executive Vice President and Chief Financial Officer (since October 1991) of SAMI. Executive Vice President and Chief Financial Officer (since October 1991) of BCM, ART, CMET, IORT, and TCI; Executive Vice President and Chief Financial Officer (October 1991 to February 1994) of NIRT and VPT; Vice President - Finance of Partnership Investments, Hallwood Group (December 1990 to October 1991); Vice President - Finance and Treasurer (October 1980 to October 1990) and Vice President - Finance (November 1976 to September 1980) of Texas Oil & Gas Corporation; and Assistant Treasurer - Finance Manager (February 1975 to October 1976) of Exxon U.S.A. THOMAS A. HOLLAND: Age 51, Senior Vice President and Chief Accounting Officer (since July 1990) of SAMI. Senior Vice President and Chief Accounting Officer (since July 1990) of BCM, ART, CMET, IORT, and TCI; Senior Vice President and Chief Accounting Officer (July 1990 to February 1994) of NIRT and VPT; Vice President and Controller of Southmark (December 1986 to June 1990); Vice President - Finance of Diamond Shamrock Chemical Company (January 1986 to December 1986); Assistant Controller of Maxus Energy Corporation (formerly Diamond Shamrock Corporation) (May 1976 to January 1986); Trustee of Arlington Realty Investors, Inc. (August 1989 to June 1990); and Certified Public Accountant (since 1970). ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Compliance with Section 16(a) of the Securities Exchange Act of 1934 Under the securities laws of the United States, the directors and executive officers of the Partnership's Managing General Partner, and any persons holding more than 10% of the Partnership's units of limited partner interest are required to report their ownership of the Partnership's units and any changes in that ownership to the Securities and Exchange Commission (the "Commission"). Specific due dates for these reports have been established and the Partnership is required to report any failure to file by these dates during 1993. All of these filing requirements were satisfied by the directors and executive officers of the Partnership's Managing General Partner and 10% holders. In making these statements, the Partnership has relied on the written representations of the directors and executive officers of the Partnership's Managing General Partner and its ten percent holders and copies of the reports that they have filed with the Commission. Administrative Agent. Pursuant to an agreement, BCM, of which Mr. Phillips served as Chief Executive Officer until September 1, 1992, performs certain administrative functions such as accounting services, mortgage servicing and real estate portfolio review and analysis for the Partnership on a cost reimbursement basis. Affiliates of BCM perform property management, loan placement services, leasing services and real estate brokerage and acquisition services, and may perform other services, for the Partnership for fees and commissions. BCM's principal business activity is the providing of advisory services for real estate companies. See ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS." The directors and principal officers of BCM are set forth below. MICKEY NED PHILLIPS: Director RYAN T. PHILLIPS: Director OSCAR W. CASHWELL: President and Director of Property and Asset Management KARL L. BLAHA: Executive Vice President and Director of Commercial Management HAMILTON P. SCHRAUFF: Executive Vice President and Chief Financial Officer CLIFFORD C. TOWNS, JR.: Executive Vice President, Finance THOMAS A. HOLLAND: Senior Vice President and Chief Accounting Officer DREW D. POTERA: Vice President, Treasurer and Securities Manager ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) ROBERT A. WALDMAN: Vice President, Corporate Counsel and Secretary Mickey Ned Phillips is Gene E. Phillips' brother and Ryan T. Phillips is Gene E. Phillips' son. Oversight Committee. As more fully described under ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement," the Partnership is a party to the Moorman Settlement Agreement that, among other things, established an Oversight Committee which will exist only until termination of the Moorman Settlement Plan. The current members of the Oversight Committee are Ronald T. Baker, Joseph S. Radovsky and Kenneth R. Kelly. Messrs. Baker and Kelly are the current Chairman and Secretary, respectively, of the Oversight Committee. Unanimous consent of the Oversight Committee is required, during the term of the Moorman Settlement Plan, for the Partnership to adopt a new unit purchase rights plan, or for SAMLP, on behalf of the Partnership, to enter into or modify any transaction (other than certain transactions expressly permitted by the Partnership Agreement) with an affiliate (as defined below) of the Partnership, SAMLP, or Mr. Phillips or William S. Friedman, a general partner of SAMLP until March 4, 1994. Majority consent of the Oversight Committee is required, during the term of the Moorman Settlement Plan, for SAMLP, on behalf of the Partnership, to purchase securities of other issuers other than certain money market instruments and mortgages in the ordinary course of the Partnership's business, or to enter any new line of business. For purposes of the Moorman Settlement Agreement, an "Affiliate" of the Partnership, SAMLP, or Messrs. Phillips and Friedman (each, a "Specified Party") is any person or entity that (i) directly or indirectly through one or more intermediaries controls or is controlled by or is under common control with the Specified Party, (ii) owns or controls 10% or more of the outstanding voting securities of the Specified Party, or (iii) is an officer or director of, general partner in, or serves in a similar capacity to the Specified Party or of which the Specified Party is an officer, director, or general partner or with respect to which the Specified Party serves in a similar capacity. On July 8, 1992, SAMLP notified the Oversight Committee of the failure to meet the Targets (as defined in ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement") for two successive years. The Moorman Settlement Agreement provides that between the date of the certification causing the General Partner's resignation and the date a successor general partner takes office, the resigning General Partner shall limit its activities, as General Partner, to the conduct of the business of the Partnership in the ordinary course, shall not, without consent of the Oversight Committee, purchase or sell any real property or other assets of the Partnership not in progress on said date, shall cooperate in the election of a successor general partner and shall cooperate with its successor to facilitate a change in the office of General Partner of the Partnership. The resigning General Partner will continue to receive fees, expenses and distributions, if any, while the solicitation is prepared. See ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Pursuant to the Moorman Settlement Agreement, the Partnership pays each member of the Oversight Committee $50,000 per year. The Partnership also pays the salary of an Oversight Committee employee, and reimburses certain of the Oversight Committee's expenses including legal fees. The principal occupations and relevant affiliations of the Oversight Committee members, as furnished to the Partnership by such members, are as follows: RONALD T. BAKER: Age 46, Chairman (since July 1990) of the Oversight Committee. President of INVENEX (formerly known as Partnership Securities Exchange, Inc.) ("INVENEX") , a company engaged in the trading of partnership securities. INVENEX was one of the initial plaintiffs in the Moorman action discussed in ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement." KENNETH R. KELLY: Age 47, Secretary (since July 1990) of the Oversight Committee. President (since 1986) of Proximity Research Corporation, a real estate partnership due diligence and income property consulting firm based in Auburn, California. Mr. Kelly has been involved in the real estate investment business throughout the United States for the past twenty years and is presently a member of Partnerships Committee of the Business Law Section of the State Bar of California. JOSEPH S. RADOVSKY: Age 50, member (since July 1992) of the Oversight Committee. Partner with Greene, Radovsky, Maloney and Share, a law firm in San Francisco, California. Fairness Committee. National Realty's Fairness Committee periodically reviews certain transactions between the Partnership and its affiliates. The Partnership Agreement requires Fairness Committee approval of the interest rate to be paid on loans from the General Partner or its affiliates, the terms of any property sales to or purchases from the General Partner or its affiliates, the purchase of securities from the General Partner or its affiliates and, upon any withdrawal of the General Partner, the purchase price of the General Partner's interest in the Partnership and in the fees and other compensation to be paid under the Partnership Agreement. The Partnership Agreement provides that the Fairness Committee shall consist of two or more natural persons, none of whom shall be affiliates (as defined in the Partnership Agreement) of the General Partner except as directors of the Managing General Partner or holders of not more than one percent of Southmark's outstanding capital stock. ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) The members of the Fairness Committee are: (i) Willie K. Davis, who is Chairman and 50% shareholder of Mid-South Financial Corporation, a holding company for Mid-South Mortgage Company and Gibbs Mortgage Company; Chairman, President and sole shareholder of FMS, Inc., a property management and real estate development firm; President of BVT Management Services, Inc., a real estate advisory and tax service firm; Director of SouthTrust Bank of Middle Tennessee; and Trustee and Treasurer of Baptist Hospital, Inc., a Tennessee general welfare nonprofit corporation, and (ii) Raymond V.J. Schrag, an attorney with the Law Offices of Paul J. Schrag in New York, New York. Messrs. Davis and Schrag serve as trustees or directors of CMET, IORT, NIRT, TCI and VPT. Since January 1, 1993, FMS, Inc., has been providing property-level management services, as a subcontractor to Carmel, Ltd., for two properties owned by NIRT. Audit Committee. National Realty's Audit Committee, which reviews certain matters relating to the Partnership's auditors and annual and quarterly financial statements, was established effective August 3, 1990, pursuant to the Moorman Settlement Agreement. The chairman of the Audit Committee is Harry J. Reidler, an attorney in private practice in New York, New York and its other member is J. Darrell Jordan, an insurance industry consultant. Mr. Reidler shares offices with Mr. Friedman and has performed legal services for the Partnership and other entities of which Mr. Friedman is a director or trustee and officer. Litigation and Claims Involving Messrs. Phillips and Friedman Southmark Bankruptcy. Until January 1989, Mr. Phillips, a Director of SAMI, and Mr. Friedman, the President and a Director, until February 15, 1994 of SAMI, were executive officers and directors of Southmark. Mr. Phillips served as Chairman of the Board and Director (since 1980) and President and Chief Executive Officer (since 1981) and Mr. Friedman served as Vice Chairman of the Board (since 1982), Director (since 1980) and Secretary (since 1984) of Southmark. As a result of a deadlock on Southmark's Board of Directors, Messrs. Phillips and Friedman reached a series of related agreements with Southmark on January 17, 1989 (collectively, the "Separation Agreement"), whereby Messrs. Phillips and Friedman resigned their positions with Southmark and certain of Southmark's subsidiaries and affiliates. The Separation Agreement was later modified by certain agreements in another set of agreements dated as of June 30, 1989 (collectively, the "June Agreements"). Southmark filed a voluntary petition in bankruptcy under Chapter 11 of the United States Bankruptcy Code on July 14, 1989. San Jacinto Savings Association. On November 30, 1990, San Jacinto Savings Association ("SJSA"), a savings institution that was owned by Southmark since 1983 and for which Mr. Phillips served as a director from 1987 to January 1989, was placed under conservatorship of the ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Litigation and Claims Involving Messrs. Phillips and Friedman (Continued) Resolution Trust Corporation ("RTC") by federal banking authorities. On December 14, 1990, SJSA was converted into a Federal Association and placed in receivership. The government has reportedly alleged that SJSA's poor financial condition was attributable in part to "a pattern of high-risk real estate investments made after Southmark bought it in 1983," and that it had "poor procedures for determining loss reserves and relied 'excessively' on deposits gathered through brokerage houses that enable(d) it to grow rapidly." The RTC is conducting an investigation of matters involving SJSA during the period in which it was owned by Southmark. On November 26, 1993, the RTC filed lawsuits in Dallas and New York City against Mr. Phillips, six former directors, auditors and lawyers of SJSA, alleging that the auditors and former directors could and should have stopped SJSA's poor lending practices during the period it was owned by Southmark and that the former directors abdicated their responsibility for reviewing loans during the same period. The Office of Thrift Supervision is also conducting a formal examination of SJSA and its affiliates. Litigation Against Southmark and its Affiliates Alleging Fraud or Mismanagement. In addition to the litigation related to the Southmark bankruptcy, there were several lawsuits pending against Southmark, its former officers and directors (including Messrs. Phillips and Friedman) and others, alleging, among other things, that such persons and entities engaged in conduct designed to defraud and mislead the investing public by intentionally misrepresenting the financial condition of Southmark. Insofar as such allegations related to them, Messrs. Phillips and Friedman deny them. Those lawsuits in which Messrs. Phillips and Friedman were also defendants are summarized below. NEITHER NATIONAL REALTY, THE OPERATING PARTNERSHIP, SAMLP NOR SAMI WAS A DEFENDANT IN ANY OF THESE LAWSUITS. In Burt v. Grant Thornton, Gene E. Phillips and William S. Friedman, the plaintiff, a purchaser of Southmark preferred stock, alleged that the defendants disseminated false and misleading corporate reports, financial analysis and news releases in order to induce the public to continue investing in Southmark. Grant Thornton served as independent certified public accountants to Southmark. The plaintiff sought actual damages in the amount of less than $10,000, treble damages and punitive damages in an unspecified amount and attorneys' fees and costs. This case was settled in October 1993. Consolidated actions entitled Salsitz v. Phillips, et al., purportedly brought as class actions on behalf of purchasers of Southmark securities during specified periods, were pending before the United States District Court for the Northern District of Texas. These actions alleged violations of the federal securities laws and state laws, based upon claims of fraud, deceit and negligent misrepresentations made in connection with the sale of Southmark securities. The plaintiffs sought unspecified damages, attorneys' fees and costs. The defendants included ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Litigation and Claims Involving Messrs. Phillips and Friedman (Continued) Messrs. Phillips and Friedman, among others. Messrs. Phillips and Friedman entered into a settlement agreement with the plaintiffs, which was approved by the court in October 1993. Messrs. Phillips and Friedman also served as directors of Pacific Standard Life Insurance Company ("PSL"), a wholly-owned subsidiary of Southmark, from October 1984 to January 1989. In a proceeding brought by the California Insurance Commissioner, a California superior Court appointed a conservator for PSL on December 11, 1989, and directed that PSL cease doing business. On October 12, 1990, the California Insurance Commissioner filed suit against Messrs. Phillips and Friedman and other former directors of PSL seeking damages of $12 million and additional punitive damages. Such lawsuit alleged, among other things, that the defendants knowingly and willfully conspired among themselves to breach their duties as directors of PSL and to loot and waste corporate assets of PSL to benefit Southmark and its other subsidiaries and certain of the defendants (including Messrs. Phillips and Friedman), resulting in a required write-down of $25 million, PSL's insolvency and conservatorship. Such suit further alleged that the defendants caused PSL to make loans to, or enter into transactions with, Southmark, Southmark affiliates and others in violation of applicable state laws, and to make loans and investments that could not be included as assets on PSL's balance sheet to entities controlled by Charles H. Keating, Jr. It was also alleged that PSL's board of directors failed to convene meetings and delegated to Mr. Phillips authority to make decisions regarding loans, investments and other transfers and exchanges of PSL assets. In August 1993, five former directors of PSL, including Messrs. Phillips and Friedman, settled the lawsuit without admitting any liability. Litigation Relating to Lincoln Savings and Loan Association, F.A. In an action filed in the United States District Court for the District of Arizona on behalf of Lincoln Savings and Loan Association, F.A. ("Lincoln") and captioned RTC v. Charles H. Keating, Jr., et al, the RTC alleges that Charles H. Keating, Jr. and other persons, including Mr. Phillips, fraudulently diverted funds from Lincoln. The RTC alleges that Mr. Phillips aided and abetted the insider defendants in a scheme to defraud Lincoln and its regulators; that Southmark, its subsidiaries and affiliates, including SJSA, facilitated and concealed the use of Lincoln funds to finance the sale, at inflated prices, of assets of Lincoln's parent, American Continental Corp. ("ACC"), in return for loans from Lincoln and participations in contrived transactions; and that the insider defendants caused Southmark to purchase ACC assets at inflated prices. The RTC alleges that Lincoln and/or ACC engaged in three illegal transactions with Southmark or its affiliates while Mr. Phillips was associated with Southmark. Neither Mr. Friedman nor Southmark is a defendant in this action. ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Litigation and Claims Involving Messrs. Phillips and Friedman (Continued) The RTC alleges nine separate causes of action against Mr. Phillips, including aiding and abetting the violation of, and conspiracy to violate, federal and state Racketeer Influenced and Corrupt Organizations Act ("RICO") statutes, violations of Arizona felony statutes, common law fraud, civil conspiracy and breach of fiduciary duty. The RTC seeks to recover from the defendants more than $1 billion, as well as treble damages under the federal RICO statutes, punitive damages of at least $100 million and attorneys' fees and costs. Mr. Phillips motion to dismiss the complaint for failure to state a cause of action and for summary judgment was heard in February 1992. The motion was denied in June 1992. Trial was scheduled to begin in June 1993, however, the case was removed from the trial docket to facilitate settlement negotiations. It has been reported that the Justice Department and the Securities and Exchange Commission have been asked to investigate Lincoln's possible links to Southmark. Southmark Partnership Litigation. One of Southmark's principal businesses was real estate syndication and from 1981 to 1987 Southmark raised over $500 million in investments from limited partners in several hundred limited partnerships. The following actions relate to and involve such activities. In an action filed in November 1990 in a Texas state court captioned Adkisson, et al. v. Friedman et al., the plaintiffs who invested approximately $50,000 in a limited partnership sponsored by Southmark, alleged breach of the partnership agreement, breach of fiduciary duty, violations of state consumer protection laws, negligence and fraud. The defendants included Messrs. Phillips and Friedman. In addition to actual damages in an unspecified amount, punitive and statutory damages, and attorneys' fees and court costs, the plaintiffs sought to rescind the partnership agreement and to obtain restitution of their capital contributions. This case was settled in July 1993 for a nominal payment. In a class action suit filed in December 1990 in the United States District Court for the Southern District of New York captioned Sable et al. v. Southmark/Envicon Capital Corp. et al., the plaintiffs, limited partners in nine Southmark-sponsored limited partnerships, alleged several claims, including conspiracy, fraud and violation of the federal and state RICO statutes. The plaintiffs also brought derivative actions on behalf of the partnerships alleging breach of fiduciary duty and waste or mismanagement of partnership assets. The plaintiffs sought to recover actual damages in an unspecified amount, treble damages pursuant to RICO, costs and injunctive relief. The defendants included, among others, Messrs. Phillips and Friedman. In April 1993, the court granted defendants' motion to dismiss for failure to state a claim and awarded sanctions against plaintiffs' counsel. ITEM 10. GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER (Continued) Litigation and Claims Involving Messrs. Phillips and Friedman (Continued) In an action filed in May 1992 in a Texas state court captioned HCW Pension Real Estate Fund, et al. v. Phillips et al., the plaintiffs, fifteen former Southmark related public limited partnerships, allege that the defendants violated the partnership agreements by charging certain administrative costs and expenses to the plaintiffs. The complaint alleges claims for breach of fiduciary duty, fraud and conspiracy to commit to fraud and seeks to recover actual damages of approximately $12.6 million plus punitive damages, attorneys' fees and costs. The defendants include, among others, Messrs. Phillips and Friedman. In October 1993, the court granted partial summary judgment in favor of Messrs. Phillips and Friedman on the plaintiffs' breach of fiduciary duty claims. The plaintiffs have not pursued the remaining claims. In an action filed in May 1992 in a Texas state court captioned Cedarwood Hills Associates, Ltd., et al. v. Phillips, et al., the plaintiffs, six former Southmark related private limited partnerships, alleged that the defendants charged the plaintiff partnerships for Southmark's corporate overhead and operating costs. The complaint alleged claims for breach of fiduciary duty, fraud and conspiracy to commit fraud and sought to recover actual damages in an unspecified amount, plus punitive damages, attorneys' fees and costs. The defendants included, among others, Messrs. Phillips and Friedman. Notice of non-suit in favor of the defendants was entered on January 20, 1994. In an action filed in June 1992 in a Georgia state court captioned Southmark/CRCA Healthcare Fund VIII, L.P. v. Southmark Investment Group 87, Inc., et al., the plaintiff, a former Southmark related public limited partnership, alleged that in 1988 the defendants caused the plaintiff to purchase five nursing homes in violation of the Partnership agreement and for the sole purpose of benefitting the defendants. The complaint alleged claims for breach of fiduciary duty and conspiracy to cause the plaintiff to acquire the properties so as to obtain improper financial benefits for the defendants. The plaintiff sought to recover actual damages in an unspecified amount, plus punitive damages, attorneys' fees and costs. The defendants included, among others, Messrs. Phillips and Friedman and TCI, which provided refinancing for the plaintiffs' purchase of the properties. This case was settled in October 1993. In an action filed in January 1993 in a Michigan state court captioned Van Buren Associates Limited Partnership, et al. v. Friedman, et al., the plaintiff, a former Southmark sponsored limited partnership, alleges a claim for breach of fiduciary duty in connection with the 1988 transfer of certain property by the partnership. The plaintiff seeks damages in an unspecified amount, plus costs and attorneys' fees. The plaintiff also seeks to quiet title to the property at issue. The defendants include, among others, Messrs. Phillips and Friedman. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Neither National Realty nor the Operating Partnership has any employees, payroll or benefit plans and pays no salary or other cash compensation directly to any person other than (i) $50,000 per year to each member of the Oversight Committee plus additional sums to an employee of the Oversight Committee, (ii) $4,000 per year to each member of the Fairness and Audit Committees and (iii) fees and expense reimbursements in accordance with the Partnership Agreement to the General Partner or its affiliates for services provided to the Partnership. See ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." SAMI has no employees, payroll or benefit plans and pays no compensation to its officers or directors. The Moorman Settlement Agreement provides that effective May 1, 1990 the Partnership's future reimbursement of any salaries which may be paid to Messrs. Phillips and Friedman shall be limited to an aggregate of $500,000 per year, for any such reimbursement of salaries to be deferred until such time as a Target, as defined in the Moorman Settlement Agreement, may be met and, if SAMLP resigns as General Partner during the pendency of the Moorman Settlement Plan, for the waiver of any reimbursement of salary so deferred. Accordingly, no reimbursement for the salaries of Messrs. Phillips and Friedman was charged to or paid by the Partnership in 1993, 1992 or 1991. Mr. Friedman resigned as a general partner of SAMLP on March 4, 1994. Mr. Phillips may indirectly benefit from other payments made by the Partnership to certain related parties. Messrs. Davis and Schrag each received $4,000 in 1993 for serving on the Partnership's Fairness Committee. Messrs. Jordan and Reidler each received $4,000 in 1993 for serving on the Partnership's Audit Committee. Messrs. Baker, Kelly and Radovsky each received $50,000 for serving on the Oversight Committee. See ITEM 10. "GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER." (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 11. EXECUTIVE COMPENSATION (Continued) Performance Graph The following performance graph compares the cumulative total unitholder return on the Partnership's units of limited partner interest with the Dow Jones Market Index ("DJ Market Index") and the Dow Jones Real Estate Index ("DJ Real Estate Index"). The comparison assumes that $100 was invested on December 31, 1988 in the Partnership's units of limited partner interest and in each of the indices and further assumes the reinvestment of all dividends. Past performance is not necessarily an indicator of future performance. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners. The following table sets forth the ownership of National Realty's units of limited partnership interest, both beneficially and of record, both individually and in the aggregate, for those persons known by National Realty to be beneficial owners of more than 5% of its units of limited partner interest, as of the close of business on March 11, 1994. Amount and Nature Name and Address of of Beneficial Percent of Beneficial Owner Ownership Class (1) --------------------------- ----------------- ---------- American Realty Trust, Inc. 942,813 44.1% 10670 N. Central Expressway Suite 300 Dallas, Texas 75231 --------------------------- (1) Percentages are based upon 2,139,607 units of limited partner interest outstanding at March 11, 1994. Security Ownership of Management. The following table sets forth the ownership of National Realty's units of limited partner interest, both beneficially and of record, both individually and in the aggregate, by SAMLP, the general partners of SAMLP, and the executive officers and directors of SAMI, as of the close of business on March 11, 1994. Percent of Name of Beneficial Owner Number of Units Units (1) - ----------------------------- --------------------- ---------- SAMLP, the general 1,008,538 (2) 47.1% partners of SAMLP, and the executive officers and directors of SAMI as a group (5 individuals) - ----------------------- (1) Percentages are based upon 2,139,607 units of limited partner interest outstanding as of March 11, 1994. (2) Includes 942,813 units owned by ART and 65,725 units owned by BCM, of which the general partners of SAMLP and executive officers of SAMI, ART and BCM may be deemed to be the beneficial owners by virtue of their positions as general partners of SAMLP and executive officers of SAMI, ART and BCM. SAMLP's general partners and the executive officers of ART and BCM disclaim beneficial ownership of such units. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain Business Relationship National Realty is the sole limited partner of the Operating Partnership and owns 99% of the beneficial interest in the Operating Partnership. SAMLP is the general partner of, and owner of a 1% beneficial interest ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Certain Business Relationships (Continued) in, each of National Realty and the Operating Partnership. Southmark Asset Management, Inc., a wholly-owned subsidiary of Southmark, was the managing general partner of SAMLP until January 17, 1989, when (as part of the agreement described in ITEM 1. "BUSINESS - Separation of Messrs. Phillips and Friedman and the Partnership from Southmark") Southmark Asset Management, Inc. exchanged its general partnership interest in SAMLP for a limited partnership interest representing an equivalent 96% beneficial interest. As a result, Messrs. Phillips and Friedman became the sole general partners of SAMLP, and each owned 2% of the beneficial interest in SAMLP. As part of the June Agreements (described and defined in ITEM 1. "BUSINESS - Separation of Messrs. Phillips and Friedman and the Partnership From Southmark"), Southmark Asset Management, Inc. subsequently transferred its 96% limited partnership interest to ART, a real estate investment company of which Messrs. Phillips and Friedman served as officers and directors until November 16, 1992 and December 31, 1992, respectively. On February 25, 1992, ART transferred a 19.2% limited partner interest in SAMLP to Southmark pursuant to the settlement of litigation with Southmark in December 1991. In addition, ART has pledged its remaining 76.8% interest in SAMLP to Southmark as collateral for the payments to be made to Southmark pursuant to the settlement of litigation. See ITEM 3. "LEGAL PROCEEDINGS - Southmark Litigation". On July 18, 1989, Messrs. Phillips and Friedman each assigned .05% of their general partner interest in SAMLP to SAMI, a corporation of which Mr. Phillips is an officer and director and of which BCM is the sole shareholder. On March 4, 1994, Mr. Friedman resigned as a general partner of SAMLP. As a result, Mr. Phillips and SAMI are the general partners of SAMLP, with 1.95% and .10%, respectively, of the beneficial interest in SAMLP. Mr. Friedman's 1.95% interest in SAMLP is now a limited partner interest. SAMI was appointed Managing General Partner of SAMLP on June 18, 1990. Oscar W. Cashwell, President and director of SAMI, was Assistant to the President, Real Estate Operations of Southmark from March 1982 to June 1989. Karl Blaha, Executive Vice President and Director of Commercial Management of SAMI, was Corporate Vice President of Southmark from April 1984 to August 1988 and President of Southmark Commercial Management from March 1986 to August 1988. Thomas A. Holland, Senior Vice President and Chief Accounting Officer of SAMI, was Vice President and Controller of Southmark from December 1986 to June 1990. Since February 1, 1990, affiliates of the Managing General Partner have provided property management services to the Partnership. Currently, Carmel Realty Services, Ltd. ("Carmel, Ltd.") provides property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In some cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Partnership at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) SWI, of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of Mr. Phillips' children. BCM is a ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Certain Business Relationships (Continued) corporation which is beneficially owned by a trust for the benefit of the children of Mr. Phillips. BCM performs certain administrative and other functions for the Partnership. See ITEM 1. "BUSINESS - Management and Operations" and ITEM 11. "EXECUTIVE COMPENSATION." Search/Lodges Diversified, L.P., in which BCM is a limited partner, currently serves as landlord for the Partnership and certain other entities. Messrs. Cashwell, Blaha, Schrauff and Holland serve as executive officers of BCM. Messrs. Phillips and Friedman served as directors of BCM until December 1989 and executive officers of BCM until September 1, 1992 and May 1, 1993, respectively. Mr. Phillips is a limited partner of Carmel, Ltd., which since February 1, 1991 has performed property management services for the Partnership's properties. Messrs. Cashwell, Blaha, Schrauff and Holland serve as executive officers of CMET, IORT, TCI and ART. BCM serves as advisor to CMET, IORT, NIRT, TCI and ART. BCM has resigned as advisor to NIRT effective March 31, 1994. FMS, Inc., a company of which Mr. Davis, who serves on the Fairness Committee, is Chairman, President and the sole shareholder, provides property-level management services, as a subcontractor to Carmel, Ltd., for two properties owned by NIRT. Mr. Schrag, who serves on the Partnership's Fairness Committee, and Mr. Davis both serve as trustees or directors of CMET, IORT, NIRT, TCI and VPT. Proximity Research Corporation, a company of which Mr. Kelly, who serves as Secretary of the Oversight Committee, has provided professional services to the Partnership. Related Party Transactions The Partnership has engaged in business transactions with certain related parties and may continue to do so, subject to unanimous approval of the Oversight Committee during the term of the Moorman Settlement Plan as discussed under ITEM 10. "GENERAL PARTNER OF THE REGISTRANT AND EXECUTIVE OFFICERS OF THE REGISTRANT'S GENERAL PARTNER - Oversight Committee." The Partnership believes that all of the related party transactions were at least as advantageous to the Partnership as could have been obtained from unrelated third parties. In November 1992, the Partnership refinanced 52 of its apartment complexes and a wraparound note receivable with a financial institution. Garden Capital, L.P. ("GCLP"), a Delaware limited partnership, was formed to facilitate such refinancing. The Operating Partnership is the sole limited partner with a 99.3% limited partnership interest in GCLP. The Operating Partnership received its limited partnership interest in exchange for the transfer of the 52 apartment complexes and the wraparound note receivable to GCLP. Garden Capital Management Incorporated ("GCMI"), a Nevada corporation, is the .7% managing general partner of GCLP. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Related Party Transactions (Continued) GCLP transferred the acquired apartment assets in exchange for a 99% limited partnership interest in each of 52 single asset limited partnerships which were formed for the purpose of operating, refinancing and holding title to the 52 apartment complexes previously owned by the Operating Partnership. The transfer of the 52 apartment complexes and the wraparound note receivable were effective November 25, 1992. The common stock of Garden Capital Incorporated ("GCI") and GCMI is owned by John A. Doyle (20%), Richard A. Green (40%) and Henry W. Simon (40%). The Partnership has paid and pays cost reimbursements, property management fees or other cash compensation to BCM and its affiliates and other related parties as described in ITEM 11. "EXECUTIVE COMPENSATION" and ITEM 1. "BUSINESS - Management and Operations." BCM performs certain administrative functions for the Partnership on a cost reimbursement basis. The Fairness Committee has approved the formula for computing the Partnership's proportionate share of certain of BCM's reimbursable costs. GCMI performs administrative functions, similar to those performed for the Partnership by BCM, for GCLP on a cost reimbursement basis. Since February 1, 1990, affiliates of BCM have provided property management services to the Partnership. Currently, Carmel, Ltd., provides such property management services. In many cases, Carmel, Ltd. subcontracts with other entities for some of the property-level management services to the Partnership. Carmel, Ltd. subcontracts the property-level management and leasing of nine of the Partnership's commercial properties to Carmel Realty, Inc., which is owned by SWI. Carmel, Ltd. does not perform property management services to the properties transferred to GCLP. Carmel, Ltd. also performs similar services for ART, CMET, IORT, TCI and through March 31, 1994, NIRT. See NOTE 11. "GENERAL PARTNER FEES AND COMPENSATION" included in Notes to Consolidated Financial Statements at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA," for a summary of fees paid and costs reimbursed by the Partnership. The Partnership's Fairness Committee periodically reviews certain transactions between the Partnership and its affiliates. See ITEM 1. "BUSINESS - - Management and Operations." The Fairness Committee has approved the terms of the Partnership's contracts and terms for services and reimbursements with affiliates. The Partnership's Oversight Committee must approve certain types of transactions between the Partnership and SAMLP or its affiliates, as defined in the Moorman Settlement Agreement. See ITEM 3. "LEGAL PROCEEDINGS - Moorman Settlement." Indebtedness of Management In return for its 1% interest in National Realty, the General Partner was required to make aggregate capital contributions to National Realty in an amount equal to 1.01% of the total initial capital contributions to the Partnership. The General Partner contributed $500,000 cash with the remaining portion evidenced by a promissory note in the principal ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Indebtedness of Management (Continued) amount of $4.2 million, bearing interest at the rate of 10% per annum compounded semi-annually is payable on the earlier of September 18, 2007, liquidation of the Partnership or a termination of the General Partner's interest in the Partnership. As of December 31, 1993, no payments had been received on such note. At December 31, 1993, accrued and unpaid interest on the note totaled $3.5 million. _____________________________________ PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. Consolidated Financial Statements Report of Independent Certified Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Operations - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Partners' Equity (Deficit) - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule X - Supplementary Income Statement Information Schedule XI - Real Estate and Accumulated Depreciation Schedule XII - Mortgage Loans on Real Estate All other schedules are omitted because they are not applicable or because the required information is shown in the Consolidated Financial Statements or the Notes thereto. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) 3. Exhibits The following documents are filed as Exhibits to this Report: Exhibit Number Description - ------- ----------- 3.1 National Realty, L.P. Amended and Restated Certificate of Limited Partnership, dated March 4, 1987 (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement No. 33-16215 on Form S-4). 3.2 National Realty, L.P. First Amended and Restated Agreement of Limited Partnership, dated as of January 29, 1987 (incorporated by reference to Exhibit 4.1 to the Registrant's Registration Statement No. 33-16215 on Form S-4). 3.3 Certificate of Amendment of Limited Partnership Agreement of National Realty, L.P. dated as of May 14, 1990 (incorporated by reference to Exhibit 4.2 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 4.1 Indenture, dated as of September 18, 1987, by and between National Realty, L.P. and Mellon Bank, N.A. (incorporated by reference to Exhibit 4.2 to the Registrant's Registration Statement No. 33-16215 on Form S-4). 4.2 Amendment No. 1, dated as of December 28, 1987, to Trust Indenture between National Realty, L.P. and Mellon Bank, N.A. (incorporated by reference to Exhibit 4.2 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 4.3 Form of Warrant Agreement between National Realty, L.P. and American Stock Transfer and Trust Company, as Warrant Agent (Incorporated by reference to Exhibit No. 4.5 to the Registrant's Registration Statement No. 33-38352 on Form S-11) 10.1 Loan Agreement dated as of November 24, 1992 by and among First Commonwealth Realty Credit Corporation as Lender, and Garden Kimberly Woods L.P. et. al., as Borrower. (incorporated by reference to Exhibit No. 10.1 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 11.1 Computation of Earnings Per Unit. 22.1 Subsidiaries of the Registrant. 28.1 Agreement of Limited Partnership of National Operating, L.P. (incorporated by reference to Exhibit 4.3 to the Registrant's Registration Statement No. 33-16215 on Form S-4). ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Exhibit Number Description - ------- ----------- 28.2 Limited Partnership Agreement of Garden Capital, L.P. between Garden Capital Management Incorporated and National Operating, L.P. (incorporated by reference to Exhibit No. 28.2 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 28.3 Settlement Agreement, dated as of May 9, 1990, relating to the action entitled Moorman et. al v. Southmark Corporation et al. (incorporated by reference to Exhibit 5.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990). 28.4 Settlement Agreement and Mutual Release, dated as of December 27, 1991, between Southmark Corporation, et al and Gene E. Phillips, et al (incorporated by reference to the Registrant's Current Report on Form 8-K, dated December 27, 1991). 28.5 Term Sheet, dated October 6, 1994, among National Realty, L.P., Syntek Asset Management, L.P., National Realty, L.P. Oversight Committee and American Realty Trust, Inc. (incorporated by reference to Exhibit No. 2 to the Registrant's Current Report on Form 8-K, dated October 6, 1993). (b) Reports on Form 8-K A Current Report on Form 8-K, dated October 6, 1993, was filed with respect to Item 5, which reports that Syntek Asset Management, L.P. (the Registrant's General Partner) and the National Realty Oversight Committee reached an agreement in principle evidenced by a detailed Term Sheet, to nominate a successor general partner for the Registrant and to consummate the 1990 Moorman Settlement. NATIONAL REALTY, L.P. Signature Page Pursuant to the requirements of Section 13 or 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. NATIONAL REALTY, L.P. By its General Partner: SYNTEK ASSET MANAGEMENT, L.P. By its General Partners: SYNTEK ASSET MANAGEMENT, INC. By: /s/ Oscar W. Cashwell Oscar W. Cashwell President and Director /s/ Gene E. Phillips Gene E. Phillips Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Syntek Asset Management, L.P., as General Partner of the Registrant and in the capacities and on the dates indicated. NATIONAL REALTY, L.P. EXHIBITS TO ANNUAL REPORT ON FORM 10-K For the Year Ended December 31, 1993 Exhibit Number Description Page - ------- ----------- ---- 11.1 Computation of Earnings Per Unit. 99 22.1 Subsidiaries of the Registrant. 100	29,596	196,894
48305_1993.txt	48305_1993	1993	48305	ITEM 1. BUSINESS Honeywell Inc., a Delaware corporation incorporated in 1927, is a Minneapolis-based international controls corporation that supplies automation and control systems, components, software, products and services for homes and buildings, industry, and space and aviation. The purpose of the company is to develop and apply advanced-technology products, systems and services to conserve energy, improve productivity, protect the environment, enhance comfort and increase safety. Development and modification occur continuously in Honeywell's business as new or improved products and services are introduced, new markets are created or entered, distribution methods are revised, and products and services are discontinued. INDUSTRY SEGMENT INFORMATION Honeywell's products and services are classified by management into three industry segments: (i) Home and Building Control, (ii) Industrial Control, and (iii) Space and Aviation Control. Financial information relating to these industry segments is set forth in Part II, Item 6 at pages 9 and 10. HOME AND BUILDING CONTROL Honeywell's Home and Building Control business provides controls and systems for building automation, energy management, fire and security, as well as thermostats, air cleaners and other environmental controls and services for buildings and homes. Honeywell manufactures, markets and installs mechanical, pneumatic, electrical and electronic control products and systems for heating, ventilation and air conditioning in homes and commercial, industrial and public buildings. The systems, which may be generic or specifically designed for each application, may include panels and computers to centralize control of mechanical and electrical functions. Honeywell also produces building management systems for commercial buildings, burner and boiler controls, lighting controls, thermostatic radiator valves, pressure regulators for water systems, thermostats, actuators, humidistats, relays, contactors, transformers, air-quality products, and gas valves and ignition controls for homes and commercial buildings. Sales of these products are made directly to original equipment manufacturers, including manufacturers of heating and air conditioning equipment, through wholesalers, distributors, dealers, contractors, hardware stores and home-care centers, and also through the company's nationwide sales and service organization. Services provided include indoor air-quality services, central-station burglary and fire protection services for homes and commercial buildings, video surveillance, access control and entry management services for commercial buildings, contract maintenance services for commercial building mechanical and control systems, automated management of building operations for building complexes, energy management services, energy retrofit services and training. INDUSTRIAL CONTROL The Industrial Control business serves the automation and control needs of its worldwide industrial customers as a major supplier of products, systems and services ranging from sensors to integrated systems designed for specific applications. Honeywell's Industrial Control segment supplies process control systems and associated software and services to customers in the refining, petrochemical, bulk and fine chemical, pulp-and-paper, electric utility, food and consumer goods, pharmaceutical, metals and transportation markets, as well as other industries. Honeywell also designs and manufactures process instruments, process controllers, recorders, programmers, programmable controllers, transmitters and other field instruments. These products are sold as stand-alone products or integrated into systems. These products are generally used in indicating, recording and automatically controlling process variables. Under the MICRO SWITCH trademark, Honeywell manufactures solid-state sensors (position, pressure, airflow, temperature and current), sensor interface devices, manual controls, explosion-proof switches and precision snap-acting switches, as well as proximity, photoelectric and mercury switches and lighted/unlighted push-buttons. These products are used in industrial, commercial, business equipment, and in consumer, medical, automotive, aerospace and computer applications. Other products include solenoid valves, optoelectronic devices, fiber-optic systems and components, as well as microcircuits, sensors, transducers and high-accuracy, noncontact measurement and detection products for factory automation, quality inspection and robotics applications. Honeywell also furnishes services, including product and component testing, instrument maintenance, repair and calibration, contract services for industrial control equipment and third-party maintenance for CAD/CAM and other industrial control equipment, training, applications service and a range of customer support services. Services are generally sold directly to users on a monthly or annual contract basis. Products are customarily sold by Honeywell on a delivered, supervised or installed basis directly to end users, to equipment manufacturers and contractors, or through third-party channels such as distributors and systems houses. SPACE AND AVIATION CONTROL Honeywell's Space and Aviation Control business supplies avionics for the commercial, military and space markets. The company designs, manufactures, services and markets a variety of sophisticated electronic control systems and components that are used on commercial and business aircraft, military aircraft and spacecraft. Products manufactured for aircraft use include ring laser gyro-based inertial reference systems, navigation and guidance systems, flight control systems, flight management systems, inertial sensors, air data computers, radar altimeters, automatic test equipment, cockpit display systems and other communication and flight instrumentation. Honeywell products and services have been involved in every major U.S. space mission since the mid-1960s. Products include guidance systems for launch and re-entry vehicles, flight and engine control systems for manned spacecraft, precision components for strategic missiles and on-board data processing. Other products include spacecraft attitude and positioning systems, and precision pointing and isolation systems. Space and Aviation Control products are sold through an integrated international marketing organization, with customer service centers providing international service for commercial and business aviation users. OTHER PRODUCTS Products and services not included in the foregoing segment information are described below. Honeywell provides systems analysis and applied research and development on systems and products, including space systems technology, application software, sensors and artificial intelligence. The company is involved in the design and development of gallium arsenide integrated circuits and the development of very high-speed integrated circuit (VHSIC) technology. Solid State Electronics Center, a semiconductor facility in Minnesota, designs and manufactures integrated circuits for Honeywell and its government customers. Honeywell, through its Aerospace and Defense Group in Germany, develops, markets and sells to European countries, among other things, military avionics and electro-optic devices for flight control and nautical systems, including sonar transducers and echo sounders. GENERAL INFORMATION RAW MATERIALS Honeywell experienced no significant or unusual problems in the purchase of raw materials and commodities in 1993. Although it is impossible to predict what effects shortages or price increases may have in the future, at present management has no reason to believe a shortage of raw materials will cause any material adverse impact during 1994. PATENTS, TRADEMARKS, LICENSES AND DISTRIBUTION RIGHTS Honeywell owns, or is licensed under, a large number of patents, patent applications and trademarks acquired over a period of many years, which relate to many of its products or improvements thereon and are of importance to its business. From time to time, new patents and trademarks are obtained and patent and trademark licenses and rights are acquired from others. In addition, Honeywell has distribution rights of varying terms in a number of products and services produced by other companies. In the judgment of management, such rights are adequate for the conduct of the business being done by Honeywell. See Item 3 at page 7 for information concerning litigation in which Honeywell is involved relating to patents. SEASONALITY Although Honeywell's business is not seasonal in the traditional sense, revenues and earnings have tended to concentrate to some degree in the fourth quarter of each calendar year, reflecting the tendency of customers to increase ordering and spending for capital goods late in the year. MAJOR CUSTOMER Approximately 4 percent of Honeywell's total sales for 1993 was attributable to sales of products and services to the United States government as a prime contractor or subcontractor, the majority of which are described under the heading "Space and Aviation Control" on page 2. Such business is significant because of its volume and its contribution to Honeywell's technical capabilities, but Honeywell's dependence upon individual programs is minimized by the large variety of products and services it provides. Contracts and subcontracts for all of such sales are subject to the standard provisions permitting the government to terminate for convenience or default. BACKLOG The total dollar amount of backlog of Honeywell's orders believed to be firm was approximately $3,128 million at December 31, 1993, and $3,603 million at December 31, 1992. All but approximately $481 million of the 1993 backlog is expected to be delivered within the current fiscal year. Backlog is not a reliable indicator of Honeywell's future revenues because a substantial portion of backlog represents the value of orders that are cancelable at the customer's option. COMPETITION Honeywell is subject to active competition in substantially all products and services. Competitors generally are engaged in business on a nationwide or an international scale. Honeywell is the largest producer of control systems and products used to regulate and control heating and air conditioning in commercial buildings, and of systems to control industrial processes worldwide. Honeywell is also a leading supplier of commercial aviation, space and avionics systems. Honeywell's automation and control businesses compete worldwide, supported by a strong distribution network with manufacturing and/or marketing capabilities, for at least a portion of these businesses, in 95 countries. Competitive conditions vary widely among the thousands of products and services provided by Honeywell, and vary as well from country to country. Markets, customers and competitors are becoming more international in outlook. In those areas of environmental and industrial components and controls where sales are primarily to equipment manufacturers, price/performance is probably the most significant competitive factor, but customer service and applied technology are also important. Competition is increasingly being applied to government procurements to improve price and product performance. In service businesses, quality, reliability and promptness of service are the most important competitive factors. Service must be offered from many areas because of the localized nature of such business. In engineering, construction, consulting and research activities, technological capability and a record of proven reliability are generally the principal competitive factors. Although in a small number of highly specialized products and services Honeywell may have relatively few significant competitors, in most markets there are many competitors. RESEARCH AND DEVELOPMENT During 1993 Honeywell spent approximately $742.2 million on research and development activities, including $404.8 million in customer-funded research, relating to the development of new products or services, or the improvement of existing products or services. Honeywell spent $703.1 million in 1992 and $674.2 million in 1991 on research and development activities, including $390.5 million and $373.5 million, respectively, in customer-funded research. No single product or service accounted for a material portion of Honeywell's research and development expenditures. ENVIRONMENTAL PROTECTION Compliance with current federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of management will not have, a material effect upon Honeywell's capital expenditures, earnings or competitive position. See Item 7 at page 13 for further information concerning environmental matters. EMPLOYEES Honeywell employed approximately 52,300 persons in total operations as of December 31, 1993. GEOGRAPHIC AREAS Honeywell engages in material operations in foreign countries. A large majority of Honeywell's foreign business is in Western Europe, Canada and the Asian Pacific Rim. Although there are risks attendant to foreign operations, such as potential nationalization of facilities, currency fluctuation and restrictions on movement of funds, Honeywell has taken action reasonably calculated to mitigate such risks. Financial information related to geographic areas is included in Note 18 to the financial statements in Part II, Item 8 at page 36. EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 2. ITEM 2. PROPERTIES Honeywell and its subsidiaries operate facilities worldwide comprising approximately 20,340,000 square feet of space for use as manufacturing, office and warehouse space, of which approximately 12,438,600 square feet is owned and approximately 7,901,400 square feet is leased. The facilities used by Honeywell are adequate and suitable for the purposes they serve. Facilities allocated for corporate use in the United States, including sales offices, comprise approximately 3,379,000 square feet of space, of which approximately 1,512,200 square feet is owned and approximately 1,866,800 square feet is leased. These figures include Honeywell's principal executive offices in Minneapolis, Minnesota which comprise approximately 957,400 square feet, all of which is owned. A summary of properties held by each segment of Honeywell is set forth below, showing major plants, their location, size and type of holding. The descriptions include approximately 232,400 square feet of space owned or leased by Honeywell's operations in the United States that has been leased or subleased to third parties. In addition, approximately 4,628,100 square feet of previously leased space in the United States is under assignment to third parties (including 2,851,700 square feet, 451,400 square feet and 102,600 square feet which is assigned to Alliant Techsystems Inc., Federal Systems Inc. and Bull HN Information Systems, Inc., respectively, all of which were formerly affiliates of the company). HOME AND BUILDING CONTROL Home and Building Control occupies approximately 2,402,000 square feet of space for operations in the United States, of which approximately 1,887,900 square feet is owned and approximately 514,100 square feet is leased. Outside the United States, Home and Building Control operations occupy approximately 3,204,900 square feet, of which approximately 1,670,100 square feet is owned and approximately 1,534,800 square feet is leased. Principal facilities operated outside the United States are located in Canada, Germany, The Netherlands, the United Kingdom and Australia. Facilities in the United States comprising 300,000 square feet or more are listed below. INDUSTRIAL CONTROL Industrial Control occupies approximately 3,320,300 square feet of space for operations in the United States, of which approximately 2,233,200 square feet is owned and approximately 1,087,100 square feet is leased. Outside the United States, Industrial Control operations occupy approximately 2,228,500 square feet, of which approximately 862,200 square feet is owned and approximately 1,366,300 square feet is leased. Principal facilities operated outside the United States are located in the United Kingdom, Australia, Canada, Switzerland, France, Germany, Belgium and The Netherlands. Facilities in the United States comprising 300,000 square feet or more are listed below. SPACE AND AVIATION CONTROL Space and Aviation Control occupies approximately 5,244,500 square feet of space for operations in the United States, of which approximately 3,819,100 square feet is owned and approximately 1,425,400 square feet is leased. Outside the United States, Space and Aviation Control operations occupy approximately 540,300 square feet, of which approximately 433,400 square feet is owned and approximately 106,900 square feet is leased. Principal facilities operated outside the United States are located in Canada, the United Kingdom and Singapore. Facilities in the United States comprising 300,000 square feet or more are listed below. OTHER Honeywell operations not included in the foregoing segment information occupy approximately 20,500 square feet of space in areas outside the United States, all of which is owned. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On March 13, 1990, Litton Systems Inc. filed suit against Honeywell in U.S. District Court, Central District of California, alleging Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes; attempted monopolization by Honeywell of certain alleged markets for products containing ring laser gyroscopes; and intentional interference by Honeywell with Litton's prospective advantage in European markets and with its contractual relationships with Ojai Research, Inc., a California corporation. Honeywell has filed counterclaims against Litton alleging, among other things, violations by Litton of various antitrust laws including attempted monopolization of markets for inertial systems and interference with Honeywell's relationships with suppliers. The trial of the patent infringement and intentional interference claims commenced June 4, 1993, and on August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on each of these claims and awarded damages in the amount of $1.2 billion and concluded that the patent infringement was willful. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has not yet entered a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. Honeywell is a party to other various claims, legal and governmental proceedings, including claims relating to previously reported environmental matters. It is the opinion of management that losses in connection with these matters and the resolution of the environmental claims will not have a material effect on income. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal U.S. market for Honeywell's common stock is The New York Stock Exchange. The high and low sales prices for the stock as reported by the consolidated transaction reporting system, of the two most recent fiscal years is set forth in Part II, Item 8 at page 41. In November 1990, as part of Honeywell's program to enhance shareholder value, the company authorized the repurchase of up to 4 million shares of its common stock in open market transactions. In 1991, Honeywell repurchased 4 million shares under this program. In November 1991, the Board of Directors authorized the repurchase of additional shares during the next five years for an amount not to exceed $600 million. In 1991, 1992 and 1993, $3 million, $189 million and $240 million, respectively, of share repurchases were made under this program. Stockholders of record on March 1, 1994 totaled 33,159, excluding individual participants in security position listings. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA HONEYWELL INC. AND SUBSIDIARIES (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONS SALES Honeywell's 1993 sales were $5.963 billion, compared with $6.223 billion in 1992 and $6.193 billion in 1991. Both U.S. and international sales declined from 1992. U.S. sales of $3.895 billion were down 3 percent primarily due to a continuing cyclical downturn in the Space and Aviation Control commercial aviation market. International sales, which represent 35 percent of total sales, declined 6 percent from 1992 to $2.068 billion. The international sales decline was the result of negative currency effects as the dollar strengthened an average of 9 percent against local currencies in countries where Honeywell does business. This decline was partially offset by positive sales growth of 4 percent measured in local currency. U.S. export sales, including exports to foreign affiliates, were $769 million in 1993, compared with $830 million in 1992 and $808 million in 1991. COST OF SALES Cost of sales was $4.020 billion in 1993, or 67.4 percent of sales, compared with $4.195 billion (67.4 percent) in 1992 and $4.185 billion (67.6 percent) in 1991. Cost as a percentage of sales remained flat for 1993 during a period of tough competitive markets and stagnation for a majority of economic sectors. Honeywell remains committed to efforts to reduce operating costs and improve margins. RESEARCH AND DEVELOPMENT Honeywell spent $337 million, or 5.7 percent of sales, on research and development in 1993, compared with $313 million (5.0 percent) in 1992 and $301 million (4.9 percent) in 1991. Honeywell also received $405 million in funds for customer-funded research and development in 1993, compared with $390 million in 1992 and $373 million in 1991. The higher R&D percentage in 1993 reflects significant investments in next-generation technologies. The company expects to return to approximately the same rate of R&D spending in 1994 as in 1992. OTHER EXPENSES AND INCOME Selling, general and administrative expenses were $1.076 billion in 1993, or 18.0 percent of sales, compared with $1.197 billion (19.2 percent) in 1992 and $1.151 billion (18.6 percent) in 1991. Excluding royalties from autofocus licensing agreements (see Note 3 to Financial Statements on page 25), the percent of sales would have been 18.6 percent and 19.5 percent in 1993 and 1992, respectively. The higher percentage in 1992 was due to increased international selling expenses. On April 16, 1993, Honeywell announced the settlement of its lawsuits against the Unisys Corporation and other parties in connection with Honeywell's 1986 purchase of the Sperry Aerospace Group. Honeywell received $70 million in cash and notes, and recorded a gain of $22 million, or $14 million ($0.10 per share) after income taxes, to offset previously incurred costs associated with the matter (see Note 3 to Financial Statements on page 25). In April 1987, Honeywell filed suit against Minolta Camera Co. alleging that Minolta autofocus cameras infringe Honeywell patents. Subsequently, Honeywell filed similar suits against other major camera manufacturers that employ autofocus technology. In March 1992, following a jury award in Honeywell's favor, Minolta agreed to pay Honeywell $127 million in settlement of the damages and Honeywell's claims for interest and legal fees. In addition to the Minolta settlement, agreements were reached with various camera manufacturers for their use of Honeywell's patented automatic focus camera technology. The total of all autofocus settlements recorded, after associated expenses, was $10 million, or $6 million ($0.05 per share) after income taxes, in 1993 and $288 million, or $171 million ($1.24 per share) after income taxes, in 1992. The pre-tax gains from litigation settlements are included in litigation settlements and special charges on the income statement. Also included in litigation settlements and special charges are provisions for special charges of $51 million, or $29 million ($0.22 per share) after income taxes, in 1993 and $128 million, or $85 million ($0.62 per share) after income taxes, in 1992. The 1993 charges were the result of implementing programs to improve productivity and reduce costs in each of Honeywell's business segments. Charges in 1992 were made to appropriately size the Space and Aviation Control business segment to current market conditions and to reposition the Home and Building Control and Industrial Control business segments to capitalize on emerging market opportunities. The special charges include provisions for work-force reductions, worldwide facilities consolidation and organizational changes in both 1993 and 1992. Net interest expense was $51 million in 1993, $59 million in 1992 and $61 million in 1991. In 1992, Honeywell reduced total debt by $108 million, including redemption of high-coupon, long-term debt. Earnings of companies owned 20 percent to 50 percent (primarily Yamatake-Honeywell), which are accounted for using the equity method, were $18 million in 1993, $16 million in 1992 and $15 million in 1991. INCOME TAXES The provision for income taxes was $156 million in 1993, compared with $235 million in 1992 and $178 million in 1991. The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which raised the U.S. federal statutory income tax rate for corporations from 34 percent to 35 percent retroactive to January 1, 1993, did not have a material impact on the 1993 provision but did result in the recognition of a one-time gain of $9 million ($0.07 per share) in 1993 from the revaluation of deferred tax assets. Further information about income taxes is provided in Note 4 to Financial Statements on page 25. EXTRAORDINARY ITEM In 1992, Honeywell recorded an extraordinary loss of $14 million, or $9 million ($0.06 per share) after income taxes, as a result of early debt redemptions that required the payment of premiums and the recognition of unamortized discounts and deferred costs. These redemptions were undertaken as part of Honeywell's efforts to reduce its debt and manage its interest-rate exposure. ACCOUNTING CHANGES In 1992, Honeywell adopted three new Statements of Financial Accounting Standards. Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," required recognition of the expected cost of providing postretirement benefits over the time employees earn these benefits. Before adopting SFAS 106, Honeywell recognized the costs of providing these benefits on a pay-as-you-go basis by expensing the cost in the year the benefit was provided. The cumulative effect of adopting SFAS 106 at January 1, 1992, was a charge to income of $244 million, or $151 million ($1.09 per share) after income taxes. The operating impact of adopting SFAS 106 for 1992 was additional expense of $16 million, or $11 million ($0.08 per share) after income taxes. Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," allowed consideration of future events in assessing the likelihood that tax benefits will be realized in future tax returns. The cumulative effect of adopting SFAS 109 at January 1, 1992, was an increase in income of $31 million ($0.23 per share) resulting from Honeywell's ability to recognize additional deferred tax assets. Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits," required that the estimated cost of providing postemployment benefits be recognized on an accrual basis. The cumulative effect of adopting SFAS 112 at January 1, 1992, was a charge to income of $40 million, or $25 million ($0.18 per share) after income taxes. The operating impact of adopting SFAS 112 for 1992 was additional expense of $4 million, or $2 million ($0.02 per share) after income taxes. NET INCOME Honeywell's net income was $322 million ($2.40 per share) in 1993, compared with $247 million ($1.78 per share) in 1992 and $331 million ($2.35 per share) in 1991. Net income in 1993 includes an after-tax gain from litigation settlements, after associated expenses, of $20 million ($0.15 per share); an after-tax provision for special charges of $29 million ($0.22 per share); and a gain of $9 million ($0.07 per share) from the revaluation of deferred tax assets. Net income in 1992 includes an after-tax gain from litigation settlements, after associated expenses, of $171 million ($1.24 per share); an after-tax provision for special charges of $85 million ($0.62 per share); an extraordinary loss after income taxes of $9 million ($0.06 per share) from the early redemption of long-term debt; and an after-tax reduction of $145 million ($1.04 per share) for the cumulative effect of accounting changes. Net income in 1992 also included the operating impact of SFAS 106 and SFAS 112, or an after-tax expense of $13 million ($0.10 per share). RETURN ON EQUITY AND INVESTMENT Return on equity was 18.4 percent in 1993, 13.8 percent in 1992 and 19.2 percent in 1991. Return on investment was 14.6 percent in 1993, 11.8 percent in 1992 and 15.4 percent in 1991. The adoption of SFAS 106 and SFAS 112 significantly reduced ROE and ROI in 1992. CURRENCY The U.S. dollar strengthened an average of 9 percent in 1993 compared with 1992 in relation to the principal foreign currencies in countries where Honeywell products are sold. A stronger dollar has a negative effect on international results because foreign-exchange-denominated profits translate into fewer U.S. dollars of profit; a weaker dollar has a positive translation effect. INFLATION Highly competitive market conditions and a relatively stagnant economy minimized inflation's impact on the selling prices of Honeywell's products and the cost of its purchased materials. Productivity improvements and cost-reduction programs largely offset the effects of inflation on other costs and expenses. EMPLOYMENT Honeywell employed 52,300 people worldwide at year-end 1993, compared with 55,400 people in 1992 and 58,200 people in 1991. Approximately 33,200 employees work in the United States, with 19,100 employed outside the country, primarily in Europe. Total compensation and benefits in 1993 were $2.7 billion, or 49 percent of total costs and expenses. Sales per employee were $110,900 in 1993, compared with $109,600 in 1992 and $106,100 in 1991. ENVIRONMENTAL MATTERS Honeywell is committed to protecting the environment, a commitment evidenced by both Honeywell's products and Honeywell's manufacturing operations. Honeywell's manufacturing sites generate both hazardous and nonhazardous wastes, the treatment, storage, transportation and disposal of which are subject to various local, state and national laws relating to protection of the environment. Honeywell is in varying stages of investigation or remediation of potential, alleged or acknowledged contamination at current or previously owned or operated sites and at off-site locations where its wastes were taken for treatment or disposal. In connection with the cleanup of various off-site locations, Honeywell, along with a large number of other entities, has been designated a potentially responsible party (PRP) by the U.S. Environmental Protection Agency under the Comprehensive Environmental Response, Compensation and Liability Act or by state agencies under similar state laws (Superfund), which potentially subjects PRPs to joint and several liability for the costs of such cleanup. In addition, Honeywell is incurring costs relating to environmental remediation pursuant to the federal Resource Conservation and Recovery Act. Based on Honeywell's assessment of the costs associated with its environmental responsibilities, compliance with federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of Honeywell management, will not have a material effect on Honeywell's financial position, results of operations, capital expenditures or competitive position. Honeywell's opinion with regard to Superfund matters is based on its assessment of the predicted investigation, remediation and associated costs, its expected share of those costs and the availability of legal defenses. Honeywell's policy is to record environmental liabilities when loss amounts are probable and reasonably estimable. DISCUSSION AND ANALYSIS BY SEGMENT HOME AND BUILDING CONTROL Sales in Home and Building Control were $2.424 billion in 1993, compared with $2.394 billion in 1992 and $2.249 billion in 1991. Sales in 1993 were up slightly as stronger U.S. sales were mostly offset by a stronger U.S. dollar and economic weakness in international markets, driven in large part by the continuing recession in Europe. Home Control gained market share in the United States through new product introductions and greater penetration of the OEM market. TotalHome-R- was introduced outside the United States in 1993. The acquisition of Enviracaire in December 1992 also contributed to the improvement in U.S. sales. Building Control experienced strong U.S. interest in its comprehensive retrofit and service solutions for schools and other institutions. The U.S. economy continues to show signs of improvement in these markets, while international market conditions have continued to deteriorate. Economic conditions may continue to impede new construction markets in 1994; however, Home and Building Control's large worldwide installed product base and market strategies should continue to support continued sales growth, given that retrofit and service revenues account for the largest portion of business. The sales increase in 1992 reflected worldwide improvement for both Home Control and Building Control despite weak commercial construction markets and erratic housing markets. Home Control experienced increased market penetration with original equipment manufacturers and retailers, and achieved growth with new product introductions. Building Control made market share gains in small-and medium-sized commercial buildings, and there was solid growth in vertical markets such as schools and health-care facilities in the United States. Home and Building Control operating profit was $233 million in 1993, compared with $193 million in 1992 and $229 million in 1991. Excluding the impact of special charges, operating profit increased slightly in 1993 despite the deepening European recession, a stronger U.S. dollar, unfavorable intra-European currency fluctuations, additional costs associated with streamlining the U.S. field organization, and costs associated with introducing the new EXCEL 5000TM building automation platform in the United States. Operating profit included special charges of $10 million for implementation of programs to improve productivity and competitiveness. Operating profit in 1992 included special charges of $43 million for costs associated with worldwide facilities consolidation, organizational changes and work-force reductions incurred to capitalize on emerging market opportunities. Excluding these added costs, operating profit increased over 1991, paced by strong performance in Home Control in the United States. Orders improved modestly in 1993 as stronger orders in the United States for both Home Control and Building Control offset international weakness and a stronger U.S. dollar. The backlog of orders showed a slight increase for 1993. INDUSTRIAL CONTROL Industrial Control sales were $1.692 billion in 1993, compared with $1.744 billion in 1992 and $1.627 billion in 1991. Sales declined slightly in 1993 due to negative currency translation trends and the divestiture of the Keyboard Division, which was sold to Key Tronic Corporation in the third quarter of 1993. Excluding these items, both Industrial Automation and Control and Control Components grew at moderate rates despite weak market conditions in the United States, Europe and Latin America. Industrial Automation and Control reported solid penetration gains in targeted worldwide markets despite a weak capital spending environment in the United States and Europe. Demand for industrial systems increased in the Middle East and Asia Pacific. Sales of field instruments showed a strong increase due to broad acceptance of Industrial Automation and Control's smart field products. Control Components experienced significant growth in solid state sensors for on-board automotive and information technology and appliance market segments as demand for durable goods improved. The company expects a slight increase in 1994 Industrial Control sales despite a slow economic environment worldwide. Industrial Control sales for 1992 increased moderately, despite the deferral of industrial automation systems purchases in the United States due to the inherent uncertainty of the economy and worldwide weakness in durable goods markets. There was modest growth in Industrial Automation and Control sales in the United States as increased sales of services and measurement and control products offset weakness in automation systems. Control Component sales increased moderately in 1992, benefiting from the trend by equipment manufacturers to increase sensor utilization for quality and productivity improvements. Industrial Control operating profit was $190 million in 1993, $157 million in 1992 and $224 million in 1991. Excluding the impact of special charges, operating profit showed a slight increase in 1993. Profits were affected by the weak capital spending environment in the United States and Europe, strength of the U.S. dollar and aggressive investments in new technologies, with R&D spending up 26 percent over 1992. Operating profit included special charges of $9 million for implementation of programs to improve productivity and competitiveness. Operating profit in 1992 included special charges of $39 million for costs associated with worldwide facilities consolidation, organizational changes and work-force reductions to capitalize on emerging market opportunities. Before special charges, operating profit was down in 1992 as a result of lower profit margins reflecting a changing product mix in Industrial Automation and Control. In 1993, Industrial Control orders declined slightly, due to negative currency translation trends. Excluding this effect, Industrial Automation and Control orders increased modestly as a result of solid showings in Asia Pacific and Latin America. Control Components orders declined slightly due to the divestiture of the Keyboard Division. Micro Switch orders were strong in North America and Asia Pacific. The backlog of orders was down modestly for the year. SPACE AND AVIATION CONTROL Sales in Space and Aviation Control were $1.675 billion in 1993, compared with $1.933 billion in 1992 and $2.132 billion in 1991. Sales in 1993 continued to decline as anticipated as a result of the continuing cyclical decline in commercial aircraft production, weak demand in the business jet market and decreased spending in the military market. We expect these trends to continue in 1994. Anticipated growth in 1992 did not materialize, and 1992 sales for commercial flight systems declined sharply as financial pressures caused airlines to defer, and in some instances cancel, aircraft and spare parts purchases. As expected, military markets were weak as a result of declining defense spending and flat NASA funding. Space and Aviation Control operating profit was $148 million in 1993, compared with $176 million in 1992 and $226 million in 1991. Operating profit declined in 1993 due to the sharp volume decline in sales of commercial flight systems and significant investments in next-generation avionics. Operating profit included special charges of $7 million for implementation of programs to improve productivity and competitiveness. Because of continued weak market conditions, revenue and operating profit are expected to decline again in 1994. Operating profit in 1992 included special charges of $35 million for costs associated with facilities consolidation, organizational changes and severance pay incurred to appropriately size operations to current and anticipated market conditions. Excluding these special charges, operating profit was down moderately in 1992 as a sharp volume decline in the commercial aviation business was partially offset by an improved cost structure and a favorable sales mix in military avionics. Space and Aviation orders were down in 1993 as commercial flight systems and military avionics showed sharp declines. Space systems orders increased moderately. The backlog of orders declined sharply from 1992 levels. OTHER Sales from other operations were $172 million in 1993, $152 million in 1992 and $185 million in 1991. These sales included the activities of various business units, such as the Solid State Electronics Center and the Systems and Research Center, which do not correspond with Honeywell's primary business segments. These operations incurred operating losses of $2 million in 1993, $9 million in 1992 and $3 million in 1991. The 1993 loss included special charges of $16 million for organizational changes and work-force reductions. The 1992 loss included special charges of $3 million that were also associated with organizational changes and work-force reductions. FINANCIAL POSITION FINANCIAL CONDITION At year-end 1993, Honeywell's capital structure comprised $188 million of short-term debt, $504 million of long-term debt and $1.773 billion of stockholders' equity. The ratio of debt to total capital was 28 percent and remained unchanged from year-end 1992. Honeywell's debt-to-total capital policy range is 30 to 40 percent. Honeywell managed its capital structure during 1993 at or below the low end of this range. Total debt decreased $9 million during 1993 to $692 million. Stockholders' equity decreased $17 million in 1993. Contributing to the decrease was a $209 million increase in treasury stock. Other changes in stockholders' equity included an increase in retained earnings of $322 million from net income, offset by dividends of $122 million; a $3 million decrease in the accumulated foreign currency translation; and a $13 million decrease from the recognition of a pension liability adjustment under Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," (see Note 16 to Financial Statements on page 33). Several events and trends that affected Honeywell's financial position are discussed below. CASH GENERATION In 1993, $475 million of cash was generated from operating activities, compared with $532 million in 1992 and $489 million in 1991. Included in 1992 operating cash flow was $194 million, net of expenses and taxes, from autofocus settlements. In 1993, cash generated from investing and financing activities included $47 million of proceeds from the sale of assets, $20 million from a reduction of investment in Sperry Aerospace Group and $18 million of proceeds from employee stock plans. These funds were primarily used to support $232 million of capital expenditures, $14 million of acquisitions, $122 million of dividend payments, $241 million of share repurchases and $7 million of long-term debt repayments. Cash balances decreased $100 million in 1993. WORKING CAPITAL Cash used for increases in the portion of working capital consisting of trade and long-term receivables and inventories, offset by accounts payable and customer advances, was $2 million in 1993. This portion of working capital as a percentage of sales was 28 percent, compared with 26 percent in 1992. Trade receivables sold at year-end 1993 were $38 million, an increase of $22 million in 1993. CAPITAL EXPENDITURES AND ACQUISITIONS Capital expenditures for property, plant and equipment in 1993 were $232 million, compared with $244 million in 1992 and $240 million in 1991. The 1993 depreciation charges were $235 million. Honeywell continues to invest at levels believed to be adequate to maintain its technological position in areas providing long-term returns. During 1993, Honeywell invested $14 million in complementary business acquisitions. SHARE REPURCHASE PLANS In November 1990, the board of directors authorized a 4 million share repurchase program. This program was completed in 1991. In November 1991, the board of directors authorized a five-year program to purchase up to $600 million of Honeywell shares. Under terms of this authorization, which expires December 31, 1996, the program may be altered depending on economic conditions, share prices and cash-flow availability. Honeywell repurchased $3 million of shares in 1991, $189 million of shares in 1992 and $240 million of shares in 1993, and has $168 million remaining under this authorization. At year-end 1993, Honeywell had 188 million shares issued, 132 million shares outstanding and 33,382 stockholders of record. At year-end 1992, Honeywell had 188 million shares issued, 137 million shares outstanding and 34,571 stockholders of record. DIVIDENDS In November 1992, the board of directors approved an 8 percent increase in the regular annual dividend to $0.89 per share, from $0.825 per share, effective in the fourth quarter 1992. In November 1993, the board of directors approved an additional 8 percent increase in the regular annual dividend to $0.96 per share effective in the fourth quarter 1993. Honeywell paid $0.9075 per share in dividends in 1993, compared with $0.84125 in 1992 and $0.76875 in 1991. Honeywell has paid a quarterly dividend since 1932 and has increased the annual payout per share in each of the last 18 years. EMPLOYEE STOCK PROGRAM Honeywell contributed 643,913 shares of Honeywell common stock to employees under its U.S. employee stock match savings plans in 1993. The number of shares contributed under this program depends on employee savings levels and company performance. PENSION CONTRIBUTIONS Cash contributions to Honeywell's Retirement Plan for U.S. non-union employees were $105 million in 1993, $79 million in 1992 and $61 million in 1991. Cash contributions to the Pension Plan for U.S. union employees were $36 million in 1993, $27 million in 1992 and $27 million in 1991. TAXES In 1993, taxes paid were $92 million. Accrued income taxes and related interest decreased $18 million during 1993. FUNDING SPECIAL CHARGES During 1993 and 1992, the company established reserves for productivity initiatives to strengthen the company's competitiveness. Future cash flows from operating activities are expected to be sufficient to fund these accrued costs. LIQUIDITY Short-term debt at year-end 1993 was $188 million, consisting of $181 million of commercial paper and $7 million of notes payable and current maturities of long-term debt. Short-term debt at year-end 1992 totaled $188 million, consisting of $182 million of notes payable and commercial paper and $6 million of current maturities of long-term debt. Through its banks, Honeywell has access to various credit facilities, including committed credit lines for which Honeywell pays commitment fees and uncommitted lines provided by banks on a non-committed, best-efforts basis. Available lines of credit at year-end 1993 totaled $2.272 billion. This consists of $1.875 billion of committed credit lines to meet Honeywell's financing requirements, including support of commercial paper and bank note borrowings and an appeal bond which could be required in the Litton litigation as described in Litigation below, and $397 million of uncommitted credit lines available to certain foreign subsidiaries. This compared with $1.002 billion of available credit lines at year-end 1992, consisting of $645 million of committed credit lines and $357 million of uncommitted credit lines available to certain foreign subsidiaries. Cash and short-term investments totaled $256 million at year-end 1993 and $346 million at year-end 1992. Honeywell believes its available cash and committed credit lines provide adequate liquidity. LITIGATION On August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on patent infringement and intentional interference claims in the amount of $1.2 billion. These claims were part of a lawsuit brought by Litton Systems Inc. alleging, among other things, Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has yet to enter a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. Honeywell continues to believe the lawsuit is without merit, and its financial position, liquidity and business strategies have not been adversely affected by the jury verdict. CREDIT RATINGS Honeywell's credit ratings remained unchanged during 1993. Ratings for long-term and short-term debt are, respectively, A/A-1 by Standard and Poor's Corporation, A/Duff1 by Duff and Phelps Corporation and A3/P-2 by Moody's Investor Service, Inc. On August 31, 1993, Moody's Investor Service, Inc. placed Honeywell on credit watch status as a result of the jury verdict in the Litton litigation. Any lowering of Honeywell's present credit ratings could lead to higher interest costs by potentially reducing Honeywell's ability to access the commercial paper market and other unsecured borrowing sources on terms as favorable as those currently available. STOCK PERFORMANCE The market price of Honeywell stock ranged from $39 3/8 to $31 in 1993, and was $34 1/4 at year end. Book value at year end was $13.48 in 1993 and $13.10 in 1992. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT To the Stockholders of Honeywell Inc.: We have audited the statement of financial position of Honeywell Inc. and subsidiaries as of December 31, 1993 and 1992, and the related statements of income and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We have conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Honeywell Inc. and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 19 to the financial statements, Honeywell is a defendant in litigation alleging (1) patent infringement, (2) market monopolization and (3) interference with the plaintiff's markets and contractual relationships. A federal court jury has returned a verdict against Honeywell on the patent infringement and intentional interference claims in the case in the amount of $1.2 billion; however, the court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any loss that may result from the resolution of this matter has been made in the accompanying financial statements. As discussed in Notes 1, 4 and 17 to the financial statements, in 1992 the Company changed its method of accounting for postemployment benefits, income taxes and postretirement benefits other than pensions. Deloitte & Touche Minneapolis, Minnesota February 11, 1994 INCOME STATEMENT HONEYWELL INC. AND SUBSIDIARIES (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) See accompanying Notes to Financial Statements. STATEMENT OF FINANCIAL POSITION HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) ASSETS See accompanying Notes to Financial Statements. STATEMENT OF CASH FLOWS HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying Notes to Financial Statements. NOTES TO FINANCIAL STATEMENTS HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 1 -- ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements and accompanying data include Honeywell Inc. and subsidiaries. All material intercompany transactions are eliminated. SALES Product sales are recorded when title is passed to the customer, which usually occurs at the time of delivery or acceptance. Sales under long-term contracts are recorded on the percentage-of-completion method measured on the cost-to-cost basis for engineering-type contracts and the units-of-delivery basis for production-type contracts. Provisions for anticipated losses on long-term contracts are recorded in full when they become evident. INCOME TAXES Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (see Note 4). Interest costs related to prior years' tax issues are included in the provision for income taxes in 1993. EARNINGS PER COMMON SHARE Earnings per common share are based on the average number of common shares outstanding during the year. STATEMENT OF CASH FLOWS Cash equivalents are all highly liquid, temporary cash investments purchased with a maturity of three months or less. Cash flows from contracts used to hedge cash dividend payments from subsidiaries are classified as part of the effect of exchange rate changes on cash. INVENTORIES Inventories are valued at the lower of cost or market. Cost is determined using the weighted-average method. Market is based on net realizable value. Payments received from customers relating to the uncompleted portion of contracts are deducted from applicable inventories. INVESTMENTS Investments in companies owned 20 to 50 percent are accounted for using the equity method. PROPERTY Property is carried at cost and depreciated primarily using the straight-line method over estimated useful lives of 10 to 40 years for buildings and improvements, and three to 15 years for machinery and equipment. INTANGIBLES Intangibles are carried at cost and amortized using the straight-line method over their estimated useful lives of not more than 40 years for goodwill, three to 17 years for patents, licenses and trademarks, and six to 24 years for software and other intangibles. Intangibles also include the asset resulting from recognition of the defined benefit pension plan minimum liability, which is amortized as part of net periodic pension cost. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 1 -- ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY Foreign currency assets and liabilities are generally translated into U.S. dollars using the exchange rates in effect at the statement of financial position date. Results of operations are generally translated using the average exchange rates throughout the period. The effects of exchange rate fluctuations on translation of assets, liabilities and hedges of cash dividend payments from subsidiaries are reported as accumulated foreign currency translation and reduced stockholders' equity $3.0 in 1993, $74.8 in 1992 and $0.1 in 1991. The carrying amounts of foreign currency contracts purchased to hedge firm foreign currency commitments are deferred and included in the measurement of the related foreign currency transaction. Foreign currency contracts that are not hedges of firm foreign currency commitments are marked to market on a current basis. Gains and losses from foreign currency transactions are included in selling, general and administrative expenses on the income statement and were not material in any year. POSTEMPLOYMENT BENEFITS In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits." The pre-tax cumulative effect of this accounting change to January 1, 1992, was $39.7 and resulted in a reduction in net income of $24.6 ($0.18 per share). The effect of this accounting change for 1992 was a decrease in income before income taxes of $3.8, or $2.5 ($0.02 per share) after income taxes. The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which made Medicare the primary provider of medical benefits for disabled former employees after 29 months of disability, reduced the accumulated benefit obligation for postemployment benefits by $33.4 in the fourth quarter of 1993. This change in estimate is included in cost of sales on the income statement. RECLASSIFICATIONS Certain amounts in the 1992 statement of financial position have been reclassified to conform to the presentation of similar amounts in the 1993 statement of financial position. NOTE 2 -- ACQUISITIONS AND SALE OF ASSETS Honeywell acquired eight companies in 1993 and nine companies in 1992 for $14.2 and $83.5 in cash, respectively. These acquisitions were accounted for as purchases, and accordingly, the assets and liabilities of the acquired entities have been recorded at their estimated fair values at the dates of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired, in the amount of $11.8 in 1993 and $44.2 in 1992, has been recorded as goodwill and is amortized over estimated useful lives. The pro forma results for 1993 and 1992, assuming these acquisitions had been made at the beginning of the year, would not be significantly different from reported results. In 1993, Honeywell sold its Keyboard Division to Key Tronic Corporation for $29.7 in cash, notes and common stock. Proceeds from other asset sales, including the collection of notes receivable and sale of stock received from asset sales made in previous years, amounted to $22.9. Gains and losses from asset sales were not material in any year and are included in selling, general and administrative expenses on the income statement. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 3 -- LITIGATION SETTLEMENTS AND SPECIAL CHARGES LITIGATION SETTLEMENTS On April 16, 1993, Honeywell announced the settlement of its lawsuits against the Unisys Corporation and other parties in connection with Honeywell's 1986 purchase of the Sperry Aerospace Group. Honeywell received $70.0 in cash and notes and recorded a gain of $22.4 in the second quarter of 1993 to offset previously incurred costs associated with the matter. In addition, the portion of the purchase price originally allocated to goodwill and other intangibles was reduced by $47.6. Honeywell has reached agreement with various camera manufacturers for their use of Honeywell's patented automatic focus camera technology. The total of all one-time settlements recorded in these matters, after associated expenses, resulted in a gain of $10.2 in the third quarter of 1993 and $287.9 in 1992. Several settlements also included licensing agreements that require the payment of royalties to Honeywell based upon the amount of product manufactured or sold by the licensee. Autofocus royalty income from the licensing agreements amounted to $31.4 in 1993 and $14.9 in 1992, and is included in selling, general and administrative expenses on the income statement. SPECIAL CHARGES Honeywell recorded special charges of $23.2 and $28.0 in the second and third quarters of 1993, respectively, for productivity initiatives to strengthen the company's competitiveness. In 1992, special charges of $128.4 were recorded to appropriately size the Space and Aviation Control business segment and to reposition the Home and Building Control and Industrial Control business segments to capitalize on emerging market opportunities. Special charges include costs for work-force reductions, worldwide facilities consolidation, organizational changes and other cost accruals. NOTE 4 -- INCOME TAXES The components of income before income taxes consist of the following: The provision for income taxes on that income is as follows: The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which raised the U.S. federal statutory income tax rate for corporations from 34 percent to 35 percent retroactive to NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 4 -- INCOME TAXES (CONTINUED) January 1, 1993, did not have a material impact on the 1993 provision for income taxes; however, the enactment of this legislation did result in a one-time gain of $9.2 million ($0.07 per share) in the third quarter of 1993 from the revaluation of deferred tax assets. In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," and elected not to restate prior years. The cumulative effect of this accounting change to January 1, 1992, was an increase in net income of $31.4 ($0.23 per share), resulting from the recognition of unrecorded deferred tax assets. This accounting change had no effect on the 1992 provision for income taxes. A reconciliation of the provision for income taxes to the amount computed using U.S. federal statutory rates is as follows: Taxes paid were $91.8 in 1993, $244.0 in 1992 and $190.4 in 1991. Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of Honeywell's assets and liabilities. Temporary differences comprising the net deferred taxes shown on the statement of financial position are: The components of net deferred taxes shown on the statement of financial position are: NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 4 -- INCOME TAXES (CONTINUED) Provision has not been made for U.S. or additional foreign taxes on $654.7 of undistributed earnings of international subsidiaries as those earnings are considered to be permanently reinvested in the operations of those subsidiaries. It is not practicable to estimate the amount of tax that might be payable on the eventual remittance of such earnings. At December 31, 1993, foreign subsidiaries had tax operating loss carryforwards of $5.4. NOTE 5 -- RECEIVABLES Receivables have been reduced by an allowance for doubtful accounts as follows: Receivables include approximately $21.1 in 1993 and $26.3 in 1992 billed to customers but not paid pursuant to contract retainage provisions. These balances are due upon completion of the contracts, generally within one year. Unbilled receivables related to long-term contracts amount to $275.6 in 1993 and $241.1 in 1992 and are generally billable and collectible within one year. Long-term, interest-bearing notes receivable from the sale of assets have been reduced by valuation reserves of $3.6 in 1993 and $2.9 in 1992 to an amount that approximates realizable value. In 1992, Honeywell entered into a three-year agreement, whereby it can sell an undivided interest in a designated pool of trade accounts receivable up to a maximum of $50.0 on an ongoing basis. As collections reduce accounts receivable sold, Honeywell may sell an additional undivided interest in new receivables to bring the amount sold up to the $50.0 maximum. The uncollected balance of receivables sold amounted to $37.9 and $16.0 at December 31, 1993 and 1992, respectively, and averaged $21.7 and $11.6 during those respective years. The discount recorded on sale of receivables is included in selling, general and administrative expenses on the income statement and amounted to $0.7, $0.6 and $5.3 in 1993, 1992 and 1991, respectively. Honeywell, as agent for the purchaser, retains collection and administrative responsibilities for the participating interests sold. NOTE 6 -- INVENTORIES Inventories related to long-term contracts are net of payments received from customers relating to the uncompleted portions of such contracts in the amounts of $36.8 and $65.0 at December 31, 1993 and 1992, respectively. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 7 -- PROPERTY, PLANT AND EQUIPMENT NOTE 8 -- FOREIGN SUBSIDIARIES The following is a summary of financial data pertaining to foreign subsidiaries: Insofar as can be reasonably determined, there are no foreign-exchange restrictions that materially affect the financial position or the operating results of Honeywell and its subsidiaries. NOTE 9 -- INVESTMENTS IN OTHER COMPANIES Following is a summary of financial data pertaining to companies 20 to 50 percent owned. The principal company included is Yamatake-Honeywell Co., Ltd., of which Honeywell owns 24.2 percent of the outstanding common stock. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 10 -- INTANGIBLE ASSETS Intangible assets have been reduced by accumulated amortization as follows: NOTE 11 -- DEBT SHORT-TERM DEBT Honeywell has lines of credit available totaling $2,271.9 at December 31, 1993. Domestic revolving credit lines with 14 banks total $1,875.0, which management believes is adequate to meet its financing requirements, including support of commercial paper and bank note borrowings and an appeal bond that could be required in the Litton litigation (see Note 19). These domestic lines have commitment fee requirements. There were no borrowings on these lines at December 31, 1993. The remaining credit facilities of $396.9 have been arranged by non-U.S. subsidiaries in accordance with customary lending practices in their respective countries of operation. Borrowings against these lines amounted to $6.6 at December 31, 1993. Short-term debt consists of the following: LONG-TERM DEBT The 8 percent dual-currency yen/U.S. dollar notes due 1995 are repayable at a fixed exchange rate and are linked to a currency exchange agreement that results in a fixed U.S. dollar interest cost of 10.5 percent. The 6 1/4 percent Deutsche mark bonds due 1997 are linked to a currency exchange agreement that converts principal and interest payments into fixed U.S. dollar obligations with an interest cost of 8.17 percent. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 11 -- DEBT (CONTINUED) In 1992, Honeywell entered into interest rate swap agreements effectively converting $100.0 of its 8 5/8 percent debentures due 2006 from fixed-rate debt to floating-rate debt based on six-month LIBOR rates. During 1993, $50.0 of the $100.0 swap was terminated resulting in a gain of $0.9, which is being amortized over the remaining life of the swap agreement. In 1993, Honeywell entered into interest rate swap agreements effectively converting the 9.6 percent Canadian dollar notes due 1996 to floating-rate debt based on three-month Canadian bankers acceptance rates. The differential to be paid or received is accrued as interest rates change and is charged to interest expense over the lives of the agreements, which expire in September 1995 for the 8 5/8 percent debentures and December 1996 for the 9.6 percent Canadian dollar notes. Honeywell is exposed to credit risk to the extent of nonperformance by the counterparties to the currency exchange agreements and the interest rate swaps discussed above. However, the credit ratings of the counterparties, which consist of a diversified group of financial institutions, are regularly monitored and risk of default is considered remote. In 1992, Honeywell redeemed its 9 3/8 percent debentures due 2005 to 2009, its 8.2 percent debentures due 1996 to 1998, its 9 7/8 percent debentures due 1998 to 2017, and certain notes due 1993 to 2004, amounting to $9.6 with interest rates ranging from 7.5 percent to 11.75 percent. These early redemptions required the payment of premiums and the recognition of unamortized discounts and deferred cost resulting in the recording of an extraordinary loss of $13.8, or $8.6 ($0.06 per share) after income taxes. Honeywell redeemed an additional $5.9 of notes due 1993 to 2000 with interest rates ranging from 10 percent to 12.1 percent in the first quarter of 1993 with no additional income statement impact. Annual sinking-fund and maturity requirements for the next five years on long-term debt outstanding at December 31, 1993, are as follows: Interest paid amounted to $63.9, $98.5 and $96.9 in 1993, 1992 and 1991, respectively. NOTE 12 -- FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of Honeywell's financial instruments at December 31, 1993 and 1992, is as follows: The estimated fair value of long-term debt is based on quoted market prices for the same or similar issues or on current rates available to Honeywell for debt of the same remaining maturities. The estimated fair value of interest-rate and currency contracts is based on quotes obtained from various financial institutions that deal in these types of instruments. The estimated fair values of all other financial instruments approximate their carrying amounts in the statement of financial position. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 13 -- LEASING ARRANGEMENTS As lessee, Honeywell has minimum annual lease commitments outstanding at December 31, 1993, with the majority of the leases having initial periods ranging from one to 10 years. Following is a summary of operating lease information. Rent expense for operating leases was $134.2 in 1993, $128.0 in 1992 and $119.6 in 1991. Substantially all leases are for plant, warehouse, office space and automobiles. A number of the leases contain renewal options ranging from one to 10 years. NOTE 14 -- CAPITAL STOCK NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 14 -- CAPITAL STOCK (CONTINUED) STOCK SPLIT On November 9, 1992, the board of directors authorized a two-for-one stock split in the form of a stock dividend payable to stockholders of record November 27, 1992. All references in the financial statements to average number of shares outstanding and related prices, per share amounts, stock plan data and the 1992 share amounts in the table above have been restated to reflect this split. KEY EMPLOYEE PLANS In 1993, the board of directors adopted, and the stockholders approved, the 1993 Honeywell Stock and Incentive Plan. The plan, which terminates December 31, 1998, provides for the award of up to 7,500,000 shares of common stock. The purpose of the plan is to further the growth, development and financial success of Honeywell and its subsidiaries by aligning the personal interests of key employees, through the ownership of shares of common stock and through other incentives, to those of Honeywell stockholders. The plan is further intended to provide flexibility to Honeywell in its ability to compensate key employees and to motivate, attract and retain the services of such key employees who have the ability to enhance the value of Honeywell and its subsidiaries. Awards made under the plan may be in the form of stock options, stock appreciation rights or other stock based awards. The plan replaced existing similar plans. Awards currently outstanding under those plans are not affected, but no new awards will be made. There were 15,118,538 shares reserved for all key employee plans at December 31, 1993. Stock options to purchase common stock have been granted to key employees at 100 percent of the market price at time of granting, pursuant to plans approved by the stockholders. The following is a summary of stock options: Options totaling 3,779,200 shares at prices ranging from $12 to $37 per share were exercisable at December 31, 1993. Restricted common stock is issued to certain key employees as compensation. Restricted shares are awarded with a fixed restriction period, usually five years, or a restriction period dependent on the achievement of performance goals within a specified measurement period. Participants have the rights of stockholders, including the right to receive cash dividends and the right to vote. Restricted shares forfeited revert to Honeywell at no cost. Restricted shares issued totaled 533,995 in 1993, 47,812 in 1992 and 174,518 in 1991. The cost of restricted stock is charged to income over the restriction period and amounted to $6.3 in 1993, $6.5 in 1992 and $6.4 in 1991. At December 31, restricted shares outstanding for key employee plans totaled 775,861 in 1993, 412,872 in 1992 and 968,750 in 1991. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 14 -- CAPITAL STOCK (CONTINUED) EMPLOYEE STOCK MATCH AND STOCK PURCHASE PLANS In 1990, Honeywell adopted Stock Match and Performance Stock Match plans under which Honeywell matches, in the form of Honeywell common stock, certain eligible U.S. employee savings plan contributions. Shares issued under the stock match plans totaled 643,913 shares in 1993, 977,716 shares in 1992 and 933,344 shares in 1991 at a cost of $22.3, $33.3 and $27.9, respectively. There were 2,348,295 shares reserved for employee stock match plans at December 31, 1993. Honeywell has granted to eligible foreign subsidiary employees the right to purchase common stock, principally at the lower of 85 percent of the market price at the time of grant or at the time of purchase. At December 31, 1993, there were 335,537 shares reserved for foreign subsidiary employee stock purchase plans. Total shares issued under the foreign stock purchase plans amounted to 49,250 in 1992 and 66,096 in 1991 at an average price per share of $33 and $27, respectively. There were no shares issued in 1993. STOCK PLEDGE In 1993, Honeywell pledged to the Honeywell Foundation a 5-year option to purchase 2,000,000 shares of common stock at $33 per share. This option is exercisable in whole or in part, subject to certain conditions, from time to time during its term. No shares were purchased under this option in 1993 and at December 31, 1993, there were 2,000,000 shares reserved for this pledge. PREFERENCE STOCK Twenty-five million preference shares with a par value of $1 have been authorized. None has been issued at December 31, 1993. NOTE 15 -- RETAINED EARNINGS Included in retained earnings are undistributed earnings of companies 20 to 50 percent owned, amounting to $121.3 at December 31, 1993. NOTE 16 -- PENSION PLANS Honeywell and its subsidiaries have noncontributory defined benefit pension plans that cover substantially all of their U.S. employees. The plan covering non-union employees provides pension benefits based on employee average earnings during the highest paid 60 consecutive calendar months of employment during the 10 years prior to retirement. The plan covering union employees provides pension benefits of stated amounts for each year of credited service. Funding for these plans is provided solely through contributions from Honeywell determined by the board of directors after consideration of recommendations from the plans' independent actuary. Such recommendations are based on actuarial valuations of benefits payable under the plans. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 16 -- PENSION PLANS (CONTINUED) The components of net periodic pension cost for U.S. defined benefit pension plans are as follows: Assumptions used in the accounting for the U.S. defined benefit plans were: Employees in foreign countries who are not U.S. citizens are covered by various retirement benefit arrangements, some of which are considered to be defined benefit pension plans for accounting purposes. The cost of all foreign pension plans charged to income was $14.2 in 1993, $9.0 in 1992 and $9.8 in 1991. The components of net periodic pension cost for foreign defined benefit pension plans are as follows: Assumptions used in the accounting for foreign defined benefit plans were: NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 16 -- PENSION PLANS (CONTINUED) The plans' funded status as of September 30 and amounts recognized in Honeywell's statement of financial position for its pension plans are summarized below. Adjustments recorded to recognize the minimum liability required for defined benefit pension plans whose accumulated benefits exceed assets amounted to $113.0 in 1993 and $74.7 in 1992. A corresponding amount was recognized as an intangible asset to the extent of unrecognized prior service cost and unrecognized transition obligation. In 1993, $21.0 of excess minimum liability resulted in a reduction in stockholders' equity, net of income taxes, of $12.8. Plan assets are held by trust funds devoted to servicing pension benefits and are not available to Honeywell until all covered benefits are satisfied after a plan is terminated. The assets held by the trust funds consist of a diversified portfolio of fixed-income investments and equity securities. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 17 -- POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires recognition of the expected cost of providing postretirement benefits over the time employees earn the benefits. Before adopting SFAS 106, Honeywell recognized the cost of providing these benefits on a pay-as-you-go basis by expensing the cost in the year the benefit was provided. Substantially all of Honeywell's domestic and Canadian employees who retire from Honeywell between the ages of 55 and 65 with 10 or more years of service are eligible to receive health-care benefits until age 65 identical to those available to active employees. Honeywell continues to fund postretirement benefits on a pay-as-you-go basis. Honeywell elected to immediately recognize the cumulative effect of this change in accounting for postretirement benefits for both U.S. and Canadian plans, reducing net income by $151.3 ($1.09 per share). The pre-tax cumulative effect of $244.1 represents the accumulated postretirement benefit obligation (APBO) existing at January 1, 1992, less $11.3 related to discontinued product lines recorded in prior years. The effect of this accounting change for 1992 was a decrease in income before income taxes of $16.4, or $10.9 ($0.08 per share) after income taxes. The pro forma effect of this change on years prior to 1992 would have been a decrease in net income in amounts approximately equal to the 1992 effect. The components of net periodic postretirement benefit cost are as follows: The amounts recognized in Honeywell's statement of financial position are as follows: The discount rate used in determining the APBO was 7.0 percent in 1993 and 8.5 percent in 1992. The assumed health-care cost trend rate used in measuring the APBO was 10.0 percent in 1993 and 1994, then declining by 0.6 percent per year to an ultimate rate of 5.5 percent. The health-care cost trend rate assumption has a significant effect on the amounts reported. For example, a 1 percent increase in the health-care trend rate would increase the APBO by 11 percent at December 31, 1993, and the net periodic postretirement benefit cost by 14 percent for 1993. NOTE 18 -- SEGMENT INFORMATION Honeywell's operations are engaged in the design, development, manufacture, marketing and service of control solutions in three industry segments -- Home and Building Control, Industrial Control and Space and Aviation Control. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) Home and Building Control provides products and services to create efficient, safe, comfortable environments by offering controls for heating, ventilation, humidification and air-conditioning equipment; security and fire alarm systems; home automation systems; energy-efficient lighting controls; and building management systems and services. Industrial Control produces systems for the automation and control of process operations in industries such as oil refining, oil and gas drilling, pulp and paper manufacturing, food processing, chemical manufacturing and power generation; solid-state sensors for position, pressure, air flow, temperature and current; precision electromechanical switches; manual controls; advanced vision-based sensors; fiber-optic components; and solenoid valves used in fluid control and processing industries. Space and Aviation Control is a full-line avionics supplier and systems integrator for commercial, military and space applications, providing automatic flight control systems, electronic cockpit displays, flight management systems, navigation, surveillance and warning systems, severe weather avoidance systems and flight reference sensors. The "other" category comprises various operations, such as Solid State Electronics Center and Systems and Research Center, that are not a significant part of Honeywell's operations either individually or in the aggregate. Information concerning Honeywell's sales, operating profit and identifiable assets by industry segment can be found in Item 6. Selected Financial Data at page 9. This information for 1993, 1992 and 1991 is an integral part of these financial statements. Sales include external sales only. Intersegment sales are not significant. Corporate and other assets include the assets of the entities in the "other" category, and cash, short term investments, investments, property and deferred taxes held by corporate. Following is additional financial information relating to industry segments: Honeywell engages in material operations in foreign countries, the majority of which are located in Europe. Other geographic areas of operation include Canada, Mexico, Australia, South America and the Far East. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) Following is financial information relating to geographic areas: Honeywell transfers products from one geographic region for resale in another. These transfers are priced to provide both areas with an equitable share of the overall profit. Operating profit is net of provision for special charges amounting to $51.2 and $128.4 in 1993 and 1992, respectively, (see Note 3) as follows: United States -- $22.4 and $79.8, Europe -- $20.3 and $29.7, other areas -- $9.3 in 1992. General corporate expense includes special charges of $8.5 in 1993 and $9.6 in 1992. General corporate expense has been reduced by royalty income of $31.4 in 1993 and $14.9 in 1992 (see Note 3). NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) The operating profit impact of implementing SFAS 106 was additional expense of $16.4 in 1992 (see Note 17) as follows: United States -- $15.3, other areas - -- $0.5, general corporate expense -- $0.6. The operating profit impact of implementing SFAS 112 was additional expense of $3.8 in 1992 (see Note 1) as follows: United States -- $3.6, general corporate expense -- $0.2. NOTE 19 -- CONTINGENCIES LITTON LITIGATION On March 13, 1990, Litton Systems Inc. filed suit against Honeywell in U.S. District Court, Central District of California, alleging Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes; attempted monopolization by Honeywell of certain alleged markets for products containing ring laser gyroscopes; and intentional interference by Honeywell with Litton's prospective advantage in European markets and with its contractual relationships with Ojai Research, Inc., a California corporation. Honeywell has filed counterclaims against Litton alleging, among other things, violations by Litton of various antitrust laws including attempted monopolization of markets for inertial systems and interference with Honeywell's relationships with suppliers. The trial of the patent infringement and intentional interference claims commenced June 4, 1993, and on August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on each of these claims and awarded damages in the amount of $1,200.0 and concluded that the patent infringement was willful. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has not yet entered a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. ENVIRONMENTAL MATTERS Honeywell's manufacturing sites generate both hazardous and nonhazardous wastes, the treatment, storage, transportation and disposal of which are subject to various local, state and national laws relating to protection of the environment. Honeywell is in varying stages of investigation or remediation of potential, alleged or acknowledged contamination at current or previously owned or operated sites and at off-site locations where its wastes were taken for treatment or disposal. In connection with the cleanup of various off-site locations, Honeywell, along with a large number of other entities, has been designated a potentially responsible party (PRP) by the U.S. Environmental Protection Agency under the Comprehensive Environmental Response, Compensation and Liability Act or by state agencies under similar state laws (Superfund), which potentially subjects PRPs to joint and several liability for the costs of such cleanup. In addition, Honeywell is incurring costs relating to environmental remediation pursuant to the federal Resource Conservation and Recovery Act. Based on Honeywell's assessment of the costs associated with its environmental responsibilities, compliance NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 19 -- CONTINGENCIES (CONTINUED) with federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of Honeywell management, will not have a material effect on Honeywell's financial position, results of operations, capital expenditures or competitive position. Honeywell's opinion with regard to Superfund matters is based on its assessment of the predicted investigation, remediation and associated costs, its expected share of those costs and the availability of legal defenses. Honeywell's policy is to record environmental liabilities when loss amounts are probable and reasonably estimable. OTHER MATTERS Honeywell is a party to a large number of other legal proceedings, some of which are for substantial amounts. It is the opinion of management that losses in connection with these matters will not have a material effect on net income. The transfer of assets by Honeywell in the 1990 spinoff of the Defense and Marine Systems Business to Alliant Techsystems Inc. (Alliant) included the assignment of various contracts between Honeywell and the U.S. government. As required by federal procurement regulations applicable to government contracts, Honeywell has entered into novation agreements with Alliant and the U.S. government that will provide, among other things, for Honeywell to directly or indirectly guarantee or otherwise become liable for the performance of Alliant's obligations under such contracts. NOTE 20 -- QUARTERLY DATA (UNAUDITED) The third quarter of 1993 includes a gain of $9.2 from the revaluation of deferred tax assets (see Note 4). The fourth quarter of 1993 benefited from a change in estimate of $33.4 for postemployment benefits (see Note 1) that was partially offset by accruals for facilities closures and other expenses in the amount of $26.9. Following is a summary of other significant items affecting 1993 results. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 20 -- QUARTERLY DATA (UNAUDITED) (CONTINUED) The first quarter of 1992 includes the cumulative effects of adopting SFAS 106 (see Note 17), SFAS 109 (see Note 4) and SFAS 112 (see Note 1) at January 1, 1992. The 1992 impact of adopting these accounting changes was a decrease in income before income taxes of approximately $5.1 on a combined basis, or $3.4 ($0.03 per share) after income taxes, for each quarter. Other significant items affecting 1992 results include the following: Stockholders of record on February 2, 1994, totaled 33,166. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No report on Form 8-K reporting a change in Honeywell's certifying independent accountants has been filed within the 24 months prior to the date of the most recent financial statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pages 3 through 9 and page 14 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pages 14 through 20 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pages 10 through 11 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS A PART OF THIS REPORT 1. FINANCIAL STATEMENTS The financial statements required to be filed as part of this Annual Report on Form 10-K are listed below with their location in this report. 2. FINANCIAL STATEMENT SCHEDULES The schedules required to be filed as part of this Annual Report on Form 10-K are listed below with their location in this report. All schedules, other than indicated above, are omitted because of the absence of the conditions under which they are required or because the information required is shown in the financial statements or notes thereto. 3. EXHIBITS Documents Incorporated by Reference: 3. EXHIBITS (CONTINUED) SIGNATURES Pursuant to the requirements of Section 13 or 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. HONEYWELL INC. By: /s/ SIGURD UELAND, JR. -------------------------------------- Sigurd Ueland, Jr., Vice President Dated: March 4, 1994 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. By: /s/ SIGURD UELAND, JR. -------------------------------------- Sigurd Ueland, Jr., ATTORNEY-IN-FACT March 4, 1994 SCHEDULE V HONEYWELL INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE VI HONEYWELL INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE VIII HONEYWELL INC. AND SUBSIDIARIES VALUATION RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE IX HONEYWELL INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) ------------------------ SCHEDULE X HONEYWELL INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) EXHIBIT (11) HONEYWELL INC. AND SUBSIDIARIES COMPUTATION OF EARNINGS PER SHARE FOR THE FIVE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) EXHIBIT (24) CONSENT OF INDEPENDENT AUDITORS Honeywell Inc.: We consent to the incorporation by reference in Registration Statements Nos. 2-64351, 2-98660, 33-29442, 33-44282, 33-44283, 33-44284 and 33-49819 on Form S-8, and No. 33-62300 on Form S-3, of our reports dated February 11, 1994, appearing in and incorporated by reference in the Annual Report on Form 10-K of Honeywell Inc. for the year ended December 31, 1993. Deloitte & Touche Minneapolis, Minnesota March 3, 1994	14,496	97,139
766421_1993.txt	766421_1993	1993	766421	ITEM 1. BUSINESS General Alaska Air Group, Inc. (Air Group or the Company) is a holding company incorporated in Delaware in 1985. Its two principal subsidiaries are Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). Both subsidiaries operate as airlines. However, each subsidiary's business plan, competition and economic risks differ substantially due to the passenger capacity and range of aircraft operated. Alaska is a national airline, operates an all jet fleet, and its average passenger trip is 860 miles. Horizon is a regional airline, primarily operates a turboprop fleet, and its average passenger trip is 200 miles. Business segment information is reported in Note 10 of the Notes to Consolidated Financial Statements. The Company's executive offices are located at 19300 Pacific Highway South, Seattle, Washington 98188. The business of the Company is somewhat seasonal. Quarterly operating income tends to peak during the third quarter. Alaska Alaska Airlines is an Alaska corporation, organized in 1937. Alaska serves 37 airports in six states (Alaska, Washington, Oregon, California, Nevada and Arizona), five cities in Mexico and three cities in Russia. Over half of the U.S. airports served by Alaska are located in the state of Alaska. In each year since 1973, Alaska has carried more passengers between Alaska and the U.S. mainland than any other airline. Alaska Airlines also serves almost 60 small communities in Alaska through subcontracts with five local carriers. In 1993, Alaska carried 6.4 million passengers. Passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 29% of Alaska's total revenue passenger miles, while West Coast traffic accounted for 59% and the Mexico markets 12%. Based on passenger enplanements, Alaska's leading airports are Seattle, Portland, Anchorage and Los Angeles. Based on revenues, its leading nonstop routes were Seattle-Anchorage, Seattle-Los Angeles and Seattle-San Francisco. Alaska's operating fleet at December 31, 1993 consisted of 66 jet aircraft. Horizon Horizon, a Washington corporation, began service in 1981 and was acquired by Air Group in 1986. It is the largest regional airline in the Pacific Northwest, and serves 33 airports in six states (Washington, Oregon, Montana, Idaho, Utah and California) and two cities in Canada. In 1993, Horizon carried 2.8 million passengers. Based on passenger enplanements, Horizon's leading airports are Seattle, Portland, Spokane and Boise. Based on revenues, its leading nonstop routes were Seattle-Portland, Seattle-Spokane, Seattle-Boise, Seattle-Vancouver, B.C. and Portland-Boise. At December 31, 1993, Horizon's operating fleet consisted of five jet and 51 turboprop aircraft. Horizon flights are listed under the Alaska Airlines designator code in airline computer reservation systems. Certain Horizon flights are dual-designated in these reservation systems as Northwest Airlines and Alaska Airlines. Currently, 31% of Horizon's passengers connect to either Alaska or Northwest. Airline Regulation United States Department of Transportation (DOT) - The DOT has the authority to regulate certain airline economic functions including financial and statistical reporting, consumer protection, computerized reservations systems and essential air transportation. The DOT is also charged with determining which U.S. carriers will receive the authority to provide service to international destinations. International operating authority is subject to bilateral agreements between the United States and the respective countries. The countries establish the number of carriers to provide service, approve the carriers which are selected to provide such service and the size of aircraft to be used. The DOT reviews the carriers authorized under bilateral agreements every five years. Horizon's authority to operate the Seattle-Vancouver route, the Seattle-Victoria route and the Portland-Vancouver route is to be reviewed in August 1997, May 1994 and January 1995, respectively. Alaska's authority to serve its various Mexico destinations are to be reviewed during 1994, 1995 and 1996. The bilateral agreement with Russia will be reviewed in April 1995. The Company expects to be granted authority to continue to operate its international routes. Federal Aviation Administration (FAA) - The FAA, an agency within the DOT, has jurisdiction to regulate aviation safety generally, including: the licensing of pilots and maintenance personnel; the establishment of minimum standards for training and maintenance; and technical standards of flight, communications and ground equipment. All aircraft must have and maintain certificates of airworthiness issued by the FAA. Alaska and Horizon aircraft, maintenance facilities and procedures are subject to inspection by the FAA. The FAA has the authority to suspend temporarily or revoke permanently the authority of an air carrier or its licensed personnel for failure to comply with Federal Aviation Regulations and to levy civil penalties for such failure. Labor Relations - The air transportation industry is regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions arising under collective bargaining agreements. Environmental - Special noise ordinances or agreements restrict the type of aircraft, the timing and the number of flights operated by Alaska and other air carriers at five Los Angeles area airports plus San Diego, Palm Springs, San Francisco, and Seattle. In late 1990, Congress passed the Airport Noise and Capacity Act of 1990 (Act). The Act addressed the need to establish a national aviation noise policy and limit the ability of airports and local communities to implement procedures that would interfere with interstate commerce or the national air transportation system. The Act also called for the phase out of Stage II airplanes (generally older aircraft not meeting certain noise emission standards) in the contiguous 48 states by December 31, 1999. The Stage II phase-out provisions of the Act do not apply to aircraft operated solely within the state of Alaska. To implement the phase out within the contiguous 48 states, the FAA has proposed regulations and a timetable. Alaska believes that its current fleet plan will enable it to comply with the FAA's proposed regulations. Competition Competition within the air transportation industry is intense. Currently, any domestic air carrier deemed fit by the U.S. Department of Transportation (DOT) is allowed to operate scheduled passenger service in the United States. Together, Alaska and Horizon carry less than 2% of all U.S. passenger traffic. Alaska and Horizon compete in the West Coast and Arizona markets with both established carriers (such as United, United Express, Delta, American, MarkAir, and America West) and new low-cost carriers (such as Morris Air and Reno Air). In December 1993, Southwest Airlines purchased Morris Air. Alaska also competes primarily with United, Northwest, Delta and MarkAir in the Lower 48- to-Alaska market. Some of these competitors are substantially larger than Alaska and Horizon, have greater financial resources and have more extensive route systems. Due to its shorthaul markets, Horizon is subject to competition from surface transportation, particularly the private automobile. Alaska and Horizon provide numerous departures from smaller cities to larger "hub" cities and, where possible, connecting flights to a passenger's final West Coast destination. Both airlines distinguish themselves from competitors by providing a higher level of customer service. The airlines' excellent service in the form of attention to customer needs, high-quality food and beverage service, more legroom, well-maintained aircraft and other amenities has been recognized by independent studies and surveys of air travelers. Alaska and Horizon maintain competitive fares, offering discount or promotional fares to the extent necessary to maintain market share. Most large U.S. carriers have developed, independently or in partnership with others, large computerized reservation systems (CRS). Since the deregulation of fares and schedules, travel agents have contracted to use these systems in selling tickets. Airlines, including Alaska and Horizon, are charged industry-set fees to have their flight schedules included in the various CRS displays. These systems have become the predominant means of distributing airline tickets. Due to their competitive importance, DOT rules require the vendors of such systems to provide unbiased displays of all airline schedules and fares. In 1992, the DOT adopted new rules in this area to reduce anti-competitive practices. Frequent Flyer Program All major airlines have established frequent flyer programs offering incentives to maximize travel on that particular carrier. Alaska has a Mileage Plan (MP) that allows customers to earn mileage credits while flying on Alaska, Horizon and other participating airlines, and by using the services of participating banks, hotels and car rental firms. Alaska reserves the right to change the MP terms, conditions, partners, mileage credits and/or award levels. Mileage credits can be redeemed for free or discounted travel and for other travel industry awards. Upon accumulating the necessary mileage credit, MP members notify Alaska of their award selection. Once selected, modifications to such awards are limited. Over 90% of the flight awards selected are subject to blackout dates and capacity-controlled seating. Currently, credits earned must be redeemed within three years, otherwise they expire. As of the year end 1993 and 1992, Alaska estimates that 698,000 and 585,000 roundtrip flight awards could have been redeemed by MP members who have mileage credits exceeding the 15,000 mile free ticket threshold. However, at December 31, 1993, fewer than 14% of these flight awards were actually issued and outstanding. Alaska accrues the incremental cost associated with flight awards above the 15,000 mile level. In addition, a proportion of the incremental cost of a flight award is accrued for 21% of the accumulated mileage credits of MP members whose account balances are less than 15,000 miles. The resulting accrued liability covers 65% of the total accumulated mileage credit. At December 31, 1993 and 1992, the accrued liability was $5.9 million and $8.4 million, respectively. The incremental cost to transport a passenger on a free trip includes the cost of fuel, meals, and insurance. The incremental cost does not include any contribution to overhead, aircraft cost or profit. The number of roundtrip flight awards used on Alaska were 188,000, 174,000 and 119,000 for the years 1993, 1992 and 1991, respectively. These awards represent approximately 5% of the total passenger miles flown for each period. Given this low usage, seat availability and seat restrictions on popular flights, Alaska believes that displacement of revenue passengers by those using flight awards is minimal. Selected Quarterly Consolidated Financial Information (Unaudited) Selected financial data for each quarter of 1993 and 1992 is as follows (in thousands, except per share): The amounts shown for the first quarter 1992 differ from that previously reported due to the January 1, 1992 adoption of Financial Accounting Standards No. 106, "Accounting for Postretirement Benefits Other than Pensions." The cumulative effect of the change in accounting is reported in the first quarter of 1992. The effect of the accounting change on subsequent quarters of 1992 is immaterial. The total of the amounts shown as quarterly earnings per share may differ from the amount shown on the Consolidated Statement of Income because the annual computation is made separately and is based upon average number of shares and equivalent shares outstanding for the year. (See Note 1 of the Notes to Consolidated Financial Statements.) A discussion of the fourth quarter 1993 results is included in Management's Discussion and Analysis of Results of Operations and Financial Condition. Employees Alaska had 6,243 active full-time and part-time employees at December 31, 1993, of which approximately 85% are represented by labor unions. The unions and the number of Alaska employees represented by each as of December 31, 1993 and the amendable dates of existing contracts are outlined below: Number of Union Employee Group Employees Contract Status International Mechanic, 1,493 Amendable 9/1/97 Association of Rampservice and Machinists and related Aerospace Workers classifications Clerical, Office 1,843 Amendable and Passenger 9/30/92 Service (In negotiation) Air Line Pilots Pilots 888 Amendable Association 12/1/97 International Association of Flight Attendants 1,011 Amendable Flight Attendants 10/1/90 (In negotiation) Mexico Workers Mexico Airport 66 Amendable 4/1/94 Association of Air Personnel Transport Transport Workers Dispatchers 16 Amendable 4/24/96 Horizon had 2,490 active full-time and part-time employees at December 31, 1993, of which approximately 20% are represented by labor unions. The unions and the number of Horizon employees represented by each as of December 31, 1993 and the amendable dates of existing contracts are outlined below: Number of Union Employee Group Employees Contract Status Transport Workers Mechanics and 234 Amendable 1/1/95 Union of America related classifications Dispatchers 26 In negotiation Association of Flight 189 Amendable 4/20/94 Flight Attendants Attendants Canadian Brotherhood Station 58 Amendable 7/10/95 of Railway, personnel in Transport and British Columbia General Workers The Company's labor contracts currently in negotiation are not expected, when finalized, to have a material adverse impact on results of operations. ITEM 2. ITEM 2. PROPERTIES Aircraft The following table describes the aircraft operated and their average age at December 31, 1993. Average Passenger Age Aircraft Type Capacity Owned Leased Total in Years Alaska Airlines Boeing 727-100 12/92 1 - 1 27 Boeing 727-200 12/131 - 4 4 14 Boeing 737-200C 0/111 3 4 7 14 Boeing 737-400 10/126 2 14 16 1 McDonnell Douglas MD-80 10/128 12 26 38 6 18 48 66 6 Horizon Fairchild Metroliner III 18 5 23 28 8 de Havilland Dash 8 37 - 23 23 5 Fokker 65 - 5 5 22 5 51 56 8 Total 23 99 122 Part II, Item 7., "Management's Discussion and Analysis of Results of Operations and Financial Condition," discusses future orders and options for additional aircraft. Twelve of the 18 aircraft owned by Alaska as of December 31, 1993 are subject to liens securing long-term debt. Alaska's leased Boeing 727-200s will all be retired by May 1994. The leased McDonnell Douglas MD-80 aircraft have expiration dates of 1994 to 2013. The B737-400 leases expire in 2000-2001. In late 1993, Horizon took delivery of two Dornier 328 aircraft, which will be placed in service in early 1994. Horizon's leased Fairchild Metroliner III, de Havilland Dash 8, Fokker and Dornier 328 aircraft have base-term expiration dates of 1994 to 2001, 1995 to 2006, 1996 to 1997, and 2008, respectively. Alaska and Horizon have the option to extend most of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then fair market value of the aircraft. The Company has the right to terminate each of the B737-400 leases on the third anniversary of an aircraft's delivery date for an average fee of $260,000. For information regarding obligations under capital leases and long-term operating leases, see Note 5 to the Consolidated Financial Statements. Ground Facilities and Services Alaska and Horizon lease ticket counters, gates, cargo and baggage, office space and other support areas at the majority of the airports they serve. Alaska also owns terminal buildings at various Alaska cities and Horizon owns its terminal at the Portland International Airport. Alaska has centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. The owned buildings, including land unless located on leased airport property, include: a three-bay hangar facility with maintenance shops; a flight operations and training center; an air cargo facility; a reservation and office facility; a four-story office building; its corporate headquarters; and two storage warehouses. Alaska also leases a two-bay hangar/office facility at Sea-Tac. Alaska's other major facilities include: its Anchorage regional headquarters building and Phoenix reservations center; a leased two- bay maintenance facility in Oakland; and a leased hangar/office facility in Anchorage. Horizon owns its Seattle corporate headquarters building and leases a maintenance facility at the Portland airport. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In October 1991, Alaska gave notice of termination of its code sharing and frequent flyer relationship with MarkAir, an airline based in the state of Alaska. Both companies have filed suit against one another in connection with that termination alleging breach of contract and other causes of action under state law. In addition, MarkAir claimed that the termination was in violation of Federal Antitrust Laws. MarkAir filed for protection under Chapter 11 of the U.S. Bankruptcy Code in June 1992. In December 1993, MarkAir agreed to dismiss all antitrust claims against the Company. That agreement is awaiting final approval by the U.S. District Court which has jurisdiction over the case. MarkAir and Alaska will be free to pursue the breach of contract and other state law claims after dismissal of the antitrust suit. In December 1992, the U.S. Department of Justice filed suit against most major domestic airlines, including the Company, alleging that they have violated the antitrust laws by conspiring to fix prices for domestic airline tickets in violation of Section 1 of the Sherman Act. Two airlines have entered into consent decrees with the U.S. Department of Justice. The Company believes the ultimate resolution of the above legal proceedings will not result in a material adverse impact on the financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Alaska Air Group, Inc., their positions and their respective ages (as of March 1, 1994) are as follows: Officer Continuously Name Position Age Since Raymond J. Vecci Chairman, President and Chief 51 1979 Executive Officer of Alaska Air Group, Inc. and Alaska Airlines, Inc. Marjorie E. Laws Vice President/Corporate Affairs 53 1983 and Corporate Secretary of Alaska Air Group, Inc. and Alaska Airlines, Inc. J. Ray Vingo Vice President/Finance & Chief 55 1983 Financial Officer of Alaska Air Group, Inc. and Alaska Airlines, Inc.; Treasurer of Alaska Air Group, Inc. Steven G. Vice President/Legal and General 54 1988 Hamilton Counsel of Alaska Air Group, Inc. and Alaska Airlines, Inc. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As of December 31, 1993, there were 13,341,621 shares of common stock issued and outstanding and 6,524 shareholders of record. The Company also held 3,153,589 treasury shares at a cost of $71.8 million. Cash dividends totaling $.15 per share were declared in 1992. In December 1992, the Company suspended the quarterly dividend on the common stock due to the 1992 net loss and the difficult economic environment. Air Group's common stock is listed on the New York Stock Exchange (symbol: ALK). The following table shows the trading range of Alaska Air Group common stock on the New York Stock Exchange for 1993 and 1992. 1993 1992 High Low High Low First Quarter 18 15-5/8 23-7/8 18-1/4 Second Quarter 17-7/8 14-1/4 22 17-1/8 Third Quarter 15 12-1/4 19-1/2 17-1/4 Fourth Quarter 17-3/8 12-1/2 17-5/8 14-3/4 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Industry Conditions The Company's operating results improved in 1993, yet the Company continued to post a net loss. The Company and the entire airline industry have been negatively impacted by a weak economy, over capacity of aircraft, continued operation of bankrupt carriers and low-cost, new entrants. These factors were particularly evident on the West Coast due to the economic recession in California and the growth of new entrant carriers. The result has been a significant decrease in air fares. The Company has responded to the changing industry environment by cutting costs, retiring older aircraft, and reducing capital spending. In 1993, the Company implemented a comprehensive cost- reduction program, which resulted in more than $80 million of annual cost savings. Results of Operations FOURTH QUARTER 1993 AND 1992 The consolidated net loss for the fourth quarter 1993 was $20.3 million, or $1.52 per share, compared to a loss of $44.6 million, or $3.47 per share, for fourth quarter 1992. Results for 1993 and 1992 include after-tax special charges of $9.8 million and $16.6 million, respectively. Before these charges, the fourth quarter 1993 net loss was $10.5 million, or $.79 per share, compared to a loss of $28.0 million, or $2.23 per share, for the fourth quarter 1992. The special charges are to recognize the lower value of the Boeing 727 fleet and the acceleration of its retirement. Fourth quarter 1993 operating revenues were $277.2 million, up 7% from the $258.9 million reported for the prior-year quarter. Passenger traffic was up 28%, but passenger yield (revenue per passenger mile) was down 17% from 17.9 cents in 1992 to 14.8 cents in 1993. Fourth quarter 1993 operating expenses decreased 6% (3% excluding the special charges) to $299.9 million from $318.4 million for fourth quarter 1992. Wages and benefits decreased $2.9 million (3%) due to a 4% decrease in employees offset by higher average wage rates. Maintenance expense decreased $6.7 million due to the replacement of old aircraft during the past year. Aircraft rent and depreciation expense increased $6.3 million (13%) with the addition of six new aircraft to the fleet over the past year. Excluding special charges, all other expenses decreased $4.3 million (3%). Increased flying combined with cost savings caused operating cost per available seat mile to decline from 12.2 cents to 10.6 cents, or 13% (excluding the special charges). Fourth quarter 1993 nonoperating net expense decreased $2.3 million primarily due to lower interest rates on debt. 1993 COMPARED WITH 1992 The consolidated net loss for 1993 was $30.9 million, or $2.51 per share, compared with $84.8 million net loss, or $6.87 per share, for 1992. The results include an after- tax charge of $9.8 million in 1993 and $16.6 million in 1992 to recognize the lower value of the Boeing 727 fleet and the acceleration of its retirement. In addition, 1992 includes a $4.6 million charge related to a change in accounting for postretirement benefits. Without such charges, the 1993 net loss would have been $21.1 million, or $1.77 per share, compared with $63.6 million net loss, or $5.28 per share, for 1992. The operating loss for 1993 was $16.8 million compared to an operating loss of $94.8 million for 1992. The improved operating results reflect lower operating expenses. Operating revenues increased 1% in 1993 to $1.128 billion. Passenger revenues, which accounted for 89% of total operating revenues, increased slightly to $1.002 billion, while freight and mail revenues increased 9% to $84.0 million, and other revenues increased by 13% to $42.3 million. Passenger revenues were negatively impacted in 1993 by aggressive fare discounting. Passenger yields were up 11% during the first half of 1993 but dropped significantly during the last half of 1993. For all of 1993, yields declined .1 cent from 16.6 cents in 1992 to 16.5 cents in 1993. A 1 cent change in yields affects annual revenues by approximately $60 million. Passenger traffic was down 12% during the first half of 1993 but lower fares stimulated traffic during the last half of 1993. For all of 1993, passenger traffic increased 1%. Freight and mail revenues increased $6.7 million (9%) in 1993 due to increased freight and mail rates and increased service in Alaska. Other-net revenues were up $4.9 million (13%) in 1993 due to increased revenues from Alaska's frequent flyer program. Operating Expenses Operating expenses decreased 5% to $1.145 billion from $1.210 billion in 1992. The $65 million reduction in expenses was primarily due to a cost reduction program initiated during the first quarter 1993. Operating expenses per ASM declined 4%, from 11.5 cents to 11.0 cents. The table below shows the major operating expense elements on a unit-cost basis for 1993 and 1992: Operating Expenses Per ASM (In Cents) Increase % 1993 1992 (Decrease) Change Wages and benefits 3.53 3.51 .02 1 Aircraft fuel 1.37 1.55 (.18) (12) Aircraft maintenance .65 .83 (.18) (22) Aircraft rent 1.49 1.18 .31 26 Commissions .77 .82 (.05) (6) Depreciation & amortization .56 .54 .02 4 Special charges .14 .25 (.11) NM Other 2.49 2.83 (.34) (12) Total 11.00 11.51 (.51) (4) Fuel expense per ASM decreased 12% due to the use of more fuel efficient aircraft and a 3% decrease in the cost of fuel. The average cost per gallon during 1993 was 67.6 cents, down from 69.6 cents in 1992. Currently, a 1 cent change in fuel prices affects annual fuel costs by approximately $2.1 million. Maintenance expense per ASM declined 22% due to the replacement of old aircraft with new aircraft. With an average age of six years at year-end 1993, Alaska's fleet is the youngest among all U.S. jet airlines. Aircraft rent and depreciation expense increased 18% in 1993 primarily due to the addition of new aircraft. As of December 31, 1993, essentially all of Alaska's Boeing 727-200 aircraft had been retired. The last two will be retired in May 1994. This is an acceleration of the retirement schedule announced previously. This action resulted in a pretax special charge of $15 million in 1993 to recognize the lower value of the Boeing 727-200 fleet. It includes a provision for future excess lease costs and the write-down of capitalized overhauls and spare parts to net realizable value. 1992 results include a similar charge of $26 million, which resulted from the Company's decision to accelerate the retirement of the Boeing 727-200 from 1996 to the end of 1994. Other expense per ASM decreased 12% due to lower expenditures for food, advertising, promotion, supplies and personnel expenses. Other Income (Expense) Nonoperating expense was $29.0 million in 1993, down from $30.9 million in 1992. Interest expense was $5.6 million lower in 1993 due to lower interest rates. There was only $446,000 interest capitalized in 1993, compared to $6.1 million in 1992. Because of the two-year delay in expected delivery of the MD- 90 aircraft, interest capitalization on the associated aircraft purchase deposits was discontinued in the fourth quarter 1992. 1992 COMPARED WITH 1991 Consolidated net loss for 1992 was $84.8 million, or $6.87 per share, compared with $10.3 million net profit, or $.27 per share, for 1991. 1992 results include an after-tax charge of $16.6 million to recognize the lower value of the Boeing 727 fleet and a $4.6 million charge related to a change in accounting for postretirement benefits. Operating loss was $94.8 million, compared to an operating profit of $34.6 million for 1991. The large operating loss was primarily due to a 13% increase in operating expenses but only a 1% increase in operating revenues. Operating revenues were $1.115 billion, 1% greater than the $1.104 billion posted a year earlier. Passenger traffic was up 13%, but was mostly offset by lower yields. Passenger yield for 1992 was 16.6 cents, down 11% from 1991's 18.7 cents. Freight and mail revenues increased $7.7 million (11%) in 1992 primarily due to increased service in Alaska. Nonoperating expense was $30.9 million in 1992 compared to $18.4 million in 1991. The increase was primarily due to higher interest expense and less interest income. Operating expenses increased 13% (11% excluding the special charges) to $1.210 billion from $1.069 billion in 1991. The primary factor contributing to the increase was the 10% increase in available seat miles resulting from the net addition of 12 aircraft during 1992. Wages and benefits rose 11% in 1992 resulting from a 7% increase in employees and a 4% increase in wages and benefits per employee. Fuel expense rose 4% primarily due to a 6% increase in fuel consumed, offset by a 2% decrease in average cost per gallon. Fuel expense per ASM was down 5% due to the addition of 16 fuel- efficient, two-engine jet aircraft and retirement of eight three- engine jet aircraft during 1992. Aircraft rent and depreciation expense rose 17% due to the addition of new aircraft. Other operating expenses increased 14% primarily due to higher costs for food, landing fees, terminal rents and outside services. LIQUIDITY AND CAPITAL RESOURCES The table below shows the major indicators of financial condition and liquidity and the changes during 1993. December 31, December 31, 1993 1992 Change (In millions, except ratios and per share) Cash and marketable securities $101.1 $83.4 $17.7 Working capital (deficit) (61.3) (85.2) 23.9 Total assets 1,135.0 1,208.4 (73.4) Long-term debt 525.4 487.8 37.6 Redeemable preferred stock - 61.2 (61.2) Shareholders' equity 166.8 196.7 (29.9) Book value per common share $12.51 $14.76 $(2.25) Debt/equity ratio 76%:24% 74%:26% N/A 1993 FINANCIAL CHANGES The Company's cash and marketable securities portfolio increased by $17.7 million during 1993. Operating activities provided $48.5 million of cash in 1993. Additional cash was provided by $83.7 million from aircraft refinancing and $20 million in short-term borrowings. Cash was used for debt payments ($79.4 million), repurchase of preferred stock ($33.4 million), and capital expenditures ($30.4 million). Like many airlines, the Company has a working capital deficit. The existence of such a deficit has not in the past impaired the Company's ability to meet its obligations as they become due and is not expected to do so in the future. Financing Arrangements During May 1993, the Company repurchased all of its outstanding 10.21% redeemable preferred stock for $60.4 million, saving the Company more than $4 million annually after taxes. The seller provided a $27 million loan carrying a 7% interest rate to assist with the stock repurchase. In November 1993, Alaska entered into a financing agreement to refinance $47.2 million in borrowings with a six-year term loan. The $47.2 million of borrowings had been classified as a current obligation at December 31, 1992. Alaska has $70 million in lines of credit. Credit advances carry variable interest rates based upon LIBOR. At December 31, 1993, there were no borrowings outstanding under these lines of credit. Commitments During 1993, Alaska took delivery of six new B737-400 aircraft under eight-year operating leases. In addition, two MD-80s were sold and leased back under operating leases of 6-1/2 and 10 years, respectively. During 1993, Alaska subleased or terminated leases on 11 B727-200 aircraft. During 1993, Horizon restructured the Dornier 328 order and the number of firm orders of the aircraft has been reduced from 35 aircraft valued at $260 million to 20 aircraft valued at $150 million. The number of aircraft under option increased from 25 to 40 aircraft. Delivery of the firm orders began in late 1993 and will continue through 1998. The option aircraft would be delivered during the years 1998 to 2003. Dornier has also agreed to provide Horizon with lease financing for the aircraft. The new aircraft are intended to replace Horizon's 18-seat Fairchild Metroliner III aircraft and should be sufficient to meet growth needs for the next decade. In addition, in 1993 Horizon took delivery of three used aircraft under operating leases ranging from one to three years. At December 31, 1993, the Company had firm orders for 40 aircraft with a total value of approximately $1.1 billion as set forth below. Delivery Period - Firm Orders Aircraft 1994 1995 1996 1997 1998 Total Boeing B737-400 6 6 Dornier 328 5 2 3 2 6 18 McDonnell Douglas MD-80 4 2 6 McDonnell Douglas MD-90 1 9 10 Total 15 4 4 11 6 40 Value (Millions) $388 $85 $73 $465 $45 $1,056 Operating leases have been completed for the B737-400 and Dornier 328 orders. The Company expects to finance the other aircraft through new long-term debt, leases and internally generated cash. The Company accrues the costs associated with returning leased aircraft over the lease period. At December 31, 1993, $30.7 million was reserved for leased aircraft returns. This reserve should be sufficient to cover the costs related to the phase-out of the Boeing 727 fleet and the obligations due at the end of the contractual rent period for other aircraft. Deferred Taxes At December 31, 1993, net deferred tax liabilities were $9 million, which includes $69 million of net temporary differences offset by $44 million net operating loss (NOL) carryforwards and $16 million related to Alternative Minimum Tax (AMT) credit carryforwards. The Company believes all of the deferred tax assets, including the NOL and AMT credit carryforwards will be realized through reversal of existing temporary differences or tax planning strategies, such as the sale of aircraft. 1992 FINANCIAL CHANGES Despite the $84.8 million net loss, operating activities provided $20.2 million of cash in 1992. During 1992, capital spending totaled $277.9 million for six MD-80 and two B737-400 aircraft, other equipment and deposits for future flight equipment. These capital expenditures were financed through debt ($47.2 million), sale/leasebacks ($214.6 million) and internally generated cash. 1991 FINANCIAL CHANGES Operations generated $82.5 million and net proceeds from the sale of convertible subordinated notes added $115 million. The $82.5 million generated by operations was lower than the $103.2 million for 1990 due to the smaller profit in 1991 and discount fares, which resulted in a high level of advance ticket sales in 1990. Liquidity was also improved by obtaining long-term financing for $48 million of short-term borrowings. The borrowings had been used to acquire two aircraft in late 1990. In 1991, long-term debt financing of $27.6 million was obtained for one aircraft, and the other aircraft was sold for $30.0 million and leased back for 19 years under an operating lease. During 1991, the Company expended approximately $213.4 million for four MD-80 aircraft, other equipment and deposits for future flight equipment. Long-term debt financing of $102.4 million was obtained for these aircraft. EFFECT OF INFLATION Inflation and specific price changes do not have a significant effect on the Company's operating revenues, operating expenses and operating income, because such revenues and expenses generally reflect current price levels. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the consolidated financial statements and supplementary data appearing on the pages of this report set forth below. Page(s) Selected Quarterly Consolidated Financial Information 4 (Unaudited) Consolidated Balance Sheet as of December 31, 1993 and 1992 21-22 Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 23 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 24 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 25 Notes to Consolidated Financial Statements 26-33 Report of Independent Public Accountants 20 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See "Election of Directors," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 17, 1994. See "Executive Officers of the Registrant" in Part I following Item 4 for information relating to executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION See "Executive Compensation," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 17, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Security Ownership of Certain Beneficial Owners and Management," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 17, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Transactions with Management and Others," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 17, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Consolidated Financial Statements See Item 8. (2) Consolidated Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991 Page(s) Schedule III - Condensed Financial Information 34-36 Schedule V - Property and Equipment 37 Schedule VI - Accumulated Depreciation and Amortization 38 Schedule VIII - Valuation and Qualifying Accounts 39 Schedule IX - Short-Term Borrowings 35 Schedule X - Supplementary Income Statement Information 38 All other schedules have been omitted, since the required information is included in the consolidated financial statements, including the notes thereto, or the circumstances requiring inclusion of such schedules are not present. (3) Exhibits See Exhibit Index on page 40. (b) Alaska Air Group did not file any reports on Form 8-K during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 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. ALASKA AIR GROUP, INC. By: /s/ Raymond J. Vecci Date: January 31, 1994 Raymond J. Vecci, Chairman, Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on January 31, 1994 on behalf of the registrant and in the capacities indicated. /s/ Raymond J. Vecci Chairman, Chief Executive Officer, Raymond J. Vecci President and Director /s/ J. Ray Vingo Vice President/Finance, Treasurer, J. Ray Vingo Chief Financial Officer and Director /s/ Kathleen H. Iskra Controller (Principal Accounting Officer) Kathleen H. Iskra /s/ William H. Clapp Director William H. Clapp /s/ Ronald F. Cosgrave Director Ronald F. Cosgrave /s/ Mary Jane Fate Director Mary Jane Fate /s/ John F. Kelly Director John F. Kelly Director Bruce R. Kennedy /s/ R. Marc Langland Director R. Marc Langland /s/ Byron I. Mallott Director Byron I. Mallott /s/ Robert L. Parker, Jr. Director Robert L. Parker, Jr. /s/ Richard A. Wien Director Richard A. Wien REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of Alaska Air Group, Inc.: We have audited the accompanying consolidated balance sheet of Alaska Air Group, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Alaska Air Group, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 7 to the financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Seattle, Washington January 25, 1994 CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. ASSETS As of December 31 (In Thousands) 1993 1992 Current Assets Cash and cash equivalents (Note 1) $27,179 $6,880 Marketable securities (Note 2) 73,970 76,551 Receivables - less allowance for doubtful accounts (1993-$2,621,000; 1992-$3,214,000) 75,274 84,409 Inventories and supplies (Note 1) 41,269 42,099 Prepaid expenses and other assets 56,498 40,546 Total Current Assets 274,190 250,485 Property and Equipment (Notes 1 and 3) Flight equipment 614,717 692,345 Other property and equipment 217,967 217,162 Deposits for future flight equipment 79,765 81,686 912,449 991,193 Less accumulated depreciation and amortization 247,145 227,693 665,304 763,500 Capital leases (Note 5) Flight and other equipment 44,381 44,381 Less accumulated amortization 19,079 16,971 25,302 27,410 Total Property and Equipment - Net 690,606 790,910 Intangible Assets-Subsidiaries (Note 1) 67,711 69,751 Other Assets (Note 2) 102,447 97,212 Total Assets $1,134,954 $1,208,358 See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. LIABILITIES AND CAPITAL As of December 31 (In Thousands) 1993 1992 Current Liabilities Accounts payable $ 45,582 $ 47,503 Accrued aircraft rent 39,119 38,189 Other accrued liabilities 46,679 48,370 Accrued wages, vacation pay and payroll taxes 40,192 36,425 Short-term borrowings 20,000 - Air traffic liability 108,360 96,791 Current portion of long-term debt and capital lease obligations 35,575 68,440 Total Current Liabilities 335,507 335,718 Long-Term Debt and Capital Lease Obligations (Notes 3 and 5) 525,418 487,847 Other Liabilities and Credits Deferred income taxes (Note 9) 20,998 29,111 Deferred income (Note 1) 25,827 36,423 Other liabilities 60,371 61,300 107,196 126,834 Commitments (Note 5) Redeemable Preferred Stock (Note 4) - 61,235 Shareholders' Equity (Notes 4 and 6) Common stock, $1 par value Authorized: 30,000,000 shares Issued: 1993 - 16,495,210 shares 1992 - 16,482,610 shares 16,495 16,483 Capital in excess of par value 152,017 151,845 Treasury stock, at cost: 1993 - 3,153,589 shares 1992 - 3,153,576 shares (71,807) (71,807) Deferred compensation (Note 7) (5,813) (10,181) Retained earnings 75,941 110,384 166,833 196,724 Total Liabilities and Capital $1,134,954 $1,208,358 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF INCOME Alaska Air Group, Inc. Year Ended December 31 (In Thousands) 1993 1992 1991 Operating Revenues Passenger $1,001,975 $1,000,618 $999,859 Freight and mail 84,048 77,311 69,590 Other - net 42,306 37,449 34,582 Total Operating Revenues 1,128,329 1,115,378 1,104,031 Operating Expenses Wages and benefits 368,152 370,567 332,041 Aircraft fuel 142,572 162,768 156,491 Aircraft maintenance 67,438 87,687 82,983 Aircraft rent 154,879 123,732 102,279 Commissions 80,108 86,335 84,345 Depreciation and amortization 58,407 56,757 51,767 Special charges (Note 8) 15,000 26,000 - Other 258,546 296,373 259,499 Total Operating Expenses 1,145,102 1,210,219 1,069,405 Operating Income (Loss) (16,773) (94,841) 34,626 Other Income (Expense) Interest income 7,088 7,374 11,698 Interest expense (37,624) (43,223) (40,180) Interest capitalized 446 6,102 8,301 Loss on sale of assets (649) (2,339) (1,148) Other - net 1,700 1,221 2,910 (29,039) (30,865) (18,419) Income (loss) before income tax expense (credit) and accounting change (45,812) (125,706) 16,207 Income tax expense (credit) (Note 9) (14,894) (45,436) 5,869 Income (loss) before accounting change (30,918) (80,270) 10,338 Cumulative effect of accounting change (Note 7) - (4,567) - Net Income (Loss) $(30,918) $(84,837) $10,338 Earnings (Loss) Per Common Share: (Note 1) Primary - Income (loss) before accounting change $(30,918) $(80,270) $10,338 Preferred stock dividends (2,525) (6,688) (6,671) Income (loss) before accounting change applicable to common shares (33,443) (86,958) 3,667 Cumulative effect of accounting change - (4,567) - Net income (loss) applicable to common shares $(33,443) $(91,525) $3,667 Average shares outstanding (000) 13,340 13,309 13,413 Earnings (loss) per common share: Income before accounting change $(2.51) $(6.53) $0.27 Cumulative effect of accounting change - (0.34) - Net income (loss) per share $(2.51) $(6.87) $0.27 The dilutive effect of the Company's common stock equivalents and convertible securities was anti-dilutive for 1993, 1992 and 1991. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF CASH FLOWS Alaska Air Group, Inc. Year Ended December 31 (In Thousands) 1993 1992 1991 Cash and cash equivalents at beginning of year $6,880 $19,086 $28,865 Cash flows from operating activities: Income (loss) before accounting change (30,918) (80,270) 10,338 Adjustments to reconcile income to cash: Depreciation and amortization 58,407 56,757 51,767 Amortization of airframe and engine overhauls 29,402 34,265 33,759 Special charges 15,000 26,000 - Loss (gain) on disposition of assets and debt retirement (315) 2,339 (504) Increase (decrease) in deferred income taxes (8,113) (25,797) 725 Decrease (increase) in accounts receivable 9,135 (23,118) 4,098 Decrease (increase) in other current assets (15,122) (7,370) (11,470) Increase (decrease) in air traffic liabliity 11,569 19,500 (16,368) Increase in other current liabilities 1,085 19,826 9,704 Interest on zero coupon notes 9,881 9,203 6,125 Leased aircraft return payments and other-net (31,554) (11,101) (5,631) Net cash provided by operating activities 48,457 20,234 82,543 Cash flows from investing activities: Proceeds from disposition of assets 7,193 793 1,331 Purchases of marketable securities (552,175) (564,787) (389,583) Sales and maturities of marketable securities 554,756 571,985 329,318 Restricted deposits (4,045) (3,007) (19,095) Future flight equipment deposits returned 2,685 3,321 - Additions to future flight equipment deposits (764) (16,873) (69,302) Additions to property and equipment (29,605) (261,073) (144,109) Payments received on loans to ESOPs 4,128 4,747 3,402 Net cash used in investing activities (17,827) (264,894) (288,038) Cash flows from financing activities: Proceeds from short-term borrowings 20,000 96,303 15,000 Repayment of short-term borrowings - (96,303) (62,953) Proceeds from sale and leaseback transactions 36,500 214,590 29,970 Proceeds from issuance of long-term debt 47,200 84,700 245,030 Long-term debt and capital lease payments (79,375) (59,904) (27,841) Proceeds from issuance of common stock 184 1,466 842 Repurchase of preferred stock (33,375) - - Cash dividends (2,429) (8,398) (9,026) Gain on debt retirement 964 - 1,652 Other - - 3,042 Net cash provided by (used in) financing activities (10,331) 232,454 195,716 Net increase in cash and cash equivalents 20,299 (12,206) (9,779) Cash and cash equivalents at end of year $27,179 $6,880 $19,086 Supplemental disclosure of cash paid during the year for: Interest (net of amount capitalized) $33,622 $38,952 $28,983 Income taxes - 1,369 10,338 Noncash investing and financing activities: 1993 - The preferred stock was repurchased in exchange for a $27 million note payable and a $33.4 million cash payment. 1992 and 1991 - None See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Alaska Air Group, Inc. December 31, 1993 Note 1. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Alaska Air Group, Inc. (Company or Air Group) and its subsidiaries, the principal subsidiaries being Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). All significant intercompany transactions are eliminated. Both subsidiaries operate as airlines. However, each subsidiary's business plan, competition and economic risks differ substantially due to the passenger capacity and range of aircraft operated. Alaska is a national airline, operates an all jet fleet and its average passenger trip is 860 miles. Horizon is a regional airline, primarily operates a turboprop fleet and its average passenger trip is 200 miles. See Note 10 for business segment information. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with original maturities of three months or less. They are carried at cost, which approximates market. Inventories and Supplies Expendable and repairable parts, materials and supplies relating to flight equipment are stated at average cost. Except for the B727 fleet, an allowance for obsolescence of flight equipment repairable parts is accrued on a straight-line basis over the estimated useful lives of the aircraft. For the B727 fleet, which is being retired, the inventory cost less the allowance for obsolescence is stated at net realizable value. The allowance at December 31, 1993 and 1992 was $8.3 million and $6.3 million, respectively. Property, Equipment and Depreciation Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which are as follows: Buildings 10-30 years Capitalized leases and leasehold improvements Term of lease Flight equipment 10-20 years Other equipment 3-15 years Assets and related obligations for equipment under capital leases are initially recorded at an amount equal to the present value of the future minimum lease payments using interest rates implicit within the leases. Interest expense is accrued on the outstanding balance of capital lease obligations. Costs of airframe and engine overhauls are capitalized when incurred and amortized over their estimated period of use. Costs of ordinary maintenance and repairs are expensed as incurred. Capitalized Interest Construction period interest is capitalized on flight equipment purchase deposits and ground facilities progress payments as an additional cost of the related asset and is depreciated over the estimated useful life of the asset. Interest capitalization is suspended during periods of substantial delay in aircraft deliveries. Intangible Assets-Subsidiaries The excess of purchase price over fair value of net assets related to previous acquisitions is recorded as an intangible asset and is being amortized over 40 years. Accumulated amortization at December 31, 1993 and 1992 was $15 million and $12.9 million, respectively. Deferred Income Deferred income results from the sale and leaseback of aircraft, manufacturer or vendor credits related to aircraft, and sale of foreign tax benefits. Income is reported on the Statement of Income over the term of the applicable agreements or asset useful life. Passenger Revenues Passenger revenues are considered earned at the time transportation service is provided. Tickets sold but not yet used are included in air traffic liability. Frequent Flyer Awards Alaska operates a frequent flyer award program that provides travel awards to members based on accumulated mileage. The estimated incremental cost of providing free travel is recognized as a liability and reported as expense as miles are accumulated. Alaska also defers recognition of income on a portion of the payments it receives from travel partners associated with its frequent flyer program. The incremental cost liability and deferred partner revenues are relieved as travel awards are used. Income Taxes In January 1992, Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes," was adopted. FAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Earnings Per Share Primary earnings per share is calculated by dividing net income after reduction for preferred stock dividends by the average number of common shares and dilutive common equivalent shares outstanding, net of treasury shares. Common equivalent shares result from the assumed exercise of stock options. Fully diluted earnings per share gives effect to the conversion of convertible debentures and notes (after elimination of related interest expense, net of income tax effect) and redeemable preferred stock. Reclassifications Certain reclassifications have been made in prior years' financial statements to conform to the 1993 presentation. Note 2. Marketable Securities and Other Assets Marketable securities are investments that are readily convertible to cash, but whose original maturity dates exceed three months. The securities are carried at cost, which approximates fair value. Marketable securities consisted of the following at December 31 (in thousands): 1993 1992 U.S. government securities $66,744 $72,658 Other 7,226 3,893 $73,970 $76,551 Other assets consisted of the following at December 31 (in thousands): 1993 1992 Restricted deposits $60,903 $56,858 Leasehold rights 16,923 24,195 Deferred costs 16,938 16,159 Interest receivable 7,683 - $102,447 $97,212 At December 31, 1993 and 1992, the fair value of restricted deposits was approximately $75 million and $63 million, respectively, based on market prices of similar investments. At December 31, 1993, the fair value of interest receivable from a financial institution under an interest rate swap agreement was approximately $7 million. Purchased leasehold rights and deferred costs are amortized over the term of the related lease or contract. Deferred costs include capitalized training costs associated with the B737-400 aircraft. These costs are amortized over a five-year period beginning April 1992. Note 3. Long-Term Debt and Capital Lease Obligations At December 31, 1993 and 1992, long-term debt and capital lease obligations were as follows (in thousands): 1993 1992 7.1%* notes payable due through 2009 $308,700 $305,692 7-3/4% convertible subordinated debentures due 2005-2010 14,638 14,638 6-7/8% convertible subordinated debentures due 2002-2014 60,181 66,614 7-1/4% zero coupon, convertible subordinated notes due 2006 143,754 133,873 Long-term debt 527,273 520,817 Capital lease obligations 33,720 35,470 Less current portion (35,575) (68,440) $525,418 $487,847 * Weighted average for 1993 Borrowings of $286.2 million are secured by flight equipment and real property. The 7-3/4% and 6-7/8% debentures are convertible into common stock at $28.25 and $33.60 per share, respectively, subject to adjustments in certain events. Each of the 7-1/4% notes can be converted into 12.4 shares of common stock. The holder of these notes has a put option to require the Company to purchase each note on April 18, 1996 for $490.58. The Company may elect to pay in cash or shares of common stock or in any combination thereof. Alaska has $70 million in lines of credit with commercial banks including a new $20 million line obtained in June 1993. Credit advances carry variable interest rates based on LIBOR. At December 31, 1993, there were no borrowings under these lines of credit. Certain Alaska loan agreements contain provisions that require maintenance of specific levels of net worth, leverage and fixed charge coverage, and limit dividends, investments, lease obligations, sales of assets and additional indebtedness. At December 31, 1993, under the most restrictive loan provisions, Alaska had $27.3 million of excess net worth and its cash dividend payments to Air Group were limited to $19 million. During 1993, the Company entered into an interest rate swap agreement to reduce the interest expense on its 7-1/4% zero-coupon notes. The agreement, which expires in 1996, effectively changes the Company's interest rate on the notes from a fixed 7-1/4% to a floating rate based on LIBOR. At December 31, 1993, long-term debt obligations for the next five years were (in thousands): 1994 $33,734 1995 $33,104 1996* $29,615 1997 $26,321 1998 $27,282 * Excludes the effect of a put option on the 7-1/4% notes. At December 31, 1993 and 1992, the fair value of long-term debt was approximately $521 million and $494 million, respectively, based on quoted market prices for the same or similar debt or on the current rates offered to the Company for debt of comparable remaining maturities. Note 4. Redeemable Preferred Stock Air Group has 5,000,000 shares of preferred stock authorized. During 1990, the Company sold 1,187,500 shares of voting, convertible Series B Cumulative Redeemable Preferred Stock (preferred stock) to International Lease Finance Corporation (ILFC), which paid $50 per share and received the dividend and voting rights. A management group purchased nontransferable investment options for $2.63 per share and received the rights to purchase and convert the preferred stock to common stock. In May 1993, the Company repurchased the preferred stock from ILFC for $60.4 million, which included a $1.0 million early redemption premium. At December 31, 1993, the 1,187,500 shares of preferred stock are held in treasury and remain subject to the investment options. The investment options of $3.1 million remain outstanding, are subject to mandatory redemption in January 1997 and are included with other liabilities on the Balance Sheet. Each share of preferred stock is convertible into common stock at $27 per share, subject to adjustments in certain events. A total of 2,314,815 shares of common stock has been reserved for such conversion. In the event of a change in control of the Company, all outstanding investment options become exercisable. The holders of the preferred stock have the right to require the Company to redeem such shares. Note 5. Commitments Lease Commitments Lease contracts for 101 aircraft have remaining lease terms of one to 19 years. The majority of airport and terminal facilities are also leased. Total rent expense was $180.4 million, $149.7 million and $124 million, in 1993, 1992 and 1991, respectively. Future minimum lease payments under capital leases and long-term operating leases as of December 31, 1993 are shown below (in thousands): Capital Leases Operating Leases Total Real Property Aircraft & Other 1994 $ 4,145 $ 163,830 $ 14,745 $ 182,720 1995 4,143 152,090 13,069 169,302 1996 4,146 141,502 11,150 156,798 1997 4,140 128,217 9,987 142,344 1998 4,138 121,969 9,611 135,718 Thereafter 23,203 581,209 47,421 651,833 Total lease payments 43,915 $1,288,817 $105,983 $1,438,715 Less amount representing interest 10,195 Present value of capital lease payments $33,720 Aircraft Commitments The Company has firm orders for 40 aircraft. The aircraft on order consist of: six B737-400s to be delivered during 1994; 18 Dornier 328s to be delivered between 1994 and 1998; six MD-80s to be delivered during 1994 and 1995; and ten MD90-30s to be delivered during 1996 and 1997. The total amount of these commitments is approximately $1.1 billion. As of December 31, 1993, deposits related to the future equipment deliveries were $66.3 million. Operating lease agreements are completed for six B737-400s being delivered during 1994 and Dornier has agreed to provide lease financing for all of the Dornier 328s. In addition to the ordered aircraft, the Company holds purchase options on 20 MD90-30s, 40 Dornier 328s, and lease options on four B737-400s. Note 6. Stock Option Plans Air Group has three stock option plans, which provide for the purchase of Air Group common stock at its market price on the date of grant by certain officers and key employees of Air Group and its subsidiaries. Under the plans, the incentive and nonqualified stock options granted have terms of up to approximately ten years. Up to half of the options provide for stock appreciation rights. Changes in the number of shares subject to option are summarized as follows: 1993 1992 1991 Outstanding, beginning of year 770,420 885,720 923,816 Granted(a) 172,200 43,100 54,100 Exercised (12,600) (98,400) (61,353) Surrendered - - (6,593) Canceled (68,658) (60,000) (24,250) Outstanding, end of year 861,362 770,420 885,720 Exercisable, end of year(b) 542,012 450,845 395,143 Available for granting in future periods 701,867 805,409 138,509 Average price of options: Exercised during the year $14.65 $14.89 $13.72 Outstanding at year-end $17.06 $17.32 $17.02 (a) The average price of the options granted in 1993 was $16.34. (b) Options exercisable at year end 1993 expire between July 1994 and December 2002. Note 7. Employee Benefit Plans Four defined benefit and six defined contribution retirement plans cover various employee groups of Air Group and its subsidiaries. The defined benefit plans provide benefits based on an employee's term of service and average compensation for a specified period of time before retirement. Contributions for the defined contribution plans are based on a percentage of participants' earnings. Pension costs are funded as required by the Employee Retirement Income Security Act of 1974 (ERISA). Alaska and Horizon also maintain an unfunded, noncontributory benefit plan for certain elected officers. The present value of unfunded benefits for these plans was accrued as of December 31, 1993. Net pension expense for the defined benefit plans included the following components for 1993, 1992 and 1991 (in thousands): 1993 1992 1991 Service cost (benefits earned during the period) $10,041 $8,395 $7,333 Interest cost on projected benefit obligation 10,449 8,883 7,984 Actual return on assets (14,123) (9,079) (17,501) Net amortization and deferral 2,244 (2,171) 9,779 Net pension expense $8,611 $6,028 $7,595 The actuarial present value of the projected benefit obligation for 1993, 1992 and 1991 was calculated using weighted average discount rates of 7.9%, 8.75% and 9.0%, respectively. The calculation assumed a 10% long-term rate of return on assets in 1993 and 1992 and a 9.5% rate in 1991. The calculation also assumed a 5.2% weighted average rate of increase for future compensation levels for 1993 and 1992 and 7.7% for 1991. The defined benefit plan assets are primarily invested in common stocks and fixed income securities. Plan assets exceeded liabilities for accumulated plan benefits at December 31, 1993 and 1992. The following table sets forth the funded status of the plans at December 31, 1993 and 1992 (in thousands): 1993 1992 Benefit obligation - Vested $126,341 $92,846 Nonvested 12,687 9,539 Accumulated benefit obligation $139,028 $102,385 Plan assets at fair value $145,974 $116,380 Projected benefit obligation 159,529 117,556 Plan assets less projected benefit obligation (13,555) (1,176) Unrecognized net assets at year-end amortized over 13 years (1,658) (1,941) Unrecognized prior service cost 1,576 988 Unrecognized loss 26,684 5,702 Prepaid pension cost $13,047 $3,573 Total expense for all retirement plans, including the defined contribution plans, officer benefit plans and Company 401(k) matching contributions, was $19.8 million, $18.8 million and $16.3 million, respectively, in 1993, 1992 and 1991. Alaska and Horizon have employee profit sharing plans. Distributions for 1993, 1992 and 1991 were $2.3 million, $1.6 million and $1.6 million, respectively. Certain employee benefit plans (Plans) have an Employee Stock Ownership Plan (ESOP) feature. The ESOPs own Air Group common shares which are held in trust for eligible employees. The Company has recorded deferred compensation to reflect the value of the shares not yet allocated to eligible employees' accounts. As these shares are allocated to employees, compensation expense is recorded and deferred compensation is reduced. The Company allows retirees to continue their medical, dental and vision benefits by paying the respective active employee plan premium until age 65. This results in a subsidy to retirees because the premiums paid are less than the actual cost of the retirees' claims. Effective January 1, 1992, Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," was adopted. The cumulative effect of the accounting change for years prior to January 1, 1992 was an after-tax charge of $4.6 million. The new accounting standard requires the cost of postretirement employee benefits other than pensions be recognized during employees' active service period. Prior to 1992, the cost of these benefits was expensed as claims were incurred. The following table sets forth the status of the postretirement benefit obligation at December 31, 1993 and 1992 (in thousands): 1993 1992 Accumulated postretirement benefit obligation (APBO): Retirees $309 $259 Active plan participants eligible for retirement 2,193 1,943 Active plan participants not eligible for retirement 6,391 6,402 Unrecognized prior service cost (381) - Unrecognized actuarial gain 980 - Accrued postretirement benefit cost $9,492 $8,604 The Company's APBO is unfunded. Net annual postretirement benefit costs for 1993 and 1992 include the following components (in thousands): 1993 1992 Service cost - benefits attributed to service during the period $655 $855 Interest on APBO 591 643 Net amortization and deferral (38) _ Net postretirement benefit cost $1,208 $1,498 A 12.5% health care cost trend rate was assumed for 1994; the rate was assumed to decrease by 1% annually to 6% for 2001 and remain at that level thereafter. Increasing the rate by 1 percentage point in each year would increase the APBO as of December 31, 1993 by $1.1 million and the net periodic postretirement benefit cost for 1993 by $222,000. The weighted-average discount rates used in determining the APBO for 1993 and 1992 were 7.9% and 9%, respectively. Note 8. Special Charges Results for 1993 and 1992 include special charges of $15 million and $26 million, respectively, to recognize an impairment of the value of the Boeing B727 fleet. The special charges include reserves for future excess lease costs and the write-down of capitalized overhauls and spare parts to net realizable value. The 1993 charge reflects the Company's intent, at the end of 1993, to retire this aircraft type by May 1994. The 1992 charge reflected the Company's intent, at the end of 1992, to retire this aircraft type by the end of 1994 rather than 1996. Note 9. Income Taxes The components of income tax expense (credit) were as follows (in thousands): 1993 1992 1991 Current tax expense (credit): Federal $(4,907) $(21,057) $4,637 State (253) (1,714) 507 Total current (5,160) (22,771) 5,144 Deferred tax expense (credit): Federal (8,164) (19,451) 561 State (1,570) (3,214) 164 Total deferred (9,734) (22,665) 725 Total before accounting change (14,894) (45,436) 5,869 Deferred income tax credit cumulative effect of FAS 106 - (2,613) - Total tax expense (credit) $(14,894) $(48,049) $5,869 The actual income tax expense (credit) reported differs from the "expected" tax expense (credit) (computed by applying the federal corporate tax rate of 35% for 1993 and 34% for 1992 and 1991) as follows (in thousands): 1993 1992 1991 Income (loss) before income tax $(45,812) $(125,706) $16,207 Computed "expected" tax expense (credit) $(16,035) $(42,740) $5,510 Nondeductible expense 1,210 1,068 1,116 Federal rate change 1,016 - - Tax-exempt interest income - (170) (327) State income tax (1,185) (3,252) 568 Other - net 100 (342) (998) Actual tax expense (credit) $(14,894) $(45,436) $5,869 Effective tax rate 33% 36% 36% Deferred income taxes result from temporary differences in the recognition of revenue and expense for tax and financial reporting purposes. The major sources of deferred tax liabilities (assets) are comprised of the following at December 31 (in thousands): 1993 1992 1991 Excess of tax over book depreciation $88,203 $94,835 $75,374 Training expense 3,167 1,953 (59) Capitalized leases 3,681 2,943 2,274 Other - net 358 2,212 613 Gross deferred tax liabilities 95,409 101,943 78,202 Loss carryforward (43,798) (24,573) - Alternative minimum tax (16,346) (22,931) (11,925) Pricing adjustment (1,083) (3,018) (1,002) Travel awards (5,576) (5,872) (4,361) Employee benefits (9,567) (8,761) (9,700) Aircraft maintenance (8,231) (8,282) 79 Gain on sale of assets (2,125) (10,090) (7,599) Gross deferred tax assets (86,726) (83,527) (34,508) Net deferred tax liabilities $8,683 $18,416 $43,694 The 1993 tax net operating loss (NOL) benefit of $21 million will be carried forward to offset taxes in future years. $7 million of alternative minimum tax was carried back to recover taxes paid in prior years. Note 10. Business Segment Information Financial information for the Company's national airline (Alaska) and regional airline (Horizon) follows (in thousands): 1993 1992 1991 Operating revenues from unaffiliated customers: Alaska $906,806 $908,286 $921,519 Horizon $223,333 $208,149 $183,142 Operating income (loss): Alaska $(24,313) $(101,013) $28,283 Horizon $8,757 $7,305 $7,897 Total assets: Alaska $1,037,546 $1,088,090 $1,103,289 Horizon $141,940 $147,076 $149,286 Depreciation and amortization expense: Alaska $48,953 $47,140 $41,917 Horizon $9,276 $9,564 $9,840 Capital expenditures: Alaska $21,116 $258,556 $186,857 Horizon $8,800 $16,389 $26,554 Note 11. Fuel Hedge Agreement The Company has a jet fuel hedge agreement that establishes a high- end fuel price and a low-end fuel price through December 1994. The agreement covers 30 million gallons per quarter which is less than each quarter's expected fuel requirement. The Company will record income or loss quarterly if the average cost of fuel, as determined by an index, exceeds the high-end fuel price or falls below the low- end price, respectively. CONDENSED FINANCIAL INFORMATION Alaska Air Group, Inc. (Parent Company Only) Schedule III BALANCE SHEET As of December 31 (In Thousands) 1993 1992 ASSETS Current Assets Cash $38 $98 Receivables from subsidiaries 77,390 90,847 Income tax receivable 7,623 20,283 Other current assets 1,205 187 Total Current Assets 86,256 111,415 Other Assets Investment in subsidiaries 353,707 378,496 Interest receivable 7,683 - Other 5,118 4,614 366,508 383,110 Total Assets $452,764 $494,525 LIABILITIES AND CAPITAL Current Liabilities Accounts payable and accrued liabilities $2,002 $687 Payable to subsidiaries 47,025 24,663 Current portion of long-term debt 9,000 - Total Current Liabilities 58,027 25,350 Long-Term Debt 7-3/4% convertible subordinated debentures due 2005-2010 14,638 14,638 6-7/8% convertible subordinated debentures due 2002-2014 60,181 66,614 7-1/4% zero coupon, convertible subordinated notes due 2006 143,754 133,873 7% term note; $2,250,000 payable quarterly beginning August 1993 13,500 - 232,073 215,125 Deferred Income Taxes (7,236) (3,909) Other Liabilities 3,067 - Redeemable Preferred Stock - 61,235 Shareholders' Equity Common stock, par value $1 per share Authorized: 30,000,000 shares Issued: 1993 - 16,495,210 shares; 1992 - 16,482,610 shares 16,495 16,483 Capital in excess of par value 152,017 151,845 Treasury stock, at cost (1993 - 3,153,589 shares; 1992 - 3,153,576 shares) (71,807) (71,807) Deferred compensation (5,813) (10,181) Retained earnings 75,941 110,384 166,833 196,724 Total Liabilities and Capital $452,764 $494,525 This schedule should be read in conjunction with the Consolidated Financial Statements and Notes thereto. CONDENSED FINANCIAL INFORMATION Alaska Air Group, Inc. (Parent Company Only) Schedule III STATEMENT OF INCOME Year Ended December 31 (In Thousands) 1993 1992 1991 Operating Revenues $ - $ - $ - Operating Expenses 1,391 1,442 1,613 Operating Loss (1,391) (1,442) (1,613) Other Income (Expense) Interest income from subsidiaries 5,435 5,714 5,355 Other interest income - - 1,015 Interest expense to subsidiaries - - (140) Other interest expense (14,024) (14,917) (12,518) Other - net 451 (321) 1,399 (8,138) (9,524) (4,889) Loss before income tax credit and subsidiaries' earnings (9,529) (10,966) (6,502) Income tax credit (3,400) (3,613) (2,444) (6,129) (7,353) (4,058) Earnings (Loss) - Subsidiaries (24,789) (77,484) 14,396 Net Income (Loss) $(30,918) $(84,837) $10,338 This schedule should be read in conjunction with the Consolidated Financial Statements and Notes thereto. CONSOLIDATED SHORT-TERM BORROWINGS Schedule IX Alaska Air Group, Inc. Maximum Average Weighted Category Weighted Amount Amount Average of Aggregate Balance Average Outstanding Outstanding Interest Rate Short-Term at End Interest During the During the During the Borrowings of Year Rate Year Year (1) Year (2) (Dollars in Thousands) Notes Payable: 1993 $20,000 4.25% $20,000 $ 1,538 4.25% 1992 $ - - $46,303 $ 7,408 4.6% 1991 $ - - $62,954 $24,517 7.3% (1) Computed by dividing the sum of the beginning of the year balance and the 12 month-end balances by 13. (2) Computed by dividing annual interest expense by the weighted average amount outstanding during the year. CONDENSED FINANCIAL INFORMATION Alaska Air Group, Inc. (Parent Company Only) Schedule III STATEMENT OF CASH FLOWS Year Ended December 31 (In Thousands) 1993 1992 1991 Cash at beginning of year $98 $3 $27,432 Cash flows from operating activities: Net income (loss) (30,918) (84,837) 10,338 Adjustment to reconcile net income to cash: Undistributed loss (earnings) of subsidiaries 24,789 77,484 (14,396) Gain on retirement of debt (964) - (1,652) Decrease in deferred income taxes (3,327) (3,639) (549) Decrease (increase) in receivables 26,117 (7,817) (77,013) Decrease (increase) in other current assets (1,018) 174 (2,450) Increase in current liabilities 23,677 11,728 7,385 Interest on zero coupon notes 9,881 9,203 6,125 Other-net (6,836) (16) (72) Net cash provided by (used in) operating activities 41,401 2,280 (72,284) Cash flows from investing activities: Purchases of marketable securities - - (162,326) Sales and maturities of marketable securities - - 182,257 Restricted deposits - - 4,298 Payments received on loans to ESOPs 4,128 4,747 3,402 Net cash provided by investing activities 4,128 4,747 27,631 Cash flows from financing activities: Loan payments from subsidiaries - - 9,000 Proceeds from issuance of long-term debt - - 114,742 Long-term debt payments (10,933) - (11,436) Proceeds from issuance of common stock 184 1,466 842 Repurchase of preferred stock (33,375) - - Acquisition of treasury stock - - (206) Cash dividends (2,429) (8,398) (9,026) Gain on retirement of debt 964 - 1,652 Investment in subsidiary - - (88,344) Net cash provided by (used in) financing activities (45,589) (6,932) 17,224 Net increase (decrease) in cash (60) 95 (27,429) Cash at end of year $38 $98 $3 Supplemental disclosure of cash paid during the year for: Interest (net of amount capitalized) $10,237 $14,880 $12,727 Income taxes - 1,119 9,325 Noncash investing and financing activities: 1993 - The preferred stock was repurchased in exchange for a $27 million note payable and a $33.4 million cash payment. 1992 and 1991 - None This schedule should be read in conjunction with the Consolidated Financial Statements and Notes thereto. CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Schedule X Alaska Air Group, Inc. Charged to costs and expenses Year Ended December 31 (In Thousands) 1993 1992 1991 Aircraft maintenance $67,438 $87,687 $82,983 Depreciation and amortization of intangible assets, preoperating costs and similiar deferrals * * * Taxes, other than payroll and income taxes $13,417 $12,881 $10,101 Royalties * * * Advertising and promotion $17,046 $34,179 $32,021 * Less than 1% of total revenues. EXHIBIT INDEX Certain of the following exhibits are filed herewith. Certain other of the following exhibits have heretofore been filed with the Commission and are incorporated herein by reference from the document described in parenthesis. 3.(i) Certificate of Incorporation of Alaska Air Group, Inc. as amended through May 20, 1987 (Exhibit 3-01 to 1987 10-K). 3.(ii) Bylaws of Alaska Air Group, Inc., as amended through September 14, 1993. 4.1 Indenture dated June 15, 1985, between Alaska Airlines, Inc. and Bankamerica Trust Company of New York, including form of Debenture (Exhibit 4-02 to Registration Statement No. 2-98555). 4.2 Rights Agreement dated as of December 2, 1986 between Alaska Air Group, Inc. and The First National Bank of Boston, as Rights Agent (Exhibit No. 1 to Form 8A filed December 12, 1986). 10.1 Lease and Assignment of Sublease Agreement dated February 1, 1979 between Alaska Airlines, Inc. and the Alaska Industrial Development Authority (Exhibit 10-15 to Registration Statement No. 2-70742). 10.2 Lease and Assignment and Sublease Agreement dated April 1, 1978 between Alaska Airlines, Inc. and the Alaska Industrial Development Authority (Exhibit 10-16 to Registration Statement No. 2-70742). 10.3 Alaska Air Group, Inc. 1975 Stock Option Plan, as amended through May 7, 1991. 10.4 Management Incentive Plan (1992 Alaska Air Group, Inc. Proxy Statement). 10.5 Loan Agreement dated as of December 1, 1984, between Alaska Airlines, Inc. and the Industrial Development Corporation of the Port of Seattle (Exhibit 10-38 to 1984 10-K). 10.6 Amended and Restated Credit Agreement dated as of April 1, 1986 between Alaska Airlines, Inc. and The Long Term Credit Bank of Japan (Exhibit 10-28 to 1986 10-K). 10.7 Alaska Air Group, Inc. 1984 Stock Option Plan, as amended through May 7, 1992. 10.8 Supplemental retirement plan arrangement between Horizon Air Industries, Inc. and John F. Kelly (1992 Alaska Air Group, Inc. Proxy Statement). 10.9 Alaska Air Group, Inc. 1988 Stock Option Plan, as amended through May 19, 1992 (Registration Statement No. 33- 523242). 10.10 Purchase Agreement between McDonnell Douglas Corporation and Alaska Airlines, Inc. DAC 88-36-D, dated October 14, 1988 (Exhibit 10-17 to 1988 10-K). 10.11 Capital Performance Plan (Exhibit 4.3 to Registration Statement 33-33087). #10.12 Purchase Agreement dated March 30, 1990 between McDonnell Douglas Corporation and Alaska Airlines, Inc. for the purchase of up to 40 MD90-30 aircraft (Exhibit 10-13 to 1990 10-K) #10.13 Lease Agreement dated January 22, 1990 between International Lease Finance Corporation and Alaska Airlines, Inc. for the lease of a B737-400 aircraft, summaries of 19 substantially identical lease agreements for 19 additional B737-400 aircraft and Letter Agreement #1 dated January 22, 1990 (Exhibit 10-14 to 1990 10-K) #10.16 Purchase Agreement dated as of May 15, 1991, between Horizon Air Industries, Inc. and Dornier Luftfahrt GmbH for the purchase of up to 60 Dornier 328 aircraft (Exhibit 10-19 to May 30, 1991 8-K). #10.17 Amendment dated as of June 25, 1993 to the Purchase Agreement dated as of May 15, 1991, between Horizon Air Industries, Inc. and Dornier Luftfahrt GmbH for the purchase of up to 60 Dornier 328 aircraft (Exhibit 10-19a to Second Quarter 1993 10-Q). 11 Computation of Earnings Per Common Share. 12 Calculation of Ratio of Earnings to Fixed Charges and Preferred Dividends. 21 Subsidiaries of the Registrant (Exhibit 22-01 to 1987 10- K). 23 Consent of Arthur Andersen & Co. * Filed herewith. # Confidential treatment was granted as to a portion of this document.	12,296	80,686
73945_1993.txt	73945_1993	1993	73945	Item 1. Business General The Ohio Bell Telephone Company (the "Company") is a close corporation incorporated under the laws of the State of Ohio and has its principal executive offices at 45 Erieview Plaza, Cleveland, Ohio 44114 (telephone number 216-822-9700). The Company is a wholly owned subsidiary of Ameritech Corporation ("Ameritech"), a Delaware corporation. Ameritech is the parent of the Company, Illinois Bell Telephone Company, Indiana Bell Telephone Company, Incorporated, Michigan Bell Telephone Company and Wisconsin Bell, Inc. (the "landline telephone companies"), as well as several other communications businesses, and has its principal executive offices at 30 South Wacker Drive, Chicago, Illinois 60606 (telephone number 312-750-5000). In 1993, Ameritech restructured its landline telephone companies and two other related businesses into a structure of customer-specific business units supported by a single, regionally coordinated network unit. The five Bell companies continue to function as legal entities, owning Bell company assets in each state and continue to be regulated by the individual state public utility commissions. Products and services are now marketed under a single common brand identity, "Ameritech," rather than using the "Bell" name. In November 1993, the Company registered two trade names with the Ohio Secretary of State, "Ameritech" and "Ameritech Ohio." The Company is engaged in the business of furnishing a wide variety of advanced telecommunications services in Ohio, including local exchange and toll service and network access services. In accordance with the Consent Decree and resulting Plan of Reorganization ("Plan") described below, the Company provides two basic types of telecommunications services within specified geographical areas termed Local Access and Transport Areas ("LATAs"), which are generally centered on a city or other identifiable community of interest. The first of these services is the transporting of telecommunications traffic between telephones and other equipment on customers' premises located within the same LATA ("intraLATA service"), which can include toll service as well as local service. The second service is providing exchange access service, which links a customer's telephone or other equipment to the network of transmission facilities of interexchange carriers which provide telecommunications service between LATAs ("interLATA service"). About three-fifths of the population and one-quarter of the area of Ohio is served by the Company. The remainder of the State is served by other local telecommunications companies. On December 31, 1993, the Company had approximately 3,481,000 customer lines in service. About four-fifths of the Company's customer lines in service are in or adjacent to six cities having populations in excess of 95,000, including the metropolitan area of Cleveland, where about 30% of the Company's customer lines are located. Other communications services offered by the Company include data transmission, transmission of radio and television programs and private line voice and data services. The following table sets forth for the Company the number of customer lines in service at the end of each year. Thousands 1993 1992 1991 1990 1989 Customer Lines in Service..... 3,481 3,380 3,314 3,268 3,214 The Company has an agreement with Ameritech Publishing, Inc. ("Ameritech Publishing"), an Ameritech business unit doing business as "Ameritech Advertising Services," under which Ameritech Publishing publishes and distributes classified directories under a license from the Company and provides services to the Company relating to both classified and alphabetical directories. Ameritech Publishing pays license fees to the Company under the agreement. Ameritech Services, Inc. ("ASI") is a company jointly owned by the Company and the other Ameritech landline telephone companies. ASI provides to those companies human resources, technical, marketing, regulatory planning and real estate asset management services, purchasing and material management support, as well as labor contract bargaining oversight and coordination. ASI acts as a shared resource for the Ameritech subsidiaries providing operational support for the landline telephone companies and integrated communications and information systems for all the business units. Ameritech Information Systems, Inc., a subsidiary of Ameritech, sells, installs and maintains business customer premises equipment and sells network and central office-based services provided by the Company and the other four landline telephone companies. It also provides expanded marketing, product support and technical design resources to large business customers in the Ameritech region. In 1993, about 91% of the total operating revenues of the Company were from telecommunications services and the remainder principally from billing and collection services, rents, directory advertising and miscellaneous nonregulated operations. About 75% of the revenues from telecommunications services were attributable to intrastate operations. Capital Expenditures Capital expenditures represent the single largest use of Company funds. The Company has been making and expects to continue to make large capital expenditures to meet the demand for telecommunications services and to further improve such services. The total investment in telecommunications plant increased from about $4,727,000,000 at December 31, 1988, to about $5,602,000,000 at December 31, 1993, after giving effect to retirements but before deducting accumulated depreciation at either date. Capital expenditures of the Company since January 1, 1989 were approximately as follows: 1989.................$361,000,000 1992...............$356,000,000 1990..................381,000,000 1993...............$327,000,000 1991..................282,000,000 Expanding on the aggressive deployment plan it began in 1992, in January 1994, Ameritech unveiled a multi-billion dollar plan for a digital network to deliver video services. Ameritech is launching a digital video network upgrade that by the end of the decade will enable six million customers in its region to access interactive information and entertainment services, as well as traditional cable TV services, from their homes, schools, offices, libraries and hospitals. The Company, for its part in the network upgrade has made an initial filing with the FCC seeking approval of the program. The filing reflects capital expenditures of approximately $83,000,000 over the next three years. The video network concept, along with other competitive concerns, is discussed on Page 10. The Company may also, depending on market demand, make additional capital expenditures under the digital video network upgrade program. The Company anticipates that its capital expenditures for the program will be funded without increasing its recent historical level of capital expenditures. Capital expenditures are expected to be about $261,000,000 in 1994. This amount excludes any capital expenditures that may occur in 1994 related to the above described video network upgrade program. Consent Decree and Line of Business Restrictions On August 24, 1982, the United States District Court for the District of Columbia ("Court") approved and entered a consent decree entitled "Modification of Final Judgment" ("Consent Decree"), which arose out of antitrust litigation brought by the Department of Justice ("DOJ"), and which required American Telephone and Telegraph Company ("AT&T") to divest itself of ownership of those portions of its wholly owned Bell operating communications company subsidiaries ("Bell Companies") that related to exchange telecommunications, exchange access and printed directory advertising, as well as AT&T's cellular mobile communications business. On August 5, 1983, the Court approved a Plan of Reorganization ("Plan") outlining the method by which AT&T would comply with the Consent Decree. Pursuant to the Consent Decree and the Plan, effective January 1, 1984, AT&T divested itself of, by transferring to Ameritech, one of the seven regional holding companies ("RHCs") resulting from divestiture, its ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech landline telephone companies, as well as its regional cellular mobile communications business. The Consent Decree, as originally approved by the Court in 1982, provided that the Company (as well as the other Bell Companies) could not, directly or through an affiliated enterprise, provide interLATA telecommunications services or information services, manufacture or provide telecommunications products or provide any product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff. The Consent Decree allowed the Company and the other Bell Companies to provide printed directory advertising and to provide, but not manufacture, customer premises equipment. The Consent Decree provided that the Court could grant a waiver to a Bell Company or its affiliates upon a showing to the Court that there is no substantial possibility that the Bell Company could use its monopoly power to impede competition in the market it seeks to enter. The Court has, from time to time, granted waivers to the Company and other Bell Companies to engage in various activities. The Court's order approving the Consent Decree provided for periodic reviews of the restrictions imposed by it. Following the first triennial review, in decisions handed down in September 1987 and March 1988, the Court continued the prohibitions against Bell Company manufacturing of telecommunications products and provision of interLATA services. The rulings allowed limited provision of information services by transmission of information and provision of information gateways, but excluded generation or manipulation of information content. In addition, the rulings eliminated the need for a waiver for entry into non-telephone related businesses. In April 1990, a Federal appeals court affirmed the Court's decision continuing the restriction on Bell Company entry into interLATA services and the manufacture of telecommunications equipment, but directed the Court to review its ruling that restricted RHC involvement in the information services business and to determine whether removal of the information services restriction would be in the public interest. In July 1991, the Court lifted the information services ban but stayed the effect of the decision pending outcome of the appeals process. Soon after the stay was lifted on appeal and in July 1993, the U.S. Court of Appeals unanimously upheld the Court's order allowing the Bell Companies to produce and package information for sale across business and home phone lines. In November 1993, the U.S. Supreme Court declined to review the lower court ruling. Members of Congress and the White House are intensifying efforts to enact legislative reform of telecommunications policy in order to stimulate the development of a modern national information infrastructure to bring the benefits of advanced communications and information services to the American people. Intrastate Rates and Regulation The Company, in providing telecommunications services, is subject to regulation by The Public Utilities Commission of Ohio (the "PUCO") with respect to intrastate rates and services, depreciation rates (for intrastate services), issuance of securities and other matters. Compensation required in connection with origination and termination of intrastate telecommunications by interexchange carriers is subject to the jurisdiction of the PUCO. The Company currently provides access service to interexchange carriers authorized by the PUCO to provide service within and between the Company's LATAs pursuant to tariffs which generally parallel the interstate access tariffs; however, the PUCO has not implemented intrastate subscriber line charges. Compensation between the Company and independent telephone companies for jointly provided telecommunications within the Company's LATAs is also subject to the jurisdiction of the PUCO. Such compensation is covered by contractual arrangements generally based on access charge levels. A prior pooling arrangement set up by the PUCO was terminated in 1987 and the current rate structures and contracts referenced above were put into effect in 1987 and 1988. In 1989, the PUCO provided instructions for final distribution of remaining pool funds. Final distribution of the pool funds has not yet been ordered. A complaint brought against the Company by Allnet Communications Services, Inc. relating to access charges was dismissed by the PUCO and is currently pending at the Ohio Supreme Court. Allnet claims that the Company's access charges are too high and that the Company is discriminating in favor of itself by failing to provide intraLATA presubscription, also known as Dial One Plus. In late 1992 and early 1993, the PUCO gave the Company approval to offer certain Integrated Services Digital Network ("ISDN") based services pursuant to tariff. ISDN is a network technology that allows simultaneous transmission of voice, data and video signals over one access line. On February 16, 1993, the PUCO issued an order setting forth its collocation policy for intrastate services as provided in a September 1992 Report and Order of the Federal Communications Commission ("FCC") on expanded interconnection (See "Competition"). The PUCO determined that in Ohio large telecommunications companies, including the Company, would be permitted to negotiate collocation arrangements based on the unique circumstances of each request, rather than follow the FCC's physical collocation requirement. These arrangements must be submitted to the PUCO for approval. One party sought rehearing of the PUCO order, which was denied in April 1993. On June 30, 1993, the Company filed with the PUCO its application for alternative regulation, called Advantage Ohio, under rules adopted by the PUCO in January 1993. The application includes, among other things, the replacement of rate of return regulation with a price cap mechanism. Under the price cap mechanism, future rate changes would be subject to a formula based on inflation, the Company's historic productivity, and service quality. The application also proposes to cap basic business and residential rates for three years. A significant commitment to invest in the communications infrastructure is also proposed. In March 1994, the Staff of the PUCO issued a Report of Investigation of the Company's application. The Company will file objections and rebuttal testimony to the Staff Report prior to hearings on the Company's application which are expected to take place beginning in May 1994. See Item 7, Management's Discussion and Analysis of Results of Operations, for further description. On April 6, 1993, the Office of Consumers' Counsel (the "OCC") filed a complaint against the Company with the PUCO alleging that the Company is earning in excess of the return established in its last rate case and that the Company's return should be reduced. The PUCO denied the Company's motion to dismiss and ordered that the case should proceed to hearing. The PUCO consolidated the complaint case with the Company's alternative regulation case, Advantage Ohio, for hearing. Hearings on the complaint case are expected to begin in May 1994. See Item 7, Managements Discussion and Analysis of Results of Operations, for further description. In an order issued in September 1993, the PUCO authorized the Company to institute new toll rate schedules which reflect rates lower for communications traffic within the Company's serving areas than for communications traffic between the Company's and independent local exchange companies' serving areas. FCC Regulatory Jurisdiction The Company is also subject to the jurisdiction of the FCC with respect to intraLATA interstate services, interstate access services and other matters. The FCC prescribes for communications companies a uniform system of accounts apportioning costs between regulated and nonregulated services, depreciation rates (for interstate services) and the principles and standard procedures ("separations procedures") used to separate property costs, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to services under the jurisdiction of the respective state regulatory authorities. The Company's interstate services regulated by the FCC are covered by a price cap plan. The plan creates incentives to improve productivity over benchmark levels in order to retain higher earnings. Price cap regulation sets maximum limits on the prices that may be charged for telecommunications services but also provides for a sharing of productivity gains. Earnings in excess of 12.25% will result in prospective reduction to the price ceilings on interstate services. In January 1994, the FCC began a scheduled fourth-year comprehensive review of price cap regulation. Interstate Access Charges The Ameritech landline telephone companies provide access services for the origination and termination of interstate telecommunications. The access charges are of three types: common line, switched access and trunking. The common line portion of interstate revenue requirements are recovered through monthly subscriber line charges and per minute carrier common line charges. The carrier common line rates include recovery of transitional and long-term support payments for distribution to other local exchange carriers. Transitional support payments were made over a four-year period which ended on April 1, 1993. Long-term support payments will continue indefinitely. Effective January 1, 1994, rates for local transport services were restructured and a new "trunking" service category created. Trunking services consist of two types: those associated with the local transport element of switched access and those associated with special access. Trunking services associated with switched access handle the transmission of traffic between a local exchange carrier's serving wire center and a Company end office where local switching occurs. Trunking services associated with special access handle the transmission of telecommunications services between any two customer-designated premises or between a customer-designated premise and a Company end office where multiplexing occurs. High volume customers generally use the flat-rated dedicated facilities associated with special access, while usage sensitive rates apply for lower-volume customers that utilize a common switching center. Local transport rate elements for switched services assess a flat monthly rate and a mileage sensitive rate for the physical facility between the customer's point of termination and the end office, a usage sensitive and mileage sensitive rate assessed for the facilities between the end office through the access tandem to the customer's serving wire center, and a minute of use charge assessed to all local transport. The flat rate transport rates and structure generally mirror special access rate elements. Customers can order direct transport between the serving wire center or end office and the access tandem and tandem switched transport between the access tandem and the end office. Special access charges are monthly charges assessed to customers for access to interstate private line service. Charges are paid for local distribution channels, interoffice mileage and optional features and functions. Competition Regulatory, legislative and judicial decisions and technological advances, as well as heightened customer interest in advanced telecommunications services, have expanded the types of available communications services and products and the number of companies offering such services. Market convergence, already a reality, is expected to intensify. The FCC has taken a series of steps that are expanding opportunities for companies to compete with local exchange carriers in providing services that fall under the FCC's jurisdiction. In September 1992, the FCC mandated that local exchange carriers provide network access for special transmission paths to competitive access providers, interexchange carriers and end users. In February 1993, Ameritech filed a tariff with the FCC, which was effective in May, making possible this type of interconnection. In August 1993, the FCC issued an order that permits competitors to interconnect to local telephone company switches. Under the new rules, certain telephone companies must allow all interested parties to terminate their switched access transmission facilities at telephone company central offices, wire centers, tandem switches and certain remote nodes. Ameritech filed a tariff in November 1993 to effect that change in February 1994. Ameritech is seeking opportunities to compete on an equal footing. Although the Company is barred from providing interLATA and nationwide cable services, our competitors are not. Cellular telephone and other wireless technologies are poised to bypass Ameritech's local access network. Cable providers, who currently serve more than eighty percent of American homes, could provide telephone service and have expressed their desire to do so. Certain interexchange carriers and competitive access providers have demonstrated interest in providing local exchange service. Ameritech's plan is to facilitate competition in the local exchange business in order to compete in the total communications marketplace. Customers First: Ameritech's Advanced Universal Access Plan In 1993, Ameritech embarked on a long-range restructuring with the intent of dramatically changing the way it serves its customers, and in the process altered its corporate framework, expanding the nature and scope of its services and supporting the development of a fully competitive marketplace. In March, Ameritech filed a plan with the FCC to change the way local telecommunications services are provided and regulated and to furnish a policy framework for advanced universal access to modern telecommunications services - - voice, data and video information. Ameritech proposes to facilitate competition in the local exchange business by allowing other service providers to purchase components of its network and to repackage them with their own services for resale, in exchange for the freedom to compete in both its existing and currently prohibited businesses. Ameritech has requested regulatory reforms to match the competitive environment as well as support of its efforts to remove restraints, such as the interLATA service restriction, which currently restrict its participation in the full telecommunications marketplace. In addition, Ameritech asks for more flexibility in pricing new and competitive services and replacement of caps on earnings with price regulation. Under the plan, customers would be able to choose from competitive providers for local service as they now can choose a provider for interexchange service. To demonstrate conclusively the substantial customer and economic benefits of full competition, in December 1993, Ameritech proposed a trial of its plan, beginning in 1995. Ameritech has petitioned the DOJ to recommend Federal District Court approval of a waiver of the long-distance restriction of the Consent Decree so that Ameritech can offer interexchange service. At the same time, Ameritech would facilitate the development of local communications markets by unbundling the local network and integrating competitors' switches. The trial would begin in Illinois in the first quarter of 1995 and would last indefinitely. Other states could be added over time. If the trial is approved by the DOJ, the request must be acted on by the Court which retains jurisdiction over administering the terms of the Consent Decree. In February 1994, Ameritech filed tariffs with the Illinois Commerce Commission that propose specific rates and procedures to open the local network in that state. Approval could take up to 11 months. Ameritech has received broad support for the plan from Midwest elected officials, national and Midwest business leaders, and education, health industry, economic development and consumer leaders. The national and local offices of the Communications Workers of America (CWA) and the International Brotherhood of Electrical Workers (IBEW) also support the plan. Ameritech's Video Network Concept In January 1994, Ameritech filed plans with the FCC to construct a digital video network upgrade that will enable it to reach six million customers by the end of the decade. Ameritech expects to spend $4.4 billion to upgrade its network to provide video services, part of a total of approximately $29 billion Ameritech estimates it will spend on network improvements over the next fifteen years. Ameritech is pursuing alliances and partnerships that will position it as a key participant in the emerging era of interactive video experiences. Pending FCC approval of Ameritech's plan and clearing of other regulatory hurdles, the construction of the first phase of the network could begin as soon as the fourth quarter of 1994. The new network, which will be separate from Ameritech's core local communications network, is planned to be expanded to approximately 1 million additional Midwest customers in each of the next five years. Ameritech will be only one of many users of the broadband network. A multitude of competing video information providers, businesses, institutions, interexchange carriers and video telephony customers will also have access to the technology. With the new system, customers will have access to a virtually unlimited variety of programming sources. These will include basic broadcast services, similar to today's cable service, and advanced interactive services such as video on demand, home health care, interactive educational software, distance learning, interactive games and shopping, and a variety of other entertainment and information services that can be accessed from homes, offices, schools, hospitals, libraries and other public and private institutions. Cable/Telco Crossownership Ban In November 1993, Ameritech filed motions in two federal courts seeking freedom from the ban on providing video services in its own service area. Ameritech asked U.S. District Courts in Illinois and Michigan to declare unconstitutional the provisions of the Cable Act of 1984 that bar the RHCs from providing cable TV service in areas where they hold monopolies on local phone service. In August 1993, a U.S. District Court in Washington, D.C. granted a request by Bell Atlantic Corporation for such an order, but that court denied similar requests by Ameritech and the other RHCs. Legislation has been introduced in Congress that would repeal the crossownership ban. For further discussion see Item 7, Management's Discussion and Analysis of Results of Operations "Regulatory Environment." Employee Relations As of December 31, 1993, the Company employed 10,023 persons, a decrease from 11,074 at December 31, 1992. During 1993, approximately 435 management employees left the payroll as a result of voluntary and involuntary work force programs, and 427 nonmanagement employees left the payroll under a Supplemental Income Protection Program (SIPP) established under labor agreements to voluntarily exit the work force. Additional restructuring was done by normal attrition. On March 25, 1994, Ameritech announced that it will reduce its nonmanagement work force by 6,000 employees by the end of 1995, including approximately 1,500 at the Company. Under terms of agreements between Ameritech, the CWA and the IBEW, Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who leave the business before the end of 1995. The reduction of the work force results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Approximately 86% of the Company's employees are represented by the CWA which is affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services reached agreement with the two unions on a work force transition plan for assigning union-represented employees to the newly established business units. The separate agreements with the CWA and the IBEW extend existing union contracts with the landline telephone companies and Ameritech Services to the new units. The pacts address a number of force assignment, employment security and union representation issues. In 1995, when union contracts are due to expire, the parties will negotiate regional contracts. Item 2. Item 2. Properties. The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, central office equipment represented 39% of the Company's investment in telecommunications plant in service; land and buildings (occupied principally by central offices) represented 10%; and connecting lines which constitute outside plant, the majority of which are on or under public roads, highways or streets and the remainder of which are on or under private property, represented 41%. Substantially all of the installations of central office equipment and administrative offices are located in buildings owned by the Company situated on land which it owns in fee. Many garages, administrative offices, business offices and some installations of central office equipment are in rented quarters. Item 3. Item 3. Legal Proceedings. Pre-divestiture Contingent Liabilities Agreement The Plan provides for the recognition and payment of liabilities that are attributable to pre-divestiture events (including transactions to implement the divestiture) but that do not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts, equal employment matters, environmental matters and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the Bell Companies, including the Company, will share the costs of any judgment or other determination of liability entered by a court or administrative agency, the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. Except to the extent that affected parties may otherwise agree, the general rule is that responsibility for such contingent liabilities will be divided among AT&T and the Bell Companies on the basis of their relative net investment (defined as total assets less reserves for depreciation) as of the effective date of divestiture. Different allocation rules apply to liabilities which relate exclusively to pre-divestiture interstate or intrastate operations. Although complete assurance cannot be given as to the outcome of any litigation, in the opinion of the Company's management any monetary liability or financial impact to which the Company would be subject after final adjudication or settlement of all such liabilities would not be material in amount to the financial position of the Company. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations (Dollars in Millions) The following is a discussion and analysis of the results of operations of the Company for the year ended December 31, 1993, compared to the year ended December 31, 1992, which is based on the Statements of Income and Reinvested Earnings on page 21. The Company has changed the presentation of its operating expenses in the Statements of Income and Reinvested Earnings to facilitate a better understanding of its operating results. Prior year amounts have been reclassified to conform with this presentation. Other pertinent data are also given in the Selected Financial and Operating Data on page 13. Revenues Total revenues were $2,100.3 in 1993 and $2,041.4 in 1992 reflecting an increase of $58.9. The increase was due primarily to higher local service revenues and higher long distance revenues, lower payments to an interstate pool and higher network access volumes. Lower interstate rates partially offset the above increases. Increase 1993 1992 (Decrease) %Change Local service . . . . . $1,144.7 $1,121.9 $22.8 2.0 The $22.8 increase in local service revenues was due mainly to growth in access lines and increased usage of custom calling services. Higher message volumes and increases in nonrecurring charge revenues and public telephone revenues also contributed to the increase. Increase 1993 1992 (Decrease) %Change Network access Interstate access . . $434.4 $427.9 $ 6.5 1.5 Intrastate access . . $144.3 $139.9 $ 4.4 3.1 Network access revenues from interstate services increased $6.5 due principally to lower payments to an interstate pool and higher volumes. A reclassification to intrastate access revenues in 1992 related to interexchange carrier claims also contributed to the increase. Lower interstate access rates partially offset these increases. Interstate access revenues increased due to higher volumes and a change in the method of recording transactions between the Company and independent telephone companies for jointly provided telecommunications. A positive revenue reclassification adjustment in 1992 related to the settlement of a billing claim and lower intrastate rates partially offset the above increases. Increase 1993 1992 (Decrease) %Change Long distance . . . . . $186.8 $169.8 $ 17.0 10.0 Higher revenue from the previously noted change in the method of recording transactions between the Company and independent telephone companies was the major contributor to the increase in long distance revenues. Management's Discussion and Analysis of Results of Operations (Continued) (Dollars in Millions) Increase 1993 1992 (Decrease) %Change Other . . . . . . . . . $190.1 $181.9 $ 8.2 4.5 Other includes revenues from directories, billing and collection services and inside wire maintenance and installation and is net of the Company's provision for uncollectible revenues. The increase was due mainly to increased revenues from inside wire maintenance and installation services and billing and collection services. Operating Expenses Total operating expenses were $1,655.4 in 1993 and $1,610.0 in 1992. The $45.4 increase was due primarily to higher depreciation expense and higher contracted services. Lower salary and wage payments in 1993 resulting from a lower employee level and lower interest expense partially offset the above increases. Increase Employee related 1993 1992 (Decrease) %Change expenses . . . . . . . $479.8 $543.9 $(64.1) (11.8) The decrease in employee related expenses was due primarily to lower salaries, wages, payroll taxes, and benefits expense as a result of lower employee levels. A lower level of incentives and adjustments in postretirement benefit expense also contributed to the decrease. These decreases were partially offset by salary and wage rate increases and lower pension credits. At December 31, 1993, the Company had 10,023 employees compared to 11,074 at December 31, 1992. The net decrease of 1,051 included 435 management employees leaving through voluntary and involuntary work force programs and 427 nonmanagement employees leaving through a voluntary force reduction program. The remainder of the reduction was due to attrition. Increase Other operating 1993 1992 (Decrease) %Change expenses . . . . . . . $567.0 $500.2 $ 66.8 13.4 The increase in other operating expenses was due principally to increased advertising expenses, higher right-to-use fees, higher access expenses and costs and expenses for contracted services. The increase in contracted services includes higher charges from ASI for services provided and the transfer of certain work functions to ASI in 1992. The higher access expense reflects the change in the method of recording transactions between the Company and independent telephone companies previously noted. The higher level of access expense resulting from the change was offset by higher intrastate access and long distance revenues. Management's Discussion and Analysis of Results of Operations (Continued) (Dollars in Millions) Increase Depreciation and 1993 1992 (Decrease) %Change amortization . . . . . $387.8 $346.1 $ 41.7 12.0 Depreciation expense increased due principally to the FCC authorized revised depreciation rates effective January 1, 1993. Higher plant investment also contributed to the increase. These increases were partially offset by the completion of the reserve imbalance amortization in 1992. Increase 1993 1992 (Decrease) %Change Taxes other than income taxes . . . . . $220.8 $219.8 $1.0 .5 Taxes other than income taxes increased due to higher sales taxes and property taxes. The property tax increase reflects an increase in the taxable plant base and higher property tax rates. Lower gross receipts taxes due to a tax credit for providing Ohio telecommunications relay service to persons with communications disabilities partially offset these increases. Other Income and Expenses Increase 1993 1992 (Decrease) %Change Interest expense. . . . $62.2 $66.1 $(3.9) (5.9) Interest expense decreased due to lower average interest rates in 1993 on outstanding debt. Early redemptions of long-term debt were funded with lower cost short-term debt and the issuance of long-term debt at lower interest rates. Increase 1993 1992 (Decrease) %Change Other expense (income)-net . . . . . $(2.0) $( .6) $ 1.4 - Other income increased due principally to higher affiliate equity income net of affiliated charges in 1992 associated with the change in accounting principles. Lower costs and expenses in 1993 related to the early redemptions of the Company's debentures also contributed to the net increase. Increase 1993 1992 (Decrease) %Change Income taxes. . . . . . $104.3 $101.1 $ 3.2 3.2 Federal income taxes on income prior to the change in accounting principles increased $3.2 due principally to increased taxable income. Management's Discussion and Analysis of Results of Operations (Continued) (Dollars in Millions) Change in Accounting Principles Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The new accounting method is essentially a refinement of the method the Company had been following and, accordingly, did not have a material impact on the Company's financial statements upon adoption. As more fully discussed in Note (C) to the financial statements, effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS No. 106) and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). The cumulative effect of these accounting changes was recognized in the first quarter of 1992 as a change in accounting principles of $347.3, net of a deferred income tax benefit of $172.1. Regulatory Accounting The Company presently gives accounting recognition to the actions of regulators where appropriate, as prescribed by Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No. 71). Under SFAS No. 71, the Company records certain assets and liabilities because of actions of regulators. Further, amounts charged to operations for depreciation expense reflect estimated useful lives and methods prescribed by regulators rather than those that might otherwise apply to unregulated enterprises. In the event the Company determines that it no longer meets the criteria for following SFAS No. 71, the accounting impact to the Company would be an extraordinary noncash charge to operations of an amount which could be material. Criteria that give rise to the discontinuance of SFAS No. 71 include (1) increasing competition which restricts the Company's ability to establish prices to recover specific costs, and (2) a significant change in the manner in which rates are set by regulators from cost-based regulation to another form of regulation. The Company periodically reviews these criteria to ensure that continuing application of SFAS No. 71 is appropriate. Regulatory Environment Customer demand, technology and the preferences of policy makers are all converging to increase competition in the local exchange business. The effects of increasing competition are apparent in the marketplace the Company serves. For example, competitive access provider(s) have requested regulatory authority to provide intrastate private line services in Ohio. The PUCO has recently stated that it has the authority to authorize other companies to provide local exchange services within the Company's serving areas. Additionally, increasing volumes of intraLATA long distance services purchased by large and medium sized business customers are sold by carriers other than the Company. Recognizing the trend, the Company's regulatory/public policy activities are focused on achieving a framework that allows for expanding competition while providing a fair opportunity for all carriers, including the Company, to succeed. The cornerstone of this effort is Ameritech's "Customers First Plan," filed with the FCC on March 1, 1993, and the Company's Advantage Ohio plan filed June 30, 1993. In a subsequent filing with the U.S. Department of Justice, Ameritech proposed that the Customers First Plan be implemented on a trial basis beginning in January 1995 in Illinois and other states thereafter. Management's Discussion and Analysis of Results of Operations (Continued) (Dollars in Millions) The Customers First Plan proposes to open all of the local telephone business in the Company's service area to competition. In exchange, Ameritech has requested three regulatory changes. First, Ameritech has requested relief from the Consent Decree's interLATA ban. Such relief would mean that the Company would be allowed to offer all long distance services. Second, Ameritech has requested a number of modifications in the FCC's price cap rules. These modifications would apply only to Ameritech, including the Company, and would eliminate any obligation to refund, in the form of its share of future rate reductions, its share of interstate earnings in excess of 12.25%. The modifications would also provide the Company increased ability to price its interstate access services in a manner appropriate to competitive conditions. Third, Ameritech has requested FCC authority to collect, in a competitively neutral manner, the social subsidies currently embedded in the rates that the Company charges long distance carriers for access to the local network. Regulatory Proceedings On June 30, 1993, the Company filed with the PUCO its application for alternative regulation, called Advantage Ohio. The application includes, among other things, the replacement of rate of return regulation with a price cap mechanism. Under the price cap mechanism future rate changes would be subject to a formula based on inflation, the Company's historic productivity and service quality. The application also proposes to cap basic business and residential rates for three years. A significant commitment to invest in the communications infrastructure is also proposed. In March 1994, the Staff of the PUCO issued its Report of Investigation of the Company's application. The Staff recommended that a price cap structure be adopted in place of the current rate of return regulation. The Staff also recommended that the Company's annual revenues should be reduced by a range of $125.0 to $144.0. The Company disagrees with certain of the Staff's recommendations including the recommended revenue reduction. The Company will file objections and rebuttal testimony to the Staff Report. Hearings on the Company's application are expected to take place beginning in May 1994. At this time the Company cannot predict if the PUCO will adopt the Company's alternative regulation plan or order rate reductions. On April 6, 1993, the OCC filed a complaint against the Company with the PUCO alleging that the Company is earning in excess of the return established in its last rate case and that the Company's return should be reduced. The PUCO denied the Company's motion to dismiss and ordered that the case should proceed to hearing. The PUCO consolidated the complaint case with the Company's alternative regulation case, Advantage Ohio, for hearing. OCC has filed testimony in the case seeking a revenue reduction of $141.0. The Company disagrees with OCC's claims and will file rebuttal testimony in April 1994 demonstrating that its earnings and rates are reasonable. Hearings on the complaint case are expected to begin in May 1994. Status of New Business Units In February 1993, following a yearlong examination of its business called "Breakthrough Leadership," Ameritech announced it would restructure its organization, including the Company, into separate units organized around Management's Discussion and Analysis of Results of Operations (Continued) (Dollars in Millions) specific customer groups such as residential customers, small businesses, interexchange companies and large corporations and a single business unit to run Ameritech's network in Illinois, Indiana, Michigan, Ohio and Wisconsin. The Ameritech landline telephone companies continue to function as legal entities owning current landline telephone company assets in each state. The network unit provides network and information technology resources in response to the needs of the other market units. This unit is the source of network capabilities for products and services offered by the other business units and is responsible for the development and day-to-day operation of an advanced information infrastructure. All of the market units and the network unit are currently operational. Ameritech has developed a new logo and is marketing all of its products and services under the single brand name "Ameritech." Digital Video Network In January 1994, Ameritech announced a program to launch a digital video network upgrade that is expected, by the end of the decade, to make available interactive information and entertainment services, as well as traditional cable TV services, to approximately six million Ameritech customers. The Company has filed an application with the FCC seeking approval of the program. The application reflects capital expenditures of approximately $83.0 over the next three years. The Company may also, depending on market demand, make additional capital expenditures under this program. The Company anticipates that its capital expenditures for the program will be funded without an increase to its recent historical level of capital expenditures. Work Force Resizing On March 25, 1994, Ameritech announced that it will reduce its nonmanagement work force by 6,000 employees by the end of 1995, including approximately 1,500 at the Company. Under terms of agreements between Ameritech, CWA and the IBEW, Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW, to selected nonmanagement employees who leave the business before the end of 1995. The above actions will result in a charge to first quarter 1994 earnings of approximately $132.5 or $86.1 after-tax. A significant portion of the program cost will be funded by Ameritech's pension plan, whereas financial incentives to be paid from Company funds are estimated to be approximately $35.5. Settlement gains, which result from the pension plan, will be reflected in income as employees leave the payroll. The Company believes this program will reduce its employee-related costs by approximately $75.0 on an annual basis upon completion of this program. The reduction of the work force results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareowner of The Ohio Bell Telephone Company: We have audited the accompanying balance sheets of The Ohio Bell Telephone Company (an Ohio corporation) as of December 31, 1993 and 1992 and the related statements of income and reinvested earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Ohio Bell Telephone Company as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note (C) to the financial statements, the Company changed its method of accounting for certain postretirement and postemployment benefits in 1992. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio January 28, 1994 THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Dollars in Millions) The Ohio Bell Telephone Company (the "Company") is a wholly owned subsidiary of Ameritech Corporation ("Ameritech"). (A) Significant Accounting Policies - The financial statements of the Company reflect the application of the accounting policies described in this Note. Basis of Accounting - The financial statements have been prepared in accordance with generally accepted accounting principles. In compliance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No. 71), the Company gives recognition to the actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset or impose a liability. Actions of a regulator can also eliminate a liability previously imposed by the regulator. Certain reclassifications have been made to the prior year financial statements to conform them to the 1993 presentation. Transactions with Affiliates - The Company has various agreements with affiliated companies. Below is a description of the significant arrangements followed by a table of the amounts involved. 1. Ameritech Services, Inc. (ASI) - The Company has a 21% ownership interest in ASI, an Ameritech controlled affiliate, that provides consolidated planning, development, management and support services to all of the Ameritech Bell companies. The Company also provides certain services, such as loaned employees, to ASI. 1993 1992 1991 Purchases of materials and charges for services from ASI . . . . $329.8 $280.8 $248.6 Recovery of costs for services provided to ASI . . . . . . . $ 14.3 $ 12.9 $ 8.3 2. Ameritech (the Company's parent) - Ameritech provides various administrative, planning, financial and other services to the Company. These services are billed to the Company at cost. 1993 1992 1991 Charges incurred for services $ 24.5 $ 22.2 $ 24.1 THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) 3. Ameritech Publishing, Inc. (API) - The Company has an agreement under which payments are made to the Company by API for license fees and billing and collection services provided by the Company. The Company also purchases directory services from API under the same agreement. 1993 1992 1991 Fees paid to the Company by API . . . . . . . . . . . . $ 85.8 $ 84.7 $ 84.1 Purchases by the Company from API . . . . . . . . . . . $ 16.6 $ 19.1 $ 18.3 4. Ameritech Information Systems, Inc. (AIS) - The Company has an agreement under which the Company reimburses AIS for costs incurred by AIS in connection with the sale of network services by AIS employees. 1993 1992 1991 Charges incurred for services $ 7.7 $ 6.8 $ 8.0 5. Bell Communications Research, Inc. (Bellcore) - Bellcore provides research and technical support to the Company. ASI has a one-seventh ownership interest in Bellcore and bills the Company for the costs. 1993 1992 1991 Charges incurred for services $ 23.2 $ 27.9 $ 27.1 Telecommunications Plant - Telecommunications plant is stated at original cost. The original cost of telecommunications plant acquired from ASI includes a return on investment to ASI. The provision for depreciation is based principally on the straight-line remaining life method of depreciation applied to individual categories of telecommunications plant with similar characteristics which provides for the full expensing of the investment in plant over its useful life. For certain accounts, reserve imbalance amortization has been authorized by regulatory authorities in conjunction with remaining life depreciation. Depreciation rates are determined for various plant categories using either vintage group or equal life group procedures. Generally, when depreciable plant is retired, the amount at which such plant has been carried in telecommunications plant in service is charged to accumulated depreciation. The cost of maintenance and repairs of plant is charged to expense. Investments - The Company's investments in ASI (21% ownership and $55.1) and The Champaign Telephone Company (50% ownership and $8.1) are reflected in the financial statements using the equity method of accounting. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) Material and Supplies - Inventories of new and reusable material and supplies are stated principally at average original cost, except that in the case of certain large individual items cost is determined on a specific identification basis. Nonreusable material is carried at net realizable value. Interest During Construction - Regulatory authorities allow the Company to accrue interest as a cost of constructing certain plant and as an item of income; i.e., allowance for debt and equity funds used to finance construction. Such income is not realized in cash currently but will be realized over the service life of the plant as the resulting higher depreciation expense is recovered in the form of increased revenues. Federal Income Taxes - The Company is included in the consolidated federal income tax return filed by Ameritech and its subsidiaries. Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The new accounting method is essentially a refinement of the liability method already followed by the Company and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. Consolidated income tax currently payable has been allocated to the Company based on the Company's contribution to consolidated taxable income and tax credits. Deferred tax assets and liabilities are based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities. Under the liability method, deferred tax assets and liabilities at the end of each period are determined using the statutory tax rates in effect when these temporary differences are expected to reverse. Deferred income tax expense is measured by the change in the net deferred income tax asset or liability during the year. In addition, for regulated companies, SFAS No. 109 requires that all deferred regulatory liabilities be recognized at the revenue requirement level. It further requires that a deferred tax liability be recorded to reflect the amount of cumulative tax benefits previously flowed through to ratepayers and that a long-term deferred asset be recorded to reflect the revenue to be recovered in telephone rates when the related taxes become payable in future years. The Company uses the deferral method of accounting for investment tax credits. Therefore, credits earned prior to the repeal of investment tax credits by the Tax Reform Act of 1986 and also certain transitional credits earned after the repeal are being amortized as reductions in tax expense over the life of the plant which gave rise to the credits. Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market. The Company considers all highly liquid, short-term investments with an original maturity of three months or less to be cash equivalents. It is the practice of the Company to make certain payments by checks and to make funds available only when the instruments are presented for payment. At times checks outstanding may exceed the cash in bank accounts. At December 31, 1993 and 1992, outstanding checks in excess of cash in banks were $12.8 and $9.6 respectively and are reflected in accounts payable. Short-Term Financing Arrangement - During 1991, Ameritech entered into an arrangement with its subsidiaries, including the Company, for the provision of short-term financing and cash management services at market rates. Ameritech issues commercial paper and notes and secures bank loans to fund the working capital requirements of its subsidiaries and invests short-term, excess funds on their behalf. See Notes (D) and (H). THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (B) Federal Income Taxes - The components of federal income tax expense before the cumulative effect of the change in accounting principles were as follows: 1993 1992 1991 Current . . . . . . . . . . . . . . . $156.1 $127.2 $ 99.4 Deferred - net . . . . . . . . . . . (35.2) (12.6) 2.3 Investment tax credits - net . . . . (16.6) (13.5) (14.7) Total . . . . . . . . . . . . . . $104.3 $101.1 $ 87.0 Deferred income tax expense (credit) results principally from temporary differences caused by the change in the book and tax bases of telecommunications plant due to the use of different depreciation methods and lives for financial reporting and federal income tax purposes. Total federal income taxes paid were $158.6, $135.7, and $93.8 in 1993, 1992 and 1991, respectively. The following is a reconciliation between the statutory federal income tax rate for each of the last three years and the Company's effective tax rate: \G54\ 1993 1992 1991 Statutory tax rate . . . . . . . . . . 35.0% 34.0% 34.0% (1) Reduction in tax expense due to amortization of investment tax credits. . . . . . . . . . . . (4.3) (3.7) (4.5) (2) Effect of adjusting the post- retirement and postemployment deferred income tax balances due to tax law changes . . . . . . (1.4) - - (3) Benefit of tax rate differential applied to reversing temporary differences . . . . . . . . . . . (3.0) (2.2) (4.0) (4) Depreciation of certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted when incurred for income tax purposes . . . . . .6 .5 .7 (5) Other . . . . . . . . . . . . . . .2 (1.0) .6 Effective federal tax rate . . . . . 27.1% 27.6% 26.8% The Revenue Reconciliation Act of 1993, enacted in August of 1993, increased the statutory federal income tax rate for 1993 to 35 percent. In accordance with the liability method of accounting, the Company adjusted, on the enactment date, its deferred income tax balances not subject to regulatory accounting prescribed by SFAS No. 71 (see Note A). The result was a reduction in deferred income tax expense of $5.3, primarily from increasing the deferred tax assets associated with the accrual of costs for postretirement and postemployment benefits (see Note C). THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) As of December 31, 1993, the Company had a regulatory asset of $68.2 (reflected in Other Assets and Deferred Charges) related to the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers. In addition, on that date, the Company had a regulatory liability of $132.3 (reflected in Other Deferred Credits) related to the reduction of deferred taxes resulting from the change in the federal statutory income tax rate to 35 percent and deferred taxes provided on unamortized investment tax credits. These amounts will be amortized over the regulatory lives of the related depreciable assets concurrent with recovery in rates. The accounting for and the impact on future net income of these amounts will depend on the ratemaking treatment authorized in future regulatory proceedings. As of December 31, 1993 and 1992 the components of long-term accumulated deferred income taxes were as follows: 1993 1992 Deferred tax assets Postretirement and $ 182.6 $ 174.5 Postemployment benefits SFAS No. 71 accounting 40.3 84.0 Other, net 4.4 - 227.3 258.5 Deferred tax liabilities Accelerated depreciation 569.5 592.6 Other .5 1.5 570.0 594.1 Net deferred tax liability $ 342.7 $ 335.6 Deferred income taxes in current assets and liabilities are not shown as they are not significant. (C) Employee Benefit Plans Pension Plans - Ameritech maintains noncontributory defined pension and death benefit plans (the "plans") covering substantially all of the Company's management and nonmanagement employees. The pension benefit formula used in the determination of pension cost is based on the average compensation earned during the five highest consecutive years of the last ten years of employment for the management plan and a flat dollar amount per year of service for the nonmanagement plan. Pension (credit) cost is allocated to subsidiaries based upon the percentage of compensation for the management plan and per employee for the nonmanagement plan. The Company's funding policy is to contribute annually an amount up to the maximum amount that can be deducted for federal income tax purposes. However, due to the funded status of the plans, no contributions have been made for the years reported below. The following data provides information on the Company's (credit) cost for the Ameritech plans: 1993 1992 1991 Pension (credit) cost $(21.6) $(24.9) $(15.8) Pension (credit) as a percent of salaries and wages (5.3%) (5.4%) (3.2%) Pension (credit) was determined using the projected unit credit actuarial method in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The resulting pension credits are primarily attributable to favorable investment performance and the funded status of the plans. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) Certain disclosures are required to be made of the components of pension costs and the funded status of the plans, including the actuarial present value of accumulated plan benefits, accumulated projected benefit obligation and the fair value of plan assets. Such disclosures are not presented for the Company because the structure of the Ameritech plans does not permit the plans' data to be readily disaggregated. The assets of the Ameritech plans consist principally of debt and equity securities, fixed income securities and real estate. As of December 31, 1993, the fair value of plan assets available for plan benefits exceeded the projected benefit obligation (calculated using a discount rate of 5.8 percent as of December 31, 1993 and 1992). The assumed long-term rate of return on plan assets used in determining pension cost was 7.25 percent for 1993, 1992 and 1991. The assumed increase in future compensation levels, also used in the determination of the projected benefit obligation, was 4.5 percent in 1993 and 1992. Postretirement Benefits Other Than Pensions - Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). SFAS No. 106 requires the cost of postretirement benefits granted to employees to be accrued and recognized as expense over the period in which the employee renders service and becomes eligible to receive benefits. The cost of health care costs and postretirement life insurance benefits for current and future retirees was recognized as determined under the projected unit credit actuarial method. In adopting SFAS No. 106, the Company elected to immediately recognize effective January 1, 1992 the transition obligation for current and future retirees. The unrecognized obligation was $481.2 less deferred income taxes of $163.6 or $317.6, net. To this amount is added the Company's 21% share of ASI's transition obligation of $12.9 for a total net charge of $330.5. As defined by SFAS No. 71, a regulatory asset and any corresponding regulatory liability associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery in the ratemaking process. Substantially all current and future retirees are covered under postretirement benefit plans sponsored by Ameritech. Such benefits include medical, dental and group life insurance. Ameritech has been prefunding (including cash received from the Company) certain of these benefits through Voluntary Employee Benefit Association trust funds ("VEBAs") and Retirement Funding Accounts ("RFAs"). The associated plan assets (primarily corporate securities and bonds) were considered in determining the transition obligation under SFAS No. 106. Ameritech intends to continue to fund its obligation appropriately, and is exploring other available funding and cost containment alternatives. Ameritech allocates its retiree health care cost on a per participant basis, whereas group life insurance is allocated based on compensation levels. SFAS No. 106 requires certain disclosures as to the components of postretirement benefit costs and the funded status of the plans. Such disclosures are not presented for the Company as the structure of the Ameritech plans does not permit the data to be readily disaggregated. However, the Company has been advised by Ameritech as to the following assumptions used in determining its SFAS No. 106 costs. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) As of December 31, 1993 the accumulated postretirement benefit obligation exceeded the fair value of plan assets available for plan benefits. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.0 percent as of December 31, 1993 and 7.5 percent as of December 31, 1992. The assumed rate of future increases in compensation levels was 4.5 percent as of December 31, 1993 and December 31, 1992. The expected long-term rate of return on plan assets was 7.25 percent in 1993 and 1992 on VEBAs and 8.0 percent in 1993 and 1992 on RFAs. The assumed health care cost trend rate in 1993 was 9.6 percent and 10 percent in 1992, and is assumed to decrease gradually to 4 percent in 2007 and remain at that level. The assumed increase in health care cost is 9.2 percent for 1994. The health care cost trend rates have a significant effect on the amounts reported for costs each year. Specifically, increasing the assumed health care cost trend rates by one percentage point in each year would increase the 1993 annual expense by approximately 18 percent. Postretirement benefit cost determined under SFAS No. 106 for 1993 and 1992 was $45.9 and $45.2, respectively. During 1991, the cost of postretirement health care benefits for retirees was $46.0. As of December 31, 1993, the Company had approximately 9,728 retirees eligible to receive health care and group life insurance benefits. Postemployment Benefits - Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to accrue the future cost of certain benefits such as workers compensation, disability benefits and health care continuation coverage. A one-time charge related to adoption of this statement was recognized as a change in accounting principle, effective as of January 1, 1992. The charge was $24.9, less deferred taxes of $8.5, or $16.4 net. To this amount is added the Company's 21% share of ASI's one-time charge of $.4 for a total charge of $16.8. Previously the Company used the cash method to account for such costs. Current expense levels are dependent upon actual claim experience, but are not materially different than prior charges to income. Work Force Reductions - During 1993, 128 management employees left the Company under an involuntary termination plan that remains in effect until December 31, 1994. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $3.0 million. Approximately 430 management employees left the Company in 1992 and early 1993 through voluntary and involuntary terminations as part of a 1992 force reduction program. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $3.8 million. During 1991, the Company offered most of its management employees an early retirement program. The net cost of this program, including termination benefits and a settlement gain from the pension plan, was $4.2 million. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (D) Debt Maturing Within One Year - Debt maturing within one year is included as debt in the computation of debt ratios and consists of the following as of December 31: Weighted Average Interest Rates 1993 1992 1991 1993 1992 1991 Notes payable Ameritech @ . . . . . . $ 35.5 $188.0 $ 42.6 3.2% 3.4% 5.1% Other # . . . . . . . . 10.8 10.8 10.8 3.1% 3.2% 3.9% Long-term debt maturing within one year . . . . . .5 .7 .7 Total . . . . . . . . $ 46.8 $199.5 $ 54.1 Average notes payable out- standing during the year $161.2 $ 76.8 $ 56.0 3.2% 3.5% 6.2% Maximum notes payable at any month end during the year $386.2 $293.3 $115.1 @ During 1991 Ameritech entered into an arrangement with its subsidiaries, including the Company, for the provision of short-term financing. See Note (A) on short-term financing arrangements. # Notes payable - other, at December 31, 1993, 1992 and 1991 consisted of funds related to an interim intrastate pooling arrangement for which the Company acts as administrator as directed by The Public Utilities Commission of Ohio. Computed by dividing the average daily face amount of advances and notes payable into the aggregate related interest expense. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (E) Long-Term Debt - Long-term debt consists principally of debentures and notes issued by the Company. The following table sets forth interest rates and maturities on long-term debt outstanding at December 31. 1993 1992 Forty year debentures 5.0 % due 2006 . . . . . . . . . . . . . . . $ 60.0 $ 60.0 5.375% due 2007 . . . . . . . . . . . . . . . 75.0 75.0 6.75 % due 2008 . . . . . . . . . . . . . . . 55.0 55.0 7.5 % due 2011 . . . . . . . . . . . . . . . 100.0 100.0 7.875% due 2013 . . . . . . . . . . . . . . . 200.0 200.0 8.75 % due 2026 . . . . . . . . . . . . . . . - 125.0 Thirty year debentures 7.85 % due 2022 . . . . . . . . . . . . . . . 100.0 100.0 Ten year notes 6.125% due 2003 . . . . . . . . . . . . . . . 150.0 - Seven year notes 5.75% due 2000. . . . . . . . . . . . . . . . 100.0 - 840.0 715.0 Long-term capital lease obligation . . . . . . . 2.1 2.3 Other . . . . . . . . . . . . . . . . . . . . . .8 1.0 Unamortized discount - net . . . . . . . . . . . (5.8) (4.6) Total . . . . . . . . . . . . . . . . . . . $837.1 $713.7 In September 1992, the Company called its 9% debentures due November 1, 2018, and its 8.75% debentures due January 1, 2010, recognizing expenses, including the call premiums, of $12.9. All $150.0 and $100.0 of the principal amounts outstanding, respectively, were redeemed in October 1992. The redemption was funded with short-term debt provided under the financing arrangement between the Company and Ameritech. In December 1992, the Company issued $100.0 of 7.85% debentures due December 15, 2022, under a "shelf" Registration Statement for $350.0 in debt securities. The proceeds from the sale of the debentures were used to repay outstanding short-term indebtedness incurred by the Company in connection with the above noted debenture redemptions. In March 1993, the Company called its 8 3/4% debentures due April 15, 2026, recognizing expenses, including the call premium, of $9.5 million. All $125.0 million of the principal amounts outstanding were redeemed on April 30, 1993. The redemption was funded with short-term debt provided under the financing arrangement between the Company and Ameritech. In April 1993, the Company sold $100.0 million of 5 3/4% notes due May 1, 2000 and in May 1993 the Company sold $150.0 million of 6 1/8% notes due May 15, 2003, under the Company's shelf Registration Statement. There are no amounts remaining under the shelf Registration Statement. The proceeds from the sales were used to repay outstanding short-term indebtedness incurred by the Company in connection with prior debenture redemptions. Early extinguishment of debt costs (including call premiums and write-offs of unamortized deferred costs) were $9.5, $12.9 and $0.0 in 1993, 1992 and 1991, respectively, and were included in other expense (income)-net on the statements of income and reinvested earnings. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (F) Lease Commitments - The Company leases certain facilities and equipment used in its operations under both operating and capital leases. Rental expenses under operating leases were $6.7, $7.8, and $12.0 for 1993, 1992 and 1991, respectively. At December 31, 1993, the aggregate minimum rental commitments under noncancellable leases were approximately as follows: Year Operating Capital 1994 . . . . . . . . . . . . . . . . . . . $ 2.8 $ .6 1995 . . . . . . . . . . . . . . . . . . . 2.4 .6 1996 . . . . . . . . . . . . . . . . . . . 1.4 .4 1997 . . . . . . . . . . . . . . . . . . . .7 .2 1998 . . . . . . . . . . . . . . . . . . . .5 .2 Thereafter . . . . . . . . . . . . . . . . 5.3 2.0 Total minimum rental commitments . . $ 13.1 $ 4.0 Less: interest cost . . . . . . . . . . . 1.5 Present value of minimum lease payments . $ 2.5 THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (G) Financial Instruments - The following table presents the estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992: Carrying Fair Value Value Debt . . . . . . . . . . . . . . . . . . . . $894.3 $903.8 Long-term payable to ASI (for postretirement benefits). . . . . . . . . . . . . . . . 19.7 19.7 Other assets . . . . . . . . . . . . . . . . 6.1 6.1 Other liabilities . . . . . . . . . . . . . . 10.2 10.2 Carrying Fair Value Value Debt . . . . . . . . . . . . . . . . . . . . $923.7 $893.3 Long-term payable to ASI (for postretirement benefits). . . . . . . . . . . . . . . . 20.8 20.8 Other assets . . . . . . . . . . . . . . . . 7.4 7.4 Other liabilities . . . . . . . . . . . . . . 8.8 8.8 The following methods and assumptions were used to estimate the fair value of financial instruments: Debt - The carrying amount (including accrued interest) of the Company's debt maturing within one year approximates fair value because of the short-term maturities involved. The fair value of the Company's long-term debt was estimated based on the year-end quoted market price for the same or similar issues. Other Assets and Liabilities - These financial instruments consist primarily of financial contracts and customer deposits. The fair values of these items are based on expected cash flows or, if available, quoted market prices. Long-term Payable to ASI - This item represents the long-term payable to ASI for the Company's proportionate share of ASI's transition obligation related to adoption of SFAS No. 106. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (H) Additional Financial Information December 31, 1993 1992 Balance Sheets Other current liabilities: Accrued payroll . . . . . . . . . . . . . . $ 12.8 $ 11.0 Compensated absences . . . . . . . . . . . 36.7 36.9 Accrued taxes . . . . . . . . . . . . . . . 168.9 170.5 Advance billings and customer's deposits. . 57.2 52.7 Accrued interest . . . . . . . . . . . . . 13.9 14.1 Dividends payable to Ameritech. . . . . . . 65.7 - Other . . . . . . . . . . . . . . . . . . 18.7 45.5 Total . . . . . . . . . . . . . . . . . $ 373.9 $ 330.7 1993 1992 1991 Statements of Income Interest expense: Interest on long-term debt . . . $ 54.9 $ 62.6 $ 67.4 Interest on notes payable - Ameritech . . . . . . . . . . . 4.8 2.3 2.4 Other . . . . . . . . . . . . . . 2.5 1.2 10.8 Total . . . . . . . . . . . . $ 62.2 $ 66.1 $ 80.6 Interest paid was $61.1, $71.7 and $68.1 in 1993, 1992 and 1991, respectively. 1993 1992 1991 Taxes other than income taxes: Property . . . . . . . . . . . . $150.4 $149.7 $143.0 Gross receipts . . . . . . . . . 64.4 66.0 66.2 Other . . . . . . . . . . . . . . 5.9 4.1 7.1 Total . . . . . . . . . . . . $220.7 $219.8 $216.3 Maintenance and repair expense . . . . . . . . . . $304.4 $324.2 $307.9 Advertising expense . . . . . . . . . $ 21.4 $ 14.3 $ 10.8 Depreciation - percentage of average depreciable telecommunications plant 7.1% 6.6% 7.1% Revenues from American Telephone & Telegraph Company, consisting principally of network access and billing and collection service revenues, comprised approximately 12%, 13% and 14% of total revenues in 1993, 1992 and 1991, respectively. No other customer accounted for more than 10% of total revenues. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) (I) Quarterly Financial Information (Unaudited) Operating income represents revenue less operating expenses excluding interest expense and other expense (income) - net. All adjustments necessary for a fair statement of results for each period have been included. Operating Net Income Calendar Quarter Revenues Income (Loss) 1st . . . . . . . . . . . . . . . $ 512.4 $ 106.4 $ 62.0 2nd . . . . . . . . . . . . . . . 524.8 114.1 73.7 3rd . . . . . . . . . . . . . . . 527.8 113.0 74.9 4th . . . . . . . . . . . . . . . 535.3 111.4 69.8 Total . . . . . . . . . . . . $2,100.3 $ 444.9 $ 280.4 1st . . . . . . . . . . . . . . . $ 503.4 $ 106.2 $(275.3) 2nd . . . . . . . . . . . . . . . 506.7 109.0 68.6 3rd . . . . . . . . . . . . . . . 512.9 107.3 56.6 4th . . . . . . . . . . . . . . . 518.4 108.9 67.6 Total . . . . . . . . . . . . $2,041.4 $ 431.4 $( 82.5) The fourth quarters of 1993 and 1992 were affected by several income and expense items. The fourth quarter of 1993 was affected by gains from work force resizing. In the fourth quarter of 1992, the Company recognized higher costs and charges resulting from its market realignment efforts and increased advertising. These costs were offset by gains resulting from work force resizing and higher than expected pension credits. Net income for the first quarter of 1993 and the third quarter of 1992 was negatively impacted by expenses related to the early retirement of debt. First quarter 1992 results reflect charges related to the adoption of SFAS Nos. 106 and 112 for postretirement and postemployment benefits, as discussed previously in Note (C). The charges totaled $347.3. (J) Calculation of Ratio of Earnings to Fixed Charges The ratio of earnings to fixed charges of the Company for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were 6.97, 6.33, 4.84, 5.05 and 5.53, respectively. For the purpose of calculating this ratio, (i) earnings have been calculated by adding to income before interest expense and accounting changes, the amount of related taxes on income and the portion of rentals representative of the interest factor, (ii) the Company considers one-third of rental expense to be the amount representing return on capital, and (iii) fixed charges comprise total interest expense and such portion of rentals. (K) Event subsequent to Date of Auditors' Report (Unaudited) On March 25, 1994, Ameritech announced it would reduce its nonmanagement work force resulting in an after-tax charge to the Company of $86.1. The charge will be recorded in the first quarter of 1994. The details of this plan are discussed on page 19 in Management's Discussion and Analysis of Results of Operations. THE OHIO BELL TELEPHONE COMPANY NOTES TO FINANCIAL STATEMENTS (Continued) (Dollars in Millions) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No changes in nor disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure occurred during the period covered by this annual report. PART IV Item 14. Item 14. Exhibits. Financial Statement Schedules and Reports on Form 8-K. (a) Documents filed as a part of the report: (1) Financial Statements: Page Selected Financial and Operating Data............... 13 Report of Independent Public Accountants............ 20 Statements of Income and Reinvested Earnings ....... 21 Balance Sheets...................................... 22 Statements of Cash Flows............................ 23 Notes to Financial Statements....................... 24 (2) Financial Statement Schedules: V - Telecommunications Plant..................... 42 VI - Accumulated Depreciation..................... 44 VIII - Allowance for Uncollectibles................. 46 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. Financial statements for certain owned corporations which are accounted for by the equity method are omitted pursuant to Rule 3.09 of Regulation S-X. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number (3)a Articles of Incorporation of the registrant as amended April 25, 1974. (Exhibit (3)a to Form 10-K for the fiscal year ended December 31, 1980, File No. 1-6781.) (3)b Regulations of the registrant as restated February 28, 1990. (Exhibit (3)b to Form 10-K for the fiscal year ended December 31, 1989, File No. 1-6781.) (4)(i) Close Corporation Agreement with Ameritech dated February 28, 1990. (Exhibit (4)(i) to Form 10-K for the fiscal year ended December 31, 1989, File NO. 1-6781.) (4)(iii)(A) No instrument which defines the rights of holders of long-term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. (10)(ii)(B)1 Reorganization and Divestiture Agreement among AT&T, Ameritech and Affiliates dated November 1, 1983. (Exhibit 10a to Form 10-K for 1983 for Ameritech, File No. 1-8612.) (10)(ii)(B)2 Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell System Operating Companies, Regional Holding Companies and Affiliates dated November 1, 1983. (Exhibit 10j to Form 10-K for 1983 for Ameritech, File No. 1-8612.) (10)(ii)(B)3 Shared Network Facilities Agreement with AT&T and AT&T Communications dated January 1, 1984. (Exhibit 10b to Form 10-K for 1983 for Ameritech, File No. 1-8612.) (12) Statement re: Computation of Ratio of Earnings to Fixed Charges for the Years Ended December 31, 1993, 1992, 1991, 1990 and 1989. (b) Reports on Form 8-K: No report on Form 8-K was filed by the registrant during the last quarter of the year covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 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. THE OHIO BELL TELEPHONE COMPANY By Richard A. Brown Richard A. Brown Vice President and Comptroller March 30, 1994 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 date indicated. Principal Executive Officer: Jacqueline F. Woods Jacqueline F. Woods President and Chief Executive Officer Principal Accounting Officer: Richard A. Brown Richard A. Brown Vice President and Comptroller March 30, 1994 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the registrant and in the capacities and on the date indicated. AMERITECH CORPORATION By Richard H. Brown Richard H. Brown Vice Chairman the sole shareholder of the registrant, which is a statutory close corporation managed by the shareholder rather than by a board of directors. March 30, 1994	13,901	87,675
873084_1993.txt	873084_1993	1993	873084	Item 1. Business The Sears Credit Account Trust 1991 A (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of March 1, 1991 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2. Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in February, 1991 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3. Item 3. Legal Proceedings None Item 4. Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13. Item 13. Certain Relationships and Related Transactions None PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Sears Credit Account Trust 1991 A (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1991 A 8.85% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated September 5, 1991 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$88.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$88.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods....................................$495,164,278.36 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods....................................$139,525,853.21 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates...............................$335,348,694.24 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$94,579,855.06 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate................................$159,815,584.12 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$44,945,998.15 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest.............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest.......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest..............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$9,999,999.96 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods..$0.00 15) The aggregate amount of Investment Income during the related Due Periods...................................$0.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.....$0.00 17) The Deficit Accumulation Amount, as of the end of the reportable year.......................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$44,250,000.00 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year...................$11,062,500.00 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1991A March 1, 1991 Sears Credit Account Trust 1991B May 15, 1991 Sears Credit Account Trust 1991C July 1, 1991 Sears Credit Account Trust 1991D September 15, 1991 Sears Credit Account Master Trust I November 18, 1992 It is understood that this report is solely for your information and is not be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations report. We found such amounts to be in agreement. Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Association as Trustee As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.	1,483	10,093
71304_1993.txt	71304_1993	1993	71304	Item 1. Business General Commonwealth Energy System, a Massachusetts trust, is an unincorporated business organization with transferable shares. It is organized under a Declaration of Trust dated December 31, 1926, as amended, pursuant to the laws of Massachusetts. It is an exempt public utility holding company under the provisions of the Public Utility Holding Company Act of 1935, holding all of the stock of four operating public utility companies. Commonwealth Energy System, the parent company, is referred to in this report as the "System" and, together with its subsidiaries, is collectively referred to as "the system." The operating utility subsidiaries of the System are engaged in the generation, transmission and distribution of electricity and the distribution of natural gas, all within Massachusetts. These subsidiaries are: Electric Gas Cambridge Electric Light Company Commonwealth Gas Company Canal Electric Company Commonwealth Electric Company In addition to the utility companies, the System also owns all of the stock of a steam distribution company (COM/Energy Steam Company), five real estate trusts and a liquefied natural gas (LNG) and vaporization facility (Hopkinton LNG Corp.). Subsidiaries of the System have common executive and financial management and receive technical assistance as well as financial, data processing, accounting, legal and other services from a wholly-owned services company subsidiary (COM/Energy Services Company). The five real estate subsidiaries are: Darvel Realty Trust, which is a joint-owner of the Riverfront Office Park complex in Cambridge; COM/Energy Acushnet Realty, which leases land to Hopkinton LNG Corp.; COM/Energy Research Park Realty, which was organized to develop a research building in Cambridge; COM/Energy Cambridge Realty, which was organized to hold various properties; and COM/Energy Freetown Realty (Freetown), which was organized in 1986 to purchase and develop 596 acres of land in Freetown, Massachusetts. As a result of unsuccessful efforts to develop an energy park on this site, the System announced on January 23, 1992 its decision to write down its investment in the Freetown project. This action resulted in the recognition of a charge (net of tax) of $14.8 million in 1991. Each of the operating utility subsidiaries previously listed serves retail customers except for Canal Electric Company (Canal) which operates an electric generating station located at the eastern end of the Cape Cod Canal in Sandwich, Massachusetts. The station consists of two oil-fired steam electric generating units: Canal Unit 1, with a rated capacity of 569 MW, wholly-owned by Canal; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by Canal and Montaup Electric Company (Montaup) (an unaffiliated company). Canal Unit 2 is operated under an agreement with Montaup which provides for the equal sharing of output, fixed charges and operating expen- ses. In October 1993, Canal reached an agreement with Montaup and Algonquin COMMONWEALTH ENERGY SYSTEM Gas Transmission Company to build a natural gas pipeline that will serve Unit 2, subject to regulatory approvals. The project will improve air quality on Cape Cod, enable the plant to exceed the stringent 1995 air quality standards established by the Massachusetts Department of Environmental Protection and strengthen Canal's bargaining position as it seeks to secure the lowest-cost fuel for its customers. Plant conversion and pipeline construction are expected to be completed in 1996. Electric service is furnished by Cambridge Electric Light Company (Cam- bridge Electric) and Commonwealth Electric Company (Commonwealth Electric) at retail to approximately 304,000 year-round customers in 41 communities in eastern Massachusetts covering 1,112 square miles and having an aggregate population of 645,000. The system also serves approximately 48,000 seasonal retail customers. The territory served includes the communities of Cambridge, New Bedford and Plymouth and the geographic area comprising Cape Cod and Martha's Vineyard. Cambridge Electric also sells power at wholesale to the Town of Belmont, Massachusetts. Natural gas is distributed by Commonwealth Gas Company (Commonwealth Gas) to approximately 232,000 customers in 49 communities in central and eastern Massachusetts covering 1,067 square miles and having an aggregate population of 1,128,000. Twelve of these communities are also served by system companies with electricity. Some of the larger communities served by Commonwealth Gas include Cambridge, Somerville, New Bedford, Plymouth, Worcester, Framingham, Dedham and the Hyde Park area of Boston. The results of the 1990 federal census taken in the system's electric and gas service areas indicated an increase in population of 15.2% and 12%, respectively, since 1980. Steam, which is produced by Cambridge Electric in connection with the generation of electricity, is purchased by COM/Energy Steam and, together with its own production, is distributed to 20 customers in Cambridge and 1 customer (Massachusetts General Hospital) in Boston. Steam is used for space heating and other purposes. On August 17, 1993 COM/Energy Steam began providing steam service to Genzyme Corporation (Genzyme), a biotechnology company that is expected to become one of the largest customers of COM/Energy Steam. Genzyme's steam need for 1994 is estimated to be 160 million pounds, which represents approximately 10% of steam unit sales, for heating, air conditioning and testing processes. After 1994, Genzyme's annual requirement is estimated to reach approximately 230 million pounds upon commercial manufacturing of a biotherapeutic product in 1995. New England Confectionery Company (Necco), began receiving steam service in October 1992 and is the fourth largest customer of COM/Energy Steam. Industry in the territories served by system companies is highly diversified. The larger industrial customers include high-technology firms and manufacturers of such products as photographic equipment and supplies, rubber products, textiles, wire and other fastening devices, abrasives and grinding wheels, candy, copper and alloys, and chemicals. Among customers served are several major educational institutions, including Harvard University and the Massachusetts Institute of Technology (MIT). COMMONWEALTH ENERGY SYSTEM Presently, MIT is constructing a 19 MW natural gas-fired cogeneration facility which is expected to be completed in January 1995. MIT expects that this cogeneration facility will meet approximately 94% of its power, heating and cooling requirements. Sales to MIT in 1993 accounted for approximately 1.9% of consolidated unit sales. MIT and Cambridge Electric are presently negotiating a buy and sell arrangement which will require the approval of the Massachusetts Department of Public Utilities (DPU). Electric Power Supply To satisfy demand requirements and provide required reserve capacity, the system supplements its generating capacity by purchasing power on a long and short-term basis through capacity entitlements under power contracts with other New England and Canadian utilities and with Qualifying Facilities and other non-utility generators through a competitive bidding process that is regulated by the DPU. System companies own generating facilities with a capability totaling 967.1 MW. Included in this amount is 569 MW provided by Canal Unit 1, of which three-quarters (427 MW) is sold to neighboring utilities under long-term contracts, and 220.5 MW provided by Canal Unit 2. In 1991, Canal executed an exchange transaction with Central Vermont Public Service Corporation (CVPS) whereby 50 MW of Canal Unit 2 was exchanged for 25 MW each of CVPS's entitle- ment in the Vermont Yankee nuclear power plant and the Merrimack 2 coal-fired unit through October 1995. These contracts are designed to reduce the system's reliance on oil. Additionally, in 1993, Canal executed an exchange transaction with New England Power Company (NEP) whereby 20 MW of Canal Unit 2 was exchanged for 20 MW of Bear Swamp Unit Nos. 1 and 2 through October 1993. As of November 1, 1993, the exchange was increased to 50 MW through April 1997. The Bear Swamp Units are pumped storage hydro electric generating facilities. Another 128.3 MW is provided by various smaller system units. Of the 540.3 MW available to the system, 65.3 MW are used principally for peaking purposes. A 3.52% ownership interest in the Seabrook 1 nuclear power plant provides 40.5 MW of capability to the system and Central Maine Power Company's Wyman Unit 4, an oil-fired facility in which the system has a 1.4% joint- ownership interest, provides 8.8 MW. In addition, through Canal's equity ownership in Hydro-Quebec Phase II, the system has an entitlement of 67.9 MW. Long-term purchase arrangements are also in place with the following natural gas-fired cogenerating units in Massachusetts: 23.8 MW from the Consolidated Power Company, 31.4 MW from Pep- perell Power Associates and 43.9 MW from Northeast Energy Associates and effective July 31 and September 1, 1993, 51 MW and 55 MW from Masspower and Altresco Pittsfield, respectively. Additionally, the system receives 67.0 MW from the SEMASS waste-to-energy plant (which includes 20.8 MW from the expansion unit which went on-line May 17, 1993); has entitlements totaling 41.6 MW through contracts with five (5) hydroelectric suppliers, including 29.1 MW of pumped storage capacity from New England Power's Bear Swamp Units 1 and 2 and 10 MW from Boott Hydropower, Inc., in Lowell, Massachusetts; and also receives 61.8 MW from a natural gas-fired independent power producer, Dartmouth Power Associates. The system anticipates providing for future peak load plus reserve requirements through existing and planned system generation, including purchasing available capacity from neighboring utilities and/or non- utility generators. COMMONWEALTH ENERGY SYSTEM In addition, the system has available 140.7 MW from four (4) nuclear units in which system distribution companies have life-of-the-unit contracts for power. Information with respect to these units is as follows: Connecticut Maine Vermont Yankee Yankee Yankee Pilgrim (Dollars in Thousands) Location Haddam Neck, Wiscasset, Vernon, Plymouth, Connecticut Maine Vermont Massachusetts Year of Initial Operation 1968 1972 1972 1972 Contract Expiration Date 1998 2008 2012 2012 System Percent of Equity Ownership 4.50% 4.00% 2.50% - System Percent of Plant Entitlement 4.50% 3.59% 2.25% 11.0% Plant Capability (MW) 560.0 870.0 496.0 664.7 System Entitlement (MW) 25.2 31.2 11.2 73.1 1991 Actual Cost $ 9,692 $5,900 $3,383 $30,992 1992 Actual Cost 9,508 6,671 3,970 37,516 1993 Actual Cost 10,016 7,050 4,076 40,578 1994 Estimated Cost 10,005 6,755 3,755 41,963 On February 26, 1992, the Yankee Atomic Electric Company (Yankee) board of directors agreed to permanently cease power operation of the Yankee nuclear power plant in Rowe, Massachusetts. For additional information, refer to Note 2(e) of the Notes to Consolidated Financial Statements filed under Item 8 of this report. On October 1, 1992, Commonwealth Electric ceased power generation at its 60 MW Cannon Street generating station located in New Bedford, Massachusetts. During the past few years, the plant had been used primarily to meet peak electric demand and as a backup unit for Commonwealth Electric and the New England Power Pool (NEPOOL) when other area units were taken off line. A sharp decline in electric demand brought about by the present economic slowdown was the key factor in management's decision to close the plant. Additionally, forecasts for electric demand indicated an excess regional supply in the near term and no need for increased generating capacity until the late-1990s or beyond. Commonwealth Electric made the decision during the second quarter of 1993 to abandon the plant and transfer its net book value to a regulatory asset subsequent to FERC approval. This decision was viewed as the most cost effective among several alternatives and leaves Commonwealth Electric with the most flexibility for future capacity planning. Cambridge Electric, Canal and Commonwealth Electric, together with other electric utility companies in the New England area, are members of NEPOOL, which was formed in 1971 to provide for the joint planning and operation of electric systems throughout New England. NEPOOL operates a centralized dispatching facility to ensure reliability of service and to dispatch the most economically available generating units of the member companies to fulfill the region's energy requirement. This concept COMMONWEALTH ENERGY SYSTEM is accomplished by use of computers to monitor and forecast load requirements and provide for the economic dispatching of generation. NEPOOL, on behalf of its members entered into an Interconnection Agree- ment with Hydro-Quebec, a Canadian utility operating in the Province of Quebec. The agreement provided for construction of an interconnection (Phase I) between the electrical systems of New England and Quebec. The parties have also entered into an Energy Contract and an Energy Banking Agreement; the former obligates Hydro-Quebec to offer NEPOOL participants up to 33 million MWH of surplus energy during an eleven-year term that began September 1, 1986 and the latter provides for energy transfers between the two systems. The Phase I Interconnection began operation in October 1986. NEPOOL has also entered into Phase II agreements for an additional purchase from Hydro-Quebec of 7 million MWH per year for a twenty-five year period which began in late 1990. The System's electric subsidiaries are also members of the Northeast Power Coordinating Council (NPCC), an advisory organization that includes the major power systems in New England and New York plus the Provinces of Ontario and New Brunswick in Canada. NPCC establishes criteria and standards for reliability and serves as a vehicle for coordination in the planning and operation of these systems in enhancing reliability. The reserve requirements used by the NEPOOL participants in planning future additions are determined by NEPOOL to meet the reliability criteria recommended by NPCC. The system estimates that, during the next ten years, reserve requirements so determined will be in the range of 23% to 29% of peak load. Power Supply Commitments and Support Agreements Cambridge Electric and Commonwealth Electric, through Canal, secure cost savings for their respective customers by planning for bulk power supply on a single system basis. Additionally, Cambridge Electric and Commonwealth Electric have long-term contracts for the purchase of electricity from various sources. Generally, these contracts are for fixed periods and require payment of a demand charge for the capacity entitlement and an energy charge to cover the cost of fuel. The system's 3.52% interest in the Seabrook nuclear power plant is owned by Canal to provide for a portion of the capacity and energy needs of Cam- bridge Electric and Commonwealth Electric. Canal began recovering 100% of its Seabrook investment through a power contract with Cambridge Electric and Commonwealth Electric in June 1990, subject to refund pending a full review of Canal's investment in the unit by the Federal Energy Regulatory Commission (FERC). In November 1991, the FERC approved a settlement agreement which resolved all Seabrook cost-of-service issues (except rate of return). In December 1991, a FERC Administrative Law Judge (ALJ) affirmed the prudence of Canal's investment in Seabrook and on January 29, 1992, the FERC approved a settlement proposal that allows a return on equity of 11.72%. The ALJ's decision was approved by the full commission in a final order issued on COMMONWEALTH ENERGY SYSTEM August 4, 1992. For additional information concerning Seabrook 1, refer to Note 2(b) of Notes to Consolidated Financial Statements filed under Item 8 of this report. In response to solicitations made to NEPOOL member companies by Northeast Utilities (NU), Canal, on behalf of Commonwealth Electric and Cambridge Electric, agreed to purchase entitlements through various contracts ranging up to five years in length. The terms of the five-year agreement stipulate the purchase of 50 MW, on average, from NU annually from November 1989 through October 1994. Commonwealth Electric and Cambridge Electric are each appropriated a portion of the power received from NU based on need. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and to meet Commonwealth Electric and Cambridge Electric capacity requirements. Canal has entered into support agreements for Phase I and Phase II of the Hydro-Quebec Project. Canal is obligated to pay its share of operating and capital costs for Phase II over a 25 year period ending in 2015. Future minimum lease payments for Phase II have an estimated present value of $14.2 million at December 31, 1993. In addition, Canal has an equity interest in Phase II which amounted to $3.9 million in 1993 and $4.2 million in 1992. Electric Fuel Supply (a) Oil Imported residual oil is the fuel used in the generation of power in system generating plants, producing approximately 31% of the system's total energy requirement for 1993. Effective July 1, 1993, Canal executed a twenty-two month contract with Coastal Oil of New England, Inc. (Coastal) for the purchase of residual fuel oil. The contract provides for delivery of a set percentage of Canal's fuel requirement, the balance (a maximum of 20%) to be met by spot purchases or by Coastal at the discretion of Canal. Energy Supply and Credit Corporation (ESCO) operates Canal's oil terminal for the purchase, receipt and payment of oil under assignment of Canal's supply contracts to ESCO (Massachusetts), Inc. Oil in the terminal's tanks is held in inventory by ESCO and delivered upon demand to Canal's tanks. Fuel oil storage facilities at the Canal site have a capacity of 1,199,000 barrels, representing 60 days of normal operation of the two units. During 1993, ESCO maintained an average daily inventory of 583,000 barrels of fuel oil which represents 30 days of normal operation of the two units. This supply is maintained by tanker deliveries approximately every ten to fifteen days. Reference is made to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for a discussion of the cost of fuel oil. COMMONWEALTH ENERGY SYSTEM (b) Nuclear Fuel Supply and Disposal Approximately 26% of the system's total energy requirement for 1993 was generated by nuclear plants. The nuclear fuel contract and inventory information for Seabrook 1 has been furnished to the system by North Atlantic Energy Services Corporation (NAESCO), the plant manager responsible for operation of the unit. The supply of fuel for nuclear generating plants generally involves the acquisition of uranium concentrate, its conversion to uranium hexafluoride, enrichment, fabrication of the nuclear fuel assemblies and disposition through reprocessing or storage of spent fuel. Seabrook's requirements for each of these fuel components are 100% covered through 1999 by existing contracts. There are no spent fuel reprocessing or disposal facilities currently operating in the United States. Instead, commercial nuclear electric generating units operating in the United States are required to retain high level wastes and spent fuel on-site. As required by the Nuclear Waste Policy Act of 1982 (the Act), as amended, the joint-owners entered into a contract with the Department of Energy for the transportation and disposal of spent fuel and high level radioactive waste at a national nuclear waste repository. Owners or generators of spent nuclear fuel or its associated wastes are required to bear all of the costs for such transportation and disposal through payment of a fee of approximately 1 mill/KWH based on net electric generation to the Nuclear Waste Fund. Under the Act, a temporary storage facility for nuclear waste was anticipated to be in operation by 1998; however, a reassess- ment of the project's schedule requires extending the completion date of the permanent facility until at least 2010. Seabrook 1 is currently licensed for enough on-site storage to accommodate all spent fuel expected to be accumulat- ed through the year 2010. Gas Supply In April 1992, the FERC issued Order 636 which became effective on November 1, 1993 and requires interstate pipelines to unbundle existing gas sales contracts into separate components (gas sales, transportation and storage services). Order 636 provides mechanisms which will allow customers such as Commonwealth Gas to reduce the level of firm services from the pipelines and "broker" excess capacity on a temporary or permanent basis. Order 636 also requires pipelines to provide transportation services that allow customers to receive the same level of service they had with the bundled contracts. In the past, Commonwealth Gas purchased the majority of its gas supplies from either Tennessee Gas Pipeline Company (Tennessee) or Algonquin Gas Transmission Company (Algonquin), a wholly-owned subsidiary of Texas Eastern Transmission Company (Texas Eastern), supplemented with third-party firm gas purchases and firm transportation from the various pipelines. Presently, Commonwealth Gas has only transportation, storage, and balancing contracts with these pipelines (and other upstream pipelines that bring gas from the supply wells to the final transporting pipelines), and contracts with a variety of independent vendors for firm gas supply. Twelve new firm gas supply contracts have been negotiated with suppliers and filed with the DPU. During the interim, Commonwealth Gas is operating under short-term firm agreements with these same vendors to provide firm supplies under similar terms and conditions as the long-term agreements, which are presently under review. Approvals are expected during the first half of 1994. COMMONWEALTH ENERGY SYSTEM In addition to firm transportation and gas supplies mentioned above, Commonwealth Gas utilizes contracts for underground storage and LNG facilities to meet its winter peaking demands. The underground storage contracts are a combination of existing agreements, that have been in existence for many years, and new agreements which are the result of Order 636 requirements for total service unbundling. The LNG facilities, described below, are used to liquefy and store pipeline gas during the warmer months for use during the heating season. During 1993, over 99% of the gas utilized by Commonwealth Gas was delivered by the interstate pipeline system, the remaining small quantity (approximately 360,000 MMBTU) was delivered as liquid LNG from Distrigas of Massachusetts. Commonwealth Gas entered into a multi-party agreement to assume a portion of Boston Gas Company's contracts to purchase Canadian gas supplies from Alberta Northeast (ANE), and have the volumes delivered by the Iroquois Gas Transmission System and Tennessee pipelines. The ANE gas supply contract was filed with the DPU and hearings were completed in April 1993. Commonwealth Gas is currently awaiting an order from the DPU. Commonwealth Gas began transporting gas on its distribution system in 1990 for end-users. There are currently only eleven customers using this transportation service, accounting for only 1,623 BBTU of throughput in 1993 which represented approximately 3.5% of system throughput. Hopkinton LNG Facility A portion of the system's gas supply during the heating season is provided by Hopkinton LNG Corp. (Hopkinton), a wholly-owned subsidiary of the System. The facility consists of a liquefaction and vaporization plant and three above-ground cryogenic storage tanks having an aggregate capacity of 3 million MCF of natural gas. In addition, Hopkinton owns a satellite vaporization plant and two above-ground cryogenic storage tanks located in Acushnet, Massachusetts with an aggregate capacity of 500,000 MCF of natural gas and are filled with LNG trucked from Hopkinton. Commonwealth Gas has a contract for LNG service with Hopkinton extending through 1996, thereafter renewable year to year with notice of termination due five years in advance. Contract payments include a demand charge sufficient to cover Hopkinton's fixed charges and an operating charge which covers liquefaction and vaporization expenses. Commonwealth Gas furnishes pipeline gas during the period April 15 to November 15 each year for liquefaction and storage. As the need arises, LNG is vaporized and placed in the distribution system of Commonwealth Gas. Based upon information presently available regarding projected growth in demand and estimates of availability of future supplies of pipeline gas, the System believes that its present sources of gas supply are adequate to meet existing load and allow for future growth in sales. COMMONWEALTH ENERGY SYSTEM Rates, Regulation and Legislation Certain of the System's utility subsidiaries operate under the jurisdic- tion of the DPU, which regulates retail rates, accounting, issuance of secur- ities and other matters. In addition, Canal and Cambridge Electric file their respective wholesale rates with the FERC. (a) Most Recent Rate Case Proceedings Electric On May 28, 1993, the DPU issued an order increasing Cambridge Electric's retail revenues by approximately $7.2 million, or 6.4%. The rates, based on a June 30, 1992 test-year and effective June 1, 1993, provide an overall return of 9.95%, including an equity return of 11% and represented approximately 70% of the amount requested. The new rates will have a positive impact on net income for the balance of 1993 and beyond. More than 80% of the increase related to: 1) plant additions since Cambridge Electric's last retail rate proceeding in 1989; 2) capacity costs associated with certain purchased power contracts; and 3) costs of postretirement benefits other than pensions. The costs associated with these postretirement benefits were determined in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," issued in 1990 and adopted as of January 1, 1993. The DPU authorized recovery of these costs over a four-year period with carrying costs on the deferred portion. The new base rates also reflect the roll-in of costs associated with the Seabrook nuclear power plant which are billed to Cambridge Electric by Canal. Previously these costs were recovered through Cambridge Electric's Fuel Charge decimal. On May 17, 1989, Cambridge Electric filed for an increase in its base rates using a 1988 test-year. On August 31, 1989, the DPU approved an Offer of Settlement between the parties which resolved all revenue requirements issues. Cambridge Electric was allowed to increase annual revenues by $4,438,000 or 5.5% of total test-year revenue, approximately 73% of the $6,111,000 originally requested. The new rates became effective on December 18, 1989 and represented the first increase in Cambridge Electric's rates since 1982. On July 1, 1991, the DPU issued an order increasing Commonwealth Elec- tric's retail electric revenues by $10.9 million, or 3.1%. The requested increase was $17.3 million. The order, based on a June 30, 1990 test-year, provided an overall return of 10.49%, including a return on equity of 12%. The DPU ordered the restructuring of the Company's rates to more closely reflect the actual cost of providing service to each customer class. The DPU also ordered Commonwealth Electric to undertake an independent management audit to address, among other areas, its management, planning and control practices. In February 1992, Ernst & Young was selected by the DPU from three management consulting firms submitted by Commonwealth Electric to perform the audit which began on March 6, 1992. On October 9, 1992, the DPU released the results of the audit which evaluated existing activities and processes and identified opportunities for improved operations in the areas of strategic planning, budget development, control of capital and operations costs, management of outside services, employment policies and customer services. COMMONWEALTH ENERGY SYSTEM Throughout 1993, follow-up discussions were held between Commonwealth Electric and the DPU regarding the status of each audit recommendation with both parties expressing overall satisfaction with their progress. Changes in the implementation plan were discussed, with the plan expected to be completed in 1994. In January 1989, Commonwealth Electric received authorization from the DPU to increase base revenues by $18 million or 6.6% of total test-year revenues. This increase, representing approximately 77% of its original $23.3 million request, included an overall rate of return of 10.89% and a return on common equity of 13%. It represented the first increase in Commonwealth Elec- tric's base rates since 1982. Gas On April 16, 1991, Commonwealth Gas requested a $27.7 million (11.3%) revenue increase in a filing with the DPU using a test-year ended December 31, 1990. On September 16, 1991, the DPU approved a settlement of the revenue requirements portion of the filing authorizing a $22.8 million increase in annual revenues, approximately 82% of the original request. The agreement included a return on equity, for accounting purposes, of 13%. The DPU later ruled on the rate design portion of the request and the new rates went into effect on November 1, 1991. The increase was necessitated by the rising costs of providing service to customers and substantial expenditures to upgrade, improve and maintain the Commonwealth Gas distribution system. (b) Wholesale Rate Proceedings Cambridge Electric requires FERC approval to increase its wholesale rates to the Town of Belmont, Massachusetts (Belmont), a "partial requirements" customer since 1986. These rates include a fuel adjustment clause which reflects changes in costs of fuels and purchased power used to supply Belmont. On March 23, 1990, Cambridge Electric filed a request with the FERC to increase its wholesale rates to Belmont by $2,252,000 annually. The request was largely due to increased purchased power costs and major additions to plant-in-service. The proposed rates were accepted by the FERC, subject to refund, on August 1, 1990. On September 19, 1990, Cambridge Electric and Belmont filed an uncontested Offer of Settlement which the FERC approved on December 6, 1990 resolving all issues with the exception of Seabrook 1 costs which were subject to change based upon the results of the FERC's final review of Canal's investment in the unit. This settlement required Cambridge Electric to adjust its Belmont rate to reflect the final allocation of power purchased by Canal on behalf of Cambridge Electric and Commonwealth Electric. Cambridge Electric made a refund to Belmont in August 1991 and filed the requisite compliance report with the FERC on September 16, 1991. A settlement agreement between Canal and Belmont addressing all Seabrook cost-of-service issues (except rate of return on common equity) was filed with the FERC on April 16, 1991 and subsequently approved by the FERC on November 13, 1991. In addition, this settlement changed the effective date of the Belmont Service Agreement from August 1, 1990 to June 30, 1990. The charges and refunds resulting from this settlement were applied to Belmont's bill in January 1992. COMMONWEALTH ENERGY SYSTEM On November 12, 1991 a settlement agreement between Canal and Belmont addressing the rate of return on common equity in the Seabrook Power Contract was filed with the FERC. The return on equity settlement, which was approved by the FERC on January 29, 1992, allowed a return on equity of 11.72% and required Canal to refund certain sums to Cambridge Electric and Commonwealth Electric and to make a compliance report to the FERC. On March 12, 1992, Canal made its compliance filing with the FERC indicating that all refunds were made to Cambridge Electric and Commonwealth Electric on February 27, 1992. As a result of the return on equity settlement, Cambridge Electric was required to refund certain sums to Belmont. On April 2, 1992 Cambridge made its requisite compliance filing with the FERC indicating that refunds were made to Belmont in the March 1992 billings. (c) Automatic Adjustment Clauses Electric Both Commonwealth Electric and Cambridge Electric have Fuel Charge rate schedules which generally allow for current recovery, from retail customers, of fuel used in electric production, purchased power and transmission costs. These schedules require a quarterly computation and DPU approval of a Fuel Charge decimal based upon forecasts of fuel, purchased power, transmission costs and billed unit sales for each period. To the extent that collections under the rate schedules do not match actual costs for that period, an appropriate adjustment is reflected in the calculation of the next subsequent calendar quarter decimal. Cambridge Electric and Commonwealth Electric collect a portion of the capacity-related purchased power costs associated with certain long-term power arrangements through base rates. The recovery mechanism for these costs uses a per kilowatthour (KWH) factor that is calculated using historical (test- period) capacity costs and unit sales. This factor is then applied to current monthly KWH sales. When current period capacity costs and/or unit sales vary from test-period levels, Cambridge Electric and Commonwealth Electric experience a revenue excess or shortfall which can have a significant impact on net income. All other capacity and energy-related purchased power costs are recovered through the Fuel Charge. Cambridge Electric and Commonwealth Electric made a filing in late 1992 with the DPU seeking an alternative method of recovery. This request was denied in a letter order issued on October 6, 1993. However, Cambridge Electric and Commonwealth Electric were encouraged by the DPU's acknowledgement that the issues presented warrant further consideration. The DPU encouraged each company to continue to work with other interested parties, including the Attorney General of Massachusetts, to reach a consensus solution on the issue for consideration in each company's next base rate proceeding. Both Commonwealth Electric and Cambridge Electric have separately stated Conservation Charge rate schedules which allow for current recovery, from retail customers, of Conservation and Load Management program costs. For further information, refer to Management's Discussion and Analysis of Financial Condition and Results of Operations filed under Item 7 of this report. COMMONWEALTH ENERGY SYSTEM Gas Commonwealth Gas has a Standard Seasonal Cost of Gas Adjustment rate schedule (CGA) which provides for the recovery, from firm customers, of purchased gas costs not collected through base rates. These schedules, which require DPU approval, are estimated semi-annually and include credits for gas pipeline refunds and profit margins applicable to interruptible sales. Actual gas costs are reconciled annually as of October 31 and any difference is included as an adjustment in the calculation of the decimals for the two subsequent six-month periods. The DPU and the Massachusetts Energy Facilities Siting Council (the Council) were merged in 1992. The Council is now a division of the DPU. Periodically, Commonwealth Gas is required to file a long-range forecast of the energy needs and requirements of its market area and annual supplements thereto with the Council. To approve a long-range forecast, the Council must find, among other things, that Commonwealth Gas plans for construction of new gas manufacturing or storage facilities and certain high-pressure gas pipelines are consistent with current health, environmental protection, and resource use and development policies as adopted by the Commonwealth of Massachusetts. Commonwealth Gas filed a long-range forecast with the Council on July 20, 1990 and updated aspects of the filing in March 1991. This forecast was combined with the DPU review of the ANE contract. Both dockets remain pending before the DPU. (d) Gas Demand, Take-or-Pay Costs and Transition Costs Commonwealth Gas is obligated, as part of its pipeline transportation contracts and supplier gas purchase contracts, to pay monthly demand charges which are recovered from customers through the CGA. In June 1991, Tennessee filed a settlement with the FERC dealing with a variety of contract restructuring issues, including the allocation of take-or- pay costs to Tennessee's customers including Commonwealth Gas. This comprehensive settlement was approved and implemented on July 1, 1992. As part of the settlement, the allocation of take-or-pay costs was changed from a deficiency basis to a contract demand basis which increased Commonwealth Gas' allocation. Future take-or-pay costs will be included in Tennessee's Temporary Gas Inventory Charge and transition costs under Tennessee's restructuring pursuant to Order 636. Algonquin made a series of filings with the FERC to recover from its customers take-or-pay charges imposed on it by its upstream suppliers. Algonquin billed Commonwealth Gas for gas supply inventory charges from Texas Eastern and others through the Algonquin commodity rate. With the implementation of Order 636, Algonquin allocated the remaining costs utilizing a formula based on actual purchases for the twelve months prior to May 1, 1993. Commonwealth Gas' allocation was in excess of $5 million. Commonwealth Gas successfully appealed Algonquin's allocation method to the FERC. The change in allocation, combined with issues being settled in Algonquin's current rate case will reduce Commonwealth Gas' allocated share by $1.5 million to $2.5 million. As a direct result of implementation of Order 636, most pipeline companies are incurring transition costs which include the cost of COMMONWEALTH ENERGY SYSTEM restructuring gas supply contracts, the value of facilities that were supporting the gas sales function and are no longer used and useful for transportation only services, the cost of contracts with upstream pipeline companies and various miscellaneous costs. For additional information on these transition costs refer to Note 2(g) of Notes to Financial Statements filed under Item 8 of this report. Commonwealth Gas is collecting take-or-pay and other contract restructuring costs from its customers through the CGA as permitted by the DPU. The remaining take-or-pay costs to be billed to Commonwealth Gas from both Algonquin and Tennessee are estimated at approximately $431,000 as of December 31, 1993, subject to change upon FERC approval. (e) Economic Development Rate Commonwealth Electric implemented an Economic Development Rate (EDR) on October 1, 1991. The rate is available to new or existing industrial customers who have an electric demand of 500 kilowatts or more and meet specific financial criteria. For additional information concerning the EDR, refer to the "Economic Development Rate" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" filed under Item 7 of this report. (f) Other Storm Damage Costs In August 1991, Commonwealth Electric's service territory was partic- ularly hard hit by Hurricane Bob. Its transmission and distribution system suffered such extensive damage that its entire service territory (with minor exceptions) was without power at one point. Commonwealth Electric's franchise is located entirely within four of the ten Massachusetts counties which were declared federal disaster zones. In April 1992, the DPU approved an offer of settlement between Commonwealth Electric, the Attorney General of Massachusetts and a Cape Cod consumer group relating to certain costs associated with this storm. For further information on this settlement, refer to Note 3 of Notes to Consolidated Financial Statements filed under Item 8 of this report. Segment Information System companies provide electric, gas and steam services to retail customers in service territories located in central and eastern Massachusetts and, in addition, sell electricity at wholesale to Massachusetts customers. Other operations of the system include the development and management of new real estate ventures and operation of rental properties and other investment activities which do not presently contribute significantly to either revenues or operating income. Reference is made to additional industry segment information in Note 11 of Notes to Consolidated Financial Statements filed under Item 8 of this re- port. COMMONWEALTH ENERGY SYSTEM Environmental Matters The system is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. Compliance with these laws and regulations has required capital expenditures by the system for the period 1968 through 1993 of approximately $51.8 million, $29.7 million of which was for facilities and studies at Seabrook. Additional capital expenditures through 1998 will require an estimated $25.1 million. For additional information concerning environmental issues including those relating to former gas manufacturing sites, refer to the "Environmental Matters" section of "Management's Discussion and Analysis of Financial Condi- tion and Results of Operations" filed under Item 7 of this report. Construction and Financing For information concerning the system's financing and construction programs refer to Management's Discussion and Analysis of Financial Condition and Results of Operations filed under Item 7 and Note 2(a) of the Notes to Consolidated Financial Statements filed under Item 8 of this report. Employees The total number of full-time employees for the system declined 8.2% to 2,217 in 1993 from 2,414 employees at year-end 1992 due to a second quarter work force reduction. Of the current total, 1,338 (60%) are represented by various collective bargaining units. Existing agreements are for varying periods and expire in 1994 and thereafter. Employee relations have generally been satisfactory and management views the current work force level to be appropriate to service the system's customers. Item 2. Item 2. Properties The system's principal electric properties consist of Canal Unit 1, a 569 MW oil-fired steam electric generating unit, and its one-half ownership in Canal Unit 2, a 580 MW oil-fired steam electric generating unit, both located at Canal Electric's facility in Sandwich, Massachusetts. Other electric properties include an integrated system of distribution lines and substations together with Commonwealth Electric's 60 MW steam electric generating station located in New Bedford, Massachusetts. This unit, which ceased operations in October 1992, was abandoned in 1993. As a result, the net book value of the plant of approximately $4 million was reclassified from property, plant and equipment to a regulatory asset in anticipation of future recovery. Cambridge Electric has two steam electric generating stations with a net capability of 76.5 MW located in Cambridge, Massachusetts. In addition, the system has a 3.52% interest (40.5 MW of capacity) in Seabrook 1 and a 1.4% or 8.8 MW joint-ownership interest in Central Maine Power Company's Wyman Unit 4. The system also owns smaller generating units totaling 65.3 MW used primarily for peaking and emergency purposes. In addition, the system's other principal properties consist of an electric division office building in Wareham, Massachusetts and other structures such as garages and service buildings. COMMONWEALTH ENERGY SYSTEM At December 31, 1993, the electric transmission and distribution system consisted of 5,784 pole miles of overhead lines, 4,095 cable miles of under- ground line, 359 substations and 371,594 active customer meters. The principal natural gas properties consist of distribution mains, ser- vices and meters necessary to maintain reliable service to customers. At the end of 1993, the gas system included 2,739 miles of gas distribution lines, 151,192 services and 237,318 customer meters together with the necessary measuring and regulating equipment. In addition, the system owns a lique- faction and vaporization plant, a satellite vaporization plant and above- ground cryogenic storage tanks having an aggregate storage capacity equivalent to 3.5 million MCF of natural gas. The system's gas division owns a central headquarters and service building in Southborough, Massachusetts, five district office buildings and several natural gas receiving and take stations. Item 3. Item 3. Legal Proceedings Refer to the "Environmental Matters" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, page 42. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None COMMONWEALTH ENERGY SYSTEM PART II. Item 5. Item 5. Market for the Registrant's Securities and Related Stockholder Matters (a) Principal Markets The System's common shares are listed on the New York, Boston and Pacific Stock Exchanges. The table below sets forth the high and low closing prices as reported on the New York Stock Exchange composite transactions tape. 1993 by Quarter First Second Third Fourth High $48 7/8 $48 5/8 $50 1/8 $49 3/4 Low 40 1/2 43 3/8 46 3/4 43 1992 by Quarter First Second Third Fourth High $39 $40 $43 $43 Low 36 3/8 34 7/8 39 1/2 40 1/4 (b) Number of Shareholders at December 31, 1993 15,877 shareholders (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Per Share Share Declaration Date Amount Declaration Date Amount March 25, 1993 $ .73 March 26, 1992 $ .73 June 24, 1993 .73 June 25, 1992 .73 September 23, 1993 .73 September 24, 1992 .73 December 16, 1993 .73 December 17, 1992 .73 $2.92 $2.92 (d) Future dividends may vary depending upon the System's earnings and capital requirements as well as financial and other conditions existing at that time. Item 6. Item 6. Selected Financial Data Information required by this item is incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, page 67. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Information required by this item is incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, pages 33 through 45. COMMONWEALTH ENERGY SYSTEM Item 8. Item 8. Financial Statements and Supplementary Data The following consolidated financial statements and supplementary data of the System and its subsidiaries are incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994 on pages 46 through 66. Proxy Page Reference Management's Report 46 Report of Independent Public Accountants 47 Consolidated Balance Sheets - At December 31, 1993 and 1992 48-49 Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991 50 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 51 Consolidated Statements of Capitalization - At December 31, 1993 and 1992 52 Consolidated Statements of Changes in Common Shareholders' Investment and in Redeemable Preferred Shares - Years Ended December 31, 1993, 1992 and 1991 53 Notes to Consolidated Financial Statements 54-66 Quarterly Information pertaining to the results of operations for the years ended December 31, 1993 and 1992 67 Item 9. Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure None COMMONWEALTH ENERGY SYSTEM PART III. Item 10. Item 10. Trustees and Executive Officers of the Registrant a. Trustees of the Registrant: Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, pages 3-5. b. Executive Officers of the Registrant: Age at December Name of Officer Position and Business Experience 31, 1993 William G. Poist President, Chief Executive Officer and 60 Trustee of the System and Chairman and Chief Executive Officer of its principal subsidiary companies since January 1, 1992; President and Chief Operating Officer of Commonwealth Gas Company* from 1983 to 1991 and Hopkinton LNG Corp.* from 1985 to 1991; Vice President of the System and COM/Energy Services Company* effective September 1, 1991. James D. Rappoli Financial Vice President and Treasurer of 42 the System and its subsidiary companies effective March 1, 1993; Treasurer of System subsidiary companies 1990; Assistant Treasurer of System subsidiary companies 1989. Russell D. Wright President and Chief Operating Officer of 47 Cambridge Electric Light Company, Canal Electric Company, COM/Energy Steam Company, and Commonwealth Electric Company (effective March 1, 1993); Financial Vice President and Treasurer of the System and Financial Vice President of its subsidiary companies (July 1987 to March 1993); Treasurer of System subsidiary companies (December 1989 to December 1990), Assistant Vice President- Finance of System subsidiary companies 1986. Kenneth M. Margossian President and Chief Operating Officer of 45 Commonwealth Gas Company* and Hopkinton LNG Corp.* effective September 1, 1991; Vice President of Operations from 1988 to 1991; Vice President of Facilities Develop- ment from 1987 to 1988; Vice President of Human Resources and Administration of Commonwealth Gas Company from 1985 to 1987. Subsidiary of the System. COMMONWEALTH ENERGY SYSTEM b. Executive officers of the Registrant (Continued): Age at December Name of Officer Position and Business Experience 31, 1993 Michael P. Sullivan Vice President, Secretary, and 45 General Counsel of the System and subsidiary companies (effective June 1993); Vice President, Secretary, and General Attorney of the System and subsidiary companies since 1981. John A. Whalen Comptroller of the System and subsidiary 46 companies since 1978. Subsidiary of the System. The term of office for System officers expires May 5, 1994, the date of the next Annual Organizational Meeting. There are no family relationships between any trustee and executive officer and any other trustee or executive of the System. There were no arrangements or understandings between any officer or trustee and any other person pursuant to which he was or is to be selected as an officer, trustee or nominee. There have been no events under any bankruptcy act, no criminal pro- ceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any trustee or executive officer during the past five years. Item 11. Item 11. Executive Compensation Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Informa- tion dated April 1, 1994, pages 6-10. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Inform- ation dated April 1, 1994, pages 3-5. Item 13. Item 13. Certain Relationships and Related Transactions Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Inform- ation dated April 1, 1994, pages 3-5. COMMONWEALTH ENERGY SYSTEM PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Consolidated financial statements and notes thereto of Commonwealth Energy System and Subsidiary Companies together with the Report of Independent Public Accountants, as detailed on page 19 in Item 8 of this Form 10-K, have been incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994. (a) 2. Index to Financial Statement Schedules Commonwealth Energy System and Subsidiary Companies Filed herewith at page(s) indicated - Report of Independent Public Accountants on Schedules (page 46). Schedule III - Investments in, Equity in Earnings of, and Dividends Received from Related Parties - Years Ended December 31, 1993, 1992 and 1991 (pages 47-49). Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 50-52). Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (page 53). Schedule VIII - Valuation and Qualifying Accounts - Years Ended December 31, 1993, 1992 and 1991 (page 54). Schedule IX - Short-Term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 55). All other schedules have been omitted because they are not applicable, not required or because the required information is included in the financial statements or notes thereto. Subsidiaries not Consolidated and Fifty-Percent or Less Owned Persons Financial statements of 50% or less owned persons accounted for by the equity method have been omitted because they do not, considered individ- ually or in the aggregate, constitute a significant subsidiary. Form 11-K, Annual Reports of Employee Stock Purchases, Savings and Similar Plans Pursuant to Rule 15(d)-21 of the Securities and Exchange Act of 1934, the information, financial statements and exhibits required by Form 11-K with respect to the Employees Savings Plan of Commonwealth Energy System and Subsidiary Companies will be filed as an amendment to this report under cover of Form 10-K/A or Form SE no later than May 2, 1994. COMMONWEALTH ENERGY SYSTEM (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Securities and Exchange Commission file numbers indicated in parentheses. b. If applicable, as designated by an asterisk, certain documents prev- iously filed by the System or its subsidiary companies have been dis- posed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the appropriate registrant and to the appropriate file number. c. During 1981, New Bedford Gas and Edison Light Company sold its gas business and properties to Commonwealth Gas Company and changed its corporate name to Commonwealth Electric Company. d. The following is a glossary of Commonwealth Energy System and subsid- iary companies' acronyms that are used throughout the following Exhibit Index: CES ......................Commonwealth Energy System CE .......................Commonwealth Electric Company CEL ......................Cambridge Electric Light Company CEC ......................Canal Electric Company CG .......................Commonwealth Gas Company NBGEL ....................New Bedford Gas and Edison Light Company HOPCO ....................Hopkinton LNG Corp. Exhibit Index Exhibit 3. Declaration of Trust Commonwealth Energy System (Registrant) 3.1.1 Declaration of Trust of CES dated December 31, 1926, as amended by vote of the shareholders and trustees May 7, 1987 (Exhibit 1 to the CES Form 10-Q (March 1987), File No. 1-7316). Exhibit 4. Instruments defining the rights of security holders, including indentures Commonwealth Energy System (Registrant) Debt Securities - 4.1.1 CES Note Agreement ($40 Million Privately Placed Senior Notes) dated June 28, 1989 (Exhibit 1 to the CES Form 10-Q (September 1989), File No. 1-7316). COMMONWEALTH ENERGY SYSTEM Subsidiary Companies of the Registrant Cambridge Electric Light Company Indenture of Trust or Supplemental Indenture of Trust - 4.2.1 Original Indenture on Form S-1 (April, 1949) (Exhibit 7(a), File No. 2-7909) 4.2.2 First Supplemental on Form S-9 (Jan., 1958) (Exhibit 2(b)2, File No. 2-13783) 4.2.3 Second Supplemental on Form 8-K (Feb., 1962) (Exhibit A, File No. 2-7909) 4.2.4 Third Supplemental on Form 10-K (1984) (Exhibit 1, File No. 2-7909) 4.2.5 Fourth Supplemental on Form 10-K (1984) (Exhibit 2, File No. 2-7909) 4.2.6 Fifth Supplemental on Form 10-K (1983) (Exhibit 1, File No. 2-7909) 4.2.7 Sixth Supplemental on Form 10-Q (June 1989) (Exhibit 1, File No. 2- 7909) 4.2.8 Seventh Supplemental on Form 10-Q (June 1992), (Exhibit 1, File No 2-7909). Canal Electric Company Indenture of Trust and First Mortgage or Supplemental Indenture of Trust and First Mortgage - 4.3.1 Indenture of Trust and First Mortgage with State Street Bank and Trust Company, Trustee, dated October 1, 1968 (Exhibit 4(b) to Form S-1, File No. 2-30057). 4.3.2 First and General Mortgage Indenture with Citibank, N.A., Trustee, dated September 1, 1976 (Exhibit 4(b)2 to Form S-1, File No. 2- 56915). 4.3.3 First Supplemental dated October 1, 1968 with State Street Bank and Trust Company, Trustee, dated September 1, 1976 (Exhibit 4(b)3 to Form S-1, File No. 2-56915). 4.3.4 Second Supplemental dated September 1, 1976 with Citibank, N.A., New York, N.Y., Trustee, dated December 1, 1983 (Exhibit 1 to 1983 Form 10-K, File No. 2-30057). 4.3.5 Third Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 3 to 1990 Form 10-K, File No. 2-30057). 4.3.6 Fourth Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 4 to 1990 Form 10-K, File No. 2-30057). COMMONWEALTH ENERGY SYSTEM Commonwealth Gas Company Indenture of Trust or Supplemental Indenture of Trust - 4.4.1 Original Indenture on Form S-1 (Feb., 1949) (Exhibit 7(a), File No. 2-7820) 4.4.2 First Supplemental on Form S-1 (Mar., 1950) (Exhibit 7(a), File No. 2-8418) 4.4.3 Second and Third Supplemental on Form S-1 (Nov., 1952) (Exhibits 4(a)(2) and 4(a)(3), File No. 2-10445) 4.4.4 Fourth Supplemental on Form S-9 (Oct., 1954) (Exhibit 2(b)(5), File No. 2-15089) 4.4.5 Fifth Supplemental on Form S-9 (Mar., 1956) (Exhibit 2(b)(6), File No. 2-15089) 4.4.6 Sixth Supplemental on Form S-9 (April, 1957) (Exhibit 2(b)(7), File No. 2-15089) 4.4.7 Seventh Supplemental on Form S-9 (June 1959) (Exhibit 2(b)(8), File No. 2-20532) 4.4.8 Eighth Supplemental on Form S-9 (Sept., 1961) (Exhibit 2(b)(9), File No. 2-20532) 4.4.9 Ninth Supplemental on Form 8-K (Aug., 1962) (Exhibit A, File No. 2- 1647) 4.4.10 Tenth Supplemental on Form 10-K (1970) (Exhibit 2, File No. 2-1647) 4.4.11 Eleventh Supplemental on Form S-1 (June, 1972) (Exhibit 4(b)(2), File No. 2-48556) 4.4.12 Twelfth Supplemental on Form S-1 (Aug., 1973) (Exhibit 4(b)(3), File No. 2-48556) 4.4.13 Thirteenth Supplemental on Form 10-K (1992) (Refiled as Exhibit 1, File No. 2- 1647) 4.4.14 Fourteenth Supplemental on Form 10-K (1990) (Exhibit 1, File No. 2- 1647) 4.4.15 Fifteenth Supplemental on Form 10-K (1982) (Exhibit 1, File No. 2- 1647) 4.4.16 Sixteenth Supplemental on Form 10-K (1986) (Exhibit 1, File No. 2- 1647) 4.4.17 Seventeenth Supplemental on Form 10-K (1990) (Exhibit 2, File No. 2-1647) COMMONWEALTH ENERGY SYSTEM Commonwealth Electric Company Indenture of Trust or Supplemental Indenture of Trust - 4.5.1 Original Indenture on Form S-1 (Nov., 1948) (Exhibit 7(a), File No. 2-7749) 4.5.2 First Supplemental on Form S-1 (Oct., 1950) (Exhibit 7(a-1), File No. 2-8605) 4.5.3 Second Supplemental on Form 10-K (1984) (Exhibit 1, File No. 2- 7749) 4.5.4 Third Supplemental on Form 8-K (Feb., 1962) (Exhibit A, File No. 2- 7749) 4.5.5 Fourth Supplemental on Form 10-K (1984) (Exhibit 2, File No. 2- 7749) 4.5.6 Fifth Supplemental on Form 10-K (1984) (Exhibit 3, File No. 2-7749) 4.5.7 Sixth Supplemental on Form 10-K (1984) (Exhibit 4, File No. 2-7749) 4.5.8 Seventh Supplemental on Form S-1 (Dec., 1975) (Exhibit 4(b)2, File No. 2-54955) Cape & Vineyard Electric Company 4.5.9 Original Indenture on Form S-1 (Apr., 1957) (Exhibit 4(b)1, File No. 2-26429) 4.5.10 First Supplemental on Form 10-K (1984) (Exhibit 5, File No. 2-7749) 4.5.11 Second Supplemental on Form 10-K (1984) (Exhibit 6, File No. 2- 7749) Merged with Commonwealth Electric Company January 1, 1971. Exhibit 10. Material Contracts 10.1 Power contracts. 10.1.1 Power contracts between CEC (Unit 1) and NBGEL and CEL dated December 1, 1965 (Exhibit 13(a)(1-4) to the CEC Form S-1, File No. 2-30057). 10.1.2 Power contract between Yankee Atomic Electric Company (YAEC) and CEL dated June 30, 1959, as amended April 1, 1975 (Refiled as Exhibit 1 to the 1991 CEL Form 10-K, File No. 2-7909). 10.1.2.1 Second, Third and Fourth Amendments to 10.1.2 as amended October 1, 1980, April 1, 1985 and May 6, 1988, respectively (Exhibit 2 to the CEL Form 10-Q (June 1988), File No. 2-7909). COMMONWEALTH ENERGY SYSTEM 10.1.2.2 Fifth and Sixth Amendments to 10.1.2 as amended June 26, 1989 and July 1, 1989, respectively (Exhibit 1 to the CEL Form 10-Q (September 1989), File No. 2-7909). 10.1.3 Power Contract between YAEC and NBGEL dated June 30, 1959, as amended April 1, 1975 (Refiled as Exhibit 2 to the 1991 CE Form 10-K, File No. 2-7749). 10.1.3.1 Second, Third and Fourth Amendments to 10.1.3 as amended October 1, 1980, April 1, 1985 and May 6, 1988, respectively (Exhibit 1 to the CE Form 10-Q (June 1988), File No. 2-7749). 10.1.3.2 Fifth and Sixth Amendments to 10.1.3 as amended June 26, 1989 and July 1, 1989, respectively (Exhibit 3 to the CE Form 10-Q (September 1989), File No. 2-7749). 10.1.4 Power Contract between Connecticut Yankee Atomic Power Company (CYAPC) and CEL dated July 1, 1964 (Exhibit 13-K1 to the System's Form S-1, (April 1967) File No. 2-25597). 10.1.4.1 Additional Power Contract providing for extension on contract term between CYAPC and CEL dated April 30, 1984 (Exhibit 5 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.4.2 Second Supplementary Power Contract providing for decommissioning financing between CYAPC and CEL dated April 30, 1984 (Exhibit 6 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.5 Power contract between Vermont Yankee Nuclear Power Corporation (VYNPC) and CEL dated February 1, 1968 (Exhibit 3 to the CEL 1984 Form 10-K, File No. 2-7909). 10.1.5.1 First Amendment dated June 1, 1972 (Section 7) and Second Amendment dated April 15, 1983 (decommissioning financing) to 10.1.5 (Exhibits 1 and 2, respectively, to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.5.2 Third Amendment dated April 1, 1985 and Fourth Amendment dated June 1, 1985 to 10.1.5 (Exhibits 1 and 2, respectively, to the CEL Form 10-Q (June 1986), File No. 2-7909). 10.1.5.3 Fifth and Sixth Amendments to 10.1.5 dated February 1, 1968, both as amended May 6, 1988 (Exhibit 1 to the CEL Form 10-Q (June 1988), File No. 2-7909). 10.1.5.4 Seventh Amendment to 10.1.5 dated February 1, 1968, as amended June 15, 1989 (Exhibit 2 to the CEL Form 10-Q (September 1989), File No. 2-7909). 10.1.5.5* Additional Power Contract dated February 1, 1984 between CEL and VYNPC providing for decommissioning financing and contract extension (Refiled as Exhibit 1 to CEL 1993 Form 10-K, File No. 2- 7909). COMMONWEALTH ENERGY SYSTEM 10.1.6 Power contract between Maine Yankee Atomic Power Company (MYAPC) and CEL dated May 20, 1968 (Exhibit 5 to the System's Form S-7, File No. 2-38372). 10.1.6.1 First Amendment dated March 1, 1984 (decommissioning financing) and Second Amendment dated January 1, 1984 (supplementary payments) to 10.1.6 (Exhibits 3 and 4 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.6.2 Third Amendment to 10.1.6 dated October 1, 1984 (Exhibit 1 to the CEL Form 10-Q (September 1984), File No. 2-7909). 10.1.7 Agreement between NBGEL and Boston Edison Company (BECO) for the purchase of electricity from BECO's Pilgrim Unit No. 1 dated August 1, 1972 (Exhibit 7 to the CE 1984 Form 10-K, File No. 2- 7749). 10.1.7.1 Service Agreement between NBGEL and BECO for purchase of stand-by power for BECO's Pilgrim Station dated August 16, 1978 (Exhibit 1 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.7.2 System Power Sales Agreement by and between CE and BECO dated July 12, 1984 (Exhibit 1 to the CE Form 10-Q (September 1984), File No. 2-7749). 10.1.7.3 Power Exchange Agreement by and between BECO and CE dated December 1, 1984 (Exhibit 16 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.7.4 Power Exchange Agreement by and between BECO and CEL dated December 1, 1984 (Exhibit 5 to the CEL 1984 Form 10-K, File No. 2- 7909). 10.1.7.5 Service Agreement for Non-Firm Transmission Service between BECO and CEL dated July 5, 1984 (Exhibit 4 to the CEL 1984 Form 10-K, File No. 2-7909). 10.1.8 Agreement for Joint-Ownership, Construction and Operation of New Hampshire Nuclear Units (Seabrook) dated May 1, 1973 (Exhibit 13(N) to the NBGEL Form S-1 dated October 1973, File No. 2-49013 and as amended below: 10.1.8.1 First through Fifth Amendments to 10.1.8 as amended May 24, 1974, June 21, 1974, September 25, 1974, October 25, 1974 and January 31, 1975, respectively (Exhibit 13(m) to the NBGEL Form S-1 (November 7, 1975), File No. 2-54995). 10.1.8.2 Sixth through Eleventh Amendments to 10.1.8 as amended April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979 and December 15, 1979, respectively (Refiled as Exhibit 1 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.8.3 Twelfth through Fourteenth Amendments to 10.1.8 as amended May 16, 1980, December 31, 1980 and June 1, 1982, respectively (Refiled as Exhibits 1, 2, and 3 to the CE 1992 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.8.4 Fifteenth and Sixteenth Amendments to 10.1.8 as amended April 27, 1984 and June 15, 1984, respectively (Exhibit 1 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.8.5 Seventeenth Amendment to 10.1.8 as amended March 8, 1985 (Exhibit 1 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.8.6 Eighteenth Amendment to 10.1.8 as amended March 14, 1986 (Exhibit 1 to the CEC Form 10-Q (March 1986), File No. 2-30057). 10.1.8.7 Nineteenth Amendment to 10.1.8 as amended May 1, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 2-30057). 10.1.8.8 Twentieth Amendment to 10.1.8 as amended September 19, 1986 (Exhibit 1 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.8.9 Twenty-First Amendment to 10.1.8 as amended November 12, 1987 (Exhibit 1 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.8.10 Settlement Agreement and Twenty-Second Amendment to 10.1.8, both dated January 13, 1989 (Exhibit 4 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.9 Interim Agreement to Preserve and Protect the Assets of and Investment in the New Hampshire Nuclear Units dated April 27, 1984 (Exhibit 2 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.10 Resolutions proposed by Merrill Lynch Capital Markets and adopted by the Joint-Owners of the Seabrook Nuclear Project regarding Project financing, dated May 14, 1984 (Exhibit 1 to the CEC Form 10-Q (March 1984), File No. 2-30057). 10.1.11 Agreement for Seabrook Project Disbursing Agent establishing YAEC as the disbursing agent under the Joint-Ownership Agreement, dated May 23, 1984 (Exhibit 4 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.11.1 First Amendment to 10.1.11 as amended March 8, 1985 (Exhibit 2 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.11.2 Second through Fifth Amendments to 10.1.11 as amended May 20, 1985, June 18, 1985, January 2, 1986 and November 12, 1987, respectively (Exhibit 4 to the CEC 1987 Form 10-K, File No. 2- 30057). 10.1.12 Agreement to Share Certain Costs Associated with the Tewksbury- Seabrook Transmission Line dated May 8, 1986 (Exhibit 2 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.13 Purchase and Sale Agreement together with an implementing Addendum dated December 31, 1981, between CE and CEC, for the purchase and sale of the CE 3.52% joint-ownership interest in the Seabrook units, dated January 2, 1981 (Refiled as Exhibit 4 to the CE 1992 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.14 Agreement to transfer ownership, construction and operational interest in the Seabrook Units 1 and 2 from CE to CEC dated January 2, 1981 (Refiled as Exhibit 3 to the 1991 CE Form 10-K, File No. 2-7749). 10.1.15 Termination Supplement between CEC, CE and CEL for Seabrook Unit 2, dated December 8, 1986 (Exhibit 3 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.16 Power Contract, as amended to February 28, 1990, superseding the Power Contract dated September 1, 1986 and amendment dated June 1, 1988, between CEC (seller) and CE and CEL (purchasers) for seller's entire share of the Net Unit Capability of Seabrook 1 and related energy (Exhibit 1 to the CEC Form 10-Q (March 1990), File No. 2-30057). 10.1.17 Agreement between NBGEL and Central Maine Power Company (CMP), for the joint-ownership, construction and operation of William F. Wyman Unit No. 4 dated November 1, 1974 together with Amendment No. 1 dated June 30, 1975 (Exhibit 13(N) to the NBGEL Form S-1, File No. 2-54955). 10.1.17.1 Amendments No. 2 and 3 to 10.1.17 as amended August 16, 1976 and December 31, 1978 (Exhibit 5(a) 14 to the System's Form S-16 (June 1979), File No. 2-64731). 10.1.18 Agreement between the registrant and Montaup Electric Company (MEC) for use of common facilities at Canal Units I and II and for allocation of related costs, executed October 14, 1975 (Exhibit 1 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.18.1 Agreement between the registrant and MEC for joint-ownership of Canal Unit II, executed October 14, 1975 (Exhibit 2 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.18.2 Agreement between the registrant and MEC for lease relating to Canal Unit II, executed October 14, 1975 (Exhibit 3 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.19 Contract between CEC and NBGEL and CEL, affiliated companies, for the sale of specified amounts of electricity from Canal Unit 2 dated January 12, 1976 (Exhibit 7 to the System's 1985 Form 10-K, File No. 1-7316). 10.1.20 Capacity Acquisition Agreement between CEC,CEL and CE dated September 25, 1980 (Refiled as Exhibit 1 to the 1991 CEC Form 10- K, File No. 2-30057). 10.1.20.1 Supplement to 10.1.20 consisting of three Capacity Acquisition Commitments each dated May 7, 1987, concerning Phases I and II of the Hydro-Quebec Project and electricity acquired from Connecticut Light and Power Company CL&P) (Exhibit 1 to the CEC Form 10-Q (September 1987), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.20.2 Supplements to 10.1.20 consisting of two Capacity Acquisition Commitments each dated October 31, 1988, concerning electricity acquired from Western Massachusetts Electric Company and/or CL&P for periods ranging from November 1, 1988 to October 31, 1994 (Exhibit 2 to the CEC Form 10-Q (September 1989), File No. 2- 30057). 10.1.20.3 Amendment to 10.1.20 as amended and restated June 1, 1993, henceforth referred to as the Capacity Acquisition and Disposition Agreement, whereby Canal Electric Company, as agent, in addition to acquiring power may also sell bulk electric power which Cambridge Electric Light Company and/or Commonwealth Electric Company owns or otherwise has the right to sell (Exhibit 1 to Canal Electric's Form 10-Q (September 1993), File No. 2-30057). 10.1.20.4 Capacity Disposition Commitment dated June 25, 1993 by and between Canal Electric Company (Unit 2) and Commonwealth Electric Company for the sale of a portion of Commonwealth Electric's entitlement in Unit 2 to Green Mountain Power Corporation (Exhibit 2 to Canal Electric's Form 10-Q (September 1993), File No. 2-30057). 10.1.21 Phase 1 Vermont Transmission Line Support Agreement and Amendment No. 1 thereto between Vermont Electric Transmission Company, Inc. and certain other New England utilities, dated December 1, 1981 and June 1, 1982, respectively (Exhibits 5 and 6 to the CE 1992 Form 10-K, File No. 2-7749). 10.1.21.1 Amendment No. 2 to 10.1.21 as amended November 1, 1982 (Exhibit 5 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.21.2 Amendment No. 3 to 10.1.21 as amended January 1, 1986 (Exhibit 2 to the CE 1986 Form 10-K, File No. 2-7749). 10.1.22 Participation Agreement between MEPCO and CEL and/or NBGEL dated June 20, 1969 for construction of a 345 KV transmission line between Wiscasset, Maine and Mactaquac, New Brunswick, Canada and for the purchase of base and peaking capacity from the NBEPC (Exhibit 13 to the CES 1984 Form 10-K, File No. 1-7316). 10.1.22.1 Supplement Amending 10.1.22 as amended June 24, 1970 (Exhibit 8 to the CES Form S-7, Amendment No. 1, File No. 2-38372). 10.1.23 Power Purchase Agreement between Weweantic Hydro Associates and CE for the purchase of available hydro-electric energy produced by a facility located in Wareham, Massachusetts, dated December 13, 1982 (Exhibit 1 to the CE 1983 Form 10-K, File No. 2-7749). 10.1.23.1 Power Purchase Agreement (Revised) between Weweantic Hydro Associ- ates and Commonwealth Electric (CE) for the purchase of available hydro-electric energy produced by a facility located in Wareham, MA, originally dated December 13, 1982, revised and dated March 12, 1993 (Exhibit 1 to the CE Form 10-Q (June 1993), File No. 2- 7749). COMMONWEALTH ENERGY SYSTEM 10.1.24* Power Purchase Agreement between Pioneer Hydropower, Inc. and CE for the purchase of available hydro-electric energy produced by a facility located in Ware, Massachusetts, dated September 1, 1983 (Refiled as Exhibit 1 to the CE 1993 Form 10-K, File No. 2-7749). 10.1.25* Power Purchase Agreement between Corporation Investments, Inc. (CI), and CE for the purchase of available hydro-electric energy produced by a facility located in Lowell, Massachusetts, dated January 10, 1983 (Refiled as Exhibit 2 to the CE 1993 Form 10-K, File No. 2-7749). 10.1.25.1 Amendment to 10.1.25 between CI and Boott Hydropower, Inc., an assignee therefrom, and CE, as amended March 6, 1985 (Exhibit 8 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.26 Phase 1 Terminal Facility Support Agreement dated December 1, 1981, Amendment No. 1 dated June 1, 1982 and Amendment No. 2 dated November 1, 1982, between New England Electric Transmission Corporation (NEET), other New England utilities and CE (Exhibit 1 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.26.1 Amendment No. 3 to 10.1.26 (Exhibit 2 to the CE Form 10-Q (June 1986), File No. 2-7749). 10.1.27 Preliminary Quebec Interconnection Support Agreement dated May 1, 1981, Amendment No. 1 dated September 1, 1981, Amendment No. 2 dated June 1, 1982, Amendment No. 3 dated November 1, 1982, Amendment No. 4 dated March 1, 1983 and Amendment No. 5 dated June 1, 1983 among certain New England Power Pool (NEPOOL) utilities (Exhibit 2 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.28 Agreement with Respect to Use of Quebec Interconnection dated December 1, 1981, Amendment No. 1 dated May 1, 1982 and Amendment No. 2 dated November 1, 1982 among certain NEPOOL utilities (Exhibit 3 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.28.1 Amendatory Agreement No. 3 to 10.1.28 as amended June 1, 1990, among certain NEPOOL utilities (Exhibit 1 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.29 Phase I New Hampshire Transmission Line Support Agreement between NEET and certain other New England Utilities dated December 1, 1981 (Exhibit 4 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.30 Agreement, dated September 1, 1985, with Respect To Amendment of Agreement With Respect To Use Of Quebec Interconnection, dated December 1, 1981, among certain NEPOOL utilities to include Phase II facilities in the definition of "Project" (Exhibit 1 to the CEC Form 10-Q (September 1985), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.31 Agreement to Preliminary Quebec Interconnection Support Agree- ment - Phase II among Public Service Company of New Hampshire (PSNH), New England Power Co. (NEP), BECO and CEC whereby PSNH assigns a portion of its interests under the original Agreement to the other three parties, dated October 1, 1987 (Exhibit 2 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.32 Preliminary Quebec Interconnection Support Agreement - Phase II among certain New England electric utilities dated June 1, 1984 (Exhibit 6 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.32.1 First, Second and Third Amendments to 10.1.32 as amended March 1, 1985, January 1, 1986 and March 1, 1987, respectively (Exhibit 1 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.32.2 Fifth, Sixth and Seventh Amendments to 10.1.32 as amended October 15, 1987, December 15, 1987 and March 1, 1988, respectively (Exhibit 1 to the CEC Form 10-Q (June 1988), File No. 2-30057). 10.1.32.3 Fourth and Eighth Amendments to 10.1.32 as amended July 1, 1987 and August 1, 1988, respectively (Exhibit 3 to the CEC Form 10-Q (September 1988), File No. 2-30057). 10.1.32.4 Ninth and Tenth Amendments to 10.1.32 as amended November 1, 1988 and January 15, 1989, respectively (Exhibit 2 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.32.5 Eleventh Amendment to 10.1.32 as amended November 1, 1989 (Exhibit 4 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.32.6 Twelfth Amendment to 10.1.32 as amended April 1, 1990 (Exhibit 1 to the CEC Form 10-Q (June 1990), File No. 2-30057). 10.1.33 Phase II Equity Funding Agreement for New England Hydro- Transmission Electric Company, Inc. (New England Hydro) (Massachusetts), dated June 1, 1985, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.34 Phase II Massachusetts Transmission Facilities Support Agreement dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 7 dated May 1, 1986 through January 1, 1989, respectively, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.35 Phase II New Hampshire Transmission Facilities Support Agreement dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 8 dated May 1, 1986 through January 1, 1990, respectively, between New England Hydro-Transmission Corporation (New Hampshire Hydro) and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1990), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.36 Phase II Equity Funding Agreement for New Hampshire Hydro, dated June 1, 1985, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.36.1 Amendment No. 1 to 10.1.36 dated May 1, 1986 (Exhibit 6 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.36.2 Amendment No. 2 to 10.1.36 as amended September 1, 1987 (Exhibit 3 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.37 Phase II New England Power AC Facilities Support Agreement, dated June 1, 1985, between NEP and certain NEPOOL utilities (Exhibit 6 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.37.1 Amendments Nos. 1 and 2 to 10.1.37 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.37.2 Amendments Nos. 3 and 4 to 10.1.37 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.38 Phase II Boston Edison AC Facilities Support Agreement, dated June 1, 1985, between BECO and certain NEPOOL utilities (Exhibit 7 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.38.1 Amendments Nos. 1 and 2 to 10.1.38 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 2 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.38.2 Amendments Nos. 3 and 4 to 10.1.38 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 4 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.39 Agreement Authorizing Execution of Phase II Firm Energy Contract, dated September 1, 1985, among certain NEPOOL utilities in regard to participation in the purchase of power from Hydro-Quebec (Exhibit 8 to the CEC Form 10-Q (September 1985), File No. 2- 30057). 10.1.40 System Power Sales Agreement by and between CE, as seller, and Central Vermont Public Service Corporation (CVPS), as buyer, dated September 15, 1984 (Exhibit 2 to the CE Form 10-Q (September 1984), File No. 2-7749). 10.1.40.1 System Sales Agreement by CVPS, as seller, and CE, as buyer, dated September 15, 1984 (Exhibit 9 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.40.2 System Sales and Exchange Agreement by and between CVPS and CE on energy transactions, dated September 15, 1984 (Exhibit 10 to the CE 1984 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.40.3 System Exchange Agreement by and between CE and CVPS for the exchange of capacity and associated energy, dated September 3, 1985 (Exhibit 1 to the CE 1985 Form 10-K, File No. 2-7749). 10.1.40.4 Purchase Agreement by and between CEC and CVPS for the purchase of capacity from CEC for the term March 1, 1991 to October 31, 1995, dated March 1, 1991 (Exhibit 1 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.40.5 Power Sale Agreement by and between CEC and CVPS for the purchase of 50 MW of capacity from CVPS's units (25 MW from Vermont Yankee and 25 MW from Merrimack 2) for the term of March 1, 1991 to October 31, 1995, dated March 1, 1991 (Exhibit 2 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.41 Agreements by and between Swift River Company and CE for the purchase of available hydro-electric energy to be produced by units located in Chicopee and North Willbraham, Massachusetts, both dated September 1, 1983 (Exhibits 11 and 12 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.41.1 Transmission Service Agreement between Northeast Utilities' companies (NU) - The Connecticut Light and Power Company (CL&P) and Western Massachusetts Electric Company (WMECO), and CE for NU companies to transmit power purchased from Swift River Company's Chicopee Units to CE, dated October 1, 1984 (Exhibit 14 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.41.2 Transformation Agreement between WMECO and CE whereby WMECO is to transform power to CE from the Chicopee Units, dated December 1, 1984 (Exhibit 15 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.42 System Power Sales Agreement by and between CL&P and WMECO, as buyers, and CE, as seller, dated January 13, 1984 (Exhibit 13 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.43 System Power Sales Agreement by and between CL&P, WMECO, as sellers, and CEL, as buyer, of power in excess of firm power customer requirements from the electric systems of the NU Companies, dated June 1, 1984, as effective October 25, 1985 (Exhibit 1 to CEL 1985 Form 10-K, File No. 2-7909). 10.1.44 Power Purchase Agreement with Respect to South Meadow Unit Nos. 11, 12, 13, and 14 of the NU system company of CL&P (seller) and CE (buyer), dated November 1, 1985 (Exhibit 1 to the CE Form 10-Q (June 1986), File No. 2-7749). 10.1.45 Power Purchase Agreement by and between SEMASS Partnership, as seller, to construct, operate and own a solid waste disposal facility at its site in Rochester, Massachusetts and CE, as buyer of electric energy and capacity, dated September 8, 1981 (Exhibit 17 to the CE 1984 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.45.1 Power Sales Agreement to 10.1.45 for all capacity and related energy produced, dated October 31, 1985 (Exhibit 2 to the CE 1985 Form 10-K, File No. 2-7749). 10.1.45.2 Amendment to 10.1.45 for all additional electric capacity and related energy to be produced by an addition to the Original Unit, dated March 14, 1990 (Exhibit 1 to the CE Form 10-Q (June 1990), File No. 2-7749). 10.1.45.3 Amendment to 10.1.45 for all additional electric capacity and related energy to be produced by an addition to the Original Unit, dated May 24, 1991 (Exhibit 1 to CE Form 10-Q (June 1991), File No. 2-7749). 10.1.46 System Power Sales Agreement by and between CE (seller) and NEP (buyer), dated January 6, 1984 (Exhibit 1 to the CE Form 10-Q (June 1985), File No. 2-7749). 10.1.47 Service Agreement by and between CE and NEP dated March 24, 1984, whereas CE agrees to purchase short-term power applicable to NEP'S FERC Electric Tariff Number 5 (Exhibit 1 to the CE Form 10-Q (June 1987), File No. 2-7749). 10.1.48 Power Sale Agreement by and between CE (buyer) and Northeast Energy Associated, Ltd. (NEA) (seller) of electric energy and capacity, dated November 26, 1986 (Exhibit 1 to the CE Form 10-Q (March 1987), File No. 2-7749). 10.1.48.1 First Amendment to 10.1.48 as amended August 15, 1988 (Exhibit 1 to the CE Form 10-Q (September 1988), File No. 2-7749). 10.1.48.2 Second Amendment to 10.1.48 as amended January 1, 1989 (Exhibit 2 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.48.3 Power Sale Agreement dated August 15, 1988 between NEA and CE for the purchase of 21 MW of electricity (Exhibit 2 to the CE Form 10-Q (September 1988), File No. 2-7749). 10.1.48.4 Amendment to 10.1.48.3 as amended January 1, 1989 (Exhibit 3 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.49 Power Sale Agreement by and between CE (buyer) and CPC Lowell Cogeneration Corp.(seller) of all capacity and related energy produced, dated September 29, 1986 (Exhibit 2 to the CE Form 10-Q (March 1987), File No. 2-7749). 10.1.49.1 Restatement of 10.1.49 as restated March 30, 1987 (Exhibit 2 to the CE Form 10-Q (June 1987), File No. 2-7749). 10.1.50 Power Sale Agreement by and between CE (buyer) and Pepperell Power Associates Limited Partnership (seller) of all electricity produced from a 38 KW generating unit, dated April 13, 1987 (Exhibit 3 to the CE Form 10-Q (March 1987), File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.51 Power Contract between CEC (seller) and CE and CEL (purchasers) dated August 14, 1989 whereby purchasers agree to purchase the capacity and energy from seller's "Slice-of-System" entitlement from CL&P for the term of November 1, 1989 to October 31, 1994 (Exhibit 1 to the CEC Form 10-Q (September 1989), File No. 2-30057). 10.1.51.1 Power Sale Agreement dated November 1, 1988, by and between CEC (buyer) and CL&P (seller), whereby buyer will purchase generating capacity totaling 250 MW from various seller's units ("Slice of System") for the term November 1, 1989 to October 31, 1994 (Exhibit 3 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.52 Exchange of Power Agreement between Montaup Electric Company and CE dated January 17, 1991 (Exhibit 2 to CE Form 10-Q (September 1991) File No. 2-7749). 10.1.52.1 First Amendment, dated November 24, 1992, to Exchange of Power Agreement between Montaup Electric Company and Commonwealth Electric Company (CE) dated January 17, 1991 (Exhibit 1 to CE Form 10-Q (March 1993) File No. 2-7749). 10.1.53 System Power Exchange Agreement by and between Commonwealth Electric Company (CE) and New England Power Company dated January 16, 1992 (Exhibit 1 to CE Form 10-Q (March 1992), File No. 2- 7749). 10.1.53.1 First Amendment, dated September 8, 1992, to System Power Exchange Agreement by and between Commonwealth Electric Company (CE) and New England Power Company dated January 16, 1992 (Exhibit 1 to CE Form 10-Q (September 1992), File No. 2-7749). 10.1.53.2 Second Amendment, dated March 2, 1993, to System Power Exchange Agreement by and between CE and New England Power Company (NEP) dated January 16, 1992 (Exhibit 2 to CE Form 10-Q (March 1993) File No. 2-7749). 10.1.54 Power Purchase Agreement and First Amendment, dated September 5, 1989 and August 3, 1990, respectively, by and between Commonwealth Electric (CE) (buyer) and Dartmouth Power Associates Limited Partnership (seller), whereby buyer will purchase all of the energy (67.6 MW) produced by a single gas turbine unit (Exhibit 1 to the CE Form 10-Q (June 1992), File No. 2-7749). 10.1.55 Power Exchange Contract, dated March 24, 1993, between NEP and Canal Electric Company (Canal) for an exchange of unit capacity in which NEP will purchase 20 MW of Canal Unit 2 capacity in exchange for Canal's purchase of 20 MW of NEP's Bear Swamp Units 1 and 2 (10 MW per unit) commencing May 31, 1993 through April 28, 1997 and NEP will purchase 50 MW of Canal's Unit 2 capacity in exchange for Canal's purchase of 50 MW of NEP's Bear Swamp Units 1 and 2 (25 MW per unit) commencing November 1, 1993 through April 28, 1997 (Exhibit 1 to Canal's Form 10-Q (March 1993) File No. 2- 30057). COMMONWEALTH ENERGY SYSTEM 10.1.56 Power Purchase Agreement by and between Masspower (seller) and Commonwealth Electric Company (buyer) for a 11.11% entitlement to the electric capacity and related energy of a 240 MW gas-fired cogeneration facility, dated February 14, 1992 (Exhibit 1 to Commonwealth Electric's Form 10-Q (September 1993), File No. 2- 7749). 10.1.57 Power Sale Agreement by and between Altresco Pittsfield, L.P. (seller) and Commonwealth Electric Company (buyer) for a 17.2% entitlement to the electric capacity and related energy of a 160 MW gas-fired cogeneration facility, dated February 20, 1992 (Exhibit 2 to Commonwealth Electric's Form 10-Q (September 1993), File No. 2-7749). 10.1.58.1 System Exchange Agreement by and among Altresco Pittsfield, L.P., Cambridge Electric Light Company, Commonwealth Electric Company and New England Power Company, dated July 2, 1993 (Exhibit 3 to Commonwealth Electric's Form 10-Q (September 1993), File No 2- 7749). 10.1.58.2 Power Sale Agreement by and between Altresco Pittsfield, L. P. (seller) and Cambridge Electric Light Company (Cambridge Electric) (buyer) for a 17.2% entitlement to the electric capacity and related energy of a 160 MW gas-fired cogeneration facility, dated February 20, 1992 (Exhibit 1 to Cambridge Electric's Form 10-Q (September 1993), File No. 2-7909). 10.2 Natural gas purchase contracts. 10.2.1 Natural gas purchase contracts between Algonquin Gas Transmission Company (AGT) and the gas subsidiaries of the System: Firm Service contracts dated October 28, 1969 and July 10, 1972; Winter Service contracts dated August 14, 1968 and July 10, 1972 (Exhibits 1, 2, 3, and 4, respectively, to the CG 1984 Form 10-K, File No. 2- 1647). 10.2.2 Service Agreement Applicable to Rate Schedule between AGT and CG for Firm natural gas services, dated January 28, 1981 (Exhibit 1 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.2.3 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from CGS, dated April 11, 1985 (Exhibit 2 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.2.4 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from National Fuel Gas Supply Corporation, dated April 11, 1985 (Exhibit 3 to the CG Form 10-Q (March 1987), File No. 1- 1647). COMMONWEALTH ENERGY SYSTEM 10.2.5 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from Texas Eastern Transmission Company, dated December 26, 1985 (Exhibit 4 to the CG Form 10-Q (March 1987), File No. 2- 1647). 10.2.6 Gas Service Contract between HOPCO and NBGEL for the performance of liquefaction, storage and vaporization service and the operation and maintenance of an LNG facility located at Acushnet, MA dated September 1, 1971 (Exhibit 8 to the CG 1984 Form 10-K, File No. 2-1647). 10.2.6.1 Gas Service Contract between HOPCO and CG for the performance of liquefaction, storage and vaporization services and the operation of LNG facilities located in Hopkinton, MA dated September 1, 1971 (Exhibit 9 to the CG 1984 Form 10-K, File No. 2-1647). 10.2.6.2 Amendments to 10.2.6 and 10.2.6.1 as amended December 1, 1976 (Exhibits 2 and 3 to the CG 1986 Form 10-K, File No. 2-1647). 10.2.6.3 Supplement 1 to Gas Service Contract between HOPCO and NBGEL dated September 1, 1973 and September 14, 1977 (Exhibit 5(c)5 to the CES Form S-16 (June 1979), File No. 2-64731). 10.2.6.4 Supplement 1 to 10.2.6.1 dated September 14, 1977 (Exhibit 5(c)6 to the CG Form S-16 (June 1979), File No. 2-64731). 10.2.6.5 Supplement 2 to 10.2.6.1 dated September 30, 1982 (Refiled as Exhibit 2 to the CG 1992 Form 10-K, File No. 2-1647). 10.2.6.6 1986 Consolidating Supplement to CG Service Contract and NBGEL Service Contract by and between CG and HOPCO dated December 31, 1986 amending and consolidating the CG Service Contract and the NBGEL Service Contract both as amended December 1, 1976 and supplemented September 14, 1977 (Exhibit 2 to CG Form 10-Q (March 1988), File No. 2-1647). 10.2.7 Operating Agreement between Air Products and Chemicals, Inc., (APC) and HOPCO, dated as of September 1, 1971, as supplemented by Supplements No. 1, No. 2 and No. 3 dated as of July 1, 1974, August 1, 1975 and January 1, 1985, respectively, with respect to the operation and maintenance by APC of HOPCO's liquefied natural gas facilities located at Hopkinton, MA (Exhibit 11 to the CES 1984 Form 10-K, File No. 1-7316). 10.2.7.1 Engineering and Prime Contracting Agreement between APC and HOPCO for performance of engineering services and capital project construction at LNG facility in Hopkinton, MA (Exhibit 12 to the CES 1984 Form 10-K, File No. 1-7316). 10.2.8 Firm Storage Service Transportation Contract by and between TGP and CG providing for firm transportation of natural gas from CGT, dated December 15, 1985 (Exhibit 1 to the CG 1985 Form 10-K, File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.9 Agency Agreement for Certain Transportation Arrangements by and between CG and Citizens Resources Corporation (CRC) whereby CRC arranges for a third party transportation of natural gas acquired by CG, dated April 14, 1986 (Exhibit 1 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.9.1 Natural Gas Sales Agreement between CG and CRC, dated April 14, 1986 (Exhibit 2 to CG Form 10-Q (June 1986), File No. 2-1647). 10.2.10 Gas Sales Agreement by and between Enron Gas Marketing, Inc. and CG relating to the sale and purchase of natural gas on an interruptible basis, dated June 17, 1986 (Exhibit 3 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.11 Agency Agreement for Certain Transportation Arrangements, dated June 18, 1985 and Gas Purchase and Sales Agreement dated August 6, 1985 by and between CG and Tenngasco Corporation and other related entities (Exhibit 4 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.12 Service Agreement dated December 14, 1985 and an amendment thereto dated May 15, 1986 by and between Texas Eastern Transmission Corporation (TET) and CG to receive, transport and deliver to points of delivery natural gas for the account of CG, dated December 14, 1985 (Exhibit 5 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.13 Gas Transportation Agreement by and between TET and CG to receive, transport and deliver on an interruptible basis, certain quantities of natural gas for the account of CG, dated January 31, 1986 (Exhibit 6 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.14 Service Agreement dated May 19, 1988, by and between TET and CG, whereby TET agrees to receive, transport and deliver natural gas to CG (Exhibit 1 to the CG Form 10-Q (September 1988), File No. 2- 1647). 10.2.15 Gas Sales Agreement by and between Texas Eastern Gas Trading Company and CG providing for the sale of certain quantities of natural gas to CG, dated May 15, 1986 (Exhibit 7 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.16 Service Agreement applicable to Rate Schedule TS-3 between TET and CG for Firm natural gas service, dated April 16, 1987 (Exhibit 1 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.2.17 Natural Gas Sales Agreement between Summit Pipeline and Producing Company and CG, dated April 16, 1987 (Exhibit 2 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.2.18 Natural Gas Sales Agreement between Natural Gas Supply Company and CG, dated May 12, 1987 (Exhibit 3 to the CG Form 10-Q (June 1987), File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.19 Natural Gas Sales Agreement between Stellar Gas Company and CG, dated April 15, 1988 (Exhibit 1 to the CG Form 10-Q (March 1988), File No. 2-1647). 10.2.20 Natural Gas Sales Agreement between Amalgamated Gas Pipeline Company and CG dated April 5, 1988 (Exhibit 1 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.21 Natural Gas Sales Agreement between Gulf Ohio Pipeline Corporation and CG dated May 18, 1988 (Exhibit 2 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.22 Natural Gas Sales Agreement between Phillips Petroleum Company and CG dated May 18, 1988 (Exhibit 3 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.23 Natural Gas Sales Agreement between TXO Gas Marketing Corp. and CG dated April 25, 1988 (Exhibit 1 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.24 Gas Transportation Agreement by and between AGT and CG to receive, transport and deliver certain quantities of natural gas on a firm basis for the account of CG dated December 1, 1988 (Exhibit 2 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.25 Natural Gas Sales Agreement between Enermark Gas Gathering Corporation and CG dated January 6, 1989 (Exhibit 3 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.26 Gas Sales Agreement between BP Gas Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated March 31, 1989 with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (March 1989), File No. 2-1647). 10.2.27 Gas Sales Agreement between Tejas Power Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated February 21, 1989 with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (March 1989), File No. 2-1647). 10.2.28 Gas Sales Agreement between Catamount Natural Gas, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated April 5, 1988, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.2.29 Gas Sales Agreement between Transco Energy Marketing Company (seller) and CG (purchaser) for the purchase of spot market gas, dated March 1, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.2.30 Gas Sales Agreement between V.H.C. Gas Systems, L.P. (seller) and CG (purchaser) for the purchase of spot market gas, dated June 2, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (June 1989), File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.31 Gas Sales Agreement between End-Users Supply System (seller) and CG (purchaser) for the purchase of spot market gas, dated June 29, 1989, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.32 Gas Sales Agreement between Entrade Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.33 Gas Sales Agreement between Fina Oil and Chemical Company (seller) and CG (purchaser) for the purchase of spot market gas, dated July 10, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.34 Gas Sales Agreement between Mobil Natural Gas Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.35 Gas Storage Agreement between Steuben Gas Storage Company (Steuben) and CG (customer) for the storage and delivery of customer's natural gas to and from underground gas storage facilities, dated May 23, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (June 1989), File No. 2- 1647). 10.2.35.1 Amendment, dated August 28, 1989, to 10.2.35 dated May 23, 1989 (Exhibit 5 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.36 Gas Sales Agreement between PSI, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated September 25. 1989, with a term of at least one year (Exhibit 1 to the CG 1989 Form 10-K, File No. 2-1647). 10.2.37 Gas Sales Agreement between Hadson Gas Systems (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least six years (Exhibit 1 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.2.38 Gas Sales Agreement between Odeco Oil Company (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least five years (Exhibit 2 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.2.39 Operating Agreement between AGT, CG and Distrigas of Massachusetts Corporation in connection with the deliveries of regasified liquified natural gas into the Algonquin J-system, dated August 1, 1990 (Exhibit 3 to the CG Form 10-Q (September 1990), File No.2- 1647). 10.2.40 Gas Sales Agreement between TEX/CON Marketing Gas Company (seller) and CG (purchaser) for the purchase of firm gas, dated September 12, 1990, with a contract term of five years (Exhibit 3 to the CG 1990 Form 10-K, File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.41 Transportation Agreement between AGT and CG to provide for firm transportation of natural gas on a daily basis, dated December 1, 1988 (Exhibit 3 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.42 Transportation Assignment Agreement between AGT and CG regarding Rate Schedule ATAP Agreement No. 9020016 which provides for the assignment, on an interruptible basis, of firm service rights on TET's system under Rate Schedule FT-1, dated January 3, 1990, for a term ending October 31, 1999 (Exhibit 4 to the CG 1991 Form 10- K, File No. 2-1647). 10.2.43 Gas Sales Agreement between AFT and CG to reduce the volume of Rate Schedule, dated October 15, 1990 (Exhibit 5 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.44 Transportation Agreement between AFT and CG for Rate Schedule AFT- 1, dated November 1, Agreement No. 90103, 1990 (Exhibit 6 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.45 Transportation Assignment Agreement between AFT and CG regarding Rate Schedule ATAP Agreement No. 90202, which provides for the assignment, on a firm basis, of firm service rights on TET's system under Rate Schedule FT-1 dated November 1, 1990 (Exhibit 7 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.46 Gas Sales Agreement between TGP and CG under TGP's CD-6 Rate Schedules dated September 1, 1991 (Exhibit 8 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.47 Transportation Agreement between TGP and CG dated September 1, 1991 (Exhibit 9 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.48 Transportation Agreement between CNG and CG to provide for transportation of natural gas on a daily basis from Steuben Gas Storage Company to TGP (Exhibit 10 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.49 Service Line Agreement by and between Commonwealth Gas Company (CG) and Milford Power Limited Partnership dated March 12, 1992 for a term ending January 1, 2013. (Exhibit 1 to the CG Form 10-Q (March 1992), File No. 2-1647. 10.3 Other agreements. 10.3.1 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Exhibit 1 to CES Form 10-Q (September 1993), File No. 1-7316). 10.3.2 Employees Savings Plan of Commonwealth Energy System and Subsid- iary Companies as amended and restated January 1, 1993.(Exhibit 2 to CES Form 10-Q (September 1993), File No. 1-7316). COMMONWEALTH ENERGY SYSTEM 10.3.3 New England Power Pool Agreement (NEPOOL) dated September 1, 1971 as amended through August 1, 1977, between NEGEA Service Corporation, as agent for CEL, CEC, NBGEL, and various other electric utilities operating in New England together with amendments dated August 15, 1978, January 31, 1979 and February 1, 1980. (Exhibit 5(c)13 to New England Gas and Electric Association's Form S-16 (April 1980), File No. 2-64731). 10.3.3.1 Thirteenth Amendment to 10.3.3 as amended September 1, 1981 (Refiled as Exhibit 3 to the System's 1991 Form 10-K, File No. 1-7316). 10.3.3.2 Fourteenth through Twentieth Amendments to 10.3.3 as amended December 1, 1981, June 1, 1982, June 15, 1983, October 1, 1983, August 1, 1985, August 15, 1985 and September 1, 1985, respectively (Exhibit 4 to the CES Form 10-Q (September 1985), File No. 1-7316). 10.3.3.3 Twenty-first Amendment to 10.3.3 as amended to January 1, 1986 (Exhibit 1 to the CES Form 10-Q (March 1986), File No. 1-7316). 10.3.3.4 Twenty-second Amendment to 10.3.3 as amended to September 1, 1986 (Exhibit 1 to the CES Form 10-Q (September 1986), File No. 1- 7316). 10.3.3.5 Twenty-third Amendment to 10.3.3 as amended to April 30, 1987 (Exhibit 1 to the CES Form 10-Q (June 1987), File No. 1-7316). 10.3.3.6 Twenty-fourth Amendment to 10.3.3 as amended March 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.3.3.7 Twenty-fifth Amendment to 10.3.3. as amended to May 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1988), File No. 1-7316). 10.3.3.8 Twenty-sixth Agreement to 10.3.3 as amended March 15, 1989 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.3.3.9 Twenty-seventh Agreement to 10.3.3 as amended October 1, 1990 (Exhibit 3 to the CES 1990 Form 10-K, File No. 1-7316) 10.3.4 Fuel Supply, Facilities Lease and Operating Contract by and between, on the one side, ESCO (Massachusetts), Inc. and Energy Supply and Credit Corporation, and on the other side, CEC, dated as of February 1, 1985 (Exhibit 1 to the CEC 1984 Form 10-K, File No. 2-30057 10.3.4.1 Amendments Nos. 1 and 2 to 10.3.5 as amended July 1, 1986 and November 15, 1989, respectively (Exhibit 3 to the CEC 1989 Form 10-K, File No. 2-30057). 10.3.5 Assignment and Sublease Agreement and Canal's Consent of Assignment thereto whereby ESCO-Mass assigns its rights and obligations under Part II of the Resupply Agreement dated February 1, 1985 to ESCO Terminals Inc., dated June 4, 1985 (Exhibit 4 to CEC Form 10-Q (June 1985), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.3.6 Oil Supply Contract by and between CEC (buyer) and Coastal Oil New England, Inc. (seller) for a portion of CEC's requirements of No. 6 residual fuel oil, dated July 1, 1991 (Exhibit 3 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.3.6.1 Assignment Agreement between CEC and ESCO (Massachusetts), Inc. (ESCO-Mass) and Energy Supply and Credit Corporation whereby CEC assigns to ESCO-Mass rights and obligations under 10.3.7 (above) dated July 1, 1991 (Exhibit 4 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.3.7 Guarantee Agreement by CEL (as guarantor) and MYA Fuel Company (as initial lender) covering the unconditional guarantee of a portion of the payment obligations of Maine Yankee Atomic Power Company under a loan agreement and note initially between Maine Yankee and MYA Fuel Company (Exhibit 3 to the CEL Form 10-K for 1985, File No. 2-7909). 10.3.8 Stock Purchase Agreement by and among Texas Eastern Corporation (purchaser) and Eastern Gas and Fuel Associates, Commonwealth Energy System and Providence Energy Corporation (sellers) for the purchase and sale of ownership interests in Algonquin Energy, Inc., dated June 10, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 1-7316). Exhibit 22. Subsidiaries of the Registrant Incorporated by reference to Exhibit 2 (page 101) to the System's 1988 Annual Report on Form 10-K, File No. 1-7316. Exhibit 99. Additional Exhibit Filed herewith as Exhibit 1 is the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994. (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Commonwealth Energy System: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Commonwealth Energy System appearing in Exhibit A to the proxy statement for the 1994 annual meeting of shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 17, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Part IV, Item 14 of this Form 10-K are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. SCHEDULE VIII COMMONWEALTH ENERGY SYSTEM AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Additions Balance Provision Deductions Balance Beginning Charged to Accounts at End Description of Year Operations Recoveries Written-Off of Year Year Ended December 31, 1993 Allowance for Doubtful Accounts $6 861 $ 9 468 $2 142 $10 710 $7 761 Year Ended December 31, 1992 Allowance for Doubtful Accounts $5 233 $12 082 $1 918 $12 372 $6 861 Year Ended December 31, 1991 Allowance for Doubtful Accounts $4 506 $10 943 $2 042 $12 258 $5 233 SCHEDULE IX COMMONWEALTH ENERGY SYSTEM AND SUBSIDIARY COMPANIES SHORT-TERM BORROWINGS(A) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in Thousands) Weighted Average Maximum Average Weighted Category of Interest Amount Amount Average Aggregate Rate OutstandingOutstanding Interest Short-Term Balance at at End During During the Rate During Borrowings End of Period of Period the Period Period (B) the Period (C) Year Ended December 31, 1993 Notes Payable to Banks $ 71 975 3.4% $165 525 $103 100 3.5% Year Ended December 31, 1992 Notes Payable to Banks $165 600 4.0% $165 600 $126 321 4.0% Year Ended December 31, 1991 Notes Payable to Banks $145 800 5.5% $150 875 $120 567 6.3% (A) Refer to Note 5 of Notes to Financial Statements filed under Item 8 of this report for the general terms of notes payable to banks. (B) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding using a rolling thirteen-month period through December 31. (C) The weighted average interest rate during the period is determined by averaging the interest rates in effect on all loans transacted for the twelve-month period ended December 31. COMMONWEALTH ENERGY SYSTEM FORM 10-K DECEMBER 31, 1993 SIGNATURES Pursuant to the requirements of Section 13 or 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. COMMONWEALTH ENERGY SYSTEM (Registrant) By: WILLIAM G. POIST William G. Poist, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: WILLIAM G. POIST March 24, 1994 William G. Poist, President and Chief Executive Officer Principal Financial Officer: JAMES D. RAPPOLI March 24, 1994 James D. Rappoli, Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 24, 1994 John A. Whalen, Comptroller A majority of the Board of Trustees: SINCLAIR WEEKS, JR. March 24, 1994 Sinclair Weeks, Jr., Chairman of the Board SHELDON A. BUCKLER March 24, 1994 Sheldon A. Buckler, Trustee HENRY DORMITZER March 24, 1994 Henry Dormitzer, Trustee B. L. FRANCIS March 24, 1994 Betty L. Francis, Trustee FRANKLIN M. HUNDLEY March 24, 1994 Franklin M. Hundley, Trustee COMMONWEALTH ENERGY SYSTEM FORM 10-K DECEMBER 31, 1993 SIGNATURES (Continued) March , 1994 William J. O'Brien, Trustee WILLIAM G. POIST March 24, 1994 William G. Poist, Trustee G. L. WILSON March 24, 1994 Gerald L. Wilson, Trustee CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of our report dated February 17, 1994 included in Exhibit A to the proxy statement for the 1994 annual meeting of shareholders and the incorporation of our reports included and incorporated by reference in this Form 10-K into the System's previously filed Registration Statements on Form S-8 File No. 33-28435 and on Form S-3 File No. 33-44161. It should be noted that we have not audited any financial statements of the System subsequent to December 31, 1993 or performed any audit procedures subsequent to the date of our report. ARTHUR ANDERSEN & CO. Arthur Andersen & Co. Boston, Massachusetts, March 30, 1994	17,913	113,320
808364_1993.txt	808364_1993	1993	808364	ITEM 1. BUSINESS THE CORPORATION First National Bank Corp. (the "Corporation") is a bank holding company under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). As a bank holding company, the Corporation is subject to regulation by the Federal Reserve Board. The Corporation was organized on December 17, 1986, under the laws of the State of Dela- ware, and acquired First National Bank in Macomb County (formerly named First National Bank in Mount Clemens) (the "Bank"), effective April 30, 1987. The Corporation organized Bankers Fund Life Insurance Company (the "Insurance Company"), effective January 9, 1987. The Corporation exists primarily for the purpose of holding all the stock of its subsidiaries, the Bank and the Insurance Company, and of such other subsidiaries as it may acquire or establish. The Corporation's principal source of operating funds is expected to be dividends from the Bank. The expenses of the Corporation are generally paid using funds derived from dividends paid to the Corporation by the Bank. THE BANK The Bank is a national banking association which has been in operation since 1926 under the laws of the United States of America, pursuant to a charter issued by the Office of the Comptroller of the Currency. The Bank is a member of the Federal Reserve System, and its deposits are insured to the maximum extent provided by the Federal Deposit Insurance Corporation. The Bank, through its main office at 49 Macomb Place, Mount Clemens, Michigan and through its branch offices provides a wide variety of commercial banking services to individuals, businesses, governmental units, financial institutions, and other institutions. Its services include accepting time, demand and savings deposits, including regular checking accounts, NOW accounts, money market certificates, and fixed rate certificates of deposit. In addition, the Bank makes secured and unsecured commercial, construction, mortgage and consumer loans; finances commercial transactions, and provides safe deposit facilities. Each location has an automated teller machine ("ATM") which participates in the Network 1 system, a regional shared network; the Cashstream system, an eastern United States regional network; the Cash Station system, a midwest regional network; and the Cirrus system, a nationwide network. In addition to the foregoing services, the Bank provides its customers with extended banking hours, and a system to perform certain transactions by telephone or personal computer. The Bank does not have trust powers, but it provides trust services via a correspondent bank relationship. THE INSURANCE COMPANY The Insurance Company is incorporated under the laws of the State of Arizona. It is subject to regulation by the Arizona Corporation Commission and the Arizona Department of Insurance. Since substantially all of its business is conducted in the State of Michigan, it is re- quired to qualify as a foreign corporation, doing business in the State of Michigan. EFFECT OF GOVERNMENT MONETARY POLICIES The earnings of the Corporation are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board's monetary poli- cies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation or combat a recession. The policies of the Federal Reserve Board have a major effect FIRST NATIONAL BANK CORP. FORM 10-K (continued) upon the levels of bank loans, investments and deposits through its open market operations in United States government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies. REGULATION AND SUPERVISION The Corporation, as a bank holding company under the Bank Holding Company Act, is required to file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act, and is subject to examination by the Federal Reserve Board. The Bank Holding Company Act limits the activities which may be engaged in by the Corporation and its subsidiaries to those of banking and the management of banking organizations, and to certain non-banking activities, including those activities which the Federal Reserve Board may find, by order or regulation, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board is empowered to differentiate between activities by a bank holding company, or a subsidiary thereof, and activities commenced by acquisition of a going concern. With respect to non-banking activities, the Federal Reserve Board has, by regulation, determined that certain non-banking activities are closely related to banking within the meaning of the Bank Holding Company Act. These activities include, among other things, operating a mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; acting as an insurance agent for certain types of credit related insurance; leasing property on a full-payout, nonoperating basis; and, subject to certain limitations, providing discount securities brokerage services for customers. The Corporation has organized the Insurance Company for the purpose of engaging in the credit life, accident, and health reinsurance business. The Corporation has no current plans to engage in other non-banking activities. The Bank is subject to certain restrictions imposed by federal law on any extension of credit to the Corporation, or any of its subsidiaries, on investments in stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Federal law prevents the Corporation from borrowing from the Bank unless the loans are secured in designated amounts. With respect to the acquisition of banking organizations, the Corporation is required to obtain the prior approval of the Federal Reserve Board before it can acquire all or substantially all of the assets of any bank, or acquire ownership or control of any voting shares of any bank, if, after such acquisition, it will own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act does not permit the Federal Reserve Board to approve the acquisition by the Corporation, or any subsidiary, of any voting shares of, or interest in, or all or substantially all of the assets of any bank located outside the State of Michigan, unless such acquisition is specifically authorized by the laws of the state in which such bank is located. Certain states within the same geographic region have enacted reciprocal legislation, allowing interstate acquisitions of and by banking organizations. The Bank is required to maintain a noninterest bearing deposit (reserve balance) with the Federal Reserve Bank, based on a percentage of the Bank's deposits. During 1993 and 1992, the average reserve balances were approximately $2,717,000 and $2,069,000, respectively. EMPLOYEES As of December 31, 1993, the Corporation and the Bank employed 244 persons (full-time equivalent). FIRST NATIONAL BANK CORP. FORM 10-K (continued) COMPETITION All phases of the business of the Bank are highly competitive. The Bank competes with numerous financial institutions, including other commercial banks, in the Macomb County and Greater Detroit area. The Bank, along with other commercial banks, competes with respect to its lending activities, and competes in attracting demand deposits, with savings banks, savings and loan associations, insurance companies, small loan companies, credit unions and with the issuers of commercial paper and other securities, such as shares in various mutual funds. Many of these institutions are substantially larger and have greater financial resources than the Bank. Interstate banking legislation has further increased competition within the financial services industry. The competitive factors among financial institutions can be classified into two categories; competitive rates and competitive services. With the advent of deregulation, rates have become more competitive, especially in the area of time deposits. From a service standpoint, financial institutions compete against each other in types of services. The Bank is generally competitive with other financial institutions in its primary service area with respect to interest rates paid on time and savings deposits, charges on deposit accounts and interest rates charged on loans. With respect to services, the Bank offers extended banking hours, personal checking services, a network of automated teller machines, and telephone banking services. Pursuant to federal regulations, the Bank is limited in the amount that it may lend to a single borrower. As of December 31, 1993, and December 31, 1992, the legal lending limits were approximately $5,568,000 and $4,918,000, respectively. ADDITIONAL STATISTICAL INFORMATION The majority of the consolidated statistical information for the Corporation is shown under the captions "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Selected Quarterly Financial Information," on pages 29 through 34 and page 35, respectively, of the Annual Report of the Corporation for the year ended December 31, 1993, and is incorporated by reference herein. The following discussion contains additional statistical information for the Corporation. FIRST NATIONAL BANK CORP. FORM 10-K (continued) SECURITY PORTFOLIO The following table shows the composition of the security portfolio as of the dates indicated: Loan and Lease Portfolio The following table details the composition of the loan and lease portfolio as of the dates indicated: FIRST NATIONAL BANK CORP. FORM 10-K (continued) Residential real estate loans are generally for owner occupied, one to four family homes, which are secured by mortgages. The majority of these loans have a fixed interest rate. The increase in commercial loans during the 1989 to 1993 period came mostly from variable rate loans secured by commercial mortgages. In 1990, a large portion of the increase also came from fixed rate loans secured by commercial mortgages; and, in 1993, variable rate lines of credit contributed significantly to the increase. A large portion of the Bank's commercial mortgages are working capital loans, in which the Bank takes real estate as security on the loan. The decrease in installment loans in 1992 and 1993 was due primar- ily to the changing nature of the economy, as automobile and boat pur- chases (and therefore lending) have slowed, and consumers have tended to reduce their levels of debt. 1991's decrease was due to the Bank's sale of its credit card portfolio. The increase in installment loans in 1990 was primarily from "equity" lines of credit. The Bank has no material foreign or agricultural loans, and no material loans to energy producing customers. The following table shows the maturity distribution, classified according to fixed or variable interest rates, for the Bank's commercial loan portfolio at December 31, 1993. ANALYSIS OF NONPERFORMING LOANS The following table details the aggregate amount of nonaccrual loans and loans past due 90 days or more (but still accruing) as of the dates indicated: FIRST NATIONAL BANK CORP. FORM 10-K (continued) Loans are placed on a nonaccrual basis when, in the opinion of management, uncertainty exists as to the ultimate collection of princi- pal and interest. For the year ended December 31, 1993, $77,000 would have been recorded in interest income for loans in nonaccrual status at December 31, 1993, assuming they had been current in accordance with the original terms of the loan agreements. Interest received on such loans is credited directly to income. Interest income of $5,000 was collected and included in net income for the year ended December 31, 1993, for loans in nonaccrual status at December 31, 1993. Included in the nonaccrual category at December 31 were loans totaling $622,000 to a commercial borrower that was experiencing cash flow problems. The loans matured in 1992, and no principal or interest payments had been received since early 1993. Unpaid interest was $55,- 000 as of December 31, 1993. The loans were secured by a commercial property of the borrower. The Bank foreclosed on the collateral, and the property was sold in January, 1994. The entire principal amount was recovered in the sale; however, no interest was received. Another fore- closed property of the same borrower is being carried in other real estate at its estimated net realizable value of $300,000 at December 31, 1993. The Corporation charged off a total of $635,000 in 1993 related to this borrower's loans and ORE properties. Further losses, if any, are not expected to have a material effect on the Corporation's operat- ing results, liquidity, or capital resources. At December 31, 1993, there were no significant loans which are not disclosed above, where known information about possible credit prob- lems of borrowers causes management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which, in management's judgment, may result in disclosure of such loans in the discussion above. Furthermore, management is not aware of any potential problem loans, except for those described above, which could have a material effect on the Corporation's operating results, liquidi- ty, or capital resources. Management is not aware of any other factors that would cause future net loan charge-offs, in total and by loan category, to signifi- cantly differ from those experienced in the past. At December 31, 1993, the Corporation's leverage ratio (Tier I capital to total assets) was 7.68%. Regulatory agencies require a con- solidated bank holding company to maintain a minimum leverage ratio of 3.00%. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ALLOWANCE FOR LOAN AND LEASE LOSSES The following table summarizes loan balances at the end of each period and daily averages; changes in the allowance for loan and lease losses arising from loans charged off and recoveries on loans previously charged off, by loan category; additions to the allowance which have been charged to expense; and selected ratios. FIRST NATIONAL BANK CORP. FORM 10-K (continued) In each accounting period, the allowance for loan and lease losses is adjusted by management to the amount necessary to maintain the allow- ance at adequate levels. Through its internal loan review department, management has attempted to allocate specific portions of the allowance for loan losses based on specifically identifiable problem loans. Mana- gement's evaluation of the allowance is further based on consideration of actual loss experience, the present and prospective financial condi- tion of borrowers, industry concentrations within the portfolio and general economic conditions. Management believes that the present al- lowance is adequate, based on the broad range of considerations listed above. The primary risk element considered by management with respect to each installment and residential real estate loan is lack of timely payment. Management has a reporting system that monitors past due loans and has adopted policies to pursue its creditor's rights in order to preserve the Bank's position. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the suffi- ciency of collateral, and lack of timely payment. Management has a policy of requesting and reviewing annual financial statements from its commercial loan customers and periodically reviews existence of collat- eral and its value. As evidenced by the table above, in 1993, the pro- vision for loan and lease losses decreased by $450,000, to $825,000, compared with a decrease of $600,000, to $1,275,000 in 1992. The prima- ry reason for the decrease was the continued improvement in the local economy, and lower levels of nonperforming loans throughout the year. Although management of the Bank believes that the allowance for loan and lease losses is adequate to absorb losses as they arise, there can be no assurance that the Bank will not sustain losses in any given period which could be substantial in relation to the size of the allow- ance for loan and lease losses. RETURN ON EQUITY AND ASSETS The following table contains selected ratios for the years indi- cated: ANALYSIS OF CHANGES IN NET INTEREST INCOME The components of fully tax-equivalent net interest income, along with the average daily balances of the earning assets and interest bear- ing liabilities, and the average rates earned and paid thereon, for each of the three years in the period ended December 31, 1993, are presented on page 31 of the Annual Report of the Corporation, for the year ended December 31, 1993, and are incorporated by reference herein. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ITEM 2. ITEM 2. PROPERTIES The Bank leases its main office in the downtown business district of Mount Clemens. The executive offices of the Corporation are located in the Corporation - owned Financial Center, in Clinton Township. The Bank operates 16 branches located in Macomb County, 12 of which are owned and 4 of which are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS As a depository of funds, the Bank is occasionally named as a defendant in lawsuits (such as garnishment proceedings) involving claims to the ownership of funds in particular accounts. All such litigation is incidental to the Bank's business. The Corporation's management believes that no litigation is threa- tened or pending in which the Corporation, or any of its subsidiaries, is likely to experience loss or exposure which would materially affect the Corporation's equity, financial position, or liquidity as presented herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE CORPORATION'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information shown under the caption "Consolidated Financial Highlights" on page 1 and "Stockholder Information" on page 36 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information detailed under the captions "Selected Financial Data" and "Selected Quarterly Financial Information" on pages 28 and 35, respectively, of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information shown under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 29 through 34 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information presented under the captions "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Changes in Stockholders' Equity," "Consolidated Statements of Cash Flow," "Notes to Consolidated Financial Statements," "Independent Audi- tors' Report," and "Selected Quarterly Financial Information" on pages 10 through 27 and page 35 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. FIRST NATIONAL BANK CORP. FORM 10-K (continued) PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information listed under the captions "Election of Directors" on pages 1 and 2, "Information about Directors and Nominees as Directors" on pages 3 and 4, and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on page 8 of the definitive Proxy Statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. EXECUTIVE OFFICERS The following is a list of the executive officers of the Corpora- tion, together with their ages, their present positions, and the posi- tions that they have held with the Corporation and the Bank during the past five years. Each of the executive officers of the Corporation has been employed as an officer or employee of the Corporation or the Bank for more than the past five years. Executive officers of the Corpora- tion are elected annually by the Corporation's Board of Directors to serve for the ensuing year and until their successors are elected and qualified. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information detailed under the captions "Board of Directors Meetings and Committees" on pages 4 and 5, "Compensation Committee Interlocks and Insider Participation" on page 5, "Report of the Compensation and Executive Compensation Committee," on pages 5 and 6, "Summary Compensation Table" on page 6, "Options granted in 1993", Aggregated Stock Option Exercises in 1993 and Year End Option Values", and "Supplemental Executive Retirement Plan" on page 7 of the definitive Proxy Statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information summarized under the caption "Certain transactions" on page 7 of the definitive proxy statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information listed under the caption "Certain Transactions" on page 7 of the definitive proxy statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this Report: (*) Refers to page number(s) of Annual Report of the Corporation for the year ended December 31, 1993 at which the named item is located, and from which it is incorporated by reference into this Report. FIRST NATIONAL BANK CORP. FORM 10-K (continued) 2.Schedules: All schedules are omitted because they are inapplicable, not required, or the information is included in the financial statements or notes thereto. 3.Exhibits: FIRST NATIONAL BANK CORP. FORM 10-K (continued) (b) Reports on Form 8-K The Corporation has not filed any reports on Form 8-K during the last quarter of the period covered by this Report. FIRST NATIONAL BANK CORP. FORM 10-K (continued) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securi- ties Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the Charter Township of Clinton, State of Michigan, on the 23rd day of March, 1994. FIRST NATIONAL BANK CORP. S/ ARIE GULDEMOND ------------------------ Arie Guldemond, Chairman S/ HAROLD W. ALLMACHER -------------------------------------- Harold W. Allmacher, Vice Chairman, President and Chief Executive Officer (Principle Executive Officer) S/ RICHARD J. MILLER ------------------------------------------ Richard J. Miller, Treasurer (Principle Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following Directors, in the capacities indicated on March 23, 1994. S/ RAYMOND M. CONTESTI S/ DAVID A. MCKINNON - ----------------------------- --------------------------- Raymond M. Contesti, Director David A. McKinnon, Director S/ JAMES T. CRESSWELL - ----------------------------- --------------------------- James T. Cresswell, Director Robert D. Morrison, Director S/ CELESTINA GILES S/ JOHN J. MULSO - ----------------------------- --------------------------- Celestina Giles, Director John J. Mulso, Director S/ FRANK E. JEANNETTE S/ GLEN D. SCHMIDT - ----------------------------- --------------------------- Frank E. Jeannette, Director Glen D. Schmidt, Director FIRST NATIONAL BANK CORP. FORM 10-K (continued) EXHIBIT INDEX The following constitute the exhibits to the Annual Report on Form 10-K of the Corporation for the fiscal year ended December 31, 1993: FIRST NATIONAL BANK CORP. FORM 10-K (continued)	3,866	25,179
16422_1993.txt	16422_1993	1993	16422	Item 1. Business. a. General Development of Business. California Water Service Company (the "Company") is a public utility water company which owns and operates 20 water systems serving 38 cities and communities and adjacent territories in California with an estimated population of more than 1,400,000. Prior to 1993, the Company had 21 operating districts; however, during 1993, the San Carlos and San Mateo districts were consolidated to become the Mid-Peninsula district. The Company, one of the largest investor-owned water companies in the United States, was incorporated under the laws of the State of California on December 21, 1926. Its principal executive offices are located at 1720 North First Street, San Jose, California, and its mailing address is Post Office Box 1150, San Jose, California 95108 (telephone number: 1-408-451-8200). The Company's Common Stock is traded in the over-the-counter market and is quoted by the National Association of Securities Dealers Automated Quotation System (NASDAQ) under the symbol CWTR. The Company is currently in the process of seeking to list its common shares on the New York Stock Exchange. During the fiscal year ended December 31, 1993 (the "1993 fiscal year"), there were no significant changes in the kind of products produced or services rendered by the Company, or in the Company's markets or methods of distribution. Regulation and Rates. The Company is subject to regulation of its rates, service and other matters affecting its business by the Public Utilities Commission of the State of California ("Commission" or "PUC"). The Company's systems, which are operated as 20 separate districts in the State of California, are not integrated with one another, and except for allocation of general office expenses and the determination of cost of capital, the expenses and revenues of individual districts are not affected by operations in other districts. Cost of capital (i.e. return on debt and equity) is determined on a Company-wide basis. Otherwise, the PUC requires that each district be considered a separate and distinct entity for rate-making purposes. The California Public Utilities Commission requires that water rates for each Company operating district be determined independently. Each year the Company attempts to file general rate increase applications for approximately one-third of its operating districts. According to its rate case processing procedures for water utilities, the Commission attempts to issue decisions within eight months of acceptance of the Application. Rates are set prospectively for a three-year period, with a provision for step increases to maintain the authorized rate of return. Offset rate adjustments are also allowed as required for changes in purchased water, power and pump tax costs. During 1993, general rate increase applications were filed with the Commission requesting rate relief of $2,100,000 in three Company districts based upon a rate of return on common equity of 12%. However, in recent proceedings, the Commission has authorized a rate of return on common equity of about 10.50%. Public hearings for these cases have been scheduled for late March 1994. In the meantime, step increases for 15 districts totaling approximately $2,233,000 were authorized in January 1994. The Company received two general rate case decisions in 1993. In April, the Commission issued a decision on general rate cases filed in July 1991 for six districts, authorizing $390,000 in additional revenue based on a return on common equity of 11.50%. Then in August 1993, the Commission issued a decision on general rate cases filed in July 1992 for seven districts, providing a revenue increase of $3,408,000 based on a return on common equity of 11%. In November 1992, hearings began in the Commission's investigation of the current financial and operational risks which confront water utilities. This investigation addresses two of the most significant challenges to the California water industry--water supply and water quality and their effect on appropriate rates of return to be authorized by the Commission. The California Water Association retained expert witnesses to put forth the industry's position. The hearings concluded in 1993 and the Commission is expected to issue its decision sometime in 1994. Interim rate relief in the Stockton district totaling $1,900,000 was granted by the Commission in July 1993 for changes in purchased water expense, purchased power costs and pump taxes. The Commission staff's continuing review of these costs had delayed recovery since 1989 when the amended Stockton supplemental water purchase contract was first implemented. As part of the staff's continuing review of the amended contract, an independent consultant was hired by the Commission staff to review the amended contract and a report is expected in early 1994. Two additional offset changes relating to the cost of surface water supplies were issued by the Commission during the past year. The first decision authorized rate relief totaling $3,500,000 effective July 1, 1993, to cover the increased cost of purchased water from the Metropolitan Water District of Southern California to serve the Company's four Los Angeles area districts, and the second decision authorized a rate reduction beginning in July and August totaling $4,300,000 for customers in the Company's three San Francisco Peninsula districts to reflect a 33% decrease in the cost of purchased water from the wholesale supplier, the San Francisco Water Department. Additional offset rate relief of $637,000 was granted for the Bakersfield district in November 1993 to allow for adjustments in the district's water production expense balancing account as permitted under the rate-making process. The Company's headquarters in San Jose was recently renovated and expanded with the addition of a new engineering-water quality building to accommodate increased staffing levels. This was the first remodeling and expansion since expansion of facilities to accommodate the Company's Information System Department in 1972. As permitted by a prior Commission order, an advice letter to recover the increased costs due to the renovation and expansion was filed with the CPUC in late 1993 requesting approximately $360,000 in additional revenue. b. Financial Information about Industry Segments. The Company has only one business segment. c. Narrative Description of Business. The sole business of the Company consists of the pro- duction, purchase, storage, purification, distribution and sale of water for domestic, industrial, public, and irrigation uses, and for fire protection. The Company's business fluctuates according to the demand for water, which is partially dictated by seasonal conditions, such as summer temperatures or the amount and timing of rain during the year. The Company holds such franchises or permits in the communities it serves as it judges necessary to operate and maintain its facilities in the public streets. The Company distributes its water to customers in accordance with accepted water utility methods, which include pumping from storage and gravity feed from high elevation reservoirs. Geographical Service Areas and Number of Customers at Year-End. The principal markets for the Company's products are users of water within the Company's service areas. The Company's geographical service areas and the approximate number of customers served in each at December 31, 1993, are as follows: SAN FRANCISCO BAY AREA Mid-Peninsula (San Mateo and San Carlos) 35,200 South San Francisco (including Colma and Broadmoor) 15,300 Bear Gulch (including Menlo Park, Atherton, Woodside and Portola Valley) 17,100 Los Altos (including Los Altos and portions of Cupertino, Los Altos Hills, Mountain View and Sunnyvale) 17,700 Livermore 14,700 100,000 SACRAMENTO VALLEY Chico (including Hamilton City) 20,100 Oroville 3,500 Marysville 3,800 Dixon 2,700 Willows 2,200 32,300 SALINAS VALLEY Salinas 22,600 King City 1,800 24,400 SAN JOAQUIN VALLEY Bakersfield 54,300 Stockton 40,700 Visalia 25,500 Selma 4,600 125,100 LOS ANGELES AREA East Los Angeles (including portions of City of Commerce and Montebello) 26,400 Hermosa Beach and Redondo Beach (including portions of Torrance) 24,700 Palos Verdes (including Palos Verdes Estates, Rancho Palos Verdes, Rolling Hills Estates and Rolling Hills) 23,400 Westlake (portion of Thousand Oaks) 6,600 81,100 TOTAL 362,900 Water Supply The Company's water supply is obtained from wells, surface runoff or diversion and by purchase from public agencies and other suppliers. The effects of the recent California drought (which ended after the 1992-93 winter) are discussed below. Except for periods of drought, the Company in the past has had adequate water supplies to meet the existing requirements of its service areas. The Company delivered approximately 95 billion gallons of water during the 1993 fiscal year, of which approximately 50% was obtained from wells, and 50% was purchased from the following suppliers: % of Supply District Purchased Source of Purchased Supply SAN FRANCISCO BAY AREA Mid-Peninsula 100% San Francisco Water Department South San Francisco 74% San Francisco Water Department Bear Gulch 86% San Francisco Water Department Los Altos 67% Santa Clara Valley Water District Livermore 73% Alameda County Flood Control and Water Conservation District SACRAMENTO VALLEY Oroville 81% Pacific Gas and Electric Company 1% County of Butte SAN JOAQUIN VALLEY Bakersfield 21% Kern County Water Agency Stockton 72% Stockton-East Water District LOS ANGELES AREA East Los Angeles 99% Central Basin Municipal Water District % of Supply District Purchased Source of Purchased Supply LOS ANGELES AREA (Continued) Hermosa Beach and Redondo Beach 100% West Basin Municipal Water District Palos Verdes 100% West Basin Municipal Water District Westlake 100% Russell Valley Municipal Water District The balance of the required supply for the above districts is obtained from wells, except for Bear Gulch where the balance is obtained from surface runoff from a local watershed. The Chico, Marysville, Dixon and Willows districts in the Sacramento Valley, the Salinas and King City districts in the Salinas Valley, and the Selma and Visalia districts in the San Joaquin Valley obtain their entire supply from wells. In these districts, although groundwater levels have declined during the six consecutive years of below normal precipitation (1986-1992), they remain, in the opinion of the Company, adequate for anticipated future needs. However, in the Salinas Valley, declining water tables have resulted in salt water intrusion in some areas adjacent to Monterey Bay. Operational changes have been made in the Salinas district in an attempt to retard the movement of salt water toward the Company's production wells. Pumping of vulnerable wells has been curtailed and supply supplemented by boosting water from other zones. The Company continues to cooperate with the Monterey County Water Resources Agency and other groups on long-term mitigation plans. Purchases for the Los Altos, Livermore, Oroville, Stockton and Bakersfield districts are pursuant to long-term contracts expiring on various dates after 2011, except for the Livermore contract which expired in July 1992. Discussions with Zone 7 of the Alameda County Flood Control and Water Conservation District regarding the renewal of the contract are currently in progress and a new contract is expected to be completed within a few months. The contract, which expired in July 1992, requires water deliveries to continue for two years after the expiration of the contract. The supplies for the East Los Angeles, Hermosa-Redondo, Palos Verdes and Westlake districts are provided to the Company by public agencies pursuant to an obligation of continued nonpreferential service to persons within their boundaries. Purchases for the South San Francisco, Mid-Peninsula and Bear Gulch districts are pursuant to long-term contracts with the San Francisco Water Department expiring June 30, 2009. Water supplies in California's major reservoirs were at 22.4 million acre feet on January 1, 1994, almost doubled that recorded one year earlier when the state was in its sixth year of drought. The state's current reservoir supply, which is at average for this time of year, was replenished during 1993 as a result of the abundant runoff which followed the above average precipitation of the 1992-93 winter season. Twelve Company districts receive all or a portion of their supply from surface water runoff captured by state and local reservoirs. While overall reservoir storage remained normal at the start of 1994, the snowpack in the Sierra on January 3, 1994, was approximately 45% of average for this date, indicating that the 1993-94 water year has started significantly drier than last year's above average season. Subsequent storms in mid-February 1994 have greatly increased the Sierra snowpack. Although substantial reserves remain in underground aquifers which serve 16 Company districts, many groundwater tables have not fully recovered from the effects of the drought. Taking this into consideration, together with the fact that California will continue to have long-term water supply problems with future growth, the Company will maintain its water conservation efforts through a variety of customer programs initiated during the drought. The state's improved supply conditions have eliminated the need for water rationing. While not under a mandatory rationing program during 1994, customers in the Company's Salinas district will be asked to voluntarily cut water use by 15% to conform to a new local ordinance. The new law, which places water use restrictions on both urban and agricultural users in Monterey County, is part of an overall program to curtail ocean salt water intrusion. Possible program options include: The use of additional supplies from southern Monterey County reservoirs for imported surface water and groundwater recharge; the use of 20,000 acre feet of reclaimed water from the Regional Water Treatment plant in Marina, recycled for irrigation use and groundwater recharge; restrictions placed upon the Salinas Valley's urban and agricultural communities on water use; and the possible development of a new dam and reservoir in the County's Arroyo Seco area for reserve storage and recharge of the underground through the Salinas and Arroyo Seco Rivers. Utility Plant Construction Program and Acquisitions. The Company is continually extending and enlarging its facilities as required to meet increasing demands and to maintain its service. Capital expenditures for these purposes and for the replacement of existing facilities amounted to approximately $29 million in 1993. Financing was obtained from funds from operations, temporary cash investments, first mortgage bonds, advances for construction, and contributions in aid of construction as set forth in the section entitled "Statement of Cash Flows" on page 20 of the Company's 1993 Annual Report and is incorporated herein by reference. Advances for construction of main extensions are received by the Company from subdivision developers under the rules of the PUC. These advances are refundable without interest over a period of years. Contributions in aid of construction consist of nonrefundable cash deposits or facilities received from developers. The Company now estimates that additions and improvements to its facilities during 1994 will amount to approximately $21,600,000 (exclusive of additions and improvements financed through advances for construction and contributions in aid of construction), which is expected to be financed with internally generated funds and short-term borrowings to be replaced by funds from issuance of approximately 600,000 shares of common stock during the year or from the issuance of first mortgage bonds. In November 1992, the Company executed a Stock Purchase Agreement to acquire Del Este Water Company located in Modesto, California, through an exchange of common stock. However, in August 1993, the Company elected not to pursue the purchase after the City of Modesto initiated condemnation proceedings to acquire the system from the present owner. Quality of Supplies. The Company maintains procedures to produce potable water in accordance with accepted water utility practice. All water entering the distribution systems from surface sources is chlorinated and in most cases filtered. Samples of water from each district are analyzed regularly by Company bacteriologists. Competition and Condemnation. The Company is a public utility regulated by the PUC. The Company provides service within filed service areas approved by the PUC. Under the laws of the State of California, no privately owned public utility may compete with the Company in any territory already served by the Company without first obtaining a certificate of public convenience and necessity from the PUC. Under PUC practice, such certificate will be issued only on a showing that the Company's service in such territory is inadequate. California law also provides that whenever a public agency constructs facilities to extend a utility service into the service area of a privately owned public utility, such an act constitutes the taking of property and for such taking the public utility is to be paid just compensation. Under the constitution and statutes of the State of California, municipalities, water districts and other public agencies have been authorized to engage in the ownership and operation of water systems. Such agencies are empowered to condemn properties already operated by privately owned public utilities upon payment of just compensation and are further authorized to issue bonds (including revenue bonds) for the purpose of acquiring or constructing water systems. To the Company's knowledge, no municipality, water district or other public agency has pending any action to condemn any of the Company's systems. Environmental Matters. The Company is subject to environmental regulation by various governmental authorities. Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, as of the date of filing of this Form lO-K, any material effect on the Company's capital expenditures, earnings or competitive position. No such material effect is anticipated for the fiscal years ending December 31, 1994 and 1995. Human Resources. As of December 31, 1993, the Company had 614 employees, of whom 150 were executive and administrative officials and supervisory employees, and 464 were members of unions. The Company presently has two-year collective bargaining agreements expiring December 31, 1995, with the Utility Workers of America, AFL-CIO, representing the majority of employees, and the International Federation of Professional and Technical Engineers, AFL-CIO, representing certain engineering department employees. d. Financial Information about Foreign and Domestic Operations and Export Sales. The Company makes no export sales. Item 2. Item 2. Properties. The Company's physical properties consist of offices and water systems for the production, storage, purification, and distribution of water. These properties are located in or near the service areas listed above in the section entitled "Water Supply." The Company maintains all of its properties in good operating condition. The Company holds all its principal properties in fee, subject to the lien of the indenture securing the Company's first mortgage bonds, of which there were outstanding at December 31, 1993, $129,608,000 in principal amount. Item 3. Item 3. Legal Proceedings. The Company is involved in only routine litigation which is incidental to the business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders in the fourth quarter of fiscal year 1993. Executive Officers of the Registrant. Name Positions and Offices with the Company Age C. H. Stump Chairman of the Board since 1991, Chief Executive Officer 1991 to May 1992. Director since 1976, and Member of 68 Executive Committee since 1977. Mr. Stump was Secretary of the Company from 1959 to 1966, Secretary and Treasurer from 1966 to 1975, Executive Vice President from 1975 to 1981, President and Chief Operating Officer from 1981 to 1986, and President and Chief Executive Officer from 1986 to 1992. Donald L. Houck President, Chief Executive Officer 61 since May 1992. Director since 1988. Mr. Houck was Executive Vice President and Chief Operating Officer from 1986 to 1992 and a Vice President since 1977. Prior to that, Mr. Houck was a supervising engineer with the California Public Utilities Commission with eighteen years experience in the rate-making process. Harold C. Ulrich Vice President and Chief Financial 64 Officer since 1976 and Treasurer since 1975. Mr. Ulrich was Controller of the Company from 1966 to 1975. Kenneth J. Roed Vice President, Corporate Communications, 64 since 1988. Mr. Roed was previously employed by the Company for 12 years as Assistant to the President and Director of Corporate Communications. Francis S. Ferraro Vice President since August 1989. Mr. 44 Ferraro previously had 15 years experience in regulatory matters with the California Public Utilities Commission, from June 1985 in the capacity of an administrative law judge. Raymond H. Taylor Vice President since April 1990. Mr. Taylor 48 had been director of water quality since 1986 and previously had been employed by the Environmental Protection Agency before joining the Company in 1982. Gerald F. Feeney Controller, Assistant Secretary and 49 Assistant Treasurer since 1976. From 1970 to 1976, Mr. Feeney was a manager with Peat Marwick Mitchell & Co. Helen Mary Kasley Secretary and Legal Counsel since 42 1993. From 1990 to 1992, Mrs. Kasley was Secretary. From 1986 to 1990, she was an associate attorney with McCutchen, Doyle, Brown & Enersen. John S. Simpson Assistant Secretary since 1992. Mr. 49 Simpson has been Manager of New Business Development for the past nine years and has held various management positions with the Company since 1967. No officer or director has any family relationship to any other executive officer or director. No executive officer is appointed for any set term. There are no agreements or understandings between any executive officer and any other person pursuant to which he was selected as an executive officer, other than those with directors or officers of the Company acting solely in their capacities as such. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information required by this item is contained in the section captioned "Quarterly Financial and Common Stock Market Data" on page 26 of the Company's 1993 Annual Report and is incorporated herein by reference. The number of holders listed in such section includes the Company's record holders and also individual participants in security position listings. Item 6. Item 6. Selected Financial Data. The information required by this item is contained in the section captioned "California Water Service Company Ten Year Financial Review" on pages 12 and 13 of the Company's 1993 Annual Report and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this item is contained in the sections captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations," on pages 14 and 15 of the Company's 1993 Annual Report and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this item is contained in the sections captioned "Balance Sheet," "Statement of Income," "Statement of Common Shareholders' Equity," "Statement of Cash Flows," "Notes to Financial Statements" and "Independent Auditors' Report" on pages 16 through 27 of the Company's 1993 Annual Report and is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Information regarding executive officers of the Company is included in a separate item captioned "Executive Officers of the Registrant" contained in Part I of this report. The information required by this item as to directors of the Company is contained in the section captioned "Election of Directors" on pages 2 through 5 of the Proxy Statement and is incorporated herein by reference. (The proxy statement was filed under EDGAR on March 14, 1994). Item 11. Item 11. Executive Compensation. The information required by this item as to directors and executive officers of the Company is contained in the section captioned "Compensation of Executive Officers" on pages 7 and 8 of the Proxy Statement and is incorporated herein by reference. (The proxy statement was filed under EDGAR on March 14, 1994). Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this item is contained in the sections captioned "Election of Directors," "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" pages 2 through 4 and 12 and 13, respectively, of the Proxy Statement and is incorporated herein by reference. (The proxy statement was filed under EDGAR on March 14, 1994). Item 13. Item 13. Certain Relationships and Related Transactions. None. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) Financial Statements: Balance Sheet as of December 31, 1993 and 1992. Statement of Income for the years ended December 31, 1993, 1992, and 1991. Statement of Common Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991. Statement of Cash Flows for the years ended December 31, 1993, 1992, and 1991. Notes to Financial Statements, December 31, 1993, 1992, and 1991. The above financial statements are contained in sections bearing the same captions on pages 16 through 26 of the Company's 1993 Annual Report and are incorporated herein by reference. (2) Financial Statement Schedules: Schedule Number - Independent Auditors' Report on Schedules, January 21, 1994. V Property, Plant, and Equipment -- years ending December 31, 1993, 1992, and 1991. VI Accumulated Depreciation of Property, Plant, and Equipment--years ending December 31, 1993, 1992, and 1991. VIII Valuation and Qualifying Accounts and Reserves--years ending December 31, 1993, 1992, and 1991. X Supplementary Income Statement Information--years ending December 31, 1993, 1992, and 1991. All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. (3) Exhibits required to be filed by Item 601 of Regulation S-K. See Exhibit Index on page 27 of this document which is incorporated herein by reference. The exhibits filed herewith are attached hereto (except as noted) and those indicated on the Exhibit Index which are not filed herewith were previously filed with the Securities and Exchange Commission as indicated. Except where stated otherwise, such exhibits are hereby incorporated by reference. Exhibits filed herewith and attached hereto under separate cover will be furnished to security holders of the Company upon written request and payment of a fee of $.30 per page which fee covers only the Company's reasonable expenses in furnishing such exhibits. (b) Report on Form 8-K. None required to be filed during the last quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 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. CALIFORNIA WATER SERVICE COMPANY Date: March 16, 1994 By /s/ Donald L. Houck DONALD L. HOUCK, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Date: March 16, 1994 /s/ William E. Ayer WILLIAM E. AYER, Member, Board of Directors Date: March 16, 1994 /s/ Robert W. Foy ROBERT W. FOY, Member, Board of Directors Date: March 16, 1994 /s/ Edward D. Harris, Jr. EDWARD D. HARRIS, JR. M.D., Member, Board of Directors Date: March 16, 1994 /s/ Donald L. Houck DONALD L. HOUCK President, Chief Executive Officer, Member, Board of Directors Date: March 16, 1994 /s/ Robert K. Jaedicke ROBERT K. JAEDICKE, Member, Board of Directors Date: March 16, 1994 /s/ Roscoe Moss, Jr. ROSCOE MOSS, JR., Member, Board of Directors /s/ L. W. LANE, JR., Member, Board of Directors Date: March 16, 1994 /s/ C. H. Stump C. H. STUMP, Chairman of the Board, Member, Board of Directors Date: March 16, 1994 /s/ Edwin E. Van Bronkhorst EDWIN E. VAN BRONKHORST, Member, Board of Directors Date: March 16, 1994 /s/ Harold C. Ulrich HAROLD C. ULRICH, Vice President, Chief Financial and Treasurer Date: March 16, 1994 /s/ Gerald F. Feeney GERALD F. FEENEY, Controller Independent Auditors' Report on Schedules Shareholders and Board of Directors California Water Service Company : Under date of January 21, 1994, we reported on the balance sheets of California Water Service Company as of December 31, 1993 and 1992, and the related statements of income, common shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement Schedules V, VI, VIII and X. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. San Jose, California /s/ KPMG Peat Marwick January 21, 1994 EXHIBIT INDEX Sequential Page Numbers Exhibit Number in this Report 3. Articles of Incorporation and By Laws: 3.1 Restated Articles of Incorporation dated March 20, 1968, Certificate of Ownership Merging Palos Verdes Water Company into California Water Service Company dated December 22, 1972; Certificate of Amendment of Restated Articles of Incorporation dated April 7, 1975; Certificate of Amendment of Restated Articles of Incorporation dated April 16, 1984; Certificate of Amendment of Restated Articles of Incorporation dated July 31, 1987; Certificate of Amendment of Restated Articles of Incorporation dated October 19, 1987 (Exhibit 3.1 to Form 10-K for fiscal year 1987, File No. 0-464). 28 3.2 Certificates of Determination of Preferences for Series C Preferred Stock (Exhibit 3.2 to Form 10-K for fiscal year 1987, File No. 0-464). 28 3.3 Certificate of Amendment of the Company's Restated Articles of Incorporation dated April 27, 1988. (Exhibit 3.3 to Form 10-K for fiscal year 1989, File No. 0-464). 28 3.4 By-Laws dated September 21, 1977, as amended November 19, 1980, April 21, 1982, June 15, 1983, September 17, 1984, and November 16, 1987 (Exhibit 3.3 to Form 10-K for fiscal year 1987, File No. 0-464). 28 3.5 Amendment to By-laws dated May 16, 1988. (Exhibit 3.5 to Form 10-K for fiscal year 1991, File No. 0-464) 28 4. Instruments Defining the Rights of Security Holders, including Indentures: Mortgage of Chattels and Trust Indenture dated April 1, 1928; Fifteenth Supplemental Indenture dated November 1, 1965; Sixteenth Supplemental Indenture dated November 1, 1966; Seventeenth Supplemental Indenture dated November 1, 1967; Twenty-First Supplemental Indenture dated October 1, 1972; Twenty-Fourth Supplemental Indenture dated November 1, 1973; (Exhibits 2(b), 2(c), 2(d), Registration Statement No. 2-53678, of which certain exhibits are incorporated by reference to Registration Statement Nos. 2-2187, 2-5923, 2-9681, 2-10517 and 2-11093.) 29 Twenty-Sixth Supplemental Indenture dated May 1, 1976 (Exhibit 4 to Form 10-K for fiscal year 1986, File No. 0-464). 29 Twenty-Seventh Supplemental Indenture dated November 1, 1977; Twenty-Eighth Supplemental Indenture dated May 1, 1978; Twenty-Ninth Supplemental Indenture dated November 1, 1979 (Exhibit 4 to Form 10-K for fiscal year 1989, File No. 0-464). 29 Thirty-Third Supplemental Indenture dated as of May 1, 1988, covering First Mortgage 9.48% Bonds, Series BB (Exhibit 4 to Form 10-Q September 30, 1988, File No. 0-464) 29 Thirty-Fourth Supplemental Indenture dated as of November 1, 1990, covering First Mortgage 9.896% Bonds, Series CC (Exhibit 4 to Form 10-K for fiscal year 1990, File No. 0-464). 29 Thirty-Fifth Supplemental Indenture dated as of November 1, 1992, covering First Mortgage 8.63% Bonds, Series DD. (Exhibit 4 to Form 10-Q for dated September 30, 1992, File No. 0-464) 29 Thirty-Sixth Supplemental Indenture dated as of May 1, 1993, covering First Mortgage 7.90% Bonds Series EE (Exhibit 4 to Form 10-Q dated June 30, 1993, File No. 0-464) 29 Thirty-Seventh Supplemental Indenture dated as of September 1, 1993, covering First Mortgage 6.95% Bonds, Series FF (Exhibit 4 to Form 10-Q dated September 30, 1993, File No. 0-464) 29 Thirty-Eighth Supplemental Indenture dated as of October 15, 1993, covering First Mortgage 6.98% Bonds, Series GG. 33 Sequential Page Numbers Exhibit No. in this Report 10. Material Contracts. 10.1 Water Supply Contracts: Supply Contract 30 between the Company and Alameda County Flood Control and Water Conservation District relating to the Company's Livermore District; Water Supply Contract between the Company and the County of Butte relating to the Company's Oroville District; Water Supply Contract between the Company and the Kern County Water Agency relating to the Company's Bakersfield District; Water Supply Contract between the Company and Stockton East Water District relating to the Company's Stockton District. (Exhibits 5(g), 5(h), 5(i), 5(j), Registration Statement No. 2-53678, which incorporates said exhibits by reference to Form 1O-K for fiscal year 1974, File No. 0-464). 10.2 Settlement Agreement and Master Water Sales 30 Contract between the City and County of San Francisco and Certain Suburban Purchasers dated August 8, 1984; Supplement to Settlement Agreement and Master Water Sales Contract, dated August 8, 1984; Water Supply Contract between the Company and the City and County of San Francisco relating to the Company's Bear Gulch District dated August 8, 1984; Water Supply Contract between the Company and the City and County of San Francisco relating to the Company's San Carlos District dated August 8, 1984; Water Supply Contract between the Company and the City and County of San Francisco relating to the Company's San Mateo District dated August 8, 1984; Water Supply Contract between the Company and the City and County of San Francisco relating to the Company's South San Francisco District dated August 8, 1984. (Exhibit 10.2 to Form lO-K for fiscal year 1984, File No. 0-464). Sequential Page Numbers Exhibit Number in this Report 10.3 Water Supply Contract dated January 27, 31 1981, between the Company and the Santa Clara Valley Water District relating to the Company's Los Altos District (Exhibit 10.3 to Form 10-K for fiscal year 1992, File No. 0-464) 10.4 Amendment dated November 28, 1979, to 31 Water Supply Contract between the Company and Alameda County Flood Control and Water Conservation District relating to the Company's Livermore District. (Exhibit 10.4 to Form 10-K for fiscal year 1992, File No. 0-464) 10.5 Amendments No. 3, 6 and 7 and Amendment 31 dated June 17, 1980, to Water Supply Contract between the Company and the County of Butte relating to the Company's Oroville District. (Exhibit 10.5 to Form 10-K for fiscal year 1992, File No. 0-464) 10.6 Amendment dated May 31, 1977, to Water 31 Supply Contract between the Company and Stockton-East Water District relating to the Company's Stockton District. (Exhibit 10.6 to Form 10-K for fiscal year 1992, File No. 0-464) 10.7 Second Amended Contract dated September 25, 31 1987 among the Stockton East Water District, the California Water Service Company, the City of Stockton, the Lincoln Village Maintenance District, and the Colonial Heights Maintenance District Providing for the Sale of Treated Water. (Exhibit 10.7 to Form 10-K for fiscal year 1987, File No. 0-464). 10.8 Dividend Reinvestment Plan. (Exhibit 10.8 to 31 Form 10-K for fiscal year 1991, File No. 0-464) 10.9 Water Supply Contract dated April 19, 1927, 31 and Supplemental Agreement dated June 5, 1953, between the Company and Pacific Gas and Electric Company relating to the Company's Oroville District. (Exhibit 10.9 to Form 10-K for fiscal year 1992, File No. 0-464) 10.10 California Water Service Company Pension Plan 31 (Exhibit 10.10 to Form 10-K for fiscal year 1992, File No. 0-464) Sequential Page Numbers Exhibit Number in this Report 10.11 California Water Service Company Supplemental Executive Retirement Plan. (Exhibit 10.11 to Form 10-K for fiscal year 1992, File No. 0-464) 32 10.12 California Water Service Company Salaried Employees' Savings Plan. (Exhibit 10.12 to Form 10-K for fiscal year 1992, File No. 0-464) 32 10.13 California Water Service Company Directors Deferred Compensation Plan (Exhibit 10.13 to Form 10-K for fiscal year 1992, File No. 0-464) 32 10.14 Board resolution setting forth the terms of the retirement plan, as amended, for Directors of California Water Service Company (Exhibit 10.14 to Form 10-K for fiscal year 1992, File No. 0-464) 32 13. Annual Report to Security Holders, Form 1O-Q or Quarterly Report to Security Holders: 1993 Annual Report. The sections of the 1993 Annual Report which are incorporated by reference in this 10-K filing. This includes those sections referred to in Part II, Item 5, Market for Registrant's Common Equity and Related Shareholder Matters; Part II, Item 6, Management's Financial Data; Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations; and Part II, Item 8, Financial Statement and Supplementary Data. 86 RECORDING REQUESTED BY AND MAIL TO: California Water Service Company P.O. Box 1150 San Jose, California 95108-1150 Attention: Helen M. Kasley, Secretary SUPPLEMENTAL MORTGAGE OF CHATTELS AND TRUST INDENTURE (Thirty-Eighth Supplemental Indenture) ------------ CALIFORNIA WATER SERVICE COMPANY to BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION Trustee ------------ Dated as of October 15, 1993 Section Page PARTIES................................................................ 1 RECITALS............................................................... 1 Execution and recordation of Original Indenture, dated April 1, 1928. 1 Change of name of Los Angeles-First National Trust & Savings Bank............................................................... 2 Change of name of American Trust Company............................. 2 Resignations of Wells Fargo Bank, National Association and Security Pacific National Bank, as trustees, and appointment of Bank of America National Trust and Savings Association, as successor trustee............................................................ 2 Execution of thirty-seven supplemental indentures.................... 3 Recordation of thirty-seven supplemental indentures.................. 4 Amount of bonds heretofore issued and now outstanding................ 5 Authorization of Original Indenture, as amended, of issuance of bonds in series and requirements for creation of new series.............. 6 Proposal of Company to issue additional bonds of new series, prescribe terms thereof and confirm lien of Original Indenture and thirty-seven prior supplemental indentures...................................... 6 Desire of Company to describe specifically additional properties acquired since date of Thirty-Seventh Supplemental Indenture................ 7 Authorization of Thirty-Eighth Supplemental Indenture by Company..... 7 Compliance with all conditions and requirements for validity of Thirty- Eighth Supplemental Indenture...................................... 7 Execution of Bond Purchase Agreements................................ 7 GRANTING CLAUSE...................................................... 7 Schedule I--Properties under prior indentures...................... 8 Properties described in prior indentures but subsequently released 8 Schedule II--Properties now owned or acquired...................... 8 1. Real estate................................................... 8 2. Franchises, rights-of-way, rights and privileges.............. 8 Schedule III--Other property now owned............................. 9 Right to retain possession and dispose of certain intangible and other property......................................................... Schedule IV--After-acquired property............................... 9 Franchises, permits, licenses, rights, etc......................... 10 Tenements, hereditaments, appurtenances, etc....................... 10 Express condition that subjection of properties to lien shall not render them unavailable for use under Indenture......................... 10 HABENDUM CLAUSE...................................................... 11 USES AND TRUSTS...................................................... 11 AGREEMENT OF COMPANY AND TRUSTEE..................................... 11 i 34 -------- PART I SERIES GG BONDS ARTICLE I--CREATION OF AND PARTICULARS OF SERIES GG BONDS Section Page 1. Creation and Designation....................................... 12 2. Terms of Series GG Bonds....................................... 12 3. Form of Series GG Bonds........................................ 16 Form of registered bond without coupons of Series GG........ 17 Form of trustee's certificate of authentication............. 21 ARTICLE II--ISSUE OF BONDS 1. Conditions Applicable to Issuance of Series GG Bonds........... 22 ARTICLE III--REDEMPTION 1. Right to Redeem; Redemption Prices............................. 22 2. Notice and Manner of Redemption................................ 22 ARTICLE IV--SINKING FUND 1. Amount and Time of Payment..................................... 23 2. Application of Sinking Fund Cash to Redemption of Bonds........ 23 3. Limitations on Use of Sinking Fund Cash in Case of Default..... 24 4. Sinking Funds for Bonds of Other Series........................ 24 ii 35 -------- PART II MISCELLANEOUS PROVISIONS WITH RESPECT TO SUPPLEMENTAL INDENTURE Section Page 1. The Trustee....................................................... 24 2. Destruction of Bonds.............................................. 24 3. Separability of Invalid Provisions................................ 25 4. Effect on Successors and Assigns of Parties....................... 25 5. Immunity of Incorporators, Stockholders, Officers and Directors... 25 6. Titles Not Part of Supplemental Indenture......................... 25 7. Counterparts...................................................... 25 8. Title to Property; Authority to Mortgage; Prior Liens............. 26 ATTESTATION........................................................... 26 EXECUTION............................................................. 26 ACKNOWLEDGMENT OF COMPANY............................................. 27 ACKNOWLEDGMENT OF BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION............................................. 28 SCHEDULE A--Recording Data as to Resignations of Wells Fargo Bank, National Association and Security Pacific National Bank, as Trustees, and Appointment of Bank of America National Trust and Savings Association as Successor Trustee............................ 29 SCHEDULE B--Recording Data as to Supplemental Indentures.............. 30 SCHEDULE C--Properties Released Since September 1, 1993............... 48 SCHEDULE D--Real Estate Acquired by the Company Since September 1, 1993 or Otherwise Not Included in the Original Indenture or any Supplemental Indenture.................... 49 iii 36 SUPPLEMENTAL MORTGAGE OF CHATTELS AND TRUST INDENTURE Thirty-Eighth Supplemental Indenture -------- THIS SUPPLEMENTAL INDENTURE, made and entered into as of the 15th day of October, 1993, by and between California Water Service Company, a corporation organized and existing under and by virtue of the laws of the State of California, and having its principal place of business in the City of San Jose, County of Santa Clara, State of California, by occupation a public utility water company (hereinafter called the "Company"), party of the first part, and Bank of America National Trust and Savings Association, a national banking association created, organized and existing under and by virtue of the laws of the United States of America, and having corporate trust offices in the cities of Los Angeles and San Francisco, State of California (hereinafter sometimes called the "Trustee"). Whereas, the Company heretofore made, executed and delivered that certain indenture, California Water Service Company to American Trust Company and Los Angeles-First National Trust & Savings Bank, as trustees, dated as of the 1st day of April, 1928 (hereinafter sometimes called the "Original Indenture"), which indenture has been recorded in the offices of the Recorders of the following counties and city and county of the State of California on the respective dates and in the respective books of record hereinafter set forth as follows: 1 37 Vol. of Page at Official Records Which County or Date of (except as Record City and County Recordation noted) Commences Contra Costa............. May 2, 1928 141 7 City and County of San Francisco.......... May 3, 1928 1637 346 (Book of Glenn.................... May 2, 1928 62 Mortgages) 190 Kings.................... Jan. 7, 1929 40 348 San Joaquin.............. May 2, 1928 243 295 Solano................... May 2, 1928 14 7 Tulare................... May 3, 1928 260 11 Alameda.................. May 2, 1928 1877 35 Sonoma................... May 2, 1928 196 136 Los Angeles.............. May 4, 1928 7105 102 (Book of Butte.................... May 2, 1928 116 Mortgages) 106 Kern..................... May 3, 1928 249 1 Shasta................... May 2, 1928 38 80 Fresno................... May 2, 1928 894 32 San Mateo................ Jan. 20, 1939 837 16 Yuba..................... Sept. 12, 1942 69 291 Santa Clara.............. Nov. 2, 1945 1305 286 Monterey................. Feb. 21, 1962 23 (Reel) 1; and Whereas, Los Angeles-First National Trust & Savings Bank changed its name to Security-First National Bank of Los Angeles and later to Security First National Bank and later to Security Pacific National Bank; and Whereas, American Trust Company changed its name to Wells Fargo Bank-American Trust Company and later to Wells Fargo Bank and Wells Fargo Bank subsequently merged into Wells Fargo Bank, National Association; and Whereas, by instrument entitled "Resignations of Wells Fargo Bank, National Association as Authenticating Trustee and Security Pacific National Bank as Trustee and Appointment and Acceptance of Bank of America National Trust and Savings Association as Authenticating Trustee under Mortgage of Chattels and Trust Indenture Dated as of April 1, 1928 As Supplemented, Amended and Modified from California Water Service Company" dated as of August 1, 1983, recorded in the offices of the Recorders of those counties and city and county of the State of California on the respective dates and in the respective books of record and/or as the respective document numbers set forth in SCHEDULE A, which is annexed hereto and hereby made a part hereof, Wells Fargo Bank, National Association resigned as authenticating trustee under the Original Indenture, as theretofore supplemented, amended and modified by thirty-one supplemental indentures, effective August 1, 1983, the Company 2 38 appointed Bank of America National Trust and Savings Association as successor authenticating trustee to Wells Fargo Bank, National Association, effective August 1, 1983, Bank of America National Trust and Savings Association accepted such appointment as authenticating trustee under the Original Indenture, as theretofore supplemented, amended and modified by thirty-one supplemental indentures, effective August 1, 1983, Security Pacific National Bank resigned as trustee under the Original Indenture, as theretofore supplemented, amended and modified by thirty-one supplemental indentures, effective August 1, 1983, the Company appointed no successor trustee to said Security Pacific National Bank, Bank of America National Trust and Savings Association as of August 1, 1983 became fully vested with all the estates, properties, rights, powers, trusts, duties and obligations of Wells Fargo Bank, National Association and Security Pacific National Bank, as trustees under the Original Indenture, as theretofore supplemented, amended and modified by thirty-one supplemental indentures, with like effect as if originally named as trustee therein, and Bank of America National Trust and Savings Association is now the authenticating trustee under the Original Indenture, as supplemented, amended and modified by the First through Thirty-Seventh Supplemental Indentures referred to below and by this supplemental indenture (hereinafter sometimes called the "Thirty-Eighth Supplemental Indenture"), said Original Indenture as so supplemented, amended and modified being hereinafter called the "Indenture"; and Whereas, the Company has heretofore made, executed and delivered thirty-seven certain supplemental indentures supplemental to said Original Indenture, to-wit, one such supplemental indenture from said California Water Service Company to said American Trust Company and said Los Angeles-First National Trust & Savings Bank, as trustees, dated January 3, 1929, hereinafter sometimes called the "First Supplemental Indenture;" twelve such supplemental indentures from said California Water Service Company to said American Trust Company and said Security-First National Bank of Los Angeles, as trustees, dated and hereinafter sometimes called, respectively, as follows: Date Name August 19, 1929 Second Supplemental Indenture February 25, 1930 Third Supplemental Indenture February 1, 1931 Fourth Supplemental Indenture March 23, 1932 Fifth Supplemental Indenture May 1, 1936 Sixth Supplemental Indenture April 1, 1939 Seventh Supplemental Indenture November 1, 1945 Eighth Supplemental Indenture May 1, 1951 Ninth Supplemental Indenture May 1, 1953 Tenth Supplemental Indenture May 1, 1954 Eleventh Supplemental Indenture May 1, 1955 Twelfth Supplemental Indenture November 1, 1956 Thirteenth Supplemental Indenture; four such supplemental indentures from said California Water Service Company to said Wells Fargo Bank and said Security First National Bank, as trustees, dated and hereinafter sometimes called, respectively, as follows: 3 39 Date Name November 1, 1963 Fourteenth Supplemental Indenture November 1, 1965 Fifteenth Supplemental Indenture November 1, 1966 Sixteenth Supplemental Indenture November 1, 1967 Seventeenth Supplemental Indenture; fourteen such supplemental indentures from said California Water Service Company to said Wells Fargo Bank, National Association and said Security Pacific National Bank, as trustees, dated and hereinafter sometimes called, respectively, as follows: Date Name November 1, 1969 Eighteenth Supplemental Indenture May 1, 1970 Nineteenth Supplemental Indenture November 1, 1970 Twentieth Supplemental Indenture October 1, 1972 Twenty-First Supplemental Indenture November 1, 1972 Twenty-Second Supplemental Indenture November 15, 1972 Twenty-Third Supplemental Indenture November 1, 1973 Twenty-Fourth Supplemental Indenture May 1, 1975 Twenty-Fifth Supplemental Indenture May 1, 1976 Twenty-Sixth Supplemental Indenture November 1, 1977 Twenty-Seventh Supplemental Indenture May 1, 1978 Twenty-Eighth Supplemental Indenture November 1, 1979 Twenty-Ninth Supplemental Indenture November 1, 1980 Thirtieth Supplemental Indenture May 1, 1982 Thirty-First Supplemental Indenture; and six such supplemental indentures from said California Water Service Company to said Bank of America National Trust and Savings Association, as trustee, dated and hereinafter sometimes called, respectively, as follows: Date Name September 1, 1983 Thirty-Second Supplemental Indenture May 1, 1988 Thirty-Third Supplemental Indenture November 1, 1990 Thirty-Fourth Supplemental Indenture November 1, 1992 Thirty-Fifth Supplemental Indenture May 1, 1993 Thirty-Sixth Supplemental Indenture September 1, 1993 Thirty-Seventh Supplemental Indenture; and Whereas, said First through Thirty-Seventh Supplemental Indentures above mentioned have been recorded in the offices of the Recorders of those counties and city and county of the State of California on the respective dates and in the respective books of record and/or as the respective document numbers set forth in SCHEDULE B, which is annexed hereto and hereby made a part hereof; and 4 40 Whereas, under and pursuant to said Original Indenture and said supplemental indentures hereinabove mentioned, the Company has heretofore issued its bonds as follows: Principal Total Amount Aggregate Outstanding Principal as of Designation Amount October 14, 1993 First Mortgage 5% Gold Bonds, Series A (Heretofore redeemed and cancelled)..... $8,738,000 First Mortgage 4% Bonds, Series B (Heretofore redeemed and cancelled)..... 11,882,000 First Mortgage 3-1/4% Bonds, Series C (Heretofore redeemed and cancelled)..... 17,822,000 First Mortgage 3-5/8% Bonds, Series D (Heretofore redeemed and cancelled)..... 3,540,000 First Mortgage 4-1/8% Bonds, Series E (Heretofore redeemed and cancelled)..... 2,000,000 First Mortgage 3.35% Bonds, Series F (Heretofore redeemed and cancelled)..... 1,500,000 First Mortgage 3-3/4% Bonds, Series G (Heretofore redeemed and cancelled)..... 4,500,000 First Mortgage 4.60% Bonds, Series H (Heretofore redeemed and cancelled)..... 3,000,000 First Mortgage 4.65% Bonds, Series I...... 3,000,000 $2,565,000 First Mortgage 4.85% Bonds, Series J...... 3,000,000 2,596,000 First Mortgage 6-1/4% Bonds, Series K..... 3,000,000 2,610,000 First Mortgage 6-3/4% Bonds, Series L..... 2,500,000 2,189,000 First Mortgage 9-1/2% Bonds, Series M (Heretofore redeemed and cancelled)..... 2,500,000 First Mortgage 9-1/4% Bonds, Series N (Heretofore redeemed and cancelled)..... 3,000,000 First Mortgage 9-1/4% Bonds, Series O (Heretofore redeemed and cancelled)..... 3,000,000 First Mortgage 7-7/8% Bonds, Series P..... 3,000,000 2,700,000 First Mortgage 4-1/2% Bonds, Series Q (Heretofore redeemed and cancelled)..... 1,171,000 First Mortgage 6.6% Bonds, Series R....... 4,653,000 (Heretofore redeemed and cancelled)..... First Mortgage 8-1/2% Bonds, Series S..... 3,000,000 2,715,000 First Mortgage 8-3/4% Bonds, Series T (Heretofore redeemed and cancelled)..... 26,000,000 First Mortgage 9-1/4% Bonds, Series U (Heretofore redeemed and cancelled)..... 4,000,000 First Mortgage 8.60% Bonds, Series V...... 3,000,000 1,785,000 First Mortgage 9-3/8% Bonds, Series W (Heretofore redeemed and cancelled)..... 4,000,000 [continued on next page] 5 41 [continued from previous page] Principal Total Amount Aggregate Outstanding Principal as of Designation Amount October 14, 1993 First Mortgage 10% Bonds, Series X (Heretofore redeemed and cancelled)..... 5,000,000 First Mortgage 13% Bonds, Series Y (Heretofore redeemed and cancelled)..... 6,000,000 First Mortgage 16-1/4% Bonds, Series Z (Heretofore redeemed and cancelled)..... 5,000,000 First Mortgage 12-7/8% Bonds, Series AA... 35,000,000 33,425,000 First Mortgage 9.48% Bonds, Series BB..... 18,000,000 17,460,000 First Mortgage 9.86% Bonds, Series CC..... 20,000,000 19,700,000 First Mortgage 8.63% Bonds, Series DD..... 20,000,000 20,000,000 First Mortgage 7.90% Bonds, Series EE..... 20,000,000 20,000,000 First Mortgage 6.95% Bonds, Series FF..... 20,000,000 20,000,000; and Whereas, the Original Indenture, as amended by the Eighth Supplemental Indenture, authorizes the bonds issuable thereunder to be issued in one or more series and provides that before the authentication and delivery of any bonds of a series not theretofore created, the Company shall furnish the Authenticating Trustee (as defined therein) either a copy of a resolution certified by the Secretary or an Assistant Secretary under the corporate seal of the Company to have been duly adopted by the Board of Directors or a supplemental indenture authorized by a resolution in like manner certified to have been duly adopted by the Board of Directors, designating the new series to be created and prescribing the amount thereof, if limited, the authorized denominations, the currency or currencies in which and the rate or rates of exchange, if any, at which principal and interest are to be paid, the date and the date or dates of maturity thereof, the place or places where principal and interest are to be paid, rate of interest and dates on which payable, provisions, if any, as to deduction and/or reimbursement of taxes, terms and rates of redemption, if redeemable, terms and rates of conversion, if convertible, terms and rates of exchange, if exchangeable, any other particulars necessary to describe and define such series, any other provisions and agreements in respect thereof and the text of the bonds and coupons, if any; and Whereas, the Company now proposes to issue additional bonds of a new series under and pursuant to and secured by the Original Indenture, as supplemented, amended and modified by the thirty-seven supplemental indentures hereinabove mentioned and particularly by the Eighth Supplemental Indenture, as more particularly provided in Article II thereof, and proposes to prescribe and provide herein the series designation, date, denominations, date of 6 42 maturity, rate of interest, interest payment dates, terms of redemption, sinking fund, place at which payable and other particulars, provisions and agreements in respect to said additional bonds and the form thereof and to confirm the lien and security of the Original Indenture and thirty-seven prior supplemental indentures with respect to such additional bonds; and Whereas, the Company also desires specifically to describe herein additional properties which have been acquired by the Company since the date of the Thirty-Seventh Supplemental Indenture and are subject to the lien and charge of the Original Indenture and the thirty-seven prior supplemental indentures; and Whereas, the Company, under and by virtue of the provisions of the Original Indenture, as amended by the Eighth Supplemental Indenture, and under and by virtue of appropriate resolutions of its Board of Directors, has duly resolved to make, execute and deliver to the Trustee this Thirty-Eighth Supplemental Indenture, in the form hereof for the purposes herein provided; and Whereas, all conditions and requirements necessary to make this supplemental indenture a valid, binding and legal instrument in accordance with its terms have been done, performed and fulfilled and the execution and delivery hereof have been in all respects duly authorized; and Whereas, the Company expects to enter into agreements dated November 1, 1993 (the "Bond Purchase Agreements") with various prospective purchasers relating to the purchase of the Series GG bonds (as hereinafter defined); Now, Therefore, This Supplemental Indenture Witnesseth: That California Water Service Company, in consideration of the premises and of the acceptance by the Trustee of the trusts hereinafter mentioned, and of the purchase and acceptance of the bonds hereinafter mentioned by the holders thereof, by way of further assurance to the Trustee and the holders of the bonds hereinafter mentioned and to confirm the lien and security of the Original Indenture and the thirty-seven prior supplemental indentures above described with respect to said bonds and to confirm the lien and security of the Original Indenture and the thirty-seven prior supplemental indentures on the properties acquired since the date of the Thirty-Seventh Supplemental Indenture hereinafter more specifically described and referred to for the benefit of all bonds issued and to be issued under the Original Indenture and/or any indenture supplemental thereto, and in order to secure the payment both of the principal and interest of the bonds hereinafter mentioned according to their tenor and effect and to secure the performance and observance by the Company of all the covenants and conditions in said bonds and in the Original Indenture, the thirty-seven prior supplemental indentures and in this Thirty-Eighth Supplemental Indenture contained, has granted, bargained, sold, released, conveyed, assigned, transferred, mortgaged, pledged, set over and confirmed, and by these presents does grant, bargain, sell, release, convey, assign, transfer, mortgage, pledge, set over and confirm unto Bank of America National Trust and Savings Association, as trustee, and to its successors in the trust and to its assigns 7 43 forever, all those certain water systems, properties, premises, rights, franchises and interests (hereinafter sometimes referred to as the "mortgaged property" or the "trust estate"), more particularly described as follows: SCHEDULE I. Properties Under Prior Indentures All properties, premises, rights, franchises and interests more particularly described in the Original Indenture and the First through Thirty-Seventh Supplemental Indentures, inclusive, referred to above, excepting therefrom, however, the following: First: All properties shown in the First through Thirty-Seventh Supplemental Indentures, inclusive, to have been released. Second: The properties, if any, described in SCHEDULE C, which is annexed hereto and hereby made a part hereof, which since September 1, 1993, have been sold, conveyed or otherwise disposed of by the Company and released and reconveyed by the Trustee under and pursuant to the terms and provisions of the Original Indenture, as amended by the Eighth Supplemental Indenture, or which have been condemned or taken by the power of eminent domain and are no longer subject to the lien of the Original Indenture or any supplement thereto. SCHEDULE II. Properties Now Owned or Acquired All other properties, premises, rights, franchises and interests now or at the date of delivery of these presents owned or acquired by the Company of whatever character and wherever situated. Said properties include, among other things, the following, but reference to or enumeration of any particular kinds, classes or items of property shall not be deemed to exclude from the operation and effect of this indenture any kind, class or item not so referred to or enumerated: 1. Real Estate. All those certain lots, pieces or parcels of land, if any, more particularly described in SCHEDULE D, which is annexed hereto and hereby made a part hereof. 2. Franchises, Rights-of-Way, Rights and Privileges. All franchises, permits, licenses, rights, easements, grants, privileges and immunities pertaining to or used or usable in connection with the water systems of the Company; all rights-of-way, water rights or privileges appurtenant to the lands, if any, described in SCHEDULE D or used or useable in connection therewith and all renewals, extensions or modifications of the foregoing. 8 44 Together with all and singular the tenements, hereditaments and appurtenances belonging or in anywise appertaining to the aforesaid property, real estate, franchises, rights, privileges and other property or any part thereof; with the reversion and reversions, remainder and remainders, tolls, rents, revenues, issues, income, product and profits thereof, and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the same and every part and parcel thereof. SCHEDULE III. Other Property Now Owned And together with all buildings, plants, systems, works, improvements, structures, fixtures, supplies, appliances, machinery, equipment, materials, transporting and distributing systems, filter systems, ditches, dams, water works, wells, pumps, reservoirs, conduits, pipes, mains, purifiers, washers, holders, boilers, engines, motors (but not motor vehicles), pipe lines, sewers, meters, services, fuel, office furniture, books, records, office supplies, tools, accounts receivable, bills receivable, cash on hand and in bank, and all personal property of every kind and nature whatsoever, appertaining to or useful in the conduct of the Company's present or future business, which the Company now owns, or in which it now has any interest; provided, however, that so long as the Company shall not be in default under the Original Indenture or any indenture supplemental thereto, it shall be entitled to retain in its possession all cash on hand or in bank, accounts receivable, bills receivable, materials and supplies and all shares of stock, bonds and other securities not specifically transferred or assigned to or pledged with the Trustee under the Original Indenture or any indenture supplemental thereto or required so to be and all proceeds of the sale, condemnation or other disposition of the same, and it shall have the power from time to time in its discretion, without reference to the Trustee to dispose of, free from the lien of the Original Indenture and any indenture supplemental thereto, any and all of said cash on hand or in bank, accounts receivable, bills receivable, materials and supplies and said shares of stock, bonds and other securities and proceeds of the same covered by the lien of the Original Indenture or any indenture supplemental thereto. SCHEDULE IV. After-Acquired Property All properties, premises, rights, franchises and interests, of whatever character and wherever situated, hereafter acquired by the Company, including, without limiting the generality of the foregoing description, all "new or additional property" and all "permanent improvements, extensions or additions" (as those terms are used in subdivision (A) of Section 2.03 of Part II of the Eighth Supplemental Indenture) hereafter acquired or constructed by the 9 45 Company, whether fully constructed or erected or in the process of construction or erection, so far as actually constructed or erected, together with all buildings, plants, systems, works, improvements, structures, fixtures, supplies, appliances, machinery, equipment, materials, transporting and distributing systems, filter systems, ditches, dams, water works, wells, pumps, reservoirs, conduits, pipes, mains, purifiers, washers, holders, boilers, engines, motors (but not motor vehicles), pipe lines, sewers, meters, services, fuel, office furniture, books, records, office supplies, tools, accounts receivable, bills receivable, cash on hand and in bank, and all personal property of every kind and nature whatsoever appertaining to or useful in the conduct of the Company's present or future business, which the Company may hereafter acquire or in which it may have any interest; provided, however, that so long as the Company shall not be in default under the Original Indenture or any indenture supplemental thereto, it shall be entitled to retain in its possession all cash on hand or in bank, accounts receivable, bills receivable, materials and supplies and all shares of stock, bonds and other securities not specifically transferred or assigned to or pledged with the Trustee under the Original Indenture or any indenture supplemental thereto or required so to be and all proceeds of the sale, condemnation or other disposition of the same and it shall have the power from time to time in its discretion, without reference to the Trustee to dispose of, free from the lien of the Original Indenture and any indenture supplemental thereto, any and all of said cash on hand or in bank, accounts receivable, bills receivable, materials and supplies and said shares of stock, bonds and other securities and proceeds of the same covered by the lien of the Original Indenture or any indenture supplemental thereto. Together with all franchises, permits, licenses, rights, easements, grants, privileges and immunities, pertaining to or used or usable in connection with said "new or additional property" and said "permanent improvements, extensions or additions"; all rights-of-way, water rights or privileges appurtenant to said "new or additional property" and said "permanent improvements, extensions or additions" or used or usable in connection therewith, and all renewals, extensions or modifications of any of the foregoing. Together with all and singular the tenements, hereditaments and appurtenances belonging or in anywise appertaining to the aforesaid "new or additional property" and "permanent improvements, extensions or additions," franchises, rights, privileges and other property, or any part thereof; with the reversion and reversions, remainder and remainders, tolls, rents, revenues, issues, income, product and profits thereof, and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the same and every part and parcel thereof. Provided, however, that nothing herein contained is intended or shall be deemed to, and the conveyance and mortgage hereby made is upon the express condition that it shall not, render any such "new or additional property" or "permanent improvements, extensions or additions" unavailable under the 10 46 Original Indenture, or any indenture supplemental thereto, or any provision of any thereof, (a) as a basis for the issue, authentication and delivery of additional bonds, or for the withdrawal of any money held by the Trustee under the Original Indenture, or any indenture supplemental thereto or by any trustee under an instrument of lien prior to the lien of the Original Indenture, or (b) as substituted property with reference to the release of property from the lien of the Original Indenture or any indenture supplemental thereto, or (c) as used or usable to provide any increase required by the provisions of subparagraphs (2) and/or (3) of Section 2.04 of Part II of the Eighth Supplemental Indenture, or (d) as used or usable as a credit against any sinking fund provided for in any instrument of lien prior to the lien of the Original Indenture, or provided for in any indenture supplemental to the Original Indenture, or (e) for any other purpose for which it is provided in the Original Indenture, as amended by the Eighth Supplemental Indenture, that the Company may use said "new or additional property" or "permanent improvements, extensions or additions." To have and to hold all the hereinbefore described properties, real, personal and mixed, mortgaged, conveyed, assigned or pledged by the Company, or intended so to be, unto the Trustee and its successors in the trusts hereby and by the Original Indenture and by the prior supplemental indentures created, and to its assigns forever; In trust nevertheless upon the terms and trusts set forth in the Original Indenture, as supplemented, amended and modified by the thirty-seven prior supplemental indentures hereinabove mentioned and particularly by the Eighth Supplemental Indenture, and set forth in this Thirty-Eighth Supplemental Indenture, and for the benefit and security of the holders of the bonds and coupons issued and to be issued under the Original Indenture and/or any indenture supplemental thereto, without preference of any said bonds and coupons over any others thereof by reason of priority in the time of issue or negotiation thereof or by reason of the date of maturity thereof, or for any reason whatsoever (subject, however, to the provisions of Section 3.02 of Part II of the Eighth Supplemental Indenture), and upon and subject to the covenants, conditions, uses and trusts set forth in the Original Indenture, as supplemented, amended and modified by the thirty-seven prior supplemental indentures hereinabove mentioned and particularly by the Eighth Supplemental Indenture, and in this Thirty-Eighth Supplemental Indenture, all with the same force and effect as though the hereinabove described properties, real estate, franchises, rights, privileges and other property were included in the granting clauses of the Original Indenture. And it is hereby covenanted, declared and agreed, by and between the parties hereto, that all bonds of Series GG hereinafter described are to be issued, authenticated and delivered and that all property subject or to become subject hereto is to be held and applied subject to the further covenants, conditions, uses and trusts hereinafter set forth; and the Company, for itself, its successors and assigns, does hereby covenant and agree to and with the Trustee, for the benefit of those who shall hold said bonds, or any of them, or any bonds or interest coupons issued or to be issued under the Original Indenture and/or any indenture supplemental thereto as follows: 11 47 PART I. SERIES GG BONDS ARTICLE I. Creation of and Particulars of Series GG Bonds Section 1. Creation and Designation. There shall be and hereby is created a new series of bonds of the Company to be designated as hereinafter set forth in the title of the form of bond contained in Section 3 of Article I hereof, and to be issued under this Thirty-Eighth Supplemental Indenture and under and subject to and in accordance with the terms and conditions of the Original Indenture, as supplemented by this Thirty-Eighth Supplemental Indenture, and as supplemented, amended and modified by the thirty-seven prior supplemental indentures and particularly by the Eighth and Ninth Supplemental Indentures. For convenience in designation said bonds are hereinafter sometimes referred to as "Series GG bonds" or "bonds of Series GG." Section 2. Terms of Series GG Bonds. The following matters are hereby prescribed with reference to Series GG bonds: (a) The aggregate principal amount of Series GG bonds shall be limited to Twenty Million Dollars ($20,000,000), except for bonds authenticated and delivered upon transfer of, or in exchange for, or in lieu of, other bonds pursuant to Sections 3 and 6 of Part II of the Ninth Supplemental Indenture and subdivisions (o), (p), and (q) of this Section 2. (b) Notwithstanding the provisions of Section 1 of Part II of the Ninth Supplemental Indenture, the definitive Series GG bonds shall be only in the form of registered bonds without coupons in the denomination of $1,000 and any denominations that are multiples of $1,000, to be substantially of the tenor and purport as recited in Section 3 of this Article I, and may have such letters, numbers or other marks of identification or designation and such legends or endorsements typed, printed, lithographed or engraved thereon as the Company may deem appropriate and as are not inconsistent with the provisions of the Indenture. The Series GG bonds shall be exchangeable and transferable for registered bonds without coupons of the several denominations at the corporate trust office of Bank of America National Trust and Savings Association, in the City of Los Angeles, State of California, in the manner and subject to the conditions in Section 3 of Part II of the Ninth Supplemental Indenture provided, except as otherwise provided in subdivisions (o), (p), (q), (r) and (s) of this Section 2. 12 48 (c) Principal, interest and premium, if any, of each of the Series GG bonds and all amounts payable in respect of the same under the Original Indenture or any indenture supplemental thereto shall be payable solely in such coin or currency of the United States of America as at the time of payment shall be legal tender for the payment of public or private debts. (d) Notwithstanding any provisions whatsoever in the Original Indenture or any prior supplemental indenture, neither principal nor interest nor premium (if any) nor any other amount payable in respect of any of the Series GG bonds shall be payable in gold coin. (e) Notwithstanding the provisions of Sections 2 and 3 of Part II of the Ninth Supplemental Indenture, each Series GG bond shall be dated the date of its authentication and, except as otherwise provided herein, shall bear interest (computed on the basis of a 360 day year of twelve 30 day months), payable semi-annually on May 1 and November 1 of each year, from the May 1 or November 1, as the case may be, next preceding the date of such bond to which interest has been paid, or if the date of such bond is the date to which interest has been paid, from the date of such bond, or, if no interest has been paid on the Series GG bonds, then from the date of authentication of the initial issue of Series GG bonds, until payment of the principal sum of such bond has been made or duly provided for. Notwithstanding the foregoing, when there is no existing default in the payment of interest on the Series GG bonds, all Series GG bonds authenticated by the Trustee after the close of business on the record date (as hereinafter defined) for any interest payment date (May 1 or November 1, as the case may be) and prior to such interest payment date, shall be dated the date of authentication and shall bear interest from such interest payment date; provided, however, that if and to the extent that the Company shall default in the interest due on such interest payment date, then such Series GG bond shall bear interest from the May 1 or November 1, as the case may be, next preceding the date of such Series GG bond to which interest has been paid or if no interest has been paid on the Series GG bonds, from the date of authentication of the initial issue of Series GG bonds. The term "record date" as used with respect to a semi-annual interest payment date shall mean the April 15 prior to such May 1 or the October 15 prior to such November 1, unless such April 15 or October 15 shall not be a business day, in which event the business day next preceding. The term "business day" as used herein shall mean a day which in said City of Los Angeles is neither a legal holiday nor a day on which banking institutions are authorized by law to close. (f) The person in whose name any Series GG bond is registered at the close of business on the record date with respect to a semi-annual interest payment date shall be entitled to receive the interest payable on such interest payment date notwithstanding the cancellation of such bond upon any transfer or exchange thereof subsequent to such record date and prior to such interest payment date; provided, however, that if and to the 13 49 extent the Company shall default in the payment of the interest due on such interest payment date, such defaulted interest shall be paid to the persons in whose names the Series GG bonds are registered at the close of business on a record date established for such payment (which must be a date subsequent to the record date for the earliest interest payment date for which there is an outstanding default in payment) by notice by or on behalf of the Company to the holders of the Series GG bonds mailed by first-class mail not less than fifteen days prior to such record date to their last addresses as the same appear on the books maintained for such purpose by or on behalf of the Company. (g) Notwithstanding the provisions of Section 3 of Part II of the Ninth Supplemental Indenture, the Company shall not be required to issue, register, transfer, or make exchanges of any Series GG bonds, which are to be redeemed pursuant to the provisions set forth in Article III of this Part I of this Thirty-Eighth Supplemental Indenture, within thirty (30) days prior to the date of redemption of such Series GG bonds. (h) All of the Series GG bonds shall mature on November 1, 2023. Notwithstanding any provision in the Original Indenture, as amended by the Eighth and Ninth Supplemental Indentures, notice of maturity of the Series GG bonds stating that final payment will be made to the holders of the Series GG bonds only after surrender of the bonds to the Trustee for cancellation shall be delivered by the Company at least thirty days prior to the date of maturity of the Series GG bonds to the respective holders of the bonds at the addresses set forth on the books maintained for such purpose by or on behalf of the Company, or, if there then be in effect any home office payment agreement between the Company and any institutional holder of Series GG bonds designating a different address for such notice, to such institutional holder at such different address. (i) All principal, interest and premiums, if any, of each and all of the Series GG bonds shall be payable at the corporate trust office of Bank of America National Trust and Savings Association, in the City of Los Angeles, State of California and may be paid by check to the order of the person entitled thereto mailed on the applicable payment date to such person's address as the same appears on the books maintained for such purpose by or on behalf of the Company, or, if there then be in effect any home office payment agreement between the Company and any particular institutional holder of Series GG bonds specifying a different address for or manner of payment, shall be paid to such institutional holder at such different address and in such different manner. (j) Each of the Series GG bonds shall bear interest at the rate per annum set forth in the title of the form of bond contained in Section 3 of Article I hereof. (k) Unless required by the laws of the United States of America or the State of California, the Series GG bonds shall not require the deduction or withholding by the Company of any taxes or any reimbursement of taxes to the bondholders. 14 50 (l) The Series GG bonds shall be redeemable as hereinafter in Article III of this Part I of this Thirty-Eighth Supplemental Indenture provided. (m) The Series GG bonds shall not be convertible into any class of stock or other type of security of the Company. (n) The Series GG bonds shall have the benefit of the sinking fund hereinafter provided in Article IV of this Part I of this Thirty-Eighth Supplemental Indenture. (o) A mutilated bond may be surrendered and, after the delivery to the Company and the Trustee of such security or indemnity as may be required by them to save them harmless, the Company shall execute and the Trustee shall authenticate and deliver in exchange therefor a new bond of like tenor and principal amount and bearing a number not contemporaneously outstanding. If there be delivered to the Company and to the Trustee: (i) evidence to their satisfaction of the destruction, loss or theft of any bond, and (ii) such security or indemnity as may be required by them to save each of them harmless, then, the Company shall execute and upon its request the Trustee shall authenticate and deliver in lieu of any such destroyed, lost or stolen bond, a new bond of like tenor and principal amount, bearing interest from the date to which interest has been paid on such destroyed, lost or stolen bond or from the date of such destroyed, lost or stolen bond if no interest has been paid thereon, and bearing a number not contemporaneously outstanding. In case any such mutilated, destroyed, lost or stolen bond has become or is about to become due and payable, the Company in its discretion may, instead of issuing a new bond, pay such bond. Upon the issuance of any new bond under this subdivision, the Company may require the payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in relation thereto and any other expenses (including fees and expenses of the Trustee) connected therewith; provided, however, that the Company shall pay all such taxes or other governmental charges and all such other expenses (including the fees and expenses of the Trustee) connected with the issuance under this subdivision of any new bond to any institutional holder. Every new bond issued pursuant to this subdivision in lieu of any destroyed, lost or stolen bond shall constitute an original additional contractual obligation of the Company, whether or not the destroyed, lost or stolen bond shall be at any time enforceable by anyone, and shall be entitled to all the benefits of the Indenture equally and proportionately with any and all other bonds duly issued hereunder. The provisions of this subdivision are exclusive and shall preclude (to the extent lawful) all other rights and remedies with respect to the replacement or payment of mutilated, destroyed, lost or stolen bonds. 15 51 (p) Notwithstanding any other provision of the Mortgage, including without limitation Section 3 of Part II of the Ninth Supplemental Indenture, or hereof, upon presentation and surrender to the Trustee of any Series GG bond or bonds accompanied by the written request of any institutional holder thereof, the Company will execute, and upon its request the Trustee will authenticate and deliver to the institutional holder or to the office of its custodian, if any, as soon as reasonably practicable after such request, in exchange for said Series GG bond or bonds, an equivalent unpaid principal amount of Series GG bonds in any denomination provided for herein, registered in the name of such institutional holder or in such other name as such institutional holder may specify or as such institutional holder may elect. (q) Notwithstanding any other provision of the Mortgage, including without limitation Section 3 of Part II of the Ninth Supplemental Indenture, or hereof, upon the presentation and surrender to the Trustee of any Series GG bond or bonds accompanied by a written instrument of transfer in a form reasonably satisfactory to the Company and the Trustee, the Company will execute, and upon its request the Trustee shall authenticate and deliver to the transferee or to the office of its custodian, as soon as reasonably practicable after surrender of such Series GG bond or bonds, an equivalent unpaid principal amount of Series GG bonds in any denomination provided for herein, registered in the name of the transferee or in such other name as may be specified in the instrument of transfer. (r) Notwithstanding any other provision of the Mortgage, including without limitation Section 3 of Part II of the Ninth Supplemental Indenture, or hereof, the Company will bear all expenses in connection with the preparation, issue, delivery and the above-mentioned exchanges and transfers of Series GG bonds, including, with respect any institutional holder of the Series GG bonds, the cost of transmitting Series GG bonds for the purpose of such exchanges to and from such institutional holder's home office or the office of its custodian, as well as the cost of transmitting Series GG bonds for the purpose of such transfers from any such institutional holder's home office or the office of its custodian and to the transferee. (s) Notwithstanding any other provision of the Mortgage, including without limitation Section 3 of Part II of the Ninth Supplemental Indenture, or hereof, if any holder of Series GG bonds is an insurance company, its own agreement of indemnity shall be deemed to be satisfactory indemnity and security where required under the Mortgage or any Supplemental Indenture. (t) The Series GG bonds shall be issued upon and subject to the other provisions and agreements in respect thereof hereinafter in this Thirty-Eighth Supplemental Indenture contained. Section 3. Form of Series GG Bonds. The registered bonds without coupons of Series GG shall be substantially in the following form: 16 52 [FORM OF REGISTERED BOND WITHOUT COUPONS OF SERIES GG] California Water Service Company First Mortgage 6.98% Bond, Series GG Due November 1, 2023 No.................. California Water Service Company, a California corporation (hereinafter called the "Company"), for value received hereby promises to pay to ...................................................... or registered assigns, the principal sum of ......................... Dollars on November 1, 2023 in such coin or currency of the United States of America as at the time of payment shall be legal tender for the payment of public and private debts, and to pay interest (computed on the basis of a 360 day year of twelve 30 day months), semi-annually on May 1 and November 1 of each year, on said principal sum, in like coin or currency, at the rate per annum specified in the title of this bond, from the May 1 or November 1, as the case may be, next preceding the date hereof to which interest has been paid, or, if the date hereof is a date to which interest has been paid, from the date hereof, or if no interest has been paid on the Series GG bonds, then from ............. [date of authentication of the initial issue of Series GG bonds], until payment of said principal sum has been made or duly provided for. Notwithstanding the foregoing, if the date hereof is after April 15 and before the next following May 1 or is after October 15 and before the next following November 1, this bond shall bear interest from such May 1 or November 1; provided, however, that if the Company shall default in the payment of interest due on such May 1 or November 1, then this bond shall bear interest from the next preceding May 1 or November 1 to which interest has been paid, or, if no interest has been paid on the Series GG bonds, from ............. [date of authentication of the initial issue of Series GG bonds]. Such principal and interest shall be payable at the corporate trust office of Bank of America National Trust and Savings Association, in the City of Los Angeles, State of California. The interest so payable on any May 1 or November 1 will, except as provided in the Indenture as hereinafter defined, be paid to the person in whose name this bond is registered at the close of business on the April 15 prior to such May 1 or the October 15 prior to such November 1 unless such April 15 or October 15 shall not be a business day (as defined in said Indenture), in which event the business day next preceding; and may be paid by check to the order of such person mailed on the payment date to such person's address as the same appears on the books maintained for such purpose by or on behalf of the Company, or, if there then be in effect any home office payment agreement between the Company and any particular institutional holder of this bond specifying a different address for or manner of payment, shall be paid to such institutional holder at such different address and in such different manner. This bond is one of an authorized issue of bonds of the Company, known generally as its First Mortgage Bonds, all issued and to be issued in one or 17 53 more series under and equally secured by an indenture executed by the Company to American Trust Company and Los Angeles-First National Trust & Savings Bank, as trustees, dated April 1, 1928 (hereinafter called the "Original Indenture"), as supplemented, amended and modified by the first eight indentures supplemental thereto and particularly by that certain Supplemental Mortgage of Chattels and Trust Indenture (hereinafter called the "Eighth Supplemental Indenture"), executed by the Company to American Trust Company and Security-First National Bank of Los Angeles (formerly known as Los Angeles-First National Trust & Savings Bank), as trustees, dated November 1, 1945, which Eighth Supplemental Indenture particularly describes the seven preceding supplemental indentures, and as further supplemented by other indentures supplemental thereto creating particular series of bonds, which Original Indenture as so supplemented, amended and modified is herein called the "Indenture." As provided in the Indenture, said bonds may be for various principal sums and are issuable in series which may mature at different times, may bear interest at different rates and may otherwise vary as in the Indenture provided or permitted. This bond is one of the bonds limited to an aggregate principal amount of Twenty Million Dollars ($20,000,000) created by the Indenture and particularly by that certain Supplemental Mortgage of Chattels and Trust Indenture (hereinafter called the "Thirty-Eighth Supplemental Indenture"), executed by the Company to Bank of America National Trust and Savings Association, as trustee, dated as of October 15, 1993, and designated therein as set forth in the title of this bond (herein sometimes referred to as the "Series GG bonds"). Reference is hereby made to the Indenture for a description of the property mortgaged and pledged, the nature and extent of the security, and the rights of the Company, of the trustee under the Indenture (hereinafter referred to as the "Trustee") and of the holders of the bonds in respect thereto. This bond may not be redeemed prior to November 1, 2003, except as provided in clauses (i), (ii) and (iii) below. On or after November 1, 2003, this bond is subject to redemption at any time, in whole or in part, at the option of the Company, initially at a redemption price equal to 103.490% of the outstanding principal amount thereof and thereafter at a redemption price equal to the principal amount thereof plus a premium equal to the following percentages, respectively, of said principal amount: During the Twelve Months Beginning November 1 Premium 2004 3.141% 2005 2.792% 2006 2.443% 2007 2.094% 2008 1.745% 2009 1.396% 2010 1.047% 2011 0.698% 2012 0.349% 2013 (and each year thereafter) 0.0000% 18 54 together with interest accrued thereon to the date fixed for redemption (such redemption price being hereinafter called the "Regular Redemption Price"); provided, however, that Series GG bonds may be redeemed (i) out of cash held in the sinking fund hereinafter mentioned, (ii) through the application of the proceeds of the sale of any complete water system or any substantial part of a water system owned by the Company, including without limiting the generality of the foregoing a sale to a municipality or other public body or agency having the power of eminent domain or the right to purchase or order the sale of such property, or (iii) in connection with a sale pursuant to involuntary liquidation of the Company, and, in case of redemption upon any such event, the applicable redemption price shall be the principal amount of such Series GG bonds so redeemed, together with interest accrued thereon to the redemption date (such redemption price being hereinafter called the "Special Redemption Price"). In each case such redemption shall only be made upon at least thirty days' notice sent by the Company (except where such redemption is made out of cash deposited in the sinking fund hereinafter mentioned) and upon the further conditions and in the manner provided in the Indenture. If this bond is called for redemption and payment therefor is duly provided, as specified in the Indenture, interest shall cease to accrue hereon from and after the date fixed for redemption; provided, however, that if only a part of the principal amount of this bond is called for redemption, interest shall cease to accrue from and after the date fixed for redemption only upon that portion of the principal amount hereof called for redemption, and in case of any such partial redemption of this bond, payment of the redemption price will be made only (a) upon surrender of this bond in exchange for a new bond or bonds of authorized denominations of this series of an aggregate principal amount equal to the unredeemed portion of this bond, (b) upon presentation of this bond for notation hereon of the payment of such portion of the principal amount hereof so called for redemption, or (c) in accordance with the applicable terms of any home office payment agreement between the Company and any institutional holder of this bond. Said Thirty-Eighth Supplemental Indenture provides a sinking fund applicable to the Series GG bonds, which requires the Company to deposit with the Trustee in cash on or before the end of each year ending October 31, commencing with the year ending October 31, 1994 through the year ending October 31, 2022, the sum of $100,000. Such annual sinking fund payments shall be made, held and applied to the retirement or for the greater security of the outstanding Series GG bonds in the manner more particularly provided in said Thirty-Eighth Supplemental Indenture, including the redemption of outstanding Series GG bonds as therein provided. To the extent and in the manner permitted by the Indenture, the provisions of the Indenture or any supplemental indenture may be modified by the Company with the consent of the Trustee and the written consent of the holders of 75% in principal amount of all bonds then outstanding under the Indenture; provided, however, (1) that the obligation of the Company to pay the principal of the bonds and the interest thereon, as the same shall from time to time 19 55 become due, shall continue unimpaired; (2) that no such modification shall give to any bond or bonds any preference over any other bond or bonds; (3) that no such modification shall authorize the creation of any lien prior or equal to the lien of the Indenture on any of the fixed property of the Company now owned or hereafter acquired and on which the same shall constitute a lien; (4) that no such modification shall reduce the percentage of the principal amount of bonds the consent of which is required to effect a modification of the Indenture or any supplemental indenture; and (5) that if any such modification shall affect one or more series of bonds and shall not affect equally the bonds of all series, then such modification shall also be consented to by the holders of 75% in principal amount of the bonds of each series which will be so affected. In case an event of default as defined in the Indenture or if certain other contingencies specified therein shall occur, the principal of this bond may become or be declared due and payable in the manner, with the effect and subject to the conditions provided in the Indenture. This bond is transferable by the registered owner hereof, in person or by attorney duly authorized in writing, at the corporate trust office of Bank of America National Trust and Savings Association, in the City of Los Angeles, State of California, upon surrender and cancellation of this bond. Upon any such transfer, a new registered bond or bonds without coupons, of the same series and for the same aggregate unpaid principal amount, will be issued to the transferee in exchange therefor. The Company and the Trustee may deem and treat the person in whose name this bond is registered as the absolute owner hereof for the purpose of receiving payment hereof or on account hereof (including principal, interest and premium, if any) and for all other purposes and shall not be affected by any notice to the contrary. The Series GG bonds are issuable in the form of registered bonds without coupons in the denomination of $1,000 and any denominations that are multiples of $1,000. No recourse shall be had for the payment of the principal of, premium, if any, or the interest on, this bond, or for any claim based hereon or on the Indenture or any indenture supplemental thereto, against any incorporator, or against any stockholder, director or officer, as such, past, present or future, of the Company, or of any predecessor or successor corporation, either directly or through the Company or any such predecessor or successor corporation, whether by virtue of any constitution, statute or rule of law, or by the enforcement of any assessment or penalty or otherwise, all such liability, whether at common law, in equity, by any constitution, statute or otherwise, of incorporators, stockholders, directors or officers being released by every holder hereof by the acceptance of this bond and as part of the consideration for the issue hereof, and being likewise released by the terms of the Indenture; provided, however, that nothing herein or in the Indenture contained shall be taken to prevent recourse to and the enforcement of the liability, if any, of any stockholder or subscriber to capital stock of the Company upon or in respect of shares of capital stock not fully paid. 20 56 This bond, with or without others of like form and series, may be exchanged for one or more new bonds of the same series of other authorized denominations, but of the same aggregate unpaid principal amount. This bond shall not become valid or obligatory until Bank of America National Trust and Savings Association, the current Trustee under the Indenture, or a successor Trustee thereunder, shall have signed the form of certificate endorsed hereon. In Witness Whereof, California Water Service Company has caused this bond to be signed, manually or in facsimile, by its President or a Vice President and its corporate seal (or a facsimile thereof) to be hereto affixed, imprinted, engraved or otherwise reproduced and attested, manually or in facsimile, by its Secretary or an Assistant Secretary. Dated: .......................... CALIFORNIA WATER SERVICE COMPANY By...................................... President Attest: ............................ Secretary [seal] [FORM OF TRUSTEE'S CERTIFICATE OF AUTHENTICATION] TRUSTEE'S CERTIFICATE This bond is one of the bonds, of the series designated therein, described in the within mentioned Indenture and registered on the registration books of the Trustee. Dated: .......................... BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION Trustee By....................................... Authorized Officer 21 57 ARTICLE II. Issue of Bonds Section 1. Conditions Applicable to Issuance of Series GG Bonds. Bonds of Series GG shall be authenticated, issued and delivered only upon and subject to the terms and conditions specified in Article II of the Original Indenture, as amended by the Eighth Supplemental Indenture, as applicable to bonds after the initial issue of bonds under the Original Indenture. ARTICLE III. Redemption Section 1. Right to Redeem; Redemption Prices. Series GG bonds may not be redeemed prior to November 1, 2003, except as provided in clauses (i), (ii) and (iii) below. On or after November 1, 2003, the Company may, at its election, evidenced by a copy of a resolution certified by the Secretary or an Assistant Secretary of the Company under its corporate seal to have been duly adopted by the Board of Directors, and delivered to the Trustee, redeem at any time or from time to time (and whether or not on an interest payment date or interest payment dates) all or any part of the bonds of Series GG at the Regular Redemption Price set forth in the form of registered bond without coupons of Series GG hereinabove recited; provided, however, that Series GG bonds may be redeemed (i) out of cash held in the sinking fund hereinafter provided for, or (ii) through the application of the proceeds of the sale of any complete water system or any substantial part of a water system owned by the Company, including without limitation of the generality of the foregoing a sale to a municipality or other public body or agency having the power of eminent domain or the right to purchase or order the sale of such property, or (iii) in connection with a sale pursuant to involuntary liquidation of the Company, and, in case of redemption upon any such event, the applicable redemption price shall be the Special Redemption Price set forth in the form of registered bond without coupons of Series GG hereinabove recited. Section 2. Notice and Manner of Redemption. Such redemption of Series GG bonds or any of the same shall only be made upon the notice and in the manner and with the effect as provided in Article IV of the Original Indenture, as amended by the Eighth and Ninth Supplemental Indentures, excepting only that notwithstanding anything in said Article IV provided, (1) no notice by publication shall be required and notice of redemption shall be sent by the Company, delivery charges prepaid, by first class mail or by same-day or overnight messenger at least thirty days prior to the redemption date to the respective registered holders of the bonds called for redemption at their last addresses appearing on the books maintained for such purpose by or on behalf of the Company, except no such notice is required to be sent by the Company where such redemption is made out of cash deposited in the sinking fund referred to in Article IV of this Thirty-Eighth Supplemental Indenture; (2) in case the Company shall redeem less than all of the bonds of Series GG, whether 22 58 through the sinking fund or otherwise, the Trustee shall redeem the bonds held by each registered holder pro rata in an amount proportional to the amount of then outstanding Series GG bonds held by such registered holder, and the notice of redemption shall specify the respective portions of the principal amount of each such bond to be redeemed in part and shall also state that payment of the redemption price will be made only (a) upon presentation of said bond for notation thereon of the payment of such portion of the principal amount thereof (b) upon surrender of said bond in exchange for a new bond or bonds of authorized denominations of the same series and of an aggregate principal amount equal to the unredeemed portion of said bond, or (c) in accordance with the applicable terms of any respective home office payment agreement(s) between the Company and any institutional holder(s) of Series GG bonds; and (3) the redemption moneys for any Series GG bonds shall be paid and deposited in lawful money of the United States of America. ARTICLE IV. Sinking Fund Section 1. Amount and Time of Payment. The Company covenants and agrees that it will establish and maintain by annual cash deposits with the Trustee a sinking fund for the benefit of holders of Series GG bonds and for the purpose of retiring and/or further securing such bonds, all as hereinafter in this Article IV provided. The amount to be deposited annually in such sinking fund (the "mandatory sinking fund payment") shall be, for the period commencing with the year ending October 31, 1994 through the year ending October 31, 2022, the sum of $100,000. The Company shall deposit said respective amounts in cash with the Trustee on or before the end of each year ending October 31, commencing on October 31, 1994. Section 2. Application of Sinking Fund Cash to Redemption of Bonds. All cash deposited with the Trustee for the sinking fund for Series GG bonds shall be held in a fund known as "Series GG Sinking Fund Cash". Notwithstanding any provisions to the contrary in Article IV of the Original Indenture, as amended by the Eighth Supplemental Indenture and Section 6 of the Ninth Supplemental Indenture, the Company shall instruct the Trustee in each year, after the deposit with the Trustee of the sinking fund payment for such year, to redeem Series GG bonds from the Series GG Sinking Fund Cash in accordance with the provisions of Article III of this Thirty-Eighth Supplemental Indenture. The Company shall fix the date for the redemption of such Series GG bonds to be the November 1 first following the deposit with the Trustee of any such sinking fund payment. However, the Trustee will redeem Series GG bonds only in denominations of $1,000 or multiples thereof. If any registered holder's share of the sinking fund payment is not an even multiple of $1,000, the Trustee shall hold for the account of such registered holder the difference between the amount of such registered holder's share and the highest multiple of $1,000 which is less than such amount. The Trustee shall apply such sum on the next possible sinking fund redemption date to redeem Series GG bonds from such registered holders in authorized multiples of $1,000. 23 59 The Company covenants and agrees to take any and all steps necessary to effect the redemption of such Series GG bonds from the Series GG Sinking Fund Cash as provided in this Thirty-Eighth Supplemental Indenture, but if the Company shall fail to do so, the Trustee is hereby authorized and empowered, to take all such steps for and in the name of the Company, including the giving of any notice of redemption. No resolution of the Board of Directors of the Company shall be necessary for such redemption and if the Trustee holds such amount of money in the sinking fund that shall, in and of itself, constitute the election of the Company to redeem the largest amount of bonds which may be thereby redeemed. Section 3. Limitations on Use of Sinking Fund Cash in Case of Default. Notwithstanding anything hereinbefore provided, the Trustee shall not use cash in said sinking fund to redeem any bonds if the Company shall be in default under the Indenture to the knowledge of the Trustee and, in the event of default, the cash in the sinking fund shall form a part of the trust estate for the equal protection of all bonds as above provided for any part of the trust estate. Section 4. Sinking Funds for Bonds of Other Series. The Company further covenants and agrees that any bonds of any other series which may be hereafter issued under the Original Indenture or any indenture supplemental thereto while any Series GG bonds are outstanding shall have a sinking fund, commencing not later than eighteen months after the date of authentication and delivery of such bonds of other series, in an annual amount not less than 1/2 of 1% of the maximum aggregate principal amount of all bonds of such other series at any time authenticated and delivered by the Trustee after deducting therefrom the aggregate principal amount of all bonds of such other series theretofore retired otherwise than through the operation of such sinking fund. PART II. Miscellaneous Provisions with Respect to Supplemental Indenture Section 1. The Trustee. The Trustee hereby accepts the trusts under this Thirty-Eighth Supplemental Indenture and agrees to perform the same on the terms and conditions set forth in the Original Indenture and supplemental indentures, including this Thirty-Eighth Supplemental Indenture. The Trustee shall not be responsible in any manner whatsoever for or in respect of the validity or sufficiency of this Thirty-Eighth Supplemental Indenture or the due execution hereof by the Company nor for or in respect of the recitals contained herein, all of which recitals are made by the Company solely. Section 2. Destruction of Bonds. The Trustee shall forthwith cancel and destroy all bonds transferred, exchanged or redeemed and delivered to the Trustee and the Trustee shall deliver a certificate of such destruction to the Company. 24 60 Section 3. Separability of Invalid Provisions. If any one or more of the covenants or agreements provided in this Thirty-Eighth Supplemental Indenture on the part of the Company or the Trustee to be performed should be contrary to any express provision of law, or contrary to the policy of express law, to such an extent as to be unenforceable in any court of competent jurisdiction, then such covenant or covenants, agreement or agreements, shall be null and void, and shall be deemed separable from the remaining covenants and agreements and shall in no wise affect or impair the validity of this Thirty-Eighth Supplemental Indenture. Section 4. Effect on Successors and Assigns of Parties. Whenever in this Thirty-Eighth Supplemental Indenture either of the parties hereto is named or referred to, the successors and assigns of such party (subject, however, to the provisions of Article IX of the Original Indenture, as amended by the Eighth Supplemental Indenture, as to the successors and assigns of the Company) shall be deemed to be included, and, subject as aforesaid, all the covenants, promises and agreements in this Thirty-Eighth Supplemental Indenture contained, by or on behalf of the Company or by or on behalf of the Trustee, shall bind and inure to the benefit of their respective successors and assigns, whether so expressed or not. Section 5. Immunity of Incorporators, Stockholders, Officers and Directors. No recourse shall be had for the payment of the principal of, premium, if any, or the interest on, any Series GG bonds, or for any claim based on any of the Series GG bonds or on the Original Indenture or any indenture supplemental thereto, against any incorporator, or against any stockholder, director or officer, as such, past, present or future, of the Company, or of any predecessor or successor corporation, either directly or through the Company or any such predecessor or successor corporation, whether by virtue of any constitution, statute or rule of law, or by the enforcement of any assessment or penalty or otherwise, all such liability, whether at common law, in equity, by any constitution, statute or otherwise, of incorporators, stockholders, or officers being released by every holder of Series GG bonds by the acceptance thereof and as part of the consideration for the issue thereof; provided, however, that nothing in the Original Indenture or any indenture supplemental thereto or in the Series GG bonds contained shall be taken to prevent recourse to and the enforcement of liability, if any, of any stockholder or subscriber to capital stock of the Company upon or in respect of shares of capital stock not fully paid. Section 6. Titles Not Part of Supplemental Indenture. The titles of Parts and Articles and headings of Sections are inserted for convenience only and are not a part of this Thirty-Eighth Supplemental Indenture. Section 7. Counterparts. This Thirty-Eighth Supplemental Indenture may be simultaneously executed in any number of counterparts and all such counterparts executed and delivered, each as an original, shall constitute but one and the same instrument. 25 61 Section 8. Title to Property; Authority to Mortgage; Prior Liens. The Company covenants and agrees that the statements contained in Section 3.01 of Part II of the Eighth Supplemental Indenture shall also apply to all properties acquired subsequent to the Eighth Supplemental Indenture and not heretofore released from the lien of the Indenture pursuant to the provisions of Article V of Part II of the Eighth Supplemental Indenture. In Witness Whereof, said California Water Service Company and said Bank of America National Trust and Savings Association have caused these presents to be signed in their respective corporate names by their respective officers thereunto duly authorized and impressed with their respective corporate seals, all as of the day and year first above written. CALIFORNIA WATER SERVICE COMPANY By /s/ DONALD L. HOUCK President and Chief Executive Officer [Seal] By /s/ HELEN MARY KASLEY Secretary BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION [Seal] By /s/ JENNIFER HOLDER Senior Trust Officer 26 62 State of California ) ) ss. County of Santa Clara ) On 10/13/93 before me, CHRISTINA M. FREEMAN , a Notary Public in and for the State of California, personally appeared Donald L. Houck and Helen M. Kasley, known to me (or proved to me on the basis of satisfactory evidence) to be the persons whose names are subscribed to the within instrument and acknowledged to me that they executed the same in their authorized capacities, and that by their signatures on the instrument the entity upon behalf of which the persons acted executed the instrument. WITNESS my hand and official seal. [Notarial Seal] /s/ CHRISTINA M. FREEMAN 27 63 State of California ) ) ss. City and County of San Francisco ) On 10/26/93 before me, NORMA L. CANTORA , a Notary Public in and for the State of California, personally appeared Jennifer Holder, known to me (or proved to me on the basis of satisfactory evidence) to be the person whose name is subscribed to the within instrument and acknowledged to me that she executed the same in her authorized capacity, and that by her signature on the instrument the entity upon behalf of which the person acted executed the instrument. WITNESS my hand and official seal. [Notarial Seal] /s/ NORMA L. CANTORA 28 64 SCHEDULE A The resignations of Wells Fargo Bank, National Association and Security Pacific National Bank as trustees and the appointment of Bank of America National Trust and Savings Association as successor trustee have been recorded in the offices of the Recorders of the following counties and city and county of the State of California on the respective dates and in the respective books of record and/or as the respective document numbers hereinafter set forth as follows: County or Book and City and Recording Document Page County Date Number (Reel-Image) Alameda........... August 1, 1983 83-137410 None Butte............. August 1, 1983 83-25375 2851-200 Fresno............ August 2, 1983 83069489 Not Available Glenn............. August 1, 1983 3329 729-170 Kern.............. August 2, 1983 12487 5576-522 Los Angeles....... August 2, 1983 83-887733 None Monterey.......... August 1, 1983 GG 34173 1655-830 City and County of San Francisco....... August 1, 1983 D 376552 D559-205 San Joaquin....... August 10, 1983 83058347 None San Mateo......... August 1, 1983 83080322 None Santa Clara....... August 1, 1983 7766085 H770-413 Solano............ August 1, 1983 32353 Page 61300 Sonoma............ August 1, 1983 83-50597 83-50597 Tulare............ August 1, 1983 35981 4093-763 Yuba.............. August 1, 1983 1056 805-423 29 65 SCHEDULE B The First through Thirty-Seventh Supplemental Indentures have been recorded in the offices of the Recorders of the following counties and city and county of the State of California on the respective dates and in the respective books of record and/or as the respective document numbers hereinafter set forth, as follows: FIRST SUPPLEMENTAL INDENTURE Page Vol. of at which Date of Official Record County Recordation Records Commences Kings.................. Jan. 7, 1929 40 432 Contra Costa........... Jan. 7, 1929 157 256 SECOND SUPPLEMENTAL INDENTURE Page Vol. of at which Date of Official Record County Recordation Records Commences Kings.................. August 20, 1929 48 442 Butte.................. August 20, 1929 116 389 Glenn.................. August 20, 1929 17 179 Alameda................ August 20, 1929 2173 334 Tulare................. August 20, 1929 337 88 Kern................... August 21, 1929 320 95 Contra Costa........... August 20, 1929 208 198 THIRD SUPPLEMENTAL INDENTURE Page Vol. of at which Date of Official Record County Recordation Records Commences Yuba................... February 28, 1930 9 238 City and County of San Francisco............ February 28, 1930 1985 257 FOURTH SUPPLEMENTAL INDENTURE Page Vol. of at which Date of Official Record County Recordation Records Commences San Mateo.............. July 17, 1931 537 1 City and County of San Francisco............ July 20, 1931 2232 284 Santa Clara............ July 17, 1931 576 175 30 66 FIFTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences City and County of San Francisco.......... March 31, 1932 2359 17 Yuba................. April 6, 1932 12 469 Sonoma............... April 6, 1932 320 39 Alameda.............. April 6, 1932 2808 77 Tulare............... April 6, 1932 466 381 Los Angeles.......... April 6, 1932 11543 85 San Joaquin.......... April 6, 1932 397 375 Santa Clara.......... April 6, 1932 606 464 San Mateo............ April 6, 1932 553 492 Butte................ April 6, 1932 83 489 Kings................ April 6, 1932 87 292 Glenn................ April 6, 1932 43 123 Shasta............... April 6, 1932 74 10 Contra Costa......... April 6, 1932 299 449 Kern................. April 6, 1932 428 473 Solano............... April 6, 1932 89 66 SIXTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. June 15, 1936 3314 406 Butte................ June 15, 1936 167 1 Contra Costa......... June 15, 1936 418 12 Glenn................ June 15, 1936 82 73 Kern................. June 15, 1936 643 64 Kings................ June 15, 1936 151 241 Los Angeles.......... June 15, 1936 14153 291 City and County of San Francisco.......... June 15, 1936 2972 1 San Joaquin.......... June 15, 1936 542 53 San Mateo............ June 15, 1936 703 1 Santa Clara.......... June 15, 1936 777 137 Shasta............... June 15, 1936 108 134 Solano............... June 15, 1936 161 1 Sonoma............... June 15, 1936 412 160 Tulare............... June 15, 1936 682 1 Yuba................. June 15, 1936 35 25 31 67 SEVENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Los Angeles.......... May 1, 1939 16572 206 City and County of San Francisco.......... May 2, 1939 3450 93 San Mateo............ May 2, 1939 840 94 Sonoma............... May 2, 1939 477 108 Kern................. May 2, 1939 869 12 EIGHTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. November 3, 1945 4780 134 Butte................ November 2, 1945 380 1 Contra Costa......... November 3, 1945 874 1 Fresno............... February 21, 1962 4681 226 Glenn................ November 2, 1945 191 1 Kern................. November 2, 1945 1292 21 Kings................ November 1, 1945 342 1 Los Angeles.......... November 2, 1945 22396 251 Monterey............. February 21, 1962 23 (Reel) 1 City and County of San Francisco.......... November 2, 1945 4346 103 San Joaquin.......... November 3, 1945 960 21 San Mateo............ November 3, 1945 1231 1 Santa Clara.......... November 1, 1945 1267 583 Solano............... November 3, 1945 344 6 Sonoma............... November 3, 1945 665 21 Tulare............... November 3, 1945 1141 382 Yuba................. November 3, 1945 94 23 32 68 NINTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. August 31, 1951 6525 237 Butte................ August 30, 1951 603 1 Contra Costa......... August 30, 1951 1814 508 Fresno............... February 21, 1962 4681 437 Glenn................ August 30, 1951 266 63 Kern................. August 29, 1951 1840 373 Kings................ August 30, 1951 502 228 Los Angeles.......... August 29, 1951 37102 345 Monterey............. February 21, 1962 23 (Reel) 207 City and County of San Francisco.......... August 30, 1951 5773 355 San Joaquin.......... August 30, 1951 1372 123 San Mateo............ August 30, 1951 2150 298 Santa Clara.......... August 30, 1951 2275 295 Solano............... August 31, 1951 592 136 Sonoma............... August 31, 1951 1072 420 Tulare............... August 30, 1951 1539 528 Yuba................. August 31, 1951 155 177 TENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. July 10, 1953 7078 451 Butte................ July 9, 1953 679 45 Contra Costa......... July 9, 1953 2157 453 Fresno............... February 21, 1962 4681 540 Glenn................ July 9, 1953 297 139 Kern................. July 8, 1953 2102 215 Kings................ July 9, 1953 561 249 Los Angeles.......... July 8, 1953 42134 371 Monterey............. February 21, 1962 23 (Reel) 314 City and County of San Francisco.......... July 9, 1953 6190 21 San Joaquin.......... July 9, 1953 1540 523 San Mateo............ July 10, 1953 2443 248 Santa Clara.......... July 9, 1953 2680 50 Solano............... July 9, 1953 677 4 Sonoma............... July 10, 1953 1218 348 Tulare............... July 9, 1953 1686 314 Yuba................. July 10, 1953 181 1 33 69 ELEVENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. August 20, 1954 7404 181 Butte................ August 20, 1954 732 496 Contra Costa......... August 20, 1954 2368 164 Fresno............... February 21, 1962 4681 604 Glenn................ August 20, 1954 314 369 Kern................. August 20, 1954 2278 74 Kings................ August 20, 1954 594 449 Los Angeles.......... August 19, 1954 45365 64 Monterey............. February 21, 1962 23 (Reel) 377 City and County of San Francisco.......... August 20, 1954 6435 421 San Joaquin.......... August 20, 1954 1662 316 San Mateo............ August 19, 1954 2636 330 Santa Clara.......... August 20, 1954 2942 331 Solano............... August 19, 1954 728 10 Sonoma............... August 20, 1954 1290 234 Tulare............... August 20, 1954 1772 388 Yuba................. August 20, 1954 195 490 TWELFTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. October 7, 1955 7806 501 Butte................ October 7, 1955 794 9 Contra Costa......... October 7, 1955 2625 417 Fresno............... February 21, 1962 4681 665 Glenn................ October 7, 1955 331 350 Kern................. October 6, 1955 2498 171 Kings................ October 7, 1955 628 1 Los Angeles.......... October 6, 1955 49158 316 Monterey............. February 21, 1962 23 (Reel) 439 City and County of San Francisco.......... October 7, 1955 6711 525 San Joaquin.......... October 7, 1955 1797 300 San Mateo............ October 7, 1955 2890 480 Santa Clara.......... October 7, 1955 3299 406 Solano............... October 7, 1955 792 422 Sonoma............... October 7, 1955 1384 2 Tulare............... October 7, 1955 1864 548 Yuba................. October 7, 1955 213 593 34 70 THIRTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. December 7, 1956 8226 15 Butte................ December 7, 1956 859 117 Contra Costa......... December 7, 1956 2894 20 Fresno............... February 21, 1962 4681 729 Glenn................ December 7, 1956 348 217 Kern................. December 6, 1956 2699 390 Kings................ December 7, 1956 666 316 Los Angeles.......... December 6, 1956 53054 61 Monterey............. February 21, 1962 23 (Reel) 503 City and County of San Francisco.......... December 10, 1956 6970 41 San Joaquin.......... December 7, 1956 1925 1 San Mateo............ December 7, 1956 3140 258 Santa Clara.......... December 7, 1956 3680 1 Solano............... December 7, 1956 860 189 Sonoma............... December 7, 1956 1489 28 Tulare............... December 7, 1956 1961 551 Yuba................. December 7, 1956 233 65 FOURTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. March 20, 1964 1155 (Reel) (Image) 2 Butte................ March 20, 1964 1303 8 Contra Costa......... March 20, 1964 4578 360 Fresno............... March 20, 1964 4980 337 Glenn................ March 20, 1964 463 1 Kern................. March 19, 1964 3706 1 Los Angeles.......... March 19, 1964 D2401 6 Monterey............. March 20, 1964 299 (Reel) 230 City and County of San Francisco............ March 20, 1964 A734 966 San Joaquin.......... March 20, 1964 2801 126 San Mateo............ March 19, 1964 4670 563 Santa Clara.......... March 20, 1964 6432 567 Solano............... March 20, 1964 1259 331 Sonoma............... March 19, 1964 2030 757 Tulare............... March 20, 1964 2491 437 Yuba................. March 20, 1964 389 535 35 71 FIFTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. November 4, 1965 1635 610 Butte................ November 4, 1965 1398 67 Contra Costa......... November 4, 1965 4987 469 Fresno............... November 4. 1965 5236 699 Glenn................ November 4, 1965 483 194 Kern................. November 3, 1965 3889 476 Los Angeles.......... November 3, 1965 D3104 7 Monterey............. November 4, 1965 432 526 City and County of San Francisco.......... November 4, 1965 A983 431 San Joaquin.......... November 4, 1965 2996 13 San Mateo............ November 4, 1965 5056 588 Santa Clara.......... November 4, 1965 7166 234 Solano............... November 3, 1965 1366 547 Sonoma............... November 3, 1965 2167 261 Tulare............... November 4, 1965 2619 12 Yuba................. November 4, 1965 422 562 SIXTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. December 2, 1966 1881 788 Butte................ December 2, 1966 1452 13 Contra Costa......... December 2, 1966 5256 298 Fresno............... December 2, 1966 5383 432 Glenn................ December 2, 1966 495 555 Kern................. December 1, 1966 3999 845 Los Angeles.......... December 1, 1966 D3496 236 Monterey............. December 2, 1966 485 472 City and County of San Francisco.......... December 2, 1966 B101 10 San Joaquin.......... December 2, 1966 3090 511 San Mateo............ December 2, 1966 5244 411 Santa Clara.......... December 2, 1966 7579 440 Solano............... December 1, 1966 1429 482 Sonoma............... December 1, 1966 2243 434 Tulare............... December 2, 1966 2686 249 Yuba................. December 2, 1966 443 434 36 72 SEVENTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. April 2, 1968 2154 273 Butte................ April 2, 1968 1511 632 Contra Costa......... April 2, 1968 5593 177 Fresno............... April 3, 1968 5554 654 Glenn................ April 2, 1968 507 326 Kern................. April 3, 1968 4147 264 Los Angeles.......... April 2, 1968 D3959 10 Monterey............. April 2, 1968 551 580 City and County of San Francisco.......... April 2, 1968 B230 362 San Joaquin.......... April 2, 1968 3199 132 San Mateo............ April 2, 1968 5453 1 Santa Clara.......... April 2, 1968 8076 99 Solano............... April 1, 1968 1501 35 Sonoma............... April 3, 1968 2323 446 Tulare............... April 3, 1968 2773 415 Yuba................. April 2, 1968 465 122 EIGHTEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. April 3, 1970 2592 708 Butte................ April 6, 1970 1608 505 Contra Costa......... April 3, 1970 6099 58 Fresno............... April 3, 1970 5775 371 Glenn................ April 6, 1970 524 168 Kern................. April 3, 1970 4384 72 Los Angeles.......... April 6, 1970 D4677 518 Monterey............. April 6, 1970 645 921 City and County of San Francisco.......... April 6, 1970 B414 258 San Joaquin.......... April 3, 1970 3381 569 San Mateo............ April 3, 1970 5766 1 Santa Clara.......... April 3, 1970 8878 585 Solano............... April 3, 1970 1618 477 Sonoma............... April 3, 1970 2453 531 Tulare............... April 3, 1970 2889 894 Yuba................. April 6, 1970 497 84 37 73 NINETEENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. June 10, 1970 2632 835 Butte................ June 11, 1970 1618 2 Contra Costa......... June 10, 1970 6146 1 Fresno............... June 10, 1970 5793 233 Glenn................ June 11, 1970 526 170 Kern................. June 9, 1970 4405 724 Los Angeles.......... June 10, 1970 D4736 731 Monterey............. June 10, 1970 653 890 City and County of San Francisco...... June 11, 1970 B430 928 San Joaquin.......... June 10, 1970 3402 124 San Mateo............ June 10, 1970 5792 57 Santa Clara.......... June 11, 1970 8949 586 Solano............... June 10, 1970 1629 158 Sonoma............... June 10, 1970 2465 923 Tulare............... June 10, 1970 2898 231 Yuba................. June 11, 1970 500 77 TWENTIETH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. April 2, 1971 2820 92 Butte................ April 2, 1971 1667 102 Contra Costa......... April 2, 1971 6351 138 Fresno............... April 2, 1971 5880 820 Glenn................ April 2, 1971 533 530 Kern................. April 1, 1971 4509 30 Los Angeles.......... April 1, 1971 D5014 368 Monterey............. April 2, 1971 695 719 City and County of San Francisco...... April 5, 1971 B507 812 San Joaquin.......... April 5, 1971 3509 305 San Mateo............ April 2, 1971 5919 363 Santa Clara.......... April 2, 1971 9278 182 Solano............... April 5, 1971 1677 384 Sonoma............... April 2, 1971 2524 671 Tulare............... April 2, 1971 2959 373 Yuba................. April 2, 1971 513 81 38 74 TWENTY-FIRST SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. December 14, 1972 3298 449 Butte................ December 14, 1972 1805 96 Contra Costa......... December 14, 1972 6821 129 Fresno............... December 14, 1972 6104 2 Glenn................ December 14, 1972 554 371 Kern................. December 15, 1972 4757 356 Los Angeles.......... December 14, 1972 D5698 815 Monterey............. December 14, 1972 815 838 City and County of San Francisco...... December 14, 1972 B708 675 San Joaquin.......... December 14, 1972 3718 161 San Mateo............ December 14, 1972 6289 367 Santa Clara.......... December 14, 1972 O154 435 Solano............... December 15, 1972 1795 147 Sonoma............... December 14, 1972 2719 547 Tulare............... December 14, 1972 3075 674 Yuba................. December 14, 1972 546 360 TWENTY-SECOND SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. December 27, 1972 3306 930 Butte................ December 27, 1972 1807 385 Contra Costa......... December 27, 1972 6829 150 Fresno............... December 27, 1972 6108 355 Glenn................ December 27, 1972 555 69 Kern................. December 29, 1972 4762 140 Los Angeles.......... December 27, 1972 D5710 690 Monterey............. December 27, 1972 818 40 City and County of San Francisco...... December 27, 1972 B712 707 San Joaquin.......... December 27, 1972 3721 317 San Mateo............ December 27, 1972 6296 114 Santa Clara.......... December 27, 1972 O171 29 Solano............... December 29, 1972 1797 530 Sonoma............... December 27, 1972 2722 782 Tulare............... December 27, 1972 3078 118 Yuba................. December 27, 1972 547 158 39 75 TWENTY-THIRD SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. December 27, 1972 3307 1 Butte................ December 27, 1972 1807 433 Contra Costa......... December 27, 1972 6829 197 Fresno............... December 27, 1972 6108 307 Glenn................ December 27, 1972 555 116 Kern................. December 29, 1972 4762 187 Los Angeles.......... December 27, 1972 D5710 737 Monterey............. December 27, 1972 818 87 City and County of San Francisco.......... December 27, 1972 B712 733 San Joaquin.......... December 27, 1972 3721 269 San Mateo............ December 27, 1972 6296 161 Santa Clara.......... December 27, 1972 O171 76 Solano............... December 29, 1972 1797 577 Sonoma............... December 27, 1972 2722 830 Tulare............... December 27, 1972 3078 165 Yuba................. December 27, 1972 547 205 TWENTY-FOURTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. March 22, 1974 3635 156 Butte................ March 22, 1974 1896 665 Contra Costa......... March 22, 1974 7183 54 Fresno............... March 22, 1974 6279 513 Glenn................ March 22, 1974 570 163 Kern................. March 22, 1974 4832 519 Los Angeles.......... March 22, 1974 D6209 133 Monterey............. March 22, 1974 902 1 City and County of San Francisco.......... March 22, 1974 B866 907 San Joaquin.......... March 22, 1974 3856 1 San Mateo............ March 22, 1974 6574 611 Santa Clara.......... March 22, 1974 815 125 Solano............... March 22, 1974 1974 11482 Sonoma............... March 22, 1974 2847 542 Tulare............... March 22, 1974 3166 315 Yuba................. March 22, 1974 571 423 40 76 TWENTY-FIFTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. June 20, 1975 4007 676 Butte................ June 20, 1975 1995 455 Contra Costa......... June 20, 1975 7543 54 Fresno............... June 20, 1975 6447 21 Glenn................ June 20, 1975 587 128 Kern................. June 20, 1975 4901 154 Los Angeles.......... June 20, 1975 D6698 184 Monterey............. June 20, 1975 985 335 City and County of San Francisco.......... June 20, 1975 C30 18 San Joaquin.......... June 20, 1975 3996 258 San Mateo............ June 20, 1975 6872 1 Santa Clara.......... June 20, 1975 B474 219 Solano............... June 20, 1975 1975 25377 Sonoma............... June 20, 1975 2970 761 Tulare............... June 20, 1975 3249 11 Yuba................. June 20, 1975 595 695 TWENTY-SIXTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. June 10, 1976 4397 342 Butte................ June 10, 1976 2077 441 Contra Costa......... June 10, 1976 7896 746 Fresno............... June 11, 1976 6608 364 Glenn................ June 10, 1976 600 137 Kern................. June 11, 1976 4960 1166 Los Angeles.......... June 10, 1976 10257 734 Monterey............. June 10, 1976 1060 798 City and County of San Francisco.......... June 10, 1976 C184 1 San Joaquin.......... June 10, 1976 4136 42 San Mateo............ June 10, 1976 7151 667 Santa Clara.......... June 10, 1976 C073 688 Solano............... June 10, 1976 1976 31463 Sonoma............... June 10, 1976 3089 913 Tulare............... June 10, 1976 3326 626 Yuba................. June 10, 1976 616 512 41 77 TWENTY-SEVENTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. March 24, 1978 5312 57 Butte................ March 24, 1978 2268 279 Fresno............... March 27, 1978 6997 25 Glenn................ March 24, 1978 626 594 Kern................. March 24, 1978 5098 1124 Los Angeles.......... March 24, 1978 78-310554 Monterey............. March 24, 1978 1227 1030 City and County of San Francisco...... March 24, 1978 C538 664 San Joaquin.......... March 27, 1978 4377 286 San Mateo............ March 24, 1978 7728 715 Santa Clara.......... March 24, 1978 D549 102 Solano............... March 24, 1978 21803 73 Sonoma............... March 24, 1978 3371 634 Tulare............... March 27, 1978 3315 618 Yuba................. March 24, 1978 662 589 TWENTY-EIGHTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. August 28, 1978 5551 62 Butte................ August 28, 1978 2318 170 Fresno............... August 28, 1978 7107 2 Glenn................ August 28, 1978 633 666 Kern................. August 28, 1978 5135 674 Los Angeles.......... August 28, 1978 78-951209 Monterey............. August 28, 1978 1270 1030 City and County of San Francisco...... August 28, 1978 C631 740 San Joaquin.......... August 28, 1978 4442 141 San Mateo............ August 28, 1978 7774 1709 Santa Clara.......... August 28, 1978 D914 715 Solano............... August 28, 1978 -- 71420 Sonoma............... August 28, 1978 3445 337 Tulare............... August 28, 1978 3566 14 Yuba................. August 28, 1978 675 331 42 78 TWENTY-NINTH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. March 28, 1980 80-055698 Butte................ March 28, 1980 2500 503 Fresno............... March 31, 1980 7494 230 Glenn................ March 31, 1980 663 509 Kern................. March 28, 1980 5275 818 Los Angeles.......... March 31, 1980 80-318971 Monterey............. March 31, 1980 1399 636 City and County of San Francisco...... March 28, 1980 C970 327 San Joaquin.......... March 31, 1980 80020795 San Mateo............ March 28, 1980 7948 1952 Santa Clara.......... March 28, 1980 366 Solano............... March 28, 1980 23159 Sonoma............... March 28, 1980 80-18782 Tulare............... March 31, 1980 3753 500 Yuba................. March 28, 1980 722 625 THIRTIETH SUPPLEMENTAL INDENTURE Page County or Vol. of at which City and Date of Official Record County Recordation Records Commences Alameda.............. January 2, 1981 81-000002 None Butte................ January 2, 1981 81-113 2583-250 Fresno............... January 2, 1981 401 7651-362 Glenn................ January 2, 1981 0023 678-226 Kern................. January 5, 1981 000286 5342-1512 Los Angeles.......... January 2, 1981 81-2293 None Monterey............. January 2, 1981 G00066 1456-551 City and County of San Francisco...... December 31, 1980 D044298 D127-551 San Joaquin.......... January 2, 1981 81000191 None San Mateo............ January 2, 1981 0507AS None Santa Clara.......... January 2, 1981 6941984 -269 Solano............... January 2, 1981 60 Pg 90-156 Sonoma............... January 2, 1981 81-000131 None Tulare............... January 2, 1981 189 3828-412 Yuba................. January 2, 1981 7644 743-99 43 79 THIRTY-FIRST SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ May 4, 1982 82-064230 None Butte.................. May 4, 1982 82-12318 2715-529 Fresno................. May 3, 1982 37212 7901-572 Glenn.................. May 4, 1982 1908 704-299 Kern................... May 3, 1982 40614 5456-1478 Los Angeles............ May 3, 1982 82-445736 None Monterey............... May 3, 1982 G17137 1549-234 City and County of San Francisco........ May 3, 1982 D198127 D392-276 San Joaquin............ May 4, 1982 82022803 None San Mateo.............. May 3, 1982 82035410 None Santa Clara............ May 3, 1982 7353398 None Solano................. May 3, 1982 15522 Page 26792 Sonoma................. May 3, 1982 82-23083 None Tulare................. May 3, 1982 19242 3961-163 Yuba................... May 3, 1982 10984 775-263 THIRTY-SECOND SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ October 13, 1983 83-191597 None Butte.................. October 13, 1983 83-34081 None Fresno................. October 13, 1983 83095135 None Glenn.................. October 13, 1983 4435 None Kern................... October 13, 1983 041161 5597-658 Los Angeles............ October 13, 1983 83-1208172 None Monterey............... October 13, 1983 G46236 1674-1194 City and County of San Francisco........ October 13, 1983 D408975 None San Joaquin............ October 13, 1983 83074718 None San Mateo.............. October 13, 1983 83112077 None Santa Clara............ October 13, 1983 7850561 H980-717 Solano................. October 13, 1983 45171 1983-85369 Sonoma................. October 13, 1983 83-69362 None Tulare................. October 13, 1983 51515 4120-726 Ventura................ October 13, 1983 117059 1983-117059 Ventura (re-recorded).. November 15,1983 130202 1983-130202 Yuba................... October 13, 1983 3764 810-614 44 80 THIRTY-THIRD SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ September 13, 1988 88-232083 None Butte.................. September 13, 1988 88-031123 None Fresno................. September 13, 1988 88101543 None Glenn.................. September 13, 1988 88-4023 None Kern................... September 13, 1988 31355 6162-1754 Los Angeles............ September 13, 1988 88-1464893 None Monterey............... September 13, 1988 47561 2273-660 City and County of San Francisco........ September 13, 1988 E243818 None San Joaquin............ September 13, 1988 88077190 None San Mateo.............. September 13, 1988 88120443 None Santa Clara............ September 13, 1988 9833944 None Solano................. September 13, 1988 54422 1988-117737 Sonoma................. September 13, 1988 88-77182 88-77182 Tulare................. September 13, 1988 58120 4745-662 Ventura................ September 13, 1988 88-133327 None Yuba................... September 13, 1988 2818 947-287 THIRTY-FOURTH SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ December 20, 1990 90-332019 None Butte.................. December 20, 1990 90-054231 None Fresno................. December 20, 1990 90155101 None Glenn.................. December 20, 1990 90-6395 None Kern................... December 20, 1990 85807 6468-709 Los Angeles............ December 20, 1990 90-2094360 None Monterey............... December 20, 1990 73725 2589-678 City and County of San Francisco........ December 20, 1990 E836831 -480 San Joaquin............ December 20, 1990 90122496 None San Mateo.............. December 20, 1990 90165083 None Santa Clara............ December 21, 1990 10758142 None Solano................. December 20, 1990 99015 None Sonoma................. December 20, 1990 90-122784 None Tulare................. December 23, 1990 83069 None Ventura................ December 20, 1990 90-187399 None Yuba................... December 20, 1990 90-14553 None 45 81 THIRTY-FIFTH SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ November 3, 1992 92-358477 None Butte.................. November 3, 1992 92-050443 None Fresno................. November 3, 1992 92167544 None Glenn.................. November 3, 1992 92-5920 None Kern................... November 3, 1992 167635 6757-1488 Los Angeles............ November 3, 1992 92-2022769 None Monterey............... November 3, 1992 78604 2867-956 City and County of San Francisco........ November 3, 1992 -0581 San Joaquin............ November 2, 1992 92127961 None San Mateo.............. November 3, 1992 92180648 None Santa Clara............ November 3, 1992 11617179 None Solano................. November 3, 1992 101527 None Sonoma................. November 3, 1992 1992-137370 None Tulare................. November 3, 1992 92-081425 None Ventura................ November 3, 1992 92-198950 None Yuba................... November 3, 1992 92-13796 None THIRTY-SIXTH SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ June 9, 1993 93-203153 None Butte.................. June 9, 1993 93-023408 None Fresno................. June 9, 1993 93086809 None Glenn.................. June 10, 1993 93-2925 None Kern................... June 9, 1993 82236 6859-1043 Los Angeles............ June 9, 1993 93-1098735 None Monterey............... June 9, 1993 38484 None City and County of San Francisco........ June 9, 1993 -0727 San Joaquin............ June 9, 1993 93067318 None San Mateo.............. June 9, 1993 93094357 None Santa Clara............ June 9, 1993 11944269 None Solano................. June 9, 1993 93-51895 None Sonoma................. June 9, 1993 93-71358 None Tulare................. June 9, 1993 93-040396 None Ventura................ June 9, 1993 93-104242 None Yuba................... June 9, 1993 93-06640 None 46 82 THIRTY-SEVENTH SUPPLEMENTAL INDENTURE County or City and Recording Document Book and Page County Date Number (Reel-Image) Alameda................ September 28, 1993 93342967 None Butte.................. September 28, 1993 93-041800 None Fresno................. September 28, 1993 93148269 None Glenn.................. September 28, 1993 93-5140 None Kern................... September 28, 1993 140436 6915-188 Los Angeles............ September 28, 1993 93-1891500 None Monterey............... September 28, 1993 66464 None City and County of San Francisco........ September 28, 1993 -511 San Joaquin............ September 28, 1993 93111959 None San Mateo.............. September 28, 1993 93164391 None Santa Clara............ September 28, 1993 12128051 None Solano................. September 28, 1993 93-88880 1993 Sonoma................. September 28, 1993 93-121864 None Tulare................. September 28, 1993 93-069108A None Ventura................ September 28, 1993 93-181168 None Yuba................... September 28, 1993 93-11284 None 47 83 SCHEDULE C None 48 84 SCHEDULE D None 49 85 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS BUSINESS California Water Service Company is a public utility supplying water service through 20 separate water systems to 362,900 customers living in 38 communities in California. These systems, or districts, are located throughout the state as shown in the tabulation of page 11. [Note to EDGAR 10K user: the tabulation "Service Areas and Customers" is on page 91 of this filing.] The Company's rates and operations are regulated by the California Public Utilities Commission (Commission) with the rates for each district determined separately. A detailed discussion of Regulation and Rates begins on page 6 of this report. [Note to EDGAR 10K user: the discussion of "Regulation and Rates" is on page 92 of this filing.] The six-year drought in California which required water rationing in a number of the Company's districts was declared officially ended after near- record precipitation in the first three months of 1993. A detailed discussion of Water Supply is on page 4 of this report. [Note to EDGAR 10K user: the discussion of "Water Supply" is on page 93 of this filing.] RESULTS OF OPERATIONS Earnings and Dividends The Company's earnings per share for 1993 were $2.70, compared with $2.18 in 1992 and $2.42 in 1991. Net income was $15,501,000 in 1993 compared with $12,529,000 in 1992 and $13,928,000 in 1991. Earnings and revenue in 1991 and 1992 were impacted by mandatory water rationing in some Company districts and water conservation in all districts. In January 1993, the Board of Directors increased the dividend rate for the twenty-sixth consecutive year. The annual rate paid in 1993 was $1.92 per share, an increase of 3.2% compared with the 1992 dividend of $1.86 per share, which represented an increase of 3.3% over the 1991 dividend of $1.80 per share. The dividend payout ratio was 71% in 1993 compared with 85% in 1992 and 74% in 1991. These increases were based on projections that the higher dividend could be sustained while still providing the Company with adequate financial flexibility. Operating Revenue Operating revenue was a record $151.7 million in 1993, compared with $139.8 million in 1992 and $127.2 million in 1991. The increase was $11.9 million, or 9%, in 1993. Step and general rate increases accounted for $2.7 million of added revenue. Offset rate adjustments, primarily for purchased water and pump tax cost increases, added $7.3 million. Average water consumption per customer increased 3%, adding $2.3 million to revenue. However, rationing loss recoveries declined $1.2 million from 1992 due to the ending of rationing. Sales to 2,200 new customers accounted for $0.8 million in additional revenue. In 1992, operating revenue increased $12.6 million from 1991. Step and general rate increases accounted for $3.4 million of added revenue. Offset rate adjustments, primarily for purchased water and pump tax cost 14 88 increases, added $7.0 million. Average water consumption per customer increased 6%, adding $3.9 million to revenue. The discontinuance of mandatory rationing in four districts in April 1992 helped account for higher water consumption. However, this also resulted in lower rationing loss recoveries of $4.0 million compared with $6.9 million in 1991. Sales to 3,100 new customers accounted for $1.2 million in additional revenue. In 1991, an October decision of the Commission authorized the Company to recover a portion of revenue lost through water rationing and conservation. In December, after the Commission approved district water management plans, $6,951,000 of revenue lost since August 8, 1990, was recorded as revenue. This included the transfer of $3,195,000 in penalty charges collected from customers who had exceeded their monthly allotments, while the remaining $3,756,000 was accrued as unbilled revenue. Surcharges on customer water bills were authorized by the Commission beginning in 1992, to allow recovery of this accrued unbilled revenue in addition to future revenue losses. Water rationing and conservation in the fifth drought year lowered average water consumption per customer by 14% causing an $11.9 million reduction in revenue. Additional revenue from drought rate relief in 1991 was $5.6 million. General and step rate increases added $4.1 million to 1991 revenue. Sales to 4,300 new customers accounted for $1.3 million in additional revenue. [Appearing within the text of Management's Discussion and Anaylsis of Financial Condition and Results of Operations is a bar chart titled "OPERATING REVENUE (Millions of Dollars)". The chart shows total revenue for the five year period 1989 through 1993. The revenue for those years were: $117.5, $124.4, $127.2, $139.8 and $151.7, respectively.] Operating and Interest Expenses Operating expenses in 1993 increased $7.8 million compared with increases of $13.2 million in 1992 and $1.8 million in 1991. Purchased water expense continued to be the largest component of operating expense at $38.5 million, an increase of $5.4 million. This was attributable to a 19% increase in water purchases to 48 billion gallons and to wholesale water suppliers' rate increases. Total water production, including well production and surface supplies was up 3% from 1992 to 95 billion gallons. Total cost of water production, including purchased water, purchased power and pump taxes, was $52.9 million in 1993, $50.2 million in 1992, and $38.8 million in 1991. Commission regulatory procedures allow offset rate adjustments for changes in these costs through use of balancing accounts. However, there was a delay in recovery of some cost increases as discussed under the caption Regulation and Rates on page 6. Employee payroll and benefits charged to operations and maintenance expense was $26.2 million in 1993 compared with $24.8 million in 1992 and $23.5 million in 1991. Bond interest expense in 1993 increased $1.5 million due to the sale of $20 million new bonds in November 1992 and the sale of additional new bonds in 1993 as discussed under the caption Liquidity and Capital Resources. However, this was partially offset by a $336,000 reduction in interest on short-term debt due to reduced borrowings. Bond interest coverage before income taxes was 3.2 in 1993, 2.9 in 1992 and 3.2 in 1991. 15 89 New Accounting Standards The Financial Accounting Standards Board has issued three new statements which affect the financial statements in 1992 or 1993. These are Statement No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions", Statement No. 107 "Disclosures About Fair Value of Financial Instruments", and Statement No. 109 "Accounting for Income Taxes". The effect of these Statements is discussed in Notes to Financial Statements: Note 5--Income Taxes; Note 6--Employee Benefit Plans and Note 7--Fair Value of Financial Instruments. LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity is primarily provided by cash generated from operations and the utilization of a short-term line of credit of $30 million as described in Note 3 to the financial statements. The credit line was temporarily increased to $40 million during the bond refinancing periods in May and November to cover short-term requirements between the calling of bonds and the issuance of new bonds. A major refinancing program was completed in 1993. Eight series of bonds in the principal amount of $49,593,000 and bearing coupons ranging from 8.6% to 12-7/8% were called prior to maturity with a portion of the proceeds from the sale of three $20 million dollar bond issues. The Series EE 7.9% first mortgage bonds were issued in June 1993, the Series FF 6.95% bonds were issued in October 1993 and the Series GG 6.98% bonds were issued in November 1993. Interest savings from the refunding will be approximately $1.9 million annually. Standard & Poor's and Moody's maintained their bond ratings of AA- and Aa3 respectively on the new Series GG bond issue. Capital requirements consist primarily of new construction expenditures for replacing and expanding the Company's utility plant facilities. They also include refunds of advances for construction and retirement of bonds. During 1993, utility plant expenditures totaled $28.8 million including $21.5 million covered by Company funding and $7.3 million being recovered from developers through refundable advances and contributions in aid of construction. Company funding was through cash generated from operations, the use of short-term line of credit and a portion of the proceeds from the sale of new bonds. The 1994 Company construction program has been authorized for $21.6 million. The funds for this program are expected to be provided by cash from operations and a new issue of common stock. Additionally, new subdivision construction will be financed by developers' refundable advances and contributions. [Appearing within the text of Management's Discussion and Anaylsis of Financial Condition and Results of Operations is a bar chart titled "GROSS ADDITIONS TO UTILITY PLANT (Millions of Dollars). The chart shows gross additions to utility plant for the years 1989 through 1993. The additions were $27.3, $26.9, $34.5, $35.2 and $28.8, respectively.] Capital Structure The Company's total capitalization at December 31, 1993, was $257.1 million. Capital ratios were: common equity 48.2% preferred stock, 1.4%; and long-term debt, 50.4%. The rate of return on year-end common equity was 12.4% compared with 10.4% in 1992 and 11.7% in 1991. 15 90 SERVICE AREAS AND CUSTOMERS SAN FRANCISCO BAY AREA Mid-Peninsula (San Mateo and San Carlos) 35,200 South San Francisco (including Colma and Broadmoor) 15,300 Bear Gulch (including Menlo Park, Atherton, Woodside and Portola Valley) 17,100 Los Altos (including Los Altos and portions Cupertino, Los Altos Hills, Mountain View and Sunnyvale) 17,700 Livermore 14,700 ------- 100,000 SACRAMENTO VALLEY Chico (including Hamilton City) 20,100 Oroville 3,500 Marysville 3,800 Dixon 2,700 Willows 2,200 ------ 32,300 SALINAS VALLEY Salinas 22,600 King City 1,800 ------ 24,400 SAN JOAQUIN VALLEY Bakersfield 54,300 Stockton 40,700 Visalia 25,500 Selma 4,600 ------- 125,100 LOS ANGELES AREA East Los Angeles (including portions of City of Commerce and Montebello) 26,400 Hermosa Beach and Redondo Beach (including portion of Torrance) 24,700 Palos Verdes (including Palos Verdes Estates,Rancho Palos Verdes, Rolling Hills Estates and Rolling Hills) 23,400 Westlake (portion of Thousand Oaks) 6,600 ------- 81,100 ------- 362,900 ======= 11 91 REGULATION AND RATES The California Public Utilities Commission requires that water rates for each Company operating district be determined independently. Each year the Company files general rate increase applications for approximately one- third of its operating districts. According to its rate case processing procedures for water utilities, the Commission attempts to issue decisions within eight month of acceptance. Offset rate adjustments are also allowed as required for changes in purchased water, power costs and pump taxes. During 1993, general rate increase applications were filed with the Commission requesting rate relief of $2,184,800 in three Company districts based upon a rate of return on common equity of 12%. However, in recent proceedings, the Commission staff has been recommending a rate of return in the 10.50% range. Public hearings for these cases have been scheduled for early February 1994. In the meantime, step increases for 15 districts totaling approximately $2,233,000 were authorized in January 1994. The Company received two general rate case decisions in 1993. In April, the Commission issued a decision on general rate cases filed in July 1991 for six districts, resulting in $390,000 in additional revenue and yielding a return on common equity of 11.50%. Then in August 1993, the Commission issued a decision on general rate cases filed in July 1992 for seven districts, providing a revenue increase of $3,408,000 and yielding a return on common equity of 11%. In November 1992, hearings began in the Commission's investigation of the financial and operational risks which confront water utilities today. This investigation addresses two of the most significant challenges to the California water industry--water supply and water quality and their affect on appropriate rates of return to be authorized by the Commission. The California Water Association retained expert witnesses to put forth the industry's position. Following the hearings, which concluded in 1993, the Commission will present its position on these matters through a formal decision anticipated sometime in 1994. Interim rate relief in the Stockton district totaling $1,900,000 was granted by the Commission for changes in purchased water expense, purchased power costs and pump taxes. The Commission staff's continuing review of these costs has delayed recovery since 1989 when the contract was first implemented. As part of the staff's review, an independent consultant was hired and a report is expected in early 1994. Two additional offset changes relating to the cost of surface water supplies were issued by the Commission during the past year. They included rate relief totaling $3,500,000 effective July 1, 1993, authorized to cover the increased cost of purchased water from the Metropolitan Water District of Southern California to serve the Company's four Los Angeles area districts; and a rate reduction in July and August totaling $4,300,000 for customers on the San Francisco Peninsula to reflect a 33% decrease in the cost of purchased water from the wholesale supplier, the San Francisco Water Department. Additional offset relief of $637,000 was granted for the Bakersfield district in November 1993 to allow for adjustments in the district's water production expense balancing account as permitted by the rate-making process. The Company's headquarters in San Jose was recently renovated to accommodate increased staffing levels at the General Office. This was the first remodeling since expansion of facilities to accommodate the Company's Information Systems Department in 1972. An advice letter to recover the 6 92 increased costs due to the renovation was filed with the CPUC in late 1993 requesting approximately $360,000 in additional revenue. WATER SUPPLY Water supplies in California's 155 major reservoirs were at 22.4 million acre feet on January 1, 1994, almost doubled that recorded one year earlier when the state was undergoing its sixth year of drought. The state's current reservoir supply, which is at average for this time of year, was replenished during 1993 as a result of the abundant runoff which followed the near record precipitation of the 1992-93 winter season. Twelve Company districts receive all or a portion of their supplies from surface water runoff captured by state and local reservoirs. While overall reservoir storage remained normal at the start of 1994, the snowpack in the Sierra on January 3, 1994, was approximately 45% of average for that date, indicating that the 1993-94 water year had started significantly dryer than last year's above average season. Subsequent storms in mid-February 1994, however, have greatly increased the Sierra snowpack. Although substantial reserves remain in underground aquifers which serve 16 Company districts, many groundwater tables have not fully recovered from the effects of the drought. Taking this into consideration, together with the fact that California will continue to have long-term water supply problems with future growth, the Company will maintain its water conservation efforts through a variety of customer programs initiated during the drought. Fortunately, the state's improved supply conditions have eliminated the need for water rationing. While not under a mandatory rationing program during 1994, customers in the Company's Salinas district will be asked to voluntarily cut water use by 15% to conform to a new local ordinance. The new law, which placed water use restrictions on both urban and agricultural users in Monterey County, is part of an overall program designed to curtail ocean salt water intrusion. The program is described in more detail on page 7 of this report. [Note to EDGAR 10K user: the detail of the Salinas progam is on page 94 of this report.] Photo Captions [The photograph referred in the following paragraph, depicts two men looking at a set of blueprints with a panoramic view of the Salinas Valley in the background.] Jim Smith, left, Company District Manager in Salinas, and William Hurst, General Manager of the Monterey County Resources Agency, review options under consideration by the Agency to protect the Salinas Valley underground aquifer against salt water intrusion from Monterey Bay. Possible programs include the use of additional supplies from both the Nacimiento and San Antonio Reservoirs in the Southern Monterey County for imported surface water and groundwater recharge; the use of 20,000 acre feet of reclaimed water from the Regional Water Treatment plant in Marina, recycled for irrigation use and groundwater recharge; restrictions placed upon the Valley's urban and agricultural communities on water use; and the possible development of a new dam and reservoir in the County's Arroyo Seco area for reserve storage and recharge of the underground through the Salinas and Arroyo Seco Rivers. 4 93 [The picture referred to the in following parapraph shows a computer designed schematic diagram of the Salinas district water distribution system with contour lines that indicate elevation.] To assist in this overall effort, the Company has developed a computer model which creates a three dimensional hydraulic network analyses of the Salinas district distribution system. The model provides an overall view of system water pressure at all locations; system mains color coded as to size and type; sources of supply (wells); water connections; booster pumps; storage tanks and reservoirs. Through use of the computer model, the Company can simulate a variety of scenarios to determine the effectiveness of different operational modes when pumping conditions are changed. 7 94 NOTES TO FINANCIAL STATEMENTS December 31, 1993, 1992 and 1991 Note 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting records of the Company are maintained in accordance with the uniform system of accounts prescribed by the California Public Utilities Commission (Commission). Certain prior years' amounts have been reclassified, where necessary, to conform to the current presentation. Revenue Revenue consists of monthly cycle customer billings for water service at rates authorized by the Commission. Revenue from metered accounts includes unbilled amounts based on the estimated usage from the latest meter reading to the end of the accounting period. Flat rate accounts which are billed at the beginning of the service period are included in revenue on a prorata basis for the portion applicable to the current accounting period. In October 1991 the Commission issued a decision on its investigation into the effects of the drought on water utilities which permitted the Company to recover revenue lost through water conservation as recorded in memorandum accounts. As a result, $6,951,000 of revenue lost since August 8, 1990 was recorded as revenue in December 1991 after the Commission approved district water management plans. Penalty charges totaling $3,195,000 collected from customers who had exceeded their monthly allotments were transferred to revenue while the remaining $3,756,000 was accrued as unbilled revenue in current assets. Of this amount $3,337,000 was recovered in 1992 by surcharges on customer water bills and transfers of penalty charges. During 1992, $4,087,000 of revenue lost due to water conservation was recorded as revenue and accrued in unbilled revenue. Of $2,355,000 was recovered through customer surcharges and penalty charge transfers. As of December 31, 1992 a total of $2,151,000 of revenue lost due to water conservation was included in unbilled revenue. In 1993, $2,904,000 was recorded as lost water conservation revenue and accrued in unbilled revenue, while $2,631,000 was recovered through customer surcharges and penalty charge transfers. As of December 31, 1993, $2,424,000 of lost water conservation revenue remains in unbilled revenue. Utility Plant Utility plant is carried at original cost when first constructed or purchased, except for certain minor units of property recorded at estimated fair values at dates of acquisition. Costs of depreciable plant retired are eliminated from utility plant accounts and such costs are charged against accumulated depreciation. Maintenance of utility plant, other than transportation equipment, is charged to operating expenses. Maintenance and depreciation of transportation equipment are charged to a clearing account and subsequently distributed primarily to operations. Interest is capitalized on plant expenditures during the construction period and amounted to $141,000 in 1993, $523,000 in 1992 and $293,000 in 1991. 21 100 Intangible assets arising during the period of initial development of the Company and those acquired as parts of water systems purchased are stated at amounts prescribed by the Commission. All other intangibles have been recorded at cost. Bond Premium, Discount and Expense The discount and expense on first mortgage bonds is being amortized over the original lives of the related bond issues. Premiums paid on the early redemption of bonds and unamortized original issue discount and expense of those bonds are amortized over the life of new bonds issued in conjunction with the early redemption. Cash Equivalents Cash equivalents include highly liquid investments, primarily a money market mutual fund, stated at cost with original maturities of three months or less. Depreciation Depreciation of utility plant for financial statement purposes is computed on the straight-line remaining life method at rates based on the estimated useful lives of the assets. The provision for depreciation expressed as a percentage of the aggregate depreciable asset balances was 2.4% in 1993 and 2.3% in 1992 and 1991. For income tax purposes, the Company computes depreciation using the accelerated methods allowed by the respective taxing authorities. Advances for Construction Advances for construction of water main extensions are primarily refundable to depositors over a 20-year or 40-year period. Refund amounts under the 20-year contracts are based on annual revenues from the extensions. Unrefunded balances at the end of the contract period are credited to Contributions in Aid of Construction and are no longer refundable. Contracts entered into since 1982 provide for full refunds at a 2 1/2% rate per year for 40 years. Estimated refunds for 1994 for all water main extension contracts are $3,600,000. Income Taxes Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". Statement 109 requires a change from the deferred method of accounting for income taxes under APB Opinion 11 to the asset and liability method. Under SFAS 109 deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Measurement of the deferred tax assets and liabilities is at enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. 22 101 Due to the implementation of SFAS 109 as of January 1, 1993, the Company recorded an increase in both net regulatory assets and net deferred income taxes of $9,905,000. There was no impact on the results of operations. It is anticipated that future rate action by the Commission will reflect revenue requirements for the tax effects of temporary differences recognized under SFAS 109 which have previously been flowed through to customers. Prior to 1993, the provision for income taxes was based on income and expenses included in the Statement of Income as prescribed by APB Opinion 11. In accordance with Commission requirements, deferred taxes were not provided for items flowed through for rate-making and accounting purposes. Flow through items included excess state tax depreciation and excess federal depreciation on assets placed in service prior to 1981. Prior year amounts have not been restated to apply the provisions of SFAS 109. The Commission has granted the Company customer rate increases to reflect the normalization of the tax benefits of the federal accelerated methods and available investment tax credits (ITC) for all assets placed in service since 1980. ITC are deferred and amortized over the lives of the related properties. Advances for Construction and Contributions in Aid of Construction received from developers subsequent to 1986 are taxable for federal income tax purposes and subsequent to 1991 subject to state income tax. Earnings per Share Earnings per share is calculated using the weighted average number of common shares outstanding during the year after deducting dividend requirements on preferred stock. NOTE 2. PREFERRED AND COMMON STOCK As of December 31, 1993, 399,200 shares of preferred stock were authorized. Dividends on outstanding shares are payable quarterly at a fixed rate before any dividends can be paid on common stock. Preferred shares are entitled to eight votes each with the right to cumulative votes at any elections of directors. The outstanding 139,000 shares of $25 par value cumulative, 4.4% Series C preferred shares are not convertible to common stock. A premium of $243,250 would be due upon voluntary liquidation of Series C. There is no premium in the event of an involuntary liquidation. The Company is authorized 8,000,000 shares of no par value common stock. As of December 31, 1993 and 1992, 5,688,754 shares of common stock were issued and outstanding. NOTE 3. SHORT-TERM BORROWINGS As of December 31, 1993 the Company maintained a bank line of credit which provided for unsecured borrowings of up to $30,000,000 at the prime lending rate or lower rates as quoted by the bank. The agreement 23 102 does not require minimum or specific compensating balances. The maximum short-term borrowings outstanding during 1993, 1992 and 1991 were $33,500,000, $24,500,000, and $14,000,000, respectively. The average amount outstanding during each of the three years was $11,746,000, $17,431,000 and $1,269,000, respectively, with weighted average interest rates on the daily balances of 4.31%, 4.85% and 5.90%, respectively. NOTE 4. FIRST MORTGAGE BONDS As of December 31, 1993 and 1992 first mortgage bonds outstanding were: In Thousands 1993 1992 Series I, 4.65% due 1993 $ -- $2,565 Series J, 4.85% due 1995 2,581 2,596 Series K, 6 1/4% due 1996 2,595 2,610 Series L, 6 3/4% due 1997 2,177 2,189 Series M, 9 1/2% due 1999 -- 2,213 Series N, 9 1/4% due 2000 -- 2,670 Series O, 9 1/4% due 2000 -- 2,670 Series P, 7 7/8% due 2002 2,685 2,700 Series S, 8 1/2% due 2003 2,700 2,715 Series U, 9 1/4% due 2003 -- 2,080 Series V, 8.60% due 2006 -- 1,785 Series W, 9 3/8% due 2007 -- 2,380 Series X, 10% due 2005 -- 2,755 Series AA, 12 7/8% due 2013 -- 33,425 Series BB, 9.48% due 2008 17,370 17,460 Series CC, 9.86% due 2020 19,600 19,700 Series DD, 8.63% due 2022 19,900 20,000 Series EE, 7.90% due 2023 20,000 -- Series FF, 6.95% due 2023 20,000 -- Series GG, 6.98% due 2023 20,000 -- -------- -------- 129,608 122,513 Less: Series AA discount --- 444 -------- -------- Total first mortgage bonds $129,608 $122,069 ======== ======== Aggregate maturities and sinking fund requirements for each of the succeeding five years 1994 through 1998 are $663,000, $3,215,000, $3,197,000, $2,759,000 and $620,000, respectively. The first mortgage bonds are secured by substantially all of the Company's utility plant. 23 103 NOTE 5. INCOME TAXES Income tax expense consists of the following: In Thousands 1993 Federal State Total Current $6,800 $2,408 $9,208 Deferred 1,400 (8) 1,392 ------- ------ ------- Total $8,200 $2,400 $10,600 ======= ====== ======= Current $3,371 $1,650 $5,021 Deferred 3,229 -- 3,229 ------- ------ ------ Total $6,600 $1,650 $8,250 ======= ====== ====== Current $4,939 $1,750 $6,689 Deferred 2,861 -- 2,861 ------- ------ ------ Total $7,800 $1,750 $9,550 ======= ====== ====== Income tax expense differs from the amount computed by applying the current federal tax rate to pretax book income. The difference is listed in the table below: In Thousands 1993 1992 1991 Computed "expected" tax expense $9,135 $8,332 $9,415 Increase (reduction) in taxes due to: State income taxes net of federal tax benefit 1,565 1,089 1,155 Investment tax credits (100) (85) (85) Other --- (1,086) (935) ------- ------- ------ Total income tax $10,600 $8,250 $9,550 ======= ======= ====== The components of deferred income tax expense in 1993, 1992 and 1991 were: In Thousands 1993 1992 1991 Depreciation $3,858 $3,314 $2,946 Developer advances and contributions (3,951) -- -- Bond redemption premiums 1,333 -- -- Other 224 -- -- Investment tax credits (72) (85) (85) ------- ------ ------ Total deferred income tax expense $1,392 $3,229 $2,861 ======= ====== ====== 24 104 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented in the following table: In Thousands Deferred tax assets: Developer deposits for extension agreements and contributions in aid of construction $25,532 Federal benefit of state tax deductions 3,798 Book plant cost reduction for future deferred ITC amortization 1,811 Insurance loss provisions 668 Miscellaneous 1,686 ------- Total deferred tax assets 33,495 ------- Deferred tax liabilities: Utility plant, principally due to depreciation differences 42,796 Premium on early retirement of bonds 1,487 Miscellaneous 257 ------- Total deferred tax liabilities 44,540 ------- Net deferred tax liability $11,045 ======= A valuation allowance was not required during 1993. Based on historical taxable income and future taxable income projections over the periods in which the deferred assets are deductible, management believes it is more likely than not the Company will realize the benefits of the deductible differences. NOTE 6. EMPLOYEE BENEFIT PLANS Pension Plan The Company provides a uniform pension plan for substantially all employees. The cost of the plan was charged to expense and utility plant. The Company makes annual contributions to fund the amounts accrued for pension cost. Plan assets are invested in pooled equity, bond and short- term investment accounts. The data below includes the supplemental executive retirement plan. 25 105 Net pension cost for the years ending December 31, 1993, 1992 and 1991 included the following components: In Thousands 1993 1992 1991 Service cost-benefits earned during the period $1,167 $1,076 $1,044 Interest cost on projected obligation 2,153 1,970 1,855 Actual return on plan assets (3,672) (1,410) (4,629) Net amortization and deferral 2,132 (262) 3,385 ------- ------- ------- Net pension cost $1,780 $1,374 $1,655 ======= ======= ======= The following table sets forth the plan's funded status as of December 31, 1993 and 1992: In Thousands 1993 1992 Accumulated benefit obligation, including vested benefits of $20,719 in 1993 and $15,849 in 1992 $(21,386) $(16,281) ========= ========= Projected benefit obligation $(31,179) $(26,652) Plan assets at fair value 29,319 25,349 --------- --------- Projected benefit obligation in excess of plan assets (1,860) (1,303) Unrecognized net gain (4,556) (5,665) Prior service cost not yet recognized in net periodic pension cost 3,925 4,307 Remaining net transition obligation at adoption date January 1, 1987 2,288 2,574 --------- --------- Accrued pension liability recognized in the balance sheet $(203) $(87) ========= ========= The projected long term rate of return on plan assets used in determining pension cost was 8.0% for the years 1993 to 1992. A discount rate of 7% in 1993 and 8.0% in 1992 and future compensation increases of 4.75% in 1993 and 6.0% in 1992 were used to calculate the projected benefit obligations for 1993 and 1992. Savings Plan The Company maintains employee savings plans which allow participants to contribute from 1% to 14% of pre-tax compensation. The Company matches fifty cents for each dollar contributed by the employee up to 6% of the employees' compensation. Company contributions were 25 106 $606,000, $561,000 and $522,000 for the years 1993, 1992 and 1991, respectively. Other Postretirement Plans The Company provides substantially all active employees medical, dental and vision benefits through a self-insured plan. Employees retiring at or after age 60 with 10 or more years of service are offered, along with their spouses and dependents, continued participation in the plan. Prior to 1993, the Company's share of the costs of this plan were recorded as expense as they were paid. Retired employees are also provided with $5,000 life insurance benefit. In 1993 the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" which requires that the costs of postretirement benefits be accrued during the employees years of active service. The Commission has issued a decision which authorizes rate recovery of tax deductible funding for postretirment benefits and permits recording of a regulatory asset for the portion of costs that will be recoverable in future rates. Net postretirement benefit cost for 1993 included the following components: In Thousands Service cost - benefits earned during the year $85 Interest cost on accumulated postretirement benefit obligation 384 Net amortization of transition obligation 248 ---- Net periodic postretirement benefit cost $717 ==== Postretirement benefit expense recorded in 1993 was $480,000. The remaining $237,000, which is recoverable through future customer rates, was recorded as a regulatory asset. The Company intends to make annual contributions to the plan up to the amount deductible for tax purposes. Plan assets are invested in high grade, short-term money market instruments and commercial paper. The following table sets forth the plan's funded status and the plan's accrued liability as of year end: In Thousands Accumulated postretirement benefit obligation: Retirees $(2,850) Other fully eligible participants (657) Other active participants (1,542) -------- Total (5,049) Plan assets at fair value 215 -------- Accumulated postretirement benefit obligation in excess of plan assets (4,834) Unrecognized net gain (119) Remaining unrecognized transition obligation 4,716 -------- Net postretirement benefit liability included in current liabilities $(237) ======== 26 107 For 1994 measurement purposes, an 8% annual rate of increase in the per capita cost of covered benefits was assumed; the rate was assumed to decrease gradually to 5% in the year 2020 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $423,000 and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year ended December 31, 1993 by $59,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993 and the long term rate of return on plan assets was 8%. NOTE 7. FAIR VALUE OF FINANCIAL INSTRUMENTS For those financial instruments for which it is practicable to estimate a fair value the following methods and assumptions were used to estimate the fair value. Cash and Temporary Cash Investments. The carrying amount of cash and temporary cash investments approximates fair value because of the short term maturity of the instruments. First Mortgage Bonds. The fair value of the Company's first mortgage bonds is estimated a $133,415,000 using a discounted cash flow analysis, based on the current rates available to the Company for debt of similar maturities. Advances for Construction. The fair value of advances for construction contracts are estimated at $22,000,000 based on data provided by brokers. NOTE 8. QUARTERLY FINANCIAL AND COMMON STOCK MARKET DATA (Unaudited) (In thousands, except per share amounts) The Company's common stock is traded in the over-the-counter market and is quoted in the National NASDAQ list with the symbol CWTR. There were approximately 5,500 holders of common stock at December 31, 1993. Quarterly dividends have been paid on common stock for 196 consecutive quarters and the quarterly rate has been increased during each year since 1968. The 1993 and 1992 quarterly range of common stock market prices was supplied by NASDAQ. 26 108 First Second Third Fourth Operating revenue $27,833 $40,504 $47,431 $35,948 Net operating income 4,116 7,747 9,377 6,615 Net income 979 4,689 6,221 3,612 Earnings per share $.17 $.82 $1.09 $.62 Common stock market price range: High 37-1/4 36-3/4 40-1/2 41-1/4 Low 32-1/2 32-1/4 33-1/2 37-1/2 Dividends paid $.48 $.48 $.48 $.48 First Second Third Fourth Operating revenue $26,867 $36,972 $42,772 $33,194 Net operating income 4,620 6,437 7,076 5,641 Net income 1,811 3,617 4,225 2,876 Earnings per share $.31 $.63 $.74 $.50 Common stock market price range: High 31 33-1/4 34-1/4 35 Low 26-1/4 28 29-1/2 29-1/4 Dividends paid $.46-1/2 $.46-1/2 $.46-1/2 $.46-1/2 26 109	28,512	191,886
31617_1993.txt	31617_1993	1993	31617	ITEM 1. BUSINESS The term "Registrant" as used in this Annual Report refers to EDO Corporation. The term "Company" as used in this Annual Report, except where the context otherwise requires, includes the Registrant and its subsidiaries. EDO Corporation was incorporated in New York in 1925 by Earl Dodge Osborn, from whose initials "EDO" is derived. In the early days of modern aviation, the Company pioneered in the development of seaplane floats and continues to manufacture floats for general aviation aircraft. Presently, the Company designs and manufactures advanced electronic, acoustic, aerodynamic and hydrodynamic equipment for military applications and for marine, aviation and other commercial markets. In response to defense spending reductions, the Company has been aggressively pursuing the application of its sophisticated and diverse defense-related technologies to civilian and commercial markets. The Company organizes its business into two segments: Military Systems; and Commercial and Other Products. A description of the principal products of the Company within the two industry segments is set forth below. The Company recently adopted a restructuring plan which consists of the discontinuance of the Company's defense business in Canada, the relocation of some United States production from New York to less costly locations, the related disposition of non-productive assets (principally land and buildings), and work force reductions. Additionally, information about the Company's restructuring plan is contained on page 14 and Note 2 on page 21 of the Company's 1993 Annual Report to Shareholders, and is incorporated by reference. Certain business segment information on the Company's operations is set forth under Note 18 on pages 27 and 28 of the Company's 1993 Annual Report to Shareholders and is incorporated by reference. MILITARY SYSTEMS The Company's operations in the Military Systems segment consist of the development and production of sophisticated electronic, acoustic, hydrodynamic and aerodynamic military systems. The Company additionally provides logistic support for its products following initial hardware deliveries. Such support consists of training operators and support personnel, supplying spare parts, and providing repair and refurbishment services. The revenues from such support services have been a significant portion of Military Systems' net sales. AIRCRAFT STORES SUSPENSION AND EJECTION SYSTEMS The Company developed and manufactures: bomb release units ("BRUs") for the U.S. Air ForceE; ejection release units ("ERUs") used on Tornado Multirole Combat Aircraft; and jettison release mechanisms ("JRMs") for the U.S. Navy. The Company designed and is developing the Advanced Medium Range Air-to-Air Missile ("AMRAAM") for the Advanced Tactical Fighter. Funded development is expected to continue through 1994. For 1993, 1992 and 1991, respectively, sales of aircraft stores suspension and ejection systems represented 12%, 11% and 12% of consolidated net sales. SONAR SYSTEMS The Company develops and produces advanced sonar systems for use in a variety of military applications. These sonar systems are an important element in anti-submarine warfare. The Company's sonar products include active and passive, and variable depth and hull-mounted systems, covering an extensive range of size and capability. The Company developed and produces "Flat-Pak" hydrophones and associated electronics for a submarine-mounted passive listening sonar system. The Company also produces the acoustic portion of the MK-39 "EMATT" training target. This program is expected to be in production until late in the decade. For 1993, 1992 and 1991, respectively, sales of military sonar systems and acoustic products represented 21%, 25% and 32% of consolidated net sales. AIRBORNE MINE COUNTERMEASURE SYSTEMS The Company is the only manufacturer of the MK-105, a helicopter-towed magnetic minesweeping system designed and developed by the Company in cooperation with the U.S. Navy. During 1991 and early 1992, the Company received contracts to develop a major upgrade of the MK-105. For 1993, 1992 and 1991, respectively, sales of helicopter-towed mine countermeasure systems represented 13%, 13% and 9% of consolidated net sales. COMMAND, CONTROL AND COMMUNICATIONS (C3) SYSTEMS The Company manufactures Command, Control and Communications ("C3") systems and develops software for these systems using commercial off-the-shelf hardware and software components. COMMERCIAL AND OTHER PRODUCTS ACOUSTIC INSTRUMENT SYSTEMS The Company manufactures data/voice communications, velocity measurement and navigation sonar commercial undersea acoustic instruments. Although designed for commercial markets, these products are also supplied to military markets worldwide. CERAMIC COMPONENTS Piezoelectric materials transform acoustic or other mechanical energy into electrical energy and vice versa. The - 1 - Company designs and manufactures piezoelectric materials and components, which have applications in sonar systems, medical instruments, ultrasonics, actuators and other specialized products. SPACEFLIGHT SYSTEMS The Company designs and manufactures electro-optical products for space including horizon sensors that provide the stabilization and orientation signals for spacecraft. In addition, the Company manufactures scientific payloads, which measure various characteristics of planets, their atmosphere and other phenomena or events observable from orbiting satellites. For 1993, 1992 and 1991, respectively, sales of spaceflight systems represented 13%, 14% and 12% of consolidated net sales. INFRARED INSTRUMENTATION The Company manufactures a line of microthermal imagers for design and reliability analysis of semiconductors in commercial applications. This line includes instrumentation used to identify thermal stresses in integrated circuits, hybrids and printed circuit boards, and an emission microscope. FIBER-REINFORCED STRUCTURES The Company designs and manufactures fiber-reinforced composite structures, including filament-wound and layup processes. The Company has applied its filament-winding technology to produce stator rings for power turbines, VT-1 missile launch tubes, and water and waste-holding tanks for commercial aircraft, as well as laid-up, autoclave cured, aerodynamic structures for commercial aircraft and laid-up sonar dome structures for ships. The Company maintains an active business in the supply of spare parts and repairs for water and waste tanks for virtually every commercial airline in the world. COMPOSITE SPORTS PRODUCTS A wholly-owned subsidiary of the Registrant, EDO Sports was formed in 1991 to commercialize advancements in composite sporting goods through the use of new, proprietary fabrication techniques. EDO Sports designs, manufactures and distributes premium-grade, high-performance golf club and sport bicycle components. COMPRESSED NATURAL GAS VEHICLE PRODUCTS The Company designed, developed and manufactures all-composite fuel tanks for vehicles operating on compressed natural gas. These tanks have been certified for use in Canada and the U.S. In December 1993, the Company purchased the assets of Automotive Natural Gas, Inc., a manufacturer of refueling stations and conversion kits for compressed natural gas vehicles. RESEARCH AND DEVELOPMENT Research and development, performed both under development contracts with customers and at Company expense, are important factors in the Company's business. The Company's research and development efforts involve approximately 140 employees in the fields of acoustic, electronic, hydrodynamic, aerodynamic, structural and material engineering. Research and development programs are designed to develop technology for new products or to extend the capability of existing products and to assess their commercial potential. Customer-sponsored research and development programs are principally related to military programs in the Military Systems segment. Major customer-sponsored research and development programs include: continued development of improvements to the AN/SQR-18A(V) TACTAS system; improvements to the MK-105 mine countermeasures system; development of a new surface ship sonar system; development of a combat integration system; and development of new and improved stores launchers. Expenditures under development contracts with customers vary in amount from year to year because of the timing of contract funding. During 1993, expenditures for customer-sponsored research and development was down 13% primarily as a result of less available funding consistent with the general decline in military spending. Company-sponsored research and development has contributed to a number of advances in sonar systems, transducers, filament-wound structures, and a new technique for manufacturing golf club shafts. Principal current research and development involves image and signal processing and other improvements for sonars, improvements to minesweeping technology; continued development of its satellite-based sensors; new advancements in sporting goods products; and new products for the compressed natural gas market. The following table sets forth research and development expenditures for the periods presented. Year Ended December 31, 1993 1992 1991 (in thousands) - - ---------------------------------------------------------------- Customer-sponsored $14,100 $16,100 $20,700 Company-sponsored 6,000 5,300 3,800 Total $20,100 $21,400 $24,500 MARKETING AND INTERNATIONAL SALES Military sales of the Company's products to both the U.S. and foreign governments are usually made under negotiated long-term contracts or subcontracts covering one or more years of production. The Company believes that its long history of association with its military customers is an - 2 - important factor in the Company's overall business, and that the experience gained through this history has enhanced the Company's ability to anticipate its customers' needs. The Company's approach to its military business is to anticipate specific customer needs and to develop systems to meet those needs either at its own expense or pursuant to research and development contracts. The Company sells products in its Military Systems segment as a prime contractor and through subcontracts with other military prime contractors. In addition to military sales to the U.S. Department of Defense, the Company also sells Military Systems segment equipment to the U.S. Government for resale to foreign governments under the Foreign Military Sales program and, subject to approval by the U.S. Department of State, directly to foreign governments. Products within the Commercial and Other Products segment are sold in industrial and commercial markets. In foreign markets piezoelectric and electronic products are generally sold commercially through a network of sales representatives. Fiber-reinforced composite products are sold, in certain product areas, on a direct basis and, in other product areas, through sales representatives. The Company's sports products are generally sold through independent distributors, dealers, and original equipment manufacturers. It is the Company's policy to denominate all foreign contracts from its U.S. operations in U.S. dollars and to incur no significant costs in connection with long-term foreign contracts until the Company has received advance payments or letters of credit on amounts due under the contracts. The Company's only significant asset outside the United States is its majority-owned subsidiary, EDO (Canada) Limited, which represents approximately 5% of the Company's total consolidated assets. BACKLOG A significant portion of the Company's sales are made to the U.S. armed services and foreign governments pursuant to long-term contracts. Accordingly, the Company's backlog of unfilled orders consists in large part of orders under these government contracts. As of December 31, 1993, the Company's total backlog was approximately $89.2 million, as compared with $94.2 million on December 31, 1992. Of the total backlog as of December 31, 1993, approximately 66% was scheduled for delivery in 1994. Total backlog as of December 31, 1993, divided between the Company's two industry segments, was Military Systems, $64.2 million, and Commercial and Other Products, $25.0 million, as compared, respectively, with $66.8 million and $27.4 million as of December 31, 1992. GOVERNMENT CONTRACTS Sales to the U.S. Government, as a prime contractor and through subcontracts with other prime contractors, accounted for 56% of the Company's 1993 net sales compared with 60% in 1992 and 61% in 1991, and consisted primarily of sales to the Department of Defense. Such sales do not include sales of military equipment to the U.S. Government for resale to foreign governments under the Foreign Military Sales program. The Company's military business can be and has been significantly affected by changes in national defense policy and spending. The Company's U.S. Government contracts and subcontracts and certain foreign government contracts contain the usual required provisions permitting termination at any time for the convenience of the government with payment for work completed and committed along with associated profit at the time of termination. The Company's contracts with the Department of Defense consist of fixed price contracts, cost-reimbursable contracts and incentive contracts of both types. Fixed-price contracts provide fixed compensation for specified work. Cost-reimbursable contracts require the Company to perform specified work in return for reimbursement of costs (to the extent allowable under government regulations) and a specified fee. In general, while the risk of loss is greater under fixed-price contracts than under cost-reimbursable contracts, the potential for profit under such contracts is greater than under cost-reimbursable contracts. Under both fixed-price incentive contracts and cost-reimbursable incentive contracts, an incentive adjustment based on attainment of scheduling, cost, quality or other goals is made in the Company's fee. The distribution of the Company's government contracts among the categories of contracts referred to above varies from time to time, although in recent years only a small percentage of the Company's contracts have been on a cost-reimbursable basis. COMPETITION AND OTHER FACTORS The Company's products are sold in competitive markets containing a number of competitors substantially larger than the Company with greater financial resources. Direct sales of military products to U.S. and foreign governments are based principally on product performance and reliability. Such products are generally sold in competition with products of other manufacturers which may fulfill an equivalent function, but which are not direct substitutes. The Company purchases certain materials and components used in its systems and equipment from independent suppliers. These materials and components are normally not purchased under long-term contracts unless the Company has actually received a long-term sales contract requiring them. The Company believes that most of the items it purchases are obtainable from a variety of suppliers and it normally obtains alternative sources for major items, although the Company is sometimes dependent on a single supplier or a few suppliers for some items. - 3 - It is difficult to state precisely the Company's market position in all of its market segments because information as to the volume of sales of similar products by its competitors is not generally available and the relevant markets are often not precisely defined. However, the Company believes that it is a significant factor in the markets for stores ejectors for military aircraft, military sonar systems, helicopter-towed mine countermeasure systems, piezoelectric ceramics, satellite horizon sensors, and natural gas vehicle refueling stations. Although the Company owns some patents and has filed applications for additional patents, it does not believe that its operations depend upon its patents. In addition, most of the Company's U.S. Government contracts license it to use patents owned by others. Similar provisions in the U.S. Government contracts awarded to other companies make it impossible for the Company to prevent the use by other companies of its patents in most domestic defense work. However, several patents recently granted to the Company and pending in the areas of sports products and compressed natural gas vehicle products may prove to be important to the Company's business in these areas. EMPLOYEES As of December 31, 1993, the Company employed 1,051 persons. EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Position and Term of Office - - ------------------------------------------------------------------------------- Gerald Albert 69 Chairman of the Board since November 1993, Chief Executive Officer since 1984 and Director since 1971. Frank A. Fariello 59 President and Chief Operating Officer since November 1993, Executive Vice President from 1989 to 1993, and Director since 1982. Marvin D. Genzer 53 Vice President since 1990, General Counsel since 1988, and Assistant Secretary since 1987. Michael J. Hegarty 54 Vice President-Finance since 1981, Treasurer since 1967, Secretary since 1985 and Director since 1982. Each executive officer is appointed by the Board of Directors (the "Board"), and holds office until the first meeting of the Board following the next succeeding annual meeting of shareholders, and thereafter until a successor is appointed and qualified, unless the executive officer dies, is disqualified, resigns or is removed in accordance with the Company's By-Laws. ITEM 2. ITEM 2. PROPERTIES All operating properties are leased facilities, except for the College Point corporate headquarters and manufacturing facility. The Company's facilities are adequate for present purposes. Although all facilities in the following listing are suitable for expansion by using available but unused space, leasing additional available space, or by physical expansion of leased or owned buildings, the Company is offering for sale a material portion of its College Point facility. The Company's obligations under the various leases are set forth in Note 16 on page 27 of the Company's 1993 Annual Report to Shareholders, which is incorporated by reference. Set forth below is a listing of the Company's principal plants and other materially important physical properties. Approximate Floor Area Location (in sq. ft.) - - -------------------------------------------------------------------------- Military Systems: Marine and Aircraft College Point, NY 318,000 Marine and Aircraft Systems Salt Lake City, UT 28,000 Command Systems Chesapeake, VA 17,000 Undersea Warfare Systems Salt Lake City, UT 70,000 Commercial and Other Products: Acoustic Products Salt Lake City, UT 47,000 Electro-Optics Division Shelton, CT 71,000 Fiber Science Salt Lake City, UT 90,000 EDO (Canada) Limited Calgary, Alberta, Canada 65,000 ANGI Milton, WI 31,000 Sports Salt Lake City, UT 15,000 ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information set forth under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 14, 15 and 16, and in Note 17 on page 27 of the Company's 1993 Annual Report to Shareholders is incorporated by reference. - 4 - ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information set forth under the headings "Common Share Prices" and "Dividends" on page 16, together with dividend information contained in the "Consolidated Statements of Shareholders' Equity" table on page 19 and Notes 9 and 10 on pages 23 and 24 of the Company's 1993 Annual Report to Shareholders are incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information set forth under the heading "Selected Financial Data" on page 13 of the Company's 1993 Annual Report to Shareholders is incorporated by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 14, 15 and 16 of the Company's 1993 Annual Report to Shareholders is incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company, together with the Independent Auditors' Report thereon of KPMG Peat Marwick and the unaudited "Quarterly Financial Information" are set forth on pages 17 through 29 of the Company's 1993 Annual Report to Shareholders, which are incorporated by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors is set forth under "Election of Directors" on pages 1 and 2 of the Company's Proxy Statement dated March 23, 1994, which is incorporated by reference. Information regarding executive officers is set forth in Part I of this Report under "Executive Officers of the Registrant." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding compensation of the Company's executive officers is set forth under "Compensation of Executive Officers" on pages 4 through 7 of the Company's Proxy Statement dated March 23, 1994, which is incorporated by reference, except for such information required by Item 402(k) and (l) of Regulation S-K, which shall not be deemed to be filed as part of this Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management is set forth on pages 3 and 8 of the Company's Proxy Statement dated March 23, 1994, which is incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements And Financial Statement Schedules And Exhibits 1. Financial Statements. The consolidated financial statements for the years ended December 31, 1993, 1992 and 1991, together with the report thereon of KPMG Peat Marwick, independent auditors, dated March 4, 1994, appearing on pages 17 through 28 of the Company's 1993 Annual Report to Shareholders, are attached as Exhibit 13 to this Report. 2. Financial Statement Schedules. Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991. The above schedules have been included elsewhere in this Report. The Financial Statement Schedules should be read in conjunction with the consolidated financial statements in the 1993 Annual Report to Shareholders. The opinion of KPMG Peat Marwick, independent auditors, precedes the aforementioned schedules. Schedules not included in these Financial Statement Schedules have been omitted - 5 - either because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. 3. Exhibits. Exhibits which are noted with an asterisk () are management contracts or compensatory plans or arrangements. 3(i) Certificate of Incorporation of the Company and amendments thereto dated June 14, 1984, July 18, 1988 and July 22, 1988. Incorporated by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 3(ii) By-Laws of the Company. 4(a) Indenture dated December 1, 1986 between Manufacturers Hanover Trust Company, as Trustee, and EDO Corporation. Incorporated by reference to Exhibit 4(b) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(b) Guarantee Agreement, dated as of July 22, 1988, as amended, made by the Company in favor of National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(c) Term Loan Agreement, dated as of July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(d) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(d) Term Note, dated July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(e) Pledge and Security Agreement, dated as of July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(f) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(f) First Amended and Restated Credit Agreement, dated as of March 3, 1994, amongst The Bank of New York, individually and as agent, Chemical Banking Corporation, National Westminster Bank USA and EDO Corporation. 4(g) Amendment No. 6 to the Guarantee Agreement referred to in Exhibit 4(b) above. Incorporated by reference to Exhibit 4(i) to the Company's Annual Report on Form 10-Q for the fiscal year ended December 31, 1992. 4(h) Amendment No. 7 to the Guarantee Agreement referred to in Exhibit 4(b) above, effective March 3, 1994. 10(a) EDO Corporation 1980 Stock Option Plan, as amended through July 22, 1988. Incorporated by reference to Exhibit 10(a) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10(b)* EDO Corporation 1985 Stock Option Plan, as amended through January 24, 1989. Incorporated by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(c)* EDO Corporation 1988 Stock Option Plan as amended through July 22, 1988. 10(d)* EDO Corporation 1983 Long-Term Incentive Plan as amended through July 22, 1988. 10(e)* EDO Corporation 1988 Long-Term Incentive Plan as amended through July 22, 1988. 10(f)* EDO Corporation Executive Termination Agreements, as amended through November 24, 1989, between the Company and four employees. Incorporated by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(g)* Executive Life Insurance Plan Agreements, as amended through January 23, 1990, between the Company and thirty-four employees and retirees. Incorporated by reference to Exhibit 10(h) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(h)* Form of Directors' and Officers' Indemnification Agreements between EDO Corporation and twenty current or former Company directors and officers. Incorporated by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10(i) Subscription Agreement, dated December 18, 1987, between EDO (Canada) Limited and Her Majesty the Queen in right of the Province of Alberta, as represented by the Minister of Economic Development - 6 - and Trade. Incorporated by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10(j) Consent Decree, entered on November 25, 1992, amongst the United States, EDO Corporation, Plessey, Inc., Vernitron Corporation and Pitney Bowes, Inc. Incorporated by reference to Exhibit 10(j) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 13 Annual Report to Shareholders of EDO Corporation for fiscal year ended December 31, 1993. Such report is furnished for the information of the Commission only and, except for those portions thereof which are expressly incorporated by reference in this Annual Report on Form 10-K, is not to be deemed filed as part of this Report (not filed electronically). 13(a) Pages 13-29 of the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 21 List of Subsidiaries. 23 Accountants' Consent to the incorporation by reference in the Company's Registration Statements on Form S-8 of their reports included in the 1993 Annual Report to Shareholders and in Item 14(a)2 hereto. 24 Powers of Attorney used in connection with the execution of this Annual Report on Form 10-K. (b) Reports on Form 8-K A Current Report on Form 8-K was filed on December 2, 1993 reporting on the acquisition by the Company of substantially all the assets of Automotive Natural Gas, Inc. Financial statements associated with and required by such Report were filed on February 14, 1994. - 7 - SIGNATURES Pursuant to the requirements of Section 13 or 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. EDO CORPORATION (Registrant) Dated: March 28, 1994 By: Michael J. Hegarty Michael J. Hegarty Vice President-Finance Pursuant to the requirements of Instruction D to Form 10-K under the Securities Exchange Act of 1934, this Report has been signed below on March 28, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. Signature Title Date - - ------------------------------------------------------------------------------- Michael J. Hegarty Vice President- March 28, 1994 (Michael J. Hegarty) Finance, Secretary, Treasurer and Director Gerald Albert Chairman of the Board, Chief Executive Officer and Director Frank A. Fariello President, Chief Operating Officer and Director Marvin D. Genzer Vice President, General Counsel and Assistant Secretary Kenneth A. Paladino Controller By: Michael J. Hegarty Alfred Brittain III Director Joseph F. Engelberger Director Michael J. Hegarty Robert M. Hanisee Director Attorney-in-Fact Robert A. Lapetina Director March 28, 1994 John H. Meyn Director Richard Rachals Director Ralph O. Romaine Director William R. Ryan Director - 8 - INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders EDO Corporation: Under date of March 4, 1994, we reported on the consolidated balance sheets of EDO Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in the notes to the consolidated financial statements, the Company changed its methods of accounting for income taxes and postretirement health care and life insurance benefits in 1993. KPMG PEAT MARWICK Jericho, New York March 4, 1994 SCHEDULE V EDO CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Balance Retirements, at sales or Balance at beginning Additions other end of Classification of period at cost changes period - - ------------------------------------------------------------------------------- Year ended December 31, 1993: Land and land $2,014 -- -- 2,014 improvements Buildings and 28,167 418 -- 28,585 building improvements Machinery and 49,341 2,786 (341) 51,786 equipment Leasehold 8,715 1,313 (24) 10,004 improvements -------- ------- ------- ------- $88,273 4,517 (365) 92,389 - - ------------------------------------------------------------------------------- Year ended December 31, 1992: Land and land $2,014 -- -- 2,014 improvements Buildings and 27,835 335 (3) 28,167 building improvements Machinery and 45,906 4,093 (658) 49,341 equipment Leasehold 8,621 138 (44) 8,715 improvements -------- ------- ------- ------- $84,376 4,566 (705) 88,237 - - ------------------------------------------------------------------------------- Year ended December 31, 1991: Land and land $2,014 -- -- 2,014 improvements Buildings and 27,523 312 -- 27,835 building improvements Machinery and 41,177 5,388 (659) 45,906 equipment Leasehold 8,850 (91) (138) 8,621 improvements -------- ------- ------- ------- $79,564 5,609 (797) 84,376 - - ------------------------------------------------------------------------------- - 9 - SCHEDULE VI EDO CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Additions Balance charged Retirements, at to costs sales or Balance beginning and other at end Classification of period expenses changes of period - - ------------------------------------------------------------------------------- Year ended December 31, 1993: Land and land $267 29 -- 296 improvements Buildings and 10,767 1,260 5,200 17,227 building improvements Machinery and 31,220 4,318 594 36,132 equipment Leasehold 3,605 844 408 4,857 improvements -------- ------- ------- ------- $45,859 6,451 6,202* 58,512 - - ------------------------------------------------------------------------------- Year ended December 31, 1992: Land and land $238 29 -- 267 improvements Buildings and 9,374 1,396 (3) 10,767 building improvements Machinery and 27,437 4,440 (657) 31,220 equipment Leasehold 3,055 595 (45) 3,605 improvements -------- ------- ------- ------- $40,104 6,460 (705) 45,859 - - ------------------------------------------------------------------------------- Year ended December 31, 1991: Land and land $207 31 -- 238 improvements Buildings and 7,929 1,438 7 9,374 building improvements Machinery and 23,966 4,137 (666) 27,437 equipment Leasehold 2,603 590 (138) 3,055 improvements -------- ------- ------- ------- $34,705 6,196 (797) 40,104 - - ------------------------------------------------------------------------------- * Includes $7,011 valuation allowance associated with restructuring. SCHEDULE X EDO CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Charged to Costs and Expenses Item 1993 1992 1991 - - ---------------------------------------------------------- Maintenance and repairs $2,653 $2,999 $3,380 Amounts for depreciation and amortization of intangible assets, pre-operating costs and similar deferrals, taxes other than payroll and income taxes, royalties and advertising costs are not presented as such amounts are less than 1% of total sales. - 10 - EXHIBIT INDEX Exhibits which are noted with an asterisk () are management contracts or compensatory plans or arrangements. 3(i) Certificate of Incorporation of the Company and amendments thereto dated June 14, 1984, July 18, 1988 and July 22, 1988. Incorporated by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 3(ii) By-Laws of the Company. 4(a) Indenture dated December 1, 1986 between Manufacturers Hanover Trust Company, as Trustee, and EDO Corporation. Incorporated by reference to Exhibit 4(b) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(b) Guarantee Agreement, dated as of July 22, 1988, as amended, made by the Company in favor of National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(c) Term Loan Agreement, dated as of July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(d) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(d) Term Note, dated July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(e) Pledge and Security Agreement, dated as of July 22, 1988, as amended, between The Bank of New York, as trustee of the trust established under the EDO Corporation Employee Stock Ownership Plan, and National Westminster Bank USA as successor in interest to Manufacturers Hanover Trust Company. Incorporated by reference to Exhibit 4(f) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4(f) First Amended and Restated Credit Agreement, dated as of March 3, 1994, amongst The Bank of New York, individually and as agent, Chemical Banking Corporation, National Westminster Bank USA and EDO Corporation. 4(g) Amendment No. 6 to the Guarantee Agreement referred to in Exhibit 4(b) above. Incorporated by reference to Exhibit 4(i) to the Company's Annual Report on Form 10-Q for the fiscal year ended December 31, 1992. 4(h) Amendment No. 7 to the Guarantee Agreement referred to in Exhibit 4(b) above, effective March 3, 1994. 10(a) EDO Corporation 1980 Stock Option Plan, as amended through July 22, 1988. Incorporated by reference to Exhibit 10(a) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10(b)* EDO Corporation 1985 Stock Option Plan, as amended through January 24, 1989. Incorporated by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(c)* EDO Corporation 1988 Stock Option Plan as amended through July 22, 1988. 10(d)* EDO Corporation 1983 Long-Term Incentive Plan as amended through July 22, 1988. 10(e)* EDO Corporation 1988 Long-Term Incentive Plan as amended through July 22, 1988. 10(f)* EDO Corporation Executive Termination Agreements, as amended through November 24, 1989, between the Company and four employees. Incorporated by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(g)* Executive Life Insurance Plan Agreements, as amended through January 23, 1990, between the Company and thirty-four employees and retirees. Incorporated by reference to Exhibit 10(h) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10(h)* Form of Directors' and Officers' Indemnification Agreements between EDO Corporation and twenty current or former Company directors and officers. Incorporated by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10(i) Subscription Agreement, dated December 18, 1987, between EDO (Canada) Limited and Her Majesty the Queen in right of the Province of Alberta, as represented by the Minister of Economic Development and Trade. Incorporated by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10(j) Consent Decree, entered on November 25, 1992, amongst the United States, EDO Corporation, Plessey, Inc., Vernitron Corporation and Pitney Bowes, Inc. Incorporated by reference to Exhibit 10(j) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 13 Annual Report to Shareholders of EDO Corporation for fiscal year ended December 31, 1993. Such report is furnished for the information of the Commission only and, except for those portions thereof which are expressly incorporated by reference in this Annual Report on Form 10-K, is not to be deemed filed as part of this Report (not filed electronically). 13(a) Pages 13-29 of the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 21 List of Subsidiaries. 23 Accountants' Consent to the incorporation by reference in the Company's Registration Statements on Form S-8 of their reports included in the 1993 Annual Report to Shareholders and in Item 14(a)2 hereto. 24 Powers of Attorney used in connection with the execution of this Annual Report on Form 10-K.	6,135	41,672
317833_1993.txt	317833_1993	1993	317833	ITEM 1 Business Introduction Great American Communications Company ("GACC") is a holding company engaged primarily in the ownership and operation of television and radio stations. Its address is One East Fourth Street, Cincinnati, Ohio 45202 and its telephone number is (513) 562-8000. American Financial Corporation and its chairman, Carl H. Lindner, (collectively, "AFC") owned approximately 32.5% of GACC's outstanding Common Stock at March 1, 1994. GACC's principal operations are conducted through its wholly-owned subsidiary, Great American Television and Radio Company, Inc. ("GATR"). On December 28, 1993, GACC completed its comprehensive financial restructuring through a prepackaged plan of reorganization under chapter 11 of the U.S. Bankruptcy Code. As part of the reorganization, GACC effected a one-for-300 reverse stock split and issued approximately 10.1 million shares of Class A Common Stock, 1.2 million shares of Class B Common Stock and $72.5 million principal amount of 14% Senior Extendable Notes initially due June 30, 2001 (the "14% Notes") in exchange for $288 million principal amount of debt, $275 million liquidation value of preferred stock of a subsidiary and $7.5 million in cash. As a result of the reorganization, indebtedness and preferred stock obligations have been reduced from $910 million to $433 million, and annual fixed charges (interest and preferred stock dividends) have been reduced from more than $94 million to approximately $41 million. The prepackaged plan of reorganization is discussed in further detail in Note B to GACC's Financial Statements. The term "Common Stock" as used herein refers to both the Class A and Class B Common Stock. The differences in these two securities are discussed in Item 5 and Note H to GACC's Financial Statements. On February 18, 1994, GACC refinanced its 14% Notes and the 13% Senior Subordinated Notes due 2001 issued by Great American Broadcasting Company ("GABC"), one of GACC's subsidiaries, through the issuance of 9-3/4% Senior Subordinated Notes due 2004. General At December 31, 1993, GATR owned and/or operated six network- affiliated television stations, twelve FM radio stations and five AM radio stations. The following tables give the location, network affiliation and market information for these stations: Substantially all of GATR's broadcast revenues come from the sale of advertising time to local and national advertisers. Local advertisements are sold by each station's sales personnel and national spots are sold by independent national sales representatives. GATR's television and radio stations compete for revenues with other stations in their respective signal coverage areas as well as with all other advertising media. Advertising revenues are significantly affected by economic conditions on both the national and local level. GATR's television stations receive a significant portion of their programming from their respective networks; the networks sell commercial advertising time within such programming. The competitive position of the stations is directly affected by viewer acceptance of network programs. In recent years, the national audience shares obtained by the networks have declined as a result of increased competition from cable television networks and other competing program sources. As of 1991, these declines began to diminish and it is expected that significant declines will not occur during the next several years. The non-network programs broadcast by the stations are either produced by the stations or acquired from other sources. Locally originated programs include a wide range of show types such as entertainment, news, sports, public affairs and religious programs. Broadcast stations also compete for audience with other forms of home entertainment, such as cable television, pay television systems of various types and home video and audio recordings. These competing services, which have the potential of providing improved signal reception or increased home entertainment selection, have experienced rapid growth in recent years. The major competing television services today are provided by a large number of advertiser-supported and pay cable television networks. Cable subscribership is presently slightly under 60% of television households in the United States, and is not expected to grow beyond 65% within the next several years. There are other related forms of home entertainment which, with continued technological advances or regulatory changes, can be expected to become increasingly competitive with GATR's broadcast properties. In addition, statutory or regulatory changes may affect the competition faced by GATR. For example, the Federal Communications Commission ("FCC") now permits telephone companies to deliver video services to homes in the companies' telephone service areas, but only on a common carrier basis. Telephone companies continue to seek authority from the FCC and from Congress to become cable operators and thereby to compete directly with presently existing cable systems. Because most radio programming originates locally, network affiliation has little effect upon the station's competitive position within the market. GATR's AM radio stations offer their listeners a wide range of programs including news, music, discussion, commentary and sports. GATR's FM radio stations offer primarily album oriented rock, classic rock and contemporary hit music programming, designed to appeal to a more youthful audience. Companies that operate radio stations must always be alert to the possibility of another station changing its programming format to compete directly for listeners and advertisers. If another station converts to a format similar to that of one of GATR's radio stations in the same geographic area, the result could be lower ratings and advertising revenue, increased promotion and other expenses and consequently lower operating results. FCC rules permitting ownership of two FM and/or two AM radio stations in certain markets (a "duopoly") have created opportunities for GATR to increase its share of advertising revenues in its existing markets and may allow certain synergies such as reduced operating expenses resulting from combined administrative staffs, combined promotional efforts, and the ability to offer advertisers a larger combined audience. GATR expects in the near future to purchase, sell or exchange radio stations in order to avail itself of the considerable operating opportunities presented by the duopoly rules. Pursuant to this effort, GATR expects to close during the second quarter of 1994 the purchase of a second FM radio station in Sacramento, and has recently announced the agreement in principle to acquire a second FM radio station in Cincinnati. Regulation GATR's business is subject to various federal and state laws and regulations which can affect the profitability of operations. GATR's television and radio broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended. Among other things, FCC regulations govern issuance, term renewal and transfer of licenses which are necessary for operation of television and radio stations. Upon application, and in the absence of conflicting applications (which would require the FCC to hold a hearing) or adverse findings as to the licensee's qualifications, such licenses are renewed without hearing for regular terms of five years for television stations and seven years for radio stations. Representatives of special interest and minority groups have, in the past, filed petitions to deny renewal applications of various broadcast stations. All of GATR's broadcast stations presently operate under regular renewal authorizations. A license renewal application is currently pending with respect to GATR's television station in Birmingham. Two organizations have filed petitions with the FCC to deny the license renewal application of GATR's Birmingham television station, alleging the station has failed to meet the FCC's equal employment opportunity requirements. GATR has opposed the petitions and expects that the license will be renewed. Grant of the renewal will continue to be delayed until the FCC has considered these petitions. The FCC's present rules permit maximum national ownership of eighteen AM and eighteen FM radio stations. A single owner may own a maximum of two AM and two FM stations in larger radio markets such as those in which GATR operates stations, so long as the combined audience share served by those stations in a single market does not exceed 25%. The FCC's rules currently permit ownership of twelve television stations nationally, and one television station in each market. Current FCC regulations also prohibit the ownership of both radio and television stations in the same geographic market area. Pursuant to waivers of those rules granted by the FCC, GATR currently owns both radio and television stations in four markets: Cincinnati, Ohio; Kansas City, Missouri; Tampa, Florida; and Phoenix, Arizona. None of the FCC waivers are limited as to time, but it is possible that the FCC might, in the future, prohibit the sale of all of the stations in any of these markets to a single purchaser. GATR's planned acquisition of a second FM radio station in Cincinnati will require a further waiver of the FCC's rules. A pending rulemaking proceeding before the FCC proposes to relax or eliminate several multiple ownership rules with respect to television and with respect to radio/television stations in the same market. The timing and substantive outcome of that rulemaking are uncertain. Legislation adopted in 1992 affords most television licensees the right either to have their station's signals carried on local cable systems or, alternatively, to require that operators of local cable systems obtain "retransmission consent" to carry each television station's signal on cable. All of GATR's television stations are presently carried by cable systems in their local service areas in most cases pursuant to retransmission consent agreements. Current technology offers several different methods of transmitting television with greatly improved definition, color rendition, sound and a wider screen picture. The most advanced type of transmission system is referred to as High Definition Television ("HDTV"). HDTV transmissions from communications satellites to homes equipped with special HDTV receivers have begun on a limited basis in Japan, but such transmissions are incompatible with reception by current television sets in use in the United States. The FCC is expected in 1995 to promulgate a technical standard or standards for a system of HDTV broadcasting to be used in the U.S. The type of HDTV standard that will be adopted by the FCC will involve the broadcast of HDTV on a separate television channel than that used for conventional broadcasting, and would thus require participating broadcasters to make significant new capital investments in order to operate a second station in each market. If broadcast stations fail to make this additional investment, they would in the long term be likely to suffer adverse competitive effects, since cable television, VCRs and direct broadcast satellites are likely to deliver HDTV signals or programs to consumers. Although these regulatory proceedings with respect to HDTV and HDTV standards are in process, GATR does not believe HDTV will be a significant factor over the next few years. After the final standards are set, manufacturers must gear up to produce both transmission equipment and receivers under the standard. Finally, penetration of the new HDTV receivers in the consumer marketplace will need to reach certain levels before stations commit to the capital investment necessary to broadcast HDTV. The FCC is also investigating new methods of "digital" radio broadcasting. "Digital radio" would permit radio transmission and reception at a level of quality comparable to that afforded by compact discs, and would be far less subject to interference than present radio broadcasts. Present day radio receivers would not be able to receive digital radio broadcasts because digital radio, in addition to utilizing different technology, may use totally different transmission frequencies than used by present radio stations. As the result of frequency allocations made by the World Administrative Radio Conference in 1992, digital radio is expected to be developed initially in the U.S. as a satellite-delivered system, and in Europe, Canada and Mexico as a terrestrial system. If terrestrial digital radio is implemented in the U.S., it will likely be through the use of "in-band" systems that send digitalized signals over the frequencies currently used for AM and FM broadcasting. Several U.S. industry groups are already experimenting with the development of such "in-band" technology. The outcome of various proceedings currently pending before the FCC concerning digital radio broadcasting may affect the long-term value of GATR's radio franchises either positively or negatively, although it is not presently anticipated that any commercial digital radio broadcasting will begin in the United States before 1996. While the FCC relies largely on the interplay of marketplace forces in lieu of direct government regulation, the FCC continues to regulate closely some aspects of broadcast station operations. Examples of such regulation include equal employment practices, political broadcast practices and rates, television stations' performance in providing educational and informational programs for children, television stations' compliance with maximum commercial limits in children's programs, and compliance with various technical regulations. It is also FCC policy to encourage increasing competition among different electronic communications media. As a result of rapidly developing technology, GATR's television stations can be expected to confront increased competition from many other systems by which information and entertainment are delivered to the home on both a free and paid basis. Such competing delivery systems include cable television, direct broadcasting to homes by communications satellites, new low power television stations authorized by the FCC, pay television delivered to homes via microwave by "wireless cable" systems, common carriers and videocassettes. The FCC now permits telephone companies to deliver video services to homes in the companies' telephone service areas, but only on a common carrier basis. Telephone companies continue to seek authority from the FCC and from Congress to become cable operators and thereby to compete directly with presently existing cable systems. Employees At December 31, 1993, GATR and its subsidiaries employed approximately 1,300 full-time employees and 250 part-time employees. ITEM 2 ITEM 2 Properties GATR owns all of its television station studios, buildings and transmission sites, except the Phoenix transmission site for which the lease expires in 2012. It owns its radio studios and buildings in Cincinnati, Kansas City and Milwaukee. All other radio station studios are operated from leased facilities. GATR owns all of its AM station transmission sites (other than Phoenix for which the lease expires in 1997) and owns its FM station transmission sites in Cincinnati, Kansas City, Milwaukee and Sacramento. GATR leases its FM station transmission sites in Atlanta, Columbus, Denver, Detroit, Portland, Phoenix and Tampa pursuant to term leases expiring in 1998, 2003, 1994, 1996, 2001, 2000 and 2027, respectively. ITEM 3 ITEM 3 Legal Proceedings An action styled W. Kenneth Tregenza, et al. v. Great American Communications Company, et al., (92-C-6384), was filed in September 1992 in the United States District Court for the Northern District of Illinois, Eastern Division. The defendants are GACC and Shearson, Lehman Brothers ("Shearson"). The action purports to be a class action on behalf of persons who purchased or otherwise acquired the Common Stock of GACC from October 11, 1989 to December 17, 1991. Plaintiffs in the action allege that certain transactions, pursuant to which GACC issued Common Stock in exchange for debt securities in October 1989, should have been effected pursuant to a registration statement. Plaintiffs also allege that material misrepresentations and omissions occurred in connection with the sales by Shearson of the stock subsequent to the exchange. The complaint asserts claims against GACC under Section 12(2) of the Securities Act of 1933, Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, and under the Illinois Securities Act. The complaint sought rescission regarding the purchase of approximately 3.65 million shares involving a monetary value of approximately $44 million. Motions by GACC and Shearson to dismiss the action were granted in May 1993. On December 23, 1993, the United States Court of Appeals for the 7th Circuit affirmed the District Court's dismissal of the Plaintiff's action. The Plaintiff's have filed a petition for certiorari with the United States Supreme Court. On December 21, 1993, Coronet Insurance Company and its affiliate, Casualty Insurance Company of Florida, filed an appeal from the decision of the U.S. Bankruptcy Court for the Southern District of Ohio confirming GACC's prepackaged plan of reorganization. The appeal, Coronet Insurance Company, et al. v. Great American Communications Company, (C-1-94-018), is now pending before the U.S. District Court for the Southern District of Ohio. Coronet contends that the Bankruptcy court erred in approving the settlement and release of certain claims by GACC as part of the reorganization. Coronet's appeal seeks reversal of only that portion of the confirmation order approving the settlement and release. Coronet contends that there was not a "sufficient factual foundation" for approving the settlements under Federal Rule of Bankruptcy Procedure 9019, because specific dollar values were not assigned to the released claims. The Bankruptcy Court found that valuation of the released claims was not possible, and that a sufficient factual foundation existed without such a valuation. Briefs on the merits of the appeal have been filed. GACC has also moved to dismiss the appeal on grounds that it is moot, due to consummation of the plan of reorganization. That motion is also pending. ITEM 4 ITEM 4 Submission of Matters to a Vote of Security Holders The Registrant solicited acceptances of its joint prepackaged plan of reorganization during October and early November 1993; the voting deadline was November 3, 1993. Votes were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934. Shareholders approved the joint prepackaged plan of reorganization with 40,441,023 shares cast in favor of the plan, 1,199,274 shares voted against the proposal and 15,089,137 shares not voted. The plan was also approved by the requisite percentage of each class of security holders and other claimants as required by the Bankruptcy Code. The results of the vote by those security holders are listed below: The plan was also unanimously approved by the holders of two other debt issues not registered under the Securities Exchange Act of 1934; the 9-1/2% Senior Secured Notes of New GACC Holdings, Inc. and GACC's Variable Rate Convertible Subordinated Debentures. PART II ITEM 5 ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters GACC's Class A Common Stock, issued in the reorganization on December 28, 1993, began trading on the National Market System of the National Association of Securities Dealers Automated Quotations Systems, Inc. ("NASDAQ") on December 31, 1993 under the symbol "GACC". As a result of the effects of the reorganization (primarily the reverse stock split, the issuance of substantial amounts of equity securities in exchange for debt securities, and the division of the common stock into two classes), per share prices quoted prior to the reorganization have been rendered meaningless and are not comparable to sales prices for GACC's Class A Common Stock subsequent to the reorganization. The following table sets forth, for the periods indicated, the high and low per share sales prices of the Class A Common Stock on the NASDAQ National Market System: High Low 1993: Fourth Quarter (December 31, 1993 only) $16.75 $16.63 1994: First Quarter (through March 1, 1994) 18.38 16.00 The Class B Common Stock is not traded. The Class A Common Stock and the Class B Common Stock have the same rights and characteristics except that the holders of Class A Common Stock are entitled to one vote for each share of Class A Common Stock held of record, while holders of Class B Common Stock are entitled to one vote for each five shares of Class B Common Stock held of record. Shares of Class B Common Stock are convertible (on a one-for-one basis) into shares of Class A Common Stock either at the option of the holders thereof or automatically upon the sale of such shares. The number of holders of record of GACC's Class A Common Stock at March 1, 1994 was approximately 2,100. At March 1, 1994, there was one holder of record of GACC's Class B Common Stock. GACC did not pay any dividends on its Common Stock in 1993 or 1992. Pursuant to GACC's debt covenants, GACC is prohibited from making any dividend payments on its Common Stock. ITEM 6 ITEM 6 Selected Financial Data The following table (in millions) sets forth certain data for the periods indicated and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations": As a result of GACC's emergence from bankruptcy and its adoption of fresh-start reporting as of December 31, 1993, GACC's Balance Sheet at and after December 31, 1993 and its Statements of Operations for periods after December 31, 1993 will not be comparable to the Financial Statements for periods included elsewhere herein. See Notes to Financial Statements. ITEM 7 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL The following discussion should be read in conjunction with the Financial Statements beginning on page. For purposes of the following discussion, the term "Predecessor" refers to GACC prior to its emergence from chapter 11 bankruptcy. LIQUIDITY AND CAPITAL RESOURCES On December 28, 1993, GACC and its principal subsidiaries successfully completed a comprehensive financial restructuring. The restructuring had been designed to address GACC's severe liquidity difficulties by: (i) reducing total indebtedness; (ii) extending scheduled principal payments and maturities; and (iii) reducing interest rates, cash interest payments and cash dividends on preferred stock. The restructuring, accomplished largely through a prepackaged plan of reorganization under chapter 11 of the U.S. Bankruptcy Code, had the following principal components: * GACC effected a one-for-300 reverse stock split, reducing the number of common shares outstanding immediately prior to the reorganization from 56.7 million to approximately 189,000 shares. The Class A Common Stock issued in the reverse stock split resulted in the pre-reorganization stockholders owning approximately 1.7% of the common stock of reorganized GACC. * Debt of GACC and two of its former subsidiaries (carrying value of approximately $288 million) and preferred stock of one of its former subsidiaries ($274.9 million liquidation value), were then exchanged for $66.2 million principal amount of 14% Notes, 9.8 million shares of Class A Common Stock and 1.2 million shares of Class B Common Stock. The 14% Notes allowed for the payment of interest in-kind through June 30, 1996, thereafter, interest was to be payable entirely in cash. The Class A and Class B Common Stock issued in these exchanges resulted in the holders of these securities owning approximately 98.3% of the voting common stock of reorganized GACC. * Two of GACC's subsidiaries reached consensual agreements with their creditors to extend the maturities of their debt obligations. GABC exchanged its 13% Senior Subordinated Notes due 2000 for 13% Senior Subordinated Notes due 2001 and GATR's bank debt due March 1995 was restructured through a new bank credit facility due December 1998 and through a new issue of 9-1/2% Notes due December 1999. As a result of the foregoing, AFC's holdings of common stock, debt securities ($44.6 million), preferred stock ($274.9 million liquidation value) and a line of credit ($42.5 million) were exchanged for Class A Common Stock equal to 33.2% of the common stock of reorganized GACC. In addition, AFC purchased approximately $6.3 million principal amount of 14% Notes and 94,837 shares of Class A Common Stock for a required capital contribution of $7.5 million in cash. On February 18, 1994, GACC refinanced the 14% PIK Notes due 2001 and GABC's 13% Senior Subordinated Notes due 2001 through the issuance of $200 million of 9-3/4% Senior Subordinated Notes due 2004. The following table (in millions) presents the effects of the reorganization and refinancing on projected minimum debt service and preferred stock dividend requirements for the next five years: GACC is a holding company and depends on advances, dividends and tax allocation payments from its operating subsidiary to meet its expenditures for administrative expenses and debt service obligations. Restrictions in GATR's debt agreements limit the amount of distributions GATR may make to GACC. All such distributions would be prohibited if GACC or its subsidiaries were not in compliance with the agreements. At December 31, 1993 and March 1, 1994 GACC and its subsidiaries were in compliance with such agreements and sufficient funds were available to meet GACC's administrative and debt service expenditures. The debt instruments of GACC and its subsidiaries also limit the amount of additional debt that can be incurred. Under the most restrictive of these covenants the additional debt capacity of GACC and its subsidiaries was $10 million. Based upon current levels of operations and anticipated growth it is expected that operating cash flow will be sufficient to meet expenditures for operations (including capital expenditures), administrative expenses and debt service through September 1998. GATR's bank credit facility requires a final maturity principal payment of $114 million in December 1998, exclusive of any excess cash sweeps prior to that date. Therefore, prior to December 31, 1998, GACC will be required to refinance GATR's bank credit facility or dispose of operating assets in order to make the final maturity payment. Unrelated to the future need to refinance the bank credit facility, GACC expects to continue in the near future to purchase, sell or exchange broadcast stations in order to avail itself of the considerable operating opportunities presented by new radio duopoly rules which permit ownership of up to two AM and two FM stations in markets in which GACC presently has radio operations. In furtherance of this strategy, GATR expects to close by second quarter's end the purchase of an additional FM radio station in Sacramento, and has recently announced the agreement in principle to acquire an additional FM radio station in Cincinnati. These purchases will be financed, in part, by the sales of GACC's radio stations in Denver, Detroit and Milwaukee. Management has also recently received expressions of interest from third parties regarding the purchase or sale of television stations and radio stations that do not present immediate duopoly opportunities. In several cases, discussions have ensued and are continuing between management and such interested third parties regarding transactions of this nature, but no agreements have been reached as management intends to continue its evaluation of potential sales and purchases in light of prevailing market and economic conditions, business prospects, industry trends and regulatory developments, and to recommend to the Board those proposals which may best maximize shareholder values. RESULTS OF OPERATIONS On December 28, 1993, GACC completed its comprehensive financial restructuring through a prepackaged plan of reorganization under chapter 11 of the Bankruptcy Code. Pursuant to the reporting principles of AICPA Statement of Position No. 90-7 entitled "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), GACC revalued its assets and liabilities to estimated fair values upon consummation of the restructuring. See Note B to the Financial Statements. In 1992, GACC recorded a provision for the revaluation of its broadcast intangible assets, reducing intangibles by $658.3 million as of December 31, 1992, to reflect the carrying value of its broadcasting assets at estimated fair values at that time, as shown under the heading "costs and expenses" in the Statement of Operations. The net earnings in 1991 and 1993 and the net loss in 1992 include significant gains from asset sales and debt refinancing transactions. GACC realized gains from asset sales, debt refinancing transactions and debt discharge totaling $218.5 million, $27 million and $408.1 million in 1991, 1992 and 1993, respectively. Gains from these types of transactions are not part of normal operations and no assurance can be given that such transactions will recur in the future or if they recur that gains will result. The financial results of GACC's business are seasonal. Television revenues are generally higher in the second and fourth calendar quarters than in the first and third quarters. The amount of broadcast advertising time available for sale by GATR's stations is relatively fixed, and by its nature cannot be stockpiled for later sale. Therefore, the primary variables affecting revenue levels are the demand for advertising time, the viewing or listening audience of the station and the entry of new stations in the marketplace. The major variable costs of operation are programming (entertainment, news and sports), sales costs related to revenues and promotional costs. The success of the programming determines the audience levels and therefore affects revenue. GACC's management believes that operating income before depreciation and amortization is helpful in understanding cash flow generated from its broadcasting operations which is available for debt service, capital expenditures and taxes, and in comparing operating performance of GACC's broadcast stations to other broadcast stations. Operating income before depreciation and amortization is also a key factor in GACC's assessment of station performance. Operating income before depreciation and amortization should not be considered an alternative to net income as an indicator of GACC's overall performance. Net revenues and operating income are shown below (in thousands): 1991 compared to 1992 Television revenues increased $20.5 million (17%) during the year ended December 31, 1992; $12.6 million of this increase was due to the acquisition of the North Carolina television station in late December 1991. The 1992 revenue increase at the five stations owned during both years was $7.8 million (6.5%). The local and national elections, the Olympics and the beginning of the turnaround in the economy increased the demand for television time during 1992. Political advertising revenues for GACC's six television stations amounted to $4.2 million in 1992. Although political advertisements are required by law to be sold at a station's lowest rates, the effects on a television station's results are not all negative. Television stations have a relatively fixed supply of advertising time available for sale, therefore, political advertising tends to cause stations to reach "sell-out" levels more quickly. This contributes to an increase in the overall rate charged for advertising time, which, in turn, results in increased revenues. The Winter Olympics were aired on GACC's CBS affiliate in Phoenix; the Summer Olympics were aired on GACC's NBC affiliate in Kansas City. Radio revenues decreased $11.1 million (15%) during 1992 resulting primarily from the sale of GACC's radio stations in Indianapolis and Pittsburgh in January of 1992, partially offset by the purchase of the radio stations in Phoenix in April 1992. Radio revenues were, on a same station basis, slightly above 1991 revenue levels. Revenues were down in the first and third quarters and up in the second and fourth quarters of the year. The Olympics and the elections did not have a significant effect on GACC's radio stations. Excluding the $658.3 million charge for revaluation of intangible assets and operating income attributable to stations sold or acquired in 1991-1992, operating income increased $6.4 million (89%) due primarily to increased television station revenues. 1992 compared to 1993 Television revenues decreased $1.2 million (less than 1%) in 1993 due primarily to the fact that Kansas City Royals' baseball broadcasts which had aired on GACC's Kansas City television station during 1992 did not air in 1993. The loss of revenues related to political advertising and the Olympics was totally offset in 1993 by increased sales to other advertisers. Radio revenues increased $1.2 million (2%) during the year ended December 31, 1993. Excluding GACC's AM radio station in Cincinnati which was sold, radio revenues increased $3.6 million (6%) primarily as a result of increased demand for radio advertising time. GACC disposed of its television program venture when it sold its 20% interest in the assets and operations of the "Entertainment Tonight" joint venture in December 1992. Operating income increased $682 million in 1993 due primarily to: (i) the $658.3 million provision for the revaluation of intangibles in December 1992 and the related decrease in amortization expense of $18.9 million for the year ended December 31, 1993; and (ii) a $5.6 million decline in revenues from television program ventures as a result of the sale of GACC's interest in "Entertainment Tonight". Excluding these items and operating results from stations sold or acquired during 1992, operating income increased $8.6 million (28%) during 1993 due primarily to decreased expenses. The majority of the expense decrease is a result of reductions in programming costs at GACC's television stations, including the elimination of the costs associated with the Kansas City Royals' baseball broadcasts. Outlook - three months ended March 31, 1993 compared to March 31, 1994 Given the January and February 1994 results and advertising orders already received for March, GACC expects to report material increases in net revenues and operating income before depreciation and amortization for its broadcast stations during the first quarter of 1994 compared to the first quarter of 1993. Other Income (Expense) Information Interest expense decreased $20 million (22%) during 1992 compared to 1991, reflecting primarily refinancings and retirements of long-term debt and, to a lesser extent, lower interest rates. Interest expense decreased $4.9 million (7%) during 1993, compared to 1992. In accordance with the provisions of SOP 90-7, GACC did not accrue interest totaling $4.9 million on debt subject to exchange after the filing of the bankruptcy petition (November 5, 1993). Included in "Miscellaneous, net" are the following items (in thousands): Reorganization Items Reorganization items represent the expenses incurred as a result of the chapter 11 filings and subsequent reorganization, including, among other things, the adjustments to record the fair values of assets and liabilities at December 31, 1993 (see Note B to GACC's Financial Statements). Discontinued Operations Discontinued operations consisted of the following (in thousands): In 1992 GACC recognized a net gain from the distribution of cash proceeds withheld from the 1991 sale of its entertainment businesses and operations. In addition, GACC recognized a net gain in 1992 from the receipt of additional proceeds related to the 1989 sale of Mid-Continent Casualty Company. GACC's discontinued operations are discussed in greater detail in Note L to the Financial Statements. Income Taxes As discussed in Note K to the Financial Statements, GACC has substantial net operating loss carryforwards, a substantial portion of which are presently unavailable to offset future taxable income. GACC's ability to utilize such operating loss carryforwards has been severely restricted as a result of the completion of its comprehensive financial restructuring. Impact Of Inflation The impact of inflation on GACC's businesses has declined over the last few years with the significant slowing of the inflation rate. GACC does not believe inflation adjusted financial information is either easily understandable or particularly informative in the context of GACC's current businesses. Overall, GACC does not believe that inflation presently has a material impact on its results of operations or financial position. ITEM 8 ITEM 8 Financial Statements and Supplementary Data PART III The information required by the following Items will be included in GACC's definitive Proxy Statement which will be filed with the Securities and Exchange Commission in connection with the 1994 Annual Meeting of Shareholders and is incorporated herein by reference: ITEM 10 ITEM 10 Directors and Executive Officers of the Registrant ITEM 11 ITEM 11 Executive Compensation ITEM 12 ITEM 12 Security Ownership of Certain Beneficial Owners and Management ITEM 13 ITEM 13 Certain Relationships and Related Transactions REPORT OF INDEPENDENT AUDITORS Board of Directors Great American Communications Company We have audited the accompanying balance sheets of Great American Communications Company and subsidiaries as of December 31, 1993 and 1992, and the related statements of operations, shareholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As more fully described in Note B to the financial statements, effective December 28, 1993, the Company emerged from bankruptcy pursuant to a plan of reorganization confirmed by the Bankruptcy Court on December 7, 1993. In accordance with an American Institute of Certified Public Accountants Statement of Position, the Company has adopted "fresh-start reporting" whereby its assets, liabilities, and new capital structure have been adjusted to reflect estimated fair values as of December 31, 1993. As a result, the balance sheet as of December 31, 1993 reflects the successor Company's new basis of accounting and, accordingly, is not comparable to the predecessor Company's pre-reorganization balance sheet. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Great American Communications Company and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Cincinnati, Ohio March 4, 1994 GREAT AMERICAN COMMUNICATIONS COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS A. ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying financial statements include the accounts of Great American Communications Company ("GACC") and its subsidiaries. Significant intercompany balances and transactions have been eliminated. On December 28, 1993 GACC completed its comprehensive financial restructuring through a prepackaged plan of reorganization under chapter 11 of the Bankruptcy Code (see Note B for a description of the plan of reorganization). Pursuant to the reporting principles of AICPA Statement of Position No. 90-7 entitled "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), GACC adjusted its assets and liabilities to their estimated fair values upon consummation of the reorganization. The adjustments to reflect the consummation of the reorganization as of December 31, 1993, including among other things, the gain on debt discharge and the adjustment to record assets and liabilities at their fair values, have been reflected in the accompanying financial statements. The Balance Sheet at December 31, 1992 and the Statements of Operations, Changes in Shareholders' Equity (Deficit) and Cash Flows for the three years ended December 31, 1993 are presented on a historical cost basis without giving effect to the reorganization. Therefore, GACC's Balance Sheet as of December 31, 1993 is generally not comparable to prior periods and is separated by a line (see Note B). For purposes of the financial statements, the term "Predecessor" refers to GACC prior to its emergence from chapter 11 bankruptcy. All acquisitions have been treated as purchases. The accounts and results of operations of companies since their formation or acquisition are included in the consolidated financial statements. At March 1, 1994, American Financial Corporation and its Chairman, Carl H. Lindner, (collectively "AFC") owned 3,683,001 shares of GACC's outstanding Class A Common Stock, representing approximately 32.5% of GACC's outstanding Common Stock, including the Class A and Class B Common Stock. BROADCAST PROGRAM RIGHTS The rights to broadcast non-network programs on GACC's television stations are stated at cost, less accumulated amortization. These costs are charged to operations on a straight-line basis over the contract period or on a per showing basis, whichever results in the greater aggregate amortization. PROPERTY AND EQUIPMENT Property and equipment are based on cost and depreciation is calculated primarily using the straight-line method. Depreciable lives are: land improvements, 8-20 years; buildings and improvements, 8-40 years; operating and other equipment, 3-20 years; and leasehold improvements, over the life of the lease. CONTRACTS, BROADCASTING LICENSES AND OTHER INTANGIBLES Contracts, broadcasting licenses and other intangibles represent the excess of the value of the broadcast station over the values of their net tangible assets, and is attributable to FCC licenses, network affiliation agreements and other contractual or market related factors. Reorganization value in excess of amounts allocable to identifiable assets represents the excess of the estimated fair value of GACC at the time of the reorganization over the estimated fair value allocated to its net identifiable assets. Intangible assets are being amortized on a straight-line basis over an average of 34 years. INCOME TAXES GACC files a consolidated Federal income tax return which includes all 80% or more owned subsidiaries. Deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized. EARNINGS (LOSS) PER SHARE As a result of the effects of the reorganization, per share data for periods ending on or prior to December 31, 1993 have been rendered meaningless and, therefore, per share information has been omitted from the accompanying financial statements for those periods. STATEMENT OF CASH FLOWS For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. All other activities are considered "operating". Short-term investments for purposes of the financial statements are those which had a maturity of three months or less when acquired. B. PLAN OF REORGANIZATION On December 28, 1993, GACC completed its comprehensive financial restructuring that was designed to enhance its long-term viability by adjusting its capitalization to reflect current and projected operating performance levels. GACC accomplished the reorganization of its debt and preferred stock obligations through "prepackaged" bankruptcy filings made under chapter 11 of the Bankruptcy Code by GACC and two of its former non- operating subsidiaries. GACC's other subsidiaries (including its primary operating subsidiary, Great American Television and Radio Company, Inc., "GATR"), were not parties to any such filings under the Bankruptcy Code. The restructuring process that began in 1992 ultimately resulted in the solicitation of acceptances for a prepackaged plan of reorganization in October and early November 1993. The plan of reorganization described below was overwhelmingly approved by the creditors and shareholders. GACC filed its bankruptcy petition with the Bankruptcy Court on November 5, 1993. The plan was confirmed on December 7, 1993 and became effective on December 28, 1993. The plan included extending the maturities of senior bank indebtedness and the 13% Senior Subordinated Notes due December 2000 of GACC's subsidiary, Great American Broadcasting Company ("GABC"), reducing GACC's overall debt service requirements and eliminating the preferred dividend requirements of GACC's former subsidiary, GACC Holding Company ("Holding"). Under the terms of the plan the following occurred: * GACC effected a reverse stock split; issuing one share of a new class of capital stock, the Class A Common Stock, for each 300 shares of common stock outstanding prior to the reorganization. * Approximately $140 million principal amount of the 9-1/2% Senior Secured Notes due in 2000 were exchanged for $65 million principal amount of 14% Senior Extendable Notes initially due June 30, 2001 (the "14% Notes"), including accrued interest from June 30, 1993, and shares of Class A and Class B Common Stock equal to 35.1% of the adjusted common stock of the reorganized entity. The interest on the 14% Notes was allowed to be paid-in-kind through the issuance of additional notes through June 30, 1996, thereafter, interest was to be payable entirely in cash (see Note F). The terms of the Class A and Class B Common Stock are summarized in Note H. * Holders of approximately $59 million principal amount of GACC's and Holding's debt (including the 20-1/2% Senior Notes, $10.3 million of the 14-1/8% Senior Notes, the 14-3/8% Senior Subordinated Debentures, the 9% Senior Subordinated Notes and the 11% Senior Debentures) received either a combination of 14% Notes and Class A Common Stock or solely Class A Common Stock in exchange for their debt securities. These holders were issued shares of Class A Common Stock amounting to approximately 29.3% of the common stock of the reorganized entity and $1.2 million principal amount of 14% Notes. * Holders of the Variable Rate Convertible Subordinated Debentures received Class A Common Stock equal to 0.5% of the common stock of the reorganized entity. * Approximately $87 million principal amount of GACC's and its subsidiaries' debt (including the $42.5 million outstanding balance of the subordinated line of credit with AFC, $21.9 million of the 9-1/2% Senior Secured Notes held by AFC and $22.6 million principal amount of the 14-1/8% Senior Notes held by AFC's Chairman), approximately $275 million liquidation value of Holding's Preferred Stock and approximately 22.8 million shares of common stock held by AFC before the reorganization were exchanged for Class A Common Stock equal to 33.2% of the common stock of the reorganized entity. * AFC fulfilled a commitment to contribute $7.5 million in cash for which it received approximately $6.3 million principal amount of 14% Notes and 94,837 shares of Class A Common Stock. The following unaudited table (in millions) illustrates the effects of the reorganization on projected cash debt service and preferred dividend requirements over the next five years: Reorganized Predecessor GACC Capital Capital Increase Structure Structure (Decrease) 1994 $185.0 $ 51.7 ($133.3) 1995 162.4 55.7 (106.7) 1996 147.4 55.5 (91.9) 1997 91.7 67.5 (24.2) 1998 90.8 175.5 84.7 Total $677.3 $405.9 ($271.4) The following assumptions were used to prepare the foregoing table: * Assumes current interest rates on the bank credit facilities. * Assumes all pay-in-kind notes in the respective capital structures are paid-in-kind for the maximum amount of time permitted under the respective agreements. * Amounts do not include any principal payments that might be due as a result of the cash sweep feature of the bank credit facility. Under the terms of the cash sweep, all cash on hand in excess of $7.5 million would be used to prepay bank debt. The effect of any such cash flow sweep would be to increase the cash debt service payments in 1995, 1996 and 1997 and to decrease the final payment due in 1998. The net expense incurred as a result of the chapter 11 filings and subsequent reorganization has been segregated from ordinary operations in the Statement of Operations. Reorganization items for 1993 include the following (in thousands): Financing Costs $25,967 Adjustments to fair value (15,961) Professional fees and other expenses related to bankruptcy 4,914 Interest Income (48) $14,872 Financing costs consist of the unamortized portion of original issue discount and deferred financing costs relating to debt subject to exchange as of the date the petition for bankruptcy was filed (November 5, 1993). Adjustments to fair value reflect the net change to state assets and liabilities at estimated fair value as of December 31, 1993. Interest income is attributable to the accumulation of cash and short-term investments after commencement of the chapter 11 cases. Pursuant to the fresh-start reporting provisions of SOP 90-7, GACC's assets and liabilities have been revalued and a new reporting entity was created with no retained earnings or accumulated deficit as of the effective date. The period from the effective date to December 31, 1993 was considered immaterial thus, December 31, 1993 was used as the effective date for recording the fresh-start adjustments. GACC's results of operations for the period from the effective date of the restructuring to December 31, 1993 have been reflected in the Statement of Operations for the year ended December 31, 1993. The reorganization values of GACC's assets and liabilities were determined based upon several factors including: prices and multiples of broadcast cash flow (operating income before depreciation and amortization) paid in purchase and business combination transactions, projected operating results of the broadcast stations, market values of publicly traded broadcast companies, economic and industry information and GACC's reorganized capital structure. The foregoing factors resulted in a range of reorganization values between $75 and $200 million. Based upon an analysis of all of this data, management determined that the reorganization value of the company would be $138.6 million. The effects of the reorganization and fresh-start adjustments on GACC's Balance Sheet at December 31, 1993 are as follows (in thousands): (a) The reduction in cash is attributable to the payment of $15.6 million of accrued interest on the 13% Senior Subordinated Notes due December 2000 and $5.8 million of fees associated with consummation of the reorganization, partially offset by receipt of $7.7 million of proceeds from the restructuring of the bank credit facility and the secured bank loan due March 1995 and $7.5 million from AFC for the purchase of 14% Notes and shares of Class A Common Stock. (b) The increase in contracts, broadcasting licenses and other intangibles represents a $26.4 million reduction in identifiable intangibles and recognition of reorganization value in excess of amounts allocable to identifiable assets totaling $77.2 million. (c) The net reduction in accounts payable, accrued expenses and other current liabilities represents: (i) the elimination of $34.7 million of accrued dividends on the preferred stock of a subsidiary; (ii) the elimination of $29.8 million of interest accrued through November 5, 1993 on debt securities discharged in the reorganization, (iii) payment of $15.6 million of accrued interest on the 13% Senior Subordinated Notes due 2000, (iv) the elimination of an $883,000 payable to AFC related to a cash advance received by GACC during 1992; and (v) $1.4 million of accrued professional fees related to the consummation of the reorganization. (d) The following table reconciles the adjustments to long-term debt (in thousands): (e) The elimination of minority interest represents the retirement of the preferred stock of a subsidiary in exchange for the issuance of Class A Common Stock. (f) The gain on debt discharge is summarized as follows (in thousands): Carrying value of debt securities subject to exchange, including accrued interest $318,447 Carrying value of preferred stock of subsidiary, including accrued dividends 309,608 Aggregate principal amount of 14% Senior Extendable Notes issued in exchanges, including accrued interest since June 30, 1993 (71,236) Aggregate value of Common Stock issued in exchanges (134,762) Expenses attributable to consummation of the reorganization (7,573) Total gain on debt discharge $414,484 (g) The adjustment to deferred income taxes represents a valuation adjustment of a deferred tax asset related to net operating loss carryforwards that are significantly restricted after 1993 due to the reorganization (See Note K). C. ACQUISITIONS AND DISPOSITIONS GACC has entered into agreements to sell its radio stations in Detroit and Milwaukee for $11.5 and $7 million, respectively. The majority of the net proceeds from these sales will be used to purchase a radio station in Sacramento for $16 million. An agreement in principle has been reached for the sale of GACC's radio station in Denver for approximately $8 million and the acquisition of a radio station in Cincinnati for approximately $15 million. The transaction is subject to the execution of a definitive agreement and the approval of the FCC. These transactions are expected to be consummated in 1994 and will not have a material effect on GACC's financial results. In December 1992, GACC sold its 20% interest in the assets and operations of the "Entertainment Tonight" joint venture for $26 million in cash. GACC retained the right to air the program on its TV stations in Cincinnati, Kansas City and Birmingham as long as it owns these stations. GACC recognized a pretax gain of approximately $9.6 million on the transaction (see Note I for gains and losses on sales of assets). In November 1992, GACC entered into a local marketing arrangement by which the programming and sales efforts of its AM radio station in Cincinnati were performed by an unrelated third party. The agreement provided for the option to purchase the station for $1.6 million in cash, which has been exercised by the other party, and such sale was completed in June 1993. As a result of the pending sale, GACC recorded a pretax loss of $5 million on the transaction during 1992 (See Note I). In April 1992, GACC acquired two radio stations in Phoenix for $11.5 million. In January 1992, GACC sold one radio station in Pittsburgh and two radio stations in Indianapolis to Broadcast Alchemy, L.P. for $52 million. A pretax loss of $5 million on the sale was recorded in the fourth quarter of 1991 (see Note I). In December 1991, GACC acquired the net assets of a television station in High Point, North Carolina from Taft Broadcasting Partners, L.P. for $28.5 million. During 1991, GACC sold its entertainment businesses and operations. The results of operations and the gain or loss on sale of the entertainment businesses and operations have been reflected in the Statement of Operations as discontinued operations (see Note L). In the fourth quarter of 1991, GACC's 12.85% interest in Black Entertainment Television was sold in an initial public offering of its common stock for approximately $37 million in cash. GACC realized a pretax gain of $36.7 million on the sale (see Note I). D. PROPERTY AND EQUIPMENT Property and equipment at December 31, consisted of the following (in thousands): Pursuant to the fresh-start reporting principles of SOP 90-7, the carrying value of property and equipment was adjusted to estimated fair value as of the effective date of the reorganization, which included the restarting of accumulated depreciation. Depreciation expense relating to property and equipment was $11.6 million, $12.0 million and $11.8 million in 1991, 1992 and 1993, respectively. E. CONTRACTS, BROADCASTING LICENSES AND OTHER INTANGIBLES Contracts, broadcasting licenses and other intangibles at December 31, consisted of the following (in thousands): GACC reduced the recorded amount of its intangibles by $658.3 million as of December 31, 1992 to reflect the carrying value of its broadcasting assets at estimated fair values at that time. GACC's carrying value of its broadcasting assets was also adjusted to estimated fair value as of the effective date of the reorganization pursuant to the reporting principles of SOP 90-7 (see Note B). This adjustment included, among other things, the restarting of accumulated amortization related to intangibles. Amortization expense relating to contracts, broadcasting licenses and other intangibles was $37.4 million, $36.0 million and $16.5 million in 1991, 1992 and 1993, respectively. F. LONG-TERM DEBT Long-term debt at December 31, consisted of the following (in thousands): * On February 18, 1994, GACC refinanced the 14% Notes and GABC's 13% Senior Subordinated Notes due 2001 through the issuance of $200 million principal amount of 9-3/4% Senior Subordinated Notes due 2004. There was no gain or loss recognized by GACC on the transaction. As disclosed in the 1992 financial statements, GACC was in default under certain of its and its subsidiaries debt securities. On December 28, 1993, the prepackaged plan of reorganization described in Note B was completed. As part of the plan, all of the debt of GACC and the 14-1/8% Senior Notes due 1996, the 20-1/2% Senior Notes due 1995 and the 9-1/2% Senior Secured Notes due 2000 of its former subsidiaries were exchanged for 14% Notes and shares of common stock of the reorganized company. In addition, GABC's 13% Senior Subordinated Notes due December 2000 were restructured through the issuance of 13% Senior Subordinated Notes due May 2001 and the bank term loan and secured bank loan due March 1995 were restructured through the bank credit facility and through the issuance of 9-1/2% Notes due December 1999. On December 31, 1993, GACC issued $5.1 million principal amount of 14% Notes in lieu of cash interest payable on that date. The bank credit facility, which matures in December 1998, bears interest at two percent over prime or, alternatively, three percent over Eurodollar-based interest rates. At December 31, 1993, the prime rate was 6% and the weighted average Eurodollar-based interest rate was 3.44%. The bank credit facility is secured by substantially all of the assets of GACC. In addition to mandatory scheduled principal payments beginning in 1994, the bank credit facility contains a provision whereby GACC's cash on hand at the end of any fiscal year in excess of $7.5 million must be used to prepay the bank credit facility in March of the following fiscal year. Any distributions received by GACC from the contingent payments withheld from the 1991 sale of Hanna-Barbera are required to be used to prepay the bank credit facility (See Note L). The 9-1/2% Notes due December 1999 are secured by the assets of GACC's television station in Greensboro/High Point, North Carolina. The bank credit facility contains covenants that restrict the operations of GACC and its subsidiaries including requirements to maintain certain financial ratios and places restrictions on: incurring additional indebtedness, paying dividends, making capital expenditures, selling broadcast stations and certain other corporate actions. Pursuant to these covenants, GACC would be prohibited from making any dividend payments in 1994. In addition, cash proceeds from sales of certain assets by GACC's subsidiaries must be used to repay certain indebtedness. GACC's other loan agreement covenants limit, among other things, the amount of dividends, loans or advances that GACC's subsidiaries may pay to GACC. At December 31, 1993, the sinking-fund payments on long term debt of GACC's subsidiaries for the next five years are as follows: 1994 - $23.5 million; 1995 - $27.5 million; 1996 - $20 million; 1997 - $26 million; and 1998 - $129 million. The sinking fund payments due in 1998 include a $114 million payment in December 1998 for the maturity of the bank credit facility. Cash interest payments (including amounts allocable to discontinued operations) were $90.2 million, $54.8 million and $45.1 million in 1991, 1992 and 1993, respectively. During 1992, GACC prepaid $44.7 million of the bank term loan from the proceeds of the sales of its Indianapolis and Pittsburgh radio stations and its interest in the "Entertainment Tonight" joint venture, coupled with a portion of the cash received from a distribution of proceeds withheld from the 1991 sale of its entertainment businesses and operations. In addition, GACC issued $13.7 million principal amount of the 9-1/2% Senior Secured Notes in exchange for $14.9 million principal amount of its 14-3/8% Debentures and $3.3 million principal amount of Holding's 14-1/8% Senior Notes through privately-negotiated transactions. In a separate privately-negotiated transaction, GACC acquired $6.5 million principal amount of Holding's 14 1/8% Senior Notes during the fourth quarter of 1992 for $2.3 million in cash. During 1991, GACC acquired approximately $180 million principal amount of Holdings 14-1/8% Senior Notes, $140 million principal amount of the 14-3/8% Debentures, $41 million principal amount of Holding's 20-1/2% Senior Notes, $16 million principal amount of GACC's 9% Senior Subordinated Notes and $5 million principal amount of GABC's 13% Senior Subordinated Notes through privately-negotiated transactions for approximately $109 million in cash, $138 million principal amount of the 9-1/2% Senior Secured Notes and 21.6 million shares of GACC Common Stock. The majority of the financing for the cash portion of these transactions was provided by a $100 million bank bridge loan executed through modifications to former bank debt agreements. GACC realized a pretax gain of approximately $117 million on debt refinancings during 1991. In addition, during 1991 GACC utilized approximately $350 million of the cash proceeds from the sales of the Entertainment Group and other investments to: (i) retire the $100 million bank revolving credit loan and $100 million bank bridge loan (borrowed during 1991) and (ii) to reduce the bank term loan and the AFC subordinated line of credit by $127.9 million and $22.5 million, respectively. The net gains from the debt retirements, refinancings and discharge are shown as an extraordinary item in the Statement of Operations in the year the transactions occur (see Note M). G. MINORITY INTEREST Minority interest consisted of outstanding preferred shares of a subsidiary. The preferred shares were non- voting cumulative shares with a liquidation value of approximately $275 million at the time of the reorganization. These shares were exchanged for 673,555 shares of Class A Common Stock in the reorganization. H. SHAREHOLDERS' EQUITY (DEFICIT) GACC is authorized to issue 500 million shares of Class A Common Stock, $.01 par value, 125 million shares of Class B Common Stock, $.01 par value and 9.5 million shares of Serial Preferred Stock, $.01 par value. Class A Common shares are entitled to one vote for each share held of record; Class B shares are entitled to one vote for every five shares held of record. Class A and Class B Common shares will vote together as a single class on all motions. The Class A and Class B shares are entitled to the same treatment per share in the event of any dividend, distribution, split-up or recapitalization. Class B shares are convertible (on a one-for-one basis) into Class A shares if such conversion does not violate the Communications Act of 1934, as amended, or the rules, regulations or policies of the FCC promulgated thereunder. The preferred stock may have such preferences and other rights and limitations as the Board of Directors may designate with respect to each series. Changes in the number of shares of Common Stock are shown in the following table: The 1991 Stock Option Plan under which 3,250,000 shares were available for grant was canceled as part of the plan of reorganization. In addition, warrants to purchase three million common shares were also terminated. No consideration was paid to any option or grant holder. Immediately following the consummation of the reorganization, the Board of Directors established the 1993 Stock Option Plan. The Plan provides for granting of both non-qualified and incentive stock options to key employees. There are 600,000 shares of Class A Common shares reserved for issuance under the Plan. During 1993, options for the purchase of 581,000 shares were granted at an exercise price of $15.00 per share. Options become exercisable at the rate of 20% per year commencing one year after grant and expire at the earlier of 10 years from the date of grant, three months after termination of employment, or one year after the death or disability of the holder. I. GAINS AND LOSSES ON SALES OF ASSETS Included in "Miscellaneous, net" are the following pretax gains (losses) on sales of assets (in thousands): Gains on sales of investments represent primarily gains on the sales of interests in Black Entertainment Television in 1991 and "Entertainment Tonight" in 1992. J. BENEFIT PLANS In March 1992, the Board of Directors authorized the termination of GABC's non-contributory defined benefit pension plan which covered substantially all full-time employees meeting the eligibility requirements. Accrued benefits under the pension plan were frozen effective June 30, 1992 and all participants became fully vested. The termination of the pension plan and the subsequent settlement of the vested benefit obligation by the purchase of non-participating annuity contracts for, or the lump-sum payments to, each covered employee, was completed in the first quarter of 1994 with no effect on GACC's results of operations. K. INCOME TAXES Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for income tax purposes. Significant components of GACC's deferred tax assets and liability as of December 31, are as follows (in thousands): As a result of the fair value adjustments made upon application of the reporting principles of SOP 90-7, GACC's net deferred tax liability increased $35.5 million primarily due to recognition of a valuation allowance for financial reporting purposes to offset the gross deferred tax asset related to net operating loss carryforwards, based on an analysis of the likelihood of realization. GACC's ability to use its net operating loss carryforwards existing as of December 31, 1993 against ordinary taxable income in the future may be severely limited due to certain provisions of the Internal Revenue Code of 1986, as amended, generally limiting the availability of net operating loss carryforwards following certain changes in ownership. At December 31, 1993, GACC had net operating loss carryforwards for Federal income tax purposes estimated at $230 million expiring as follows: 2003 - $18 million; 2004 - $2 million; and 2008 - $210 million. The following is a reconciliation of Federal income taxes at the "statutory" rates of 34% in 1991 and 1992 and 35% in 1993 and as shown in the Statement of Operations (in thousands): The Federal income tax benefit as applied to continuing operations consists of (in thousands): GACC recognized Federal income tax expense of approximately $3 million and $1.1 million in 1991 and 1992, respectively, representing alternative minimum tax. GACC paid Federal income taxes of $500,000 and $775,000 in cash during 1991 and 1992, respectively. L. DISCONTINUED OPERATIONS Discontinued operations consisted of the following (in thousands): In May 1991, GACC sold its investment in Spelling Entertainment, Inc. common and convertible preferred stock to The Charter Company, an affiliate of AFC at that time, for $107.5 million in cash. A pretax loss of $17.2 million on the sale was recorded in the first quarter of 1991. In December 1991, GACC sold its subsidiary, Hanna-Barbera Productions, Inc., along with the rights to distribute Hanna-Barbera programs, to a joint venture between Turner Broadcasting System, Inc. and Apollo Investment Fund, L.P. for $320 million, which includes $40 million in contingent payments expected to be received over time as certain conditions in the sale agreement are satisfied. As part of this transaction, GACC acquired the Hanna-Barbera distribution rights from Worldvision Enterprises, Inc., a wholly- owned subsidiary of Spelling, in exchange for $24 million in cash, the GACC live action program library and a licensing and merchandising subsidiary, Hamilton Projects, Inc. These distribution rights were in turn sold to the purchaser of Hanna- Barbera as part of the overall transaction. GACC recognized a pretax gain of approximately $82 million on the sale during the fourth quarter of 1991, which did not include any gain from the $40 million in contingent payments. In 1992, GACC received distributions totaling $25 million of the contingent payments withheld from the sale. GACC recognized a pretax gain of $9 million related to these distributions in the third quarter of 1992, after deductions for post closing sale adjustments, settlement of certain tax liabilities and other items related thereto. Interest expense of $21.7 million has been allocated to discontinued operations for the year ended December 31, 1991. The allocation was based on interest expense incurred for long-term debt retired with the proceeds of the sale of the entertainment assets and operations, including Spelling. M. EXTRAORDINARY ITEMS Extraordinary items consisted of the following (in thousands): N. PENDING LEGAL PROCEEDINGS Management, after review and consultation with counsel, considers that any liability from litigation pending against GACC and any of its subsidiaries would not materially affect the consolidated financial position or results of operations of GACC and its subsidiaries. O. RELATED PARTIES Included in the gain from retirement and refinancing of long-term debt in 1991, is a pretax gain of approximately $23 million on the purchase from AFC and a GACC Director of $64.8 million principal amount of GACC's and its subsidiaries' Notes and Debentures in exchange for cash and 9-1/2% Senior Secured Notes on the same terms as those negotiated with unrelated parties during 1991. In January 1991, GACC sold a subsidiary whose primary operations consist of operating a recreation and entertainment complex to an executive officer of AFC for $3.8 million, a price based on an appraisal prepared by an independent third party appraiser. Included in the Balance Sheet at December 31, 1992 is a net payable to AFC of $883,000, representing miscellaneous accounts payable. This amount was canceled in the reorganization and no consideration was paid to AFC. P. ADDITIONAL INFORMATION Quarterly Operating Results (Unaudited) - The following are quarterly results of consolidated operations for 1992 and 1993 (in thousands). See Notes B, I, L and M for the effects of gains or losses from asset sales, debt retirements and other items recognized in individual quarters. GACC's financial results are seasonal. Television broadcasting revenues are higher in the second and fourth quarters than in the first and third quarters. In the fourth quarter of 1992, GACC recorded an adjustment of $658.3 million to reflect its broadcasting assets at estimated fair value as of December 31, 1992. In the fourth quarter of 1993, GACC recorded net earnings of $399.6 million directly attributable to its comprehensive financial restructuring (see Note B). Included in selling, general and administrative expenses in 1991, 1992 and 1993 are charges of $8.1 million, $6.6 million and $6.6 million, respectively, for advertising and charges of $2.1 million, $2.3 million and $2.4 million, respectively, for repairs and maintenance. PART IV ITEM 14 ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note P to GACC's Financial Statements. B. Schedules filed herewith: Page For 1991, 1992 and 1993: III - Condensed Financial Information of Registrant S-2 All other schedules for which provisions are made in the applicable regulation of Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. 3. Exhibits - see Exhibit Index. (b) Reports on Form 8-K filed during the fourth quarter of 1993: Date of Report Event Reported December 7, 1993 Confirmation of GACC's prepackaged plan of reorganization by the U.S. Bankruptcy Court. S-1 S-2 S-4 S-6 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Great American Communications Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GREAT AMERICAN COMMUNICATIONS COMPANY By: /s/ JOHN P. ZANOTTI Chief Executive Officer Signed: March 14, 1994 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: * Member of the Audit Committee GREAT AMERICAN COMMUNICATIONS COMPANY INDEX TO EXHIBITS	11,607	75,585
42293_1993.txt	42293_1993	1993	42293	ITEM 1. BUSINESS REGISTRANT Golden West Financial Corporation (Golden West or Company) is a savings and loan holding company, the principal business of which is the operation of a savings and loan business through its wholly owned subsidiary, World Savings and Loan Association, a Federal Savings and Loan Association (World or Association). Golden West also has two other subsidiaries, Atlas Advisers, Inc., and Atlas Securities, Inc. These companies were formed to provide services to Atlas Assets, Inc., a series open-end registered investment company sponsored by the Company. Atlas Advisers, Inc., is a registered investment adviser and the investment manager of Atlas Assets, Inc.'s twelve portfolios (the Atlas Funds). Atlas Securities, Inc., is a registered broker-dealer and the sole distributor of Atlas Fund shares. The Company was incorporated in 1959 and has its headquarters in Oakland, California. THE ASSOCIATION World was incorporated in 1912 as a capital stock savings and loan association and has its home office in Oakland, California. World became a federally chartered savings and loan association in September 1981. See Note T to the Financial Statements included in Item 14 for the contribution of the Association to the earnings of the Company. REGULATORY FRAMEWORK The Company is a savings and loan holding company within the meaning of the National Housing Act, as amended, (the Holding Company Act), and is subject to the regulation, examination, supervision, and reporting requirements of the Holding Company Act. The Association is a member of the Federal Home Loan Bank System and owns stock in the Federal Home Loan Bank (FHLB) of San Francisco, Topeka, and New York. The Association's savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC) Savings Association Insurance Fund (SAIF), up to the maximum amounts provided by law. The Company and the Association are subject to extensive examination, supervision, and regulation by the Office of Thrift Supervision (OTS) and the FDIC. Applicable regulations govern, among other things, the Associa- tion's lending and investment powers, the types of accounts it is permitted to offer, the types of business in which it may engage, and capital requirements. The Association is also subject to regulations of the Board of Governors of the Federal Reserve System (Federal Reserve Board) with respect to reserve requirements and certain other matters (see Regulation). ITEM 1. BUSINESS (Continued) OFFICE STRUCTURE As of December 31, 1993, the Company operated 112 savings branch offices in California, 59 in Colorado, 19 in Florida, 11 in Texas, ten in Kansas, nine in Arizona, and seven in New Jersey. The Company also operates 175 loan origination offices of which 154 are located in the same states as savings branch offices. The remaining 21 loan origination offices are located in Connecticut, Delaware, Idaho, Illinois, Maryland, Missouri, Nevada, New Mexico, Oregon, Pennsylvania, Utah, Virginia, Washington, and Wisconsin. Of the 154 offices mentioned earlier, 15 are fully-staffed offices that are located in the same premises as savings branch offices and 75 others are savings branch offices that have a single loan officer on site. The remaining loan origination offices are located in facilities that are separate from savings branch offices. ACQUISITIONS/DIVESTITURES On August 13, 1993, the Company acquired $320 million in deposits and seven branches in Arizona from PriMerit Bank. On September 17, 1993, the Company sold $133 million of savings in two Ohio branches to Trumbull Savings and Loan. On October 15, 1993, the Company sold its remaining five Ohio branches with $131 million in deposits to Fifth Third Bancorp. During 1992, the Company sold one branch in California containing $40 million in deposits to American Savings Bank and two branches in the state of Washington containing $37 million in deposits to Washington Mutual Savings Bank. On July 15, 1991, the Company took title to the common stock of Beach Federal Savings and Loan Association (Beach) of Boynton Beach, Florida, and its $1.5 billion in assets. The transaction has been accounted for as a purchase, and the subsidiary's results of operations have been included with those of the Company's since July 15, 1991. As a result of the Beach acquisition, the Company recognized, for tax purposes, certain Beach net operating losses that resulted in a $25 million benefit in 1992 and a $103 million benefit in 1991. For financial statement reporting, this benefit has been recorded as negative goodwill and is being amortized into income over ten years. In 1993, 1992, and 1991, $13 million, $12 million, and $5 million, respectively, of the negative goodwill was amortized. On March 31, 1991, World Savings and Loan Association of Ohio (World of Ohio), a wholly owned subsidiary of Golden West, was merged into World. In conjunction with Golden West's acquisition of World of Ohio in 1988, the benefits of net operating loss carryforwards resulted in recording $18 million of negative goodwill in 1991. This benefit was amortized into income over the period 1989 to 1993. In 1993, 1992, and 1991, $3 million, $4 million, and $11 million, respectively, of the negative goodwill was amortized. ITEM 1. BUSINESS (Continued) ACQUISITIONS (continued): During 1991, World acquired from the Resolution Trust Corporation a total of $355 million of deposits and 11 branches from four separate acquisitions. The foregoing acquisitions are not material to the financial position or net earnings of Golden West and pro forma information is not deemed necessary. OPERATIONS The principal business of the Company, through the Association, is attracting funds, primarily in the form of savings deposits acquired from the general public, and investing those funds principally in loans secured by deeds of trust or mortgages on residential and other real estate, and mortgage-backed securities (MBS)--securities backed by pools of residential loans that have many of the characteristics of mortgages including the monthly payment of principal and interest. Funds for the Association's operations are also provided through earnings, loan repayments, borrowings from the Federal Home Loan Banks, and debt collateralized by mortgages, MBS, or other securities. In addition, the Association has a number of other alternatives available to provide liquidity or finance operations. These include borrowings from public offerings of debt or equity, sales of loans and MBS, negotiable certificates of deposit, issuance of commercial paper, and borrowings from commercial banks. Furthermore, under certain conditions, World may borrow from the Federal Reserve Bank of San Francisco to meet short-term cash needs. The availability of these funds will vary depending on policies of the FHLB, the Federal Reserve Bank of San Francisco, and the Federal Reserve Board. The principal sources of funds for the holding company, Golden West, are dividends from World and the proceeds from the issuance of debt and equity securities. CUSTOMER DEPOSIT ACTIVITIES Customer deposit flows are affected by changes in general economic conditions, changes in prevailing interest rates, and competition among depository institutions and other investment alternatives. The Company currently offers a number of alternatives for depositors, including passbook, checking, and money market deposit accounts from which funds may be withdrawn at any time without penalty, and certificate accounts with varying maturities ranging up to seven years. The Company's certificate accounts are issued in non-negotiable form through its branch offices. All types of accounts presently offered by the Company have rates that are set by the Company consistent with prevailing interest rates. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) During 1993, customer deposits increased $880 million, including interest credited of $567 million and excluding $320 million from acquisitions and $264 million from divestitures compared to a decrease of $255 million, including interest credited of $676 million and excluding divestitures of $77 million during 1992. Customer deposits increased $640 million in 1991, including $903 million of interest credited and excluding $1.8 billion from acquisitions. The Company does not solicit brokered deposit accounts. Rates paid on new and repricing accounts dropped steadily in 1993 and 1992, reaching the lowest level in 20 years for most products. Although rates paid on new accounts were lower than they had been in previous years, consumer funds were attracted during 1993 as a result of special promotions in the Company's savings markets. The Company experienced a net outflow of deposits during 1992 because the Company elected to emphasize other, more cost-effective sources of funds, primarily Federal Home Loan Bank advances. The table below summarizes the Company's customer deposits by original term to maturity at December 31. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) The table below sets forth the Company's customer deposits by interest rate at December 31. The table below shows the maturities of customer deposits at December 31, 1993, by interest rate. (a) Includes passbook, checking, and money market deposit accounts, which have no stated maturity. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) As of December 31, 1993, the aggregate amount outstanding of time certificates of deposits in amounts of $100,000 or more was $1.5 billion of which $109 million were retail jumbo CDs. The following table presents the maturity of these time certificates of deposit at December 31, 1993. More information regarding customer deposits is included in Note J to the Financial Statements, in Item 14. BORROWINGS The Company generally may borrow from the FHLB of San Francisco upon the security of a) the capital stock of the FHLB owned by the Company, b) certain of its residential mortgage loans or c) certain other assets (principally obligations of, or guaranteed by, the United States Government or a federal agency). The Company uses FHLB borrowings, also known as "advances" to supplement cash flow and to provide funds for loan origination activities. Advances offer strategic advantages for asset- liability management, including long-term maturities and, in certain cases, prepayment at the Company's option. Each advance has a specified maturity and interest rate, which may be fixed or variable, as determined by the FHLB. At December 31, 1993, the Company had $6.3 billion in FHLB advances outstanding, compared to $5.5 billion at yearend 1992. From time to time, the Company enters into reverse repurchase agreements with selected major government securities dealers, as well as large banks. A reverse repurchase agreement involves the sale and delivery of U.S. Government securities or mortgage-backed securities by the Company to a broker or dealer coupled with an agreement to buy the securities back at a later date. Under generally accepted accounting principles, these transactions are properly accounted for as borrowings secured by securities. The Company pays the brokers and dealers a variable or fixed rate of interest for the use of the funds for the period involved, usually less than one year. At maturity, the borrowings are repaid (by repurchase ITEM 1. BUSINESS (Continued) BORROWINGS (continued) of the same securities) and the same securities are returned to the Company. These transactions are used to take advantage of arbitrage investment opportunities and to supplement cash flow. The Company also enters into dollar reverse repurchase agreements (dollar reverses) with selected major government securities dealers, as well as large banks. A dollar reverse involves the sale and delivery of mortgage-backed securities by the Company to a broker or dealer, coupled with an agreement to purchase securities of the same type and interest coupon at a fixed price for settlement at a later date. Under generally accepted accounting principles, these transactions are properly accounted for as borrowings secured by mortgage-backed securities. The Company pays the brokers and dealers a fixed rate of interest for the use of the funds for the period involved, which is generally short-term. At maturity, the secured borrowings are repaid (by purchase of similar securities) and similar securities are delivered to the Company. These transactions are used to take advantage of arbitrage investment opportunities and to supplement cash flow. The Company monitors the level of activity with any one party in connection with reverse repurchase agreements and dollar reverses in order to minimize its risk exposure in these transactions. Reverse repurchase agreements and dollar reverses with dealers and banks amounted to $377 mil- lion at December 31, 1993, compared to $486 million at yearend 1992. Golden West currently has on file a registration statement with the Securities and Exchange Commission for the sale of up to $100 million of subordinated debt securities. The Company issued subordinated debt securities of $100 million in January 1993 and $200 million in October 1993, bringing the total amount issued to $1.0 billion at December 31, 1993. As of December 31, 1993, Golden West's subordinated debt securities had ratings of A3 and A- from Moody's Investors Service (Moody's) and Standard & Poor's Corporation (S&P), respectively. World currently has on file a shelf registration with the OTS for the issuance of $2.0 billion of unsecured medium-term notes. At December 31, 1993, $1.2 billion was available for issuance. In total, at December 31, 1993, the Association had $677 million of medium-term notes outstanding under the current and prior registrations compared to $81 million at yearend 1992. As of December 31, 1993, the Association's medium-term notes had ratings of A1 and A+ from Moody's and S&P, respectively. World also has on file a registration statement with the OTS for the sale of up to $250 million of subordinated notes. Under a prior filing with the OTS, $50 million of subordinated notes remain unissued. As of December 31, 1993, the Association had issued a total of $200 million of ITEM 1. BUSINESS (Continued) BORROWINGS (continued) subordinated notes. As of December 31, 1993, World's subordinated notes had ratings of A2 and A from Moody's and S&P, respectively. The subordinated notes are included in the Association's risk-based regulatory capital as Supplementary Capital. The table below sets forth the composition of the Company's borrowings at December 31. More information concerning the borrowings of the Company is included in Notes K, L, M, and N to the Financial Statements, in Item 14. LENDING ACTIVITIES Income from real estate loans provides the principal source of revenue to the Company in the form of interest, loan origination fees, and other fees. Loans made by the Company are generally secured by first liens primarily on residential properties. Although the Company has from time to time made commercial real estate and construction loans, the Company is not currently active in these segments of the lending market. The Company has the power to originate loans in any part of the United States. The Company is currently originating loans primarily in California, as well as in Arizona, Colorado, Connecticut, Delaware, Florida, Idaho, Illinois, Kansas, Maryland, Missouri, Nevada, New Mexico, New Jersey, Oregon, Pennsylvania, Texas, Utah, Virginia, Washington, and Wisconsin. The Company also makes loans to customers on the security of their deposit accounts. Customer deposit loans constituted less than one percent of the Company's total loans outstanding as of December 31, 1993, and 1992. The tables on the following two pages set forth the Company's loan portfolio by state as of December 31, 1993, and 1992. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) (a) The Company has no commercial loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) (a) The Company has no commercial loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The table below sets forth the composition of the Company's loan portfolio (excluding mortgage-backed securities) by type of security at December 31. At December 31, 1993, 98% of the loans in the portfolio had remaining terms to maturity in excess of 10 years. The table below sets forth the amount of loans due after one year that have predetermined interest rates and the amount that have floating interest rates at December 31, 1993. The table on the following page sets forth information concerning new loans made by the Company during 1993, 1992, and 1991 by type and purpose of loan. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) Note: During 1993, 1992, and 1991, the Company also purchased $14 million, $5 million, and $302 million, respectively, of loans (not included above) of which $304 thousand, $1 million, and $178 million, respectively, were one-unit residential loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) Although the Company has lending operations in 21 states, the primary mortgage origination focus continues to be on residential properties in California. In 1993, 73% of total loan originations were on residential properties in California, compared to 83% and 88% in 1992 and 1991, respectively. Although California originations continue to be a large portion of total originations, the decrease in 1993 as compared to 1992 and 1991 was due to increased penetration by the Company in markets outside California and the slight decrease of originations in California. The percentage of the total loan portfolio (excluding mortgage-backed securities) that is comprised of residential loans in California was 81% at December 31, 1993, compared to 83% at yearend 1992. New loan originations in 1993, 1992, and 1991 amounted to $6.4 billion, $6.5 billion, and $4.9 billion, respectively. Refinanced loans constituted 59% of new loan originations in 1993 compared to 56% in 1992 and 46% in 1991. The new loan origination levels achieved in 1993 and 1992 were due, in large part, to strong demand in the marketplace for refinancing of existing loans due to the low interest rate environment. In addition, in 1992 and 1991, capital deficiencies and loan portfolio problems inhibited many of Golden West's competitors from making loans. The total portfolio growth for each of the years ended December 31, 1993, and 1992, was $1.9 billion or 9%. Federal regulations permit federally chartered savings and loan associations to make or purchase both fixed-rate loans and loans with periodic adjustments to the interest rate. These latter types of loans are subject to the following primary limitations: (i) the adjustments must be based on changes in a specified interest rate index, which may be selected by the association but which must be beyond the control of the association and readily verifiable by the borrower; and (ii) adjustments to the interest rate may be implemented through changes in the monthly payment amount and/or adjustment to the outstanding principal balance or terms, except that the original loan term may not be increased to more than 40 years. Pursuant to these powers, the Company began offering adjustable rate mortgages (ARMs) in the early 1980s and this type of mortgage continues to be the Company's primary real estate loan. The portion of the mortgage portfolio (excluding mortgage-backed securities) composed of rate-sensitive loans was 87% at yearends 1993, 1992, and 1991. Despite stiff competition from mortgage bankers who aggressively marketed fixed-rate mortgages at the lowest rates seen in the past 20 years, Golden West's ARM originations constituted approximately 75% of new mortgage loans made by the Company in 1993, compared with 80% in 1992 and 89% in 1991. Most of the Company's ARMs carry an interest rate that changes monthly based on movements in certain interest rate or cost of funds indices. During the life of the loan, the interest rate may not be raised above a ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) lifetime cap, set at the time of origination or assumption. Lifetime caps on the Company's ARMs are typically between 350 and 625 basis points (a basis point is one one-hundredth of one percent) higher than the loan's initial fully-indexed contract rate. On most of the Company's ARMs, monthly payments of principal and interest are adjusted annually with a maximum increase or decrease of 7-1/2% of the prior year's payment. At five year intervals, the payment may be adjusted without limit, to amortize the loan fully within the then remaining term. Within these five year periods, negative amortization (deferred interest) may occur to the extent that the loan balance remains below 125% of the original mortgage amount, unless the original loan to value ratio exceeded 85%, in which case the loan balance cannot exceed 110% of the original mortgage amount. On certain other ARMs, the payment and interest rate change every six months, with the maximum rate change capped at one percent. These ARMs do not allow negative amortization and, consequently, do not have the 7-1/2% payment increase limitation. The Company also offers a "modified" ARM, a loan that usually offers a low fixed rate from 1% to 3% below the initial fully indexed contract rate for an initial period, normally three to 36 months. (However, the borrower must generally qualify at the initial fully-indexed contract rate.) The weighted average maximum lifetime cap rate on the Company's ARM and modified ARM loan portfolio was 13.82%, or 7.39% above the actual weighted average rate at December 31, 1993, versus 14.18%, or 6.99% above the weighted average rate at yearend 1992. Approximately $4.5 billion of the Company's loans have terms that state that the interest rate may not fall below a lifetime floor, set at the time of origination or assumption. Due to the decline in interest rates, as of December 31, 1993, $1.5 billion of these loans had reached their rate floors. The weighted average floor rate on these loans was 7.4% at yearend 1993. Interest rates charged by the Company on real estate loans are affected principally by competition, and also by the supply of money available for lending, loan demand, and factors that are, in turn, affected by general economic conditions, regulatory and monetary policies of the federal government, the OTS and the Federal Reserve Board, and legislation and other governmental action dealing with budgetary and tax matters. The Company originates loans through offices that are staffed by salaried personnel who contact local real estate brokers regarding possible lending opportunities. All loan applications are completed, reviewed, and approved in the loan origination offices and forwarded to the Company's central offices in Oakland, California; Costa Mesa, California; or Denver, Colorado, for processing. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The Company also utilizes the services of selected mortgage brokers to obtain completed loan applications. In such cases, the Company, in addition to the review by the mortgage broker, performs its own quality review, including a physical inspection of the property, before processing the application and funding the loan. The Company's loan approval process is intended to assess both the borrower's ability to repay the loan and the adequacy of the pro-posed security. Documentation for all loans is maintained in the Company's loan servicing offices in San Leandro, California. The Company generally lends up to 80% of the appraised value of residential real property and, under certain circumstances, up to 90% of the appraised value of single-family residences. Commencing in 1992, it is the Company's policy that all loans originated in excess of 80% of the appraised value of the property are required to have mortgage insurance ex- cept on loans to facilitate the sale of REO. During 1993, 1992, and 1991, less than 3% of loans originated were in excess of 80% of the appraised value of the residence. The Company requires title insurance for all mortgage loans and requires that fire and casualty insurance be maintained on all improved properties that are security for its loans. The original contractual loan payment period for residential loans normally ranges from 15 to 40 years with most having original terms of 30 years. However, the majority of such loans remain outstanding for a shorter period of time. To generate income and to provide additional funds for lending and liquidity, the Company has from time to time sold, without recourse, par- ticipations in loans and, in limited instances, whole loans, to the Federal Home Loan Mortgage Corporation (FHLMC), the Federal National Mortgage Asso- ciation (FNMA), and to institutional purchasers. Under loan participation sale agreements, the Company usually continues to collect payments on the loans as they become due, and otherwise to service the loans. The Company pays an agreed-upon yield on the participant's portion of the loans. This yield is usually less than the interest agreed to be paid by the borrower, with the difference being retained by the Company as servicing fee income. At December 31, 1993, the Company was engaged in servicing approximately $807 million of loan participations and whole loans for others. For the year ended December 31, 1993, fees received for such servicing activities totalled $3 million, or approximately one-tenth of one percent of total revenues. The Company sold $432 million of loans during 1993 compared to $281 million and $67 million in 1992 and 1991, respectively. The Company recognized pre-tax gains of $5.7 million compared to $1.7 million in 1992 and $381 thousand in 1991. The Company originated $443 million of loans held for sale during 1993 compared to $278 million in 1992 and $77 million in 1991. The loan held for sale portfolio had a balance of $56 million at December 31, 1993, and is carried at the lower of cost or market. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The Company also purchases, on a selective basis and only after a strict underwriting review, residential mortgage whole loans in the secondary market. Loan purchases in 1993, 1992, and 1991 amounted to $14 million, $5 million, and $302 million, respectively. Loan repayments consist of monthly loan amortization, loan payoffs, and loan refinances. During 1993, 1992, and 1991, repayments amounted to $3.8 billion, $4.1 billion, and $2.8 billion, respectively. The decrease in repayments in 1993 over 1992 was due to lower mortgage payoffs within our loan portfolio. The increase in repayments in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates by replacing older, high-cost debt with new, more attractively priced instruments. The Company adopted Statement of Financial Accounting Standards No. 114 (FAS 114), "Accounting by Creditors for Impairment of a Loan," in the fourth quarter of 1993, retroactive to January 1, 1993. FAS 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. The valuation allowance and provision for loan losses are adjusted for changes in the present value of impaired loans for which impairment is measured based on the present value of expected future cash flows. The Company had previously measured loan impairment in accordance with the methods prescribed in FAS 114. As a result, no additional loss provisions were required by early adoption of the pronouncement. FAS 114 requires that impaired loans for which foreclosure is probable should be accounted for as loans. As a result, $16 million of in-substance foreclosed loans, with a valuation allowance of $7 million, were reclassified from real estate held for sale to loans receivable. Prior year amounts have not been restated. It is too early to predict with any precision potential losses to the Company resulting from the Northridge (southern California) earthquake in January 1994; however, based on early assessments of severity of damage, borrower equity, and levels of insurance coverage, the Company believes that any potential loss to the Company will not be material to the financial condition and results of operations of the Company. In addition to interest earned on loans, the Company receives fees for originating loans and for making loan commitments. The income represented by such fees varies with the volume and types of loans made. The Company also charges fees for loan prepayments, loan assumptions and modifications, late payments and other miscellaneous services. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The table below sets forth information relat-ing to interest rates and loan fees charged for the years indicated. (a) excludes loans purchased NONPERFORMING ASSETS If a borrower fails to make required payments on a loan, the Company usually takes the steps required under applicable law to foreclose upon the security for the loan. If a delinquency is not cured, the property is generally acquired by the Company in a foreclosure sale or by taking a deed in lieu of foreclosure. If the applicable period of redemption by the borrower (which varies from state to state and by method of foreclosure pursued) has expired, the Company is free to sell the property. The property may then be sold generally with a loan conforming to normal loan requirements, or with a "loan to facilitate sale" involving terms more favorable to the borrower than those normally permitted. Various antideficiency and homeowner protective provisions of state law may limit the remedies available to lenders when a residential mortgage borrower is in default. The effect of these provisions, in most cases, is to limit the Company to foreclosing upon, or otherwise obtaining ownership of, the property securing the loan after default and to prevent the Company from recovering from the borrower any deficiency between the amount real- ized from the sale of such property and the amount owed by the borrower. One measure of the soundness of the Company's portfolio is its ratio of nonperforming assets (NPAs) to total assets. Nonperforming assets include non-accrual loans (loans that are 90 days or more past due) and real estate acquired through foreclosure. Loans in-substance foreclosed were no longer classified as part of the real estate held for sale portfolio upon adoption of FAS 114 during December 1993 and are now included in the Company's total loan portfolio as previously discussed. No interest is recognized on non-accrual loans. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) The table below sets forth the components of the Company's nonperforming assets and the ratio of nonperforming assets to total assets at December 31. The increase in NPAs in 1993 and 1992 was primarily in single-family loans and foreclosed real estate in California. The continued weak California economy and high unemployment led to a slowdown in the real estate market, resulting in an increase in loan delinquencies and, in cer- tain areas, decreases in real estate prices. The growth in NPAs was also impacted by an increase in bankruptcy filings in 1992 and a continued high level of bankruptcy filings in 1993, which often delay the collection process and extend the length of time a loan remains delinquent. The Company continues to closely monitor all delinquencies and takes appropriate steps to protect its interests. Interest foregone on non- accrual loans amounted to $20 million in 1993, $17 million in 1992, and $17 million in 1991. The tables on the following two pages show the Company's nonperforming assets by state at December 31, 1993, and 1992. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) (a) Non-accrual loans are 90 days or more past due and have no unpaid interest accrued. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) (a) Non-accrual loans are 90 days or more past due and have no unpaid interest accrued. The Company's troubled debt restructured (TDRs), which are loans that have been modified due to a weakness in the collateral and/or borrower, were $37 million, or 0.13% of assets, at December 31, 1993, compared to $13 million, or 0.06% of assets, at yearend 1992. The increase is due in part to the FAS 114 reclassification previously discussed, which included loans that had been modified. The great majority of the Company's TDRs have temporary interest rate reductions and have been made primarily to customers negatively impacted by adverse economic conditions. Interest foregone on TDRs amounted to $275 thousand in 1993 compared to $217 thousand in 1992 and $328 thousand in 1991. At December 31, 1993, approximately $310 million of the Company's loans were 30 to 89 days past due and an additional $85 million of loans ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) were performing under bankruptcy protection. Management has included its estimate of potential losses on these loans in the allowance for possible loan losses. The Company provides allowances for losses on loans when impaired and real estate owned when any significant and permanent decline in value is identified and based upon trends in the basic portfolio. Additions to and reductions from the allowances are reflected in current earnings. Periodic reviews are made of major loans and real estate owned, and major lending areas are regularly reviewed to determine potential problems. Where indicated, valuation allowances are established or adjusted. In estimating possible losses, consideration is given to the estimated sale price, cost of refurbishing, payment of delinquent taxes, cost of disposal, and cost of holding the property. The table below summarizes the changes in the allowance for loan losses for the years indicated: The Company continues to use a methodology for monitoring and estimating loan losses that is based on both historical experience in the loan portfolio and factors reflecting current economic conditions. This approach utilizes a data base that identifies losses on loans and fore- closed real estate from past years to the present, broken down by year of origination, type of loan and geographical area. Management is then able to estimate a range of loss allowances to cover future losses in the port- folio. The increase in the allowance and the provision in 1993 over 1992 was considered prudent given the slowdown in the California housing market, the increase in the size of the loan portfolio, and the increase in nonper- forming assets and loan losses experienced by the Association in 1993. Chargeoffs increased as a result of the increase in nonperforming loans, the increase in the percentage of nonperforming loans that became real estate owned, and the increased losses on real estate owned primarily due to the weakening of the California housing market. ITEM 1. BUSINESS (Continued) INVESTMENT ACTIVITIES Golden West's investment securities portfolio is composed primarily of federal funds, short-term repurchase agreements collateralized by mortgage-backed securities, and short-term money market instruments. In determining the amounts of assets to invest in each class of securities, the Company considers relative rates, liquidity, and credit quality. When opportunities arise, the Company enters into arbitrage transactions with secured borrowings and short-term investments to profit from the rate differential. The level of the Company's investments position in excess of its liquidity requirements at any time depends on liquidity needs and available arbitrage opportunities. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (FAS 115), "Accounting for Certain Investments in Debt and Equity Securities." FAS 115 establishes classifications of investments into three categories: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify investment securities as either held to maturity or available for sale. The Company has no trading securities. Held to maturity securities are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Securities held to maturity are recorded at cost because the Company has the ability to hold these securities to maturity and because it is Management's intention to hold them to maturity. At December 31, 1993, the Company had no securities held to maturity. Securities available for sale increase the Company's portfolio management flexibility for investments and are reported at fair value. Net unrealized gains and losses are excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had securities available for sale in the amount of $1.6 billion and unrealized gains on securities available for sale included in stockholders' equity of $41 million. Gains or losses on sales of securities are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the security, using specific identification, adjusted for any unamortized premium or discount. The adoption of FAS 115 resulted in the reclassification of certain securities from the investment securities portfolio to the securities available for sale portfolio. The Company has other investments that are not required to be classified under one of the categories of FAS 115 and that are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Prior to December 31, 1993, securities were classified as either securities held for sale or investment securities. Securities held for sale were recorded at the aggregate portfolio's lower of amortized cost or market, with the unrealized gains and losses included in earnings. Investment securities were recorded at amortized cost. ITEM 1. BUSINESS (Continued) INVESTMENT ACTIVITIES (continued) The table below sets forth the composition of the Company's securities available for sale at December 31. The table below sets forth the composition of the Company's other investments at December 31. The reduction in 1993 versus 1992 resulted from the classification required under FAS 115. The weighted average yield on the other investments portfolio was 3.42% at December 31, 1993. As of December 31, 1993, the entire other investments portfolio matures in 1994. MORTGAGE-BACKED SECURITIES FAS 115 also requires the same three classifications for mortgage- backed securities (MBS): held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify MBS as either held to maturity or available for sale. The Company has no trading MBS. Mortgage- backed securities held to maturity are recorded at cost because the Company has the ability to hold these MBS to maturity and because management intends to hold these securities to maturity. Premiums and discounts on ITEM 1. BUSINESS (Continued) MORTGAGE-BACKED SECURITIES (continued) MBS are amortized or accreted using the interest method, also known as the level yield method, over the life of the security. At December 31, 1993, the Company had mortgage-backed securities held to maturity in the amount of $408 million. MBS available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had mortgage-backed securities available for sale in the amount of $1.1 billion and unrealized gains on mortgage-backed securities included in stockholders' equity of $44 million. Gains or losses on sales of MBS are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the MBS, using specific identification, adjusted for any unamortized premium or discount. Prior to December 31, 1993, all MBS were recorded at amortized cost. Repayments of MBS during the years 1993, 1992, and 1991 amounted to $646 million, $552 million, and $200 million, respectively. The increase in repayments in 1993 over 1992 and in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates. The portion of the Company's loans receivable represented by MBS was 6%, 8%, and 9% at yearends 1993, 1992, and 1991, respectively. STOCKHOLDERS' EQUITY The Company has increased its total stockholders' equity in each of the years 1993, 1992, and 1991 through the retention of a high percentage of net earnings. In addition, stockholders' equity increased in 1993 by $85 million due to the adoption of FAS 115 as of December 31, 1993. The Company has on file a shelf registration statement with the Securities and Exchange Commission to issue up to two million shares of its preferred stock. The preferred stock may be sold from time to time in one or more transactions for total proceeds of up to $200 million. The preferred stock may be issued in one or more series, may have varying provisions and designations, and may be represented by depository shares. The preferred stock is not convertible into common stock. No preferred stock has yet been issued under the registration. The Company's preferred stock has been preliminarily rated a2 by Moody's. On October 28, 1993, the Company's Board of Directors' authorized the purchase by the Company of up to 3.2 million shares of Golden West's common stock. As of December 31, 1993, 204,000 shares had been repurchased and retired. YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS Information regarding the Company's yield on interest-earning assets and cost of funds at December 31, 1993, 1992, and 1991 is contained in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and is incorporated herein by reference. ITEM 1. BUSINESS (Continued) YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS (continued) The gap table and related discussion included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, gives information on the repricing characteristics of the Company's interest-earning assets and interest-bearing liabilities at December 31, 1993, and is incorporated herein by reference. The dollar amounts of the Company's interest income and interest expense fluctuate depending both on changes in the respective interest rates and on changes in the respective amounts (volume) of interest-earning assets and interest-bearing liabilities. The following table sets forth certain information with respect to the yields earned and rates paid on the Company's interest-earning assets and interest-bearing liabilities. (a) Includes non-accrual loans (90 days or more past due). The table on the following page presents the changes for 1993 and 1992 from the respective preceding year of the interest income and expense associated with each category of interest-bearing asset and liability as allocated to changes in volume and changes in rates. ITEM 1. BUSINESS (Continued) YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS (continued) (a) The change in volume is calculated by multiplying the difference between the average balance of the current year and the prior year by the prior year's average yield. The change in rate is calculated by multiplying the difference between the average yield of the current year and the prior year by the prior year's average balance. The mixed changes in rate/volume is calculated by multiplying the difference between the average balance of the current year and the prior year by the difference between the average yield of the current year and the prior year. This amount is then allocated proportionately to the volume and rate changes calculated previously. (b) The effects of hedging activity have been allocated to income and expense of the related assets and liabilities. (c) Includes non-accrual loans (90 days or more past due). ITEM 1. BUSINESS (Continued) COMPETITION AND OTHER MATTERS The Company experiences strong competition in both attracting customer deposits and making real estate loans. Competition for savings deposits has historically come from money market mutual funds, other savings associa- tions, commercial banks, credit unions, and government and corporate debt securities. In addition, traditional financial institutions have found themselves in competition with new entrants into the financial services field, such as securities dealers, insurance companies, and others. The principal methods used by the Company to attract customer deposits, in addition to the interest rates and terms offered, include the offering of a variety of services and the convenience of office locations and hours of public operation. Competition in making real estate loans comes principally from other savings associations, mortgage banking companies, and commercial banks. A weak commercial real estate sector and a reduced volume of speculative transactions, such as leveraged buy-outs, have provided added incentive for banks to deploy their resources in new areas, and, as a result, they are increasing their investments in residential real estate mortgages. In addition, the volume of real estate lending by mortgage banking companies that originate and sell loans immediately has increased significantly. Traditionally privately owned, many mortgage banking companies have gone public and participated heavily in the refinance-driven loan market in recent years. Many of the nation's largest savings associations, mortgage banking companies, and commercial banks are headquartered or have a significant number of branch offices in the areas in which the Company competes. Changes in the government's monetary, tax, or housing financing policies can also affect the ability of lenders to compete profitably. The primary factors in competing for real estate loans are interest rates, loan fee charges, underwriting standards, and the quality of service to borrowers and their real estate brokers. SAVINGS AND LOAN INDUSTRY The operations of savings associations are significantly influenced by general economic conditions, by the related monetary and fiscal policies of the federal government, and by the policies of financial institution regulatory authorities. Customer deposit flows and costs of funds are impacted by interest rates on competing investments and general market rates of interest. Lending and other investment activities are affected by the demand for mortgage financing and for consumer and other types of loans, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting the supply of housing and the availability of funds. REGULATION FEDERAL HOME LOAN BANK SYSTEM. The FHLB system functions in a reserve credit capacity for its members, which may include savings associations, commercial banks and credit unions. As a member, World is required to own capital stock of an FHLB in an amount that depends generally upon its outstanding home mortgage loans or advances from such FHLB and is authorized to borrow funds from such FHLB (see Borrowings). ITEM 1. BUSINESS (Continued) REGULATION (continued) LIQUIDITY. The OTS requires insured institutions, such as World, to maintain a minimum amount of cash and certain qualifying investments for liquidity purposes. The current minimum requirement is equal to a monthly average of 5% of customer deposits and short-term borrowings. For the months ended December 31, 1993, and 1992, World's regulatory average liquidity ratio was 8% and 7%, respectively, consistently exceeding the requirement. FEDERAL DEPOSIT INSURANCE CORPORATION. The customer deposit accounts of World are insured by the FDIC as part of the Savings Association Insurance Fund up to the maximum amount permitted by law, currently $100,000 per insured depositor. As a result, the Association is subject to supervision by regulation and examination by the FDIC. FDIC insurance is required for all federally chartered associations. Such insurance may be terminated by the FDIC under certain circumstances involving violations of regulations or unsound practices. The annual premium charged for FDIC-SAIF insurance is determined by the FDIC using a risk-based system beginning in 1993. Under the system, associations are charged a variable rate ranging from a low of $.23 to a high of $.31 per $100 of deposits. The amount of capital an institution maintains and its examination scores are the most important factors determining the assessment. World qualifies for the lowest premium assessment of $.23 per $100 of deposits under the system. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) generally imposes a moratorium until 1994 on conversions from SAIF membership to Bank Insurance Fund (BIF) membership. However, a savings institution may convert to a bank charter if the resulting bank remains a member of SAIF. After expiration of the moratorium, such conversion requires payment of an exit fee to the insurance fund that the institution leaves and an entrance fee to the insurance fund the institution enters. In addition, bank holding companies, which were previously authorized to acquire savings institutions only in connection with supervisory transactions, may now acquire savings institutions generally. OFFICE OF THRIFT SUPERVISION. As a federally chartered savings and loan association, the principal regulator of World is the OTS. Under various regulations of the OTS, savings and loan associations are required, among other things, to pay assessments to the OTS, maintain required regulatory capital, maintain liquid assets at levels fixed from time to time, and to comply with various limitations on loans to one borrower and limitations on equity investments, investments in real estate, and investments in corporate debt securities that are not investment grade. World is subject to examination by the OTS and is in compliance with its current requirements. FEDERAL RESERVE SYSTEM. Federal Reserve Board regulations require savings institutions to maintain noninterest-earning reserves against their ITEM 1. BUSINESS (Continued) REGULATION (continued) checking accounts. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements. World is currently in compliance with all applicable Federal Reserve Board reserve requirements. Savings and loan associations have authority to borrow from the Federal Reserve Bank "Discount Window," but the Federal Reserve Board requires savings and loan associations to exhaust all FHLB sources before borrowing from the Federal Reserve Bank. REGULATORY CAPITAL. The OTS requires federally insured institutions such as World to meet certain minimum capital requirements. The table below summarizes World's regulatory capital ratios and compares them to the OTS minimum requirements at December 31. The table below summarizes World's regulatory capital ratios and compares them to the fully phased-in OTS minimum requirements at December 31. ITEM 1. BUSINESS (Continued) REGULATION (continued) The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required each federal banking agency to implement prompt corrective actions for institutions that it regulates to resolve the problems of insured depository institutions at the least possible long-term loss to the deposit insurance fund. In response to this requirement, the OTS adopted final rules as to capital adequacy, effective December 19, 1992, based upon FDICIA's five capital tiers. The rules provide that a savings association is "well capitalized" if its total risk-based capital ratio is 10% or greater, its Tier 1 risk-based capital ratio is 6% or greater, its leverage ratio is 5% or greater, and the institution is not subject to a capital directive. A savings association is "adequately capitalized" if its total risk-based capital ratio is 8% or greater, its Tier 1 risk-based capital ratio is 4% or greater, and its leverage ratio is 4% or greater (3% or greater for one-rated institutions). An institution is considered "undercapitalized" if its total risk-based capital ratio is less than 8%, its Tier 1 risk-based capital ratio is less than 4%, or its leverage ratio is less than 4% (less than 3% for one-rated institutions). An institution is "significantly undercapitalized" if its total risk-based capital ratio is less than 6%, its Tier 1 risk-based capital ratio is less than 3%, or its leverage ratio is less than 3%. A savings association is deemed to be "critically undercapitalized" if its ratio of tangible equity to total assets is equal to, or less than, 2%. At its discretion, the OTS may determine that an institution is in a capitalization category that is lower than is indicated by its actual capital position. As used herein, total risk-based capital ratio means the ratio of total capital to risk-weighted assets, Tier 1 risk-based capital ratio means the ratio of core capital to risk-weighted assets, and leverage ratio means the ratio of core capital to adjusted total assets, in each case as calculated in accordance with current OTS capital regulations. World met the "well capitalized" standard as of December 31, 1993. The table below shows a reconciliation of World's equity capital to regulatory capital under FIRREA and FDICIA at December 31, 1993. (1) All goodwill is required to be deducted from tangible capital. Goodwill arising prior to April 12, 1989, in excess of a sliding scale limit (.75% of assets at December 31, 1993), is required to be deducted from all other capital computations on a phased-in basis through December 1994. Goodwill arising after April 12, 1989, must be deducted from all capital computations. (2) All but $2,443 of the Association's positive goodwill arose prior to April 12, 1989. (3) The Association's negative goodwill arose after April 12, 1989. (4) Equity and certain other investments are required to be deducted from total risk-based capital on a phased-in basis (60% at December 31, 1993) through June 1994. The table below shows a reconciliation of World's equity capital to regulatory capital under FIRREA and FDICIA at December 31, 1992. (1) All goodwill is required to be deducted from tangible capital. Goodwill arising prior to April 12, 1989, in excess of a sliding scale limit (1% of assets at December 31, 1992), is required to be deducted from all other capital computations on a phased-in basis through December 1994. Goodwill arising after April 12, 1989, must be deducted from all capital computations. (2) All but $193 of the Association's positive goodwill arose prior to April 12, 1989. (3) The Association's negative goodwill arose after April 12, 1989. (4) Equity and certain other investments are required to be deducted from total risk-based capital on a phased-in basis (40% at December 31, 1992) through June 1994. ITEM 1. BUSINESS (Continued) REGULATION (continued) The table below compares World's regulatory capital to the well capitalized classification of FDICIA's capital standards at December 31. World's leverage, Tier 1 risk-based, and total risk-based capital ratios under the fully phased-in 1995 OTS minimum requirements at December 31, 1993, were 7.27%, 14.17%, and 16.21%, respectively. World's leverage, Tier 1 risk-based, and total risk-based capital ratios under the fully phased-in 1995 OTS minimum requirements at December 31, 1992, were 6.54%, 12.68%, and 14.63%, respectively. CAPITAL DISTRIBUTIONS BY SAVINGS ASSOCIATIONS. The OTS adopted regulations in 1990 with respect to capital distributions by savings associations such as World. Under these regulations, a savings association is classified as either Tier 1, if it meets each of its fully phased-in capital requirements immediately prior to and after giving effect to the proposed capital distribution; Tier 2, if it meets each of its current capital requirements but does not meet one or more of its fully phased-in capital requirements immediately prior to or after giving effect to the proposed capital distribution; or Tier 3, if it does not meet its current capital requirements immediately prior to or after giving effect to the proposed capital distribution. A savings association that would otherwise be classified as Tier 1 is treated as Tier 2 or Tier 3 if the OTS so notifies the association based on OTS' conclusion that the association is in need of more than normal supervision. Under the regulations, a Tier 1 association may make capital distributions during a calendar year up to 100% of its net income to date during the calendar year plus up to one-half of its capital in excess of the fully phased-in requirement at the end of the prior year. A Tier 2 association may make capital distributions from 25% to 75% of its net ITEM 1. BUSINESS (Continued) REGULATION (continued) income over the most recent four quarter period, with the percentage varying based on its level of risk-based capital. Any capital distributions by a Tier 3 association or in excess of the foregoing amounts by a Tier 1 or Tier 2 association are subject to either prior OTS approval or notice must be given to the OTS, which may disapprove the distribution. However, FDICIA legislation prohibits capital distributions by an institution that does not meet its capital requirements. Savings associations are required to give the OTS 30-day advance written notice of all proposed capital distributions. For purposes of capital distributions, the OTS has classified World as a Tier 1 association. LIMITATION ON LOANS TO ONE BORROWER. FIRREA subjects savings associations to the same loans-to-one borrower restrictions that are applicable to national banks with limited provisions for exceptions. In general, the national bank standard restricts loans to a single borrower to no more than 15% of a bank's unimpaired capital and unimpaired surplus, plus an additional 10% if the loan is collateralized by certain readily marketable collateral. (Real estate is not included in the definition of "readily marketable collateral.") At December 31, 1993, the maximum amount that World could have loaned to one borrower (and related entities) was $325 million. At such date, the largest amount of loans that World had outstanding to any one borrower was $39 million. SAVINGS AND LOAN HOLDING COMPANY LAW. The Company is a "savings and loan holding company" under the National Housing Act of 1934. As such, it has registered with the OTS and is subject to OTS regulation and OTS and FDIC examination, supervision, and reporting requirements. Among other things, the OTS has authority to determine that an activity of a savings and loan holding company constitutes a serious risk to the financial safety, soundness, or stability of its subsidiary savings institutions and thereupon may impose, among other things, restrictions on the payment of dividends by the subsidiary institutions and on transactions between the subsidiary institutions, the holding company and subsidiaries or affiliates of either. As World's parent company, Golden West is considered an "affiliate" of the Association for regulatory purposes. Savings associations are subject to the rules relating to transactions with affiliates and loans to insiders generally applicable to commercial banks that are members of the Federal Reserve System set forth in Sections 23A, 23B, and 22(h) of the Federal Reserve Act, as well as additional limitations set forth in FIRREA and as adopted by the OTS. In addition, FIRREA generally prohibits a savings association from lending or otherwise extending credit to an affiliate, other than the association's subsidiaries, unless the affiliate is engaged only in activities that the Federal Reserve Board has determined to be permissible for bank holding companies and that the OTS has not ITEM 1. BUSINESS (Continued) REGULATION (continued) disapproved. In 1991, the OTS adopted regulations to implement the affiliate transactions limitations contained in FIRREA. Among other things, the regulations provide guidance in determining an affiliate of a savings association and in calculating compliance with the quantitative limitations on transactions with affiliates. TAXATION. Savings and loan associations that meet certain definitional tests and other conditions prescribed by the Internal Revenue Code are allowed a bad debt reserve deduction computed as a percentage of taxable income before such deduction. Accordingly, qualifying savings and loan associations are subject to a lower effective federal income tax rate than that applicable to corporations generally. The effective federal income tax rate applicable to qualifying savings and loan associations is approximately 32.2%, depending on the extent of "tax preference" items in addition to the bad debt reserve deduction. The bad debt reserve deduction computed as a percentage of taxable income is available only to the extent that amounts accumulated in the bad debt reserve for certain real estate loans defined as "qualifying real estate loans" do not exceed 6% of such loans at yearend. In addition, the deduction is further limited to the amount by which 12% of customer deposits at yearend exceeds the sum of surplus, undivided profits and reserves at the beginning of the year. At December 31, 1993, the 6% and 12% limitations did not restrict the bad debt reserve deduction of World, and it is expected that such limitations will not be restricting factors in the future. Qualifying savings and loan associations that file income tax returns as members of a consolidated group are required to reduce their bad debt reserve deduction for tax losses attributable to non-savings and loan association members of the group whose activities are functionally related to the activities of the savings and loan association member. If the accumulated bad debt reserves are used for any purpose other than to absorb bad debt losses, federal income taxes may be imposed at the then applicable rates. In addition, if such reserves are used to pay dividends or to make other distributions with respect to a savings and loan association stock (such as redemption or liquidation), special additional taxes would be imposed. Although generally similar, differences exist, with respect to the determination of taxable income, among the Internal Revenue Code and the tax codes of the states in which the Company operates. These states do not allow the special percentage of taxable income method of computing the bad debt reserve, discussed above, which can cause the Company's taxable income, at the state level, to be significantly different from its taxable income at the federal level. ITEM 1. BUSINESS (Continued) REGULATION (continued) Golden West utilizes the accrual method of accounting for income tax purposes and for preparing its published financial statements. For financial reporting purposes only, the Company uses "purchase accounting" in connection with certain assets acquired through mergers. The purchase accounting portion of income is not subject to tax. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes." FAS 109 required a change from the deferred to the liability method of computing deferred income taxes. The Company has applied FAS 109 prospectively. The cumulative effect of this change in accounting for income taxes for the periods ending prior to January 1, 1993, is not material. FAS 109 required the Company to adjust its purchase accounting for prior business combinations by increasing deferred tax assets and reducing goodwill by $23 million to reflect the non-taxability of purchase accounting income. This deferred tax asset is being amortized over the remaining lives of the related purchased assets. EMPLOYEE RELATIONS The Company had a total of 3,635 full-time and 741 permanent part-time employees at December 31, 1993. None of the employees of the Company are represented by any collective bargaining group. The management of the Company considers employee relations to be good. ITEM 2. ITEM 2. PROPERTIES Properties owned by the Company are located in Arizona, California, Colorado, Florida, Kansas, New Jersey, and Texas. The executive offices of the Company are located at 1901 Harrison Street, Oakland, California, in leased facilities. The Company continuously evaluates the suitability and adequacy of the offices of the Company and has a program of relocating or remodel-ing them as necessary to maintain efficient and attractive facilities. The Company is currently building a 300,000 square-foot office complex on an 111-acre site in San Antonio, Texas, which will house its Loan Service, Savings Operations, and Information Systems Departments. The expected completion date is September 1994. The Company owns 175 of its branches, some of which are located on leased land. For further information regarding the Company's investment in premises and equipment and expiration dates of long-term leases, see Note I to the Financial Statements, in Item 14. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Savings and loan associations and other financial institutions that take consumer deposits in California have been named from time to time in class action proceedings that question the legality of certain terms of deposit agreements and the implementation of such agreements. World is named as a defendant in one action that purports to be a class action of this type. This action was dismissed at the trial court level, and, upon appeal, the dismissal was affirmed in part and reversed in part. The action was subsequently remanded to the trial court level, where a class has been certified. However, in the opinion of management, the result of this action will not have a material effect on the Company's consolidated financial condition or results of operations. The Company and its subsid- iaries are parties to other actions arising in the ordinary course of business, none of which, in the opinion of management, is material to the Company's consolidated financial condition or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS MARKET PRICES OF STOCK Golden West's stock is listed on the New York Stock Exchange and Pacific Stock Exchange and traded on the Boston and Midwest Stock Exchanges under the ticker symbol GDW. The quarterly price ranges for the Company's common stock during 1993 and 1992 were as follows: ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS (Continued) PER SHARE CASH DIVIDENDS DATA Golden West's cash dividends paid per share for 1993 and 1992 were as follows: The principal sources of funds for the payment by Golden West of cash dividends are cash dividends paid to it by World Savings, investment income, and short-term borrowings. Under OTS regulations, the OTS must be given at least 30 days' advance notice by the Association of any proposed dividend to be paid to the parent. Under OTS regulations, World Savings is classified as a Tier 1 association and is, therefore, allowed to distribute dividends up to 100% of its net income in any year plus one-half of its capital in excess of the OTS fully phased-in capital requirement as of the end of the prior year. At December 31, 1993, $354 million of the Association's retained earnings had not been subjected to federal income taxes due to the application of the bad debt deduction, and $1.8 billion of the Association's retained earnings were available for the payment of cash dividends without the imposition of additional federal income taxes. STOCKHOLDERS At the close of business on March 18, 1994, 63,994,385 shares of Golden West's Common Stock were outstanding and were held by 1,911 stockholders of record. The transfer agent and registrar for the Golden West Common Stock is First Interstate Bank, San Francisco, California 94104. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial and other data for Golden West for the years indicated. Such information is qualified in its entirety by the more detailed financial information set forth in the financial statements and notes thereto appearing in the documents incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA (Continued) ITEM 6. SELECTED FINANCIAL DATA (Continued) ITEM 6. SELECTED FINANCIAL DATA (Continued) (a) Earnings represent income from continuing operations before income taxes and fixed charges. Fixed charges include interest expense and amortization of debt expense. (b) The definition of nonperforming assets includes non-accrual loans (loans that are 90 days or more past due) and real estate owned acquired through foreclosure. (c) The requirements were 1.5%, 3.0%, and 8.0% (7.2% prior to December 31, 1992) for tangible, core, and risk-based capital, respectively, at December 31, 1992, and 1993. World Savings and Loan Association currently meets its fully phased-in capital requirement. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following narrative focuses on the significant financial statement changes that have taken place at Golden West over the past three years and includes a discussion of the Company's financial condition and results of operations during that period. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION The accompanying table summarizes the Company's major asset, liability, and equity components in percentage terms at yearends 1993, 1992, 1991, and 1990. As the table shows, customer deposits represent the majority of the Company's liabilities. On the other side of the balance sheet, the loan portfolio, which consists primarily of long-term mortgages, is the largest asset component. The disparity between the repricing (maturity or interest rate change) of deposits and other liabilities and the repricing of mortgage loans can affect the Company's liquidity and can have a material impact on the Company's results of operations. The difference between the repricing of assets and liabilities is commonly referred to as the gap. The gap table on the following page shows that, as of December 31, 1993, the Company's assets reprice sooner than its liabilities. Consequently, one would expect falling interest rates to lower Golden West's earnings and rising rates to increase the Company's earnings. However, Golden West's earnings are also affected by the built-in lag inherent in the Eleventh District Cost of Funds Index (COFI), which is the benchmark the Company uses to determine the rate on the great majority of its adjustable rate mortgages. Specifically, there is a two-month delay in reporting the COFI because of the time required to gather the data needed to compute the index. As a result, the current COFI actually reflects the Eleventh District's cost of ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) funds at the level it was two months prior. Consequently, when the interest rate environment changes, the COFI reporting lag causes assets to initially reprice more slowly than liabilities, enhancing earnings when rates are falling and holding down income when rates rise. (a) Based on scheduled maturity or scheduled repricing, loans reflect scheduled repayments and projected prepayments of principal. (b) Includes cash in banks, FHLB stock, and loans collateralized by customer deposits. (c) Liabilities with no maturity date, such as passbook and money market deposit accounts, are assigned zero months. CASH AND INVESTMENTS Golden West's investment portfolio is composed primarily of federal funds, short-term repurchase agreements collateralized by mortgage-backed securities, and short-term money market securities. In determining the amounts of assets to invest in each class of investments, the Company considers relative rates, liquidity, and credit quality. When opportunities arise, the Company enters into arbitrage transactions with ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) secured borrowings and short-term investments to profit from the rate differential. The level of the Company's investments position in excess of its liquidity requirements at any time depends on liquidity needs and available arbitrage opportunities. The Office of Thrift Supervision requires insured institutions, such as World Savings, to maintain a minimum amount of cash and certain qualifying investments for liquidity purposes. The current minimum requirement is equal to a monthly average of 5% of customer deposits and short-term borrowings. For the months ended December 31, 1993, 1992, and 1991, World's regulatory average liquidity ratio was 8%, 7%, and 8%, respectively, consistently exceeding the requirement. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." FAS 115 establishes three investment classifications: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify investment securities as either held to maturity or available for sale. The Company has no trading securities. Held to maturity securities are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Securities held to maturity are recorded at cost because the Company has the ability to hold these securities to maturity and because it is Management's intention to hold them to maturity. At December 31, 1993, the Company had no securities held to maturity. Securities available for sale increase the Company's portfolio management flexibility for investments and are reported at fair value. Net unrealized gains and losses are excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had no securities held to maturity or for trading. At December 31, 1993, the Company had securities available for sale in the amount of $1.6 billion and unrealized gains on securities available for sale recorded to stockholders' equity of $41 million. Gains or losses on sales of securities are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the security, using specific identification, adjusted for any unamortized premium or discount. The Company has other investments which are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. The adoption of FAS 115 resulted in the reclassification of certain securities from the investment securities portfolio to the securities available for sale portfolio. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) Prior to December 31, 1993, securities were classified as either securities held for sale or investment securities. Securities held for sale were recorded at the aggregate portfolio's lower of amortized cost or market, with the unrealized gains and losses included in earnings. Investment securities were recorded at amortized cost. MORTGAGE-BACKED SECURITIES FAS 115 also requires the same three classifications for mortgage-backed securities: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify MBS as either held to maturity or available for sale. The Company has no trading MBS. Mortgage-backed securities held to maturity are recorded at cost because the Company has the ability to hold these MBS to maturity and because management intends to hold these securities to maturity. Premiums and discounts on MBS are amortized or accreted using the interest method, also known as the level yield method, over the life of the security. At December 31, 1993, the Company had mortgage-backed securities held to maturity in the amount of $408 million. MBS available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had mortgage-backed securities available for sale in the amount of $1.1 billion and unrealized gains on mortgage-backed securities recorded to stockholders' equity of $44 million. Gains or losses on sales of MBS are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the MBS, using specific identification, adjusted for any unamortized premium or discount. Prior to December 31, 1993, all MBS were recorded at amortized cost. Repayments of MBS during the years 1993, 1992, and 1991 amounted to $646 million, $552 million, and $200 million, respectively. The increase in repayments in 1993 over 1992 and in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates. The portion of the Company's loans receivable represented by MBS was 6%, 8%, and 9% at yearends 1993, 1992, and 1991, respectively. LOAN PORTFOLIO New loan originations in 1993, 1992, and 1991 amounted to $6.4 billion, $6.5 billion, and $4.9 billion, respectively. Refinanced loans constituted 59% of new loan originations in 1993 compared to 56% in 1992 and 46% in 1991. The 1993 origination volume remained high due to the continued demand in the marketplace for refinancing of existing loans, plus expansion of the Company's loan origination capacity. Although the Company ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) has lending operations in 21 states, the primary mortgage origination focus continues to be on residential property in California. In 1993, 73% of total loan originations were on residential properties in California, compared to 83% and 88% in 1992 and 1991, respectively. Although California originations continue to be a large portion of total originations, the decrease in 1993 as compared to 1992 and 1991 was due to increased penetration by the Company in markets outside California and the slight decrease of originations in California. The percentage of the total loan portfolio (excluding mortgage-backed securities) that is comprised of residential loans in California was 81% at December 31, 1993, and 83% at December 31, 1992, and 1991. The total growth in the portfolio for each of the years ended December 31, 1993, and 1992, was $1.9 billion or 9%. Golden West continues to emphasize adjustable rate mortgages (ARMs)--loans with interest rates that change periodically in accordance with movements in specified indexes. The portion of the mortgage portfolio (excluding MBS) composed of rate-sensitive loans was 87% at yearends 1993, 1992, and 1991. Despite stiff competition from mortgage bankers who aggressively marketed fixed-rate mortgages at the lowest rates seen in the past 20 years, Golden West's ARM originations constituted approximately 75% of new mortgage loans made by the Company in 1993, compared with 80% in 1992 and 89% in 1991. Repayments of loans during the years 1993, 1992, and 1991 amounted to $3.8 billion, $4.1 billion, and $2.8 billion, respectively. The decrease in repayments in 1993 over 1992 was due to lower mortgage payoffs within our loan portfolio. The increase in repayments in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates by replacing older, high-cost debt with new, more attractively priced instruments. The Company adopted Statement of Financial Accounting Standards No. 114 (FAS 114), "Accounting by Creditors for Impairment of a Loan," in the fourth quarter of 1993, retroactive to January 1, 1993. FAS 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. The valuation allowance and provision for loan losses are adjusted for changes in the present value of impaired loans for which impairment is measured based on the present value of expected future cash flows. The Company had previously measured loan impairment in accordance with the methods prescribed in FAS 114. As a result, no additional loss provisions were required by early adoption of the pronouncement. FAS 114 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) requires that impaired loans for which foreclosure is probable should be accounted for as loans. As a result, $16 million of in-substance foreclosed loans, with a valuation allowance of $7 million, were reclassified from real estate held for sale to loans receivable. Prior year amounts have not been restated. One measure of the soundness of the Company's portfolio is its ratio of nonperforming assets to total assets. Nonperforming assets include non-accrual loans (loans that are 90 days or more past due) and real estate acquired through foreclosure. In prior years, loans considered in-substance foreclosed were included in real estate held for sale, but upon adoption of FAS 114, impaired loans are now classified with loans receivable. NPAs amounted to $394 million, $330 million, and $282 million at yearends 1993, 1992, and 1991, respectively. The increase in NPAs in 1993 and 1992 was primarily in single-family loans and foreclosed real estate in California. The continued weak California economy and high unemployment rate resulted in an increase in loan delinquencies and, in certain areas, decreases in real estate prices. The growth in NPAs has also been impacted by high levels of bankruptcy filings, which often delay the collection process and extend the length of time a loan remains delinquent. The Company continues to closely monitor all delinquencies and takes appropriate steps to protect its interests. The Company's troubled debt restructured, which are loans that have been modified due to a weakness in the collateral and/or borrower, were $37 million, or 0.13% of assets, at December 31, 1993, compared to $13 million, or 0.06% of assets, at December 31, 1992, and $18 million, or 0.08% of assets, at December 31, 1991. The increase is due in part to the FAS 114 reclassification which included loans that had been modified. A majority of the Company's TDRs have temporary interest rate reductions and have been made primarily to customers negatively impacted by adverse economic conditions. The Company's ratio of NPAs and TDRs to total assets increased to 1.50% at December 31, 1993, from 1.33% and 1.24% at yearends 1992 and 1991, respectively. REAL ESTATE HELD FOR SALE Real estate acquired through foreclosure increased to $63 million at December 31, 1993, from $57 million a year earlier. The increase occurred primarily in one- to four-family properties in California. The Company's total Real Estate Held for Sale portfolio decreased to $64 million at December 31, 1993, from $67 million a year earlier due to the reclassification of loans in-substance foreclosed upon adoption of FAS 114 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) during December 1993. The components of the real estate held for sale portfolio at December 31, 1993, 1992, and 1991, are shown below: (a) All amounts are net of general valuation allowances. ALLOWANCE FOR LOAN LOSSES The Company's allowance for loan losses was $107 million at December 31, 1993, compared to $71 million and $48 million at yearends 1992 and 1991, respectively. The provision for loan losses was $66 million, $43 million, and $35 million in 1993, 1992, and 1991, respectively. The 1993 increase in the allowance and the provision over 1992 was considered prudent given the continued difficulties in the California economy, which led to an increase in nonperforming assets and chargeoffs. CUSTOMER DEPOSITS Customer deposits increased by $880 million, excluding those arising from acquisition and sales activity, compared to a decrease of $255 million in 1992, excluding branch sales, and an increase of $640 million in 1991. Rates paid on deposit accounts dropped steadily in 1993 and 1992, reaching the lowest level in 20 years for most products. Although rates paid on new accounts were lower than they had been in previous years, consumer funds were attracted during 1993 as a result of special promotions in the Company's savings markets. The Company experienced a net outflow of deposits during 1992 because the Company emphasized other, more cost-effective sources of funds, primarily Federal Home Loan Bank advances. In 1993, the Company acquired seven branches in Arizona containing $320 million in deposits and sold all seven of the Ohio branches with $264 million in deposits. The Company has no brokered deposits. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) ADVANCES FROM FEDERAL HOME LOAN BANKS The Company uses Federal Home Loan Bank borrowings, also known as "advances," to supplement cash flow and to provide funds for loan origination activities. Advances offer strategic advantages for asset-liability management including long-term maturities and, in certain cases, prepayment at the Company's option. FHLB advances increased by $782 million in 1993 compared to increases of $1.3 billion and $325 million in 1992 and 1991, respectively. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE The Company borrows funds through transactions in which securities are sold under agreements to repurchase. These funds are used to take advantage of arbitrage investment opportunities and to supplement cash flow. Reverse Repos are entered into with selected major government securities dealers, as well as large banks, typically using MBS from the Company's portfolio. Reverse Repos with dealers and banks amounted to $377 million, $486 million, and $579 million at yearends 1993, 1992, and 1991, respectively. OTHER BORROWINGS At December 31, 1993, Golden West had on file registration statements with the Securities and Exchange Commission for the sale of up to $100 million of subordinated notes. Golden West issued subordinated debt securities of $100 million in January 1993, and $200 million in October 1993, bringing the balance to $1.0 billion at December 31, 1993. As of December 31, 1993, the Company's subordinated debt was rated A3 and A- by Moody's Investors Service (Moody's) and Standard & Poor's Corporation (S&P), respectively. World Savings currently has on file a shelf registration with the OTS for the issuance of $2.0 billion of unsecured medium-term notes. As of December 31, 1993, $1.2 billion was available for issuance. The Association had medium-term notes outstanding under the current and prior registrations with principal amounts of $677 million at December 31, 1993, compared to $81 million at December 31, 1992, and $167 million at December 31, 1991. As of December 31, 1993, the Association's medium-term notes were rated A1 and A+ by Moody's and S&P, respectively. World Savings also has on file a registration statement with the OTS for the sale of up to $250 million of subordinated notes. Under a prior filing with the OTS, $50 million of subordinated notes remain unissued. As of December 31, 1993, World Savings had issued $200 million of subordinated securities. As of December 31, 1993, World Savings' subordinated notes were rated A2 and A by Moody's and S&P, respectively. The subordinated ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) notes are included in World Savings' risk-based regulatory capital as Supplementary Capital. STOCKHOLDERS' EQUITY The Company has increased its total stockholders' equity in each of the years 1993, 1992, and 1991 through the retention of a high percentage of net earnings. In addition, stockholders' equity increased in 1993 by $85 million due to the adoption of FAS 115 as of December 31, 1993. The Company has on file a shelf registration statement with the Securities and Exchange Commission to issue up to two million shares of its Preferred Stock. The Preferred Stock may be sold from time to time in one or more transactions for total proceeds of up to $200 million. The Preferred Stock may be issued in one or more series, may have varying provisions and designations, and may be represented by depository shares. The Preferred Stock is not convertible into Common Stock. No Preferred Stock has yet been issued under the registration. On October 28, 1993, the Company's Board of Directors' authorized the purchase by the Company of up to 3.2 million shares of Golden West's common stock. As of December 31, 1993, 204,000 shares had been repurchased and retired. The OTS requires federally insured institutions, such as World, to meet minimum capital requirements. Under these regulations, a savings institution is required to meet three separate capital requirements. The first requirement is to have tangible capital of 1.5% of adjusted total assets. At December 31, 1993, World Savings had tangible capital of $2.0 billion, or 7.27% of adjusted total assets, $1.6 billion in excess of the regulatory requirement. The second requirement is to have core capital of 3% of adjusted total assets. Core capital is defined as tangible capital plus certain allowable amounts of supervisory goodwill and direct investments. However, the amount of supervisory goodwill and direct investments that can be counted as core capital will be phased-down to zero by January 1, 1995. At December 31, 1993, World Savings had core capital of $2.2 billion, or 8.02% of adjusted total assets, $1.4 billion in excess of the regulatory requirement. The third capital requirement is to have risk-based capital equal to 8.0% of risk-weighted assets. At December 31, 1993, World Savings had risk-based capital in the amount of $2.5 billion, or 17.42% of risk-weighted assets, exceeding the current requirement by $1.4 billion. It should be noted that World Savings also continues to exceed all three capital requirements on a fully phased-in basis. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) The Federal Deposit Insurance Corporation Improvement Act of 1991 required each federal banking agency to implement prompt corrective actions for capital deficient institutions that it regulates. In response to this requirement, the OTS adopted final rules, effective December 19, 1992, based upon FDICIA's five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The determination of whether an association falls into a certain classification depends primarily on its capital ratios. The following table summarizes the capital ratios for each of the five classifications and shows that World Savings met the "well capitalized" standard as of December 31, 1993. (a) Core capital divided by adjusted total assets. (b) Core capital divided by risk-weighted assets. (c) Total capital is the same as risk-based capital and consists of such items as qualifying subordinated debt, cumulative perpetual and intermediate-term preferred stock, certain convertible debt securities, and general allowances for loan losses. The OTS limits capital distributions by savings and loan associations. For purposes of capital distributions, the OTS has classified World Savings as a Tier 1 association; thus, the Association may pay dividends during a calendar year of up to 100% of net income to date during the calendar year plus up to one-half of capital in excess of the fully phased-in requirement ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) at the end of the prior year subject to thirty days' advance notice to the OTS. RESULTS OF OPERATIONS PROFIT MARGINS/SPREADS An important determinant of Golden West's earnings is its primary spread--the difference between its yield on earning assets and its cost of funds. The Company's primary spread is somewhat dependent on changes in interest rates because Golden West's liabilities tend to respond more rapidly to rate movements than do its assets. Because of the relatively stable interest rate environment during 1993, the benefit from the COFI timing lag was significantly smaller, resulting in a lower spread than a year ago. The primary spread was unusually high during 1992 because, during that year's falling interest rate environment, the cost of deposits and borrowings declined much faster than the yield on the Company's major earning asset, the loan portfolio, in large part due to the two month reporting lag of the Eleventh District Cost of Funds Index to which $19.5 billion of Golden West's assets are tied. YIELD ON EARNING ASSETS Golden West originates ARMs to manage the rate sensitivity of the asset side of the balance sheet. Most of the Company's ARMs have interest rates that change monthly in accordance with an index based on the cost of deposits and borrowings of savings institutions that are members of the FHLB of San Francisco (the COFI). Consequently, when interest rates de- creased in 1991 and 1992, the yield on the Company's loan portfolio also decreased. During 1993, although interest rates were more stable, the index continued to decline somewhat. In addition, during 1992 and 1993, the Company experienced large payoffs of high-rate fixed loans and MBS, which also contributed to the decrease in the yield on loans. The yield on earning assets showed a decline throughout 1991, 1992, and 1993 from a high of 10.22% in January 1991 to 6.61% at December 31, 1993, due in large part to decreases in the COFI during the period. COST OF FUNDS Approximately 81% of Golden West's liabilities are subject to repricing in less than one year. Because the cost of these liabilities is affected by short-term interest rates, a fall in the general level of interest rates led to a decrease in the Company's cost of funds during 1993, 1992, and 1991. The effect of these changes on asset yields and liability costs may be seen in the following table, which shows the components of the Company's primary spread at the end of the years 1991 through 1993. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) INTEREST ON LOANS In 1993 and 1992, interest on loans decreased due to a decline in the average portfolio yield partially offset by an increase in the average portfolio balance. INTEREST ON MBS In 1993 and 1992, interest on MBS decreased due to a decline in the average portfolio yield and a decrease in the average portfolio balance. INTEREST AND DIVIDENDS ON INVESTMENTS The income earned on the investment portfolio fluctuates, depending upon the volume outstanding and the yields available on short-term investments. Income from the Company's investments was higher in 1993 than in 1992 due to a higher average portfolio balance and increased FHLB dividends. Interest and dividends on investments was lower in 1992 than in 1991 due to a lower portfolio yield. INTEREST ON CUSTOMER DEPOSITS The major portion of the Company's customer deposit base consists of savings accounts with remaining maturities of less than one year. Thus, the amount of interest paid on these funds depends upon the level of short-term interest rates and the savings balances outstanding. The decrease in interest on customer deposits in 1993 and 1992 was due to a decrease in the average cost of deposits. INTEREST ON ADVANCES Interest paid on FHLB advances was higher in 1993 than in 1992 due to an increase in the average balance of these liabilities partially offset by a decrease in the average cost. Interest paid on FHLB advances was lower in 1992 than in 1991 due to a decrease in the average cost of these liabilities partially offset by an increase in the average balance of these liabilities. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) OTHER BORROWINGS Interest expense on other borrowings amounted to $158 million, $154 million, and $165 million for the years ended 1993, 1992, and 1991, respectively. The increase in the expense from 1993 over 1992 was due to an increase in the average balance of these liabilities partially offset by a decrease in the average cost. The decrease in the expense from 1992 over 1991 was due to a decrease in the average cost of other borrowings and a decrease in the average balance. PROVISION FOR LOAN LOSSES The provision for loan losses was $66 million, $43 million, and $35 million for the years ended 1993, 1992, and 1991, respectively. The increase in the provision from 1993 over 1992 and 1992 over 1991 reflected increased chargeoffs, increased nonperforming assets, and the continued weak California economy. GAIN (LOSS) ON THE SALE OF SECURITIES AND MORTGAGE-BACKED SECURITIES The gain (loss) on the sale of securities and mortgage-backed securities was a gain of $23 million and $4 million for the years ended 1993 and 1992, respectively, compared to a loss of $1 million for the year ended 1991. The 1993 gain included a $24 million reduction of a valuation allowance on investments charged to income in a previous year compared to a $4 million reduction in 1992. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses increased during the three years under discussion. The primary reasons for the increases for all three years were general inflation, growth of mortgage and deposit balances, the expansion of loan origination capacity, the installation of enhancements to data processing systems, and the expansion at Atlas Mutual Funds. The increase in 1993 was also due to the expansion of savings and loan activity outside of California and the relocation of some of our administrative operations to San Antonio, Texas. General and administrative expense as a percentage of average assets was 0.97%, 0.99%, and 0.99% at December 31, 1993, 1992, and 1991, respectively. TAXES ON INCOME Golden West utilizes the accrual method of accounting for income tax purposes and for preparing its published financial statements. For financial reporting purposes only, the Company uses "purchase accounting" in connection with certain assets acquired through mergers. The purchase accounting portion of income is not subject to tax. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) FAS 109 requires a change from the deferred method to the liability method of computing deferred income taxes. The Company has applied FAS 109 prospectively. The cumulative effect of this change in accounting for income taxes for the periods ending prior to January 1, 1993, is not material. FAS 109 required the Company to adjust its purchase accounting for prior business combinations by increasing deferred tax assets and reducing goodwill by $23 million to reflect the non-taxability of purchase accounting income. This deferred tax asset is being amortized over the remaining lives of the related purchased assets. The consolidated financial statements presented for the years prior to 1993 reflect income taxes under the deferred method required by previous accounting standards. Taxes as a percentage of earnings increased in 1993 over 1992 due to the effect of the amortization of the deferred tax asset related to the $23 million adjustment arising from the adoption of FAS 109, as well as the effect of the federal legislation enacted during 1993 that increased the federal corporate income tax rate from 34% to 35%. ACQUISITIONS During 1993, the Company acquired $320 million in deposits and seven branches in Arizona from PriMerit Bank. On July 15, 1991, the Company took title to the common stock of Beach Federal Savings and Loan Association of Boynton Beach, Florida, and its $1.5 billion in assets. The transaction has been accounted for as a purchase, and the results of operations have been included with the Company's results of operations since July 15, 1991. As a result of the Beach acquisition, Golden West recognized, for tax purposes, certain Beach net operating losses that resulted in a $25 million benefit in 1992 and a $103 million benefit in 1991. For financial statement reporting, this benefit has been recorded as negative goodwill and is being amortized into income over ten years. In 1993, 1992, and 1991, $13 million, $12 million, and $5 million, respectively, of the negative goodwill was amortized. On March 31, 1991, World Savings and Loan Association of Ohio, a wholly owned subsidiary of Golden West, was merged into World Savings. In conjunction with Golden West's acquisition of World of Ohio in 1988, the benefits of net operating loss carryforwards resulted in recording $18 million of negative goodwill in 1991. This benefit has been amortized into income over the period 1989 to 1993. In 1993, 1992, and 1991, $3 million, $4 million, and $11 million, respectively, of the negative goodwill was amortized. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) During 1991, World Savings acquired from the Resolution Trust Corporation (RTC) $355 million of deposits and 11 branches from four separate acquisitions. The acquisitions are not material to the financial position or net earnings of Golden West and pro forma information is not deemed necessary. DIVESTITURES During 1993, the Company sold $133 million of savings in two Ohio branches to Trumbull Savings and Loan and its remaining five Ohio branches with $131 million deposits to Fifth Third Bancorp. During 1992, the Company sold one branch in California containing $40 million in deposits and two branches in the state of Washington containing $37 million in deposits. LIQUIDITY AND CAPITAL RESOURCES The Association's principal sources of funds are cash flows generated from earnings; customer deposits; loan repayments; borrowings from the FHLB; issuance of medium-term notes; and debt collateralized by mortgages, MBS, or securities. In addition, the Association has a number of other alternatives available to provide liquidity or finance operations. These include borrowings from public offerings of debt or equity, sales of loans, negotiable certificates of deposit, issuance of commercial paper, and borrowings from commercial banks. Furthermore, under certain conditions, World Savings may borrow from the Federal Reserve Bank of San Francisco to meet short-term cash needs. The availability of these funds will vary depending upon policies of the FHLB, the Federal Reserve Bank of San Francisco, and the Federal Reserve Board. The principal sources of funds for the Association's parent, Golden West, are dividends from World Savings and the proceeds from the issuance of debt and equity securities. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index included on page 66 and the financial statements, which begin on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Inapplicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of the Company are as follows (see footnote explanations on the following page): Name and Age Position ------------ -------- Herbert M. Sandler, 62 Chairman of the Board and Chief Executive Officer Marion O. Sandler, 63 Chairman of the Board and Chief Executive Officer (a) James T. Judd, 55 Senior Executive Vice President (b) Russell W. Kettell, 50 President (c) J. L. Helvey, 62 Group Senior Vice President (d) David C. Welch, 51 Group Senior Vice President and Treasurer (e) Dirk S. Adams, 42 Group Senior Vice President (f) Robert C. Rowe, 38 Vice President and Secretary (g) Louis J. Galen, 68 Director William P. Kruer, 49 Director William D. McKee, 67 Director Bernard A. Osher, 66 Director Kenneth T. Rosen, 45 Director Paul Sack, 66 Director ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) Each of the above persons holds the same position with World with the exception of James T. Judd who is President, Chief Operating Officer, and Director of World and Russell W. Kettell who is a Senior Executive Vice President and Director of World. Each executive officer has had the principal occupations shown for the prior five years except as follows: (a) Marion O. Sandler was elected Chairman of the Board of the Company in February 1993. Prior thereto, Mrs. Sandler served as President and Chief Executive Officer since 1980. (b) James T. Judd was elected Senior Executive Vice President of the Company in July 1989. Prior thereto, Mr. Judd served as Executive Vice President since 1984 and Senior Vice President since 1975. (c) Russell W. Kettell was elected President of the Company in February 1993. Prior thereto, Mr. Kettell served as Senior Executive Vice President since 1989, Executive Vice President since 1984, Senior Vice President since 1980, and Treasurer from 1976 until 1984. (d) J. L. Helvey was elected Group Senior Vice President of the Company in November 1988. Prior thereto, Mr. Helvey served as Senior Vice President since 1973. (e) David C. Welch was elected Group Senior Vice President and Treasurer of the Company in November 1988. Prior thereto, Mr. Welch served as Senior Vice President and Treasurer since 1985, Vice President and Treasurer since 1984, and Vice President and Assistant Treasurer since 1980. (f) Dirk S. Adams was elected Group Senior Vice President of the Company in November 1990. Prior thereto, Mr. Adams served as Senior Vice President since 1987. Prior to that, Mr. Adams served as Senior Vice President and General Counsel to the Federal Home Loan Bank of San Francisco since 1983. (g) Robert C. Rowe was elected Vice President and Secretary of the Company in February 1991. Prior thereto, Mr. Rowe served as Assistant Vice President and Secretary since 1989 and as General Counsel since 1988. Prior to that, Mr. Rowe was a legal counsel to the Federal Home Loan Bank of San Francisco since 1984. For further information concerning the directors and executive officers of the Registrant, see pages 2 through 10 of the Registrant's Proxy Statement dated March 14, 1994, which is incorporated herein by reference. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION The information required by this Item 11 is set forth in Registrant's Proxy Statement dated March 14, 1994, on pages 8 through 10 and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is set forth on pages 2 through 10 of Registrant's Proxy Statement dated March 14, 1994, and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Inapplicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Index to Financial Statements See Index included on page 66 and the financial statements, which begin on page. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (a) (2) Index to Financial Statement Schedules Financial statement schedules are omitted because they are not required or because the required information is included in the financial statements or the notes thereto. (3) Index To Exhibits Exhibit No. Description ----------- ----------- 3 (a) Certificate of Incorporation, as amend- ed, and amendments thereto, are incorpo- rated by reference from Exhibit 3(a) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1990. 3 (b) By-Laws, as amended, are incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 4 (a) The Registrant agrees to furnish to the Commission, upon request, a copy of each instrument with respect to issues of long-term debt, the authorized principal amount of which does not exceed 10% of the total assets of the Company. 10 (a) 1978 Stock Option Plan, as amended, is incorporated by reference from Exhibit 10(a) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 10 (b) 1987 Stock Option Plan, as amended, is incorporated by reference from Exhibit 10(b) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1991. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (a) (3) Index To Exhibits (continued) Exhibit No. Description ----------- ----------- 10 (c) Deferred Compensation Agreement between the Company and James T. Judd is incorporated by reference from Exhibit 10(b) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (d) Deferred Compensation Agreement between the Company and Russell W. Kettell is incorporated by reference from Exhibit 10(c) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (e) Deferred Compensation Agreement between the Company and J. L. Helvey is incorpo- rated by reference from Exhibit 10(d) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (f) Deferred Compensation Agreement between the Company and David C. Welch is incorporated by reference from Exhibit 10(f) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 10 (g) Operating lease on Company headquarters building, 1901 Harrison Street, Oakland, California 94612, is incorporated by reference from Exhibit 10(e) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (h) Form of Supplemental Retirement Agreement between the Company and cer- tain executive officers is incorporated by reference from Exhibit 10(j) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1990. 21 (a) Subsidiaries of the Registrant is incorporated by reference from Exhibit 22(a) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 23 (a) Independent Auditors' Consent. ITEM l4. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (b) Financial Statement Schedules The response to this portion of Item 14 is submitted as a part of section (a), Exhibits. (c) Reports on Form 8-K The Registrant did not file any current reports on Form 8-K with the commission in the fourth quarter. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 2-66913 (filed January 19, 1982) and 33-14833 (filed June 5, 1987): 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 foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities Exchange Commission 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 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 Act and will be governed by the final adjudication of such issue. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GOLDEN WEST FINANCIAL CORPORATION By: /s/ Herbert M. Sandler ------------------------------- Herbert M. Sandler, Chairman of the Board and Chief Executive Officer By: /s/ Marion O. Sandler ------------------------------- Marion O. Sandler, Chairman of the Board and Chief Executive Officer By: /s/ J. L. Helvey ------------------------------- J. L. Helvey, Group Senior Vice President and Chief Financial and Accounting Officer Dated: March 23, 1994 Pursuant to the requirements of the Securities Exchange Act of l934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated: /s/ Louis J. Galen 3/23/94 /s/ Kenneth T. Rosen 3/23/94 - ---------------------------------- ---------------------------------- Louis J. Galen, Kenneth T. Rosen, Director Director - ---------------------------------- ---------------------------------- William P. Kruer, Paul Sack, Director Director /s/ William D. McKee 3/23/94 /s/ Herbert M. Sandler 3/23/94 - ---------------------------------- ---------------------------------- William D. McKee, Herbert M. Sandler, Director Director /s/ Bernard A. Osher 3/23/94 /s/ Marion O. Sandler 3/23/94 - ---------------------------------- ---------------------------------- Bernard A. Osher, Marion O. Sandler, Director Director Page ---- Independent Auditors' Report Golden West Financial Corporation and Subsidiaries: Consolidated Statement of Financial Condition as of December 31, 1993, and 1992 , Consolidated Statement of Net Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Stockholders' Equity for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992, and 1991 , Notes to Consolidated Financial Statements All supplemental schedules are omitted as inapplicable or because the required information is included in the financial statements or notes thereto.	18,184	117,034
897732_1993.txt	897732_1993	1993	897732	Item 1. Business. - ------ -------- and Item 2. Item 2. Properties. - ------ ---------- GENERAL. On July 1, 1993, pursuant to an Agreement and Plan of ------- Merger approved by the shareholders of Consolidated Rail Corporation on May 26, 1993, each share of Consolidated Rail Corporation common stock that was issued and outstanding or held in the treasury, and each outstanding share of Consolidated Rail Corporation preferred stock, all of which were held by the Non-union Employee Stock Ownership Plan (the "ESOP"), were automatically converted into one share of common stock and preferred stock, respectively, of Conrail Inc., which was incorporated in Pennsylvania on February 12, 1993 to be the holding company of Consolidated Rail Corporation. On July 1, 1993, Conrail Inc. became the publicly held entity and holding company of Consolidated Rail Corporation, which remains Conrail Inc.'s only significant subsidiary and primary asset. Consolidated Rail Corporation is a Pennsylvania corporation incorporated on February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization Act of 1973, the rail properties of many of the railroads in the northeast and midwest region of the United States which had gone bankrupt during the early 1970's, the largest of which was the Penn Central Transportation Company. Reports on Form 10-K for years prior to 1993 were filed by Consolidated Rail Corporation, and historic data presented herein and therein reflect the results of Consolidated Rail Corporation for those time periods. Unless otherwise indicated, references to Conrail prior to July 1, 1993 denote Consolidated Rail Corporation and its consolidated subsidiaries, and references to Conrail after July 1, 1993 denote Conrail Inc. and its consolidated subsidiaries. RAIL OPERATIONS. Conrail, through its wholly-owned subsidiary --------------- Consolidated Rail Corporation, provides freight transportation services within the northeast and midwest United States. Conrail interchanges freight with other United States and Canadian railroads for transport to destinations within and outside Conrail's service region. Conrail operates no significant line of business other than the freight railroad business and does not provide common carrier passenger or commuter train service. Conrail serves a heavily industrial region that is marked by dense population centers which constitute a substantial market for consumer durable and non-durable goods, and a market for raw materials used in manufacturing and by electric utilities. Conrail's traffic levels are substantially affected by its ability to compete with trucks, the economic strength of the industries and metropolitan areas that produce and consume the freight Conrail hauls, and the traffic generated by Conrail's connecting railroads. Conrail remains dependent on non-bulk traffic, which tends to generate higher revenues than bulk commodities, but also involves higher costs and is more vulnerable to truck competition. Conrail expects the national economy to continue to grow slowly and its traffic levels to reflect such growth. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - 1994 Outlook." Conrail's significant freight commodity groups include chemicals and related products, coal, intermodal, automotive parts and finished vehicles, metals and related products, food and grain products, and forest products. Revenues for these freight commodity groups for 1989 through 1993, together with total annual traffic volumes, are set forth in the following tables. Chemicals and Related Products. This group consists of a wide ------------------------------ variety of commodities, including agricultural and organic chemicals, fertilizers, plastic pellets, soda ash, construction minerals, and petroleum products. The majority of traffic is joint- line and the primary flows are between Louisiana and Texas, on the one hand, and Delaware, New Jersey, and Pennsylvania on the other. This segment's customer base and origin/destination pair mix are both large and diverse, with none occupying a dominant position in terms of Conrail's traffic volume or revenues. Conrail's chemical traffic fluctuated moderately from 1989 through 1993, but has increased in each of the last two years. In 1993, a 6.4% increase in volume resulted in a 3.5% increase in revenues compared with 1992. Conrail's chemical traffic includes chlorine, smaller volumes of other hazardous chemicals and non-hazardous substances which, if spilled or released into the atmosphere, could be dangerous and could result in significant liability to Conrail. Under catastrophic circumstances, such liability could exceed Conrail's $250 million in insurance coverage for such accidents. It is impossible to eliminate the risk of such liability; however, Conrail has not experienced any significant liability as a result of an accident involving chlorine or any other such substance and has safety procedures designed to prevent the occurrence of such accidents, or limit their impact should they occur. Increasing regulation by federal, state and local governments of the transportation and handling of hazardous and non-hazardous substances and waste has increased the administrative burden and costs of transporting certain commodities in this group. Coal. In 1993, revenues for this group declined from 1992 by ---- 13.9%, reflecting a 9.2% decline in traffic volume. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Strategic Business Plan." Utility coal traffic makes up the majority of Conrail's coal business and was adversely affected by decreased coal production resulting from an eight month strike at unionized coal mines. Utility coal moves from mines located on and off Conrail's system to electric utilities located on Conrail. Annual traffic volumes fluctuate with the inventory practices of the electric utilities, their use of alternative sources of energy and the weather. In 1993, coal traffic decreased as utilities depleted much of their coal stockpiles and did not replenish them due to the strike. In addition, the utilities in Conrail's service territory increased their use of nuclear fuel to near capacity levels. The federal acid rain legislation enacted in October 1990, which requires electric utilities to significantly limit sulphur dioxide emissions from their generating plants by burning lower sulphur coal or installing emissions control devices, has reduced demand for the higher sulphur coal from mines on Conrail's system, particularly in central Pennsylvania. However, the decline in the volume of coal from mines located on Conrail is being offset, in part, by an increase in Conrail's handling of lower sulphur coal from sources on Conrail lines formerly owned by The Monongahela Railway Company (now merged into Conrail) and from off-line sources to utilities located on Conrail's system. Metallurgical, industrial/cogeneration and export coal represent the three remaining segments of Conrail's coal traffic with volumes essentially equal in each of these areas. Conrail's traffic volume and revenue from metallurgical coal increased slightly in 1993 due to gains in market share, after having declined in each year since 1989 as the domestic steel industry eliminated inefficient production capacity. Conrail's traffic volume and revenue for industrial/cogenera- tion coal also increased slightly in 1993, although growth in this area is not expected to be as strong as originally projected, as a result of slow growth by cogeneration facilities. Export coal traffic declined approximately 35% from 1992, a year in which export volumes had declined 16% from the record levels of 1991. The 1993 declines were, in significant part, the result of the coal strike, which created increased domestic demand for coal historically used for export, as well as continuing competition by exports from South Africa and the former Soviet republics. Intermodal. Conrail continues to be one of the rail industry's ---------- leaders in handling intermodal traffic, with revenues increasing 9% in 1993 and significantly higher volumes, 11.2%, over 1992. For the sixth consecutive year, Conrail handled over 1 million units of intermodal traffic. Conrail's intermodal traffic consists of three segments. The first segment is Conrail's premium service traffic which principally involves shipments for the U.S. Postal Service, United Parcel Service and less-than-truck-load companies. The four-year U.S. Postal Service contracts for over 1,000 origin-destination points, which were awarded in July 1989, were renewed in July 1993 for a period extending to July 1995. During 1991, the Postal Service implemented incentive rates permitting its bulk mail customers to receive discounts for providing their own transportation to destination Postal Service facilities. This change has reduced Conrail's postal traffic; however, Conrail has offset this decline, in part, by increased traffic directly from bulk mailers. The second segment is domestic traffic, which includes a variety of commodities and customers. Most of the 15% growth in this segment in 1993 was attributable either to market share gains through new partnerships with major nationwide truckload carriers, or to RoadRailer growth through Triple Crown Services Company, a joint venture with Norfolk Southern Corporation. International container traffic constitutes the third segment of Conrail's intermodal traffic. International container traffic chiefly involves goods produced in the Pacific Basin and shipped by rail from west coast ports to east coast markets. Conrail and its western railroad connections are able to participate in this traffic because they have established superior transit times compared with the all-water route through the Panama Canal. Conrail also participates in traffic moving through Atlantic ports for import and export trade with European and Mediterranean markets. Conrail's Atlantic traffic increased 14% over 1992 levels. Automotive Parts and Finished Vehicles. Conrail's automotive -------------------------------------- parts and finished vehicles traffic continues to benefit from the strengthening domestic economy and the approximately 10% increase in North American vehicle production in 1993 over 1992. Reflecting this increase in domestic production, finished vehicles volume increased 21%, while automotive parts volume increased 4.5%. Total 1993 volume increased 13.4% from 1992, with 1993 revenues 14.3% higher than 1992. In terms of revenues, General Motors and Ford were among Conrail's five largest customers in 1993; Chrysler was among Conrail's ten largest customers. This commodity group, especially the automotive parts segment, is subject to vigorous truck competition. The increase in automotive parts traffic represents, in addition to increased production, Conrail's gain in market share through the use of new products and logistics services. In 1993, Conrail's automotive parts and finished vehicles traffic was favorably affected by the increased strength of the yen against the U.S. dollar, which created incentives for foreign-based domestic manufacturers to shift additional production to the United States and to export domestically produced vehicles. Conrail also expects the enactment of the North American Free Trade Agreement to continue to increase its automotive parts and vehicle traffic to and from Mexico. Metals and Related Products. This commodity group includes --------------------------- metals (such as iron, steel, and aluminum), iron ores, scrap metal, and coke from coal. An increase in traffic volume in 1993 of 5.1% resulted in increased revenue of 7.5% from 1992 levels. Revenue from metals traffic, which accounted for approximately $310 of the $399 million for this group, increased approximately 13% on increased volume of approximately 16.5%. Increases in volume due to gains in market share from trucks were partially offset by declining revenues from shorter hauls. Conrail serves directly, or via short line switching carriers, many of the nation's largest active integrated steel production facilities, as well as the major sources of scrap, the raw material used by mini-mills located both on and off Conrail to make steel. Although a significant portion of the active domestic steel industry is along the Cleveland-Chicago corridor on Conrail's system, the traditional domestic steel industry (using integrated steel production facilities) continues to eliminate inefficient production capacity, which has adversely affected the volume of raw materials for steel production handled by Conrail, and could continue to do so. In 1993, coke and iron ore revenue declined approximately 9% on decreased volumes of 11% compared to 1992 levels. Food and Grain Products. This commodity group includes fresh ----------------------- and processed food products moving primarily in boxcars, and grain and grain products moving in covered hopper and tank cars. In 1993, food and grain revenue increased 3.7% on increased volume of 3.6%, primarily as the result of substantial increases in export grain traffic. Grain and grain products generated $240 million of the $345 million in revenue in 1993. Export grain traffic, which is highly variable and depends on the value of the U.S. dollar and the size of domestic and international grain harvests, increased significantly (approximately 60%) over 1992, a year in which traffic declined 25% from 1991 levels. Food products revenue and volume declined approximately 4.5%. Forest Products. This commodity group includes paper and wood --------------- products moving in boxcars and certain lumber and related products moving on flatcars. These commodities generated $286 million in revenue in 1993, representing increased revenue of 3.0% on increased volume of 6.5% over 1992 levels. Other. Other commodity groups include miscellaneous ----- commodities that are transported in boxcars, such as general manufactured goods, and stone and construction materials. These commodities generated $73 million in revenue in 1993. Volume remained stable compared with 1992 levels. The Service Group System. In late 1993, Conrail announced the ------------------------ reorganization of its Marketing and Sales and Operating Departments into four service networks: Intermodal Service, Automotive Service, Unit Trains Service and Core Service. The Unit Trains network will handle coal and ore traffic, with the remaining commodities, other than automobiles and intermodal, to be handled by the Core network. Effective in 1994, each of these groups controls the integrated planning, pricing and operating functions that will enable them to tailor services, develop products and make capital investments directed toward the special requirements of their respective customers. Beginning in 1994, Conrail's traffic and revenue statistics will be reported on a service group basis. Certain Statistics. The following tables provide various ------------------ measurements relating to Conrail's rail operations from 1989 through 1993: COMPETITION. Conrail's rail operations face significant ----------- competition from trucks, from the availability of the same or substitute goods made by producers located at points not served by Conrail, and from other railroads. The trucking industry is especially competitive in this part of the country because, on average, freight in this region is moved shorter distances than in the West, and the cost characteristics of the railroad and trucking industries generally make trucks more competitive over shorter distances. Price and service competition from trucks is especially evident in the movement of intermodal freight, auto parts, and finished steel. Competition from trucks has been increased by the passage of legislation removing certain barriers to entry into the trucking business and allowing the use of wider, longer, and heavier trailers and multiple trailer combinations. The introduction of larger trailers and multiple trailer combinations in recent years has substantially increased productivity in the trucking industry. Any future legislation permitting further increases in truck capacity could have a substantial adverse effect on the competitiveness of railroads. CSX Corporation and Norfolk Southern Corporation are Conrail's principal railroad competitors. Conrail is also subject to competi- tion from smaller, regional railroads. The assets of the Delaware & Hudson Railway Company ("D&H"), a regional competitor of Conrail's, have been purchased by a subsidiary of CP Rail, a large Canadian railroad. CP Rail's use of D&H's former tracks, coupled with addi- tional trackage rights it has obtained, has resulted in increased rail competition in Conrail's service area. The consummation of a merger or joint cooperation agreement between CP Rail and Canadian National Railroad could result in increased competition in certain portions of Conrail's service territory, depending upon the nature and terms of any such arrangement. In addition, certain of Conrail's railroad competitors have become multi-modal transportation companies by purchasing previously independent water carriers or small shipment motor carriers, or both, and have thereby extended their operations into Conrail's service area. An important influence on Conrail's competitive position is government regulation as administered by the Interstate Commerce Commission ("ICC"). Prior to 1980, regulation significantly inhibited the ability of railroads to respond to changing transportation markets. The Staggers Rail Act of 1980 ("Staggers Act") substantially reduced the restrictions of regulation. In particular, railroads were given more freedom to reduce costs and adjust prices, which enabled them to compete more effectively and to raise prices for traffic previously carried at a loss or at below market prices. Under the Staggers Act, the ICC also has deregulated a significant amount of railroad traffic, including intermodal and most boxcar traffic, finished vehicles and miscellaneous commodities moving in other types of equipment. The Staggers Act further enhanced railroads' competitive options by permitting the use of railroad-shipper contracts for traffic still regulated by the ICC, under which the parties can set the price, service standards and term for a special transportation movement. These contracts generally provide for prices lower than tariff rates and usually do not guarantee that any given amount of freight will be shipped during their term. As of December 31, 1993, Conrail was a party to 3,962 such contracts for regulated traffic, which Conrail estimates accounted for 35% of its line-haul revenues in 1993. Although some contracts have a term longer than one year, most contracts are for one year or less. The majority of Conrail's multi-year contracts are subject to cost-related adjustments that provide for flat percentage increases. The cost-based provisions in certain of these contracts are tied to indices under the jurisdiction of the ICC. Action by the ICC to adjust these indices for productivity gains by the railroads has had an adverse impact on Conrail's ability to recover costs under such contracts, which accounted for less than 3% of Conrail's line haul revenues in 1993. For a discussion of regulation of the railroad industry, see "Government Regulation" and Item 3 Item 3. Legal Proceedings. References to Conrail in "Item 3. Legal - ------ ----------------- Proceedings" shall denote Consolidated Rail Corporation unless otherwise expressly noted. Occupational Disease Litigation. Conrail has been named as a ------------------------------- defendant in lawsuits filed pursuant to the provisions of the Federal Employers' Liability Act ("FELA") by persons alleging (1) personal injury or death caused by exposure to asbestos in connection with railroad employment; (2) complete or partial loss of hearing caused by exposure to excessive noise in the course of railroad employment; and (3) repetitive motion injury in connection with railroad employment. As of December 31, 1993, Conrail is a defendant in 694 pending asbestosis suits, 1,262 pending hearing loss suits and 16 pending repetitive motion injury suits, and had notice of 609 potential asbestosis claims, 4,746 potential hearing loss claims and 1,049 potential repetitive motion injury claims. Conrail expects to be named as a defendant in a significant number of occupational disease cases in the future. Structure and Crossing Removal Disputes in Connection With ---------------------------------------------------------- Lines Abandoned Under NERSA. Conrail may be responsible, in whole - --------------------------- or in part, for the costs of removal of several hundred overhead and underpass crossings located on railroad lines it has abandoned under the Northeast Rail Service Act of 1981 ("NERSA") (and, in some instances, responsible for the removal of the lines of railroad themselves as well as appurtenant structures). Conrail's liability for the removal of such lines, crossings and structures will be determined on a case-by-case basis. Some states have imposed upon Conrail the obligation to remove certain crossings. In 1989, an organization of interests that own property under and adjacent to Conrail's elevated West 30th Street rail line running along the west side of lower Manhattan filed a petition with the ICC seeking to force Conrail to abandon the line and finance its removal, which could cost in excess of $30 million. The ICC voted in January 1992 to grant the property owners' petition, subject to the owners posting a bond indemnifying Conrail for any demolition costs exceeding $7 million. The property owners have refused to post the bond. The parties have appealed to the United States Court of Appeals for the District of Columbia. Conrail Withdrawal from RCAF Master Tariff. The Rail Cost ------------------------------------------ Adjustment Factor ("RCAF") is an index of rail costs issued by the ICC according to which railroads may adjust their regulated rates for inflation and cost increases free of regulatory interference. In March 1989, the ICC decided to offset the quarterly RCAF by the entirety of the average rail industry productivity gain, in a proceeding previously disclosed by Conrail in its quarterly report on Form 10-Q for the period ended June 30, 1992 ("Productivity Adjustment to Cost Recovery Process"). On January 1, 1990, Conrail ceased applying RCAF increases to its regulated rates, by ending its participation in the RCAF master tariff. Effective July 1, 1990, Conrail published a series of inde- pendent rate increases approximately equal to its increases in costs as reflected by the RCAF. Conrail's action was contested, but was upheld by the ICC. Since July 1, 1990, Conrail has continued to make independent selective increases to its regulated rates. These regulated rates will continue to be subject to individual challenge to the extent the levels of the increases exceed those previously permitted pursuant to the RCAF and no other statutory provisions bar ICC jurisdiction. In January 1991, the ICC commenced a proceeding at the request of a shippers' organization to clarify the legal effect of Conrail's (and other railroads') withdrawal from the RCAF master tariff, including the shippers' assertion that railroads thereby lose protection from challenge for rates previously adjusted under these procedures. In April 1991, Conrail individually opposed and participated in the rail industry's opposition to the petition. A decision is awaited. Engelhart v. Conrail. In connection with the Special Voluntary -------------------- Retirement Program offered to certain employees in late 1989 and early 1990, Conrail used surplus funds in its overfunded Supplemental Pension Plan ("Plan") to fund certain aspects of that program. In December 1992, certain former Conrail employees brought suit challenging the use of surplus Plan funds (i) to pay administrative Plan expenses previously paid by Conrail, (ii) to fund the Special Voluntary Retirement Program, and (iii) to pay life insurance and medical insurance premiums of former employees as improper and unlawful, and alleging that employees who have made contributions to the Plan or its predecessor plans are entitled to share in the surplus assets of the Plan. In August 1993, the federal district court granted Conrail's Motion to Dismiss the majority of counts in the complaint, but declined to dismiss the issue of Conrail's use of Plan assets to pay administrative expenses of the Plan, which are estimated to be approximately $25 million as of December 31, 1993. However, Conrail believes that the use of surplus Plan assets for this purpose is lawful and proper. Conrail intends to use surplus Plan assets in a similar manner in connection with the 1994 early retirement program. (See "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - 1994 Outlook.") Environmental Litigation. Conrail is subject to various ------------------------ federal, state and local laws and regulations regarding environmental matters. In certain instances, Conrail has received notices of violations of such laws and regulations and either has taken or plans to take appropriate steps to address the problems cited or to contest the allegations of violation. As of December 31, 1993, Conrail had received inquiries from governmental agencies or had been identified, together with other companies, as a potentially responsible party for cleanup and/or removal costs due to its status as an alleged transporter, generator or property owner at 114 locations throughout the country. However, Conrail, through its own investigations and assessments, believes it may have some potential responsibility at only 54 of these sites. (See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters.") The significant environmental proceedings, including Superfund sites, are discussed below. United States v. Southeastern Pennsylvania Transportation --------------------------------------------------------- Authority ("SEPTA"), National Railroad Passenger Corporation - ------------------------------------------------------------ ("Amtrak"), and Consolidated Rail Corporation. In March 1986, the - --------------------------------------------- United States Environmental Protection Agency ("EPA") filed an action in the United States District Court for the Eastern District of Pennsylvania for cost recovery, injunctive relief, and a declaratory judgment against Conrail, Southeastern Pennsylvania Transportation Authority ("SEPTA") and National Railroad Passenger Corp. ("Amtrak") under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA" or "Superfund Law"), as amended. In 1990, the Pennsylvania Department of Environmental Resources intervened as a plaintiff. Suit is based on the release or threatened release at the Paoli Railroad Yard, Paoli, Chester County, Pennsylvania, of polychlorinated biphenyls ("PCBs"), a listed hazardous substance under CERCLA. Conrail is sued in its capacity as the operator of the rail yard from April 1, 1976 through December 31, 1982, under an agreement with SEPTA to provide commuter rail service. In March 1992, Penn Central brought suit before the Special Court arguing that the terms of the transfer of its properties to Conrail did not contemplate environmental liability for conditions existing at the time of the transfer. The Special Court has determined it has jurisdiction to hear the matter. In February 1993, Penn Central petitioned the district court to stay all proceedings with respect to it pending the outcome of the proceeding before the Special Court. The EPA has responded by filing a petition to stay the district court proceeding in its entirety pending resolution of the Special Court proceeding. Motions and cross-motions for summary judgment by the parties are pending. Pursuant to a series of partial preliminary consent decrees, defendants have performed a series of cleanup actions both on and off-site and have conducted a Remedial Investigation/Feasibility Study ("RI/FS"). As of December 31, 1993, the cost of the RI/FS and of the interim cleanup measures performed by the three defendants is approximately $9 million. Those costs have been shared equally among the three defendants but are subject to reallocation. All work done to date has been performed subject to a denial of liability and without waiving any defense to the governmental claim for cleanup costs or other relief. On September 16, 1992, the EPA issued a Special Notice Letter to Conrail, SEPTA, Amtrak and Penn Central Corporation requesting the parties to provide, within 60 days, a good-faith offer to perform all necessary remediation of the Paoli rail yard site, as well as reimbursement of approximately $2.6 million in past response costs of the EPA. The EPA estimates that its remediation plan as set forth in its Record of Decision will cost approximately $28 million. On November 16, 1992, the parties submitted an offer to pay a portion of the estimated cost of the remediation action selected by the EPA. On January 8, 1993, the EPA rejected the parties' offer on several bases, including that the proposal addressed only a portion of the EPA's recommended remedy for the site. The EPA may now issue an administrative order directing any party to carry out its remediation plan, subject to treble damages and daily penalties for failure to comply without sufficient cause. The estimated cost of Conrail's portion of the parties' proposed remedy was included in the 1991 special charge and subsequent adjustments to accruals. United States v. Conrail. The EPA has listed Conrail's ------------------------ Elkhart Yard in Indiana on the National Priorities List. The EPA contends that chemicals have migrated from the yard and contaminated drinking wells in the area. On February 14, 1990, the EPA filed a civil action against Conrail in the U.S. District Court for the Northern District of Indiana seeking recovery of approximately $345,000 for costs incurred in protecting the water supply. In addition, the EPA seeks a declaratory judgment against Conrail for all future costs incurred in responding to the release or threatened release of hazardous substances from the site. Conrail believes it is not the sole source and may not be a contributing source to the contamination alleged by the EPA. Conrail filed a third-party action joining Penn Central as a defendant, to which Penn Central has responded by filing a declaratory judgment action in Special Court. (See previous discussion regarding the Special Court under "United States v. SEPTA, et al"). On July 7, 1992, the EPA issued an order requiring Conrail and Penn Central to implement the interim remedy set forth in the Record of Decision. Conrail is performing the interim remedy in compliance with the EPA order and is simultaneously in litigation with the EPA over the implementation of the remedy. Penn Central has declined to participate. The estimated cost of remediation was included in Conrail's 1991 special charge and subsequent adjustments to accruals. United States v. Conrail, et al. Conrail has been identified ------------------------------- as the fifth largest generator of waste oil at the Berks Associates Superfund site in Douglasville, Pennsylvania. In addition, Conrail has become aware that it and its predecessor, Penn Central, owned a small portion of land that was leased to the operator of the Berks site. As such, Conrail's liability could increase due to its ques- tionable status as both an owner and a generator. In August 1991, the EPA issued an administrative order against Conrail and thirty- five other entities mandating the implementation of an approximately $2 million partial remedy and filed a complaint in the U.S. District Court for the recovery of approximately $8 million in costs incurred by the government. The parties have negotiated an administrative order with the EPA and have filed an answer to the civil action. A group of potentially responsible parties (including Conrail) undertook compliance with the administrative order. Conrail and the 35 other defendants have filed a third-party complaint against approximately 630 entities seeking contribution for the costs of the remedy and government costs. Conrail, along with other defendants, is negotiating a settlement with the EPA. On June 30, 1993, the EPA issued another administrative order against Conrail and 33 other entities, mandating the remediation of the southern portion of the site. The effective date of the order has been delayed in light of the negotiations. The most expensive aspect of the remediation of the site is the clean-up of Source Area 2, which the government estimates at between $45 and $55 million. This Source Area was closed prior to Conrail's incorporation, and therefore Conrail has maintained that it is not liable for the cost of remediating Source Area 2. United States v. Conrail, et al. Conrail is a potentially ------------------------------- responsible party ("PRP"), along with more than 50 other parties, in the United Scrap Lead federal Superfund action in Troy, Ohio, where substantial quantities of batteries were disposed of over a period of several years. The EPA sued Conrail and nine other parties in August 1991 in the Southern District of Ohio for the recovery of approximately $2 million in past costs. Conrail and other PRP's have commissioned treatability studies. The court has imposed a stay to discuss whether this matter can be settled. The parties are negotiating over the nature of the remediation to be undertaken at the site. Commonwealth of Massachusetts v. Conrail. On April 21, 1992, ---------------------------------------- the Massachusetts Attorney General filed suit in Superior Court of Massachusetts alleging Conrail's violation of the Massachusetts Clean Air Act and its implementing regulations by allowing diesel engines to idle unnecessarily and/or in excess of thirty minutes. On May 4, 1992, the court entered a preliminary injunction, the terms of which are substantially consistent with Conrail's existing idling policy. The Attorney General subsequently filed a complaint alleging Conrail's violation of the preliminary injunction. On February 2, 1993, the parties entered into a partial settlement agreement; however, the Attorney General has alleged that Conrail has failed to comply with certain provisions of the settlement. United States v. Consolidated Rail Corporation, The Monongahela --------------------------------------------------------------- Railway Company, et al. On September 30, 1992, Region VIII of the - ---------------------- EPA filed an administrative action for civil penalties against Conrail and its former wholly-owned subsidiary, The Monongahela Railway Company (now merged into Conrail), under the Toxic Substances Control Act for allegedly improper handling of a shipment of PCB contaminated soil. The other railroads in the movement and the shipper were served with similar complaints. Conrail is currently negotiating with EPA. New York State Department of Environmental Conservation Order ------------------------------------------------------------- On Consent. On February 18, 1993, the New York State Department of - ---------- Environmental Conservation ("NYSDEC") served Conrail with a draft Order on Consent requiring the payment of fines in connection with its inspection of Selkirk Yard. The order also seeks compensation for the hiring of three full-time NYSDEC employees to monitor Conrail's compliance at Selkirk and two other rail yards in New York. Conrail is negotiating the terms of the Order with NYSDEC. Conway Yard, Pittsburgh. In 1991, Conrail received Notices of ----------------------- Violation ("NOV") from the Pennsylvania Department of Environmental Resources ("PADER") alleging violations of the Clean Streams Act for discharges of oil into the Ohio River. In September 1993, PADER sent to Conrail a draft Consent Order and Agreement requiring a comprehensive site remediation for soil, ground water, surface waters and sediments at the Conway rail yard and requiring the payment of an undisclosed amount of civil fines in connection with violations at the yard, including continuing ground water contamination. Conrail and PADER are negotiating the extent of the investigation and remediation to be undertaken at the yard. Other. In addition to the above proceedings, Conrail has been ----- named in various legal proceedings arising out of its activities as an employer and as an operator of a freight railroad, including personal injury actions brought by its employees under FELA, as well as administrative proceedings with and investigation by government agencies. In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly in certain matters described above in which substantial damages are or may be sought, Conrail cannot state what the eventual outcomes of such legal proceedings will be. Certain of these matters, if determined adversely to Conrail, could result in the imposition of substantial damage awards against, or increased costs to, Conrail that could have a material adverse effect on Conrail's results of operations and financial position. Conrail's management believes, however, based on current knowledge, that such legal proceedings will not have a material adverse effect on Conrail's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- There were no matters submitted to a vote of security holders during the fourth quarter of 1993. Executive Officers of the Registrant. - ------------------------------------ Conrail's officers are elected annually by the Board of Directors at its first meeting held after the meeting of shareholders at which directors are elected, and they hold office until their successors are elected. There are no family relationships among the officers or directors, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of March 1, 1994, relating to the executive officers of Conrail and Consolidated Rail Corporation. An asterisk () indicates that such individual is an officer of Consolidated Rail Corporation only: Name, Age, Present Position Business Experience During - --------------------------- Past 5 Years ---------------------------------------- James A. Hagen, 61, Present position since May 18, 1989. Chairman, Served as President - CSX Distribution President and Chief Services, Inc. from March 1988 to April Executive Officer 1989. David M. LeVan, 48, Present position since December 1993. Executive Vice President Served as Senior Vice President - Operations between July 1992 and December 1993. Served as Senior Vice President-Operating Systems and Strategies between November 1991 and June 1992. Served as Senior Vice President - Corporate Systems between November 1990 and November 1991. Served as Vice President - Corporate Strategy between September 1988 and November 1990. H. William Brown, 55, Senior Present position since April 1992. Served Vice President - Finance as Senior Vice President - Finance and Administration between April 1986 and April 1992. Gordon H. Kuhn, 43, Senior Present position since December 1993. Vice President - Core Served as Senior Vice President - Marketing and Service Group Sales between January 1990 and December 1993. Served as Vice President - Marketing between August 1987 and January 1990. Charles N. Marshall, 52, Present position since January 1990. Senior Vice President - Served as Senior Vice President - Development Marketing and Sales between March 1985 and January 1990. Bruce B. Wilson, 58, Senior Present position since April 1987. Vice President - Law John T. Bielan, Jr., 46, Present position since March 1992. Vice President - Continuous Served as Assistant Vice President - Automotive Quality Improvement between April 1989 and March 1992. Ronald J. Conway, 50, Vice Present position since December 1993. President - Intermodal Served as Assistant Vice President - Service Group* Petrochemicals and Minerals between April 1992 and December 1993. Served as General Manager - Philadelphia Division between 1989 and April 1992. Timothy P. Dwyer, 44, Vice Present position since December 1993. President - Unit Trains Served as General Manager - Philadelphia Service Group* Division between April 1992 and December 1993. Served as Assistant Vice President - Metals between 1989 and April 1992. Gerald T. Gates, 40, Vice Present position since December 1993. President - Mechanical* Served as Assistant Vice President - Operations Planning and Administration between July 1992 and December 1993. Served as General Manager - Indianapolis Division between September 1990 and July 1992. Served as Assistant General Manager - Albany Division between 1989 and September 1990. Donald W. Mattson, 51, Vice Present position since May 1993. Served as President - Treasurer Vice President - Controller between August 1988 and May 1993. John A. McKelvey, 42, Vice Present position since May 1993. Served as President - Controller Vice President - Treasurer between 1988 and May 1993. William B. Newman, Jr., 43, Present position since 1981. Vice President and Washington Counsel* Frank H. Nichols, 47, Vice Present position since February 1993. President - Resource Served as Assistant Vice President - Development* Finance between November 1988 and February 1993. Timothy T. O'Toole, 38, Vice Present position since May 1989. President and General Served as an attorney in the Law Counsel Department prior to that time. Richard S. Pyson, 52, Vice Present position since March 1992. President - Served as Vice President - Engineering Transportation* between March 1991 and March 1992. Served as Assistant Vice President - Engineering and Maintenance between March 1990 and March 1991. Served as Chief Engineer - Communications and Signals between 1988 and March 1990. John M. Samuels, 50, Vice Present position since March 1992. President - Engineering* Served as Vice President - Continuous Quality Improvement between April 1990 and March 1992. Served as Assistant Vice President - Industrial Engineering between 1980 and April 1990. Allan Schimmel, 53, Vice Present position since November 1990. President - Administrative Served as Corporate Secretary and Services and Corporate Assistant to the Chairman since 1980. Secretary Robert E. Swert, 67, Vice Present position since 1981. President - Labor Relations* George P. Turner, 52, Vice Present position since December 1993. President - Automotive Served as Assistant Vice President - Service Group* Automotive between April 1992 and December 1993. Served as Assistant Vice President- Petrochemicals and Minerals between March 1990 and April 1992. Served as Assistant Vice President - Sales between 1987 and March 1990. Ralph von dem Hagen, 49, Present position since September 1989. Vice President - Customer Served as Assistant Vice President - Car Service* Management between September 1984 and September 1989. Robert O. Wagner, 57, Present position since June 1991. Vice President - Served as Vice President - Information Information Systems* Services for Pan American World Airways, Inc. between 1983 and May 1991. (1) Jeremy T. Whatmough, 59, Present position since 1979. Vice President - Materials and Purchasing* Gery M. Williams, Jr., 52, Present position since January 1990. Vice President - State Served as Vice President - Sales between and Local Affairs* March 1985 and January 1990. ______________________________ (1) On January 8, 1991, Pan American World Airways, Inc. and its subsidiaries filed petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the U.S. Bankruptcy Court for the Southern District of New York. PART II Item 5. Item 5. Market for Registrant's Common Equity - ------ ------------------------------------- and Related Stockholder Matters. ------------------------------- Conrail's common stock is listed for trading on the New York Stock Exchange and the Philadelphia Stock Exchange. The number of holders of record of Conrail common stock on March 4, 1994 was 19,735. For the high and low sales prices of Conrail's common stock on the New York Stock Exchange and the frequency and amount of cash dividends for 1993 and 1992. (See Note 13 to the Consolidated Financial Statements included elsewhere in this Annual Report.) Item 6. Item 6. Selected Financial Data. - ------ ----------------------- The selected consolidated financial data included in the following tables have been derived from Conrail's Consolidated Financial Statements. The consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993 and the consolidated balance sheets as of December 31, 1993 and 1992 appear elsewhere in this Annual Report and have been audited by Coopers & Lybrand, independent accountants, as indicated in their report thereon. For purposes of the following selected consolidated financial data, references to Conrail reflect the consolidated entities of Consolidated Rail Corporation for periods prior to July 1, 1993 and Conrail Inc. for subsequent periods. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and related notes and other financial information included elsewhere in this Annual Report. NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA 1. Conrail adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), effective January 1, 1993. As a result, in the first quarter of 1993 Conrail recorded cumulative after-tax charges of $22 million and $52 million, respectively. In addition, as a result of the increase in the federal corporate income tax rate from 34% to 35%, effective January 1, 1993, income tax expense includes $34 million of a retroactive nature, primarily for the effects of adjusting deferred income taxes and the special income tax obligation for the rate increase as required under SFAS 109. See Notes 1, 7 and 8 to the Consolidated Financial Statements included elsewhere in this Annual Report. 2. In 1990, Conrail completed a financial restructuring plan which included a Dutch auction tender offer, the establishment of an employee stock ownership plan for non-union employees ("Non-union ESOP") and a related open market common stock purchase program. Through the Dutch auction tender offer, Conrail purchased 44.64 million shares of its outstanding common stock at a price of $24.50 per share, or an aggregate of $1.094 billion. In March 1990, Conrail issued 9,979,562 shares of Series A ESOP Convertible Junior Preferred stock to the Non-union ESOP in exchange for a promissory note of $288 million. In connection with its restructuring, Conrail acquired 8,715,902 shares of its common stock in the open market for $200 million. The cost of the restructuring was financed with approximately $450 million of available funds, $50 million in short-term borrowings (commercial paper) and with proceeds from the sale of $250 million principal amount of 9 3/4% Notes due 2000 and $550 million principal amount of 9 3/4% Debentures due 2020. 3. Included in 1991 operating expenses is a special charge totalling $719 million, which reduced net income by $447 million. Without the special charge, net income would have been $240 million ($2.73 and $2.48 per share, primary and fully diluted, respectively). The 1989 special charge of $234 million reduced net income by $147 million ($1.08 per share). The 1991 special charge is described in Note 10 to the Consolidated Financial Statements included elsewhere in this Annual Report. The 1989 special charge included $109 million related to a non- union employee reduction program; a $92 million increase in casualty reserves based on an actuarial valuation; and $33 million for realignment and consolidation of certain administrative and operating functions. 4. In 1993, Conrail committed to a plan for the disposition of its investment in Concord Resources Group, Inc. Pursuant to this plan, Conrail recorded an estimated loss of $80 million for the disposition of its investment, including $19 million for operating losses expected to be incurred during the phase-out period and disposition costs. Conrail also recorded estimated federal tax benefits of $30 million relating to the disposition. See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report. 5. Net income (loss) and dividends per common share include the effects of the common stock split which is described in Note 2 to the Consolidated Financial Statements included elsewhere in this Annual Report. The calculations of income (loss) per common share for 1993, 1992 and 1991 are shown in Exhibit 11, Part IV included elsewhere in this Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial - ------ ------------------------------------------------- Condition and Results of Operations. ----------------------------------- Overview - -------- For 1993, Conrail's net income was $160 million compared with net income of $282 million for 1992, and a net loss of $207 million for 1991. Results for 1993 include the effects of recording one- time after tax charges of $74 million for adoption of required changes in accounting for income taxes and postretirement benefits other than pensions; the estimated net loss on the planned disposition of Concord Resources Group, Inc. ("Concord"), $50 million; and the one-time effects on deferred taxes of the increase in the 1993 federal corporate income tax rate, $34 million (see Notes 1, 3, 7 and 8 to the Consolidated Financial Statements elsewhere in this Annual Report). Absent these charges, Conrail's net income for 1993 would have been $318 million. The results for 1991 included the effects of a $719 million special charge ($447 million after income taxes); without the special charge, net income for 1991 would have been $240 million. The 1993 results were favorably affected by an improvement in traffic volume (5.0%) and operating revenues (3.2%) compared with 1992, primarily due to the improvement in the economy and an increase in Conrail's market share. In addition, effective cost reduction and containment programs enabled Conrail to limit the increase in its operating expenses to 1.8% over 1992. Traffic volume and operating revenues increased in 1992 compared with 1991 (3.8% and 2.9%, respectively), and the increase in Conrail's operating expenses (excluding the 1991 special charge) was less than one percent over 1991, despite higher traffic volume. Holding Company Formation - ------------------------- In May 1993, the shareholders of Consolidated Rail Corporation approved a plan for the adoption of a holding company structure. Under the plan, each share of Consolidated Rail Corporation common stock that was issued and outstanding or held in the treasury and each share of Consolidated Rail Corporation Series A ESOP Convertible Junior Preferred Stock ("ESOP Stock") held by the Non- union Employee Stock Ownership Plan were automatically converted on July 1, 1993 into one share of common stock and one share of ESOP Stock, respectively, of a newly created holding company, Conrail Inc. As a result, Conrail Inc. became the publicly held entity effective July 1, 1993. The change in corporate structure does not represent a change in operations or Strategic Business Plan (see Strategic Business Plan). On July 1, 1993, Conrail Inc. had the - ----------------------- same consolidated operations, assets, liabilities and stockholders' equity as Consolidated Rail Corporation had on June 30, 1993. In this Annual Report, references to the "Company" or "Conrail" will denote the consolidated entities Consolidated Rail Corporation for periods prior to July 1, 1993 and Conrail Inc. for subsequent periods (see Note 2 to the Consolidated Financial Statements elsewhere in this Annual Report). Strategic Business Plan - ----------------------- Conrail's Strategic Business Plan (the "Plan") for the five year period 1992-1996 set specific 1996 financial goals of an operating ratio (operating expenses as a percent of revenues) of 80% and a return on funded assets at least equal to Conrail's cost of capital. The Plan also targeted revenue growth of $1 billion for that time period. During the second quarter of 1993, Conrail reevaluated the Plan's assumptions, including changes that had occurred or were expected to occur in economic conditions, demand for products of customers served by Conrail and Conrail's market share in each of the industry segments served. Consequently, Conrail revised its revenue growth target to $600 million by 1996. About half of the difference was due to a change in the anticipated demand for coal attributable to slower growth in electrical demand than previously expected, fewer cogeneration plants planned and delays in the start-up of others, and the impact of world competitive market conditions on U.S. coal exports. Changes in the general forecast for the U.S. economy accounted for the remaining difference. Conrail expects an average real annual growth rate for industrial production of 2.8% for the 1991-1996 period, versus the 3.3% originally projected, and inflation is projected at 2.4% annually for the period, compared to an original projection of 3.4%. Industrial production growth affects freight traffic volume, and annual inflation affects freight revenue. Despite the lower revenue target, Conrail's financial goal for 1996 of a return on funded assets equal to its cost of capital remains unchanged, which, if achieved, will require an operating ratio of 78.5% in 1996, based on current assumptions. For 1993, Conrail achieved an operating ratio of 82.9% and a return on funded assets of approximately 9.0% compared to its cost of capital of 11%. 1994 Outlook - ------------ Conrail expects the 1994 economy to continue its slow growth. Despite signs of a strengthening economy in the fourth quarter of 1993, there is still uncertainty as to whether that pace can be sustained throughout 1994. Conrail's 1994 plans are based on an assumption of 3.0% growth in real gross domestic product and 3.4% growth in industrial production. A key Conrail goal for 1994 is to achieve an operating ratio of 81.5%, excluding any one-time charges. On December 15, 1993, the Board of Directors approved a voluntary early retirement program for eligible members of its non- union workforce. Eligible employees had until February 28, 1994 to elect to retire under the program, and the cost of the program is expected to have a material adverse effect on the results of operations for the first quarter of 1994. The transaction will not significantly affect Conrail's cash position as approximately 85% of the cost will be paid from the Company's overfunded pension plan (see Notes 8 and 12 to the Consolidated Financial Statements elsewhere in this Annual Report). Conrail has announced that 330 employees, or 80% of those eligible, accepted the voluntary retirement program for non-union employees. Preliminary estimates of the cost of the program were between $75 million and $85 million before taxes. In addition, the Company expects the extreme winter weather in January, February and early March of 1994 to have a substantial adverse effect on first quarter earnings. Conrail expects to implement the service group structure without replacing most of the employees who elected to retire under the non-union employee retirement program. The Company is also reviewing its current utilization of assets required to support the new structure with the goal of identifying excess assets. If identified, certain of such assets may be written down to their realizable values, resulting in a charge to operations. (See Item 1 - "Business - The Service Group System.") Results of Operations - --------------------- 1993 Compared with 1992 Net income for 1993 was $160 million ($1.82 per share, primary and $1.70 per share, fully diluted) compared with 1992 net income of $282 million ($3.28 per share, primary and $2.99 per share, fully diluted). The decrease in net income is attributable primarily to the following unusual or one-time charges in 1993: one-time after tax charges of $74 million for adoption of required changes in accounting for income taxes and postretirement benefits other than pensions; the recording of the estimated net loss on the disposition of Concord, $50 million; and the one-time effects on deferred taxes of the increase in the 1993 federal corporate income tax rate, $34 million (see Notes 1, 3, 7 and 8 to the Consolidated Financial Statements elsewhere in this Annual Report). Absent these charges, Conrail's net income for 1993 would have been $318 million ($3.78 per share, primary and $3.43 per share, fully diluted). Operating revenues (primarily freight line haul revenues, but also including switching, demurrage and incidental revenues) increased $108 million, or 3.2%, from $3,345 million in 1992 to $3,453 million in 1993. A 5.0% increase in traffic volume, as measured in units (freight cars and intermodal trailers and containers), resulted in a $160 million increase in revenues that was partially offset by a 1.6% decrease in average revenue per unit which reduced revenues $54 million. The decline in average revenue per unit is attributable to decreases in average rates which reduced revenue by $62 million, partially offset by a favorable mix of traffic which increased revenues $8 million. Traffic volume increases occurred in the following freight commodity groups: automotive parts and finished vehicles, 13.4%; intermodal, 11.2%; forest products, 6.5%; chemicals and related products, 6.4%; metals and related products, 5.1%; and food and grain products, 3.6%. Coal traffic decreased 9.2%. Switching, demurrage and incidental revenues increased $2 million. Operating expenses increased $51 million, or 1.8%, from $2,811 million in 1992 to $2,862 million in 1993. The following table sets forth the operating expenses for the two years: Compensation and benefits costs decreased $8 million, or 0.6%, with relatively stable employment levels. The decrease is attributable primarily to a decrease in payroll taxes, partially offset by increases in fringe benefit costs and increased wage rates. Compensation and benefits as a percent of revenues was 35.6% in 1993 compared with 37.0% in 1992. The increase of $15 million, or 5.2%, in equipment rents reflects the effects of new operating leases for equipment and the increase in traffic volume, partially offset by improvement in equipment utilization. Depreciation and amortization expense decreased $11 million, or 3.7%, primarily due to lower depreciation rates for locomotives and freight cars as a result of a depreciation study required by the Interstate Commerce Commission. Other operating expenses increased $55 million, or 11.3%, primarily due to increases in property and corporate taxes, increases in write-downs of uncollectible accounts, and a reduction in 1992 due to reducing accruals related to the 1991 special charge with no corresponding reduction in 1993. Conrail's operating ratio was 82.9% for 1993 compared with 84.0% for 1992. Interest expense increased $13 million, or 7.6%, from $172 million in 1992 to $185 million in 1993 due to the net addition of long-term debt in 1993. The loss on disposition of subsidiary, $80 million, represents Conrail's estimated gross loss on the planned disposition of Concord (see Note 3 to the Consolidated Financial Statements elsewhere in this Annual Report). Other income, net, (representing interest and rental income, property sales and other non-operating items, net) increased $16 million, or 16.3%, from $98 million in 1992 to $114 million in 1993, principally due to higher gains from property sales and increased equity income as a result of higher net income of Conrail's affiliated companies. 1992 Compared with 1991 Net income for 1992 was $282 million ($3.28 per share, primary and $2.99 per share, fully diluted) compared with a 1991 net loss of $207 million ($2.70 loss per share, primary and fully diluted). The net loss for 1991 included the effects of a $719 million special charge which reduced after-tax earnings by $447 million (see Note 10 to the Consolidated Financial Statements elsewhere in this Annual Report). Without the special charge, net income for 1991 would have been $240 million, and net income per common share would have been $2.73 primary and $2.48 fully diluted. Based on events which occurred in the third quarter of 1992, certain accruals related to the 1991 special charge were adjusted, reducing 1992 operating expenses by $11 million. Operating revenues increased $93 million, or 2.9%, from $3,252 million in 1991 to $3,345 million in 1992. A 3.8% increase in traffic volume resulted in a $119 million increase in revenues. The increase in traffic volume was partially offset by a 1.1% decrease in average revenue per unit, attributable to both decreases in average rates and an unfavorable traffic mix, which reduced revenues $37 million. Traffic volume increases occurred in the following freight commodity groups: automotive parts and finished vehicles, 10.3%; intermodal, 10.1%; food and grain products, 4.6%; metals and related products, 3.2%; and chemicals and related products, 2.1%. Coal traffic decreased 4.9%. Switching, demurrage and incidental revenues increased $11 million. Operating expenses decreased $702 million from $3,513 million in 1991, which included a $719 million special charge, to $2,811 million in 1992. Excluding the 1991 special charge, operating expenses increased $17 million, or 0.6%. The following table sets forth the operating expenses for the two years: Although there was only a $4 million increase in compensation and benefits, the results were affected by the settlement in 1992 of labor contracts covering the majority of Conrail's union employees. Increased wage rates were partially offset by reduced fringe benefit costs and lower employment levels principally attributable to reduced crew sizes under the new labor agreement with the United Transportation Union. Compensation and benefits as a percent of revenues was 37.0% in 1992 compared with 37.9% in 1991. Fuel costs decreased $14 million, or 7.5%, principally as a result of significantly lower average fuel prices, primarily in the first six months of 1992, $23 million. Prices in 1991 had been adversely affected by the war in the Persian Gulf. An increase in consumption due to increased traffic levels, $9 million, partially offset the lower fuel prices. The increase of $17 million, or 9.4%, in material and supplies costs was due to a planned increase in programs for repairs and maintenance of locomotives and freight cars, and, to a lesser extent, increased traffic volumes. The increase of $11 million, or 3.9%, in equipment rents reflects the effects of new operating leases for equipment and the increase in traffic volume. Depreciation and amortization expense decreased $12 million, or 3.9%, due principally to asset reductions relating to lease expirations and property sales, partially offset by an increase in depreciable assets in 1992. The increase in casualties and insurance of $11 million, or 9.0%, was primarily due to an increase in occupational health claims expense based on an assessment of both the total number of expected claims and the anticipated costs to settle such claims. The special charge of $719 million included in 1991 operating expenses is discussed more fully in Note 10 to the Consolidated Financial Statements elsewhere in this Annual Report. Conrail's operating ratio was 84.0% for 1992 compared with 108.0% for 1991. The 1991 operating ratio would have been 85.9% in the absence of the special charge. The reduction in interest expense, $9 million, or 5.0%, from $181 million in 1991 to $172 million in 1992, was due to capital lease expirations and lower interest rates. Other income, net also decreased $9 million, or 8.4%, from $107 million in 1991 to $98 million in 1992, primarily due to losses of Concord (see Note 3 to the Consolidated Financial Statements elsewhere in this Annual Report), and a decrease in interest income, partially offset by an increase in rental income. Liquidity and Capital Resources - ------------------------------- Conrail's cash and cash equivalents decreased $2 million, from $40 million at December 31, 1992 to $38 million at December 31, 1993. Cash generated from operations, principally from its wholly- owned subsidiary, Consolidated Rail Corporation, and borrowings are Conrail's principal sources of liquidity and are used primarily for capital expenditures, debt service, and dividends. Operating activities provided cash of $504 million in 1993, compared with $496 million in 1992 and $570 million in 1991. Issuance of long- term debt provided cash of $485 million in 1993. The principal uses of cash in 1993 were for property and equipment acquisitions, $566 million, payment of long-term debt including capital lease and equipment obligations, $195 million, the repurchase of common stock, $64 million, net repayment of commercial paper, $48 million, and cash dividends on preferred and common stock, $117 million. A working capital (current assets less current liabilities) deficiency of $13 million existed at December 31, 1993, compared with a deficiency of $489 million at December 31, 1992. The decrease in the deficiency is attributable primarily to the increase of $52 million in accounts receivable; the recording of $227 million of current deferred tax assets as a result of adopting SFAS 109 (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report); and reductions in short-term borrowings, $48 million, current maturities of long-term debt, $61 million, and accrued and other current liabilities, $63 million. Management believes that Conrail's financial position allows it sufficient access to credit sources on investment grade terms, and, if necessary, additional intermediate or long-term debt could be issued for working capital requirements. In July 1992, Conrail began a common stock repurchase program of up to $100 million. At December 31, 1992, Conrail had acquired 1,208,004 shares for $50 million under this program. This program was completed in September 1993, at a total of 2,150,293 shares. In July 1993, Conrail's Board of Directors authorized a new $100 million repurchase program, under which Conrail had acquired 237,855 shares for approximately $14 million through December 31, 1993. During 1993, Conrail issued an additional $114 million of commercial paper and repaid $162 million. Of the remaining $179 million outstanding at December 31, 1993, $100 million is classified as long-term debt since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by a long- term credit facility. In February 1993, Conrail issued $94 million of Pass Through Certificates to finance the acquisition of equipment. Of these certificates, $54 million are direct obligations of Conrail and are secured by the acquired equipment. The remaining $40 million of certificates were issued to finance equipment which Conrail will utilize under a capital lease, and while such certificates are not direct obligations of or guaranteed by Conrail, the amounts payable by Conrail under the lease will be sufficient to pay principal and interest on the certificates. Conrail issued $79 million of medium-term notes during the first quarter of 1993 under a shelf registration statement filed in April 1990. In May 1993, Conrail sold $250 million of 7 7/8% Debentures due 2043 under the same shelf registration statement. During 1993, Conrail redeemed $85 million of medium-term notes that were issued in 1988 and 1989. In June 1993, Conrail and Consolidated Rail Corporation filed a new shelf registration statement on Form S-3 which will enable Consolidated Rail Corporation to issue up to $500 million in debt securities or Conrail to issue up to $500 million in convertible debt or equity securities. Consolidated Rail Corporation issued approximately $63 million of 1993 Equipment Trust Certificates, Series A, in September 1993, under this registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which Consolidated Rail Corporation will utilize under an operating lease. Although the certificates are not direct obligations of, or guaranteed by Consolidated Rail Corporation, the amounts payable by Consolidated Rail Corporation under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, Consolidated Rail Corportion issued $102 million of 1993 Equipment Trust Certificates, Series B, to finance approximately 85% of the cost of 80 new locomotives. These certificates are direct obligations of Consolidated Rail Corporation and were not issued pursuant to the 1993 shelf registration statement. During the third quarter of 1993, Conrail reached a settlement with the Internal Revenue Service related to the audit of Conrail's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, Conrail paid $51 million, including interest (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report). Capital Expenditures - -------------------- Capital expenditures totalled $650 million, $491 million and $398 million in 1993, 1992 and 1991, respectively. Of these capital expenditures, Conrail directly financed $232 million in 1993, $13 million in 1992, and $76 million in 1991 through private third-party financing. In addition, the proceeds of notes and debentures sold in those years, $329 million, $80 million, and $30 million, respectively, were available to fund capital expenditures. Capital expenditures for 1993, $650 million, exceeded planned expenditures by $100 million principally due to the accelerated acquisition of locomotives originally expected to be acquired in 1994. Capital expenditures for 1994 are expected to be approximately $490 million. Inflation - --------- Generally accepted accounting principles require the use of historical costs in preparing financial statements. This approach does not consider the effects of inflation on the costs of replacing assets. The replacement cost of Conrail's property and equipment is substantially higher than its historical cost basis. Similarly, depreciation expense on a replacement cost basis would be substantially in excess of the amount recorded under generally accepted accounting principles. Environmental Matters - --------------------- Conrail's operations and property are subject to various federal, state and local laws regulating the environment. Consolidated Rail Corporation is a party to numerous proceedings brought by regulatory agencies and private parties under federal, state and local laws, including Superfund laws, and has also received inquiries from governmental agencies with respect to other potential environmental issues. As of December 31, 1993, Consolidated Rail Corporation had received, together with other companies, notices of its involvement as a potentially responsible party or requests for information under the Superfund laws with respect to cleanup and/or removal costs due to its status as an alleged transporter, generator or property owner at 114 locations throughout the country. However, based on currently available information, Conrail believes Consolidated Rail Corporation may have some potential responsibility at only 54 of these sites. Due to the number of parties involved at many of these sites, the wide range of costs of the possible remediation alternatives, changing technology and the length of time over which these matters develop, it is not always possible to estimate Consolidated Rail Corporation's liability for the costs associated with the assessment and remediation of contaminated sites. At December 31, 1993 Conrail had accrued $77 million for estimated future environmental expenses. Although Conrail's operating results and liquidity could be significantly affected in any quarterly or annual reporting period in which Consolidated Rail Corporation was held principally liable in certain of these actions, Conrail believes the ultimate liability for these matters will not materially affect its financial condition. (See Note 12 to the Consolidated Financial Statements elsewhere in this Annual Report). Consolidated Rail Corporation spent $7 million in each of 1992 and 1993 for environmental remediation and anticipates spending a similar amount in 1994. In addition, Consolidated Rail Corporation's capital expenditures for environmental control and abatement projects were approximately $2 million in 1993, and are anticipated to be approximately $6 million in 1994. Conrail has an Environmental Quality Department, the mission of which is to institute and promote compliance with environmentally sound operating practices and to monitor and assess the status of sites where liability under environmental laws may exist. Item 8. Item 8. Financial Statements and Supplementary Data. - ------ ------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS The Stockholders and Board of Directors Conrail Inc. We have audited the consolidated financial statements and financial statement schedules of Conrail Inc. and subsidiaries listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Conrail Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its methods for accounting for income taxes and postretirement benefits other than pensions in 1993. COOPERS & LYBRAND COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania January 24, 1994 CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies ------------------------------------------ Industry -------- Conrail Inc. ("Conrail") is a holding company of which the principal subsidiary is Consolidated Rail Corporation ("CRC"), a freight railroad which operates in the Northeast-Midwest quadrant of the United States and the Province of Quebec. Principles of Consolidation --------------------------- The consolidated financial statements include Conrail and majority- owned subsidiaries. Investments in 20% to 50% owned companies are accounted for by the equity method. Cash Equivalents ---------------- Cash equivalents consist of commercial paper, certificates of deposit and other liquid securities purchased with a maturity of three months or less, and are stated at cost which approximates market value. Material and Supplies --------------------- Material and supplies consist mainly of fuel oil and items for maintenance of property and equipment, and are valued at the lower of cost, principally weighted average, or market. Property and Equipment ---------------------- Property and equipment are recorded at cost. Depreciation is provided using the composite straight-line method. The cost (net of salvage) of depreciable property retired or replaced in the ordinary course of business is charged to accumulated depreciation and no gain or loss is recognized. Revenue Recognition ------------------- Revenue is recognized proportionally as a shipment moves on the Conrail system from origin to destination. Earnings Per Share ------------------ Primary earnings (loss) per share are based on net income (loss) adjusted for the effects of preferred dividends net of income tax benefits, divided by the weighted average number of shares outstanding during the period including the dilutive effect of stock options. Fully diluted earnings (loss) per share assume CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) conversion of Series A ESOP Convertible Junior Preferred Stock ("ESOP Stock") into Conrail common stock unless they are antidilutive as they were in 1991. Net income amounts applicable to fully diluted earnings per share in 1993 and 1992 have been adjusted by the increase, net of income tax benefits, in ESOP- related expenses assuming conversion of all ESOP Stock to common stock. The weighted average number of shares of common stock outstanding (Note 2) during each of the most recent three years ended December 31, 1993 are as follows: 1993 1992 1991 ---------- ---------- ---------- Primary weighted average shares 80,646,495 81,743,648 81,883,970 Fully diluted weighted average shares 90,835,982 91,856,193 81,883,970 Ratio of Earnings to Fixed Charges ---------------------------------- Earnings used in computing the ratio of earnings to fixed charges represent income before income taxes plus fixed charges, less equity in undistributed earnings of 20% to 50% owned companies. Fixed charges represent interest expense together with interest capitalized and a portion of rent under long-term operating leases representative of an interest factor. In 1991, when CRC recorded a special charge (Note 10), earnings were insufficient to cover fixed charges. New Accounting Standards ------------------------ Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") (Note 8) and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") (Note 7). As a result, the Company recorded cumulative after tax charges of $22 million and $52 million for SFAS 106 and SFAS 109, respectively. In November 1992, the Financial Accounting Standards Board issued a standard ("SFAS 112") related to accounting for postemployment benefits, which is effective January 1994. This standard requires employers to recognize their obligation to provide salary continuation, supplemental unemployment benefits, and other benefits provided after employment but before retirement when certain conditions are met. The Company has determined that this standard would not have a material effect on its financial statements. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 2. Corporate Structure and Presentation ------------------------------------ In May 1993, the shareholders of CRC approved a plan for the adoption of a holding company structure. Under the plan, each share of CRC common stock that was issued and outstanding or held in the treasury of CRC, and each share of CRC ESOP Stock, all of which were held by the Non-union Employee Stock Ownership Plan (the "Non-union ESOP"), were automatically converted on July 1, 1993, into one share of common stock and one share of ESOP Stock, respectively, of a newly created holding company, Conrail Inc. As a result, Conrail Inc. became the publicly held entity effective July 1, 1993. The change in corporate structure does not represent a change in the operations or financial position of the consolidated entity. On July 1, 1993, Conrail had the same consolidated operations, assets, liabilities and stockholders' equity as CRC had on June 30, 1993. In this report, references to the "Company" will denote the consolidated entities Consolidated Rail Corporation for periods prior to July 1, 1993 and Conrail Inc. for subsequent periods. In 1992, the Company's Board of Directors authorized a two-for-one common stock split which was effected in the form of a common stock dividend. An amount equal to the par value of the common shares issued was transferred from additional paid-in capital to the common stock account. In addition, a stock dividend on the ESOP Stock in the amount of one share of ESOP Stock for each share of ESOP Stock outstanding was also distributed, and the number of authorized shares of ESOP Stock was increased from 7.5 million to 10 million shares. All references in the financial statements with regard to the number of shares, and related dividends and per share amounts for both common stock (including treasury shares) and ESOP Stock have been restated to reflect the stock split. Stock compensation and other plans that provide for the issuance of common stock, ESOP Stock, or an amount equivalent to their respective fair market values, have also been amended to reflect the stock split. 3. Disposition of Subsidiary ------------------------- In 1992, the Company acquired additional common shares of its affiliate, Concord Resources Group, Inc. ("Concord") increasing its ownership from 50% to 81.25%. In 1993, the Company committed to a plan for the disposition of its investment in Concord. Pursuant to this plan, the Company recorded the estimated loss of $80 million in September 1993 for the disposition of its investment, including $19 million for operating losses expected to be incurred during the phase-out period and disposition costs. The Company also recorded estimated federal tax benefits of $30 million relating to the disposition. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 4. Property and Equipment ---------------------- Conrail acquired equipment and incurred related long-term debt under various capital leases of $75 million in 1993, $13 million in 1992, and $76 million in 1991. 5. Accrued and Other Current Liabilities ------------------------------------- CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6. Long-Term Debt -------------- Long-term debt outstanding, including the weighted average interest rates at December 31, 1993, is composed of the following: Using current market prices when available, or a valuation based on the yield to maturity of comparable debt instruments having similar characteristics, credit rating and maturity, the total fair value of the Company's long-term debt, including the current portion, but excluding capital leases, is $1,782 million in 1993 and $1,310 million in 1992, compared with carrying values of $1,544 million and $1,200 million in 1993 and 1992, respectively. The Company's noncancelable long-term leases generally include options to purchase at fair value and to extend the terms. Capital leases have been discounted at rates which average 8.3% and are collateralized by assets with a net book value of $439 million at December 31, 1993. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Minimum commitments, exclusive of executory costs borne by the Company, are: Operating lease rent expense was $88 million in 1993, $71 million in 1992, and $50 million in 1991. The Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission in April 1990 for $1.25 billion of debt securities. In May 1993, the Company issued $250 million of 7 7/8% Debentures Due 2043, and has $11 million remaining to be issued under this shelf registration at December 31, 1993. In June 1993, the Company and CRC filed a new shelf registration statement on Form S-3 which will enable CRC to issue up to $500 million in debt securities or the Company to issue up to $500 million in convertible debt or equity securities. In February 1993, the Company issued $94 million of Pass Through Certificates, Series 1993-A1 and 1993-A2 to finance the acquisition of equipment. The Series 1993-A1 certificates, $41 million, have an interest rate of 5.71%, and Series 1993-A2 certificates, $53 million, have an interest rate of 6.86%. Certificates issued in the amount of $54 million are direct obligations of the Company and are secured by the acquired equipment. The remaining certificates, $40 million, were issued to finance equipment which the Company will utilize under a capital lease, and while such certificates are not direct obligations of, or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. In September 1993, CRC issued approximately $63 million of 5.98% 1993 Equipment Trust Certificates, Series A, due 2013, pursuant to the 1993 registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which CRC will utilize under an operating CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) lease. Although the certificates are not direct obligations of, or guaranteed by CRC, amounts payable by CRC under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, CRC issued $102 million of 1993 Equipment Trust Certificates, Series B, with interest rates ranging from 3.57% to 5.90%, maturing annually from 1994 through 2008. These certificates are obligations of CRC issued for the purchase of locomotives which will serve as collateral for the obligations. Equipment and other obligations mature in 1994 through 2013 and are collateralized by assets with a net book value of $200 million at December 31, 1993. Maturities of long-term debt other than capital leases and commercial paper are $74 million in 1994, $62 million in 1995, $95 million in 1996, $10 million in 1997, $40 million in 1998, and $1,163 million in total from 1999 through 2043. Conrail had $179 million of commercial paper outstanding at December 31, 1993. Of the total amount outstanding, $100 million is classified as long-term since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by the long-term credit facility mentioned below. The Company maintains a $300 million uncollateralized revolving credit facility with a group of banks under which no borrowings were outstanding at December 31, 1993. The credit facility, which expires in 1995, requires interest to be paid on borrowings at rates based on various defined short-term market rates and an annual maximum fee of .1% of the facility amount. The credit facility contains, among other conditions, restrictive covenants relating to leverage ratio, debt, and consolidated tangible net worth. Interest payments were $164 million in 1993, $162 million in 1992, and $167 million in 1991. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 7. Income Taxes ------------ The provisions for (benefits from) income taxes are composed of the following: Effective January 1, 1993, the Company adopted the provisions of SFAS 109 which requires a liability approach for measuring deferred tax assets and liabilities based on differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates in effect when those differences are expected to reverse. As a result, the Company recorded a cumulative adjustment of $52 million. The primary effects of the adoption of this standard on the balance sheet were the recording of a current deferred tax asset of $147 million with a corresponding increase in the long-term deferred income tax liability and the net deferred income tax liabilities related to the cumulative accounting adjustment for the adoption of SFAS 109 and SFAS 106 (Note 8). Prior years' financial statements have not been restated to apply the provisions of the new standard. In conjunction with the public sale in 1987 of the 85% of the Company's common stock owned by the U.S. Government, federal legislation was enacted which resulted in a reduction of the tax basis of certain of the Company's assets, particularly property and equipment, thereby substantially decreasing tax depreciation deductions and increasing future federal income tax payments. Also, net operating loss and investment tax credit carryforwards were cancelled. As a result of the sale-related transactions, a special income tax obligation was recorded in 1987 based on an estimated effective federal and state income tax rate of 37.0%. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As a result of the increase in the federal corporate income tax rate from 34% to 35% enacted August 10, 1993, and effective January 1, 1993, income tax expense for 1993 was increased by $38 million, of which $34 million related to the effects of adjusting deferred income taxes and the special income tax obligation for the rate increase. During the third quarter of 1993, the Company reached a settlement with the Internal Revenue Service related to the audit of the Company's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, the Company paid $51 million, including interest, all of which had been previously provided for in prior years resulting in no income statement effect in 1993. Federal and state income tax payments were $39 million in 1993 (excluding tax settlement), $31 million in 1992, and $45 million in 1991. Significant components of the Company's special income tax obligation and deferred income tax liabilities and (assets) as of December 31, 1993 are as follows: CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The tax effects of each source of deferred income taxes and special income tax obligation (disclosure for 1993 is not required nor applicable under SFAS 109)are as follows: As of December 31, 1993, the Company has approximately $77 million of alternative minimum tax credits available to offset future U.S. federal income taxes on an indefinite carryforward basis. Deferred income taxes and the special income tax obligation for 1991 include reductions of $159 million and $113 million, respectively, related to the 1991 Special Charge (Note 10). Reconciliations of the U.S. statutory tax rates with the effective tax rates follow: 1993 1992 1991 ----- ----- ----- Statutory tax rate 35.0% 34.0% (34.0)% State income taxes, net of federal benefit 5.1 3.9 (3.5) Effect of federal tax increase on deferred taxes 7.7 Other (1.0) .8 (.7) ----- ----- ----- Effective tax rate 46.8% 38.7% (38.2)% ===== ===== ===== 8. Employee Benefits ----------------- Pension Plans ------------- The Company and certain subsidiaries maintain defined benefit pension plans which are noncontributory for all non-union employees and generally contributory for participating union employees. Benefits are based primarily on credited years of service and the level of compensation near retirement. Funding is based on the minimum amount required by the Employee CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Retirement Income Security Act of 1974. Pension credits include the following components: 1993 1992 1991 ----- ----- ---- (In Millions) Service cost - benefits earned during the period $ 8 $ 7 $ 6 Interest cost on projected benefit obligation 46 45 42 Return on plan assets - actual (124) (66) (175) - deferred 42 (13) 100 Net amortization and deferral (15) (15) (18) ---- ---- ---- $(43) $(42) $(45) ==== ==== ==== The funded status of the pension plans and the amounts reflected in the balance sheets are as follows: 1993 1992 ------ ------ (In Millions) Accumulated benefit obligation ($532 million and $505 million vested, respectively) $ 537 $ 506 ====== ====== Market value of plan assets 1,043 977 Projected benefit obligation (632) (580) ------ ------ Plan assets in excess of projected benefit obligation 411 397 Unrecognized prior service cost 43 61 Unrecognized transition net asset (159) (179) Unrecognized net gain (101) (124) ------ ------ Net prepaid pension cost $ 194 $ 155 ====== ====== The assumed weighted average discount rates used in 1993 and in 1992 are 7.25% and 8.0%, respectively, and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation as of December 31, 1993 and 1992 is 6.0%. The expected long-term rate of return on plan assets (primarily equity securities) in 1993 and 1992 is 9.0%. Savings Plans ------------- The Company and certain subsidiaries also provide 401(k) savings plans for union and non-union employees. Under the Non-union ESOP, 100% of employee contributions are matched in the form of ESOP Stock for the first 6% of a participating employee's base pay. Under the union employee plan, employee contributions are not matched by the Company. Savings plan expense, including Non- union ESOP expense, was $5 million in 1993 and $4 million in 1992 and 1991. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) In connection with the Non-union ESOP, the Company issued 9,979,562 of the authorized 10 million shares of its ESOP Stock to the Non-union ESOP in exchange for a 20 year promissory note with interest at 9.55% from the Non-union ESOP in the principal amount of $288 million. In addition, unearned ESOP compensation of $288 million was recognized as a charge to stockholders' equity coincident with the Non-union ESOP's issuance of its $288 million promissory note to the Company. The debt of the Non-union ESOP was recorded by the Company and offset against the promissory note from the Non-union ESOP. Unearned ESOP compensation is charged to expense as shares of ESOP Stock are allocated to participants. An amount equivalent to the preferred dividends declared on the ESOP Stock partially offsets compensation and interest expense related to the Non-union ESOP. The Company is obligated to make dividend payments at a rate of 7.51% on the ESOP Stock and additional contributions in an aggregate amount sufficient to enable the Non-union ESOP to make the required interest and principal payments on its note to the Company. Interest expense incurred by the Non-union ESOP on its debt to the Company was $29 million in 1993, and $28 million in 1992 and 1991. Compensation expense related to the Non-union ESOP was $10 million in 1993, $9 million in 1992, and $8 million in 1991. Preferred dividends paid to the Non-union ESOP were $21 million in 1993, 1992 and 1991. The Company received debt service payments from the Non-union ESOP of $26 million in 1993, and $21 million in 1992 and 1991. Postretirement Benefits Other Than Pensions ------------------------------------------- The Company provides health and life insurance benefits to certain eligible retired non-union employees. Certain non-union employees are eligible for retiree medical benefits, while substantially all non-union employees are eligible for retiree life insurance benefits. Generally, company-provided health care benefits terminate when covered individuals reach age 65. Retiree medical benefits are funded by a combination of Company and retiree contributions. The cost of medical benefits provided by the Company as self-insurer was previously recognized as claims and administrative expenses were paid. Retiree life insurance benefits are provided by insurance companies whose premiums are based on claims paid during the year and the cost of such benefits was previously recognized as the annual insurance premium. The expense of providing both non-union retiree medical and life insurance benefits for 1992 and 1991 was $5 million and $2 million, respectively. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Retiree life insurance plan assets consist of a retiree life insurance reserve held in the Company's group life insurance policy. There are no plan assets for the retiree health benefits plan. Effective January 1, 1993, the Company adopted SFAS 106, which requires that the cost of retiree benefits other than pensions be accrued during the period of employment rather than when benefits are paid. The Company elected the immediate recognition method allowed under the statement and accordingly recorded a cumulative, one-time charge of $22 million (net of tax benefits of $14 million). This accrual was in addition to the remaining balance of $21 million which had been accrued for postretirement health benefits for employees who participated in the Company's 1989 non-union voluntary retirement program. The accumulated postretirement obligation at January 1, 1993 was $41 million for the medical plan and $21 million for the life insurance plan. Plan assets attributed to the life insurance plan at January 1, 1993 totalled $5 million. The following sets forth the plan's funded status reconciled with amounts reported in the Company's balance sheet at December 31, 1993: Life Medical Insurance Plan Plan ------- --------- (In Millions) Accumulated postretirement benefit obligation: Retirees $31 $16 Fully eligible active plan participants 9 1 Other active plan participants 2 6 --- --- Accumulated benefit obligation 42 23 Market value of plan assets (6) --- --- Accumulated benefit obligation in excess of plan 42 17 assets Unrecognized losses (3) (2) Accrued benefit cost recognized in the --- --- Consolidated Balance Sheet $39 $15 === === Net periodic postretirement benefit cost for 1993, primarily interest cost $ 3 $ 1 === === An 11.5% rate of increase in per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 6% by the year 2008. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $4 million and would have an immaterial effect on the service cost and interest cost components of net periodic postretirement benefit cost for 1993. A discount rate of 7.0% was used to determine the accumulated postretirement benefit CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) obligations for both the medical and life insurance plans. The assumed rate of compensation increase is 5.0%. 9. Capital Stock ------------- The Company is authorized to issue 25 million shares of preferred stock with no par value. The Board of Directors has the authority to divide the preferred stock into series and to determine the rights and preferences of each. The Company cannot pay dividends on its common stock unless full cumulative dividends have been paid on its ESOP Stock, and no distributions can be made to the holders of common stock upon liquidation or dissolution of the Company unless the holders of the ESOP Stock have received a cash liquidation payment of $28.84375 per share, plus unpaid dividends up to the date of such payment. The ESOP Stock is convertible into common stock on a share-for-share basis and is entitled to one vote per share, voting together as a single class with common stock on all matters. In September 1993, the $100 million 1992 stock repurchase program was completed at a total of 2,150,293 shares. On July 21, 1993, the Board of Directors authorized an additional $100 million repurchase program. At December 31, 1993, the Company had acquired 237,855 shares for approximately $14 million under this program. During 1993, the Company reclassified 4,787,579 shares of repurchased common stock (treasury stock) as authorized but unissued. The activity and status of treasury stock follow: 1993 1992 1991 --------- --------- ------- Shares, beginning of year 3,690,002 546,400 Acquired 1,181,322 3,143,602 546,400 Reclassified as authorized but unissued (4,787,579) --------- --------- ------- Shares, end of year 83,745 3,690,002 546,400 ========= ========= ======= The Company's 1987 Long-Term Incentive Plan (the "1987 Incentive Plan") authorizes the granting to officers and key employees of up to 4 million shares of common stock through stock options, stock appreciation rights, and awards of restricted or performance shares. A stock option is exercisable for a specified term commencing after grant at a price not less than the fair market value of the stock on the date of grant. The CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 1987 Incentive Plan also provides for the granting of stock to employees, contingent on either a specified period of employment or achievement of certain financial or performance goals. The Company's 1991 Long-Term Incentive Plan (the "1991 Incentive Plan") authorizes the granting to officers and key employees of up to 3.2 million shares of common stock, through stock options, stock appreciation rights and awards of restricted or performance shares. The Company has granted 169,005 shares of restricted stock under its incentive plans through December 31, 1993. The activity and status of stock options under the incentive plans follow: In 1989, the Company declared a dividend of one common share purchase right (the "Right") on each outstanding share of common stock. The Rights are not exercisable or transferable apart from the common stock until the occurrence of certain events arising out of an actual or potential acquisition of 10% or more of the Company's common stock, and would at such time provide the holder with certain additional entitlements. If the Rights become exercisable, each Right will entitle stockholders to CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) purchase one share of common stock at an exercise price of $52.50. At the Company's option, the Rights are redeemable prior to becoming exercisable at one-half cent ($.005) per Right. The Rights expire in July 1999 and do not have any voting privileges or rights to receive dividends. 10.1991 Special Charge ------------------- In 1991, the Company recorded in operating expenses a special charge totalling $719 million which was composed of $362 million for disposition of certain under-utilized rail lines and other facilities, $212 million for labor settlements primarily representing certain expected costs associated with a new labor agreement that reduced the size of train crews, $57 million for certain environmental clean up costs, and $88 million for legal matters including settlement of the Amtrak-Conrail collision at Chase, Maryland in January 1987. The 1991 special charge reduced net income by $447 million, and without the special charge net income would have been $240 million ($2.73 and $2.48 per share, primary and fully diluted, respectively). 11.Other Income, Net ----------------- 1993 1992 1991 ---- ---- ---- (In Millions) Interest income $ 39 $ 40 $ 48 Rental income 56 60 53 Property sales 20 6 9 Other, net (1) (8) (3) ---- ---- ---- $114 $ 98 $107 ==== ==== ==== 12.Commitments and Contingencies ----------------------------- Non-union Voluntary Retirement Program -------------------------------------- On December 15, 1993, the Board of Directors approved a voluntary early retirement program for eligible members of its non-union workforce. The eligible employees had until February 28, 1994 to elect to retire under the program, and based on the results of a similar program completed in 1990, the cost of the program is expected to have a material effect on the income statement for the first quarter of 1994. The transaction will not significantly affect the Company's cash position as approximately 85% of the cost will be paid from the Company's overfunded pension plan (Note 8). CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Environmental ------------- The Company is subject to various federal, state and local laws and regulations regarding environmental matters. CRC is a party to various proceedings brought by both regulatory agencies and private parties under federal, state and local laws, including Superfund laws, and has also been named as a potentially responsible party in many governmental investigations and actions for the cleanup and removal of hazardous substances due to its alleged involvement as either a transporter, generator or property owner. Due to the number of parties involved at many of these sites, the wide range of costs of possible remediation alternatives, the changing technology and the length of time over which these matters develop, it is often not possible to estimate CRC's liability for the costs associated with the assessment and remediation of contaminated sites. Although the Company's operating results and liquidity could be significantly affected in any quarterly or annual reporting period if CRC were held principally liable in certain of these actions, at December 31, 1993, the Company had accrued $77 million, an amount it believes is sufficient to cover the probable liability and remediation costs that will be incurred at Superfund sites and other sites based on known information and using various estimating techniques. The Company believes the ultimate liability for these matters will not materially affect its consolidated financial condition. The Environmental Quality Department of the Company is charged with promoting the Company's compliance with laws and regulations affecting the environment and instituting environmentally sound operating practices. The department monitors the status of the sites where the Company is alleged to have liability and continually reviews the information available and assesses the adequacy of the recorded liability. Other Contingencies ------------------- The Company is involved in various legal actions, principally relating to occupational health claims, personal injuries, casualties, property damage and loss and damage. The Company has recorded liabilities on its balance sheet for amounts sufficient to cover the expected payments for such actions. At December 31, 1993 these liabilities are presented net of estimated insurance recoveries of approximately $80 million. Conrail may be contingently liable for approximately $102 million at December 31, 1993 under indemnification provisions related to sales of tax benefits. CONRAIL INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 13.Condensed Quarterly Data (Unaudited) ----------------------------------- Effective January 1, 1993, the Company adopted SFAS 106 and SFAS 109, related to the accounting for postretirement benefits other than pensions and income taxes, respectively. As a result, the Company recorded cumulative after tax charges totalling $74 million ($.91 per share, primary and fully diluted) in the first quarter of 1993 (Notes 1, 7 and 8). During the third quarter of 1993, the Company recorded an estimated loss for the disposition of its investment in its subsidiary, Concord Resources Group, Inc. (Note 3). As a result, net income for the quarter was reduced by the loss of $80 million less the estimated tax benefits of $30 million. Also, in the third quarter, as a result of the increase in the federal corporate income tax rate enacted August 10, 1993 and effective January 1, 1993, income tax expense for the third quarter of 1993, includes a charge of $36 million, primarily related to the adjustment of deferred taxes and the special income tax obligation as required by SFAS 109 (Note 7). Without these two charges, net income per common share for the third quarter of 1993 would have been $1.00 on a primary basis and $.91 on a fully diluted basis. Item 9. Item 9. Changes in and Disagreements with Accountants - ------ --------------------------------------------- on Accounting and Financial Disclosure. -------------------------------------- Previously reported in Conrail's Current Report on Form 8-K, filed February 18, 1994. PART III Item 10. Item 10. Directors and Executive Officers - ------- -------------------------------- of the Registrant. ----------------- Item 11. Item 11. Executive Compensation. - ------- ---------------------- Item 12. Item 12. Security Ownership of Certain Beneficial - ------- ---------------------------------------- Owners and Management. --------------------- and Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- In accordance with General Instruction G(3), the information called for by Part III is incorporated herein by reference from Conrail's definitive Proxy Statement for the Conrail Annual Meeting of Shareholders to be held on May 18, 1994, which definitive Proxy Statement will be filed with the Commission pursuant to Regulation 14A. The information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I under "Executive Officers of the Registrant." PART IV Item 14. Item 14. Exhibits, Financial Statement - ------- ----------------------------- Schedules, and Reports on Form 8-K. ---------------------------------- (a) The following documents are filed as a part of this report: 1. Financial Statements: Page ---- Report of Independent Accountants..................... 37 Consolidated Statements of Income for each of the three years in the period ended December 31, 1993... 38 Consolidated Balance Sheets at December 31, 1993 and 1992 ........................................... 39 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1993...................... 40 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 .................................. 41 Notes to Consolidated Financial Statements............ 42 2. Financial Statement Schedules: The following financial statement schedules should be read in connection with the financial statements listed in Item 14(a)1 above. Index to Financial Statement Schedules -------------------------------------- Page ---- Schedule V - Property, Plant and Equipment...... S-1 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment.... S-2 Schedule VIII - Valuation and Qualifying Accounts... S-3 Schedule X - Supplementary Income Statement Information...................... S-4 Schedules other than those listed above are omitted for reasons that they are not required, are not applicable, or the information is included in the financial statements or related notes. 3. Exhibits: Exhibit No. ---------- 2. Agreement and Plan of Merger among Consolidated Rail Corporation, Conrail Inc. and Conrail Subsidiary Corporation dated as of February 17, 1993, filed as Appendix A to the Proxy Statement of Consolidated Rail Corporation, dated April 16, 1993 and incorporated herein by reference. 3.1 Articles of Incorporation of the Registrant filed as Appendix B to the Proxy Statement of Consolidated Rail Corporation, dated April 16, 1993 and incorporated herein by reference. 3.2 By-Laws of the Registrant, filed as Exhibit 3.3(ii) to the Registrant's Form 8-B, dated July 13, 1993 and incorporated herein by reference. 4.1 Articles of Incorporation of the Registrant filed as Appendix B to the Proxy Statement of Consolidated Rail Corporation, dated April 16, 1993 and incorporated herein by reference. 4.2 Form of Certificate of Common Stock, par value $1.00 per share, of the Registrant, filed as Exhibit 3.4(i)(c) to the Registrant's Form 8-B dated July 13, 1993 and incorporated herein by reference. 4.3 Form of Certificate of Series A ESOP Convertible Junior Preferred Stock, no par value, of the Registrant filed as Exhibit 3.4(i)(d) to the Registrant's Form 8-B dated July 13, 1993 and incorporated herein by reference. 4.4 Rights Agreement dated as of July 19, 1989, between Consolidated Rail Corporation and First Chicago Trust Company of New York, together with Form of Right Certificate and Summary of Rights to Purchase Common Shares as exhibits thereto, filed as Exhibit 1 to Consolidated Rail Corporation's Form 8-K dated July 31, 1989 and incorporated herein by reference. 4.5 Amendment to Rights Agreement dated as of March 21, 1990, filed as Exhibit 4.5 to Consolidated Rail Corporation's Report on Form 8-K dated March 27, 1990 and incorporated herein by reference. 4.6 Amendment, Assignment and Assumption Agreement, dated as of February 17, 1993, with respect to the Rights Agreement, filed as Exhibit 3.4(i)(g) to the Registrant's Form 8-B dated July 13, 1993 and incorporated herein by reference. 4.7 Form of Indenture between Consolidated Rail Corporation and The First National Bank of Chicago, as Trustee, with respect to the issuance of up to $1.25 billion aggregate principal amount of Consolidated Rail Corporation's debt securities, filed as Exhibit 4 to Consolidated Rail Corporation's Registration Statement on Form S-3 (Registration No. 33-34040) and incorporated herein by reference. In accordance with Item 601(b)(4)(iii) of Regulation S- K, copies of instruments of the Registrant and its subsidiaries with respect to the rights of holders of certain long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10.1 Second Amended and Restated Northeast Corridor Freight Operating Agreement dated October 1, 1986 between National Railroad Passenger Corporation and Consolidated Rail Corporation, filed as Exhibit 10.1 to Consolidated Rail Corporation's Registration Statement on Form S-1 (Registration No. 33-11995) and incorporated herein by reference. 10.2 Letter agreements dated September 30, 1982 and July 19, 1986 between Consolidated Rail Corporation and The Penn Central Corporation, filed as Exhibit 10.5 to Consolidated Rail Corporation's Registration Statement on Form S-1 (Registration No. 33-11995) and incorporated herein by reference. 10.3 Letter agreement dated March 16, 1988 between Consoli- dated Rail Corporation and Penn Central Corporation re- lating to hearing loss litigation, filed as Exhibit 19.1 to Consolidated Rail Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1988 and incorporated herein by reference. Management Compensation Plans and Contracts ------------------------------------------- 10.4 Consolidated Rail Corporation Annual Profit Incentive Plan for 1991, filed as Exhibit 10.6 to Consolidated Rail Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 and incorporated herein by reference. 10.5 Consolidated Rail Corporation 1992 Annual Performance Achievement Reward Plan, filed as Exhibit 10.6 to Consolidated Rail Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference. 10.6 Consolidated Rail Corporation 1993 Annual Performance Achievement Reward Plan, filed as Exhibit 3.10(v) to the Registrant's Form 8-B dated July 13, 1993 and incorporated herein by reference. 10.7 Conrail 1987 Long-Term Incentive Plan, filed as Exhibit 4.4 to Consolidated Rail Corporation's Registration Statement on Form S-8 (Registration No. 33-19155) and incorporated herein by reference. 10.8 Conrail 1991 Long-Term Incentive Plan, filed as Exhibit 4.8 to Consolidated Rail Corporation's Registration Statement on Form S-8 (Registration No. 33-44140) and incorporated herein by reference. 10.9 Employment Agreement between James A. Hagen and Consolidated Rail Corporation, dated as of April 3, 1989, filed as Exhibit 10.11 to Consolidated Rail Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 10.10 Agreement for Supplemental Employee Retirement Plan between James A. Hagen and Consolidated Rail Corporation, dated as of January 17, 1990, filed as Exhibit 10.12 to Consolidated Rail Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 10.11 Form of Continuation Agreement between Consolidated Rail Corporation and each of its officers other than James A. Hagen, dated as of January 15, 1990, filed as Exhibit 10.14 to Consolidated Rail Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 11 Statement of earnings (loss) per share computations. 12 Computation of the ratio of earnings to fixed charges. 21 Subsidiaries of the Registrant. 23 Consent of Independent Accountants. 24 Each of the officers and directors signing this Annual Report on Form 10-K has signed a power of attorney, contained on page 66 hereof, with respect to amendments to this Annual Report. (b) Reports on Form 8-K. Current Report on Form 8-K dated October 7, 1993, filed in connection with Consolidated Rail Corporation's issuance of $63,156,000 of 5.98% 1993-A Equipment Trust Certificates Due 2013 pursuant to its current Registration Statement on Form S-3 (No. 33-64670). (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)3 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial state ments specified by this Item are included in Item 14(a)2 or are otherwise omitted for reasons that they are not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" hereby authorizes H. William Brown and Bruce B. Wilson, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints H. William Brown and Bruce B. Wilson, or either of them, as attorneys-in-fact to sign on his or her behalf, individually and in each capacity stated below, and to file any and all amendments to this report. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act 1934, Conrail Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CONRAIL INC. Date: March 16, 1994 By James A. Hagen ----------------------------- James A. Hagen Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 16th day of March, 1994, by the following persons on behalf of Conrail Inc. and in the capacities indicated. Signature Title - --------- ----- James A. Hagen Chairman, President and Chief - ------------------------ Executive Officer and Director James A. Hagen (Principal Executive Officer) H. William Brown Senior Vice President - Finance - ------------------------ and Administration H. William Brown (Principal Financial Officer) John A. McKelvey Vice President - Controller - ------------------------ (Principal Accounting Officer) John A. McKelvey H. Furlong Baldwin Director - ------------------------ H. Furlong Baldwin Claude S. Brinegar Director - ------------------------ Claude S. Brinegar Daniel S. Burke Director - ------------------------ Daniel B. Burke Kathleen Foley Feldstein Director - ------------------------ Kathleen Foley Feldstein Roger S. Hillas Director - ------------------------ Roger S. Hillas E. Bradley Jones Director - ------------------------ E. Bradley Jones David B. Lewis Director - ------------------------ David B. Lewis John C. Marous Director - ------------------------ John C. Marous William G. Milliken Director - ------------------------ William G. Milliken Raymond T. Schuler Director - ------------------------ Raymond T. Schuler David H. Swanson Director - ------------------------ David H. Swanson E-1 EXHIBIT INDEX Page Number in SEC Sequential Numbering Exhibit No. System - ----------- -------------------- 11 Statement of earnings (loss) per share computations 12 Computation of the ratio of earnings to fixed charges 21 Subsidiaries of the Registrant 23 Consent of Independent Accountants Exhibits 2, 3.1, 3.2, 4.1, 4.2, 4.3, 4.4, 4.5, 4.6, 4.7, 10.1, 10.2, 10.3, 10.4, 10.5, 10.6, 10.7, 10.8, 10.9, 10.10 and 10.11 are incorporated herein by reference. Powers of attorney with respect to amendments to this Annual Report are contained on page 66.	18,283	121,554
771498_1993.txt	771498_1993	1993	771498	ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings required to be reported in response to this item. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1993 to a vote of security holders. EXECUTIVE OFFICERS OF THE REGISTRANT Listed below are the names and ages as of March 1, 1994, of each of the present executive officers of the Company together with principal occupations held by each during the past five years. Executive officers are appointed annually to serve for the ensuing year or until their successors have been appointed. No officer is related to any other by blood, marriage or adoption. No arrangement or understanding exists between any officer and any other person under which any officer was elected. Messrs. Mazur, Quinn and Reisbick have been employed with the Company since July 1985. KARL E. ELERS previously served as President and Chief Operating Officer of the Company from April 1988 until April 1990. Mr. Elers also serves as a member of the Executive Committee and of the Environmental Affairs and Ethics Committee of the Company's Board of Directors. KENNETH R. WERNEBURG was Executive Vice President of the Company from November 1989 until April 1990. Prior to joining the Company, Mr. Werneburg served as Chairman and Chief Executive Officer of Hill Refrigeration Corporation (commercial refrigeration equipment) since April 1989. From 1985 through 1988, Mr. Werneburg served as Executive Vice President of St. Joe Minerals Corporation (international mining and manufacturing). Mr. Werneburg also serves as a member of the Executive Committee of the Company's Board of Directors. ANDRE J. DOUCHANE was Manager of North American Operations from July 1991 until April 1992. Prior to joining the Company in July 1991, Mr. Douchane was employed by Round Mountain Gold Corp. as Vice President and General Manager. R. DENNIS O'CONNELL was Vice President of the Company from May 1992 until July 1992 when he was named Vice President - Finance and Chief Financial Officer. Prior to joining the Company, Mr. O'Connell served as Assistant Controller, Worldwide Exploration and Production for Marathon Oil Company since January 1991. From July 1988 through January 1991, Mr. O'Connell served as Manager, Finance and Administration, Worldwide Production for Marathon Oil Company. From January 1987 through July 1988, Mr. O'Connell served as Director, Finance and Administration of Marathon Oil U.K., Ltd. ROBERT J. QUINN previously served as Secretary and Corporate Counsel of the Company until 1989. FRED B. REISBICK previously served as General Manager, North America Exploration until November 1992. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF COMMON STOCK The Company's common stock, par value $0.10 per share (the "Common Stock"), is traded on the New York Stock Exchange (the "NYSE"), the Toronto Stock Exchange, the Australian Stock Exchange Limited, the Swiss Stock Exchanges and the Frankfurt Stock Exchange. The ticker symbol for the Common Stock on the exchanges is "BMG." The following table sets forth for the periods indicated the high and low sales prices for the Common stock as reported on the NYSE Composite Tape. As of March 7, 1994, the Company had 22,559 record holders of Common Stock. Cash dividends of $0.025 per share were paid in each quarter of fiscal 1992. Cash dividends of $0.025 per share were paid in each half of fiscal 1993 pursuant to the Company's October 1992 announcement of its intention to reduce cash dividends. A determination to pay future dividends and the amount thereof will be made by the Company's Board of Directors and will depend on the Company's future earnings, capital requirements, financial condition and other relevant factors. The Company's ability to pay dividends is subject to certain restrictions contained in the Company's committed revolving credit facility. These restrictions are not expected to affect the payment of dividends. For a further discussion of the credit facility and of restrictions on Inti Raymi to pay dividends to BMG, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and Note 11 of Notes to Consolidated Financial Statements under Item 8 herein. The Company intends to retain most of its earnings to support current operations, to fund exploration and development projects and to provide funds for acquiring gold properties. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain consolidated financial data for the respective periods presented and should be read in conjunction with the Consolidated Financial Statements and the related notes thereto in Item 8 and Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations During 1993, the Company completed the transition of its primary production stream from the Fortitude mine in Nevada to the 85 percent owned Kori Kollo mine in Bolivia. As expected, there was little change in the Company's total gold production during this transition period. However, increased costs related to the transition to a lower grade ore body at the Fortitude mine and lower than anticipated production levels from the heap leach operations at the Battle Mountain complex and the San Cristobal mine resulted in an increase in total operating costs per equivalent ounce of gold for 1993. The Company reported a net loss of $4.4 million for 1993. In 1992, the Company increased its gold production as it realized the first full year of production from three new mines: the San Luis mine in Colorado, the San Cristobal mine in Chile and the Red Dome mine in Australia. For 1992, the Company reported a net loss of $36.4 million as a result of weak gold prices, impairment in value of the Company's San Luis mine and the Canyon Placer facility and higher operating costs associated with its newer, low-grade mines. In particular, the San Luis mine experienced an extended period of start-up difficulties. This compares with a net loss of $1.2 million for 1991, which included the impairment in value of the Company's San Juan project. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," and SFAS No. 106, "Employer's Accounting for Postretirement Benefits other than Pensions." (See Notes 6 and 7 to the Consolidated Financial Statements.) Revenues Gross revenue of $207.3 million in 1993 represented an increase of 8 percent from gross revenue of $192.2 million in 1992. This increase, resulting from increased sales volumes and improved gold prices in 1993, followed a 9 percent gross revenue increase realized in 1992, which reflected the growth in volumes of gold production and sales that the Company achieved through the acquisition and development of new mines. Gold sales volumes increased 3 percent in 1993 to a total of 503,000 ounces (of which 417,000 ounces were attributable to BMG) following an increase of 8 percent in 1992. Also contributing to improved revenues in 1993 was an increase in average realized gold prices (to $366 per ounce in 1993 from $359 per ounce in 1992). During 1992, lower average realized gold prices partially offset volume gains. In the upcoming years, the Company expects development and evaluation projects at the Battle Mountain complex and the Crown Jewel site to be permitted, and the Kori Kollo mine to be expanded. Because of these factors, the Company expects continued production growth through the mid-1990's. Selling and Operating Costs Freight, allowances and royalties increased to $13.8 million ($24 per equivalent ounce of gold sold) in 1993 from $10.4 million ($19 per equivalent ounce of gold sold) in 1992 and $6.2 million ($13 per equivalent ounce of gold sold) in 1991. The increase in 1993 resulted from higher costs associated with new smelting and refining agreements for Red Dome mine concentrates and increased sales from the Kori Kollo mine. The 1992 increase was primarily attributable to the first full year of production of Red Dome mine concentrates which had characteristics requiring significant additional freight, smelting and refining costs for conversion to salable products. Higher costs primarily associated with the production transition from the Fortitude mine to the Kori Kollo mine and higher sales volumes contributed to higher aggregate mining, milling and other costs in 1993. Increases in production and sales volumes resulted in higher costs in 1992 as compared with 1991. These costs increased to $128.5 million ($227 per equivalent ounce of gold sold) in 1993 from $117.4 million ($219 per equivalent ounce of gold sold) in 1992 and $89.4 million ($191 per equivalent ounce of gold sold) in 1991. Depreciation, depletion and amortization expense increased to $41.4 million ($73 per equivalent ounce of gold sold) in 1993 from $38.6 million ($72 per equivalent ounce of gold sold) in 1992, and $28.1 million ($60 per equivalent ounce of gold sold) in 1991, as a result of the higher capital costs associated with the Company's newer operations and increases in sales volumes. Increased production and sales volumes, and the higher acquisition costs of new reserves, will cause depreciation, depletion and amortization to increase in the future. Selling and operating costs per equivalent ounce of gold sold are based on actual sales and include inventoried costs; therefore, these costs are not directly comparable to production costs per equivalent ounce of gold. Exploration Costs Exploration and evaluation expenses were reduced to $9.5 million in 1993 from $17.1 million in 1992 and from $27.4 million in 1991 as a result of the Company's decision to focus its exploration efforts on fewer, higher potential targets. Exploration and evaluation expenses are expected to increase to about $14 million in 1994 as the Company expands its international exploration program and intensifies its efforts to evaluate targets already in hand. (See "-- Liquidity and Capital Resources -- Exploration and Capital Expenditures.") Write-downs The volatility of gold prices requires that the Company, in assessing the impact of prices on recoverability, exercise judgement as to whether price changes are temporary or are likely to persist. The Company performs a comprehensive evaluation of the recoverability of its assets on a periodic basis to assess the impact of significant changes in market conditions and other factors. During 1992, the Company recognized charges totalling approximately $23.3 million, net of $11.1 million in income tax benefits for the impairment in value of certain of the Company's assets. The charges included: (1) a write-down of $17.6 million, net of a $9.1 million income tax benefit, of BMG's investment in the San Luis mine in Colorado that reduced the carrying value of the investment to a level which BMG believed would be recoverable under then existing and expected future market conditions (lower gold prices, compared with those at the time of project conception, and greater than anticipated capital expenditures resulting from a difficult start-up period led to the write-down), (2) a write-off of $4 million, net of a $2 million income tax benefit, of BMG's investment in the previously closed Canyon Placer facility, which was abandoned because of a persistently weak gold market, and (3) an impairment of $1.7 million, included as Other income (expense), net, to adjust to current market the carrying value of certain marketable equity security investments. These charges compare with a 1991 charge of $4.5 million (net of a $1.1 million tax benefit) to adjust the carrying value of the Company's investment in the San Juan project in California to the purchase price set forth in the Company's agreement to sell the project to another gold mining company. No similar write-downs were recorded in 1993. Additional asset write-downs may occur if the Company determines that the carrying values attributed to individual assets are not recoverable given reasonable expectations for future market conditions, although no write-downs are currently anticipated. General and Administrative Costs As a result of cost reduction efforts initiated in 1992, the Company's general and administrative expenses have decreased to $17.5 million in 1993 from $17.9 million in 1992 and from $21.1 million in 1991. Included in these expenses are $6.7 million, $6.3 million and $8.2 million, respectively, attributable to the general and administrative costs incurred by the Company's majority-owned subsidiaries. Absent material changes in the Company's manner of operation, general and administrative expenses are not expected to significantly change in the foreseeable future. Other Interest income increased to $4.6 million in 1993 from $1.8 million in 1992. This increase resulted from greater levels of cash available arising primarily from the proceeds of the Company's 1993 convertible preferred stock offering (see "-- Liquidity and Capital Resources -- Financing"). The 1992 amount represents a decrease from $4.4 million in 1991 which can be attributed to lower interest rates and lower levels of cash available for investment. Future declines in interest income are expected for the near term because of lower levels of cash available as a result of continuing major capital investments and debt service requirements. Gross interest expense, including amounts capitalized, amounted to $15.1 million in 1993, $10.3 million in 1992 and $8.3 million in 1991. Interest expense with respect to borrowings attributable to any given project in the pre-production stage is capitalized until such time as that project begins commercial production. Interest expense charged against income increased in 1993 because interest expense related to the Kori Kollo sulfide project financing has not been capitalized since commencement of commercial operations in February 1993 and since project financing was outstanding for the entire year. Prior to 1993, the majority of interest expense was capitalized and was related primarily to the $100 million of 6 percent convertible subordinated debentures and to amounts outstanding under a committed $150 million revolving credit facility. Should additional borrowings be required to fund acquisitions and mine development, interest expense would be expected to increase accordingly. Other net income of $5.7 million in 1993 represents an improvement from other net expense of $1.2 million in 1992 and $1.2 million in 1991. The 1993 income resulted from gains of $3.7 million from the sale of an ore deposit at BMG's Plutonic Bore Exploration project in Western Australia and $2 million from the sale of certain long-term investments held by Niugini Mining. Exclusive of the taxes provided on cumulative effects of accounting changes for the periods presented, income tax provisions resulted in a $4.1 million benefit in 1993, and a $12.2 million benefit in 1992 compared with income tax expense of $1 million in 1991. The changes in the tax provisions are primarily attributable to changes relative to the level of income or losses before taxes. It is anticipated that the Australian income tax, which had no material impact on the Company's income in 1993 or previous years, will not materially affect the Company's future results of operations. Earnings from the Company's wholly- owned Australian subsidiary are subject to a 15 percent Australian withholding tax and U.S. Federal income tax to the extent such earnings are paid as a dividend to the parent company. The results of operations for BMG's majority-owned subsidiaries Inti Raymi and Niugini Mining are consolidated with the Company's results. Minority interest of $(4.7) million in 1993, $(1.2) million in 1992 and $5.4 million in 1991 represents the minority shareholders' share of combined net (income) loss for these subsidiaries during the respective periods. For 1992, the Company's Consolidated Statement of Income reflects an accrued charge of $5.3 million (net of $1.4 million in income tax benefits) and a credit of $3.9 million, representing the cumulative prior periods' effects of the adoption of SFAS No. 106 and SFAS No. 109, respectively. Recently Issued Accounting Standards See Notes 4, "Marketable Securities" and 7, "Benefits Plans," of Notes to Consolidated Financial Statements for a discussion of the impact that recently issued accounting standards will have on the Company's consolidated financial statements when adopted. Liquidity and Capital Resources As of December 31, 1993, the Company had net working capital of $140.3 million and a current ratio of 4.5 to 1 as compared with net working capital of $36 million and a current ratio of 1.7 to 1 at December 31, 1992. The increase in working capital resulted primarily from $111 million in net proceeds received from a convertible preferred stock offering, less subsequent debt repayment of $59.9 million. An increase in accounts receivable of $21.1 million was attributable primarily to accruals for certain tax refunds, especially in Bolivia, and the timing of shipments to customers. Product inventory decreased by $10.1 million, reflecting the timing of customer shipments. An $11.2 million increase in materials and supplies inventories reflected the start-up of the Kori Kollo sulfide mine. For 1993, cash from operations totaled $30.1 million, and borrowings aggregated $36.9 million. Uses of cash included $50.4 million for capital expenditures, excluding capitalized interest, $7.6 million for investment in the Crown Jewel project, $6.6 million of direct expenditures for project exploration and evaluation, annual interest payments, which were capitalized, of $6 million on the $100 million principal amount of convertible subordinated debentures due 2005 and dividends on common and preferred stock of $4 million and $3.7 million, respectively. Financing On May 20, 1993, BMG completed an offering of 2.3 million shares of its convertible preferred stock valued at $115 million. The net proceeds of the offering were approximately $111 million. The preferred stock carries a $50 per share liquidation preference and, subject to Board vote, provides for annual cumulative dividends of $3.25 per share, which are payable in quarterly installments. Each share of the stock is convertible at any time at the option of the holder into 4.762 shares of BMG's common stock. It is also redeemable at the option of BMG solely for shares of BMG's common stock beginning May 15, 1996. BMG has used a portion of the proceeds of this offering to repay all amounts outstanding under its revolving credit facilities. The remainder is being used for working capital and for general corporate purposes, which include capital expenditures and may include potential future acquisitions relating to the businesses in which the Company currently engages. As of February 9, 1994, BMG has effective a registration statement under the Securities Act of 1933 for what is commonly referred to as a "universal shelf" filing covering up to $200 million of its debt securities, preferred stock, depositary shares, common shares and warrants, which BMG may elect to offer from time to time and in any combination. BMG can borrow funds under a committed revolving credit agreement, which is scheduled to expire on December 31, 1996. Scheduled $9.4 million quarterly reductions in commitments under the agreement began on March 31, 1993, and will continue until the agreement expires. As of December 31, 1993, the remaining availability under this agreement was $112.5 million. This agreement contains certain financial covenants as well as restrictions on additional dispositions of major assets and the payment of dividends. These restrictions are not expected to affect planned operations. BMG may borrow an additional $15 million through a separate uncommitted revolving credit facility. As of February 17, 1994, no borrowings were outstanding under either of these facilities. BMG's majority owned Bolivian subsidiary, Inti Raymi, has borrowed funds from three international agencies, the Overseas Private Investment Corporation ("OPIC") ($40 million), the International Finance Corporation ("IFC") ($40 million) and the Corporacion Andina de Fomento ("CAF") ($15 million) under three separate but coordinated financing facilities. These facilities provided most of the funding necessary for the development of the Kori Kollo mine. Each of these facilities imposes restrictions on dividend payments and loan repayments by Inti Raymi to its shareholders, and limits additional fixed asset purchases or dispositions, debt and liens. As of February 17, 1994, Inti Raymi owed an aggregate of $92.4 million under these facilities. This amount includes $3.8 million previously owed by Inti Raymi to OPIC. The IFC facility includes a $5 million convertible loan payable on March 1, 2002, which may be converted at any time, at IFC's option, into a 3.98 percent ownership interest in Inti Raymi. Other than the convertible portion, loans under the facilities are to be repaid in semi-annual installments which commenced in December 1993 and will continue through June 2000. Certain prepayments would be required in the event of substantial Kori Kollo reserve losses or significantly improved gold prices. Having met certain prerequisite physical and financial completion tests set forth in the facility agreements, Inti Raymi has applied for project completion by submitting certain certifications to the lenders. Under the terms of the facilities, BMG has agreed to provide financial support to Inti Raymi to the extent necessary for Inti Raymi to meet its financial obligations until the lenders approve the application for project completion, which is expected to occur during the first half of 1994. Of the Company's $140.3 million net working capital at December 31, 1993, $48.4 million was attributable to Niugini Mining and $24.6 million to Inti Raymi. Inti Raymi is currently restricted in its ability to pay dividends or otherwise advance funds to BMG under the terms of Inti Raymi's project financing agreements, as described above. Upon project completion, as defined in the facility agreements, Inti Raymi may pay dividends and debt repayments subject to compliance with loan covenants. BMG does expect to receive dividends from Inti Raymi in 1994. In addition, the Company does not expect Niugini Mining to pay dividends currently because of Niugini Mining's other business commitments and plans for its working capital (see "Development Projects".) In December 1993, Niugini Mining issued 5.8 million of its common shares at A$5 per share in a public offering which provided net proceeds of approximately $19.1 million U.S. equivalent. These proceeds are to be used to partially fund the acquisition of an additional 16 percent ownership interest in the Lihir project in Papua New Guinea ("PNG"). See discussion under "Development Projects - Lihir Project" further herein. As a result of this stock offering, BMG's ownership interest in Niugini Mining decreased from 56.5 percent to 52.6 percent. In December 1993, the Company recorded a $2.1 million adjustment to reduce the carrying value of its investment in Niugini Mining to reflect the reduction in ownership interest. This adjustment was charged to shareholders' equity and not charged against net income because the Company believed the carrying value of the investment to be fully recoverable. After giving effect to potential dilution for the exercise of outstanding Niugini Mining stock options, BMG retains a majority ownership position. Development Projects At present, the Company has interests in five projects which have matured beyond advanced stages of evaluation. Lihir Project - BMG holds an interest in the Lihir project through its 52.6 percent ownership of Niugini Mining. In March 1992, the PNG government extended, until March 1994, the Prospecting Authority for the Lihir project in which Niugini Mining currently holds a 20 percent interest and a subsidiary of RTZ Corporation, plc ("RTZ") holds an 80 percent interest. RTZ is the manager of the Lihir project. Also, in March 1992, the Lihir joint venture submitted a Proposal for Development of the Lihir project for government approval. On August 9, 1993, the Company announced that Niugini Mining had reached an agreement with RTZ to acquire an additional 16 percent of the Lihir Joint Venture for $3 million cash per percentage point, or $48 million. This agreement anticipates that the PNG government will acquire a 30 percent contributing interest in the project and that following the acquisition by the government and consummation of Niugini Mining's purchase of the additional interest from RTZ, Niugini Mining would have a 30 percent interest in the project and RTZ would retain a 40 percent interest. The transaction is contingent on, among other things, PNG government approval of the transaction, the purchase by the PNG government of a 30 percent interest and the granting of a Special Mining Lease by the PNG government. It is anticipated that Niugini Mining would finance the acquisition by a combination of working capital, debt and proceeds from the 1993 issuance of common stock. No funding would be required by BMG. On September 25, 1993, an agreement in principle was reached between the joint venture partners and the PNG government for the government to acquire a 30 percent interest in the project and for the parties to pool their respective Lihir joint venture interests into a newly formed, single purpose company tentatively named Lihir Gold Limited ("LGL"). The new company would therefore be initially owned 30 percent by Niugini Mining, 40 percent by RTZ and 30 percent by the PNG government. Related to this proposed restructuring, the carried interest arrangement between Niugini Mining and RTZ would be terminated with no further rights or obligations continuing to either party. LGL would enter into a management contract with RTZ whereby RTZ would manage the administration, financing, construction and subsequent operation of the project. The project is expected to be funded through the offering of an estimated 25 to 40 percent of the equity of LGL common stock to the public. Niugini Mining's interest in LGL would thereby be expected to be reduced to between 18 percent and 22.5 percent. On this basis, BMG's attributable interest in the Lihir project would be between 9 and 11 percent. Any additional funding required for the project is expected to be provided in the form of debt financing by LGL. The capital costs for Lihir project development are presently estimated by the manager of the project at $625 million. These capital costs are based on the planned use of mining contractors for the first five years of operations. Over the first 15 years of operations, the manager's estimate of total cash operating costs is $209 per ounce and, over the expected 37 year life of the mine, is $228 per ounce. The estimate of minable sulfide reserves has been revised from 89.3 million metric tons, or 13.7 million contained gold ounces, to 104 million metric tons, or 14.6 million contained gold ounces, with the average grade changing from 4.77 to 4.37 grams of gold per metric ton. The PNG government is expected to issue the Special Mining Lease for the project after landowner negotiations are completed and all necessary statutory approvals are obtained. As soon as practical after the Special Mining Lease is granted, preliminary development work would commence. This preliminary work is expected to be funded by the joint venture partners until LGL is formed and financing is arranged, after which LGL would be responsible. It is anticipated that Niugini Mining will fund its share of the preliminary development costs from its working capital. As of December 31, 1993, the carrying value of the Company's investment in the Lihir project was approximately $135 million. If the Lihir project does not proceed as contemplated, the Company may be required to write down part or all of its investment in the Lihir project. Red Dome Expansion - Niugini Mining is proceeding with the expansion of the existing Red Dome pit. It is estimated that the total cost of the expansion will be approximately $24.5 million, of which $17.3 million had been spent through December 31, 1993. The proposed expansion, to be completed by mid-1994, is expected to extend the life of the mine through 1996 and increase the reserves at Red Dome by approximately 227,000 contained ounces of gold and 28 million pounds of copper. The new reserves are based on an additional 2.7 million tons of ore at an average grade of .09 ounce of gold per ton and containing .52 percent copper with a cutoff grade of .05 ounce of gold per ton. Niugini Mining received all requisite permits and commenced the pit expansion in mid-1993. Crown Jewel Project - BMG is continuing to seek permits for the Crown Jewel project in Washington state. BMG expects to construct a 3,000 ton per day milling facility with start-up possible in fall of 1996, depending on the length of the permitting process, the effect of possible legal challenges by project opponents and the potential impact of proposed legislation to amend or replace state and federal laws and regulations affecting mining projects. The delays in obtaining permits for the Crown Jewel project relate primarily to delays in regulatory approvals for certain site data collection activities and the time taken for agency development of certain wildlife studies. To acquire a 51 percent ownership interest in the project, BMG will have to fund all expenditures for exploration, evaluation and development of the project through commencement of commercial production. Under the terms of the joint venture agreement, the minority partner will not reimburse BMG for any portion of funding provided through the commencement of commercial production. These expenditures, including acquisition costs, are currently estimated to be approximately $95.3 million, of which $33.1 million ($24.6 million of which has been capitalized) has been incurred through December 31, 1993. Management expects that BMG should be able to more than recover its total investment in the project from its 51 percent interest in the project's operating cash flows based on current market conditions and current expectations of the timing of obtaining permitting. To maintain BMG's right to earn a 51 percent interest in the project, BMG could be required to make payments to the co-venturer in amounts of $1 million per quarter for the period commencing with the third quarter of 1993 through commencement of commercial production. BMG believes that it is entitled under "force majeure" provisions of the joint venture agreement to suspend application of these quarterly payment requirements because of delays in the permitting process. The Company's financial position as of December 31, 1993, does not reflect a liability for any such payments. An arbitration proceeding has been initiated between BMG and the co- venturer and the $1 million payments are being deposited in an escrow account pending resolution of the dispute. Reona Project - BMG has announced a decision to develop the Reona project, including construction of a heap leach facility, in the Copper Canyon area of the Battle Mountain complex. The cost of developing the project is estimated to be approximately $13.8 million, of which $2.1 million has been spent through December 31, 1993. The project contains reserves of approximately 13.5 million tons of ore at an average ore grade of .028 ounce of gold per ton, equivalent to approximately 370,000 contained ounces of gold. The project also contains approximately 2.3 million contained ounces of silver. The cutoff grade used in determining reserves was .013 ounce of gold per ton with an estimated gold recovery factor of approximately 66 percent. On January 12, 1994, the local Bureau of Land Management ("BLM") issued a Finding of No Significant Impact (based on an Environmental Assessment ("EA")) and a Record of Decision approving BMG's Plan of Operations ("POO") for the project. The Company has commenced development activities pursuant to the approved POO. The local BLM decision is subject to appeal by certain third parties through February 1994 and is subject to reversal by the Secretary of the Interior and the Director of the BLM. Third party comments on the draft EA have requested that an Environmental Impact Statement be prepared for the Reona project. The project could be in production in 1994 assuming the POO approval is not appealed or reversed. The project could also be impacted by proposed federal legislation to amend or replace the General Mining Law. (See "Government Regulation".) Cindy Project - In Queensland, Australia, BMG is proceeding with the $3.4 million development of the Cindy ore deposit, containing approximately 42,500 ounces of gold, adjacent to BMG's Pajingo mine. Ore from the Cindy deposit is to be processed at the existing Pajingo milling facility beginning in September 1994 and is expected to extend the productive life of the Pajingo district to October of 1995. New Reserve Potential BMG is currently evaluating the feasibility of mining and milling deposits of low grade sulfide mineralization known as the Phoenix milling project (formerly called the Fortitude Extension) located in the Copper Canyon area of the Battle Mountain complex. Feasibility evaluation of this mineralization is expected to be completed in 1994. Niugini Mining has recently announced the discovery of significant mineralization at its Mungana project in the Red Dome area. Prefeasibility studies are underway there to determine the existence of sufficient ore to warrant proceeding with feasibility and permitting activities. An additional 220,000 contained ounces of gold reserves have been recently defined at Niugini Mining's San Cristobal mine. Niugini Mining will be conducting an intensive drilling program in the area of the San Cristobal mine during 1994 to evaluate an associated gold resource. Government Regulation All of the Company's mining and processing operations are subject to reclamation requirements. The Company believes it is making sufficient accruals for known reclamation obligations. Such accruals, amounting to an aggregate of $9.5 million at December 31, 1993, are included as long-term liabilities in the Company's consolidated balance sheet. At the Battle Mountain complex, assuming the Reona project is developed as currently permitted and the Phoenix project proceeds, aggregate reclamation expenditures required to be spent in the area are expected to amount to approximately $7.7 million, of which $4.7 million remained accrued at December 31, 1993. Estimated reclamation obligations and related amounts accrued as of December 31, 1993, respectively, for each of the Company's other operating mines are as follows: San Luis $3.3 million and $1.0 million, Pajingo $2.6 million and $.8 million, Kori Kollo $10.0 million and $.4 million, Red Dome $4.2 million and $2.6 million. Reclamation expenditures for the Company's San Cristobal mine are not expected to be material. BMG has been issued a water pollution control permit for the Battle Mountain complex project facilities from the Nevada Division of Environmental Protection. The permit provides the framework for the development of a "final closure plan". BMG has applied for reclamation and stormwater runoff permits covering the Battle Mountain complex area. Activity expected to be performed as part of the development and operation of the Reona and Pheonix projects would eliminate certain possible reclamation costs. If one or both of these projects does not proceed, reclamation expenditures would be expected to be up to $4 million higher than current estimates. BMG is currently conducting further site characterization studies for the Battle Mountain complex area and is communicating with the Nevada Division of Environmental Protection to determine the ultimate permit requirements. Potentially adverse site characterization results or the imposition by regulatory authorities of unanticipated reclamation standards could substantially increase future reclamation requirements and expenditures. Laws and regulations applicable to these permits have been amended during the past few years, and it is difficult to ascertain the exact terms and conditions which will be required thereunder. Based on data collected to date, management does not expect that potential future adverse site characterization results will have a material adverse effect on the Company's financial condition. Reclamation obligations could also be impacted by proposed federal legislation to amend or replace the General Mining Law. The Company's Crown Jewel and Lihir development projects are dependent upon securing requisite permits and approvals and the impacts of legal challenges, as would be the Phoenix and Mungana projects if a development decision is made. Although the Company believes the requisite permits and approvals for its development properties can be obtained in due course, the requisite permitting efforts are complex, time consuming and subject to legal challenge. At this time, the Company does not believe that the impact of existing permitting requirements or existing environmental laws and regulations will have a material adverse effect on the Company's business, financial condition or results of operations. There can be no assurance that future changes in laws and regulations and legal challenges to regulatory actions would not result in additional expense, capital expenditures, restrictions and delays associated with the development and operation of the Company's properties. Legislation has been passed by the U.S. Senate ("S.775") and the U.S. House of Representatives ("H.R.322") which would amend or replace the General Mining Law under which the Company holds claims on public lands. A compromise bill is expected to be developed by a conference committee in 1994. As written, S.775 proposes a 2 percent royalty on the value of minerals measured at the point of extraction and H.R.322 proposes an 8 percent royalty on, effectively, gross revenue. H.R.322 also proposes new environmental standards, additional reclamation requirements and extensive new procedural steps which could result in delays and additional expenditures for all phases of mining activity. Approximately 40 percent of the Reona reserves and 80 percent of the Crown Jewel ore body are on public lands and could be subject to the proposed royalties. These projects, as well as reclamation and closure activities at the Battle Mountain complex, could be subject to extensive additional permitting and environmental requirements. The Company has applied for patents covering the unpatented portion of the Crown Jewel ore body but has not yet received the "first half" of the final certificate. While the extent to which existing law might change is not yet known it is expected to be unfavorable in most respects. The Company cannot yet predict the impact of any such change on its U.S. activities. However, the adoption of either version of the new mining law, as currently written, is not expected to render uneconomic any of the Company's existing operating mines or development projects, assuming current gold prices. Exploration and Capital Expenditures The Company currently estimates that it will spend approximately $14 million on its 1994 exploration programs to identify potential additional mineral deposits. Of this amount, 16 percent is budgeted to be spent in North America, 28 percent in Latin America and the Caribbean, 24 percent in Australia and the South Pacific and 25 percent in various countries by Niugini Mining. Seven percent of the budgeted amount is as yet undesignated. During 1993, the Company spent approximately $9.7 million on exploration and evaluation activities. The Company has budgeted $56.7 million for capital expenditures for 1994 which includes $13.8 million for construction and development of the Reona project, $7.8 million for the Red Dome expansion, lesser amounts for development of the Crown Jewel, Phoenix, Cindy, Lihir and Kori Kollo expansion projects and $14.1 million for additions and replacements. Of the total 1994 budget, 35 percent is expected to be spent in North America, 28 percent in Latin America and the Caribbean, 32 percent in various countries by Niugini Mining and 5 percent in the South Pacific. The Company spent $57.1 million for capital expenditures in 1993. The Company routinely evaluates additional capital project, acquisition and merger opportunities. Forward Sales and Hedging In order to minimize exposure to decreasing prices for portions of its gold production, the Company has in the past and may in the future, from time to time, hedge future gold production by entering into contracts, such as spot deferred sales contracts, fixed forward sales contracts and put options. Fixed forward sales contracts require the future delivery of gold at a specified price on a specified delivery date. Spot deferred sales contracts allow the Company to defer the delivery of gold under the contract to a later date at the original contract price plus the prevailing premium at the time of deferral, as long as certain conditions are satisfied. Although spot deferred sales contracts could limit amounts realizable during a period of rising prices, the Company may "roll forward" its spot deferred contracts to future periods in order to realize current market increases, while maintaining future downside protection. Various factors influence the decision to close a spot deferred sales contract or to roll the contract forward to a later date. Purchased put options give the Company the right, but not the obligation to sell gold at a predetermined price on a predetermined date thereby allowing full participation by the Company in favorable price movements. As of December 31, 1993, the following table summarized the Company's hedging transactions: Gains and losses related to these hedging transactions are recognized in revenues when the related production is sold. In addition, costs associated with the purchase of certain of the hedge instruments, amounting to $.6 million for open put options and $1.5 million for Inti Raymi's open spot deferred sales contracts as of December 31, 1993, are also deferred and recognized concurrently with the revenues related to the hedged production. The aggregate amount by which the net market value of the Company's open fixed forward and spot deferred sales contracts is less than $390 per ounce of gold, which was the spot price as of December 31, 1993, is $19.4 million, of which $6.2 million is attributable to minority interests. In January 1994, the Company allowed options contracts covering 22,500 ounces of gold to expire. At the December 31 market price of $390 per ounce of gold, the Company would allow all remaining open put option contracts (covering 157,500 ounces of gold) to expire. Open spot deferred sales contracts would be evaluated to determine if it would be in the best long-term interests of the Company to either "roll the contracts forward" or deliver against them. Delivery against spot deferred sales contracts in a period in which current market prices exceed contract prices will result in recognition of revenues at prices below current market conditions. In future periods, the Company may continue to employ selective hedging strategies, where appropriate, to protect cash flow for specific needs. Foreign Operations The Company continues to expand and geographically diversify its resource base through the exploration, acquisition, development and exploitation of foreign gold reserves. The Company's identifiable assets attributable to foreign mining as of December 31, 1993, were approximately $488 million and foreign mining operations represented approximately 77 percent of the total gross revenues of the Company for the year ended December 31, 1993. As a result, the Company is exposed to risks normally associated with foreign operations, including political, economic, social and labor instabilities, as well as foreign exchange controls and currency fluctuations. Foreign operations and investments may also be subject to laws and policies of the United States affecting foreign trade, investment and taxation which could affect the conduct or profitability of those operations. Dividends Effective with the calendar year 1993, BMG reduced its annual dividend on common stock by 50 percent, by replacing its quarterly $.025 per share dividend payment with semi-annual payments of $.025 per share. Each semi-annual payment totals approximately $2 million. BMG's dividend policy is subject to periodic review by BMG's Board of Directors. During the third quarter of 1993, BMG commenced quarterly dividend payments to its preferred stockholders. Each such quarterly payment totals approximately $1.8 million. Conclusion During the year ended December 31, 1993, BMG raised $111 million in net proceeds from the sale of its convertible preferred stock. The Company expects the cash currently remaining from this offering along with cash flows from operations and financing facilities currently in place, to be adequate to meet its cash needs at least through 1994. Funding may also be provided from offerings of additional securities under the Company's $200 million universal shelf registration statement, assuming any such offering could be completed under satisfactory terms. Proposed Incentive Plan Management intends to propose to the Board of Directors adoption in 1994 of a new long-term incentive executive compensation plan under which 4 million shares of common stock of BMG would be reserved for grant. The proposed plan, subject to shareholder approval, would provide for grants of the following types of executive compensation awards: stock options, stock appreciation rights, stock grants and cash. Inflation and Changing Prices Gold production costs and corporate expenses are subject to normal inflationary pressures, which, to date, have not had a significant impact on the Company. The Company's results of operations and cash flows may also be affected by fluctuations in the market prices of gold, silver and copper, and to a lesser extent by changes in foreign currency exchange rates. While gold prices for the last three years have remained, on average, well below 1990 levels, prices have recently strengthened. Changing gold prices, in conjunction with operating costs incurred by the Company for its operations, affect the net margins realized by the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Battle Mountain Gold Company: We have audited the accompanying consolidated balance sheets of Battle Mountain Gold Company (a Nevada corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements of Niugini Mining Limited and subsidiaries, which statements reflect assets and net sales of 17 percent and 29 percent, respectively, of the consolidated totals as of and for the year ended December 31, 1993, and 15 percent and 35 percent, respectively, of the consolidated totals as of and for the year ended December 31, 1992. We did not audit the financial statements of Niugini Mining Limited and subsidiaries or Empresa Minera Inti Raymi S.A., which statements reflect assets and net sales of 29 percent and 29 percent, respectively, of the consolidated totals as of and for the year ended December 31, 1991. Those statements were audited by other auditors whose reports have been furnished to us and our opinion, insofar as it relates to the amounts included for those entities, is based solely on the reports of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Battle Mountain Gold Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 6 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes with the adoption of Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes." Also, as explained in Note 7 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pension plans with the adoption of Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions." Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14 (a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These financial statement schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, based on our audits and the reports of other auditors, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Houston, Texas February 18, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Battle Mountain Gold Company and the Board of Niugini Mining Limited: We have audited the consolidated balance sheet of Niugini Mining Limited (a company incorporated in Papua New Guinea) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993 and the consolidated financial statement schedules which are not presented separately in the Battle Mountain Gold Company December 31, 1993 Form 10-K. Battle Mountain Gold Company is the Company's majority shareholder. Those financial statements and the financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on those financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Niugini Mining Limited and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Sydney, Australia January 22, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors Battle Mountain Gold Company Houston, Texas, U.S.A. We have audited the balance sheets of Empresa Minera Inti Raymi S.A. as of December 31, 1991, and the related statements of income, retained earnings and cash flows for the year then ended, expressed in United States dollars (not presented herein). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The financial statements have been prepared to enable the Company's majority shareholder, Battle Mountain Gold Company, to prepare consolidated financial statements. Accordingly, the financial statements are prepared utilizing accounting principles that conform to the accounting policies of Battle Mountain Gold Company rather than the Company's adopted accounting policies. In our opinion, the financial statements referred to above, prepared for the purposes described in the preceding paragraph, present fairly, in all material respects, the financial position of Empresa Minera Inti Raymi S.A. at December 31, 1991 and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles accepted in the United States of America as adopted by Battle Mountain Gold Company. Our audit of the financial statements of Empresa Minera Inti Raymi S.A. also included an audit of the related financial statement schedules (not presented herein) listed in Item 14(a) of Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. MORENO MUNOZ Y CIA. La Paz, Bolivia January 17, 1992 BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED STATEMENT OF INCOME - -------------------------------------------------- The accompanying notes are an integral part of these financial statements. BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED BALANCE SHEET - -------------------------------------------------- The accompanying notes are an integral part of these financial statements. BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY - -------------------------------------------- The accompanying notes are an integral part of these financial statements. BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED STATEMENT OF CASH FLOWS - ---------------------------------------------------- The accompanying notes are an integral part of these financial statements. BATTLE MOUNTAIN GOLD COMPANY Notes to Consolidated Financial Statements Note 1. Summary of Significant Accounting Policies Principles of Consolidation - The accompanying consolidated financial statements include the accounts of the Battle Mountain Gold Company ("BMG"), its wholly-owned and majority-owned subsidiaries and corporate joint ventures in which the Company owns a majority share ("the Company"). The accounts of Niugini Mining Limited, a Papua New Guinea precious metals exploration, development and production company ("Niugini Mining"), have been consolidated with the Company's from January 1, 1989 (See Note 8). The accounts of Empresa Minera Inti Raymi S.A., a Bolivian gold mining company ("Inti Raymi"), have been consolidated with the Company's from April 1, 1990 (See Note 8). All significant intercompany transactions have been eliminated in consolidation. Majority-owned, non-corporate joint ventures are proportionately consolidated. Non-corporate joint ventures in which the Company owns less than a majority interest and has the ability to exercise significant influence are proportionately consolidated, while such corporate joint ventures are accounted for by the equity method. All other joint ventures are carried at cost. The issuance of stock by subsidiaries is accounted for as a capital transaction in the consolidated financial statements. Certain prior-period items have been reclassified in the consolidated financial statements in order to conform with current year presentation. Inventories - Inventories, consisting of gold, silver and copper, are reported at the lower of cost, using the first-in, first-out method, or market. Property, Plant and Equipment - Property, plant and equipment are stated at cost. Expenditures for development of new mines and major development expenditures at existing mines, which are expected to benefit future periods, are capitalized and amortized, generally, on the units of production method. Exploration and development costs expended to maintain production at operating mines are charged to expense as incurred. Other property, plant and equipment includes capitalized lease costs and mine development in progress. Capitalized exploration lease costs are apportioned to expense in interim periods through a provision for abandonment of unproductive projects. Actual abandonments of unproductive projects are charged against the allowance. The balance in the allowance for abandonment is then evaluated on an annual basis and adjusted as necessary. Generally, depreciation, depletion and amortization of mining properties and related assets are determined using the units of production method based upon estimated recoverable ore reserve tonnages at the beginning of the year. However, assets having an estimated life of less than the estimated life of the mineral deposits are depreciated on the straight-line method based on the expected life of the asset. Write-downs and write-offs of depreciable properties are included in accumulated depreciation, depletion and amortization. Exploration and Evaluation Expenditures - With the exception of lease acquisition costs incurred to acquire mineral rights, the Company charges all exploration and predevelopment evaluation expenditures to expense as incurred. Capitalization of Operating Results During Mine Development - During the start-up period for each developing mine, operating costs may exceed revenues earned from the sale of precious metals produced. In these instances, all costs incurred during this precommercial production period, net of revenues earned, are capitalized as property costs. Capitalization of Interest - Interest expense incurred in connection with borrowings attributable to pre-production stage projects is capitalized until those projects commence commercial production. Reclamation - Reserves for estimated future costs for reclamation of the Company's operating sites are accrued on a units of production basis over the estimated lives of the respective mines. These costs are charged to milling and other plant costs as accrued (See Note 14). Revenue Recognition - Revenue is recognized when the dore (a combination of gold and silver) or concentrates are delivered against sales agreements or contracts and risk of loss passes to the buyer. Currency Translation - Foreign currency financial statements are translated into U.S. dollars using current exchange rates and translation gains and losses are accumulated in the balance sheet caption "Cumulative Foreign Currency Translation Adjustment," a separate component of shareholders' equity. Earnings (Loss) Per Share - Earnings (loss) per share is computed by dividing net income (loss) attributable to common stock by the weighted average number of shares outstanding for the year, adjusted for common stock equivalents, if dilutive. The effects of common stock equivalents and other dilutive securities are not included in the computation of the 1993, 1992 or 1991 losses per share because of their antidilutive effect. Statement of Cash Flows - At December 31, 1993, cash and cash equivalents included $44.7 million and $9.3 million attributable to Niugini Mining and Inti Raymi, respectively. Cash and cash equivalents at December 31, 1992, included $29.6 million and $7.3 million held by Niugini Mining and Inti Raymi, respectively. At December 31, 1993 and December 31, 1992, other assets included $1.3 million and $1.4 million, respectively, of restricted cash held by Niugini Mining. For purposes of the Consolidated Statement of Cash Flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. For the years ended December 31, 1993, 1992, and 1991, the Company paid $.7 million, $3.2 million and $7 million respectively, for income taxes. The Company paid $6.8 million, $1.4 million and $1.5 million in interest, net of amounts capitalized, during 1993, 1992, and 1991, respectively. For 1993 and 1992, the Company's investing activities included no significant non-cash transactions. During 1991, non- cash investing activities included the issuance of 8,233,788 shares of BMG's common stock (market value of $65.9 million) to increase BMG's equity interest in Inti Raymi to 85 percent. Hedging Transactions - To hedge the effect of price changes on a portion of its production, the Company periodically sells metals products under fixed forward and spot deferred sales contracts. Spot deferred sales contracts allow the Company to defer the delivery of gold under the contract to a later date at the original contract price plus the prevailing premium at the time of deferral, as long as certain conditions are satisfied. Although spot deferred sales contracts could limit amounts realizable during a period of rising prices, the Company may "roll forward" its spot deferred contracts to future periods in order to realize current market price increases, while maintaining future downside protection. It also purchases put option contracts on metals products. Gains, losses or expenses related to these transactions are netted against revenue when the hedged production is sold (See Note 15). Note 2. Asset Impairments During the third quarter of 1992, the Company recognized charges totalling approximately $23.3 million, net of $11 million in income tax benefits for the impairment in value of certain of the Company's assets. The charges included (1) a write- down of $17.6 million, net of a $9 million income tax benefit, of the Company's investment in the San Luis mine in Colorado to reduce the carrying value of the investment to a level which the Company believed would be recoverable under then existing and expected future market conditions (lower gold prices, compared with those at the time of project conception, and greater than anticipated capital expenditures resulting from a difficult start-up period led to the write-down), (2) a write-off of $4 million, net of a $2 million income tax benefit, of the Company's investment in the previously closed Canyon Placer facility, which was abandoned because of a persistently weak gold market, and (3) an impairment of $1.7 million, included as other income (expense), net, to adjust to current market the carrying value of certain marketable equity security investments acquired upon the previous disposition of a discontinued project. The Company did not recognize any similar charges for asset impairments during 1993. Note 3. Investments The Company's long-term investments include the following: Crown Jewel Joint Venture - On March 14, 1990, the Company purchased, for $5 million, an option to acquire a 51 percent joint venture interest in Crown Resources Corporation's Crown Jewel gold project and surrounding exploration rights in Washington state. The Company paid an additional $5 million on January 4, 1991, to exercise the option and retain the right to acquire an ownership interest in the project. The Company has spent an additional $23.1 million as of December 31, 1993, evaluating and developing the project. The evaluation expenditures were charged to expense in the periods incurred prior to March 31, 1992, when the Company decided to proceed with the development of the project. Since that time, all evaluation expenditures ($14.4 million) have been capitalized. To earn a 51 percent undivided interest in the project and certain adjacent mineral claims, the Company would be required to fund an estimated additional $62 million for construction and development of the project through commencement of commercial production. Other Joint Ventures - Other joint ventures consist primarily of capitalized lease costs incurred by exploration joint ventures to acquire mineral rights. Note 4. Marketable Securities The Company carries any non-current portfolios of marketable securities at the lower of aggregate cost or market. As of December 31, 1993, the Company had sold all of its marketable securities. For 1992, the non-current marketable securities consisted of common stocks and were included in investments (See Note 3). Net unrealized losses associated with the marketable securities portfolios are charged to shareholders' equity. Net realized gains or losses are charged to other income. Gross and net realized gains of $2.7 million were included in other income (expense), net, during the year ended December 31, 1993. There were no gains or losses realized during the years ended December 31, 1992 and 1991. During 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This standard changes the methods of classifying and accounting for investments in equity securities that have readily determinable fair values and all investments in debt securities. The Company is required to adopt the new accounting and disclosure rules in the first quarter of 1994. Adoption of the standard is not expected to have a material effect on the Company's financial position or on its results of operations. Note 5. Other Income (Expense), Net Included in other income (expense), net, are certain non-operating revenues, net of related expenses, consisting of: Note 6. Federal and International Income Tax The discussion of income taxes herein does not include the cumulative income tax effects of accounting changes explained in Note 7 to these Consolidated Financial Statements. Federal and international income tax expense (benefit) consisted of the following: Consolidated income before income taxes and the cumulative effect of the accounting change includes income (loss) from international operations of $13.8 million, $1.7 million and $(6.5) million in 1993, 1992 and 1991, respectively. Effective January 1, 1992, the Company adopted the provisions of SFAS No. 109. SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Effective January 1, 1992, the Company recorded a deferred tax liability of $12,611,000, representing the net effect of adopting SFAS No. 109 as of that date. This liability was comprised of a $16,491,000 purchase acquisition liability related to the Westworld acquisition (See Note 8), which was capitalized to property, and a partially-offsetting net $3,880,000 tax benefit which has been reflected in the consolidated statement of income as the cumulative effect of the accounting change. For the year 1992, loss before cumulative effects of accounting changes includes an additional income tax benefit of approximately $8,741,000 or $.11 per share resulting from the adoption of SFAS No. 109. The significant components of the deferred tax benefit in 1992 were as follows: Prior to the adoption of SFAS No. 109, the Company's provision for deferred income tax resulted from timing differences in the recognition of revenue and expense for tax and financial reporting purposes. For the year ended December 31, 1991, the sources of these differences and the tax effect of each are as follows: The Company's deferred tax position at December 31, 1993 and 1992, is comprised of the following: Temporary differences and carryforwards which gave rise to significant portions of deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows: A reconciliation of income tax at the statutory rate to income tax expense (benefit) follows: The Omnibus Budget Reconciliation Act of 1993, enacted on August 10, 1993, retroactively increased the federal statutory income tax from 34 percent to 35 percent for periods beginning on or after January 1, 1993. The effect of the rate change was not significant to the Company's net deferred income tax position. Taxes have been provided on the undistributed earnings of subsidiaries and joint ventures with the exception of Niugini Mining which is in a cumulative loss position. The Company and its domestic subsidiaries file a consolidated U.S. federal income tax return. Such returns have been closed through the year 1990. At December 31, 1993, the Company had approximately $5.8 million of alternative minimum tax credits available on an indefinite carryforward basis, and approximately $17.2 million of regular tax net operating losses expiring beginning in 2007, available to offset future U.S. federal income tax. Note 7. Benefits Plans Pension Plans - Substantially all U.S. employees of the Company are covered by non-contributory pension plans. The U.S. plans provide benefits based on participants' years of service and compensation or defined amounts for each year of service. The Company makes annual contributions to the U.S. plans that comply with the minimum funding provisions of the Employee Retirement Income Security Act ("ERISA"). During 1993, the plans for Australian employees were changed from non-contributory defined benefit plans to defined contribution plans. Pension costs are generally accrued and charged to expense currently. Net periodic pension cost included the following components: The projected long-term rate of return on U.S. plan assets was 9 percent at December 31, 1993. At December 31, 1992 and 1991, the projected long-term rate of return was 8 percent for the U.S. plans and 9 percent for the Australian plans. Actual return on U.S. plans' assets was $.3 million for the year ended December 31, 1993, $1.1 million for the year ended December 31, 1992, and $5.3 million for the year ended December 31, 1991. For Australian plans, actual return on plan assets for the years ended December 31, 1992 and 1991 was $(.1) million and $.1 million, respectively. The following sets forth the plans' funded status and the related amounts as of December 31, 1993 and 1992: Plan assets include equity securities, common trust funds and various debt securities. Weighted average rate assumptions used in determining estimated benefit obligations were as follows: Early Retirement Program - In July 1992, twenty-nine of the Company's salaried employees elected to accept early retirement benefits offered by the Company as part of general cost reduction efforts. In connection with these special benefits, a $1.3 million charge (net of a $.7 million income tax benefit) was taken against 1992 earnings. Contribution Plans - The Company has defined contribution plans available for all full-time U.S. salaried employees and all full-time U.S. hourly employees. The plans provide for savings contributions by employees from 1 to 16 percent of their compensation, subject to ERISA limitations. The Company matches 50 to 100 percent of employee contributions with BMG's common stock, subject to a limit of 6 percent of an employee's compensation during each plan year. The Company began matching of the hourly employees' contributions with BMG's common stock on July 1, 1991. The Company has defined contribution plans available for all Australian salaried and hourly employees. The Company's contributions to the salaried plan are determined in accordance with the trust deed. The Company's contributions to the hourly plan are determined in accordance with the union award. All Company contributions to the plans are expensed and funded currently. The cost of such Company contributions was $.7 million in 1993, $.4 million in 1992, and $.8 million in 1991. Postretirement Health Care and Life Insurance Benefits - Substantially all of the Company's U.S. employees may become eligible for certain unfunded health care and life insurance benefits when they reach retirement age while working for the Company. Prior to 1992, the cost of retiree health care and life insurance benefits has been minimal and has been recognized as an expense as claims or premiums were paid. In October 1992, the Company announced its decision to adopt SFAS No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions", effective January 1, 1992. This standard requires that the expected cost of these benefits must be charged to expense during the years that the employees render service. As a result of the adoption, the Company's results of operations for the year ended December 31, 1992, reflected an accrued charge of $5.3 million (net of $1.4 million in income tax benefits) representing the cumulative effect of the change in accounting principle for periods prior to 1992. Ongoing postretirement benefit costs recognized under this standard do not differ significantly from those that would have been reported under the previous method. Net periodic postretirement benefit cost for the years ended December 31, 1993 and 1992, included the following components (in thousands): The following table presents the plans' status at December 31, 1993 and 1992 (in thousands): The discount rate used in determining the accumulated postretirement benefit obligation was 7 percent for 1993 and 9 percent for 1992. For 1993 and 1992, the assumed annual rate of increase in the per capita cost of covered health care benefits was 14 percent. In 1993 and 1992, a gradual decrease in the rate is assumed through the years, 1999 and 2001, respectively, when the rate is estimated to reach 7 percent and remain at that level thereafter. A one-percentage-point increase in the assumed health care cost trend rates would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately $1.8 million, and the total of the service and interest cost components of net periodic postretirement health care cost for 1993 by approximately $187,000. Postemployment Benefits - During 1992, FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits". This standard requires that the expected cost of these benefits must be charged to expense during the periods that employees vest in these benefits. This is a change from the Company's current policy of recognizing these costs as an expense when paid. The Company is required to adopt the new accounting and disclosure rules in the first quarter of 1994. Adoption of the standard will not have a material effect on the Company's financial position or on its results of operations. Note 8. Acquisitions Niugini Mining - In the aggregate, since January 1, 1989, the Company has paid $179.6 million for 47.5 million shares of the common stock of Niugini Mining. In December 1993, Niugini Mining issued 5.8 million of its common shares at A$5.00 per share in a public offering which provided net proceeds of approximately $19.1 million U.S. equivalent. As a result of this stock offering, BMG's ownership interest in Niugini Mining decreased from 56.5 percent to 52.6 percent. In December 1993, the Company recorded a $2.1 million adjustment to reduce the carrying value of its investment in Niugini Mining to reflect the reduction in ownership interest. This adjustment was charged to shareholders' equity and not charged against net income because the Company believed the carrying value of the investment to be fully recoverable. Based on existing Niugini Mining employee incentive option schemes, the Company ownership could be diluted to as low as 50.03 percent. The acquisition of Niugini Mining has been accounted for under the purchase method of accounting. The Company has allocated its purchase cost to the fair value of its share of Niugini Mining's net assets. The allocation to the individual assets and liabilities acquired was based on the estimated fair value of those assets and liabilities as of the acquisition date. At December 31, 1993, the carrying value attributed to the Company's share of the Lihir gold project exceeded its proportionate share of Niugini Mining's historical cost basis in the project by $132.5 million. Such excess will be amortized based on the estimated recoverable reserves attributable to the Lihir project upon commencement of production. Interest costs amounting to $6 million in 1993, $6 million in 1992, and $6 million in 1991 were capitalized in connection with the Lihir gold project. Inti Raymi - On March 31, 1989, the Company purchased 33.3 percent of the outstanding stock of Inti Raymi. In April 1990, the Company acquired an additional 17.7 percent of the outstanding stock of Inti Raymi to increase the Company's ownership interest to 51 percent. From April 1, 1990, the accounts of Inti Raymi have been consolidated with those of the Company. On May 28, 1991, the Company completed a merger with Westworld Resources, Inc., a U.S. natural resources company ("Westworld"), and a separate acquisition of additional shares of Inti Raymi from Zeland Mines S.A., a Panamanian mining company ("Zeland"). In combination, these transactions increased the Company's equity ownership of Inti Raymi from 51 percent to 85 percent. As of December 31, 1993, the Company had invested an aggregate of $35.9 million in cash and 9 million of its common shares (valued at approximately $76.3 million) to acquire its 85 percent equity interest in Inti Raymi. Using the purchase method of accounting, the Company has allocated its Inti Raymi purchase cost to the fair value of its share of Inti Raymi's net assets. At December 31, 1993, the carrying value attributed to the Company's share of the Kori Kollo gold deposit (including a $16.5 million deferred tax charge capitalized in connection with the Westworld purchase acquisition) (See Note 6), exceeded its proportionate share of Inti Raymi's historical cost basis in the deposit by $119.9 million. This excess has been capitalized to property and is being amortized by the units of production method based on the deposit's estimated recoverable reserves. Amortization of the excess cost amounted to $8.6 million in 1993, $3.0 million in 1992 and $1.9 million in 1991. Interest costs amounting to $.6 million in 1993 and $2.8 million in 1992 were capitalized in connection with the Kori Kollo project. Pro Forma Financial Information - The following unaudited pro forma information presents consolidated net sales, net loss and loss per share for the year ended December 31, 1991, as if the Company had acquired its 85 percent equity interest in Inti Raymi at the beginning of that period. This unaudited pro forma information is not necessarily indicative of the actual results of operations that would have been achieved had the acquisition been consummated as of the assumed date. Note 9. Common Stock and Stock Options Common Stock - On May 28, 1991, in a merger agreement with Westworld, which owned 24.5 percent of Inti Raymi's outstanding shares, the Company exchanged 6,004,196 of its common shares (valued at approximately $48 million) with Westworld shareholders for all of Westworld's outstanding shares. Simultaneously, the Company exchanged 2,229,592 of its common shares (valued at approximately $17.9 million) with Zeland for 9.5 percent of Inti Raymi's outstanding shares (See Note 8). Reference is made to Notes 10 and 11 for discussion regarding the number of shares of common stock reserved for issuance for the conversion of the Company's outstanding convertible preferred stock and convertible subordinated debentures. Stock Options - The Company has a stock option plan available to officers and key employees covering non-qualified and incentive stock options. A total of 1,980,000 shares of common stock is reserved for issuance under the plan, of which 8,549 shares remained available for granting at December 31, 1993. At December 31, 1992, there were 868,335 shares available for granting under the plan. During 1993, 71,815 stock option shares expired and were put back into the available pool. Non-employee directors of the Company are granted non-qualified stock options under the Non-qualified Stock Option Plan for Outside Directors, which was approved by the Company's shareholders on April 21, 1992. Under this plan, a total of 250,000 shares of the Company's common stock are reserved for issuance, of which 177,500 shares remained available for granting at December 31, 1993. At December 31, 1992, there were 198,000 shares available for granting under the plan. Options granted under the above plans are exercisable under the terms of the respective option agreements at the market price of the common stock at the date of grant, subject to antidilution adjustments in certain circumstances. Payment of the exercise price may be made in cash or in shares of common stock previously owned by the optionee, valued at current market value. Under the deferred income stock option plan for officers and directors, each participant may elect to receive a non- qualified stock option in lieu of a portion of his compensation. A maximum of 2,000,000 shares of common stock is issuable under the plan, of which 1,774,641 shares remained available for granting at December 31, 1993. At December 31, 1992, 1,793,758 shares remained available for granting under the plan. Options granted pursuant to the plan become exercisable at the beginning of the calendar year immediately following the year in which the option was granted. They expire no later than 10 years after the date of grant. The amount of deferred compensation is accrued as compensation expense during the period earned. Additional information for 1993 related to the Company's stock option plans follows: At December 31, 1993, expiration dates for the outstanding options ranged from July 1, 1996 to August 16, 2003. The weighted average exercise price per share was $8.83. Additionally, the Company has reserved 950,000 shares for issuance under restricted stock and stock award plans. At December 31, 1993, a total of 707,971 shares remained available for issuance under these plans. Compensation expense related to the plans is accrued ratably over periods vested. Note 10. Preferred Stock and Stock Rights The Company's Board of Directors is authorized to divide the preferred stock into series. With respect to each series the Board may determine the dividend rights, dividend rates, conversion rights and voting rights (which may be greater or less than the voting rights of the common stock). The Board may also determine the redemption rights and terms, liquidation preferences, sinking fund rights and terms, the number of shares constituting the series and the designation of each series. Pursuant to their authority to divide the preferred stock into series, the Board of Directors in 1988 designated 2,000,000 shares of preferred stock as "Series A Junior Participating Preferred Stock" for possible issuance upon the exercise of stock rights as described below. Stock Rights - Since November 21, 1988, when the Company's Board of Directors declared a dividend of one right for each outstanding share of the Company's common stock, each share of the Company's outstanding common stock carries with it such right. Each right entitles the holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $1.00 per share, for an exercise price of $60, subject to adjustment. The rights expire on November 10, 1998. They will not be exercisable nor transferable apart from the common stock until such time as a person or group acquires 20 percent of the Company's common stock or initiates a tender offer that will result in ownership of 30 percent of the Company's common stock. In the event that the Company is merged, and its common stock is exchanged or converted, the rights will entitle the holders to buy shares of the acquiror's common stock at a 50 percent discount. Under certain other circumstances, the rights can become rights to purchase the Company's common stock at a 50 percent discount. The rights may be redeemed by the Company for one cent per right at any time until 10 days following the first public announcement of a 20 percent acquisition of beneficial ownership of the Company's common stock. Convertible Preferred Stock - On May 20, 1993, the Company received $111 million in net proceeds from the issuance of 2.3 million shares of its convertible preferred stock with a liquidation preference of $50 per share plus any accrued and unpaid dividends. Each share of preferred stock will pay an annual cumulative dividend of $3.25 and is convertible at any time at the option of the holder into 4.762 shares of Battle Mountain Gold Company common stock. The preferred stock is redeemable at the option of the Company solely for shares of the Company's common stock beginning May 15, 1996. There are 11 million shares of the Company's common stock reserved for issuance upon conversion of the preferred stock. Note 11. Debt Long-term debt outstanding as of December 31: On January 4, 1990, the Company received net proceeds of $97.4 million upon the completion of a $100 million Euromarket issue of 6 percent convertible subordinated debentures, due January 4, 2005. The debentures are convertible into shares of the Company's common stock at a conversion price of $20 5/8 per share, subject to adjustment in case of certain events. The debentures are redeemable at the Company's option at any time after January 4, 1993 (except that they may not be redeemed prior to 1995 unless the closing market price of the common stock has been at least 130 percent of the conversion price during a specified period prior to redemption). There are 4.8 million shares of the Company's common stock reserved for issuance upon conversion of the debentures. Interest payments are due annually on the anniversary date of the issuance. Proceeds from the issuance were added to working capital and used for general corporate purposes, including mineral acquisitions and development of properties. There are no sinking fund requirements imposed under the debenture agreement. As of February 17, 1994 and 1993, the market value of the debentures represents a discount to face value of approximately 5 and 30 percent, respectively. During 1992, the Company's majority-owned subsidiary, Inti Raymi, established separate but coordinated term credit facilities with three multilateral agencies (Overseas Private Investment Corporation ("OPIC"), International Finance Corporation ("IFC") and Corporacion Andina de Fomento ("CAF")) for the development of its Kori Kollo expansion project in Bolivia. Each loan is secured by a lien on the project and is to be repaid in semi-annual installments which commenced in December 1993 and will continue through June 2000, with certain provisions for accelerated repayment in the event of substantial Kori Kollo reserve losses or significantly improved gold market conditions. Through certain ratio tests, each loan may restrict payments by Inti Raymi to the owners of shares of its capital stock. Additional covenants exist which limit fixed asset purchases, additional debt and liens, and require compliance with Bolivian and World Bank environmental standards. During 1993, the project met the prerequisite physical and financial completion tests as set forth in the facility agreements and is waiting to obtain project completion status from the lenders, which the Company expects to receive in the first half of 1994. Until the project obtains completion status, Inti Raymi is restricted from repaying borrowings from the Company or paying dividends and the Company is required to provide financial support to ensure Inti Raymi's ability to meet its obligations. The OPIC facility provided for borrowings of $40 million. Interest rates under the facility are based on LIBOR plus 2.0 percent. Additionally, $4.1 million of previously existing OPIC loans to Inti Raymi were restructured as loan obligations under the terms of the agreement, with the exception that they are subject to their originally agreed interest rates. As of December 31, 1993 and 1992, Inti Raymi owed $41.0 million and $40.7 million, respectively, under these combined facilities. Interest charges for the years ended December 31, 1993 and 1992, were based on weighted average interest rates of 5.6 percent and 6.2 percent, respectively. Under the IFC commitment, borrowings of $40 million were made. The interest rate for the non-convertible portion of the loan is based on LIBOR plus 2.375 percent, but Inti Raymi has the right to request an interest rate cap or collar, or may elect at any time to pay a fixed rate of interest. Of the total IFC borrowings, $5 million represents a convertible loan due on March 1, 2002, carrying a fixed annual interest rate of 11 percent with an additional interest rate provision which varies with the price of gold. Interest charges for the years ended December 31, 1993 and 1992 were based on weighted average interest rates of 6.0 percent and 6.2 percent, respectively, for the non-convertible portion of the loan and 12 percent and 11 percent, respectively, for the convertible portion of the loan. The loan may be converted, at IFC's option, into up to a 3.98 percent equity interest in Inti Raymi. Upon the conversion of the convertible loan into equity, the Company and Inti Raymi's minority owner would have their interests in the capital stock of Inti Raymi diluted proportionately. Each share of Inti Raymi common stock issued by Inti Raymi as a result of such conversion will carry a put option which, when exercised by IFC, would require BMG and Inti Raymi's minority shareholder to purchase such share at its fair market value as determined at the time the put is exercised. As of December 31, 1993 and 1992, Inti Raymi owed $37.5 million and $37.0 million under this facility, respectively. The CAF facility provided for borrowings of $15 million. Interest rates under the facility are based on LIBOR. These funds were obtained from several sources. CAF charged a supervision and oversight fee and a commitment fee in addition to fees charged by the participants in the funding. As of December 31, 1993 and 1992, Inti Raymi owed $13.9 million and $15 million, respectively, under this facility. Interest charges for the years ended December 31, 1993, and 1992, were based on weighted average interest rates of 4.7 percent and 4.8 percent, respectively. Due to the generally variable interest rate features of the OPIC, IFC and CAF loans, the Company believes the amounts outstanding under these loans presented on the Company's balance sheet approximate the fair value of this debt as of December 31, 1993 and 1992. The Company has a revolving credit facility with a syndicate of seven banks, led by Citibank N.A. as agent. At December 31, 1993, the facility would provide unsecured borrowings up to $112.5 million. The facility provides for quarterly reductions in commitments of $9.4 million which are scheduled to continue until the facility termination date of December 31, 1996. As a result of 1992 amendments, the facility permits the Company to pledge its shareholdings in Inti Raymi and restricts the amounts that the Company may borrow under the facility if the Company's financial support for the Kori Kollo project loans extends beyond June 30, 1994, or if the Company does not meet certain net worth criteria. The amendments also impose additional facility costs in the form of amendment arrangement fees and increased interest rates. Interest rates under this facility are based on the facility agent bank's base rate, LIBOR or applicable certificate of deposit rates. Interest charges for the years ended December 31, 1993 and 1992, were based on weighted average interest rates of 3.9 to 6.0 percent and 4.0 to 6.5 percent, respectively. Other costs associated with the facility include commitment fees of one-eighth percent per annum on the unused portion of the facility and facility fees of one-eighth percent per annum of the average daily commitment. The credit agreement imposes certain financial covenants upon the Company which include covenants relating to leverage, net worth and working capital, as well as certain restrictions on liens, additional debt or lease obligations and the acquisition or disposition of major assets. Additionally, the agreement sets forth restrictions limiting the amount of dividends the Company may pay based on the Company's equity position applied on a cumulative basis from the date of the agreement. As of December 31, 1993, cumulative dividend restriction levels exceeded cumulative dividends paid or declared by $123.7 million. Due to the variable interest rate of this facility, the Company believes the $12.5 million outstanding under this facility on the Company's 1992 balance sheet approximated the fair value of the debt. No amounts were outstanding under this revolving credit facility as of December 31, 1993. On August 17, 1992, the Company established a $15 million uncommitted revolving credit facility with a major international bank. Interest rates under the facility are variable, based on either the bank's base rate or a negotiated rate. There are no additional costs or financial restrictions imposed on the Company by this facility. No amounts were outstanding under this revolving credit facility as of December 31, 1993. As of December 31, 1992, $10 million classified as short term debt was outstanding under this revolving credit facility. Interest charges for the years ended December 31, 1993 and 1992, were based on weighted average interest rates of 3.5 to 4.3 percent and 3.4 to 4.5 percent, respectively. Maturities of the Company's long-term debt over the next five years are as follows: $13.4 million in 1994, $13.4 million in 1995, $13.4 million in 1996, $13.4 million in 1997 and $13.4 million in 1998. As of February 9, 1994, BMG has effective a registration statement under the Securities Act of 1933, as amended, for what is commonly referred to as a "universal shelf" filing covering up to $200 million of its debt securities, preferred stock, depository shares, common shares and warrants which BMG may elect to offer from time to time and in any combination. Note 12. Major Customers and Export Sales During 1993, sales to three separate buyers accounted for $55.3 million, $36.2 million and $25.3 million of total sales, respectively, representing 56.4 percent of total sales. International sales for 1993 were $205.7 million, of which $47.9 million were export sales of U.S. product. In 1992, sales to five separate buyers of $34.9 million, $30.0 million, $28.9 million, $28.6 million and $27.7 million, respectively, accounted for 78.1 percent of total sales. Of the Company's $192.2 million international sales in 1992, $83.6 million were export sales of U.S. product. For 1991, 75.3 percent of the Company's total sales was distributed among four separate buyers who accounted for $46.6 million, $37.7 million, $30.7 million and $17.9 million in sales, respectively. International sales of $176.5 million in 1991 included $102.1 million in export sales of U.S. product. Alternate buyers are available to replace the loss of any of the Company's principal customers. All sales of the Company's products are made to precious metals smelters, refiners or traders. As such, the precious metals industry has substantial influence over the market for the Company's products. Note 13. Geographic Segment Information The following table sets forth certain financial information relating to international and domestic operations: Note 14. Commitments and Contingencies Total operating lease rental expenses (exclusive of mineral leases) were $1.4 million, $1.6 million and $1.3 million for 1993, 1992 and 1991, respectively. Aggregate minimum rentals (exclusive of mineral leases) subsequent to December 31, 1993, under non-cancelable leases for the years ending December 31, 1994 to 1998, are estimated to be $2.3 million, $2 million, $1.9 million, $1.3 million and $.8 million, respectively. Lease commitments beyond 1998 total $2.9 million. The Company spent $3.2 million in 1993, and has no future commitments, in connection with several unrelated exploration joint ventures. To maintain BMG's right to earn a 51 percent interest in the Crown Jewel project, BMG could be required to make payments to the co-venturer in the amounts of $1 million per quarter for the period commencing with the third quarter of 1993 through commencement of commercial production. BMG believes that it is entitled under "force majeure" provisions of the joint venture agreement to suspend application of these quarterly payment requirements because of delays in the permitting process. The Company's financial position as of December 31, 1993, does not reflect a liability for any such payments. An arbitration proceeding has been initiated between BMG and the co- venturer, and the $1 million payments are being deposited in an escrow account pending resolution of the dispute. Pursuant to pricing provisions as set out in dore customer contracts, as of December 31, 1993, the Company had committed to sell 11,200 ounces of gold contained in dore valued at approximately $4.3 million at prices determined during various pricing periods in 1993, none of which exceeds 45 days. The average price of gold sold under this commitment is approximately $382 per ounce. The Company has provided a $3.3 million guarantee to ensure that the reclamation of the Company's San Luis mine will be performed as specified in the operating permit issued by the State of Colorado. All of the Company's mining and processing operations are subject to reclamation requirements. The Company believes it is making sufficient accruals for known reclamation obligations and has accrued an aggregate of $9.5 million at December 31, 1993. The accrued reclamation charges are included as long-term liabilities in the Company's consolidated balance sheet. At the Battle Mountain complex, assuming the Reona project is developed as currently permitted and Phoenix project proceeds, aggregate reclamation expenditures required to be spent in the area are expected to amount to approximately $7.7 million, of which $4.7 million remained accrued at December 31, 1993. Activity expected to be performed as part of the development and operation of the Reona and Phoenix projects will eliminate certain reclamation costs. If one or both of these projects does not proceed, reclamation expenditures would be expected to be up to $4 million higher than current estimates. Estimated reclamation obligations and related amounts accrued as of December 31, 1993, respectively, for each of the Company's other operating mines is as follows: San Luis $3.3 million and $1.0 million, Pajingo $2.6 million and $.8 million, Kori Kollo $10.0 million and $.4 million and Red Dome $4.2 million and $2.6 million. Reclamation expenditures for the San Cristobal mine are not expected to be material. Note 15. Forward Sales and Hedging In order to minimize exposure to decreasing prices for portions of its gold production, the Company has in the past and may in the future, from time to time, hedge future gold production by entering into contracts, such as spot deferred sales contracts, fixed forward sales contracts and put options. The Company's hedging transactions included the following at December 31, 1993: Gains and losses related to these hedging transactions are recognized in revenues when the related production is sold. In addition, costs associated with the purchase of certain of the hedge instruments, amounting to $.6 million for open put options and $1.5 million for open spot deferred sales contracts as of December 31, 1993, are also deferred and recognized concurrently with the revenues related to the hedged production. The aggregate amount by which the net market value of the Company's open fixed forward and spot deferred sales contracts is less than the current spot price of $390 per ounce of gold as of December 31, 1993, is $19.4 million, of which $6.2 million is attributable to minority interests. SUPPLEMENTAL FINANCIAL INFORMATION (UNAUDITED) QUARTERLY RESULTS - --------------------------- (1) Restated to give effect to retroactive application of 1992 adoption of SFAS No. 109," Accounting for Income Taxes." The cumulative effect of the adoption of SFAS No. 109 on periods prior to 1992 (a $3.9 million tax benefit or $.05 per share) is included in the first quarter of 1992 as is the cumulative effect of adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions" (a charge of $5.3 million net of related income tax benefit or $.07 per share). (See Notes 6 and 7 of Notes to Consolidated Financial Statements.) (2) Includes non-cash asset impairments totalling $23.3 million (net of related income tax benefit) or 29 cents per share. (See Note 2 of Notes to Consolidated Financial Statements.) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing under the captions "Nominees" and "Directors with Terms Expiring in 1995 and 1996" set forth under "Election of Three Directors and Director Compensation" in the Company's definitive Proxy Statement for its annual meeting of shareholders to be held April 21, 1994, as filed within 120 days of December 31, 1993, pursuant to Regulation 14A under the Security Exchange Act of 1934, as amended (the "Company's 1994 Proxy Statement"), is incorporated herein by reference. See also "Executive Officers of the Registrant" appearing in Part I of this Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the captions "Board Organization and Committees" set forth under "Election of Three Directors and Director Compensation" and "Executive Compensation" (other than the Compensation and Stock Option Committee Report on Executive Compensation)in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the caption "Security Ownership" set forth under "Election of Three Directors and Director Compensation" in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements and Supplementary Data. Consolidated financial statements of the Company and its subsidiaries are incorporated under Item 8 of this Form 10-K. (a)(2) Financial Statement Schedules. Other schedules of Battle Mountain Gold Company and subsidiaries are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements or notes thereto. (a)(3) Exhibits: See attached exhibit index, page E-1, which also includes the management contracts or compensatory plans or arrangements required to be filed as exhibits to this Annual Report by Item 601 (10)(iii) of Regulation S-K. (b) Reports on Form 8-K: None. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 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. BATTLE MOUNTAIN GOLD COMPANY By /s/ R. DENNIS O'CONNELL -------------------------------- R. DENNIS O'CONNELL VICE PRESIDENT -- FINANCE AND CHIEF FINANCIAL OFFICER Date: March 21, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. BATTLE MOUNTAIN GOLD COMPANY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET - -------------------------------------------------- * Eliminated in consolidation This condensed statement should be read in conjunction with the Consolidated Financial Statements and Notes thereto which are included in Item 8 herein. S-1 BATTLE MOUNTAIN GOLD COMPANY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF INCOME - -------------------------------------------------- * Eliminated in consolidation ** For 1992, includes adoption of SFAS No. 106 ($5,341) and SFAS No. 109 ($2,573). This condensed statement should be read in conjunction with the Consolidated Financial Statements and Notes thereto which are included in Item 8 herein. S-2 BATTLE MOUNTAIN GOLD COMPANY SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF CASH FLOWS * Eliminated in consolidation This condensed statement should be read in conjunction with the Consolidated Financial Statements and Notes thereto which are included in Item 8 herein. S-3 SCHEDULE V BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT (1) Consists of a Capitalized Deferred Tax Charge in connection with the Westworld purchase resulting from the adoption of SFAS No. 109. (See Note 6 of Notes to Consolidated Financial Statements.) (2) "Acquisition Premium" reflects the fair value attributed to the Company's share of the Lihir project and the Kori Kollo gold deposit at the date of acquisition in excess of Niugini Mining's and Inti Raymi's historical cost basis, respectively. (3) Additions at cost for 1993 include $6.7 million in capitalized interest in connection with Niugini Mining's Lihir project and plant construction at Inti Raymi's Kori Kollo mine. Additions at cost also include development of the Reona Project, the Red Dome mine extension, development at the San Cristobal mine, development of the Lihir project and plant construction expenditures for the Kori Kollo mine. (See Note 8 of Notes to Consolidated Financial Statements.) (4) Additions at cost for 1992 include $8.9 million in interest capitalized in connection with Niugini Mining's Lihir project and plant construction at Inti Raymi's Kori Kollo mine. Additions also include the capitalization of a heap leach facility at the Battle Mountain complex. (See Note 8 of Notes to Consolidated Financial Statements.) (5) Additions at cost for 1991 include $6.0 million in interest capitalized in connection with Niugini Mining's Lihir project. Additions at cost for 1991 also include the San Luis development, the Red Dome acquisition, additional development at San Cristobal, development of the Kori Kollo mine and the acquisition of an additional 34 percent equity interest in the Kori Kollo mine. The Company issued 8.2 million shares of stock (valued at $65.9 million) for such additional interest. (See Note 8 of Notes to the Consolidated Financial Statements.) S-4 SCHEDULE VI BATTLE MOUNTAIN GOLD COMPANY CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (1) Includes write-downs of $12.2 million, for the impairment in value of certain of the Company's assets (See Note 2 of Notes to Consolidated Financial Statements). (2) Includes write-downs of $20.4 million, for the impairment in value of certain of the Company's assets (See Note 2 of Notes to Consolidated Financial Statements). S-5 SCHEDULE X BATTLE MOUNTAIN GOLD COMPANY SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION S-6 INDEX OF EXHIBITS E-1 E-2 E-3 E-4 ________________________ * Incorporated by reference as indicated. + Represent management contracts or compensatory plans or arrangements required to be filed as exhibits to this Annual Report by Item 601(10)(iii) of Regulation S-K. . Pursuant to Instruction 2 accompanying paragraph (a) and the Instruction accompanying paragraph (b)(10)(iii)(B)(6) of Item 601 of Regulation S-K, the registrant has not filed each executive officer's individual Executive Supplemental Retirement Income Agreement with the Company as an exhibit hereto; the registrant has agreements substantially identical to Exhibit 10(f)(2) above with each of Karl E. Elers, Kenneth R. Werneburg, Andre Douchane, Joseph L. Mazur, R. Dennis O'Connell, Robert J. Quinn and Fred B. Reisbick except that the monthly benefits for such executive officers under such agreements are $12,917, $10,292, $6,083, $6,125, $6,458, $5,750 and $4,417, respectively. In addition, the registrant has not filed each executive officer's individual Severance Agreement with the Company as an exhibit hereto; the registrant has agreements substantially identical to Exhibit 10(g)(1) above with each of Messrs. Elers, Werneburg, Mazur, Quinn, Douchane and Reisbick. E-5 APPENDIX TO 10-K re graphics on page 5 The graphics on page 5 consist of maps depicting the Company's mines and offices in North America, South America and the Austral Pacific. The North America map references the following Company offices: BMG's headquarters in Houston, Texas; BMG's North American Regional Office in Denver, Colorado; BMG's Latin American Exploration Office in Tucson, Arizona; and BMG's U.S. Exploration Office in Reno, Nevada. The North America map also includes the following operating locations: the San Luis Mine in southern Colorado; the Battle Mountain complex in northern Nevada; and the Crown Jewel Project in northeast Washington. The South America map references BMG's South American Regional Office and Inti Raymi's headquarters in La Paz, Bolivia; the Kori Kollo mine in central Bolivia; and the San Cristobal mine in northern Chile. The Austral Pacific map references Niugini Mining's office in Sydney, Australia; BMG's Australian Exploration Office in Perth, Australia; the Red Dome and Pajingo mines in northeastern Australia; and the Lihir Project northeast of mainland Papua New Guinea.	17,384	112,428
83604_1993.txt	83604_1993	1993	83604	Item 1. BUSINESS Reynolds Metals Company (the "Registrant") was incorporated in 1928 under the laws of the State of Delaware. As used herein, "Reynolds" and "Company" each means the Registrant and its consolidated subsidiaries unless otherwise indicated. GENERAL Reynolds serves global markets as a supplier and recycler of aluminum and other products, with its core business being as an integrated producer of a wide variety of value-added aluminum products. Reynolds produces alumina, carbon products and primary and reclaimed aluminum, principally to supply the needs of its fabricating operations. These fabricating operations produce aluminum foil, sheet, plate, cans and extruded products (including heat exchanger tubing, driveshafts, bumpers and windows), flexible packaging and wheels, among other items. Reynolds also produces a broad range of plastic products, including film, bags, containers and lids, for consumer products, foodservice and packaging uses. The Company markets an extensive line of consumer products under the Reynolds brand name, including the well-known Reynolds Wrap aluminum foil. Reynolds' largest market for its products is the packaging and containers market, which includes consumer products. Reynolds is also a gold producer through operations in Western Australia. To describe more fully the nature of its operations, Reynolds has separated its vertically integrated operations into two areas -- (1) Finished Products and Other Sales and (2) Production and Processing. Finished Products and Other Sales includes the manufacture and distribution of various finished aluminum products, such as cans, containers, flexible packaging products, foodservice and household foils (including Reynolds Wrap), laminated and printed foil and aluminum building products. Finished Products and Other Sales also includes the sale of plastic bags and food wraps (for example, Reynolds Plastic Wrap, Reynolds Crystal Color Plastic Wrap, Reynolds Oven Bags and Presto disposer bags), plastic lidding and container products, plastic film packaging, Reynolds Freezer Paper, Reynolds Baker's Choice baking cups, Reynolds Cut-Rite wax paper and wax paper sandwich bags, composite and nonaluminum building products, and printing cylinders and machinery. Production and Processing includes the refining of bauxite into alumina, calcination of petroleum coke and production of prebaked carbon anodes, all of which are vertically integrated with aluminum production and processing plants. These plants produce and sell primary and reclaimed aluminum and a wide range of semifinished aluminum mill products, including flat rolled products, extruded and drawn products, cast products and other aluminum products. Examples of flat rolled products include aluminum can stock and machined plate. Examples of extruded and drawn products include heat exchanger tubing, driveshafts and bumpers. Examples of cast products include aluminum wheels. Production and Processing also includes the sale of gold and other nonaluminum products, technology, and various licensing, engineering and other services related to the production and processing of aluminum. In the second quarter of 1993, Reynolds completed the sale of its Benton Harbor, Michigan aluminum reclamation plant to ALRECO Acquisition Corp., a subsidiary of FFS Inc. On November 1, 1993, Reynolds acquired the aluminum beverage can and end manufacturing operations of Miller Brewing Company ("Miller"), increasing Reynolds' U.S. aluminum can capacity by almost 50 percent to 16 billion cans per year. Included in the purchase were five plants located in Wisconsin, New York, Texas, North Carolina and Georgia, having a combined annual capacity of 5 billion aluminum beverage cans and ends. Reynolds also entered into a long-term supply agreement with Miller to supply substantially all of Miller's aluminum beverage can requirements. In the fourth quarter of 1993, Reynolds started production at a new facility in Arkansas which converts spent potliner from Reynolds' and other producers' North American aluminum smelting operations into an environmentally safe material with potential for recycling. Reynolds has entered into an agreement with a third party to market the treated residue from the facility for such uses as refractories and road construction. The facility, which is the only one of its kind, has the capacity to treat an estimated 115,000 metric tons of spent potliner each year. In late 1993, Reynolds decided to take actions to restructure certain of its operations, principally in the fabricating area, to improve worldwide performance at a time of extremely difficult market conditions in the aluminum industry. The restructuring actions are in line with Reynolds' strategy of redirecting resources to those areas that meet its goal of profitable growth within its core businesses. The most significant operations affected are portions of Reynolds' business conducted at its McCook, Illinois sheet and plate plant, where a part of the plant's aluminum sheet production will be discontinued by mid-1994. As a result of its ongoing review of the economic viability of certain of its operations, Reynolds also decided to discontinue production of extruded irrigation tubing at its Torrance, California facility, idling the extrusion press at that facility effective December 31, 1993, and to eliminate extruded shapes operations at its Louisville, Kentucky extrusion plant, focusing instead on production of heat exchanger tubing products. See the discussion under "Costs and Expenses - Restructuring Charges" in Item 7, and under Note N to the consolidated financial statements in Item 8, of this report regarding the costs of these restructuring actions. Information on shipments and net sales by classes of similar products is shown in Table 1. Financial information relating to Reynolds' operations and identifiable assets by major operating and geographic areas is presented in Note J to the consolidated financial statements in Item 8 of this report. Reynolds' products are generally sold to producers and distributors of industrial and consumer products in various markets. Information on sales of products by principal geographic and business markets is shown in Tables 2 and 3. TABLE 2 Principal Geographic Markets Approximate Percentage of Sales _________________________ 1993 1992 1991 ____ ____ ____ United States 75% 75% 75% Canada 6 5 5 Other (Principally Europe) 19 20 20 Total 100% 100% 100% TABLE 3 Principal Business Markets Approximate Percentage of Sales _________________________ 1993 1992 1991 ____ ____ ____ Packaging and Containers 45% 45% 44% Distributors and Fabricators 13 15 15 Building and Construction 12 12 12 Automotive and Transportation 11 11 9 Electrical* 3 5 5 Other 16 12 15 Total 100% 100% 100% _________________ Reynolds sold its North American electrical cable operations in September, 1992. COMPETITION Principal Competitors Reynolds' principal competitors in the sale in North America of products derived from primary aluminum are ten other domestic companies, a Canadian company and other foreign companies. Reynolds and many other companies produce reclaimed aluminum. In the sale of semifinished and finished products, Reynolds competes with (i) other producers of primary and reclaimed aluminum, which are also engaged in fabrication, (ii) other fabricators of aluminum and other products and (iii) other producers of plastic products. Reynolds' principal competitors in Europe are seven major multinational producers and a number of smaller European producers of aluminum semifabricated products. Aluminum and related products compete with various products, including those made of iron, steel, copper, zinc, tin, titanium, lead, glass, wood, plastic, magnesium and paper. Plastic products compete with products made of glass, aluminum, steel, paper, wood and ceramics, among others. Competition is based upon price, quality and service. Reynolds' strategy is to continue improving its competitive position as an integrated producer of value-added aluminum products, with emphasis on growth opportunities in its core downstream fabricating operations, and to expand its packaging and containers and engineered automotive components businesses. Reynolds has undertaken continuing intensive cost reduction and performance improvement programs to improve its competitiveness that include work force reductions, permanent closures of higher cost facilities, disposal of uneconomic and non-core assets, and operational and organizational restructuring. Industry Conditions A worldwide oversupply of aluminum, caused by high exports from the Commonwealth of Independent States ("CIS"), start-up of substantial new capacity in the industry and economic weakness, has severely depressed the price of aluminum on world commodity markets. This supply-demand imbalance, with its resultant effect on prices, has dramatically affected the aluminum industry and Reynolds. The timing and magnitude of any improvements in these conditions cannot be predicted with certainty. Multilateral government negotiations have been conducted to develop strategies to integrate the CIS aluminum industries into the world market. In late January, 1994, the governments of the six major aluminum-producing countries announced acceptance of a Memorandum of Understanding (the "MOU") addressing global supply-demand imbalance. The six governments finalized the text of the MOU during the week of February 28 and agreed to meet again on April 21, 1994 to review the global market situation. Among other things, the MOU contemplates reductions in Russian primary aluminum production of up to 500,000 metric tons per year for up to two years. Whether the MOU or other multilateral negotiations will be successful, and their ultimate effect on the supply-demand imbalance if successful, cannot be predicted with certainty. If multilateral negotiations are unsuccessful, unilateral trade sanctions (including, for example, import quotas or anti-dumping actions) may be pursued by governments or private parties. Such sanctions, if implemented, could result in improved prices in certain countries or regions but could also negatively impact Reynolds' globally integrated operations. The overall impact such sanctions might have on Reynolds' results of operations or competitive position therefore cannot be predicted with certainty. RAW MATERIALS AND PRECIOUS METALS Bauxite, Alumina and Related Materials Bauxite, the principal raw material used in the production of aluminum, is refined into alumina, which is then reduced by an electrolytic process into primary aluminum. Reynolds' bauxite requirements and a portion of its alumina requirements are met from sources outside the United States. Reynolds has long-term arrangements to obtain bauxite at negotiated prices from sources in Australia, Brazil, Guinea and Jamaica. Reynolds also has a long-term arrangement with the U.S. government under which Reynolds has agreed to purchase at a negotiated price an aggregate of approximately 1,450,000 long dry tons of Jamaican bauxite stored next to Reynolds' Sherwin alumina plant near Corpus Christi, Texas, for the period 1994 through 1998. Reynolds refines bauxite into alumina at its Sherwin alumina plant. Reynolds also acquires alumina from two joint ventures in which it has interests, one located in Western Australia, known as the Worsley Joint Venture ("Worsley"), and the other located in Stade, Germany, known as Aluminium Oxid Stade ("Stade"). See Table 4 under this Item and the discussion of Worsley under "Australia". Production and purchases of bauxite and production of alumina are adjusted from time to time in response to changes in demand for primary aluminum and other factors. Reynolds has reduced production at its Sherwin plant in connection with the curtailment of operations at its U.S. primary aluminum production plants. See "Aluminum Production". At December 31, 1993, the Sherwin plant was operating at 65% of capacity. Australia Reynolds has a 50% ownership interest in Worsley, which has a rated capacity of 1,600,000 metric tons of alumina per year (expandable to 2,400,000 metric tons per year). Worsley has proven bauxite reserves sufficient to operate the alumina plant at its rated capacity (taking into account future expansions to increase rated capacity to up to 2,400,000 metric tons per year) for at least the next 50 years. The joint venture has no specified termination date. Reynolds has a long-term purchase arrangement under which it may purchase from a third party an aggregate of approximately 18,000,000 dry metric tons of Australian bauxite for the period 1994 through 2021. Of this amount, Reynolds has agreed to purchase 1,000,000 dry metric tons annually through 1996. Reynolds has agreements under which it has agreed to purchase from two other third parties 300,000 dry, and 65,000 wet, metric tons, respectively, of Australian bauxite in 1994. Brazil Reynolds and various other companies are participants in the Trombetas bauxite mining project in Brazil. Reynolds has a 5% equity interest in the project and has agreed to purchase an aggregate of approximately 2,400,000 dry metric tons of Brazilian bauxite from the project for the period 1994 through 1999. Reynolds is also maintaining an interest in other, undeveloped bauxite deposits in Brazil. Guinea Reynolds owns a 6% interest in Halco (Mining), Inc. ("Halco"). Halco owns 51% and the Guinean government owns 49% of Compagnie des Bauxites de Guinee ("CBG"), which has the exclusive right through 2038 to develop and mine bauxite in a 10,000 square-mile area in northwestern Guinea. Reynolds has a bauxite purchase contract with CBG which will provide Reynolds with an aggregate of approximately 1,200,000 dry metric tons of Guinean bauxite for the period 1994 through 1995. Guyana Reynolds and the Guyanese government each own a 50% interest in a bauxite mining project in the Berbice region of Guyana. Reynolds has a bauxite purchase contract under which it has agreed to purchase 625,000 dry metric tons of Guyanese bauxite from the project in 1994. Indonesia Reynolds has a purchase arrangement under which it has agreed to purchase from a third party 350,000 dry metric tons of Indonesian bauxite in 1994. Jamaica Reynolds has a long-term purchase arrangement under which it has agreed to purchase from a third party an aggregate of 3,000,000 dry metric tons of Jamaican bauxite for the period 1994 through 1995. Reynolds' present sources of bauxite and alumina are more than adequate to meet the forecasted requirements of its primary aluminum production operations for the foreseeable future. To utilize excess alumina capacity, Reynolds enters into third-party sales arrangements. Reynolds also enters into arrangements to sell bauxite in excess of its needs to third parties. Other materials used in making aluminum are either purchased from others or supplied from Reynolds' carbon products plants in Baton Rouge and Lake Charles, Louisiana. Precious Metals Reynolds is currently a 40% participant in the Boddington gold project, and the owner of the Mt. Gibson gold project and the Marvel Loch gold property, all located in Western Australia. Mt. Gibson commenced production in late 1986; Boddington commenced production in mid-1987; and Reynolds acquired Marvel Loch in 1991. Reynolds announced on February 9, 1994 that it has reached an agreement to sell Reynolds Australia Metals, Ltd., which holds its 40% interest in Boddington, to Poseidon Gold, Limited. The transaction, which is subject to certain conditions, was originally scheduled for completion in March, 1994. Another Boddington joint venturer has asserted that it has pre- emptive rights with respect to the transaction. Legal proceedings have been filed in the Supreme Court of Western Australia to resolve this issue. These proceedings will likely delay completion of the transaction until the second quarter of 1994 and, if adversely determined, could prevent completion of the transaction. In the second quarter of 1993, Reynolds acquired the remaining 50% interest in the Mt. Gibson gold project that it did not previously own. In 1993, Mt. Gibson produced for Reynolds' account 64,300 ounces of gold. Mt. Gibson has a mining and processing capacity of up to 1.1 million metric tons of ore annually using standard carbon-in-leach technology. In 1993, Mt. Gibson commissioned a heap leach operation which has the capacity to process an additional 2.0 million metric tons of ore annually. In 1993, Boddington produced for Reynolds' account 149,700 ounces of gold. Boddington has a mining and processing capacity of up to 7.2 million metric tons of ore per year. In 1993, Boddington commissioned a new underground mine which is supplying ore to its supergene/basement plant which has the capacity to process up to 100,000 additional metric tons of ore annually. The Marvel Loch gold property has a processing capacity of up to 1.0 million metric tons of ore annually. In 1993, Marvel Loch produced 145,200 ounces of gold. Each of the Australian sites is being prospected for possible additional reserves. Reynolds is also searching for gold at other sites in Australia and in North America. ALUMINUM PRODUCTION Reynolds owns and operates three primary aluminum production plants in the United States and one located at Baie Comeau, Quebec, Canada. Reynolds is also entitled to a share of the primary aluminum produced at three joint ventures in which it participates, one located in Quebec, Canada, known as the Becancour joint venture ("Becancour"), one located in Hamburg, Germany, known as Hamburger Aluminium-Werk GmbH ("Hamburg"), and the third in Ghana, Africa, known as Volta Aluminium Company Limited ("Ghana"). See Table 5 under this Item and note (h) thereto for information on these primary aluminum production plants. Reynolds also buys primary aluminum on the open market. Reynolds has a 25% equity interest in Becancour and is entitled to a proportionate share of production. The plant currently consists of three fully operational potlines, each with a capacity of 120,000 metric tons of aluminum per year. Production at the primary aluminum plants listed in Table 5 can vary due to a number of factors, including changes in worldwide supply and demand. Due to the continuing worldwide aluminum supply-demand imbalance, Reynolds has temporarily shut down 88,000 metric tons of primary aluminum production capacity at its Massena, New York (41,000 metric tons) and Longview, Washington (47,000 metric tons) plants, effective in the fourth quarter of 1993. Taking into account these latest curtailments, Reynolds has idled a total of 209,000 metric tons, or 21% of its 991,000 metric tons of primary aluminum capacity. Reynolds' Troutdale, Oregon plant, with a capacity of 121,000 metric tons, has been idle since 1991. At December 31, 1993, the U.S. plants listed in Table 5 were operating collectively at a rate of 53% of capacity; all other plants listed in Table 5 were operating at full capacity. See Table 6 under this Item. In order to balance its alumina supply system, Reynolds temporarily reduced production by 20% at its Sherwin alumina plant in Texas in connection with the latest curtailments. Production at the Sherwin alumina plant was previously reduced in connection with the Troutdale curtailment. See "Raw Materials and Precious Metals - Bauxite, Alumina and Related Materials". (See the discussion of threatened legal proceedings relating to the Massena, New York plant under "Environmental Compliance" and in Item 3 of this report.) Reynolds has an 8% equity interest in C.V.G. Aluminio del Caroni, S.A., which produces primary aluminum in Venezuela. Reynolds has agreed to acquire a 10% equity interest in the Aluminum Smelter Company of Nigeria (ALSCON), with the Nigerian government and private interests holding the remaining equity. As part of the arrangement, Reynolds will purchase at market-related prices 140,000 metric tons of primary aluminum annually from a 180,000 metric ton smelter being constructed by ALSCON in Nigeria. Reynolds produces reclaimed aluminum from aluminum scrap at Bellwood, Virginia and Sheffield, Alabama. See Table 6 under this Item. Scrap for these facilities is obtained through Reynolds' nationwide recycling network and other scrap purchases and from Reynolds' manufacturing operations. In 1993, Reynolds obtained approximately 299,000 metric tons of recycled aluminum from its recycling network and other scrap purchases. Reynolds sold its Benton Harbor, Michigan aluminum reclamation plant in the second quarter of 1993. See "General". FABRICATING OPERATIONS Reynolds' semifinished and finished aluminum products and nonaluminum products are produced at numerous domestic and foreign plants wholly or partly owned by Reynolds. These plants are included in Table 7 under Item 2 Item 2. PROPERTIES For information on the location and general nature of Reynolds' principal domestic and foreign properties, see Item 1, BUSINESS. Table 7 lists as of February 7, 1994 Reynolds' wholly-owned domestic and foreign operations and shows the domestic and foreign locations of operations in which Reynolds has interests. The properties listed are held in fee except as otherwise indicated. Properties held other than in fee are not, individually or in the aggregate, material to Reynolds' operations and the arrangements under which such properties are held are not expected to limit their use. Reynolds believes that its facilities are suitable and adequate for its operations. With the exception of the Longview, Massena and Troutdale primary aluminum production plants and the Sherwin alumina plant, as explained above, there is no significant surplus or idle capacity at any of Reynolds' major manufacturing facilities. The restructured operations at Reynolds' McCook sheet and plate plant and Torrance and Louisville extrusion facilities are not considered as surplus or idle capacity. See Item 1 under the caption "General". TABLE 7 Wholly-Owned Domestic and Foreign Operations Manufacturing, Mining and Distribution Alumina: Recycling: Corpus Christi, Texas Recycling Plants and Malakoff, Texas Centers (U.S.)(638)* Calcined Coke: Reclamation: Baton Rouge, Louisiana Sheffield, Alabama (2) Lake Charles, Louisiana Bellwood, Virginia Carbon Anodes: Mill Products: Lake Charles, Louisiana Sheffield, Alabama McCook, Illinois Primary Aluminum: Bellwood, Virginia Massena, New York Cap-de-la-Madeleine, Troutdale, Oregon Quebec, Canada Longview, Washington Hamburg, Germany*** Baie Comeau, Quebec, Canada Latina, Italy Aluminum Cans: Spent Potliner Treatment: San Francisco, California Gum Springs, Arkansas Torrance, California Tampa, Florida Extruded Products: Moultrie, Georgia Auburn, Indiana Honolulu, Hawaii Louisville, Kentucky Kansas City, Missouri El Campo, Texas Fulton, New York Ashland, Virginia* Middletown, New York Bellwood, Virginia Reidsville, North Carolina (cans and Richmond Hill, Ontario, Canada ends) Ste. Therese, Quebec, Canada Salisbury, North Carolina Nachrodt, Germany* Fort Worth, Texas Harderwijk, Netherlands Houston, Texas Lelystad, Netherlands Seattle, Washington Maracay, Venezuela Milwaukee, Wisconsin Rocklin, California (ends) Bristol, Virginia (ends) Enzesfeld, Austria# Guayama, Puerto Rico Powder and Paste: Building and Construction Louisville, Kentucky Products: Eastman, Georgia* Electrical Rod: Bourbon, Indiana Becancour, Quebec, Canada Ashville, Ohio Lynchburg, Virginia Foil Feed Stock: Weston, Ontario, Canada Hot Springs, Arkansas Merxheim, France* Nachrodt, Germany Packaging and Consumer Dublin, Ireland* Products: Harderwijk, Netherlands Beacon Falls, Connecticut Lisburn, Northern Ireland* Louisville, Kentucky Service Centers (U.S.)(46)** Mt. Vernon, Kentucky Sparks, Nevada* Downingtown, Pennsylvania Lewiston, Utah Bellwood, Virginia Printing Cylinders: Grottoes, Virginia Longmont, Colorado* Richmond, Virginia Atlanta, Georgia* South Boston, Virginia Clarksville, Indiana* Appleton, Wisconsin (2) Louisville, Kentucky Little Chute, Wisconsin Newport, Kentucky* Weyauwega, Wisconsin Battle Creek, Michigan* Rexdale, Ontario, Canada St. Louis, Missouri Cap-de-la-Madeleine, Phoenix, New York* Quebec, Canada Wilmington, North Carolina* Latina, Italy Exton, Pennsylvania* Franklin, Tennessee* Richmond, Virginia Wheels: Can Machinery and Systems: Ferrara, Italy Richmond, Virginia Gold: Reynolds Aluminum Supply Marvel Loch and Mt. Gibson, Company: Western Australia, Australia Service Centers (U.S.)(22)** Processing Centers (U.S.)(2) Research and Development Richmond, Virginia: Corpus Christi, Texas: Can Development Center Alumina Technology Corporate Research and Development Sheffield, Alabama: Central Laboratories Manufacturing Technology Packaging Technology Laboratory Other Operations In Which Reynolds Has Interests Australia: Guinea: Bauxite and alumina, gold## Bauxite Belgium: Guyana: Building products and extrusions Bauxite* Italy: Brazil: Reclamation Bauxite, aluminum cans and ends, recycling Philippines: Mill products, extrusions, foil Canada: Primary aluminum, electric Russia: power generation, aluminum Foil feed stock wheels Colombia: Spain: Mill products, extrusions, Mill products, extrusions, foil, foil wire and cable, packaging and consumer products, printing Egypt: cylinders Extrusions Venezuela: Germany: Primary aluminum, mill products, Alumina, primary aluminum* foil, aluminum cans and ends, recycling, aluminum wheels Ghana: Primary aluminum* ____________________________ * Leased. Recycling Plants and Centers - 629 leased. Building and Construction Products Service Centers - 44 leased. Reynolds Aluminum Supply Company Service Centers - 14 leased. * Held under an installment purchase arrangement. # Reynolds announced on February 15, 1994 an agreement to sell its Austria Dosen aluminum beverage can plant to PLM AB. The transaction, which is subject to certain conditions, is expected to be completed by the end of March, 1994. ## Reynolds has reached an agreement to sell Reynolds Australia Metals, Ltd., which holds its 40% interest in the Boddington gold project. See the discussion under Item 1 of this report under the caption "Raw Materials and Precious Metals - Precious Metals". The titles to Reynolds' various properties were not examined specifically for this report. Item 3. Item 3. LEGAL PROCEEDINGS On January 11, 1993, the Registrant received from the California Earth Corps ("CEC") a 60-day notice of intent to sue under the "Proposition 65" provision of the California Health and Safety Code. The notice alleges that the Registrant's Torrance Can Plant failed to provide a required warning of the public's exposure to certain chemicals listed pursuant to California law. Under California law, CEC may take action against the Registrant and receive a bounty if the action is successful. Penalties of up to $2,500 per day of violation could be sought in the potential action. The Registrant has responded to the notice, denying the alleged violations. CEC has taken no action to date. On July 29, 1992, the U.S. Environmental Protection Agency (the "EPA") filed an administrative complaint against the Registrant alleging paperwork violations and failure to determine whether certain materials in storage constituted hazardous wastes under the federal Resource Conservation and Recovery Act and state hazardous waste regulations at the Registrant's Longview, Washington primary aluminum production plant. The EPA sought $296,000 in civil penalties. Based on the Registrant's response to the complaint, the EPA dropped certain claims and amended others. The parties have tentatively agreed to a settlement of the matter under which the Registrant would pay a penalty of $11,250 and agree to install certain parts washing stations that would result in a reduction in the generation of solvent wastes at the Longview plant. The parties are preparing documents to finalize the settlement. As previously reported in the Registrant's Report on Form 10-Q for the Quarter ended March 31, 1993, on June 10, 1988, the Atlantic States Legal Foundation ("Atlantic States") filed suit against the Registrant in the U.S. District Court for the Western District of New York (the "Court") under the "citizen suit" provision of the federal Clean Water Act. The State of New York intervened in the case on December 1, 1989. The suit involved the discharge of substances from the Registrant's Massena, New York primary aluminum production plant. An agreement of the parties to settle the suit for payments by the Registrant aggregating $515,000, resolving claims for penalties and other costs, was approved by the Court on May 12, 1992; however, the Court retained jurisdiction of the matter. In a letter dated April 12, 1993, Atlantic States informed the Registrant that it has withdrawn its waiver of enforcement, citing violations at the Massena plant of interim effluent limits contained in the settlement agreement and other effluent limit violations. Atlantic States has stated that it would be providing the Registrant a settlement offer concerning such violations, which the Registrant to date has not received. On November 9, 1993, counsel for the St. Regis Mohawk Tribe served the Registrant with a notice of intent to file a citizen suit for alleged violations of the federal Clean Air Act and certain New York state air emission standards at the Registrant's Massena, New York primary aluminum production plant. At a meeting with tribal and state representatives in December, 1993, the State of New York alleged that the Registrant's emissions were causing a violation of ambient air standards for benzo-a- pyrene. The state and Mohawk Tribe asked, among other things, that the Registrant agree to accelerate capital investments to achieve compliance with the Clean Air Act's Maximum Achievable Control Technology ("MACT") standards (although the EPA is not expected to establish such standards until 1996 or 1997). Discussions to resolve the matter are ongoing among the parties. Capital expenditures to achieve MACT standards at the Massena plant, together with related capital expenditures, could exceed $150 million. See the discussion of Clean Air Act compliance costs in Item 1 under the caption "Environmental Compliance". See the discussion of legal proceedings related to the proposed sale of Reynolds Australia Metals, Ltd. under the caption "Raw Materials and Precious Metals - Precious Metals" in Item 1 of this report. Various other suits and claims are pending against Reynolds. In the opinion of Reynolds' management, after consultation with counsel, disposition of these suits and claims and the actions referred to in the preceding paragraphs, either individually or in the aggregate, will not have a material adverse effect on Reynolds' competitive or financial position or its ongoing results of operations. No assurance can be given, however, that the disposition of one or more of such suits, claims or actions in a particular reporting period will not be material in relation to the reported results for such period. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Registrant's security holders during the fourth quarter of 1993. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Registrant are as follows: Name Age Positions Held During Past Five Years Richard G. Holder 62 Chairman of the Board and Chief Executive Officer since May 1992. President and Chief Operating Officer 1988-1992. Director since 1984. Yale M. Brandt 63 Vice Chairman since May 1992. Executive Vice President, Fabricated Industrial Products 1990-1992. Executive Vice President, Fabricating Operations 1988-1990. Director since 1988. Randolph N. Reynolds 52 Vice Chairman since January 1994. Executive Vice President, International 1990-1994. Vice President 1985-1990. President, Reynolds International, Inc., a subsidiary of the Company, since November 1980, and Chief Executive Officer of that subsidiary since November 1981. Director since 1984. Jeremiah J. Sheehan 55 President and Chief Operating Officer since January 1994. Executive Vice President, Fabricated Products 1993-1994. Executive Vice President, Consumer and Packaging Products 1990-1993. Vice President, Can Division 1988-1990. Director since January 1994. Henry S. Savedge, Jr. 60 Executive Vice President and Chief Financial Officer since May 1992. Vice President, Finance 1990-1992. Vice President, Planning and Analysis 1987-1990. Director since September 1992. Donald T. Cowles 46 Executive Vice President, Human Resources and External Affairs since February 1993. Vice President, General Counsel and Secretary 1989-1993. Secretary and Assistant General Counsel 1985-1989. J. Wilt Wagner 52 Executive Vice President, Raw Materials, Metals and Industrial Products since March 1993. Executive Vice President, Fabricated Industrial Products 1992-1993. Vice President, Mill Products Division 1990-1992. Mill Products Division General Manager 1989-1990. Mill Products Division Operations Manager 1988-1989. Thomas P. Christino 54 Vice President, Flexible Packaging Division since November 1993. Flexible Packaging Division General Manager 1992-1993. Flexible Packaging Products National Sales and Marketing Manager 1987-1992. E. Jack Gates 52 Vice President, Raw Materials and Precious Metals Division since April 1993. Raw Materials and Precious Metals Division General Manager 1993. Reduction Division General Manager 1990-1993. Reduction Division Operations Manager 1983-1990. Rodney E. Hanneman 57 Vice President, Quality Assurance and Technology Operations since March 1985. Douglas M. Jerrold 43 Vice President, Tax Affairs since April 1990. Corporate Director of Tax Affairs 1987-1990. D. Michael Jones 40 Vice President, General Counsel and Secretary since February 1993. Associate General Counsel and Assistant Secretary 1990-1993. Senior Attorney and Assistant Secretary 1987-1990. John B. Kelzer 57 Vice President, Extrusion Division since April 1993. Extrusion Division General Manager 1990-1993. Manager of the Company's McCook, Illinois Sheet and Plate Plant 1985- 1990. William E. Leahey, Jr. 44 Vice President, Can Division since April 1993. Can Division General Manager 1992- 1993. Can Division Sales and Marketing Director 1990-1992. Vice President, Asia Pacific Division, Continental Can International 1986-1990. John M. Lowrie 53 Vice President, Consumer Products Division since October 1988. John M. Noonan 60 Vice President, Construction Products and Properties Divisions since January 1984. William G. Reynolds, Jr. 54 Vice President, Government Relations and Public Affairs since 1980. Julian H. Taylor 50 Vice President, Treasurer since April 1988. C. Stephen Thomas 54 Vice President, Mill Products Division since May 1992. Vice President, Can Division 1990-1992. Vice President, Operations, Can Division July-December 1990. Vice President, Extrusion Division 1987-1990. Nicholas D. Triano 62 Vice President, Materials Management since April 1989. Corporate Director, Materials Management 1987-1989. Allen M. Earehart 51 Controller since March 1993. Director, Corporate Accounting 1982-1993. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock is listed on the New York Stock Exchange and the Chicago Stock Exchange. At February 22, 1994, there were 10,876 holders of record of the Registrant's Common Stock. The high and low sales prices for shares of the Registrant's Common Stock as reported on the New York Stock Exchange Composite Transactions Tape and the dividends declared per share during the periods indicated are set forth below: High Low Dividends First Quarter $58-7/8 $48-5/8 $.45 Second Quarter 49 42 .25 Third Quarter 52-3/4 41-5/8 .25 Fourth Quarter 48-7/8 41-1/8 .25 First Quarter $59-3/8 $48-7/8 $.45 Second Quarter 64-3/8 54 .45 Third Quarter 60-1/2 48-5/8 .45 Fourth Quarter 56-5/8 47 .45 On February 18, 1994, the Board of Directors declared a dividend of $0.25 per share of Common Stock, payable April 1, 1994 to stockholders of record on March 4, 1994. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Item 7 should be read in conjunction with the consolidated financial statements and notes thereto, and with the other sections of this report. All tonnage figures in Item 7 are expressed in metric tons. STATE OF THE INDUSTRY The past year marked a continuation of one of the most difficult periods in the history of the aluminum industry. One could best characterize our business climate as structurally changed and extremely competitive. On the positive side, Western world demand for aluminum continues to grow, despite weakness in several major global economies, especially Europe and Japan. Global consumption of aluminum has set records every year since 1983, and 1994 is forecast to be yet another record year. While the rate of growth has slowed to an average of 1.5% over the last three years, compared to an average of 3% over the last seven years, we believe continued growth during this latest recession is an indicator of underlying long-term demand strength. The industry's problem is on the supply side. Aluminum's previous down cycles were due primarily to excess capacity from overexpansion, a decline in demand, or some combination of the two. Today's supply problems are primarily the result of an extraordinary, unprecedented phenomenon in the industry-exports from the Commonwealth of Independent States (CIS), mostly from Russia. CIS exports have increased from 250,000 tons annually in 1989 to 1.7 million tons in 1993. Even in the best of times, with strong demand growth, there would be no way for the market to absorb this surge of aluminum, which approaches 10% of total world capacity. As a result, inventories on the London Metal Exchange ballooned during the same period from 100,000 tons to over 2.5 million tons, and primary aluminum ingot prices plummeted to an all-time low, on an inflation-adjusted basis. Low ingot prices in turn have had a negative impact on most fabricated aluminum prices. While the industry's boom years during the mid-to-late 1980s led many producers to increase primary aluminum capacity, this was largely offset by closing uneconomic capacity. Except for Russia's unexpected increased participation in the market, supply and demand essentially would be in balance today, even with the capacity increases. The state of the industry is painfully evident in our results, which have deteriorated substantially since our third consecutive year of record earnings in 1989 - the last year before the flood of aluminum from Russia began. OUR BUSINESS Reynolds is a vertically integrated producer of aluminum products. We also manufacture and sell a number of non-aluminum products which complement our aluminum business. In addition to reporting results for the Company as a whole, we provide a breakdown into two groups in order to more fully describe our operations: "Finished Products and Other Sales" and "Production and Processing". For additional information on results and special items, see Notes H, I, M, N and the quarterly results of operations in Item 8 Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information concerning the directors and nominees for directorship, see the information under the caption "Election of Directors" in the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on April 20, 1994, which information is incorporated herein by reference. Information concerning executive officers of the Registrant is shown in Part I - Item 4A of this report. Item 11. Item 11. EXECUTIVE COMPENSATION For information required by this item, see the information under the captions "Election of Directors - Board Compensation and Benefits", "Election of Directors - Other Compensation", "Report of Compensation Committee on Executive Compensation", "Performance Graphs" and "Executive Compensation" in the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on April 20, 1994, which information is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information required by this item, see the information under the caption "Beneficial Ownership of Securities" in the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on April 20, 1994, which information is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information required by this item, see the information under the captions "Election of Directors - Other Compensation" and "Executive Compensation - Pension Plan Table" in the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on April 20, 1994, which information is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The consolidated financial statements, financial statement schedules and exhibits listed below are filed as a part of this report. (1) Consolidated Financial Statements: Page Consolidated statement of income and retained earnings - Years ended December 31, 1993, 1992 and 1991. 32 Consolidated balance sheet - December 31, 1993 and 1992. 33 Consolidated statement of cash flows - Years ended December 31, 1993, 1992 and 1991. 34 Notes to consolidated financial statements. 35 Report of Ernst & Young, Independent Auditors. 51 (2) Financial Statement Schedules S-1 Schedule No. V. Property, plant and equipment VI. Accumulated depreciation, depletion and amortization of property, plant and equipment IX. Short-term borrowings 1993, 1992, 1991 X. Supplementary income statement information 1993, 1992, 1991 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because they are not required, are inapplicable or the required information has otherwise been given. Individual financial statements of Reynolds Metals Company have been omitted because the restricted net assets (as defined in Accounting Series Release 302) of all subsidiaries included in the consolidated financial statements filed, in the aggregate, do not exceed 25% of the consolidated net assets shown in the consolidated balance sheet as of December 31, 1993. Financial statements of all associated companies (20% to 50% owned) have been omitted because no associated company is individually significant. Summarized financial information of all associated companies has been omitted because associated companies in the aggregate are not significant. (3) Exhibits EXHIBIT 2 - None * EXHIBIT 3.1 - Restated Certificate of Incorporation, as amended to the date hereof. (File No. 1-1430, Registration Statement on Form 8-A dated February 23, 1994, pertaining to Common Stock and Preferred Stock Purchase Rights, EXHIBIT 1) * EXHIBIT 3.2 - By-Laws, as amended to the date hereof. (File No. 1-1430, Registration Statement on Form 8-A dated February 23, 1994, pertaining to Common Stock and Preferred Stock Purchase Rights, EXHIBIT 2) EXHIBIT 4.1 - Restated Certificate of Incorporation. See EXHIBIT 3.1. EXHIBIT 4.2 - By-Laws. See EXHIBIT 3.2. * EXHIBIT 4.3 - Indenture dated as of April 1, 1989 (the "Indenture") between Reynolds Metals Company and The Bank of New York, as Trustee, relating to Debt Securities. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1989, EXHIBIT 4(c)) * EXHIBIT 4.4 - Amendment No. 1 dated as of November 1, 1991 to the Indenture. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.4) * EXHIBIT 4.5 - $1,100,000,000 Credit Agreement (the "Credit Agreement") dated as of November 24, 1987 among Reynolds Metals Company, Canadian Reynolds Metals Company, Limited - Societe Canadienne de Metaux Reynolds, Limitee, the several banks parties thereto, Manufacturers Hanover Bank (Delaware), The Bank of Nova Scotia, Manufacturers Hanover Trust Company, and Manufacturers Hanover Agent Bank Services Corporation. (Registration Statement No. 33-20498 on Form S-8, dated March 7, 1988, EXHIBIT 4.4) * EXHIBIT 4.6 - Amendment No. 1 dated as of July 1, 1988 to the Credit Agreement. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1988, EXHIBIT 4(e)) * EXHIBIT 4.7 - Amendment No. 2 dated as of February 8, 1989 to the Credit Agreement. (File No. 1-1430, 1988 Form 10-K Report, EXHIBIT 4.6) * EXHIBIT 4.8 - Amendment No. 3 dated as of August 4, 1989 to the Credit Agreement. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1989, EXHIBIT 4(g)) * EXHIBIT 4.9 - Amendment No. 4 dated as of November 1, 1990 to the Credit Agreement. (Registration Statement No. 33-38020 on Form S-3, dated November 30, 1990, EXHIBIT 4.12) * EXHIBIT 4.10 - Rights Agreement dated as of November 23, 1987 (the "Rights Agreement") between Reynolds Metals Company and The Chase Manhattan Bank, N.A. (File No. 1-1430, Registration Statement on Form 8-A dated November 23, 1987, pertaining to Preferred Stock Purchase Rights, EXHIBIT 1) * EXHIBIT 4.11 - Amendment No. 1 dated as of December 19, 1991 to the Rights Agreement. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.11) * EXHIBIT 4.12 - Form of 9-3/8% Debenture due June 15, 1999. (File No. 1-1430, Form 8-K Report dated June 6, 1989, EXHIBIT 4) * EXHIBIT 4.13 - Form of Fixed Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.3) * EXHIBIT 4.14 - Form of Floating Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.4) * EXHIBIT 4.15 - Form of Book-Entry Fixed Rate Medium-Term Note. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.15) * EXHIBIT 4.16 - Form of Book-Entry Floating Rate Medium- Term Note. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.16) * EXHIBIT 4.17 - Form of 9% Debenture due August 15, 2003. (File No. 1-1430, Form 8-K Report dated August 16, 1991, Exhibit 4(a)) * EXHIBIT 4.18 - Articles of Continuance of Canadian Reynolds Metals Company, Limited -- Societe Canadienne de Metaux Reynolds, Limitee ("CRM"), as amended to the date hereof. (Registration Statement No. 33-59168 on Form S-3, dated March 5, 1993, EXHIBIT 4.1) * EXHIBIT 4.19 - By-Laws of CRM, as amended to the date hereof. (File No. 1-1430, Form 10-Q Report for the Quarter Ended September 30, 1993, EXHIBIT 4.19) * EXHIBIT 4.20 - Indenture dated as of April 1, 1993 among CRM, Reynolds Metals Company and The Bank of New York, as Trustee. (File No. 1-1430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(a)) * EXHIBIT 4.21 - Form of 6-5/8% Guaranteed Amortizing Note due July 15, 2002. (File No. 1-1430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(d)) EXHIBIT 9 - None #* EXHIBIT 10.1 - Reynolds Metals Company 1982 Nonqualified Stock Option Plan, as amended through May 17, 1985. (File No. 1-1430, 1985 Form 10-K Report, EXHIBIT 10.2) #* EXHIBIT 10.2 - Reynolds Metals Company 1987 Nonqualified Stock Option Plan. (Registration Statement No. 33-13822 on Form S-8, dated April 28, 1987, EXHIBIT 28.1) #* EXHIBIT 10.3 - Reynolds Metals Company 1992 Nonqualified Stock Option Plan. (Registration Statement No. 33-44400 on Form S-8, dated December 9, 1991, EXHIBIT 28.1) #* EXHIBIT 10.4 - Reynolds Metals Company Performance Incentive Plan, as amended and restated effective January 1, 1985. (File No. 1-1430, 1985 Form 10-K Report, EXHIBIT 10.3) #* EXHIBIT 10.5 - Consulting Agreement dated April 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1986, EXHIBIT 19) #* EXHIBIT 10.6 - Form of Deferred Compensation Agreement dated February 17, 1984 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, 1983 Form 10-K Report, EXHIBIT 10.9) #* EXHIBIT 10.7 - Deferred Compensation Agreement dated May 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1986, EXHIBIT 19) #* EXHIBIT 10.8 - Agreement dated December 9, 1987 between Reynolds Metals Company and Jeremiah J. Sheehan. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.9) #* EXHIBIT 10.9 - Supplemental Death Benefit Plan for Officers. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.8) #* EXHIBIT 10.10 - Financial Counseling Assistance Plan for Officers. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.11) #* EXHIBIT 10.11 - Management Incentive Deferral Plan. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.12) # EXHIBIT 10.12 - Deferred Compensation Plan for Outside Directors as Amended and Restated Effective December 1, 1993 #* EXHIBIT 10.13 - Retirement Plan for Outside Directors. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.10) #* EXHIBIT 10.14 - Death Benefit Plan for Outside Directors. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.11) #* EXHIBIT 10.15 - Form of Indemnification Agreement for Directors and Officers. (File No. 1-1430, Form 8-K Report dated April 29, 1987, EXHIBIT 28.3) #* EXHIBIT 10.16 - Form of Executive Severance Agreement between Reynolds Metals Company and key executive personnel, including each of the individuals listed in Item 4A hereof (other than Messrs. Christino, Jones, Leahey and Earehart). (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.18) #* EXHIBIT 10.17 - Renewal dated February 21, 1992 of Consulting Agreement dated April 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 10.19) #* EXHIBIT 10.18 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective May 20, 1988. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1988, EXHIBIT 19(a)) #* EXHIBIT 10.19 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective October 21, 1988. (File No. 1-1430, Form 10-Q Report for the Quarter Ended September 30, 1988, EXHIBIT 19(a)) #* EXHIBIT 10.20 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 1, 1987. (File No. 1-1430, 1988 Form 10-K Report, EXHIBIT 10.22) #* EXHIBIT 10.21 - Amendment to Reynolds Metals Company Performance Incentive Plan effective January 1, 1989. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1989, EXHIBIT 19) #* EXHIBIT 10.22 - Form of Stock Option and Stock Appreciation Right Agreement, as approved February 16, 1990 by the Compensation Committee of the Company's Board of Directors. (File No. 1-1430, 1989 Form 10-K Report, EXHIBIT 10.24) #* EXHIBIT 10.23 - Amendment to Reynolds Metals Company 1982 Nonqualified Stock Option Plan effective January 18, 1991. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.25) #* EXHIBIT 10.24 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 18, 1991. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.26) #* EXHIBIT 10.25 - Letter Agreement dated January 18, 1991 between Reynolds Metals Company and William O. Bourke. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.29) #* EXHIBIT 10.26 - Form of Stock Option Agreement, as approved April 22, 1992 by the Compensation Committee of the Company's Board of Directors. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1992, EXHIBIT 28(a)) #* EXHIBIT 10.27 - Consulting Agreement dated May 1, 1992 between Reynolds Metals Company and William O. Bourke. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1992, EXHIBIT 28(b)) # EXHIBIT 10.28 - Renewal dated February 18, 1994 of Consulting Agreement dated May 1, 1992 between Reynolds Metals Company and William O. Bourke EXHIBIT 11 - Omitted; see Item 8 for computation of earnings per share EXHIBIT 12 - Not applicable EXHIBIT 13 - Not applicable EXHIBIT 16 - Not applicable EXHIBIT 18 - None EXHIBIT 21 - List of Subsidiaries of Reynolds Metals Company EXHIBIT 22 - None EXHIBIT 23 - Consent of Independent Auditors EXHIBIT 24 - Powers of Attorney EXHIBIT 27 - Not applicable EXHIBIT 28 - Not applicable ____________________________ * Incorporated by reference. # Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. Pursuant to Item 601 of Regulation S-K, certain instruments with respect to long-term debt of the Company are omitted because such debt does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of any such instrument to the Commission upon request. (b) Reports on Form 8-K During the fourth quarter of 1993, the Registrant filed with the Commission Current Reports on Form 8-K dated (i) November 23, 1993 reporting that it had filed with the Commission a Registration Statement on Form S-3 relating to the offer and resale from time to time by The Chase Manhattan Bank (National Association), as trustee of the Reynolds Metals Company Pension Plans Master Trust (the "Master Trust"), of up to 3,000,000 shares of Common Stock, without par value, of the Registrant proposed to be issued and contributed from time to time by the Registrant to one or more of the pension plans the assets of which are held by the Master Trust; (ii) December 10, 1993 reporting that the Registrant was considering actions to restructure certain of its operations, principally in the fabricating area; and (iii) December 30, 1993 reporting that the Registrant had filed with the Commission pre-effective Amendment No. 1 to Registration Statement No. 33-51631 on Form S-3 relating to the public offering of shares of convertible preferred stock of the Registrant. SIGNATURES Pursuant to the requirements of Section 13 or 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. REYNOLDS METALS COMPANY By Richard G. Holder Richard G. Holder, Chairman of the Board and Chief Executive Officer Date March 15, 1994 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. By Henry S. Savedge, Jr. By Richard G. Holder Henry S. Savedge, Jr., Director, Richard G. Holder, Director, Executive Vice President and Chairman of the Board and Chief Chief Financial Officer Executive Officer Date March 15, 1994 Date March 15, 1994 By William O. Bourke By Yale M. Brandt William O. Bourke, Director Yale M. Brandt, Director Date March 15, 1994 Date March 15, 1994 By Thomas A. Graves, Jr. By Gerald Greenwald Thomas A. Graves, Jr., Director Gerald Greenwald, Director Date March 15, 1994 Date March 15, 1994 By John R. Hall By Robert L. Hintz John R. Hall, Director Robert L. Hintz, Director Date March 15, 1994 Date March 15, 1994 By David P. Reynolds By Randolph N. Reynolds David P. Reynolds, Director Randolph N. Reynolds, Director Date March 15, 1994 Date March 15, 1994 By Charles A. Sanders, M.D. By Jeremiah J. Sheehan Charles A. Sanders, M.D., Director Jeremiah J. Sheehan, Director Date March 15, 1994 Date March 15, 1994 By Ralph S. Thomas By Robert J. Vlasic Ralph S. Thomas, Director Robert J. Vlasic, Director Date March 15, 1994 Date March 15, 1994 By Joe B. Wyatt By Allen M. Earehart Joe B. Wyatt, Director Allen M. Earehart, Controller Date March 15, 1994 Date March 15, 1994 By D. Michael Jones D. Michael Jones, Attorney-in-Fact Date March 15, 1994 FINANCIAL STATEMENT SCHEDULES AND OTHER FINANCIAL INFORMATION YEAR ENDED DECEMBER 31, 1993 REYNOLDS METALS COMPANY RICHMOND, VIRGINIA SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 EXHIBITS TO FORM 10-K For the fiscal year ended December 31, 1993 Commission File No. 1-1430 REYNOLDS METALS COMPANY Attached herewith are Exhibits 10.12, 10.28, 23 and 24 INDEX Sequential Page No. ___________ EXHIBIT 2 - None EXHIBIT 3.1 - Restated Certificate of Incorporation, as amended to the date hereof. (File No. 1-1430, Registration Statement on Form 8-A dated February 23, 1994, pertaining to Common Stock and Preferred Stock Purchase Rights, EXHIBIT 1) EXHIBIT 3.2 - By-Laws, as amended to the date hereof. (File No. 1-1430, Registration Statement on Form 8-A dated February 23, 1994, pertaining to Common Stock and Preferred Stock Purchase Rights, EXHIBIT 2) EXHIBIT 4.1 - Restated Certificate of Incorporation. See EXHIBIT 3.1. EXHIBIT 4.2 - By-Laws. See EXHIBIT 3.2. EXHIBIT 4.3 - Indenture dated as of April 1, 1989 (the "Indenture") between Reynolds Metals Company and The Bank of New York, as Trustee, relating to Debt Securities. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1989, EXHIBIT 4(c)) EXHIBIT 4.4 - Amendment No. 1 dated as of November 1, 1991 to the Indenture. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.4) EXHIBIT 4.5 - $1,100,000,000 Credit Agreement (the "Credit Agreement") dated as of November 24, 1987 among Reynolds Metals Company, Canadian Reynolds Metals Company, Limited - Societe Canadienne de Metaux Reynolds, Limitee, the several banks parties thereto, Manufacturers Hanover Bank (Delaware), The Bank of Nova Scotia, Manufacturers Hanover Trust Company, and Manufacturers Hanover Agent Bank Services Corporation. (Registration Statement No. 33-20498 on Form S-8, dated March 7, 1988, EXHIBIT 4.4) EXHIBIT 4.6 - Amendment No. 1 dated as of July 1, 1988 to the Credit Agreement. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1988, EXHIBIT 4(e)) EXHIBIT 4.7 - Amendment No. 2 dated as of February 8, 1989 to the Credit Agreement. (File No. 1-1430, 1988 Form 10-K Report, EXHIBIT 4.6) EXHIBIT 4.8 - Amendment No. 3 dated as of August 4, 1989 to the Credit Agreement. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1989, EXHIBIT 4(g)) EXHIBIT 4.9 - Amendment No. 4 dated as of November 1, 1990 to the Credit Agreement. (Registration Statement No. 33-38020 on Form S-3, dated November 30, 1990, EXHIBIT 4.12) EXHIBIT 4.10 - Rights Agreement dated as of November 23, 1987 (the "Rights Agreement") between Reynolds Metals Company and The Chase Manhattan Bank, N.A. (File No. 1-1430, Registration Statement on Form 8-A dated November 23, 1987, pertaining to Preferred Stock Purchase Rights, EXHIBIT 1) EXHIBIT 4.11 - Amendment No. 1 dated as of December 19, 1991 to the Rights Agreement. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.11) EXHIBIT 4.12 - Form of 9-3/8% Debenture due June 15, 1999. (File No. 1-1430, Form 8-K Report dated June 6, 1989, EXHIBIT 4) EXHIBIT 4.13 - Form of Fixed Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.3) EXHIBIT 4.14 - Form of Floating Rate Medium-Term Note. (Registration Statement No. 33-30882 on Form S-3, dated August 31, 1989, EXHIBIT 4.4) EXHIBIT 4.15 - Form of Book-Entry Fixed Rate Medium-Term Note. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.15) EXHIBIT 4.16 - Form of Book-Entry Floating Rate Medium- Term Note. (File No. 1-1430, 1991 Form 10-K Report, EXHIBIT 4.16) EXHIBIT 4.17 - Form of 9% Debenture due August 15, 2003. (File No. 1-1430, Form 8-K Report dated August 16, 1991, Exhibit 4(a)) EXHIBIT 4.18 - Articles of Continuance of Canadian Reynolds Metals Company, Limited -- Societe Canadienne de Metaux Reynolds, Limitee ("CRM"), as amended to the date hereof. (Registration Statement No. 33-59168 on Form S-3, dated March 5, 1993, EXHIBIT 4.1) EXHIBIT 4.19 - By-Laws of CRM, as amended to the date hereof. (File No. 1-1430, Form 10-Q Report for the Quarter Ended September 30, 1993, EXHIBIT 4.19) EXHIBIT 4.20 - Indenture dated as of April 1, 1993 among CRM, Reynolds Metals Company and The Bank of New York, as Trustee. (File No. 1-1430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(a)) EXHIBIT 4.21 - Form of 6-5/8% Guaranteed Amortizing Note due July 15, 2002. (File No. 1-1430, Form 8-K Report dated July 14, 1993, EXHIBIT 4(d)) EXHIBIT 9 - None EXHIBIT 10.1 - Reynolds Metals Company 1982 Nonqualified Stock Option Plan, as amended through May 17, 1985. (File No. 1-1430, 1985 Form 10-K Report, EXHIBIT 10.2) EXHIBIT 10.2 - Reynolds Metals Company 1987 Nonqualified Stock Option Plan. (Registration Statement No. 33-13822 on Form S-8, dated April 28, 1987, EXHIBIT 28.1) EXHIBIT 10.3 - Reynolds Metals Company 1992 Nonqualified Stock Option Plan. (Registration Statement No. 33-44400 on Form S-8, dated December 9, 1991, EXHIBIT 28.1) EXHIBIT 10.4 - Reynolds Metals Company Performance Incentive Plan, as amended and restated effective January 1, 1985. (File No. 1-1430, 1985 Form 10-K Report, EXHIBIT 10.3) EXHIBIT 10.5 - Consulting Agreement dated April 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1986, EXHIBIT 19) EXHIBIT 10.6 - Form of Deferred Compensation Agreement dated February 17, 1984 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, 1983 Form 10-K Report, EXHIBIT 10.9) EXHIBIT 10.7 - Deferred Compensation Agreement dated May 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1986, EXHIBIT 19) EXHIBIT 10.8 - Agreement dated December 9, 1987 between Reynolds Metals Company and Jeremiah J. Sheehan. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.9) EXHIBIT 10.9 - Supplemental Death Benefit Plan for Officers. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.8) EXHIBIT 10.10 - Financial Counseling Assistance Plan for Officers. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.11) EXHIBIT 10.11 - Management Incentive Deferral Plan. (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.12) EXHIBIT 10.12 - Deferred Compensation Plan for Outside ------ Directors as Amended and Restated Effective December 1, 1993 EXHIBIT 10.13 - Retirement Plan for Outside Directors. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.10) EXHIBIT 10.14 - Death Benefit Plan for Outside Directors. (File No. 1-1430, 1986 Form 10-K Report, EXHIBIT 10.11) EXHIBIT 10.15 - Form of Indemnification Agreement for Directors and Officers. (File No. 1-1430, Form 8-K Report dated April 29, 1987, EXHIBIT 28.3) EXHIBIT 10.16 - Form of Executive Severance Agreement between Reynolds Metals Company and key executive personnel, including each of the individuals listed in Item 4A hereof (other than Messrs. Christino, Jones, Leahey and Earehart). (File No. 1-1430, 1987 Form 10-K Report, EXHIBIT 10.18) EXHIBIT 10.17 - Renewal dated February 21, 1992 of Consulting Agreement dated April 16, 1986 between Reynolds Metals Company and David P. Reynolds. (File No. 1- 1430, 1991 Form 10-K Report, EXHIBIT 10.19) EXHIBIT 10.18 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective May 20, 1988. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1988, EXHIBIT 19(a)) EXHIBIT 10.19 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective October 21, 1988. (File No. 1-1430, Form 10-Q Report for the Quarter Ended September 30, 1988, EXHIBIT 19(a)) EXHIBIT 10.20 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 1, 1987. (File No. 1-1430, 1988 Form 10-K Report, EXHIBIT 10.22) EXHIBIT 10.21 - Amendment to Reynolds Metals Company Performance Incentive Plan effective January 1, 1989. (File No. 1-1430, Form 10-Q Report for the Quarter Ended June 30, 1989, EXHIBIT 19) EXHIBIT 10.22 - Form of Stock Option and Stock Appreciation Right Agreement, as approved February 16, 1990 by the Compensation Committee of the Company's Board of Directors. (File No. 1-1430, 1989 Form 10-K Report, EXHIBIT 10.24) EXHIBIT 10.23 - Amendment to Reynolds Metals Company 1982 Nonqualified Stock Option Plan effective January 18, 1991. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.25) EXHIBIT 10.24 - Amendment to Reynolds Metals Company 1987 Nonqualified Stock Option Plan effective January 18, 1991. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.26) EXHIBIT 10.25 - Letter Agreement dated January 18, 1991 between Reynolds Metals Company and William O. Bourke. (File No. 1-1430, 1990 Form 10-K Report, EXHIBIT 10.29) EXHIBIT 10.26 - Form of Stock Option Agreement, as approved April 22, 1992 by the Compensation Committee of the Company's Board of Directors. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1992, EXHIBIT 28(a)) EXHIBIT 10.27 - Consulting Agreement dated May 1, 1992 between Reynolds Metals Company and William O. Bourke. (File No. 1-1430, Form 10-Q Report for the Quarter Ended March 31, 1992, EXHIBIT 28(b)) EXHIBIT 10.28 - Renewal dated February 18, 1994 of ______ Consulting Agreement dated May 1, 1992 between Reynolds Metals Company and William O. Bourke EXHIBIT 11 - Omitted; see Item 8 for computation of earnings per share EXHIBIT 12 - Not applicable EXHIBIT 13 - Not applicable EXHIBIT 16 - Not applicable EXHIBIT 18 - None EXHIBIT 21 - List of Subsidiaries of Reynolds Metals Company EXHIBIT 22 - None EXHIBIT 23 - Consent of Independent Auditors ______ EXHIBIT 24 - Powers of Attorney ______ EXHIBIT 27 - Not applicable EXHIBIT 28 - Not applicable ____________________________ * Incorporated by reference.	10,030	65,778
90498_1993.txt	90498_1993	1993	90498	ITEM 1. BUSINESS. THE COMPANY AND THE BANKS The Simmons First National Corporation (the "Company") is a bank holding company registered under the Bank Holding Company Act of 1956. At December 31, 1993, the Company had consolidated total assets of $738.8 million, consolidated net loans of $387.0 million and total equity capital of $75.3 million. The Company owns three subsidiary banks in Arkansas. Its lead bank, Simmons First National Bank (the "Bank"), is a national bank which has been in operation since 1903. In the past two years the Bank has received substantial favorable national media coverage for offering one of the lowest credit card interest rates in the United States. The Bank's primary market area, with the exception of its nationally-provided credit card and mortgage banking services, is the State of Arkansas. The Company also owns two community banks, Simmons First Bank of Jonesboro ("Simmons/Jonesboro"), and Simmons First Bank of Lake Village ("Simmons/Lake Village"), both acquired in 1984. The Company's banking subsidiaries conduct their operations through 23 branches located in 10 communities in Arkansas. Through its banking subsidiaries, the Company emphasizes retail banking services, and it considers the Bank to be a national leader in providing credit card services. The Bank has offered credit card services since 1967, and at December 31, 1993, the Bank had approximately 194,000 active Visa and MasterCard accounts in all 50 states, the District of Columbia and certain U.S. territories, with outstanding balances totalling $168.7 million, or approximately 43% of total consolidated loans. Approximately 70% of the Bank's cardholders, representing approximately 70% of the aggregate outstanding balances in the credit card portfolio, reside outside the State of Arkansas. The Bank has consistently employed stringent, subjectively- based credit standards in making credit decisions concerning card applicants, rather than using a credit scoring, or statistical profile system typically employed by other credit card issuers. Management believes this individualized approach to decision-making, emphasizing credit histories and individual borrower profiles, has been a significant positive factor in producing a high quality credit card loan portfolio. At December 31, 1993, the Bank's credit card delinquency and net loss ratios were 0.34% and .098%, respectively, compared to the national averages of such ratios for all Visa card issuers of 3.50% and 3.86%, respectively. The Bank's credit card delinquency and net loss ratios for 1993 are believed by management to be among the lowest such ratios for all credit card providers in the United States. The Bank is the largest provider of guaranteed student loans in Arkansas, based on lender originations, and in 1993 originated approximately $29.1 million in student loans to approximately 10,500 borrowers. At December 31, 1993, the Bank owned and serviced approximately 17,600 outstanding student loans totalling approximately $65.4 million, or approximately 17% of the Company's total consolidated loans. The Company provides mortgage banking services through the Bank's production, sale and servicing of residential real estate mortgages on properties located primarily in the South, Midwest and Southwest United States. At December 31, 1993, the Bank serviced, primarily for others, approximately 32,000 mortgages with an aggregate principal balance of approximately $1.4 billion. The Company's banks also provide commercial banking services to individuals and businesses, including a wide range of commercial and agricultural loans, deposit, checking and savings accounts, personal and corporate trust services and investment management, and securities and investment services through selected banking locations in the State of Arkansas. Growth Strategy The Company's growth strategy is to expand in its primary market area of the State of Arkansas, by capitalizing on its recent entry into Northwest Arkansas, one of the fastest growing areas in the state, and emphasizing commercial and agricultural lending in that area, and by expanding through further banking acquisitions where the Company believes the acquired assets can be redeployed into higher yielding credit card loans and other retail banking services. COMPETITION The activities engaged in by the Company and its subsidiaries are highly competitive. In all aspects of its business, the Company encounters intense competition from other banks, lending institutions, credit unions, savings and loan associations, brokerage firms, mortgage companies, industrial loan associations, finance companies, and several other financial and financial service institutions. The amount of competition among commercial banks and other financial institutions has increased significantly over the past few years since the deregulation of the banking industry. The Company's subsidiary banks actively compete with other banks and financial institutions in their efforts to obtain deposits and make loans, in the scope and type of services offered, in interest rates paid on time deposits and charged on loans and in other aspects of commercial banking. Management believes that the single most important competitive factor in the credit card business is price, in the form of interest rates and membership fees charged to cardholders, discount fees charged to participating merchants, and the level of fees and credits shared with members of the agent bank network for their participation in the Bank's network. Maintenance of the Bank's agent bank network is a key element in maintaining the Bank's dominant position in the credit card business in Arkansas. Management believes that the Bank's principal competitive strength in both the Arkansas and national markets for new cardholder business has been its low interest rate charged to cardholders and resulting favorable national recognition. The largest bank holding company in Arkansas, which has substantially greater financial resources than those of the Company, has recently recommenced active marketing as a card issuer for Visa and MasterCard inside and outside Arkansas, after having discontinued such activities several years ago, and has advertised interest rates on its credit cards competitive with the rates charged by the Bank. Management cannot predict the effect on its credit card business of this and other new entrants into the market, but believes the Bank's continuous participation and experience in this market since 1967 provides it with unique marketing and other strengths in competing for new cardholder business. As more credit card issuers have entered the market for merchant customers in Arkansas during the past three years, competition has intensified for merchant customers and their related business, primarily on the basis of price and quality of service. While the Bank's merchant purchase volume has remained flat during the past three years, management believes that most established card issuers in the Arkansas market have experienced declines in their merchant purchase volume as a result of the increased competition. Management expects that the Bank's merchant purchase volume will remain flat or decline in the future as a result of continuing competitive conditions. The Company's banking subsidiaries are also in competition with major national and international retail banking establishments, brokerage firms and other financial institutions within and outside Arkansas. Competition with these financial institutions is expected to increase, especially with the passage of legislation authorizing interstate banking. According to information obtained from the Arkansas Association of Bank Holding Companies, during 1993 there were approximately 35 multi-bank holding companies in Arkansas and an approximately 102 additional single bank holding companies. As of December 31, 1993, the Company was the sixth largest multi- bank holding company in Arkansas, based upon total assets and total deposits. EMPLOYEES As of March 15, 1994, the Company and its subsidiaries had 642 full time equivalent employees. None of the employees are represented by any union or similar groups, and the Company has not experienced any labor disputes or strikes arising from any such organized labor groups. The Company considers its relationship with its employees to be good. EXECUTIVE OFFICERS OF THE COMPANY The following is a list of all executive officers of the Company. All of said officers are elected annually by the Board of Directors. SUPERVISION AND REGULATION THE COMPANY The Company, as a bank holding company, is subject to both federal and state regulation. Under federal law, a bank holding company must generally obtain approval from the Board of Governors of the Federal Reserve System ("FRB") before acquiring ownership or control of the assets or stock of a bank or a bank holding company. Prior to approval of any proposed acquisition, the FRB will review the effect on competition of the proposed acquisition, as well as other regulatory issues. The federal law generally prohibits a bank holding company from directly or indirectly engaging in non-banking activities. This prohibition does not include loan servicing, liquidating activities or other activities so closely related to banking as to be a proper incident thereto. As a bank holding company, the Company is required to file with the FRB an annual report and such additional information as may be required by law. From time to time, the FRB examines the financial condition of the Company and its subsidiaries. The FRB, through civil and criminal sanctions, is authorized to exercise enforcement powers over bank holding companies and non-banking subsidiaries, to limit activities that represent unsafe or unsound practices or constitute violations of law. The Company is subject to certain laws and regulations of the State of Arkansas applicable to bank holding companies, including examination and supervision by the Arkansas Bank Commissioner. Under Arkansas law, a bank holding company is prohibited from owning more than one subsidiary bank, if any subsidiary bank owned by the holding company has been chartered for less than 10 years and, further, requires the approval of the Arkansas Bank Commissioner for any acquisition of more than 10% of the capital stock of any other bank located in Arkansas. No bank acquisition may be approved if, after such acquisition, the holding company would control, directly or indirectly, banks having 25% of the total bank deposits in the State of Arkansas, excluding deposits of other banks and public funds. Bank holding companies located in Arkansas are authorized to acquire banks and bank holding companies located in any of 17 states generally located in the Southern and Midwestern United States. Further, bank holding companies located in any of those states may acquire banks and bank holding companies located in Arkansas, if such state permits bank holding companies located in Arkansas to acquire banks and bank holding companies located in that state on a non-discriminatory basis. SUBSIDIARY BANKS Simmons First National Bank, a national banking association, is subject to regulation and supervision, of which regular bank examinations are a part, by the Office of the Comptroller of the Currency of the United States ("OCC"). Simmons/Jonesboro and Simmons/Lake Village, as state chartered banks, are subject to the supervision and regulation, of which regular bank examinations are a part, by the Federal Deposit Insurance Corporation ("FDIC") and the Arkansas State Bank Department. The lending powers of each of the subsidiary banks are generally subject to certain restrictions, including the amount which may be lent to a single borrower. The subsidiary banks, with numerous exceptions, are subject to the application of the laws of the State of Arkansas, including the limitation of the maximum permissible interest rate on loans. This limitation for general loans is 5% over the Federal Reserve Discount Rate, with an additional maximum limitation of 17% per annum for consumer loans and credit sales. Certain loans secured by first liens on residential real estate and certain loans controlled by federal law (e.g., guaranteed student loans, SBA loans, etc.) are exempt from this limitation; however, a very substantial portion of the loans made by the subsidiary banks, including all credit card loans, are subject to this limitation. All of the Company's subsidiary banks are members of the FDIC, which currently insures the deposits of each member bank to a maximum of $100,000 per deposit relationship. For this protection, each bank pays a statutory assessment to the FDIC each year. Federal law substantially restricts transactions between banks and their affiliates. As a result, the Company's subsidiary banks are limited in making extensions of credit to the Company, investing in the stock or other securities of the Company and engaging in other financial transactions with the Company. Those transactions which are permitted must generally be undertaken on terms at least as favorable to the bank, as those prevailing in comparable transactions with independent third parties. POTENTIAL ENFORCEMENT ACTION FOR BANK HOLDING COMPANIES AND BANKS Enforcement proceedings seeking civil or criminal sanctions may be instituted against any bank, any director, officer, employee or agent of the bank, that is believed by the federal banking agencies to be violating any administrative pronouncement or engaged in unsafe and unsound practices. In addition, the FDIC may terminate the insurance of accounts, upon determination that the insured institution has engaged in certain wrongful conduct, or is in an unsound condition to continue operations. Recent legislation has significantly expanded the enforcement powers of the federal banking agencies and increased the penalties for violations of the law and regulations. RISK-WEIGHTED CAPITAL REQUIREMENTS FOR THE COMPANY AND THE BANKS After December 31, 1992, banking organizations (including bank holding companies and banks) were required to meet a minimum ratio of Total Capital to Total Risk-Weighted Assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. A well capitalized institution is one that has at least a 10% "total risk based capital" ratio. For a tabular summary of the Company and the subsidiary banks' risk-weighted capital ratios, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital." A banking organization's qualifying total capital consists of two components: Tier 1 Capital (core capital) and Tier 2 Capital (supplementary capital). Tier 1 Capital is an amount equal to the sum of common shareholders' equity, certain preferred stock and the minority interest in the equity accounts of consolidated subsidiaries. For bank holding companies, goodwill may not be included in Tier 1 Capital after December 31, 1992. Identifiable intangible assets may be included in Tier 1 Capital for banks and bank holding companies, in accordance with certain further requirements. At least 50% of the banking organization's total regulatory capital must consist of Tier 1 Capital. Tier 2 Capital is an amount equal to the sum of the qualifying portion of the allowance for loan losses, certain preferred stock not included in Tier 1, hybrid capital instruments (instruments with characteristics of debt and equity), certain long term debt securities and eligible term subordinated debt, in an amount up to 50% of Tier 1 Capital. The eligibility of these items for inclusion as Tier 2 Capital is subject to certain additional requirements and limitations of the federal banking agencies. Under the risk-based capital guidelines, balance sheet assets and certain off-balance sheet items, such as standby letters of credit, are assigned to one of four risk weight categories (0%, 20%, 50%, or 100%), according to the nature of the asset, its collateral or the identity of the obligor or guarantor. The aggregate amount in each risk category is adjusted by the risk weight assigned to that category, to determine weighted values, which are then added to determine the total risk-weighted assets for the banking organization. For example, an asset, such as a commercial loan, assigned to a 100% risk category, is included in risk-weighted assets at its nominal face value, but a loan secured by a one-to-four family residence is included at only 50% of its nominal face value. The applicable ratios reflect capital, as so determined, divided by risk-weighted assets, as so determined. RECENT LEGISLATION FOR BANK HOLDING COMPANIES AND BANKS The Federal Deposit Insurance Corporation Improvement Act ("FDICIA"), enacted in 1991, requires the FDIC to increase assessment rates for insured banks and authorizes one or more "special assessments", as necessary for the repayment of funds borrowed by the FDIC or any other necessary purpose. As directed in FDICIA, the FDIC has adopted a transitional risk-based assessment system, under which the assessment rate for insured banks will vary, according to the level of risk incurred in the bank's activities. The risk category and risk-based assessment for a bank is determined from its classification, pursuant to the regulation, as well capitalized, adequately capitalized or undercapitalized. FDICIA substantially revised the bank regulatory provisions of the Federal Deposit Insurance Act and other federal banking statutes, requiring federal banking agencies to establish capital measures and classifications. Pursuant to the regulations issued under FDICIA, a depository institution will be deemed to be well capitalized if it significantly exceeds the minimum level required for each relevant capital measure; adequately capitalized if it meets each such measure; undercapitalized if it fails to meet any such measure; significantly undercapitalized if it is significantly below any such measure; and critically undercapitalized if it fails to meet any critical capital level set forth in regulations. The federal banking agencies must promptly mandate corrective actions by banks that fail to meet the capital and related requirements, in order to minimize losses to the FDIC. On December 1, 1992, the Company was advised by the FDIC and OCC that the subsidiary banks had been classified as well capitalized under these regulations. The federal banking agencies are required by FDICIA to prescribe standards for banks and bank holding companies, relating to operations and management, asset quality, earnings, and stock valuation and compensation. A bank or bank holding company that fails to comply with such standards will be required to submit a plan designed to achieve compliance. If no plan is submitted or the plan is not implemented, the bank or holding company would become subject to additional regulatory action or enforcement proceedings. A variety of other provisions included in FDICIA may affect the operations of the Company and the subsidiary banks, including new reporting requirements, revised regulatory standards for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch. ITEM 2. ITEM 2. PROPERTIES. The principal properties of the Company and the Bank consist of an eleven-story office building, located in the central business district of the City of Pine Bluff, Arkansas. Originally constructed in 1929, the entire building has since been completely renovated and modernized. The building is comprised of approximately 107,000 square feet of floor space, approximately 7,474 square feet of which is leased to various tenants as office space. The office building is situated on approximately one-fourth of a city block, the remainder of which, together with approximately one additional city block of adjacent property, is presently being used as a parking complex for customers of the Company and its subsidiaries, tenants of the Company and its subsidiaries and their customers, and the public. Additional office space was made available in 1980, with the renovation of a storage facility to provide a 9,601 square foot office complex, now housing the Company and its subsidiary real estate and investment departments. In 1992, additional office space was made available for the Bank's activities, when the Bank purchased a three-story concrete office building, containing approximately 27,000 square feet of space, across the street from its main bank building in Pine Bluff, Arkansas. The Bank leased a portion of the building prior to purchasing the building. In 1993, an additional 6,000 square feet were made available when the Company leased a three-story brick building adjoining the one purchased in 1992. This building was later purchased also. This added another 5,000 square feet of storage in addition to the office space for a total of approximately 11,000 square feet. This facility houses the Company's student loan operation. The Company is in the process of renovating the building purchased in 1992 and plans are to move into that space in late 1994. The Company and the Bank also operate eight drive-in banking facilities, located throughout the city of Pine Bluff, Arkansas, and banking facilities at Watson Chapel, White Hall and Sherrill, Arkansas, as well as the newly acquired offices at Fort Smith, Rogers, Springdale, and Bella Vista, Arkansas. The largest banking facility comprises approximately 4,200 square feet of floor space, and the smallest comprises approximately 300 square feet. The principal property of Simmons/Lake Village consists of a one-story building located in the central business area of the City of Lake Village, comprising approximately 6,000 square feet of floor space. The principal property of Simmons/Jonesboro consists of a three-story building, located in the central business district of the City of Jonesboro, Arkansas, comprising approximately 47,108 square feet of floor space, 14,252 feet of which is available for lease. In addition, Simmons/Jonesboro operates two drive-in banking facilities located in that city. All of the above properties are owned in fee simple and unencumbered, except (a) approximately one-fourth city block in Pine Bluff, which is leased from various persons for terms expiring in 2007 with options to extend for an additional 50 years, which leased parcels comprise a portion of the parking complex and lie partially under a small portion of a one-floor extension of the office building, (b) the lands upon which five of the drive-in banking facilities in Pine Bluff are situated, one of which parcels is leased for a term expiring in 1994, one in 1995, one in 1997, another in 2010, and the other of which parcels is leased for a term expiring in 2035, and (c) the building and land described in a preceding paragraph for the banking facility in Jonesboro, which has a first mortgage lien to an insurance company with monthly payments of $12,243 including interest at 9.75%. The newest Pine Bluff Office and the Rogers, Springdale, and Fort Smith Stonewood facilities were purchased during 1991. Lease agreements were signed during 1991 for the Bella Vista office, as well as the other two Fort Smith facilities. Terms of the Bella Vista and Fort Smith South lease expire in 1994, and the Fort Smith Central Mall lease expires in 1995. The offices of Simmons First Mortgage Company and the dealer bank division comprise approximately 20,000 square feet of all floors of the three-story leased building, with approximately 36,000 total square feet available for lease. The leasing terms expire in 1997. The Company and its subsidiaries also own or lease various small parcels of land, on some of which are located improvements, the aggregate of which would comprise an insignificant portion of the properties of registrant and its subsidiaries. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In late 1990, the Bank agreed to sell a substantial portion of its mortgage servicing rights. During 1991, the Bank received $1,250,000 in settlement of a lawsuit for failure of the defendant to complete the purchase. In July, 1992, the defendant in the previous suit, brought action against the Bank alleging misrepresentations in the settlement agreement and other causes. The complaint seeks $1,000,000 in compensatory damages and $500,000 in punitive damages, plus attorney's fees. Management has determined, through the investigation of facts and relevant laws, that the plaintiff's suit is without merit and the likelihood of an unfavorable outcome to the Bank is remote. A number of legal proceedings exist in which the Company and/or its subsidiaries are either plaintiffs or defendants or both. Most of the lawsuits involve loan foreclosure activities. The various unrelated legal proceedings pending against the subsidiary banks in the aggregate are not expected to have a material adverse effect on the financial position of the Company and its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS No matters were submitted to a vote of security-holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. ITEM 5. PRICE RANGE OF SOMMON STOCK AND DIVIDEND INFORMATION The Common Stock is traded and quoted on the over-the-counter NASDAQ National Market System under the symbol "SFNCA." Prior to October 26, 1992, the Common Stock was traded on the NASDAQ over-the-counter market. The following table sets forth, for all the periods indicated, cash dividends paid, and the high and low bid prices for the Common Stock as reported by NASDAQ for periods prior to October 26 1992. Price information for periods prior to that date are inter-dealer prices, without retail mark-up, mark-down or commissions paid, and may not necessarily reflect actual transactions. Price information for periods on and after October 26, 1992 reflect the last sale price as reported by NASDAQ. Prior to 1993, historically, the Common Stock had not been actively traded. All price quotations and dividend information have been restated to reflect the 100% stock dividend on the Common Stock effected June 5, 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company is a bank holding company, comprised of three commercial bank subsidiaries, with $738.8 million in assets, as of December 31, 1993. The Company achieved record earnings performance in 1993. For the year ended December 31, 1993, net income totaled $9.4 million, a $1.9 million, or 25.7%, increase over 1992 net income of $7.5 million. Return on average assets was 1.33% in 1993, compared to 1.09% in 1992, and .84% in 1991. Return on average equity was 14.03% in 1993, compared to 15.43% in 1992, and 12.50% in 1991. On a per share basis, net income for 1993 was $2.78, compared to $2.60 in 1992 and $1.89 in 1991. Dividends for 1993 and 1992 were $.40, compared to dividends of $.37 in 1991. Stockholders' equity at December 31, 1993, was $75.3 million, an increase of 24.1% over the 1992 amount. On December 24, 1991, an additional 72,378 shares as (adjusted to reflect the 100% stock dividend in June 1992) of common stock were issued to the Company's employee stock ownership plan for cash in the amount of $923,000. The growth in capital is attributable to the Company's record earnings and, to a larger extent, the issuance of 805,000 shares of the Company's common stock at $22.00 per share during the second quarter of 1993. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. ACQUISITIONS In December 1990, Simmons First National Bank, the lead bank of the Company, entered into an agreement with the Resolution Trust Corporation ("RTC") to acquire selected assets and deposits of four offices of a closed savings and loan association located in Northwest Arkansas. The Bank assumed approximately $77.5 million in deposits through acquired offices located in Fort Smith, Bella Vista, Rogers, and Springdale, Arkansas. These offices became full service branches of the Bank and created an opportunity for the Bank to provide banking services in one of the fastest growing areas in Arkansas. In July 1991, Bank entered into an agreement with the RTC to acquire selected assets and deposits of three offices of a savings and loan association, of which two offices were located in Fort Smith and one was located in Pine Bluff, Arkansas. The deposits in the Pine Bluff office were consolidated into the existing operations, while the two Fort Smith offices became full service branches of the Bank. In September 1991, the Bank entered into an agreement with the RTC to acquire selected assets and deposits of an office of a savings and loan association located in Pine Bluff, Arkansas. In March 1992, another agreement was reached between the Bank and the RTC for the acquisition of selected assets and deposits of an office of another savings and loan association in Pine Bluff. These offices became full service branches of the Bank. The Bank assumed approximately $83.0 million in deposits through these acquisitions in 1991 and 1992, and further expanded its operations in Northwest Arkansas. INCOME STATEMENT REVIEW FOR THE YEARS 1993, 1992 AND 1991 In 1993, the Company reported record net earnings of $9.4 million, and record earnings per share of $2.78. This compares to then-record net earnings of $7.5 million, and then-record earnings per share of $2.60, reported in 1992. The earnings increase in 1993 was a result of an increase in net interest income and non-interest income, which again was partially offset by an increase in non-interest expense. Net Interest Income Net interest income, the Company's principal source of earnings, is the difference between the income generated by earning assets and the total interest cost of the deposits and borrowings obtained to fund those assets. Factors that determine the level of net interest income include the volume of earning assets and interest-bearing liabilities, yields earned and rates paid, the level of non-performing loans, and the amount of non-interest bearing liabilities supporting earning assets. Net interest income is analyzed in the discussion and tables below on a fully tax equivalent basis. The adjustment to convert certain income to a fully taxable equivalent basis consists of dividing tax exempt income by one minus the federal income tax rate (34% for 1993, 1992 and 1991). For the year ended December 31, 1993, net interest income on a fully tax equivalent basis was $29.8 million, an increase of approximately $2.2 million, or 7.9%, from 1992 net interest income. The increase in net interest income resulted primarily from a more precipitous drop in rates paid on interest bearing liabilities than the related decline in yields on earning assets. For the year ended December 31, 1992, net interest income on a fully tax equivalent basis increased approximately $4.2 million, or 18.0%, from comparable figures in 1991. This increase in net interest income is primarily attributable to an increase in earning assets related to the deposit acquisitions in late 1990, 1991 and 1992. The tables below reflect an analysis of net interest income on a fully taxable equivalent basis for the years ended December 31, 1993, 1992 and 1991, respectively, as well as changes in fully taxable equivalent net interest income for the years 1993 vs. 1992 and 1992 vs. 1991. The following table shows for each major category of earning assets and interest bearing liabilities the average amount outstanding, the interest earned or expensed on such amount, and the average rate earned or expensed for each of the years in the three-year period ending December 31, 1993. The table also shows the average rate earned on all earning assets, the average rate expensed on all interest bearing liabilities, the net interest spread and the net interest margin for the same periods. The analysis is presented on a fully taxable equivalent basis. Nonaccrual loans were included in average loans for the purpose of calculating the rate earned on total loans. Under Financial Accounting Standard ("SFAS") 91, loan fees and related costs are deferred and amortized as part of interest income. Non-accrual loans are included in above totals. The following table shows changes in interest income and interest expense, resulting from changes in volume and changes in interest rates for each of the years ended December 31, 1993 and 1992, as compared to prior years. The changes in interest rate and volume have been allocated to changes in average volume and changes in average rates, in proportion to the relationship of absolute dollar amounts of the change in rate and volume. Provision for Loan Losses The provision for loan losses represents management's determination of the amount necessary to be charged against the current period's earnings, in order to maintain the allowance for loan losses at a level which is considered adequate, in relation to the estimated risk inherent in the loan portfolio. The provision for 1993 was $3.0 million, a decrease of $.7 million, or 19.7%, when compared to the provision in 1992. The provision for 1992 was $3.7 million, an increase of $.2 million, or 5.3%, from 1991. The increase in 1992 from 1991 relates primarily to increases in the provision for real estate mortgage and construction loans. Non-Interest Income Total non-interest income reached $26.1 million in 1993, compared to $25.6 million in 1992 and $23.1 million in 1991. Non-interest income can generally be broken down into three main sources: fee income, which includes service charges on deposits, trust fees, credit card fees, and loan servicing fees; income on the sale of mortgage loans and trading account profits; and any gain or loss on the sale of securities. The table below shows non-interest income for the years ended December 31, 1993, 1992 and 1991, respectively, as well as changes in 1993 from 1992 and in 1992 from 1991. Income Taxes The provision for income taxes for 1993 was $3.5 million, compared to $2.9 million in 1992 and $1.9 million in 1991. The effective income tax rates for the years ended 1993, 1992 and 1991 were 27.0%, 28.0% and 26.7%, respectively. Management adopted SFAS No. 109 retroactively to January 1, 1989, and its implementation did not have a material impact on net income on stockholders' equity. BALANCE SHEET REVIEW FOR THE YEARS 1993 AND 1992 Loan Portfolio The Company's loan portfolio averaged $395.7 million during 1993 and $360.4 million during 1992. As of December 31, 1993, total loans were $394.4 million, compared to $367.7 million on December 31, 1992. The most significant components of the loan portfolio were loans to individuals, in the form of credit card loans, student loans, and single family residential real estate loans. The Company seeks to manage its credit risk by diversifying its loan portfolio, determining that borrowers have adequate sources of cash flow for loan repayment without liquidation of collateral, obtaining and monitoring collateral, providing an adequate allowance for loan losses, and regularly reviewing loans through the independent loan review process. The loan portfolio is diversified by borrower, purpose, industry and, in the case of credit card loans, which are unsecured loans, by geographic region. The Company seeks to use diversification within the loan portfolio to reduce credit risk, thereby minimizing the adverse impact on the portfolio, if weaknesses develop in either the economy or a particular segment of borrowers. Collateral requirements are based on credit assessments of borrowers and may be used to recover the debt in case of default. The Company uses the allowance for loan losses as a method to value the loan portfolio at its estimated collectible amount. Loans are regularly reviewed, to facilitate identification and monitoring of deteriorating credits. Consumer loans consist of credit card loans, student loans and other consumer loans. Consumer loans were $270.8 million at December 31, 1993, or 68.6% of total loans, compared to $252.9 million, or 68.7% of total loans at December 31, 1992. At year end, 1993, credit card loans were $168.7 million, or 42.7% of total loans, versus $162.3 million, or 44.1% of total loans at December 31, 1992. The increase relates, in part, to the increased demand resulting from the Company's capitalizing on national media coverage of the Bank's having one of the lowest credit card rates in the United States. The lead Bank has provided diversified credit card services since 1967, when it became the first Arkansas bank to issue internationally accepted credit cards. The Bank is a member of both the Visa and Mastercard associations, and at April 30, 1993, was ranked 67th among all U.S. banks, based on the number of cardholders in such banks. The Bank generated income from its credit card operation primarily from interest charged on daily balances and from annual membership and other fees paid by cardholders, from discounts paid by merchants on purchases made with the Bank's cards, and from interchange fees paid by depository and agent banks for whom the Bank processes credit card transactions. Since 1985, when it began receiving national recognition about the low interest rates charged on cards issued by the Bank, the Bank has provided these services to selected customers located throughout the United Sates. Credit card customers reside in all 50 states, the District of Columbia and certain U.S. territories. Approximately 70% of these customers reside outside the State of Arkansas, representing approximately 70% of aggregate outstanding credit card balances. The following table reflects the growth of the Bank's credit card business since 1989: At the end of 1993, commercial, agricultural and financial institution loans were $39.2 million, or 9.9% of total loans, a 6.2% increase from 1992 year end's $36.9 million. Real estate construction and land development loans at December 31, 1993, were $6.3 million, or 1.6% of total loans, compared to $4.7 million, or 1.3% of total loans at the end of 1992. Single family real estate loans at December 31, 1993 were $36.7 million, or 9.3% of total loans, compared to $42.2 million, or 11.46% of total loans at December 31, 1992. The amount of loans outstanding at the indicated dates are reflected in the following table, according to type of loan. The following table reflects the remaining maturities of loans at December 31, 1993. The following table reflects for the above loans, the amounts which have predetermined interest rates and the amounts which have floating interest rates due after one year at December 31, 1993. Asset Quality Nonperforming loans are comprised of (a) non-accrual loans, (b) loans which are contractually past due 90 days and (c) other loans whose terms have been restructured, to provide a reduction or deferral of interest or principal, because of a deterioration in the financial position of the borrower. The subsidiary banks recognize income principally on the accrual basis of accounting. When loans are classified as nonaccrual, the accrued interest is charged off, and no further interest is accrued. Loans, excluding credit card loans, are placed on a nonaccrual basis either: (1) when there are serious doubts regarding the collectibility of principal or interest, or (2) when payment of interest or principal is 90 days or more past due and either (i) not fully secured or (ii) not in the process of collection. If a loan is determined by management to be uncollectible, the portion of the loan determined to be uncollectible is then charged to the allowance for loan losses. Credit card loans are classified as sub-standard when payment of interest or principal is 90 days past due. Litigation accounts are placed on non-accrual until such time as deemed uncollectable. Credit card loans are charged off when payment of interest or principal exceeds 180 days past due, but are turned over to the credit card recovery department, to be pursued until such time as they are determined, on a case-by-case basis, to be uncollectible. The following tables present information concerning nonperforming assets, including nonaccrual and restructured loans and other real estate owned. Approximately $347,000 and $363,000 of interest income would have been recorded for the periods ended December 31, 1993 and 1992, respectively, if the nonaccrual loans had been accruing interest in accordance with their original terms. There was no interest income on the nonaccrual loans recorded for the period ended December 31, 1993. Allowance for Loan Losses An analysis of the allowance for loan losses for the last five fiscal years is shown in the table below: The amounts of additions to the allowance during the year 1993 were based on management's judgment, with consideration given to the composition of the portfolio, historical loan loss experience, assessment of current economic conditions, past due loans, loans which could be future problems and net losses from loan charge-offs for the past five years. It is management's practice to review the allowance on a monthly basis, to determine whether additional provisions should be made to the allowance after considering the factors noted above. The Bank's senior loan committee, comprised of outside directors, has oversight responsibility for approving commercial and individual loans in excess of $100,000 unsecured, and $200,000 secured, and monitoring loan delinquencies, the status of non-performing assets and the evaluation of allowance for loan losses. In addition, the committee ratifies and/or approves loans made by other banking subsidiaries in excess of 13.5% of any such bank's equity capital. The Bank's agricultural committee, composed of outside directors whose occupations are closely tied to the farming industry, have oversight responsibility for the agricultural loan portfolio. The responsibilities and approval authorities of this committee are the same as the senior loan committee, as they pertain to agricultural loans. The Company's special services group is responsible for serving all subsidiaries of the Company in the audit, loan review, and compliance areas. In the area of loan review, periodic audits of each subsidiary are scheduled for the purpose of evaluating asset quality, adequacy of loan losses, and effectiveness of loan administration. The special services group prepares loan review reports, which identify deficiencies, establish recommendations for improvement, and outline management's proposed action plan for curing the deficiencies. This report is provided to a corporate audit committee, which includes outside members of the Company's Board of Directors and selected senior affiliate directors. The audit committee monitors the reported items until the exceptions are cleared. Based on the above-noted procedures, management is of the opinion that the allowance at December 31, 1993, of $7.4 million is adequate. While management believes the current allowance is adequate, changing economic conditions and other conditions may require future additions to the allowance. Moreover, the allowance is subject to regulatory examination and determination as to adequacy. Although not presently anticipated, adjustments to the allowance may result from regulatory examinations. The Company allocates the allowance for possible loan losses according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the categories of loans set forth in the tables below. Investments and Securities The Company's securities portfolio is the second largest component of earning assets and provides a significant source of revenue. Securities are classified as investments when the Company has the ability and intent to hold them to maturity. The portfolio is held for long-term profitability and is stated at adjusted cost. In considering whether securities can be held until maturity, management considers whether there are conditions which would impair its ability to hold such securities until maturity. At present, management is not aware of any such conditions. Management has reviewed the securities individually, to determine whether there are permanent declines identified in net realizable values, and write downs have been recorded, when required. Investment securities were $198.6 million at December 31, 1993, compared to $203.0 million at December 31, 1992. The Company's philosophy regarding investments is conservative, based on investment type and maturity. All investments are anticipated to be held to maturity and are structured on a ten year ladder, with a minimum of 30% of the securities maturing in the first two years. Investments in the portfolio include U.S. Treasury securities, U.S. government agencies, and municipalities. As of December 31, 1993, $146.0 million, or 73.5%, of the portfolio was invested in U.S. Treasury securities and obligations of U.S. government agencies, of which $54.4 million, or 37.3%, was invested in securities with maturities of one year or less, and $80.8 million, or 55.3%, was invested in securities with maturities of one to five years. To reduce the Company's income tax burden, an additional $49.4 million, or 24.9%, of the total securities portfolio was invested in tax-exempt obligations of state and political subdivisions. There were no securities of any one issuer exceeding ten percent of the Company's stockholders' equity at December 31, 1993. The Company has approximately $3.2 million, or 1.6%, in GNMA and other securities. At December 31, 1993, the Company had no collateralized mortgage obligations in its securities portfolio. It is the Company's general policy to not invest in derivative type investments. As of December 31, 1993, the investment portfolio had gross unrealized gains of $9.2 million and $0.1 million of gross unrealized losses. Net gains from the sale of securities for 1993 were $140,000, up from net gains of $59,000 and $50,000 in 1992 and 1991, respectively. The table below presents the carrying value and the fair value of investment securities for each of the years indicated. The following table reflects the amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, the weighted average yields (for tax-exempt obligations on a fully taxable basis, assuming a 34% tax rate) of such securities and the taxable equilvalent adjustment used in calculating the yields. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties. As of January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires the classification of securities into one of three categories: Trading, Available for Sale or Held to Maturity. Management will determine the appropriate classification of debt securities at the time of purchase and re-evaluate the classifications periodically. Trading account securities are used to provide inventory for resale. These securities will be carried at market value and will be included in short-term investments. Gains and losses, both realized and unrealized, are reflected in earnings. Debt securities are classified as Held to Maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to Maturity securities will be stated at amortized cost. Securities not classified as Trading or Held to Maturity will be classified as Available for Sale. Available for sale securities will be stated at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. The Company may sell these securities prior to maturity in response to liquidity demands. They also may be used as a means of adjusting the interest rate sensitivity of the Company's balance sheet, through sale and reinvestment. As of January 1, 1994, the adoption of FASB No. 115 resulted in a net increase in stockholders' equity of approximately $946,000. This increase in stockholders' equity will adjust in future periods, as changes in market conditions occur. Trading Portfolio The Company's trading account is established and maintained for the benefit of the dealer bank division. All activities in the account are performed by dealer bank personnel solely for operations in that division. The trading account is typically used to provide inventory for resale and is not used to take advantage of short-term price movements. Deposits and Short-Term Borrowings Total average deposits for 1993 were $585.6 million, compared to $578.1 million in 1992. A significant portion of the average deposit increases for that period is attributable to the deposit acquisitions in 1990, 1991 and 1992. The year-end balances of certificates of deposits over $100,000 were $61.4 million in 1993, compared to $61.0 million in 1992. The following table reflects the classification of the average deposits and the average rate paid on each deposit category which are in excess of 10 percent of average total deposits for the three years ended December 31, 1993. The following table sets forth by time remaining to maturity, deposits (exclusive of regular savings) in amounts of $100,000 or more at December 31, 1993 and 1992, respectively. Federal funds purchased and securities sold under agreements to repurchase were $26.3 million at December 31, 1993, as compared to $39.2 million at December 31, 1992. Other short-term borrowings, consisting of U.S. Treasury Note borrowings, increased at December 31, 1993, to $5.0 million, as compared to $2.9 million at December 31, 1992. The Company has historically funded its growth in earning assets through the use of core deposits, large certificates of deposits from local markets, and federal funds purchased. On May 12, 1993, the Company issued 700,000 shares of Class A Common Stock. And on June 10, 1993, the Company issued an additional 105,000 shares. The net proceeds to the Company stockholders' equity after expenses was $16.1 million. Management anticipates that these sources will provide necessary funding in the foreseeable future. It is the Company's general policy to avoid the use of brokered deposits. Long Term Debt The Company's long-term debt was $12.2 million at December 31, 1993 and 1992, respectively. The Company's Capital Notes due June 30, 1997, of which $11.0 million were outstanding at December 31, 1993 and 1992, respectively, are the major component of the Company's long-term debt. Interest on the Capital Notes is payable quarterly, and the interest rate is adjusted quarterly to the then prime rate offered by Chase Manhattan in New York. At December 31, 1993, the Chase Manhattan prime rate was 6%. Capital Appropriate capital management is essential to finance future growth and maintain the confidence of deposit customers, investors, and banking regulatory agencies. The Federal Reserve Board has approved new risk-based guidelines which establish a risk-adjusted ratio, relating capital to different categories of assets and off-balance sheet exposures, such as loan commitments and standby letters of credit. With respect to capital, the guidelines place a strong emphasis on tangible common stockholders' equity as the core element of the capital base, with appropriate recognition of other components of capital. The guidelines set a minimum risk-adjusted ratio for total capital of 8.0% by the end of 1993. At December 31, 1993, the Tier 1 Capital ratio was 17.2%, while the Company's risk-adjusted ratio for total capital, as of December 31, 1993, was 20.0%, both of which exceed the capital minimums established in the new risk-based capital requirements. The risk-based capital ratios showed improvement over December 31, 1992, primarily due to a reduction in risk-weighted assets, resulting from the sale of approximately $70 million in off-balance sheet recourse mortgage loan servicing. The Company's risk-based capital ratios at December 31, 1993 and 1992 are presented below, followed by the capital ratios of each of the three bank subsidiaries, as of December 31, 1993. LIQUIDITY AND INTEREST RATE SENSITIVITY Parent Company The Company has leveraged its investment in subsidiary banks and depends upon the dividends paid to it, as the sole shareholder of the subsidiary banks, as a principal source of funds for debt service requirements. At December 31, 1993, retained earnings of the Company's subsidiaries were approximately $52.7 million, of which approximately $11.9 million was available for the payment of dividends to the Company without regulatory approval. In addition to dividends, other sources of liquidity for the Company are the sale of equity securities and the borrowing of funds. Banking Subsidiaries Generally speaking, the Company's banking subsidiaries rely upon net inflows of cash from financing activities, supplemented by net inflows of cash from operating activities, to provide cash used in their investing activities. As is typical of most banking companies, significant financing activities include: deposit gathering; use of short-term borrowing facilities such as federal funds purchased and repurchase agreements; and the issuance of long-term debt. The banks' primary investing activities include loan originations and purchases of investment securities, offset by loan payoffs and investment maturities. Liquidity represents an institution's ability to provide funds to satisfy demands from depositors and borrowers, by either converting assets into cash or accessing new or existing sources of incremental funds. It is a major responsibility of management to maximize net interest income within prudent liquidity constraints. Internal corporate guidelines have been established to constantly measure liquid assets, as well as relevant ratios concerning earning asset levels and purchased funds. Each bank subsidiary is also required to monitor these same indicators and report regularly to its own senior management and board of directors. At year end, each bank was within established guidelines, and total corporate liquidity was strong. At December 31, 1993, cash and due from banks, investment securities, and federal funds sold and securities purchased under agreements for resale were 33.5% of total assets, as compared to 37.80% at December 31, 1992. Interest Rate Sensitivity Management continuously reviews the Company's exposure to changes in interest rates. Among the factors considered during its evaluations are changes in the mix of earning assets, growth of earning assets, interest rate spreads and repricing periods. Management forecasts and models the impact various interest rate fluctuations would have on net interest income. One such model measures the interest rate sensitivity gap, which presents, at a particular point in time, the matching of interest rate sensitive assets with interest rate sensitive liabilities. As shown in the schedule below, the cumulative rate sensitive assets to rate sensitive liabilities at six months and one year, respectively, was 112.73% and 113.12%. A financial institution is considered to be liability sensitive, or as having a negative GAP,when the amount of its interest bearing liabilities maturing or repricing within a given time period exceeds the amount of its interest earning assets also maturing or repricing within that time period. Conversely, an institution is considered to be asset sensitive, or as having a positive GAP, when the amount of its interest bearing liabilities maturing and repricing is less than the amount of itsinterest earning assets also maturing or repricing during the same period. Generally, in a falling interest rate environment, a negative GAP should result in an increase in net interest income, and in a rising interest rate environment this negative GAP should adversely affect net interest income. The converse would be true for a positive GAP. The long-term effect of rising interest rates would tendto increase net interest income because of the positive gap ratio. However, the negative gap for the short-term would cause a decreasein net interest income, as a result of rising rates for approximately six months. Since conditions change on a daily basis, these theoretical conclusions may not be indicative of actual future results. QUARTERLY RESULTS Selected unaudited quarterly financial information for the latest eight quarters is shown in the table below. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX Page Independent Accountants' Report . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets December 31, 1993 and 1992 . . . . . . . . Consolidated Statements of Income Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 1993, 1992, and 1991 . . . . . . . . Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . . . . Note: Supplementary Data may be found in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Quarterly Results" on page 51 hereof. INDEPENDENT ACCOUNTANTS' REPORT ------------------------------- Board of Directors Simmons First National Corporation Pine Bluff, Arkansas We have audited the accompanying consolidated balance sheets of SIMMONS FIRST NATIONAL CORPORATION as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SIMMONS FIRST NATIONAL CORPORATION as of December 31, 1993 and 1992, the results of its operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 20 to the financial statements, in 1993, the Company retroactively adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." BAIRD, KURTZ & DOBSON Pine Bluff, Arkansas January 28, 1994 NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS Simmons First National Corporation provides a full range of banking and mortgage services to individual and corporate customers through its subsidiaries and branch banks in Arkansas. The Company is subject to competition from other financial institutions. The Company also is subject to the regulation of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities. BASIS OF FINANCIAL STATEMENT PRESENTATION The financial statements have been prepared in accordance with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, as of the date of the balance sheet, and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowances for loan losses and the valuation of foreclosed assets. In connection with the determination of the allowances for loan losses and the valuation of foreclosed assets, management obtains independent appraisals for significant properties. Management believes that the allowances for losses on loans and the valuation of foreclosed assets are adequate. While management uses available information to recognize losses on loans and the valuation of foreclosed assets, future losses may be accruable, based on changes in economic conditions, particularly in Arkansas. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks' allowances for losses on loans and valuation of foreclosed assets. Such agencies may require the Bank to recognize additional losses, based on their judgments of information available to them at the time of their examination. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Simmons First National Corporation and its subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. RECLASSIFICATIONS Various items within the accompanying financial statements for previous years have been reclassified, to provide more comparative information. These reclassifications had no effect on net earnings. CASH EQUIVALENTS The Company considers all amounts due from banks and federal funds sold and securities purchased under agreements to resell as cash equivalents. The banking subsidiaries are required to maintain average reserve balances with the Federal Reserve Bank, based on a percentage of deposits. The average amounts of those reserve balances for the years ended December 31, 1993 and 1992, were $6,312,000 and $3,807,000, respectively. The Federal Reserve requirement on transaction account reserves dropped from twelve to ten percent during 1993. Generally, federal funds and securities purchased under agreement to resell are purchased and sold for varying periods up to thirty days. These securities are purchased from other financial institutions and are held in the name of Simmons First National Bank at the Federal Reserve Bank until maturity of the agreement. INVESTMENT SECURITIES Investments in debt securities intended to be held until maturity are valued at cost, and adjusted for amortization of premium and accretion of discount. Premiums and discounts on investment securities are amortized (deducted) and accreted (added), respectively, to interest income on the constant-yield method over the period to maturity of the related securities. Interest and dividends on investment securities are reported in operating income. Realized gains and losses on the sale of investment securities are reported separately as securities gains (losses). Gains and losses on security transactions are recognized, using the specific identification method. In considering whether securities can be held until maturity, management considers whether there are conditions which would impair its ability to hold such securities until maturity. At present, management is not aware of any such conditions. Management has reviewed the securities individually, to determine whether there are permanent declines in values, and write downs have been recorded, if required. MORTGAGE LOANS HELD FOR SALE Loans held for sale are carried at the lower of cost or market. Market is determined, based upon the agreed upon price at date of purchase of the loans. ASSETS HELD FOR TRADING Securities held for trading are carried at fair value, based on quoted market price or dealer quotes. Gains and losses recognized upon the sales are determined on a specific identification basis. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is increased by provisions charged to expense and reduced by loans charged off, net of recoveries. The allowance is maintained at a level considered adequate to provide for potential loan losses, based on management's evaluation of the loan portfolio, as well as on prevailing and anticipated economic conditions and historical losses by loan category. General reserves have been established, based upon the aforementioned factors and allocated to the individual loan categories. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of interest is doubtful. ALLOWANCE FOR LOSSES ON RESIDENTIAL MORTGAGE LOANS SERVICED FOR OTHERS A recourse loss allowance on loans serviced for others, including Veterans Administration loans included in Government National Mortgage Association and Federal National Mortgage Association pools, is provided, based on management's evaluation of historical losses, as well as prevailing and anticipated economic conditions. PREMISES AND EQUIPMENT Depreciable assets are stated at cost, less accumulated depreciation. Depreciation is charged to expense, using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are capitalized and amortized by the straight-line method over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. FORECLOSED ASSETS HELD FOR SALE Assets acquired by foreclosure or in settlement of debt and held for sale are valued at estimated fair value, as of the date of foreclosure, and a related valuation allowance is provided for estimated costs to sell the assets. Management evaluates the value of foreclosed assets held for sale periodically and increases the valuation allowance for any subsequent declines in fair value. Changes in the valuation allowance are charged or credited to other expense. Assets acquired by foreclosure also include loans upon which the foreclosure process is imminent or has been initiated but not completed and considered in-substance foreclosed. Such assets are carried at estimated fair value, and a related valuation allowance is provided for estimated costs to sell the assets. EXCESS COSTS OVER FAIR VALUE OF NET ASSETS ACQUIRED Unamortized costs of purchased subsidiaries, in excess of the estimated fair value of underlying net tangible assets acquired, aggregated $1,041,000 (originally $2,646,000) at December 31, 1993, and are being amortized over a 20-year period, using the straight-line method. Unamortized costs allocated to the future earnings potential of acquired deposits were $36,000 (originally $730,000) at December 31, 1993, and are being amortized over ten years, using the straight-line method. Amortization expense was $192,000 for 1993, 1992 and 1991. The amount paid to the Resolution Trust Corporation of $1,994,000, to purchase four of the branch operations of First American Savings Bank of Fort Smith, Arkansas, has been allocated, in part, to the future earnings potential of acquired deposits (originally $1,360,000), which will be amortized over ten years, using the straight-line method. Unamortized costs at December 31, 1993, were $944,000. The remaining intangible (originally $634,000) will be amortized over fifteen years, using the yield method. Unamortized costs at December 31, 1993, were $410,000. Amortization for the period ended December 31, 1993, and 1992, was $205,000 and $210,000, respectively. The amount paid to the Resolution Trust Corporation of $684,000, to purchase three of the branch operations of First Savings Bank of Arkansas and one branch of Home Federal Savings Association, has been allocated, in part, to the future earnings potential of acquired deposits (approximately $336,000), which will be amortized over ten years, using the straight-line method. The remaining intangible will be amortized over fifteen years, using the yield method. Amortization for the period ended December 31, 1993, and 1992, was $73,000 and $76,000, respectively. FEE INCOME Periodic bank card fees, net of direct origination costs, are recognized as revenue on a straight-line basis, over the period the fee entitles the cardholder to use the card. Other loan fees, net of direct origination costs, are recognized as revenue on a yield basis over the term of the loans. Income Taxes Deferred tax liabilities and assets are recognized for the tax effects of differences between the financial statement and taxbases of assets and liabilities. A valuation allowance is established to reduce deferred tax assets, if it is more likely than not that a deferred tax asset will not be realized. Earnings Per Common Share Earnings per common share are based on the weighted average number of common shares outstanding during each year. Common share equivalents in the form of employee stock options, were not materially dilutive. On April 13, 1992, the Board of Directors of the Company declared a 100% stock dividend. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. Weighted average shares outstanding were 3,378,200; 2,464,281 and 2,872,378, for 1993, 1992 and 1991, respectively. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), requires that the Company disclose estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions are set forth in Note 21 to the consolidated financial statements. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on and off balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Also, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the fair value. NOTE 2: INVESTMENT SECURITIES The amortized cost and estimated fair value of investments in debt securities are as follows: Maturities of investment securities at December 31, 1993, are as follows: The book value of securities pledged as collateral, to secure public deposits and for other purposes, amounted to $74,492,000 at December 31, 1993, and $63,055,000 at December 31, 1992. The approximate fair value of pledged securities amounted to $79,588,000 at December 31, 1993, and $68,648,000 at December 31, 1992. The book value of securities sold under agreement to repurchase amounted to $152,000 and $693,000 for December 31, 1993 and 1992, respectively. During 1993, there were no securities sold. The gross realized gains of $143,000 and gross realized losses of $3,000 were the result of called bonds. Approximately 18 percent of the state and political subdivisions are rated A or above. Of the remaining securities, most are nonrated bonds and represent small, Arkansas issues, which are evaluated internally for credit worthiness on an ongoing basis. At January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires the classification of securities into one of three categories: Trading, Available for Sale, or Held to Maturity. This resulted in a net increase in stockholders' equity of approximately $946,000. NOTE 3: ACQUISITIONS On July 26, 1991, Simmons purchased from the Resolution Trust Corporation, for $586,000, selected assets and deposits of three offices of First Savings Bank of Arkansas, located in Fort Smith and Pine Bluff. Simmons received $54,500,000 in cash and $60,000 in installment loans and assumed $55,100,000 in deposits. On September 20, 1991, Simmons assumed $17,700,000 in deposits of Savers Savings Associations' Pine Bluff branch and received an equal amount of cash. On March 30, 1992, Simmons acquired selected assets and deposits of a Pine Bluff office of Home Federal Savings Association of Kansas City. Simmons paid $98,000 to assume approximately $10,000,000 in deposits. NOTE 4: LOANS AND ALLOWANCE FOR LOAN LOSSES The various categories are summarized as follows: Loans on which the accrual of interest has been discontinued aggregated $2,813,000 and $4,374,000, at December 31, 1993 and 1992, respectively. If interest on those loans had been accrued, such income would have approximated $347,000 and $507,000 for 1993 and 1992, respectively. NOTE 5: FORECLOSED ASSETS HELD FOR SALE At December 31, 1993 and 1992, foreclosed assets held for sale included $363,000 and $1,225,000 in loans which were considered in-substance foreclosed, respectively. Transactions in the allowance for losses on foreclosed assets were as follows: NOTE 6: PREMISES AND EQUIPMENT Major classifications of premises and equipment, stated at cost, are as follows: NOTE 7: INCOME TAXES The provision for income taxes is comprised of the following components: The tax effects of temporary differences related to deferred taxes shown on the balance sheet were: The valuation allowance relates to the benefits of state income tax carry forwards included in deferred tax assets. A reconciliation of income tax expense at the statutory rate to the Company's actual income tax expense is shown below: NOTE 8: TIME DEPOSITS Time deposits include approximately $61,353,000 and $60,991,000 of certificates of deposit of $100,000 or more, at December 31, 1993 and 1992, respectively. Deposits are the Company's primary funding source for loans and investment securities. The mix and repricing alternatives can significantly affect the cost of this source of funds and, therefore, impact the margin. NOTE 9: LONG-TERM DEBT AND CAPITAL NOTES Long-term debt and capital notes at December 31, 1993 and 1992, consisted of the following components: Capital notes of Simmons First National Corporation are due June 30, 1997, with interest payable quarterly and rates adjusted quarterly to the then prime rate offered by Chase Manhattan in New York, which was adjusted at December 31, 1993, to 6%. Other debt consists of a mortgage note payable to Mutual Benefit Life Insurance Corporation, secured by land and building with a book value of $2,347,000, payable in equal monthly installments of $12,000, including interest at approximately 9.75% per annum. Final payment is due August, 2008. Aggregate annual maturities of long-term debt at December 31, 1993 are: NOTE 10: CAPITAL STOCK In addition to the common stock from which stock has been issued, as shown on the balance sheet, the following classes of stock have been authorized: Class B common stock of $1.00 par value per share, authorized 300 shares: none issued. Class A preferred stock of $100.00 par value per share, authorized 50,000 shares: none issued. Class B preferred stock of $100.00 par value per share, authorized 50,000 shares: none issued. On April 13, 1992, the board of directors of the Company declared a 100% stock dividend to shareholders of record on May 15, 1992, payable on June 5, 1992. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. On May 12, 1993, the Company issued 700,000 shares of Class A Common Stock. And on June 10, 1993, the Company issued an additional 105,000 shares. The net proceeds to the Company stockholders' equity after expenses was $16.1 million. NOTE 11: UNDIVIDED PROFITS The subsidiary banks are subject to a legal limitation on dividends that can be paid to the parent company without prior approval of the applicable regulatory agencies. The approval of the Office of the Comptroller of the Currency is required, if the total of all the dividends declared by a national bank in any calendar year exceeds the total of its net profits, as defined, for that year, combined with its retained net profits of the preceding two years. Arkansas bank regulators have specified that the maximum dividend limit state banks may pay to the parent company without prior approval is 50% of the current year earnings. At December 31, 1993, the bank subsidiaries had $11,900,000 in undivided profits available for payment of dividends to the Company, without prior approval of the regulatory agencies. The most restrictive regulatory capital requirements at December 31, 1993 and 1992, were $35,392,000 and $36,208,000, respectively. The risk-based capital guidelines of the Federal Reserve Board required a minimum risk-adjusted ratio for total capital of 8% by the end of 1992. The Federal Reserve Board has further refined its guidelines to include the definitions for (1) a well-capitalized institution, (2) an adequately capitalized institution, and (3) an undercapitalized institution. The criteria for a well-capitalized institution is one that has at least a 10% "total risk-based capital" ratio, a 6% "Tier 1 risk-based capital" ratio, and a 5% "Tier 1 leverage capital" ratio. At December 31, 1993, each of the three subsidiary banks met the capital standards for a well-capitalized institution. The Company's risk-based capital ratio at December 31, 1993, was 20.01%. NOTE 12: LEASES At December 31, 1993, 1992, and 1991, there were obligations under a number of long-term land and office operating leases, which required minimum annual rentals, aggregating approximately $589,000 for 1993, $580,000 for 1992, and $504,000 for 1991. The leases extend for varying periods, up to the year 2057. Minimum annual rentals under these non-cancelable leases at December 31, 1993, are as follows: The corporate subsidiaries are obligated under equipment leases on a month- to-month basis, which are expected to be renewed and had aggregate annual rentals of approximately $166,000 in 1993, $242,000 in 1992, and $261,000 in 1991. The subsidiaries are also obligated on one-year leases for office and storage space, having aggregate annual rentals of approximately $63,000 in 1993, $113,000 in 1992, and $221,000 in 1991. NOTE 13: TRANSACTIONS WITH RELATED PARTIES At December 31, 1993 and 1992, the subsidiary banks had loans outstanding to executive officers, directors, and to companies in which the banks' executive officers or directors were principal owners, in the amount of $4,687,000 in 1993, and $3,888,000 in 1992. In management's opinion, such loans and other extensions of credit and deposits were made in the ordinary course of business and were made on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons. Further, in management's opinion, these loans did not involve more than normal risk of collectibility or present other unfavorable features. NOTE 14: EMPLOYEE BENEFIT PLANS In October, 1990, the Board of Directors approved the adoption of a 401(k) retirement plan, effective January 1, 1991, covering substantially all employees. Employees may contribute up to 12% of their compensation, with the Company and its subsidiaries matching 25% of the employee's contribution on the first 5% of the employee's compensation. The charges to income for this contribution in 1993, 1992 and 1991 were $106,000, $94,000 and $88,000, respectively. The Company and its subsidiaries have a discretionary profit sharing and employee stock ownership plan covering all employees. The charges to income for the plan were $550,000 for 1993, $485,000 for 1992, and $440,000 for 1991. On May 14, 1990, the Board of Directors adopted an incentive and nonqualified stock option plan. Pursuant to the plan, an aggregate of 140,000 shares were reserved for future issuance by the Company, upon exercise of stock options to be granted to officers and other key employees. The table below summarizes the transactions under the Company's stock option plan: Also, Simmons First National Bank and Simmons First Bank Jonesboro have a deferred compensation agreement with certain active and retired officers. The agreement provides monthly payments which, together with payments from the deferred annuities issued pursuant to the terminated pension plan, equal 50 percent of average compensation prior to retirement or death. The charges to income for the plans were $187,000 for 1993, $120,000 for 1992 and $89,000 for 1991. Such charges reflect the straight-line accrual over the employment period of the present value of benefits due each participant, as of their full eligibility date, using an 8% discount factor. NOTE 15: CONTINGENT LIABILITIES In late 1990, Simmons agreed to sell a substantial portion of its mortgage servicing rights. During 1991, Simmons received $1,250,000 in settlement of a lawsuit, for failure of the defendant to complete the purchase. In July, 1992, the defendant in the previous suit brought action against Simmons, alleging misrepresentations in the settlement agreement and other causes. The complaint seeks $1,000,000 in compensatory damages and $500,000 in punitive damages, plus attorneys' fees. Management has determined, through the investigation of facts and relevant laws, that the plaintiff's suit is without merit and the likelihood of an unfavorable outcome to the bank is remote. Various other unrelated legal proceedings, most of which involve loan foreclosure activity, pending against the Company and/or its subsidiary banks in the aggregate, are not expected to have a material adverse effect on the financial position of the Company and its subsidiaries. Mortgage loans serviced for others totaled $1,395,424,004 and $1,368,748,000 at December 31, 1993 and 1992, respectively, of which mortgage- backed securities serviced totaled $1,123,747,000 and $1,171,757,000 at December 31, 1993 and 1992, respectively. At December 31, 1993, Simmons First National Bank serviced approximately $187,338,000 in Veterans Administration loans subject to certain recourse provisions. A reserve of $310,000 has been established for potential loss obligations, based on management's evaluation of historical losses, as well as prevailing and anticipated economic conditions, giving consideration for specific reserves. Such reserve is included in other liabilities. Below are the transactions in that reserve: NOTE 16: ADDITIONAL CASH FLOW INFORMATION FOR 1993, 1992, AND 1991 NOTE 17: OTHER OPERATING EXPENSE Other non-interest expense consists of the following: NOTE 18: COMMITMENTS AND CREDIT RISK The three subsidiary banks grant agri-business, credit card, commercial, and residential loans to customers throughout the state. Although the banks have a diversified loan portfolio, unsecured debt in the form of credit card receivables comprised approximately 42.8% and 44.1% of the portfolio, as of December 31, 1993 and 1992, respectively. Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the counter party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. At December 31, 1993 and 1992, the Company had outstanding commitments to originate loans aggregating approximately $48,238,000 and $43,699,000, respectively. The commitments extended over varying periods of time, with the majority being disbursed within a one year period. Loan commitments at fixed rates of interest amounted to $12,025,000 and $12,381,000 at December 31, 1993 and 1992, respectively, with the remainder at floating market rates. Letters of credit are conditional commitments issued by the bank subsidiaries of the Company, to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Company had total outstanding letters of credit amounting to $820,000 and $638,000 at December 31, 1993 and 1992, respectively, with terms ranging from 95 days to ten years. Lines of credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Lines of credit generally have fixed expiration dates. Since a portion of the line may expire without being drawn upon, the total unused lines do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit, is based on management's credit evaluation of the counter party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. Management uses the same credit policies in granting lines of credit as it does for on balance sheet instruments. At December 31, 1993, the Company had granted unused lines of credit to borrowers, aggregating approximately $3,615,000 and $132,140,000 for commercial lines and open-end consumer lines, respectively. At December 31, 1992, unused lines of credit to borrowers aggregated approximately $5,160,000 for commercial lines and $131,631,000 for open-end consumer lines, respectively. For the risks related to residential mortgage loans serviced for others, see Note 15. NOTE 19: FUTURE CHANGES IN ACCOUNTING PRINCIPLES As of January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires the classification of securities into one of three categories: Trading, Available for Sale, or Held to Maturity. The adoption of SFAS No. 115 resulted in a net increase in stockholders' equity of approximately $946,000. Management will determine the appropriate classification of debt securities at the time of purchase and re-evaluate the classifications periodically. Trading account securities are used to provide inventory for resale. Debt securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. Securities not classified as held to maturity or trading are classified as available for sale. The Financial Accounting Standards Board recently adopted Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan" which requires that impaired loans be measured, based on the present value of expected cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent. This Statement applies to financial statements for fiscal year 1995. The extent to which the standard will have an impact, if any, on the Company has not been determined. NOTE 20: CHANGE IN ACCOUNTING PRINCIPLES The Company has adopted Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). The Company elected to adopt FAS 109 with a retroactive restatement of stockholders' equity, as of January 1, 1989. The adoption of SFAS 109 had no material impact on 1992, 1991, 1990 and 1989 earnings. NOTE 21: DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments: CASH AND CASH EQUIVALENTS The carrying amount for cash and cash equivalents approximates fair value. INVESTMENTS For securities held as investments and in trading accounts, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated, using quoted market prices for similar securities. The carrying amount of occrued interest receivable approximates its fair value. MORTGAGE LOANS HELD FOR SALE For homogeneous categories of loans, such as mortgage loans held for sale, fair value is estimated, using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. LOANS The fair value of loans is estimated by discounting the future cash flows, using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans with similar characteristics were aggregated for purposes of the calculations. The carrying amount of accrued interest approximates its fair value. The comparative figures for 1993 reflect an increase in value as compared to the carrying value relative to the 1992 figures. DEPOSITS The fair value of demand deposits, savings accounts, NOW accounts, and certain money market deposits is the amount payable on demand at the reporting date (i.e., their carrying amount). The fair value of fixed-maturity time deposits is estimated, using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value. The comparative figures for 1993 show an increase in the fair value of liabilities relative to the carrying value over the 1992 figures. SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE AND OTHER BORROWINGS The carrying amount for securities sold under agreement to repurchase and other borrowings is a reasonable estimate of fair value. LONG-TERM DEBT AND CAPITAL NOTES PAYABLE Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. COMMITMENTS TO EXTEND CREDIT, LETTERS OF CREDIT AND LINES OF CREDIT The fair value of commitments is estimated, using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit and lines of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date. The following table represents estimated fair values of the Company's financial instruments. The fair values of certain of these instruments were calculated by discounting expected cash flows, which method involves significant judgments by management and uncertainties. Fair value is the estimated amount at which financial assets or liabilities could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Because no market exists for certain of these financial instruments and because management does not intend to sell these financial instruments, the Company does not know whether the fair values shown below represent values at which the respective financial instruments could be sold individually or in the aggregate. NOTE 22: CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No items are reportable hereunder. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1 and 2. Financial Statements and any Financial Statement Schedules The financial statements and financial statement schedules listed in the accompanying index to consolidated financial statements and financial statement schedules are filed as part of this annual report. 3. Exhibits The exhibits listed in the accompanying index to exhibits are filed as part of this annual report. (b) Reports on Form 8-K No Current Reports on Form 8-K were filed during the three-month period ended December 31, 1993. SIGNATURES ------------ Pursuant to the requirements of Section 13 or 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. /s/ John L. Rush March 28, 1994 -------------------------------------------- John L. Rush, Secretary Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 28, 1994. Signature Title ----------- ---- /s/ W. E. Ayres Chairman, Chief Executive Officer and Director - ------------------------- W. E. Ayres /s/ J. Thomas May President and Director - ------------------------- J. Thomas May /s/ Barry L. Crow Executive Vice President and Chief Financial - ------------------------- Officer (Principal Financial and Accounting Officer) Barry L. Crow /s/ Donald W. Stone Director - ------------------------- Donald W. Stone /s/ C. Ramon Greenwood Director - ------------------------- C. Ramon Greenwood /s/ David R. Perdue Director - ------------------------- David R. Perdue /s/ Adam B. Robinson Director - ------------------------- Adam B. Robinson /s/ Harry L. Ryburn Director - ------------------------- Harry L. Ryburn /s/ Ben V. Floriani Director - ------------------------- Ben V. Floriani Director - ------------------------- Paul M. Henson ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company is a bank holding company, comprised of three commercial bank subsidiaries, with $738.8 million in assets, as of December 31, 1993. The Company achieved record earnings performance in 1993. For the year ended December 31, 1993, net income totaled $9.4 million, a $1.9 million, or 25.7%, increase over 1992 net income of $7.5 million. Return on average assets was 1.33% in 1993, compared to 1.09% in 1992, and .84% in 1991. Return on average equity was 14.03% in 1993, compared to 15.43% in 1992, and 12.50% in 1991. On a per share basis, net income for 1993 was $2.78, compared to $2.60 in 1992 and $1.89 in 1991. Dividends for 1993 and 1992 were $.40, compared to dividends of $.37 in 1991. Stockholders' equity at December 31, 1993, was $75.3 million, an increase of 24.1% over the 1992 amount. On December 24, 1991, an additional 72,378 shares as (adjusted to reflect the 100% stock dividend in June 1992) of common stock were issued to the Company's employee stock ownership plan for cash in the amount of $923,000. The growth in capital is attributable to the Company's record earnings and, to a larger extent, the issuance of 805,000 shares of the Company's common stock at $22.00 per share during the second quarter of 1993. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. ACQUISITIONS In December 1990, Simmons First National Bank, the lead bank of the Company, entered into an agreement with the Resolution Trust Corporation ("RTC") to acquire selected assets and deposits of four offices of a closed savings and loan association located in Northwest Arkansas. The Bank assumed approximately $77.5 million in deposits through acquired offices located in Fort Smith, Bella Vista, Rogers, and Springdale, Arkansas. These offices became full service branches of the Bank and created an opportunity for the Bank to provide banking services in one of the fastest growing areas in Arkansas. In July 1991, Bank entered into an agreement with the RTC to acquire selected assets and deposits of three offices of a savings and loan association, of which two offices were located in Fort Smith and one was located in Pine Bluff, Arkansas. The deposits in the Pine Bluff office were consolidated into the existing operations, while the two Fort Smith offices became full service branches of the Bank. In September 1991, the Bank entered into an agreement with the RTC to acquire selected assets and deposits of an office of a savings and loan association located in Pine Bluff, Arkansas. In March 1992, another agreement was reached between the Bank and the RTC for the acquisition of selected assets and deposits of an office of another savings and loan association in Pine Bluff. These offices became full service branches of the Bank. The Bank assumed approximately $83.0 million in deposits through these acquisitions in 1991 and 1992, and further expanded its operations in Northwest Arkansas. INCOME STATEMENT REVIEW FOR THE YEARS 1993, 1992 AND 1991 In 1993, the Company reported record net earnings of $9.4 million, and record earnings per share of $2.78. This compares to then-record net earnings of $7.5 million, and then-record earnings per share of $2.60, reported in 1992. The earnings increase in 1993 was a result of an increase in net interest income and non-interest income, which again was partially offset by an increase in non-interest expense. Net Interest Income Net interest income, the Company's principal source of earnings, is the difference between the income generated by earning assets and the total interest cost of the deposits and borrowings obtained to fund those assets. Factors that determine the level of net interest income include the volume of earning assets and interest-bearing liabilities, yields earned and rates paid, the level of non-performing loans, and the amount of non-interest bearing liabilities supporting earning assets. Net interest income is analyzed in the discussion and tables below on a fully tax equivalent basis. The adjustment to convert certain income to a fully taxable equivalent basis consists of dividing tax exempt income by one minus the federal income tax rate (34% for 1993, 1992 and 1991). For the year ended December 31, 1993, net interest income on a fully tax equivalent basis was $29.8 million, an increase of approximately $2.2 million, or 7.9%, from 1992 net interest income. The increase in net interest income resulted primarily from a more precipitous drop in rates paid on interest bearing liabilities than the related decline in yields on earning assets. For the year ended December 31, 1992, net interest income on a fully tax equivalent basis increased approximately $4.2 million, or 18.0%, from comparable figures in 1991. This increase in net interest income is primarily attributable to an increase in earning assets related to the deposit acquisitions in late 1990, 1991 and 1992. The tables below reflect an analysis of net interest income on a fully taxable equivalent basis for the years ended December 31, 1993, 1992 and 1991, respectively, as well as changes in fully taxable equivalent net interest income for the years 1993 vs. 1992 and 1992 vs. 1991. The following table shows for each major category of earning assets and interest bearing liabilities the average amount outstanding, the interest earned or expensed on such amount, and the average rate earned or expensed for each of the years in the three-year period ending December 31, 1993. The table also shows the average rate earned on all earning assets, the average rate expensed on all interest bearing liabilities, the net interest spread and the net interest margin for the same periods. The analysis is presented on a fully taxable equivalent basis. Nonaccrual loans were included in average loans for the purpose of calculating the rate earned on total loans. Under Financial Accounting Standard ("SFAS") 91, loan fees and related costs are deferred and amortized as part of interest income. Non-accrual loans are included in above totals. The following table shows changes in interest income and interest expense, resulting from changes in volume and changes in interest rates for each of the years ended December 31, 1993 and 1992, as compared to prior years. The changes in interest rate and volume have been allocated to changes in average volume and changes in average rates, in proportion to the relationship of absolute dollar amounts of the change in rate and volume. Provision for Loan Losses The provision for loan losses represents management's determination of the amount necessary to be charged against the current period's earnings, in order to maintain the allowance for loan losses at a level which is considered adequate, in relation to the estimated risk inherent in the loan portfolio. The provision for 1993 was $3.0 million, a decrease of $.7 million, or 19.7%, when compared to the provision in 1992. The provision for 1992 was $3.7 million, an increase of $.2 million, or 5.3%, from 1991. The increase in 1992 from 1991 relates primarily to increases in the provision for real estate mortgage and construction loans. Non-Interest Income Total non-interest income reached $26.1 million in 1993, compared to $25.6 million in 1992 and $23.1 million in 1991. Non-interest income can generally be broken down into three main sources: fee income, which includes service charges on deposits, trust fees, credit card fees, and loan servicing fees; income on the sale of mortgage loans and trading account profits; and any gain or loss on the sale of securities. The table below shows non-interest income for the years ended December 31, 1993, 1992 and 1991, respectively, as well as changes in 1993 from 1992 and in 1992 from 1991. Income Taxes The provision for income taxes for 1993 was $3.5 million, compared to $2.9 million in 1992 and $1.9 million in 1991. The effective income tax rates for the years ended 1993, 1992 and 1991 were 27.0%, 28.0% and 26.7%, respectively. Management adopted SFAS No. 109 retroactively to January 1, 1989, and its implementation did not have a material impact on net income on stockholders' equity. BALANCE SHEET REVIEW FOR THE YEARS 1993 AND 1992 Loan Portfolio The Company's loan portfolio averaged $395.7 million during 1993 and $360.4 million during 1992. As of December 31, 1993, total loans were $394.4 million, compared to $367.7 million on December 31, 1992. The most significant components of the loan portfolio were loans to individuals, in the form of credit card loans, student loans, and single family residential real estate loans. The Company seeks to manage its credit risk by diversifying its loan portfolio, determining that borrowers have adequate sources of cash flow for loan repayment without liquidation of collateral, obtaining and monitoring collateral, providing an adequate allowance for loan losses, and regularly reviewing loans through the independent loan review process. The loan portfolio is diversified by borrower, purpose, industry and, in the case of credit card loans, which are unsecured loans, by geographic region. The Company seeks to use diversification within the loan portfolio to reduce credit risk, thereby minimizing the adverse impact on the portfolio, if weaknesses develop in either the economy or a particular segment of borrowers. Collateral requirements are based on credit assessments of borrowers and may be used to recover the debt in case of default. The Company uses the allowance for loan losses as a method to value the loan portfolio at its estimated collectible amount. Loans are regularly reviewed, to facilitate identification and monitoring of deteriorating credits. Consumer loans consist of credit card loans, student loans and other consumer loans. Consumer loans were $270.8 million at December 31, 1993, or 68.6% of total loans, compared to $252.9 million, or 68.7% of total loans at December 31, 1992. At year end, 1993, credit card loans were $168.7 million, or 42.7% of total loans, versus $162.3 million, or 44.1% of total loans at December 31, 1992. The increase relates, in part, to the increased demand resulting from the Company's capitalizing on national media coverage of the Bank's having one of the lowest credit card rates in the United States. The lead Bank has provided diversified credit card services since 1967, when it became the first Arkansas bank to issue internationally accepted credit cards. The Bank is a member of both the Visa and Mastercard associations, and at April 30, 1993, was ranked 67th among all U.S. banks, based on the number of cardholders in such banks. The Bank generated income from its credit card operation primarily from interest charged on daily balances and from annual membership and other fees paid by cardholders, from discounts paid by merchants on purchases made with the Bank's cards, and from interchange fees paid by depository and agent banks for whom the Bank processes credit card transactions. Since 1985, when it began receiving national recognition about the low interest rates charged on cards issued by the Bank, the Bank has provided these services to selected customers located throughout the United Sates. Credit card customers reside in all 50 states, the District of Columbia and certain U.S. territories. Approximately 70% of these customers reside outside the State of Arkansas, representing approximately 70% of aggregate outstanding credit card balances. The following table reflects the growth of the Bank's credit card business since 1989: At the end of 1993, commercial, agricultural and financial institution loans were $39.2 million, or 9.9% of total loans, a 6.2% increase from 1992 year end's $36.9 million. Real estate construction and land development loans at December 31, 1993, were $6.3 million, or 1.6% of total loans, compared to $4.7 million, or 1.3% of total loans at the end of 1992. Single family real estate loans at December 31, 1993 were $36.7 million, or 9.3% of total loans, compared to $42.2 million, or 11.46% of total loans at December 31, 1992. The amount of loans outstanding at the indicated dates are reflected in the following table, according to type of loan. The following table reflects the remaining maturities of loans at December 31, 1993. The following table reflects for the above loans, the amounts which have predetermined interest rates and the amounts which have floating interest rates due after one year at December 31, 1993. Asset Quality Nonperforming loans are comprised of (a) non-accrual loans, (b) loans which are contractually past due 90 days and (c) other loans whose terms have been restructured, to provide a reduction or deferral of interest or principal, because of a deterioration in the financial position of the borrower. The subsidiary banks recognize income principally on the accrual basis of accounting. When loans are classified as nonaccrual, the accrued interest is charged off, and no further interest is accrued. Loans, excluding credit card loans, are placed on a nonaccrual basis either: (1) when there are serious doubts regarding the collectibility of principal or interest, or (2) when payment of interest or principal is 90 days or more past due and either (i) not fully secured or (ii) not in the process of collection. If a loan is determined by management to be uncollectible, the portion of the loan determined to be uncollectible is then charged to the allowance for loan losses. Credit card loans are classified as sub-standard when payment of interest or principal is 90 days past due. Litigation accounts are placed on non-accrual until such time as deemed uncollectable. Credit card loans are charged off when payment of interest or principal exceeds 180 days past due, but are turned over to the credit card recovery department, to be pursued until such time as they are determined, on a case-by-case basis, to be uncollectible. The following tables present information concerning nonperforming assets, including nonaccrual and restructured loans and other real estate owned. Approximately $347,000 and $363,000 of interest income would have been recorded for the periods ended December 31, 1993 and 1992, respectively, if the nonaccrual loans had been accruing interest in accordance with their original terms. There was no interest income on the nonaccrual loans recorded for the period ended December 31, 1993. Allowance for Loan Losses An analysis of the allowance for loan losses for the last five fiscal years is shown in the table below: The amounts of additions to the allowance during the year 1993 were based on management's judgment, with consideration given to the composition of the portfolio, historical loan loss experience, assessment of current economic conditions, past due loans, loans which could be future problems and net losses from loan charge-offs for the past five years. It is management's practice to review the allowance on a monthly basis, to determine whether additional provisions should be made to the allowance after considering the factors noted above. The Bank's senior loan committee, comprised of outside directors, has oversight responsibility for approving commercial and individual loans in excess of $100,000 unsecured, and $200,000 secured, and monitoring loan delinquencies, the status of non-performing assets and the evaluation of allowance for loan losses. In addition, the committee ratifies and/or approves loans made by other banking subsidiaries in excess of 13.5% of any such bank's equity capital. The Bank's agricultural committee, composed of outside directors whose occupations are closely tied to the farming industry, have oversight responsibility for the agricultural loan portfolio. The responsibilities and approval authorities of this committee are the same as the senior loan committee, as they pertain to agricultural loans. The Company's special services group is responsible for serving all subsidiaries of the Company in the audit, loan review, and compliance areas. In the area of loan review, periodic audits of each subsidiary are scheduled for the purpose of evaluating asset quality, adequacy of loan losses, and effectiveness of loan administration. The special services group prepares loan review reports, which identify deficiencies, establish recommendations for improvement, and outline management's proposed action plan for curing the deficiencies. This report is provided to a corporate audit committee, which includes outside members of the Company's Board of Directors and selected senior affiliate directors. The audit committee monitors the reported items until the exceptions are cleared. Based on the above-noted procedures, management is of the opinion that the allowance at December 31, 1993, of $7.4 million is adequate. While management believes the current allowance is adequate, changing economic conditions and other conditions may require future additions to the allowance. Moreover, the allowance is subject to regulatory examination and determination as to adequacy. Although not presently anticipated, adjustments to the allowance may result from regulatory examinations. The Company allocates the allowance for possible loan losses according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the categories of loans set forth in the tables below. Investments and Securities The Company's securities portfolio is the second largest component of earning assets and provides a significant source of revenue. Securities are classified as investments when the Company has the ability and intent to hold them to maturity. The portfolio is held for long-term profitability and is stated at adjusted cost. In considering whether securities can be held until maturity, management considers whether there are conditions which would impair its ability to hold such securities until maturity. At present, management is not aware of any such conditions. Management has reviewed the securities individually, to determine whether there are permanent declines identified in net realizable values, and write downs have been recorded, when required. Investment securities were $198.6 million at December 31, 1993, compared to $203.0 million at December 31, 1992. The Company's philosophy regarding investments is conservative, based on investment type and maturity. All investments are anticipated to be held to maturity and are structured on a ten year ladder, with a minimum of 30% of the securities maturing in the first two years. Investments in the portfolio include U.S. Treasury securities, U.S. government agencies, and municipalities. As of December 31, 1993, $146.0 million, or 73.5%, of the portfolio was invested in U.S. Treasury securities and obligations of U.S. government agencies, of which $54.4 million, or 37.3%, was invested in securities with maturities of one year or less, and $80.8 million, or 55.3%, was invested in securities with maturities of one to five years. To reduce the Company's income tax burden, an additional $49.4 million, or 24.9%, of the total securities portfolio was invested in tax-exempt obligations of state and political subdivisions. There were no securities of any one issuer exceeding ten percent of the Company's stockholders' equity at December 31, 1993. The Company has approximately $3.2 million, or 1.6%, in GNMA and other securities. At December 31, 1993, the Company had no collateralized mortgage obligations in its securities portfolio. It is the Company's general policy to not invest in derivative type investments. As of December 31, 1993, the investment portfolio had gross unrealized gains of $9.2 million and $0.1 million of gross unrealized losses. Net gains from the sale of securities for 1993 were $140,000, up from net gains of $59,000 and $50,000 in 1992 and 1991, respectively. The table below presents the carrying value and the fair value of investment securities for each of the years indicated. The following table reflects the amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, the weighted average yields (for tax-exempt obligations on a fully taxable basis, assuming a 34% tax rate) of such securities and the taxable equilvalent adjustment used in calculating the yields. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties. As of January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires the classification of securities into one of three categories: Trading, Available for Sale or Held to Maturity. Management will determine the appropriate classification of debt securities at the time of purchase and re-evaluate the classifications periodically. Trading account securities are used to provide inventory for resale. These securities will be carried at market value and will be included in short-term investments. Gains and losses, both realized and unrealized, are reflected in earnings. Debt securities are classified as Held to Maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to Maturity securities will be stated at amortized cost. Securities not classified as Trading or Held to Maturity will be classified as Available for Sale. Available for sale securities will be stated at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. The Company may sell these securities prior to maturity in response to liquidity demands. They also may be used as a means of adjusting the interest rate sensitivity of the Company's balance sheet, through sale and reinvestment. As of January 1, 1994, the adoption of FASB No. 115 resulted in a net increase in stockholders' equity of approximately $946,000. This increase in stockholders' equity will adjust in future periods, as changes in market conditions occur. Trading Portfolio The Company's trading account is established and maintained for the benefit of the dealer bank division. All activities in the account are performed by dealer bank personnel solely for operations in that division. The trading account is typically used to provide inventory for resale and is not used to take advantage of short-term price movements. Deposits and Short-Term Borrowings Total average deposits for 1993 were $585.6 million, compared to $578.1 million in 1992. A significant portion of the average deposit increases for that period is attributable to the deposit acquisitions in 1990, 1991 and 1992. The year-end balances of certificates of deposits over $100,000 were $61.4 million in 1993, compared to $61.0 million in 1992. The following table reflects the classification of the average deposits and the average rate paid on each deposit category which are in excess of 10 percent of average total deposits for the three years ended December 31, 1993. The following table sets forth by time remaining to maturity, deposits (exclusive of regular savings) in amounts of $100,000 or more at December 31, 1993 and 1992, respectively. Federal funds purchased and securities sold under agreements to repurchase were $26.3 million at December 31, 1993, as compared to $39.2 million at December 31, 1992. Other short-term borrowings, consisting of U.S. Treasury Note borrowings, increased at December 31, 1993, to $5.0 million, as compared to $2.9 million at December 31, 1992. The Company has historically funded its growth in earning assets through the use of core deposits, large certificates of deposits from local markets, and federal funds purchased. On May 12, 1993, the Company issued 700,000 shares of Class A Common Stock. And on June 10, 1993, the Company issued an additional 105,000 shares. The net proceeds to the Company stockholders' equity after expenses was $16.1 million. Management anticipates that these sources will provide necessary funding in the foreseeable future. It is the Company's general policy to avoid the use of brokered deposits. Long Term Debt The Company's long-term debt was $12.2 million at December 31, 1993 and 1992, respectively. The Company's Capital Notes due June 30, 1997, of which $11.0 million were outstanding at December 31, 1993 and 1992, respectively, are the major component of the Company's long-term debt. Interest on the Capital Notes is payable quarterly, and the interest rate is adjusted quarterly to the then prime rate offered by Chase Manhattan in New York. At December 31, 1993, the Chase Manhattan prime rate was 6%. Capital Appropriate capital management is essential to finance future growth and maintain the confidence of deposit customers, investors, and banking regulatory agencies. The Federal Reserve Board has approved new risk-based guidelines which establish a risk-adjusted ratio, relating capital to different categories of assets and off-balance sheet exposures, such as loan commitments and standby letters of credit. With respect to capital, the guidelines place a strong emphasis on tangible common stockholders' equity as the core element of the capital base, with appropriate recognition of other components of capital. The guidelines set a minimum risk-adjusted ratio for total capital of 8.0% by the end of 1993. At December 31, 1993, the Tier 1 Capital ratio was 17.2%, while the Company's risk-adjusted ratio for total capital, as of December 31, 1993, was 20.0%, both of which exceed the capital minimums established in the new risk-based capital requirements. The risk-based capital ratios showed improvement over December 31, 1992, primarily due to a reduction in risk-weighted assets, resulting from the sale of approximately $70 million in off-balance sheet recourse mortgage loan servicing. The Company's risk-based capital ratios at December 31, 1993 and 1992 are presented below, followed by the capital ratios of each of the three bank subsidiaries, as of December 31, 1993. LIQUIDITY AND INTEREST RATE SENSITIVITY Parent Company The Company has leveraged its investment in subsidiary banks and depends upon the dividends paid to it, as the sole shareholder of the subsidiary banks, as a principal source of funds for debt service requirements. At December 31, 1993, retained earnings of the Company's subsidiaries were approximately $52.7 million, of which approximately $11.9 million was available for the payment of dividends to the Company without regulatory approval. In addition to dividends, other sources of liquidity for the Company are the sale of equity securities and the borrowing of funds. Banking Subsidiaries Generally speaking, the Company's banking subsidiaries rely upon net inflows of cash from financing activities, supplemented by net inflows of cash from operating activities, to provide cash used in their investing activities. As is typical of most banking companies, significant financing activities include: deposit gathering; use of short-term borrowing facilities such as federal funds purchased and repurchase agreements; and the issuance of long-term debt. The banks' primary investing activities include loan originations and purchases of investment securities, offset by loan payoffs and investment maturities. Liquidity represents an institution's ability to provide funds to satisfy demands from depositors and borrowers, by either converting assets into cash or accessing new or existing sources of incremental funds. It is a major responsibility of management to maximize net interest income within prudent liquidity constraints. Internal corporate guidelines have been established to constantly measure liquid assets, as well as relevant ratios concerning earning asset levels and purchased funds. Each bank subsidiary is also required to monitor these same indicators and report regularly to its own senior management and board of directors. At year end, each bank was within established guidelines, and total corporate liquidity was strong. At December 31, 1993, cash and due from banks, investment securities, and federal funds sold and securities purchased under agreements for resale were 33.5% of total assets, as compared to 37.80% at December 31, 1992. Interest Rate Sensitivity Management continuously reviews the Company's exposure to changes in interest rates. Among the factors considered during its evaluations are changes in the mix of earning assets, growth of earning assets, interest rate spreads and repricing periods. Management forecasts and models the impact various interest rate fluctuations would have on net interest income. One such model measures the interest rate sensitivity gap, which presents, at a particular point in time, the matching of interest rate sensitive assets with interest rate sensitive liabilities. As shown in the schedule below, the cumulative rate sensitive assets to rate sensitive liabilities at six months and one year, respectively, was 112.73% and 113.12%. A financial institution is considered to be liability sensitive, or as having a negative GAP,when the amount of its interest bearing liabilities maturing or repricing within a given time period exceeds the amount of its interest earning assets also maturing or repricing within that time period. Conversely, an institution is considered to be asset sensitive, or as having a positive GAP, when the amount of its interest bearing liabilities maturing and repricing is less than the amount of itsinterest earning assets also maturing or repricing during the same period. Generally, in a falling interest rate environment, a negative GAP should result in an increase in net interest income, and in a rising interest rate environment this negative GAP should adversely affect net interest income. The converse would be true for a positive GAP. The long-term effect of rising interest rates would tendto increase net interest income because of the positive gap ratio. However, the negative gap for the short-term would cause a decreasein net interest income, as a result of rising rates for approximately six months. Since conditions change on a daily basis, these theoretical conclusions may not be indicative of actual future results. QUARTERLY RESULTS Selected unaudited quarterly financial information for the latest eight quarters is shown in the table below. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX Page Independent Accountants' Report . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets December 31, 1993 and 1992 . . . . . . . . Consolidated Statements of Income Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 1993, 1992, and 1991 . . . . . . . . Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . . . . Note: Supplementary Data may be found in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Quarterly Results" on page 51 hereof. INDEPENDENT ACCOUNTANTS' REPORT ------------------------------- Board of Directors Simmons First National Corporation Pine Bluff, Arkansas We have audited the accompanying consolidated balance sheets of SIMMONS FIRST NATIONAL CORPORATION as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SIMMONS FIRST NATIONAL CORPORATION as of December 31, 1993 and 1992, the results of its operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 20 to the financial statements, in 1993, the Company retroactively adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." BAIRD, KURTZ & DOBSON Pine Bluff, Arkansas January 28, 1994 NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS Simmons First National Corporation provides a full range of banking and mortgage services to individual and corporate customers through its subsidiaries and branch banks in Arkansas. The Company is subject to competition from other financial institutions. The Company also is subject to the regulation of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities. BASIS OF FINANCIAL STATEMENT PRESENTATION The financial statements have been prepared in accordance with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, as of the date of the balance sheet, and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowances for loan losses and the valuation of foreclosed assets. In connection with the determination of the allowances for loan losses and the valuation of foreclosed assets, management obtains independent appraisals for significant properties. Management believes that the allowances for losses on loans and the valuation of foreclosed assets are adequate. While management uses available information to recognize losses on loans and the valuation of foreclosed assets, future losses may be accruable, based on changes in economic conditions, particularly in Arkansas. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks' allowances for losses on loans and valuation of foreclosed assets. Such agencies may require the Bank to recognize additional losses, based on their judgments of information available to them at the time of their examination. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Simmons First National Corporation and its subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. RECLASSIFICATIONS Various items within the accompanying financial statements for previous years have been reclassified, to provide more comparative information. These reclassifications had no effect on net earnings. CASH EQUIVALENTS The Company considers all amounts due from banks and federal funds sold and securities purchased under agreements to resell as cash equivalents. The banking subsidiaries are required to maintain average reserve balances with the Federal Reserve Bank, based on a percentage of deposits. The average amounts of those reserve balances for the years ended December 31, 1993 and 1992, were $6,312,000 and $3,807,000, respectively. The Federal Reserve requirement on transaction account reserves dropped from twelve to ten percent during 1993. Generally, federal funds and securities purchased under agreement to resell are purchased and sold for varying periods up to thirty days. These securities are purchased from other financial institutions and are held in the name of Simmons First National Bank at the Federal Reserve Bank until maturity of the agreement. INVESTMENT SECURITIES Investments in debt securities intended to be held until maturity are valued at cost, and adjusted for amortization of premium and accretion of discount. Premiums and discounts on investment securities are amortized (deducted) and accreted (added), respectively, to interest income on the constant-yield method over the period to maturity of the related securities. Interest and dividends on investment securities are reported in operating income. Realized gains and losses on the sale of investment securities are reported separately as securities gains (losses). Gains and losses on security transactions are recognized, using the specific identification method. In considering whether securities can be held until maturity, management considers whether there are conditions which would impair its ability to hold such securities until maturity. At present, management is not aware of any such conditions. Management has reviewed the securities individually, to determine whether there are permanent declines in values, and write downs have been recorded, if required. MORTGAGE LOANS HELD FOR SALE Loans held for sale are carried at the lower of cost or market. Market is determined, based upon the agreed upon price at date of purchase of the loans. ASSETS HELD FOR TRADING Securities held for trading are carried at fair value, based on quoted market price or dealer quotes. Gains and losses recognized upon the sales are determined on a specific identification basis. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is increased by provisions charged to expense and reduced by loans charged off, net of recoveries. The allowance is maintained at a level considered adequate to provide for potential loan losses, based on management's evaluation of the loan portfolio, as well as on prevailing and anticipated economic conditions and historical losses by loan category. General reserves have been established, based upon the aforementioned factors and allocated to the individual loan categories. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of interest is doubtful. ALLOWANCE FOR LOSSES ON RESIDENTIAL MORTGAGE LOANS SERVICED FOR OTHERS A recourse loss allowance on loans serviced for others, including Veterans Administration loans included in Government National Mortgage Association and Federal National Mortgage Association pools, is provided, based on management's evaluation of historical losses, as well as prevailing and anticipated economic conditions. PREMISES AND EQUIPMENT Depreciable assets are stated at cost, less accumulated depreciation. Depreciation is charged to expense, using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are capitalized and amortized by the straight-line method over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. FORECLOSED ASSETS HELD FOR SALE Assets acquired by foreclosure or in settlement of debt and held for sale are valued at estimated fair value, as of the date of foreclosure, and a related valuation allowance is provided for estimated costs to sell the assets. Management evaluates the value of foreclosed assets held for sale periodically and increases the valuation allowance for any subsequent declines in fair value. Changes in the valuation allowance are charged or credited to other expense. Assets acquired by foreclosure also include loans upon which the foreclosure process is imminent or has been initiated but not completed and considered in-substance foreclosed. Such assets are carried at estimated fair value, and a related valuation allowance is provided for estimated costs to sell the assets. EXCESS COSTS OVER FAIR VALUE OF NET ASSETS ACQUIRED Unamortized costs of purchased subsidiaries, in excess of the estimated fair value of underlying net tangible assets acquired, aggregated $1,041,000 (originally $2,646,000) at December 31, 1993, and are being amortized over a 20-year period, using the straight-line method. Unamortized costs allocated to the future earnings potential of acquired deposits were $36,000 (originally $730,000) at December 31, 1993, and are being amortized over ten years, using the straight-line method. Amortization expense was $192,000 for 1993, 1992 and 1991. The amount paid to the Resolution Trust Corporation of $1,994,000, to purchase four of the branch operations of First American Savings Bank of Fort Smith, Arkansas, has been allocated, in part, to the future earnings potential of acquired deposits (originally $1,360,000), which will be amortized over ten years, using the straight-line method. Unamortized costs at December 31, 1993, were $944,000. The remaining intangible (originally $634,000) will be amortized over fifteen years, using the yield method. Unamortized costs at December 31, 1993, were $410,000. Amortization for the period ended December 31, 1993, and 1992, was $205,000 and $210,000, respectively. The amount paid to the Resolution Trust Corporation of $684,000, to purchase three of the branch operations of First Savings Bank of Arkansas and one branch of Home Federal Savings Association, has been allocated, in part, to the future earnings potential of acquired deposits (approximately $336,000), which will be amortized over ten years, using the straight-line method. The remaining intangible will be amortized over fifteen years, using the yield method. Amortization for the period ended December 31, 1993, and 1992, was $73,000 and $76,000, respectively. FEE INCOME Periodic bank card fees, net of direct origination costs, are recognized as revenue on a straight-line basis, over the period the fee entitles the cardholder to use the card. Other loan fees, net of direct origination costs, are recognized as revenue on a yield basis over the term of the loans. Income Taxes Deferred tax liabilities and assets are recognized for the tax effects of differences between the financial statement and taxbases of assets and liabilities. A valuation allowance is established to reduce deferred tax assets, if it is more likely than not that a deferred tax asset will not be realized. Earnings Per Common Share Earnings per common share are based on the weighted average number of common shares outstanding during each year. Common share equivalents in the form of employee stock options, were not materially dilutive. On April 13, 1992, the Board of Directors of the Company declared a 100% stock dividend. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. Weighted average shares outstanding were 3,378,200; 2,464,281 and 2,872,378, for 1993, 1992 and 1991, respectively. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), requires that the Company disclose estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions are set forth in Note 21 to the consolidated financial statements. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on and off balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Also, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the fair value. NOTE 2: INVESTMENT SECURITIES The amortized cost and estimated fair value of investments in debt securities are as follows: Maturities of investment securities at December 31, 1993, are as follows: The book value of securities pledged as collateral, to secure public deposits and for other purposes, amounted to $74,492,000 at December 31, 1993, and $63,055,000 at December 31, 1992. The approximate fair value of pledged securities amounted to $79,588,000 at December 31, 1993, and $68,648,000 at December 31, 1992. The book value of securities sold under agreement to repurchase amounted to $152,000 and $693,000 for December 31, 1993 and 1992, respectively. During 1993, there were no securities sold. The gross realized gains of $143,000 and gross realized losses of $3,000 were the result of called bonds. Approximately 18 percent of the state and political subdivisions are rated A or above. Of the remaining securities, most are nonrated bonds and represent small, Arkansas issues, which are evaluated internally for credit worthiness on an ongoing basis. At January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires the classification of securities into one of three categories: Trading, Available for Sale, or Held to Maturity. This resulted in a net increase in stockholders' equity of approximately $946,000. NOTE 3: ACQUISITIONS On July 26, 1991, Simmons purchased from the Resolution Trust Corporation, for $586,000, selected assets and deposits of three offices of First Savings Bank of Arkansas, located in Fort Smith and Pine Bluff. Simmons received $54,500,000 in cash and $60,000 in installment loans and assumed $55,100,000 in deposits. On September 20, 1991, Simmons assumed $17,700,000 in deposits of Savers Savings Associations' Pine Bluff branch and received an equal amount of cash. On March 30, 1992, Simmons acquired selected assets and deposits of a Pine Bluff office of Home Federal Savings Association of Kansas City. Simmons paid $98,000 to assume approximately $10,000,000 in deposits. NOTE 4: LOANS AND ALLOWANCE FOR LOAN LOSSES The various categories are summarized as follows: Loans on which the accrual of interest has been discontinued aggregated $2,813,000 and $4,374,000, at December 31, 1993 and 1992, respectively. If interest on those loans had been accrued, such income would have approximated $347,000 and $507,000 for 1993 and 1992, respectively. NOTE 5: FORECLOSED ASSETS HELD FOR SALE At December 31, 1993 and 1992, foreclosed assets held for sale included $363,000 and $1,225,000 in loans which were considered in-substance foreclosed, respectively. Transactions in the allowance for losses on foreclosed assets were as follows: NOTE 6: PREMISES AND EQUIPMENT Major classifications of premises and equipment, stated at cost, are as follows: NOTE 7: INCOME TAXES The provision for income taxes is comprised of the following components: The tax effects of temporary differences related to deferred taxes shown on the balance sheet were: The valuation allowance relates to the benefits of state income tax carry forwards included in deferred tax assets. A reconciliation of income tax expense at the statutory rate to the Company's actual income tax expense is shown below: NOTE 8: TIME DEPOSITS Time deposits include approximately $61,353,000 and $60,991,000 of certificates of deposit of $100,000 or more, at December 31, 1993 and 1992, respectively. Deposits are the Company's primary funding source for loans and investment securities. The mix and repricing alternatives can significantly affect the cost of this source of funds and, therefore, impact the margin. NOTE 9: LONG-TERM DEBT AND CAPITAL NOTES Long-term debt and capital notes at December 31, 1993 and 1992, consisted of the following components: Capital notes of Simmons First National Corporation are due June 30, 1997, with interest payable quarterly and rates adjusted quarterly to the then prime rate offered by Chase Manhattan in New York, which was adjusted at December 31, 1993, to 6%. Other debt consists of a mortgage note payable to Mutual Benefit Life Insurance Corporation, secured by land and building with a book value of $2,347,000, payable in equal monthly installments of $12,000, including interest at approximately 9.75% per annum. Final payment is due August, 2008. Aggregate annual maturities of long-term debt at December 31, 1993 are: NOTE 10: CAPITAL STOCK In addition to the common stock from which stock has been issued, as shown on the balance sheet, the following classes of stock have been authorized: Class B common stock of $1.00 par value per share, authorized 300 shares: none issued. Class A preferred stock of $100.00 par value per share, authorized 50,000 shares: none issued. Class B preferred stock of $100.00 par value per share, authorized 50,000 shares: none issued. On April 13, 1992, the board of directors of the Company declared a 100% stock dividend to shareholders of record on May 15, 1992, payable on June 5, 1992. Earnings per common share and dividends per common share presented in the financial statements have been restated retroactively, to reflect the effects of the stock dividend on a consistent basis. On May 12, 1993, the Company issued 700,000 shares of Class A Common Stock. And on June 10, 1993, the Company issued an additional 105,000 shares. The net proceeds to the Company stockholders' equity after expenses was $16.1 million. NOTE 11: UNDIVIDED PROFITS The subsidiary banks are subject to a legal limitation on dividends that can be paid to the parent company without prior approval of the applicable regulatory agencies. The approval of the Office of the Comptroller of the Currency is required, if the total of all the dividends declared by a national bank in any calendar year exceeds the total of its net profits, as defined, for that year, combined with its retained net profits of the preceding two years. Arkansas bank regulators have specified that the maximum dividend limit state banks may pay to the parent company without prior approval is 50% of the current year earnings. At December 31, 1993, the bank subsidiaries had $11,900,000 in undivided profits available for payment of dividends to the Company, without prior approval of the regulatory agencies. The most restrictive regulatory capital requirements at December 31, 1993 and 1992, were $35,392,000 and $36,208,000, respectively. The risk-based capital guidelines of the Federal Reserve Board required a minimum risk-adjusted ratio for total capital of 8% by the end of 1992. The Federal Reserve Board has further refined its guidelines to include the definitions for (1) a well-capitalized institution, (2) an adequately capitalized institution, and (3) an undercapitalized institution. The criteria for a well-capitalized institution is one that has at least a 10% "total risk-based capital" ratio, a 6% "Tier 1 risk-based capital" ratio, and a 5% "Tier 1 leverage capital" ratio. At December 31, 1993, each of the three subsidiary banks met the capital standards for a well-capitalized institution. The Company's risk-based capital ratio at December 31, 1993, was 20.01%. NOTE 12: LEASES At December 31, 1993, 1992, and 1991, there were obligations under a number of long-term land and office operating leases, which required minimum annual rentals, aggregating approximately $589,000 for 1993, $580,000 for 1992, and $504,000 for 1991. The leases extend for varying periods, up to the year 2057. Minimum annual rentals under these non-cancelable leases at December 31, 1993, are as follows: The corporate subsidiaries are obligated under equipment leases on a month- to-month basis, which are expected to be renewed and had aggregate annual rentals of approximately $166,000 in 1993, $242,000 in 1992, and $261,000 in 1991. The subsidiaries are also obligated on one-year leases for office and storage space, having aggregate annual rentals of approximately $63,000 in 1993, $113,000 in 1992, and $221,000 in 1991. NOTE 13: TRANSACTIONS WITH RELATED PARTIES At December 31, 1993 and 1992, the subsidiary banks had loans outstanding to executive officers, directors, and to companies in which the banks' executive officers or directors were principal owners, in the amount of $4,687,000 in 1993, and $3,888,000 in 1992. In management's opinion, such loans and other extensions of credit and deposits were made in the ordinary course of business and were made on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons. Further, in management's opinion, these loans did not involve more than normal risk of collectibility or present other unfavorable features. NOTE 14: EMPLOYEE BENEFIT PLANS In October, 1990, the Board of Directors approved the adoption of a 401(k) retirement plan, effective January 1, 1991, covering substantially all employees. Employees may contribute up to 12% of their compensation, with the Company and its subsidiaries matching 25% of the employee's contribution on the first 5% of the employee's compensation. The charges to income for this contribution in 1993, 1992 and 1991 were $106,000, $94,000 and $88,000, respectively. The Company and its subsidiaries have a discretionary profit sharing and employee stock ownership plan covering all employees. The charges to income for the plan were $550,000 for 1993, $485,000 for 1992, and $440,000 for 1991. On May 14, 1990, the Board of Directors adopted an incentive and nonqualified stock option plan. Pursuant to the plan, an aggregate of 140,000 shares were reserved for future issuance by the Company, upon exercise of stock options to be granted to officers and other key employees. The table below summarizes the transactions under the Company's stock option plan: Also, Simmons First National Bank and Simmons First Bank Jonesboro have a deferred compensation agreement with certain active and retired officers. The agreement provides monthly payments which, together with payments from the deferred annuities issued pursuant to the terminated pension plan, equal 50 percent of average compensation prior to retirement or death. The charges to income for the plans were $187,000 for 1993, $120,000 for 1992 and $89,000 for 1991. Such charges reflect the straight-line accrual over the employment period of the present value of benefits due each participant, as of their full eligibility date, using an 8% discount factor. NOTE 15: CONTINGENT LIABILITIES In late 1990, Simmons agreed to sell a substantial portion of its mortgage servicing rights. During 1991, Simmons received $1,250,000 in settlement of a lawsuit, for failure of the defendant to complete the purchase. In July, 1992, the defendant in the previous suit brought action against Simmons, alleging misrepresentations in the settlement agreement and other causes. The complaint seeks $1,000,000 in compensatory damages and $500,000 in punitive damages, plus attorneys' fees. Management has determined, through the investigation of facts and relevant laws, that the plaintiff's suit is without merit and the likelihood of an unfavorable outcome to the bank is remote. Various other unrelated legal proceedings, most of which involve loan foreclosure activity, pending against the Company and/or its subsidiary banks in the aggregate, are not expected to have a material adverse effect on the financial position of the Company and its subsidiaries. Mortgage loans serviced for others totaled $1,395,424,004 and $1,368,748,000 at December 31, 1993 and 1992, respectively, of which mortgage- backed securities serviced totaled $1,123,747,000 and $1,171,757,000 at December 31, 1993 and 1992, respectively. At December 31, 1993, Simmons First National Bank serviced approximately $187,338,000 in Veterans Administration loans subject to certain recourse provisions. A reserve of $310,000 has been established for potential loss obligations, based on management's evaluation of historical losses, as well as prevailing and anticipated economic conditions, giving consideration for specific reserves. Such reserve is included in other liabilities. Below are the transactions in that reserve: NOTE 16: ADDITIONAL CASH FLOW INFORMATION FOR 1993, 1992, AND 1991 NOTE 17: OTHER OPERATING EXPENSE Other non-interest expense consists of the following: NOTE 18: COMMITMENTS AND CREDIT RISK The three subsidiary banks grant agri-business, credit card, commercial, and residential loans to customers throughout the state. Although the banks have a diversified loan portfolio, unsecured debt in the form of credit card receivables comprised approximately 42.8% and 44.1% of the portfolio, as of December 31, 1993 and 1992, respectively. Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the counter party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. At December 31, 1993 and 1992, the Company had outstanding commitments to originate loans aggregating approximately $48,238,000 and $43,699,000, respectively. The commitments extended over varying periods of time, with the majority being disbursed within a one year period. Loan commitments at fixed rates of interest amounted to $12,025,000 and $12,381,000 at December 31, 1993 and 1992, respectively, with the remainder at floating market rates. Letters of credit are conditional commitments issued by the bank subsidiaries of the Company, to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Company had total outstanding letters of credit amounting to $820,000 and $638,000 at December 31, 1993 and 1992, respectively, with terms ranging from 95 days to ten years. Lines of credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Lines of credit generally have fixed expiration dates. Since a portion of the line may expire without being drawn upon, the total unused lines do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit, is based on management's credit evaluation of the counter party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. Management uses the same credit policies in granting lines of credit as it does for on balance sheet instruments. At December 31, 1993, the Company had granted unused lines of credit to borrowers, aggregating approximately $3,615,000 and $132,140,000 for commercial lines and open-end consumer lines, respectively. At December 31, 1992, unused lines of credit to borrowers aggregated approximately $5,160,000 for commercial lines and $131,631,000 for open-end consumer lines, respectively. For the risks related to residential mortgage loans serviced for others, see Note 15. NOTE 19: FUTURE CHANGES IN ACCOUNTING PRINCIPLES As of January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires the classification of securities into one of three categories: Trading, Available for Sale, or Held to Maturity. The adoption of SFAS No. 115 resulted in a net increase in stockholders' equity of approximately $946,000. Management will determine the appropriate classification of debt securities at the time of purchase and re-evaluate the classifications periodically. Trading account securities are used to provide inventory for resale. Debt securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. Securities not classified as held to maturity or trading are classified as available for sale. The Financial Accounting Standards Board recently adopted Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan" which requires that impaired loans be measured, based on the present value of expected cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent. This Statement applies to financial statements for fiscal year 1995. The extent to which the standard will have an impact, if any, on the Company has not been determined. NOTE 20: CHANGE IN ACCOUNTING PRINCIPLES The Company has adopted Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). The Company elected to adopt FAS 109 with a retroactive restatement of stockholders' equity, as of January 1, 1989. The adoption of SFAS 109 had no material impact on 1992, 1991, 1990 and 1989 earnings. NOTE 21: DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments: CASH AND CASH EQUIVALENTS The carrying amount for cash and cash equivalents approximates fair value. INVESTMENTS For securities held as investments and in trading accounts, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated, using quoted market prices for similar securities. The carrying amount of occrued interest receivable approximates its fair value. MORTGAGE LOANS HELD FOR SALE For homogeneous categories of loans, such as mortgage loans held for sale, fair value is estimated, using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. LOANS The fair value of loans is estimated by discounting the future cash flows, using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans with similar characteristics were aggregated for purposes of the calculations. The carrying amount of accrued interest approximates its fair value. The comparative figures for 1993 reflect an increase in value as compared to the carrying value relative to the 1992 figures. DEPOSITS The fair value of demand deposits, savings accounts, NOW accounts, and certain money market deposits is the amount payable on demand at the reporting date (i.e., their carrying amount). The fair value of fixed-maturity time deposits is estimated, using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value. The comparative figures for 1993 show an increase in the fair value of liabilities relative to the carrying value over the 1992 figures. SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE AND OTHER BORROWINGS The carrying amount for securities sold under agreement to repurchase and other borrowings is a reasonable estimate of fair value. LONG-TERM DEBT AND CAPITAL NOTES PAYABLE Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. COMMITMENTS TO EXTEND CREDIT, LETTERS OF CREDIT AND LINES OF CREDIT The fair value of commitments is estimated, using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit and lines of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date. The following table represents estimated fair values of the Company's financial instruments. The fair values of certain of these instruments were calculated by discounting expected cash flows, which method involves significant judgments by management and uncertainties. Fair value is the estimated amount at which financial assets or liabilities could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Because no market exists for certain of these financial instruments and because management does not intend to sell these financial instruments, the Company does not know whether the fair values shown below represent values at which the respective financial instruments could be sold individually or in the aggregate. NOTE 22: CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No items are reportable hereunder. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 10, 1994, to be filed pursuant to Regulation 14A. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1 and 2. Financial Statements and any Financial Statement Schedules The financial statements and financial statement schedules listed in the accompanying index to consolidated financial statements and financial statement schedules are filed as part of this annual report. 3. Exhibits The exhibits listed in the accompanying index to exhibits are filed as part of this annual report. (b) Reports on Form 8-K No Current Reports on Form 8-K were filed during the three-month period ended December 31, 1993. SIGNATURES ------------ Pursuant to the requirements of Section 13 or 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. /s/ John L. Rush March 28, 1994 -------------------------------------------- John L. Rush, Secretary Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 28, 1994. Signature Title ----------- ---- /s/ W. E. Ayres Chairman, Chief Executive Officer and Director - ------------------------- W. E. Ayres /s/ J. Thomas May President and Director - ------------------------- J. Thomas May /s/ Barry L. Crow Executive Vice President and Chief Financial - ------------------------- Officer (Principal Financial and Accounting Officer) Barry L. Crow /s/ Donald W. Stone Director - ------------------------- Donald W. Stone /s/ C. Ramon Greenwood Director - ------------------------- C. Ramon Greenwood /s/ David R. Perdue Director - ------------------------- David R. Perdue /s/ Adam B. Robinson Director - ------------------------- Adam B. Robinson /s/ Harry L. Ryburn Director - ------------------------- Harry L. Ryburn /s/ Ben V. Floriani Director - ------------------------- Ben V. Floriani Director - ------------------------- Paul M. Henson	25,559	166,523
48896_1993.txt	48896_1993	1993	48896	null	0	0
38777_1993.txt	38777_1993	1993	38777	Item 1. Business (a) General development of business Franklin Resources, Inc. ("FRI") and its predecessors have been engaged in the financial services business since 1947. FRI was organized in Delaware in November 1969. The term "Company" as used herein, unless the context otherwise requires, refers to Franklin Resources, Inc. and its subsidiaries. The Company's principal executive and administrative offices are at 777 Mariners Island Boulevard, San Mateo, California 94404. As of September 30, 1993, on a worldwide basis the Company employed approximately 3,500 employees, consisting of officers, investment management, distribution, administrative, sales and clerical support staff. The Company also employs additional temporary help as necessary to meet unusual requirements. Management believes that its relations with its employees are excellent. On October 30, 1992, the Company and certain of its direct and indirect subsidiaries consummated the acquisition (the "Acquisition") of substantially all of the assets and liabilities of Templeton, Galbraith & Hansberger Ltd, a corporation organized under the laws of the Cayman Islands and based in Nassau, Bahamas ("Old TGH"), which provided diversified investment management and related services on a worldwide basis directly and through subsidiaries to various domestic open-end and closed-end investment companies as well as to a variety of international investment portfolios and to domestic and international private and institutional accounts. At the time of the Acquisition, assets under management by Old TGH and related companies exceeded $20 billion. Unless the context otherwise requires, references herein to "Templeton" are deemed to refer to the business operations acquired by the Company in connection with the Acquisition. Subsequent to the Acquisition, the Company has operated the Franklin and Templeton businesses on a unified basis. The Company and its subsidiaries paid to Old TGH an aggregate of $731.6 million in addition to the assumption of certain liabilities, which with certain other adjustments, had the effect of increasing the purchase price for financial reporting purposes to approximately $786 million. The Acquisition was funded by a $360 million term loan facility with a syndicate of financial institutions; the issuance in August 1992 in anticipation of such Acquisition of $150 million of 6.25% subordinated debentures of Templeton Worldwide, Inc., a newly formed subsidiary holding company formed by the Company; $189 million in cash; and an $87 million issuance of the Company's $.10 par value Common Stock to certain Old TGH major stockholders and to Templeton employees. Ownership of certain of such Company shares by Templeton employees vest over time and is subject to continued employment by such employees with the Company or a subsidiary thereof. In September 1993, the Company entered into an agreement which was consummated in November, 1993, after the close of the fiscal year, to manage and advise the approximate $150 million Huntington Funds of Pasadena, California now called the Franklin/Templeton Global Trust. This open-end investment company of several currency portfolio series, includes the Global Currency Fund, The Hard Currency Fund and The High Income Currency Fund, which invests in high quality foreign equivalent money market instruments in various global currencies as well as the German Government Bond Fund, which invests in German government bonds and equivalents. A fifth portfolio, which was a money market fund, is in process of liquidation. The Company is principally a holding company primarily engaged, through various subsidiaries, in providing investment management, marketing, distribution, transfer agency and administrative services to the open-end investment companies in the Franklin Group of Funds and the Templeton Group of Funds and to domestic and international based private and institutional managed accounts. The Company also provides investment management and related services to 10 closed-end investment companies whose shares are traded on various major stock exchanges. In addition, the Company provides investment management, marketing and distribution services to certain sponsored investment companies organized in the Grand Duchy of Luxembourg (hereinafter referred to as "SICAV Funds"), which are distributed in market-places outside of North America and to certain investment funds and portfolios in Canada (hereinafter referred to as "Canadian Funds") as well as to certain other international portfolios in the United Kingdom and elsewhere. The Franklin Group of Funds consist of 34 open-end investment companies (mutual funds) consisting of approximately 109 portfolios. The Templeton Group of Funds consist of twelve (12) open-end investment companies (mutual funds) consisting of approximately 23 portfolios. The investment companies in the Franklin and Templeton Groups of Funds are registered as such under the Investment Company Act of 1940 (the "40 Act"). The Franklin and Templeton Groups of Funds are hereinafter referred to individually as a "Franklin Fund" or a "Templeton Fund" and collectively as the "Franklin Funds" or the "Templeton Funds" or when applicable to both fund groups as the "Funds" or a "Fund". The SICAV Funds, the Canadian Funds, and the domestic and international based private and institutional managed accounts and other domestic and international portfolios are collectively referred to as the "Managed Accounts". The Franklin and Templeton Groups of Funds along with the Managed Accounts are collectively referred to as the Franklin/Templeton Group. As of September 30, 1993 in the Franklin/Templeton Group, total assets under management were $107.5 billion, the make-up of which was approximately as follows: for the Franklin Group of Funds, $78.6 billion; for the Templeton Group of Funds, $21.9 billion; for the Managed Accounts, $7.0 billion. This makes the Franklin\Templeton Group one of the largest investment management complexes in the United States. The Company, through certain subsidiaries, also provides advisory services, sponsors and manages public and private real estate programs and variable annuity products. Other subsidiaries offer consumer banking services, insured deposits, and credit cards. The Company also provides custodial, trustee and fiduciary services to IRA and Keogh plans and to qualified retirement plans and private trusts. On a consolidated worldwide basis, the Company provides domestic and international individual and institutional investors with a broad range of investment products and services designed to meet varying investment objectives, which affords its clients the opportunity to allocate their investment resources among various alternative investment products as changing worldwide economic and market conditions warrant. Subsidiaries-Investment Management, Administration, Distribution and Related Services The Company's principal line of business is providing investment management, administration, distribution, and related services to the Franklin and Templeton Groups of Funds and to the Managed Accounts. This business is primarily conducted through the wholly owned direct and indirect subsidiary companies described below. Revenues are generated primarily by subsidiaries that provide advisory and management services. Franklin Advisers, Inc. Franklin Advisers, Inc. ("Advisers") is a California corporation formed in 1985 and is based in San Mateo, California. Advisers is registered as an investment advisor with the Securities and Exchange Commission ( the "SEC") under the Investment Advisers Act of 1940 (the "Advisers Act") and is also registered as an investment adviser in the States of California, and New Jersey. Advisers provides investment advisory, portfolio management and administrative services under management agreements with most of the Funds in the Franklin Group of Funds. Advisers manages more than 50% of total assets under management which generates more than 50% of total Company revenues. Templeton, Galbraith & Hansberger Ltd Templeton, Galbraith & Hansberger Ltd ("New TGH") is a Bahamian corporation located in Nassau, Bahamas formed in connection with the Acquisition and is the successor company to Old TGH. New TGH is registered as an investment advisor with the SEC under the Advisers Act. New TGH provides investment advisory, portfolio management and administrative services under various management agreements with certain of the Templeton Funds and Managed Accounts. New TGH is the principal investment advisor to the Templeton Funds. Revenues are derived primarily from investment management fees calculated on a sliding scale fund-by-fund basis in relation to Templeton Fund assets under management. Templeton Investment Counsel, Inc. Templeton Investment Counsel, Inc. ("TICI") is a Florida corporation formed in October, 1979, based in Ft. Lauderdale, Florida and was acquired by the Company in connection with the Acquisition. TICI is the principal investment advisor to the Managed Accounts. In addition, it provides investment advisory portfolio management services to certain of the Templeton Funds and subadvisory services to certain of the Franklin Funds. Templeton Global Investors, Inc Templeton Global Investors, Inc ("TGII") is a Delaware corporation formed in January, 1988 based in Ft. Lauderdale, Florida and was acquired by the Company in connection with the Acquisition. TGII provides business management services, including fund accounting, securities pricing, trading, compliance and other related administrative activities under various management agreements to certain of the Templeton Funds. Revenues are derived from business management fees calculated on a sliding scale fund-by-fund basis in relation to assets under management. Templeton Investment Management (Hong Kong) Limited Templeton Investment Management (Hong Kong) Limited ("Templeton Hong Kong") is a corporation organized under the laws of and is based in Hong Kong. It was formed as a successor company to an Old TGH subsidiary in connection with the Acquisition. Templeton Hong Kong is registered as the foreign equivalent of an investment advisor in Hong Kong and is also registered with the SEC under the Advisers Act. Revenues are derived from investment management fees calculated on a fund-by-fund basis in relation to assets under management. Templeton Hong Kong is principally an investment advisor to emerging market equity portfolios. Templeton Investment Management (Singapore) Pte. Ltd. Templeton Investment Management (Singapore) Pte. Ltd ("Templeton Singapore") is a corporation organized under the laws of and based in Singapore and was formed in connection with the Acquisition. It is registered as the foreign equivalent of an investment advisor in Singapore with the Monetary Authority of Singapore and provides investment advisory and related services to certain Templeton portfolios. Templeton Singapore is principally an investment advisor to emerging market equity portfolios. Templeton Management Limited Templeton Management Limited is a Canadian corporation formed in October, 1982 which with its subsidiaries was purchased in the Acquisition and is registered in Canada as the foreign equivalent of an investment advisor and a mutual fund dealer with the Ontario Securities Commission. It provides investment advisory, portfolio management, distribution and administrative services under various management agreements with the Canadian Funds and with private and institutional accounts. Franklin/Templeton Distributors, Inc. Franklin/Templeton Distributors, Inc. ("Distributors") is a New York corporation formed in 1947 and whose name was changed from Franklin Distributors, Inc. in connection with the post-Acquisition unification of the Templeton and Franklin organizations. It is registered with the SEC as a broker/dealer and as an investment adviser and is a member of the National Association of Securities Dealers ("NASD"). As the underwriter of the shares of most of the Franklin/Templeton Group of Funds, it earns underwriting commissions on distribution of shares of the Funds. Templeton Quantitative Advisors, Inc. Templeton Quantitative Advisors, Inc. ("TQA") is a Delaware corporation formed in July, 1990 and was acquired in the Acquisition. TQA is registered with the SEC as an investment advisor to institutional accounts, including limited partnerships. TQA also offers sophisticated financial research services to third parties through its DAIS division. Templeton/Franklin Investment Services, Inc. Templeton/Franklin Investment Services, Inc. ("TFIS") is a Delaware corporation formed in October 1987 and was acquired in the Acquisition. TFIS is registered with the SEC as an investment adviser and as a broker/dealer and is a member of the NASD. TFIS provides advisory services to wrap fee and comprehensive fee accounts. Franklin/Templeton Investor Services, Inc. Franklin/Templeton Investor Services, Inc. ("FTIS") is a California corporation formed in 1981 whose name was changed from Franklin Administrative Services, Inc in connection with the post- Acquisition unification of operations of the Templeton and Franklin organizations. FTIS provides shareholder record keeping services and acts as transfer agent and dividend-paying agent for the Franklin/Templeton Groups of Funds.. FTIS is registered with the SEC as a transfer agent under the Securities Exchange Act of 1934 (the "Exchange Act"). FTIS is compensated under an agreement with each Franklin and Templeton open-end mutual fund on the basis of a fixed annual fee per account, which varies with the Fund and the type of services being provided. Other Templeton Investment Advisory and Related Subsidiaries were acquired in connection with the Acquisition and are organized and located in Florida, California, England, Scotland, Luxembourg, Germany and Australia and provide investment advisory and related services to various domestic and foreign portfolios and private and institutional accounts. Franklin Trust Company Franklin Trust Company, a California corporation formed in 1983, ("FTC") is a trust company licensed by the California Superintendent of Banks. FTC serves primarily as custodian for Individual Retirement Accounts and Keogh Plans whose assets are invested in the Franklin Group of Funds, and as trustee or fiduciary of private trusts and retirement plans. Templeton Funds Trust Company Templeton Funds Trust Company, a Florida corporation formed in December, 1985, (TFTC") is a trust company licensed by the Florida Office of the Comptroller. TFTC serves primarily as custodian for Individual Retirement Accounts and Keogh Plans whose assets are invested in the Templeton Group of Funds, and as trustee of commingled trusts for qualified retirement plans. Franklin Management, Inc. Franklin Management, Inc., a California corporation organized in 1978, is a registered investment advisor for private accounts. Franklin Institutional Services Corporation Franklin Institutional Services Corporation ("FISCO") is a California corporation organized in 1991. FISCO is a registered investment adviser and provides services to bank trust departments, municipalities, corporate and public pension plans and pension consultants. Franklin Agency, Inc. Franklin Agency, Inc. ("Agency") is a California corporation organized in December, 1971. Agency provides insurance agency services for the Franklin Valuemark annuity products. Templeton Funds Annuity Company Templeton Funds Annuity Company ("TFAC") is a Florida corporation formed in January, 1984 and purchased in the Acquisition which offers variable annuity products. TFAC is regulated by the Florida Department of Insurance and Treasurer. Templeton Worldwide, Inc. Templeton Worldwide, Inc. is a Delaware corporation organized as a holding company for all of the Templeton companies acquired or formed in connection with the Acquisition. Subsidiaries-Other Financial Services The Company is also engaged in three other lines of business in the financial services marketplace conducted through the subsidiaries described below: consumer banking services, the sponsorship and management of public and private real estate programs and the marketing and distribution of primarily investment related insurance products. Banking Services Franklin Bank ("Bank"), formerly Pacific Union Bank & Trust Company, a 98% owned subsidiary of the Company, is a non-Federal Reserve member California State chartered bank. The Bank was formed in 1974 and was acquired by the Company in December, 1985. The Bank, with total assets of $211 million as of September 30, 1993, provides consumer banking products and services such as credit cards, deposit accounts and consumer loans. The Bank does not exercise its commercial lending powers in order to maintain its status as a "non-bank bank" pursuant to the provisions of the Competitive Equality Banking Act of 1987 ("CEBA") which permits the Company, a "non banking company" prior to CEBA, to remain exempt from the Bank Holding Company Act under the "grandfathering" provisions of CEBA. As a non-bank bank, it is subject to various regulatory limitations, including limits on the increase in its asset growth to 7% on an annual basis as well as a prohibition on engaging in any activity in which it was not engaged in March of 1987. Real Estate Subsidiaries The Company's real estate related line of business is conducted primarily through three principal subsidiary corporations. Franklin Properties, Inc. ("FPI") is a real estate investment and property management company organized in California in 1988, which sponsors and manages real estate investment trusts. Property Resources, Inc. ("PRI"), a California corporation organized in 1967 and acquired by the Company in December 1985, is a real estate syndication company, serving as general partner or advisor for real estate investment programs. Franklin Real Estate Management, Inc. ("FREMI") is registered with the SEC as an investment advisor and was formed in March 1991 to pursue the institutional sector of the real estate market. Insurance Services ILA Financial Services, Inc. ("ILA") is an Arizona corporation that is 80% owned by the Company. It was formed in 1969 as an insurance holding company. Its principal subsidiary is Arizona Life Insurance Company ("Arizona Life") based in Phoenix, Arizona. ILA specializes in marketing term life insurance and annuities. ILA and Arizona Life are registered as life insurance companies in seven states. Investment Management The Franklin/Templeton Group of Funds and Managed Accounts accommodate a variety of investment objectives, including, capital appreciation, growth and income, income, tax-free income and stability of principal. In seeking to achieve its objectives each portfolio emphasizes different investment securities. Portfolios seeking income focus on taxable and tax-exempt money market instruments, tax-exempt municipal bonds, fixed income debt securities of corporations and of the United States government and its agencies and instrumentalities such as the Government National Mortgage Association ("GNMA" or "Ginnie Mae"), the Federal National Mortgage Association ("Fannie Mae"), and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Portfolios that seek capital appreciation invest primarily in equity securities in a wide variety of markets, including international and domestic; some seek broad national market exposure, while others focus on narrower sectors such as precious metals, health care, emerging technology, mid-cap companies, real estate securities, and utilities. A majority of the assets managed are income-oriented. Equity investments such as common stocks represent approximately 33% of total assets managed. The Managed Accounts include many of the world's largest corporations, endowments, charitable foundations, pension funds and other institutions. Investment management services for such portfolios focus on specific client objectives utilizing the various investment techniques offered by the Franklin/Templeton Group. Except for the Company's money market funds, and funds specifically designed for institutional investors, whose shares are sold without a sales charge at all purchase levels, shares of the open end funds in the Franklin/Templeton Group of Funds are generally sold at their respective net asset value per share plus a sales charge which varies depending on the individual fund and the amount purchased. In accordance with certain terms and conditions described in the prospectuses for such funds, certain investors are eligible to purchase shares at net asset value or at reduced rates, and investors may generally exchange their shares of a fund at net asset value for shares of another fund in the Franklin/Templeton Group when they believe such an investment decision is appropriate. As of September 30, 1993, the net asset holdings of the four largest funds in the Franklin/Templeton Group were Franklin Custodian Funds, Inc. ($22.5 billion), Franklin California Tax-Free Income Fund, Inc. ($14.3 billion), Franklin Federal Tax-Free Income Fund ($6.9 billion), and the Franklin New York Tax-Free Income Fund, Inc. ($4.7 billion). At September 30, 1993, these four mutual funds represented, in the aggregate, 48% of all net assets under management in the Franklin/Templeton Groups of Funds. The Franklin Custodian Funds, Inc. ("Custodian") consists of five separate series, each representing a separate portfolio with its own investment objectives and policies. The largest of these is the U.S. Government Securities Series which is invested almost exclusively in GNMA obligations. As of September 30, 1993, the aggregate net assets of the U.S. Government Securities Series exceeded $14.3 billion. The Company believes that among the factors contributing to investor demand for shares of the Franklin U.S. Government Securities Series is its relatively high yield in an environment of low interest rates and the government's guarantee of timely payment of principal and interest on the GNMA certificates in the portfolio of such fund. During the period from 1991 to 1993, yields on GNMA securities funds ranged from a high of 7.2% to a low of 6.0%. The Franklin California Tax-Free Income Fund, Inc., the Franklin New York Tax-Free Income Fund, Inc. and the Franklin Federal Tax- Free Income Fund, emphasize investments in a diversified portfolio of municipal securities, the interest on which is exempt from federal income tax. The Franklin California Tax-Free Income Fund, Inc. and the Franklin New York Tax-Free Income Fund, Inc. have the further investment objective of paying dividends to their shareholders which are exempt, respectively, from California and New York personal income taxes. The Franklin California Tax-Free Income Fund, Inc. is believed to be the largest municipal bond mutual fund in the nation. General Fund Description Set forth in the tables below is a brief description of the funds and of the principal investments and investment strategies of such funds or portfolios comprising most of the funds or portfolios in the Franklin/Templeton Group separated into 15 different general categories as follows: (i) Franklin Funds Seeking Preservation of Capital and Income (ii) Franklin Funds Seeking Current Income (iii)Franklin Funds Seeking Tax Free Income (iv) Franklin Funds Seeking Growth and Income (v) Franklin Funds Seeking Capital Growth (vi) Franklin Funds for Tax-Deferred Investments (Valuemark variable annuity) (vii)Franklin Closed-End Funds (viii)Franklin Funds for Institutional Investors (ix) Templeton Funds Seeking Capital Growth from Global Portfolios (x) Templeton Funds Seeking Capital Growth from Domestic Portfolios (xi) Templeton Funds Seeking High Current Income from Global Portfolios (xii)Templeton SICAV Funds (xiii)Templeton Canadian Funds (xiv)Templeton Closed-End Funds (xv) Representative Templeton International Portfolios (i) Franklin Funds Seeking Peservation of Capital and Income Recent Mutual Fund Introductions The mutual funds referenced above include four new municipal bond funds introduced during the year ended September 30, 1993: Franklin Arizona Insured Tax-Free Income Fund, Franklin California High Yield Municipal Fund, Franklin Florida Insured Tax-Free Income Fund, and Franklin Washington Municipal Bond Fund.. During the year, Templeton also successfully introduced two closed-end funds. The Templeton China World Fund, which invests primarily in equity securities of companies in China, Hong Kong and Taiwan raised a net amount of $281 million and the Templeton Emerging Markets Income Fund which invests in emerging market debt securities raised a net amount of $659 million. In addition, Franklin also introduced the FISCO MidCap Growth Fund (b) Financial information about industry segments Information on the Company's operations in various geographic areas of the world and a breakout of business segment information is contained in Footnote 5 to the Consolidated Financial Statements contained in Item 8. herein. (c) Narrative Description of Business Investment Management and Administrative Services The Company, through its principal subsidiaries described above, provides investment advisory, portfolio management, transfer agent and administrative services to the Franklin/Templeton Group. Such services are provided pursuant to agreements in effect with each of the U.S. registered Franklin and Templeton Funds. Comparable agreements are in effect with foreign registered funds and with private and institutional managed accounts. The management agreements for the Franklin and Templeton Funds continue in effect for successive annual periods, providing such continuance is specifically approved at least annually by a vote cast in person at a meeting of such Fund's Boards of Trustees or Directors called for that purpose, or by a vote of the holders of a majority vote of the Fund's outstanding voting securities, and in either event, by a majority of such Fund's Trustees or Directors who are not parties to such agreement or interested persons of the Funds or the Company within the meaning of the 40 Act. Trustees and Directors of Fund Boards are hereinafter referred to as "directors". Each such agreement automatically terminates in the event of its "assignment" (as defined in the 40 Act) and either party may terminate the agreement without penalty after written notice ranging from 30 to 60 days. "Assignment" is defined in the 40 Act as including any direct or indirect transfer of a controlling block of voting stock. Control is defined as the power to exercise a controlling influence over the management or policies of a company. If there were to be a termination of a significant number of the management agreements between the Franklin and Templeton Funds and the Company's subsidiaries, such termination would have a material adverse impact upon the Company. To date, no management agreements of the Company or any of its subsidiaries with any of the Franklin or Templeton Funds have been involuntarily terminated. As of September 30, 1993, substantially all of the stock of the various directly and indirectly owned subsidiary companies was owned directly by FRI or subsidiaries thereof, except for nominal numbers of shares with respect to certain foreign entities required to be owned by nationals of such countries in accordance with foreign law. Charles B. Johnson, Rupert H. Johnson, Jr. and R. Martin Wiskemann beneficially own approximately 20%, 16% and 10%, respectively, of the outstanding voting common stock of FRI. Charles B. Johnson and his brother Rupert H. Johnson, Jr. serve on the Board of Directors of FRI as well as on most of the Franklin and some of the Templeton Fund boards. Under the terms of the management agreements with the Franklin and Templeton Funds, the companies described above generally supervise and implement such Fund's investment activities and provide the administrative services and facilities which are necessary to the operation of such Fund's business. Such companies also conduct research and provide investment advisory services and, subject to and in accordance with any directions such Fund's boards may issue from time to time, such companies decide which securities such Funds will purchase, hold or sell. In addition, such companies take all steps necessary to implement such decisions, including the selection of brokers and dealers to execute transactions for such Funds, in accordance with detailed criteria set forth in the management agreement for such Funds. Generally, the Company or a subsidiary provides and pays the salaries of personnel who serve as officers of the Franklin and Templeton Funds, including the President and such other administrative personnel as are necessary to conduct such Funds' day-to-day business operations, including maintaining a Fund's portfolio records, answering shareholder inquiries, providing information, creating and publishing literature, compliance with securities regulations, accounting systems and controls, preparation of annual reports and other administrative activities. The Funds generally pay their own expenses such as legal and auditing fees, reporting and board and shareholder meeting costs, SEC and state registration and similar expenses. Generally, the Funds pay advisory companies a fee payable monthly based upon a Fund's net assets. Annual rates under the various investment management agreements range from 0.25% to a maximum of 1.25% and are generally reduced as average net assets exceed various threshold levels. The investment management agreements permit advisory companies to act as an advisor to more than one Fund so long as such company's ability to render services to such Fund is not impaired, and so long as purchases and sales appropriate for all such Funds are made on a proportionate or other equitable basis. Management of the Company and the directors of the Funds regularly review the fund fee structures in the light of fund performance, the level and range of services provided, industry conditions and other relevant factors. Advisory fees are generally waived or reduced when a new Fund is first established and then increased to contractual levels with the growth in net assets. The investment advisory services provided by such advisory companies include fundamental investment research and valuation analyses, encompassing original country, industry and company research, utilizing such sources as the inspection of corporate activities, management interviews, company prepared information, publicly available information as well as analyses of suppliers, customers and competitors. In addition, research services provided by brokerage firms are used to support other research. In this regard, some brokerage business from the Funds is allocated in recognition of value-added research services received consistent with receiving the best execution of Fund trades. Fixed income research includes economic analysis, credit analysis and value analysis. The economic analysis function monitors and evaluates numerous factors that influence the supply and demand for credit on a worldwide basis. Credit analysts research the credit worthiness of debt issuers and their individual short-term and long- term debt issues. Yield spread differential analysis reviews the relative value of market sectors that represent buying and selling opportunities. Additional shareholder administrative services are provided by FTIS which receives administrative fees from the Funds for providing shareholder record keeping services and for acting as transfer and dividend-paying agent for the Funds. Such compensation is based upon an annual fee per shareholder account, ranging between $6 and $21.72, a pro rated portion of which is paid monthly. Distribution and Marketing Distributors acts as the principal underwriter and distributor of shares of the Franklin and Templeton Groups of Funds. Pursuant to underwriting agreements with the Funds, Distributors generally pays the expenses of distribution of Fund shares. Although the Company does significant advertising and sales promotions through media sources, Fund shares are sold primarily through a very large network of independent participating securities dealers. As of September 30, 1993, approximately 3,200 local, regional and national securities brokerage firms offered shares of the Franklin and Templeton Groups of Funds for sale to the investing public. The Company has approximately 47 "wholesalers" who interface with the broker/dealer community. Fund shares are offered to individuals, qualified groups, trustees, IRA and Keogh plans, employee benefit plans, trust companies, bank trust departments and institutional investors. Sales of Fund shares are generally subject to sales charges which range from zero to 5.75% depending upon the amount invested, the type of investor and the particular Fund product. A similar sales charge is also assessed by some of the Franklin Funds upon the reinvestment of dividends. The Company's money market and institutional funds are sold to investors without a sales charge. As of September 30, 1993, there were approximately 3.6 million shareholder accounts in the Franklin/Templeton Group of Funds. Broker/dealers are paid a commission for services in matching investors with Funds whose investment objectives match such investor's goals. Brokers/dealers also assist in explaining the operations of the Funds, servicing the account and in various other distribution services. Commissions paid to broker/dealers are typically paid at the time of the purchase as a percentage of the amount invested. For most of the Franklin Funds, Distributors currently reallows all related sales charges paid by a shareholder to the broker/dealer originating a sale. Distributors retains a portion of the sales charge in certain of the Templeton Funds. The sales charges from the reinvestment of Franklin Fund dividends are generally split equally with the broker/dealers. All of the U.S registered Templeton Funds and some of the U.S. registered Franklin Funds have adopted distribution plans under Rule 12b-1 promulgated under the 40 Act. The Boards of the remaining Franklin Funds presently without such plans (excluding money funds) have adopted such plans, subject to shareholder approval. Planning for solicitation of shareholder approval is now in process. Pursuant to such plans, Distributors is or will be entitled to reimbursement from each of such Funds in amounts ranging from 0.1% to 0.5% for expenditures which are primarily intended to result in the sale of such Fund's shares. The 40 Act requires that such a plan of distribution be initially approved by the Fund's directors, including a majority of such directors who are not "interested persons" and by the vote of a majority of the outstanding voting shares of the Fund. If approved, such plan of distribution may be for a term of one year, and thereafter must be approved at least annually by the Fund Board and by a majority of disinterested directors. All such plans are subject to termination at any time by a majority vote of the disinterested directors or by the Fund shareholders. Upon implementation of such plans by Funds which do not presently have them in place, it is anticipated that sales charges by such Funds upon reinvestment of dividends will be eliminated. Revenues The Company's revenues are derived primarily from its investment managment activities. Total operating revenues are set forth in the table below. Investment management fees have comprised approximately 76% of total operating revenue for each of the three fiscal years reported. Underwriting commissions from mutual fund activities contributed approximately 11.9%, 13.6% and 13.6% in 1991, 1992 and 1993, respectively. Transfer, trust and related fees from mutual fund activities contributed 6.5%, 5.3% and 7.0% in 1991, 1992 and 1993, respectively. Other Financial Services The Company's insurance related activities consist primarily of the sale of variable annuity products of the Franklin Valuemark Funds. The Company's consumer banking, real estate and insurance related businesses do not contribute significantly to either the revenues or the net income of the Company. The consumer banking operations are limited by national banking laws and no immediate significant increase in earnings is anticipated. The real estate operations have incurred net losses since inception and the Company does not anticipate any immediate improvement in this line of business. Regulatory Considerations Virtually all aspects of the Company's businesses are subject to various foreign, federal and state laws and regulations. As discussed above, the Company and a number of its subsidiaries are registered with various foreign, federal and state governmental agencies. Foreign, federal and state laws and regulations grant such supervisory agencies broad administrative powers, including the power to limit or restrict the Company from carrying on its business if it fails to comply with such laws and regulations. In such event, the possible sanctions which may be imposed include the suspension of individual employees, limitations on the Company's (or a subsidiary's) engaging in business for specified periods of time, the revocation of the investment advisor or broker/dealer registrations of subsidiaries and censures and fines. The Company's officers, directors and employees may from time to time own securities which are also held by the Funds. The Company's internal policies with respect to individual investments require prior clearance and reporting of transactions and restrict certain transactions so as to reduce the possibility of conflicts of interest. To the extent that existing or future regulations affecting the sale of Fund shares or their investment strategies cause or contribute to reduced sales of Fund shares or impair the investment performance of the Funds, the Company's aggregate net assets under management and its revenues might be adversely affected. Changes in regulations affecting free movement of international currencies might also adversely affect the Company. In 1993, the NASD received SEC approval for a new Rule of Fair Practice which limits the amount of aggregate sales charges which may be paid in connection with the purchase and holding of investment company shares sold through brokers. The Rule provides that funds with an asset-based sales charge (most commonly provided in Distribution Plans pursuant to SEC 40 Act Rule 12b-1) may impose no more than 6.25% - 7.25% (depending upon whether or not the fund also pays "service fees") in combined front-end, deferred sales charges and asset- based sales charges. The effect of that Rule might be to limit the amount of fees that could be paid pursuant to a fund's 12b-1 Plan in a situation where a fund has no, or limited new sales for a prolonged period of time. In that event, it is possible that a fund which was experiencing weak sales would have the situation exacerbated by the fact that it would have to limit fees to brokers under its 12b-1Plan, or reduce its upfront sales charge. None of the Franklin or Templeton Funds is in , or close to that situation at the present time. Competition The investment company and privately managed funds industry is highly competitive. In the United States, there are over 4,300 mutual funds of varying sizes and investment policies and objectives whose shares are being offered to the public. During the past three fiscal years, assets under management in the mutual fund industry increased by over $800 billion. During this same time period, the Company was able to maintain an approximate 4% market share of such net assets by a combination of service to customers, yields and performance on investments and extensive marketing activities with its broker/dealer network. In addition, the Templeton Acquisition has materially strengthened the ability of the Company to compete in the growing marketplace for global investing. In addition, the Company has advertised in major national financial publications as well as on radio and television to promote name recognition and to assist its broker/dealer network. Such activities included purchasing network and cable programming, sponsorship of The Nightly Business Report on public television and extensive newspaper and magazine advertising. Competition for sales of Fund shares is influenced by various factors, including general securities market conditions, government regulations, global economic conditions, portfolio performance, advertising and sales promotional efforts, share distribution channels and the type and quality of dealer and shareholder services. Many securities dealers, whose large retail distribution systems play an important role in the sale of shares in the Franklin Funds, also sponsor competing proprietary mutual funds. The Company believes that such securities dealers value the ability to offer customers a broad selection of investment alternatives and will continue to sell the Company's Funds notwithstanding the availability of proprietary products. However, to the extent that these firms limit or restrict the sale of Franklin or Templeton Fund shares through their brokerage systems in favor of these proprietary mutual funds, net assets under management might decline and the Company's revenues might be adversely affected. Another element of competition among mutual funds is the rates at which fees and sales charges are imposed. The Company believes that its investment management and other fee structures are already relatively competitive and does not presently anticipate significant competitive pressures for further reductions. However, a number of mutual fund sponsors presently market their funds without sales charges. As investor interest in the mutual fund industry has increased, competitive pressures have increased on sales charges of broker/dealer distributed funds. The Company believes that, although this trend will continue, a significant portion of the investing public still relies on the services of the broker/dealer community, particularly during weaker market conditions. However, in response to competitive pressures or for other similar reasons, the Company might be forced to lower sales charges which are currently substantially reallowed to broker/dealers. The reduction in such sales charges could make the sale of shares of the Franklin and Templeton Groups of Funds somewhat less attractive to the broker/dealer community, which could in turn have a material adverse effect on the Company's revenues. The Company believes that it is well positioned to deal with such changes in marketing trends as a result of its already extensive advertising activities and broad based marketplace recognition. In addition to competition from other investment company managers and investment advisers, the Company and the investment company industry are in competition with the financial services and other investment alternatives offered by stock brokerage and investment banking firms, insurance companies, banks, savings and loan associations and other financial institutions. Many of these competitors have substantially greater resources than the Company. The Company has and continues to actively pursue sales relationships with banks and insurance companies to broaden its distribution network in response to such competitive pressures. Recently, Congress has considered various proposals which would permit bank holding companies and their subsidiaries to engage in various, presently prohibited activities, including sponsoring mutual funds and distributing their securities. These or similar proposals, if enacted, would enable bank affiliates to compete directly with the mutual fund industry. In addition, the Office of the Comptroller of the Currency has proposed amendments to its regulations governing common trust funds which, if adopted, may increase competition between banks and mutual fund companies. The Investment Company Institute and others have opposed various aspects of these proposals. The Company cannot determine at the present time whether such proposals will be adopted, or, if adopted, what effect they may have on the Company. Special Considerations General As discussed above, the Company's revenues are derived primarily from invesment management activities and the distribution of mutual fund shares. Although net assets under management have increased from $57.9 billion in 1991 to $69.2 billion in 1992 to $107.5 billion in 1993, it is also possible for net assets under management to decline. A decline in net assets under management would adversely affect the Company's revenues proportional to such decline in net assets. Broadly speaking, the direction and amount of changes in the net assets of the funds are dependent upon two factors: (1) the level of sales of shares of the funds as compared to redemptions of shares of the funds; and (2) the increase or decrease in the market value of the securities owned by the funds. A discussion of the effect of net sales as compared to market value changes during the last three fiscal years is set forth in Management's Discussion and Analysis in Item 7. below. These factors in turn are affected by many things, including the general condition of national and world economics and the direction and volume of changes in interest rates and/or inflation rates. Because the effects of these factors on equity funds and fixed income funds often operate inversely, it is difficult to predict the net effect of any particular set of conditions on the level of assets under management. Templeton Acquisition As a result of the Templeton Acquisition, the portfolio mix of the combined Templeton and Franklin Funds changed from primarily fixed income oriented to both equity and fixed income components increasing the potential impact of changes in the international equity market on the net assets under management of the combined entity. On the other hand, the Company believes that the combined mutual fund complex will be more competitive in the future as a result of a greater diversity of product mix available to its customers. Item 2. Item 2. Properties General The Company owns or leases offices and facilities in four locations in the immediate vicinity of its principal executive and administrative offices located at 777 Mariners Island Boulevard, San Mateo, California. In addition, the Company owns several buildings near Sacramento, California as well as buildings in St. Petersburg, Florida and Nassau, Bahamas. Since the Company is operated on a unified basis, in most instances corporate activities, fund related activities, accounting operations, sales, real estate and banking operations, management information system activities, publishing and printing operations, shareholder service operations and other business activities and operations take place in all such locations. In addition, the Company or its subsidiaries lease office space in New York, New Jersey, Florida and in several other states as well as in Canada, England, Scotland, Luxembourg, Germany, Hong Kong, Singapore, and Australia. Property Description The Company leases approximately 177,000 square feet of space at the Mariners Island Boulevard location for a monthly rental of approximately $452,030 under a lease expiring February 16, 2001. The lease is subject to adjustment to market value rentals in 1996. The Company also leases 120,942 square feet of office space at 1147 and 1149 Chess Drive in Foster City, California at a monthly rental of $118,588 expiring in June, 2000. The Company also owns and occupies an $8.9 million office building with 69,200 square feet of office space at 1800 Gateway Drive, Foster City, California. The Company also leases approximately 21,053 square feet of office space at 901 Mariners Island Boulevard, San Mateo, California and, in addition to the Florida and Sacramento locations described below, an aggregate of approximately 56,000 square feet in other locations in the United States. The Company owns an 88,800 square foot facility in St. Petersburg, Florida, primarily devoted to shareholder servicing activities and leases approximately 24,000 square feet in St. Petersburg. The principal Templeton offices are located in 58,000 square feet of space in Ft. Lauderdale, Florida for a monthly rental of approximately $103,580 under various leases expiring in December 2000. The Company also owns an approximate 17,300 square foot office building in Nassau, Bahamas as well as a nearby condominium residence. In addition, the Company leases approximately 35,462 square feet of office space for its offices in Canada, England, Scotland, Germany, Luxembourg, Hong Kong, Singapore and Australia. The Company has implemented a plan to geographically diversify its operations to avoid any disruption to its business activities from natural or other disasters. During the fiscal year ended September 30, 1993, the Company opened a customer service and data processing facility in a $6.8 million office building which it acquired and remodeled at 10600 White Rock Road, Rancho, Cordova, California near Sacramento, California. The Company occupies approximately 67,630 square feet in this property and has leased out approximately 52,646 square feet until February 2000 at a monthly rate of $67,920. The Company has constructed two buildings of approximately 65,000 square feet each on an additional eighteen acres of adjoining, previously undeveloped land for $3.6 million and has plans for the development of additional facilities but has not yet commenced construction. One of such buildings is used for customer service activities and the other is presently used for storage purposes. Other The Company is the sole limited partner with a 60% partnership interest in Mariner Partners, a California limited partnership formed in 1984 to develop, operate and hold the property occupied by the Company at 777 Mariners Island Boulevard. Mariner Partners obtained 30 year non-recourse financing for the property from Metropolitan Life Insurance Company at an interest rate of 8-7/8%. The principal balance outstanding as of September 30, 1993 was $26.8 million. The loan is due in November 1996. The Company anticipates that Mariner Partners will have no difficulty in refinancing the property. Item 3. Item 3. Pending Legal Proceedings On December 31, 1990, a lawsuit was filed in the Superior Court of California, San Mateo County, by a plaintiff who was not, and never had been a shareholder, against the AGE High Income Fund, Inc.(the "Fund"), its manager, Franklin Advisers, Inc., its principal underwriter, Franklin/Templeton Distributors, Inc. and its shareholder services agent, Franklin/Templeton Investor Services, Inc collectively "Defendants". The suit, filed pursuant to the California Business and Profession Code, sought to enjoin certain advertising and to obtain restitution for certain alleged losses by shareholders. The suit was amended in mid 1993 to add the Company as a Defendant. On December 7, 1993, the Court entered an order dismissing the suit with prejudice. The order was entered pursuant to a settlement agreement that provided no injunctive relief, damages or restitution. Defendants agreed to add certain non- material statements to the Fund's prospectus and shareholder reports and Defendants, other than the Fund, paid a portion of plaintiff's attorneys fees, most of which was reimbursed by insurance. Item 4. Item 4. Submission of Matters to a Vote of Security Owners During the fourth quarter of the fiscal year covered by this report, no matter was submitted to a vote of security holders. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's common stock is traded on the New York Stock Exchange ("NYSE") and the Pacific Stock Exchange (Symbol: BEN). At December 3, 1993, there were approximately 1,600 shareholders of record. The high and low sales prices (as adjusted for stock splits) by quarter for the 1992 and 1993 fiscal years, as traded on the NYSE Composite Tape, were as follows: The Company paid dividends, as adjusted for the March 1992 common stock split, of $.26 per share in fiscal 1992 and $.28 per share in fiscal 1993. The Company expects to continue paying dividends to common stockholders depending upon earnings and other relevant factors. Item 6. Item 6. Selected Financial Highlights (in 000's, except per share amounts) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General Franklin Resources, Inc. and its majority-owned subsidiaries ("the Company") derives its revenue from its principal line of business providing investment management, administration, and related services to the Franklin and Templeton Groups of Mutual Funds, managed accounts and other investment products. For all periods presented, the Company's operations have been characterized by a substantial increase in assets under management, which have resulted in a significant increase in net income. Total assets under management as of September 30, 1993 were $107.5 billion. The Company continues to expand its range of investment products and services in the United States and abroad. The most significant development during the fiscal year ended September 30, 1993 was the Company's acquisition on October 30, 1992 of the assets and liabilities of Templeton, Galbraith & Hansberger Ltd., ("Templeton"), a Cayman Island corporation for approximately $786 million. The acquisition of the investment management, distribution and related companies servicing the Templeton Group of Mutual Funds and managed accounts had the effect of increasing the Company's net assets under management by over $20 billion to $90.7 billion on the date of acquisition. The Company has a diversified base of assets under management and a full range of investment management products and services to meet the needs of most individuals and institutions. The Company's revenues are derived largely from the amount and composition of assets under management. Consequently, fluctuations in financial markets impact revenues and the results of operations. Although current industry expectations are for continued growth, no assurance can be given that historical growth levels will be maintained. Results of Operations Net income for the year ended September 30, 1993 was $175.5 million, an increase of $51.4 million (41%) from $124.1 million in 1992, which increased $25.9 million (26%) from $98.2 million in 1991. These increases were primarily attributable to a substantial increase in the amount of revenues received from the Franklin and Templeton Groups of Funds. The Franklin and Templeton businesses have operated as a unified organization since the time of the acquisition. Since that time, significant progress has been made integrating those activities which create a more effective organization, including shareholder services, sales and marketing, legal and finance. Assets Under Management Total assets under management were $107.5 billion at September 30, 1993, an increase of $38.3 billion (55%) from 69.2 billion at September 30, 1992, which increased $11.3 billion (20%) from $57.9 billion at September 30, 1991. Such increases during the two-year period ended September 30, 1993 are principally attributable to increased net additions to assets under management and to market appreciation. Of the total increase, $20.3 billion (53%) was attributable to the Company's acquisition of Templeton with an additional increase of $8.1 billion (21%) by Templeton subsequent to the acquisition date and a $9.9 billion (26%) increase in net assets managed by Franklin. As shown in the following table, a material portion (56%) of the net assets under management at September 30, 1993 were in fixed income instruments held in portfolios of tax-free income funds and U.S. government bond funds. Net assets of U.S. government bond funds were $19.7 billion at September 30, 1993, an increase of $3.4 billion (21%) over the two year period from 1991 to 1993. During 1993, investors were attracted to tax-free income funds due to the increase in federal income tax rates and away from U.S. government bond funds as interest rates generally declined. Net assets of equity and equity income funds were $35.0 billion at September 30, 1993, an increase of $28.1 billion (407%) over the two year period from 1991 to 1993. Of this increase, 282% was attributable to the Templeton assets. Equity and equity income funds represent 33% of the Company's total assets under management at September 30, 1993 as compared to 12% at September 30, 1991. Investors have been attracted to the higher returns generated in the equity and equity income funds during this period. The Templeton products, which invest primarily in the global equity markets, received increased investor interest as compared to prior periods. Managed accounts assets under management were $7.0 billion at September 30, 1993, an increase of $3.8 billion (118%) during the period from 1991 to 1993 and an increase of $4.2 billion (151%) from 1992. This increase was attributable to Templeton. Managed accounts assets represent 6% of the Company's total assets under management. The Company strongly believes there are significant opportunities in the managed account business and intends to aggressively expand in this area. FRANKLIN RESOURCES, INC. Net Assets Under Management (In $ millions) The diversification of the Company's assets under management during the past two fiscal years may afford the Company increased stability in results of operations. The Company has continued this diversification with the acquisition of the $150 million Huntington international currency funds in November of 1993. The Company expects continued interest in its full range of products with greater growth in the global/international equity and tax-free income products over the near-term. Set forth below are the statements of income for the periods ending 1991 through 1993, including a consolidating statement of income for the period ended September 30, 1993 showing the separate results of operations of Templeton for the eleven-month period ending September 30, 1993. Consolidating Statements of Income for the years ended September 30, 1991, 1992 and 1993 (dollar amounts in thousands, except per share amounts) Operating Revenues Total operating revenues were $640.7 million for the period ended September 30, 1993, an increase of $269.8 million (73%) from $370.9 million in 1992, which increased $70.3 million (23%) from $300.6 million in 1991, the components of which are described below. (HORIZONTAL BAR GRAPH OF REVENUES FROM INVESTMENT MANAGEMENT FEES OMITTED HERE. IDENTICAL INFORMATION CONTAINED IN CONSOLIDATING STATEMENTS OF INCOME IN ITEM 7. ABOVE) Investment management fees for the period ended September 30, 1993 were $489.7 million, an increase of $205.7 million (72%) from $284.0 million in 1992, which increased $53.6 million (23%) from $230.4 million in 1991. Of the 1993 increase, $155.6 million is attributable to the addition of the Templeton operations during the period while the remainder during this period and the prior periods is the result of a general increase in assets under management. Investment management fees have comprised approximately 76% of total operating revenue for each of the three fiscal years reported. The Company's revenues from investment management fees are derived primarily from fixed fee arrangements with open-end and closed-end investment companies and from managed accounts. Annual rates under the various investment management agreements range from .25% to a maximum of 1.25% and generally decline as average net assets exceed various threshold levels. There have been no significant changes in the fee structures for the Franklin Group of Funds during the last three fiscal years. On January 1, 1992, the fee structures of a number of the Templeton Funds increased. HORIZONTAL BAR GRAPH OF REVENUES FROM UNDERWRITING COMMISSIONS OMITTED HERE. IDENTICAL INFORMATION CONTAINED IN CONSOLIDATING STATEMENTS OF INCOME IN ITEM 7. ABOVE) Underwriting commissions for the year ended September 30, 1993 were $87.1 million, an increase of $36.7 million (73%) from $50.4 million in 1992, which increased $14.6 million (41%) from $35.8 million for 1991. These increases resulted from higher sales than in prior periods, of which $3.5 million in 1993 is attributable to Templeton. Sales of Franklin and Templeton Funds include a commission of which a significant portion is reallowed to selling intermediaries. Revenues from underwriting commissions are earned primarily from Templeton mutual fund sales and through commissions charged on the reinvestment of dividends into most Franklin Funds. During the year, the Company combined the mutual fund marketing and sales activities of the Franklin and Templeton Groups of Funds, resulting in a more effective marketing and sales effort. The Boards of Directors of the Franklin Mutual Funds have adopted, subject to shareholder approval, distribution plans pursuant to Rule 12b-1 of the Investment Company Act of 1940. In conjunction with the implementation of these Plans, it is the intention to modify the Franklin Mutual Fund sales commission structure to eliminate commissions on reinvestment of dividends. The impact of these changes is expected to have a minimal overall impact on revenue while providing a more competitive sales structure. The Company anticipates shareholder approval of these distribution plans which would permit implementation during the third quarter of 1994. The Templeton Group of Funds registered in the United States adopted distribution plans pursuant to Rule 12b-1, effective January 1, 1992, which had the effect of increasing revenues for the eleven-month period ended September 30, 1993. (HORIZONTAL BAR GRAPH OF REVENUES TRANSFER, TRUST AND RELATED FEES OMITTED HERE. IDENTICAL INFORMATION CONTAINED IN CONSOLIDATING STATEMENTS OF INCOME IN ITEM 7. ABOVE) Transfer, trust and related fees were $45.1 million for the period ended September 30, 1993, an increase of $25.6 million (131%) as compared to 1992. Of this increase $24.5 million is attributable to Templeton. These fees are generally fixed charges per account which vary with the particular type of mutual fund and service being rendered. Consequently, these fees are dependent upon the number of shareholder accounts, with the amount of mutual fund sales or redemptions generally having a direct impact. During the year, the Company combined its transfer agency activities into a single entity which has, and should continue to result in improved efficiencies and services. Banking, real estate and other revenues for the year ended September 30, 1993 were $18.8 million, an increase of $1.8 million (10%) from $17.0 million in 1992, which increased $2.0 million (13%) from $15.0 million in 1991. These increases are a result of growth in interest earnings by Franklin Bank. The banking subsidiary contributed $114,000, $858,000 and $1.1 million to operating income in 1991, 1992 and 1993, respectively. Management does not currently anticipate any immediate significant increase in earnings due to regulatory limitations. The Company's real estate operations incurred operating losses of $2.9 million, $4.4 million and $7.9 million in 1991, 1992 and 1993, respectively, as a result of the continued depressed real estate market. Operating Expenses Operating expenses were $355.9 million for the year ended September 30, 1993, an increase of $171.5 million (93%) from $184.4 million in 1992, which increased $24.2 million (15%) from $160.2 million in 1991. These increases principally result from the general expansion of the organization, with the Templeton acquisition being the material factor in 1993. General and administrative expenses for the year ended September 30, 1993 were $258.1 million, an increase of $131.1 million (103%) as compared to 1992. Of this increase, $97.2 million is attributable to Templeton. General and administrative expenses increased $19.6 million (18%) in 1992 as compared to 1991. Operating income as a percentage of operating revenue was 44% for the year ended 1993 as compared to 50% and 47% for the years ended 1992 and 1991, respectively. The decrease in the operating profit margin for the year ending 1993 as compared to 1992 is primarily attributable to purchase accounting and other costs related to the acquisition of Templeton. For the year ended 1993, amortization of goodwill represents 13% of Templeton's operating expenses and 5% of the Company's total operating expenses. Also, the Company entered into future incentive compensation arrangements with certain eligible employees which provide for the payment of both cash and restricted stock to such employees pursuant to a vesting schedule. The costs associated with these incentive compensation arrangements are being amortized over the contract period. These incentives began vesting in 1993 and extend through 1998. The Company's Board of Directors has approved an annual incentive compensation plan, which is subject to shareholder approval, that provides for incentive payment of cash, restricted stock, options and stock appreciation rights as a means to motivate, retain and continue to attract talented individuals. This plan will initially have the effect of increasing employment costs. Selling expenses were $71.5 million for the year ended September 30, 1993, an increase of $24.7 million (53%) as compared to 1992, which increased of $5.5 million (13%) from $41.3 million in 1991. Templeton represents $14.9 million of the 1993 increase. The Company has sought to capitalize on the positive environment in the investment management industry by advertising and promoting the Company's range of investment products and services in the United States and other international markets. Interest expense of the banking subsidiary was $9.4 million, a decrease of $1.2 million (11%) from 1992, which decreased $1 million (8%) from $11.5 million in 1991. These decreases result primarily from falling levels of market interest rates during the period. Total operating expenses will likely continue to increase with the overall expansion of the business, the increase in competition and the Company's commitment to continually improving its products and services. Other Income (Expense) Interest and other income for the year ended September 30, 1993 was $14.7 million, a decrease of $5.6 million (27%) from 1992, which decreased $2.1 million (9%) from $22.5 million in 1991. The net change in investment income results from a combination of factors, including the decline in the average level of interest rates, lower dividend rates on investments and realization of capital losses. However, the principal reason for the reduction in investment income is due to the approximate 40% reduction in amounts available for investment due to the liquidation of investment portfolios to fund the cash portion of the Templeton acquisition in 1993. Non-banking interest expense for the year ended September 30, 1993 was $25.2 million, an increase of $23.1 million from 1992, which increased $2.0 million from $94 thousand in 1991. The increase in interest expense is attributable to the debt incurred in the Company's acquisition of Templeton. Financial Condition, Liquidity And Capital Resources Stockholders' equity was $720.4 million at September 30, 1993, an increase of $253.2 million (54%) from $467.2 million at year end 1992, which increased $104.2 million (29%) from $363.0 million at year end 1991. Cash provided by operating activities for the period ended September 30, 1993 was $199.4 million an increase of $22.2 million (13%) from $177.2 million in 1992. Net cash expended in investing activities in 1993 aggregated $539.8 million including $631.9 million used in the purchase of Templeton and $20.1 million used in the purchase of premises and equipment. The remainder came from the Company's investment portfolio, including its bank and real estate operations. The Company generated net cash of $334.7 million in 1993 of which $360.0 million was from the issuance of bank debt which was used for the Company's acquisition of Templeton. The Company expended $22.3 million for dividends to stockholders. At September 30, 1993, the Company held liquid assets in excess of $564.8 million, including $303.0 million of cash and cash equivalents. Financing for the Templeton acquisition was provided by the proceeds of $150 million of subordinated debentures with option rights, issued prior to the beginning of the current fiscal year specifically to finance the purchase, a $360 million term loan, approximately $87 million in Franklin stock issued to Templeton management and employee shareholders, and approximately $189 million of additional cash. The $150 million of subordinated debentures require the payment of semi-annual interest at the rate of 6.25% per annum, resulting in semi-annual payments of approximately $4.7 million. The debentures are redeemable at the election of the holder, anytime on or after August 3, 1997, at a price ranging from 93.65% to 100% of face value. The original $360 million term loan was refinanced and modified on June 28, 1993. The primary changes to the loan were a reduction of the principal balance to $346 million, accelerating the maturity date of the loan from a seven (7) year period to a five (5) year period from the amendment date, conversion of the loan from a term loan to a revolving credit and competitive auction facility with an annual reduction in the amount available under such facility. Additional charges included the lowering of the interest rate margins on the facility, elimination of quarterly amortization, mandatory annual prepayments based upon cash flows, elimination of, or favorable adjustments to, various restrictive covenants and ratios under the original loan facility. The Company was in compliance with all covenants as of September 30, 1993. Swap agreements, previously entered into in order to fix interest rates on $205 million of the original term loan, were amended to remain applicable to the new facility. Fixed rates of interest under these swap arrangements range from 3.73% to 5.02% on original maturities of one to three years. The effective rate of interest under the new loan facility, including the reduced margin and payments to be made pursuant to the swap arrangements, was 4.22% as of September 30, 1993. The Company anticipates that 1994 property and equipment acquisitions, initially budgeted at more than $22 million, will be funded from liquid assets currently available and from future operating cash inflows. Changes In Accounting Principles During fiscal 1993, the Company adopted Statements of Financial Accounting Standards Nos. 109, "Accounting for Income Taxes," and 115, "Accounting for Certain Investments in Debt and Equity Securities." As more fully discussed in Note 1 to the consolidated financial statements, the cumulative effects of adopting these standards are immaterial. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index Of Consolidated Financial Statements And Schedules for the years ended September 30, 1991, 1992 and 1993 CONTENTS Consolidated Financial Statements of Franklin Resources, Inc: Pages Report of Independent Accountants Consolidated Balance Sheets September 30, 1992 and 1993 to Consolidated Statements of Income, for the years ended September 30, 1991, 1992, and 1993 Consolidated Statements of Stockholders' Equity, for the years ended September 30, 1991, 1992 and 1993 Consolidated Statements of Cash Flows, for the years ended September 30, 1991, 1992 and 1993 Notes to Consolidated Financial Statements to Schedule: II. Consolidated Amounts Receivable from Employees X. Consolidated Supplementary Profit and Loss Information All other schedules have been omitted as the information is provided in the financial statements or in related notes thereto or are not required to be filed as the information is not applicable. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Franklin Resources, Inc.: We have audited the consolidated financial statements and financial statement schedules of Franklin Resources, Inc. and Subsidiaries listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As discussed in Note 1 to the financial statements, during 1993 the Company adopted a classified balance sheet which separately discloses current assets and liabilities and, in connection with that change, the company changed its method of accounting for cash and cash equivalents. In addition, as also discussed in Note 1 to the financial statements, during 1993 the Company changed its methods of accounting for income taxes and investments in debt and equity securities. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Franklin Resources, Inc. and Subsidiaries as of September 30, 1993 and 1992, and the consolidated results of its operations and its consolidated cash flows for each of the three years in the period ended September 30, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. Coopers & Lybrand /s/ Coopers & Lybrand San Francisco, California December 3, 1993 Franklin Resources, Inc. Consolidated Balance Sheets September 30, 1992 and 1993 (dollar amounts in thousands) Franklin Resources, Inc. Consolidated Balance Sheets (Continued) September 30, 1992 and 1993 (dollar amounts in thousands) Franklin Resources, Inc. Consolidated Statements Of Income for the years ended September 30, 1991, 1992 and 1993 (dollar amounts in thousands, except per share data) Franklin Resources, Inc. Consolidated Statements Of Stockhoholders' Equity for the years ended September 30, 1991, 1992 and 1993 (shares and dollars in thousands) Franklin Resources, Inc. Consolidated Statements Of Cash Flows for the years ended September 30, 1991, 1992 and 1993 (dollars in thousand) Franklin Resources, Inc. Notes To Consolidated Financial Statements 1. Significant Accounting Policies: Basis of Presentation: The consolidated financial statements include the accounts of Franklin Resources, Inc. and its majority-owned subsidiaries (the "Company"). The acquired Templeton, Galbraith & Hansberger Ltd. ("Templeton") operations are included from the acquisition date, October 30, 1992. All material intercompany accounts and transac tions have been eliminated from the consolidated financial state ments. Foreign Currency Translation: Assets and liabilities of foreign subsidiaries have been translated at current exchange rates, and related revenues and expenses have been translated at average exchange rates in effect during the period. The resulting cumulative translation adjustment has been recorded as a separate component of stockholders' equity. Foreign currency gains and losses are reflected in income current ly. Major Customers: Substantially all revenues earned by the Company are from providing investment management, underwriting, stock transfer and trust services to the Franklin/Templeton Group of Funds that operate in the United States, Canada, Europe and other international markets under various rules and regulations set forth by the Securities and Exchange Commission, individual state agencies and foreign governments. All services are provided to these mutual funds under contracts that definitively set forth the fees to be charged for these services. The majority of these contracts are subject to periodic review and approval by each fund's Board of Directors/Trustees and shareholders (See Note 13). Recognition of Revenues: Investment management, stock transfer and trust fees and investment income are all accrued as earned. Underwriting commissions on the sale of mutual fund shares and dividend reinvest ments are recorded on trade date, net of amounts paid to unaffiliated intermediaries. Deferred Costs: Deferred costs result from the sale of certain U.S., Canadian and European based mutual funds which have deferred sales charges and distribution fees. Amortization of such deferred costs is charged against mutual fund underwriting commission revenues on a straight- line basis over a period of five years for the U.S. based funds, forty months for the Canadian based funds and four years for Europ ean funds. Deferred costs related to the issuance of debt are amortized to interest expense over the life of the related debt. Taxes on Income: Effective October 1, 1992, the Company changed its method of accounting for income taxes from the income method to the liability method required by Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 109. The effect of adopting SFAS No. 109 on the current period income was immaterial, as was the cumulative effect of the accounting change on prior years. Cash and Cash Equivalents: Cash and cash equivalents include cash on hand, demand deposits with banks or other high credit quality financial institutions, debt instruments with original maturities of three months or less, and other highly liquid investments, including money market funds, which are readily convertible into cash. During 1993 the Company changed its presentation from a non- classified balance sheet to a classified balance sheet. In connection with this change, the Company also changed its method of accounting for cash and cash equivalents to include investments in money market funds which were previously included in marketable securities. This change resulted in the reclassification of money market funds from investments to cash and cash equivalents of $238,348,000, $305,686,000 and $244,987,000 in 1993, 1992 and 1991, respectively. All of these money fund investments are in the Franklin/Templeton Group of Funds. The Company believes that this change provides for a better presentation of the Company's financial position and conforms with common industry practice. Investment Valuation: In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Effective September 30, 1993 the Company elected to adopt SFAS No. 115. This statement requires the Company to classify and account for debt and equity securities as follows: Held-to-Maturity: Debt securities that management has the positive intent and ability to hold until maturity are carried at their remaining unpaid principal balance, net of unamortized premiums or unaccreted discounts. Premiums are amortized and discounts are accreted using the level interest yield method over the estimated remaining term of the underlying security. Trading Securities: Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are reported at market value, with unrealized gains and losses included in earnings. Available-for-Sale: Debt and equity securities that are neither held to maturity nor trading securities are classified as available-for-sale and are carried at market value. Market values for investments in open-end mutual funds are based on the last reported net asset value. Market values for other investments are based on the last reported price on the exchange on which they are traded. Investments not traded on an exchange are carried at estimated market value. Unrealized gains and losses are excluded from earnings and reported net of tax as a separate component of stockholders' equity until realized. For periods prior to the adoption of SFAS No. 115, the Company valued investments at the lower of cost or market, except that the Company's broker/ dealer subsidiaries carried investments at market value. There was no effect to the previously reported stockholders' equity or current earnings of applying the new stan dard. Realized gains and losses are recognized on the specific identification method and are included in investment income. Financial Instruments: Fair Value of Financial Instruments In December 1991, the FASB issued SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," effective for financial statements issued for fiscal years ending after December 15, 1992. SFAS No. 107 requires the disclosure of estimated fair values of all asset, liability and off-balance sheet financial instruments. Fair value estimates are determined as of the balance sheet date, utilizing quoted market prices, where available, or various assumptions and estimates. The methods and assumptions used to estimate the fair values of each class of financial instruments are as follows: Cash and Cash Equivalents: Due to the relatively short-term nature of these intruments, the carrying value approximates fair value. Available-for-Sale Investment Securities: These instruments are carried at fair values as determined by quoted market prices. Loans Receivable: The fair values of the banking subsidiary's performing residential mortgage loans and home equity loans are estimated using current market comparable information for securitizable mortgages, adjusting for credit and other relevant characteristics. The fair value of consumer loans is estimated by discounting the cash flows using interest rates that consider the current credit and interest rate risk inherent in the loans and current economic and lending conditions. Deposits: The fair values of the banking subsidiary's deposits subject to immediate withdrawal are equal to the amount payable on demand at the reporting date. Fair values for fixed-rate certificates of deposit are estimated by discounting future cash flows using interest rates currently offered on time deposits with similar remaining maturities. Long-Term Debt: The fair value of long-term debt is estimated using disounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair value of the option rights attached to the subordinated debentures is calculated based on the Company's closing stock price and the option and redemption prices on September 30, 1993. Financial Instruments with Off-Balance Sheet Risk The Company is a party to financial instruments with off-balance sheet risk. At September 30, 1993 the Company had interest rate swap agreements in effect on a portion of its long-term debt. The differential to be paid or received is accrued as the interest rates change and is recognized over the life of the agreements. The carrying value of these instruments approximates fair value. At September 30, 1993 the only instrument with off-balance sheet risk to which the banking subsidiary was a party were commitments to extend credit. Since many of the commitments are expected to expire without being drawn upon, the total committed amounts do not necessarily represent the future cash requirements. Fair value for these instruments are based on current settlement values and fees and interest rates currently charged to enter into similar agreements, taking into account the remaining term of the agreements and the counterparties' credit standing. Furniture, Equipment and Leasehold Improvements: Furniture and equipment are recorded at cost and are depreciated on the straight-line basis over their estimated useful lives. Expenditures for repairs and maintenance are charged to expense when incurred. Leasehold improvements are amortized on the straight-line basis over their estimated useful lives or the lease term, whichever is shorter. Goodwill: Goodwill represents the excess cost over the fair market value of the Company's acquisition of Templeton. The goodwill is being amortized on a straight-line basis over a period of forty years. Earnings Per Share: Earnings per share is computed by dividing net income by the weighted average number of shares of common stock and common stock equivalents (stock options and debenture option rights) considered outstanding during each year. The weighted average number of shares outstanding during 1991, 1992 and 1993 were 78,002,182, 77,971,835, and 81,594,765, respectively. The weighted average numbers of shares outstanding reflect retroactive application of the stock split in March 1992. Common stock equivalents utilized in computing earnings per share were 1,261,833 for primary and 2,117,004 for fully diluted and had an immaterial effect on fully diluted earnings per share prior to 1993. Reclassifications: Certain amounts in the 1991 and 1992 financial statements have been reclassified to correspond to the 1993 presentation. These reclassifications did not affect previously reported net income or retained earnings. 2. Banking Subsidiary Loans and Allowance for Loan Losses and Fair Value of Deposits: Banking subsidiary loans at September 30, 1992 and 1993 consisted of the following (in thousands): The estimated fair value of net loans receivable as of September 30, 1993 was $129.6 million. Included in banking subsidiary loans is an allowance for loan losses for the years ended September 30, 1991, 1992, and 1993 as follows (in thousands): The carrying values at September 30, 1993 of interest bearing and non-interest bearing demand deposits were $10.8 million and $9.0 million, respectively, which approximated fair value. The fair value of savings and time deposits was approximately $178.4 million. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." SFAS No. 114 requires that certain im paired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. The Company is required to adopt this new standard by fiscal year 1996. The Company anticipates that the adoption of SFAS No. 114 will not have a material effect on the financial statements. 3. Investments: Investments at September 30, 1993 and 1992 consisted of the following (in thousands): Investments in the Frankin/Templeton Group of Funds are shares of regulated investment companies for which the Company acts as invest ment manager. Investments in real estate include limited partner ships, carried at cost of $13,489,000. Proceeds from the sale of investment securities for 1993 and 1992 were $57.2 million and $24.3 million, respectively. Gains of $1.5 million and $2.5 million were realized on these sales for 1993 and 1992, respectively. At September 30, 1993, debt securities of the bank's investment portfolio at amortized cost and estimated market value with schedu led maturities were as follows (in thousands): Other debt securities have scheduled maturities as follows (in thousands): 4. Premises and Equipment The following is a summary of premises and equipment at September 30, 1992 and 1993 (in thousands): 5. Segment Information: The Company conducts operations in four principal geographic areas of the world: North America, the Bahamas, Europe and Asia/Pacific. Revenue by geographic area includes fees and commissions charged to customers and fees charged to affiliates. Operating income by geographic area is defined as net income less non-banking interest expense. Identifiable assets are those assets used exclusively in the operations of each geographic area. The table below is for the year ended September 30, 1993 (in thousands). Summarized below are the business segments (in thousands): The mutual funds segment's assets are primarily receivables from, and investments in, mutual funds and goodwill from the acquisition of Templeton. The banking affiliate's assets are primarily invest ment securities and consumer loans. 6. Long-Term Debt: Long-term debt is summarized as follows (in thousands): Principal payments on long-term debt excluding capital lease obligations are as follows (in thousands): On June 28, 1993 the Company entered into a modification of its term debt agreement providing for a 5-year revolving credit and competitive auction facility ("bank debt"). The bank debt has a variable interest rate which as of September 30, 1993 was 3.625% and provides for annual reducing levels of available credit. On February 4, 1993, the Company entered into interest swap agreements in order to fix interest rates on $205 million of the term loan. The fixed rates of interest range from 3.73% to 5.02% on maturities of one to three years. The effective rate of interest on the bank debt, including the payments to be made pursuant to the swap arrangements, was 4.22% as of September 30, 1993. The interest rate swap agreements have varying maturities over the life of the underlying debt. The bank debt agreement includes various restrictive covenants, including: a capitalization ratio, interest coverage ratio, minimum working capital and limitation on additional debt. The Company was in compliance with all covenants as of September 30, 1993. The subordinated debentures mature on August 3, 2002 and have a fixed interest rate of 6.25% per annum. Under certain circumstances, all or a portion of the debentures could pay additional interest, increasing to a maximum rate of 7.77%. The subordinated debentures have non-detachable option rights which allow the holder to purchase common shares of the Company at any time during the term of the debentures, for cash or in redemp tion of the debentures. The Company may redeem the debentures any time after August 3, 1997, or sooner to the extent options are exercised. The maximum number of shares purchasable under the option rights is 4,721,435 shares. The option price ranges from $28.65 to $31.77 per share and the redemption price ranges from 93.65% to 100% of face value, over the term of the debentures. The estimated fair value of the term loan approximates carrying value as of September 30, 1993. The estimated fair value of the subordinated debentures approximates $232.5 million. Included in deferred costs are debt issuance costs of $5,627,151 net of accumulated amortization of $388,095. The debt issuance costs are amortized using the effective interest method, over the life of the related debt. 7. Investment Income (in thousands): Substantially all of the Company's dividends were generated by investments in the Franklin/Templeton Group of Funds (See Note 3). 8. Taxes on Income: Taxes on income for the years ended September 30, 1991, 1992 and 1993 are comprised of the following (in thousands): The major components of the deferred provision for income taxes for the years ended September 30, 1991 and 1992 consisted of the following (in thousands): The major components of the net deferred tax liability as of September 30, 1993 were as follows (in thousands): Net current deferred tax assets of $6.0 million were made up of current deferred tax assets of $15.6 million and current deferred tax liabilities of $9.6 million. Net non-current deferred tax liabilities of $11.0 million were made up of non-current deferred tax assets of $1.4 million and non-current deferred tax liabilities of $12.4 million. Undistributed earnings of the Company's foreign subsidiaries amounted to approximately $12 million at September 30, 1993. Those earnings are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to U.S. income taxes. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the foreign credits and offsets associated with its hypothetical calculation. The following is a reconciliation between the amount of tax expense at the federal statutory rate of 34%, 34% and 34.75% and taxes on income as reflected in operations for the years ended September 30, 1991, 1992 and 1993, respectively (in thousands): 9. Commitments and Contingencies: The Company leases office space (including from an unconsolidated affiliate) and equipment under long-term operating leases expiring at various dates through fiscal year 2001. Lease expenses amounted to $7.8 million, $8.4 million and $12.1 million for the fiscal years ended September 30, 1991, 1992 and 1993, respectively. At September 30, 1993, remaining operating lease commitments are as follows (in thousands): The Company has also entered into capital leases for certain equipment (primarily computer equipment) with a cost of $7.9 million and accumulated amortization of $2.6 million at September 30, 1993. Future minimum payments under such leases as of Septem ber 30, 1993 are as follows (in thousands): At September 30, 1993, the Company's banking subsidiary had commitments to extend credit as follows (in thousands): The carrying value of these commitments approximates fair value. The Company acts as fiduciary for retirement and employee benefit plans. At September 30, 1993, assets held in trust amounted to approximately $8.6 billion. 10. Stockholders' Equity: On March 5, 1992, the Board of Directors approved a two-for-one stock split, for which the Company issued 38,991,437 additional shares of common stock. During the years ended September 30, 1991, 1992 and 1993, the Company paid dividends to common stockholders of $.23, $.26, and $.28 per share, respectively (as restated for the March 1992 two- for-one stock split). 11. Employee Stock Option Plans: The stockholders have adopted 1984 and 1989 stock option plans. These plans provide for the grant of options to purchase up to 2,156,250 shares of the Company's common stock to officers and other key employees of the Company. Terms and conditions (including price, exercise date and number of shares) are determined by the Board of Directors, which administers the plans. Information on the plans for the three years ended September 30, 1993, adjusted to reflect the 1992 stock split, is as follows (shares and total in thousands): There were 1,146,770 unoptioned shares available for the granting of options under the plans at September 30, 1992 and 1993. The Company recognizes no charge to income in connection with the plans as the options are granted at the fair market value of the common stock at the time of grant. As part of the Templeton acquisition, the Company issued options to purchase 169,498 shares of the Company's common stock to employees of certain foreign subsidiaries. The option prices range from $8.93 to $30.00 per share with a total exercise price of $2.6 million. 12. Employee Benefit and Incentive Plans: The Company has defined contribution profit sharing plans covering all U.S. employees of the Company who are not covered by a collective bargaining agreement, who have at least 12 months of employment and whose minimum age is 21 at the nearest birthday. Contributions are based on the Company's prior year's results of operations and are made at the discretion of the Company's Board of Directors. The Company contributed $2.1 million, $2.6 million and $2.8 million during 1991, 1992 and 1993, respectively, that related to the 1990, 1991 and 1992 plan years. The Company sponsors a 401(k) defined contribution pension plan in which most U.S. employees are eligible to participate. The Company funds the 401(k) plan by matching employee contributions, subject to statutory limitations. Employer contributions were $617 thousand and $844 thousand for the years ended September 30, 1992 and 1993, respectively. The Company sponsors restricted stock arrangements for its employees. The Company has issued shares of its common stock in the names of the employees, a portion of which replaced Templeton restricted shares, at a value of $24.9 million as of September 30, 1993. The deferred compensation cost of these securities is being amortized on a straight-line basis to the date the stock vests with the employees. The unamortized cost of the restricted shares is shown as a reduction of stockholder's equity. The Company also holds in its name shares with a carrying value of $2.5 million in certain of the Templeton mutual funds as part of certain non-qualified, deferred compensation arrangements. The cost of these shares is being amortized on a straight-line basis over the deferral period. 13. Other Matters: Commission and fee revenue from the following mutual funds accounted for more than 10% of total revenues in the years indicated: Other receivables include outstanding loans and notes receivable from officers and directors at September 30, 1992 and 1993 of $658 thousand and $698 thousand, respectively. 14. Quarterly Results of Operations (unaudited) (in thousands, except per share of amounts): 15. Acquisition of Templeton: On October 30, 1992, the Company acquired substantially all of the assets and liabilities of Templeton, manager of the Templeton Family of Mutual Funds and private accounts. The acquisition was accounted for as a purchase, with a purchase price of approximately $786 million of which approximately $713 million was allocated to goodwill. The purchase was financed by $360 million in bank debt, $150 million in subordinated debentures with option rights, $189 million in cash and $87 million in the Company's common stock. Based on unaudited financial data, had the acquisition been made on October 1, 1991, pro forma revenues, net income and net income per share for the year ended September 30, 1992, would have been approximately $540 million, $130 million and $1.60, respectively. Pro forma results for the year ended September 30, 1993, as if the acquisition had been made on October 1, 1992, are not presented as they would not be materially different from the reported results which include the operations of Templeton for the period from October 30, 1992 to September 30, 1993. Franklin Resources, Inc. Schedule II. Consolidated Amounts Receivable From Employees for the years ended September 30, 1991, 1992, and 1993 Franklin Resources, Inc. Schedule X. Consolidated Supplementary Profit And Loss Information for the years ended September 30, 1991, 1992 and 1993 Maintenance and repairs, depreciation and amortization of furniture and equipment, and royalties were either not present or were immaterial in amount. Information related to rental income is shown in Note 7 to the financial statements. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - NONE PART III Items 10-13 are incorporated by reference to the Company's definitive proxy soliciting material to be used in connection with the annual meeting of shareholders to be held on January 19, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8K (a)(1)Please see the index in Item 8 for a list of the financial statements filed as part of this report. (2)Please see the index in Item 8 for a list of the financial statement schedules filed as part of this report. (3) The following exhibits are filed as part of this report: 3(i) Registrant's Articles of Incorporation are incorporated by reference to Form 10 (File No. 06952) 3(ii) Registrant's By-Laws are incorporated by reference to Form 10 (File No. 06952) 10.1 Representative Distribution Plan between Templeton Growth Fund, Inc. and Franklin/ Templeton Investor Services, Inc. 10.2 Representative Business Management Agreement between Templeton Growth Fund, Inc. and Templeton Global Investors, Inc. 10.3 Representative Transfer Agent Agreement between Templeton Growth Fund, Inc. and Franklin/Templeton Investor Services, Inc. 10.4 Representative Distribution Agreement between Templeton Growth Fund, Inc. and Franklin/ Templeton Distributors, Inc. 10.5 Representative Investment Management Agreement between Templeton Growth Fund, Inc. and Templeton, Galbraith and Hansberger Ltd. 10.6 Representative Management Agreement between Advisers and the Franklin Group of Funds incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10K for the fiscal year ended September 30, 1992 (the "1992 Annual Report") 10.7 Representative Distribution Agreement between Distributors and the Franklin Group of Funds incorporated by reference to Exhibit 10.2 to the 1992 Annual Report 10.8 Representative Distribution 12b-1 Plan between Distributors and the Franklin Group of Funds incorporated by reference to Exhibit 10.3 to the 1992 Annual Report 10.9 Representative Shareholder Services Agreement between FTIS and the Franklin Group of Funds incorporated by reference to Exhibit 10.4 to the 1992 Annual Report 10.10 Representative Amendment to Shareholder Services Agreement between FTIS and the Franklin Group of Funds incorporated by reference to Exhibit 10.5 to the 1992 Annual Report 18 Letter re: Change in Accounting Principles 21 List of Subsidiaries 23 Consent of Independent Accountant 99 (i) Report on internal accounting control of transfer agent from Coopers & Lybrand 99(ii) Report on internal accounting control of transfer agent from McGladrey & Pullen (b) No reports on Form 8-K were filed for the quarter ended 9/30/93 (c) See Item. 14(a)(3) above. (d) No separate financial statements are required; schedules are included in Item 8. Exhibit 10.1 DISTRIBUTION PLAN WHEREAS, Templeton Growth Fund, Inc. (the "Fund") is registered as an open-end diversified management investment company under the Investment Company Act of 1940 (the "1940 Act"); and WHEREAS, the Fund and Franklin/Templeton Distributors, Inc. (the "Selling Company"), a wholly owned subsidiary of Franklin Resources, Inc. and a broker-dealer registered under the Securities Exchange Act of 1934, have entered into an Underwriting Agreement pursuant to which the Selling Company will act as principal underwriter of Shares of the Fund for sale to the public; and WHEREAS, the Board of Directors of the Fund has determined to adopt this Distribution Plan (the "Plan"), in accordance with the requirements of the 1940 Act and has determined that there is a reasonable likelihood that the Plan will benefit the Fund and its Shareholders. NOW THEREFORE, the Fund hereby adopts the Plan on the following terms and conditions: 1. The Fund will reimburse the Selling Company for costs and expenses incurred in connection with the distribution and marketing of Shares of the Fund. Such distribution costs and expenses may include: (a) payments to broker-dealers who provide certain services of value to the Fund's Shareholders (sometimes referred to as a "trail fee"); (b) reimbursement of expenses relating to selling and servicing efforts or of organizing and conducting sales seminars; (c) payments to employees or agents of the Selling Company who engage in or support distribution of Shares; (d) payment of the costs of preparing, printing and distributing prospectuses and reports to prospective investors and of printing and advertising expenses; (e) payment of dealer commissions and wholesaler compensation in connection with sales of Fund Shares exceeding $1 million (on which the Fund imposes no initial sales charge) and interest or carrying charges in connection therewith; and (f) such other similar services as the Fund's Board of Directors determines to be reasonably calculated to result in the sale of Shares. The Selling Company will be reimbursed for such costs, expenses or payments on a monthly basis, subject to a limit of 0.25% per annum of the Fund's average daily net assets. Payments made out of or charged against the assets of the Fund must be in reimbursement for costs and expenses in connection with any activity which is primarily intended to result in the sale of Fund Shares. The costs and expenses not reimbursed in any one given month (including costs and expenses not reimbursed because they exceeded the limit of 0.25% per annum of the Fund's average daily net assets) may be reimbursed in subsequent months or years. 2. The Plan shall not take effect with respect to the Fund until it has been approved by a vote of at least a majority (as defined in the 1940 Act) of the outstanding voting Shares of the Fund. With respect to the submission of the Plan for such a vote, it shall have been effectively approved with respect to the Fund if a majority of the outstanding voting Shares of the Fund votes for approval of the Plan. 3. The Plan shall not take effect until it has been approved, together with any related agreements and supplements, by votes of a majority of both (a) the Board of Directors of the Fund, and (b) those Directors of the Fund who are not "interested persons" (as defined in the 1940 Act) and have no direct or indirect financial interest in the operation of the Plan or any agreements related to it (the "Plan Directors"), cast in person at a meeting (or meetings) called for the purpose of voting on the Plan and such related agreements. 4. The Plan shall continue in effect so long as such continuance is specifically approved at least annually in the manner provided for approval of the Plan in paragraph 3. 5. Any person authorized to direct the disposition of monies paid or payable by the Fund pursuant to the Plan or any related agreement shall provide to the Fund's Board of Directors, and the Board shall review, at least quarterly, a written report of the amounts so expended and the purposes for which such expenditures were made. 6. Any agreement related to the Plan shall be in writing and shall provide: (a) that such agreement may be terminated at any time as to the Fund, without payment of any penalty, by vote of a majority of the Plan Directors or by vote of a majority of the outstanding voting Shares of the Fund, on not more than 60 days' written notice to any other party to the agreement; and (b) that such agreement shall terminate automatically in the event of its assignment. 7. The Plan may be terminated at any time with respect to the Fund, without payment of any penalty, by vote of a majority of the Plan Directors, or by vote of a majority of the outstanding voting Shares of the Fund. 8. The Plan may be amended at any time with respect to the Fund by the Fund's Board of Directors, provided that (a) any amendment to increase materially the costs which the Fund may bear for distribution pursuant to the Plan shall be effective only upon approval by a vote of a majority of the outstanding voting Shares of the Fund, and (b) any material amendments of the terms of the Plan shall become effective only upon approval as provided in paragraph 3 hereof. 9. While the Plan is in effect, the selection and nomination of Directors who are not "interested persons" (as defined in the 1940 Act) of the Fund shall be committed to the discretion of the Directors who are not interested persons. 10. The Fund shall preserve copies of the Plan, any related agreement and any report made pursuant to paragraph 5 hereof, for a period of not less than six years from the date of the Plan, such agreement or report, as the case may be, the first two years of which shall be in an easily accessible place. IN WITNESS WHEREOF, the Fund has executed this Distribution Plan on this 1st day of June, 1993. TEMPLETON GROWTH FUND, INC. ATTEST: By: Thomas M. Mistele Secretary Harold F. McElraft Vice President Exhibit 10.2 BUSINESS MANAGEMENT AGREEMENT BETWEEN TEMPLETON GROWTH FUND, INC. AND TEMPLETON GLOBAL INVESTORS, INC. AGREEMENT dated as of April 1, 1993, between Templeton Growth Fund, Inc., a Maryland corporation which is a registered open-end investment company (the "Fund") and Templeton Global Investors, Inc. ("TGII"). In consideration of the mutual promises herein made, the parties hereby agree as follows: (1) TGII agrees, during the life of this Agreement, to be responsible for: (a) providing office space, telephone, office equipment and supplies for the Fund; (b) paying compensation of the Fund's officers for services rendered as such; (c) authorizing expenditures and approving bills for payment on behalf of the Fund; (d) supervising preparation of annual and semiannual reports to Shareholders, notices of dividends, capital gains distributions and tax credits, and attending to routine correspondence and other communications with individual Shareholders; (e) daily pricing of the Fund's investment portfolio and preparing and supervising publication of daily quotations of the bid and asked prices of the Fund's Shares, earnings reports and other financial data; (f) monitoring relationships with organizations serving the Fund, including custodians, transfer agents and printers; (g) providing trading desk facilities for the Fund; (h) supervising compliance by the Fund with recordkeeping requirements under the Investment Company Act of 1940 (the "1940 Act") and the rules and regulations thereunder, with state regulatory requirements, maintenance of books and records for the Fund (other than those maintained by the custodian and transfer agent), preparing and filing of tax reports other than the Fund's income tax returns; (i) monitoring the qualifications of tax deferred retirement plans for the Fund; and (j) providing executive, clerical and secretarial personnel needed to carry out the above responsibilities. (2) The Fund agrees, during the life of this Agreement, to pay to TGII as compensation for the foregoing a monthly fee equal on an annual basis to 0.15% of the first $200 million of the aggregate average daily net assets of the Fund during the month preceding each payment, reduced as follows: on such net assets in excess of $200 million up to $700 million, a monthly fee equal on an annual basis to 0.135%; on such net assets in excess of $700 million up to $1.2 billion, a monthly fee equal on an annual basis to 0.1%; and on such net assets in excess of $1.2 billion, a monthly fee equal on an annual basis to 0.075%. (3) This Agreement shall remain in full force and effect through December 31, 1993 and thereafter from year to year to the extent continuance is approved annually by the Board of Directors of the Fund. (4) This Agreement may be terminated by the Fund at any time on sixty (60) days' written notice without payment of penalty, provided that such termination by the Fund shall be directed or approved by the vote of a majority of the Directors of the Fund in office at the time or by the vote of a majority of the outstanding voting securities of the Fund (as defined by the 1940 Act); and shall automatically and immediately terminate in the event of its assignment (as defined by the 1940 Act). (5) In the absence of willful misfeasance, bad faith or gross negligence on the part of TGII, or of reckless disregard of its duties and obligations hereunder, TGII shall not be subject to liability for any act or omission in the course of, or connected with, rendering services hereunder. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed by their duly authorized officers and their respective corporate seals to be hereunto duly affixed and attested. TEMPLETON GROWTH FUND, INC. By: Harold F. McElraft Vice President ATTEST: Thomas M. Mistele Secretary TEMPLETON GLOBAL INVESTORS, INC. By: ATTEST: Gregory E. McGowan Secretary November 2, 1989 Exhibit 10.3 TRANSFER AGENT AGREEMENT BETWEEN TEMPLETON GROWTH FUND, INC. AND FRANKLIN/TEMPLETON INVESTOR SERVICES, INC. AGREEMENT dated as of September 1, 1993 between TEMPLETON GROWTH FUND, INC., a registered open-end investment company with offices at 700 Central Avenue, St. Petersburg, Florida 33701 (the "Fund") and FRANKLIN/TEMPLETON INVESTOR SERVICES, INC., a registered transfer agent with offices at 700 Central Avenue, St. Petersburg, Florida 33701 ("FTIS"). W I T N E S S E T H: That for and in consideration of the mutual promises hereinafter set forth, the Fund and FTIS agree as follows: 1. Definitions. Whenever used in this Agreement, the following words and phrases, unless the context otherwise requires, shall have the following meanings: (a) "Articles of Incorporation" shall mean the Articles of Incorporation of the Fund as the same may be amended from time to time; (b) "Authorized Person" shall be deemed to include any person, whether or not such person is an officer or employee of the Fund, duly authorized to give Oral Instructions or Written Instructions on behalf of the Fund as indicated in a certificate furnished to FTIS pursuant to Section 4(c) hereof as may be received by FTIS from time to time; (c) "Custodian" refers to the custodian and any sub- custodian of all securities and other property which the Fund may from time to time deposit, or cause to be deposited or held under the name or account of such custodian pursuant to the Custody Agreement; (d) "Oral Instructions" shall mean instructions, other than written instructions, actually received by FTIS from a person reasonably believed by FTIS to be an Authorized Person; (e) "Shares" refers to shares of common stock, par value $.20 per share, of the Fund; and (f) "Written Instructions" shall mean a written communication signed by a person reasonably believed by FTIS to be an Authorized Person and actually received by FTIS. 2. Appointment of FTIS . The Fund hereby appoints and constitutes FTIS as transfer agent for Shares of the Fund and as shareholder servicing agent for the Fund, and FTIS accepts such appointment and agrees to perform the duties hereinafter set forth. 3. Compensation. (a) The Fund will compensate or cause FTIS to be compensated for the performance of its obligations hereunder in accordance with the fees set forth in the written schedule of fees annexed hereto as Schedule A and incorporated herein. Schedule A does not include out-of-pocket disbursements of FTIS for which FTIS shall be entitled to bill the Fund separately. FTIS will bill the Fund as soon as practicable after the end of each calendar month, and said billings will be detailed in accordance with Schedule A. The Fund will promptly pay to FTIS the amount of such billing. Out-of-pocket disbursements shall include, but shall not be limited to, the items specified in the written schedule of out- of-pocket expenses annexed hereto as Schedule B and incorporated herein. Schedule B may be modified by FTIS upon not less than 30 days' prior written notice to the Fund. Unspecified out-of-pocket expenses shall be limited to those out-of-pocket expenses reasonably incurred by FTIS in the performance of its obligations hereunder. Reimbursement by the Fund for expenses incurred by FTIS in any month shall be made as soon as practicable after the receipt of an itemized bill from FTIS. (b) Any compensation agreed to hereunder may be adjusted from time to time by attaching to Schedule A of this Agreement a revised Fee Schedule. 4. Documents. In connection with the appointment of FTIS, the Fund shall, on or before the date this Agreement goes into effect, but in any case, within a reasonable period of time for FTIS to prepare to perform its duties hereunder, deliver or cause to be delivered to FTIS the following documents: (a) If applicable, a specimen of the certificate for Shares of the Fund; (b) All account application forms and other documents relating to Shareholder accounts or to any plan, program or service offered by the Fund; (c) A certificate identifying the Authorized Persons and specimen signatures of Authorized Persons who will sign Written Instructions; and (d) All documents and papers necessary under the laws of Florida, under the Fund's Articles of Incorporation, and as may be required for the due performance of FTIS's duties under this Agreement or for the due performance of additional duties as may from time to time be agreed upon between the Fund and FTIS. 5. Distributions Payable in Shares. In the event that the Board of Directors of the Fund shall declare a distribution payable in Shares, the Fund shall deliver or cause to be delivered to FTIS written notice of such declaration signed on behalf of the Fund by an officer thereof, upon which FTIS shall be entitled to rely for all purposes, certifying (i) the number of Shares involved, and (ii) that all appropriate action has been taken. 6. Duties of the Transfer Agent. FTIS shall be responsible for administering and/or performing transfer agent functions; for acting as service agent in connection with dividend and distribution functions; and for performing shareholder account and administrative agent functions in connection with the issuance, transfer and redemption or repurchase (including coordination with the Custodian) of Shares. The operating standards and procedures to be followed shall be determined from time to time by agreement between the Fund and FTIS. Without limiting the generality of the foregoing, FTIS agrees to perform the specific duties listed on Schedule C. 7. Recordkeeping and Other Information. FTIS shall create and maintain all necessary records in accordance with all applicable laws, rules and regulations. 8. Other Duties. In addition, FTIS shall perform such other duties and functions, and shall be paid such amounts therefor, as may from time to time be agreed upon in writing between the Fund and FTIS. Such other duties and functions shall be reflected in a written amendment to Schedule C, and the compensation for such other duties and functions shall be reflected in a written amendment to Schedule A. 9. Reliance by Transfer Agent; Instructions. (a) FTIS will be protected in acting upon Written or Oral Instructions reasonably believed to have been executed or orally communicated by an Authorized Person and will not be held to have any notice of any change of authority of any person until receipt of a Written Instruction thereof from an officer of the Fund. FTIS will also be protected in processing Share certificates which it reasonably believes to bear the proper manual or facsimile signatures of the officers of the Fund and the proper countersignature of FTIS. (b) At any time FTIS may apply to any Authorized Person of the Fund for Written Instructions and may seek advice at the Fund's expense from legal counsel for the Fund or from its own legal counsel, with respect to any matter arising in connection with this Agreement, and it shall not be liable for any action taken or not taken or suffered by it in good faith in accordance with such Written Instructions or in accordance with the opinion of counsel for the Fund or for FTIS. Written Instructions requested by FTIS will be provided by the Fund within a reasonable period of time. In addition, FTIS, or its officers, agents or employees, shall accept Oral Instructions or Written Instructions given to them by any person representing or acting on behalf of the Fund only if said representative is known by FTIS, or its officers, agents or employees, to be an Authorized Person. 10. Acts of God, etc. FTIS will not be liable or responsible for delays or errors by reason of circumstances beyond its control, including acts of civil or military authority, national emergencies, labor difficulties, fire, mechanical breakdown beyond its control, flood or catastrophe, acts of God, insurrection, war, riots or failure beyond its control of transportation, communication or power supply. 11. Duty of Care and Indemnification. The Fund will indemnify FTIS against and hold it harmless from any and all losses, claims, damages, liabilities or expenses (including reasonable counsel fees and expenses) resulting from any claim, demand, action or suit not resulting from willful misfeasance, bad faith or gross negligence on the part of FTIS, and arising out of, or in connection with, its duties hereunder. In addition, the Fund will indemnify FTIS against and hold it harmless from any and all losses, claims, damages, liabilities or expenses (including reasonable counsel fees and expenses) resulting from any claim, demand, action or suit as a result of: (i) any action taken in accordance with Written or Oral Instructions, or any other instructions or Share certificates reasonably believed by FTIS to be genuine and to be signed, countersigned or executed, or orally communicated by an Authorized Person; (ii) any action taken in accordance with written or oral advice reasonably believed by FTIS to have been given by counsel for the Fund or by its own counsel; (iii) any action taken as a result of any error or omission in any record (including but not limited to magnetic tapes, computer printouts, hard copies and microfilm copies) delivered, or caused to be delivered by the Fund to FTIS in connection with this Agreement; or (iv) any action taken in accordance with oral instructions given under the Telephone Exchange and Redemption Privileges, as described in the Fund's current prospectus, when believed by FTIS to be genuine. In any case in which the Fund may be asked to indemnify or hold FTIS harmless, the Fund shall be advised of all pertinent facts concerning the situation in question and FTIS will use reasonable care to identify and notify the Fund promptly concerning any situation which presents or appears likely to present a claim for indemnification against the Fund. The Fund shall have the option to defend FTIS against any claim which may be the subject of this indemnification, and, in the event that the Fund so elects, such defense shall be conducted by counsel chosen by the Fund and satisfactory to FTIS, and thereupon the Fund shall take over complete defense of the claim and FTIS shall sustain no further legal or other expenses in such situation for which it seeks indemnification under this Section 11. FTIS will not confess any claim or make any compromise in any case in which the Fund will be asked to provide indemnification, except with the Fund's prior written consent. The obligations of the parties hereto under this Section shall survive the termination of this Agreement. 12. Term and Termination. (a) This Agreement shall be effective as of the date first written above and shall continue through December 31, 1993 and thereafter shall continue automatically for successive annual periods ending on December 31 of each year, provided such continuance is specifically approved at least annually by (i) the Fund's Board of Directors or (ii) a vote of a "majority" (as defined in the Investment Company Act of 1940 (the "1940 Act")) of the Fund's outstanding voting securities, provided that in either event the continuance is also approved by a majority of the Board of Directors who are not "interested persons" (as defined in the 1940 Act) of any party to this Agreement, by vote cast in person at a meeting called for the purpose of voting such approval; (b) Either party hereto may terminate this Agreement by giving to the other party a notice in writing specifying the date of such termination, which shall be not less than 60 days after the date of receipt of such notice. In the event such notice is given by the Fund, it shall be accompanied by a resolution of the Board of Directors of the Fund, certified by the Secretary of the Fund, designating a successor transfer agent or transfer agents. Upon such termination and at the expense of the Fund, FTIS will deliver to such successor a certified list of shareholders of the Fund (with names and addresses), an historical record of the account of each Shareholder and the status thereof, and all other relevant books, records, correspondence, and other data established or maintained by FTIS under this Agreement in a form reasonably acceptable to the Fund, and will cooperate in the transfer of such duties and responsibilities, including provisions for assistance from 's FTIS's personnel in the establishment of books, records and other data by such successor or successors. 13. Amendment. This Agreement may not be amended or modified in any manner except by a written agreement executed by both parties. 14. Subcontracting. The Fund agrees that FTIS may, in its discretion, subcontract for certain of the services described under this Agreement or the Schedules hereto; provided that the appointment of any such agent shall not relieve FTIS of its responsibilities hereunder. 15. Miscellaneous. (a) Any notice or other instrument authorized or required by this Agreement to be given in writing to the Fund or FTIS shall be sufficiently given if addressed to that party and received by it at its office set forth below or at such other place as it may from time to time designate in writing. To the Fund: Templeton Growth Fund, Inc. 700 Central Avenue St. Petersburg, Florida 33701 To FTIS: Franklin/Templeton Investor Services, Inc. 700 Central Avenue St. Petersburg, Florida 33701 (b) This Agreement shall extend to and shall be binding upon the parties hereto, and their respective successors and assigns; provided, however, that this Agreement shall not be assignable without the written consent of the other party. (c) This Agreement shall be construed in accordance with the laws of the State of California. (d) This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original; but such counterparts shall, together, constitute only one instrument. (e) The captions of this Agreement are included for convenience of reference only and in no way define or delimit any of the provisions hereof or otherwise affect their construction or effect. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their respective corporate officers thereunder duly authorized as of the day and year first above written. TEMPLETON GROWTH FUND, INC. ATTEST BY: Thomas M. Mistele Harold F. McElraft Secretary Vice President FRANKLIN/TEMPLETON INVESTOR SERVICES, INC. ATTEST BY: Thomas M. Mistele Harold F. McElraft Secretary Vice President For Schedule A - I pulled the sheet from our Contracts Binders - it appeared to be a more current version and had the correct CPI rates. Schedule A Schedule B OUT-OF-POCKET EXPENSES The Fund shall reimburse FTIS monthly for the following out-of- pocket expenses: o postage and mailing o forms o outgoing wire charges o telephone o Federal Reserve charges for check clearance o if applicable, magnetic tape and freight o retention of records o microfilm/microfiche o stationary o insurance o if applicable, terminals, transmitting lines and any expenses incurred in connection with such terminals and lines o all other miscellaneous expenses reasonably incurred by FTIS The Fund agrees that postage and mailing expenses will be paid on the day of or prior to mailing as agreed with FTIS. In addition, the Fund will promptly reimburse FTIS for any other expenses incurred by FTIS as to which the Fund and FTIS mutually agree that such expenses are not otherwise properly borne by FTIS as part of its duties and obligations under the Agreement. Schedule C DUTIES AS TRANSFER AGENT FOR INVESTORS IN THE FUND, FTIS WILL: o Record in its transfer record, countersign as transfer agent, and deliver certificates signed manually or by facsimile, by the President or a Vice-President and by the Secretary or the Assistant Secretary of the Fund, in such names and for such number of authorized but hitherto unissued Shares of the Fund as to which FTIS shall receive instructions; and o Transfer on its records from time to time, when presented to it for that purpose, certificates of said Shares, whether now outstanding or hereafter issued, when countersigned by a duly authorized transfer agent, and upon the cancellation of the old certificates, record and countersign new certificates for a corresponding aggregate number of Shares and deliver said new certificates. AS SHAREHOLDER SERVICE AGENT FOR INVESTORS IN THE FUND, FTIS WILL: o Receive from the Fund, from the Fund's Principal Underwriter or from a Shareholder, on a form acceptable to FTIS, information necessary to record sales and redemptions and to generate sale and/or redemption confirmations; o Mail sale and/or redemption confirmations using standard forms; o Accept and process cash payments from investors, clear checks which represent payments for the purchase of Shares; o Requisition Shares in accordance with instructions of the Principal Underwriter of the Shares of the Fund; o Produce periodic reports reflecting the accounts receivable and the paid pending (free stock) items; o Open, maintain and close Shareholder accounts; o Establish registration of ownership of Shares in accordance with generally accepted form; o Maintain monthly records of (i) issued Shares and (ii) number of Shareholders and their aggregate Shareholdings classified according to their residence in each State of the United States or foreign country; o Accept and process telephone exchanges and redemptions for Shares in accordance with the Fund's Telephone Exchange and Redemption Privileges as described in the Fund's current prospectus. o Maintain and safeguard records for each Shareholder showing name(s), address, number of any certificates issued, and number of Shares registered in such name(s), together with continuous proof of the outstanding Shares, and dealer identification, and reflecting all current changes. On request, provide information as to an investor's qualification for Cumulative Quantity Discount. Provide all accounts with year-to-date and year-end historical confirmation statements; o Provide on request a duplicate set of records for file maintenance in the Fund's office in St. Petersburg, Florida; o Out of money received in payment for Share sales, pay to the Fund's Custodian Account with the Custodian, the net asset value per Share and pay to the Principal Underwriter its commission; o Redeem Shares and prepare and mail (or wire) liquidation proceeds; o Pass upon the adequacy of documents submitted by a Shareholder or his legal representative to substantiate the transfer of ownership of Shares from the registered owner to transferees; o From time to time, make transfers upon the books of the Fund in accordance with properly executed transfer instructions furnished to FTIS and make transfers of certificates for such Shares as may be surrendered for transfer properly endorsed, and countersign new certificates issued in lieu thereof; o Upon receipt of proper documentation, place stop transfers, obtain necessary insurance forms, and reissue replacement certificates against lost, stolen or destroyed Share certificates; o Check surrendered certificates for stop transfer restrictions. Although FTIS cannot insure the genuineness of certificates surrendered for cancellation, it will employ all due reasonable care in deciding the genuineness of such certificates and the guarantor of the signature(s) thereon; o Cancel surrendered certificates and record and countersign new certificates; o Certify outstanding Shares to auditors; o In connection with any meeting of Shareholders, upon receiving appropriate detailed instructions and written materials prepared by the Fund and proxy proofs checked by the Fund, print proxy cards; deliver to Shareholders all reports, prospectuses, proxy cards and related proxy materials of suitable design for enclosing; receive and tabulate executed proxies; and furnish a list of Shareholders for the meeting; o Answer routine correspondence and telephone inquiries about individual accounts. Prepare monthly reports for correspondence volume and correspondence data necessary for the Fund's Semi-Annual Report on Form N- SAR; o Prepare and mail dealer commission statements and checks; o Maintain and furnish the Fund and its Shareholders with such information as the Fund may reasonably request for the purpose of compliance by the Fund with the applicable tax and securities laws of applicable jurisdictions; o Mail confirmations of transactions to investors and dealers in a timely fashion; o Pay or reinvest income dividends and/or capital gains distributions to Shareholders of record, in accordance with the Fund's and/or Shareholder's instructions, provided that: (a) The Fund shall notify FTIS in writing promptly upon declaration of any such dividend and/or distribution, and in any event at least forty-eight (48) hours before the record date; (b) Such notification shall include the declaration date, the record date, the payable date, the rate, and, if applicable, the reinvestment date and the reinvestment price to be used; and (c) Prior to the payable date, the Fund shall furnish FTIS with sufficient fully and finally collected funds to make such distribution; o Prepare and file annual United States information returns of dividends and capital gains distributions (Form 1099) and mail payee copies to Shareholders; report and pay United States income taxes withheld from distributions made to nonresidents of the United States, and prepare and mail to Shareholders the notice required by the U.S. Internal Revenue Code as to realized capital gains distributed and/or retained, and their proportionate share of any foreign taxes paid by the Fund; o Prepare transfer journals; o Set up wire order trades on file; o Receive payment for trades and update the trade file; o Produce delinquency and other trade file reports; o Provide dealer commission statements and payments thereof for the Principal Underwriter; o Sort and print shareholder information by state, social code, price break, etc.; and o Mail promptly the Statement of Additional Information of the Fund to each Shareholder who requests it, at no cost to the Shareholder. In connection with the Fund's Cash Withdrawal Program, FTIS will: o Make payment of amounts withdrawn periodically by the Shareholder pursuant to the Program by redeeming Shares, and confirm such redemptions to the Shareholder; and o Provide confirmations of all redemptions, reinvestment of dividends and distributions, and any additional investments in the Program, including a summary confirmation at the year-end. In connection with Tax Deferred Retirement Plans involving the Fund, FTIS will: o Receive and process applications, accept contributions, record Shares issued and dividends reinvested; o Make distributions when properly requested; and o Furnish reports to regulatory authorities as required. Exhibit 10.4 TEMPLETON GROWTH FUND, INC. 700 Central Avenue St. Petersburg, Florida 33701-3628 Franklin/Templeton Distributors, Inc. 700 Central Avenue St. Petersburg, Florida 33701-3628 Re: Distribution Agreement Gentlemen: We are a Maryland corporation operating as an open-end management investment company. As such, our company, Templeton Growth Fund, Inc. (referred to herein as the "Fund") is registered under the Investment Company Act of 1940, (the "1940 Act"), and its shares are registered under the Securities Act of 1933 (the "1933 Act"). We desire to begin issuing our authorized but unissued shares of common stock (the "Shares") to authorized persons in accordance with applicable Federal and State securities laws. You have informed us that your company is registered as a broker- dealer under the provisions of the Securities Exchange Act of 1934 and that your company is a member of the National Association of Securities Dealers, Inc. You have indicated your desire to act as the exclusive selling agent and distributor for the Shares. We have been authorized to execute and deliver this Agreement to you by a resolution of our Board of Directors passed at a meeting at which a majority of our Directors, including a majority who are not otherwise interested persons of the Fund and who are not interested persons of our investment adviser, its related organizations or with you or your related organizations, were present and voted in favor of the said resolution approving this Agreement. 1. Appointment of Underwriter. Upon the execution of this Agreement and in consideration of the agreements on your part herein expressed and upon the terms and conditions set forth herein, we hereby appoint you as the exclusive sales agent for our Shares (except for sales made directly by the Fund without sales charge) and agree that we will deliver such Shares as you may sell. You agree to use your best efforts to promote the sale of Shares, but are not obligated to sell any specific number of Shares. 2. Independent Contractor. You will undertake and discharge your obligations hereunder as an independent contractor and shall have no authority or power to obligate or bind us by your actions, conduct or contracts except that you are authorized to accept orders for the purchase or repurchase of Shares as our agent. You may appoint sub-agents or distribute through dealers or otherwise as you may determine from time to time, but this Agreement shall not be construed as authorizing any dealer or other person to accept orders for sale or repurchase on our behalf or otherwise act as our agent for any purpose. You may allow such sub-agents or dealers such commissions or discounts not exceeding the total sales commission as you shall deem advisable so long as any such commissions or discounts are set forth in our current prospectus to the extent required by the applicable Federal and State securities laws. 3. Offering Price. The Shares of the Fund shall be offered for sale at a price equivalent to their respective net asset value (as specified in the Fund's prospectus) plus a variable percentage of the public offering price as sales commission. On each business day on which the New York Stock Exchange is open for business, we will furnish you with the net asset value of the Shares which shall be determined in accordance with our then effective prospectus. All Shares will be sold in the manner set forth in our then effective prospectus. 4. Sales Commission. You shall be entitled to charge a sales commission on the sale of our Shares in the amount set forth in our then effective prospectus. Such commission (subject to any quantity or other discounts or eliminations of commission as set forth in our then current effective prospectus) shall be an amount mutually agreed upon between us and equal to the difference between the net asset value and the public offering price of our Shares. You may reallow to dealers all or any part of the discount you are allowed. 5. Terms and Conditions of Sales. Shares of the Fund shall be offered for sale only in those jurisdictions where they have been properly registered or are exempt from registration, and only to those groups of people which the Board of Directors may from time to time determine to be eligible to purchase such shares. 6. Payment of Shares. At or prior to the time of delivery of any of our Shares you will pay or cause to be paid to our Custodian or its successor, for our account, an amount in cash equal to the net asset value of such Shares. In the event that you pay for Shares sold by you prior to your receipt of payment from purchasers you are authorized to reimburse yourself for the net asset value of such Shares from the offering price of such Shares when received by you. 7. Purchases for Your Own Account. You shall not purchase our Shares for your own account for purposes of resale to the public, but you may purchase Shares for your own investment account upon your written assurance that the purchase is for investment purposes and that the Shares will not be resold except through redemption by us. 8. Sale of Shares at Net Asset Value. You may sell our Shares at net asset value in accordance with the terms of the Fund's then current prospectuses. 9. Allocation of Expenses. We will pay the expenses: (a) Of the preparation of the audited and certified financial statements of our company to be included in any Post-Effective Amendments ("Amendments") to our Registration Statement under the 1933 Act or 1940 Act, including the prospectus and statement of additional information included therein; (b) Of the preparation, including legal fees, and of printing all Amendments or supplements filed with the Securities and Exchange Commission, including the copies of the prospectuses included in the Amendments which we send to our existing shareholders other than those necessitated by your (including your "Parent's") activities or Rules and Regulations related to your activities where such Amendments or supplements result in expenses which we would not otherwise have incurred; (c) Of the preparation, printing and distribution of any reports or communications which we send to our existing shareholders; and (d) Of filing and other fees to Federal and State securities regulatory authorities necessary to continue offering our Shares of the Fund as you may require in connection with your duties as underwriter. You will pay the expenses: (a) Of printing the copies of the prospectuses and any supplements thereto and statement of additional information which are necessary to continue to offer our Shares; (b) Of the preparation, excluding legal fees, and printing of all Amendments and supplements to our prospectuses and statement of additional information if the Amendment or supplement arises from your (including your "Parent's") activities or Rules and Regulations related to your activities and those expenses would not otherwise have been incurred by us; (c) Of printing additional copies, for use by you as sales literature, of reports or other communications which we have prepared for distribution to our existing shareholders; and (d) Incurred by you in advertising, promoting and selling our Shares. 10. Furnishing of Information. We will furnish to you such information with respect to the Fund and its Shares, in such form and signed by such of our officers as you may reasonably request, and we warrant that the statements therein contained when so signed will be true and correct. We will also furnish you with such information and will take such action as you may reasonably request in order to qualify our Shares for sale to the public under the Blue Sky Laws of jurisdictions in which you may wish to offer them. We will furnish you with annual audited financial statements of our books and accounts certified by independent public accountants, with semi-annual financial statements prepared by us, and, from time to time, with such additional information regarding our financial condition as you may reasonably request. 11. Conduct of Business. Other than our currently effective prospectus, you will not issue any sales material or statements except literature or advertising which conforms to the requirements of Federal and State securities laws and regulations and which have been filed, where necessary, with the appropriate regulatory authorities. You will furnish us with copies of all such materials prior to their use and no such material shall be published if we shall reasonably and promptly object. You shall comply with the applicable Federal and State laws and regulations where our Shares are offered for sale and conduct your affairs with us and with dealers, brokers or investors in accordance with the Rules of Fair Practice of the National Association of Securities Dealers, Inc. and in strict accordance with the applicable provisions of the Articles of Incorporation and By-Laws of the Fund. In the absence of willful misfeasance, bad faith or gross negligence on your part, or of reckless disregard of your obligations hereunder, you shall not be subject to liability for any act or omission in the course of, or connected with, rendering services hereunder. 12. Contingent Deferred Sales Charges. You shall be entitled to receive a contingent deferred sales charge from the proceeds of redemption of Shares of the Fund on such terms and in such amounts as are set forth in the then current prospectus of the Fund. In addition, you may retain any amounts authorized for payment to you under the Fund's Distribution Plan. 13. Redemption or Repurchase Within Seven Days. If Shares are tendered to us for redemption or repurchase by us within seven business days after your acceptance of the original purchase order for such Shares, you will immediately refund to us the full sales commission (net of allowances to dealers or brokers) allowed to you on the original sale, and will promptly, upon receipt thereof, pay to us any refunds from dealers or brokers of the balance of sales commissions reallowed by you. We shall notify you of such tender for redemption within 10 days of the day on which notice of such tender for redemption is received by us. 14. Other Activities. Your services pursuant to this Agreement shall not be deemed to be exclusive, and you may render similar services and act as an underwriter, distributor or dealer for other investment companies in the offering of their shares. 15. Term of Agreement. This Agreement shall become effective on the date of its execution, and shall remain in effect for a period of two (2) years. The Agreement is renewable annually thereafter with respect to the Fund for successive periods not to exceed one year (i) by a vote of a majority of the outstanding voting securities of the Fund or by a vote of the Board of Directors of the Fund, and (ii) by a vote of a majority of the Directors of the Fund who are not parties to the Agreement or interested persons of any parties to the Agreement (other than as Directors of the Fund), cast in person at a meeting called for the purpose of voting on the Agreement. This Agreement may at any time be terminated by the Fund without the payment of any penalty, (i) either by vote of the Board of Directors of the Fund or by vote of a majority of the outstanding voting securities of the Fund, on 60 days' written notice to you; or (ii) by you on 60 days' written notice to the Fund; and shall immediately terminate with respect to the Fund in the event of its assignment. 16. Suspension of Sales. We reserve the right at all times to suspend or limit the public offering of the Shares of the Fund upon two days' written notice to you. 17. Miscellaneous. This Agreement shall be subject to the laws of the State of California and shall be interpreted and construed to further promote the operation of the Fund as an open- end investment company. As used herein the terms "Net Asset Value", "Offering Price", "Investment Company", "Open-End Investment Company", "Assignment", "Principal Underwriter", "Interested Person", "Parents", "Affiliated Person", and "Majority of the Outstanding Voting Securities" shall have the meanings set forth in the 1933 Act or the 1940 Act and the Rules and Regulations thereunder. If the foregoing meets with your approval, please acknowledge your acceptance by signing each of the enclosed copies, whereupon this will become a binding agreement as of the date set forth below. Very truly yours, TEMPLETON GROWTH FUND, INC By: Accepted: FRANKLIN/TEMPLETON DISTRIBUTORS, INC. By: DATED: June 1, 1993 Exhibit 10.5 INVESTMENT MANAGEMENT AGREEMENT AGREEMENT made as of the 30th day of October, 1992, between TEMPLETON GROWTH FUND, INC., a corporation organized under the laws of the State of Maryland (hereinafter referred to as the "Fund"), and TEMPLETON, GALBRAITH & HANSBERGER LTD. (hereinafter referred to as the "Investment Manager"). In consideration of the mutual agreements herein made, the Fund and the Investment Manager understand and agree as follows: (1) The Investment Manager agrees, during the life of this Agreement, to furnish the Fund with investment research and advice and continuously to furnish the Fund with an investment program for the assets of the Fund consistent with the provisions of the Articles of Incorporation of the Fund and the investment policies adopted and declared by the Fund's Board of Directors. It is understood that all acts of the Investment Manager in performing this Agreement are performed by it outside the United States. (2) The Investment Manager is not required to furnish any personnel, overhead items or facilities for the Fund, including trading desk facilities or daily pricing of the Fund's portfolio. (3) The Investment Manager shall be responsible for selecting members of securities exchanges, brokers and dealers (such members, brokers and dealers being hereinafter referred to as "brokers") for the execution of the Fund's portfolio transactions consistent with the Fund's brokerage policy and, when applicable, the negotiation of commissions in connection therewith. All decisions and placements shall be made in accordance with the following principles: (A) Purchase and sale orders will usually be placed with brokers which are selected by the Investment Manager as able to achieve "best execution" of such orders. "Best execution" shall mean prompt and reliable execution at the most favorable securities price, taking into account the other provisions hereinafter set forth. The determination of what may constitute best execution and price in the execution of a securities transaction by a broker involves a number of considerations, including, without limitation, the overall direct net economic result to the Fund (involving both price paid or received and any commissions and other costs paid), the efficiency with which the transaction is executed, the ability to effect the transaction at all where a large block is involved, availability of the broker to stand ready to execute possibly difficult transactions in the future, and the financial strength and stability of the broker. Such considerations are judgmental and are weighed by the Investment Manager in determining the overall reasonableness of brokerage commissions. (B) In selecting brokers for portfolio transactions, the Investment Manager shall take into account its past experience as to brokers qualified to achieve "best execution", including brokers who specialize in any foreign securities held by the Fund. (C) The Investment Manager is authorized to allocate brokerage business to brokers who have provided brokerage and research services, as such services are defined in Section 28(e) of the Securities Exchange Act of 1934 (the "1934 Act") for the Fund and/or other accounts, if any, for which the Investment Manager exercises investment discretion (as defined in Section 3(a)(35) of the 1934 Act) and, as to transactions for which fixed minimum commission rates are not applicable, to cause the Fund to pay a commission for effecting a securities transaction in excess of the amount another broker would have charged for effecting that transaction, if the Investment Manager determines in good faith that such amount of commission is reasonable in relation to the value of the brokerage and research services provided by such broker, viewed in terms of either that particular transaction or the Investment Manager's overall responsibilities with respect to the Fund and the other accounts, if any, as to which it exercises investment discretion. In reaching such determination, the Investment Manager will not be required to place or attempt to place a specific dollar value on the research or execution services of a broker or on the portion of any commission reflecting either of said services. In demonstrating that such determinations were made in good faith, the Investment Manager shall be prepared to show that all commissions were allocated and paid for purposes contemplated by the Fund's brokerage policy; that the research services provide lawful and appropriate assistance to the Investment Manager in the performance of its investment decision-making responsibilities, and that the commissions were within a reasonable range. Whether commissions were within a reasonable range shall be based on any available information as to the level of commission known to be charged by other brokers on comparable transactions, but there shall be taken into account the Fund's policies that (i) obtaining a low commission is deemed secondary to obtaining a favorable securities price, since it is recognized that usually it is more beneficial to the Fund to obtain a favorable price than to pay the lowest commission; and (ii) the quality, comprehensiveness, and frequency of research studies which are provided for the Investment Manager are useful to the Investment Manager in performing its advisory services under its Agreement. Research services provided by brokers to the Investment Manager are considered to be in addition to, and not in lieu of, services required to be performed by the Investment Manager under this Agreement. Research furnished by brokers through which the Fund effects securities transactions may be used by the Investment Manager for any of its accounts, and not all such research may be used by the Investment Manager for the Fund. When execution of portfolio transactions is allocated to brokers trading on exchanges with fixed brokerage commission rates, account may be taken of various services provided by the broker. (D) Purchases and sales of portfolio securities within the United States other than on a securities exchange shall be executed with primary market makers acting as principal, except where, in the judgment of the Investment Manager, better prices and execution may be obtained on a commission basis or from other sources. (E) Sales of Fund Shares (which shall be deemed to include also Shares of other registered investment companies which have either the same adviser or an investment adviser affiliated with the Fund's Investment Manager) by a broker are one factor among others to be taken into account in deciding to allocate portfolio transactions (including agency transactions, principal transactions, purchases in underwritings or tenders in response to tender offers) for the account of the Fund to that broker; provided that the broker shall furnish "best execution," as defined in subparagraph A above, and that such allocation shall be within the scope of the Fund's policies as stated above; provided further, that in every allocation made to a broker in which the sale of Fund Shares is taken into account, there shall be no increase in the amount of the commissions or other compensation paid to such broker beyond a reasonable commission or other compensation determined, as set forth in subparagraph C above, on the basis of best execution alone or best execution plus research services, without taking account of or placing any value upon such sale of Fund's Shares. (4) The Fund agrees to pay to the Investment Manager as compensation for such services a monthly fee equal on an annual basis to 0.75% of the first $200,000,000 of the average daily net assets of the Fund during the month preceding each payment, reduced to a fee equal on an annual basis to 0.675% of such average net assets in excess of $200,000,000 up to $1,300,000,000 and further reduced to a fee equal on an annual basis of 0.60% of such net assets in excess of $1,300,000,000. Notwithstanding the foregoing, if the total expenses of the Fund (including the fee to the Investment Manager) in any fiscal year of the Fund exceed any expense limitation imposed by applicable State law, the Investment Manager shall reimburse the Fund for such excess in the manner and to the extent required by applicable State law. The term "total expenses," as used in this paragraph, does not include interest, taxes, litigation expenses, distribution expenses, brokerage commissions or other costs of acquiring or disposing of any of the Fund's portfolio securities or any costs or expenses incurred or arising other than in the ordinary and necessary course of the Fund's business. When the accrued amount of such expenses exceeds this limit, the monthly payment of the Investment Manager's fee will be reduced by the amount of such excess, subject to adjustment month by month during the balance of the Fund's fiscal year if accrued expenses thereafter fall below the limit. (5) This Agreement shall become effective on October 30, 1992 and shall continue in effect until December 31, 1993. If not sooner terminated, this Agreement shall continue in effect for successive periods of 12 months each thereafter, provided that each such continuance shall be specifically approved annually by the vote of a majority of the Fund's Board of Directors who are not parties to this Agreement or "interested persons" (as defined in Investment Company Act of 1940 (the "1940 Act")) of any such party, cast in person at a meeting called for the purpose of voting on such approval and either the vote of (a) a majority of the outstanding voting securities of the Fund, as defined in the 1940 Act, or (b) a majority of the Fund's Board of Directors as a whole. (6) Notwithstanding the foregoing, this Agreement may be terminated by either party at any time, without the payment of any penalty, on sixty (60) days' written notice to the other party, provided that termination by the Fund is approved by vote of a majority of the Fund's Board of Directors in office at the time or by vote of a majority of the outstanding voting securities of the Fund (as defined by the 1940 Act). (7) This Agreement will terminate automatically and immediately in the event of its assignment (as defined in the 1940 Act). (8) In the event this Agreement is terminated and the Investment Manager no longer acts as Investment Manager to the Fund, the Investment Manager reserves the right to withdraw from the Fund the use of the name "Templeton" or any name misleadingly implying a continuing relationship between the Fund and the Investment Manager or any of its affiliates. (9) Except as may otherwise be provided by the 1940 Act, neither the Investment Manager nor its officers, directors, employees or agents shall be subject to any liability for any error of judgment, mistake of law, or any loss arising out of any investment or other act or omission in the performance by the Investment Manager of its duties under the Agreement or for any loss or damage resulting from the imposition by any government of exchange control restrictions which might affect the liquidity of the Fund's assets, or from acts or omissions of custodians, or securities depositories, or from any war or political act of any foreign government to which such assets might be exposed, or for failure, on the part of the custodian or otherwise, timely to collect payments, except for any liability, loss or damage resulting from willful misfeasance, bad faith or gross negligence on the Investment Manager's part or by reason of reckless disregard of the Investment Manager's duties under this Agreement. It is hereby understood and acknowledged by the Fund that the value of the investments made for the Fund may increase as well as decrease and are not guaranteed by the Investment Manager. It is further understood and acknowledged by the Fund that investment decisions made on behalf of the Fund by the Investment Manager are subject to a variety of factors which may affect the values and income generated by the Fund's portfolio securities, including general economic conditions, market factors and currency exchange rates, and that investment decisions made by the Investment Manager will not always be profitable or prove to have been correct. (10) It is understood that the services of the Investment Manager are not deemed to be exclusive, and nothing in this Agreement shall prevent the Investment Manager, or any affiliate thereof, from providing similar services to other investment companies and other clients, including clients which may invest in the same types of securities as the Fund, or, in providing such services, from using information furnished by others. When the Investment Manager determines to buy or sell the same security for the Fund that the Investment Manager or one or more of its affiliates has selected for clients of the Investment Manager or its affiliates, the orders for all such security transactions shall be placed for execution by methods determined by the Investment Manager, with approval by the Fund's Board of Directors, to be impartial and fair. (11) This Agreement shall be construed in accordance with the laws of the State of Maryland, provided that nothing herein shall be construed as being inconsistent with applicable Federal and state securities laws and any rules, regulations and orders thereunder. (12) If any provision of this Agreement shall be held or made invalid by a court decision, statute, rule or otherwise, the remainder of this Agreement shall not be affected thereby and, to this extent, the provisions of this Agreement shall be deemed to be severable. (13) Nothing herein shall be construed as constituting the Investment Manager an agent of the Fund. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers and their respective corporate seals to be hereunto duly affixed and attested. TEMPLETON GROWTH FUND, INC. By: Daniel Calabria Vice President ATTEST: Thomas M. Mistele Secretary TEMPLETON, GALBRAITH & HANSBERGER LTD. By: Thomas L. Hansberger President ATTEST: Gregory E. McGowan Secretary December 3, 1993 Exhibit 18 Franklin Resources, Inc. 777 Mariners Island Blvd San Mateo, CA 94404 We are providing this letter to you for inclusion as an exhibit to your Form 10-K filing pursuant to Item 601 of Regulation S-K. We have read management's justification for the change from an unclassified balance sheet to a classified balance sheet and the related change in items included in Cash and Cash Equivalents in the financial statements contained in the Company's Form 10-K for the year ended September 30, 1993. Based on our reading of the data and discussions with Company officials of the business judgment and business planning factors relating to the changes, we believe management's justifications to be reasonable. Accordingly, we concur that the newly adopted accounting principles described above are preferable in the Company's circumstances to the methods previously applied. Very truly yours, /s/ Coopers & Lybrand Coopers & Lybrand EXHIBIT 21 Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement of Franklin Resources, Inc. on Form S-8 for the 1988 Restricted Stock Plan and Form S-8 for the Canada Stock Option Plan of our report dated December 3, 1993, on our audits of the consolidated financial statements and financial statement schedules of Franklin Resources, Inc. as of September 30, 1993 and 1992, and for the years ended September 30, 1993, 1992, and 1991, which report is included in this Annual Report on Form 10-K. Coopers & Lybrand /s/ Coopers & Lybrand San Francisco, California December 17, 1993 Exhibit 99(i) Board of Directors Franklin/Templeton Investor Services, Inc.: In planning and performing our audit of the consolidated financial statements of Franklin Resources, Inc. (FRI) for the year ended September 30, 1993, we have considered the internal control structure, including what we considered relevant to the criteria established by the Securities and Exchange Commission as set forth in Rule 17ad-13 (a) (3) of the Securities Exchange Act of 1934, of San Mateo, California operations of Franklin/Templeton Investor Services, Inc. (the Company), the mutual fund transfer and shareholder servicing subsidiary of FRI, in order to determine our auditing procedures for the purpose of expressing our opinion on the consolidated financial statements and not to provide assurance on the internal control structure. The study of the internal accounting and administrative procedures of the Florida operations of the Company was performed by other auditors, who issued their separate report thereon. Under Rule 17ad-13(a)(3), the objectives of a transfer agent's system of internal accounting control for the transfer of record ownership and the safeguarding of related securities and funds should be to provide reasonable, but not absolute, assurance that securities and funds are safeguarded against loss from unauthorized use or disposition and that transfer agent activities are performed promptly and accurately. The Rule defines a material inadequacy as a condition wherein the prescribed procedures or the degree of compliance with them do not reduce to a relatively low level the risk that errors or irregularities, in amounts that would have a significant adverse effect on the transfer agent's ability promptly and accurately to transfer record ownership and safeguard related securities and funds, would occur or not be detected within a timely period by employees in the normal course of performing their assigned functions. Occurrence of errors or irregularities more frequently than in isolated instances may be evidence that the system has a material inadequacy. A significant adverse effect on a transfer agent's ability promptly and accurately to transfer record ownership and safeguard related securities and funds could result from any condition or conditions that individually, or taken as a whole, would reasonably be expected to (1) inhibit the transfer agent from promptly and accurately discharging its responsibilities under its contractual agreement with the issuer; (2) result in material financial loss to the transfer agent; or (3) result in a violation of regulations set forth in Rule 17ad-13(a) (3) (iii). The management of the Company is responsible for establishing and maintaining an internal control structure and the practices and procedures referred to in the preceding paragraph. In fulfilling this responsibility, estimates and judgments by management are required to assess the expected benefits and related costs of internal control structure policies and procedures and of the practices and procedures referred to in the preceding Board of Directors December 3, 1993 Franklin/Templeton Investors Services, Inc.: Page 2 paragraph and to assess whether those practices and procedures can be expected to achieve the Commission's above mentioned objectives. Two of the objectives of an internal control structure and the practices and procedures are to provide management with reasonable, but not absolute, assurance that assets for which the Company has responsibility are safeguarded against loss from unauthorized use or disposition and that transactions are executed in accordance with management's authorization and recorded properly to permit the preparation of financial statements in conformity with generally accepted accounting principles. Rule 17ad-13(a)(3) lists additional objectives of the practices and procedures listed in the preceding paragraph. Because of inherent limitations in any internal accounting control procedures or the practices and procedures referred to above, errors or irregularities may occur and not be detected. Also, projection of any evaluation of them to future periods is subject to the risk that they may become inadequate because of changes in conditions or that the effectiveness of their design may deteriorate. Our consideration of the internal control structure would not necessarily disclose all matters in the internal control structure that might be material weaknesses under standards established by the American Institute of Certified Public Accounts. A material weakness is a condition in which the design or operation of the specific internal control structure elements does not reduce to a relatively low level the risk that errors or irregularities in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions. However, we noted no matters involving the internal control structure including procedures for safeguarding securities, that we consider to be material weaknesses as defined above. We understand that practices and procedures that accomplish the objectives referred to in the second paragraph of this report are considered by the Commission to be adequate for its purposes in accordance with the Securities Exchange Act of 1934 and related regulations, and that practices and procedures that do not accomplish such objectives in all material respects indicate a material inadequacy for such purposes. Based on this understanding and on our study, we believe that the Company's San Mateo, California practices and procedures were adequate at September 30, 1993, to meet the Commission's objectives. This report is intended solely for the use of management, the Securities and Exchange Commission, the New York Stock Exchange and other regulatory agencies which rely on Rule 17ad-13(a)(3) under the Securities Exchange Act of 1934, and should not be used for any other purpose. Coopers & Lybrand /s/ Coopers & Lybrand San Francisco, California December 3, 1993 Exhibit 99(ii) To the Board of Directors Franklin/Templeton Investor Services, Inc. St. Petersburg, FL We have made a study and evaluation of the internal control structure over the TITAN Mutual Fund Shareholder System and Related Shareholder Servicing Functions of Franklin/Templeton Investor Services, Inc. located in St. Petersburg, FL (the "Service Center") in effect as of September 17, 1993. Our study and evaluation was made in accordance with standards established by the American Institute of Certified Public Accountants using the criteria established by the Securities and Exchange Commission as set forth in Rule 17 AD-13(a)(3) of the Securities Exchange Act of 1934. Under the aforementioned Rule, a transfer agent's internal control structure for the transfer of record ownership and the safeguarding of related securities and funds should provide reasonable, but not absolute, assurance that securities and funds are safeguarded against loss from unauthorized use or disposition and that transfer agent activities are performed promptly and accurately. The Rule defines a material inadequacy as a condition wherein the prescribed procedures or the degree of compliance with them do not reduce to a relatively low level the risk that errors or irregularities, in amounts that would have a significant adverse effect on the transfer agent's ability to promptly and accurately transfer record ownership and safeguard related securities and funds, would occur and not be detected within a timely period by employees in the normal course of performing their assigned functions. Occurrence of errors or irregularities more frequently than in isolated instances may be evidence that the system has a material inadequacy. A significant adverse effect on a transfer agent's ability to properly and accurately transfer record ownership and safeguard related securities and funds could result from any condition or conditions that individually, or taken as a whole, would reasonably be expected to (1) inhibit the transfer agent from promptly and accurately discharging its responsibilities under its contractual agreement with the issuer; (2) result in material financial loss to the transfer agent; or (3) result in a violation of regulations set forth in Rule 17 AD-13(a)(3)(iii). The management of the Service Center is responsible for establishing and maintaining an internal control structure and the practices and procedures referred to in the preceding paragraph. In fulfilling this responsibility, estimates and judgments by management are required to assess the expected benefits and related costs of control procedures. The objectives of such a system are to provide management with reasonable, but not absolute, assurance that assets for which the Service Center has responsibility are safeguarded against loss from unauthorized use or disposition and that transactions are executed in accordance with management's authorization and in accordance with governing instruments and are recorded properly to permit the preparation of reliable financial data. Because of inherent limitations in any internal control structure or the practices and procedures referred to above, errors or irregularities may nevertheless occur and not be detected. Also, projection of any evaluation of them to future periods is subject to the risk that they may become inadequate because of changes in conditions or that the degree of compliance with them may deteriorate. In our opinion, the internal control structure of the Service Center that existed as of September 17, 1993, taken as a whole, was sufficient to meet the objectives stated above insofar as those objectives pertain to the prevention or detection of a condition that would be material in relation to the financial statements of Franklin/Templeton Investor Services, Inc. In addition, we understand that practices and procedures that accomplish the objectives referred to in the second paragraph of this report are considered by the Commission to be adequate for its purposes in accordance in the Securities Exchange Act of 1934 and related regulations, and that practices and procedures that do not accomplish such objectives in all material respects indicate a material inadequacy for such purposes. Based on this understanding and on our study, we believe that the Company's practices and procedures were adequate as of September 17, 1993, to meet the Commission's objectives. This report is intended solely for the use of management and the Securities and Exchange Commission and should not be used for any other purpose McGladrey & Pullen /s/ McGladrey & Pullen New York, New York September 17, 1993 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FRANKLIN RESOURCES, INC. Date: December 8, 1993 By /s/ Charles B. Johnson Charles B. Johnson, President 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: December 8, 1993 By /s/ Charles B. Johnson Charles B. Johnson, Principal Executive Officer and Director Date: December 8, 1993 By /s/ Harmon E. Burns Harmon E. Burns, Executive Vice President Legal and Administrative, Secretary and Director Date: December 8, 1993 By /s/ Martin L. Flanagan Martin L. Flanagan, Treasurer and Chief Financial Officer Date: December 8, 1993 By /s/ Philip A. Scatena Philip A. Scatena, Controller Date: December 8, 1993 By /s/ Judson R. Grosvenor Judson R. Grosvenor, Director Date: December 8, 1993 By /s/ F. Warren Hellman F. Warren Hellman, Director Date: December 8, 1993 By /s/ Rupert H. Johnson Rupert H. Johnson, Jr., Director Date: December 8, 1993 By /s/ Harry O. Kline Harry O. Kline, Director Date: December 8, 1993 By /s/ Louis E. Woodworth Louis E. Woodworth, Director Date: December 8, 1993 By /s/ Peter M. Sacerdote Peter M. Sacerdote, Director GRAPHICAL APPENDIX PURSUANT TO REGULATION S-T 232.304 1. HORIZONTAL BAR GRAPH OF REVENUES SHOWING INVESTMENT MANAGEMENT FEES HAS BEEN OMITTED FROM THE MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IN ITEM 7. ABOVE. IDENTICAL INFORMATION IS CONTAINED IN THE NARRATIVE DESCRIPTION SURROUNDING SUCH BAR GRAPH AND IN THE CONSOLIDATING STATEMENTS OF INCOME. 2. HORIZONTAL BAR GRAPH OF REVENUES SHOWING UNDERWRITING COMMISSIONS HAS BEEN OMITTED FROM THE MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IN ITEM 7. ABOVE. IDENTICAL INFORMATION IS CONTAINED IN THE NARRATIVE DESCRIPTION SURROUNDING SUCH BAR GRAPH AND IN THE CONSOLIDATING STATEMENTS OF INCOME 3. HORIZONTAL BAR GRAPH OF REVENUES SHOWING TRANSFER, TRUST AND RELATED FEES HAS BEEN OMITTED FROM THE MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IN ITEM 7. ABOVE. IDENTICAL INFORMATION IS CONTAINED IN THE NARRATIVE DESCRIPTION SURROUNDING SUCH BAR GRAPH AND IN THE CONSOLIDATING STATEMENTS OF INCOME.	27,328	177,019
102237_1993.txt	102237_1993	1993	102237	Item 1. Business The Upjohn Company (the "Company") operates in the human health care and agricultural business segments. HUMAN HEALTH CARE SEGMENT The Company historically has engaged primarily in the research, development, production and sale of prescription pharmaceuticals, and it continues to be one of the largest drug manufacturers in the United States. The Company manufactures a broad line of prescription drugs, primarily central nervous system agents, nonsteroidal anti-inflammatory and analgesic agents, antibiotics, steroids, oral antidiabetes agents and a hair growth product. These are principally products which were developed or invented in its laboratories or for which licenses to make, use and sell have been obtained from others. They are sold to pharmacies and other retail stores, wholesalers, distributors, physicians, hospitals and governmental agencies. The Company also manufactures for distribution to the general public certain nonprescription drugs and manufactures pharmaceutical chemicals for use in its own products and for bulk sales. The Company's most important pharmaceutical products, many of which it sells under other trademarks in foreign markets, are discussed below, together with a summary indication of their principal uses and applications. During 1993 U.S. patent protection expired on ANSAID, CLEOCIN-T, XANAX and HALCION. Additionally, no significant patent protection remains on PROVERA. The U.S. patent on MICRONASE expired in 1992; however, a moratorium on the approval of Abbreviated New Drug Applications (ANDAs) for products containing glyburide, the generic name for MICRONASE, continues until May 1994. A moratorium on the approval of ANDAs also protects exclusivity for GLYNASE, a new formulation of glyburide, until March 1995. For further information on the impact of this loss of patent protection, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, incorporated by reference to the 1993 Annual Report to Shareholders (Exhibit 13). The Company produces two major drugs for central nervous system ("CNS") disorders. XANAX Tablets, containing alprazolam, are used for symptomatic relief of anxiety with and without depressive symptoms and for the treatment of panic disorder. HALCION Tablets, containing triazolam, are a hypnotic agent for the treatment of insomnia. The use patent for the panic disorder indication for XANAX expires in 2002. HALCION, which has been subject to controversy for a number of years, has received increased adverse publicity, particularly in the United States and the United Kingdom, and worldwide regulatory action since mid-1991. For a more detailed description of recent United States and foreign regulatory action taken with respect to HALCION, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, incorporated by reference to the 1993 Annual Report to Shareholders (Exhibit 13). The Company's major oral antidiabetes agent is MICRONASE Tablets, containing glyburide. The Company also markets GLYNASE PresTab Tablets, a new formulation of glyburide for the treatment of non-insulin-dependent diabetes. The Company markets ANSAID Tablets, a nonsteroidal anti-inflammatory product containing flurbiprofen, for treatment of osteoarthritis and rheumatoid arthritis. The Company also markets MOTRIN Tablets, a nonsteroidal anti-inflammatory product containing ibuprofen, used in the treatment of rheumatoid arthritis and osteoarthritis and as a general analgesic for mild to moderate pain, including dysmenorrhea. MOTRIN is not subject to significant patent protection. The Company and its subsidiaries provide a broad line of antibiotic products including CLEOCIN and LINCOCIN products, neither of which is subject to significant United States patent protection. CLEOCIN PHOSPHATE is an injectable form of clindamycin that is used in the treatment of certain life-threatening anaerobic infections. CLEOCIN T is a topical formulation for treatment of acne. CLEOCIN VAGINAL CREAM is used to treat bacterial vaginosis. LINCOCIN is used in the treatment of serious infections caused by many strains of gram-positive bacteria. Upjohn has exclusive U.S. marketing rights to VANTIN Tablets and Oral Suspension, an advanced cephalosporin antibiotic, under patents licensed from Sankyo Company, Ltd., which rights will become semi-exclusive in 1997. The Company also markets ZEFAZONE Sterile Powder, another cephalosporin antibiotic, under license from Sankyo. The Company markets several steroid hormones having a variety of uses, including the treatment of allergic reactions, inflammation, asthma and certain hormone deficiencies, none of which are subject to significant patent protection. The most important synthetic hormone is PROVERA Tablets, which is a female sex hormone replacement agent. The Company produces various forms of chemical modifications of hormones, under the trademark MEDROL, which is used to treat a number of inflammatory and allergic conditions. SOLU-CORTEF Sterile Powder and SOLU-MEDROL Sterile Powder are injectable corticosteroid products. The Company recently introduced DEPO-PROVERA Contraceptive Injection in the U.S. In 1993, the government of India granted the Company permission to market DEPO-PROVERA Contraceptive Injection in that country. The Company also markets certain prostaglandin products, including PROSTIN E2 Vaginal Suppository, which is generally used for pregnancy disorders, and PROSTIN VR PEDIATRIC Sterile Solution, for cardiovascular use, neither of which is subject to significant patent protection. The Company has recently introduced in the U.S. PREPIDIL Gel, used for cervical ripening, which is protected by U.S. patents until 2003. In 1993, the Company obtained worldwide marketing rights to OGEN Tablets and Vaginal Cream, an estrogen replacement product, from Abbott Laboratories. The Company produces and sells ROGAINE Topical Solution, a 2% solution of minoxidil applied topically to restore hair growth in men with male pattern baldness and in women with androgenetic alopecia, or hereditary hair loss. The product is also sold in numerous foreign countries. The United States patents covering ROGAINE expire in 1996. Other prescription drugs include ATGAM Sterile Solution, an immunosuppressant product, COLESTID Granules and Flavored Granules, a cholesterol-lowering agent, and CYTOSAR-U Sterile Powder, used for the treatment of leukemia. These products are no longer subject to significant patent protection. Geneva Pharmaceuticals, Inc., a subsidiary of CIBA-GEIGY Corporation, has certain rights to market generic versions of the Company's XANAX, HALCION, ANSAID, MICRONASE and CLEOCIN T products under an agreement with the Company. The Company also markets certain generic products through its subsidiary, Greenstone, Ltd. The Company manufactures and distributes other products which do not require a prescription, including MOTRIN IB Tablets and Caplets, an analgesic; MOTRIN IB Sinus Tablets and Caplets, a sinus pain formula; KAOPECTATE products, for diarrhea; CORTAID products, anti-inflammatory topical products; the family of UNICAP vitamin products; DRAMAMINE, anti-motion sickness medicines, and MYCITRACIN, an antibiotic ointment for treatment of minor skin infections and burns. The Company also holds a license from Hoechst-Roussel Pharmaceuticals Inc. for exclusive United States rights to the nonprescription laxative products DOXIDAN and SURFAK. The Company also has a U.S. marketing arrangement with McNeil Consumer Products Company whereby the Company will receive access to several ibuprofen-based and other products being developed by McNeil. The Company has an agreement with Biopure Corporation under which the Company will acquire sales and marketing rights to any bovine hemoglobin-derived blood substitute products developed for human or animal use by Biopure. The Company has joint marketing agreements with Hoechst-Roussel Pharmaceuticals Inc. to jointly market ALTACE Capsules, a product for the treatment of hypertension, and with Solvay S.A. to jointly market Solvay's fluvoxamine, for the treatment of depression (which is approved in Europe and Canada but not yet approved in the United States), and Upjohn's XANAX. In 1992, the Company entered into a collaboration with Boehringer Ingelheim International GmbH to develop and market worldwide four CNS compounds. International Pharmaceutical Operations The Company manufactures and sells throughout the world many of the prescription pharmaceuticals described above. The principal markets are Europe, Japan, the Pacific Region, Latin America, the Middle East and Canada. The Company competes with a large number of other companies primarily on the basis of product differentiation and price. The most significant product areas for the Company's international sales are antibiotics, central nervous system agents and corticosteroids. Delta West Pty. Limited, an Australian subsidiary of the Company, manufactures and distributes a broad line of generic products for hospital applications, with particular emphasis on injectable oncolytic products in plastic containers, primarily in Australia, New Zealand and Southeast Asia. Delta West is in the process of expanding its export efforts through the Asia- Pacific region and other markets. In 1993, Delta West and the Company entered into a collaboration with Gensia Laboratories Inc. to develop and market Delta West and Gensia generic oncology and pain products in the United States. Sale of the first product approved by the Food and Drug Administration from the collaboration with Gensia, injectable etoposide, commenced in February 1994. The Company, through its subsidiary, Sanorania GmbH, markets a broad line of branded generic pharmaceutical products throughout Germany. Competition It is estimated there are at least 50 companies that are significant competitors in the United States in the sale of prescription and nonprescription pharmaceutical products. A major feature of this competition is the effort to discover, develop and introduce new or improved products for the treatment and prevention of disease. Other competitive features include quality, price, dissemination of technical information, competent product recall capability and medical support advice. Significant changes in marketing conditions are occurring in both the U.S. and foreign pharmaceutical markets, including decreased pricing flexibility, restrictions on promotional and marketing practices and the impact of managed care, particularly with respect to product selections and pricing concessions. See "Governmental Regulation" under "General" below for a description of the competitive effects of FDA regulation. Distribution The Company has a domestic pharmaceutical sales force of technically trained representatives who call on physicians, pharmacists, hospital personnel, HMOs and other managed health care organizations and wholesale drug outlets. Most sales of pharmaceutical products are made directly to pharmacies, hospitals, chain warehouses, wholesalers and other distributors, although some are made to physicians and governments. Nonprescription drugs are also sold to other retail stores. Domestic customers are served from several distribution centers located throughout the United States. Separate sales forces handle nonprescription drug sales and foreign pharmaceutical sales. Puerto Rico Operations The Company conducts substantial pharmaceutical manufacturing operations in Puerto Rico through a wholly owned subsidiary. Under current law, the earnings from this subsidiary will be partially exempt from both United States and Puerto Rico income taxes. The Omnibus Budget Reconciliation Act of 1993 will reduce, in years subsequent to 1994, the amount of Puerto Rico tax benefits available under Section 936 of the Internal Revenue Code (ultimately reducing the benefit under the current law by 60 percent). If earnings from the Company's Puerto Rican subsidiary are repatriated in the form of a dividend to the Company, such earnings would be subject to a Puerto Rican withholding tax of up to 10% of the amount repatriated. Under the Puerto Rico tax exemption grant, certain credits are available to reduce Puerto Rican withholding taxes. See Notes E and H of "Notes to Consolidated Financial Statements" in the 1993 Annual Report to Shareholders (Exhibit 13), which is hereby incorporated by reference, and Schedule I on page 36 herein, for further information, including the effect on the Company's net earnings of the Puerto Rican tax exemption grant and the investment of earnings from Puerto Rican operations. AGRICULTURAL SEGMENT Asgrow Seed Company, a wholly owned subsidiary, is, directly and through its affiliated companies, one of the leading worldwide breeders, developers, producers and marketers of vegetable and agronomic seed. Among Asgrow's major vegetable seed products are peas, beans, sweet corn, cucumbers, tomatoes, carrots, lettuce, onions and cantaloupe; and its major agronomic seed products are hybrid corn, hybrid sorghum and soybeans. Asgrow competes with a large number of other seed producers primarily on the basis of price, quality and yields. The sale of seeds is seasonal. The Company also participates in a 50-percent-owned joint venture with Tyson Foods, Inc., called Cobb-Vantress, Inc., for developing, producing and marketing broiler chicken breeders. In late 1993, the Company sold the assets of Asgrow Florida Company, a distributor of agricultural chemicals and supplies in Florida, to Terra Industries, Inc. The vegetable and agronomic seed varieties previously sold by Asgrow Florida Company will continue to be sold by Asgrow Seed Company. The Company develops, manufactures and sells animal pharmaceutical products and animal feed additives, the sales of which fluctuate with changes in the agricultural economy. These products are sold to veterinarians, feed manufacturers, distributors and growers who choose the Company's products primarily because of their efficacy and suitability for particular uses. Major products include NAXCEL Sterile Powder, an antibiotic for bovine and swine respiratory disease and early chick mortality; LINCO-SPECTIN Soluble Powder and Premix, a combination lincomycin/spectinomycin antibiotic; LINCOMIX 20 and LINCOMIX 50 Feed Medication, which are feed-additive antibiotics; MGA Premix, which is a growth-promoting feed additive for feedlot heifers; various products for the treatment of mastitis; DELTA ALBAPLEX Tablets and LINCOCIN, which are small-animal antibiotics; and LUTALYSE Sterile Solution, which is used to synchronize breeding performance in mares and cattle. In addition, the Company sells a line of animal health vaccines through Oxford Veterinary Laboratories, Inc. (Bio-Vac Labs, Inc.). Separate sales units handle the sales of animal health products and seeds. GENERAL Research and Patents Total research and development expenditures have increased each year for more than a decade, amounting to $522.9 million in 1991, $581.5 million in 1992, and $642.0 million in 1993. There are continuing research programs principally in the areas of cardiovascular diseases, central nervous system diseases, infectious diseases, atherosclerosis and thrombosis, hypersensitivity diseases, cancer, diabetes, hair growth, virology, gastrointestinal diseases, AIDS, trauma, biotechnology, agricultural microbiology and nutrition, agricultural growth physiology, agricultural parasitology, agronomic and vegetable seed germ plasm development and seed technology. The Company and its subsidiaries have a large number of United States and foreign patents expiring at various times. The Company considers that the overall protection from its patents and trademarks and from licenses under patents belonging to others is of material value. However, it is believed that no single patent or license is of material importance in relation to the business as a whole. Rights under patents and know-how are both given and taken. In 1993, the Company recorded income for use of know-how and patents totaling approximately $10 million and expenses totaling approximately $54 million. Raw Materials and Energy From time to time, for a number of reasons, there has been difficulty in obtaining certain raw materials for the manufacture of some pharmaceutical products. However, the principal raw materials used by the Company are at this time readily available. Possible effect on the Company of increased costs and possible shortages of material or energy in the future cannot be predicted. Environment Significant capital and operating expenses will be incurred to address environmental remediation and control in connection with the phasing out of its industrial chemical operations at the North Haven, Connecticut plant, improving controls on air emissions at the Kalamazoo manufacturing facilities, addressing other environmental issues at all company facilities and the Company's involvement in certain Superfund sites. The information under the caption "Financial Review" and Notes J and K of "Notes to Consolidated Financial Statements" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. Since several capital projects are undertaken for both environmental control and other business purposes, such as production process improvements, it is difficult to estimate the specific capital expenditures for environmental control. However, including all such multi-purpose capital projects as environmental expenditures, it is estimated that capital expenditures for environmental protection for 1994 and 1995 may exceed $60 million and $45 million each year, respectively. Operating expenses in 1993 for compliance with environmental protection laws and regulations are estimated to have been approximately $40 million. Such operating expenses in 1994 are estimated to be approximately $50 million. Cash payments charged to environmental reserves in 1993 totaled $6 million and are expected to be approximately $20 million in 1994. Among the sites on the United States Environmental Protection Agency's ("EPA") National Priorities List, in connection with which the Company has been identified as a potentially responsible party ("PRP"), is the West KL Avenue Landfill located in Kalamazoo County, Michigan. In September 1991, the Company and three local governmental units agreed to a consent decree with the EPA, which has been approved by the United States Department of Justice and entered by a Federal Court, to undertake necessary remedial action. The costs of remediation may exceed $40 million, of which other viable parties are expected to contribute more than half. Negotiations continue in connection with remediation of the site of the Company's discontinued industrial chemical operations in North Haven, Connecticut. The Town is seeking to force the Company to remove a sludge pile located on the plant site because it violates local zoning ordinances. As a result of the detection of PCBs in the pile in concentrations that may require compliance with additional laws and regulations relative to disposal of PCBs, coupled with significant changes in applicable regulations relating to disposal of hazardous waste, the cost of off-site disposal (if, in fact, such disposal is possible, legal and ultimately required) could be approximately $200 million. The Company cannot at the present time predict the final resolution of the sludge pile issue. Because the Company believes in-place closure of the sludge pile is the most responsible course of action and the Connecticut Department of Environmental Protection and the U.S. Environmental Protection Agency had earlier approved the Company's plan for in-place closure of the sludge pile, which is substantially less expensive than removal, the Company has not established any reserves for the cost of off-site disposal. The Company is also in the process of evaluating other existing environmental conditions at the North Haven, Connecticut facility with the intention of addressing concerns that may be determined appropriate. The Company believes that it has established sufficient reserves to cover the cost of any actions required to be taken after the evaluation process is completed. Governmental Regulation and Legal Compliance The Company's products have for many years been subject to regulation by federal, state and foreign governments. Such regulation has generally been aimed at product safety and labeling. In the United States, most human and animal pharmaceutical products manufactured or sold by the Company are subject to regulation by the U.S. Food and Drug Administration ("FDA") as well as by other federal and state agencies. The FDA regulates the introduction of new drugs, advertising of prescription drug products, good manufacturing and good laboratory practices, labeling, packaging and record keeping with respect to drug products. In addition, the FDA reviews the safety and effectiveness of marketed drugs and may require withdrawal of products from the market and modification of labeling claims where necessary. The FDA regulations require promotional use of generic names with trademarks for prescription drugs. Government approval of new drugs under the federal Food, Drug and Cosmetic Act requires substantial evidence of safety and efficacy. As a result of this requirement, as interpreted by the FDA, the length of time and the laboratory and clinical information required for approval of a New Drug Application ("NDA") is considerable. The FDA has adopted streamlined procedures for the approval of duplicate drugs (drugs containing the same active ingredient as the originator's product), including Abbreviated New Drug Applications ("ANDAs"). Approval of ANDAs may not be made effective prior to expiration of valid patents. The FDA has established a similar expedited approval process for antibiotics. The availability of the ANDA and expedited antibiotic approval processes has reduced the time period and expense required to obtain FDA approval of some competing products and facilitated generic competition. At the state level, so-called "generic substitution" legislation permits the dispensing pharmacist to substitute a different manufacturer's version of a drug for the one prescribed. In a number of states, such substitution is mandatory unless precluded by the prescribing physician. Interest in the FDA approval mechanism for duplicate or generic drugs and "generic substitution" by pharmacists has been increased by limits on government reimbursement of drug costs in health and welfare programs (Medicare and Medicaid). Beginning in 1991, all pharmaceutical manufacturers were required to provide rebates to the state governments for prescriptions covered by Medicaid. Rebates for single-source and innovator multiple-source drugs are 15 percent of the average manufacturer price ("AMP") for each drug or the AMP minus the best price a company offered to any given purchaser (excluding certain federal customers), whichever was greater. At any time, additional rebates are required if the cumulative price increases exceed the change in the Consumer Price Index, for the time period beginning October 1990. Approximately 10% of the Company's pharmaceutical business involves Medicaid. In November 1992, ceiling prices were placed on products sold to the Department of Defense, the Veterans Administration and the Public Health Service. In addition, manufacturers are required to sell products to PHS grantees at the net Medicaid price (AMP minus the Medicaid rebate). The issue of further price controls on sales of prescription drugs continues to be considered in Congress, and additional federal legislation to limit prices of prescription drugs is possible. It is difficult to predict the ultimate effect of streamlined approval of duplicate or generic drugs, "generic substitution," the Medicaid reimbursement and rebate programs and possible price limitations. However, the Company believes that its development of patented and exclusively licensed products may moderate the impact of programs and legislation focusing mainly on products available from multiple suppliers. Similar product regulatory laws are found in most other countries in which the Company manufactures or sells its products. There, too, the thrust of governmental inquiry and action has been primarily toward reducing the prices of prescription drugs. The Company is subject to administrative action by the various regulatory agencies. Such actions may include product recalls, seizures of products and other civil and criminal actions. In 1993, the Company conducted an internal review of the Company's compliance with United States export control, trade embargo and antiboycott laws. This review determined that although the Company was generally in compliance with these laws, there may have been transactions effected by certain foreign subsidiaries which may not have been in compliance with these laws, including failure to report a small percentage of boycott-related customer requests to the U.S. Department of Commerce, issuance of four negative certificates of origin in response to customer requests and shipments of a small amount of United States-origin products by two foreign subsidiaries to embargoed countries. These matters have been reported voluntarily by the Company to the U.S. Department of Treasury and the U.S. Department of Commerce, and the Company has taken other corrective action. Although the Company cannot predict the outcome, the Company does not believe that any actions that may be taken by federal agencies against the Company as a result of these matters will have a material adverse effect on the Company's business, financial condition or results of operations. International Operations The Company's international operations are subject to certain risks which are inherent in conducting business outside the United States, particularly fluctuations in currency exchange rates, price controls, differing rates of economic growth, inflation, political instability and varying controls on the repatriation of earnings. Employees The Company had 18,600 regular employees on December 31, 1993. The Company believes that it has good relations with its employees. Except for certain employees at the Company's plant in North Haven, Connecticut, none of the Company's United States employees are represented by unions or covered by collective bargaining agreements. Employees at several non-U.S. locations are represented either by freely elected unions or by legally mandated workers' councils or similar organizations. Financial Information Financial information about industry segments and foreign and domestic operations appearing under the caption "Consolidated Statements of Segment Operations" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. For additional information, see Notes S and T of "Notes to Consolidated Financial Statements" and the segment discussions included in the "Human Health Care and Agricultural" sections of the "Financial Review" in the 1993 Annual Report to Shareholders (Exhibit 13), which are hereby incorporated by reference. Employee Stock Ownership Plan The Company maintains an Employee Stock Ownership Plan ("ESOP") as part of The Upjohn Employee Savings Plan. Assets of the ESOP are held through a trust (the "ESOP Trust"). The ESOP Trust has issued debt securities to the public, and the Company has unconditionally guaranteed payment of the principal and interest on the debt securities. Holders of the debt securities have no recourse against the assets of the ESOP Trust except cash contributions made by the Company to pay such debt securities, and earnings attributable to such contributions. A summary description of the liabilities of the ESOP Trust under such debt securities and of the cash contributions made by the Company to the ESOP Trust during 1993 is set forth in Note N of "Notes to Consolidated Financial Statements" in the 1993 Annual Report to Shareholders (Exhibit 13), which is hereby incorporated by reference. Item 2. Item 2. Properties Human Health Care Segment The Company owns its main pharmaceutical plants and general offices, which consist of a group of buildings containing approximately 5,000,000 square feet of floor space, all of which were constructed since 1948 and are considered adequate for the Company's present needs, on about 500 acres of a 2,200 acre tract located six miles southeast of Kalamazoo, Michigan. The Company's main manufacturing building, which is located at the Kalamazoo site, contains about 1,630,000 square feet. Other major buildings at the Kalamazoo site include a large fermentation plant where antibiotics and steroids are produced, a new complex used for production of fine chemicals, and buildings devoted to chemical and fermentation process development. The Henrietta Street complex, owned by the Company and consisting of approximately 33 acres, includes a group of buildings aggregating about 2,500,000 square feet that houses the Company's research laboratories and offices. Pharmaceutical fermentation, production, warehouse and office facilities, containing approximately 510,000 square feet, are located on a 259 acre site owned by the Company near Arecibo, Puerto Rico. The Company also owns or leases distribution warehouses in several major cities in the United States. Agricultural Segment The Company owns a 2,140 acre farm complex northeast of Kalamazoo, which includes the principal offices of the Company's agricultural business, including Asgrow Seed Company, and agricultural and veterinary research facilities, with offices, laboratory and farm buildings aggregating about 410,000 square feet. The agricultural segment also has animal health products production, grain storage, seed conditioning, breeding and research facilities in several locations in the United States and in foreign countries. Item 3. Item 3. Legal Proceedings Various suits and claims arising in the ordinary course of business, primarily for personal injury and property damage alleged to have been caused by the use of the Company's products, are pending against the Company and its subsidiaries; and the ultimate liability with respect thereto is not presently determinable. The Company is a defendant in approximately 100 product liability lawsuits involving its benzodiazepine product, HALCION, some of which seek punitive damages based on alleged deficiencies in the product approval process. The Company has entered into a consent judgment with the Michigan Department of Natural Resources, and approved by the Michigan Circuit Court, regarding compliance with air control regulations. Pursuant to this consent judgment, the Company has paid the State of Michigan $1.5 million to cover the costs of surveillance, enforcement of applicable laws and natural resource damages; and the Company is installing significant air pollution control equipment at its Kalamazoo facility. The installation of these controls is expected to be nearly completed during 1994 and will require additional capital spending of approximately $40 to $50 million. Two shareholder class action complaints are pending in the United States District Court for the Western District of Michigan against the Company and certain directors and officers of the Company seeking damages resulting from the alleged failure of the Company to disclose material adverse information about HALCION. The plaintiffs claim that the failure to disclose information on HALCION caused the price of the Company's stock to be artificially inflated, which caused them to purchase Upjohn stock at an excessive price. One of the actions contains a derivative complaint alleging a pattern of misconduct by the Company and named defendants purposely concealing or minimizing reports of side effects related to HALCION, which allegedly caused damage and loss to Upjohn as a company, improper election of directors and payment of excessive incentive compensation and stock option bonuses to the named defendants. The Company does not believe that there is merit to the claims and will defend the cases. In October 1991, a Cook County, Illinois jury returned a verdict against the Company in the amount of approximately $127.5 million, of which approximately $124.5 million constituted punitive damages which was subsequently reduced to $35 million. The Plaintiff lost his left eye after his physician inadvertently injected the drug DEPO-MEDROL, a corticosteroid manufactured and marketed by the Company, directly into the eye instead of near the eye, as he had intended. The Company believes the decision was erroneous and will vigorously appeal this judgment, but, as with any litigation, the outcome is uncertain. The Company's insurance carriers have denied liability for punitive damages, and the Company is in litigation with its insurance carriers to determine the extent to which the Company's insurance policies cover punitive damages. In addition to actions involving the West KL Avenue Landfill discussed above under Item 1, General, Environment, the Company is involved in several administrative and judicial proceedings relating to environmental matters, including actions brought by the EPA and state environmental agencies for cleanup at approximately 40 "Superfund" or comparable sites. The Company is not able to determine its ultimate exposure in connection with most of these environmental situations due to uncertainties related to cleanup procedures to be employed, if any, the cost of cleanup and the Company's share of a site's cost. The Company is a party along with approximately thirty other defendants in several civil antitrust lawsuits alleging price discrimination and price- fixing with respect to the level of discounts and rebates provided to certain customers. The Company is of the opinion that, although the outcome of the litigation and proceedings referred to above cannot be predicted with any certainty, appropriate accruals have been made in the Company's financial statements and the ultimate liability should not have a material adverse effect on the Company's consolidated financial position. See the information under the caption "Other Items" in the "Financial Review" section and Notes J and K of the "Notes to Consolidated Financial Statements" in the 1993 Annual Report to Shareholders (Exhibit 13) for other information concerning environmental matters, which information is hereby incorporated by reference. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the quarter ended December 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The Company's Common Stock is traded on the New York Stock Exchange under the symbol UPJ. As of February 28, 1994, there were 35,489 holders of record of the Company's Common Stock, $1 par value. In addition, there were 11,459 accounts under the Company's Dividend Reinvestment Plan which are not included in the number above. Information regarding the market prices and dividends for the Company's Common Stock and related stockholder matters appearing under the caption "Selected Financial and Quarterly Data" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. Item 6. Item 6. Selected Financial Data The information under the captions "Financial Review," "Notes to Consolidated Financial Statements," "Summary of Continuing Operations" and "Selected and Quarterly Data" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information under the caption "Financial Review" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. Item 8. Item 8. Financial Statements and Supplementary Data The information under the caption "Report of Independent Accountants," the consolidated financial statements, and the information under the caption "Selected Financial and Quarterly Data" in the 1993 Annual Report to Shareholders (Exhibit 13) is hereby incorporated by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The Directors of the Company, who are elected annually for a three-year term, are as follows: RICHARD H. BROWN, age 46, Vice Chairman of Ameritech Corp., a telecommunications company. Mr. Brown was elected Ameritech Vice Chairman in January 1993. He joined Illinois Bell as President and Chief Executive Officer in 1990 and, prior to that, he was Executive Vice President of United Telecom and U.S. Sprint. He is secretary of the Illinois Business Roundtable, a member of the Economic Club of Chicago and serves actively in many non- profit organizations in Illinois. Mr. Brown is a director of Ameritech Corp. and serves on a number of other boards. He has served as a Director of The Upjohn Company since September 1993 and is a member of the Compensation and Incentive; the Nominating; and the Social Responsibility Committees of the Board of Directors. FRANK C. CARLUCCI, age 63, Chairman, The Carlyle Group, a merchant bank in Washington, D.C. Mr. Carlucci was vice chairman of The Carlyle Group from 1989 to 1993. He served as U.S. Secretary of Defense from 1987 to 1989. Mr. Carlucci is currently on the board of directors of Ashland Oil, Inc.; Bell Atlantic Corporation; Connecticut Mutual Life Insurance Company; East New York Savings Bank; Ecotech, Inc.; General Dynamics Corporation; International Planning and Analysis Center; Kaman Corporation; Neurogen Corporation; Northern Telecom Limited; The Quaker Oats Company; SunResorts, Ltd., N.V.; Texas Biotechnological Corporation; Westinghouse Electric Corporation; and serves on the board of trustees for the nonprofit Rand Corporation. Mr. Carlucci has served as a Director of The Upjohn Company since 1990 and is a member of the Audit; the Compensation and Incentive; the Finance; and the Nominating Committees of the Board of Directors. M. KATHRYN EICKHOFF, age 54, President, Eickhoff Economics Incorporated, economic consultants. Ms. Eickhoff is the former associate director for Economic Policy, United States Office of Management and Budget. She serves as a director of AT&T, National Westminster Bancorp. Inc. and Tenneco Inc. Ms. Eickhoff is a member of several business organizations including The Conference of Business Economists, The Economic Club of New York and the National Association of Business Economists. She served as a Director of The Upjohn Company from 1982 to 1985 and returned as a Director in 1987. She is a member of the Audit; the Executive; the Finance; and the Nominating Committees of the Board of Directors. DARYL F. GRISHAM, age 67, President and Chief Executive Officer, Parker House Sausage Company. Mr. Grisham joined Parker House Sausage Company in 1954. He has been a director of that company since 1961 and was promoted to his current position in 1969. Mr. Grisham is a former director for G. D. Searle and Company and Illinois Bell Telephone Co. He serves as a director of Harris Bankcorp, Inc.; Lincoln Park Zoological Society and the Rehabilitation Institute of Chicago. He also serves as a trustee for the Chicago Museum of Science & Industry and Northwestern University. He was named to the Chicago Business Hall of Fame in 1984. He has served as a Director of The Upjohn Company since 1989 and is a member of the Compensation and Incentive; the Executive; the Nominating; and the Social Responsibility Committees of the Board of Directors. LAWRENCE C. HOFF, age 65, former President and Chief Operating Officer of the Company. Mr. Hoff has long been active in major industry and educational associations including: director, American Diabetes Association, Inc.; trustee, Borgess Medical Center; director, Council on Family Health; chairman, Pharmaceutical Manufacturers Association; member, U.S. Chamber of Commerce, International Policy Committee. He holds an honorary Doctor of Science in Pharmacy degree from Massachusetts College of Pharmacy and Allied Health Sciences, and is currently a director of Alpha Beta Technology, Inc.; Curative Technologies, Inc.; and MedImmune, Inc. He has served as a Director of The Upjohn Company since 1973 and is a member of the Audit and the Social Responsibility Committees of the Board of Directors. GERALDINE A. KENNEY-WALLACE, age 51, President and Vice-Chancellor of McMaster University, Hamilton, Ontario, Canada. Dr. Kenney-Wallace is a member of the board of directors of the Bank of Montreal, Dofasco Inc., DMR Inc., General Motors (Canada), and Northern Telecom Ltd. She serves on the advisory board of the Canadian Foundation for AIDS Research, the Manning Foundation, and is currently the Honorary Chairman of the Canadian Donner Foundation. During her scientific career in lasers, ultra-fast phenomena and opto-electronics, Dr. Kenney-Wallace has received numerous honors and scientific awards. She has served as a Director of The Upjohn Company since September 1993 and is a member of the Audit; the Finance; and the Social Responsibility Committees of the Board of Directors. WILLIAM E. LAMOTHE, age 67, former Chairman of the Board and Chief Executive Officer of Kellogg Company, a food company. Mr. LaMothe is a former director of the Food and Drug Law Institute, Kimberly Clark Corporation, Unisys Corporation and the Western Michigan University Foundation. He is currently a director of Allstate Insurance Companies, Kellogg Company, and Sears Roebuck and Company; and he is a member of the board and a trustee for the W. K. Kellogg Foundation Trust. Mr. LaMothe serves on the board of governors of the Battle Creek Community United Arts Council and The Battle Creek Community Foundation. He has served as a Director of The Upjohn Company since 1986 and is a member of the Audit; the Compensation and Incentive; the Executive; and the Nominating Committees of the Board of Directors. JERRY R. MITCHELL, M.D., Ph.D., age 52, Vice Chairman of the Board and President, Upjohn Laboratories. Previously, Dr. Mitchell had been Executive Vice President and President, Upjohn Laboratories (1991-92); Senior Vice President and President, Upjohn Laboratories (1990); and Vice President for Pharmaceutical Research (1989-90). Prior to joining The Upjohn Company, Dr. Mitchell was a professor of internal medicine and the director of the Center for Experimental Therapeutics, Baylor College of Medicine and Affiliated Hospitals. During his distinguished career, Dr. Mitchell has served on many national advisory boards and committees and has received numerous honors and scientific awards. He has published two books and has written hundreds of manuscripts and abstracts. Dr. Mitchell has been a Director of The Upjohn Company since 1991. WILLIAM D. MULHOLLAND, age 67, former Chairman of the Board and Chief Executive Officer of the Bank of Montreal. Mr. Mulholland is currently a director of the Bank of Montreal; Brooks Fashion Stores, Inc. and Canadian Pacific Ltd. He is a trustee of Queen's University and a member of the Advisory Committee on Canadian Studies at the School of Advanced International Studies, Johns Hopkins University. Mr. Mulholland has received honorary Doctor of Laws degrees from Memorial University and Queen's University. He has served as a Director of The Upjohn Company since 1977 and is a member of the Compensation and Incentive; the Executive; the Finance; and the Nominating Committees of the Board of Directors. RAY T. PARFET, JR., age 71, former Chairman of the Board and Chief Executive Officer of the Company. Mr. Parfet is also a former chairman of the Pharmaceutical Manufacturers Association. He has served as a director for The ARO Corporation, Michigan Bell Telephone Company and Union Pump Company and as a trustee of the National 4-H Council in Washington, D.C. and Bronson Healthcare Group, Inc. He is currently a director of The W. E. Upjohn Unemployment Trustee Corporation. He has served as a Director of The Upjohn Company since 1958 and is a member of the Executive Committee of the Board of Directors. WILLIAM U. PARFET, age 47, President and Chief Executive Officer of Richard-Allan Medical Industries, Inc., a manufacturer of surgical equipment and medical supplies. Prior to joining Richard-Allan in October 1993, Mr. Parfet had been Vice Chairman of the Board of the Company, and was President (1991-93) and Executive Vice President (1989-91) before that. Mr. Parfet serves on various boards of directors, including CMS Energy Corporation, the Financial Accounting Foundation, Flint Ink Corporation, Old Kent Financial Corporation, Stryker Corporation and Universal Foods, Inc. He has served as a Director of The Upjohn Company since 1985 and is a member of the Finance and the Social Responsibility Committees of the Board of Directors. LEY S. SMITH, age 59, President and Chief Operating Officer of the Company. Mr. Smith was elected President, Chief Operating Officer and Acting Chief Executive Officer in 1993; he became Vice Chairman of the Board in 1991; and was elected Executive Vice President in January 1989. Mr. Smith is active in a wide variety of business, community, and medical- and pharmaceutical-related activities, including the Pharmaceutical Manufacturers Association; the Virginia Neurological Institute; the Health, Welfare and Retirement Income Task Force of the Business Roundtable; and the Greater Kalamazoo United Way. He has served as a Director of The Upjohn Company since 1989. JOHN L. ZABRISKIE, Ph.D., age 54, Chairman of the Board and Chief Executive Officer of the Company. Prior to joining the Company earlier this year, Dr. Zabriskie had spent his entire career with Merck & Co., Inc. During the last five years, he has held several officer positions with Merck in sales, marketing, public affairs and manufacturing, serving most recently as executive vice president of Merck & Co., Inc., and president, Merck Manufacturing Division. He is active in the debate over U.S. health care reform as a member of the Jackson Hole Group for Healthcare Reform and the Healthcare Leadership Council. He is also active in the Pharmaceutical Manufacturers Association. Dr. Zabriskie has served on the boards of Penjerdel Corporation; Pennsylvania Biotechnology Association; the National Pharmaceutical Council, Inc.; Morristown Memorial Hospital and Wells College; he is currently a director of First of America Bank Corporation. He began serving as a Director of The Upjohn Company in January 1994 and is a member of the Executive and the Finance Committees of the Board of Directors. In addition to J. L. Zabriskie, Ph.D., L. S. Smith and J. R. Mitchell, M.D., Ph.D., the executive officers of the Company, who are elected annually for a one-year term, are as follows: Item 11. Item 11. Executive Compensation Board of Directors Compensation Compensation for non-employee members of the Board of Directors consists of an annual retainer fee of $24,000 plus a $1,000 fee for each Board meeting attended; a $1,000 fee for attending the first committee meeting held on any day and a $750 fee for attending subsequent committee meetings held on the same day. In addition, the chairperson for each committee receives a quarterly retainer fee of $1,000. Employee directors do not receive compensation for serving on the Board or on the Board's committees. The Company maintains a retirement plan for outside directors which provides that a director will receive retirement benefits for a period of time equal to the length of his non-employee Board service in an amount equal to 50% of his last annual retainer after 5 years of non-employee service plus 5% for each additional year of non-employee Board service up to a total of 100% of his last annual retainer. The Company also maintains a deferred compensation plan for outside directors, which enables a director to defer payment of his fees until he leaves the Board. Report of the Compensation and Incentive Committee The Compensation and Incentive Committee, consisting of five independent directors, none of whom has ever served as an officer or employee of the Company or has any known conflicts, recommends to the Board the salaries of all corporate officers and administers the Company's incentive compensation plans. The Committee also reviews with the Board its recommendations relating to the future direction of corporate compensation and benefit policies and practices. Annually, the Compensation and Incentive Committee reviews: (a) the financial and operational performance of the Company and its major business segments; (b) the performance of each corporate officer; (c) the compensation paid key executives in similar positions within the pharmaceutical industry and industry generally; and (d) the design and appropriate use of specific short-term and long- term reward vehicles that will support the achievement of business goals and commitment to the Company's shareholders. In general, the Company seeks to encourage and reward executive efforts which create shareholder value through achievement of corporate objectives, business strategies and performance goals, by blending annual and long-term cash and equity compensation and, in so doing, to align the interests of executives with those of shareholders. The Committee's policies through 1993 can be summarized as follows: (a) to increase the proportion of total compensation comprised of variable, or incentive-based, compensation, while reducing the proportion of fixed compensation; (b) to place increasing reliance upon individual and business unit performance when awarding individual incentive compensation, while reducing the proportion based upon total corporate performance; (c) to place increasing reliance upon external standards of competitive performance rather than internally defined standards when fixing the total amount of incentive compensation that may be awarded; and (d) to maintain a competitive level of total executive compensation for competitive performance; and, similarly, to recognize superior performance. For 1993, the proportion of senior executive compensation that was fixed, base salary ranged from 50% to 60%. Base salary is set at competitive levels and based on job level, experience and performance. The remaining 40% to 50% was variable, incentive compensation, 75% of which was dependent upon the extent to which actual corporate earnings before tax ("EBT") met budgeted EBT levels and 25% of which was based upon the Company's earnings growth as compared with the median earnings growth of our peer companies. The comparator group used to assess competitive practices is the group of companies included in the peer group index identified on page 23. In addition to the stock options granted in February 1993, the Committee granted special stock options in December 1993 to selected employees whose individual performance and leadership were deemed critical to the Company's future success. These stock options will become exercisable if the Company's stock price appreciates by certain thresholds over the market price on the date of grant. In reviewing the compensation policies at the end of 1993, the Committee determined that it had approached an appropriate level of variable compensation based upon our existing business objectives. In addition, the Committee decided that a greater proportion of the variable compensation should be based on the Company's performance relative to that of peer pharmaceutical companies. Accordingly, the Committee's policies were revised for 1994 and can be summarized as: (a) total executive compensation should be maintained at a competitive level for competitive performance; and, similarly, superior performance should be recognized; (b) variable, or incentive-based compensation should range from 30% to 50% of total compensation with the higher-ranking executives having a greater proportion of variable or incentive-based compensation; (c) with respect to variable, or incentive-based compensation, at least 50% should be based upon external standards of competitive performance rather than internally established financial goals; and (d) equity-based compensation (stock options, restricted stock, performance shares and deferred incentive compensation) should be increasingly used to link employee performance to shareholder interests; promote and encourage stock ownership in the Company and provide an incentive to create long-term shareholder value. Listed below are several actions that illustrate the Committee's commitment to these revised policies. In 1994, 50% of incentive compensation will be dependent upon the extent to which actual corporate EBT meets budgeted corporate EBT levels, and the remaining 50% will be determined by Upjohn's Total Market Return performance relative to the average Total Market Return of peer pharmaceutical companies. Consistent with our focus on performance-driven compensation, the Company eliminated the Christmas Bonus for 1994 and subsequent years (which had been equal to 5% of base salary after eight years of service), and increased incentive compensation target ranges by 5% of base salary. As in prior years, 20% of incentive compensation earned each year will be deferred in shares of Company stock which will not vest until retirement. The Committee grants annual ten-year stock options, having a value based on the level of stock price appreciation over the market price on the date of grant. The Committee considers the level of stock options granted by competitive companies and the number of Upjohn stock options previously granted, currently outstanding and proposed to be granted in reaching its decision to make additional grants of stock options to executive officers. Restricted stock, which cannot be sold or transferred until earned in future years, is issued on an infrequent and selective basis based on the Committee's assessment of appropriate recognition and retention factors. To further increase executive stock ownership and enhance the focus on the long-term competitive financial performance of the Company, the Committee made two initial grants of performance shares in 1994, one measured over a two-year period and one measured over a three-year period. The utilization of performance shares was approved by shareholders as part of The Upjohn Management Incentive Program of 1992. The stock reserved for payment of performance share awards was reallocated from the stock that would normally have been reserved for issuance as stock options. The Performance Shares will be payable in shares of the Company's Common Stock and will be earned based upon the Company's relative Total Market Return, Return on Net Assets and Net Earnings Growth, as compared to the group of peer pharmaceutical companies. Because of the extensive time required to discover, develop, test and obtain approval to sell new drugs, a process which often takes ten or more years, performance of executives in the pharmaceutical industry cannot be adequately measured by short-term changes in stock price. Efforts expended today will not reap benefits until several years in the future. Management has taken many difficult but significant steps to position the Company for the future, including realigning its core businesses, sharpening the focus of its research, streamlining product development and regulatory activities, implementing cost containment measures, reducing the number of employees, globalizing operations, forming new strategic partnerships and establishing a corporate commitment to total quality. The Internal Revenue Code was recently amended to limit the Company's ability to deduct more than $1 million of an executive's nonperformance-based compensation. The Committee will endeavor in the future to design and administer the Company's performance-based compensation plans (incentive compensation, stock options and performance shares) in a manner that will comply with the IRS exclusion for performance-based compensation, including shareholder approval, administration by disinterested directors and use of nondiscretionary, preestablished performance goals. Base salary will be determined on the basis of job performance and competitive requirements and may, therefore, exceed the $1 million deduction limit, although currently no base compensation exceeds $800,000. In recruiting Dr. Zabriskie to serve as the Company's Chairman and Chief Executive Officer, the Company committed to pay a minimum performance bonus for 1995 that will not be fully deductible under the new limitation. Compensation and Incentive Committee R. H. Brown F. C. Carlucci D. F. Grisham W. E. LaMothe W. D. Mulholland EXECUTIVE COMPENSATION The following table shows the total compensation received for the last three calendar years by the Company's Acting Chief Executive Officer at year-end; by the next four most highly compensated executive officers who were in office at year-end; and by T. Cooper, M. Novitch and W. U. Parfet who were executive officers for part of 1993. Footnotes to the table are included on the next page. The following table shows the number and percentage of stock options granted to the named executive officers during 1993, the exercise price and expiration date of the options and the potential realizable value of each grant assuming that the market price of the stock appreciates in value from the date of grant to the expiration date at assumed annualized 5% and 10% rates. Options can be exercised in full after one year of employment from the date of grant with payment in either cash or shares of the Company's Common Stock. Upon a stock-for-stock exercise, the optionee will receive a new, non- qualified reloaded stock option at the then current market price for the number of shares tendered to exercise the option. No reloaded stock options were issued to executive officers in 1994. The reloaded stock option will have an exercise term equal to the remaining term of the exercised option. Options may only be exercised during employment or within three months after employment ceases, except that following retirement at or after age 65 or other approved termination of employment (as was the case with M. Novitch and W. U. Parfet), stock options may be exercised for periods up to five years (but not beyond the original expiration date of the option). The Company is unable to predict or estimate the Company's actual future stock price or place a reasonably accurate present value on the options granted. The following table shows the number of stock options exercised and the value realized by the named executive officers during 1993 and the number of unexercised stock options remaining at year end and the potential value thereof based on the year-end market price of the Company's Common Stock of $29.25: COMPARISON OF CUMULATIVE TOTAL SHAREHOLDER RETURN The following graphs compare the yearly change over the last five years and, for a longer-term perspective, over the last ten years, in the Company's cumulative total shareholder return (stock price appreciation plus the cumulative value of reinvested dividends) compared to the Standard & Poor's 500 Stock Index and a Combined Standard & Poor's Drug Group Index consisting of Abbott Laboratories, American Cyanamid Co., American Home Products Corporation, Bristol-Myers Squibb Company, Johnson & Johnson, Eli Lilly and Company, Merck & Co., Inc., Pfizer Inc., Schering-Plough Corporation, Syntex Corporation, The Upjohn Company and Warner Lambert Company. Under this peer group index, the returns of each component company are weighted according to their respective stock market capitalization as of the beginning of each period for which a return is indicated. The graphs assume $100 was invested on December 31, 1988 (for five-year graph) and December 31, 1983 (for ten-year graph) and that all dividends were reinvested. The stock performance as shown on the Performance Graph should not be interpreted as a prediction of future stock performance. Retirement Benefits The following table illustrates the estimated annual benefits payable under the Company's pension plan upon retirement to persons in the specified remuneration and years-of-service classifications, assuming retirement at the normal Social Security retirement age and assuming the participant's remuneration is equivalent to his Final Average Salary under the plan and is equal to or greater than 150% of his Social Security Covered Compensation. The amounts shown include additional non-qualified pension benefits, represent straight-life annuity amounts notwithstanding the availability of joint survivorship provisions and are not subject to any offset or reduction for Social Security benefits. The compensation included as remuneration is the amounts listed under "Annual Compensation" in the Summary Compensation Table on page 20. The current number of years of service credited for the following individuals at December 31, 1993, were: L. S. Smith, 35 years; J. R. Mitchell, 8 years; G. A. Welch, 34 years; D. R. Parfet, 16 years; and R. C. Salisbury, 19 years. Employment Agreements and Termination of Employment Arrangements Under an agreement made with J. L. Zabriskie when he joined the Company, he will receive a base salary of $800,000 and a bonus of at least $600,000 payable in March 1995 for services rendered in 1994. In addition, he received 15,000 shares of restricted stock to be earned in equal amounts in January 1995 and January 1996, which amount will be reduced by the value of any future performance share awards received from his prior employer. He was also granted a stock option for 250,000 shares that will become exercisable on January 3, 1995; a stock option for 50,000 shares that will become exercisable after January 3, 1996 when the stock price exceeds $34.06; and a stock option for 50,000 shares that will become exercisable after January 3, 1997 when the stock price exceeds $39.06. All of the stock options have a ten-year term and an exercise price of $29.06 per share. When Dr. Zabriskie retires, he will receive a retirement benefit under the Company's plans as if he had been employed by Upjohn for 28 years plus his actual years of service with the Company less the value of his pension from former employment. If Dr. Zabriskie's employment is terminated within the next four years, he will receive a severance payment of at least two years' base salary. Under an agreement made with J. R. Mitchell when he joined the Company, he will receive a retirement benefit equal to that which he would receive if he were granted 1.67 years of service for each actual year of service under the Company's pension plans, reduced by the value of the pension to be received by him from his former employment. The Company has a separation payment plan for eligible individual employee terminations, including executive officers, ranging from one week's base pay for employees with three months' service to 31 weeks' base pay for 30 or more years of service. The Company also has a plan for employees, including executive officers, who are terminated as a result of having their position eliminated, which provides for separation payments ranging from two weeks' base pay for employees with one year of service to 62 weeks' base pay for employees with 30 or more years of service. In addition, the Company has a change-in-control severance plan for eligible employees, excluding executive officers, which may be terminated by the Board of Directors at any time prior to a change in control of the Company, which will provide severance benefits ranging from 4 weeks' base pay for employees with one year of service to 104 weeks' base pay for employees with 30 or more years of service payable in the event their employment is terminated within two years following a change in control of the Company. The Company has entered into a severance agreement with each executive officer providing for the payment of severance pay equal to 2.5 times the officer's annualized salary in the event his employment is terminated other than for cause, disability or retirement within 24 months following a change in control of the Company. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Under regulations of the Securities and Exchange Commission, persons who have power to vote or dispose of shares of the Company, either alone or jointly with others, are deemed to be beneficial owners of such shares. Because the voting or dispositive power of certain shares listed in the following table is shared, the same securities in such cases are listed opposite more than one name in the table. The total number of shares of Common Stock of the Company listed below for directors and executive officers as a group eliminates such duplication. Pursuant to a Schedule 13G filed with the Securities and Exchange Commission by State Street Bank and Trust Company, 225 Franklin Street, Boston, Massachusetts 02110, as Trustee of The Upjohn Employee Savings Plan, the Bank indicated beneficial ownership equivalent to 7.4% of the Company's outstanding Common Stock as of December 31, 1993. Pursuant to a Schedule 13G filed with the Securities and Exchange Commission by The Capital Group, Inc., 333 South Hope Street, Los Angeles, California 90071, Capital Research and Management Company, a registered investment adviser and an operating subsidiary of The Capital Group, Inc., exercised, as of December 31, 1993, investment discretion, but not voting power, with respect to 11,001,900 shares, or 6.3% of outstanding shares of the Company's Common Stock, which were owned by various institutional investors. Set forth in the following table are the beneficial holdings as of the close of business on March 31, 1994 of individual directors and nominees, the five most highly compensated executive officers for 1993 and all directors and executive officers as a group. Item 13. Item 13. Certain Relationships and Related Transactions D. R. Parfet, Executive Vice President for Administration, is the brother of W. U. Parfet and both are sons of R. T. Parfet, Jr.; W. U. Parfet and R. T. Parfet, Jr., are directors of the Company. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)1. Financial Statements The following are included in the 1993 Annual Report to Shareholders (Exhibit 13) and are incorporated by reference into this Form 10-K pursuant to Item 8: Report of Independent Accountants. Consolidated Statements of Earnings--Years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheets--December 31, 1993 and 1992. Consolidated Statements of Shareholders' Equity--Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows--Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Segment Operations--Years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. (a)2. Financial Statement Schedules Report of Independent Accountants. . . . . . . . . . . . . .35 Schedules: I Marketable Securities--Other Investments, December 31, 1993 . . . . . . . . . . . . . . . 36 For the years ended December 31, 1993, 1992 and 1991: V Property, Plant and Equipment . . . . . . . . . 37 VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . 38 IX Short-term Borrowings . . . . . . . . . . . . . 39 Notes: (1) Schedules other than those listed above are omitted because they are either not required, are not applicable or because equivalent information has been included in the financial statements, the notes thereto or elsewhere herein. (2) Financial statements of 50 percent-or-less-owned affiliated persons are omitted because such persons, in the aggregate, do not constitute a significant subsidiary. (a)3. Exhibits - Management and compensation-related agreements and plans are included as Exhibits (10)(a) through (10)(q). (3)(i) Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit (3)(a) to the Registrant's Form 10-K for the year ending December 31, 1987). (3)(ii) By-laws of the Registrant, as amended, June 21, 1988 (incorporated by reference to Exhibit (3)(b) to the Registrant's Form 10-K for the year ending December 31, 1988). (4)(a) Loan Agreement between Puerto Rico Industrial, Medical and Environmental Pollution Control Facilities Financing Authority and The Upjohn Company, dated as of December 1, 1983, and Trust Agreement between Puerto Rico Industrial, Medical and Environmental Pollution Control Facilities Financing Authority and The Chase Manhattan Bank (National Association), Trustee, dated as of December 1, 1983 (not filed pursuant to Regulation S-K, Item 601 (b)(4)(iii)(A); the Registrant agrees to furnish a copy of these documents to the Securities and Exchange Commission upon request). (4)(b) Indenture dated as of February 1, 1990, with respect to debt securities issued by The Upjohn Company Employee Stock Ownership Trust and 9.79% Amortizing Notes, Series A, Due February 1, 2004, issued by The Upjohn Company Employee Stock Ownership Trust and guaranteed by the Registrant (not filed pursuant to Regulation S-K, Item 601 (b)(4)(iii)(A); the Registrant agrees to furnish a copy of these documents to the Securities and Exchange Commission upon request). (4)(c) Rights Agreement dated as of June 17, 1986 (incorporated by reference to Exhibit 4(d) to the Registrant's Form 8-K dated June 17, 1986), as amended by First Amendment dated as of March 22, 1989 (incorporated by reference to Exhibit 4 to the Registrant's Form 8-K dated March 27, 1989). (4)(d) Certificate of Designation, Preferences and Rights of Series A Participating Cumulative Preferred Stock (incorporated by reference to Exhibit 4(a) to the Registrant's Form 8-K dated June 17, 1986). (4)(e) Certificate of Designations, Preferences and Rights of Series B Convertible Perpetual Preferred Stock (incorporated by reference to Exhibit (4)(f) to the Registrant's Form 10-K for the year ending December 31, 1989). (4)(f) Indenture dated as of August 1, 1991 between the Company and The Bank of New York, as trustee, with respect to Debt Securities to be issued thereunder from time to time (not filed pursuant to Regulation S-K, Item 601(b)(4)(iii)(A); the Registrant agrees to furnish a copy of these documents to the Securities and Exchange Commission upon request). (10)(a) Agreements with J. R. Mitchell relating to additional pension benefits (incorporated by reference to Exhibit (10)(e) to the Registrant's Form 10-K for the year ending December 31, 1988 and Exhibit (10)(f) to the Registrant's Form 10-K for the year ending December 31, 1989). (10)(b) Restricted Stock Agreement with L. S. Smith (incorporated by reference to Exhibit (10)(q) to the Registrant's Form 10-K for the year ending December 31, 1990). (10)(c) Restricted Stock Agreement with J. R. Mitchell (incorporated by reference to Exhibit (10)(i) to the Registrant's Form 10-K for the year ending December 31, 1991). (10)(d) The Upjohn Management Incentive Program of 1992, consisting of Incentive Compensation Plan, Stock Option Plan and Performance Share Plan (incorporated by reference to Exhibit (10)(j) to the Registrant's Form 10-K for the year ending December 31, 1991). (10)(e) Form of Indemnification Agreement entered into with Each Officer and Director (incorporated by reference to Exhibit (10)(h) to the Registrant's Form 10-K for the year ending December 31, 1986). (10)(f) Grantor Trust Agreement with The Chase Manhattan Bank, N.A. (incorporated by reference to Exhibit (10)(l) to the Registrant's Form 10-K for the year ending December 31, 1988). (10)(g) Form of Severance Agreement Entered into with Each Officer of The Upjohn Company (incorporated by reference to Exhibit (10)(m) to the Registrant's Form 10-K for the year ending December 31, 1988). (10)(h) The Upjohn Replacement and Deferred Benefit Plan (incorporated by reference to Exhibit (10)(p) to the Registrant's Form 10-K for the year ending December 31, 1988). (10)(i) The Upjohn Directors' Retirement Benefit Plan (incorporated by reference to Exhibit (10)(o) to the Registrant's Form 10-K for the year ending December 31, 1989). (10)(j) Deferred Compensation Plan for Directors (incorporated by reference to Exhibit (10)(p) to the Registrant's Form 10-K for the year ending December 31, 1989). (10)(k) Special Retirement Agreement dated as of September 14, 1992 between the Company and R.G. Tomlinson (incorporated by reference to Exhibit (10)(q) to the Registrant's Form 10-K for the year ending December 31, 1992). (10)(l) Form of Restricted Stock Agreement with L.S. Smith (incorporated by reference to Exhibit (10)(t) to the Registrant's Form 10-K for the year ending December 31, 1992). (10)(m) Restricted Stock Agreement with R.G. Tomlinson (incorporated by reference to Exhibit (10)(v) to the Registrant's Form 10-K for the year ending December 31, 1992). (10)(n) Form of Restricted Stock Agreement with K.M. Cyrus and R.C. Salisbury (incorporated by reference to Exhibit (10)(w) to the Registrant's Form 10-K for the year ending December 31, 1992). (10)(o) Agreement with W. U. Parfet dated September 17, 1993. (10)(p) Agreement with M. Novitch dated October 17, 1993. (10)(q) Employment Agreement with J. L. Zabriskie dated March 14, 1994. (11)(a) Computation of Earnings Per Share - Primary (11)(b) Computation of Earnings Per Share - Fully Diluted (12) Computation of Ratio of Earnings to Fixed Charges (13) Portions of The Upjohn Company's 1993 Annual Report to Shareholders (21) Subsidiaries of the Registrant. (23) Consent of Independent Accountants. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 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. Dated: March 15, 1994 THE UPJOHN COMPANY (Registrant) By: J. L. ZABRISKIE J. L. Zabriskie Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date J. L. ZABRISKIE Chairman of the Board and J. L. Zabriskie Chief Executive Officer L. S. SMITH President and Director L. S. Smith R. C. SALISBURY Executive Vice President for March 15, 1994 R. C. Salisbury Finance and Chief Financial Officer; also Principal Accounting Officer Director R. H. Brown F. C. CARLUCCI Director F. C. Carlucci Director M. K. Eickhoff D. F. GRISHAM Director D. F. Grisham L. C. HOFF Director L. C. Hoff G. A. KENNEY-WALLACE Director G. A. Kenney-Wallace March 15, 1994 W. E. LaMOTHE Director W. E. LaMothe J. R. MITCHELL Director J. R. Mitchell W. D. MULHOLLAND Director W. D. Mulholland R. T. PARFET, JR. Director R. T. Parfet, Jr. W. U. PARFET Director W. U. Parfet REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors The Upjohn Company Our report on the consolidated financial statements of The Upjohn Company and Subsidiaries has been incorporated by reference in this Form 10-K from page 25 of the 1993 Annual Report to Shareholders of The Upjohn Company. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed under Item 14.(a)2 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand Chicago, Illinois January 31, 1994	11,512	76,336
17109_1993.txt	17109_1993	1993	17109	Item 1. Business. Capital Cities/ABC, Inc., directly or through its subsidiaries (the "Company"), operates the ABC Television Network, eight television stations, the ABC Radio Networks and 18 radio stations, and provides programming for cable television. The Company, through joint ventures, is engaged in international broadcast/cable services and television production and distribution. The Company also publishes daily and weekly newspapers, shopping guides, various specialized and business periodicals, books, provides research services and also distributes information from data bases. Employees At December 31, 1993, the Company had approximately 19,250 full-time equivalent employees: 10,000 in broadcasting operations, 9,000 in publishing operations and 250 in corporate activities. Industry Segments Information relating to the industry segments of the Company's operations is included on page 37 of the Company's Annual Report to Shareholders and is hereby incorporated by reference. In 1993, the Company derived approximately 85% and 70% of its broadcasting and publishing revenues, respectively, from the sale of advertising. The remainder of the broadcasting revenues are principally derived from subscriber-related fees and programming distribution activities. The balance of publishing revenues are derived primarily from subscription and other circulation receipts and the sale of books. Broadcasting Television and Radio Networks The Company operates the ABC Television Network which as of December 31, 1993 had 228 primary affiliated stations reaching 99.9% of all U.S. television households. A number of secondary affiliated stations add to the primary coverage. The ABC Television Network broadcasts programs in "dayparts" and types as follows: Monday through Friday early morning, daytime and late night, Monday through Sunday Prime Time and News, Children's and Sports. The Company also operates the ABC Radio Networks which served a total of approximately 3,400 affiliates as of December 31, 1993 through eight different program services, each with its own group of affiliated stations. The ABC Radio Networks also produces and distributes a number of radio program series for radio stations nationwide. Generally, the Company pays the cost of producing or purchasing the broadcast rights for its network programming and pays varying amounts of compensation to its affiliated stations for broadcasting the programs and commercial announcements included therein. Substantially all revenues from network operations are derived from the sale to advertisers of time in network programs for commercial announcements. The ability to sell time for commercial announcements and the rates received are dependent on the quantitative and qualitative audience that the network can deliver to the advertiser. The Company also produces television programs for the ABC Television Network and for other exhibitors of television programs. For television programs it produces, the Company pays the costs of production and typically receives a license fee from the exhibitor for initial exhibition. Generally, the license fees received are less than the costs of production. The Company then licenses the programs it owns for foreign exhibition and, ultimately, for repeat exhibition in the United States. K-2 Television and Radio Stations The Company owns seven very high frequency (VHF) television stations, one ultra high frequency (UHF) television station, nine standard (AM) radio stations and nine frequency modulation (FM) radio stations. All television stations are affiliated with the ABC Television Network and all radio stations, except as noted, are affiliated with the ABC Radio Networks. Markets, frequencies and other station details are set forth in the following tables: - ---------- (1) Based on Nielsen U.S. Television Household Estimates, 1993-1994 season. (2) See "Licenses -- Federal Regulation of Broadcasting/Renewal Matters" below for description of pending license renewal applications and other matters. (3) No ABC network affiliation. (4) Based on Arbitron Radio Market Survey Schedule and Population Rankings (metro survey area) as of Fall 1993. K-3 Cable and International Broadcast The Company's Cable and International Broadcast operations are principally involved in the production and distribution of cable television programming, in the licensing of programming to domestic and international markets and in joint ventures in foreign-based television operations and television production and distribution entities. Its primary services are: ESPN, an 80%-owned cable sports programming service reaching 62,700,000 households domestically and 49,000,000 households in 90 countries internationally; ESPN2 reaching 13,000,000 households. ESPN also owns 33% of Eurosport, a pan-European satellite-delivered cable and direct-to-home sports programming service reaching 48,700,000 households; and 20% of Japan Sports Network reaching 910,000 households; Arts & Entertainment Network, a 37 1/2%-owned cable programming service devoted to cultural and entertainment programming and reaching 52,900,000 households; Lifetime, a 33 1/3%-owned cable programming service devoted to women's lifestyle programming and reaching 58,800,000 households; Tele-Munchen Fernseh GmbH & Co., a 50%-owned Munich, Germany based television and theatrical production/distribution company with interests in cinemas and a minority interest in a Munich radio station; RTL 2 Fernsehen GmbH & Co., a 20%-owned Cologne, Germany based general entertainment commercial broadcasting company reaching 19,600,000 households; Scandinavian Broadcasting System SA, a 24%-owned Luxembourg based company operating television stations in Denmark reaching 1,300,000 households, and satellite-delivered cable and direct-to-home general entertainment television programming services in Sweden and Norway reaching 1,700,000 and 900,000 households, respectively; Hamster Productions, S.A., 33 1/3%-owned, and Tesauro, S.A., 25%-owned, television and theatrical production/distribution companies based in Paris, France and Madrid, Spain, respectively; and DIC Productions, L.P., a 95%-owned production/distribution venture of animated and live action programming for the children's television and video markets, and DIC Entertainment, L.P., a 100%-owned film library of similar type programming. Multimedia In late 1993, the Company created a Multimedia Group with the mandate to explore using video and print material to create new programming and software and to explore investment opportunities in emerging multimedia and interactive technologies. The division includes the Capital Cities/ABC Video Publishing unit, which acquires rights to and produces programming for the home video market. Competition The ABC Television Network competes for viewers with the other television networks, independent television stations and other video media such as cable television, multipoint distribution services ("MDS," which employ non-broadcast frequencies to transmit subscription television services to individual homes and businesses), satellite television program services and video cassettes; in the sale of advertising time, it competes with the other television networks, independent television stations, suppliers of cable television programs, and other advertising media such as newspapers, magazines and billboards. Substantial competition also exists for exclusive broadcasting rights for television programming. The ABC Radio Networks likewise compete with other radio networks and radio programming services, independent radio stations, and other advertising media. The Company's television and radio stations are in competition with other television and radio stations, cable television systems, MDS, satellite television program services, video cassettes and other advertising media such as newspapers, magazines and billboards. Such competition occurs primarily in individual market areas. Generally, a television station in one market does not compete directly with K-4 other stations in other market areas. Nor does a group of stations, such as those owned by the Company, compete with any other group of stations as such. While the pattern of competition in the radio station industry is basically the same, it is not uncommon for radio stations outside of a market area to place a signal of sufficient strength within that area (particularly during nighttime hours) to gain a share of the audience. However, they generally do not realize significantly increased advertising revenues as a result. The Company's Cable and International Broadcast operations compete with a number of companies involved in developing and supplying program services for cable, television syndication and theatrical distribution, and with conventional television broadcasters. The Multimedia operations face competition from numerous broadcast, cable, computer software, production and distribution companies which are also pursuing opportunities in the new technologies. The development of these businesses could adversely affect the future of conventional television broadcasting. In addition, the Company's broadcast operations face potential competition from numerous new satellite, cable and telephone technologies and distribution systems, and from signal-enhancing technologies such as high definition television or, in radio, "digital audio" radio. Although most of these technologies are in experimental phases, all have the potential to further increase the entertainment and information alternatives available to consumers. In some instances, the Company may itself participate in these new technologies. Regulatory, technical and economic issues make it impossible to predict whether or when, such technologies will become viable or competitive. Licenses--Federal Regulation of Broadcasting Television and radio broadcasting are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act empowers the FCC, among other things, to issue, revoke or modify broadcasting licenses, determine the location of stations, regulate the equipment used by stations, adopt such regulations as may be necessary to carry out the provisions of the Communications Act and impose certain penalties for violation of its regulations. Renewal Matters Broadcasting licenses are granted for a maximum period of seven years, in the case of radio stations, and five years, in the case of television stations, and are renewable upon application therefor. During certain periods when a renewal application is pending, new applicants may file for the frequency and may be entitled to compete with the renewal applicant in a comparative hearing, and others may file petitions to deny the application for renewal of license. Renewal applications are now pending for KABC(AM), KLOS-FM, KTRK-TV, KABC-TV, KGO-TV and KFSN-TV. In the case of KABC(AM), KLOS-FM, KABC-TV, KGO-TV and KFSN- TV, the time to file competing applications and petitions to deny has passed, and no such filings have been made against these stations. In the case of KTRK- TV, two petitions to deny have been filed. The Company believes both petitions are without merit and is vigorously opposing them. All of the Company's other owned stations have been granted license renewals by the FCC for regular terms. On April 15, 1992, the U.S. District Court for the District of Columbia issued a Memorandum Opinion and Order in Shepherd et al. v. American Broadcasting Companies, Inc. et al., Civil Action No. 88-0954 (RCL), which entered a default judgment against American Broadcasting Companies, Inc. and the Company on a complaint alleging discrimination in employment practices at the ABC News Bureau in Washington, DC, in violation of District of Columbia law. The default was based on a conclusion that "the defendants impeded and obstructed the litigation process by . . . destruction and alteration of a crucial document and through the harassment of witnesses and filing false and misleading affidavits." On September 3, 1993, the District Court issued a Memorandum Opinion on reconsideration that withdrew many of the findings of misconduct previously made but reaffirmed other such findings (as well as the default judgment) and called for further proceedings with respect to damages. The Company believes that the District Court's decision is factually and legally incorrect, and it is seeking to obtain a review of the default judgment (and the supporting findings of misconduct that remain) by the U.S. Court of Appeals for the District of Columbia Circuit. However, the policies of the FCC call for the agency to evaluate whether an adjudication of misconduct of the kind found in Shepherd should bear on the qualifications of the licensee, even though the adjudication is pending K-5 on appeal. The FCC has recently approved the Company's acquisition of radio station WYAY(FM), Gainesville, GA without prejudice to any action the agency may take in light of the ultimate outcome of the Shepherd decision. On January 14, 1994, the Company submitted to the FCC amendments to its pending license renewal applications urging that it and its subsidiaries should be found fully qualified to hold broadcast licenses, even if the misconduct findings of the District Court were ultimately upheld. Pending FCC action on that issue the Company will urge thc FCC to apply the Gainesville, GA precedent to permit the acquisition of new stations, the sale of existing stations or the renewal of existing licenses. Ownership Matters The Communications Act prohibits the assignment of a license or the transfer of control of a licensee without prior approval of the FCC, and prohibits the Company from having any officer or director who is an alien, and from having more than one-fifth of its shares owned of record or voted by aliens, representatives of aliens, foreign governments, representatives of foreign governments or corporations organized under the laws of foreign countries. The FCC's "multiple ownership" rules impose a variety of restrictions on the ownership or control of broadcast stations by a single party. The television "duopoly" rule bars control or ownership of significant interests in two television stations that serve the same area. Less severe restraints are imposed on the control or ownership of AM and FM radio stations that serve the same area; in a number of situations, a single party may control or own an AM and/or an FM "duopoly" -- two AM and/or two FM stations -- in the same market area. The rules also preclude the grant of applications for station acquisitions that would result in the creation of new radio-television combinations in the same market under common ownership, or the sale of such a combination to a single party, subject to the availability of waiver. Under FCC policy, waiver applications that involve radio-television station combinations in the top 25 TV markets where there would be at least 30 separately owned, operated and controlled broadcast licensees after the proposed combination will generally be favorably received. Under present FCC rules, a single entity may directly or indirectly own, operate or have a significant interest in up to eighteen AM and eighteen FM radio stations, and up to twelve television stations (VHF or UHF), provided that those television stations operate in markets containing cumulatively no more than 25% of the television households in the country. For this purpose, ownership of a UHF station will result in the attribution of only 50% of the television households in the relevant market. The Company owns eight television stations, of which seven are VHF, resulting in a total penetration of the nation's television households, for purposes of the multiple ownership rules, of 23.63%. The Company also owns nine AM and nine FM radio stations. Furthermore, under the FCC's rules, radio and/or television licensees may not acquire new ownership interests in daily newspapers published in the same markets served by their broadcast stations. The Company currently owns daily newspapers in two markets in which it also holds radio licenses. For purposes of these rules, The Oakland Press and WJR(AM) and WHYT(FM), licensed to Detroit, are treated as in the same market, as are the Fort Worth Star-Telegram and WBAP(AM) and KSCS(FM), licensed to Fort Worth. Absent an FCC waiver, the Company could not under the rules acquire additional broadcast stations in these markets nor could the current broadcast/newspaper combinations be transferred together. In 1993, the Congress relaxed a restriction previously imposed on the FCC so as to allow the FCC to grant waivers of the rules with respect to newspaper/radio station cross-ownership in the top 25 markets where at least 30 independent broadcast voices would remain following a transfer if the FCC determines that a waiver would serve the public interest. This new policy creates potential new acquisition opportunities for the Company. The FCC's rules also provide that television licensees may not own cable television systems in communities within the service contours of their television stations. In 1992, the FCC relaxed the rule that previously prohibited common ownership of television networks and cable television systems to permit such combinations subject to a national limit of 10% of "homes passed" (i.e., homes within the service areas of cable systems) by cable as well as a local limit of 50% of homes passed within any ADI (Area of Dominant Influence, i.e., local television market area as defined by Arbitron Television Ratings). The FCC's rules generally provide that an entity will have the licensee's broadcast stations or newspapers attributed to it for purposes of the multiple ownership rules only if it holds the power to vote or control the vote of 5% or more of the stock of a licensee. Qualifying mutual funds, insurance K-6 companies, or bank trust departments may vote or control the vote of up to 10% of the stock of a broadcast licensee before the licensee's stations would be attributed to that entity. Network Regulations In May 1993, the FCC eliminated rules that previously restricted the ability of the Company as well as CBS Inc. ("CBS") and National Broadcasting Company, Inc. ("NBC") to acquire financial interests in network television programs. In the same proceeding, the FCC retained (subject to a complex two-year sunset provision) rules that prevent the networks from engaging in active first-run or "off-network" syndication of programs to television stations in the United States, constrain the networks' discretion to determine when programs owned by them will be made available for syndication, and prevent the networks from acquiring from independent producers interests in first-run syndicated programs. In September 1993, the FCC substantially denied petitions for reconsideration of its May 1993 decision. The lawfulness of the regulations the agency has retained, and of the 1993 modications, has been challenged in proceedings currently pending in the United States Court of Appeals for the Seventh Circuit. The Company is not able to predict the outcome of these proceedings. In addition, other FCC rules effectively restrict the regular prime-time programming schedules of ABC, CBS and NBC to three hours per night during the period 7:00 P.M. to 11:00 P.M. on Monday through Saturday. The Company's television network operations are subject to a consent judgment (United States v. American Broadcasting Companies, Inc., 74-3600-RJK), in the United States District Court for the Central District of California, entered into and effective on November 14, 1980. Similar judgments have been entered against CBS and NBC with respect to their television networks. In November 1993 the United States District Court, upon a joint motion by the United States Department of Justice, the Company, CBS and NBC, modified the consent judgment to eliminate those provisions which prohibited the acquisition of subsidiary rights and interests in television programs produced by independent suppliers and restricted the ability of the Company (as well as CBS and NBC) to engage in the business of distributing programs directly to television stations in the United States or overseas. The consent judgment continues to contain provisions regulating for a period expiring in 1995 certain aspects of the Company's contractual relationships with suppliers of entertainment programming and with talent performers and other creative contributors to ABC Television Network entertainment programming. Cable Television and Other Competing Services Cable television can provide more competition to a television station by making additional signals available to the audience. In 1992, Congress enacted the Cable Television Consumer Protection and Competition Act. The Act gives television stations the right to elect "must carry" protection (including protection on channel position) on local cable systems. (The FCC's "must carry" rules require cable television systems generally to carry the signals of television stations in whose service areas they operate.) In the alternative, the Act permits local stations to negotiate with cable systems the terms and conditions of "retransmission consent" to carry their signals and to withhold their signals in the event that no consent on terms and conditions is reached. The Act also reimposes cable system rate regulation and introduces new regulations designed to ensure that MDS and other multi-channel video programmers have access to programming to facilitate competition with cable systems. The Act requires the FCC to conduct rulemaking proceedings to establish national cable system ownership limits and limits on cable channels devoted to video programmers in which the cable system has an interest, and to prohibit coercive or discriminatory practices by cable operators in dealings with video programmers (such as ESPN, ESPN2, Arts & Entertainment and Lifetime). The FCC has adopted regulations implementing all of these statutory provisions. Cable operators have filed lawsuits challenging many of the new Act's provisions. The must carry, retransmission consent, rate regulation and program access provisions have been upheld as constitutional in federal court decisions. The decision relating to must carry is pending on appeal in the Supreme Court of the United States. The decision relating to the Act's other provisions has been appealed to the United States Court of Appeals for the District of Columbia Circuit. The Company cannot predict the outcome of this litigation. Most cable television systems supply additional programming to subscribers that is not originated on, or transmitted from, conventional television broadcasting stations. Many of these services K-7 (including ESPN, ESPN2, Arts & Entertainment and Lifetime) are also being distributed directly to viewers by means of satellite transmissions to home satellite reception dishes. The FCC also authorizes broadcast subscription television services and MDS, and has expanded the number of frequencies available for MDS by allocating two groups of four channels each for the so-called multichannel MDS, to be awarded by lottery. The FCC has authorized licensees in the Instructional Television Fixed Service to lease their excess capacity for commercial use, including subscription television service, and has adopted rules facilitating direct broadcast satellite operations. It has also created a new service of low power television facilities to supplement existing conventional television broadcast service. The Company also faces potential competition to its broadcast and cable program services and to its newspaper operations from telephone companies. Telephone companies are seeking to expand their broadband networks to provide both data transmission services ("electronic publishing") and video services to the home. Until 1991, the regional Bell operating companies were prohibited from providing information services by the Modified Final Judgment that governed the break-up of American Telephone and Telegraph Company. While that prohibition has been lifted, there is a provision in the Cable Act of 1984 that prohibits telephone companies from providing video programming directly to their telephone subscribers ("the telco/cable cross ownership ban"). A number of recent developments may affect potential telephone company competition. First, the FCC decided in 1991 and 1992 to permit telephone companies to offer "video dialtone" distribution services to programmers on a common carrier basis without having to obtain a municipal cable franchise. Appeals challenging this decision are pending in the United States Court of Appeals for the District of Columbia Circuit. Second, in a suit filed by Bell Atlantic Corporation, a U.S. District Court ruled in August 1993 that the telco/cable cross ownership ban is unconstitutional. The decision has been appealed to the United States Court of Appeals for the Fourth Circuit. Finally, there are a number of legislative proposals that would either eliminate or modify the telco/cable cross ownership ban. The Company cannot predict the outcome of these developments or the competitive effect of these services or potential services. From time to time legislation may be introduced in Congress which, if enacted, might affect the Company's operations or its advertising revenues. Proceedings, investigations, hearings and studies are periodically conducted by Congressional committees and by the FCC and other government agencies with respect to problems and practices of, and conditions in, the broadcasting industry. The Company cannot generally predict whether new legislation or regulations may result from any such studies or hearings or the adverse impact, if any, upon the Company's operations which might result therefrom. The information contained under this heading does not purport to be a complete summary of all the provisions of the Communications Act and the rules and regulations of the FCC thereunder, or of pending proposals for other regulation of broadcasting and related activities. For a complete statement of such provisions, reference is made to the Communications Act, and to such rules, regulations and pending proposals thereunder. * * * * * K-8 Publishing The Company publishes newspapers and shopping guides, various specialized and business periodicals and books; provides research services and also distributes information from data bases. Following is a summary of the Company's historical operating performance, by type of publication, for the last five years (000's omitted): - ---------- (a) Does not include inserts. (b) Excludes 1993 and 1992 acquisitions, start-ups and disposals. K-9 Daily Newspapers The Company publishes eight daily newspapers in eight communities (six of which have Sunday editions). The daily newspapers and their paid circulation are as follows: Weekly Newspapers The Company publishes weekly community newspapers in seven states. The location by state, number of publications and aggregate circulation is set forth below: Shopping Guides and Real Estate Magazines The Company distributes shopping guides and real estate magazines in thirteen states. The location by state, number of publications and aggregate circulation is set forth below: K-10 Specialized Publications The Specialized Publications consists of three groups: the Diversified Publishing Group, the Fairchild Publications Group, and the Financial Services and Medical Group. Through these groups it is engaged in gathering and publishing business news and ideas for industries covered by its various publications; in the publishing of consumer, special interest, trade and agricultural publications; and in research and data base services. All of the publications are printed by outside printing contractors. Following are the significant publications and services: K-11 - ---------- All, or substantially all, controlled circulation. Certain operations within the Publishing Group also publish philatelic magazines, cable guides, books, visuals, journals and newsletters, and conduct meetings and seminars. K-12 Competition The Company's newspapers, specialized publications and shopping guides operate in a highly competitive environment. In the Company's various news publishing activities it competes with almost all other information media, including broadcast media, and this competition may become more intense as new technologies are developed. Magazines and many newspapers publish substantial amounts of similar business news and information, and deal with the same or related special interests or industries, as those covered by the Company's specialized publications. The Company's newspapers, specialized publications and shopping guides compete for advertising with all other advertising forms of media. Raw Materials The primary raw materials used by the Company's Publishing Group are newsprint and other paper stock, which are purchased from paper merchants, paper mills and contract printers and are readily available from numerous suppliers. Item 2. Item 2. Properties. The Company's headquarters building at 77 West 66th Street in New York City houses the corporate offices and the television network administrative staff, and is owned by the Company. The Company owns the ABC Television Center adjacent to the Company's headquarters building on West 66th Street and the ABC Radio Networks' studios at 125 West End Avenue in New York City. In Los Angeles, the Company owns the ABC Television Center. The Company leases the ABC Television Network offices in Los Angeles, the ABC News Bureau facility in Washington, DC and the computer facility in Hackensack, NJ under leases expiring on various dates through 2034. The Company's broadcast operations and engineering facility and local television studios and offices in New York City are leased, but the Company has the right to acquire such properties for a nominal sum in 1997. The Company's 80%-owned subsidiary ESPN owns ESPN Plaza in Bristol, CT from which it conducts its technical operations. The Company owns the majority of its other broadcast studios and offices and broadcast transmitter sites elsewhere, and those which it does not own are occupied under leases expiring on various dates through 2039. The Company owns and leases publishing subsidiaries' executive, editorial and other offices and facilities in various cities. For leased properties, the leases expire on various dates through 2006. All of the significant premises occupied by the newspapers are owned by the Company. Item 3. Item 3. Legal Proceedings. All litigation pending during 1993 was routine and incidental to the business of the Company. For a discussion of the relevance of one item of litigation in the regulatory context, see "Licenses - Federal Regulation of Broadcasting" under Item 1. Business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. The information called for by this item is not applicable. K-13 Executive Officers of the Company There is no relationship by blood, marriage or adoption among the officers. All officers hold office at the pleasure of the Board of Directors. K-14 PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters. The information called for by this item is included on page 41 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 6. Item 6. Selected Financial Data. The information called for by this item is included on pages 26 and 27 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information called for by this item is included on pages 21 through 25 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The information called for by this item is included on pages 28 through 41 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. The information called for by this item is not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated herein by reference to the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on May 19, 1994. Information concerning the executive officers is included in Part 1, on page K-14. Item 11. Item 11. Executive Compensation. Incorporated herein by reference to the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on May 19, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by reference to the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on May 19, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. The information called for by this item is not applicable. K-15 PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. & 2. Financial statements and financial statement schedules. The financial statements and schedules listed in the accompanying index to the consolidated financial statements are filed as part of this annual report. 3. Exhibits. The exhibits listed on the accompanying index to exhibits are filed as part of this annual report. (b) Reports on Form 8-K. None filed during Fourth Quarter 1993. K-16 CAPITAL CITIES/ABC,INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF CERTIFIED PUBLIC ACCOUNTANTS (Item 14(a) 1. & 2.) All other schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. * * * * The consolidated financial statements of Capital Cities/ABC, Inc., listed in the above index which are included in the Annual Report to Shareholders for the year ended December 31, 1993, are hereby incorporated by reference. With the exception of the Items referred to in Items 1, 5, 6, 7 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. - -------------------------------------------------------------------------------- CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report on Form 10-K of Capital Cities/ABC, Inc. for the year ended December 31, 1993 of our report dated February 28, 1994, included in the 1993 Annual Report to Shareholders of Capital Cities/ABC, Inc. Our audits also included the financial statement schedules of Capital Cities/ABC, Inc. listed in item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statements Form S-8 No. 2-59014 for the registration of 287,195 shares of the Company's common stock, Form S-8 No. 2-86863 for the registration of 300,000 shares, Form S-8 No. 33-2196 relating to the issuance of an indeterminate number of shares, Form S-8 No. 33-11806 for the registration of 200,000 shares, Form S-8 No. 33-16206 for the registration of 300,000 shares, Form S-8 No. 33-25918 for the registration of 200,000 shares, Form S-8 No. 33-33761 for the registration of 200,000 shares, Form S-3 No. 33-38117 for the registration of Debt Securities and Warrants to purchase Debt Securities, Form S-3 No. 33-39652 for the registration of Debt Securities and Warrants to purchase Debt Securities, and Form S-8 No. 33-52563 for the registration of 60,000 shares, and in the related Prospectuses and documents constituting Prospectuses, of our above report. ERNST & YOUNG New York, New York March 14, 1994 K-17 CAPITAL CITIES/ABC, INC. INDEX TO EXHIBITS (Item 14 (a) 3.) (3)(a) Restated Certificate of Incorporation of the Company, with amendments. Incorporated by reference to Exhibit (3)(a) to the Company's Annual Report on Form 10-K for 1989. (3)(b) Current By-laws of the Company. Incorporated by reference to Exhibit (3) to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1990. (4)(a) Capital Cities/ABC, Inc. Standard Multiple-Series Indenture Provisions dated December 7, 1990. Incorporated by reference to Exhibit (4)(a) to Registration Statement No. 33-38117. (4)(b) Indenture, dated as of December 15, 1990, between the Company and Manufacturers Hanover Trust Company (now Chemical Bank), as Trustee, with respect to Senior Debt Securities. Incorporated by reference to Exhibit (4)(b) to Registration Statement No. 33-38117. (4)(c) Indenture, dated as of April 1, 1991 between the Company and Manufacturers Hanover Trust Company (now Chemical Bank), as Trustee, with respect to Subordinated Debt Securities. Incorporated by reference to Exhibit (4)(c) to Registration Statement No. 33-39652. (4)(d) Revolving Credit Agreement, dated as of January 3, 1986, as amended and restated as of June 30, 1987, among the Company, Chemical Bank and certain other banks. Incorporated by reference to Exhibit (4)(d) to the Company's Annual Report on Form 10-K for 1987. (4)(e) Second Amendment, dated as of June 30, 1989, to the Revolving Credit Agreement set forth in Exhibit (4)(d) above. Incorporated by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for 1989. (4)(f) Third Amendment, dated as of April 30, 1992, to the Revolving Credit Agreement set forth in Exhibits (4)(d) and (4)(e) above. Incorporated by reference to Exhibit 4(f) to the Company's Annual Report on Form 10-K for 1992. (4)(g) Other instruments defining the rights of holders of long-term debt of the Company and its consolidated subsidiaries are not being filed since the total amount of securities authorized under any of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. (4)(h) Rights Agreement, dated December 14, 1989, between the Company and Harris Trust Company of New York with respect to the Preferred Share Purchase Rights. Incorporated by reference to Exhibit 1 to the Company's Form 8-K dated December 15,1989. (10)(a) Stock Purchase Agreement between the Company and Berkshire Hathaway Inc., dated March 18, 1985. Incorporated by reference to Appendix B to the Company's and American Broadcasting Companies, Inc.'s Joint Proxy Statement- Prospectus dated May 10, 1985. (10)(b) Stock Purchase Agreement among the Company, Berkshire Hathaway Inc., National Indemnity Company, National Fire and Marine Insurance Company, Columbia Insurance Company, Nebraska Furniture Mart, Inc. and Cornhusker Casualty Company, dated January 2, 1986. Incorporated by reference to Exhibit A to the Schedule 13D dated January 8, 1986 filed by Berkshire Hathaway Inc. and others in regard to the Company's common stock. (10)(c) Amendment dated October 29, 1993 to the Stock Purchase Agreement set forth in Exhibit (10)(b) above. Incorporated by reference to Exhibit 99(c) to the Company's Schedule 13E-4 dated November 2, 1993. (10)(d) Supplemental Profit Sharing Plan of the Company, as amended through April 9, 1992. Incorporated by reference to Exhibit (10)(c) to the Company's Annual Report on Form 10-K for 1992. (10)(e) Benefit Equalization Plan of the Company, as amended through January 1, 1994. (10)(f) Incentive Compensation Plan of the Company, as amended through December 9, 1993. (10)(g) Employee Stock Option Plan of the Company, as amended through December 15, 1987. Incorporated by reference to Exhibit (10)(f) to the Company's Annual Report on Form 10-K for 1992. (10)(h) 1991 Stock Option Plan of the Company, as amended through March 19, 1991. Incorporated by reference to Exhibit (10)(g) to the Company's Annual Report on Form 10-K for 1992. (10)(i) Contract dated January 2, 1968 between John B. Fairchild and Fairchild Publications, Inc., as amended by contract of June 1977 between Mr. Fairchild and Capital Cities Media, Inc. (a subsidiary of the Company) as successor to Fairchild Publications, Inc. (Mr. Fairchild is an executive K-18 officer and a director of the Company.) Incorporated by reference to Exhibit (10)(h) to the Company's Annual Report on Form 10-K for 1992. (10)(j) The Company's Retirement Plan for Nonemployee Directors, as adopted by Board of Directors resolution dated March 20, 1990. Incorporated by reference to Exhibit (10)(i) to the Company's Annual Report on Form 10-K for 1992. (13) The Company's 1993 Annual Report to Shareholders. (This report, except for the portions thereof which are incorporated by reference in this Form 10-K, is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of this Form 10-K.) (21) Subsidiaries of the Company. (99)(a) Form 11-K for the Company's Savings & Investment Plan for the year ended December 31, 1993. (99)(b) Undertakings. - ---------- Executive officers' and directors' compensation plans and arrangements. K-19 CAPITAL CITIES/ABC, INC. PROPERTY, PLANT AND EQUIPMENT -- SCHEDULE V (Thousands of Dollars) - ---------- (a) Represents adjustments related to the adoption of Financial Accounting Standard No. 109 "Accounting for Income Taxes." VALUATION AND QUALIFYING ACCOUNTS -- SCHEDULE VIII (Thousands of Dollars) K-20 CAPITAL CITIES/ABC, INC. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT--SCHEDULE VI (Thousands of Dollars) - ---------- Depreciation is computed on the straight-line method over the following estimated useful lives: buildings and improvements--10 to 55 years; broadcasting equipment--4 to 20 years; printing machinery and equipment--5 to 20 years. SUPPLEMENTARY INCOME STATEMENT INFORMATION--SCHEDULE X (Thousands of Dollars) K-21 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. CAPITAL CITIES/ABC, INC. (Registrant) /s/ THOMAS S. MURPHY ------------------------ (Thomas S. Murphy) Chairman of the Board and Chief Executive Officer March 14, 1994 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 date indicated: K-22	6,459	43,227
66904_1993.txt	66904_1993	1993	66904	ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2 ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) (d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) (f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) (a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) (a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. (a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. (a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. (a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. (a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. (a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. (c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. (c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. (a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. (c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 (c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. (c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. (f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN (a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA (b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA (c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF (d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI (e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH (f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN (a) - Power of Attorney and resolution. ALABAMA (b) - Power of Attorney and resolution. GEORGIA (c) - Power of Attorney and resolution. GULF (d) - Power of Attorney and resolution. MISSISSIPPI (e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20	91,950	598,707
310826_1993.txt	310826_1993	1993	310826	ITEM 1. BUSINESS Protective Life Insurance Company ("Protective") is a wholly-owned and the principal operating subsidiary of Protective Life Corporation ("PLC"), an insurance holding company. Founded in 1907, Protective provides financial services through the production, distribution, and administration of insurance and investment products. Protective markets individual life and health insurance and annuities nationally through professional, independent general agents. Protective serves the individual payroll deduction market by offering universal life and cancer insurance, and Protective distributes group life, health, and dental insurance products through full-time field representatives who market to employers and associations through agents and brokers. Protective markets annuities and investment products, credit life, and disability products through broker-dealers and financial institutions to their customers, and Protective sells guaranteed investment contracts. Over the last twenty-five years PLC has made thirty-two acquisitions of smaller insurance companies or blocks of policies. Many of these transactions included Protective. Additionally, PLC has from time to time merged other life insurance companies it has acquired into Protective. In 1990 Protective reinsured two separate blocks of insurance which were assumed by Protective during 1991. PLC acquired a small life insurance company and merged it into Protective in early 1992. In July 1992, Protective assumed a block of credit life and credit accident and health insurance business. In July 1993, Protective acquired a Wisconsin insurer and Protective reinsured a block of universal life policies. Since 1983, Protective has owned 100% of American Foundation Life Insurance Company ("American Foundation"). Since 1988, Protective owned convertible preferred stock of Southeast Health Plan, Inc. ("SEHP"), a Birmingham-based health maintenance organization. On August 31, 1991, Protective converted the preferred stock into 80% of the common stock of SEHP. In January 1993, Protective's ownership of SEHP was transferred to PLC. In August 1993, PLC sold its interest in SEHP. ITEM 2. ITEM 2. PROPERTIES Protective's administrative office building is located at 2801 Highway 280 South, Birmingham, Alabama. This building includes the original 142,000 square-foot building which was completed in 1976 and a second contiguous 220,000 square-foot building which was completed in 1985. In addition, parking is provided for approximately 1,000 vehicles. Protective leases administrative space in Birmingham, Alabama; Brentwood, Tennessee; Greenville, South Carolina; Cary, North Carolina; and Oklahoma City, Oklahoma. Substantially all of these offices are rented under leases that run for periods of three to five years. The aggregate monthly rent is approximately $28 thousand. Marketing offices are leased in 15 cities, substantially all under leases for periods of three to five years with only two leases being over five years. The aggregate monthly rent is approximately $24 thousand. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings pending by or against Protective other than routine litigation incidental to its insurance business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not required in accordance with General Instruction J(2)(c). PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Protective is a wholly-owned subsidiary of PLC which also owns all of the redeemable preferred stock issued by Protective's subsidiary, American Foundation. Therefore, neither Protective's Common Stock nor American Foundation's Preferred Stock is publicly traded. At December 31, 1993, $295 million of consolidated stockholder's equity represented net assets of Protective that cannot be transferred to PLC in the form of dividends, loans, or advances. In addition, under the insurance laws of the States of Tennessee, Alabama and Wisconsin, certain restrictions are imposed on dividends from insurers domiciled in those states. Also, distributions, including cash dividends to PLC in excess of approximately $184 million would be subject to Federal income tax at rates then effective. Protective does not anticipate involuntarily paying tax on such distributions. The American Foundation Preferred Stock pays, when and if declared, annual minimum cumulative dividends of $0.1 million and noncumulative participating dividends to the extent American Foundation's statutory earnings for the immediately preceding fiscal year exceed $1 million. In 1993 and 1992, respectively American Foundation paid preferred dividends of $1.5 million and $1.4 million. During 1993, Protective transferred its ownership interest in SEHP to PLC in the form of a common dividend. Protective paid no other dividends to PLC during 1993. Protective paid common dividends of $1.9 million in 1992. Protective and American Foundation expect to continue to pay cash dividends, subject to their earnings and financial condition and other relevant factors. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Not required in accordance with General Instruction J(2)(a). ITEM 7. ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS OF THE RESULTS OF OPERATIONS In accordance with General Instruction J(2)(a), Protective includes the following analysis with the reduced disclosure format. REVENUES The following table sets forth revenues by source for the periods shown: Premiums and policy fees increased 8.8% in 1993 over 1992. The transfer of Protective's ownership of SEHP to PLC represents a $40.5 million decrease in premiums and policy fees. Increases in premiums and policy fees from the Agency, Group, and Financial Institutions Divisions represented increases of $14.6 million, $13.0 million and $30.4 million, respectively. Effective July 1, 1992, the Financial Institutions Division assumed Durham Life Insurance Company's credit business representing $15.1 million of the segment's $30.4 million increase. On July 30, 1993, Protective completed its acquisition of Wisconsin National Life Insurance Company ("Wisconsin National"). The acquisition increased premiums and policy fees by $11.7 million. The reinsurance of a block of universal life policies on July 1, 1993 resulted in a $3.2 million increase. Decreases in older acquired blocks of ordinary policies represented a $5.6 million decrease in premiums and policy fees. Net investment income increased 28.8% in 1993 over 1992 primarily due to an increase in the average amount of invested assets. Invested assets increased during 1993 primarily due to receiving individual annuity and guaranteed investment contract ("GIC") deposits and the acquisition of Wisconsin National. Annuity and GIC deposits are not considered revenues in accordance with generally accepted accounting principles. These deposits are included in the liability section of the balance sheet. The Wisconsin National acquisition increased 1993 investment income approximately $14.5 million. Due to the general decline in interest rates, Protective's percentage earned on average cash and investment was 8.4% for 1993, slightly below the 8.6% for 1992. Protective generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. The sales of investments that have occurred result from portfolio management decisions to maintain proper matching of assets and liabilities. Protective maintains an allowance for uncollectible amounts on investments based upon industry default rates for different asset types. The allowance totaled $35.2 million at December 31, 1993. Additions to the allowance are treated as realized investment losses. During 1993, Protective added $8.7 million to this allowance which partially offset the $13.8 million of net realized investment gains in the period. Other income consists primarily of fees from administrative-services-only types of group accident and health insurance contracts, and from rental of space in its administrative building to PLC. The transfer of SEHP to PLC decreased other income $5.1 million. INCOME BEFORE INCOME TAX The following table sets forth income or loss before income tax by business segment for the periods shown: In 1993 Protective changed the method used to apportion net investment income to the various divisions. This change resulted in increased income attributable to the Agency, Investment Products, and Acquisitions Divisions of $3.0 million, $2.0 million, and $2.6 million, respectively, while decreasing income of the Corporate and Other segment. Agency pretax earnings increased $7.3 million in 1993 as compared to 1992. The improvement in earnings is largely due to growth in the amount of business in force brought about by sales, continued strong persistency, and favorable mortality experience. Group pretax earnings were $2.7 million higher in 1993 as compared to 1992. Group life and annuity earnings improved by $1.7 million, and group health earnings improved by $1.0 million primarily due to improved cancer and dental earnings. Pretax earnings of the Financial Institutions Division were $2.6 million higher in 1993 as compared to 1992. Effective July 1, 1992, Protective assumed all of the policy obligations associated with the credit life and credit accident and health insurance business produced by Durham Life Insurance Company ("Durham"). The Durham acquisition represented $0.7 million of the increase. The balance of the increase was due to premium growth and improved claims ratios in the Division's other lines. The Investment Products Division's pretax earnings were $0.8 million lower in 1993 compared to 1992 primarily due to the $3.2 million more rapid amortization of deferred policy acquisition costs, in part, to shorten the amortization period on book value annuities, sales of which were substantially discontinued at the end of 1992. Annuity deposits were $836 million at December 31, 1993 compared to $674 million at December 31, 1992. Average deposits for the year were $742 million, 42% higher than for 1992. The Guaranteed Investment Contracts ("GIC") Division had pretax earnings of $27.2 million in 1993 and $18.2 million in 1992. GIC earnings have increased due to the growth in GIC deposits placed with Protective. At December 31, 1993, GIC deposits totaled $2.0 billion compared to $1.7 billion one year earlier. Pretax earnings from the Acquisitions Division increased $9.8 million in 1993 as compared to 1992. Earnings from the Acquisitions Division are normally expected to decline over time (due to the lapsing of policies resulting from deaths of insureds or terminations of coverage) unless new acquisitions are made. On July 30, 1993, Protective completed its acquisition of Wisconsin National. Protective also reinsured a block of universal life policies in the 1993 third quarter. These two acquisitions contributed approximately $5.1 million to 1993 earnings. The Division also experienced improved results in its other blocks of acquired policies. The Corporate and Other segment consists of several small insurance lines of business, net investment income and other operating expenses not identified with the preceding business segments (including interest on substantially all debt), and the operations of a small noninsurance subsidiary. Pre-tax losses for this segment were 6.7 million higher in 1993 as compared to 1992 primarily due to the aforementioned reapportionment of net investment income within Protective. INCOME TAX EXPENSE The following table sets forth the effective income tax rates for the periods shown: For the year ended December 31, 1992, the effective income tax rate was 29.6%. In August 1993, the corporate income tax rate was increased from 34% to 35%, which resulted in a one-time increase to income tax expense of $1.2 million due to a recalculation of Protective's deferred income tax liability. The effective income tax rate for 1993, excluding the one-time increase, was 33.4%. Management's estimate of the effective income tax rate for 1994 is 32%. NET INCOME The following table sets forth net income for the periods shown: Compared to 1992, net income in 1993 increased 39.6%, reflecting improved earnings in most of its major lines which were partially offset by a higher effective income tax rate and the $1.2 million one-time increase to income tax expense discussed above. Additionally, 1992 includes a reduction to income of approximately $1.1 million representing the cumulative effect of a change in accounting principle associated with Protective's adoption of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." RECENTLY ISSUED ACCOUNTING STANDARDS In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." Protective anticipates that the impact of adopting SFAS No. 114 on its financial condition will be insignificant. ITEM 8. ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS To the Directors and Stockholder Protective Life Insurance Company Birmingham, Alabama We have audited the consolidated financial statements and the financial statement schedules of Protective Life Insurance Company and Subsidiaries listed in the index on page 33 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Protective Life Insurance Company and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note A to the Consolidated Financial Statements, the Company changed its method of accounting for certain investments in debt and equity securities in 1993. Also, as discussed in Note L to the Consolidated Financial Statements, the Company changed its method of accounting for postretirement benefits other than pensions in 1992. COOPERS & LYBRAND February 14, 1994 PROTECTIVE LIFE INSURANCE COMPANY CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. PROTECTIVE LIFE INSURANCE COMPANY CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. PROTECTIVE LIFE INSURANCE COMPANY CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See notes to consolidated financial statements. PROTECTIVE LIFE INSURANCE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements of Protective Life Insurance Company and subsidiaries ("Protective") are prepared on the basis of generally accepted accounting principles. Such accounting principles differ from statutory reporting practices used by insurance companies in reporting to state regulatory authorities. See also Note B. ENTITIES INCLUDED The consolidated financial statements include the accounts, after intercompany eliminations, of Protective Life Insurance Company and its wholly-owned subsidiaries including Wisconsin National Life Insurance Company ("Wisconsin National") and American Foundation Life Insurance Company ("American Foundation"). Protective is a wholly-owned subsidiary of Protective Life Corporation ("PLC"), an insurance holding company. Additionally, the financial statements include the accounts of majority-owned subsidiaries. The ownership interest of the other stockholders of these subsidiaries is called a minority interest and is reported as a liability of Protective and as an adjustment to income. PLC has from time to time merged other life insurance companies it has acquired (or formed) into Protective. Acquisitions have been accounted for as purchases by PLC. The results of such mergers have been included in the accompanying financial statements as if the mergers into Protective had occurred on the dates the merged companies were acquired (or formed) by PLC. Such mergers into Protective have been accounted for in a manner similar to that in pooling-of-interests accounting. RECENTLY ISSUED ACCOUNTING STANDARDS In 1992, Protective adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting For Postretirement Benefits Other Than Pensions." SFAS No. 106 was accounted for as a change in accounting principle with the cumulative effect reported as a reduction to income. In 1993, Protective adopted SFAS No. 109, "Accounting for Income Taxes." Adoption of this accounting standard did not have a material effect on Protective's financial statements. Protective also adopted in 1993 SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." This statement eliminates the reporting of insurance activities net of the effects of reinsurance ceded. The adoption of this statement increased reported assets and liabilities by approximately $97.9 million at December 31, 1993. Protective has not restated any previously reported financial statements as a result of adopting this statement. At December 31, 1993, Protective adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." For purposes of adopting SFAS No. 115 Protective has classified all of its investments in fixed maturities, equity securities, and short-term investments as "available for sale." As prescribed by SFAS No. 115, these investments are recorded at their market values at December 31, 1993 with the resulting net unrealized gain recorded as an increase in stockholder's equity. The effect of adopting SFAS No. 115 at December 31, 1993 was to increase fixed maturities by $65.6 million, decrease deferred policy acquisition PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) costs by $12.4 million, increase the liability for deferred income taxes by $18.6 million, and increase stockholder's equity by $34.6 million. In accordance with the provisions of SFAS No. 115, 1992 amounts have not been restated. INVESTMENTS Investments are reported on the following bases less allowances for uncollectible amounts on investments, if applicable: - Fixed maturities (bonds, bank loan participations, and redeemable preferred stocks) -- 1993: at current market value; 1992: at cost, adjusted for amortization of premium or discount and other than temporary market value declines. - Equity securities (common and nonredeemable preferred stocks) -- at current market value. - Mortgage loans on real estate -- at unpaid balances, adjusted for loan origination costs, net of fees, and amortization of premium or discount. - Investment real estate -- at cost, less allowances for depreciation computed on the straight-line method. With respect to real estate acquired through foreclosure, cost is the lesser of the loan balance plus foreclosure costs or appraised value. - Policy loans -- at unpaid balances. - Other long-term investments -- at a variety of methods similar to those listed above, as deemed appropriate for the specific investment. - Short-term investments -- at cost, which approximates current market value. Substantially all short-term investments have maturities of three months or less at the time of acquisition and include approximately $11 million in bank deposits voluntarily restricted as to withdrawal. Realized gains and losses on sales of investments are recognized in net income using the specific identification basis. Temporary changes in market values of certain investments are reflected as unrealized gains or losses directly in stockholder's equity (net of income tax) and accordingly have no effect on net income. A combination of futures contracts and options on treasury notes are currently being used as hedges for asset/liability management of certain investments, primarily mortgage loans on real estate, and liabilities arising from interest sensitive products such as guaranteed investment contracts and individual annuities. Realized investment gains and losses on such contracts are deferred and amortized over the life of the hedged asset. Protective also uses interest rate swap contracts to convert certain investments from a variable to a fixed rate of interest. At December 31, 1993, open interest rate swap contracts were in a $9.0 million unrealized gain position. CASH Cash includes all demand deposits reduced by the amount of outstanding checks and drafts. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PROPERTY AND EQUIPMENT Property and equipment are reported at cost. Protective uses both accelerated and straight-line methods of depreciation based upon the estimated useful lives of the assets. Major repairs or improvements are capitalized and depreciated over the estimated useful lives of the assets. Other repairs are expensed as incurred. The cost and related accumulated depreciation of property and equipment sold or retired are removed from the accounts, and resulting gains or losses are included in income. Property and equipment consisted of the following at December 31: REVENUES, BENEFITS, CLAIMS, AND EXPENSES - Traditional Life and Health Insurance Products -- Traditional life insurance products consist principally of those products with fixed and guaranteed premiums and benefits, and include whole life insurance policies, term life insurance policies, limited-payment life insurance policies, and certain annuities with life contingencies. Life insurance and immediate annuity premiums are recognized as revenue when due. Health insurance premiums are recognized as revenue over the terms of the policies. Benefits and expenses are associated with earned premiums so that profits are recognized over the life of the contracts. This is accomplished by means of the provision for liabilities for future policy benefits and the amortization of deferred policy acquisition costs. Liabilities for future policy benefits on traditional life insurance products have been computed using a net level method including assumptions as to investment yields, mortality, persistency, and other assumptions based on Protective's experience modified as necessary to reflect anticipated trends and to include provisions for possible adverse deviation. Reserve investment yield assumptions are graded and range from 2.5% to 7.0%. The liability for future policy benefits and claims on traditional life and health insurance products includes estimated unpaid claims that have been reported to Protective and claims incurred but not yet reported. Policy claims are charged to expense in the period that the claims are incurred. - Universal Life and Investment Products -- Universal life and investment products include universal life insurance, guaranteed investment contracts, deferred annuities, and annuities without life contingencies. Revenues for universal life and investment products consist of policy fees that have been assessed against policy account balances for the costs of insurance, policy administration, and surrenders. That is, universal life and investment product deposits are not considered revenues in accordance with generally accepted accounting principles. Benefit reserves for universal life and PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) investment products represent policy account balances before applicable surrender charges plus certain deferred policy initiation fees that are recognized in income over the term of the policies. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances and interest credited to policy account balances. Interest credit rates for universal life and investment products ranged from 3.0% to 9.4% in 1993. At December 31, 1993, Protective estimates the fair value of its guaranteed investment contracts to be $2,105 million using discounted cash flows. The surrender value of Protective's annuities which approximates fair value was $1,003 million. - Policy Acquisition Costs -- Commissions and other costs of acquiring traditional life and health insurance, universal life insurance, and investment products that vary with and are primarily related to the production of new business have been deferred. Traditional life and health insurance acquisition costs are amortized over the premium-payment period of the related policies in proportion to the ratio of annual premium income to total anticipated premium income. Acquisition costs for universal life and annuities are being amortized over the lives of the policies in relation to the present value of estimated gross profits from surrender charges and investment, mortality, and expense margins. For 1993, these costs have been reduced by an amount equal to the amortization that would have been recorded if unrealized gains or losses on investments associated with Protective's universal life and investment products had been realized. At the time it adopted SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments," Protective made certain assumptions regarding the mortality, persistency, expenses, and interest rates it expected to experience in future periods. Under SFAS No. 97, these assumptions are to be best estimates and are to be periodically updated whenever actual experience and/or expectations for the future change from initial assumptions. Accordingly, Protective has substituted its actual experience to date for that previously assumed. The cost to acquire blocks of insurance representing the present value of future profits from such blocks of insurance is also included in deferred policy acquisition costs, discounted at interest rates averaging 15%. For acquisitions occurring after 1988, Protective amortizes the present value of future profits over the premium-payment period including accrued interest at 8%. The unamortized present value of future profits for such acquisitions was approximately $39.4 million and $29.9 million at December 31, 1993 and 1992, respectively. During 1993 $12.4 million of present value of future profits on acquisitions made during the year was capitalized, and $0.4 million was amortized. The unamortized present value of future profits for all acquisitions was $69.9 million at December 31, 1993 and $65.4 million at December 31, 1992. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PARTICIPATING POLICIES Participating business comprises approximately 4% of the ordinary life insurance in force and 4% of the ordinary life insurance premium income. Policyholder dividends totaled $2.6 million in 1993, $2.6 million in 1992, and $2.8 million in 1991, respectively. INCOME TAXES Protective uses the liability method of accounting for income taxes. Income tax provisions are generally based on income reported for financial statement purposes. Deferred federal income taxes arise from the recognition of temporary differences between income determined for financial reporting purposes and income tax purposes. Such temporary differences are principally related to the deferral of policy acquisition costs and the provision for future policy benefits and expenses. RECLASSIFICATIONS Certain reclassifications have been made in the previously reported financial statements to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on the previously reported net income, total assets, or stockholder's equity. NOTE B -- RECONCILIATION WITH STATUTORY REPORTING PRACTICES Financial statements prepared in conformity with generally accepted accounting principals ("GAAP") differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. The most significant differences are: (a) acquisition costs of obtaining new business are deferred and amortized over the approximate life of the policies rather than charged to operations as incurred, (b) benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions, (c) deferred income taxes are provided for significant temporary differences between financial and taxable earnings, (d) the Asset Valuation Reserve and Interest Maintenance Reserve are restored to stockholder's equity, (e) furniture and equipment, agents' debit balances, and prepaid expenses are reported as assets rather than being charged directly to surplus (referred to as nonadmitted items), (f) certain items of interest income, principally accrual of mortgage and bond discounts are amortized differently, and (g) bonds are stated at market instead of amortized cost. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE B -- RECONCILIATION WITH STATUTORY REPORTING PRACTICES (CONTINUED) The reconciliations of net income and stockholder's equity prepared in conformity with statutory reporting practices to that reported in the accompanying consolidated financial statements are as follows: PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE C -- INVESTMENT OPERATIONS Major categories of investment income for the years ended December 31 are summarized as follows: Realized investment gains (losses) for the years ended December 31 are summarized as follows: Protective has established an allowance for uncollectible amounts on investments. The allowance totaled $35.2, $26.5 million, and $16.8 million at December 31, 1993, 1992, and 1991, respectively. Additions to the allowance are included in realized investment losses. Without such additions, Protective had realized investment gains of $13.8 million, $9.5 million, and $7.4 million in 1993, 1992, and 1991, respectively. In 1993, gross gains on the sale of investments available for sale (fixed maturities, equity securities and short-term investments) were $8.3 million and gross losses were less than $0.4 million. In 1992, gross gains on the sale of fixed maturities were $12.8 million and gross losses were $1.7 million. In 1991, gross gains were $4.8 million and gross losses were $1.9 million. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE C -- INVESTMENT OPERATIONS (CONTINUED) The amortized cost and estimated market value of Protective's investments classified as available for sale at December 31, 1993 are as follows: PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE C -- INVESTMENT OPERATIONS (CONTINUED) The amortized cost and estimated market values of Protective's investments in fixed maturities at December 31, 1992 are as follows: The amortized cost and estimated market value of fixed maturities at December 31, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay certain of these obligations. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE C -- INVESTMENT OPERATIONS (CONTINUED) The approximate percentage distribution of Protective's fixed maturity investments by quality rating at December 31 is as follows: At December 31, 1993, Protective had bonds which were rated less than investment grade of $67.3 million having an amortized cost of $66.7 million. Additionally, Protective had bank loan participations which were rated less than investment grade of $121.7 million, having an amortized cost of $121.7 million. The change in unrealized gains (losses) on fixed maturity and equity securities for the years ended December 31 is summarized as follows: At December 31, 1993, all of Protective's mortgage loans were commercial loans of which 79% were retail, 9% were warehouses, and 8% were office buildings. Protective specializes in making mortgage loans on either credit-oriented or credit-anchored commercial properties, most of which are strip shopping centers in smaller towns and cities. No single tenant's leased space represents more than 7% of mortgage loans. Approximately 85% of the mortgage loans are on properties located in the following states listed in decreasing order of significance: Alabama, North Carolina, Tennessee, Georgia, South Carolina, Texas, Florida, Mississippi, Virginia, Colorado, California, Ohio, Wisconsin, Illinois, Indiana, and Michigan. Many of the mortgage loans have call provisions after five to seven years. Assuming the loans are called at their next call dates, approximately $50.2 million would become due in 1994, $480.1 million in 1995 to 1998, and $218.7 million in 1999 to 2003. At December 31, 1993, the average mortgage loan was $1.4 million, and the weighted average interest rate was 9.6%. The largest mortgage loan was $9.3 million. While Protective's $1,408.4 million of mortgage loans do not have quoted market values, at December 31, 1993, Protective estimates the market value of its mortgage loans to be $1,524.2 million using discounted cash flows from the next call date. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE C -- INVESTMENT OPERATIONS (CONTINUED) At December 31, 1993 and 1992, Protective's problem mortgage loans and foreclosed properties totaled $27.1 million and $16.4 million, respectively. Protective expects no significant loss of principal. Certain investments, principally real estate, with a carrying value of $9.9 million were nonincome producing for the twelve months ended December 31, 1993. Mortgage loans to Fletcher Bright and Kenneth Karl totaling $92.1 million and $48.5 million, respectively, exceeded 10% of stockholder's equity at December 31, 1993. The Company believes it is not practicable to determine the fair value of its policy loans since there is no stated maturity, and policy loans are often repaid by reductions to policy benefits. Policy loan interest rates generally range from 4.5% to 8.0% The fair values of Protective's other long-term investments approximate cost. NOTE D -- FEDERAL INCOME TAXES Protective's effective income tax rate varied from the maximum federal income tax rate as follows: In August 1993, the corporate income tax rate was increased from 34% to 35% which resulted in a one-time increase to income tax expense of $1.2 million due to a recalculation of Protective's deferred income tax liability. The effective income tax rate for 1993 of 33.4% excludes the one-time increase. The provision for federal income tax differs from amounts currently payable due to certain items reported for financial statement purposes in periods which differ from those in which they are reported for income tax purposes. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE D -- FEDERAL INCOME TAXES (CONTINUED) Details of the deferred income tax provision for the years ended December 31 are as follows: The components of Protective's net deferred income tax liability as of December 31, 1993 were as follows: Under pre-1984 life insurance company income tax laws, a portion of Protective's gain from operations which was not subject to current income taxation was accumulated for income tax purposes in a memorandum account designated as Policyholders' Surplus. The aggregate accumulation in this account at December 31, 1993 was approximately $50.7 million. Should the accumulation in the Policyholders' Surplus account exceed certain stated maximums, or should distributions including cash dividends be made to PLC in excess of approximately $184 million, such excess would be subject to federal income taxes at rates then effective. Deferred income taxes have not been provided on amounts designated as Policyholders' Surplus. Protective does not anticipate involuntarily paying income tax on amounts in the Policyholders' Surplus accounts. At December 31, 1993 Protective has no unused income tax loss carryforwards. Protective's income tax returns are included in the consolidated income tax returns of PLC. The allocation of income tax liabilities among affiliates is based upon separate income tax return calculations. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE E -- DEBT Short-term and long-term debt at December 31 are summarized as follows: At December 31, 1993, PLC had borrowed under a term note that contains, among other provisions, requirements for maintaining certain financial ratios, and restrictions on indebtedness incurred by PLC's subsidiaries including Protective. Additionally, PLC, on a consolidated basis, cannot incur debt in excess of 40% of its total capital. Included in indebtedness to related parties are three surplus debentures issued by Protective to PLC. At December 31, 1993, the balance of the three surplus debentures combined was $48.9 million. Interest expense totaled $5.0 million, $3.3 million, and $3.5 million in 1993, 1992, and 1991, respectively. NOTE F -- ACQUISITIONS In March 1992, regulatory approval was received to merge Employers National Life Insurance Company into Protective. Additionally, effective July 1, 1992, Protective assumed all of the policy obligations associated with the credit life and credit accident and health insurance business produced by Durham Life Insurance Company. In July 1993, Protective acquired Wisconsin National Life Insurance Company ("Wisconsin National"). In addition, Protective reinsured a block of universal life policies. These transactions have been accounted for as purchases, and the results of the transactions have been included in the accompanying financial statements since the effective dates of the agreements. Summarized below are the consolidated results of operations for 1993 and 1992, on an unaudited pro forma basis, as if the Wisconsin National acquisition had occurred as of January 1, 1992. The pro forma information is based on Protective's consolidated results of operations for 1993 and 1992 and on data provided by Wisconsin National, after giving effect to certain pro forma adjustments. The pro forma financial information does not purport to be indicative of results of operations that would have occurred had the transaction occurred on the basis assumed above nor are they indicative of results of the future operations of the combined enterprises. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE G -- COMMITMENTS AND CONTINGENT LIABILITIES At December 31, 1993, Protective was committed to fund mortgage loans and to purchase fixed maturity and other long-term investments in the amount of approximately $168.0 million. Also, Protective has issued a guarantee in connection with the sale of certain tax-exempt mortgage loans which may be put to Protective in the event of default. At December 31, 1993, the loans totaled $25.8 million. Under insurance guaranty fund laws, in most states, insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. Protective does not believe such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer's own financial strength. NOTE H -- STOCKHOLDER'S EQUITY AND RESTRICTIONS At December 31, 1993, approximately $295 million of consolidated stockholder's equity represented net assets of Protective that cannot be transferred in the form of dividends, loans, or advances to PLC. Generally, the net assets of Protective available for transfer to PLC are limited to the amounts that Protective's net assets, as determined in accordance with statutory accounting practices, exceed certain minimum amounts. However, payments of such amounts as dividends may be subject to approval by regulatory authorities. NOTE I -- REDEEMABLE PREFERRED STOCK PLC owns all of the 2,000 shares of redeemable preferred stock issued by Protective's subsidiary, American Foundation. The entire issue was reissued in 1991 and will be redeemed September 30, 1996 for $1 thousand per share, or $2 million. The stock pays, when and if declared, annual minimum cumulative dividends of $50 per share, and noncumulative participating dividends to the extent American Foundation's statutory earnings for the immediately preceding fiscal year exceed $1 million. Dividends of $1.5 million, $1.4 million, and $2.5 million were paid to PLC in 1993, 1992, and 1991, respectively. NOTE J -- RELATED PARTY MATTERS Receivables from related parties consisted of receivables from affiliates under control of PLC in the amounts of $382 thousand and $279 thousand at December 31, 1993 and 1992, respectively. Protective routinely receives from or pays to affiliates under the control of PLC reimbursements for expenses incurred on one another's behalf. Receivables and payables among affiliates are generally settled monthly. On August 6, 1990, PLC announced that its Board of Directors approved the formation of an Employee Stock Ownership Plan ("ESOP"). On December 1, 1990, Protective transferred to the ESOP 520,000 shares of PLC's common stock held by it in exchange for a note. The outstanding balance of the note, $6.0 million at December 31, 1993, is accounted for as a reduction to stockholder's equity. The stock will be used to match employee contributions to PLC's existing 401(k) Plan. The ESOP shares are dividend paying. Dividends on the shares are used to pay the ESOP's note to Protective. Protective leases furnished office space and computers to affiliates. Lease revenues were $2.8 million in 1993, $2.6 million in 1992, and $2.8 million in 1991. Protective purchases data processing, legal, investment PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE J -- RELATED PARTY MATTERS (CONTINUED) and management services from affiliates. The costs of such services were $20.4 million, $27.5 million, and $24.7 million in 1993, 1992, and 1991, respectively. Commissions paid to affiliated marketing organizations of $5.8 million, $4.8 million, and $2.8 million in 1993, 1992, and 1991, respectively, were included in deferred policy acquisition costs. Certain corporations with which PLC's directors were affiliated paid Protective premiums and policy fees for various types of group insurance. Such premiums and policy fees amounted to $10.3 million, $10.9 million, and $10.4 million in 1993, 1992, and 1991, respectively. For a discussion of indebtedness to related parties, see Note E. NOTE K -- BUSINESS SEGMENTS Protective operates predominantly in the life and accident and health insurance industry. The following table sets forth total revenues, income before income tax, and identifiable assets of Protective's business segments. The primary components of revenues are premiums and policy fees, net investment income, and realized investment gains and losses. Premiums and policy fees are attributed directly to each business segment. Net investment income is allocated based on directly related assets required for transacting that segment of business. Realized investment gains (losses) and expenses are allocated to the segments in a manner which most appropriately reflects the operations of that segment. Unallocated realized investment gains (losses) are deemed not to be associated with any specific segment. Assets are allocated based on policy liabilities and deferred policy acquisition costs directly attributable to each segment. There are no significant intersegment transactions. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE K -- BUSINESS SEGMENTS (CONTINUED) PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE K -- BUSINESS SEGMENTS (CONTINUED) NOTE L -- EMPLOYEE BENEFIT PLANS PLC has a defined benefit pension plan covering substantially all of its employees. The plan is not separable by affiliates participating in the plan. However, approximately 76% of the participants in the plan are employees of Protective. The benefits are based on years of service and the employee's highest thirty-six consecutive months of compensation. PLC's funding policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements of ERISA plus such additional amounts as PLC may determine to be appropriate from time to time. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE L -- EMPLOYEE BENEFIT PLANS (CONTINUED) The actuarial present value of benefit obligations and the funded status of the plan taken as a whole at December 31 is as follows: Net pension cost includes the following components for the years ended December 31: Protective's share of the net pension cost was $1,543 thousand, $816 thousand, and $315 thousand, in 1993, 1992, and 1991, respectively. Assumptions used to determine the benefit obligations as of December 31 were as follows: Assets of the pension plan are included in the general assets of Protective. Upon retirement, the amount of pension plan assets vested in the retiree is used to purchase a single premium annuity from Protective in the retiree's name. Therefore, amounts presented above as plan assets exclude assets relating to retirees. PLC also sponsors an unfunded Excess Benefits Plan, which is a nonqualified plan that provides defined pension benefits in excess of limits imposed by federal tax law. At December 31, 1993, the projected benefit obligation of this plan totaled $2.6 million. PROTECTIVE LIFE INSURANCE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (ALL DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS) NOTE L -- EMPLOYEE BENEFIT PLANS (CONTINUED) In addition to pension benefits, PLC provides limited health care benefits to eligible retired employees until age 65. PLC and Protective have adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." At January 1, 1992, PLC recognized a $1.6 million accumulated postretirement benefit obligation, of which $0.9 million relates to current retirees and $0.7 million relates to active employees. The $1.6 million (representing Protective's entire liability for such benefits), net of $0.5 million tax, was accounted for as a cumulative effect of a change in accounting principle and shown as a reduction to income. The postretirement benefit is provided by an unfunded plan. At December 31, 1993, the liability for such benefits totaled $1.6 million. The expense recorded by Protective was $0.2 million in 1993 and 1992. PLC's obligation is not materially affected by a 1% change in the health care cost trend assumptions used in the calculation of the obligation. Life insurance benefits for retirees are provided through the purchase of life insurance policies upon retirement equal to the employees' annual compensation. This plan is partially funded at a maximum of $50 thousand face amount of insurance. In 1990, PLC established an Employee Stock Ownership Plan to match employee contributions to PLC's existing 401(k) Plan. Previously, PLC matched employee contributions in cash. The expense recorded by PLC for this employee benefit was $249 thousand, $412 thousand and $451 thousand in 1993, 1992, and 1991, respectively. NOTE M -- REINSURANCE Protective assumes risks from and reinsures certain parts of its risks with other insurers under yearly renewable term, coinsurance, and modified coinsurance agreements. Yearly renewable term and coinsurance agreements are accounted for by passing a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate part of the premiums less commissions and is liable for a corresponding part of all benefit payments. Modified coinsurance is accounted for similarly to coinsurance except that the liability for future policy benefits is held by the original company, and settlements are made on a net basis between the companies. While the amount retained on an individual life will vary based upon age and mortality prospects of the risk, Protective will not carry more than $500 thousand individual life insurance on a single risk. Protective has reinsured approximately $7.5 billion, $7.0 billion, and $5.3 billion in face amount of life insurance risks with other insurers representing $37.9 million, $34.8 million, and $28.3 million of premium income for 1993, 1992, and 1991, respectively. Protective has also reinsured accident and health risks representing $88.9 million, $74.6 million, and $61.6 million of premium income for 1993, 1992, and 1991, respectively. In 1992, policy liabilities and accruals are shown net of policy and claim reserves relating to insurance ceded of $90.1 million. In 1993, policy and claim reserves relating to insurance ceded of $97.8 million are included in reinsurance receivables. Should any of the reinsurers be unable to meet its obligation at the time of the claim, obligation to pay such claim would remain with Protective. At December 31, 1993 and 1992, Protective had paid $4.8 million and $4.4 million, respectively, of ceded benefits which are recoverable from reinsurers. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Not required in accordance with General Instruction J(2)(c). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Not required in accordance with General Instruction J(2)(c). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Not required in accordance with General Instruction J(2)(c). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not required in accordance with General Instruction J(2)(c). PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements (Item 8) 2. Financial Statement Schedules (see index annexed) 3. Exhibits: The exhibits listed in the Exhibit Index on page 40 of this Form 10-K are filed herewith or are incorporated herein by reference. No management contract or compensatory plan or arrangement is required to be filed as an exhibit to this form. The Registrant will furnish a copy of any of the exhibits listed upon the payment of $5.00 per exhibit to cover the cost of the Registrant in furnishing the exhibit. (b) Reports on Form 8-K: None SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Birmingham, State of Alabama on March 25, 1994. PROTECTIVE LIFE INSURANCE COMPANY By: /s/ DRAYTON NABERS, JR. ----------------------------------- President Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated: All other schedules to the consolidated financial statements required by Article 7 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted. SCHEDULE I -- SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (DOLLARS IN THOUSANDS) SCHEDULE IV -- INDEBTEDNESS OF AND TO RELATED PARTIES PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (DOLLARS IN THOUSANDS) SCHEDULE V -- SUPPLEMENTARY INSURANCE INFORMATION PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (IN THOUSANDS) SCHEDULE VI -- REINSURANCE PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (DOLLARS IN THOUSANDS) SCHEDULE IX -- SHORT TERM BORROWINGS PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (DOLLARS IN THOUSANDS) EXHIBIT INDEX	8,115	55,240
38079_1993.txt	38079_1993	1993	38079	ITEM 1. BUSINESS THE COMPANY Forest Oil Corporation and its subsidiaries (Forest or the Company) are engaged in the acquisition and exploitation of, exploration for and development and production of oil and natural gas. The Company was incorporated in New York in 1924, the successor to a company formed in 1916, and has been a publicly held company since 1969. The Company is active in several of the major exploration and producing areas in and offshore the United States. Forest's principal reserves and producing properties are located in the Gulf of Mexico and in Texas, Oklahoma and Wyoming. The Company operates from production offices located in Lafayette, Louisiana and Denver, Colorado. Its corporate offices are located in Denver, Colorado. On December 31, 1993, Forest had 187 employees, of whom 129 were salaried and 58 were hourly. OPERATING STRATEGY In 1991, Forest adopted a new operating strategy which focuses primarily on acquiring domestic reserves that have significant exploitation potential, increasing production from existing fields through the application of the Company's technical and operating expertise and participating in exploration through farmout arrangements. The Company believes that it has competitive advantages with respect to acquiring and exploiting properties because of its technical and operating expertise, its seismic data base and its ability to operate both onshore and offshore. The Company seeks to acquire interests in properties in which it would have a significant working interest and which it can operate. Since 1991, the Company has implemented its operating strategy by acquiring estimated proved reserves of approximately 181 BCF of natural gas and 8 million barrels of oil and condensate at an average property acquisition cost of $1.08 per MCFE through December 31, 1993. (An MCF is one thousand cubic feet of natural gas. MMCF is used to designate one million cubic feet of natural gas and BCF refers to one billion cubic feet of natural gas. MCFE means thousands of cubic feet of natural gas equivalents, using a conversion ratio of one barrel of oil to 6 MCF of natural gas. With respect to oil, the term BBL means one barrel of oil whereas MBBLS is used to designate one thousand barrels of oil.) During 1993, the Company completed four major acquisitions. In two separate transactions completed in May 1993 and December 1993, the Company purchased interests in two onshore fields and seven offshore blocks from Atlantic Richfield Company (ARCO) for approximately $60,862,000. Total estimated proved reserves acquired in the ARCO acquisitions were 40.1 BCF of natural gas and 1.3 million barrels of oil. The ARCO acquisitions were financed in part by volumetric production payments. In December 1993, the Company purchased interests in two producing offshore fields in the West Cameron and Eugene Island areas (the West Cameron/Eugene Island acquisition) and three exploratory blocks from a private company for approximately $24,050,000. Total estimated proved reserves acquired as a result of the West Cameron/Eugene Island acquisition were 16.3 BCF of natural gas and 269,000 barrels of oil. Also in December 1993, the Company purchased interests in the Loma Vieja Field in south Texas from another private company for approximately $59,458,000. Total estimated proved reserves acquired as a result of the Loma Vieja acquisition were 33.9 BCF of natural gas. In addition, the Loma Vieja acquisition included 8 prospects with exploitation or exploration potential, covering 2,332 net acres. The West Cameron/Eugene Island and the Loma Vieja acquisitions were financed with proceeds of a nonrecourse secured loan, internally generated funds, and funds obtained under a bank credit facility. In other property acquisitions in 1993 Forest acquired estimated proved reserves totaling 4.4 BCF of natural gas and 102,000 barrels of oil for an aggregate purchase price of $4,700,000. The Company's operating strategy also includes exploitation activities in the areas of reservoir management and development drilling. Reservoir management involves the effort to enhance value by a combination of reduced costs and the use of such techniques as workovers to increase hydrocarbon recovery. The Company engages in development drilling for additional reserves that offset existing production with the objective of either increasing the density in which wells are drilled or extending reservoirs. The Company believes that it can increase production from, and otherwise enhance the value of, existing fields by utilizing its technical expertise to undertake selective workovers, recompletions and development drilling. In total, the Company undertook 39 workover and development projects in 1993 with the following results: Such results are not necessarily indicative of future results of the Company's workover and development projects. The Company participates in exploration activities primarily through farmout arrangements. The Company's farmouts enable Forest to participate in its exploration prospects without incurring additional exploration costs, although with a reduced ownership in each prospect. During 1993, the Company entered into farmout agreements covering 27 prospects, pursuant to which 14 wells were drilled resulting in 9 commercially productive properties. For further information concerning the Company's farmout activity, see Item 2. ITEM 2. PROPERTIES Forest's principal properties are oil and gas properties located in the Gulf of Mexico and in Texas, Oklahoma, and Wyoming. RESERVES Information regarding the Company's proved and proved developed oil and gas reserves and the standardized measure of discounted future net cash flows and changes therein is included in Note 19 of Notes to Consolidated Financial Statements. Since January 1, 1993, Forest has not filed any oil or natural gas reserve estimates or included any such estimates in reports to any Federal or foreign governmental authority or agency, other than the Securities and Exchange Commission (SEC), the MMS and the Department of Energy (DOE). The reserve estimate report filed with the MMS related to Forest's Gulf of Mexico reserves and there were no differences between the reserve estimates included in the MMS report, the SEC report, the DOE report and those included herein, except for production and additions and deletions due to the difference in the "as of" date of such reserve estimates. PRODUCTION The following table shows net oil and natural gas production for Forest and its wholly-owned subsidiaries for the three years ended December 31, 1993: Net production reported by CanEagle for its fiscal year ended September 30, 1993 was 2.1 BCF of natural gas and 281,000 barrels of oil. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. AVERAGE SALES PRICES AND PRODUCTION COSTS PER UNIT OF PRODUCTION The following table sets forth the average sales prices per MCF of natural gas and per barrel of oil and condensate and the average production cost per equivalent unit of production for the three years ended December 31, 1993 for Forest and its wholly-owned subsidiaries: Average sales prices received by CanEagle for its fiscal year ended September 30, 1993 were $1.77 CDN per MCF of natural gas and $20.77 CDN per barrel of oil. CanEagle's natural gas production was sold under long-term contracts and its oil production was sold on the spot market. The average production cost per MCFE reported by CanEagle was $.49 CDN per MCFE. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. PRODUCTIVE WELLS The following summarizes total gross and net productive wells of the Company and its wholly-owned subsidiaries at December 31, 1993, all of which are in the United States: At September 30, 1993, CanEagle had 33 net productive oil wells and 32 net productive gas wells. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. DEVELOPED AND UNDEVELOPED ACREAGE Forest and its wholly-owned subsidiaries held acreage as set forth below at December 31, 1993 and 1992. A majority of the developed acreage is subject to a mortgage lien securing either the Company's bank indebtedness or its nonrecourse secured debt. A portion of the developed acreage is also subject to production payments. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 4, 5 and 7 of Notes to Consolidated Financial Statements. During 1993, the Company's gross and net developed acreage increased approximately 12% and 92%, respectively, primarily as a result of property acquisitions. The Company's gross and net undeveloped acreage decreased 35% and 27%, respectively, because the acquisitions made during the year were more than offset by reductions in acreage as a result of reclassifications to developed acreage, lease expirations and the Company's decision not to renew certain leases which were located primarily offshore Louisiana and in Texas. Approximately 13% of the Company's total net undeveloped acreage is under leases that have terms expiring in 1994, if not held by production, and another approximately 44% of net undeveloped acreage will expire in 1995 if not also held by production. At September 30, 1993, CanEagle held 31,705 gross developed acres, 8,179 net developed acres, 95,847 gross undeveloped acres and 33,478 net undeveloped acres. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. DRILLING ACTIVITY Forest and its wholly-owned subsidiaries owned interests in net exploratory and net development wells for the three years ended December 31, 1993 as set forth below. This information does not include wells drilled under farmout agreements as discussed below. During its fiscal year ended September 30, 1993, CanEagle drilled 2.1 productive net development wells in Canada. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. FARMOUT AGREEMENTS Forest entered into farmout agreements with respect to 27 exploration prospects during 1993. Under these agreements, outside parties undertake exploration activities using prospects owned by Forest. This enables the Company to participate in the exploration prospects without incurring additional capital costs, although with a substantially reduced ownership interest in each prospect. Eleven of the farmouts cover onshore prospects and 16 cover prospects located in the Gulf of Mexico. Fourteen of the 27 farmout prospects were drilled during 1993, resulting in nine productive properties. Forest retained overriding royalty interests ranging from 2.083% to 12.5% before payout, increasing to interests ranging from a 10% overriding royalty interest to a 40% net working interest after payout. One additional well was drilled and commenced production in 1994; the Company anticipates that the 12 remaining undrilled farmouts will be drilled during 1994. During 1993, the Company entered into an exploration agreement under which a third party agreed to drill a minimum of six additional exploratory wells offshore. The Company retained overriding royalty interests in these prospects of between 8.33% and 12.5% with the option to convert to working interests ranging from 25% to 33 1/3% after payout of the first well on each prospect. Four of these six wells were drilled by the end of 1993, resulting in one productive well. The remaining two wells are scheduled to be drilled in the first half of 1994. The Company intends to continue to seek farmouts of exploration prospects when they can be arranged on terms that are believed to be favorable. During its fiscal year ended September 30, 1993, CanEagle concluded two farmout agreements under which two successful gas wells were drilled and completed. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. PRESENT ACTIVITIES At December 31, 1993, Forest and its wholly owned subsidiaries had three development wells that were in the process of being drilled. All three wells were determined to be productive in January 1994 and are currently being tested. There was one well being drilled under a farmout agreement at year- end, which was subsequently completed as a producing well. At September 30, 1993 CanEagle had one development well that was in the process of being drilled. This well was determined to be a gas well and commenced production in November 1993. The Company's investment in and advances to CanEagle are discussed in Note 3 of Notes to Consolidated Financial Statements. DELIVERY COMMITMENTS At December 31, 1993 Forest and its wholly-owned subsidiaries were obligated to deliver approximately 36.3 BCF of natural gas and 479,000 barrels of oil under the terms of volumetric production payments. The delivery commitments cover approximately 35% and 12% of the estimated net proved reserves of natural gas and oil, respectively, attributable to the subject properties. The production payments are nonrecourse to other properties owned by the Company. The Company is further obligated to deliver approximately .8 BCF of natural gas under existing long-term contracts. For further information concerning the Company's production payment agreements, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 7 of Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has two natural gas sales contracts with Columbia Gas Transmission Corp. (Transmission), a subsidiary of Columbia Gas System (CGS). On July 31, 1991, CGS and Transmission filed Chapter 11 bankruptcy petitions with the United States Bankruptcy Court for the District of Delaware. Both contracts have been rejected pursuant to the bankruptcy proceedings. The Company has filed a proof of claim in the bankruptcy proceeding consisting of a secured claim of $1,600,000 based on Louisiana vendor lien laws and an unsecured claim relating to the rejection of the contracts. The secured claim arises from Transmission's failure to pay the contract price for a period of time prior to rejection of the contracts. The unsecured claim was calculated on an undiscounted basis and without any assumption of mitigation of damages through spot market sales. No prediction can be given as to when or how these matters will ultimately be concluded. The Company, in the ordinary course of business, is a party to various other legal actions. In the opinion of management, none of these actions, including those discussed above, will have a material adverse effect, either individually or in the aggregate, on the financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable ITEM 4A. EXECUTIVE OFFICERS OF FOREST The following information with respect to the executive officers of Forest is furnished pursuant to Instruction 3 to Item 401(b) of Regulation S-K. YEARS WITH NAME (A) AGE FOREST OFFICE (B) -------- --- ---------- ---------- William L. Dorn* 45 22 Chairman of the Board and Chairman of the Executive Committee since July 1991. Member of the Executive Committee since August 1988. President from February 1990 until November 1993 and Chief Executive Officer since February 1990. Executive Vice President from August 1989 until February 1990, and prior thereto Vice President. Member of the Royalty Bonus Committee since August 1991. Robert S. Boswell* 44 5 President since November 1993. Vice President from May 1991 until November 1993 and Chief Financial Officer since May 1991. Financial Vice President from September 1989 until May 1991. Member of the Executive Committee since July 1991, member of the Royalty Bonus Committee since August 1991. Chief Financial Officer of Bovaird Supply Company, Inc., from January 1988 until September 1989. Bulent A. Berilgen 45 9 Vice President of Operations since December 1993. Prior thereto Vice President - Engineering and Development since January 1992. Prior thereto Regional Reservoir Engineer. Kenton M. Scroggs 41 11 Vice President since December 1993 and Treasurer since May 1988. Prior thereto Assistant Treasurer. Member of the Administrative Committee of the Company's Retirement Savings Plan and Chairman of the Board of Trustees of the Company's Pension Trust. YEARS WITH NAME (A) AGE FOREST OFFICE (B) -------- --- ---------- ---------- Forest D. Dorn 39 16 Vice President since February 1991 and General Business Manager since December 1993. Prior thereto General Manager - Operations since January 1992. Prior thereto Assistant Division Manager of the Southern Division. Member of the Contributions Committee. David H. Keyte 37 6 Vice President and Chief Accounting Officer since December 1993. Prior thereto Corporate Controller since January 1989. Prior thereto Manager of Tax. Chairman of the Administrative Committee of the Company's Retirement Savings Plan and member of the Board of Trustees of the Company's Pension Trust. Daniel L. McNamara 48 22 Secretary and Corporate Counsel since January 1991. Prior thereto Assistant Secretary and Associate Corporate Counsel. Joan C. Sonnen 40 4 Controller since December 1993. Prior thereto Director of Financial Accounting and Reporting since April 1991 and Manager of Financial Systems and Reporting since July 1989. Prior thereto a principal with Arthur Young & Company. - ------------- Also a Director (A) William L. Dorn and Forest D. Dorn are brothers, and they are nephews of John C. Dorn, a director of the Company. (B) The term of office of each officer is one year from the date of his or her election immediately following the last annual meeting of shareholders and until the officer's respective successor has been elected and qualified or until his or her earlier death, resignation or removal from office whichever occurs first. Each of the named persons has held the office indicated since the last annual meeting of shareholders, except as otherwise indicated. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Forest Oil Corporation has one class of common equity securities outstanding. The Common Stock, par value $.10 per share, has one vote per share. During 1993, each share of the Class B Stock, par value $.10 per share, which had 10 votes per share, was reclassified into 1.1 shares of Common Stock pursuant to a vote of the shareholders. In the event of dissolution, liquidation or insolvency, holders of Common Stock share ratably in the net assets of Forest, subject to the liquidation rights of the holders of the $.75 Convertible Preferred Stock. As of March 1, 1994, 27,942,755 shares of Common Stock were held by 2,109 recordholders and 1,244,715 Warrants were held by 88 recordholders. The Company also has outstanding Warrants to purchase shares of its Common Stock. Each Warrant entitles the holder to purchase one share of Common Stock at a price of $3.00, is non-callable and expires on October 1, 1996. Subject to the prior right of the holders of Forest's $.75 Convertible Preferred Stock, the only restrictions on its present or future ability to pay dividends are (i) the provisions of the New York Business Corporation Law (NYBCL), (ii) certain restrictive provisions in the Indenture executed in connection with Forest's 11 1/4% Senior Subordinated Notes due September 1, 2003 pursuant to which the Company is currently prohibited from paying any cash dividends other than on its $.75 Convertible Preferred Stock, and (iii) the Company's Credit Agreement dated December 1, 1993 with The Chase Manhattan Bank (National Association), as agent, under which the Company is restricted in amounts it may pay as dividends (other than dividends payable in common stock). Under the dividend restriction in the Credit Agreement, the Company currently has the ability to pay dividends in the approximate amount of $1,920,000, assuming the cash dividend on the $.75 Preferred Stock declared by the Company in February 1994 is paid in May 1994. There is no assurance that Forest will pay any dividends. For further information on Forest's ability to pay cash dividends on its Common Stock and $.75 Convertible Preferred Stock, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 4, 6, 9 and 10 of Notes to Consolidated Financial Statements. The Company has one class of preferred stock outstanding. Annual dividends on the $.75 Convertible Preferred Stock are cumulative and are payable quarterly each February 1, May 1, August 1 and November 1, when and as declared. Dividends may be paid in cash or, at the Company's election, in shares of Common Stock or in a combination of cash and Common Stock. Whenever dividends on the $.75 Convertible Preferred Stock have not been paid, the amount of the deficiency, plus an amount equal to the accumulated dividend for the then current quarterly dividend period, must be fully paid, or declared and set apart for payment, before any dividend may be declared and paid or set apart for payment upon the Common Stock, except for dividends paid in shares of Common Stock. Whenever $.75 Convertible Preferred Stock dividends are in arrears in an amount equivalent to six full quarterly dividends, the holders of the $.75 Convertible Preferred Stock, voting separately as a class and with one vote per share, will have the right to elect two directors. If two consecutive dividend payments are in arrears, the holder of each share of $.75 Convertible Preferred Stock will be entitled to a penalty conversion right enabling such holder to convert each such share, plus accumulated dividends, into a share of Common Stock during a two-day period 30 days after the second dividend payment date at a conversion price of 75% of the average of the last reported sales prices of the Common Stock during the period from such second dividend payment date to five trading days prior to the conversion date. The holder of each share of $.75 Convertible Preferred Stock has the right to convert each such share into 3.5 shares of Common Stock at any time. The conversion rate is subject to adjustment in certain events. The $.75 Convertible Preferred Stock may be redeemed at the option of the Company, in whole or in part, upon notice duly given, at any time after the earlier of (i) July 1, 1996, and (ii) the date on which the last reported sales price of the Common Stock will have been $7.50 or higher for at least 20 of the prior 30 trading days, at the redemption prices set forth below, in each case with an amount equal to dividends (whether or not declared) accrued to the date fixed for redemption and remaining unpaid: As of March 1, 1994, 2,880,973 shares of $.75 Convertible Preferred Stock were held by 86 recordholders. Forest's Common Stock is traded on the National Market System of the National Association of Securities Dealers, Inc., Automated Quotation System (NASDAQ/NMS). The High and Low sales prices of the Common Stock for each quarterly period of the years presented as reported by the NASDAQ/NMS are listed in the chart below. The Class B Stock was not traded in any public trading market. There were no dividends on Common Stock or Class B Stock in 1992, 1993 or in the first quarter of 1994. On March 15, 1994, the last reported sales price of the Common Stock as quoted on the NASDAQ/NMS was $3-11/16 per share. The Warrants are traded on the NASDAQ/NMS. The High and Low sales prices of the Warrants for each quarterly period of the years presented as reported by the NASDAQ/NMS are listed in the chart below. On March 15, 1994, the last reported sales price of the Warrants as quoted on the NASDAQ/NMS was $1-7/8 per Warrant. The $.75 Convertible Preferred Stock is traded on the NASDAQ/NMS. The High and Low sales prices of the $.75 Convertible Preferred Stock for each quarterly period of the years presented as reported by the NASDAQ/NMS are listed in the chart below. On March 15, 1994, the last reported sales price of the $.75 Convertible Preferred Stock as quoted on the NASDAQ/NMS was $14-1/4 per share. In October 1993, the Board of Directors adopted a shareholders' rights plan. The Company issued a dividend of a preferred stock purchase right (the "Rights") on each outstanding share of Common Stock of the Company, which, after the Rights become exercisable, entitle the holder to purchase 1/100th of a share of a newly issued series of the Company's preferred stock at a purchase price of $30 per 1/100th of a preferred share, subject to adjustment. The Rights expire on October 29, 2003 unless extended or redeemed earlier. The Rights will become exercisable (unless previously redeemed or the expiration date of the Rights has occurred) following a public announcement that a person or group (an "Acquiring Person") has acquired 20% or more of the Common Stock or has commenced (or announced an intention to make) a tender offer or exchange offer for 20% or more of the Common Stock. In certain circumstances each holder of Rights (other than an Acquiring Person) will have the right to receive, upon exercise, (i) shares of Common Stock of the Company having a value significantly in excess of the exercise price of the Rights, or (ii) shares of Common Stock of an acquiring company having a value significantly in excess of the exercise price of the Rights. ITEM 6. ITEM 6. SELECTED FINANCIAL AND OPERATING DATA The following table sets forth selected data regarding the Company as of and for each of the years in the five-year period ended December 31, 1993. This data should be read in conjunction with Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto. RESULTS OF OPERATIONS NET EARNINGS (LOSS). The Company's net loss was $21,213,000 in 1993 compared to net earnings of $7,298,000 in 1992 and a net loss of $25,348,000 in 1991. There would have been a net loss of $16,745,000 in 1992 excluding the effects of the settlement of gas contract litigation with ONEOK Inc. (the ONEOK settlement). Total revenue less operating expenses (consisting of oil and gas production expense and expensed general and administrative costs) increased in 1993 compared to the 1992 results (excluding the effects of the ONEOK settlement) as a result of the acquisition of properties; however, this increase was more than offset by higher depreciation and depletion expense, an extraordinary loss of $10,735,000 (net of tax benefit of $4,652,000) recorded as a result of the redemption or purchase of all of the Company's 12 3/4% Senior Secured Notes and long-term subordinated debt and a charge of $1,123,000 to reflect the effects of cumulative changes in accounting principles related to postretirement benefits and income taxes. The 1992 results improved significantly compared to 1991 due to approximately $24,043,000 of net earnings associated with the ONEOK settlement in December 1992 and because there was no writedown of the carrying value of the Company's oil and gas properties required in 1992 by SEC regulations. The 1991 loss included a writedown of the Company's oil and gas properties of $22,400,000 on an after-tax basis, offset by an extraordinary gain of $9,502,000 (net of income taxes of $4,895,000) on extinguishment of debt. The ONEOK settlement in 1992 had a significant impact on the Company's reported revenue, expense and net earnings. A summary of the Company's income and expenses for 1992, before and after the amounts recorded as a result of the ONEOK settlement, is as follows: The inclusion of the effects of the ONEOK settlement in a discussion of the Company's results of operations distorts the trends which would otherwise be reported. In the discussion which follows, results for 1992 exclude the effects of the ONEOK settlement in order to more meaningfully compare and discuss the Company's results of operations for 1993, 1992 and 1991. REVENUE. Total revenue increased 39% to $105,148,000 in 1993 from $75,645,000 in 1992, primarily due to increased production from newly-acquired properties. Total revenue increased by 8% to $75,645,000 in 1992 from $69,897,000 in 1991. The increase is due primarily to increased production volumes, despite a decrease in average sales prices for both oil and natural gas. Oil and gas sales increased to $102,883,000 from $76,847,000, or by approximately 34% in 1993 from 1992, primarily due to increased production from newly-acquired properties and an 11% increase in the average sales price for natural gas. In 1993, oil production volumes were up 3% and natural gas production volumes were up 41% compared to 1992. The increase in revenue attributable to the increased production was partially offset by a 6% decrease in the average sales price for oil. Oil and gas sales increased to $76,847,000 from $68,876,000 or by approximately 12% in 1992 from 1991. The increase primarily resulted from increased production volumes, despite a decrease in average sales prices for both oil and natural gas. In 1992, oil production volumes were up 71% and natural gas production volumes were up 22% compared to 1991. The increased volumes were primarily the result of property acquisitions in 1992. The increase in revenue attributable to the increased production was partially offset by a 28% decrease in the average sales price for oil and an 8% decrease in the average sales price for natural gas. The production volumes and average sales prices for the three years ended December 31, 1993 for Forest and its wholly-owned subsidiaries were as follows: Natural gas sold pursuant to volumetric production payment agreements and other long-term fixed price contracts represented approximately 46% of production in 1993 versus 33% in 1992 and 28% in 1991. In recent years, the industry trend has been for more natural gas to be sold on the spot market as long-term contracts expire. The increase experienced by Forest in natural gas sold under long-term fixed price contracts in 1993, 1992 and 1991 was the result of the Company entering into volumetric production payment agreements. Miscellaneous net revenue of $2,265,000 in 1993 included $1,380,000 of interest income on short-term investments and an adjustment to reduce accrued severance taxes based on discussions with the applicable state taxing authorities. The net expense of $1,202,000 in 1992 was primarily attributable to a $926,000 provision for future rent payments on vacated office space. The 1991 amount of $1,021,000 included interest income of $1,314,000 on cash balances invested in short-term investments and $2,032,000 of revenue associated with a favorable ruling by a Texas court with respect to severance tax on take-or-pay settlements, offset by $1,550,000 provided for uncollectible receivables and $850,000 of refund claims which were abandoned. OIL AND GAS PRODUCTION EXPENSE. Oil and gas production expense increased 37% to $19,540,000 in 1993 compared to $14,276,000 in 1992 due primarily to increased production from newly acquired properties and increased workover expense. Oil and gas production expense increased 14% to $14,276,000 in 1992 compared to $12,548,000 in 1991 due to increased production. In 1993, production expense was approximately $.39 on an MCFE basis, compared to $.38 in 1992 and $.43 in 1991. The decrease in 1992 compared to 1991 was the result of cost-savings measures coupled with economies of scale achieved when certain fixed operating costs were spread over a larger asset base. GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense for 1993 was $12,003,000 compared to $12,088,000 in 1992. Increases attributable to severance and employee relocation costs and the effects of the postretirement medical benefit accrual in 1993 were more than offset by lower office and storage rentals and lower professional services expense. General and administrative expense for 1992 increased 27% to $12,088,000 from $9,541,000 in 1991, reflecting a decrease in the capitalization rate applied to total overhead costs. The decrease in the capitalization rate was the result of a decrease in the percentage of employees' time spent working directly on exploration and development projects. The capitalization rate remained relatively constant from 1992 to 1993. The Company has devoted significant effort to reducing total overhead costs. Total overhead costs, including amounts related to exploration and development activities, were $19,561,000 in 1993, $19,237,000 in 1992 and $23,292,000 in 1991. The increase in 1993 from 1992 was only 2% despite charges amounting to $2,300,000 for severance and employee relocation costs and $480,000 for postretirement medical benefits; without these charges, total overhead costs would have decreased by approximately 13% in 1993 compared to 1992. Severance and employee relocation costs of approximately $2,300,000 in 1993 resulted from the termination of 10 executives and middle level managers and a loss incurred on an employee's former residence in accordance with the Company's relocation policy. The decrease in total overhead costs in 1992 from 1991 was primarily due to reductions in workforce which occurred during 1991. The following table summarizes the total overhead costs incurred during the periods, including retirement benefits for executives and directors: RETIREMENT BENEFITS FOR EXECUTIVES AND DIRECTORS. In December 1990, the Company entered into retirement agreements with seven executives and directors ("Retirees") pursuant to which the Retirees will receive supplemental retirement payments totalling approximately $1,127,700 per year through 1996, $1,087,400 in 1997, $938,400 in 1998 and approximately $740,400 per year in 1999 and 2000. The liability to the Retirees was recorded in 1990. Additional expense of $950,000 was recorded in 1991 to reflect the accrual of amounts due to certain Retirees upon resignation as directors of the Company. RESTRUCTURING. Restructuring expense in 1991 includes the costs of the Company's implementation of a reorganization and consolidation plan. Costs recorded in 1991 of approximately $3,585,000 related to reductions in workforce and a consolidation of the Company's technical staff, reduced by a credit recognized upon curtailment of the Company's defined benefit pension plan. INTEREST EXPENSE. Interest expense of $23,729,000 in 1993 decreased $4,071,000 or 15% compared to 1992, primarily due to redemptions or purchases of certain of the Company's subordinated debentures and 12 3/4% Senior Secured Notes in 1993, partially offset by the interest expense incurred in connection with the Company's new 11 1/4% Senior Subordinated Notes. Interest expense of $27,800,000 in 1992 increased $4,494,000 or 19% compared to 1991 due to increased indebtedness in the form of a dollar-denominated production payment related to the acquisition of properties. DEPRECIATION AND DEPLETION EXPENSE. Depreciation and depletion expense increased 30% to $60,581,000 in 1993 from $46,624,000 in 1992 due to increased production in the 1993 period as a result of property acquisitions and workovers. Depreciation and depletion expense increased 22% to $46,624,000 in 1992 from $38,229,000 in 1991 due to increased production volumes despite a slightly lower rate per MCFE. The depletion rate was $1.19 per MCFE for U.S. production in 1993 compared to corresponding rates of $1.21 for U.S. production and $1.19 for Canadian production in 1992 and $1.28 for U.S. production and $1.37 for Canadian production in 1991. IMPAIRMENT OF OIL AND GAS PROPERTIES. The Company recorded a writedown of its oil and gas properties of $34,000,000 in 1991 due to the poor results of the Company's 1990 exploration program and depressed natural gas prices. Additional writedowns of the full cost pools may be required if prices decrease, estimated proved reserve volumes are revised downward or costs incurred in exploration, development or acquisition activities exceed the discounted future net cash flows from additional reserves, if any. The average spot market price received by the Company for Gulf Coast natural gas production was approximately $2.48 per MCF at December 31, 1993. The West Texas Intermediate price for crude oil received by the Company was $12.00 per barrel at December 31, 1993. The average Gulf Coast spot price received by the Company for natural gas declined from $2.48 per MCF at December 31, 1993 to $2.46 per MCF at March 1, 1994. The West Texas Intermediate price for crude oil increased from $12.00 per barrel at December 31, 1993 to $13.00 per barrel at March 1, 1994. INVESTMENT IN AND ADVANCES TO AFFILIATE. In May 1992, the Company transferred substantially all of its Canadian oil and gas properties to a wholly-owned Canadian subsidiary, Forest Canada I Development Ltd. (FCID). On September 30, 1992 FCID sold its Canadian assets and related operations to CanEagle for approximately $51,250,000 in Canadian funds ($41,000,000 U.S.). An independent third party financed the purchase by CanEagle. In the transaction, FCID received cash of approximately $28,000,000 CDN ($22,400,000 U.S.), net of expenses, and provided financing to the third party in the aggregate principal amount of $22,000,000 CDN ($17,600,000 U.S.). CanEagle's capital was restructured in 1993. At December 31, 1993, the Company's ownership interest in CanEagle consisted of 15,400,000 shares of Class A Preferred Shares and 1,400,000 shares of Class B Preferred Shares of CanEagle and a $6,000,000 CDN subordinated debenture. Substantial uncertainty exists regarding whether CanEagle is a going concern due to a required principal payment of $16,300,000 on its Senior Debenture due June 30, 1994. CanEagle is in the process of refinancing the Senior Debenture with its lender, but there is no assurance that such refinancing can be completed on mutually acceptable terms prior to the due date. No gain was recognized as a result of the CanEagle transaction because collection of the remaining sales price was not reasonably assured. Due to its continuing financial interest in CanEagle, the Company is accounting for its investment in CanEagle under the equity method. Accordingly, losses will be recognized to the extent that such losses exceed (a) amounts attributable to securities subordinate to the Company's interest, and (b) a basis difference of $780,000 CDN attributable to the 1993 capital restructuring of CanEagle. Under this method, no portion of the CanEagle loss was required to be recorded by the Company in 1993. Earnings related to the Company's interest in CanEagle will be recognized only if realization is assured. Accordingly, amounts received as interest on the subordinated note during 1993 (approximately $540,000 CDN) were recorded as a reduction of the Company's investment in and advances to CanEagle. There were no dividends received in 1993. The excess of the carrying value of properties sold over the cash received, or approximately $16,451,000 U.S. at December 31, 1993, represents Forest's investment in CanEagle. CHANGES IN ACCOUNTING Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," (SFAS No. 106) required the Company to accrue expected costs of providing postretirement benefits to employees and the employees' beneficiaries and covered dependents. The Company adopted the provisions of SFAS No. 106 in the first quarter of 1993. The accumulated postretirement benefit obligation as of January 1, 1993 was approximately $4,822,000. This amount, reduced by applicable income tax benefits, was charged to operations in the first quarter of 1993 as the cumulative effect of a change in accounting principle. The annual net postretirement benefit cost (included in total overhead costs) was approximately $480,000 for 1993. Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (SFAS No. 109), required the Company to adopt the liability method of accounting for income taxes. The Company adopted such method on a prospective basis as of January 1, 1993 and, as such, prior periods have not been restated. The cumulative effect of adopting SFAS No. 109 as of January 1, 1993 resulted in a reduction of the net amount of deferred income taxes recorded as of December 31, 1992 of approximately $2,060,000. This amount was credited to operations in the first quarter of 1993 as the cumulative effect of a change in accounting principle. CAPITAL RESOURCES AND LIQUIDITY CASH FLOW. Historically, one of the Company's primary sources of capital has been net cash provided by operating activities, which has varied dramatically in the last three years. The majority of the increases and decreases in net cash provided by operating activities is attributable to increases and decreases in oil and gas revenue. While expenses associated with operations have been relatively stable, revenue from operations has varied dramatically each year depending upon factors such as natural gas contract settlements and price fluctuations, which are difficult to predict. The following summary table reflects comparative cash flows for the Company for the periods ended December 31, 1993, 1992 and 1991: SHORT-TERM LIQUIDITY AND WORKING CAPITAL DEFICIT. In December 1993, the Company entered into a secured master credit facility (the Credit Facility) with The Chase Manhattan Bank, NA. (Chase) as agent for a group of banks. Under the Credit Facility, the Company may borrow up to $17,500,000 for acquisition or development of proved oil and gas reserves, which amount is subject to semi- annual redetermination, and up to $17,500,000 for working capital and general corporate purposes. The Credit Facility is secured by a lien on, and a security interest in, a majority of the Company's proved oil and gas properties and related assets (subject to prior security interests granted to holders of volumetric production payment agreements), a pledge of accounts receivable, material contracts and the stock of material subsidiaries, and a negative pledge on remaining assets. Borrowings under the Credit Facility bear interest at the Chase base rate plus 3/8 of 1% or 1,2,3 or 6 month LIBOR plus 1 and 5/8%, payable quarterly. A commitment fee of 1/2 of 1% is charged on unused availability. The maturity date of the Credit Facility is December 31, 1996. Under the terms of the Credit Facility, the Company is subject to certain covenants, including restrictions or requirements with respect to working capital, net cash flow, additional debt, asset sales, mergers, cash dividends on capital stock and reporting responsibilities. At December 31, 1993 the outstanding balance under this facility was $25,000,000. Due to the significant capital requirements of acquisition and development activities undertaken in December 1993, the Company reported a working capital deficit of $14,496,000 at December 31, 1993. The Company did not meet the test imposed by the working capital covenant of the Credit Facility; compliance with this covenant was waived by Chase at December 31, 1993. The deficit was funded in the first quarter of 1994 primarily by additional borrowings of $9,000,000 under the Credit Facility, net proceeds of $2,600,000 from the sale of non- strategic oil and gas properties, and a short-term loan from The Chase Manhattan Bank, N.A. of $4,000,000 secured by a pledge of the Company's CanEagle securities. These cash inflows, in addition to cash provided by operating activities, enabled the Company to meet its obligations with respect to principal and interest payments and other short-term obligations. The Company currently has no additional borrowing capacity under the Credit Facility. The Company continues to explore additional sources of short-term liquidity to fund its working capital deficits, including an increase in the Credit Facility, sale of additional non-strategic properties and excess equipment, monetization of its investment in and advances to CanEagle and other measures. Expected increases in operating cash flows from recent property acquisitions are also expected to improve the Company's short-term liquidity, although there can be no assurance that this will be the case due to uncertainties in the markets for oil and natural gas and the unpredictability inherent in oil and gas operations. LONG-TERM LIQUIDITY. Since 1991, the Company has taken several significant steps to improve its long-term liquidity. In 1991, the Company consummated its recapitalization pursuant to which the Company's outstanding debt and preferred stock were restructured in order to reduce its fixed financial costs. The Company also undertook certain actions in 1991 to implement its operating strategy, to control and reduce its operating costs, and to improve its operating efficiency. The Company continues to devote significant efforts in these areas. On December 24, 1992, the Company received gross proceeds of $51,250,000 as a result of the ONEOK settlement. The net proceeds, after payment of related royalties and production taxes, were approximately $36,429,000. Pursuant to the terms of its 12 3/4% Senior Secured Notes, the Company was required to make an offer to purchase $16,000,000 principal amount of the 12 3/4% Senior Secured Notes at a purchase price of 100% of their principal amount plus accrued interest to the date of purchase. Pursuant to such offer, the Company purchased approximately $3,926,000 principal amount of 12 3/4% Senior Secured Notes in February, 1993. The remainder of the net proceeds were used for general corporate purposes, including working capital, debt reduction and the acquisition of oil and gas properties. On June 15, 1993, the Company issued 11,080,000 shares of Common Stock for $5.00 per share in a public offering. The net proceeds from the issuance of the shares totalled approximately $51,506,000 after issuance costs and underwriting fees, of which the Company used approximately $30,300,000 to purchase or redeem 12 3/4% Senior Secured Notes. The remainder of the net proceeds was used for general corporate purposes, including working capital, debt reduction and the acquisition of oil and gas properties. On September 8, 1993, the Company completed a public offering of $100,000,000 aggregate principal amount of 11-1/4% Senior Subordinated Notes due September 1, 2003. The 11 1/4% Senior Subordinated Notes were issued at a price of 99.259% yielding 11.375% to the holders. On October 13, 1993 the Company used the net proceeds from the sale of the 11 1/4% Senior Subordinated Notes of approximately $95,827,000, together with approximately $19,400,000 of available cash, to redeem all of its outstanding 12 3/4% Senior Secured Notes and long-term subordinated debentures. On November 9, 1993, the Company purchased $308,000 principal amount of its 5 1/2% Convertible Subordinated Debentures. The remaining $7,171,000 principal amount of the 5 1/2% Debentures was redeemed February 1, 1994. On December 30, 1993, the Company entered into a nonrecourse secured loan agreement (the Enron loan) arranged by Enron Finance Corp., an affiliate of Enron Gas Services. For a further discussion of the Enron loan, see "Nonrecourse Secured Loan and Dollar-Denominated Production Payment" below. This financing provided acquisition capital, and capital to execute Forest's exploitation strategy. Many of the factors which may affect the Company's future operating performance and long-term liquidity are beyond the Company's control, including, but not limited to, oil and natural gas prices, governmental actions and taxes, the availability and attractiveness of properties for acquisition, the adequacy and attractiveness of financing and operational results. VOLUMETRIC PRODUCTION PAYMENTS. Through December 31, 1993, the Company received approximately $134,705,000 (net of fees) from the sale of volumetric production payments and, in return, committed to deliver from the subject properties approximately 77.4 BCF of natural gas and 770,000 barrels of oil to entities associated with Enron Corp. (Enron). As of December 31, 1993, the volumes remaining to be delivered were approximately 36.3 BCF of natural gas and 479,000 barrels of oil. Amounts received for volumetric production payments are recorded as deferred revenue, which is amortized as sales are recorded based upon the scheduled deliveries under the production payment agreements. The purchaser of a volumetric production payment determines the amount paid to the Company for the production payment by calculating the net present value of the scheduled deliveries priced using the purchaser's assumed future prices. However, the sales price per MCFE recorded by the Company upon delivery of production payment volumes is determined by dividing the net proceeds from the sale of the production payment by the total volumes scheduled to be delivered. This price is therefore fixed at the inception of the production payment and does not change. There is no interest expense recorded with respect to a volumetric production payment, the interest factor having been effectively netted against the calculated sales price. In addition, the Company must pay applicable royalties on volumes delivered and is responsible for production- related costs associated with operating the properties subject to the production payment agreements. These accounting treatments should be considered when assessing the Company's financial statements and related information, including information presented with respect to cash flows and average prices for volumes sold under fixed contracts. Deferred revenue relating to production payments was $67,228,000 as of December 31, 1993. The annual amortization of deferred revenue and the corresponding delivery and net sales volumes are set forth below: NONRECOURSE SECURED LOAN AND DOLLAR-DENOMINATED PRODUCTION PAYMENT. Under the terms of the Enron loan agreement and a dollar-denominated production payment sold in February 1992 in connection with the acquisition of the Harbert Energy Corporation properties, the Company is required to make payments based on the net proceeds, as defined, from certain subject properties. As of December 31, 1993, the Enron loan of $57,400,000, which bears annual interest at the rate of 12.5%, was recorded at $53,101,000 to reflect the conveyance to the lender of a 20% interest in the net profits, as defined, of the Loma Vieja properties. Under the terms of the Enron loan, additional funds may be advanced to fund a portion of the development projects which will be undertaken by the Company on the properties pledged as security for the loan. Payments of principal and interest under the Enron loan are due monthly and are equal to 90% of total net operating income from the secured properties, reduced by 80% of allowable capital expenditures, as defined. The Company's current estimate is that 1994 payments will reduce the recorded liability by approximately $983,000. Payments, if any, under the net profits conveyance will commence upon repayment of the principal amount of the Enron loan and will cease when the lender has received an internal rate of return, as defined, of 18% (15.25% through December 31, 1995). Properties to which approximately 22% of the Company's estimated proved reserves are attributable, on an MCFE equivalent basis, are dedicated to repayment of the Enron loan. The original amount of the dollar-denominated production payment was $37,550,000, which was recorded as a liability of $28,805,000 after a discount to reflect a market rate of interest. At December 31, 1993 the remaining recorded liability was $21,305,000. Under the terms of the dollar-denominated production payment, the Company must make a monthly cash payment which is the greater of a base amount or 85% of the net proceeds from the subject properties, as defined, except that the amount required to be paid in any given month shall not exceed 100% of the net proceeds from the subject properties. The Company's current estimate is that 1994 payments will reduce the recorded liability by approximately $3,388,000. Properties to which approximately 7% of the Company's estimated proved reserves are attributable, on an MCFE basis, are dedicated to this production payment financing through July 1999. HEDGING PROGRAM. In addition to the volumes of natural gas and oil dedicated to volumetric production payments, the Company has also used energy swaps and other financial agreements to hedge against the effects of fluctuations in the sales prices for oil and natural gas. In a typical swap agreement, the Company receives the difference between a fixed price per unit of production and a price based on an agreed upon third-party index if the index price is lower. If the index price is higher, the Company pays the difference. The Company's current swaps are settled on a monthly basis. At December 31, 1993 the Company had natural gas swaps for an aggregate of approximately 30 MMBTU per day of natural gas during 1994 at fixed prices ranging from $1.90 to $2.30 per MMBTU. At December 31, 1993 the Company had no oil swaps in place. OPTION AGREEMENT. Under another agreement (the Option Agreement), the Company paid a premium of $516,000 in conjunction with the closing of the Enron loan agreement. The payment of this premium gives Forest the right to set a floor price of $1.70 per MMBTU on a total of 18.4 BBTU of natural gas over a five year period commencing January 1, 1995. In order to exercise this right to set a floor, the Company must pay an additional premium of 10 CENTS per MMBTU, effectively setting the floor at $1.60 per MMBTU. The premium of $516,000 related to the Option Agreement was recorded as a long-term asset and will be amortized as a reduction to oil and gas income beginning in 1995 based on the volumes involved. TRIGGER AGREEMENTS. Two trigger agreements were entered into during 1993. Under a "trigger" agreement, the Company agrees to enter into a swap agreement at a later date based upon a specified margin over an agreed-upon third party index. One agreement originally entered into in July 1993 obligated the Company to enter into a gas swap arrangement in 1994. This agreement was terminated in December 1993, in exchange for which the Company will pay $0.2675 per MMBTU on 5,000 MMBTU per day for each contract month, which equates to $488,000. The discounted value of this amount, or $457,000, has been recorded as expense and as a liability at December 31, 1993 and will be paid in monthly installments of approximately $41,000 during 1994. The second trigger agreement was converted into a natural gas swap and is included in the natural gas swaps discussed above. The Company currently has no open trigger agreements. SUMMARY OF CASH FLOW CONSIDERATIONS AND EXPOSURE TO PRICE AND RESERVE RISK. Pursuant to certain of the Company's financing arrangements, significant amounts of production are contractually dedicated to production payments and the repayment of nonrecourse debt over the next five years (dedicated volumes). The dedicated volumes decrease over the next five years and also decrease as a percentage of the Company's total production during this period. The production volumes not contractually dedicated to repayment of nonrecourse debt (undedicated volumes) are relatively stable but increase as a percentage of the Company's total production over the next five years. This relative stability of undedicated volumes is due to the fact that the decrease in dedicated volumes corresponds generally to the Company's estimates of the decrease in its total production. In the Company's opinion, the relative stability of undedicated volumes should provide a more constant level of cash flow available for corporate purposes other than debt repayment. The following table presents, on a percentage basis, the Company's estimates of dedicated and undedicated volumes as a percentage of estimated total production: As a result of volumetric production payments, energy swaps, and fixed contracts, the Company currently estimates that approximately 62% of its natural gas production and 15% of its oil production will not be subject to price fluctuations from January 1994 through December 1994. Existing hedge agreements currently cover approximately 42% of the Company's natural gas production and 12% of its oil production for the year ending December 31, 1995. Currently, it is the Company's intention to commit no more than 75% of its production to such arrangements at any point in time. See "Hedging Program" below. The Company's hedging strategy for dedicated volumes differs from that for undedicated volumes. The Company believes that hedging of dedicated volumes provides for greater assurance of debt repayment and decreased financial risk. The Company believes that hedging undedicated volumes is also warranted in order to facilitate its short-term planning and budgeting. The Company has not hedged significant amounts of undedicated volumes beyond 24 months. The Company may consider long-term hedging of undedicated volumes in the future if product prices rise to significantly higher levels. The Company believes that stability of cash flow should be considered by separately reviewing its hedge position relative to dedicated volumes and undedicated volumes. The following table reflects the estimated hedge position as a percentage of the Company's undedicated volumes: The Company believes it is important to hedge volumes dedicated to production payments or required to repay debt. The following table reflects the estimated hedge position as a percentage of the Company's dedicated volumes. (Volumes dedicated to volumetric production payments are treated as hedged for purposes of this presentation): Estimates of commercially recoverable oil and gas reserves and of the future net cash flows therefrom are based upon a number of variable factors and assumptions, such as historical production from the subject properties, comparison with other producing properties, the assumed effects of regulation by governmental agencies and assumptions concerning future oil and gas prices and future operating costs, severance and excise taxes, abandonment costs, development costs and workover and remedial costs, all of which may in fact vary considerably from actual results. All such estimates are to some degree speculative. Actual production, revenues, severance and excise taxes, development expenditures, workover and remedial expenditures, abandonment expenditures and operating expenditures with respect to the Company's reserves will likely vary from such estimates, and such variances may be material. CAPITAL EXPENDITURES. In 1991, the Company implemented its capital investment strategy of acquiring proved properties. During 1992 and 1993, the Company completed six major acquisitions under this strategy. The Company's expenditures for property acquisition, exploration and development for the past three years, including overhead related to these activities which was capitalized, were as follows: In 1993, the Company's property acquisition expenditures of $144,916,000 resulted in proved reserve additions of an estimated 94.7 BCF of natural gas and 1.7 million barrels of oil, as measured at the closing dates of the acquisitions for financial accounting purposes, as well as eight exploitation prospects and three exploratory offshore blocks. In 1992, the Company's property acquisition expenditures, as measured at the closing dates, of $88,772,000 resulted in proved reserve additions of an estimated 63 BCF of natural gas and 5.8 million barrels of oil, including reserves acquired as a result of gas balancing settlements. For the year ended December 31, 1993, finding costs were $1.26 per MCFE and reserve replacement was 271%. This compares to $1.20 and 235% in 1992 and $1.56 and 79% in 1991. Finding costs are the total costs incurred in oil and gas acquisition, exploration and development activities, including capitalized overhead, for any period, divided by net additions to proved reserves on an MCFE basis (including revisions, extensions and discoveries and purchases of reserves in place) for such period. Reserve replacement represents estimated proved reserve additions as a percentage of production before taking into account sales of oil and gas reserves in place. It is currently anticipated that the Company's 1994 expenditures for exploration and development will be approximately $3,900,000, and $24,300,000, respectively, including capitalized overhead of $900,000 and $5,600,000, respectively. Under the terms of the Enron loan, 80% of direct development expenditures on the properties subject to the loan reduce payments which would otherwise be due; however, planned levels of capital expenditures may still be restricted if the Company experiences lower than anticipated net cash provided by operations or other liquidity problems. During 1994, the Company intends to aggressively pursue a strategy of acquiring reserves; however, no assurance can be given that the Company can locate or finance any property acquisitions. In order to finance future acquisitions, the Company is exploring many options including, but not limited to: a variety of debt instruments; the issuance of net profits interests; sales of non-strategic properties, prospects and technical information; joint venture financing; the issuance of common or preferred equity of the Company; sale of production payments and other nonrecourse financing; as well as additional bank financing. Availability of these sources of capital will depend upon a number of factors, some of which are beyond the control of the Company. DIVIDENDS. To increase liquidity and fund a portion of its capital budget, the Company deferred payment of dividends on its $15.75 Redeemable Preferred Stock and its $2.125 Convertible Preferred Stock throughout 1991. All dividend arrearages were eliminated at the end of 1991 when the $15.75 Redeemable Preferred Stock and $2.125 Convertible Preferred Stock were recapitalized. Throughout most of 1991, the Company did not have the legal ability under the NYBCL to pay dividends. Upon completion of the recapitalization, this restriction was removed and the Company once again has the legal ability under the NYBCL to pay dividends, although it is subject to certain restrictive provisions in the Indenture executed in connection with the 11 1/4% Senior Subordinated Notes due 2003 and in the Credit Facility. The Company was required to pay dividends, when and if declared, on its $.75 Convertible Preferred Stock in shares of Common Stock through 1993. On February 1, 1994, a cash dividend of $.1875 on its $.75 Convertible Preferred Stock was paid to holders of record on January 14, 1994. On February 20, 1994 the Board of Directors declared a cash dividend of $.1875 on the $.75 Convertible Preferred Stock, payable May 1, 1994 to holders of record on April 8, 1994. For further information concerning dividends, see Item 5. Market for Registrant's Common Equity and Related Stockholder Matters and Notes 4, 6, 9 and 10 of Notes to Consolidated Financial Statements. OTHER MATTERS GAS BALANCING. It is customary in the industry for various working interest partners to produce more or less than their entitlement share of natural gas from time to time. During 1993, the Company's net overproduced position decreased from approximately 13 BCF to approximately 10 BCF. In 1992, the Company's net overproduced position decreased from approximately 16 BCF to approximately 13 BCF. In 1991, the Company's net overproduced position did not change appreciably due to the offseting effects of gas balancing settlements and production in excess of entitlements. The Company has entered into gas balancing agreements for most of its imbalance position and currently estimates that approximately 3 BCF and 2 BCF will be repaid in 1994 and 1995 under such agreements. In the absence of a gas balancing agreement, the Company is unable to determine when its partners may choose to make up their share of production. If and when the Company's partners do make up their share of production, the Company's deliverable natural gas volumes could decrease, adversely affecting revenue and cash flow. For futher information, see Note 1 of Notes to Consolidated Financial Statements. UNFUNDED PENSION LIABILITIES. In 1993, in response to market conditions, the Company lowered from 9% to 7.5% the discount rate used in determining the actuarial present value of the projected benefit obligations under its qualified defined benefit trusteed pension plan and its supplemental executive retirement plan. As a result of the change in the discount rate, the Company recorded a liability of $3,038,000 representing the unfunded liabilities of these plans and a corresponding decrease in capital surplus. The Company does not expect the change in discount rate to have a significant impact on future expense due to a pension plan curtailment effected May 31, 1991. The Company currently is not required to make a contribution to the pension plan under the minimum funding requirements of ERISA, but may choose to do so or be required to do so in the future. NATURAL GAS SALES CONTRACTS. The Company had two natural gas sales contracts with Columbia Gas Transmission Corp. (Transmission), a subsidiary of Columbia Gas System (CGS). On July 31, 1991, CGS and Transmission filed Chapter 11 bankruptcy petitions with the United States Bankruptcy Court for the District of Delaware. Both contracts have been rejected pursuant to the bankruptcy proceedings. The Company has filed a proof of claim in the bankruptcy proceeding consisting of a secured claim of $1,600,000 based on Louisiana vendor lien laws and an unsecured claim relating to the rejection of the contracts. The secured claim arises from Transmission's failure to pay the contract price for a period of time prior to rejection of the contracts. The unsecured claim was calculated on an undiscounted basis and without any assumption of mitigation of damages through spot market sales. No prediction can be given as to when or how these matters will ultimately be concluded. NET OPERATING LOSS AND TAX CREDIT CARRYFORWARDS. At December 31, 1993, the Company estimated that for United States federal income tax purposes, it had consolidated net operating loss carryforwards of $28,439,000, depletion carryforwards of approximately $20,174,000 and investment tax credit carryforwards of approximately $3,885,000. The availability of some of these tax attributes to reduce current and future taxable income of the Company is subject to various limitations under the Internal Revenue Code of 1986, as amended (the Code). In particular, the Company's ability to utilize such tax attributes could be severely restricted due to the occurrence of an "ownership change" within the meaning of Section 382 of the Code resulting from the 1991 recapitalization. At December 31, 1993, the Company estimated that net operating loss and investment tax credit carryforwards would be limited to offset current taxable income to the extent described below. The net operating loss carryforwards, which expire in 2008, are not subject to the provisions of Section 382 as they were generated subsequent to the ownership change. Even though the Company is limited in its ability to use the remaining net operating loss carryforwards under the general provisions of Section 382, it may be entitled to use these net operating loss carryovers to offset (a) gains recognized in the five years following the ownership change on the disposition of certain assets, to the extent that the value of the assets disposed of exceeds its tax basis on the date of the ownership change or (b) any item of income which is properly taken into account in the five years following the ownership change but which is attributable to periods before the ownership change ("built-in gain"). The ability of the Company to use these net operating loss carryovers to offset built-in gain first requires that the Company have total built-in gains at the time of the ownership change which are greater than a threshold amount. In addition, the use of these net operating loss carryforwards to offset built-in gain cannot exceed the amount of the total built-in gain. The Company believes that due to the amount of built-in gain as of the date of ownership change, and the recognition of such gain through December 31, 1993, that there will be no significant limitation on the Company's ability to use these net operating loss carryforwards or investment tax credit carryforwards. CHANGE IN FEDERAL CORPORATE INCOME TAX RATES. The Omnibus Budget Reconciliation Act of 1993 increased the federal corporate tax rate from 34% to 35% retroactively to January 1, 1993. As a result of this tax increase, the tax benefit at December 31, 1993 on the loss from continuing operations was approximately $167,000 less than it would have been without such increase in the tax rate. However, due to limitations on the recognition of deferred tax assets under FAS 109, the total tax benefit at December 31, 1993, including the tax benefit on the extraordinary loss on extinguishment of debt, is unaffected by the tax rate increase. The impact of the tax rate increase on the Company's total tax expense will be recognized when future taxable income absorbs the present unrecognized deferred tax asset. ACCOUNTING POLICIES. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). This statement requires the accrual of the estimated cost of certain postemployment benefits provided to former employees. SFAS No. 112 is effective for years beginning after December 15, 1993. The initial effect of applying this statement is to be accounted for as a cumulative effect of a change in accounting principle. The Company has not determined precisely what effect, if any, the adoption of SFAS No. 112 will have on its financial statements, but believes the effect will be immaterial because the Company has already recorded liabilities for any of the affected costs that would be significant. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information concerning this Item begins on the following page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Forest Oil Corporation: We have audited the accompanying consolidated balance sheets of Forest Oil Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Forest Oil Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 8 and 13 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. KPMG PEAT MARWICK Denver, Colorado February 22, 1994 FOREST OIL CORPORATION CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements FOREST OIL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to consolidated financial statements FOREST OIL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY See accompanying notes to consolidated financial statements FOREST OIL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: - -------------------------------------------------------------------------------- BASIS OF CONSOLIDATION - The consolidated financial statements include the accounts of Forest Oil Corporation (the Company) and its wholly-owned subsidiaries. Significant intercompany balances and transactions are eliminated. The Company's investment in CanEagle Resources Corporation (CanEagle) is accounted for using the equity method (See Note 3). CASH EQUIVALENTS - For purposes of the statements of cash flows, the Company considers all debt instruments with original maturities of three months or less to be cash equivalents. PROPERTY AND EQUIPMENT - The Company uses the full cost method of accounting for oil and gas properties. Separate cost centers are maintained for each country in which the Company has operations. All costs incurred in the acquisition, exploration and development of properties (including costs of surrendered and abandoned leaseholds, delay lease rentals, dry holes and overhead related to exploration and development activities) are capitalized. Costs applicable to each cost center, including capitalized costs as wells as estimated costs of future development, surrender and abandonment, are depleted using the units of production method. Unusually significant investments in seismic data and unproved properties, including related capitalized interest costs, are not depleted pending the determination of the existence of proved reserves and the commencement of sales from the properties. As of December 31, 1993 and 1992, there were undeveloped property costs of $41,216,000 and $18,306,000, respectively, in the United States which were not being depleted, all of which relate to property acquisitions in 1992 and 1993. At December 31, 1991 there were no costs in any cost centers which were not subject to depletion. Depletion per unit of production was determined based on conversion to common units of measure using one barrel of oil as an equivalent to six MCF of natural gas. Depletion per unit of production (MCFE) for each of the Company's cost centers was as follows: UNITED STATES CANADA ------------- ------ 1993 $ 1.19 - 1992 1.21 1.19 1991 1.28 1.37 Capitalized costs less related accumulated depletion and deferred income taxes may not exceed the sum of (1) the present value of future net revenue from estimated production of proved oil and gas reserves; plus (2) the cost of properties not being amortized, if any; plus (3) the lower of cost or estimated fair value of unproved properties included in the costs being amortized, if any; less (4) income tax effects related to differences in the book and tax basis of oil and gas properties. As a result of this limitation on capitalized costs of each of the cost centers, the accompanying financial statements include a provision for impairment of oil and gas property costs of $15,000,000 in the United States and $19,000,000 in Canada in 1991. There was no impairment of oil and gas property costs required to be recorded in 1993 or 1992. No gain or loss is recognized on the sale of oil and gas properties except in the case of properties involving significant remaining reserves. Proceeds from sales of insignificant reserves and undeveloped properties are applied to reduce the costs in the cost centers. Buildings, transportation and other equipment are depreciated on the straight- line method based upon estimated useful lives of the assets ranging from five to forty-five years. (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D): - -------------------------------------------------------------------------------- INCOME TAXES - The adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), effective January 1, 1993 changed the Company's method of accounting for income taxes from the deferred method to an asset and liability method. Previously, the Company deferred the tax effects of timing differences between financial reporting and taxable income. The asset and liability method requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between tax bases and financial reporting bases of all other assets and liabilities. Temporary differences are principally the result of certain development, exploration and other costs which are deducted for income tax purposes but capitalized for financial accounting purposes. FOREIGN CURRENCY TRANSLATION - Balance sheet accounts of Canadian activities are translated into United States dollars using the year-end exchange rates. Income and expense items have been translated at rates applicable during each year. Adjustments resulting from these translations are accumulated in a separate component of shareholders' equity. GAS REVENUE - The Company uses the sales method of accounting for amounts received from natural gas sales. Under this method, all proceeds from production credited to the Company are recorded as revenue until such time as the Company has produced its share of related estimated remaining reserves. Thereafter, additional amounts received are recorded as a liability. As of December 31, 1993 the Company had produced approximately 10 BCF more than its entitled share of production. The undiscounted value of this imbalance is approximately $17,000,000 using the lower of the price received for the natural gas, the current market price or the contract price, as applicable. Amounts received for approximately 7 BCF of this production have been recorded as revenue and as reductions of the Company's reserve quantities and reserve values described in Note 19. Amounts received for the remaining 3 BCF of this production have been recorded as a liability as this volume exceeds the Company's share of the related estimated remaining reserves. The liability is recorded in accordance with the settlement provisions of the applicable gas balancing agreements and amounted to approximately $3,887,000 at December 31, 1993. ENERGY SWAPS AND OTHER FINANCIAL ARRANGEMENTS - In order to hedge against the effects of declines in oil and natural gas prices, the Company enters into energy swap agreements and other financial arrangements with third parties. In a typical swap agreement, the Company receives the difference between a fixed price per unit of production and a price based on an agreed-upon third party index if the index price is lower. If the index price is higher, the Company pays the difference. The Company's current swaps are settled on a monthly basis. For the years ended December 31, 1993, 1992 and 1991, the Company incurred swap gains (losses) of $(2,050,000), $(1,642,000) and $3,564,000, respectively. The Company recognizes gains or losses on such agreements as adjustments to revenue recorded for the related production. EARNINGS (LOSS) PER SHARE - Primary earnings (loss) per share is computed by dividing net earnings (loss) attributable to common stock by the weighted average number of common shares and common share equivalents outstanding during each period, excluding treasury shares. Net earnings (loss) attributable to common stock represents net earnings (loss) less preferred stock dividend requirements of $2,250,000 in 1993, $2,348,000 in 1992, and $5,209,000 in 1991. Common share equivalents include, when applicable, dilutive stock options and warrants using the treasury stock method. Fully diluted earnings per share assumes, in addition to the above, (i) that convertible debentures were converted at the beginning of each period or date of issuance, if later, with earnings being increased for interest expense, net of taxes, that would not have been incurred had conversion taken place, (ii) that convertible preferred stock was converted at the beginning of each period or date of issuance, if later, and (iii) the additional dilutive effect of stock options and warrants. The effects of these assumptions were anti-dilutive in 1993 and 1991. The weighted average number of shares outstanding on a fully- diluted basis was 26,515,000 for the year ended December 31, 1992. (2) ACQUISITIONS: - -------------------------------------------------------------------------------- On May 18, 1993 and December 10, 1993, the Company purchased interests in properties from Atlantic Richfield Company (ARCO) for approximately $60,862,000. In conjunction with the acquisitions, the Company sold volumetric production payments from certain of the ARCO properties for approximately $40,468,000 (net of fees). On December 14, 1993, the Company purchased interests in offshore properties in the West Cameron/Eugene Island area from a private company for approximately $24,050,000. On December 30, 1993, the Company purchased interests in properties in the Loma Vieja field in south Texas for approximately $59,458,000. In conjunction with the acquisitions, the Company entered into a nonrecourse secured loan agreement for $51,600,000. The remainder of the purchase price for these two acquisitions, $31,908,000, was financed through internal funds and from funds obtained under the Company's secured master credit facility. The Company's results of operations for the year ended December 31, 1993 include the effects of the first ARCO acquisition since May 1, 1993 and the West Cameron/Eugene Island properties and the second ARCO acquisition since December 1, 1993. On February 1, 1992, Forest I Development Company, a wholly-owned subsidiary of the Company, purchased substantially all of the assets of Harbert Energy Corporation and its associated entities in an acquisition accounted for as a purchase. The purchase price of $40,400,000 consisted of payment of approximately $7,120,000 in cash (including acquisition costs), assumption by Forest of certain liabilities, and the sale of a dollar-denominated production payment which was recorded at its present value of $28,805,000. On July 31, 1992, the Company purchased Transco Exploration and Production Company (TEPCO) for approximately $45,000,000. In conjunction with the acquisition, the Company sold a volumetric production payment from certain of the TEPCO properties for approximately $38,500,000 (net of fees). In addition, the Company issued a $2,000,000 promissory note to Transco Energy Corporation as part of the purchase price. Approximately $4,062,000 was paid in cash, including acquisition costs. The Company's results of operations for the year ended December 31, 1992 include the effects of the Harbert and TEPCO acquisitions since February 1, 1992 and July 31, 1992, respectively. (3) INVESTMENT IN AND ADVANCES TO AFFILIATE: - -------------------------------------------------------------------------------- In May 1992, the Company transferred substantially all of its Canadian oil and gas properties to a wholly-owned Canadian subsidiary, Forest Canada I Development Ltd. (FCID). On September 30, 1992, FCID sold its Canadian assets and related operations to CanEagle for approximately $51,250,000 in Canadian funds ($41,000,000 U.S.). CanEagle was formed for the purpose of acquiring the assets and related operations of FCID. An independent third party financed the purchase by CanEagle. In the transaction, FCID received cash of approximately $28,000,000 CDN ($22,400,000 U.S.), net of expenses, and provided financing to the third party in the aggregate principal amount of $22,000,000 CDN ($17,600,000 U.S.). In connection with the transaction, CanEagle issued to the third party (a) a $19,000,000 CDN senior debenture, secured by its oil and gas properties, (b) a $6,000,000 CDN subordinated debenture, secured by its oil and gas properties and subordinated to the senior debenture, (c) a $16,000,000 CDN senior subordinated note, unsecured and subordinated to the debentures, (d) convertible notes for $6,250,000 CDN, unsecured and subordinated to the debentures and the senior subordinated note, and (e) preferred stock for $4,000,000 CDN. A Canadian bank provided financing to the third party secured by a pledge of the senior debenture. Forest's financing to the third party is secured by a pledge of the subordinated debenture and the senior subordinated note. The notes received by Forest from the third party, the subordinated debenture and the senior subordinated note were due March 31, 1998 and bore interest at 9% per annum payable quarterly. As part of the transaction, Forest retained 100% of the common equity of CanEagle and granted an option to a third party to purchase 80% of the common equity of CanEagle for nominal consideration. The original option lapsed unexercised in December 1992. Forest subsequently agreed to sell all of the common equity interest to the third party, subject to certain revisions to aspects of CanEagle's capital structure. This sale was completed on September 29, 1993 for nominal consideration. (3) INVESTMENT IN AND ADVANCES TO AFFILIATE (CONT'D): - -------------------------------------------------------------------------------- On September 29, 1993, Forest exchanged the $16,000,000 CDN senior subordinated note plus $780,000 CDN accrued interest thereon for 15,400,000 shares of Class A Preferred Shares and 1,400,000 shares of Class B Preferred Shares of CanEagle. The Class A and Class B Preferred Shares have liquidation preference rights of $1.00 CDN per share. The Class A Preferred Shares are entitled to annual fixed cumulative preferential cash dividends of $.03 per share, payable quarterly. Dividends may be paid through issuance of noninterest-bearing promissory notes due not later than September 30, 1998. Class B Preferred Shares are entitled to an annual $.03 fixed cumulative cash dividend payable only after all Class A Preferred Shares have been redeemed. CanEagle may redeem first the Class A and then the Class B Preferred Shares at $1.00 CDN per share plus all accumulated but unpaid dividends thereon at any time subsequent to issuance, on a pro rata basis from all holders of each issue, but is required to redeem all of the then outstanding shares of both issues on or before September 30, 1998. While any of the Class A and Class B Preferred Shares are outstanding, CanEagle is prohibited from making dividends or distributions on, or redeeming or purchasing any of its common shares, issuing any additional preferred shares, incurring any indebtedness other than as permitted under the restated articles of incorporation or undertaking certain other prohibited transactions unless unanimously approved by holders of the Class A shares. No gain was recognized as a result of the CanEagle transaction because collection of the remaining sales price was not reasonably assured. Due to its continuing financial interest in CanEagle, the Company is accounting for its investment in CanEagle under the equity method. Accordingly, losses will be recognized to the extent that such losses exceed (a) amounts attributable to securities subordinate to the Company's interest, and (b) the basis difference of $780,000 CDN attributable to the 1993 capital restructuring of CanEagle. Under this method, no portion of the CanEagle loss was required to be recorded by the Company in 1993. Earnings related to the Company's interest in CanEagle will be recognized only if realization is assured. Accordingly, amounts received as interest on the subordinated note during 1993 (approximately $540,000 CDN) were recorded as a reduction of the Company's investment in and advances to CanEagle. No dividends were paid on the Class A Preferred Shares in 1993. The excess of the carrying value of properties sold over the cash received, or approximately $16,451,000 U.S. at December 31, 1993, represents Forest's investment in CanEagle. In March 1994, the Company pledged its CanEagle securities as collateral for a $4,000,000 loan from The Chase Manhattan Bank, NA due June 1, 1994. (3) INVESTMENT IN AND ADVANCES TO AFFILIATE (CONT'D): - -------------------------------------------------------------------------------- CanEagle reports its annual results on a fiscal year ending on September 30. Condensed financial statement information for CanEagle as of September 30, 1993 and 1992 and for the year ended September 30, 1993 is as follows: (3) INVESTMENT IN AND ADVANCES TO AFFILIATE (CONT'D): - -------------------------------------------------------------------------------- Substantial uncertainty exists regarding whether CanEagle is a going concern due to the required principal payment of $16,300,000 on its Senior Debenture due June 30, 1994. CanEagle is in the process of refinancing the Senior Debenture with its lender, but there is no assurance that such refinancing can be completed on mutually acceptable terms prior to the due date. The above condensed financial statements do not include any adjustments relating to the ultimate outcome of this uncertainty. The following information is presented in accordance with Statement of Financial Accounting Standards No. 69, "Disclosure about Oil and Gas Producing Activities," (SFAS No. 69). (A) Unaudited information with respect to costs incurred by CanEagle for oil and gas exploration and development activities is as follows: (B) Unaudited information with respect to CanEagle's estimated proved oil and gas reserves at September 30, 1993 and 1992 follows. Such estimates are inherently imprecise and may be subject to substantial revisions. (3) INVESTMENT IN AND ADVANCES TO AFFILIATE (CONT'D): - -------------------------------------------------------------------------------- (C) The standardized measure of discounted future net cash flows of CanEagle, calculated in accordance with the provisions of SFAS 69 is as follows: (4) LONG-TERM BANK DEBT: - -------------------------------------------------------------------------------- In December 1993, the Company entered into a secured master credit facility (the Credit Facility) with The Chase Manhattan Bank, NA. (Chase) as agent for a group of banks. Under the Credit Facility, the Company may borrow up to $17,500,000 for acquisition or development of proved oil and gas reserves, which amount is subject to semi-annual redetermination, and up to $17,500,000 for working capital and general corporate purposes. The Credit Facility is secured by a lien on, and a security interest in, a majority of the Company's proved oil and gas properties and related assets (subject to prior security interests granted to holders of volumetric production payment agreements), a pledge of accounts receivable, material contracts and the stock of material subsidiaries, and a negative pledge on remaining assets. Borrowings under the Credit Facility bear interest at the Chase base rate plus 3/8 of 1% or 1,2,3 or 6 month LIBOR plus 1 and 5/8%, payable quarterly. A commitment fee of 1/2 of 1% is charged on unused availability. The maturity date of the Credit Facility is December 31, 1996. Under the terms of the Credit Facility, the Company is subject to certain covenants, including restrictions or requirements with respect to working capital, net cash flow, additional debt, asset sales, mergers, cash dividends on capital stock and reporting responsibilities. At December 31, 1993 the outstanding balance under the credit facility was $25,000,000 at an interest rate of 6.375%. The Company did not meet the test imposed by the working capital covenant of the Credit Facility; compliance with this covenant was waived by Chase at December 31, 1993. (5) NONRECOURSE SECURED LOAN AND PRODUCTION PAYMENT OBLIGATION: - -------------------------------------------------------------------------------- NONRECOURSE SECURED LOAN: On December 30, 1993, the Company entered into a nonrecourse secured loan agreement which bears annual interest at the rate of 12.5%, arranged by Enron Finance Corp., an affiliate of Enron Gas Services (the Enron loan). Approximately $51,600,000 was advanced on December 30, 1993 to provide financing for a portion of the West Cameron/Eugene Island and Loma Vieja acquisitions. Another $5,800,000 of the available balance was advanced on December 30, 1993 to fund a portion of the development projects which will be undertaken by the Company on the properties pledged as security for the loan. Under the terms of the Enron loan, additional funds may be advanced to fund additional development projects which will be undertaken by the Company on the properties pledged as security for the loan. The loan amount of $57,400,000 was recorded as a liability of $53,101,000 to reflect conveyance to the lender of a 20% interest in the net profits, as defined, of the Loma Vieja properties. The loan discount of $4,299,000 will be amortized over the life of the loan using the effective interest method. Payments of principal and interest under the Enron loan are due monthly and are equal to 90% of total net operating income from the secured properties, reduced by 80% of allowable capital expenditures, as defined. The Company's current estimate, based on expected production and prices, budgeted capital expenditure levels and expected discount amortization, is that 1994 payments will reduce the recorded liability by approximately $983,000; this amount is included in current liabilities. Estimated liability reductions for 1995 through 1997, (5) NONRECOURSE SECURED LOAN AND PRODUCTION PAYMENT OBLIGATION (cont'd): - ------------------------------------------------------------------------------- under the same production, pricing, capital expenditure and amortization scenario, are $12,385,000, $20,485,000, and $19,248,000, respectively. Payments, if any, under the net profits conveyance will commence upon repayment of the principal amount of the Enron loan and will cease when the lender has received an internal rate of return, as defined, of 18% (15.25% through December 31, 1995). Properties to which approximately 22% of the Company's estimated proved reserves are attributable, on an MCF equivalent basis, are dedicated to repayment of the Enron loan. PRODUCTION PAYMENT OBLIGATION: The original amount of the dollar-denominated production payment was $37,550,000, which was recorded as a liability of $28,805,000 after a discount to reflect a market rate of interest of 15.5%. At December 31, 1993 the remaining recorded liability was $21,305,000. Under the terms of the dollar- denominated production payment agreement entered into in 1992 in connection with the Harbert acquisition, Forest I Development Company must make a monthly cash payment which is the greater of a base amount or 85% of net proceeds from the subject properties, as defined, except that the amount required to be paid in any given month shall not exceed 100% of the net proceeds from the subject properties. The Company's current estimate, based on expected production and prices, budgeted capital expenditure levels and expected discount amortization, is that 1994 payments will reduce the recorded liability by approximately $3,388,000; this amount is included in current liabilities. Estimated liability reductions for 1995 through 1998, under the same production, pricing, capital expenditure and discount scenario, are $1,949,000, $3,522,000, $4,492,000 and $2,340,000, respectively. Properties to which approximately 7% of the Company's estimated proved reserves are attributable, on an equivalent barrel basis, are pledged under the production payment financing through July 1999. (6) SENIOR SECURED NOTES AND SUBORDINATED DEBENTURES: SENIOR SECURED NOTES: The Senior Secured Notes were issued in 1991 in connection with the Company's recapitalization and were redeemed in full during 1993. Amounts outstanding at December 31, 1992 were as follows (In Thousands): Accretion of the original issue discount relating to the Senior Secured Notes was calculated using the effective interest method over the life of the issue. The Senior Secured Notes bore interest at 12-3/4%, were due June 1, 1998, and were initially secured by liens on substantially all of the Company's oil and gas properties in the United States, including all reserves attributable thereto. The provisions of the Senior Secured Notes contained restrictions on dividends or cash distributions on or purchases of capital stock, prohibited payment of cash dividends on the Company's Common Stock and Class B Stock prior to January 1, 1994 and were subject to required purchase provisions upon occurrence of certain specified events. Pursuant to the provisions of the Senior Secured Notes, the Company was required to make an offer to purchase Senior Secured Notes with 50% of the net cash proceeds (as defined) of the ONEOK litigation. (See Note 11). The amount of Senior Secured Notes tendered pursuant to such offer was $3,926,000. The purchase resulted in a loss of $614,000 which was recorded as a reduction of miscellaneous net revenue in 1992. (6) SENIOR SECURED NOTES AND SUBORDINATED DEBENTURES (cont'd): - ------------------------------------------------------------------------------- The Senior Secured Notes were senior in right of payment to the 13-5/8% Debentures, 12-1/2% Debentures, 13-7/8% Debentures and 5-1/2% Debentures. The redemption of the Senior Secured Notes was completed using the net proceeds from a Common Stock offering and a portion of the proceeds from the sale of 11- 1/4% Senior Subordinated Notes described below. The outstanding principal value of the Senior Secured Notes of $61,847,000 at December 31, 1992 was redeemed during 1993, resulting in a loss of $9,419,000. Subordinated Debentures: Subordinated debentures outstanding at December 31 were as follows: On September 8, 1993 the Company completed a public offering of $100,000,000 aggregate principal amount of 11-1/4% Senior Subordinated Notes due September 1, 2003. The Senior Subordinated Notes were issued at a price of 99.259% yielding 11.375% to the holders. The Company used the net proceeds from the sale of the Senior Subordinated Notes of approximately $95,827,000, together with approximately $19,400,000 of available cash, to redeem all of its outstanding Senior Secured Notes and long-term subordinated debentures. The Senior Subordinated Notes will be redeemable at the option of the Company, in whole or in part, at any time on or after September 1, 1998 initially at a redemption price of 105.688%, plus accrued interest to the date of redemption, declining at the rate of 1.896% per year to September 9, 2000 and at 100% thereafter. In addition, the Company may, at its option, redeem prior to September 1, 1996, up to 30% of the initially outstanding principal amount of the Notes at 110% of the principal amount thereof, plus accrued interest to the date of redemption, with the net proceeds of any future public offering of its Common Stock. Under the terms of the Senior Subordinated Notes, the Company must meet certain tests before it is able to pay cash dividends (other than dividends on the Company's $.75 Convertible Preferred Stock) or make other restricted payments, incur additional indebtedness, engage in transactions with its affiliates, incur liens and engage in certain sale and leaseback arrangements. The terms of the Senior Secured Notes also limit the Company's ability to undertake a consolidation, merger or transfer all or substantially all of its assets. In addition, the Company is, subject to certain conditions, obligated to offer to repurchase Senior Subordinated Notes at par value plus accrued and unpaid interest to the date of repurchase, with the net cash proceeds of certain sales or dispositions of assets. Upon a change of control, as defined, the Company will be required to make an offer to purchase the Senior Subordinated Notes at 101% of the principal amount thereof, plus accrued interest to the date of purchase. The 13-5/8% Debentures were due September 15, 1998. The outstanding balance of the 13-5/8% Debentures of $72,374,000 at December 31, 1992 was redeemed during 1993, resulting in a loss of $5,839,000. The 12-1/2% Debentures were due May 1, 1999. The outstanding balance of the 12- 1/2% Debentures of $4,408,000 at December 31, 1992 was redeemed during 1993, resulting in a loss of $78,450. (6) SENIOR SECURED NOTES AND SUBORDINATED DEBENTURES (CONT'D): - ------------------------------------------------------------------------------- The 13-7/8% Debentures were due June 1, 2000. The outstanding balance of the 13-7/8% Debentures of $4,914,000 at December 31, 1992 was redeemed during 1993, resulting in a loss of $53,000. During 1993, the Company purchased $308,000 principal amount of its 5-1/2% Convertible Subordinated Debentures, resulting in a gain of $2,000. The remaining balance of $7,171,000 was paid in full on the February 1, 1994 due date. In 1991, the Company consummated exchange offers pursuant to which the Company's outstanding debt was exchanged for Senior Secured Notes and warrants to purchase Common Stock. Holders of $62,010,000 principal amount of the Company's 12-1/2% Debentures, 13-7/8% Debentures and 13-5/8% Debentures accepted the Company's exchange offers, which were accounted for as extinguishments of debt. Therefore, the Company recognized an extraordinary gain on such transactions equal to the excess of the carrying amount of the debentures exchanged over the estimated market value of the Senior Secured Notes and Warrants issued. The gain on the transactions of $14,397,000, reduced by applicable income taxes of $4,895,000, was recorded as an extraordinary gain on extinguishment of debt in 1991. (7) DEFERRED REVENUE: - -------------------------------------------------------------------------------- In April 1991, the Company sold a volumetric production payment from the Company's interest in four properties to Enron Reserve Acquisition Corporation (Enron) for net proceeds of $43,680,000. The production payment agreement covered approximately 30 BCF of natural gas to be delivered over six years at an average price of $1.38 per MMBTU. From November 1991 through February 1992, the Company acquired additional interests in one of the subject properties for $15,465,000 and sold a second volumetric production payment to Enron for net proceeds of $12,035,000. This second production payment covered approximately 9 BCF of natural gas to be delivered over four years at an average price of $1.26 per MMBTU. In connection with the purchase of TEPCO in July 1992, a volumetric production payment from certain of the TEPCO properties was sold to Enron for net proceeds of $38,522,000. This production payment covered approximately 18 BCF of natural gas at an average price of $1.39 per MMBTU and 770,000 barrels of oil at an average price of $15.99 per barrel to be delivered over four years. In connection with the purchase of interests in properties from ARCO in May 1993, a volumetric production payment from certain of the ARCO properties was sold to Enron for net proceeds of $27,260,000. This production payment covered approximately 13.1 BCF of natural gas at an average price of $1.92 per MMBTU to be delivered over three years. Effective November 1, 1993, the four separate volumetric payment financings described above between the Company and Enron were consolidated into one production payment. The delivery schedules from the previously separate production payments were not adjusted; however, delivery shortfalls on any property can now be made up from excess production from any other property which is dedicated to the production payment obligation. The consolidation also provided that certain acreage previously committed to the production payments was released and can be developed by the Company unburdened by the delivery obligations of the production payment. The Company may grant liens on properties subject to this production payment agreement, but it must notify prospective lienholders that their rights are subject to the prior rights of the production payment owner. In connection with the purchase of interests in properties from ARCO in December 1993, a volumetric production payment from certain of the ARCO proerties was sold to Enron for net proceeds of $13,207,000. This production payment covered approximately 7.3 BCF of natural gas at an average price of $1.68 per MMBTU to be delivered over 8 years. The Company is responsible for royalties and for production costs associated with operating the properties subject to the production payment agreements. (7) DEFERRED REVENUE (CONT'D): - -------------------------------------------------------------------------------- Amounts received were recorded as deferred revenue. Annual amortization of deferred revenue, based on the scheduled deliveries under the production payment agreements, is as follows: The Company includes reserves dedicated to the volumetric production payments in its estimated proved oil and gas reserves. (See Note 19.) (8) INCOME TAXES: - -------------------------------------------------------------------------------- The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (SFAS No. 109) on a prospective basis effective January 1, 1993. The cumulative effect of this change in accounting for income taxes of $2,060,000 is determined as of January 1, 1993 and is reported separately in the Consolidated Statement of Operations for the year ended December 31, 1993. The income tax expense (benefit) is different from amounts computed by applying the statutory Federal income tax rate for the following reasons: The Omnibus Budget Reconciliation Act of 1993 increased the federal corporate tax rate from 34% to 35% retroactively to January 1, 1993. As a result of this tax increase, the tax benefit at December 31, 1993 on the loss from continuing operations was approximately $167,000 less than it would have been without such increase in the tax rate. However, due to limitations on the recognition of deferred tax assets under SFAS No. 109, the total tax benefit at December 31, 1993, including the tax benefit on the extraordinary loss on extinguishment of debt, is unaffected by the tax rate increase. The impact of the tax rate increase on the Company's total tax expense will be recognized when future taxable income absorbs the present unrecognized deferred tax asset. (8) INCOME TAXES (CONT'D): - -------------------------------------------------------------------------------- Income taxes that are classified as deferred are generally the result of recognizing income and expenses at different times for financial and tax reporting. These differences result from recording proceeds from the sale of properties in the full cost pool, capitalization of certain development, exploration and other costs under the full cost method of accounting and the provision for impairment of oil and gas properties for financial accounting purposes. The components of the net deferred tax liability, computed in accordance with SFAS No. 109 are as follows: The valuation allowance for deferred tax assets as of January 1, 1993 was $5,234,000. The net change in the total valuation allowance for the year ended December 31, 1993 was an increase of $2,034,000. The Alternative Minimum Tax (AMT) credit carryforward available to reduce future Federal regular taxes aggregated $2,206,000 at December 31, 1993. This amount may be carried forward indefinitely. Regular and AMT net operating loss carryforwards at December 31, 1993 were $28,439,000 and $23,916,000, respectively, and will expire in the years indicated below: AMT net operating loss carryforwards can be used to offset 90% of AMT income in future years. Investment tax credit carryforwards available to reduce future Federal income taxes aggregated $3,885,000 at December 31, 1993 and expire at various dates through the year 2001. Percentage depletion carryforwards available to reduce future Federal taxable income aggregated $20,174,000 at December 31, 1993. This amount may be carried forward indefinitely. The net operating loss and investment tax credit carryforwards have been recognized as a reduction of deferred taxes, subject to a valuation allowance. (8) INCOME TAXES (cont'd): - -------------------------------------------------------------------------------- The availability of some of these tax attributes to reduce current and future taxable income of the Company is subject to various limitations under the Internal Revenue Code. In particular, the Company's ability to utilize such tax attributes could be severely restricted due to the occurrence of an "ownership change" within the meaning of Section 382 of the Internal Revenue Code resulting from the Recapitalization. At December 31, 1993, the Company estimated that net operating loss and investment tax credit carryforwards would be limited to offset current taxable income to the extent described below. The net operating loss carryforwards which expire in 2008 are not subject to the provisions of Section 382 as they were generated subsequent to the ownership change. Even though the Company is limited in its ability to use the remaining net operating loss carryovers under the general provisions of Section 382, it may be entitled to use these net operating loss carryovers to offset (a) gains recognized in the five years following the ownership change on the disposition of certain assets, to the extent that the value of the assets disposed of exceeds its tax basis on the date of the ownership change or (b) any item of income which is properly taken into account in the five years following the ownership change but which is attributable to periods before the ownership change ("built-in gain"). The ability of the Company to use these net operating loss carryovers to offset built-in gain first requires that the Company have total built-in gains at the time of the ownership change which are greater than a threshold amount. In addition, the use of these net operating loss carryforwards to offset built-in gain cannot exceed the amount of the total built-in gain. The Company believes that due to the amount of built-in gain as of the date of ownership change, and the recognition of such gain through December 31, 1993, there is no significant limitation on the Company's ability to use these net operating loss carryforwards or investment tax credit carryforwards. (9) PREFERRED STOCK: - ------------------------------------------------------------------------------- At December 31, 1993, there were 2,880,973 outstanding shares of $.75 Convertible Preferred Stock, par value $.01 per share. This stock is convertible at any time, at the option of the holder, at the rate of 3.5 shares of Common Stock for each share of $.75 Convertible Preferred Stock, subject to adjustment upon occurrence of certain events. During 1993, 248,817 shares of $.75 Convertible Preferred Stock were converted into 870,858 shares of Common Stock. The $.75 Convertible Preferred Stock is redeemable, in whole or in part, at the option of the Company, at any time after the earlier of (i) July 1, 1996 or (ii) the date on which the last reported sales price of the Common Stock will have been $7.50 or higher for at least 20 of the prior 30 trading days, at a redemption price of $10.50 per share during the twelve-month period which began July 1, 1993 and declining ratably to $10.00 per share at July 1, 1996 and thereafter, including accumulated and unpaid dividends. Cumulative annual dividends of $.75 per share are payable quarterly, in arrears, on the first day of February, May, August and November, when and as declared. Until December 31, 1993, the Company has paid such dividends in shares of Common Stock. Thereafter, dividends may be paid in cash or, at the Company's election, in shares of Common Stock or in a combination of cash and Common Stock. Common Stock delivered in payment of dividends will be valued for dividend payment purposes at between 75% and 90%, based on trading volume, of the average last reported sales price of the Common Stock during a specified period prior to the record date for the dividend payment. If two consecutive dividend payments are in arrears, the holders of $.75 Convertible Preferred Stock may exercise a penalty conversion right during a specified period and may convert shares of $.75 Convertible Preferred Stock, plus accumulated dividends, to Common Stock at a conversion price of 75% of the average last reported sales price during a specified period prior to the conversion date. If six consecutive dividend payments are in arrears, the holders of the $.75 Convertible Preferred Stock shall have the right to elect two directors. During any period in which dividends on preferred stock are in arrears, no dividends or distributions, except for dividends paid in shares of Common Stock, may be paid or declared on the Common Stock, nor may any shares of Common Stock be acquired by the Company. In 1985, the Company issued 350,000 shares of $15.75 Cumulative Preferred Stock (Redeemable Preferred Stock), par value $.01 per share. In February 1990, the Company issued 2,300,000 shares of $2.125 Convertible Preferred (9) PREFERRED STOCK (cont'd): - -------------------------------------------------------------------------------- Stock with a par value of $.01 per share and liquidation value of $25 per share. In December 1991, in connection with the Company's recapitalization, the Company's shareholders approved an amendment to the Company's Restated Certificate of Incorporation whereby each share of Redeemable Preferred Stock, including accumulated dividends, was acquired by the Company for seven shares of $.75 Convertible Preferred Stock or, at the election of the holder, for $50 principal amount of Senior Secured Notes and 1.2 shares of $.75 Convertible Preferred Stock and whereby each share of the Company's $2.125 Convertible Preferred Stock, including accumulated dividends, was reclassified into one share of $.75 Convertible Preferred Stock. In December 1991, also in connection with the recapitalization, the Company's shareholders approved an amendment to the Company's Restated Certificate of Incorporation whereby each share of the Company's $2.125 Convertible Preferred Stock, including accumulated dividends, was reclassified into one share of $.75 Convertible Preferred Stock. (10) COMMON STOCK: - -------------------------------------------------------------------------------- At December 31, 1993 the Company has one class of Common Stock, par value $.10 per share, which is entitled to one vote per share. Prior to May 1993 the Company also had Class B stock which had superior voting rights to the Company's Common Stock, had limited transferability and was not traded in any public market but was convertible at any time into shares of Common Stock on a share- for-share basis. At the Company's Annual Meeting of Shareholders on May 12, 1993, the shareholders adopted amendments to the Company's Restated Certificate of Incorporation to increase the number of authorized shares of Common Stock to 112,000,000 and to reclassify each share of Class B Stock into 1.1 shares of Common Stock. On June 15, 1993, the Company issued 11,080,000 shares of Common Stock for $5.00 per share in a public offering. The net proceeds from the issuance of the shares totalled approximately $51,506,000 after deducting issuance costs and underwriting fees. On October 29, 1993 the Company paid a dividend distribution of one Preferred Share Purchase Right on each outstanding share of the Company's Common Stock. The Rights are exercisable only if a person or group acquires 20% or more of the Company's Common Stock or announces a tender offer which would result in ownership by a person or group of 20% or more of the Common Stock. Each Right initially entitles each shareholder to buy 1/100th of a share of a new series of Preferred Stock at an exercise price of $30.00, subject to adjustment upon certain occurrences. Each 1/100th of a share of such new Preferred Stock that can be purchased upon exercise of a Right has economic terms designed to approximate the value of one share of Common Stock. The Rights will expire on October 29, 2003, unless extended or terminated earlier. The Company has Warrants outstanding which permit holders thereof to purchase 1,244,715 shares of Common Stock at an exercise price of $3.00 per share. The Warrants are noncallable by the Company and expire on October 1, 1996. The exercise price is payable in cash. In March 1992, the Company adopted the 1992 Stock Option Plan under which non- qualified stock options may be granted to key employees and non-employee directors. The aggregate number of shares of Common Stock which the Company may issue under options granted pursuant to this plan may not exceed 10% of the total number of shares outstanding or issuable at the date of grant pursuant to outstanding rights, warrants, convertible or exchangeable securities or other options. The exercise price of an option may not be less than 85% of the fair market value of one share of the Company's Common Stock on the date of grant. During 1992 the Company granted options to 42 employees to purchase a total of 1,740,000 shares of Common Stock at an exercise price of $3.00 per share. During 1993, the Company granted options to 33 employees to purchase a total of 1,525,000 shares of Common Stock at an exercise price of $5.00 per share. The options vest 20% on the date of grant and an additional 20% on each grant anniversary date thereafter. The Company may, in its discretion, grant each optionee a cash bonus upon the exercise of each granted option. At December 31, 1993, there are 1,529,000 options outstanding at an exercise price of $3.00 per share, of which 776,600 are exercisable, and 1,525,000 options outstanding at $5.00 per share, of which 525,000 are exercisable. (11) GAS PURCHASE CONTRACT SETTLEMENT: - -------------------------------------------------------------------------------- On December 17, 1992, the Company and ONEOK, Inc. (ONEOK) agreed to settle the case styled Forest Oil Corporation v. ONEOK, Inc. (Number 71,582) and its companion case styled Forest Oil Corporation v. ONEOK, Inc. (Case No. C-89-53). The cases involved take-or-pay damages relating to a natural gas purchase contract between the Company and ONEOK. The settlement encompassed all disputed contracts, claims and future claims. The cash proceeds of $51,250,000 were received by the Company on December 24, 1992. Proceeds after deducting related royalties and production taxes were approximately $36,429,000. The ONEOK settlement increased the Company's net earnings for 1992 by approximately $24,043,000 or $1.75 per share. (12) RESTRUCTURING: - -------------------------------------------------------------------------------- Restructuring expense in 1991 of approximately $3,585,000 related to reductions in workforce and a consolidation of the Company's technical staff, reduced by a credit recognized upon curtailment of the Company's defined benefit pension plan. (13) EMPLOYEE BENEFITS: - -------------------------------------------------------------------------------- PENSION PLANS: The Company has a qualified defined benefit pension plan (Pension Plan). In 1991, in conjunction with its reorganization, the Company effected a curtailment of the Pension Plan pursuant to which all benefit accruals were suspended effective May 31, 1991. As a result of the curtailment, the projected benefit obligation was reduced significantly. Accordingly, the Company recorded a credit to restructuring expense of $806,000 in accordance with Statement of Financial Accounting Standards No. 88. The benefits under the Pension Plan are based on years of service and the employee's average compensation during the highest consecutive sixty-month period in the fifteen years prior to retirement. The Company's funding policy has been to contribute annually an amount in excess of the minimum required by Federal regulations. No contribution was made in 1993, 1992 or 1991. The following table sets forth the Pension Plan's funded status and amounts recognized in the Company's consolidated financial statements at December 31: For 1993 the discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% and the expected long-term rate of return on assets was 9%. The discount rate used in determining the actuarial present value of the projected benefit obligation was 9% and the expected long- term rate of return on assets was 9% for both 1992 and 1991. (13) EMPLOYEE BENEFITS (cont'd): - ------------------------------------------------------------------------------- In 1990, the Company adopted a non-qualified unfunded supplementary retirement plan that provides certain officers with defined retirement benefits in excess of qualified plan limits imposed by Federal tax law. Benefit accruals under this plan were suspended effective May 31, 1991 in connection with suspension of benefit accruals under the Company's Pension Plan. At December 31, 1993 the projected benefit obligation under this plan totaled $493,000, which is included in other liabilities in the accompanying balance sheet. The projected benefit obligation is determined using the same discount rate as is used for calculations for the Pension Plan. As a result of the change in the discount rate for the Pension Plan and the supplementary retirement plan, the Company recorded a liability of $3,038,000 representing the unfunded pension liability and a corresponding decrease in capital surplus. RETIREMENT SAVINGS PLAN: The Company sponsors a qualified tax deferred savings plan in accordance with the provisions of Section 401(k) of the Internal Revenue Code. Employees may defer up to 10% of their compensation, subject to certain limitations. The Company matches the employee contributions up to 5% of employee compensation. In 1993, 1992 and 1991, Company contributions were made using treasury stock. The expense associated with the Company's contribution was $367,000 in 1993, $454,000 in 1992 and $492,000 in 1991. Effective January 1, 1992 the plan was amended to include profit-sharing contributions by the Company. The Company's profit-sharing contributions were made using Company stock valued at $276,000 and $465,000 for 1993 and 1992, respectively. ANNUAL INCENTIVE PLAN: The Forest Oil Corporation Annual Incentive Plan (the Incentive Plan), which became effective January 1, 1992, permits participating employees to earn annual bonus awards payable in cash or in whole shares of the Company's Common Stock, generally based in part upon the Company attaining certain levels of performance. In 1993 and 1992, the Company accrued bonuses of $426,000 and $930,000, respectively, under the Incentive Plan. Amounts awarded will be disbursed in equal annual installments over the succeeding three-year period. EXECUTIVE RETIREMENT AGREEMENTS: The Company entered into Agreements in December 1990 (the Agreements) with certain executives and directors (the Retirees) whereby each executive retired from the employ of the Company as of December 28, 1990. Pursuant to the terms of the Agreements, the Retirees are entitled to receive supplemental retirement payments from the Company in addition to the amounts to which they are entitled under the Company's retirement plan. In addition, the Retirees and their spouses are entitled to lifetime coverage under the Company's group medical and dental plans, tax and other financial services, and payments by the Company in connection with certain club membership dues. The Retirees will also continue to participate in the Company's royalty bonus program until December 31, (13) EMPLOYEE BENEFITS (cont'd): - ------------------------------------------------------------------------------- 1995. The Company has also agreed to maintain certain life insurance policies in effect at December 1990, for the benefit of each of the Retirees. Six of the Retirees have subsequently resigned as directors. One of the Retirees continues to serve as a director and will be paid the customary non- employee director's fee. Pursuant to the terms of the retirement agreements, the former directors and any other Retiree who ceases to be a director (or his spouse) will be paid $2,500 a month until December 2000. The Company's obligation to one retiree under a revised retirement agreement is payable in Common Stock or cash, at the Company's option, in May of each year from 1993 through 1996 at approximately $190,000 per year with the balance ($149,000) payable in May 1997. The retirement agreements for the other six Retirees, one of whom received in 1991 the payments scheduled to be made in 1999 and 2000, provide for supplemental retirement payments totalling approximately $938,400 per year through 1998 and approximately $740,400 per year in 1999 and 2000. The present value of the amounts due under the agreements discounted at an annual rate of 13% has been recorded as retirement benefits payable to executives and directors. LIFE INSURANCE: The Company provides life insurance benefits for certain key employees and retirees under split dollar life insurance plans. The premiums paid for the life insurance policies were $861,000, $995,000, and $1,534,000 in 1993, 1992 and 1991, respectively, including $766,000, $765,000, and $1,335,000 paid for policies for retired executives. Under the split dollar life insurance plans, the Company was assigned a portion of the benefits payable under the policies which were generally designed to recover the premiums paid by the Company as well as any bonuses paid to the employees and retirees in connection with the policies. In December 1991 the Company replaced the existing policies with new, lower cost policies which provide the same death benefits to the employees and retirees. The Company is assigned a portion of the benefits which is designed to recover the premiums paid. As a result of the change in policies, the Company was able to receive 100% of the cash surrender value of the old policies, net of outstanding policy loans. The net cash surrender value of $4,422,000 was received in 1992. HEALTH AND DENTAL INSURANCE: The Company provides health and dental insurance to all of its employees, eligible retirees and eligible dependents. The Company provides these benefits at nominal cost to employees and retirees and recognizes the expense in the year incurred. Effective January 1, 1992, the Company replaced its health and dental plans with new plans which require employees and eligible retirees to contribute an estimated 50% of the cost of dependent coverage. In 1993, 1992 and 1991 the costs of providing these benefits for both active and retired employees totalled $1,350,000, $1,359,000, and $2,111,000, respectively. The 1993 cost includes $993,110 related to 184 participating active employees and 4 employees on long- term disability and $356,890 related to 125 eligible retirees. The 1992 cost includes $1,011,000 related to 183 participating active employees and $348,000 related to 119 eligible retirees. The cost of providing these benefits during 1991 for the 164 eligible retirees are not separable from the costs of providing these benefits for the 182 participating active employees. POSTRETIREMENT BENEFITS: In December 1990, the Financial Accounting Standards Board issued the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," (SFAS No. 106). This statement required the Company to accrue expected costs of providing postretirement benefits to employees, their beneficiaries and covered dependents effective for fiscal years beginning after December 15, 1992. The Company adopted the provisions of SFAS No. 106 in the first quarter of 1993. The estimated accumulated postretirement benefit obligation as of January 1, 1993 was approximately $4,822,000. This amount, reduced by applicable income tax benefits, was charged to operations in the first quarter of 1993 as the cumulative effect of a change in accounting principle. The annual net postretirement benefit cost was approximately $483,000 for 1993. (13) EMPLOYEE BENEFITS (cont'd): - ------------------------------------------------------------------------------- At January 1 and December 31, 1993 the discount rates used in determining the actuarial present value of the accumulated postretirement benefit obligation were 8.5% and 7.5%, respectively. POSTEMPLOYMENT BENEFITS: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). This statement requires the accrual of the estimated cost of certain postemployment benefits provided to former employees. SFAS No. 112 is effective for years beginning after December 15, 1993. The initial effect of applying this statement is to be accounted for as a cumulative effect of a change in accounting principle. The Company has not determined precisely what effect, if any, the adoption of SFAS No. 112 will have on its financial statements, but believes the effect will be immaterial because the Company has already recorded liabilities for many of the affected costs. (14) RELATED PARTY TRANSACTIONS: - ------------------------------------------------------------------------------- The Company uses a real estate complex (the Complex) owned directly or indirectly by certain stockholders and members of the Board of Directors for Company-sponsored seminars, the accommodation of business guests, the housing of personnel attending corporate meetings and for other general business purposes. The Company incurred expenses for its use of the Complex of $635,000 in 1993, $611,000 in 1992, and $691,000 in 1991. The Company has notified the owners that it intends to terminate its annual usage after 1994, and it will pay $600,000 for its 1994 usage and $300,000 as a partial reimbursement of deferred maintenance costs. John F. Dorn resigned as an executive officer and director of the Company in 1993. The Company has agreed to pay John F. Dorn his salary at time of resignation through September 30, 1996. In addition, the Company has provided certain other benefits and services to Mr. Dorn. The present value of the severance package is estimated at $500,000, which amount was recorded as an expense and a liability at December 31, 1993. In March 1994, the Company sold certain non-strategic oil and gas properties for $4,400,000 to an entity controlled by John F. Dorn and another former executive officer of the Company. The Company established the sales price based upon an opinion from an independent third party. The purchasers financed 100% of the purchase price with a loan bearing interest at the rate of prime plus 1%. The loan is secured by a mortgage on the properties and personal guarantees of the purchasers. The Company participated as a lender in the loan in the amount of approximately $800,000. In addition, the Company agreed to subordinate to the other lender its right of payment of principal on default. The purchasers have separately agreed with the Company that certain options to purchase company stock will be cancelled to the extent that the Company's participation in the loan is not repaid in full. Collectively, the purchasers have options to purchase 275,000 shares of the Company's Common Stock at $3.00 per share and 275,000 shares at $5.00 per share. (15) COMMITMENTS AND CONTINGENCIES: - ------------------------------------------------------------------------------- Future rental payments for office facilities and equipment under the remaining terms of noncancelable leases are $2,210,000, $1,324,000 and $130,000 for the years ending December 31, 1994, 1995 and 1996, respectively. Net rental payments applicable to exploration and development activities and capitalized in the oil and gas property accounts aggregated $688,000 in 1993, $874,000 in 1992 and $1,562,000 in 1991. Net rental payments charged to expense amounted to $3,098,000 in 1993, $3,112,000 in 1992 and $2,748,000 in 1991. Rental payments include the short-term lease of vehicles. None of the leases are accounted for as capital leases. The Company, in the ordinary course of business, is a party to various legal actions. In the opinion of management, none of these actions, either individually or in the aggregate, will have a material adverse effect on the financial condition of the Company. (16) FINANCIAL INSTRUMENTS: - ------------------------------------------------------------------------------- Statement of Financial Accounting Standards No. 105 requires certain disclosures about financial instruments with off-balance-sheet risk. The Company is exposed to off-balance-sheet risks associated with energy swap agreements arising from movements in the prices of oil and natural gas and from the unlikely event of non-performance by the counterparty to the swap agreements. In order to hedge against the effects of declines in oil and natural gas prices, the Company enters into energy swap agreements with third parties. In a typical swap agreement, the Company receives the difference between a fixed price per unit of production and a price based on an agreed-upon third party index if the index price is lower. If the index price is higher, the Company pays the difference. The Company's current swaps are settled on a monthly basis. The following table indicates outstanding energy swaps of the Company which were in place at December 31, 1993: Under another agreement (the Option Agreement), the Company paid a premium of $516,000 in conjunction with the closing of the Enron loan agreement. The payment of this premium gives Forest the right to set a floor price of $1.70 per MMBTU on a total of 18.4 BBTU of natural gas over a five year period commencing January 1, 1995. In order to exercise this right to set a floor, the Company must pay an additional premium of 10 cents per MMBTU, effectively setting the floor at $1.60 per MMBTU. The premium of $516,000 related to the Option Agreement was recorded as a long-term asset and will be amortized as a reduction to oil and gas income beginning in 1995 based on the volumes involved. In December 1991, the Financial Accounting Standards Board issued Statement 107, "Disclosures about Fair Value of Financial Instruments." The statement requires disclosure of the estimated fair value of certain on and off-balance sheet financial instruments in the financial statements. The following methods and assumptions were used to estimate the fair value of the Company's financial instruments as of December 31, 1993: CASH AND CASH EQUIVALENTS, ACCOUNTS RECEIVABLES AND ACCOUNTS PAYABLE: The carrying amount of these instruments approximates fair value because of their short maturity. (16) FINANCIAL INSTRUMENTS (cont'd): - -------------------------------------------------------------------------------- PRODUCTION PAYMENT OBLIGATION: The fair value of the Company's production payment obligation has been estimated as approximately $20,433,000 by discounting the projected future cash payments required under the agreement by 12.5%. This rate corresponds to the rate on the Company's recent nonrecourse loan agreement. SENIOR SUBORDINATED NOTES The fair value of the Company's 11 1/4% Subordinated Notes was approximately $112,179,000, based upon quoted market prices for the same or similar issues. ENERGY SWAP AGREEMENTS: The fair value of the Company's energy swap agreements was approximately $508,000, based upon the estimated net amount the Company would receive to terminate the agreements. (17) MAJOR CUSTOMERS: - -------------------------------------------------------------------------------- The Company's sales of oil and natural gas to individual customers which exceeded 10% of the Company's total sales (exclusive of the effects of energy swaps and hedges) were: (19) SUPPLEMENTAL FINANCIAL DATA - OIL AND GAS PRODUCING ACTIVITIES (unaudited): - -------------------------------------------------------------------------------- The following information is presented in accordance with Statement of Financial Accounting Standards No. 69, "Disclosure about Oil and Gas Producing Activities," (SFAS No. 69). (A) COSTS INCURRED IN OIL AND GAS EXPLORATION AND DEVELOPMENT ACTIVITIES - The following costs were incurred in oil and gas exploration and development activities during the three years ended December 31, 1993: (B) AGGREGATE CAPITALIZED COSTS - The aggregate capitalized costs relating to oil and gas activities were incurred as of the date indicated: (19) SUPPLEMENTAL FINANCIAL DATA - OIL AND GAS PRODUCING ACTIVITIES (unaudited) (cont'd) - -------------------------------------------------------------------------------- (C) RESULTS OF OPERATIONS FROM PRODUCING ACTIVITIES - Results of operations from producing activities for 1993, 1992 and 1991 are presented below. Income taxes are different from income taxes shown in the Consolidated Statements of Operations because this table excludes general and administrative and interest expense. (19) SUPPLEMENTAL FINANCIAL DATA - OIL AND GAS PRODUCING ACTIVITIES (unaudited) (cont'd): - -------------------------------------------------------------------------------- (D) ESTIMATED PROVED OIL AND GAS RESERVES - The Company's estimate of its proved and proved developed future net recoverable oil and gas reserves and changes for 1991, 1992 and 1993 follows. Such estimates are inherently imprecise and may be subject to substantial revisions. Proved oil and gas reserves are the estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions; i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided only by contractual arrangement, including energy swap agreements (see Note 16), but not on escalations based on future conditions. The Company has decreased these quantities for overproduced volumes recognized as revenue, as discussed in Note 1. The reserve volumes include quantities subject to volumetric production payments discussed in Note 7. Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Additional oil and gas expected to be obtained through the application of fluid injection or other improved mechanisms of primary recovery are included as "proved developed reserves" only after testing by a pilot project or after the operation of an installed program has confirmed through production response that increased recovery will be achieved. Purchases of reserves in place represent volumes recorded on the closing dates of the acquisitions for financial accounting purposes. (19) SUPPLEMENTAL FINANCIAL DATA - OIL AND GAS PRODUCING ACTIVITIES (unaudited) (cont'd): - -------------------------------------------------------------------------------- (D) ESTIMATED PROVED OIL AND GAS RESERVES (cont'd) (E) STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS - The standardized measure of discounted net cash flows is calculated in accordance with the provisions of SFAS No. 69. Future oil and gas sales and production and development costs have been estimated using prices and costs in effect at the end of the years indicated, except in those instances where the sale of oil and natural gas is covered by contracts, energy swap agreements or volumetric production payments. In the case of contracts, the applicable contract prices, including fixed and determinable escalations, were used for the duration of the contract. Thereafter, the current spot price was used. Prior to December 31, 1993 the contracts included natural gas sales contracts with a Company which is involved in Chapter 11 bankruptcy proceedings. At December 31, 1993 the volumes applicable to this contract were priced at spot prices. Future oil and gas sales include the estimated effects of existing energy swap agreements and the volumetric production payments, as discussed in Notes 7 and 16, and have been reduced for overproduced volumes recognized as revenue, as discussed in Note 1. Future income tax expenses are estimated using the statutory tax rate of 35%. Estimates for future general and administrative and interest expenses have not been considered. Changes in the demand for oil and natural gas, inflation and other factors make such estimates inherently imprecise and subject to substantial revision. This table should not be construed to be an estimate of the current market value of the Company's proved reserves. Management does not rely upon the information that follows in making investment decisions. Undiscounted future income tax expense in the United States was $35,028,000 at December 31, 1993 and $32,718,000 at December 31, 1992. (19) SUPPLEMENTAL FINANCIAL DATA - OIL AND GAS PRODUCING ACTIVITIES (unaudited) (cont'd): - -------------------------------------------------------------------------------- (E) STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS (cont'd) CHANGES IN THE STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES - An analysis of the decrease during each of the last three years of the total standardized measure of discounted future net cash flows is as follows: PART III For information concerning Item 10 Item 10 - Executive Officers of Registrant, see Part I - Item 4A. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a).(1) FINANCIAL STATEMENTS 1. Independent Auditors' Report 2. Consolidated Balance Sheets - December 31, 1993 and 1992 3. Consolidated Statements of Operations - Years ended December 31, 1993, 1992 and 1991 4. Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 5. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 6. Notes to Consolidated Financial Statements - Years ended December 31, 1993, 1992 and 1991 (2) FINANCIAL STATEMENT SCHEDULES 1. Independent Auditors' Report 2. Schedule V: Property and Equipment - Years ended December 31, 1993, 1992 and 1991 3. Schedule VI: Accumulated Depreciation, Depletion and Valuation Allowance of Property and Equipment - Years ended December 31, 1993, 1992 and 1991 4. Schedule X: Supplementary Operating Statement Information - Years ended December 31, 1993, 1992 and 1991 Financial statement schedules omitted: All other schedules have been omitted because the information is either not required or is set forth in the financial statements or the notes thereto. (3) Exhibits - Forest shall, upon written request to Daniel L. McNamara, Corporate Secretary of Forest, addressed to Forest Oil Building, Bradford, Pennsylvania 16701, provide copies of each of the following Exhibits: Exhibit 3(i) Restated Certificate of Incorporation of Forest Oil Corporation dated October 14, 1993, incorporated herein by reference to Exhibit 3(i) to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 3(ii) Restated By-Laws of Forest Oil Corporation as of May 9, 1990, Amendment No. 1 to By-Laws dated as of April 2, 1991, Amendment No. 2 to By-Laws dated as of May 8, 1991, Amendment No. 3 to By-Laws dated as of July 30, 1991, Amendment No. 4 to By-Laws dated as of January 17, 1992, Amendment No. 5 to By-Laws dated as of March 18, 1993 and Amendment No. 6 to By-Laws dated as of September 14, 1993, incorporated herein by reference to Exhibit 3(ii) to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 3(ii)(a) Amendment No. 7 to By-Laws dated as of December 3, 1993. Exhibit 3(ii)(b) Amendment No. 8 to By-Laws dated as of February 24, 1994. Exhibit 4.1 Indenture dated as of September 8, 1993 between Forest Oil Corporation and Shawmut Bank Connecticut, National Association, incorporated herein by reference to Exhibit 4.1 to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 4.2 Credit Agreement dated as of December 1, 1993 between Forest Oil Corporation and Subsidiary Borrowers and Subsidiary Guarantors and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.3 Amendment No. 1 dated as of December 28, 1993 relating to Exhibit 4.2 hereof. Exhibit 4.4 Amendment No. 2 dated as of January 27, 1994 relating to Exhibit 4.2 hereof. Exhibit 4.5 Security Agreement dated as of December 1, 1993 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.6 Deed of Trust, Mortgage, Security Agreement, Assignment of Production, Financing Statement (Personal Property including Hydrocarbons), and Fixture Filing dated as of December 1, 1993 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.7 Loan Agreement between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership dated as of December 28, 1993, incorporated herein by reference to Exhibit 4.1 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.8 Deed of Trust, Assignment of Production, Security Agreement and Financing Statement dated as of December 28, 1993 by and between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership, incorporated herein by reference to Exhibit 4.2 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.9 Act of Mortgage, Assignment of Production, Security Agreement and Financing Statement dated as of December 28, 1993 between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership, incorporated herein by reference to Exhibit 4.3 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.10 Warrant Agreement dated as of December 3, 1991 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as Warrant Agent (including Form of Warrant), incorporated herein by reference to Exhibit 4.7 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). Exhibit 4.11 Rights Agreement between Forest Oil Corporation and Mellon Securities Trust Company, as Rights Agent dated as of October 14, 1993, incorporated herein by reference to Exhibit 4.3 to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). No other instruments regarding long-term debt are filed because the amount of the securities authorized thereunder do not, in any case, exceed 10% of the total assets of Forest Oil Corporation on a consolidated basis, but a copy of such instruments will be furnished to the Commission upon request. +Exhibit 10.1 Description of Employee Overriding Royalty Bonuses, incorporated herein by reference to Exhibit 10.1 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.2 Description of Executive Life Insurance Plan, incorporated herein by reference to Exhibit 10.2 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.3 Form of non-qualified Deferred Compensation Agreement, incorporated herein by reference to Exhibit 10.3 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.4 Form of non-qualified Supplemental Executive Retirement Plan, incorporated herein by reference to Exhibit 10.4 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.5 Form of Executive Retirement Agreement, incorporated herein by reference to Exhibit 10.5 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.6 Forest Oil Corporation 1992 Stock Option Plan and Option Agreement, incorporated herein by reference to Exhibit 10.7 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.7 Letter Agreement with Richard B. Dorn relating to a revision to Exhibit 10.5 hereof, incorporated herein by reference to Exhibit 10.11 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.8 Forest Oil Corporation Annual Incentive Plan effective as of January 1, 1992, incorporated herein by reference to Exhibit 10.8 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1992 (File No. 0-4597). +Exhibit 10.9 Form of Executive Severance Agreement. +Exhibit 10.10 Form of Settlement Agreement and General Release between John F. Dorn and Forest Oil Corporation dated March 7, 1994. Exhibit 11 Forest Oil Corporation and Subsidiaries - Calculation of Earnings per Share of Common Stock. Exhibit 24 Independent Auditors' Consent. Exhibit 25 Powers of Attorney of the following Officers and Directors: Donald H. Anderson, Austin M. Beutner, Robert S. Boswell, Richard J. Callahan, Dale F. Dorn, John C. Dorn, William L. Dorn, Harold D. Hammar, David H. Keyte, James H. Lee, Daniel L. McNamara, Jeffrey W. Miller, Jack D. Riggs and Michael B. Yanney. Exhibit 28 Form 11-K of the Thrift Plan of Forest Oil Corporation for the year ended December 31, 1993. Filed with this report. *To be filed by amendment. + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) of this report. (b). REPORTS ON FORM 8-K The following reports on Form 8-K were filed by Forest during the last quarter of 1993: SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FOREST OIL CORPORATION (Registrant) Date: March 28, 1994 By: /s/ Daniel L. McNamara -------------------------------- Daniel L. McNamara Secretary 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 in the capacities and on the dates indicated. SIGNATURES TITLE DATE ---------- ----- ---- William L. Dorn Chairman of the Board and March 28, 1994 (William L. Dorn) Chief Executive Officer (Principal Executive Officer) Robert S. Boswell* President and Chief Financial Officer March 28, 1994 (Robert S. Boswell) (Principal Financial Officer) David H. Keyte* Vice President and Chief Accounting March 28, 1994 (David H. Keyte) Officer (Principal Accounting Officer) Donald H. Anderson* (Donald H. Anderson) Austin M. Beutner* (Austin M. Beutner) Robert S. Boswell* (Robert S. Boswell) Directors of the Registrant March 28, 1994 Richard J. Callahan* (Richard J. Callahan) Dale F. Dorn* (Dale F. Dorn) John C. Dorn* (John C. Dorn) SIGNATURES TITLE DATE ---------- ----- ---- William L. Dorn* (William L. Dorn) Harold D. Hammar* (Harold D. Hammar) James H. Lee* (James H. Lee) Directors of the Registrant March 28, 1994 Jeffrey W. Miller* (Jeffrey W. Miller) Jack D. Riggs* (Jack D. Riggs) Michael B. Yanney* (Michael B. Yanney) By /s/ Daniel L. McNamara March 28, 1994 ----------------------------- Daniel L. McNamara (as attorney-in-fact for each of the persons indicated) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Forest Oil Corporation: Under date of February 22, 1994, we reported on the consolidated balance sheets of Forest Oil Corporation and subsidaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we have also audited the related financial statement schedules V, VI, and X. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audit. In our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 8 and 13 to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits. KPMG PEAT MARWICK Denver, Colorado February 22, 1994 SCHEDULE V FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Property and Equipment Years ended December 31, 1993, 1992 and 1990 (In Thousands) SCHEDULE VI FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Accumulated Depreciation, Depletion and Valuation Allowance of Property and Equipment Years ended December 31, 1993, 1992 and 1991 (In Thousands) SCHEDULE X FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 Other supplementary income statement information required by Rule 12-11 is not presented because the required item does not exceed 1 percent of total sales and revenues reported in the related income statement, except for maintenance and repair costs included in the Company's oil and gas production expense. Such maintenance and repair costs cannot be distinguished from other components of lease operating expense. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a).(1) FINANCIAL STATEMENTS 1. Independent Auditors' Report 2. Consolidated Balance Sheets - December 31, 1993 and 1992 3. Consolidated Statements of Operations - Years ended December 31, 1993, 1992 and 1991 4. Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 5. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 6. Notes to Consolidated Financial Statements - Years ended December 31, 1993, 1992 and 1991 (2) FINANCIAL STATEMENT SCHEDULES 1. Independent Auditors' Report 2. Schedule V: Property and Equipment - Years ended December 31, 1993, 1992 and 1991 3. Schedule VI: Accumulated Depreciation, Depletion and Valuation Allowance of Property and Equipment - Years ended December 31, 1993, 1992 and 1991 4. Schedule X: Supplementary Operating Statement Information - Years ended December 31, 1993, 1992 and 1991 Financial statement schedules omitted: All other schedules have been omitted because the information is either not required or is set forth in the financial statements or the notes thereto. (3) Exhibits - Forest shall, upon written request to Daniel L. McNamara, Corporate Secretary of Forest, addressed to Forest Oil Building, Bradford, Pennsylvania 16701, provide copies of each of the following Exhibits: Exhibit 3(i) Restated Certificate of Incorporation of Forest Oil Corporation dated October 14, 1993, incorporated herein by reference to Exhibit 3(i) to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 3(ii) Restated By-Laws of Forest Oil Corporation as of May 9, 1990, Amendment No. 1 to By-Laws dated as of April 2, 1991, Amendment No. 2 to By-Laws dated as of May 8, 1991, Amendment No. 3 to By-Laws dated as of July 30, 1991, Amendment No. 4 to By-Laws dated as of January 17, 1992, Amendment No. 5 to By-Laws dated as of March 18, 1993 and Amendment No. 6 to By-Laws dated as of September 14, 1993, incorporated herein by reference to Exhibit 3(ii) to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 3(ii)(a) Amendment No. 7 to By-Laws dated as of December 3, 1993. Exhibit 3(ii)(b) Amendment No. 8 to By-Laws dated as of February 24, 1994. Exhibit 4.1 Indenture dated as of September 8, 1993 between Forest Oil Corporation and Shawmut Bank Connecticut, National Association, incorporated herein by reference to Exhibit 4.1 to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). Exhibit 4.2 Credit Agreement dated as of December 1, 1993 between Forest Oil Corporation and Subsidiary Borrowers and Subsidiary Guarantors and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.3 Amendment No. 1 dated as of December 28, 1993 relating to Exhibit 4.2 hereof. Exhibit 4.4 Amendment No. 2 dated as of January 27, 1994 relating to Exhibit 4.2 hereof. Exhibit 4.5 Security Agreement dated as of December 1, 1993 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.6 Deed of Trust, Mortgage, Security Agreement, Assignment of Production, Financing Statement (Personal Property including Hydrocarbons), and Fixture Filing dated as of December 1, 1993 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as agent. Exhibit 4.7 Loan Agreement between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership dated as of December 28, 1993, incorporated herein by reference to Exhibit 4.1 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.8 Deed of Trust, Assignment of Production, Security Agreement and Financing Statement dated as of December 28, 1993 by and between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership, incorporated herein by reference to Exhibit 4.2 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.9 Act of Mortgage, Assignment of Production, Security Agreement and Financing Statement dated as of December 28, 1993 between Forest Oil Corporation and Joint Energy Development Investments Limited Partnership, incorporated herein by reference to Exhibit 4.3 to Form 8-K for Forest Oil Corporation dated December 30, 1993 (File No. 0-4597). Exhibit 4.10 Warrant Agreement dated as of December 3, 1991 between Forest Oil Corporation and The Chase Manhattan Bank (National Association), as Warrant Agent (including Form of Warrant), incorporated herein by reference to Exhibit 4.7 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). Exhibit 4.11 Rights Agreement between Forest Oil Corporation and Mellon Securities Trust Company, as Rights Agent dated as of October 14, 1993, incorporated herein by reference to Exhibit 4.3 to Form 10-Q for Forest Oil Corporation for the quarter ended September 30, 1993 (File No. 0-4597). No other instruments regarding long-term debt are filed because the amount of the securities authorized thereunder do not, in any case, exceed 10% of the total assets of Forest Oil Corporation on a consolidated basis, but a copy of such instruments will be furnished to the Commission upon request. +Exhibit 10.1 Description of Employee Overriding Royalty Bonuses, incorporated herein by reference to Exhibit 10.1 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.2 Description of Executive Life Insurance Plan, incorporated herein by reference to Exhibit 10.2 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.3 Form of non-qualified Deferred Compensation Agreement, incorporated herein by reference to Exhibit 10.3 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.4 Form of non-qualified Supplemental Executive Retirement Plan, incorporated herein by reference to Exhibit 10.4 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.5 Form of Executive Retirement Agreement, incorporated herein by reference to Exhibit 10.5 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1990 (File No. 0-4597). +Exhibit 10.6 Forest Oil Corporation 1992 Stock Option Plan and Option Agreement, incorporated herein by reference to Exhibit 10.7 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.7 Letter Agreement with Richard B. Dorn relating to a revision to Exhibit 10.5 hereof, incorporated herein by reference to Exhibit 10.11 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1991 (File No. 0-4597). +Exhibit 10.8 Forest Oil Corporation Annual Incentive Plan effective as of January 1, 1992, incorporated herein by reference to Exhibit 10.8 to Form 10-K for Forest Oil Corporation for the year ended December 31, 1992 (File No. 0-4597). +Exhibit 10.9 Form of Executive Severance Agreement. +Exhibit 10.10 Form of Settlement Agreement and General Release between John F. Dorn and Forest Oil Corporation dated March 7, 1994. Exhibit 11 Forest Oil Corporation and Subsidiaries - Calculation of Earnings per Share of Common Stock. Exhibit 24 Independent Auditors' Consent. Exhibit 25 Powers of Attorney of the following Officers and Directors: Donald H. Anderson, Austin M. Beutner, Robert S. Boswell, Richard J. Callahan, Dale F. Dorn, John C. Dorn, William L. Dorn, Harold D. Hammar, David H. Keyte, James H. Lee, Daniel L. McNamara, Jeffrey W. Miller, Jack D. Riggs and Michael B. Yanney. Exhibit 28 Form 11-K of the Thrift Plan of Forest Oil Corporation for the year ended December 31, 1993. Filed with this report. *To be filed by amendment. + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) of this report. (b). REPORTS ON FORM 8-K The following reports on Form 8-K were filed by Forest during the last quarter of 1993: SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FOREST OIL CORPORATION (Registrant) Date: March 28, 1994 By: /s/ Daniel L. McNamara -------------------------------- Daniel L. McNamara Secretary 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 in the capacities and on the dates indicated. SIGNATURES TITLE DATE ---------- ----- ---- William L. Dorn Chairman of the Board and March 28, 1994 (William L. Dorn) Chief Executive Officer (Principal Executive Officer) Robert S. Boswell* President and Chief Financial Officer March 28, 1994 (Robert S. Boswell) (Principal Financial Officer) David H. Keyte* Vice President and Chief Accounting March 28, 1994 (David H. Keyte) Officer (Principal Accounting Officer) Donald H. Anderson* (Donald H. Anderson) Austin M. Beutner* (Austin M. Beutner) Robert S. Boswell* (Robert S. Boswell) Directors of the Registrant March 28, 1994 Richard J. Callahan* (Richard J. Callahan) Dale F. Dorn* (Dale F. Dorn) John C. Dorn* (John C. Dorn) SIGNATURES TITLE DATE ---------- ----- ---- William L. Dorn* (William L. Dorn) Harold D. Hammar* (Harold D. Hammar) James H. Lee* (James H. Lee) Directors of the Registrant March 28, 1994 Jeffrey W. Miller* (Jeffrey W. Miller) Jack D. Riggs* (Jack D. Riggs) Michael B. Yanney* (Michael B. Yanney) *By /s/ Daniel L. McNamara March 28, 1994 ----------------------------- Daniel L. McNamara (as attorney-in-fact for each of the persons indicated) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Forest Oil Corporation: Under date of February 22, 1994, we reported on the consolidated balance sheets of Forest Oil Corporation and subsidaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we have also audited the related financial statement schedules V, VI, and X. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audit. In our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 8 and 13 to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits. KPMG PEAT MARWICK Denver, Colorado February 22, 1994 SCHEDULE V FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Property and Equipment Years ended December 31, 1993, 1992 and 1990 (In Thousands) SCHEDULE VI FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Accumulated Depreciation, Depletion and Valuation Allowance of Property and Equipment Years ended December 31, 1993, 1992 and 1991 (In Thousands) SCHEDULE X FOREST OIL CORPORATION AND CONSOLIDATED SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 Other supplementary income statement information required by Rule 12-11 is not presented because the required item does not exceed 1 percent of total sales and revenues reported in the related income statement, except for maintenance and repair costs included in the Company's oil and gas production expense. Such maintenance and repair costs cannot be distinguished from other components of lease operating expense.	25,573	167,328
2488_1993.txt	2488_1993	1993	2488	ITEM 1. BUSINESS GENERAL Advanced Micro Devices, Inc. was incorporated under the laws of the state of Delaware on May 1, 1969. The mailing address of its executive offices is One AMD Place, P.O. Box 3453, Sunnyvale, California 94088-3453, and its telephone number is (408) 732-2400. Unless otherwise indicated, the terms "Advanced Micro Devices," the "Corporation" and "AMD" in this report refer to Advanced Micro Devices, Inc. and its subsidiaries. The Corporation designs, develops, manufactures and markets complex monolithic integrated circuits for use by manufacturers of a broad range of electronic equipment and systems. PRODUCTS The Corporation's products are primarily standard or catalog items or are made from designs based on such items, as opposed to custom circuits designed for a single customer. While a substantial portion of AMD's products are still standard or catalog items, many of the recently developed devices are designed for specific applications such as telecommunications, personal computers, engineering workstations, optical disk memory or local area networks. As a service to major customers, the Corporation modifies portions of these application-specific devices to meet specific customer needs. The resulting "semi-standard" devices are produced in significant volumes for particular customers. The Corporation began as an alternate-source manufacturer of integrated circuits originally developed by other suppliers and has gradually shifted its emphasis to proprietary products (i.e. products resulting from the Corporation's design or technology innovations). Over the past five years, the Corporation has made a significant research and development investment which has contributed toward its leadership in manufacturing and process technology within the integrated circuit industry. The Corporation has focused its future product development activities on the three areas of its business: X86 and other microprocessors and related peripheral chips for personal computers, applications solutions products, and programmable logic and non-volatile memory devices. Personal computer (PC) products include microprocessors and related peripheral chips used in computers. Applications solutions products are products which are either proprietary to AMD or have a limited supplier base, are targeted at specialized markets, and typically require substantial applications interface between AMD and its customers. AMD's applications solutions products are focused on networks, voice/data communications (WORLD NETWORK(Registered Trademark)), and on computer peripherals, computer interfaces and mass storage. Those programmable logic devices (PLDs) and memory devices that are high-volume commodity products are typically produced by more than one manufacturer, subject to intense competition, and broadly applicable across a wide customer base. Since a substantial portion of the Corporation's products are utilized in personal computers and related peripherals, the Corporation's future growth is closely tied to the performance of the PC industry. Integrated circuits have generally been manufactured with either bipolar or metal-oxide semiconductor (MOS) process technologies. Historically, bipolar was the technology of choice where the highest speed or analog precision was needed, and MOS offered higher levels of integration and lower power consumption than bipolar. Advances in complementary metal-oxide semiconductor (CMOS) technology are yielding bipolar performance with the density and power advantages of MOS technology. Consequently, the Corporation is focusing process development on advanced CMOS technology to support its designated product areas. By the end of 1993, over two-thirds of the Corporation's total sales were derived from CMOS products. Microprocessors X86 Microprocessors. A microprocessor is the central processing unit (CPU) of a computer. A CPU microprocessor processes system data and controls input/output, peripheral and memory devices. A CPU microprocessor may also be used in connection with other microprocessors such as microcontrollers which are embedded microprocessors contained in peripherals or other coprocessors which perform certain functions such as arithmetic calculations. The iAPX architecture, originally developed by Intel Corporation, has been the leading architecture for personal computer microprocessors. AMD's strategy has been to serve as an alternative source for iAPX microprocessors, introducing products at comparable prices to competitive products, but with additional customer-driven features. The Corporation in 1993 entered into a license agreement with Microsoft(Registered Trademark), the personal computer industry's leading supplier of operation systems software, pursuant to which the Microsoft(Registered Trademark) Windows(Trademark) compatible logo now appears on AMD's microprocessor packaging and advertising indicating that the Corporation's product is compatible with such software. This approach is also representative of the computer industry's shift from an emphasis on hardware compatibility to software compatibility. The PC market is currently divided into laptop, personal information devices, desktop and portable varieties, and AMD plays a significant role in such arenas. The Corporation has developed the Am386(Registered Trademark) microprocessor, which is designed to meet the specifications of the Intel 80386 microprocessor. The Am386 family of microprocessors accounted for approximately seventeen percent (17%) of the Corporation's 1993 revenues. The Corporation believes that its success with the Am386 family has been largely due to its competitive features and pricing coupled with customers' demand for a reasonably priced second source. As is often the case in the semiconductor industry, the average selling price of the Am386 has experienced significant downward pressure as it approaches the end of its product life cycle. Most computer manufacturers have made a transition from the 386 to the 486 family of microprocessors. The Corporation now offers a Am486(Trademark) family of products. The Corporation began shipping Am486DX products in the second quarter of 1993, and began volume shipment of its Am486SX products in 1994. The Corporation's 486DX and 486SX products are the subject of microcode litigations with Intel Corporation. (For more information see Item 3, Legal Proceedings, Numbers 2-8). The Corporation is currently in the process of developing additional Am486 products. It is anticipated that development of such 486 products will be completed by the end of 1994. The Corporation is currently developing its next generation of CPU microprocessor products known as the K series, based on superscalar RISC type architecture. The K series products will be compatible with software such as Microsoft(Registered Trademark) Windows(Trademark) currently compatible with the X86 CPU microprocessors. The Corporation anticipates that the development of the first K series products will be completed sometime in late 1994. The Corporation currently offers a family of RISC microprocessors for embedded control applications discussed below. The future outlook for the Corporation's microprocessor products is highly dependent on the timing of new product introductions, the outcome of its various litigation matters with Intel, and other microprocessor market conditions. Applications Solutions Products Computer Systems, Interfaces and Mass Storage. The Corporation offers a range of products which are utilized in a variety of computer systems. Computer systems include a peripheral chip which is a special-purpose component that works with central processing units, managing selected input/output or other system functions. Other systems components control disk drives, keyboards and printers. Through the use of communication peripherals, computers can operate in networks and communicate locally and over long distances. Many of these systems require a high-performance microprocessor for embedded control. The Corporation's proprietary Am29000(Trademark) family of RISC microprocessors is used extensively by a wide range of customers for embedded control applications. Examples of these applications include high-performance laser printer controllers, high-resolution graphics controllers, communications controllers, and accelerator cards. Many manufacturers, such as Motorola, Intel, IDT, National Semiconductor and Texas Instruments offer RISC-based microprocessors which compete with the Am29000 family in certain applications. The Corporation expects that the RISC microprocessor market will continue to grow. The Corporation also supplies a range of products specially designed to add additional functions, improve performance and reduce costs in computer peripheral, interface or mass storage applications. These are generally special-purpose products which are optimized for a specific application and are frequently proprietary products of the Corporation or in the case of selected large customers, products which have been tailored for that customer. Networks and Voice/Data Communications. The Corporation provides a wide variety of products for a broad spectrum of connectivity solutions. These include applications in central office switches, PBX equipment, voice/data terminals, and different performance classes of Local Area Networks (LANs) used to connect workstations and personal computers. In addition to providing the integrated circuits for these applications, the Corporation also provides various forms of hardware evaluation tools, development software and interface software. AMD continues to be a major supplier of Ethernet LAN devices for workstation applications. During 1993, the Corporation introduced several Ethernet products designed for use on Personal Computer motherboards and add-in cards. AMD also is a principal supplier for chip sets to support the 100-megabit-per-second Fiber Distributed Data Interface (FDDI) local area network standard which is primarily used to connect high performance workstations and servers. The Corporation has also developed, in cooperation with systems manufacturers, a family of devices for the 10Base-T standard, which allows transmission of data using Ethernet protocols on twisted-pair wiring, rather than on the more expensive coaxial cable. The Subscriber Line Interface Circuit (SLIC) and the Subscriber Line Audio-Processing Circuit (SLAC(Trademark)), co-invented and manufactured by the Corporation, are an integral part of one of the leading designs for digital telephone switching equipment. The SLIC connects the user's telephone wire to the telephone company's digital switching equipment. The SLAC is a coder/decoder which converts analog voice signals to a digital format and back. The Corporation enjoys its continued success with these products in the European market, and more recently has seen increased demand from nations committed to upgrading their telecommunications infrastructure. High-Volume Commodity Products Programmable Logic Devices (PLDs). The Corporation is a leading supplier of high-speed, field-programmable integrated circuits. PLDs generally afford a user increased design flexibility relative to standard logic devices. The initial design time and design cost in customizing a programmable device is significantly less than designing a custom integrated circuit or customizing a gate array logic device. The Corporation's Programmable Array Logic (PAL(Registered Trademark)) architecture was invented by Monolithic Memories, Inc. (MMI), which was acquired by the Corporation in 1987, and AMD's PAL devices continue to comprise a large share of the worldwide market for field-programmable logic devices. These devices combine off-the-shelf availability, ease of use and the low cost of standard products with a capability for semi-custom design, making them attractive to a broad range of users. The Corporation's PLDs are generally manufactured with transistor-to-transistor logic (TTL) designs in bipolar technology for low-density, high-speed devices, and CMOS for complex architecture, high-density and low-power devices. In the past several years, the Corporation has utilized CMOS technology for lower power and more complex architectures. Programmable devices have generally been manufactured using bipolar technology to provide users with high-speed products. The Corporation offers several products using CMOS technology and has continued to expand its product portfolio in this area. Non-Volatile/Volatile Memories. Memory components are used to store computer programs and data entered during system operation. There are two types of memory storage capability, volatile and non-volatile. Volatile memories include Dynamic and Static Random Access Memories (DRAMs and SRAMs). Non- volatile memories retain data when system power is shut off, while volatile memories do not. Non-volatile memories include Erasable Programmable Read-Only Memories (EPROMs) and the new generation Flash Memory. The Corporation's memory products are primarily non-volatile memories used in a wide range of applications such as PCs, workstations, peripherals, instrumentation, PBX equipment, avionics and a variety of other equipment where programmed data storage is needed. The Corporation now has a complete family of CMOS EPROM devices from 64K (64,000 bits) to 4 megabits (4,000,000 bits) in density. AMD generally offers the highest performance at each density of any standard EPROM supplier. The Corporation has developed a family of Flash EPROMs to address the emerging market for PC memory cards, solid-state disks, cellular communications and networking applications. Flash Memory is a potential alternative to bulky and relatively slow hard-disk drives for PCs because it is smaller, faster and can store data almost indefinitely, yet can be erased, read and programmed efficiently. The Corporation is developing a family of Flash EPROMs to address the demand for PC memory cards, solid-state disks, cellular communications and networking applications. The Corporation's joint venture with Fujitsu Limited (Fujitsu) will allow it to take advantage of expected growth in Flash Memory sales. Under the joint venture, AMD and Fujitsu will jointly manufacture EPROMs and Flash Memory. (See discussion of Joint Venture with Fujitsu Limited below). Joint Venture with Fujitsu Limited. In 1993, AMD and Fujitsu entered into various agreements for a comprehensive collaboration covering joint development, manufacturing and sales of integrated circuits and formed a Joint Venture, Fujitsu AMD Semiconductor Limited (the "Joint Venture"). Through the Joint Venture, AMD expects to further develop its strong position in EPROMs and Flash Memory. Under the Joint Venture, the two companies are cooperating in building and operating an $800 million wafer fabrication facility in Aizu-Wakamatsu, Japan to produce non-volatile memory devices such as EPROMs and Flash Memories. The percentage of the equity of the Joint Venture owned by the Corporation and Fujitsu are 49.95% and 50.05%, respectively (the "Ownership Percentage"). Currently, the primary mission of the Joint Venture is the production of Flash Memory devices. Each company will contribute toward funding and supporting the Joint Venture in proportion to its Ownership Percentage. In 1993, AMD contributed approximately $2 million to the Joint Venture and it anticipates it will make additional contributions in 1994 of approximately $135 million. AMD is expected to contribute approximately one-half of its share of funding in cash as equity investment, and guarantee third party loans made to the Joint Venture for the remaining one-half. Accordingly, each company is obligated to invest up to approximately $200 million as equity in the Joint Venture. As the forecasted Joint Venture costs and funding commitments are denominated in Yen, the dollar amounts involved are subject to change due to fluctuations in exchange rates. The agreements provide that the Joint Venture will borrow funds required for capital investment and working capital purposes which are in excess of the participants' equity contributions. Each participant is obligated to guarantee a portion of such borrowings proportionate to its Ownership Percentage. To the extent that such borrowings cannot be made on the strength of a participant's guarantee, the participant is obligated to make direct cash loans to the Joint Venture. The ability of the Corporation to sell products produced by the Joint Venture into certain territories, including the United Kingdom and Japan, is limited under the terms of the Joint Venture agreement. AMD and Fujitsu will not independently produce EPROM and Flash Memory products with geometries of one-half (0.5) micron and smaller outside of the Joint Venture and thus will not compete with the Joint Venture in such products. Also under the agreement, Fujitsu acquired a minority equity position in AMD and will continue to increase its position over five (5) years. AMD has acquired a minority equity position in Fujitsu. The respective equity investments will be less than five percent of the common stock of each company. The new facility is expected to begin volume production in 1995, and will utilize eight-inch wafers and process technologies capable of producing products with geometries of one-half (0.5) micron and smaller. In connection with the Joint Venture, the Corporation and Fujitsu have entered into various joint development, cross-license and investment arrangements. Accordingly, AMD and Fujitsu will provide their product designs and process and manufacturing technologies to the Joint Venture. In addition, both companies will collaborate in developing manufacturing processes and designing integrated circuits for the Joint Venture. The right of each company to use the licensed intellectual property of the other with respect to certain products is limited to certain geographic areas. Consequently, AMD's ability to sell certain products incorporating Fujitsu intellectual property, whether or not produced by the Joint Venture, is also limited in certain territories, including the United Kingdom and Japan. MARKETING AND SALES Advanced Micro Devices markets and sells its products primarily to original equipment manufacturers of computation and communication equipment. AMD's products are sold under the AMD(Registered Trademark) trademark. The Corporation recently entered into an agreement with Compaq Computer Corporation (Compaq) under which the Corporation will supply Compaq with microprocessor products; however, the agreement does not require Compaq to purchase microprocessor products from the Corporation. The Corporation sells to a broad base of customers; no single customer accounted for more than ten percent (10%) of sales during the fiscal year ended December 26, 1993. Through its principal facilities in Santa Clara County, California, and field offices throughout the United States and abroad (primarily Europe and the Asia-Pacific Basin) the Corporation employs a direct sales force. The Corporation also sells its products through third-party distributors and independent representatives in both domestic and international markets pursuant to nonexclusive agreements. The distributors also sell products manufactured by AMD's competitors, including those products for which the Corporation is an alternate source. Distributors typically maintain an inventory of AMD's products. The Corporation, pursuant to its agreements with the distributors, employs procedures which provide protection to the distributors for their inventory of Advanced Micro Devices' products against price reductions as well as products that are slow moving or have been discontinued by the Corporation. These agreements, which may be cancelled by either party on a specified notice, generally contain a provision for the return of AMD's products to the Corporation in the event the agreement with the distributor is terminated. (See Note 1 of Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders.) Advanced Micro Devices has established sales subsidiaries that have offices in Belgium, Canada, China, France, Germany, Hong Kong, Italy, Japan, Korea, Singapore, Sweden, Switzerland, Taiwan, and the United Kingdom. (See Note 9 of Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders.) The international sales force also works with independent sales representatives and distributors in approximately 30 countries, including, those where Advanced Micro Devices has sales subsidiaries. The Corporation's international sales operations entail political and economic risks including expropriation, currency controls, exchange fluctuations, changes in freight rates, and changes in rates and exemptions for taxes and tariffs. The Corporation has not experienced any material adverse effects associated with such risks. BACKLOG Since Advanced Micro Devices manufactures and markets a standard line of products, a significant portion of its sales are made from inventory on a current basis. Sales are made primarily pursuant to (1) purchase orders for current delivery of standard items, or (2) agreements covering purchases over a period of time, which are frequently subject to revision and cancellation. Generally, in light of current industry practice and experience, the Corporation does not believe that such agreements provide reliable backlog figures. COMPETITION Numerous firms are engaged in the manufacture and sale of integrated circuits competitive with those of the Corporation. Some of these firms have resources greater than those of the Corporation and do not depend upon integrated circuits as their principal source of revenue. There is also significant captive production by certain large users of circuits such as manufacturers of computers, telecommunications equipment and consumer electronics products. The industry typically experiences rapid technological advances together with substantial price reductions in maturing products. After a product is introduced, prices normally decrease over time as production efficiency and competition increase, and a successive generation of products is developed and introduced for sale. According to Dataquest, an industry research firm, during 1993, the Corporation was the fifth-largest independent U.S. manufacturer of integrated circuits, and the thirteenth largest worldwide (excluding IBM), ranked according to sales to unaffiliated customers. Advanced Micro Devices competes for integrated circuit market share with Texas Instruments, Motorola, National Semiconductor, Intel, North American Philips, and with several prominent Japanese firms. These firms include Nippon Electric Co., Hitachi, Toshiba, Fujitsu, Matsushita and Mitsubishi, who are making active efforts to increase their respective and collective worldwide market shares. (For more information concerning Fujitsu, see section Joint Venture with Fujitsu Limited above.) All of the above-mentioned competitors are either substantially larger in both gross sales and in total assets than Advanced Micro Devices or are part of larger corporate enterprises to whose resources, financial and other, the competitors have access. In addition to the above, many other companies dedicated to only one or two process technologies and product types compete with the Corporation in those technologies and product types. RESEARCH AND DEVELOPMENT In keeping with its objective of increasing emphasis on the development of proprietary products while maintaining its role as a high-volume producer of popular designs, Advanced Micro Devices endeavors to manufacture products utilizing advanced technology which is consistently reproducible in an industry where the technology is complex and subject to rapid change. The Corporation directs its research and development efforts towards the advancement of wafer processing technology and the design of new circuits utilizing consistently reproducible advanced technologies. (For information concerning these advances see section Process Technology and Manufacturing below.) The Corporation emphasizes research and development efficiency improvements through the use of computer-aided design workstations and complementary circuit design software. The semiconductor industry is subject to rapid changes in technology and requires a high level of capital spending and extensive research and development programs to maintain the state of the art. The Corporation's expenses for research and development in 1991, 1992 and 1993, were $213,765,000, $227,860,000, and $262,802,000, respectively. Such expenses were 17.4%, 15.0% and 16.0% of sales in 1991, 1992 and 1993, respectively. Advanced Micro Devices' research and development expenses are charged to operations as incurred. Most of the research and development personnel are integrated into the engineering staff. PROCESS TECHNOLOGY AND MANUFACTURING Monolithic integrated circuits are manufactured from a circuit layout separated into layers that are produced on photomasks (working plates). The actual production of the integrated circuit includes wafer fabrication, wafer sort, assembly and final test. The semiconductor industry is increasingly process-based, meaning that the advance of semiconductor technology requires the ability to develop new design and manufacturing processes. The process technologies generally utilized in the manufacture of integrated circuits are bipolar and metal-oxide semiconductor (MOS). CMOS products require less power than circuits built with other processes, such as bipolar or N-MOS (N-channel MOS). In addition, CMOS technology allows for a much broader circuit design capability than NMOS or bipolar and thus CMOS designs are displacing both NMOS and bipolar product designs. The advances and advantages of CMOS technology have created an increased demand for products manufactured with CMOS processes. During 1993, over two-thirds of the Corporation's total sales were derived from CMOS products. With advances in CMOS processing technology and the continued erosion of demand for products manufactured with bipolar technology, the Corporation has significantly streamlined its wafer fabrication capacity by restructuring its manufacturing capabilities from an emphasis on bipolar process technology to an emphasis on CMOS process technology. The Corporation is primarily a CMOS manufacturer and has achieved cost-effective production in its Submicron Development Center (SDC) which was completed in 1991 and continues to be improved to incorporate more advanced technology. Am386 microprocessors have been produced using 0.8-micron CMOS technology, and the vast majority of AMD's manufacturing capacity is now sub-micron CMOS. In 1993, the Corporation began to prepare the SDC for the anticipated demand for its Am486 microprocessor family and its 5-volt Flash Memory through the investment of additional funds in 1993, bringing the total investment in the SDC to more than $360 million in 1993, and it is estimated to reach approximately $460 million in 1994. AMD has developed different base processes that are optimized for logic, memory and programmable logic designs. Having process expertise which is reproducible across different product designs allows AMD to bring new and improved designs quickly into production. The Corporation's capital commitment to improvements in process technology has led to reductions in feature size and defect densities, which in turn result in the higher transistor count, speed, functionality and power efficiency of AMD's integrated circuits. In 1993, the Corporation continued building development versions of 0.7-micron triple-layer metal logic products and memory devices with 0.5-micron feature sizes, and researched patterning methods that will eventually produce 0.25-micron feature sizes. In 1993, the Corporation also began shipment of 0.7-micron triple-layer metal logic products (Am486). In addition, 0.5 micron feature size logic and memory devices are in the final stages of development. Research is also being carried out on process and patterning methods to produce 0.35-micron and 0.25-micron feature size devices. Product design and development and wafer fabrication activities are currently conducted at Advanced Micro Devices' facilities in California and in Texas. A subsidiary of Sony Corporation manufactures bipolar products for the Corporation in San Antonio, Texas, using equipment owned by the Corporation. Nearly all product assembly and final testing is performed at the Corporation's manufacturing facilities in Penang, Malaysia; Singapore; and Bangkok, Thailand, or by subcontractors in Asia. A limited amount of testing of products destined for delivery in Europe and Asia is performed at the Corporation's facilities in Basingstoke, England. Foreign manufacture entails political and economic risks, including political instability, expropriation, currency controls and fluctuations, changes in freight rates and in interest rates, and exemptions for taxes and tariffs. For example, if the Corporation were not able to assemble and test its products abroad, or if air transportation between the United States and these facilities were disrupted, there could be a material adverse effect on the Corporation's operations. The Corporation has not experienced any material adverse effects associated with such risks. In July 1993, the Corporation commenced construction of its 700,000 square foot submicron semiconductor manufacturing facility in Austin, Texas (FAB 25). The Corporation estimates that the cost of this facility will be approximately $1 billion when fully equipped. The Corporation anticipates the facility will commence volume production in 1995. The Corporation has also recently entered in to an agreement with Digital Equipment Corporation (DEC(Registered Trademark)) under which DEC will provide a foundry in Queensferry, Scotland, for production of the Corporation's Am486 products; however, under the terms of such arrangement both parties have certain rights to terminate this relationship earlier, in the event of adverse developments in the Corporation's litigations with Intel. DEC will produce wafers for the Corporation in the Queensferry foundry utilizing an adaptation of DEC's 0.68-micron process technology. A major portion of the Corporation's current effort in both process technology and circuit design is directed toward the development of large scale integration products for microprocessor, programmable logic and memory applications. The Corporation has entered into a strategic alliance with Hewlett-Packard Corporation to collaborate on the development of advanced process technology that will enable the Corporation to produce microprocessors and logic devices with 0.35 micron CMOS logic technology. The Corporation anticipates the technology will be developed by the end of 1995 and that the production of such products will commence sometime in 1996. The Corporation is also placing emphasis on the development of CMOS non-volatile memories, programmable logic and VLSI (Very Large Scale Integration) logic products and specialized circuits for the telecommunications market. (For information concerning product development refer to the section entitled Products above.) Quality Assurance. The Corporation's long-established quality program has allowed it to achieve one of the highest quality and reliability levels in the industry. This program is led by top management through an Executive Quality Board comprised of senior executives. The Corporation's Total Quality Management (TQM) Program is actuated by Market Driven Quality (MDQ) principles and implemented at all levels within the Corporation. TQM and MDQ principles are applied through team empowerment, and business process technology and manufacturing qualification. The Corporation's proprietary product management methodology starts with detailed analysis of the requirements of developing and supporting a new product, as well as extensive product simulation before production to assure that the finished product meets specifications free of defects. The program uses statistical process control techniques and involves all aspects of the manufacture of AMD products. The Corporation has also implemented leading international quality system standards, has been certified to ISO-9000 standards in its manufacturing operations in Asia, and will soon have a wafer fabrication facility ISO certified. All of the Corporation's facilities follow uniform quality policies set by the Corporation's corporate quality organizations in Sunnyvale, California and in Austin, Texas. Materials and Energy. The principal raw materials used by the Corporation in the manufacture of its products are silicon wafers, processing chemicals and gases, ceramic and plastic packages, and some precious metals. Certain of the raw materials used in the manufacture of circuits are available from a limited number of suppliers in the United States and elsewhere. For example, for several types of the integrated circuit packages that are purchased by Advanced Micro Devices, as well as by the majority of other companies in the semiconductor industry, the principal suppliers are Japanese companies. The Corporation does not generally depend on long-term fixed supply contracts with its suppliers. However, shortages could occur in various essential materials due to interruption of supply or increased demand in the industry. If Advanced Micro Devices were unable to procure certain of such materials from any source, it would be required to reduce its manufacturing operations. To date, the Corporation has experienced no significant difficulty in obtaining the necessary raw materials. The Corporation's operations also depend upon a continuing adequate supply of electricity, natural gas and water. Environmental Regulations. To the Corporation's knowledge, compliance with federal, state and local regulatory provisions enacted or adopted for protection of the environment has had no material effect upon the capital expenditures, earnings or competitive position of Advanced Micro Devices. (See also Item 3, Legal Proceedings, Number 1.) INTELLECTUAL PROPERTY AND LICENSING The Corporation and its subsidiaries have been granted 746 United States patents, and approximately 305 patent applications are pending in the United States. Where appropriate, the Corporation has filed corresponding applications in foreign jurisdictions. The Corporation expects to file future patent applications in both the United States and abroad on significant inventions which may be made by its employees or consultants. Advanced Micro Devices plans to protect its innovations by various means, including litigation where appropriate, and patents and mask work registrations, even though patent and mask work registration protection may not be essential to maintain the Corporation's market position. (See Microprocessors discussed above concerning the Microsoft license.) As is common in the semiconductor industry, from time to time Advanced Micro Devices has been notified that it may be infringing patents issued to others. Such claims are referred to counsel for evaluation and resolution. While patent owners in such instances generally express a willingness to grant a license, the Corporation cannot presently estimate the dollar amount, if any, that might be involved in such disputes. No assurance can be given that all necessary licenses can be obtained on satisfactory terms, nor that litigation may always be avoided. (See also Item 3, Legal Proceedings, Numbers 2-8.) Under a technology exchange agreement and patent cross-license agreement with Intel Corporation, the Corporation manufactures various iAPX products, including the 8051 single-chip microcontroller and the 8086, 8088, 80186, 80286, 80386 and 80486 microprocessors and the 80287, a math co-processor. Certain rights and obligations under the agreements with Intel are currently the subject of litigation between AMD and Intel. (See Item 3, Legal Proceedings, Numbers 2-8). The Corporation has entered into numerous cross-licensing and technology exchange agreements under which it both transfers and receives technology and intellectual property rights. Such arrangements include licenses between the Corporation and Hewlett-Packard Company and Fujitsu Limited. (See information under sections Joint Venture with Fujitsu Limited and Process Technology and Manufacturing above.) EMPLOYEES Attracting and retaining competent employees and motivating them to meet corporate objectives are essential elements of maintaining profitability in the intensely competitive semiconductor industry where such personnel are in high demand. Since its inception in 1969, Advanced Micro Devices has implemented policies designed to create a favorable working environment for its employees. For example, the Corporation makes available stock option and stock purchase plans, pays special bonuses and maintains a profit-sharing program for some or all employees, depending upon the plan or program. (See Note 10 of Notes to Consolidated Financial Statements contained in the 1994 Annual Report to Stockholders.) Like other semiconductor manufacturers, at times the Corporation experiences difficulty in hiring and retaining experienced personnel. The Corporation intends to utilize whatever forms of compensation, benefits and other activities are necessary and cost effective in order to continue to attract and retain the quality of personnel required for its business. On December 26, 1993, Advanced Micro Devices and its subsidiaries employed approximately 12,060 employees. Management considers its employee relations to be very good. Direct communication among all employees and management is encouraged. No employees of Advanced Micro Devices are represented by a collective bargaining agent. ITEM 2. ITEM 2. PROPERTIES The Corporation's principal engineering, manufacturing, warehouse and administrative facilities comprise approximately 2 million square feet and are located in Santa Clara County, California and in Austin, Texas. (See Item 1, Process Technology and Manufacturing and Item 7, Management's Discussion). Over 1.2 million square feet of this space is in buildings owned by the Corporation. Of these properties, approximately 264,300 square feet is subject to a mortgage with a remaining term of up to fourteen years. In 1992, the Corporation entered into certain operating leases and an arrangement for the purchase of certain property containing a building with approximately 318,000 square feet, located on 45.6 acres of land in Sunnyvale, California (One AMD Place). The Corporation intends to utilize One AMD Place for its corporate sales, marketing and administrative offices upon completion of alterations to the building in 1994. This arrangement provides the Corporation with the option to purchase One AMD Place during the lease term, and at the end of the lease term the Corporation is obligated to either purchase One AMD Place or arrange for the sale of One AMD Place to a third party with a guarantee of residual value to the seller of One AMD Place. In 1993, the Corporation entered into a lease agreement for approximately 175,000 square feet located adjacent to One AMD Place to be used in connection with One AMD Place. The Corporation also owns or leases facilities containing approximately 718,300 square feet for its operations in Malaysia, Singapore and Thailand. (See Item 1, Process Technology and Manufacturing and Item 7, Management's Discussion). Of the entire worldwide facilities owned or leased by the Corporation nearly 947,300 square feet are currently vacant, of which approximately 487,000 are currently under improvement or construction. The Corporation holds 74 undeveloped acres of land in the Republic of Ireland, approximately 8 acres were sold in 1993. The Corporation also has an equity interest in 61 acres of land in Albuquerque, New Mexico. The Corporation maintains 35 sales offices in North America and 18 sales offices in Asia and Europe for its direct sales force. These offices are located in cities in major electronics markets where concentrations of Advanced Micro Devices' customers are located. Leases covering the Corporation's facilities expire over terms of generally 1 to 20 years. The Corporation anticipates no difficulty in either retaining occupancy of any of its facilities through lease renewals prior to expiration or through month-to-month occupancy, or replacing them with equivalent facilities. (See Note 12 of Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders.) ITEM 3. ITEM 3. LEGAL PROCEEDINGS 1. Environmental Matters. Since 1981, the Corporation has discovered, investigated and begun remediation of three sites where releases from underground chemical tanks at its facilities in Santa Clara County, California adversely affected the groundwater. There is no indication, however, that any public drinking water supplies have been affected. The chemicals released into the groundwater were commonly in use in the semiconductor industry in the wafer fabrication process prior to 1979. At least one of the released chemicals (which is no longer used by the Corporation) has been identified as a probable carcinogen. In 1991, the Corporation received four Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board, San Francisco Bay Region (RWQCB) relating to the three sites. One of the sites (Final Site Clean-up Requirements Order No. 91-102) includes clean-up of groundwater contamination from TRW Microwave, Inc. (TRW), Philips Semiconductor (formerly Signetics Corporation) and the Corporation which the RWQCB claims merged. The Corporation is proceeding jointly with Philips and TRW to clean-up the merged contamination and the parties are contributing to the clean-up equally. Another of the sites (Final Site Clean-up Requirements Order Nos. 91-139 and 91-140) includes clean-up of groundwater contamination from National Semiconductor Corporation, the Corporation and others, which the RWQCB claims merged. National Semiconductor Corporation and the Corporation have been named in the orders as primarily responsible and have commenced clean-up efforts in accordance with their respective orders. However, there has been no allocation of responsibility for the groundwater contamination. The third site (Final Site Clean-up Requirements Order No. 91-101) is primarily the responsibility of the Corporation. In each instance mentioned above, the Corporation conducted appropriate programs of remedial action that involved soil removal, installation of monitoring and extraction wells and water treatment systems, disposal of inoperative tank systems, and repair and alterations to existing facilities. The final clean-up plan includes continued groundwater monitoring, extraction and treatment and, in one instance, soil vapor extraction. Federal and State governmental agencies have approved the final clean-up plans being implemented. The Corporation has not yet determined to what extent the costs of such remedial actions will be covered by insurance. The three sites are on the National Priorities List (Superfund). If the Corporation fails to satisfy federal compliance requirements or inadequately performs the compliance measures, the government (a) can bring an action to enforce compliance, or (b) can undertake the desired response actions itself and later bring an action to recover its costs and penalties, up to three times the costs of clean-up activities, if appropriate. It is expected that these matters will not have a material adverse effect on the financial condition or results of operations of the Corporation. In addition, homeowners residing in the vicinity of two of the Superfund sites filed a class action lawsuit against the Corporation, TRW and Signetics in the Superior Court of Santa Clara County, California (Case No. 716064). The class action suit alleged that groundwater contamination caused by the defendants lowered property values and that the plaintiff class suffered emotional distress and fear. In May 1993, the action was settled and the complaint was dismissed with prejudice in July 1993. 2. AMD/Intel Technology Agreement Arbitration. A 1982 technology exchange agreement (the "1982 Agreement") between AMD and Intel Corporation has been the subject of a dispute which was submitted to Arbitration through the Superior Court of Santa Clara County, California and the matter is now at the California Supreme Court on appeal. The dispute centers around issues relating to whether Intel breached its agreement with AMD and whether that breach injured AMD, as well as the remedies available for such a breach to AMD. In February 1992, the Arbitrator awarded AMD several remedies including the following: a permanent, royalty-free, nonexclusive, nontransferable worldwide right to all Intel copyrights, patents, trade secrets and mask work rights, if any, contained in the then-current version of AMD's Am80386 family of microprocessors; and a two-year extension, until December 31, 1997, of the copyright and patent rights granted to AMD. Intel appealed this decision as it relates to the technology award. On May 22, 1992, the Superior Court in Santa Clara County confirmed the Arbitrator's award and entered judgment in the Corporation's favor on June 1, 1992. Intel appealed the decision confirming the Arbitrator's award in state court. On June 4, 1993, the California Court of Appeal affirmed in all respects the Arbitrator's determinations that Intel breached the 1982 Agreement, however, the Court of Appeal held that the arbitrator exceeded his powers in awarding to AMD a license to Intel intellectual property, if any, in AMD's Am386 microprocessor and in extending the 1976 patent and copyright agreement between AMD and Intel (the "1976 Agreement") by two years. As a result, the Court of Appeal ordered the lower court to correct the award to remove these rights and then confirm the award as so corrected. On September 2, 1993, the California Supreme Court granted the Corporation's petition for review of the California Court of Appeal decision that the Arbitrator exceeded his authority. The Corporation has requested that the California Supreme Court affirm the judgment confirming the Arbitrator's award to the Corporation, which includes the right to the Intel 386 microcode. If the California Supreme Court affirms the judgment confirming the Arbitrator's award, the Corporation would assert an additional defense against Intel's intellectual property claims in the 386 and 486 Microcode Litigations (discussed below) which could preclude Intel from continuing to pursue any damage or intellectual property claims regarding the Am386. If the Supreme Court does not affirm the judgment it could: (i) decide to remand the matter for a new Arbitration proceeding either on the merits or solely on the issue of relief including the damages due to the Corporation, or (ii) order no further proceedings which would foreclose the possibility of AMD collecting additional monetary damages through the Arbitration and/or potentially impact AMD's ability to use the Arbitration Award as a defense in the 386 or 486 Microcode Litigations discussed below. The California Supreme Court is expected to decide the case by the end of 1994. The Corporation believes it has the right to use Intel technology to manufacture and sell AMD's microprocessor products based on a variety of factors including: (i) the 1982 Agreement, (ii) the Arbitrator's award in the Arbitration which is pending review by the California Supreme Court and (iii) the 1976 Agreement. An unfavorable decision by the California Supreme Court could materially affect other AMD/Intel Microcode Litigations discussed herein. The AMD/Intel Litigations involve multiple interrelated and complex issues of fact and law. Therefore, the ultimate outcome of the AMD/Intel Litigations cannot presently be determined. Accordingly, no provision for any liability that may result upon the adjudication of the AMD/Intel Litigations has been made in the Corporation's financial statements. 3. 287 Microcode Litigation. (Case No. C-90-20237, N. D. Cal.) On April 23, 1990, Intel Corporation filed an action against the Corporation in the U.S. District Court, Northern District of California, seeking an injunction and damages with respect to the Corporation's 80C287, a math coprocessor designed to function with the 80286. Intel's suit alleges several causes of action, including infringement of Intel copyright on the Intel microcode used in its 287 math coprocessor. In June 1992, a jury determined that the Corporation did not have the right to use Intel microcode in the 80C287. On December 2, 1992, the court denied the Corporation's request for declaratory relief to the effect it has the right, under the 1976 Agreement with Intel to distribute products containing Intel microcode. The Corporation filed a motion on February 1, 1993, for a new trial based upon the discovery by AMD of evidence improperly withheld by Intel at the time of trial. In April, 1993, the court granted AMD a new trial on the issue of whether the 1976 Agreement with Intel Corporation granted AMD a license to use Intel microcode in its products. The ruling vacated both an earlier jury verdict holding that the 1976 Agreement did not cover the rights to microcode contained in the Intel 80287 math coprocessor and the December 2, 1992 ruling (discussed above). A new trial commenced in January, 1994 and a decision is expected in either the first or second quarter of 1994. The impact of the ultimate outcome of the 287 Microcode Litigation is highly uncertain and dependent upon the scope and breadth of the final decision in the case. A decision of broad scope could not only result in a damages award but also impact the Corporation's ability to continue to ship and produce its Am486DX product or other microprocessor products adjudicated to contain any copyrighted Intel microcode. The Corporation's inability to ship product could have a material adverse impact on the Corporation's trends in results of operations and financial condition. The outcome of the 287 litigation could also materially impact the outcomes in the other AMD/Intel Microcode Litigations discussed herein. The AMD/Intel Litigations involve multiple interrelated and complex issues of fact and law. Therefore, the ultimate outcome of the AMD/Intel Litigations cannot presently be determined. Accordingly, no provision for any liability that may result upon the adjudication of the AMD/Intel Litigations has been made in the Corporation's financial statements. 4. 386 Microcode Litigation. (Case No. A-91-CA-800, W.D. Texas and Case No. C-92-20039, N.D. Cal.) On October 9, 1991, Intel Corporation filed an action against the Corporation in the U.S. District Court for the Western District of Texas (Case No. A-91-CA-800, W.D. Texas), alleging the separate existence and copyrightability of the logic programming in a microprocessor and characterizing that logic as a "control program," and further alleging that the Corporation violated copyrights on this material and on the Intel microcode contained in the Am386 microprocessor. This action has been transferred to the U.S. District Court, Northern District of California (Case No. C-92-20039, N.D. Cal.). The complaint in this action asserts claims for copyright infringement of what Intel describes as: (1) its 386 microprocessor microcode program and revised programs, (2) its control program stored in a 386 microprocessor programmable logic array and (3) Intel In-Circuit Emulation (ICE) microcode. The complaint seeks damages and injunctive relief arising out of the Corporation's development, manufacture and sale of its Am386 microprocessors and seeks a declaratory judgment as to the Intel-AMD license agreements (1976 and 1982 Agreements). The monetary relief sought by Intel is unspecified. The Corporation has answered and counterclaimed seeking declaratory relief. The Corporation believes that Intel's microcode copyright claims are substantively the same as claims made in the 287 Microcode Litigation (Case No. C-90-20237, N.D. Cal.) (discussed above). Intel has also asserted that federal law prevents the Corporation from asserting as a defense the intellectual property rights that were awarded in the Intel Arbitration (discussed above). Intel has made this claim both in its appeal of the Arbitration decision and in the '386 Microcode Litigation. On October 29, 1992, the court in the '386 Microcode Litigation granted the Corporation's motion to stay further proceedings pending resolution of the state court Arbitration appeal. On December 28, 1993, the U.S. Court of Appeals for the Ninth Circuit reversed the stay order and the case was remanded for further proceedings. The Corporation will file a petition for writ of certiorari in the Supreme Court of the United States. If the Ninth Circuit decision is not reversed or modified, this action will proceed. In any event, the Corporation expects Intel will argue that the Arbitration is not a defense in this action. As discussed above, in the 287 Microcode Litigation, the ultimate outcome of the 287 Microcode Litigation could materially impact the outcome in the 386 Microcode Litigation and thus affect the Corporation's ability to produce Am386 products. An unfavorable final decision in the 386 Microcode Litigation could result in a material monetary damages award to Intel and/or preclude the Corporation from continuing to produce the Am386 and any other microprocessors which are adjudicated to contain any copyrighted Intel microcode, either or both of which could have a material adverse impact on the Corporation's trends in results of operations and financial condition. The AMD/Intel Litigations involve multiple interrelated and complex issues of fact and law. Therefore, the ultimate outcome of the AMD/Intel Litigations cannot presently be determined. Accordingly, no provision for any liability that may result upon the adjudication of the AMD/Intel Litigations has been made in the Corporation's financial statements. 5. 486 Microcode Litigation. (Case No. C-93-20301 PVT, N.D. Cal). On April 28, 1993 Intel Corporation filed an action against AMD in the U.S. District Court, Northern District of California, seeking an injunction and damages with respect to the Corporation's Am486 microprocessor. The suit alleges several causes of action, including infringement of various Intel copyrighted computer programs. Intel's Fourth Amended Complaint was filed on November 2, 1993. The Fourth Amended Complaint seeks damages and injunctive relief based on: (1) AMD's alleged copying and distribution of 486 "Processor Microcode Programs" and "Control Programs" and (2) AMD's alleged copying of 486 "Processor Microcode" as an intermediate step in creating proprietary microcode for the AMD version of the 486. The Fourth Amended Complaint also seeks a declaratory judgment that (1) AMD has induced third party copyright infringement through encouraging third parties to import Am486-based products ("Third Party Inducement Claim"); (2) AMD's license rights to Intel microcode expire as of December 31, 1995 ("License Expiration Claim"); (3) that AMD's license rights to Intel microcode do not extend to In-Circuit Emulation (ICE) microcode ("ICE Claim"); and (4) that AMD is not licensed to authorize third parties to manufacture products containing copies of Intel microcode ("Have Made Claim"). Intel's Fourth Amended Complaint further seeks damages and injunctive relief based on AMD's alleged copying and distribution of Intel's "386 Processor Microcode Program" in AMD's 486SX microprocessor. The Corporation answered the complaint in January, 1994. On December 1, 1993, Intel moved for partial summary judgment on its claim for copyright infringement of Intel's 486 ICE microcode. This motion was heard on March 1, 1994. The Court requested further briefing from the parties, and indicated its intention to rule on the motion after the briefing is completed on March 9, 1994. By order dated December 21, 1993, the Court granted the Corporation's motion to stay Intel's claim that AMD's 486SX infringes Intel copyrights on its 386 microcode. In light of the Ninth Circuit decision discussed above in the 386 Microcode Litigation reversing the Court's order staying the case, the stay order in this action may be vacated and/or appealed and the litigation concerning this claim may proceed. AMD believes that the microcode copyright infringement claims made by Intel in the 486 Microcode Litigation are substantively the same as claims: (i) made in the 287 Microcode Litigation with regard to the Intel microcode, discussed above and (ii) made in the 386 Microcode Litigation with regard to AMD's rights to utilize the so-called Intel microcode, "control programs" and ICE microcode. Intel has also made the following two new allegations not contained in either the 386 or 287 Microcode Litigations: (i) despite any rights AMD may have to copy the Intel microcode, those rights do not extend to foundry rights and thus AMD cannot use foundries to manufacture the Am486 product with Intel microcode and (ii) AMD's rights to Intel copyrights terminate on December 31, 1995. As discussed above, in the 287 Microcode Litigation, the ultimate outcome of the 287 Microcode Litigation could materially impact the outcome in the 486 Microcode Litigation. The outcomes in the 287 or the 486 Microcode Litigations could affect the Corporation's ability to continue to ship and produce its Am486DX products and thus have an immediate, material adverse impact on the Corporation's trends in results of operations and financial condition. The AMD/Intel Litigations involve multiple interrelated and complex issues of fact and law. Therefore, the ultimate outcome of the AMD/Intel Litigations cannot presently be determined. Accordingly, no provision for any liability that may result upon the adjudication of the AMD/Intel Litigations has been made in the Corporation's financial statements. 6. Intel Antitrust Case. On August 28, 1991, the Corporation filed an antitrust complaint against Intel Corporation in the U.S. District Court for the Northern District of California (Case No. C-91-20541-JW-EAI), alleging that Intel engaged in a series of unlawful acts designed to secure and maintain a monopoly in iAPX microprocessor chips. The complaint alleges that Intel illegally coerced customers to purchase Intel chips through selective allocation of Intel products and tying availability of the 80386 to purchases of other products from Intel, and that Intel filed baseless lawsuits against AMD in order to eliminate AMD as a competitor and intimidate AMD customers. The complaint requests significant monetary damages (which may be trebled), and an injunction requiring Intel to license the 80386 and 80486 to AMD, or other appropriate relief. On December 17, 1991, the Court dismissed certain of AMD's claims relating to Intel's past practices on statute of limitations grounds. Intel has filed a motion for partial summary judgment on one of AMD's remaining claims for relief, and the hearing on this motion is scheduled for March 4, 1994. The current trial date is October 3,1994. 7. Intel Business Interference Case. On November 12, 1992, the Corporation filed a proceeding against Intel Corporation in the Superior Court of Santa Clara County, California (Case No. 726343), for tortious interference with prospective economic advantage, violation of California's Unfair Competition Act, breach of contract and declaratory relief arising out of Intel's efforts to require licensees of an Intel patent to pay royalties if they purchased 386 and 486 microprocessors from suppliers of those parts other than Intel. The patent involved, referred to as the Crawford '338 patent, covers various aspects of how the Intel 386 microprocessor, the 486 microprocessor and future X86 processors manage memory and how these microprocessors generate memory pages and page tables when combined with external memory and multi-tasking software such as Microsoft(Registered Trademark) Windows(Trademark), OS/2(Registered Trademark) or UNIX(Registered Trademark). The action was subsequently removed to the Federal District Court where AMD amended its complaint to include causes of action for violation of the Lanham Act and a declaration of patent invalidity and unenforceability. The complaint alleges that Intel is demanding royalties for the use of the Intel patents from the Corporation's customers, without informing the Corporation's customers that the Corporation's license arrangement with Intel protects the Corporation's customers from an Intel patent infringement lawsuit. No royalties for the license are charged to customers who purchase these microprocessors from Intel. 8. International Trade Commission Proceeding. The United States International Trade Commission Proceeding (the "ITC Proceeding") (Investigation No. 337-TA-352) was filed by Intel Corporation on May 7, 1993, against two respondents, Twinhead International and its U.S. subsidiary, Twinhead Corporation. Twinhead is a Taiwan-based manufacturer which is a customer of both AMD and Intel. Twinhead purchases microprocessors from AMD and Intel, and incorporates these microprocessors into computers sold by Twinhead. Intel claims that the respondents induce computer end-users to infringe on what is known as the Crawford '338 patent when the computers containing AMD microprocessors are used with multi-tasking software such as Windows, Unix or OS/2. Intel seeks a permanent exclusion order from entry into the United States of certain Twinhead personal computers and an order directing Twinhead to cease and desist from demonstrating, testing or otherwise using such computers in the United States. AMD's dispute with Intel in the Intel Business Interference Case (Case No. C-92-20789, N.D. Cal) (discussed above) requests a declaration that the Crawford '338 patent is invalid; accordingly, AMD intervened in the ITC Proceeding as a real party in interest by filing a motion with the ITC to intervene on the side of the respondents. On July 2, 1993, the ITC granted AMD's motion to intervene in the ITC Proceeding on the side of respondents and to participate fully in all proceedings as a party. The Corporation has vigorously contested the relief Intel seeks. A hearing date before an administrative law judge has been set for May 2, 1994. Any decision by an administrative judge would then be confirmed or not be confirmed by the International Trade Commission (ITC). On February 4, 1994, the Corporation filed a motion to suspend immediately and thereafter to terminate the ITC proceeding on the ground that Intel is collaterally estopped from pursuing the relief it seeks by reason of a judgment soon to be entered in favor of Cyrix Corporation, also an intervenor in the ITC Proceeding, and against Intel in a lawsuit involving the Crawford 338 patent trial in Texas federal court. Intel opposed the motion, and filed a motion of its own requesting that the ITC proceeding be suspended, not terminated, pending appellate review of the Cyrix Judgment. On February 22, 1994, ITC Administrative Law Judge Sidney Harris granted AMD's motion to suspend, and indicated his intent to terminate the ITC Proceeding upon entry of the judgment in the Texas federal court as AMD has requested. Judge Harris denied Intel's motion to suspend the ITC Proceeding until its appeal of the judgment in favor of Cyrix has been resolved. An unfavorable outcome before the ITC could have an adverse effect on the Corporation's ability to sell microprocessors to Twinhead and other computer manufacturers in Taiwan and potentially, other countries. An unfavorable outcome could have a material adverse impact on the Corporation's trends in results of operations and financial condition. 9. In Re Advanced Micro Devices Securities Litigation. Between September 8 and September 10, 1993, five class actions were filed, purportedly on behalf of purchasers of the Corporation's stock, alleging that the Corporation and various of its officers and directors violated Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934, 15 U.S.C. sec.sec. 78j(b) and 78t(a), respectively, and Rule 10b-5 promulgated thereunder, 17 C.F.R. sec. 240.10b-5, by issuing allegedly false and misleading statements about the Corporation's development of its 486SX personal computer microprocessor products, and the extent to which that development process included access to Intel's 386 microcode. Some or all of the complaints alleged that the Corporation's conduct also constituted fraud, negligent misrepresentation and violations of the California Corporations Code. By order dated October 13, 1993, these five cases, as well as any subsequently filed cases, were consolidated under the caption "In Re Advanced Micro Devices Securities Litigation", with the lead case for the consolidated actions being Samuel Sinay v. Advanced Micro Devices, Inc., et al., (No. C-93-20662-JW, N.D. Cal). A consolidated amended class action complaint was filed on December 3, 1993, containing all the claims described above and an additional allegation that the Corporation made false and misleading statements about its revenues and earnings during the third quarter of its 1993 fiscal year. The amended complaint seeks damages in an unspecified amount. On January 14, 1994, the Company filed a motion to dismiss various claims in the amended and consolidated class action complaint. The motion to dismiss is currently scheduled for hearing on March 25, 1994. The Company has responded to initial document requests and interrogatories, but has not yet produced documents. No depositions have been taken. This case is in the early stage of discovery. The Corporation believes that the ultimate outcome of this litigation will not have a material adverse effect upon the financial condition or trends in results of operations of the Corporation. 10. George A. Bilunka, et al. v. Sanders, et al. (93-20727JW, N.D. Cal.). On September 30, 1993, an AMD shareholder, George A. Bilunka, purported to commence an action derivatively on the Corporation's behalf against all of the Corporation's directors and certain of the Corporation's officers. The Corporation is named as a nominal defendant. This purported derivative action essentially alleges that the individual defendants breached their fiduciary duties to the Corporation by causing, or permitting, the Corporation to make allegedly false and misleading statements about the Corporation's development of its 486SX personal computer microprocessor products, and the extent to which that development process included access to Intel's 386 microcode. The action alleges that a pre-suit demand on the Corporation's Board of Directors would have been futile because of alleged director involvement. Damages are sought against the individual defendants in an unspecified amount. On November 10, 1993, the Corporation, as nominal defendant, filed a motion to dismiss the action for failure to make a demand upon the Corporation's Board of Directors. The plaintiff then filed an amended derivative complaint on December 17, 1993. The Corporation has again moved to dismiss the complaint. The motion was heard on February 4, 1994, and on March 1, 1994 the Court denied the motion. The Corporation believes that the ultimate outcome of this litigation will not have a material adverse effect upon the financial condition or trends in results of operations of the Corporation. 11. SEC Investigation. The Securities and Exchange Commission (SEC) has notified the Corporation that it is conducting an informal investigation of the Corporation into the Corporation's disclosures about the development of its Am486SX products. The Corporation is cooperating fully with the SEC. 12. Other Matters. The Corporation is a defendant or plaintiff in various other actions which arose in the normal course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the financial condition or overall trends in the results of operations of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT There is no family relationship between any executive officers of the Corporation. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information regarding market price range, dividend information and number of holders of Common Stock of Advanced Micro Devices appearing under the caption "Supplemental Financial Data" on pages 30 and 31 of the Corporation's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information regarding selected financial data for the fiscal years 1989 through 1993 under the caption "Financial Summary" on pages 30 and 31 of the Corporation's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information appearing under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 14 through 16 of the Corporation's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Advanced Micro Devices' consolidated financial statements at December 29, 1991, December 27, 1992, and at December 26, 1993, and for each of the three fiscal years in the period ended December 26, 1993, and the report of independent auditors thereon, and the unaudited quarterly financial data of Advanced Micro Devices for the two-year period ended December 26, 1993, on pages 17 through 29 of the Corporation's 1993 Annual Report to Stockholders are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing at the end of Part I under the caption "Executive Officers of the Registrant" and under the captions "Proposal No. 1-Election of Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Corporation's Proxy Statement to be mailed to Stockholders on or before March 27, 1994 is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information under the paragraphs entitled "Directors Fees and Expenses" under the caption "Committees and Meetings of the Board of Directors", and the information under the captions "Executive Compensation" (not including the performance graph on page 12), "Material Compensation Agreements", "Change in Control Arrangements" and "Compensation Committee Interlocks and Insider Participation" in the Corporation's Proxy Statement to be mailed to Stockholders on or before March 27, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the captions "Principal Stockholders" and "Stock Ownership Table" in the Corporation's Proxy Statement to be mailed to Stockholders on or before March 27, 1994 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under the caption "Transactions with Management" in the Corporation's Proxy Statement to be mailed to Stockholders on or before March 27, 1994 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The financial statements listed in the accompanying Index to Consolidated Financial Statements and Financial Statement Schedules Covered by Report of Independent Auditors are filed or incorporated by reference as part of this annual report. The following is a list of such Financial Statements: 2. Financial Statement Schedules The financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Financial Statement Schedules Covered by Report of Independent Auditors are filed or incorporated by reference as part of this annual report. The following is a list of such Financial Statement Schedules: 3. EXHIBITS The exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this annual report. The following is a list of such Exhibits: The Corporation will furnish a copy of any exhibit on request and payment of the Corporation's reasonable expenses of furnishing such exhibit. * Management contracts and compensatory plans or arrangements required to be filed as an Exhibit to comply with Item 14(a)(3). ** Confidential treatment has been requested as to certain portions of these Exhibits. (b) Reports on Form 8-K. 1. A current Report on Form 8-K dated January 27, 1994, was filed announcing an agreement with Compaq Computer Corporation. 2. A current Report on Form 8-K dated February 10, 1994, was filed announcing an agreement with Digital Equipment Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 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. ADVANCED MICRO DEVICES, INC. Registrant March 1, 1994 By: /s/ MARVIN D. BURKETT ------------------------------------ Marvin D. Burkett Senior Vice President, Chief Administrative Officer and Secretary; Chief Financial Officer and Treasurer 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. ADVANCED MICRO DEVICES, INC. ------------------------ INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS ITEM 14(A)(1) AND (2) The information under the following captions, which is included in the Corporation's 1993 Annual Report to Stockholders, a copy of which is attached hereto as Exhibit 13, is incorporated herein by reference: All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements or notes thereto. With the exception of the information incorporated by reference into Parts I, II and IV of this Form 10-K, the 1993, Annual Report to Stockholders is not to be deemed filed as part of this report. CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Advanced Micro Devices, Inc. of our report dated January 6, 1994, included in the 1993 Annual Report to Stockholders of Advanced Micro Devices, Inc. Our audits also included the financial statement schedules of Advanced Micro Devices, Inc. listed in Item 14(a). These schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statement on Form S-3 (No. 33-12011) pertaining to Depositary Convertible Exchangeable Preferred Shares, in the Registration Statement on Form S-4 (No. 33-15015) pertaining to shares issued in connection with the acquisition of Monolithic Memories, Inc. (MMI), in the Registration Statement on Form S-8 (No. 33-16060) pertaining to options granted under the MMI stock option plans, the Registration Statement on Form S-8 (No. 33-16095) pertaining to the 1987 Restricted Stock Award Plan of Advanced Micro Devices Inc., in the Registration Statement on Form S-8 (No. 33-39747) pertaining to the 1991 Stock Purchase Plan of Advanced Micro Devices, Inc., in the Registration Statements on Form S-8 (Nos. 2-70376, 2-80148, 2-93392, 33-10319, 33-26266, 33-36596 and 33-46578) pertaining to the Stock Option and Stock Appreciation Rights Plans of the Corporation, and in the Registration Statement on Form S-8 (No. 33-46577) pertaining to the 1992 Stock Incentive Plan of Advanced Micro Devices, Inc., and in the related prospectuses, of our report dated January 6, 1994, with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the consolidated financial statement schedules included in this Annual Report (Form 10-K) of Advanced Micro Devices, Inc. ERNST & YOUNG March 3, 1994 San Jose, California SCHEDULE I ADVANCED MICRO DEVICES, INC. ------------------------ MARKETABLE SECURITIES YEAR ENDED DECEMBER 26, 1993 (THOUSANDS) - --------------- (A) Stated at cost which approximates market. No individual security or group of securities of an issuer exceeds 2 percent of total assets. SCHEDULE II ADVANCED MICRO DEVICES, INC. ------------------------ AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES YEARS ENDED DECEMBER 29, 1991, DECEMBER 27, 1992 AND DECEMBER 26, 1993 - --------------- (1) Promissory note secured by real property bearing interest at the rate of 8.74 percent per year due in July/1995. (2) Non-interest bearing promissory note secured by real property paid off in quarter 4/1993. (3) Non-interest bearing, non-secured loan to be paid in three equal installments of $40,000 due in July/1993, 1994 and 1995. (4) Non-secured, interest bearing loan at the rate of 4.0 percent due in February/1996. SCHEDULE V ADVANCED MICRO DEVICES, INC. ------------------------ PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 29, 1991, DECEMBER 27, 1992 AND DECEMBER 26, 1993 (THOUSANDS) The annual provisions for depreciation and amortization have been computed principally in accordance with the following estimated useful lives: SCHEDULE VI ADVANCED MICRO DEVICES, INC. ------------------------ ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 29, 1991, DECEMBER 27, 1992 AND DECEMBER 26, 1993 (THOUSANDS) - --------------- (1) Provision for write-down to net realizable value. SCHEDULE VIII ADVANCED MICRO DEVICES, INC. ------------------------ VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 29, 1991, DECEMBER 27, 1992 AND DECEMBER 26, 1993 (THOUSANDS) - --------------- (1) Accounts (written off) recovered, net. SCHEDULE X ADVANCED MICRO DEVICES, INC. ------------------------ SUPPLEMENTARY OPERATIONS STATEMENT INFORMATION YEARS ENDED DECEMBER 29, 1991, DECEMBER 27, 1992 AND DECEMBER 26, 1993 (THOUSANDS) All other information is either not material or included in the consolidated financial statements, notes thereto, or other schedules. ADVANCED MICRO DEVICES, INC. ------------------------ INDEX TO EXHIBITS (ITEM 14(A)(3)) The Corporation will furnish a copy of any exhibit on request and payment of the Corporation's reasonable expenses of furnishing such exhibit. * Management contracts and compensatory plans or arrangements required to be filed as an Exhibit to comply with Item 14(a)(3). ** Confidential treatment has been requested as to certain portions of these Exhibits. AMD -- 90185	11,712	80,148
821480_1993.txt	821480_1993	1993	821480	Item 1. Regulation and Legislation. Generally, the franchising authority can decide not to renew a franchise only if it finds that the cable operator has not substantially complied with the material terms of the franchise, has not provided reasonable service in light of the community's needs, does not have the financial, legal and technical ability to provide the services being proposed for the future, or has not presented a reasonable proposal for future service. A final decision of non-renewal by the franchising authority is appealable in court. The General Partner and its affiliates recently have experienced lengthy negotiations with some franchising authorities for the granting of franchise renewals and transfers. Some of the issues involved in recent renewal negotiations include rate reregulation, customer service standards, cable plant upgrade or replacement and shorter terms of franchise agreements. The inability of a Partnership to renew a franchise, or lengthy negotiations or litigation involving the renewal process could have an adverse impact on the business of a Partnership. The inability of a Partnership to transfer a franchise could have an adverse impact on the ability of a Partnership to accomplish its investment objectives. COMPETITION. The Systems face competition from a variety of alternative entertainment media, such as: Multichannel Multipoint Distribution Service ("MMDS"), which is often called a "wireless cable service" and is a microwave service authorized to transmit television signals and other communications on a complement of channels, which when combined with instructional fixed television and other channels, is able to provide a complement of television signals potentially competitive with cable television systems; Satellite Master Antenna Television System ("SMATV"), commonly called a "private" cable television system, which is a system wherein one central antenna is used to receive signals and deliver them to, for example, an apartment complex; and Television Receive-Only Earth Stations ("TVRO"), which are satellite receiving antenna dishes that are used by "backyard users" to receive satellite delivered programming directly in their homes. Programming services sell their programming directly to owners of TVROs as well as through third parties. The competition from MMDS and TVRO potentially diminishes the pool of subscribers to the Systems because persons who subscribe to MMDS services or who own backyard satellite dishes are not likely to subscribe to all of the Systems' cable television services. In the near future, the Systems will also face competition from direct satellite to home transmission ("DBS"). DBS can provide to individuals on a wide-scale basis premium channel services and specialized programming through the use of high-powered DBS satellites that transmit such programming to a rooftop or side-mounted antenna. There are currently no DBS operators in the areas served by the Systems. DBS systems' ability to compete with the cable television industry will depend on, among other factors, the ability to obtain access to programming and the availability of reception equipment at reasonable prices. The first DBS satellite was recently launched, and it is anticipated that DBS services will become available throughout the United States during 1994. The Systems also face competition from video cassette rental outlets and movie theaters in the Systems' service areas. The General Partner believes the preponderance of video cassette recorder ("VCR") ownership in the Systems' service areas may be a positive rather than a negative factor because households that have VCRs are attracted to non-commercial programming delivered by the Systems, such as movies and sporting events on cable television, that they can tape at their convenience. Cable television franchises are not exclusive, so that more than one cable television system may be built in the same area (known as an "overbuild"), with potential loss of revenues to the operator of the original cable television system. The Systems currently face no direct competition from other cable television operators. Although the Partnerships have not yet encountered competition from a telephone company entering into the cable television business, the Partnerships' Systems could potentially face competition from telephone companies doing so. Bell Atlantic, a regional Bell operating company ("RBOC"), has announced its intention, if permitted by the courts, to build a cable television system in Alexandria, Virginia, and has won a lawsuit to obtain such authority. The case is on appeal. The General Partner currently owns and manages the cable television system in Alexandria, Virginia. Another RBOC, Ameritech, has also indicated its intention to build and operate a cable television system in Naperville, Illinois, a location where the General Partner manages a system on behalf of one of its managed limited partnerships. Other RBOCs have indicated their intention to enter the cable television market, and have filed lawsuits similar to the one being pursued by Bell Atlantic and Ameritech. Widespread competition through overbuilds by RBOCs could have a negative impact on companies like the General Partner that are already established cable television system operators. COMPETITION FOR SUBSCRIBERS IN THE PARTNERSHIPS' SYSTEMS. Following is a summary of competition from MMDS, SMATV and TVRO operators in the Partnerships' franchise areas: REGULATION AND LEGISLATION. The cable television industry is regulated through a combination of the Federal Communications Commission ("FCC"), some state governments, and most local governments. In addition, the Copyright Act of 1976 imposes copyright liability on all cable television systems. Cable television operations are subject to local regulation insofar as systems operate under franchises granted by local authorities. Cable Television Consumer Protection and Competition Act of 1992. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act"), which became effective on December 4, 1992. This legislation effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services and ordered an interim freeze on these rates effective on April 15, 1993. The rate freeze recently was extended by the FCC until the earlier of May 15, 1994, or the date on which a cable system's basic service rate is regulated by a franchising authority. The FCC's rate regulations became effective on September 1, 1993. On February 22, 1994, the FCC announced a revision of its rate regulations which it believes will generally result in a further reduction of rates for basic and non-basic services. The 1992 Cable Act encourages competition with existing cable systems by allowing municipalities, which are otherwise legally qualified, to own and operate their own cable systems without having to obtain a franchise; prevents franchising authorities from granting exclusive franchises; or unreasonably refusing to award additional franchises covering an existing cable system's service area. The 1992 Cable Act also makes several procedural changes to the process under which a cable operator seeks to enforce renewal rights which could make it easier in some cases for a franchising authority to deny renewal. The 1992 Cable Act prohibits the common ownership of cable systems and co-located MMDS or SMATV systems, and absent certain exceptions, the sale or transfer of ownership of a cable system within 36 months after its acquisition or initial construction. The 1992 Cable Act also precludes video programmers affiliated with cable companies from favoring cable operators over competitors and requires such programmers to sell their programs to other multichannel video distributors. This provision may limit the ability of cable program suppliers to offer exclusive programming arrangements with cable companies and could affect the volume discounts that program suppliers currently offer to the General Partner in its capacity as a multiple system operator. The 1992 Cable Act has eliminated the latitude of operators to set rates for commercially leased access channels and requires that leased access rates be set according to a formula determined by the FCC. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable television system carry its signal, or to require the cable television system to negotiate with the station for "retransmission consent." A cable television system is generally required to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial broadcast television stations, and non-commercial television stations are also given mandatory carriage rights, although such stations are not given the option to negotiate retransmission consent for the carriage of their signals by cable television systems. Additionally, cable television systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable television systems. See Item 1. Cable Television Services. There have been several lawsuits filed by cable television operators and programmers in Federal court challenging various aspects of the 1992 Cable Act, including provisions relating to mandatory broadcast signal carriage, retransmission consent, access to cable programming, rate regulation, commercial leased channels and public access channels. On April 8, 1993, a three-judge Federal district court panel issued a decision upholding the constitutional validity of the mandatory signal carriage requirements of the 1992 Cable Act. That decision has been appealed directly to the United States Supreme Court. Appeals have been filed in the Federal appellate court challenging the validity of the FCC's retransmission consent rules. Ownership and Market Structure. The FCC rules and federal law generally prohibit the direct or indirect common ownership, operation, control or interest in a cable television system, on the one hand, and a local television broadcast station whose television signal reaches any portion of the community served by the cable television system, on the other hand. The FCC recently lifted its ban on the cross-ownership of cable television systems by broadcast networks. The FCC revised its regulations to permit broadcast networks to acquire cable television systems serving up to 10% of the homes passed in the nation, and up to 50% of the homes passed in a local market. Neither the Partnerships nor the General Partner has any direct or indirect ownership, operation, control or interest in a television broadcast station, or a telephone company, and they are thus presently unaffected by the cross-ownership rules. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") and FCC regulations generally prohibit the common operation of a cable television system and a telephone company within the same service area. Until recently, a provision of a Federal court antitrust consent decree also prohibited the regional Bell operating companies ("RBOCs") from engaging in cable television operations. This prohibition was recently removed when the court retaining jurisdiction over the consent decree ruled that the RBOCs could provide information services over their facilities. This decision permits the RBOCs to acquire or construct cable television systems outside of their own service areas. The 1984 Cable Act prohibited local exchange carriers, including the RBOCs, from providing video programming directly to subscribers within their local exchange telephone service areas, except in rural areas or by specific waiver of FCC rules. This statutory provision has recently been challenged on constitutional grounds by Bell Atlantic, one of the RBOCs. The court held that the 1984 Cable Act cross-ownership provision is unconstitutional, and it issued an order enjoining the United States Justice Department from enforcing the cross-ownership ban. The National Cable Television Association, an industry group of which the General Partner is a member, has appealed this landmark decision, and the case could ultimately be reviewed by the United States Supreme Court. This federal cross-ownership rule is particularly important to the cable industry since these telephone companies already own certain facilities needed for cable television operation, such as poles, ducts and associated rights-of-way. The FCC has conducted a comprehensive proceeding examining whether and under what circumstances telephone companies should be allowed to provide cable television services, including video programming, to their customers. The FCC has concluded that under the 1984 Cable Act interexchange carriers (such as AT&T, which provide long distance services) are not subject to the restrictions which bar the provision of cable television service by local exchange carriers. In addition, the FCC concluded that neither a local exchange carrier providing a video dialtone service nor its programming suppliers leasing the dialtone service are required to obtain a cable television franchise. This determination has been appealed. If video dialtone services become widespread in the future, cable television systems could be placed at a competitive disadvantage because cable television systems are required to obtain local franchises to provide cable television service and must comply with a variety of obligations under such franchises. The FCC has tentatively concluded that construction and operation of technologically advanced, integrated broadband networks by carriers for the purpose of providing video programming and other services would constitute good cause for waiver of the cable/telephone cross-ownership prohibitions. In July 1989, the FCC granted a California telephone company a waiver of the cross-ownership restrictions based on a showing of "good cause," but the FCC's decision was reversed on appeal, and as a result of this decision, the FCC may be required to follow a stricter policy in granting such waivers in the future. As part of the same proceeding, the FCC recommended that Congress amend the 1984 Cable Act to allow Local Exchange Carriers ("LECs") to provide their own video programming services over their facilities. The FCC recently decided to loosen ownership and affiliation restrictions currently applicable to telephone companies, and has proposed to increase the numerical limit on the population of areas qualifying as "rural" and in which LECs can provide cable service without a FCC waiver. Legislation is pending in Congress which would permit the LECs to provide cable television service within their own operating areas conditioned on establishing separate video programming affiliates. The legislation would generally prohibit, however, telephone companies from acquiring cable systems within their own operating areas. The legislation would also enable cable television companies and others, subject to regulatory safeguards, to offer telephone services by eliminating state and local barriers to entry. ITEM 2. ITEM 2. PROPERTIES The cable television systems owned at December 31, 1993 by the Partnerships are described below. The following tables set forth (i) the monthly basic plus service rates charged to subscribers, (ii) the number of basic subscribers and pay units, (iii) the number of homes passed by cable plant, (iv) the miles of cable plant and (v) the range of franchise expiration dates for the cable television systems owned and operated by the Partnerships. The monthly basic plus service rates set forth herein represent, with respect to systems with multiple headends, the basic plus service rate charged to the majority of the subscribers within the system. While the charge for basic plus service may have increased in some cases as a result of the FCC's rate regulations, overall revenues to the Partnerships may have decreased due to the elimination of charges for additional outlets and certain equipment. In cable television systems, basic subscribers can subscribe to more than one pay TV service. Thus, the total number of pay services subscribed to by basic subscribers are called pay units. Figures for numbers of subscribers, miles of cable plant and homes passed are compiled from the General Partner's records and may be subject to adjustments. CABLE TV FUND 14-A, LTD. As of December 31, 1993, the number of homes passed and the miles of cable plant were 43,400 and 726, respectively. Franchise expiration dates range from July 1995 to January 2003. As of December 31, 1993, the number of homes passed and the miles of cable plant were 19,266 and 409, respectively. Franchise expiration date for all franchises is September 1999. As of December 31, 1993, the number of homes passed and the miles of cable plant were 34,921 and 452, respectively. Franchise expiration dates range from December 1999 to April 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 22,400 and 679, respectively. Franchise expiration dates range from July 1999 to January 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 24,570 and 314, respectively. Franchise expiration dates range from April 1994 to September 2004. Any franchise that expires in 1994 is in the process of franchise renewal negotiations. CABLE TV FUND 14-B, LTD. At December 31, --------------- Surfside, South Carolina 1993 1992 1991 - ------------------------ ---- ---- ---- Monthly rate basic plus service $ 23.25 $ 20.60 $ 18.95 Basic subscribers 17,770 17,275 17,665 Pay units 10,168 10,422 11,748 As of December 31, 1993, the number of homes passed and the miles of cable plant were 32,100 and 489, respectively. Franchise expiration dates range from June 2006 to December 2013. At December 31, --------------- Little Rock, California 1993 1992 1991 - ----------------------- ---- ---- ---- Monthly rate basic plus service $ 21.77 $ 20.00 $ 17.95 Basic subscribers 4,875 4,859 4,338 Pay units 4,171 3,717 3,553 As of December 31, 1993, the number of homes passed and the miles of cable plant were 6,910 and 192, respectively. Franchise expiration date is October 2000. CABLE TV FUND 14-A/B VENTURE At December 31, --------------- BROWARD COUNTY, FLORIDA 1993 1992 1991 - ----------------------- ---- ---- ---- Monthly basic plus service rate $ 24.00 $ 23.95 $ 19.50 Basic subscribers 45,515 42,945 41,153 Pay units 37,684 33,735 33,950 As of December 31, 1993, the number of homes passed and the miles of cable plant were 89,000 and 938, respectively. Franchise expiration dates range from July 1994 to December 2024. Any franchise that expires in 1994 is in the process of franchise renewal negotiations. PROGRAMMING SERVICES Programming services provided by the Systems include local affiliates of the national broadcast networks, local independent broadcast channels, the traditional satellite services (e.g., American Movie Classics (AMC), Arts & Entertainment (ARTS), Black Entertainment Network (BET), C-SPAN, The Discovery Channel (DISC), Lifetime (LIFE), Entertainment Sports Network (ESPN), Home Shopping Network (HSN), Mind Extension University (MEU), Music Television (MTV), Nickelodeon (NICK), Turner Network Television (TNT), The Nashville Network (TNN), Video Hits One (VH-1), and superstations WOR, WGN and TBS. The Partnerships' Systems also provide a selection, which varies by system, of premium channel programming (e.g., Bravo (BRVO), Cinemax (CMAX), The Disney Channel (DISN), Encore (ENC), Home Box Office (HBO), Showtime (SHOW) and The Movie Channel (TMC)). ITEM 3. ITEM 3. LEGAL PROCEEDINGS In April 1989, a few months after it had acquired the Surfside System, Fund 14-B acquired a small cable television system in the Surfside Beach area from Tritek/Southern Communications, Ltd. At the time of the acquisition, this system served approximately 1,450 subscribers in the same area as the Surfside System. In May 1990, the Federal Trade Commission ("FTC") commenced an investigation into the effect of this acquisition on competition in the Surfside Beach area. Fund 14-B submitted its response to the FTC's request for information concerning the acquisition in July 1990. The FTC conducted recorded interviews with certain employees of the General Partner in September 1991. No further action has been taken by the FTC, although to the best of the General Partner's knowledge the investigation is still pending. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS While the Partnerships are publicly held, there is no public market for the limited partnership interests and it is not expected that a market will develop in the future. As of March 1, 1994, the approximate number of equity security holders was: Item 6. Item 6. Selected Financial Data * Cable TV Fund 14-B's selected financial data includes 100 percent of the Cable TV Fund 14-A/B accounts on a consolidated basis. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CABLE TV FUND 14-B Results of Operations The results of operations for Cable TV Fund 14-B ("Fund 14-B") are summarized below: 1993 Compared to 1992 - Partnership owned - Revenues in Fund 14-B's wholly-owned cable television systems increased $319,096, or approximately 3 percent, from $9,347,000 in 1992 to $9,666,096 in 1993. Basic service rate adjustments as well as increases in revenues from advertising sales and pay-per-view were primarily responsible for the increase in revenues. Such increases were offset, in part, by decreases in premium service revenue. In addition, the increase in revenues would have been greater but for the reduction in basic rates due to new basic rate regulations issued by the FCC in May 1993 with which Fund 14-B complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Operating, general and administrative expenses increased $180,421, or approximately 4 percent, from $5,130,821 in 1992 to $5,311,242 in 1993. Operating, general and administrative expenses represented 55 percent of revenue in both 1993 and 1992. Increases in programming fees were primarily responsible for the increase in operating, general and administrative expense. No other individual factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from the General Partner increased $54,980, or approximately 4 percent, from $1,270,685 in 1992 to $1,325,665 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expense from the General Partner. Depreciation and amortization expense decreased $213,407, or approximately 3 percent, from $6,673,468 in 1992 to $6,460,061 in 1993. This decrease is due to the maturation of Fund 14-B's asset base. Operating loss decreased $297,102, or approximately 8 percent, from $3,727,974 in 1992 to $3,430,872 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative and management fees and allocated overhead from the General Partner as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $83,695, or approximately 3 percent, from $2,945,494 in 1992 to $3,029,189 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from the General Partner. Interest expense decreased $164,771, or approximately 18 percent, from $923,922 in 1992 to $759,151 in 1993. This decrease is due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $471,996, or approximately 10 percent, from $4,673,447 in 1992 to $4,201,451 in 1993. These losses were primarily the result of the factors discussed above and are expected to continue in the future. Venture owned - In addition to its wholly owned systems, Fund 14-B owns an approximate 73 percent interest in the Venture. Revenues of the Venture's Broward County System increased $1,856,065, or approximately 9 percent, from $20,212,867 in 1992 to $22,068,952 in 1993. Increases in basic and premium subscribers accounted for approximately 48 percent of the increase in revenue. Basic and premium subscribers increased 6 percent and 14 percent, respectively, during 1993. Advertising sales accounted for approximately 19 percent of the increase in revenues. Basic service rate adjustments accounted for approximately 15 percent of the increase in revenues. The increase in revenues would have been greater but for the reduction in basic rates due to the new basic rate regulations issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $1,287,088, or approximately 12 percent, from $11,052,427 in 1992 to $12,339,515 in 1993. Operating, general and administrative expenses represented 56 percent of revenue in 1993, compared to 55 percent in 1992. The increase in operating, general and administrative expenses was due primarily to increases in programming fees and marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $219,910, or approximately 9 percent, from $2,481,658 in 1992 to $2,701,568 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $619,107, or approximately 6 percent, from $9,971,915 in 1992 to $9,352,808 in 1993. The decrease in depreciation and amortization expense is attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $968,164, or approximately 29 percent, from $3,293,133 in 1992 to $2,324,939 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $349,087, or approximately 5 percent, from $6,678,782 in 1992 to $7,027,869 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $114,318, or approximately 4 percent, from $2,564,990 in 1992 to $2,450,672 in 1993 due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $1,472,607, or approximately 24 percent, from $6,186,107 in 1992 to $4,713,500 in 1993. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above and are expected to continue in the future. 1992 Compared to 1991 - Partnership owned - Revenues in Fund 14-B's wholly-owned cable television systems increased $686,278, or approximately 8 percent, from $8,660,722 in 1991 to $9,347,000 in 1992. Service rate adjustments implemented in each of Fund 14-B's systems accounted for approximately 54 percent of the increase in revenues. Increases in basic subscribers accounted for approximately 19 percent of the increase in revenues. Increases in basic commercial customers accounted for approximately 11 percent of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expenses decreased $160,732, or approximately 3 percent, from $5,291,553 in 1991 to $5,130,821 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 compared to 61 percent in 1991. The decrease in operating, general and administrative expense was due primarily to decreases in copyright fees and professional service fees. In 1991, the Partnership incurred fees relating to a Federal Trade Commission investigation initiated in May 1990, but no such fees were incurred in 1992. These decreases were partially offset by increases in personnel related costs and programming fees. No other individual factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from the General Partner increased $125,886, or approximately 11 percent, from $1,144,799 in 1991 to $1,270,685 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expense from the General Partner. Depreciation and amortization expense increased $159,250, or approximately 2 percent, from $6,514,218 in 1991 to $6,673,468 in 1992. This increase in depreciation and amortization expense is attributable to additions in the depreciable asset base. Operating loss decreased $561,874, or approximately 13 percent, from $4,289,848 in 1991 to $3,727,974 in 1992. This decrease was due to the increase in revenues and the decrease in operating, general and administrative expenses exceeding the increases in management fees and allocated overhead from the General Partner and depreciation and amortization expense. Operating income before depreciation and amortization expense increased $721,124, or approximately 32 percent, from $2,224,370 in 1991 to $2,945,494 in 1992 due to the increase in revenues and the decrease in operating, general and administrative expenses exceeding the increase in management fees and allocated overhead from the General Partner. Interest expense decreased $351,475, or approximately 28 percent, from $1,275,397 in 1991 to $923,922 in 1992. This decrease was due to lower effective interest rates on interest bearing obligations. Net loss decreased $874,390, or approximately 16 percent, from $5,547,837 in 1991 to $4,673,447 in 1992. These losses were primarily the result of the factors discussed above. Venture owned - Revenues of the Venture's Broward County System increased $1,845,986, or approximately 10 percent, from $18,366,881 in 1991 to $20,212,867 in 1992. Basic service rate adjustments accounted for approximately 51 percent of the increase in revenues. Increases in basic commercial customers and customer late fees accounted for approximately 22 percent and 7 percent, respectively, of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $987,683, or approximately 10 percent, from $10,064,744 in 1991 to $11,052,427 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 and 1991. The increase in operating, general and administrative expenses was due to increases in personnel related costs and programming fees, which were partially offset by decreases in marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from the General Partner increased $290,942, or approximately 13 percent, from $2,190,716 in 1991 to $2,481,658 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from the General Partner. Depreciation and amortization expense decreased $500,706, or approximately 5 percent, from $10,472,621 in 1991 to $9,971,915 in 1992. The decrease in depreciation and amortization expense was attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $1,068,067, or approximately 24 percent, from $4,361,200 in 1991 to $3,293,133 in 1992. This decrease was due to the increase in revenues exceeding the increases in operating, general and administrative expenses, management fees and allocated overhead from the General Partner, as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $567,361, or approximately 9 percent, from $6,111,421 in 1991 to $6,678,782 in 1992 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from the General Partner. Interest expense decreased $1,078,926, or approximately 30 percent, from $3,643,916 in 1991 to $2,564,990 in 1992 due to lower effective interest rates on interest bearing obligations. Net loss before minority interest in consolidated net loss decreased $1,852,613, or approximately 23 percent, from $8,038,720 in 1991 to $6,186,107 in 1992. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above. Financial Condition In addition to the Surfside System and the Little Rock System owned exclusively by it, Fund 14-B owns an approximate 73 percent interest in the Venture. The accompanying consolidated financial statements include 100 percent of the accounts of Fund 14- B and those of the Venture reduced by Fund 14-A's 27 percent minority interest in the Venture. See discussion of the Venture's financial condition. Fund 14-B expended approximately $1,638,000 on capital additions during 1993 in its Surfside System and Little Rock System. Approximately 32 percent of these expenditures were for the construction of cable plant extensions. Approximately 23 percent and 17 percent of the expenditures were for the construction of drops to subscribers homes and cable plant upgrades, respectively. The remainder of the expenditures were for various enhancements in Fund 14-B's cable television systems. Funding for these expenditures was provided by cash generated by operations. Anticipated capital expenditures for 1994 are approximately $1,500,000. Approximately 37 percent of these expenditures are expected to be used for new plant construction in Fund 14-B's systems. Approximately 21 percent are for service drops to homes. The remainder of these expenditures are for various enhancements in each of Fund 14-B's systems. The actual level of capital expenditures will depend, in part, upon the General Partner's determination as to the proper scope and timing of such expenditures in light of the FCC's announcement of a further rulemaking regarding the 1992 Cable Act on February 22, 1994 and Fund 14-B's liquidity position. Funding for these improvements will be provided by cash generated from operations and borrowings under Fund 14-B's credit facility. Fund 14-B's credit agreement had an original commitment of $20,000,000. Such commitment consisted of a $10,000,000 reducing revolving credit facility and a $10,000,000 term loan. The reducing revolving credit commitment reduced to $9,500,000 on December 31, 1993, reduces to $8,500,000 on December 31, 1994 and is payable in full at December 31, 1995. At December 31, 1993, $5,600,000 was outstanding under this agreement, leaving $3,900,000 of borrowings available until December 31, 1994 for the needs of Fund 14-B. The $10,000,000 term loan is payable in quarterly installments which began March 31, 1993 and the term loan matures December 31, 1995. As of December 31, 1993, $9,750,000 was outstanding on this term loan due to installment payments made during 1993 totalling $250,000. Installments due during 1994 total $500,000. Currently, interest on the outstanding principal balance on each loan is at Fund 14-B's option of prime plus .20 percent, LIBOR plus 1.20 percent or CD rate plus 1.325 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 4.71 percent and 4.98 percent, respectively. In January 1993, the Partnership entered into an interest rate cap agreement covering outstanding debt obligations of $8,000,000. The Partnership paid a fee of $77,600. The agreement protected the Partnership from interest rates that exceeded seven percent for three years from the date of the agreement. The General Partner believes that Fund 14-B has sufficient sources of capital to service its presently anticipated needs, subject to the regulatory matters discussed below. As a result of the climate of the cable industry in recent years and the regulatory matters discussed below, the fair market values of Fund 14-B's cable television systems have declined on a per subscriber basis since acquired by Fund 14-B. Fund 14- B has no intention to sell the systems in the near term; however, it can not predict whether market conditions will improve in the future or whether the systems ultimately will appreciate in value. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which Fund 14-B complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on the General Partner's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, Fund 14-B reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in Fund 14-B's revenue of approximately $700,000, or approximately 7 percent, and a decrease in operating income before depreciation and amortization of approximately $620,000, or approximately 13 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on Fund 14-B's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non- subscribers. To the extent such reductions are not mitigated, the values of Fund 14-B's cable television systems, which are calculated based on cash flow, could be further adversely impacted. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by the cable systems. The retransmission consent rules went into effect October 6, 1993. In the cable television systems owned by Fund 14-B, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Los Angeles. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur . If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. CABLE TV FUND 14-A/B VENTURE Results of Operations 1993 Compared to 1992- Revenues of the Venture's Broward County System increased $1,856,065, or approximately 9 percent, from $20,212,867 in 1992 to $22,068,952 in 1993. Increases in basic and premium subscribers accounted for approximately 48 percent of the increase in revenue. Basic and premium subscribers increased 6 percent and 14 percent, respectively, during 1993. Advertising sales accounted for approximately 19 percent of the increase in revenues. Basic service rate adjustments accounted for approximately 15 percent of the increase in revenues. The increase in revenues would have been greater but for the reduction in basic rates due to the new basic rate regulations issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $1,287,088, or approximately 12 percent, from $11,052,427 in 1992 to $12,339,515 in 1993. Operating, general and administrative expenses represented 56 percent of revenue in 1993, compared to 55 percent in 1992. The increase in operating, general and administrative expenses was due primarily to increases in programming fees and marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $219,910, or approximately 9 percent, from $2,481,658 in 1992 to $2,701,568 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $619,107, or approximately 6 percent, from $9,971,915 in 1992 to $9,352,808 in 1993. The decrease in depreciation and amortization expense is attributable to the maturation of the Venture's tangible asset base. Operating loss decreased $968,164, or approximately 29 percent, from $3,293,133 in 1992 to $2,324,939 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $349,087, or approximately 5 percent, from $6,678,782 in 1992 to $7,027,869 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $114,318, or approximately 4 percent, from $2,564,990 in 1992 to $2,450, 672 in 1993 due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $1,472,607, or approximately 24 percent, from $6,186,107 in 1992 to $4,713,500 in 1993. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above and are expected to continue in the future. 1992 Compared to 1991- Revenues of the Venture's Broward County System increased $1,845,986, or approximately 10 percent, from $18,366,881 in 1991 to $20,212,867 in 1992. Basic service rate adjustments accounted for approximately 51 percent of the increase in revenues. Increases in basic commercial customers and customer late fees accounted for approximately 22 percent and 7 percent, respectively, of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $987,683, or approximately 10 percent, from $10,064,744 in 1991 to $11,052,427 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 and 1991. The increase in operating, general and administrative expenses was due primarily to increases in personnel related costs and programming fees, which were partially off set by decreases in marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $290,942, or approximately 13 percent, from $2,190,716 in 1991 to $2,481,658 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $500,706, or approximately 5 percent, from $10,472,621 in 1991 to $9,971,915 in 1992. The decrease in depreciation and amortization expense was attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $1,068,067, or approximately 24 percent, from $4,361,200 in 1991 to $3,293,133 in 1992. This decrease was due to the increase in revenues exceeding the increase in operating, general and administrative expenses, management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $567,361, or approximately 9 percent, from $6,111,421 in 1991 to $6,678,782 in 1992 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $1,078,926, or approximately 30 percent, from $3,643,916 in 1991 to $2,564,990 in 1992 due to lower effective interest rates on interest bearing obligations. Net loss decreased $1,852,613, or approximately 23 percent, from $8,038,720 in 1991 to $6,186,107 in 1992. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above. Financial Condition The Venture expended approximately $3,040,000 on capital additions during 1993. Cable television plant extensions accounted for approximately 27 percent of these expenditures. The construction of service drops to homes and the purchase of converters accounted for approximately 25 percent and 12 percent, respectively, of the expenditures. The remainder of these expenditures related to various enhancements in the Broward County System. These capital expenditures were funded from cash on hand and cash generated from operations. The Venture plans to expend approximately $3,125,000 for capital additions in 1994. Of this total, approximately 24 percent is for cable television plant extensions. Approximately 26 percent will relate to the construction of service drops to homes. Approximately 14 percent will relate to upgrades and rebuild of the Broward County System. The remainder of the anticipated expenditures are for various enhancements in the Broward County System. These capital expenditures are expected to be funded from cash on hand and cash generated from operations and, if necessary, borrowings under a renegotiated credit facility, as discussed below. On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000. The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. The General Partner is currently negotiating to reduce principal payments (to provide liquidity for capital expenditures) and to adjust certain leverage covenants. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively. In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceeded 7 percent for three years from the date of the agreement. Subject to regulatory matters discussed below and the General Partner's ability to successfully renegotiate the Venture's credit facility, the General Partner believes that the Venture has sufficient sources of capital to service its presently anticipated needs. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which the Venture complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on the General Partner's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, the Venture reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in the Venture's revenue of approximately $1,800,000, or approximately 8 percent, and a decrease in operating income before depreciation and amortization of approximately $1,100,000, or approximately 10 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on the Venture's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. To the extent such reductions are not mitigated, the values of the Venture's cable television systems, which are calculated based on cash flow, could be adversely impacted. In addition, the FCC's rulemakings may have an adverse effect on the Venture's ability to renegotiate its credit facility. Item 8. Item 8. Financial Statements CABLE TV FUND 14 FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 and 1992 INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 14-B: We have audited the accompanying consolidated balance sheets of CABLE TV FUND 14-B (a Colorado limited partnership) and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital (deficit) and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 14-B and subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO Denver, Colorado, March 11, 1994. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business Cable TV Fund 14-B ("Fund 14-B"), a Colorado limited partnership, was formed on September 9, 1987, under a public program sponsored by Jones Intercable, Inc. ("Intercable"). Fund 14-B was formed to acquire, construct, develop and operate cable television systems. Intercable is the "General Partner" and manager of Fund 14-B. The General Partner and its subsidiaries also own and operate cable television systems. In addition, the General Partner manages cable television systems for other limited partnerships for which it is general partner and, also, for other affiliated entities. Contributed Capital, Commissions and Syndication Costs The capitalization of Fund 14-B is set forth in the accompanying statements of partners' capital (deficit). No limited partner is obligated to make any additional contribution to partnership capital. The General Partner purchased its interest in Fund 14-B by contributing $1,000 to partnership capital. An affiliate of the General Partner, Jones International Securities, Ltd., received a commission of 10 percent of capital contributions of the limited partners, from which the affiliate paid all commissions of participating broker-dealers which sold the partnership interests. The General Partner was reimbursed 3.75 percent of capital contributions of the limited partners for all offering costs. Commission costs and reimbursements to the General Partner for costs of raising partnership capital were charged to limited partners' capital. All profits and losses of Fund 14-B are allocated 99 percent to the limited partners and 1 percent to the General Partner, except for income or gain from the sale or disposition of cable television properties, which will be allocated to the partners based upon the formula set forth in the Partnership Agreement and interest income earned prior to the first acquisition by Fund 14-B of a cable television system, which was allocated 100 percent to the limited partners. Formation of Joint Venture and Partnership Acquisitions Formation of Joint Venture On January 8, 1988, Cable TV Fund 14-A and Fund 14-B formed Cable TV Fund 14-A/B Venture (the "Venture"), to acquire the cable television system serving areas in and around Broward County, Florida (the "Broward County System"). Cable TV Fund 14-A contributed $18,975,000 to the capital of the Venture for an approximate 27 percent ownership interest and Fund 14-B contributed $51,025,000 of its net contributed capital for an approximate 73 percent ownership interest. Cable Television System Acquisitions Fund 14-B, acquired the cable television system serving Surfside, South Carolina (the "Surfside System") in 1988 and the cable television system serving Little Rock, California (the "Little Rock System") in 1989. The above acquisitions were accounted for as purchases with the individual purchase prices allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of net tangible assets acquired; second, to the value of subscriber lists and noncompete agreements with previous owners; third, to franchise costs; and fourth, to costs in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of the General Partner (Note 3) and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Fund 14-B's tax returns are also prepared on the accrual basis. Principles of Consolidation As a result of Fund 14-B's ownership interest in the Venture of approximately 73 percent, the accompanying financial statements present Fund 14-B's and the Venture's financial condition and results of operations on a consolidated basis with the ownership interest of Cable TV Fund 14-A in the Venture shown as a minority interest. The Venture does not have any ownership interest in the Surfside System or Little Rock System. These systems are owned 100 percent by Fund 14-B. All interpartnership accounts and transactions have been eliminated. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Replacements, renewals, and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises, subscriber lists, noncompete agreement and costs in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services for Fund 14-B. For brokering the acquisition of the Surfside System for Fund 14-B, The Jones Group, Ltd. earned a fee totalling $1,920,000, or 4 percent of the purchase price, during the year ended December 31, 1988. Approximately $920,000 of such fee has been deferred until the sale of the Surfside System. For brokering the acquisition of an SMATV system in the Broward County System for the Venture, The Jones Group, Ltd. was paid a fee of $2,456, or 4 percent of the purchase price, in 1992. There were no brokerage fees paid in 1991 or 1993. Management Fees, Distribution Ratios and Reimbursements The General Partner manages Fund 14-B and the Venture and receives a fee for its services equal to five percent of the gross revenues of Fund 14-B and the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to the General Partner by Fund 14-B and the Venture for the years ended December 31, 1993, 1992 and 1991 were $1,586,750, $1,477,993 and $1,351,380, respectively. Any partnership distributions made from cash flow (defined as cash receipts derived from routine operations, less debt principal and interest payments and cash expenses) are allocated 99 percent to the limited partners and 1 percent to the General Partner. Any distributions other than interest income on limited partner subscriptions earned prior to the acquisition of the partnership's first cable television system or from cash flow, such as from the sale or refinancing of a system or upon dissolution of the partnership, will be made as follows: first, to the limited partners in an amount which, together with all prior distributions, will equal 125 percent of the amount initially contributed to the partnership capital by the limited partners; the balance, 75 percent to the limited partners and 25 percent to the General Partner. Fund 14-B and the Venture reimburse the General Partner for certain allocated overhead and administrative expenses. These expenses include salaries and benefits paid for corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, accounting, administrative, legal, and investor relations services to Fund 14-B and to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each partnership managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the partnership. Systems owned by the General Partner and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. The General Partner believes that the methodology used in allocating overhead and administrative expense is reasonable. Reimbursements made to the General Partner for allocated overhead and administrative expenses during the years ended December 31, 1993, 1992 and 1991 were $2,440,481, $2,274,350 and $1,984,135, respectively. Fund 14-B and the Venture were charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due the General Partner, which approximated the General Partner's weighted average cost of borrowing. Total interest charged Fund 14-B and the Venture by the General Partner was $2,361, $7,219 and $5,512 for the years ended December 31, 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services Fund 14-B and the Venture receive programming from Superaudio and The Mind Extension University, affiliates of the General Partner. Payments to Superaudio totalled approximately $46,177, $45,603 and $40,707, in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totalled approximately $26,824, $26,131 and $25,005 in 1993, 1992 and 1991, respectively. (4) DEBT On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000 . The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. The General Partner is currently negotiating to reduce principal payments to provide liquidity for capital expenditures. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively. In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceeded 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of the agreement using the straight-line method. Fund 14-B's credit agreement had an original commitment of $20,000,000. Such commitment consisted of a $10,000,000 reducing revolving credit facility and a $10,000,000 term loan. The reducing revolving credit commitment reduced to $9,500,000 on December 31, 1993, reduces to $8,500,000 on December 31, 1994 and is payable in full at December 31, 1995. At December 31, 1993, $5,600,000 was outstanding under this revolving credit agreement, leaving $3,900,000 of borrowings available until December 31, 1994 for the needs of Fund 14-B. The $10,000,000 term loan is payable in quarterly installments which began March 31, 1993 and matures on December 31, 1995. As of December 31, 1993, $9,750,000 was outstanding on this term loan due to installment payments made during 1993 totalling $250,000. Currently, interest is payable on each loan at Fund 14-B's option of prime plus .20 percent, LIBOR plus 1.20 percent or CD Rate plus 1.325 percent. The effective interest rates on amounts outstanding on Fund 14-B's credit facility as of December 31, 1993 and 1992 were 4.71 percent and 4.98 percent, respectively. In January 1993, the Partnership entered into an interest rate cap agreement covering outstanding debt obligations of $8,000,000. The Partnership paid a fee of $77,600. The agreement protected the Partnership from interest rates that exceeded 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: At December 31, 1993, substantially all of Fund 14-B's and the Venture's property, plant and equipment secured the above indebtedness. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners. The Federal and state income tax returns of Fund 14-B are prepared and filed by the General Partner. Fund 14-B's tax returns, the qualification of Fund 14-B as such for tax purposes, and the amount of distributable Partnership income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to Fund 14-B's qualification as such, or in changes with respect to Fund 14-B's recorded income or loss, the tax liability of the general and limited partners would likely be changed accordingly. Taxable loss reported to the partners is different from that reported in the statements of operations due to the difference in depreciation recognized under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable loss and the net loss reported in the consolidated statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act:") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in the rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by the cable systems. The retransmission consent rules went into effect October 6, 1993. In the cable television systems owned by Fund 14-B, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Los Angeles. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur . If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. Office and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totalled $97,288, $86,704 and $93,928, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for each of the five years in the period ending December 31, 1998 and thereafter are as follows: (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective periods is presented below: (8) OPERATING RESULTS OF SURFSIDE AND LITTLE ROCK SYSTEMS The results of operations of Fund 14-B's wholly owned Surfside System and Little Rock System on a stand-alone basis are presented below. Fund 14-B's share of the Venture owned Broward County System operations is also presented. CABLE TV FUND 14-B SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993,1992 and 1991 CABLE TV FUND 14-B SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 14-A/B Venture: We have audited the accompanying balance sheets of CABLE TV FUND 14-A/B VENTURE (a Colorado general partnership) as of December 31, 1993 and 1992, and the related statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 14-A/B Venture as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11,1994. CABLE TV FUND 14-A/B VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 14-A/B VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF OPERATIONS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF PARTNERS' CAPITAL The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) NOTES TO FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business On January 8, 1988, Cable TV Funds 14-A and 14-B (the "Venture Partners") formed a Colorado general partnership known as Cable TV Fund 14-A/B Venture (the "Venture") by contributing $18,975,000 and $51,025,000, respectively, for approximate 27 percent and 73 percent ownership interests, respectively. The Venture was formed for the purpose of acquiring the cable television system serving areas in and around Broward County, Florida (the "Broward County System"). Jones Intercable, Inc., ("Intercable") general partner of each of the Venture Partners, manages the Venture. Intercable and its subsidiaries also own and operate cable television systems. In addition, Intercable manages cable television systems for other limited partnerships for which it is general partner and for other affiliated entities. Contributed Capital The capitalization of the Venture is set forth in the accompanying statements of partners' capital. All Venture distributions, including those made from cash flow, from the sale or refinancing of Venture property and on dissolution of the Venture, shall be made to the Venture Partners in proportion to their approximate 27 and 73 percent interests in the Venture. Cable Television System Acquisition The Broward County System acquisition was accounted for as a purchase with the purchase price allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of net tangible assets acquired; second, to the value of subscriber lists and noncompete agreements with previous owners; third, to franchise costs; and fourth, to costs in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of the General Partner and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. The Venture's tax returns are also prepared on the accrual basis. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Replacements, renewals, and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises, subscriber lists, noncompete agreement and costs in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services in connection with the acquisition of systems for the Venture. For brokering the acquisition of a SMATV system in the Broward County System for the Venture, The Jones Group, Ltd. was paid a fee of $2,456, or 4 percent of the purchase price, during 1992. There were no brokerage fees paid in 1993 or 1991. Management Fees and Reimbursements Intercable manages the Venture and receives a fee for its services equal to five percent of the gross revenues of the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to Intercable by the Venture for the years ended December 31, 1993, 1992 and 1991 were $1,103,448, $1,010,643 and $918,344, respectively. The Venture reimburses Intercable for allocated overhead and administrative expenses. These expenses include salaries and related benefits paid for corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, accounting, administrative, legal, and investor relations services to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each entity managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the entity. Systems owned by Intercable and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. Intercable believes that the methodology used in allocating overhead and administrative expenses is reasonable. Reimbursements made to Intercable by the Venture for allocated overhead and administrative expenses during the years ended December 31, 1993, 1992 and 1991 were $1,598,120, $1,471,015 and $1,272,372, respectively. The Venture was charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due Intercable, such rate approximated Intercable's weighted average cost of borrowing. Total interest charged the Venture by Intercable was $2,361, 10,475 and $4,131 for the years ended December 31, 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Venture receives programming from Superaudio and The Mind Extension University, affiliates of Intercable. Payments to Superaudio totalled $30,018, $28,679 and $25,872 in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totalled $17,451, $16,434 and $15,882 in 1993, 1992 and 1991, respectively. (4) DEBT On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000. The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. Intercable is currently negotiating to reduce principal payments to provide liquidity for capital expenditures. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceed 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of the agreement using the straight-line method. On August 22, 1988, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $20,000,000. The Venture paid a fee of $310,000. The agreement protected the Venture from interest rates that exceeded ten percent for three years from the date of the agreement. The fee was charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: $3,561,519, $4,731,519 , $5,901,519, $8,207,173, $9,360,000 and $11,700,000 . At December 31, 1993, substantially all of the Venture's property, plant and equipment secured the above indebtedness. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners of Cable TV Funds 14-A and 14-B, which are general partners in the Venture. The Venture's tax returns, the qualification of the Venture as such for tax purposes, and the amount of distributable Venture income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to the Venture's qualification as such, or in changes with respect to the Venture's recorded income or loss, the tax liability of the Venture's general partners would likely be changed accordingly. Taxable loss reported to the partners is different from that reported in the statements of operations due to the difference in depreciation recognized under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable loss and the net loss reported in the statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act:") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in the rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. Office and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totalled $46,521, $45,406 and $54,702 respectively for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for each of the five years in the period ending December 31, 1998 and thereafter are as follows: 1994 $ 46,520 1995 46,520 1996 28,507 1997 5,724 1998 1,431 Thereafter - -------- $128,702 ======== (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective periods is presented below: CABLE TV FUND 14-A/B VENTURE SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 CABLE TV FUND 14-A/B VENTURE SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnerships themselves have no officers or directors. Certain information concerning directors and executive officers of the General Partner is set forth below. Mr. Glenn R. Jones has served as Chairman of the Board of Directors and Chief Executive Officer of the General Partner since its formation in 1970, and he was President from June 1984 until April 1988. Mr. Jones was elected a member of the Executive Committee of the Board of Directors in April 1985. He is also Chairman of the Board of Directors and Chief Executive Officer of Jones Spacelink, Ltd., a publicly held cable television company that is a subsidiary of Jones International, Ltd. and the parent of the General Partner. Mr. Jones is the sole shareholder, President and Chairman of the Board of Directors of Jones International, Ltd. He is also Chairman of the Board of Directors of the subsidiaries of the General Partner and of certain other affiliates of the General Partner. Mr. Jones has been involved in the cable television business in various capacities since 1961, is a past member of the Board of Directors of the National Cable Television Association and is a former member of its Executive Committee. Mr. Jones is a past director and member of the Executive Committee of C-Span. Mr. Jones has been the recipient of several awards including the Grand Tam Award in 1989, the highest award from the Cable Television Administration and Marketing Society, the Chairman's Award from the Investment Partnership Association, which is an association of sponsors of public syndications; the cable television industry's Public Affairs Association President's Award in 1990; the Donald G. McGannon award for the advancement of minorities and women in cable; the STAR Award from American Women in Radio and Television, Inc., for exhibition of a commitment to the issues and concerns of women in television and radio; and the Women in Cable Accolade in 1990 in recognition of support of this organization. Mr. Jones is also a founding member of the James Madison Council of the Library of Congress, is on the Board of Governors of the American Society of Training and Development and is a director of the National Alliance of Business. Mr. James B. O'Brien, the General Partner's President, joined the General Partner in January 1982 as System Manager, Brighton, Colorado, and was later promoted to the position of General Manager, Gaston County, North Carolina. Prior to being elected President and a Director of the General Partner in December 1989, Mr. O'Brien served as a Division Manager, Director of Operations Planning/Assistant to the CEO, Fund Vice President and Group Vice President/Operations. As President, he is responsible for the day-to-day operations of the cable television systems managed and owned by the General Partner. Mr. O'Brien is also President and a Director of Jones Cable Group, Ltd., Jones Global Funds, Inc., and Jones Global Management, Inc., all affiliates of the General Partner. Mr. O'Brien is a board member of Cable Labs, Inc., the research arm of the cable television industry. He also serves as a director of the Cable Television Administration and Marketing Association and as a director of the Walter Kaitz Foundation. Ms. Ruth E. Warren joined the General Partner in August 1980 and served in various capacities, including system manager and Fund Vice President, since then. Ms. Warren was elected Group Vice President/Operations of the General Partner in September 1990. Ms. Warren also serves as Vice President/Operations of Jones Spacelink, Ltd. Mr. Kevin P. Coyle joined The Jones Group, Ltd. in July 1981 as Vice President/Financial Services. In September 1985, he was appointed Senior Vice President/Financial Services. He was elected Treasurer of the General Partner in August 1987, Vice President/Treasurer in April 1988 and Group Vice President/Finance in October 1990. Mr. Christopher J. Bowick joined the General Partner in September 1991 as Group Vice President/Technology and Chief Technical Officer. Previous to joining the General Partner, Mr. Bowick worked for Scientific Atlanta's Transmission Systems Business Division in various technical management capacities since 1981, and as Vice President of Engineering since 1989. Mr. Timothy J. Burke joined the General Partner in August 1982 as corporate tax manager, was elected Vice President/Taxation in November 1986 and Group Vice President/Taxation/Administration in October 1990. He is also a member of the Board of Directors of Jones Spacelink, Ltd. Mr. Raymond L. Vigil joined the General Partner in April 1993 as Group Vice President/Human Resources and was elected a Director of the General Partner in November 1993. Previous to joining the General Partner, Mr. Vigil served as Executive Director of Learning with USWest from September 1989 to April 1993. Prior to that, Mr. Vigil worked in various human resources posts over a 14-year term with the IBM Corporation. Mr. James J. Krejci joined Jones International, Ltd. in March 1985 as Group Vice President. He was elected Group Vice President and Director of the General Partner in August 1987. He is also an officer of Jones Futurex, Inc., a subsidiary of Jones Spacelink, Ltd. engaged in manufacturing and marketing data encryption devices, Jones Information Management, Inc., a subsidiary of Jones International, Ltd. providing computer data and billing processing facilities and Jones Lightwave, Ltd., a company owned by Jones International, Ltd. and Mr. Jones, and several of its subsidiaries engaged in the provision of telecommunications services. Prior to joining Jones International, Ltd., Mr. Krejci was employed by Becton Dickinson and Company, a medical products manufacturing firm. Ms. Elizabeth M. Steele joined the General Partner in August 1987 as Vice President/General Counsel and Secretary. Ms. Steele also is an officer of Jones Spacelink, Ltd. From August 1980 until joining the General Partner, Ms. Steele was an associate and then a partner at the Denver law firm of Davis, Graham & Stubbs, which serves as counsel to the General Partner. Mr. Michael J. Bartolementi joined the General Partner in September 1984 as an accounting manager and was promoted to Assistant Controller in September 1985. He was named Controller in November 1990. Mr. George J. Feltovich was elected a Director of the General Partner in March 1993. Mr. Feltovich has been a private investor since 1978. Prior to 1978, Mr. Feltovich served as an administrative and legal consultant to various private and governmental housing programs. Mr. Feltovich was admitted to practice law in California, Pennsylvania and the District of Columbia and is a member of the California Bar Association. Mr. Patrick J. Lombardi has been a Director of the General Partner since February 1984 and has served as a member of the Audit Committee of the Board of Directors since February 1985. In September 1985, Mr. Lombardi was appointed Vice President of The Jones Group, Ltd., and in June 1989 was elected President of Jones Global Group, Inc., both affiliates of the General Partner. Mr. Lombardi is President and a director of Jones Financial Group, Ltd., an affiliate of the General Partner, and Group Vice President/Finance and a director of Jones International, Ltd. Mr. Howard O. Thrall was elected a Director of the General Partner in December 1988 and serves as a member of the Audit Committee and the special Stock Option Committee, which was established in August of 1992. From 1984 until August 1993, Mr. Thrall was associated with Douglas Aircraft Company, an aircraft manufacturing firm, most recently as Regional Vice President Marketing. In September 1993, Mr. Thrall joined World Airways, Inc. as Vice President of Sales, Asian Region. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Partnerships have no employees; however, various personnel are required to operate the cable television systems owned by the Partnerships. Such personnel are employed by the General Partner and, pursuant to the terms of the limited partnership agreements of the Partnerships, the cost of such employment is charged by the General Partner to the Partnerships as a direct reimbursement item. See Item 13. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGERS No person or entity owns more than 5 percent of the limited partnership interests in either of the Partnerships. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The General Partner and its affiliates engage in certain transactions with the Partnerships as contemplated by the limited partnership agreements of the Partnerships and as disclosed in the Prospectus for the Partnerships. The General Partner believes that the terms of such transactions, which are set forth in the Partnerships' limited partnership agreements, are generally as favorable as could be obtained by the Partnerships from unaffiliated parties. This determination has been made by the General Partner in good faith, but none of the terms were or will be negotiated at arm's-length and there can be no assurance that the terms of such transactions have been or will be as favorable as those that could have been obtained by the Partnerships from unaffiliated parties. The General Partner charges the Partnerships for management fees, and the Partnerships reimburse the General Partner for certain allocated overhead and administrative expenses in accordance with the terms of the limited partnership agreements of the Partnerships. These expenses consist primarily of salaries and benefits paid to corporate personnel, rent, data processing services and other facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Partnerships. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each Partnership managed. Remaining overhead costs are allocated based on revenues and/or the costs of assets managed for the Partnerships. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the General Partner, are also allocated a proportionate share of these expenses. The General Partner also advances funds and charges interest on the balance payable from the Partnerships. The interest rate charged the Partnerships approximates the General Partner's weighted average cost of borrowing. Affiliates of the General Partner have received amounts from the Partnerships for performing brokerage services. The Systems receive stereo audio programming from Superaudio, a joint venture owned 50% by an affiliate of the General Partner and 50% by an unaffiliated party, for a fee based upon the number of subscribers receiving the programming. These systems also receive educational video programming from Mind Extension University, Inc., an affiliate of the General Partner, for a fee based upon the number of subscribers receiving the programming. The charges to the Partnerships for related transactions are as follows for the periods indicated: * Cable TV Fund 14-B's consolidation includes 100% of the Venture. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K SIGNATURES Pursuant to the requirements of Section 13 or 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. CABLE TV FUND 14-A, LTD. CABLE TV FUND 14-B, LTD. Colorado limited partnerships By: Jones Intercable, Inc., their general partner By: /s/ GLENN R. JONES Glenn R. Jones Chairman of the Board and Chief Dated: March 25, 1994 Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.	14,983	99,628
75042_1993.txt	75042_1993	1993	75042	ITEM 1. BUSINESS (a) General Development of Business Oshkosh B'Gosh, Inc. (together with its subsidiaries, the "Company") was founded in 1895 and was incorporated in the state of Delaware in 1929. The Company designs, manufactures, sources and sells apparel for the children's wear, youth wear, and men's wear markets. While its heritage is in the men's workwear market, the Company is currently best known for its line of high quality children's wear. The children's wear business represented approximately 89% of consolidated Company revenues for 1993. The success of the children's wear business can be attributed to the Company's core themes: quality, durability, style, trust and Americana. These themes have propelled the Company to the position of market leader in the branded children's wear industry. The Company also leverages the economic value of the OshKosh B'Gosh name via both domestic and international licensing agreements. The Company's long-term strategy is to provide high quality, high value clothing for the entire family. Toward this end the Company continues to expand its business lines and avenues for marketing its products. Essex Outfitters, Inc. ("Essex"), a wholly owned subsidiary the Company acquired in 1990, is a vertically integrated children's wear retailer. Essex sources its apparel from third party manufacturers, primarily offshore, imports these goods and sells them primarily through its own chain of 52 retail stores. OshKosh B'Gosh International Sales, Inc. was created in 1985 for the sale of Oshkosh B'Gosh products to foreign distributors. In 1990, the Company formed OshKosh B'Gosh Europe, S.A. in conjunction with a joint venture with Poron Diffusion, S.A. to provide further access to European markets. In 1992 the Company acquired Poron's 49% interest in OshKosh B'Gosh Europe, S.A. During 1993 OshKosh B'Gosh made moves to strategically position itself for international expansion. OshKosh B'Gosh Asia/Pacific Ltd. was created in Hong Kong to oversee licensees and distributors in the Pacific Rim, to assist international licensees with the sourcing of product, and to expand the Company's presence in that region. OshKosh B'Gosh U.K. Ltd. and OshKosh B'Gosh Deutschland GmbH, incorporated in the United Kingdom and Germany respectively, were established to increase sales emphasis in those countries. The Company's chain of 40 OshKosh B'Gosh factory outlet stores sell irregular and first quality OshKosh B'Gosh merchandise throughout the United States. In 1993, the Company distributed its first children's wear mail order catalog, further expanding its channels of distribution. The Company has been expanding its utilization of off-shore sourcing as a cost-effective means to produce its products and to this end leased a production facility in Honduras in 1990 under its wholly owned subsidiary Manufacturera International Apparel S.A. (b) Financial Information About Industry Segments The Company is engaged in only one line of business, namely, the apparel industry. (c) Narrative Description of Business Products The Company designs, manufactures, sources and markets a broad range of children's clothing as well as lines of youth wear and men's casual and work wear clothing under the OshKosh, OshKosh B'Gosh, Baby B'Gosh or Boston Trader labels. The products are distributed primarily through better quality department and specialty stores, 92 of the Company's own stores, direct mail catalogs and foreign retailers. The children's wear business, which is the largest segment of the business, accounted for approximately 89% of 1993 sales compared to approximately 96% and 93% of such sales in 1992 and 1991 respectively. The children's wear and youth wear business is targeted to reach the middle to upper middle segment of the sportswear market. Children's wear is in size ranges from newborn/infant to girls 6X and boys 7. Youth wear is in size ranges girls 7 to 14 and boys 8 to 20. The Company's children's wear and youth wear businesses include a broad range of product categories organized primarily in a collection format whereby the products in that collection share a primary design theme which is carried out through fabric design, screenprint, embroidery, and trim applications. The Company also offers basic denim products with multiple wash treatments. The product offerings for each season will typically consist of a variety of clothing items including bib overalls, pants, jeans, shorts, and shortalls (overalls with short pant legs), shirts, blouses and knit tops, skirts, jumpers, sweaters, dresses, playwear and fleece. The men's wear line is the original business that started the Company back in 1895. The current line comprises the traditional bib overalls, several styles of waistband work, carpenter, and painters pants, five and six pocket jeans, work shirts and flannel shirts as well as a coats and jackets. The line is designed with a full array of sizes up to and including size 60 inch waists and 5x size shirts. Most products are designed by an in-house staff. Product design requires long lead times, with products generally being designed a year in advance of the time they actually reach the retail market. In general, the Company's products are traditional in nature and not intended to be "designer" items. In designing new products and styles, the Company attempts to incorporate current trends and consumer preferences in their traditional product offerings. In selecting fabrics and prints for its products, the Company seeks, where possible, to obtain exclusive rights to the fabric design from its suppliers in order to provide the Company with some protection from imitation by competitors for a limited period of time. Raw Materials, Manufacturing and Sourcing All raw materials used in the manufacture of Company products are purchased from unaffiliated suppliers. In 1993, approximately 65% of the Company's direct expenditures for raw materials were from its five largest suppliers, with the largest such supplier accounting for approximately 25% of total raw material expenditures. Fabric and various non-fabric items, such as thread, zippers, rivets, buckles and snaps are purchased from a variety of independent suppliers. The fabric and accessory market in which OshKosh B'Gosh purchases its raw materials is composed of a substantial number of suppliers with similar products and capabilities, and is characterized by a high degree of competition. As is customary in its industry, the Company has no long-term contracts with its suppliers. To date, the Company has experienced little difficulty in satisfying its requirements for raw materials, considers its sources of supply to be adequate, and believes that it would be able to obtain sufficient raw materials should any one of its product suppliers become unavailable. In 1993, approximately 79% of the Company products were manufactured in the United States using American-made textiles. Production administration is primarily coordinated from the Company's headquarters facility in Oshkosh with most production taking place in its eleven Tennessee and five Kentucky plants. Overseas labor is also accessed through a leased sewing plant in Honduras, where cut apparel pieces are received from the United States and are reimported by OshKosh B'Gosh as finished goods. In addition, product is produced by contractors in 14 countries and imported. The majority of the product engineering and sample making, allocation of production among plants and independent suppliers, material purchases and invoice payments are done through the Company's Oshkosh headquarters. All designs and specifications utilized by independent manufacturers are provided by the Company. While no long-term, formal arrangements exist with these manufacturers, the Company considers these relationships to be satisfactory. The Company believes it could obtain adequate alternative production capacity if any of its independent manufacturers become unavailable. Because higher quality apparel manufacturing is generally labor intensive (sewing, pressing, finishing and quality control) the Company has continually sought to upgrade its manufacturing and distribution facilities. Economies are therefore realized by technical advances in areas like computer-assisted design, computer-controlled fabric cutting, computer evaluation and matching of fabric colors, automated sewing processes, and computer-assisted inventory control and shipping. In order to realize economies of operation within the domestic production facilities, cutting operations are located in 5 of the Company's 18 plants, with all product washing, pressing and finishing done in one facility in Tennessee and all screenprint and embroidery done in one facility in Kentucky. Quality control inspections of both semi-finished and finished products are required at each plant, including those of independent manufacturers, to assure compliance. Customer orders for fashion products are booked from three to six months in advance of shipping. Because most Company production of styled products is scheduled to fill orders already booked, the Company believes that it is better able to plan its production and delivery schedules than would be the case if production were in advance of actual orders. In order to secure necessary fabrics on a timely basis and to obtain manufacturing capacity from independent suppliers, the Company must make substantial advance commitments, often as much as five to seven months prior to receipt of customer orders. Inventory levels therefore depend on Company judgment of market demand. Trademarks The Company utilizes the OshKosh, OshKosh B'Gosh or Baby B'Gosh trademarks on most of its products, either alone or in conjunction with a white triangular background. In addition, "The Genuine Article" is embroidered on the small OshKosh B'Gosh patch to signify apparel that is classic in design and all-but- indestructible in quality construction. The Company currently uses approximately 21 registered and unregistered trademarks in the United States. These trademarks and universal awareness of the OshKosh B'Gosh name are significant in marketing the products. In addition the Company licenses the Boston Trader and Trader Kids trademarks for use on its youth wear and some children's wear. The Company has recently decided to replace its Boston Trader line of children's apparel with a new brand called Genuine Kids. Seasonality Products are designed and marketed primarily for three principal selling seasons: RETAIL SALES SEASON PRIMARY BOOKING PERIOD SHIPPING PERIOD Spring/Summer August-September January-April Fall/Back-to-School January-February May-August Winter/Holiday May-June September-December Spring/Summer and Fall/Back-to-School are the Company's primary selling seasons and together accounted for approximately 65% of the Company's 1993 wholesale sales. The Company has historically experienced and expects to continue to experience seasonal fluctuations in its sales and net income from its OshKosh B'Gosh factory stores and Trader Kids outlet stores. Historically, a disproportionately high amount of the Company's retail sales and a majority of its net income have been realized during the months of August and November. Working Capital Working capital needs are affected primarily by inventory levels, outstanding accounts receivables and trades payables. The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totalling $60 million at December 31, 1993 including $45 million under commercial paper borrowing arrangements. These credit arrangements are used to support working capital needs as well a support letters of credit issued for product being imported and other corporate needs. As of December 31, 1993 there were no outstanding obligations against these credit arrangements. Letters of credit of approximately $15 million were outstanding at December 31, 1993. Inventory levels are affected by order backlog and anticipated sales, accounts receivables are affected by payment terms offered. It is general practice in the apparel industry to offer payment terms of ten to sixty days from date of shipment. The Company offers net 30 days terms only. The Company believes that its working capital requirements and financing resources are comparable with those of other major, financially sound apparel manufacturers. Sales and Marketing Company products are sold primarily through better quality department and specialty stores, although sales are also made through direct mail catalog companies, foreign retailers and other outlets, including 91 Company operated retail factory stores and one retail showcase store. One customer, J. C. Penney Company, Inc., accounted for approximately 10.2% of the Company's 1993 sales, and its largest ten and largest 100 customers accounted for approximately 47% and 67% of sales, respectively. In 1993, the Company's products were sold to approximately 4,200 customers (14,000 to 15,000 stores) throughout the United States, and a sizeable number of international accounts. Products are sold primarily by a direct employee sales force with the balance of sales made through manufacturer's representatives, to in-house accounts or through outlet stores. In addition to the central sales office in Oshkosh, the Company maintains regional sales offices and product showrooms in Dallas and New York. Most members of the Company's sales force are assigned to defined geographic territories, with some assigned to specific large national accounts. In sparsely populated areas and new markets, a manufacturer's representative represents the Company on a non-exclusive basis. Direct advertising in consumer and trade publications is the primary method of advertising used. The Company also offers a cooperative advertising program, paying half of its customers' advertising expenditures for their products, generally up to two percent of the higher of the customer's prior or current year's gross purchases from the Company. Backlog The dollar amount of backlog of orders believed to be firm as of the end of the Company's fiscal year and as of the preceding fiscal year is not material for an understanding of the business of the Company taken as a whole. Competitive Conditions The apparel industry is highly competitive and consists of a number of domestic and foreign companies. Some competitors have assets and sales greater than those of the Company. In addition, the Company competes with a number of firms that produce and distribute only a limited number of products similar to those sold by the Company or sell only in certain geographic areas being supplied by the Company. A characteristic of the apparel industry is the requirement that a manufacturer recognize fashion trends and adequately provide products to meet such trends. Competition within the apparel industry is generally in terms of quality, price, service, style and, with respect to branded product lines, consumer recognition and preference. The Company believes that it competes primarily on the basis of quality, style, and consumer recognition and to a lesser extent on the basis of service and price. The Company is focusing attention on the issue of price and service and has taken and will continue to take steps to reduce prices, become more competitive in the eyes of value conscious consumers and deliver the service expected by its customers. The Company's share of the overall children's wear market is quite small. This is due to the diverse structure of the market where there is no truly dominant producer of children's garments across all size ranges and garment types. In the Company's channel of distribution, department and speciality stores, it holds the largest share of the children's wear market. Environmental Matters The Company's compliance with Federal, State, and local environmental laws and regulations had no material effect upon its capital expenditures, earnings, or competitive position. The Company does not anticipate any material capital expenditures for environmental control in either the current or succeeding fiscal years. Employees At December 31, 1993, the Company employed approximately 6,400 persons. Approximately 43% of the Company's personnel are covered by collective bargaining agreements with the United Garment Workers of America. The Company considers its relations with its personnel to be good. ITEM 2. ITEM 2. PROPERTIES The Company's principal executive and administrative offices are located in Oshkosh, Wisconsin. Its principal office, manufacturing and distribution operations are conducted at the following locations: Approximate Floor Area in Principal Location Square Feet Use Albany, KY 20,000 Manufacturing Byrdstown, TN 32,000 Manufacturing Celina, TN 100,000 Manufacturing Celina, TN 90,000 Laundering/Pressing Columbia, KY 78,000 Manufacturing Columbia, KY 23,000 Manufacturing Dallas, TX (1) 1,995 Sales Offices/Showroom Dover, TN 87,000 Manufacturing Gainesboro, TN 61,000 Manufacturing Gainesboro, TN 29,000 Warehousing Hermitage Springs, TN 52,000 Manufacturing Jamestown, TN 43,000 Manufacturing Liberty, KY 218,000 Manufacturing/Warehousing Liberty, KY 32,000 Warehousing Los Angeles, CA (2) 1,145 Sales Offices/Showroom Marrowbone, KY 27,000 Manufacturing McEwen, TN (3) 29,000 Manufacturing New York City, NY (4) 18,255 Sales Offices/Showrooms Oshkosh, WI 99,000 Exec. & Operating Co. Offices Oshkosh, WI 88,000 Manufacturing Oshkosh, WI 86,000 Wholesale Distribution /Warehousing Oshkosh, WI 42,000 Retail Distribution /Warehousing Red Boiling Springs,TN 41,000 Manufacturing White House, TN 284,000 Distribution/Warehousing All properties are owned by the Registrant with the exception of: (1) Lease expiration date - 1994, (2) Lease expiration date - 1993, (3) Lease expiration date - 1997, (4) Lease expiration date - 2007. The Company believes that its properties are well maintained and its manufacturing equipment is in good operating condition and sufficient for current production. Substantially all of the Company's retail stores occupy leased premises. For information regarding the terms of the leases and rental payments thereunder, refer to the "Leases" note to the consolidated financial statements on page 26 of this Form 10-K. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not parties to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's Class A Common Stock and Class B Common Stock is traded in the over-the-counter market on the NASDAQ National Market System under the symbols GOSHA and GOSHB, respectively. The table reflects the "last" price quotation on the NASDAQ National Market System and does not reflect mark-ups, mark-downs, or commissions and may not represent actual transactions. The Company has paid cash dividends on its common stock each year since 1936. The Company's Certificate of Incorporation requires that when any dividend (other than a dividend payable solely in shares of the Company's stock) is paid on the Company's Class B Common Stock, a dividend equal to 115% of such amount per share must concurrently be paid on each outstanding share of Class A Common Stock. As of March 11, 1994, there were 2,081 holders of record of Class A Common Stock and 203 holders of record of Class B Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net sales in 1993 were $340.2 million, down 1.7% from 1992 sales of $346.2 million. The Company's domestic wholesale business of approximately $257 million in 1993 was 9.3% less than 1992 sales, due primarily to a decline in unit shipments of approximately 10% in 1993 from 1992. The decrease in domestic wholesale unit shipments related primarily to the effects of the competitive pricing environment in the children's wear business, the Company's difficulty in meeting the delivery requirements of its wholesale customers as well as the Company's expanding focus on its retail operations. The Company currently anticipates further reduction in its domestic wholesale unit shipments in 1994. In an effort to improve customer delivery requirements, the Company is currently undertaking a significant reengineering process. The Company anticipates continued improvement in its delivery performance in 1994. Company retail sales at its Oshkosh B'Gosh branded outlet stores and its wholly-owned subsidiary Essex Outfitters Trader Kids stores expanded to approximately $65.0 million in 1993, a 49.4% increase over 1992 retail sales of approximately $43.5 million. Retail sales increases resulted primarily from the opening of an additional 38 retail stores during 1993. The Company anticipates continued expansion in its retail business through the opening of an additional 35 to 45 retail stores in 1994, which should offset the reduction in the domestic wholesale business. Gross margin as a percent of sales improved to 28.0% in 1993, compared with 25.1% in 1992. During 1993, the Company experienced a slight improvement in its domestic wholesale gross margins. Increased retail store sales, at higher gross profit margins, had a significant impact on improved overall gross margin performance. Gross margins for 1992 were unfavorably impacted by manufacturing inefficiencies resulting from the restructuring of production lines and increasing workers' compensation insurance and employee health care costs. The Company currently anticipates further modest improvement in its gross margins in the second half of 1994. Selling, general and administrative expenses increased $12.1 million in 1993 from 1992. As a percent of net sales, selling, general and administrative expenses were 23.1% in 1993, up from 19.2% in 1992. The primary reason for increasing selling, general and administrative expenses is the Company's increasing focus on its retail business. In addition, the Company initiated a catalog division in the second half of 1993 which added approximately $1.2 million to its selling, general and administrative expense. Increasing emphasis on foreign sales opportunities, including the start-up costs associated with the opening of sales offices, have also added to the Company's selling, general and administrative expense structure. In 1994, the Company's continued expansion in its retail business, along with further development of its foreign business and catalog division will result in higher selling, general and administrative expenses in relation to its net sales. During the fourth quarter of 1993, the Company recorded a pretax restructuring charge of $10.8 million. Restructuring costs (net of income tax benefit) reduced net income by $7.1 million ($.49 per share) in 1993. After review of the Company's manufacturing capacity, operational effectiveness, sales volume and alternative sourcing opportunities, the Company decided to sell its Camden, Tennessee and McKenzie, Tennessee manufacturing plants as well as evaluate other capacity reduction alternatives. During 1993 the Company reduced its total workforce by over 1,200 employees. Sale of the McKenzie plant in 1994 will reduce the Company's workforce by approximately 230 employees. The Company's $10.8 million restructuring charge includes approximately $3.3 million for facility closings, write-down of the related assets and severance costs pertaining to workforce reductions. The restructuring charge also reflects the Company's decision to market its Boston Trader line of children's apparel under the new trade name Genuine Kids and the resulting costs of the Company's decision not to renew the Boston Trader license arrangement beyond 1994, as well as expenses to consolidate its retail operations. Accordingly, the restructuring charge includes approximately $7.5 million for write-off of previously capitalized trademark rights and expenses related to consolidating the Company's retail operations. The Company anticipates that these restructuring actions, net of income tax benefit, will require expenditures of approximately $2.5 million of cash over the next year, which will be funded entirely by internally generated cash. Company management believes that while these restructuring actions will not result in material short term earnings improvement, the restructuring will better position the Company competitively over a longer term period of time. In 1991, the Company recorded the impact of its decision to discontinue the manufacturing and sale of its Absorba line of infant's apparel. A pretax restructuring charge of $5.6 million represented provisions for facility closing and lease termination costs, severance pay, write-down of the related assets and estimated operating losses until closing. These restructuring costs (net of income tax benefit) reduced 1991's net income by $3.6 million ($.25 per share). During 1992, the Company reduced its estimate of the Absorba line restructuring costs by $2.8 million due to the efficient and orderly wind down of operations and favorable settlement of lease obligations. This adjustment to restructuring costs (net of income taxes) increased 1992 net income by $1.8 million ($.12 per share). Royalty income, net of expenses, was $3.4 million in 1993, as compared to $2.6 million in 1992. The increase in net royalty income resulted primarily from additional foreign license agreements. The effective tax rate for 1993 was 51.3% compared to 39.8% in 1992. The higher 1993 effective tax rate is the result of the Company's foreign operating losses, which provide no tax benefit, combined with the Company's substantially lower income before income taxes in 1993 (which resulted in part from the restructuring charge). The Company's early adoption of Statement of Financial Accounting Standards No. 109 on accounting for income taxes in 1992 had no material impact on 1992's results of operations. Company management believes that the $10.7 million deferred tax asset at December 31, 1993 can be fully realized through reversals of existing taxable temporary differences and the Company's history of substantial taxable income which allows the opportunity for carrybacks of current or future losses. The Company elected early adoption of the of the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1992. The Company elected to record the entire transition obligation in 1992, which resulted in a net $.6 million after tax ($.04 per share) reduction in net income. In November of 1992, the Financial Accounting Standards Board issued its Statement No. 112 entitled "Employers' Accounting for Postemployment Benefits." The Statement must be applied in the preparation of the Company's consolidated financial statements for the year ending December 31, 1994. The Company has determined that this standard will not have a significant effect on its consolidated financial statements. In September 1993, the Company signed a letter of intent to purchase Rio Sportswear, Inc. and affiliated companies (collectively "Rio"). In March, 1994, the Company announced that negotiations with Rio had terminated. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net sales for 1992 were $346.2 million, a 5.2% decrease from 1991 sales of $365.2 million. The decrease in net sales was due primarily to a 3.9% dollar decrease (1.2% in units) in the Oshkosh B'Gosh domestic wholesale business. The Company's decision to discontinue the sale of United States licensed Absorba products in 1992 also had a negative impact on reported 1992 sales, as 1991 sales of Absorba products amounted to $10.3 million. Sales by the Company's remaining subsidiaries totaled $23.2 million, a 44.2% increase over their 1991 sales. Gross margins as a percent of sales declined from 29.7% in 1991 to 25.1% in 1992. The decline resulted primarily from a 6.2% reduction in gross margins of the domestic wholesale children's wear business. Gross margins for 1992 were also unfavorably impacted by manufacturing inefficiencies resulting from the restructuring of production lines to meet the demands of product complexity and delivery schedules. Rapidly escalating workers' compensation insurance costs, employee health care costs, and other employee fringe benefit costs adversely impacted gross margins. In addition, in 1992 the Company initiated a volume discount program which placed added pressure on Company gross margins. Variations in gross margins of subsidiaries had no material effect on consolidated results. Selling, general and administrative expenses decreased $1.3 million from 1991. As a percent of net sales, selling, general and administrative expenses were 19.2% and 18.6% for 1992 and 1991 respectively. The primary reason for the decline in the dollar amount of selling, general and administrative expenses was the discontinuance of the Absorba operations, offset in part by increased advertising and factory store expenses. The increased factory store expenses were primarily the result of opening 7 additional Oshkosh B'Gosh retail stores. Subsidiary marketing and administrative expenses increased primarily from the addition of 16 retail stores at the Company's Essex Outfitters, Inc. subsidiary. During 1991 the Company decided to discontinue the manufacture and sale of its United States licensed Absorba products. An estimated pretax restructuring cost of $5.6 million was recorded in 1991 for facility closings, severance pay, loss on disposal of assets and estimated operating losses until closing. Favorable settlements of lease obligations, efficient and orderly wind down of operations, and disposition of remaining assets and inventories at favorable amounts resulted in a reduction in the Company's provision for restructuring costs by $2.8 million ($1.8 million net of income taxes). The net effect of this reduction in provision for restructuring costs increased 1992's income by $.12 per share. As of December 31, 1992, substantially all assets of Absorba, Inc. were sold and all operations were ceased. Results of operations of the Company's three remaining subsidiaries decreased 1992 income before tax by approximately $.4 million. Results of operations of the remaining subsidiaries (excluding Absorba) decreased 1991 income by approximately $.9 million. Losses were experienced in operations of Oshkosh B'Gosh Europe, S.A. and Manufacturera International Apparel, S.A. (our Honduras manufacturing subsidiary), while Essex Outfitters net income was approximately equal to that realized in 1991. The effective tax rate for 1992 and 1991 was 39.8%. The Company's early adoption of the Financial Accounting Standards Board Statement No. 109 on accounting for income taxes in 1992 had no material impact on 1992's results of operations. FINANCIAL CONDITION During 1993 total assets increased by $2.9 million or 1.3% over 1992. Accounts receivable at December 31, 1993 were $19.5 million compared to $24.4 million at December 31, 1992. Inventories at the end of 1993 were $100 million, up $7.2 million from 1992. This increase in inventories relates primarily to the Company's expanding retail business. Management believes that year end 1993 inventory levels are generally appropriate for anticipated 1994 business activity. Accrued liabilities at the end of 1993 were $29.8 million, up $13.6 million from 1992. This increase is due primarily to the Company's provision for restructuring costs recorded in the fourth quarter of 1993. On February 20, 1992, the Company finalized a $7 million Industrial Development Revenue Bond issue to finance construction of the Celina, Tennessee finishing plant. As a result of additional capital expenditures associated with the project and the possible restrictions to future expansion because of limits imposed by existing Industrial Development Revenue Bond regulations, the bonds were called on December 18, 1992 and paid off on January 19, 1993. LIQUIDITY AND CASH FLOW The Corporation maintains a relatively liquid financial position. Net working capital at the end of 1993 was $111.8 million, approximately the same as at the end of 1992. The current ratio was 3.8 to 1 at 1993 year end, compared to 4.2 to 1 at year end 1992. Cash provided by operations was approximately $21.6 million in 1993, compared to $22.9 million in 1992. Capital expenditures were approximately $9 million in 1993 and $12.6 million in 1992. Capital expenditures for 1994 are currently budgeted at approximately $12 million. Liquidity is also provided by short-term borrowings that fund seasonal working capital needs. The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totaling $60 million at December 31, 1993 including $45 million under commercial paper borrowing arrangements. The Company believes its present liquidity, in combination with cash flow from future operations and its available credit facilities, is sufficient to meet its continuing operating and capital requirements in the foreseeable future. Dividends on the Company's Class A and Class B Common Stock totaled $.5125 per share and $.45 per share, respectively, in 1993, the same as in 1992. The dividend payout rate was 163% in 1993 and 49% in 1992. The Company's lower earnings from operations in 1993 combined with the fourth quarter 1993 restructuring charge resulted in the unusually high 1993 payout rate. INFLATION The effects of inflation on the Company's operating results and financial condition were not significant. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Financial Statements: Reports of Independent Auditors 15 Consolidated Balance Sheets - December 31, 1993 and 1992 17 Consolidated Statements of Income - years ended December 31, 1993, 1992 and 1991 18 Consolidated Statements of Changes in Shareholders' Equity - - - years ended December 31, 1993, 1992, and 1991 19 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991 20 Notes to Consolidated Financial Statements 22 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors Oshkosh B'Gosh, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Oshkosh B'Gosh, Inc. and Subsidiaries as of December 31, 1993, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the year then ended. Our audit also included the 1993 financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oshkosh B'Gosh, Inc. and Subsidiaries at December 31, 1993, and the consolidated results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related 1993 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Milwaukee, Wisconsin ERNST & YOUNG February 11, 1994 REPORT OF SCHUMAKER, ROMENESKO & ASSOCIATES, S.C., INDEPENDENT AUDITORS The Board of Directors Oshkosh B'Gosh, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Oshkosh B'Gosh, Inc. and Subsidiaries as of December 31, 1992, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1992 and 1991. Our audits also included the 1992 and 1991 financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oshkosh B'Gosh, Inc. and Subsidiaries at December 31, 1992, and the consolidated results of their operations and their cash flows for the years ended December 31, 1992 and 1991 in conformity with generally accepted accounting principles. Also, in our opinion, the related 1992 and 1991 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 9 and 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and nonpension postretirement benefits. Oshkosh, Wisconsin SCHUMAKER, ROMENESKO & ASSOCIATES, S.C. February 15, 1993 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands, except share and per share amounts) December 31, 1993 1992 Assets Current assets Cash and cash equivalents $ 17,853 $ 21,129 Accounts receivable, less allowances of $3,310 in 1993 and $2,265 in 1992 19,477 24,425 Inventories 99,999 92,752 Prepaid expenses and other current assets 3,810 2,185 Deferred income taxes 10,716 5,819 Total current assets 151,855 146,310 Property, plant and equipment, net 71,755 72,312 Other assets 5,521 7,573 Total assets $229,131 $226,195 Liabilities and Shareholders' Equity Current liabilities Current maturities of long-term debt $ 536 $ 7,896 Accounts payable 9,720 11,096 Accrued liabilities 29,805 16,243 Total current liabilities 40,061 35,235 Long-term debt 757 1,293 Deferred income taxes 3,040 3,680 Employee benefit plan liabilities 13,275 10,834 Commitments - - Shareholders' equity Preferred stock, par value $.01 per share: Authorized - 1,000,000 shares; Issued and outstanding - None - - Common stock, par value $.01 per share: Class A, authorized - 30,000,000 shares; Issued and outstanding - 13,280,572 shares in 1993, 12,776,860 shares in 1992 133 128 Class B, authorized - 3,750,000 shares; Issued and outstanding - 1,305,228 shares in 1993, 1,808,940 shares in 1992 13 18 Additional paid-in capital 2,971 2,971 Retained earnings 169,182 172,036 Cumulative foreign currency translation adjustments (301) - Total shareholders' equity 171,998 175,153 Total liabilities and shareholders'equity $229,131 $226,195 See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Income (Dollars in thousands, except per share amounts) Year Ended December 31, 1993 1992 1991 Net sales $340,186 $346,206 $365,173 Cost of products sold 244,926 259,344 256,755 Gross profit 95,260 86,862 108,418 Selling, general and administrative expenses 78,492 66,414 67,726 Restructuring 10,836 (2,800) 5,600 Operating income 5,932 23,248 35,092 Other income (expense): Interest expense (626) (797) (897) Interest income 1,114 1,022 1,134 Royalty income, net of expenses 3,417 2,562 3,047 Minority interest in loss of consolidated subsidiary - 108 602 Miscellaneous (545) (17) 174 Other income - net 3,360 2,878 4,060 Income before income taxes and cumulative effect of accounting change 9,292 26,126 39,152 Income taxes 4,769 10,390 15,576 Income before cumulative effect of accounting change 4,523 15,736 23,576 Cumulative effect of change in accounting for nonpension postretirement benefits - (601) - Net income $ 4,523 $ 15,135 $ 23,576 Income per share before cumulative effect of accounting change $.31 $1.08 $1.62 Change in accounting for nonpension postretirement benefits - (.04) - Net income per common share $.31 $1.04 $1.62 See notes to consolidated financial statements. See notes to consolidated financial statements OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Cash flows from operating activities Net income $ 4,523 $15,135 $23,576 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 9,233 8,375 6,568 (Gain) loss on disposal of assets 63 85 (14) Minority interest in loss of consolidated subsidiary - (108) (602) Provision for deferred income taxes (5,537) 35 (2,832) Pension expense, net of contributions 1,852 1,753 2,304 Cumulative effect of accounting change - 1,001 - Restructuring 10,836 (2,800) 5,600 Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable 4,948 (643) 6,149 Inventories (7,247) 1,478 (3,096) Prepaid expenses and other current assets (1,624) (252) (1,336) Accounts payable (1,376) (2,522) 3,925 Accrued liabilities 5,940 1,313 (339) Net cash provided by operating activities 21,611 22,850 39,903 Cash flows from investing activities Additions to property, plant and equipment (8,990)(12,563) (19,569) Proceeds from disposal of assets 1,159 625 256 Investments in subsidiaries - (900) - Additions to other assets (1,783) (1,602) (580) Net cash used in investing activities (9,614)(14,440) (19,893) See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (continued) (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Cash flows from financing activities Net decrease in short-term borrowings $ - $ - $(4,706) Proceeds from long-term borrowings - 7,000 - Payments of long-term debt (7,896) (1,270) (1,071) Dividends paid (7,377) (7,362) (7,362) Proceeds from issuance of subsidiary stock - - 642 Net cash used in financing activities (15,273) (1,632) (12,497) Net increase (decrease) in cash and cash equivalents (3,276) 6,778 7,513 Cash and cash equivalents at beginning of year 21,129 14,351 6,838 Cash and cash equivalents at end of year $17,853 $21,129 $14,351 Supplementary disclosures Cash paid for interest $ 1,030 $ 823 $ 946 Cash paid for income taxes $12,194 $ 9,877 $21,895 See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 1. Significant accounting policies Business - Oshkosh B'Gosh, Inc. and its majority-owned subsidiaries (the Company) is engaged primarily in the design, manufacture and marketing of apparel to wholesale customers and through Company owned retail stores. Principles of consolidation - The consolidated financial statements include the accounts of all majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Minority interest represents the minority shareholder's proportionate share of the net loss of Oshkosh B'Gosh Europe, S.A. until the Company acquired the remaining interest in July, 1992. Cash equivalents - Cash equivalents consist of highly liquid debt instruments such as money market accounts with original maturities of three months or less. The Company's policy is to invest cash in conservative instruments as part of its cash management program and to evaluate the credit exposure of any investment. Cash and cash equivalents are stated at cost, which approximates market value. Inventories - Inventories are stated at the lower of cost or market. Inventories stated on the last-in, first-out (LIFO) basis represent 90.6% of total 1993 and 96.3% of total 1992 inventories. Remaining inventories are valued using the first- in, first-out method. Property, plant and equipment - Property, plant and equipment are carried at cost. Depreciation and amortization for financial reporting purposes is calculated using the straight line method based on the following useful lives: Years Land improvements 10 to 15 Buildings 10 to 40 Leasehold improvements 5 to 10 Machinery and equipment 5 to 10 Income taxes - Effective January 1, 1992, the Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This Statement requires recognition of deferred tax assets and liabilities for all temporary differences between the financial reporting and income tax basis of Company assets and liabilities. In 1991, deferred income taxes were accounted for under APB Opinion No. 11. The effect of this accounting change at January 1, 1992 was not material. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 1. Significant accounting policies (continued) Foreign currency translation - The functional currency for certain foreign subsidiaries is the local currency. Accordingly, assets and liabilities are translated at year end exchange rates, and income statement items are translated at average exchange rates prevailing during the year. Such translation adjustments are recorded as a separate component of shareholders' equity. Revenue recognition - Revenue within wholesale operations is recognized at the time merchandise is shipped to customers. Retail store revenues are recognized at the time of sale. Income per common share - Income per common share amounts are computed by dividing income by the number of shares of common stock outstanding (14,585,800 in each year). There are no common stock equivalents. Reclassifications - Certain reclassifications of financial information for the years ended December 31, 1991 and 1992 have been made to conform with the 1993 presentation. Note 2. Restructuring During the fourth quarter of 1993, the Company recorded a pretax restructuring charge of $10,836. The restructuring charge includes approximately $3,300 for facility closings, write-down of the related assets and severance costs pertaining to work force reductions. The restructuring charge also reflects the Company's decision to market its Trader Kids line of children's apparel under the new name Genuine Kids and the resulting costs of the Company's decision not to renew its Boston Trader license arrangement beyond 1994, as well as expenses to consolidate its retail operations. Accordingly, the restructuring charge includes approximately $7,500 for write-off of unamortized trademark rights and expenses related to consolidating the Company's retail operations. Restructuring costs (net of income tax benefit) reduced net income by $7,100 ($.49 per share) in 1993. The Company recorded the impact of its decision to discontinue the manufacturing and sales of its Absorba line of infant's apparel in 1991. Restructuring costs of $5,600 represented provisions for facility closing and lease termination costs, severance pay, write-down of the related assets and estimated operating losses until closing. Restructuring costs (net of income tax benefit) reduced net income by $3,600 ($.25 per share) in 1991. During 1992, the Company reduced its estimate of the Absorba line restructuring costs by $2,800 due to the efficient and orderly wind down of operations and favorable settlement of lease obli- gations. This adjustment to restructuring costs (net of income taxes) increased 1992 net income by $1,800 ($.12 per share). OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 3. Inventories A summary of inventories follows: December 31, 1993 1992 Finished goods $82,737 $71,290 Work in process 5,008 6,695 Raw materials 12,254 14,767 $99,999 $92,752 The replacement cost of inventory exceeds the above LIFO costs by $14,716 and $17,462 at December 31, 1993 and 1992, respectively. Note 4. Property, plant and equipment A summary of property, plant and equipment follows: December 31, 1993 1992 Land and improvements $ 4,172 $ 3,896 Buildings 37,640 38,107 Leasehold improvements 5,268 2,953 Machinery and equipment 67,026 62,357 Construction in progress 291 537 114,397 107,850 Less: accumulated depreciation and amortization 42,642 35,538 Property, plant and equipment, net $ 71,755 $ 72,312 Depreciation and amortization expense on property, plant and equipment for the years ended December 31, 1993, 1992, and 1991 amounted to approximately $8,425, $7,909, and $6,136, respectively. Note 5. Short-term borrowings The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totaling $60,000 at December 31, 1993 including $45,000 under commercial paper borrowing arrangements. Bank credit lines are maintained in full support of outstanding commercial paper. Interest under the lines is at or below the lenders' prime rate. There were no outstanding obligations against these credit arrangements at December 31, 1993 or 1992. Letters of credit of approximately $15,000 were outstanding at December 31, 1993, with $41,000 of the unused line of credit available for borrowing. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 6. Accrued liabilities A summary of accrued liabilities follows: December 31, 1993 1992 Compensation $ 4,701 $ 4,181 Group health insurance 1,700 1,900 Worker's compensation 8,600 5,705 Income taxes 640 753 Restructuring costs 8,186 422 Other 5,978 3,282 $29,805 $16,243 Note 7. Long-term debt The Company's long-term debt is summarized as follows: December 31, 1993 1992 Obligations under industrial development revenue bonds: Fixed rate $ - $ 80 Floating rate 666 8,372 Other mortgage notes and loans with interest at varying rates 627 737 Total 1,293 9,189 Less current maturities 536 7,896 Total long-term debt $ 757 $1,293 The industrial development revenue bonds are due in varying installments through 1995. The floating interest rates on the bonds range from 65% to approximately 80% of prime rate (prime rate was 6.0% at December 31, 1993). Annual total maturities of principal on long-term debt are as follows: Year ending December 31, 1994 $ 536 1995 240 1996 42 1997 43 1998 45 Thereafter 387 1,293 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 8. Leases The Company leases certain property and equipment including retail sales facilities and regional sales offices under operating leases. Certain leases provide the Company with renewal options. Leases for retail sales facilities provide for minimum rentals plus contingent rentals based on sales volume. Minimum future rental payments under noncancellable operating leases are as follows: Year ending December 31, 1994 $ 7,346 1995 6,668 1996 5,639 1997 4,662 1998 3,858 Thereafter 13,587 Total minimum lease payments $41,760 Total rent expense charged to operations for all operating leases is as follows: Year Ended December 31, 1993 1992 1991 Minimum rentals $7,718 $5,921 $4,873 Contingent rentals 167 179 201 Total rent expense $7,885 $6,100 $5,074 Note 9. Income taxes Income tax expense (credit) is comprised of the following: Year Ended December 31, 1993 1992 1991 Current: Federal $ 8,571 $ 8,155 $15,370 State and local 1,735 1,800 3,038 10,306 9,955 18,408 Deferred (5,537) 435 (2,832) Totals $ 4,769 $10,390 $15,576 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 9. Income taxes (continued) The components of the Company's deferred tax asset and deferred tax liability include: December 31, 1993 1992 [Assets (Liabilities)] Current deferred taxes Accounts receivable allowances $ 1,272 $ 844 Inventory valuation 2,129 1,403 Accrued liabilities 3,714 3,304 Restructuring costs 3,204 160 Other 397 108 Total net current deferred tax assets$10,716 $ 5,819 Non-current deferred taxes Depreciation $(8,266) $(7,304) Deferred employee benefits 4,419 3,496 Trademark 807 128 Foreign losses 1,807 979 Valuation allowance (1,807) (979) Total net long-term deferred tax liabilities $(3,040) $(3,680) The sources of deferred income taxes for the year ended December 31, 1991 and the tax effect of each are as follows: Depreciation $1,047 Accounts receivable allowances (90) Deferred employee benefits (498) Inventory valuation (837) Restructuring costs (2,000) Other (454) Totals $(2,832) For financial reporting purposes, income before income taxes and cumulative effect of accounting change includes the following components: Year Ended December 31, 1993 1992 1991 Pretax income (loss): United States $11,704 $27,574 $41,272 Foreign (2,412) (1,448) (2,120) $ 9,292 $26,126 $39,152 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 9. Income taxes (continued) A reconciliation of the federal statutory income tax rate to the effective tax rates reflected in the consolidated statements of income follows: Year Ended December 31, 1993 1992 1991 Federal statutory tax rate 35.0% 34.0% 34.0% Differences resulting from: State and local income taxes, net of federal income tax benefit 4.1 4.2 4.1 Foreign losses with no tax benefit 9.1 1.9 1.8 Other 3.1 (.3) (.1) 51.3% 39.8% 39.8% Note 10. Retirement plans The Company has defined contribution and defined benefit pension plans covering substantially all employees. Charges to operations by the Company for these pension plans totaled $4,621, $4,477, and $4,615 for 1993, 1992 and 1991, respectively. Defined benefit pension plans - The Company sponsors several qualified defined benefit pension plans covering certain hourly and salaried employees. In addition, the Company maintains a supplemental unfunded salaried pension plan to provide those benefits otherwise due employees under the salaried plan's benefit formulas, but which are in excess of benefits permitted by the Internal Revenue Service. The benefits provided are based primarily on years of service and average compensation. The pension plans' assets are comprised primarily of listed securities, bonds, treasury securities, commingled equity and fixed income investment funds and cash equipvalents. Plan assets included 7,000 and 10,000 shares of Oshkosh B'Gosh, Inc. Class A common stock at December 31, 1993 and 1992, respectively, and 5,000 shares of Oshkosh B'Gosh, Inc. Class B common stock in both years, with a total market value of approximately $236 and $307 at December 31, 1993 and 1992, respectively. The Company's funding policy for qualified plans is to contribute amounts which are actuarially determined to provide the plans with sufficient assets to meet future benefit payment requirements consistent with the funding requirements of federal laws and regulations. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement Plans (continued) The actuarial computations utilized the following assumptions. December 31, 1993 1992 1991 Discount rate 7.0% 7.0-7.5% 6.5-7.0% Expected long-term rate of return on assets 7.0% 7.5-8.0% 7.0-7.5% Rates of increase in compensation levels 0-4.5% 0-5.5% 0-6.0% Net periodic pension cost was comprised of: December 31, 1993 1992 1991 Service cost - benefits earned during the period $2,318 $2,309 $2,077 Interest cost on projected benefit obligations 1,808 1,601 1,409 Actual return on plan assets (1,708) (1,037) (2,351) Net amortization and deferral 1,259 636 2,213 Net periodic pension cost $3,677 $3,509 $3,348 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement plans (continued) The following table sets forth the funded status of the Company's defined benefit plans and the amount recognized in the Company's consolidated balance sheets. The funded status of plans with assets exceeding the accumulated benefit obligation (ABO) is segregated by column from that of plans with the ABO exceeding assets. December 31, 1993 1992 Assets ABO Assets ABO Exceed Exceeds ExceedExceeds ABO Assets ABO Assets Actuarial present value of benefit obligations: Vested benefits $ 9,051 $ 6,308 $ 6,423$ 5,118 Nonvested benefits 1,604 449 1,119 449 Total accumulated benefit obligation $10,655 $ 6,757 $ 7,542$ 5,567 Projected benefit obligation $22,299 $ 6,835 $18,026$ 6,076 Plan net assets at fair value 12,070 2,777 10,363 2,456 Projected benefit obligation in excess of plan net assets (10,229) (4,058) (7,663)(3,620) Unamortized transition (asset) obligation (1,535) (23) (1,689) 175 Unrecognized prior service cost 2,821 2,867 3,055 2,589 Unrecognized net (gain) loss 3,546 (592) 2,950 (539) Adjustment to recognize minimum liability - (2,200) - (1,716) Accrued pension liability at December 31 $(5,397)$(4,006)$(3,347)$(3,111) Defined contribution plan - The Company maintains a defined contribution retirement plan covering certain salaried employees. Annual contributions are discretionary and are determined by the Company's Executive Committee. Charges to operations by the Company for contributions under this plan totaled $565, $658 and $853 for 1993, 1992 and 1991, respectively. The Company also has a supplemental retirement program for designated employees. Annual provisions to this unfunded plan are discretionary and are determined by the Company's Executive Committee. Charges to operations by the Company for additions to this plan totaled $379, $310 and $414 for 1993, 1992 and 1991, respectively. Deferred employee benefit plans - The Company has deferred compensation and supplemental retirement arrangements with certain key officers. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement plans (continued) Postretirement health and life insurance plan - The Company sponsors an unfunded defined benefit postretirement health insurance plan that covers eligible salaried employees. Life insurance benefits are provided under the plan to qualifying retired employees. The postretirement health insurance plan is offered, on a shared cost basis, only to employees electing early retirement. This coverage ceases when the employee reaches age 65 and becomes eligible for Medicare. Retiree contributions are adjusted periodically. In 1992, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." In applying this pronouncement, the Company elected to immediately recognize the accumulated postretirement benefit obligation as of the beginning of 1992 of approximately $1 million in the first quarter of 1992 as a change in accounting principle. The charge, net of an income tax benefit of $400, was $601 or $.04 per share. The following table sets forth the funded status of the plan and the postretirement benefit cost recognized in the Company's consolidated balance sheets: December 31, 1993 1992 Accumulated postretirement benefit obligation: Retirees $ 119 $ 140 Fully eligible active plan participants 216 231 Other active plan participants 670 795 1,005 1,166 Plan assets - - Unrecognized net gain 281 - Accrued postretirement benefit cost $1,286 $1,166 Net periodic postretirement benefit cost was comprised of: Year Ended December 31, 1993 1992 Service cost - benefits attributed to employee service during the year $ 98 $119 Interest cost on accumulated postretirement benefit obligation 61 75 Net amortization and deferral (18) - Net periodic postretirement benefit cost $141 $194 The discount rate used in determining the accumulated postretirement benefit obligation was 7.0% in 1993 and 7.5% in 1992. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 15%, declining gradually to 6% by 2012 and then declining further to an ultimate rate of 4% by 2022. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement Plans (continued) The health care cost trend rate assumption has a significant impact on the amounts reported. Increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation at December 31, 1993 by approximately $121 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by approximately $26. The charge for retiree health care benefits prior to the adoption of SFAS No. 106 was immaterial. Note 11. Common stock In May, 1993 shareholders of the Company approved a stock conversion plan whereby shares of Class B common stock may be converted to an equal number of Class A common shares. The Company's common stock authorization provides that dividends be paid on both the Class A and Class B common stock at any time that dividends are paid on either. Whenever dividends (other than dividends of Company stock) are paid on the common stock, each share of Class A common stock is entitled to receive 115% of the dividend paid on each share of Class B common stock. The Class A common stock shareholders are entitled to receive a liquidation preference of $7.50 per share before any payment or distribution to holders of the Class B common stock. Thereafter, holders of the Class B common stock are entitled to receive $7.50 per share before any further payment or distribution to holders of the Class A common stock. Thereafter, holders of the Class A common stock and Class B common stock share on a pro-rata basis in all payments or distributions upon liquidation, dissolution or winding up of the Company. Note 12. Business and credit concentrations The Company provides credit, in the normal course of business, to department and specialty stores. The Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses. The Company's customers are not concentrated in any specific geographic region. Sales to a customer, as a percentage of total sales, amounted to approximately 10% in 1993. In 1992, sales to two customers, as a percentage of total sales, amounted to approximately 12% each. In 1991, sales to a single customer, as a percentage of total sales, amounted to approximately 12%. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements Financial statements for Oshkosh B'Gosh, Inc. listed in the Index to Financial Statements and Supplementary Data on page 14 are filed as part of this Annual Report. (2) Financial Statement Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings Schedule X - Supplementary Income Statement InformationF-5 Schedules and notes not included have been omitted because they are not applicable or the required information is included in the consolidated financial statements and notes thereto. (3) Index to Exhibits (b) Reports on Form 8-K The registrant filed a Form 8-K, Item 4 Change of Independent Auditors, on December 13, 1993. 3) Exhibits 3.1 Certificate of Incorporation of Oshkosh B'Gosh, Inc., as restated, October 20, 1988, previously filed as Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File Number 0-13365, is incorporated herein by reference. 3.2 By-laws of Oshkosh B'Gosh, Inc., as adopted through May 1, 1992, previously filed as Exhibit 3.2 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. 10.1 Employment Agreement dated July 7, 1980, between Oshkosh B'Gosh, Inc. and Charles F. Hyde as extended by "Request For Later Retirement" dated April 15, 1986 and accepted by Board of Directors' resolution on May 2, 1986, previously filed as Exhibit 10.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission File Number 0-13365, is incorporated herein by reference. 10.2 Employment Agreement dated July 7, 1980, between Oshkosh B'Gosh, Inc. and Thomas R. Wyman, previously filed as Exhibit 10.2 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.3 Oshkosh B'Gosh, Inc. Pension Plan as amended, previously filed as Exhibit 10.3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0-13365, is incorporated herein by reference. 10.4 Oshkosh B'Gosh, Inc. Profit Sharing Plan, as amended on August 5, 1985, previously filed as Exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File Number 0- 13365, is incorporated herein by reference. 10.5 Oshkosh B'Gosh, Inc. Restated Excess Benefit Plan as amended, previously filed as Exhibit 10.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. 10.6 Oshkosh B'Gosh, Inc. Executive Deferred Compensation Plan as amended, previously filed as Exhibit 10.6 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. Represents a plan that covers compensation, benefits and/or related arrangements for executive management. 10.7 Oshkosh B'Gosh, Inc. Officers Medical and Dental Reimbursement Plan, previously filed as Exhibit 10.7 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.8 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of the Town of Dover, Tennessee, dated as of May 1, 1984 (Series 1984A), previously filed as Exhibit 10.8 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.9 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of the Town of Dover, Tennessee, dated as of May 1, 1984 (Series 1984B), previously filed as Exhibit 10.9 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.10 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of December 1, 1983 (Series 1983A), previously filed as Exhibit 10.10 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.11 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of December 1, 1983 (Series 1983B), previously filed as Exhibit 10.11 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.12 Loan Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of November 1, 1983, previously filed as Exhibit 10.12 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.13 Lease Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of March 1, 1975, previously filed as Exhibit 10.13 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.14 Acknowledgement and Guaranty Agreement between City of Liberty, Casey County, Kentucky and Oshkosh B'Gosh, Inc., dated October 4, 1984, and related Contract of Lease and Rent dated as of November 26, 1968, previously filed as Exhibit 10.14 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. Represents a plan that covers compensation, benefits and/or related arrangements for executive management. 10.15 Loan Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of October 1, 1985, previously filed as Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File Number 0-13365, is incorporated herein by reference. 10.16 Indemnity Agreement between Oshkosh B'Gosh, Inc. and William P. Jacobsen (Vice President and Treasurer of Oshkosh B'Gosh, Inc.) dated as of June 8, 1987, previously filed as Exhibit 10.16 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File Number 0-13365, is incorporated herein by reference. (Note: Identical agreements have been entered into by the Company with each of the following officers: Charles F. Hyde, Thomas R. Wyman, John F. Beckman, Anthony S. Giordano, Douglas W. Hyde, Michael D. Wachtel, and Kenneth H. Masters). 10.17 Employment agreement dated December 14, 1989 and effective February 1, 1990, between Oshkosh B'Gosh, Inc. and Harry M. Krogh, previously filed as Exhibit 10.17 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 0-13365, is incorporated herein by reference. 10.18 Oshkosh B'Gosh, Inc. Executive Non-Qualified Profit Sharing Plan effective as of January 1, 1989, previously filed as Exhibit 10.18 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 0-13365, is incorporated herein by reference. 10.19 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of February 1, 1992. Represents a plan that covers compensation, benefits and/or related arrangements for executive management. 21 The following is a list of the subsidiaries of the Company as of December 31, 1993. The consolidated financial statements reflect the operations of all subsidiaries as they existed on December 31, 1993. State or Other Jurisdiction of Name of Incorporation or Subsidiary Organization Term Co. (formerly Absorba, Inc.) Delaware Essex Outfitters, Inc. Delaware Grove Industries, Inc. Delaware Manufacturera International Apparel, S.A. Honduras Oshkosh B'Gosh Europe, S.A. France Oshkosh B'Gosh International Sales, Inc. Virgin Islands Oshkosh B'Gosh Asia/Pacific Ltd. Hong Kong Oshkosh B'Gosh U.K. Ltd. United Kingdom Oshkosh B'Gosh Deutschland GmbH Germany OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule V Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Balance at Balance Beginning Additions at End Classification of Year at Cost Retirements of Year Year Ended December 31, 1993: Construction in Progress $ 537 $ (246) $ - $ 291 Land 1,647 287 59 1,875 Land Improvements 2,249 70 22 2,297 Buildings 38,107 555 1,022 37,640 Machinery and Equipment 62,357 5,909 1,240 67,026 Leasehold Improvements 2,953 2,415 100 5,268 Total $107,850 $ 8,990 $ 2,443 $114,397 Year Ended December 31, 1992: Construction in Progress $ 7,380 $(6,843) $ - $ 537 Land 1,264 383 - 1,647 Land Improvements 1,981 268 - 2,249 Buildings 30,122 8,005 20 38,107 Machinery and Equipment 55,096 11,163 3,902 62,357 Leasehold Improvements 1,805 1,431 283 2,953 Total $97,648 $14,407 $ 4,205 $107,850 Year Ended December 31, 1991: Construction in Progress $ 3,917 $ 3,463 $ - $ 7,380 Land 1,264 - - 1,264 Land Improvements 1,849 132 - 1,981 Buildings 26,409 3,713 - 30,122 Machinery and Equipment 43,802 11,995 701 55,096 Leasehold Improvements 1,533 272 - 1,805 Total $78,774 $19,575 $ 701 $97,648 Depreciation and Amortization Depreciation and amortization for financial reporting purposes is calculated using straight-line methods based on the following useful lives: Years Land Improvements 10 to 15 Buildings 10 to 40 Equipment 5 to 10 Leasehold Improvements 5 to 10 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Balance atCharged to Balance BeginningCosts and at End Classification of Year Expenses Retirements of Year Year Ended December 31, 1993: Land Improvements $ 877 $ 211 $ 3 $ 1,085 Buildings 7,577 1,520 267 8,830 Machinery and Equipment 26,070 6,208 879 31,399 Leasehold Improvements 1,014 486 172 1,328 Total $35,538 $8,425* $1,321 $42,642 Year Ended December 31, 1992: Land Improvements $ 674 $ 203 $ - $ 877 Buildings 6,101 1,480 4 7,577 Machinery and Equipment 21,567 5,994 1,491 26,070 Leasehold Improvements 914 232 132 1,014 Total $29,256 $7,909* $1,627 $35,538 Year Ended December 31, 1991: Land Improvements $ 497 $ 177 $ - $ 674 Buildings 5,135 966 - 6,101 Machinery and Equipment 17,237 4,783 453 21,567 Leasehold Improvements 704 210 - 914 Total $23,573 $6,136* $ 453 $29,256 * Excludes amortization of other assets of $808 in 1993, $466 in 1992, and $432 in 1991. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule VIII Valuation and Qualifying Accounts (Dollars in Thousands) Years Ended December 31, 1993 1992 1991 Accounts Receivable - Allowances: Balance at Beginning of Period $2,265 $2,335 $2,075 Charged to Costs and Expenses 5,979 4,500 4,513 Deductions - Bad Debts Written off, Net of Recoveries and Other Allowances (4,934) (4,570) (4,253) Balance at End of Period $3,310 $2,265 $2,335 Years Ended December 31, 1993 1992 1991 Restructuring Costs - Allowances: Balance at Beginning of Period $ 422 $ 5,600 $ - Charged to Cost and Expenses 10,836 (2,800) 5,600 Actual Restructuring Costs Incurred(3,072) (2,378) - Balance at End of Period $ 8,186 $ 422 $5,600 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule IX Short-Term Borrowings Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Weighted Maximum Average Average Weighted Amount Amount Interest Category of Balance Average OutstandingOutstanding Rate Aggregate at End Interest During During During Borrowings of Year Rate the Period the Year the Year Notes Payable to Banks: 1993 $ -0- -0-% $ 798 $ 2 3.60% 1992 $ -0- -0-% $ 4,990 $ 602 6.39% 1991 $ -0- -0-% $ 5,945 $ 1,047 8.94% Commercial Paper: 1993 $ -0- -0-% $23,223 $ 4,269 3.59% 1992 $ -0- -0-% $17,231 $ 2,237 4.29% 1991 $ -0- -0-% $25,854 $ 7,048 6.77% Notes payable to banks represent short-term borrowings payable under credit arrangements with lending banks. Borrowings are arranged on an as needed basis at various terms. The average amount outstanding during the year represents the average daily principal balances outstanding during the year. The weighted average interest rates were computed by dividing the actual interest incurred on short-term borrowings by the average short-term borrowings. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule X Supplementary Income Statement Information Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) 1993 1992 1991 Advertising $11,209 $10,180 $8,917 Maintenance and Repairs $ 4,609 $4,277 Amounts for taxes other than payroll and income taxes, royalties and amortization of intangible assets for the years ended December 31, 1993, 1992 and 1991 and maintenance and repairs for the year ended December 31, 1993 are not presented as each such amount does not exceed 1% of net sales as shown in the related statements of income. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly cause this report to be signed on its behalf by the undersigned, thereunto duly authorized. OSHKOSH B'GOSH, INC. BY: DOUGLAS W. HYDE President and Chief Executive Officer BY: DAVID L. OMACHINSKI Vice President, Treasurer and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, tis report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. CHARLES F. HYDE Chairman of the Board 3/31/94 STEVEN R. DUBACK Secretary and Director 3/29/94 DOUGLAS W. HYDE President, Chief Executive Officer 3/28/94 and Director WILLIAM P. JACOBSEN Senior Vice President and Director 3/30/94 MICHAEL D. WACHTEL Executive Vice President, Chief 3/27/94 Operating Officer and Director	11,834	78,864
709145_1993.txt	709145_1993	1993	709145	Item 1. Business GENERAL Leaservice Income Fund-I (the "Partnership") was organized as a limited partnership under the Uniform Limited Partnership Law of the State of California on April 22, 1983. During the period from June 23, 1983 to October 9, 1984, the Partnership sold an aggregate of 76,328 units of limited partnership interests ("Units") in the Partnership at a purchase price of $100 per Unit pursuant to a Registration Statement on Form S-1 (File No. 2-80216) declared effective by the Securities and Exchange Commission on June 23, 1983. The Partnership actively engaged in the equipment leasing business from 1983 until June 1986 during which it purchased equipment subject to nineteen operating leases having an aggregate purchase price of approximately $9,462,615. Since June 1986 the Partnership has not purchased any equipment. Since May 24, 1991, when the Partnership was dissolved by virtue of the dissolution of its sole general partner, Leaservice Partners, a New York general partnership, the Partnership has been in the process of winding up its business. By December 31, 1993, all operating leases to which the Partnership's equipment had been subject had expired and all of its equipment, which by then had been fully depreciated, was written off. A Certificate of Cancellation was filed with the Secretary of State of the State of California on December 17, 1997 DISSOLUTION OF THE PARNERSHIP The Partnership's sole general partner was Leaservice Partners, a New York general partnership which initially consisted of three corporate partners: (i) National Industrial Services Corp., a New York corporation (which changed its name to Capital Market Services Corp and was merged with and into Pittsburgh Annealing Box Company, a Pennsylvania corporation ("PAB")in October 1987), and which served as the managing partner of Leaservice Partners; (ii) Mid-States Resources, Inc., a Missouri corporation which dissolved on March 1, 1996; and (iii) Mid-States Leasing, Inc., a Missouri corporation which on May 24, 1991 withdrew from Leaservice Partners causing the general partnership's dissolution; Mid-States Leasing, Inc. was formally dissolved on June 29, 1991. The dissolution of Leaservice Partners on May 24, 1991, caused the dissolution of the Partnership pursuant to the terms of the Partnership's Amended and Restated Agreement of Limited Partnership (the "Limited Partnership Agreement") . The Partnership's limited partners were advised of the dissolution of Leaservice Partners and its effect on the Partnership and were given the opportunity, pursuant to the terms of the Limited Partnership Agreement to continue the Partnership and elect a new general partner at a meeting of limited partners scheduled for July 8, 1991. At this meeting, the requisite number of limited partners failed to vote to continue the Partnership. Accordingly, since May 1991, the Partnership has been in the process of winding up its affairs. From May 1991 until January 1998, PAB, (as the successor to the sole managing partner of Leaservice Partners, the general partnership that served as the sole general partner of the Partnership) oversaw the winding up of the business of Leaservice Partners and the Partnership. On January 7, 1998, Capital Resource Group, L.L.C., a Pennsylvania limited liability company ("CRG") assumed all of the rights and all of the obligations of PAB in the Partnership and in Leaservice Partners. CRG is overseeing the final stages of the winding up of the affairs of the Partnership. Item 2. Item 2. Properties During the year ended December 31, 1993 and thereafter, the Partnership has not owned or leased any material property. Item 3. Item 3. Legal Proceedings None. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year covered by this report or at anytime thereafter. PART II Item 5. Item 5. Market for the Partnership's Common Equity and Related Stockholder Matters (a) The Partnership's Units have never been publicly traded. Pursuant to the terms of the Partnership's Limited Partnership Agreement, a Unit could be transferred only after certain requirements were satisfied and transferees could become limited partners only with the consent of the general partner, which consent could be granted or withheld at the sole discretion of the general partner. There has never been a market for such Units and no public trading market ever developed for the Units. (b) As of December 31, 1993 and through the date of the filing of this Annual Report on Form 10-K, there were approximately 800 holders of record of the Partnership's Units and one holder of a general partnership interest in the Partnership. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS The Partnership was dissolved in fiscal 1991 and continued to wind up its affairs during the fiscal year ended December 31, 1993. See Item 1 "Business". The Partnership ceased purchasing equipment subject to operating leases in June 1986, because, in the opinion of the general partner, total prospective returns attainable on such leases (taking into consideration residual equipment value risks which the Partnership would be subject to) were not been favorable to the Partnership. During the fiscal year ended December 31, 1993, all operating leases to which the Partnership's equipment had been subject expired or were otherwise terminated and all equipment then owned by the Partnership (which had an original cost of $104,197 and which had been fully depreciated) was written off. During the fiscal year ended December 31, 1993, customer deposits totaling $81,212 which were to be applied to the final months rent upon termination of the applicable operating leases were recognized as income. During the fiscal year ended December 31, 1993 operating lease rentals were $300 compared to $0.00 and $34,884 for the years ended December 31, 1992 and December 31, 1991, respectively. The decreases in income from operating lease rentals were due to the maturity of certain operating lease agreements, the sale of equipment subject to leases, and the inability of the Partnership to acquire additional leases. Operating expenses declined from $81,110 in 1991 to $26,735 in 1992 and to $4,450 in 1993 primarily as a result of decreases in marketing and management fees. Net income (loss) for the years ended December 31, 1993, 1992 and 1991 was $81,637, ($21,115) and ($34,620), respectively. Net income in 1993 and was allocated $69,381 (85%) to the limited partners and $12,246 (15%) to the general partner. Net (loss) for the years December 31, 1992 and 1991 was allocated ($20,904) and ($34,274) (99%), respectively, to the limited partners and ($211) (1%) and ($346) (1%), respectively, to the general partner. For the years ended December 31, 1993, 1992 and 1991, income (loss) per Unit on a weighted average basis was $.91, ($.27) and ($.45), respectively. LIQUIDITY AND CAPITAL RESOURCES The Partnership had sufficient funds to cover its diminishing expenses in 1994. Item 8. Item 8. Financial Statements and Supplementary Data (Annexed hereto starting on page) Item 9. Item 9. Changes in and Disagreements on Accounting and Financial Disclosure As reported in the Company's Annual Report on Form 10-K for the year ended December 31, 1992, on May 14, 1993 the Company notified Deloitte & Touche, which had previously been the independent accountant of the Company, that it had been dismissed. On September 10, 1992 Capuano & Hartley CPAs was selected to audit the Company's financial statements for the year ended December 31, 1991. Capuano & Hartley, CPAs served as the Partnership's independent accountants from September 10, 1992 until they were formally dismissed on December 31, 1997. As reported in the Company's Current Report on Form 8-K dated February 5, 1998, on December 31, 1997, the Partnership formally dismissed Capuano & Hartley, CPAs as its independent accountant because Capuano & Hartley, CPAs had disbanded in 1996. On December 23, 1997, the Partnership engaged Wiss & Co. to serve as its independent accountants to audit the Partnership's financial statements for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 as part of the Partnership's effort to complete winding up its affairs following the Partnership's dissolution on May 24, 1991. As reported in the Company's Current Report on Form 8-K dated February 5, 1998, while serving as the Partnership's independent accountants from September 10, 1992 until December 31, 1997, Capuano & Hartley, CPAs audited the Registrant's annual financial statements for the years ended December 31, 1991 and 1992 and their reports on these financial statements did not contain an adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, scope or accounting principals. Until December 23, 1997, the Partnership had not requested Capuano & Hartley, CPAs or any other independent accountant to audit the Partnership's financial statements for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 because as more particularly described in Item 1 above, the Partnership has been in the process of winding up its affairs since its dissolution during fiscal 1991, has engaged in no new business since June 1986 and believed that the cost of annual audits exceeded the value to be derived from same in light of the Partnership's small and diminishing assets and the lack of a public market for its Units of limited partnership interest. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The general partner of the Partnership was Leaservice Partners, a New York general partnership which has dissolved on May 21, 1991. From May 1991 until January 1998, PAB, (as the successor to the sole managing partner of Leaservice Partners, the general partnership that served as the sole general partner of the Partnership) oversaw the winding up of the business of Leaservice Partners and the Partnership. On January 7, 1998, CRG assumed all of the rights and all of the obligations of PAB in the Partnership and in Leaservice Partners. CRG is overseeing the final stages of the winding up of the affairs of the Partnership. The executive officers and directors of PAB during the year ended December 31, 1993 were Sam Michaels, Chief Executive Officer, President and Director, Edward J. Landau, Secretary and Director and John A. Kenna, Vice President The executive officers and managers of CRG are Sam Michaels, Chairman of the Board and Manager, Edward J. Landau, Secretary and Manager and Gary Hitechew, President and Manager. Item 11. Item 11. Management Remuneration and Transactions (Certain of the capitalized terms used in this section are defined at the end of the section.) The Partnership's Limited Partnership Agreement provides that the general partner is compensated for services performed in connection with, among other things, managing the operations of the Partnership. As compensation for the management services it performs the general partner receives a management fee payable quarterly in an amount equal to 3% of the Partnership's gross revenues derived from full payout leases, 6% of the partnership's gross revenues derived from operating leases and 3% of the Partnership's gross revenues derived from the sale of equipment. If the Partnership does not generate sufficient cash from operations to pay the management fee or even if it does, at the discretion of the General Partner, such fees will be accrued as debt of the Partnership payable out of cash available for distribution. In addition to the management fee, the general partner is allocated 1% of the Partnership's net losses and 15% of the Partnership's net income. The general partner also is reimbursed for any direct expenses incurred by it, its employees or agents in connection with the Partnership's business and on behalf of the Partnership, except that the general partner is not reimbursed for any general and administrative expenses or other overhead expenses of the general partner and is not reimbursed for any organizational and offering expenses in excess of 3% of the gross proceeds of the offering of Units. During the fiscal year ended December 31, 1993, the Partnership did not pay or accrue a management fee applicable to the general partner; the general partner was allocated $12,246 (15%) of the net income of the Partnership for such year. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record, or is known by the Partnership to own beneficially, more than 5% of any class of the voting securities of the Partnership (b)The general partner's general partnership interest in the Partnership represents a 15% interest in the Partnership's annual net income for financial reporting purposes and tax allocations of 1% of net losses and 15% of net income. Item 13. Item 13. Certain Relationships and Related Transactions None. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Exhibits (3) Restated and Amended Agreement of Limited Partnership of the Partnership dated as of June 23, 1983. Incorporated by reference to Exhibit A to the definitive Prospectus dated June 23, 1983 filed with the Securities and Exchange Commission pursuant to Rule 424(b) under the Securities Act of 1933. (b) Financial Statements and Schedules Financial Statements Page No. -------------------- -------- Independent Auditors' Reports Balance Sheets as of December 31, 1993 and 1992 Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Partners' Equity (Deficiency) for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedules Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 All other schedules are omitted because they are not required or because the required information is presented in the financial statements or related notes. (c) Reports on Form 8-K The Partnership did not file any Current Reports on Form 8-K during the last quarter of the fiscal year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LEASERVICE INCOME FUND - I (dissolved) By: LEASERVICE PARTNERS (dissolved) By: CAPITAL RESOURCE GROUP LLC (successor to the managing partner of Leaservice Partners) Dated: September 29, 1998 By: /s/ Edward J. Landau -------------------- Edward J. Landau Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Title Date - --------- ----- ---- /s/ Sam Michaels Chairman of the Board September 29, 1998 - ---------------- and Manager Sam Michaels (Principal Executive Officer) /s/ Patrick Costello Consultant September 29, 1998 - -------------------- Principal Accounting and Patrick Costello Financial Officer /s/ Edward J. Landau Secretary and Manager September 29, 1998 - -------------------- Edward J. Landau INDEPENDENT AUDITORS' REPORT General Partner and Limited Partners Leaservice Income Fund - I We have audited the accompanying balance sheet of Leaservice Income Fund - I (A California Limited Partnership) as of December 31, 1993 and the related statements of operations, changes in partners' equity (deficiency), cash flows, and Schedules V and VI of Item 13(b) of annual report on Form 10-K to Securities and Exchange Commission for the year ended December 31, 1993. These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. The financial statements of Leaservice Income Fund - - I as of December 31, 1992 were audited by other auditors whose report dated March 1, 1993 expressed an unqualified opinion on those statements including Schedules V and VI of item 13(b) on annual report on Form 10-K to Securities and Exchange Commission. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedules presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements and schedules referred to above present fairly, in all material respects, the financial position of Leaservice Income Fund - I (A California Limited Partnership) as of December 31, 1993 and the results of its operations and its cash flows for the year ended December 31, 1993 in conformity with generally accepted accounting principles. As indicated in the Notes to the financial statements, the Partnership has not purchased any new equipment for lease, has not entered into any new agreements and does not have any equipment out on lease. WISS & COMPANY, LLP Livingston, New Jersey January 3, 1998 INDEPENDENT AUDITOR'S REPORT General Partner and Limited Partners Leaservice Income Fund - I White Plains, New York We have audited the accompanying balance sheet of Leaservice Income Fund - I (a California limited partnership) as of December 31, 1992 and 1991 and the related statements of operations, changes in partners' equity, cash flows, and Schedules V and VI of Item 13(b) of annual report on Form 10-K to Securities and Exchange Commission for the years ended December 31, 1992 and 1991. These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. The financial statements of Leaservice Income Fund - - I as of December 31,1990 were audited by other auditors whose report dated January 29, 1991 expressed an unqualified opinion on those statements including Schedules V and VI of item 13(b) on annual report on Form 10-K to Securities and Exchange Commission. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedules presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such financial statements and schedules present fairly, in all material respects, the financial position of Leaservice Income Fund - I (a California limited partnership) as of December 31, 1992 and 1991 and the results of its operations and its cash flows for the years ended December 31, 1992 and 1991 in conformity with generally accepted accounting principles. As indicated in Note B to the financial statements, the Partnership has not purchased any new equipment for lease and has not entered into any new agreements. CAPUANO & HARTLEY, CPAs March 1,1993 LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) BALANCE SHEETS December 31, ------------ 1993 1992 ---------- ---------- ASSETS CASH AND CASH EQUIVALENTS ............................ $ 144,469 $ 173,479 Computer equipment held for rental at cost, net of accumulated depreciation and provision for impairment in carrying value - $0 in 1993 and $104,197 in 1992 ............................... -- -- ---------- ---------- $ 144,469 $ 173,479 LIABILITIES AND PARTNERS' EQUITY (DEFICIENCY) LIABILITIES: Customer deposits .................................. $ -- $ 81,212 Accrued expenses ................................... 3,239 22,674 Sales tax payable .................................. 44,216 54,216 Due to General Partner ............................. 23,515 23,515 --------- --------- 70,970 181,617 --------- --------- PARTNERS' EQUITY (DEFICIENCY): Limited Partners ................................ 81,594 12,203 General Partners ................................ (8,095) (20,341) --------- --------- Total Partners' Equity (Deficiency) 73,499 (8,138) --------- --------- $ 144,469 $ 173,479 See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) STATEMENTS OF OPERATIONS Year Ended December 31, ----------------------- 1993 1992 1991 -------- -------- -------- INCOME: Operating lease rentals ................... $ 296 $ -- $ 34,884 Lease termination ......................... 81,212 -- -- Gain on sale of equipment ................. -- -- 2,000 Interest .................................. 4,579 5,620 9,606 -------- -------- -------- 86,087 5,620 46,490 OPERATING EXPENSES .......................... 4,450 26,735 81,110 -------- -------- -------- NET INCOME (LOSS) ........................... $ 81,637 $(21,115) $(34,620) ======== ======== ======== ALLOCATION OF NET INCOME (LOSS): Net income (loss) allocable to General Partner ....................... $ 12,246 $ (211) $ (346) ======== ======== ======== Net income (loss) allocable to Limited Partners ...................... $ 69,391 $(20,904) $(34,274) ======== ======== ======== Net income (loss) per weighted average Limited Partnership Unit ................. $ 0.91 $ (0.27) $ (0.45) ======== ======== ======== See the accompanying notes to financial statements. See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS Note 1 - Nature of the Business and Summary of Significant Accounting Policies: NATURE OF THE BUSINESS - Leaservice Income Fund - I ("the Partnership") is a California Limited Partnership formed for the purpose of acquiring various types of capital equipment and leasing same to third parties primarily on a short-term basis. On August 18, 1983, the first limited partners were admitted to the Partnership. The leasing of acquired equipment commenced on October 1, 1983. Leaservice Partners ("Leaservice"), a New York General Partnership, was the sole General Partner of the Partnership until May 24, 1991. The Partnership was informed that effective as of such date, Leaservice had been dissolved due to the withdrawal from that partnership of one of its general partners. Section 14.1.1 of the Amended and Restated Partnership Agreement of the Partnership provides that the Partnership is dissolved upon the dissolution of a general partner. A meeting of limited partners was scheduled for the purposes of considering whether the Partnership should be continued and a new general partner elected. However, limited partners owning 50% or more of the total outstanding Units of the Fund voting in person or by proxy did not vote to continue the existence of the Partnership or to elect a new general partner. The sole remaining entity that once constituted Leaservice is winding up the business of the Partnership. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. ALLOCATION OF INCOME AND LOSSES - Net income is allocated 15% to the General Partner, and 85% to the Limited Partners. Net losses incurred as a result of operations are allocated 1% to the General Partner, and 99% to the Limited Partners. DISTRIBUTIONS - To the extent that cash available for distribution allows, distributions to limited partners will not be less than an amount equal to 50% of the limited partners' share of the net income of the Partnership. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS FINANCIAL INSTRUMENTS - Financial instruments include cash and accrued expenses. The amounts reported for financial instruments are considered to be reasonable approximations of their fair values, based on market information available to management. CASH AND CASH EQUIVALENTS - Includes cash and interest bearing deposits with original maturity dates of less than 90 days. The Partnership maintains its cash balances in a financial institution which is insured by the Federal Deposit Insurance Corporation for up to $100,000. At December 31, 1993, the Partnership had uninsured balances totalling approximately $121,000. INCOME TAXES - Leaservice Income Fund - I is classified as a partnership for Federal income tax purposes. Net income and losses are allocated between the General and Limited Partners in the same ratio as for financial reporting purposes. RECLASSIFICATION - Certain amounts in the 1992 financial statements have been reclassified for comparability. Note 2 - Operations: The Partnership has not purchased any equipment subject to operating leases since June 1986 and no equipment was held for rental under operating leases at December 31, 1993. During 1993, fully depreciated equipment previously held for rental under operating leases with a cost of $104,197 was written off as none of the equipment was reclaimed from the lessees. Customer deposits totalling $81,212 which were to be applied to the final month's rent upon termination of the lease have been recognized as income during the year ended December 31, 1993. Note 3 - Partners' Equity (Deficiency): From August 8, 1983 to October 9, 1984, the expiration date of the offering, Limited Partners representing 76,328 units were admitted to the Partnership. As a result thereof, the Partnership realized net proceeds of $7,022,176 from the sale of such units. Pursuant to the limited partnership agreement, Leaservice receives from the Partnership as General Partner, a quarterly management fee equal to 3% of the Partnership's gross revenues derived from full payout leases, 6% of the Partnership's gross revenues derived from operating leases and 3% of the Partnership's gross revenues derived from the sale of equipment. For the years ended December 31,1993, 1992 and 1991, terms of such agreement amounted to $-0-, $-0- and $1,283, respectively. Net income is allocated 15% to the General Partner and 85% to the Limited Partners. In addition, the General Partner is entitled to receive an annual cash distribution an amount equal to 15% of the Partnership's net income subject to certain limitations. Net losses are allocated 1% to the General Partner and 99% to the Limited Partners. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS Organization and offering expenses up to a maximum of 3% of the gross proceeds of the offering have been reimbursed to the General Partner by the Partnership from the proceeds of the public offering. Net income (loss) per weighted average limited partnership unit has been computed based on the weighted average number of limited partnership units outstanding as of the first day of each month during the years ended December 31, 1993, 1992 and 1991. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) PROPERTY, PLANT AND EQUIPMENT COMPUTER EQUIPMENT HELD FOR RENTAL: December 31, 1991: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 1,275,132 $ -- $(1,170,935) $ 104,197 ----------- ----------- ----------- ----------- December 31, 1992: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 104,197 $ -- $ -- $ 104,197 ----------- ----------- ----------- ----------- December 31, 1993: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 104,197 $ -- $ 104,197 $ -- ----------- ----------- ----------- ----------- See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT COMPUTER EQUIPMENT HELD FOR RENTAL: December 31, 1991: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 1,275,132 $ -- $(1,170,935) $ 104,197 ----------- ----------- ----------- ----------- December 31, 1992: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 104,197 $ -- $ -- $ 104,197 ----------- ----------- ----------- ----------- December 31, 1993: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 104,197 $ -- $ 104,197 $ -- ----------- ----------- ----------- -----------	4,606	30,173
355787_1993.txt	355787_1993	1993	355787	Item 2. Properties. The Company and its subsidiaries own or lease space for offices, studio and production facilities, antenna sites and certain equipment for each of its stations. The Company believes that its other facilities are suitable and adequate for carrying on its broadcasting and other operations and that no major capital improvements will be necessary over the next year. Renewal options are available for the majority of the leases. (See Note 15 of the Notes to Consolidated Financial Statements for information on minimum lease payments of the Company and its subsidiaries for the next five years.) Certain subsidiaries of the Company own the land which is used for transmitter sites and studio facilities. Item 3. Item 3. Legal Proceedings. On November 29, 1993, Apollo Investment Fund, L.P. ("Apollo"), commenced an action by way of temporary restraining order and order to show cause in the Supreme Court of the State of New York, County of New York, entitled Apollo Investment Fund, L.P. v. Price Communications Corporation, Price Publishing Corporation, W.R. Huff Asset Management Co., L.P., and William R. Huff, Index No. 130011/93, seeking to enjoin the Company and PPC from selling their interest in Alexandra Publishing Corporation ("Alexandra"), to the Huff defendants, or in the alternative, if the sale had already been completed, rescission of the transaction. Apollo based its claim on an Amended and Restated Shareholders Agreement, dated as of May 8, 1992, (the "Shareholders Agreement"), among Apollo, the Company, PPC, Alexandra, and The New York Law Publishing Company, which purports to restrict the sale of shares of Alexandra held by the Company or PPC. On December 20, 1993, the Company answered the complaint asserting that the challenged transaction involved only the sale of shares of PPC, Alexandra's parent, which was not restricted by the Shareholders Agreement. The Company also asserted a counterclaim against Apollo pursuant to paragraph 11 of the Shareholders Agreement, for the legal fees and expenses incurred in connection with the defense of the litigation. On December 23, 1993, the defendants filed a joint opposition to plaintiff's motion for a preliminary injunction, and also filed a joint cross-motion for summary judgment dismissing the complaint. Shortly thereafter, settlement discussions began and are continuing. The hearing on the motion and cross-motion were adjourned pending the outcome of the settlement discussions. The Company believes that this suit may have errors and has not been brought on sound legal advice of Plaintiffs' Counsel and that it is without merit and the Company intends to vigorously defend this action if it is not settled. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Executive Officers of the Registrant The following table sets forth the executive officers of the Company, their respective ages, the year in which each was first elected an executive officer and the office of the Company held by each. Each executive officer will hold office until removed or until their respective successors have been duly elected and qualified. Executive Officer's Name Age Position Officer Since Robert Price 61 President, 1979 Chief Executive Officer and Treasurer Bill Bengtson 62 Senior Vice 1989 President/ Television Kim I. Pressman 37 Senior Vice 1984 President Lee K. Strasser 37 Vice President/Radio 1992 Alisa R. Diamond-Lichaw 31 Vice President- l990 Corporate Affairs and Secretary Robert Price (Director, President, Chief Executive Officer and Treasurer of the Company), an attorney, is a former General Partner of Lazard Freres & Co. He has served as an Assistant United States Attorney, practiced law in New York and served as Deputy Mayor of New York City. In the early sixties, Mr. Price served as President and Director of Atlantic States Industries, a corporation owning weekly newspapers and four radio stations. After leaving public office, Mr. Price became Executive Vice President of The Dreyfus Corporation and an Investment Officer of The Dreyfus Fund. In 1972 he joined Lazard Freres & Co. Mr. Price has served as a Director of Holly Sugar Corporation, Atlantic States Industries, The Dreyfus Corporation, Graphic Scanning Corp. and Lane Bryant, Inc., and is currently a member of The Council on Foreign Relations. Mr. Price is also a Director and Chairman of TLM Corporation, and a Director and President of Atlas Cellular Corporation. Bill Bengtson has held a variety of positions in the broadcasting industry for 34 years and assumed his current position in July 1989. Mr. Bengtson is also Vice President and General Manager of KSNF-TV, the Company's NBC affiliate in Joplin, Missouri/Pittsburg, Kansas, a position he has held since April 1987. From January 1985 to March 1987, he was Vice President and General Manager of KRCG-TV, a CBS affiliate in Jefferson City/Columbia, Missouri formerly owned by the Company. Prior to joining the Company in 1985, Mr. Bengtson was Vice President and General Manager of KOAM-TV in Pittsburg, Kansas for 12 years. Mr. Bengtson has served on the National Association of Broadcasters' Television Board of Directors, and as President of the Pittsburg, Kansas Chamber of Commerce, President of the Pittsburg, Kansas Industrial Development Corporation and Mayor of Pittsburg, Kansas. Kim I. Pressman, a certified public accountant, is a graduate of Indiana University and holds an M.B.A. from New York University. Before assuming her present office as Senior Vice President in January 1990, Ms. Pressman was Vice President and Treasurer of the Company from November 1987 to December 1989. She was also Secretary of the Company from July 1989 to February 1990. She was Vice President-Broadcasting and Vice President, Controller, and Assistant Treasurer of the Company from 1984 to October 1987. Prior to joining the Company in 1984, Ms. Pressman was employed for three years by Peat, Marwick, Mitchell & Co., a national certified public accounting firm, and for more than three years thereafter was Supervisor, Accounting Policies for International Paper Company and then Manager, Accounting Operations for Corinthian Broadcasting Division of Dun & Bradstreet Company, a large group owner of broadcasting stations. Ms. Pressman is a Director, Vice President, Treasurer and Secretary of TLM Corporation, and a Director, Vice President and Treasurer of Atlas Cellular Corporation. Lee K. Strasser is a cum laude graduate of the University of Miami's School of Communications. Mr. Strasser is also Vice President and General Manager of WIRK-FM/WBZT-AM, the Company's Country FM and news/talk AM radio stations in West Palm Beach, Florida, a position he has held since December 1991. Previously, he served as General Sales Manager of the stations from 1987 to December 1991. Prior to joining the Company in 1987, Mr. Strasser had been an account executive in the Palm Beach County marketplace since 1985. He began his career in the Miami radio market in 1981 at WNWS radio. Alisa R. Diamond-Lichaw attended Washington University in St. Louis and is a graduate of New York University. Ms. Diamond- Lichaw has been Vice President - Corporate Affairs since January 1990 and became Secretary in December 1991. Previously, Ms. Diamond-Lichaw had been Assistant Vice President of the Company since June 1989. She was also an Assistant Secretary of the Company from September 1987 to January 1990. She served as Administrator-Corporate Services of the Company from November 1986 to June 1989 and prior to that was employed in a variety of positions at the Company since joining it in October 1984. Before joining the Company Ms. Diamond-Lichaw was employed at MTV in promotion and marketing, worked in marketing sales services at NBC and was an Account Executive at Izod Lacoste. Ms. Diamond-Lichaw is also an Assistant Secretary of TLM Corporation. PART II Item 5. Item 5. Market for Company's Common Stock and Related Stockholder Matters a) Market for Common Stock The Company's Common Stock is listed for trading on the American Stock Exchange ("AMEX") under the ticker symbol "PR". The range of high and low last sale prices for the Company's Common Stock on the AMEX for each of the four quarters of l993 and l992, as reported by the AMEX (adjusted for stock dividends and stock splits, including the 1 for 20 reverse stock split which occurred on December 30, 1992, and rounded to the nearest eighth) was: l993 l992 Quarter High Low High Low First 2 7/8 2 7 1/2 1 7/8 Second 2 15/16 2 6 1/4 1 7/8 Third 3 3/16 2 3/8 3 3/4 1 1/4 Fourth 4 3/8 2 3/4 2 1/2* 1 1/4* [through 12/24/92] The high and low last sale prices for the Company's Common Stock on the AMEX for January l994, as reported by the AMEX were 4 3/8 and 3 1/2, respectively. The Common Stock of the Company, as reorganized pursuant to the Plan of Reorganization, began trading on a when issued basis on the AMEX on December 28, 1992. The high and low last sale prices of the Reorganized Company's Common Stock for the remainder of the Fourth Quarter of 1992 were 2 3/4 and 1 7/8, respectively. The Company's Common Stock has been afforded unlisted trading privileges on the Pacific Stock Exchange under the ticker symbol "PR.P", on the Chicago Stock Exchange under the ticker symbol "PR.M" and on the Boston Stock Exchange under the ticker symbol "PR.B". b) Holders On January 31, l994, there were 749 holders of record of the Company's Common Stock. The Company estimates that brokerage firms hold Common Stock in street name for approximately 5,000 persons. c) Dividends The Company, to date, has paid no cash dividends on its Common Stock. The Board of Directors will determine future dividend policy based on the Company's earnings, financial condition, capital requirements and other circumstances. In addition, it is the present policy of the Board of Directors to retain cash and any earnings of the Company for the operation of the Company, and therefore it is not anticipated that dividends will be paid on its Common Stock in the foreseeable future. Item 6. Item 6. Selected Financial Data. The following table sets forth certain selected consolidated financial data with respect to the Company for each of the five years in the period ended December 3l, l993, derived from audited consolidated financial statements of the Company and Notes thereto. A vertical black line has been placed to separate pre- reorganization consolidated operating statement and balance sheet items from the post-reorganization consolidated operating statement and balance sheet items since they are not prepared on a comparable basis (See Note 1 of Notes to Consolidated Financial Statements). See accompanying notes to consolidated financial statements. Price Communications Corporation and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 - -------------------------------------------- Reorganized \| Company \| Predecessor Company - -------------------------------------------- 1993 \| 1992 1991 - -------------------------------------------- Cash flows (used in) \| provided by operating \| activities \| Net (loss) income $(1,704,591) \| $289,214,986 $(56,624,384) - -------------------------------------------- Adjustments to \| reconcile net (loss) \| income to net cash \| (used in) provided by \| operating activities: \| Items not affecting \| cash: \| Amortization of debt \| discount and deferred 766,075 \| 1,003,578 2,038,509 debt expense \| Depreciation and 2,343,015 \| 4,873,136 5,132,446 amortization \| Share of loss of \| partially owned 1,118,293 \| 2,933,763 9,004,587 companies \| Loss on disposition 425 \| 364,024 54,333 of equipment \| Reserves for losses on - \| - 2,915,712 notes receivable \| Deficiency of film \| broadcast rights - \| (103,320) (339,475) amortization over \| payments \| (continued) Price Communications Corporation and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 - -------------------------------------------- Reorganized \| Company \| Predecessor Company - -------------------------------------------- 1993 \| 1992 1991 - -------------------------------------------- Unrealized noncash \| loss (recovery) on 145,884 \| (145,884) (8,475,606) marketable securities \| Valuation \| adjustment, net of - \| 6,732,774 - working capital \| valuation \| Change in assets and \| liabilities, net of \| effects of \| reorganization: \| (Increase) decrease in \| net accounts receivable (354,058) \| (959,580) 214,844 (Increase) \| decrease in prepaid (297,915) \| 395,910 (930,882) expenses and other \| assets \| Decrease in film 209,948 \| 129,953 42,659 broadcast rights \| Decrease in due from - \| 1,410,960 605,857 broker/dealer \| (Decrease) increase in \| accounts payable and (1,859,013) \| 1,028,242 425,740 accrued expenses \| (Decrease) \| increase in accrued (343,602) \| 15,243,681 35,673,639 interest payable, net \| of forgiveness \| (continued) Price Communications Corporation and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 - -------------------------------------------- Reorganized \| Company \| Predecessor Company - -------------------------------------------- 1993 \| 1992 1991 - -------------------------------------------- (Decrease) \| increase in other (1,080,826) \| (514,252) 2,032,559 liabilities \| Reclassification of \| transactions to \| investing and financing \| activities: \| Loss on purchase of Common Stock 3,976,597 Gain on early \| extinguishments of debt (2,010,332) \| - - Gain on \| forgiveness of debt and - \| (312,678,036) - partial sale of \| subsidiary \| (Gain) loss on sale of (6,609) \| (6,940) 7,996,741 securities \| Recovery on notes (2,730,432) \| (387,588) - receivable \| - -------------------------------------------- Total adjustments (122,550) \| (280,679,579) 56,391,663 - -------------------------------------------- Net cash (used in) \| provided by operating (1,827,141) \| 8,535,407 (232,721) activities \| - -------------------------------------------- (continued) Price Communications Corporation and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 - -------------------------------------------- Reorganized \| Company \| Predecessor Company - -------------------------------------------- 1993 \| 1992 1991 - -------------------------------------------- Cash flows provided by \| (used in) investing \| activities \| Sale of businesses and $11,000,214 \| $4,738,627 $- equipment \| Investment in (454,337) \| - - businesses \| Purchases of securities \| under agreements to (8,050,811) \| - - resell \| Capital expenditures (577,918) \| (704,681) (514,467) Purchases of marketable \| securities and mutual (36,704,873) \| (10,476,315) (9,551,596) funds \| Proceeds from sale of \| marketable securities 54,394,512 \| 1,034,640 13,932,705 and mutual funds \| Proceeds from notes 5,630,432 \| 654,707 32,851 receivable \| - -------------------------------------------- Net cash provided by \| (used in) investing 25,237,219 \| (4,753,022) 3,899,493 activities \| Cash flows used in \| financing activities \| Repurchases and (20,846,643) \| (5,300,960) (5,126,035) payments of long-term \| debt \| Net borrowings under \| (repayment of) (4,930,083) \| 4,930,083 - repurchase agreements \| Net borrowings under 3,020,065 \| - - line of credit \| agreement \| (continued) Price Communications Corporation and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 - -------------------------------------------- Reorganized \| Company \| Predecessor Company - -------------------------------------------- 1993 \| 1992 1991 - -------------------------------------------- Purchase of common (8,434,058) \| - - stock \| Proceeds from stock 56,216 \| - - options exercised \| - -------------------------------------------- Net cash used in (31,134,503) \| (370,877) (5,126,035) financing activities \| - -------------------------------------------- Net (decrease) \| increase in cash and (7,724,425) \| 3,411,508 (1,459,263) cash equivalents \| Cash and cash \| equivalents at 9,119,527 \| 5,708,019 7,167,282 beginning of year \| - -------------------------------------------- Cash and cash $1,395,102 \| $9,119,527 $5,708,019 equivalents at end \| of year \| ============================================ Supplemental \| disclosures of cash \| flow information \| Income taxes paid, net $158,878 \| $ 255,225 $55,046 of refunds \| ============================================ Interest paid $1,828,991 \| $3,170,272 $5,799,497 ============================================ Chapter 11 items: \| Interest received $- \| $357,000 $- ============================================ Professional and \| administrative expenses $26,085 \| $505,144 $- paid \| ============================================ See accompanying notes to consolidated financial statements. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies a. Basis of Presentation-The consolidated financial statements include the accounts of Price Communications Corporation (the "Company" or "Price") and its subsidiaries. All significant intercompany items and transactions have been eliminated. b. Fresh Start Reporting-The Company reorganized and emerged from Chapter 11 bankruptcy proceedings on December 30, 1992 (the "Effective Date"-see Note 2), and adopted Fresh Start Reporting in accordance with the guidelines established by the American Institute of Certified Public Accountants in Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." Under Fresh Start Reporting, assets and liabilities are recorded at their estimated fair market value and the historical deficit is eliminated. Accordingly, the Company's financial statements have been prepared as if it is a new reporting entity (referred to as the "Reorganized Company") as of the Effective Date. A vertical black line has been placed to separate the consolidated statements of operations and cash flows of the Company prior to the reorganization (referred to as the "Predecessor Company") from those of the Reorganized Company, since they are not prepared on a comparable basis. The Company's operations for the two-day period of December 30 and December 31, 1992 were insignificant. Accordingly, December 31, 1992 was used as the cut-off date for financial reporting purposes in lieu of the Effective Date. The revaluation of the Company's assets and liabilities as of December 31, 1992 was based on an independent appraisal, modified as appropriate, and resulted in a reduction in net carrying values of assets and liabilities of approximately $5,027,000. The components of this adjustment are shown in the "Fresh Start Reporting" column of Note 17. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) c. Depreciation and Amortization-Depreciation is computed on the straight-line method on the basis of estimated useful lives, as follows: Buildings-15 to 25 years Broadcasting equipment-10 to 12 years Leasehold improvements-the life of the underlying lease Furniture and fixtures-3 to 10 years Transportation equipment-3 years d. Intangible Assets: i. Excess of purchase price over the fair value of net assets acquired prior to December 31, 1992 includes FCC licenses, station call letters, and goodwill. As a result of the implementation of Fresh Start Reporting, unamortized goodwill has been eliminated and FCC licenses have been restated at their approximate fair value as of December 31, 1992. These assets are integral determinants of a communica tions property's economic value, and have long and productive lives. The Predecessor Company amortized such intangible assets over a 40-year period, the maximum life allowable under Accounting Principles Board Opinion No. 17. The Reorganized Company continues to amortize the assets over a 40-year life commencing from the original date of acquisition. ii. Deferred expenses associated with debt instruments were amortized under the straight-line method over their respective lives. Debt discounts are amortized under the effective interest method. As of December 31, 1992, the unamortized carrying value of deferred debt expense and unamortized debt discount associated with debt forgiven or exchanged under the Company's Plan of Reorganization (the "Plan"-see Note 2) was eliminated. e. Reorganization Value in Excess of Amounts Allocable to Identifiable Assets-The reorganization value in excess of amounts allocable to identifiable assets, which results from the implementation of Fresh Start Reporting is amortized using the straight-line method over 20 years. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) f. Per Share Data-Primary income per common share is based on income for the period divided by the weighted average number of shares of common stock and common stock equivalents outstanding, which was approximately 11.9 million shares for 1993. Per share amounts for the Predecessor Company are not presented because they are neither comparable nor meaningful due to forgiveness of debt, partial sale of subsidiary, issuance of new common stock and adoption of Fresh Start Reporting. g. Allowance for Doubtful Accounts-The Company provides an allowance for doubtful accounts based on reviews of its customers' accounts. Included in operating expense is bad debt expense of approximately $264,000, $514,000, and $780,000 for the years ended December 31, 1993, 1992 and 1991, respectively. h. Barter Transactions-Revenue from barter transactions (advertising provided in exchange for goods and services) is recognized as income when advertisements are broadcast, and merchandise or services received are charged to expense when received or used. i. Advertising Revenues-Sales of advertisements are recognized as income when advertisements are broadcasted or printed. j. Film Broadcast Rights-The capitalized cost of film broadcast rights is amortized on the basis of the estimated number of showings or, if unlimited showing are permitted, over the term of the broadcast license agreements. Unamortized film broadcast rights are classified as current or noncurrent on the basis of their estimated future usage. Amortization of film broadcast rights is included in operating expenses and amounted to approximately $800,000, $940,000, and $1,036,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) k. Cash and Cash Equivalents-For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments, including Treasury bills, purchased with maturities of three months or less at the time of purchase to be cash equivalents. l. Marketable Securities-Investment in marketable securities was stated at the lower of aggregate cost or market. Dividend and interest income were accrued as earned. As of December 31, 1992, the carrying value of marketable securities, which consisted of 6.375% U.S. Treasury Notes due August 15, 2002, was increased by approximately $146,000, to reflect the increase in market value over cost, in accordance with Fresh Start Reporting. Net realized gains (losses) on sales of investment in mutual funds and marketable securities are based upon weighted average cost (see Note 11). m. Income Taxes-Effective December 31, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("Statement 109") issued by the Financial Accounting Standards Board (see Note 10). The cumulative effect of this change had no significant impact on the Company's consolidated financial statements, including income tax expense. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) m. (continued) Prior to December 31, 1992, the Company accounted for income taxes pursuant to the deferred method under APB Opinion 11. Under the deferred method, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of calculation. 2. Reorganization On December 30, 1992, the Plan, which had been approved by the United States Bankruptcy Court for the Southern District of New York in July of that year, became effective. Under the Plan, the following occurred: a. Holders of approximately $31 million principal amount of the Company's 10% Convertible Senior Subordinated Debentures (the "10% Debentures") received new $31 million face amount seven-year 5% Senior Secured Notes (the "Secured Notes"-see Note 9). b. Apollo Investment Fund, L.P. and James Finkelstein purchased 75% of Alexandra Publishing Corporation, which owns The New York Law Publishing Company, in exchange for the cancellation of approximately $19 million of principal amount of 10% Debentures, and the payment to the Company of approximately $7.5 million in cash and the assumption or repayment of certain liabilities of the Company totaling approximately $45 million. See note 13 for subsequent disposal of the remaining 25% interest in the publishing subsidiaries. c. The holders of the existing subordinated debt received 94.5% of the common stock of Price. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 2. Reorganization (continued) d. Shareholders received shares which constitute 3.5% of the common stock of the Reorganized Company, and Robert Price, President of the Company, received 2% of such common stock in exchange for the junior common stock, all of which was held by Mr. Price. In addition, Mr. Price entered into a three-year employment contract. The gain on the partial sale of publishing companies and the gain from cancellation of indebtedness resulted in extraordinary income of approximately $312.7 million which is net of a tax provision of $900,000 relating to the sale of the publishing companies. The gain resulting from the forgiveness of debt is not taxable for Federal income tax purposes. In a related transaction, on August 5, 1992, the Company exchanged its interest in TLM Corporation (until then a 90.7% owned subsidiary) for 90.7% of the assets of TLM Corporation. These assets consisted of cash and common stock and certain public debt securities of the Company. The Company's loss from the transaction was de minimis. 3. Notes Receivable Investments in notes made through private placements include the following: a. The note receivable at December 31, 1992 represented a 14-1/2% $3.2 million subordinated note due in 1993 from the buyers of WIBA-AM/FM stated at its approximate fair value based on the independent appraisal (see Note 1) completed in connection with Fresh Start Reporting. In 1993, this note was paid in full, resulting in a recovery of approximately $300,000. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 3. Notes Receivable (continued) b. In connection with the sale in 1987 of seven radio stations to Fairmont Communications Corporation ("Fairmont") for an aggregate sale price of $120 million, the Company loaned $50 million to Fairmont (the "Fairmont Notes") and acquired a 27% equity interest in Fairmont. The Fairmont Notes were issued in three series of 12 1/2% increasing rate subordinated notes due in 1992, extendible at Fairmont's option to 1994. Interest on the notes was payable quarterly in cash or additional notes at Fairmont's election. On August 28, 1992, Fairmont filed for voluntary relief under Chapter 11 of the U.S. Bankruptcy Code. At that date the Company ceased to record additional notes related to interest paid in kind since it is not entitled to interest after that date under the Bankruptcy Code. The $94.8 million principal amount of Fairmont Notes owned by the Company (which includes accrued interest paid in additional Fairmont Notes) and the Company's equity investment in Fairmont had no book value as of December 31, 1993 and 1992. By order dated September 10, 1993, the United States Bankruptcy Court for the Southern District of New York confirmed the Chapter 11 Plan of Reorganization (the "Fairmont Plan") for Fairmont and the Fairmont subsidiaries. Essentially, the Fairmont Plan provides for the orderly liquidation of the assets of Fairmont and the Fairmont subsidiaries, and the distribution of the proceeds derived therefrom according to the relative priorities of the parties asserting interests therein. The Company believes that the level of asset sales may be sufficiently high to provide for some recovery upon the Fairmont Notes, although the exact amount of any such recovery is unclear at this time. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 4. Investment in Partially Owned Company On December 30, 1992, the Company, in connection with its Plan of Reorganization, sold 75% of its publishing subsidiaries (see Note 2). The Company retained a 25% interest in Alexandra Publishing Corporation which owns 100% of The New York Law Publishing Company. This investment was recorded at its approximate fair value of $4 million as of December 31, 1992 as a result of Fresh Start Reporting (see Note 1). In November 1993, in connection with the repurchase of common stock (see Note 13), the Company transferred its remaining 25% interest in Alexandra Publishing, which had a carrying value of approximately $3.8 million. For the years ended December 31, 1992 and 1991, these subsidiaries were consolidated in the statement of operations and cash flows of the Predecessor Company. Based upon audited financial information, Alexandra Publishing Corporation and subsidiary had net revenue and income of approximately $32.6 million and $2.9 million (including intercompany expenses of $1.3 million), respectively, for the year ended December 31, 1992. For the year ended December 31, 1993, the 25% interest in such subsidiaries was accounted for by the equity method of accounting and the Reorganized Company recognized a charge to operations of approximately $230,000 for its period of ownership. 5. Investment in Cellular Communication Properties The Company accounted for its investment in PriCellular Corporation ("PriCellular") under the equity method of accounting as it believed its control in PriCellular to be temporary. The Company recognized 75% of PriCellular's losses as a charge to operations to the extent of its investment in PriCellular representing $2.9 million and $4.3 million for the years ended December 31, 1992 and 1991, respectively. Prior to Fresh Start Reporting, the Predecessor Company's investment in PriCellular had been Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 5. Investment in Cellular Communication Properties (continued) reduced to zero book value. In accordance with the court approved Plan, the Company transferred 1% of PriCellular's common stock to Robert Price, reducing the Company's interest to 74%. The consolidated financial statements of the Reorganized Company as of December 31, 1992 reflect an approximate fair value of the investment of $11.5 million, in connection with Fresh Start Reporting (see Note 1). On October 1, 1993, the Company sold its remaining 74% interest in PriCellular to a subsidiary of PriCellular for $11 million in cash. Under the agreement of sale, PriCellular and such subsidiary indemnified the Company against all liabilities and claims relating to PriCellular and its business. The proceeds from the sale have been used to repurchase a portion of the Secured Notes, in accordance with the terms of the indenture of such notes (see Note 9). During 1993, the Company recognized a charge of approximately $890,000 related to its share of PriCellular's losses through October 1, 1993, and realized no gain or loss from the sale of its interest in PriCellular. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 6. Property and Equipment Property and equipment consist of the following: December 31 1993 1992 --------------------------- Land $2,328,000 $2,328,000 Buildings 3,468,209 3,439,000 Broadcasting equipment 7,720,940 7,315,000 Outdoor fixtures 801,320 756,417 Leasehold improvements 229,783 229,000 Furniture and fixtures 619,870 541,000 Transportation equipment 432,814 341,000 --------------------------- 15,600,936 14,949,417 Less, accumulated 1,872,765 - depreciation --------------------------- Net property and equipment $13,728,171 $14,949,417 =========================== As discussed in Note 1, in conjunction with the consummation of the Plan, the Company implemented Fresh Start Reporting. Accordingly, as of December 31, 1992, all property and equipment were restated to reflect approximate fair value and accumulated depreciation was eliminated. 7. Accounts Payable and Accrued Expenses Accounts payable and accrued expenses consist of the following: December 31 1993 1992 --------------------------- Accounts payable-suppliers $906,770 $1,186,035 Accrued professional fees 299,113 979,214 Accrued Chapter 11 expenses 47,664 807,435 Other 995,857 1,135,733 --------------------------- $2,249,404 $4,108,417 =========================== Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 8. Other Liabilities Other liabilities consist of: December 31 1993 1992 --------------------------- Liability for film $507,603 $724,199 broadcast rights Income and franchise taxes 522,512 1,250,000 payable Other 80,217 216,959 --------------------------- 1,110,332 2,191,158 Less, amounts due currently (1,035,585) (1,984,069) --------------------------- $74,747 $207,089 =========================== Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 9. Long-Term Debt Long-term debt consists of the following notes payable by the Company and its wholly-owned subsidiaries at December 31, 1993 and 1992 as follows: December 31 1993 1992 --------------------------- Subsidiaries: Atlantic Broadcasting Corporation, Southeast Texas Broadcasting Corporation, Texoma Broadcasting Corporation and Tri-State Broadcasting Corporation: $3,200,000 Note payable to Bank of - Montreal under term loan agreement (A) Parent Company: 5% Senior Secured Notes, due October 9, 1999; interest payable semiannually; net of unamortized discount - $22,100,000 of $8,705,000 (effective interest rate of 11.04%) (B) --------------------------- Total debt $3,200,000 $22,100,000 =========================== Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 9. Long-Term Debt (continued) (A) On December 21, 1993, certain subsidiaries of the Company entered into a Line of Credit Agreement (the "Line of Credit") with the Bank of Montreal ("BOM"). The Line of Credit is for $10 million, reduced by $2 million, $2.5 million, $2.5 million and $3 million in 1994, 1995, 1996 and 1997, respectively. Borrowings under the Line of Credit bear interest at the BOM Base Rate, as defined (or at other rates at the borrowers' option), and are secured by the assets of the subsidiaries which have book value of approximately $26 million. There is also a fee of 1/2 of 1% on the unused portion of the Line of Credit. On December 24, 1993, the Company borrowed $5.6 million pursuant to this agreement and the proceeds were used to retire the remaining $7.6 million face amount of Secured Notes. On December 31, 1993, the proceeds from the sale of the Company's position in Northstar Television Group ("NTG" - see Note 11) were used to repay $2.4 million of borrowings under the Line of Credit. (B) In connection with the Plan, the Company issued $30,805,000 face amount of the Senior Notes. The Company recorded these notes net of a discount of $8,705,000 under Fresh Start Reporting (see Note 1). Accrued interest related to these notes was approximately $351,000 at December 31, 1992. During October and December 1993, the Company repurchased all of the Secured Notes for approximately $20.8 million, plus accrued interest, and realized a gain of approximately $2.0 million, net of taxes of zero. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 10. Income Taxes As discussed in Note 1, the Company adopted Statement 109 as of December 31, 1992. The cumulative effect of this change had no significant impact on the Company's consolidated financial statements, including tax expense, for the year then ended. The Company had, as of December 31, 1993 and 1992, deferred tax assets, which were subject to a valuation allowance of approximately $46,031,000 and $44,604,000, respectively, and deferred tax liabilities of approximately $3,943,000 and $4,169,000, respectively. These deferred tax assets and liabilities consist of the following: December 31, 1993 1992 Deferred tax assets Accounts receivable, principally due to allowance for doubtful accounts $166,000 $ 192,000 Notes from and investment in partially owned 15,251,000 31,785,000 companies Minimum tax credit carryforward 642,000 - Capital loss carryforwards 19,905,000 - Net operating loss carryforwards 13,910,000 13,931,000 Investment tax credit carryforwards 100,000 100,000 Notes Receivable, principally due to reserves - 787,000 Investment in cellular communications properties, principally due to Fresh Start Reporting - 1,978,000 $49,974,000 $48,773,000 December 31, 1993 1992 Deferred tax liabilities Property and equipment, principally due to differences in depreciation and the effects of Fresh Start Reporting $3,662,000 $3,393,000 Deferred compensation 281,000 - Unamortized debt discount - 727,000 Unrealized gain on marketable securities - 49,000 $3,943,000 $4,169,000 Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 10. Income Taxes (continued) Income tax expense in 1993 and 1992 consist of approximately $124,000 and $499,000, respectively, primarily for state and local income taxes. In addition, a provision of $900,000, primarily for Federal alternative minimum tax, has been included in extraordinary items for the year ended December 31, 1992 (see Note 2). Income tax benefit in 1991 consists of refunds for Federal alternative minimum tax of $505,104 related to the carryback of capital losses incurred in 1991 and 1990 and state and local taxes of $178,322. Net operating loss carryforwards aggregating approximately $41.0 million are available for federal income tax purposes at December 31, 1993. These carryforwards expire in the years 2002 through 2006. The Company also has available investment tax credit carryforwards of approximately $100,000 expiring in the year 2000. All of these carryforwards arose prior to the reorganization and are subject to the limitations of Internal Revenue Code Sections 382 and 383. 11. Other Expense (Income)-Net Other expense (income)-net consist of: 1993 1992 1991 ------------------------------------- (Gains) loss on sales $(6,609) $(6,940) $7,996,741 of securities Interest income (715,918) (543,252) (1,092,880) Loss on disposition of 425 364,024 54,333 equipment Compensation-bonus under employment - - 2,512,200 contract (Recovery) reserves for losses on notes (2,730,432) (387,588) 2,915,712 receivable Loss on purchase of Common Stock (Note 13) 3,976,597 - - Other-net 15,226 538,264 539,118 ------------------------------------- $539,289 $(35,492) $12,925,224 ===================================== Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 11. Other Expense (Income)-Net (continued) As of December 31, 1992, in conjunction with the adoption of Fresh Start Reporting, the investment in common and preferred stock of NTG was removed from the Company's consolidated balance sheet since its estimated realizable value was zero (see Note 1). In December 1993, the Company sold its investment in NTG for approximately $2.4 million in cash and recognized a gain of approximately $2.4 million on the sale. 12. Segment Data The Reorganized Company's business operations are classified into two segments: Television and Radio Broadcasting and Other. The Predecessor Company's business operations included Publishing with Other. The Company's Publishing operations were transferred to third parties in 1992 (see Note 2) and therefore, are no longer consolidated in the Reorganized Company's operations. There are no transfers between segments of the Company. The segment data follows: Year ended December 31, 1993 --------------------------------------------------- Broadcasting Television Radio Other Consolidated --------------------------------------------------- Net revenue $11,744,547 $10,271,892 $773,753 $22,790,192 Operating 7,484,486 8,226,346 623,929 16,334,761 expenses Depreciation and 1,153,860 834,346 354,809 2,343,015 amortization --------------------------------------------------- Operating $3,106,201 $1,211,200 $(204,985) $4,112,416 income (loss) =================================================== Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 12. Segment Data (continued) Year ended December 31, 1992 --------------------------------------------------- Broadcasting Publishing Television Radio and Other Consolidated --------------------------------------------------- Net revenue $11,239,395 $9,309,229 $33,408,010 $53,956,634 Operating 7,570,105 7,544,032 24,453,255 39,567,392 expenses Depreciation and 1,683,309 1,074,407 2,115,420 4,873,136 amortization --------------------------------------------------- Operating $1,985,981 $690,790 $6,839,335 $9,516,106 income* =================================================== Year ended December 31, 1991 --------------------------------------------------- Broadcasting Publishing Television Radio and Other Consolidated --------------------------------------------------- Net revenue $10,359,913 $8,095,942 $29,996,283 $48,452,138 Operating 7,472,675 7,334,037 22,375,150 37,181,862 expenses Depreciation and 1,778,524 1,045,864 2,308,058 5,132,446 amortization --------------------------------------------------- Operating $1,108,714 $(283,959) $5,313,075 $6,137,830 income (loss)* =================================================== * Operating income (loss) is before corporate expenses, other expense (income)-net, interest expense, amortization of debt discount and deferred debt expense, unrealized non- cash loss (recovery) on marketable securities, share of loss of partially owned companies, reorganization items, income taxes and extraordinary items. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 12. Segment Data (continued) Identifiable Capital Assets Expenditures ------------------------------ 1993: Television broadcasting $16,208,021 $397,604 Radio broadcasting 13,988,511 200,600 Other 3,673,912 50,069 Corporate 3,401,056 3,885 ------------------------------ Consolidated $37,271,500 $652,158 ============================== 1992: Television broadcasting $17,067,971 $354,779 Radio broadcasting 17,584,247 253,442 Publishing and other 19,322,971 273,955 Corporate 20,351,715 19,959 ------------------------------ Consolidated $74,326,904 $902,135 ============================== 1991: Television broadcasting $38,099,678 $448,543 Radio broadcasting 15,692,764 33,400 Publishing and other 21,714,768 173,486 Corporate 16,839,618 9,933 Consolidated $92,346,828 $665,362 Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 13. Shareholders' Equity (Deficit) A. Refer to notes 1 and 2 for a description of changes to shareholders' equity (deficit) pursuant to the Plan of Reorganization. B. On November 24, 1993, the Company purchased from investment advisory clients of W. R. Huff Asset Management Co., L.P. ("Huff") a block of 2,249,086 shares of its common stock. The purchase price consisted of $3.75 per share in cash, plus the stock of its indirect wholly-owned subsidiary, Price Publishing Corporation, which held the remaining 25% interest in the New York Law Publishing Company (see Note 2). The stock of Price Publishing Corporation had a book value of approximately $3,836,000 at such date which in the opinion of management approximated its fair value (see Note 4). In connection with this transaction, the Company recorded a loss of approximately $3,977,000 reflecting the difference between the value of the cash and stock of Price Publishing Corporation transferred to Huff and the then current trading market price of the common stock. The loss has been included in other expense (income) in the accompanying statement of operations (see Note 11) and the common stock purchased from Huff has been treated as constructively retired in the accompanying balance sheet at December 31, 1993. The purchase agreement includes a provision for certain additional payments to Huff (or rescission of the agreement if such payments are not made) if, among other things, litigation, as defined, is pending at the end of one year from the purchase date. Also, additional payments to Huff may be required if there has been a change in control of or other specified transaction involving the Company at such purchase anniversary date. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 13. Shareholders' Equity (Deficit) (continued) In connection with the Company's purchase of common stock from Huff, the Company has deposited $1,500,000 with a collateral agent to secure certain obligations under the purchase agreement. C. In connection with the Plan, warrants on the Company's common stock, originally issued on April 12, 1990, were amended. The warrants will be exercisable for approximately 124,000 shares of the Reorganized Company's common stock at an exercise price of $4.23 per share during the five-year period commencing October 1, 1993. D. The Company has an employment agreement with Robert Price, covering base salary and incentive compensation based on Company performance. The agreement provides for bonuses payable in common stock to Mr. Price during specified periods after December 30, 1992 commencing on specified events and/or performance achievements by the Company and its subsidiaries. The number of shares awarded under such agreement will be based upon a predetermined percentage of the then outstanding shares of Price's common stock. 14. Stock Option Plan A long-term incentive plan, (the "1992 Long Term Incentive Plan") was established under the Plan, which provides for granting incentive stock options, as defined under current tax law, and other stock-based incentives to key employees and officers. The maximum number of shares of the Company that are subject to awards granted under the 1992 Long Term Incentive Plan is 1,000,000. The exercise of such options, other than those granted on December 10, 1992, will be exer cisable at a price not less than the fair market value on the date of the grant, for a period up to ten years. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 14. Stock Option Plan (continued) New incentive stock options were granted on December 10, 1992 under the 1992 Long Term Incentive Plan to key employees and officers. The number of options issued represents essentially a 1 for 2 reverse split for all previously awarded stock options granted, which were canceled pursuant to the Plan, except for options previously awarded to Robert Price which were surrendered by Mr. Price. Options granted on December 10, 1992 represent 170,911 shares and the exercise price was set at $2.67 per share. During 1993, options for 21,055 shares were exercised and as of December 31, 1993, options for 140,630 shares remained outstanding. Also, at December 31, 1993, common stock of 838,315 shares remain reserved for the issuance of stock options. 15. Commitments and Contingencies The Company is involved in various claims and litigation arising in the ordinary course of business. In the opinion of legal counsel and management, the ultimate disposition of these matters will not have a material adverse effect on the Company's financial condition. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements (continued) 15. Commitments and Contingencies (continued) The Company and its subsidiaries lease a variety of assets used in their operations, including office space and antenna sites. Renewal options are available in the majority of leases. The following is a schedule of the Company's minimum rental commitment for operating leases of real and personal property for each of the five years subsequent to 1993 and in the aggregate: Operating Leases ---------- Year: 1994 $261,000 1995 257,000 1996 269,000 1997 268,000 1998 263,000 Thereafter 210,000 ---------- Total minimum lease payments $1,528,000 ========== Rental expense for operating leases was approximately $312,000, $1,468,000, and $1,384,000 for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, the Company is committed to the purchase of film broadcast rights of various syndicated programming aggregating approximately $135,000, $235,000, $21,000 and $11,000 for the years 1994, 1995, 1996 and 1997, respectively. Price Communications Corporation and Subsidiaries Notes to Consolidated Financial Statements 16. Subsequent Events On December 27, 1993, the Company announced that it entered into an agreement to sell substantially all the assets of its radio stations, WWKB-AM and WKSE-FM in Buffalo, New York, for $5 million in cash. This transaction has been approved by the Federal Communications Commission ("FCC") and management expects it to close during the first half of 1994. The Company expects to realize a gain on the transaction. On February 16, 1994, the Company entered into an agreement to buy WHTM-TV, Channel 27, serving the Harrisburg-York-Lancaster- Lebanon, Pennsylvania market for approximately $41 million. This transaction is subject to FCC approval. The Company expects to close on this purchase during the second half of 1994. On February 16, 1994, the Company sold its outdoor advertising business for a total of $875,000, including $200,000 cash and a note from the buyer for $675,000. A pre- tax loss of approximately $340,000 will be recognized in 1994 on the sale. In March 1994, the Company entered into an agreement to sell radio stations WOWO-AM and WOWO-FM in Fort Wayne, Indiana, for $2.3 million in cash. The transaction is subject to FCC approval. The Company expects to realize a gain on the transaction. PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (17)Plan of Reorganization (Continued) PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (17), Continued The Apollo Transaction includes the sale of 75% of the Company's interest in Alexandra Publishing Corporation, which owns The New York Law Publishing Company. As a result of this transaction, the Company will no longer consolidate its interest in these companies. During 1992, The New York Law Publishing Company contributed approximately $32.6 million to the Company's net revenue, $23.9 million to operating expenses and $1.6 million to depreciation and amortization. The gain on the partial sale of publishing companies and the gain from cancellation of indebtedness resulted in extraordinary income of approximately $312.7 million which is net of a tax provision of $900,000 relating to the sale of the publishing companies. The gain resulting from the forgiveness of debt is not taxable for Federal income tax purposes. (18)Supplemental Cash Flow Information The following is a supplemental schedule of noncash investing activities for the years ended December 31, 1993, 1992 and 1991: 1993 1992 1991 Fairmont (Note 3): Notes received - 8,983,281 11,064,240 Deferred income - (8,983,281) (11,064,240) NTG (Note 11): Dividends accumulated - 11,030,660 9,420,794 Deferred income - (11,030,660) (9,420,794) /AUDIT-REPORT PART III The information called for by Items 10, 11, 12 and 13 is incorporated herein by reference from the following portions of the definitive proxy statement to be filed by the Company in connection with its 1994 Meeting of Shareholders. Item Incorporated from Item 10. Item 10. Directors and Executive Directors and Executive Officers of the Company Officers Item 11. Item 11. Executive Compensation "Executive Compensation" and "Certain Transactions" Item 12. Item 12. Security Ownership of "Principal Shareholders" and Certain Beneficial "Securities Ownership of Owners and Management Management" Item 13. Item 13. Certain Relationships "Executive Compensation" and and Related Transactions "Certain Transactions" PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) and (2) List of financial statements and financial statement schedules: Independent Auditors' Reports Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity (Deficit) for Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements III. Condensed Financial Information of Registrant V. Property, Plant and Equipment VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts X. Supplementary Income Statement Information (Schedules other than those listed are omitted for the reason that they are not required or are not applicable or the required information is shown in the financial statements or notes thereto.) (3) Exhibits See Exhibit Index at page E-l, which is incorporated herein by reference. (b) Reports on Form 8-K. During the quarter ended December 31, 1993, Registrant filed the following Current Reports on Form 8-K: On October 14, 1993, Registrant filed a report on Form 8-K wherein a disposition of assets occurring on October 1, 1993 was reported at Item 2. No financial statements were included in or as exhibits to this Current Report. On December 2, 1993, Registrant filed Amendment No. 1 to its Current Report on Form 8-K filed on October 14, 1993. The Amendment No. 1 reported certain recent developments and included certain pro forma financial statements as Exhibit 99(ii). Also on December 2, 1993, Registrant filed a report on Form 8-K wherein a repurchase of Registrant's common stock occurring on November 24, 1993, and the institution of litigation against Registrant on November 29, 1993, were reported at Item 5. PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS DECEMBER 1993, 1992 AND 1991 Balance at Additions Balance at Beginning Charged to End of Description of Period Expenses Deductions (a) Period For the year ended December 31, 1993: Allowance for doubtful accounts $565,351 $263,909 ($341,684) $487,576 For the year ended December 31, 1992: Allowance for doubtful accounts $612,438 $513,908 ($560,995)(b) $565,351 For the year ended December 31, 1991: Allowance for doubtful accounts $418,283 $780,039 ($585,884) $612,438 (a) Amounts written off as uncollectible and payments. (b) $85,000 relates to the partial sale of companies in 1992. /TABLE PRICE COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31 Reorganized Company Predecessor Company Classification 1993 1992 1991 Maintenance and repairs $331,325 $569,556 $556,317 Royalties $404,205 $324,763 $374,936 Advertising $656,275 $3,379,941 $2,768,538 Securities and Exchange Commission Washington, D.C. 20549 Price Communications Corporation Commission File No. 1-8309 Annual Report on Form 10-K for the year ended December 31, 1993 Exhibits Item 14(a)(3). EXHIBIT INDEX Item 14(a)(3) Price Communications Corporation Annual Report on Form 10-K for the year ended December 31, 1993 Page (3)(a) Restated Certificate of Incorporation of the Registrant as filed with the Secretary of State of the State of New York on December 29, 1992, incorporated by reference to Exhibit 3(a) to Registrant's Form 10-K for the year ended December 31, 1992. (b) Restated Bylaws of the Registrant. (4)(a) Indenture dated as of December 30, 1992 between the Registrant and IBJ Schroder Bank & Trust Company, as trustee, relating to the Company's 5% Senior Secured Notes due 1999 (the "Indenture"), incorporated by reference to Exhibit 4(a) to Registrant's Form 10-K for the year ended December 31, 1992. (b) Pledge, Intercreditor and Collateral Agency Agreement dated as of December 30, 1992, among the Registrant, IBJ Schroder Bank & Trust Company, as Trustee under the Indenture, and IBJ Schroder Bank & Trust Company, as Collateral Agent, incorporated by reference to Exhibit 4(b) to Registrant's Form 10-K for the year ended December 31, 1992. (10)(a) The Registrant's 1992 Long Term Incentive Plan, incorporated by reference to Exhibit 10(a) to Registrant's Form 10-K for the year ended December 31, 1992. (b) Amended and Restated Employment Agreement dated as of May 8, 1992 between The New York Law Publishing Company and Robert Price, incorporated by reference to Exhibit 10(b) to Registrant's Form 10-K for the year ended December 31, 1992. (c)Employment Agreement with Robert Price, dated May 8, 1992, incorporated by reference to Exhibit 10(c) to Registrant's Form 10-K for the year ended December 31, 1992. (d) Agreement dated May 8, 1992 between the Registrant and Robert Price with respect to PriCellular Corporation, incorporated by reference to Exhibit 10(d) to Registrant's Form 10-K for the year ended December 31, 1992. (e) Amended and Restated Stock Purchase Agreement dated as of May 8, 1992 among the Registrant, Price Publishing Corporation, Alexandra Publishing Corporation, The New York Law Publishing Company and Apollo Investment Fund, L.P., incorporated by reference to Exhibit 10(e) to Registrant's Form 10-K for the year ended December 31, 1992. (f) Amended and Restated Shareholders Agreement dated as of May 8, 1992 among the Registrant, Apollo Investment Fund, L.P., Price Publishing Corporation, Alexandra Publishing Corporation, and The New York Law Publishing Company, incorporated by reference to Exhibit 10(f) to Registrant's Form 10-K for the year ended December 31, 1992. (g) Registration Rights Undertaking, incorporated by reference to Exhibit 10(g) to Registrant's Form 10-K for the year ended December 31, 1992. (h) Warrant Agreement dated April 12, 1990 between Price Communications Corporation and Warner Communications Investors, Inc., incorporated by reference to Exhibit (4) to Registrant's Form 8-K filed to report an event of April 12, 1990. (i) Form of Amendment to Time Warner Warrant, incorporated by reference to Exhibit 10(i) to Registrant's Form 10-K for the year ended December 31, 1992. (j) Stock Purchase Agreement, dated as of April 27, 1987, among Registrant, Republic Broadcasting Corporation and Fairfield Broadcasting, Inc., as amended July 16, 1987, incorporated by reference to Annex I to Registrant's Definitive Proxy Statement dated July 27, 1987. (k) Notes and Stock Purchase Agreement between and among Fairfield Broadcasting, Inc., Price Communications Corporation and Republic Broadcasting Corporation dated as of September 30, 1987, as amended, incorporated by reference to Exhibit 10(a) to Registration Statement on Form S-1 (File No. 33-30318). (l) Stockholders' Agreement among Fairfield Broadcasting, Inc., Price Communications Corporation, Citicorp Venture Capital Ltd., Osborn Communications Corporation and Prudential-Bache Interfunding Inc., dated as of September 30, 1987, incorporated by reference to Exhibit 10(b) to Registration Statement on Form S-1 (File No. 33-30318). (m) Asset Purchase Agreement by and among NTG, Inc., Price Communications Corporation and Western Michigan Broadcasting Corporation, Rhode Island Broadcasting Corporation, Magnolia Broadcasting Corporation and Keystone Broadcasting Corporation, dated as of June 28, 1989, incorporated by reference to Exhibit 10(c) to Registration Statement on Form S-1 (File No. 33-30318). (n) Stock Purchase Agreement between NTG Holdings, Inc. and Price Communications Corporation, dated as of June 28, 1989, incorporated by reference to Exhibit 10(d) to Registration Statement on Form S-1 (File No. 33-30318). (o) Network Affiliation Agreement, dated September 10, 1982, between National Broadcasting Company, Inc. and Tri-State Broadcasting Corporation, as amended (KSNF-TV), incorporated by reference to Exhibit 10(v) to Registration Statement on Form S-1 (File No. 33-30318). (p) Network Affiliation Agreement, dated April 22, 1989, between National Broadcasting Company, Inc. and Continental Broadcasting Corporation (KJAC-TV), incorporated by reference to Exhibit 10(w) to Registration Statement on Form S-1 (File No. 33-30318). (q) Network Affiliation Agreement, dated January 1, 1981, between National Broadcasting Company, Inc. and Clay Broadcasting Corporation of Texas, as amended (KFDX-TV), incorporated by reference to Exhibit 10(x) to Registration Statement on Form S-1 (File No. 33-30318). (r) Stock Purchase Agreement dated March 1, 1990 among Time Warner Inc., Warner Communications Investors, Inc., Price Communications Corporation, and PriCellular Corporation, incorporated by reference to Exhibit (1) to Registrant's Form 8-K filed to report events of April 12, 1990. (s) Amendment No. 1 to Stock Purchase Agreement dated April 6, 1990, among Time Warner Inc., Warner Communications Investors, Inc., Price Communications Corporation, and PriCellular Corporation, incorporated by reference to Exhibit (2) to Registrant's Form 8-K filed to report an event of April 12, 1990. (t) Stock Option Agreement, dated April 12, 1990 between PriCellular Corporation and Warner Communications Investors, Inc., incorporated by reference to Exhibit (3) to Registrant's Form 8-K filed to report an event of April 12, 1990. (u) Line of Credit Agreement, dated as of December 21, 1993, among Atlantic Broadcasting Corporation, Southeast Texas Broadcasting Corporation, Texoma Broadcasting Corporation, Tri-State Broadcasting Corporation, the Lenders Parties Thereto and the Bank of Montreal. (v) Securities Purchase Agreement, dated December 30, 1993, among Apple Publishing Corporation, Price Communications Corporation, Equity-Linked Investors, L.P. and Equity-Linked Investors-II. (w) Agreement dated November 19, 1993, between Price Communications Corporation, Apple Publishing Corporation, the Sellers listed on Exhibit A thereto and W.R. Huff Asset Management Co., L.P. (x) Stock Purchase Agreement, dated as of October 1, 1993, by and between Price Communications Cellular, Inc., Price Communications Corporation and Atlas Cellular Corporation, incorporated by reference to Exhibit 10 to Registrant's Form 8-K filed to report an event of October 1, 1993. (y) Form of Indemnification Agreement between Registrant and its officers and directors. (11) Statement regarding computation of per share earnings (omitted; computation can be clearly determined from material contained in the Report). (22) Subsidiaries of Registrant (24.2) Consent of Ernst & Young Consent of KPMG Peat Marwick (25) The powers of attorney to sign amendments to this Report appear on the signature page. EXHIBIT 22 Subsidiaries of Price Communications Corporation as of December 31, 1993. Name of Subsidiary State of Incorporation Atlantic Broadcasting Corporation Delaware Republic Broadcasting Corporation New York Wayne Broadcasting Corporation Indiana Huntington Broadcasting Corporation Delaware Federal Broadcasting Corporation New York Atlas Broadcasting Corporation New York Eagle Broadcasting Corporation Delaware Price Outdoor Media Corporation of America Delaware Price Outdoor Media of Missouri Inc. Delaware Apple Publishing Corporation Delaware The Red Bank Register New Jersey Empire State Broadcasting Corporation Delaware Eimar Realty Corporation Delaware Continental Broadcasting Corporation Delaware Texoma Broadcasting Corporation Texas Tri-State Broadcasting Corporation Delaware Southeast Texas Broadcasting Corporation Texas SIGNATURES Pursuant to the requirements of Section 13 and 15(d) of the Securities and Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PRICE COMMUNICATIONS CORPORATION By/s/ Robert Price Robert Price, President Dated: March 31, 1994 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. Each person whose signature appears below hereby authorizes and appoints Robert Price as his attorney-in-fact to sign and file in his behalf individually and in each capacity stated below any and all amendments to this Annual Report. Dated: March 31, l994 By/s/ Robert Price Robert Price, Director and President (Principal Executive Officer, Financial Officer and Accounting Officer) Dated: March 31, l994 By/s/ George H. Cadgene George H. Cadgene, Director Dated: March 31, 1994 By/s/ Harold A. Christiansen Harold A. Christiansen, Director Dated: March 31, 1994 By/s/ James H. Duncan., Jr. James H. Duncan Jr., Director Dated: March 31, l994 By/s/ Robert F. Ellsworth Robert F. Ellsworth, Director Dated: March 31, 1994 By/s/ Kim I. Pressman Kim I. Pressman Director	9,676	67,188
778439_1993.txt	778439_1993	1993	778439	ITEM 1. BUSINESS INTRODUCTION Rayonier Timberlands, L.P. (the Partnership or RTLP) is a Delaware limited partnership formed by Rayonier Inc. (Rayonier) in October 1985 to succeed to substantially all of Rayonier's timberlands business. Rayonier Forest Resources Company (RFR or Managing General Partner), a wholly owned subsidiary of Rayonier formed in September 1985, is the Managing General Partner of the Partnership and Rayonier is the Special General Partner. On November 19, 1985, Rayonier contributed approximately 1.19 million acres of its timberlands owned in fee or held under long-term leases (the Timberlands) to the Partnership in exchange for 20,000,000 Class A Depositary Units (Class A Units) representing Class A limited partners' interests in the Partnership and 20,000,000 Class B Depositary Units (Class B Units) representing Class B limited partners' interests in the Partnership. Also on such date, in a registered public offering, Rayonier offered and sold 5,060,000 Class A Units. Therefore, at all times after such date to and including December 31, 1993, Rayonier has held 74.7 percent of the Partnership's issued and outstanding Class A Units and 100 percent of the Partnership's issued and outstanding Class B Units. On February 28, 1994, ITT Corporation (ITT), Rayonier's sole shareholder, distributed all the Common Shares of Rayonier to ITT's shareholders. In connection with the distribution, Rayonier changed its name from ITT Rayonier Incorporated to Rayonier Inc. and became a publicly traded company listed on the New York Stock Exchange under the symbol "RYN". RTLP will continue to be listed separately and trade under the symbol "LOG." Class A unitholders' financial interest will not be affected in any manner by ITT's distribution of Rayonier to its shareholders. DESCRIPTION OF BUSINESS The Partnership is engaged in the timberlands business, which includes forestry management, reforestation, timber thinning and the marketing and sale of standing timber from the Timberlands. The Partnership will occasionally purchase, for short term resale, standing timber from other ownerships. The Partnership's business plan is to operate the Timberlands for sustained long- range harvest and to satisfy the Partnership's need to generate regular cash flow in light of its cash distribution policy as determined from time to time by the Managing General Partner's Board of Directors. The Partnership operates through Rayonier Timberlands Operating Company, L.P. (the Operating Partnership or RTOC), a Delaware limited partnership formed by Rayonier in October 1985 in which the Partnership holds a 99 percent limited partner's interest. RFR is the Managing General Partner of the Partnership and the Operating Partnership, and Rayonier is the Special General Partner of both partnerships. As general partners, Rayonier and RFR hold an aggregate 1 percent interest in each partnership and, therefore, have an aggregate 1.99 percent interest in the Partnership and the Operating Partnership on a combined basis. Unless the context otherwise requires, all references in this Form 10-K to the Partnership are also references to the Operating Partnership. The Partnership negotiates and contracts for the sale of standing timber (stumpage) with buyers who generally cut and pay for the trees during the contract period. Current contracts usually entail a 20 percent deposit and/or performance bond and generally have a 12 to 24 month life. The Partnership conducts, or contracts for third parties to conduct, harvesting operations if the Managing General Partner believes that the timber cannot be sold as profitably as stumpage or that the tract in question is particularly environmentally sensitive. In addition, the Partnership may sell or exchange portions of the Timberlands and acquire additional timber properties for cash, additional Units or other consideration. Partnership sales to Rayonier for use in Rayonier's specialty pulp, log trading and wood products businesses are an important contributor to Partnership results. For further information, see "Timber Markets and Sales; Affiliated Party Transactions." - 1 - In 1993, two customers under common ownership (not affiliated with the Partnership) accounted for approximately 15 percent of total revenues while in 1992 two unaffiliated customers accounted for approximately 34 percent of total revenues. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." No unaffiliated customer accounted for sales in excess of 10 percent of total revenues in 1991. The Partnership and the Operating Partnership have no officers, directors or employees; in addition, RFR has no employees. Officers of RFR and officers and employees of Rayonier perform all management functions for the Partnership. As of December 31, 1993, Rayonier had approximately 2,600 employees of which approximately 150 are active in its Forest Resources Division. FORESTRY OPERATIONS The Partnership's forest management operations and harvesting schedules are based on biological information, environmental issues, and other data concerning species, site index, classification of soils, estimates of timber inventory and the types, size and age classification of the timber base. From this information the Partnership routinely refines its long-term harvest schedule based on existing and anticipated economic and market conditions, with a view toward maximizing the value of its timber and timberland assets. Particular forestry practices vary by geographic region and depend upon factors such as soil productivity, tree size, age and stocking. Forest stands may be thinned periodically to improve stand quality until they are harvested. Different areas within a forest may be planted or seeded in successive years to provide a distribution of age classes within the forest. A distribution of age classes will tend to provide a regular source of cash flow as the various timber stands reach harvestable age. The Partnership's forest management practices include thinning of timber stands, controlled burning, fertilization of timber plantations, disease and insect control and reforestation. Reforestation activities include intensive land preparation and planting. The Partnership has a fully established tree improvement program in the Southeast which, in conjunction with its seed orchards and seedling nursery, supplies up to 100 percent of the annual planting requirements with first and second generation genetically improved planting stock. The Partnership also maintains a genetics program in the Northwest, but it cannot yet fully supply that region's seedling needs. The Partnership's activities include the maintenance and building of roads as necessary for timber access within the Timberlands. In the Northwest either the Partnership or the timber purchaser will build and maintain roads, depending on contract requirements. In the Southeast it is typically the obligation of the landowner. Each of the major regions within the Timberlands has well established road systems that permit access to substantially the entire area throughout the year. The Timberlands contain over 4,000 miles of roads that, together with public roads and roads built by other private landowners, provide such access. The timing of harvest of merchantable timber depends in part on the maturing cycles of timber and on economic conditions. Timber on the Partnership's 369,000 acres of timberlands in the state of Washington (the Northwestern Timberlands), consisting predominantly of conifer species, is currently thinned at approximately 15 years of age and is harvested after attaining approximately 45-50 years of age. The Partnership's long standing policy has been to reach a sustainable annual harvest level in the Northwest by gradually reducing its harvest volume each year. Although 1994's harvest volume is expected to include 1993's shortfall, management's projection of the annual harvest in this region from 1995 through 2000 remains at approximately 80 percent of the 1992 harvest. Timber on the Partnership's 793,000 acres of timberland in Georgia, Florida and South Carolina (the Southeastern Timberlands) typically has a shorter maturity cycle than timber in the Northwestern United States. Pine plantations in the Southeastern Timberlands are harvested after they reach approximately 20-25 years of age. Due to intensive forest and land management as well as silvicultural investment, pine volume available for harvest on the Southeastern Timberlands is expected generally to increase 2 to 3 percent annually. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." By the year 2000, the annual pine harvest rate in this region is now expected to be nearly 16 percent greater than the 1993 harvest. See "Federal and State Regulation" for a description of issues which may impact Partnership's timber harvest rates. DESCRIPTION OF TIMBERLANDS The Timberlands consist of approximately 1.16 million acres, as of December 31, 1993, located in the state of Washington, primarily on the Olympic Peninsula, and in Georgia, Florida and South Carolina. Approximately 1.03 - 2 - million acres are owned in fee, while approximately 137,000 acres are held under long-term lease. Each of these regions contains tracts of timber located within the operating radius of a number of pulp and paper mills, sawmills, plywood mills, and wood treating plants. ACREAGE. The following table sets forth, as of December 31, 1993, the location and type of ownership that the Partnership has with respect to the Timberlands. 1 The long-term leases permit the Partnership as lessee to manage and harvest timberlands throughout the term of the lease. These leases typically have initial terms of approximately 30 to 65 years, with renewal provisions in some cases. The remaining portions of the initial terms of these leases averaged 23 years as of December 31, 1993. Annual rentals are paid to the lessor and, in some cases, the leases provide for payment of a percentage of stumpage values to the lessor as timber is cut. In addition, the leases impose certain duties on the lessee regarding management and reforestation of the leased acres. In general, leased acreage has less value than the same acreage would have if owned in fee because of the obligations imposed upon the lessee under the terms of the lease. TIMBER INVENTORY. The Timberlands owned in fee or held under long-term leases include, as of December 31, 1993, total estimated merchantable timber inventory of approximately 10.3 million cunits of wood, of which approximately 81 percent is softwood (see definition of "Merchantable Timber"). A cunit represents 100 cubic feet of fiber and is the customary common unit of measure to consolidate regional information based on local commercial measurements such as board feet or tons. The following table sets forth the volumes of merchantable timber on the Timberlands by location and type, as of December 31, 1993. 1 The merchantable timber inventory volumes represent estimates by the Partnership for management purposes based on its continuing inventory system, which involves periodic statistical sampling of the Timberlands, with updating adjustments made on the basis of growth estimates and harvest information. It is not a reflection of the amount of timber that will be available to cut in any specific period of time (see "Forestry Operations") as future growth is not predicted. - 3- THE NORTHWESTERN TIMBERLANDS. The Northwestern Timberlands are located in Washington, primarily on the Olympic Peninsula. All of these Timberlands are owned in fee. The Northwestern Timberlands include approximately 314,000 acres of conifer (softwood) stands, approximately 74 percent of which is stocked with hemlock and the remainder of which is stocked with Douglas fir, western red cedar and white fir. The Northwestern Timberlands also include approximately 18,000 acres of hardwood timber stands, consisting principally of alder and maple, with lesser amounts of conifers. The remaining 37,000 acres are classified as non-forest lands. Rain, site and soil conditions typically cause softwood timber in the Northwest, particularly hemlock, to maintain a relatively high growth rate for a longer period of time in comparison with softwood timber in other parts of the United States, resulting in longer rotation cycles. Site indices for conifer lands in the Northwestern United States generally range from 90 to 145, and average approximately 105. The average site index of the conifer lands in the Northwestern Timberlands is also 90 to 145 and averages approximately 110. The Northwestern Timberlands are near ocean ports and are well-positioned to serve the Pacific Rim export market. Approximately 70 percent of the timber sold from the Northwestern Timberlands has been of export quality. Rayonier operates a pulp mill at Port Angeles. There are also eight pulp and paper mills and numerous sawmills, plywood plants, and other wood converting facilities in the region. THE SOUTHEASTERN TIMBERLANDS. The Southeastern Timberlands are located in Georgia, Florida and South Carolina and include approximately 656,000 acres of timberlands owned in fee and approximately 137,000 acres held under long-term leases. The Southeastern Timberlands include approximately 508,000 acres of pine (softwood) lands, approximately 270,000 acres of hardwood lands and approximately 15,000 non-forest acres. The predominant pine species are loblolly and slash pine. Site indices for pine lands in the Southeastern United States generally range from 55 to 65 and average approximately 60. The pine lands included in the Southeastern Timberlands have an average site index of 60. Hardwood lands included in the Southeastern Timberlands are principally bottomlands. Principal hardwood species are red oak, sweet gum, black gum, red maple, cypress and green ash. The Southeastern region is generally recognized as being the most competitive timberlands area in the United States. There are 19 pulp and paper mills and numerous sawmills, plywood plants and treating plants for poles and pilings located in the area of the Southeastern Timberlands. Rayonier operates two sawmills and two pulp mills in this region. STUMPAGE PRICES AND INDUSTRY CONDITIONS Stumpage prices vary depending on the market for end use products which rely on timber and wood fiber as raw materials. Stumpage values tend to be higher for larger diameter trees because of higher value end uses. Larger diameter trees are used as sawtimber which is processed into lumber, plywood, and poles, while smaller diameter trees are used as pulpwood for the manufacture of paper and pulp. International, as well as domestic, supply and demand forces (including the value of the U.S. dollar in foreign exchange markets) also affect U.S. regional stumpage prices. Local stumpage prices are dependent upon factors such as geographic location of the property, proximity to a mill or export facility, logging conditions, accessibility of the timber, size and quality of the timber, species composition of the stand and the timber volume per acre. The Northwest and the Southeast represent major timber growing regions of the United States. In both areas, timber markets are very competitive, but each region has different types of timber, markets and competitive factors. For further information see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" and "Future Operations." - 4 - COMPETITION Timber and wood fiber consuming facilities tend to purchase raw materials within relatively small geographic areas, generally within a 100 mile radius. Competitive factors within a market area generally will include price, species and grade, proximity to wood consuming facilities and ability to meet delivery requirements. The Partnership competes in the timber market with numerous private industrial and non-industrial land and timber owners as well as with the Department of Natural Resources of Washington State and the U.S. Government, principally the U.S. Forest Service and the Bureau of Land Management. Currently, timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. See "Federal and State Regulation." TIMBER MARKETS AND SALES; AFFILIATED PARTY TRANSACTIONS The Partnership sells timber provided by the Timberlands to Rayonier and to unaffiliated domestic purchasers. See "Stumpage Prices and Industry Conditions" for a discussion of end-use markets for the Partnership's timber. Since the inception of the Partnership, 38 percent of its timber sales in the Northwest and 14 percent of its timber sales in the Southeast have been to Rayonier. The following table shows the volumes of timber sold by the Partnership to Rayonier for the three years ended December 31, 1993. It also shows the volumes of timber on the Timberlands that were sold to unaffiliated purchasers for the periods indicated. Rayonier continues to rely on the Timberlands as one of its major sources of timber for its pulp mills, sawmill facilities and its log export business. For example, although Rayonier purchased directly only 13 percent of the Partnership's 1993 Southeast harvest volume, the Partnership estimates that an additional 9 percent of its pulpwood timber sold in the Southeast in 1993 was purchased by Rayonier on the open market from Partnership customers. See "Conflicts of Interest." Any shutdowns of plants or curtailments of sales by customers for Partnership timber, including Rayonier, could adversely affect future volumes of timber sales by the Partnership or the prices at which such sales are made. Rayonier's Forest Resources Division is responsible for management of the Timberlands for the benefit of the Partnership; its organization is separate from Rayonier's log export and wood procurement organizations, which are responsible for timber procurement by Rayonier. In conducting the activities described in the following paragraphs with respect to negotiations and other relationships between the Partnership and Rayonier, employees of Rayonier's Forest Resources Division act on behalf of the Partnership and employees of Rayonier's log export and wood procurement organizations act on behalf of Rayonier. The Partnership develops an annual sales plan identifying the specific tracts to be sold. The Partnership's strategy is to award contracts during those periods of the year (typically the first and fourth quarters) in which it expects to receive the best prices. However, under current market conditions, the Partnership is placing fewer sales out for bid at one time. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." - 5 - Before the Partnership offers a tract for sale, it determines whether the highest price is likely to be achieved through public bid or direct negotiation. The decision considers such factors as timber quality, unusual logging conditions, number of potential bidders, and general market activity. In 1993, approximately 95 percent in the Northwest and 73 percent in the Southeast of the total contract value of contracts entered into by the Partnership were awarded through public bid; when Rayonier submits a bid, it is treated no differently than bids from unaffiliated parties. Occasionally, tract and market circumstances favor a negotiated sale to a target buyer. Of the contract value awarded through direct negotiation in 1993, approximately 7 percent in the Southeast were purchased by Rayonier. In 1993, there were no directly negotiated sales with Rayonier in the Northwest. Typically, the Partnership attempts to structure sales contracts with Rayonier and unaffiliated purchasers as transactions in which the Partnership retains title to timber until it is severed and the purchaser assumes responsibility for delivery. In these cases the Partnership recognizes income for both financial statement and tax purposes when and as the timber is cut and measured. Accordingly, there is a time lag between the signing of a sales contract and the recognition by the Partnership of income therefrom. The Partnership's contracts, whether with Rayonier or with unaffiliated purchasers, generally provide for payment of a fixed price per unit (by species and volume in the Northwest and by weight in the Southeast), cutting over periods of up to 24 months in the Northwest and up to 18 months in the Southeast, an initial deposit and utilization standards which the buyer must satisfy when cutting and removing timber from the property. The Partnership's contracts with unaffiliated purchasers may require a performance bond from the buyer, whereas the Partnership does not require such a bond from Rayonier. All contracts between Rayonier and the Partnership are subject to review by the Conflicts Committee established by RFR's Board of Directors. See "Conflicts of Interest." For information as to timber sales contracts in effect at December 31, 1993, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." CONFLICTS OF INTEREST Conflicts of interest can arise in selecting, pricing and scheduling timber sold to Rayonier. Other conflicts of interest can arise in allocating revenues and costs between the Class A Units and the Class B Units, in scheduling timber sales to occur before or after the Initial Term expires, and in setting the terms of any loans between the Partnership and Rayonier. The Conflicts Committee of the Board of Directors of RFR, which is comprised of non-employee directors, reviews these transactions and obtains opinions from outside consultants as to their fairness. ENVIRONMENTAL PROTECTION Management of the Timberlands to protect the environment is a continuing concern of the Partnership. The Partnership expends considerable efforts to comply with regulatory requirements for the use of pesticides and minimization of stream sedimentation and soil erosion. From time to time the Partnership volunteers to, or may be required to, clean up certain dump sites created by the general public. The Partnership also participates in cooperative projects with environmental agencies such as a program with the Georgia Department of Natural Resources to monitor hairy rattleweed, a threatened species, and another effort with the U.S. Fish and Wildlife Service to develop an information base on whether Bartram's Ixia constitutes an endangered species. See "Federal and State Regulation." The costs of environmental compliance by the Partnership have not been significant and are not expected to be significant in the future. The Partnership does not project any significant capital expenditures for environmental protection. - 6 - FEDERAL AND STATE REGULATION In the management and operation of the Timberlands, the Partnership is subject to various state and federal laws regulating land use. To some degree, these laws may operate as constraints on the manner in which portions of the Timberlands are managed and operated and the markets into which the timber from the Timberlands may be sold. Regional timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. The Partnership's operations are subject to laws restricting or regulating to some extent development and/or logging activity near coastal shorelines. In addition, land located in areas exposed to flood hazard are subject to regulations specifying acceptable types of development. The federal government regulates the use of "wetlands" pursuant to the Clean Water Act, the Rivers and Harbors Act and the Federal Water Pollution Control Act. The Timberlands include property designated as wetlands, and the Partnership is subject to permit procedures imposed by both federal and state agencies in connection with any logging or developmental activity on such land. In addition, activity is regulated on lands adjacent to scenic rivers designated under federal and state Wild and Scenic Rivers Acts. Reforestation by independent contractor crews is regulated by the federal Migrant and Seasonal Worker Protection Act, which imposes upon the landowner the burden of insuring to the federal government regulatory compliance by the contractor. Portions of the Timberlands are located within, or adjacent to, National Forests. Access to such parcels may be obtained generally through road use permits subject to the terms and conditions of applicable regulations. Access across Forest Service land may be restricted where habitat of threatened or endangered species is involved. The state of Washington has enacted several laws that regulate or limit forestry operations. The most comprehensive of these is the Forest Practices Act, which addresses many growing, harvesting and processing activities on forest lands. Among other requirements, the Forest Practices Act imposes certain reforestation obligations on the owner of forest land. The Act restricts the size of clear-cut harvests, restricts timber harvest to protect wildlife listed as threatened or endangered and requires that timber be left standing in stream buffers and wildlife management areas. Other Washington state laws regulate timber slash burning, operations during fire hazard periods, logging activities affecting or utilizing watercourses or in proximity to certain ocean and inland shorelines and some grading and road construction activities. The states of Georgia and Florida also regulate forestry operations. Subsequent to July 1, 1993, Georgia statutory law mandates all timber sales to be by tonnage or actual measured volume, prohibiting sales where payment is based upon conversion factors from volume to tonnage or vice-versa. Florida and Georgia both regulate slash burns, control burns and logging activities within streamside management zones. Florida law and regulation limits activities allowable or permittable in wetlands, and is developing integrated regulations under statutory mandate for ecosystem management. Under one such rule, the St. Johns Water Management District (a semi-autonomous Florida agency whose regulatory jurisdiction includes much of the Partnership's Florida timberlands) published regulations for July 1, 1994 implementation which would regulate timber road grading, construction, maintenance and management and a variety of surface water management restrictions. The final form of the rule may change before implementation, however the District must have an ecosystem management rule of this sort adopted by July 1, 1994. The Partnership is complying, and intends to comply, with these Federal and state laws regulating its use of the Timberlands and does not expect them, as currently enacted, to be materially burdensome. There can be no assurance, however, that future legislative, regulatory or judicial decisions would not adversely affect the Partnership or its ability to harvest the Timberlands in the manner otherwise contemplated. In particular, although recently imposed restrictions on - 7 - the export of logs from the Northwest have only affected state lands, political pressure to restrict log exports from the Northwest continues. If in the future restrictions should be imposed on the export of logs from private lands, the revenue and earnings of the Partnership could be adversely affected. PARTNERSHIP'S TITLE; CLAIMS AND INTERESTS OF OTHERS Rayonier transferred record title to the Timberlands, excluding any oil, gas or mineral interests, to the Partnership without warranty. The Partnership's title to the Timberlands is subject to presently existing easements, rights of way, flowage rights, servitudes, cemeteries, camp sites, hunting and other leases, licenses, permits, undertakings and any other existing encumbrances or title defects. Properties acquired by the Partnership in the future generally will be acquired and held on record in the Partnership's name, but Rayonier will have the right to purchase the underlying mineral interests. The Partnership owns only the merchantable timber rights (except for 50 trees per acre) on approximately 18,000 acres of real estate owned by Rayonier and Rayland Company, Inc., a real estate subsidiary of Rayonier. Pursuant to the right given to it under the Partnership Agreement, Rayonier has withdrawn 3,309 acres of the Southeastern Timberlands from the Partnership. This withdrawal will not have a material impact on Partnership operations during the Initial Term of the Partnership and was reviewed by the Conflicts Committee of the Board of Directors of RFR. The state of Florida claims title to lands within Florida that were under navigable waters in 1845 when Florida became a state. Affected lands include not only those still under water but lands that are now uplands due to drainage, fill or other category. The Partnership does not believe that the encumbrances or defects to which its title is subject or any possible reclamation by the state of Florida would have a material adverse impact on the Timberlands as a whole. DESCRIPTION OF PARTNERSHIP ALLOCATIONS OF PARTNERSHIP INTEREST. The Partnership records all of its activities in two accounts, the Primary Account and the Secondary Account. Income and expenses are recorded in the Primary Account if they affect timber that is expected to be harvested on or before December 31, 2000 (the Initial Term), and in the Secondary Account if they relate to the Partnership's other assets (including timber that is not planned to be harvested until after December 31, 2000). During the Initial Term, the Secondary Account is essentially an investment account to which the expenditures and debt related to longer-term harvests are assigned. The Class A unitholders, the Class B unitholders, and the General Partners all participate in both accounts, but in different percentages. The participation of the partners in the revenues and expenses of the Partnership is as follows: Primary Secondary Account Account ------- --------- Class A unitholders 95% 4% Class B unitholders 4% 95% General Partners 1% 1% When the Partnership makes a sale of timberland that includes timber, the proceeds are divided between the Primary and Secondary Accounts. Proceeds arising from trees that would have been harvested prior to December 31, 2000 are allocated to the Primary Account. The balance of the proceeds, which apply to the underlying land and timber planned to be harvested beyond the year 2000, are allocated to the Secondary Account. TERMS OF THE PARTNERSHIP AGREEMENT. The Partnership Agreement provides that the Partnership continues in existence until December 31, 2035, but that the Initial Term of the Partnership will end on December 31, 2000. At the end of the Initial Term there will be no distributions of the partners' capital accounts, but the Primary Account will be closed following distribution of any cash remaining in that account (after the repayment of all Partnership borrowings attributed to the Primary Account) concurrently to all partners in accordance with their respective Primary Account percentage interests as indicated in the above table. The Managing General Partner expects that most of the cash credited to the Primary Account (and not used to repay borrowings) will have been distributed prior to the end of the Initial Term. Therefore, unitholders should not expect to receive a return of their original investment, or any substantial amount of cash, as a result of the end of the Initial Term on December 31, 2000. After 2000, all unitholders and General Partners will only participate in the Secondary Account, so that Class A unitholders will then have a 4 percent interest in all Partnership activities. Through the Initial Term, the Secondary Account will incur substantial debt attributable to reforestation and the - 8 - management of the timber base to be cut after the year 2000. This debt will have to be repaid from future cash flow beginning in 2001 and will reduce the amount available for distribution after the end of the Initial Term. CLASS A UNITHOLDERS SHOULD EXPECT THAT THE MARKET PRICE OF CLASS A UNITS WILL BEGIN TO DECREASE SUBSTANTIALLY SOMETIME PRIOR TO DECEMBER 31, 2000. AS INDICATED ABOVE, THEY WILL PROBABLY NOT RECEIVE ANY SIGNIFICANT AMOUNT OF CASH AS A RESULT OF THE END OF THE INITIAL TERM IN THE YEAR 2000. THE PERCENTAGE OF CASH AVAILABLE TO THEM FROM PARTNERSHIP HARVESTING ACTIVITIES AFTER THAT YEAR (AFTER ALLOWING FOR THE REPAYMENT OF SECONDARY ACCOUNT DEBT) WILL DECLINE FROM 95 PERCENT TO 4 PERCENT. DISTRIBUTIONS. A unitholder (Limited Partner) of Rayonier Timberlands, L.P., assuming there are sufficient sales and profits, will receive cash distributions from the Primary Account activity. In accordance with the Partnership Agreement, the distribution policy is to make quarterly distributions to Class A unitholders from cash available from operations after provision for working capital, capital expenditures, asset acquisitions and such other reserves as the Managing General Partner's Board of Directors deems appropriate. On February 8, 1994, the Board declared a special distribution of $4.00 per Class A Unit, payable on March 31, 1994 to unitholder's of record February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared since the Managing General Partner estimated that cash and investment balances were substantially in excess of funding requirements for the balance of the Initial Term ending December 31, 2000. As of March 31, 1994, approximately $1.00 per Class A Unit will remain for capital expenditure, working capital and other funding requirements. TAXES. Rayonier Timberlands, L.P., is a partnership and is not taxed as a corporation. Each unitholder is responsible for taxes on his or her proportionate share of the Partnership's income. Each year, the Managing General Partner will provide unitholders with the necessary tax information based on the unitholder's apportioned share of income and expense from the Partnership. The income reported for each individual unitholder will vary substantially from the income reported in the financial statements, as the unitholder's income is based on his or her costs of acquisition (the market price of the unit at the time of acquisition), and not on the Partnership's historical cost basis as reported in the financial statements. During 1993, the Partnership made distributions totaling $4.60 per Class A Unit. TO THE EXTENT DISTRIBUTIONS EXCEED THE INCOME REPORTED FOR A UNITHOLDER AND THE UNITHOLDER HAS REMAINING TAX BASIS IN THE UNITS, SUCH DISTRIBUTIONS ARE TREATED AS A RETURN OF CAPITAL AND ARE NOT TAXABLE. As such, the distributions serve to reduce the unitholder's basis in the units. For tax-exempt entities (including individual retirement accounts (IRAs) and other retirement plans) that acquired Partnership units after December 17, 1987, the gross income through 1993 attributable to their investment in the Partnership constitutes unrelated business taxable income. Such entities may be required to report income from the Partnership to the Internal Revenue Service and to pay taxes on such income. Beginning with 1994, only a small portion of the Partnership's income will constitute such unrelated business income. - 9 - GLOSSARY OF FORESTRY TERMS The terms defined below relate to the timber industry in general. BOARD FOOT (BF): A unit of measure for sawtimber as well as lumber which is 12 inches square and one inch thick. BOTTOMLANDS: The flood plains of streams, creeks and rivers which generally support quality hardwood stands. CLEAR-CUT: Harvesting all trees in a stand of timber at the same time. Usually done to prepare for establishing a plantation or for converting the land to crop, pasture or other use. CONTROLLED BURNING: Setting fire to the forest floor to reduce the accumulation of logging debris, dead and fallen timber, weeds and underbrush which pose a wildfire hazard or compete with the trees for water and nutrients. CORD: A unit of measure equal to a stack of wood 4x4x8 feet, or 128 cubic feet of wood, bark and air. A common unit of measure for pricing pulpwood. CUNIT: A unit of measure for standing timber equal to one hundred cubic feet of solid wood. It is the customary common unit of measure to consolidate regional information based on local commercial measurements such as board feet or tons. A cunit equals approximately .43 MBF or 3.83 tons. CUTTING CONTRACTS: A contractual right to cut certain described timber over a specified period of time on a specified tract of property. D.B.H.: The abbreviation means "diameter at breast height," a term frequently used to describe a tree measurement taken 4 1/2 feet above the average ground level. HARDWOODS: Trees that usually have broad leaves and are deciduous (losing leaves every year). MBF: One thousand board feet. A common unit of measure for pricing standing timber as well as lumber. MERCHANTABLE TIMBER: Minimum size timber for which there might be a commercial market. In the South, trees as small as five inches D.B.H. can be used by the industry while in the Northwest trees must be much larger to be usable. For convenience, the Partnership follows the convention that timber older than 13 years in the Southeast and 40 years in the Northwest is of minimum merchantable size. It should be recognized that timber of minimum merchantable size has not yet reached its optimum economic value and the typical harvest cycle is about 25 years in the Southeast and 55 years in the Northwest. NATURAL REGENERATION: The process of a forest regenerating itself with seeds from mature trees or sprouts from stumps or roots. Natural regeneration results in new tree growth without regard to genetic quality of the trees. NATURAL STAND: A forest stand resulting from natural regeneration. NON-FOREST LANDS: Lands consisting of or containing roads, water or easements, such as gas and electric transmission lines, timbered buffers not harvested due to environmental concerns, currently non-commercially viable acreage and certain wastelands. PLANTATION: A timber stand established by planting seedlings in a prepared seedbed. Trees in a plantation are of the same age and size, which tends to simplify harvesting. POLES: Straight, tall trees suitable for manufacturing telephone poles, wharf pilings or the like, typically at least eight inches in diameter at the base and at least 25 feet tall. Trees suitable for use as poles generally command a superior price. PRE-MERCHANTABLE TIMBER: Usually young, or small size timber for which no commercial market exists. For example, in the Southeast, pine trees under five inches D.B.H. and in the Northwest, timber stands less than 40 years of age. PULPWOOD: Wood used to produce pulp in the manufacture of paper and other cellulose products; normally cut from trees that are approximately five to eight inches D.B.H., or trees over eight inches D.B.H. which are either too small, of inferior quality or the wrong species to be used in the manufacture of lumber or plywood. - 10 - SAWTIMBER: Trees containing logs of sufficient size and quality to be suitable for conversion into lumber or plywood. SEEDLINGS: Live trees less than one inch in diameter at ground level. SILVICULTURE: The practice of cultivating forest crops based on the knowledge of forestry; more particularly, controlling the establishment, composition and growth of forests. SITE INDEX: A measure of forest site quality, which takes into account topography, soil fertility, moisture and other factors affecting forest growth rates. A site index indicates the height (in feet) an average dominant tree of a given species will attain on that site in a well-stocked stand in a given period, generally 50 years in the Northwest and 25 years in the Southeast. SOFTWOODS: Coniferous trees, usually evergreen and having needle or scale-like leaves, such as Douglas fir, white pine, spruce and loblolly pine. In the Pacific Northwest, softwood timber is commonly referred to as conifer. STAND: An area of trees possessing sufficient uniformity of age, size and composition to be distinguishable from adjacent areas so as to form a management unit. The term is usually applied to forests of commercial value. STOCKING: An indication of the number of trees in a stand as compared to the desirable number for best growth and management, such as well-stocked, over-stocked or partially stocked. STUMPAGE VALUE: The value of standing timber (timber as it stands uncut in the woods). SUPERIOR SEEDLINGS: Seedlings that are the product of a genetic breeding program. Superior seedlings produce trees that grow faster, are of higher quality and are more disease resistant than their ordinary counterparts. THINNING: Removal of selected trees, usually to eliminate overcrowding, to remove diseased trees and to promote more rapid growth of desired trees. TIMBER DEED: An instrument conveying certain described timber on a specific tract of property and providing a term during which the timber may be cut and removed. TIMBER INVENTORY: As defined under "Description of Timberlands - Timber Inventory." WOOD FIBER: Generally refers to pulpwood or chips used in the manufacture of pulp and paper. ITEM 2. ITEM 2. PROPERTIES See "Item 1. Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is a party to several legal proceedings incidental to its business. Neither the Partnership nor its counsel believes that any liability or costs related to such proceedings will have a material adverse effect on the financial position or results of operations of the Partnership. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the period covered by this report. - 11 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The above table reflects the range of market prices of RTLP Class A Units as reported in the consolidated transaction reporting system of the New York Stock Exchange, the principal market in which this security is traded, under the trading symbol "LOG." During the two-month period ended February 28, 1994, the high and low market prices of RTLP Class A Units were $40.00 and $27.63. Class A Units - Distributions (dollars) --------------------------------------- 1993 1992 QUARTER ENDED ------------- March 31 $1.15 $ .90 June 30 1.15 .90 September 30 1.15 .90 December 31 1.15 .90 On February 8, 1994, the Board of Directors of RFR declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit, payable on March 31, 1994 to all unitholders of record as of February 28, 1994. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Cash Flow." There were approximately 2,850 unitholders of record of Class A Units as of February 28, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected historical financial information set forth below is derived from the financial statements of Rayonier Timberlands, L.P. Such selected historical financial information should be read in conjunction with such financial statements and notes thereto appearing elsewhere herein. - 12 - 1 The consolidated harvest activity is expressed in cunits, a unit of measure for standing timber equal to one hundred cubic feet of solid wood. A cunit is the customary common unit of measure that is used to consolidate regional information based on local commercial measurements such as thousand board feet (MBF) or tons. A cunit equals approximately .43 MBF or 3.83 tons. 2 The Northwestern Timberlands are in the state of Washington and consist of approximately 369,000 acres owned in fee, and contain approximately 2.3 million MBF of wood, approximately 92 percent of which is softwood. Stumpage volumes for 1992, 1991 and 1990 exclude the Quinault timberland sales. 3 The Southeastern Timberlands are in the states of Georgia, Florida and South Carolina and consist of approximately 793,000 acres owned in fee or held under long-term leases, and contain approximately 19.8 million tons of wood, approximately 67 percent of which is pine. - 13 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS In 1993, limited timber availability, particularly in the Northwest United States, fueled a period of strongly rising prices, leading to a record year in timber sales. Excluding the effect of two timberland sales that occurred in 1992, year over year partnership income increased 17 percent. The following table summarizes the sales and operating income of the Partnership, for the periods indicated, by United States geographic region (in thousands of dollars): Timber and timberland sales in 1993 of $116.0 million were $0.4 million lower than 1992 sales of $116.4 million with a current year increase of $16.3 million in timber sales offsetting $16.8 million realized in 1992 from two timberland sales. Partnership income for 1993 of $82.2 million decreased $3.4 million, or 4 percent, compared to 1992, which included $15.6 million from the timberland sales. Sales in 1992 increased 15 percent from 1991 sales of $101.2 million, and Partnership income in 1992 increased 17 percent from 1991 income of $73.0 million. Timber sales for 1993 of $114.9 million represented an increase of $16.3 million or 17 percent versus the prior year's timber sales, following an increase of 8 percent from 1991 to 1992. Higher 1993 sales reflected an overall improvement in prices due to worldwide concern over timber availability and increased harvest activity in the Southeast region, partially offset by reduced harvest volume in the Northwest region. In 1992, timber sales increased $7.4 million from 1991 levels as prices improved due to stronger demand for exportable timber from increased harvest activity in the Northwest region, partially offset by reduced harvest volume in the Southeast region. In both 1993 and 1992, timber sales to Rayonier represented 17 percent of total timber sales as compared to 32 percent in 1991. In addition, timber sales to two customers under common ownership (not affiliated with the Partnership) accounted for approximately 15 percent and 10 percent of total timber sales in 1993 and 1992, respectively. In 1992, the Partnership also had one other unaffiliated customer who accounted for approximately 12 percent of timber sales. See Note 4 of the accompanying Notes to Financial Statements for further information. Timberland sales in 1993 of $1.1 million were $16.7 million lower than 1992 levels which, in turn, were $7.8 million higher than 1991. Sales for 1992 and 1991 include $16.8 million and $8.0 million, respectively, from major timberland tract sales in the Northwest region to the Quinault Indian Nation. The two tracts sold in 1992 completed the Partnership's program to divest land within the Quinault Indian Reservation. The Quinault sales contributed $15.6 million and $7.6 million to Partnership income in 1992 and 1991, respectively. - 14 - Income per publicly traded Class A Unit was $4.45 in 1993, a decrease of 4 cents or 1 percent from 1992's income of $4.49 per Class A Unit. Excluding the effect of last year's Quinault timberland sales, income per publicly traded Class A Unit improved 57 cents. Results in 1992 reflected a per unit increase of 56 cents or 14 percent compared to the 1991's level of $3.93. Income per Class A Unit in 1992 and 1991 include 61 cents and 31 cents respectively from the timberland sales. Operating cash flow allocable to Class A unitholders, after capital expenditures and certain provisions for working capital, was $92.5 million in 1993, a decrease of $0.4 million from the 1992 level of $92.9 million, and, on a per unit basis, a decrease of 6 cents, or 1 percent, to $4.66 from the 1992 level of $4.72 per unit. Excluding the effect of last year's Quinault timberland sales, operating cash flow improved 57 cents. Operating cash flow in 1992 was $10.6 million higher than the 1991 level of $82.3 million and represented an increase of 50 cents per unit from the $4.22 generated in 1991. The amounts for operating cash flow allocable to a Class A Unit include 63 cents and 32 cents in 1992 and 1991, respectively, from the timberland sales. In the Northwest, most of the timber from Partnership lands is resold by the Partnership's customers into log export markets, primarily in Japan, Korea and China. Timber sales in the Northwest of $70.6 million increased $5.6 million from 1992 sales levels, after having increased $9.8 million from 1991 levels. Operating income in 1993 of $56.2 million decreased $12.1 million reflecting lower 1993 Northwest timberland sales. In 1992, operating income increased $16.2 million from 1991's level as a result of higher 1992 timber and timberland sales in the region. Average stumpage prices in the Northwest were 53 percent above 1992 levels as limited timber availability throughout the Northwest, due to environmental restrictions and litigation, caused contract stumpage prices to rise steadily late in 1992 and into the second quarter of 1993. During the second half of 1993 prices declined due to high consumer inventories and a marked increase in alternative global timber supplies. In 1992, average stumpage prices increased 10 percent from 1991 prices as the decline in the availability of competitive timber resulting from an overall reduced level of harvest-eligible timber, as well as environmental and legal restrictions related to the spotted owl, caused stumpage prices to increase throughout the year, particularly in the second half. Total 1993 sales volume in the Northwest of 143 million board feet represented a decrease of 27 percent from the 1992 levels as harvesting of contract timber slowed in response to changing market conditions and the Partnership's continuing program of gradually reducing the amount of timber offered in the region. See "Future Operations." This decrease followed a 5 percent increase from 1991 to 1992, as a result of customers accelerating their harvesting at the end of 1992 to take advantage of higher selling prices for logs. In the Southeast, pulpwood timber harvested from Partnership lands is sold by our customers to mills for the production of pulp and paper with sawlog timber sold to lumber and plywood manufacturers. Timber sales in 1993 in the Southeast of $44.3 million rose $10.7 million from 1992 reflecting both improved pricing and increased harvest volumes which, in turn, caused operating income in the Southeast of $33.5 million to rise $9.9 million from 1992. Timber sales of $33.6 million in 1992 declined $2.4 million from 1991 while operating income decreased $2.9 million from 1991's level of $26.5 million reflecting lower harvest volumes in 1992 partially offset by improved pricing. Southeast pine prices in 1993 were 24 percent greater than 1992 levels, benefiting from the worldwide concern over timber availability and from strong demand for lumber as a result of the resurgence in U.S. housing. In 1992, average pine prices were 6 percent higher than 1991, as log demand from lumber mills and a continuation of wet weather conditions limited the supply of available pulpwood in the region to the Partnership's primary customers. In 1993, Southeast pine volume was 1.7 million tons, increasing 7 percent from 1992. In 1992, pine volume was 13 percent below the 1991 level due to a planned reduction in available harvest volumes to balance 1991's higher than planned harvest. Corporate and other operating income is comprised of general and administrative expenses not specifically attributable to either the Northwest or Southeast region. Corporate expenses decreased $1.0 million during 1993 to $2.3 million reflecting lower commission expenses paid to a foreign sales corporation affiliated with the Partnership's Special General Partner, Rayonier Inc. (Rayonier). In 1992, corporate expenses decreased $1.0 million from 1991's level of $4.3 million reflecting lower commission and software amortization costs in 1992. Overall harvesting activity in 1993 and 1992 followed the historical cutting pattern that is more concentrated in the first half of the year, with 59 percent and 60 percent, respectively, of the total cut completed by June 30. During 1991, harvesting activity was more evenly distributed with 45 percent being cut in the first half. Early in 1991, customers in both the Northwest and Southeast regions delayed harvesting to the second half of the year due to environmental and market concerns. The Partnership is continuing its strategy of gradually reducing the amount of timber offered each year in the Northwest until it reaches a sustainable harvest level. See "Future Operations." However, because customers postponed harvesting under 1993 contracts, Northwest harvest volume in 1994 is expected to be higher than the 1993 level. At - 15 - December 31, 1993 approximately 25 percent of 1994's Northwest harvest plan, including volume remaining on delayed 1993 harvesting, was under contract compared to 49 percent of 1993's harvest that was under contract as of the prior year-end. Three customers under common ownership (not affiliated with the Partnership) accounted for approximately 78 percent of the harvest volume under contract as of December 31, 1993. Average prices on uncut contracts at December 31, 1993 were 52 percent higher than the average of harvest prices realized in 1993. The Southeast 1994 harvest plan anticipates a volume increase of approximately 6 percent versus 1993. In the Southeast, in anticipation of more favorable prices occurring early in 1994, the Partnership had awarded contracts for only 16 percent of the 1994 harvest plan volume as of December 31, 1993 as compared to 18 percent as of December 31, 1992. Two customers (not affiliated with the Partnership) accounted for approximately 12 percent and 10 percent, respectively, of the harvest volume under contract as of December 31, 1993. Average prices on uncut contracts at December 31, 1993 were approximately 2 percent higher than those realized for the 1993 actual harvest in the region. Operating costs and expenses in 1993 were $30.9 million, representing an increase of $1.1 million over 1992, after an increase of $1.0 million from 1991 to 1992. Cost of timber sold rose $2.7 million in 1993, reflecting higher logging costs in the Northwest region resulting from increased contract logging and pre-commercial thinning activities. Cost of timber sold rose $0.2 million from 1991 to 1992, reflecting the introduction of a timber severance tax on harvest volume in Georgia partially offset by lower depletion costs resulting from a decreased Southeast harvest. Cost of timberland sold decreased $1.7 million during 1993 due primarily to the Quinault timberland sales in 1992. Legislation, enacted effective August 10, 1993, eliminated tax benefits related to log exports for foreign sales corporations. Accordingly, commission expense for sales agency services, paid to a foreign sales corporation affiliated with the Partnership's Special General Partner, Rayonier, declined $1.0 million during 1993 to $0.7 million. The Partnership's commission expense had been fully allocated to Rayonier and the General Partners, and therefore the legislation did not impact the earnings or cash flows of the publicly traded Class A Units. See Note 1 of the accompanying Notes to Financial Statements for further information. Commission expense in 1992 was $0.5 million lower than 1991 due to lower timber sales to Rayonier. Interest income, earned mainly from the Primary Account's short-term investment notes of Rayonier, decreased by $0.8 million to $5.1 million in 1993 due to lower interest rates. Interest expense of $9.5 million, primarily on Rayonier's loans and advances to the Secondary Account, was $1.4 million higher than 1992 levels due to higher loan balances. FUTURE OPERATIONS The Partnership's harvesting plans and therefore its earnings and cash flow can be substantially affected by the cyclical nature of timber markets both in general and on a geographical basis. In addition, various legislative initiatives, such as major restrictions on timber clear-cutting, export restrictions on logs sourced from privately owned properties, harvest restrictions to protect threatened or endangered species and limitations on timber harvesting on wetlands, could adversely affect Partnership results. Moreover, in certain economic situations, Partnership results can be adversely affected by reductions in the rate at which stumpage is harvested as well as the failure of buyers to fulfill their contractual obligations. The Partnership's long standing policy has been to reach a sustainable annual harvest level in the Northwest by gradually reducing its harvest volume each year. Although 1994's harvest volume is expected to include 1993's shortfall, the projected annual harvest in this region from 1995 through 2000 remains at approximately 80 percent of the 1992 harvest. In the Southeast, due to intensive forest and land management as well as silvicultural investment, pine volume available for harvest is expected to increase 2 to 3 percent annually. Regional timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which - 16 - would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. LIQUIDITY AND CASH FLOW As of December 31, 1993, the Partnership was due trade and intercompany receivables from Rayonier and affiliates of $4.1 million. In addition, the Primary Account of the Partnership held short-term investment notes of Rayonier of $106.2 million primarily resulting from the cumulative net cash flow, since inception, of the Primary Account after distributions to unitholders. The Partnership can call the short-term investment notes at any time to fund Partnership working capital requirements, capital expenditures, asset acquisitions and reserves. See Note 5 of the accompanying Notes to Financial Statements for further information. The Secondary Account of the Partnership had total outstanding debt of $121.8 million at December 31, 1993 including long-term notes payable to Rayonier of $120.9 million that mainly represent the obligations incurred as a result of Secondary Account advances by Rayonier. See Note 6 of the accompanying Notes to Financial Statements for further information. Capital expenditures for reforestation, capitalized lease payments, property taxes and other improvements to the land and timber assets were $13.4 million in 1993, $14.0 million in 1992 and $13.7 million in 1991. Capital expenditures are expected to be approximately $13.3 million in 1994. Funding of future capital requirements is expected to continue from Rayonier. The Partnership distributed $92.0 million ($4.60 per Class A Unit) in 1993 and $72.0 million ($3.60 per Class A Unit) in both 1992 and 1991 to all outstanding Class A unitholders. An additional $4.8 million in 1993 and $3.8 million in both 1992 and 1991 was distributed in cash to Class B unitholders and to the General Partners. Recontributions of $1.0 million, $1.7 million and $2.3 million were made in 1993, 1992 and 1991, respectively, by Rayonier and the General Partners of RTLP relating to the commission expense paid to a Rayonier affiliated foreign sales corporation. On February 8, 1994, the Board of Directors of Rayonier Forest Resources Company declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit (representing an increase of 15 cents over the previous regular quarterly distribution), payable on March 31, 1994 to unitholders of record February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared following a determination by the Managing General Partner that cash and investment balances would likely exceed funding requirements for the balance of the Initial Term ending December 31, 2000. As of the distribution date, it is expected that approximately $1.00 per Class A Unit will be available for normal capital expenditure, working capital and other funding requirements. The increase in the quarterly distribution resulted from projections of increased operating cash flows. When the Initial Term ends on December 31, 2000, the Primary Account of the Partnership will be closed but there will not be any redemption of the partners' capital accounts. The interest of Class A unitholders in the Partnership's future revenues, expenses and cash flows will then decrease from 95 percent to 4 percent. Positive cash flows will be substantially affected by Secondary Account debt that will have to be repaid. As a result, it is expected that the market price of Class A Units should begin to decrease substantially sometime prior to December 31, 2000. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See "Index to Financial Statements" on Page ii. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - 17 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Neither the Partnership nor the Operating Partnership has any directors or officers. Set forth below is certain information concerning directors and executive officers of RFR. Presently, all directors and officers of RFR are elected annually. DIRECTORS AND EXECUTIVE OFFICERS 1 Member of the Conflicts and Audit Committees of RFR's Board of Directors. 2 Served as a Director of RFR from 1985 to 1991. 3 Served as a Director of RFR from 1987 to 1991. RONALD M. GROSS, 60, is Chairman, President and Chief Executive Officer of Rayonier. He joined Rayonier in March 1978 as President and Chief Operating Officer and a Director. He was elected Chief Executive Officer in 1981 and Chairman in 1984. From 1968 to 1978, he was with Canadian Cellulose Company Limited of Vancouver, British Columbia, where he held various senior positions before becoming President and Chief Executive Officer and Director in 1973. Mr. Gross is currently a director of Lukens Inc. He serves as a member of the Executive Committee of the Board of Directors of the American Forest and Paper Association (AFPA) and is Vice Chairman of the AFPA International Business Committee. He is a member of the Investment Policy Advisory Committee of the United States Trade Representative. WILLIAM J. ALLEY, 64, is Chairman of the Board and Chief Executive Officer of American Brands, Inc., a diversified manufacturing and other businesses company. He joined The Franklin Life Insurance Company in 1967 and was Chairman, President and Chief Executive Officer of that organization when it was acquired by American Brands, Inc. in 1979. He was elected to the Board of Directors of American Brands in 1979 and subsequently held various senior executive positions with American Brands before being elected to his present position on June 15, 1987. He is also a director of Rayonier Inc., CIPSO Incorporated, Bunn-O-Matic Corporation, Moorman Manufacturing Company, The Business Council of Southwestern Connecticut (SACIA), Co-operation Ireland, United Way of Tri-State and the Connecticut Business for Education Coalition, Inc. and on the Advisory Board of Governors of the National Women's Economic Alliance Foundation. He is a member of the Business Roundtable and is also a member of The Conference - 18 - Board, The Board of Overseers of the Executive Council on Foreign Diplomats, The Ambassadors' Roundtable Advisory Council and The Economic Club of New York. GEORGE S. ARESON, 58, was elected Acting Corporate Controller of Rayonier and RFR on October 11, 1993. He joined Rayonier in February 1984 as Pulp Products Controller and became Operations Controller, Pulp and Forest Products in February 1988. Prior to employment at Rayonier, he was the Director of Finance of Continental Corrugated, Inc. Currently he is a member of both the American Institute of Certified Public Accountants and the New York State Society of Certified Public Accountants. Mr. Areson did not file a Form 3 reporting that he owned no Class A Units until March 1994. MACDONALD AUGUSTE, 45, was elected Treasurer of Rayonier effective February 27, 1989 and Treasurer of RFR on March 6, 1989. From 1983 to February 1989, he was Assistant Treasurer of Rayonier, which he joined in April 1975 as Cash and Financial Planning Coordinator. Previously he was employed by St. Regis Paper Company. WILLIAM S. BERRY, 52, was elected Senior Vice President, Forest Resources and Corporate Development, of Rayonier in January 1994. He was Senior Vice President, Land and Forest Resources, of Rayonier from January 1986 to January 1994. From October 1981 to January 1986 he was Vice President and Director of Forest Products Management. Mr. Berry joined Rayonier in 1980 as Director of Wood Products Management. Since May 1988 he has served as a Senior Vice President of RFR after having been Vice President of RFR from September 1985. He also serves on the Executive Boards of the American Forest Council and the Center for Streamside Studies. Prior to joining Rayonier, Mr. Berry was employed with Champion International and Kimberly-Clark Corporation. JOHN B. CANNING, 50, has served as Corporate Secretary and Associate General Counsel of Rayonier since February 1985 and as Corporate Secretary of RFR since September 1985. Mr. Canning joined Rayonier in 1977 as Associate General Counsel - Financial. He is a member of the American Bar Association and of the Corporate Bar Association of Westchester and Fairfield, Inc. DONALD W. GRIFFIN, 57, is President and Chief Operating Officer of the Olin Corporation, a diversified manufacturing corporation. He joined Olin in 1961 and was part of its Brass Division marketing organization beginning in 1963. He advanced through various managerial positions and in 1983 was elected an Olin corporate vice president and appointed president of the Brass Division. He became president of the Winchester Division of Olin in 1985, was appointed president of Olin's Defense Systems Group in 1986 and was elected an executive vice president of Olin in 1987. He became a director of Olin in 1990 and was elected Vice Chairman of the Board for Operations on January 12, 1993. He was elected President and Chief Operating Officer on February 24, 1994. He is also a director of Rayonier Inc., the Sporting Arms and Ammunition Manufacturers Institute, the Wildlife Management Institute, the National Shooting Sports Foundation, River Bend Bancshares, Inc. and Illinois State Bank and Trust in East Alton, Illinois. He is a trustee of the Buffalo Bill Historical Center, the Olin Charitable Trust and the National Security Industrial Association. He is a member of the American Society of Metals, the Association of the U.S. Army and the American Defense Preparedness Association. He is a life member of the Navy League of the United States and the Surface Navy Association. THOMAS W. KEESEE, JR. 79, is a former Director, President and Chief Executive Officer of Bessemer Securities Corporation and Bessemer Trust Company. He is a corporate director and financial consultant. He is a director of King Ranch Inc. and a director emeritus of ITT Corporation (ITT) and of Duke University Asset Management Co. He is former Chairman of the Board of Directors of the National Audubon Society. From 1985 to 1991, Mr. Keesee served on the Board of Directors of RFR. GERALD J. POLLACK, 52, was elected Senior Vice President and Chief Financial Officer of Rayonier in May 1992. From July 1986 until May 1992, he was Vice President and Chief Financial Officer. Mr. Pollack joined Rayonier in June 1982 as Vice President and Controller. He served as Controller of RFR from September 1985 until August 1986, when he became a Vice President as well. He was elected Chief Financial Officer of RFR on March 6, 1989 and a Senior Vice President of RFR on July 27, 1992. Prior to joining Rayonier, Mr. Pollack was employed with Avis, Inc. where he held a number of positions, including Vice President and Corporate Comptroller and finally Vice President-Operations, Europe, Africa and Middle East Divisions in England. DEROY C. THOMAS, 68, is a partner in the law firm of LeBoeuf, Lamb, Greene & MacRae. He is retired President and Chief Operating Officer of ITT. Prior to moving to the parent ITT, Mr. Thomas was Chairman, President and Chief Executive Officer of The Hartford Insurance Group. Before going to The Hartford, Mr. Thomas was assistant general counsel of the Association of Casualty and Surety Companies in New York City and was an associate professor of law at Fordham School of Law. Mr. Thomas serves on the board of directors of ITT Hartford, as well as Connecticut Natural - 19 - Gas Corporation and Houghton Mifflin Company. He also serves as Chairman of the Old State House, Hartford, CT; Chairman of the Connecticut Health System, Inc., Hartford, CT; Director, Goodspeed Opera House; Trustee, Fordham University; Trustee, Wheelock College; Trustee Emeritus, University of Hartford and as a member of the Advisory Board of Iona College. From 1987 to 1991, Mr. Thomas served on the Board of Directors of RFR. - 20 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Neither Rayonier nor RFR receive any compensation as general partners of the Partnership and the Operating Partnership in the form of promotional interests, management fees, acquisition fees, incentive compensation or otherwise. The Partnership and the Operating Partnership reimburse Rayonier and RFR for all direct costs incurred in organizing and managing such partnerships and indirect costs (principally general and administrative and overhead costs) reasonably allocable to such partnerships. The allocations of direct and indirect costs incurred by Rayonier between the Partnership and Rayonier's other activities will be made solely by Rayonier. Neither the Partnership nor the Operating Partnership has any officers or directors. No officers or directors of Rayonier or RFR are compensated by the Partnership or the Operating Partnership. The allocable share of Rayonier's and RFR's general and administrative overhead expenses charged to the Partnership includes a portion of the compensation paid by Rayonier and RFR to their officers and directors. The three directors of RFR who were not employed by ITT or Rayonier received a fee of $1,000 for each RFR Board meeting or Committee meeting attended. These fees were paid by RFR and charged to the Partnership. During 1993, the Partnership was charged for compensation paid to 13 officers and directors of RFR in an amount totaling $186,000. The Partnership was not charged for cash compensation to any officer or director of RFR in excess of $100,000. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All references to beneficial ownership in this Item 12 are as of March 14, 1994. * Mrs. Ronald M. Gross owns 100 Class A Units of the Partnership. Her husband, who is President of Rayonier and RFR, disclaims any beneficial interest in those units. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Item 1. Business" for a description of transactions between the Partnership and Rayonier. There are no other transactions or relationships to be reported in response to this item. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report: 1. See Index to Financial Statements on page ii for a list of the financial statements filed as part of this report. 2. See Index to Financial Statement Schedules on page ii for a list of the financial statement schedules filed as a part of this report. 3. See Exhibit Index on page B for a list of the exhibits filed or incorporated herein as a part of this report. (b) No report on Form 8-K was filed by the registrant during the period covered by this report. - 21 - REPORT OF MANAGEMENT Rayonier Timberlands, L.P. (RTLP), through the management of both Rayonier Inc. (Rayonier) (the Special General Partner) and Rayonier Forest Resources Company (RFR) (the Managing General Partner), is responsible for the preparation and integrity of the information contained in the accompanying financial statements and other sections of the Annual Report. The financial statements are prepared in accordance with generally accepted accounting principles, and, where necessary, include amounts that are based on management's informed judgments and estimates. Other information in the Annual Report is consistent with the financial statements. RTLP's financial statements are audited by Arthur Andersen & Co., independent public accountants. Management has made available to Arthur Andersen & Co. RTLP's financial records and related data and believes that the representations made to the independent public accountants are valid and complete. A system of internal controls is a major element in management's responsibility for the fair presentation of the financial statements. These internal controls, including accounting controls and the internal auditing program, are designed to provide reasonable assurance that the assets are safeguarded, that transactions are executed in accordance with management's authorization and are properly recorded, and that fraudulent financial reporting is prevented or detected. An important part of the internal controls system is the involvement of the General Partners who provide all required services to ensure the adequacy of internal controls. Procedures also exist to assess compliance with the terms of the Partnership Agreement and to identify and resolve any business issues arising between the Partnership and the General Partners. Internal controls provide for the careful selection and training of personnel and for appropriate division of responsibility. The controls are documented in written codes of conduct, policies and procedures that are communicated to employees of Rayonier and RFR. Management continually monitors the system of internal controls for compliance. Internal auditors independently assess the effectiveness of internal controls and make recommendations for improvement. Arthur Andersen & Co. also evaluate internal controls and perform tests of procedures and accounting records to enable them to express their opinion on RTLP's financial statements. They also make recommendations for improving internal controls, policies and practices. Management takes appropriate action in response to each recommendation from the internal auditors and the independent public accountants. The Board of Directors of RFR monitors management's administration of the Partnership's financial and accounting policies and practices and the preparation of financial reports. The Audit Committee of the Board of Directors of RFR, which is comprised of non-employee directors, meets periodically with management and with the internal and external auditors to evaluate the effectiveness of the work performed by them in discharging their respective responsibilities and to assure their independent and free access to the Committee. Rayonier controls RFR, and depends partially on the Partnership timberlands for timber for use in Rayonier's mills and log export business. Conflicts of interest can arise in selecting, pricing and scheduling timber sold to Rayonier. Other conflicts of interest can arise in allocating revenues and costs between the Class A Units and the Class B Units, in scheduling timber sales to occur before or after the Initial Term expires, and in setting the terms of any loans between the Partnership and Rayonier. The Conflicts Committee of the Board of Directors of RFR, which is comprised of non-employee directors, reviews these transactions and obtains opinions from outside consultants as to their fairness. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Rayonier Timberlands, L.P.: We have audited the accompanying balance sheets of Rayonier Timberlands, L.P. (a Delaware limited partnership) as of December 31, 1993 and 1992 and the related statements of income, cash flows and partners' capital for each of the three years in the period ended December 31, 1993. These financial statements and schedules referred to below are the responsibility of Rayonier Timberlands, L.P., through the management of both Rayonier Inc., the Special General Partner, and Rayonier Forest Resources Company, the Managing General Partner of the Partnership. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Rayonier Timberlands, L.P. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the Index to Financial Statement Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Stamford, Connecticut March 1, 1994 RAYONIER TIMBERLANDS, L.P. STATEMENTS OF INCOME FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars, except per unit data) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (thousands of dollars) ASSETS LIABILITIES AND PARTNERS' CAPITAL The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. STATEMENTS OF CASH FLOWS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. STATEMENTS OF PARTNERS' CAPITAL FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND CONTROL Rayonier Timberlands, L.P. (RTLP), a Delaware limited partnership, began operations on November 20, 1985 succeeding to substantially all of the timberlands business of Rayonier Inc. (Rayonier). Rayonier Forest Resources Company (RFR), a wholly owned subsidiary of Rayonier, is the Managing General Partner of RTLP and Rayonier is the Special General Partner of RTLP. RTLP operates through Rayonier Timberlands Operating Company, L.P. (RTOC), a Delaware limited partnership, in which RTLP holds a 99 percent limited partner interest, and RFR and Rayonier together hold a 1 percent general partner interest. RFR is the Managing General Partner of RTOC and Rayonier is the Special General Partner of RTOC. In addition to its General Partners' interests, Rayonier is also a Limited Partner and owns 74.7 percent of RTLP's issued and outstanding Class A Units and 100 percent of RTLP's issued and outstanding Class B Units. RTLP and RTOC have no officers, directors or employees. The officers, directors and employees of Rayonier and RFR perform all management and business activities for RTLP and RTOC. ALLOCATIONS OF PARTNERSHIP INTEREST RTLP records all of its activities in two accounts, the Primary Account and the Secondary Account. The Class A unitholders, the Class B unitholders and the General Partners all participate in both accounts, but in different percentages. The participation in the revenues and expenses of RTLP is as follows: IN ACCORDANCE WITH RTLP'S PARTNERSHIP AGREEMENT THE PRIMARY ACCOUNT WILL BE CLOSED AT THE END OF THE INITIAL TERM ON DECEMBER 31, 2000. SUBSEQUENT TO THAT DATE THE CLASS A UNITHOLDERS WILL ONLY PARTICIPATE IN 4 PERCENT OF THE REVENUES AND EXPENSES OF RTLP, AND CASH FLOW ONLY AFTER ALL SECONDARY ACCOUNT DEBT HAS BEEN REPAID. INVESTING AND FINANCING ACTIVITIES The excess of operating cash flow generated by the Primary Account over amounts distributed to unitholders is invested with Rayonier in accordance with the Partnership Agreement and is repayable on demand. Interest is due quarterly and the stated interest rates are at least equivalent to the rate Rayonier would be charged by an outside party for equivalent short-term borrowings. The Partnership has expenditures that relate primarily to timber that will be harvested after the Initial Term, such as costs of site preparation, planting, reforestation, pre-commercial thinning and similar activities, all of which are allocated to the Secondary Account of the Partnership. Rayonier funds these expenditures on behalf of the Partnership and, in accordance with the Partnership Agreement, RTLP incurs obligations to Rayonier which mature on January l, 2001. Under the terms of the Partnership Agreement, cash credited to the Primary Account may not be loaned or otherwise used for the benefit of the Secondary Account. Accordingly, the Partnership is not permitted to use proceeds from the Primary Account Short-Term Investment Notes of Rayonier to repay the Secondary Account Long-Term Notes Payable to Rayonier. See Notes 5 and 6 for further information. NOTES TO FINANCIAL STATEMENTS (CONTINUED) SPECIAL ALLOCATIONS In 1989, the Partnership Agreements of RTLP and RTOC were amended to provide for the special allocation of certain costs to Rayonier's and RFR's interests as General Partners of both Partnerships and to Rayonier's interest as a Limited Partner of RTLP. These costs reduce Rayonier's and RFR's income from RTLP and RTOC, and the cash flow attributed to their Partnership interests. The special allocations do not impact the interest of publicly traded Class A Units nor their cash distributions. On January 1, 1989, RTOC entered into a sales agency agreement with a Rayonier-affiliated foreign sales corporation. The affiliate, RayFor Foreign Sales Corporation (FSC), acts as a commission agent in selling Rayonier's interest in stumpage that is eventually exported from the United States. As a result, Rayonier gains certain tax benefits that are basically only available to tax-paying corporations. Effective with the first quarter of 1989, a commission expense was paid by RTOC to FSC. The Board of Directors of the Managing General Partner approved amendments to the Partnership Agreements of both RTLP and RTOC that allow for the allocation of FSC commission expense and associated administrative expenses only to Rayonier and RFR, as General Partners of RTOC and RTLP, and to Rayonier as a Limited Partner of RTLP, and do not affect the earnings or cash flow of publicly traded Class A Units. Effective August 10, 1993, legislation was enacted eliminating tax benefits related to log exports for foreign sales corporations. Since the Partnership's commission expense had been fully allocated to Rayonier and the General Partners, the legislation did not impact the earnings or cash flows of publicly traded Class A Units. CONSOLIDATION The financial statements consolidate the accounts of RTLP and RTOC. Intercompany transactions have been eliminated. The Rayonier and RFR 1 percent general partner interest in RTOC is presented as minority interest in these financial statements. Certain reclassifications have been made to prior years' financial statements to conform to current year presentation. REVENUE RECOGNITION Timber sales are generally recognized when legal ownership and the risk of loss passes to the purchaser and the quantity sold is determinable. This generally occurs when the purchaser severs and measures the timber. Revenues have been based on actual harvest volumes multiplied by contractually agreed upon prices awarded in sealed-bid auctions or negotiated at arm's length with the purchasers, including Rayonier. These prices are periodically and independently tested for reasonability to market prices in comparable geographic areas. Bulk timber sales are generally recognized when legal ownership and the risk of loss passes to the purchaser and the amount of profit is determinable. Timberland and land sales are recognized when legal ownership passes, the amount of profit is determinable, and specified levels of down payment are received. DEFERRED SOFTWARE COSTS Software costs related to the development of the initial tax data collection and computation system necessary to prepare the pro forma tax return information for individual unitholders had been capitalized and were amortized over a period of 60 months, ending in March 1992. TIMBER AND TIMBERLANDS The acquisition cost of land, timber, real estate taxes, lease payments, site preparation and other costs relating to the planting and growing of timber are capitalized. Such costs attributed to merchantable timber are charged against revenue at the time the timber is harvested based on the relationship of harvested timber to the estimated volume of currently recoverable timber. Timber and timberlands are stated at the lower of original acquisition cost, net of timber cost depletion or market value. The timber originally contributed by Rayonier is stated at Rayonier's historical cost. NOTES TO FINANCIAL STATEMENTS (CONTINUED) LOGGING ROADS Logging roads, including bridges, are stated at cost, less accumulated amortization. The costs of roads developed for reforestation activities are amortized using the straight-line method over their useful lives estimated at 40 years for roads and 20 years for bridges. Road costs associated with harvestable timber access are charged to a prepaid account and amortized as the related timber is sold, generally within two years. PARTNERS' CAPITAL The partners' capital accounts have been included on a historical cost basis as determined by the cash and net book value of assets originally contributed to RTLP by Rayonier and RFR. These accounts have been adjusted for the allocation of revenues and costs in accordance with the Partnership Agreement, for distributions made to partners and for recontributions made by Rayonier and RFR. Revenues and costs are allocated to Primary and Secondary Accounts based upon their relationship to the harvest plan of the Initial Term (through December 31, 2000) or to the harvest plan subsequently (2001 and thereafter). The partners' capital accounts were adjusted for RTLP distributions, recontributions to RTLP and a 1991 land withdrawal by Rayonier (see Note 3 for further information) as follows (thousands of dollars): The amount recontributed by Rayonier and RFR is equal to the foreign sales commission expense paid by the Partnership during the year, which is fully allocated to Rayonier and the General Partners. (See Special Allocations). In addition to the RTLP distributions, RTOC distributed $978,000 in 1993 and $764,000 in 1992 and 1991 to its General Partners. Recontributions were also made to RTOC by the General Partners for their interest in the commission expense paid. 2. INCOME AND OTHER TAXES RTLP is not a separate taxable entity for Federal or state income tax purposes. Any taxable income or loss is reported by the partners in accordance with the Partnership Agreement. Accrued taxes relating to obligations of RTLP as of December 31 were as follows (thousands of dollars): 3. RELATED PARTY TRANSACTIONS RTLP is a major supplier of timber to Rayonier for use in its log export business, and pulp and lumber manufacturing facilities. Timber sales to Rayonier for the years ended December 31, 1993, 1992 and 1991 totaled $19,929,000, $16,982,000 and $29,012,000, respectively. RTLP's related-party revenues represent the fair market value of timber sold to Rayonier. In 1990, Rayonier designated 3,309 acres of Southeast timberland to be withdrawn from RTLP in accordance with the original Partnership Agreement, which granted Rayonier the right to designate on or before December 31, 1990 up to 15,000 acres to be retained by Rayonier. RTLP recorded the distribution of land to Rayonier at historical cost in 1991 after review by the Conflicts Committee of RFR's Board of Directors. NOTES TO FINANCIAL STATEMENTS (CONTINUED) RTLP engages in various transactions with Rayonier and its affiliates that are characteristic of a consolidated group under common control. Receipts, disbursements and net cash position are currently managed by Rayonier through an RTLP centralized treasury system. Accordingly, cash generated by and cash requirements of RTLP flow through intercompany accounts. Any loans to or borrowings from Rayonier are made at an interest rate equivalent to that which would be charged Rayonier by an unrelated third party for a comparable loan for the same period. The balances in the current RTLP intercompany accounts with Rayonier as of December 31 were as follows (thousands of dollars): Interest income received from Rayonier on the Primary Intercompany Account balance was $147,000 and $193,000 in 1993 and 1992 on an average outstanding receivable of $4,185,000 and $4,381,000, respectively. Interest expense paid to Rayonier on the Secondary Intercompany Account was $334,000 and $371,000 in 1993 and 1992 on an average outstanding payable of $11,740,000 and $9,313,000, respectively. RTLP is charged by Rayonier with direct costs and expenses associated with RTLP's operations. In addition, indirect costs were allocated to RTLP for forest management, overhead and general and administrative expenses related to RTLP's operations. Such allocated costs totaled $6,850,000 in 1993, $6,031,000 in 1992 and $6,156,000 in 1991. 4. MAJOR UNAFFILIATED CUSTOMERS Sales for 1992 and 1991 include $16,800,000 and $8,000,000, respectively, from major timberland tract sales in the Northwest to the Quinault Indian Nation. In addition, 1993 and 1992 sales include timber stumpage sales of $16,900,000 and $10,200,000, respectively, to two customers affiliated with the Quinault Indian Nation. In 1992, the Partnership also had one other unaffiliated customer in the Northwest to whom sales of timber stumpage represented $12,100,000 of total sales. No unaffiliated customer accounted for sales in excess of 10 percent of total revenues in 1991. 5. SHORT-TERM INVESTMENT NOTES OF RAYONIER Cash balances including the excess of operating cash flow generated by the Primary Account over amounts distributed to unitholders are being invested in Rayonier as short-term investment notes. These funds are invested in accordance with the Partnership Agreement and are repayable on demand. Interest is due quarterly and the interest rates are at least equivalent to the rate Rayonier would be charged by an outside party for equivalent short-term borrowings. At both December 31, 1993 and 1992 the RTLP Primary Account included short-term investment notes of Rayonier of $106,200,000. The notes bear fixed interest rates that range from 3.9 to 4.2 percent, as of December 31, 1993, and 3.8 to 5.4 percent, as of December 31, 1992. The fair value of the short-term investment notes of Rayonier approximates its carrying value. The weighted average interest rate, based on the principal amount, was 4.1 percent as of December 31, 1993 and 4.6 percent as of December 31, 1992. Interest income earned by the Primary Account on the investment notes of Rayonier was $4,964,000 in 1993, $5,718,000 in 1992 and $6,062,000 in 1991. 6. LONG-TERM NOTES PAYABLE TO RAYONIER The Partnership has expenditures that relate primarily to timber that will be harvested after the Initial Term, such as costs of site preparation, planting, reforestation, pre-commercial thinning and similar activities, all of which are allocated to the Secondary Account of the Partnership. Rayonier funds these expenditures on behalf of the Partnership and, in accordance with the Partnership Agreement, RTLP incurs obligations to Rayonier which mature on January 1, 2001. Advances made by Rayonier to the Secondary Account in any year bear interest through December 31 of that year at the actual average rate of Rayonier's revolving credit borrowings. On each such December 31, advances made in that year including interest are converted into a note bearing interest through January 1, 2001 at a fixed rate determined as of that December 31 equal to an appropriate spread over the yield on U. S. Government Notes having a maturity date in early 2001. Interest is due quarterly, and all or any part of the unpaid principal may be prepaid at any time without penalty or premium. The long-term notes payable to Rayonier amounted to $120,900,000 and $98,100,000 as of December 31, 1993 and 1992, respectively. Based on the spread over the current rates of U. S. Government Notes having a maturity date in early 2001, the fair value of the long-term notes payable to Rayonier is $135,800,000. NOTES TO FINANCIAL STATEMENTS (CONTINUED) As of December 31, 1993 interest rates on the individual notes range from 6.5 to 10.6 percent, with a weighted average interest rate of 8.7 percent. As of December 31, 1992 the range of interest rates on the individual notes was 7.8 to 10.6 percent, with a weighted average interest rate of 9.2 percent. Interest expense incurred by the Secondary Account on the notes payable to Rayonier was $9,118,000 in 1993, $7,737,000 in 1992 and $6,237,000 in 1991. 7. LONG-TERM TIMBER OBLIGATIONS As of December 31, 1993 and 1992 total timber obligations amounted to $931,000 and $1,254,000, respectively. Interest rates ranged from 6.0 to 8.6 percent, with a weighted average interest rate of 8.4 and 8.3 percent at December 31, 1993 and 1992, respectively. The obligations are payable as follows: 1994 - $138,000; 1995 - $148,000; 1996 - - $159,000; 1997 - $149,000; 1998 - $162,000; and $175,000 during 1999 to 2003. 8. ENVIRONMENTAL MATTERS Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. 9. SUBSEQUENT EVENTS On February 8, 1994, the Board of Directors of Rayonier Forest Resources Company declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit (representing an increase of 15 cents over the previous regular quarterly distribution), payable on March 31, 1994 to unitholders of record on February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared following a determination by the Managing General Partner that cash and investment balances would likely exceed funding requirements for the balance of the Initial Term ending December 31, 2000. As of March 31, 1994, approximately $1.00 per Class A Unit will remain for normal capital expenditure, working capital and other funding requirements. The increase in the quarterly distribution resulted from projections of increased operating cash flows. On February 28, 1994, ITT Corporation (ITT), Rayonier's sole shareholder, distributed all the Common Shares of Rayonier to ITT's shareholders. In connection with the distribution, Rayonier changed its name from ITT Rayonier Incorporated to Rayonier Inc. and became a publicly traded company listed on the New York Stock Exchange under the symbol "RYN." RTLP will continue to be listed separately and trade under the symbol "LOG." Class A unitholder's financial interest will not be affected in any manner by ITT's distribution of Rayonier to its shareholders. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 10. COMPUTATION OF INCOME PER CLASS A UNIT The Partnership Agreement provides for the allocation of Partnership income among the General and Limited Partners. The following tables present the computation of income per Class A Unit for the three years ended December 31, 1993 (thousands of dollars, except per unit data): NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. OPERATING CASH FLOW ALLOCABLE TO CLASS A UNITS Operating cash flow allocable to a Class A Unit is calculated by multiplying 99 percent (Limited Partners' interest in RTLP) of operating cash flow allocated to the Primary and Secondary Accounts by the respective 95 percent and 4 percent Class A Unit interest in those accounts. In determining operating cash flow, Partnership results are adjusted for non-cash costs and expenses without the effects of changes in working capital. The following tables present the calculations of operating cash flow allocable to Class A Units for the three years ended December 31, 1993 (thousands of dollars, except per unit data): QUARTERLY RESULTS FOR 1993 AND 1992 (Unaudited) (thousands of dollars, except per unit data): RAYONIER TIMBERLANDS, L.P. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT (thousands of dollars) NOTES (a) Represents timber depletion charged to income and applied directly against the asset accounts. S-1 RAYONIER TIMBERLANDS, L.P. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (thousands of dollars) S-2 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: RAYONIER FOREST RESOURCES COMPANY Managing General Partner By: GEORGE S. ARESON --------------------------------- George S. Areson March 30, 1994 Acting Corporate Controller 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. RAYONIER FOREST RESOURCES COMPANY -A- EXHIBIT INDEX - B - EXHIBIT INDEX (CONTINUED) * Registrant's only subsidiary is Rayonier Timberlands Operating Company, L.P., a Delaware limited partnership in which Registrant holds a 99% limited partner's interest. See Item 1 - "Business - Description of Business." - C -	16,170	104,399
54381_1993.txt	54381_1993	1993	54381	Item 1. Business - ----------------- Kaman Corporation, incorporated in 1945, and its subsidiaries (collectively, the "Corporation") serve government, industrial and commercial markets through two industry segments: Diversified Technologies and Distribution. The Diversified Technologies group provides design and manufacture of advanced technology products and systems, advanced technology services and aircraft manufacturing. The Distribution segment distributes industrial products, distributes and manufactures music products and provides support services to its customers and provides aviation services. Diversified Technologies - ------------------------ The Diversified Technologies segment consists of several wholly-owned subsidiaries, including Kaman Diversified Technologies Corporation, Kaman Aerospace Corporation, Kaman Sciences Corporation, Raymond Engineering Inc., Kamatics Corporation, Kaman Electromagnetics Corporation, and Kaman Instrumentation Corporation, as well as a 50% interest in two additional subsidiaries, Advanced Energetic Materials Corporation of America and Advanced Energetic Materials Corporation of Europe. The Diversified Technologies segment develops and manufactures various advanced technology products and systems which are used in markets that the Corporation serves. Among the products manufactured are ruggedized tape and disk memory systems used primarily in aircraft and missile systems, safing and fuzing systems for use in missiles, a severe environment flash memory system, self lubricating bearings used on aircraft and in other systems, flexible couplings for helicopters, specialty wrenches and equipment for precision bolting requirements, precision measuring instruments, composite flyer bows, RF transmission and delay lines, telecommunication products, and photonic and optical systems. The Corporation also develops and produces various motors, generators, alternators, launchers and electric drive systems using electromagnetic technology, and a high speed multi-channel data recording system used extensively by a Government agency for acquisition of very large amounts of data during testing operations. In addition, the Corporation has contracts with the U.S. government for a number of advanced technology programs relating to some of the systems described above and to other proprietary systems developed by the Corporation. The Diversified Technologies segment also provides advanced technology services to a number of customers, including all branches of the armed forces, various Government agencies, the Department of Energy, Department of Transportation, various defense contractors, utilities and industrial organizations. The services offered include software engineering and maintenance, operation of Government information analysis centers, field and laboratory testing services, communication system design and analysis, signal intelligence, electromagnetic interference and compatibility evaluations, analysis and simulation of electronic signals, various types of artificial intelligence systems and weapon system evaluation. A third category of this segment's business is aircraft manufacturing, including the development and manufacture of helicopters and the integration of systems related to helicopters. The Corporation is the prime contractor for the SH-2 series helicopter, a multi-mission aircraft serving the U.S. Navy around the world, however reductions in defense spending and realignment of defense priorities have resulted in a de-emphasis on the Navy's requirements for this helicopter. The Corporation's present contract with the Navy is for retrofitting of certain model SH-2F helicopters to the SH-2G configuration and this contract is scheduled to be completed in 1994. The Corporation is proceeding with production of its new commercial helicopter, known as the K-MAX "aerial truck" incorporating intermeshing rotor technology developed by the Corporation and previously embodied in a test demonstrator produced by the Corporation identified as a multi-mission intermeshing rotor aircraft (MMIRA). The K-MAX is designed to provide superior lift and operational capabilities. A substantial portion of the Corporation's research and development activities have been devoted to this product and commercial certification by the Federal Aviation Administration (FAA) is expected by mid-1994. The production phase for the first five helicopters has begun and units are expected to be delivered to initial customers shortly after certification is received. The Corporation will lease the first group under a special program in order to maintain active involvement in the product's introduction to the marketplace. Kaman manufactures subcontract aircraft products for government and commercial customers on programs such as the McDonnell Douglas C-17 and the Boeing 767 and 777, manufactures composite rotor blades for helicopters, and manufactures airborne systems for use in detecting and imaging. Such systems include imaging LIDAR systems and the Corporation's proprietary Magic Lantern (registered trademark) system which allows underwater objects to be detected from an airborne platform. Distribution - ------------ The Distribution segment consists of several wholly-owned subsidiaries including the following: Kaman Industrial Technologies Corporation, Kaman Music Corporation, and AirKaman of Jacksonville, Inc. This segment distributes industrial products, manufactures and distributes music products, and provides aviation services. Kaman Industrial Technologies Corporation is a national distributor of industrial products operating through more than 150 service centers located in 28 states and British Columbia, Canada. The Corporation supplies a broad range of industries with original equipment, repair and replacement products needed to maintain traditional manufacturing processes and, increasingly, with products of higher technological content that are required to support automated production processes. The Corporation serves nearly every sector of heavy and light industry, including automobile manufacturing, agriculture, food processing, pulp and paper manufacturing, mining, chemicals, electronics and general manufacturing. Products available include various types of standard and precision mounted and unmounted bearings; mechanical power transmission equipment such as V-belts, couplings, and gear reducers; electrical power transmission products, motors, AC/DC controls, sensors and motion control devices; materials handling equipment, belts, conveyor idlers and pulleys; hydraulic drive systems and parts; and accessory products such as lubricants and seals. Although the vast majority of the company's business consists of resale of products, operations include some design, fabrication, and assembly work in connection with products sold. The Corporation continues to develop certain support service capabilities in order to meet the maintenance needs of its customers' manufacturing operations. These services include electrical panel and systems fabrication centers capabilities and similar capabilities for hydraulic and pneumatic control panels and material handling systems. In 1993 the Corporation, on a limited basis, continued to act as a supplier of capital equipment to various systems engineering and manufacturing customers by acting as a sales agent for certain equipment manufacturers. As the Corporation has entered new market areas, it has invested in new product inventory and in some instances it has established inventory on consignment in customer locations. The Corporation maintains a management information system, consisting of an on-line computer network linking all of its mainland U.S. and Canadian industrial distribution facilities, which enhances its ability to provide more efficient nationwide service and to improve inventory management. Kaman Music Corporation distributes more than 13,000 different music instruments and accessories to independent retailers in the United States and Great Britain and to international distributors throughout the world. Products include acoustic, acoustic-electric and electric guitars and basses, music strings for all fretted instruments, drums, percussion products and related accessories, instrument and P.A. amplification systems, electronic tuners and metronomes, educational percussion and brass instruments and a full range of accessories for all musical instruments. The Corporation manufactures and distributes certain guitars under the Corporation's various brand names including Ovation and Hamer guitars, fretted musical instrument strings of various brands, and the Trace Elliot range of stringed instrument amplification equipment. Operations are conducted through three (3) manufacturing facilities and six (6) distribution centers, an international sales division based in the United States and a manufacturing and distribution facility in Great Britain. The segment also distributes aviation fuel and provides aviation services at Jacksonville International Airport, Jacksonville, Florida where the Corporation conducts fixed base operations for general and commercial aviation under a contract with the Port Authority of the City of Jacksonville which extends through the year 2008. FINANCIAL INFORMATION - --------------------- Information concerning each segment's performance for the last three fiscal years appears in the Corporation's 1993 Annual Report to Shareholders and is included in Exhibit 13 to this Form 10-K, and is incorporated by reference. Principal Products and Services - ------------------------------- Following is information for the three preceding fiscal years concerning the percentage contribution of the Corporation's classes of products and services to the Corporation's consolidated net sales: Research and Development Expenditures - ------------------------------------- Government sponsored research expenditures by the Diversified Technologies segment were $142.3 million in 1993, $124.5 million in 1992, and $127.0 million in 1991. Independent research and development expenditures were $18.4 million in 1993, $17.8 million in 1992, and $14.0 million in 1991. Backlog - ------- Program backlog of the Diversified Technologies segment was approximately $240.8 million at December 31, 1993, $361.4 million at December 31, 1992, and $408.8 million at December 31, 1991. The Corporation anticipates that approximately 84.6% of its backlog at the end of 1993 will be performed in 1994. Approximately 71.6% of the backlog at the end of 1993 is related to government contracts or subcontracts which are included in backlog to the extent that funding has been appropriated by Congress and allocated to the particular contract by the relevant procurement agency. Certain of these government contracts, less than 1% of the backlog, have been funded but not signed. Government Contracts - -------------------- During 1993, approximately 53% of the work performed by the Corporation directly or indirectly for the United States government was performed on a fixed-price basis and the balance was performed on a cost-reimbursement basis. Under a fixed-price contract, the price paid to the contractor is negotiated at the outset of the contract and is not generally subject to adjustment to reflect the actual costs incurred by the contractor in the performance of the contract. Cost reimbursement contracts provide for the reimbursement of allowable costs and an additional negotiated fee. The Corporation's United States government contracts and subcontracts contain the usual required provisions permitting termination at any time for the convenience of the government with payment for work completed and associated profit at the time of termination. Competition - ----------- The Diversified Technologies segment operates in a highly competitive environment with many other organizations which are substantially larger and have greater financial and other resources. For sales of advanced technology products and systems, the Corporation competes with a wide range of manufacturers primarily on the basis of price and the quality, endurance, reliability and special performance characteristics of those products. Operations also depend in part on the ability to develop new technologies which have effective commercial and military applications. Examples of proprietary or patented products developed by the Corporation include the Magic Lantern (Registered Trademark) system for detecting underwater objects from a helicopter, the Kamatics line of specialty bearings and the Corporation's line of electromagnetic motors and drives, among others. In providing scientific services and systems development, the Corporation competes primarily on the basis of the technical capabilities and experience of its personnel in specific fields. When bidding for aerospace contracts and subcontracts, the Corporation competes on the basis of price and quality of its products and services as well as the availability of its facilities, equipment and personnel to perform the contract. Defense market conditions have been significantly affected by an ongoing slowdown in defense spending; continued decreases in federal government expenditures are anticipated in future periods as well. The change in defense program emphasis and greater constraints in the federal budget have increased the level of competition for such programs. The Corporation's contract to retrofit certain of its SH-2 series helicopters to the SH-2G configuration for the U.S. Navy is scheduled to be completed in 1994 as a result of such reductions in military spending and the change in defense budget priorities. As the U.S. Navy reduces the size of its fleet, the number of SH-2 series helicopters remaining in active service will also be reduced with a corresponding reduction in the level of logistics and spare parts provided by the Corporation for the SH-2G. In providing spare parts, the Corporation competes with other helicopter manufacturers on the basis of price, performance and product capabilities and also on the basis of its experience as a manufacturer of helicopters. The Corporation's K-MAX helicopters will compete with other helicopters suitable for lifting and with alternative methods of meeting lifting requirements. Distribution operations are subject to a high degree of competition from several other national distributors and many regional and local firms both in the U.S. and elsewhere in the world. Certain musical instrument products of the Corporation are subject to competition from U.S. and foreign manufacturers also. The Corporation competes in these markets on the basis of service, price, performance, and inventory variety and availability. The Corporation also competes on the basis of quality and market recognition of its music products and has established certain trademarks and trade names under which certain of its music products are produced both in the United States and under private label manufacturing in foreign countries. Employees - --------- As of December 31, 1993, the Corporation employed 5,363 individuals throughout its industry segments as follows: Patents and Trademarks - ---------------------- The Corporation holds patents reflecting scientific and technical accomplishments in a wide range of areas covering both basic production of certain products, including aerospace products and musical instruments, as well as highly specialized devices and advanced technology products in such areas as nuclear sciences, strategic defense and other commercial, scientific and defense related fields. Although the Corporation's patents enhance its competitive position, management believes that none of such patents or patent applications is singularly or as a group essential to its business as a whole. The Corporation holds or has applied for U.S. and foreign patents with expiration dates that range through the year 2010. These patents are allocated among the Corporation's industry segments as follows: Trademarks of Kaman Corporation include Adamas, Applause, Hamer, KAflex, KAron, K-Max, K-ramic, Magic Lantern, and Ovation. In all, the Corporation maintains 186 U.S. and foreign trademarks with 57 applications pending, most of which relate to music products in the Distribution segment. Compliance with Environmental Protection Laws - --------------------------------------------- In the opinion of management, based on the Corporation's knowledge and analysis of relevant facts and circumstances, there will be no material adverse effect upon the capital expenditures, earnings or competitive position of the Corporation or any of its subsidiaries occasioned by compliance with any environmental protection laws. The Corporation is subject to the usual reviews and inspections by environmental agencies of the various states in which the Corporation has facilities, and the Corporation has entered into agreements and consent decrees at various times in connection with such reviews. On occasion the Corporation also has been identified as a potentially responsible party ("PRP") by the U.S. Environmental Protection Agency in connection with its investigation of certain waste disposal sites. In each such instance to date, the Corporation's involvement, if any, has been either of a de minimis nature or the Corporation has been able to determine, based on its current knowledge, that resolution of such matters is not likely to have a material adverse effect on the future financial condition of the Corporation. In arriving at this conclusion, the Corporation has taken into consideration site-specific information available regarding total costs of any work to be performed, and the extent of work previously performed. Where the Corporation has been identified as a PRP at a particular site, the Corporation, using information available to it, also has reviewed and considered (i) the financial resources of other PRP's involved in each site, and their proportionate share of the total volume of waste at the site; (ii) the existence of insurance, if any, and the financial viability of the insurers; and (iii) the success others have had in receiving reimbursement for similar costs under similar policies issued during the periods applicable to each site. Foreign Sales - ------------- Substantially all (94%) of the sales of the Corporation are made to customers located in the United States. In 1993, the Corporation continued its efforts to develop international markets for its products and foreign sales (including sales for export). Item 2. Item 2. Properties - ------------------- The Corporation occupies approximately 4.3 million square feet of space throughout the United States, Canada, and Great Britain, distributed as follows: Diversified Technologies principal facilities are located in Arizona, Colorado, Connecticut, Florida, Massachusetts, Pennsylvania and Virginia; other facilities including offices and smaller manufacturing and assembly operations are located in several other states. These facilities are used for manufacturing, scientific research and development, engineering and office purposes. The U.S. Government owns 154 thousand square feet of the space occupied by Kaman Aerospace Corporation in Bloomfield, Connecticut in accordance with a facility contract. In 1993 the Corporation constructed a 14,000 square foot hangar building in Bloomfield, Connecticut, on land owned by the Corporation for use in connection with the development and manufacture of the Corporation's new K-Max helicopter, and purchased a 75 thousand square foot office building which it had occupied in Colorado Springs, Colorado, for continued use by its subsidiary, Kaman Sciences Corporation. The Distribution segment occupies approximately two million square feet of space throughout the United States with principal facilities located in California, Colorado, Connecticut, New York and Utah; approximately 100 thousand square feet of space in British Columbia, Canada; and approximately 30 thousand square feet of space in Essex, England. These facilities consist principally of regional distribution centers, service centers and office space with a portion used for fabrication and assembly work. Also included are facilities used for manufacturing musical instruments and facilities leased in Florida for aviation services operations. In 1993 the Corporation constructed a 15 thousand square foot warehouse addition and a 28 thousand square foot office building in Bloomfield, Connecticut, as a corporate headquarters for its subsidiary, Kaman Music Corporation. Kaman Corporation occupies a 40 thousand square foot Corporate headquarters building in Bloomfield, Connecticut. The Corporation's facilities are suitable and adequate to serve its purposes. While substantially all of such properties are currently fully utilized, the Corporation expects some consolidation of its properties in the Diversified Technologies segment during the next few years. Many of the properties, especially within the Distribution segment, are leased and certain of the Corporation's properties are subject to mortgages. Item 3. Item 3. Legal Proceedings - -------------------------- There are no material pending legal proceedings to which the Corporation or any of its subsidiaries is a party or to which any of their property is subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters - ---------------------------------------------------------- CAPITAL STOCK AND PAID-IN CAPITAL Information required by this item appears in the Corporation's 1993 Annual Report to Shareholders and is included in Exhibit 13 to this Form 10-K, and is incorporated herein by reference. DIVIDEND REINVESTMENT PLAN Registered shareholders of Kaman Class A common stock are eligible to participate in the Automatic Dividend Reinvestment Program. A booklet describing the plan may be obtained by writing to the Corporation's transfer agent, Chemical Bank, Securityholder Relations, J.A.F. Building, P. O. Box 3068, New York, NY 10116-3068. Kaman's Depositary shares (each representing a one-quarter interest in a share of its Preferred Stock), issued in October 1993, traded in a range between 48 and 51 1/2, closing the year at 51 1/2. NASDAQ market quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. ANNUAL MEETING The Annual Meeting of Shareholders will be held on Monday, April 18, 1994 at 11:00 a.m. in the offices of the Corporation, 1332 Blue Hills Avenue, Bloomfield, Connecticut 06002. Item 6. Item 6. Selected Financial Data - -------------------------------- Information required by this item appears in the Corporation's 1993 Annual Report to Shareholders and is included in Exhibit 13 to this Form 10-K, and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ---------------------------------------------------------- Information required by this item appears in the Corporation's 1993 Annual Report to Shareholders and is included in Exhibit 13 to this Form 10-K, and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- Information required by this item appears in the Corporation's 1993 Annual Report to Shareholders and is included in Exhibit 13 to this Form 10-K, and is incorporated herein by reference. Item 9. Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure - --------------------------------------------------------- There has been no change in the Corporation's independent accountants within 24 months prior to, or in any period subsequent to, the date of the Corporation's most recent financial statements. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------ Following is information concerning each Director and Executive Officer of Kaman Corporation including name, age, position with the Corporation, and business experience during the last five years: T. Jack Cahill Mr. Cahill, 45, has held various positions with Kaman Industrial Technologies Corporation, a subsidiary of the Corporation, since 1975. He was appointed President of Kaman Industrial Technologies in 1993. Frank C. Carlucci Mr. Carlucci, 63, has been a Director since 1989. He is Chairman of The Carlyle Group, merchant bankers, having formerly served as Vice Chairman since 1989. Prior to that he served as U.S. Secretary of Defense. Mr. Carlucci is also a Director of Westinghouse Electric Corporation, Ashland Oil, Inc., Bell Atlantic Corporation, General Dynamics Corporation, Neurogen Corporation, Northern Telecom Limited, Quaker Oats Company, The Upjohn Company and Sun Resorts, Inc. William P. Desautelle Mr. Desautelle, 54, has been Senior Vice President and Treasurer since 1990 and was also designated Chief Investment Officer in April 1992. Prior to that he had served as Vice President and Treasurer. John A. DiBiaggio Dr. DiBiaggio, 61, has been a Director since 1984. He is President and Chief Executive Officer of Tufts University. Prior to that he was President and Chief Executive Officer of Michigan State University. Edythe J. Gaines Dr. Gaines, 71, has been a Director since 1982. She is a retired Commissioner of the Public Utility Control Authority of the State of Connecticut. Robert M. Garneau Mr. Garneau, 49, has been Senior Vice President and Controller since 1990 and was also designated Chief Financial Officer in April, 1992. Prior to that he had served as Vice President and Controller. Huntington Hardisty Admiral Hardisty (USN-Ret.), 64, has been a Director since 1991. He retired from the U.S. Navy in 1991 having served as Commander-in-Chief for the U.S. Navy Pacific Command since 1988. Charles H. Kaman Mr. Kaman, 74, has been Chief Executive Officer and Chairman of the Board of Directors since 1945. He was also President from 1945 to 1990. C. William Kaman II Mr. Kaman, 42, has been a Director since 1992. He has held various positions with Kaman Music Corporation, a subsidiary of the Corporation, since 1974, serving as President of Kaman Music since 1986. Mr. Kaman is the son of Charles H. Kaman, Chairman and Chief Executive Officer of the Corporation. Walter R. Kozlow Mr. Kozlow, 58, has held various positions with Kaman Aerospace Corporation, a subsidiary of the Corporation, since 1960. He has been President of Kaman Aerospace since 1986. Hartzel Z. Lebed Mr. Lebed, 66, has been a Director since 1982. He is the retired President of CIGNA Corporation. Harvey S. Levenson Mr. Levenson, 53, has been a Director since 1989. He has been President and Chief Operating Officer since April, 1990. Prior to that he had served as Senior Vice President and Chief Financial Officer. He is also a director of Connecticut Natural Gas Corporation and Security-Connecticut Corporation. Walter H. Monteith, Jr. Mr. Monteith, 63, has been a Director since 1987. He is Chairman of Southern New England Telecommunications Corporation. Mr. Monteith is also a director of Shawmut Bank. John S. Murtha Mr. Murtha, 80, has been a Director since 1948. He is counsel to and a former senior partner of the law firm of Murtha, Cullina, Richter and Pinney. Robert L. Newell Mr. Newell, 71, has been a Director since 1976. He is the retired Chairman of Hartford National Corporation. Patrick L. Renehan Mr. Renehan, 60, has been a Vice President of Kaman Diversified Technologies Corporation, a subsidiary of the Corporation, since 1987. Prior to that he served as a Vice President of Kaman Aerospace Corporation. Wanda L. Rogers Mrs. Rogers, 61, has been a Director since 1991. She is Chief Executive Officer of Rogers Helicopters, Inc. She is also Chairman of the Board of Clovis Community Bank. Richard E.W. Smith Mr. Smith, 59, was appointed a Vice President of the Corporation in 1989. He has been President of Kaman Diversified Technologies Corporation, a subsidiary of the Corporation, since 1990 and prior to that he served as Vice President of Kaman Sciences Corporation, a subsidiary of the Corporation. Each Director and Executive Officer has been elected for a term of one year and until his or her successor is elected. The terms of all such Directors and Executive Officers are expected to expire as of the Annual Meeting of the Shareholders and Directors of the Corporation to be held on April 18, 1994. Item 11. Item 11. Executive Compensation - -------------------------------- A) General. The following tables provide certain information relating to the compensation of the Corporation's Chief Executive Officer, its four other most highly compensated executive officers and its directors. B) Summary Compensation Table. Information for years ending prior to December 15, 1992 is not required to be disclosed. 1. As of December 31, 1993, aggregate restricted stock holdings and their year end value were: C.H. Kaman, none; H.S. Levenson, 32,200 shares valued at $326,025; W.R. Kozlow, 9,000 shares valued at $91,125; R.E.W. Smith, 8,900 shares valued at $90,113; P.L. Renehan, 7,900 shares valued at $79,988. Restrictions lapse at the rate of 50% per year on Mr. Kaman's awards and 20% per year for all other awards, beginning one year after the grant date. Awards reported in this column are as follows: C. H. Kaman, 10,000 shares in 1991; H.S. Levenson, 4,000 shares in 1993 and 5,000 shares each in 1992 and 1991; W.R. Kozlow, 3,000 shares each in 1993, 1992 and 1991; R. E. W. Smith, 3,000 shares each in 1993, 1992, and 1991; P. L. Renehan, 3,000 shares in 1993, and 2,500 shares each in 1992 and 1991. Dividends are paid on the restricted stock. 2. Amounts reported in this column consist of: C. H. Kaman, $53,000 - Officer 162 Insurance Program, $16,768 - medical expense reimbursement program ("MERP"); H.S. Levenson, $2,729 - Senior executive life insurance program ("Executive Life"), $4,524 - Officer 162 Insurance Program, $2,249 - employer matching contributions to the Kaman Corporation Thrift and Retirement Plan (the "Thrift Plan employer match"), $4,101 - supplemental employer contributions under the Deferred Compensation Plan ("supplemental matching contributions"), $5,000 - MERP; W. R. Kozlow, $3,767 - Executive Life, $2,249 - Thrift Plan employer match, $1,077 - supplemental matching contributions, $3,353 - MERP; R. E. W. Smith, $4,148 - Executive Life, $2,068 - Thrift Plan employer match, $1,182 - supplemental matching contributions, $1,814 - MERP; P. L. Renehan, $4,606 - Executive Life, $2,249 - Thrift Plan employer match, $814 - supplemental matching contributions, $1,130 - MERP. 3. Amounts reported in this column include $62,164 for tax and estate planning services provided to Mr. Kaman by third parties, for which the Corporation provides reimbursement under a program for the benefit of executive officers. C) Option/SAR Grants in the last fiscal year: D) Aggregated Option/SAR Exercises in the Last Fiscal Year, and Fiscal Year-End Option/SAR Values. E) Long Term Incentive Plan Awards: No long term incentive plan awards were made to any named executive officer in the last fiscal year. F) Pension and Other Defined Benefit Disclosure. The following table shows estimated annual benefits payable at normal retirement age to participants in the Corporation's Pension Plan at various compensation and years of service levels using the benefit formula applicable to Kaman Corporation. Pension benefits are calculated based on 60 percent of the average of the highest five consecutive years of "covered compensation" out of the final ten years of employment less 50 percent of the primary social security benefit, reduced proportionately for years of service less than 30 years: Remuneration: Average of the highest five consecutive years of "Covered Compensation" out of the final ten years of service. "Covered Compensation" means "W-2 earnings" or "base earnings", if greater, as defined in the Pension Plan. W-2 earnings for pension purposes consist of salary (including 401(k) and Section 125 Plan contributions but not deferrals under a non- qualified Deferred Compensation Plan), bonus and taxable income attributable to restricted stock awards. Salary and bonus amounts for the named Executive Officers for 1993 are as shown on the Summary Compensation Table. Compensation deferred under the Corporation's non-qualified deferred compensation plan is included in Covered Compensation here because it is covered by the Corporation's unfunded supplemental employees' retirement plan for the participants in that plan. Current Compensation covered by the Pension Plan for any named executive whose Covered Compensation differs by more than 10% from the compensation disclosed for that executive in the Summary Compensation Table: Mr. Kaman, $927,075; Mr. Levenson, $679,669. Federal law imposes certain limitations on annual pension benefits under the Pension Plan. For the named executive officers, the excess will be paid under the Corporation's unfunded supplemental retirement plan. The Executive Officers named in Item 11(b) are participants in the plan and as of January 1, 1994, had the number of years of credited service indicated: Mr. Kaman - 48 years; Mr. Levenson - 11 years; Mr. Kozlow - 34 years; Mr. Renehan - 10 years; and Mr. Smith - 34 years. Benefits are computed generally in accordance with the benefit formula described above. G) Compensation of Directors. Non-officer members of the Board of Directors of the Corporation receive an annual retainer of $14,000 and a fee of $750 for attending each meeting of the Board and each meeting of a Committee of the Board, except that the Chairman of the Audit Committee receives $850 for attending each meeting of that Committee. These fees may be received on a deferred basis. H) Employment Contracts and Termination, Severance and Change of Control Arrangements. The Corporation has no employment contract, plan or arrangement with respect to any named executive which relates to employment termination for any reason, including resignation, retirement or otherwise (except as described in connection with the Corporation's Pension Plan and the Corporation's non-qualified Deferred Compensation Plan), or a change in control of the Corporation or a change in any such executive officer's responsibilities following a change of control, which exceeds or could exceed $100,000. I) Not Applicable. J) Compensation Committee Interlocks and Insider Participation in Compensation Decisions. 1) The following persons served as members of the Personnel and Compensation Committee of the Corporation's Board of Directors during the last fiscal year: Dr. Gaines, Mr. Carlucci, Mr. Murtha, Mr. Newell and Mr. Monteith. None of these individuals was an officer or employee of the Corporation or any of its subsidiaries during the last fiscal year. Mr. Murtha was Secretary of the Corporation in years prior to April 1989 and his relationship with the Corporation is further disclosed in Item 13 of this report. 2) During the last fiscal year no executive officer of the Corporation served as a director of or as a member of the compensation committee (or other board committee performing equivalent functions) of another entity, one of whose executive officers served as a director of, or on the Personnel and Compensation Committee of the Corporation. K) Not Applicable. L) Not Applicable. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------- (a) Security Ownership of Certain Beneficial Owners. Following is information about persons known to the Corporation to be beneficial owners of more than five percent (5%) of the Corporation's voting securities. Ownership is direct unless otherwise noted. (1) Excludes 1,471 shares held by Mrs. Kaman. Excludes 199,802 shares reported separately above and held by Newgate Associates Limited Partnership, a limited partnership in which Mr. Kaman serves as general partner. (2) Includes 15,192 shares held by Mr. Moses as Trustee, and 33,537 shares held by Paulson and Company as follows: 11,481 shares for the benefit of Mr. Moses, and 22,056 shares held for a partnership controlled by Mr. Moses. (b) Security Ownership of Management. The following is information concerning beneficial ownership of the Corporation's stock by each Director of the Corporation, each Executive Officer of the Corporation named in the Summary Compensation Table, and all Directors and Executive Officers of the Corporation as a group. Ownership is direct unless otherwise noted. (1) Held jointly with Mrs. Carlucci. (2) Excludes the following: 24,132 shares held by Mrs. Kaman; 6,685 shares held by Fidelco Guide Dog Foundation, Inc., a charitable foundation of which Mr. Kaman is President and Director, in which shares Mr. Kaman disclaims beneficial ownership; and 184,434 shares held by Newgate Associates Limited Partnership, a limited partnership of which Mr. Kaman is the general partner. Included are 45,000 shares subject to exercisable portion of stock options. (3) Excludes the following: 1,471 shares held by Mrs. Kaman and 199,802 shares held by Newgate Associates Limited Partnership, a limited partnership of which Mr. Kaman is the general partner. (4) Includes 10,400 shares subject to exercisable portion of stock options; and excludes 69,290 shares held by Mr. Kaman as Trustee, in which shares Mr. Kaman disclaims any beneficial ownership. (5) Includes 4,800 shares held by Mr. Kaman as Trustee in which shares Mr. Kaman disclaims any beneficial ownership. (6) Includes 15,400 shares subject to exercisable portion of stock options. (7) Includes 7,121 shares held jointly with Mrs. Lebed, excludes 480 shares held by Mrs. Lebed. (8) Includes 24,800 shares subject to exercisable portion of stock options. (9) Excludes 500 shares held by Mrs. Levenson. (10)Held by Fleet National Bank pursuant to a revocable trust. Excludes 7,980 shares held by Fleet National Bank pursuant to a revocable trust for the benefit of Mrs. Murtha. (11)Includes 10,700 shares subject to exercisable portion of stock options; and includes 1,275 shares held jointly with Mrs. Renehan. (12)Includes 7,500 shares subject to exercisable portion of stock options; and includes 7,478 shares held jointly with Mrs. Smith. (13)Includes 126,776 shares subject to exercisable portion of stock options. * Less than one percent. ** Excludes 24,612 Class A shares and 1,971 Class B shares held by wives of certain Directors and Executive Officers. Item 13. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- During 1993, the Corporation obtained legal services from the Hartford, Connecticut law firm of Murtha, Cullina, Richter and Pinney of which Mr. Murtha, a Director of the Corporation, is counsel. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - ----------------------------------------------------------------- (a)(1) Financial Statements. See Item 8 concerning financial statements appearing as Exhibit 13 to this Report. (a)(2) Financial Statement Schedules. An index to the financial statement schedules immediately precedes such schedules. (a)(3) Exhibits. An index to the exhibits filed or incorporated by reference immediately precedes such exhibits. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993, which year is covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 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, in the Town of Bloomfield, State of Connecticut, on this 11th day of March, 1994. KAMAN CORPORATION (Registrant) By /s/ Charles H. Kaman ----------------------- Charles H. Kaman, Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. KAMAN CORPORATION AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (Dollars in Thousands) KAMAN CORPORATION AND SUBSIDIARIES Schedule X -- Supplemental Income Statement Information (Dollars in Thousands) Depreciation and amortization of intangible assets, preoperating costs and similar deferrals; taxes, other than payroll and income taxes; royalties and advertising costs were not included above since they were not of a significant amount. KAMAN CORPORATION INDEX TO EXHIBITS Exhibit 3a The Amended and Restated by reference Certificate of Incorporation of the Corporation, as amended, including the form of amendment designating the Corporation's Series 2 Preferred Stock has been filed as Exhibits 2.1 and 2.2 to the Corporation's Form 8-A (Document No. 0-1093 filed on September 27, 1993), and is incorporated in this report by reference. Exhibit 3b The By-Laws of the Corporation by reference were filed as Exhibit 3(b) to the Corporation's Annual Report on Form 10-K for 1990 (Document No. 0-1093, filed with the Securities and Exchange Commission on March 14, 1991). Exhibit 4a Indenture between the Corporation by reference and Manufacturers Hanover Trust Company, as Indenture Trustee, with respect to the Corporation's 6% Convertible Subordinated Debentures, has been filed as Exhibit 4.1 to Registration Statement No. 33 - 11599 on Form S-2 of the Corporation filed with the Securities and Exchange Commission on January 29, 1987 and is incorporated in this report by reference. Exhibit 4b The Revolving Credit Agreement by reference between the Corporation and The Connecticut National Bank, as agent, dated December 31, 1991, was previously filed as Exhibit 4a to the Corporation's Annual Report on Form 10K for 1991 (Document No. 0-1093 filed with the Securities and Exchange Commission on March 16, 1992) and is incorporated in this report by reference. Exhibit 4c The Revolving Credit Agreement by reference between the Corporation and The Bank of Nova Scotia, as agent, dated as of September 5, 1991, has been filed as Exhibit (a)(4)(a) to Form 10-Q filed for the quarter ended September 30, 1991 (Document No. 0-1093 filed with the Securities and Exchange Commission on November 12, 1991) and is incorporated in this report by reference. Exhibit 4d The First Amendment to the by reference Revolving Credit Agreement between the Corporation and the Bank of Nova Scotia, as agent, dated November 16, 1992, has been filed as Exhibit 4e to the Corporation's Annual Report on Form 10-K for 1992 (Document No. 0-1093 filed with the Securities and Exchange Commission on March 13, 1993) and is incorporated in this report by reference. Exhibit 4e Deposit Agreement dated as of by reference October 15, 1993 between the Corporation and Chemical Bank as Depositary and Holder of Depositary Shares has been filed as Exhibit (c)(1) to Schedule 13E-4 (Document No. 5-34114 filed with the Securities and Exchange Commission on September 15, 1993) and is incorporated in this report by reference. Exhibit 4f The Corporation is party to certain by reference long-term debt obligations, such as real estate mortgages, copies of which it agrees to furnish to the Commission upon request. Exhibit 10a The 1983 Stock Incentive Plan by reference (formerly known as the 1983 Stock Option Plan) has been filed as Exhibit 10b(iii) to the Corporation's Annual Report on Form 10-K for 1988 (Document No. 0-1093 filed with the Securities and Exchange Commission on March 22, 1989) and is incorporated in this report by reference. Exhibit 10b The Kaman Corporation 1993 Stock Page 34 Incentive Plan. Exhibit 10c The Kaman Corporation Employees Page 49 Stock Purchase Plan as amended. Exhibit 11 Statement regarding computation Page 56 of per share earnings. Exhibit 13 Portions of the Corporation's Page 57 1993 Annual Report to Shareholders as required by Item 8. Exhibit 21 Subsidiaries. Page 89 Exhibit 23 Consent of Independent Auditors. Page 90 Exhibit 24 Power of attorney under which Page 91 this report has been signed on behalf of certain directors. EXHIBIT 10b KAMAN CORPORATION 1993 STOCK INCENTIVE PLAN 1. PURPOSE. This Plan includes a continuation and extension of the incentive stock program of the Corporation set forth in the Predecessor Plan and is designed to give directors, officers and key employees of the Corporation and other persons an expanded opportunity to acquire stock in the Corporation or receive other long-term incentive remuneration in order that they may better participate in the Corporation's growth and be motivated to remain with the Corporation and promote its further development and success. 2. DEFINITIONS. The following terms shall have the meanings given below unless the context otherwise requires: (a) "Act" means the Securities Exchange Act of 1934, as amended. (b) "Award" or "Awards" except where referring to a particular category of grant under the Plan shall include Incentive Stock Options, Non-Statutory Stock Options, Stock Appreciation Rights and Restricted Stock Awards. (c) "Board" means the Board of Directors of the Corporation. (d) "Code" means the Internal Revenue Code of 1986, as amended, and any successor Code, and related rules, regulations and interpretations. (e) "Committee" means the committee of the Board established under Section 9 hereof. (f) "Corporation" means Kaman Corporation. (g) "Disability" or "disabled" means disability or disabled as defined by the Code. (h) "Disinterested Person" shall have the meaning set forth in Rule 16b-3(c)(2)(i) promulgated under the Act, and any successor to such rule. (i) "Eligible Person" means any person, including a person who is not an employee of the Corporation or a Subsidiary, or entity who satisfies all the eligibility requirements set forth in either Section 3(a) or 3(b) hereof, excluding, however, any member of the Committee and any alternate member of the Committee. (j) "Fair Market Value" of the Stock on any given date shall be the closing price of the Stock in the NASDAQ National Market System on such date, or, if no sales of the Stock occurred on that day, the then most recent prior day on which sales were reported. (k) "Incentive Stock Option" means a stock option qualifying under the provisions of Section 422 of the Code. (l) "Non-Employee Director Participant" means an Eligible Person, who at the time of grant of an Award is a director of the Corporation but not an employee of the Corporation or a Subsidiary. (m) "Non-Statutory Option" means a stock option not qualifying for incentive stock option treatment under the pro- visions of Section 422 of the Code. (n) "Optionee" means the holder of any option granted under the Plan. (o) "Participant" means the holder of any Award granted under the Plan. (p) "Plan" means the Kaman Corporation 1993 Stock Incentive Plan. (q) "Predecessor Plan" means the Kaman Corporation 1983 Stock Incentive Plan. (r) "Principal Shareholder" means any individual owning stock possessing more than ten percent (10%) of the total combined voting power of all classes of capital stock of the Corporation. (s) "Restricted Stock" means Stock received pursuant to a Restricted Stock Award. (t) "Restricted Stock Award" is defined in Section 8(a). (u) "Stock" or "shares" means shares of Class A Common Stock of the Corporation. (v) "Stock Appreciation Right" or "Right" means a right described in Section 7. (w) "Subsidiary" means any corporation in which the Corporation owns, directly or indirectly, a majority of the out- standing voting stock. 3. ELIGIBILITY. (a) Incentive Stock Options. Incentive Stock Options may be granted to any Eligible Persons who are full-time, salaried employees of the Corporation or a Subsidiary and who in the sole opinion of the Committee are, from time to time, responsible for the management and/or growth of all or part of the business of the Corporation. (b) Awards Other than Incentive Stock Options. Awards, other than Incentive Stock Options, may be granted to any Eligible Persons who in the sole opinion of the Committee are, from time to time, responsible for the growth and/or the management of all or a part of the business of the Corporation. (c) Substitute Awards. The Committee, in its discretion, may also grant Awards in substitution for any stock incentive awards previously granted by companies acquired by the Corporation or one of its Subsidiaries. Such substitute awards may be granted on such terms and conditions as the Committee deems appropriate in the circumstances, provided, however, that substitute Incentive Stock Options shall be granted only in accordance with the Code. 4. TERM OF PLAN. The Plan shall take effect on November 1, 1993 and shall remain effective for ten (10) years thereafter, expiring on October 31, 2003. 5. STOCK SUBJECT TO THE PLAN. The aggregate number of shares of Stock which may be issued pursuant to all Awards granted under the Plan shall not exceed 960,000 shares of Stock, subject to adjustment as hereinafter provided in Section 10, which shall be in addition to all shares of Stock reserved for issuance the under Predecessor Plan but remaining unissued on the effective date of the Plan, and which may be treasury shares or authorized but unissued shares. In the event that any Award under the Plan for any reason expires, is terminated, forfeited, reacquired by the Corporation, or satisfied without the issuance of Stock (except in the cases of (i) a Stock Appreciation Right to the extent settled in cash; (ii) the Stock otherwise issuable under an Award but retained by the Corporation for payment of the exercise price of an option under Section 6(e)(iv)(C) for the payment of withholding taxes under Section 14(b) hereof; and (iii) stock otherwise issuable under a stock option but for which the Corporation has made a discretionary payment under Section 7(d) hereof) the shares allocable to the unexercised or forfeited portion of such Award may again be made subject to an Award under the Plan. 6. STOCK OPTIONS. The following terms and conditions shall apply to each option granted under the Plan and shall be set forth in a stock option agreement between the Corporation and the Optionee together with such other terms and conditions not inconsistent herewith as the Committee may deem appropriate in the case of each Optionee: (a) OPTION PRICE. The purchase price under each Incentive Stock Option shall be as determined by the Committee but not less than 100% of the Fair Market Value of the shares subject to such option on the date of grant, provided that such option price shall not be less than 110% of such Fair Market Value in the case of any Incentive Stock Option granted to a Principal Shareholder. The purchase price per share of Stock deliverable upon the exercise of a Non-Statutory Option shall be determined by the Committee, but shall not be less than 85% of the Fair Market Value of such Stock on the date of grant and in no event less than the par value per share of such Stock. (b) TYPE OF OPTION. All options granted under the Plan shall be either Incentive Stock Options or Non-Statutory Options. All provisions of the Plan applicable to Incentive Stock Options shall be interpreted in a manner consistent with the provisions of, and regulations under, Section 422 of the Code. (c) PERIOD OF INCENTIVE STOCK OPTION. Each Incentive Stock Option shall have a term not in excess of ten (10) years from the date on which it is granted, except in the case of any Incentive Stock Option granted to a Principal Shareholder which shall have a term not in excess of five (5) years from the date on which it is granted; provided that any Incentive Stock Option granted or the unexercised portion thereof, to the extent exercisable at the time of termination of employment, shall terminate at the close of business on the day three (3) months following the date on which the Optionee ceases to be employed by the Corporation or a Subsidiary unless sooner expired or unless a longer period is provided under Subsection (g) of this Section in the event of the death or disability of such an Optionee. (d) PERIOD OF NON-STATUTORY OPTION. Each Non-Statutory Option granted under the Plan shall have a term not in excess of ten (10) years and one (1) day from the date on which it is granted; provided that any Non-Statutory Option granted to an employee of the Corporation or a Subsidiary or to a Non-Employee Director Participant, or the unexercised portion thereof shall terminate not later than the close of business on the day three (3) months following the date on which such employee ceases to be employed by the Corporation or a Subsidiary or the date on which such Non-Employee Director ceases to be a director of the Corporation, as the case may be, unless a longer period is provided under Subsection (g) of this Section in the event of the death or disability of such an Optionee. Such an Optionee's Non-Statutory Option shall be exercisable, if at all, during such three (3) month period only to the extent exercisable on the date such Optionee's employment terminates or the date on which such Optionee ceases to be a director, as the case may be. (e) EXERCISE OF OPTION. (i) Each option granted under the Plan shall become exercisable on such date or dates and in such amount or amounts as the Committee shall determine. In the absence of any other provision by the Committee, each option granted under the Plan shall be exercisable with respect to not more than twenty percent (20%) of such shares subject thereto after the expiration of one (1) year following the date of its grant, and shall be exercisable as to an additional twenty percent (20%) of such shares after the expiration of each of the succeeding four (4) years, on a cumulative basis, so that such option, or any unexercised portion thereof, shall be fully exercisable after a period of five (5) years following the date of its grant; provided, however, that in the absence of any other provision by the Committee, each Incentive Stock Option granted to a Principal Shareholder shall be exercisable with respect to not more than twenty-five percent (25%) of the shares subject thereto after the expiration of one (1) year following the date of its grant, and shall be exercisable as to an additional twenty-five percent (25%) after the expiration of each of the succeeding three (3) years, on a cumulative basis, so that such option, or any unexercised portion thereof, shall be fully exercisable after a period of four (4) years following the date of its grant. (ii) The Committee, in its sole discretion, may, from time to time and at any time, accelerate the vesting provisions of any outstanding option, subject, in the case of Incentive Stock Options, to the provisions of Subsection (6)(i) relating to "Limit on Incentive Options". (iii) Notwithstanding anything herein to the contrary, except as provided in subsection (g) of this Section, no Optionee who was, at the time of the grant of an option, an employee of the Corporation or a Subsidiary, may exercise such option or any part thereof unless at the time of such exercise he shall be employed by the Corporation or a Subsidiary and shall have been so employed continuously since the date of grant of such option, excepting leaves of absence approved by the Committee; provided that the option agreement may provide that such an Optionee may exercise his option, to the extent exercisable on the date of termination of such continuous employment, during the three (3) month period, ending at the close of business on the day three (3) months following the termination of such continuous employment unless such option shall have already expired by its term. (iv) An option shall be exercised in accordance with the related stock option agreement by serving written notice of exercise on the Corporation accompanied by full payment of the purchase price in cash. As determined by the Committee, in its discretion, at (or, in the case of Non-Statutory Options, at or after) the time of grant, payment in full or in part may also be made by delivery of (A) irrevocable instructions to a broker to deliver promptly to the Corporation the amount of sale or loan proceeds to pay the exercise price, or (B) previously owned shares of Stock not then subject to restrictions under any Corporation plan (but which may include shares the disposition of which constitutes a disqualifying disposition for purposes of obtaining incentive stock option treatment for federal tax purposes), or (C) shares of Stock otherwise receivable upon the exercise of such option; provided, however, that in the event the Committee shall determine in any given instance that the exercise of such option by withholding shares otherwise receivable would be unlawful, unduly burdensome or otherwise inappropriate, the Committee may require that such exercise be accomplished in another acceptable manner. For purposes of subsections (B) and (C) above, such surrendered shares shall be valued at Fair Market Value on the date of exercise. (f) NONTRANSFERABILITY. No option granted under the Plan shall be transferable by the Optionee otherwise than by will or by the laws of descent and distribution, and such option shall be exercisable, during his lifetime, only by him. (g) DEATH OR DISABILITY OF OPTIONEE. In the event of the death or disability of an Optionee while in the employ of the Corporation or a Subsidiary or while serving as a director of the Corporation, his stock option or the unexercised portion thereof may be exercised within the period of one (1) year succeeding his death or disability, but in no event later than (i) ten (10) years (five (5) years in the case of a Principal Shareholder) from the date the option was granted in the case of an Incentive Stock Option, and (ii) ten (10) years and one (1) day in the case of a Non-Statutory Option, by the person or persons designated in the Optionee's will for that purpose or in the absence of any such designation, by the legal representative of his estate, or by the legal representative of the Optionee, as the case may be. Notwithstanding anything herein to the contrary and in the absence of any contrary provision by the Committee, during the one-year period following termination of employment or cessation as a director by reason of death or disability, an Optionee's stock option shall continue to vest in accordance with its terms and be and become exercisable as if employment or service as a director had not ceased. (h) SHAREHOLDER RIGHTS. No Optionee shall be entitled to any rights as a shareholder with respect to any shares subject to his option prior to the date of issuance to him of a stock certificate representing such shares. (i) LIMIT ON INCENTIVE STOCK OPTIONS. The aggregate Fair Market Value (determined at the time an option is granted) of shares with respect to which Incentive Stock Options granted to an employee are exercisable for the first time by such employee during any calendar year (under all incentive stock option plans of the Corporation and its Subsidiaries to the extent required under the Code) shall not exceed $100,000. (j) NOTIFICATION OF DISQUALIFYING DISPOSITION. Participants granted Incentive Stock Options shall undertake, in the Incentive Stock Option agreements, as a precondition to the granting of such option by the Corporation, to promptly notify the Corporation in the event of a disqualifying disposition (within the meaning of the Code) of any shares acquired pursuant to such Incentive Stock Option agreement and provide the Corporation with all relevant information related thereto. 7. STOCK APPRECIATION RIGHTS; DISCRETIONARY PAYMENTS. (a) NATURE OF STOCK APPRECIATION RIGHT. A Stock Appreciation Right is an Award entitling the Participant to receive an amount in cash or shares of Stock (or forms of payment permitted under Section 7(d) hereof) or a combination thereof, as determined by the Committee at the time of grant, having a value equal to (or if the Committee shall so determine at time of grant, less than) the excess of the Fair Market Value of a share of Stock on the date of exercise over the Fair Market Value of a share of Stock on the date of grant (or over the option exercise price, if the Stock Appreciation Right was granted in tandem with a stock option) multiplied by the number of shares with respect to which the Stock Appreciation Right shall have been exercised. (b) GRANT AND EXERCISE OF STOCK APPRECIATION RIGHTS. (i) Stock Appreciation Rights may be granted in tandem with, or independently of, any stock option granted under the Plan. In the case of a Stock Appreciation Right granted in tandem with a Non-Statutory Option, such Right may be granted either at or after the time of grant of such option. In the case of a Stock Appreciation Right granted in tandem with an Incentive Stock Option such Right may be granted only at the time of the grant of such option. A Stock Appreciation Right or applicable portion thereof granted in tandem with a given stock option shall terminate and no longer be exercisable upon the termination or exercise of the related stock option, except that a Stock Appreciation Right granted with respect to less than the full number of shares covered by a related stock option shall not be reduced until the exercise or termination of the related stock option exceeds the number of shares not covered by the Stock Appreciation Right. (ii) Each Stock Appreciation Right granted under the Plan shall become exercisable on such date or dates and in such amount or amounts as the Committee shall determine; provided, however, that any Stock Appreciation Right granted in tandem with a stock option shall be exercisable in relative proportion to and to the extent that such related stock option is exercisable; provided further, however, that, notwithstanding anything herein to the contrary, any Stock Appreciation Right granted in tandem with a Non-Statutory Option which has a purchase price at the date of grant of less than Fair Market Value shall not be exercisable at all until at least one (1) year after the date of grant of such option. Except as provided in the immediately preceding sentence, in the absence of any other provision by the Committee, each Stock Appreciation Right granted under the Plan shall be exercisable with respect to not more than twenty percent (20%) of such shares subject thereto after the expiration of one (1) year following the date of its grant, and shall be exercisable as to an additional twenty percent (20%) of such shares after the expiration of each of the succeeding four (4) years, on a cumulative basis, so that such Right, or any unexercised portion thereof, shall be fully exercisable after a period of five (5) years following the date of its grant. The Committee, in its sole discretion, may, from time to time and at any time, accelerate the vesting provisions of any outstanding Stock Appreciation Right. (iii) Notwithstanding anything herein to the contrary, except as provided in subsections (c)(v) and (c)(vi) of this Section, no Participant who was, at the time of the grant of a Stock Appreciation Right, an employee of the Corporation or a Subsidiary, may exercise such Right or any part thereof unless at the time of such exercise, he shall be employed by the Corporation or a Subsidiary and shall have been so employed continuously since the date of grant of such Right, excepting leaves of absence approved by the Committee; provided that the Stock Appreciation Right agreement may provide that such a Participant may exercise his Stock Appreciation Right, to the extent exercisable on the date of termination of such continuous employment unless such Right shall have already expired by its terms. (iv) Notwithstanding anything herein to the contrary, except as provided in subsections (c)(v) and (c)(vi) of this Section, no Non-Employee Director Participant may exercise a Stock Appreciation Right or part thereof unless at the time of such exercise he shall be a director of the Corporation and shall have been a director of the Corporation continuously since the date of grant of such Right excepting leaves of absence approved by the Committee; provided that the Stock Appreciation Right agreement may provide that such Participant may exercise his Stock Appreciation Right, to the extent exercisable on the date he ceased to be a director of the Corporation, during the three (3) month period ending at the close of business on the day three (3) months following the cessation of such continuous service as a director unless such Right shall already have expired by its terms. (v) A Stock Appreciation Right shall be exercised in accordance with the related Stock Appreciation Right Agreement by serving written notice of exercise on the Corporation. (c) TERMS AND CONDITIONS OF STOCK APPRECIATION RIGHTS. Stock Appreciation Rights shall be subject to such terms and conditions as shall be determined from time to time by the Committee, subject to the following: (i) Stock Appreciation Rights granted in tandem with stock options shall be exercisable only at such time or times and to the extent that the related stock options shall be exercisable; (ii) Upon the exercise of a Stock Appreciation Right, the applicable portion of any related stock option shall be surrendered. (iii) Stock Appreciation Rights granted in tandem with a stock option shall be transferable only with such option. Stock Appreciation Rights shall not be transferable otherwise than by will or the laws of descent and distribution. All Stock Appreciation Rights shall be exercisable during the Participant's lifetime only by the Participant or the Participant's legal representative. (iv) A Stock Appreciation Right granted in tandem with a stock option may be exercised only when the then Fair Market Value of the Stock subject to the stock option exceeds the exercise price of such option. A Stock Appreciation Right not granted in tandem with a stock option may be exercised only when the then Fair Market Value of the Stock exceeds the Fair Market Value of the Stock on the date of grant of such Right. (v) Each Stock Appreciation Right shall have a term not in excess of ten (10) years from the date on which it is granted (ten (10) years and one (1) day in the case of a Stock Appreciation Right granted in tandem with a Non-Statutory Option); provided that any Stock Appreciation Right granted to (aa) an employee of the Corporation or a Subsidiary shall terminate not later than the close of business on the day three (3) months following the date such Participant ceases to be employed by the Corporation or a Subsidiary, excepting leaves of absences approved by the Committee, and (bb) a Non-Employee Director Participant shall terminate not later than the close of business on the day three (3) months following the date such Participant ceases to be a director of the Corporation, unless a longer period is provided under subsection (c)(vi) below in the event of death or disability of a Participant. Such a Participant's Stock Appreciation Right shall be exercisable, if at all, during such three (3) month period only to the extent exercisable on the date his employment terminates or the date he ceases to be a director, as the case may be. (vi) In the event of the death or disability of a Participant while in the employ of the Corporation or a Subsidiary or while serving as a director of the Corporation, his Stock Appreciation Right or the unexercised portion thereof may be exercised within the period of one (1) year succeeding his death or disability, but in no event later than (i) ten (10) years from the date on which it was granted (ten (10) years and one (1) day in the case of a Non-Statutory Option), by the person or persons designated in the Participant's will for that purpose or in the absence of any such designation, by the legal representative of his estate, or by the legal representative of the Participant, as the case may be. Notwithstanding anything herein to the contrary and in the absence of any contrary provision by the Committee, during the one-year period following termination of employment or cessation as a director by reason of death or disability, a Participant's Stock Appreciation Right shall continue to vest in accordance with its terms and be and become exercisable as if employment or service as a director had not ceased. (d) DISCRETIONARY PAYMENTS. Upon the written request of an Optionee whose stock option is not accompanied by a Stock Appreciation Right, the Committee may, in its discretion, cancel such option if the Fair Market Value of the shares subject to the option at the exercise date exceeds the exercise price thereof; in that event, the Corporation shall pay to the Optionee an amount equal to the difference between the Fair Market Value of the shares subject to the cancelled option (determined as of the date the option is cancelled) and the exercise price. Such payment shall be by check or in Stock having a Fair Market Value (determined on the date the payment is to be made) equal to the amount of such payments or any combination thereof, as determined by the Committee. (e) RULES RELATING TO EXERCISE. In the case of a Participant subject to the restrictions of Section 16(b) of the Act, no stock appreciation right (as referred to in Rule 16b-3(e) or any successor Rule under the Act), including a Stock Appreciation Right granted hereunder, shall be settled in cash (and no request for payment under paragraph (d) above shall be honored by the Corporation or made by such a Participant) except in compliance with any applicable requirements of Rule 16b-3(e) or any successor rule. 8. RESTRICTED STOCK. (a) Nature of Restricted Stock Award. A Restricted Stock Award is an Award entitling the Participant to receive shares of Stock, subject to such conditions, including a Corporation right during a specified period or periods to require forfeiture of such shares upon the Participant's termination of employment with the Corporation or a Subsidiary or cessation as a director of the Corporation, as the case may be, as the Committee may determine at the time of grant. The Committee, in its sole discretion, may, from time to time and at any time, waive any or all restrictions and/or conditions contained in the Restricted Stock Award agreement. Notwithstanding anything herein to the contrary, the Committee, in its discretion, may grant Restricted Stock without any restrictions or conditions whatsoever. Restricted Stock shall be granted in respect of past services or other valid consideration. (b) AWARD AGREEMENT. A Participant who is granted a Restricted Stock Award shall have no rights with respect to such Award unless the Participant shall have accepted the Award within 60 days (or such shorter date as the Committee may specify) following the Award date by executing and delivering to the Corporation a Restricted Stock Award Agreement in such form as the Committee shall determine. (c) RIGHTS AS A SHAREHOLDER. Upon complying with paragraph (b) above, a Participant shall have all the rights of a shareholder with respect to the Restricted Stock including voting and dividend rights, subject to nontransferability and Corporation forfeiture rights described in this Section 8 and subject to any other conditions contained in the Award agreement. Unless the Committee shall otherwise determine, certificates evidencing shares of Restricted Stock shall remain in the possession of the Corporation until such shares are free of any restrictions under the Plan. The Committee in its discretion may, as a precondition of the Corporation's obligation to issue a Restricted Stock Award, require the Participant to execute a stock power or powers or other agreement or instruments necessary or advisable in connection with the Corporation's forfeiture rights with respect to such shares. (d) RESTRICTIONS. Shares of Restricted Stock may not be sold, assigned, transferred or otherwise disposed of or pledged or otherwise encumbered. In the event of termination of employment of the Participant with the Corporation or a Subsidiary for any reason, or cessation as a director of the Corporation in the case of a Non-Employee Director Participant, such shares shall be forfeited to the Corporation, except as set forth below: (i) The Committee at the time of grant shall specify the date or dates (which may depend upon or be related to the attainment of performance goals and other conditions) on which the nontransferability of the Restricted Stock and the Corporation's forfeiture rights with respect thereto shall lapse. The Committee at any time may accelerate such date or dates and otherwise waive or, subject to Section 13, amend any conditions of the Award. (ii) Except as may otherwise be provided in the Award agreement, in the event of termination of a Participant with the Corporation or a Subsidiary for any reason or cessation as a director of the Corporation for any reason, all of the Participant's Restricted Stock shall be forfeited to the Corporation without the necessity of any further act by the Corporation, the Participant or the Participant's legal representative; provided, however, that in the event of termination of employment or cessation of service as a director of the Corporation by reason of death or disability, all conditions and restrictions relating to a Restricted Stock Award held by such a Participant shall thereupon be waived and shall lapse. (iii) In the absence of any other provision by the Committee, each Restricted Stock Award granted to (A) an employee of the Corporation or a Subsidiary shall be subject to forfeiture to the Corporation conditioned on the Participant's continued employment and (B) Non-Employee Director Participants shall be subject to forfeiture to the Corporation conditioned on the Participant's continued service as a director of the Corporation, and in the case of clause (A) or (B), such forfeiture rights shall lapse as follows: with respect to twenty percent (20%) of the shares subject to the Restricted Stock Award on the date one year following the date of grant, and with respect to an additional twenty percent (20%) of such shares after the expiration of each of the succeeding four (4) years thereafter, on a cumulative basis, so that such Restricted Stock shall be free of such risk of forfeiture on the date five (5) years following the date of its grant. (e) WAIVER, DEFERRAL, AND INVESTMENT OF DIVIDENDS. The Restricted Stock Award agreement may require or permit the immediate payment, waiver, deferral or investment of dividends paid with respect to the Restricted Stock. 9. THE COMMITTEE. (a) ADMINISTRATION. The Committee shall be a committee of not less than three (3) members of the Board who are Disinterested Persons, appointed by the Board. Vacancies occurring in membership of the Committee shall be filled by the Board. The Committee shall keep minutes of its meetings. One or more members of the Committee may participate in a meeting of the Committee by means of conference telephone or similar communications equipment provided all persons participating in the meeting can hear one another. A majority of the entire Committee shall constitute a quorum, and the acts of a majority of the members present at or so participating in any meeting at which a quorum is constituted shall be the acts of the Committee. The Committee may act without meeting by unanimous written consent. Absent some other provision by the Board, the power and responsibilities of the Committee shall be vested in and assumed by the Personnel and Compensation Committee of the Board. (b) AUTHORITY OF COMMITTEE. Subject to the provisions of the Plan, the Committee shall have full and final authority to determine the persons to whom Awards shall be granted, the number of shares to be subject to each Award, the term of the Award, the vesting provisions of the Award, if any, restrictions on the Award, if any, and the price at which the shares subject thereto may be purchased. The Committee is empowered, in its discretion, to modify, extend or renew any Award theretofore granted and adopt such rules and regulations and take such other action as it shall deem necessary or proper for the administration of the Plan. The Committee shall have full power and authority to construe, interpret and administer the Plan, and the decisions of the Committee shall be final and binding upon all interested parties. 10. ADJUSTMENTS. Any limitations, restrictions or other provisions of this Plan to the contrary notwithstanding, each Award agreement shall make such provision, if any, as the Committee may deem appropriate for the adjustment of the terms and provisions thereof (including, without limitation, terms and provisions relating to the exercise price and the number and class of shares subject to the Award) in the event of any merger, consolidation, reorganization, recapitalization, stock dividend, divisive reorganization, issuance of rights, combination or split-up or exchange of shares, or the like. In the event of any merger consolidation, reorganization, recapitalization, stock dividend, divisive reorganization, issuance of rights, combination or split- up or exchange of shares, or the like, the Committee shall make an appropriate adjustment in the number of shares authorized to be issued pursuant to the Plan. 11. OPTIONS UNDER PREDECESSOR PLAN . Options presently outstanding which have been granted under the Predecessor Plan shall continue to be governed and interpreted under the terms of such plan and not by the terms hereof. 12. AMENDMENT TO AND TERMINATION OF THE PLAN. The Board may from time to time amend the Plan in such way as it shall deem advisable provided the Board may not extend the expiration date of the Plan, change the class of Eligible Persons, increase the maximum Award term, decrease the minimum exercise price or increase the total number of authorized shares (except in accordance with Section 10 hereof) for which Awards may be granted. The Board, in its discretion, may at any time terminate the Plan prior to its expiration in accordance with Section 4 hereof. No amendment to or termination of the Plan shall in any way adversely affect Awards then outstanding hereunder. 13. STATUS OF PLAN. Until shares pursuant to an Award or exercise thereof are actually delivered to a Participant, a Participant shall have no rights to or with respect to such shares greater than those of a general creditor of the Corporation unless the Committee shall otherwise expressly determine in connection with any Award or Awards. 14. GENERAL PROVISIONS. (a) OTHER COMPENSATION ARRANGEMENTS; NO RIGHT TO RECEIVE AWARDS; NO EMPLOYMENT OR OTHER RIGHTS. Nothing contained in this Plan shall prevent the Board from adopting other or additional capital stock based compensation arrangements, subject to stockholder approval if such approval is required, and such arrangements may be either generally applicable or applicable only in specific cases. No Eligible Person shall have any right to receive Awards except as the Committee may determine. The Plan does not confer upon any employee any right to continued employment with the Corporation or a Subsidiary or upon any director or officer of the Corporation any right to continued service as a director or officer of the Corporation, nor does it interfere in any way with the right of the Corporation or a Subsidiary to terminate the employment of any of its employees or for the Corporation to remove a director or officer with or without cause at any time. (b) TAX WITHHOLDING, ETC. Any obligation of the Corporation to issue shares pursuant to the grant or exercise of any Award shall be conditioned on the Participant having paid or made provision for payment of all applicable tax withholding obligations, if any, satisfactory to the Committee. The Corporation and its Subsidiaries shall, to the extent permitted by law, have the right to deduct any such taxes from any payment of any kind otherwise due to the Participant. In the case of Non-Statutory Options, and Stock Appreciation Rights exercisable only for Stock, the Participant exercising such an award shall satisfy federal income tax withholding requirements occasioned by the exercise thereof by the surrender of shares otherwise to be received on the exercise of such award, such shares to be valued at the Fair Market Value thereof on the date of exercise; provided, however, that in the event the Committee shall determine in any given instance that the satisfaction of federal income tax withholding requirements by the surrender of shares would be unlawful, unduly burdensome or otherwise inappropriate, the Committee may require that such income tax withholding requirements be satisfied in another acceptable manner. (c) SECTION 83(B) OF THE CODE. Participants may not make, and each Award agreement shall prohibit, an election under Section 83(b) of the Code, with respect to any Award. (d) RESTRICTIONS ON TRANSFERS OF SHARES. Although the Corporation presently intends to register under applicable securities laws all shares acquired or received by Participants under the Plan, the Corporation is not required to cause such shares to be registered under the Securities Act of 1933 or the securities laws of any State. Accordingly, the shares acquired or received may be "restricted securities" as defined in Rule 144 under said Securities Act of 1933 or other rule or regulation of the Securities and Exchange Commission. Any certificate evidencing any such shares may bear a legend restricting the transfer of such shares, and the recipient may be required to assert that the shares are being acquired for his own account and not with a view to the distribution thereof as a condition to the granting or exercise of an Award. (e) ISSUANCE OF SHARES. Any obligation of the Corporation to issue shares pursuant to the grant or exercise of any Award shall be conditioned on the Corporation's ability at nominal expense to issue such shares in compliance with all applicable statutes, rules or regulations of any governmental authority. The Participant shall provide the Corporation with any assurances or agreements which the Committee, in its sole discretion, shall deem necessary or advisable in order that the issuance of such shares shall comply with any such statutes, rules or regulations. (f) DATE OF GRANT. The date on which each Award under the Plan shall be considered as having been granted shall be the date on which the award is authorized by the Committee, unless a later date is specified by the Committee; provided, however, in the case of options intended to qualify as Incentive Stock Options, the date of grant shall be determined in accordance with the Code. EXHIBIT 10c KAMAN CORPORATION EMPLOYEES STOCK PURCHASE PLAN As Amended effective February 18, 1992 1. PURPOSE; AUTHORIZED SHARES. The Kaman Corporation Employees Stock Purchase Plan (the "Plan") was adopted by the Board of Directors (the "Board") of Kaman Corporation (the "Corporation") on February 28, 1989 for the purpose of providing employees of the Corporation and its subsidiaries an opportunity to purchase Kaman Corporation Class A common stock through payroll deductions during consecutive offerings commencing July 1, 1989. One Million Five Hundred Thousand (1,500,000) shares of the Corporation's Class A common stock in the aggregate have been approved for purposes of the Plan by the Board. 2. OFFERING PERIODS. Each offering shall be made over a period of one or more whole or partial Plan Years as determined by the Committee (as defined in paragraph 3), provided that in no event shall an offering period be greater than five (5) Plan Years. 3. ADMINISTRATION. The Plan will be administered by a committee (the "Committee") appointed by the Board, consisting of at least three of its members. Members of the Committee shall not be eligible to participate in the Plan. The Committee will have authority to make rules and regulations for the administration of the Plan, and its interpretations and decisions with respect to the Plan shall be final and conclusive. Absent some other provision by the Board, the power and responsibilities of the Committee shall be vested in and assumed by the Personnel and Compensation Committee of the Board. 4. ELIGIBILITY. All full-time regular employees of the Corporation and its subsidiaries, with at least three (3) months of service as of the effective date of each offering hereunder, will be eligible to participate in the Plan, subject to such rules as may be prescribed from time to time by the Committee. Such rules, however, shall neither permit nor deny participation in the Plan contrary to the requirements of the Internal Revenue Code of 1986, as amended (the "Code"), including, but not limited to, Section 423 thereof, and regulations promulgated thereunder. To the extent consistent with Code Section 423, and regulations promulgated thereunder, the Committee may permit persons who are not full-time regular employees of the Corporation or one of its subsidiaries at the commencement of an offering period, or who have not satisfied the aforementioned three (3) month service requirement at the commencement of an offering period, to participate in such offering beginning on the date or at a specified date after such person has been a full-time, regular employee of the Corporation or one of its subsidiaries for at least three (3) months. No employee may be granted a right under the Plan if such employee, immediately after the right is granted, would own five percent (5%) or more of the total combined voting power or value of the stock of the Corporation or any subsidiary. For purposes of the preceding sentence, the rules of Section 425(d) of the Code shall apply in determining stock ownership of an employee, and stock which the employee may purchase under outstanding rights shall be treated as stock owned by the employee. 5. PARTICIPATION. An eligible employee may begin participation in an offering at any time by completing and forwarding a payroll deduction authorization form to the employee's appropriate payroll location. The form will authorize a regular payroll deduction from the employee's compensation, and must specify the date on which such deduction is to commence. The authorization may not be retroactive. 6. DEDUCTIONS. Payroll deduction accounts will be maintained for all participating employees. An employee may authorize a payroll deduction in terms of dollars and cents per payroll period of not less than $1.00 or more than ten (10%) percent of the compensation of the employee during any such payroll period. 7. DEDUCTION CHANGES. An employee may at any time increase or decrease the employee's payroll deduction by filing a new payroll deduction authorization form. The change may not become effective sooner than the next pay period after receipt of the form. A payroll deduction may be increased only twice and may be reduced only twice during any Plan Year of an offering period, unless any such additional change is required to permit the purchase of the whole number of shares for which rights have been granted to the employee under the provisions of paragraph 10. 8. INTEREST. Since the amount of time that the Corporation will be holding funds withheld from employees' compensation is minimal, no interest will be credited to employees' accounts. 9. WITHDRAWAL OF FUNDS. An employee may at any time and for any reason permanently withdraw the balance of funds accumulated in the employee's payroll deduction account, and thereby withdraw from participation in an offering. Upon any such withdrawal, the employee shall be entitled to receive in cash the value of any fractional share (rounded to four decimal places) allocated to such employee's account determined on the basis of the market value thereof as of the date of withdrawal. The employee may thereafter begin participation again only once during each Plan Year of an offering period. Partial withdrawals will not be permitted. 10. PURCHASE OF SHARES. Subject to the payroll deduction limitation set forth in paragraph 6 and the limitation below, each employee participating in an offering under this Plan will be granted a right to purchase shares of the Corporation's Class common stock which have an aggregate purchase price (determined under paragraph 11) equal to the sum of (a) up to ten percent (10%) of his or her compensation during each pay period of each offering period in which he or she participates and (b) any cash dividends reinvested in accordance with paragraph 12. In no event may an employee be granted a right which permits such employee's rights to purchase stock under this Plan, and any other stock purchase plan of the Corporation and its subsidiaries, to accrue at a rate which exceeds $25,000 of fair market value of stock (determined at the date of grant of the right) for each calendar year in which the right is outstanding at any time. No right may be exercised in any manner other than by payroll deduction as specified in paragraph 6 or dividend reinvestment as specified in paragraph 12. 11. PURCHASE PRICE AND PAYMENT. The purchase price to participating employees for each share of Class A common stock purchased under the Plan will be 85% of its market value at the time of purchase. Purchases of shares pursuant to the Plan shall be made on the fifteenth (15th) day of each month. The number of whole and fractional shares allocated to each employee's account as of each date of purchase shall be based upon the balance of funds in an employee's account available for the purchase of shares as of the close of the immediately preceding month. A participating employee's payroll deduction account shall be charged with the purchase price of each whole and fractional share allocated to the employee as of the date of purchase and the employee shall be deemed to have exercised a right to acquire such whole and fractional share as of such date. Additional shares covered by the participating employee's rights under the Plan will be purchased in the same manner, provided funds have again accrued in his account. 12. DIVIDENDS. Any cash dividends paid with respect to the shares held under the Plan shall be paid in cash to the participating employees for whom shares are so held on the basis of the number of whole and fractional shares so held or, if a participating employee so elects, such dividends shall be combined with payroll deductions, added to the funds held under the Plan, and applied to the purchase of additional shares of stock purchased pursuant to the Plan. A participating employee choosing to have dividends reinvested under this paragraph may terminate such election during an offering period by filing a written form at the appropriate payroll location, but may thereafter resume his election to reinvest such cash dividends only once during each Plan Year of an offering period. An election to either stop or resume dividend reinvestment will be effective with respect to the dividend payment next following receipt of the form; provided that if the form is filed within thirty (30) days before a dividend record date declared by the Board, then such election will not be effective with respect to that particular dividend declaration. 13. STOCK CERTIFICATES. Stock certificates will only be issued to participating employees promptly after their request or promptly after the participating employee's withdrawal from the Plan for any reason. 14. REGISTRATION OF CERTIFICATES. Certificates may be registered only in the name of the employee, or if the employee so indicates on the employee's payroll deduction authorization form, in the employee's name jointly with a member of the employee's family, with right of survivorship. An employee who is a resident of a jurisdiction which does not recognize such a joint tenancy may have certificates registered in the employee's name as tenant in common with a member of the employee's family, without right of survivorship. 15. DEFINITIONS. The following terms when used herein shall have the meanings set forth below: (a) The phrase "market value" or "fair market value" means the closing price of the Corporation's Class A common stock in the Over-the-Counter NASDAQ National Market System, as reported in the Hartford, Connecticut local issue of The Wall Street Journal, on the business day immediately preceding the day of purchase or the effective date of the offering as the context requires. (b) The term "subsidiary" means a subsidiary of the Corporation within the meaning of Section 425(f) of the Internal Revenue Code and the regulations thereunder, provided, however, that each consecutive offering under this Plan shall not be deemed to cover the employees of any subsidiary acquired or established after the effective date of such offering, unless so authorized by the Committee. (c) a "Plan Year" means the calendar year. 16. RIGHTS AS A SHAREHOLDER. None of the rights or privileges of a shareholder of the Corporation shall exist with respect to (a) rights granted to a participating employee under the Plan or, (b) except as provided in paragraph 12, any fractional shares credited to the participating employee's account. 17. RIGHTS ON RETIREMENT, DEATH OR TERMINATION OF EMPLOYMENT. In the event of a participating employee's retirement, death or termination of employment, no payroll deduction shall be taken from any pay due and owing to an employee at such time, and the balance in the employee's account (including the value of any fractional shares calculated in the manner described in paragraph 9) shall be paid to the employee or, in the event of the employee's death, to the employee's estate; provided, however, that in the event shares credited to the account of a deceased employee would have been issued to the employee and a joint tenant with right of survivorship as permitted in paragraph 14 if issued immediately prior to such employee's death, then such shares shall be issued to such joint tenant, if living at the time such shares are issued. 18. OBLIGATION OF CORPORATION TO PURCHASE. In the event of personal or family circumstances of an emergency nature, for a period of one year after the exercise of a right to purchase a share or shares as described in paragraphs 10 and 11, a participating employee shall have the right to offer such shares back to the Corporation at the price at which such shares were purchased, and the Corporation shall have the obligation to make such repurchase. 19. RIGHTS NOT TRANSFERABLE. Rights under this Plan are not transferable by a participating employee and are exercisable during an employee's lifetime only by the employee. 20. APPLICATION OF FUNDS. All funds received or held by the Corporation under this Plan may be used for any corporate purpose. 21. ADJUSTMENT IN CASES OF CHANGES AFFECTING CLASS A STOCK. In the event of any merger, consolidation, reorganization, recapitalization, stock dividend, combination, issuance of rights, split-up or spin-off of the Corporation, or the like, the number of shares approved for this Plan shall be increased appropriately and such other adjustments to the terms of this Plan shall be made as may be deemed equitable by the Board. In the event of any other change affecting such stock, such adjustments shall be made as may be deemed equitable by the Board to give proper effect to such event. 22. AMENDMENT OF THE PLAN. The Board may at any time, or from time to time, amend this Plan in any respect, except that, without the approval of each class of stock of the Corporation then issued and outstanding and entitled to vote on the matter by applicable law, no amendment shall be made (i) increasing the number of shares approved for this Plan (other than as provided in paragraph 21); (ii) decreasing the purchase price per share; (iii) withdrawing the administration of this Plan from the Committee; or (iv) changing the designation of subsidiaries eligible to participate in the Plan, except adding a subsidiary as provided in paragraph 15(b). 23. TERMINATION OF PLAN. This Plan and all rights of employees under an offering hereunder shall terminate: (a) on the date that participating employees' accumulated payroll deductions pursuant to paragraph 6 and amounts reinvested pursuant to paragraph 12 are sufficient to purchase a number of shares equal to or greater than the number of shares remaining available for purchase. If the number of shares so purchasable is greater than the shares remaining available, the available shares shall be allocated by the Committee among such participating employees in such manner as it deems equitable, or (b) at any time at the discretion of the Board. Upon termination of the Plan all amounts in the accounts of participating employees not applied to the purchase of shares hereunder, together with the value of any fractional shares calculated in the manner described in paragraph 9, shall be promptly refunded. 24. GOVERNMENT REGULATIONS. The Corporation's obligation to sell and deliver shares of its Class A common stock under this Plan is subject to the approval of any governmental authority required in connection with the authorization, issuance or sale of such stock. 25. SHARES USED TO FUND PLAN. The Corporation may utilize unissued or treasury shares to fund the Plan. Purchases of outstanding shares may also be made pursuant to and on behalf of the Plan, upon such terms as the Corporation may approve, for delivery under the Plan. 26. QUALIFIED PLAN. This Plan is intended to qualify as an Employee Stock Purchase Plan as defined in Section 423 of the Code. The term "right" as used herein shall mean "option" as used in Section 423, and is used herein only to avoid confusion with "options" granted under the Kaman Corporation 1983 Stock Incentive Plan. 27. SUCCESSOR CORPORATION. The rights and obligations of the Corporation under this Plan shall inure to and be binding upon any successor to all or substantially all of the Corporation's assets and business. 28. BUSINESS DAYS. If any event provided for in this Plan is scheduled to take place on a day which is not a business day then such event shall take place on the immediately preceding business day. 29. SPECIAL RULE APPLICABLE TO EXECUTIVE OFFICERS AND DIRECTORS OF THE CORPORATION. Notwithstanding any other provision of the Plan, participants who are Executive Officers or Directors and who cease to participate in the Plan shall be thereafter prohibited, for a period of six (6) months following the date of such cessation from again electing to participate in the Plan. For purposes of this section, the term "Executive Officer" means an "Executive Officer" as defined in Section 3b-7 of the Securities Exchange Act of 1934. EXHIBIT 11 KAMAN CORPORATION AND SUBSIDIARIES EARNINGS PER SHARE COMPUTATION(In Thousands Except Per Share Amounts) EXHIBIT 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Revenues for 1993 were $794.1 million compared to $784.7 million in 1992 and $780.4 million in 1991. The corporation's performance in 1993 was affected by reductions in defense expenditures, a slowdown in the commercial aircraft industry, and continued weakness in domestic economic growth. Results were also affected by the recording of a pre-tax restructuring charge in the amount of $69.5 million to reflect costs associated with downsizing the corporation's defense and commercial aircraft manufacturing businesses and development of defense conversion initiatives. Diversified Technologies segment revenues were down 5% in both 1993 and 1992, and down 7% in 1991. Segment performance continues to be affected by conditions in defense markets and in the commercial aircraft industry. The defense portion of Diversified Technologies business (82% in 1993) has been influenced for some time now by the changing nature of U.S. defense planning and spending priorities and by federal budget constraints which continue to result in reductions in defense expenditures. As the federal government attempts to address the ongoing issues of the budget deficit, weak economic growth, and basic reform to the U.S. healthcare system, it appears likely that defense spending will be even further reduced in future periods. Management believes that certain types of programs are likely to fare better than others in this environment. As the defense establishment responds to the fact that the form of military threat throughout the world has changed and that the public has grown more intolerant of the loss of lives in military conflict, it is moving toward greater emphasis on more cost effective advanced technology "smart" weapons which are intended to limit loss of life and unnecessary destruction of property. The corporation has significant expertise in this area, having performed a multitude of government contracts for advanced technology programs over the years. Management believes that the corporation is particularly well positioned to compete in a defense environment that emphasizes advanced technology products and systems, and advanced technology services such as computer software development, intelligence analysis, and scientific and research and development services. This change in defense program emphasis along with the federal government's fiscal condition have created an environment in which military hardware programs are increasingly subject to risks of one form or another, whether it be lack of funding, contract cancellation, or simply the ending of an entire program. The corporation is feeling the effects of these risks, principally with respect to its SH-2 helicopter. The corporation expects to finish its contract to retrofit certain SH-2F's to the SH-2G configuration sometime in 1994. Given the fact that the U.S. Navy is beginning to reduce the size of its fleet, management does not believe that the Navy will require further retrofits of this helicopter. Moreover, as fleet size decreases, so will the number of these helicopters remaining in active service. The corporation will continue to provide logistics and spare parts support for the SH-2 at somewhat lower levels than in the past. The corporation's other military hardware programs have shrunk further during 1993 as a result of the cancellation of a contract relating to the rewinging of the A-6. Within the Diversified Technologies segment, management has been successful in the development of a variety of commercial markets. The corporation performs work on a number of commercial airframe manufacturing programs, although reductions in commercial air travel and consolidation in the domestic aircraft industry have caused a slowdown in aircraft production rates which adversely affected several of our programs in 1993. Late in 1993 the corporation received a stop work order with respect to its manufacture of thrust reverser fixed structures for the GE CF6 engines which will cause further reductions in 1994. One important facet of the segment's commercial diversification is the new K-MAX helicopter, a medium to heavy lift "aerial truck" with unique operating characteristics that distinguish it from other helicopters used for logging, fire fighting, and other utility applications. A substantial portion of the corporation's research and development expenditures during the last few years have been devoted to this product and FAA certification is expected by mid 1994. The production phase for the first five helicopters has begun and units are expected to be delivered to initial customers shortly after certification is received. The corporation will lease the first group under a special program in order to maintain active involvement in the product's introduction to the marketplace. Although management believes that this program is an important part of the corporation's defense conversion effort, in the shorter term the program is not expected to materially offset the effects of reduced defense spending. Distribution segment revenues increased by almost 7% in 1993, and 6% in 1992 compared to a decrease of 4% in 1991. Industrial technologies sales (about 75% of this segment's business in 1993) are made to nearly every sector of U.S. industry so demand for products tends to be influenced by industrial production levels. While industrial technologies sales increased during 1993 in a very competitive market environment, relatively slow growth in industrial output during the last few years has continued to affect segment sales. The increased sales reflect ongoing programs designed to further enhance the technological content of the products distributed and the services provided. Music Distribution sales increased significantly during 1993, largely as a result of further development of international markets for the company's products. As a result of the third quarter pre-tax restructuring charge, the corporation had an operating loss of $37.2 million and a net loss of $28.8 million for 1993. In 1992, the corporation had operating income of $36.5 million and net earnings of $17.4 million. The Diversified Technologies segment had an operating loss of $41.3 million for 1993 compared to an operating profit of $31.0 million for the previous year, with the loss being attributable to the restructuring charge. The Distribution segment had operating profits of $16.5 million for 1993 compared to $15.2 million for 1992, with the increase being attributable to increased sales in the Music Distribution business. These results also reflect the fact that the overall mix of the corporation's activities is in the process of shifting to businesses with somewhat lower profit margins. The third quarter charge reflects restructuring and other non- recurring costs which the corporation has incurred or expects to incur in the next two years as it reduces the size of its defense and commercial aircraft manufacturing programs and develops defense conversion initiatives. Personnel and facility reductions, contract close out and related expenses associated with downsizing account for about half of the charge; the balance relates to the write-off of costs incurred for development, retooling and start-up for defense conversion initiatives, notably the K-MAX commercial helicopter. During future periods, the corporation will work to successfully implement the elements of this restructuring. The corporation's operating income was relatively even and net earnings were up 2.4% for the year ended December 31, 1992 compared to 1991. Diversified Technologies operating profits for 1992 were down by 6.9% and Distribution segment operating profits were up by 19%. The Diversified Technologies segment results were primarily attributable to reductions in defense spending, research and development expenditures which increased by 27% in 1992 and by 42% in 1991, the ongoing shift in its business mix to products and services with somewhat lower profit margins and continued program costs associated with qualification of the SH- 2G helicopter. The Distribution segment's performance was primarily the result of increased sales and internal initiatives to increase the efficiency of operations. The fully diluted loss per share figure for 1993 does not reflect the potential conversion of the 6% convertible subordinated debentures, potential conversion of the corporation's new Series 2 Preferred Stock (issued in the fourth quarter) or the exercise of stock options, since their effect was anti-dilutive. Fully diluted earnings per share figures for 1992 and 1991 include the potential conversion of the debentures and exercise of stock options since they were dilutive. Interest expense was relatively flat for 1993 compared to a decrease of 13.5% in 1992. The corporation had higher average bank borrowings during 1993, however, interest expense was offset somewhat as a result of the exchange of the majority of the outstanding 6% convertible subordinated debentures during the fourth quarter. The reduction in 1992 was due to lower interest rates and lower average bank borrowings. The corporation had other income in 1993 principally due to the net gain realized upon the exchange of the debentures. The corporation recorded an income tax benefit at an overall rate of 28.9% for 1993. This benefit is principally represented by the recording of a deferred tax asset resulting from the charge for the restructuring and other costs. The income tax benefit for 1993 is lower than it otherwise would have been due to the unavailability of certain state income tax benefits on the net operating loss and provisions made for prior years tax examinations. The corporation's consolidated effective income tax rate was 40.1% for 1992 and 1991. Effective January 1, 1993, the corporation adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The cumulative effect of this change in accounting for income taxes determined as of January 1, 1993 was immaterial to the consolidated statements of earnings. Effective January 1, 1993, the corporation adopted Statement of Financial Accounting Standards No. 106 concerning rules for certain post-retirement benefits. Retirees are generally responsible for the cost of their post-retirement benefits, therefore, adoption of this statement did not result in any material adjustment to or disclosure in the consolidated financial statements. Effective January 1, 1993, the corporation also adopted Statement of Financial Accounting Standards No. 112 concerning accounting for certain post-employment benefits. Adoption of this statement did not result in any material adjustment to or disclosure in the consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES The corporation's cash flow from operations has generally been sufficient to finance a significant portion of its working capital and other capital requirements. During 1993, however, investments of cash from operations into the corporation's developing programs resulted in the need to supplement cash flow from operations with increased average bank borrowings. During the third quarter of 1993, the corporation made an offer pursuant to which holders of its 6% convertible subordinated debentures might exchange them for the corporation's newly created Series 2 Preferred Stock. The purpose of the offer was to increase the corporation's equity capital while reducing its indebtedness. On October 22, 1993 the corporation exchanged $61.8 million of debentures (66.73% of the amount actually tendered) for $57.2 million of preferred stock (285,837 shares of preferred stock represented by 1,143,348 depositary shares). The preferred stock is convertible to Class A common stock at a price of $12.56 per share and has a 6.5% cumulative dividend rate. The corporation recorded a net gain of $3 million as a result of the exchange. While the transaction was favorable to the corporation from a debt to equity standpoint, it resulted in further dilution of outstanding common stock in the event of conversion of the preferred stock and some dilution of the earnings that would otherwise be available for common shareholders. For general borrowing purposes, the corporation has revolving credit agreements involving several banks located in the U.S., Canada and Europe. These agreements currently provide unsecured lines of credit totaling $145 million and contain various covenants, including working capital and tangible net worth requirements. Eighty million dollars of the total revolving credit commitment is scheduled to end in January, 1996 with the balance expiring in September, 1996, at which time borrowings may be converted to term loans. There were no borrowings under these agreements during 1993 or 1992. The corporation also maintains other short-term credit arrangements with various banks. As of December 31, 1993, these bank borrowings were at $31.2 million. Average bank borrowings against these short-term arrangements were approximately $43.2 million in 1993 compared to $16.7 million for 1992. The corporation began a stock repurchase program in 1987, predominantly for the purpose of meeting the needs of its Employees Stock Purchase Plan and Stock Incentive Plan; the program was renewed in early 1992 authorizing the purchase of up to 700,000 of the company's Class A shares. Through December 31, 1993, 653,000 shares had been repurchased under the renewed program. The corporation believes that its cash flow from operations and available unused bank lines of credit under its revolving credit agreements will be sufficient to finance its working capital and other capital requirements for the foreseeable future. SELECTED QUARTERLY FINANCIAL DATA - --------------------------------- Gross profit for 1993 excludes the effect of restructuring and other costs. The conversion of the convertible subordinated debentures (and to the extent applicable the Series 2 preferred stock) along with the exercise of the stock options were not assumed in the net loss per common share - primary and fully diluted calculations for the third quarter of and year 1993 because they had an anti- dilutive effect. As a result, the quarterly per common share amounts when added together do not equal the total for the year 1993. CONSOLIDATED BALANCE SHEETS Kaman Corporation and Subsidiaries December 31, 1993 and 1992 (In thousands except share and per share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF EARNINGS Kaman Corporation and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (In thousands except per share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Kaman Corporation and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (In thousands except share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Kaman Corporation and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (In thousands) SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: On October 22, 1993, the corporation exchanged $61,804 of its 6% convertible subordinated debentures for $57,167 of its new Series 2 preferred stock. See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Kaman Corporation and Subsidiaries December 31, 1993, 1992 and 1991 (In thousands except share and per share amounts) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the parent corporation and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS Excess funds are invested in cash equivalents which consist of highly liquid investments with original maturities of three months or less. LONG-TERM CONTRACTS-REVENUE RECOGNITION Certain sales are made under fixed price and cost reimbursement type contracts. Estimated profits under such contracts are recorded concurrently with costs incurred thereon on the basis of percentage of completion. Any anticipated total contract losses are charged to operations during the period the loss is first indicated. Profits and losses accrued include the cumulative effect of changes in prior periods' price and cost estimates. INVENTORIES Inventory of merchandise for resale and parts are stated at cost (using the average costing method) or market, whichever is lower. Contracts and work in process are valued at production cost represented by material, labor and overhead, including general and administrative expenses where applicable. Contracts and work in process are not recorded in excess of net realizable values. PROPERTY, PLANT AND EQUIPMENT Depreciation of property, plant and equipment is computed primarily on a straight-line basis over the estimated useful lives of the assets. At the time of retirement or disposal, the acquisition cost of the asset and related accumulated depreciation are eliminated and any gain or loss is credited or charged against income. Maintenance and repair items are charged against income as incurred, whereas renewals and betterments are capitalized and depreciated. GOODWILL Amortization of goodwill is calculated on a straight-line method over its estimated useful life but not in excess of forty years. Such amortization amounted to $1,268 in 1993, $1,265 in 1992 and $1,261 in 1991. Accumulated amortization amounted to $9,998 at December 31, 1993. RESEARCH AND DEVELOPMENT Research and development costs not specifically covered by contracts are charged against income as incurred. Such costs amounted to $18,350 in 1993, $17,778 in 1992 and $13,995 in 1991. INCOME TAXES The corporation adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, effective January 1, 1993. Under the asset and liability method prescribed by SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases using enacted tax rates expected to apply in the years in which temporary differences are expected to be recovered or settled. Prior to adopting SFAS 109, deferred income taxes were recorded for differences in the recognition of items of income and expense for financial and tax reporting purposes using the tax rates applicable in the year of the calculation. RESTRUCTURING AND OTHER COSTS The corporation recorded a pre-tax charge of $69,500 in the third quarter of 1993 which resulted in a net loss of $28,800 for the year. The third quarter charge reflects restructuring and other non- recurring costs which the corporation has incurred or expects to incur in the next 24 months as it develops defense conversion initiatives and downsizes the defense and commercial aircraft manufacturing business of the Diversified Technologies segment. About half of the charge is attributable to personnel and facility reductions, contract close out and related expenses associated with downsizing; the balance relates to the write-off of costs incurred for development, retooling and start-up for defense conversion initiatives, notably the K-MAX "aerial truck" commercial helicopter. EXCHANGE OF CONVERTIBLE SUBORDINATED DEBENTURES On October 22, 1993, pursuant to an exchange offer to all debentureholders, the corporation exchanged $61,804 of its 6% convertible subordinated debentures for $57,167 of its new 6 1/2% cumulative convertible Series 2 preferred stock (convertible into Class A common stock at $12.56 per share). The pre-tax gain on the exchange of the debentures was $3,037 net of expenses of approximately $1,600. Additional issuance expenses of $400 were charged directly to additional paid-in capital. ACCOUNTS RECEIVABLE Accounts receivable consist of the following: Recoverable costs and accrued profit-not billed represent costs incurred on contracts, including contract retentions, which will become billable upon future deliveries or completion of engineering and service type contracts. Management estimates that approximately $6,500 of such costs and accrued profits at December 31, 1993 will be collected after one year. INVENTORIES Progress payments of approximately $7,100 and $8,500 were netted against contracts in process at December 31, 1993 and 1992, respectively. The aggregate amounts of general and administrative costs allocated to inventories during 1993, 1992 and 1991 were $57,654, $54,277 and $56,044, respectively. The estimated amounts of general and administrative costs remaining in inventories at December 31, 1993 and 1992 amount to $5,141 and $8,915, respectively, and are based on the ratio of such allocated costs to total costs incurred. PROPERTY, PLANT AND EQUIPMENT, NET CREDIT ARRANGEMENTS - SHORT-TERM BORROWINGS AND LONG-TERM DEBT SHORT-TERM BORROWINGS The corporation has arrangements with several banks to borrow funds on a short-term basis with interest at current market rates. There were borrowings of $31,161 outstanding under these arrangements at December 31, 1993. LONG-TERM DEBT The corporation has long-term debt as follows: REVOLVING CREDIT/TERM LOAN AGREEMENTS The corporation has two revolving credit/term loan agreements involving several domestic and foreign lenders, with an aggregate maximum commitment of $145,000. Interest under both agreements is payable at various market rates. With respect to $80,000 of the total commitment, the revolving credit period ends on January 2, 1996 whereupon outstanding borrowings may be converted to a term loan, payable in twelve equal quarterly installments. As to the balance of the commitment, the revolving credit period ends on September 30, 1996 at which time outstanding borrowings may be converted to a term loan payable in sixteen equal quarterly installments. CONVERTIBLE SUBORDINATED DEBENTURES The corporation issued $95,000 of its 6% convertible subordinated debentures during 1987. The debentures are convertible into shares of the Class A common stock of Kaman Corporation at any time on or before March 15, 2012 at a conversion price of $23.36 per share at the option of the holder unless previously redeemed by the corporation. Pursuant to a sinking fund requirement beginning March 15, 1997, the corporation will redeem 5% of the outstanding principal amount of the debentures annually. The debentures are subordinated to the claims of senior debt holders and general creditors. The corporation exchanged $61,804 of these debentures for its new Series 2 preferred stock on October 22, 1993. The remaining debentures have a fair value of $28,200 at December 31, 1993 based upon current market prices. OTHER OBLIGATIONS These obligations consist primarily of notes issued by the corporation to industrial and economic development authorities in connection with the issuance of their bonds in similar amounts. The proceeds were used by the corporation to finance certain of its building construction within the regions of the authorities. These obligations are secured by mortgages and generally have interest rates and payment terms more favorable than conventional financing. LONG-TERM DEBT ANNUAL MATURITIES The aggregate amounts of annual maturities of long-term debt for each of the next five years are approximately as follows: RESTRICTIVE COVENANTS The most restrictive of the covenants contained in the loan agreements require the corporation to have operating income, as defined, at least equal to 250% of interest expense, consolidated current assets at least equal to 160% of consolidated current liabilities and consolidated net worth at least equal to $175,600 at December 31, 1993. INTEREST PAYMENTS Cash payments for interest were $8,092, $7,103 and $8,607 for 1993, 1992 and 1991, respectively. INCOME TAXES The corporation adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, effective January 1, 1993. The cumulative effect of this change in accounting for income taxes determined as of January 1, 1993 was immaterial to the consolidated statements of earnings. The components of income taxes are as follows: Deferred income taxes are recorded for differences in the recognition of certain items of income and expense for financial and tax reporting purposes. The sources of these differences and the tax effect of each are as follows: The components of the deferred tax assets and deferred tax liabilities as of December 31, 1993 are presented below: No valuation allowance has been recorded because the corporation believes that these deferred tax assets will, more likely than not, be realized. This determination is based largely upon the corporation's historical earnings trend as well as its ability to carry back reversing items within three years to offset taxes paid. In addition, the corporation has the ability to offset deferred tax assets against deferred tax liabilities created for such items as depreciation and amortization. The provisions for federal income taxes approximate the amounts computed by applying the U.S. federal income tax rate to earnings (loss) before income taxes after giving effect to state income taxes. The federal tax benefit in 1993 has been reduced $1,800 to provide for prior years' tax examinations. Cash payments for income taxes were $7,988, $15,708 and $15,580 in 1993, 1992 and 1991, respectively. PENSION PLAN The corporation has a non-contributory defined benefit pension plan covering all of its full-time employees. Benefits under this plan are based upon an employee's years of service and compensation levels during employment and there is an offset provision for social security benefits. It is the corporation's policy to fund pension costs accrued. Plan assets are invested in a diversified portfolio consisting of equity and fixed income securities (including $7,721 of Class A common stock of Kaman Corporation at December 31, 1993). The pension plan costs were computed using the projected unit credit actuarial cost method and include the following components: The funded status of the pension plan is as follows: The actuarial assumptions used in determining the funded status of the pension plan are as follows: The expected long-term rates of return on plan assets used to compute the net periodic pension costs were 9 1/4% for 1993 and 9 1/2% for 1992. COMMITMENTS AND CONTINGENCIES Rent commitments under various leases for office space, warehouse, land and buildings expire at varying dates from January 1994 to December 2012. Certain annual rentals are subject to renegotiation, with certain leases renewable for varying periods. Lease periods for machinery and equipment vary from 1 to 7 years. Substantially all real estate taxes, insurance and maintenance expenses are obligations of the corporation. It is expected that in the normal course of business, leases that expire will be renewed or replaced by leases on other properties. The following future minimum rental payments are required under operating leases that have initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993: Lease expense for all operating leases, including leases with terms of less than one year, amounted to $15,172, $15,221 and $15,650 for 1993, 1992 and 1991, respectively. From time to time, the corporation is subject to various claims and suits arising out of the ordinary course of business, including commercial, employment and environmental matters. While the ultimate result of all such matters is not presently determinable, based upon its current knowledge, management does not expect that their resolution will have a material adverse effect on the corporation's consolidated financial position. COMPUTATION OF EARNINGS (LOSS) PER COMMON SHARE The primary earnings (loss) per common share computation is based on the weighted average number of shares of common stock outstanding in 1993, 1992 and 1991 and includes the common stock equivalency of options granted to employees under the stock incentive plan. The fully diluted earnings per share computation also assumes that the 6% convertible subordinated debentures were converted at their date of issuance with the resultant reduction in interest costs net of tax and the additional dilutive effect of the stock options. Subsequent to the exchange of debentures for Series 2 preferred stock on October 22, 1993, the corporation added the preferred stock dividend requirement of $702 for the balance of 1993 to its net loss to arrive at net loss applicable to common stock to calculate its loss per common share-primary for 1993. In addition, in order to determine the fully diluted loss per common share, it is assumed that the Series 2 preferred stock would be converted into Class A common stock from its date of issuance and the preferred stock dividend requirement eliminated. Due to the net loss during 1993, however, the dilutive effect from conversion of the outstanding 6% convertible subordinated debentures and the Series 2 preferred stock is anti- dilutive and accordingly not included in the computation. EMPLOYEES STOCK PURCHASE PLAN The Kaman Corporation Employees Stock Purchase Plan allows employees to purchase Class A common stock of the corporation, through payroll deductions, at 85% of the market value of shares at the time of purchase. The plan provides for the grant of rights to employees to purchase a maximum of 1,500,000 shares of Class A common stock of the corporation commencing July 1, 1989. There are no charges or credits to income in connection with the plan. During 1993, 241,808 shares were issued to employees at prices ranging from $7.86 to $9.78 per share. During 1992, 226,296 shares were issued to employees at prices ranging from $7.33 to $8.82 per share. During 1991, 252,837 shares were issued to employees at prices ranging from $6.59 to $8.08 per share. Effective November 1, 1993, the maximum number of shares available for issuance under the Plan was replenished to 1,500,000 shares, subject to shareholder approval at the 1994 annual meeting of shareholders. At December 31, 1993, there were approximately 1,457,000 shares available for offering under the plan. STOCK INCENTIVE PLAN On September 20, 1993, the corporation adopted the 1993 Stock Incentive Plan--to be effective November 1, 1993 and subject to shareholder approval at the 1994 annual meeting of shareholders. The 1993 Plan includes a continuation and extension of the stock incentive program of the corporation set forth in the 1983 Stock Incentive Plan which terminated on October 31, 1993. The 1993 Plan provides for the grant of non-statutory stock options, incentive stock options, restricted stock awards and stock appreciation rights primarily to officers and other key employees. The corporation has designated 962,199 shares of its Class A common stock for this plan, including 2,199 shares previously reserved under the 1983 plan. Stock options are generally granted at prices not less than the fair market value at the date of grant. Options granted under the plan generally expire ten years from the date of grant and are exercisable on a cumulative basis with respect to 20% of the optioned shares on each of the five anniversaries from the date of grant. Restricted stock awards are generally granted with restrictions that lapse at the rate of 20% per year and are amortized accordingly. These awards are subject to forfeiture if a recipient separates from service with the corporation. Stock appreciation rights generally expire ten years from the date of grant and are exercisable on a cumulative basis with respect to 20% of the rights on each of the five anniversaries from the date of grant. At December 31, 1993, there were outstanding options issued under the plan for the purchase of 807,893 shares at prices ranging from $7.50 to $13.83 per share. As of that date options covering 463,363 shares were exercisable at $7.50 to $13.83 per share. Options for 37,929, 16,550 and 11,960 shares were exercised during 1993, 1992 and 1991, respectively, at prices ranging from $3.98 to $9.48 per share. Restricted stock awards were made for 34,000 shares at $9.50 per share in 1993, 36,000 shares at $9.88 per share in 1992 and 39,500 shares at $8.00 per share in 1991. At December 31, 1993, there were 115,900 shares remaining subject to restrictions pursuant to these awards. No stock appreciation rights have been issued under the plan. SEGMENT INFORMATION The corporation serves government, industrial and commercial markets through two industry segments Diversified Technologies and Distribution. Through its diversified technologies operations, the corporation provides a range of technical professional services involving either advanced information technologies or high technology science and engineering to government and industrial customers; advanced technology products such as electromagnetic motors, safety and fusing systems; memory systems, sliding bearings, and non-contact measuring systems for military and industrial customers; commercial airframe subcontracting programs, and manufacturing work along with spare parts and logistics for the SH-2 helicopter for the U.S. Navy. Additionally, the development of the K-MAX helicopter, which represents a significant new commercial effort for the corporation, is included in the Diversified Technologies segment. The Diversified Technologies' segment operating loss for 1993 includes the impact of the $69,500 charge for restructuring and other costs accrued in the third quarter to address various downsizing and product conversion efforts. Through its distribution operations, the corporation supplies nearly every sector of industry with industrial replacement parts (including bearings, power transmission equipment, fluid power, linear motion, and materials handling items) as well as industrial engineering and systems services. Operations are conducted from approximately 150 service centers located in 28 states and British Columbia, Canada. Our music operations manufacture and distribute musical instruments and accessories in the United States and abroad through both domestic and U.K. based offices. Summarized financial information by business segment is as follows: Operating profit (loss) is total revenues less cost of sales and selling, general and administrative expense (including restructuring and other costs in 1993) other than general corporate expense. Identifiable assets are year-end assets at their respective net carrying value segregated as to industry segment and corporate use. Corporate assets are principally cash and cash equivalents and net property, plant and equipment. Net sales by the Diversified Technologies segment made under contracts with U.S. Government agencies account for $279,530 in 1993, $260,823 in 1992 and $298,482 in 1991. REPORT OF INDEPENDENT AUDITORS KPMG Peat Marwick Certified Public Accountants CityPlace II Hartford, Connecticut 06103 The Board of Directors and Shareholders Kaman Corporation: Under date of January 27, 1994, we reported on the consolidated balance sheets of Kaman Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick Hartford, Connecticut January 27, 1994 SELECTED FINANCIAL DATA - ----------------------- Kaman Corporation and Subsidiaries (In thousands except per share amounts, shareholders and employees) EXHIBIT 21 KAMAN CORPORATION SUBSIDIARIES Following is a list of the Corporation's subsidiaries, each of which is wholly owned by the Corporation either directly or through another subsidiary. Second-tier subsidiaries are listed under the name of the parent subsidiary. Name State of Incorporation - ------------------------------------------------------------------- Registrant: KAMAN CORPORATION Connecticut Subsidiaries: Kaman Diversified Technologies Corporation Connecticut Kaman Aerospace Corporation Delaware Kamatics Corporation Connecticut Kaman Aerospace International Corporation Connecticut Kaman X Corporation Connecticut Kaman Sciences Corporation Delaware Kaman Instrumentation Corporation Connecticut Kaman Electromagnetics Corporation Massachusetts Raymond Engineering Inc. Connecticut AirKaman of Jacksonville, Inc. Connecticut Kaman Industrial Technologies Corporation Connecticut Kaman Industrial Technologies, Ltd. Canada Kaman Music Corporation Connecticut KMI Europe, Inc. Delaware Kaman U.K. Limited Great Britain Trace Elliot Limited Great Britain Advanced Energetic Materials Corporation of America* Delaware Advanced Energetic Materials Corporation of Europe* France * Fifty percent (50%) of voting stock owned by Kaman Corporation EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS KPMG Peat Marwick Certified Public Accountants CityPlace II Hartford, Connecticut 06103 The Board of Directors and Shareholders Kaman Corporation: We consent to incorporation by reference in the Registration Statements (Nos. 33-51483 and 33-51485) on Form S-8 of Kaman Corporation of our reports dated January 27, 1994, relating to the consolidated balance sheets of Kaman Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, changes in shareholders' equity and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993 which reports appear or are incorporated by reference in the December 31, 1993 annual report on Form 10-K of Kaman Corporation. /s/ KPMG Peat Marwick Hartford, Connecticut March 11, 1994 EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned does hereby appoint and constitute Charles H. Kaman and Harvey S. Levenson and each of them as his or her agent and attorney-in-fact to execute in his or her name, place and stead (whether on behalf of the undersigned individually or as an officer or director of Kaman Corporation or otherwise) the Annual Report on Form 10-K of Kaman Corporation respecting its fiscal year ended December 31, 1993 and any and all amendments thereto and to file such Form 10-K and any such amendment thereto with the Securities and Exchange Commission. Each of the said attorneys shall have the power to act hereunder with or without the other. IN WITNESS WHEREOF, the undersigned have executed this instrument this 11th day of March, 1994. /s/Frank C. Carlucci /s/Hartzel Z. Lebed /s/John A. DiBiaggio /s/Harvey S. Levenson /s/Edythe J. Gaines /s/Walter H. Monteith, Jr. /s/Huntington Hardisty /s/John S. Murtha /s/Charles H. Kaman /s/Robert L. Newell /s/C. William Kaman, II /s/Wanda L. Rogers	21,543	139,536
15615_1993.txt	15615_1993	1993	15615	Item 1. BUSINESS General Development of Business: On March 11, 1994, Church & Tower, Inc. ("CT") and Church & Tower of Florida ("CTF" and, together with CT, the "CT Group"), privately held corporations under common control, were acquired (the "Acquisition") through an exchange of stock, by Burnup & Sims Inc., ("Burnup") a Delaware public company. As a result of the Acquisition, the former CT Group shareholders received approximately 65% of shares of Burnup in exchange for 100% of the shares of CT Group. Under generally accepted accounting principles, the Acquisition was accounted for as a purchase by the CT Group and, therefore, the accompanying financial statements and disclosures are those of the CT Group only. Immediately following the Acquisition, the name of Burnup was changed to MasTec, Inc. ("MasTec" or the "Company") and the fiscal year end was changed to December 31. See Condensed Pro Forma Financial Information in the Notes to the Combined Financial Statements for information regarding Burnup. As a result of the Acquisition, the Company will be able to provide a wider range of engineering, cable design, installation and maintenance services to telephone, CATV and utility customers throughout the United States and abroad. The Company will provide such services through subsidiaries located principally in California, Florida, Georgia, Mississippi, North and South Carolina and Texas. In addition, the Company owns a manufacturer of uninteruptible backup power supplies for the CATV industry, a motion picture theater chain in the southeastern U.S. and a commercial printing and graphic arts company. Operations of the Company are somewhat seasonal, and this has historically resulted in reduced revenues during the months of November, December and January relative to other months. During winter months, inclement weather in certain areas reduces the volume and efficiency of outside service activities. Additionally, certain utility services customers may reduce expenditures for outside plant construction and maintenance during the latter part of their budgetary year, which typically ends in December. The sale of the Company's goods and services to foreign markets is expected to generate less than 5% of revenues for fiscal year 1994. Burnup's sales to foreign markets generated less than one percent of revenues for its 1993 fiscal year. The Company is currently pursuing additional offshore opportunities and has entered into joint venture agreements with local partners in certain South American and east European countries to provide telecommunications services. The Company intends to finance its portion of such projects with internally-generated funds and, as necessary, through the redeployment of machinery and equipment, technical expertise and supervisory personnel from certain domestic areas of operation. The CT Group's backlog of orders which is substantially represented by written contracts and purchase orders and does not include work to be performed under telephone and utility master contracts, approximated $9 million at December 31, 1992 related to its General Construction Services. The Company obtains the majority of its raw materials and supplies from customers for which it provides services. Page 3 of 50 CTF was incorporated under the laws of Florida in 1968. Since that date, CTF has performed engineering, construction and maintenance services for regional telephone companies, long distance carriers and private business, including BellSouth Telecommunications ("BellSouth"), pursuant to master contracts covering outside plant work, and customer installation and hookup services for cable television "CATV" subscribers. CTF currently holds three such master contracts, expiring at various times through 1996, for Dade County and south Broward County, Florida. The revenues generated under such contracts constitute approximately 64% of CT Group's total combined revenues. CTF also provides fiber-optic installation services which require specialized skills for BellSouth and alternate access providers. Customers typically supply materials such as poles, cable, conduit and telephone equipment, and the CT Group provides expertise, tools and equipment necessary to perform the installation services and engineering and other types of personnel to supplement day-to-day requirements of telephone companies and to meet their emergency and peak load maintenance and installation needs. CTF also provides construction and maintenance services under individual contracts to local utilities, including the Miami-Dade Water and Sewer Authority. The services provided to telephone, CATV and utility companies are collectively referred to as Utilities Services. CT was incorporated under the laws of Florida in 1990 to engage in selected construction projects in the public and private sectors ("General Construction Services"). In 1990, a joint venture (the "9001 Joint Venture"), of which CT is the majority partner, was established for the purpose of constructing a detention facility in Dade County with a capacity of approximately 2,500 beds. The detention facility was completed in 1993. In September 1990, CT entered into a joint venture (the "OCT Joint Venture") of which CT is a 20% minority partner with Constructora Norberto Odebrecht, an international construction contractor, to construct governmental projects. The OCT Joint Venture has completed the Brickell Extension Project of the City of Miami's Metro Mover, an elevated transportation system, and has as of December 31, 1993 completed approximately 56% of the construction of a landfill in south Dade County. In May 1992, CT merged with Communication Contractors, Inc., an affiliate of CTF engaged primarily in providing manpower and equipment to CTF. Since the merger, work under the BellSouth master contracts has been primarily subcontracted to CT. In the latter part of 1992, the CT Group entered into a joint venture for the removal of debris related to Hurricane Andrew. The CT Group has a 25% interest in this venture and recorded approximately $1,087,000 of income during 1993 related to its equity in the earnings of this venture. The venture was essentially completed in 1993. See "Business Segments" in Note 11 to the Combined Financial Statements for information related to revenues, operating profits, and identifiable assets of each of the CT Group's principal business segments. At December 31, 1993, the CT Group employed 437 people and Burnup employed 1,999 people. Page 4 of 50 As previously mentioned, the CT Group operates primarily in two industry segments: the Utilities Services and General Construction Services. See Note 4 to the Combined Financial Statements for information related to revenues derived from work performed under MasTec contract. The Company may be compensated on an hourly basis or at a fixed unit price for services rendered. Master contracts are generally for one to three year terms and may be terminated upon 60 days notice by either party. Master contracts may be renewed through negotiations between the Company and its customers or customers may elect to award these contracts on the basis of competitive bidding. Burnup's telephone and cable television and utility services industry segment operate in substantially the same manner as the CT Group's Utilities Services industry segment. However, Burnup provides its services in approximately 35 states and certain foreign countries. Additionally, Burnup operates a motion picture theatre chain consisting of 94 screens at 32 locations in Florida and two locations in Georgia. Twenty-two of the theatres are indoor and 12 are drive-ins. The Company derives a substantial portion of its theatre revenues and profits from food and beverage concessions which it operates in all of the theatres. The market for Utilities Services is highly competitive and management believes the factors for success include quality, reliability, price and promptness of performance. Although most companies in this field tend to operate in a limited geographical area, a number of competitors may bid on a particular project without regard to location. On a national basis, neither the Company nor any of its competitors can be considered dominant in the industry, which is fragmented and characterized by a large number of small companies. Changes in the level of telephone company capital expenditures, influenced by prevailing interest rates and the allowance or disallowance of telephone rate increases by public regulatory agencies, may affect the volume of work available to the Company. Additionally, certain telephone companies may utilize their own personnel to perform all or some part of the types of services provided by the Company. The CATV industry is regulated by local, state and federal laws, and such governmental regulation has a direct effect upon whether new CATV systems are built or existing systems are improved, thus directly affecting the availability of work for which the Company may compete. The industry is characterized by a large number of companies which provide CATV services. Providing General Construction services to the public and private sectors is highly competitive. Projects are awarded based on a bidding process. The Company's theatres exhibit first, second and third run films of major motion picture distributors. The availability of popular films has a significant effect on both admission and concession revenues. The Company's theatre operations are highly dependent on major film distributors for an adequate supply of such films. The Company competes with numerous other film exhibitors and entertainment attractions in its operating areas. The Company also offers commercial printing products and graphic arts services. The principal customers are businesses located in Florida and the northeast United States. The printing business is extremely competitive and no one company is considered dominant. Page 5 of 50 Environment The Company's facilities are subject to federal, state, and local provisions involving the protection of the environment. Accruals for environmental matters are recorded in operating expenses when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. To determine appropriate accrual amounts, management and outside experts review currently available facts to evaluate the probability and scope of potential liability. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, evolving governmental standards regarding liability, and changing technologies for handling site remediation and restoration. At December 31, 1993, $630,000 had been accrued for site remediation and is reflected in the Balance Sheet as part of "Other current liabilities" with a corresponding amount charged to costs of revenues. It is estimated that future additional costs, if any, in this respect will not be significant. Item 2. Item 2. PROPERTIES The CT Group's principal facilities are located in South Florida and consist of offices, equipment yards and temporary storage locations. The CT Group does not consider any specific owned or leased facility to be indispensable to its operations since much of the work is performed upon the customer's premises or upon public rights-of-way. In addition, the CT Group believes that equally suitable alternative locations are available in all areas where it currently does business. Burnup owns two indoor and eight drive-in theatres located on approximately 117 acres in ten Florida cities and leases 18 indoor and three drive-in theatres located in 19 Florida cities and two indoor locations in south Georgia. Substantially all of the leased theatres are subject to long-term leases, many of which contain long-term renewal options that are exercisable at the discretion of the Company. Burnup also owns a 60,000 square-foot printing plant located in Stuart, Florida and a 50,000 square foot manufacturing plant located in Athens, Georgia, each of which currently operates at less than full capacity. Other operations, principally telephone services, are conducted through approximately 53 subsidiary and branch locations, of which approximately 31 are owned. A majority of the leased facilities consists of offices and temporary equipment yards or storage locations which are subject to short-term or cancelable leases. At December 31, 1993, the CT Group operated approximately 250 licensed vehicles, all of which are owned. In addition, it owns various types of construction equipment including approximately 65 off-road vehicles. Burnup operated approximately 1,400 licensed vehicles, substantially all of which are owned. In addition, it owns various types of construction equipment including approximately 600 off-road vehicles. The CT Group believes that its properties, as well as Burnup's, are generally in good condition and suitable for their intended uses. The Company has no material amounts of idle equipment. Page 6 of 50 In addition to its operating properties, Burnup owns approximately 1,850 acres of real estate located throughout central and southwest Florida which are being held for investment purposes as well as a 124,000 square foot plant located on approximately 43 acres in Freehold, New Jersey. Certain of the Company's properties and vehicles are encumbered pursuant to loan agreements. Item 3. Item 3. LEGAL PROCEEDINGS The following is a summary of legal proceedings involving the Company. Albert H. Kahn v. Nick A. Caporella, et al., Civil Action No. 11890 was filed on December 1990 by a stockholder of the Company in the Court of Chancery of the State of Delaware in and for New Castle County against the Company, the members of the Board of Directors, and against National Beverage Corporation ("NBC"), as a purported class action and derivative lawsuit. In May 1993, plaintiff amended its class action and shareholder derivative complaint (the "Amended Complaint"). The class action claims allege, among other things, that the Board of Directors, and NBC, as its then largest stockholder, breached their respective fiduciary duties in approving (i) the distribution to the Company's stockholders of all of the common stock of NBC owned by it (the "Distribution") and (ii) the exchange by NBC of 3,846,153 shares of Common Stock for certain indebtedness of NBC held by the Company (the "Exchange") (the Distribution and the Exchange are hereinafter referred to as the "1991 Transaction"), and allegedly placing the interests of NBC ahead of the interests of the other stockholders of the Company. The derivative action claims allege, among other things, that the Board of Directors has breached its fiduciary duties by approving executive officer compensation arrangements, by financing NBC's operations on a current basis, and by permitting the interests of the Company to be subordinated to those of NBC. In the lawsuit, plaintiff seeks to rescind the 1991 Transaction and to recover damages in an unspecified amount. The Amended Complaint alleges that the Special Transaction Committee that approved the 1991 Transaction was not independent and that, therefore, the 1991 Transaction was not protected by the business judgment rule or conducted in accordance with a settlement agreement (the "1990 Settlement") entered into in 1990 pertaining to certain prior litigation. The Amended Complaint also makes to other allegations which involve (i) further violations of the 1990 Settlement by the Company's engaging in certain transactions not approved by the Special Transaction Committee; (ii) the sale of a subsidiary of the Company to a former officer of the Company, (iii) the timing of the 1991 Transaction and (iv) the treatment of executive stock options in the 1991 Transaction. In November 1993, plaintiff filed a class action and derivative complaint, Civil Action 13248, (the "1993 Complaint") against the Company, the members of the Board of Directors, CT, CTF, Jorge Mas Canosa, Jorge Mas and Juan Carlos Mas (CT,CTF, Jorge Mas Canosa, Jorge Mas and Juan Carlos Mas are referred to as the "CT Defendants"). In December 1993, plaintiffs amended the 1993 Complaint ("1993 Amended Complaint"). The 1993 Amended Complaint alleges, among other things, that (i) the Board of Directors and NBC, as the Company's largest stockholder at the time, breached their respective fiduciary duties by approving the Acquisition Agreement and the Redemption (as defined in the Proxy Statement dated February 10, 1994) which, according to the allegations of the 1993 Complaint, benefits Mr. Caporella at the expense of the Company's stockholders, Page 7 of 50 (ii) the CT Defendants had knowledge of the fiduciary duties owed by NBC and the Board of Directors and knowingly and substantially participated in their breaches thereof, and (iii) the Special Transaction Committee of the Board of Directors which approved the Acquisition Agreement and Redemption was not independent and, as such, was not in accordance with the 1990 Settlement, (iv) the Board of Directors breached its fiduciary duties by failing to take an active and direct role in the sale of the Company and failing to ensure the maximization of stockholder value in the sale of control of the company; and (v) the Board of Directors and NBC, as the Company's largest stockholder at the time, breached their respective fiduciary duties by failing to disclose completely all material information regarding the Acquisition Agreement and the Redemption. The 1993 Complaint also claims derivatively that each member of the Board of Directors engaged in mismanagement, waste and breach of their fiduciary duties in managing the Company's affairs. On November 29, 1993, plaintiff filed a motion for an order preliminarily and permanently enjoining the Acquisition and the Redemption. On March 7, 1994, the court heard arguments with respect to plaintiff's motion to enjoin the Acquisition and Redemption and on March 10, 1994, the court denied plaintiff's request for injunctive relief. The Company believes that the allegations in the complaint, the Amended Complaint and the 1993 Complaint and the 1993 Amended Complaint are without merit, and intends to vigorously defend this action. William C. Deviney, Jr. v. Burnup & Sims Inc., et al. Civil Action No. 152350 was filed in the Chancery Court of the First Judicial District of Hines County, Mississippi on May 3, 1993. The plaintiff in this action filed suit seeking specific performance of alleged obligations of the Company pursuant to a stock purchase agreement and related agreements entered into in 1988. Pursuant to the agreements, the Company sold to plaintiff a minority interest in a Telephone Services subsidiary and granted to plaintiff an option to purchase the remaining stock if certain conditions were satisfied. Alternatively, plaintiff seeks unspecified damages for breach of contract and for alleged breaches of fiduciary duties, and seeks an award of punitive damages and attorneys' fees for alleged bad faith conduct in connection with the stock purchase agreement and related matters. The Company believes that the allegations in the complaint are without merit and is vigorously defending this action. Additionally, the Company has filed counterclaims which, among other things, seek a declaratory judgment that the plaintiff's failure to satisfy certain material conditions terminated his rights under the stock purchase agreement. The evidentiary portion of the trial proceedings relative to these actions concluded on November 19, 1993. On June 8, 1994 the judge entered an Opinion of The Court which held for the Plaintiffs without specifying damages pending the issuance of a judgment. The opinion denied punitive damages against the Company. In the opinion of management, the ultimate outcome of the legal proceedings is not expected to have a material adverse effect on the financial position of the Company. Jorge Gamez, as Personal Representative of the Estate of Jorge A. Gamez, deceased, vs. Church & Tower, Inc., a Florida corporation, et al. Civil Action 93-07318 CA 20, filed in the Circuit Court of the 11th Judicial Circuit in and for Dade County, Florida on March 22, 1993, and amended on April 20, 1994, to include MasTec, Inc. The claim alleges that a CT Group employee was negligent in the operation of a truck and trailer combination which resulted in a death. Although no amounts are stated in the preliminary case filings, the plaintiff has made a demand for $7.2 million. Page 8 of 50 The Company is also a defendant in other legal actions arising in the normal course of business. Management believes, based on consultations with its legal counsel, that the amount provided in the financial statements of the Company are adequate to cover the estimated losses expected to be incurred in connection with these matters. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no vote of security holders during the fourth quarter of the last fiscal year. On March 11, 1994, however, security holders of the Company voted on certain matters. Results of votes of security holders are included in the Company's quarterly report for the period ended March 31, 1994 and are hereby incorporated by reference. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The following information relates to the Company's common stock, par value $.10 per share, (the "Common Stock") which currently trades on the NASDAQ National Market System under the symbol MASX (formerly BSIM). The high and low closing quotations of the Common Stock for each quarter of the last two fiscal years, as reported by NASDAQ, are set forth below: 1993 1992 High Low High Low First Quarter $ 3 7/16 $ 2 5/8 $ 8 3/4 $ 6 3/4 Second Quarter 2 7/16 2 8 1/4 4 Third Quarter 4 1/8 1 7/8 5 1/8 3 3/4 Fourth Quarter 5 5/16 3 5/16 6 2 7/8 No cash dividends were declared for the years ended December 31, 1993 and 1992 with respect to the Company. See Note 3 to the Combined Financial Statements for information concerning the payment of dividends to the CT Group shareholders. Item 6. Item 6. SELECTED FINANCIAL DATA Five-year Summary of Operations and Financial Information The following tables present summary historical combined financial information of CT Group, summary unaudited consolidated financial data for Burnup and summary unaudited pro forma consolidated financial data for the Company. The unaudited pro forma operating statement data for fiscal 1993 and 1992 assume that the Acquisition had occurred on January 1, 1992. The unaudited pro forma balance sheet data assume that the Acquisition had occurred on December 31, 1993. The unaudited pro forma consolidated financial data do not purport to represent what the Company's consolidated results of operations or financial position actually would have been had the Acquisition occurred on the dates indicated, or to project the Company's results of operations or financial position for any future period or date. The summary unaudited pro forma data should be read in conjunctin with the Combined Financial Statements. Page 9 of 50 (In Thousands, Except Earnings Per Common Share) CT Group Years Ended December 31 1993 1992 1991 1990 1989 Statement of Operations Data: Contract Revenue $ 44,683 $ 34,136 $ 31,588 $ 18,640 $ 15,670 Costs and Expenses 39,108 25,441 25,841 14,196 12,896 Income from Operations 5,575 8,695 5,747 4,444 2,774 Net Income 6,752 8,280 5,301 4,757 3,093 Common Shares Outstanding (1) 10,250 10,250 10,250 10,250 10,250 Earnings per Common Share (1) $ 0.66 $ 0.81 $ 0.50 $ 0.47 $ 0.30 Balance Sheet Data (at end of period): Working Capital $ 9,091 $ 12,767 $ 7,154 $ 5,209 $ 4,254 Property - Net 4,632 3,656 2,406 2,100 2,039 Total Assets 21,325 23,443 11,733 8,849 7,613 Non-Current Debt 3,579 855 371 333 323 Stockholders' Equity(2) 10,942 15,690 9,436 7,296 6,127 Burnup Years Ended January 31 1994 1993 1992 1991 1990 Statement of Operations Data: Contract Revenue $137,732 $143,990 $155,254 $188,656 $181,474 Costs and Expenses 147,953 148,720 153,612 192,983 175,724 Income (Loss) from Operations (10,221) (4,730) 1,642 (4,327) 5,750 Net Income (7,294) (2,992) 731 (3,138) 4,384 Common Shares Outstanding 8,768 8,768 8,768 9,664 9,662 Earnings per Common Share $ (0.83) $ (0.34) $ 0.08 $ (0.32) $ 0.45 Balance Sheet Data (at end of period): Working Capital $ 17,308 $ 19,175 $ 24,003 $ 27,009 $ 50,266 Property - Net 16,875 18,252 22,760 24,234 30,927 Total Assets 101,798 107,550 116,816 131,914 148,488 Non-Current Debt 32,028 37,036 38,506 38,095 47,082 Stockholders' Equity 33,988 40,098 43,090 58,966 61,962 Page 10 of 50 Pro Forma (3) (CT Group and Burnup Combined) Years Ended December 31, 1993 1992 Statement of Operations Data: Contract Revenue $182,415 $178,126 Costs and Expenses 187,449 176,590 Income (Loss) from Operations (5,034) 1,536 Net Income (Loss) (2,621) 724 Common Shares Outstanding (4) 15,865 15,865 Earnings (Loss) per Common Share (4) $ (0.17) $ 0.05 Balance Sheet Data (at end of period): Working Capital $ 18,581 Property - Net 44,048 Total Assets 137,112 Non-Current Debt 35,607 Stockholders' Equity 44,311 (1) Reflects the shares of the Company's common stock received by the former stockholders of the CT Group pursuant to the Acquisition. (2) See Note 3 to the Combined Financial Statements regarding dividends declared. (3) The pro forma amounts have been prepared based upon the same assumptions as are used in preparing the Pro Forma Condensed Financial Statements included in the notes to the financial statements. (4) Reflects the shares which would have been outstanding had the Acquisition occured on January 1, 1992. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of financial condition and results of operations should be read in conjunction with the Combined Financial Statements and notes thereto included elsewhere herein. Results of Operations Revenues Revenues for the fiscal year ended December 31, 1993, were $44,683,403 compared to $34,135,788 for the year ended December 31, 1992 and $31,588,228 for the year ended December 31, 1991. These increases resulted primarily from an increase in the CT Group's customer base coupled with an increase in the volume of work from BellSouth arising in connection with the rebuilding necessitated by Hurricane Andrew, the expansion of outside plant systems approved under BellSouth's increased Master Budget Plan and the growth in private sector telecommunication projects. The revenues generated by services provided to BellSouth constitutes substantially all of the increase in total combined revenues. Accordingly, the loss of all or a significant portion of work from BellSouth could have a material adverse impact on the CT Group's results of operations. Page 11 of 50 As a result of the Acquisition, the Company will adjust the value of certain assets and liabilities in accordance with generally accepted accounting principles. See Note 13 to the Combined Financial Statements for a detailed description of the adjustments. As a result of these adjustments, on a pro forma basis for fiscal year 1993 and 1992, assuming that the Acquisition was effective on January 31, 1992, the Company would have reported a net loss of $2.6 million for 1993 and net income of $0.7 million for 1992. Pro Forma Revenue Revenues in 1993 would have increased by $4.3 million as a result of an increase in the volume of work by the CT Group from BellSouth arising in connection with the rebuilding necessitated by Hurricane Andrew, offset by a decline in revenue generated by Burnup as a result of uncommonly harsh winter conditions which reduced the volume and efficiency of outside plant service activity. Pro Forma Operating Costs and Expenses Cost of revenues would have increased from $148.4 million to $154.1 million and would have been 85% and 83% as a percentage of revenues for 1993 and 1992, respectively. The decrease in gross profit reflects and losses incurred on Burnup's telephone service contracts, mobilization expenses related to changes in geographic areas of operation, and start-up costs caused by the diversification of commercial printing services offered by Burnup. General and administrative expenses for the year would have increased by $8 million from $20.4 million for 1992 to $28.4 million for 1993. This increase would have been primarily due to bonuses paid to certain employee/shareholders of the CT Group as a result of a change in tax status in contemplation of Acquisition, as well as increased stock option compensation incurred by Burnup based upon an increase in the market value of the common stock coupled with non-recurring expenses associated with provisions for litigation and environmental expenditures recorded by the CT Group. Expressed as a percentage of revenues, general and administrative expenses would have been 16% in 1993 and 11% in 1992. Depreciation and amortization would have decreased by $3.2 million from $6.5 million for 1992 to $3.3 million for 1993 primarily as a result of the write-off of certain goodwill recorded by Burnup in 1992. Expressed as a percent of revenue, depreciation and amortization expense would have been 1.8% and 3.7% for 1993 and 1992, respectively. Pro Forma Other Income and Expense Interest expense would have decreased by $0.6 million from $4.9 million for 1992 to $4.3 million for 1993 due to reduced levels of Burnup borrowings offset by an increase in the CT Group borrowings required to support volume increases and scheduled fleet replacements. Other income decreased by $0.9 million from $3.6 million in 1992 to $2.7 million in 1993. This would have primarily been due to a loss on disposition of assets by the CT Group and a write-down of certain tangible assets by Burnup. Page 13 of 50 The Company's effective tax rate would have decreased as a percent of pretax income from 25.8% for 1992 to 24.5% for 1993 primarily due to the effect on taxable income of certain state income taxes and reduced permanent differences resulting from the 1992 goodwill write-off. Liquidity and Capital Resources Cash and cash equivalents decreased $1,260,445 from $10,190,412 at December 31, 1992 to $8,929,967 at December 31, 1993. Working capital decreased from $12,767,411 at December 31, 1992 to $9,091,495 at December 31, 1993. The decrease in working capital resulted primarily from a decrease in cash and contract receivables. During the year ended December 31, 1993, the CT Group declared dividends otalling $11,500,000 of which $8,500,000 was paid prior to year end. In 1993, cash of $8,411,250 was generated from operations. Cash of $1,212,374 was used in investing activities, including investmens in unconsolidated joint ventures of $660,000 offset by distributions from such ventures of $1,484,000 and $2,036,374 was used primarily for additions to machinery and equipment. Cash of $8,500,000 was used to pay distributions to shareholders. The CT Group's principal sources of liquidity were internally generated cash, and, to a lesser extent, trade financing. The CT Group currently has no material commitments for capital expenditures. Management expects to meet its future working capital needs primarily through cash flow from operations and to a lessor extent trade and external financing. As a result of the Acquisition, significant adjustmenst to the balance sheet will be recorded (See Note 13 to the Combined Financial Statements). The CT Group assumed the existing debt of Burnup pursuant to the Acqusition. The debt agreements contain, among other things, restrictions on the payments of dividends and require the maintenance of certain financial convenants. Pursuant to such covenants, the Company is currently prohibited from declaring or paying dividends. The Company anticipates that operating cash requirements, capital expenditures, and debt service will substantially be funded from cash flow generated by operations and, to a lesser extent, external financing. The Company currently has no material commitments for capital expenditures; however, it is continuoulsy evaluating the need for fleet improvements. Environmental matters The CT Group is in the process of removing, restoring and upgrading underground fuel storage tanks. As explained more fully in the notes to the Combined Financial Statements, the CT Group does not expect the ultimate disposition of the matters to have a material adverse effect on its financial position or results of operations. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See index to Combined Financial Statements and Combined Financial Statement Schedules on page 12. Page 14 of 50 Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On March 11, 1994, the Company changed accountants. For further information, refer to Form 8-K, Item 4, filed on March 18, 1994 which is hereby incorporated by reference. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See the information relating to directors of the Company under the caption "MANAGEMENT," contained on pages 47 through 52 of the Company's Proxy Statement filed February 11, 1994 related to the Annual and Special Meeting of Shareholders held on March 11, 1994 which is hereby incorporated by reference. The following information indicates the position and age of the executive officers at December 31, 1993 of the CT Group: Officer Age Positions and offices presently held and business experience Jorge L. Mas Canosa 54 President and Chief Executive Officer of CTF during the past five years Jorge Mas 30 During the past five years has served for part or all of such period as President and Chief Executive Officer of CT (and its predecessor company Communication Contractors, Inc.) Neff Rental Inc., Neff Machinery, Inc., Atlantic Real Estate Holding Corp. & U.S. Development Corp., each a company controlled by the CT Group stockholders. Pursuant to the Acquisition, the following individuals were appointed officers of the Company. Officer Age Position Principal Occupation or Employment during the Past Five Years Jorge L. Mas Canosa 54 Chairman of the President and Chief Executive Board of Directors Officer of CTF during the past five years Jorge Mas 30 President, Chief President and Chief Executive Executive Officer Officer of CT (and its predecessor company Communication Contractors, Inc.) Neff Rental Inc., Neff Machinery, Inc., Atlantic Real Estate Holding Corp. & U.S. Development Corp., each a company controlled by the CT Group stockholders. Page 15 of 50 Ismael Perera 45 Senior Executive Director of Network Operations Vice President - for BellSouth Telecommunica- Operations tions prior to joining C & T Group. Over 23 years experience in the Tele- communications industry. Carlos A. Valdes 31 Senior Vice- Chief Financial Officer for CT President, Finance since 1991. Vice President at First Union/Southeast Bank, N.A. from 1986 to 1991. Carmen Sabater 29 Corporate Controller Corporate Controller for MasTec since April 1994. Certified Public Accountant affiliated with Deloite & Touche, an international public accounting firm since 1985. Nancy J. Damon 44 Corporate Secretary Paralegal for Burnup for over four years. Paralegal for Holland & Knight for five years. Has over 20 years legal expierence. Item 11. Item 11. EXECUTIVE COMPENSATION For the year ended December 31, 1993, CT Group paid the following amounts to its most highly compensated executive officers for their services in all capacities to the CT Group . The table below does not set forth certain of the tabular formats set forth in the SEC's recently expanded rules on executive compensation disclosure dealing with other annual compensation and long-term compensation awards and payouts, since no plans regarding awards or compensation existed during this period. Name and Principal Position Salary $ Bonus $ Jorge L. Mas Canosa, 1,524,460 1,560,000 President of CTF Jorge Mas, President and Chief Executive Officer of CT 852,000 832,000 For the eight month period ended December 31, 1993, Burnup paid the following amounts to its most highly compensated executive officers for their services in all capacities to Burnup . The table below does not set forth certain of the tabular formats set forth in the SEC's recently expanded rules on executive compensation disclosure dealing with other annual compensation and long-term compensation awards and payouts, since no plans regarding awards or compensation existed during this period. Name and Principal Position Salary $ Bonus $ Nick A. Caporella, Chairman of the Board, President and Chief Executive Officer -0- -0- Page 16 of 50 Gerald W. Hartman, Senior Vice President of the Company and President of Burnup & Sims ComTec, Inc. and Burnup & Sims of California, Inc., wholly- owned subsidiaries of the Company 140,000 -0- Leo J. Hussey, Executive Vice President, and Director of the Company, and President of Southeastern Printing Company, Inc. and The Deviney Company, wholly-owned subsidiaries of the Company 140,000 -0- George R. Bracken, Vice President 66,667 -0- & Treasurer Pursuant to the Acquisition, the individuals listed above resigned their position with the Company and new executive officers were appointed by the Board of Directors. The following table sets forth the proposed annual base compensation for the Chief Executive Officer of the Company and the other two most highly compensated executive officers of the Company whose salary will exceed $100,000 during the 1994 fiscal year. Name and Principal Position Salary ($) Jorge Mas, President and Chief 300,000 Executive Officer Ismael Perera, Senior Vice 150,000 President-Operations Carlos A. Valdes, Senior Vice- 115,000 President-Finance Bonus compensation will be determined by the Compensation and Stock Option Committee of the Board of Directors. The aforementioned officers and other key salaried employees of the Company will be eligible to receive options and awards as determined from time to time by the Compensation and Stock Option Committee of the Board of Directors. See the description of the stock option plans of the Company contained on pages 38 through 44 of the Company's Proxy Statement filed February 11, 1994, related to the Annual and Special Meeting of Shareholders held on March 11, 1994 (the "Meeting"), which is hereby incorporated by reference. The referenced plans were approved by the stockholders at the Meeting. Options Granted No options were granted by the CT Group during the year ended December 31, 1993. As described in the Notes to Burnup's Form 10-Q for the quarterly period ended July 31, 1993, which is hereby incorporated by reference, options to purchase 238,000 shares were cancelled and replaced with options to purchase 114,000 shares. Additionally, options to purchase 137,000 shares were granted. Page 17 of 50 Aggregate Fiscal Year-End Stock Option Value Table There were no stock options outstanding for the CT Group as of December 31, 1993. The following table summarizes the options held at December 31, 1993 by individuals named in the Summary Compensation Table for Burnup; no stock options were exercised by such persons during the eight month period December 31, 1993. Such options however, were exercised in March 1994 as a result of the Acquisition. Number of Unexercised Value of Unexercised Options at In-the-Money Options December 31, 1993 (#) at December 31, 1993 ($) Name Exercisable Unexercisable Exercisable Unexercisable Nick A. Caporella 100,000 0 $ 583,750 $ 0 Leo J. Hussey 30,000 10,000 175,125 39,375 Gerald W. Hartman 20,000 5,000 116,750 19,687 George R. Bracken 4,500 0 26,269 0 The following table summarizes the options granted on March 11, 1994 by individuals named in the Summary Compensation Table for the new executive officers of the Company; such options are exercisable over a five year period in equal increments of 20% per year beginning the year after the date of grant and must be exercised at an exercised price no less than the fair market value of the shares at grant date. Number of Unexercised Value of Unexercised Options at In-the-Money Options March 31, 1994 (#) at March 31, 1994 ($) Name Exercisable Unexercisable Exercisable Unexercisable Jorge Mas 0 0 0 0 Ismael Perera 0 20,000 0 0 Carlos A. Valdes 0 20,000 0 0 Long-Term Incentive and Pension Plans The CT Group and Burnup do not have any long-term incentive or pension plans. Notwithstanding anything to the contrary set forth in any of the Company's previous filings under the Securities Act of 1934, as amended, that might incorporate future filings, including this transition report on Form 10-K, in whole or in part, the following Compensation and Stock Option Committee Report and Performance Graph shall not be incorporated by reference into any such filings. Report of the Compensation and Stock Option Committee The CT Group did not have a compensation and stock option committee. The following report is that of the Company's Compensation Committee. Page 18 of 50 The Compensation and Stock Option Committee of the Board of Directors is responsible for approving the compensation levels of the executive officers of the Company, including the Chief Executive Officer. The Compensation Committee also reviews with the Chief Executive Officer guidelines for salary adjustments and aggregate bonus awards applicable to management and employees other than executive officers. The Compensation Committee, which is composed of three non-employee directors of the Company, reviews its recommendations with the members of the Board. The following report is submitted by the Compensation Committee regarding compensation paid during the eight month period ended December 31, 1993: The compensation program of the Company is designed to enable the Commpany to attract, motivate, reasonably reward, and retain professional personnel who will effectively manage the assets of the Company and maximize corporate performance and stockholder value over time. Compensation packages include a mix of salary, incentive bonus awards, and stock options. Salaries of executive officers are established based on an individual's performance and general market conditions. Salary levels are determined based upon the challenge and responsibility of an individual's position with the Company and are dependent on subjective considerations. In addition to paying a base salary, the Company provides incentive bonus awards as a component of overall compensation. Bonus awards are measured based upon overall performance of the executive officer's area of responsibility or operating performance of the operation under control of the executive, if any. Due to the fact that Burnup's financial results for the last three years reflect volume declines and net losses, salaries of executive officers during the eight months ended December 31, 1993, (with certain exceptions for outstanding merit) are frozen at previous levels. In addition, in light of these factors, the Burnup's President and Chief Executive Officer and Chairman of the Board prior, to the Acquisition, Nick A. Caporella, declined to accept any salary or bonus compensation for fiscal years 1992 or 1993 and through the eight months ended December 31, 1993. Long-term incentive compensatin for executives consisted of stock-based awards made under the Company's two non-qualified stock option plans (the "Option Plans"). The Option Plans provided for the granting of options to purchase Common Stock to key employees at $2.00. The Compensation Committee believes that the maximization of stockholder wealth through appreciation in the value of Common Stock is created through the use of stock options. At December 31, 1993, there were 205,300 stock options granted under the Option Plans held by executive officers. Compensation and Stock Option Committee Samuel C. Hathorn, Jr. William A. Morse Eliot C. Abbott Page 19 of 50 PERFORMANCE GRAPH The following graph compares the cumulative total stockholder return on Common Stock from December 31, 1988 through December 31, 1993 for Burnup only with the cumulative total return of the S & P 500 Stock Index and a Burnup constructed index of two peer companies consisting of Dycom Industries, Inc. and the L.E. Myers Company. The graph assumes that the value of the investment in Common Stock was $100 on December 31, 1988 and that all dividends were reinvested. This data does not take into consideration what the cumulative stockholder return on common stock would have been had the Acquisition happened at an earlier date and is not necessarily indicative of future results. 1988 1989 1990 1991 1992 1993 Burnup & Sims Inc. 100.00 90.00 47.33 21.33 14.67 31.33 Dycom Industries, Inc. 100.00 86.59 59.46 70.43 32.93 25.61 L.B. Myers Company Group 100.00 200.89 454.77 456.02 471.93 336.24 Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the names of all persons who, on March 31, 1994, were known by the CT Group to be the beneficial owners (as defined in the rules of the Securities and Exchange Commission) of more than 5% of the shares of Common Stock of the CT Group: Name Beneficial Amount and Nature of Percent of Owner Beneficial Ownership Class Samuel C. Hathorn, Jr. 5,200(1) * Jorge L. Mas Canosa 5,330,000 33.2% Jorge Mas 3,936,000 24.6% All Executive Officers and Directors as a group (ten persons) 9,271,200 57.8% (1) Includes 200 shares held by the children of Mr. Hathorn, as to which Mr. Hathorn discloses benefial ownership. * Less than one percent. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See Note 3 to the Combined Financial Statements. Page 20 of 50 Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of the report. 1. Combined Financial Statements Page Number Reports of Independent Accountants 22-24 Combined Balance Sheets at December 31, 1993 and 1992 25-26 Combined Statements of Income and Retained Earnings for the three years ended December 31, 1993 27 Combined Statements of Cash Flows for the three years ended December 31, 1993 28-29 Notes to Combined Financial Statements 30-47 2. Financial Statement Schedules V - Property, Plant and Equipment 48 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 49 Schedules other than those listed above are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (b) Report on Form 8-K The Company did not file any reports on Form 8-K during the three months ended December 31, 1993. However, a Form 8-K was filed on March 18, 1994 regarding the Acquisition, change in name, change in fiscal year end and change in accountants and is hereby incorporated by reference. Page 21 of 50 Report of Independent Accountants To the Boards of Directors and Shareholders of Church & Tower Group In our opinion, the combined financial statements listed in the accompanying index present fairly, in all material respects, the financial position of the Church & Tower Group at December 31, 1993, and the results of their operations and their cash flows for the year in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Group's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which 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 audit provides a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Miami, Florida April 22, 1994 Page 22 of 50 Report of Predecessor Independent Accountants To the Boards of Directors and Shareholders of Church & Tower Group We have audited the combined financial statements of the Church & Tower Group listed in the accompanying index as of December 31, 1992 and for each of the two years then ended. These financial statements are the responsibility of the Group's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of 9001 Joint Venture, a joint venture that is majority-owned by a company in the Group, for the years ended December 31, 1992 and 1991. These statements reflect total assets of $3,064,573 as of December 31, 1992 and total revenues of $14,495,378 and $8,240,290 for each of the two years ended December 31, 1992, respectively. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for 9001 Joint Venture, is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based upon our audits and the report of other auditors, the combined financial statements referred to above present fairly, in all material respects, the financial position of the Church & Tower Group as of December 31, 1992 and the results of their operations and their cash flows for each of the two years ended December 31, 1992 in conformity with generally accepted accounting principles. VICIANA AND SHAFER Coral Gables, Florida June 15, 1993 Page 23 of 50 Report of Independent Accountants To the partners of 9001 Joint Venture We have audited the balance sheet of 9001 Joint Venture as of December 31, 1992 and the related statements of earnings, partners' capital, and cash flows for each of the two years then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 9001 Joint Venture as of December 31, 1992 and the results of its operations and its cash flows for each of the two years then ended in conformity with generally accepted accounting principles. E.F. ALVAREZ & COMPANY Miami, Florida March 15, 1993 Page 24 of 50 CHURCH & TOWER GROUP COMBINED BALANCE SHEETS December 31, 1993 and 1992 Assets 1993 1992 - - ------- ---- ---- Cash and cash equivalents $ 8,929,967 $ 10,190,412 Accounts receivable, net of allowance for doubtful accounts of $250,000 in 1993 6,350,434 6,783,906 Contract receivables 400,000 2,542,833 Other current assets 186,234 129,558 ------------ ------------ Total current assets 15,866,635 19,646,709 ------------ ------------ Investment in unconsolidated joint ventures 152,725 5,000 ------------ ------------ Property and equipment, net 4,632,321 3,655,855 ------------ ------------ Other assets 673,122 135,142 ------------ ------------ Total assets $ 21,324,803 $ 23,442,706 ============ ============ The accompanying notes are an integral part of these combined financial statements. Page 25 of 50 CHURCH & TOWER GROUP COMBINED BALANCE SHEET December 31, 1993 and 1992 Liabilities and Shareholders' Equity 1993 1992 - - ------------------------------------ ---- ---- Current liabilities: Accounts payable and accrued expenses $ 3,323,865 $ 4,291,580 Billings in excess of costs and estimated earnings on uncompleted contracts - 1,527,012 Current maturities of long-term notes payable 508,364 691,667 Current portion of notes payable to shareholders 500,000 - Other current liabilities 2,442,911 153,267 Deficit in unconsolidated joint venture's capital account - 215,772 ------------ ------------ Total current liabilities 6,775,140 6,879,298 Notes payable 1,079,201 855,219 Notes payable to shareholders 2,500,000 - ------------ ------------ Total liabilities 10,354,341 7,734,517 ------------ ------------ Commitments and contingencies - - ------------ ------------ Minority interest in consolidated joint venture 28,197 17,751 ------------ ------------ Shareholders' equity: Common stock 1,025,000 1,025,000 Retained earnings 9,917,265 14,665,438 ------------ ------------ Total shareholders' equity 10,942,265 15,690,438 ------------ ------------ Total liabilities and shareholders' equity $ 21,324,803 $ 23,442,706 ============ ============ The accompanying notes are an integral part of these combined financial statements. Page 26 of 50 CHURCH & TOWER GROUP COMBINED STATEMENTS OF INCOME AND RETAINED EARNINGS Three Years Ended December 31, 1993 1993 1992 1991 ---- ---- ---- Contract revenue $ 44,683,403 $ 34,135,788 $ 31,588,228 ------------ ------------ ------------ Costs and expenses: Cost of contract revenue (exclusive of depreciation shown separately below) 28,729,144 22,162,792 22,969,522 Depreciation 609,268 371,488 359,236 General and administrative expenses 9,870,635 3,289,163 2,795,528 Interest expense 133,572 33,525 28,779 Interest income (314,524) (206,881) (226,722) Other, net 80,532 (209,444) (85,295) ------------ ------------ ------------ Total costs and expenses 39,108,627 25,440,643 25,841,048 ------------ ------------ ------------ Income from operations 5,574,776 8,695,145 5,747,180 Equity in earnings (losses) of unconsolidated joint ventures 1,187,497 (372,972) 179,051 Minority interest in earnings of consolidated joint venture (10,446) (42,618) (625,542) ------------ ------------ ------------ Net income 6,751,827 8,279,555 5,300,689 ------------ ------------ ------------ Retained earnings, beginning of year (as restated for reverse acquisition) 14,665,438 8,411,017 6,271,083 Distributions to shareholders (11,500,000) (2,025,134) (3,160,755) ------------ ------------ ------------ Retained earnings, end of year $ 9,917,265 $ 14,665,438 $ 8,411,017 ============ ============ ============ Earnings per common share $ 0.66 $ 0.81 $ 0.52 ============ ============ ============ The accompanying notes are an integral part of these combined financial statements. Page 27 of 50 CHURCH & TOWER GROUP COMBINED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 1993 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net income $ 6,751,827 $ 8,279,555 $ 5,300,689 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 609,268 371,488 359,236 Loss on disposition of assets 282,640 - - Equity in (earnings) losses of unconsolidated joint ventures (1,187,497) 372,972 (179,051) Minority interest in net income of consolidated joint venture 10,446 42,618 625,542 Changes in assets and liabilities: Decrease (increase) in net accounts receivable 433,472 (4,304,916) 994,082 Decrease (increase) in contract receivables 2,142,833 (758,645) (1,423,863) Decrease (increase) in other current assets 111,324 (567,371) 111,775 (Increase) in other assets (537,980) (91,037) - (Decrease) increase in accounts payable and accrued expenses (967,715) 2,520,005 667,310 Increase (decrease) in other current liabilities 2,289,644 179,624 (167,472) (Decrease) increase in billings in excess of costs and estimated earnings on uncompleted contracts (1,527,012) 1,284,095 56,109 ------------ ------------ ------------ Net cash provided by operating activities 8,411,250 7,328,388 6,344,357 ------------ ------------ ------------ Cash flows from investing activities: Distribution from unconsolidated joint venture 1,484,000 48,000 24,051 Investments in unconsolidated joint ventures (660,000) (190,578) - Investment in joint venture - (5,000) - Purchases of equipment, net (2,036,374) (1,739,864) (327,288) ------------ ------------ ------------ Net cash used in investing activities (1,212,374) (1,887,442) (303,237) ------------ ------------ ------------ Page 28 of 50 CHURCH & TOWER GROUP COMBINED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 1993 Cash flows from financing activities: Proceeds from notes payable 989,271 1,700,000 - Principal payments on notes payable (948,592) (201,751) (14,728) Distributions to shareholders (8,500,000) (2,025,134) (3,160,755) Distributions to partners of consolidated joint venture - - (602,549) Repayment of loans from affiliates - (334,610) - ------------ ------------ ------------ Net cash used in financing activities (8,459,321) (861,495) (3,778,032) ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents (1,260,445) 4,579,451 2,263,088 Cash and cash equivalents, beginning of year 10,190,412 5,610,961 3,347,873 ------------ ------------ ------------ Cash and cash equivalents, end of year $ 8,929,967 $10,190,412 $ 5,610,961 ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid during the year for interest $ 133,570 $ 33,525 $ 4,496 ============ ============ ============ Supplemental disclosure of noncash financing activities: During 1993, the Group declared distributions to shareholders of $11,500,000. Of the amounts declared, $8,500,000 was paid in cash and $3,000,000 remains payable at December 31, 1993 as notes payable to shareholders. The accompanying notes are an integral part of these combined financial statements. Page 29 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 1 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Church & Tower Group (the Group) represents the combination of two Florida corporations, Church & Tower of Florida, Inc. (CT Florida) and Church & Tower, Inc. (CT), which, prior to March 11, 1994, were owned by members of the Mas family. Effective March 11, 1994, the Group was acquired by Burnup & Sims Inc. See Note 2. CT Florida, established in 1968, is engaged in the construction and maintenance of outside plant (underground cable and conduit, aerial lines, manholes, etc.) for utility companies servicing the geographical areas of Dade and Broward counties in South Florida. CT, incorporated in 1990 under the laws of the State of Florida, engages in construction contracts and serves, primarily, as CT Florida's manpower and equipment subcontractor. CT Florida holds three Master Contracts with BellSouth Telecommunications (Bell South). The contracts expire at various times through 1996, and provide for annual price revisions based on changes in the construction price index, as calculated and published by the U.S. Department of Commerce. CT Florida also provides construction services under individual contracts to Bell South and Miami-Dade Water & Sewer Authority (Miami-Dade). In 1990, CT formed 9001 Joint Venture for the purpose of constructing a detention center for Metro-Dade County. From its initial 60% interest in the joint venture, CT increased its participation to 89.8% and 99.7% during 1991 and 1992, respectively. Accordingly, the accounts of 9001 Joint Venture have been consolidated with the accounts of CT in the accompanying combined financial statements. Also in 1990, CT entered into a joint venture agreement with an international construction contractor. In this venture, CT has had a 20% interest in two governmental projects and accounts for its investment under the equity method. Effective June 1, 1992, CT merged its operations with those of Communication Contractors, Inc. (CCI) in a transaction accounted for as a pooling of interests. CCI, also wholly owned by a member of the Mas family, provided construction subcontracting services (manpower and equipment) to CT Florida during the year ended December 31, 1991 and for the period from January 1, 1992 through May 31, 1992. The accompanying financial statements for 1992 and 1991 include the operations of CCI. In the latter part of 1992, the Group entered into a joint venture for the removal of debris related to Hurricane Andrew. The Company has a 25% interest in this venture and recorded approximately $1,087,000 of income during 1993 related to its equity in the earnings of this venture. The venture was essentially completed in 1993. A summary of the significant accounting policies followed in the preparation of the accompanying combined financial statements is presented below: Page 30 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Principles of combination The combined financial statements include the accounts of CT Florida and CT and their majority owned joint venture. All significant intercompany balances and transactions have been eliminated. Revenue recognition Revenues and related costs for short term construction projects are recognized when the projects are completed. Revenues from long term construction contracts are recognized under the percentage-of-completion method. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Billings in excess of costs and estimated earnings on uncompleted contracts are classified as current liabilities and represent billings in excess of revenues recognized. Property and equipment, net Property and equipment are recorded at cost, less accumulated depreciation. Depreciation is computed using the straight line method over the estimated useful lives of the related assets. Leasehold improvements are amortized over the shorter of the term of the lease or the estimated useful lives of the improvements. Expenditures for repairs and maintenance are charged to expense as incurred. Expenditures for betterments and major improvements are capitalized. Beginning in 1993, the Group changed prospectively the estimated useful life of construction and excavation equipment from 10 to 7 years. This change in estimated useful lives did not have a material effect on the 1993 financial statements. Income taxes CT Florida and CT have elected to be taxed under the Subchapter S provisions of the Internal Revenue Code, which provide that taxable income is to be included in the Federal income tax returns of the individual shareholders. Accordingly, no provision for income taxes has been recorded in the accompanying combined statements of income and retained earnings. As explained in Note 2, the Group has been acquired by Burnup & Sims Inc. ("Burnup"). As a result of this acquisition, the Group will be taxed as a C Corporation. Upon its change in tax status, the Group will record income taxes under the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, which requires the Group to use the liability method of accounting for income taxes based on temporary taxable and deductible differences between the tax bases of the Group's assets and liabilities and their financial reporting bases. The change in tax status by the Group is expected to result in a net deferred tax asset of approximately $435,000 due to the tax effect of deductible temporary differences, principally related to certain provisions recorded at December 31, 1993 related to environmental and other matters. Page 31 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Earnings per share Earnings per share for the three years ended December 31, 1993, were computed using the number of shares outstanding after giving effect to the exchange of shares at March 11, 1994 as described in Notes 2 and 10. Cash and cash equivalents The Group has defined cash and cash equivalents as those highly liquid investments purchased with an original maturity of three months or less. Environmental expenditures Environmental expenditures that result from the remediation of an existing condition caused by past operations, that do not contribute to current or future revenues, are expensed. Liabilities are recognized when cleanup is probable and the cost can be reasonably estimated. Reclassifications Certain accounts in the accompanying combined financial statements for the years ended December 31, 1992 and 1991 have been reclassified for comparative purposes. 2 - ACQUISITION: On October 15, 1993, the shareholders of the Group entered an agreement, as amended, pursuant to which the Group was acquired, through an exchange of stock, effective March 11, 1994, by Burnup, a publicly traded company with business activities similar to the Group. As a result of the acquisition, the shareholders of the Group received approximately 65% of the shares of Burnup in exchange for 100% of the shares of CT and CT Florida. The reverse acquisition was accounted for as a purchase of Burnup by the Group. The name of the resulting merged entity was changed to MasTec, Inc. ("MasTec"). The results of operations of the Group will be included with those of MasTec for periods subsequent to the effective date of the acquisition. 3 - RELATED PARTY TRANSACTIONS: The Group rents and purchases construction equipment from affiliates. During 1993, 1992 and 1991, the Group incurred approximately $249,000, $222,000 and $497,000 of equipment rental expense and purchased approximately $1,432,000, $127,000 and $605,000, respectively, from these affiliates. Additionally, at December 31, 1993 and 1992 the Group had recorded $97,450 and $42,839 as amounts due from affiliates. These amounts are included in accounts receivable in the accompanying combined balance sheets. Page 32 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) During 1993, the Group declared distributions to shareholders of $11,500,000. Of the amounts declared, $8,500,000 was paid in cash and $3,000,000 remains payable at December 31, 1993 in the form of notes payable to shareholders. The notes bear interest at the prime rate of interest plus 2% (8% at December 31, 1993) and are payable in semi-annual instalments of $500,000 beginning in August 1994, plus accrued interest, through February 1997. The loans are unsecured. The Group is a party to certain non-cancelable operating leases expiring October 1998 with an affiliate related to its equipment yards. Annual rental payments are $48,000. 4 - SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK: The Group provides construction services primarily to BellSouth and Miami-Dade. As a result, the Group is exposed to a concentration of credit risk with respect to these customers. Revenues from BellSouth and Miami-Dade for the years ended December 31, 1993, 1992 and 1991 were approximately $29.1 million, $22.3 million and $15.7 million; and $4.4 million, $1.9 million and $1.1 million, respectively. Accounts receivable from BellSouth and Miami-Dade at December 31, 1993 and 1992 were $3.3 million and $5.7 million; and $2.4 million and $108,000, respectively. In addition, the Group, through its 9001 Joint Venture, recognized revenue from Metro-Dade County in connection with the construction of the detention center of approximately $10.7 million, $8.2 million and $14.4 million during the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 there were contracts receivable from Metro-Dade County in the amount of $400,000 and $2,542,833, respectively. 5 - PROPERTY AND EQUIPMENT: Property and equipment was comprised of the following as of December 31, 1993 and 1992: Estimated useful lives 1993 1992 (in years) ------------ ------------ ---------- Land $ 216,395 $ 216,395 - Buildings and improvements 526,942 526,942 5-30 Machinery and Equipment 4,881,088 4,262,138 7-10 Office furniture and equipment 442,390 457,473 10 ------------ ------------ 6,066,815 5,462,948 Less-accumulated depreciation (1,434,494) (1,807,093) ------------ ------------ $ 4,632,321 $ 3,655,855 ============ ============ Page 33 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) 6 - OTHER ASSETS: Included in other assets at December 31, 1993, are approximately $541,000 of deferred costs related to the acquisition of Burnup. 7 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES: At December 31,1993 and 1992, accounts payable and accrued expenses consisted of the following: 1993 1992 ---- ---- Trade accounts payable $ 1,843,551 $ 3,278,170 Accrued insurance premiums 818,000 640,000 Accrued payroll 240,814 193,693 Bank overdraft - 9001 Joint Venture 281,500 - Other accrued expenses 140,000 179,717 ------------ ------------ $ 3,323,865 $ 4,291,580 ============ ============ 8 - COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS: Billings in excess of costs and estimated earnings on uncompleted contracts with Metro-Dade County at December 31, 1992, were as follows: Costs incurred on uncompleted contracts $ 18,119,364 Estimated earnings 5,079,299 ------------- 23,198,663 Less - billings to date (24,725,675) -------------- $ (1,527,012) ============== Page 34 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) 9 - NOTES PAYABLE: Notes payable at December 31, 1993 and 1992 consisted of: 1993 1992 ---- ---- Instalment note payable to bank, original amount of $2 million fully disbursed in January 1993, due in monthly instalments of $41,667 plus interest at 7.7% through January 1997, collateralized by receivables and equipment. $ 1,561,112 $ 1,010,729 Note payable to bank, payable in monthly instalments of $19,444 plus interest at Prime plus 1/2% (6 1/2% at December 31, 1992) beginning in May 1992 through April 1995, collateralized by receivables and equipment. - 502,778 Other 26,453 33,379 ------------- ------------ 1,587,565 1,546,886 Less - current maturities (508,364) (691,667) ------------- ------------ $ 1,079,201 $ 855,219 ============= ============ Principal maturities are as follows: 1994 $ 508,364 1995 508,365 1996 569,477 1997 1,359 ----------- $ 1,587,565 =========== 10 - SHAREHOLDERS' EQUITY: As a result of the reverse acquisition by the Group of Burnup in March 1994, described in Note 2, the Group's historical shareholders' equity has been retroactively restated in the accompanying combined balance sheets at December 31, 1993 and 1992. The restatement gives effect to the number of shares of MasTec received by the Group at the date of acquisition, as well as the par value of the shares received. The effect of the restatement is as follows: Page 35 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Additional Common paid in Treasury Retained stock capital stock earnings 1993 ------ ---------- -------- --------- - - ---- Historical amount $ 6,000 $ 42,000 $ (14,169) $ 10,908,434 Adjustment for reverse acquisition 1,019,000 (42,000) 14,169 (991,169) ----------- ----------- ----------- ------------- Restated balances $ 1,025,000 $ - $ - $ 9,917,265 =========== =========== =========== ============= Historical amount $ 6,000 $ 42,000 $ (14,169) $ 15,656,607 Adjustment for reverse acquisition 1,019,000 (42,000) 14,169 (991,169) ----------- ----------- ----------- ------------- Restated balances $ 1,025,000 $ - $ - $ 14,665,438 =========== =========== =========== ============= MasTec shares have a $.10 par value. The weighted average number of shares outstanding used in the computations of earnings per share are summarized as follows: 1993 1992 1991 ---- ---- ---- Weighted average common shares outstanding 6,000 6,000 6,000 Adjustment for shares received in connection with the reverse acquisition of Burnup 10,244,000 10,244,000 10,244,000 ---------- ---------- ---------- Weighted average shares used in the per share computations 10,250,000 10,250,000 10,250,000 ========== ========== ========== Page 36 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) 11 - BUSINESS SEGMENTS: Business segment information is summarized as follows: (In thousands) 1993 1992 1991 ---- ---- ---- Contract revenue: Utility services $ 34,010 $ 25,896 $ 17,093 General construction 10,673 8,240 14,495 ---------- ---------- ---------- Total $ 44,683 $ 34,136 $ 31,588 ========== ========== ========== Income from operations: Utility services $ 9,351 $ 8,472 $ 3,900 General construction 2,266 2,149 2,747 Corporate (6,042) (1,926) (900) ---------- ---------- ---------- Total $ 5,575 $ 8,695 $ 5,747 ========== ========== ========== Identifiable assets: Utility services $ 17,405 $ 17,726 $ 6,658 General construction 400 3,065 2,738 Corporate 3,520 2,651 2,337 ---------- ---------- ---------- Total $ 21,325 $ 23,442 $ 11,733 ========== ========== ========== Depreciation expense: Utility services $ 609 $ 371 $ 359 ---------- ---------- ---------- Total $ 609 $ 371 $ 359 ========== ========== ========== Capital expenditures: Utility services $ 2,036 $ 1,740 $ 327 ---------- ---------- ---------- Total $ 2,036 $ 1,740 $ 327 ========== ========== ========== The Group's operations are organized into two principal business segments - utility services and general construction. Income from operations consists of income before equity in earnings of unconsolidated joint ventures and minority interest in earnings of consolidated joint venture. There are no material intersegment sales or transfers. Identifiable assets are those assets used for operations in each business segment. Corporate assets are principally invested cash and investments in unconsolidated joint ventures. Page 37 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) 12 - COMMITMENTS AND CONTINGENCIES: In connection with certain construction contracts, the Group has signed certain agreements of indemnity in the aggregate amount of approximately $20 million, of which approximately $9 million relate to the uncompleted portion of contracts in process. These agreements are to secure the fulfillment of obligations and performance of the related contracts. Management believes that no losses will be sustained from these agreements. Federal, state and local laws and regulations govern the Group's operation of underground fuel storage tanks. The Group is in the process of removing, restoring and upgrading these tanks, as required by the applicable laws, and has identified certain tanks and surrounding soil which will require remedial cleanups. Under the terms of the contract with Metro-Dade County, the Group has provided a warranty to the County with respect to materials and workmanship for a one year period from the date of substantial completion, as defined in the contract. In management's opinion, no significant losses are expected as a result of this warranty. Jorge Gamez, as Personal Representative of the Estate of Jorge A. Gamez, deceased, vs. Church & Tower, Inc., a Florida corporation, et al. Civil Action 93-07318 CA 20, filed in the Circuit Court of the 11th Judicial Circuit in and for Dade County, Florida on March 22, 1993, as amended on April 20, 1994, to include MasTec, Inc. The claim alleges that a Group employee was negligent in the operation of a truck and trailer combination which resulted in a death. Although no amounts are stated in the preliminary case filings, the plaintiff has made a demand for $7.2 million. During the year ended December 31, 1993, the Group provided approximately $2.3 million, net of $1 million of insurance coverage, related to the above matters. This amount has been included in other current liabilities in the accompanying combined balance sheet at December 31, 1993. Management believes, based on consultations with its legal and other advisors, that the amount provided is adequate to cover the estimated losses expected to be incurred in connection with these matters. In November 1993, Albert H. Kahn (the "plaintiff") filed a class action and derivative complaint, Civil Action 13248, (the "1993 Complaint") against Burnup, the members of Burnup's Board of Directors, CT, CT Florida, Jorge Mas Canosa, Jorge Mas and Juan Carlos Mas (CT, CT Florida, Jorge Mas Canosa, Jorge Mas and Juan Carlos Mas are referred to as the "CT Defendants"). In December 1993, plaintiff amended the 1993 Complaint ("1993 Amended Complaint"). The 1993 Amended Complaint alleges, among other things, that (i) the Burnup's Board of Directors and National Beverage Corp. ("NBC"), as Burnup's largest stockholder at the time, breached their respective fiduciary duties by approv- the acquisition which, according to the allegations of the 1993 Complaint, benefits Mr. Caporella at the expense of Burnup's stockholders, (ii) the CT Defendants had knowledge of the fiduciary duties owed by NBC and Burnup's Board Page 38 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) of Directors and knowingly and substantially participated in their breaches thereof, (iii) the Special Transaction Committee of Burnup's Board of Directors which approved the Acquisition Agreement and Redemption was not independent and, as such, was not in accordance with the 1990 Settlement, (iv) Burnup's Board of Directors breached its fiduciary duties by failing to take an active and direct role in the sale of the Company and failing to ensure the maximization of stockholder value in the sale of control of the company; and (v) Burnup's Board of Directors and NBC, as Burnup's largest stockholder, breached their respective fiduciary duties by failing to disclose completely all material information regarding the acquisition. The 1993 Complaint also claims derivatively that each member of Burnup's Board of Directors engaged in mismanagement, waste and breach of their fiduciary duties in managing Burnup's affairs. On November 29, 1993, plaintiff filed a motion for an order preliminarily and permanently enjoining the acquisition. On March 7, 1994, the court heard arguments with respect to plaintiff's motion to enjoin the acquisition and on March 10, 1994, the court denied plaintiff's request for injunctive relief. The Company believes that the allegations in the 1993 Complaint and the 1993 Amended Complaint are without merit, and intends to vigorously defend this action. Effective January 1994, the Group entered into a non-cancelable operating lease for its office facilities. Future minimum rentals under the lease agreement are $123,900 for 1994 and 1995. Page 39 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) 13 - CONSOLIDATED PRO FORMA FINANCIAL INFORMATION (UNAUDITED): The following unaudited pro forma consolidated statements of income of Burnup and the CT Group for the years ended December 31, 1992 and 1993 are presented as if the acquisition had occurred on January 1, 1992. The unaudited pro forma consolidated balance sheet is presented as if the acquisition had occurred on December 31, 1993. The pro forma data is presented for informational purposes only and may not be indicative of the future results of operations or financial position of MasTec, or what the results of operations or financial position of MasTec would have been if the acquisition had occurred on the dates set forth. These pro forma consolidated financial statements should be read in conjunction with the historical combined financial statements and notes thereto of the CT Group included herein. As discussed in Note 1, the acquisition will be treated as a "reverse acquisition" for financial reporting purposes, with the CT Group considered to be the acquiring entity. As a result, the pro forma adjustments include adjustments to reflect the estimated fair values of the net assets of Burnup; the capital structure has been adjusted to reflect the outstanding capital structure of the surviving legal entity. MasTec has not yet finalized the allocation of the purchase price but believes that a substantial portion of the purchase price ultimately will be allocated to property and real estate investments. The purchase accounting adjustments have been made assuming a fair value of $5.60 per share for Burnup's Common Stock, which was determined in accordance with Accounting Principles Board Opinion No. 16 "Business Combinations" using the average trading price for the period from the date the acquisition was announced to the date of consummation (March 11, 1994). The fair value approximates the price determined by the CT Group and Burnup in arriving at the number of shares to be issued. The unaudited pro forma consolidated financial statements are derived from the historical financial statements of Burnup and the CT Group. The pro forma consolidated balance sheet combines Burnup's January 31, 1994 balance sheet with the CT Group's December 31, 1993 balance sheet. The pro forma consolidated statements of income combine Burnup's historical statements of operations for the twelve months ended January 31, 1994 and 1993 with the CT Group's historical statements of income for the fiscal year ended December 31, 1993 and 1992, respectively. Page 40 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) MasTec, Inc. PRO FORMA CONSOLIDATED BALANCE SHEET (UNAUDITED) (IN THOUSANDS) CT GROUP BURNUP December January PRO FORMA CONSOLIDATED 31, 1993 31, 1994 ADJUSTMENTS PROFORMA --------- -------- ----------- ---------- ASSETS Current Assets Cash and Cash Equivalents $ 8,930 $ 6,605 $ (227) (2) $ 15,308 Accounts Receivable-Net and Unbilled Revenues 6,751 18,369 25,120 Other Current Assets 186 14,500 (2,500) (1) 12,186 --------- ---------- ------------ ---------- Total Current Assets 15,867 39,474 (2,727) 52,614 --------- ---------- ------------ ---------- Investment in NBC 0 28,495 (17,401) (1)(3) 11,094 Property-Net 4,632 16,875 22,541 (3) 44,048 Goodwill 0 3,174 665 (3) 3,839 Other Assets 826 13,780 10,911 (3) 25,517 --------- ---------- ------------ ---------- TOTAL ASSETS $ 21,325 $ 101,798 $ 13,989 $ 137,112 ========= ========== ============ ========== Page 41 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) MasTec, Inc. PRO FORMA CONSOLIDATED BALANCE SHEET (UNAUDITED) (IN THOUSANDS) CT GROUP BURNUP December January PRO FORMA CONSOLIDATED 31, 1993 31, 1994 ADJUSTMENTS PROFORMA --------- -------- ----------- ---------- LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Current Maturities of Debt $ 1,008 $ 3,930 $ $ 4,938 Accounts Payable and Accrued Expenses 3,324 11,815 5,092 (2)(5) 20,231 Other Current Liabilities 2,443 6,421 8,864 --------- ---------- ------------- --------- Total Current Liabilities 6,775 22,166 5,092 34,033 Other Liabilities 28 13,616 9,517 (3)(4)(5) 23,161 --------- ---------- ------------ ---------- Long-Term Debt 3,579 32,028 35,607 --------- ---------- ------------ ---------- Shareholders' Equity Common Stock 1,025 1,602 (1,024) (1)(2) 1,603 (7) Capital Surplus 72,860 (30,587) (1)(2) 42,273 (5)(6)(7) Retained Earnings 9,918 33,666 (43,149) (4)(6)(8) 435 Treasury Stock (74,140) 74,140 (7) 0 --------- ---------- ------------ ---------- Total Shareholders' Equity 10,943 33,988 (620) 44,311 --------- ---------- ------------ ---------- $ 21,325 $ 101,798 $ 13,989 $ 137,112 ========= ========== ============ ========== Page 42 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) MasTec, Inc. PRO FORMA CONSOLIDATED STATEMENT OF INCOME (UNAUDITED) (In Thousands Except Per Share Amounts) TWELVE MONTHS ENDED CT GROUP BURNUP December January PRO FORMA CONSOLIDATED 31, 1993 31, 1994 ADJUSTMENTS PROFORMA --------- ---------- ----------- --------- Revenues $ 44,683 $ 137,732 $ $ 182,415 --------- ---------- ------------ ---------- Costs and Expenses Costs of Revenues (exclusive of depreciation and amortization shown separately below) 28,729 125,378 154,107 General and Administrative 9,870 18,528 28,398 Depreciation and Amortization 609 5,169 (2,450) (1) 3,328 Interest Expense 134 4,047 153 (2) 4,334 Interest and Dividend Income (315) (3,922) 2,685 (3) (1,552) Other 81 (1,247) (1,166) --------- ---------- ------------ ---------- Total Costs and Expenses 39,108 147,953 388 187,449 --------- ---------- ------------ ---------- Income (Loss) Before Income Taxes, Equity in Earnings (Losses) of Unconsolidated Joint Ventures and Minority Interest in Earnings of Consolidated Joint Venture 5,575 (10,221) (388) (5,034) Provision (Credit) for Income Taxes 0 (2,927) 1,691 (4) (1,236) --------- ---------- ------------ ---------- Income (Loss) Before Equity in Earnings (Losses) of Unconsolidated Joint Ventures and Minority Interest in Earnings of Consolidated Joint Venture 5,575 (7,294) (2,079) (3,798) Equity in Earnings (Losses) of Unconsolidated Joint Ventures 1,187 0 1,187 Minority Interest in Earnings of Consolidated Joint Venture (10) 0 (10) --------- ---------- ------------ ---------- NET INCOME (LOSS) $ 6,752 $ (7,294) $ (2,079) $ (2,621) ========= ========== ============ ========== Average Shares Outstanding(5) 10,250 8,768 (3,153) 15,865 ========= ========== ============ ========== Earnings (Loss) Per Share $ 0.66 $ (.83) $ (0.17) ========= ========== ========== Page 43 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) MasTec, Inc. PRO FORMA CONSOLIDATED STATEMENT OF INCOME (UNAUDITED) (In Thousands Except Per Share Amounts) TWELVE MONTHS ENDED CT GROUP BURNUP December January PRO FORMA CONSOLIDATED 31, 1992 31, 1993 ADJUSTMENTS PROFORMA --------- -------- ----------- ----------- Revenues $ 34,136 $ 143,990 $ $ 178,126 --------- ---------- ------------ ---------- Costs and Expenses Costs of Revenues (exclusive of depreciation and amortization shown separately below) 22,163 126,233 148,396 General and Administrative 3,289 17,075 20,364 Depreciation and Amortization 371 6,600 (433) (1) 6,538 Interest Expense 34 4,718 177 (2) 4,929 Interest and Dividend Income (207) (4,038) 2,685 (3) (1,560) Other (209) (1,868) (2,077) --------- ---------- ------------ ---------- Total Costs and Expenses 25,441 148,720 2,429 176,590 --------- ---------- ------------ ---------- Income (Loss) Before Income Taxes, Equity in Earnings (Losses) of Unconsolidated Joint Ventures and Minority Interest in Earnings of Consolidated Joint Venture 8,695 (4,730) (2,429) 1,536 Provision (Credit) for Income Taxes 0 (1,738) 2,135 (4) 397 --------- ---------- ------------ ---------- Income (Loss) Before Equity in Losses of Unconsolidated Joint Ventures and Minority Interest in Earnings of Consolidated Joint Venture 8,695 (2,992) (4,564) 1,139 Equity in Losses of Unconsolidated Joint Ventures (373) 0 (373) Minority Interest in Earnings of Consolidated Joint Venture (42) 0 (42) --------- ---------- ------------ ---------- NET INCOME (LOSS) $ 8,280 $ (2,992) $ (4,564) $ 724 ========= ========== ============ ========== Average Shares Outstanding(5) 10,250 8,768 (3,153) 15,865 ========= ========== ============ ========== Earnings (Loss) Per Share $ 0.81 $ (0.34) $ 0.05 ========= ========== ========== Page 44 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Notes to Unaudited Pro Forma Financial Statements Balance Sheet - - ------------- (1) To record exchange with NBC as follows: (000's) (a) redemption of subordinated debenture and other investment included in Other current assets $ 2,500 (b) redemption of subordinated debenture and other indebtedness included in Investment in NBC $ 15,401 (c) retirement of Common stock $ 315 (d) reduction in Capital surplus $ 17,586 (2) To record stock options and stock appreciation rights ("SAR's") exercised by Burnup employees prior to the consummation date as follows: (a) issuance of 163,100 shares of common stock par value $.10 $ 16 ========= (b) increase in capital surplus $ 1,027 ========= (c) net decrease in cash from exercise of stock options and SAR's $ 227 ========= (d) decrease in accrued compensation expense as a result of SAR's exercised $ 1,297 ========= (3) To allocate the purchase price of $32,897,000 (based on 5,777,592 shares outstanding at $5.60 per share, plus transaction cost of $550,000) Net book value of Burnup at January 31, 1994 $ 33,988 Less: Effect of exchange with NBC and loss for period to acquisition (21,363) --------- Net book value at acquisition 12,625 Purchase price 32,906 --------- Excess purchase price over net assets acquired included in Capital Surplus $ 20,281 ========= Page 45 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Allocated as follows: Incr. (Decr.) in net assets ------------- (a) Increase in Land included in Property to fair value $20,471 (b) Increase in buildings included in Property to fair value 2,070 (c) Increase in real estate investment included in Other assets to fair value 10,911 (d) Decrease in value of Investment in preferred stock and notes Receivables (2,000) (e) Decrease in value of historical Goodwill (3,174) (f) Increase in deferred taxes included in Other liabilities resulting from above adjustments (11,836) (g) Goodwill on acquisition 3,839 -------- $20,281 ======== (4) To recognize deferred tax asset of $435,000 included in Other liabilities regarding deductible temporary differences related to the Group. (5) To accrue losses of $6,389,000 (related tax benefit of $1,884,000 included in Other liabilities) for period February 1, 1994, to acquisition. (These losses include $2,682,000 related to non recurring expenses in connection with the acquisition: bonus pool, transactions costs, options and SAR's). (6) To transfer from Retained earnings to Capital surplus $9,918,000 of the Group's retained earnings at December 31, 1993 considered to be permanently capitalized undistributed earnings. (7) To retire 7,253,375 shares in treasury stock as follows: Common stock 7,253,375 shares @ $.10 par value $ 725 Capital surplus 73,415 -------- $74,140 ======== (8) To transfer to Capital Surplus Burnup's Retained earnings of $33,666,000 at January 31, 1994. Page 46 of 50 CHURCH & TOWER GROUP NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Continued) Statement of Operations - - ----------------------- (1) To record the effect on depreciation and amortization resulting from the adjustments described above as follows: 1993 1992 ---- ---- (a) depreciation expense on fair value of buildings which were revalued (20 year life) $279 $279 (b) elimination of historical depreciation- of revalued buildings per (a) above (556) (556) (c) elimination of historical goodwill amortization and writedown of Goodwill in April 1993 of $2,017,000 (2,365) (348) (d) amortization of goodwill on acquisition of Burnup (20 years) 192 192 ------ ------ ($2,450) ($433) ======== ====== (2) To record increase in interest expenses as a result of the notes payable issued to the CT Group shareholders for dividends payable. (3) To reverse interest income earned on NBC Subordinated Debentures and other indebtedness and reduced other income as a result of decreased cash. (4) To record income tax benefit on pro forma adjustments and to record tax provision on the income of the CT Group as follows: 1993 1992 ---- ---- (a) tax provision on the income of the CT Group $2,536 $3,105 (b) tax benefit on pro forma adjustments (845) (970) ------ ------- $1,691 $2,135 ====== ======= (5) Adjusted for redemption and issuance of shares as in the notes to the pro forma balance sheet. ******** Page 47 of 50 CHURCH & TOWER GROUP FINANCIAL STATEMENT SCHEDULES DECEMBER 31, 1993 SCHEDULE V - PROPERTY, PLANT and EQUIPMENT BALANCE ADDITIONS BALANCE 1993 12/31/92 AT COST RETIREMENTS 12/31/93 LAND $ 216,395 $ 216,395 BUILDINGS & IMPROVEMENTS 526,942 526,942 MACHINERY & EQUIPMENT 4,262,138 $ 2,095,742 $ 1,476,792 4,881,088 FURNITURE & FIXTURES 457,473 33,282 48,365 442,390 ---------- ----------- ----------- ----------- TOTAL $5,462,948 $ 2,129,024 $ 1,525,157 $ 6,066,815 ========== =========== =========== =========== BALANCE ADDITIONS BALANCE 1992 12/31/91 AT COST RETIREMENTS 12/31/92 LAND $ 216,395 $ 216,395 BUILDINGS & IMPROVEMENTS 526,942 526,942 MACHINERY & EQUIPMENT 2,780,098 $1,482,040 4,262,138 FURNITURE & FIXTURES 399,318 58,155 457,473 ---------- ---------- ----------- ----------- TOTAL $3,922,753 $1,540,195 $ 0 $ 5,462,948 ========== ========== =========== =========== BALANCE ADDITIONS BALANCE 1991 12/31/90 AT COST RETIREMENTS 12/31/91 LAND $ 216,395 $ 216,395 BUILDINGS & IMPROVEMENTS 525,410 $ 1,532 526,942 MACHINERY & EQUIPMENT 2,433,162 652,212 $ 305,276 2,780,098 FURNITURE & FIXTURES 383,419 15,899 399,318 ---------- ---------- ----------- ----------- TOTAL $3,558,386 $ 669,643 $ 305,276 $ 3,922,753 ========== ========== =========== =========== Page 48 of 50 CHURCH & TOWER GROUP FINANCIAL STATEMENT SCHEDULES DECEMBER 31, 1993 SCHEDULE VI - ACCUMULATED DEPRECIATION ADDITIONS BALANCE CHARGED TO BALANCE 1993 12/31/92 EXPENSES RETIREMENTS 12/31/93 BUILDINGS & IMPROVEMENTS $ 203,310 $ 18,367 $ 221,677 MACHINERY & EQUIPMENT 1,302,941 524,416 $ 981,867 845,490 FURNITURE & FIXTURES 300,842 66,485 367,327 ---------- ---------- ----------- ----------- TOTAL $1,807,093 $ 609,268 $ 981,867 $ 1,434,494 ========== ========== =========== =========== ADDITIONS BALANCE CHARGED TO BALANCE 1992 12/31/91 EXPENSES RETIREMENTS 12/31/92 BUILDINGS & IMPROVEMENTS $ 184,943 $ 18,367 $ 203,310 MACHINERY & EQUIPMENT 1,096,772 206,169 1,302,941 FURNITURE & FIXTURES 234,921 65,921 300,842 ---------- ---------- ----------- ----------- TOTAL $1,516,636 $ 290,457 $ 0 $ 1,807,093 ========== ========== =========== =========== ADDITIONS BALANCE CHARGED TO BALANCE 1991 12/31/90 EXPENSES RETIREMENTS 12/31/92 BUILDINGS & IMPROVEMENTS $ 166,576 $ 18,367 $ 184,943 MACHINERY & EQUIPMENT 1,143,209 262,624 $ 309,061 1,096,772 FURNITURE & FIXTURES 180,745 54,176 234,921 ---------- ---------- ----------- ----------- TOTAL $1,490,530 $ 335,167 $ 309,061 $ 1,516,636 ========== ========== =========== =========== Page 49 of 50 MasTec, Inc. FORM 10-K SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its be half by the undersigned, thereunto duly authorized. MasTec, Inc. (Registrant) /s/ Carlos A. Valdes - - ---------------------- Carlos A. Valdes Senior Vice President (Principal Financial and Accounting Officer) Dated: June 9, 1994 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. /s/ Jorge L. Mas - - ------------------------------- President & Chief Executive Officer (Principal Executive Officer) /s/ Jorge Mas Canosa - - ------------------------------- Chairman of the Board /s/ Arthur B. Laffer - - ------------------------------ Director /s/ Eliot C. Abbott - - ------------------------------- Director Page 50 of 50	14,593	96,537
811930_1993.txt	811930_1993	1993	811930	ITEM 1 - BUSINESS GENERAL Michael Foods, Inc. (the "Company") is a diversified producer and distributor of food products operating in five basic areas - eggs and egg products, distribution of refrigerated grocery products, refrigerated and frozen potato products, dairy products and prepared foods. The Company, through its eggs and egg products division, is one of the largest producers, processors and distributors of shell eggs, extended shelf-life liquid eggs and dried, hard-cooked and frozen egg products in the United States. The refrigerated distribution division distributes a broad line of refrigerated grocery products directly to supermarkets, including cheese, shell eggs, bagels, butter, margarine, muffins, potato products, juice and ethnic foods. The potato products division processes and distributes refrigerated and frozen potato products for foodservice and retail markets throughout the United States. The dairy products division processes and distributes ice milk mix, ice cream mix, frozen yogurt mix and extended shelf-life ultrapasteurized milk and specialty dairy products to fast food businesses and other foodservice outlets, independent retailers, ice cream manufacturers and others. The prepared foods division processes and distributes refrigerated soups and salads for foodservice and retail markets, primarily in the eastern United States. The following table sets forth the percentage of net sales accounted for by each of the Company's operating divisions for the periods indicated: The strategy of the Company is to enhance the value of its businesses by employing capital and technology to achieve maximum production efficiencies, to develop new products to address specific market needs and to expand the geographic distribution of its products. Decentralized management has been a key factor in the growth of each of the Company's operating divisions. The Company has grown, in part, through selective acquisition of value-added food businesses and intends to continue to do so in the future. EGGS AND EGG PRODUCTS M. G. Waldbaum Company ("Waldbaum") is a producer, processor and distributor of numerous egg products and shell eggs. Principal value-added egg products are ultrapasteurized "Easy Eggs-R-", which is a proprietary extended shelf-life and salmonella- negative (pursuant to United States Department of Agriculture ("USDA") regulations) liquid egg product, hard-cooked eggs, and Simply Eggs-R- Brand Liquid Scrambled Egg Mix. Other egg products include frozen and dried egg whites, yolks and whole eggs, pre- cooked frozen egg patties and omelets, and frozen breakfast entrees. Management believes that Waldbaum is the second largest egg producer in the United States. Waldbaum is the largest supplier of ultrapasteurized whole eggs and hard-cooked eggs in the United States and is a leading supplier of dried, frozen and liquid refrigerated whole eggs, whites and yolks. Waldbaum distributes its egg products to food processors and foodservice customers throughout the United States and has international sales in Europe and Japan. Easy Eggs-R- and other egg products are marketed nationally to a wide variety of foodservice and industrial customers. Most of Waldbaum's shell eggs are sold to the Company's refrigerated distribution division, Crystal Farms Refrigerated Distribution Company, which, in turn, distributes them throughout its 23 state territory. Shell eggs are essentially a commodity and are sold based upon reported egg prices. Egg prices, in turn, are significantly influenced by shifts in supply and demand. Pricing of shell eggs is also typically affected by seasonal demand related to increased consumption during holiday periods. In general, egg market pricing in the United States reflects levels reported by Urner Barry Spot Egg Market Quotations ("Urner Barry"), a recognized publication. Prices for certain of the Company's products are affected by these factors, particularly shell eggs. The Company has endeavored to moderate these effects primarily through a continuing emphasis on value-added products and internal production of shell eggs. In 1993, the Company's egg operations derived approximately 20% of net sales from shell eggs with the remaining 80% derived from the sales of value-added egg products. This compares with sales of shell eggs representing over 90% of egg sales in 1987. In 1993, approximately 90% of the Company's egg needs were satisfied by production from Company- owned hens, with the balance purchased on the spot market. The Company's shell egg and egg products businesses are fully integrated from the production and maintenance of laying flocks through processing of shell eggs and further processed egg products. The Company maintains facilities with approximately 2,500,000 pullets located in Nebraska, Minnesota and Wisconsin. Fully automated laying barns, housing approximately 12,000,000 producing hens, are located in Nebraska, Colorado, Minnesota and Wisconsin. In addition, approximately 750,000 Company-owned producing hens are housed in contract facilities. Major laying facilities also maintain their own grain and feed storage facilities. Principal egg processing plants are located in Nebraska, Minnesota and Colorado. During 1993, the Company was a partner in a joint venture with an unrelated company for the purpose of producing reduced cholesterol liquid egg yolk used in the Company's reduced cholesterol liquid whole eggs product. The Company owned 50% of the joint venture, with the balance owned by a German company. Under the terms of the joint venture agreement, the Company paid a processing toll to the joint venture covering the processing of cholesterol reduced liquid egg yolks. This toll was calculated to cover the costs of production, less revenue from the sale of by-products, plus an amount to provide a return on each partner's investment in the joint venture. The Company was obligated to pay the joint venture a minimum annual processing toll. The Company and its partner shared equally in the net operating results of the joint venture. Due to significant continuing losses and lack of adequate market acceptance, the Company decided in December 1993 to cause the early termination of the joint venture and cease production and sale of the reduced cholesterol liquid whole eggs product. In March 1994, the Company acquired the interest of its joint venture partner and the joint venture was terminated. See Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's 1993 Annual Report to Stockholders for discussion of charges recorded in 1993's fourth quarter relating to this termination. REFRIGERATED DISTRIBUTION Over the past 20 years Crystal Farms Refrigerated Distribution Company ("Crystal Farms") has augmented its shell egg distribution business by delivering a wide range of refrigerated grocery products directly to retailers. The Company believes that its strategy of offering quality branded products, many of which are sold under the Crystal Farms name, as a lower-priced alternative to national brands, on a direct to store basis, has contributed to the growth of Crystal Farms. These distributed refrigerated products, which consist principally of cheese, bagels, butter, margarine, muffins, potato products, juice and ethnic foods, are supplied by vendors, or other divisions of the Company, to Crystal Farms' specifications. Cheese accounts for approximately 45% of Crystal Farms' annual sales. Crystal Farms operates a cheese packaging facility in Lake Mills, Wisconsin, which allows for the cutting and wrapping of various cheese products for its Crystal Farms brand cheese business and for private label customers. Crystal Farms has expanded its market area both directly and through the use of independent egg producers as distributors. Whereas Crystal Farms' market area covered only seven states in 1987, it now includes 23 states primarily in the Midwest, Southeast and Southwest. Retail locations served by Crystal Farms number over 1,500. In 1993, sales to the warehouse operations of Super Valu Stores, Inc. and Cub Food Stores, which are owned or franchised by Super Valu Stores, aggregated approximately 30% of Crystal Farms' net sales. Crystal Farms maintains a fleet of refrigerated tractor-trailers to deliver products daily to its retail customers from eleven distribution centers located centrally in its key trade areas. POTATO PRODUCTS Potato products are produced and sold by Northern Star Co. ("Northern Star"), Drallos Potato Co., Inc. ("Drallos") and Farm Fresh Foods, Inc. ("Farm Fresh"). The Company's potato products division processes and sells frozen potato products, primarily french fries, and refrigerated potato products to both foodservice and retail markets. The retail refrigerated business of this division did not exist before 1989. Refrigerated products consist of a line of hash brown, mashed, au gratin and scalloped potato products. In 1993, approximately 20% of the potato division's net sales were to the retail trade, with the balance to foodservice. Refrigerated potato products accounted for approximately 45% of divisional net sales in 1993. The Company typically purchases approximately 80%-90% of its annual potato requirements from contract producers, of which a large majority are grown on irrigated land. The balance of the Company's potato requirements are purchased on the spot market. The Company maintains storage facilities in North Dakota, Wisconsin and Minnesota. Processing and refrigerated/frozen warehouse facilities are located principally in Minnesota, with smaller plants in California and Michigan. The Company maintains a high percentage of its contracted supply from irrigated fields, as well as maintaining geographic diversification of its sources. However, weather remains an important factor in determining raw potato prices and small variations in the purchase price of potatoes can have a significant effect on the potato products division's operating results. DAIRY PRODUCTS Through Kohler Mix Specialties, Inc. ("Kohler"), the Company processes and sells ice milk mix, ice cream mix, frozen yogurt mix, milk and specialty dairy products, many of which are ultra- high temperature ("UHT") pasteurized products. The Company believes that Kohler supplies the majority of the ice milk mix, and is a major supplier of ice cream mix, sold in Minnesota, Wisconsin and South Dakota. Kohler also sells its products throughout much of the balance of the United States. In February 1993 Kohler began leasing a UHT dairy plant in Texas, which is allowing for a greater emphasis on supplying customers in the southern United States. UHT processing is designed to produce bacteria-free milk, ice milk mix and specialty dairy products such as whipping cream, half and half and cordials. Many of Kohler's products have an extended shelf life of up to eight weeks, thus extending the trade territory which can be effectively served by Kohler to include much of the United States. Kohler ice milk, frozen yogurt and ice cream mixes are made to customer's specifications. Currently, Kohler produces approximately 65 different formulations. Kohler believes that the customization of high quality products and high customer service levels are critical to their business. Kohler has approximately 600 customers, including branded ice cream manufacturers, distributors to fast food businesses, other foodservice outlets and independent ice milk and ice cream retailers. In 1993, approximately 90% of Kohler's net sales were generated from customers who purchased products on a cost-plus basis. This includes sales to most of the large fast food chains operating in its market area. Sales of ice milk mix, frozen yogurt mix and ice cream mix are more seasonal than the Company's other products, with higher sales volume occurring between May and September. The addition of fluid milk and specialty dairy products in recent years has somewhat offset this seasonality. PREPARED FOODS In May 1991, the Company acquired all of the common stock of Sunnyside Vegetable Packing, Inc. ("Sunnyside"). Sunnyside is a processor and distributor of refrigerated soups and salads for the foodservice and retail markets, primarily in the eastern United States. See discussion regarding Sunnyside in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's 1993 Annual Report to Stockholders. MARKETING AND CUSTOMER SERVICE Each of the Company's five divisions has developed a marketing strategy which emphasizes high quality products and customer service. In June 1992 a new group (Michael Foods Sales) was formed to sell egg products and potato products nationally to, primarily, foodservice and industrial customers. Waldbaum and Northern Star joined their sales staffs and now each salesperson handles egg products, principally Easy Eggs-R-, hard-cooked eggs, frozen egg patties, and Simply Eggs-R- Brand Liquid Scrambled Egg Mix, as well as refrigerated and frozen potato products. This sales group is supported by a centralized order entry and customer service staff. Additionally, the Waldbaum division maintains a small sales group in Wakefield, Nebraska, which handles shell egg sales and certain egg product sales. Shell eggs are sold mainly to Crystal Farms. Customers for egg products include food manufacturers and foodservice businesses. Crystal Farms sales personnel obtain orders from retail stores which are usually placed no more than one day ahead of the requested delivery date. This sales force assists retail grocers in displaying and stocking Crystal Farms products. In-store and co-op advertising programs are utilized with grocers on a market-by-market basis. The dairy products division employs customer service representatives to service individual customer accounts. The prepared foods division employs customer service representatives to service individual customer accounts. ACQUISITIONS Acquisitions have played a significant role in the Company's growth. In 1988, the Company acquired one-half of the Milton G. Waldbaum Company for $24,100,000. Acquisition of the remaining one-half was completed in early 1990 for $49,250,000. This was the largest acquisition made by the Company and contributed to the substantial growth of its egg and egg products business between 1988 and 1990. In 1990 and 1991, the Company acquired two separate businesses for an aggregate purchase price of approximately $5,494,000. One of these acquisitions was of Sunnyside, the beginning of the Company's prepared foods division. Hard-cooked egg operations were benefited by the acquisition of Hale's Hardy Eggs, Inc. Both of these acquisitions were accounted for as purchases. While there were no acquisitions in 1992 or 1993, the Company anticipates that it will continue to make acquisitions as part of its strategic plan. In March 1994, the Company acquired the 50% of a joint venture it did not own from its joint venture partner (see "Eggs and Egg Products"). PROPRIETARY TECHNOLOGIES In 1988, the Company acquired an exclusive license to use a patented process, developed at North Carolina State University, for the ultrapasteurization of liquid eggs. The patent expires in 2006. The process results in liquid eggs that are salmonella and listeria negative, pursuant to USDA regulations. Salmonella and listeria are bacteria which can contaminate shell eggs. The process also extends the shelf life of liquid eggs from less than two weeks to ten weeks or more. In 1989, the Company completed construction of an aseptic plant in Gaylord, Minnesota which processes all of the ultrapasteurized liquid egg needs of the Company. The Company and the patent holder have initiated litigation against several processors of competing liquid egg products, claiming infringement of the original and subsequent related process patents with respect to ultrapasteurized liquid egg production. In 1992, a jury for the United States District Court for the middle district of Florida found the original patent to be valid and that a processor, Bartow Food Co., willfully and deliberately infringed the patent. In another action, against Papetti's Hygrade Egg Products, Inc., the United States District Court for the District of New Jersey found in 1992 and 1993 that the defendant had infringed the patents and that the licensed patents are valid and enforceable. Pending the defendant's appeal of the latter summary judgment, the issue of damages remains for trial. See Item 3 "Legal Proceedings." During 1993 the Company produced and marketed reduced cholesterol liquid whole eggs made via an extraction technology which removes at least 80% of the cholesterol from egg yolks. The yolks are combined with egg whites, resulting in reduced cholesterol liquid whole eggs. The Company has a non-exclusive license to the technology in North America, but discontinued production of the reduced cholesterol liquid whole eggs product in early 1994 (see "Eggs and Egg Products"). TRADENAMES Waldbaum markets its products using several tradenames including "Logan Valley", "Wakefield", "Sunny Side Up-R-" and "MGW". Ultrapasteurized liquid eggs are marketed using the "Easy Eggs-R-" tradename. The Company's liquid scrambled egg mix is marketed under the tradename "Simply Eggs-R- Brand". Crystal Farms products are marketed principally under the "Crystal Farms-R-" tradename. In addition, Crystal Farms is the principal distributor of "Bongards" cheese in Minnesota. Crystal Farms also distributes eggs, butter, cheese and margarine under a number of other customer-owned tradenames. Within the potato products division, Northern Star markets its frozen potatoes to foodservice customers under a variety of labels, including "Northern Star". The "Simply Potatoes-TM-" label is used for retail refrigerated products, with "Farmer Select" used on retail frozen products. Drallos and Farm Fresh also maintain various tradenames for certain of their products. Within the dairy products division, there are two main tradenames-"Kohler" and "Midwest Mix, Inc." Sunnyside markets its products under the tradenames, "Sunnyside Soups & Salads", "Simply Soups" and "Griddle Fresh". COMPETITION All aspects of the Company's businesses are extremely competitive. In general, food products are price sensitive and affected by many factors beyond the control of the Company, including changes in consumer tastes, fluctuating commodity prices, and changes in supply due to weather, production and feed costs. The Company's egg and egg products division is considered the second largest egg producer and the second largest egg products supplier in the United States, and competes with other suppliers of shell eggs and egg products. While the shell egg and egg products industry is highly fragmented, there has been a trend toward consolidation in recent years and further consolidation in the industry is expected. Other major egg producers include Cal- Maine Foods, Inc. and Rose Acre Farms, Inc. A major egg products producer is Papetti's Hygrade Egg Products, Inc. The Company believes that Waldbaum is among the lowest cost egg producers in the United States. The Company also believes that Easy Eggs'-R- salmonella-negative aspect, extended shelf-life and ease of use are significant competitive advantages in the foodservice and industrial food markets for eggs. The Company's refrigerated distribution division competes with the refrigerated products of other suppliers such as Beatrice Companies, Inc., Kraft, Inc., Land O' Lakes, Inc., and Sargento Cheese Company, Incorporated. Crystal Farms believes that its emphasis on a high level of direct service and lower-priced branded products has enabled it to compete in its market area with larger distributors of nationally branded products. Within the potato products division, Northern Star's frozen potato products compete with larger producers such as Carnation Co., J. R. Simplot Co., Lamb-Weston, Inc., McCain Foods, Inc. and Universal Foods Corporation. Within the retail frozen market, Ore-Ida Foods, Inc. is a major competitor. Competition in refrigerated potato products, where all three of the Company's potato subsidiaries compete, is generally limited to smaller local or regional companies. Within the dairy products division, management believes that Kohler provides the majority of the ice milk mix, and a significant percentage of ice cream mix, sold in Minnesota, Wisconsin and South Dakota. Kohler also has a large percentage of the UHT ice milk mix and UHT fluid milk business with fast food chains in the Upper Midwest. Competitors in areas outside of its immediate region generally are local and regional dairies. GOVERNMENT REGULATION All of the Company's subsidiaries are subject to federal and state regulations relating to grading, quality control, product branding and labeling, waste disposal and other aspects of their businesses. The subsidiaries are subject to USDA or FDA regulation regarding grading, quality, labeling and sanitary control. Waldbaum's egg breaking plants and Sunnyside's plant are subject to continuous on-site USDA inspection. All other subsidiaries are subject to periodic USDA inspections. Crystal Farms' cheese and butter products and Kohler's ice milk mix and ice cream mix are affected by milk price supports established by the USDA. The support price serves as an artificial minimum price for these products, which may not be indicative of market conditions that would prevail if such supports were abolished. All of the Company's subsidiaries must also comply with state and local waste disposal requirements. Waldbaum disposes of chicken waste to farmers for use as fertilizer. Northern Star disposes of solid waste from potato processing by selling the solid waste to a processor who converts it to animal feed and disposes of effluent under a waste discharge permit issued by the Minneapolis-St. Paul Metropolitan Waste Control Commission. Farm Fresh holds a permit with the Los Angeles County Sanitation District to discharge industrial waste into the Sanitation District's sewage system. Crystal Foods and Waldbaum have permits to discharge waste products into available sewer systems and maintain discharge ponds for certain wastes. Sunnyside is licensed by the State of New Jersey Department of Environmental Protection to spray, as irrigation, its waste water on property it leases. EMPLOYEES The Company employed approximately 2,550 employees at December 31, 1993. Of this total, Waldbaum employed approximately 1,300 full-time and 250 part-time employees, none of whom are represented by a union. Crystal Farms employed approximately 300 employees, none of whom are represented by a union. Northern Star employed approximately 350 employees of whom 289 are represented by the Bakery, Laundry, Allied Sales Drivers and Warehousemen Union affiliated with the Teamsters. Farm Fresh had 26 employees and Drallos had 4 employees at December 31, 1993 with none being represented by a union. Kohler employed 127 people at December 31, 1993. Historically, Kohler increases its number of employees by approximately 10 to 20 percent during the summer season. Its production personnel and drivers are represented by the Milk Drivers and Dairy Employees Union. Sunnyside employed 93 employees, none of whom are represented by a union. The Michael Foods Sales and Customer Service groups employed approximately 100 people at December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Officer Name Age Position Since - ---- --- -------- ------- Gregg A. Ostrander 41 President and Chief Executive 1993 Officer (1); previously Chief Operating Officer of the Company and held various executive positions with Armour Swift-Eckrich, Inc., a subsidiary of ConAgra, Inc. Jeffrey M. Shapiro 46 Executive Vice President 1987 and Secretary John D. Reedy 48 Vice President - Finance, 1988 Chief Financial Officer and Treasurer William L. Goucher 47 President - Waldbaum; 1993 previously Senior Vice President of Armour Swift-Eckrich, Inc. Food Service Division James J. Kohler 40 President - Kohler 1988 Kevin S. Murphy 40 Chief Executive 1988 Officer - Northern Star; previously Secretary/ Treasurer of the Company Officer Name Age Position Since - ---- --- -------- ------- Norman A. Rodriguez 51 President - Crystal 1989 Farms; previously held various executive positions with United Foods, Inc., including President and Chief Operating Officer Kevin O. Kelly 36 President - Michael Foods 1993 Sales; previously President - Crystal Farms Midwest and Vice President - Sales and Marketing of Kohler (1) Mr. Ostrander was named President and Chief Executive Officer as of January 1, 1994 and was Chief Operating Officer from February 1993 through December 1993. Richard G. Olson was President and Chief Executive Officer in 1993. ITEM 2 ITEM 2 - PROPERTIES FACILITIES The Company maintains leased space for the executive headquarters of its operations in Minneapolis, Minnesota. The egg and egg products division owns and operates 27 pullet growing houses, each containing approximately 14,600 square feet in Wakefield, Nebraska; two grain elevators in Wayne, Nebraska; 80 laying houses each containing approximately 19,500 square feet in Wakefield, Nebraska, Bloomfield, Nebraska and Hudson, Colorado; two feed mills in Wakefield, Nebraska, one in Bloomfield, Nebraska and one in Hudson, Colorado; processing facilities in Wakefield, Nebraska (approximately 323,000 square feet), Hudson, Colorado (approximately 49,000 square feet), Bloomfield, Nebraska (approximately 80,000 square feet); and warehouse, office and distribution facilities aggregating approximately 40,000 square feet located in Wakefield, Nebraska, Hudson, Colorado, Daytona Beach, Florida, and Bloomfield, Nebraska. Waldbaum owns in the aggregate approximately 950 acres of land in Nebraska, Colorado and Minnesota and leases the land in Bloomfield. The egg and egg products division also operates facilities under the Crystal Foods subsidiary, including a facility in Gaylord, Minnesota consisting of an 164,000 square foot egg products processing plant. A section of this plant was converted into the joint venture's cholesterol extraction plant in 1992 which was repurchased by the Company in early 1994. A facility in LeSueur, Minnesota consists of a 29,000 square foot egg processing plant. A facility in Palmyra, Wisconsin consists of a 12,000 square foot egg processing plant. In addition, 326,000 square feet of laying houses are maintained in Gaylord, 326,000 square feet of laying houses are maintained in LeSueur and 103,000 square feet of laying houses are maintained in Palmyra, Wisconsin. Each of the facilities at Gaylord, LeSueur and Palmyra operate their own feedmills. Crystal Foods also operates 12 pullet growing houses totaling 160,000 square feet. The Gaylord facility includes a centralized warehouse for the distribution of the Company's refrigerated foodservice egg and potato products. All of these facilities are owned by Crystal Foods. Waldbaum owns an unused facility located on eight acres of land near Richfield, North Carolina. This facility contains approximately 53,000 square feet and is being leased. The refrigerated distribution division leases administrative and sales offices in Minneapolis and several small warehouses across the United States. In January 1994, a new 33,000 square foot distribution center was opened in LeSueur, Minnesota. Wisco Farm Cooperative owns and operates a 48,200 square foot refrigerated warehouse on a 19 acre site in Lake Mills, Wisconsin. A 19,000 square foot cheese packaging facility is also located in Lake Mills. Within the potato products division, Northern Star owns its processing plant and five raw potato storage facilities in Minnesota, Wisconsin and North Dakota totaling over 290,000 square feet. Four of these facilities are located on land owned by Northern Star. The East Grand Forks, Minnesota facility is located on leased land. These facilities have an aggregate storage capacity of approximately 170 million pounds of raw potatoes. The processing plant contains approximately 175,000 square feet of production area and an automated frozen storage area with a capacity of over 20 million pounds of finished product. Farm Fresh leases three buildings in Bell Gardens, California, comprising approximately 22,000 square feet, from the former owner of Farm Fresh. Drallos owns a building in Detroit, Michigan comprising approximately 65,000 square feet. In the dairy products division, Kohler's facilities in White Bear Lake, Minnesota consist of three company-owned buildings, with the main plant containing approximately 104,000 square feet. Kohler also leases a UHT dairy plant in Sulphur Springs, Texas comprising approximately 20,000 square feet. The prepared foods division operates a facility in Millville, New Jersey of approximately 50,000 square feet for the processing of soups and salads. A new facility of approximately 35,000 square feet is under construction in Lake Mills, Wisconsin. Management believes that the facilities of the Company, together with budgeted capital improvements in each of its five operating divisions, are adequate to meet the Company's anticipated requirements for its current lines of business over the foreseeable future. NEBRASKA CONSTITUTIONAL PROVISION A substantial portion of the egg production and processing operations of Waldbaum is located in the state of Nebraska. With certain exceptions, a provision of the Nebraska constitution generally prohibits corporations from engaging in farming or ranching in Nebraska. Although the constitutional provision contains an exemption for agricultural land operated by a corporation for the purpose of raising poultry, the Nebraska Attorney General has, in written opinions, taken the position that facilities devoted primarily to the production of eggs do not fall within such exemption and therefore are subject to the restrictions contained in the constitutional provision. The Company believes that the egg production facilities of Waldbaum are part of Waldbaum's integrated facilities for the production, processing and distribution of eggs and egg products, and therefore, that any agricultural land presently owned by Waldbaum is being used for non-farming and non-ranching purposes. The constitution empowers the Nebraska Attorney General, or if the Attorney General fails to act, a Nebraska citizen, to obtain a court order to, among other things, force divestiture of land held in violation of the constitutional provision. If land subject to such a court order is not divested within a two-year period, the constitutional provision directs the court to declare the land escheated to the State of Nebraska. The Company is not aware of any proceedings under such constitutional provision pending or threatened against either Waldbaum or the Company. Until the scope of such provision has been clarified by further judicial, legislative, or executive action, there can be no assurance as to the effect, if any, that it may have on the business of Waldbaum or the Company. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS The Company and the owner of the patents for ultrapasteurizing liquid eggs initiated litigation on November 8, 1989 against a processor of liquid egg products, Papetti's Hygrade Egg Products, Inc. ("Papetti's"), claiming infringement of the process patents with respect to ultrapasteurized liquid egg production. The action was brought in the United States District Court for the District of New Jersey. In November 1992 the Company was granted summary judgment that Papetti's had infringed the claims in the patents. In July 1993 the Court granted summary judgment that the patents were valid and enforceable. The relief sought by the plaintiffs included damages and costs and disbursements, including attorneys' fees. The defendant in this action contended that their process did not infringe the patents and that the patents are invalid. The defendant has filed an appeal of the 1993 summary judgment with the Federal Circuit Court of Appeals. Discovery on the question of damages has been suspended during the pendency of the appeal, which is expected to be heard in the Spring of 1994. On July 2, 1992 Sunny Fresh Foods, Inc. commenced an action in the U. S. District Court for the District of Minnesota against the Company and the owner of the patents for ultrapasteurizing liquid eggs seeking declaratory judgment that the patents licensed by the Company are invalid. The Company and the patent holder have counterclaimed for infringement of the patents by the plaintiff. The relief sought by the Company includes damages and costs and disbursements, including attorneys' fees. Discovery is presently underway and is expected to continue through 1994. On August 12, 1993 Nulaid Foods, Inc. commenced an action in the U. S. District Court for the Eastern District of California against the Company seeking declaratory judgment that the patents licensed by the Company for the ultrapasteurization of liquid eggs are invalid. The Company and the patent holder have counterclaimed for infringement of the patents by the plaintiff. The relief sought by the Company includes damages and costs and disbursements, including attorneys' fees. Discovery is presently underway. The action brought in 1992 in the U. S. District Court for the District of Minnesota by the Company's Northern Star Company ("Northern Star") subsidiary against Archer Daniels Midland, Inc. ("ADM") and Burlington Northern, Inc. ("BN"), seeking a determination that the defendants are responsible for all costs associated with the investigation and remediation of a contaminated site purchased by Northern Star. The parties reached a settlement in the fourth quarter of 1993. Under the separate settlement agreements, ADM and BN agreed to remediate the contaminated site subject to approval by the Minnesota Pollution Control Agency. In addition, ADM has agreed to lease to Northern Star certain property for the construction of a waste water treatment facility and a parking lot. Separately, Northern Star asserted a crossclaim against the Port Authority of the City of St. Paul, Minnesota (the "Port Authority") for the recovery of certain remediation costs relating to the property acquired from the Port Authority. An agreement in principal has been reached with the Port Authority in settlement of this crossclaim. The Company is also engaged in routine litigation incidental to its business, which management believes will not have a material adverse effect upon its business or consolidated financial position. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Pursuant to General Instruction G(2), information is incorporated by reference to "Market Price Ranges" on the inside back cover of the Company's Annual Report to Stockholders for 1993. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Pursuant to General Instruction G(2), information is incorporated by reference to "Summary Consolidated Financial Data" on page 19 of the Company's Annual Report to Stockholders for 1993. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction G(2), information is incorporated by reference to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 8 and 9 of the Company's Annual Report to Stockholders for 1993. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pursuant to General Instruction G(2), information is incorporated by reference to "Report of Independent Certified Public Accountants" and "Consolidated Financial Statements of Michael Foods, Inc. and Subsidiaries" on pages 10-18 , and "Quarterly Financial Data" on page 20, of the Company's Annual Report to Stockholders for 1993. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3), information is incorporated by reference to "Election of Directors" on pages 1-3 of the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 25, 1994. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION Pursuant to General Instruction G(3), information is incorporated by reference to "Executive Compensation" on pages 4-11 of the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 25, 1994. In addition, James J. Kohler, President of Kohler Mix Specialties, Inc., Norman A. Rodriguez, President of Crystal Farms Refrigerated Distribution Company, Kevin O. Kelly, President of Michael Foods Sales, and John D. Reedy, Vice President -- Finance are participants in the Severance Plan for Eligible Employees of Michael Foods, Inc. and its Subsidiaries (the "Plan"). Under the Plan, certain identified employees of Michael Foods, Inc. are entitled to severance pay upon termination of employment if such termination of employment occurs within two years following a change in control, as defined in the Plan, and such termination is due to reasons other than death, permanent disability, retirement, cause, or resignation by the employee other than for Good Reason. Good Reason is a defined term which includes, among other things, a termination by the employee due to a significant change in his responsibilities, titles or offices, a requirement that he or she move outside of his or her geographic location, a reduction in the employee's base salary or the failure of the employer to increase compensation proportionate to other similarly situated employees; the failure of the employer to maintain any benefit plan or a substantial modification in such plan which would reduce the employee's benefits, and any purported termination of employment by the Company which is not effected pursuant to a notice of termination as required under the Plan. The amount of compensation to which Messrs. Kohler, Rodriguez, Kelly and Reedy would become entitled equals two times their Annual Compensation, as defined, which generally means base compensation excluding bonuses, benefits and allowances. The Plan automatically terminates unless it is renewed by action of the Board of Directors of the Company prior to July 1, 1994 and annually thereafter, except that the Plan will remain in effect after a change in control for at least 24 months unless otherwise terminated by the Board of Directors of the Company with the consent of 80% of the Plan participants who were Plan participants at the time of the change in control. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3), information is incorporated by reference to "Security Ownership" on pages 12 and 13 of the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 25, 1994. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3), information is incorporated by reference to "Related Party Transactions" on page 3 of the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 25, 1994. Part IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K EXHIBITS 3.1 Certificate of Incorporation of Michael Foods, Inc. (1) 3.2 Certificate of Amendment to Certificate of Incorporation dated April 29, 1988 (2) 3.3 Certificate of Amendment to Certificate of Incorporation dated April 30, 1990 (3) 3.4 Bylaws of Michael Foods, Inc. (1) 3.5 Amendment of the Company's Bylaws dated February 23, 1988 (7) 4.1 Form of Common Stock Certificate (9) 10.10 Employment Agreement between Michael Foods, Inc. and Richard G. Olson dated November 29, 1989 (6) 10.11 Employment Agreement between Michael Foods, Inc. and Jeffrey M. Shapiro dated March 1, 1990 (6) 10.15 Michael Foods, Inc. 1987 Incentive Stock Option Plan and Incentive Stock Option Agreement (1) 10.16 Michael Foods, Inc. 1987 Non-Qualified Stock Option Plan and Non-Qualified Stock Option Agreement (1) 10.25 Form of Michael Foods, Inc. Director Stock Option Agreement (1) 10.34 Agreement for the Purchase of Capital Stock of Milton G. Waldbaum Company, dated as of April 29, 1988, and Amendment No. 1 and 2, with Exhibits (4) 10.40 Retirement Compensation Agreement between Milton G. Waldbaum Company and Daniel W. Gardner dated September 24, 1987 (6) 10.41 Employment Agreement between Milton G. Waldbaum Company and Daniel W. Gardner dated May 31, 1988 (6) 10.42 Consulting and Non-Competition Agreement between Milton G. Waldbaum Company and Daniel W. Gardner dated May 31, 1988 (6) 10.43 Loan Agreement and Promissory Note between Metropolitan Life Insurance Company and Michael Foods, Inc., dated December 1, 1989 (6) 10.44 Amendment No. 1 to Put and Call Agreement between Michael Foods, Inc. and the Gardner Family (6) 10.45 Addendum No. 1 to Employment Agreement between Michael Foods, Inc. and Richard G. Olson dated March 1, 1990 (6) 10.46 Revolving Loan Agreement between Continental Bank, N.A., as Agent, and Michael Foods, Inc. dated March 30, 1990 (10) 10.47 Consulting Agreement between Michael Foods, Inc. and John M. Stafford dated January 7, 1991 (10) 10.48 First Amendment to Revolving Loan Agreement between Continental Bank, N.A., as Agent, and Michael Foods, Inc., dated March 7, 1991 (10) 10.49 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated July 15, 1990 (10) 10.50 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated September 15, 1990 (10) 10.54 Employment Agreement between Milton G. Waldbaum Company and David Gardner dated March 15, 1990 (10) 10.55 Amendment to Michael Foods, Inc. Incentive and Non- Qualified Stock Option Plans, dated November 21, 1989 (8) 10.56 License Agreement between Michael Foods, Inc. and North Carolina State University dated November 28, 1989 (10) 10.57 Severance Plan for Eligible Employees of Michael Foods, Inc. and its Subsidiaries (5) 10.58 Partnership Agreement between SKW Nature's Products, Inc. and MIKL, Inc. (11) 10.59 Addendum No. 2 to Employment Agreement between Michael Foods, Inc. and Richard G. Olson dated June 28, 1991 (12) 10.60 Second Amendment to Revolving Loan Agreement between Continental Bank, N.A., as Agent, and Michael Foods, Inc., dated February 25, 1992 (12) 10.61 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company dated February 24, 1992 (12) 10.62 Third Amendment to Revolving Loan Agreement between Continental Bank , N.A., as Agent, and Michael Foods, Inc., dated April 24, 1992 (13) 10.63 Fourth Amendment to Revolving Loan Agreement between Continental Bank , N.A., as Agent, and Michael Foods, Inc., dated October 16, 1992 (14) 10.64 First Amendment to July 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated October 7, 1992 (14) 10.65 First Amendment to September 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated October 7, 1992 (14) 10.66 First Amendment to February 24, 1992 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company dated October 7, 1992 (14) 10.67 First Amendment to December 1, 1989 Loan Agreement and Promissory Note between Michael Foods, Inc. and Metropolitan Life Insurance Company dated October 14, 1992 (14) 10.68 Amended and Restated Annual Incentive Compensation Plan (14) 10.69 Amendment to the Non-Qualified Stock Option Plan (15) 10.70 Stock Option Plan for Non-Employee Directors (16) 10.71 Memorandum of Agreement effective as of January 1, 1993 amending Partnership Agreement between SKW Nature's Products, Inc. and MIKL, Inc. (17) 10.72 Amendment to Severance Plan for Eligible Employees of Michael Foods, Inc. and its Subsidiaries adopted by resolution of the Board of Directors on July 29, 1993 (17) 10.73 Resolution adopted by the Board of Directors on April 27, 1993 extending the termination date of the Severance Plan for Eligible Employees of Michael Foods, Inc. and its Subsidiaries for one additional year (17) 10.74 Assignment Agreement between Westpac Banking Corporation and Toronto Dominion (Texas), Inc. (17) 10.75 Revolving Note between Michael Foods, Inc. and Toronto Dominion (Texas), Inc. (17) 10.76 Michael Foods, Inc. 1994 Executive Incentive Plan 10.77 Michael Foods, Inc. 1994 Executive Performance Stock Award Plan 10.78 Fifth Amendment to Revolving Loan Agreement between Continental Bank, N. A., as Agent, and Michael Foods, Inc., dated February 4, 1994 10.79 Employment Agreement between Michael Foods, Inc. and Gregg A. Ostrander dated January 31, 1994 10.80 Retirement and Consulting Agreement between Michael Foods, Inc. and Richard G. Olson dated December 23, 10.81 Second Amendment to December 1, 1989 Loan Agreement and Promissory Note between Michael Foods, Inc. and Metropolitan Life Insurance Company dated February 23, 10.82 Second Amendment to July 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated February 15, 1994 10.83 Second Amendment to September 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated February 15, 1994 10.84 Second Amendment to February 24, 1992 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company dated February 15, 1994 10.85 Purchase and Sale Agreement by and between SKW Nature's Products, Inc. and Michael Foods, Inc. dated March 11, 10.86 Technology License Agreement by and between SKW Trostberg AG and Michael Foods, Inc. dated March 11, 13.1 1993 Annual Report to Stockholders 21.1 Schedule of Michael Foods, Inc. Subsidiaries 23.1 Auditors' Consent - Grant Thornton Management Contract or Compensation Plan Arrangement ** Request for confidential treatment has been filed with the Commission for the redacted portions of these Exhibits - ---------------------------- (1) Incorporated by reference from the Company's Registration Statement on Form S-1 Registration No. 33-12949. (2) Incorporated by reference from the Company's Report on Form 10-Q for the Quarter ended March 31, 1988. (3) Incorporated by reference from the Company's Report on Form 10-Q for the Quarter ended June 30, 1990. (4) Incorporated by reference from Exhibit 2.1 of the Company's Report on Form 8-K dated June 6, 1988. (5) Incorporated by reference from the Company's Form 8, Amendment No. 1 to Report on Form 10-K for the year ended December 31, 1990. (6) Incorporated by reference from the Company's Report on Form 10-K for the year ended December 31, 1989. (7) Incorporated by reference from the Company's Report on Form 10-K for the year ended December 31, 1987. (8) Incorporated by reference to Exhibit 4.6 of the Company's Registration Statement on Form S-8 effective November 21, 1989 Registration No. 33-31914. (9) Incorporated by reference from the Company's Registration Statement on Form S-3 Registration No. 33-40071. (10) Incorporated by reference from the Company's Report on Form 10-K for the year ended December 31, 1990. (11) Incorporated by reference to Exhibit 10.58 of the Company's Form 8, Amendment No. 1 to Report on Form 10-K for the year ended December 31, 1991. (12) Incorporated by reference from the Company's Report on Form 10-K for the year ended December 31, 1991. (13) Incorporated by reference from the Company's Report on Form 10-Q for the quarter ended March 31, 1992. (14) Incorporated by reference from the Company's Report on Form 10-K for the year ended December 31, 1992. (15) Incorporated by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-8 effective June 9, 1993 Registration No. 33-64078. (16) Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-8 effective June 9, 1993 Registration No. 33-64076. (17) Incorporated by reference from the Company's Report on Form 10-Q for the quarter ended June 30, 1993. FINANCIAL STATEMENTS The consolidated financial statements of Michael Foods, Inc. and Subsidiaries as of December 31, 1993 and 1992 and for the 3 years ended December 31, 1993 are incorporated by reference to the Company's Annual Report to Stockholders for 1993, which includes the following: Page Number (in the Company's Annual Report to Stockholders for 1993) ------------------------ Report of Independent Certified Public Accountants 18 Consolidated Balance Sheets 10 Consolidated Statements of Operations 11 Consolidated Statements of Stockholders' Equity 12 Consolidated Statements of Cash Flows 13 Notes to Consolidated Financial Statements 14-17 FINANCIAL STATEMENT SCHEDULES Michael Foods, Inc. and Subsidiaries Report of Independent Certified Public Accountants on Schedules Schedule II - Amounts Receivable from Related Parties Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short Term Borrowings Schedule X - Supplementary Income Statement Information OTHER FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidated financial statements or notes thereto. REPORTS ON FORM 8-K A report on Form 8-K was filed on December 21, 1993 regarding the announcement of a fourth quarter 1993 restructuring charge. Signatures Pursuant to the requirements of Section 13 or 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. MICHAEL FOODS, INC. Date: March 31, 1994 By: /s/ Gregg A. Ostrander ----------------------- Gregg A. Ostrander (President and Chief Executive Officer) Date: March 31, 1994 By: /s/ John D. Reedy ------------------ John D. Reedy (Vice-President-Finance, Treasurer, Chief Financial Officer and Principal Accounting 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: /s/ James H. Michael March 31, 1994 - --------------------- James H. Michael (Chairman of the Board) /s/ Gregg A. Ostrander March 31, 1994 - ----------------------- Gregg A. Ostrander (Director, President & Chief Executive Officer) /s/ Miles E. Efron March 31, 1994 - ------------------- Miles E. Efron (Director) /s/ Richard A. Coonrod March 31, 1994 - ----------------------- Richard A. Coonrod (Director) /s/ Orville L. Freeman March 31, 1994 - ----------------------- Orville L. Freeman (Director) /s/ Arvid C. Knudtson March 31, 1994 - ---------------------- Arvid C. Knudtson (Director) /s/ Joseph D. Marshburn March 31, 1994 - ------------------------ Joseph D. Marshburn (Director) /s/ Jeffrey J. Michael March 31, 1994 - ----------------------- Jeffrey J. Michael (Director) /s/ Richard G. Olson March 31, 1994 - --------------------- Richard G. Olson (Director) Report of Independent Certified Public Accountants on Schedules Board of Directors Michael Foods, Inc. In connection with our audits of the consolidated financial statements of Michael Foods, Inc. and Subsidiaries referred to in our report dated February 16, 1994, which is included in the Annual Report to Stockholders and incorporated by reference in Part II of this form, we have also audited Schedules II, V, VI, VIII, IX and X for each of the three years in the period ended December 31, 1993. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. /s/ GRANT THORNTON Minneapolis, Minnesota February 16, 1994 EXHIBIT INDEX ------------- EXHIBITS PAGE NUMBER NUMBER - ------ ------ 10.76 Michael Foods, Inc. 1994 Executive Incentive Plan 10.77 Michael Foods, Inc. 1994 Executive Performance Stock Award Plan 10.78 Fifth Amendment to Revolving Loan Agreement between Continental Bank, N. A., as Agent, and Michael Foods, Inc., dated February 4, 10.79 Employment Agreement between Michael Foods, Inc. and Gregg A. Ostrander dated January 31, 10.80 Retirement and Consulting Agreement between Michael Foods, Inc. and Richard G. Olson dated December 23, 1993 10.81 Second Amendment to December 1, 1989 Loan Agreement and Promissory Note between Michael Foods, Inc. and Metropolitan Life Insurance Company dated February 23, 1994 10.82 Second Amendment to July 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated February 15, 1994 10.83 Second Amendment to September 15, 1990 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company and Washington Square Capital, as Agent, dated February 15, 1994 10.84 Second Amendment to February 24, 1992 Note Purchase Agreement between Michael Foods, Inc. and The Principal Mutual Life Insurance Company dated February 15, 1994 10.85 Purchase and Sale Agreement by and between SKW Nature's Products, Inc. and Michael Foods, Inc. dated March 11, 1994 10.86 Technology License Agreement by and between SKW Trostberg AG and Michael Foods, Inc. dated March 11, 1994 13.1 1993 Annual Report to Stockholders 21.1 Schedule of Michael Foods, Inc. Subsidiaries 23.1 Auditors' Consent - Grant Thornton * Management Contract or Compensation Plan Arrangement ** Request for confidential treatment has been filed with the Commission for the redacted portions of these Exhibits	8,234	54,552
63908_1993.txt	63908_1993	1993	63908	Item 1. Business McDonald's Corporation, the registrant, together with its subsidiaries, is referred to herein as the "Company". (a) General development of business There have been no significant changes to the Company's corporate structure during 1993, nor material changes in the Company's method of conducting business. (b) Financial information about industry segments Industry segment data for the years ended December 31, 1993, 1992 and 1991 is included in Part II, item 8, pages 33 and 41 of this Form 10-K. (c) Narrative description of business General The Company develops, operates, franchises and services a worldwide system of restaurants which prepare, assemble, package and sell a limited menu of value-priced foods. These restaurants are operated by the Company or, under the terms of franchise arrangements, by franchisees who are independent third parties, or by affiliates operating under joint-venture agreements between the Company and local businesspeople. The Company's franchising program assures consistency and quality. The Company is selective in granting franchises and is not in the practice of franchising to investor groups or passive investors. Under the conventional franchise arrangement, franchisees supply capital - initially, by purchasing equipment, signs, seating, and decor, and over the long term, by reinvesting in the business. The Company shares the investment by owning or leasing the land and building; franchisees then contribute to the Company's revenues through payment of rent and service fees based upon a percent of sales, with specified minimum payments. Generally, the conventional franchise arrangement lasts 20 years and franchising practices are consistent throughout the world. Further discussion regarding site selection is included in Part 1, item 2, page 6 of this Form 10-K. Training begins at the restaurant with one-on-one instruction and videotapes. Aspiring restaurant managers progress through a development program of classes in basic and intermediate operations, management and equipment. Assistant managers are eligible to attend the advanced operations and management class at one of the five Hamburger University (H.U.) campuses in the U.S., Germany, England, Japan or Australia. The curriculum at H.U. concentrates on skills and practices essential to delivering customer satisfaction and running a restaurant business. The Company's global brand is well-known. Marketing and promotional activities are designed to nurture this brand image and differentiate the Company from competitors by focusing on value and customer satisfaction. Funding for promotions is handled at the local restaurant level; funding for regional and national efforts is handled through advertising cooperatives. Franchised, Company-operated and affiliated restaurants throughout the world make voluntary contributions to cooperatives which purchase media. Production costs for certain advertising efforts are borne by the Company. Products McDonald's restaurants offer a substantially uniform menu consisting of hamburgers and cheeseburgers, including the Big Mac and Quarter Pounder with Cheese sandwiches, the Filet-O-Fish, McGrilled Chicken and McChicken sandwiches, french fries, Chicken McNuggets, salads, low fat shakes, sundaes and cones made with low fat frozen yogurt, pies, cookies and a limited number of soft drinks and other beverages. In addition, the restaurants sell a variety of products during limited promotional time periods. McDonald's restaurants operating in the United States are open during breakfast hours and offer a full breakfast menu including the Egg McMuffin and the Sausage McMuffin with Egg sandwiches, hotcakes and sausage; three varieties of biscuit sandwiches; Apple-Bran muffins; and cereals. McDonald's restaurants in many countries around the world offer many of these same products as well as other products and limited breakfast menus. The Company tests new products on an ongoing basis. The Company, its franchisees and affiliates purchase food products and packaging from numerous independent suppliers. Quality specifications for both raw and cooked food products are established and strictly enforced. Alternative sources of these items are generally available. Quality assurance labs in the U.S., Europe and the Pacific work to ensure that the Company's high standards are consistently met. The quality assurance process involves ongoing testing and on-site inspections of suppliers' facilities. Independently owned and operated distribution centers distribute products and supplies to most McDonald's restaurants. The restaurants then prepare, assemble and package these products using specially designed production techniques and equipment to obtain uniform standards of quality. Trademarks and patents The Company has registered trademarks and service marks, some of which, including "McDonald's", "Ronald McDonald" and other related marks, are of material importance to the Company's business. The Company also has certain patents on restaurant equipment which, while valuable, are not material to its business. Seasonal operations The Company does not consider its operations to be seasonal to any material degree. Working capital practices Information about the Company's working capital practices is incorporated herein by reference to Management's Discussion and Analysis of the Company's financial position and the consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 in Part II, item 7, pages 26 through 28, and Part II, item 8 page 35 of this Form 10-K. Customers The Company's business is not dependent upon a single customer or small group of customers. Backlog Company-operated restaurants have no backlog orders. Government contracts No material portion of the business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the U.S. government. Competition McDonald's restaurants compete with international, national, regional, and local retailers of food products. The Company competes on the basis of price and service and by offering quality food products. The Company's competition in the broadest perspective includes restaurants, quick-service eating establishments, pizza parlors, coffee shops, street vendors, convenience food stores, delicatessens, and supermarket freezers. In the U.S., about 372,000 restaurants generate nearly $213 billion in annual sales. McDonald's accounts for about 2.5% of those restaurants and approximately 6.7% of those sales. No reasonable estimate can be made of the number of competitors outside of the U.S.; however, the Company's business in foreign markets continues to grow. Research and development The Company operates research and development facilities in Illinois. While research and development activities are important to the Company's business, these expenditures are not material. Independent suppliers also conduct research activities for the benefit of the McDonald's System, which includes franchisees and suppliers, as well as McDonald's, its subsidiaries and joint ventures. Environmental matters The Company is not aware of any federal, state or local environmental laws or regulations which will materially affect its earnings or competitive position, or result in material capital expenditures; however, the Company cannot predict the effect on its operations of possible future environmental legislation or regulations. During 1993, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated. Number of employees During 1993, the Company's average number of employees was approximately 167,000. (d) Financial information about foreign and domestic operations Financial information about foreign and domestic markets is incorporated herein by reference from selected Financial Data, Management's Discussion and Analysis and Segment and Geographic Information in Part II, item 6, page 10, Part II, item 7, pages 11 through 29 and Part II, item 8, page 41, respectively, of this Form 10-K. Item 2. Item 2. Properties The Company identifies and develops sites that offer convenience to customers and provide for long-term sales and profit potential. To assess potential, the Company analyzes traffic and walking patterns, census data, school enrollments and other relevant data. The Company's experience and access to advanced technology aids in evaluating this information. In order to control occupancy costs and rights, the Company owns restaurant sites and buildings where feasible and where it is not practical, secures long-term leases. Restaurant profitability for both the Company and franchisees is important; therefore, ongoing efforts are made to lower average development costs through construction and design efficiencies and by leveraging the Company's global sourcing system. Additional information about the Company's properties is incorporated herein by reference to Management's Discussion and Analysis and the related financial statements with footnotes in Part II, item 7, pages 11 through 29 and Part II, item 8, pages 34, 35, 37, 38, 42, 46 and 47, respectively, of this Form 10-K. Item 3. Item 3. Legal Proceedings The Company has pending a number of lawsuits which have been filed from time to time in various jurisdictions. These lawsuits cover a broad variety of allegations spanning the Company's entire business. The following is a brief description of the more significant of these categories of lawsuits and government regulations. Franchising A substantial number of McDonald's restaurants are franchised to independent businesspeople operating under arrangements with the Company. In the course of the franchise relationship, occasional disputes arise between the Company and its franchisees relating to a broad range of subjects including, without limitation, quality, service and cleanliness issues, contentions regarding grants or terminations of franchises, franchisee claims for additional franchises or rewrites of franchises, and delinquent payments. Suppliers The Company and its affiliates and subsidiaries do not supply, with minor exceptions outside of the United States, food, paper, or related items to any McDonald's restaurants. The Company relies upon independent suppliers which are required to meet and maintain the Company's standards and specifications. There are a number of such suppliers worldwide and on occasion disputes arise between the Company and its suppliers on a number of issues including, by way of example, compliance with product specifications and McDonald's business relationship with suppliers. Employees Thousands of persons are employed by the Company and in restaurants owned and operated by subsidiaries of the Company. In addition, thousands of persons, from time to time, seek employment in such restaurants. In the ordinary course of business, disputes arise regarding hiring, firing and promotion practices. Customers McDonald's restaurants serve a large cross-section of the public and in the course of serving so many people, disputes arise as to products, service, accidents and other matters typical of an extensive restaurant business such as that of the Company. Trademarks McDonald's has registered trademarks and service marks, some of which are of material importance to the Company's business. From time to time, the Company may become involved in litigation to defend and protect its use of such registered marks. Government Regulations Local, state and federal governments have adopted laws and regulations involving various aspects of the restaurant business, including, but not limited to, franchising, health, environment, zoning and employment. The Company does not believe that it is in violation of any existing statutory or administrative rules, but it cannot predict the effect on its operations from promulgation of additional requirements in the future. Item 4. Item 4. Submission of Matters to a Vote of Shareholders None. Executive Officers of the Registrant All of the executive officers of McDonald's Corporation as of March 1, 1994 are shown below. Each of the executive officers has been continuously employed by the Company for at least five years and has a term of office until the May 1994 Board of Directors' meeting. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters The Company's common stock trades under the symbol MCD and is listed on the following stock exchanges in the United States: New York, Chicago and Pacific. The common stock price range on the New York Stock Exchange composite tape has been as follows: --------------------------------------------------------- Quarter 1993 1992 --------------------------------------------------------- First $54 1/4 - 46 3/4 $45 - 38 3/8 Second $53 1/2 - 45 1/2 $47 1/2 - 39 3/8 Third $55 5/8 - 48 1/4 $47 1/4 - 41 1/8 Fourth $59 1/8 - 51 1/4 $50 3/8 - 40 7/8 --------------------------------------------------------- Year $59 1/8 - 45 1/2 $50 3/8 - 38 3/8 --------------------------------------------------------- The approximate number of shareholders of record and beneficial owners of the Company's common stock as of December 31, 1993 was estimated to be 459,000. Given the Company's returns on equity and assets, the Company's management believes it is prudent to reinvest a significant portion of earnings back into the business. The Company has paid 72 consecutive quarterly dividends on common stock and has increased the per share amount 19 times since the first dividend was paid in 1976. Additional dividend increases will be considered after reviewing returns to shareholders, profitability expectations and financing needs. Dividends per common share for the years ended December 31, 1993 and 1992 are incorporated herein by reference from Part II, item 8, page 33. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ----------------------------------------------------------------------- CONSOLIDATED OPERATING RESULTS ----------------------------------------------------------------------- INCREASES (DECREASES) IN OPERATING RESULTS OVER PRIOR YEAR ----------------------------------------------------------------------- (Dollars rounded to millions, 1993 1992 except per common share data) Amount % Amount % ----------------------------------------------------------------------- SYSTEMWIDE SALES $1,702 8 $1,957 10 ----------------------------------------------------------------------- REVENUES Sales by Company-operated restaurants $ 55 1 $ 194 4 Revenues from franchised restaurants 220 11 244 14 ----------------------------------------------------------------------- TOTAL REVENUES 275 4 438 7 ----------------------------------------------------------------------- OPERATING COSTS AND EXPENSES Company-operated restaurants 38 1 97 2 Franchised restaurants 32 9 42 14 General, administrative and selling expenses 81 9 66 8 Other operating (income) expense--net 2 (3) 50 (44) ----------------------------------------------------------------------- TOTAL OPERATING COSTS AND EXPENSES 153 3 255 5 ----------------------------------------------------------------------- OPERATING INCOME 122 7 183 11 ----------------------------------------------------------------------- Interest expense (58) (15) (18) (5) Nonoperating income (expense)--net 48 N/M (52) N/M ----------------------------------------------------------------------- INCOME BEFORE PROVISION FOR INCOME TAXES 228 16 149 11 ----------------------------------------------------------------------- Provision for income taxes 104 21 50 11 ----------------------------------------------------------------------- NET INCOME $ 124 13 $ 99 12 ======================================================================= NET INCOME PER COMMON SHARE $ .31 12 $ .25 11 ----------------------------------------------------------------------- N/M - Not Meaningful SYSTEMWIDE SALES AND RESTAURANTS Systemwide sales are comprised of sales by restaurants operated by the Company, franchisees and affiliates operating under joint-venture agreements between McDonald's and local businesspeople. The 1993 increase was due to new restaurant expansion and higher sales at existing restaurants worldwide, offset in part by weaker foreign currencies and one less day in 1993 since 1992 was a leap year. The 1992 increase was due to new restaurant expansion, higher sales at existing restaurants and stronger foreign currencies. Sales by Company-operated restaurants grew at a slower rate than Systemwide sales in 1993 and 1992. The slower rate of growth in 1993 occurred primarily because weaker foreign currencies had a greater impact on sales by Company-operated restaurants than on Systemwide sales, combined with an increasing global base of franchised restaurants from expansion. The slower rate of growth in 1992 reflected the franchising of certain Company-operated businesses. Average sales by restaurants open at least one year were $1,768,000 in 1993, which was $35,000 higher than in 1992. Average sales both in the U.S. and outside of the U.S. improved due to the value program and various promotional efforts. Expansion has continued at an accelerated pace as 900 restaurants were added in 1993, compared with 675 in 1992 and 615 in 1991. Restaurants opened during the year (excluding satellite locations) contributed $572 million to Systemwide sales in 1993, $478 million in 1992 and $460 million in 1991. McDonald's plans to add between 900 and 1,200 restaurants (excluding satellite locations) around the world in 1994 and in each of the next several years. The mix of net additions will remain the same -- approximately one-third in the U.S. and two-thirds in markets outside of the U.S. Our global expansion plan also includes satellites -- sites that leverage the infrastructure of existing restaurants, either by using their storage capability or by drawing on their management talent and labor pool. At year-end 1993, 170 satellites were operating around the world. In addition, we expect to add several hundred satellite locations around the world each year. TOTAL REVENUES Total revenues consist of sales by Company-operated restaurants and fees from restaurants operated by franchisees and affiliates, based upon a percent of sales with specified minimum payments. The minimum franchise fee generally has been 12% of sales for new U.S. franchise arrangements since 1987. Higher fees are charged for sites that require a higher investment on the part of the Company. Fees paid by franchisees outside of the U.S. vary according to local business conditions. These fees, together with occupancy and operating rights, are stipulated in franchise arrangements that generally have 20-year terms. Revenues grow as restaurants are added and as existing restaurants build sales. Menu price adjustments affect revenues as well as sales; however, different pricing structures, new products, promotions, and product mix variations make it impractical to quantify the impact for the System. The rates of increases in total revenues for 1993 and 1992 were less than the rates of increases in Systemwide sales. In 1993, this reflected weaker foreign currencies which had a greater impact on revenues than on Systemwide sales and the increasing global base of franchised restaurants, occurring primarily from expansion. In 1992, the franchising of certain Company-operated restaurant businesses primarily in the U.S. and Canada affected the rate of increase. Growth rates in sales by Company-operated restaurants and revenues from franchised restaurants varied because of expansion and changes in ownership and because sales by Company-operated restaurants were impacted to a greater degree by changing foreign currencies than were revenues. In 1993, about 53% of sales by Company-operated restaurants were outside of the U.S., compared with 33% of revenues from franchised restaurants. RESTAURANT MARGINS Company-operated restaurant margins were 19.2% of sales in 1993, compared with 19.1% in 1992 and 17.9% in 1991. As a percent of sales, food and paper costs increased, while occupancy, other operating and payroll costs declined in 1993. All costs as a percent of sales declined in 1992. Franchised restaurant margins were 83.1% of applicable revenues for 1993, compared with 82.8% in 1992 and 1991. Franchised margins include revenues and expenses associated with restaurants operating under business facilities lease arrangements. Under these arrangements, the Company leases the businesses -- including equipment -- to franchisees who have options to purchase the businesses. While higher fees are charged under these arrangements, margins are generally lower because of equipment depreciation. When these purchase options are exercised, the resulting gains compensate the Company for lower margins prior to exercise and are included in other operating (income) expense--net. At year-end 1993, 544 restaurants were operating under such arrangements, compared with 583 and 584 at year-end 1992 and 1991, respectively. GENERAL, ADMINISTRATIVE AND SELLING EXPENSES The 1993 increase was due primarily to higher employee costs associated with expansion and key priorities, partially offset by weaker foreign currencies. The 1992 increase was due to higher employee costs associated with expansion, partially offset by a reduction in U.S. marketing costs associated with the value program. These expenses as a percent of Systemwide sales have remained relatively constant over the past five years, and were 4.0% in 1993 and 3.9% in 1992. OTHER OPERATING (INCOME) EXPENSE--NET This category is comprised primarily of gains on sales of restaurant businesses, equity in earnings of unconsolidated affiliates, and net gains or losses from property dispositions. The 1993 and 1992 amounts were relatively constant, reflecting greater income from affiliates and gains on sales of restaurant businesses in 1993, offset by the favorable settlement of a sales tax case in Brazil in 1992. Major factors contributing to the 1992 decrease included lower affiliate results due to 1991 gains from property dispositions and lower operating results in Japan, lower gains on sales of restaurant businesses, and greater losses on property dispositions, partially offset by the favorable settlement of a sales tax case in Brazil in 1992. Gains on sales of restaurant businesses include gains from exercises of purchase options by franchisees operating under business facilities lease arrangements and from sales of Company-operated restaurants. As a franchisor, McDonald's purchases and sells businesses in transactions with franchisees and affiliates in an ongoing effort to achieve the optimal ownership mix in each market. These transactions and the resulting gains are integral to franchising, and are appropriately recorded in operating income. Equity in earnings of unconsolidated affiliates is reported after interest expense and income taxes, except for U.S. partnerships that are reported before income taxes. The Company actively participates in, but does not control, these businesses. Net gains or losses from property dispositions result from disposal of excess properties that occur because of closings, relocations and other transactions. OPERATING INCOME The 1993 and 1992 increases reflected better results from combined restaurant margins, partially offset by higher general, administrative and selling expenses. Additionally, 1993 was impacted by weaker foreign currencies, while 1992 was impacted by lower income from other operating transactions and stronger foreign currencies. INTEREST EXPENSE The 1993 and 1992 decreases were primarily due to lower average debt balances and lower average interest rates; 1993 also was impacted by weaker foreign currencies. The trends have been positively affected by the fact that cash provided by operations exceeded capital expenditures in each of the last three years. NONOPERATING INCOME (EXPENSE)--NET This category includes interest income, gains and losses related to investments and financings, as well as miscellaneous income and expense. The 1993 increase reflected $9 million in gains related to debt extinguishments and $29 million in charges related to various early redemptions of high-coupon, U.S. Dollar debt in 1992. PROVISION FOR INCOME TAXES The effective tax rate increased to 35.4% for 1993, compared with 33.8% for 1992 and 1991, primarily as a result of new U.S. tax legislation enacted in the third quarter of 1993 and lower foreign tax benefits. The full-year impact of the U.S. tax law changes on the 1993 income tax provision was approximately $20 million. Of this amount, the retroactive impact was $15 million, comprised of nearly $14 million attributable to a one-time, noncash revaluation of deferred tax liabilities, and $1 million related to periods prior to the third quarter. The Company expects its 1994 effective income tax rate to be in the 35.5% to 36.0% range. Consolidated net deferred tax liabilities included tax assets of $148 million, net of valuation allowance, in 1993 and 1992. Substantially all of the tax assets arose from profitable markets and the majority is expected to be realized in future U.S. income tax returns. NET INCOME AND NET INCOME PER COMMON SHARE Net income and net income per common share increased 13 and 12 percent, respectively, in 1993. These increases were negatively affected by weaker foreign currencies and the new U.S. tax legislation. ---------------------------------------------------------------- NET INCOME (Dollars in NET INCOME PER millions) COMMON SHARE ---------------------------------------------------------------- AMOUNT % AMOUNT % ---------------------------------------------------------------- 1993 AS REPORTED $1,083 13 $2.91 12 Impact of changing foreign currencies 32 .09 Retroactive impact of U.S. tax law changes 15 .04 ---------------------------------------------------------------- 1993 AS ADJUSTED $1,130 18 $3.04 17 ================================================================ IMPACT OF CHANGING FOREIGN CURRENCIES Changing foreign currencies do impact reported results from time to time, but McDonald's manages foreign currencies to mitigate business risk and the reporting impact. As previously noted, weaker foreign currencies had a significant negative impact on 1993 results, while stronger foreign currencies had a positive impact in 1992. Further discussion of our approach to managing changing foreign currencies can be found on pages 26 through 28 in Financings and Total Shareholders' Equity. ----------------------------------------------------------------------- Impact of changing foreign currencies 1993 ----------------------------------------------------------------------- Reported Adjusted ----------------------------------------------------------------------- (Dollars in millions) Amount % Amount % ----------------------------------------------------------------------- Systemwide sales $23,587 8 $23,993 10 Revenues 7,408 4 7,721 8 Operating income 1,984 7 2,051 10 Net income 1,083 13 1,114 16 ----------------------------------------------------------------------- ----------------------------------------------------------------------- Systemwide sales $21,885 10 $21,717 9 Revenues 7,133 7 7,116 6 Operating income 1,862 11 1,846 10 Net income 959 12 953 11 ----------------------------------------------------------------------- ------------------------------------------------------------------------ U.S. OPERATIONS ------------------------------------------------------------------------ SALES The 1993 and 1992 increases were due to higher sales and transaction counts at existing restaurants and expansion. Sales and transaction counts in 1993 were positively driven by the emphasis on value and customer satisfaction in the form of Extra-Value Meals, Happy Meals, "2 for $2" offers and the Burger of the Month program; as well as the NBA Fantasy Pack Trading Card, Happy Birthday Big Mac, Jurassic Park, Double Plays and Holiday Video promotions. ------------------------------------------------------------------------ Five Ten years years (In millions of dollars) 1993 1992 1991 ago ago ------------------------------------------------------------------------ Operated by franchisees $11,435 $10,615 $ 9,873 $ 8,574 $5,322 Operated by the Company 2,420 2,353 2,410 2,629 1,716 Operated by affiliates 331 275 236 177 31 ------------------------------------------------------------------------ U.S. sales $14,186 $13,243 $12,519 $11,380 $7,069 ======================================================================== RESTAURANTS There were 324 restaurants added in the U.S. in 1993, representing 36% of Systemwide additions, compared with 195 additions and 29% in 1992, and 340 additions and 56% five years ago. McDonald's expects to boost U.S. expansion in 1994 and in each of the next several years by adding between 300 and 400 restaurants, exclusive of satellites. ------------------------------------------------------------------------ Five Ten years years 1993 1992 1991 ago ago ------------------------------------------------------------------------ Operated by franchisees 7,628 7,375 7,149 6,017 4,791 Operated by the Company 1,433 1,395 1,446 1,758 1,430 Operated by affiliates 222 189 169 132 30 ------------------------------------------------------------------------ U.S. restaurants 9,283 8,959 8,764 7,907 6,251 ======================================================================== Restaurants operated by franchisees and affiliates represented 85% of U.S. restaurants at year-end 1993, compared with 78% five years ago. During the period 1989 through 1991, the Company franchised certain restaurants it previously operated, while continuing to own or control the land and buildings. The restaurants that had been franchised either were generating weak operating results, not building sales as expected, or located in outlying markets. The franchising of these businesses accomplished several objectives. On-site, entrepreneurial owners with an equity stake in the business improved operations, sales and profits; and franchising of these restaurants also improved consolidated profits. OPERATING RESULTS ------------------------------------------------------------------------ (In millions of dollars) 1993 1992 1991 1990 1989 ------------------------------------------------------------------------ REVENUES Sales by Company- operated restaurants $2,420 $2,353 $2,410 $2,655 $2,728 Revenues from franchised restaurants 1,511 1,396 1,300 1,216 1,159 ------------------------------------------------------------------------ TOTAL REVENUES 3,931 3,749 3,710 3,871 3,887 ------------------------------------------------------------------------ OPERATING COSTS AND EXPENSES Company-operated restaurants 1,977 1,920 2,000 2,221 2,250 Franchised restaurants 247 235 217 202 180 General, administrative and selling expenses 638 566 549 511 490 Other operating (income) expense--net (18) (13) (56) (49) (22) ------------------------------------------------------------------------ TOTAL OPERATING COSTS AND EXPENSES 2,844 2,708 2,710 2,885 2,898 ------------------------------------------------------------------------ U.S. OPERATING INCOME $1,087 $1,041 $1,000 $ 986 $ 989 ======================================================================== U.S. revenues were positively impacted by strong sales and expansion in 1993 and 1992, and negatively affected by the franchising of certain Company-operated restaurant businesses in 1992, 1991 and 1990. U.S. Company-operated margins increased $11 million or 3% in 1993. These margins were 18.3% of sales in 1993, compared with 18.4% in 1992 and 17.0% in 1991. U.S. franchised margins rose $102 million or 9% in 1993, reflecting sales improvement and expansion. These margins were 83.6% of applicable revenues in 1993, compared with 83.2% in 1992 and 83.3% in 1991. While it is difficult to assess the potential effects of federal and state legislation in the U.S. that may impact the industry, the Company believes it can maintain operating margins within the same range of the past ten years by continuing to build sales and reduce costs. U.S. operating income rose $46 million or 4% in 1993 and was 55% of consolidated operating income, compared with 56% in 1992. This increase resulted primarily from higher combined restaurant margins, partially offset by higher general, administrative and selling expenses in the form of higher employee costs and other expenditures to support our global strategies and strengthen our competencies. The 1992 increase was driven by strong sales and combined restaurant margins, partially offset by lower gains on sales of restaurant businesses in 1992 and a gain on the sale of real estate by a U.S. affiliate in 1991. Operating income included $348 million of depreciation and amortization in 1993, compared with $330 million in 1992 and $325 million in 1991. ASSETS AND CAPITAL EXPENDITURES ------------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 1990 1989 ------------------------------------------------------------------------- New restaurants $ 332 $ 196 $ 214 $ 446 $ 490 Existing restaurants 122 125 151 249 283 Other properties 130 76 45 51 74 ------------------------------------------------------------------------- U.S. capital expenditures $ 584 $ 397 $ 410 $ 746 $ 847 ========================================================================= U.S. assets $6,385 $6,410 $6,154 $6,060 $5,646 ------------------------------------------------------------------------- U.S. assets decreased $25 million or .4% in 1993, due to the utilization of year-end 1992 cash balances. At year-end 1993, 53% of consolidated assets were located in the U.S., compared with 55% at year-end 1992. Capital expenditures increased $187 million or 47% in 1993, and represented 44% of consolidated capital expenditures, compared with 60% five years ago. The amounts excluded expenditures made by franchisees such as their initial investments in equipment, signs, seating and decor and over the long term, ongoing reinvestment in their businesses. New restaurant expenditures increased $136 million or 69% because of accelerated expansion, tempered by lower average development costs. Expenditures for existing restaurants included modifications to achieve higher levels of customer satisfaction and implementation of technology to improve service and food quality. The decline over time highlighted aggressive reinvestment in prior years. Rebuilding and relocating restaurants has generated additional sales, reflecting our ability to adjust to changing demographics, traffic patterns and market opportunities. More than $35 million was spent for these investments in 1993 and $291 million over the past five years. The rise in other property expenditures was attributable to the further testing of Leaps & Bounds, a family play center concept. ------------------------------------------------------------------------- (In thousands of dollars) 1993 1992 1991 1990 1989 ------------------------------------------------------------------------- Land $ 328 $ 361 $ 433 $ 433 $ 472 Building 482 515 608 720 682 Equipment 317 361 362 403 416 ------------------------------------------------------------------------- U.S. average costs $1,127 $1,237 $1,403 $1,556 $1,570 ========================================================================= Average land costs declined as a result of the implementation of low-cost building designs, which require smaller parcels, and a softer real estate market. Average building costs decreased due to low-cost building designs and construction efficiencies. Low-cost building designs comprised nearly 80% of 1993 openings, compared with 60% in 1992. Average equipment costs decreased due to standardization and global sourcing. McDonald's intends to pursue ongoing development cost reductions by taking further advantage of standardization, global sourcing and economies of scale. The Company continues to emphasize restaurant property ownership. Real estate ownership yields long-term benefits, including the ability to fix occupancy costs. In addition to purchasing new properties, previously leased properties are acquired. The Company owned 68% of U.S. sites at year-end 1993, the same as five years ago. ---------------------------------------------------------------------- OPERATIONS OUTSIDE OF THE U.S. ---------------------------------------------------------------------- SALES The 1993 and 1992 increases were due to expansion and higher sales at existing restaurants; however, 1993 was impacted by weaker foreign currencies, most notably the European currencies along with the Canadian and Australian Dollars. On the other hand, 1992 benefited from stronger foreign currencies in the form of the Japanese Yen, Deutsche Mark and French Franc. Strong operating results have been achieved in the past several years despite weak economies in several countries, particularly Canada, England and Japan. ---------------------------------------------------------------------- Five Ten years years (In millions of dollars) 1993 1992 1991 ago ago ---------------------------------------------------------------------- Operated by franchisees $4,321 $3,859 $3,085 $1,850 $ 607 Operated by the Company 2,737 2,750 2,499 1,567 581 Operated by affiliates 2,343 2,033 1,825 1,267 430 ---------------------------------------------------------------------- Sales outside of the U.S. $9,401 $8,642 $7,409 $4,684 $1,618 ====================================================================== European sales rose because of accelerated expansion and higher sales at existing restaurants, partially offset by weaker foreign currencies. Asia/Pacific sales grew because of expansion coupled with the favorable impact of a stronger Japanese Yen. Latin American sales increased because of expansion and higher sales at existing restaurants. Canadian sales were negatively impacted by the weaker currency, partially offset by higher sales at existing restaurants and expansion. In 1993, four of the six largest markets outside of the U.S. -- France, Germany, Australia and England -- reported double digit sales increases on a local currency basis. Other markets -- including Argentina, Austria, Belgium, Brazil, Canada, Denmark, Hong Kong, Hungary, Italy, Malaysia, Netherlands, New Zealand, Norway, Panama, Puerto Rico, Scotland, Singapore, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey and Wales -- delivered excellent results on a local currency basis. RESTAURANTS During the past five years, 60% of Systemwide additions have been outside of the U.S. Of the 576 restaurants added in 1993, 54% were in the six largest markets, compared with 57% in 1992 and 63% in 1991. This continued relative decline was indicative of the growing importance of emerging markets. McDonald's expects to boost expansion outside of the U.S. in 1994 and in each of the next several years by adding between 600 and 800 restaurants, exclusive of satellites. ----------------------------------------------------------------------- Five Ten years years 1993 1992 1991 ago ago ----------------------------------------------------------------------- Operated by franchisees 2,204 1,862 1,586 1,093 580 Operated by the Company 1,266 1,156 1,101 842 519 Operated by affiliates 1,240 1,116 967 671 428 ----------------------------------------------------------------------- Restaurants outside of the U.S. 4,710 4,134 3,654 2,606 1,527 ======================================================================= About 82% of Company-operated restaurants outside of the U.S. were in England, Canada, Germany, Australia, Hong Kong and France. About 71% of franchised restaurants outside of the U.S. were in Canada, Germany, Australia, France, Japan and the Netherlands. Restaurants operated by affiliates were principally located in Japan and other Asia/Pacific countries. OPERATING RESULTS ----------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 1990 1989 ----------------------------------------------------------------------- REVENUES Sales by Company- operated restaurants $2,737 $2,750 $2,499 $2,364 $1,873 Revenues from franchised restaurants 740 634 486 405 306 ----------------------------------------------------------------------- TOTAL REVENUES 3,477 3,384 2,985 2,769 2,179 ----------------------------------------------------------------------- OPERATING COSTS AND EXPENSES Company-operated restaurants 2,188 2,206 2,029 1,915 1,528 Franchised restaurants 133 114 90 77 61 General, administrative and selling expenses 303 295 246 213 166 Other operating (income) expense--net (44) (51) (58) (46) (25) ----------------------------------------------------------------------- TOTAL OPERATING COSTS AND EXPENSES 2,580 2,564 2,307 2,159 1,730 ----------------------------------------------------------------------- OPERATING INCOME OUTSIDE OF THE U.S. $ 897 $ 820 $ 678 $ 610 $ 449 ======================================================================= The 1993 and 1992 revenue and operating income increases reflected accelerated expansion and better performance despite weak economies in several major markets. Changing foreign currencies had a negative effect in 1993 and a positive one in 1992 on these increases. Company-operated and franchised dollar margins were negatively impacted by weaker foreign currencies. Company-operated margins increased $6 million or 1% in 1993. These margins improved to 20.1% of sales in 1993, compared with 19.8% in 1992 and 18.8% in 1991. Franchised margins grew $86 million or 17% in 1993. These margins were 82.0% of applicable revenues in 1993, compared with 82.1% in 1992 and 81.5% in 1991. The 1993 and 1992 increases in general, administrative and selling expenses were due primarily to higher employee costs associated with expansion, partially offset by weaker foreign currencies in 1993. Other operating income decreased in 1993 due to the favorable settlement of a sales tax case in Brazil in 1992, offset somewhat by 1993 increases in gains on sales of restaurant businesses and greater affiliate earnings. Other operating income decreased in 1992 due to lower affiliate results and lower gains on sales of restaurant businesses, offset somewhat by the favorable settlement of a sales tax case in Brazil. Operations outside of the U.S. continued to contribute greater amounts to consolidated results as shown below: --------------------------------------------------------------------- (As a percent of consolidated) 1993 1992 1991 1990 1989 --------------------------------------------------------------------- Systemwide sales 40 39 37 35 31 Total revenues 47 47 45 42 36 Operating income 45 44 40 38 31 Restaurant margins Company-operated 55 56 53 51 42 Franchised 32 31 27 24 20 Systemwide restaurants 34 32 29 27 26 Assets 47 45 46 43 38 --------------------------------------------------------------------- The Europe/Africa/Middle East segment accounted for 64% of revenues and 61% of operating income outside of the U.S. in 1993, growing $49 and $64 million, respectively. Germany, England and France accounted for 85% of this segment's operating income, compared with 90% in 1992. The 1993 increases were primarily due to strong operating results in Germany and France, as well as many emerging markets, offset by weaker foreign currencies. England's operating income decrease was due to the significant impact of the weaker currency. The majority of the 1992 revenue and operating income increases were generated by Germany, France and England. Asia/Pacific revenues grew $60 million and operating income increased $27 million in 1993; 82% of the operating income was contributed by Australia, Japan and Hong Kong. The 1993 increases were attributable to expansion and developing economies in many Asia/Pacific markets, with the exception of Japan which continues to suffer from a weak economy. In 1992, stronger operations in Australia, and better results in Hong Kong and Singapore improved operating income, while earnings from Japan were affected by the economy. Latin American revenues grew $22 million, while operating income decreased $12 million in 1993. The 1993 increase in revenues was primarily a function of expansion, while the decrease in operating income reflected the favorable settlement of a sales tax case in Brazil in 1992, partially offset by better results in Argentina. Brazil was affected by a weak economy in 1993 and 1992. Canadian revenues decreased $37 million due to a weaker Canadian Dollar in 1993. Operating income decreased $2 million, reflecting the weaker currency and a decrease in other operating income, partially offset by better Company-operated margins. Revenues decreased in 1992 due to the franchising of certain restaurant businesses and the weaker currency, while operating income declined due to lower gains on sales of restaurant businesses and the weaker currency. ASSETS AND CAPITAL EXPENDITURES Assets outside of the U.S. rose $379 million or 7% in 1993; the effects of expansion were partially offset by weaker foreign currencies. At year-end 1993, about 47% of consolidated assets were located outside of the U.S.; 64% of these assets were located in England, France, Germany, Canada and Australia. ----------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 1990 1989 ----------------------------------------------------------------------- New restaurants $ 609 $ 603 $ 612 $ 639 $ 486 Existing restaurants 94 91 94 126 148 Other properties 55 47 39 74 64 ----------------------------------------------------------------------- Capital expenditures outside of the U.S. $ 758 $ 741 $ 745 $ 839 $ 698 ======================================================================= Assets outside of the U.S. $5,650 $5,271 $5,195 $4,608 $3,529 ----------------------------------------------------------------------- In the past five years, nearly $3.8 billion has been invested outside of the U.S.; in 1993, capital expenditures rose in all geographic segments except Canada. Weaker foreign currencies negatively impacted Europe, Asia/Pacific and Canada. Approximately 72% of capital expenditures outside of the U.S. were invested in Europe -- primarily in Germany, France and England. In general, average development costs for new restaurants for the five largest, majority-owned markets -- Australia, Canada, England, France and Germany -- were nearly double the U.S. average; such costs accommodate higher sales volumes and transaction counts. Even so, 1993 average development costs have decreased approximately one-third since 1991 in these markets. Over the past two years, average development costs have decreased due to construction and design efficiencies, standardization, global sourcing and changes in the mix of openings, and because of weaker foreign currencies in 1993. Expenditures for existing restaurants included seating and decor upgrades, and equipment required for new products and operating efficiencies. The majority of these expenditures were in Europe. Expenditures for other properties were principally for office facilities. As in the U.S., business outside of the U.S. emphasizes restaurant property ownership. However, various laws and regulations make property acquisition and ownership much more difficult than in the U.S. Ownership is obtained when practical; otherwise, long-term leases are an alternative. In addition, certain markets have laws and customs that offer stronger tenancy rights than are available in the U.S. The Company and affiliates owned 36% of sites outside of the U.S. at year-end 1993, compared with 35% five years ago. Capital expenditures made by affiliates -- which were not included in consolidated amounts -- were $207 million in 1993, compared with $206 million in 1992. The majority of the 1993 expenditures were for development in Japan, Argentina and Russia. Included in the amounts for Russia were costs for constructing an office building which is leased primarily to third parties. ----------------------------------------------------------------------- FINANCIAL POSITION ----------------------------------------------------------------------- TOTAL ASSETS AND CAPITAL EXPENDITURES Total assets grew $354 million or 3% in 1993; net property and equipment represented 84% of total assets and rose $484 million. Capital expenditures increased $204 million or 18%, reflecting higher expansion, partially offset by lower average development costs and weaker foreign currencies. CASH PROVIDED BY OPERATIONS Cash provided by operations increased $254 million or 18% in 1993, and was relatively flat in 1992 mainly due to $159 million in payments related to various prior years' tax matters. Together with other sources of cash such as borrowings, cash provided by operations was used primarily for capital expenditures, debt repayments, share repurchase and dividends. For the third straight year, cash provided by operations exceeded capital expenditures. While cash generated is significant relative to cash required, the Company also has the ability to meet short-term needs through commercial paper borrowings and line of credit agreements. Accordingly, a relatively low current ratio has been purposefully maintained; it was .60 at year-end 1993. The Company believes that cash flow measures are meaningful indicators of growth and financial strength, when evaluated in the context of absolute dollars, uses and consistency. Over the past five years, cash flow coverage has improved significantly. Cash provided by operations is expected to cover capital expenditures over the next several years, even as expansion continues to accelerate. ----------------------------------------------------------------------- (Dollars in millions) 1993 1992 1991 1990 1989 ----------------------------------------------------------------------- Cash provided by operations $1,680 $1,426 $1,423 $1,301 $1,246 Cash provided by operations minus capital expenditures $ 363 $ 339 $ 294 $ (270) $ (309) Cash provided by operations as a percent of capital expenditures 128 131 126 83 80 Cash provided by operations as a percent of total debt 45 37 31 27 31 ----------------------------------------------------------------------- FINANCINGS The Company strives to minimize interest expense and the impact of changing foreign currencies, while maintaining the capacity to meet increasing growth requirements. To accomplish these objectives, McDonald's generally finances long-term assets with long-term debt in the currencies in which the assets are denominated, while remaining flexible to take advantage of changing foreign currencies and interest rates. Over the years, major capital markets and various techniques have been utilized to meet financing requirements and reduce interest expense. Currency exchange agreements have been employed in conjunction with borrowings to obtain desired currencies at attractive rates. Interest-rate exchange agreements and interest-rate caps have been used to effectively convert fixed-rate to floating-rate debt, or vice versa, and to limit interest expense. Foreign-denominated debt has been used to lessen the impact of changing foreign currencies on net income and shareholders' equity. Total foreign-denominated debt, including the effects of currency exchange agreements, was $3.1 and $2.7 billion at year-end 1993 and 1992, respectively. The Company manages its debt portfolio, including the use of derivatives, in order to respond to changes in interest rates and foreign currencies. Accordingly, the Company periodically retires, redeems, and repurchases debt, and terminates exchange agreements. While changing foreign currencies affect reported results, the Company actively hedges the seven currencies that have significant potential impact in order to minimize the cash exposure of royalty and other payments received in the U.S. in foreign currencies. In addition, McDonald's restaurants primarily purchase goods and services in local currencies resulting in natural hedges; McDonald's typically finances in local currencies creating economic hedges; and the Company's foreign currency exposure is diversified within a basket of currencies, as opposed to one or several. ----------------------------------------------------------------------- (Includes the net asset positions of currency exchange agreements) 1993 1992 1991 1990 1989 ----------------------------------------------------------------------- Fixed-rate debt as a percent of total debt at year end 77 75 78 78 76 Weighted average annual interest rate 9.1 9.3 9.4 9.4 9.4 Foreign-denominated debt as a percent of total debt at year end 86 72 61 60 59 ----------------------------------------------------------------------- Moody's and Standard & Poor's have rated McDonald's debt Aa2 and AA, respectively, since 1982. Duff & Phelps began rating the debt in 1990, and currently rates it AA+. The Company has not experienced, nor does it expect to experience, difficulty in obtaining financing or in refinancing existing debt. The Company had $1.7 billion under line of credit agreements and $685 million under previously filed shelf registrations available at year-end 1993 for future debt issuance. Although McDonald's prefers to own real estate, leases are an alternative financing method. As in the past, some new properties will be leased. Such leases frequently include renewal and/or purchase options. In the past five years, McDonald's has leased properties related to 41% of U.S. openings and 67% of openings outside of the U.S. During the past three years, the Company has improved its balance sheet by reducing leverage while simultaneously increasing expansion and repurchasing shares. Total debt as a percent of total capitalization -- defined as total debt and total shareholders' equity -- was 37% at year-end 1993, compared with 40% and 49% at year- end 1992 and 1991, respectively. TOTAL SHAREHOLDERS' EQUITY Total shareholders' equity rose $382 million and represented 52% of total assets at year-end 1993. One technique used to enhance common shareholder value is share repurchase through excess cash flow or debt capacity, while maintaining a strong equity base for future expansion. At year-end 1993, the market value of shares repurchased by the Company and recorded as common stock in treasury was $3.5 billion. In conjunction with efforts to enhance common shareholder value, the Company recently announced its intention to purchase up to $1 billion of its common stock within the next three years, primarily from excess cash flow. In 1993, the Company completed a $700 million common share repurchase program begun in 1992. In order to lower the cost of equity capital, the Company issued $500 million of Series E 7.72% Cumulative Preferred Stock in 1992; at the same time, the Board of Directors authorized a $500 million common share repurchase program and the use of derivatives. Subsequently, the Board authorized an additional $200 million expenditure for share repurchase in 1993. Weaker foreign currencies reduced shareholders' equity by $65 million in 1993; however, financing foreign-denominated assets with foreign-denominated debt tempered the effect. At year-end 1993, foreign-denominated assets not entirely financed with the related foreign-denominated debt were primarily located in England, Canada, Australia, France and Germany. RETURNS Return on average assets is computed using income before provision for income taxes, preferred dividends and interest expense. Net income, less preferred stock dividends (net of tax in 1993 and 1992), is used to calculate return on average common equity. Month-end balances are used to compute both average assets and average common equity. ---------------------------------------------------------------------- 1993 1992 1991 1990 1989 ---------------------------------------------------------------------- Return on average assets 17.1 16.1 15.8 16.7 17.3 Return on average common equity 19.0 18.2 19.1 20.7 20.5 ---------------------------------------------------------------------- The 1993 and 1992 improvements in return on average assets reflected better global operating results and a slower rate of asset growth. The 1993 improvement in return on average common equity reflected higher levels of share repurchase, whereas declines in 1992 and 1991 resulted from lower levels of share repurchase as excess cash flow was used to reduce debt. In recent years, returns were affected by soft economies in the U.S. and certain markets outside of the U.S. Also influencing these returns were expansion outside of the U.S. and, prior to 1991, escalating development costs and higher reinvestment. EFFECTS OF CHANGING PRICES--INFLATION McDonald's has demonstrated an ability to manage inflationary cost increases effectively. Rapid inventory turnover, the ability to adjust prices, substantial property holdings--many of which are at fixed costs and partially financed by debt made cheaper by inflation-- and cost controls have enabled McDonald's to mitigate the effects of inflation. Item 8. Item 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reference --------- Management's Report 31 Report of independent auditors 32 Consolidated statement of income for each of the three years in the period ended December 31, 1993 33 Consolidated balance sheet at December 31, 1993 and 1992 34 Consolidated statement of cash flows for each of the three years in the period ended December 31, 1993 35 Consolidated statement of shareholders' equity for each of the three years in the period ended December 31, 1993 36 Notes to consolidated financial statements (Financial comments) 37-50 Quarterly Results (unaudited) 51 MANAGEMENT'S REPORT Management is responsible for the preparation and integrity of the consolidated financial statements and Financial Comments appearing in this annual report. The financial statements were prepared in accordance with generally accepted accounting principles and include certain amounts based on management's best estimates and judgments. Other financial information presented in the annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded, and that transactions are executed as authorized and are recorded and reported properly. This system of controls is based upon written policies and procedures, appropriate divisions of responsibility and authority, careful selection and training of personnel and utilization of an internal audit program. Policies and procedures prescribe that the Company and all employees are to maintain the highest ethical standards and that business practices throughout the world are to be conducted in a manner which is above reproach. Ernst & Young, independent auditors, has audited the Company's financial statements and their report is presented herein. The Board of Directors has an Audit Committee composed entirely of outside Directors. Ernst & Young has direct access to the Audit Committee and periodically meets with the Committee to discuss accounting, auditing and financial reporting matters. McDONALD'S CORPORATION Oak Brook, Illinois January 27, 1994 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders McDonald's Corporation Oak Brook, Illinois We have audited the accompanying consolidated balance sheet of McDonald's Corporation as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of McDonald's Corporation management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of McDonald's Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. ERNST & YOUNG Chicago, Illinois January 27, 1994 MCDONALD'S CORPORATION FINANCIAL COMMENTS -------------------------------------------------------------------- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -------------------------------------------------------------------- CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries. Investments in 50% or less owned affiliates are carried at equity in the companies' net assets. FOREIGN CURRENCY TRANSLATION The functional currency of each operation outside of the U.S., except for those located in hyperinflationary countries, is the respective local currency. INCOME TAXES In 1992, the Company adopted Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes. The effects were not material, as the Company had previously adopted Statement No. 96. PROPERTY AND EQUIPMENT Property and equipment are stated at cost with depreciation and amortization provided on the straight-line method over the following estimated useful lives: buildings--up to 40 years; leasehold improvements--lesser of useful lives of assets or lease terms including option periods; and equipment--3 to 12 years. INTANGIBLE ASSETS Intangible assets consist primarily of franchise rights reacquired from franchisees and affiliates, and are amortized on the straight- line method over an average life of 29 years. FINANCIAL INSTRUMENTS Non-U.S. Dollar financing transactions generally are effective as hedges of long-term investments in the corresponding currency. Interest-rate exchange agreements are designated and generally are effective as hedges of the Company's interest-rate exposures. The carrying amounts for cash and equivalents and notes receivable approximated fair value. For noninterest-bearing security deposits by franchisees, no fair value was provided as these deposits are an integral part of the overall franchise arrangements. STATEMENT OF CASH FLOWS The Company considers all highly liquid investments with short-term maturity dates to be cash equivalents. The impact of changing foreign currencies on cash and equivalents was not material. ---------------------------------------------------------------------- NUMBER OF RESTAURANTS IN OPERATION ---------------------------------------------------------------------- 1993 1992 1991 1990 ---------------------------------------------------------------------- Operated by franchisees 9,288 8,654 8,151 7,578 Operated under business facilities lease arrangements 544 583 584 553 Operated by the Company 2,699 2,551 2,547 2,643 Operated by 50% or less owned affiliates 1,462 1,305 1,136 1,029 ---------------------------------------------------------------------- Systemwide restaurants 13,993 13,093 12,418 11,803 ====================================================================== Franchisees operating under business facilities lease arrangements have options to purchase the businesses. The results of operations of restaurant businesses purchased and sold in transactions with franchisees and affiliates were not material to the consolidated financial statements for periods prior to purchase and sale. ---------------------------------------------------------------------- OTHER OPERATING (INCOME) EXPENSE--NET ---------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 ---------------------------------------------------------------------- Gains on sales of restaurant businesses $(48.2) $(43.1) $ (64.0) Equity in earnings of unconsolidated affiliates (34.6) (29.5) (57.5) Net losses from property dispositions 15.5 18.1 9.9 Other--net 5.3 (9.5) (2.2) ---------------------------------------------------------------------- Other operating (income) expense--net $(62.0) $(64.0) $(113.8) ====================================================================== Gains on sales of restaurant businesses are recognized as income when the sales are consummated and other stipulated conditions are met. Proceeds from certain sales of restaurant businesses and property include notes receivable. --------------------------------------------------------------------- INCOME TAXES --------------------------------------------------------------------- Income before provision for income taxes and the provision for income taxes, classified by source of income, were as follows: --------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 --------------------------------------------------------------------- U.S. $ 986.0 $ 873.3 $ 847.3 Outside of the U.S. 689.7 574.8 452.1 --------------------------------------------------------------------- Income before provision for income taxes $1,675.7 $1,448.1 $1,299.4 ===================================================================== U.S. $ 391.9 $ 316.8 $ 312.6 Outside of the U.S. 201.3 172.7 127.2 --------------------------------------------------------------------- Provision for income taxes $ 593.2 $ 489.5 $ 439.8 ===================================================================== Income before provision for income taxes outside of the U.S. and the related provision for income taxes reflect fees received in the U.S. from operations outside of the U.S. Income before provision for income taxes in the U.S. and the related provision for income taxes reflect interest received in the U.S. from operations outside of the U.S. The provision for income taxes, classified by the timing and location of payment, consisted of: ------------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 ------------------------------------------------------------------------- Current U.S. federal $331.6 $256.8 $230.8 U.S. state 62.0 56.3 45.3 Outside of the U.S. 147.2 154.0 99.0 ------------------------------------------------------------------------- 540.8 467.1 375.1 ------------------------------------------------------------------------- Deferred U.S. federal 21.9 (10.3) 46.9 U.S. state 3.4 4.0 8.2 Outside of the U.S. 27.1 28.7 9.6 ------------------------------------------------------------------------- 52.4 22.4 64.7 ------------------------------------------------------------------------- Provision for income taxes $593.2 $489.5 $439.8 ========================================================================= Included in the 1993 deferred tax provision were $14.0 million attributable to a one-time, noncash revaluation of deferred tax liabilities resulting from the increase in the statutory U.S. federal income tax rate. Net deferred tax liabilities were comprised of: ------------------------------------------------------------------------- (In millions of dollars) December 31, 1993 1992 ------------------------------------------------------------------------- Property and equipment basis differences $786.1 $738.2 Other 175.4 154.8 ------------------------------------------------------------------------- Total deferred tax liabilities 961.5 893.0 ------------------------------------------------------------------------- Deferred tax assets before valuation allowance (1) (192.8) (183.8) Valuation allowance 44.5 35.7 ------------------------------------------------------------------------- Net deferred tax liabilities (2) $813.2 $744.9 ========================================================================= (1) Includes loss carryforwards: 1993--$46.7 million; 1992--$44.4 million. (2) Net of assets recorded in current income taxes: 1993--$22.1 million; 1992--$3.7 million. Reconciliations of the statutory U.S. federal income tax rates to the effective income tax rates are shown in the following table. -------------------------------------------------------------------- 1993 1992 1991 -------------------------------------------------------------------- Statutory federal income tax rates 35.0% 34.0% 34.0% State income taxes, net of related federal income tax benefit 2.5 2.7 2.7 Other (2.1) (2.9) (2.9) -------------------------------------------------------------------- Effective income tax rates 35.4% 33.8% 33.8% ==================================================================== U.S. income and foreign withholding taxes have not been provided on $760.8 million of undistributed earnings of certain subsidiaries and affiliates outside of the U.S. at December 31, 1993. These earnings are considered to be permanently invested in the businesses and, under the tax laws, are not subject to taxes until distributed as dividends. If these earnings were not considered permanently invested, no additional taxes would be provided due to the overall higher tax rates in markets outside of the U.S. and the ability to recover withholding taxes as foreign tax credits in the U.S. ---------------------------------------------------------------------- SEGMENT AND GEOGRAPHIC INFORMATION ---------------------------------------------------------------------- The Company operates exclusively in the foodservice industry. Substantially all revenues result from the sale of menu products at restaurants operated by the Company, franchisees or affiliates. Operating income includes the Company's share of operating results of affiliates. All intercompany revenues and expenses are eliminated in computing revenues and operating income. Fees received in the U.S. from subsidiaries outside of the U.S. were: 1993--$202.8 million; 1992--$187.8 million; 1991--$153.1 million. ---------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 ---------------------------------------------------------------------- U.S. $3,931.2 $3,749.4 $3,710.2 Europe/Africa/Middle East 2,235.9 2,187.0 1,806.0 Canada 557.8 595.1 629.5 Asia/Pacific 494.4 434.6 392.5 Latin America 188.8 167.2 156.8 ---------------------------------------------------------------------- Total revenues $7,408.1 $7,133.3 $6,695.0 ====================================================================== U.S. $1,087.1 $1,041.6 $1,000.4 Europe/Africa/Middle East 547.5 484.0 361.3 Canada 111.2 113.5 120.7 Asia/Pacific 190.6 163.2 157.2 Latin America 47.6 59.3 38.9 ---------------------------------------------------------------------- Operating income $1,984.0 1,861.6 1,678.5 ====================================================================== U.S. $6,385.4 $6,410.6 $6,154.3 Europe/Africa/Middle East 3,473.2 3,290.9 3,316.1 Canada 562.5 587.4 618.2 Asia/Pacific 1,103.2 980.3 925.0 Latin America 510.9 412.0 335.5 ---------------------------------------------------------------------- Total assets $12,035.2 $11,681.2 $11,349.1 ====================================================================== ------------------------------------------------------------------------ PROPERTY AND EQUIPMENT ------------------------------------------------------------------------ (In millions of dollars) December 31, 1993 1992 ------------------------------------------------------------------------ Land $2,587.2 $2,440.0 Buildings and improvements on owned land 5,209.4 4,906.0 Buildings and improvements on leased land 3,673.0 3,423.7 Equipment, signs and seating 1,545.4 1,467.2 Other 444.0 421.1 ------------------------------------------------------------------------ 13,459.0 12,658.0 ------------------------------------------------------------------------ Accumulated depreciation and amortization (3,377.6) (3,060.6) ------------------------------------------------------------------------ Net property and equipment $10,081.4 $9,597.4 ======================================================================== Depreciation and amortization were: 1993--$492.8 million; 1992--$492.9 million; 1991--$456.9 million. Contractual obligations for the acquisition and construction of property amounted to $193.1 million at December 31, 1993. ------------------------------------------------------------------------ DEBT FINANCING ------------------------------------------------------------------------ LINE OF CREDIT AGREEMENTS The Company has a long-term line of credit agreement for $700.0 million, which remained unused at December 31, 1993, and which continues indefinitely unless terminated by the participating banks upon advance notice of at least 18 months. Each borrowing under the agreement bears interest at one of several specified floating rates, to be selected by the Company at the time of borrowing. The agreement provides for fees of .15 of 1% per annum on the unused portion of the commitment. In addition, certain subsidiaries outside of the U.S. had unused lines of credit totaling $1.0 billion at December 31, 1993; these were principally short-term and denominated in various currencies at local market rates of interest. EXCHANGE AGREEMENTS The Company uses derivatives and has entered into agreements for the exchange of various currencies. Certain of these agreements also provide for the periodic exchange of interest payments. These agreements, as well as additional interest-rate exchange agreements, expire through 2003 and provide for an effective right of offset; therefore, the related receivable and liability are offset in the financial statements. The counterparties to these exchange agreements consist of a diverse group of financial institutions. The Company continually monitors its positions and the credit ratings of its counterparties, and adjusts positions as appropriate. The Company also had short-term forward foreign exchange contracts outstanding at December 31, 1993, with a U.S. Dollar equivalent of $83.4 million in various currencies, primarily the Japanese Yen, Deutsche Mark and British Pound Sterling. AGGREGATE MATURITIES Included in the 1995 maturities are $700.0 million of notes maturing within one year, as 1995 is the earliest time at which the banks can terminate the line of credit agreement, which supports the classification in long-term debt. Under certain agreements, the Company has the option to retire debt prior to maturity, either at par or at a premium over par. During 1993, $264.5 million was retired prior to maturity. GUARANTEES Included in total debt at December 31, 1993, were $171.3 million of 7.60% ESOP Notes Series A and $89.0 million of 7.23% ESOP Notes Series B issued by the Leveraged Employee Stock Ownership Plan (LESOP), with payments through 2004 and 2006, respectively, which are guaranteed by the Company. Interest rates on the notes were adjusted due to U.S. tax law changes in 1993. The Company has agreed to repurchase the notes upon the occurrence of certain events. The Company also has guaranteed certain foreign affiliate loans of $154.7 million at December 31, 1993. The Company also was a general partner in 48 domestic partnerships with total assets of $174.3 million and total liabilities of $95.8 million at December 31, 1993. FAIR VALUES The carrying amounts for notes payable and short-term forward foreign exchange contracts approximated fair value at December 31, 1993. The fair value of the remaining debt obligations (excluding capital leases), including the net effects of currency and interest-rate exchange agreements, was estimated using quoted market prices, various pricing models or discounted cash flow analyses. At December 31, 1993, the fair value of these obligations, which were primarily used to finance property and equipment, was $3.7 billion, compared to a carrying value of $3.4 billion. The Company currently has no plans to retire any of these obligations prior to maturity. The Company believes that the fair value of total assets is higher than their carrying value. DEBT OBLIGATIONS ------------------------------------------------------------------- OTHER LONG-TERM LIABILITIES AND MINORITY INTERESTS ------------------------------------------------------------------- (In millions of dollars) December 31, 1993 1992 ------------------------------------------------------------------- Security deposits by franchisees $121.4 $116.6 Preferred interests in consolidated subsidiaries 106.7 12.8 Minority interests in consolidated subsidiaries 38.2 32.1 Other 68.1 63.7 ------------------------------------------------------------------- Other long-term liabilities and minority interests $334.4 $225.2 =================================================================== In 1993, a Company subsidiary issued 50 million British Pounds Sterling (U.S. $74.0 million at December 31, 1993) of 5.91% Series A Preferred Stock which, unless redeemed earlier at the Company's option, must be redeemed on February 19, 1998. Also, another subsidiary issued additional preferred stock. All of the preferred stock of this subsidiary has a dividend rate adjusted annually (8.2% at December 31, 1993) and is redeemable at the option of the holder at a current redemption price of $32.7 million. Both of these issues were reflected in preferred interests in consolidated subsidiaries. Included in other was the $100.00 per share redemption value of 181,868 shares of 5% Series D Preferred Stock issued in connection with the Company's 1991 increase in ownership of its Hawaii affiliate. This stock, which carries one vote per share, must be redeemed on the occurrence of specified events. --------------------------------------------------------------------- LEASING ARRANGEMENTS --------------------------------------------------------------------- At December 31, 1993, the Company was lessee at 2,294 restaurant locations under ground leases (the Company leases land and constructs and owns buildings) and at 2,305 locations under improved leases (lessor owns land and buildings). Land and building lease terms are generally for 20 to 25 years and, in many cases, provide for rent escalations and one or more five-year renewal options with certain leases providing purchase options. The Company is generally obligated for the related occupancy costs that include property taxes, insurance and maintenance. In addition, the Company is lessee under noncancelable leases covering offices and vehicles. Future minimum payments required under operating leases with initial terms of one year or more after December 31, 1993, are: ------------------------------------------------------------ (In millions of dollars) Restaurant Other Total ------------------------------------------------------------ 1994 $ 277.0 $ 34.7 $ 311.7 1995 266.7 33.3 300.0 1996 255.7 31.5 287.2 1997 242.4 28.4 270.8 1998 227.2 25.8 253.0 Thereafter 2,334.1 165.0 2,499.1 ------------------------------------------------------------ Total minimum payments $3,603.1 $318.7 $3,921.8 ============================================================ Rent expense was: 1993--$339.0 million; 1992--$320.2 million; 1991-$283.6 million. Included in these amounts were percentage rents based on sales by the related restaurants in excess of minimum rents stipulated in certain lease agreements: 1993--$29.0 million; 1992--$26.1 million; 1991--$26.3 million. ---------------------------------------------------------------------- FRANCHISE ARRANGEMENTS ---------------------------------------------------------------------- Franchise arrangements, with franchisees who operate in various geographic locations, generally provide for initial fees and continuing payments to the Company based upon a percentage of sales, with minimum rent payments. Among other things, franchisees are provided the use of restaurant facilities, generally for a period of 20 years. They are required to pay related occupancy costs that include property taxes, insurance, maintenance and a refundable, noninterest-bearing security deposit. On a limited basis, the Company receives notes from franchisees. Generally the notes are secured by interests in restaurant equipment and franchises. ---------------------------------------------------------------------- (In millions of dollars) 1993 1992 1991 ---------------------------------------------------------------------- Minimum rents Owned sites $ 573.6 $ 538.7 $ 494.5 Leased sites 381.7 353.3 303.7 ---------------------------------------------------------------------- 955.3 892.0 798.2 ---------------------------------------------------------------------- Percentage fees 1,272.1 1,120.6 970.4 Initial fees 23.5 18.2 17.9 ---------------------------------------------------------------------- Revenues from franchised restaurants $2,250.9 $2,030.8 $1,786.5 ====================================================================== Future minimum payments based on minimum rents specified under franchise arrangements after December 31, 1993, are: ---------------------------------------------------------------------- Owned Leased (In millions of dollars) sites sites Total ---------------------------------------------------------------------- 1994 $ 618.4 $ 404.7 $ 1,023.1 1995 607.4 390.3 997.7 1996 593.2 375.9 969.1 1997 579.5 365.2 944.7 1998 567.3 353.2 920.5 Thereafter 5,309.1 3,406.6 8,715.7 ---------------------------------------------------------------------- Total minimum payments $8,274.9 $5,295.9 $13,570.8 ====================================================================== At December 31, 1993, net property and equipment under franchise arrangements totaled $5.9 billion (including land of $1.8 billion), after deducting accumulated depreciation and amortization of $1.7 billion. ---------------------------------------------------------------------- PROFIT SHARING PROGRAM ---------------------------------------------------------------------- The Company has a program for U.S. employees which includes profit sharing, 401(k) (McDESOP), and leveraged employee stock ownership features. McDESOP allows employees to invest in McDonald's common stock by making contributions that are partially matched by the Company. Assets of the profit sharing plan can be invested in McDonald's common stock, or among several other alternatives. Certain subsidiaries outside of the U.S. also offer profit sharing, stock purchase or other similar benefit plans. Total U.S. program costs were: 1993--$47.1 million; 1992--$38.8 million; 1991--$46.4 million. Total plan costs outside of the U.S. were: 1993--$13.0 million; 1992-- $14.0 million; 1991--$9.8 million. The Company does not provide any other postretirement benefits, and postemployment benefits were immaterial. ---------------------------------------------------------------------- STOCK OPTIONS ---------------------------------------------------------------------- Under the 1992 Stock Ownership Incentive and the 1975 Stock Ownership Option Plans, options to purchase common stock are granted at prices not less than fair market value of the stock on date of grant. Substantially all of these options become exercisable in four equal biennial installments, commencing one year from date of grant, and expire ten years from date of grant. At December 31, 1993, 41.5 million shares of common stock were reserved for issuance under both plans. ----------------------------------------------------------------------- (In millions, except per common share data) 1993 1992 1991 ----------------------------------------------------------------------- Options outstanding at January 1 25.1 23.7 21.6 Options granted 6.0 5.8 5.5 Options exercised (2.7) (3.8) (2.6) Options forfeited (.9) (.6) (.8) ----------------------------------------------------------------------- Options outstanding at December 31 27.5 25.1 23.7 ======================================================================= Options exercisable at December 31 8.8 7.7 7.8 Common shares reserved for future grants at December 31 14.0 19.1 6.3 Option prices per common share Exercised during the year $ 9 to $48 $9 to $45 $6 to $34 Outstanding at year end $10 to $56 $9 to $48 $9 to $34 ----------------------------------------------------------------------- ---------------------------------------------------------------------- CAPITAL STOCK ---------------------------------------------------------------------- PER COMMON SHARE INFORMATION Income used in the computation of per common share information was reduced by preferred stock cash dividends (net of tax benefits in 1993 and 1992) and divided by the weighted average shares of common stock outstanding during each year: 1993--355.9 million; 1992--363.2 million; 1991--358.1 million. The effect of potentially dilutive securities was not material. PREFERRED STOCK In December 1992, the Company issued $500.0 million of Series E 7.72% Cumulative Preferred Stock; 10,000 preferred shares are equivalent to 20.0 million depositary shares having a liquidation preference of $25.00 per depositary share. Each preferred share is entitled to one vote under certain circumstances, and is redeemable at the option of the Company beginning on December 3, 1997, at its liquidation preference plus accrued and unpaid dividends. In September 1989 and April 1991, the Company sold $200.0 million of Series B and $100.0 million of Series C ESOP Convertible Preferred Stock, respectively, to the LESOP. The LESOP financed the purchase by issuing notes that are guaranteed by the Company and are included in long-term debt, with an offsetting reduction in shareholders' equity. Each preferred share has a liquidation preference of $28.75 and $33.125, respectively, and is convertible into a minimum of .7692 and .8 common share (conversion rate), respectively. Upon termination, employees are guaranteed a minimum value payable in common shares equal to the greater of the conversion rate; the fair market value of their preferred shares; or the liquidation preference plus accrued dividends, not to exceed one common share. Each preferred share is entitled to one vote and is redeemable at the option of the Company three years after issuance and, under certain circumstances, is redeemable prior to that date. In 1992, 4.1 million Series B shares were converted into 3.2 million common shares. COMMON EQUITY PUT OPTIONS In December 1992, the Company sold 2.0 million common equity put options. At December 31, 1992, the $94.0 million exercise price of these options was classified in common equity put options and the related offset was recorded in common stock in treasury, net of premiums received. In April 1993, these options expired unexercised. In April 1993, the Company also sold 1.0 million common equity put options which expired unexercised in July 1993. SHAREHOLDER RIGHTS PLAN In December 1988, the Company declared a dividend of one Preferred Share Purchase Right (Right) on each outstanding share of common stock. Under certain conditions, each Right may be exercised to purchase one two-hundredth of a share of Series A Junior Participating Preferred Stock (the economic equivalent of one common share) at an exercise price of $125.00 (which may be adjusted under certain circumstances), and is transferable apart from the common stock ten days following a public announcement that a person or group has acquired beneficial ownership of 20% or more of the outstanding common shares, or ten business days following the commencement or announcement of an intention to make a tender or exchange offer, resulting in beneficial ownership by a person or group of 20% or more of the outstanding common shares. If a person or group acquires 20% or more of the outstanding common shares, or if the Company is acquired in a merger or other business combination transaction, each Right will entitle the holder, other than such person or group, to purchase at the then current exercise price, stock of the Company or the acquiring company having a market value of twice the exercise price. Each Right is nonvoting and expires on December 28, 1998, unless redeemed by the Company, at a price of $.005, at any time prior to the public announcement that a person or group has acquired beneficial ownership of 20% or more of the outstanding common shares. At December 31, 1993, 2.1 million shares of the Series A Junior Participating Preferred Stock were reserved for issuance under this plan. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information regarding directors is incorporated herein by reference from the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 1993. On December 1, 1993, Donald R. Keough, Chairman of Allen & Company, Inc., was appointed to the Company's Board of Directors. Information regarding all of the Company's executive officers is included in Part I. Item 11. Item 11. Executive Compensation Incorporated herein by reference from the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 1993. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference from the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 1993. Item 13. Item 13. Certain Relationships and Related Transactions Incorporated herein by reference from the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 1993. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial statements Consolidated financial statements filed as part of this report are listed under Part II, Item 8 of this Form 10-K. 2. Financial statement schedules The financial schedules listed in the accompanying index to consolidated financial statement schedules are filed as part of this report. 3. Exhibits (3) Restated Certificate of Incorporation, dated as of February 2, 1993, incorporated herein by reference from Exhibit (3) of Form 10-K dated December 31, 1992. By-laws incorporated herein by reference from Exhibit 3 of Form 10-K dated December 31, 1991. (4) Instruments defining the rights of security holders, including indentures (A): (a) Debt Securities. Indenture dated as of March 1, 1987 incorporated herein by reference from Exhibit 4(a) of Form S-3 Registration Statement, SEC file no. 33-12364. (i) Supplemental Indenture No. 5 incorporated herein by reference from Exhibit (4) of Form 8-K dated January 23, 1989. (ii) 9-3/4% Notes due 1999. Supplemental Indenture No. 6 incorporated herein by reference from Exhibit (4) of Form 8-K dated January 23, 1989. (iii) Medium-Term Notes, Series B, due from nine months to 30 years from Date of Issue. Supplemental Indenture No. 12 incorporated herein by reference from Exhibit (4) of Form 8-K dated August 18, 1989 and Forms of Medium-Term Notes, Series B, incorporated herein by reference from Exhibit (4)(b) of Form 8-K dated September 14, 1989. (iv) 9-3/8% Notes due 1997. Form of Supplemental Indenture No. 14 incorporated herein by reference from Exhibit (4) of Form 10-K for the year ended December 31, 1989. (v) Medium-Term Notes, Series C, due from nine months to 30 years from Date of Issue. Form of Supplemental Indenture No. 15 incorporated herein by reference from Exhibit 4(b) of Form S-3 Registration Statement, SEC file no. 33-34762 dated May 14, 1990. (vi) Medium-Term Notes, Series C, due from nine months/184 days to 30 years from Date of Issue. Amended and restated Supplemental Indenture No. 16 incorporated herein by reference from Exhibit (4) of Form 10-Q for the period ended March 31, 1991. (vii) 8-7/8% Debentures due 2011. Supplemental Indenture No. 17 incorporated herein by reference from Exhibit (4) of Form 8-K dated April 22, 1991. (viii)Medium-Term Notes, Series D, due from nine months/184 days to 60 years from Date of Issue. Supplemental Indenture No. 18 incorporated herein by reference from Exhibit 4(b) of Form S-3 Registration Statement, SEC file no. 33-42642 dated September 10, 1991. (ix) 7-3/8% Notes due July 15, 2002. Form of Supplemental Indenture No. 19 incorporated herein by reference from Exhibit (4) of Form 8-K dated July 10, 1992. (x) 6-3/4% Notes due February 15, 2003. Form of Supplemental Indenture No. 20 incorporated herein by reference from Exhibit (4) of Form 8-K dated March 1, 1993. (xi) 7-3/8% Debentures due July 15, 2033. Form of Supplemental Indenture No. 21 incorporated herein by reference from Exhibit (4)(a)of Form 8-K dated July 15, 1993. (b) Form of Deposit Agreement dated as of November 25, 1992 by and between McDonald's Corporation, First Chicago Trust Company of New York, as Depositary, and the Holders from time to time of the Depositary Receipts. (c) Rights Agreement dated as of December 13, 1988 between McDonald's Corporation and The First National Bank of Chicago, incorporated herein by reference from Exhibit 1 of Form 8-K dated December 23, 1988. (i) Amendment No. 1 to Rights Agreement incorporated herein by reference from Exhibit 1 of Form 8-K dated May 25, 1989. (ii) Amendment No. 2 to Rights Agreement incorporated herein by reference from Exhibit 1 of Form 8-K dated July 25, 1990. (d) Indenture and Supplemental Indenture No. 1 dated as of September 8, 1989, between McDonald's Matching and Deferred Stock Ownership Trust, McDonald's Corporation and Pittsburgh National Bank in connection with SEC Registration Statement Nos. 33-28684 and 33-28684-01, incorporated herein by reference from Exhibit (4)(a) of Form 8-K dated September 14, 1989. (e) Form of Supplemental Indenture No. 2 dated as of April 1, 1991, supplemental to the Indenture between McDonald's Matching and Deferred Stock Ownership Trust, McDonald's Corporation and Pittsburgh National Bank in connection with SEC Registration Statement Nos. 33-28684 and 33-28684-01, incorporated herein by reference from Exhibit (4)(c) of Form 8-K dated March 22, 1991. (10) Material Contracts (a) Material contract between McDonald's Corporation and Joan B. Kroc, incorporated herein by reference from Exhibit (10) of Form 10-K for the year ended December 31, 1984. (b) Director's Deferred Compensation Plan, incorporated herein by reference from Exhibit (10)(b)of Form 10-K for the year ended December 31, 1992. (c) Profit Sharing Program, as amended, McDonald's Supplemental Employee Benefit Equalization Plan, McDonald's Profit Sharing Program Equalization Plan and McDonald's 1989 Equalization Plan, incorporated by reference from Form 10-K/A dated May 4, 1993, Amendment No. 1 to Form 10-K for the year ended December 31, 1992. (i) Amendment No. 1 to McDonald's 1989 Equalization Plan, incorporated herein by reference from Form 10-Q for the period ended June 30, 1993. (ii) Amendment No. 2 to McDonald's 1989 Equalization Plan, attached hereto as an Exhibit. (iii)Amendment No. 1 to McDonald's Supplemental Employee Benefit Equalization Plan, attached hereto as an Exhibit. (iv) Amendment No. 2 to McDonald's Supplemental Employee Equalization Plan, attached hereto as an Exhibit. (v) Amendment No. 5 to the Profit Sharing Program, as amended, attached hereto as an Exhibit. Amendment No. 6 to the Profit Sharing Program, as (vi) amended, attached hereto as an Exhibit. (d) 1975 Stock Ownership Option Plan, incorporated herein by reference from Exhibit (10)(d) of Form 10-K for the year ended December 31, 1992. (e) Stock Sharing Plan, incorporated herein by reference from Exhibit (10)(e) of Form 10-K for the year ended December 31, 1992. (f) 1992 Stock Ownership Incentive Plan, incorporated herein by reference from exhibit pages 20-34 of McDonald's 1992 Proxy Statement and Notice of 1992 Annual Meeting of Shareholders dated April 10, 1992. (g) McDonald's Corporation Deferred Incentive Plan, incorporated herein by reference from Exhibit(10) of Form 10-Q for the period ended September 30, 1993. (11) Statement re: Computation of per share earnings. (12) Statement re: Computation of ratios. (21) Subsidiaries of the registrant. (23) Consent of independent auditors. -------------------- * Denotes compensatory plan. (A) Other instruments defining the rights of holders of long-term debt of the registrant and all of its subsidiaries for which consolidated financial statements are required to be filed and which are not required to be registered with the Securities and Exchange Commission, are not included herein as the securities authorized under these instruments, individually, do not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. An agreement to furnish a copy of any such instruments to the Securities and Exchange Commission upon request has been filed with the Commission. (b) Reports on Form 8-K The following reports on Form 8-K were filed for the last quarter covered by this report, and subsequently up to March 29, 1994. Financial Statements Date of Report Item Number required to be filed -------------- ----------- -------------------- November 22, 1993 Item 7 No January 18, 1994 Item 7 No McDONALD'S CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES (Item 14) (a) The following documents are filed as part of this report: Page 1. Financial Statement Schedules Reference Report of Independent Auditors 58 Consolidated schedules for the years ended December 31, 1993, 1992 and 1991: V - Property and equipment 59 VI - Accumulated depreciation and amortization of property and equipment 60 IX - Short-term borrowings 62 X - Supplementary income statement information 63 Consolidated schedule at December 31, 1993: VII - Guarantees of securities of other issuers 61 All other schedules have been omitted as the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto. REPORT OF INDEPENDENT AUDITORS We have audited the consolidated financial statements of McDonald's Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 27, 1994 (included elsewhere in this Annual Report on Form 10-K). Our audits also included the consolidated financial statement schedules of McDonald's Corporation listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Ernst & Young Chicago, Illinois January 27, 1994 McDonald's Corporation Exhibit Index (Item 14) Amendment No. 2 to McDonald's 1989 Equalization Plan Amendment No. 1 to McDonald's Supplemental Employee Benefit Equalization Plan Amendment No. 2 to McDonald's Supplemental Employee Benefit Equalization Plan Amendment No. 5 to the Profit Sharing Program Amendment No. 6 to the Profit Sharing Program Statement re: Computation of per share earnings Statement re: Computation of ratios Subsidiaries of the registrant Consent of independent auditors SIGNATURES Pursuant to the requirements of Section 13 or 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. McDONALD'S CORPORATION (Registrant) By Jack M. Greenberg ---------------------- Jack M. Greenberg Vice Chairman, Chief Financial Officer March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signature Title Date --------- ----- ---- ------------------------- Director Hall Adams, Jr. Robert M. Beavers, Jr. ------------------------- Senior Vice President March 29, 1994 Robert M. Beavers, Jr. and Director James R. Cantalupo ------------------------- President and Chief Executive March 29, 1994 James R. Cantalupo Officer-International and Director Michael L. Conley ------------------------- Senior Vice President, March 29, 1994 Michael L. Conley Controller Gordon C. Gray ------------------------- Director March 29, 1994 Gordon C. Gray Jack M. Greenberg ------------------------- Vice Chairman, March 29, 1994 Jack M. Greenberg Chief Financial Officer and Director ------------------------- Director Donald R. Keough Signature Title Date --------- ----- ---- Donald G. Lubin ------------------------- Director March 29, 1994 Donald G. Lubin ------------------------- Director Andrew J. McKenna Michael R. Quinlan ------------------------- Chairman, Chief Executive March 29, 1994 Michael R. Quinlan Officer and Director Edward H. Rensi ------------------------- President and Chief Executive March 29, 1994 Edward H. Rensi Officer-U.S.A. and Director ------------------------- Director Terry Savage Paul D. Schrage ------------------------- Senior Executive Vice March 29, 1994 Paul D. Schrage President, Chief Marketing Officer and Director ------------------------- Director Ballard F. Smith ------------------------- Director Roger W. Stone Robert N. Thurston ------------------------- Director March 29, 1994 Robert N. Thurston Fred L. Turner ------------------------- Senior Chairman and Director March 29, 1994 Fred L. Turner B. Blair Vedder, Jr. ------------------------- Director March 29, 1994 B. Blair Vedder, Jr.	13,763	102,571
726517_1993.txt	726517_1993	1993	726517	ITEM 1 - BUSINESS MERCHANTS BANCSHARES, INC., (the Company) was organized on July 1, 1983 as a Vermont corporation, for the purpose of acquiring, investing in or holding stock in any subsidiary enterprise permitted under the Bank Holding Company Act of 1956. On January 24, 1984 the Company acquired The Merchants Bank; and on October 4, 1988 the Company organized Merchants Properties, Inc. On June 2, 1987 shareholders approved a resolution to change the state of incorporation of the Company from Vermont to Delaware. THE MERCHANTS BANK, (the Bank) was organized in 1849, and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974 the Bank converted its national charter to a state-bank charter, becoming known as The Merchants Bank. As of December 31, 1993 the Bank was the third largest commercial banking operation in Vermont, with deposits totalling $619.3 million, net loans of $553.4 million, and total assets of $735.4 million, on a consolidated basis. Since September 30, 1988, The Merchants Bank has participated as an equity partner in the development of several AFFORDABLE HOUSING PARTNERSHIPS which were formed to provide residential housing units within the State of Vermont. During the past four years these partnerships have developed 695 units of residential housing, 446 (64%) of which qualify as "affordable housing units for eligible low income owners or renters", and 249 (36%) of which are "market rate units". These partnerships have invested in 14 affordable and elderly housing projects within 11 Vermont communities: St. Albans, Middlebury, Williston, Winooski, Brattleboro, Montpelier, Burlington, Springfield, St. Johnsbury, Colchester and Swanton. MERCHANTS PROPERTIES, INC., a wholly owned subsidiary of the Company, was organized for the purpose of developing and owning affordable rental housing units throughout the state of Vermont. As of December 31, 1993 the corporation owned one development located in Enosburg, Vermont, consisting of a 24-unit low income family rental housing project, which was completed and rented during 1989. Total assets of this corporation at December 31, 1993 were $1,328,295. The Bank owns controlling interest in MERCHANTS TRUST COMPANY, a corporation chartered in 1870 for the purpose of offering fiduciary services such as estate settlement, testamentary trusts, guardianships, agencies, intervivos trusts, employee benefit plans and corporate trust services. The Merchants Trust Company also operates a discount brokerage office, through Olde Discount Corporation, enabling investors to purchase or sell stocks and bonds on a discounted commission schedule. As of December 31, 1993, the Merchants Trust Company had fiduciary responsibilities for assets valued at market in excess of $311 million. Total income for 1993 was $1,756,523, total expense was $1,016,153 resulting in net profit for the year of $740,370. This income is included in the consolidated tax return of its parent company, The Merchants Bank. QUENESKA CAPITAL CORPORATION, a wholly-owned subsidiary of The Merchants Bank was established on April 4, 1988 as a Federal licensee under the Small Business Act of 1958 to provide small business enterprises with loans and/or capital. As of December 31, 1993, the corporation had assets of $1,536,668, a liability of $5,524 due to the parent company for accrued management fees, and equity capital of $1,531,144. QUENESKA Capital Corporation has no employees, relying on the personnel resources of its parent company to operate. As compensation for its services QUENESKA pays the Bank a management fee in the amount of 1.5% on annual average assets ($21,673) in 1993. This fee is eliminated in the financial statement consolidation of the parent company. The corporation's taxable income or loss is included in the consolidated tax return of its parent company, The Merchants Bank. QUENESKA computes its income tax provision or benefit on an individual basis and reimburses, or is reimbursed, by the parent company an amount equal to the annual provision or benefit. RETAIL SERVICES A variety of deposit, credit and other miscellaneous financial services are offered by the Bank, encompassing the following: Checking accounts are offered in the form of regular, N.O.W., Super N.O.W. and senior citizen accounts. The Bank also offers a basic account called the Thrift account. Statement savings accounts are offered with a related account feature to a number of personal checking account products which may satisfy the checking account minimum balance requirements. ATF (automatic transfer of funds) provides overdraft protection benefits for personal checking accounts through electronic funds transfer. Certificates of deposit provide investment opportunities with varying maturities and yields. Money Market and Preferred Investment accounts offer competitive annual percentage yields and the ability to engage in third party transactions. A flexible I.R.A. program offers several deposit options for retirement investment using both fixed and adjustable rate offerings with varying maturities. A Christmas Club account is also available for the accumulation of savings with an annual disbursement. The Consumer Credit program consists of installment loans, Mastercard, University of Vermont Affinity Mastercard, VISA, a home equity line of credit, and fixed and adjustable rate residential real estate mortgages. Four unique mortgage programs are: an accelerated amortization mortgage which allows mortgagors to make biweekly payments resulting in interest savings and an earlier payoff compared to monthly payment mortgages; a Two Step program with an affordable low fixed rate for the first five or seven years which then adjusts once based upon a specific index; a loan under the Farmers' Home Administration Rural Guaranteed Housing Program which provides for up to 100% financing, flexible qualifying ratios, and a government guarantee for loans on properties in the rural portions of the state; and a "jumbo" loan program providing salable loans for customers with requirements for larger mortgage balances. The Bank also participates in the state's housing finance agency program which assists the low to moderate income home buyer. The Bank provides strong customer support with thirty Automated Teller machines statewide and including one drive-up machine and 106 on- line electronic teller stations. The bank's expanded personal computer networks now connect each of our thirty nine banking offices to the main frame computer with CRT capability as well as with electronic mail and other PC software. Miscellaneous retail services include safe deposit boxes, travelers and gift checks, bank drafts, personal money orders, and several methods of automated money transfer, including Federal Reserve wire services. COMMERCIAL SERVICES The Bank provides commercial banking services to individuals, partnerships and corporations, as well as to public and governmental organizations. Corporate Cash Management services provide several vehicles for managing and investing idle funds on a daily and weekly basis. Business Credit Card services offer full participation in Mastercard and VISA programs and feature various types of electronic deposit options. Regular and Small Business checking accounts address the need for essential deposit and disbursement services for commercial customers. Commercial loans are offered for a wide range of private and public funding needs. Included in this area is the Bank's Small Business Preferred Lender Program. Also offered are commercial real estate loans, lines of credit, business credit cards, and irrevocable letters of credit. Other miscellaneous commercial banking services include night depository, coin and currency handling, and employee benefits management and fiduciary services available through the Merchants Trust Company. EXPANSION EFFORTS The Merchants Bank operates thirty-eight full-service banking facilities within Vermont; and a remote ATM unit located at the Burlington International Airport. Since 1963 the Bank has established eleven de novo offices, and since 1969 has acquired seven Vermont banks by merger. The Merchants Bank's most recent acquisition occurred in June of 1993 with the acquisition of the assets and deposits of New First National Bank of Vermont from the FDIC. Through this acquisition the Merchants Bank extended its presence on the east side of the State gaining offices in Springfield, Windsor, E. Thetford, Fairlee, Bradford, Newbury and Groton and on the west side of the State an office in Fair Haven. This acquisition also resulted in The Merchants Bank increasing market share in Hardwick, St. Johnsbury and Northfield. Each decision to expand the branch network has been based upon strategic planning and analysis indicating that the new or acquired facility would provide enhanced banking resources within the community, insure the competitive viability of the Bank through potential growth of deposits and lending activities. On March 14, 1994 The Merchants Bank opened a limited service office on the Wake Robin Retirement Community Campus in Shelburne, Vermont. COMPETITION Competition for financial services remains very strong in Vermont. As of December 31, 1993, there were twelve state chartered commercial banks, nine national banks, five savings banks and three savings and loan associations operating in Vermont. In addition, other financial intermediaries such as brokerage firms, credit unions, and out-of-state banks also compete for deposit and loan activities. At year-end 1993 The Merchants Bank was the third largest bank in Vermont, enjoying a strong competitive franchise within the state, with thirty-nine banking offices. Whereas Vermont does have a nationwide interstate banking law there was no merger or acquisition activity during 1993. No material part of the Bank's business is dependent upon one, or a few customers, or upon a particular market segment, the loss of which would have a materially adverse impact on the operations of the Bank. NUMBER OF EMPLOYEES As of December 31, 1993 Merchants Bancshares, Inc. had four officers: Dudley H. Davis, President and Chief Executive Officer; Susan D. Struble, Secretary; Edward W. Haase, Treasurer; and Susan M. Verro, Assistant Secretary. No officers of the Company are on a salary basis. As of December 31, 1993, The Merchants Bank employed 388 full-time and 80 regular part-time employees, representing a full-time equivalent complement of 432 employees. The Bank maintains a comprehensive employee benefits program which provides major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance, a pension plan and a 401(k) Employee Stock Ownership Plan. In addition, the Bank offers a Performance Progress Sharing Plan, which is available to all eligible employees. Employee benefits offered by the Bank are very competitive with comparable plans provided by other Vermont banks. REGIONAL ECONOMY In New England the long and deep recession which eliminated about one out of every nine jobs, appears to be abating. The year-end 1993 forecast from the New England Economic Project (NEEP) predicts that payroll surveyed jobs will be growing in 1994 in all six New England states. However, by gradual economic improvement within the region, business activity and labor markets have not yet returned to "normal". It may take another decade for this region to regain the jobs lost since the recession which started in 1989. Some segments of the economy are recovering better than others. For example, 1993 building permits for new home construction had risen more that 25% above their 1991 lows. By the end of 1997, NEEP predicts that permits will be up an additional 15%. Even so, the level of home building activity will still be less than half what it was in 1986, when New Englanders took out 112,000 permits at the peak of the speculative housing period. The economy of the New England states is expected to underperform the national economy, with the economy of the southern three N.E. states expected to be weaker than the three northern states. Connecticut has been especially hard hit by defense restructuring and by restructuring in the insurance industry. Continued tough economic times for the region's richest state is not favorable news for New England. New Hampshire is currently the bright spot in New England, because of its position as the low cost producer in the region. Non farm employment is forecast to add 9,000 jobs in 1994 (up 1.9%) and an additional 15,000 jobs in 1995 (up 2.9%). Overall, however, it appears unlikely that any significant economic expansion is on the horizon for the New England region. Growth will need to come from the expansion of existing businesses operating within the region, and from the region's natural environmental appeal for tourism. VERMONT ECONOMY A conclusion of the Vermont Business Roundtable is that "not since the Great Depression has there been a period of such extended and steep decline in employment in Vermont". Many of the reasons for this decline are attributable to regional and national factors; specifically the following: The end of the national defense build-up. The direct and indirect economic impact of defense spending in Vermont could account for as much as 10 percent of the state's total annual economic activity. Maturation of high-technology and computer industries. There has been a decline in the high-tech, computer business in Vermont as foreign competition has been intense, and changes within the computer industry have hurt job growth since its mid-1980's employment peak. Problems in agriculture. The dramatic decline in milk prices over the past two years has placed many Vermont dairy farmers at considerable financial risk. Over the past ten years the number of dairy farms has declined 31 percent, from 3,170 in 1984 to 2,187 this year. Loss of Vermont's and New England's cost competitiveness to domestic competition. Vermont's businesses find themselves facing increasingly sharp cost competition from national and foreign concerns. This loss of competitiveness has resulted in numerous work-force reductions and cost-cutting initiatives among key employers across the state. Restructuring in financial services. Ongoing employment restructuring in the banking and financial services sector in Vermont has had a negative impact on the economy as firms seek to reduce payroll and overhead costs in order to restore profitability. Problems associated with the national recession and subsequent weak recovery. Vermont is not immune to the inevitable ups and downs associated with the national business cycle. The manufacturing sector has been negatively impacted by the slow recovery in markets for durable goods products. In spite of the problems discussed above, Vermont's labor market has recently expanded. The Vermont unemployment rate was 4.5% in November 1993, versus 6.4% nationally. Jobs within the service sector have increased 3% over the past year, and now account for approximately 29% of all jobs in Vermont. The total state labor force expanded by 2,300 jobs between December 31, 1992 and November 30, 1993. Many have recommended that it's time to take inventory of Vermont's advantages and disadvantages and to capitalize on the state's many attributes, while at the same time assessing and finding reasonable solutions to the problems facing Vermont's current economy. ITEM 2 ITEM 2 - PROPERTIES The Merchants Bank operates thirty-nine banking facilities as indicated in Schedule A below. Corporate administrative offices are located at 123 Church Street, Burlington, Vermont, and the operations data processing center is located at 275 Kennedy Drive, South Burlington, Vermont. Schedule B (below) indicates properties owned by the Bank as possible future expansion sites. A. SCHEDULE OF BANKING OFFICES BY LOCATION Burlington 123 Church Street Corporate offices 164 College Street Merchants Trust Co. 172 College Street Branch office 1014 North Avenue Branch office 112 Colchester Avenue 2 Branch office Essex Junction 54 Pearl Street Branch office South Burlington 50 White Street Branch office 947 Shelburne Road 1 Branch office 275 Kennedy Drive Operations Center Branch office Burlington Airport 1 ATM Bristol 15 West Street Branch office Barre 105 North Main Street Branch office Northfield Depot Street Branch office South Hero Route 2 Branch office Hardwick Wolcott Street Branch office Hinesburg Route 116/Shelburne Falls Rd Branch office Vergennes Monkton Road Branch office Winooski 364 Main Street Branch office Johnson Main Street Branch office Colchester 8 Porters Point Road 2 Branch office Jericho Route 15 Branch office Enosburg Falls 155 Main Street Branch office No. Bennington Bank Street Branch office Manchester 515 Main Street Branch office Brattleboro 205 Main Street 3 Branch office Wilmington West Main Street Branch office Bennington Putnam Square 2 Branch office Wallingford Route 7 2 Branch office St. Johnsbury 90 Portland Street Branch office Bradford 1 Main Street Branch office Danville Main Street Branch office Fairlee U.S. Route #5 Branch office Groton U.S. Route #302 Branch office East Thetford U.S. Route #5 & Vt 113 Branch office Newbury U.S. Route #5 Branch office Fair Haven 97 Main Street Branch office Springfield 56 Main Street Branch office Springfield Plaza Springfield Shopping Plaza Branch office Windsor 160 Main Street Branch office Notes: 1: Facilities owned by the bank are located on leased land. 2: Facilities located on leased land with improvements also leased. 3: As of December 31, 1993 a mortgage with an unpaid principal balance of $209,909 is outstanding on the Brattleboro office. This mortgage is being amortized at $1,736 per month, at a rate of 9% through the year 2020. B. SCHEDULE OF PROPERTIES OWNED FOR FUTURE EXPANSION 1 Year Description Acquired Location Purpose Land & Building 1973 Corner of Church Future Expansion & College Sts. Burlington, VT Land 1977 30 Main Street Future Expansion Burlington, VT Land & Building 1979 Plainfield, VT Future Expansion Land & Building 1981 8 White Street Future Expansion So. Burlington, VT Land & Building 1985 U.S. Route 7 Future Expansion Shelburne, VT Land & Building 1986 Pearl Street Future Expansion Essex Jct., VT Land & Building 1986 So. Summit St. Future Expansion Essex Jct., VT Land 1990 45 College Street Future Expansion Burlington, VT Land & Building 1990 60 Main Street Future Expansion Burlington, VT Note: 1: Buildings identified in Schedule B are all rented or leased to tenants. Leases are generally for short-term periods and are at varying rental amounts depending upon the location and the amount of space leased. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS The Company is involved in various legal proceedings arising in the normal course of business. Based on consultation with legal counsel, management believes that the resolution of these matters will not have a material effect on the consolidated financial statements of the Company. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of calendar year 1993 no matters were submitted to a vote of security holders through a solicitation of proxies or otherwise. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of the Company is traded on the over-the-counter NASDAQ exchange under the trading symbol MBVT. Quarterly stock prices during the last eight quarters are as indicated below based upon quotations as provided by the National Association of Securities Dealers, Inc. Prices of transactions between private parties may vary from the ranges quoted below. CASH DIVIDEND QUARTER ENDING HIGH LOW PAID PER SHARE March 31, 1992 $14.75 $11.50 .20 June 30, 1992 15.50 11.75 .20 September 30, 1992 16.50 14.00 .20 December 31, 1992 17.00 14.50 .20 March 31, 1993 17.00 14.75 .20 June 30, 1993 16.50 10.25 * September 30, 1993 16.00 11.25 * December 31, 1993 15.00 11.00 * On December 11, 1992 a three percent stock dividend was issued to shareholders of record on November 30, 1992. Cash dividends were suspended for the second, third and fourth quarters of 1993. As of December 31, 1993 Merchants Bancshares, Inc. had 1,630 shareholders. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA The supplementary financial data presented in the following tables and narrative contains information highlighting certain significant trends in the Company's financial condition and results of operations over an extended period of time. The following information should be analyzed in conjunction with the year-end audited consolidated financial statements as contained in the 1993 Annual Report to Shareholders, a copy of which is attached as an addendum to this Form 10K. The five-year summary of operations, interest management analysis, and management's discussion and analysis, all as contained on pages 27 through 33 in the 1993 Annual Report to Shareholders are herein incorporated by reference. Tables included on the following pages concern the following: Deposits; return on equity and assets; distribution of assets, liabilities, and stockholders' equity; analysis of changes in net interest income; investment securities and U.S. Treasury and Agency obligations; and the estimated maturity / repricing structure of the Company's interest earning assets and interest bearing liabilities. DEPOSITS The following schedule shows the average balances of various classifications of deposits. Dollar amounts are expressed in thousands. 1993 1992 1991 Demand Deposits $ 81,761 $ 68,494 $ 63,986 Savings, Money Market and NOW Accounts 315,254 272,729 233,873 Time Deposits Over $100,000 17,752 18,170 9,534 Other Time Deposits 155,227 132,971 183,331 -------- -------- -------- Total Average Deposits $569,994 $492,364 $490,724 ======== ======== ======== Time Deposits over $100,000 at December 31, 1993 had the following schedule of maturities (In Thousands): Three Months or Less $ 6,725 Three to Six Months 1,717 Six to Twelve Months 6,517 Over Twelve Months 6,255 -------- Total $ 21,214 ======== RETURN ON EQUITY AND ASSETS The return on averageassets, return on average equity,dividend payout ratio and average equity to average assets ratio for the three years ended December 31, 1993 were as follows: 1993 1992 1991 Return on Average Total Assets -0.82% 0.94% 0.86% Return on Average Stockholders' Equity -11.92% 11.01% 10.53% Dividend Payout Ratio N/A 58.48% 62.69% Average Stockholders' Equity to Average Total Assets 6.88% 8.56% 8.22% SHORT-TERM BORROWINGS Refer to Notes 9 and 10 to the consolidated financial statements for this information. INVESTMENT SECURITIES The Company invests in securities with short maturities, consisting primarily of U.S. government securities. The Company's investment portfolio is used primarily to fund the seasonality of loan growth and deposit run-off as well as for asset/liability management purposes. The table below showsthe classification of the investmentportfolio by type of investment security based on lower of cost or market value at December 31, 1993, 1992, and 1991, respectively. In addition, the subsequent table shows the maturity distribution and weighted average yield of the investment portfolio by security type as of December 31, 1993. All dollar amounts are expressed in thousands. December 31, 1993 1992 1991 U.S. Treasury and Agency Obligations $85,945 $103,187 $ 63,262 Other Securities 1,451 4,333 4,371 ------- -------- -------- Total Investment Securities $87,396 $107,530 $ 67,643 Net Unrealized Depreciation (439) 0 0 -------- -------- -------- Total $86,957 $107,530 $ 67,643 ======= ======== ======== The following table shows the maturity distribution and the weighted average yields of such investment portfolio and the securities as of December 31, 1993: Book Average Value Yield U.S. Treasury and Agency Obligations(thousands) Due Within 1 Year $ 0 --- Due After 1 but Within 5 Years 85,714 3.71% Due After 5 but Within 10 Years 0 --- Due After 10 Years 231 7.67% ------- ----- Total $85,945 3.72% ------- ----- Other Securities Due Within 1 Year $ 0 --- Due After 1 but Within 5 Years 0 --- Due After 5 but Within 10 Years 0 --- Due After 10 Years 0 Equity Securities 1,451 3.64% -------- ------ Total $ 1,451 3.64% -------- ------ Total $ 87,396 3.71% ======== ====== Total Securities Due Within 1 Year $ 0 --- Due After 1 but Within 5 Years 85,714 3.71% Due After 5 but Within 10 Years 0 --- Due After 10 Years 231 7.67% Equity Securities* 1,451 3.64% ------- ------ Total $87,396 3.71% ======= ====== * Yields are adjusted to fully taxable equivalent basis, assuming a 34% Federal tax rate. LOAN PORTFOLIO The following tables display the composition of the Bank's loan portfolio for the consecutive five year period 1989 through 1993, along with a schedule profiling the loan maturity distribution over the next five years. COMPOSITION OF LOAN PORTFOLIO The table belowpresents the composition ofthe Bank's loan portfolioby type of loan as of December 31 for each of the past five years. All dollar amounts are expressed in thousands. Amounts are shown gross of net deferred loan fees of $1,310,416 in 1993, $1,183,400 in 1992, $1,098,100 in 1991, $955,000 in 1990 and $950,000 in 1989, which principally relate to real estate mortgages. As of December 31, Type of Loan 1993 1992 1991 1990 1989 ------------ -------- -------- -------- -------- -------- Commercial, Financial & Agricultural $ 98,936 $ 76,141 $120,033 $129,830 $113,169 Industrial Revenue Bonds 6,695 8,721 11,968 16,296 19,741 Real Estate - Construction 30,526 18,776 16,392 23,763 69,282 Real Estate - Mortgage 413,112 305,513 294,769 288,845 262,723 Installment 22,836 18,332 20,930 25,070 29,124 Lease Financing 42 630 1,769 4,144 6,005 All Other Loans 1,324 1,422 4,287 7,452 2,071 -------- -------- -------- -------- -------- Total Loans $573,471 $429,535 $470,148 $495,400 $502,115 ======== ======== ======== ======== ======== PROFILE OF LOAN MATURITY DISTRIBUTION The table below presents the distribution of the varying contractual maturities or repricing opportunities of the loan portfolio at December, 1993. All dollar amounts are expressed in thousands. Over One One Year Through Over Five Or Less 5 Years Years Total Commercial Loans, Industrial Revenue Bonds, Lease Financing and All Other Loans $ 95,694 $ 8,313 $ 3,136 $107,143 Real Estate Loans 398,319 26,971 18,130 $443,420 Installment Loans 15,007 7,869 32 $22,908 -------- -------- -------- -------- $509,020 $ 43,153 $ 21,298 $573,471 ======== ======== ======== ======== Residential mortgage lending during 1993 was very active due to prevailing low interest rates for various mortgage products. Approximately 75% of the Bank's 1993 mortgage activity was for refinancing of existing debt. In 1993 a total of 1,098 one-to-four family residential mortgage loans were closed by the bank totaling $103.2 million. Approximately 95% of these originations were sold on the secondary market. The remaining 5%, or $4.9 million was placed in the Bank's portfolio. The Bank currently services $347.9 million in residential mortgage loans, $257.1 of which it services for other investors such as federal government agencies (FNMA and FHLMC) and for financial investors such as insurance companies and pension funds located outside Vermont. At the end of 1993, the Bank had 181 residential mortgage loans in various stages of processing. Approximately 68% of these loans were refinancings of existing debt. During 1993 the Bank continued to be very active in the U.S. Small Business Administration guaranteed loan program. Forty new loans totaling $7.1 million were originated during 1993 with SBA guarantees ranging from 70% to 90%. This represents an approximate decrease of 13% in originations over 1992. The reason for the decline in volume is believed to be the sluggish Vermont economy. In most instances the Bank sells the guaranteed portion of its SBA guaranteed loans to secondary investors outside Vermont. This selling activity has the positive effect on Vermont of importing capital into the State from other parts of the country. SBA guarantees are advantageous to the Bank because they reduce risk in the Bank's loan portfolio and allow the Bank to increase its commercial loan base and market share with minimal impact on capital. In June 1993, the Bank purchased certain assets of the New First National Bank of Vermont (NFNBV) from the Federal Deposit Insurance Corporation, Division of Liquidation. The bulk of the assets purchased were loans. Therefore, the majority of the net increase in assets, by loan category, occurred as a result of this acquisition. The Bank booked approximately $107,000,000 in new commercial loan business in 1993. This business was written primarily out of the Bank's Western Division. LOAN REVIEW The Bank's Board of Directors grants each loan officer the authority to originate loans on behalf of the Bank. The Board also establishes restrictions regarding the types of loans that may be granted and sets limits for each lender. These authorized lending limits are established at least annually and are based upon the lender's job assignment, training, and experience. Loan requests that exceed a lender's authority are referred to senior loan officers having higher lending authorities. All extensions of credit of $2.5 million to any one borrower, or related party interest, are reviewed and approved by the Bank's Board of Directors. By using a variety of management reports (new loans, largest exposures, delinquencies, watched assets), the Bank's loan portfolio is continuously monitored by the Board of Directors, senior loan officers, and the loan review department. The loan portfolio as a whole, as well as individual loans, are reviewed for loan performance, credit worthiness, and strength of documentation. Credit ratings are assigned to commercial loans and routinely are reviewed. All loan officers are required to service their own loan portfolios and account relationships. As necessary, loan officers take remedial actions to assure full and timely payment of loan balances. LOAN QUALITY AND RESERVES FOR POSSIBLE LOAN LOSSES (RPLL) Merchants Bancshares, Inc. reviews the adequacy of the RPLL at least quarterly. The method used in determining the amount of the RPLL is not based upon maintaining a specific percentage of RPLL to total loans or total non-performing assets, but rather a comprehensive analytical process of assessing the credit risk inherent in the loan portfolio. This assessment incorporates a broad range of factors which are indicative of both general and specific credit risk, as well as a consistent methodology for quantifying probable credit losses. As part of the Merchants Bancshares, Inc.'s analysis of specific credit risk, a detailed and extensive review is done on larger credits and problematic credits identified on the watched asset list, non-performing asset listings, and credit rating reports. The more significant factors considered in the evaluation of the adequacy of the RPLL based on the analysis of general and specific credit risk include: Status of non-performing loans Status of adversely-classified credits Historic charge-off experience by major loan category Size and composition of the loan portfolio Concentrations of credit risk Renewals and extensions Current local and general economic conditions and trends Loan growth trends in the portfolio Off balance sheet credit risk relative to commitments to lend Overall, management maintains the RPLL at a level deemed to be adequate, in light of historical, current and prospective factors, to reflect the level of risk in the loan portfolio. An analysis of the allocation of the RPLL follows. Both the specific and general components of the RPLL are grouped by loan categories. The allocation of the RPLL is based upon loan loss experience, loan portfolio composition, and an assessment of possible loan losses in the categories shown. Allocation of the Reserve for Possible Loan Losses December 31, 1993 (000's omitted) Percent of loans in Balance at End of Period Percent each category Applicable to: Amount Allocation to total Loans Domestic: Commercial, Financial, and Agricultural & IRB's $6,500 32% 19% Real Estate - Construction 2,000 10% 5% Real Estate - Mortgage 11,000 55% 72% Installment Loans to 350 2% 4% Individuals Lease Financing 25 All Other Loans 185 1% ------- ---- ---- Total: $20,060 100% 100% ======= ==== ==== Key data that are used in the assessment of the loan portfolio and the analysis of the adequacy of the RPLL are presented in the tables and schedules that follow in this discussion. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the RPLL. The table below reflects the Bank's loan loss experience and activity in the RPLL for the past five years. All dollar amounts are expressed in thousands. LOAN LOSSES AND RPLL RECONCILIATION Year Ended December 31, 1993 1992 1991 1990 1989 Average Loans Outstanding $578,187 $447,652 $471,141 $482,756 $482,582 Reserve for Possible Loan Losses at Beginning of Year 7,412 6,650 5,075 5,151 4,358 Loans Charged Off (NOTE 1): Commercial, Lease Financing and all Other Loans (5,567) (2,938) (3,367) (2,318) (1,162) Real Estate - Construction (275) (253) (1,802) 0 0 Real Estate - Mortgage (7,651) (4,096) (718) (2,236) (175) Installment & Credit Cards (459) (452) (617) (575) (463) --------- -------- -------- -------- -------- Total Loans Charged Off ($13,952) ($7,739) ($6,504) ($5,129) ($1,800) Recoveries on Loans: Commercial, Lease Financing and all Other Loans 392 232 366 471 22 Real Estate - Construction 0 0 379 0 0 Real Estate - Mortgage 301 108 0 3 5 Installment & Credit Cards 85 111 91 87 86 -------- ------- ------- ------- ------- Total Recoveries on Loans $ 778 $ 451 $ 836 $ 561 $ 113 Net Loans Charged Off (13,174) (7,288) (5,668) (4,568) (1,687) Provision for Loan Losses Charged to Operations (NOTE 2) 23,822 8,050 7,243 4,492 2,480 Loan Loss Reserve-Acquired Loans (NOTE 3) 2,000 --- --- --- --- -------- -------- -------- -------- -------- Reserve for Possible Loan Losses at End of Year $20,060 $7,412 $6,650 $5,075 $5,151 ======== ======== ======== ======== ======== Loan Loss Reserve to Total Loans at Year End 3.50% 1.73% 1.41% 1.03% 1.03% Ratio of Net Charge-Offs During the Year to Average Loans Outstanding During the Year 2.28% 1.63% 1.20% 0.95% 0.35% NOTE 1: Prior to 1991, loans secured by real estate were not broken out between construction and permanent financing for purposes of loan charge-off and recovery analysis. NOTE 2: The loan loss provision is charged to operations. When actual losses differ from these estimates, and if considered necessary, they are reported in operations in the periods in which they become known. NOTE 3: See Note 2 to the consolidated financial statements regarding the acquisition of New First National Bank of Vermont. The increase in the reserve for possible loan losses from $7,412,000 at December 31, 1992 to $20,060,000 at December 31, 1993, reflects management's efforts to maintain the reserve at an appropriate level to provide for potential loan losses based on an evaluation of known and inherent risks in the loan portfolio. Given the continued slow pace in the economy which affected many of the Company's borrowers in 1993, and the increase in nonperforming assets, management determined that a significant increase in the reserve was appropriate. The provision for possible loan losses increased from $8,050,000 for 1992 to $23,822,000 in 1993. NON-PERFORMING ASSETS --------------------- The following tables summarize the Bank's non-performing assets. The first table shows a breakout of nonperforming assets covered by a loss sharing arrangement related to the acquisition of the NFNBV on June 4, 1993. The terms of the Purchase and Assumption Agreement related to the purchase of NFNBV require that the FDIC pay the Bank 80% of net charge-offs up to $41,100,000 on any loans that qualify as loss sharing loans for a period of three years from the date of the acquisition. If net charge offs on qualifying loss sharing loans exceed $41,100,000 during the three year period, the FDIC is required to pay 95% of such qualifying charge offs. This arrangement significantly reduces the exposure that the Bank faces on Nonperforming assets (NPAs) that are covered by loss sharing. As of December 31, 1993 NPAs covered by loss sharing totaled approximately $17,469,000. The aggregate amount of loans covered by the loss sharing arrangement at December 31, 1993 was $132,879,000. Loss Sharing Loans Assets Total ----------- ----------- ----------- Nonaccrual loans $29,712,089 $17,356,607 $47,068,696 Restructured loans 2,772,783 68,389 2,841,172 Loans Past due 90 days or more and still accruing 712,391 2,978 715,369 Other Real Estate Owned 13,633,383 40,876 13,674,259 ----------- ----------- ----------- Total $46,830,646 $17,468,850 $64,299,496 =========== =========== =========== The second table shows nonperforming assets as of year end 1989 through 1993 (in thousands): 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Nonaccrual Loans $47,069 $12,148 $ 8,333 $ 2,914 $ 2,893 Loans Past Due 90 Days or More and Still Accruing 715 7,251 8,613 5,908 5,964 Renegotiated Loans 2,841 1,838 5,679 0 0 ------- ------- ------- ------ ------ Total Non-Performing Loans $50,625 $21,237 $22,625 $ 8,822 $8,857 Other Real Estate Owned 13,674 12,661 6,110 4,652 318 ------- ------- ------- ------ ------ Total Non-Performing Assets $64,299 $33,898 $28,735 $13,474 $9,175 ======= ======= ======= ====== ====== Percentage of Non-Performing Assets to Total Loans plus Other Real Estate Owned 8.83% 4.94% 4.81% 1.78% 1.76% Percentage of Non-Performing Loans to Total Loans 10.95% 7.67% 6.03% 2.70% 1.83% ======= ======= ====== ====== ====== The nonperforming assets table above shows an increasing trend in nonperforming assets in general. Historically, the Company has worked closely with borrowers and also pursued vigorous collection efforts. As the local recession continued and property values declined further, the Company redoubled its efforts to collect troubled assets. Policies and procedures related to collection of nonaccruing assets in particular were examined. Additionally, the Company enhanced its Loan Review and Loan Workout functions to provide additional resources to address nonperforming assets. Based partly on the continued increases in nonperforming assets in 1993, management significantly increased provisions for possible loan losses during 1993, resulting in a reserve level of $20,060,000 at year end 1993. During the fourth quarter of 1993, as a result of significant increases in nonperforming assets and continuing weakness in the regional economy, the Company provided reserves for possible loan losses of $5 million in addition to the planned provision of $1.75 million for the quarter. Based upon the result of the Company's assessment of the factors affecting the RPLL, as noted in this discussion, management determined that the balance of the RPLL at December 31, 1993, is adequate. DISCUSSION OF 1993 EVENTS AFFECTING THE RESERVE FOR POSSIBLE LOAN LOSSES (RPLL) Non-performing assets at year end 1993 increased from $33,899,000 at December 31, 1992 to $64,299,000 at December 31, 1993. $19,637,000 of the increase was the direct result of the acquisition of NFNBV. As discussed, $17,469,000 of the NPAs at December 31, 1993 are covered under a loss sharing arrangement with the FDIC and represent significantly reduced credit exposure to the Bank. The individual categories of NPA's are shown below: 12-31-93 9-30-93 6-30-93 3-31-93 12-31-92 -------- ------- ------- ------- -------- Non-Accrual Loans $47,069 $34,280 $27,190 $6,719 $12,148 Loans Past Due 90 days 715 3,144 8,566 6,827 7,251 or more and Still Accruing Restructured Loans 2,841 3,106 763 7,992 1,838 Other Real Estate Owned 6,235 6,249 3,712 5,245 3,874 Insubstance Foreclosure 7,439 8,125 10,863 8,705 8,787 ------- ------- ------- ------- ------- Total: $64,299 $54,904 $51,094 $35,488 $33,898 ======= ======= ======= ======= ======= All categories of NPAs had significant changes during 1993. The events affecting each category of NPAs are discussed below: NON-ACCRUAL LOANS: ------------------ The migration of loans 90 days or more overdue and still accruing, and the acquisition of NFNBV principally accounted for the increase in nonaccrual loans of $34,921,000 from December 31, 1992 to December 31, 1993. $19,525,000 is directly attributable to the acquisition of NFNBV. Of the $19,525,000 amount $17,357,000 is covered by the loss sharing arrangement with the FDIC. The remainder of the increase results from the migration of loans 90 days or more overdue. LOANS PAST DUE 90 DAYS OR MORE AND STILL ACCRUING: -------------------------------------------------- The net decline in this category of $6,536,000 results primarily from the migration of these loans to non-accruing. Loans Past Due 90 Days or More and Still Accruing were briefly inflated during the quarter ended June 30, 1993. This resulted from a provision in the Purchase and Assumption Agreement with the FDIC that allowed the Bank to accrue 90 days of additional interest from the June 4, 1993 acquisition date. The accrued interest associated with these loans was covered by the loss sharing arrangement previously described. RESTRUCTURED LOANS: ------------------- The significant events affecting this category include the migration to Other Real Estate Owned (OREO) of a commercial office and retail shopping center for $2,000,000 and a commercial office building for $640,000. One loan of $955,000 was paid off. Significant charge downs in two loans were taken in the amounts of $990,000 and $798,000. The remaining balance of these two loans are included in the nonaccruing TDR amount previously mentioned. OTHER REAL ESTATE OWNED AND INSUBSTANCE FORECLOSURE: ---------------------------------------------------- The increase in OREO resulted primarily from three properties being acquired - a retail shopping and commercial office space center for $2,000,000, a residential building development for $560,000, and a commercial office building for $640,000. The Bank had notable success in the first half of 1993 in disposing of OREO and continues to aggressively market such properties. OREO includes specific assets to which legal title has been taken as the result of transactions related to real estate loans. The criteria for designation of loans as in-substance foreclosure are that the debtor has little or no equity in the collateral, proceeds for repayment of the loan will come only from the operation or sale of the collateral, and the debtor has formally or effectively abandoned control of the assets or is not expected to rebuild equity in the collateral. The collateral underlying these loans is recorded at the lower of cost or market value less estimated selling costs. The total amount of Other Real Estate Owned and In-Substance Foreclosure at December 31 in each of the last five years is as follows: 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ Other Real Estate Owned $6,235 $3,874 $2,650 $1,968 $318 In-Substance $7,439 $8,787 $3,460 $2,684 ------- ------- ------ ------ ------ Total: $13,674 $12,661 $6,110 $4,652 $318 ======= ======= ====== ====== ====== POLICIES AND PROCEDURES RELATING TO THE ACCRUAL OF INTEREST INCOME ------------------------------------------------------------------ The Bank normally recognizes income on earning assets on the accrual basis, which calls for the recognition of income as earned, as opposed to when it is collected. The Bank's policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due in excess of 90 days and, in the judgement of management, the ultimate collectability of principal or interest becomes doubtful. The amount of interest which was not earned but which would have been earned had the nonaccrual and re- structured loans performed in accordance with their original terms and conditions was approximately $2,688,000 and $1,268,000 in 1993 and 1992, respectively. In addition to the above policy, interest previously accrued is reversed if management deems the past due conditions to be an indication of uncollectability. Also, loans may be placed on a nonaccrual basis at any time prior to the period specified above if management deems such action to be appropriate. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of the Financial Condition and Results of Operations as contained on pages 25 through 29 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets of Merchants Bancshares, Inc. of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity and cash flows, for each of the three years in the period ended December 31, 1993 together with the related notes and the opinion of Arthur Andersen & Co., independent public accountants, all as contained on pages 7 through 24 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. Part III -------- ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers, directors and ten percent shareholders to file initial reports of ownership and reports of changes of ownership of the Company's common stock with the Securities and Exchange Commission. Based upon a review of these filings, there were no late filings of SEC Form 4's during 1993. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is hereby made to pages 3 through 13 of the Company's Proxy Statement to Shareholders dated April 21, 1994, wherein pursuant to Regulation 14 A information concerning the above subjects (Items 10 through 13) is incorporated by reference. Pursuant to Rule 12 b-23, definitive copies of the Proxy Statement will be filed within 120 days subsequent to the end of the Company's fiscal year covered by Form 10-K. PART IV ------- ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (1) The following consolidated financial statements as included in the 1993 Annual Report to Shareholders, are incorporated herein by reference: Consolidated Balance Sheets, December 31, 1993 and December 31, 1992. Consolidated Statements of Income for years ended December 31, 1993, 1992, 1991. Consolidated Statements of Changes in Stockholder's Equity for years ended December 31, 1993, 1992, 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, 1991. Notes to Consolidated Financial Statements, December 31, 1993. (2) The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference. Exhibit Description (3a) Restated Certificate of Incorporation of the Company, filed on April 25, 1987 as Exhibit B to the Proxy Statement filed as part of the pre-effective amendment No. 1 to the Company's Registration Statement on Form S-14 (Registration No. 2-86103) is incorporated herein by reference. (3b) Amended By-Laws of the Company, filed on April 25, 1987 as Exhibit C to the Company's Proxy Statement is incorporated herein by reference. (4) Investments, defining the rights of security holders including indentures; incorporated by reference from the Registrant's Form S-14 Registration Statement (Registration No. 2-86103), as filed on September 14, 1983. (10) Material Contracts: The following are major contracts preceded by applicable number to Registrant's Form S-14 (Registration No. 2-86103) and are incorporated herein by reference. 15 (10a) Service Agreement as amended between First Data Resources, Inc., and Registrant dated June 1993 (effective through May 1998) for Mastercard Services. 17 (10c) 401(k) Employee Stock Ownership Plan of Registrant, dated January 1, 1990, for the employees of the Bank. 19 (10d) Merchants Bank Pension Plan, as amended and restated on January 1, 1989, for employees of the Bank. 20 (10e) Agreement between Specialty Underwriters, Inc., and Registrant dated January 12, 1993 for equipment maintenance services. (11) Statement re: computation of per share earnings. (13) 1993 Annual Report to Shareholders is furnished for the information of the Commission only and is not to be deemed filed as part of this report, except as expressly provided herein. (23) The Registrant's Proxy Statement to Shareholders for the calendar year ended December 31, 1993 will be filed within 120 days after the end of the Company's fiscal year. Other schedules are omitted because of the absence of conditions under which they are required, or because the required information is provided in the financial statements or notes thereto. (23a) Reports on Form 8-K The Company filed a Form 8-K with the Securities and Exchange Commission on June 4, 1993. This report detailed the terms and conditions of a Purchase and Assumption Agreement among the Federal Deposit Insurance Corporation, Receiver of the New First National Bank of Vermont, National Association, the Federal Deposit Insurance Corporation and The Merchants Bank, dated June 4, 1993. INDEMNIFICATION UNDERTAKING BY REGISTRANT In connection with Registrant's Form S-8 Registration Statement under the Securities Act of 1933 with respect to the Registrant's 401(k) Employee Stock Ownership Plan, the Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into such Registration Statement on Form S-8: 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 foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission, 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 Act and will be governed by the final adjudication of such issue. SIGNATURES ---------- Pursuant to the requirement of Section 13 or 15 (d) of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on it's behalf by the undersigned, thereunto duly authorized. Merchants Bancshares, Inc. Date March 25, 1994 By s/Dudley H. Davis -------------------------------- Dudley H. Davis, President & CEO Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of MERCHANTS BANCSHARES, INC., and in the capacities and on the date as indicated. by by s/ Dudley H. Davis ----------------------------- ------------------------------------ Charles A. Davis, Director Dudley H. Davis, Director, President & CEO of the Company and the Bank by s/ Jeffrey L. Davis by s/ Jack DuBrul II ----------------------------- ------------------------------------ Jeffrey L. Davis, Director Jack DuBrul, II, Director by s/ Michael G. Furlong by ----------------------------- ------------------------------------ Michael G. Furlong, Director Thomas F. Murphy, Director by s/ Edward W. Haase by s/ Leo O'Brien, Jr. ----------------------------- ----------------------------------- Edward W. Haase, Treasurer of the Leo O'Brien, Jr, Director Company and the Bank, Senior Vice President and Controller of the Bank by by ----------------------------- ----------------------------------- Raymond C. Pecor, Jr., Director Patrick S. Robins, Director by by s/ Robert A. Skiff ----------------------------- ----------------------------------- Benjamin F. Schweyer, Director Robert A. Skiff, Director by s/ Susan D. Struble ----------------------------- Susan D. Struble, Director	8,139	53,166
20520_1993.txt	20520_1993	1993	20520	Item 1. Description of Business ----------------------- (a) General Development of Business ------------------------------- The "company" includes Citizens Utilities Company and its subsidiaries except where the context or statement indicates otherwise. The company was incorporated in Delaware in 1935 to acquire the assets and business of a predecessor public utility corporation. Since then, the company has grown as a result of investment in owned utility operations and numerous acquisitions of additional utility operations. It continues to consider and carry out business expansion through significant acquisitions and joint ventures in traditional public utility and related fields and the rapidly evolving telecommunications and cable television industries. The company directly, or through subsidiaries, provides telecommunications, electric, gas and water/wastewater services to more than 1,000,000 customer connections in areas of sixteen states: Arizona, California, Colorado, Hawaii, Idaho, Illinois, Indiana, Louisiana, Ohio, Oregon, Pennsylvania, Tennessee, Utah, Vermont, Washington and West Virginia. Other than the acquisition of the GTE Telephone Properties discussed below, there have not been any material changes in the business of the company during the past fiscal year. The company's strong financial resources and consistent operating performance enable it to make the investments and conduct the operations necessary to serve growing areas and to expand through acquisitions. The company is aggressively and enthusiastically integrating continuous improvement into every aspect of its business with the goal of exceeding customer expectations, ensuring employee satisfaction and increasing shareholder value. In keeping with its commitment to continuous improvement the company has centralized the administration of its Mohave County, Arizona operations, which provide five different utility services, resulting in the ability to enhance customer service and to realize operating cost efficiencies. On May 19, 1993, the company and GTE Corporation announced the signing of ten definitive agreements under which the company would purchase from GTE Corporation, for approximately $1,100,000,000 in cash, 500,000 local telephone access lines in nine states ("the GTE Telephone Properties"). These transactions are consistent with the company's growth strategy, will enable the company to achieve operating economies of scale and increase the company's annual revenues to more than $1,000,000,000 once the operations are fully integrated. These transactions require the approval of the Federal Communications Commission and the regulatory commissions of the nine states in which the properties are located. On December 31, 1993, 189,000 access lines in Idaho, Tennessee, Utah and West Virginia were transferred to the company. The remaining access lines are expected to be transferred during 1994. (b) Financial Information about Industry Segments --------------------------------------------- The Consolidated Statements of Income and Note 10 of the Notes to Consolidated Financial Statements included herein sets forth financial information about industry segments of the company for the last three fiscal years. (c) Narrative Description of Business --------------------------------- Telecommunications ------------------ The company provides telecommunications services in Arizona, California, Idaho, Oregon, Pennsylvania, Tennessee, Utah, Washington and West Virginia to customers served by approximately 340,000 access lines as of December 31, 1993. The company will provide telecommunications services to customers served by approximately 311,000 additional access lines in Arizona, California, Montana, New York and Oregon upon completion of the transfer of the remaining GTE Telephone Properties in 1994. Telecommunications services consist of local service, centrex service, network access service, long distance service, competitive access service, cellular service and other related services. The company's telecommunications services and/or rates are subject to the jurisdiction of the Federal Communications Commission and state regulatory agencies. The Public Utility Commission of the State of California ("CPUC") continues with its efforts to open the California telecommunications markets to competition. The proceedings call for, among other things, authorized competition for intrastate intraLATA switched toll services; alternative regulatory frameworks for local exchange carriers; less regulation of radio telephone utilities and the elimination of the toll settlement pools for mid- sized local exchange carriers. In support of these CPUC efforts, the company's California telephone subsidiary exited the intrastate toll settlement pools in 1991 and entered into a transition contract with Pacific Bell. Pursuant to the contract, Pacific Bell has agreed to continue to make payments to the company through December 31, 1994, by which time the company expected to have concluded a general rate case permitting the implementation of new higher rates. In the event a general rate case is concluded prior to December 31, 1994, the Pacific Bell payments would be reduced. Such a reduction, if any, would not materially affect 1994 consolidated revenues or earnings. The Pacific Bell contract was designed to partially offset the declines in revenues and earnings which resulted from exiting the intrastate toll settlement pools. The Pacific Bell contract payments, which are received in lieu of revenues from the intrastate toll settlement pools, are included in their entirety in the company's telecommunications revenues and income from operations. The introduction of competition for intrastate intraLATA switched toll services once the CPUC's decision to authorize intrastate intraLATA switched toll competition is implemented could have a negative impact on the California subsidiary's revenues and earnings; however, the subsidiary's properties should be least effected by such competition since they are located in small- and medium-size towns and communities and the CPUC's decision will allow the company to compete for switched toll revenues and earnings in markets that it is not currently allowed to serve. The CPUC's decision, originally expected in 1993, is now expected in 1994. Thus, the time available to the company to complete its general rate case and implement new higher rates and an Incentive Regulatory Framework ("IRF") after the CPUC decision and prior to the expiration of the Pacific Bell contract has been shortened. In order to have a new rate design in effect prior to the expiration of the Pacific Bell contract, the company proceeded with its general rate case filing on December 15, 1993. The delay in the CPUC's decision is likely to have a negative impact on the California subsidiary's revenues and earnings, since this delay could result in a period in which intrastate intraLATA competition for switched toll services is implemented, Pacific Bell contract payments would no longer be received and the IRF and increased rates from the general rate case would not yet be implemented, or, alternatively, interim rate relief would not be approved. The Pacific Bell contract payments represent 6% of the company's 1993 consolidated revenues and 4% of the company's 1993 consolidated revenues pro forma for the acquisition of all the GTE Telephone Properties (see Note 3 of Notes to Consolidated Financial Statements). The company has taken the following measures to offset this negative impact on revenues and earnings and simultaneously position itself for a more competitive telecommunications environment: the company has pending proposals before the CPUC to enter new and existing markets (including the intrastate intraLATA toll market as a toll provider and the market for broadband services, including two way interactive video applications such as distance learning), to enter into an IRF under which the company would be allowed to earn rates of return in excess of those allowed under traditional rate base rate of return regulation and to rebalance its rate structure to be more competitive; the company has implemented state-of-the-art operational cost control systems and force management systems which provide for the ongoing monitoring and improvement of business processes and will continue to generate cost reductions which, under an IRF, will benefit shareholders and customers; the company's acquisition of the GTE Telephone Properties positions the company for the new competitive environment since these properties are located in small-and medium- size towns and communities which should be least affected by competition and will provide growth opportunities; and the company is also investing in competitive telecommunications services such as competitive access, cellular and cable operations. The company continues to invest in its subsidiary,Electric Lightwave, Inc., a competitive access provider in Oregon and Washington, with planned expansion to California, Utah and Arizona. The Federal Communications Commission has granted the company a permit to construct a fiber-optic route from Nevada to Arizona which will provide centralized equal access service for the company's telecommunications customers in Arizona. This project will allow the company to interface with any carrier desiring equal access in the service area and make it possible for the company to enter the long distance market as a competitor. The company has contributed $29,120,000 through the year ended December 31, 1993 towards the expansion of Electric Lightwave, Inc.'s operations. In January 1993, the company, through its Mohave Cellular subsidiary as general managing partner, began the operation of a cellular partnership in Arizona. The partnership currently owns five cell sites in Arizona. In 1993, a subsidiary of the company conducted tests to determine the viability of Personal Communications Networks ("PCN") and is exploring means to participate by either acquiring a spectrum on its own or as part of a partnership or consortium. In March 1993, the company signed an agreement to purchase, through a joint venture with Century Communications Corp. ("Century"), the assets of two cable television systems serving approximately 45,000 subscribers in California. The joint venture will pay a purchase price of up to approximately $89,000,000 for the systems and intends to enter into an agreement with Century pursuant to which Century will manage the systems. The purchase is subject to regulatory approval for the transfer of licenses and is expected to be consummated in 1994. The GTE Telephone Properties acquired and to be acquired increases the company's number of access lines serving customers by approximately 500,000. To best manage these new businesses, as well as the growth in its existing properties, the company is in the process of consolidating support service functions and establishing a centralized telecommunications infrastructure to carry out these functions. Natural Gas - ----------- Operating divisions of the company provide gas transmission and distribution services to residential, commercial and industrial customers in Arizona, Colorado and Louisiana. Total number of gas customers served as of December 31, 1993 was approximately 350,000. The provision of services and/or rates charged are subject to the jurisdiction of federal and state regulatory agencies. The company purchases all needed gas supplies, the supply of which is believed to be adequate to meet current demands and to provide for additional sales to new customers. The gas industry is subject to seasonal demand, with the peak demand occurring during the heating season of November 1 through March 31. The gas division experiences third party competition from fuel oil, propane, and other natural gas suppliers for most of its large consumption customers and from electricity for all of its customer base. The competitive position of natural gas at any given time depends primarily on the relative prices of natural gas and these other energy sources. Various federal and state tax incentive programs call for replacing other fuels with compressed natural gas. However, these regulations may, in certain circumstances, promote the use of other fuels to replace natural gas. Numerous opportunities for expansion are available to the company in connection with its northern Arizona gas transmission and distribution system build out program. In addition, gas powered cogeneration opportunities with industrial customers have emerged as a result of the relatively high price of electricity. Natural gas heat pumps that also cool would generate large demand during the Summer months when natural gas consumption is historically low. On December 22, 1993, the company acquired Natural Gas Company of Louisiana ("NGL") by merger. In the merger, NGL's 59,980 outstanding shares were converted into 568,748 shares of the company's Series B common stock, for an aggregate value of $10,522,000. NGL is a local gas distribution company serving 15,500 customers in Louisiana. NGL will operate as part of the company's Louisiana gas division. Electric - -------- Operating divisions of the company provide electric services to approximately 98,000 residential, commercial and industrial customers in Arizona, Hawaii and Vermont as of December 31, 1993. The provision of services and/or rates charged are subject to the jurisdiction of federal and state regulatory agencies. The company purchases over 80% of needed electric supplies, the supply of which is believed to be adequate to meet current demands and to provide for additional sales to new customers. As a whole, the company's electric segment does not experience material seasonal fluctuations. In response to regulatory initiatives, the company's electric divisions are all proceeding with demand-side management programs and integrated resource planning techniques designed to promote the most efficient use of electricity and to reduce the environmental impacts associated with new generation facilities. The company's Kauai Electric Division ("KED") has restored all transmission and distribution lines, poles and equipment that were damaged as a result of Hurricane Iniki in September 1992. As of December 31, 1993, all customers whose facilities were capable of receiving service (approximately 24,300 of the KED's 24,500 pre-hurricane customers) had been reconnected. Sales volume has been slowly recovering as construction throughout the island continues on residential homes, commercial establishments and hotels. The Hawaii Public Utilities Commission ("HPUC") approved a stipulation on December 9, 1992 specifying regulatory treatment of certain costs associated with the restoration of KED facilities. As part of this stipulation, KED agreed to defer its next general rate increase application until 1994 with rates becoming effective no earlier than January 1, 1995 (the "deferred rate case"). Under the terms of this stipulation, KED is authorized to earn an allowance for funds used during construction ("AFUDC") on the restoration costs. The allowed restoration costs, plus associated AFUDC earnings, will be included in rate base to be recovered in the deferred rate case. Restoration costs plus associated AFUDC earnings not ultimately allowed in rate base should be recovered by the company in the deferred rate case over an amortization period to be determined in that case. Depreciation expense on the restoration plant is being deferred and will be amortized over the remaining useful life of the restored plant when rates are approved in the deferred rate case. Lost gross margin (unrecovered costs and the allowed return on investment based on the rate award received by the KED in November, 1992) and interest, compounded monthly, on the lost gross margin is authorized to be accrued and is subject to recovery in the deferred rate case. The company is participating in research and development of electric powered vehicles which could provide new opportunities to expand its electric business. At the same time, the company is taking a leadership role toward enhancing and protecting the environment by sponsoring a study to protect endangered species of birds, employment of new technology to reduce emissions from generating facilities at the company's Kauai electric division and conducting extensive studies at the company's Vermont electric division to protect and preserve waterways, while balancing the need for hydrogeneration. The United States Environmental Protection Agency ("EPA") named the company a potentially responsible party ("PRP") with respect to three sites which have been designated for federally supervised clean-up under the Comprehensive Environmental Response, Compensation and Liability Act. These three sites are Missouri Electric Works in Cape Girardeau, Missouri; Northwest Transformer in Everson, Washington; and Rose Chemicals in Holden, Missouri. The EPA has determined that the electric divisions' participation in each site is less than 0.5%. The number of named PRP's ranges from 40 to 700 at each site. Significant parties have accepted responsibility and are currently funding the clean-up activity as required. The company's remaining financial liability is estimated to be less than $141,000. During 1993, the company acquired Franklin Electric Light Company, Incorporated whose operations are contiguous with its Vermont electric division. The company issued 51,500 shares of Series B common stock to complete the acquisition. This acquisition will allow for greater economies of scale and will result in more efficient customer service. Water/Wastewater - ---------------- The company provided water and/or wastewater services to approximately 254,000 customer connections in Arizona, California, Illinois, Indiana, Ohio and Pennsylvania as of December 31, 1993. The provision of these services and/or rates charged are subject to the jurisdiction of federal, state and local regulatory agencies. A significant portion of the company's water/wastewater construction expenditures necessary to serve new customers are made under agreements with land developers who generally advance construction monies to the company that are later refunded in part as new customers and revenues are added in their developments. Water/wastewater public utility property of the company, from time to time, has been subjected to condemnation proceedings initiated by municipalities or utility districts seeking to acquire and take control of the operation of such property. During 1992, one operation in Illinois became subject to such proceeding; this condemnation is being contested by the company. In September 1992, the United States Environmental Protection Agency ("EPA") filed a complaint with the United States District Court for the Northern District of Illinois relating to alleged violations by the company's Illinois subsidiary with respect to National Pollutant Discharge Elimination System permit requirements. The company is unable to estimate exposure at this time, but believes the Illinois subsidiary has meritorious defenses. The company believes the risk of material loss from this action is remote. General - ------- The company's public utility operations are conducted primarily in small- and medium-size towns and communities. No material part of the company's business is dependent upon a single customer or upon a small group of customers. The loss of one or more of such customers would not have a material adverse effect on operating income. As a result of its diversification, the company is not dependent upon any single geographic area or upon any one type of utility service for its revenues. Due to this diversity, no single regulatory body regulates a utility service of the company accounting for more than 18% of its 1993 revenues. The company is subject to regulation by the respective state Public Utility Commissions and federal regulatory agencies. The company is not subject to the Public Utility Holding Company Act. Order backlog is not a significant consideration in the company's business, and the company has no contracts or subcontracts which may be subject to renegotiation of profits or termination at the election of the federal government. The company holds franchises with local governmental bodies, which vary in duration. The company also holds certificates of convenience and necessity granted by various state commissions which are generally of indefinite duration. The company has no special working capital practices. The company's research and development activities are not material. There are no patents, trademarks, licenses or concessions held by the company that are material. The company employed 2,917 full time and 50 part time employees at December 31, 1993 (includes employees of the GTE Telephone Properties acquired December 31, 1993). (d) Financial Information about Foreign and Domestic Operations and --------------------------------------------------------------- Export Sales ------------ The company does not have any material foreign operations or export sales. Item 2. Item 2. Description of Property ------------------------ The administrative offices of the company are located at High Ridge Park, Stamford, Connecticut, 06905 and are leased. The company owns property including: telecommunications outside plant, central office, microwave radio and fiber-optic facilities; electric generation, transmission and distribution facilities; gas transmission and distribution facilities; water production, treatment, storage, transmission and distribution facilities; and wastewater treatment, transmission, collection and discharge facilities; all as necessary to provide services at the locations listed below. * Certain telecommunications properties are subject to a mortgage deed. Item 3. Item 3. Legal Proceedings ----------------- In September 1992, the United States Environmental Protection Agency filed a complaint with the United States District Court for the Northern District of Illinois relating to alleged violations by the company's Illinois subsidiary with respect to National Pollutant Discharge Elimination System permit requirements. The company is unable to estimate exposure at this time, but believes the Illinois subsidiary has meritorious defenses. On February 19, 1993, the company was served with a summons and complaint in an action brought by the Sun City Taxpayers' Association in the United States District Court for the District of Connecticut. The plaintiff alleged that the company, through its Sun City Water Company and Sun City Sewer Company subsidiaries, misrepresented rate-base investment in rate applications submitted to the Arizona Corporation Commission ("ACC") between 1968 and 1978 and claimed damages of $65,000,000 before trebling. The plaintiff made substantially the same allegations in a regulatory proceeding before the ACC in 1986 and the ACC rejected those allegations. On February 1, 1994, the company's motion to dismiss this action was granted and the complaint was dismissed by an opinion and order of the court. On February 9, 1994, plaintiff filed a notice of appeal and is seeking review of the court's ruling by the United States Court of Appeals for the Second Circuit. In June 1993, several stockholders commenced purported derivative actions in the Delaware Court of Chancery against the company's Board of Directors. These stockholders allege that the compensation approved by the Board of Directors for the company's Chairman is excessive and seek, among other things, an accounting for alleged corporate waste and a declaration that the Chairman's employment agreement and existing stock options are invalid. These stockholders further allege that certain corporate transactions involving the company and Century Communications Corp. ("Century") benefitted Century to the detriment of the company. Certain of these stockholders have also asserted individual and purported class claims based upon the company's alleged failure to disclose facts relating to the Chairman's compensation and certain stock options granted to members of the company's Board of Directors and the allegedly improper accounting treatment with respect to Citizens' investment in Centennial Cellular Corp. ("Centennial"). The company's Board of Directors has moved to dismiss the complaints for failure to state a claim and for failure to comply with the demand requirements applicable to a derivative suit. The motions are currently pending. In November 1993, another purported derivative action was filed in the Court of Chancery against the company's Board of Directors and Century. Plaintiffs challenge both the Chairman's compensation and the merger which resulted in the creation of Centennial. Certain of the above actions, commenced in June 1993, were consolidated (the "Consolidated Action"). In February 1994, a Memorandum of Understanding was executed among counsel for several of the stockholders in the Consolidated Action and counsel for the company's Board of Directors. The parties to the Memorandum of Understanding will attempt to agree upon, execute and present to the Delaware Court of Chancery a stipulation of settlement resolving all of the claims in the Consolidated Action. The Memorandum of Understanding sets forth the contemplated terms of the stipulation of settlement. Consummation of the proposed settlement will be subject to: (a) the drafting and execution of a stipulation of settlement; (b) the completion by plaintiffs of appropriate confirmatory discovery in the Consolidated Action; and (c) final approval of the settlement by the Delaware Court of Chancery and dismissal of the Consolidated Action with prejudice. It is contemplated that the stipulation of settlement will provide for the complete release and settlement of all claims against the company's Board of Directors arising out of the allegations in the Consolidated Action. It is also contemplated that plaintiffs' counsel will seek an award of attorneys' fees and expenses in connection with the settlement. No understanding has been reached with respect to the amount of fees and expenses to be sought, but it is contemplated that the company will pay, on behalf of the defendant directors, the amount of fees and expenses, if any, to be awarded by the Delaware Court of Chancery to plaintiffs' counsel. In June 1993, a stockholder of the company commenced a purported class action in the United States District Court for the District of Delaware against the company and the company's Board of Directors. The stockholder's complaint, amended in July 1993, alleges that the proxy statements disseminated by the company from 1990 to 1993 failed to disclose material information regarding, among other things, the Chairman's compensation and certain purported related- party transactions and thereby violated federal and state disclosure requirements. The relief sought includes a declaration that the results of the 1993 Annual Meeting of the stockholders are null and void, a declaration that the Chairman's employment agreement is invalid and unspecified damages. Defendants have filed a motion to dismiss this action. The motion is currently pending. The company believes the risk of material loss from the above actions is remote. Item 4. Item 4. Submission of Matters to Vote of Security Holders ------------------------------------------------- None in fourth quarter 1993. Executive Officers ------------------ Information as to Executive Officers of the company as of January 31, 1994, follows: There is no family relationship between any of the officers of the Registrant. The term of office of each of the foregoing officers of the Registrant will continue until the next annual meeting of the Board of Directors and until a successor has been elected and qualified. LEONARD TOW has been associated with the Registrant since April 1989 as a Director. In June 1990, he was elected Chairman of the Board and Chief Executive Officer. In October 1991, he was appointed to the additional position of Chief Financial Officer of the Registrant. He has also been a Director, Chief Executive Officer and Chief Financial Officer of Century Communications Corporation since its incorporation in 1973, and Chairman of its Board of Directors since October 1989. DARYL A. FERGUSON has been associated with the Registrant since July 1989. He was Vice President, Administration from July 1989 through March 1990 and Senior Vice President, Operations and Engineering from March 1990 through June 1990. He has been President and Chief Operating Officer since June 1990. During the period April 1987 through July 1989, he was President and Chief Executive Officer of Microtecture Corporation. ROBERT J. DeSANTIS has been associated with the Registrant since January 1986. He was Assistant to the Treasurer through May 1986 and Assistant Treasurer from June 1986 through September 1991. He has been Vice President and Treasurer since October 1991. CHARLES R. ALDRICH has been associated with the Registrant since December 1990 as Vice President of the Registrant's Gas Operations. He was associated with Louisiana General Services, Inc. from 1971 until that company was merged with the Registrant in December 1990. He served as President of LGS Pipeline, Inc. from January 1983 through June 1988 and President of Louisiana Gas Service Company from July 1988 through December 1990. JAMES P. AVERY has been associated with the Registrant since August 1981. He was Project Manager, Electric through June 1988, Assistant Vice President, Electric Operations from June 1988 through December 1990 and Acting Vice President from December 1990 through April 1991. He has been Vice President, Electric Operations since May 1991. RICHARD A. FAUST, JR. has been associated with the Registrant since December 1990. He was associated with Louisiana General Services, Inc. from 1972 until that company was merged with the Registrant in December 1990. He served as Vice President, General Counsel and Secretary of Louisiana General Services, Inc. from March 1984 through May 1993. He was elected Assistant Secretary for the Registrant in June 1991 and Vice President, Mohave County, Arizona Operations in June 1993. J. MICHAEL LOVE has been associated with the Registrant since May 1990 and from November 1984 through January 1988. He was Assistant Vice President, Regulatory Affairs and Community Relations from June 1986 through January 1988. He left the Registrant in January 1988 to become President and General Counsel of Southern New Hampshire Water Company. He rejoined the Registrant in April 1990 and was Assistant Vice President, Corporate Planning from June 1990 through March 1991. He has been Vice President, Corporate Planning since March 1991. ROBERT L. O'BRIEN has been associated with the Registrant since March 1975. He has been Vice President, Regulatory Affairs since June 1981. DONALD K. ROBERTON has been associated with the Registrant since January 1991 and has been Vice President, Telecommunications since that date. Prior to joining the Registrant, he was Vice President, Western Operations at Henkels & McCoy from December 1989 through December 1990. From January 1984 through November 1989, he was a Vice President with Centel Communications Systems. LIVINGSTON E. ROSS has been associated with the Registrant since August 1977. He was Manager of Reporting from September 1984 through March 1988, Manager of General Accounting from April 1988 through September 1990 and Assistant Controller from October 1990 through November 1991. He has been Vice President and Controller since December 1991. RONALD E. WALSH has been associated with the Registrant since January 1986. He was Attorney and Assistant Secretary from November 1987 through August 1992. He has been Vice President, Water and Wastewater Operations since August 1992. PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder ---------------------------------------------------------------- Matters ------- PRICE RANGE OF COMMON STOCK The company's Common Stock is traded on the New York Stock Exchange under the symbols CZNA and CZNB for Series A and Series B, respectively. The following table indicates the high and low prices per share as taken from the daily quotations published in the "Wall Street Journal" during the periods indicated. Prices are adjusted for intervening stock dividends, the July 24, 1992 3-for-2 stock split and the August 31, 1993 2-for-1 stock split, rounded to the nearest 1/8th. (See Note 7 of Notes to Consolidated Financial Statements.) The December 31, 1993 prices were: Series A $18.125 high, $17.875 low; Series B $18.125 high, $17.875 low. As of January 31, 1994, the approximate number of record security holders of the company's Series A and Series B Common Stock was 37,715. This information was obtained from the company's transfer agent. DIVIDENDS Quarterly stock dividends declared and issued on both Series A and Series B Common Stock were 1.2% for the first quarter of 1993, 1.0% for the second quarter of 1993, 1.1% for the third quarter of 1993 and 1.0% for the fourth quarter of 1993. Quarterly stock dividends declared and issued on both Series A and Series B Common Stock were 1.6% for the first quarter of 1992, 1.5% for the second quarter of 1992 and 1.2% for each of the third and fourth quarters of 1992. An annual cash dividend equivalent rate of $0.745 and $0.675 per share (adjusted for subsequent stock dividends and stock splits) was considered by the company's Board of Directors in establishing the Series A and Series B stock dividends during 1993 and 1992, respectively. (See Note 7 of Notes to Consolidated Financial Statements.) Item 6. Item 6. Selected Financial Data (In thousands, except for per-share ----------------------------------------------------------- amounts) ------- /(1)/ Adjusted for intervening stock dividends and splits; no adjustment has been made for the company's 1.1% first quarter 1994 stock dividend because the effect is immaterial. /(2)/ Annual rate of quarterly stock dividends compounded. /(3)/ The 1990 amount represents cash dividend payments by Louisiana General Services, Inc. prior to its merger into the company on December 4, 1990. The 1989 amount represents cash dividend payments by Louisiana General Services, Inc. prior to its merger into the company in 1990 and payments by the company. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- (a) Liquidity and Capital Resources ------------------------------- The company's primary source of funds was from operations. Funds requisitioned from the 1993, 1992 and 1991 Series Industrial Development Revenue Bond construction fund trust accounts and funds from advances for specific capital expenditures from parties desiring utility service were used to pay for the construction of utility plant. Funds from the issuance of commercial paper were used to repay $11,489,000 of higher-coupon first mortgage bonds on October 15, 1993. Commercial paper notes payable in the amount of $438,953,000 were outstanding as of December 31, 1993, of which $380,000,000 was issued to temporarily and partially fund the GTE Telephone Properties acquired on December 31, 1993. The $380,000,000 of commercial paper is expected to be repaid from maturing temporary investments and proceeds from the planned issuance of equity securities in 1994. On March 10, 1993, the company arranged for the issuance of $42,560,000 of 1993 Series Industrial Development Revenue Bonds. The bonds were issued as money market bonds with an initial interest rate of 2.25% and an ultimate maturity date of December 1, 2027. On November 16, 1993, the company arranged for the issuance of $25,600,000 of 1993 Series Industrial Development Revenue Bonds; the bonds were issued as Demand Purchase Bonds bearing interest at a composite rate of approximately 5.8% and mature on November 15, 2028. On December 15, 1993, the company arranged for the issuance of $35,700,000 of 1993 Series Special Purpose Revenue Bonds; these bonds were issued as Residual Interest Bonds/Select Auction Variable Rate Securities and bear interest at a fixed annual interest rate of 5.6% and mature on December 15, 2023. The company has received approval from the Federal Energy Regulatory Commission to issue up to $1,250,000,000 in various forms of additional securities over the next two years to fund the acquisition of the GTE Telephone Properties and for other corporate purposes. The company has filed a shelf-registration statement with the Securities and Exchange Commission to offer, from time to time, up to $1,000,000,000 in securities to fund the acquisition of the GTE Telephone Properties and for other corporate purposes. The company considers its operating cash flows and its ability to raise debt and equity capital as the principal indicators of its liquidity. Although working capital is not considered to be an indicator of the company's liquidity, the company experienced a decrease in its working capital at December 31, 1993. The decrease is primarily due to the issuance of short-term debt to temporarily and partially fund the acquisition of the GTE Telephone Properties acquired on December 31, 1993. Capital expenditures for the years 1993, 1992 and 1991, respectively, were $182,480,000, $148,027,000 and $115,884,000, and for 1994 are expected to be approximately $280,000,000. These expenditures were, and in 1994 will be, for utility and related facilities and properties, including the GTE Telephone Properties. The company anticipates that the funds necessary for its 1994 capital expenditures will be provided from operations; from 1991, 1992 and 1993 Series Industrial Development Revenue Bond construction fund trust account requisitions; from Rural Telephone Bank loan contract advances; from commercial paper notes payable; from parties desiring utility service; from debt, equity and other financing at appropriate times; and, if deemed advantageous, from short-term borrowings under bank credit lines. The company has committed lines of credit with banks under which it may borrow up to $1,200,000,000. In March 1993, the company signed an agreement to purchase, through a joint venture with Century Communications Corp. ("Century"), the assets of two cable television systems serving approximately 45,000 subscribers in California. The joint venture will pay a purchase price of up to approximately $89,000,000 for the systems and intends to enter into an agreement with Century pursuant to which Century will manage the systems. The purchase is subject to regulatory approval for the transfer of licenses and is expected to be consummated in 1994. On May 19, 1993, the company and GTE Corporation announced the signing of ten definitive agreements under which the company would purchase from GTE Corporation, for approximately $1,100,000,000 in cash, 500,000 local telephone access lines in nine states ("the GTE Telephone Properties"). These transactions are consistent with the company's growth strategy, will enable the company to achieve operating economies of scale, and will increase the company's annual revenues to more than $1,000,000,000 once the operations are fully integrated. These transactions require the approval of the Federal Communications Commission and the regulatory commissions of the nine states in which the properties are located. On December 31, 1993, 189,000 access lines in Idaho, Tennessee, Utah and West Virginia were transferred to the company. The remaining access lines are expected to be transferred during 1994. During 1993, the company acquired Franklin Electric Light Company, Incorporated which operations are contiguous with its Vermont electric division. The company issued 51,500 shares of Series B common stock to complete the acquisition. This acquisition will allow for greater economies of scale and will result in more efficient customer service. On December 22, 1993, the company acquired Natural Gas Company of Louisiana ("NGL") by merger. In the merger, NGL's 59,980 outstanding shares were converted into 568,748 shares of the company's Series B common stock, for an aggregate value of $10,522,000. NGL is a local gas distribution company serving 15,500 customers in Louisiana, and will operate as part of the company's Louisiana gas division. Regulatory Matters - ------------------ Pursuant to the 1972 Clean Water Act, as amended, National Pollutant Discharge Elimination System ("NPDES") permits are required for wastewater treatment facilities which discharge to surface waters. In September 1992, the United States Environmental Protection Agency ("EPA") filed a complaint with the United States District Court for the Northern District of Illinois relating to alleged violations by the company's Illinois subsidiary with respect to NPDES permit requirements. The company is unable to estimate exposure at this time, but believes the Illinois subsidiary has meritorious defenses. The company believes the risk of material loss from this action is remote. On February 19, 1993, the company was served with a summons and complaint in an action brought by the Sun City Taxpayers' Association in the United States District Court for the District of Connecticut. The plaintiff alleged that the company, through its Sun City Water Company and Sun City Sewer Company subsidiaries, misrepresented rate-base investment in rate applications submitted to the Arizona Corporation Commission ("ACC") between 1968 and 1978 and claimed damages of $65,000,000 before trebling. The plaintiff made substantially the same allegations in a regulatory proceeding before the ACC in 1986 and the ACC rejected those allegations. On February 1, 1994, the company's motion to dismiss this action was granted and the complaint was dismissed by an opinion and order of the court. On February 9, 1994, plaintiff filed a notice of appeal and is seeking review of the court's ruling by the United States Court of Appeals for the Second Circuit. The EPA named the company a potentially responsible party ("PRP") with respect to three sites which have been designated for federally supervised clean-up under the Comprehensive Environmental Response, Compensation and Liability Act. These three sites are Missouri Electric Works in Cape Girardeau, Missouri; Northwest Transformer in Everson, Washington; and Rose Chemicals in Holden, Missouri. The EPA has determined that the company's participation in each site is less than 0.5%. The number of named PRP's ranges from 40 to 700 at each site. Significant parties have accepted responsibility and are currently funding the clean-up activity as required. The company's remaining financial liability is estimated to be less than $141,000. The Public Utility Commission of the State of California ("CPUC") continues with its efforts to open the California telecommunications markets to competition. The proceedings call for, among other things, authorized competition for intrastate intraLATA switched toll services; alternative regulatory frameworks for local exchange carriers; less regulation of radio telephone utilities; and the elimination of the toll settlement pools for mid- sized local exchange carriers. In support of these CPUC efforts, the company's California telephone subsidiary exited the intrastate toll settlement pools in 1991 and entered into a transition contract with Pacific Bell. Pursuant to the contract, Pacific Bell has agreed to continue to make payments to the company through December 31, 1994, by which time the company expected to have concluded a general rate case permitting the implementation of new higher rates. In the event a general rate case is concluded prior to December 31, 1994, the Pacific Bell payments would be reduced. Such a reduction, if any, would not materially affect 1994 consolidated revenues or earnings. The Pacific Bell contract was designed to partially offset the declines in revenues and earnings which resulted from exiting the intrastate toll settlement pools. The Pacific Bell contract payments, which are received in lieu of revenues from the intrastate toll settlement pools, are included in their entirety in the company's telecommunications revenues and income from operations. The introduction of competition for intrastate intraLATA switched toll services, once the CPUC's decision to authorize intrastate intraLATA switched toll competition is implemented, could have a negative impact on the California subsidiary's revenues and earnings; however, the subsidiary's properties should be least affected by such competition since they are located in small-and medium-size towns and communities and the CPUC's decision will allow the company to compete for switched toll revenues and earnings in markets that it is not currently allowed to serve. The CPUC's decision, originally expected in 1993, is now expected in 1994. Thus, the time available to the company to complete its general rate case and implement new higher rates and an Incentive Regulatory Framework ("IRF") after the CPUC decision and prior to the expiration of the Pacific Bell contract has been shortened. In order to have a new rate design in effect prior to the expiration of the Pacific Bell contract, the company proceeded with its general rate case filing on December 15, 1993. The delay in the CPUC's decision is likely to have a negative impact on the California subsidiary's revenues and earnings, since this delay could result in a period in which intrastate intraLATA competition for switched toll services is implemented, Pacific Bell contract payments would no longer be received and the IRF and increased rates from the general rate case would not yet be implemented, or, alternatively, interim rate relief would not be approved. The Pacific Bell contract payments represent 6% of the company's 1993 consolidated revenues and 4% of the company's 1993 consolidated revenues pro forma for the acquisition of the GTE Telephone Properties (see Note 3 of Notes to Consolidated Financial Statements). The company has taken the following measures to offset this negative impact on revenues and earnings and simultaneously position itself for a more competitive telecommunications environment: the company has pending proposals before the CPUC to enter new and existing markets (including the intrastate intraLATA toll market as a toll provider and the market for broadband services, including two-way interactive video applications such as distance learning), to enter into an IRF under which the company would be allowed to earn rates of return in excess of those allowed under traditional rate base rate of return regulation and to rebalance its rate structure to be more competitive; the company has implemented state-of-the-art operational cost control systems and force management systems which provide for the ongoing monitoring and improvement of business processes and will continue to generate cost reductions which, under an IRF, will benefit shareholders and customers; the company's acquisition of the GTE Telephone Properties positions the company for the new competitive environment since these properties are located in small- and medium-size towns and communities which should be least affected by competition and will provide growth opportunities; and the company is also investing in competitive telecommunications services such as competitive access, cellular and cable operations. New Accounting Pronouncements - ----------------------------- The Financial Accounting Standards Board ("FASB") has issued Statement of Financial Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postemployment Benefits," effective for fiscal years beginning after December 15, 1993. Adoption of SFAS No. 112 will require accrual of the expected cost of providing benefits, if any, to former or inactive employees after termination of employment for reasons other than retirement. Adoption of SFAS No. 112 will not have a material effect on the Consolidated Financial Statements. The FASB has issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. Adoption of SFAS No. 115 will require Fair Value reporting for certain investments in debt and equity securities. The company does not expect the adoption of SFAS No. 115 to have a material impact on the Consolidated Statements of Income, but does expect there to be an increase to investments on the Consolidated Balance Sheets with an accompanying increase in shareholders' equity. (b) Results of Operations --------------------- Operating revenues for the years ended December 31, 1993 and 1992 increased compared to the like prior year periods primarily due to increased natural gas, electric, water/wastewater revenues. Telecommunications revenues decreased 5% in 1993 and 6% in 1992, primarily due to regulatory changes in the state of California, as discussed in the "Regulatory Matters" section. The decrease in 1993 was partially offset by $2,626,000 of increased local revenues as a result of customer growth and $2,548,000 of increased toll revenues as a result of increased toll volume. The acquisition of the GTE Telephone Properties is expected to increase annual consolidated revenues to more than $1,000,000,000 once the operations are fully integrated. Natural gas revenues increased 12% in 1993 primarily due to $7,089,000 of revenues from Natural Gas Company of Louisiana ("NGL"), which was acquired by the company in 1993; $3,624,000 from increased average revenue per MCF of gas sold to industrial customers; $5,229,000 from increased average revenue per MCF of gas sold to residential and commercial customers and $9,322,000 from pass-ons to residential and commercial customers of increases in the wholesale costs of commodities purchased. These increases were partially offset by decreased consumption due to warmer weather conditions. Pass-ons are required under tariff provisions and do not affect net income. Natural gas revenues increased 25% in 1992 primarily due to $29,333,000 of revenues from northern Arizona gas properties acquired by the company on December 3, 1991, $5,430,000 from increased rates and $11,463,000 from pass-ons to residential and commercial customers of increases in the wholesale costs of commodities purchased. These increases were partially offset by decreased consumption due to warmer weather conditions. Electric revenues increased 13% in 1993 primarily due to $10,245,000 of increased unit revenues and $4,737,000 from customer consumption. Electric revenues increased 5% in 1992 primarily because of increased consumption resulting from increased customer usage due to warmer weather conditions. Water/wastewater revenues increased 10% in 1993 primarily due to $2,826,000 of rate increases; $2,018,000 from customer growth and increased customer usage; as well as $1,256,000 of revenues received from a water/wastewater property acquired in December 1992. Water/wastewater revenues increased 3% in 1992 primarily due to rate increases. Electric energy and fuel oil purchased costs increased 9% in 1993 and 7% in 1992. Electric energy purchased costs for 1993 totaled $68,224,000 a 6% increase over the 1992 amount of $64,077,000, which was a 15% increase over the 1991 cost of $55,480,000. The increased cost of electricity purchased in 1993 and 1992 was primarily due to increased customer demand and increased supplier prices. The increase in 1992 was partially offset by a decline in customer consumption at the company's Kauai electric division due to Hurricane Iniki. Fuel oil purchased in 1993 of $14,895,000 increased 22% from the 1992 amount of $12,209,000 primarily due to higher supplier prices and increased volume to satisfy increased customer consumption. Fuel oil purchased costs in 1992 of $12,209,000 decreased 23% from the 1991 amount of $15,843,000, primarily due to decreasing supplier prices. Natural gas purchased costs increased 15% in 1993, primarily due to higher supplier prices. Natural gas purchased costs increased 26% in 1992, primarily due to the acquisition of northern Arizona gas properties. Under tariff provisions, changes in the company's wholesale costs of electric energy, fuel oil and natural gas purchased are largely passed on to customers. Operating and maintenance expenses increased .4% in 1993 primarily due to the acquisition of Natural Gas Company of Louisiana. Operating and maintenance expenses increased 2% in 1992 primarily due to the acquisition of northern Arizona gas properties in December 1991. In addition, in 1992 the company's operations were impacted by several natural disasters; forest fires in northern California, Hurricane Andrew in Louisiana and Hurricane Iniki on Kauai. Depreciation expense increased 9% in 1993 and 6% in 1992, primarily due to increased investment in plant in service and increases in the authorized depreciation rates for the company's Arizona electric operations in 1993 and California telephone operations in 1992. Taxes other than income increased 3% in 1993 and 7% in 1992, primarily due to increased real estate taxes resulting from higher tax rates and assessment values and the acquisition of northern Arizona gas properties in 1992. Interest expense decreased 4% in 1993, primarily due to the refinancing of higher-coupon First Mortgage Bonds with lower cost debentures and increased allowance for funds used during construction related to borrowings, which is a reduction to interest expense. The decrease in interest expense was partially offset by an increase in industrial development revenue bond borrowings. Interest expense increased 17% in 1992, primarily due to additional industrial development revenue bond construction fund requisitions and interest on debentures issued in January 1992, the proceeds of which were used to redeem higher-coupon debt in February and March 1992. Investment income increased 5% in 1993, primarily due to realization of gains on sales of securities and an increase in income from the company's Centennial investment; partially offset by lower investment balances and market yields. Investment income increased 24% in 1992, primarily due to the temporary investment of debenture proceeds, increased industrial development revenue bond proceeds held-in-trust, and income from the company's Centennial investment. Other income-net increased 66% in 1993 primarily due to an increase in the allowance for funds used during construction related to equity, as a result of increased property, plant and equipment. Income taxes increased 19% in 1993 and 1% in 1992, primarily due to increased taxable income and an increase in the effective tax rate resulting from an increase in the federal corporate income tax rate. Cost increases, including those due to inflation, are offset in due course by increases in revenues obtained under established regulatory procedures. Item 8. Item 8. Financial Statements and Supplementary Data ------------------------------------------- The following documents are filed as part of this Report: 1. Financial Statements: See Index on page. 2. Supplementary Data: Quarterly Financial Data is included in the Financial Statements (see 1. above). Item 9. Item 9. Disagreements with Auditors on Accounting and Financial Disclosure ------------------------------------------------------------------ None PART III -------- The company intends to file with the Commission a definitive proxy statement for the 1994 Annual Meeting of Stockholders pursuant to Regulation 14A not later than 120 days after December 31, 1993. The information called for by this Part III is incorporated by reference to that proxy statement. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K --------------------------------------------------------------- (a) The following documents are filed as part of this Report: 1. The financial statements indexed on page of this Report. 2. The financial statement schedules required to be filed by Item 8 will be filed as an amendment to this Report on or before April 29, 1994. 3. The Exhibits listed below: The company agrees to furnish to the Commission upon request copies of the Realty and Chattel Mortgage, dated as of March 1, 1965, made by Citizens Utilities Rural Company, Inc., to the United States of America (the Rural Electrification Administration and Rural Telephone Bank) and the Mortgage Notes which that mortgage secures; and the several subsequent supplemental Mortgages and Mortgage Notes; copies of the instruments governing the long-term debt of Louisiana General Services, Inc.; and copies of separate loan agreements and indentures governing various Industrial development revenue bonds. A Report on Form 8-K was filed as of December 20, 1993, transmitting Condensed Financial Statements as of September 30, 1993 and for the twelve month period then ended for certain of the individual GTE Telephone Properties listed below proposed to be acquired by Citizens Utilities Company. - Contel of New York, Inc. - Contel of West Virginia, Inc. - West Virginia Division GTE South, Inc. - Arizona Division Contel of the West, Inc. - Idaho Division Contel of the West, Inc. - Tennessee Division GTE South, Inc. A Report on Form 8-K was filed as of December 23, 1993 updating the initiatives of the Public Utility Commission of the State of California to open the California Telecommunications market to competition and pending stockholders' litigation. A Report on Form 8-K/A was filed as of December 23, 1993, amending the Form 8-K filed December 15, 1993, to include the Reports of Independent Public Accountants. A Report on Form 8-K was filed as of December 31, 1993, transmitting a press release dated January 3, 1994, announcing the transfer of GTE's 189,000 access lines in southern Idaho, Tennessee, Utah and West Virginia to Citizens Utilities Company effective December 31, 1993, pursuant to agreements dated May 19, 1993. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 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. CITIZENS UTILITIES COMPANY -------------------------- (Registrant) By: /s/ Leonard Tow ------------------------ Leonard Tow Chairman of the Board; Chief Executive Officer; Chief Financial Officer; Member, Executive Committee and Director March 15, 1994 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 indicated on the 15th day of March 1994. Signature Title --------- ----- /s/ Robert J. DeSantis Vice President and Treasurer - ------------------------------------------ (Robert J. DeSantis) /s/ Livingston E. Ross Vice President and Controller - ------------------------------------------ (Livingston E. Ross) Norman I. Botwinik* Member, Executive Committee and - ------------------------------------------ Director (Norman I. Botwinik) Aaron I. Fleischman* Member, Executive Committee and - ------------------------------------------ Director (Aaron I. Fleischman) Stanley Harfenist* Member, Executive Committee and - ------------------------------------------ Director (Stanley Harfenist) Andrew N. Heine* Director - ------------------------------------------ (Andrew N. Heine) Elwood A. Rickless* Director - ------------------------------------------ (Elwood A. Rickless) John L. Schroeder* Director - ------------------------------------------ (John L. Schroeder) Robert D. Siff* Director - ------------------------------------------ (Robert D. Siff) Robert A. Stanger* Director - ------------------------------------------ (Robert A. Stanger) Edwin Tornberg* Director - ------------------------------------------ (Edwin Tornberg) Claire L. Tow* Director - ------------------------------------------ (Claire L. Tow) By: /s/ Robert J. DeSantis -------------------------------------- (Robert J. DeSantis) Attorney-in-Fact CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Independent Auditors' Report The Board of Directors and Shareholders Citizens Utilities Company: We have audited the accompanying consolidated balance sheets of Citizens Utilities Company and subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of income, shareholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens Utilities Company and subsidiaries at December 31, 1993, 1992 and 1991, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. As discussed in Notes 9 and 13 to the consolidated financial statements, the company has adopted Statements of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. KPMG Peat Marwick New York, New York March 9, 1994 CITIZENS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993, 1992 and 1991 (In thousands) The accompanying Notes are an integral part of these Consolidated Financial Statements. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In thousands, except for per-share amounts) The accompanying Notes are an integral part of these Consolidated Financial Statements. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In thousands, except for per-share amounts) The accompanying Notes are an integral part of these Consolidated Financial Statements. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In thousands) The accompanying Notes are an integral part of these Consolidated Financial Statements. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies: ------------------------------------------ (a) Principles of Consolidation: The Consolidated Financial Statements include the accounts of Citizens Utilities Company and all subsidiaries after elimination of intercompany balances and transactions. The Consolidated Balance Sheet at December 31, 1993, includes $469,487,000 of property, plant and equipment representing the GTE Telephone Properties acquired on December 31, 1993, in a purchase transaction (See Note 3 of Notes to Consolidated Financial Statements). Certain reclassifications of balances previously reported have been made to conform to current presentation. (b) Revenues: Electric, natural gas and water/wastewater - The company records revenues from electric, natural gas and water/wastewater customers when billed. These customers are billed on a cycle basis based on monthly meter readings. The company accrues unbilled revenues earned from the dates customers were last billed to the end of the accounting period. Telecommunications - The company records revenues from telecommunications services when earned. Revenues from local service are primarily derived from providing local telephone services. Revenues from long- distance service are derived from charges for access to the company's local exchange network, subscriber line charges and contractual arrangements. Certain toll and access services revenues are estimated under cost separation procedures that base revenues on current operating costs and investments in facilities to provide such services. (c) Construction Costs and Maintenance Expense: Property, plant and equipment are stated at original cost, including general overhead and an allowance for funds used during construction ("AFUDC"). AFUDC represents the borrowing costs and a return on common equity of funds used to finance construction. AFUDC is capitalized as a component of additions to property, plant and equipment and is credited to income. AFUDC does not represent current cash earnings; however, under established regulatory rate- making practices, after the related plant is placed in service, the company is permitted to include in the rates charged for utility services a fair return on and depreciation of such AFUDC included in plant in service. The amount relating to equity is included in other income ($10,123,000, $6,398,000 and $7,250,000 for 1993, 1992 and 1991, respectively) and the amount relating to borrowings is a reduction of interest expense ($2,678,000, $1,805,000 and $2,045,000 for 1993, 1992 and 1991, respectively). The weighted average rates used to calculate AFUDC were 12%, 14% and 13% in 1993, 1992 and 1991, respectively. Maintenance and repairs are charged to operating expenses as incurred. The cost, net of salvage, of routine property dispositions is charged against accumulated depreciation. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (d) Depreciation Expense: Depreciation expense, calculated using the straight-line method, is based upon the estimated service lives of various classifications of property, plant and equipment and represented approximately 4% of the gross depreciable property, plant and equipment for 1993, 1992 and 1991. (e) Temporary Investments and Short-Term Debt: Temporary investments include investments in state and municipal securities held by the company which mature in 1994 and are to be used to partially finance the acquisition of the GTE Telephone Properties (see Note 3 of Notes to Consolidated Financial Statements). The fair value of temporary investments at December 31, 1993, was $93,438,000. Short-term debt outstanding, was issued in the form of commercial paper notes payable to temporarily and partially fund the GTE Telephone Properties acquired on December 31, 1993. This short-term debt had a weighted average interest rate of 3.26% at December 31, 1993 and is expected to be repaid from maturing temporary investments and proceeds from the planned issuance of equity securities in 1994. The fair value of short-term debt at December 31, 1993, was $380,000,000. (f) Investment in Centennial Cellular Corp.: The company recorded its investment in Centennial Cellular Corp. Convertible Redeemable Preferred Stock (the "Preferred Security") and Class B Common Stock at the historical cost of the company's investment in Citizens Cellular Company. The terms of the Preferred Security provide that the Preferred Security accretes a liquidation value preference at a fixed dividend rate of 7.5%, compounded quarterly, on an initial liquidation value preference of $125,700,000 until the Preferred Security reaches a liquidation value preference of$186,000,000 on August 31, 1996. The company recognizes the non-cash accretion as it is earned in each period as investment income and increases the book value of its investment in Centennial by the same amount. On a quarterly basis, the company assesses whether the book value of the Preferred Security can be realized by comparing such book value to the market value of Centennial's common equity and by evaluating other relevant indicators of realizability, including Centennial's ability to redeem the Preferred Security. The book value of the Preferred Security would be deemed impaired to the extent that such book value exceeds the estimated realizability of the Preferred Security based on all existing facts and circumstances, including the company's assessment of its ability to realize the book value of the Preferred Security through mandatory redemption. (See Notes 3 and 5 of Notes to Consolidated Financial Statements) (g) Deferred Income Taxes and Investment Tax Credits: The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective for fiscal years beginning after December 15, 1992. SFAS No. 109 required a change from the deferred to the liability method of computing deferred income taxes. The company adopted the provisions of SFAS No. 109 in 1993 without restating the prior years financial statements; there was no material effect of the adoption of SFAS No. 109 on net income in 1993. Adoption of SFAS No. 109 resulted in recording a net increase in the liability for deferred income taxes of $115,437,000. Such increase resulted principally from income tax benefits previously flowed through to customers and the allowance for funds used during construction; partially offsetting these items were the effects of tax law changes and the tax benefit associated with the unamortized deferred CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements investment tax credits. Due to the effects of utility regulation, the company recorded regulatory assets and liabilities of $143,813,000 and $28,376,000, respectively, as offsets to the increase in the deferred income taxes. Prior to the adoption of SFAS No. 109, deferred income taxes resulted from the tax effect of using accelerated depreciation methods and certain other timing differences between income reported on the Consolidated Financial Statements and taxable income reported on the company's income tax returns. The investment tax credits relating to utility properties, as defined by applicable regulatory authorities, have been deferred and are being amortized to income over the life of the related properties. (h) Earnings Per Share: Earnings per share is based on the average number of outstanding shares. Earnings per share is presented for each series separately, with historical adjustment for stock dividends and stock splits for each series. The calculation has not been adjusted for the 1.1% stock dividend declared on February 8, 1994, because its effect is immaterial. The effect on earnings per share of the exercise of dilutive options is immaterial. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (2) Property, Plant and Equipment: ------------------------------ The components of property, plant and equipment at December 31, 1993, 1992 and 1991 are as follows: (3) Mergers and Acquisitions: ------------------------- On May 19, 1993, the company and GTE Corporation announced the signing of ten definitive agreements under which the company would purchase from GTE Corporation, for approximately $1,100,000,000 in cash, 500,000 local telephone access lines in nine states ("the GTE Telephone Properties"). These transactions require the approval of the Federal Communications Commission and the regulatory commissions of the nine states in which the properties are located. On December 31, 1993, 189,000 access lines in Idaho, Tennessee, Utah and West Virginia were transferred to the company. The remaining access lines are expected to be transferred during 1994. No revenues were recorded during 1993 since this acquisition was accounted for by the purchase method. The following unaudited pro forma financial information presents the combined results of operations of the company and the GTE Telephone Properties acquired and to be acquired as if the acquisition had occurred at the beginning of the respective periods. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the company and the GTE Telephone Properties constituted a single entity during such periods. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements In 1993, the company separately acquired Natural Gas Company of Louisiana ("NGL") and Franklin Electric Light Company, Incorporated ("Franklin") by merger. In the mergers, the company issued 568,748 shares of Series B common stock for all of the common stock of NGL and Franklin, respectively. The acquisitions were accounted for as poolings of interests. Prior years' financial statements were not restated for the effects of these transactions because the amounts were not significant. On December 3, 1991, the company acquired Southern Union Company's northern Arizona gas utility operations, which serve more than 65,000 customers, for a purchase price of $46,000,000. The purchase price was comprised of approximately $39,000,000 in cash, allocated to utility plant, and $7,000,000 in net liabilities assumed. On August 30, 1991, the company and Century Communications Corp. ("Century") completed the merger of their respective interests in the cellular telephone field. The combination was effected through a merger of Citizens Cellular Company, a subsidiary of the company having an adjusted book value of $69,668,000, with and into Century Cellular Corp., a wholly owned subsidiary of Century Communications Corp. In connection with the merger, the company received Centennial Cellular Corp. (formerly Century Cellular Corp.) Convertible Redeemable Preferred Stock with an initial liquidation value preference of $125,700,000 and Class B Common Stock representing 12% of the currently outstanding common equity of Centennial Cellular Corp. These securities are included in the investments caption of the Consolidated Balance Sheets. In March 1993, the company signed an agreement to purchase, through a joint venture with Century the assets of two cable television systems serving approximately 45,000 subscribers in California. The joint venture will pay a purchase price of up to approximately $89,000,000 for the systems and intends to enter into an agreement with Century pursuant to which Century will manage the systems. The purchase is subject to regulatory approval for the transfer of licenses and is expected to be consummated in 1994. The chairman and chief executive officer of the company is also chairman and chief executive officer of Century Communications Corp. (4) Dispositions: ------------- During 1993, the company disposed of its Santa Cruz County, Arizona water and wastewater properties, Idaho water property and Aalert Paging Company. The sale of the Santa Cruz properties yielded net proceeds of $1,694,000 and had a net investment of $94,000. The company received net proceeds of $1,221,000 from the sale of the Idaho water property and had a net investment of $1,249,000. The sale of Aalert Paging Company yielded net proceeds of $5,498,000 and had a net investment of $5,287,000. The resulting gains and losses are included in other income - net. During 1992, the company disposed of two water properties in California. One property was transferred to a municipality through condemnation proceedings. The company received net proceeds of $3,400,000 and had a net investment of $1,877,000. The other property was sold for net proceeds of $6,618,000; the company's net investment was $4,160,000. In December 1992, the company disposed of its Idaho electric operations. The company received $1,177,500 and had a net investment of $706,000. The resulting gains on dispositions are included in other income-net. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (5) Investments: ----------- Investments include high-grade, short- and intermediate-term fixed- income securities (primarily state and municipal debt obligations) and equity securities. Fixed-income securities are stated at cost. Marketable equity securities are stated at the lower of cost or market. The company's investment in Centennial Cellular Corp. (See Note 3 of Notes to Consolidated Financial Statements) includes 102,187 Convertible Redeemable Preferred Shares and 1,367,099 Class B Common Shares. The liquidation value preference earned on the Convertible Redeemable Preferred Stock for 1993, 1992 and 1991 was $9,594,000, $8,803,000 and $2,563,000, respectively, and was recorded as investment income. The book value of the investment in Centennial at December 31, 1993, as presented in the table below, represents the historical book value of the investment of $69,668,000 ($19,826,000 of which relates to the Class B common shares) plus $20,960,000 of liquidation value preference earned on the Preferred Security by the company to date. The Preferred Security is mandatorily redeemable in the year 2007. The company believes it can realize its investment in Centennial either by cash redemption by the issuer funded through refinancing by the issuer, by temporary conversion to common equity securities followed by the sale of the common equity securities, or by sale of its current investment holdings. The aggregate market value of marketable equity securities at December 31, 1993, was $27,492,000. Total unrealized gains on marketable equity securities at December 31, 1993 were $14,210,000. Net realized gains on marketable equity securities included in the determination of net income for the years 1993, 1992 and 1991, respectively, were $0, $259,000 and $670,000. The cost of securities sold was based on the actual cost of the shares of each security held at the time of sale. Marketable equity securities at December 31, 1993, includes 1,758,428 shares (adjusted for stock dividends) of Class A Common Stock of Century Communications Corp. These shares represent less than 2% of the total outstanding common stock of Century Communications Corp. The chairman and chief executive officer of the company is also chairman and chief executive officer of Century Communications Corp. The components of investments at December 31, 1993, 1992 and 1991 are as follows: The fair value of investments, presented as required by SFAS No. 107, was $501,273,000 and $649,366,000 at December 31, 1993 and 1992 respectively, based on relative market information about each financial instrument. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (6) Long-term Debt: --------------- Certain commercial paper notes payable have been classified as long-term debt because these obligations are expected to be refinanced ultimately through the issuance of long-term debt securities. The company has available lines of credit with commercial banks in the amounts of $1,000,000,000 and $200,000,000, which expire on December 14, 1994 and December 16, 1996, respectively, and have associated facility fees of one-twentieth of one percent per annum and one- twelfth of one percent per annum, respectively. The terms of the lines of credit provide the company with certain extension options. The total principal amounts of industrial development revenue bonds at December 31, 1993, 1992 and 1991, respectively, were $377,890,000, $274,030,000 and $264,030,000. Amounts presented in the preceding table have been reduced by funds held by trustees to be used for payment of qualifying construction expenditures. Holders of certain industrial development revenue bonds may tender at par prior to maturity. The next tender date is August 1, 1997, for $30,350,000 of principal amount of bonds. In the years 1993, 1992 and 1991, respectively, interest payments were $40,217,000, $37,913,000 and $34,645,000. The fair value of long-term debt, presented as required by SFAS No. 107 at December 31, 1993 and 1992, respectively, was $602,710,000 and $550,724,000, based on relative market information and information about each financial instrument. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements The installment principal payments and maturities of long-term debt for the next five years are as follows: (7) Capital Stock: -------------- The common stock of the company is in two series, Series A and Series B. The company is authorized to issue up to 200,000,000 shares of Series A common stock and 300,000,000 shares of Series B common stock. Quarterly stock dividends are declared and issued at the same rate on both Series A and Series B. The series differ in that, since 1992, Series B shareholders have the option of enrolling in the "Series B Common Stock Dividend Sale Plan." The Plan offers Series B shareholders the opportunity to have their stock dividends sold quarterly by the Plan Broker and the net cash proceeds of the sale distributed to them quarterly. Series A shares are convertible share-for-share into Series B shares. Series B shares, however, are not convertible into Series A. In all other respects, the shares of both series have the same voting rights and participate ratably in liquidation. On April 14, 1992, the company declared a 3-for-2 stock split of its Series A and Series B common stock. The stock split was distributed on July 24, 1992, to shareholders of record on July 1, 1992. On May 21, 1993, the company declared a 2-for-1 stock split of its Series A and Series B common stock. The stock split was distributed on August 31, 1993, to shareholders of record on August 16, 1993. Quarterly stock dividend rates declared on Series A and Series B common stock are based upon cash equivalent rates and share market prices, and have been as follows: Annualized stock dividend cash equivalent rates considered by the company's Board of Directors in establishing the stock dividends during 1993, 1992 and 1991, respectively, were $0.745, $0.675 and $0.585 per share (adjusted for subsequent stock dividends and stock splits). CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements The activity in shares of outstanding common stock for Series A and Series B during 1993, 1992 and 1991 is summarized as follows: The company used 7,000 Series B shares (not adjusted for subsequent stock dividends and stock split) acquired from employees pursuant to the Management Equity Incentive Plan ("MEIP") in partial payment of the 1993 stock dividend. These shares had a cost of $215,000. The company purchased 93,000 Series B shares (not adjusted for subsequent stock dividends and stock splits) at a cost of $2,558,000 for use in partial payment of the 1991 stock dividend. The company has 50,000,000 authorized shares of preferred stock ($.01 par), none of which has been issued. The preferred stock may be issued by the Board of Directors (without further approval by shareholders) in one or more series, having such attributes as may be designated by the Board of Directors at the time of issuance. (8) Employee Stock Plans: -------------------- On June 22, 1990, shareholders approved the Citizens Utilities Company Management Equity Incentive Plan ("MEIP"). Under the MEIP, awards of the company's Series A or Series B common stock may be granted to eligible officers and other management employees of the company and its subsidiaries in the form of incentive stock options, non-qualified stock CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements options, stock appreciation rights, restricted stock or other stock-based awards. The MEIP is administered by the Compensation Committee of the Board of Directors. The maximum number of shares of common stock which may be issued pursuant to awards at any time is 5% of the company's common stock outstanding from time to time; provided that no more than 8,147,000 shares (adjusted for stock dividends and stock splits) will be issued pursuant to incentive stock options under the MEIP. No awards will be granted more than ten years after the effective date of the MEIP. The exercise price of stock options and stock appreciation rights ("SARs") shall be equal to or greater than the fair market value of the underlying common stock on the date of grant. Stock options are generally not exercisable on the date of grant but vest over a period of time. Some options were awarded in tandem with related SARs. SARs provide the MEIP participant with the alternative of electing not to exercise the related stock option, but to receive instead an amount in cash or in common stock equal to the difference between the option price and the fair market value of the common stock on the date the SAR is exercised. Either the SAR or the related option may be exercised, but not both. During 1993, there were no SARs granted. During 1992, 613,000 SARs were exercised at an average exercise price of $12.21 per share (not adjusted for subsequent stock dividends and stock splits). This resulted in the cancellation of the 613,000 tandem stock options. At December 31, 1993 and 1992, no SARs were outstanding. Under the terms of the MEIP, subsequent stock dividends and stock splits have the effect of increasing the option shares outstanding, which correspondingly decreases the average exercise price of outstanding options. The following summary of shares subject to option under the MEIP reflects the original options granted at original option prices adjusted for subsequent stock splits. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements Represents adjustment to outstanding option shares to reflect stock dividends. During 1993 and 1992, the company granted restricted stock awards to key employees in the form of the company's Series B common stock. The number of Series B shares issued as restricted stock awards during 1993 and 1992 was 142,000 and 754,000, respectively (adjusted for stock dividends and stock splits). None of the restricted stock awards may be sold, assigned, pledged or otherwise transferred, voluntarily or involuntarily, by the employee. The restrictions lapse on 20% of the restricted stock awards each year over a five- year period. At December 31, 1993, 701,000 shares (adjusted for stock dividends and stock splits) of restricted stock were outstanding. The company's Employee Stock Purchase Plan ("ESP Plan") was approved by shareholders on June 12, 1992 and amended on May 21, 1993. Under the ESP Plan, eligible employees of the company and its subsidiaries may subscribe to purchase shares of Series B common stock at the lower of 85% of the average market price on the first day of the purchase period or on the last day of the purchase period. An employee may elect to have up to 20% of annual base pay withheld in equal installments throughout the designated payroll-deduction period for the purchase of shares. The value of an employee's subscription may not exceed $25,000 in any one calendar year. As of December 31, 1993, there are 1,217,000 shares (adjusted for stock dividends and stock splits) of Series B common stock reserved for issuance under the ESP Plan. These shares will be adjusted for any future stock dividends or stock splits. The ESP Plan will terminate when all 1,217,000 shares reserved have been subscribed for, unless terminated earlier by the Board of Directors. The ESP Plan is administered by a committee of the Board of Directors. As of January 1, 1993, the number of employees participating in the ESP Plan was 1,058 and the number of shares subscribed for was 182,000 at a price of $11.63 per share (which reflects the 15% discount and is adjusted for stock dividends and stock splits). CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (9) Income Taxes: ------------ The following is a reconciliation of the provision for income taxes at federal statutory rates to the reported provision for income taxes: For 1993, 1992 and 1991, accumulated deferred income taxes amounted to $194,165,000, $72,969,000 and $83,157,000, respectively, and the unamortized deferred investment tax credits amounted to $19,306,000, $22,253,000 and $24,610,000, respectively. Income taxes paid during the year were $24,139,000, $22,798,000 and $29,309,000 for 1993, 1992 and 1991, respectively. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements The components of the net deferred tax liability at December 31, 1993 are as follows: * There was no change in the valuation allowance during 1993. The provision for federal and state income taxes includes amounts both payable currently and deferred for payment in future periods. The company and its subsidiaries are included in a consolidated federal income tax return using a calendar year reporting period. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (10) Segment Information: -------------------- *$469,487,000 of which constitutes a portion of the GTE Telephone Properties. These properties were acquired on December 31, 1993, in a transaction accounted for under the purchase method. CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (11) Quarterly Financial Data (unaudited): ------------------------------------ (12) Supplemental Cash Flow Information: ---------------------------------- Schedule of net cash provided by operating activities for the years ended December 31, CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (13) Pension and Retirement Plans: ---------------------------- The company and its subsidiaries have noncontributory pension plans covering all employees who have met certain service and age requirements. The benefits are based on years of service and final average pay or pay rate. Contributions are made in amounts sufficient to fund the plans' current service costs and to provide for benefits expected to be earned in the future. Plan assets are invested in a diversified portfolio of equity and fixed-income securities. Pension costs for 1993, 1992 and 1991 include the following components: Assumptions used in the computation of pension costs and the actuarial present value of projected benefit obligations included the following: As of December 31, 1993, 1992 and 1991, respectively, the fair values of plan assets were $73,233,000, $68,506,000 and $63,654,000. The actuarial present values of the accumulated benefit obligations were $57,216,000, $48,661,000 and $44,513,000 for 1993, 1992 and 1991, respectively. The actuarial present values of the vested accumulated benefit obligation for 1993, 1992 and 1991, respectively, were $54,591,000, $46,819,000 and $43,484,000. The total projected benefit obligations for 1993, 1992 and 1991, respectively, were $75,531,000, $63,199,000 and $62,915,000. The company has agreed to assume the pension liabilities associated with employees of the GTE Telephone Properties acquired on December 31, 1993. GTE Corporation has agreed to transfer to the company plan assets in an amount equal to the assumed liabilities. Such amounts will be determined in 1994. The company provides certain medical, dental and life insurance benefits for retired employees and their beneficiaries and covered dependents. In January 1993, the company implemented SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions". SFAS No. 106 requires the company to accrue the expected costs of CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements providing postretirement benefits to employees and to employees' beneficiaries and covered dependents, during the years the employee renders the necessary service. The company's 1993 annualized costs were approximately $3,671,000, of which approximately $1,601,000 were recorded as regulatory assets for states whose regulatory commissions to date have not but will likely allow recovery of accrued costs in future rate proceedings. The company's accumulated postretirement benefit obligation at December 31, 1993, was approximately $24,000,000. The company's annual cost includes 20-year prospective recognition of the transition obligation. The company is currently assessing the costs and benefits of alternative funding methods. For measurement purposes, the company used a 7.5% discount rate and a 9% annual rate of increase in the per capita cost of covered health care benefits, gradually decreasing to 6% in the year 2030 and remaining at that level thereafter. The effect of a 1% increase in the assumed health care cost trend rates for each future year on the aggregate of the service and interest cost components of the total postretirement benefit cost would be $314,000 and the effect on the accumulated postretirement benefit obligation for health benefits would be $2,609,000. The components of the net periodic postretirement benefit cost for the year ended December 31, 1993, is as follows: The following table sets forth the accrued postretirement benefit cost recognized in the company's balance sheet at December 31, 1993: CITIZENS UTILITIES COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (14) Commitments and Contingencies: ------------------------------ The company has budgeted expenditures for facilities in 1994 of approximately $280,000,000 and certain commitments have been entered into in connection therewith. On May 19, 1993, the company and GTE Corporation announced the signing of ten definitive agreements under which the company would purchase from GTE Corporation, for approximately $1,100,000,000 in cash ($469,487,000 of the total purchase price has been paid to date), 500,000 access lines in nine states. These transactions are consistent with the company's growth strategy, will enable the company to achieve operating economies of scale and will increase the company's annual revenues to more than $1,000,000,000 once the operations are fully integrated. These transactions require the approval of the Federal Communications Commission and the regulatory commissions of the nine states in which the properties are located. On December 31, 1993, 189,000 access lines in Idaho, Tennessee, Utah and West Virginia were transferred to the company. The remaining access lines are expected to be transferred during 1994. CITIZENS UTILITIES COMPANY EXHIBITS TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993	14,078	95,043
50863_1993.txt	50863_1993	1993	50863	ITEM 1. BUSINESS INDUSTRY Intel Corporation and its subsidiaries (collectively called "Intel," the "Company" or the "Registrant") operate in one dominant industry segment. The Company designs, develops, manufactures and markets advanced microcomputer components and related products at various levels of integration. Intel components consist of silicon-based semiconductors etched with complex patterns of transistors. Each one of these integrated circuits (ICs) can perform the functions of thousands- or even millions-of individual transistors, diodes, capacitors and resistors. PRODUCTS Intel's product strategy is twofold: the Company offers to OEMs (original equipment manufacturers) a wide range of PC (personal computer) building-block products to meet their needs, and offers to PC users products that expand the capability of their systems and networks. The Company's major products include microprocessors, embedded products, memory chips, computer modules and boards, network and communication products, personal conferencing products and parallel supercomputers. MICROPROCESSORS. A microprocessor is the central processing unit of a PC. It processes system data and controls other devices in the system, acting as the brains of a PC. Intel's 32-bit processors include the flagship Pentium(TM) family and the Intel486(TM) microprocessor family. Pentium processors are the latest extension of an architecture that is pervasive worldwide; the market research firm Dataquest estimates that over 105 million PCs based on Intel architecture are currently in use (compared to fewer than 20 million PCs based on other architectures). The Company's strategy is to develop products in the Intel architecture family which are compatible with the installed base of software applications. Intel's developments in the art of semiconductor design and manufacturing have made it possible to decrease the feature size of circuits etched into silicon. This means that a greater number of transistors can be fit on each silicon wafer, resulting in microprocessors that are smaller, faster running, more energy efficient, and less expensive to make. Within the Intel486 microprocessor product family, certain designations and product names differentiate the processors from one another. SX and DX are used to designate the earlier, lower-cost generations of the family. The IntelDX2(TM) chip is designed with speed-doubling technology that is up to twice the speed of the Intel486 DX processor and is targeted at high-volume entry level systems for business and home users. Introduced in early 1994, the IntelDX4(TM) processor, the fastest member of the Intel486 microprocessor family, is appropriate for both desktop and mobile systems. The IntelDX4 processor family offers up to 50 percent more performance than the 66-MHz IntelDX2 microprocessor. In addition, the Company has added its SL technology to the Intel486 CPU line, allowing computer manufacturers to implement power-management features in hardware at no price premium. In 1993, Intel introduced the 60- and 66-MHz Pentium processors that process up to 112 million instructions per second (MIPS). In March 1994, Intel announced 3.3 volt, 90- and 100-MHz Pentium processors that process up to 166 MIPS. All members of the Pentium family contain energy- efficient circuitry. The Company is planning to release its next-generation microprocessor, now under development and code-named the P6, in 1995. Completely binary compatible with previous generations of the Intel architecture, the P6 is expected to operate between 250-300 MIPS. Sales of the Intel486 CPU family of microprocessors comprised a majority of the Company's revenues and a substantial majority of its gross margin in 1992 and 1993. In 1991, combined sales of the Intel486 and Intel386(TM) microprocessor families comprised a majority of revenues and a substantial majority of gross margin. The Pentium processor began to contribute significantly to overall revenue growth in the fourth quarter of 1993. The Company expects its Intel486 family of microprocessors to follow a normal price maturity curve, but some distortion could occur if imitation products enter the market in significant volume or alternative architectures gain acceptance. Intel expects to ship several million Pentium processors in 1994, but to some extent such sales depend on peripheral products supplied by other companies. EMBEDDED PRODUCTS. Embedded chips provide the computing power in devices other than PCs and workstations. Embedded products are dedicated to specific application functions and are found in printers, copiers, fax machines, VCRs, cable converter boxes and other TV equipment, in commercial and military avionics, in medical instrumentation, and in factory automation control products. Intel's embedded product line consists of 32-bit processors, including the i960(R) processor family, which are the best selling RISC (reduced instruction set computing) chips in the world in terms of units sold (according to Dataquest); embedded Intel386 processors that primarily use the DOS operating system; 16-bit microcontrollers, such as the 8096 and the 80C196; and 8-bit microcontrollers, such as the MCS(R)51 microcontroller family. The Company introduced several embedded products in 1993 including the Intel386 CX and EX chips, the 87C196MD controller for motor control applications, and the small 82078 floppy disk controller targeted for PC notebooks. MEMORY CHIPS. Memory components are used to store computer programs and data entered by users. Flash memories are nonvolatile and do not require power to retain information. Intel supplies a broad line of flash memory components. The Company's newest generation of flash memory products is designed for sub-notebook and handheld computers and communication devices in addition to many embedded applications. Flash memory chips are serving as disk drive replacements in the mobile market, storing the BIOS (basic input/output software) that controls the basic operation of mobile and desktop systems and other software that controls circuitry in both mobile and desktop systems, and meeting many embedded data storage needs. In 1993, Intel introduced 16- and 32-Mbit flash chips; 4-, 20- and 40-Mbyte flash cards; and 5- and 10-Mbyte flash drives. COMPUTER MODULES AND BOARDS. Hundreds of microcomputer platforms and single-board computers based on Intel components are now widely accepted as basic building blocks for technical and commercial applications. Many OEMs build their own PCs, microcomputers, real-time control systems and other products based on these modules. NETWORK AND COMMUNICATION PRODUCTS. Sold to PC users through retail channels, these hardware and software products improve the performance or capabilities of PC systems and networks. Some Intel products make PC networks easier for LAN administrators to install and manage. When PC users install other cards and software, their systems are able to access online services and transmit information to and from fax machines or other PC faxmodems. Supporting a "smart network" services strategy are new or upgraded LAN products: EtherExpress(TM) LAN adapters that use flash memory for one-step installation and configuration; StorageExpress(TM) back up servers; NET SatisFAXtion(R) software; NetportExpress(TM) print servers; and LANDesk(TM) Manager software that combines management of desktop systems, servers, wire segments and services on LANs. In 1993, Intel also introduced the Intel wireless modem, the Value Line faxmodems and three credit-card-size Intel PCMCIA (PC Memory Card International Association) faxmodems. PERSONAL CONFERENCING PRODUCTS. PC users can install Intel software and cards that let two users view and manipulate the same documents simultaneously and, in some cases, see the other user. Personal conferencing products merge the power of the PC with the real-time immediacy of the telephone. Intel introduced its ProShare(TM) personal conferencing products, including the ProShare Video System 200, in early 1994. PARALLEL SUPERCOMPUTERS. The fastest computer systems available, supercomputers are intended to solve the most computationally intensive problems. Parallel supercomputers use the processing power of multiple microprocessors working simultaneously. Intel offers two lines of parallel supercomputers: the iPSC(R)/860 supercomputer, based on up to 128 i860(TM) XR microprocessors; and the Paragon(TM) XP/S massively parallel supercomputer, with up to 4,000 i860 XR microprocessors working together. MANUFACTURING Intel's domestic facilities in Chandler, Arizona; Aloha and Hillsboro, Oregon; Las Piedras, Puerto Rico; Santa Clara and Folsom, California; and Rio Rancho, New Mexico conduct most of the Company's VLSI (very-large-scale-integration) wafer production, some product assembly and final testing, and most production of microcomputers and memory boards and systems. Outside of the United States, a significant and growing portion of Intel's VLSI wafer manufacturing, including some Intel486 microprocessor production, is conducted at fabrication plants in Jerusalem, Israel and Leixlip, Ireland. A significant portion of Pentium processor production is planned for the Ireland site, which opened in early 1994. Most of Intel's VLSI component assembly and testing is conducted at facilities in Penang, Malaysia and Manila, Philippines. Some production of microcomputers and memory boards and systems is conducted at another Leixlip, Ireland plant. To augment capacity, Intel uses subcontractors to perform assembly of certain products and wafer fabrication for certain VLSI components, including flash memory. The Company cannot give assurances that it will be able to fully satisfy demand for certain of its products. The manufacture of integrated circuits is a complex process. Normal manufacturing risks include errors in the fabrication process, defects in raw materials, as well as other factors, all of which can affect yields. In general, if Intel were unable to assemble, test, or perform wafer fabrication on its products abroad, or if air transportation between its foreign facilities and the United States were disrupted, there could be a materially adverse effect upon the Company's operations. In addition to normal manufacturing risks, foreign operations are subject to certain additional exposures including political instability, currency controls and fluctuations, and tariff and import restrictions. To date, Intel has not experienced significant difficulties related to these foreign business risks. EMPLOYEES At December 25, 1993, the Company employed approximately 29,500 people worldwide. SALES Most of Intel's products are sold or licensed through sales offices located near major concentrations of users throughout the United States, Europe, Japan, Asia-Pacific, and other parts of the world. The Company also uses distributors (industrial and retail) and representatives to distribute its products both in the United States and overseas. Typically, distributors handle a wide variety of products, including those competitive with Intel products, and fill orders for many customers. Most of Intel's sales to distributors are made under agreements allowing for price protection and/or the right of return on unsold merchandise. Sales representatives generally do not offer directly competitive products, but may carry complementary items manufactured by others. Representatives do not maintain a product inventory; instead, their customers place large quantity orders directly with Intel and are referred to distributors for smaller orders. Sales of Intel products during 1993 were made to many thousands of customers worldwide, one of which, International Business Machines Corp., accounted for 10% of total revenues. BACKLOG Intel's sales are made primarily pursuant to standard purchase orders for delivery of standard products. Intel has some agreements that give a customer the right to purchase a specific number of products during a time period. Although not generally obligating the customer to purchase any particular number of such products, some of these agreements do contain billback clauses. As a matter of industry practice, billback clauses are difficult to enforce. The quantity actually purchased by the customer, as well as the shipment schedules, are frequently revised during the agreement term to reflect changes in the customer's needs. In light of industry practice and experience, Intel does not believe that such agreements are meaningful for determining backlog figures. Intel believes that only a small proportion of its order backlog is noncancellable and that the dollar amount associated with the noncancellable portion is immaterial. Therefore, Intel does not believe that backlog as of any particular date is necessarily indicative of future results. COMPETITION The Company competes in different product lines to various degrees on the basis of price, performance, availability and quality. Many companies compete with Intel and are engaged in the same basic fields of activity, including research and development. Both foreign and domestic, these competitors range in size from large multinationals to smaller companies competing in specialized markets. Intel is engaged in a rapidly advancing field of technology in which its ability to compete depends upon the continuing improvement of its products, continuing cost reductions, and the development of new products to meet changing customer requirements. Prices decline rapidly in the semiconductor industry as unit volume grows, as competition develops, and as production experience is accumulated. In the microcomputer and memory boards and systems area, Intel competes with component manufacturers and microprocessor-based computer manufacturers. Some of these competitors are also Intel customers. A number of competitors have developed products that imitate some of the Company's key products, including the Intel486 and Intel386 microprocessor families. Some of these products obtained market acceptance and Intel's revenues and margins with respect to certain of these products were adversely affected. In addition, other competitors have indicated their intention to develop imitations of the Pentium processor. On March 10, 1994, a jury returned a verdict in favor of Advanced Micro Devices, Inc. ("AMD") regarding AMD's right to copy certain microcode. (See "Legal Proceedings.") Intel intends to appeal the verdict. If AMD ultimately prevails in its position that it has a license to use Intel microcode (rather than having to develop its own microcode independently), AMD will be able to more easily develop and ship imitations of certain Intel products, including Intel microprocessors. In February 1994, the Company settled a lawsuit with Cyrix Corp. under which the Company dismissed certain patent infringement claims and granted certain licenses. The Company also faces significant competition from companies that offer rival microprocessor architectures. The Company cannot predict whether such rival architectures will gain market acceptance or provide increased competition to the Company's products. The Company continues to believe that its Intel486 microprocessors will follow a normal price maturity curve, but some distortion could occur if imitation products enter the market in significant volume or alternative architectures gain market acceptance. It continues to be Intel's strategy to maintain its competitive advantage through the development and marketing of advanced products which provide greater functionality to its customers than is provided by competitive products. Intel also is committed to the protection of its intellectual property rights against illegal use. There can be no assurance, however, that competitors will not introduce new products (either imitative or of rival architectural designs) or reduce prices on existing products. Such developments could have an adverse effect on Intel's revenues and margins. RESEARCH AND DEVELOPMENT The Company's competitive position has developed to a large extent because of its emphasis upon research and development. This emphasis has enabled Intel to deliver products before they have become available from competitors, and thus has permitted Intel's customers to commit to the use of these new products in the development of their own products. Intel's research and development activities are directed towards developing new products and improving existing products and lowering their cost. Intel's expenditures for research and development were $970, $780 and $618 million in fiscal years 1993, 1992 and 1991, respectively. As of December 25, 1993, Intel had approximately 6,200 employees engaged in research and development. The results of Intel's research and development depend upon competitive circumstances and Intel's ability to transfer new products to production in a timely and cost effective manner. Most design and development of VLSI components and systems is performed at Intel's facilities in Santa Clara and Folsom, California; Aloha and Hillsboro, Oregon; Chandler, Arizona; and Haifa, Israel. The Company also has design facilities in Tsukuba, Japan. INTELLECTUAL PROPERTY AND LICENSING Intellectual property rights which apply to various Intel products include patents, copyrights, trade secrets, trademarks and maskwork rights. Because of the rapidly changing technology and a broad distribution of patents in the semiconductor industry, Intel's present intention is not to rely primarily on intellectual property rights to protect or establish its market position. However, Intel has established an active program to protect its investment in technology by enforcing all of its intellectual property rights. Intel does not intend to broadly license its intellectual property rights unless it can obtain adequate consideration. Reference is also made to the captions "Competition" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Intel has filed and obtained a number of patents in the United States and abroad. Intel has entered into cross license agreements with many of its major competitors. Intel protects many of its computer programs by copyrighting the programs. Intel has registered numerous copyrights with the United States Copyright Office. The ability to protect or to copyright software in some foreign jurisdictions is not clear. However, Intel has a policy of requiring customers to sign a software license contract before providing a customer with certain computer programs. Certain VLSI components have computer programs embedded in them, and Intel has obtained copyright protection for some of these computer programs as well. Beginning in 1985, Intel has obtained protection for the maskworks for a number of its components under the Chip Protection Act of 1984. Intel has obtained certain trademarks and trade names for its products to distinguish genuine Intel products from those of its competitors and is currently engaged in a cooperative program with OEM manufacturers to identify personal computers that incorporate genuine Intel microprocessors with the Intel Inside(R) logo. Intel maintains certain details about its processes, products and strategies as trade secrets. As is the case with many companies in the semiconductor industry, Intel has, from time to time, been notified of claims that it may be infringing certain patent rights of others. These claims have been referred to counsel and they are in various stages of evaluation and negotiation. If it appears necessary or desirable, Intel may seek licenses for these intellectual property rights. Intel can give no assurance that licenses will be offered by all claimants or that the terms of any offered licenses will be acceptable to Intel or that in all cases the dispute will be resolved without litigation. COMPLIANCE WITH ENVIRONMENTAL REGULATIONS To Intel's present knowledge, compliance with federal, state and local provisions enacted or adopted for protection of the environment has had no material effect upon its operations. However, reference is made to Item 3., Legal Proceedings, of this Form 10-K. EXECUTIVE OFFICERS The following sets forth certain information with regard to executive officers of Intel (ages are as of December 25, 1993): Craig R. Barrett (age 54) has been Chief Operating Officer since 1993, a director of Intel Corporation since 1992, and Executive Vice President since 1992; and Vice President and General Manager of the Microcomputer Components Group from 1989 to 1992. Andrew S. Grove (age 57) has been a director of Intel Corporation since 1974, President since 1979 and Chief Executive Officer since 1987. Gordon E. Moore (age 65) has been a director of Intel Corporation since 1968 and Chairman of the Board of Intel Corporation since 1979. Leslie L. Vadasz (age 57) has been a director of Intel Corporation since 1988 and Senior Vice President, Director of Corporate Business Development since 1991; and Senior Vice President and General Manager of the Systems Group from 1986 to 1990. Frank C. Gill (age 50) has been Senior Vice President and General Manager, Intel Products Group since 1991; Senior Vice President and President of the Systems Group from 1990 to 1991; Senior Vice President and Director of Sales from 1989 to 1990; and Vice President and Director of Sales from 1987 to 1989. David L. House (age 50) has been Senior Vice President and Director, Corporate Strategy, since 1991; Senior Vice President and President of Microcomputer Components Group from 1990 to 1991; and Senior Vice President and General Manager, Microcomputer Components Group from 1987 to 1990. Paul S. Otellini (age 43) has been Senior Vice President and General Manager, Microprocessor Products Group, since January 1993; Vice President and General Manager, Microprocessor Products Group from 1991 to 1992; Vice President/General Manager, Micro Products Group from 1990 to 1991; Vice President/Assistant to the President from 1989 to 1990; and Vice President/General Manager, Folsom Microcomputer Division from 1988 to 1989. Gerhard H. Parker (age 50) has been Senior Vice President and General Manager, Technology & Manufacturing Group since 1992; Vice President and Director, Technology & Manufacturing Group from 1991 to 1992; Vice President and Director, Technology Group from 1990 to 1991; Vice President and General Manager, Technology and Manufacturing Group during 1990; Vice President and General Manager, Component Technology and Development Group from 1989 to 1990; and Vice President and Director of Technology Development from 1979 to 1989. Robert W. Reed (age 47) has been Senior Vice President and General Manager, Semiconductor Products Group since 1991; Senior Vice President and Chief Financial Officer from 1990 to 1991; Senior Vice President, Chief Financial Officer and Director of Administration from 1989 to 1990; and Vice President, Chief Financial Officer and Director of Administration from 1987 to 1989. Ronald J. Whittier (age 57) has been Senior Vice President and General Manager, Architecture and Software Technology Group since January 1993; Vice President and General Manager, Software Technology Group from 1991 to 1992; Vice President and Director of Marketing from 1990 to 1991; and Vice President and Director of Corporate Marketing from 1985 to 1990. Albert Y.C. Yu (age 52) has been Senior Vice President and General Manager, Microprocessor Products Group, since January 1993; Vice President and General Manager, Microprocessor Products Group from 1991 to 1992; Vice President and General Manager, Micro Products Group from 1990 to 1991; Vice President and General Manager, Component Technology and Development Group from 1989 to 1990; and Vice President/General Manager, Development, Microcomputer Components Group from 1987 to 1989. Michael A. Aymar (age 46) has been Vice President and General Manager, Intel 486(TM) Microprocessor Division since January 1994; Vice President and General Manager, Mobile Computing Group, from 1991 to 1994; Vice President/General Manager, Santa Clara Microcomputer Division from 1989 to 1991; Vice President, Component Technology & Development Group; and Director, Design Technology from 1988 to 1989. Andy D. Bryant (age 43) has been Vice President and Chief Financial Officer since February 1994; Vice President, Intel Products Group from 1990 to 1994; and Director of Finance from 1987 to 1990. F. Thomas Dunlap, Jr. (age 42) has been Vice President, General Counsel and Secretary since 1987. G. Carl Everett (age 43) has been Vice President and Director, Worldwide Sales Group since 1990; Vice President and Director of North American Sales during 1990; and Vice President, Sales and Marketing Group from 1987 to 1990. Kenneth B. Fine (age 52) has been Vice President and General Manager, Semiconductor Products Group since January 1993; Vice President/General Manager, Multimedia and Supercomputing Components Group from 1991 to 1992; Vice President/General Manager, Embedded Controller and Memory Group from 1990 to 1991; and General Manager, Chandler Microcomputer/ASIC Division from 1988 to 1990. Harold E. Hughes, Jr. (age 47) has been Vice President and Director of Planning since February 1994; Vice President and Chief Financial Officer from 1991 to 1994; Vice President and Controller, Microcomputer Components Group from 1990 to 1991; Vice President and Director of Business Development, Microcomputer Components Group during 1990; and Vice President and Director of Business Development, Component Technology and Development Group from 1988 to 1990. ITEM 2. ITEM 2. PROPERTIES At December 25, 1993, Intel owned the major facilities described below: At December 25, 1993, Intel also leased 18 major facilities in the U.S. totaling approximately 1,388,000 square feet and 6 facilities in other countries totaling approximately 169,000 square feet. These leases expire at varying dates through 2002, including renewals at the option of Intel. Intel believes that its existing facilities are suitable and adequate, and the productive capacity in such facilities is in general being utilized. Intel has other facilities available that it can equip to meet future demand as such demand materializes. These include 2.7 million square feet of building space under various stages of construction in the United States and abroad for manufacturing and administration purposes. The Company has plans for an additional 1.3 million square feet of manufacturing building space in the United States. ______________________________ (A) Includes an idle, 131,000 square foot facility formerly utilized for wafer fabrication and administration, that is currently for sale. (B) The lease on a portion of the land used for these facilities expires in 2032. (C) Leases on land expire in 1998, 2002 and 2008. ITEM 3. ITEM 3. LEGAL PROCEEDINGS A. LITIGATION Intel v. Advanced Micro Devices ("AMD") U.S. District Court for the Northern District of California (C90-20237) - Intel287(TM) Copyright Infringement Suit In a letter dated March 23, 1990 from AMD, AMD asserted a right to copy and distribute Intel-copyrighted microcode in an AMD 80287 math coprocessor. In response to the letter, Intel filed a suit on April 23, 1990 in the U.S. District Court for the Northern District of California, alleging that AMD infringed Intel's copyright on the microcode for the Intel287 math coprocessor. In its defense, AMD claimed a license to copy and distribute Intel copyrighted microcode based on a clause in a 1976 patent cross license agreement which gives AMD the right "...To copy microcodes contained in Intel microcomputers and peripheral products sold by Intel." On June 17, 1992, a jury rendered its verdict that AMD did not prove that the 1976 copyright license, which AMD was using as a defense in the case, covered the Intel287 math coprocessor. On April 15, 1993, Judge Ingram granted AMD a new trial in this case. The judge ruled that Intel's failure to disclose and produce a press release and related documents during the discovery phase of the trial was grounds for a new trial. The ruling overturned the jury verdict and a subsequent ruling by Judge Ingram that AMD did not have the right under this agreement to distribute products containing Intel microcode. On March 10, 1994, a second jury found that AMD does have a license to copy microcode in Intel microprocessors and peripheral products. Intel intends to appeal this second verdict as well as ask the court to reinstate the original verdict. If AMD ultimately prevails and maintains the right to copy and distribute Intel microcode (rather than having to develop its own microcode independently), AMD will be able to sell products which more closely imitate Intel products, including microprocessors. Any such right could continue through December 31, 1995. However, AMD is expected to claim that any such microcode right continues beyond termination of the agreement on December 31, 1995. Intel v. Advanced Micro Devices, Inc. ("AMD") U.S. District Court for the Northern District of California (C92-20039, C93-20301) - Intel386(TM)/Intel486(TM) Copyright Infringement Suit On October 9, 1991, Intel filed another copyright infringement suit against AMD in which Intel alleges that AMD copied the Intel386 microcode and a control program which is stored in a programmable logic array. Intel has asked for over $600 million in damages. AMD filed a motion with the court to stay this case pending the outcome of Intel's appeal of an arbitrator's award in a state court action. On October 29, 1992, Judge Patricia Trumbull granted AMD's motion to stay this case pending the outcome of the state court appeal. On December 28, 1993, the Court of Appeals for the Ninth Circuit reversed the stay. AMD has yet to file a petition for certiorari with respect to the Court of Appeals decision. This action has been consolidated with the Intel386 suit against AMD for discovery purposes. These suits cover certain copyright infringement claims on AMD's versions of Intel386 and Intel486 microprocessors and relate to both allegedly copied microcode and what AMD claims are various clean room versions of the microcode, as well as other copyrighted programs. The complaint seeks equitable relief, damages and declaratory relief including interpretation of various contract clauses. A trial on the in-circuit-emulation microcode contained on those products is expected in April 1994. Advanced Micro Devices, Inc. ("AMD") v. Intel Corporation U.S. District Court for the Northern District of California (C91-20541) - Antitrust Suit On August 29, 1991, AMD filed a lawsuit against Intel in the U.S. District Court, Northern District of California. In this lawsuit, AMD alleges that Intel violated the Sherman Act by committing unlawful acts and conspiring with customers and distributors to secure and maintain monopoly positions in microprocessor and math coprocessor markets. AMD seeks $2 billion in actual damages and is requesting treble damages under the antitrust laws. Intel's motion to dismiss a portion of AMD's allegations was granted on December 17, 1991 and AMD's motion for reconsideration of that decision has been denied. Intel's summary judgement motion to dismiss AMD's claim that Intel filed sham litigation was granted on March 4, 1994. A trial date is currently set for October 1994. Intel denies the charges and intends to continue to defend these allegations vigorously. Although the ultimate outcome of these claims cannot be determined at this time, management, including internal counsel, does not believe that the ultimate outcome will have a material adverse effect on Intel's financial condition. B. ENVIRONMENTAL PROCEEDINGS Intel has been named to the California and Federal Superfund lists for three of its sites and has completed, along with two other companies, a Remedial Investigation/Feasibility study with the Federal Environmental Protection Agency (EPA) to evaluate the ground water in areas adjacent to its Mountain View, California site. The EPA has issued a Record of Decision with respect to a groundwater cleanup plan at that site. Under the California and Federal Superfund statutes, liability for cleanup of the Mountain View site and adjacent area is joint and several. The Company has reached agreement in principle with those same two companies which should significantly limit the Company's liabilities under the proposed cleanup plan. The EPA has negotiated a consent decree with Intel and one of the other two companies referenced above which specifies the cleanup activities for which Intel and the other company will be responsible. The EPA has also issued a cleanup order to the third company and seven other companies specifying cleanup activities to be completed by these eight companies which are complementary to those specified in the consent decree. Also, the Company has completed extensive studies at its other sites and is engaged in cleanup at several of these sites. In the opinion of management, including internal counsel, the potential losses to the Company in excess of amounts already accrued arising out of these matters would not have a material adverse effect on the Company's financial position, even if joint and several liability were to be assessed. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Reference is made to the information regarding market, market price range and dividend information appearing under the caption "Financial Information by Quarter (Unaudited)" on page 23 of the Registrant's Annual Report to Stockholders and to the information regarding the stockholders' rights plan appearing on pages 10 and 11 of the Registrant's Annual Report to Stockholders under the caption "Common Stock," which information is hereby incorporated by reference. (b) As of February 26, 1994, there were 38,341 holders of record of the Registrant's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to the information regarding selected financial data for the fiscal years 1989 through 1993, including the related footnotes, under the caption "Financial Summary" on page 20 of the Registrant's Annual Report to Stockholders, which information is hereby incorporated by reference. In addition, the ratios of earnings to fixed charges for each of the five years in the period ended December 25, 1993 are as follows: Fixed charges consist of interest expense and the estimated interest component of rent expense. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to the information appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 21 through 23 of the Registrant's 1993 Annual Report to Stockholders, which information is hereby incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated financial statements of Intel Corporation at December 25, 1993 and December 26, 1992 and for each of the three years in the period ended December 25, 1993 and the Report of Independent Auditors thereon and Intel Corporation's unaudited quarterly financial data for the two year period ended December 25, 1993 are incorporated by reference from the Registrant's 1993 Annual Report to Stockholders, on pages 6 through 23. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to the information regarding Directors and Executive Officers appearing under the caption "Election of Directors" on pages 2 and 3 in the Registrant's Proxy Statement dated March 21, 1994, which information is hereby incorporated by reference, and to the information under the caption "Executive Officers" in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to the information appearing under the captions "Executive Compensation," "Directors' Compensation," and "Compensation Committee Interlocks and Insider Participation," on pages 7 through 10 of the Registrant's Proxy Statement dated March 21, 1994, which information is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to information appearing in the Registrant's Proxy Statement dated March 21, 1994, under the caption "Security Ownership of Certain Beneficial Owners and Management," on pages 12 and 13, which information is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the information appearing under the caption "Certain Relationships and Related Transactions" on page 13 of the Registrant's Proxy Statement dated March 21, 1994, which information is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The financial statements listed in the accompanying index to financial statements and financial statement schedules are filed or incorporated by reference as part of this annual report. 2. Financial Statement Schedules The financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this annual report. 3. Exhibits The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this annual report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the fiscal year covered by this filing. AND FINANCIAL STATEMENT SCHEDULES (ITEM 14 (A)) All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements or notes thereto. The consolidated financial statements listed in the above index which are included in the Registrant's Annual Report to Stockholders are hereby incorporated by reference. With the exception of the pages listed in the above index and the portions of such report referred to in Items 5, 6, 7, and 8 of this Form 10-K, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this report. Page references to the 1993 Annual Report to Stockholders relate to the bound, printed version of the report. INTEL CORPORATION SCHEDULE I - MARKETABLE SECURITIES At December 25, 1993 (In Millions of Dollars) (A) Stated at cost which approximates market. No individual security or group of securities of an issuer exceeds 2% of total assets except for the bonds noted at (C), below. (B) Includes $31 million deposited with Mitsubishi Bank. (C) Includes $278 million in bonds issued by the government of Italy. (D) Includes $44 million issued by Osaka Gas Company. INTEL CORPORATION SCHEDULE II-AMOUNTS RECEIVABLE FROM DIRECTORS, OFFICERS AND EMPLOYEES Year Ended December 25, 1993 (In Thousands of Dollars) (A) Year end balance represents fourteen loans at zero to 7% interest granted to employees, none of whom is an officer or a director. These loans expire at varying dates through 1998 and are secured by real property. During the year ended December 25, 1993, ten loans were granted to employees and twelve were repaid. INTEL CORPORATION SCHEDULE II-AMOUNTS RECEIVABLE FROM DIRECTORS, OFFICERS AND EMPLOYEES Year Ended December 26, 1992 (In Thousands of Dollars) (B) Year end balance represents sixteen loans at zero to 7% interest granted to employees, none of whom is an officer or a director. These loans expire at varying dates through 1997 and are secured by real property. During the year ended December 26, 1992, five loans were granted to employees and eight were repaid. INTEL CORPORATION SCHEDULE II-AMOUNTS RECEIVABLE FROM DIRECTORS, OFFICERS AND EMPLOYEES Year Ended December 28, 1991 (In Thousands of Dollars) (C) Year end balance represents nineteen loans at zero to 7% interest granted to employees, none of whom is an officer or a director. These loans expire at varying dates through 1997 and are secured by real property. During the year ended December 28, 1991, eleven loans were granted to employees and seven were repaid. (D) Amounts Receivable from Officers includes only amounts outstanding during service as an executive officer; at other times, balances are classified as Amounts Receivable from Employees. INTEL CORPORATION SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 28, 1991, December 26, 1992 and December 25, 1993 (In Millions of Dollars) Annual depreciation and amortization provisions have been computed based upon the following estimated lives: Buildings and Improvements . . . . . . . . . . . . 8 to 45 years Machinery and Equipment. . . . . . . . . . . . . . 2 to 4 years INTEL CORPORATION SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 28, 1991, December 26, 1992 and December 25, 1993 (In Millions of Dollars) INTEL CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 28, 1991, December 26, 1992 and December 25, 1993 (In Millions of Dollars) (A) Uncollectible accounts written off, net of recoveries. INTEL CORPORATION SCHEDULE IX - SHORT-TERM BORROWINGS Years Ended December 28, 1991, December 26, 1992 and December 25, 1993 (In Millions of Dollars) Short-term borrowings from banks at December 28, 1991 includes $121 million borrowed under foreign and domestic lines of credit and $43 million borrowed under other arrangements. Short-term borrowings from banks at December 26, 1992 includes $126 million borrowed under foreign and domestic lines of credit and $67 million borrowed under other arrangements. The year-end interest rate on bank borrowings is high due to a foreign currency borrowing of $32 million at an average rate of 34.2% to hedge certain net assets in that currency. Short-term borrowings at December 25, 1993 includes $85 million borrowed under foreign and domestic lines of credit, $197 million borrowed under reverse repurchase agreements, and $115 million borrowed under other arrangements. The weighted average interest rate during the year equals interest expense divided by average borrowings outstanding. Average borrowings outstanding is calculated on the basis of daily balances. INTEL CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 28, 1991, December 26, 1992 and December 25, 1993 (In Millions of Dollars) Items omitted if less than one percent of total revenues or separately reported in financial statements in Registrant's Annual Report to Stockholders. INDEX TO EXHIBITS (Item 14 (a)) Description 3.1 Intel Corporation Certificate of Incorporation (incorporated by reference to Exhibit 3.1 of Registrant's Form 10-Q for the quarter ended June 26, 1993 (Commission File No. 0-6217) as filed on August 10, 1993). 3.2 Intel Corporation Bylaws as amended, (incorporated by reference to Exhibit 3.2 of Registrant's Registration Statement on Form 10-Q for the quarter ended September 25, 1993 (Commission File No. 0-6217) as filed on November 9, 1993). 4.1 Agreement to Provide Instruments Defining the Rights of Security Holders (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 28, 1986). 4.2 Indenture dated as of May 1, 1985 among Intel Overseas Corporation, Intel Corporation and Wachovia Bank Trust Company N.A. related to $236,500,000 principal amount of zero coupon notes due 1995 issued by Intel Overseas Corporation and guaranteed by Intel Corporation (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-Q for the quarter ended June 29, 1985 (Commission File No. 0-6217) as filed on August 13, 1985). 4.3 Rights Agreement dated as of May 1, 1989, as amended between the Registrant and Harris Trust and Savings Bank (as successor Rights Agent), together with Exhibit A, the form of Rights Certificate to be distributed on the Distribution Date (incorporated by reference to Exhibit 1 or Registrant's Form 8-A (Commission File No. 0-6217) as filed on May 3, 1989), together with the First Amendment to Rights Agreement dated as of January 17, 1994 and Amendment No. 2 to Rights Agreement dated as of January 20, 1994. 4.4 Warrant Agreement dated as of March 1, 1993, as amended between the Registrant and Harris Trust and Savings Bank (as successor Warrant Agent) related to the issuance of 1998 Step-Up Warrants to purchase Common Stock of Intel Corporation (incorporated by reference to Exhibit 4.6 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 25, 1993), together with the First Amendment to Warrant Agreement dated as of October 18, 1993 and the Second Amendment to Warrant Agreement dated as of January 17, 1994. 10.1 Intel Corporation 1979 Stock Option Plan as amended (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 28, 1990). 10.2 Intel Corporation 1984 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-Q for the quarter ended June 26, 1993 (Commission File No. 0-6217) as filed on August 10, 1993). 10.3 Intel Corporation Profit-Sharing Retirement Plan dated April 20, 1990 as amended and restated effective January 1, 1989 (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 26, 1992). 10.4 Second Amendment dated March 2, 1992 to Intel Corporation Profit-Sharing Retirement Plan dated April 20, 1990 as amended and restated effective January 1, 1989 (incorporated by reference to Exhibit 10.4 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 26, 1993). 10.5 Intel Corporation Defined Benefit Pension Plan and Trust dated September 7, 1988 as amended (incorporated by reference to Exhibit 10.5 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 28, 1990). 10.6 Intel Corporation 1988 Executive Long Term Stock Option Plan as amended (incorporated by reference to Exhibit 10.6 of Form 10-Q for the quarter ended June 26, 1993 (Commission File No. 0-6217) as filed on August 10, 1993). 10.7 Intel Corporation Sheltered Employee Retirement Plan Plus dated December 1, 1991 (incorporated by reference to Exhibit 10.6 of Registrant's Form 10-K (Commission File No. 0-6217) as filed on March 26, 1992). 10.8 Intel Corporation Executive Officer Bonus Plan dated January 1, 1994. 11.1 Computation of Per Share Earnings. 12.1 Statement Setting Forth the Computation of Ratios of Earnings to Fixed Charges. 13. Portions of the Annual Report to Stockholders for fiscal year ended December 25, 1993 expressly incorporated by reference herein. 21. Intel Subsidiaries. 23. Consent of Ernst & Young, Independent Auditors. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. INTEL CORPORATION Registrant By /s/ F. Thomas Dunlap, Jr. F. Thomas Dunlap, Jr. Vice President and Secretary March 22, 1994 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. GRAPHICS APPENDIX LIST* * In this Appendix, the following descriptions of graphs on pages 21 and 22 of the Company's 1993 Annual Report to Stockholders that are omitted from the EDGAR text are more specific with respect to the actual amounts and percentages than can be determined from the graphs themselves. The Company submits such more specific descriptions only for the purpose of complying with EDGAR requirements for transmitting this Annual Report on Form 10-K; such more specific descriptions are not intended in any way to provide information that is additional to that otherwise provided in the 1993 Annual Report to Stockholders. REVENUES AND INCOME (Dollars in millions) COSTS AND EXPENSES (Percent of revenues) OTHER INCOME AND EXPENSE (Dollars in millions) CASH AND INVESTMENTS (Dollars in billions)	7,358	48,623
85153_1993.txt	85153_1993	1993	85153	Item 1. Business. Roseville Telephone Company (the "Company"), incorporated under the laws of the State of California in 1914, is engaged in the business of furnishing communications services, mainly local and toll telephone service and network access services, in a territory covering approximately 83 square miles in Placer and Sacramento Counties, California. Toll service to points outside the Company's own area is furnished through connection at Roseville with facilities of Pacific Bell, AT&T, and other interexchange carriers. The City of Roseville, which is centrally located in the Company's service area, is 18 miles northeast of Sacramento. During recent years, including the year ended December 31, 1993, the area served by the Company has experienced both land subdividing activity for home building purposes and significant commercial and industrial development. The Company continues to be engaged in the expansion of its facilities and operations to meet current and anticipated service demand increases and to maintain modern and efficient service. Currently, no other telephone company operates in the area served by the Company. However, the Company's future operations may be impacted by several proceedings pending before the Public Utilities Commission of the State of California (the "P.U.C.") which are considering whether certain services presently provided solely by the Company within its "Local Access Transport Area" ("LATA") should be opened to competition. See "Item 3 - Legal Proceedings" and "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company, with a 23.5% equity interest, is one of four limited partners of Sacramento-Valley Limited Partnership (the "Partnership"), a California limited partnership formed for the construction and operation of a cellular mobile radiotelephone system, which now operates in the following Standard Metropolitan Statistical Areas ("SMSA"): Sacramento Reno Stockton Yuba City - Marysville Modesto Redding - Chico In addition, the Partnership also operates in the Tehama, Sierra and Storey (Carson City) Rural Statistical Areas ("RSA"). PacTel Cellular, a wholly owned subsidiary of the Pacific Telesis Group, is the sole general partner of the Partnership and responsible for the construction, operation, maintenance and marketing of the cellular mobile radiotelephone system. In each SMSA and RSA, the Federal Communications Commission (the "F.C.C.") has granted or will grant one license to provide cellular services to a wireline carrier and one license to a non-wireline carrier. The Partnership is the wireline carrier licensee for each SMSA and RSA in which it operates and competes with the non-wireline licensee in each of those areas. The table that follows reflects the percentage amounts of operating revenues of the Company contributed by various services, excluding income from the Partnership. Network Access and Local Telephone Long Distance Year Service Service Miscellaneous ---- ------- ------- ------------- 1993 38.1% 46.8% 15.1% 1992 35.9% 49.1% 15.0% 1991 33.0% 53.3% 13.7% 1990 34.5% 51.7% 13.8% 1989 34.5% 50.0% 15.5% As indicated above, revenues from local, network access and long distance services constituted approximately 85% of the Company's total operating revenues in 1993. Miscellaneous operating revenues include primarily revenues from billing and collection services and directory advertising services, in addition to revenues from nonregulated activities. Nonregulated revenues are derived from the sale, lease and maintenance of telecommunications equipment, and the provision of alarm monitoring and paging services. Revenues from telephone service are affected by rates authorized by various regulatory agencies. The Company's local service rates are subject to regulation by the P.U.C. As discussed more fully in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations", the Company completed negotiations with Pacific Bell concerning new compensation agreements, the effects of which were first realized in 1992, that affected extended area service settlements and a significant portion of network access and long distance revenues. With respect to calls terminating outside the Company's LATA, access charges to interexchange carriers are assessed based on tariffs filed by Pacific Bell for intrastate services. With respect to interstate services, the Company has filed its own tariff with the F.C.C. for all elements of access except carrier common line charges, with respect to which the Company concurs with tariffs filed by the National Exchange Carrier Association. Extensive cost separation studies are utilized to determine both the final settlements and access charges. Substantially all of the Company's revenues were from communications and related services. As discussed more fully in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations", approximately 36% and 34% of the Company's consolidated operating revenues in 1993 and 1992, respectively, were derived from access charges and charges for other services to, and transition contract payments from Pacific Bell pursuant to certain agreements (such amounts represented less than 10% of the Company's consolidated operating revenues in 1991). Approximately 10%, 10% and 11% of the Company's consolidated operating revenues in 1993, 1992 and 1991, respectively, were derived from the provision of services to AT&T. The revenues from services provided to AT&T were received primarily from access charges, but also included revenues from the provision of operator, billing and collection, and other interexchange services. No other customers accounted for more than 10% of consolidated operating revenues. In addition to its regulatory authority with respect to rates, the P.U.C. also has the power, among other things, to establish the terms and conditions of service, to regulate securities issues, to prescribe uniform systems of accounts to be kept by public utilities and to regulate the mortgaging or disposition of public utility properties. The Company uses public streets and highways in the conduct of its public utility telephone business under a non-exclusive perpetual franchise granted by Section 7901 of the California Public Utilities Code. At December 31, 1993, the Company employed 463 persons, none of whom is represented by any union. Item 2. Item 2. Properties. The Company owns central office buildings and related equipment in Roseville, Citrus Heights, Granite Bay, and other locations in Placer County, and completed construction of a new 135,000 square foot operations facility in November 1993. The Company's 68,000 square foot principal business office and administrative headquarters is located in Roseville. Other land is held for future expansion. The Company has appropriate easements, rights of way and other arrangements for the accommodation of its pole lines and underground conduits and for its aerial and underground cables and wires. In addition to land and structures, the Company's property consists of equipment required in providing telephone service. This includes central office equipment, customer premises equipment and connections, radio antennas, pole lines, aerial and underground cable and wire facilities, vehicles, furniture and fixtures and other equipment. The Company also owns certain other communications equipment held as inventory for sale or lease. In addition to plant and equipment that the Company wholly owns, the Company utilizes poles and conduit systems wholly owned by, or jointly owned with, other utilities and leases space on facilities wholly or jointly owned by the Company to other utilities. These arrangements are in accordance with written agreements customary in the industry. The Partnership owns certain equipment used in the provision of cellular mobile radiotelephone services. Item 3. Item 3. Legal Proceedings. Except for the proceedings described below the Company is not aware of any material pending legal proceedings, other than ordinary routine litigation incidental to its business, to which it is a party or to which any of its property is subject. As appears in Item 1, above, the Company is subject to regulation by the F.C.C. and P.U.C. In the past there have been various proceedings before these agencies to which the Company has been a party. Reference is made to Item 1 for further information regarding the nature of the jurisdiction of the F.C.C. and P.U.C. over the business and operations of the Company. The regulatory proceedings discussed below relate to matters which may effect the Company prospectively and are not expected to effect the Company's 1993 financial statements. In March 1985, the P.U.C. commenced an investigation into the "rates, tolls, rules, charges, operations, costs, separations, intercompany settlements, contracts, service and facilities of the operations of independent telephone companies" (I. 85-03-078), and consolidated this investigation with Application No. 85-01-034 of Pacific Bell. In connection with the application, the P.U.C. issued an interim rate design effective in 1988 for Pacific Bell which resulted in a local rate increase for the Company and a decrease in settled toll revenues. The P.U.C. has stated that it will order a final rate design during 1994, in conjunction with I. 87-11-033 discussed below, which could have a material impact on the sources and amount of the Company's revenues. The P.U.C. has instituted an investigation (I. 87-11-033) into the manner in which it regulates local exchange carriers, including the Company. In the course of this investigation, it will consider whether certain services presently provided solely by the Company within its LATA should be open to competition. In the course of this current proceeding the Company has proposed adjustments to its rates that would maintain revenues at their present level, while the P.U.C. staff has proposed a revenue reduction of approximately $6 million. A July 1991 decision of the P.U.C. ordered a phase-down of settlement pool payments after January 1, 1993. The Company completed negotiations and has entered into new agreements with Pacific Bell to replace these settlement procedures effective as of January 1, 1992. In addition, the July 1991 decision expressed the Commission's expectation that the Company will file a general rate proceeding, including a request for regulation under the new incentive-based regulatory framework. As a result of delays in issuing a final order, the Company expects to submit a test year 1995 general rate case application during calendar year 1994. In April 1993, the P.U.C. opened an investigation and rulemaking proceeding (R. 93-04-003) to establish rules that will provide non-discriminatory access by competing service providers to the network capabilities of local exchange carriers. The P.U.C. proposed applying these rules to the five largest local exchange carriers in California, including the Company. In connection with this proceeding, the P.U.C. issued a further order in August 1993 proposing additional rules to allow broader competition in the provision of specific special access and switched transport services. The Company has filed comments and expects a decision during 1994. In November 1993, the P.U.C. issued a report to the Governor of the State of California in which it proposed opening all markets to competition by January 1, 1997. Specifically, the P.U.C. proposed streamlining regulation and eliminating all remaining legal barriers to competition for telecommunications services in order to accelerate the pace of innovation in the California telecommunications marketplace. There are a number of regulatory proceedings occurring at the federal level that may have a material impact on the Company. These regulatory proceedings include, but are not limited to, implementation of revised separations procedures that shift revenue requirements and costs between interstate and intrastate jurisdictions and implementation of revised procedures to allocate costs between regulated and non-regulated operations. In addition, the F.C.C. periodically establishes the authorized rate of return for interstate access services, which in 1994 will remain at the 1993 rate of 11.25%. In September 1992, the F.C.C. issued an order, which is currently under appeal, granting to competitors expanded interconnection rights to the facilities of local exchange carriers with annual revenues from regulated operations in excess of $100 million. While not yet applicable to the Company, this order will permit competitors to terminate their own facilities in telephone company central offices to which the order applies. In addition, the F.C.C. initiated a separate notice of proposed rulemaking establishing a two-phased proceeding to modify interstate access rate structures to further competition in the provision of interstate services. These two proceedings may broaden the scope of competition in the provision of interstate services, the effects of which on the Company cannot yet be determined. The Company is subject to certain legal proceedings and claims arising in the ordinary course of its business. In the opinion of management, any liability which may ultimately be incurred with respect to these matters will not materially affect the consolidated financial position or results of operations of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages and positions of the executive officers of the Company as of March 14, 1994 are as follows: Name Age Office Robert L. Doyle(1) 75 Chairman of the Board; President and Chief Executive Officer from 1954 to Brian H. Strom 51 President and Chief Executive Officer (since December 1993); Vice President and Chief Financial Officer from 1989 to 1993 A. A. Johnson 72 Executive Vice President and Chief Operating Officer (since December 1993); Vice President-Operations from 1989 to 1993 Thomas E. Doyle(1) 65 Vice President (since 1972) and Secretary-Treasurer (since 1965) Michael D. Campbell 45 Vice President and Chief Financial Officer (since March 1994); Partner, Ernst & Young, from 1983 to 1994. (1) Robert L. Doyle and Thomas E. Doyle are brothers. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Common Stock of the Company trades principally in local transactions without the benefit of an established public trading market. As a result of the minimal number of stock transactions, the Company's information with respect to price per share is derived from reports provided by the Company's Retirement Supplement Plan and disclosure, in limited circumstances, of third party transactions. Retirement Supplement Plan transactions in the Company's Common Stock were effected at approximately $22 per share in all quarters of 1992 through January 1993, approximately $23 per share from the balance of the first quarter through the beginning of the fourth quarter of 1993 and approximately $24 per share thereafter. As of February 28, 1994, the approximate number of holders of the Company's Common Stock was 9,500. The Company pays quarterly cash dividends on its Common Stock. The Company paid cash dividends of $.15 per share for each quarter during 1992 and 1993. Item 6. Item 6. Selected Financial Data. 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (Dollars in thousands, except per share amounts) Total operating revenues $ 96,780 $ 92,280 $ 88,461 $ 73,629 $ 61,293 Net income $ 22,518 $ 21,816 $ 19,940 $ 16,830 $ 14,740 Net income per share of common stock (1) $ 1.68 $ 1.63 $ 1.49 $ 1.26 $ 1.14 Cash dividends per share of common stock (1) $ .58 $ .55 $ .53 $ .50 $ .40 Property, plant and equipment, at cost $ 228,927 $ 203,379 $ 181,552 $ 159,880 $144,001 Total assets (2) $ 226,459 $ 190,760 $ 165,380 $ 143,264 $131,268 Long-term debt $ 40,000 $ 25,000 $ 13,270 $ 5,590 $ 6,400 Shares of common stock used to calculate per share data (1) 13,399,194 13,399,194 13,399,194 13,399,194 12,940,861 (1)Shares used in the computation of net income and cash dividends per share of common stock are based on the weighted average number of shares outstanding in each period after giving retroactive effect to 5% stock dividends issued in 1993, 1992, 1991 and 1990. (2)The 1989 through 1992 total asset amounts have been conformed to the presentation of the 1993 amount. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Results of Operations 1993 versus 1992 Operating Revenues: In years prior to 1992, a significant portion of the Company's network access and long distance service revenues, as well as certain portions of local service revenues, resulted from the Company's participation in pooling and settlement arrangements. Such arrangements are processes whereby amounts billed by local exchange carriers are reported to the pool and ultimately divided among the pool participants on the basis of a pool-wide rate of return. Beginning in 1992, there was a significant shift in the sources of these revenues as a result of the Company's tentative agreements with Pacific Bell (the "Pacific Bell Agreements"), effective concurrently with the Company's exit from the intrastate settlement pools. Of the Company's total revenues in 1993 and 1992, 36% and 34%, respectively, was recorded under these tentative agreements. Definitive agreements were executed in February 1994 and had no significant effect on revenues recorded in 1993 and 1992 under the tentative agreements. In addition, certain billings to interexchange carriers previously reported to and divided by the pool are now retained by the Company. Under the Pacific Bell Agreements, the Company billed Pacific Bell various charges in connection with the provision of services within the Company's Local Access Transport Area, one of ten in California. In addition, as a result of the Pacific Bell Agreements the Company recognized transition revenues of $16.5 million and $15 million in 1993 and 1992, respectively, which will be reduced over an approximate six year period, commencing in a year to be determined by future regulatory developments, and ultimately eliminated. To avoid potential adverse effects on future results of operations, the Company must either seek adjustments to tariffed rates for services, increase productivity or both. Local service revenues increased approximately $3.8 million, or 11% over 1992. Of the total increase, approximately $2.3 million was related to an increase in extended area service revenues recognized under the Pacific Bell Agreements discussed above. In addition, local service revenues were positively affected by a 5% growth in access lines and increased revenues associated with custom calling and enhanced network services. Network access and long distance revenues result from charges assessed to carriers and end users for use of the local exchange network and from transition revenues described above. In 1993, network access revenues increased slightly to $37.5 million, reflecting growth in minutes of use volumes and higher interstate settlements from the National Exchange Carrier Association. Positive settlement adjustments which were recorded in 1992 and did not reoccur in 1993 reduced the effect of this increase and also caused a decrease in long distance revenues. Long distance revenues, comprised largely of transition revenues from Pacific Bell, decreased $727,000 to $7.8 million. Operating Expenses: Operating expenses in 1993 increased approximately $5.1 million or 9% compared to 1992. The increase in operating expenses was due primarily to a combination of 1) software purchases and improvements in the Company's data systems to implement movement from a mainframe platform to a client/server platform and to implement a wide area network, 2) higher costs associated with the Company's numerous regulatory proceedings, 3) higher pension costs resulting from changes in actuarial assumptions, 4) normal inflationary factors, and 5) increased costs associated with serving a larger number of access lines. Depreciation expense increased as a result of increased plant levels. Other Income (Expense): Other income, which consists primarily of income attributable to the Company's interest in Sacramento-Valley Limited Partnership, interest income from cash equivalents and short-term investments and allowance for funds used during construction (AFUDC), increased $2.4 million over 1992, due primarily to improved results of operations of the partnership and a significant increase in AFUDC due to the construction of the Company's new Industrial Avenue facility. Other expense consists primarily of interest expense arising from the $25,000,000 long-term debt facility obtained in March 1992 and the $15,000,000 facility obtained in November 1993. Total interest expense was approximately $2.2 million compared to $2.1 million in 1992 resulting from a combination of slightly increased average borrowings offset by lower interest rates. Income Taxes: Income tax expense for 1993 increased approximately $932,000 due to the increase in income subject to tax and an increase in the effective tax rate resulting from the implementation of the Revenue Reconciliation Act of 1993 which retroactively increased the corporate federal income tax rate to 35% beginning January 1, 1993. The effective federal and state income tax rate was 40.6% compared to 39.9% in 1992. 1992 versus 1991 Operating Revenues: The Pacific Bell Agreements, effective beginning in 1992, as previously discussed, significantly affected the comparability of certain revenue categories between 1992 and 1991. Local service revenues increased approximately $3.9 million, or 13% over 1991. Of this total increase, $2.0 million was due to increased extended area service revenues recognized under the Pacific Bell Agreements. Additionally, local service revenues were positively affected by a 4% growth in access lines and increased custom calling and enhanced network service revenues. In 1992, long distance service revenues resulted primarily from transition revenues. In the aggregate, network access and long distance service revenues decreased $1.8 million or 4%. In 1991, the Company received approximately $4 million from the California High Cost Fund ("CHCF"), and did not request CHCF support for 1992. This decrease was partially offset by an increase in interstate switched access revenues due to increases in minutes of use volumes and in tariffed rates, and higher settlements from the National Exchange Carrier Association. The remaining increase in network access revenues and the remaining decrease in long distance service revenues was due to the shift in the sources of these revenues as described above. Operating Expenses: Total operating expenses in 1992 remained at essentially the same level as in 1991. The cost of services and products decreased by $1.6 million primarily due to decreases in network software expense and the cost of sales associated with lower nonregulated equipment sales volumes. Depreciation expense increased by $1.5 million due to an increase in average plant in service. General and administrative expenses decreased due to the incurrence of nonrecurring information management expenses in 1991. Other Income (Expense): Other income (expense), net increased approximately $973,000 over 1991, due primarily to an increase in interest expense of $1.1 million as a result of the Company's incurrence of $25 million in long-term indebtedness in March 1992 for major construction projects and general corporate purposes. Income Taxes: Income tax expense for 1992 increased approximately $1.2 million due principally to the increase in income subject to tax. The effective federal and state income tax rate was 39.9% in both 1992 and 1991. Liquidity and Capital Resources As reflected in the Consolidated Statements of Cash Flows, the Company's operations continue to provide positive cash flows. Net cash provided by operating activities amounted to $36.6 million, $31.4 million and $33.2 million in 1993, 1992 and 1991, respectively. The increase in 1993 was due primarily to increases in net income, payables, accrued liabilities and other deferred credits. During 1993, the Company utilized cash flows from operations and existing cash and cash equivalents to fund capital expenditures in the amount of $35.5 million and cash dividends of $7.8 million. Capital expenditures were larger in 1993 than the $22.6 million in 1992 and the $25.9 million in 1991 due to the completion in 1993 of the new Industrial Avenue facility. In February 1992, the Company received authority from the P.U.C. to issue and sell up to an aggregate $40 million of its long-term notes. The Company issued the initial $25 million in March 1992, and the remaining $15 million in November 1993. The Company's most significant use of funds in 1994 is expected to be for budgeted capital expenditures of approximately $21.5 million for central office equipment and cable and wire facilities. It is anticipated that the Company's capital requirements in 1994 will be met from cash flows from operations and existing cash, cash equivalents and short-term investments. The Company does not presently anticipate that it will commence any securities offerings in 1994. Inflation While the Company is not immune from increased costs brought on by inflation and regulatory requirements, the impact of such items on the Company's operations and financial condition depends partly on results of future rate cases and the extent to which increased rates can be translated into improved earnings. Regulatory Matters The Company's financial condition is and continues to be affected by recent and future proceedings by the P.U.C. Pending before the P.U.C. are proceedings which are considering: Broad competition for the first time within the Company's LATA with regard to IntraLATA toll Rate design proposals by all California local exchange carriers to revise toll, access, private line and basic exchange rates Rules that will provide non-discriminatory access by competing service providers to the network capabilities of local exchange carriers Rules that will allow non-discriminatory open access to the local exchange company's central office and authorize broader competition for intrastate switched transport services The P.U.C. has expressed its expectation that the Company will file an application for a general rate proceeding and its election under the new incentive-based regulatory framework for telephone utilities. The Company anticipates submitting a test year 1995 general rate case application during calendar year 1994. The potential future impact of this proceeding can not be determined. In November 1993, the P.U.C. issued a report to the Governor of the State of California in which it proposes to open all markets to competition by January 1, 1997 and aggressively streamline regulation to accelerate the pace of innovation in the California telecommunications marketplace. The P.U.C. plans to consider these proposals in future proceedings. The Company believes it meets the criteria of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" ("SFAS No. 71"), which requires the Company to give effect in its financial statements to certain actions of regulators. Accordingly, the Company's consolidated financial statements have been prepared on that basis. As a result of increasing competition and rapid changes in the telecommunications industry, the Company periodically monitors whether it continues to meet the criteria which require the use of SFAS No. 71. In the future, should the Company determine it no longer meets the SFAS No. 71 criteria, a material, extraordinary, noncash charge would result. Item 8. Item 8. Financial Statements and Supplementary Data. Page Report of independent auditors Consolidated balance sheets as of December 31, 1993 and 1992 Consolidated statements of income for each of the three years in the period ended December 31, 1993 Consolidated statements of shareholders' equity for each of the three years in the period ended December 31, 1993 Consolidated statements of cash flows for each of the three years in the period ended December 31, 1993 Notes to consolidated financial statements REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Roseville Telephone Company We have audited the accompanying consolidated balance sheets of Roseville Telephone Company as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Roseville Telephone Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Sacramento, California February 25, 1994 ROSEVILLE TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------ ------ ----- Current assets: Cash and cash equivalents $ 9,847,000 $ 11,200,000 Short-term investments 8,920,000 - Accounts receivable (less allowances of $47,000 and $94,000, respectively) 16,109,000 15,017,000 Refundable income taxes 944,000 - Inventories 1,115,000 860,000 Deferred income tax asset 1,129,000 1,029,000 Prepaid pension cost - 824,000 Prepaid expenses and other current assets 434,000 456,000 ------------ ------------ Total current assets 38,498,000 29,386,000 Property, plant and equipment: In service 226,170,000 189,447,000 Under construction 2,757,000 13,932,000 ------------ ------------ 228,927,000 203,379,000 Less accumulated depreciation 60,356,000 58,694,000 ------------ ------------ 168,571,000 144,685,000 Investments and other assets: Cellular partnership 17,327,000 15,771,000 Deferred charges and other assets 2,063,000 918,000 ------------ ------------ 19,390,000 16,689,000 ------------ ------------ $226,459,000 $190,760,000 ============ ============ See accompanying notes. ROSEVILLE TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS (CONTINUED) December 31, 1993 and 1992 LIABILITIES AND SHAREHOLDERS' EQUITY 1993 1992 ------------------------------------ ---- ---- Current liabilities: Accounts payable and other accrued liabilities $ 7,908,000 $4,777,000 Net payables to telecommunications entities 6,569,000 7,531,000 Advance billings and customer deposits 1,375,000 1,394,000 Accrued income taxes - 52,000 Accrued pension cost 603,000 - Accrued compensation 2,688,000 2,398,000 ------------ ------------ Total current liabilities 19,143,000 16,152,000 Long-term debt 40,000,000 25,000,000 Commitments and contingencies (Notes 1 and 5) Deferred credits and other liabilities: Deferred income taxes 20,071,000 18,225,000 Deferred investment tax credits 885,000 1,103,000 Other 3,439,000 2,121,000 ------------ ------------ 24,395,000 21,449,000 Shareholders' equity: Common stock, without par value; 20,000,000 shares authorized, 13,399,194 shares issued and outstanding (12,765,141 shares in 1992) 130,287,000 115,704,000 Retained earnings 12,634,000 12,455,000 ------------ ------------ Total shareholders' equity 142,921,000 128,159,000 ------------ ------------ $226,459,000 $190,760,000 ============ ============ See accompanying notes. ROSEVILLE TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ---- ---- ---- Operating revenues: Local service $36,883,000 $33,108,000 $29,173,000 Network access service 37,466,000 36,807,000 31,587,000 Long distance service 7,781,000 8,508,000 15,539,000 Directory advertising 6,085,000 5,592,000 4,755,000 Other 8,565,000 8,265,000 7,407,000 ------------ ------------ ----------- Total operating revenues 96,780,000 92,280,000 88,461,000 Operating expenses: Cost of services and products 23,138,000 21,454,000 23,063,000 Depreciation 12,453,000 12,249,000 10,725,000 Customer operations 10,717,000 9,533,000 9,208,000 General and administrative 11,951,000 9,947,000 10,450,000 Other 1,571,000 1,575,000 1,555,000 ------------ ------------ ------------ Total operating expenses 59,830,000 54,758,000 55,001,000 ------------ ------------ ------------ Income from operations 36,950,000 37,522,000 33,460,000 Other income (expense): Interest income 285,000 403,000 59,000 Interest expense (2,220,000) (2,056,000) (992,000) Equity in earnings of cellular partnership 1,579,000 66,000 484,000 Allowance for funds used during construction 1,356,000 393,000 315,000 Other, net (48,000) (60,000) (147,000) ------------ ------------ ------------ Total other income (expense), net 952,000 (1,254,000) (281,000) ------------ ------------ ------------ Income before income taxes 37,902,000 36,268,000 33,179,000 Income taxes 15,384,000 14,452,000 13,239,000 ------------ ------------ ----------- Net income $22,518,000 $21,816,000 $19,940,000 ============ ============ =========== Per share of common stock: Net income $1.68 $1.63 $1.49 ===== ===== ===== Cash dividends $ .58 $ .55 $ .53 ===== ===== ===== Shares of common stock used to calculate per share data 13,399,194 13,399,194 13,399,194 ============ ============ =========== See accompanying notes. ROSEVILLE TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years ended December 31, 1993, 1992 and 1991 Common Stock ------------------------- Number of Retained Shares Amount earnings Total ------------ ------------ ------------ ------------ Balance at December 31, 1990 11,586,000 $89,763,000 $11,068,000 $100,831,000 5% stock dividend, at fair value: Shares 575,251 12,655,000 (12,655,000) - Cash in lieu of fractional shares - - (89,000) (89,000) Cash dividends - - (6,952,000) (6,952,000) Net income - - 19,940,000 19,940,000 ------------ ------------ ------------ ------------ Balance at December 31, 1991 12,161,251 102,418,000 11,312,000 113,730,000 5% stock dividend, at fair value: Shares 603,890 13,286,000 (13,286,000) - Cash in lieu of fractional shares - - (91,000) (91,000) Cash dividends - - (7,296,000) (7,296,000) Net income - - 21,816,000 21,816,000 ----------- ------------ ------------ ------------ Balance at December 31, 1992 12,765,141 115,704,000 12,455,000 128,159,000 5% stock dividend, at fair value: Shares 634,053 14,583,000 (14,583,000) - Cash in lieu of fractional shares - - (97,000) (97,000) Cash dividends - - (7,659,000) (7,659,000) Net income - - 22,518,000 22,518,000 ----------- ------------ ------------ ------------ Balance at December 31, 1993 13,399,194 $130,287,000 $12,634,000 $142,921,000 =========== ============ ============ ============ See accompanying notes. ROSEVILLE TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 Increase (Decrease) in Cash and Cash Equivalents 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net income $22,518,000 $21,816,000 $19,940,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 12,453,000 12,249,000 10,725,000 Equity component of allowance for funds used during construction (976,000) (322,000) (277,000) Amortization of investment tax credits (218,000) (217,000) (222,000) Provision for deferred income taxes 2,743,000 2,912,000 1,625,000 Equity in earnings of cellular partnership (1,579,000) (66,000) (484,000) Other, net 121,000 105,000 219,000 Net changes in: Accounts receivable, net (1,092,000) (2,401,000) (1,132,000) Refundable income taxes (944,000) - - Inventories, prepaid expenses and other current assets 591,000 756,000 (1,468,000) Payables, accrued liabilities and other deferred credits 3,082,000 (2,320,000) 3,734,000 Accrued income taxes (52,000) (1,134,000) 586,000 ----------- ----------- ----------- Net cash provided by operating activities 36,647,000 31,378,000 33,246,000 Cash flows from investing activities: Capital expenditures for property, plant and equipment (35,484,000) (22,588,000) (25,865,000) Purchases of short-term investments (8,920,000) - - Investment in cellular partnership (1,387,000) (1,721,000) (4,218,000) Return of investment in cellular partnership 1,410,000 - - Other, net (863,000) (402,000) 152,000 ----------- ------------ ----------- Net cash used in investing activities (45,244,000) (24,711,000) (29,931,000) See accompanying notes. ROSEVILLE TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years ended December 31, 1993, 1992 and 1991 Increase (Decrease) in Cash and Cash Equivalents 1993 1992 1991 ---- ---- ---- Cash flows from financing activities: Proceeds of short-term borrowings - - 4,550,000 Proceeds of long-term debt 15,000,000 25,000,000 - Principal payments of long-term debt - (13,270,000) (1,180,000) Dividends paid and fractional share amounts (7,756,000) (7,387,000) (7,041,000) ----------- ----------- ----------- Net cash provided by (used in) financing activities 7,244,000 4,343,000 (3,671,000) Increase (decrease) in cash and cash equivalents (1,353,000) 11,010,000 (356,000) Cash and cash equivalents at beginning of year 11,200,000 190,000 546,000 ----------- ----------- ---------- Cash and cash equivalents at end of year $9,847,000 $11,200,000 $ 190,000 =========== =========== ========== See accompanying notes. ROSEVILLE TELEPHONE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business and basis of accounting Roseville Telephone Company (the "Company") is engaged in the business of furnishing communications and related services principally within its service area in Northern California. The Company maintains its accounts in accordance with the Uniform System of Accounts prescribed for telephone companies by the Federal Communications Commission (the "F.C.C"). The Company believes it meets the criteria of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" ("SFAS No. 71"), which requires the Company to give effect in its financial statements to certain actions of regulators. Accordingly, the Company's consolidated financial statements have been prepared on that basis. As a result of increasing competition and rapid changes in the telecommunications industry, the Company periodically monitors whether it continues to meet the criteria which require the use of SFAS No. 71. In the future, should the Company determine it no longer meets the SFAS No. 71 criteria, a material, extraordinary, noncash charge would result. The Company engages in nonregulated activities through its RCC Communications division ("RCC"). Products and services provided by RCC include the sale, lease and maintenance of telecommunications equipment, and the provision of alarm monitoring and paging services. Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. All significant intercompany transactions have been eliminated. The Company's 23.5% interest in the Sacramento- Valley Limited Partnership is accounted for using the equity method. The Company's portion of undistributed earnings of this partnership included in the Company's consolidated retained earnings at December 31, 1993 amounted to approximately $3,075,000. Cash equivalents and short-term investments The Company invests its excess cash in various investment grade, short- term, interest-bearing investments. As of December 31, 1993, cash equivalents and short-term investments consist of an interest-bearing cash account and commercial paper. The Company has not experienced any losses on such investments. For purposes of reporting cash flows, the Company considers highly liquid investments with original maturities of three months or less as cash equivalents. 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Fair values of financial instruments As of December 31, 1993 and 1992, the Company's financial instruments consist of cash, cash equivalents, short-term investments and long-term debt. Management of the Company believes that their carrying amounts approximate their fair values as of December 31, 1993 and 1992. Fair values for short-term investments were determined by quoted market prices and for long-term debt by a discounted cash flow analysis based on the Company's current incremental borrowing rates for similar instruments. Inventories Telephone construction inventories consist of materials and supplies, which are stated at average cost. Equipment and other nonregulated inventory held for resale are stated at the lower of average cost or market. Property, plant and equipment Property, plant and equipment is recorded at cost. Retirements and other reductions of regulated telephone plant and equipment of approximately $9,886,000, $947,000 and $4,353,000 in 1993, 1992 and 1991, respectively, were charged against accumulated depreciation with no gain or loss recognized. When property applicable to nonregulated operations is sold or retired, the asset and related accumulated depreciation are removed from the accounts and the associated gain or loss is recognized. The cost of maintenance and repairs is charged to operating expense when incurred. Investment tax credits Investment tax credits on utility property acquired subsequent to 1980 were deferred and are being amortized to income over the productive lives of the related property for rate-making and financial reporting purposes. For tax return purposes, investment tax credits reduced federal income tax expense in the year they arose or became available. The Tax Reform Act of 1986 effectively eliminated investment tax credits after December 31, 1985. Revenues The Company is subject to regulation by the F.C.C. and the Public Utilities Commission of the State of California (the "P.U.C."). Pending and future regulatory actions may have a significant impact on the Company's future operations and financial condition. 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) In years prior to 1992, a significant portion of the Company's network access and long distance service revenues, as well as certain portions of local service revenues, resulted from the Company's participation in pooling and settlement arrangements. Such arrangements are processes whereby amounts billed by local exchange carriers are reported to the pool and ultimately divided among the pool participants on the basis of a pool- wide rate of return. Beginning in 1992, there was a significant shift in the sources of these revenues as a result of the Company's tentative agreements with Pacific Bell (the "Pacific Bell Agreements"), effective concurrently with the Company's exit from the intrastate settlement pools. Of the Company's total revenues in 1993 and 1992, 36% and 34%, respectively, was recorded under these tentative agreements. Definitive agreements were executed in February 1994 and had no significant effect on revenues recorded in 1993 or 1992 under the tentative agreements. In addition, certain billings to interexchange carriers previously reported to and divided by the pool are now retained by the Company. Under the Pacific Bell Agreements, the Company billed Pacific Bell various charges in connection with the provision of services within the Company's Local Access Transport Area, one of ten in California. In addition, as a result of the Pacific Bell Agreements the Company recognized transition revenues of $16.5 million and $15 million in 1993 and 1992, respectively, which will be reduced over an approximate six year period, commencing in a year to be determined by future regulatory developments and ultimately eliminated. To avoid potential adverse effects on future results of operations, the Company must either seek adjustments of tariffed rates for services, increase productivity or both. The implementation of the Pacific Bell Agreements significantly affected the comparability of certain revenue categories between 1992 and 1991. Depreciation Depreciation of regulated telephone plant and equipment is computed on a straight-line basis using rates approved by the P.U.C. Average annual composite depreciation rates were 6.56%, 6.75% and 6.55% in 1993, 1992 and 1991, respectively. The cost of property, plant and equipment used in nonregulated activities is depreciated over their estimated useful lives, which range from 3 to 5 years, on a straight-line basis. Allowance for funds used during construction The F.C.C. and the P.U.C. allow the Company to capitalize an allowance for funds used during construction, which includes both an interest and return on equity component. Such amounts are reflected as a cost of constructing certain plant assets and as an element of "Other income." 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Income taxes Effective January 1, 1993, the Company prospectively adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109") and, accordingly, the Company's prior consolidated financial statements were not restated. SFAS No. 109 requires companies to record deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements and tax returns. Additionally, SFAS No. 109 requires adjustments of deferred tax assets and liabilities for changes in tax laws or rates (such as the Revenue Reconciliation Act of 1993), and requires recognition of a regulatory asset or liability when it is probable that deferred taxes would be reflected in future rates of regulated companies. The adoption of SFAS No. 109 and the implementation of the Revenue Reconciliation Act of 1993 did not have a material effect on the Company's consolidated financial position or results of operations. Prior to January 1, 1993, deferred income taxes were provided in accordance with Accounting Principles Board Opinion No. 11 ("APB No. 11")for the tax effect of all timing differences between financial statement income and taxable income, except for items that were not allowable by the P.U.C. as deferred tax expense for rate-making purposes. Per share amounts Net income and cash dividends per share of common stock are based on the weighted average number of shares outstanding each year after giving retroactive effect to stock dividends. Statements of cash flows information During 1993, 1992 and 1991, the Company made payments for interest and income taxes as follows (in thousands): 1993 1992 1991 ---- ---- ---- Interest (net of amounts capitalized) $ 1,747 $ 1,497 $ 1,049 Income taxes $13,855 $ 12,891 $11,250 Reclassifications Certain amounts in the 1992 and 1991 consolidated financial statements have been reclassified to conform with the presentation of the 1993 consolidated financial statements. 2. LONG-TERM DEBT Long-term debt outstanding as of December 31, 1993 consisted of the following: $25,000,000 under an unsecured, long-term credit arrangement with a bank, with interest payable quarterly at rates increasing from 8.16% to 8.46% during the period of the loan. Principal payments are due in equal quarterly installments of $893,000, commencing in June 1995, and ending in April 2002. On November 17, 1993, the Company borrowed $15,000,000 under an unsecured, long-term credit arrangement with a bank. Borrowings under the new credit arrangement bear interest, which is payable quarterly, at a fixed rate of 6.22%. Principal payments are due in equal quarterly installments of $536,000, commencing in March 31, 1997, and ending in December 2003. At December 31, 1993, the aggregate maturity requirements on all long-term debt are $2,679,000, $3,572,000, $5,716,000, and $5,716,000 in 1995, 1996, 1997 and 1998, respectively. The aforementioned credit arrangements contain various positive and negative covenants with respect to cash flow coverage, tangible net worth and leverage ratio. These provisions could restrict the payment of dividends in certain circumstances; however, the entire amount of retained earnings at December 31, 1993 was unrestricted. 3. INCOME TAXES The income tax provisions consist of the following components (in thousands): 1993 1992 1991 ---- ---- ---- Current expense: Federal $9,633 $8,730 $8,810 State 3,226 3,027 3,026 ------- ------- ------- 12,859 11,757 11,836 Deferred expense: Federal 2,484 2,552 1,550 State 259 360 75 ------ ------- ------- 2,743 2,912 1,625 Amortization of investment tax credits (218) (217) (222) -------- ------- ------- $15,384 $14,452 $13,239 ======== ======= ======= The income tax provisions differ from those computed by using the statutory federal rate (35% in 1993, and 34% in 1992 and 1991) for the following reasons (in thousands): 1993 1992 1991 ---- ---- ---- Computed at statutory rates $13,266 $12,331 $11,281 Increase (decrease): State taxes, net of federal benefit 2,265 2,235 2,047 Benefit of the rate differential applied to reversing timing differences (115) (207) (325) Other, net (32) 93 236 ------- ------- ------- Income tax provision $15,384 $14,452 $13,239 ======= ======= ======= Effective federal and state rate 40.6% 39.9% 39.9% ======= ======= ======= 3. INCOME TAXES (CONTINUED) The significant components of the Company's deferred income tax assets and liabilities were as follows at December 31, 1993 (in thousands): Deferred Income Taxes ---------------------- Assets Liabilities ------ ----------- Property, plant and equipment - primarily due to depreciation differences $ - $ 21,614 Differences in the timing of recognition of revenues 2,871 - Cellular partnership - 2,708 State franchise taxes 1,129 - Other, net 1,380 - ---------- ---------- Total 5,380 24,322 Less current portion 1,129 - ----------- ---------- $ 4,251 $ 24,322 =========== ========== Net long-term deferred income tax liability $ 20,071 ========== As of January 1, 1993 and December 31, 1993, there was no valuation allowance for deferred tax assets. 3. INCOME TAXES (CONTINUED) During 1992 and 1991, in accordance with APB No. 11, the deferred income tax provisions resulted from differences in the timing of recognizing certain revenues and expenses for financial reporting and income tax purposes. The components of the aggregate deferred income tax provisions were as follows (in thousands): 1992 1991 ---- ---- Tax depreciation in excess of book depreciation $ 1,759 $ 2,268 Differences in the timing of recognition of revenues 504 (633) Differences between book and tax income (loss) attributable to the Company's investment in a cellular partnership 736 260 Benefit of the rate differential applied to reversing timing differences (207) (325) Other, net 120 55 --------- ---------- Deferred income tax provision $ 2,912 $ 1,625 ========= ========== 4. PENSION, OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS The Company sponsors a noncontributory defined benefit pension plan covering substantially all employees. Benefits are based on years of service and the employee's average compensation during the five highest consecutive years of the last ten years of credited service. The Company's funding policy is to contribute annually an actuarially determined amount consistent with applicable federal income tax regulations. Contributions are intended to provide for benefits attributed to service to date. Plan assets are primarily invested in collective trust accounts, government and government agency obligations, publicly traded stocks and bonds and mortgage-related securities. Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 includes the following components (in thousands): 1993 1992 1991 ---- ---- ---- Service cost-benefits earned during the period $2,149 $1,544 $1,252 Interest cost on projected benefit obligation 3,131 2,727 2,252 Actual return on plan assets (2,313) (1,592) (3,113) Net amortization and deferral 910 (80) 1,786 ------- ------- ------- Net pension cost $3,877 $2,599 $2,177 ======= ======= ======= The following table sets forth the defined benefit plan's funded status and amounts recognized in the consolidated balance sheets as of December 31, 1993 and 1992 (in thousands): 1993 1992 ---- ---- Actuarial present value of benefit obligations: Vested benefit obligation $29,717 $25,054 Nonvested benefit obligation 646 483 --------- -------- Accumulated benefit obligation $30,363 $25,537 ========= ======== Plan assets at fair value $31,369 $27,659 Less projected benefit obligation (47,383) (39,609) -------- -------- Projected benefit obligation in excess of plan assets (16,014) (11,950) Unrecognized net loss 12,614 9,260 Unrecognized transition obligation 3,247 3,514 -------- -------- Prepaid (accrued) pension cost $ (603) $ 824 ======== ======== 4. PENSION, OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (CONTINUED) The discount rates used in determining the projected benefit obligation at December 31, 1993 and 1992 were 7% and 7.5%, respectively. The assumed rate of increase in future compensation levels used to measure the projected benefit obligation was 6% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets used in determining net pension cost was 8% in 1993, and 8.5% in 1992 and 1991. Changes in the discount rate and expected long-term rate of return on plan assets increased pension cost $1,054,000 in 1993. The Company also maintains a retirement supplement plan providing both a retirement and savings feature for substantially all employees. The retirement feature allows for tax deferred contributions by employees under Section 401(k) of the Internal Revenue Code. Subject to certain limitations, one-half of all employee contributions made to the retirement supplement plan are matched by the Company. Such matching contributions, as defined in the plan, amounted to approximately $903,000, $731,000 and $623,000 in 1993, 1992 and 1991, respectively. At December 31, 1993, 7% of the Company's outstanding shares of common stock were held by the retirement supplement plan. Effective January 1, 1993, the Company adopted Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires accrual of the expected ultimate cost of providing benefits during the years that the employee renders the necessary service. Prior to the Company's adoption of SFAS No. 106, the cost of postretirement benefits was generally recognized as paid. Presently, the Company provides certain postretirement benefits other than pensions to substantially all employees, including a stated reimbursement for Medicare supplemental insurance and life insurance benefits. SFAS No. 112 establishes certain requirements for accounting for benefits provided to former or inactive employees after employment but before retirement. The adoption of SFAS No. 106 and No. 112 did not have a material effect on the Company's consolidated financial position or results of operations. 5. COMMITMENTS AND CONTINGENCIES Operating leases The Company leases certain facilities and equipment used in its operations and reflects lease payments as rental expense for the periods to which they relate. Total rental expense amounted to $1,137,000, $936,000 and $961,000 in 1993, 1992 and 1991, respectively. At December 31, 1993, the aggregate minimum rental commitments under noncancellable operating lease obligations are not significant. Other commitments The Company's budgeted capital expenditures for the year ending December 31, 1994 approximate $21.5 million. Binding commitments for such planned expenditures at December 31, 1993 were not significant. Litigation The Company is subject to certain legal proceedings and claims arising in the ordinary course of its business. In the opinion of management, any liability which may ultimately be incurred with respect to these matters will not materially affect the consolidated financial condition or results of operations of the Company. 6. CONCENTRATIONS OF CREDIT RISK AND SIGNIFICANT CUSTOMERS Substantially all of the Company's revenues were from communications and related services provided in the Northern California area. The Company performs ongoing credit evaluations of its customers' financial condition and management believes that an adequate allowance for doubtful accounts has been provided. As discussed more fully in Note 1 - Revenues, approximately 36% and 34% of the Company's consolidated operating revenues in 1993 and 1992, respectively, were derived from access charges and other charges to, and transition contract payments from Pacific Bell pursuant to the Pacific Bell Agreements (such amounts represented less than 10% of the Company's consolidated operating revenues in 1991). Approximately 10%, 10% and 11% of the Company's consolidated operating revenues in 1993, 1992 and 1991, respectively, were derived from the provision of services to AT&T. The revenues from services provided to AT&T were received primarily from access charges, but also included revenues from the provision of operator, billing and collection, and other interexchange services. No other customers accounted for more than 10% of consolidated operating revenues. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. For information regarding the executive officers of the Company, see "Executive Officers of the Registrant" at the end of Part I of this report. Other information required by this item is incorporated herein by reference from the proxy statement for the annual meeting of the Company's shareholders to be held on June 17, 1994. Item 11. Item 11. Executive Compensation. Incorporated herein by reference from the proxy statement for the annual meeting of the Company's shareholders to be held on June 17, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by reference from the proxy statement for the annual meeting of the Company's shareholders to be held on June 17, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. None. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1 and 2. Financial Statements and Financial Statement Schedules The financial statements and schedules listed in the accompanying Index to Financial Statements and Financial Statement Schedules are filed as part of this annual report. 3. Exhibits The exhibits listed on the accompanying Index to Exhibits are filed as part of this annual report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. ROSEVILLE TELEPHONE COMPANY AND FINANCIAL STATEMENT SCHEDULES (Item 14(a) 1 and 2) PAGE Report of independent auditors 14 Consolidated balance sheets as of December 31, 1993 and 1992 15 Consolidated statements of income for each of the three years in the period ended December 31, 1993 17 Consolidated statements of shareholders' equity for each of the three years in the period ended December 31, 1993 18 Consolidated statements of cash flows for each of the three years in the period ended December 31, 1993 19 Notes to consolidated financial statements 21 Financial statement schedules for each of the three years in the period ended December 31, 1993 V Property, plant and equipment 34 VI Accumulated depreciation 36 VIII Valuation and qualifying accounts 37 IX Short-term borrowings 38 X Supplementary income statement information 39 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. ROSEVILLE TELEPHONE COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years ended December 31, 1993, 1992 and 1991 (In thousands) Balance Net Other Balance at additions changes at beginning (transfers) Retire- - add end of Classification of period at cost ments (deduct) period --------------- --------- ---------- --------- --------- --------- Year ended December 31, 1993: In service: Land $ 3,908 $ - $ - $ - $ 3,908 Buildings 28,777 24,232 4 - 53,005 Central office equipment 63,968 12,638 8,951 - 67,655 Cable and wire facilities 75,351 5,220 578 - 79,993 Furniture and office equipment 10,650 4,341 278 - 14,713 Vehicles and other work equipment 4,634 511 75 - 5,070 Nonregulated equipment 2,159 693 1,026 - 1,826 --------- --------- -------- -------- -------- 189,447 47,635 10,912 - 226,170 Under construction 13,932 (11,175) - - 2,757 --------- --------- -------- -------- -------- $203,379 $ 36,460 $ 10,912 $ - $228,927 ======== ========= ======== ======== ======== Year ended December 31, 1992: In service: Land $ 3,909 $ - $ 1 $ - $ 3,908 Buildings 28,127 651 1 - 28,777 Central office equipment 62,229 2,126 387 - 63,968 Cable and wire facilities 69,254 6,397 300 - 75,351 Furniture and office equipment 9,499 1,296 145 - 10,650 Vehicles and other work equipment 4,247 500 113 - 4,634 Nonregulated equipment 1,855 440 136 - 2,159 ---------- --------- -------- --------- -------- 179,120 11,410 1,083 - 189,447 Under construction 2,432 11,500 - - 13,932 ---------- ---------- -------- --------- --------- $ 181,552 $ 22,910 $ 1,083 $ - $203,379 ========== ========== ========= ========= ========= ROSEVILLE TELEPHONE COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (CONTINUED) Years ended December 31, 1993, 1992 and 1991 (In thousands) Balance Net Other Balance at additions changes at beginning (transfers) Retire- - add end of Classification of period at cost ments (deduct) period --------------- --------- ---------- --------- --------- --------- Year ended December 31, 1991: In service: Land $ 2,436 $ 1,473 $ - $ - $ 3,909 Buildings 26,086 2,071 30 - 28,127 Central office equipment 51,390 13,720 2,881 - 62,229 Cable and wire facilities 63,347 6,334 427 - 69,254 Furniture and office equipment 8,896 1,421 818 - 9,499 Vehicles and other work equipment 3,971 473 197 - 4,247 Nonregulated equipment 1,634 338 117 - 1,855 --------- --------- --------- --------- -------- 157,760 25,830 4,470 - 179,120 Under construction 2,120 312 - - 2,432 --------- --------- --------- --------- -------- $159,880 $ 26,142 $ 4,470 $ - $181,552 ========= ========= ========= ========= ======== ROSEVILLE TELEPHONE COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION Years ended December 31, 1993, 1992 and 1991 (In thousands) Balance Net Other Balance at additions changes at beginning (transfers) Retire- - add end of Classification of period at cost ments (deduct) period --------------- --------- ---------- --------- --------- --------- Year ended December 31, 1993: Buildings $ 6,944 $ 900 $ 6 $ - $ 7,838 Central office equipment 22,655 5,977 8,735 - 19,897 Cable and wire facilities 20,616 3,152 639 - 23,129 Furniture and office equipment 4,331 1,624 279 - 5,676 Vehicles and other work equipment 2,220 413 50 - 2,583 Nonregulated equipment 1,928 387 1,082 - 1,233 --------- --------- -------- --------- --------- $ 58,694 $ 12,453 $10,791 $ - $60,356 ========= ========= ======== ========= ========= Year ended December 31, 1992: Buildings $ 6,103 $ 841 $ - $ - $ 6,944 Central office equipment 16,910 6,009 264 - 22,655 Cable and wire facilities 18,068 2,930 382 - 20,616 Furniture and office equipment 3,069 1,405 143 - 4,331 Vehicles and other work equipment 1,934 384 98 - 2,220 Nonregulated equipment 1,339 680 91 - 1,928 --------- --------- -------- --------- -------- $47,423 $ 12,249 $ 978 $ - $58,694 ======== ======== ======== ========= ======== Year ended December 31, 1991: Buildings $ 5,347 $ 785 $ 29 $ - $ 6,103 Central office equipment 14,345 5,234 2,669 - 16,910 Cable and wire facilities 15,861 2,704 497 - 18,068 Furniture and office equipment 2,577 1,308 816 - 3,069 Vehicles and other work equipment 1,752 355 173 - 1,934 Nonregulated equipment 1,067 339 67 - 1,339 --------- --------- --------- --------- --------- $ 40,949 $ 10,725 $ 4,251 $ - $ 47,423 ========= ========= ========= ========= ========= (1)Sales and retirements are net of salvage value and costs of removal. ROSEVILLE TELEPHONE COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1993, 1992 and 1991 (In thousands) Additions ------------------------ Balance at Charged to Charged to Balance at beginning of costs and other end of Description period expenses accounts(1) Deductions(2) period - ----------- ------------ ----------- ----------- ------------- ------------ Allowance for doubtful accounts: 1993 $ 94 $106 $122 $275 $ 47 ==== ==== ==== ==== ==== 1992 $162 $ 87 $116 $271 $ 94 ==== ==== ==== ==== ==== 1991 $235 $ 69 $244 $386 $162 ==== ==== ==== ==== ==== (1) Represents collection of accounts previously written-off. (2) Represents accounts written-off. ROSEVILLE TELEPHONE COMPANY SCHEDULE IX - SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (In thousands) Weighted Maximum Average average Balance Weighted amount amount interest at end average outstanding outstanding rate Category of aggregate of interest during the during the during the short-term borrowings period rate period period(1) period(2) - --------------------- ------- ----- ------- --------- --------- Year ended December 31, 1993 - ---------------------------- Not applicable $ - -% $ - $ - -% Year ended December 31, 1992 - ---------------------------- Not applicable(3) $ - -% $ - $ - -% Year ended December 31, 1991 - ---------------------------- Bank line of credit agreement $ -(3) 5.25% $ 13,500 $ 5,587 6.97% (1)The average amount of short-term borrowings during each period was determined by multiplying the amount of each advance during the period by the percentage of the period for which it was outstanding. (2)The approximate weighted average interest rate for each period was determined by dividing interest expense applicable to the borrowing by the average amount outstanding during the period. (3)Borrowings outstanding under this bank line of credit agreement at December 31, 1991, and subsequent thereto until its refinancing in March 1992 on a long-term basis, were classified as long-term debt in the Company's Consolidated Balance Sheet. ROSEVILLE TELEPHONE COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 (In thousands) Charged to costs and expenses ----------------------------- Year ended December 31, ----------------------- 1993 1992 1991 ---- ----- ---- 1. Taxes, other than payroll and income taxes $1,571 $1,575 $1,555 Maintenance and repairs is the primary component of plant operations expense, which is included in "Cost of services and products" in the Company's Consolidated Statements of Income. Plant operations expense amounted to $12,911,000, $11,397,000 and $12,419,000 in 1993, 1992 and 1991, respectively. Depreciation and amortization of intangible assets, preoperating costs and similar deferrals, royalties paid and advertising costs incurred were insignificant in each year presented. SIGNATURES Pursuant to the requirements of Section 13 or 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. ROSEVILLE TELEPHONE COMPANY (Registrant) Date: March 25, 1994 By: /s/ Robert L. Doyle Robert L. Doyle, Chairman of the Board Date: March 25, 1994 By: /s/ Brian H. Strom Brian H. Strom, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 25, 1994 By: /s/ Robert L. Doyle Robert L. Doyle, Chairman of the Board Date: March 25, 1994 By: /s/ Brian H. Strom Brian H. Strom, President and Chief Executive Officer (Chief Financial Officer and Principal Accounting Officer); Director Date: March 25, 1994 /s/ Thomas E. Doyle Thomas E. Doyle Director Date: March 25, 1994 /s/ Ralph E. Hoeper Ralph E. Hoeper, Director Date: March 25, 1994 /s/ John R. Roberts III John R. Roberts III Director ROSEVILLE TELEPHONE COMPANY INDEX TO EXHIBITS (Item 14(a) 3) Method Exhibit No. Description of Filing Page ----------- ----------- --------- ---- 3(a) Restated Articles of Incorporation of the Incorporated - Company (Filed as Exhibit I to Form 10-Q by reference Quarterly Report for the quarter ended June 30, 1980), together with Certificate of Amendment amending such Restated Articles of Incorporation (as filed with Exhibit 3(a) to Form 10-K Annual Report for the year ended December 31, 1982), and Certificate of Amendment further amending such Restated Articles of Incorporation, as amended (Filed as Exhibit 3A to Form 10-K Annual Report for the year ended December 31, 1983) 3(b) Certificate of Amendment of Articles of Incorporated - Incorporation (Filed as Exhibit 3(b) to by reference Form 10-K Annual Report for the year ended December 31, 1988) 3(c) Bylaws of the Company, as amended to date Incorporated - (Filed as Exhibit 3(c)to Form 10-K Annual by reference Report for the year ended December 31, 1988) 10(a) Sacramento-Valley Limited Partnership Incorporated - Agreement, dated April 4, 1984 (Filed as by reference Exhibit I to Form 10-Q Quarterly Report for the quarter ended March 31, 1984) 10(b) Credit Agreement with Bank of America Incorporated - National Trust and Savings Association, by reference dated March 27, 1992, with respect to $25,000,000 term loan. (Filed as Exhibit 10(a) to Form 10-Q Quarterly Report for the quarter ended March 31, 1992) 10(c) Credit Agreement with Bank of America Filed - National Trust and Savings Association, herewith dated January 4, 1994, with respect to $15,000,000 term loan. 22(a) List of subsidiaries (Filed as Exhibit Incorporated - 22(a) to Form 10-K Annual Report for the by reference year ended December 31, 1981) SIGNATURES Pursuant to the requirements of Section 13 or 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. ROSEVILLE TELEPHONE COMPANY (Registrant) Date: March 25, 1994 By: Robert L. Doyle, Chairman of the Board Date: March 25, 1994 By: Brian H. Strom, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 25, 1994 Robert L. Doyle, Chairman of the Board Date: March 25, 1994 Brian H. Strom, President and Chief Executive Officer (Chief Financial Officer and Principal Accounting Officer); Director Date: March 25, 1994 Thomas E. Doyle, Director Date: March 25, 1994 Ralph E. Hoeper, Director Date: March 25, 1994 John R. Roberts III, Director	10,731	72,797
861388_1993.txt	861388_1993	1993	861388	ITEM 1. Business. ORGANIZATION LG&E Energy Corp. (the Company), incorporated November 14, 1989, is a diversified energy-services holding company with two direct subsidiaries: Louisville Gas and Electric Company (LG&E) and LG&E Energy Systems Inc. (Energy Systems). In August 1990, the Company and LG&E implemented a corporate reorganization pursuant to a mandatory share exchange whereby each share of outstanding common stock of LG&E was exchanged on a share-for-share basis for the common stock of LG&E Energy Corp. The reorganization created a corporate structure that gives the Company the flexibility to take advantage of opportunities to expand into other businesses while insulating LG&E's utility customers and senior security holders from risks associated with such businesses. LG&E preferred stock and first mortgage bonds were not exchanged and remained securities of LG&E. The Company is not currently engaged in any business activity independent of LG&E and Energy Systems. LG&E is a regulated public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. LG&E's service area covers approximately 700 square miles in 17 counties and has an estimated population of 800,000. Included in this area is the Fort Knox Military Reservation, to which LG&E provides both gas and electric service, but which maintains its own distribution systems. LG&E also provides gas service in limited additional areas. LG&E's coal fired generating plants, which are all equipped with systems to remove sulfur dioxide, produce most of LG&E's electricity; the remainder is generated by a hydroelectric power plant and combustion turbines. Underground gas storage fields help LG&E provide economical and reliable gas service to customers. During 1993, the Company's financial condition and results of operation depended to a large degree on the financial condition and results of operations of LG&E. In 1991, LG&E Energy Systems Inc. was formed to direct the Company's expansion into the non-utility marketplace and to separate the regulated utility from new business initiatives. This subsidiary explores business opportunities that fit the corporate strategy aimed at energy services opportunities, including cogeneration and independent power production; and fuel-related businesses, such as gathering, storing, transporting and marketing natural gas. Consistent with the Company's expansion strategy, Energy Systems purchased Hadson Power Systems, Incorporated, of Irvine, California, from Hadson Corporation in December 1991. Following the acquisition, Hadson Power Systems was renamed LG&E Power Systems Inc. and has been subsequently renamed LG&E Power Inc. (LPI). LPI develops, designs, builds, owns, operates, and maintains power generation facilities that sell energy to local industries and utilities. In 1992, Energy Systems acquired a 36.5% interest in Natural Gas Clearinghouse (NGC). Located in Houston, Texas, NGC is the largest independent natural gas marketer in the United States. In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation of Alberta, Canada. See Note 3 of Notes to Financial Statements under Item 8, for a further discussion of the sale of NGC. In February 1994, LPI announced it had reached a preliminary agreement with the DuPont Company (DuPont) to form a partnership that will own, improve, and operate energy production facilities at nine DuPont fiber manufacturing plants in the mid-Atlantic and southeastern regions of the United States. LPI will be the general partner in the arrangement and hold a 50% interest in the partnership. DuPont will be a limited partner and own the other half. Virginia Power and Electric Company (Virginia Power), one of the utilities in whose service territory the DuPont facilities reside, has made an administrative filing with the Virginia State Corporation Commission questioning certain aspects of the proposed transaction. See Item 3, Legal Proceedings - Other, for further discussion of this matter. In November 1993, the Company announced a major realignment and formation of new business units, effective January 1, 1994, to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. The realignment does not affect the Company's legal structure, regulation of LG&E by the Kentucky Public Service Commission (the "Kentucky Commission" or "Commission") or the Company's status as an exempt holding company. Under the realignment, the Company has formed a national business unit, LG&E Energy Services, to develop and manage all of its utility and non-utility electric power generation and concentrate on the marketing and brokering of electric power on a regional and national basis. The realignment will allow the other business unit, LG&E, to increase its focus on customer service and to develop more customer options as the local utility industry becomes more competitive in the future. In addition to this realignment, the Company is currently in the process of re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which the Company has recorded as regulatory assets. See Future Outlook, under Item 7, for a further disclosure of this issue. The Company began consideration of investment in international power projects in 1993. While it recognizes the increased risks associated with international projects, the Company believes significant opportunities exist as well. It has been working with strong international partners, successful financial institutions and industry leaders in the United States to review the risk/reward profiles of potential projects. The Company and its subsidiaries currently are exempt from all provisions, except Section 9(a)(2), of the Public Utility Holding Company Act of 1935 (the "Holding Company Act") on the basis that the Company and LG&E are incorporated in the same state and their business is predominately intrastate in character and carried on substantially in the state of incorporation. It is necessary for the Company to file an annual exemption statement with the Securities and Exchange Commission (SEC). The Company is not a public utility under the laws of the Commonwealth of Kentucky and is not subject to regulation as such by the Kentucky Commission. See Louisville Gas and Electric Company - Regulation and Rates below for a description of the regulation of LG&E by the Kentucky Commission, which includes the ability to regulate certain intra-company transactions between LG&E and the Company, including the Company's non-utility subsidiaries. LOUISVILLE GAS AND ELECTRIC COMPANY General LG&E's Trimble County Unit 1 (Trimble County or the Unit), a 495-megawatt, coal-fired electric generating unit, which LG&E began constructing in 1979, was placed in commercial operation on December 23, 1990. The Unit has been subject to numerous reviews by the Kentucky Commission. In July 1988, the Kentucky Commission issued an order stating that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. For a more detailed discussion of the proceedings relating to Trimble County Unit 1, see Note 11 of the Notes to Financial Statements under Item 8. In February 1993, LG&E sold a 12.88% ownership interest in the Unit to Indiana Municipal Power Agency, completing LG&E's plan to sell the 25% not allowed for ratemaking. LG&E had previously sold a 12.12% ownership interest in the Unit to the Illinois Municipal Electric Agency in 1991. See Note 12 of the Notes to Financial Statements under Item 8 for a further discussion. Competition among energy suppliers is increasing. In particular, competition for off-system sales, which is based primarily on price and availability of energy, has become much more intense in recent years. The addition of electric generating capacity by other utilities in the Midwest has reduced the opportunities for LG&E to make interchange sales and has heightened price competition for such sales. However, such additional capacity has made lower cost power available for purchase by LG&E which, in certain instances, is at a cost lower than the variable cost of generating power from the generating stations owned by LG&E. In addition, the 1992 Energy Policy Act will provide utilities a wider choice of sources for their electrical supply than previously available. The Act also creates generating supply options that did not exist under previous legislation and is expected to increase competition for wholesale electric sales. (See Energy Policy Act of 1992 under Item 7 for a further discussion.) LG&E is responding to increased competition in a number of ways designed to lower its costs and increase sales. One such response has been the realignment by LG&E Energy Corp. into new business units as described on page 2 effective January 1, 1994. The realignment will allow LG&E to increase its focus on customer service and to develop more customer options as the utility industry becomes more competitive. The realignment does not affect the regulation of LG&E by the Commission. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by LG&E. The market-based rate tariff enables LG&E to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables LG&E to sell an unlimited amount of non-firm power at market-based rates, as long as the power is from LG&E's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from LG&E. These tariffs provide open access to LG&E's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across LG&E's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. In responding to competition in the gas distribution business, LG&E has upgraded gas storage facilities and invested in new equipment. By using the storage fields strategically, LG&E can buy gas when prices are low, store it, and retrieve the gas when demand is high. Accessing least cost gas was made easier in November 1993 when FERC's Order No. 636 went into effect. Previously, LG&E and other utilities purchased most of their gas services from pipeline companies. The order "unbundled" gas services, allowing utilities to purchase gas, transportation, and storage services separately from many different sources. Currently, LG&E buys competitively priced gas from several large producers under contracts of varying duration. By purchasing from multiple suppliers, and storing any excess gas, LG&E is able to secure favorably priced gas for its customers. Without storage capacity, LG&E would be forced to buy gas when customer demand increases, which is usually when the price is highest. (See FERC Order No. 636 under Item 7 for a further discussion.) LG&E is experiencing some of the issues common to electric and gas utility companies, namely, increased competition for customers, delays and uncertainties in the regulatory process and costs of compliance with environmental laws and regulations. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxide by electric utility generating plants. While LG&E will incur some capital expenditures to comply with the Act's requirements, the overall impact of the Act on LG&E is expected to be minimal. See Environmental under Note 8 of Notes to Financial Statements under Item 8. For the year ended December 31, 1993, 74% of total utility revenues was derived from LG&E's electric operations and 26% from LG&E's gas operations. Electric and gas operating revenues and the percentages by classes of service on a combined basis for this period were as follows: See Note 13 of the Notes to Financial Statements under Item 8 for financial information concerning segments of business for the three years ended December 31, 1993. Electric Operations The sources of electric operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: At December 31, 1993, LG&E had 336,124 electric customers. LG&E uses efficient coal-fired boilers that are fully equipped with sulfur dioxide removal systems to generate electricity. LG&E's system wide emission rate for sulfur dioxide in 1993 was approximately .78 lbs./MMBtu of heat input, which is significantly below the Phase II limit of 1.2 lbs./MMBtu established by the Clean Air Act Amendments for the year 2000. On Monday, August 30, 1993, LG&E set a record local peak load of 2,239 Mw, when the temperature at the time of peak reached 94 degrees F (average for the day was 84 degrees F). The record system peak of 3,223 Mw (which included purchases from and short-term sales to other electric utilities) occurred on Thursday, May 30, 1991. The reliability criterion for generation capacity planning is to provide a minimum reserve margin of 18%. At February 28, 1994, LG&E owned steam and combustion turbine generating facilities with a capacity of 2,613 Mw and an 80 Mw hydroelectric facility on the Ohio River. See Item 2, Properties. LG&E is a participating owner with 14 other electric utilities of Ohio Valley Electric Corporation (OVEC) whose primary customer is the Portsmouth Area uranium-enrichment complex of the U.S. Department of Energy at Piketon, Ohio. LG&E has electric transmission interconnections and/or interconnection/interchange agreements with PSI Energy, Kentucky Utilities Company, Southern Indiana Gas and Electric Company, The Cincinnati Gas & Electric Company, Indiana Michigan Power Company, OVEC, Big Rivers Electric Corporation, Tennessee Valley Authority, Wabash Valley Power Association, Indiana Municipal Power Agency, East Kentucky Power Cooperative (East Kentucky), Illinois Municipal Electric Agency, Jacksonville Electric Authority, and Ogelthorpe Power Corporation providing for various interchanges, emergency services, and other working arrangements. LG&E and East Kentucky have an agreement that allows East Kentucky to purchase power during its peak season, that period during which the utility's customers use the greatest amount of power, and LG&E to sell power during its off-peak season. The agreement entitles East Kentucky to buy from LG&E 30 to 145 megawatts from mid-December to mid-February through 1994-95. On February 28, 1991, LG&E sold a 12.12% ownership interest in Trimble County Unit 1 to the Illinois Municipal Electric Agency (IMEA), based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County Unit. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. Both IMEA and IMPA pay their proportionate share for operation and maintenance expenses of the Unit and for fuel and reactant used. They are also responsible for their proportionate share of incremental capital assets acquired. Electric and magnetic fields (sometimes referred to as EMF) surround electric wires or conductors of electricity such as electrical tools, household wiring and appliances, and high voltage electric transmission lines such as those owned by LG&E. Certain studies have suggested a possible association between electric and magnetic fields and adverse health effects. The Electric Power Research Institute, of which LG&E is a participating member, has expended approximately $65 million since 1987 in its investigation and research with regard to possible health effects posed by exposure to electric and magnetic fields. Gas Operations The sources of gas operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: At December 31, 1993, LG&E had 258,185 gas customers. LG&E has extensive underground natural gas storage fields that help provide economical and reliable gas service to ultimate consumers. Reflecting the changing nature of the gas business, a number of industrial customers purchase their natural gas requirements directly from producers or brokers for delivery through LG&E's distribution system. Transportation of natural gas for LG&E's customers does not have an adverse effect on earnings because of the offsetting decrease in gas supply expenses. The transportation rates are designed to make LG&E economically indifferent as to whether gas is sold or merely transported. The all-time maximum day gas sendout of 545,000 Mcf occurred on Sunday, January 20, 1985, when the average temperature for the day was -11 F. During 1993, the maximum day gas sendout was 447,000 Mcf, occurring on February 18, when the average temperature for the day was 11 F. Supply on that day consisted of 171,000 Mcf from purchases, 238,000 Mcf delivered from underground storage and 38,000 Mcf transported for industrial customers. For further discussion, see Gas Supply. On November 1, 1993, LG&E began purchasing and transporting its natural gas supplies under the new requirements created by FERC Order No. 636 which was issued in 1992. While LG&E had previously been able to purchase natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), LG&E now purchases only transportation services from Texas Gas pursuant to its FERC-approved tariff and acquires its supply of natural gas from several other sources. Throughout 1993, LG&E undertook a review to evaluate and select the pipeline services and gas supplies needed. As a result of this review, LG&E entered into several distinct transportation and purchase agreements. LG&E should benefit from Order No. 636 through enhanced access to competitively priced natural gas supplies as well as more flexible transportation services. LG&E has made the necessary modifications to its operations and to its gas supply clause to reflect these Order No. 636 changes. (For further discussion see Gas Supply.) Regulation and Rates The Kentucky Commission has regulatory jurisdiction over the rates and service of LG&E and over the issuance of certain of its securities. LG&E is a "public utility" as defined in the Federal Power Act, and is subject to the jurisdiction of the Department of Energy and the FERC with respect to the matters covered in such Act, including the sale of electric energy at wholesale in interstate commerce. In addition, the FERC has sole jurisdiction over the issuance by LG&E of short-term securities. For a discussion of the most recent rate order of the Kentucky Commission, see Rates and Regulation under Item 7 and Note 11 of the Notes to Financial Statements under Item 8. Increases and decreases in the cost of fuel for electric generation are reflected in the rates charged to all of LG&E's electric customers by means of LG&E's fuel adjustment clause. The Kentucky Commission requires public hearings at six-month intervals to examine past fuel adjustments, and at two-year intervals for the purpose of additional examination and transfer of the then current fuel adjustment charge or credit to the base charges. The Commission also requires that electric utilities, including LG&E, file certain documents relating to fuel procurement and the purchase of power and energy from other utilities. LG&E's gas rates contain a gas supply clause (GSC), whereby increases or decreases in the cost of gas supply are reflected in LG&E's rates, subject to approval of the Kentucky Commission. The GSC procedure prescribed by order of the Commission provides for quarterly rate adjustments to reflect the expected cost of gas supply in that quarter. In addition, the GSC contains a mechanism whereby any over- or under-recoveries of gas supply cost from prior quarters will be refunded to or recovered from customers through the adjustment factor determined for subsequent quarters. In November 1993, the Commission approved a comprehensive agreement on demand side management (DSM) programs. The agreement contains a rate mechanism that provides for the recovery of DSM program costs, allows LG&E to recover revenues due to lost sales associated with the DSM programs and provides LG&E an incentive for implementing DSM programs. See Rates and Regulation under Item 7 for a further discussion of DSM. As part of the corporate reorganization whereby the Company became the parent of LG&E, LG&E obtained the approval of the Kentucky Commission. The order of the Kentucky Commission authorizing LG&E to reorganize into a holding company structure contains certain provisions, which, among other things, ensure the Kentucky Commission access to books and records of the Company and its affiliates which relate to transactions with LG&E; require the Company and its subsidiaries to employ accounting and other procedures and controls and to protect against subsidization of non-utility activities by LG&E's customers; and preclude LG&E from guaranteeing any obligations of the Company without prior written consent from the Kentucky Commission. In addition, such order provides that LG&E's board of directors has the responsibility to use its dividend policy consistent with preserving the financial strength of the utility and that the Kentucky Commission, through its authority over LG&E's capital structure, can protect LG&E's ratepayers from the financial effects resulting from non-utility activities. Construction Program and Financing LG&E's construction program is designed to assure that there will be adequate capacity to meet the future electric and gas needs of its service area. These needs are continually being reassessed and appropriate revisions are made, when necessary, in construction schedules. The Company's estimates of its construction expenditures can vary substantially due to numerous items beyond the Company's control, such as changes in LG&E's rates, economic conditions, construction costs, and new environmental or other governmental laws and regulations. For a further discussion of construction expenditures and financing, see Construction Expenditures and Capitalization and Liquidity under Item 7. During the five years ended December 31, 1993, LG&E's gross property additions amounted to $580 million. Funds for about 97% of these gross additions were generated internally. The gross additions during this period amounted to approximately 24% of total utility plant at December 31, 1993, and consisted of $480 million for electric properties and $100 million for gas properties. Gross retirements during the same period were $40 million, consisting of $29 million for electric properties and $11 million for gas properties. Coal Supply Ninety percent of LG&E's present electric generating capacity is coal-fired, the remainder being made up of a hydroelectric plant and combustion turbine peaking units fueled by natural gas and oil. Coal will be the predominant fuel used by LG&E in the foreseeable future, with natural gas and oil being used for peaking capacity and flame stabilization in coal-fired boilers or in emergencies. LG&E has no nuclear generating units and has no plans to build any in the foreseeable future. In 1992, LG&E entered into coal supply agreements with various suppliers for coal deliveries for 1993 and beyond. LG&E normally augments its coal supply agreements with spot market purchases which, during 1993, were about 10% of total purchases. LG&E has a coal inventory policy, which is in compliance with the Kentucky Commission's directives and which LG&E believes provides adequate protection under most contingencies. LG&E had on hand at December 31, 1993, a coal inventory of approximately 433,000 tons, or a 28 day supply. LG&E expects, for the foreseeable future, to continue purchasing most of its coal from western Kentucky and southwest Indiana, which has a sulfur content in the 2%-3.5% range. The abundant supply of this relatively low priced coal, combined with present and future desulfurization technologies, is expected to enable LG&E to continue to provide adequate electric service in a manner acceptable under existing environmental laws and regulations. Coal for LG&E's Mill Creek plant is delivered by rail and barge, whereas deliveries to the Cane Run plant are primarily by rail and also by truck. Deliveries to the Trimble County plant are by barge only. The average delivered cost of coal purchased by LG&E, per ton and per million Btu, for the periods shown were as follows: Gas Supply During 1993, LG&E continued to purchase natural gas from and transport other natural gas supplies through Texas Gas at rates and terms regulated by the FERC. LG&E also continued purchasing a portion of its natural gas supplies on the spot-market and transporting those supplies under various transportation agreements with Texas Gas pursuant to applicable FERC-approved tariffs. LG&E received standby service from Texas Gas until its implementation of FERC Order No. 636. As a result of FERC Order No. 636 and effective November 1, 1993, LG&E entered into new transportation service agreements with Texas Gas. These agreements provide for 30,000 MMBtu (29,268 Mcf) per day in Firm Transportation (FT) throughout the year. This FT agreement expires October 31, 1997. During the winter months, LG&E also has 184,900 MMBtu (180,390 Mcf) per day in No-Notice Service (NNS); during the summer months that NNS level is 135,000 MMBtu (131,707 Mcf) per day. LG&E's NNS agreements with Texas Gas incorporate terms of 2, 5, and 8 years, and include unilateral roll-over provisions at LG&E's option. These transportation services are provided by Texas Gas pursuant to its FERC-approved tariff. Contemporaneously with the conclusion of its transportation arrangements with Texas Gas, LG&E also entered into a series of long-term firm supply arrangements with various suppliers in order to meet its firm sales obligation. The gas supply arrangements include pricing provisions which are market-responsive. These firm supplies, in tandem with pipeline transportation services, provide the reliable and flexible supply needed to replace the bundled sales service formerly supplied by the pipeline. During 1994, LG&E will be participating in several regulatory proceedings at FERC. Particularly, LG&E will be involved in reviewing Texas Gas' most recent rate filing, and Texas Gas' filing to recover certain transition costs associated with the FERC-mandated implementation of FERC Order No. 636. As a separate matter, the Kentucky Commission has indicated in an order issued in its Administrative Case No. 346 that transition costs, which are clearly identified as being related to the cost of the commodity itself, are appropriately recovered as a gas cost through LG&E's purchased gas adjustment. LG&E operates five underground gas storage fields with a current working gas capacity of 14.6 million Mcf. Gas is purchased and injected into storage during the summer season and is then withdrawn to supplement pipeline supplies to meet the gas-system load requirements during the winter heating season. The estimated maximum deliverability from storage during the early part of the 1992-1993 heating season was approximately 373,000 Mcf per day. Deliverability decreases during the latter portion of the heating season as the storage inventory is reduced by seasonal withdrawals. The average cost per Mcf of natural gas purchased by LG&E was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Although upcoming regulatory changes may alter the ways in which LG&E contracts for natural gas supplies, it is expected that LG&E will continue to have adequate access to natural gas supplies at market sensitive prices. Environmental Matters Protection of the environment is a major priority for LG&E. LG&E engages in a variety of activities within the jurisdiction of federal, state, and local regulatory agencies. Those agencies have issued LG&E permits for various activities subject to air quality, water quality, and waste management laws and regulations. For the five year period ending with 1993, expenditures for pollution control facilities represented $128 million or 22% of total construction expenditures. The cost of operating and maintaining these facilities amounted to $22 million in both 1993 and 1992. LG&E's anticipated capital expenditures for 1994 to comply with environmental laws are approximately $22 million. See Item 3 and Note 10 of the Notes to Financial Statements under Item 8 for a discussion of specific environmental proceedings affecting LG&E. LG&E ENERGY SYSTEMS INC. In 1991, the Company formed LG&E Energy Systems Inc. (Energy Systems) to direct the Company's expansion into the non-utility marketplace. In December 1991, Energy Systems purchased Hadson Power Systems, Incorporated, which was renamed at the time of purchase to LG&E Power Systems Inc. and subsequently renamed LG&E Power Inc. (together with its subsidiaries, "LPI"). In 1992, Energy Systems acquired a 36.5% interest in Natural Gas Clearinghouse (NGC). In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation of Alberta, Canada, which was completed in January 1994. See Note 3 of Notes to Financial Statements under Item 8 and Future Outlook under Item 7 for a further discussion of the NGC sale. LPI is involved in the development, design, construction, ownership, operation, and maintenance of power generation facilities in the United States. LPI, through its predecessor, has been in the independent power business since 1982 and has approximately 500 employees. It currently has in operation or under construction, projects capable of generating over 527 megawatts of electric power capacity in Maine, North Carolina, Virginia, and New York. For a description of LPI's projects and the ownership interests of LPI in such projects, see Item 3, Properties. Each of these projects currently is, or upon its completion will be, a qualifying cogeneration facility under the Public Utility Regulatory Policy Act of 1978 (PURPA). In addition, LPI has sought and obtained exempt wholesale generator (EWG) status for the entity which owns the Roanoke Valley I project in North Carolina. Such status will allow LPI to own and operate the 165 megawatt Roanoke Valley I facility without complying with PURPA's qualifying cogeneration facility operating standards. EWGs are not required to comply with such standards if the rates charged for a facility's electric generation have been accepted for filing by FERC. Such a filing was made and accepted for the Roanoke Valley I facility in December 1993. Generally, qualifying facility status exempts projects from the application of the Holding Company Act, many provisions of the Federal Power Act, and state laws and regulations respecting rates and financial or organization regulation of electric utilities. Exempt wholesale generators also are exempt from application of the Holding Company Act and many provisions of the Federal Power Act, but once such an entity files its electric generation rates with FERC, it becomes a jurisdictional public utility under the Federal Power Act. As such a "public utility," an EWG's rates and some of its corporate activity are subject to FERC regulation. Exempt wholesale generators also are subject to non-rate regulation under state laws governing electric utilities. While qualifying facility or exempt wholesale generator status entitles LPI's projects to certain regulatory exceptions and benefits under PURPA and the Holding Company Act, each project must still comply with other federal, state, and local laws, including those regarding siting, construction, operation, licensing, and pollution abatement. Through an affiliate, LPI also operates and maintains 12 projects in which it does not have an ownership interest that are located in California, Pennsylvania, and Montana. In order to permit it to operate EWGs, such affiliate also has been designated as an exempt wholesale generator under the Holding Company Act. LPI currently is involved in the construction of three cogeneration facilities, Roanoke Valley I, Roanoke Valley II, and Rensselaer. The Roanoke Valley I and II projects each are owned with Westmoreland Energy, Inc., a subsidiary of Westmoreland Coal Company (Westmoreland). The Roanoke Valley I project is a 165 megawatt coal-fired facility located near Weldon, North Carolina. The Roanoke Valley II project is a 44 megawatt coal-fired facility located adjacent to the Roanoke Valley I project. These facilities share certain common facilities. Both facilities will sell electricity to North Carolina Power and steam to Patch Rubber Company, a subsidiary of Myers Industries. TECO Coal Company is obligated to supply all of the plants' coal requirements although Westmoreland has entered into a subcontract arrangement with TECO whereby it is entitled to supply approximately 80% of such coal requirements. Subsidiaries of LPI will engineer, construct, and operate each project. The project owner has obtained a $393 million construction and term loan facility to finance its construction and operation of these projects. The Rensselaer project, a 79 megawatt gas-fired cogeneration plant, also is owned jointly with Westmoreland Energy, Inc. and is located in Rensselaer, New York. This facility will sell electricity to Niagara Mohawk Power Corp. and steam to BASF Corp. LPI is engaged in the construction of such facility and the project owner has arranged a $123 million construction and term loan facility to finance the construction and operation of this project. Completion of the Roanoke Valley I and Rensselaer projects are projected for mid-1994 and completion of the Roanoke Valley II project is expected for mid-1995. The financing and overall structure of the Roanoke Valley and Rensselaer projects are similar to that followed for previous LPI cogeneration projects. Subsidiaries of LPI, as builders of the projects, are contractually obligated to construct the project and to assure it meets certain performance standards. Financing for the construction of the project is provided to a partnership which is the owner of the project and in which LPI (or a wholly owned entity) is a partner. The partners are obligated to make equity contributions to the project at various stages prior to its completion. Each project has a long-term contract with the local utility to purchase electricity generated by the project and, for those projects which are qualifying cogeneration facilities, with an industrial company to purchase the steam from the project. Revenues from the sale of electricity and steam are designed to be sufficient to repay the debt incurred in financing the project. LPI's ownership interest in the project and the revenues from the sale of steam and electricity from the project are pledged as security to the lenders providing financing for the project. Although the financing of the project is non-recourse to the partnership owning the project, the various obligations of LPI under the contracts for construction of the project and LPI's equity commitments are guaranteed by Energy Systems. Through a support agreement with Energy Systems for the benefit of the project lenders, the Company has agreed in substance to provide Energy Systems with the necessary funds and financial support to meet these contingencies. See Project Obligations under Note 10 of the Notes to Financial Statements under Item 8. Westmoreland has similar guarantee obligations with respect to the equity commitments of Westmoreland Energy for the Roanoke Valley and Rensselaer projects. In April 1993, Westmoreland requested that Energy Systems provide financial assistance with respect to its guarantee obligations. Energy Systems agreed to provide such financial assistance by guaranteeing to the lenders for the Roanoke Valley and Rensselaer projects payment of those equity commitments of Westmoreland, up to a maximum aggregate amount of approximately $35.5 million ($26.9 million for the Roanoke Valley projects and $8.6 million for the Rensselaer project). LPI is entitled to receive fees for the provision of such financial assistance. The obligations of Westmoreland to repay any amounts actually paid by Energy Systems with respect to such guarantees and the other obligations which Westmoreland has to Energy Systems under this credit support arrangement are secured by pledges of Westmoreland Energy's ownership interests in the projects. In December 1993, Energy Systems and LPI entered into an arrangement with Nations Financial Capital Corporation (Nations), whereby Nations has agreed to fund on its behalf those amounts which Energy Systems is obligated to fund for Westmoreland with respect to the Roanoke Valley projects. While Energy Systems remains directly responsible to the Roanoke Valley lenders for the payment of Westmoreland's equity obligations for such projects, Nations has agreed that Westmoreland, and not Energy Systems, will be responsible for repayment of any amounts which Nations is obligated to fund. As security for the payment to Nations of any amounts so funded, the Company assigned to Nations those pledged interests in the Roanoke Valley projects and those related rights which were received from Westmoreland in April 1993. Energy Systems paid a fee to Nations in connection with the assumption by Nations of Westmoreland's Roanoke Valley funding obligations. Energy Systems is able to terminate such arrangement at any time. Both the lenders for the Roanoke Valley projects as well as Westmoreland have consented to Energy Systems' arrangements with Nations. LABOR RELATIONS LG&E's 1,652 operating, maintenance, and construction employees are members of the International Brotherhood of Electrical Workers (IBEW) Local 2100. On May 31, 1992, the IBEW voted to ratify a new three-year collective bargaining agreement. The new agreement became effective in November 1992 and will expire in November 1995. EMPLOYEES The Company and its subsidiaries had 3,293 full-time employees at December 31, 1993. During the last quarter of 1993 and early 1994, LG&E eliminated a number of full-time positions and made early retirement available to a number of other employees. See Note 5 of Notes to Financial Statements under Item 8 for a further discussion of this matter. ITEM 2. ITEM 2. PROPERTIES. At February 28, 1994, LG&E owned and operated the following electric generating stations: LG&E's steam stations consist mainly of coal-fired units except for Cane Run Unit 3 which must use natural gas because of restrictions mandated by environmental regulations. LG&E also owns an 80 Mw hydroelectric generating station located in Louisville, operated under license issued by the Federal Energy Regulatory Commission. At December 31, 1993, LG&E's electric transmission system included 20 substations with a total capacity of approximately 10,518,897 Kva and approximately 645 structure miles of lines. The electric distribution system included 84 substations with a total capacity of approximately 2,948,768 Kva, 3,499 structure miles of overhead lines, 231 miles of underground conduit, and 5,170 miles of underground conductors. LG&E's gas transmission system includes 177 miles of transmission mains, and the gas distribution system includes 3,226 miles of distribution mains. LG&E operates underground gas storage facilities with a current working gas capacity of approximately 14.6 million Mcf. See Gas Supply under Item 1. In 1990, LG&E entered into an operating lease for its corporate office building located in downtown Louisville, Kentucky. The lease is for a period of 15 years and is scheduled to expire June 30, 2005. Other properties owned by LG&E include office buildings, service centers, warehouses, garages, and other structures and equipment, the use of which is common to both the electric and gas departments. The trust indenture securing LG&E's First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by LG&E. At December 31, 1993, LPI owned the percentage indicated of the following qualifying cogeneration projects in operation or being constructed: LPI's ownership interests in these projects and the revenues from the sale of electricity and steam from the projects are pledged as security to the lenders who provided the financing for the project. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Rate Case and Trimble County Station For a discussion of the most recent rate order of the Public Service Commission of Kentucky and a detailed discussion of the orders of the Kentucky Commission and rulings of the Franklin Circuit Court and the Kentucky Court of Appeals concerning Trimble County Unit 1, see Item 7 and Note 11 of the Notes to Financial Statements under Item 8. Statewide Power Planning As required by the regulations of the Kentucky Commission, on November 15, 1993, LG&E filed its 1993 biennial Integrated Resource Plan with the Kentucky Commission. The plan which updates LG&E's first Integrated Resource Plan filed in 1991, proposes to meet customers' future demand through 2007 by adding resources in small increments such as short-term power purchases (1996-1999), a customer-owned standby generation program (1997), two combustion turbines (1999-2000), an air conditioner load controls program (2001-2003), an upgrade to LG&E's existing hydroelectric plant (2003), and a compressed air energy storage plant (2004). The Kentucky Commission staff is in the process of reviewing LG&E's plan, and is not expected to issue its report and recommendations concerning the plan until late 1994 at the earliest. The Kentucky Commission's regulations do not require it to hold any hearings or issue any formal orders regarding the Plan. Environmental The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. This legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency. While LG&E will incur some capital expenditures to comply with the Act's requirements, the overall impact of the Act on LG&E is expected to be minimal. LG&E is closely monitoring the continuing rule-making process, in order to assess the precise impact of the legislation on LG&E. For a complete discussion of the Company's environmental issues concerning its Mill Creek and Cane Run generating plants, manufacturing gas plant sites, and certain other environmental issues, see Note 10 of the Notes to Financial Statements under Item 8. Based upon prior precedents established by the Kentucky Commission and the Environmental Cost Recovery legislation, LG&E expects to have an opportunity to recover through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Like LG&E, LPI and its subsidiaries are subject to extensive federal, state, and local environmental laws and regulations governing the operations of the various power plants in which they participate as an owner or managing operator. Among other things, these laws and regulations govern the discharge of materials into waterways, the air, and the ground and, if violated, may require the owner or operator to take remedial action to maintain the affected facility's operating status. To the extent any such remedial environmental actions have been required of LPI or its subsidiaries in the past, related expenditures have not been material. Other As discussed in Item 1, LPI announced a preliminary agreement with the DuPont Company to form a power partnership. Virginia Power, one of the utilities in whose service territory the DuPont facilities reside, has made an administrative filing with the Virginia State Corporation Commission (SCC) questioning certain aspects of the proposed transaction. Virginia Power has requested that the SCC, among other things, enter a declaratory order determining that the proposed arrangement is unlawful and violates Virginia Power's rights under its certificate of public convenience and necessity. Due to the preliminary nature of this proceeding, it is not possible to predict with any certainty its outcome at this time. Nonetheless, LPI intends to vigorously pursue the proposed transaction. LG&E is a defendant in lawsuits seeking compensatory and, in certain instances, punitive damages for injuries purportedly incurred by individuals coming into contact with LG&E's electric or gas facilities and/or services. To the extent that damages are assessed in any of these lawsuits, LG&E believes that its insurance coverage is adequate and that the effect of any such damages will not be material. LPI and LPI's subsidiaries are defendants in lawsuits seeking compensatory damages primarily associated with various employment related matters. To the extent that damages are assessed in any of these lawsuits, LPI believes that the effect will not be material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None Executive Officers of the Company. Each of the following officers is an executive officer of a subsidiary of the Company and for purposes of the requirements of this report may also be considered an executive officer of the Company: The present term of office of each of the above executive officers extends to the meeting of the Board of Directors following the Annual Meeting of Stockholders, scheduled to be held May 24, 1994. There are no family relationships between executive officers of the Company or those executive officers of its subsidiaries. Mr. Hale was named to the position shown above concurrent with a corporate restructuring completed on August 17, 1990, pursuant to which LG&E became a subsidiary of the Company. Prior to January 1, 1994, Mr. Casey was Executive Vice President and Chief Financial Officer, and prior to January 1, 1993, President - LG&E Energy Systems (a subsidiary of the Company). Prior to January 1, 1994, Mr. Wood was Senior Vice President and Chief Administrative Officer - LG&E, and prior to December 1992, held the same position concurrently for the Company and LG&E. Prior to January 1, 1993, Mr. Markel was Senior Vice President and Chief Financial Officer, and prior to January 1992, Vice President-Finance and Treasurer. Messrs. Hale and Markel are also executive officers of the Company's subsidiary, LG&E. Mr. Fowler, Ms. Heck, Mr. Hermann, and Mr. Markel have been employed for more than five years in executive or management positions with the Company or its subsidiary, LG&E. Prior to election to the position shown in the table, the following executive officers held other positions with the Company or LG&E since January 1, 1989: Ms. Heck was Manager-Internal Audit prior to January 1990, Vice President-Internal Auditing prior to January 1, 1992, Vice President-Fuels and Operating Services prior to January 1, 1993, and Vice President-Fuels and Information Services thereafter; Mr. Hermann was Manager-Administration, Power Production prior to November 1989, General Manager-Power Production prior to January 1992 and General Manager-Wholesale Electric thereafter; Mr. Markel was Vice President and Treasurer prior to March 1, 1990, Vice President-Finance and Treasurer prior to January 1, 1992, and Senior Vice President and Chief Financial Officer thereafter. Effective January 1, 1993, Mr. Markel was named Corporate Vice President-Finance and Treasurer of the parent company, LG&E Energy Corp. Prior to election to his current position, Mr. Hale held the position of Chairman of the Board, President and Chief Executive Officer of LG&E, and prior to February 1, 1990, Mr. Hale was President and Chief Executive Officer of LG&E. Prior to June 1, 1989, Mr. Hale was employed by BellSouth Enterprises, Inc. and held the position of Executive Vice President. Prior to election to his current position, Mr. Staffieri was Senior Vice President-Public Policy, and General Counsel of the Company and LG&E, and prior to November 15, 1992, Senior Vice President, General Counsel and Corporate Secretary. Prior to March 15, 1992, Mr. Staffieri was employed by Long Island Lighting Company and held the position of General Counsel and Secretary from April 1989 to March 1992, and Deputy General Counsel prior to April 1989. Prior to election to his current position, Mr. Carey was Vice President and General Manager, Retail Electric Business of LG&E, prior to January 1, 1993, Vice President-Marketing and General Manager, Electric Service, prior to January 1, 1992, Vice President-Marketing and Planning, and prior to July 14, 1990, Vice President-Marketing and Sales. Prior to January 1990, Mr. Carey was employed by AT&T General Business Systems and held the position of Director-Strategic and Business Planning. Prior to election to his current position, Mr. Bennett was Vice President and General Manager, Gas Service Business of LG&E, and prior to January 1, 1992, General Manager, Gas Operations. Prior to May 1990, Mr. Bennett was employed by the Railroad Commission of Texas and held the position of Director of Transportation-Gas Utility Division. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is listed on the New York and Chicago Stock Exchanges. The ticker symbol is "LGE". The newspaper stock exchange listings are "LGE Energy" or "LGE EN". The following table gives information with respect to price ranges, as reported in THE WALL STREET JOURNAL as New York Stock Exchange Composite Transactions, and dividends paid for the periods shown. Effective May 15, 1992, the outstanding shares of common stock were split on a three-for-two basis. The new shares were issued to shareholders of record on April 30, 1992. Prior period shares of common stock, dividends paid, prices, earnings per share of common stock, and dividends declared reported in this item and Item 6 ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION. OVERVIEW LG&E Energy Corp.'s net income and earnings per share of common stock increased in 1993 as compared to 1992 because of strong performances by both the utility and the non-utility businesses. The contribution from Louisville Gas and Electric Company (LG&E) resulted primarily from a more normalized weather pattern in the utility's service area and the sale of a 12.88% interest in Trimble County Unit 1. Contributions to net income from the Company's non-utility businesses resulted primarily from earnings from projects under construction and in operation, project finance closings, and earnings from plants operated and maintained on behalf of third parties. In addition, earnings from the Company's 36.5% investment in Natural Gas Clearinghouse (NGC) increased in 1993 as compared to 1992. In December 1993, the Company agreed to sell its partnership interest in NGC to NOVA Corporation of Alberta, Canada. The sale was completed in January 1994, and the Company expects to post a pre-tax gain of approximately $87 million in the first quarter of 1994. Effective January 1, 1994, the Company announced a major realignment of its business units to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. In addition to this organizational change, the Company is presently re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which the Company has recorded as regulatory assets. See Future Outlook for a further discussion of this matter. The following discussion and analysis by management focuses on those factors that had a material effect on the Company's financial results of operations and financial condition during 1993 and 1992 and should be read in connection with the consolidated financial statements and notes thereto. The Company's financial results and conditions are dependent to a large degree on the financial results and conditions of Louisville Gas and Electric Company. RESULTS OF OPERATIONS Earnings per Share The Company's earnings per common share increased 36 cents for 1993 over 1992, including the 10 cents per common share gain recognized from the sale of a 12.88% portion of the Trimble County plant to the Indiana Municipal Power Agency (IMPA). LG&E's contribution to earnings came from increased electric sales as a result of the warmer summer weather experienced in 1993, higher sales to other utilities and reduced costs for debt and preferred stock attributable to favorable refinancing activities. Contributions to earnings from the non-utility businesses came from construction profits recognized by LG&E Power Inc. (LPI), earnings from operating power projects, a financial closing related to a power project and strong performance by NGC. After excluding the 13 cents per common share gain recognized in 1991 by LG&E on the sale of a 12.12% portion of the Trimble County plant to Illinois Municipal Electric Agency (IMEA), earnings for 1992 decreased 10 cents from 1991. This decrease was due primarily to lower electric sales to residential customers as a result of the cooler summer experienced in 1992 (40 cents), increased operating and depreciation expenses (15 cents), decreased interest earned on temporary cash investments of LG&E (3 cents), and various other factors (4 cents). These items were partially offset by the contribution to earnings from non-utility operations in 1992 (40 cents) and favorable financing activities of LG&E (12 cents). Rates and Regulation LG&E is subject to the jurisdiction of the Public Service Commission of Kentucky (Commission) in virtually all matters related to electric and gas utility regulation. LG&E last filed for a rate increase with the Commission in June 1990 based on the test-year ended April 30, 1990. The request was for a general rate increase of $34.9 million ($31.0 million electric and $3.9 million gas). A final order was issued in September 1991 that effectively granted LG&E an annual increase in rates of $6.8 million ($6.1 million electric and $.7 million gas). The Commission's order authorized a rate of return on common equity of 12.5%. On April 21, 1993, LG&E, the Kentucky Attorney General, the Jefferson County Attorney, and representatives of several customer-interest groups filed with the Commission a request for approval of a comprehensive agreement on demand side management (DSM) programs. Under the agreement, LG&E will commit up to $3.3 million over three years (from 1994 through 1996) for initial programs that include a residential energy conservation and education program and a commercial conservation audit program. Future programs will be developed through a formal collaborative process. The agreement contains a rate mechanism that will (1) provide LG&E concurrent recovery of DSM program costs, (2) provide LG&E an incentive for implementing DSM programs, and (3) allow LG&E to recover revenues due to lost sales associated with the DSM programs. On November 12, 1993, the Commission approved the agreement. Revenues from lost sales to residential customers are collected through a "decoupling mechanism". LG&E's residential decoupling mechanism breaks the link between the level of LG&E's residential kilowatt-hour and Mcf sales and its non- fuel revenues. Under traditional regulation, a utility's revenue varies with changes in its level of kilowatt-hour or Mcf sales. The residential decoupling mechanism will allow LG&E to recover a predetermined level of revenue per customer based on the rate set in LG&E's last rate case, which will not vary with the level of kilowatt-hour or Mcf sales. Residential revenues will be adjusted to reflect (1) changes in the number of residential customers and (2) a pre-established annual growth factor in residential revenue per customer. Decoupling, in effect, removes the impact on LG&E's non-fuel revenues from changes in kilowatt-hour or Mcf sales due to weather, fluctuations in the economy, and conservation efforts. Under this mechanism, if actual sales produce lower revenues than are produced by the predetermined per-customer amount, the difference is deferred for recovery from customers through an adjustment in rates over a period that will not exceed two years. Conversely, if actual sales produce more revenues than would be realized using the predetermined per-customer amount, the difference will be returned to customers through subsequent rate adjustments over a period not to exceed two years. Residential revenues reported in the financial statements for 1994 through 1996 will be determined in accordance with the predetermined amount per customer plus growth, and recovery of fuel and gas costs. The difference between the revenues shown in the financial statements and the amounts billed to customers will be recorded on the balance sheet and deferred for future recovery from or return to customers. As more fully discussed in Note 11 of Notes to Financial Statements under Item 8, the Commission has set a procedural schedule to determine the appropriate ratemaking treatment to exclude 25% of the Trimble County plant from customer rates. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by LG&E. This tariff enables LG&E to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables LG&E to sell an unlimited amount of non-firm power at market-based rates, as long as the power is from LG&E's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from LG&E. These tariffs provide open access to LG&E's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across LG&E's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. Revenues A comparison of LG&E's revenues for the years 1993 and 1992 with the immediately preceding years reflects both increases and decreases which have been segregated by the following principal causes (in thousands of $): Electric revenues increased in 1993 primarily because of the warmer summer weather. Sales of electricity to other utilities increased over 1992 levels due to LG&E's aggressive efforts in marketing off-system sales of energy. The increase in gas sales for 1993 is largely attributable to cooler winter weather in the region and customer growth. Non-utility revenues of $123.5 million are $6.5 million or 5% lower than last year due to lower project development fees and revenues. Construction revenues of $120 million were roughly equal to 1992, as progress continued on LPI's currently active projects at Roanoke Valley I and II in North Carolina, and Rensselaer in New York. LPI derives the majority of its revenues from the construction of power plants while its operating profit consists of plant development and construction profits in addition to earnings from operating power projects. LPI's ability to sustain this level of revenues is dependent, in part, upon its ability to continue to obtain major engineering and construction contracts. Expenses Fuel for electric generation and gas supply expenses account for a large segment of the Company's total operating costs. LG&E's electric and gas rates contain a fuel adjustment clause and a gas supply clause, respectively, whereby increases or decreases in the cost of fuel and gas supply may be reflected in LG&E's rates, subject to the approval of the Commission. Fuel expenses increased in 1993 primarily because of an increase in generation and the higher cost of coal purchased. The average delivered cost per ton of coal purchased for LG&E was $26.58 in 1993, $25.17 in 1992, and $24.51 in 1991. LG&E's increase in power purchased expense reflects an increase in the quantity of power purchased mainly because of wheeling arrangements with other utilities. Gas supply expenses increased in 1993 and 1992 largely because of an increase in both the cost and the volume of gas purchased. The average unit cost per Mcf of purchased gas for LG&E was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Utility operating and maintenance expenses increased approximately $5 million in 1993. This increase is primarily attributable to increased expenses for operation and maintenance of electric generating plants and higher administrative and general costs. The $2 million increase in 1992 over 1991 resulted primarily from costs associated with legal settlements relating to personal injury claims and storm damage expenses. General increases in labor and material costs are also reflected in operation and maintenance expenses. Non-utility expenses reflect the operating and business development expenses associated with the Company's non-utility operations. The majority of the expenses reflected herein pertain to LPI, including construction, project development, and general and administrative costs. LPI was acquired in December 1991. Other income and (deductions) decreased in 1993. Other income includes a $3.9 million before-tax gain on the sale of a 12.88% ownership interest in LG&E's Trimble County Unit 1 to IMPA. Other deductions reflect charges applicable to business restructurings and other non-recurring charge-offs. A decrease in 1992 from 1991 resulted primarily from a $7.9 million gain recorded in 1991 on the sale of a 12.12% ownership interest in Trimble County to IMEA and decreased interest income of $3 million from temporary cash investments. Interest charges decreased in 1993 and 1992 primarily because of an aggressive program to refinance at lower interest rates. LG&E refinanced approximately $205 million of its outstanding debt in 1993. The lower interest requirement at LG&E was partially offset by interest charges related to debt issued for the Company's expansion into non-utility businesses. Variations in income tax expenses are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35% effective January 1, 1993. Preferred dividends reflect the lower dividend rates that resulted from LG&E's refunding of the $25 million, $8.90 Series with a $5.875 Series in May 1993. In February 1992, LG&E refunded the $8.72 and $9.54 Series with $50 million of Auction Rate Series. LG&E's weighted average preferred dividend rate at December 31, 1993, was 4.72%; at December 31, 1992, 5.36%. Income from discontinued operations reflect the net earnings realized from the Company's investment in NGC. In January 1994, the Company sold its interest in NGC. (See Note 3 of Notes to Financial Statements under Item 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Thousands of $ Except Per Share Data) CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION. The consolidated financial statements include the accounts of LG&E Energy Corp. and its wholly-owned subsidiaries - Louisville Gas and Electric Company (LG&E) and LG&E Energy Systems Inc. (Energy Systems), collectively referred to herein as the "Company." In consolidation all intercompany transactions have been eliminated. The Company is exempt from regulation as a registered holding company under the Public Utility Holding Company Act of 1935. Accounting for the regulated utility business conforms with generally accepted accounting principles as applied to regulated public utilities and as prescribed by the Federal Energy Regulatory Commission (FERC) and the Public Service Commission of Kentucky (Commission). LG&E is subject to Statement of Financial Accounting Standards No. 71, ACCOUNTING FOR THE EFFECTS OF CERTAIN TYPES OF REGULATION. LG&E has recorded certain regulatory assets at December 31, 1993, totaling approximately $31 million. See Note 5, Post-Retirement Benefits and Early Retirement/Work Force Reduction, and Note 10, Environmental, for a discussion of these regulatory assets. See Future Outlook under Item 7, Management's Discussion and Analysis, for a discussion of the Company's re-evaluation of its current regulatory strategy in regards to these assets. During 1992, Energy Systems acquired a 36.5% partnership interest in Natural Gas Clearinghouse (NGC), a natural gas marketing company based in Houston, Texas. In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation with a closing date in January 1994. Accordingly, the Company's equity interest in NGC's earnings has been classified as Income from Discontinued Operations in the accompanying financial statements. See Note 3, Discontinued Operations. In December 1991, Energy Systems acquired Hadson Power Systems, Incorporated (HPS), in a transaction accounted for as a purchase. Subsequent to the acquisition, HPS was renamed LG&E Power Systems Inc. and has been subsequently renamed LG&E Power Inc. (LPI). LPI develops, designs, builds, owns, operates, and maintains power generation facilities that sell energy to local industries and utilities. LPI's revenues and expenses are classified as "non-utility" in the accompanying financial statements; approximately $97 million and $102 million of the expenses classified as "non-utility" primarily represented costs of construction revenues in 1993 and 1992, respectively. See Note 2, Acquisitions. UTILITY PLANT. LG&E's utility plant is stated at original cost, which includes payroll-related costs such as taxes, fringe benefits, and administrative and general costs. Construction work in progress has been included in the rate base, and, accordingly, LG&E has not recorded any allowance for funds used during construction. The cost of utility plant retired or disposed of in the normal course of business is deducted from utility plant accounts and such cost plus removal expense less salvage value is charged to the reserve for depreciation. When complete operating units are disposed of, appropriate adjustments are made to the reserve for depreciation and gains and losses, if any, are recognized. In December 1990, the 25% portion of the construction costs of the Trimble County Generating Station (Trimble County), which the Commission disallowed in setting customer rates, was reclassified from the Utility Plant section on the balance sheet to Other Property and Investments. In February 1991, LG&E sold a 12.12% undivided interest in Trimble County to the Illinois Municipal Electric Agency (IMEA). In February 1993, the remaining 12.88% of Trimble County not allowed in rates was sold to the Indiana Municipal Power Agency (IMPA). See Notes 11 and 12, Trimble County Generating Plant and Jointly Owned Electric Utility Plant, respectively, for a further discussion. DEPRECIATION. Depreciation is provided on the straight-line method over the estimated service lives of depreciable plant. The amounts provided for LG&E in 1993 and 1992 were 3.3% (3.2% electric, 3.2% gas, and 5% common); and for 1991, 3.3% (3.2% electric, 3% gas, and 6% common) of average depreciable plant. CASH AND TEMPORARY CASH INVESTMENTS. The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Temporary cash investments are carried at cost, which approximates fair value. DEFERRED INCOME TAXES. Deferred income taxes have been provided for all book-tax temporary differences. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, ACCOUNTING FOR INCOME TAXES, effective January 1, 1993. SFAS No. 109 adopts the liability method of accounting for income taxes, requiring deferred income tax assets and liabilities to be computed using tax rates that will be in effect when the book and tax temporary differences reverse. For LG&E, the change in tax rates applied to accumulated deferred income taxes was not immediately recognized in operating results because of ratemaking treatment. At December 31, 1993, the deferred tax asset, which resulted primarily from unamortized investment tax credits, amounted to approximately $47 million. The deferred tax liability, which resulted primarily from book/tax utility property basis differences, totaled approximately $40 million. Regulatory assets and liabilities were established to recognize the future revenue requirement impact from these deferred taxes. The adoption of SFAS No. 109 did not have a material impact on the results of operations or financial position for either the regulated or non-regulated companies. The deferred tax balances and related regulatory assets and liabilities reflect the increase in the corporate income tax rate from 34% to 35%. INVESTMENT TAX CREDITS. Investment tax credits resulted from provisions of the tax law that permitted a reduction of the Company's tax liability based on credits for certain construction expenditures. Investment tax credits deferred and charged to income in prior years are being amortized to income over the estimated lives of the related property that gave rise to the credits. DEBT PREMIUM AND EXPENSE. Debt premium and expense are amortized over the lives of the related debt issues, consistent with regulatory practices. COMMON STOCK. Effective May 15, 1992, the outstanding shares of common stock were split on a three-for-two basis. The new shares were issued to shareholders of record on April 30, 1992. Prior period shares, dividends, and earnings per share of common stock have been restated to reflect the stock split. REVENUE RECOGNITION. Utility revenues are recorded based on service rendered to customers through month end. LG&E accrues an estimate for unbilled revenues from the date of each meter reading date to the end of the accounting period. See Management's Discussion and Analysis, Rates and Regulation under Item 7, for changes in recording residential revenues effective January 1, 1994. The Company's non-utility construction activities recognize revenues using the percentage of completion method of accounting. FUEL AND GAS COSTS. The cost of fuel for electric generation is charged to expense as used, and the cost of gas supply is charged to expense as delivered to the distribution system. REVENUES AND CUSTOMER RECEIVABLES. LG&E is an operating public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. Customer receivables and gas and electric revenues arise from deliveries of natural gas and electric energy to a diversified base of residential, commercial and industrial customers and to public authorities and other utilities. For the year ended December 31, 1993, 74% of total utility revenue was derived from electric operations and 26% from gas operations. FAIR VALUE OF FINANCIAL INSTRUMENTS. Pursuant to the Financial Accounting Standards Board SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, the Company is required to disclose the fair value of financial instruments where practicable. The fair value for certain of the Company's investments and debt are estimated based on quoted market prices for those or similar instruments. Investments for which there are no quoted market prices are stated at cost because a reasonable estimate of fair value cannot be made without incurring excessive costs. The cost and estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992, are as follows (in thousands of $): NOTE 2 - ACQUISITIONS In December 1991, Energy Systems acquired LPI (Hadson Power Systems, Incorporated), a developer, designer, builder, owner, and operator of non-regulated power generation facilities, headquartered in Irvine, California, for approximately $49.1 million, including acquisition related expenses. The Company accounted for the acquisition of LPI as a purchase, and accordingly, the net assets were recorded at their fair value on the acquisition date in the accompanying balance sheets. The excess of the purchase price over the fair value of the net assets acquired was recorded as goodwill, and is being amortized on a straight-line basis over 40 years. See Note 10, Commitments and Contingencies for information concerning equity funding commitments that LPI is required to provide. NOTE 3 - DISCONTINUED OPERATIONS In December 1993, the Company agreed to sell its 36.5% equity interest in NGC to NOVA Corporation for approximately $170 million. The sale of NGC, which was completed in January 1994, will result in a pre-tax gain of approximately $87 million. NGC was acquired in 1992 at a cost of approximately $70 million. At the disposal date, the Company's investment in NGC was approximately $83 million. This transaction was recorded as the disposal of a business segment and, accordingly, the investment balance and related equity in earnings of NGC have been classified as discontinued operations within the accompanying financial statements. NOTE 4 - INVESTMENTS IN AFFILIATES The Company's investments in affiliates reflect LPI's interest in partnerships that own and/or operate power producing plants. These investments are recorded using the equity method and were $63,241,000 and $59,273,000 at December 31, 1993 and 1992, respectively. The ownership percentages of LPI's joint ventures are summarized below: The Company's carrying amount exceeded the underlying equity in affiliates by $34,618,000 and $35,750,000 at December 31, 1993 and 1992, respectively. The difference represents adjustments to reflect the fair value of the underlying net assets acquired and goodwill. The fair value adjustments are being amortized over periods ranging from two to 25 years, and the goodwill is being amortized over 40 years. NOTE 5 - PENSION PLANS AND RETIREMENT BENEFITS PENSION PLANS. The Company has two non-contributory, defined-benefit pension plans, covering all eligible employees. Retirement benefits are based on the employee's years of service and compensation. The Company's policy is to fund annual actuarial costs, up to the maximum amount deductible for income tax purposes, as determined under the frozen entry age actuarial cost method. In addition, the Company has a supplemental executive retirement plan which covers officers of the Company. The plan provides retirement benefits based on average earnings during the final three or five years prior to retirement, reduced by social security benefits, any pension benefits received from plans of prior employers, and by amounts received under the pension plans mentioned in the preceding paragraph. Pension cost was $3,048,000 for 1993, $2,664,000 for 1992, and $2,245,000 for 1991, of which approximately $425,000, $241,000, and $306,000, respectively, were charged to construction. The components of periodic pension expense are shown below (in thousands of $): The assets of the plans consist primarily of common stocks, corporate bonds, United States government securities, and interests in a pooled real estate investment fund. The funded status of the pension plans at December 31 is shown below (in thousands of $): The projected benefit obligation was determined using an assumed discount rate of 7.5% for 1993 and 8.5% for 1992. An assumed annual rate of increase in future compensation levels ranged from 3.5% to 4.5% for 1993 and 3.5% to 6.5% for 1992. The assumed long-term rate of return on plan assets was 8.5% for both periods. Transition assets and prior service costs are being amortized over the average remaining service period of active participants. POST-RETIREMENT BENEFITS. The Company adopted Statement of Financial Accounting Standards No. 106, EMPLOYERS' ACCOUNTING FOR POST-RETIREMENT BENEFITS OTHER THAN PENSIONS (SFAS No. 106) January 1, 1993. SFAS No. 106 requires the accrual of the expected cost of retiree benefits other than pensions during the employee's years of service with the Company. The Company is amortizing the discounted present value of the post-retirement benefit obligation at the date of adoption over 20 years. The Company provides certain health care and life insurance benefits for eligible retired employees. Post-retirement health care benefits are subject to a maximum amount payable by the Company. Prior to January 1, 1993, the cost of retiree health care and life insurance benefits was generally recognized when paid. Beginning in 1993, the Company began to account for post-retirement benefits according to the provisions of SFAS No. 106. LG&E, based on an order from the Commission, has created a regulatory asset and is deferring the level of SFAS No. 106 expense in excess of the previous level of pay-as-you-go expense. The Commission's generic order stated that the proper level of expense for SFAS No. 106 would be determined in each utility's next general rate case. The components of the net periodic post-retirement benefit cost for 1993 as calculated under SFAS No. 106 are as follows (in thousands of $): The accumulated post-retirement benefit obligation as calculated under SFAS No. 106 at December 31, 1993, is shown below (in thousands of $): The annual service cost was calculated using an assumed discount rate of 8.5% at January 1, 1993, and 7.5% at December 31, 1993. A medical cost increase factor that ranged between 6% and 11% was also used. A 1% increase in the health care cost trend rate would increase the Accumulated Post-Retirement Benefit Obligation by approximately $1.8 million and the annual service and interest cost by approximately $200,000. No funding has been established by the Company for post-retirement benefits. POST-EMPLOYMENT BENEFITS. The Financial Accounting Standards Board issued SFAS No. 112, EMPLOYERS' ACCOUNTING FOR POST-EMPLOYMENT BENEFITS, which requires the accrual of the expected cost of benefits to former or inactive employees after employment but before retirement. The Company adopted the new standard effective January 1, 1994, as required. Adoption of SFAS No. 112 will not have a material adverse impact on the financial position or results of operation of the Company. EARLY RETIREMENT/WORK FORCE REDUCTION. During the last quarter of 1993 and early 1994, LG&E eliminated approximately 350 full-time positions. The cost of the employee reduction program, approximately $11.5 million, consists primarily of separation payments, enhanced early retirement benefits, and health care benefits. In 1992, an early retirement program was made available to all LG&E union employees who had reached age 55, or who had 35 years or more of continuous service regardless of age. The cost of the program was approximately $7 million and consisted primarily of enhanced early retirement and post-retirement health care benefits. THRIFT SAVINGS PLAN. The Company has Thrift Savings Plans under Section 401(k) of the Internal Revenue Code. Under these plans, eligible employees may defer and contribute to the plan a portion of current compensation in order to provide future retirement benefits. The Company makes contributions to the plans by matching a portion of employees' contributions according to a formula established by the plans. These costs were approximately $3,542,000 for 1993, $2,204,000 for 1992, and $598,000 for 1991. The increase in 1993 401(k) expenses is due to the expansion of the program to LG&E union employees; the increase in 1992 is due to the inclusion of LPI's Thrift Savings Plan. NOTE 6 - FEDERAL AND STATE INCOME TAXES Components of income tax expense from continuing operations are shown in the table below (in thousands of $): Variations in the 1993 income tax expense from 1992 and 1991 are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35%, effective January 1, 1993. Provisions for deferred income taxes from continuing operations consist of the tax effects of the following temporary differences (in thousands of $): Depreciation and amortization fluctuations for 1993 are primarily attributable to the reversal of prior years' accumulated taxes as a result of the sale of a portion of Trimble County Unit 1 to IMPA. See Note 11, Trimble County Generating Plant, for a further discussion of the sale. The following are the tax effects of book-tax temporary differences resulting in deferred tax assets and liabilities as of December 31, 1993 (in thousands of $): The Company's effective income tax rate is computed by dividing the aggregate of current income taxes, deferred income taxes-net, and the investment tax credit-net, by income from continuing operations before income taxes. Reconciliation of the statutory Federal income tax rate to the effective income tax rate for continuing operations is shown in the table below: NOTE 7 - CAPITAL STOCK Changes in shares of common stock outstanding are shown in the table below (in thousands): The Company's Automatic Dividend Reinvestment and Stock Purchase Plan was modified on April 14, 1991, to provide that reinvested dividends and optional cash payments would be used to buy shares of common stock on the open market. Prior to this date, authorized but unissued shares of common stock were issued to plan participants. The plan was changed in 1993 to issue authorized but unissued common stock under the plan effective with the January 15, 1993, dividend. Effective January 15, 1994, the plan has been revised and reinvested dividends and optional cash payments will again be applied to purchase shares of the Company's stock on the open market. The Company has a long-term incentive plan whereby, in addition to other types of stock-based and related awards, incentive and nonqualified stock options can be granted to key personnel. A total of 299,250 shares of common stock have been reserved for issuance under the plan. Under the nonqualified stock option portion of the plan, the Company may grant stock options at an exercise price approximating market value. Each option entitles the holder to acquire one share of the Company's common stock no earlier than one year from the date granted. The options generally expire 10 years from the date granted. Common stock equivalents resulting from the options granted would not have a material dilutive effect on reported earnings per share. A summary of the status of the Company's nonqualified stock options follows: In 1990, the Company adopted a Shareholders Rights Plan designed to protect shareholders' interests in the event the Company is ever confronted with an unfair or inadequate acquisition proposal. Pursuant to the plan, the Company declared a dividend distribution of one "right" for each share of LG&E Energy Corp. common stock. As a result of the three-for-two stock dividend effective May 15, 1992, each share of common stock will have two-thirds of a "right" associated with it. Each right entitles the holder to purchase from the Company one one-hundredth of a share of new preferred stock of the Company under certain circumstances. The rights may be exercised if a person or group announces its intention to acquire, or does acquire, 20% or more of LG&E Energy Corp. common stock. Under certain circumstances, the holders of the rights will be entitled to purchase either shares of common stock of LG&E Energy Corp. or common stock of the acquirer at a reduced percentage of market value. The rights will expire in the year 2000 unless they are redeemed or exchanged. In May 1993, LG&E issued $25 million of $5.875 Cumulative Preferred Stock. The proceeds from the sale were used to redeem the outstanding $8.90 Cumulative Preferred Stock. NOTE 8 - FIRST MORTGAGE BONDS Annual requirements for the sinking funds of LG&E's First Mortgage Bonds (other than the First Mortgage Bonds issued in connection with the Pollution Control Bonds) are the amounts necessary to redeem 1% of the highest principal amount of each series of bonds at any time outstanding. Property additions (166 2/3% of principal amounts of bonds otherwise required to be so redeemed) have been applied in lieu of cash. It is the intent of LG&E to apply property additions to meet 1994 sinking fund requirements of the First Mortgage Bonds. The trust indenture securing the First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by LG&E. The indenture, as supplemented, provides in substance that, under certain specified conditions, portions of retained earnings will not be available for the payment of dividends on common stock. No portion of retained earnings is presently restricted by this provision. Pollution Control Bonds (LG&E Projects) issued by Jefferson and Trimble Counties, Kentucky, are secured by the assignment of loan payments by LG&E to the Counties pursuant to loan agreements, and further secured by the delivery from time to time of an equal amount of LG&E's First Mortgage Bonds, Pollution Control Series. First Mortgage Bonds so delivered are summarized in the Statements of Capitalization. No principal or interest on these First Mortgage Bonds is payable unless default on the loan agreements occurs. The interest rate reflected in the Statements of Capitalization applies to the Pollution Control Bonds. In March 1993, due to the sale of 12.88% of Trimble County Unit 1, LG&E completed the defeasance of $25 million of its Pollution Control Bonds ($16.665 million of the 7.625% Series and $8.335 million of the 6.55% Series). LG&E issued several series of lower interest bearing First Mortgage and Pollution Control Bonds in 1993 to refinance bonds with higher interest rates. In August, LG&E issued two separate series of Pollution Control Bonds (a $35.2 million, Variable Rate Series, which had an interest rate of 2.586% at December 31, 1993, and a $102 million, 5.625% Series) and redeemed five series of Pollution Control Bonds totaling $137.2 million with interest rates ranging from 6.125% to 6.7%. In August, LG&E also issued $42.6 million of 6% First Mortgage Bonds and redeemed two series of First Mortgage Bonds ($19.7 million at 8.25% and $21.362 million at 8.5%). In November, LG&E issued $26 million of Pollution Control Bonds, 5.45% Series and redeemed the $26 million, 9.75% Series. LG&E also entered into an agreement in November 1993 with Goldman, Sachs & Co. to issue $40 million of tax-exempt Pollution Control Bonds in 1995 at a rate of 5.9%. The issuance of the bonds in 1995 is subject to certain conditions. If issued, the proceeds will be used to redeem, in 1995, the outstanding 9.25% Series of Pollution Control Bonds due July 1, 2015. LG&E has outstanding interest rate swap agreements totaling $30 million. Under the agreements, which were entered into in 1992, LG&E pays a fixed rate of 4.35% on $15 million for a five-year period and 4.74% on $15 million for a seven-year period. In return, LG&E receives a floating rate based on the weighted average JJ Kenny index. At December 31, 1993, the rate on the JJ Kenny index was 3.25%. LG&E's First Mortgage Bonds, 5.625% Series of $16 million is scheduled to mature in 1996 and the 6.75% Series of $20 million is scheduled to mature in 1998. There are no scheduled maturities of Pollution Control Bonds for the five years subsequent to December 31, 1993. NOTE 9 - NOTES PAYABLE At December 31, 1993, Energy Systems had notes payable outstanding of $20 million at an interest rate of 3.75%; at December 31, 1992, notes payable were $50 million at 3.82%. LG&E had no notes payable at December 31, 1993. At December 31, 1992, trust demand notes of LG&E amounted to $8 million, on which the composite interest rate was 3.45%. At December 31, 1993, lines of credit were in place totaling $320 million ($145 million for LG&E, $150 million for Energy Systems, and $25 million for LG&E Energy Corp.), for which the companies pay commitment or facility fees. These lines of credit were unused, except for the $20 million of Energy Systems' line mentioned above. The credit lines are scheduled to expire at various periods during 1994 and 1996. Management intends to renegotiate these lines when they expire. NOTE 10 - COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM. The Company had commitments, primarily in connection with the construction program of LG&E, aggregating approximately $6 million at December 31, 1993. LG&E's construction expenditures for the calendar years 1994 and 1995 are estimated to total approximately $200 million. PROJECT OBLIGATIONS. In connection with the financing of various power projects, Energy Systems and LPI provide equity funding commitments and guarantee the construction and performance of the projects. Ascertainable equity funding commitments were $36 million and $38 million at December 31, 1993 and 1992, respectively. Contingent construction and project performance guarantees totaled approximately $198 million and $94 million at December 31, 1993 and 1992, respectively. Through a support agreement with Energy Systems for the benefit of certain Energy Systems' lenders, LG&E Energy Corp. has agreed to provide Energy Systems with the necessary funds and financial support to meet the foregoing contingencies. Westmoreland Energy Inc. (WEI) is a partner along with LPI in six cogeneration projects in operation or under construction. Under an agreement signed on April 15, 1993, LPI and Energy Systems have guaranteed (in exchange for fees and other consideration) the equity funding commitment of WEI in connection with the following three projects: Roanoke Valley I, Roanoke Valley II, and Rensselaer. The additional commitments resulting from this agreement total $35.5 million. During December 1993, the Company signed an agreement with Nations Financial Capital Corporation (Nations Financial) under which Nations Financial agreed, in exchange for fees, to assume $26.9 million of the Company's contingent equity funding commitment for Roanoke Valley I and II resulting from its April 15, 1993, agreement with WEI. FERC ORDER NO. 636. Order No. 636, which was issued by FERC in 1992, required LG&E and all other local distribution companies to revise their practices for purchasing and transporting gas. Whereas LG&E had previously purchased natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), LG&E now purchases only transportation services from Texas Gas and purchases natural gas from other sources. Under Order No. 636 pipelines may recover costs associated with the transition to and implementation of this order from pipeline customers, including LG&E. Based on pipeline filings to date, LG&E estimates that its share of transition costs, which must be approved by FERC, will be approximately $2 million to $3 million a year for both 1994 and 1995. The Commission issued an order, based on proceedings that were held to investigate the impact of Order No. 636 on utilities and ratepayers in Kentucky, providing that transition costs assessed on utilities by the pipelines, which are clearly identifiable as being related to the cost of the commodity itself, are appropriate to be recovered from customers through the gas supply clause. OPERATING LEASES. LG&E Energy Corp. has an operating lease for its corporate office space with an expiration date of 1996. LG&E has an operating lease for its corporate office building that is scheduled to expire in June 2005. LPI has operating lease commitments related to two office facilities with expiration dates ranging from two to eight years. Total lease expense for 1993, 1992, and 1991 was $4,526,000, $5,454,000, and $2,736,000, respectively. The future minimum annual lease payments under these lease agreements for years subsequent to December 31, 1993, are as follows (in thousands of $): ENVIRONMENTAL. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency (USEPA). LG&E is closely monitoring the continuing rule-making process in order to assess the precise impact of the legislation on the Company. All of LG&E's coal-fired boilers are equipped with sulfur dioxide "scrubbers" and already achieve the final sulfur dioxide emission rates required by the year 2000 under the legislation. However, as part of its ongoing capital construction program, LG&E anticipates incurring capital expenditures during the next four years of approximately $40 million for remedial measures necessary to meet the Act's requirements for nitrogen oxides. The overall financial impact of the legislation on LG&E is expected to be minimal. LG&E is well-positioned in the market to be a "clean" power provider without the large capital expenditures that are expected to be incurred by many other utilities. In 1992, LG&E entered two agreed orders with the Air Pollution Control District (APCD) of Jefferson County in which LG&E committed to undertake remedial measures to address certain particulate emissions and excess sulfur dioxide emissions from its Mill Creek generating plant. LG&E is currently conducting work in compliance with the agreed-upon schedule for remedial measures and has incurred total capital expenditures of approximately $24 million through 1993. Based on current remedial designs, LG&E anticipates incurring additional capital costs of approximately $14 million for this project in 1994 as part of its ongoing capital construction program. In an effort to resolve property damage claims relating to particulate emissions from the Mill Creek plant, in July 1993, LG&E commenced extensive negotiations and property damage settlements with adjacent residents. LG&E currently estimates that property damage claims for the particulate emissions should be settled for an aggregate amount of approximately $12 million. Accordingly the Company has recorded an accrual of this amount. In August 1993, 34 persons filed a complaint in Jefferson Circuit Court against LG&E in which they are seeking certification of a class consisting of all persons within 2.5 miles of the Mill Creek plant. The court has not acted on the request for certification of a class. The plaintiffs seek compensation for alleged personal injury and property damage attributable to emissions from the Mill Creek plant, injunctive relief, a fund to finance future medical monitoring of area residents, and other relief. LG&E intends to vigorously defend itself in the pending litigation. In response to a notification from the APCD that LG&E's Cane Run plant may be the source of a potential exceedance of the National Ambient Air Quality Standards for sulfur dioxide, LG&E retained a contractor to conduct certain air dispersion modeling. In 1992, LG&E submitted a draft action plan and modeling schedule to the APCD and USEPA. The APCD and USEPA have approved the submittals and LG&E's contractor is currently conducting additional modeling activities. Although it is expected that corrective action will be accomplished through capital improvements, until the contractor completes its modeling activities, LG&E cannot determine the precise impact of this matter. LG&E owns or formerly owned three primary sites where manufactured gas plant operations were located. Such manufactured gas plant operations, conducted in the 1838 to 1960 time period, typically produced coal tar byproducts and other constituents that may necessitate cleanup measures. LG&E commenced site investigations at the two company owned sites to determine if significant levels of contaminants are present. LG&E has commenced discussions with the current owner of the third site regarding joint performance of a site investigation. LG&E anticipates spending a total of approximately $1.3 million on site investigations expected to be completed by 1995. Preliminary testing at all three sites has identified contaminants typical of manufactured gas plant operations. Until an investigation and associated regulatory review is completed for each site, LG&E will be unable to predict what, if any, cleanup activities may be necessary. In November 1993, LG&E was served with a third-party complaint filed in federal district court in Illinois by three third-party plaintiffs. The third-party plaintiffs allege that LG&E and 31 other parties are liable for contributions under the Comprehensive Environmental Response, Compensation, and Liability Act as amended (CERCLA) for $1.4 million in costs allegedly incurred by USEPA in conducting cleanup activities at the M.T. Richards site in Crossville, Illinois. A number of de minimis third-party defendants, including LG&E, have commenced preliminary discussions with the third-party plaintiffs. In LG&E's opinion, the resolution of the issue will not have a material adverse impact on its financial position or results of operations. In February 1993, LG&E was served with an amended complaint filed in federal district court in West Virginia by three potentially responsible parties (PRP) against LG&E and 39 other parties. The plaintiffs alleged that the parties were liable under CERCLA for in excess of $3 million in costs allegedly incurred by the plaintiffs in conducting cleanup activities at the Spencer Transformer Site located in Roane County, West Virginia. In November 1993, the federal court approved a consent decree that resolved the case as to LG&E and nine other de minimis parties. Under the terms of the consent decree, LG&E reimbursed the plaintiffs for $10,000 in cleanup costs. No further involvement of LG&E is anticipated. In June 1992, USEPA identified LG&E as a PRP allegedly liable under CERCLA for $1.6 million in costs allegedly incurred by USEPA in cleanup of the Sonora Site and Carlie Middleton Burn Site located in Hardin County, Kentucky. In November 1992, USEPA demanded immediate payment from the PRPs. To date, USEPA has identified nine PRPs for the site. LG&E and several other parties have commenced discussions with USEPA. In LG&E's opinion, the resolution of this issue will not have a material adverse impact on its financial position or results of operations. In 1987, USEPA identified LG&E as one of the numerous PRPs allegedly liable under CERCLA for the Smith's Farm site in Bullitt County, Kentucky. In March 1990, USEPA issued an administrative order requiring LG&E and 35 other PRPs to conduct certain cleanup activities. In February 1992, four PRPs filed a complaint in federal district court in Kentucky against LG&E and 52 other PRPs. Under the law, each PRP could be held jointly and severally liable for the cost of site cleanup, but would have the right to seek contribution from other PRPs. In July 1993, upon motion of the plaintiffs, the federal court dismissed LG&E and a number of others from the litigation in order to facilitate settlement negotiations among the parties. Cleanup costs for the site are currently estimated at approximately $70 million. LG&E and several other parties have shared certain cleanup costs in the interim until a voluntary allocation of liability can be reached among the parties. It is not possible at this time to predict the outcome or precise impact of this matter. However, management believes that this matter should not have a material adverse impact on the financial position or results of operations of LG&E as other financially viable PRPs appear to have primary liability for the site. Based upon prior precedents established by the Commission and the Environmental Cost Recovery legislation, LG&E expects to have an opportunity to recover, through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Like LG&E, LPI and its subsidiaries are subject to extensive federal, state, and local environmental laws and regulations governing the operation of the various power plants in which they participate as an owner or managing operator. Among other things, these laws and regulations govern the discharge of materials into waterways, the air and the ground and, if violated, may require the owner or operator to take remedial action to maintain the affected facility's operating status. To the extent any such remedial environmental actions have been required of LPI or its subsidiaries in the past, related expenditures have not been material. NOTE 11 - TRIMBLE COUNTY GENERATING PLANT. Trimble County Unit 1, a 495-megawatt, coal-fired electric generating unit, was placed in commercial operation on December 23, 1990. This Unit, which during its first three years of commercial operations has operated more reliably than projected, has been the subject of numerous regulatory and legal proceedings. The current regulatory process involving Trimble County is related to an order issued by the Commission on July 1, 1988, which stated that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. In a rehearing order issued in April 1989, the Commission reaffirmed its decision that LG&E would not be allowed to include 25% of the cost of the Unit in customer rates; however, this order stated that "the disallowed portion of Trimble County remains with the Company and stockholders for their use." In 1989, the Commission initiated a proceeding to determine the appropriate ratemaking treatment to carry out the order that disallowed rate recovery for 25% of the Unit. Prior to the start of the hearings in this proceeding, LG&E filed a motion requesting the Commission to adopt a proposed plan to settle all of the issues surrounding Trimble County. Settlement discussions ensued between LG&E, intervenors, and the Commission staff. On October 2, 1989, the Commission approved the settlement agreement reached between LG&E and the Commission staff and, in accordance with the terms of the agreement, LG&E refunded $2.5 million to its customers in 1989 and reduced its electric rates by $8.5 million for the year beginning January 1, 1990. Certain intervenors, who participated in the proceedings but did not agree to the settlement, appealed the Commission's order approving the settlement to Franklin Circuit Court, claiming, among other things, that the Commission lacked the statutory authority to approve the agreement and that the intervenors who refused to sign the agreement were deprived of due process rights. In February 1991, the Franklin Circuit Court vacated the October 2, 1989 order of the Commission approving the settlement agreement. On September 27, 1991, the Court issued an opinion requiring a refund to ratepayers in excess of $100 million as a result of the Commission's order that disallowed 25% of the total cost of Trimble County from customer rates. The Court further ordered LG&E to post a bond if it appealed the Circuit Court's decision. LG&E posted a bond of $107 million and appealed all orders of the Circuit Court to the Kentucky Court of Appeals. On April 23, 1993, the Kentucky Court of Appeals overturned the Franklin Circuit Court ruling previously entered in the case. Although the decision upheld the Circuit Court's order vacating the 1989 settlement agreement approved by the Commission, the appeals court ruled that the Franklin Circuit Court order of September 27, 1991, improperly set utility rates in ordering refunds. The intervenor parties requested the Kentucky Supreme Court to review the case, and their request for review was denied on October 20, 1993. Under Kentucky procedural rules, this ruling makes final the Court of Appeals decision and returns the case to the Commission for further proceedings. The Commission has issued orders which set a portion of the procedural schedule for the case. Pursuant to the Commission's orders, LG&E filed direct testimony on January 7, 1994. Intervenor parties are scheduled to file testimony on March 28, 1994. No date has been set for a hearing. LG&E anticipates that the focus of Commission proceedings will be the determination of the appropriate ratemaking treatment to insulate ratepayers from 25% of Trimble County's costs and the amount of additional refunds, if any, that LG&E should return to ratepayers. In previous proceedings in 1988, the Commission had authorized rate increases, subject to refund, of $11.4 million on an annual basis, pending a determination of the appropriate ratemaking treatment for the disallowance. The order remained in effect from May 1988 through December 1990, resulting in an amount subject to refund of approximately $30 million. LG&E, through refunds and rate reductions, has already returned to its customers approximately $11 million of the total amount subject to refund. LG&E's position is that no additional refunds are needed to carry out the Commission's objective of reflecting the disallowance of 25% of Trimble County in customer rates and LG&E may be entitled to recover a portion, or all, of the amounts previously returned to customers. However, LG&E is unable to predict the outcome of the Commission proceedings, the amount of additional refunds or recoveries, if any, that may be ordered or whether the Commission will revise its earlier position. SALE OF PORTION OF TRIMBLE COUNTY. On February 28, 1991, LG&E sold a 12.12% ownership interest in the Trimble County Unit to the Illinois Municipal Electric Agency, based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. The sale price was $94.2 million and a book gain of $4.2 million, after-tax, was recognized in 1991 as a result of this sale. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County plant. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. The sale price was $91.1 million and an after-tax book gain of $3.2 million was recorded in 1993 as a result of this sale. LG&E has now completed the sale of the entire 25% of Trimble County that the Commission disallowed from customer rates. NOTE 12 - JOINTLY OWNED ELECTRIC UTILITY PLANT As of December 31, 1993, LG&E owned a 75% undivided interest in Trimble County Unit 1. Accounting for the 75% portion of the Unit, which the Commission has allowed to be reflected in customer rates, is similar to LG&E's accounting for other wholly owned utility plants. Of the remaining 25% of the Unit: * Illinois Municipal Electric Agency (IMEA) purchased a 12.12% undivided interest in the Unit on February 28, 1991. IMEA pays for 12.12% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. * Indiana Municipal Power Agency (IMPA) purchased a 12.88% undivided interest in the Unit on February 1, 1993. IMPA is responsible for 12.88% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. The following data represent shares of the jointly owned property: NOTE 13 - SEGMENTS OF BUSINESS LG&E Energy Corp. has business operations in both the regulated and non-regulated energy markets. The regulated business is conducted through LG&E, a public utility engaged in the generation, transmission, distribution, and sale of electricity and the transmission, distribution and sale of natural gas. The non-regulated energy business is conducted through Energy Systems, which manages the Company's non-utility operations. Energy Systems directly owns LPI. LPI and its subsidiaries develop, design, build, own, operate, and maintain power generation facilities that sell energy to local industries and utilities. In January 1994, Energy Systems sold its 36.5% partnership interest in NGC. See Note 3 of Notes to Financial Statements for further discussion. REPORT OF MANAGEMENT The management of LG&E Energy Corp. and subsidiaries is responsible for the preparation and integrity of the consolidated financial statements and related information included in this Annual Report. These statements have been prepared in accordance with generally accepted accounting principles applied on a consistent basis and, necessarily, include amounts that reflect the best estimates and judgment of management. The Company's financial statements have been audited by Arthur Andersen & Co., independent public accountants whose report follows the Notes to Financial Statements. Management has made available to Arthur Andersen & Co. all the Company's financial records and related data as well as the minutes of shareholders' and directors' meetings. Management has established and maintains a system of internal controls that provides reasonable assurance that transactions are completed in accordance with management's authorization, that assets are safeguarded and that financial statements are prepared in conformity with generally accepted accounting principles. Management believes that an adequate system of internal controls is maintained through the selection and training of personnel, appropriate division of responsibility, establishment and communication of policies and procedures and by regular reviews of internal accounting controls by the Company's internal auditors. Management reviews and modifies its system of internal control in light of changes in conditions and operations, as well as in response to recommendations from the internal auditors and the independent public accountants. These recommendations for the year ended December 31, 1993 did not identify any significant deficiencies in the design and operation of the Company's internal control structure. The Audit Committee of the Board of Directors is composed entirely of outside directors. In carrying out its oversight role for the financial reporting and internal controls of the Company, the Audit Committee meets regularly with the Company's independent public accountants, internal auditors and management. The Audit Committee reviews the results of the independent accountants' audit of the consolidated financial statements and their audit procedures, and discusses the adequacy of internal accounting controls. The Audit Committee also approves the annual internal auditing program, and reviews the activities and results of the internal auditing function. Both the independent public accountants and the internal auditors have access to the Audit Committee at any time. LG&E Energy Corp. and subsidiaries maintain and internally communicate a written code of business conduct that addresses, among other items, potential conflicts of interest, compliance with laws, including those relating to financial disclosure, and the confidentiality of proprietary information. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO LG&E ENERGY CORP.: We have audited the accompanying consolidated balance sheets and statements of capitalization of LG&E Energy Corp. (a Kentucky corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LG&E Energy Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As further discussed in Note 11, the potential amount of future rate refunds that may be required, if any, once the outcome of the legal and regulatory process is known, is uncertain at this time. As discussed in Notes 1 and 5 to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and post-retirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed under Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Louisville, Kentucky, Arthur Andersen & Co. January 28, 1994 ---------------------------------- SELECTED QUARTERLY FINANCIAL DATA (Unaudited) Selected financial data for the four quarters of 1993 and 1992 are shown below. Because of seasonal fluctuations in temperature and other factors, results for quarters may fluctuate throughout the year. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEMS 10, 11, 12 AND 13 are omitted pursuant to General Instruction G, inasmuch as the Company filed copies of a definitive proxy statement with the Commission on March 28, 1994, pursuant to Regulation 14A under the Securities Exchange Act of 1934. Such proxy statement is incorporated herein by this reference. In accordance with General Instruction G of Form 10-K, the information required by Item 10 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements (included in Item 8): Statements of Income for the three years ended December 31, 1993 (page 30). Statements of Retained Earnings for the three years ended December 31, 1993 (page 30). Balance Sheets - December 31, 1993, and 1992 (page 31). Statements of Cash Flows for the three years ended December 31, 1993 (page 32). Statements of Capitalization - December 31, 1993, and 1992 (page 33). Notes to Financial Statements (pages 34-52). Report of Management (page 53). Report of Independent Public Accountants (page 54). Selected Quarterly Financial Data for 1993, and 1992 (page 55). 2. Financial Statement Schedules (included in Part IV): Schedule V - Property, Plant and Equipment for the three years ended December 31, 1993 (pages 71-73). Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 (pages 74-76). Schedule VIII - Valuation and Qualifying Accounts for the three years ended December 31, 1993 (page 77). Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 (page 78). Schedule X - Supplementary Income Statement Information for the three years ended December 31, 1993 (page 79). All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Financial Statements or the accompanying Notes to Financial Statements. 3. Exhibits: Exhibit No. Description -------- ----------- 3.01 Copy of Articles of Incorporation. [Filed as Exhibit 4.01 to Registration Statement 33-33687 and incorporated by reference herein] 3.02 Amendment to Articles of Incorporation dated December 5, 1990. [Filed as Exhibit 3.02 to the Company's Annual Report on Form 10- K for the year ended December 31, 1990, and incorporated by reference herein] 3.03 Copy of Bylaws as amended through December 4, 1991. [Filed as Exhibit 3.03 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 4.01 Copy of Trust Indenture dated November 1, 1949, from LG&E to Harris Trust and Savings Bank, Trustee. [Filed as Exhibit 7.01 to LG&E's Registration Statement 2-8283 and incorporated by reference herein] 4.02 Copy of Supplemental Indenture dated February 1, 1952, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.05 to LG&E's Registration Statement 2-9371 and incorporated by reference herein] 4.03 Copy of Supplemental Indenture dated February 1, 1954, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.03 to LG&E's Registration Statement 2-11923 and incorporated by reference herein] 4.04 Copy of Supplemental Indenture dated September 1, 1957, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.04 to LG&E's Registration Statement 2-17047 and incorporated by reference herein] 4.05 Copy of Supplemental Indenture dated October 1, 1960, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.05 to LG&E's Registration Statement 2-24920 and incorporated by reference herein] 4.06 Copy of Supplemental Indenture dated June 1, 1966, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.06 to LG&E's Registration Statement 2-28865 and incorporated by reference herein] 4.07 Copy of Supplemental Indenture dated June 1, 1968, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.07 to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 4.08 Copy of Supplemental Indenture dated June 1, 1970, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.08 to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 4.09 Copy of Supplemental Indenture dated August 1, 1971, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.09 to LG&E's Registration Statement 2-44295 and incorporated by reference herein] 4.10 Copy of Supplemental Indenture dated June 1, 1972, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.10 to LG&E's Registration Statement 2-52643 and incorporated by reference herein] 4.11 Copy of Supplemental Indenture dated February 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.11 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.12 Copy of Supplemental Indenture dated September 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.12 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.13 Copy of Supplemental Indenture dated September 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.13 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.14 Copy of Supplemental Indenture dated October 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.14 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.15 Copy of Supplemental Indenture dated June 1, 1978, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.15 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.16 Copy of Supplemental Indenture dated February 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.16 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.17 Copy of Supplemental Indenture dated September 1, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.17 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.18 Copy of Supplemental Indenture dated September 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.18 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.19 Copy of Supplemental Indenture dated September 15, 1981, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.19 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 4.20 Copy of Supplemental Indenture dated March 1, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.20 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.21 Copy of Supplemental Indenture dated March 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.21 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.22 Copy of Supplemental Indenture dated September 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.22 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.23 Copy of Supplemental Indenture dated February 15, 1984, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.23 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1984, and incorporated by reference herein] 4.24 Copy of Supplemental Indenture dated July 1, 1985, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.24 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 4.25 Copy of Supplemental Indenture dated November 15, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.25 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.26 Copy of Supplemental Indenture dated November 16, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.26 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.27 Copy of Supplemental Indenture dated August 1, 1987, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.27 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 4.28 Copy of Supplemental Indenture dated February 1, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.28 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.29 Copy of Supplemental Indenture dated February 2, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.30 Copy of Supplemental Indenture dated June 15, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.30 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.31 Copy of Supplemental Indenture dated November 1, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.31 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.32 Copy of Supplemental Indenture dated September 1, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.32 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.33 Copy of Supplemental Indenture dated September 2, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.34 Copy of Supplemental Indenture dated August 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.34 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 4.35 Copy of Supplemental Indenture dated August 16, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.35 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 4.36 Copy of Supplemental Indenture dated October 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.36 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.01 Copy of Agreement dated September 1, 1970, between Texas Gas Transmission Corporation and LG&E covering the purchase of natural gas. [Filed as Exhibit 4.01 to LG&E's Registration Statement 2-40985 and incorporated by reference herein] 10.02 Copies of Agreement between Sponsoring Companies re: Project D of Atomic Energy Commission, dated May 12, 1952, Memorandums of Understanding between Sponsoring Companies re: Project D of Atomic Energy Commission, dated September 19, 1952 and October 28, 1952, and Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission, dated October 15, 1952. [Filed as Exhibit 13(y) to LG&E's Registration Statement 2-9975 and incorporated by reference herein] 10.03 Copy of Modification No. 1 dated July 23, 1953, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4.03(b) to LG&E's Registration Statement 2-24920 and incorporated by reference herein] 10.04 Copy of Modification No. 2 dated March 15, 1964, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02c to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.05 Copy of Modification No. 3 and No. 4 dated May 12, 1966 and January 7, 1967, respectively, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibits 4(a)(13) and 4(a)(14) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.06 Copy of Modification No. 5 dated August 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 13(c) to LG&E's Registration Statement 2-27316 and incorporated by reference herein] 10.07 Copies of (i) Inter-Company Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies (which Agreement includes as Exhibit A the Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Indiana-Kentucky Electric Corporation); (ii) First Supplementary Transmission Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iii) Inter-Company Bond Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iv) Inter-Company Bank Credit Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 5.02f to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.08 Copy of Modification No. 1 and No. 2 dated June 3, 1966 and January 7, 1967, respectively, to Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibits 4(a)(8) and 4(a)(10) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.09 Copies of Amendments to Agreements (iii) and (iv) referred to under 10.07 above as follows: (i) Amendment to Inter-Company Bond Agreement and (ii) Amendment to Inter-Company Bank Credit Agreement. [Filed as Exhibit 5.02h to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.10 Copy of Modification No. 1, dated August 20, 1958, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02i to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.11 Copy of Modification No. 2, dated April 1, 1965, to the First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02j to LG&E's Registration Statement 2-6l607 and incorporated by reference herein] 10.12 Copy of Modification No. 3, dated January 20, 1967, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 4(a)(7) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.13 Copy of Modification No. 6 dated November 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4(g) to LG&E's Registration Statement 2-28524 and incorporated by reference herein] 10.14 Copy of Modification No. 3 dated November 15, 1967, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 4.02m to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 10.15 Copy of Modification No. 7 dated November 5, 1975, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02n to LG&E's Registration Statement 2-56357 and incorporated by reference herein] 10.16 Copy of Modification No. 4 dated November 5, 1975, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 5.02o to LG&E's Registration Statement 2-56357 and incorporated by reference herein] 10.17 Copy of Modification No. 4 dated April 30, 1976, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02p to LG&E's Registration Statement 2-6l607 and incorporated by reference herein] 10.18 Copy of Modification No. 8 dated June 23, 1977, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02q to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.19 Copy of Modification No. 9 dated July 1, 1978, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02r to LG&E's Registration Statement 2-63149 and incorporated by reference herein] 10.20 Copy of Modification No. 10 dated August 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 2 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.21 Copy of Modification No. 11 dated September 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 3 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.22 Copy of Modification No. 5 dated September 1, 1979, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 4 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.23 Copy of Agreement dated December 16, 1966, between Peabody Coal Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.23 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.24 Copy of Amendments to Coal Supply Agreement referred to in 10.23 above as follows: (i) Amendment effective July 1, 1970, (ii) effective January 1, 1975, and (iii) effective December 1, 1976. [Filed as Exhibit 10.24 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.25 Copy of Modification No. 12 dated August 1, 1981, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.25 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.26 Copy of Modification No. 6 dated August 1, 1981, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 10.26 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.27 Copy of Agreement dated December 20, 1985, between Shawnee Coal Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.27 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 10.28 Copy of Diversity Power Agreement dated September 9, 1987, between East Kentucky Power Cooperative and LG&E covering the purchase and sale of power between the two companies from 1988 through 1995. [Filed as Exhibit 10.28 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 10.29 Copy of Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of LG&E. [Filed as Exhibit 10.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.30 Copy of Termination Agreement and Release dated February 1, 1989, between Peabody Coal Company and LG&E canceling the Coal Supply Agreement dated December 16, 1966 referred to in Exhibit Nos. 10.23 and 10.24. [Filed as Exhibit 10.30 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.31 Copy of Agreements dated February 1 and February 15, 1989, between Peabody Development Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.31 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.32 Copy of Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 4.01 to LG&E's Registration Statement 33-38557 and incorporated by reference herein] 10.33 Copy of Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 10.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.34 Copy of LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of the Company and its subsidiaries. [Filed as Exhibit 10.34 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.35 Copy of Agreement dated August 1, 1991, between Texas Gas Transmission Corporation and LG&E covering the purchase of natural gas. [Filed as Exhibit 10.35 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.36 Copy of Credit Agreement dated as of March 11, 1992, among LG&E Energy Systems Inc. as Borrower, the Banks named therein, and Citibank, N.A. as Agent. [Filed as Exhibit 10.36 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.37 Copy of Support Agreement dated as of December 9, 1991, between LG&E Energy Corp. and LG&E Energy Systems Inc. [Filed as Exhibit 10.37 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.38 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and Louisville Gas and Electric Company effective February 1, 1992. [Filed as Exhibit 10.36 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.39 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and Louisville Gas and Electric Company effective November 1, 1992. [Filed as Exhibit 10.37 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.40 Copy of form of change in control agreement for officers of LG&E Energy Corp. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.41 Copy of Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.42 Copy of Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.43 Copy of Nonqualified Savings Plan covering officers of the Company, effective January 1, 1992. [Filed as Exhibit 10.43 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.44 Copy of Modification No. 13 dated September 1, 1989, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.42 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.45 Copy of Modification No. 7 dated January 15, 1992, to Inter- Company Power Agreement dated July 10, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 10.44 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.46 Copy of Modification No. 14 dated January 15, 1992, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.43 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.47 Copy of Modification No. 15 dated February 15, 1993, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.45 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.48 Firm Transportation Agreement, dated November 1, 1993, between Texas Gas Transmission Corporation and LG&E covering the transmission of natural gas. [Filed as Exhibit 10.46 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.49 Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (8-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (2-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (5-year term) covering the transmission of natural gas. [Filed as Exhibit 10.47 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.50 Employment Contract between the Company and Roger W. Hale effective November 3, 1993. 10.51 Copy of LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. 21 Subsidiaries of the Registrant 23 Consent of Independent Public Accountants 24 Power of Attorney (b) Executive Compensation Plans and Arrangements: Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of LG&E. [Filed as Exhibit 10.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 4.01 to LG&E's Registration Statement 33-38557 and incorporated by reference herein] Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 10.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of the Company and its subsidiaries. [Filed as Exhibit 10.34 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] Form of change in control agreement for officers of LG&E Energy Corp. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Nonqualified Savings Plan covering officers of the Company effective January 1, 1992. [Filed as Exhibit 10.43 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Employment Contract between the Company and Roger W. Hale effective November 3, 1993. [Filed as Exhibit 10.50 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993] LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. [Filed as Exhibit 10.51 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993] (c) Reports on Form 8-K: The following 8-K reports were filed during the fourth quarter of 1993: (i) On October 27, 1993, a report on Form 8-K was filed announcing the following: Trimble County Generating Plant. On October 20, 1993, the Kentucky Supreme Court declined to review a Kentucky Court of Appeals order overturning a lower court's order that had improperly directed LG&E to refund approximately $150 million to its customers in a case involving LG&E's Trimble County electric generating station. Management Change. Walter M. Higgins, III, President and Chief Operating Officer of LG&E resigned to accept the position of President and Chief Operating Officer of Sierra Pacific Resources. Sierra Pacific Resources indicated plans for Mr. Higgins to become Chief Executive Officer early in 1994. (ii) On November 23, 1993, a report on Form 8-K was filed announcing that the Company would undergo a major realignment and formation of new business units effective January 1, 1994, to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. (iii) On December 22, 1993, a report on Form 8-K was filed announcing that the Company had agreed to sell its 36.5% interest in Natural Gas Clearinghouse of Houston, Texas, to NOVA Corporation of Alberta, a Canadian natural gas and chemical company, for $170 million in cash. SCHEDULE V (Page 1 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE V (Page 2 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of $) SCHEDULE V (Page 3 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of $) SCHEDULE VI (Page 1 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE VI (Page 2 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of $) SCHEDULE VI (Page 3 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of $) SCHEDULE VIII LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE IX LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE X LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) The amounts of royalties and advertising costs charged to operating expenses were each less than one percent of total operating revenues. SIGNATURES Pursuant to the requirements of Section 13 or 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. LG&E ENERGY CORP. Registrant March 28, 1994 By /s/ Charles A. Markel III ----------------------------------------------------- (Date) Charles A. Markel III Corporate Vice President, Finance and Treasurer 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 date indicated. Signature Title Date ROGER W. HALE Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer); CHARLES A. MARKEL III Corporate Vice President, Finance and Treasurer (Principal Financial and Accounting Officer); WILLIAM C. BALLARD, JR. Director; OWSLEY BROWN II Director; S. GORDON DABNEY Director; GENE P. GARDNER Director; DAVID B. LEWIS Director; ANNE H. MCNAMARA Director; T. BALLARD MORTON, JR. Director; and DR. DONALD C. SWAIN Director. By /s/ Charles A. Markel III March 28, 1994 ------------------------------------------ CHARLES A. MARKEL III (Attorney-In-Fact)	22,770	148,014
49146_1993.txt	49146_1993	1993	49146	Item 1. Business General Hunt Manufacturing Co. and its subsidiaries (herein called the "Company", unless the context indicates otherwise) are primarily engaged in the manufacture and distribution of office products and art/craft products which the Company markets worldwide. Business Segments The following table sets forth the Company's net sales and operating profit by business segment for the last three fiscal years: 1993 1992 1991 -------- -------- -------- (In thousands) Net Sales: Office products....... $142,462 $126,101 $120,103 Art/Craft products.... 113,688 108,828 108,519 -------- -------- -------- Total........... $256,150 $234,929 $228,622 ======== ======== ======== Operating Profit: Office products....... $ 11,411 $ 8,541 $ 6,369 Art/Craft products.... 18,832 18,516 17,618 -------- -------- -------- Total........... $ 30,243 $ 27,057 $ 23,987 ======== ======== ======== - ------------- See Items 6 and 7 herein and Note 15 to Consolidated Financial Statements herein for further information concerning the Company's business segments (including information concerning identifiable assets). Office Products The Company has three major classes of office products: mechanical and electromechanical products; office furniture and related products; and desktop accessory products. The amounts and percentages of net sales of these product classes for the last three fiscal years were as follows: 1993 1992 1991 -------------- --------------- --------------- (Dollars in thousands) Product Class: Mechanical and Electromechanical.... $ 70,047 49% $ 62,323 49% $ 57,592 48% Office furniture....... 44,233 31 37,271 30 36,526 30 Desktop accessories.... 28,182 20 26,507 21 25,985 22 ------- --- -------- --- -------- --- Total.............. $142,462 100% $126,101 100% $120,103 100% ======== === ======== === ======== === The Company's mechanical and electromechanical office products consist of a variety of items sold under the Company's BOSTON brand, including manual and electric pencil sharpeners; paper punches; paper trimmers and paper shredders; electric letter openers; spring clips used to hold sheets of paper; manual and electronic staplers; electric air cleaners and other related products. The Company's specialty office furniture and related products are designed primarily to meet specific needs created by new office technologies and are sold under the BEVIS brand name. These products include conference, computer, utility and folding tables; office chairs; bookcases and screen panels; metal and wood workstations for computer terminals, personal computers, word processors, printers and other similar electronic office equipment; and home/office furniture. The Company's desktop accessory products consist of an array of items marketed under its LIT-NING brand, including metal horizontal and vertical files, letter trays, desk organizers and paper sorting racks. Also included in desktop accessory products are a broad range of products that support the use of computers such as computer diskette storage devices, printer stands, mouse pads, and surge suppressors which are marketed under the MEDIAMATE brand name. The Company consistently has sought to expand its office products business through internal product development, the acquisition of distribution rights to products which complement or extend the Company's established lines, the acquisition of complementary businesses and through increased distribution of its office products to the general consumer. Examples of new office product introductions by the Company in recent years are BOSTON brand electronic staplers, various models of air cleaners, automatic personal paper shredder, and desk-top laminators; BEVIS UNIWORX, BEVIS ULTRAWORX and BEVIS MEGAWORX lines of modular offices furniture systems; BEVIS STACKAWAYS stackable chairs; MEDIAMATE LASERRAK printer stands; MEDIAMATE FASTRAC mouse pads; MEDIAMATE multi-media storage files and MEDIAMATE POWER TAMER surge suppressors. There are three major and generally distinct domestic markets for the Company's office products: commercial offices, home offices and the gen- eral consumer. The commercial line of the Company's office products is distributed primarily through a network of office supply wholesalers and dealers and office product superstores. Sales to the home office and the general consumer include mechanical and electromechanical products which are sold through large retail outlets, such as office superstores, drug and food chain stores, variety stores, discount chains, catalog showrooms and membership chains. The consumer market has increased significantly over the last few years primarily due to the dramatic growth of office superstores. A more limited line of products is sold to schools through specialized school supply distributors. Art/Craft Products The Company manufactures and distributes three major classes of art/craft products: mounting and laminating products; art supplies; and hobby/craft products. The amounts and percentages of net sales of these three product classes for the last three fiscal years were as follows: 1993 1992 1991 ------------- ------------- ------------- (Dollars in thousands) Product Class: Mounting and laminating.... $ 68,734 61% $ 63,475 58% $ 61,851 57% Art supplies... 27,569 24 29,134 27 29,569 27 Hobby/craft.... 17,385 15 16,219 15 17,099 16 -------- --- --------- --- --------- --- Total......... $113,688 100% $108,828 100% $108,519 100% ======== === ======== === ======== === The Company's mounting and laminating products are used largely by picture framers, graphic artists, display designers and photo laboratories, and include a range of BIENFANG foam boards; TECHMOUNT dry mount adhesive products; pressure sensitive and dry mount adhesive products sold under the SEAL and ADEMCO-SEAL brands, as well as under the COLORMOUNT, SEALEZE and PRINT GUARD brand names; an array of mounting and laminating equipment sold under the CLEAR TECH, SEALEZE, and IMAGE SERIES brand names; and specialty tapes and films supplied under various private brands. The Company's art supply products are used primarily by commercial and amateur artists, and include commercial and fine art papers which the Company converts, finishes and sells under its BIENFANG brand; various types of X-ACTO brand knives and blades; SPEEDBALL paint markers and acrylic and water-color paints; and CONTE(1) pastels, crayons and related drawing products, for which the Company is the exclusive United States and Canadian distributor. The Company's hobby/craft products generally are used by hobbyists and craft enthusiasts and include SPEEDBALL print-making products; ACCENT MATS beveled-edge picture framing mats; SPEEDBALL ELEGANT WRITERS and PANACHE calligraphy products; and X-ACTO brand tools and kits. The Company consistently has sought to expand its art/craft business primarily through acquisitions of complementary businesses and of distribution rights to complementary products manufactured by others, through internal product development, and through increased distribution of its art/craft products to the general consumer. Major art/craft products introduced during - ------------ (1). Trademark of Conte S.A. the last several fiscal years include BIENFANG colored foam board, as well as SINGLE STEP adhesive coated BIENFANG foam board; BIENFANG project display board; PANACHE calligraphy products; SPEEDBALL FABRIC PAINTERS non-toxic pen- type acrylic-based paint markers; TECHMOUNT dry mount adhesive products; CLEAR TECH pouch laminators; IMAGE SERIES large format laminators; CLEAR GUARD protective adhesive film; THERMASHIELD laminating film, and X-ACTO board cutter, self healing mats, hobby rulers and rotary cutters. The acquisition of the Graphic Arts Group from Bunzl plc during fiscal 1990 has significantly expanded the number of the Company's mounting and laminating products and enhanced the Company's position in the framing and photomounting markets. In 1993, the Company acquired IMAGE TECHNOLOGIES, Inc., a start-up company engaged in the development and production of large format laminators, which has allowed the Company to broaden its distribution into the digital imaging market. BIENFANG foam board has been particularly important, as it has allowed the Company to penetrate the picture framing and sign and display exhibit markets, yet it also holds wide appeal to the traditional customer groups in art supply and hobby/craft markets. The success of foam board has been attributable, in significant part, to the Company's ability to offer the end-user a variety of value-added foam board products, such as colored or adhesive coated foam board. Traditionally, the Company's art/craft products have been distributed primarily through wholesalers (framing, photomounting, art and hobby), dealers (specialized art supply and hobby/craft stores), general consumer-oriented retail outlets (primarily office product superstores and chain stores), industrial concerns (photo labs, screen printers) and through specialized school supply distributors. Over the last several years, consumer-oriented retail outlets have become an increasingly important distribution channel for the Company's art/craft products. Sales and Marketing General The Company has over 15,000 active customers, the ten largest of which (three being office product superstore chains) accounted for approximately 37% of its sales in fiscal 1993. The largest single customer accounted for approximately 7% of sales for that year. There is a continuing trend toward consolidation of wholesalers, dealers and superstores, resulting in an increasing percentage of the Company's sales being attributable to a smaller number of customers. See Item 7 of this report. Because most of the Company's sales are made from inventory, the Company customarily operates without a material backlog. The Company's sales generally are not subject to significant seasonal fluctuations. See Note 14 to Consolidated Financial Statements herein. Domestic Operations Domestic marketing of the Company's office products and art/craft products is effected principally through six separate sales forces, one each for office products, furniture, computer accessory products, art/craft products, photomounting and mass market. The combined sales forces are comprised of over 30 Company salespeople and over 300 independent manufacturers' representatives. The Company maintains domestic distribution centers in Florence, Kentucky; Florence, Alabama; and Laredo, Texas, for office products; Naugatuck, Connecticut; and Cottage Grove, Wisconsin, for art/craft products; and in Statesville, North Carolina, for both office and art/craft products. Foreign Operations The Company distributes its products in more than 60 foreign markets through its own sales force of seven area sales managers and 18 salespersons, and through over 40 independent sales agents and over 150 distributors. Sales of office products and art/craft products represented approximately 47% and 53%, respectively, of the Company's export sales in fiscal 1993, with electrical and mechanical pencil sharpeners, paper punches, staplers, X-ACTO brand knives and blades, BIENFANG paper and foam board products and pressure sensitive and dry mount adhesive products accounting for the major portion of these sales. Sales from foreign operations were attributable to the Graphic Arts Group acquired in 1990 and included mounting and laminating products, as well as specialty tapes and films. See Note 15 to Consolidated Financial Statements herein for further information concerning the Company's foreign operations. The Company maintains distribution centers in Ontario, Canada; Basildon, England; and in Kornwestheim, Germany. Foreign operations are subject to the usual risks of doing business abroad, particularly currency fluctuations and foreign exchange controls. See also Note 1 to Consolidated Financial Statements herein for information concerning hedging. Manufacturing and Production The Company's operations include manufacturing and converting of products, as well as purchasing and assembly of various component parts. Excluding products for which it acts as a distributor, the vast majority of the Company's sales are of products which are either manufactured, converted or assembled by it. See Item 2 Item 2. Properties The Company presently maintains its principal executive offices at 230 South Broad Street, Philadelphia, PA 19102 in approximately 35,000 square feet of leased space under a lease expiring in 1994. The following table sets forth information with respect to certain of the other facilities of the Company: (1) During fiscal 1992, the Company transferred the manufacturing (but not the warehouse and distribution) function of this facility to Florence, Kentucky, in connection with the relocation and consolidation of its LIT-NING operations. See Note 2 to Consolidated Financial Statements herein for additional information. Recently, the Company decided to transfer the remaining warehouse and distribution function of this facility to Florence, Kentucky, during fiscal 1994. (2) The construction and expansion of this facility was financed by the issuance of industrial revenue bonds by the City of Florence, Kentucky. The City retains title to the property and leases it to the Company for rental payments equal to principal and interest payments on the bonds. The Company has the option, subject to certain conditions, to purchase the property. During fiscal 1989 two of the three bond issues relating to this financing matured. The third bond issue matured in fiscal 1993. In each instance, the Company exercised its option to continue to lease from the City, at a nominal consideration, the properties associated with the respective bond issues for a period of ten years. See Notes 6 and 11 to Consolidated Financial Statements herein for information concerning indebtedness and capital lease obligations relating to various of the Company's facilities. (3) A portion of this facility was financed by the issuance of industrial revenue bonds by the City of Florence, Alabama, which are collateralized by a plant facility and certain equipment. (4) A portion of this facility was financed by the issuance of industrial revenue bonds by the Iredell County Industrial Facilities and Pollution Control Financing Authority. The Authority retains title to the property and leases it to the Company for rental payments equal to principal and interest payments on the bonds. The Company has the option, subject to certain conditions, to purchase the property. At present, the Company's facilities generally are believed to be adequately utilized and suitable for the Company's present needs, except for one warehouse facility that has excess capacity which the Company has successfully subleased. Item 3. Item 3. Pending Legal Proceedings There currently are no material pending legal proceedings (within the meaning of the Form 10-K Instructions), other than routine litigation incidental to the business of the Company, to which the Company is a party or to which any of its property is subject. See Note 11 to Consolidated Financial Statements herein and Item 1 - - "Environmental Matters" herein. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the security holders of the Company during the fourth quarter of the fiscal year covered by this report. Additional Information The following information is furnished in this Part I pursuant to Instruction 3 to Item 401(b) of Regulation S-K: Executive Officers of the Company Name Age Position ---- --- -------- Ronald J. Naples 48 Chairman of the Board and Chief Executive Officer Robert B. Fritsch 62 President and Chief Operating Officer John W. Carney 50 Vice President, Human Resources William E. Chandler 50 Senior Vice President, Finance (Chief Financial Officer), and Secretary Roy M. Delizia 50 Vice President, Corporate Planning and Development Spencer W. O'Meara 47 Vice President and General Manager W. Ernest Precious 52 Vice President and General Manager Robert K. Scribner 47 Vice President and General Manager Eugene A. Stiefel 46 Vice President, Information Services The executive officers of the Company customarily are elected annually by the Board of Directors to serve, at the pleasure of the Board, for a period of one year or until their successors are elected. All of the executive officers of the Company, except for Messrs. Chandler, Scribner, Delizia and Stiefel have served in varying executive capacities with the Company for over five years. Mr. Chandler was elected an executive officer of the Company in February 1993. He joined the Company in September 1992 after three years at Bally Manufacturing Corporation during which he held positions as Acting Chief Financial Officer and Vice President, Financial Operations and Controller. Prior to that, he served for three years at Household Manufacturing, Inc. as Senior Vice President of Finance, Treasurer and Chief Financial Officer. Mr. Scribner was elected an executive officer of the Company in December 1990. He joined the Company in December 1986 as Vice President, Sales and Marketing, Office Products. Messrs. Delizia and Stiefel were elected executive officers of the Company in April 1993. Mr. Delizia joined the Company in October 1983 and has served as Vice President, Corporate Development and Planning since 1987. Mr. Stiefel joined the Company in February 1985 and has served as Vice President, Information Services since 1987. ------------------------------------------ For the purposes of calculating the aggregate market value of the shares of common stock of the Company held by nonaffiliates, as shown on the cover page of this report, it has been assumed that all the outstanding shares were held by nonaffiliates except for the shares held by directors and officers of the Company. However, this should not be deemed to constitute an admission that all directors and officers of the Company are, in fact, affiliates of the Company, or that there are not other persons who may be deemed to be affiliates of the Company. Further information concerning shareholdings of officers, directors and principal shareholders is included in the Company's definitive proxy statement filed or to be filed with the Securities and Exchange Commission. ----------------------------------------- PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) The Company's common stock is traded on the New York Stock Exchange (trading symbol "HUN"). The following table sets forth the high and low quarterly sales prices of the Company's common stock during the two most recent fiscal years (all as reported by The Wall Street Journal): Fiscal Quarter -------------------------------------------- First Second Third Fourth ----- ------ ----- ------ High $15 1/4 $16 1/4 $16 1/4 $16 3/8 Low 12 3/4 13 5/8 13 1/4 15 1/4 Fiscal Quarter -------------------------------------------- First Second Third Fourth ----- ------ ----- ------ High $17 1/8 $16 7/8 $16 1/8 $14 3/8 Low 13 5/8 14 1/8 12 1/4 11 1/4 See Note 10 to Consolidated Financial Statements herein for information concerning certain Rights which were distributed by the Company to shareholders in 1990 and which currently are deemed to be attached to the Company's common stock. (b) As of February 1, 1994, there were approximately 1,200 record holders of the Company's common stock, which number does not include shareholders whose shares were held in nominee name. (c) During the past two fiscal years, the Company has paid regular quarterly cash dividends on its common stock at the following rates per share: 1993 - $.0875 per quarter and 1992 - $.085 per quarter. Certain of the Company's credit agreements contain restrictions on the Company's present and future ability to pay dividends. See Note 6 to Consolidated Financial Statements herein. Item 6. Item 6. Selected Financial Data The following table contains selected financial data for each of the Company's last five fiscal years. This data should be read in conjunction with the Company's Consolidated Financial Statements (and related notes) appearing elsewhere in this report and with Item 7 Item 7 of this report. Year Ended -------------------------------------------------------- Nov. 28, Nov. 29, Dec. 1, Dec. 2, Dec. 3, 1993 1992 1991(1) 1990(2) 1989(3) ------- ------- ------- ------- ------- (In thousands, except per share data) Net Sales $256,150 $234,929 $228,622 $220,099 $203,444 Net Income 14,928 13,302 9,586 12,011 18,804 Net Income Per Share(4) .93 .83 .60 .75 1.17 Total Assets 156,317 144,170 151,824 154,361 127,947 Long-Term Debt 3,003 6,160 17,271 26,498 9,674 Cash Dividends Per Share(4) .35 .34 .32 .31 .27 - ----------------------- (1) In the fourth quarter of fiscal 1991, the Company recorded a charge to net income of approximately $2.7 million, or $.17 per share, for anticipated costs relating to the relocation and consolidation of certain manufacturing and distribution operations. See Note 2 to Consolidated Financial Statements herein. (2) The Company acquired the Graphic Arts Group from Bunzl plc on May 4, 1990. In addition, in the fourth quarter of fiscal 1990, the Company recorded a charge to net income of approximately $1 million, or $.06 per share, relating to the discontinuance of certain products. (3) The Company acquired the Data Products Division of Amaray International Corporation on June 23, 1989. (4) Adjusted for stock splits. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Condition The Company improved its already strong financial condition in fiscal 1993, with net cash flow provided by operating activities increasing to $23.2 million from $20.4 million and $19.9 million in fiscal 1992 and 1991, respectively. These fiscal 1993 net cash flows were more than sufficient to fund additions to property, plant and equipment of $10.3 million, to pay cash dividends of $5.6 million and to reduce debt by $1.2 million. The percentage of debt to equity was reduced to 5.3% at the end of fiscal 1993 from 6.9% and 18.1% at the end of fiscal 1992 and 1991, respectively. Working capital increased to $47.1 million at November 28, 1993 from $45.5 million at November 29, 1992 as a net result of an $8.5 million increase in current assets, partially offset by a $6.9 million increase in current liabilities. The increase in current assets was primarily due to a $4.8 million increase in cash and cash equivalents, as well as to a $3 million increase in inventories. Higher inventories were largely the result of new products introduced in fiscal 1993, as well as higher anticipated sales volume. Accounts receivable turnover improved in fiscal 1993, and the balance of past due accounts was reduced significantly. The increase in current liabilities was principally the result of higher accounts payable (up $2.8 million), accrued salaries, wages and commissions (up $2.0 million) and current portion of long-term debt balance (up $1.9 million). The accounts payable increase was due to timing of and payment for raw materials received near the end of the fiscal year. The increase in accrued salaries, wages and commissions was primarily due to higher management incentive compensation accrued for fiscal 1993. Management expects that expenditures for additions to property, plant and equipment to increase capacity and productivity in fiscal 1994 will approximate the level expended for such purposes in fiscal 1993. The Company currently has line-of-credit agreements with three banks providing for borrowing capacity totaling $45 million. There were no borrowings under these line-of-credit agreements at the end of fiscal 1993. Management believes that funds generated from operations combined with existing credit agreements are sufficient to meet currently anticipated working capital and other capital and financing requirements. If additional resources are needed, management believes that the Company could obtain funds at competitive costs. Results of Operations Comparison of Fiscal 1993 vs. 1992 Net Sales and Earnings. Net sales of $256.2 million for fiscal 1993 increased 9% from $234.9 million in fiscal 1992 due primarily to higher unit volume largely attributable to new products. Average selling prices decreased approximately 3% in fiscal 1993 from fiscal 1992 prices due to continuing competitive pressures discussed below and to foreign currency exchange rate changes of approximately 1%. Office products sales increased 13% in fiscal 1993 to $142.5 million from $126.1 million in fiscal 1992. This increase was led by higher sales of office furniture products, which were up 18.7%, primarily due to broadened distribution for these products gained in fiscal 1993. Mechanical and electromechanical products sales grew by 12.4% in fiscal 1993 due, in large part, to higher sales of Boston brand products, and desktop accessory products were up 6.3% attributable principally to new products, particularly MediaMate brand computer-related accessories. Export sales of office products increased 5.2% in fiscal 1993 largely as a result of higher sales in Canada. Art/craft products sales of $113.7 million for fiscal 1993 increased 4.5% from fiscal 1992 sales of $108.8 million. This increase was the net result of higher sales of mounting and laminating products (up 8.3%) and hobby/craft products (up 7.2%), partially offset by lower sales of art supplies (down 5.4%). The mounting and laminating sales increase was principally attributable to higher sales of Seal brand laminating equipment. The hobby/craft products sales increase was largely due to higher sales of X-Acto brand knife and tool kits. The decrease in sales of art supplies was attributable primarily to lower sales of Bienfang brand art paper products. Export sales of art/craft products were essentially unchanged in fiscal 1993, and foreign sales decreased 11.3% primarily due to a decrease in the value of the British pound sterling. Excluding the effect of exchange rate changes, foreign sales increased 3.2% in fiscal 1993. Net income of $14.9 million for fiscal 1993 grew 12.2% from fiscal 1992 net income of $13.3 million, and earnings per share increased to $.93 in fiscal 1993 from $.83 reported for fiscal 1992. Higher sales volume and lower interest expense were significant factors leading to the earnings increase. In December 1993 the Company was selected by Schwan-STABILO, a prominent manufacturer based in Germany, to be the exclusive distributor in the U. S. of its STABILO(R) BOSS(R) fluorescent highlighting markers and a wide range of other products for the office, art and graphics markets. The purchase of inventories and commencement of distribution is expected to take place at the end of the first quarter of fiscal 1994. Gross Profit. The Company's gross profit margin decreased to 40.1% of net sales in fiscal 1993 from 40.7% in 1992. The domestic gross profit margin decreased to 40.3% from 41%, and the foreign gross profit margin decreased to 26.7% from 28.6% in 1993 and 1992, respectively. The overall decrease was attributable to lower selling prices which were largely offset by lower raw material costs, the favorable effect of higher sales volume leveraging relatively fixed manufacturing overhead costs and lower employee fringe benefit expenses. Management expects the pressure on selling prices to continue due to the competitive environment for many of the Company's products, and also expects upward pressure on costs for certain raw material commodities, such as wood and steel, due to market conditions. Management plans to continue to seek productivity and operating process improvements and further cost reductions for other materials to offset these pressures. Selling, Shipping, Administrative and General Expenses. Selling and shipping expenses, as a percentage of net sales, were reduced to 20.6% in fiscal 1993 from 21.1% in fiscal 1992 primarily as a result of lower sales force commission expenses due, in part, to changes in customer sales mix. Administrative and general expenses increased to $25.4 million in fiscal 1993 from $23.1 million in fiscal 1992 primarily as a result of higher management incentive compensation expenses and higher management consulting fees. Interest Expense. Interest expense was reduced to $.2 million in fiscal 1993 from $1.1 million in fiscal 1992 due principally to debt reduction at the end of fiscal 1992 and in fiscal 1993, as well as to an increase in capitalized interest in fiscal 1993 related to additions to property, plant and equipment. Provision for Income Taxes. The Company's effective tax rate decreased to 37.9% in fiscal 1993 from 38.4% in fiscal 1992 as a net result of losses incurred by the European operations in fiscal 1992 which did not generate offsetting tax benefits, partially offset by an increase in the U. S. statutory corporate tax rate in fiscal 1993 from 34% to 35% retroactive to January 1, 1993. Environmental Matters. The Company is involved on a continuing basis in monitoring its compliance with environmental laws and in making capital and operating improvements necessary to comply with existing and anticipated environmental requirements. Despite its efforts, the Company has been cited for occasional violations or alleged violations of environmental laws or permits. Expenses incurred by the Company to date relating to violations of and compliance with environmental laws and permits have not been material. While it is impossible to predict with certainty, management currently does not foresee such expenses in the future as having a material effect on the Company's business, results of operations or financial condition (see Note 11 of the Notes to Consolidated Financial Statements). Comparison of Fiscal 1992 vs. 1991 Net Sales and Earnings. Net sales increased 2.8% to $234.9 million in fiscal 1992 from $228.6 million in fiscal 1991. This increase was largely the result of higher unit volume, as selling prices were essentially unchanged in fiscal 1992 from those in fiscal 1991. Office products sales of $126.1 million for fiscal 1992 increased 5% from the $120.1 million for fiscal 1991. The increase was led by higher sales of mechanical and electro-mechanical products, which grew by 8.2%, while desktop accessory and office furniture products grew by 2%. The growth in sales of mechanical and electromechanical products was primarily due to higher sales of Boston brand products. Export sales of office products increased 5.8% in fiscal 1992. Art/craft products sales of $108.8 million in fiscal 1992 were essentially unchanged from those in fiscal 1991 as a net result of higher sales of mounting and laminating products (up 2.6%), offset by lower sales of hobby/craft products (down 5.1%) and art supplies (down 1.5%). The decrease in sales of hobby/craft products was due, in large part, to lower sales of X-Acto brand knife and tool kits. Export sales of art/craft products decreased 1.3% in fiscal 1992 and foreign sales decreased 7.2%. The foreign sales decrease was attributable, in significant part, to the unfavorable economic environment in the United Kingdom. Net income of $13.3 million and earnings per share of $.83 for fiscal 1992 increased by more than 38% from net income of $9.6 million, or $.60 per share for fiscal 1991. The 1991 results included an after-tax provision of $2.7 million, or $.17 per share, for the relocation and consolidation of the Company's Lit-Ning office products operations in California and distribution operations in the United Kingdom. Excluding this provision, net income and earnings per share increased approximately 8% in fiscal 1992 on a comparable basis with fiscal 1991 results. Gross Profit. The Company's gross profit was 40.7% of net sales in fiscal 1992, which approximated the fiscal 1991 percentage. This was largely the net result of higher gross profit percentages generated by the Company's foreign operations, partially offset by lower gross profit percentages for the domestic operations. The gross profit percentage increase for the Company's foreign operations, which improved to 28.6% in fiscal 1992 from 21.1% in fiscal 1991, was due to a decrease in 1992 in write-offs of excess inventories incurred by the United Kingdom operations as compared to 1991. These higher write-offs, which depressed fiscal 1991 gross profits for the foreign operations, related principally to inventories of laminating equipment determined to be excess or obsolete. The gross profit percentage decrease for the U. S. operations, which declined to 41% in fiscal 1992 from 42.2% in fiscal 1991, was attributable to several factors, including higher raw material costs and employee fringe benefit expenses, particularly health care and workers' compensation insurance. These higher costs were not able to be offset by higher selling prices because of the competitive environment in the distribution channels for certain of the Company's products, particularly office products and certain mounting and laminating products. Selling, Shipping, Administrative and General Expenses. Selling and shipping expenses, as a percentage of net sales, increased to 21.1% in fiscal 1992 from 20.4% in fiscal 1991, largely due to higher sales promotional allowances, freight costs and new product development and packaging expenses. Administrative and general expenses were reduced 1.7% in fiscal 1992 to $23.1 million from $23.5 million in fiscal 1991, which was principally attributable to lower consulting fees and reductions in management incentive compensation. Interest Expense. Interest expense was reduced to $1.1 million in fiscal 1992 from $2.1 million in fiscal 1991 due primarily to reduction of long-term debt at the end of fiscal 1991 and during fiscal 1992 and, to a lesser extent, to lower interest rates. Provision for Income Taxes. The Company's effective tax rate decreased to 38.4% in fiscal 1992 from 44% in fiscal 1991 attributable, in large part, to a reduction in losses incurred by the European operations which did not generate current offsetting tax benefits. New Accounting Standards Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," will require the calculation of deferred income taxes using the asset and liability method, which includes a requirement for adjustment of deferred tax balances for income tax rate changes. Future years' net income will be subject to increased volatility depending upon the frequency of tax rate changes. The Company will adopt the provisions of SFAS No. 109 in the first quarter of fiscal 1994, and the cumulative effect of this change of accounting principle for income taxes is expected to increase fiscal 1994 earnings per share by approximately $.05. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," requires accrual accounting for all postretirement benefits other than pensions. When adopted in fiscal 1994, based on the Company's current fringe benefit policies, the requirements of SFAS No. 106 are expected to have no impact on the results of operations or financial condition of the Company. SFAS No. 112, "Employers' Accounting for Postemployment Benefits," requires the accrual of postemployment benefits if the obligation is attributable to employees' services already rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. When adopted in fiscal year 1995, the Company currently does not believe SFAS No. 112 will have a material effect on the results of its operations or financial condition. Item 8. Item 8. Financial Statements and Supplementary Data Financial statements and supplementary financial information specified by this Item, together with the report of Coopers & Lybrand thereon, are presented following Item 14 of this report. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure Not applicable. PART III Incorporated by Reference The information called for by Item 10 Item 12 "Security Ownership of Certain Beneficial Owners and Management" and Item 13 Item 13 "Certain Relationships and Related Transactions" is incorporated herein by reference to the Company's definitive proxy statement for its Annual Meeting of Shareholders scheduled to be held April 13, 1994, which definitive proxy statement is expected to be filed with the Commission not later than 120 days after the end of the fiscal year to which this report relates. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents Filed as a part of the Report 1. Financial Statements: -------------------- Pages ------ Report of Independent Accountants Consolidated Statements of Income for the fiscal years 1993, 1992 and 1991 Consolidated Balance Sheets, November 28, 1993 and November 29, 1992 Consolidated Statements of Stockholders' Equity for the fiscal years 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the fiscal years 1993, 1992 and 1991 Notes to Consolidated Financial -22 Statements 2. Financial Statement Schedules: ----------------------------- II. Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties for the fiscal years 1993, 1992, and 1991 V. Property, Plant and Equip- ment for the fiscal years 1993, 1992 and 1991 VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment for the fiscal years 1993, 1992 and 1991 VIII. Valuation and Qualifying Accounts for the fiscal years 1993, 1992 and 1991 X. Supplementary Income State- ment Information for the fiscal years 1993, 1992 and 1991 All other schedules not listed above have been omitted, since they are not applicable or are not required, or because the required information is included in the consolidated financial statements or notes thereto. Individual financial statements of the Company have been omitted, since the Company is primarily an operating company and any subsidiary companies included in the consolidated financial statements are directly or indirectly wholly-owned and are not indebted to any person, other than the parent or the consolidated subsidiaries, in an amount which is material in relation to total consolidated assets at the date of the latest balance sheet filed, except indebtedness incurred in the ordinary course of business which is not overdue and which matures in one year. 3. Exhibits: (3) Articles of incorporation and bylaws: (a) Restated Articles of Incorporation, as amended (composite) (incorp. by ref. to Ex. 4(a) to Reg. Stmt. No. 33-6359 on Form S-8). (b) By-laws, as amended (incorp. by ref. to Ex. 4(b) to fiscal 1990 Form 10-K). (4) Instruments, defining rights of security holders, including indentures: (a) Credit Agreement dated as of October 2, 1990, between the Company and The Chase Manhattan Bank, N.A. (incorporated by reference to Ex. 4.1 to third quarter fiscal 1990 Form 10-Q). (b) Credit Agreement dated as of October 2, 1990, between the Company and Mellon Bank (East) PSFS, N.A. (incorp. by ref. to Ex. 4.2 to third quarter fiscal 1990 Form 10-Q). (c) Credit Agreement dated as of October 2, 1990, between the Company and Philadelphia National Bank, incorporated as CoreStates Bank, N.A. (incorp. by ref. to Ex. 4.3 to third quarter fiscal 1990 Form 10-Q). (d) Rights Agreement dated as of August 8, 1990 (including as Exhibit A thereto the Designation of Powers, Preferences, Rights and Qualifications of Preferred Stock), between the Company and Mellon Bank (East), N.A., as original Rights Agent (incorp. by ref. to Ex. 4.1 to August, 1990 Form 8-K) and Assignment and Assumption Agreement dated December 2, 1991, with American Stock Transfer and Trust Company, as successor Rights Agent (incorp. by ref. to Ex. 4(d) to fiscal 1991 Form 10-K). Miscellaneous long-term debt instruments and credit facility agreements of the Company, under which the underlying authorized debt is equal to less than 10% of the total assets of the Company and its subsidiaries on a consolidated basis, may not be filed as exhibits to this report. The Company agrees to furnish to the Commission, upon request, copies of any such unfiled instruments.* (10) Material contracts: (a) Lease Agreement dated June 1, 1979 between the Iredell County Industrial Facilities and Pollution Control Financing Authority and the Company (incorp. by ref. to Ex. 10(d) to fiscal 1988 Form 10-K). (b) 1978 Stock Option Plan, as amended, of the Company (incorp. by ref. to Ex. 28(a) to Reg. Stat. No. 33-25947 on Form S-8). (c) 1983 Stock Option and Stock Grant Plan, as amended, of the Company (incorp. by. ref. to Ex. 10(c) to fiscal 1992 Form 10-K). (d) 1993 Stock Option and Stock Grant Plan of the Company (incorp. by ref. to Ex. 10(d) to fiscal 1992 Form 10-K). (e) 1988 Long-Term Incentive Compensation Plan of the Company (incorp. by ref. to Appendix to 1988 Proxy Statement). (f) 1994 Non-Employee Directors' Stock Option Plan (filed herewith). (g) Loan and Security Agreement dated January 31, 1984, as amended, between the Company and Ronald J. Naples (incorp. by ref. to Ex. 10(h) to fiscal 1988 Form 10-K). (h) Loan and Security Agreement dated April 20, 1988 between the Company and Robert B. Fritsch (incorp. by ref. to Ex. 10(i) to fiscal 1988 Form 10-K). (i) (1) Form of Change in Control Agreement between the Company and various officers of the Company (incorp. by ref. to Ex. 10(h) to fiscal 1992 Form 10-K) and (2) list of executive officers who are parties (filed herewith) (j) Employment-Severance Agreement between the Company and William E. Chandler (filed herewith). (k) (1) Supplemental Executive Benefits Plan of the Company, effective April 16, 1992, and (2) related Amended and Restated Trust Agreement, effective February 17, 1993 (incorp. by ref. to Ex. 10(j) to fiscal 1992 Form 10-K). (l) Master Agreement dated May 3, 1990 between the Company and Bunzl Public Limited Company (incorp. by ref. to Ex. 2(a) to May 1990 Form 8-K). (m) Stock Acquisition Agreement dated May 3, 1990 between Seal Purchase Corp. and Bunzl Graphic Arts, Inc. relating to Seal (incorp. by ref. to Ex 2(b) to May 1990 Form 8-K). (11) Statement re: computation of per share earnings (filed herewith). (21) Subsidiaries (filed herewith). (23) Consent of Coopers & Lybrand to incorporation by reference, in Registration Statement No.s 33-70660, 33-25947, 33-6359 and 2-83144 on Form S-8, of their report on the consolidated financial statements and schedules included in this report (filed herewith). - --------------- * Reference also is made to (i) Articles 5th, 6th, 7th and 8th of the Company's composite Articles of Incorporation (Ex. 3(a) to this report), and (ii) to Sections 1, 7 and 8 of the Company's By-laws (Ex. 3 (b) to this report). ** Indicates a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K The Company did not file any reports on Form 8-K during the last quarter of the fiscal year covered by this report. --------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Stockholders and the Board of Directors of Hunt Manufacturing Co.: We have audited the accompanying consolidated financial statements and the financial statement schedules of Hunt Manufacturing Co. and Subsidiaries as listed in the index on pages 22 and 23 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hunt Manufacturing Co. and Subsidiaries as of November 28, 1993 and November 29, 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended November 28, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information required to be included therein. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania January 17, 1994 HUNT MANUFACTURING CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME for the fiscal years 1993, 1992 and 1991 (In thousands except per share amounts) 1993 1992 1991 -------- -------- -------- Net sales $256,150 $234,929 $228,622 Cost of sales 153,353 139,366 135,887 -------- -------- -------- Gross profit 102,797 95,563 92,735 Selling and shipping expenses 52,831 49,605 46,560 Administrative and general expenses 25,405 23,064 23,466 Provision for relocation and consolidation of operations - - 3,644 -------- -------- -------- Income from operations 24,561 22,894 19,065 Interest expense (less $283, $50 and $121 capitalized in 1993, 1992 and 1991, respectively) (242) (1,073) (2,098) Interest income 190 422 630 Other expense, net (471) (634) (479) --------- -------- --------- Income before income taxes 24,038 21,609 17,118 Provision for income taxes 9,110 8,307 7,532 --------- -------- -------- Net Income $ 14,928 $ 13,302 $ 9,586 ========= ======== ======== Average shares of common stock outstanding 16,107 16,104 16,080 ========= ======== ======== Earnings per common share $ .93 $ .83 $ .60 ========= ======== ======== See accompanying notes to consolidated financial statements. HUNT MANUFACTURING CO. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS November 28, 1993 and November 29, 1992 (In thousands except share and per share amounts) See accompanying notes to consolidated financial statements. HUNT MANUFACTURING CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY for the fiscal years 1993, 1992 and 1991 (in thousands except share and per share amounts) See accompanying notes to consolidated financial statements. HUNT MANUFACTURING CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS for the fiscal years 1993, 1992 and 1991 (in thousands) See accompanying notes to consolidated financial statements. HUNT MANUFACTURING CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands except share and per share amounts) 1. Summary of Significant Accounting Policies: ------------------------------------------ Basis of Consolidation: ---------------------- The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. Fiscal Year: ----------- The Company's fiscal year ends on the Sunday nearest the end of November. Fiscal year 1993 ended November 28, 1993; fiscal year 1992 ended November 29, 1992; and fiscal year 1991 ended December 1, 1991. All three fiscal years are comprised of 52 weeks. Cash Equivalents: ---------------- The Company considers all highly liquid temporary cash investments purchased with a maturity of three months or less to be cash equivalents. Inventories: ----------- Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for approximately half of the inventories and by the first-in, first-out (FIFO) method for the remainder. The Company uses the FIFO method of inventory valuation for certain acquired businesses because the related products and operations are separate and distinct from the Company's other businesses. Property, Plant and Equipment: ----------------------------- Expenditures for additions and improvements to property, plant and equipment are capitalized, and normal repairs and maintenance are charged to expense as incurred. The related cost and accumulated depreciation of depreciable assets disposed of are eliminated from the accounts, and any profit or loss is reflected in other expense, net. Excess of Acquisition Cost Over Net Assets Acquired: --------------------------------------------------- Excess of acquisition cost over net assets acquired relates principally to the Company's acquisitions of X-Acto (1981), Bevis Custom Tables, Inc. (1985), and the Graphic Arts Group of Bunzl plc (1990) and is amortized on a straight-line basis over periods ranging from 20 to 40 years. The Company's policy is to record an impairment loss against the net unamortized excess of acquisition cost over net assets acquired in the period when it is determined that the carrying amount of the net assets may not be recoverable. This determination includes evaluation of factors such as current market value, future asset utilization, business climate and future cash flows expected to result from the use of the net assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 1. Summary of Significant Accounting Policies, continued: ------------------------------------------- Depreciation and Amortization: ----------------------------- Depreciation for financial reporting purposes is computed by the straight- line method. Depreciation for tax purposes is computed principally using accelerated methods. The costs of intangible assets are amortized on a straight-line basis over their respective estimated useful lives, ranging from five to thirty years. Amortization of assets under capital leases which contain purchase options is provided over the assets' useful lives. Other capital leases are amortized over the terms of the related leases or asset lives, if shorter. Currency Translation: -------------------- The assets and liabilities of subsidiaries having a functional currency other than the U.S. dollar are translated at the fiscal year-end exchange rate, while elements of the income statement are translated at the weighted average exchange rate for the fiscal year. The cumulative translation adjustment is recorded as a separate component of stockholders' equity. Gains and losses on foreign currency transactions are included in the determination of net income as other expense, net. Such gains and losses are not material for any of the years presented. Income Taxes: ------------ Taxes on income are calculated under the deferred method pursuant to Accounting Principles Board Opinion No. 11. Generally, the deferred method recognizes income taxes on financial statement income, and the tax effect of differences between financial income and taxable income is deferred at tax rates in effect during the period. Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," will require the calculation of deferred income taxes using the asset and liability method, which includes a requirement for adjustment of deferred tax balances for income tax rate changes. Future years' net income will be subject to increased volatility depending upon the frequency of tax rate changes. The Company will adopt the provisions of SFAS No. 109 in the first quarter of fiscal 1994, and the cumulative effect of this change of accounting principle for income taxes is expected to increase fiscal 1994 earnings per share by approximately $.05. Hedging: ------- The Company enters into forward exchange contracts to hedge foreign currency transactions on a continuing basis for periods generally consistent with its committed exposure. Cash flows from hedges are classified in the statement of cash flows in the same category as the item being hedged. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 1. Summary of Significant Accounting Policies, continued: -------------------------------------------- Earnings Per Share: ------------------ Earnings per share are calculated based on the weighted average number of common shares outstanding. The effect of outstanding stock options and stock grants is not material and has not been included in the calculation. Employee Benefit Plans: ---------------------- The Company and its subsidiaries have non-contributory, defined benefit pension plans covering the majority of their employees. It is the Company's policy to fund pension contributions in accordance with the requirements of the Employee Retirement Income Security Act of 1974. The benefit formula used to determine pension costs is the final-average-pay method. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," requires accrual accounting for all postretirement benefits other than pensions. When adopted in fiscal year 1994, based on the Company's current fringe benefit policies, the requirements of SFAS No. 106 are expected to have no impact on the results of operations or financial condition of the Company. SFAS No. 112, "Employers' Accounting for Postemployment Benefits," requires the accrual of postemployment benefits if the obligation is attributable to employees' services already rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. When adopted in fiscal year 1995, the Company currently does not believe SFAS No. 112 will have a material effect on the results of its operations or financial condition. 2. Provision for Relocation and Consolidation of Operations: -------------------------------------------------------- In the fourth quarter of fiscal year 1991, the Company recorded a provision of $3.6 million (approximately $2.7 million after income taxes, or $.17 per share) relating to the Company's decision to relocate and consolidate certain operations. The pre-tax charge was comprised of a $2.7 million provision for anticipated costs relating to the relocation and consolidation of a Lit-Ning office products operation in California and a $.9 million provision for the relocation and consolidation of distribution operations in the United Kingdom. The provision included recognition of future lease obligations, write-off of property, plant and equipment, relocation costs, employee severance costs and other related costs. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 3. Inventories: ----------- The classification of inventories at the end of fiscal years 1993 and 1992 is as follows: 1993 1992 ---- ---- Finished goods $13,094 $11,554 Work in process 5,289 4,463 Raw materials 9,577 8,990 ------- ------- $27,960 $25,007 ======= ======= Inventories determined under the LIFO method were $13,299 and $13,120 at November 28, 1993 and November 29, 1992, respectively. The current replacement cost for these inventories exceeded the LIFO cost by $5,569 and $6,237 at November 28, 1993 and November 29, 1992, respectively. Inventory reductions in fiscal years 1993 and 1992 resulted in a liquidation of certain LIFO inventories carried at lower costs prevailing in prior years. The effect of these reductions was to increase net income by $101, or $.01 per share, and $262, or $.02 per share, in fiscal years 1993 and 1992, respectively. 4. Property, Plant and Equipment: ----------------------------- Property, plant and equipment at the end of fiscal years 1993 and 1992 is as follows: 1993 1992 ---- ---- Land and land improvements $ 3,698 $ 3,701 Buildings 17,434 16,779 Machinery and equipment 61,718 58,242 Leasehold improvements 661 706 Construction in progress 5,439 2,412 ------- ------- 88,950 81,840 Less accumulated depreciation and amortization 42,333 39,185 ------- ------- $46,617 $42,655 ======= ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 5. Intangible Assets: ----------------- Intangible assets at the end of fiscal years 1993 and 1992 are as follows: 1993 1992 ---- ---- Covenants not to compete $11,643 $11,545 Customer lists 1,510 1,510 Patents 1,533 1,528 Trademarks 1,400 1,411 Licensing agreements 1,154 1,154 Other 1,751 1,782 ------- ------- 18,991 18,930 Less accumulated amortization 9,026 7,756 ------- ------- $ 9,965 $11,174 ======= ======= 6. Debt: ---- Credit Agreements and Lines of Credit: ------------------------------------- At November 28, 1993, the Company had revolving credit agreements with three banks that provide for unsecured borrowings up to $45 million which expire October 2, 1995. There were no borrowings under these agreements at November 28, 1993. Amounts borrowed under these agreements would be converted to term loans upon expiration of the revolving credit termination dates. Principal payments would be made in quarterly installments beginning January 2, 1996 through October 2, 1999. Interest on borrowings under these agreements are at varying rates based, at the Company's option, on the banks' prime rate, certificate of deposit rate, or money market rate, the London Interbank Offering Rate, or the as offered rate. None of these agreements have compensating balance requirements. Commitment fees of 1/8 of 1% are payable under these agreements. Long-Term Debt: -------------- Long-term debt at the end of fiscal years 1993 and 1992 is as follows: 1993 1992 ---- ---- Term loan (a) $1,875 $2,813 Capitalized lease obligations (see Note 11) 2,000 2,100 Industrial development revenue bonds (b) 1,559 1,559 Industrial development revenue bonds (c) 700 820 Other 27 78 ------ ------ 6,161 7,370 Less current portion 3,158 1,210 ------ ------ $3,003 $6,160 ====== ====== NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) Debt, continued: ---- (a) The principal of this term loan is payable in equal quarterly installments of $234.4 through September 29, 1995. Interest on the borrowing is payable quarterly at a rate of 10.93% per annum on the outstanding principal amount of the loan. (b) These bonds bear interest (3.9% at November 28, 1993) at 65% of the lending bank's average daily prime rate and are payable on June 15, 1994. (c) These bonds bear interest (4.536% at November 28, 1993) at 75.6% of the lending bank's average daily prime rate. One bond with a principal balance of $575 at November 28, 1993 is payable on May 1, 1994. The other bond with a principal balance of $125 is payable in semiannual installments of $60 on November 1, 1994 and May 1, 1995 and one payment of $5 on November 1, 1995. Both bonds are collateralized by a plant facility and certain equipment. The terms of certain financing agreements contain, among other provisions, requirements for maintaining certain working capital and other financial ratios, and restrictions on incurring additional indebtedness and obligate the Company to equally and ratably collateralize the indebtedness undersuch agreements if the Company grants or assumes certain liens on its assets. Under the most restrictive covenants, dividends and purchases of capital stock of the Company may not exceed, on a cumulative basis, 75% of the cumulative net income of the Company at any time during the period beginning November 28, 1983. As of November 28, 1993, $46 million was available to the Company under this provision for future cash dividends and future purchases of its own capital stock. In addition, as of November 28, 1993, the Company exceeded its minimum tangible net worth requirement of $59 million by $30.2 million. The capitalized lease obligations are collateralized by the property, plant and equipment described in Note 11. Aggregate annual maturities for all long-term debt, including the capitalized leases, for each of the four fiscal years subsequent to November 27, 1994 are as follows: 1995 - $1,353 1996 - 370 1997 - 400 1998 - 425 7. Income Taxes: ------------ Income before provision for income taxes consists of the following: 1993 1992 1991 ---- ---- ---- Domestic $21,758 $20,341 $16,982 Foreign 2,280 1,268 136 ------- ------- ------- $24,038 $21,609 $17,118 ======= ======= ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 7. Income Taxes, continued: ------------ The provision for income taxes consists of the following: 1993 1992 1991 ---- ---- ---- Currently payable: Federal $8,406 $6,694 $7,162 State 877 815 800 Foreign 283 159 221 ------ ------ ------ 9,566 7,668 8,183 Deferred (456) 639 (651) ------ ------ ------ $9,110 $8,307 $7,532 ====== ====== ====== Deferred income taxes relate to the following timing differences between amounts reported for financial accounting and income tax purposes: 1993 1992 1991 ---- ---- ---- Depreciation $ 53 $ 119 $ 197 Provision for relocation and consolidation of operations 61 622 (975) Other, net (570) (102) 127 ----- ----- ----- $(456) $ 639 $(651) ===== ===== ===== The following is a reconciliation of the statutory federal income tax rate with the Company's effective income tax rate: 1993 1992 1991 ---- ---- ---- Statutory federal rate 34.9% 34.0% 34.0% State income taxes, net of federal tax benefit 2.2 2.6 2.5 Losses of foreign subsidiaries with no current offsetting tax benefit (including a provision for relocation and consolidation of foreign operations of 1.8% in 1991) - 1.0 6.0 Other, net .8 .8 1.5 ---- ---- ---- Effective tax rate 37.9% 38.4% 44.0% ==== ==== ==== As of November 28, 1993, the Company had a foreign net operating loss carry-forward for financial reporting purposes of approximately $3.5 million, the benefit of which has not been reflected in the financial statements. For tax return purposes, the Company has available approximately $2.4 million of foreign tax operating loss carryforwards which may be carried forward indefinitely, approximately $1 million of which were acquired in connection with business acquisitions. The use of foreign tax operating loss carryforwards acquired in connection with business acquisitions is subject to approval by the foreign taxing authorities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 8. Employee Benefit Plans: ---------------------- Pension Plans: ------------- Net pension costs for fiscal years 1993, 1992 and 1991 consist of the following components: 1993 1992 1991 ---- ---- ---- Service cost-benefits earned during the period $1,580 $1,595 $1,379 Interest cost on projected benefit obligation 1,852 1,672 1,415 Actual return on plan assets (1,863) (1,692) (3,342) Net amortization and deferral 107 184 2,133 ------ ------ ------ Net pension costs $1,676 $1,759 $1,585 ====== ====== ====== Net amortization and deferral consists of the deferral of the excess of actual return on assets over estimated return and amortization of the net unrecognized transition asset on a straight-line basis, principally over 15 years. The funded status of the Company's pension plans at September 30, 1993 and 1992 (dates of actuarial valuations) is as follows: ----------------------- Overfunded Underfunded 1992 ---------- ----------- ---- Plan assets at fair value $24,327 $ 660 $22,356 ------- ------- ------- Actuarial present value of benefit obligations: Vested 19,139 1,718 15,626 Non-vested 390 249 1,739 ------- ------- ------- Accumulated benefit obligation 19,529 1,967 17,365 Effect of increase in compensation 7,288 875 6,973 ------- ------- ------- Projected benefit obligation 26,817 2,842 24,338 ------- ------- ------- Projected benefit obligation in excess of plan assets (2,490) (2,182) (1,982) Unrecognized net loss 2,612 486 731 Unrecognized transition asset (1,890) (22) (2,127) Unrecognized prior service cost 857 1,218 2,255 ------- ------- ------- Pension liability $ (911) $ (500) $(1,123) ======= ======= ======= The increase in the projected benefit obligation in fiscal 1993 was due primarily to a decrease in the discount rate assumption. Plan assets consist principally of common stocks and U.S. Government Agency obligations. Pension costs are determined using the assumptions as of the beginning of the year. The funded status is determined using the assumptions as of the end of the year. Significant assumptions at year- end include: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 8. Employee Benefit Plans, continued: ---------------------- Pension Plans: ------------- 1993 1992 1991 ---- ---- ---- Discount rate 7.00% 7.75% 8.00% Rate of increase in compensation levels 6.00% 6.00% 6.00% Expected long-term rate of return on plan assets 7.50% 7.50% 7.50% Supplemental Executive Retirement Plan: -------------------------------------- In 1992 the Company instituted a nonqualified, Supplemental Executive Retirement Plan covering all officers. Expenses of $331 and $325 in fiscal years 1993 and 1992, respectively, relating to this plan were actuarially determined and are included in the pension costs described above. Employee Savings Plan: --------------------- The Company has a defined contribution 401(k) plan available to all nonunion employees in the U.S. Contributions to the 401(k) plan by the Company were $379, $300 and $260 for fiscal years 1993, 1992 and 1991, respectively. 9. Stock Options, Stock Grant, Long-Term Incentive Compensation and Bonus Plans: -------------------------------------- In 1993 the Company adopted with shareholders' approval the 1993 Stock Option and Stock Grant Plan, which is intended to replace the expired 1983 Stock Option and Stock Grant Plan. The 1993 plan authorized the issuance of up to 1,750,000 common shares, of which up to 525,000 common shares may be issued in the form of stock grants. The terms of the 1993 plan are essentially similar to the terms of the 1983 plan described below. No options were granted under this plan in fiscal year 1993. The Company's 1983 Stock Option and Stock Grant Plan and the 1978 Stock Option Plan expired by their terms in February 1993 and November 1988, respectively, and, while incentive stock options granted under them remain outstanding, no further options may be granted under these plans. Under the 1983 plan, common shares were authorized for the granting of incentive stock options, nonqualified stock options and stock grants to key employees, provided that stock grants may be made for no more than 373,125 common shares. The option price of options granted under the plan may not be less than the market value of the shares at the date granted. Options may be granted for terms of between two and ten years and generally become exercisable not less than one year following the date of grant. Stock grants under this plan are subject to a vesting period or periods of between one and five years from the date of grant. Common shares were not actually issued to a grantee until such shares have vested under the plan. The plan also provided for the payment of an annual cash bonus to recipients of stock grants in an amount equal to the cash dividends which would have been received had the shares not yet vested NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 9. Stock Options, Stock Grant, Long-Term Incentive Compensation and Bonus Plans, continued: -------------------------------------- under the grant been actually held by the recipients. During fiscal 1987, the Company made a stock grant in the amount of 22,500 common shares to a key employee. By its terms, this grant vested in four equal installments of 5,625 shares each on April 22 of each year through 1991. The charge to administrative and general expenses, including the cash bonus, with respect to stock grants under the plan amounted to $28 in fiscal year 1991. Under the 1978 plan, options for 632,813 common shares were authorized for the granting of options to key employees at option prices not less than the market value of the common shares at the date of grant. Options granted under this plan have terms of not more than ten years and generally become exercisable not less than one year following the date of grant. Payment upon exercise of stock options under the 1993, 1983 and 1978 plans may be by cash and/or by the Company's common stock in an amount equivalent to the market value of the stock at the date exercised. A summary of options under the Company's stock option plans is as follows: 1983 Plan 1978 Plan --------------- ------------- 1993 1992 1993 1992 ---- ---- ---- ---- Outstanding, beginning of year 756,486 644,558 3,493 3,493 Options granted 148,200 132,850 - - Options exercised (at an average price per share of $10.47, $7.77 and $6.22, respectively) (102,282) (17,022) (855) - Options terminated (23,400) (3,900) - - ------- ------- ----- ----- Outstanding, end of year 779,004 756,486 2,638 3,493 ======= ======= ===== ===== Average option price per share $13.43 $13.21 $10.58 $9.52 Outstanding exercisable options 506,754 511,526 2,638 3,493 Shares reserved for future stock options and grants - 259,932 - - In 1991 there were 22,429 and 2,193 options exercised at average prices of $8.52 and $6.22 relating to the 1983 and 1978 plans, respectively. The Company's 1988 Long-Term Incentive Compensation Plan provides for the granting to management-level employees of long-term incentive awards, which are payable in cash and/or by the Company's common stock at the end of a designated performance period of from two to five years, based upon the degree of attainment of pre-established performance standards during the performance period. A maximum of 180,000 shares are authorized for issuance under this plan. As of the end of fiscal 1993, an aggregate of 48,966 shares have been earned under this plan (13,394, 4,300 and 8,127 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 9. Stock Options, Stock Grant, Long-Term Incentive Compensation and Bonus Plans, continued: -------------------------------------- shares in 1993, 1992 and 1991, respectively, and 23,145 shares in all previous years), and an aggregate of 50,587 shares were subject to outstanding unvested grants. There is no stated limitation on the aggregate amount of cash payable under this plan, but the maximum amount (in cash and/or shares) which may be paid to a participant under all long-term incentive awards under the plan with respect to the same performance period may not exceed 125% of the participant's base salary in effect at the time the award initially was made. The charge to administrative and general expenses relating to this plan was $563, $88 and $228 in fiscal years 1993, 1992 and 1991, respectively. 10. Shareholders' Rights Plan: ------------------------- During fiscal 1990 the Company adopted a Shareholders' Rights Agreement and declared a dividend of one right (a "Right") for each outstanding share of the Company's common shares held of record as of the close of business on August 22, 1990. The Rights initially are deemed to be attached to the common stock and detach and become exercisable only if (with certain exceptions and limitations) a person or group attempts to obtain beneficial ownership of 15% or more of the Company's common shares or is determined to be an "adverse person" by the Board of Directors of the Company. Each Right, if and when it becomes exercisable, initially will entitle holders of the Company's common shares to purchase one one-thousandth of a share of Junior Participating Preferred Shares (Series A, of which 50,000 shares currently are authorized for issuance) for $60, subject to adjustment. The Rights will convert into the right to purchase common shares or other securities or property of the Company or an acquiring company in certain other potential or actual takeover situations. The Rights are redeemable by the Company at $.01 per Right in certain circumstances and expire, unless earlier exercised or redeemed, on December 31, 2000. 11. Commitments and Contingencies: ----------------------------- Leases: ------ Capitalized lease obligations (see Note 6) represent amounts payable under leases which are, in substance, installment purchases. Property, plant and equipment includes the following assets under capital leases: 1993 1992 ---- ---- Land $ 314 $ 314 Buildings 2,632 2,632 Machinery and equipment 1,009 1,009 Accumulated depreciation (2,639) (2,531) ------- ------- $ 1,316 $ 1,424 ======= ======= The Company has the option to purchase the above assets at any time during the term of the leases for amounts sufficient to redeem and retire the underlying lessor debt obligations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 11. Commitments and Contingencies, continued: ----------------------------- Leases, continued: ------ The minimum rental commitments under all noncancellable leases as of November 28, 1993 are as follows: Fiscal Operating Capitalized Period Leases Leases ------ --------- ---------- 1994 $ 3,539 $ 150 1995 2,779 562 1996 1,809 480 1997 1,406 448 1998 1,325 491 Thereafter 7,163 489 ------- ----- Minimum lease payments $18,021 2,620 ======= ===== Less interest 620 Present value of ------ minimum lease payments $2,000 ====== Rent expense, including related real estate taxes charged to operations, amounted to $4,217, $4,076 and $4,047 for fiscal years 1993, 1992 and 1991, respectively. Contingencies: ------------- The Company has employment/severance (change in control) agreements with its officers, as well as a severance policy covering Company employees generally. Under such agreements and policy, severance payments and benefits would become payable in the event of specified terminations of employment following a change in control (as defined) of the Company. In the event of a change in control of the Company and subsequent termination of all employees, the maximum contingent severance liability would have been approximately $14.3 million at November 28, 1993. Prior to the acquisition of the Graphic Arts Group by the Company from Bunzl plc in May 1990, it was discovered that some hazardous waste materials had been stored on the premises of one of the Graphic Arts Group companies, Seal, located in Naugatuck, Connecticut. In compliance with applicable state law, this environmental condition was reported to the Connecticut Department of Environmental Protection by Bunzl. Seal, which is now a subsidiary of the Company, may be partially responsible under law for the environmental conditions on the premises and any liabilities resulting therefrom. However, in connection with the Company's acquisition of Seal, Bunzl agreed to take responsibility for correcting such environmental conditions and, for a period of seven years, to indemnify Seal and the Company for such resulting liabilities, subject to certain limitations. Management believes that this contingency will not have a material effect on the Company's results of operations or financial condition. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 11. Commitments and Contingencies, continued: ----------------------------- Contingencies, continued: ------------- The Company is also involved on a continuing basis in monitoring its compliance with environmental laws and in making capital and operating improvements necessary to comply with existing and anticipated environmental requirements. Despite its efforts, the Company has been cited for occasional violations or alleged violations of environmental laws or permits. Expenses incurred by the Company to date relating to violations of and compliance with environmental laws and permits have not been material. While it is impossible to predict with certainty, management currently does not foresee such expense in the future as having a material effect on the Company's business, results of operations or financial condition. There are other contingent liabilities with respect to product warranties, legal proceedings and other matters occurring in the normal course of business. In the opinion of management, all such matters are adequately covered by insurance or by accruals, and if not so covered, are without merit or are of such kind, or involve such amounts, as would not have significant effect on the financial condition or results of operations of the Company, if disposed of unfavorably. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 12. Research and Development: ------------------------ Research and development expenses were approximately $1,657, $1,519, and $1,153 in fiscal years 1993, 1992 and 1991, respectively. 13. Cash Flow Information: --------------------- Cash payments for interest and income taxes (net of refunds) were as follows: 1993 1992 1991 ---- ---- ---- Interest paid $ 580 $ 863 $1,889 Income taxes 8,761 5,987 7,170 14. Quarterly Financial Data (unaudited): ------------------------------------ Results of operations for each of the quarters during fiscal years 1993 and 1992 are as follows: ---- First Second Third Fourth Total ----- ------ ----- ------ ----- Net sales $57,117 $60,825 $65,021 $73,187 $256,150 Gross profit 22,465 24,701 25,702 29,929 102,797 Net income 2,533 3,544 3,856 4,995 14,928 Net income per share .16 .22 .24 .31 .93 ---- First Second Third Fourth Total ----- ------ ----- ------ ----- Net sales $53,016 $56,982 $61,795 $63,136 $234,929 Gross profit 21,275 23,037 24,940 26,311 95,563 Net income 2,191 3,219 3,854 4,038 13,302 Net income per share .14 .20 .24 .25 .83 15. Industry Segment Information: ---------------------------- The Company operates in two industry segments, Office Products and Art/Craft Products. Total export sales aggregated $21,580 in fiscal 1993, $20,919 in fiscal 1992 and $20,534 in fiscal 1991 of which $11,619, $10,981 and $11,074 in fiscal years 1993, 1992 and 1991, respectively, were made in Canada. Operating profits include all revenues and expenses of the reportable segment except for general corporate expenses, interest expense, interest income, other expenses, other income and income taxes. Identifiable assets are those assets used in the operations of each business segment. Corporate assets include cash and miscellaneous other assets not identifiable with any particular segment. Capital additions include amounts related to acquisitions. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 15. Industry Segment Information, continued: ---------------------------- Office Art/Craft Corp. Fiscal Year 1993 Products Products Assets Consolidated ---------------- -------- -------- ------ ------------ Net sales $142,462 $113,688 $256,150 ======== ======== ======== Operating profit $ 11,411 $ 18,832 $ 30,243 ======== ======== General corporate (5,682) Interest expense (242) Interest income 190 Other expense, net (471) Income before income -------- taxes $ 24,038 ======== Identifiable assets $ 74,098 $ 67,619 $ 14,600 $156,317 ======== ======== ======== ======== Capital additions $ 5,559 $ 4,082 $ 698 $ 10,339 ======== ======== ======== ======== Depreciation and amortization $ 3,898 $ 3,234 $ 532 $ 7,664 ======== ======== ======== ======== Office Art/Craft Corp. Fiscal Year 1992 Products Products Assets Consolidated ---------------- -------- -------- ------ ------------ Net sales $126,101 $108,828 $234,929 ======== ======== ======== Operating profit $ 8,541 $ 18,516 $ 27,057 ======== ======== General corporate (4,163) Interest expense (1,073) Interest income 422 Other expense, net (634) Income before income -------- taxes $ 21,609 ======== Identifiable assets $ 69,894 $ 64,715 $ 9,561 $144,170 ======== ======== ======== ======== Capital additions $ 3,666 $ 1,813 $ 523 $ 6,002 ======== ======== ======== ======== Depreciation and amortization $ 3,552 $ 3,521 $ 485 $ 7,558 ======== ======== ======== ======== NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 15. Industry Segment Information, continued: ---------------------------- Office Art/Craft Corp. Fiscal Year 1991 Products Products Assets Consolidated ---------------- -------- -------- ------ ------------ Net sales $120,103 $108,519 $228,622 ======== ======== ======== Operating profit* $ 6,369 $ 17,618 $ 23,987 ======== ======== General corporate (4,922) Interest expense (2,098) Interest income 630 Other expense, net (479) Income before income -------- taxes $ 17,118 ======== Identifiable assets $ 71,960 $ 68,292 $11,572 $151,824 ======== ======== ======== ======== Capital additions $ 2,736 $ 1,875 $ 338 $ 4,949 ======== ======== ======== ======== Depreciation and amortization $ 3,528 $ 3,494 $ 445 $ 7,467 ======== ======== ======== ======== * Includes the provision for relocation and consolidation of operations which reduced the office products operating profit by $3.2 million and art/craft products operating profit by $.4 million. The Company's operations by geographical areas for fiscal years 1993, 1992 and 1991 are presented below. Intercompany sales to affiliates represent products which are transferred between geographic areas on a basis intended to reflect as nearly as possible the market value of the products. Intercompany sales between areas were not material in fiscal year 1991. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 15. Industry Segment Information, continued: ---------------------------- Fiscal Year 1991 North America Europe Corporate Consolidated ------------- ------ --------- ------------ Net sales $210,687 $17,935 $228,622 ======== ======= ======== Operating profit (loss)* $ 26,786 $(2,799) $ 23,987 ======== ======= ======== Identifiable assets $117,791 $22,461 $11,572 $151,824 ======== ======= ======= ======== * Includes the provision for relocation and consolidation of operations which reduced operating profit in North America by $2.7 million and in Europe by $.9 million. 16. Financial Instruments: --------------------- Off-Balance Sheet Risk: ---------------------- The Company had $992 in forward exchange contracts outstanding as of November 28, 1993 to hedge accounts receivable denominated in Canadian dollars. No forward exchange contracts were outstanding as of November 29, 1992. The forward exchange contracts generally have maturities which do not exceed six months and require the Company to exchange Canadian dollars for U.S. dollars at maturity at rates agreed to at the inception of the contracts. Letters of credit are issued by the Company during the ordinary course of business through major domestic banks as required by certain vendor contracts. As of November 28, 1993 and November 29, 1992, the Company had outstanding letters of credit for $511 and $1,426, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (In thousands except share and per share amounts) 16. Financial Instruments, continued: --------------------- Concentrations of Credit Risk: ----------------------------- Financial instruments which potentially subject the Company to concentration of credit risk consist principally of temporary cash investments and trade receivables. The Company places its temporary cash investments ($7.3 million and $4.5 million at November 28, 1993 and November 29, 1992, respectively) with quality financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across many different industries and geographies. Generally, the Company does not require collateral or other security to support customer receivables. Fair Value: ---------- The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents - ------------------------- The carrying amount approximates fair value because of the short maturity of these instruments. Debt (excluding capital lease obligations) - ------------------------------------------ The fair value of the Company's debt is estimated based on the current rates offered to the Company for debt of the same remaining maturities. Forward exchange contracts - -------------------------- The fair value of forward exchange contracts (used for hedging purposes) approximates fair value because of the short maturity of these instruments. The estimated fair values of the Company's financial instruments at November 28, 1993 are as follows: Carrying Fair Amount Value -------- ----- Cash and cash equivalents $10,778 $10,778 Debt (excluding capital lease obligations) 4,161 4,324 Forward exchange contracts 992 992 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HUNT MANUFACTURING CO. Dated: February 22, 1994 By: /s/ Ronald J. Naples -------------------------- Ronald J. Naples Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on behalf of the registrant and in the capacities and on the dates indicated: /s/ Ronald J. Naples - ------------------------------ February 22, 1994 Ronald J. Naples Chairman of the Board and Chief Executive Officer /s/ William E. Chandler - ------------------------------ February 22, 1994 William E. Chandler Senior Vice President, Finance (Principal Financial and Accounting Officer) /s/ Vincent G. Bell, Jr. - ------------------------------ February 22, 1994 Vincent G. Bell, Jr. Director /s/ Jack Farber - ------------------------------ February 22, 1994 Jack Farber Director /s/ Robert B. Fritsch - ------------------------------ February 22, 1994 Robert B. Fritsch Director /s/ William F. Hamilton, Ph.D. - ------------------------------ February 22, 1994 William F. Hamilton, Ph.D. Director /s/ Mary R. Henderson - ------------------------------ February 22, 1994 Mary R. (Nina) Henderson Director /s/ Gordon A. MacInnes, Jr. - ------------------------------ February 16, 1994 Gordon A. MacInnes, Jr. Director /s/ Wilson D. McElhinny - ------------------------------ Wilson D. McElhinny February 22, 1994 Director /s/ Robert H. Rock - ------------------------------ February 22, 1994 Robert H. Rock Director /s/ Roderic H. Ross - ------------------------------ February 22, 1994 Roderic H. Ross Director - ------------------------------ February , 1994 Victoria B. Vallely Director	13,088	87,456
27996_1993.txt	27996_1993	1993	27996	Item 1. Description of Business Deluxe Corporation was incorporated under the laws of Minnesota in 1920 as the successor to a business founded in 1915. Unless the context otherwise requires, the term "Company," as used herein, refers to Deluxe Corporation and its seven wholly owned subsidiaries. The seven wholly owned subsidiaries are: Deluxe Data Systems, Inc., a supplier of software and processing services for automated teller machines, point-of-sale systems, automated clearing houses and government benefit transfers; Chex Systems, Inc., a new-account verification business providing services to financial institutions; Electronic Transaction Corporation, a data base business providing check authorization information to retailers; Deluxe U.K. Limited, a manufacturer of short-run computer and business forms in the United Kingdom; PaperDirect, Inc., a direct mail marketer of specialty paper; Nelco, Inc., a supplier of tax forms, tax forms software, and electronic tax filing services ; and Current, Inc., a direct mail marketer of greeting cards, stationery, bank checks and related consumer specialty products. The Company has three basic business units: (1) Payment Systems, in which the Company provides check printing, electronic funds transfer, automated terminal machine (ATM) card services and credit reporting services; (2) Business Systems, in which the Company manufactures and supplies computer and business forms, record-keeping systems, and a variety of related office products and services; and (3) Consumer Specialty Products, in which the Company manufactures and distributes, primarily through direct mail, greeting cards, gift wrap, stationery, bank checks, and other products for household use. With the exception of a relatively small volume of business forms and paper sales in the United Kingdom, practically all of the Company's products and services are sold in the United States. Reference is made to the information contained in Note 9, Business Segment Information, in the Notes to Consolidated Financial Statements on page 37 in the Company's Annual Report. PAYMENT SYSTEMS The Company's Payment Systems Division prints and sells to banks and other financial institutions and depositors a variety of checks and related banking forms. It directs its efforts to the production and marketing of checks and deposit tickets for personal and business - 2 - accounts. Several check styles are offered; some are designed for desk or office use; others are designed to be carried in a pocket or purse. Substantially all of the Company's checks and related banking forms are imprinted with magnetic ink and are designed to conform with the specifications of the magnetic ink character recognition (MICR) program currently utilized by the U.S. banking system. For several years the banking industry and others have been seeking ways to improve the payment system and a variety of alternatives to the bank check as a medium for settling financial transactions have been introduced, including, for example, charge cards, credit cards, debit cards, telephone bill payment, etc. Although such alternative means of settling financial transactions may reduce the demand for checks, the Company is unable to predict the precise extent of application of such alternatives or their effect on its future operations. In the case of checks, depositors commonly submit initial orders and reorders to their financial institutions which forward them to one of the Company's printing plants. Completed orders are sent directly by the Company to the depositors, typically on the business day after receipt of the order. The Company's charges are paid by the financial institutions, which in turn usually deduct the amounts from the depositors' accounts. Skeleton check forms are lithographed in three of the Company's regional warehouse and distribution centers, principally on high-speed roll-fed presses. From these centers, the forms are distributed to the Company's 48 check production plants, where names, addresses, financial institution name and other information are printed on the documents. The Company's facilities are located in major metropolitan areas throughout the United States. The Company has no material backlog of orders. Approximately 96 percent of all check orders received by the Company in 1993 were completed and shipped no later than the first working day after receipt of the order. The approximate number of financial institutions (not including branches as separate entities) to which the Company made gross sales of checks and related banking forms in excess of $100,000 during the year was 1,926. No single institution, including its branches, accounted for more than approximately 2 percent of the Company's 1993 check sales. The Company's principal raw materials are safety paper and special MICR bond papers. The Company purchases substantially all of its safety paper from Simpson Paper Company, which finishes and warehouses the paper in its plants in Warwick, New York, and Burlington, Iowa. Most of the Company's special MICR bond papers are obtained from Georgia Pacific Corporation, primarily from its facility in Port Edwards, Wisconsin. The Company has no long-term contract with any of its suppliers and has never experienced a shortage of either safety paper or MICR bond papers. In order to assure adequate sources of supply, the Company is continually experimenting with the use of special MICR bond papers from other suppliers. Other raw materials used by the Company are of a standard composition and are purchased from a number of sources at competitive prices. The Company's primary competitors in the sale of bank checks and related banking forms are two other large national printers who specialize in check printing. However, any printer which complies with the American Bankers Association's specifications for MICR - 3 - printing is a potential competitor. The Company is the largest firm engaged principally in check printing. The Company is also a major supplier of electronic funds transfer software and processing services, particularly software and services for automated teller machines, processing of ATM interchange transactions within and between regional shared networks, and electronic benefit transactions. Deluxe provides ATM transaction processing technology and services to six of the 10 largest ATM networks. The Company provides electronic benefit transactions services for the automated payment of aid to dependent children and food stamp benefits in Maryland and New Jersey. Competition for the Company's electronic funds transfer software and processing services comes from several large financial institutions and communications companies. BUSINESS SYSTEMS This division directs its primary efforts to the production and marketing of short-run printed computer and business forms and record-keeping systems for small businesses and professional practices. In addition, it is a direct mail marketer of decorated and other specialty papers to users of laser printers and office copiers. Other products and services marketed by the division include tax forms, tax forms software, one-write accounting systems, and electronic tax filing services. The division has no material backlog of orders and does not carry significant inventory. Approximately 94 percent of all personalized standard forms orders were completed and shipped no later than the third working day after receipt, and all custom forms were completed and shipped no later than the fifth day after receipt. Orders for specialty papers were typically filled no later than the first day after receipt. Business Systems' products are sold primarily through direct mail and check package advertisements. Business Systems' products are produced or inventoried in nine of the Company's plants. Its competition consists of a large number of national and local business forms and office products suppliers and tax filing service providers. CONSUMER SPECIALTY PRODUCTS This division produces and markets greeting cards, gift wrap, miscellaneous stationery and bank checks. In addition, it markets a variety of novelty items for household use, many of which have been created by the division and are sold under its proprietary trademarks. All such products are sold to consumers by means of catalogs and other direct mail advertisements. Many of the division's promotions are based on holidays, and due to the relative size of the year-end holiday season, approximately 40 percent of the division's sales occur in the fourth quarter. Consumer Specialty Products are produced in two of the Company's plants. The division's competitors are primarily the national greeting card and stationery printers that market their products through owned and franchised card and gift shops, and a large number of check printers that solicit orders by direct mail. - 4 - EMPLOYEES Including its subsidiaries, the Company has approximately 17,748 full and part-time employees. It has a number of employee benefit plans, including medical, hospitalization and retirement plans. The Company has never experienced a work stoppage or strike and considers its employee relations to be good. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company are elected by the board of directors each year. The term of office of each executive officer will expire at the annual meeting of the board after the annual shareholders' meeting on May 9, 1994. The principal occupation of each of the executive officers listed below is with the Company. OFFICER NAME POSITION AGE SINCE - ---- -------- --- ------- Harold V. Haverty Chairman, President and Chief 63 1969 Executive Officer Jerry K. Twogood Executive Vice President 53 1974 Charles M. Osborne Senior Vice President and Chief Financial Officer 40 1981 Arnold A. Angeloni Senior Vice President 53 1985 Kenneth J. Chupita Senior Vice President 52 1981 Each of the executive officers has held his current position during the past five years. Item 2. Item 2. Properties The Company conducts production operations in 73 facilities located in 30 states, Puerto Rico, and the United Kingdom aggregating approximately 4,623,000 square feet; in addition, the Payment Systems Division occupies three facilities in Shoreview, Minnesota, aggregating approximately 433,000 square feet, which are devoted to administration, information systems, research and development, the Business Systems Division occupies a 156,000 square foot administration building in Shoreview, Minnesota, and the Consumer Specialty Products Division occupies a 148,000 square foot administration and product design building in Colorado Springs, Colorado. All but four of the production facilities are of one story construction and most were constructed and equipped in accordance with the Company's plans and specifications. Over one-half of the Company's total production area has been constructed during the past 20 years. The Company owns 58 of its facilities and leases the remainder for terms expiring from 1994 to 2001. Depending upon the circumstances, when a lease expires, the Company either renews the lease or constructs a new facility to replace the leased facility. All facilities are adequately equipped for the Company's operations. - 5 - Item 3. Item 3. Legal Proceedings There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or of which any of such company's property is the subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Reference is made to the information contained under the caption "Financial Highlights" on page 1, and "Shareholder Information" on page 40 of the Company's Annual Report. Item 6. Item 6. Selected Financial Data Reference is made to the information contained under the caption "Eleven-Year Summary" on pages 22 and 23 in the Company's Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the information contained under the caption "Management's Discussion and Analysis" on pages 24 through 26 in the Company's Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data Reference is made to the financial statements , notes and independent auditors' report on pages 21 through 39 of the Company's Annual Report and the information contained under the caption "Summarize Quarterly Financial Data" on page 39 in the Company's Annual Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III ITEMS 10, 11, 12 AND 13. Directors and Executive Officers of the Registrant, Compliance with Section 16(a) of the Exchange Act, Executive Compensation, Security Ownership of Certain Beneficial Owners and Management, and Certain Relationships and Related Transactions. - 6 - Reference is made to the Company's Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following financial statements, schedules and independent auditors' report and consent are filed as part of this report: Page in Annual Report (1) Financial Statements: Consolidated Balance Sheets at December 31, 1993 and 1992 . . . 28 - 29 Consolidated Statements of Income for the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . 30 Consolidated Statements of Cash Flows for the three years in the period ended December 31, 1993. . . . . . . . . . . 31 Notes to Consolidated Financial Statements. . . . . . . . . . . 32 - 38 Independent Auditors' Report. . . . . . . . . . . . . . . . . . 39 (2) Supplemental Financial Information (Unaudited): Summarized Quarterly Financial Data . . . . . . . . . . . . . . 39 Page in this Form 10-K (3) Financial Statement Schedules: Independent Auditors' Report on the Financial Statement Schedules. . . . . . . . . . . . . . . . . . . . . . . . . V - Property, Plant and Equipment. . . . . . . . . . . . . . . S-1 VI - Accumulated Depreciation of Property, Plant and Equipment. S-2 IX - Short-Term Borrowings. . . . . . . . . . . . . . . . . . . S-3 X - Supplementary Income Statement Information . . . . . . . . S-4 (4) Independent Auditors' Consent to the incorporation by reference of its reports in the Company's Registration Statements Nos. 2-94462, 2-96963, 33-32279 and 33-58510 . . . . . . . . . . . . Schedules other than those listed above are not required or are not applicable, or the required information is shown in the financial statements or notes. (b) The Company did not file a report on Form 8-K during the fourth quarter of 1993. (c) The following exhibits are filed as part of or are incorporated in this report by reference: - 7 - (3) A - Articles of Incorporation, incorporated by reference to the Company's Form 10-K for the year ended December 31, 1990. B - Bylaws, incorporated by reference to the Company's Form 10-K for the year ended December 31, 1990. (4) A - Rights Agreement, incorporated by reference to the Company's Form 8-K dated February 17, 1988. B - Indenture, incorporated by reference to the Company's Form S-3 dated November 24, 1989. (10) A - Deferred Compensation Plan, incorporated by reference to the Company's Form 10-K for the year ended December 31, 1985. B - Supplemental Benefits Plan, incorporated by reference to the Company's Form 10-K for the year ended December 31, 1985. C - Stock Option Plan, incorporated by reference to the Company's Form 10-K for the year ended December 31, 1989. (13) 1993 Annual Report to Shareholders (24) Independent Auditors' Consent, incorporated by reference to page of the Company's Form 10-K for the year ended December 31, 1993. (25) Powers of Attorney of officers and directors signing by an attorney-in-fact. (28) Proxy Statement, incorporated by reference to the Company's definitive proxy statement dated March 28, 1994. [Note to recipients of Form 10-K: Copies of exhibits will be furnished upon written request and payment of the Company's reasonable expenses ($.25 per page) in furnishing such copies.] - 8 - Pursuant to the requirements of Section 13 or 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. DELUXE CORPORATION Date: March 28, 1994 By /s/ Harold V. Haverty -------------------------- Harold V. Haverty Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 28, 1994 By /s/ Harold V. Haverty --------------------------------- Harold V. Haverty for Himself and Harold V. Haverty, Director and as Attorney-In-Fact for the Named Principal Executive Officer Directors and Officers Eugene R. Olson, Director Edward W. Asplin, Director John Schreiner, Director H. William Lurton, Director Whitney MacMillan, Director James J. Renier, Director Jerry K. Twogood, Director Barbara B. Grogan, Director Allen F. Jacobson, Director Charles M. Osborne, Principal Financial Officer and Principal Accounting Officer - 9 - INDEPENDENT AUDITORS' REPORT Deluxe Corporation: We have audited the consolidated financial statements of Deluxe Corporation and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 10, 1994; such consolidated financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Deluxe Corporation and subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche Deloitte & Touche Saint Paul, Minnesota February 10, 1994 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 2-94462 and 2-96963 on Forms S-8 and Nos. 33-32279 and 33-58510 on Forms S-3 of our reports dated February 10, 1994 appearing in or incorporated by reference in this Annual Report on Form 10-K of Deluxe Corporation for the year ended December 31, 1993. /s/ Deloitte & Touche Deloitte & Touche Saint Paul, Minnesota March 28, 1994 S-1 S-2 S-3 S-4	2,988	18,911
52428_1993.txt	52428_1993	1993	52428	Item 1. Business IDS Certificate Company (IDSC) is incorporated under the laws of Delaware. Its principal executive offices are located in the IDS Tower, Minneapolis, Minnesota, and its telephone number is (612) 671-3131. IDS Financial Corporation (IDS), a Delaware corporation, IDS Tower 10, Minneapolis, Minnesota 55440-0010, owns 100% of the outstanding voting securities of IDSC. IDS is a wholly owned subsidiary of American Express Company (American Express), a New York Corporation, with headquarters at American Express Tower, World Financial Center, New York, New York. IDSC is a face-amount certificate investment company registered under the Investment Company Act of 1940 (1940 Act). IDSC is in the business of issuing face-amount certificates. Face-amount certificates issued by IDSC entitle the certificate holder to receive, at maturity, a stated amount of money and interest or credits declared from time to time by IDSC, in its discretion. IDSC is continuously engaged in new product development. IDSC currently offers seven certificates to the public: "IDS Future Value Certificate", "IDS Cash Reserve Certificate", "IDS Flexible Savings Certificate" (formerly "IDS Variable Term Certificate"), "IDS Installment Certificate", "IDS Stock Market Certificate", "IDS Investors Certificate" and "IDS Special Deposits". The IDS Special Deposits is only offered for sale in London, England, and is not registered for sale in the United States. All certificates are currently sold without a sales charge. The IDS Installment Certificate, the IDS Flexible Savings Certificate, the IDS Stock Market Certificate, the IDS Investors Certificate and the IDS Special Deposits currently bear surrender charges for premature surrenders. All of the above described certificates, except the IDS Special Deposits, are distributed pursuant to a Distribution Agreement with IDS Financial Services Inc., an affiliate of IDSC. With respect to the IDS Investors Certificate and the IDS Stock Market Certificate, IDS Financial Services Inc., in turn, has a Selling Agent Agreement with American Express Bank International, a subsidiary of American Express, for selling the certificate. IDS Financial Services Inc. also distributes the IDS Stock Market Certificate. With respect to the IDS Special Deposits, IDSC has a Marketing Agreement with American Express Bank Ltd., a subsidiary of American Express, for marketing the certificate. IDSC also offers one certificate in connection with certain employee benefit plans available to eligible IDS employees, financial planners and retirees. This certificate is called the Series D-1 Investment Certificate. Except for the IDS Investors Certificate and the IDS Special Deposits, all of the certificates are available as qualified investments for Individual Retirement Accounts (IRAs), or 401(k) plans and other qualified retirement plans. The specified maturities of the certificates range from four to twenty years. Within that maturity period, most certificates have terms ranging from three to thirty-six months. Interest rates change and certificateholders can surrender their certificates without penalty at term end. The IDS Future Value Certificate is a single payment certificate that guarantees interest in advance for a 4, 5, 6, 7, 8, 9 or 10-year maturity, at the buyer's option. The IDS Cash Reserve Certificate is a single pay certificate that permits additional investments and guarantees interest in advance for a three-month term. The IDS Flexible Savings Certificate is a single payment certificate that permits a limited amount of additional payments and guarantees interest in advance for a term of 6, 12, 18, 24, 30 or 36 months, at the buyer's option. The IDS Installment Certificate is an installment payment certificate that declares interest in advance for a three-month period and offers bonuses in the third through sixth years for regular investments. The IDS Stock Market Certificate is a single payment certificate that offers the certificate holder the opportunity to have all or part of his interest tied to stock market performance, as measured by a broad stock market index, with guaranteed return of principal. The holder can also choose to earn a guaranteed fixed rate of interest. In addition to being sold to IDS clients pursuant to a Distribution Agreement with IDS Financial Services Inc., this certificate is sold by American Express Bank International (AEBI), under a Selling Agent Agreement with IDS Financial Services Inc. to AEBI's clients who are neither citizens nor residents of the United States. The IDS Investors Certificate is a single payment certificate that permits additional payments within 15 days of term renewal. Interest rates are guaranteed in advance for a term of 1, 2, 3, 6, 12, 24 or 36 months, at the buyer's option. This certificate is currently sold by AEBI, through a Selling Agent Agreement with IDS Financial Services Inc., only to AEBI's clients who are neither citizens nor residents of the United States. The IDS Special Deposits is a single payment certificate that permits additional payments within 15 days of term renewal. Interest rates are guaranteed in advance for a term of 1, 2, 3, 6, 12, 24 or 36 months, at the buyer's option. This certificate is currently sold by American Express Bank Ltd. ("AEB") in the London office, through a Marketing Agreement with IDSC, only to AEB's clients who are neither citizens nor residents of the United States. This certificate is not registered for sale in the United States. IDSC is by far the largest issuer of face-amount certificates in the United States. However, such certificates compete with many other investments offered by banks, savings and loan associations, mutual funds, broker-dealers and others, which may be viewed by potential clients as offering a comparable or superior combination of safety and return on investment. In particular, some of IDSC's products are designed to be competitive with the types of investment offered by banks and thrifts. Since IDSC's face-amount certificates are securities, their offer and sale are subject to regulation under federal and state securities laws. IDSC's certificates are backed by its qualified assets on deposit and are not insured by any governmental agency. For all of the certificates, except for the IDS Investors Certificate and the IDS Special Deposits, IDSC's current policy is to re-evaluate the certificate rates weekly to respond to marketplace changes. For the IDS Investors Certificate and the IDS Special Deposits, IDSC's current policy is to re-evaluate the rates on a daily basis. For each product, IDSC refers to an independent index to set the rates for new sales. Except for IDS Special Deposits, IDSC must set the rates within a specified range of the rate from such index. For renewals, IDSC uses such rates as an indication of the competitors' rates, but is not required to set rates within a specified range. For the IDS Flexible Savings Certificate, IDS Cash Reserve Certificate and the IDS Series D-1 Investment Certificate, the published rates of the BANK RATE MONITOR National Index (trademark) for various length bank certificates of deposit are used as the guide in setting rates. For the IDS Installment Certificate, the average interest rate for money market deposit accounts, as published by the BANK RATE MONITOR National Index (trademark), North Palm Beach, FL, is used as a guide in setting rates. For the IDS Future Value Certificate, the average quoted yields of certain U.S. Treasury Bonds for similar maturities, as published in the Wall Street Journal and the New York Times, are used as a guide in setting rates. For the IDS Investors Certificate and IDS Special Deposits, the published average rates for comparable length dollar deposits available on an interbank basis, referred to as the London Interbank Offered Rates (LIBOR), are used as a guide in setting rates. To compete with popular short-term investment vehicles such as certificates of deposit, money market certificates and money market mutual funds that offer comparable yields, liquidity and safety of principal, IDSC offers the IDS Cash Reserve Certificate and the IDS Flexible Savings Certificate. The yields and features on these products are designed to be competitive with such short-term products. The IDS Investors Certificate and IDS Special Deposits also compete with short-term products but use LIBOR rates. The IDS Future Value Certificate has certain features similar to those of zero coupon bonds and is intended to compete with that type of investment as well as with intermediate to long-term certificates of deposit. The IDS Installment Certificate is intended to help clients save systematically and may compete with passbook savings and NOW accounts. The IDS Stock Market Certificate is designed to offer interest tied to a major stock market index and guaranteed principal. Certain banks offer certificates of deposit that have features similar to the Stock Market Certificate. IDSC's gross income is derived principally from interest and dividends generated by its investments. IDSC's net income is determined by deducting from such gross income its provision for certificate reserves, and other expenses, including taxes, the fee paid to IDS for advisory and other services and the distribution fees paid to IDS Financial Services Inc. and AEBI and marketing fees paid to AEB. The following table shows IDSC's sales and surrenders of certificates for the three years ended December 31, 1993: 1993 1992 1991 Single Payment* (Cash Basis) ($ in millions) Non-Qualified Sales $ 822.5 $1,046.3 $1,208.0 Surrenders 1,162.9 1,368.3 1,536.0 Qualified Sales 115.4 136.5 157.6 Surrenders 220.4 249.1 232.6 Installment Payment (Face-amount Basis) Non-Qualified Sales 369.0 392.7 358.3 Surrenders 327.5 330.9 333.8 Qualified Sales 6.1 9.9 20.2 Surrenders 23.1 48.5 47.6 Includes Cash Reserve, Flexible Savings, Single Payment, Future Value, Investors, Stock Market and IDS Special Deposits certificates. In 1993 approximately 12% of single payment certificate sales and 2% of installment certificate sales were of tax-qualified certificates for use in IRAs, and 401(k) plans and other qualified retirement plans. The certificates offered by IDS Financial Services Inc. are sold pursuant to a distribution agreement which is terminable on 60 days' notice and is subject to annual approval by IDSC's Board of Directors, including a majority of the directors who are not "interested persons" of IDS Financial Services Inc. or IDSC as that term is defined in the 1940 Act. The agreement provides for the payment of distribution fees to IDS Financial Services Inc. for services provided thereunder. IDS Financial Services Inc. is a wholly owned subsidiary of IDS. For the distribution of the IDS Investors Certificate, IDS Financial Services Inc., in turn, has a Selling Agent Agreement with AEBI. For distribution of IDS Special Deposits, IDSC has a Marketing Agreement with AEB. Both agreements are terminable upon 60 days' notice and similarly subject to annual approval of the disinterested directors of IDSC. IDSC receives advice, statistical data and recommendations with respect to the acquisition and disposition of securities for its portfolio from IDS, under an investment management agreement which is subject to annual renewal by IDSC's Board of Directors, including a majority of the directors who are not "interested persons" of IDS or IDSC. IDSC is required to maintain "qualified investments" meeting the standards of Section 28(b) of the 1940 Act. The carrying value of said investments must be at least equal to IDSC's net liabilities on all outstanding face-amount certificates plus $250,000. IDSC's qualified assets consist of cash and cash equivalents, first mortgage loans on real estate, U.S. government and government agency securities, municipal bonds, corporate bonds, preferred stocks and other securities meeting specified standards. IDSC is subject to annual examination and supervision by the State of Minnesota, Department of Commerce (Banking Division). Distribution fees on sale of certain certificates are deferred and amortized over the estimated lives of the related certificates, which is approximately 10 years. Upon surrender, unamortized deferred distribution fees are charged against income. Thus, these certificates must remain in effect for a period of time to permit IDSC to recover such costs. Item 2. Item 2. Properties None. Item 3. Item 3. Legal Proceedings Registrant has no material pending legal proceedings other than ordinary routine litigation incidental to its business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Item omitted pursuant to General Instructions J(1)(a) and (b) of Form 10-K. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters There is no market for the Registrant's common stock since it is a wholly owned subsidiary of IDS and, indirectly, of American Express. Frequency and amount of dividends declared during the past two years are as follows: Dividend Payable Date Cash In-Kind For year ended December 31, 1993: February 9, 1993 $11,000,000 $ - May 13, 1993 13,000,000 - August 10, 1993 13,000,000 - November 10, 1993 12,500,000 - December 31, 1993 15,000,000 - Total $64,500,000 $ - Dividend Payable Date Cash In-Kind* For year ended December 31, 1992: February 10, 1992 $ 7,300,000 $ - May 8, 1992 15,200,000 - August 10, 1992 21,250,000 - November 10, 1992 40,000,000 - December 30, 1992 - 64,557,994 Total $83,750,000 $64,557,994 * Consisted of an investment security at amortized cost. Restriction on the Registrant's present or future ability to pay dividends: Certain series of installment certificates outstanding provide that cash dividends may be paid by IDSC only in calendar years for which additional credits of at least 1/2 of 1% on such series of certificates have been authorized by IDSC. This restriction has been removed for 1994 and 1995 by action of IDSC on additional credits in excess of this requirement. Appropriated retained earnings resulting from the predeclaration of additional credits to IDSC's certificate holders are not available for the payment of dividends by IDSC. In addition, IDSC will discontinue issuance of certificates subject to the predeclaration of additional credits and will make no further predeclaration as to outstanding certificates if at any time the capital and unappropriated retained earnings of IDSC should be less than 5% of net certificate reserves (certificate reserves less certificate loans). At December 31, 1993, the capital and unappropriated retained earnings amounted to 5.84% of net certificate reserves. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS IDS Certificate Company's (IDSC) earnings are derived from the after-tax yield on invested assets less investment expenses and interest credited on certificate reserve liabilities. Significant changes and trends occur largely due to interest rate changes and the difference between rates of return on investments, rates of interest credited to certificate holder accounts and the mix of fully taxable and tax-advantaged investments in the IDSC portfolio. In 1989 and 1990, total assets and certificate reserve liabilities increased due to certificate sales exceeding certificate maturities and surrenders. The increases in total assets in 1989 and 1990 also reflect capital contributions from its parent, IDS Financial Corporation (IDS). (See Liquidity and Cash Flow Discussion) Total assets and certificate reserve liabilities decreased in 1993, 1992 and 1991 due to certificate maturities and surrenders exceeding certificate sales. The excess of certificate maturities and surrenders over certificate sales in 1993, 1992 and 1991 resulted primarily from lower accrual rates declared by IDSC in those years, reflecting lower interest rates available in the marketplace. 1993 Compared to 1992 Gross investment income decreased 20 percent due to a lower balance of invested assets and lower investment yields. The 6.1 percent decrease in investment expenses resulted primarily from lower distribution fees due to lower certificate sales, and lower investment advisory and services fee due to a lower asset base on which the fee is calculated. These decreases were partially offset by higher amortization of interest rate caps. The higher amortization reflects additional purchases and accelerated amortization of certain interest rate caps in 1993. Net provision for certificate reserves decreased 31 percent reflecting lower accrual rates and a lower average balance of certificate reserves. The $7.1 million decrease in income tax benefit resulted primarily from lower tax-advantaged income in 1993. The impact of the change in Federal statutory income tax rate in 1993 was an increase in income tax benefit of $.6 million of which $.4 million reflects the increase in rate on the Dec. 31, 1992 balance of temporary differences. 1992 Compared to 1991 Net investment income of $58.7 million in 1992 was 16 percent higher than in 1991. The primary reason was an interest rate environment in 1992, that resulted in slightly lower long-term investment yields than in 1991 while short-term rates declined significantly. As a result, IDSC's investment yields decreased, however, interest rates credited on certificate reserve liabilities were significantly lower due to the short-term repricing nature of certificate products. Gross investment income decreased 16 percent due to a lower balance of invested assets and lower investment yields. The 10 percent increase in investment expenses resulted primarily from higher amortization of premiums paid for interest rate caps and index options used as hedges against changes in rates credited on certificate liabilities. Distribution fees were lower due primarily to lower certificate sales. Investment advisory and services fee was lower due a lower asset base on which the fee is calculated. Net provision for certificate reserves decreased 31 percent reflecting lower accrual rates and a lower average balance of certificate reserves. The decrease in income tax benefit resulted primarily from higher pretax income and lower tax-advantaged income in 1992. LIQUIDITY AND CASH FLOW IDSC's principal sources of cash are reserve payments from sales of face-amount certificates and cash flows from investments. In turn, IDSC's principal uses of cash are payments to certificate holders for matured and surrendered certificates, purchase of investments and payments of dividends to IDS. Although certificate sales volume decreased 18 percent in 1993, total sales remained strong reflecting clients' ongoing desire for safety of principal. Sales of single payment certificates totaled $.9 billion compared to $1.1 billion during 1992, $1.4 billion during 1991 and $1.6 billion during both 1990 and 1989. IDSC, as an issuer of face-amount certificates, is affected whenever there is a significant change in interest rates. In view of the uncertainty in the investment markets and due to the short-term repricing nature of certificate reserve liabilities, IDSC continues to invest in securities with relatively short maturities and in securities that provide for more immediate, periodic interest/principal payments, resulting in improved liquidity. To accomplish this, IDSC continues to invest much of its cash flow in mortgage-backed securities and in sinking-fund preferred stock. IDSC's investment program is designed to maintain an investment portfolio that will produce the highest possible after-tax yield within acceptable risk standards with additional emphasis on liquidity. The program considers investment securities as investments acquired with the intent and ability to hold for the foreseeable future and is designed to meet anticipated certificate holder obligations. IDSC normally holds its portfolio securities until maturity or retirement, at which time the carrying values are expected to be recovered. At Dec. 31, 1993, securities carried at cost decreased to $2.4 billion from $2.9 billion at Dec. 31, 1992. These securities, which comprise 85 percent of IDSC's total invested assets, are highly rated and well diversified. 96 percent are of investment grade and, other than U.S. Government Agency mortgage-backed securities, no one issuer represents more than two percent of these securities. See note 3 to Financial Statements for additional information on ratings and diversification. Gross unrealized gains and gross unrealized losses on investment securities carried at cost were $119 million and $6.5 million, respectively, at Dec. 31, 1993. In 1993, in reaction to the changing interest rate environment, IDSC continued to restructure a portion of its investment security portfolio by selling $349 million of investment securities. The sales included $253 million of mortgage-backed securities purchased at a premium. These securities were sold to decrease exposure to prepayment activity on the underlying pool of mortgages that could have had a negative impact on future yields on these securities. Cash flows of $897 million from operating activities, scheduled maturities, and redemptions of investments in 1993, were more than adequate to fund the net cash outflow of $603 million related to certificate obligations. During 1992, IDSC charged earnings with $23.7 million of write-downs in the value of certain interest-only, mortgage-backed securities that resulted from high prepayments due to refinancing and additional payment activity on the underlying pool of mortgages due to declining interest rates. At Dec. 31, 1992, the carrying value of these securities was $30.2 million. During 1993, additional write-downs of $.6 million were recorded and all of these securities with a carrying value of $27.4 million were sold for $14.3 million. During 1993, IDSC's reserve for possible losses on its below investment grade securities was reduced by $12.2 million from $14.2 million at Dec. 31, 1992 to $2.0 million at Dec. 31, 1993. The reduction reflects sales and exchanges of certain of these issues in 1993. IDSC does not generally invest in below investment grade securities and is limited by regulation as to the amount of such securities it can hold. IDSC's holdings in these securities result principally from the downgrading of the securities subsequent to purchase by IDSC. Management believes that reserves for possible losses on securities owned at Dec. 31, 1993, are adequate, however, future economic factors could impact the ratings of securities owned and additional reserves for losses may need to be recognized. Impact of New Accounting Standards In May of 1993, the Financial Accounting Standards Board issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which IDSC will implement, effective Jan. 1, 1994. Underthe new rules, debt securities that IDSC has both the positive intent and ability to hold to maturity will be carried at amortized cost. Debt securities that IDSC does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale and carried at fair value. Unrealized gains and losses on securities classified as available-for-sale will be carried as a separate component of Stockholder's Equity. The effect of the new rules will be to increase Stockholder's Equity by approximately $4 million, net of taxes, as of Jan. 1, 1994. SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," is expected to have no material impact on IDSC's results of operations or financial condition. Dividends Cash dividends ranging from $17.9 million to $83.8 million were declared during each of the years 1989 to 1993. In addition, dividends-in-kind were declared consisting of an investment security of $64.6 million in 1992 and a reduction in the notes receivable from IDS of $25.5 million and $1.5 million in 1991 and 1989, respectively. As a result of projected adequate earnings in 1994 and capital in excess of regulatory requirements, IDSC anticipates declaring regular cash dividends of approximately $50 million in 1994. Capital Contributions IDSC received capital contributions from IDS of $54.7 million in Fund American Companies, Inc. preferred stock in 1990 and $18.5 million in cash and $85.9 million in Fund American Companies, Inc. preferred stock in 1989. American Express Company made capital contributions to several subsidiaries in 1989 and IDSC, through IDS, was able to take advantage of this special opportunity. The contributions benefited IDSC by providing support for the increased certificate sales volumes in 1991, 1990 and 1989, allowing for future growth and for payment of regular dividends. Due to the decrease in IDSC's assets in 1992, IDSC felt its holding in Fund American Companies, Inc. preferred stock was too large an exposure to a single credit risk, resulting in IDSC's dividend-in-kind of the issue to IDS. IDS subsequently contributed capital to IDSC of $52.3 million. The contribution was necessary in management of IDSC's regulatory capital requirements. Ratios The ratio of stockholder's equity to total assets less certificate loans at Dec. 31, 1993, was 5.59 percent, compared to 5.34 percent in 1992. IDSC intends to manage this ratio to five percent in 1994, which meets current regulatory requirements. IDS CERTIFICATE COMPANY Item 8. Item 8. Financial Statements and Supplementary Data 1. Financial Statements and Schedules Required under Regulation S-X Index to Financial Statements and Schedules Page Financial Statements: Report of Independent Auditors 21 Responsibility for Preparation of Financial Statements 22 Balance Sheet, December 31, 1993 and 1992 23-24 Statement of Operations, year ended December 31, 1993, 1992 and 1991 25-26 Statement of Stockholder's Equity, year ended December 31, 1993, 1992 and 1991 27 Statement of Cash Flows, year ended December 31, 1993, 1992 and 1991 28 Notes to Financial Statements 29-43 Schedules: I - Investments in Securities of Unaffiliated Issuers, December 31, 1993 II - Investments in and Advances to Affiliates and Income Thereon, December 31, 1993, 1992 and 1991 III - Mortgage Loans on Real Estate and Interest earned on Mortgages, year ended December 31, 1993 V - Qualified Assets on Deposit, December 31, 1993 IX - Supplementary Profit and Loss Information, three years ended December 31, 1993 XI - Certificate Reserves, year ended December 31, 1993 XII - Valuation and Qualifying Accounts, year ended December 31, 1993, 1992 and 1991 Schedules III and XI for the year ended December 31, 1992 and Schedule XI for the year ended December 31, 1991 are included in Registrant's Annual Reports on Form 10-K for the fiscal years ended December 31, 1992 and December 31, 1991, respectively, Commission file 2-23772, and are incorporated herein by reference. 2. Supplementary Data None Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None PART III Items omitted pursuant to General Instructions J(1)(a) and (b) of Form 10-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) List the following documents filed as a part of the report: 1. All financial statements. See Item 8. 2. Financial statement schedules. See Item 8. 3. Exhibits (1)a. The Distribution Agreement dated November 18, 1988, between Registrant and IDS Financial Services Inc., filed electronically as Exhibit 1(a) to the Registration Statement for the American Express International Investment Certificate (now called the IDS Investors Certificate), is incorporated herein by reference. (1)b. Form of the Distribution Agreement for the American Express Savings Certificate between Registrant and American Express Service Corporation, filed electronically as Exhibit 1(b) to the Registration Statement for the American Express International Investment Certificate (now called the IDS Investors Certificate), is incorporated herein by reference. (1)c. Selling Agent Agreement dated June 1, 1990, between American Express Bank International and IDS Financial Services Inc., for the IDS Investors and IDS Stock Market Certificates, filed electronically as Exhibit 1(c) to the Post-Effective Amendment No. 5 to Registration Statement No. 33-26844 for the IDS Investors Certificate, is incorporated herein by reference. (1)d. Marketing Agreement dated October 10, 1991, between Registrant and American Express Bank Ltd., filed electronically as Exhibit 1(d) to Post-Effective Amendment No. 31 to Registration Statement No. 2-55252 for the Series D-1 Investment Certificate, is incorporated herein by reference. (3)a. The ISA Certificate of Incorporation and ISA By- Laws, filed electronically as Exhibit 3(a) and 3(c) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 are incorporated herein by reference. (3)c. Certificate of Amendment, dated April 2, 1984, to ISA's Certificate of Incorporation filed electronically as Exhibit 3(b) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (4) Forms of Cash Reserve Certificate, Future Value Certificate, Installment Investment Certificate, Series D-1 Investment Certificate and Variable Term Certificate filed electronically as Exhibit 4 to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 are incorporated by reference. Form of Certificate for IDS Stock Market Certificate filed electronically as Exhibit 4 to Pre-Effective Amendment No. 2 to Registration Statement No. 33-22503, is incorporated herein by reference. (10)a. The Investment Advisory and Services Agreement between ISA and IDS/American Express Inc. dated January 12, 1984 filed electronically as Exhibit 10(a) to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)b. Depository and Custodial Agreement dated September 30, 1985 between IDS Certificate Company and IDS Trust Company, filed electronically as Exhibit 10(b) to Registrant's Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)c. Loan Agreement between Registrant and Investors Syndicate Development Corporation dated October 13, 1970, filed electronically as Exhibit 10(c) to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)d. Agreement for the servicing of Residential Mortgage Loans between ISA and Advance Mortgage Company, Ltd., dated August 31, 1980, filed electronically as Exhibit 10(d) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)e. Agreement for the servicing of Commercial Mortgage Loans between ISA and FBS Mortgage Corporation, dated October 1, 1980, filed electronically as Exhibit 10(e) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)f. Agreement by and between registrant and IDS/American Express Inc. ("IDS") providing for the purchase by IDS of a block of portfolio securities from registrant, filed as Exhibit 10.5 to the September 30, 1981 Quarterly Report on Form 10-Q of Alleghany Corporation, is incorporated herein by reference. (10)g. Transfer Agent Agreements for the servicing of the American Express Savings Certificate, filed electronically as Exhibit 10(g) to Pre-Effective Amendment No. 1 to Registration Statement No. 33-25385, are incorporated herein by reference. (10)h. Foreign Deposit Agreement dated November 21, 1990, between IDS Certificate Company and IDS Bank & Trust, filed electronically as Exhibit 10(h) to Post- Effective Amendment No. 5 to Registration Statement No. 33-26844, is incorporated herein by reference. (25)a. Officers' Power of Attorney dated February 1, 1994, filed as Exhibit 25(a) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, is incorporated herein by reference. (25)b. Directors' Power of Attorney dated February 1, 1994, filed as Exhibit 25(b) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, is incorporated herein by reference. (b) Reports on Form 8-K filed during the last quarter of the period covered by this report. None SIGNATURES Pursuant to the requirements of Section 13 or 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. REGISTRANT IDS CERTIFICATE COMPANY /s/ Stuart A. Sedlacek BY BRUCE A. KOHN NAME AND TITLE Stuart A. Sedlacek* ** President DATE March 29, 1994 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. BY BRUCE A. KOHN NAME AND TITLE Stuart A. Sedlacek* ** President Principal Executive Officer and Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE John M. Knight,* Controller (Principal Accounting Officer) DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Morris Goodwin,* Treasurer and Principal Financial Officer DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE David R. Hubers, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Charles W. Johnson, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Edward Landes,** Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Peter A. Lefferts,* Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE John V. Luck, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE James A. Mitchell, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Harrison Randolph, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Gordon H. Ritz,** Director DATE March 29, 1994 * Signed pursuant to Officers' Power of Attorney dated February 1, 1994 filed as Exhibit 25(a) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, incorporated herein by reference. _______________________ Bruce A. Kohn ** Signed pursuant to Directors' Power of Attorney dated February 1, 1994 filed as Exhibit 25(b) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, incorporated herein by reference. _______________________ Bruce A. Kohn REPORT OF INDEPENDENT AUDITORS The Board of Directors and Security Holders IDS Certificate Company: We have audited the accompanying balance sheets of IDS Certificate Company as of December 31, 1993 and 1992, and the related statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at item 8. These financial statements and schedules are the responsibility of the management of IDS Certificate Company. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. Our procedures included confirmation of investments owned as of December 31, 1993 and 1992 by correspondence with custodians and brokers. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of IDS Certificate Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Minneapolis, Minnesota February 3, 1994 IDS Certificate Company Responsibility for Preparation of Financial Statements The management of IDS Certificate Company is responsible for the preparation of the financial statements and related notes included in this Form 10-K. The statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances, and include amounts based on the best judgment of management. Financial information included elsewhere in this Form 10-K is consistent with these financial statements. In recognition of its responsibility for the integrity and objectivity of data in the financial statements, management maintains a system of internal accounting controls. This system includes an organizational structure with clearly defined lines of responsibility and delegation of authority. To ensure the effective administration of internal control, employees are carefully selected and trained, written policies and procedures are developed and disseminated, and appropriate communication channels are provided to foster an environment conducive to the effective functioning of controls. The system is supported by an internal auditing function that reports its findings to management throughout the year. IDS Certificate Company's independent auditors are engaged to express an opinion on the year-end financial statements. They objectively and independently review the performance of management in carrying out its responsibility for reporting operating results and financial condition. With the coordinated support of the internal auditors, they review and test the system of internal accounting controls and the data contained in the financial statements. Notes to Financial Statements ($ in thousands unless indicated otherwise) - ------------------------------------------------------------------- 1. Summary of Significant Accounting Policies IDS Certificate Company (IDSC) is a wholly owned subsidiary of IDS Financial Corporation (IDS), which is a wholly owned subsidiary of American Express Company. IDSC is in the business of issuing face-amount investment certificates. Described below are certain accounting policies that are important to an understanding of the accompanying financial statements. Basis of Financial Statement Presentation The accompanying financial statements are presented on a historical cost basis without adjustment of the net assets attributable to the 1984 acquisition of IDS by American Express Company. They include only the accounts of IDSC. IDSC uses the equity method of accounting for its investment in its wholly owned unconsolidated subsidiary, which is the method prescribed by the Securities and Exchange Commission (SEC) for issuers of face-amount certificates. Certain amounts from prior years have been reclassified to conform to the current year presentation. Fair Values of Financial Instruments The fair values of financial instruments disclosed in the notes to financial statements are estimates based upon current market conditions and perceived risks, and require varying degrees of management judgment. Preferred Stock Dividend Income IDSC recognizes dividend income from cumulative redeemable preferred stocks with fixed maturity amounts on an accrual basis similar to that used for recognizing interest income on debt securities. Securities Cash equivalents are carried at amortized cost, which approximates fair value. IDSC has defined cash and cash equivalents as cash in banks and highly liquid investments with a maturity of three months or less at acquisition and are not interest rate sensitive. IDSC's investment program considers investment securities as long-term investments and is designed to meet contractual investment certificate obligations. IDSC has the ability to hold these securities to their maturities and has the intent to hold them for the foreseeable future. Notes to Financial Statements (continued) - ------------------------------------------------------------------- Marketable equity securities and other securities without fixed maturity dates are carried at aggregate cost or market value, whichever is lower. A valuation allowance is established for net unrealized depreciation on marketable equity securities and is charged against stockholder's equity. Bonds and notes, and preferred stocks that either must be redeemed by the issuer or may be redeemed by the issuer at the holder's request are carried at amortized cost. The basis for determining realized gains and losses on securities is the amortized cost of bonds and notes on a "first-in, first-out" basis and the average cost of individual issues of stocks. When there is a decline in value, that is other than temporary, the securities are carried at estimated realizable value. First Mortgage Loans on Real Estate Mortgage loans are carried at amortized cost, less reserves for losses, which is the basis for determining any realized gains or losses. When economic evaluations of the underlying real estate indicate a loss on a loan is likely to occur, an allowance for such loss is recorded. IDSC generally stops accruing interest on loans for which interest is delinquent more than three months. Certificates Investment certificates may be purchased either with a lump-sum payment or by installment payments. Certificate holders are entitled to receive at maturity a definite sum of money. Payments from certificate holders are credited to investment certificate reserves. Investment certificate reserves accumulate at specified percentage rates. Reserves also are maintained for advance payments made by certificate holders, accrued interest thereon, and for additional credits and accrued interest thereon. On certificates allowing for the deduction of a surrender charge, the cash surrender values may be less than accumulated investment certificate reserves prior to maturity dates. Cash surrender values on certificates allowing for no surrender charge are equal to certificate reserves. The payment distribution, reserve accumulation rates, cash surrender values, reserve values and other matters are governed by the Investment Company Act of 1940 ("the 1940 Act"). Deferred Distribution Fee Expense On certain series of certificates, distribution fees are deferred and amortized over the estimated lives of the related certificates, which is approximately 10 years. Upon surrender, unamortized deferred distribution fees are charged against income. Federal Income Taxes IDSC's taxable income or loss is included in the consolidated federal income tax return of American Express Company. IDSC provides for income taxes on a separate return basis, except that, Notes to Financial Statements (continued) - ------------------------------------------------------------------- under an agreement between IDS and American Express Company, tax benefits are recognized for losses to the extent they can be used in the consolidated return. It is the policy of IDS and its subsidiaries that IDS will reimburse a subsidiary for any tax benefits recorded. 2. Deposit of Assets and Maintenance of Qualified Assets A. Under the provisions of its certificates and the 1940 Act, IDSC was required to have qualified assets (as that term is defined in Section 28(b) of the 1940 Act) in the amount of $2,767,057 and $3,244,505 at Dec. 31, 1993 and 1992, respectively. IDSC had qualified assets of $2,931,737 at Dec. 31, 1993 and $3,411,173 at Dec. 31, 1992, including investment securities loaned to brokers of $nil and $1,643 at Dec. 31, 1993 and 1992, respectively. Qualified assets are valued in accordance with such provisions of the Code of the District of Columbia as are applicable to life insurance companies. Qualified assets for which no provision for valuation is made in such Code are valued in accordance with rules, regulations or orders prescribed by the SEC. These values are the same as financial statement carrying values, except for securities which are carried at the lower of aggregate cost or market in the financial statements but are valued at cost for qualified asset and deposit maintenance purposes. B. Pursuant to provisions of the certificates, the 1940 Act, the central depositary agreement and to requirements of various states, qualified assets of IDSC were deposited as follows: Net unrealized gains on fixed maturities amounted to $112,712 and $77,435 at Dec. 31, 1993 and 1992, respectively. IDSC's reserve for possible losses on its below investment grade securities was $2,049 at Dec. 31, 1993 compared to $14,210 at Dec. 31, 1992. The decrease reflects sales and exchanges of certain of these issues in 1993. The amortized cost and fair value of investments in securities with fixed maturities by contractual maturity, are shown below. Cash flows will differ from contractual maturities because issuers may have the right to call or prepay obligations. Proceeds from sales of investments in securities with fixed maturities during 1993 and 1992 were $330,851 and $420,713, respectively. Gross gains of $3,272 and $17,514 and gross losses of $19,927 and $2,730 were realized on those sales during 1993 and 1992, respectively.Notes to Financial Statements (continued) - ------------------------------------------------------------------- B. Investments in securities with fixed maturities comprised 85 percent and 88 percent of IDSC's total invested assets at Dec. 31, 1993 and 1992, respectively. Securities are rated by Moody's and Standard & Poors (S&P), or by IDS internal analysts, using criteria similar to Moody's and S&P, when a public rating does not exist. A summary of investments in securities with fixed maturities by rating of investment is as follows: Rating 1993 1992 - ------------------------------------------ Aaa/AAA...................... 35% 35% Aa/AA........................ 4 4 Aa/A......................... 1 1 A/A.......................... 22 21 A/BBB........................ 3 6 Baa/BBB...................... 31 28 Below investment grade....... 4 5 - ------------------------------------------ 100% 100% - ------------------------------------------ Of the securities rated Aaa/AAA, 87 percent at Dec. 31, 1993 and 89 percent at Dec. 31, 1992, are U.S. Government Agency mortgage-backed securities that are not rated by a public rating agency. Approximately 23 percent at Dec. 31, 1993 and 25 percent at Dec, 31, 1992 of other securities with fixed maturities are rated by IDS internal analysts. No investment in any one issuer at Dec. 31, 1993 and 1992, is greater than two percent and one percent, respectively, of IDSC's total investment in securities with fixed maturities. At Dec. 31, 1993 and 1992, approximately ten percent and seven percent, respectively, of IDSC's invested assets were first mortgage loans on real estate. A summary of first mortgage loans by region and by type of real estate is as follows: Region 1993 1992 Property Type 1993 1992 - -------------------------------- -------------------------------------- South Atlantic....... 23% 21% Apartments................. 40% 46% East North Central... 23 25 Retail/shopping centers.... 28 19 West North Central... 21 24 Industrial buildings....... 13 11 Middle Atlantic...... 14 16 Office buildings........... 10 12 West South Central... 8 6 Hotels/motels.............. 1 2 Mountain............. 6 3 Retirement homes........... 1 1 Pacific.............. 3 2 Residential................ - 3 New England.......... 2 3 Other...................... 7 6 - -------------------------------- -------------------------------------- 100% 100% 100% 100% - -------------------------------- -------------------------------------- Notes to Financial Statements (continued) - ------------------------------------------------------------------- The carrying amounts and fair values of first mortgage loans on real estate are as follows at Dec. 31. The fair values are estimated using discounted cash flow analysis, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. At Dec. 31, 1993 and 1992, commitments for fundings of first mortgage loans, at market interest rates, aggregated $nil and $30.6 million, respectively. IDSC employs policies and procedures to ensure the creditworthiness of the borrowers and that funds will be available on the funding date. IDSC's first mortgage loan fundings are restricted to 75 percent or less of the market value of the real estate at the time of the loan funding. Management believes there is no fair value for these commitments. C. IDSC reserves freedom of action with respect to its acquisition of restricted securities that offer advantageous and desirable investment opportunities. In a private negotiation, IDSC may purchase for its portfolio all or part of an issue of restricted securities. Since IDSC would intend to purchase such securities for investment and not for distribution, it would not be "acting as a distributor" if such securities are resold by IDSC at a later date. The fair values of restricted securities are determined by the Board of Directors using the procedures and factors described in paragraph A of note 3.Notes to Financial Statements (continued) - ------------------------------------------------------------------- In the event IDSC were to be deemed to be a distributor of the restricted securities, it is possible that IDSC would be required to bear the costs of registering those securities under the Securities Act of 1933, although in most cases such costs would be borne by the issuer of the restricted securities. D. IDSC will implement, effective Jan. 1, 1994, Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Under the new rules, debt securities that IDSC has both the positive intent and ability to hold to maturity will be carried at amortized cost. Debt securities that IDSC does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale and carried at fair value. Unrealized gains and losses on securities classified as available- for-sale will be carried as a separate component of Stockholder's Equity. The effect of the new rules will be to increase Stockholder's Equity by approximately $4,304, net of taxes, as of Jan. 1, 1994. The measurement of unrealized securities gains and losses in Stockholder's Equity is affected by market conditions, and therefore, subject to volatility. The new rules will not have a material impact on IDSC's results of operations. 4. Certificate Reserves Reserves maintained on outstanding certificates have been computed in accordance with the provisions of the certificates and Section 28 of the 1940 Act. The average rates of accumulation on certificate reserves at Dec. 31, 1993 and 1992 were: Notes to Financial Statements (continued) - ------------------------------------------------------------------- A. There is no minimum rate of accrual on these reserves. Interest is declared periodically, quarterly or annually, in accordance with the terms of the separate series of certificates. B. On certain series of single payment certificates, additional interest is predeclared for periods greater than one year. At Dec. 31, 1993, $2,726 of retained earnings had been appropriated for the predeclared additional interest, which represents the difference between certificate reserves on these series, calculated on a statutory basis, and the reserves maintained per books. C. Certain series of installment certificates guarantee accrual of interest on advance payments at an average of 3.05 percent. IDSC has increased the rate of accrual to 3.51 percent through April 30, 1995. An appropriation of retained earnings amounting to $25 has been made, which represents the estimated additional accrual that will result from the increase granted by IDSC. D. IDS Stock Market Certificate enables the certificate holder to participate in any relative rise in a major stock market index without risking loss of principal. Generally the certificate has a term of 12 months and may continue for up to 14 successive terms. The reserve balance at Dec. 31, 1993 and 1992 was $402,801 and $445,021, respectively. E. The carrying amounts and fair values of certificate reserves consisted of the following at Dec. 31, 1993 and 1992. Fair values of certificate reserves with interest rate terms of one year or less approximated the carrying values less any applicable surrender charges. The fair values for other certificate reserves is a discounted cash flow analysis using interest rates currently offered for certificates with similar remaining terms, less any applicable surrender charges.Notes to Financial Statements (continued) - ------------------------------------------------------------------- 5. Dividend Restriction Certain series of installment certificates outstanding provide that cash dividends may be paid by IDSC only in calendar years for which additional credits of at least one-half of 1 percent on such series of certificates have been authorized by IDSC. This restriction has been removed for 1994 and 1995 by action of IDSC on additional credits in excess of this requirement. 6. Fees Paid to IDS and Affiliated Companies ($ not in thousands) A. The basis of computing fees paid or payable to IDS for investment advisory and services is: The investment advisory and services agreement with IDS provides for a graduated scale of fees equal on an annual basis to 0.75 percent on the first $250 million of total book value of assets of IDSC, 0.65 percent on the next $250 million, 0.55 percent on the next $250 million, 0.50 percent on the next $250 million and 0.45 percent on the amount in excess of $1 billion. The fee is payable monthly in an amount equal to one-twelfth of each of the percentages set forth above. Excluded from assets for purposes of this computation are first-mortgage loans, real estate and any other asset on which IDSC pays a service fee.Notes to Financial Statements (continued) - ------------------------------------------------------------------- B. The basis of computing fees paid or payable to IDS Financial Services Inc. (an affiliate) for distribution services is: Fees payable to IDS Financial Services Inc. on sales of IDSC's certificates are based upon terms of agreements giving IDS Financial Services Inc. the exclusive right to distribute the certificates covered under the agreements. The agreements provide for payment of fees over a period of time. The aggregate fees payable under the agreements per $1,000 face amount of installment certificates and $1,000 purchase price of single payments, and a summary of the periods over which the fees are payable, shown by series are: Fees on Cash Reserve and Flexible Savings (formerly Variable Term) certificates are paid at a rate of 0.25 percent of the purchase price at time of issuance and 0.25 percent of the reserves maintained for these certificates at the beginning of the second and subsequent quarters from issue date. Fees on the Investors Certificate are paid at an annualized rate of 1 percent of the reserves maintained for the certificates. Fees are paid at the end of each term on certificates with a one, two or three-month term. Fees are paid each quarter from date of issuance on certificates with a six, 12, 24 or 36-month term. Fees on the Stock Market Certificate are paid at a rate of 1.25 percent of the purchase price on the first day of the certificate's term and 1.25 percent of the reserves maintained for these certificates at the beginning of each subsequent term. (a) At the end of the sixth through the 10th year, an additional fee is payable of 0.5 percent of the daily average balance of the certificate reserve maintained during the sixth through the 10th year, respectively.Notes to Financial Statements (continued) - ------------------------------------------------------------------- C. The basis of computing depositary fees paid or payable to IDS Bank & Trust (an affiliate) is: - ------------------------------------------------------------------- Maintenance charge per account..... 5 cents per $1,000 of assets on deposit Transaction charge................. $20 per transaction Security loan activity: Depositary Trust Company receive/deliver................ $20 per transaction Physical receive/deliver......... 25 per transaction Exchange collateral.............. 15 per transaction - ----------------------------------------------------------------------- A transaction consists of the receipt or withdrawal of securities and commercial paper and/or a change in the security position. The charges are payable quarterly except for maintenance, which is an annual fee. D. The basis for computing fees paid or payable to American Express Service Corporation (an affiliate) in connection with the American Express Savings certificate was: Distribution Fees - Fees were paid at a rate of 0.25 percent of the reserves maintained at the end of the first and subsequent calendar quarters. Transfer Agent Fees - Fees of $3.50 per certificate account were paid each month. E. The basis for computing fees paid or payable to American Express Bank Ltd. (an affiliate) for the distribution of the IDS Special Deposits certificate on an annualized basis is 0.80 percent of the reserves maintained for the certificates on an amount from $250,000 to $499,000, 0.65 percent on an amount from $500,000 to $999,000 and 0.50 percent on an amount $1,000,000 or more. Fees are paid at the end of each term on certificates with a one, two or three-month term. Fees are paid at the end of each quarter from date of issuance on certificates with a six, 12, 24 or 36-month term. Notes to Financial Statements (continued) - ------------------------------------------------------------------- 7. Income Taxes Income tax expense (benefit) as shown in the statement of operations for the three years ended Dec. 31, consists of: Income tax expense (benefit) differs from that computed by using the U.S. statutory rate of 35 percent for 1993 and 34 percent for 1992 and 1991. The principal causes of the difference in each year are shown below: Deferred income taxes result from the net tax effects of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. Principal components of IDSC's deferred tax assets and liabilities as of Dec. 31, are as follows: 9. Options IDSC offers a series of certificates which pay interest based upon the relative change in a major stock market index between the beginning and end of the certificates' term. The certificate holders have the option of participating in the full amount of increase in the index during the term (subject to a specified maximum) or a lesser percentage of the increase plus a guaranteed minimum rate of interest. As a means of hedging its obligations under the provisions of these certificates, IDSC purchases and writes call options on the major market index. The options are cash settlement options, that is, there is no underlying security to deliver at the time the contract is closed out. There is the risk that the counterparties to the purchased call option contracts may be unable to fulfill their obligations. IDSC employs policies and procedures to ensure the adequacy of the creditworthiness of counterparties. Following is a summary of open option contracts at Dec. 31, 1993 and 1992. Notes to Financial Statements (continued) - ------------------------------------------------------------------- The option contracts are less than one year in term and are carried at the aggregate of the amortized cost and underlying intrinsic value of the contracts. These carrying amounts may be different than fair value depending on market conditions and other factors. The amortization of the cost of purchased and the proceeds of written call options is included net in investment expenses and the changes in the intrinsic value of the contracts are included net in provision for certificate reserves, in the statement of operations. The purchased options are included in other qualified assets and the written options are included in other liabilities. The carrying amounts and fair values of options consisted of the following at Dec. 31, 1993 and 1992. Fair values are determined using the procedures and factors described in paragraph A of note 3. PAGE 44 SCHEDULE I NOTES: (a) The classification "residential" includes single dwellings only. business". (b) Real estate taxes and easements, which in the opinion of the Company are not undue burden on the properties, have been excluded from the determination of "prior liens". (c) In this schedule III, carrying amount of mortgage loans represents unpaid principal balances plus unamortized premiums less unamortized dicounts and allowance for loss. (d) Interest in arrears for less than three months has been disregarded in computing the total amount of principal subject to delinquent interest. The amounts of mortgage loans being forclosed are also included in amounts subject to delinquent interest. (e) Information as to interest due and accrued at the end of the period is shown by type of mortgage loan. Information as to interest due and accrued for the various classes within the types of mortgage loans is not readily available and the obtaining thereof would involve unreasonable effort and expense. The Company does not accrue interest on loans which are over three months delinquent. (f) Information as to interest income by type and class of loan has been omitted because it is not readily available and the obtaining thereof would involve unreasonable effort and expense. In lieu thereof, the average gross interest rates (exclusive of amort- tization of discounts and premiums) on mortgage loans held at December 31, 1993 are shown by type and class of loan. The average gross interest rates on mortgage loans held at December 31, 1993, 1992 and 1991 are summarized as follows: 1993 1992 1991 First mortgages: ----- ----- ----- Insured by Federal Housing Administration 7.076% 5.817% 5.765% Partially guaranteed under Servicemen's Readjustment Act of 1944, as amended 8.000 6.719 6.447 Other 9.055 9.282 9.628 ----- ----- ----- Combined average 9.055% 9.207% 9.433% ===== ===== ===== (g) Following is a reconciliation of the carrying amount of mortgage loans for the years ended December 31, 1993, 1992 and 1991. 1993 1992 1991 ---- ---- ---- [S] [C] [C] [C] Balance at beginning of period $ 233,796 $ 145,055 $ 96,083 Additions during period: New loans acquired: Nonaffiliated companies 59,183 98,314 61,990 Allowance for loss transferred to real estate 530 350 0 Allowance for loss real estate 220 0 0 Amortization of discount/premium 90 61 129 ---------- ---------- ---------- Total additions 60,023 98,725 62,119 ---------- ---------- ---------- 293,819 243,780 158,202 ---------- ---------- ---------- Deductions during period: Collections of principal 5,908 9,484 12,147 Cost of mortgages sold 6,046 0 0 Allowance for loss 0 500 782 Writeoff 0 0 218 ---------- ---------- ---------- Total deductions 11,954 9,984 13,147 ---------- ---------- ---------- Balance at end of period $ 281,865 $ 233,796 $ 145,055 ========== ========== ========== (h) The aggregate cost of mortgage loans for federal income tax purposes at December 31, 1993 was $282,865. (i) At December 31, 1993, an allowance for loss of $961 is recorded to reduce the carrying value of conventional loans since evidence indicates that a loss is likely to occur. Part 4 - Amounts Periodically Credited to Certificate Holders' Accounts to Accumulate the Maturity Amount of Installment Certificates. Information as to (1) amounts periodically credited to each class of security holders' accounts from installment payments and (2) such other amounts periodically credited to accumulate the maturity amount of the certificate (on a $1,000 face-amount certificate basis for the term of the certificate), is filed in Part 4 of Schedule IX as part of Post- effective Amendment No. 9 to Registration Statement No. 2-17681, Post effective Amendment No. 1 to Registration Statement No. 2-23772 and Post-effective Amendment No. 1 to Registration Statement No. 2-258081 and is incorporated herein by reference.	9,811	65,084
59558_1993.txt	59558_1993	1993	59558	Item 1. Business Lincoln National Corporation ("LNC") is a holding company. Through subsidiary companies, LNC operates multiple insurance businesses. Operations are divided into four major business segments, 1) Property-Casualty, 2) Life Insurance and Annuities, 3) Life-Health Reinsurance and 4) Employee Life-Health Benefits. Although one of the subsidiaries held by LNC was formed as early as 1905, LNC itself was formed in 1968. LNC is an Indiana corporation with its principal office at 200 East Berry Street, Fort Wayne, Indiana 46802-2706. As of December 31, 1993, there were 215 persons on the staff of LNC. Total employment of Lincoln National Corporation at December 31, 1993 on a consolidated basis was 11,890. Although acquisition and disposition activity has occurred, there has been no activity of this nature during the past five years involving all or predominately all of a business segment. Numeric presentations showing revenues, pre-tax income, and assets for LNC's four major business segments and other operations in which LNC engages through its subsidiaries are included in this report as part of the consolidated financial statements (see note 8 to the consolidated financial statements on page 54). The LNC "Other Operations" category includes LNC's investment management companies and unallocated corporate items, including corporate investment income, interest expense on short-term and long-term borrowings, and unallocated corporate overhead expenses. Following is a brief description of the four major business segments: 1. Property-Casualty Property-Casualty insurance includes automobile, boiler and machinery, workers' compensation, fire and allied lines, inland marine, home-owners, general casualty, special risks and multiple peril insurance. Fidelity and surety bonds are also included within property-casualty insurance. Most of LNC's property-casualty business is conducted through American States Insurance Company ("American States"), headquartered in Indianapolis, Indiana, and its property-casualty subsidiaries. These companies operate a multi-line property-casualty insurance business in most states of the United States through 22 semi-autonomous division offices with broad authority for underwriting, agency contracting, marketing and claims settlement for most lines of business. The distribution network involves approximately 5,000 independent local agencies. Other companies within this business segment include Lincoln National Specialty Insurance Company ("LNSIC") which underwrites select coverages in the sports and entertainment market and Lincoln National Reinsurance Company which is a property-casualty company that is involved in servicing a closed block of reinsurance business. Approximately 3,900 employees are involved in this business segment. 2. Life Insurance and Annuities The primary company within this business segment is The Lincoln National Life Insurance Company ("LNL"). Other companies within this business segment include, Security-Connecticut Life Insurance Company ("Security- Connecticut"), First Penn-Pacific Life Insurance Company ("First Penn"), American States Life Insurance Company ("American States Life"), and Lincoln National (UK) PLC. LNL, the 6th largest U.S. stockholder-owned life insurance Company (1992 Fortune Rankings of 50 Largest Life Insurance Companies by Assets) is an Indiana corporation headquartered in Fort Wayne, Indiana. A network of 36 life insurance agencies, independent life insurance brokers, insurance agencies located within financial institutions and specifically trained employees sells fixed annuities, variable annuities, pension products, universal life, variable universal life and other individual insurance coverages in most states of the United States and various foreign countries including Canada. The distribution network includes approximately 1,900 career agents, 13,000 brokers and access to 42,000 stockbrokers and financial planners. Security-Connecticut is a Connecticut corporation headquartered in Avon, Connecticut. It specializes in writing universal life and term insurance through independent general agencies in most states of the United States. A wholly owned subsidiary of Security-Connecticut, Lincoln Security Life Insurance Company, operates in the state of New York. In January 1993, LNC announced it would seek a buyer for Security-Connecticut. The sale of the common stock of Security-Connecticut Corporation (a recently formed holding company to which ownership of the operating companies was transferred prior to the sale) was completed on February 2, 1994 through an Initial Public Offering (IPO). First Penn, headquartered in Oakbrook Terrace, Illinois, specializes in the writing and administration of universal life products through independent marketing companies and the sale of LNL's annuities through insurance agencies located within financial institutions in most states of the United States. American States Life is an Indiana corporation headquartered in Indianapolis, Indiana. Its products, principally universal life and term insurance, are marketed through independent local agencies (who also offer property-casualty insurance) in most states of the United States. Lincoln National (UK) PLC is a United Kingdom company headquartered in Wembley, England that is licensed to do business throughout the United Kingdom. The principal products produced by this operation known as unit- linked assets are similar to U.S. produced universal life products. This company was previously named Cannon Assurance Limited, but was renamed following the acquisition and merger of another UK company that previously operated as Citibank Life (UK). Lincoln National (UK) is the 16th largest writer of unit-linked new business premiums in the UK as measured in 1992 (Money Management Survey-New Business Trends, published in June 1993.) Approximately 4,325 employees are involved in this business segment. 3. Life-Health Reinsurance The primary companies within this business segment are Lincoln National Life Reinsurance Company ("LNLR"), Lincoln National Reassurance Company, ("LNRAC"), Lincoln National Health & Casualty Insurance Company ("LNH&C") and LNL. These companies are headquartered in Fort Wayne, Indiana. A broad range of risk management products and services are offered to insurance companies, HMOs, self-funded employers and other primary market risk accepting organizations throughout the United States and economically attractive international markets. Marketing efforts are conducted primarily through the efforts of a reinsurance sales staff. Some business is presented by reinsurance intermediaries and brokers. The reinsurance organization is one of the largest life-health reinsurers worldwide (Swiss Re survey, May 1993). LNH&C offers accident and health products and services on both a direct and reinsurance basis. Other companies in this business segment include various general business corporations and foreign reinsurance companies. The general business corporations are used to support the segment's sales, service and administration efforts. One of the general business corporations, Lincoln National Risk Management Inc. has developed and patented a knowledge based underwriting system ("Life Underwriting System") which it is marketing to other insurance companies. The foreign reinsurance corporations are used to support LNC's U.S. companies through reinsuring select business. Approximately 575 employees are involved in this business segment. 4. Employee Life-Health Benefits This segment's business is conducted through Employers Health Insurance Company ("Employers Health"), a Wisconsin Corporation, headquartered in Green Bay, Wisconsin. Employers Health manufactures and distributes group life and health insurance, managed health care, dental, disability products and flexible benefit administrative services with a primary focus on the small business market (companies with 2-150 employees). It also provides administrative services to medium and large self-funded accounts in Wisconsin and is extending such services to other core market areas for self-funded groups of 100 - 1,000 lives. Employers Health has a strong market position in the Midwest, California, Texas, Colorado, Georgia, Tennessee, Maryland and Virginia, representing approximately 80 percent of its in-force business. In December 1993, LNC announced it would attempt to sell a portion of its ownership in Employers Health through an initial public offering (IPO) of Common Stock in a newly formed holding company known as EMPHESYS Financial Group, Inc. In March 1994, this IPO was completed and resulted in the sale of 64% of the company. Approximately 2,590 employees are involved in this segment. Liabilities for losses and loss adjustment expenses ("LAE") for the property- casualty business segment are estimated at the end of each accounting period using case-basis evaluations and statistical projections. These liabilities include estimates for the ultimate cost of claims 1) which have been reported but not settled and 2) which have been incurred but not yet reported. A provision for inflation is implicitly considered in the estimated liability as the development of the estimated liability is based on historical data which reflects past inflation and on other factors which are judged to be appropriate modifiers of past experience. Adjustments to previously established estimates are reflected in current operating results along with initial estimates for claims arising within the current accounting period. Further, beginning in 1993 such estimates no longer recognize the effects of reinsurance recoverable because such amounts are now recorded as an asset with the adoption of FAS 113 (see note 2 to the consolidated financial statements on page 38). The reconciliation shows an increase (decrease) of ($26.5) million, $47.0 million, and $12.3 million to the December 31, 1992, 1991 and 1990 liability for losses and LAE, respectively, for claims arising in prior years. Such reserve adjustments, which affected current operations during 1993, 1992 and 1991, respectively, resulted from developed losses for prior years being different than were anticipated when the liabilities for losses and LAE were originally estimated. The following table shows the development of the estimated liability for loss and LAE for the ten year period prior to 1993. Each column shows the liability as originally estimated and cumulative data on payments and re- estimated liabilities for that accident year and all prior accident years, making up that calendar year-end liability; and all amounts are reflected net of reinsurance recoverable for all years. As a result of adopting FAS 113 in 1993, the 1993 liability is $225 million less than reported in the financial statements. The resulting redundancy (deficiency) is also a cumulative amount for that year and all prior years. The reserves include an estimated liability for unreported environmental losses. Prior to 1993, this liability was generally recognized in the more recent accident years and allocated to the appropriate accident year when reported. In 1993, this estimated liability for unreported environmental losses was reallocated to more appropriate accident years and as a result increased the deficiency for the period 1983 and prior. Beginning in 1986, the overall reserves were strengthened and this action has been maintained as evidenced by the cumulative development reported for 1987 through 1993. Conditions and trends that have affected the development of these liabilities in the past may not necessarily recur in the future; therefore, it would not be appropriate to use this cumulative history in the projection of future performance. In order to protect itself against losses greater than the amount it is willing to retain on any one risk or event, LNC's insurance subsidiaries purchase reinsurance from unaffiliated insurance companies (see note 7 to the consolidated financial statements on page 50). In order to maximize returns on its investment portfolio, LNC's investment personnel continually monitor both current investment income produced by the portfolio and current market values of the portfolio. The type, maturity, quality and liquidity of investments selected to place in the segmented portfolios vary depending on the nature of the underlying liabilities that are being supported. All the areas of business activity in which LNC is involved are highly competitive because of the marketing structure and the large number of competing companies. At the end of 1992, the latest year for which data is available, there were approximately 1,200 groups and unaffiliated individual companies selling property and casualty insurance. LNC's group of companies writing property-casualty insurance ranked 25th in net written premiums for 1992 (A.M. Best Aggregates and Averages) among all such groups and companies. At the end of 1992 there were more than 2,100 life insurance companies in the United States and LNL was the 13th largest stock and mutual life insurance company in the United States based on assets and 15th based on insurance in-force (1992 Fortune Ranking of 50 Largest Life Insurance Companies by Assets). The business of LNC's property-casualty, life insurance and annuities, life-health reinsurance and employee life-health benefits business segments, in common with those of other insurance companies, is subject to regulation and supervision by the states, territories and foreign countries in which they are admitted to do business. The laws of these jurisdictions generally establish supervisory agencies with broad administrative powers relative to granting and revoking licenses to transact business, regulating trade practices, licensing agents, prescribing and approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, regulating competitive matters, prescribing the form and content of financial statements and reports, and regulating the type and amount of investments permitted. The ability to continue an insurance business is dependent upon the maintenance of the licenses in the various jurisdictions. Because of the nature of the insurance business, there is no single customer or group of customers upon whom the business is dependent. Factors such as backlog, raw materials, patents (including trademarks, licenses, franchises, and any other concessions held), seasonality, or environmental impact do not have a material effect upon such business. However, within LNC's Life-Health Reinsurance segment, Lincoln National Risk Management, Inc. does own the patent for a knowledge based underwriting system known as "Life Underwriting System." LNC does not have a separate unit that conducts market research. Research activities related to new products or services or the improvement of existing products or services is completed by persons within the business segments. Expenses related to such activities are not material. Also, sales are not dependent upon select geographic areas and foreign sales are not material in relationship to either LNC's total sales or sales of individual business segments. Item 2. Item 2. Properties LNC and the various operating businesses headquartered in Fort Wayne lease approximately 1.3 million square feet of office space in the Fort Wayne area. Approximately 1.0 million square feet of space is leased by operating businesses headquartered in Indianapolis, Indiana; Oakbrook Terrace, Illinois; Green Bay, Wisconsin; and Wembley, London England. In addition, branch offices owned or leased for all of the operating businesses referenced above as well as the space for some smaller operations total approximately 1.2 million square feet. As shown in the notes to consolidated financial statements, (see note 7 to the consolidated financial statements on page 49) the rental expense on operating leases for office space and equipment for continuing operations totaled $55.9 million for 1993 of which $49.6 million was for office space. This discussion regarding properties does not include information on investment properties. Item 3. Item 3. Legal Proceedings LNC and its subsidiaries are involved in various pending or threatened legal proceedings arising from the conduct of their business. In some instances, these proceedings include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or requests for equitable relief. After consultation with counsel and a review of available facts, it is management's opinion that these proceedings ultimately will be resolved without materially affecting the consolidated financial statements of LNC. Item 4. Item 4. Submission of Matters to a Vote of Security Holders During the fourth quarter of 1993, no matters were submitted to security holders for a vote. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Exchanges: New York, Chicago, Pacific, London and Tokyo. Stock Exchange Symbol: LNC Dividend Guideline: The dividend on LNC's Common Stock is determined each quarter by the Corporation's Board of Directors. The Board takes into consideration the financial condition of the Corporation, including current and expected earnings, projected cash flows and anticipated financing needs. The Board also considers the ability to maintain the dividend through bad times as well as good so that the dividend rate would need to be reduced only under unusual circumstances. One guideline that the Board has found useful in recent years is to consider a dividend approximately equal to five percent of the book value per share with such book value computed excluding the impact of marking its securities available-for-sale to fair value. Notes: 1. The data for 1992 and the first quarter of 1993 has been adjusted to reflect the effects of a June 1993 two-for-one split of LNC's Common Stock. 2. At December 31, 1993, the number of shareholders of record of LNC's Common Stock was 13,600. 3. The payment of dividends to shareholders is subject to the restrictions described in notes 5, Supplemental Financial Data, and 7, Restrictions, Commitments and Contingencies to the consolidated financial statements (see pages 45 and 48) and is discussed in the Management's Discussion and Analysis of Financial Information (see page 28). Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The pages to follow review LNC's results of operations and financial condi- tion. Historical financial information is presented and analyzed. Where appropriate, factors that may affect future financial performance are identified and discussed. On pages 9 through 22, the financial results of our business segments, investments and other operations are presented and discussed. Within these business segment discussions reference is made to "Income from Operations" (see definition in item 6 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no disagreements with LNC's independent auditors which are reportable pursuant to Item 304 of Regulation S-K. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information for this item relating to directors of LNC is incorporated by reference to the sections captioned "NOMINEES FOR DIRECTOR" and "DIRECTORS CONTINUING IN OFFICE" of LNC's Proxy Statement for the Annual Meeting scheduled for May 12, 1994. Executive Officers of the Registrant as of December 31, 1993 were as follows: Name Position with LNC and Business Experience (Age) During the Past Five Years Robert A. Anker President, Chief Operating Officer and Director, (52) LNC since 1992. President and Chief Executive Officer, American States* (1990-1991). President and Chief Operating Officer, American States* (1985-1990). Jon A. Boscia Executive Vice President, LNC since 1991. (42) President, Lincoln National Investment Management Company* since 1991. Senior Vice President, LNL* (1985-1991). George E. Davis Senior Vice President, LNC since March 1993. (51) Vice President, Eastman Kodak Co. (1985-March 1993). P. Kenneth Dunsire Executive Vice President, LNC since 1986. (62) Jack D. Hunter Executive Vice President, LNC since 1986. General (57) Counsel since 1971. William J. Lawson President and Chief Executive, Officer, Employers (54) Health* since 1988. Senior Vice President, LNL* (1984-1988). F. Cedric McCurley President and Chief Executive Officer, American (59) States* since 1992. Executive Vice President, American States* (1986-1991). H. Thomas McMeekin, III Senior Vice President, LNC since 1992. (40) Executive Vice President, Lincoln National Investment Management Company* (1987-1992). Richard S. Robertson Executive Vice President, LNC since 1986. (51) Ian M. Rolland Chairman and Director, LNC since 1992. (60) President and Director, LNC (1975-1991). Chief Executive Officer, LNC since 1977. Richard C. Vaughan Senior Vice President and Chief Financial Officer, (44) LNC since 1992. Senior Vice President, LNL* since 1990. Vice President, EQUICOR, Inc. (1988-1990). Donald L. Van Wyngarden Second Vice President and Controller, LNC since (54) 1975. Thomas M. West Executive Vice President, LNL* since 1981. (53) Denotes a subsidiary of LNC There is no family relationship between any of the foregoing executive officers, all of whom are elected annually. Item 11. Item 11. Executive Compensation Information for this item is incorporated by reference to the section cap- tioned "EXECUTIVE COMPENSATION" of LNC's Proxy Statement for the Annual Meeting scheduled for May 12, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information for this item is incorporated by reference to the sections captioned "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "SECURITY OWNERSHIP OF DIRECTORS, NOMINEES AND EXECUTIVE OFFICERS" of LNC's Proxy Statement for the Annual Meeting scheduled for May 12, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Information for this item is incorporated by reference to the section cap- tioned "TERMINATION OF EMPLOYMENT ARRANGEMENTS" of LNC's Proxy Statement for the Annual Meeting scheduled for May 12, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Item 14(a)(1) Financial Statements The following consolidated financial statements of Lincoln National Corpora- tion and subsidiaries are included in Item 8: Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Auditors Item 14(a)(2) Financial Statement Schedules The following consolidated financial statement schedules of Lincoln National Corporation and subsidiaries are included in Item 14(d): I - Summary of Investments - Other than Investments in Related Parties III - Condensed Financial Information of Registrant V - Supplementary Insurance Information VI - Reinsurance VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Information Concerning Property-Casualty Insurance Operations All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are inapplicable, or the required information is included in the consolidated financial statements, and therefore have been omitted. Item 14(a)(3) Listing of Exhibits The following exhibits of Lincoln National Corporation and subsidiaries are included in Item 14(c) - (Note: The numbers preceding the exhibits correspond to the specific numbers within Item 601 of Regulation S-K.): 3(a) The Articles of Incorporation of LNC as last amended May 24, 1991 are incorporated by reference to Exhibit 3(a) of LNC's Form 10-K for the year ended December 31, 1991 filed with the Commission on March 27, 1992. 3(b) The Bylaws of LNC as last amended January 1, 1992 are incorporated by reference to Exhibit 3(b) of LNC's Form 10-K for the year ended December 31, 1991 filed with the Commission on March 27, 1992. 4(a) Indenture for 8% Notes of LNC due March 15, 1997 and the specimen Notes is incorporated by reference to Exhibit 4(b) of LNC's Form 10-K for the year ended December 31, 1991, filed with the Commission on March 27, 1992. 4(b) First Supplemental Indenture and Specimen Notes for LNC's 7 1/8% Notes due July 15, 1999 are incorporated by reference to Annex B and Annex C of LNC's Form 8-K filed with the Commission on July 7, 1992. 4(c) First Supplemental Indenture and Specimen Notes for LNC's 7 5/8% Notes due July 15, 2002 are incorporated by reference to Annex B and Annex D of LNC's Form 8-K filed with the Commission on July 7, 1992. 4(d) Fiscal Agency Agreement related to sale of $100,000,000 aggregate principal amount of 9 3/4% Notes of LNC due October 20, 1995 and the specimen of 9 3/4% Notes. 10(a) The Lincoln National Corporation 1986 Stock Option Incentive Plan as last amended May 13, 1993. 10(b)* The Lincoln National Corporation 1982 Stock Option Incentive Plan as last amended May 7, 1987. 10(c)* The Lincoln National Corporation Executives' Salary Continuation Plan as last amended January 1, 1992 is incorporated by reference to Exhibit 10(c) of LNC's Form 10-K for the year ended December 31, 1992, filed with the Commission on March 30, 1993. 10(d)* The Lincoln National Corporation Executive Value Sharing Plan is incorporated by reference to Exhibit 10(d) of LNC's Form 10-K for the year ended December 31, 1992, filed with the Commission on March 30, 1993. 10(e)* The Lincoln National Corporation Management Incentive Plan II as last amended August 1, 1989, is incorporated by reference to Exhibit 10(e) of LNC's Form 10-K for the year ended December 31, 1989, filed with the Commission on March 29, 1990. 10(f)* Lincoln National Corporation Executives' Severance Benefit Plan as last amended January 10, 1990, is incorporated by reference to Exhibit 10(f) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. 10(g)* The Lincoln National Corporation Outside Directors Retirement Plan as last amended March 15, 1990, is incorporated by reference to Exhibit 10(g) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. 10(h)* The Lincoln National Corporation Outside Directors Benefits Plan is incorporated by reference to Exhibit 10(h) of LNC's Form 10-K for the year ended December 31, 1992, filed with the Commission on March 30, 1993. 10(i) Lease and Agreement dated August 1, 1984, with respect to the American States' home office property, is incorporated by reference to Exhibit 10(i) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. 10(j) Lease and Agreement dated August 1, 1984, with respect to LNL's home office property, is incorporated by reference to Exhibit 10(j) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. 10(k) Lease and Agreement dated August 1, 1984, with respect to Lincoln National Pension Insurance Company's ("LNP") home office property, is incorporated by reference to Exhibit 10(k) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. [LNP was merged into its parent, LNL, effective January 1, 1989.] 10(l) Lease dated March 1, 1984, with respect to Security- Connecticut's home office property, is incorporated by reference to Exhibit 10(l) of LNC's Form 10-K for the year ended December 31, 1990, filed with the Commission on March 28, 1991. 10(m)* Descriptions of compensation arrangements with Executive Officers. 10(n)* The Lincoln National Corporation Executives' Supplemental Pension Benefit Plan is incorporated by reference to Exhibit 10(n) of LNC's Form 10-K for the year ended December 31, 1992, filed with the Commission on March 30, 1993. 10(o)* Lincoln National Corporation Executive Savings and Profit Sharing Plan as amended as of January 1, 1992 is incorporated by reference to Exhibit 10(o) of LNC's Form 10-K for the year ended December 31, 1992, filed with the Commission on March 30, 1993. 10(p) Lease dated February 14, 1991, with respect to property occupied by select Fort Wayne operations of the Registrant is incorporated by reference to Exhibit 10(q) of LNC's Form 10-K for the year ended December 31, 1991 filed with the Commission on March 27, 1992. 10(q)* Lincoln National Corporation 1993 Stock Plan for Non-Employee Directors. 10(r)* Lincoln National Corporation Executives' Excess Compensation Benefit Plan. This exhibit is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. 11 Computation of Per Share Earnings 21 The List of Subsidiaries of LNC. 23 Consent of Independent Auditors. 28 Information from Reports Furnished to State Insurance Regulatory Authorities. Item 14(b) - During the fourth quarter of the year ended December 31, 1993, no reports on Form 8-K were filed with the Commission. Item 14(c) - The exhibits of Lincoln National Corporation and subsidiaries are listed in Item 14(a)(3) above. Item 14(d) - The financial schedules for Lincoln National Corporation and subsidiaries follow on pages 59 through 68. (A) Investments which are deemed to have declines in value that are other than temporary are written down or reserved for to reduce their carrying value to their estimated realizable value. These condensed financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes of Lincoln National Corporation and subsidiaries (see pages 30 through 54). These condensed financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes of Lincoln National Corporation and subsidiaries (see pages 30 through 54). These condensed financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes of Lincoln National Corporation and subsidiaries (see pages 30 through 54). LINCOLN NATIONAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX FOR THE ANNUAL REPORT ON FORM 10-K For the Year Ended December 31, 1993 Exhibit Number Page 3(a) Articles of Incorporation of LNC as last amended May 24, 1991. 3(b) Bylaws of LNC as last amended January 1, 1992. 4(a) Indenture for 8% Notes due March 15, 1997 and Specimen Notes. 4(b) Indenture for 7 1/8% due July 15, 1999 and Specimen Notes. 4(c) Indenture for 7 5/8% Notes due July 15, 2002 and Specimen Notes.* 4(d) Fiscal Agency Agreement for 9 3/4% Notes due October 30, 1995, and Specimen Notes. 71 10(a) Lincoln National Corporation 1986 Stock Option Incentive Plan. 101 10(b) Lincoln National Corporation 1982 Stock Option Incentive Plan. 110 10(c) The Lincoln National Corporation Executives' Salary Continuation Plan.* 10(d) The Lincoln National Corporation Executive Value Sharing Plan.* 10(e) The Lincoln National Corporation Management Incentive Plan II.* 10(f) Lincoln National Corporation Executives' Severance Benefit Plan as last amended January 10, 1990.* 10(g) The Lincoln National Corporation Outside Directors Retirement Plan.* 10(h) The Lincoln National Corporation Outside Directors Benefits Plan.* 10(i) Lease and Agreement dated August 1, 1984, with respect to the American States' home office property.* 10(j) Lease and Agreement dated August 1, 1984, with respect to LNL's home office property.* 10(k) Lease and Agreement dated August 1, 1984, with respect to LNP's home office property.* 10(l) Lease dated March 1, 1984, with respect to the Security-Connecticut's home office property.* 10(m) Descriptions of Compensation Arrangements with Executive Officers. 118 10(n) The Lincoln National Corporation Executives' Supplemental Pension Benefit Plan.* 10(o) The Lincoln National Corporation Executive Savings and Profit Sharing Plan as last amended January 1, 1992.* 10(p) Lease dated February 14, 1991, with respect to select Fort Wayne business operation's office space.* 10(q) Lincoln National Corporation 1993 Stock Plan for Non- Employee Directors. 120 10(r) Lincoln National Corporation Executives' Excess Compensation Benefit Plan. 125 11 Computation of Per Share Earnings. 128 21 List of Subsidiaries of LNC. 129 23 Consent of Independent Auditors. 135 28 Information from Reports Furnished to State Insurance Regulatory Authorities. P 136 *Incorporated by Reference Signature Page LINCOLN NATIONAL CORPORATION Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act By /s/ Ian M. Rolland March 10, 1994 of 1934, LNC has duly caused Ian M. Rolland, this report to be signed on (Chairman, Chief Executive Officer and behalf by the under- Director) signed, thereunto duly authorized. By /s/ Robert A. Anker March 10, 1994 Robert A. Anker, (President, Chief Operating Officer and Director) By /s/ Richard C. Vaughan March 10, 1994 Richard C. Vaughan, (Senior Vice President and Chief Financial Officer) By /s/ Donald L. Van Wyngarden March 10, 1994 Donald L. Van Wyngarden (Second Vice President and Controller) Pursuant to the requirements By /s/ J. Patrick Barrett March 10, 1994 of the Securities Exchange J. Patrick Barrett Act of 1934, this report has been signed below by By /s/ Thomas D. Bell, Jr. March 10, 1994 the following Directors Thomas D. Bell, Jr of LNC on the date indicated. By /s/ Daniel R. Efroymson March 10, 1994 Daniel R. Efroymson By /s/ Harry L. Kavetas March 10, 1994 Harry L. Kavetas By /s/ M. Leanne Lachman March 10, 1994 M. Leanne Lachman By /s/ Leo J. McKernan March 10, 1994 Leo J. McKernan By /s/ Earl L. Neal March 10, 1994 Earl L. Neal By /s/ John M. Pietruski March 10, 1994 John M. Pietruski By /s/ Jill S. Ruckelshaus March 10, 1994 Jill S. Ruckelshaus By /s/ Gordon A. Walker March 10, 1994 Gordon A. Walker By /s/ Gilbert R. Whitaker,Jr. March 10, 1994 Gilbert R. Whitaker,Jr.	5,153	34,523
726957_1993.txt	726957_1993	1993	726957	Item 1. Business - ---------------- Park Communications, Inc., as of March 1, 1994 owns and operates through its subsidiaries nine television stations, eleven AM and eleven FM radio stations, 30 daily newspapers, 17 Sunday newspapers, 29 non-daily newspapers and 48 non-daily controlled distribution publications. Its operations are located in 21 states. The Company, in 1977, became the first to own 21 broadcasting licenses, the maximum then allowed by law. As used herein "Company" means Park Communications, Inc., its Subsidiaries and Predecessors unless the context otherwise requires. The Company was incorporated in Delaware in 1971, as the holding and management company for various communications properties acquired by companies owned by Roy H. Park. Prior to October 26, 1983, the Company was wholly owned by Mr. Park. On that date a public offering of 2,219,625 shares (retroactively adjusted for stock splits) of the Company's Common Stock was made, or 10.7% of the total shares presently outstanding. Roy H. Park died October 25, 1993. At the time of his death, Mr. Park was the Company's Chairman of the Board of Directors and Chief Executive Officer, and the owner of approximately 89.7% of the Company's outstanding Common Stock. His widow, Dorothy D. Park, as Personal Representative of the Estate of Roy H. Park, controls those shares of Common Stock formerly owned by him. On March 25, 1994, at a Special Meeting of the Company's Board of Directors, Mrs. Park, in her capacity as Personal Representative of the Estate, informed the Company of the Estate's decision to sell the Estate-held shares of the Company. In response to this announcement, the Board voted to seek a sale of the entire Company. It is intended that such a sale be accomplished by selling the Company's outstanding Common Stock (including all of the Estate-held shares) to a third party. However, there is no guarantee that such a sale will be achieved. An alternative method for selling the Company would be selling the Company's assets to one or more purchasers (e.g., selling one or more divisions of the Company or particular properties). Pursuit of either of these alternatives could possibly result in, among other things, a change in control of the Company, a restructuring of the Company, a business combination (e.g., merger), or a decrease in the size of the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" (pages 14-15) of the Company's Annual Report filed as Exhibit 13.1 hereto and incorporated herein by reference. At a meeting of the Company's Board of Directors in November, 1993, Mrs. Park was elected Chairman of the Board of Directors of the Company. See the information under the caption "Ownership By Certain Beneficial Owners of More Than 5% of Common Stock" (page 4) incorporated herein by reference to the Company's Proxy statement dated March 30, 1994 (see Exhibit 22.1 hereto). The Company has increased its ownership of communications properties by means of acquisitions. The first television acquisition by a Park company was station WNCT-TV in Greenville, North Carolina in 1962. The first Park radio operations were WNCT-AM, acquired in 1963, and WNCT-FM, put on the air in 1963, both also in Greenville, North Carolina. The first Park newspaper acquisition was the Daily Sun, located in Warner Robins, Georgia, in 1972. In every year since 1977, when it reached the then applicable legal ownership limit of 21 television and radio broadcast licenses, the Company has made one or more newspaper acquisitions, with the exceptions of 1990 and 1993. In December, 1993, the Company sold 33 of its smaller publications in 13 communities in 9 states. Included were 11 dailies (four with Sunday editions), 7 paid weeklies, 13 free-distribution shoppers and 2 monthlies. The dailies had a combined circulation of 37,675, each with less than 6,000 paid circulation. The sale of these publications will allow the Company to focus its resources on larger publications. In November, 1993, the Company purchased its ninth television station, KALB-TV in Alexandria, Louisiana, a VHF station affiliated with the NBC network. See "Business-Federal Regulation of Television and Radio Broadcasting" on pages 5-8 of this report. Any future acquisitions may be financed from a variety of sources, including subordinated debt issued to sellers, current cash flow from operations, bank borrowings and the Company's available cash. The Company does not presently contemplate issuing any Common Stock in connection with future acquisitions, although it may do so depending on future circumstances. The Company's industry segments are television broadcasting, radio broadcasting and newspaper publishing. Financial information for these segments is incorporated herein by reference to Note 7 under the caption "Notes to Consolidated Financial Statements" (pages 24-25) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. TELEVISION BROADCASTING The Company owns and operates six VHF and three UHF television stations. A listing of the television stations, their network affiliations and the markets they serve is incorporated herein by reference to the information under the caption "Operating Units of Park Communications, Inc." (page 6) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. All nine of the Company's stations are affiliated with national television networks under standard two-year contracts and each has been affiliated with the same network continuously since its acquisition by the Company. A network contract is typically continued for successive two-year terms, unless the Company or the network exercises its respective right thereunder to cancel such contract. Under standard network contracts, networks offer to affiliated stations a variety of sponsored and unsponsored programs which the affiliated stations must refuse before they can be offered to any other television station in the same market. Of approximately 152 hours of television broadcasting per week for each of the Company's stations, approximately 95 hours are network programs. When not carrying network programs, the Company's stations broadcast programs produced by the station (most of which are news and public affair programs) and programs such as movies or syndicated programs acquired from independent sources. The principal source of television revenue for the Company is the sale of time to advertisers. Advertising is sold in time increments and is priced on the basis of a station's audience ratings. The ratings of a local station affiliated with a national television network can be affected by the network's programming. A time sale may involve all or part of a program, or spot announcements within or between programs. COMPETITION--TELEVISION BROADCASTING The Company's television stations compete for revenues with other advertising media such as newspapers and magazines distributed within their broadcasting area, other television and radio stations serving the same or nearby areas and billboard advertising. Other sources of present and potential competition include CATV, pay cable, Multichannel Multipoint Distribution Service ("MMDS" or "Wireless Cable"), video cassette recordings, satellite-to- home broadcasting (including Direct Broadcast Satellite or "DBS" service), Local Multipoint Distribution Service ("LMDS"), low-power television, and the participation of telephone companies in the provision of "video dialtone" transmission service for the delivery of video programming by wire. On December 17, 1993, two parties with DBS authorizations, Hughes Communications Galaxy, Inc. ("Hughes"), and United States Satellite Broadcasting Company jointly launched a new high-powered satellite with 16 transponders from which they can provide approximately 150 video channels of DBS service to the entire country. Service is expected to begin sometime during the first half of 1994. Hughes also expects to launch a second 16 transponder DBS satellite in late spring 1994. There are 7 other companies with DBS authorizations but which have not yet launched their proposed satellites. The Company cannot predict the competitive effect of DBS operations on the terrestrial television broadcast industry in general or the Company's operations in particular. The Company's television broadcasting operations are dependent on a number of factors, including the general strength of the economy, population growth, overall advertising revenues, ability to provide attractive programming, ratings, relative efficiency compared to other advertising media, technological capabilities and governmental regulations and policies. RADIO BROADCASTING The Company owns and operates eleven AM and eleven FM radio stations in eleven markets in eleven states. A listing of the radio stations and the markets they serve is incorporated herein by reference to the information under the caption "Operating Units of Park Communications, Inc." (page 6) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. The Company's radio stations employ various formats for their programming. The Company creates its own formats and purchases formats from various outside sources. The formats are adapted to the characteristics of each market. Substantially all of the Company's radio broadcasting revenues are derived from advertising. COMPETITION--RADIO BROADCASTING The Company's radio stations compete for revenues with other advertising media such as newspapers and magazines distributed within their broadcasting area, other radio and television stations serving the same or nearby areas and billboard advertising. In addition, currently pending are proceedings in which the FCC is examining alternatives for the possible implementation of digital audio radio services ("DARS"). DARS systems potentially could allow delivery of audio signals with fidelity comparable to compact discs. In a rulemaking proceeding, the FCC is considering a proposed spectrum allocation for satellite DARS. There also are four applications on file at the FCC for satellite DARS licenses. Further, the FCC has undertaken an inquiry into the terrestrial broadcast of DARS signals. As is the case with television, the Company's radio broadcasting operations are dependent on a number of factors, including the general strength of the economy, population growth, overall advertising revenues, an ability to provide attractive programming, ratings, relative efficiency compared to other advertising media, technological capabilities and governmental regulations and policies. FEDERAL REGULATION OF TELEVISION AND RADIO BROADCASTING The Company's television and radio broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Act"). Under authority of the Act, the FCC, among other things, assigns frequency bands for broadcasting; determines the particular frequencies, location and power of stations; issues, renews, revokes and modifies station licenses and related authorizations; regulates equipment used by stations; and adopts and implements regulations and policies which directly or indirectly affect the ownership, operation and profitability of broadcast stations. For example, the FCC has imposed limitations on the amount of commercialization of television programs produced for children ages 12 and under, and recently increased the penalties to be imposed on stations for non-compliance with the FCC's equal employment opportunity policies. LIMITATIONS ON OWNERSHIP OF THE COMPANY'S STOCK AND OTHER MATTERS The Act prohibits the assignment or transfer of broadcasting licenses, including the transfer of control of any corporation holding such licenses, without the prior approval of the FCC. The Act also would prohibit the Company from continuing to control broadcast licenses if, in the absence of FCC approval, any officer or more than one-fourth of the directors were aliens, or if more than one-fourth of the Company's capital stock were acquired or voted directly or indirectly by alien individuals, corporations, or governments, or if the Company otherwise fell under alien influence or control in a manner determined by the FCC to be contrary to the public interest. Since the number of AM,FM and TV broadcast stations is limited by FCC rules, any purchaser of the Company's Common Stock who currently has an interest in one or more AM, FM or TV stations, attributable to such person under the FCC rules, could possibly violate those rules if that person were to acquire an interest in the Company that resulted in the attribution of the Company's broadcast holdings to the stockholder. Generally speaking broadcast holdings are attributed to (a) any officer, director, partner or joint venturer of a broadcast licensee, or to an individual licensee; and (b) a stockholder with 5% or greater stock interest in a broadcast licensee provided, however, that if the stockholder is a mutual fund, bank trust department, insurance company or other qualifying investment entity, a 10% or greater interest results in attribution to the stockholder. The FCC is considering increasing the levels of ownership interest in a broadcast station that will be treated as "attributable" to the holder for purposes of the FCC's multiple ownership rules. In addition, if the purchaser of the Company's Common Stock has an attributable interest in either a cable television company or daily newspaper and acquires an attributable interest in the Company, violation of FCC rules could result, depending upon the location of the cable system or daily newspaper in relation to the broadcast stations controlled by the Company. Roy H. Park, the sole majority shareholder of the Company, died on October 25, 1993. See the discussion under "Item 1. Business" (page 2) above. An application reflecting the transfer control of the Company to Mr. Park's widow, Dorothy D. Park, as Personal Representative of the Estate of Roy H. Park, has been submitted to and approved by the FCC. As noted above under "Item 1. Business," the Company's Board has voted to seek a sale of the entire Company. It is intended that such a sale be accomplished by selling the Company's outstanding common stock (including all of the Estate-held shares) to a third party. However, there is no guarantee that such a sale will be achieved. An alternative method for selling the Company would be selling the Company's assets to one or more purchasers (e.g., selling one or more divisions or particular properties). Any such transactions which affect the control of television and radio stations owned by the Company will be subject to prior FCC consent. BROADCAST LICENSES Broadcast licenses are granted for specific periods of time, and upon application, are renewable for additional terms. If a competing application is filed, or if a substantial and material question of fact is raised, or if for any reason the FCC is unable to determine that renewal of a license would serve the public interest, convenience and necessity, the FCC is required to hold a hearing on the renewal application. Petitions to deny license renewals and other applications are authorized to be filed against licensees and applicants. Such petitions can be used by interested parties, including members of the public, to raise issues before the FCC. Seven of the Company's nine television broadcast stations have been granted renewal of their broadcast licenses for five year terms. An application to renew the license for WUTR-TV, Utica, New York was filed on February 1, 1994 and remains pending. The application for renewal of the license of the Company's television station in Birmingham, WBMG- TV, is pending before the FCC awaiting disposition of a petition to deny filed by the NAACP, alleging violations of the FCC's policies regarding hiring of minorities. Management believes that the Birmingham station license ultimately will be renewed. Twenty of the Company's 22 radio broadcast stations have been granted renewal of their broadcast licenses for seven year terms. The licenses for KEZX AM/FM, Seattle, Washington, following FCC determination of shortfalls in the stations' equal employment opportunity ("EEO") plan, recently were renewed for a short term period ending February 1, 1995, in order to facilitate FCC monitoring of the stations' EEO program. The renewals also were conditioned on the submission of annual reports to the FCC describing the stations' affirmative action efforts. LIMITATION ON ACQUISITIONS Under FCC rules, limits are placed on an applicant's ownership, operation or control of television and radio broadcast stations, and the transferability of such licenses and facilities is restricted. Currently, one entity may have an attributable interest in 12 television stations nationwide. As to radio station ownership, one entity may have an attributable interest in 18 AM and 18 FM stations nationwide. The national caps for radio station ownership will increase to 20 AM and 20 FM stations on September 16, 1994. Local limits vary according to market size, and in some circumstances, market share. In markets with 14 or fewer stations, one entity may own up to three stations, with no more than two in the same service, and only if the number of commonly owned stations is less than 50% of the total number of stations in the market. In markets with 15 or more stations, one entity may own up to 4 stations with no more than 2 in the same service, as long as the total combined audience share is less than 25% of the market. The Company owns no more than one station in each service in each of its markets. Accordingly, assuming compliance with the restrictions on market share and compliance with other ownership limitations, the Company would be qualified under this rule to acquire additional radio stations in its existing markets. FCC rules also place certain limits on common ownership, operation and other interests in (a) television and radio broadcast stations serving the same area ("one to a market" rule), (b) broadcast stations and newspapers serving the same area, and (c) television broadcast stations and cable systems serving the same area. FCC rules affect the number, type and location of newspaper, broadcast and cable properties that the Company might acquire in the future. Under current rules, the Company might not be permitted to acquire any daily newspapers or broadcast or cable television properties (other than LPTV) in a market in which it now owns one or more FCC regulated properties. These rules do not require any change in the Company's present ownership of newspapers and broadcast stations. POSSIBLE NEW REGULATORY AND TECHNOLOGICAL DEVELOPMENTS, AND NEW LEGISLATION The Congress and the FCC have under consideration and may in the future consider and adopt new laws, regulations and policies regarding a wide variety of matters which could, directly or indirectly, affect the operation and ownership of the Company's broadcast properties. Such matters include, for example, a review by the FCC of its limitations on television ownership, as noted above. Also, under re-examination is the license renewal process, including the legitimate renewal expectancy of an incumbent broadcast licensee as well as the standards to be applied to both contested and non-contested renewal applications and the adverse weight, if any, to be given to multi- station or multi-media or other communications ownership interests. Also various programming and advertising questions and licensee employment practices are being considered. In addition, the economic position and practices of the major television networks vis-a-vis program producers, distributors and affiliated stations are current matters of controversy. Other matters which could affect the Company's broadcast properties include: technological innovations, including development of standards for high definition television production and broadcasting (HDTV) and digital audio broadcasting (DAB), affecting the mass communications industry; regulations governing satellite- to-home broadcasting; technical and allocations matters such as the allocation of channels for additional radio and television broadcast stations, including low-power and television translator stations, which could cause electrical interference to and loss of audience and revenues for existing broadcast stations; and the provision of MMDS services, and potentially LMDS, that may provide television programming in competition with the Company's operations. The Company cannot predict the outcome or effect of these various matters. However, they could affect the Company's revenues and profits from broadcasting, either adversely or favorably. On December 4, 1992, the Cable Television Consumer Protection and Competition Act of 1992 (the "Act") reregulating the cable industry became effective. In addition to imposing regulation of rates charged to cable subscribers, the new cable law imposes certain restrictions and obligations on the carriage of television signals by cable operators. The signal carriage, or "must carry," provisions of the Act require cable operators to carry the signals of qualified local commercial and non-commercial television stations and certain low power television stations. The Act also includes a retransmission consent provision that prohibits cable operators and other multi-channel video programming providers from carrying broadcast station signals without obtaining their consent in certain circumstances. Every three years, television broadcasters must make a choice between whether to proceed under the must carry rules or whether to waive that right to mandatory, but uncompensated, carriage and instead negotiate a grant of retransmission consent permitting the cable system to carry the station's signal, in most cases in exchange for some form of consideration from the cable operator. A challenge to the validity of the FCC's must carry rules currently is pending before the United States Supreme Court. Federal courts of appeals previously have declared former versions of must carry provisions to be unconstitutional. The Act also codified the FCC's existing EEO regulations and reporting forms used by television broadcast stations. In addition, pursuant to the Act's requirements, the FCC has adopted new rules providing for a review of the EEO performance of each television station at the mid-point in its license term (in addition to a review at the time of renewal). Such a review will give the FCC an opportunity to inform the licensee of any improvements in recruiting practices that may be needed as a result of the review. See the discussion under the caption "Broadcast Licenses" on page 6 above. Pursuant to the United States FY 1994 Budget Reconciliation act, broadcast stations (as well as other spectrum users) will be required to pay to the federal government a fee for use of the broadcast spectrum. Fees will range from $200 - $900 for radio stations and from $4,000 - $18,000 for television stations. The FCC has announced that it will begin collecting the fees after April 1, 1994, and is expected to begin a rulemaking proceeding soon to develop regulations under which the fees will be assessed. Imposition of these fees will not have a material effect on the Company. NEWSPAPER PUBLISHING The Company publishes paid circulation newspapers, both daily and non- daily, as well as controlled distribution publications ("shoppers"). A listing of the Company's newspaper and advertising publications owned as of March 1, 1994 and the communities in which they are published, is herein incorporated by reference to information under the caption "Operating Units of Park Communications, Inc." (pages 6-7) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. Daily newspapers are published in 30 markets in 12 states, and Sunday newspapers are published in 17 markets in 8 states. The Company's dailies are the only dailies of general circulation published in each of their respective cities or towns, which are generally areas of small or medium populations. However, other dailies published in adjacent or nearby locations also are generally circulated in some of these markets. Each daily newspaper maintains separate news reporting and editorial staffs. Non-daily newspapers are published one or more times per week. Non- dailies are published in 29 markets in 8 states. Many of the markets where non-dailies are published are too small to support a daily newspaper. In almost all cases, such markets are close to cities where the Company publishes daily newspapers. Shoppers are generally distributed free, on a weekly basis. They contain certain local and classified advertising with little originally produced news or editorial comment. The Company publishes shoppers in many of the markets where it also publishes daily or non-daily newspapers. Shoppers typically are distributed to non-subscribers of a Company daily or non-daily newspaper and allow the Company to cover an entire market with advertising contained in its publications. In December, 1993, the Company sold 33 of its smaller publications in 13 communities in 9 states. Included were 11 dailies (4 with Sunday editions), 7 paid weeklies, 13 free-distribution shoppers and 2 monthlies. The dailies had a combined circulation of 37,675, each with less than 6,000 paid circulation. The sale of these publications will allow the Company to focus its resources on larger publications. The Company's daily and non-daily newspapers are published primarily for home delivery and are generally sold by independent carriers and circulation dealers. The Company's shoppers are distributed free of charge, by various delivery methods, including third-class mail. All publications are produced using photocomposition technology and printed using an offset method. Automated text editing and classified advertising systems are in operation at all of the newspapers. The basic raw material of publishing operations is newsprint. The Company purchases newsprint under contract with 18 suppliers in the United States and Canada, the 5 largest of which provide approximately 93% of the tonnage used by the Company. In accordance with the industry practice the Company's newsprint contracts generally have one-year terms and provide for tonnage at prices determined from time to time by the suppliers. The Company believes that its newsprint sources of supply under existing arrangements are adequate and that there are adequate alternative sources of supply. Substantially all of the Company's publishing revenues are derived from advertising and circulation. Advertising rates and rate structures vary among the publications and are based, among other things, on circulation and type of advertising (whether classified, national or retail). Substantially all of the total publication advertising revenues are derived from local retailers and classified advertisers. COMPETITION--NEWSPAPERS While the Company's daily newspapers are the only daily newspapers of general circulation published in their respective cities or towns, each of these publications competes in varying degrees with other newspapers having a regional or national circulation as well as with magazines, radio, television and other advertising media. In addition, certain of the Company's daily newspapers compete within their own markets with other daily newspapers of general circulation published in adjacent or nearby cities and towns. There are no local television stations in any of the Company's 30 daily newspaper markets. Most of the Company's non-daily newspapers and shoppers also compete with other advertising media in their respective markets. EMPLOYEES The Company currently employs approximately 2,140 full-time persons, of whom 590 are in its television operations, 1,300 are in its newspaper operations and 250 are in its radio operations. Two broadcasting operations have a total of approximately 16 full-time employees represented by unions. The Company has never experienced a strike or work stoppage, and believes it has good relations with its employees. Item 2. Item 2. Properties - -------------------- The Company uses equipment, buildings and land at each of the locations listed under the caption "Operating Units of Park Communications, Inc." (pages 6-7) incorporated herein by reference to the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. See also the information under "Certain Transactions" (page 15) of the Company's Proxy Statement dated March 30, 1994, incorporated herein by reference (Exhibit 22.1 hereto). No one location's property is material to the Company's overall operations. The Company's television stations are located in offices and studio buildings of typically 8,000 square feet. Eight are owned and one is under a lease which expires in 1997. These stations transmit from antennas located on towers ranging from 840 feet to 2,300 feet above average terrain. Of the nine towers, the Company owns seven and leases two towers under leases expiring in 1997 and 2015. The Company's radio stations are typically located in 3,000 to 4,000 square foot offices and studio buildings. Of its eleven radio locations, seven are owned and four are leased under leases expiring in 1994, 1998, 1999 and 2001. Generally, the tower and antenna are located at a distance from the office and studio, to obtain a height advantage. The Company's radio station towers range from 150 feet to 2,000 feet above average terrain. Of 22 towers, the Company owns 17 towers and leases five towers under leases expiring in various years from 1994 through 2003. The Company's daily newspaper operations are typically housed in 10,000 square foot, one-story buildings. Of the 30 daily newspaper buildings, 22 are owned and 8 are leased under leases expiring in various years from 1996 through 2003. All of the Company's daily newspapers own their own printing presses, with the exception of one daily newspaper, which leases its press. The Company does not anticipate any material difficulties in renewing the leases referred to above. The Company believes that its properties are generally adequate for its operations, although opportunities to upgrade facilities are continuously reviewed. Item 3. Item 3. Legal Proceedings - ------------------------- As noted above under the caption "Broadcast Licenses", the Company's Birmingham television station's application for renewal of license currently is pending before the FCC awaiting disposition of petitions to deny filed by the NAACP and/or NBMC alleging violation of the FCC's policies regarding hiring of minorities. Management believes that the station's license ultimately will be renewed, without a material adverse effect on the Registrant's results of operations, financial condition, equity, liquidity and capital resources. On January 31, 1994, the licenses held by Roy H. Park Broadcasting of Washington, Inc. (a wholly owned subsidiary of the Company), to operate radio stations KEZX-AM and KEZX-FM, Seattle, Washington, were renewed for a short term period ending February 1, 1995, with the requirement that annual reports be submitted relating to the station's Equal Employment Opportunity Program. The NAACP filed with the FCC on January 2, 1991, a petition to deny the renewal of the FCC licenses to operate KEZX-AM and KEZX-FM. The petition was part of a filing initiated by the NAACP against Washington radio stations licensed to the Company's subsidiary and to other entities. The Company is not a party to any other lawsuit or proceeding, which in the opinion of management, is likely to have a material adverse effect on the Registrant's results of operations, financial condition, equity, liquidity and capital resources. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ----------------------------------------------------------- Not applicable. Executive Officers of the Company - --------------------------------- Certain information concerning the Executive Officers of the company is set forth below: NAME AGE POSITION - ------------------------------------------------------------------------------- Dorothy D. Park 81 Chairman of the Board of Directors and Secretary Wright M. Thomas 58 President, Chief Operating Officer, Treasurer, Assistant Secretary and Director Jack E. Claiborne 62 Vice President - Assistant to the Chairman W. Randall Odil 51 Vice President - Television Rick A. Prusator 41 Vice President - Radio Robert J. Rossi 66 Vice President - Newspapers Randel N. Stair 43 Vice President - Controller and Assistant Secretary Dorothy D. Park has been Chairman of the Board since November, 1993 and has been Secretary of the Company and Director since 1971. Mrs. Park is also a Director, President and Secretary of RHP Incorporated. See the information under the caption "Certain Transactions" (page 15) herein incorporated by reference to the Company's Proxy Statement filed as Exhibit 22.1 hereto. Wright M. Thomas has been a Director since August, 1983 and has been with the Company since 1974. He has been President and Chief Operating Officer of the Company since July, 1987 and Treasurer and Assistant Secretary of the Company since August, 1983. He was Executive Vice President of the Company from April, 1986 to July, 1987. He was Senior Vice President - Finance of the Company from July, 1979 to April, 1986, and was Vice President-Finance of the Company from 1974-1979. Prior to that time, he was employed by INA Corporation and Coopers & Lybrand. Mr. Thomas is also a Director, Vice President and Assistant Secretary of RHP Incorporated. See the information under the caption "Certain Transactions" (page 15) herein incorporated by reference to the Company's Proxy Statement filed as Exhibit 22.1 hereto. Jack E. Claiborne has been Vice President - Assistant to the Chairman since October, 1990. Prior thereto, he was employed by The Charlotte Observer since 1955, where he was the Associate Editor from 1972 to September, 1990. From 1955 to 1972, he was employed in various editorial and reporting positions. W. Randall Odil has been Vice President - Television since October, 1986. From February, 1982 to October, 1986, he was Vice President and General Manager of the Company's WSLS-TV Station in Roanoke, Virginia. Prior thereto, he was employed by WBKO-TV in Bowling Green, Kentucky for 20 years in various positions, including Vice President - Sales/Station Manager from 1978 to February, 1982. Rick A. Prusator has been Vice President - Radio since August, 1991. From August, 1989 to August, 1991 he was Vice President of Park Broadcasting - Western Radio Division. He was Vice President and General Manager of the Company's WNAX-AM Station in Yankton, South Dakota, from February, 1985 to August, 1991. He was General Manager of KYNT/KKYA in Yankton, South Dakota, from 1984 to February, 1985. Prior thereto, he was employed by Leighton Enterprises, Inc from 1978 to December, 1983, and was its Vice President of Iowa operations from 1981 to December, 1983. Robert J. Rossi has been associated with the Company's newspaper publishing business since 1974. He was Vice President - Newspapers from 1974 through 1978 and was a consultant to the Company from 1978 through October, 1983. In October, 1983 he became General Manager and Editor of the Company's daily newspaper in Blytheville, Arkansas, and regional coordinator of the Company's Central Newspaper Division. In January, 1986, he rejoined the Company's central management group as Vice President - Newspapers. Randel N. Stair has been Vice President - Controller of the Company since 1980, Assistant Secretary since August, 1983 and Vice President - Controller of Park Newspapers, Inc., a subsidiary of the Company, since 1979. Prior thereto he was associated with Multimedia, Inc., since 1974, most recently as Assistant Corporate Controller. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder - ---------------------------------------------------------------------------- Matters - ------- The Company's Common Stock has traded in the over-the-counter market and has been quoted on NASDAQ (symbol PARC) since its initial public offering in October, 1983. On January 22, 1985, the Common Stock commenced trading in the NASDAQ National Market System. The latest trading price of the Company's Common Stock was $22 3/4 on March 28, 1994. The following table sets forth for the periods indicated and as reported by NASDAQ, the high and low sale prices of the Company's Common Stock in the NASDAQ National Market System. Calendar Year High Low - ---------------- ------------------------------- 1993: First Quarter............................ 20 1/4 17 1/4 Second Quarter........................... 20 1/2 18 Third Quarter............................ 20 18 Fourth Quarter........................... 24 19 1992: First Quarter............................ 16 14 Second Quarter........................... 16 3/4 15 Third Quarter............................ 18 1/4 15 3/4 Fourth Quarter........................... 18 1/4 16 5/8 The Company has never declared or paid any dividends and has no present intention of doing so. Declaration of dividends in the future will remain within the discretion of the Company's Board of Directors, who will review such dividend policy from time to time. As of February 16, 1994, there were 522 holders of record of the Company's Common Stock. Item 6. Item 6. Selected Financial Data - ------------------------------- Incorporated herein by reference to the information under the caption "Selected Financial Data" (page 13) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations - ------------- Incorporated herein by reference to the information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" (pages 14-15) of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. Item 8. Item 8. Financial Statements and Supplementary Data - --------------------------------------------------- Financial statements are incorporated herein by reference to pages 15-25 of the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. Supplementary data not applicable. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ----------------------------------------------------------------------- Financial Disclosure - -------------------- Not Applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant - ----------------------------------------------------------- Incorporated herein by reference to the information under the caption "Election of Directors" (pages 7-8) of the Company's Proxy Statement dated March 30, 1994 (see Exhibit 22.1 hereto). The information regarding Executive Officers is on pages 11 and 12 of this report. Item 11. Item 11. Executive Compensation - ------------------------------- Incorporated herein by reference to the information under the captions "Director's Meetings and Compensation" (page 10) and "Executive Compensation" (pages 10-14) of the Company's Proxy Statement dated March 30, 1994 (see Exhibit 22.1 hereto), except as provided below. The registrant specifically is not required to and does not incorporate by reference the "Report of the Compensation Committee of the Board of Directors" and "Five-Year Total Stockholder Return" sections included in the Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- Incorporated herein by reference to the information under the captions "Ownership by Certain Beneficial Owners of More Than 5% of Common Stock" (page 4) and "Common Stock Owned by Directors and Officers as of February 1, 1994" (pages 5-6) of the Company's Proxy Statement dated March 30, 1994 (see Exhibit 22.1 hereto). Item 13. Item 13. Certain Relationships and Related Transactions - ------------------------------------------------------- Incorporated herein by reference to the information under the caption "Certain Transactions" (page 15) of the Company's Proxy Statement dated March 30, 1994 (see Exhibit 22.1 hereto). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - ------------------------------------------------------------------------- (a.) 1. Financial Statements and Report of Independent Auditors incorporated herein by reference to the Company's 1993 Annual Report filed as Exhibit 13.1 hereto. Reference to Page Number in 1993 Annual Report --------------------- Report of Independent Auditors on the Financial Statements 15 Consolidated Balance Sheets as of December 31, 1993 and 1992 16-17 Consolidated Statements of Income and Retained Earnings for years ended December 31, 1993, 1992 and 1991 18 Consolidated Statements of Cash Flows for years ended December 31, 1993, 1992 and 1991 19 Notes to Consolidated Financial Statements 20-25 2. Financial Statement Schedules Included in this Annual Report on Form 10-K I - Marketable securities - other investments as of December 31, 1993 VIII - Valuation and qualifying accounts and reserves for the years ended December 31, 1993, 1992 and 1991 X - Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 All other schedules are inapplicable and, therefore, have been omitted. 3. Exhibits 3.1 - Certificate of Incorporation as Amended, filed as Exhibit 3.1 of the Company's Registration Statement on Form S-1 filed on September 1, 1983, File No. 2-86258 and incorporated herein by reference. Amendment to Certificate of Incorporation dated June 30, 1989 filed as Exhibit 4.1 of the Company's Registration Statement on Form S-8 filed on March 29, 1993, File No. 33-60238 and incorporated herein by reference. 3.2 - By-laws dated October 13, 1971, filed as Exhibit 3.2 of the Company's Registration Statement on Form S-1 on September 1, 1983, File No. 2-86258 and incorporated herein by reference. 4.1 - Certificate of Incorporation and By-laws (included in Exhibits 3.1 and 3.2), filed as Exhibit 4.1 of the Company's Registration Statement on Form S-1 filed on September 1, 1983, File No. 2-86258 and incorporated herein by reference. Amendment to Certificate of Incorporation dated June 30, 1989 (included in Exhibit 3.1), filed as Exhibit 4.1 of the Company's Registration Statement on Form S-8 filed on March 29, 1993, File No. 33-60238 and incorporated herein by reference. 4.2 - Form of Indenture, dated as of March 1, 1986, to Wachovia Bank and Trust Company, N.A., Trustee, filed as Exhibit 4.2 of the Company's Registration Statement on Form S-1 filed on February 26, 1986, File No. 33-3588 and incorporated herein by reference. 4.3 - Form of Debenture, filed as Exhibit 4.3 of the Company's Registration Statement on Form S-1 (Amendment No. 1) filed on March 4, 1986, File No. 33-3588 and incorporated herein by reference. 4.4 - Specimen of Common Stock certificate, filed as Exhibit 4.4 of the Company's Registration Statement on Form S-1 filed on February 26, 1986, File No. 33-3588 and incorporated herein by reference. 4.5 - The Company hereby agrees to file upon request of the Securities and Exchange Commission a copy of all instruments, not otherwise filed, with respect to long-term debt of the Company or any of its subsidiaries for which the total amount of debt authorized under such instrument does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. 10.1 - Television broadcasting network affiliation agreements and consents to assignment to the Company or its subsidiaries of such agreements listed below, filed as Exhibit 10.1 (a) through (k) of the Company's Registration Statement on Form S-1 filed on September 1, 1983, File No. 2-86258 and incorporated herein by reference. (a) Contract for Affiliation between WNCT-TV in Greenville, NC and CBS (b) Consent to Assignment of WNCT-TV Affiliation to Roy H. Park Broadcasting, Inc. (c) Contract for Affiliation between WDEF-TV in Chattanooga, TN and CBS (d) Consent to Assignment of WDEF-TV Affiliation to Roy H. Park Broadcasting, Inc. (e) Contract for Affiliation between WJHL-TV in Johnson City, TN and CBS (f) Consent to Assignment of WJHL-TV Affiliation to Roy H. Park Broadcasting of the Tri-Cities, Inc. (g) Contract for Affiliation between Havens & Martin, Inc. in Richmond, VA and CBS (h) Consent to Assignment for WTVR-TV Affiliation to Roy H. Park Broadcasting of Virginia, Inc. (i) Contract for Affiliation between WUTR-TV in Utica, NY and ABC (j) Contract for Affiliation between WSLS-TV in Roanoke, VA and NBC (k) Contract for Affiliation between WBMG-TV in Birmingham, AL and CBS 10.2 - Television broadcasting network affiliation agreement and consent to assignment to a subsidiary of the Company of such agreement listed below, filed as Exhibit 10.2 (a) through (b) of the Company's 1991 Annual Report on Form 10-K filed on March 13, 1992, File No. 0-12743 and incorporated herein by reference. (a) Contract for affiliation between WTVQ-TV in Lexington, KY and ABC (b) Consent to assignment of WTVQ-TV affiliation to Park Broadcasting of Kentucky, Inc. 10.3 - Television broadcasting network affiliation agreement and consent to assignment to a subsidiary of the Company of such agreement listed below. (a) Contract for affiliation between KALB-TV in Alexandria, LA. and NBC. (b) Consent to assignment of KALB-TV affiliation to Park Broadcasting of Louisiana, Inc. 10.4 - FCC television license renewal certificates listed below, filed as Exhibit 10.3 (a) through (c) of the Company's 1992 Annual Report on Form 10-K filed on March 25, 1993, File No. 0-12743 and incorporated herein by reference. (a) WJHL-TV (b) WDEF-TV (c) WTVQ-TV 10.5 - FCC radio license renewal certificates listed below, filed as exhibit 10.11 (a) through (d) of the company's 1988 Annual Report on Form 10-K filed on March 28, 1989, File No. 0-12743 and incorporated herein by reference. (a) WTVR-AM (b) WTVR-FM (c) WNCT-AM (d) WNCT-FM 10.6 - FCC television license renewal certificate listed below, filed as exhibit 10.11 (a) of the Company's 1989 Annual Report on Form 10-K filed on March 29, 1990, File No. 0-12743 and incorporated herein by reference. (a) WUTR-TV 10.7 - FCC radio license renewal certificates listed below, filed as exhibit 10.12 (a) through (d) of the Company's 1989 Annual Report on Form 10-K filed on March 29, 1990, File No. 0-12743 and incorporated herein by reference. (a) WDEF-AM (b) WDEF-FM (c) KWLO-AM (d) KFMW-FM 10.8 - FCC radio license renewal certificates listed below, filed as exhibit 10.10 (a) through (e) of the Company's 1990 Annual Report on Form 10-K filed on March 26, 1991, File No. 0-12743 and incorporated herein by reference. (a) KJJO-AM (formerly KZOW-AM) (b) KJJO-FM (c) KWJJ-AM (d) KWJJ-FM (e) WNAX-AM 10.9 - FCC radio license renewal certificates listed below, filed as Exhibit 10.9 (a) through (d) of the Company's 1991 Annual Report on Form 10-K filed on March 13, 1992, File No. 0-12743 and incorporated herein by reference. (a) WHEN-AM (b) WHEN-FM (formerly WRHP-FM) (c) WPAT-AM (d) WPAT-FM 10.10 - FCC television license renewal certificates listed below, filed as Exhibit 10.10 (a) through (c) of the Company's 1991 Annual Report on Form 10-K filed on March 13, 1992, File No. 0-12743 and incorporated herein by reference. (a) WNCT-TV (b) WTVR-TV (c) WSLS-TV 10.11 - FCC radio license renewal certificate listed below, filed as Exhibit 10.11 (a) of the Company's 1991 Annual Report on Form 10-K filed on March 13, 1992, File No. 0-12743 and incorporated herein by reference. (a) WNAX-FM (Formerly WQHG-FM and KBCM-FM) 10.12 - FCC authorization to operate television station WBMG-TV, Birmingham, Alabama, beyond the license expiration date pending final determination on license renewal application received by the FCC on November 26, 1991, filed as Exhibit 10.12 (a) of the Company's 1992 Annual Report on Form 10-K filed on March 25, 1993, File No. 0-12743 and incorporated herein by reference. (a) WBMG-TV 10.13 - FCC television license renewal and consent to assignment. (a) KALB-TV 10.14 - FCC radio license renewal certificates. (a) KEZX-AM (b) KEZX-FM 10.15 - FCC radio license renewal certificates and consents to assignment. (a) WNLS-AM (formerly WYYN-AM) (b) WTNT-FM 10.16 - Lease between East Carolina Tower, Inc. and WNCT-TV, dated September 20, 1991 listed below, filed as Exhibit 10.13 of the Company's 1991 Annual Report on Form 10-K filed on March 13, 1992, File No. 0-12743 and incorporated herein by reference. 10.17 - Lease between East Carolina Tower, Inc. and WNCT-FM, dated January 1, 1982, filed as Exhibit 10.6 of the Company's Registration Statement on Form S-1 filed on September 1, 1983. File No. 2-86258 and incorporated herein by reference. 10.18 - Contingent retirement arrangement with W.M. Thomas, filed as Exhibit 10.10 of the Company's Registration Statement on Form S-1 filed on September 1, 1983, File No. 2-86258 and incor- porated herein by reference. 10.19 - FCC consent to transfer control from Roy H. Park to Dorothy D. Park, Personal Representative of the Estate of Roy H. Park. 13.1 - The information under the captions "Operating Units of Park Communications, Inc." (pages 6-7), "Selected Financial Data" (page 13), "Management's Discussion and Analysis of Financial Condition and Results of Operations" (pages 14-15) and the financial statements (pages 15 - 25) in the Company's 1993 Annual Report. 21.1 - List of subsidiaries of the Company. 22.1 - The Company's Proxy Statement dated March 30, 1994, filed on March 31, 1994, and incorporated herein by reference. The Registrant specifically is not required to and does not incorporate by reference the "Report of the Compensation Committee of the Board of Directors" and "Five-Year Total Stockholder Return" sections included in the Proxy Statement. 23.1 - Consents of Independent Auditors. (b) During the quarter ended December 31, 1993, the Registrant filed a Current Report on Form 8-K dated December 10, 1993 reporting Change of Control from Roy H. Park, who was the Chairman of the Board of the Registrant, and owner of approximately 89.67% of Registrants outstanding Common Stock, and who died on October 25, 1993, to Mr. Park's widow, Dorothy D. Park, as Personal Representative of Mr. Park's estate. At a meeting of the Registrant's board of directors on November 12, 1993, Dorothy D. Park was elected Chairman of the Board of the Registrant. SIGNATURES Pursuant to the requirements of Section 13 or 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. PARK COMMUNICATIONS, INC. Date: March 31, 1994 /s/ Dorothy D. Park -------------------- ------------------------------- Dorothy D. Park Chairman of the Board of Directors and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - ----------------------- ---------------------------------- -------------- /s/Dorothy D. Park Chairman of the Board March 31, 1994 - ----------------------- and Secretary Dorothy D. Park Director March 31, 1994 - ----------------------- Harry F. Byrd, Jr. Director March 31, 1994 - ----------------------- J. Markham Green /s/John F. McNair III Director March 31, 1994 - ----------------------- John F. McNair III /s/Wright M. Thomas President, Chief Operating March 31, 1994 - ----------------------- Officer, Treasurer, Wright M. Thomas Assistant Secretary and Director (Principal Financial Officer) /s/Roy H. Park, Jr. Director March 31, 1994 - ----------------------- Roy H. Park, Jr. /s/Randel N. Stair Vice President - Controller March 31, 1994 - ----------------------- and Assistant Secretary Randel N. Stair (Principal Accounting Officer) INDEX EXHIBIT INDEX Exhibit ------- (a) Exhibits 10.3 - Television broadcasting network affiliation agreement and consent to assignment to a subsidiary of the Company of such agreement listed below. (a) Contract for affiliation between KALB-TV in Alexandria, LA. and NBC. (b) Consent to assignment of KALB-TV affiliation to Park Broadcasting of Louisiana, Inc. 10.13 - FCC television license renewal and consent to assignment. (a) KALB-TV. 10.14 - FCC radio license renewal certificates. (a) KEZX-AM (b) KEZX-FM 10.15 - FCC radio license renewal Certificates and Consents to assignment. (a) WNLS-AM (formerly WYYN-AM) (b) WTNT-FM 10.19 - FCC consent to transfer control from Roy H. Park to Dorothy D. Park, Personal Representative of the Estate of Roy H. Park. 13.1 - The information under the captions "Operating Units of Park Communications, Inc." (pages 6-7), "Selected Financial Data" (page 13), "Management's Discussion and Analysis of Financial Condition and Results of Operations" (pages 14-15) and the financial statements (pages 15 - 25) in the Company's 1993 Annual Report. 21.1 - List of subsidiaries of the Company. 23.1 - Consents of Independent Auditors. (b) Financial Statement Schedules Schedule I - Marketable securities - other investments Schedule VIII - Valuation of qualifying accounts and reserves Schedule X - Supplementary income statement information	8,158	53,792
84548_1993.txt	84548_1993	1993	84548	ITEM 1. BUSINESS. (a) GENERAL DEVELOPMENT OF BUSINESS. Registrant and its predecessors have been engaged in the mining of coal in central and western Pennsylvania since 1881. Since the mid-1960's, Registrant and its subsidiaries have been principally engaged in the deep mining of bituminous steam coal for sale to electric generating plants located adjacent to or near Registrant's mines. Substantially all of these sales have been made pursuant to long-term coal supply contracts. Because of the continued availability of low priced coal from other sources, during 1993 the utility customers of Registrant's subsidiaries continued to purchase coal at near minimum contract requirements. In addition, during 1993, a seven-month strike (May 25 through December 16, 1993) by the United Mine Workers of America (the "UMWA") against members of the Bituminous Coal Operators Association (the "BCOA"), including operations of two of Registrant's subsidiaries, had a significant adverse impact on Registrant's operating results. Tonnage produced and sold was reduced by approximately 42% in 1993 versus 1992. A partial offset in volume and cost of sales, however, occurred because a substantial portion of the costs incurred by the operations of Registrant on strike were reimbursable under the terms of Registrant's subsidiaries long-term coal sales agreements. In 1993, another subsidiary of Registrant commenced development and rehabilitation work at the mine it acquired in 1992. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. Registrant is of the opinion that all of its material operations are within one industry segment and that no information as to business segments is required pursuant to Statement of Financial Accounting Standards No. 14 or Regulation S-K. (c) NARRATIVE DESCRIPTION OF BUSINESS. Registrant, through its subsidiaries, is principally engaged in deep and, to a very minor extent, surface mining of bituminous steam coal in Pennsylvania. Substantially all of Registrant's deep-mined production in 1993 was sold pursuant to two long-term contracts, described below, to two mine-mouth electric generating plants adjacent to or near its mines. Steam coal is not suitable for metallurgical use because of excessive levels of ash or sulphur. United Eastern Coal Sales Corporation ("United Eastern"), a wholly- owned subsidiary, is a coal broker and sales agent which buys and sells, either as principal or agent, coal produced in the United States. Registrant's wholly-owned subsidiary, Rochester & Pittsburgh Coal Co. (Canada) Limited, is engaged in the sale of coal to customers in Canada. Each of Registrant's subsidiaries which buys and sells coal produced by others serves customers principally in the Mid-Atlantic states and the Province of Ontario. Leatherwood, Inc. ("Leatherwood"), a wholly-owned subsidiary of Registrant, is engaged in developing, owning, and managing solid waste management facilities. To date, Leatherwood has submitted a permit application to the Pennsylvania Department of Environmental Resources (the "DER") for a new municipal solid waste landfill in Jefferson County, Pennsylvania. This facility will also accept residual waste. Two Pennsylvania counties have designated this landfill as a secondary disposal facility in their statutorily-required county master plan for the disposal of solid waste and, upon receipt of a permit by Leatherwood, will deem the landfill a primary disposal facility. Discussions with other counties and waste collectors are continuing. Two contracts with collection companies or brokers have been executed contingent, however, upon a permit being issued. The permit application is subject to stringent regulatory standards and is under review by DER. An official response on the application, which will be subject to administrative and judicial review, is expected early in 1994. In 1992, Registrant established two wholly-owned subsidiaries, Eighty-Four Mining Company ("Eighty-Four") and Lucerne Land Company ("Lucerne Land") to acquire coal properties and Mine No. 84 from Bethlehem Steel Corporation and affiliated entities ("Bethlehem"). The final purchase price of Mine No. 84 was $53.6 million after taking into effect post-closing adjustments. Mine No. 84 was idled in February 1993 to permit renovation, rehabilitation, and replacement of key operating systems. This work will include replacement of the haulage system, by installing a new five mile long, 6,700 ton per hour underground belt conveyor system, upgrading of surface, coal handling and preparation facilities, and installation of two longwall mining units. When these renovations are fully completed and full capacity is reached, which is expected to occur in 1997, Eighty-Four's facilities will permit production of approximately 6.6 million tons of coal per year. Development mining is expected to begin during the second quarter of 1994 in preparation for installation of the first longwall unit in the third quarter of 1995. The properties acquired are estimated to contain approximately 175 million saleable1 tons of high quality Pittsburgh Seam steam and metallurgical coal. The reserve estimate, which was developed by Registrant's Geology and Engineering personnel, is based upon review of data and test results provided by Bethlehem, data available from outside sources, application of generally accepted mining practices in the geographic area of mining, and generally accepted mining practices in the Pittsburgh Seam utilizing longwall mining techniques. This estimate is being further reviewed and verified by Registrant's Geology and Engineering personnel. - ---------------------------------- 1 Saleable means total coal mine output less tonnage rejected during processing for market. While no arrangements or contracts for the sale of coal by Eighty-Four exist at present, extensive efforts to achieve such arrangements occurred in 1993 and are continuing. Written expressions of interest from potential customers have been obtained. The coal from Mine No. 84, however, is of such quality that it should position Registrant to respond to the increased demand for coals that will meet the air quality standards under Phase I of The Clean Air Act when it takes effect in 1995. Longer-term demand for this lower sulphur coal should remain strong because, after cleaning, the coal will remain a cost-effective product for electric generating stations utilizing scrubbers. Additionally, a significant portion of the coal from Mine No. 84 has historically been sold on the domestic and international metallurgical market. Marketing activities undertaken by Eighty-Four have been directed to a diverse geographic and customer base, thus reducing reliance upon a single customer, group of customers, or type of market while enabling price escalation risks to be hedged due to the varying contract durations anticipated. Registrant's wholly-owned subsidiary, Keystone Coal Mining Corporation ("KCMC") is a party to a coal supply agreement effective as of January 1, 1991 (the "Keystone Agreement") with the seven public utilities (the "Keystone Owners") that own the Keystone Steam Electric Station (the "Keystone Station") near Shelocta, Pennsylvania. The Keystone Agreement amended, extended, and restated an earlier agreement dated January 1, 1972, among the same parties pursuant to which coal has been delivered to the Keystone Station by KCMC. The Keystone Agreement has a term ending December 31, 2004, and under it KCMC was to sell and deliver 3,900,000 tons to the Keystone Station in 1991, 3,700,000 tons in 1992 and, from 1993 through 1999, will sell and deliver 3,250,000 tons annually subject to increase or decrease by up to 250,000 tons. As a direct result of the strike by the UMWA against KCMC's facilities, in 1993, KCMC delivered 2,339,033 tons to the Keystone Station pursuant to the Keystone Agreement. Should the parties not agree to an extension of the Keystone Agreement beyond its initial term, production and deliveries will decrease between 2000 and 2004 with an aggregate of 6,500,000 tons to be delivered during that five-year period. Substantially all of the coal sold pursuant to the Keystone Agreement is delivered by a series of conveyor belts directly from KCMC's mines (the "Keystone Mines") to the Keystone Station. In connection with its Keystone Mines, KCMC also owns and operates a coal handling and preparation facility (the "Keystone Cleaning Plant") which processes coal to enhance the thermal value of the product delivered to the Keystone Station. The price paid by the Keystone Owners to KCMC pursuant to the Keystone Agreement consists of an amount equal to all costs of production incurred by KCMC in mining, processing, and delivering the coal, subject to a price cap, including mine development costs and capital expenditures, mine closing costs, general and administrative costs, interest costs, plus a profit that varies according to KCMC's ability to meet or exceed certain cost standards, plus a royalty of $.25 per ton, with an annual minimum royalty payment of $375,000. The profit calculation is subject to adjustment for cumulative changes in the Gross National Product Implicit Price Deflator ("GNP Deflator") based upon the Btu content of the coal delivered and KCMC's cost of production compared to standard costs established in the Keystone Agreement. The standard costs are adjusted according to various cost and market price indices. KCMC dedicated approximately 90,000,000 tons of coal at January 1, 1991 pursuant to the Keystone Agreement and said coal cannot be mined for sale to others without the Keystone Owners' consent. KCMC has the option on and after July 1, 1995, to remove certain coal properties from the area of dedication if it determines that the same are not required to fulfill its obligations under the Keystone Agreement. Substantially all of the dedicated coal properties are leased or subleased by KCMC from Registrant. Under certain conditions described in the Keystone Agreement, the Keystone Owners have the option to purchase all of the capital stock of KCMC at the net book value thereof at the time of exercising the option ($18,816,536 at December 31, 1993) or its net assets at book value, and to lease KCMC's coal properties from Registrant. In such event, Registrant would receive a royalty per ton equal to approximately $1.03, a substantial portion of which would be adjusted for changes in the GNP Deflator from December 1990. See Note C to the Consolidated Financial Statements incorporated herein by reference. The Keystone Owners also have the right to terminate the Keystone Agreement effective at the end of 1999 or any calendar year thereafter, upon five years prior notice, if the Keystone Owners determine, in their sole discretion, that it is unlawful or commercially impracticable, in light of the then applicable governmental regulations, to operate the Keystone Station with the coal KCMC is able to produce. The Keystone Owners, after a series of progressive steps, also have the right to terminate the Keystone Agreement if certain size and quality requirements are not met by KCMC. In 1993, KCMC delivered 2,301,690 tons of coal from its Keystone Mines and 37,343 tons of purchased coal to the Keystone Station, compared with deliveries to the Keystone Station in 1992 of 3,700,086 tons of deep-mined coal and 27,387 tons of purchased coal. Registrant's wholly-owned subsidiary, Helvetia Coal Company ("Helvetia"), is a party to a coal sales agreement dated December 22, 1966, and subsequently amended, (the "Homer City Agreement") with the two public utilities (the "Homer City Owners") that own the Homer City Steam Electric Station (the "Homer City Station") near Homer City, Pennsylvania. The Homer City Agreement, which has a term extending until 2007, provides that Helvetia will sell and deliver to the Homer City Owners annual amounts of coal as specified therein and that the Homer City Owners will purchase from Helvetia the lesser of 1,800,000 tons or 50% of the coal requirements of the Homer City Station. Coal sold pursuant to the Homer City Agreement is delivered to the Homer City Station by conveyor belts and trucks. Under the Homer City Agreement, Helvetia is required only to reduce raw coal to 1- 1/4 inches top size. In this process, a Bradford Breaker, which removes some of the impurities from the coal, is used. The price paid by the Homer City Owners to Helvetia pursuant to the Homer City Agreement consists of an amount equal to all costs incurred by Helvetia in mining, processing, and delivering the coal, including mine development costs and capital expenditures, mine closing costs, general and administrative costs, interest costs, a royalty of $.25 per ton and a "standard" profit of $1.50 per ton subject to adjustment for cumulative changes in a composite index from calendar year 1988, and also subject to adjustment if certain costs of production are more or less than the standard costs as defined in the Homer City Agreement and quality requirements are met. Additionally, Helvetia is assured a minimum profit of $.60 per ton adjusted for cumulative changes in the composite index so long as quality requirements are met. If minimum quality requirements are not met, Helvetia's minimum profit is reduced below $.60 per ton, depending on quality level, but will not be reduced below zero. Under the Homer City Agreement, Helvetia dedicated up to 85,000,000 tons of coal, all of which are leased from Registrant. Under certain conditions described in the Homer City Agreement, the Homer City Owners have the option to purchase all of the capital stock of Helvetia or its net assets at the net book value thereof ($6,167,174 at December 31, 1993). In such event, the royalty payable to Registrant would be increased from $.25 to $.35 per ton, unless the option were exercised by reason of the default of Helvetia under the Homer City Agreement, in which case the royalty would remain at $.25 per ton. See Note C to the Consolidated Financial Statements incorporated herein by reference. As a direct result of the strike by the UMWA against Helvetia's facilities, during 1993, 839,750 tons of coal were delivered to the Homer City Station from Helvetia's deep mines compared with deliveries of 1,799,949 tons in 1992. Projections provided by the Homer City Owners call for deliveries at the average annual rate of approximately 1,800,000 tons per year through 1997. Negotiations between the Homer City Owners and Helvetia regarding a new fixed price, with escalation, contract for Helvetia to continue providing approximately 1.8 million tons of coal per year to the Homer City Station are continuing, and are anticipated to be concluded and effective before the end of 1994. If an agreement is concluded, it would require the opening of a new mine by Helvetia. The Florence Mining Company, ("Florence"), formerly a wholly-owned subsidiary of Registrant, was party to a Coal Supply Agreement (the "Conemaugh Agreement") with nine public utilities (the "Conemaugh Owners") that own the Conemaugh Steam Electric Station (the "Conemaugh Station") near New Florence, Pennsylvania. In October 1991, the Conemaugh Owners notified Registrant that they were electing to exercise their option, entered into simultaneously with the Conemaugh Agreement, to acquire the capital stock of Florence and were assigning the option to Quent, Inc., which would exercise it. On October 29, 1991, the capital stock of Florence was transferred to Quent, Inc. In 1993, eight deep mines of Registrant's subsidiaries supplied coal to the Homer City and Keystone Stations. The mines are described in Item 2, to which reference is hereby made. Registrant maintains comprehensive general liability and umbrella liability, pollution liability, and boiler and machinery insurance for all of its operations. Registrant also maintains business interruption and property damage insurance for all of its subsidiaries operations and properties except for KCMC. KCMC is not fully insured for business interruption and property damage because it is able to recover such losses in whole or in part under its long-term coal sales agreement. Registrant has self-insurance programs for workers' compensation and has insurance coverage for catastrophic losses. Registrant also has automobile liability, fiduciary liability, and fidelity insurance. The bituminous coal industry in general is intensely competitive. Although substantially all of Registrant's coal production is sold pursuant to the Keystone and Homer City Agreements, because of the nature of the power supply system in the Mid-Atlantic Region of the United States, Registrant remains subject to material competition from other coal suppliers primarily as to price, coal quality, and environmental considerations, and other types of fuel, principally oil, natural gas, hydroelectric power, and nuclear fuel. That system is operated as a pool of electric power so to the extent that other sources of power within the system, or available to it, are cheaper than the power produced at the Keystone and Homer City Stations, the Owners could reduce the amount of power produced by those Stations and, consequently, the amount of coal purchased from Registrant under the Keystone and Homer City Agreements could be reduced. During 1993, Registrant's surface-mined coal was sold on the commercial market. To the extent that Registrant is engaged in the wholesale and retail sale of coal, it constitutes a minor competitive factor in such industry and is in competition with other sellers of coal and other fuels, principally oil and natural gas. Registrant's business is materially dependent on the two long-term coal sales agreements, the Keystone Agreement and the Homer City Agreement, described herein. See also Note C to the Consolidated Financial Statements incorporated herein by reference. Gross sales pursuant to the Keystone Agreement and the Homer City Agreement accounted for approximately 66% and 26%, respectively, of Registrant's sales in the year ended December 31, 1993. If the Owners of the Keystone and Homer City Stations were to use other stations not served by Registrant to meet a greater percentage of their power generation demand, or if power were procured from other sources, their requirements for the Keystone and Homer City Stations could decrease, and if such decrease were significant, the change could materially adversely affect the business of Registrant. Registrant's business also was affected by the sale of Florence since sales under the Conemaugh Agreement accounted for approximately 28% of Registrant's sales in the year ended December 31, 1991. See also Note C of the Notes to the Consolidated Financial Statements incorporated herein by reference. Information concerning backlog is not considered material to an understanding of Registrant's business. At December 31, 1993, Registrant had an estimated recoverable2 reserve base3 in leased or owned properties in Armstrong, Indiana, Westmoreland, Washington, and other nearby Pennsylvania counties, of approximately 738,000,000 tons of coal. During 1993, Registrant produced approximately 3,218,013 tons of coal excluding a small quantity of coal produced from Mine No. 84. Of the 738,000,000 tons of estimated recoverable reserve base, approximately 150,000,000 tons of coal (20%), are dedicated under the Keystone and Homer City Agreements. With the exception of the 175,000,000 saleable tons of coal acquired from Bethlehem, recovery of the remaining recoverable reserve base would require new mines which would entail substantial capital expenditures the amount of which cannot be estimated at this time. Registrant has made no decision regarding any new mines and, depending upon Registrant's continuing evaluation of economic conditions affecting the sale of coal in Registrant's present area of operations and the effect of increasingly stringent environmental requirements, Registrant may not open new mines to access its - ---------------------------------- 2 Recoverable means those portions of the Reserve Base owned or leased by the Registrant that are potentially extractable using an appropriate factor to account for coal lost-in-mining. 3 Reserve base means those parts of an identified resource, proven and probable, that are currently economic, marginally economic and some of those that are currently sub-economic that have a reasonable potential for becoming economically available within planning horizons beyond those that assume proven technology and current economics. existing, undedicated coal. The estimated recoverable reserve base stated herein was determined by Registrant's staff based upon the prior experience of Registrant in mining in the area of its present recoverable reserve base and upon data from tests conducted by Registrant, and represent coal which is recoverable on the basis of current mining practices and techniques, and Registrant's mining experience in the seams and area of Registrant's present recoverable reserve base. Consequently, Registrant's estimates are subject to continuing review and refinement. Registrant also owns coal lands in West Virginia, some of which are under lease to another, unrelated coal company. The leased reserves are near exhaustion. Registrant also subleases coal lands in West Virginia to another unrelated coal company. Patents and licenses are not material to the operation of Registrant's business. In order to acquire, and to determine the location and extent of, new sources of coal properties, Registrant has entered into option agreements with owners of coal lands in various parts of Pennsylvania. Under these agreements, Registrant obtains the right to explore for and, at its option, to acquire title by lease or purchase to the coal. Registrant has made no public announcement, nor has information otherwise become public, about any new product or line of business which would require the investment of a material amount of Registrant's total assets, other than the development of Leatherwood and the acquisition and development of Mine No. 84 and coal reserves as noted above. While a substantial capital investment may ultimately be made in development of Leatherwood's projects, the amount of such investment has not yet been determined. Registrant has made an equity investment in Eighty-Four and Lucerne Land of $100,000,000 (including the $53.6 million adjusted purchase price). Arrangements are in progress for $85,000,000 in long-term debt and for capital and operating leases to provide remaining funding requirements of the project. See also Notes B and D of the Notes to the Consolidated Financial Statements incorporated herein by reference. Registrant's business is subject to numerous state and federal statutes which establish strict standards with respect to mining health and safety and environmental consequences. In addition to prescribing civil and criminal penalties for violations, both the Federal Mine Safety and Health Act of 1977 and the Surface Mining Control and Reclamation Act of 1977 authorize the closure under certain circumstances of noncomplying operations. Pennsylvania statutes applicable to Registrant's mining operations are both more and less stringent than the federal statutes. Numerous federal and state laws and regulations, pertaining to the discharge of materials into the environment, impose requirements for capital expenditures in the normal course of mine development and for subsequent events which cause adverse environmental effects, irrespective of fault or willfulness by the mining company involved. These statutes have in the past and will in the future require substantial capital investments and may adversely affect productivity. Because of the inclusion of environmental related elements in the normal expenditures for mine development and operation, their costs cannot be precisely isolated but Registrant does not believe they have materially adversely affected Registrant's financial condition. See also Item 3 hereof. Both federal and state law and regulations impose sulphur emission standards, which will increase in stringency during the next several years, on uses of coal. However, substantially all of Registrant's coal is sold pursuant to the Keystone and Homer City Agreements, which contain no provisions warranting that the sulphur content of the coal will meet emission standards when burned. The impact of recent legislation on Registrant's business, especially the Clean Air Act Amendments of 1990, cannot be ascertained at this time. Registrant believes that improvements in clean coal technologies or in techniques to neutralize or treat emissions from generating stations are such that, with the benefit of such technologies, its coal will meet standards under currently enacted legislation. However, these amendments could have an adverse effect on the sales of coal to the Keystone Station and the Homer City Station (the "Stations"). Also, as described above, at the end of 1999 and any year thereafter, the Keystone Owners have the right to terminate the Keystone Agreement if it is unlawful or commercially impracticable, in light of then applicable government regulations, to operate the Keystone Station with the coal KCMC is able to produce. Moreover, in the event of the enactment of legislation or regulations imposing more stringent environmental standards on the Stations, Registrant could be adversely affected if the owners of the Stations purchased more coal from others or generate less electricity from these Stations. Fuel strategies adopted by utilities have yet to be announced. Environmental legislation and regulation may have an adverse effect on Registrant's ability to market its coal reserves not dedicated under existing contracts and may require modifications to the marketing plans of Eighty-Four. As indicated in the Consolidated Financial Statements incorporated herein by reference, Registrant has made substantial capital investments in the past three years. Inasmuch as a substantial portion of these investments has been for several purposes, e.g., to extend mine and equipment life, to increase productivity, and to comply with safety and/or environmental legislation, Registrant cannot indicate with precision capital investments required solely to comply with environmental and safety legislation. However, Registrant estimates such expenditures totalled approximately $2,600,000 in the five years ended December 31, 1993, and it is estimated that annual capital expenditures of approximately $1,600,000 per year for the next several years will be attributable to environmental and safety laws. Such legislation also adversely affected Registrant's deep mine productivity. While no assurance can be given that additional, more stringent mining and environmental legislation will not be enacted or that such legislation, if enacted, would not have a material adverse effect upon Registrant's operations, it should be noted that for coal sold under the Keystone and Homer City Agreements, Registrant's cost of compliance with such statutes is recovered from the Owners as a cost of production. However, should the cost of compliance as an element of production costs become burdensome, the competitive position and earnings of Registrant could be adversely affected. Registrant currently employs approximately 1,555 persons, of whom 1,400 are engaged directly in the production and processing of coal for sale and 155 are engaged in executive, administrative, engineering, exploration, sales, and clerical capacities. Registrant has approximately 1,120 employees who are covered by the National Bituminous Coal Wage Agreement of 1993 (the "1993 Agreement") with the UMWA, which, as noted above, was ratified on December 16, 1993 after a seven-month strike against BCOA member companies. The 1993 Agreement will terminate on or after August 1, 1998 by either party giving to the other party at least 60 days notice of the desired termination date. Additionally, the 1993 Agreement may be reopened at the election of the UMWA prior to the third and fourth anniversary dates for the sole purpose of renegotiating changes in wage rates and pension benefits. The 1993 Agreement may be reopened at the election of the UMWA or the BCOA prior to the third and fourth anniversary dates for the sole purpose of renegotiating changes in the health care bonus and annual health care deductible established under the 1993 Agreement. Registrant's business is not seasonal in any material respect. Registrant is engaged principally in a single line of business, the mining and sale of coal. The following table sets forth the amount of Registrant's sales contributed by each class of Registrant's products which accounted for more than 10% of Registrant's total sales during each of Registrant's three fiscal years ended December 31, 1993, 1992, and 1991. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. In the years ended December 31, 1993, 1992, and 1991, Registrant's subsidiary, Rochester & Pittsburgh Coal Co. (Canada) Limited, had sales of $8,093,174, $9,415,110, and $7,794,813, respectively, primarily to customers located in Canada. Registrant does not consider its sales of coal in Canada to be subject to any particular risks merely because its customers are located there. However, foreign business in general can be subject to special risks, including exchange controls, changes in currency valuations, restrictions on the repatriation of funds, restrictions on the ownership of foreign corporations or the composition of their boards of directors, export restrictions, the imposition or increase of taxes and tariffs, and international financial instability. No assurance can be given that any of these factors might not have an adverse effect on Registrant's future foreign operations. ITEM 2. ITEM 2. PROPERTIES. Registrant's executive and administrative offices are located in a 76,309 square foot building in Indiana, Pennsylvania, which it owns and which was extensively renovated and expanded in 1984. Registrant also owns approximately 39,900 acres of surface land in Pennsylvania. Registrant's subsidiaries lease various properties in the United States and Canada under leases having a current annual aggregate rental of approximately $229,000. These leases expire at various times over the next four years and the amount of aggregate rental payable during that period will depend on the extent of renewals. As indicated in Item 1 hereof, as of December 31, 1993, based upon the prior experience of Registrant in mining in the area of Registrant's operations and data from tests conducted by it and, in the case of the coal acquired from Bethlehem, a review of data provided by others and mining practices in the area and seam acquired, Registrant had an estimated recoverable reserve base in leased or owned properties in Indiana, Armstrong, Westmoreland, Washington and other nearby Pennsylvania counties of approximately 738,000,000 tons of coal. Substantially all of the coal leased by Registrant is leased until exhaustion. Registrant has not conducted sufficient tests to determine the degree to which reserves, if any, exist on its owned or leased properties located outside of Indiana, Armstrong, Westmoreland, Washington and other nearby Pennsylvania counties. Registrant operated nine underground mines in 1993. Information on the estimated recoverable reserves and production of these mines is as follows: - ---------------------- (1) These estimated proven and probable reserves which can be economically mined under current conditions are recoverable through existing mine openings and plant facilities and represent calculations based upon continuing refinement of estimates, and are rounded to the nearest thousand. "Proven Reserves" represent areas of the total reserve estimate which are within approximately 2,000 feet of an exploration drill hole or other known point. "Probable Reserves" represent areas of the total reserve estimate which are greater than 2000 feet from an exploration drill hole or other known point and when consideration is made for other factors, such as mining conditions, coal quality, and mine operating experience. (2) Operated by Helvetia Coal Company. (3) Operated by Keystone Coal Mining Corporation. (4) Operated by The Florence Mining Company. The Florence #2 and Heshbon Mines were transferred to the assignee of the Conemaugh Owners on October 29, 1991. (5) Tonnage figures represent clean coal after washing and preparation at the Florence Preparation Plant, at the Keystone Cleaning Plant or at Mine No. 84's preparation facilities. See also Item 1 hereof. (6) The 1991 figure represents production from "E" and "D" seam facilities, 120,672 and 303,354 tons, respectively. (7) Operated by Eighty-Four Mining Company Surface mining is also conducted by Registrant and by independent contractors utilized by Registrant, who are obligated by law and by contract with Registrant to restore the surface in accordance with Pennsylvania and federal laws. Production from surface mining for the last three years has been as follows: 1991--339,950 tons, 1992--91,921 tons and 1993--53,744 tons. All surface-mined coal produced in 1993 was sold on the commercial market. Registrant anticipates limited surface mining activity in the near future and, therefore, while Registrant is continuing to acquire additional coal properties suitable for surface mining, no assurance can be given that Registrant will be able to maintain adequate resources for surface-mined coal in the future. All of the properties of Registrant and its subsidiaries dedicated under the Keystone and Homer City Agreements are subject to mortgages given as security for indebtedness of Registrant's subsidiaries. See Note D to the Consolidated Financial Statements incorporated by reference herein. Registrant has miscellaneous other non-coal mineral interests, primarily natural gas, which it leases to unrelated parties. Registrant has expanded its role in the natural gas area by participating in joint ventures for 95 natural gas wells in Pennsylvania and nearby states during the past several years. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The nature of Registrant's business subjects it to numerous state and federal laws and regulations pertaining to environmental matters and administrative and judicial proceedings involving alleged violations thereof are considered incidental to Registrant's business. Registrant is not a party to any pending litigation which it deems material to its financial condition, although it is a party to litigation incidental to the conduct of its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Registrant did not submit any matters to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF REGISTRANT. Information on executive and other officers of Registrant as of February 28, 1994, is as follows: - -------------------- (1) Mr. Peter Iselin is the father of Mr. O'Donnell Iselin II, and the uncle of Mr. Gordon B. Whelpley, Jr., Directors of Registrant. Officers of Registrant are elected annually by the Board of Directors at its organization meeting following the Annual Meeting of Shareholders. Each of the officers of Registrant named above has held a position with Registrant or a subsidiary for the past five years with the exception of: Mr. Majcher who joined Registrant as Vice President--Corporate Development in January 1990. Prior to 1990, he had been Director--Planning (1989) BP Coal International, Director--Strategy Development (1988) BP America, Manager--Acquisitions & Divestitures (1987) The Standard Oil Company (Ohio), and Business Manager--Indiana Division (1986) Old Ben Coal Company, all subsidiaries of The British Petroleum Company, P.L.C. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The answer to this Item is incorporated by reference to Registrant's 1993 Annual Report to Shareholders, which is included as Exhibit (13) to this Form 10-K Report, at page 28. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The answer to this Item is incorporated by reference to Registrant's 1993 Annual Report to Shareholders, which is included as Exhibit (13) to this Form 10-K Report, at pages 24 and 25. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The answer to this Item is incorporated by reference to Registrant's 1993 Annual Report to Shareholders, which is included as Exhibit (13) to this Form 10-K Report, at pages 24 through 27. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The answer to this Item is incorporated by reference to Registrant's 1993 Annual Report to Shareholders, which is included as Exhibit (13) to this Form 10-K Report, at page 6, Report of Ernst & Young, Independent Auditors, at pages 7 through 23, and by reference to Item 14 hereof. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. During applicable time periods, Registrant has not changed accountants and has had no disagreements with its accountants on accounting and financial disclosure matters. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Except for information concerning executive officers of Registrant included as an unnumbered item in Part I above, information relating to the Directors of the Registrant is set forth under the caption "Directors and Nominees For Election as Director" in Registrant's definitive Proxy Statement in connection with its Annual Meeting of Shareholders to be held May 3, 1994. Such information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information relating to executive compensation is set forth under the caption "Executive Compensation" in Registrant's definitive Proxy Statement in connection with its Annual Meeting of Shareholders to be held May 3, 1994. Such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to the ownership of equity securities of the Registrant by certain beneficial owners and management is set forth under the caption "Beneficial Ownership of Common Stock" in Registrant's definitive Proxy Statement in connection with its Annual Meeting of Shareholders to be held May 3, 1994. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information relating to certain relationships and certain related transactions is set forth under the caption "Directors and Nominees For Election as Director" in Registrant's definitive Proxy Statement in connection with its Annual Meeting of Shareholders to be held May 3, 1994. Such information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements, Financial Statement Schedules and Exhibits: 1. Financial Statements The following consolidated financial statements of Rochester & Pittsburgh Coal Company and subsidiaries, included in the Annual Report of Registrant to its shareholders for the year ended December 31, 1993, are incorporated herein by reference in Item 8 (pages 7 through 23 and page 6): Consolidated balance sheets-- December 31, 1993, 1992, and 1991 Statements of consolidated income-- Years ended December 31, 1993, 1992, and 1991 Statements of consolidated shareholders' equity-- Years ended December 31, 1993, 1992, and 1991 Statements of consolidated cash flows-- Years ended December 31, 1993, 1992, and 1991 Notes to consolidated financial statements-- December 31, 1993 Report of independent auditors The following financial information for the years 1993, 1992, and 1991 is submitted herewith. All other schedules for Rochester & Pittsburgh Coal Company and subsidiaries for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits (3) Articles of Incorporation and By-laws A. Articles of Incorporation, as Amended. Registrant's Articles of Incorporation, as amended, were filed with Registrant's Annual Report on Form 10-K dated March 28, 1991. The Articles, as amended, are incorporated herein by reference. B. By-Laws of Registrant, as Amended. Registrant's By-Laws, as amended, were filed with Registrant's Annual Report on Form 10-K dated March 30, 1989. An Amendment to the By-Laws was filed with Registrant's Annual Report on Form 10-K dated March 28, 1991. The By-Laws, as amended, are incorporated herein by reference. (10) Material Contracts A. 1991 Keystone Coal Supply Agreement. The 1991 Keystone Coal Supply Agreement was filed as an exhibit to Registrant's Annual Report on Form 10-K dated March 28, 1991. The Agreement is incorporated herein by reference. B. Homer City Coal Sales Agreement, as Amended. The Homer City Coal Sales Agreement was filed with Registrant's Form 10 Registration Statement dated April 26, 1973. Amendments to the Homer City Coal Sales Agreement were filed with Registrant's Annual Report on Form 10-K dated March 26, 1981, and with Registrant's Annual Report on Form 10-K dated March 28, 1991. The Agreement and amendments are incorporated herein by reference. Executive Compensation Plans and Arrangements C. Employment and Deferred Compensation Agreement between Registrant and W. G. Kegel, as Amended. The Employment and Deferred Compensation Agreement between Registrant and W. G. Kegel was filed with Registrant's Annual Report on Form 10-K dated March 26, 1981. Amendments to Employment and Deferred Compensation Agreement were filed with Registrant's Annual Report on Form 10-K dated March 30, 1989. The Agreement and amendments are incorporated herein by reference. D. Registrant's Key Executives Incentive Compensation Plan. The Rochester & Pittsburgh Coal Company Key Executives Incentive Compensation Plan was filed with Registrant's Annual Report on Form 10-K dated March 26, 1992. The Plan is incorporated herein by reference. E. Registrant's Pension Plan, as Amended. Registrant's Pension Plan was filed with Registrant's Annual Report on Form 10-K dated February 25, 1988. Amendments to the Pension Plan were filed with Registrant's Annual Report on Form 10-K dated March 29, 1990, with Registrant's Annual Report on Form 10-K dated March 28, 1991, with Registrant's Annual Report on Form 10-K dated March 26, 1992, and with Registrant's Annual Report on Form 10-K dated March 25, 1993. The Plan and amendments are incorporated herein by reference. F. Employment Agreement between Registrant and T. W. Garges, Jr. Employment Agreement between Registrant and T. W. Garges, Jr. was filed with Registrant's Annual Report on Form 10-K dated March 30, 1989. The Agreement is incorporated herein by reference. G. Registrant's 401(k) Savings and Retirement Plan. Registrant's 401(k) Savings and Retirement Plan was filed with Registrant's Annual Report on Form 10-K dated March 28, 1991. The Plan is incorporated herein by reference. H. Employment Agreement between Registrant and Thomas W. Garges, Jr. Employment Agreement between Registrant and Thomas W. Garges, Jr., dated as of May 1, 1992, was filed with Registrant's Annual Report on Form 10-K dated March 25, 1993. The Agreement is incorporated herein by reference. I. Asset Purchase Agreement Between Bethlehem Steel Corporation and Lucerne Land Company. The Asset Purchase Agreement between Bethlehem Steel Corporation and Lucerne Land Company, dated December 20, 1992, was filed with Registrant's Current Report on Form 8-K dated January 13, 1993. The Agreement is incorporated herein by reference. J. Asset Purchase Agreement Between BethEnergy Mines Inc. and Lucerne Land Company. The Asset Purchase Agreement between BethEnergy Mines Inc. and Lucerne Land Company dated December 10, 1992 was filed with Registrant's Current Report on Form 8-K dated January 13, 1993. The Agreement is incorporated herein by reference. K. Asset Purchase Agreement between Bethlehem Steel Corporation and Eighty-Four Mining Company. The Asset Purchase Agreement between Bethlehem Steel Corporation and Eighty-Four Mining Company dated December 10, 1992 was filed with Registrant's Current Report on Form 8-K dated January 13, 1993. The Agreement is incorporated herein by reference. L. Asset Purchase Agreement between BethEnergy Mines Inc. and Eighty-Four Mining Company. The Asset Purchase Agreement between BethEnergy Mines Inc. and Eighty-Four Mining Company dated December 10, 1992 was filed with Registrant's Current Report on Form 8-K dated January 13, 1993. The Agreement is incorporated herein by reference. (13) Annual Report To Security Holders The following sections of the accompanying Rochester & Pittsburgh Coal Company Annual Report 1993, [filed as Exhibit (13) to this Annual Report on Form 10-K] comprising the respective pages indicated in parentheses, are incorporated herein by reference: (i) Market for Registrant's Common Equity and Related Stockholder Matters (page 28). (ii) Selected Financial Data (pages 24 and 25). (iii) Management's Discussion and Analysis of Financial Condition and Results of Operations (pages 24 through 27). (iv) Financial Statements and Supplementary Data (page 6, Report of Ernst & Young, Independent Auditors, and pages 7 through 23). Except as expressly incorporated by reference, the accompanying Rochester & Pittsburgh Coal Company Annual Report 1993 is not to be deemed filed herewith. (21) Subsidiaries of the Registrant Registrant's list of subsidiaries [filed as Exhibit (21) to this Annual Report on Form 10-K]. (b) Reports on Form 8-K: None. (c) Exhibits to this Form 10-K: Page ---- Exhibit (13) -- Annual Report to Shareholders for 1993 41 Exhibit (21) -- Subsidiaries of Registrant 73 (d) Financial Statement Schedules Page ---- Schedule I -- Marketable Securities-- other investments 29 Schedule V -- Property, plant and equipment 30 Schedule VI -- Accumulated depreciation, depletion and amortization of property, plant and equipment 31 Schedule VIII -- Valuation and Qualifying Accounts 32 Schedule IX -- Short-term borrowing 33 Schedule X -- Supplementary income statement information 34 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. ROCHESTER & PITTSBURGH COAL COMPANY By: THOMAS W. GARGES, JR. Thomas W. Garges, Jr., President and Chief Executive Officer Date: March 24, 1994 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 date indicated. ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) and (2) and ITEM 14(c) and (d) FINANCIAL STATEMENTS AND FINANCIAL STATEMENTS SCHEDULES YEAR ENDED DECEMBER 31, 1993 ROCHESTER & PITTSBURGH COAL COMPANY INDIANA, PENNSYLVANIA ERNST & YOUNG One Oxford Centre Phone: 412-644-7800 Pittsburgh, Pennsylvania 15222 REPORT OF INDEPENDENT AUDITORS To the Shareholders Rochester & Pittsburgh Coal Company We consent to the incorporation by reference in this Annual Report (Form 10-K) of Rochester & Pittsburgh Coal Company and subsidiaries of our report dated March 11, 1994, included in the 1993 Annual Report to Shareholders of Rochester & Pittsburgh Coal Company and subsidiaries. Our audits also included the financial statement schedules of Rochester & Pittsburgh Coal Company listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Ernst & Young March 11, 1994 FINANCIAL STATEMENT SCHEDULES ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES DECEMBER 31, 1993 SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES December 31, 1993 (Dollars in thousands) SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES (DOLLARS IN THOUSANDS) (1) Additions related principally to the purchase of and expansion and equipping of mines, and for the 1992 purchase of the Mine No. 84 properties. (2) Represents net change for the year. (3) Represents cost of development net of sales revenue from coal produced incidental to development, and includes $3,993 of depreciation charged to capitalized development. (4) Property, plant, and equipment included in the sale of The Florence Mining Company in October, 1991. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES (Dollars in thousands) (1) Includes $3,993 of depreciation charged to Mine No. 84 capitalized development costs. (2) Accumulated depreciation and depletion included in the sale of The Florence Mining Company in October, 1991. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES (Dollars in thousands) (1) Interest earned on funds invested to meet reserve requirements. (2) Expense incurred to satisfy previously reserved requirements. (3) Deductions from the mine closing reserve in 1991 include $1,325 of expenses incurred to satisfy previously reserved requirements and $10,958 related to the sale of The Florence Mining Company in October, 1991. (4) Of this amount, $1,057 represents interest earned on funds invested to meet reserve requirements, and $1,500 represents estimated mine closing obligations assumed with the purchase of Mine No. 84 properties in December 1992. SCHEDULE IX - SHORT-TERM BORROWINGS ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES (Dollars in thousands) (1) Notes payable to bank represent borrowings under a line of credit borrowing arrangement which is in effect until September 30, 1995. Thereafter, annual extensions may be requested. (2) The average amount outstanding during the period was computed by dividing the total daily outstanding principal balances by 360. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION ROCHESTER & PITTSBURGH COAL COMPANY AND SUBSIDIARIES (Dollars in thousands) Amounts for depreciation and amortization of intangible assets, preoperating costs and similar deferrals, royalties, and advertising costs are not presented as such amounts are less than 1% of total sales and revenues. SECURITIIES AND EXCHANGE COMMISSION Washington, D.C. 20549 EXHIBITS to FORM 10-K Annual Report Under The Securities Exchange Act of 1934 ROCHESTER & PITTSBURGH COAL COMPANY (Exact name of registrant as specified in its charter) 3. Exhibits Page (13) Annual Report to Shareholders for 1993 (21) Subsidiaries of Registrant	7,768	51,468
853436_1993.txt	853436_1993	1993	853436	ITEM 2. PROPERTIES Momentum's executive offices, which are leased, are located at Koll Center Bellevue, Suite 1900, 500 108th Avenue N.E. Bellevue, Washington 98004. Principal properties are summarized as follows: Momentum believes that its facilities are well suited to its business needs and are adequate to accommodate its current business and expected growth for the next two years. It is not anticipated there will be any difficulty in acquiring and/or leasing additional facilities as and when needed. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Momentum is involved in various contractual, personal injury and general liability cases and claims which are considered normal to its business. In the opinion of Management, these claims, when finally concluded, will not have a material adverse impact on the consolidated financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTER TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the year. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of Momentum is traded on the Over-The-Counter NASDAQ National Market System under the symbol: MMDI. The number of common shareholders of record as of March 24, 1994, was 1,502. The prices below reflect closing prices for Momentum as reported by NASDAQ for the years ended December 31: (Prices have been adjusted to reflect the three-for-one stock split in July, 1992) No cash dividends have been declared since incorporation. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL In September 1993, the Company sold its Textiles Group composed of VWR Textiles & Supplies Inc. and Momentum Textiles Inc. The financial statements have been restated to report the Textiles Group as discontinued operations. Accordingly, the following discussion and analysis is for the continuing operations. Two subsequent events, when completed, will have a significant impact on the future of the Company, and accordingly, the applicability of the current results to future periods. As described under Part I, Item I, Business, the Company has signed two agreements in principle, one to buy the assets of T.K. Gray, Inc., a regional distributor of photographic and graphic arts supplies and equipment, with sales in excess of $40 million, and a second to combine with Phillips & Jacobs, Incorporated, a national distributor of photographic and graphic arts supplies and equipment, with sales in excess of $160 million. Due to the significance of these transactions, the analysis of 1993 and applicability of 1993 to subsequent periods may be of limited value. COMPARISON OF 1993 TO 1992 Sales in 1993 were $116.8 million or 4% greater than 1992. Sales were hampered by an 8% decrease in sales on the west coast, which was strongly impacted by the weak California economy and a contraction in demand for reprographic and professional photographic products in the defense industry. Sales excluding the west coast locations increased by almost 9% for the year. This gain is primarily attributable to strong sales growth of electronic-prepress systems. The gross margin percentage decreased from 19.6% to 19.3%, primarily due to competitive price pressure and changes in product mix. Selling and administrative expenses increased 8% between years. This increase, which was higher than the sales growth, was primarily due to increased sales and marketing expenses. During the year, the Company replaced the traditional sales structure with a team of sales and technical specialists, which will better meet customer requirements as the graphics industry goes through the current period of rapid technological changes. This restructuring resulted in increased fixed costs, but with an ongoing decrease in variable costs. Thus, in the future, as the Company's sales volume increases, the incremental sales and marketing expenses should increase at a slower rate. In 1993, the Company incurred $2.4 million in restructure and other charges. One million was incurred for the restructure of the sales and marketing function as discussed above. These costs were primarily for employee severance and relocation costs. In addition, computer equipment of $.8 million was written-off as a result of the Company's decision to replace this equipment with new more efficient and cost effective equipment. The balance of the charge, $.6 million, represents salaries and benefits applicable to positions which have been eliminated as a result of the divestiture of the Textiles Group. Similar charges for 1992 amount to $.6 million for salaries and benefits applicable to positions which have been eliminated as a result of the divestiture of the Textiles Group. The full benefit of the restructure and other charges will not occur until 1994. Interest expense decreased $144,000 or 26% in 1993. This decrease was primarily due to the repayment of the Company's revolving debt with the proceeds from the sales of the Textiles Group. The effective tax rate for both 1993 and 1992 approximated the statutory federal rate of 34%. COMPARISON OF 1992 TO 1991 Sales increased 15% in 1992 to $112 million. This growth was primarily the result of increased penetration in the market. The gross margin percentage remained constant between years at 19.6%. Selling and administrative expenses increased 5%. Due to the significant sales growth and relationship of fixed to variable expenses selling and administrative expenses as a percent of sales decreased from 22.4% to 20.4%. Interest expense decreased $131,000 or 19% in 1992. This decrease was primarily due to a reduction of interest rates charged under the revolving credit agreements. Restructure and other charges of $.6 million in 1992 and 1991 represent salaries and benefits applicable to positions which have been eliminated as a result of the divestiture of the Textiles Group. The effective tax rate for both years approximated the statutory federal rate of 34%. FINANCIAL CONDITION AND LIQUIDITY The Company had negative cash flow from operations of approximately $1.6 million in 1993 which was primarily due to an increase in income taxes receivable which will be recovered in 1994 as refunds. Investing activities consisted of $17.1 million in cash proceeds from the sale of the discontinued operations offset by additions to property and equipment and other assets of $3.1 million. Financing activities resulted in a net cash outflow of $7 million. This was primarily the result of using funds from the sales of the discontinued operations to pay off the outstanding balances under the Company's revolving credit agreements. The Company's primary source of debt financing is two revolving credit agreements, with a total commitment of $17.5 million, subject to certain covenant restrictions. Both agreements expire in January, 1995. At December 31, 1993, there was no outstanding debt under these agreements. At December 31, 1993, the Company had over $6 million in short-term investments. These funds combined with available bank financing and payments from outstanding notes receivable will be adequate to fund on-going operations and the expansion of these operations both internally and through acquisitions. During inflationary times, the Company's prices generally rise in tandem with costs. Operating results partially provide for the effects of inflation by using LIFO inventory accounting, so that the cost of sales generally reflects the most recent cost of the inventory sold. Asset values are based upon historical costs that do not necessarily represent either replacement costs or result in charges to operations based on replacement costs; however, since the Company is not capital intensive, it is the Company's opinion that charging operations for replacement costs of long-lived assets would not significantly reduce income from operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MOMENTUM CORPORATION AND SUBSIDIARY Consolidated Statements of Operations See Notes to Consolidated Financial Statements MOMENTUM CORPORATION AND SUBSIDIARY Consolidated Balance Sheets See Notes to Consolidated Financial Statements MOMENTUM CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows See Notes to Consolidated Financial Statements MOMENTUM CORPORATION AND SUBSIDIARY Consolidated Statements of Shareholders' Equity See Notes to Consolidated Financial Statements MOMENTUM CORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The accompanying consolidated financial statements include the accounts of Momentum Corporation (the Company/Momentum) and its wholly owned subsidiary, Momentum Graphics Inc. Material intercompany balances and transactions have been eliminated. DISCONTINUED OPERATIONS The consolidated financial statements for 1992 and prior have been restated to show the Textiles Group, VWR Textiles & Supplies Inc. and Momentum Textiles Inc., as discontinued operations. As further described in the following Notes to Consolidated Financial Statements, this group was sold in September, 1993. CASH AND CASH EQUIVALENTS For purposes of the cash flow statement, the Company considers investments which have an original maturity of three months or less to be cash equivalents. In addition, the Company's cash management system operates so that a cash overdraft for uncleared checks exists in the disbursing account. To the extent the outstanding balance for uncleared checks exceeds the cash balances, the net balance is reported as a current liability on the balance sheet and is included as cash and cash equivalents on the cash flow statement. SHORT-TERM INVESTMENTS The Company invests idle funds in short-term investments, with maturities of three months or less. The Company records these investments at cost which approximates market. All investments are in investment grade commercial paper. CAPITALIZATION, DEPRECIATION AND AMORTIZATION Property and equipment are recorded at cost. Expenditures for maintenance and repairs are expensed as incurred. Depreciation is computed using the straight-line method for financial reporting purposes and, generally, using accelerated methods for income tax purposes. Capital leases are included under property and equipment with the corresponding amortization included in depreciation. The related financial obligations under the capital leases are included in long-term obligations. INCOME (LOSS) PER SHARE Income (loss) per share is based on the weighted average number of shares and dilutive common share equivalents outstanding during the year. Common stock equivalents related to stock options have not been considered in computing the loss per share for 1991 as the effect is antidilutive. The weighted average number of shares outstanding were 3,629,089, 3,492,568, and 3,422,310 for the years ended December 31, 1993, 1992 and 1991, respectively. Shares outstanding include shares held by the Momentum Employee Stock Ownership Plan. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk, as defined by Financial Accounting Standards Board Statement No. 105, are primarily accounts receivable. Concentrations of credit risk with respect to the receivables are limited due to the large number of customers in the Company's customer base, and their dispersion across different industries and geographic areas. The Company maintains an allowance for losses based upon the expected collectibility of all accounts receivable. RECLASSIFICATION Certain prior year amounts have been reclassified to conform with current year presentation. INVENTORIES Inventories consist primarily of purchased goods for sale. Substantially all of the Company's inventories are valued at lower of cost or market using the last-in, first-out (LIFO) method of accounting. Inventories at current costs exceed those reported under the LIFO method by approximately $2.2 million at December 31, 1993 and $2.4 million at December 31, 1992. PROPERTY AND EQUIPMENT Net property and equipment at December 31 consisted of: LONG-TERM OBLIGATIONS AND REVOLVING CREDIT AGREEMENTS The long-term obligations of the Company at December 31 consisted of: Maturities of long-term obligations for each of the five years beginning January 1, 1994 are as follows: The Company has two unsecured revolving credit agreements, with a total commitment of $17.5 million. Under the terms of these agreements, the Company can borrow under several options including rates tied to prime, certificate of deposit, and LIBOR. The approximate weighted average interest rates were 5.0%, 5.8% and 7.3% for 1993, 1992, and 1991, respectively. One of the revolving credit agreements provides for conversion of up to $5 million of the line into term loans with a maximum term period extending to March, 1997. Among other provisions, the revolving credit agreements include various limitations on working capital, tangible net worth, current ratio, debt to equity and cash flow to interest expense. Under the most restrictive of these terms, none of the Company's shareholders' equity would have been available for cash dividends in 1993. Under the terms of a March, 1990 agreement with the Company's former parent company, VWR Corporation (VWR), VWR is obligated through February, 1995 to make available to the Company an unsecured subordinated revolving line of credit of approximately $5 million. At December 31, 1993, the Company had no outstanding debt under this agreement. Under terms of its insurance policies and claims handling agreements, the Company is required to maintain certain standby letters of credit. At December 31, 1993 these totaled approximately $1,500,000. INCOME TAXES Income tax benefit for the years ended December 31 consisted of: Reconciliation of the statutory Federal tax benefit to the actual tax benefit for the years ended December 31 consisted of: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the deferred tax assets and liability at December 31, consisted of: (Thousands of dollars) 1993 1992 - -------------------------------------------------------------------------------- PENSION AND OTHER EMPLOYEE BENEFITS PENSION PLANS The Company has a defined benefit pension plan (the Plan/pension plan) covering substantially all employees. Pension benefits are based on years of credited service and highest five consecutive years average compensation. Contributions to the Plan are based on funding standards established by the Employee Retirement Income Security Act of 1974 (ERISA). The Plan's funded status and the amounts recognized in the Company's consolidated balance sheet at December 31 were: The assets of the Plan consist predominantly of undivided interests in several funds structured to duplicate the performance of various stock and bond indexes. The net pension asset is included in other current assets and other assets. The assumptions used for computing the net pension asset were: Net pension expense for the years ended December 31 included the following components: Net pension expense includes pension expense applicable to discontinued operations of approximately $123,000, $88,000, and $117,000 for 1993, 1992, and 1991, respectively. In calculating the net pension expense, an expected long-term rate of return on plan assets of 10% was used for 1993, 1992, and 1991. The Company maintains a supplemental pension plan for certain senior officers. Expenses for this plan were $34,000, none, and $18,000 for 1993, 1992, and 1991, respectively. RESTRICTED STOCK AWARDS Under the Company's 1989 Long-term Incentive Stock Plan, the Company provides for grants of restricted Company common stock to directors, officers and managers. The vesting periods on the stock range from two to four years. The fair market value of the stock at the date of grant establishes the compensation amount which is amortized to operations over the restricted period. During 1993, 107,190 shares were granted at a fair market value of $731,000. At December 31, 1993, the unamortized balance of the restricted stock awards was approximately $301,000, as shown in the shareholders' equity section of the consolidated balance sheets. STOCK OPTIONS Under stock option plans (vesting over one to ten years), options have been granted to certain officers and managers to purchase common stock of the Company at its fair market value at the date of grant. Changes in options outstanding for the three years ended December 31, 1993 are: Options exercisable at December 31, 1993, were 74,302. Under the Company's 1989 Long-term Incentive Stock Plan, approximately 223,000 shares of the Company's common stock has been reserved for issuance under various stock option and award plans. MOMENTUM MONEY-MAKER 401(K) RETIREMENT PLAN The Momentum Money-Maker 401(k) Retirement Plan (Money-Maker) is a voluntary savings plan available to all employees covered under the Company pension plan. Company matching contributions, if any, are determined by the Board of Directors based on the historical performance of the Company. The Company's expense for the Money-Maker was approximately $35,000, $56,000 and $122,000 for 1993, 1992, and 1991, respectively. MOMENTUM EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) The ESOP was established in 1990 as a means to provide employees with increased ownership in the Company. All full time employees with one year of service are eligible to participate. Total shares to be allocated to the employees for each year is determined by the Board of Directors based on the performance of the Company, with a minimum contribution each year of 30 shares to each employee. The Company's expense for the ESOP, based on the shares allocated or to be allocated to the employees' accounts, was approximately $40,000, $37,000 and $47,000 in 1993, 1992, and 1991 respectively. The ESOP held 103,591 unallocated shares of the Company's common stock at December 31, 1993, including 6,770 shares earned in 1993 but not allocated until 1994. The ESOP acquired the Company's common stock by issuing a note to the Company. The balance of the note is shown as a reduction of shareholders' equity on the consolidated balance sheets. The repayment of the note and the accompanying interest is made by a contribution in the form of a forgiveness of the debt by the Company as the shares are allocated to the employees' accounts. LEASES The Company leases various facilities and equipment under non-cancellable lease arrangements. The major leases are for terms of three to ten years. Renewal and purchase options are available on certain of these leases. Future minimum lease payments as of December 31, 1993 under non-cancellable operating leases, having initial lease terms of more than one year are: Rent expense, net of non-cancellable sublease rentals, was approximately $1.1, $1.6 and $1.6 million for 1993, 1992, and 1991, respectively. RESTRUCTURE AND OTHER CHARGES The Company incurred restructure and other charges of $2,382,000, $619,000 and $553,000 for 1993, 1992 and 1991, respectively. For 1993, the expense includes (a) $1 million for the restructuring of the sales and marketing function, which is composed predominantly of employee severance and relocation costs; (b) $800,000 for the write-off of computer hardware; and (c) $582,000 for employee salaries and benefits applicable to positions which have been eliminated as a result of the divestiture of the Textiles Group. For 1992 and 1991, the expense represents the portion of the salaries and benefits applicable to positions which have been eliminated as a result of the divestiture of the Textiles Group. DISCONTINUED OPERATIONS In September 1993, the Company sold its Textiles Group composed of VWR Textiles & Supplies Inc. and Momentum Textiles Inc. The net proceeds on the sales were $20.5 million, including $3.4 million in short-term notes receivable. The consolidated financial statements show the Textiles Group as discontinued operations. Net sales of the Textiles Group were $60,511,000 for the period ended September 30, 1993 and $82,300,000 and $68,102,000 for the years 1992 and 1991, respectively. Interest expense, which included interest on debt assumed by the buyers and an allocation of interest on other debt based on the average net assets of the discontinued operations to the consolidated net assets, was $238,000, $356,000, and $198,000 for 1993, 1992, and 1991, respectively. Income tax expense for discontinued operations was $841,000 for the period ended September 30, 1993 and $1,439,000 and $799,000 for the years 1992 and 1991, respectively. Income tax expense on the gain on the sales was $3,913,000. SUBSEQUENT EVENTS ACQUISITION On February 17, 1994, the Company signed an agreement in principle to acquire the assets of T.K. Gray, Inc. (Gray), a regional distributor of photographic and graphic arts supplies and equipment, for a purchase price in excess of $14 million, predominantly in cash. The acquisition, which is expected to be accounted for as a purchase, is subject to the execution of a definitive agreement, receipt of customary regulatory approval, and satisfactory completion of due diligence investigations. Completion of the acquisition is anticipated in April, 1994. COMBINATION On March 17, 1994, the Company signed an agreement in principle to form a new holding company and combine, in a tax-free reorganization, with Phillips & Jacobs, Incorporated (P&J), a national distributor of photographic and graphic arts supplies and equipment. P&J common stock is traded on the NASDAQ National Market System and is headquartered in Pennsauken, N.J. Under the agreement, each share of outstanding P & J common stock will be exchanged for one share of the new company. Each share of Momentum common stock will be exchanged for .71 shares of the new company. The combination is subject to the execution of a definitive agreement, the approval of the stockholders of both Momentum and P&J, satisfactory completion of due diligence investigations by both parties, receipt of customary regulatory approvals, and satisfaction of certain other standard conditions. QUARTERLY FINANCIAL DATA (UNAUDITED) (1) Income from discontinued operations for the third quarter of 1993 includes the gain on the sales of the discontinued operations of $6,146,000 ($1.69 per share). (2) Due to changes in the outstanding shares during the year, the sum of the quarterly income (losses) per share for 1993 will not equal the loss per share for the year. REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Momentum Corporation We have audited the accompanying consolidated balance sheets of Momentum Corporation and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Momentum Corporation and subsidiary at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. BY (SIGNATURE) ERNST & YOUNG Seattle, Washington March 8, 1994 (except for the subsequent event note regarding combination, as to which the date is March 17, 1994) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from the definitive proxy statement to be filed with the Securities and Exchange Commission by April 30, 1994, except information regarding executive officers which appears under Part I. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the Registrants' definitive proxy statement to be filed with the Securities and Exchange Commission by April 30, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the Registrants' definitive proxy statement to be filed with the Securities and Exchange Commission by April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the Registrants' definitive proxy statement to be filed with the Securities and Exchange Commission by April 30, 1994. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------------------------------------------------------------------------- (a)(1) Financial Statements The following financial statements have been included as part of this report: Form 10-K Page ---- Consolidated Statements of Operations 8 Consolidated Balance Sheets 9 Consodated Statements of Cash Flows 10 Consolidated Statements of Shareholders' Equity 11 Notes to Consolidated Financial Statements 12 Report of Independent Auditors 20 (2) Financial Statement Schedule (a) The following financial statement schedules are submitted herewith: -Schedule I Marketable Securities - Other Investments -Schedule VIII Valuation of Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (b) Reports on Form 8-K No Forms 8-K were filed for the Registrant during the fourth quarter covered by this report. (c) Exhibits The required exhibits are included at the back of this Form 10-K and are described in the Exhibit Index immediately preceding the first exhibit. MOMENTUM CORPORATION AND SUBSIDIARY SCHEDULE I -- MARKETABLE SECURITIES SCHEDULE VIII -- VALUATION OF QUALIFYING ACCOUNTS (1) Uncollectible accounts written-off, net of recoveries MOMENTUM CORPORATION AND SUBSIDIARY SIGNATURES Pursuant to the requirements of Section 13 or 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. MOMENTUM CORPORATION AND SUBSIDIARY Date March 29, 1994 BY (SIGNATURE) John H. Goddard, Jr. President Chief Executive Officer (principal executive officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on the behalf of the registrant and in the capacities and on the dates indicated. Date March 29, 1994 BY (SIGNATURE) Patsy R. Turnipseed Senior Vice President Chief Financial Officer (principal financial and accounting officer) DIRECTORS Richard E. Engebrecht } John C. Dimmer } John H. Goddard } Jerrold B. Harris } Gary MacLeod } BY (SIGNATURE} Andrew V. Smith } Patsy R. Turnipseed William K. Street } Attorney in fact James H. Wiborg } Power of Attorney dated February 22, 1994 Date: March 29, 1994 EXHIBIT INDEX EXHIBIT NUMBER AND DESCRIPTION * Management contracts and/or compensatory plans, contracts or arrangements in which a director and/or an executive officer participates.	4,322	28,670
752290_1993.txt	752290_1993	1993	752290	Item 1. Business General Unimar Company (the Company) was organized as a general partnership in 1984 under the Texas Uniform Partnership Act. The partners are LASMO (Ustar), Inc. (Ultrastar), a Delaware corporation and an indirect, wholly owned subsidiary of LASMO plc (LASMO), a public limited company organized under the laws of England, and Unistar, Inc. (Unistar), a Delaware corporation and a direct subsidiary of Union Texas Petroleum Holdings, Inc. (UTPH), a Delaware corporation. UTPH is approximately 38 percent owned by two partnerships controlled by an affiliate of Kohlberg Kravis Roberts & Co. (KKR) with the remaining outstanding common stock publicly held. The Company's sole business is its ownership of ENSTAR Corporation (ENSTAR) which, through its wholly-owned subsidiaries, Virginia International Company (INTERNATIONAL) and Virginia Indonesia Company (VICO), has a 23.125 percent working interest in, and is the operator of, a joint venture (the Joint Venture) for the exploration, development and production of oil and natural gas (gas) in East Kalimantan, Indonesia, under a production sharing contract (Production Sharing Contract or PSC) with Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina), the state petroleum enterprise of the Republic of Indonesia. The majority of the revenue derived from the Joint Venture results from the sale of liquefied natural gas (LNG). Currently, the LNG is sold principally to utility and industrial companies in Japan, Taiwan and Korea. See "The Joint Venture" below. The principal executive offices of the Company are at 1221 McKinney, Suite 600, Houston, Texas 77010 and its telephone number is (713) 654-8550. A Management Board consisting of six members, three appointed by each partner, exercises management, budgeting and financial control of the Company. As of December 31, 1993, VICO, in its capacity as the Joint Venture operator, had approximately 2,130 employees in the United States and Indonesia. The Company presently does not have any other employees. All aspects of the Company's business that are not associated with the management of the Joint Venture, such as operations, legal, accounting, tax and other management functions, are supplied by employees of the partners in accordance with management agreements. The Company can give no assurance as to the future trend of its business and earnings, or as to future events and developments that could affect the Company in particular or the oil industry in general. These include such matters as environmental quality control standards, new discoveries of hydrocarbons, and the demand for petroleum products. Furthermore, the Company's business could be profoundly affected by future events including price changes or controls, payment delays, increased expenditures, legislation and regulations affecting the Company's business, expropriation of assets, renegotiation of contracts with foreign governments, political instability, currency exchange and repatriation losses, taxes, litigation, the competitive environment, and international economic and political developments including actions of members of the Organization of Petroleum Exporting Countries (OPEC). See Item 7 - Management Discussion and Analysis of Financial Condition and Results of Operations. Description of the Company's Indonesian Participating Units (a) Market information. The Company's Indonesian Participating Units (IPUs) are listed for trading on the American Stock Exchange under the symbol "UMR." The following table shows the reported high and low sales prices of the IPUs on a quarterly basis: INDONESIAN PARTICIPATING UNITS' PRICE RANGE First Qtr. Second Qtr. Third Qtr. Fourth Qtr. High 9-1/8 10-1/4 9-3/4 9-1/2 Low 6-7/8 8-1/4 8-5/8 8-1/4 High 8 6-1/2 7 7-5/8 Low 5 5-1/4 5-3/4 6-3/8 Source of prices: American Stock Exchange (b) Holders. As of March 1, 1994, 10,778,590 IPUs were outstanding and held by approximately 4,301 holders of record. (c) Payments per Indonesian Participating Unit. Period Payment Date Payment First Quarter - 1992 June 1, 1992 0.35 Second Quarter - 1992 August 31, 1992 0.37 Third Quarter - 1992 November 30, 1992 0.54 Fourth Quarter - 1992 March 1, 1993 0.44 First Quarter - 1993 June 1, 1993 0.46 Second Quarter - 1993 August 30, 1993 0.28 Third Quarter - 1993 November 29, 1993 0.45 Fourth Quarter - 1993 March 1, 1994 0.38 Each IPU entitles the holder thereof to receive until September 25, 1999, a payment (Participation Payment) for any quarterly period equal to the product of (i) a fraction, the numerator of which is 1 and the denominator of which is equal to the number of IPUs outstanding on the last business day of such quarterly period, multiplied by (ii) the amount by which cumulative Net Cash Flow (as defined below) through the end of such quarterly period exceeds the aggregate amount of all preceding Participation Payments in respect of all IPUs. If Net Cash Flow is zero or negative for any quarterly period, no Participation Payment for that quarter will be made. The amount of Net Cash Flow for any quarterly period is equal to the product of (i) a fraction, the numerator of which is equal to the number of IPUs outstanding on the last business day of such quarterly period, and the denominator of which is 14,077,747, multiplied by (ii) 32 percent of (a) all cash actually received in the United States by INTERNATIONAL and VICO (for purposes hereof, the Special Subsidiaries) during such quarterly period from their aggregate 23.125 percent interest in the Joint Venture (or actually received by them outside the United States if they voluntarily elect not to repatriate such cash) minus (b) an amount equal to the sum of (A) the aggregate amount of all accruals or expenditures made by the Special Subsidiaries during such quarterly period as a result of their interest in the Joint Venture, (B) foreign or domestic taxes paid by the Special Subsidiaries, (C) any award, judgment or settlement and related legal fees incurred by the Special Subsidiaries, (D) certain operating expenses incurred by the Special Subsidiaries, and (E) the amortization of capitalized advances made by the Special Subsidiaries for certain major capital expenditures, together with interest thereon. Participation Payments for any quarterly period will be paid 60 days in arrears to holders of record on the date 45 days after the last day of the period. Participation Payments of less than $0.01 per IPU for any quarterly period will be accumulated and paid when Participation Payments in any succeeding quarter, together with previously unpaid amounts, exceed $0.01 per IPU. Units of Measure Restatement In order to better conform the Company's disclosures to those of its partners, the definition of a Net Equivalent Cargo and MCF have been revised. All relevant disclosures relating to prior years have been restated to conform to these two new definitions. Net Equivalent Cargo (NEC) In prior years one NEC equaled the quantity of LNG delivered for the Joint Venture's 97.9 percent interest in a 1973 Sales Contract shipment or any average of 2,873 BBTUs of gas. The definition of a NEC has now been changed to the quantity of LNG delivered in a 1973 Sales Contract shipment or an average of 2,942 BBTUs. MMCF of Gas In prior years an MMCF of gas was referred to as "wet gas" which contained residual amounts of condensate. This definition has been changed to "dry gas" after any residual condensate has been removed. As an example, approximately 3.1 billion cubic feet of wet gas are required to produce 2.9 trillion BTUs of LNG; whereas, approximately 3.0 billion cubic feet of dry gas are required to produce 2.9 trillion BTUs of LNG. BUSINESS The Joint Venture The Joint Venture participants are INTERNATIONAL (15.625%), VICO (7.5%), LASMO Sanga Sanga Limited (an indirect subsidiary of LASMO formerly called Ultramar Indonesia Limited) (26.25%), Union Texas East Kalimantan Limited (an indirect subsidiary of UTPH) (26.25%), and Universe Gas & Oil Company, Inc. (a subsidiary of a consortium led by Japan Petroleum Exploration Co., Ltd.) (4.375 %). In addition, Opicoil Houston, Inc. (an affiliate of the Chinese Petroleum Corporation) holds a 16.67 percent equity interest and a 20 percent voting interest, with the remaining 3.33 percent non-voting equity interest held by assignees of Opicoil Houston, Inc. VICO in its capacity as the Joint Venture operator conducts exploration and development activities within the PSC area. The cost of such activities is funded by the Joint Venture participants. The vote of participants holding 66-2/3 percent of the total ownership is generally required for approval of significant matters pertaining to the Joint Venture. Terms of Production Sharing Contract Under a PSC with Pertamina that was amended and extended in 1990 until August 7, 2018, the Joint Venture is authorized to explore for, develop, and produce petroleum reserves in an approximate 1.4 million acre area in East Kalimantan. In accordance with the requirements of the PSC, during 1991, the Joint Venture selectively relinquished approximately 10 percent of the PSC area. The Joint Venture must relinquish 10 percent of the PSC area by April 23, 1994; 10 percent by August 7, 1998; 10 percent by December 31, 2000; 15 percent by December 31, 2002 and 15 percent by December 31, 2004. However, the Joint Venture is not required to relinquish any of the PSC area in which oil or gas is held for production. Additionally, pursuant to the terms of the PSC, the Joint Venture, having produced 185 million barrels of oil, paid Pertamina a $5 million non-cost recoverable bonus in March 1993. Under the PSC, the Joint Venture participants are entitled to recover cumulative operating and certain capital costs out of the crude oil, condensate and gas produced each year, and to receive a share of the remaining crude oil and condensate production and a share of the remaining revenues from the sale of gas on an after-Indonesian tax basis. The method of recovery of capital costs is a system of depreciation and amortization that is similar to U.S. tax accounting methods. The share of revenues from the sale of gas after cost recovery through August 7, 1998 will remain at 35 percent to the Joint Venture after Indonesian income taxes and 65 percent to Pertamina. The split after August 7, 1998, will be 25 percent to the Joint Venture after Indonesian income taxes and 75 percent to Pertamina for gas sales under the 1973 and 1981 LNG Sales Contracts, Korean carryover quantities and the seven 1986 liquefied petroleum gas (LPG) Sales Contracts (and any extensions thereto) to the extent that the gas to fulfill these contracts is committed from the Badak or Nilam fields; after August 7, 1998, all other LNG sales contract revenues will be split 30 percent to the Joint Venture after Indonesian income taxes and 70 percent to Pertamina. Based on current and projected oil production, the revenue split from oil sales after cost recovery through August 7, 2018 will remain at 15 percent to the Joint Venture after Indonesian income taxes and 85 percent to Pertamina. These revenue splits are based on Indonesian income tax rates of 56 percent through August 7, 1998 and 48 percent thereafter. In addition, the Joint Venture is required to sell out of its share of production 8.5 percent (7.2 percent after August 7, 1998) of the total oil and gas condensate production from the contract area for Indonesian domestic consumption. The sales price for the domestic market consumption is $0.20 per barrel with respect to fields commencing production prior to February 23, 1989. For fields commencing production after that date, domestic market consumption is priced at 10 percent of the weighted average price of crude oil sold from such fields. However, for the first sixty consecutive months of production from new fields, domestic market consumption is priced at the official Indonesian Crude Price (ICP). The participants' remaining oil and condensate production is generally sold in world markets. The Joint Venture has no ownership interest in the oil and gas reserves. The Joint Venture has long-term supply agreements with Pertamina for the supply of gas and petroleum gas to be liquefied at a liquefaction plant owned by Pertamina at Bontang Bay (the LNG Plant) and sold to certain buyers pursuant to sales contracts. The Joint Venture, other participating production sharing contractors and Pertamina together market the LNG and the LPG produced at the LNG Plant and LPG facilities and, as to the amounts allocable to the PSC, the Joint Venture and Pertamina divide the net proceeds in accordance with the percentages set out above. Payment for LNG and LPG is made in U. S. dollars to a U. S. bank as trustee for Pertamina, the Joint Venture, other participating production sharing contractors and lenders that have provided funds to build the LNG Plant and the LPG facilities. The LNG Plant's processing costs, principal and interest payable on borrowings from such lenders, transportation costs, and certain other miscellaneous costs are deducted from the gross LNG and LPG sales proceeds. The remaining amount represents the net proceeds for gas delivered to the LNG Plant and is divided among Pertamina, the Joint Venture, and the other production sharing contractors in accordance with the terms of their respective agreements. Exploration and Development From inception in 1972 up to and including December 31, 1993, the following wells were drilled in the East Kalimantan contract area: Total Completed Field Wells Productive Dry Suspended Location Drilled Wells Holes Wells Badak 184 174 7 3 Nilam 154 154 - - Semberah 53 49 4 - Mutiara 44 37 6 1 Pamaguan 32 26 6 - Wailawi 6 6 - - Other 44 8 30 6 Totals 517 454 53 10 Two significant fields, Badak and Nilam, have been discovered in the East Kalimantan area. The Badak field is in the northeast portion of the East Kalimantan contract area, and the Nilam field is located immediately south of the Badak field. Total Indonesie and Indonesia Petroleum, Ltd. (the Total Group), who are not parties to the Joint Venture but have interests in the Nilam and Badak fields, are parties to unitization agreements with the Joint Venture in both fields. All gas and condensate from the Badak and Nilam fields and all oil from the Nilam field, as well as all allowable costs incurred in connection therewith, are deemed attributable to the Joint Venture and the Total Group in the ratio of their respective participating interests under the Badak and Nilam unitization agreements. VICO acts as operator for the Joint Venture and the Total Group in both fields. See "Business - The Joint Venture." The Joint Venture is also producing from four additional fields in the East Kalimantan area: Pamaguan, Mutiara, Semberah and Wailawi. The tables below summarize completed exploratory and development drilling from 1991 through 1993 for the East Kalimantan contract area. EXPLORATORY DRILLING Wells Dry Year Drilled Discoveries Holes 1991 2 1 1 1992 2 0 2 1993 3 0 3 Totals 7 1 6 DEVELOPMENT OR FIELD EXTENSION DRILLING Completed Wells For For For Dual Dry Year Drilled Gas Oil Oil & Gas Holes 1991 37 30 3 4 - 1992 31 24 5 2 - 1993 31 25 1 3 2 Totals 99 79 9 9 2 Of 454 completed productive wells in the East Kalimantan contract area, approximately 250 contain more than one completion in the same bore hole. Six wells were in progress as of December 31, 1993. This includes wells that were drilled but not completed at the end of 1993. None of the suspended or "in-progress" wells are included in the tables above. The Company's share of the costs of the above wells ranged from 18.53 percent to 23.125 percent. The following table sets forth total gas liquefied and sold as LNG, the Company's net share of such production (calculated on a million cubic feet equivalency basis as described in Note b below), average sales prices (excluding transportation costs) and production (lifting) costs of such production for the years 1991 through 1993. Years ended December 31, (a) 1993 1992 1991 (Restated) Gas Production for LNG (MMCF) (b) 637,847 621,600 579,001 Company's Net Share (MMCF equivalency) (c) 80,873 77,264 78,598 Average Sales Price per MCF (d) $2.75 $2.92 $3.07 Average Production (Lifting) Cost per MCF $0.13 $0.14 $0.15 (a) All amounts appearing in this table are for dry gas. The 1992 and 1991 amounts were previously reported on a wet gas basis and have been restated as dry gas. (b) Represents the volumes of LNG delivered and sold to purchasers which is measured by its British Thermal Unit (BTU) content and, for purposes of this table, has been converted to MMCF equivalents based on a ratio of approximately 3.0 billion cubic feet (BCF) of gas required at the plant to produce 2.9 trillion BTUs of LNG. The Gas Production for LNG includes production attributable to UNOCAL Indonesia Ltd., the Total Group and Pertamina. The term "MMCF" refers to 1,000,000 cubic feet of gas measured at 60 degrees Fahrenheit and 14.7 pounds per square inch of pressure. (c) The net share figures shown above have been calculated by dividing the Company's total LNG revenues for each year by the average price per MCF (in the form of LNG) received by Pertamina for the sale of LNG during such year. The result represents the MCF equivalent of the Company's LNG revenues. (d) The sales price is based on the average sales price (excluding transportation) per MMBTU of LNG received by Pertamina. The term "MMBTU" refers to 1,000,000 British Thermal Units. The sales price per MMBTU has been converted to a price per MCF based on the conversion ratio referred to in note (b) above. The term "MCF" refers to 1,000 cubic feet of gas measured at 60 degrees Fahrenheit and 14.7 pounds per square inch of pressure. The Company's production costs are small in relation to its revenues because the Joint Venture's revenues under the LNG contracts are net of costs associated with transporting and converting the gas to LNG and shipping the LNG to the purchasers. The costs, which are considered to be production costs, are those costs incurred to operate and maintain wells and related equipment and facilities. During 1993, the Company's share of the Joint Venture's expenditures was approximately $59 million, including $5 million of exploration expenditures and $37 million of development expenditures. In 1994, the Company's share of the Joint Venture's expenditures is expected to total $56 million, including $3 million of exploration expenditures and $35 million of development expenditures. The 1994 budgeted expenditures primarily reflect continued development drilling required to maintain adequate gas deliverability. Reserves The Company files no reports which include estimates of oil or gas reserves with any federal agency other than the Securities and Exchange Commission. The estimated proved reserves of gas and of oil and condensate as of December 31, 1990, 1991, 1992 and 1993 attributable to the Joint Venture's interest in the PSC in East Kalimantan were prepared by petroleum engineers employed by LASMO, an affiliate of Ultrastar. Gross proved field reserves are as follows: Crude Oil and Condensate Gas Total Proved Reserves (000's barrels) (Dry MMCFs) Dec. 31, 1990 (Gas restated) 149,194 7,294,804 Dec. 31, 1991 (Gas restated) 135,712 7,615,739 Dec. 31, 1992 (Gas restated) 146,055 7,436,171 Dec. 31, 1993 203,068 7,187,995* * equivalent to approximately 6,966 trillion BTUs. The Joint Venture, and thus the Company, has no ownership interest in oil and gas reserves but rather has the right to receive production and revenues from the sale of oil, condensate, gas, LNG and LPG in accordance with the PSC and other agreements. The Company has revised its method of disclosing all proved and proved developed gas reserves from a wet gas basis to a dry gas basis. This change has been effected to conform to the reporting method used by the Company's partners. The Company's estimates of its net share of proved developed and undeveloped reserves, as of December 31 of each year since 1990, are included in the Supplemental Financial Information in Item 8. LNG Plant Gas produced from the Joint Venture's interest in the PSC reserves is liquefied at the LNG Plant, which is owned by Pertamina and operated on a cost-reimbursement basis by a corporation in which the Joint Venture owns a 20 percent interest. The LNG Plant currently consists of six processing units (trains) having a combined input capacity at year-end 1993 of approximately 2.6 billion cubic feet of gas per operating day and a production capacity of approximately 626,000 barrels or 99,500 cubic meters of LNG and 28,000 barrels of condensate per day. The five storage tanks at the LNG Plant have a total capacity of 3.2 million barrels of LNG. Gas is supplied to the plant through three pipelines (two 36 inch and one 42 inch) which are connected to the central gas facilities at the Badak field, 35 miles south of the LNG Plant. The LNG Plant has been developed in four phases. The original facility, which consisted of two trains (Trains A and B) and a dock, was constructed with financing arranged by Pertamina with the Central Bank of the Republic of Indonesia, a consortium of Japanese banks and a corporation owned substantially by the Japanese LNG purchasers, and became fully operational in August 1977. Final payment on the loans was made in the first quarter of 1990. Expansion of the LNG Plant from two to four trains (Trains C and D) was completed in 1983. Funding was arranged by Pertamina with Japan Indonesia LNG Co., Ltd. (JILCO). Final payment on this financing arrangement was made in the third quarter of 1993. A fifth processing train (Train E) was completed in 1989 and supplies LNG required for the Taiwan LNG Sales Contract with the Chinese Petroleum Corporation (CPC), the state petroleum enterprise of the Republic of China (Taiwan). Project financing was arranged through a trustee borrowing with a consortium of Japanese banks and is supported by revenues from such sales contract, as well as in certain limited circumstances by portions of other revenue streams. The financing contains two tranches, with tranche A totalling $176.4 million at a fixed interest rate of 11.5 percent, and tranche B totalling $117.6 million at a floating interest rate initially of LIBOR plus 1 percent. The financing is repayable in graduated quarterly payments over ten years that began in the fourth quarter of 1990. The sixth processing train (Train F) was completed in November 1993 and will supply the LNG required for the LNG sales contract signed in October 1990 with Osaka Gas, Tokyo Gas and Toho Gas (the Buyers) for the sale of 2,020 trillion BTUs over a twenty-year period commencing in 1994. In August 1991, Pertamina and an international consortium of commercial banks completed project financing of $750 million to fund the construction of Train F and related support facilities at an interest rate of LIBOR plus 1.25 percent. Financial support for the financing is limited to revenues from such sales contract. The financing is repayable over ten years in graduated quarterly payments commencing in December 1994. Only $699 million of the $750 million project financing will be required to complete the construction of Train F and its related support facilities. As a result of the production performance of Train E, Pertamina had undertaken modifications to Trains A through D known as "debottlenecking." Trains C and D were modified in 1992 during regularly scheduled maintenance shutdowns. Likewise, Trains A and B were modified in 1993 during regularly scheduled maintenance shutdowns. Capacity tests on all four trains exceeded design rates such that Trains A through D are now capable of LNG production rates comparable to the most recently completed Train F, an increase of 14 percent, or 22 cargoes in total. The total cost of the Trains A through D debottlenecking project amounted to $79 million. These costs were funded through Package IV revenues (See description of Package IV beginning on page 15). With the completion of Train F and the debottlenecking project, the expanded six train plant is expected to have the capacity to deliver 275 cargoes per year. LPG Facilities and Second Dock The LPG processing facilities at the LNG Plant were constructed concurrently with the fifth processing train. The LPG facilities were completed in 1988, at a cost of approximately $158 million. Financing was made available to Pertamina through a consortium of Japanese banks. A significant portion of the LPG sales proceeds is dedicated to the financing, which is repayable through 1999. A second dock facility at the LNG Plant is used for both LNG and LPG deliveries. The portion of the second dock costs attributable to the LPG trade was financed through the same consortium of Japanese banks that financed the LPG processing facilities at the LNG Plant. Financing for the LNG portion of the second dock was provided by a trustee borrowing from Japanese banks. The table below sets forth information regarding the status of the project financings incurred or arranged by Pertamina to construct the LNG Plant: Original Principal/ Balance at Final Primary Payment December 31, Payment Source of Financing Amount 1993 Date Repayment (000's) (000's) Trains A&B and 1st Loading Dock $771,500 $ - - 1973 LNG Sales Contract Trains C & D 995,800 - - 1981 LNG Sales Contract Train E 294,000 217,560 2000 Taiwan LNG Sales Contract Train F and Support Facilities (a) 750,000 633,000 2004 Train F LNG Sales Contract Misc. Capital Projects 42,700 - - 1973 LNG Sales Contract (b) 2nd Loading Dock & Train E Support Facilities 135,000 48,600 1995 1973 LNG Sales Contract (b) LPG Facilities 157,700 91,640 1999 LPG Sales Contract (a) Total financing required is not expected to exceed $699 million. (b) Debt service is allocated among all of the gas producers according to the quantity of gas delivered. Marketing and Distribution of LNG Certain information regarding deliveries of LNG from the LNG Plant is set forth below: BTUs Average Number of LNG in Trillions Price Per Tanker Liftings (Approximate) MMBTU 1991 . . . . . 197 564 $3.16 1992 . . . . . 211 606 $3.00 1993 . . . . . 216 621 $2.82 As a result of variations in LNG tanker capacity among the various sales contracts, the measure of a net equivalent cargo has been established. One net equivalent cargo equates to the quantity of LNG delivered in a 1973 Sales Contract shipment or an average of 2,942 BBTUs. The following table sets forth information regarding the LNG Plant share of the LNG Sales Contracts grouped together by the Joint Venture's participating percentages in the sales contracts (each such group being referred to as a "package"): Commencing in 1994, LNG is primarily sold under five long- term sales contracts between Pertamina and buyers in Japan, Taiwan and Korea. These contracts are the 1973 LNG Sales Contract (Package I), the 1981 LNG Sales Contract (Package II), the Taiwan LNG Sales Contract (included in Package IIIB), the Train F LNG Sales Contract and the Korea II LNG Sales Contract (both included in Package IV). The gas processed by the LNG Plant is supplied from the Joint Venture's contract area as well as other fields in which the Joint Venture has no interest. LNG sales contracts and amendments thereto are executed between Pertamina and the buyers for the sale and delivery of a fixed quantity of BTUs of LNG at a price that reflects an LNG element derived from a basket of Indonesian crude oil prices that is recalculated monthly. A transportation charge is added to the LNG element under all contracts except for Package II where the buyers bear the risk of loss and the transportation costs. In those instances when the seller bears the risk of loss during shipment, the cargoes are insured. The buyers also bear the risk of loss and transportation costs for cargoes under the Train F LNG Sales Contract (included in Package IV), which commenced deliveries in early 1994. The LNG to be delivered under the sales contracts is supplied from the LNG Plant and from a separate facility at Arun in Sumatra (Arun Plant). The Joint Venture does not supply gas to the Arun Plant or have any interest in revenues from the sale of its product. The allocation of contract quantities between the LNG Plant and the Arun Plant is determined by Pertamina. Presently, all deliveries under the 1981 LNG Sales Contract (Package II), the Taiwan LNG Sales Contract (included in Package IIIB) and the Train F LNG Sales Contract (included in Package IV) are exclusively supplied by the LNG Plant. The Joint Venture and other gas producers in this area have the opportunity to participate in each sales package. The Joint Venture's equity interest in a sales package is based on its share of gas reserves available for commitment to the package and represents the percentage of gross revenues attributable to the Joint Venture before deducting plant operating costs and debt service. In January of 1990, certain of the buyers under the 1973 Sales Contract agreed to increase their purchased commitments during the years 1997 through 1999 by approximately 667 trillion BTUs. The LNG Plant will provide 67.1 percent of the additional quantities and the Arun Plant the remainder. The Joint Venture's participation percentage for these quantities was finalized at 27.2064 percent in early January of 1994 after agreement with Pertamina and the East Kalimantan producers. In October of 1990, Pertamina signed an LNG sales contract with Osaka Gas, Tokyo Gas, and Toho Gas (Train F LNG Sales Contract) for the sale of at least 2,020 trillion BTUs over a twenty-year period commencing in January 1994. In May of 1991, Pertamina signed an LNG sales contract with Korea Gas Corporation for the sale of at least 2,044 trillion BTUs over a twenty-year period commencing in July 1994, at a price similar to the LNG element of the 1973 LNG Sales Contract. The LNG Plant will provide 50 percent and the Arun Plant 50 percent of the LNG requirements for the contract. In August of 1991, Pertamina signed a contract with Tokyo Gas for delivery of six cargoes from the LNG Plant over two years commencing in 1992. Three of the six cargoes were delivered in 1992 and the remaining three were delivered in 1993. The contract price is similar to the 1973 LNG Sales Contract price. The Joint Venture's participation percentage for these contracts was finalized at 27.2064 percent in early January of 1994 after agreement with Pertamina and the East Kalimantan producers. In October and November of 1991, Pertamina signed agreements with Osaka Gas and Toho Gas to increase deliveries in 1992 and 1993 by 69 cargoes, of which 51 cargoes would be shipped from the LNG Plant. Of the cargoes to be supplied by the LNG Plant, 25 were shipped in 1992 and the remaining 26 were shipped in 1993. These contracts were split between Package III and Package IV sharing percentages. In December of 1991, Pertamina entered into an LNG sales contract with several Japanese buyers (the Medium City Gas Companies) for the sale of 358 trillion BTUs over a twenty-year period commencing in 1996. The LNG Plant will provide 50 percent of the LNG requirements for the contract. The Joint Venture's participation percentage for this contract was finalized at 27.2064 percent in early January of 1994 after agreement with Pertamina and the East Kalimantan producers. As a result of the sales agreements entered into by Pertamina and expected spot sales, the Company anticipates that the Joint Venture will ship approximately 135 net equivalent cargoes in 1994. Other Gas Sales - The Joint Venture is also obligated to supply approximately 74 MMCF per day of gas to three local fertilizer plants at a price of $1.00 per MMBTU subject to a pipeline tariff. In addition, the Joint Venture is required to supply approximately 5 MMCF per day of gas to the Balikpapan refinery at a price of $1.49 per MMBTU. Marketing and Distribution of LPG Pertamina has individual sales contracts with seven Japanese utility companies for the sale and delivery of 1,950,000 metric tons per year of LPG through the year 1998, of which 315,000 metric tons, subject to Pertamina's right to increase or decrease such amount, will be produced by the LPG facilities at the LNG Plant. In 1993, 23 cargoes, including spot sales, totaling 453,000 metric tons were shipped to Japan. The first 285,000 metric tons of LPG sold under the contract were sold at the weighted average price for all LPG imported into Japan, except Indonesia and Abu Dhabi, plus $3 per ton. The next 168,000 metric tons of LPG were sold at the aforementioned price plus a premium of $20 to $22 per metric ton. The LPG is extracted from the LNG stream and stored at facilities at the LNG Plant. Based on dedicated reserves, the Joint Venture is allocated 29.6 percent of the revenues from the first 385,000 metric tons sold and 27.2 percent for sales in excess of 385,000 metric tons per year, after deducting LPG-related operating costs and debt service. Marketing of Oil and Condensate Each party to the Joint Venture and Pertamina are entitled to take their respective shares of oil and condensate in kind and to market such shares separately. The Company, through affiliates of Ultrastar and Unistar, markets its share of oil and condensate f.o.b. Santan Terminal, in East Kalimantan, independently of Pertamina and the other Joint Venture participants. The Santan Terminal (operated by UNOCAL Indonesia Ltd.) is used for storing and loading oil produced by the Joint Venture. The Company's percentage share of the Joint Venture's oil and condensate, except for that sold to Pertamina for Indonesian domestic consumption, is sold at ICP. Prior to July 1, 1993, the price for crude and condensate sales reflected world market conditions at the time of sale. The sales price for the domestic market consumption is $0.20 per barrel with respect to fields commencing production prior to February 23, 1989. For fields commencing production after that date, domestic market consumption is priced at 10 percent of the weighted average price of crude oil sold from such fields. However, for the first sixty consecutive months of production from new fields, domestic market consumption is priced at ICP. Substantially all of the oil and condensate currently being produced by the Joint Venture from the PSC contract area is being produced from the Badak, Nilam, Mutiara and Semberah fields. The Company's average sales prices and production (lifting) costs for 1991 through 1993 are: Years ended December 31, 1993 1992 1991 Total Oil and Condensate Sales (barrels) (a) 20,905,232 18,633,441 15,089,945 Company's Net Share (barrel equivalency) (a) 1,928,005 1,804,511 1,337,349 Average Sale Price - f.o.b. Indonesia (per barrel) (b) $18.31 $20.65 $20.59 Average Production (Lifting) Cost (per barrel) $0.77 $ 0.80 $ 0.84 (a) The total oil and condensate sales include production attributable to other contractors' shares of unitized operations in the Badak and Nilam fields. See "Exploration and Development." The net share figures shown above have been calculated by dividing the Company's total oil revenues for each year by the average price per barrel received for sale of oil during such year. The result represents the barrel equivalent of the Company's oil revenues. (b) Excludes domestic consumption sales. Also excluded are gains or losses incurred on the sale of the Company's share of oil, which resulted in marketing gains/(losses) of $(0.32), $(0.02) and $0.07 per barrel in 1993, 1992 and 1991, respectively. Effective July 1, 1993, the Company is no longer exposed to marketing gains/(losses) incurred on the sale of its share of oil and condensate. The Joint Venture's sales of oil and condensate averaged approximately 48,600 barrels per day (BOPD) during 1993, compared to approximately 42,700 BOPD during 1992. Competition and Risks Indonesian oil competes in the world market with oil produced from other nations. Indonesia is a member of OPEC, and any OPEC-imposed restrictions on oil or LNG exports in which Indonesia participates could have a material adverse effect on the Company. In addition to the LNG being sold from the Arun Plant, LNG plants in the Middle East, Australia, Malaysia, or elsewhere may provide competition for sales of any additional Joint Venture LNG to Japanese and other markets, beyond the amount under current contracts. The Joint Venture's activities in Indonesia are subject to risks common to foreign operations in the oil and gas industry, including political and economic uncertainties, the risks of cancellation or unilateral modification of contract rights, operating restrictions, currency repatriation restrictions, expropriation, export restrictions, increased taxes and other risks arising out of foreign governmental sovereignty over areas in which the Joint Venture's operations are conducted. The Company's foreign operations and investment may also be subject to the laws and policies of the U. S. affecting foreign trade, investment and taxation that could affect the conduct and profitability of those operations. All of the Company's oil and gas activities are subject to the risks normally incident to exploration for and production of oil and gas, including blowouts, cratering and fires, each of which could result in damage to life and property. Production from the LNG Plant, which is the source of most of the Company's revenues, is subject to the risks associated with maintaining and operating a complex, technologically intensive processing plant, including the risks of equipment failures, fire and explosion. To the extent that the seller of the LNG produced by the LNG Plant bears the risk of loss of cargoes, the seller is subject to the usual risks of maritime transportation, including adverse incidents arising from loading and unloading cargoes. In accordance with customary industry practices, the Company carries insurance against some, but not all, of these risks. Losses and liabilities arising from such events would reduce revenues and increase costs of the Company to the extent not covered by insurance. Item 2. Item 2. Properties See Item 1. Business. Item 3. Item 3. Legal Proceedings The Company has pending litigation arising in the ordinary course of its business. However, none of the litigation is expected to have a material adverse effect on the Company's financial position or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Item 5. Market for Registrant's Common Equity and Shareholder Matters Refer to Item 12 for a description of the Registrant's Equity. Refer to Item 1 for a description of the Indonesian Participating Units. Item 6. Item 6. Selected Financial Data The following financial data was derived from the audited consolidated financial statements of the Company and should be read in conjunction with the consolidated financial statements and related notes included elsewhere herein. 1993 1992 1991 1990 1989 (millions of dollars) Operating revenues $201 $206 $208 $203 $146 Earnings (loss) from continuing operations 30 24 18 7 (15) Net earnings 30 24 18 11 11 Total assets 449 472 500 519 608 Debt and security subject to mandatory redemption 33 32 31 50 111 See Note 2(e) to Notes to Consolidated Financial Statements. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Cash flow from operations amounted to $81.5 million in 1993, compared to 1992 cash flow of $93.4 million. Capital expenditures of $40.1 million were primarily spent on continued development drilling in the Badak, Nilam, Mutiara and Semberah fields as was the case in 1992. Net capital distributions in 1993 to the partners from the Company were $41.1 million (1992, $58.2 million). On January 5, 1994, the Company redeemed its 8-1/4 percent convertible subordinated guaranteed debentures, originally due in 1995, in the amount of $36.4 million at a loss of $3.1 million. The redemption was funded through contributions from the partners of the Company. The Company's ability to generate cash is primarily dependent on the prices it receives for the sale of LNG, and to a lesser extent, the sale of crude oil and LPG. In the event cash generated from operations is not sufficient to meet capital investment and other requirements, any shortfall will be funded through additional cash contributions by the partners. The Company cannot predict with any degree of certainty the prices it will receive in 1994 and future years for its crude oil and LNG. The Company's financial condition, operating results and liquidity will be materially affected by any significant fluctuations in sales prices. LNG sales are made under five principal long-term contracts and several short- and medium-term contracts with Japanese, Korean and Taiwanese industrial and utility companies. Sales pursuant to the fourth long-term contract (Train F LNG Sales Contract) commenced in the first quarter of 1994; sales under the fifth long- term contract will commence in July 1994. The long- term contracts contain take-or-pay provisions that generally require that the purchasers either take the contracted quantities or pay for such quantities if not taken; such provisions tend to support the Company's ability to generate cash. During 1993, 127 net equivalent cargoes were shipped, of which 107 were under these long-term contracts. In 1994, the Company anticipates shipping approximately 135 net equivalent cargoes. The sixth processing train (Train F) was completed in November 1993 and will supply the LNG required for the fourth long-term LNG sales contract signed in October 1990 with Osaka Gas, Tokyo Gas and Toho Gas for the sale of at least 2,020 trillion BTUs over a twenty-year period commencing in 1994. In January of 1990, certain of the buyers under the 1973 Sales Contract agreed to increase their purchased commitments during the years 1997 through 1999 by approximately 667 trillion BTUs. The LNG Plant will provide 67.1 percent of the additional quantities and the Arun Plant the remainder. In May of 1991, Pertamina signed an LNG sales contract with Korea Gas Corporation for the sale of at least 2,044 trillion BTUs over a twenty-year period commencing in July 1994, at a price similar to the LNG element of the 1973 LNG Sales Contract. The LNG Plant will provide 50 percent and the Arun Plant 50 percent of the LNG requirements for the contract. In December of 1991, Pertamina entered into an LNG sales contract with several Japanese buyers (the Medium City Gas Companies) for the sale of 358 trillion BTUs over a twenty-year period commencing in 1996. The LNG Plant will provide 50 percent of the LNG requirements for the contract. The debottlenecking of Trains A through D was completed in 1993. Capacity tests on all four trains exceeded design rates such that the four trains are now capable of LNG production rates comparable to the recently completed Train F, an increase of 14 percent or 22 cargoes in total. The Company's operating and capital expenditures are directed toward the Joint Venture. Capital expenditures of the Joint Venture relate to the exploration and development of the oil and gas fields. In 1994, the Company's share of the Joint Venture expenditures is expected to total $56 million, including $3 million of exploration expenditures and $35 million of development expenditures. The 1994 budgeted expenditures primarily reflect continued development drilling required to maintain gas deliverability. The Company can give no assurance as to the future trend of its business and earnings, or as to future events and developments that could affect the Company in particular or the oil industry in general. These include such matters as environmental quality control standards, new discoveries of hydrocarbons and the demand for petroleum products. Furthermore, the Company's business could be profoundly affected by future events including price changes or controls, payment delays, increased expenditures, legislation and regulations affecting the Company's business, expropriation of assets, renegotiation of contracts with foreign governments, political instability, currency exchange and repatriation losses, taxes, litigation, the competitive environment and international economic and political developments including actions of members of the Organization of Petroleum Exporting Countries (OPEC). The Company's revenues are predominately based on the market price of crude oil, which is denominated in U. S. dollars. Certain operating costs, taxes and capital costs represent commitments settled in foreign currency. Currency exchange rate fluctuations on transactions in currencies other than U. S. dollars are recognized as adjustments to the U. S. dollar cost of the transaction. The Company is unaware of any unrecorded environmental claims as at December 31, 1993 which would have a material impact upon the Company's financial condition or operations. Results of Operations 1993 Compared to 1992 Net earnings for the year 1993 were $30.5 million as compared to $23.7 million in 1992. Cash flow from operations for 1993 was $81.5 million (1992, $93.4 million). Oil and gas production revenues for 1993 were $200.6 million, or lower by $5.3 million when compared to 1992 revenues of $205.9 million. The increase in the Joint Venture's share of delivered LNG sales volumes was not sufficient to offset a decline in the average LNG sales price. The quantity of LNG delivered from the LNG Plant was 621 trillion BTU's (216 cargoes) in 1993 as compared to 606 trillion BTU's (211 cargoes) in 1992. The Joint Venture's interest in the LNG delivered was 369 trillion BTU's (127 net equivalent cargoes) in 1993 as compared to 363 trillion BTU's (124 net equivalent cargoes) in 1992. The average LNG sales price, excluding transportation charges, declined to $2.82 per million BTU's in 1993 as compared to $3.00 per million BTU's in 1992. Crude oil sales volumes of 1.93 million barrels were higher by 7 percent in 1993 as compared to 1992's 1.8 million barrels, while the average crude oil realized sales price of $17.99 per barrel was lower than 1992 by $2.64 per barrel. Production costs of $18.8 million were lower than 1992 costs by about $6.8 million. This improvement in production costs was caused by a provision included in 1992 related to the Company's prior years' windfall profits tax liability. After a re- evaluation of the ultimate exposure on this tax liability, the Company has reversed $3.5 million as being no longer required. At the same time, the Company has provided an offsetting amount for the potential exposure in a royalty dispute. Depletion , depreciation and amortization of $52.7 million was lower than 1992 by $4.6 million primarily as a result of a lower depletion rate associated with the increase in proved reserves that more than offset the higher level of LNG volumes delivered. Exploration costs, including dry holes, of $4.9 million were lower than 1992 by $4.2 million due to a lower level of seismic and dry hole costs. General and administrative expenses of $1.8 million were $1.0 million lower than last year's $2.8 million due to the absence of certain non-recurring charges. Both interest expense and interest income were in line with last year's results. Other income in 1992 included a non-recurring benefit due to the favorable disposition of a legal action. The effective tax rates for 1993 and 1992 were 74 percent and 78 percent respectively. These rates were the aggregate of Indonesian source income taxed at a 56 percent rate, and certain expenses attributable to the Unimar activities which are not deductible in the partnership. 1992 Compared to 1991 Net earnings for 1992 were $23.7 million as compared to $18.3 million in 1991. Revenues of $205.9 million in 1992 were lower by $1.9 million when compared to last year as an increase in the Joint Venture's share of delivered LNG volumes was not sufficient to offset a decline in the average LNG price. The quantity of LNG delivered from the LNG Plant increased to 606 trillion BTUs (211 cargoes) in 1992 from 564 trillion BTUs (197 cargoes) in 1991. The Joint Venture's interest in the LNG delivered was 363 trillion BTUs (126 net equivalent cargoes) in 1992 as compared to 354 trillion BTUs (123 net equivalent cargoes) in 1991. The average unit LNG price, excluding delivery charges, declined to $3.00 per million BTUs in 1992 from $3.16 per million BTUs in 1991. The average realized crude oil price decreased slightly to $20.63 per barrel in 1992 from $20.64 per barrel in 1991, while crude oil sales volumes increased 36 percent to 1.8 million barrels. Production costs of $25.6 million increased $5.0 million and included an amount related to a proposed adjustment by the U. S. federal tax authorities relating to the Company's prior years' windfall profit tax liability. Depletion, depreciation and amortization of $57.3 million declined $4.2 million principally as a result of a lower depletion rate associated with an increase in proved developed reserves that more than offset the impact of the higher level of volumes delivered. Exploration costs of $9.1 million decreased $0.6 million over last year's costs. General and administrative expenses of $2.8 million were $0.3 million lower than last year's level. Interest expense of $4.7 million declined $5.0 million primarily as a result of the payoff of an Indonesian Production Payment bank loan in 1991. Interest income of $0.6 million was $0.7 million lower than 1991 primarily as a result of declining interest rates on short-term deposits. Other income of $1.2 million in 1992 principally represented the reversal of a provision due to a favorable disposition of certain legal action. In 1991, other (expense) of $0.9 million was mainly a provision for residual domestic operations costs. The effective tax rates relating to continuing operations for the 1992 and 1991 periods were 78 percent and 82 percent respectively. These rates were the aggregate of Indonesian source income taxed at a 56 percent rate and certain expenses attributable to Unimar activities not deductible in the partnership. The decrease in the effective rate is principally the result of decreased non-deductible interest expense. In 1992, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 109, "Accounting for Income Taxes". The effect of adopting Statement 109 was to decrease net income by $0.3 million and $2.6 million for the years ended December 31, 1991 and 1990 respectively. Refer to Note 2(e) of the Notes to Consolidated Financial Statements for further discussion of the effects of this adoption. In 1992, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The effect of adopting the new rules did not significantly impact the Company's profits. Postretirement benefit costs for 1991 and 1990, which were recorded on a cash basis, have not been restated. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT AUDITORS To The Partners of Unimar Company We have audited the accompanying consolidated balance sheets of Unimar Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, cash flows and partners' capital for each of the three years in the period ending December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As more fully described in the notes to the consolidated financial statements, the Company has material transactions with its partners and affiliates. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Unimar Company and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Houston, Texas February 28, 1994 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The management, budgeting and financial control of the Company's interest in the Indonesian Joint Venture operations are exercised by a Management Board consisting of six members, three appointed by each partner. The following persons currently serve as members of the Company's Management Board: GEORGE W. BERKO (age 47) was appointed to the Company's Management Board in May 1992. Since May 1992, he has served as the Partners' representative for Investor Relations, Treasurer and Chief Financial and Accounting Officer of ENSTAR, ENSTAR Indonesia, Inc., INTERNATIONAL, and certain of their subsidiaries, and has been LASMO America Ltd.'s Vice President - Unimar Accounting. From October 1990 until April 1992, he was Vice President, Controller of Ultramar Oil and Gas Limited, and prior to that time, he was a General Manager of American Ultramar Ltd. from December 1984. IAN D. BROWN (age 44) was appointed to the Company's Management Board in February 1993. He is also Director and Chairman of ENSTAR and certain of its affiliates. In January 1994 he was appointed President and General Manager of LASMO Companies in Indonesia. In January 1993, he was appointed Director, Indonesian Joint Venture for LASMO plc and a member of the VICO Board. Since May 1986, he served as Commercial Manager for LASMO plc, and from February 1987, Managing Director, LASMO Trading Limited, the marketing, trading and transportation affiliates of the parent company. LARRY D. KALMBACH (age 42) was appointed to the Company's Management Board in February 1993. Since February 1, 1993, he has been Vice President-Finance of UTPH after serving as Vice President and Controller of UTPH since September 1986. Prior to that time, he held various financial management positions with UTPH since 1974. WILLIAM M. KRIPS (age 54) was appointed to the Company's Management Board in January 1987. He is also a Director of ENSTAR and certain of its affiliates. Since December 1991, he has been Senior Vice President Exploration & Production of UTPH. Prior to that time, he served as Senior Vice President and General Manager - U. S. Exploration and Production, Senior Vice President and General Manager - Hydrocarbon Products Group and Vice President and General Manager - International Operations. ARTHUR W. PEABODY (age 50) was appointed to the Company's Management Board in February 1992 and in April 1993 was appointed Chairman of the Management Board. He is also a Director of ENSTAR, ENSTAR Indonesia, Inc., INTERNATIONAL and VICO. Since February 1992, he has been Senior Vice President - Exploration and Production of UTPH, and prior to that time, he held various positions at UTPH including Senior Vice President and General Manager - Hydrocarbon Products Group, Vice President - Planning and Administration and Vice President - Acquisitions and Planning. JERRY L. PICKERILL (age 56) was appointed to the Company's Management Board in June 1992 and also serves as a Director of ENSTAR Corporation. Since February of 1989, he has served as President of LASMO Energy Corporation and is currently President and Director of LASMO America Limited, the holding company for the LASMO U. S. subsidiaries. He previously served as Vice President and General Counsel for CNG Producing Company, Tulsa Division, Vice President and General Counsel of Mapco Oil & Gas, Inc., and an attorney for Amerada Hess Corporation. As set forth above, control of the Company's operations is exercised by the Management Board. The Company, a Texas general partnership, does not have any Executive Officers. Item 11. Item 11. Executive Compensation. The Company has no executive officers, and no members of the Management Board are paid directly by the Company. All members of the Management Board are full-time employees of UTPH or LASMO, or their respective subsidiaries, and do not receive from the Company any remuneration for their services to the Company. Moreover, the Company has no employees who are compensated for their services to the Company. VICO, a subsidiary of the Company, has employees who are responsible for the daily operating activities of the Joint Venture and are compensated by the Joint Venture. See Item 13 below for information concerning the Company's reimbursement to LASMO for services rendered to the Company by one of LASMO's designees on the Management Board. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The Company is a Texas general partnership and as such has no voting securities apart from the general partnership interests owned by the partners. The table below reflects the beneficial ownership of 100 percent of the partnership interests in the Company as of March 15, 1994: Name and Address of Amount Beneficially Title of Class Beneficial Owner Owned General Partnership LASMO plc 50% Interest 100 Liverpool Street London EC2M 2BB England Name and Address of Amount Beneficially Title of Class Beneficial Owner Owned General Partnership Union Texas Petroleum 50% Interest Holdings, Inc. 1330 Post Oak Boulevard Houston, Texas 77252 Item 13. Item 13. Certain Relationships and Related Transactions. The partners of the Company provide management expertise, office space, and administrative, legal and professional services. For such services, a management fee of approximately $508 and $600 was charged in 1993 and 1992, respectively, including $138 ($96 in 1992) paid in respect of Mr. Berko's services. The Company holds demand notes in the amount of $40 million from or generated by affiliates of each partner. These funds will be made available to the Company if additional working capital is required. As operator of the Joint Venture, VICO conducts exploration and development activities within the PSC area. The cost of such activities is funded by the Joint Venture participants to VICO. In addition, VICO performs services for the operator of the LNG Plant, P.T. Badak Natural Gas Liquefaction Company (P.T. Badak). For the year ended December 31, 1993, VICO charged P.T. Badak approximately $32 million ($41 million in 1992) for engineering services and costs incurred on P.T. Badak's behalf. Also, during 1993 VICO billed P.T. Badak approximately $1.5 million ($1.8 million in 1992) principally for field pipeline maintenance services. Accounts receivable from P.T. Badak approximated $3.3 million at December 31, 1993 ($3.0 million at December 31, 1992). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1) Financial Statements listed below are included as Part II, Item 8 hereof on the pages indicated: Report of Independent Auditors 25 Consolidated Balance Sheet, December 31, 1993 and 1992 26 Consolidated Statement of Earnings, Years ended December 31, 1993, 1992 and 1991 27 Consolidated Statement of Cash Flows, Years ended December 31, 1993, 1992 and 1991 28 Consolidated Statement of Changes in Partners' Capital, Years ended December 31, 1993, 1992 and 1991 29 Notes to Consolidated Financial Statements 30-44 Supplemental Financial Information (unaudited) 45-51 (2) Financial Statement Schedules listed below are filed as a part hereof on the pages indicated: V - Property, Plant and Equipment 52 VI - Accumulated Depreciation and Depletion of Property, Plant and Equipment 53 All other schedules are omitted as they are not required or are not applicable. (a)(3) The following documents are included as Exhibits to this Report. Unless it has been indicated that a document listed below is incorporated by reference herein, copies of the document have been filed herewith. (2)-1- Merger Agreement, dated May 22, 1984, and Amendment Agreements thereto, dated June 8, 1984 and June 12, 1984 (incorporated by reference to Annex A to the Prospectus/Proxy Statement included in the Company's Registration Statement on Form S-14 (No. 2-93037)).* (2)-2- Agreement of Merger, dated as of August 28, 1984 (incorporated by reference to Annex B to the Prospectus/Proxy Statement included in the Company's Registration Statement on Form S-14 (No. 2-93037)).* (2)-3- Divestiture Agreement, dated June 20, 1984 (filed as Exhibit 2.3 to the Company's Registration Statement on Form S-14 (No. 2-93037)).* (3)-1- Amended and Restated Agreement of General Partnership of Unimar Company dated September 11, 1990 between Unistar, Inc. and Ultrastar, Inc. (filed as Exhibit (3)-4- to the Company's 1990 Form 10-K (No. 18791)).* (4)-1- Form of Indenture between Unimar and Irving Trust Company, as Trustee (filed as Exhibit 4 to the Company's Registration Statement on Form S-14 (No. 2-93037)).* (4)-2- First Supplemental Indenture, dated as of October 31, 1986, to the Indenture between Unimar and Irving Trust Co., as Trustee (Exhibit (4)-1 above) (Filed as Exhibit 10.114 to Union Texas Petroleum Holdings, Inc.'s Registration Statement on Form S-1 (No. 33-16267)).* (10)-1- Joint Venture Agreement, dated August 8, 1968, among Roy M. Huffington, Inc., Virginia International Company, Austral Petroleum Gas Corporation, Golden Eagle Indonesia, Limited, and Union Texas Far East Corporation, as amended (filed as Exhibit 6.6 to Registration Statement No. 2- 58834 of Alaska Interstate Company).* (10)-2- Agreement dated as of October 1, 1979, among the parties to the Joint Venture Agreement referred to in Exhibit (10)-1- above (filed as Exhibit 5.2 to Registration Statement No. 2-66661 of Alaska Interstate Company).* * Incorporated herein by reference. (10)-3- Amendment to the Operating Agreement dated April 1, 1990, between Roy M. Huffington, Inc., a Delaware corporation, Ultramar Indonesia Limited, a Bermuda corporation, Virginia Indonesia Company, a Delaware corporation, Virginia International Company, a Delaware corporation, Union Texas East Kalimantan Limited, a Bahamian corporation, and Universe Gas & Oil Company, Inc., a Liberian corporation. (10)-4- Amended and Restated Production Sharing Contract dated April 23, 1990 (effective August 8, 1968 - August 7, 1998) by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Roy M. Huffington, Inc., Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Huffington Corporation. (10)-5- Production Sharing Contract dated April 23, 1990 (effective August 8, 1998 - August 7, 2018) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Roy M. Huffington, Inc., Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Huffington Corporation. (10)-6- Nilam Unit Agreement, effective as of January 1, 1980, to establish the manner in which the Joint Venture and Total will cooperate to develop the unitized area of the Nilam Field (filed as Exhibit (10)-58- to the Company's 1991 Form 10-K (No. 1- 8791)).* (10)-7- Third Amended and Restated Implementation Procedures for Crude Oil Liftings, effective as of July 1, 1993, among Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company. (10)-8- Amended and Restated 1973 LNG Sales Contract, dated as of the 1st day of January 1990, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., The Kansai Electric Power Co., Inc., Kyushu Electric Power Co., Inc., Nippon Steel Corporation, Osaka Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. * Incorporated herein by reference. (10)-9- Amendment to the 1973 LNG Sales Contract dated as of the 3rd day of December, 1973, amended by Amendment No. 1 dated as of the 31st day of August, 1976, and amended and restated as of the 1st day of January, 1990 ("1973 LNG Sales Contract"), is entered into as of the 1st day of June, 1992, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, a state enterprise of the Republic of Indonesia (Seller), on the one hand, and Kyushu Electric Power Co., Inc. (Kyushu Electric), Nippon Steel Corporation (Nippon Steel), and Toho Gas Co., Ltd. (Toho Gas), all corporations organized and existing under the laws of Japan, on the other hand. (10)-10- Amended and Restated Supply Agreement (In Support of the Amended and Restated 1973 LNG Sales Contract) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective December 3, 1973. (10)-11- Amended and Restated Badak LNG Sales Contract, dated as of the 1st day of January, 1990, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., The Kansai Electric Power Co., Inc., Osaka Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. (10)-12- Supply Agreement, dated as of April 14, 1981 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement, including the Company. (10)-13- Seventh Supply Agreement for Excess Sales (Additional Fixed Quantities under Badak LNG Sales Contract as a Result of Contract Amendment and Restatement) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Virginia Indonesia Company, Opicoil Houston, Inc., Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company, dated September 28, 1992, but effective as of January 1, 1990. * Incorporated herein by reference. (10)-14- Bontang II Trustee and Paying Agent Agreement Amended and Restated as of July 15, 1991 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Virginia International Company, Union Texas East Kalimantan Limited, Ultramar Indonesia Limited, Opicoil Houston, Inc., Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International. (10)-15- Producers Agreement No. 2 dated as of June 9, 1987 by Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina), Roy M. Huffington, Inc., Virginia International Company, Ultramar Indonesia Limited, Virginia Indonesia Company, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Huffington Corporation in favor of The Industrial Bank of Japan Trust Company as Agent (filed as Exhibit (10)-30- to the Company's 1987 Form 10-K (No. 1-8791)).* (10)-16- Badak III LNG Sales Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) as Seller and Chinese Petroleum Corporation as Buyer signed on March 19, 1987 (filed as Exhibit (10)-59- to the Company's 1991 Form 10-K (No. 1- 8791)).* (10)-17- Badak III LNG Sales Contract Supply Agreement, dated October 19, 1987 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. (10)-18- LNG Sales and Purchase Contract (Korea II) effective May 7, 1991 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Korea Gas Corporation. (10)-19- Schedule A to the LNG Sales and Purchase Contract (Korea II FOB) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Korea Gas Corporation. (10)-20- Bontang III Producers Agreement, dated February 9, 1988, among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. * Incorporated herein by reference. (10)-21- Amendment No. 1 to Bontang III Producers Agreement dated as of May 31, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Train-E Finance Co., Ltd., as Tranche A Lender, The Industrial Bank of Japan Trust Company, as Agent and The Industrial Bank of Japan Trust Company on behalf of the Tranche B Lenders. (10)-22- Amendment No. 2 to Producers Agreement No. 2 dated as of May 31, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited and Universe Tankships, Inc. (filed as Exhibit (10)-44- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-23- $316,000,000 Bontang III Loan Agreement dated February 9, 1988 among Continental Bank International as Trustee, Train-E Finance Co., Ltd. as Tranche A Lender and The Industrial Bank of Japan Trust Company as Agent. (10)-24- Bontang III Trustee and Paying Agent Agreement, dated February 9, 1988, among Pertamina, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, VICO, Ultrastar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesia, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International (filed as Exhibit 10.42 to the Union Texas Petroleum Holdings, Inc.'s 1991 Form 10-K (Commission File No. 1-9019)).* (10)-25- Amendment No. 1 to Bontang III Trustee and Paying Agent Agreement, dated as of December 11, 1992, among Pertamina, VICO, Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Opicoil Houston, Inc., Universe Gas & Oil Company, Inc., Total Indonesia, Unocal Indonesia Ltd., Indonesia Petroleum, Ltd. and Continental Bank International, as Bontang III Trustee (Filed as Exhibit 10.83 to the Union Texas Petroleum Holdings, Inc.'s 1992 Form 10-K (Commission File No. 1-9019)).* * Incorporated herein by reference. (10)-26- Amended and Restated Debt Service Allocation Agreement dated February 9, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Roy M. Huffington, Inc., Virginia International Company, Ultramar Indonesia Limited, Virginia Indonesia Company, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Huffington Corporation, Total Indonesie, Unocal Indonesia, Ltd. and Indonesia Petroleum, Ltd. (filed as Exhibit (10)- 40- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-27- Letter agreement between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Chinese Petroleum Corporation, dated December 1, 1989. (10)-28- Memorandum of Agreement (Yokkaichi Extension), made as of December 21, 1989, between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., as Buyer (filed as Exhibit (10)-60- to the Company's 1989 Form 10-K (No. 1-8791)).* (10)-29- Badak IV LNG Sales Contract dated October 23, 1990 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina), as Seller and Osaka Gas Co., Ltd., Tokyo Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. (10)-30- LNG Sales Contract dated as of October 13, 1992 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller and Hiroshima Gas Co., Ltd. and Nippon Gas Co., Ltd., as Buyers. (10)-31- LNG Sales Contract dated as of October 13, 1992 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller and Osaka Gas Co., Ltd., as Buyer. (10)-32- Supply Agreement for Natural Gas to Badak IV LNG Sales Contract dated August 12, 1991 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company. (10)-33- Second Supply Agreement for Package IV Excess Sales (Osaka Gas Contract - Package IV Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective January 1, 1991. * Incorporated herein by reference. (10)-34- Third Supply Agreement for Package IV Excess Sales (Toho Gas Contract - Package IV Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 28, effective January 1, 1991. (10)-35- Eleventh Supply Agreement for Package IV Excess Sales (1973 Contract Build-Down Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective January 1, 1990. (10)-36- Bontang IV Producers Agreement dated August 26, 1991 by Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd. and Indonesia Petroleum, Ltd., in favor of The Chase Manhattan Bank, N.A. as Agent for the Lenders. (10)-37- $750,000,000 Bontang IV Loan Agreement dated August 26, 1991 among Continental Bank International as Trustee under the Bontang IV Trustee and Paying Agent Agreement as Borrower, Chase Manhattan Asia Limited and The Mitsubishi Bank, Limited as Coordinators, the other banks and financial institutions named herein as Arrangers, Co- Arrangers, Lead Managers, Managers, Co-Managers and Lenders, The Chase Manhattan Bank, N.A. and the Mitsubishi Bank, Limited as Co-Agents and The Chase Manhattan Bank, N.A. as Agent. (10)-38- Bontang IV Trustee and Paying Agent Agreement dated August 26, 1991 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International. * Incorporated herein by reference. (10)-39- Amended and Restated Bontang Processing Agreement dated February 9, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and P.T. Badak Natural Gas Liquefaction Company (filed as Exhibit (10)-39- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-40- Bontang Capital Projects Loan Agreement No. 1 between Continental Bank International as Trustee under the Badak Trustee and Paying Agent Agreement, Borrower, and The Industrial Bank of Japan Trust Company, Agent, for the Lenders dated as of September 10, 1986 (filed as Exhibit (4)-13- to the Company's 1986 Form 10-K (No. 1-8791)).* (10)-41- Bontang Capital Projects Loan Agreement No. 2 dated June 9, 1987, among Continental Bank International, as Trustee under the Badak Trustee and Paying Agent Agreement (Borrower), the banks named therein as Lead Managers and Lenders and The Industrial Bank of Japan Trust Company (Agent) (filed as Exhibit (10)-31 to the Company's 1987 Form 10-K (No. 1- 8791)).* (10)-42- Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and National Federation of Agricultural Co-Operative Associations (Zen-Noh), as Buyer, dated February 21, 1992. (10)-43- Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Japan Indonesia Oil Co., Ltd., as Buyer, dated February 20, 1992. (10)-44- Arun and Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) as Seller and Mitsubishi Corporation, Cosmo Oil Co., Ltd., Nippon Petroleum Gas Co., Ltd., Showa Shell Sekiyu K.K., Kyodo Oil Co., Ltd., Idemitsu Kosan Co., Ltd. and Mitsui Liquefied Gas Co., Ltd. as Buyers dated July 15, 1986 (filed as Exhibit (10)-60- to the Company's 1991 Form 10-K (No. 1-8791)).* (10)-45- Bontang LPG Supply Agreement, dated November 17, 1987, between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. * Incorporated herein by reference. (10)-46- Advance Payment Agreement between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Arun Bontang Project Finance Co., Ltd., dated February 16, 1987 (filed as Exhibit (4)-15- to the Company's 1986 Form 10-K (No. 1-8791)).* (10)-47- Agreement and Plan of Reorganization of ENSTAR Corporation, dated December 22, 1989, by and among Unimar Company, Ultrastar, Inc., Unistar, Inc., ENSTAR Corporation, Newstar Inc., Union Texas Development Corporation, Union Texas Petroleum Corporation and Ultramar America Limited. (10)-48- Amendment to Agreement and Plan of Reorganization of ENSTAR Corporation, dated May 1, 1990, by and among Unimar Company, Ultrastar, Inc., Unistar, Inc., ENSTAR Corporation, Ultramar Production Company, Union Texas Development Corporation, Union Texas Petroleum Corporation and Ultramar America Limited. (21)-1- List of Subsidiaries of the Company. (23)-1- Consent of Ernst & Young. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the last quarter of the fiscal year ended December 31, 1993. * Incorporated herein by reference. SIGNATURES Pursuant to the requirements of Section 13 or 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. UNIMAR COMPANY March 24, 1994 By /S/ ARTHUR W. PEABODY Arthur W. Peabody Chairman of the Management Board 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 indicated as of March 24, 1994. By /S/ GEORGE W. BERKO By /S/ LARRY D. KALMBACH George W. Berko Larry D. Kalmbach Management Board Management Board (LASMO Representative) (UTPH Representative) By /S/ IAN D. BROWN By /S/ WILLIAM M. KRIPS Ian D. Brown William M. Krips Management Board Management Board (LASMO Representative) (UTPH Representative) By /S/ JERRY L. PICKERILL By /S/ ARTHUR W. PEABODY Jerry L. Pickerill Arthur W. Peabody Management Board Chairman of the (LASMO Representative) Management Board (UTPH Representative) INDEX TO EXHIBITS Sequential Numbered Exhibit Number Page The following documents are included as Exhibits to this Report. Unless it has been indicated that a document listed below is incorporated by reference herein, copies of the document have been filed herewith. (2)-1- Merger Agreement, dated May 22, 1984, and Amendment Agreements thereto, dated June 8, 1984 and June 12, 1984 (incorporated by reference to Annex A to the Prospectus/Proxy Statement included in the Company's Registration Statement on Form S- 14 (No. 2-93037)).* (2)-2- Agreement of Merger, dated as of August 28, 1984 (incorporated by reference to Annex B to the Prospectus/Proxy Statement included in the Company's Registration Statement on Form S-14 (No. 2-93037)).* (2)-3- Divestiture Agreement, dated June 20, 1984 (filed as Exhibit 2.3 to the Company's Registration Statement on Form S-14 (No. 2-93037)).* (3)-1- Amended and Restated Agreement of General Partnership of Unimar Company dated September 11, 1990 between Unistar, Inc. and Ultrastar, Inc. (filed as Exhibit (3)-4- to the Company's 1990 Form 10-K (No. 18791)).* (4)-1- Form of Indenture between Unimar and Irving Trust Company, as Trustee (filed as Exhibit 4 to the Company's Registration Statement on Form S-14 (No. 2-93037)).* (4)-2- First Supplemental Indenture, dated as of October 31, 1986, to the Indenture between Unimar and Irving Trust Co., as Trustee (Exhibit (4)-1 above) (Filed as Exhibit 10.114 to Union Texas Petroleum Holdings, Inc.'s Registration Statement on Form S- 1 (No. 33-16267)).* (10)-1- Joint Venture Agreement, dated August 8, 1968, among Roy M. Huffington, Inc., Virginia International Company, Austral Petroleum Gas Corporation, Golden Eagle Indonesia, Limited, and Union Texas Far East Corporation, as amended (filed as Exhibit 6.6 to Registration Statement No. 2-58834 of Alaska Interstate Company).* * Incorporated herein by reference. (10)-2- Agreement dated as of October 1, 1979, among the parties to the Joint Venture Agreement referred to in Exhibit (10)-1- above (filed as Exhibit 5.2 to Registration Statement No. 2-66661 of Alaska Interstate Company).* (10)-3- Amendment to the Operating Agreement dated April 1, 1990, between Roy M. Huffington, Inc., a Delaware corporation, Ultramar Indonesia Limited, a Bermuda corporation, Virginia Indonesia Company, a Delaware corporation, Virginia International Company, a Delaware corporation, Union Texas East Kalimantan Limited, a Bahamian corporation, and Universe Gas & Oil Company, Inc., a Liberian corporation. (10)-4- Amended and Restated Production Sharing Contract dated April 23, 1990 (effective August 8, 1968 - August 7, 1998) by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Roy M. Huffington, Inc., Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Huffington Corporation. (10)-5- Production Sharing Contract dated April 23, 1990 (effective August 8, 1998 - August 7, 2018) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Roy M. Huffington, Inc., Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Huffington Corporation. (10)-6- Nilam Unit Agreement, effective as of January 1, 1980, to establish the manner in which the Joint Venture and Total will cooperate to develop the unitized area of the Nilam Field (filed as Exhibit (10)-58- to the Company's 1991 Form 10-K (No. 1- 8791)).* (10)-7- Third Amended and Restated Implementation Procedures for Crude Oil Liftings, effective as of July 1, 1993, among Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company. * Incorporated herein by reference. (10)-8- Amended and Restated 1973 LNG Sales Contract, dated as of the 1st day of January 1990, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., The Kansai Electric Power Co., Inc., Kyushu Electric Power Co., Inc., Nippon Steel Corporation, Osaka Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. (10)-9- Amendment to the 1973 LNG Sales Contract dated as of the 3rd day of December, 1973, amended by Amendment No. 1 dated as of the 31st day of August, 1976, and amended and restated as of the 1st day of January, 1990 ("1973 LNG Sales Contract"), is entered into as of the 1st day of June, 1992, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, a state enterprise of the Republic of Indonesia (Seller), on the one hand, and Kyushu Electric Power Co., Inc. (Kyushu Electric), Nippon Steel Corporation (Nippon Steel), and Toho Gas Co., Ltd. (Toho Gas), all corporations organized and existing under the laws of Japan, on the other hand. (10)-10- Amended and Restated Supply Agreement (In Support of the Amended and Restated 1973 LNG Sales Contract) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective December 3, 1973. (10)-11- Amended and Restated Badak LNG Sales Contract, dated as of the 1st day of January, 1990, by and between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., The Kansai Electric Power Co., Inc., Osaka Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. (10)-12- Supply Agreement, dated as of April 14, 1981 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement, including the Company. (10)-13- Seventh Supply Agreement for Excess Sales (Additional Fixed Quantities under Badak LNG Sales Contract as a Result of Contract Amendment and Restatement) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Virginia Indonesia Company, Opicoil Houston, Inc., Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company, dated September 28, 1992, but effective as of January 1, 1990. * Incorporated herein by reference. (10)-14- Bontang II Trustee and Paying Agent Agreement Amended and Restated as of July 15, 1991 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Virginia International Company, Union Texas East Kalimantan Limited, Ultramar Indonesia Limited, Opicoil Houston, Inc., Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International. (10)-15- Producers Agreement No. 2 dated as of June 9, 1987 by Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina), Roy M. Huffington, Inc., Virginia International Company, Ultramar Indonesia Limited, Virginia Indonesia Company, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Huffington Corporation in favor of The Industrial Bank of Japan Trust Company as Agent (filed as Exhibit (10)-30- to the Company's 1987 Form 10-K (No. 1-8791)).* (10)-16- Badak III LNG Sales Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) as Seller and Chinese Petroleum Corporation as Buyer signed on March 19, 1987 (filed as Exhibit (10)-59- to the Company's 1991 Form 10-K (No. 1-8791)).* (10)-17- Badak III LNG Sales Contract Supply Agreement, dated October 19, 1987 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. (10)-18- LNG Sales and Purchase Contract (Korea II) effective May 7, 1991 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Korea Gas Corporation. (10)-19- Schedule A to the LNG Sales and Purchase Contract (Korea II FOB) between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Korea Gas Corporation. (10)-20- Bontang III Producers Agreement, dated February 9, 1988, among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. * Incorporated herein by reference. (10)-21- Amendment No. 1 to Bontang III Producers Agreement dated as of May 31, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Train-E Finance Co., Ltd., as Tranche A Lender, The Industrial Bank of Japan Trust Company, as Agent and The Industrial Bank of Japan Trust Company on behalf of the Tranche B Lenders. (10)-22- Amendment No. 2 to Producers Agreement No. 2 dated as of May 31, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited and Universe Tankships, Inc. (filed as Exhibit (10)-44- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-23- $316,000,000 Bontang III Loan Agreement dated February 9, 1988 among Continental Bank International as Trustee, Train-E Finance Co., Ltd. as Tranche A Lender and The Industrial Bank of Japan Trust Company as Agent. (10)-24- Bontang III Trustee and Paying Agent Agreement, dated February 9, 1988, among Pertamina, Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, VICO, Ultrastar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesia, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International (filed as Exhibit 10.42 to the Union Texas Petroleum Holdings, Inc.'s 1991 Form 10-K (Commission File No. 1- 9019)).* (10)-25- Amendment No. 1 to Bontang III Trustee and Paying Agent Agreement, dated as of December 11, 1992, among Pertamina, VICO, Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Opicoil Houston, Inc., Universe Gas & Oil Company, Inc., Total Indonesia, Unocal Indonesia Ltd., Indonesia Petroleum, Ltd. and Continental Bank International, as Bontang III Trustee (Filed as Exhibit 10.83 to the Union Texas Petroleum Holdings, Inc.'s 1992 Form 10-K (Commission File No. 1-9019)).* * Incorporated herein by reference. (10)-26- Amended and Restated Debt Service Allocation Agreement dated February 9, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Roy M. Huffington, Inc., Virginia International Company, Ultramar Indonesia Limited, Virginia Indonesia Company, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Huffington Corporation, Total Indonesie, Unocal Indonesia, Ltd. and Indonesia Petroleum, Ltd. (filed as Exhibit (10)- 40- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-27- Letter agreement between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Chinese Petroleum Corporation, dated December 1, 1989. (10)-28- Memorandum of Agreement (Yokkaichi Extension), made as of December 21, 1989, between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Chubu Electric Power Co., Inc., as Buyer (filed as Exhibit (10)-60- to the Company's 1989 Form 10-K (No. 1-8791)).* (10)-29- Badak IV LNG Sales Contract dated October 23, 1990 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina), as Seller and Osaka Gas Co., Ltd., Tokyo Gas Co., Ltd. and Toho Gas Co., Ltd., as Buyers. (10)-30- LNG Sales Contract dated as of October 13, 1992 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller and Hiroshima Gas Co., Ltd. and Nippon Gas Co., Ltd., as Buyers. (10)-31- LNG Sales Contract dated as of October 13, 1992 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller and Osaka Gas Co., Ltd., as Buyer. (10)-32- Supply Agreement for Natural Gas to Badak IV LNG Sales Contract dated August 12, 1991 between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc. and Virginia International Company. (10)-33- Second Supply Agreement for Package IV Excess Sales (Osaka Gas Contract - Package IV Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective January 1, 1991. * Incorporated herein by reference. (10)-34- Third Supply Agreement for Package IV Excess Sales (Toho Gas Contract - Package IV Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 28, effective January 1, 1991. (10)-35- Eleventh Supply Agreement for Package IV Excess Sales (1973 Contract Build-Down Quantities) between Pertamina and Virginia Indonesia Company, LASMO Sanga Sanga Limited, Opicoil Houston, Inc., Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., and Virginia International Company dated September 22, 1993, effective January 1, 1990. (10)-36- Bontang IV Producers Agreement dated August 26, 1991 by Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd. and Indonesia Petroleum, Ltd., in favor of The Chase Manhattan Bank, N.A. as Agent for the Lenders. (10)-37- $750,000,000 Bontang IV Loan Agreement dated August 26, 1991 among Continental Bank International as Trustee under the Bontang IV Trustee and Paying Agent Agreement as Borrower, Chase Manhattan Asia Limited and The Mitsubishi Bank, Limited as Coordinators, the other banks and financial institutions named herein as Arrangers, Co-Arrangers, Lead Managers, Managers, Co-Managers and Lenders, The Chase Manhattan Bank, N.A. and the Mitsubishi Bank, Limited as Co-Agents and The Chase Manhattan Bank, N.A. as Agent. (10)-38- Bontang IV Trustee and Paying Agent Agreement dated August 26, 1991 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, Virginia Indonesia Company, Opicoil Houston, Inc., Virginia International Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Gas & Oil Company, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and Continental Bank International. * Incorporated herein by reference. (10)-39- Amended and Restated Bontang Processing Agreement dated February 9, 1988 among Perusahaan Pertambangan Minyak Dan Gas Bumi Negara and Roy M. Huffington, Inc., Huffington Corporation, Virginia International Company, Virginia Indonesia Company, Ultramar Indonesia Limited, Union Texas East Kalimantan Limited, Universe Tankships, Inc., Total Indonesie, Unocal Indonesia, Ltd., Indonesia Petroleum, Ltd. and P.T. Badak Natural Gas Liquefaction Company (filed as Exhibit (10)-39- to the Company's 1988 Form 10-K (No. 1-8791)).* (10)-40- Bontang Capital Projects Loan Agreement No. 1 between Continental Bank International as Trustee under the Badak Trustee and Paying Agent Agreement, Borrower, and The Industrial Bank of Japan Trust Company, Agent, for the Lenders dated as of September 10, 1986 (filed as Exhibit (4)-13- to the Company's 1986 Form 10-K (No. 1-8791)).* (10)-41- Bontang Capital Projects Loan Agreement No. 2 dated June 9, 1987, among Continental Bank International, as Trustee under the Badak Trustee and Paying Agent Agreement (Borrower), the banks named therein as Lead Managers and Lenders and The Industrial Bank of Japan Trust Company (Agent) (filed as Exhibit (10)-31 to the Company's 1987 Form 10-K (No. 1-8791)).* (10)-42- Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and National Federation of Agricultural Co-Operative Associations (Zen-Noh), as Buyer, dated February 21, 1992. (10)-43- Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara, as Seller, and Japan Indonesia Oil Co., Ltd., as Buyer, dated February 20, 1992. (10)-44- Arun and Bontang LPG Sales and Purchase Contract between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) as Seller and Mitsubishi Corporation, Cosmo Oil Co., Ltd., Nippon Petroleum Gas Co., Ltd., Showa Shell Sekiyu K.K., Kyodo Oil Co., Ltd., Idemitsu Kosan Co., Ltd. and Mitsui Liquefied Gas Co., Ltd. as Buyers dated July 15, 1986 (filed as Exhibit (10)-60- to the Company's 1991 Form 10-K (No. 1-8791)).* (10)-45- Bontang LPG Supply Agreement, dated November 17, 1987, between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and the parties to the Joint Venture Agreement. * Incorporated herein by reference. (10)-46- Advance Payment Agreement between Perusahaan Pertambangan Minyak Dan Gas Bumi Negara (Pertamina) and Arun Bontang Project Finance Co., Ltd., dated February 16, 1987 (filed as Exhibit (4)-15- to the Company's 1986 Form 10-K (No. 1- 8791)).* (10)-47- Agreement and Plan of Reorganization of ENSTAR Corporation, dated December 22, 1989, by and among Unimar Company, Ultrastar, Inc., Unistar, Inc., ENSTAR Corporation, Newstar Inc., Union Texas Development Corporation, Union Texas Petroleum Corporation and Ultramar America Limited. (10)-48- Amendment to Agreement and Plan of Reorganization of ENSTAR Corporation, dated May 1, 1990, by and among Unimar Company, Ultrastar, Inc., Unistar, Inc., ENSTAR Corporation, Ultramar Production Company, Union Texas Development Corporation, Union Texas Petroleum Corporation and Ultramar America Limited. (21)-1- List of Subsidiaries of the Company. (23)-1- Consent of Ernst & Young. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the last quarter of the fiscal year ended December 31, 1993. * Incorporated herein by reference.	15,341	98,574
810113_1993.txt	810113_1993	1993	810113	Item 1. BUSINESS General Maritrans Inc. (the "Corporation" or the "Registrant"), together with its predecessor, Maritrans Partners L.P. (the "Partnership"), herein called "Maritrans," has historically served the petroleum and petroleum product distribution industry by providing marine transportation services along the East and Gulf Coasts of the United States utilizing its barges and tugboats. Maritrans has recently broadened its participation in distribution services by adding marine terminal facilities, distribution coordination and oil spill contingency management services. Structure The Registrant is a Delaware corporation whose common stock ("Common Stock") is publicly traded. The Registrant conducts most of its marine transportation business activities through Maritrans Operating Partners L.P. and Maritrans General Partner Inc., wholly owned subsidiaries of the Registrant. Most of the Registrant's terminalling, spill contingency and ancillary services are conducted through subsidiaries of Maritrans Holdings Inc., a wholly owned subsidiary of the Registrant. Direct and indirect subsidiaries of the Registrant include: Maritrans Operating Partners L.P. (the "Operating Partnership") Maritrans General Partner Inc. Maritrans Holdings Inc. Response Members Inc. Maritrans Capital Corp. Response Services Inc. CCF Acquisition Corp. Maritank Philadelphia Inc. Inter-Cities Navigation (Texas) Corp. Maritank Maryland Inc. Interstate Towing (Texas) Co. Marispond Inc. Maritrans Eastern Inc. Maritrans Inland Inc. Maritrans Gulf Inc. Based on its internal research regarding Maritrans' competition, Maritrans believes that it is one of the largest United States marine transporters of petroleum and petroleum products in the U.S. Coastwise trade (i.e. from port to port within the United States), excluding affiliates of integrated oil companies, and that it owns one of the largest domestic fleets of U.S. flag oceangoing tank barges. Founded in the 1850's and incorporated in 1928 under the name Interstate Oil Transport Company, Maritrans' predecessor was one of the first tank barge operators in the United States, with a fleet which increased in size and capacity as United States consumption of petroleum products increased. On December 31, 1980, Maritrans' predecessor operations and its tugboat and barge affiliates were acquired by Sonat Inc. ("Sonat"). On April 14, 1987, Maritrans acquired the tug and barge business and related assets of the tug and barge affiliates of Sonat. Since 1981, Maritrans and its predecessors have transported annually over 200 million barrels of crude oil and refined petroleum products. On March 31, 1993, the limited partners of the Partnership voted on a proposal to convert the Partnership to corporate form (the "Conversion"). The proposal was approved, and on April 1, 1993, Maritrans Inc., then a newly-formed Delaware corporation, succeeded to all assets and liabilities of the Partnership. The holders of general and limited partnership interests in the Partnership and in the Operating Partnership were issued shares of Common Stock, par value $.01 per share, of the Corporation, representing substantially the same percentage equity interest in the Corporation as they had in the Partnership, directly or indirectly, in exchange for their partnership interest. Each previously held Unit of Limited Partnership Interest in the Partnership was exchanged for one share of Common Stock of the Corporation. For financial accounting purposes, the conversion to corporate form has been treated as a reorganization of affiliated entities, with the assets and liabilities recorded at their historical costs. In addition, the Partnership recognized a net deferred income tax liability for temporary differences in accordance with Statement of Financial Accounting Standard ("FAS") No. 109, Accounting for Income Taxes, which resulted in a one-time charge to earnings of $16.6 million in the first quarter of 1993. Maritrans' present business plan for complying with the Oil Pollution Act of 1990, (the "OPA"), includes the implementation of an on-going, company-wide Quality Improvement Program, which focuses on improving each area of vessel operations in order to eliminate oil spills, increased training and awareness of marine personnel (including recertification of masters and mates, watchstanding procedures and cargo transfer operations), improved vessel maintenance procedures to address repairs before an accident occurs, maintaining a comprehensive risk- management program, including $700 million in oil spill pollution liability insurance coverage on its fleet of petroleum barges, the maximum amount of such coverage generally carried at commercial rates, and implementing an in-house oil pollution regulatory program designed to keep management and operating personnel knowledgeable about all pertinent developments in regulations promulgated under the OPA and in state oil pollution laws and regulations. Since the double-hull requirements of the OPA do not begin to impact materially on Maritrans' present barge fleet until January 1, 2005, it is difficult to say precisely how Maritrans will finance the conversion of its fleet to double-hull vessels. However, Maritrans expects that, where economically feasible, it will take steps to construct new, double-hulled vessels and/or convert its present single-hull vessels. The timing of the construction or conversion of such vessels will depend in large measure on market conditions, particularly demand for double-hulled vessels and the rates which petroleum shippers are willing to pay to use such vessels. Maritrans expects to finance such construction or conversion primarily from internally generated funds and outside sources, including the equity market, borrowing from conventional sources such as banks and insurance companies and U.S. Government- guaranteed ship financing, if available, and financial leases. There is no assurance that such financing will be available in the amounts and at interest rates which will allow Maritrans to replace its current single-hull barge fleet. For a further description of Maritrans' present business plan for complying with the OPA, see "Regulation - Oil Pollution Legislation." In January 1992, Maritrans restructured its marine operations into three divisions - Eastern, Inland and Gulf, supported by executive and service units. The three divisions also provide marketing, logistical, and operational support for Maritrans' vessels, which are assigned to divisions based on market conditions. This divisional restructuring was designed to move Maritrans closer to its markets and customers, improve productivity and efficiency in operations and permit more rapid decisions and responses to changing conditions. The Gulf Division, headquartered in Tampa, Florida, provides marine transportation services for petroleum products from refineries located in Texas, Louisiana and Mississippi to distribution points along the Gulf and Atlantic Coasts generally south of Cape Hatteras, North Carolina and particularly into Florida. The Eastern Division, supported by a major fleet center in Philadelphia, Pennsylvania, transports petroleum products from East Coast refineries (primarily located in and near Philadelphia) and pipeline terminals located in the New York Harbor area to distribution terminals primarily located along the Eastern Seaboard between the Canadian Maritime Provinces and Cape Hatteras, North Carolina. Maritrans also provides, as part of its Eastern Division, lightering services for large tank ships (a process of off-loading crude oil or petroleum products from an inbound tanker into barges, thereby enabling the tanker to navigate draft-restricted rivers and ports to discharge cargo at a refinery or storage and distribution terminal). The Inland Division is also supported by fleet center operations in Philadelphia, Pennsylvania, and transports petroleum products and chemicals between refineries and distribution points along the Delaware River and in the Chesapeake Bay. In 1993, the Inland Division and Maritank Maryland Inc., which owns a marine terminal in Salisbury, Maryland, began to deliver distribution services through petroleum exchange agreements with customers requiring both marine transportation and terminalling services. The petroleum exchange agreements are structured so that Maritrans bears none of the exposure to fluctuations in inventory price movements. Maritrans operates a fleet of tank barges and tugboats. Its largest barge has a capacity of approximately 400,000 barrels, and its current operating barge fleet capacity aggregates approximately 4 million barrels. Demand for Maritrans' services is dependent primarily upon general demand for petroleum and petroleum products in the geographic areas served by its vessels. Management believes that United States petroleum consumption, and particularly consumption in New England and Florida, are significant indicators of demand for Maritrans' services. Increases in product consumption generally increase demand for Maritrans' services; conversely, decreases in consumption generally lessen demand for Maritrans' services. Management further believes that the level of domestic consumption of imported product is also significant to Maritrans' business. Imported petroleum products generally can be shipped on foreign-flag vessels directly into United States ports for storage, distribution and eventual consumption. These shipments reduce the need for domestic marine transportation service providers such as Maritrans to carry products from United States refineries to such ports. While Maritrans does benefit somewhat from the increase in demand for domestic redistribution services that results from the delivery of excess product to terminals by foreign-flag vessels, the overall effect of refined product imports on the demand for Maritrans' services is generally negative. In June 1991, Maritrans, through a subsidiary, Maritank Philadelphia Inc., acquired a one-million barrel, deepwater marine terminal located in Philadelphia. This facility is a full-service petroleum product terminal able to receive, store and subsequently redistribute product by pipeline, marine vessel and truck. This facility is also capable of performing cleaning of Maritrans' petroleum carrying vessels. Under current law, a vessel owner is jointly and severally liable with the barge cleaning contractor and the waste disposal contractor in the event that either such contractor improperly disposes of any portion of tank cleaning residues from the vessel which is hazardous. Not only have the tank cleaning rates paid by Maritrans to third parties been increasing substantially, but, in addition, Maritrans believes that at least some of these sources for tank cleaning will not be available in the near future. Management believes the ability to control the cleaning of its vessels will lessen its environmental exposure, as discussed above, since it can then control this activity. Maritrans also believes that this facility will provide it with a long-term strategic advantage since it will be able to assure itself of the availability of these services at a reasonable cost and, by controlling the facility, it will be able to ensure that it can manage vessel turn-around time, thereby increasing vessel availability, and that the facility is run in an environmentally sound manner. In early 1993, Maritank Maryland Inc. ("MMI") and Marispond Inc. ("Marispond") were established as indirect subsidiaries of the Registrant. MMI provides marine terminalling and, together with the Inland Division, distribution services in Salisbury, Maryland. Marispond provides a series of services, most of which arise from requirements of the OPA. These services include oil spill contingency planning, response management and other services on a contract basis to Maritrans and other vessel owners from around the world whose vessels call on United States ports. Maritrans also established an office in Houston, Texas in 1993 in conjunction with efforts it is undertaking to expand its distribution services. Sales and Marketing Maritrans provides marine transportation, storage, and distribution coordination services primarily to integrated oil companies, independent oil companies, and petroleum distributors in the southern and eastern United States. Maritrans relies primarily on direct sales efforts, minimizing its use of chartering brokers. Maritrans monitors the supply and distribution patterns of its actual and prospective customers and focuses its efforts on providing services that are responsive to the current and future needs of these customers. Maritrans does business on a spot market basis, a term contract basis and, more recently, on a product exchange basis. Maritrans strives to maintain an appropriate mix of contracted business, based on current market conditions. In light of the potential liabilities of oil companies and other shippers of petroleum products under the OPA and analogous state laws, management believes that some shippers have begun to select transporters in larger measure than in the past on the basis of a demonstrated record of safe operations. Therefore, Maritrans has implemented a number of measures in order to promote higher quality operations and continues to stress its longstanding commitment to safe transportation of petroleum products in its marketing efforts. In 1993, approximately 71% of Maritrans' revenues were generated from ten customers. In 1993, contracts with Chevron U.S.A., Inc. (including affiliates, "Chevron"), and British Petroleum Corp. (including affiliates) accounted in the aggregate for approximately 17% and 15%, respectively, of Maritrans' revenues. There could be a material adverse effect on Maritrans if either of these customers were to cancel or terminate their various agreements with Maritrans. Management believes that cancellation or termination of all of its business with any of its larger customers is unlikely. In February 1994, Chevron announced a tentative agreement to sell its refinery along the Delaware River in Philadelphia, Pennsylvania, to Sun Company, Inc., a Maritrans customer. Based on public announcements by the prospective buyer, Maritrans believes such a sale would not have a material adverse effect on its business. Competition and Competitive Factors Overview. The maritime petroleum transportation industry is highly competitive. The Jones Act, a federal law, restricts United States port-to-port maritime shipping to vessels built in the United States, owned by U.S. citizens and manned by U.S. crews. In Maritrans' market areas, its primary direct competitors are the operators of U.S. flag oceangoing barges and U.S. flag tankers. In the Gulf market, the primary competitors are the fleets of both other independent petroleum transporters and integrated oil companies. In the Eastern and Inland market, management believes, based on its extensive knowledge and experience in the industry, that Maritrans primarily competes with other independent oceangoing barge operators and with the captive fleets of integrated oil companies and, in lightering operations, has competed with foreign-flag operators which lighter offshore. Some of the integrated oil company fleets with which Maritrans competes are larger than Maritrans' fleet. Additionally, in certain geographic areas and in certain business activities, Maritrans competes with the operators of petroleum product pipelines. Competitive factors which also affect Maritrans include the output of United States refineries and the importation of petroleum products. The primary competition for Maritrans' marine terminals is proprietary storage capacity of integrated oil companies, merchant refiners, and independent marine terminal operators. U.S. Flag Barges and Tankers. Maritrans' most direct competitors are the other operators of U.S. flag oceangoing barges and tankers. Because of the restrictions imposed by the Jones Act, there is a finite number of vessels that are currently eligible to engage in U.S. maritime petroleum transport. Therefore, the size and capacity of Maritrans' fleet relative to those of others in the industry is an important factor in competing for business on the basis of safety and service. The number of vessels eligible to engage in Jones Act trade has declined significantly over the past several years. The gradual implementation of regulations requiring significant capital modifications and in some cases loss of vessel capacity, as well as a decrease in the number of new vessels constructed since 1982, have been the major causes of this decline. Competition in the industry is based upon price and service (including vessel availability) and is intense. Maritrans is engaged in several different market activities. A significant portion of its revenues in 1993 was generated in the coastal transportation of petroleum products from refineries or pipeline terminals in the Gulf of Mexico to ports which are not served by pipelines. Management believes that the optimal vessel size suited to serve these ports is between 20,000 deadweight tons ("DWT") (approximately 160,000 barrels) and 40,000 DWT (approximately 320,000 barrels). Maritrans currently operates six barges in this size range in this market, which comprises a significant number of the vessels able to compete in this market. The relatively large size of Maritrans' fleet generally provides greater flexibility in meeting customers' needs. Maritrans competes with operators of generally smaller vessels in its Inland and Eastern transportation activities. In this activity Maritrans is competing primarily with other barge operators. This is a diverse market allowing a broader size range of vessels to participate than in the Gulf of Mexico. Management believes that, for the most part, Maritrans' independent competitors do not provide the same level of service, quality performance, or attention to safe operations as Maritrans due to its fleet size, maintenance and training programs, and spill record. General Agreement on Trade in Services ("GATS") and North American Free Trade Agreement ("NAFTA"). The possible inclusion of maritime services within the scope of the GATS and the NAFTA was the subject of discussion in the recently concluded Uruguay Round of GATS negotiations and NAFTA negotiations. If maritime services were deemed to include cabotage and were included in either of these multi-national trade agreements, the result would have been to open the Jones Act trade, (i.e., transportation of maritime cargo between U.S. ports in which Maritrans and other U.S. vessel owners operate) to foreign-flag vessels which would operate at lower costs. Maritrans understands that cabotage (vessel trade or marine transportation between two points within the same country) will not be included in the GATS and the NAFTA in the foreseeable future; however, the possibility exists that cabotage could be included in either the GATS or the NAFTA, or both, in the future. In the meantime, Maritrans and the maritime industry will continue to resist vigorously the inclusion of cabotage in the GATS and the NAFTA. Refined Product Pipelines. Existing refined product pipelines generally are the lowest incremental cost method for the long-haul movement of petroleum and refined petroleum products. Other than the Colonial Pipeline system, which originates in Texas and terminates at New York Harbor, and smaller regional pipelines between Philadelphia and New York, there are no pipelines carrying refined petroleum products to the major storage and distribution facilities currently served by Maritrans. While the Colonial Pipeline system reduces the amount of refined product transported into the New York area by ship, it provides an origination point for Maritrans' business of transporting such products from New York Harbor to New England ports. Management believes that high capital costs, tariff regulation and environmental considerations make it unlikely that a new refined product pipeline system which would have a material adverse effect on Maritrans' business will be built in its market areas in the foreseeable future. It is possible, however, that, as noted above, new pipeline segments (including pipeline segments that connect with existing pipeline systems) could be built or that existing pipelines could be converted to carry refined petroleum products, either of which could effectively compete with Maritrans in particular locations. Natural Gas Pipelines. In December 1991, a 370 mile natural gas pipeline from the Canadian border to the northeastern United States markets was completed. The operation of this pipeline increases the amount of natural gas supplied to the northeastern United States, thus potentially reducing the demand for residual fuel for power generation and ultimately reducing the demand for marine transportation of residual fuel and other petroleum products to and within the area. Whether this reduction occurs will depend on the relative prices between residual fuel and natural gas, including transportation costs, in the future. If these pipelines cause a reduction in demand for marine transportation of petroleum products, Maritrans and other carriers active in the trade would suffer negative effects to their business in this market area. Imported Refined Petroleum Products. A significant factor affecting the level of Maritrans' business operations is the level of refined petroleum product imports, particularly in Florida and New England. Imported refined petroleum products may be transported on foreign-flag vessels, which are generally less costly to operate than U.S. flag vessels. To the extent that there is an increase in the importation of refined petroleum products to any of the markets served by Maritrans, there could be a decrease in the demand for the transportation of refined products from United States refineries, which would likely have an adverse impact upon Maritrans. One possible outcome of the Clean Air Act could be the importing of more refined product from outside the United States in order to avoid the expense of upgrading United States refineries to comply with such Act. In this case, while there would still be a need for marine petroleum transportation, the demand would decrease, thereby possibly materially adversely affecting the coastwise business of Maritrans and its competitors. On the other hand, this development could prove beneficial to Maritrans' terminalling business, due to the likely increased demand for storage capacity for the imported refined product. Delaware River Channel Depth. Legislation has been approved by the United States Congress which authorizes the U.S. Army Corps of Engineers to deepen the channel of the Delaware River between the river's mouth and Philadelphia from forty to forty-five feet late in the 1990's. If further legislation appropriating the funds for this project should become law and this project is implemented and used by vessels calling on the Delaware Valley refineries, it would have a material adverse effect on Maritrans' lightering business which currently transports crude oil which is off-loaded from deeply laden tankers from the mouth of the Delaware Bay up the Delaware River to the Delaware Valley refineries. Employees and Employee Relations At December 31, 1993, Maritrans and its subsidiaries employed a total of 605 persons. Of these employees, 100 are employed at the Philadelphia, Pennsylvania headquarters of the Registrant or at the Philadelphia and Tampa fleet centers, 465 are seagoing employees who work aboard the tugs and barges, and 40 are employed by Maritrans' non-marine affiliates. Maritrans and its predecessors have had collective bargaining agreements with the Seafarers' International Union of North America, Atlantic, Gulf and Inland District, AFL-CIO ("SIU"), and with American Maritime Officers ("AMO"), formerly District 2 Marine Engineers Beneficial Association, Associated Maritime Officers, AFL-CIO, for approximately 31 years. Approximately one-half of the total number of seagoing employees employed are supervisors and, hence, as part of management, are not represented by maritime unions. The collective bargaining agreement with the SIU covers approximately 194 employees. The collective bargaining agreement with the AMO covers approximately 44 employees. Each expires on May 31, 1996. The employees of the subsidiaries of Maritrans Holdings Inc. are not covered by any collective bargaining agreement. Management believes that the seagoing supervisory and non-supervisory personnel contribute significantly to responsive customer service. Maritrans maintains a policy of seeking to promote from within, where possible, and generally seeks to draw from its union and non-union personnel to fill supervisory and other management positions as vacancies occur. Management believes that an extensive training program and operational audit program (performed by Tidewater School of Navigation, Inc.) is essential to insure that its employees are knowledgeable and highly skilled in the performance of their duties as well as in their preparedness for any unforeseen emergency situations that may arise. Consequently, various training sessions and additional skill improvement seminars are held throughout the year on subjects including deck officer training, tankerman training, substance abuse awareness, fire fighting, emergency response and personal professional development. In 1991, Maritrans introduced its Quality Improvement Program. All employees participate in quality training seminars in addition to the skills improvement training mentioned above. Regulation Marine Transportation - General. The Interstate Commerce Act exempts from economic regulation the water transportation of petroleum cargos in bulk. Accordingly, Maritrans' transportation rates, which are negotiated with its customers, are not subject to special rate regulation under the provisions of such act or otherwise. The operation of tugboats and barges is subject to regulation under various federal laws and international conventions, as interpreted and implemented by the United States Coast Guard, as well as certain state and local laws. Tugboats and barges are required to meet construction and repair standards established by the American Bureau of Shipping, a private organization, and the United States Coast Guard and to meet operational and safety standards presently established by the United States Coast Guard. Maritrans' seagoing supervisory personnel are licensed by the United States Coast Guard. Seamen and tankermen are certificated by the United States Coast Guard. Jones Act. The Jones Act, a federal law, restricts maritime transportation between United States points to vessels built and registered in the United States and owned by United States citizens. The entities in the Maritrans organizational structure engaged in maritime transportation between United States points are subject to the provisions of the law. Therefore, it is the responsibility of Maritrans to monitor ownership of these entities and take any remedial action necessary to insure that no violation of the Jones Act occurs. In addition, the Jones Act requires that all United States flag vessels be manned by United States citizens, which significantly increases the labor and certain other operating costs of United States flag vessel operations compared to foreign-flag vessel operations. Foreign-flag seamen generally receive lower wages and benefits than those received by United States citizen seamen. In addition, a significant number of foreign governments subsidize, at least to some extent, the wages and/or benefits received by the seamen of those nations. Furthermore, certain of these foreign governments subsidize those nations' shipyards, resulting in lower shipyard costs both for new vessels and repairs than those paid by United States-flag vessel owners such as Maritrans to United States shipyards. Finally, the United States Coast Guard and American Bureau of Shipping maintain the most stringent regime of vessel inspection in the world, which tends to result in higher regulatory compliance costs for United States-flag operators than those paid by owners of vessels registered under foreign flags of convenience. Because Maritrans transports petroleum and petroleum products between United States ports, most of its business depends upon the Jones Act remaining in effect. There have been various unsuccessful attempts in the past by foreign governments and companies to gain access to the Jones Act trade. Management expects that efforts of this type will continue. Environmental Matters. Maritrans is subject to various legislation and regulations enacted to protect the environment. Marine Storage Terminal Regulation. Maritrans marine terminal subsidiaries are subject to various federal, state and local environmental laws and regulations, particularly with respect to air quality, the handling of materials removed from the tanks of vessels which are cleaned, and any spillage of petroleum products on or adjoining marine terminal premises. Management believes that this regulatory scheme will become progressively stricter in the future, resulting in greater capital expenditures by Maritrans for environmentally related equipment. Also, there are significant fines and penalties for any violations of this scheme. Management intends to reflect any such additional expenditures, to the extent they are able, in the rates which are charged to customers from time to time for services. Oil Pollution Legislation. Many of the states in which Maritrans does business have enacted laws providing for strict, unlimited liability for vessel owners in the event of an oil spill. In addition, numerous states have enacted or are considering legislation or regulations involving at least some of the following provisions: tank- vessel-free zones, contingency planning, state inspection of vessels, additional operating, maintenance and safety requirements, and state financial responsibility requirements. As a result of this legislation and regulation, Maritrans has curtailed its carriage of persistent oils, primarily crude and #6 oil, to or through portions of several of these states. Persistent oils are those which continue to exist longer in the water when spilled, thus making them more difficult to clean up. In August 1990, the OPA became law. The OPA substantially changes the liability exposure of owners and operators of vessels, oil terminals and pipelines from that imposed under prior law. Under the OPA, each responsible party for a vessel or facility from which oil is discharged will be jointly, strictly and severally liable for all oil spill containment and clean-up costs and certain other damages arising from the discharge. These other damages are defined broadly to include (i) natural resource damage (recoverable only by government entities), (ii) real and personal property damage, (iii) net loss of taxes, royalties, rents, fees and other lost revenues (recoverable only by government entities), (iv) lost profits or impairment of earning capacity due to property or natural resource damage, and (v) net cost of public services necessitated by a spill response, such as protection from fire, safety or health hazards. The owner or operator of a vessel from which oil is discharged will be liable under the OPA unless it can be demonstrated that the spill was caused solely by an act of God, an act of war, or the act or omission of a third party unrelated by contract to the responsible party. Even if the spill is caused solely by a third party, the owner or operator must pay all removal cost and damage claims and then seek reimbursement from the third party or the trust fund established under the OPA. The OPA establishes a federal limit of liability of the greater of $1,200 per gross ton or $10 million per tank vessel. A vessel owner's liability is not limited, however, if the spill results from a violation of federal safety, construction or operating regulations. In addition, the OPA does not preclude states from adopting their own liability laws. Numerous states in which Maritrans operates have adopted legislation imposing unlimited strict liability for vessel owners and operators. Management believes that the liability provisions of the OPA and similar state laws have greatly expanded Maritrans' potential liability in the event of an oil spill, even where Maritrans is not at fault. The OPA requires all vessels to maintain a certificate of financial responsibility for oil pollution in an amount equal to the greater of $1,200 per gross ton per vessel, or $10 million per vessel in conformance with regulations that have not been promulgated in final form by the U.S. Coast Guard. Additional financial responsibility in the amount of $300 per gross ton will be required under regulations to be promulgated by the U.S. Coast Guard under the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"), the federal Superfund law. The previous requirement was $150 per gross ton per vessel, or $250,000, whichever is larger. Owners of more than one tank vessel, such as Maritrans, however, will only be required to demonstrate financial responsibility in an amount equal to cover the vessel having the greatest maximum liability (approximately $40 million in Maritrans' case). It is uncertain, however, whether Maritrans or other vessel operators will be able to acquire such certificates through existing international insurance underwriters or any other source. This uncertainty is due to the fact that the final federal financial responsibility regulations have not been issued by the U.S. Coast Guard, and if such regulations require the international insurance underwriters to in effect guarantee the payment of clean-up costs and damages up to the OPA statutory limit, they have stated that they are going to refuse to do so. Since the final regulations have not been issued, this position threatened by the international insurance underwriters has not been taken. The operation of tank vessels in marine transportation of oil and petroleum products without such certificates is unlawful and such unlawful operation would not be conducted by Maritrans. This could result in materially adverse effects on Maritrans. The OPA requires all newly constructed petroleum tank vessels engaged in marine transportation of oil and petroleum products in the U.S. to be double-hulled and all such existing single-hulled vessels to be retrofitted with double hulls or phased out of the industry beginning January 1, 1995, in order to comply with new standards for such vessels. Because of the age and size of Maritrans' individual barges, the first of its operating vessels will be required to be retired or retrofitted by January 1, 2003, and most of its large ocean-going, single-hulled vessels will be similarly affected on January 1, 2005. As a result of this legislation, the expected lives of some of Maritrans' barges have been shortened, thus forcing Maritrans to accelerate the depreciation of these vessels. This change in depreciation calculation began in September 1990 and caused an increase of Maritrans' annual depreciation expense by approximately $1.4 million. The OPA directs the Coast Guard to develop interim measures for single hull tank vessels over 5,000 gross tons "that provide as substantial protection to the environment as is economically and technologically feasible." The Coast Guard issued a Notice of Proposed Rulemaking which proposed the adoption of several alternative structural measures to meet this requirement. The regulation would have required substantial modification of 14 of Maritrans' largest barges, with a significant cost impact. However, in response to comments from industry, the Coast Guard is reexamining these structural proposals, and further action on structural requirements has been deferred. In the meantime, the Coast Guard is expected to adopt a series of operational measures which, while increasing current standards, should not have an appreciable effect on Maritrans. The double-hulled or double-bottomed tank barges currently owned by Maritrans account for approximately 15% of its fleet capacity. None of these vessels, however, comply with the current regulations promulgated under the OPA for double-hulled vessels, although it is possible that some of these vessels may be grandfathered under changes in these regulations which may be adopted in the future. Management believes that it would, for example, cost approximately $20 million to build a 20,000 DWT double-hulled barge. The cost of retrofitting an existing 20,000 DWT barge with a double hull may be somewhat less than the cost of a new barge, but the retrofitting cost would depend upon a variety of construction and engineering factors. Therefore, retrofitting may not be a viable economic alternative to the purchase of a new double-hulled barge. The prices of retrofitting and constructing new vessels may increase materially as a result of increased demand for shipyard capacity arising from the OPA. The OPA further required all tank vessel operators to submit, by February 18, 1993, for federal approval, detailed vessel oil spill contingency plans setting forth their capacity to respond to a worst case spill situation. Maritrans filed its plans prior to that deadline. Several states have similar contingency or response plan requirements. Because of the large number of ports served by Maritrans, the cost of compliance may be substantial, and, while Maritrans is presently in compliance, there is no assurance that Maritrans will be able to remain in compliance with all the federal requirements or those of one or more states. The OPA is expected to have a continuing adverse effect on the entire U.S. oil and petroleum marine transportation industry, including Maritrans. The effects on the industry could include, among others, (i) increased requirements for capital expenditures, which the independent marine transporters of petroleum may not be able to finance, to fund the cost of double-hulled vessels, (ii) increased maintenance, training, insurance and other operating costs, (iii) civil penalties and liability, (iv) decreased operating revenues as a result of a further reduction of volumes transported by vessels and (v) increased difficulty in obtaining sufficient insurance, particularly oil pollution coverage. These effects could adversely affect Maritrans' profitability and liquidity. The following table sets forth Maritrans' quantifiable oil spill record for the period January 1, 1988 through December 31, 1993: ---------- * Results for 1993 exclude the product lost, mostly burned, in the collision of Maritrans' barge, the OCEAN 255, with vessels owned by others off the coast of Florida in August 1993. Management believes that Maritrans was not at fault in this incident. Maritrans believes that its spill ratio compares favorably with the other independent, coastwise operators in the Jones Act trade. Water Pollution Regulations. The Federal Water Pollution Control Act of 1972 ("FWPCA"), as amended by the Clean Water Act of 1977, imposes strict prohibitions against the discharge of oil (and its derivatives) and hazardous substances into navigable waters of the United States. FWPCA provides civil and criminal penalties for any discharge of petroleum products in harmful quantities and imposes substantial liability for the clean-up costs of removing an oil spill. State laws for the control of water pollution also provide varying civil and criminal penalties and clean-up cost liabilities in the case of a release of petroleum or its derivatives into surface waters. In the course of its vessel operations, Maritrans engages contractors in addition to Maritank Philadelphia Inc. to remove and dispose of waste material, including tank residue. In the event that any of such waste is deemed "hazardous," as defined in FWPCA or the Resource Conservation and Recovery Act, and is disposed of in violation of applicable law, Maritrans could be jointly and severally liable with the disposal contractor for the clean-up costs and any resulting damages. The United States Environmental Protection Agency ("EPA") previously determined not to classify most common types of "used oil" as a "hazardous waste," provided that certain recycling standards are met, but has since decided to review this issue again. While it is unlikely that used oil will be classified as hazardous, the management of used oil under EPA's proposed regulations will increase the cost of disposing of or recycling used oil from Maritrans' vessels. Some states in which Maritrans operates, however, have classified "used oil" as hazardous. Maritrans has found it increasingly expensive to manage the wastes generated in its operations. Air Pollution Regulations. The 1990 amendments to the Clean Air Act give the EPA and the states the authority to regulate emissions of volatile organic compounds ("VOCs") and any other air pollutant from tank vessels in all ports served by Maritrans. Several states with ports served by Maritrans already have established regulations to require the installation of vapor recovery equipment on petroleum-carrying vessels to reduce the emissions of VOCs. Compliance with these federal and state regulations has required material capital expenditures for the retrofitting of Maritrans' barges and has increased operating costs. The EPA also has the authority to regulate emissions from marine vessel engines; however, with the possible exception of the use of low sulfur fuels, direct regulation of marine engine emissions is not likely in the near future in ports served by Maritrans. However, it is possible that the EPA and/or various state environmental agencies ultimately may require that additional air pollution abatement equipment be installed in tug boats, including those owned by Maritrans. Such a requirement could result in a material expenditure by Maritrans, which could have an adverse effect on Maritrans' profitability if it is not able to recoup these costs through increased charter rates. Port and Tanker Safety Act; Interim Measures. The Port and Tanker Safety Act of 1978 ("PTSA") required certain oil-carrying tankships to be fitted with segregated ballast tanks. PTSA required self-propelled vessels to be retrofitted to meet these standards. Barges were not generally affected by such requirements. However, if the environmental standards of PTSA were to be made applicable to the large barges operated by Maritrans, Maritrans would be required to make significant capital expenditures to retrofit such barges, and the cargo-carrying capacity of such barges would also be decreased. There have been no recent regulatory efforts to apply the PTSA standards to large barges such as those operated by Maritrans. User Fees and Taxes. The Water Resources Development Act of 1986 permits local non-federal entities to recover a portion of the costs of new port and harbor improvements from vessel operators with vessels benefitting from such improvements. Management does not believe that Maritrans' vessels currently benefit from such improvements. However, there can be no assurance that such entities will not seek to recover a portion of such costs from Maritrans. Federal legislation has been enacted imposing user fees on vessel operators such as Maritrans to help fund the United States Coast Guard's regulatory activities. Other federal, state and local agencies or authorities could also seek to impose additional user fees or taxes on vessel operators or their vessels. The approved U.S. budget for its 1992 fiscal year directs the Coast Guard to collect fees for vessel inspection and documentation, licensing and tank vessel examinations. Maritrans does not expect that initially these fees will be material to it. There can be no assurance that user fees, which could have a material adverse effect upon the financial condition and results of operations of Maritrans, will not be imposed in the future. Item 2. Item 2. PROPERTIES Vessels. The Operating Partnership owned, at December 31, 1993, a fleet of 67 vessels, of which 39 are barges and 28 are tugboats. Two additional tugs are operated under long-term leases. The barge fleet consists of a variety of vessels falling within six different barge classifications. The largest vessels in the fleet are the 14 superbarges ranging in capacity from 188,065 to 400,000 barrels. The oldest vessel in that class is the OCEAN 250 which was constructed in 1970, while the largest and most recently reconstructed vessel is the OCEAN 400, for which modifications were completed as recently as 1990. For the most part, however, the bulk of the superbarge fleet was constructed during the 1970's and early 1980's. The fleet's next ten largest barges range in capacity from 61,638 barrels to 165,881 barrels and were constructed or substantially renovated between 1967 and 1981. The fleet also includes two specially equipped chemical barges. The remainder of the barge fleet is comprised of three vessels falling in the 50,000 barrel class, seven vessels in the 30,000 barrel class and three vessels in the small barge classification. The majority of these vessels were constructed between 1961 and 1977. The Operating Partnership's tugboat fleet is comprised of one 11,000 horsepower class vessel, eleven 5,600 horsepower class vessels, four 4,000 horsepower class vessels, five 3,200 horsepower class vessels, six 2,200 horsepower class vessels and two pusher class vessels. One of the 4,000 horsepower class vessels was sold in January 1994. The year of construction or substantial renovation of these vessels ranges from 1962 to 1990 with the bulk of the tugboats having been constructed sometime between 1967 and 1981. Substantially all of the vessels in the fleet are subject to first preferred ship mortgages to secure payment of the notes of the Operating Partnership. These mortgages require the Operating Partnership to maintain the vessels at a high standard and continue a life-extension program for certain of its larger barges. At December 31, 1993 Maritrans is not in violation of the Operating Partnership's mortgage covenants. At December 31, 1993 Maritrans owns ten barges and one tugboat which were not in a state of operational readiness. Most of these vessels were too small to achieve satisfactory returns in current market conditions, or were purchased as non-operating hulls for potential refurbishment in the event market conditions were to improve sufficiently to merit additional expenditures. Maritrans does not believe market conditions in 1994 will merit such refurbishments. Marine Terminals. MPI owns 35 acres on the west bank of the Schuylkill River in Philadelphia where twelve storage tanks with a total capacity of 1,040,000 barrels, truck loading racks, office space and related equipment used in MPI's marine terminal and tank cleaning operations are located. In early 1993, MMI acquired 25 acres on the Wicomico River in Salisbury, Maryland where fourteen storage tanks with a total capacity of 170,000 barrels, office space and related equipment used in MMI's marine terminal operations are located. Other Real Property. The Registrant's operations are headquartered in Philadelphia, Pennsylvania, where it leases office space, expiring in 1998. Eastern fleet operations are located on the west bank of the Schuylkill River in Philadelphia, Pennsylvania where the Operating Partnership owns approximately six acres of improved land. In addition, it also leases a bulkhead of approximately 430 feet from the federal government for purposes of mooring vessels adjacent to the owned land. This lease was renewed in 1993 and expires in 1998. The Inland Division leases space from MPI. In the Philadelphia area, the Operating Partnership has several short term (one year or less) leases for nearby pier space for the purpose of mooring vessels and warehouse space for the purpose of storage and shop facilities. The Operating Partnership also leases four acres of Port Authority land in Tampa, Florida for use as its Gulf Division fleet center, which lease expires in 2004, with three renewal options of ten years each and a limited amount of office space in Wilmington, Delaware for itself and its affiliated entities. The Operating Partnership also has an office space agreement in Houston, Texas for its distribution services business. Item 3. Item 3. LEGAL PROCEEDINGS Maritrans is a party to routine, marine-related lawsuits and labor arbitrations arising in the ordinary course of its business. The claims made in connection with Maritrans' marine operations are covered by marine insurance, subject to applicable policy deductibles which are not material as to any type of insurance coverage. Management believes, based on its current knowledge, that such lawsuits and claims, even if the outcomes were to be adverse, would not have a material adverse effect on Maritrans' financial condition. In connection with the sale of Main Iron Works, Inc. ("MIW"), Maritrans' predecessor agreed to reimburse MIW for certain ongoing workmen's compensation claims arising prior to the sale of MIW, and retained an assignment of the shipyard's rights against its former workmen's compensation insurance carrier, which has been in liquidation proceedings. Due to the size and complexity of the liquidation proceeding, it is unlikely that this matter will be resolved for several years. Maritrans assumed its predecessor's reimbursement obligations to MIW and obtained an assignment of the predecessor's rights against the workmen's compensation insurance carrier. Maritrans' predecessor originally accrued a liability of $1.3 million for claim payments pursuant to such reimbursement agreement with MIW. Management believes, based on its current knowledge, that such accrual will be adequate. However, there is a possibility that future claims could exceed such amount. Management believes, based on its current knowledge, that the ultimate resolution of these claims, even if in excess of the amount accrued, would not have a material adverse effect on Maritrans' financial condition. Maritrans' predecessor was sued in the U.S. District Court in Ohio by nine individuals, eight who at most worked briefly for such predecessor and a ninth who still works for Maritrans, alleging unspecified damages for exposure to asbestos. Maritrans has been sued in a similar suit in New Orleans by a plaintiff and Philadelphia by two plaintiffs with whom Maritrans has no employment records, and in Philadelphia by an employee of Maritrans' predecessor which suit was settled by a payment of $4,000 by Maritrans. Although Maritrans believes these claims are without merit, it is impossible at this juncture to express a definitive opinion on the final outcome of any such suit. Management believes that any liability would not have a material adverse effect as it is adequately covered by applicable insurance. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Registrant's security holders, through the solicitation of proxies or otherwise, during the last quarter of the year ended December 31, 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market Information and Holders Maritrans Inc. Common Shares (and prior to April 1, 1993, Maritrans Partners L.P. Depositary Units) trade on the New York Stock Exchange under the symbol "TUG." The following table sets forth, for the periods indicated, the high and low sales prices per share/unit as reported by the New York Stock Exchange. QUARTERS ENDING IN 1993: HIGH LOW ----------------------- --------------- March 31, 1993 $4.125 $2.500 June 30, 1993 4.250 3.375 September 30, 1993 4.250 3.250 December 31, 1993 4.250 3.625 QUARTERS ENDING IN 1992: HIGH LOW ----------------------- ---------------- March 31, 1992 $4.875 $ 3.625 June 30, 1992 4.000 2.750 September 30, 1992 3.375 2.500 December 31, 1992 2.750 1.750 As of January 31, 1994, the Registrant had 12,523,000 Common Shares outstanding and approximately 1,212 shareholders of record. Dividends and Distributions For the period April 1, 1993 to December 31, 1993, Maritrans Inc. paid no dividends to stockholders. While dividend policy is determined at the discretion of the Board of Directors of Maritrans Inc., management believes that it is not likely Maritrans will pay any dividends in the near future. For the period January 1, 1992 to March 31, 1993, Maritrans Partners L.P. paid the following cash distributions to the unitholders: PAYMENTS IN 1992: PER UNIT ---------------- -------- February 24, 1992 $ .2875 May 26, 1992 .2875 -------- TOTAL $ .5750 ======== Maritrans Partners L.P. cash distributions should not be compared with dividends paid on common stock by corporations. Dividends paid by corporations are taxable as ordinary income, while distributions from partnerships may be treated partially or fully as a nontaxable return of capital. Item 6. Item 6. SELECTED FINANCIAL DATA ($000) ---------- (1) Maritrans Inc., the successor to Maritrans Partners L.P. effective April 1, 1993, is subject to income taxation. See note 1 and 4 to Financial Statements. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion of the consolidated financial condition and results of operations of Maritrans Inc. (the "Corporation"), and, together with its subsidiaries and Maritrans Partners L.P.(the "Partnership"), herein called "Maritrans." Overview Historically, Maritrans has served the petroleum and petroleum product distribution industry by providing marine transportation services along the East and Gulf Coasts of the United States utilizing its barges and tugboats. Maritrans has recently broadened its participation in distribution services by adding marine terminal facilities and oil spill contingency management services. Over the last several years, Maritrans has been implementing steps to become more competitive and more customer-oriented. In the fourth quarter of 1993, Maritrans announced a corporate streamlining which is expected to lower its costs by $5 million in 1994 as compared to 1993. This streamlining resulted in a $2 million charge in the fourth quarter of 1993, with $1 million being charged to general and administrative costs and $1 million charged to operation expense. Most of these charges related to severance costs and other continuation benefits for the terminating and retiring employees. Increased United States oil consumption, as well as a shortening of average voyage length, contributed to Maritrans transporting an increasing number of barrels from 1988 through 1990. Volumes transported by Maritrans declined approximately 14% in 1991 and were relatively stable in 1992 and 1993, declining less than 3% in 1992 and increasing less than 2% in 1993. Maritrans increased vessel capacity from 1988 to 1990, particularly by placing in service the OCEAN 400, Maritrans' largest barge, in May 1990. In 1993, Maritrans reduced owned capacity through the disposal of vessels excess to its long-term business needs. In addition, a barge involved in a collision off the coast of Florida in August 1993 was declared a constructive total loss. During most of 1993, Maritrans had one or more large barges out of service for vessel performance improvements, resulting in Maritrans utilizing, to a greater extent than in 1992, vessels chartered from third parties. Operating income declined in 1989 and 1990 from previous levels as increased costs, particularly in maintenance and insurance, could not be fully offset by rate increases. Lower business activity levels in 1991 through 1993 exacerbated this effect. Maintenance costs had increased markedly in 1989 through 1991 due to three factors: (1) response to the Oil Pollution Act of 1990 (the "OPA"), through management's proactive stepping up of maintenance to achieve even higher quality operations than existed previously, as measured by less work time lost due to critical equipment malfunctions; (2) additions to the fleet in that period; and (3) the effects of inflation and an aging fleet. Lower activity levels and improved maintenance processes lowered maintenance expense levels in 1992 and 1993. Costs related to measures taken to reduce the risk of oil spills, as well as inflation, have also reduced operating income in the years 1990 through 1993. In June 1991, Maritrans purchased a one-million barrel, deepwater marine terminal facility located on the Schuylkill River in Philadelphia, which provides terminalling services to outside customers and vessel-cleaning services for Maritrans. The facility was purchased for $12 million, mainly with the proceeds of a bank loan. In 1992, more than $2 million was spent to increase vessel cleaning capability. In February 1993, Maritrans purchased adjoining terminals in Salisbury, Maryland, with storage capacity totalling 170,000 barrels, to provide marine terminalling services. The facilities were purchased for less than $2 million, and Maritrans now operates the merged facilities as a single terminal and has distribution service agreements with the former owners. Factors that will affect future results of Maritrans include: overall U.S. oil consumption, particularly oil consumption in Florida and the Northeastern United States, environmental laws and regulations, oil companies' operating and sourcing decisions, competition and labor costs, training costs, liability insurance costs, and Maritrans' recent broadening of its participation in petroleum distribution services. Legislation The enactment of the OPA in 1990 significantly increased the liability exposure of marine transporters of petroleum in the event of an oil spill. In addition, most states in which Maritrans operates have enacted (and the others in which it operates may enact) legislation increasing the liability for oil spills in their waters. Maritrans maintains oil pollution liability insurance of $700 million on its vessels which is generally the maximum amount of oil spill liability insurance carried by marine transporters of petroleum. There can be no assurance that such insurance will be adequate to cover potential liabilities in the event of a catastrophic spill, that additional premium costs will be recoverable through increased rates, or that such insurance will continue to be available in satisfactory amounts. Moreover, this legislation has increased other operating costs as Maritrans has taken steps to minimize the risk of potential spills, such as costs for additional training, safety and contingency programs that have not yet been fully recovered through increased rates. Additionally, management believes that the legislation has had the effect of reducing the total volume of waterborne petroleum transportation as shippers of petroleum have attempted to reduce their exposure to the impact of the OPA. Therefore, although management cannot predict the continuing adverse impact of this legislation on Maritrans, the legislation has had a material adverse effect on Maritrans' operations and financial results, including an increase in depreciation expense due to the shortening of expected lives of some of Maritrans' barges as a result of the OPA. The OPA is expected to have a continuing adverse effect on the entire U.S. oil and petroleum marine transportation industry, including Maritrans. The effects on the industry could include, among others, (i) increased requirements for capital expenditures, which the independent marine transporters of petroleum may not be able to finance, to fund the cost of double-hulled vessels, (ii) increased maintenance, training, insurance and other operating costs, (iii) civil penalties and liability, (iv) decreased operating revenues as a result of a further reduction of volumes transported on vessels and (v) increased difficulty in obtaining sufficient insurance, particularly oil pollution coverage. These effects could adversely affect Maritrans' profitability and liquidity. The OPA requires the retirement or retrofitting of most of Maritrans' existing barges beginning in 2003 through 2005. Some of Maritrans' barges are not scheduled for retirement until 2015. A small number of barges may be treated as meeting the double-hull requirements and, therefore, be allowed to continue operating without modification. If Maritrans were to rebuild its entire barge capacity with double-hulls, the estimated cost would be approximately $500 million. This estimate could be higher as shipyard costs increase. An investment banking firm was retained in 1991 to assist in evaluating Maritrans' ongoing financial strategies and company structural issues in light of strategic considerations at that time. In April 1992, the Board of Directors of the managing general partner of the Partnership, a master limited partnership, decided to seek unitholder approval to convert from the master limited partnership form to corporate form. On April 1, 1993, after a vote of the unitholders, the Partnership was converted to Maritrans Inc., a corporation. Results of Operations 1993 Compared With 1992 Revenues of $132.5 million for the year ended December 31, 1993 decreased by $0.6 million, or less than one percent, from $133.1 million for the year ended December 31, 1992. Barrels of cargo transported increased by 3.8 million barrels, from 244.6 million to 248.4 million, respectively. Severe price competition for oil transportation services has existed in the markets served by Maritrans in recent years, and is expected to continue. In 1993, more barrels were transported shorter distances, lowering the fleet's average revenue per barrel. Revenue from sources other than marine transportation increased from 2.8% of total revenue in 1992 to 4.9% in 1993, due to additional terminalling operations, contingency management activities, and other services supplied to third-party vessel owners. Operating expenses of $123.9 million for the year ended December 31, 1993, increased by $0.8 million, or less than one percent, from operating expenses of $123.1 million for the year ended December 31, 1992. Lower vessel activity levels, due in part to time out of service for vessel improvements, and improvements in maintenance processes have decreased operation and maintenance expense levels. During most of 1993, Maritrans utilized vessels chartered from others while one or more of its large barges were out of service for vessel performance improvements and maintenance. Crew costs were lower as a result of lower activity levels, including shipyarding periods, and the previously described disposal of equipment throughout the year. Fuel expense decreased due to a decline in price per gallon and fewer gallons consumed. General and administrative costs decreased from the comparable prior period when general and administrative costs included the early termination of a lease for office space and costs related to the transaction to convert from partnership to corporate form. In 1993, general and administrative costs and operation expense each included a charge of $1 million (for a total of $2 million) for corporate streamlining costs, most of which relates to severance costs and other continuation benefits for terminating and retiring employees. A charge of $0.6 million was recorded in 1992 for workforce reduction related costs. In 1993, Maritrans recorded $5.9 million in gains on the sales and liquidation of fixed assets as part of other income. In 1992, $3 million was recorded in other income as a result of a settlement of outstanding litigation, discussed further below in "1992 Compared With 1991." The adoption of FAS No. 109, Accounting for Income Taxes, caused the Partnership to recognize a net deferred income tax provision of $16.6 million in the first quarter of 1993. The adoption of this accounting rule was prescribed by the conversion of the Partnership to corporate status, which occurred April 1, 1993. The net loss for the year ended December 31, 1993, was $11.8 million as compared with net income of $3.4 million for the year ended December 31, 1992. The loss was the result of the previously noted provision of $16.6 million for income taxes. Income before income taxes for the period increased to $5.2 million from $3.4 million in the comparable period in 1992. While the change in operating income reflected the small decline in revenues and small increase in operating expenses, the most significant factors affecting income before income taxes were the gains on sales/liquidation of vessels in 1993 and the settlement receipts from litigation in 1992. 1992 Compared With 1991 Revenues of $133.1 million for the year ended December 31, 1992 decreased by $13.5 million, or 9%, from $146.6 million for the year ended December 31, 1991. Barrels of cargo transported decreased by 5.8 million barrels, from 250.4 million to 244.6 million, respectively. Lower revenue levels resulted from lower average daily charter rates and decreased volumes. The continuing period of lower oil consumption has caused severe price competition for oil transportation services. Operating expenses of $123.0 million for the year ended December 31, 1992, decreased by $16.1 million, or 12%, from operating expenses of $139.1 million for the year ended December 31, 1991. Lower activity levels and improvements in maintenance processes have lowered maintenance expense levels. Management believes that these practices have not caused the condition of vessels to deteriorate. Personnel training costs were higher in 1991 due to the initiation and implementation of comprehensive training programs. Crew costs were lower as a result of lower utilization of marine personnel. Fuel expense decreased due to a decline in price per gallon and fewer gallons consumed. General and administrative costs increased due to the early termination of a lease for office space and costs related to the potential transaction to convert to corporate form. A charge of $0.6 million was recorded in the third quarter for workforce reduction related costs. In November, 1992, the Partnership dismissed its suit against its former law firm and a partner of that firm pursuant to a settlement agreement among the parties. As part of the settlement the Partnership received a payment of $3 million, and the trial court dissolved the preliminary injunction which previously barred the defendants from representing certain of Maritrans' economic competitors in labor negotiations. The payment received is reflected in other income for the year ended December 31, 1992. Net income of $3.4 million for the year ended December 31, 1992, increased by $5.0 million from a net loss of $1.6 million for the year ended December 31, 1991. While revenues have declined from levels in the comparable period in 1991, larger declines in operating expenses and the settlement of litigation mentioned above in the same period have caused the improvement in results. Liquidity and Capital Resources In 1993, funds provided by investing and operating activities were sufficient to fully meet debt service obligations and loan agreement restrictions. The total of $19.3 million in proceeds from the disposal of equipment was generated by the sale of non-strategic assets and from the insurance proceeds for the constructive total loss of a barge involved in a collision. The net funds provided by operating activities of $3.5 million included $16.6 million from the provision for deferred income taxes recorded for the Conversion in conjunction with the adoption of FAS No. 109 Accounting for Income Taxes. The primary uses of funds were $17.5 million in capital expenditures, principally for vessel improvements and marine terminal purchases, and $6.0 million in long-term debt repayment. Maritrans believes that in 1994 funds provided by operating activities, augmented by financing transactions and investing activities, will be sufficient to provide the funds necessary for operations, anticipated capital expenditures, lease payments and required debt repayments. No dividends are expected to be made in 1994. Maritrans believes capital expenditures in 1994 for improvements to its currently operating vessels and existing marine terminals will be approximately $3 million. However, Maritrans will continue to evaluate the potential purchase of marine storage terminal and other investments consistent with its long-term strategic interests, and the potential sources of funds for those potential investments. No material commitments existed at December 31, 1993, for capital expenditures. Working Capital and Other Balance Sheet Changes Working capital increased approximately $13.0 million from December 31, 1992 to December 31, 1993. Current assets increased $14.0 million from the prior comparable period. These increases were largest in other accounts receivable, due to increases in outstanding insurance claims receivable. Maritrans expects these claims to be fully recoverable from insurance underwriters. Additionally, the current benefit of deferred income taxes recognized on temporary differences are shown on the financial statements for December 31, 1993 but were not included in the financial statements for December 31, 1992, because of the then current partnership status of Maritrans. Prepaid expenses also increased due to an increase in advance payments to shipyards for their services and a change in the timing of payments for certain insurance premiums. Current liabilities increased approximately $1 million. The ratio of current assets to current liabilities increased to 1.94 at December 31, 1993 from 1.54 at December 31, 1992. Debt Obligations and Borrowing Facility At December 31, 1993, Maritrans had $116.9 million in total outstanding debt, secured by mortgages on substantially all of the fixed assets of the subsidiaries of the Corporation. The current portion of this debt at December 31, 1993, is $6.3 million. Maritrans has a $10 million working capital facility, secured by its marine receivables and inventories, which expires June 30, 1994 and which it expects to renew. Item 8. Item 8. FINANCIAL STATEMENTS & SUPPLEMENTAL DATA Report of Independent Auditors Stockholders and Board of Directors Maritrans Inc. We have audited the accompanying consolidated balance sheets of Maritrans Inc. as of December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(A). These financial statements and schedules are the responsibility of the management of Maritrans Inc. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Maritrans Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Philadelphia, Pennsylvania January 25, 1994 MARITRANS INC. CONSOLIDATED BALANCE SHEETS ($000) See accompanying notes. MARITRANS INC. CONSOLIDATED STATEMENTS OF INCOME ($000 except per share/unit amounts) See accompanying notes. MARITRANS INC. CONSOLIDATED STATEMENTS OF CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ($000) See accompanying notes. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Significant Accounting Policies Organization At December 31, 1993, Martrans Inc. owns Maritrans Operating Partners L.P. (the "Operating Partnership") and Maritrans Holdings Inc. (collectively, the "Company"). These subsidiaries, directly and indirectly, own and operate tugs and barges principally used in the transportation of oil and related products, and own and operate petroleum storage facilities. On March 31, 1993, the limited partners of Maritrans Partners L.P. (the "Partnership") voted on a proposal to convert the Partnership to corporate form (the "Conversion"). The proposal was approved, and on April 1, 1993, Maritrans Inc., then a newly-formed Delaware corporation (the "Corporation") succeeded to all assets and liabilities of the Partnership. The holders of general and limited partnership interests in the Partnership and the Operating Partnership were issued shares of common stock, par value $.01 per share ("Common Stock"), of the Corporation, representing substantially the same percentage equity interest in the Corporation as they had in the Partnership, directly or indirectly, in exchange for their partnership interest. Each previously held unit of limited partnership interest in the Partnership was exchanged for one share of Common Stock of the Corporation. For financial accounting purposes, the conversion to corporate form has been treated as a reorganization of affiliated entities, with the assets and liabilities recorded at their historical costs. In addition, the Partnership recognized a net deferred income tax liability for temporary differences in accordance with Statement of Financial Accounting Standard ("FAS") No. 109, Accounting for Income Taxes, which resulted in a one-time charge to earnings of $16.6 million in the first quarter of 1993. Principles of Consolidation The consolidated financial statements include the accounts of Maritrans Inc. and subsidiaries, all of which are wholly owned. Prior to the Conversion, the financial statements included the accounts of the Partnership, the Operating Partnership and subsidiaries. All significant intercompany transactions and accounts have been eliminated in consolidation. Marine Vessels and Equipment Equipment, which is carried at cost, is depreciated using the straight-line method. Vessels are depreciated over a period of up to 30 years. Certain electronic equipment is depreciated over periods of 7 to 10 years. Petroleum storage tanks are depreciated over periods of up to 25 years. Other equipment is depreciated over periods ranging from 3 to 20 years. Gains or losses on dispositions of fixed assets are included in other income in the accompanying consolidated statements of income. During the year ended December 31, 1991, two vessels were sold and subsequently leased back. The resulting deferred gain is included in the consolidated NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 1. Organization and Significant Accounting Policies -- (Continued) statement of cash flows as non-current changes related to investing activities and is being amortized into income over the life of the related leases. The Oil Pollution Act, passed in 1990, requires all newly constructed petroleum tank vessels engaged in marine transportation of oil and petroleum products in the U.S. to be double hulled and all such existing single-hulled vessels to be retrofitted with double hulls or phased out of the industry beginning January 1, 1995. Because of the age and size of Maritrans' individual barges, the first of its operating vessels will be required to be retired or retrofitted by January 2003, and most of its large oceangoing, single-hulled vessels will be similarly affected on January 1, 2005. During 1990, the depreciable lives of certain marine vessels and equipment were revised to reflect more closely expected remaining lives. Maintenance and Repairs Provision is made for the cost of upcoming major periodic overhauls of vessels and equipment in advance of performing the related maintenance and repairs. The current portion of this estimated cost is included in accrued shipyard costs while the portion of this estimated cost not expected to be incurred within one year is classified as long-term. Both the provisions for major periodic overhauls as well as non-overhaul maintenance and repairs are expensed as incurred. Inventories Inventories, consisting of materials, supplies and fuel, are carried at specific cost which does not exceed net realizable value. Income Taxes Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and the amount used for income tax purposes. Significant Customers During the years ended December 31, 1993, 1992 and 1991, the Company derived revenues of $22,232,000, $24,169,000 and $27,219,000 from one customer aggregating 17%, 18% and 19% of total revenues, respectively. Also during 1993, 1992 and 1991, the Company derived revenues of $19,720,000, $19,855,000 and $16,691,000 from another customer aggregating 15%, 15% and 11% of total revenues. Credit is extended to various companies in the petroleum industry in the normal course of business. This concentration of credit risk within this industry may be affected by changes in economic or other conditions and may, accordingly, affect overall credit risk of the Company. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 1. Organization and Significant Accounting Policies -- (Continued) Related Parties The Company obtained protection and indemnity insurance coverage from a mutual insurance association, whose chairman is also the chairman of Maritrans Inc. The related insurance expense was $2,472,000, $3,365,000 and $3,034,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Earnings per common share/Limited Partner unit Earnings per common share/Limited Partner unit are based on the average number of common shares or Limited Partner units outstanding. The potential effect of outstanding stock options is not dilutive. 2. Cash and Cash Equivalents Cash and cash equivalents at December 31, 1993, and 1992 consisted of cash and commercial paper, the carrying value of which approximates fair value. For purposes of the consolidated statements of cash flows, short-term highly liquid debt instruments with maturities of three months or less are considered to be cash equivalents. 3. Partnership and Stockholders' Equity Changes in partnership equity prior to the Conversion are summarized below: NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 3. Partnership and Stockholders' Equity -- (Continued) Consolidated income statement data for the period January 1 to March 31, 1993 (prior to the Conversion) and for the period April 1 to December 31, 1993 (after the Conversion) is as follows: NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 3. Partnership and Stockholders' Equity -- (Continued) Changes in stockholders' equity since the Conversion are summarized below: ---------- (1) Includes $92,000 related to grant of shares. Maritrans Inc. established a stock incentive plan (the "Plan") concurrent with the Conversion whereby key employees may be granted stock, stock options and, in certain cases receive cash under the Plan. Any outstanding options granted under the Plan are exercisable at a price not less than market value on the date of grant. There are 1,250,000 shares of Common Stock authorized for issuance under the Plan, of which 23,000 shares were issued in 1993. Compensation expense equal to the fair market value on the date of the grant is included in general and administrative expense in the consolidated statement of income. At December 31, 1993, 803,597 remaining shares were reserved for grant. Information on stock options for 1993 follows: Exercise Number of Price Shares ------------------------ Outstanding at beginning of year........ - - Granted................................. $4.00 476,074 Exercised .............................. - - Cancelled .............................. $4.00 52,671 Outstanding at end of year ............. $4.00 423,403 Exercisable at end of year ............. - - Outstanding options are exercisable in installments over two to four years and expire in 2002. 4. INCOME TAXES In connection with the Conversion to corporate form, the Partnership recognized a net deferred income tax liability for temporary differences NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 4. INCOME TAXES -- (Continued) in accordance with Statement of Financial Accounting Standards ("FAS") No. 109, Accounting for Income Taxes, which resulted in a one-time charge to earnings of $16.6 million in the first quarter of 1993. Prior to the Conversion, Maritrans Partners L.P. and Maritrans Operating Partners L.P., as partnerships, were not subject to income taxation at the partnership level. However, income taxes, which were not significant, were provided for the incorporated subsidiaries of the partnerships prior to the Conversion. The income tax provision consists of: -------- ($000) Current: Federal ................................................ - State .................................................. - Deferred ................................................... $ 407 Deferred-resulting from Conversion ......................... 16,568 -------- $16,975 ======== The differences between the federal income tax rate of 34% and the effective tax rate was as follows: -------- ($000) Statutory federal tax provision ............................ $ 1,764 State income taxes, net of federal income tax benefit ...... 116 Partnership income for the first quarter, not subject to income tax ............................................... (1,388) Recognition of tax liability for cumulative temporary differences .............................................. 16,568 Other ...................................................... (85) ------- $16,975 ======= NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 4. INCOME TAXES -- (Continued) Principal items comprising deferred income tax liabilities and assets as of December 31, 1993 are: -------- ($000) Deferred tax liabilities: Tax over book depreciation ............................. $28,519 Other .................................................. 1,203 ------- 29,722 ------- Deferred tax assets: Reserves and accruals .................................. 8,092 Net operating loss carryforwards ....................... 3,116 Other .................................................. 848 ------- 12,056 ------- Net deferred tax liabilities ............................... $17,666 ======= At December 31, 1993, Maritrans Inc. has net operating loss carry forwards of approximately $9.2 million for income tax purposes which expire in the year 2005 and thereafter. 5. Retirement Plans Most of the shoreside employees and substantially all of the seagoing supervisors participate in a qualified defined benefit retirement plan of Maritrans Inc. Net periodic pension costs were $1,232,000, $1,400,000 and $1,529,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and were determined under the projected unit credit actuarial method. Pension benefits are primarily based on years of service and begin to vest after two years. Employees covered by collective bargaining agreements and employees of Maritrans Holdings Inc. or its subsidiaries are not eligible to participate in the qualified defined benefit retirement plan of Maritrans Inc. The weighted average discount rate, used to determine the actuarial present value of the projected benefit obligation, and the expected long-term rate of return on plan assets for the period were each 7%. The weighted average assumed rate of compensation increase used to determine the actuarial present value of the projected benefit obligation was 5%. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 5. Retirement Plans -- (Continued) Net periodic pension costs included the following components for the respective periods: The following table sets forth the plan's funded status at December 31, 1993 and 1992: December 31, ------------------ 1993 1992 ------------------ ($000) Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $10,449 and $9,675, respectively ... $11,534 $ 9,801 Projected benefit obligation for service rendered to date ........................................ 3,851 4,895 ------------------ Projected benefit obligation ..................... 15,385 14,696 Plan assets at fair value, primarily publicly traded stocks and bonds ........................ 16,110 13,718 ------------------ Plan assets greater than (less than) projected benefit obligation ............................. 725 (978) Unrecognized net gain on plan's assets ........... 2,723 997 Net assets being amortized over 15 years ......... 1,616 1,818 ------------------ Accrued pension cost recognized in the financial statements ..................................... $ 3,614 $ 3,793 ================== Substantially all of the shoreside employees and seagoing supervisors also participate in a qualified defined contribution plan. Contributions under the plan are determined annually by the Board of Directors of NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 5. Retirement Plans -- (Continued) Maritrans Inc. The cost of the plan was $685,000, $609,000 and $61,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Contributions to industry-wide, multi-employer seamen's pension plans which cover substantially all seagoing personnel covered under collective bargaining agreements were approximately $423,000, $515,000 and $1,016,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These contributions include funding for current service costs and amortization of prior service costs of the various plans over periods of 30 to 40 years. The pension trusts and union agreements provide that contributions be made at a contractually determined rate per man-day worked. Maritrans Inc. and its subsidiaries are not administrators of the multi-employer seamen's pension plans. 6. Debt At December 31, 1993, total outstanding debt of the subsidiaries of Maritrans Inc. is $116.9 million, $110.6 million of which is long-term. At December 31, 1992, total outstanding debt was $122.9 million, $116.9 million of which was long-term. The debt is secured by mortgages on substantially all of the fixed assets of those subsidiaries. The debt consists of $1.7 million maturing through 1995, $35.2 million maturing through 1997, and $80 million maturing from 1998 through 2007. The weighted average interest rate on this indebtedness is 8.63%. Terms of the indebtedness require the subsidiaries to maintain their properties in a specific manner, maintain specified insurance on their properties and business, and abide by other covenants which are customary with respect to such borrowings. At December 31, 1992, the total outstanding debt consisted of $2.5 million maturing through 1995, $40.4 million maturing through 1997, and $80 million maturing from 1998 through 2007. The Operating Partnership has a $10 million working capital facility secured by its receivables and inventories. There were no borrowings under this facility during fiscal 1993. Based on the borrowing rates currently available for loans with similar terms and maturities, the fair value of long term debt was $122.1 million and $121.8 million at December 31, 1993 and 1992, respectively. The maturity schedule for outstanding indebtedness under existing debt agreements at December 31, 1993, is as follows: NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 6. Debt -- (Continued) ($000) -------- 1994 ................................... $ 6,311 1995 ................................... 7,256 1996 ................................... 8,200 1997 ................................... 15,100 1998 ................................... 8,000 1999 - 2007 ............................ 72,000 -------- $116,867 ======== 7. Commitments and Contingencies Minimum future rental payments under noncancelable operating leases at December 31, 1993, are as follows: ($000) ------- 1994.................................... $ 1,200 1995.................................... 1,200 1996.................................... 1,200 1997 ................................... 1,200 1998 ................................... 1,117 1999 - 2005 ............................ 7,544 ------- $13,461 ======= The indenture governing the Operating Partnership's long-term debt permits cash distributions by Maritrans Operating Partners L.P. to Maritrans Inc. so long as no default exists under the indenture and provided that such distributions do not exceed contractually prescribed amounts. On August 10, 1993, one of the Company's tug/barge units was involved in a collision off the coast of Florida. Claims resulting from this incident have been and are expected to be covered by insurance. In 1993, Maritrans received insurance proceeds in excess of the barge's net book value for the constructive total loss of the barge. In November 1992, the Partnership dismissed its suit against its former law firm and a partner of that firm pursuant to a settlement agreement among the parties. As part of the settlement, the Partnership received a payment of $3 million and the trial court dissolved the preliminary injunction which previously barred the defendants from representing certain of Maritrans' economic competitors in labor NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) 7. Commitments and Contingencies -- (Continued) negotiations. The payment received is reflected in other income for the year ended December 31, 1992. In the ordinary course of its business, claims are filed against the Company for alleged damages in connection with its operations Management is of the opinion that the ultimate outcome of such claims at December 31, 1993, will not have a material adverse effect on the consolidated financial statements. 8. Quarterly Financial Data (Unaudited) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information with respect to directors of the Registrant, and information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934, is incorporated herein by reference to the Registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission not later than 120 days after the close of the year ended December 31, 1993, under the captions "Information Regarding Nominees For Election As Directors And Regarding Continuing Directors" and "Section 16 Requirements." The individuals listed below are directors and executive officers of Maritrans Inc. or its subsidiaries. ---------- (1) As of March 1, 1994 (2) Member of the Compensation Committee (3) Member of the Audit Committee (4) Member of the Finance Committee Mr. Van Dyck has been Chairman of the Board and Chief Executive Officer of the Company and its predecessor since April 1987. For the previous year, he was a Senior Vice President - Oil Services, of Sonat Inc. and Chairman of the Boards of the Sonat Marine Group, another predecessor, and Sonat Offshore Drilling Inc. For more than five years prior to April 1986, Mr. Van Dyck was the President and a director of the Sonat Marine Group and Vice President of Sonat Inc. Mr. Van Dyck is also the Chairman of the Board and a director of the West of England Ship Owners Mutual Insurance Association (Luxembourg), a mutual insurance association. He is a member of the Company's Finance Committee of the Board of Directors. See "Certain Transactions." Dr. Boni retired as Chairman of Armco Inc., a steel, oil field equipment and insurance corporation on November 30, 1990. Dr. Boni became Chief Executive Officer of Armco Inc. in 1985 and Chairman in 1986. He became Non-Executive Chairman of the Board of Alexander & Alexander Services Inc., an insurances services company, in January 1994. He is a member of the Company's Compensation (Chairman), Audit and Finance Committees of the Board of Directors. Dr. Dorman is serving as Deputy Director Defense Research and Engineering for Laboratory Management, U.S. Department of Defense on an Intergovernmental Personnel Act assignment from the Woods Hole Oceanographic Institution. He was Director and Chief Executive Officer of Woods Hole Oceanographic Institution from 1989 until 1993. From 1962 to 1989, Dr. Dorman was an officer in the U.S. Navy, most recently Rear Admiral and Program Director for Anti-Submarine Warfare. He is a member of the Company's Audit Committee of the Board of Directors. Mr. Johnson recently became Managing Director of Glenthorne Capital Inc., investment bankers. He was President and Chief Operating Officer of the Company and its predecessor from February 1, 1990 until December 17, 1993. For the four years prior to joining Maritrans, Mr. Johnson was President of Lavino Shipping Company, a terminalling and stevedoring corporation. Neither Lavino nor any of the companies invested in by Glenthorne Capital Inc. compete with Maritrans. He is a director of several closely-held companies. Mr. Lindsay has been Managing Director of Brind-Lindsay & Co. Inc., an investment corporation, since 1986. From 1983 through 1986, Mr. Lindsay was Group Vice President, Industrial Services, of Sun Company, Inc., an integrated oil corporation. During that time, he also served as a director and officer of various subsidiaries of Sun Company, Inc. He is a director of several closely-held corporations. He is a member of the Company's Audit (Chairman), Finance (Chairman) and Compensation Committees of the Board of Directors. Mr. Sanborn was Executive Vice President of the Company and its predecessor since April 1987, until his retirement in December 1993. Prior to April 1987, he was President of the Sonat Marine Group, another predecessor, a position he held since April 1986. Prior to this position, he served as Vice President-Operations and Vice President - East Coast Group of the Sonat Marine Group. Mr. Sanborn was employed in various capacities by the Company and its predecessors since 1978. Mr. Sheridan was named President of the Distribution Services Division of the Operating Partnership in February 1993. He previously held various positions with Star Enterprise and Texaco since 1963. Mr. Telford was named President of the Gulf Division of the Operating Partnership in September 1992. He previously held various positions with Stolt-Nielson Inc. from 1988 to 1992. Mr. Newcomb has been Vice President, General Counsel and Secretary of Maritrans Inc. since April 1993, and previously held these titles with Maritrans GP Inc. since 1987. He held a similar position with the Sonat Marine Group since 1983. Mr. Newcomb has been employed in various capacities by Maritrans or its predecessors since 1975. Mr. Schaefer has been Vice President, Chief Financial Officer and Treasurer of Maritrans Inc. since April 1993, and previously held these titles with Maritrans GP Inc. since January 1990. Previously, Mr. Schaefer was Vice President, Controller and Treasurer. He held a similar position with the Sonat Marine Group since 1986. Prior to this position, Mr. Schaefer was Assistant Vice President and Controller. Mr. Schaefer has been employed in various capacities by Maritrans or its predecessors since 1976. Mr. Flood has been Chairman of Maritrans Holdings Inc. since February 4, 1991. Mr. Flood is also Chairman of MPI and MMI. Previously, Mr. Flood was Vice President of Maritrans GP Inc. from October 1990 to February 1991. Prior to October 1990, he was President and Chief Operating Officer of Unitank, a Philadelphia-based terminal company, which was sold and merged with GATX, which does not compete with Maritrans. Mr. Ward was named President of the Eastern Division of the Operating Partnershp in May 1993. Previously, Mr. Ward was President of the Inland Division of the Operating Partnership since February 1992 and prior to that was Manager, Traffic, a position he held since September 1990. Mr. Ward was East Coast Chartering Manager from June 1989 to September 1990. Prior to that position, Mr. Ward was Traffic Manager - Black Oil. He held a similar position with the Sonat Marine Group. Mr. Ward has been employed in various capacities by Maritrans or its predecessors since 1975. Mr. York was named President of the Inland Division of the Operating Partnership in May 1993. Previously, Mr. York was continuously employed since 1985 by the Company or its predecessors in various capacities including Manager, Market Planning; Manager, Corporate Planning; and Business Leader (Information Services). Mr. Gillon was named Chairman of the Board of Marispond Inc. in February 1993. Previously, Mr. Gillon was a consultant to the Company since November 1992. Prior to that, he was President, Chief Executive Officer and a Director of Wescol Shipping Inc. from July 1990. From April 1980 until July 1989, he was President of Lavino Agency Group, and served as a Director of Lavino Shipping Company. Mr. Bromfield has been Controller of Maritrans Inc. since April 1993, and previously held that title with Maritrans GP Inc. since February 1992. Previously, Mr. Bromfield was Assistant Controller. He held a similar position with the Sonat Marine Group since October 1986. Mr. Bromfield has been employed in various capacities by Maritrans or its predecessors since 1981. Items 11, 12 and 13. The information required by Item 11, Executive Compensation, by Item 12, Security Ownership of Certain Beneficial Owners and Management, and by Item 13, Certain Relationships and Related Transactions, is incorporated herein by reference to the Company's definitive Proxy Statement to be filed with the Commission not later than 120 days after the close of the fiscal year ended December 31, 1993, under the headings "Compensation of Directors and Executive Officers", "Security Ownership of Certain Beneficial Owners and Management" and "Certain Transactions". PART IV (c) Exhibits * Incorporated by reference herein to the Exhibit number in parentheses filed on March 24, 1988 as Amendment No. 1 to Maritrans Partners L. P. Form 10-K Annual Report, dated March 3, 1988, for the fiscal year ended December 31, 1987. + Incorporated by reference herein to the Exhibit number in parentheses filed with Maritrans Partners L. P. Form S-1 Registration Statement No. 33-11652 dated January 30, 1987 or Amendment No. 1 thereto dated March 20, 1987. # Incorporated by reference herein to the Exhibit of the same number filed with the Registrant's Post-Effective Amendment No. 1 to Form S-4 Registration Statement No. 33-57378 dated January 26, 1993. & Incorporated by reference herein to Exhibit A of the Registrant's definitive Proxy Statement to be filed with the Commission not later than 120 days after the close of the fiscal year ended December 31, 1993. @ Incorporated by reference herein to the Exhibit number in parentheses filed with Maritrans Partners L. P. Form 10-K Annual Report, dated March 29, 1993 for the fiscal year ended December 31, 1992. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MARITRANS INC. (Registrant) By: /s/ Stephen A. Van Dyck ------------------------ Stephen A. Van Dyck Chairman of the Board Dated: March 30 , 1994 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. MARITRANS INC. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT ($000) MARITRANS INC. SCHEDULE VI - ACCUMULATED DEPRECIATION ($000) MARITRANS INC. SCHEDULE VIII - VALUATION ACCOUNT ($000) ---------- (a) Deductions are a result of write-offs of uncollectible accounts receivable for which allowances were previously provided.	15,061	101,166
836102_1993.txt	836102_1993	1993	836102	Item 1. Business 1 Item 2. Item 2. Properties 15 Item 3. ITEM 3. LEGAL PROCEEDINGS The Company has been made a defendant in a lawsuit brought by Entech Sales & Service, Inc., on behalf of a purported class of contractors engaged in the service and repair of commercial air conditioning equipment. The suit, which was filed on March 5, 1993, in the United States District Court for the Northern District of Texas, alleges principally that the manner in which Air Conditioning Products distributes repair service parts for its equipment violates Federal antitrust laws and demands $680 million in damages (which are subject to trebling under the antitrust laws) and injunctive relief. The Company has filed an answer denying all claims and is preparing to defend itself vigorously. The issue of whether Entech may maintain this action as a class action is pending before the court. In management's opinion the litigation should not have any material adverse effect on the financial position, cash flows, or results of operations of the Company. There are no other material legal proceedings. For a discussion of German tax issues see "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Liquidity and Capital Resources". For a discussion of environmental issues see "ITEM 1. BUSINESS -- Regulations and Environmental Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS By a vote of a majority of the holders of the common stock of the Company dated as of December 2, 1993, the following individuals were elected as directors of the Company, each to serve in office until the next annual meeting of the stockholder of the Company or until such individual's respective successor shall have been elected and shall qualify, or until such individual's earlier death, resignation or removal as provided in the By-laws of the Company: Horst Hinrichs Frank T. Nickell Emmanuel A. Kampouris J. Danforth Quayle George H. Kerckhove John Rutledge Shigeru Mizushima Joseph S. Schuchert PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) There is no established public trading market for shares of Holding common stock, par value $.01 per share. Shares of Holding common stock were sold to Kelso ASI Partners, L.P. ("ASI Partners"), the American Standard Inc. Employee Stock Ownership Plan ("ESOP"), and executive officers and other management personnel of American Standard Inc. and its subsidiaries (the "Management Investors"). The Management Investors purchased their shares pursuant to a Stockholders Agreement among ASI Partners, Holding, and the Management Investors, dated as of July 7, 1988, as amended ("Stockholders Agreement"). The Stockholders Agreement restricts transfers by Management Investors of Holding common stock for a period up to ten years after July 7, 1988, but obligates Holding, subject to restrictions contained in the Company's various debt agreements, to repurchase shares of Holding common stock in the case of death, disability, retirement, or other termination of employment of Management Investors. The repurchase by Holding is made at fair market value based on independent valuations, generally at year-end dates, with the valuation dates dependent on the election made by the Management Investor following employment termination. The timing of payment by Holding is subject to constraints of the debt agreements, as supplemented by a Schedule of Priorities established by Holding's Board of Directors, and by the valuation election of the Management Investor. Shares have been issued by the ESOP to participants, and additional shares have been issued in connection with other Company plans. (b) The number of stockholders of record of Holding at March 10, 1994, was 287. (c) Holding has no separate operations; its ability to pay dividends or repurchase its common stock will be totally dependent upon the extent to which it receives dividends or other funds from American Standard Inc. Covenants of the agreements under which the debt of the Company was issued substantially restrict American Standard Inc. from declaring any dividends, except to the extent necessary to permit Holding to make repurchases of its common stock (i) from participants to whom shares of common stock are distributed from the ESOP to the extent required by the terms thereof, or (ii) held by Management Investors (in the circumstances contemplated by the Stockholders Agreement) or credited to the accounts of officers and employees under the Company's incentive and savings plans, provided certain conditions are met and the aggregate amount of such purchases does not exceed specified limits in any calendar year, which under the most restrictive debt agreement is currently $5 million a year. Accordingly, no dividends can be expected to be paid by Holding at least until all borrowings under such agreements with the debt holders have been repaid. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As a result of the Acquisition, results of operations include purchase accounting adjustments and reflect a highly leveraged capital structure. Sales Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $2,100 $ 1,892 $ 1,836 Plumbing Products 1,167 1,170 1,018 Transportation Products 563 730 741 Sales $3,830 $ 3,792 $ 3,595 ====== ======= ======= Operating Income (Loss) Before Income Taxes, Extraordinary Loss, and Cumulative Effects of Changes in Accounting Methods Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $133 $ 104 $ 55 Plumbing Products 108 108 66 Transportation Products 41 88 121 Operating income 282 300 242 Interest expense (278) (289) (286) Corporate items(b) (85) (63) (44) Loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods $(81) $ (52) $ (88) ==== ===== ===== (a) For 1991 the amounts presented for Air Conditioning Products include the following amounts for Tyler Refrigeration (which was sold on September 30, 1991): sales of $99 million and operating loss of $18 million (including a $22 million loss on the sale). (b) Corporate items include administrative and general expenses, accretion charges on postretirement benefit liabilities, minority interest, foreign exchange transaction gains and losses, and miscellaneous income and expense. The following section summarizes the Company's consolidated results of operations and then discusses the results of its three operating segments. The Company's businesses are cyclical. Air Conditioning Products and Plumbing Products are particularly affected by the level of residential and commercial building activity. The following table presents a summary of statistics on U.S. non-residential construction activity and housing starts for the years 1989 through 1993. U.S. Non- Residential Contract Awards U.S. Housing (Millions % Change Starts % Change of square Year (Thousands of Year feet)(a) to Year units)(b) to Year 1989 1,322 - 1% 1,376 - 8% 1990 1,155 -13% 1,193 -13% 1991 953 -17% 1,015 -15% 1992 903 - 5% 1,200 +18% 1993 (c) 930 + 3% 1,290 + 7% (a) Source: F.W. Dodge Division, McGraw Hill, Inc. (b) Source: U.S. Department of Commerce, Bureau of Census. (c) Preliminary data. The market for replacement sales and servicing of air conditioning and plumbing products, which accounts for a substantial portion of sales for Air Conditioning Products and Plumbing Products, is less cyclical and sometimes countercyclical. The following table presents a summary of statistics on unit production of trucks, buses, and trailers in excess of six tons in Western Europe for the years 1989 through 1993 (units in thousands). Western Europe % Change Western Europe % Change Truck and Bus Year Trailer Year Production(a) to Year Production(a) to Year 1989 376 4% 125 9% 1990 343 -9% 128 2% 1991 353 3% 139 9% 1992 314 -11% 115 -17% 1993 223 -29% 88 -23% (a) Principal sources: Verband der Deutschen Automobilindustrie (Germany); Society of Motor Manufacturers and Traders (United Kingdom); and Chambre Syndicate des Constructeurs Automobiles (France). 1993 Compared with 1992 U.S. housing starts increased by 7% in 1993 from the 1992 level, which was up 18% over 1991 after four consecutive years of decline. U.S. non-residential contract awards increased by 3% in 1993 after five years of decline. The 1993 improvement in housing starts came in the second half of the year with third- and fourth-quarter starts up 10% and 12%, respectively, over the preceding quarter. The gain in non-residential awards occurred over the last nine months of 1993. Western European truck and bus production declined 29% in 1993 after an 11% decline in 1992. However, the rate of decline in the truck market slowed in the fourth quarter of 1993. Consolidated sales for 1993 were $3.83 billion, an increase of 1% (6% excluding the unfavorable effects of foreign exchange) over the $3.79 billion for 1992. A sales increase of 11% for Air Conditioning Products was partly offset by a sales decline for Transportation Products of 23% (16% excluding the unfavorable effects of foreign exchange). Sales for Plumbing Products were flat (but up by 9% excluding the effects of foreign exchange). Operating income for 1993 was $282 million, a decrease of $18 million, or 6% (but an increase of less than 1% excluding the effects of foreign exchange), from $300 million in 1992. The increase in operating income of 28% for Air Conditioning Products was more than offset by a 53% decrease in operating income for Transportation Products. Plumbing Products' operating income was flat (but increased 15% excluding the effects of foreign exchange). The gain for Air Conditioning Products was the result of higher volume, increased sales of higher-margin products, the benefits of manufacturing improvements, and the effects of restructuring and cost-containment efforts undertaken in 1991 and 1992, offset partly by the costs of further restructuring in 1993. For Plumbing Products the effects of increased volume for the Far East Group were offset partly by lower margins for the U.S. group and lower volumes and unfavorable foreign exchange effects for the European group. Transportation Products' operating income decreased primarily as a result of lower volumes due to reduced demand in depressed markets in Europe, offset partly by the effects of improvements in manufacturing efficiency. Air Conditioning Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Domestic portion $1,786 $1,572 $1,453 Foreign portion 314 320 284 Subtotal 2,100 1,892 1,737 Tyler Refrigeration - - 99 Total $2,100 $1,892 $1,836 ====== ====== ====== Operating income (loss): Domestic portion $ 148 $ 112 $ 58 Foreign portion (15) (8) 15 Subtotal 133 104 73 Tyler Refrigeration - - (18)(a) Total $ 133 $ 104 $ 55 ====== ====== ====== Assets $1,167 $1,156 $1,174 Goodwill and purchase accounting adjustments included in assets 372 398 417 Capital expenditures 38 33 46(b) Depreciation and amortization 53 55 56(c) (a) Includes $22 million loss on the sale of Tyler Refrigeration. (b) Includes capital expenditures of Tyler Refrigeration of $1 million. (c) Includes depreciation and amortization of Tyler Refrigeration of $3 million. The domestic portion of Air Conditioning Products is composed of the Unitary Products Group, the Commercial Systems Group (excluding Canada), and exports from the United States by the International Group. The foreign portion consists of the foreign-based operations of the International Group and the Canadian operations of the Commercial Systems Group. Sales and operating income of Air Conditioning Products both increased in 1993 despite the continuing recession in U.S. and Canadian commercial new construction and only moderate increase in residential new construction in the U.S. and despite the economic decline in Europe. Sales of Air Conditioning Products, which accounted for approximately 55% of the Company's 1993 sales, increased by 11% (with little effect from foreign exchange) to $2,100 million in 1993 from $1,892 million in 1992. There was a significant sales increase for each of the three operating groups. Operating income of Air Conditioning Products increased year to year by 28% (with little effect from foreign exchange) to a record high of $133 million in 1993 from $104 million in 1992. The increase was attributable to gains achieved by all three groups. Unitary Products Group In 1993 sales of the Unitary Products Group, which accounted for approximately 42% of Air Conditioning Products sales, increased by 15% over the 1992 sales level. Residential markets were up 15%, as a result of an unusually hot summer in the northern United States and a 7% increase in housing starts. Sales of residential products increased by 18% year over year, principally because of higher volumes driven by the improved market, increased furnace sales in the replacement market, and a shift in the market to more efficient products, offset partly by the continuation from 1992 of price degradation due to competitive pressures. Commercial markets for unitary products were up 9% overall from the 1992 markets, as the commercial replacement market strengthened further. New-construction activity continued to struggle, however. Sales of commercial unitary products increased by 10% overall, primarily as a result of higher volume (driven by the strong replacement market for both light and large commercial products); a shift to higher-priced, higher-tonnage products; and a gain in market share for light commercial products due to the success of the large Voyager products (packaged rooftop air conditioners). As a result of these factors, together with product cost improvements, improved labor productivity, and the benefits of organizational restructuring which reduced the salaried workforce in 1992, the operating income for Unitary Products in 1993 increased by 43% year over year. This improvement was achieved even though 1993 included the initial start-up costs of the new national distribution center in St. Louis, Missouri, and higher advertising costs. Unitary Products' sales increased through the success of new and redesigned products introduced recently and improved distribution channels. Commercial products that were introduced included the 20-to-25-ton Voyager products in 1992, which more than doubled market share in that size range; commercial microprocessor-controlled products; a line of convertible air handlers; and rooftop and air cooled chiller products using more efficient scroll compressors. Residential products introduced included the American-Standard brand outdoor units and new lines of luxury and conventional retail residential products. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 37% of Air Conditioning Products' sales, increased 10%, primarily on volume increases for most product lines, especially air handling systems and water chillers (principally due to improved replacement markets and increased market share), and increased revenue from Company-owned sales offices (acquisitions and volume growth). These gains were partly offset by lower volume in Canada, which continues to be adversely affected by recession. The non-residential new-construction market increased 3% in the United States in 1993, following decreases of 5% in 1992 and 17% in 1991. The non-residential replacement market was up by 6% over 1992. Operating income for Commercial Systems increased 12% in 1993 over the recession-affected amount of 1992. The increase was primarily the result of volume gains, improvements in manufacturing efficiency, operating expense reductions, and the benefits of restructuring actions taken in 1992. The effects of these factors were partly offset by slightly lower prices, increases in material, labor, and benefit costs, the costs of additional restructuring actions in 1993, and a larger loss in the weak Canadian market. Product development emphasis for Commercial Systems in 1993 and 1992 was on new compressor, heat transfer and microelectronic control technology; adaptation of products to refrigerants that comply with recent government regulations; energy-efficient products; products for the aftermarket and replacement market (which exceeded the new-construction market in both 1993 and 1992); and products redesigned to improve manufacturing productivity. This strategy benefited operations in 1993 and 1992, and the Company expects that this product development emphasis will result in greater sales over the next several years. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1993 sales, increased 7% from those of 1992 (10% excluding the unfavorable effect of foreign exchange). Most of the gain was from higher volume in the Far East (especially Hong Kong, Taiwan, and export sales from the U.S.) resulting from expanded markets and increased penetration; higher export sales from the U.S. to the Middle East (markets were significantly stronger) and Latin America (improved penetration in a market that was up 20%); and higher volumes in Mexico. These gains were partly offset by lower sales in Europe (lower prices and volumes in a declining market). Markets were down in all European countries except the U.K., but the effect was partly offset by increased revenues from service companies acquired in 1992 and prior years. Market growth in the Far East was 6% overall, led by the PRC market, which was up by 21%. The sales growth in Hong Kong was driven by the very strong market in the PRC. Markets in Thailand also grew, and the Latin American market grew by 20%. Operating income for the International Group increased by approximately 39% in 1993. The increase was primarily the result of higher export sales from the U.S. to the Middle East and Far East, offset partly by a larger operating loss in Europe primarily because of the weak markets and lower margins, costs related to restructuring in response to the lower markets, and the unfavorable effects of lower volume on factory performance. Overall, income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expansion of distribution channels and joint ventures and development of new and improved products to support present and future growth. Environmental Matters For a discussion of environmental matters see "Business -- Regulations and Environmental Matters." Backlog The worldwide backlog for Air Conditioning Products at the end of 1993 was $407 million, up 13% from 1992, excluding the effects of foreign exchange. The backlog increased as a result of increased volume for the Commercial Systems Group, market penetration and improved distribution channels in the Middle East and Far East, and sales growth for commercial Unitary Products. Plumbing Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Foreign portion $ 865 $ 885 $ 783 Domestic portion 302 285 235 Total $1,167 $1,170 $1,018 ====== ====== ====== Operating income (loss): Foreign portion $ 131 $ 124 $ 93 Domestic portion (23) (16) (27) Total $ 108 $ 108 $ 66 ====== ====== ====== Assets $ 960 $1,002 $1,069 Goodwill and purchase accounting adjustments included in assets 376 392 447 Capital expenditures 46 48 40 Depreciation and amortization 49 49 48 The foreign portion of Plumbing Products is composed of the European Plumbing Products Group, the Americas International Group, and the Far East Group. The domestic portion of sales and operating results is generated primarily by the U.S. Plumbing Products Group and by export sales from the U.S. Sales of Plumbing Products in 1993, at $1,167 million, which accounted for approximately 30% of the Company's 1993 sales, were at essentially the same level as the $1,170 million of sales in 1992 (but increased by 9% excluding the unfavorable effects of foreign exchange). Sales increases of 42% for the Far East Group (46% excluding foreign exchange), 9% for the Americas International Group (14% excluding foreign exchange), and 6% for the U.S. Plumbing Products Group were offset partly by a sales decrease of 10% for the European Plumbing Products Group (which had a 4% increase excluding the effects of foreign exchange). In 1993 operating income of Plumbing Products was $108 million, the same amount as in 1992, but excluding the unfavorable effects of foreign exchange operating income increased by 15%. The increase (on an exchange-adjusted basis) was attributable primarily to increased profitability for the Far East Group and for the Americas International Group, offset partly by a decline for the U.S. group. European Plumbing Products Group Sales of the European group, which accounted for approximately 51% of Plumbing Products' sales for 1993, decreased 10% in 1993 from 1992 but increased by 4% excluding the unfavorable effects of foreign exchange. The exchange-adjusted gain resulted from price increases, especially in Italy, Germany, the U.K., and Greece, offset partly by lower volume in most countries because of depressed markets. In Italy sales were up with price increases for most product lines, offset partly by lower volume and a less favorable product mix. The German market was stable in total, as price gains were offset by volume and mix declines. Greece, which had been in recession for three years, recovered somewhat in 1993. The European group's strength has been sales in the replacement market, which has more than made up for the effects of poor new-construction markets. Operating income for the European group decreased 7% but increased 10% excluding the effects of foreign exchange. This increase occurred primarily because of the price gains and cost reductions resulting from restructuring and efficiency improvements in the U.K., France, Italy, and Germany. Partly offsetting those favorable effects were the effects of lower volumes and the unfavorable effect on margins caused by the decline in value of many European currencies agains the Deutschemark. The increased cost of fittings purchased from Germany could not be completely recovered through sales price increases in most of the operations in other countries. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 26% of total 1993 Plumbing Products sales, increased 6% in 1993. During 1993 the U.S. building industry continued to be adversely affected by the low level of new construction, although non-residential construction increased 3% from 1992 and new residential construction continued to recover from the lowest levels since the mid-1940's (up by 7% in 1993 and 18% in 1992 but still below pre-1990 levels). A basic shift from wholesale distribution channels to retail channels has been developing over the last few years, a trend the Company believes will continue and will be beneficial to the Company because of strong product and brand-name recognition. Retail markets now account for 20% of the total sales of the U.S. group. The growth of sales for the U.S. group was largely the result of increased export sales from the U.S. and to a lesser extent price increases on certain products, a more favorable sales mix, and a small increase in the growing retail channel business. The overall gain in the retail business was small because significant volume gains due to an expanding customer base were partly offset by the loss of an important customer. The operating loss for the U.S. group in 1993 was greater than that of the prior year. Despite higher sales, operating results were poorer primarily because of lower margins on both domestic and export sales, increased advertising costs and other expenses associated with expansion of the retail distribution channel, costs related to start-up and expansion of the low-water-volume toilet line (now mandated for new construction), and factory performance problems caused in part by the effects of fluctuating volumes. In addition, costs were incurred in business system re-engineeering activities intended to improve customer service. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 23% of total Plumbing Products sales, increased 21% in 1993 (26% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation of Incesa (a previously unconsolidated group of Central American joint ventures) effective January 1, 1993, as a result of the purchase of additional shares of stock, and to higher volume and prices in Thailand, the PRC, the Philippines, and Brazil, offset partly by decreases in sales in Mexico, Canada, and Korea. Combined operating income of the Americas International and Far East Groups in 1993 increased 72% over the 1992 level. Gains were realized in all operations except Mexican chinaware operations, which were adversely affected by poor economic conditions and the uncertainty related to the North American Free Trade Agreement. The increase was primarily from higher prices and volumes in Brazil, Thailand, and the PRC the consolidation of Incesa, and a smaller loss for Mexican fittings operations. Environmental Matters For a discussion of environmental matters see "ITEM 1. BUSINESS -- Regulations and Environmental Matters." Backlog Plumbing Products' year-end 1993 backlog of $143 million was down 9% from 1992, excluding foreign exchange effects. The decrease resulted from a significant drop for European Plumbing Products (particularly Italy because of economic uncertainty, tempered somewhat by increases for England and Germany), and a drop in backlog for export sales from the U.S., partly offset by increases in the Far East (primarily Thailand). Transportation Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales $ 563 $730 $741 Operating income 41 88 121 Assets 652 722 828 Goodwill and purchase accounting adjustments included in assets 422 458 510 Capital expenditures 14 27 24 Depreciation and amortization 35 37 34 Sales of Transportation Products, which accounted for 15% of the Company's 1993 sales, were $563 million, down 23% from $730 million in 1992 (16% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a 29% decrease in Western European truck and bus production, led by a 34% decline in Germany, and a 23% decrease in Western European trailer production. Volumes were also down in all other European countries in which Transportation Products has operations, although at the end of 1993 sales and order trends were upward. Volume in Brazil was slightly higher. Original equipment sales volume in Europe was down 22%, and aftermarket business was down 10%. These declines affected both conventional and electronic products. Operating income for Transportation Products in 1993 decreased 53% (50% excluding foreign exchange effects) to $41 million from $88 million in 1992, principally because of the lower sales and production volume and the inability to pass on material and labor cost increases in a very competitive, declining market. In response to reduced production levels, plant employment was reduced by 15%, the costs of which further depressed 1993 operating income. Those effects were partly offset by the favorable effects of cost improvements in manufacturing from Demand Flow implementa- tion and reduced operating expenses. Despite the market downturn, significant progress was made during 1993 in obtaining market acceptance of electronically controlled air suspension systems for commercial vehicles and for antilock braking systems on trailers. Backlog Transportation Products' year-end 1993 order backlog of $185 million was 2% lower than the 1992 year-end backlog, excluding the effects of foreign exchange, as a result of the poor market conditions. Financial Review 1993 Compared with 1992 The Company's financing and corporate costs were $363 million and $352 million in 1993 and 1992, respectively. The principal causes of the increase were effects of year-to-year changes in foreign exchange transaction gains and losses, higher minority interest, lower equity income, higher accretion expense on postretirement benefits, and lower miscellaneous income. Interest expense, which accounted for most of these costs, decreased primarily because of lower overall interest rates on new debt issued as part of the Refinancing (described below), partly offset by additional interest expense as a result of the exchange of the 12-3/4% Exchangeable Preferred Stock for the 12-3/4% Junior Subordinated Debentures. The tax provision for 1993 was $36 million despite a pre-tax loss of $81 million, whereas in 1992 the tax provision was $5 million on a pre-tax loss from continuing operations of $52 million. The 1993 provision reflected taxes payable on profitable foreign operations and was higher than in 1992 primarily because no tax benefits were available on domestic losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. As a result of the Refinancing in 1993 there was an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit. Liquidity and Capital Resources As a result of the Acquisition the Company's capital structure became highly leveraged. Net cash flow from operations, after cash interest expense of $195 million, was $201 million for the year ended December 31, 1993. Utilizing this cash flow and cash on hand at December 31, 1992, the Company devoted $98 million to capital expenditures, including $8 million of investments in affiliated companies, and repaid $50 million of term loans. In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million, and the amount available under the Credit Agreement by its terms was reduced to $950 million. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12 months ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. The Credit Agreement provides the Company with increased operating and financial flexibility, including the ability to shift from time to time a portion of borrowings among borrowers and currencies. As a result of the Refinancing there was a significant reduction in annual interest expense, which was partly offset by additional interest expense on the 12-3/4% Junior Subordinated Debentures exchanged for the 12-3/4% Exchangeable Preferred Stock. The Company believes that the amounts available from operating cash flows and under the Revolving Credit Facility will be sufficient to meet its expected cash needs, including planned capital expenditures. As described in Note 8 of Notes to Consolidated Financial Statements, the Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemptions of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amendments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and convenants, and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar amendments or waivers in the future. On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993, with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required the Company expects that it will be able to meet such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures, and therefore subsequent results of operations for any particular quarterly or annual period, could be adversely affected. Capital Expenditures The Company's capital expenditures for 1993 amounted to $98 million, including investments of $8 million in affiliated companies. The amount of capital expenditures was $10 million less than in 1992 ($6 million less excluding the effects of foreign exchange). Decreases in capital spending by Plumbing Products and Transportation Products were partly offset by an increase in spending by Air Conditioning Products. The Company believes capital spending was sufficient for maintenance purposes, for important product and process redesigns, for expansion projects, and for strategic investments. Capital expenditures by Air Conditioning Products were $38 million in 1993. This amount was 15% more than that of 1992. Capital expenditures in 1993 included continuing projects related to Demand Flow and spending on new products such as the Voyager III (medium-tonnage product line), the scroll compressor, and the Series R chiller line, expansion of Voyager I and Voyager II capacity and tooling and equipment for the American Standard product line. Plumbing Products' capital expenditures in 1993 were $46 million, including investments of $8 million in affiliated companies in France (Porcher) and the Czech Republic. Excluding the investments in affiliated companies and the effects of foreign exchange, capital spending was 34% higher than in 1992 as a result of spending increases in Europe and the Far East. Major projects included capacity expansion in Thailand and China and various projects related to Demand Flow implementation. Capital expenditures for Transportation Products totaled $14 million in 1993. Excluding the effects of foreign exchange, capital spending was 41% less than in 1992, a year with significant spending related to Demand Flow cost-reduction projects in production and material flow. 1992 Compared with 1991 U.S. housing starts increased by 18% in 1992 from the 1991 level, but non-residential contract awards decreased by 5%. Both of these economic indicators had declined in each of the previous four years. Consolidated sales for 1992 were $3.8 billion, an increase of 5% (4% excluding the favorable effects of foreign exchange) over the $3.6 billion for 1991. The 1991 amount included the sales of Tyler Refrigeration, which was sold September 30, 1991. Excluding Tyler Refrigeration, sales in 1992 were up 8% (7% excluding foreign exchange effects). Sales increases of 15% for Plumbing Products and 9% for Air Conditioning Products (excluding Tyler Refrigeration) were partly offset by a sales decline for Transportation Products of 1% (6% excluding the favorable effects of foreign exchange). Operating income for 1992 was $300 million, an increase of $58 million, or 24% (19% excluding the effects of foreign exchange), from $242 million in 1991. The 1991 amount included a loss for Tyler Refrigeration. Excluding Tyler Refrigeration, operating income in 1992 was up 15% (10% excluding foreign exchange effects.) Increases in operating income of 42% for Air Conditioning Products (excluding Tyler Refrigeration) and 64% for Plumbing Products were partly offset by a 27% decrease in operating income for Transportation Products. Except as otherwise indicated, the following discussion, including the financial comparisons, does not include the results of Tyler Refrigeration or the $22 million loss on the sale of Tyler Refrigeration in 1991. Air Conditioning Products Segment Sales of Air Conditioning Products, which accounted for approximately 50% of the Company's 1992 sales, increased by 9% to $1,892 million in 1992 from $1,737 million in 1991. There was a significant sales increase for each of the three operating groups -- for the Unitary Products Group in both residential and commercial products primarily because of higher volume and more favorable product mix (partly offset by lower prices), for the Commercial Systems Group primarily because of higher volume and prices, and for the International Group principally because of increased volume in Europe and the Far East. Operating income of Air Conditioning Products increased year to year by 42% (with little effect from foreign exchange) to $104 million in 1992 from $73 million in 1991. The increase was attributable to the sales gains, the benefits of manufacturing improvements and restructuring and cost containment in the Unitary Products and Commercial Systems Groups, and the fact that in 1991 results of the Commercial Systems Group had been adversely affected by a 54-day work stoppage at its LaCrosse, Wisconsin, facility. The impact of these factors was partly offset by a margin decline for the International Group and costs related to the start-up of new facilities, sales offices, and distribution channels. Unitary Products Group Sales in 1992 of the Unitary Products Group, which accounted for approximately 41% of Air Conditioning Products sales, increased by 6% over the 1991 sales level. Commercial markets for unitary products were up 6% overall from the depressed 1991 markets, as a very strong commercial replacement market more than offset the effects of low new-construction activity. Sales of commercial unitary products increased by 7% overall, primarily as a result of higher volume (driven by the strong replacement market), a shift to higher-priced, higher-tonnage products, and a gain in market share for light commercial products. Residential markets were down 3.5%, as poor replacement activity, a result of an unseasonably cool summer, more than offset the 18% increase in new housing starts. Despite this poorer market, sales of residential products increased by 5% year over year, principally because of larger market share, improved furnace markets, and a partial shift in the market to more efficient products stimulated by Federal standards, offset partly by price degradation due to competitive pressures. As a result of these factors, together with benefits of manufacturing improvements, cost containment, and organizational restructuring which reduced the salaried workforce, the operating profit for Unitary Products in 1992 increased by 50% from the depressed level of 1991. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 38% of Air Conditioning Products' sales, increased 9% primarily on volume increases in aftermarket replacement and parts sales, increased revenue from Company-owned sales offices (volume growth and acquisitions), and small price increases on most product lines. Other factors contributing to the increase were higher sales of large applied systems and the fact that in 1991 there was a 54-day work stoppage at the LaCrosse, Wisconsin, plant. These gains were partly offset by lower volume in Canada, which was adversely affected by recession. Operating income for Commercial Systems increased 129% in 1992 over the recession-affected and work-interrupted level of 1991. The increase was primarily the result of the volume and price gains, improvements in manufacturing efficiency, cost containment and restructuring, and the fact that 1991 included the adverse impact of the LaCrosse work stoppage. The effects of these factors were partly offset by slightly lower gross margins, as the price increases did not completely recover increases in material, labor and benefits costs. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1992 sales, increased 15% from those of 1991 (10% excluding the favorable effect of foreign exchange). Most of the gain was from higher volumes in Mexico (two new sales offices resulted in expanded distribution and penetration), the Far East (especially Hong Kong and Singapore), the Middle East (markets were significantly stronger), and Europe (sales of new products and increased penetration despite declining markets). Markets were down in almost all European countries except Italy, with the largest drop in the U.K., offset partly by increased revenues from acquired service companies. Operating income for the International Group decreased by approximately 68% in 1992. The decline occurred in Europe, primarily because of the weak markets and lower prices, costs related to the start-up of new facilities and new distribution networks in the U.K. and France, costs related to the introduction of new products, start-up costs of a company in Spain acquired near the end of 1991, and foreign exchange transaction losses from currency fluctuations in the latter half of 1992. Income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expanded distribution channels, start-up of new joint ventures, and development of new and improved products to support present and future growth. Plumbing Products Segment Sales of Plumbing Products, which accounted for approximately 31% of the Company's 1992 sales, increased by 15% in 1992 (14% excluding the effects of foreign exchange) to $1,170 million from $1,018 million in 1991. The improvement resulted from sales increases of 9% (7% excluding the effects of foreign exchange) for the European Plumbing Products Group, 21% for the U.S. Plumbing Products Group, 4% for the Americas International Group (7% excluding foreign exchange), and 101% for the Far East Group (98% excluding foreign exchange). In 1992 operating income of Plumbing Products increased 64% (56% excluding the effects of foreign exchange) to $108 million from $66 million in 1991. The increase was attributable primarily to increased profitability for the European group on higher prices and volumes (especially in Italy and Germany) although improved results in the U.S., Americas International, and Far East groups contributed. European Plumbing Products Group Sales of the European group, which accounted for approximately 57% of Plumbing Products' sales for 1992, increased 9% in 1992 over 1991, 7% excluding the favorable effects of foreign exchange. The gain resulted primarily from price and volume increases, especially in Italy and Germany, offset partly by lower volume in France from declining demand and lower prices in the U.K. caused by a very poor market. In Italy sales were up 9%, with gains for most product lines in price, volume and market share. The gains in Germany were the result of higher volumes and prices for brass fittings and luxury chinaware. Operating income for the European group increased 28% (23% excluding the effects of foreign exchange) primarily from the price and volume gains in Italy and Germany and higher margins on German brass operations resulting from improved manufacturing processes and cost containment, offset partly by lower profitability in France because of decreased volume and in the U.K. because of the recession. A recession depressed operating results in Greece. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 24% of total 1992 Plumbing Products sales, increased 21% in 1992. During 1992 the U.S. building industry continued to be severely affected by the low level of new construction, with non-residential construction down 5% from 1991 and with new residential construction recovering from the lowest levels since the mid-1940's (though up by 18%, it was still low in historical terms). The U.S. market for plumbing products was up an estimated 3% to 4%, with more than half the gain occurring in the replacement and remodeling markets, which accounts for about 60% of the total U.S. market. The growth of sales for the U.S. group was largely a result of the strength of retail business (which had a significant increase in volume and accounted for 20% of sales of the U.S. group in 1992) and increased export sales from the U.S., together with smaller gains resulting from price increases and higher wholesaler distribution sales. Sales of AMERICAST products more than doubled in 1992, and smaller volume gains were achieved for acrylic products, fixtures, and faucets. The operating loss for the U.S. group in 1992 was less than that of the prior year. The improvement was primarily due to price increases and secondarily to volume and margin gains (as a result of sourcing product from the Company's Latin American plants), offset partly by non-recurring costs related to implementation of improved manufacturing processes and the effects of a shift in overall sales mix from commercial and luxury to lower-margin products. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 19% of total Plumbing Products sales, increased 26% in 1992 (28% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation in 1992 of a previously unconsolidated joint venture in Thailand and to a lesser extent to price and volume increases in Mexico and Korea and higher volumes in Brazil, offset partly by lower sales in Canada, which were adversely affected by severe recession. Combined operating income of the Americas International and Far East Groups in 1992 increased 134% over the 1991 level. Gains were realized in all operations except Canada and the Philippines, both of which were adversely affected by poor economies. The increase was primarily from price and volume gains in Mexico and Korea, higher volume and margins in Brazil, and higher volume in China. Transportation Products Segment Sales of Transportation Products, which accounted for 19% of the Company's 1992 sales, were $730 million, down 1% from $741 million in 1991 (6% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a significant decrease in truck and bus production. Volumes were also down in nearly all other European countries in which Transportation Products has operations except the U.K. There was also a decline in prices of electronic control products, primarily as a result of industry cost reductions. Operating income for Transportation Products in 1992 decreased 27% (32% excluding foreign exchange effects) to $88 million from $121 million in 1991, principally because of the lower sales and production volume, lower prices, and increased spending for product engineering. Plant employment was kept in line with reduced production levels, but the costs associated with these reductions also depressed 1992 operating income. Those effects were partly offset by the favorable effects of cost reductions and increases in efficiency achieved in manufacturing operations. Financial Review 1992 Compared with 1991 The Company's financing and corporate costs were $352 million and $330 million in 1992 and 1991, respectively. The principal causes of the increase were year-to-year effects of changes in foreign exchange transaction gains and losses, higher minority interest, and lower miscellaneous income. Interest expense and accretion expense on postretirement benefits, which accounted for most of these costs, also increased. The tax provision for 1992 was $5 million despite a pre-tax loss of $52 million, whereas in 1991 the tax provision was $23 million on a pre-tax loss from continuing operations of $88 million. The 1992 provision reflected taxes payable on profitable foreign operations offset partly by available domestic tax benefits. The 1992 provision was lower than in 1991 primarily because of lower pre-tax earnings in foreign operations. In 1992 the provision was also lower because of future income tax benefits resulting from carrybacks of foreign net operating losses and the existence of deferred tax credits which reverse in the carryforward period applicable to other foreign net operating losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RESPONSIBILITY FOR FINANCIAL STATEMENTS The accompanying consolidated balance sheets at December 31, 1993 and 1992, and related consolidated statements of operations, stockholders' equity (deficit), and cash flows for the years ended December 31, 1993, 1992 and 1991, have been prepared in conformity with generally accepted accounting principles, and the Company believes the statements set forth a fair presentation of financial condition and results of operations. The Company believes that the accounting systems and related controls that it maintains are sufficient to provide reasonable assurance that the financial records are reliable for preparing financial statements and maintaining accountability for assets. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control must be related to the benefits derived and that the balancing of those factors requires estimates and judgment. Reporting on the financial affairs of the Company is the responsibility of its principal officers, subject to audit by independent auditors, who are engaged to express an opinion on the Company's financial statements. The Board of Directors has an Audit Committee of non-employee Directors which meets periodically with the Company's financial officers, internal auditors, and the independent auditors and monitors the accounting affairs of the Company. ASI Holding Corporation New York, New York March 14, 1994 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors ASI Holding Corporation We have audited the accompanying consolidated balance sheets of ASI Holding Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ASI Holding Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/Ernst & Young Ernst & Young New York, New York March 14, 1994 ASI HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in thousands except share amounts) ASSETS At December 31, 1993 1992 Current assets Cash and certificates of deposit $ 53,237 $ 111,549 Cash in escrow 932 1,722 Accounts receivable, less allowance for doubtful accounts-- 1993, $15,666; 1992, $12,827 507,322 468,731 Inventories 325,819 384,857 Future income tax benefits 24,562 33,192 Other current assets 29,811 31,199 Total current assets 941,683 1,031,250 Facilities, at cost net of accumulated depreciation 820,523 832,811 Other assets Goodwill, net of accumulated amortization -- 1993, $169,879; 1992, $141,858 1,025,774 1,101,716 Debt issuance costs, net of accumulated amortization-- 1993 $9,670; 1992, $77,776 78,102 51,308 Other 120,997 109,333 $2,987,079 $3,126,418 ========== ========== LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities Loans payable to banks $ 38,036 $ 99,150 Current maturities of long-term debt 105,939 13,458 Accounts payable 307,326 271,855 Accrued payrolls 99,758 105,400 Other accrued liabilities 263,322 230,335 Taxes on income 47,003 18,848 Total current liabilities 861,384 739,046 Long-term debt 2,191,737 2,032,064 Other long-term liabilities Reserve for postretirement benefits 387,038 368,868 Deferred tax liability 45,625 73,307 Other 224,108 228,521 Total liabilities 3,709,892 3,441,806 Commitments and contingencies Exchangeable preferred stock - 133,176 Stockholders' deficit Preferred stock, Series A, par value $.01, 1,000 shares issued and outstanding - - Common stock $.01 par value, 28,000,000 shares authorized; 23,858,335 shares issued and outstanding in 1993, 23,608,587 in 1992 239 236 Capital surplus 188,744 192,351 Subscriptions receivable (2,588) (3,316) ESOP shares (4,331) (9,527) Accumulated deficit (750,003) (541,436) Foreign currency translation effects (149,220) (86,872) Minimum pension liability adjustment (5,654) - Total stockholders' deficit (722,813) (448,564) $2,987,079 $3,126,418 =========== ========== See notes to consolidated financial statements. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation ASI Holding Corporation ("Holding") is a Delaware corporation that was formed in 1988 by an affiliate of Kelso & Company L.P. ("Kelso"), an investment banking firm that specializes in leveraged buyouts. On March 21, 1988, the Kelso affiliate commenced a tender offer (the "Tender Offer") for all of the common stock of American Standard Inc. at $78 per share in cash. On April 27, 1988, the Kelso affiliate completed the Tender Offer with the purchase of approximately 95% of the shares of American Standard Inc. Pursuant to an Agreement and Plan of Merger, a merger was consummated (the "Merger") on June 29, 1988, whereby American Standard Inc. became a wholly owned subsidiary of Holding. At that time the remaining shares of American Standard Inc.'s common stock were converted into the right to receive cash of $78 per share. Hereinafter "the Company" will refer to Holding or to its subsidiary, American Standard Inc., as the context requires. The Tender Offer, Merger, and related transactions are hereinafter referred to as the "Acquisition." For financial statement purposes the Acquisition has been accounted for under the purchase method. Note 2. Accounting Policies Consolidation The financial statements include on a consolidated basis the results of all majority-owned subsidiaries. All material intercompany transactions are eliminated. Investments in affiliated companies are included at cost plus the Company's equity in their net results. Translation of Foreign Financial Statements Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the income statements are translated at the average rates of exchange for the period. Gains or losses resulting from translating foreign currency financial statements are accumulated in a separate component of stockholder's equity until the entity is sold or substantially liquidated. Gains or losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's local currency) are included in net income. For operations in countries that have high rates of inflation, net income includes gains and losses from translating assets and liabilities at year-end rates of exchange, except for inventories and facilities, which are translated at historical rates. Revenue Recognition Sales are recorded when shipment to a customer occurs. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statement of Cash Flows Cash and certificates of deposit include all highly liquid investments with an original maturity of three months or less. Inventories Inventory costs are determined by the use of the last-in, first-out (LIFO) method on a worldwide basis, and inventories are stated at the lower of such cost or realizable value. Facilities The Company capitalizes costs, including interest during construction, of fixed asset additions, improvements, and betterments that add to productive capacity or extend the asset life. Maintenance and repair expenditures are charged against income. Significant foreign investment grants are amortized into income over the period of benefit. Goodwill Goodwill is being amortized over 40 years. Debt Issuance Costs The costs related to the issuance of debt are amortized using the interest method over the lives of the related debt. Warranties The Company provides for estimated warranty costs at the time of sale. Warranty obligations beyond one year are included in other long-term liabilities. The Company changed its method of accounting for revenues from extended warranty contracts at the beginning of 1991 to conform with the FASB Technical Bulletin, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts." The bulletin requires the deferral of the revenue from the sales of such contracts and amortization thereof on a straight-line basis over the terms of the contracts. The cumulative effect of this accounting change for all contracts in place as of December 31, 1990, increased the net loss in 1991 by $7 million, net of income tax benefit. The effect on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. Leases The asset values of capitalized leases are included with facilities, and the associated liabilities are included with long-term debt. Postretirement Benefits Postretirement benefits are provided for substantially all employees of the Company, both in the United States and abroad. In the United States the Company also provides various postretirement health care and ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS life insurance benefits for some of its employees. Effective January 1, 1991, such costs are calculated in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). Depreciation Depreciation and amortization are computed on the straight-line method based on the estimated useful life of the asset or asset group. Research and Development Expenses Research and development costs are expensed as incurred except for costs incurred (after technological feasibility is established) for computer software products expected to be sold. The Company expensed costs of approximately $41 million in 1993, $40 million in 1992, and $36 million in 1991 for research activities and product development. Computer software product development costs capitalized in 1993 amounted to $2 million. Income Taxes In 1991 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), and elected to apply the provisions retroactively to January 1, 1989. The Company recognizes deferred tax assets for the tax effects of items that will be deducted for tax purposes in later years together with the tax effects of income items included in current reporting for tax purposes but in later years for financial statement purposes and the effects of certain tax attributes such as net operating losses. The Company provides for United States income taxes and foreign withholding taxes on foreign earnings expected to be repatriated. Deferred tax liabilities are provided on the excess of the financial statement basis over the tax basis of certain assets, primarily for inventories and fixed assets, including fair value adjustments resulting from purchase accounting in connection with the Acquisition; fixed assets due to accelerated depreciation deductions for tax purposes; and non-permanent investments in certain foreign subsidiaries. Earnings per share Earnings per share have been computed using the weighted average number of common shares outstanding. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Financial Instruments with Off-Balance-Sheet Risk The Company from time to time enters into foreign currency exchange agreements in the management of foreign currency exposure. Gains and losses from exchange rate changes are included in income unless the contract hedges a net investment in a foreign entity or a firm commitment, in which case gains and losses are deferred as a component of foreign currency translation effects in stockholder's equity or included as a component of the transaction. Note 3. Postretirement Benefits The Company sponsors postretirement benefit plans covering substantially all employees, including an Employee Stock Ownership Plan (the "ESOP") for the Company's U.S. salaried employees and certain U.S. hourly employees. In 1988 in conjunction with the Acquisition the ESOP purchased 5,000,000 shares (adjusted for a 100-for-1 stock split) of common stock of Holding. The ESOP is an individual account, defined contribution plan. The valuation of the ESOP shares is determined by independent appraisals. The common stock acquired by the ESOP is being allocated to the accounts of eligible employees over a period not exceeding eight plan years, including basic allocation of 3% of covered compensation and a matching Company contribution of up to 6% of covered compensation invested in the Company's savings plan by employees. Pension plan benefits are generally based on years of service and employees' compensation during the last years of employment. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Funding decisions are based upon the tax and statutory considerations in each country. Accretion expense is the implicit interest cost associated with amounts accrued and not funded and is included in "other expense". At December 31, 1993, funded plan assets related to pensions were held primarily in fixed income and equity funds. Postretirement health and life insurance benefits are not prefunded. Effective January 1, 1991, the Company changed its method of accounting for postretirement benefits other than pensions to conform with FAS 106. The cumulative effect of this change increased the recorded obligation for such benefits by $40 million, thereby increasing the net loss in 1991 by $25 million (net of the related income tax benefit). The effect of the change on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. The following table sets forth the Company's postretirement plans' funded status and amounts recognized in the balance sheet at December 31, 1993 and 1992. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4. Other Expense Other income (expense) was as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Interest income $ 8.5 $ 8.7 $ 8.3 Royalties 2.6 3.8 2.5 Equity in net income (loss) of affiliated companies (0.1) 4.9 10.2 Minority interest (14.0) (9.8) (3.1) Accretion expense (30.5) (29.8) (27.9) Other, net (4.8) (2.5) 1.9 $(38.3) $(24.7) $ (8.1) ====== ====== ====== The decrease in equity in net income of affiliated companies and the increase in minority interest in 1993 and 1992 compared with 1991 were primarily the result of consolidation of the plumbing companies in Thailand, the People's Republic of China, and Incesa, previously unconsolidated joint ventures. Note 5. Income Taxes The Company's loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods ("pre-tax income (loss)") and the applicable provision (benefit) for income taxes were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pre-tax income (loss): Domestic $ (223.2) $ (170.1) $(272.6) Foreign 142.7 117.5 184.8 Pre-tax loss $ (80.5) $ (52.6) $ (87.8) Provision (benefit) for income taxes: Current: Domestic $ 12.4 $ 5.1 $ 5.1 Foreign 43.0 63.0 71.3 55.4 68.1 76.4 Deferred: Domestic 1.1 (35.8) (52.4) Foreign (20.3) (27.6) (1.0) (19.2) (63.4) (53.4) Total provision $ 36.2 $ 4.7 $ 23.0 ======== ======== ======= ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation between the actual income tax expense provided and the income tax benefit computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the pre-tax loss is as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Tax benefit at statutory rate $(28.2) $(17.9) $(29.9) Nondeductible goodwill charged to operations 10.4 10.5 10.6 Nondeductible goodwill related to operations sold - 25.1* Nondeductible ESOP allocations 6.1 4.9 4.6 Rate differences and withholding taxes related to foreign operations 9.0 1.4 4.7 Foreign exchange gains (7.0) (6.3) (2.1) State tax benefits (5.5) (3.3) (3.4) Other, net 8.7 5.5 5.6 Increase in valuation allowance 42.7 9.9 7.8 Total provision $ 36.2 $ 4.7 $ 23.0 ====== ====== ====== * Includes goodwill eliminated in the sale of Tyler Refrigeration. In addition to the valuation allowance increase of $42.7 million shown above, a valuation allowance of $32.1 million was provided for the entire amount of the tax benefit related to the extraordinary loss on retirement of debt (see Note 8 of Notes to Consolidated Financial Statements). The following table details the gross deferred liabilities and the gross deferred tax assets and the related valuation allowances. At December 31, 1993 1992 (dollars in millions) Deferred tax liabilities: Facilities (accelerated depreciation, capitalized interest and purchase accounting differences) $ 141.1 $ 154.1 Inventory (LIFO and purchase accounting differences) 18.5 30.3 Employee benefits 11.0 6.6 Foreign investments 50.1 48.8 Other 26.2 26.6 246.9 266.4 Deferred tax assets: Employee benefits (pensions and other postretirement benefits) 110.7 97.7 Warranties 37.4 30.0 Alternative minimum tax 19.4 21.8 Foreign tax credits and net operating losses 57.5 42.3 Reserves 58.7 45.1 Other 46.0 18.5 Valuation allowances (103.9) (29.1) 225.8 226.3 Net deferred tax liabilities $ 21.1 $ 40.1 ========= ======== ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred tax assets related to foreign tax credits, net operating loss carryforwards, and future tax deductions have been reduced by a valuation allowance since realization is dependent in part on the generation of future foreign source income as well as on income in the legal entity which gave rise to tax losses. Other deferred tax assets have not been reduced by valuation allowances because of carrybacks and existing deferred tax credits which reverse in the carryforward period. The foreign tax credits and net operating losses are available for utilization in future years. In some tax jurisdictions the carryforward period is limited to as little as five years; in others it is unlimited. As a result of the Acquisition (see Note 1) and the allocation of purchase accounting (principally goodwill) to foreign subsidiaries, the book basis in the net assets of the foreign subsidiaries exceeds the related U.S. tax basis in the subsidiaries' stock. Such investments are considered permanent in duration, and accordingly no deferred taxes have been provided on such differences, which are significant. It is impracticable because of the complex legal structure of the Company and the numerous tax jurisdictions in which the Company operates to determine such deferred taxes. Cash taxes paid were $41 million, $56 million, and $79 million in the years 1993, 1992, and 1991, respectively. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993 with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required, the Company expects that it will be able to make such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures and therefore subsequent results of operations for any particular quarterly or annual period could be adversely affected. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 6. Inventories The components of inventory are as follows: At December 31, 1993 1992 (Dollars in millions) Finished products $169.0 $200.6 Products in process 78.0 95.8 Raw materials 78.8 88.5 Inventory at cost $325.8 $384.9 ====== ====== The carrying cost of inventories reflects purchase accounting adjustments and therefore exceeds current cost. Note 7. Facilities The components of facilities, at cost, are as follows: At December 31, 1993 1992 (Dollars in millions) Land $ 66.2 $ 65.0 Buildings 314.6 310.2 Machinery and equipment 739.9 719.4 Improvements in progress 54.4 45.6 Gross facilities 1,175.1 1,140.2 Less: accumulated depreciation 354.6 307.4 Net facilities $ 820.5 $ 832.8 ======== ======== Note 8. Debt The 1993 Refinancing In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 (the "12-7/8% Senior Subordinated Debentures") at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 (the "14-1/4% Subordinated Discount Debentures") at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility ("Tranche A") available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility ("Tranche B") available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility ("Tranche C") available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million and the amount available under the Credit Agreement by its terms was reduced to $950 million. Borrowings under the Periodic Access Facility and the Term Loans generally bear interest at the London interbank offered rate ("LIBOR") plus 2-1/2% except for the $225 million U.S. dollar facility, which bears interest at LIBOR plus 3%, and the $200 million Deutschemark facility, which bears interest at LIBOR plus 2%. The Company pays a commitment fee of 0.5% per annum on the unused portion of the Revolving Credit Facility and a fee of 2.5% plus issuance fees for letters of credit. As a result of the Refinancing, results for the year ended December 31, 1993, included an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit (see Note 5). Short-term The Revolving Credit Facility (the "Revolver") provides for aggregate borrowings of up to $250 million for working capital purposes, of which up to $200 million may be used for the issuance of letters of credit and $40 million of which is available for same-day short-term borrowings ("Swingline Loans"). At December 31, 1993, there were $7 million of borrowings outstanding under the Revolver and $66 million of letters of credit. Availability under the Revolver at December 31, 1993, was $177 million. Average borrowings under this facility and under the revolving credit facility available under the previous 1988 Credit Agreement for 1993, 1992, and 1991 were $39 million, $14 million, and $44 million, respectively. The Revolver and the Swingline Loans bear interest at the prime rate plus 1-1/2% or LIBOR plus 2-1/2%. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12-month period ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. Other short-term borrowings are available outside the United States under informal credit facilities and are typically a result of overdrafts. At December 31, 1993, the Company had $31 million of such foreign short-term debt outstanding at an average interest rate of 11% per annum. The Company also had an additional $50 million of unused foreign facilities. These facilities may be withdrawn by the banks at any time. Long-term Long-term debt was as follows: At December 31, 1993 1992 (Dollars in millions) Credit Agreement $ 689.9 $ - 1988 Credit Agreement - 402.3 9 1/4% sinking fund debentures, due in installments from 1997 to 2016 150.0 150.0 10 7/8% senior notes due 1999 150.0 150.0 11 3/8% senior debentures due 2004 250.0 250.0 9 7/8% senior subordinated notes due 2001 200.0 - 10 1/2% senior subordinated discount debentures (net of unamortized discount of $272.9 million in 1993) due in installments from 2003 to 2005 477.8 - 12 7/8% senior subordinated debentures - 545.0 14 1/4% subordinated discount debentures (net of unamortized discount of $36.3 million in 1992) due in installments from 2002 to 2003 175.0 509.5 Other long-term debt 63.1 53.3 12 3/4% junior subordinated debentures due in installments from 2001 to 2003 (Note 9) 141.8 - Foreign currency swap contracts - (14.6) 2,297.6 2,045.5 Less current maturities 105.9 13.4 $ 2,191.7 $ 2,032.1 ========= ========= The amounts of long-term debt maturing from 1995 through 1998 are: 1995-$126.3 million, 1996-$123.5 million, 1997 $121.2 million, 1998-$117.5 million. Interest costs capitalized as part of the cost of constructing facilities for the years ended December 31, 1993, 1992, and 1991, were $2.7 million, $3.1 million, and $3.6 million, respectively. Cash interest paid for those same years on all outstanding indebtedness amounted to $198 million, $210 million, and $224 million, respectively. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Credit Agreement loans, maturities, and effective weighted average interest rates in effect at December 31, 1993, were as follows: U.S. Dollar Equivalent (in millions) Periodic Access Facility, due in semi-annual installments from February 1994 to February 2000: British sterling loans at 7.85% $ 95.8 Deutschemark loans at 9.06% 49.4 Canadian dollar loans at 6.50% 20.2 French franc loans at 9.17% 18.5 Italian lira loans at 12.19% 8.7 Total Periodic Access loans 192.6 Term Loans: Tranche A U.S. dollar loans, due in semi-annual installments from August 1997 to February 2000 at 6.50% 225.0 Tranche B Deutschemark loans, due in semi-annual installments from February 1994 to February 1997 at 7.88% 172.3 Tranche C U.S. dollar loans, due in semi-annual installments from February 1994 to August 1999 at 6.01% 100.0 Total Term Loans 497.3 Total Credit Agreement long-term loans 689.9 Revolver loans at 7.5% 7.0 Total Credit Agreement loans $ 696.9 ======== Under the 1988 Credit Agreement the various term loans and effective weighted average interest rates in effect at December 31, 1992, were as follows: U.S. Dollar Equivalent (in millions) Deutschemark loans at 11.4% $249.8 Canadian dollar loans at 13.05% 152.5 Total $402.3 ====== The 9-7/8% Senior Subordinated Notes may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 102.82% in 1998 to 100% on June 1, 2000, and thereafter. The 10-1/2% Senior Subordinated Discount Debentures may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 104.66% in 1998 to 100% on June 1, 2002, and thereafter. The payment of the principal and interest on the ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9-7/8% Senior Subordinated Notes and on the 10-1/2% Senior Subordinated Discount Debentures (together the "Senior Subordinated Debt") is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement and the 9-1/4% Sinking Fund Debentures, the 10-7/8% Senior Notes, and the 11-3/8% Senior Debentures (the said notes and debentures together the "Senior Securities"). The 9-1/4% Sinking Fund Debentures are redeemable at the Company's option, in whole or in part, at redemption prices declining from 105.55% in 1994 to 100% in 2006 and thereafter. The 10-7/8% Senior Notes are not redeemable by the Company. The 11-3/8% Senior Debentures are redeemable at the option of the Company, in whole or in part, on or after May 15, 1997, at redemption prices declining from 105.69% in 1997 to 100% on May 15, 2002, and thereafter. The 14-1/4% Subordinated Discount Debentures are redeemable at the Company's option, in whole or in part, at redemption prices of 105% prior to June 30, 1994, declining to 100% on and after June 30, 1995. The payment of the principal and interest on the 14-1/4% Subordinated Discount Debentures issued by the Company in 1988 is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, and the Senior Subordinated Debt. The 14-1/4% Subordinated Discount Debentures rank senior to the 12-3/4% Junior Subordinated Debentures (described below). The 12-3/4% Junior Subordinated Debentures may be redeemed, at the Company's option, in whole or in part at a redemption price of 101.8% prior to June 30, 1994, and at 100% thereafter. The payment of principal and interest on the 12-3/4% Junior Subordinated Debentures is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, the Senior Subordinated Debt, and the 14-1/4% Subordinated Discount Debentures. Obligations under the Credit Agreement are guaranteed by ASI Holding Corporation (the Company's parent), the Company, and significant domestic subsidiaries of the Company (with foreign borrowings also guaranteed by certain foreign subsidiaries) and are secured by U.S., Canadian, and U.K. properties, plant, and equipment; by liens on receivables, inventories, intellectual property, and other intangibles; and by a pledge of the Company's stock and nearly all shares of subsidiary stock. In addition, the obligations of the Company under the Senior Securities are secured, to the extent required by the related indentures, by mortgages on the principal U.S. properties of the Company equally and ratably with the indebtedness under the Credit Agreement and certain related indebtedness. The Senior Subordinated Debt, the 14-1/4% Subordinated Discount Debentures, and the 12-3/4% Junior Subordinated Debentures are unsecured. The Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemption of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amend- ments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and covenants and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar waivers or amendments in the future. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. Note 9. Exchange of Exchangeable Preferred Stock On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. Note 10. Foreign Currency Translation Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the resulting gains or losses, net of income tax effects, are accumulated in a separate component of stockholder's equity. Changes in exchange rates which gave rise to significant translation effects included in stockholder's equity for the years ended December 31, 1993, 1992, and 1991, are summarized in the accompanying table. Change in End of Period Exchange Rate Currency 1993 1992 1991 British sterling (2)% (19)% (3)% Canadian dollar (4) ( 9) - French franc (6) (6) (2) Deutschemark (7) (6) (1) Italian lira (14) (22) (2) ===== ===== ===== Translation loss included in stockholder's equity, net of tax (dollars in millions) $ (62.3) $ (36.2) $ (2.1) ====== ====== ===== ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The allocation of purchase costs increased the net asset exposure of foreign operations; however, since June 29, 1988, the date of the Merger, the effects of exchange volatility have been ameliorated by the fact that a portion of the Company's borrowings has been denominated in foreign currencies. The losses from foreign currency transactions and translation from operations in countries with high inflation rates reflected in expense were $21.9 million in 1993, $19.3 million in 1992, and $14.4 million in 1991. Note 11. Fair Values of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Values of Financial Instruments" ("FAS 107"), requires disclosure information about all financial instruments of a company except certain excluded instruments and instruments for which it is not practicable to estimate fair value. The fair values presented below are estimates as of December 31, 1993, and are not necessarily indicative of amounts the Company could realize or settle currently or indicative of the intent or ability of the Company to dispose of or liquidate such instruments. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and certificates of deposit: The carrying amount reported in the balance sheet for cash and certificates of deposit approximates its fair value. Long- and short-term debt: The fair values of the Company's Credit Agreement loans are estimated using indicative market quotes obtained from a major bank. The fair values of senior notes, senior debentures, senior subordinated notes, senior subordinated discount debentures, subordinated discount debentures, the sinking fund debentures, and the junior subordinated debentures are based on indicative market quotes obtained from a major securities dealer. The fair values of other loans approximate their carrying value. The carrying amounts and estimated fair values of selected financial instruments at December 31, 1993 are as follows: (dollars in millions) Carrying Fair Amount Value Credit Agreement loans $ 697 $ 679 10 7/8% senior notes 150 163 11 3/8% senior debentures 250 276 9 7/8% senior subordinated notes 200 208 10 1/2% senior subordinated discount debentures 478 505 14 1/4% subordinated discount debentures 175 184 9 1/4% sinking fund debentures 150 152 12-3/4% junior subordinated debentures 142 143 Other loans 63 63 ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12. Related Party Transactions The Company has agreed to pay Kelso an annual fee of $2.75 million for providing management consulting and advisory services. In June 1993 the Company issued 1,000 shares of a new, non-voting Series A Preferred Stock, par value $.01 per share, for $10,000 to an affiliate of Kelso & Company. The Company is committed to contribute $5 million of capital to a Kelso limited partnership. In addition, Tyler Refrigeration was sold to an affiliate of Kelso in 1991. Note 13. Leases The cumulative minimum rental commitments under the terms of all noncancellable operating leases in effect at December 31, 1993, were $108 million. Net rental expenses for operating leases were $34 million, $32 million, and $28 million for the years ended December 31, 1993, 1992, and 1991, respectively. Note 14. Commitments and Contingencies The Company and certain of its subsidiaries are parties to a number of pending legal and tax proceedings. The Company is also subject to federal, state and local environmental laws and regulations and is involved in environmental proceedings concerning the investigation and remediation of numerous sites. In those instances where it is probable that the Company will incur costs from such proceedings and the amounts can be reasonably determined the Company has recorded a liability. The Company believes that these legal, tax, and environmental proceedings will not have a material adverse effect on its consolidated financial position, cash flows, or results of operations. The tax returns of the Company's German subsidiaries are currently under examination by the German tax authorities (see Note 5). Note 15. Segment Data Sales and operating income by geographic location for the years ended December 31, 1993, 1992, and 1991, are shown on the following page. Identifiable assets are also shown as at years ended 1993, 1992, and 1991. See "Business" for a description of each business segment and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for capital expenditures and depreciation and amortization. ASI HOLDING CORPORATION AND SUBSIDIARIES QUARTERLY DATA (Unaudited) (Dollars in millions) First Second Third Fourth Sales $879.4 $995.5 $976.5 $979.1 Cost of sales 650.5 754.5 727.7 769.9 Income (loss) before income taxes and extraordinary loss (9.5) (28.2) 4.1 (46.9) Tax provision 8.1 6.1 7.2 14.8 Loss before extraordinary loss (17.6) (34.3) (3.1) (61.7) Extraordinary loss (Note 8) - (91.9) - - Net loss $(17.6) $(126.2) $ (3.1) $(61.7) ====== ======= ====== ====== Per share: Loss before extraordinary loss $ (.92) $ (1.63) $ (.13) $(2.60) Extraordinary loss - (3.87) - - Net loss $ (.92) $ (5.50) $ (.13) $(2.60) ====== ======= ====== ====== Average number of common shares (thousands) 23,699 23,756 23,690 23,756 First Second Third Fourth Sales $901.0 $995.9 $980.9 $914.1 Cost of sales 672.0 734.1 742.2 703.9 Income (loss) before income taxes (8.1) 11.4 (16.5) (39.3) Tax provision (benefit) 5.5 9.2 (1.5) (8.5) Net income (loss) $(13.6) $ 2.2 $(15.0) $(30.8) ====== ======= ====== ====== Per share: Net loss $ (.74) $ (.07) $ (.81) $(1.49) ====== ======= ====== ====== Average number of common shares (thousands) 23,339 23,470 23,467 23,506 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCING DISCLOSURE. Not applicable. MANAGEMENT ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information as of March 31, 1994, with respect to each person who is an executive officer or director of the Company: Name Age Position with Company Emmanuel A. Kampouris 59 Chairman, President and Chief Executive Officer, and Director Horst Hinrichs 61 Senior Vice President, Transportation Products, and Director George H. Kerckhove 56 Senior Vice President, Plumbing Products, and Director Fred A. Allardyce 52 Vice President and Chief Financial Officer Alexander A. Apostolopoulos 51 Vice President and Group Executive, Americas, Plumbing Products Thomas S. Battaglia 51 Vice President and Treasurer Roberto Canizares M. 44 Vice President, Air Conditioning Products' Asia/America Zone Wilfried Delker 53 Vice President and Group Executive, Worldwide Fittings, Plumbing Products Adrian B. Deshotel 48 Vice President, Human Resources Cyril Gallimore 65 Vice President, Systems and Technology Luigi Gandini 55 Vice President and Group Executive, European Plumbing Products Daniel Hilger 53 Vice President and Group Executive, Air Conditioning Products in Europe, Middle East and Africa Joachim D. Huwendiek 63 Vice President, Automotive Products in Germany Name Age Position with Company Frederick W. Jaqua 72 Vice President and General Counsel and Secretary W. Craig Kissel 42 Vice President and Group Executive, Unitary Products Group William A. Klug 62 Vice President, Trane International Philippe Lamothe 57 Vice President, Automotive Products in France G. Eric Nutter 58 Vice President, Automotive Products in the United Kingdom Raymond D. Pipes 44 Vice President and Group Executive, Plumbing Products in the Far East Bruce R. Schiller 49 Vice President and Group Executive, Compressor Business James H. Schultz 45 Vice President and Group Executive, Commercial Systems Group G. Ronald Simon 52 Vice President and Controller Wade W. Smith 43 Vice President, U.S. Plumbing Products Benson I. Stein 56 Vice President, General Auditor Robert M. Wellbrock 47 Vice President, Taxes Shigeru Mizushima 50 Director Roger W. Parsons 52 Director Frank T. Nickell 46 Director J. Danforth Quayle* 47 Director John Rutledge 45 Director Joseph S. Schuchert* 65 Director * The Management Development Committee functions as the compensation committee of the Company. Since December 2, 1993, its members have been Messrs. Quayle and Schuchert. Prior thereto Mr. Schuchert and two other directors who retired in December, Richard M. Cyert and Edward Donley, served as members of the committee. Directors are elected to hold office until the next annual meeting of stockholders or until their successors are elected. Messrs. Kampouris, Mizushima, Nickell, and Schuchert were elected in 1988; Mr. Kerckhove in September 1990; Mr. Hinrichs in March 1991; Dr. Rutledge in March 1993; Mr. Quayle in September 1993; and Mr. Parsons in March 1994. Holding, Kelso ASI Partners, L.P. (the 73 percent owner of Holding) ("ASI Partners"), and executive officers and certain other management personnel of the Company who purchased shares of Holding common stock ("Management Investors") entered into a Stockholders Agreement that, among other things, provides for arrangements regarding the control of the election of directors of Holding. Until the earlier of (i) the occurrence of a public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Holding common stock to the public and underwritten by an investment banking firm of nationally recognized standing and (ii) July 7, 1998, the Management Investors as a group are entitled to nominate at least two directors to the Board of Directors of Holding, and ASI Partners is entitled to nominate the remaining directors. As a result, during such period ASI Partners will control the Board of Directors. To effectuate their rights, the Management Investors and ASI Partners have agreed in the Stockholders' Agreement to grant an irrevocable proxy to the Secretary of Holding to vote their shares of common stock in accordance with such nominations. Such grant of an irrevocable proxy terminates upon Holding's becoming subject to the proxy rules under the Securities Exchange Act of 1934. At present the Board of Directors of Holding consists of nine directors. The sole holder of the outstanding common stock of American Standard Inc. is Holding, and Holding exclusively elects the directors of American Standard Inc. Currently the directors of Holding are also the directors of American Standard Inc. Set forth below is the principal occupation of each of the executive officers and directors named above during the past five years (except as noted, all positions are with the Company). Mr. Kampouris was elected Chairman in December 1993 and President and Chief Executive Officer in February 1989. Prior thereto he was Senior Vice President, Building Products, from 1984 to February 1989. He is also a director of Daido Hoxan Inc. Mr. Kampouris has served as a director of the Company since July 1988. Mr. Hinrichs was elected Senior Vice President, Transportation Products, in December 1990. Prior thereto he served as Vice President and Group Executive, Automotive Products, from 1987 to 1990. Mr. Hinrichs has served as a director of the Company since March 1991. Mr. Kerckhove was elected Senior Vice President, Plumbing Products, in June 1990. Prior thereto he was Vice President (from 1985 until June 1990) and Group Executive (from 1988 until June 1990) of European Plumbing Products. Mr. Kerckhove has served as a director of the Company since September 1990. Mr. Allardyce was elected Vice President and Chief Financial Officer in January 1992. Prior thereto he served as Vice President and Controller from February 1983 until December 1991. Mr. Apostolopoulos was elected Vice President and Group Executive, Americas Plumbing Products, in December 1990. Prior thereto he served as the executive in charge of Plumbing Products' joint ventures from September 1989 to November 1990 and Managing Director of the Company's Egyptian subsidiary from July 1984 to August 1989. Mr. Battaglia was elected Vice President and Treasurer in September 1991. Prior thereto he was Assistant Treasurer. Mr. Canizares was elected Vice President, Air Conditioning Products' Asia/America Zone, in December 1990. Prior thereto he served as the executive in charge of this zone and Manager of Planning and Distribution from November 1986 to November 1990. Mr. Delker was elected Vice President and Group Executive, Worldwide Fittings, Plumbing Products, in April 1990. Prior thereto he served as executive in charge of the Company's brass fittings manufacturing operations from June 1982 until March 1990. Mr. Deshotel was elected Vice President, Human Resources, in January 1992. Prior thereto he served as Group Vice President, Human Resources, for U.S. Plumbing Products from September 1986 until December 1991. Mr. Gallimore was elected Vice President, Systems and Technology, in December 1990. Prior thereto he served as the executive in charge of Manufacturing and Technology from 1984 to November 1990. Mr. Gandini was elected Vice President and Group Executive, European Plumbing Products, in July 1990. Prior thereto he served as General Manager of Ideal Standard S.p.A., the Italian subsidiary of the Company, from January 1978 until June 1990. Mr. Hilger was elected Vice President and Group Executive, Air Conditioning Products, in Europe, Middle East and Africa, in June 1988. Mr. Huwendiek was elected Vice President, Automotive Products in Germany, in January 1992. Prior thereto he served as Managing Director of WABCO Germany since June 1987. Mr. Jaqua was elected Vice President and General Counsel and Secretary in April 1989. Prior thereto he was Associate General Counsel and Assistant Secretary. Mr. Kissel was elected Vice President in charge of Air Conditioning Products' Unitary Products Group in January 1992, becoming Group Executive in March 1994. He served as Vice President, Sales and Distribution, for Air Conditioning Products, from December 1990 until January 1992 and served as divisional Senior Vice President in charge of U.S. Sales from January to November 1990. He was in charge of Western Regional Sales from January 1989 to January 1990. Mr. Klug was elected Vice President in 1985 and has been in charge of Trane International since December 1993. He served as Group Executive, Unitary Products Group, from April 1990 until December 1993. He was Group Executive, North American Sales and Distribution, Air Conditioning Products, from October 1987 to March 1990. Mr. Lamothe was elected Vice President, Automotive Products in France, in January 1992. He served as Group Vice President of the French transportation business during 1991 and prior thereto was General Manager of the French transportation subsidiary. Mr. Nutter was elected Vice President, Automotive Products in the United Kingdom, in January 1992. Prior thereto he served as Vice President and General Manager of WABCO Transportation U.K. Limited, the United Kingdom transportation subsidiary of the Company from March 1991 until December 1991 and Group Managing Director of the United Kingdom transportation subsidiary from June 1987 until February 1991. Mr. Pipes was elected Vice President and Group Executive for the Far East Region of Plumbing Products in May 1992. Prior thereto he served as Managing Director of the Company's Philippine subsidiary from May 1990 until April 1992 and was Group Vice President, Control & Finance, of U.S. Plumbing Products from March 1985 until April 1990. Mr. Schiller was elected Vice President and Group Executive, Compressor Business (Air Conditioning Products) in March 1994. Prior thereto he served as General Manager, Compressor Business Group, from May 1993 to February 1994 and Manager and then General Manager of the Company's Tyler, Texas, facility from March 1986 to April 1993. Mr. Schultz was elected Vice President and Group Executive, Commercial Systems, in 1987. Mr. Simon was elected Vice President and Controller in January 1992. Prior thereto he served as Vice President and Controller of the Air Conditioning Products' Commercial Systems Group from December 1984 to December 1991. Mr. Wade W. Smith was elected Vice President, U.S. Plumbing Products, in May 1992. Prior thereto he served as Group Vice President in charge of the Chinaware Business Unit of U.S. Plumbing Products from February 1992 until April 1992 and from April 1987 to February 1992 he was Vice President and General Manager of the Building Automation Systems Division of the Commercial Systems Group of Air Conditioning Products. Mr. Stein was elected Vice President, General Auditor, in March 1994; from December 1986 to February 1994 he was the Company's General Auditor. Mr. Wellbrock was elected Vice President, Taxes, effective January 1, 1994. Prior thereto he served as Director of Taxes from 1988 through 1993. Mr. Mizushima has been President and Chief Operating Officer of Daido Hoxan Inc. since the merger in April 1993 of Hoxan Corporation with Daido Sanso Company (a subsidiary of Air Products and Chemicals Inc.). Prior thereto Mr. Mizushima was President of Hoxan Corporation, a position he held since 1984. He is also a director of Daido Hoxan. Daido Hoxan Inc is the second largest supplier of industrial gases in Japan. One of its subsidiaries is a distributor of American-Standard plumbing products in Japan. Mr. Mizushima has served as a director of the Company since July 1988. Mr. Nickell has been President and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Nickell was a general partner of Kelso & Company, L.P. He is also a director of Club Car, Inc.; King Holding Corp; and Tyler Holdings Corporation. Mr. Nickell has served as a director of the Company since May 1988. Mr. Parsons is Managing Director of Rea Brothers Group PLC ("Rea Brothers Group"), which he joined in 1988 after a long banking career. Rea Brothers Group is a U.K. holding company of subsidiaries engaged in the investment banking business. He also holds directorships in several subsidiaries of Rea Brothers Group. Mr. Parsons was elected as a director of the Company on March 2, 1994. Mr. Quayle served as Vice President of the United States from January 1989 to January 1993. Since leaving that office Mr. Quayle has been associated with Circle Investors, Inc. (an investment planning and consulting firm), and FX Strategic Advisors, Inc. (an international trade consulting firm), both of which he serves as Chairman. He is a Director of Central Newspapers, Inc. Mr. Quayle has served as a director of the Company since September 1993. Dr. Rutledge has been Chairman of Rutledge & Company, Inc., a merchant banking firm, since January 1991. He is the founder and Chairman of Claremont Economics Institute, an economic research firm established in 1975. He is also a director of Earle M. Jorgensen & Company, Lazard Freres Funds, Medical Specialties Group, and Utendahl Capital Partners and is a special advisor to Kelso & Company. Dr. Rutledge has served as a director of the Company since March 1993. Mr. Schuchert has been Chairman, CEO, and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Schuchert was managing general partner of Kelso & Company, L.P. He is also a director of Earle M. Jorgensen & Company. Mr. Schuchert has served as a director of the Company since May 1988. On December 23, 1992, Kelso & Company and its chief executive officer, Mr. Schuchert, without admitting or denying the findings contained therein, consented to an administrative order in respect of a Securities and Exchange Commission ("Commission") inquiry relating to the 1990 acquisition of a portfolio company by a Kelso affiliate. The order found that Kelso's tender offer filing in connection with the acquisition did not comply fully with the Commission's tender offer reporting requirements, and required Kelso and Mr. Schuchert to comply with these requirements in the future. Compensation Committee Interlocks and Insider Participation Mr. Schuchert is a member of the Management Development Committee (the Compensation Committee) of the Company's Board of Directors. He is Chairman of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.) and a general partner of American Standard Partners, the general partner of Kelso ASI Partners. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V") in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P., is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Supplemental Plan benefits are based on credited years of service and average annual compensation for the highest three calendar years of the final ten calendar years of employment (not exceeding 60 percent of average annual compensation for such years of service) and are reduced by an offset consisting of certain other retirement benefits, including amounts payable under the Terminated Plan, annual allocations to the executive officer's Employee Stock Ownership Plan ("ESOP") accounts, and Social Security benefits. Benefits under the Supplemental Plan are vested after five years of service or employment continuation through age 65. Compensation used in determining Supplemental Plan benefits (covered compensation) includes only salary and bonus reflected in the Summary Compensation Table above. No covered compensation of any Named Officer differs by more than 10% from the salary and bonus set forth in the Summary Compensation Table. The years of credited service under the Supplemental Plan for the Named Officers are as follows: Mr. Kampouris, 28 years; Mr. Hinrichs, 35 years; Mr. Kerckhove, 32 years; Mr. Allardyce, 17 years; Mr. Gandini, 33 years; and Mr. H.T. Smith, 13 years. The current annual target benefit for Mr. Kampouris is approximately 20 percent higher than that shown in the above table since a different benefit formula under the pre-1990 version of the Supplemental Plan applies to his period of service and earnings prior to April 27, 1991. The method of calculating the lump sum payable to Mr. Kampouris that is attributable to his accrued benefit through April 27, 1991, has been adjusted to reflect the recent increase in the Federal ordinary income tax rates. An amendment to the Supplemental Plan in 1993 established minimum annual lump sum payments for certain Named Officers which, after giving effect to Plan offsets, are estimated as follows: Mr. Kampouris, $427,000; Mr. Hinrichs, $143,000; Mr. Kerckhove, $37,000; and Mr. Gandini, $24,000. Shares of Holding Common Stock distributable to Plan participants are delivered to a grantor's trust for their benefit. The trust will terminate following a public offering of Holding Common Stock, at which time shares or cash credited to each participant's account is to be distributed. Payment, however, may be deferred if an event of default under the Company's loan agreements or debt indentures has occurred or will occur as a result of such payment. Until distribution, assets of the trust are subject to the claims of creditors of Holding or the Company. Shares held by the trust are voted by the trustee in accordance with the Company's directions. Directors' Fees and Other Arrangements In the first half of 1993 each outside director was paid a fee of $5,000 per calendar quarter and in addition received a fee of $500 for each meeting of the Board attended; in the last half each outside director was paid a fee of $6,750 per calendar quarter and in addition received a fee of $1,000 for each meeting of the Board attended. Effective with the third quarter, an outside director is also paid $1,000 for attending a Committee meeting. (Previously an outside director was paid $500 for attending a Committee meeting not held on the day of a Board meeting.) The only directors currently eligible for directors' fees are directors who are neither employees of the Company or Kelso. They are Messrs. Mizushima, Parsons, Quayle, and Rutledge. All directors are reimbursed for reasonable expenses incurred in connection with attendance at any meetings. No separate directors' fees are paid for attendance at meetings of Holding that are held on the same day the Company's Board meets. A Supplemental Compensation Plan for Outside Directors ("Supplemental Compensation Plan") was adopted in June 1989. A Plan Account was establish- ed for each participating director at that time consisting of units equivalent to $50,000 of Holding common stock with each unit having a value of $19 per share, the independently appraised value of the shares of Holding as of December 31, 1988. For the purpose of providing a measure of parity among the directors, the $50,000 amount was increased to $100,000 for participating directors who became Board Members after January 1, 1993, with such amount converted into units for the account of such directors at the rate of $42.96 per unit ($42.96 representing the independently appraised value of the shares of Holding as of December 31, 1992). When a participating director ceases to be a member of the Board, he or his beneficiary will receive a cash payment equal to the number of units in his Plan Account multiplied by the per-share value of Holding common stock based on the then last year-end appraisal. If a participating director is removed for cause, his entire interest in the Plan is forfeited. Employee-directors and Messrs. Nickell and Schuchert do not participate in this Plan. Mr. Donley and Dr. Cyert, directors who retired in December 1993, each received a payment of $113,053 pursuant to the Supplemental Compensation Plan. Corporate Officers Severance Plan and Other Employment or Severance Arrangements The Board of Directors approved a severance plan for executive officers (the "Officers Severance Plan"), effective April 27, 1991. The Officers Severance Plan provides that any participant whose employment is involuntarily terminated by the Company without "Cause" (as defined in the Officers Severance Plan) or who leaves the Company for "Good Reason" (as defined in the Officers Severance Plan) shall be paid an amount equal to the sum of two (three in the case of the Chief Executive Officer) times such participant's annual base salary at the rate in effect at the time of termination, a proration of the then Annual Incentive Plan target award (described previously), and one (two in the case of the Chief Executive Officer) times such target award. In addition, group life, accident, and disability insurance coverages, as well as group medical coverage, will be continued for up to 24 (36 in the case of the Chief Executive Officer) months following such officer's termination. The Named Officers (other than Mr. Smith, who retired in December 1993) are participants in this Plan. An agreement was entered into with H. Thompson Smith in December 1993 concerning the terms of his termination of employment and retirement. Under that agreement he is entitled to receive his 1993 Annual Incentive Plan award in the amount of $154,000 and will be entitled to receive the same amount in March 1995. In addition, Mr. Smith is retained as a consultant through 1995 at the rate of $29,583 per month. In the event of Mr. Smith's death, the fees remaining through the end of 1995 are payable in a lump sum to his spouse or estate. He is also entitled to receive payments under the Company's Long-Term Incentive Compensation Plan for the 1992-1994 and 1993-1995 performance periods in accordance with its terms, such awards to be prorated to December 31, 1993. Mr. Smith continues under the Company's medical and life insurance programs through 1995. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None Signatures Pursuant to the requirements of Section 13 or 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. ASI HOLDING CORPORATION By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) ASI HOLDING CORPORATION AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991 Report of Independent Auditors 84 III Condensed Financial Information of Registrant 85-88 V Facilities 89 VI Accumulated Depreciation of Facilities 90 VIII Reserves 91 IX Short-Term Borrowings 92 X Supplementary Income Statement Information 93 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors ASI Holding Corporation We have audited the consolidated financial statements of ASI Holding Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (Parent Company Separately) (Dollars in thousands) Year Ended Year Ended December 31, December 31, 1993 1992 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (208,567) $ (57,238) Adjustments to reconcile net loss to net cash provided by operating activities: Equity in net loss of subsidiary 208,567 57,238 - --------------------------------------------------------------------- Net cash flow from operating activities 0 0 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY INVESTING ACTIVITIES: Investment in subsidiary (4,585) (3,103) Purchase of common stock by subsidiary 12,194 10,950 - --------------------------------------------------------------------- Net cash provided by investing activities 7,609 7,847 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY FINANCING ACTIVITIES: Issuance of common stock 4,585 3,103 Common stock repurchased (12,194) (10,950) Repayments on subscriptions receivable 482 653 Repayment of loan from subsidiary (482) (653) - --------------------------------------------------------------------- Net cash used by financing activities (7,609) (7,847) - --------------------------------------------------------------------- Net change in cash and cash equivalents $ 0 $ 0 ===================================================================== See notes to the financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (cont'd) NOTES TO FINANCIAL STATEMENTS (Parent Company Separately) (A) The notes to the consolidated financial statements of ASI Holding Corporation (the "Parent Company" or "Holding") are an integral part of these condensed financial statements. (B) Holding was organized by Kelso & Company, L.P., a private merchant banking firm, to participate in the acquisition of American Standard Inc. American Standard Inc. is now a wholly owned subsidiary of Holding. Holding has no other investments or operations. ASI HOLDING CORPORATION INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of ASI Holding Corporation, the Registrant, and for all Exhibits incorporated by reference is 33-23070, except those Exhibits incorporated by reference in filings made by American Standard Inc. (the "Company") whose File Number is 1-470) (3) (i) Certificate of Incorporation of ASI Holding Corporation ("Holding"); previously filed as Exhibit 3.1 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (ii) Amendment to Certificate of Incorporation amending Article FOURTH thereof; previously filed as Exhibit (3)(ii) in Holding's Form 10-K for the fiscal year ended December 31, 1991, and herein incorporated by reference. (iii) By-laws of Holding; previously filed as Exhibit 3.2 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit 4(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee, under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit (4)(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture, dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; copy of Indenture previously filed as Exhibit (4)(i) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; copy of Indenture previously filed as Exhibit (4)(iii) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit (4)(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in (4)(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Debenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above; copy of Amendment is being filed as Exhibit (4)(xvii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 to the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Paragraph 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993. (xxii) Revised Schedule of Priorities, effective as of September 5, 1991, as adopted by the Board of Directors of Holding pursuant to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in l0(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (l0)(iv) by the Company in its Form l0-K for the year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan; copy of Trust Agreement being filed as Exhibit (10)(iv) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year, and herein incorporated by reference. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) by the Company in its Form l0-K for the fiscal year ended December 31, 1988, and is herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993; copy of restated program is being filed as Exhibit (10)(vii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Amended Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, and is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (l0)(xiv) by the Company in its Form l0-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors as amended through September 1993; copy of Plan is being filed as Exhibit (10)(xv) by the Company in its Form l0-K for the year ended December 31, 1993 concurrently with the filing of Holding's 10-K for the same year and herein incorporated by reference. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit (l0)(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted by the Company in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvi) Estate Preservation Plan, adopted by the Company in December, 1990; previously filed as Exhibit (l0)(xx) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above; copy of Amendment is being filed as Exhibit (10)(xix) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Summary of terms of Unfunded Deferred Compensation Plan adopted December 2, 1993; copy of Summary is being filed as Exhibit (10)(xviii) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company; copy of Agreement is being filed as Exhibit (10)(xix) by Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (21) Listing of Holding's subsidiaries. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As a result of the Acquisition, results of operations include purchase accounting adjustments and reflect a highly leveraged capital structure. Sales Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $2,100 $ 1,892 $ 1,836 Plumbing Products 1,167 1,170 1,018 Transportation Products 563 730 741 Sales $3,830 $ 3,792 $ 3,595 ====== ======= ======= Operating Income (Loss) Before Income Taxes, Extraordinary Loss, and Cumulative Effects of Changes in Accounting Methods Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $133 $ 104 $ 55 Plumbing Products 108 108 66 Transportation Products 41 88 121 Operating income 282 300 242 Interest expense (278) (289) (286) Corporate items(b) (85) (63) (44) Loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods $(81) $ (52) $ (88) ==== ===== ===== (a) For 1991 the amounts presented for Air Conditioning Products include the following amounts for Tyler Refrigeration (which was sold on September 30, 1991): sales of $99 million and operating loss of $18 million (including a $22 million loss on the sale). (b) Corporate items include administrative and general expenses, accretion charges on postretirement benefit liabilities, minority interest, foreign exchange transaction gains and losses, and miscellaneous income and expense. The following section summarizes the Company's consolidated results of operations and then discusses the results of its three operating segments. The Company's businesses are cyclical. Air Conditioning Products and Plumbing Products are particularly affected by the level of residential and commercial building activity. The following table presents a summary of statistics on U.S. non-residential construction activity and housing starts for the years 1989 through 1993. U.S. Non- Residential Contract Awards U.S. Housing (Millions % Change Starts % Change of square Year (Thousands of Year feet)(a) to Year units)(b) to Year 1989 1,322 - 1% 1,376 - 8% 1990 1,155 -13% 1,193 -13% 1991 953 -17% 1,015 -15% 1992 903 - 5% 1,200 +18% 1993 (c) 930 + 3% 1,290 + 7% (a) Source: F.W. Dodge Division, McGraw Hill, Inc. (b) Source: U.S. Department of Commerce, Bureau of Census. (c) Preliminary data. The market for replacement sales and servicing of air conditioning and plumbing products, which accounts for a substantial portion of sales for Air Conditioning Products and Plumbing Products, is less cyclical and sometimes countercyclical. The following table presents a summary of statistics on unit production of trucks, buses, and trailers in excess of six tons in Western Europe for the years 1989 through 1993 (units in thousands). Western Europe % Change Western Europe % Change Truck and Bus Year Trailer Year Production(a) to Year Production(a) to Year 1989 376 4% 125 9% 1990 343 -9% 128 2% 1991 353 3% 139 9% 1992 314 -11% 115 -17% 1993 223 -29% 88 -23% (a) Principal sources: Verband der Deutschen Automobilindustrie (Germany); Society of Motor Manufacturers and Traders (United Kingdom); and Chambre Syndicate des Constructeurs Automobiles (France). 1993 Compared with 1992 U.S. housing starts increased by 7% in 1993 from the 1992 level, which was up 18% over 1991 after four consecutive years of decline. U.S. non-residential contract awards increased by 3% in 1993 after five years of decline. The 1993 improvement in housing starts came in the second half of the year with third- and fourth-quarter starts up 10% and 12%, respectively, over the preceding quarter. The gain in non-residential awards occurred over the last nine months of 1993. Western European truck and bus production declined 29% in 1993 after an 11% decline in 1992. However, the rate of decline in the truck market slowed in the fourth quarter of 1993. Consolidated sales for 1993 were $3.83 billion, an increase of 1% (6% excluding the unfavorable effects of foreign exchange) over the $3.79 billion for 1992. A sales increase of 11% for Air Conditioning Products was partly offset by a sales decline for Transportation Products of 23% (16% excluding the unfavorable effects of foreign exchange). Sales for Plumbing Products were flat (but up by 9% excluding the effects of foreign exchange). Operating income for 1993 was $282 million, a decrease of $18 million, or 6% (but an increase of less than 1% excluding the effects of foreign exchange), from $300 million in 1992. The increase in operating income of 28% for Air Conditioning Products was more than offset by a 53% decrease in operating income for Transportation Products. Plumbing Products' operating income was flat (but increased 15% excluding the effects of foreign exchange). The gain for Air Conditioning Products was the result of higher volume, increased sales of higher-margin products, the benefits of manufacturing improvements, and the effects of restructuring and cost-containment efforts undertaken in 1991 and 1992, offset partly by the costs of further restructuring in 1993. For Plumbing Products the effects of increased volume for the Far East Group were offset partly by lower margins for the U.S. group and lower volumes and unfavorable foreign exchange effects for the European group. Transportation Products' operating income decreased primarily as a result of lower volumes due to reduced demand in depressed markets in Europe, offset partly by the effects of improvements in manufacturing efficiency. Air Conditioning Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Domestic portion $1,786 $1,572 $1,453 Foreign portion 314 320 284 Subtotal 2,100 1,892 1,737 Tyler Refrigeration - - 99 Total $2,100 $1,892 $1,836 ====== ====== ====== Operating income (loss): Domestic portion $ 148 $ 112 $ 58 Foreign portion (15) (8) 15 Subtotal 133 104 73 Tyler Refrigeration - - (18)(a) Total $ 133 $ 104 $ 55 ====== ====== ====== Assets $1,167 $1,156 $1,174 Goodwill and purchase accounting adjustments included in assets 372 398 417 Capital expenditures 38 33 46(b) Depreciation and amortization 53 55 56(c) (a) Includes $22 million loss on the sale of Tyler Refrigeration. (b) Includes capital expenditures of Tyler Refrigeration of $1 million. (c) Includes depreciation and amortization of Tyler Refrigeration of $3 million. The domestic portion of Air Conditioning Products is composed of the Unitary Products Group, the Commercial Systems Group (excluding Canada), and exports from the United States by the International Group. The foreign portion consists of the foreign-based operations of the International Group and the Canadian operations of the Commercial Systems Group. Sales and operating income of Air Conditioning Products both increased in 1993 despite the continuing recession in U.S. and Canadian commercial new construction and only moderate increase in residential new construction in the U.S. and despite the economic decline in Europe. Sales of Air Conditioning Products, which accounted for approximately 55% of the Company's 1993 sales, increased by 11% (with little effect from foreign exchange) to $2,100 million in 1993 from $1,892 million in 1992. There was a significant sales increase for each of the three operating groups. Operating income of Air Conditioning Products increased year to year by 28% (with little effect from foreign exchange) to a record high of $133 million in 1993 from $104 million in 1992. The increase was attributable to gains achieved by all three groups. Unitary Products Group In 1993 sales of the Unitary Products Group, which accounted for approximately 42% of Air Conditioning Products sales, increased by 15% over the 1992 sales level. Residential markets were up 15%, as a result of an unusually hot summer in the northern United States and a 7% increase in housing starts. Sales of residential products increased by 18% year over year, principally because of higher volumes driven by the improved market, increased furnace sales in the replacement market, and a shift in the market to more efficient products, offset partly by the continuation from 1992 of price degradation due to competitive pressures. Commercial markets for unitary products were up 9% overall from the 1992 markets, as the commercial replacement market strengthened further. New-construction activity continued to struggle, however. Sales of commercial unitary products increased by 10% overall, primarily as a result of higher volume (driven by the strong replacement market for both light and large commercial products); a shift to higher-priced, higher-tonnage products; and a gain in market share for light commercial products due to the success of the large Voyager products (packaged rooftop air conditioners). As a result of these factors, together with product cost improvements, improved labor productivity, and the benefits of organizational restructuring which reduced the salaried workforce in 1992, the operating income for Unitary Products in 1993 increased by 43% year over year. This improvement was achieved even though 1993 included the initial start-up costs of the new national distribution center in St. Louis, Missouri, and higher advertising costs. Unitary Products' sales increased through the success of new and redesigned products introduced recently and improved distribution channels. Commercial products that were introduced included the 20-to-25-ton Voyager products in 1992, which more than doubled market share in that size range; commercial microprocessor-controlled products; a line of convertible air handlers; and rooftop and air cooled chiller products using more efficient scroll compressors. Residential products introduced included the American-Standard brand outdoor units and new lines of luxury and conventional retail residential products. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 37% of Air Conditioning Products' sales, increased 10%, primarily on volume increases for most product lines, especially air handling systems and water chillers (principally due to improved replacement markets and increased market share), and increased revenue from Company-owned sales offices (acquisitions and volume growth). These gains were partly offset by lower volume in Canada, which continues to be adversely affected by recession. The non-residential new-construction market increased 3% in the United States in 1993, following decreases of 5% in 1992 and 17% in 1991. The non-residential replacement market was up by 6% over 1992. Operating income for Commercial Systems increased 12% in 1993 over the recession-affected amount of 1992. The increase was primarily the result of volume gains, improvements in manufacturing efficiency, operating expense reductions, and the benefits of restructuring actions taken in 1992. The effects of these factors were partly offset by slightly lower prices, increases in material, labor, and benefit costs, the costs of additional restructuring actions in 1993, and a larger loss in the weak Canadian market. Product development emphasis for Commercial Systems in 1993 and 1992 was on new compressor, heat transfer and microelectronic control technology; adaptation of products to refrigerants that comply with recent government regulations; energy-efficient products; products for the aftermarket and replacement market (which exceeded the new-construction market in both 1993 and 1992); and products redesigned to improve manufacturing productivity. This strategy benefited operations in 1993 and 1992, and the Company expects that this product development emphasis will result in greater sales over the next several years. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1993 sales, increased 7% from those of 1992 (10% excluding the unfavorable effect of foreign exchange). Most of the gain was from higher volume in the Far East (especially Hong Kong, Taiwan, and export sales from the U.S.) resulting from expanded markets and increased penetration; higher export sales from the U.S. to the Middle East (markets were significantly stronger) and Latin America (improved penetration in a market that was up 20%); and higher volumes in Mexico. These gains were partly offset by lower sales in Europe (lower prices and volumes in a declining market). Markets were down in all European countries except the U.K., but the effect was partly offset by increased revenues from service companies acquired in 1992 and prior years. Market growth in the Far East was 6% overall, led by the PRC market, which was up by 21%. The sales growth in Hong Kong was driven by the very strong market in the PRC. Markets in Thailand also grew, and the Latin American market grew by 20%. Operating income for the International Group increased by approximately 39% in 1993. The increase was primarily the result of higher export sales from the U.S. to the Middle East and Far East, offset partly by a larger operating loss in Europe primarily because of the weak markets and lower margins, costs related to restructuring in response to the lower markets, and the unfavorable effects of lower volume on factory performance. Overall, income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expansion of distribution channels and joint ventures and development of new and improved products to support present and future growth. Environmental Matters For a discussion of environmental matters see "Business -- Regulations and Environmental Matters." Backlog The worldwide backlog for Air Conditioning Products at the end of 1993 was $407 million, up 13% from 1992, excluding the effects of foreign exchange. The backlog increased as a result of increased volume for the Commercial Systems Group, market penetration and improved distribution channels in the Middle East and Far East, and sales growth for commercial Unitary Products. Plumbing Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Foreign portion $ 865 $ 885 $ 783 Domestic portion 302 285 235 Total $1,167 $1,170 $1,018 ====== ====== ====== Operating income (loss): Foreign portion $ 131 $ 124 $ 93 Domestic portion (23) (16) (27) Total $ 108 $ 108 $ 66 ====== ====== ====== Assets $ 960 $1,002 $1,069 Goodwill and purchase accounting adjustments included in assets 376 392 447 Capital expenditures 46 48 40 Depreciation and amortization 49 49 48 The foreign portion of Plumbing Products is composed of the European Plumbing Products Group, the Americas International Group, and the Far East Group. The domestic portion of sales and operating results is generated primarily by the U.S. Plumbing Products Group and by export sales from the U.S. Sales of Plumbing Products in 1993, at $1,167 million, which accounted for approximately 30% of the Company's 1993 sales, were at essentially the same level as the $1,170 million of sales in 1992 (but increased by 9% excluding the unfavorable effects of foreign exchange). Sales increases of 42% for the Far East Group (46% excluding foreign exchange), 9% for the Americas International Group (14% excluding foreign exchange), and 6% for the U.S. Plumbing Products Group were offset partly by a sales decrease of 10% for the European Plumbing Products Group (which had a 4% increase excluding the effects of foreign exchange). In 1993 operating income of Plumbing Products was $108 million, the same amount as in 1992, but excluding the unfavorable effects of foreign exchange operating income increased by 15%. The increase (on an exchange-adjusted basis) was attributable primarily to increased profitability for the Far East Group and for the Americas International Group, offset partly by a decline for the U.S. group. European Plumbing Products Group Sales of the European group, which accounted for approximately 51% of Plumbing Products' sales for 1993, decreased 10% in 1993 from 1992 but increased by 4% excluding the unfavorable effects of foreign exchange. The exchange-adjusted gain resulted from price increases, especially in Italy, Germany, the U.K., and Greece, offset partly by lower volume in most countries because of depressed markets. In Italy sales were up with price increases for most product lines, offset partly by lower volume and a less favorable product mix. The German market was stable in total, as price gains were offset by volume and mix declines. Greece, which had been in recession for three years, recovered somewhat in 1993. The European group's strength has been sales in the replacement market, which has more than made up for the effects of poor new-construction markets. Operating income for the European group decreased 7% but increased 10% excluding the effects of foreign exchange. This increase occurred primarily because of the price gains and cost reductions resulting from restructuring and efficiency improvements in the U.K., France, Italy, and Germany. Partly offsetting those favorable effects were the effects of lower volumes and the unfavorable effect on margins caused by the decline in value of many European currencies agains the Deutschemark. The increased cost of fittings purchased from Germany could not be completely recovered through sales price increases in most of the operations in other countries. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 26% of total 1993 Plumbing Products sales, increased 6% in 1993. During 1993 the U.S. building industry continued to be adversely affected by the low level of new construction, although non-residential construction increased 3% from 1992 and new residential construction continued to recover from the lowest levels since the mid-1940's (up by 7% in 1993 and 18% in 1992 but still below pre-1990 levels). A basic shift from wholesale distribution channels to retail channels has been developing over the last few years, a trend the Company believes will continue and will be beneficial to the Company because of strong product and brand-name recognition. Retail markets now account for 20% of the total sales of the U.S. group. The growth of sales for the U.S. group was largely the result of increased export sales from the U.S. and to a lesser extent price increases on certain products, a more favorable sales mix, and a small increase in the growing retail channel business. The overall gain in the retail business was small because significant volume gains due to an expanding customer base were partly offset by the loss of an important customer. The operating loss for the U.S. group in 1993 was greater than that of the prior year. Despite higher sales, operating results were poorer primarily because of lower margins on both domestic and export sales, increased advertising costs and other expenses associated with expansion of the retail distribution channel, costs related to start-up and expansion of the low-water-volume toilet line (now mandated for new construction), and factory performance problems caused in part by the effects of fluctuating volumes. In addition, costs were incurred in business system re-engineeering activities intended to improve customer service. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 23% of total Plumbing Products sales, increased 21% in 1993 (26% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation of Incesa (a previously unconsolidated group of Central American joint ventures) effective January 1, 1993, as a result of the purchase of additional shares of stock, and to higher volume and prices in Thailand, the PRC, the Philippines, and Brazil, offset partly by decreases in sales in Mexico, Canada, and Korea. Combined operating income of the Americas International and Far East Groups in 1993 increased 72% over the 1992 level. Gains were realized in all operations except Mexican chinaware operations, which were adversely affected by poor economic conditions and the uncertainty related to the North American Free Trade Agreement. The increase was primarily from higher prices and volumes in Brazil, Thailand, and the PRC the consolidation of Incesa, and a smaller loss for Mexican fittings operations. Environmental Matters For a discussion of environmental matters see "ITEM 1. BUSINESS -- Regulations and Environmental Matters." Backlog Plumbing Products' year-end 1993 backlog of $143 million was down 9% from 1992, excluding foreign exchange effects. The decrease resulted from a significant drop for European Plumbing Products (particularly Italy because of economic uncertainty, tempered somewhat by increases for England and Germany), and a drop in backlog for export sales from the U.S., partly offset by increases in the Far East (primarily Thailand). Transportation Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales $ 563 $730 $741 Operating income 41 88 121 Assets 652 722 828 Goodwill and purchase accounting adjustments included in assets 422 458 510 Capital expenditures 14 27 24 Depreciation and amortization 35 37 34 Sales of Transportation Products, which accounted for 15% of the Company's 1993 sales, were $563 million, down 23% from $730 million in 1992 (16% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a 29% decrease in Western European truck and bus production, led by a 34% decline in Germany, and a 23% decrease in Western European trailer production. Volumes were also down in all other European countries in which Transportation Products has operations, although at the end of 1993 sales and order trends were upward. Volume in Brazil was slightly higher. Original equipment sales volume in Europe was down 22%, and aftermarket business was down 10%. These declines affected both conventional and electronic products. Operating income for Transportation Products in 1993 decreased 53% (50% excluding foreign exchange effects) to $41 million from $88 million in 1992, principally because of the lower sales and production volume and the inability to pass on material and labor cost increases in a very competitive, declining market. In response to reduced production levels, plant employment was reduced by 15%, the costs of which further depressed 1993 operating income. Those effects were partly offset by the favorable effects of cost improvements in manufacturing from Demand Flow implementa- tion and reduced operating expenses. Despite the market downturn, significant progress was made during 1993 in obtaining market acceptance of electronically controlled air suspension systems for commercial vehicles and for antilock braking systems on trailers. Backlog Transportation Products' year-end 1993 order backlog of $185 million was 2% lower than the 1992 year-end backlog, excluding the effects of foreign exchange, as a result of the poor market conditions. Financial Review 1993 Compared with 1992 The Company's financing and corporate costs were $363 million and $352 million in 1993 and 1992, respectively. The principal causes of the increase were effects of year-to-year changes in foreign exchange transaction gains and losses, higher minority interest, lower equity income, higher accretion expense on postretirement benefits, and lower miscellaneous income. Interest expense, which accounted for most of these costs, decreased primarily because of lower overall interest rates on new debt issued as part of the Refinancing (described below), partly offset by additional interest expense as a result of the exchange of the 12-3/4% Exchangeable Preferred Stock for the 12-3/4% Junior Subordinated Debentures. The tax provision for 1993 was $36 million despite a pre-tax loss of $81 million, whereas in 1992 the tax provision was $5 million on a pre-tax loss from continuing operations of $52 million. The 1993 provision reflected taxes payable on profitable foreign operations and was higher than in 1992 primarily because no tax benefits were available on domestic losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. As a result of the Refinancing in 1993 there was an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit. Liquidity and Capital Resources As a result of the Acquisition the Company's capital structure became highly leveraged. Net cash flow from operations, after cash interest expense of $195 million, was $201 million for the year ended December 31, 1993. Utilizing this cash flow and cash on hand at December 31, 1992, the Company devoted $98 million to capital expenditures, including $8 million of investments in affiliated companies, and repaid $50 million of term loans. In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million, and the amount available under the Credit Agreement by its terms was reduced to $950 million. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12 months ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. The Credit Agreement provides the Company with increased operating and financial flexibility, including the ability to shift from time to time a portion of borrowings among borrowers and currencies. As a result of the Refinancing there was a significant reduction in annual interest expense, which was partly offset by additional interest expense on the 12-3/4% Junior Subordinated Debentures exchanged for the 12-3/4% Exchangeable Preferred Stock. The Company believes that the amounts available from operating cash flows and under the Revolving Credit Facility will be sufficient to meet its expected cash needs, including planned capital expenditures. As described in Note 8 of Notes to Consolidated Financial Statements, the Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemptions of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amendments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and convenants, and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar amendments or waivers in the future. On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993, with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required the Company expects that it will be able to meet such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures, and therefore subsequent results of operations for any particular quarterly or annual period, could be adversely affected. Capital Expenditures The Company's capital expenditures for 1993 amounted to $98 million, including investments of $8 million in affiliated companies. The amount of capital expenditures was $10 million less than in 1992 ($6 million less excluding the effects of foreign exchange). Decreases in capital spending by Plumbing Products and Transportation Products were partly offset by an increase in spending by Air Conditioning Products. The Company believes capital spending was sufficient for maintenance purposes, for important product and process redesigns, for expansion projects, and for strategic investments. Capital expenditures by Air Conditioning Products were $38 million in 1993. This amount was 15% more than that of 1992. Capital expenditures in 1993 included continuing projects related to Demand Flow and spending on new products such as the Voyager III (medium-tonnage product line), the scroll compressor, and the Series R chiller line, expansion of Voyager I and Voyager II capacity and tooling and equipment for the American Standard product line. Plumbing Products' capital expenditures in 1993 were $46 million, including investments of $8 million in affiliated companies in France (Porcher) and the Czech Republic. Excluding the investments in affiliated companies and the effects of foreign exchange, capital spending was 34% higher than in 1992 as a result of spending increases in Europe and the Far East. Major projects included capacity expansion in Thailand and China and various projects related to Demand Flow implementation. Capital expenditures for Transportation Products totaled $14 million in 1993. Excluding the effects of foreign exchange, capital spending was 41% less than in 1992, a year with significant spending related to Demand Flow cost-reduction projects in production and material flow. 1992 Compared with 1991 U.S. housing starts increased by 18% in 1992 from the 1991 level, but non-residential contract awards decreased by 5%. Both of these economic indicators had declined in each of the previous four years. Consolidated sales for 1992 were $3.8 billion, an increase of 5% (4% excluding the favorable effects of foreign exchange) over the $3.6 billion for 1991. The 1991 amount included the sales of Tyler Refrigeration, which was sold September 30, 1991. Excluding Tyler Refrigeration, sales in 1992 were up 8% (7% excluding foreign exchange effects). Sales increases of 15% for Plumbing Products and 9% for Air Conditioning Products (excluding Tyler Refrigeration) were partly offset by a sales decline for Transportation Products of 1% (6% excluding the favorable effects of foreign exchange). Operating income for 1992 was $300 million, an increase of $58 million, or 24% (19% excluding the effects of foreign exchange), from $242 million in 1991. The 1991 amount included a loss for Tyler Refrigeration. Excluding Tyler Refrigeration, operating income in 1992 was up 15% (10% excluding foreign exchange effects.) Increases in operating income of 42% for Air Conditioning Products (excluding Tyler Refrigeration) and 64% for Plumbing Products were partly offset by a 27% decrease in operating income for Transportation Products. Except as otherwise indicated, the following discussion, including the financial comparisons, does not include the results of Tyler Refrigeration or the $22 million loss on the sale of Tyler Refrigeration in 1991. Air Conditioning Products Segment Sales of Air Conditioning Products, which accounted for approximately 50% of the Company's 1992 sales, increased by 9% to $1,892 million in 1992 from $1,737 million in 1991. There was a significant sales increase for each of the three operating groups -- for the Unitary Products Group in both residential and commercial products primarily because of higher volume and more favorable product mix (partly offset by lower prices), for the Commercial Systems Group primarily because of higher volume and prices, and for the International Group principally because of increased volume in Europe and the Far East. Operating income of Air Conditioning Products increased year to year by 42% (with little effect from foreign exchange) to $104 million in 1992 from $73 million in 1991. The increase was attributable to the sales gains, the benefits of manufacturing improvements and restructuring and cost containment in the Unitary Products and Commercial Systems Groups, and the fact that in 1991 results of the Commercial Systems Group had been adversely affected by a 54-day work stoppage at its LaCrosse, Wisconsin, facility. The impact of these factors was partly offset by a margin decline for the International Group and costs related to the start-up of new facilities, sales offices, and distribution channels. Unitary Products Group Sales in 1992 of the Unitary Products Group, which accounted for approximately 41% of Air Conditioning Products sales, increased by 6% over the 1991 sales level. Commercial markets for unitary products were up 6% overall from the depressed 1991 markets, as a very strong commercial replacement market more than offset the effects of low new-construction activity. Sales of commercial unitary products increased by 7% overall, primarily as a result of higher volume (driven by the strong replacement market), a shift to higher-priced, higher-tonnage products, and a gain in market share for light commercial products. Residential markets were down 3.5%, as poor replacement activity, a result of an unseasonably cool summer, more than offset the 18% increase in new housing starts. Despite this poorer market, sales of residential products increased by 5% year over year, principally because of larger market share, improved furnace markets, and a partial shift in the market to more efficient products stimulated by Federal standards, offset partly by price degradation due to competitive pressures. As a result of these factors, together with benefits of manufacturing improvements, cost containment, and organizational restructuring which reduced the salaried workforce, the operating profit for Unitary Products in 1992 increased by 50% from the depressed level of 1991. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 38% of Air Conditioning Products' sales, increased 9% primarily on volume increases in aftermarket replacement and parts sales, increased revenue from Company-owned sales offices (volume growth and acquisitions), and small price increases on most product lines. Other factors contributing to the increase were higher sales of large applied systems and the fact that in 1991 there was a 54-day work stoppage at the LaCrosse, Wisconsin, plant. These gains were partly offset by lower volume in Canada, which was adversely affected by recession. Operating income for Commercial Systems increased 129% in 1992 over the recession-affected and work-interrupted level of 1991. The increase was primarily the result of the volume and price gains, improvements in manufacturing efficiency, cost containment and restructuring, and the fact that 1991 included the adverse impact of the LaCrosse work stoppage. The effects of these factors were partly offset by slightly lower gross margins, as the price increases did not completely recover increases in material, labor and benefits costs. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1992 sales, increased 15% from those of 1991 (10% excluding the favorable effect of foreign exchange). Most of the gain was from higher volumes in Mexico (two new sales offices resulted in expanded distribution and penetration), the Far East (especially Hong Kong and Singapore), the Middle East (markets were significantly stronger), and Europe (sales of new products and increased penetration despite declining markets). Markets were down in almost all European countries except Italy, with the largest drop in the U.K., offset partly by increased revenues from acquired service companies. Operating income for the International Group decreased by approximately 68% in 1992. The decline occurred in Europe, primarily because of the weak markets and lower prices, costs related to the start-up of new facilities and new distribution networks in the U.K. and France, costs related to the introduction of new products, start-up costs of a company in Spain acquired near the end of 1991, and foreign exchange transaction losses from currency fluctuations in the latter half of 1992. Income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expanded distribution channels, start-up of new joint ventures, and development of new and improved products to support present and future growth. Plumbing Products Segment Sales of Plumbing Products, which accounted for approximately 31% of the Company's 1992 sales, increased by 15% in 1992 (14% excluding the effects of foreign exchange) to $1,170 million from $1,018 million in 1991. The improvement resulted from sales increases of 9% (7% excluding the effects of foreign exchange) for the European Plumbing Products Group, 21% for the U.S. Plumbing Products Group, 4% for the Americas International Group (7% excluding foreign exchange), and 101% for the Far East Group (98% excluding foreign exchange). In 1992 operating income of Plumbing Products increased 64% (56% excluding the effects of foreign exchange) to $108 million from $66 million in 1991. The increase was attributable primarily to increased profitability for the European group on higher prices and volumes (especially in Italy and Germany) although improved results in the U.S., Americas International, and Far East groups contributed. European Plumbing Products Group Sales of the European group, which accounted for approximately 57% of Plumbing Products' sales for 1992, increased 9% in 1992 over 1991, 7% excluding the favorable effects of foreign exchange. The gain resulted primarily from price and volume increases, especially in Italy and Germany, offset partly by lower volume in France from declining demand and lower prices in the U.K. caused by a very poor market. In Italy sales were up 9%, with gains for most product lines in price, volume and market share. The gains in Germany were the result of higher volumes and prices for brass fittings and luxury chinaware. Operating income for the European group increased 28% (23% excluding the effects of foreign exchange) primarily from the price and volume gains in Italy and Germany and higher margins on German brass operations resulting from improved manufacturing processes and cost containment, offset partly by lower profitability in France because of decreased volume and in the U.K. because of the recession. A recession depressed operating results in Greece. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 24% of total 1992 Plumbing Products sales, increased 21% in 1992. During 1992 the U.S. building industry continued to be severely affected by the low level of new construction, with non-residential construction down 5% from 1991 and with new residential construction recovering from the lowest levels since the mid-1940's (though up by 18%, it was still low in historical terms). The U.S. market for plumbing products was up an estimated 3% to 4%, with more than half the gain occurring in the replacement and remodeling markets, which accounts for about 60% of the total U.S. market. The growth of sales for the U.S. group was largely a result of the strength of retail business (which had a significant increase in volume and accounted for 20% of sales of the U.S. group in 1992) and increased export sales from the U.S., together with smaller gains resulting from price increases and higher wholesaler distribution sales. Sales of AMERICAST products more than doubled in 1992, and smaller volume gains were achieved for acrylic products, fixtures, and faucets. The operating loss for the U.S. group in 1992 was less than that of the prior year. The improvement was primarily due to price increases and secondarily to volume and margin gains (as a result of sourcing product from the Company's Latin American plants), offset partly by non-recurring costs related to implementation of improved manufacturing processes and the effects of a shift in overall sales mix from commercial and luxury to lower-margin products. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 19% of total Plumbing Products sales, increased 26% in 1992 (28% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation in 1992 of a previously unconsolidated joint venture in Thailand and to a lesser extent to price and volume increases in Mexico and Korea and higher volumes in Brazil, offset partly by lower sales in Canada, which were adversely affected by severe recession. Combined operating income of the Americas International and Far East Groups in 1992 increased 134% over the 1991 level. Gains were realized in all operations except Canada and the Philippines, both of which were adversely affected by poor economies. The increase was primarily from price and volume gains in Mexico and Korea, higher volume and margins in Brazil, and higher volume in China. Transportation Products Segment Sales of Transportation Products, which accounted for 19% of the Company's 1992 sales, were $730 million, down 1% from $741 million in 1991 (6% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a significant decrease in truck and bus production. Volumes were also down in nearly all other European countries in which Transportation Products has operations except the U.K. There was also a decline in prices of electronic control products, primarily as a result of industry cost reductions. Operating income for Transportation Products in 1992 decreased 27% (32% excluding foreign exchange effects) to $88 million from $121 million in 1991, principally because of the lower sales and production volume, lower prices, and increased spending for product engineering. Plant employment was kept in line with reduced production levels, but the costs associated with these reductions also depressed 1992 operating income. Those effects were partly offset by the favorable effects of cost reductions and increases in efficiency achieved in manufacturing operations. Financial Review 1992 Compared with 1991 The Company's financing and corporate costs were $352 million and $330 million in 1992 and 1991, respectively. The principal causes of the increase were year-to-year effects of changes in foreign exchange transaction gains and losses, higher minority interest, and lower miscellaneous income. Interest expense and accretion expense on postretirement benefits, which accounted for most of these costs, also increased. The tax provision for 1992 was $5 million despite a pre-tax loss of $52 million, whereas in 1991 the tax provision was $23 million on a pre-tax loss from continuing operations of $88 million. The 1992 provision reflected taxes payable on profitable foreign operations offset partly by available domestic tax benefits. The 1992 provision was lower than in 1991 primarily because of lower pre-tax earnings in foreign operations. In 1992 the provision was also lower because of future income tax benefits resulting from carrybacks of foreign net operating losses and the existence of deferred tax credits which reverse in the carryforward period applicable to other foreign net operating losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RESPONSIBILITY FOR FINANCIAL STATEMENTS The accompanying consolidated balance sheets at December 31, 1993 and 1992, and related consolidated statements of operations, stockholders' equity (deficit), and cash flows for the years ended December 31, 1993, 1992 and 1991, have been prepared in conformity with generally accepted accounting principles, and the Company believes the statements set forth a fair presentation of financial condition and results of operations. The Company believes that the accounting systems and related controls that it maintains are sufficient to provide reasonable assurance that the financial records are reliable for preparing financial statements and maintaining accountability for assets. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control must be related to the benefits derived and that the balancing of those factors requires estimates and judgment. Reporting on the financial affairs of the Company is the responsibility of its principal officers, subject to audit by independent auditors, who are engaged to express an opinion on the Company's financial statements. The Board of Directors has an Audit Committee of non-employee Directors which meets periodically with the Company's financial officers, internal auditors, and the independent auditors and monitors the accounting affairs of the Company. ASI Holding Corporation New York, New York March 14, 1994 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors ASI Holding Corporation We have audited the accompanying consolidated balance sheets of ASI Holding Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ASI Holding Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/Ernst & Young Ernst & Young New York, New York March 14, 1994 ASI HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in thousands except share amounts) ASSETS At December 31, 1993 1992 Current assets Cash and certificates of deposit $ 53,237 $ 111,549 Cash in escrow 932 1,722 Accounts receivable, less allowance for doubtful accounts-- 1993, $15,666; 1992, $12,827 507,322 468,731 Inventories 325,819 384,857 Future income tax benefits 24,562 33,192 Other current assets 29,811 31,199 Total current assets 941,683 1,031,250 Facilities, at cost net of accumulated depreciation 820,523 832,811 Other assets Goodwill, net of accumulated amortization -- 1993, $169,879; 1992, $141,858 1,025,774 1,101,716 Debt issuance costs, net of accumulated amortization-- 1993 $9,670; 1992, $77,776 78,102 51,308 Other 120,997 109,333 $2,987,079 $3,126,418 ========== ========== LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities Loans payable to banks $ 38,036 $ 99,150 Current maturities of long-term debt 105,939 13,458 Accounts payable 307,326 271,855 Accrued payrolls 99,758 105,400 Other accrued liabilities 263,322 230,335 Taxes on income 47,003 18,848 Total current liabilities 861,384 739,046 Long-term debt 2,191,737 2,032,064 Other long-term liabilities Reserve for postretirement benefits 387,038 368,868 Deferred tax liability 45,625 73,307 Other 224,108 228,521 Total liabilities 3,709,892 3,441,806 Commitments and contingencies Exchangeable preferred stock - 133,176 Stockholders' deficit Preferred stock, Series A, par value $.01, 1,000 shares issued and outstanding - - Common stock $.01 par value, 28,000,000 shares authorized; 23,858,335 shares issued and outstanding in 1993, 23,608,587 in 1992 239 236 Capital surplus 188,744 192,351 Subscriptions receivable (2,588) (3,316) ESOP shares (4,331) (9,527) Accumulated deficit (750,003) (541,436) Foreign currency translation effects (149,220) (86,872) Minimum pension liability adjustment (5,654) - Total stockholders' deficit (722,813) (448,564) $2,987,079 $3,126,418 =========== ========== See notes to consolidated financial statements. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation ASI Holding Corporation ("Holding") is a Delaware corporation that was formed in 1988 by an affiliate of Kelso & Company L.P. ("Kelso"), an investment banking firm that specializes in leveraged buyouts. On March 21, 1988, the Kelso affiliate commenced a tender offer (the "Tender Offer") for all of the common stock of American Standard Inc. at $78 per share in cash. On April 27, 1988, the Kelso affiliate completed the Tender Offer with the purchase of approximately 95% of the shares of American Standard Inc. Pursuant to an Agreement and Plan of Merger, a merger was consummated (the "Merger") on June 29, 1988, whereby American Standard Inc. became a wholly owned subsidiary of Holding. At that time the remaining shares of American Standard Inc.'s common stock were converted into the right to receive cash of $78 per share. Hereinafter "the Company" will refer to Holding or to its subsidiary, American Standard Inc., as the context requires. The Tender Offer, Merger, and related transactions are hereinafter referred to as the "Acquisition." For financial statement purposes the Acquisition has been accounted for under the purchase method. Note 2. Accounting Policies Consolidation The financial statements include on a consolidated basis the results of all majority-owned subsidiaries. All material intercompany transactions are eliminated. Investments in affiliated companies are included at cost plus the Company's equity in their net results. Translation of Foreign Financial Statements Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the income statements are translated at the average rates of exchange for the period. Gains or losses resulting from translating foreign currency financial statements are accumulated in a separate component of stockholder's equity until the entity is sold or substantially liquidated. Gains or losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's local currency) are included in net income. For operations in countries that have high rates of inflation, net income includes gains and losses from translating assets and liabilities at year-end rates of exchange, except for inventories and facilities, which are translated at historical rates. Revenue Recognition Sales are recorded when shipment to a customer occurs. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statement of Cash Flows Cash and certificates of deposit include all highly liquid investments with an original maturity of three months or less. Inventories Inventory costs are determined by the use of the last-in, first-out (LIFO) method on a worldwide basis, and inventories are stated at the lower of such cost or realizable value. Facilities The Company capitalizes costs, including interest during construction, of fixed asset additions, improvements, and betterments that add to productive capacity or extend the asset life. Maintenance and repair expenditures are charged against income. Significant foreign investment grants are amortized into income over the period of benefit. Goodwill Goodwill is being amortized over 40 years. Debt Issuance Costs The costs related to the issuance of debt are amortized using the interest method over the lives of the related debt. Warranties The Company provides for estimated warranty costs at the time of sale. Warranty obligations beyond one year are included in other long-term liabilities. The Company changed its method of accounting for revenues from extended warranty contracts at the beginning of 1991 to conform with the FASB Technical Bulletin, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts." The bulletin requires the deferral of the revenue from the sales of such contracts and amortization thereof on a straight-line basis over the terms of the contracts. The cumulative effect of this accounting change for all contracts in place as of December 31, 1990, increased the net loss in 1991 by $7 million, net of income tax benefit. The effect on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. Leases The asset values of capitalized leases are included with facilities, and the associated liabilities are included with long-term debt. Postretirement Benefits Postretirement benefits are provided for substantially all employees of the Company, both in the United States and abroad. In the United States the Company also provides various postretirement health care and ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS life insurance benefits for some of its employees. Effective January 1, 1991, such costs are calculated in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). Depreciation Depreciation and amortization are computed on the straight-line method based on the estimated useful life of the asset or asset group. Research and Development Expenses Research and development costs are expensed as incurred except for costs incurred (after technological feasibility is established) for computer software products expected to be sold. The Company expensed costs of approximately $41 million in 1993, $40 million in 1992, and $36 million in 1991 for research activities and product development. Computer software product development costs capitalized in 1993 amounted to $2 million. Income Taxes In 1991 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), and elected to apply the provisions retroactively to January 1, 1989. The Company recognizes deferred tax assets for the tax effects of items that will be deducted for tax purposes in later years together with the tax effects of income items included in current reporting for tax purposes but in later years for financial statement purposes and the effects of certain tax attributes such as net operating losses. The Company provides for United States income taxes and foreign withholding taxes on foreign earnings expected to be repatriated. Deferred tax liabilities are provided on the excess of the financial statement basis over the tax basis of certain assets, primarily for inventories and fixed assets, including fair value adjustments resulting from purchase accounting in connection with the Acquisition; fixed assets due to accelerated depreciation deductions for tax purposes; and non-permanent investments in certain foreign subsidiaries. Earnings per share Earnings per share have been computed using the weighted average number of common shares outstanding. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Financial Instruments with Off-Balance-Sheet Risk The Company from time to time enters into foreign currency exchange agreements in the management of foreign currency exposure. Gains and losses from exchange rate changes are included in income unless the contract hedges a net investment in a foreign entity or a firm commitment, in which case gains and losses are deferred as a component of foreign currency translation effects in stockholder's equity or included as a component of the transaction. Note 3. Postretirement Benefits The Company sponsors postretirement benefit plans covering substantially all employees, including an Employee Stock Ownership Plan (the "ESOP") for the Company's U.S. salaried employees and certain U.S. hourly employees. In 1988 in conjunction with the Acquisition the ESOP purchased 5,000,000 shares (adjusted for a 100-for-1 stock split) of common stock of Holding. The ESOP is an individual account, defined contribution plan. The valuation of the ESOP shares is determined by independent appraisals. The common stock acquired by the ESOP is being allocated to the accounts of eligible employees over a period not exceeding eight plan years, including basic allocation of 3% of covered compensation and a matching Company contribution of up to 6% of covered compensation invested in the Company's savings plan by employees. Pension plan benefits are generally based on years of service and employees' compensation during the last years of employment. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Funding decisions are based upon the tax and statutory considerations in each country. Accretion expense is the implicit interest cost associated with amounts accrued and not funded and is included in "other expense". At December 31, 1993, funded plan assets related to pensions were held primarily in fixed income and equity funds. Postretirement health and life insurance benefits are not prefunded. Effective January 1, 1991, the Company changed its method of accounting for postretirement benefits other than pensions to conform with FAS 106. The cumulative effect of this change increased the recorded obligation for such benefits by $40 million, thereby increasing the net loss in 1991 by $25 million (net of the related income tax benefit). The effect of the change on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. The following table sets forth the Company's postretirement plans' funded status and amounts recognized in the balance sheet at December 31, 1993 and 1992. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4. Other Expense Other income (expense) was as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Interest income $ 8.5 $ 8.7 $ 8.3 Royalties 2.6 3.8 2.5 Equity in net income (loss) of affiliated companies (0.1) 4.9 10.2 Minority interest (14.0) (9.8) (3.1) Accretion expense (30.5) (29.8) (27.9) Other, net (4.8) (2.5) 1.9 $(38.3) $(24.7) $ (8.1) ====== ====== ====== The decrease in equity in net income of affiliated companies and the increase in minority interest in 1993 and 1992 compared with 1991 were primarily the result of consolidation of the plumbing companies in Thailand, the People's Republic of China, and Incesa, previously unconsolidated joint ventures. Note 5. Income Taxes The Company's loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods ("pre-tax income (loss)") and the applicable provision (benefit) for income taxes were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pre-tax income (loss): Domestic $ (223.2) $ (170.1) $(272.6) Foreign 142.7 117.5 184.8 Pre-tax loss $ (80.5) $ (52.6) $ (87.8) Provision (benefit) for income taxes: Current: Domestic $ 12.4 $ 5.1 $ 5.1 Foreign 43.0 63.0 71.3 55.4 68.1 76.4 Deferred: Domestic 1.1 (35.8) (52.4) Foreign (20.3) (27.6) (1.0) (19.2) (63.4) (53.4) Total provision $ 36.2 $ 4.7 $ 23.0 ======== ======== ======= ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation between the actual income tax expense provided and the income tax benefit computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the pre-tax loss is as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Tax benefit at statutory rate $(28.2) $(17.9) $(29.9) Nondeductible goodwill charged to operations 10.4 10.5 10.6 Nondeductible goodwill related to operations sold - 25.1* Nondeductible ESOP allocations 6.1 4.9 4.6 Rate differences and withholding taxes related to foreign operations 9.0 1.4 4.7 Foreign exchange gains (7.0) (6.3) (2.1) State tax benefits (5.5) (3.3) (3.4) Other, net 8.7 5.5 5.6 Increase in valuation allowance 42.7 9.9 7.8 Total provision $ 36.2 $ 4.7 $ 23.0 ====== ====== ====== * Includes goodwill eliminated in the sale of Tyler Refrigeration. In addition to the valuation allowance increase of $42.7 million shown above, a valuation allowance of $32.1 million was provided for the entire amount of the tax benefit related to the extraordinary loss on retirement of debt (see Note 8 of Notes to Consolidated Financial Statements). The following table details the gross deferred liabilities and the gross deferred tax assets and the related valuation allowances. At December 31, 1993 1992 (dollars in millions) Deferred tax liabilities: Facilities (accelerated depreciation, capitalized interest and purchase accounting differences) $ 141.1 $ 154.1 Inventory (LIFO and purchase accounting differences) 18.5 30.3 Employee benefits 11.0 6.6 Foreign investments 50.1 48.8 Other 26.2 26.6 246.9 266.4 Deferred tax assets: Employee benefits (pensions and other postretirement benefits) 110.7 97.7 Warranties 37.4 30.0 Alternative minimum tax 19.4 21.8 Foreign tax credits and net operating losses 57.5 42.3 Reserves 58.7 45.1 Other 46.0 18.5 Valuation allowances (103.9) (29.1) 225.8 226.3 Net deferred tax liabilities $ 21.1 $ 40.1 ========= ======== ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred tax assets related to foreign tax credits, net operating loss carryforwards, and future tax deductions have been reduced by a valuation allowance since realization is dependent in part on the generation of future foreign source income as well as on income in the legal entity which gave rise to tax losses. Other deferred tax assets have not been reduced by valuation allowances because of carrybacks and existing deferred tax credits which reverse in the carryforward period. The foreign tax credits and net operating losses are available for utilization in future years. In some tax jurisdictions the carryforward period is limited to as little as five years; in others it is unlimited. As a result of the Acquisition (see Note 1) and the allocation of purchase accounting (principally goodwill) to foreign subsidiaries, the book basis in the net assets of the foreign subsidiaries exceeds the related U.S. tax basis in the subsidiaries' stock. Such investments are considered permanent in duration, and accordingly no deferred taxes have been provided on such differences, which are significant. It is impracticable because of the complex legal structure of the Company and the numerous tax jurisdictions in which the Company operates to determine such deferred taxes. Cash taxes paid were $41 million, $56 million, and $79 million in the years 1993, 1992, and 1991, respectively. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993 with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required, the Company expects that it will be able to make such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures and therefore subsequent results of operations for any particular quarterly or annual period could be adversely affected. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 6. Inventories The components of inventory are as follows: At December 31, 1993 1992 (Dollars in millions) Finished products $169.0 $200.6 Products in process 78.0 95.8 Raw materials 78.8 88.5 Inventory at cost $325.8 $384.9 ====== ====== The carrying cost of inventories reflects purchase accounting adjustments and therefore exceeds current cost. Note 7. Facilities The components of facilities, at cost, are as follows: At December 31, 1993 1992 (Dollars in millions) Land $ 66.2 $ 65.0 Buildings 314.6 310.2 Machinery and equipment 739.9 719.4 Improvements in progress 54.4 45.6 Gross facilities 1,175.1 1,140.2 Less: accumulated depreciation 354.6 307.4 Net facilities $ 820.5 $ 832.8 ======== ======== Note 8. Debt The 1993 Refinancing In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 (the "12-7/8% Senior Subordinated Debentures") at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 (the "14-1/4% Subordinated Discount Debentures") at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility ("Tranche A") available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility ("Tranche B") available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility ("Tranche C") available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million and the amount available under the Credit Agreement by its terms was reduced to $950 million. Borrowings under the Periodic Access Facility and the Term Loans generally bear interest at the London interbank offered rate ("LIBOR") plus 2-1/2% except for the $225 million U.S. dollar facility, which bears interest at LIBOR plus 3%, and the $200 million Deutschemark facility, which bears interest at LIBOR plus 2%. The Company pays a commitment fee of 0.5% per annum on the unused portion of the Revolving Credit Facility and a fee of 2.5% plus issuance fees for letters of credit. As a result of the Refinancing, results for the year ended December 31, 1993, included an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit (see Note 5). Short-term The Revolving Credit Facility (the "Revolver") provides for aggregate borrowings of up to $250 million for working capital purposes, of which up to $200 million may be used for the issuance of letters of credit and $40 million of which is available for same-day short-term borrowings ("Swingline Loans"). At December 31, 1993, there were $7 million of borrowings outstanding under the Revolver and $66 million of letters of credit. Availability under the Revolver at December 31, 1993, was $177 million. Average borrowings under this facility and under the revolving credit facility available under the previous 1988 Credit Agreement for 1993, 1992, and 1991 were $39 million, $14 million, and $44 million, respectively. The Revolver and the Swingline Loans bear interest at the prime rate plus 1-1/2% or LIBOR plus 2-1/2%. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12-month period ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. Other short-term borrowings are available outside the United States under informal credit facilities and are typically a result of overdrafts. At December 31, 1993, the Company had $31 million of such foreign short-term debt outstanding at an average interest rate of 11% per annum. The Company also had an additional $50 million of unused foreign facilities. These facilities may be withdrawn by the banks at any time. Long-term Long-term debt was as follows: At December 31, 1993 1992 (Dollars in millions) Credit Agreement $ 689.9 $ - 1988 Credit Agreement - 402.3 9 1/4% sinking fund debentures, due in installments from 1997 to 2016 150.0 150.0 10 7/8% senior notes due 1999 150.0 150.0 11 3/8% senior debentures due 2004 250.0 250.0 9 7/8% senior subordinated notes due 2001 200.0 - 10 1/2% senior subordinated discount debentures (net of unamortized discount of $272.9 million in 1993) due in installments from 2003 to 2005 477.8 - 12 7/8% senior subordinated debentures - 545.0 14 1/4% subordinated discount debentures (net of unamortized discount of $36.3 million in 1992) due in installments from 2002 to 2003 175.0 509.5 Other long-term debt 63.1 53.3 12 3/4% junior subordinated debentures due in installments from 2001 to 2003 (Note 9) 141.8 - Foreign currency swap contracts - (14.6) 2,297.6 2,045.5 Less current maturities 105.9 13.4 $ 2,191.7 $ 2,032.1 ========= ========= The amounts of long-term debt maturing from 1995 through 1998 are: 1995-$126.3 million, 1996-$123.5 million, 1997 $121.2 million, 1998-$117.5 million. Interest costs capitalized as part of the cost of constructing facilities for the years ended December 31, 1993, 1992, and 1991, were $2.7 million, $3.1 million, and $3.6 million, respectively. Cash interest paid for those same years on all outstanding indebtedness amounted to $198 million, $210 million, and $224 million, respectively. ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Credit Agreement loans, maturities, and effective weighted average interest rates in effect at December 31, 1993, were as follows: U.S. Dollar Equivalent (in millions) Periodic Access Facility, due in semi-annual installments from February 1994 to February 2000: British sterling loans at 7.85% $ 95.8 Deutschemark loans at 9.06% 49.4 Canadian dollar loans at 6.50% 20.2 French franc loans at 9.17% 18.5 Italian lira loans at 12.19% 8.7 Total Periodic Access loans 192.6 Term Loans: Tranche A U.S. dollar loans, due in semi-annual installments from August 1997 to February 2000 at 6.50% 225.0 Tranche B Deutschemark loans, due in semi-annual installments from February 1994 to February 1997 at 7.88% 172.3 Tranche C U.S. dollar loans, due in semi-annual installments from February 1994 to August 1999 at 6.01% 100.0 Total Term Loans 497.3 Total Credit Agreement long-term loans 689.9 Revolver loans at 7.5% 7.0 Total Credit Agreement loans $ 696.9 ======== Under the 1988 Credit Agreement the various term loans and effective weighted average interest rates in effect at December 31, 1992, were as follows: U.S. Dollar Equivalent (in millions) Deutschemark loans at 11.4% $249.8 Canadian dollar loans at 13.05% 152.5 Total $402.3 ====== The 9-7/8% Senior Subordinated Notes may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 102.82% in 1998 to 100% on June 1, 2000, and thereafter. The 10-1/2% Senior Subordinated Discount Debentures may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 104.66% in 1998 to 100% on June 1, 2002, and thereafter. The payment of the principal and interest on the ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9-7/8% Senior Subordinated Notes and on the 10-1/2% Senior Subordinated Discount Debentures (together the "Senior Subordinated Debt") is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement and the 9-1/4% Sinking Fund Debentures, the 10-7/8% Senior Notes, and the 11-3/8% Senior Debentures (the said notes and debentures together the "Senior Securities"). The 9-1/4% Sinking Fund Debentures are redeemable at the Company's option, in whole or in part, at redemption prices declining from 105.55% in 1994 to 100% in 2006 and thereafter. The 10-7/8% Senior Notes are not redeemable by the Company. The 11-3/8% Senior Debentures are redeemable at the option of the Company, in whole or in part, on or after May 15, 1997, at redemption prices declining from 105.69% in 1997 to 100% on May 15, 2002, and thereafter. The 14-1/4% Subordinated Discount Debentures are redeemable at the Company's option, in whole or in part, at redemption prices of 105% prior to June 30, 1994, declining to 100% on and after June 30, 1995. The payment of the principal and interest on the 14-1/4% Subordinated Discount Debentures issued by the Company in 1988 is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, and the Senior Subordinated Debt. The 14-1/4% Subordinated Discount Debentures rank senior to the 12-3/4% Junior Subordinated Debentures (described below). The 12-3/4% Junior Subordinated Debentures may be redeemed, at the Company's option, in whole or in part at a redemption price of 101.8% prior to June 30, 1994, and at 100% thereafter. The payment of principal and interest on the 12-3/4% Junior Subordinated Debentures is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, the Senior Subordinated Debt, and the 14-1/4% Subordinated Discount Debentures. Obligations under the Credit Agreement are guaranteed by ASI Holding Corporation (the Company's parent), the Company, and significant domestic subsidiaries of the Company (with foreign borrowings also guaranteed by certain foreign subsidiaries) and are secured by U.S., Canadian, and U.K. properties, plant, and equipment; by liens on receivables, inventories, intellectual property, and other intangibles; and by a pledge of the Company's stock and nearly all shares of subsidiary stock. In addition, the obligations of the Company under the Senior Securities are secured, to the extent required by the related indentures, by mortgages on the principal U.S. properties of the Company equally and ratably with the indebtedness under the Credit Agreement and certain related indebtedness. The Senior Subordinated Debt, the 14-1/4% Subordinated Discount Debentures, and the 12-3/4% Junior Subordinated Debentures are unsecured. The Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemption of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amend- ments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and covenants and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar waivers or amendments in the future. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. Note 9. Exchange of Exchangeable Preferred Stock On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. Note 10. Foreign Currency Translation Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the resulting gains or losses, net of income tax effects, are accumulated in a separate component of stockholder's equity. Changes in exchange rates which gave rise to significant translation effects included in stockholder's equity for the years ended December 31, 1993, 1992, and 1991, are summarized in the accompanying table. Change in End of Period Exchange Rate Currency 1993 1992 1991 British sterling (2)% (19)% (3)% Canadian dollar (4) ( 9) - French franc (6) (6) (2) Deutschemark (7) (6) (1) Italian lira (14) (22) (2) ===== ===== ===== Translation loss included in stockholder's equity, net of tax (dollars in millions) $ (62.3) $ (36.2) $ (2.1) ====== ====== ===== ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The allocation of purchase costs increased the net asset exposure of foreign operations; however, since June 29, 1988, the date of the Merger, the effects of exchange volatility have been ameliorated by the fact that a portion of the Company's borrowings has been denominated in foreign currencies. The losses from foreign currency transactions and translation from operations in countries with high inflation rates reflected in expense were $21.9 million in 1993, $19.3 million in 1992, and $14.4 million in 1991. Note 11. Fair Values of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Values of Financial Instruments" ("FAS 107"), requires disclosure information about all financial instruments of a company except certain excluded instruments and instruments for which it is not practicable to estimate fair value. The fair values presented below are estimates as of December 31, 1993, and are not necessarily indicative of amounts the Company could realize or settle currently or indicative of the intent or ability of the Company to dispose of or liquidate such instruments. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and certificates of deposit: The carrying amount reported in the balance sheet for cash and certificates of deposit approximates its fair value. Long- and short-term debt: The fair values of the Company's Credit Agreement loans are estimated using indicative market quotes obtained from a major bank. The fair values of senior notes, senior debentures, senior subordinated notes, senior subordinated discount debentures, subordinated discount debentures, the sinking fund debentures, and the junior subordinated debentures are based on indicative market quotes obtained from a major securities dealer. The fair values of other loans approximate their carrying value. The carrying amounts and estimated fair values of selected financial instruments at December 31, 1993 are as follows: (dollars in millions) Carrying Fair Amount Value Credit Agreement loans $ 697 $ 679 10 7/8% senior notes 150 163 11 3/8% senior debentures 250 276 9 7/8% senior subordinated notes 200 208 10 1/2% senior subordinated discount debentures 478 505 14 1/4% subordinated discount debentures 175 184 9 1/4% sinking fund debentures 150 152 12-3/4% junior subordinated debentures 142 143 Other loans 63 63 ASI HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12. Related Party Transactions The Company has agreed to pay Kelso an annual fee of $2.75 million for providing management consulting and advisory services. In June 1993 the Company issued 1,000 shares of a new, non-voting Series A Preferred Stock, par value $.01 per share, for $10,000 to an affiliate of Kelso & Company. The Company is committed to contribute $5 million of capital to a Kelso limited partnership. In addition, Tyler Refrigeration was sold to an affiliate of Kelso in 1991. Note 13. Leases The cumulative minimum rental commitments under the terms of all noncancellable operating leases in effect at December 31, 1993, were $108 million. Net rental expenses for operating leases were $34 million, $32 million, and $28 million for the years ended December 31, 1993, 1992, and 1991, respectively. Note 14. Commitments and Contingencies The Company and certain of its subsidiaries are parties to a number of pending legal and tax proceedings. The Company is also subject to federal, state and local environmental laws and regulations and is involved in environmental proceedings concerning the investigation and remediation of numerous sites. In those instances where it is probable that the Company will incur costs from such proceedings and the amounts can be reasonably determined the Company has recorded a liability. The Company believes that these legal, tax, and environmental proceedings will not have a material adverse effect on its consolidated financial position, cash flows, or results of operations. The tax returns of the Company's German subsidiaries are currently under examination by the German tax authorities (see Note 5). Note 15. Segment Data Sales and operating income by geographic location for the years ended December 31, 1993, 1992, and 1991, are shown on the following page. Identifiable assets are also shown as at years ended 1993, 1992, and 1991. See "Business" for a description of each business segment and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for capital expenditures and depreciation and amortization. ASI HOLDING CORPORATION AND SUBSIDIARIES QUARTERLY DATA (Unaudited) (Dollars in millions) First Second Third Fourth Sales $879.4 $995.5 $976.5 $979.1 Cost of sales 650.5 754.5 727.7 769.9 Income (loss) before income taxes and extraordinary loss (9.5) (28.2) 4.1 (46.9) Tax provision 8.1 6.1 7.2 14.8 Loss before extraordinary loss (17.6) (34.3) (3.1) (61.7) Extraordinary loss (Note 8) - (91.9) - - Net loss $(17.6) $(126.2) $ (3.1) $(61.7) ====== ======= ====== ====== Per share: Loss before extraordinary loss $ (.92) $ (1.63) $ (.13) $(2.60) Extraordinary loss - (3.87) - - Net loss $ (.92) $ (5.50) $ (.13) $(2.60) ====== ======= ====== ====== Average number of common shares (thousands) 23,699 23,756 23,690 23,756 First Second Third Fourth Sales $901.0 $995.9 $980.9 $914.1 Cost of sales 672.0 734.1 742.2 703.9 Income (loss) before income taxes (8.1) 11.4 (16.5) (39.3) Tax provision (benefit) 5.5 9.2 (1.5) (8.5) Net income (loss) $(13.6) $ 2.2 $(15.0) $(30.8) ====== ======= ====== ====== Per share: Net loss $ (.74) $ (.07) $ (.81) $(1.49) ====== ======= ====== ====== Average number of common shares (thousands) 23,339 23,470 23,467 23,506 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCING DISCLOSURE. Not applicable. MANAGEMENT ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information as of March 31, 1994, with respect to each person who is an executive officer or director of the Company: Name Age Position with Company Emmanuel A. Kampouris 59 Chairman, President and Chief Executive Officer, and Director Horst Hinrichs 61 Senior Vice President, Transportation Products, and Director George H. Kerckhove 56 Senior Vice President, Plumbing Products, and Director Fred A. Allardyce 52 Vice President and Chief Financial Officer Alexander A. Apostolopoulos 51 Vice President and Group Executive, Americas, Plumbing Products Thomas S. Battaglia 51 Vice President and Treasurer Roberto Canizares M. 44 Vice President, Air Conditioning Products' Asia/America Zone Wilfried Delker 53 Vice President and Group Executive, Worldwide Fittings, Plumbing Products Adrian B. Deshotel 48 Vice President, Human Resources Cyril Gallimore 65 Vice President, Systems and Technology Luigi Gandini 55 Vice President and Group Executive, European Plumbing Products Daniel Hilger 53 Vice President and Group Executive, Air Conditioning Products in Europe, Middle East and Africa Joachim D. Huwendiek 63 Vice President, Automotive Products in Germany Name Age Position with Company Frederick W. Jaqua 72 Vice President and General Counsel and Secretary W. Craig Kissel 42 Vice President and Group Executive, Unitary Products Group William A. Klug 62 Vice President, Trane International Philippe Lamothe 57 Vice President, Automotive Products in France G. Eric Nutter 58 Vice President, Automotive Products in the United Kingdom Raymond D. Pipes 44 Vice President and Group Executive, Plumbing Products in the Far East Bruce R. Schiller 49 Vice President and Group Executive, Compressor Business James H. Schultz 45 Vice President and Group Executive, Commercial Systems Group G. Ronald Simon 52 Vice President and Controller Wade W. Smith 43 Vice President, U.S. Plumbing Products Benson I. Stein 56 Vice President, General Auditor Robert M. Wellbrock 47 Vice President, Taxes Shigeru Mizushima 50 Director Roger W. Parsons 52 Director Frank T. Nickell 46 Director J. Danforth Quayle* 47 Director John Rutledge 45 Director Joseph S. Schuchert* 65 Director * The Management Development Committee functions as the compensation committee of the Company. Since December 2, 1993, its members have been Messrs. Quayle and Schuchert. Prior thereto Mr. Schuchert and two other directors who retired in December, Richard M. Cyert and Edward Donley, served as members of the committee. Directors are elected to hold office until the next annual meeting of stockholders or until their successors are elected. Messrs. Kampouris, Mizushima, Nickell, and Schuchert were elected in 1988; Mr. Kerckhove in September 1990; Mr. Hinrichs in March 1991; Dr. Rutledge in March 1993; Mr. Quayle in September 1993; and Mr. Parsons in March 1994. Holding, Kelso ASI Partners, L.P. (the 73 percent owner of Holding) ("ASI Partners"), and executive officers and certain other management personnel of the Company who purchased shares of Holding common stock ("Management Investors") entered into a Stockholders Agreement that, among other things, provides for arrangements regarding the control of the election of directors of Holding. Until the earlier of (i) the occurrence of a public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Holding common stock to the public and underwritten by an investment banking firm of nationally recognized standing and (ii) July 7, 1998, the Management Investors as a group are entitled to nominate at least two directors to the Board of Directors of Holding, and ASI Partners is entitled to nominate the remaining directors. As a result, during such period ASI Partners will control the Board of Directors. To effectuate their rights, the Management Investors and ASI Partners have agreed in the Stockholders' Agreement to grant an irrevocable proxy to the Secretary of Holding to vote their shares of common stock in accordance with such nominations. Such grant of an irrevocable proxy terminates upon Holding's becoming subject to the proxy rules under the Securities Exchange Act of 1934. At present the Board of Directors of Holding consists of nine directors. The sole holder of the outstanding common stock of American Standard Inc. is Holding, and Holding exclusively elects the directors of American Standard Inc. Currently the directors of Holding are also the directors of American Standard Inc. Set forth below is the principal occupation of each of the executive officers and directors named above during the past five years (except as noted, all positions are with the Company). Mr. Kampouris was elected Chairman in December 1993 and President and Chief Executive Officer in February 1989. Prior thereto he was Senior Vice President, Building Products, from 1984 to February 1989. He is also a director of Daido Hoxan Inc. Mr. Kampouris has served as a director of the Company since July 1988. Mr. Hinrichs was elected Senior Vice President, Transportation Products, in December 1990. Prior thereto he served as Vice President and Group Executive, Automotive Products, from 1987 to 1990. Mr. Hinrichs has served as a director of the Company since March 1991. Mr. Kerckhove was elected Senior Vice President, Plumbing Products, in June 1990. Prior thereto he was Vice President (from 1985 until June 1990) and Group Executive (from 1988 until June 1990) of European Plumbing Products. Mr. Kerckhove has served as a director of the Company since September 1990. Mr. Allardyce was elected Vice President and Chief Financial Officer in January 1992. Prior thereto he served as Vice President and Controller from February 1983 until December 1991. Mr. Apostolopoulos was elected Vice President and Group Executive, Americas Plumbing Products, in December 1990. Prior thereto he served as the executive in charge of Plumbing Products' joint ventures from September 1989 to November 1990 and Managing Director of the Company's Egyptian subsidiary from July 1984 to August 1989. Mr. Battaglia was elected Vice President and Treasurer in September 1991. Prior thereto he was Assistant Treasurer. Mr. Canizares was elected Vice President, Air Conditioning Products' Asia/America Zone, in December 1990. Prior thereto he served as the executive in charge of this zone and Manager of Planning and Distribution from November 1986 to November 1990. Mr. Delker was elected Vice President and Group Executive, Worldwide Fittings, Plumbing Products, in April 1990. Prior thereto he served as executive in charge of the Company's brass fittings manufacturing operations from June 1982 until March 1990. Mr. Deshotel was elected Vice President, Human Resources, in January 1992. Prior thereto he served as Group Vice President, Human Resources, for U.S. Plumbing Products from September 1986 until December 1991. Mr. Gallimore was elected Vice President, Systems and Technology, in December 1990. Prior thereto he served as the executive in charge of Manufacturing and Technology from 1984 to November 1990. Mr. Gandini was elected Vice President and Group Executive, European Plumbing Products, in July 1990. Prior thereto he served as General Manager of Ideal Standard S.p.A., the Italian subsidiary of the Company, from January 1978 until June 1990. Mr. Hilger was elected Vice President and Group Executive, Air Conditioning Products, in Europe, Middle East and Africa, in June 1988. Mr. Huwendiek was elected Vice President, Automotive Products in Germany, in January 1992. Prior thereto he served as Managing Director of WABCO Germany since June 1987. Mr. Jaqua was elected Vice President and General Counsel and Secretary in April 1989. Prior thereto he was Associate General Counsel and Assistant Secretary. Mr. Kissel was elected Vice President in charge of Air Conditioning Products' Unitary Products Group in January 1992, becoming Group Executive in March 1994. He served as Vice President, Sales and Distribution, for Air Conditioning Products, from December 1990 until January 1992 and served as divisional Senior Vice President in charge of U.S. Sales from January to November 1990. He was in charge of Western Regional Sales from January 1989 to January 1990. Mr. Klug was elected Vice President in 1985 and has been in charge of Trane International since December 1993. He served as Group Executive, Unitary Products Group, from April 1990 until December 1993. He was Group Executive, North American Sales and Distribution, Air Conditioning Products, from October 1987 to March 1990. Mr. Lamothe was elected Vice President, Automotive Products in France, in January 1992. He served as Group Vice President of the French transportation business during 1991 and prior thereto was General Manager of the French transportation subsidiary. Mr. Nutter was elected Vice President, Automotive Products in the United Kingdom, in January 1992. Prior thereto he served as Vice President and General Manager of WABCO Transportation U.K. Limited, the United Kingdom transportation subsidiary of the Company from March 1991 until December 1991 and Group Managing Director of the United Kingdom transportation subsidiary from June 1987 until February 1991. Mr. Pipes was elected Vice President and Group Executive for the Far East Region of Plumbing Products in May 1992. Prior thereto he served as Managing Director of the Company's Philippine subsidiary from May 1990 until April 1992 and was Group Vice President, Control & Finance, of U.S. Plumbing Products from March 1985 until April 1990. Mr. Schiller was elected Vice President and Group Executive, Compressor Business (Air Conditioning Products) in March 1994. Prior thereto he served as General Manager, Compressor Business Group, from May 1993 to February 1994 and Manager and then General Manager of the Company's Tyler, Texas, facility from March 1986 to April 1993. Mr. Schultz was elected Vice President and Group Executive, Commercial Systems, in 1987. Mr. Simon was elected Vice President and Controller in January 1992. Prior thereto he served as Vice President and Controller of the Air Conditioning Products' Commercial Systems Group from December 1984 to December 1991. Mr. Wade W. Smith was elected Vice President, U.S. Plumbing Products, in May 1992. Prior thereto he served as Group Vice President in charge of the Chinaware Business Unit of U.S. Plumbing Products from February 1992 until April 1992 and from April 1987 to February 1992 he was Vice President and General Manager of the Building Automation Systems Division of the Commercial Systems Group of Air Conditioning Products. Mr. Stein was elected Vice President, General Auditor, in March 1994; from December 1986 to February 1994 he was the Company's General Auditor. Mr. Wellbrock was elected Vice President, Taxes, effective January 1, 1994. Prior thereto he served as Director of Taxes from 1988 through 1993. Mr. Mizushima has been President and Chief Operating Officer of Daido Hoxan Inc. since the merger in April 1993 of Hoxan Corporation with Daido Sanso Company (a subsidiary of Air Products and Chemicals Inc.). Prior thereto Mr. Mizushima was President of Hoxan Corporation, a position he held since 1984. He is also a director of Daido Hoxan. Daido Hoxan Inc is the second largest supplier of industrial gases in Japan. One of its subsidiaries is a distributor of American-Standard plumbing products in Japan. Mr. Mizushima has served as a director of the Company since July 1988. Mr. Nickell has been President and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Nickell was a general partner of Kelso & Company, L.P. He is also a director of Club Car, Inc.; King Holding Corp; and Tyler Holdings Corporation. Mr. Nickell has served as a director of the Company since May 1988. Mr. Parsons is Managing Director of Rea Brothers Group PLC ("Rea Brothers Group"), which he joined in 1988 after a long banking career. Rea Brothers Group is a U.K. holding company of subsidiaries engaged in the investment banking business. He also holds directorships in several subsidiaries of Rea Brothers Group. Mr. Parsons was elected as a director of the Company on March 2, 1994. Mr. Quayle served as Vice President of the United States from January 1989 to January 1993. Since leaving that office Mr. Quayle has been associated with Circle Investors, Inc. (an investment planning and consulting firm), and FX Strategic Advisors, Inc. (an international trade consulting firm), both of which he serves as Chairman. He is a Director of Central Newspapers, Inc. Mr. Quayle has served as a director of the Company since September 1993. Dr. Rutledge has been Chairman of Rutledge & Company, Inc., a merchant banking firm, since January 1991. He is the founder and Chairman of Claremont Economics Institute, an economic research firm established in 1975. He is also a director of Earle M. Jorgensen & Company, Lazard Freres Funds, Medical Specialties Group, and Utendahl Capital Partners and is a special advisor to Kelso & Company. Dr. Rutledge has served as a director of the Company since March 1993. Mr. Schuchert has been Chairman, CEO, and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Schuchert was managing general partner of Kelso & Company, L.P. He is also a director of Earle M. Jorgensen & Company. Mr. Schuchert has served as a director of the Company since May 1988. On December 23, 1992, Kelso & Company and its chief executive officer, Mr. Schuchert, without admitting or denying the findings contained therein, consented to an administrative order in respect of a Securities and Exchange Commission ("Commission") inquiry relating to the 1990 acquisition of a portfolio company by a Kelso affiliate. The order found that Kelso's tender offer filing in connection with the acquisition did not comply fully with the Commission's tender offer reporting requirements, and required Kelso and Mr. Schuchert to comply with these requirements in the future. Compensation Committee Interlocks and Insider Participation Mr. Schuchert is a member of the Management Development Committee (the Compensation Committee) of the Company's Board of Directors. He is Chairman of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.) and a general partner of American Standard Partners, the general partner of Kelso ASI Partners. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V") in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P., is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Supplemental Plan benefits are based on credited years of service and average annual compensation for the highest three calendar years of the final ten calendar years of employment (not exceeding 60 percent of average annual compensation for such years of service) and are reduced by an offset consisting of certain other retirement benefits, including amounts payable under the Terminated Plan, annual allocations to the executive officer's Employee Stock Ownership Plan ("ESOP") accounts, and Social Security benefits. Benefits under the Supplemental Plan are vested after five years of service or employment continuation through age 65. Compensation used in determining Supplemental Plan benefits (covered compensation) includes only salary and bonus reflected in the Summary Compensation Table above. No covered compensation of any Named Officer differs by more than 10% from the salary and bonus set forth in the Summary Compensation Table. The years of credited service under the Supplemental Plan for the Named Officers are as follows: Mr. Kampouris, 28 years; Mr. Hinrichs, 35 years; Mr. Kerckhove, 32 years; Mr. Allardyce, 17 years; Mr. Gandini, 33 years; and Mr. H.T. Smith, 13 years. The current annual target benefit for Mr. Kampouris is approximately 20 percent higher than that shown in the above table since a different benefit formula under the pre-1990 version of the Supplemental Plan applies to his period of service and earnings prior to April 27, 1991. The method of calculating the lump sum payable to Mr. Kampouris that is attributable to his accrued benefit through April 27, 1991, has been adjusted to reflect the recent increase in the Federal ordinary income tax rates. An amendment to the Supplemental Plan in 1993 established minimum annual lump sum payments for certain Named Officers which, after giving effect to Plan offsets, are estimated as follows: Mr. Kampouris, $427,000; Mr. Hinrichs, $143,000; Mr. Kerckhove, $37,000; and Mr. Gandini, $24,000. Shares of Holding Common Stock distributable to Plan participants are delivered to a grantor's trust for their benefit. The trust will terminate following a public offering of Holding Common Stock, at which time shares or cash credited to each participant's account is to be distributed. Payment, however, may be deferred if an event of default under the Company's loan agreements or debt indentures has occurred or will occur as a result of such payment. Until distribution, assets of the trust are subject to the claims of creditors of Holding or the Company. Shares held by the trust are voted by the trustee in accordance with the Company's directions. Directors' Fees and Other Arrangements In the first half of 1993 each outside director was paid a fee of $5,000 per calendar quarter and in addition received a fee of $500 for each meeting of the Board attended; in the last half each outside director was paid a fee of $6,750 per calendar quarter and in addition received a fee of $1,000 for each meeting of the Board attended. Effective with the third quarter, an outside director is also paid $1,000 for attending a Committee meeting. (Previously an outside director was paid $500 for attending a Committee meeting not held on the day of a Board meeting.) The only directors currently eligible for directors' fees are directors who are neither employees of the Company or Kelso. They are Messrs. Mizushima, Parsons, Quayle, and Rutledge. All directors are reimbursed for reasonable expenses incurred in connection with attendance at any meetings. No separate directors' fees are paid for attendance at meetings of Holding that are held on the same day the Company's Board meets. A Supplemental Compensation Plan for Outside Directors ("Supplemental Compensation Plan") was adopted in June 1989. A Plan Account was establish- ed for each participating director at that time consisting of units equivalent to $50,000 of Holding common stock with each unit having a value of $19 per share, the independently appraised value of the shares of Holding as of December 31, 1988. For the purpose of providing a measure of parity among the directors, the $50,000 amount was increased to $100,000 for participating directors who became Board Members after January 1, 1993, with such amount converted into units for the account of such directors at the rate of $42.96 per unit ($42.96 representing the independently appraised value of the shares of Holding as of December 31, 1992). When a participating director ceases to be a member of the Board, he or his beneficiary will receive a cash payment equal to the number of units in his Plan Account multiplied by the per-share value of Holding common stock based on the then last year-end appraisal. If a participating director is removed for cause, his entire interest in the Plan is forfeited. Employee-directors and Messrs. Nickell and Schuchert do not participate in this Plan. Mr. Donley and Dr. Cyert, directors who retired in December 1993, each received a payment of $113,053 pursuant to the Supplemental Compensation Plan. Corporate Officers Severance Plan and Other Employment or Severance Arrangements The Board of Directors approved a severance plan for executive officers (the "Officers Severance Plan"), effective April 27, 1991. The Officers Severance Plan provides that any participant whose employment is involuntarily terminated by the Company without "Cause" (as defined in the Officers Severance Plan) or who leaves the Company for "Good Reason" (as defined in the Officers Severance Plan) shall be paid an amount equal to the sum of two (three in the case of the Chief Executive Officer) times such participant's annual base salary at the rate in effect at the time of termination, a proration of the then Annual Incentive Plan target award (described previously), and one (two in the case of the Chief Executive Officer) times such target award. In addition, group life, accident, and disability insurance coverages, as well as group medical coverage, will be continued for up to 24 (36 in the case of the Chief Executive Officer) months following such officer's termination. The Named Officers (other than Mr. Smith, who retired in December 1993) are participants in this Plan. An agreement was entered into with H. Thompson Smith in December 1993 concerning the terms of his termination of employment and retirement. Under that agreement he is entitled to receive his 1993 Annual Incentive Plan award in the amount of $154,000 and will be entitled to receive the same amount in March 1995. In addition, Mr. Smith is retained as a consultant through 1995 at the rate of $29,583 per month. In the event of Mr. Smith's death, the fees remaining through the end of 1995 are payable in a lump sum to his spouse or estate. He is also entitled to receive payments under the Company's Long-Term Incentive Compensation Plan for the 1992-1994 and 1993-1995 performance periods in accordance with its terms, such awards to be prorated to December 31, 1993. Mr. Smith continues under the Company's medical and life insurance programs through 1995. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None Signatures Pursuant to the requirements of Section 13 or 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. ASI HOLDING CORPORATION By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) ASI HOLDING CORPORATION AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991 Report of Independent Auditors 84 III Condensed Financial Information of Registrant 85-88 V Facilities 89 VI Accumulated Depreciation of Facilities 90 VIII Reserves 91 IX Short-Term Borrowings 92 X Supplementary Income Statement Information 93 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors ASI Holding Corporation We have audited the consolidated financial statements of ASI Holding Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (Parent Company Separately) (Dollars in thousands) Year Ended Year Ended December 31, December 31, 1993 1992 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (208,567) $ (57,238) Adjustments to reconcile net loss to net cash provided by operating activities: Equity in net loss of subsidiary 208,567 57,238 - --------------------------------------------------------------------- Net cash flow from operating activities 0 0 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY INVESTING ACTIVITIES: Investment in subsidiary (4,585) (3,103) Purchase of common stock by subsidiary 12,194 10,950 - --------------------------------------------------------------------- Net cash provided by investing activities 7,609 7,847 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY FINANCING ACTIVITIES: Issuance of common stock 4,585 3,103 Common stock repurchased (12,194) (10,950) Repayments on subscriptions receivable 482 653 Repayment of loan from subsidiary (482) (653) - --------------------------------------------------------------------- Net cash used by financing activities (7,609) (7,847) - --------------------------------------------------------------------- Net change in cash and cash equivalents $ 0 $ 0 ===================================================================== See notes to the financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (cont'd) NOTES TO FINANCIAL STATEMENTS (Parent Company Separately) (A) The notes to the consolidated financial statements of ASI Holding Corporation (the "Parent Company" or "Holding") are an integral part of these condensed financial statements. (B) Holding was organized by Kelso & Company, L.P., a private merchant banking firm, to participate in the acquisition of American Standard Inc. American Standard Inc. is now a wholly owned subsidiary of Holding. Holding has no other investments or operations. ASI HOLDING CORPORATION INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of ASI Holding Corporation, the Registrant, and for all Exhibits incorporated by reference is 33-23070, except those Exhibits incorporated by reference in filings made by American Standard Inc. (the "Company") whose File Number is 1-470) (3) (i) Certificate of Incorporation of ASI Holding Corporation ("Holding"); previously filed as Exhibit 3.1 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (ii) Amendment to Certificate of Incorporation amending Article FOURTH thereof; previously filed as Exhibit (3)(ii) in Holding's Form 10-K for the fiscal year ended December 31, 1991, and herein incorporated by reference. (iii) By-laws of Holding; previously filed as Exhibit 3.2 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit 4(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee, under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit (4)(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture, dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; copy of Indenture previously filed as Exhibit (4)(i) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; copy of Indenture previously filed as Exhibit (4)(iii) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit (4)(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in (4)(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Debenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above; copy of Amendment is being filed as Exhibit (4)(xvii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 to the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Paragraph 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993. (xxii) Revised Schedule of Priorities, effective as of September 5, 1991, as adopted by the Board of Directors of Holding pursuant to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in l0(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (l0)(iv) by the Company in its Form l0-K for the year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan; copy of Trust Agreement being filed as Exhibit (10)(iv) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year, and herein incorporated by reference. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) by the Company in its Form l0-K for the fiscal year ended December 31, 1988, and is herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993; copy of restated program is being filed as Exhibit (10)(vii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Amended Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, and is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (l0)(xiv) by the Company in its Form l0-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors as amended through September 1993; copy of Plan is being filed as Exhibit (10)(xv) by the Company in its Form l0-K for the year ended December 31, 1993 concurrently with the filing of Holding's 10-K for the same year and herein incorporated by reference. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit (l0)(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted by the Company in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvi) Estate Preservation Plan, adopted by the Company in December, 1990; previously filed as Exhibit (l0)(xx) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above; copy of Amendment is being filed as Exhibit (10)(xix) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Summary of terms of Unfunded Deferred Compensation Plan adopted December 2, 1993; copy of Summary is being filed as Exhibit (10)(xviii) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company; copy of Agreement is being filed as Exhibit (10)(xix) by Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (21) Listing of Holding's subsidiaries. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None Signatures Pursuant to the requirements of Section 13 or 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. ASI HOLDING CORPORATION By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) ASI HOLDING CORPORATION AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991 Report of Independent Auditors 84 III Condensed Financial Information of Registrant 85-88 V Facilities 89 VI Accumulated Depreciation of Facilities 90 VIII Reserves 91 IX Short-Term Borrowings 92 X Supplementary Income Statement Information 93 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors ASI Holding Corporation We have audited the consolidated financial statements of ASI Holding Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (Parent Company Separately) (Dollars in thousands) Year Ended Year Ended December 31, December 31, 1993 1992 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (208,567) $ (57,238) Adjustments to reconcile net loss to net cash provided by operating activities: Equity in net loss of subsidiary 208,567 57,238 - --------------------------------------------------------------------- Net cash flow from operating activities 0 0 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY INVESTING ACTIVITIES: Investment in subsidiary (4,585) (3,103) Purchase of common stock by subsidiary 12,194 10,950 - --------------------------------------------------------------------- Net cash provided by investing activities 7,609 7,847 - --------------------------------------------------------------------- CASH PROVIDED (USED) BY FINANCING ACTIVITIES: Issuance of common stock 4,585 3,103 Common stock repurchased (12,194) (10,950) Repayments on subscriptions receivable 482 653 Repayment of loan from subsidiary (482) (653) - --------------------------------------------------------------------- Net cash used by financing activities (7,609) (7,847) - --------------------------------------------------------------------- Net change in cash and cash equivalents $ 0 $ 0 ===================================================================== See notes to the financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (cont'd) NOTES TO FINANCIAL STATEMENTS (Parent Company Separately) (A) The notes to the consolidated financial statements of ASI Holding Corporation (the "Parent Company" or "Holding") are an integral part of these condensed financial statements. (B) Holding was organized by Kelso & Company, L.P., a private merchant banking firm, to participate in the acquisition of American Standard Inc. American Standard Inc. is now a wholly owned subsidiary of Holding. Holding has no other investments or operations. ASI HOLDING CORPORATION INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of ASI Holding Corporation, the Registrant, and for all Exhibits incorporated by reference is 33-23070, except those Exhibits incorporated by reference in filings made by American Standard Inc. (the "Company") whose File Number is 1-470) (3) (i) Certificate of Incorporation of ASI Holding Corporation ("Holding"); previously filed as Exhibit 3.1 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (ii) Amendment to Certificate of Incorporation amending Article FOURTH thereof; previously filed as Exhibit (3)(ii) in Holding's Form 10-K for the fiscal year ended December 31, 1991, and herein incorporated by reference. (iii) By-laws of Holding; previously filed as Exhibit 3.2 in Registration Statement No. 33-23070 under the Securities Act of 1933, as amended, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit 4(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee, under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit (4)(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture, dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; copy of Indenture previously filed as Exhibit (4)(i) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; copy of Indenture previously filed as Exhibit (4)(iii) by the Company in its Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit (4)(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in (4)(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Debenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above; copy of Amendment is being filed as Exhibit (4)(xvii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 to the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Paragraph 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993. (xxii) Revised Schedule of Priorities, effective as of September 5, 1991, as adopted by the Board of Directors of Holding pursuant to the Stockholders Agreement dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) in Holding's Form l0-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in l0(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (l0)(iv) by the Company in its Form l0-K for the year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan; copy of Trust Agreement being filed as Exhibit (10)(iv) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year, and herein incorporated by reference. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) by the Company in its Form l0-K for the fiscal year ended December 31, 1988, and is herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993; copy of restated program is being filed as Exhibit (10)(vii) by the Company in its Form 10-K for the year ended December 31, 1993, concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Amended Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, and is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (l0)(xiv) by the Company in its Form l0-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors as amended through September 1993; copy of Plan is being filed as Exhibit (10)(xv) by the Company in its Form l0-K for the year ended December 31, 1993 concurrently with the filing of Holding's 10-K for the same year and herein incorporated by reference. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit (l0)(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted by the Company in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (xvi) Estate Preservation Plan, adopted by the Company in December, 1990; previously filed as Exhibit (l0)(xx) by the Company in its Form l0-K for the year ended December 31, 1990, and said Plan is herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above; copy of Amendment is being filed as Exhibit (10)(xix) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xviii) Summary of terms of Unfunded Deferred Compensation Plan adopted December 2, 1993; copy of Summary is being filed as Exhibit (10)(xviii) by the Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company; copy of Agreement is being filed as Exhibit (10)(xix) by Company in its Form 10-K for the year ended December 31, 1993 concurrently with the filing of Holding's Form 10-K for the same year and herein incorporated by reference. (21) Listing of Holding's subsidiaries.	50,522	328,632
806085_1993.txt	806085_1993	1993	806085	ITEM 1. BUSINESS GENERAL As used herein, "Holdings" or the "Registrant" means Lehman Brothers Holdings Inc., a Delaware corporation, incorporated on December 29, 1983. American Express Company, a New York corporation ("American Express"), owns 100 percent of the outstanding common stock of Holdings, which represents approximately 93 percent of Holdings' issued and outstanding voting stock. The remainder of Holdings' voting stock, the 5% Cumulative Convertible Voting Preferred Stock, Series A (the "Series A Preferred Stock"), is owned by Nippon Life Insurance Company ("Nippon Life"). Assuming the exercise by Nippon Life of a warrant to purchase shares of Holdings' common stock, American Express' ownership percentage of Holdings' voting stock would be 88 percent. Holdings and its subsidiaries are collectively referred to as the "Company" or "Lehman Brothers," and the principal subsidiary of Holdings, Lehman Brothers Inc., a Delaware corporation, is referred to herein as "LBI." The Company is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. Its executive offices are located at 3 World Financial Center, New York, New York 10285 and its telephone number is (212) 298-2000. Distribution of Holdings Common Stock On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all the common stock of Holdings (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Change of Fiscal Year On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $30 million pre-tax in the first quarter of 1994 as a result of these terminations. The Primerica Transaction On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation) ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participation Right payment in the first quarter of 1994. It is anticipated that all of the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, the Company received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39.00 per share. In August 1993, American Express purchased such preferred stock and warrant from LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. The Mellon Transaction On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between Lehman Brothers and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction") The Boston Company, Inc. ("The Boston Company") which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50.00 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million. Shearson Lehman Hutton Mortgage Corporation Transaction LBI completed the sale of its wholly owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC"), to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire indebtedness of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. The Company's worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by offices in 19 additional locations in the United States, 11 in Europe and the Middle East, four in Latin and South America and seven in the Asia Pacific region. The Company is engaged primarily in providing financial services. Other businesses in which the Company is engaged represent less than 10 percent of consolidated assets, revenues or pre-tax income. The Company's business includes capital raising for clients through securities underwriting and direct placements; corporate finance and strategic advisory services; merchant banking; securities sales and trading; asset management; research; and the trading of foreign exchange, derivative products and certain commodities. The Company acts as a market maker in all major equity and fixed income products in both the domestic and international markets. Lehman Brothers is a member of all principal securities and commodities exchanges in the United States, as well as the National Association of Securities Dealers, Inc. ("NASD"), and holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt and Milan stock exchanges. Since 1990, Lehman Brothers has followed a "client/customer-driven" strategy. Under this strategy, Lehman Brothers concentrates on serving the needs of major issuing and advisory clients and investing customers worldwide to build an increasing "flow" of business that leverages the Company's capabilities and generates a majority of the Company's revenues and profits. Developing lead relationships with issuing clients and investing customers is a central premise of the Company's client/customer-driven strategy. Based on management's belief that each client and customer directs a majority of its financial transactions to a limited number of investment banks, Lehman Brothers' investment banking and sales professionals work together with global products and services professionals to identify and develop lead relationships with priority clients and customers worldwide. The Company believes that such relationships position Lehman Brothers to receive a substantial portion of its clients' and customers' financial business and lessen the volatility of revenues generally associated with the securities industry. Lehman Brothers' strategy consists of the following four key elements: (1) Focused coverage of major issuing clients and institutional and high net worth individual investing customers. The Company's Investment Banking and Sales areas develop and maintain relationships with clients and customers to understand and meet their financial needs. Business volume generated through these relationships accounts for the majority of Lehman Brothers' business. (2) Comprehensive product and service capabilities. Lehman Brothers has built capabilities in major product and service categories to enable the Company to develop lead relationships with its clients and customers, meet their diverse needs and increase the Company's overall volume of business. Each of these product and service capabilities is provided to clients and customers by Investment Banking and Sales. (3) Global scope of business activities. Lehman Brothers pursues a global strategy in order to: (i) enhance the Company's product and service capabilities; (ii) position the Company to increase its flow of business as the international markets continue to expand; (iii) leverage the Company's infrastructure to benefit from economies of scale; and (iv) geographically diversify the Company's revenues. (4) Organizational structure that enables and encourages the Company's business units to act in a coordinated fashion as "One Firm." The Company is organized to provide the delivery of products and services through teams comprised of professionals with specialized expertise focused on meeting the financial objectives of the Company's clients and customers. Lehman Brothers also engages in activities such as arbitrage and proprietary trading which leverage the Company's expertise and infrastructure and provide attractive profit opportunities, but generally entail a higher degree of risk as the Company makes investments for its own account. FOCUSED CLIENT AND CUSTOMER COVERAGE Investment Banking Lehman Brothers is a leading underwriter of equity and equity-related securities in the equity capital markets and of taxable and tax-exempt fixed income securities denominated in U.S. dollars and other currencies in the fixed income markets. The Company also engages in project and real estate financings around the world. According to Securities Data Company, Inc., Lehman Brothers was the third ranked underwriter of debt and equity securities worldwide in 1993, compared to a ranking of eighth in 1990. During 1993, Lehman Brothers lead managed 784 offerings of debt and equity securities worldwide with a total volume of $129.4 billion. Investment Banking professionals are responsible for developing and maintaining relationships with issuing clients, gaining a thorough understanding of their specific needs and bringing together the full resources of Lehman Brothers to accomplish their financial objectives. Investment Banking is organized into industry and geographic coverage groups, enabling individual bankers to develop specific expertise in particular industries and markets. Industry coverage groups include consumer products, financial institutions, health care, industrial, media, merchandising, natural resources, real estate, technology, telecommunications, transportation and utilities. Where appropriate, professionals with specialized expertise in Strategic Advisory, Equities, Fixed Income, Foreign Exchange, Commodities, Derivatives and Project Finance are integrated into the client coverage teams. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, divestitures, leveraged transactions, takeover defenses, spin-offs, corporate reorganizations and recapitalizations, tender and exchange offers, privatizations, opinion letters and valuations. The Company's Strategic Advisory Group works closely with industry and geographic coverage investment bankers and product specialists around the world. As mergers and acquisitions activity has become increasingly global, Lehman Brothers has maintained its position as a leader in cross-border transactions. In 1993, Lehman Brothers was ranked fourth in terms of mergers and acquisitions transactions worldwide according to Securities Data Company, Inc., the same ranking it held in 1990. In 1993, the Company advised clients worldwide on transactions totaling $23.2 billion. Lehman Brothers has increased its international presence during the past few years in recognition of the current and anticipated growth in international markets. Most recently, in 1993 the Company strengthened its presence in Germany, initiated banking coverage of the People's Republic of China, and in early 1994, opened an office in Beijing. During 1993, Lehman Brothers also brought together resources from around the world to advise on a complete range of financial and strategic issues in other emerging markets such as Mexico and Turkey. Institutional Sales Institutional Sales serves the investing and liquidity needs of major institutional investors worldwide and provides the distribution mechanism for new issues and secondary market securities. Lehman Brothers maintains a network of over 750 sales professionals in 19 locations around the world. Institutional Sales focuses on the major institutional investors that constitute the major share of global buying power in the financial markets. Lehman Brothers' goal is to be considered one of the top three investment banks by such institutional investors. By serving the needs of these customers, the Company also gains insight into investor sentiment worldwide regarding new issues and secondary products and markets, which in turn benefits the Company's issuing clients. Institutional Sales is organized into four distinct sales forces, operating globally and specialized by the following product types: Equities, Fixed Income, Foreign Exchange/Commodities and Asset Management. Institutional Sales professionals work together to coordinate coverage of major institutional investors through customer teams. Depending on the size and investment objectives of the institutional investor, a customer team can be comprised of from two to five sales professionals, each specializing in a specific product. This approach positions Lehman Brothers to understand and to deliver the full resources of the Company to its customer base. High Net Worth and Middle Market Sales The Company's Financial Services Division serves the investment needs of high net worth individual investors and small and mid-sized institutions. This division has one of the largest sales forces of its kind among major investment banks, with over 500 investment representatives located in seven offices in the major financial centers of the United States and 19 offices in major financial centers in Latin America, Europe, the Middle East and the Asia Pacific region. The Company's investment representatives provide investing customers with ready access to Lehman Brothers' equity and fixed income research, execution capabilities and global product offerings. The Financial Services Division also enables the Company's issuing clients to access a diverse investor base throughout the world. The global network of investment representatives is supported by the Investor Services Group located in New York, London and Hong Kong. This group provides an integrated, global approach to transaction execution, marketing support, asset allocation strategies, and product development. The Investor Services Group also works closely with Lehman Brothers Global Asset Management to develop proprietary product offerings for investing customers. Through Lehman Brothers Bank (Switzerland) S.A. (the "Bank"), the Financial Services Division provides high net worth investors the traditional personalized services of a Swiss bank, combined with the global resources of a leading securities company. The Bank's services include deposit facilities, international investment products, multi-currency secured lending and global custodial services. COMPREHENSIVE PRODUCT AND SERVICE CAPABILITIES Lehman Brothers provides equity, fixed income, foreign exchange, commodities, asset management and merchant banking products and services to clients and customers worldwide. Each area is organized on a global basis, and professionals are integrated into teams, supported by a dedicated administrative and operations staff, to provide the highest quality products and services. Equities Lehman Brothers combines professionals from the sales, trading, financing, derivatives and research areas of Equities, together with investment bankers, into teams to serve the financial needs of the Company's equity clients and customers. The integrated nature of the Company's global operations and the equity expertise delivered through the Company's client and customer teams enable Lehman Brothers to structure and execute global equity transactions for clients worldwide. The Company is a leading underwriter of initial public and secondary offerings of equity and equity-related securities. Lehman Brothers also makes markets in these and other securities, and executes block trades on behalf of clients and customers. The Company also actively participates in assisting governments around the world in raising equity capital as part of their privatization programs. According to Securities Data Company, Inc., Lehman Brothers ranked fourth in lead managed equity and equity-related securities offerings worldwide in 1993, compared to a ranking of sixth in 1990. During 1993, the Company lead managed 138 equity offerings worldwide totaling $10.6 billion. The Equities product group is responsible for the Company's equity operations and all dollar and non-dollar equity and equity-related products worldwide. These products include listed and over-the-counter ("OTC") securities, American Depository Receipts, convertibles, options, warrants and derivatives. The Company participates in the global equity and equity-related markets in all major currencies through its worldwide presence and membership in major stock exchanges, including among others, those in New York, London, Tokyo, Hong Kong, Frankfurt and Milan. During 1993, Lehman Brothers made markets in the top 300 NASDAQ stocks as measured by volume. The Company also makes markets in almost all major European large capitalization stocks. In addition, the Company's convertible securities trading professionals make markets in nearly 300 convertible debenture issues and 100 convertible preferred stock issues around the world. Derivative Products. Lehman Brothers offers equity derivative capabilities across a wide spectrum of products and currencies, including listed options and futures, portfolio trading, OTC options, equity swaps, warrants and similar products. In 1993, Lehman Brothers developed and marketed several innovative products designed to help investors establish or hedge positions in global markets and currencies. These included products such as certain call and put warrants that use major stock indices as a benchmark, including the Hang Seng, the FT-SE Eurotrack 200, the Mexican Bolsa, and the Nikkei Index. Warrants were also issued on baskets of stocks, including the Company's Ten Uncommon Valuessm, which is based on the recommendations of Lehman Brothers' equity research analysts. In addition, Lehman Brothers lead managed the largest ever stand-alone U.S. corporate warrant issue in 1993. Equities Research. The Equities research department is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Equities research is to have in place high quality research analysts covering industry and geographic sectors that support the activities of the Company's clients and customers. The Equities research department is comprised of regional teams staffed by industry specialists, covering more than 50 industry sectors and 1,000 companies worldwide from locations in New York, London, Hong Kong and Tokyo. During 1993, the Company expanded its global economics coverage and technical market analysis capabilities. Equity Finance. Lehman Brothers operates a comprehensive equity finance business to support the funding, sales and trading activities of the Company and its clients and customers. Margin lending for the purchase of equities and equity derivatives, securities lending and short sale facilitation are among the main functions of the equity finance group. This group also engages in a conduit business, whereby the Company seeks to earn a positive net spread on matched security borrowing and lending activities. Fixed Income Lehman Brothers actively participates in all major fixed income product areas worldwide and maintains a 24-hour trading presence in global fixed income securities. The Company combines professionals from the sales, trading, financing, derivatives and research areas of Fixed Income, together with investment bankers, into teams to serve the financial needs of the Company's clients and customers. The Company is a leading underwriter of new issues, and also makes markets in these and other fixed income securities. The Company's global presence facilitates client and customer transactions and provides liquidity in marketable fixed and floating rate debt securities. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed fixed income securities offerings worldwide in 1993, compared to a ranking of ninth in 1990. During 1993, the Company lead managed 646 offerings worldwide for a total of $118.8 billion of fixed income securities. Fixed Income products consist of dollar and non-dollar government, sovereign and supranational agency obligations; money market products; corporate debt securities; mortgage and asset-backed securities; emerging market securities; municipal and tax-exempt securities; derivative products and research. In addition, the Company's central funding operation provides global access to cost efficient debt financing sources, including repurchase agreements, for the Company and its clients and customers. Government and Agency Obligations. Lehman Brothers is one of the leading 39 primary dealers in U.S. Government securities, as designated by the Federal Reserve Bank of New York, and participates in the underwriting of, and maintains positions in, U.S. Treasury bills, notes and bonds, and securities of federal agencies. The Company is also a market maker in the government securities of all G7 countries, and participates in other major European and Asian government bond markets. Money Market Products. Lehman Brothers is a global market leader in the origination and distribution of short-term debt obligations, including commercial paper, short-term notes, preferred stock and Money Market Preferred Stock(R). The Company is an appointed dealer for approximately 600 commercial paper programs on behalf of companies and government agencies worldwide. Corporate Debt Securities. Lehman Brothers is a leader in the underwriting and market making of fixed, floating dollar and non-dollar investment grade debt worldwide and trades in approximately $2.0 billion of these securities on a daily basis. According to Securities Data Company, Inc., during 1993, Lehman Brothers ranked third in new issue domestic investment grade debt. The Company also underwrites and makes markets in non-investment grade debt securities and bank loans. Lehman Brothers trades in excess of $2.0 billion of high yield securities on a monthly basis. Mortgage and Asset-Backed Securities. The Company is a leading underwriter of and market maker in mortgage and asset-backed securities. Lehman Brothers makes markets and trades in the full range of U.S. agency-backed mortgage products, as well as public and private collateralized mortgage obligations and whole loan products. The Company's trading activity in the secondary mortgage market exceeds $4.0 billion on a daily basis. According to Securities Data Company, Inc., the Company ranked second with $39.9 billion of residential, commercial and multi-family mortgage securities underwritten on a lead managed basis in 1993. Emerging Market Securities. The Company is a leader in the trading, structuring and underwriting of Latin American, Eastern European, and Asian dollar and local currency instruments. In 1993, the emerging markets group lead managed over $1 billion of new issues and traded over $150 billion of loans and Brady bonds. Municipal and Tax-Exempt Securities. Lehman Brothers is a leading dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities, and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds. Lehman Brothers is also a leader in the structuring, underwriting and sale of tax-exempt and taxable securities and derivative products for city, state, not-for-profit and other public sector clients. The Company's Public Finance group advises state and local governments on the issuance of municipal securities, and works closely with the municipal sales and trading area to underwrite both negotiated and competitive short-and long-term offerings. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed municipal securities offerings in 1993 with a total volume of $29.3 billion. Derivative Products. The Company offers a broad range of derivative product services in more than 15 currencies on a 24-hour basis in nine major financial centers. Derivatives professionals are integrated into all of the Company's major fixed income product areas. In 1993, Lehman Brothers assisted over 1,000 clients and customers worldwide, in the execution of over 3,900 transactions aggregating over $265 billion (notional amount). In 1993, the Company introduced several new derivative products to meet the needs of both issuers and investors, including Step-Up Recovery Floating Rate Notes and Range Floaters. These innovative products are designed to offer issuers and investors the opportunity to diversify their investment and liability portfolios. In late 1993, Lehman Brothers incorporated Lehman Brothers Financial Products Inc. ("LBFP"), a separately capitalized triple-A rated derivatives subsidiary. Lehman Brothers established LBFP to increase the volume of its derivatives business and capture additional underwriting and trading business. It is expected that LBFP will commence its derivatives activities in the third quarter of 1994. Central Funding. The central funding unit engages in two major activities, matched book funding and secured financing. Matched book funding involves lending cash on a short-term basis to institutional customers collateralized by marketable securities, typically government or government agency securities. These arrangements are classified on the Company's balance sheet as "securities purchased under agreements to resell." The Company may also enter into short-term contractual agreements, referred to as "securities sold under agreements to repurchase," whereby securities are pledged as collateral in exchange for cash. The Company enters into these agreements in various currencies and seeks to generate profits from the difference between interest earned and interest paid. Central funding works with the Company's institutional sales force to identify customers that have cash to invest and/or securities to pledge to meet the financing and investment objectives of the Company and its customers. Central funding also coordinates with the Company's treasury area to provide collateralized financing for a large portion of the Company's securities and other financial instruments owned. Fixed Income Research. Fixed Income research at Lehman Brothers encompasses a broad range of research disciplines: quantitative, economic, strategic, credit, portfolio and market-specific analysis. Fixed Income research is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Fixed Income research is to have in place high quality research analysts covering industry, geographic and economic sectors that support the activities of the Company's clients and customers. Fixed Income research specialists are based in New York, London, Tokyo and Hong Kong. Their expertise includes U.S. government and agency securities, sovereign and supranational issues, corporate securities, high yield, asset and mortgage-backed securities and emerging market debt. Fixed Income research expanded its quantitative capabilities and its coverage of the commercial real estate market during 1993. Foreign Exchange According to a leading market research firm, Lehman Brothers is one of the top two global investment banks that trade foreign exchange for clients and customers. Through its foreign exchange operations, Lehman Brothers seeks to provide its clients and customers with superior trading execution, price protection and hedging strategies to manage volatility. The Company, through operations in New York, London, and Hong Kong, engages in trading activities in all major currencies and maintains a 24-hour foreign exchange market making capability for clients and customers worldwide. In 1993, Lehman Brothers enhanced its foreign exchange capabilities by becoming the first U.S. investment bank to join the Electronic Broking Service in Europe. In addition to the Company's traditional client/customer-driven foreign exchange activities, Lehman Brothers also trades foreign exchange for its own account. Commodities and Futures Lehman Brothers engages in commodities and futures trading in three business lines: market making in metals and energy, exchange futures execution services, and managed futures. To service the needs of the Company's clients and customers in the energy industry, Lehman Brothers is an active market maker in energy-related refined products. The Company seeks to provide clients and customers with innovative investment and hedging strategies to satisfy their investing and risk management objectives. In 1993, professionals from Commodities, Investment Banking and Equities worked together to structure and issue gold-denominated preferred stock, which was the first commodity-linked equity security to be listed on the New York Stock Exchange. Asset Management Lehman Brothers Global Asset Management ("LBGAM") provides discretionary and non-discretionary investment management services to institutional and high net worth investors worldwide. LBGAM's asset management philosophy combines fundamental research with quantitative techniques to identify investment opportunities that span the global equity, fixed income and currency markets. Established in late 1992, LBGAM's assets under management were over $12 billion at December 31, 1993. During 1993, LBGAM launched the Lehman Brothers Institutional Funds, a family of money market funds directed toward U.S. institutional investors, and expanded its offshore mutual funds directed toward non-U.S. investors and its managed futures funds for investors throughout the world. LBGAM serves its customers from four principal locations in New York, Boston, London and Tokyo. Merchant Banking Fund Management Since 1989, the Company's principal method of making merchant banking investments has been through a series of partnerships (the "1989 Partnerships"), for which the Company acts as general partner, and in some cases as a limited partner. Merchant banking activities have consisted principally of making equity and certain other investments in merger, acquisition, restructuring and leveraged capital transactions, including leveraged buyouts, either independently or in partnership with the Company's clients. Current merchant banking investments include both publicly traded and privately held companies diversified on a geographic and industry basis. The 1989 Partnerships have a 10 year life with capital available for investment for only the first five years, which period ended in March 1994. Accordingly, during the remaining life of the Partnerships, the Company's merchant banking activities, with respect to investments made by the 1989 Partnerships, will be directed toward selling or otherwise monetizing such investments. The Company is currently considering the establishment of a new merchant banking fund and participation in other merchant banking opportunities. Other Business Activities While Lehman Brothers concentrates on its client/customer-driven strategy, the Company also participates in business opportunities such as arbitrage and proprietary trading that leverage the Company's expertise, infrastructure and resources. These businesses may generate substantial revenues but generally entail a higher degree of risk as the Company trades for its own account. Arbitrage. Lehman Brothers engages in a variety of arbitrage activities. In traditional or "riskless" arbitrage, the Company seeks to benefit from temporary price discrepancies that occur when a security is traded in two or more markets, or when a convertible or derivative security is trading at a price disparate from its underlying security. The Company's "risk" arbitrage activities involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the extent that these anticipated transactions do not materialize in a manner consistent with the Company's expectations, the Company is subject to the risk that the value of these investments will decline in value. Lehman Brothers' arbitrage activities benefit from the Company's presence in the global capital markets, access to advanced information technology, in-depth market research, proprietary risk management tools and general experience in assessing rapidly changing market conditions. Proprietary Trading. Lehman Brothers engages in the trading of various securities, derivatives, currencies and commodities for its own account. The Company's proprietary trading activities bring together various research and trading disciplines allowing it to take market positions, which at times may be significant, consistent with the Company's expectations of future events (such as movements in the level of interest rates, changes in the shape of yield curves and changes in the value of currencies). The Company is subject to the risk that actual market events will be different from the Company's expectations, which may result in significant losses associated with such proprietary positions. The Company's proprietary trading activities are generally carried out in consultation with personnel from the relevant major product area (e.g., mortgages, derivatives and foreign exchange). ADMINISTRATION AND OPERATIONS The Company's administration and operations staff supports its businesses through the processing of certain securities and commodities transactions; receipt, identification and delivery of funds and securities; internal financial controls; safeguarding of customers' securities; and compliance with regulatory and legal requirements. In addition, this staff is responsible for information systems, communications, facilities, legal, internal audit, treasury, tax, accounting and other support functions. In response to the needs of certain of its domestic and international businesses, the Company has acquired sophisticated data processing and telecommunications equipment. The Company believes such acquisition was necessary to provide the high level of technological and analytical support required to process, settle and account for transactions in a worldwide marketplace. Automated systems also provide sophisticated decision support which enhances trading capability and the management of the Company's cash and collateral resources. There is considerable fluctuation within each year and from year to year in the volume of business that the Company must process, clear and settle. GLOBAL SCOPE OF BUSINESS ACTIVITIES Through its network of offices in 44 cities around the world, Lehman Brothers pursues a global strategy to meet more effectively the needs of clients and customers and to generate increased business volume for the Company. The Company's headquarters in New York and regional headquarters located in London and Tokyo provide support for and are closely linked to the Company's other regional offices. Because Lehman Brothers' global strategy is based on a unified team approach to serving the financial needs of its clients and customers, the Company's regional offices enable Investment Banking and Sales to more effectively develop relationships and deliver products and services to clients and customers whose businesses are located in a given area or who predominantly transact business in that region. Based on the growth in international business activities over the past several years and the continued development of a more integrated global financial economy, Lehman Brothers expects international business activities to continue to grow in the future. The Company believes that its global presence and operating strategy position it to continue to increase the Company's flow of business, and thereby continue to realize greater benefits from economies of scale. ORGANIZATION The organization and culture of Lehman Brothers represent the fourth element of the Company's overall strategy. This strategy requires close integration of investment bankers and sales professionals and product and service professionals to maximize the Company's effectiveness in developing client and customer relationships. To effect this strategy, Lehman Brothers is managed as an integrated global operation. Business planning and execution is coordinated between regional locations and product heads. The Company's 18-member Operating Committee is the principal governing body of Lehman Brothers, and is comprised of representatives from every major area of the organization, including the senior managers from the Company's operations in the European and Asia Pacific regions. This structure promotes communication and cooperation, enabling Lehman Brothers to rapidly identify and address opportunities and issues on a global, firm-wide level. The Operating Committee facilitates management's ability to run the business as a whole, as opposed to managing the business units separately. This structure is reinforced with a culture and operating practices that promote integration through the implementation and communication of organizational values and principles consistent with the Company's "One Firm" philosophy. An example of one of these operating practices is the Company's approach to compensation, whereby employees are compensated to a significant extent on the overall performance of the Company and to a lesser extent on the performance of any individual business area. RISK MANAGEMENT Risk is an inherent part of all of Lehman Brothers' businesses and activities. The extent to which Lehman Brothers properly and effectively identifies, assesses, monitors and manages each of the various types of risks involved in its trading, brokerage and investment banking activities is critical to the success and profitability of the Company. The principal types of risk involved in Lehman Brothers' activities are market risks, credit or counterparty risks and transaction risks. Lehman Brothers has developed a control infrastructure to monitor and manage each type of risk on a global basis throughout the Company. Market Risk In its trading, market making and underwriting activities, Lehman Brothers is subject to risks relating to fluctuations in market prices and liquidity of specific securities, instruments and derivative products, as well as volatility in market conditions in general. The markets for these securities and products are affected by many factors, including the financial performance and prospects of specific companies and industries, domestic and international economic conditions (including inflation, interest and currency exchange rates and volatility), the availability of capital and credit, political events (including proposed and enacted legislation) and the perceptions of participants in these markets. Lehman Brothers has developed a multi-level approach for monitoring and managing its market risk. The base level control is at the trading desks where various risk management functions are performed, including daily mark to market by traders and on-going monitoring of inventory aging and pricing by trading desk managers, product area management and the independent risk managers for each product area. The next level of management of market risk occurs in the Trade Analysis department, which independently reviews the prices of the Company's trading positions and regularly monitors the aging of inventory positions. The final level of the risk management process is the Senior Risk Management Committee, which is composed of senior management from the various product areas and from credit, trade analysis and risk management. In addition, when appropriate, Lehman Brothers employs hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Credit or Counterparty Risks Lehman Brothers is exposed to credit risks in its trading activities from the possibility that a counterparty to a transaction could fail to perform under its contractual commitment, resulting in Lehman Brothers incurring losses in liquidating or covering its position in the open market. The responsibility for managing these credit risks rests with the Corporate Credit department which has operations in New York, London, Frankfurt, Tokyo and Hong Kong. The department, which is organized along both industry and geographic lines, is independent from any of Lehman Brothers' product areas. Corporate Credit manages the Company's credit risks by establishing and monitoring counterparty limits, structuring and approving specific transactions, actively managing credit exposures and participating in the new product review process. In addition, Lehman Brothers, when appropriate, may require collateral from the counterparty to secure its obligations to the Company or seek some other form of credit enhancement (such as financial covenants, guarantees or letters of credit) to support the counterparty's contractual commitment. Transaction Risk In connection with its investment banking and product origination activities, Lehman Brothers is exposed to risks relating to the merits of proposed transactions. These risks involve not only the market and credit risks associated with underwriting securities and developing derivative products, but also potential liabilities under applicable securities and other laws which may result from Lehman Brothers' role in the transaction. Each proposed transaction involving the underwriting or placement of securities by Lehman Brothers is reviewed by the Company's Commitment Committee. The Commitment Committee is staffed by senior members of the Company with extensive experience in the securities industry. The principal function of the Commitment Committee is to determine whether Lehman Brothers should participate in a transaction in which the Company's capital and reputation will be at risk. Fairness opinions and valuation letters to be delivered by Lehman Brothers must be reviewed and approved by the Company's Fairness Opinion Committee, which is composed of senior investment bankers who provide an independent evaluation of the opinions and conclusions to be rendered to the Company's clients. In connection with its investment banking or merchant banking activities, the Company may from time to time make proprietary investments in securities that are not readily marketable. These investments primarily result from the Company's efforts to help clients achieve their financial and strategic objectives. Any such proposed investment which falls within established criteria with respect to the amount of capital invested, the anticipated holding period and the degree of liquidity of the securities must be reviewed and approved by the Company's Investment Committee, which is composed of senior investment bankers. The Investment Committee reviews in detail the proposed investment and applies relevant valuation methodologies to evaluate the risk of loss of capital compared to the anticipated returns from the investment and determine whether to proceed with the transaction. Lehman Brothers recently established a New Products and Business Committee (the "NPBC") for new products developed by Lehman Brothers or new businesses to be entered into by the Company. The NPBC will work in cooperation with the originators or sponsors of a new product or business to evaluate its feasibility, assess its potential risks and liabilities and analyze its costs and benefits. NON-CORE ASSETS Prior to 1990, the Company participated in a number of activities that are not central to its current business as an institutional investment banking firm. As a result of these activities, the Company carries on its balance sheet a number of relatively illiquid assets (the "Non-Core Assets"), including a number of individual real estate assets, limited partnership interests, certain bridge loans and a number of smaller investments. Subsequent to their purchase, the values of certain of these Non-Core Assets declined below the recorded values on the Company's balance sheet, which necessitated the write-down of the carrying values of these assets and corresponding charges to the Company's income statement. Certain of these activities have resulted in various legal proceedings. Since 1990, management has devoted substantial resources to reducing the Company's Non-Core Assets. Between December 31, 1990 and December 31, 1993, the Company's Non-Core Assets decreased from $2.3 billion in 1990 to approximately $481 million in 1993, with Non-Core Assets defined as carrying value plus contingent exposures net of reserves. Management's intention with regard to these Non-Core Assets is the prudent liquidation of these investments as and when possible. RELATIONSHIP WITH SMITH BARNEY On July 31, 1993, the Company completed the sale of Shearson which consisted of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name), substantially all of its asset management business, the operations and data processing functions that supported those businesses and certain related assets and liabilities. Securities Clearing, Data Services and General Services Agreements Pursuant to a clearing agreement (the "Clearing Agreement"), Smith Barney carries and clears, on a fully disclosed basis, all accounts introduced to it by Lehman Brothers, and performs all clearing and settlement functions for equities, municipal securities and corporate debt which were previously performed by Shearson. Lehman Brothers also conducts certain securities lending activities as agent for Smith Barney under the Clearing Agreement. Pursuant to Data Services and General Services Agreements, Smith Barney provides to the Company all of the same data processing and related services that it previously received from Shearson. Charges for services under these three agreements are generally calculated using the intercompany transfer pricing methodology in effect prior to the Primerica Transaction. These agreements expire on December 31, 1994, but may be extended for up to an additional six months upon payment by the Company of up to $5 million. The Company has been reviewing alternative clearing, data processing and other servicing arrangements to take effect after the expiration of its arrangements with Smith Barney. Certain Arrangements Revolving Cash Subordination Agreement. The Company has agreed to lend to Smith Barney up to $150 million to cover capital charges in excess of $50 million incurred by Smith Barney as a result of carrying LBI's customer and proprietary positions (the "Lehman Capital Charges"). The Company will lend additional amounts to Smith Barney in the event that the Lehman Capital Charges increase above $200 million. As of March 28, 1994, $150 million was outstanding. Under certain circumstances, Travelers is required to purchase all or part of Smith Barney's indebtedness to the Company under the facility up to $250 million. The Company is only required to fund in excess of $250 million under this facility if Travelers agrees to a corresponding increase in its purchase obligation; provided that, without such agreement, the Company may not engage in any activity which results in the Lehman Capital Charges exceeding $300 million. Revolving Credit Agreements. Pursuant to a Revolving Credit Agreement, Smith Barney may borrow funds from LBI secured by securities having a market value equal to not less than 130% of the aggregate unpaid principal amount borrowed for the purpose of funding customer margin debits carried by Smith Barney. As of March 28, 1994, there were no amounts outstanding under this facility. Pursuant to an Unsecured Revolving Credit Agreement, Holdings has agreed to advance funds to Smith Barney in order to finance, in part, certain of the cash demands of the securities lending activities conducted under the Clearing Agreement. As of March 28, 1994, $756 million was outstanding under this facility. These facilities will terminate upon the termination of the Clearing Agreement. Non-Solicitation. In connection with the Primerica Transaction, both LBI and Smith Barney agreed that they would refrain from soliciting each other's employees and certain customers for varying periods of time after July 31, 1993. The majority of the customer-related non-solicitation provisions have expired. Shearson Related Litigation. LBI and Smith Barney agreed to a division of litigation relating to Shearson pursuant to which, subject to certain exceptions, Smith Barney is liable for such litigations arising after April 11, 1993. With respect to matters arising on or before April 11, 1993, LBI transferred to Smith Barney a $50 million reserve. If that reserve is exhausted, the parties have agreed to share liability on the matters arising on or before April 11, 1993. LBI retained liability for regulatory matters. COMPETITION All aspects of the Company's business are highly competitive. The Company competes in domestic and international markets directly with numerous other brokers and dealers in securities and commodities, investment banking firms, investment advisors and certain commercial banks and, indirectly for investment funds, with insurance companies and others. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, several small and specialized securities firms have been successful in raising significant amounts of capital for their merger and acquisition activities and merchant banking investment vehicles and for their own accounts. These developments have increased competition from firms, many of whom have significantly greater equity capital than the Company. REGULATION The securities industry in the United States is subject to extensive regulation under both federal and state laws. LBI and certain other subsidiaries of Holdings are registered as broker-dealers and investment advisers with the Commission and as such are subject to regulation by the Commission and by self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the Commission as LBI's primary regulator, and the Municipal Securities Rulemaking Board. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. LBI is a registered broker-dealer in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico. The Commission, self-regulatory organizations and state securities commissions may conduct administrative proceedings, which may result in censure, fine, the issuance of cease-and-desist orders or suspension or expulsion of a broker-dealer or an investment adviser, its officers or employees. LBI is registered with the CFTC as a futures commission merchant and is subject to regulation as such by the CFTC and various domestic boards of trade and other commodity exchanges. The Company's U.S. commodity futures and options business is also regulated by the National Futures Association, a not-for-profit membership corporation which has been designated as a registered futures association by the CFTC. The Company does business in the international fixed income, equity and commodity markets and undertakes investment banking activities through its London subsidiaries. The U.K. Financial Services Act of 1986 (the "Financial Services Act") governs all aspects of the United Kingdom investment business, including regulatory capital, sales and trading practices, use and safekeeping of customer funds and securities, record keeping, margin practices and procedures, registration standards for individuals, periodic reporting and settlement procedures. Pursuant to the Financial Services Act, the Company is subject to regulations administered by The Securities and Futures Authority Limited, a self regulatory organization of financial services companies (which regulates the Company's equity, fixed income, commodities and investment banking activities) and the Bank of England (which regulates its wholesale money market, bullion and foreign exchange businesses). Holdings' subsidiary, Lehman Brothers Japan Inc., is a licensed securities company in Japan and a member of the Tokyo Stock Exchange, the Osaka Stock Exchange and the Tokyo Financial Futures Exchange and, as such, is regulated by the Japanese Ministry of Finance, the Japan Securities Dealers Association and such exchanges. The Company believes that it is in material compliance with regulations described herein. The Company anticipates regulation of the securities and commodities industries to increase at all levels and for compliance therewith to become more difficult. Monetary penalties and restrictions on business activities by regulators resulting from compliance deficiencies are also expected to become more severe. CAPITAL REQUIREMENTS As registered broker-dealers LBI and Lehman Government Securities Inc. ("LGSI"), a wholly owned subsidiary of LBI, are subject to the Commission's net capital rule (Rule 15c3-1, the "Net Capital Rule") promulgated under the Exchange Act. The NYSE and the NASD monitor the application of the Net Capital Rule by LBI and LGSI, respectively. LBI and LGSI compute net capital under the alternative method of the Net Capital Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if its net capital is less than 4% of aggregate debit balances and may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances. In addition, the Net Capital Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances. The Net Capital Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Net Capital Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Commission when net capital after the withdrawal would be less than 25% of its securities position haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Net Capital Rule requires broker-dealers to notify the Commission and the appropriate self- regulatory organization two business days before a withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000, or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000, or 20% of excess net capital. Finally, the Net Capital Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the Company or would jeopardize the broker-dealer's ability to pay its customers. Certain of LBI's other subsidiaries are also subject to the Net Capital Rule. Compliance with the Net Capital Rule could limit those operations of LBI that require the intensive use of capital, such as underwriting and trading activities and the financing of customer account balances, and also could restrict the ability of Holdings to withdraw capital from LBI, which in turn could limit the ability of Holdings to pay dividends, repay debt and redeem or purchase shares of its outstanding capital stock. See Footnote 18 of Notes to Consolidated Financial Statements. EMPLOYEES As of December 31, 1993 the Company employed approximately 9,300 persons, including 6,900 in the U.S. and 2,400 internationally. The Company considers its relationship with its employees to be good. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters occupy approximately 915,000 square feet of space at 3 World Financial Center in New York, New York, which is owned by the Company as tenants-in-common with American Express and various other American Express subsidiaries. The Company expects to relocate in or about August 1994, certain administrative personnel from 388 and 390 Greenwich Street to five floors in the World Financial Center which are currently occupied by subsidiaries of American Express. These five floors will be added to the Company's interest in the World Financial Center, resulting in total occupancy of approximately 1,147,000 square feet. The Company entered into a lease for approximately 392,000 square feet for offices located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The Operations Center will be used by systems, operations, and certain administrative personnel and contains certain back-up trading facilities. The lease term is approximately 16 years and is expected to commence in August 1994. The Company occupies 14 floors at 388 and 390 Greenwich Street which it expects to vacate by July 31, 1994 and will relocate the personnel to the Operations Center and the World Financial Center. The Company leases approximately 344,000 square feet of office space in London, England. The Company consolidated most of its London operations into this space in 1987. Most of the Company's other offices are located in leased premises, the leases for which expire at various dates through the year 2007. Facilities owned or occupied by the Company and its subsidiaries are believed to be adequate for the purposes for which they are currently used and are well maintained. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against the Company and others with respect to transactions in which the Company acted as an underwriter or financial advisor, actions arising out of the Company's activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms of which the Company is one. Although there can be no assurance as to the ultimate outcome, the Company has denied, or believes it has a meritorious defense and will deny, liability in all significant cases pending against it including the matters described below, and intends to defend vigorously each such case. Although there can be no assurance as to the ultimate outcome, based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on the business or consolidated financial condition of the Company. General Acquisition, Inc. et al. v. GenCorp, Inc. et al. v. Wagner & Brown, et al. and Shearson Lehman Brothers Inc. and Shearson Lehman Brothers Holdings Inc. This litigation in the United States District Court for the Southern District of Ohio (the "Ohio Court") arose out of the Company's representation of Wagner & Brown and AFG Industries, Inc. ("AFG") in connection with their effort to acquire GenCorp, Inc. ("GenCorp") in March 1986. In response to the tender offer and the litigation commenced by Wagner & Brown and AFG on March 17, 1986, GenCorp amended its answer and counterclaims on April 2, 1986 to assert claims against LBI and the Company. Only GenCorp's counterclaims against LBI remain pending. GenCorp asserted common law claims for breach of fiduciary duty, fraud, negligence and unjust enrichment against LBI. The claims are based on prior contacts between LBI and GenCorp and LBI's subsequent role in advising and assisting Wagner & Brown and AFG with respect to the tender offer. GenCorp seeks $258 million in damages and the imposition of a constructive trust on the fees and profits the Company earned in the transaction. On or about October 2, 1992, the Ohio Court granted LBI's motion for summary judgment and dismissed GenCorp's claim for compensatory damages. GenCorp has appealed this decision to the United States Court of Appeals for the Sixth Circuit. No decision has been rendered. GenCorp's claim for disgorgement of the fees that LBI received has been stayed pending the appeal. Bamaodah v. E.F. Hutton & Company Inc. In April 1986, Ahmed and Saleh Bamaodah commenced an action against E.F. Hutton & Company Inc. ("EFH"), a subsidiary of The E.F. Hutton Group Inc. ("Hutton"), to recover all losses the Bamaodahs had incurred since May 1981 in the trading of commodity futures contracts in a nondiscretionary EFH trading account. The Dubai Civil Court ruled that the trading of commodity futures contracts constituted illegal gambling under Islamic law and that therefore the brokerage contract was void. In January 1987, a judgment was rendered against EFH in the amount of $48,656,000. On January 5, 1991, the Dubai Court of Appeals affirmed the judgment. On March 22, 1992, the Court of Cassation, Dubai's highest court, revoked and quashed the decision of the Court of Appeals and ordered that the case be remanded to the Court of Appeals for a further review. FDIC v. Cheng, et al. On or about February 16, 1990, the Federal Deposit Insurance Corporation (the "FDIC"), as manager of the Federal Savings and Loan Insurance Corporation ("FSLIC") Resolution Fund (the "FSLIC Resolution Fund"), which is the receiver of Guaranty Federal Savings and Loan Association ("Guaranty Federal"), filed a complaint in the U.S. District Court for the Northern District of Texas (the "Texas District Court") in an action entitled Federal Deposit Insurance Corporation v. Paul Sau-Ki Cheng, et al. On or about February 2, 1993, the FDIC served a Third Amended Complaint naming EFH, Holdings, LBI, four former EFH brokers, Drexel Burnham Lambert Inc. and a subsidiary of it (collectively "Drexel"), a former Drexel broker, Paul Sau-Ki Cheng and Simon Edward Heath, both former directors and co-chairmen of the board of directors of Guaranty Federal and certain other parties not affiliated with LBI as defendants. On or about February 11, 1993, the Company filed its answer to the Third Amended Complaint, denying all material allegations and asserting several affirmative defenses. The FDIC's claims related to trading losses and other alleged damages suffered by Guaranty Federal, its creditors, stockholders and depositors, the FSLIC and the FSLIC Resolution Fund as a result of U.S. government bond trading by Cheng and Heath through EFH and Drexel, as well as alleged violations of the Commodities Exchange Act. As a result, the FDIC sought $129,980,000 in alleged actual damages against all defendants and $387.6 million in punitive damages against all defendants except EFH, Holdings and LBI. On October 25, 1993, the Company and the FDIC entered into a settlement agreement, and on November 16, 1993, the Texas District Court entered an order and dismissed all claims with prejudice. Paul Williams and Beverly Kennedy, et al. v. Balcor Pension Investors et al. In February 1990, a purported class action complaint was filed in the United States District Court for the Northern District of Illinois. The complaint names eight separate limited partnerships originated by The Balcor Company ("Balcor"), which was then a wholly owned subsidiary of LBI, known as the Balcor Pension Investors series. Also named as defendants were the general partner of each named limited partnership, including Balcor, and Balcor Securities Co., LBI and American Express. The complaint which was amended on October 10, 1990 alleges that the named entities violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in connection with the offering of limited partnership interests. The complaint also alleges breach of fiduciary duty, fraud, negligence and violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO"). The complaint seeks compensatory damages and punitive damages. Defendants' Amended Counterclaim filed on September 19, 1990, asserts common law claims of fraud and breach of warranty against plaintiffs. Defendants seek to recover for the alleged damage to their reputation and business as well as their costs and attorneys fees in defending against the claims brought by plaintiffs. On November 29, 1990, W.B. Copeland, Trustee, Ploof Truck Lines, Inc. Profit Sharing Plan and Allan Hirschfield filed a class action counterclaim against defendants which is identical to the Amended Complaint seeking, among other things, leave to join this action as named plaintiffs. On September 8, 1993, the plaintiffs filed a Third Amended Complaint adding additional named plaintiffs and an amended motion for class certification which motions had previously been denied. No plaintiff class has yet been certified and no judicial determination has been made. No merits discovery has been conducted. Ralph Majeski, et al. v. Balcor Entertainment Company, Ltd. et al.; Robert Eckstein, et al. v. Balcor Film Investors, et al. These two actions were filed in United States District Court for the Eastern District of Wisconsin (the "Wisconsin District Court"). LBI is a defendant only in the Majeski case. Plaintiffs allege that the named defendants in the lawsuits violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests in Balcor Film Investors, a partnership of which a Balcor subsidiary is the general partner. The Majeski complaint also alleges, in general, breach of fiduciary duty, common law fraud, misrepresentation, breach of contract and a cause of action in the nature of a derivative action. On January 18, 1991, the Wisconsin District Court entered an order certifying a plaintiffs class of all persons who purchased or currently own interests in the Partnership which were purchased from January 8, 1985 through December 31, 1985. The Wisconsin District Court also consolidated the Eckstein and Majeski actions for the remainder of the pretrial proceedings and trial, but did not merge such actions. On March 11, 1992, the Wisconsin District Court granted defendants' motions to dismiss on statute of limitations grounds in both actions. In August 1993, the U.S. Court of Appeals for the Seventh Circuit (the "Court of Appeals") issued an opinion which reversed the order of the Wisconsin District Court and remanded the cases to such court for further proceedings. The defendants sought a writ of certiorari in the U.S. Supreme Court which was denied in January 1994. Upon remand to the Wisconsin District Court, plaintiffs filed a motion to amend the complaint to assert a RICO claim; defendants opposed this amendment, and the motion is pending. In addition, defendants have renewed their motions to dismiss. These motions are pending before the Wisconsin District Court. On or about March 8, 1993, the Majeski plaintiffs filed an action in the Circuit Court for Milwaukee County, Wisconsin. The allegations, including damages, in this complaint are essentially the same as in their federal court action, described above. Plaintiff's counsel has represented that this state court action will be dismissed. Glynwill Investment, Ltd. v. Shearson Lehman Brothers Inc. Glynwill Investment, Ltd. ("Glynwill"), a corporation chartered in Curacao, N.A., commenced an action against LBI "as successor in interest to E.F. Hutton & Co., Inc." in May of 1990 in the Supreme Court of the State of New York (the "New York Court"), alleging fraud and breach of contract on the part of EFH in overcharging Glynwill for foreign exchange transactions executed for Glynwill. The New York Court, on LBI's motion to dismiss, held that the release signed by Glynwill after Glynwill's repayment of approximately one half of the $10 million unsecured debit created in Glynwill's account was not a general release encompassing the claims raised by Glynwill in this action and denied LBI's motion. Discovery is ongoing. Sanford F. Kaplan v. The E.F. Hutton Group Inc., et al; Christopher J. Harris v. The E.F. Hutton Group Inc., et al. On or about December 30, 1987 and January 11, 1988, the Kaplan and Harris complaints were filed as purported class actions. The complaints in these two actions, brought in New York State Supreme Court (the "State Court") and the United States District Court for the Southern District of New York (the "District Court"), respectively, name as defendants Hutton, LBI and SLBP Acquisition Corp., and purport to be brought on behalf of classes of certain holders of nonvested employee stock options or equity grants awarded under Hutton's Equity Ownership Plan (the "Plan"). Plaintiffs alleged, among other things, that as a result of the execution of the Agreement and Plan of Merger between Hutton, SLBP Acquisition Corp. and LBI and the acquisition by LBI of a majority of the shares of Hutton, their stock options and equity grants vested. They sought compensatory damages, declaratory relief and, in the case of Kaplan, injunctive relief. Classes were certified in each action. On December 29, 1993, the District Court issued a final judgment and order approving a settlement and dismissing the Harris action. On January 13, 1993, the State Court issued a final judgment and order approving the settlement and dismissing the Kaplan case. Actions Relating To First Capital Holdings Inc. FCH Derivative Actions. On or about March 29, 1991, two identical purported shareholder derivative actions were filed, entitled Mentch v. Weingarten, et al. and Isaacs v. Weingarten, et al. The complaints in these two actions, pending in the Superior Court of the State of California, County of Los Angeles, are filed allegedly on behalf of and naming as a nominal defendant FCH. Other defendants include Holdings, two former officers and directors of FCH, Robert Weingarten and Gerry Ginsberg, the four outside directors of FCH, Peter Cohen, Richard DeScherer, William L. Mack and Jerome H. Miller (collectively, the "Outside Directors"), and Michael Milken. The complaints allege generally breaches of fiduciary duty, gross corporate mismanagement and waste of assets in connection with FCH's purchase of non-rated bonds underwritten by Drexel Burnham Lambert Inc. and seek damages for losses suffered by FCH, punitive damages and attorneys' fees. The actions have been stayed pursuant to the bankruptcy of FCH. Concurrent with the bankruptcy filing of FCH and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company ("First Capital Life") and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life") (First Capital Life and Fidelity Bankers Life collectively, the "Insurance Subsidiaries"), a number of additional actions were instituted, naming one or more of Holdings, LBI and American Express as defendants (individually or collectively, as the case may be, the "American Express Defendants"). FCH Shareholder and Agent Actions. Three actions were commenced in the United States District Courts for the Southern District of New York and the Central District of California allegedly as class actions on behalf of the purchasers of FCH securities during certain specified periods, commencing no earlier than May 4, 1988 and ending no later than May 31, 1991 (the "Shareholder Class"). The complaints are captioned Larkin, et al. v. First Capital Holdings Corp., et al., amended on May 15, 1991 to add American Express as a defendant, Zachary v. American Express Company, et al., filed on May 20, 1991, and Morse v. Weingarten, et al., filed on June 13, 1991 (the "Shareholder Class Actions"). The complaints raise claims under the federal securities laws and allege that the defendants concealed adverse material information regarding the finances, financial condition and future prospects of FCH and made material misstatements regarding these matters. On July 1, 1991 an action was filed in the United States District Court for the Southern District of Ohio entitled Benndorf v. American Express Company, et al. The action is brought purportedly on behalf of three classes. The first class is similar to the Shareholder Class; the second consists of managing general agents and general agents who marketed various First Capital Life products from April 2, 1990 to the filing of the suit and to whom it is alleged misrepresentations were made concerning FCH (the "Agent Class"); and the third class consists of Agents who purchased common stock of FCH through the First Capital Life Non Qualified Stock Purchase Plan ("FSPP") and who have an interest in the Stock Purchase Account under the FSPP (the "FSPP Class"). The complaint raises claims similar to those asserted in the other Shareholder Class Actions, along with additional claims relating to the FSPP Class and the Agent Class alleging damages in marketing the products. In addition, on August 15, 1991, Kruthoffer v. American Express Company, et al. was filed in the United States District Court for the Eastern District of Kentucky, whose complaint is nearly identical to the Benndorf complaint (collectively the "Agent Class Actions"). On November 14, 1991, the Judicial Panel on Multidistrict Litigation issued an order transferring and coordinating for all pretrial purposes all related actions concerning the sale of FCH securities, including the Shareholder Class Action and Agent Class Actions, and any future filed "tag-along" actions, to Judge John G. Davies of the United States District Court for the Central District of California (the "California District Court"). The cases are captioned In Re: First Capital Holdings Corporation Financial Products Securities Litigation, MDL Docket No.-901 (the "MDL Action"). On January 18, 1993, an amended consolidated complaint (the "Third Amended Complaint") was filed on behalf of the Shareholder Class and the Agent Class. The Third Complaint names as defendants the American Express defendants, Weingarten and his wife, Palomba Weingarten, Ginsberg, Philip A. Fitzpatrick (FCH's Chief Financial Officer), the Outside Directors and former FCH outside directors Jeffrey B. Lane and Robert Druskin (the "Former Outside Directors"), Fred Buck (President of First Capital Life) and Peat Marwick. The complaint raises claims under the federal securities law and the common law of fraud and negligence. On March 10, 1993, the American Express defendants answered the Third Amended Complaint, denying its material allegations. On March 11, 1993, the California District Court entered an order granting class certification to the Shareholder Class. The class consists of all persons, except defendants, who purchased FCH common stock, preferred stock and debentures during the period May 4, 1988 to and including May 10, 1991. It also issued an order denying class certification to the Agent Class. The FSPP Class action had been previously dropped by the plaintiffs. The American Express Shareholder Action. On or about May 20, 1991, a purported class action was filed on behalf of all shareholders of American Express who purchased American Express common shares during the period beginning August 16, 1990 to and including May 10, 1991. The case is captioned Steiner v. American Express Company, et al. and was commenced in the United States District Court for the Eastern District of New York. The defendants are Holdings, American Express, James D. Robinson, III, Howard L. Clark, Jr., Harvey Golub and Aldo Papone. The complaint alleges generally that the defendants failed to disclose material information in their possession with respect to FCH which artificially inflated the price of the common shares of American Express from August 16, 1990 to and including May 10, 1991 and that such nondisclosure allegedly caused damages to the purported shareholder class. The action has been transferred to California and is now part of the MDL Action. The defendants have answered the complaint, denying its material allegations. The Bankruptcy Court Action. In the FCH bankruptcy, pending in the United States Bankruptcy Court for the Central District of California (the "Bankruptcy Court"), on February 11, 1992, the Official Committee of Creditors Holding Unsecured Claims (the "Creditors' Committee") obtained permission from the Bankruptcy Court to file an action for and on behalf of FCH and the parent corporations of the Insurance Subsidiaries. On March 3, 1992, the Creditors' Committee initiated an adversary proceeding in the Bankruptcy Court, Case No. AD 92-01723, in which they assert claims for breach of fiduciary duty and waste of corporate assets against Holdings; fraudulent transfer against both Holdings and LBI; and breach of contract against LBI. Also named as defendants are the Outside Directors, the Former Outside Directors, Weingarten and Ginsberg. Holdings and LBI have answered this complaint, denying the material allegations. Fact discovery has been completed and the contract claim has been dropped by plaintiffs. No trial date has been set. The Virginia Commissioner of Insurance Action. On December 9, 1992, a complaint was filed in federal court in the Eastern District of Virginia by Steven Foster, the Virginia Commissioner of Insurance as Deputy Receiver of Fidelity Bankers Life. The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a former director of FCH and Fidelity Bankers Life, as defendants. The action was subsequently transferred to California to be part of the MDL Action. The Complaint alleges that Holdings acquiesced in and approved the continued mismanagement of Fidelity Bankers Life and that it participated in directing the investment of Fidelity Bankers Life assets. The complaint asserts claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleges violations of the Virginia Securities laws by Holdings. It allegedly seeks no less than $220 million in damages to Fidelity Bankers Life and its present and former policyholders and creditors and punitive damages. Holdings has answered the complaint, denying its material allegations. In re Computervision Corporation Securities Litigation In connection with public offerings of notes and common stock of Computervision, actions were commenced in federal district court in Massachusetts against Computervision, certain of its executive officers, the directors of Computervision, LBI, Donaldson, Lufkin & Jenrette Securities Corporation, The First Boston Corporation and Hambrecht & Quist Incorporated, the Company and J.H. Whitney & Co. in the United States District Court for the District of Massachusetts (collectively the "Massachusetts Case"). These actions have been consolidated in a consolidated amended class action complaint which alleges in substance that the registration statement and prospectus used in connection with the offerings contained materially false and misleading statements and material omissions related to Computervision's anticipated operating results for 1992 and 1993. The plaintiffs purport to represent a class of individuals who purchased in the public offering or in the aftermarket. The complaint seeks damages for negligent misrepresentation and under Sections 11, 12 and 15 of the Securities Act. In addition, three suits were filed in the United States District Court for the Southern District of New York. The suits raise claims similar to those in the Massachusetts Case against the same defendants. The Judicial Panel on Multidistrict Litigation has ordered these cases consolidated with the Massachusetts Case. State Court Action. Lehman Brothers was named as the sole defendant in a putative class action, Greenwald v. Lehman Brothers Inc., brought in New York State Supreme Court (the "State Court"). The complaint alleges in substance that LBI breached a fiduciary duty owed to its customers in selling them the common stock, senior notes and senior subordinated notes of Computervision during the class period, as defined in the complaint. The State Court dismissed the complaint. Sims v. Shearson Lehman Brothers Hutton Inc. In March 1990, LBI was sued in the United States District Court for the Northern District of Texas (the "Texas District Court") on behalf of a purported class of all purchasers of limited partnership interests in a limited partnership offering called Kanland Associates. The partnership was sold by EFH in 1982 and raised approximately $20 million. In 1987, the partnership's property was lost in a foreclosure. On May 29, 1992, a second Amended Complaint was filed against LBI alleging claims under Section 10(b) of the Exchange Act, common law fraud, breach of fiduciary duty and RICO relating to disclosures made in connection with the sale of the partnership and alleged breaches of fiduciary duty subsequent to the foreclosure. On August 10, 1992, the Texas District Court issued an order certifying a class of all persons who purchased limited partnership interests in Kanland pursuant to the offering materials distributed by EFH. On November 29, 1993, the Texas District Court signed a final judgment and order approving the class action settlement agreed to by the parties, and dismissed the action with prejudice. CC&F Medford III Investment Company v. The Boston Company, Inc. and Wellington-Medford III Properties, Inc. In September 1992, Wellington-Medford Properties, Inc. ("W-M III"), then a subsidiary of The Boston Company and now a subsidiary of LBI, and The Boston Company, then a subsidiary of LBI, were sued in Superior Court of the Commonwealth of Massachusetts by a limited partner in a partnership (the "Partnership") of which W-M III is the general partner. The Partnership's principal asset is an office building which is leased to The Boston Company. Financing in the amount of $74 million provided to the Partnership by The Sanwa Bank, Ltd. ("Sanwa") is secured by the office building and the lease with The Boston Company. The financing matured in December 1992 and Sanwa has initiated a foreclosure process. The complaint alleges that W-M III has breached its obligation to secure successor financing in order to prevent The Boston Company from being required to pay increased rental pursuant to a rental formula in its lease. The complaint seeks damages in an unspecified amount and a declaration regarding The Boston Company's lease obligations and W-M III's obligations to secure successor financing. W-M III and The Boston Company have answered, denying the material allegations of the complaint. In April 1993, The Boston Company filed a third-party complaint against Sanwa seeking a declaration as to The Boston Company's obligations pursuant to its lease of the office building. Sanwa answered and asserted claims against The Boston Company and W-M III, including claims for treble damages based on alleged breaches of the construction loan agreement. In December 1993, the parties entered into a stay of proceedings for purposes of facilitating negotiations of a possible settlement. Those negotiations are ongoing but have not resulted in agreement. The stay has been extended and now expires on April 15, 1994, with trial scheduled to commence on or after May 16, 1994. Easton & Co. v. Mutual Benefit Life Insurance Co., et al.; Easton & Co. v. Lehman Brothers Inc. LBI has been named as a defendant in two consolidated class action complaints pending in the United States District Court for the District of New Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life Insurance Co., et al. ("Easton I"), and Easton & Co. v. Lehman Brothers Inc. ("Easton II"). The plaintiff in both of these actions is Easton & Co., which is a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege federal securities law claims and pendent common law claims in connection with the sale of certain municipal bonds as to which Mutual Benefit Life Insurance Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is an insurance company which was placed in rehabilitation proceedings under the supervision of the New Jersey Insurance Department on or about July 16, 1991. In the Matter of the Rehabilitation of Mutual Benefit Life Insurance Company, (Sup. Ct. N.J. Mercer County.) Easton I was commenced on or about September 17, 1991. In addition to LBI, the defendants named in this complaint are MBLI, Henry E. Kates (MBLI's former Chief Executive Officer) and Ernst & Young (MBLI's accountants). The litigation is purportedly brought on behalf of a class consisting of all persons and entities who purchased DeKalb, Georgia Housing Authority Multi-Family Housing Revenue Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994 (the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds were issued) through July 16, 1991. Lehman Brothers acted as underwriter for this bond issue, which was in the aggregate principal amount of $18.7 million. The complaint alleges that LBI violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and seeks damages in an unspecified amount or rescission. The complaint also alleges a common law negligent misrepresentation claim against LBI and the other defendants. Easton II was commenced on or about May 18, 1992, and names LBI as the only defendant. Plaintiff purports to bring this second lawsuit on behalf of a class composed of all persons who purchased "MBLI-backed Bonds" from LBI during the period April 19, 1991 through July 16, 1991. The complaint alleges that LBI violated Section 10(b) and Rule 10b-5, and seeks monetary damages in an unspecified amount, or rescission pursuant to Section 29(b) of the Exchange Act. The complaint also contains a common law claim of alleged breach of duty and negligence. On or about February 9, 1993, the New Jersey District Court granted plaintiffs' motion for class certification in Easton I. The parties have agreed to certification of a class in Easton II for purchases of certain fixed-rate MBLI-backed bonds during the class period. Maxwell Related Litigation Certain of Holdings' subsidiaries are defendants in several lawsuits arising out of transactions entered into with the late Robert Maxwell or entities controlled by Maxwell interests. These actions are described below. Berlitz International Inc. v. Macmillan Inc. et al. This interpleader action was commenced in Supreme Court, New York County (the "Court") on or about January 2, 1992, by Berlitz International Inc. ("Berlitz") against Macmillan Inc. ("Macmillan"), Lehman Brothers Holdings PLC ("PLC"), Lehman Brothers International Limited (now known as Lehman Brothers International (Europe), "LBIE") and seven other named defendants. The interpleader complaint seeks a declaration of the rightful ownership of approximately 10.6 million shares of Berlitz common stock, including 1.9 million shares then registered in PLC's name, alleging that Macmillan claimed to be the beneficial owner of all 10.6 million shares, while the defendants did or might claim ownership to some or all of the shares. As a result of its bankruptcy filing, Macmillan sought to remove this case to the Bankruptcy Court for the Southern District of New York. LBIE and PLC have moved to remand the case back to the Court. Macmillan, Inc. v. Bishopsgate Investment Trust, Shearson Lehman Brothers Holdings PLC et al. This action was commenced by issuance of a writ in the High Court of Justice in London, England on or about December 9, 1991. In this action, Macmillan sought a declaration that it is the legal and beneficial owner of approximately 10.6 million shares of Berlitz common stock, including 1.9 million shares then registered in PLC's name. (The same shares that are at issue in the Berlitz case in New York discussed above.) After a trial, on December 10, 1993, the High Court of Justice handed down a judgment finding for the Company on all aspects of its defense and dismissing Macmillan's claims. MGN Pension Trustees Limited v. Invesco MIM Management Limited, Capel-Cure Myers Capital Management Limited and Lehman Brothers International Limited. This action was commenced by issuance of a writ in the High Court of Justice, London, England on or about June 5, 1992. It was alleged that LBIE knew or should have known that certain securities received by it as collateral on a stock loan account held by Bishopsgate Investment Management were in fact beneficially owned by the Mirror Group Pension Scheme ("MGPS") or by MGN Pension Trustees Limited (the trustee of MGPS). On this basis, the plaintiff sought a declaration that LBIE holds or held a portfolio of securities in constructive trust for plaintiff. According to the writ, LBIE sold certain of these securities for L32,024,918, and that LBIE still holds certain of these securities, allegedly worth approximately L1,604,240. The plaintiff sought return of the securities still held and the value of the securities liquidated in connection with the stock loan account. On January 31, 1994, the Company, along with the other defendants, settled the case. Bishopsgate Investment Management Limited (in liquidation) v. Lehman Brothers International (Europe) and Lehman Brothers Holdings PLC. In August 1993, Bishopsgate Investment Management Limited ("BIM") served a Writ and Statement of Claim against LBIE and PLC. The Statement of Claim alleges that LBIE and PLC knew or should have known that certain securities received by them, either for sale or as collateral in connection with BIM's stock loan activities, were in fact, beneficially owned by various pension funds associated with the Maxwell Group entities. BIM seeks recovery of any securities still held by LBIE and PLC or recovery of any proceeds from securities sold by them. The total value of the securities is alleged to be L100 million. BIM also commenced certain proceedings for summary disposition of its claims relating to certain of the securities with a value of approximately L30 million. On January 11, 1994, the parties agreed to a settlement of that portion of the claim relating to BIM's request for summary disposition with respect to certain securities. Under this agreement, two securities holdings were delivered to BIM. The Company continues to defend the balance of BIM's claim for recovery of other assets alleged to be worth approximately L70 million. The case is scheduled for trial in April 1995. Mellon Bank Corporation v. Lehman Brothers Inc., et al. In September 1993, Mellon Bank filed a complaint in the U.S. District Court for the Western District of Pennsylvania against LBI and American Express. The complaint alleges that LBI, through the conduct of Smith Barney and Travelers, breached certain covenants contained in the Mellon Agreement. The covenants, which relate to the provision of custodial and administrative services to certain mutual funds, were assumed by Smith Barney in connection with the Primerica Transaction. In a separate action Smith Barney and Travelers were also sued by Mellon Bank in connection therewith. By order dated January 26, 1994, the action against LBI and American Express was dismissed. Warren D. Chisum, et al. v. Lehman Brothers Inc. et al. On February 28, 1994 a purported class action was filed in the United States District Court for the Northern District of Texas. The complaint names Lehman Brothers and two former E. F. Hutton & Company Inc. employees as defendants. The complaint alleges that defendants violated Section 10b of the Exchange Act and RICO, breached their fiduciary duties and the limited partners' contract and committed fraud in connection with the origination, sale and operation of four EFH net lease real estate limited partnerships. Plaintiffs seek: (i) to certify a class of all persons who purchased limited partnership interests in the four partnerships at issue, (ii) damages in excess of $140 million plus interest or rescission, (iii) punitive damages and (iv) accounting and attorneys' fees. The Company believes it has several meritorious defenses and intends to vigorously defend this case. Other Matters In connection with the regulatory attention focused on the U.S. treasury market, LGSI received from the Commission and the U.S. Department of Justice, Antitrust Division, subpoenas and letters requesting information and testimony in connection with a review of the activities of various participants in the government securities market. LGSI has responded to the subpoenas and letters. The Company continues to cooperate and supply documents and testimony requested. As of the date hereof, the Company does not believe that the investigations will have a material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Pursuant to General Instruction J of Form 10-K, the information required by Item 4 is omitted. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the outstanding common stock of the Company is owned by American Express. For dividend information with respect to the Registrant's common stock, see Consolidated Statement of Operations appearing at page hereof, which is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Set forth on the following pages is Lehman Brothers Holdings Inc. and Subsidiaries Selected Consolidated Financial Data. SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA The following table summarizes certain consolidated financial information with respect to the Company and is derived from the audited historical financial statements of the Company. During 1993, the Company completed the sales of three businesses: The Boston Company on May 21; Shearson on July 31; and SLHMC on August 31. In the Company's historical financial statements, the operating results of The Boston Company are accounted for as a discontinued operation while the operating results of Shearson and SLHMC are included in the Company's results from continuing operations through their respective sale dates. As a result, the Company's results of operations for 1993 are not directly comparable with the results for prior periods or with the pro forma consolidated financial data. In addition, historical financial information may not be indicative of the Company's future performance subsequent to the Distribution. - --------------- (a) Certain revenue and expense amounts for each of the years prior to 1993 have been reclassified to conform to the current period's presentation. (b) 1992 amount includes $90 million in litigation reserves and a $162 million write-down of the carrying value of certain real estate investments. Other expenses in 1991 includes $32 million write-down of the Company's equity investment in DR Holdings Inc., the former parent company of Computervision Corporation. (c) Includes $32 million of reserves for certain non-core partnership syndication activities in which the Company is no longer actively engaged and $120 million of reserves related to the sale of SLHMC. (d) Amounts reflect a write-down of the carrying value of the Company's holdings of Computervision Corporation in 1992, the write-off of the Company's investment in First Capital Holdings Corporation in 1991 and charges associated with the restructuring of the Company in 1990. (e) Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions," for the Company's retiree health and other benefit plans. The cumulative effect of adopting SFAS No. 106 reduced 1992 net income by $76 million (net of taxes of $52 million). Of this amount, $5 million (net of taxes of $3 million) related to discontinued operations. The Company adopted SFAS No. 109 "Accounting for Income Taxes," as of January 1, 1992 and recorded a $69 million increase in consolidated net income from the cumulative effect of a change in accounting principle, $64 million of which related to discontinued operations. Effective as of January 1, 1990, the Company adopted the policy of expensing the cost of all internally developed software as incurred. The cumulative effect of the change for periods prior to January 1, 1990 increased the 1990 net loss by $157 million, $58 million of which related to discontinued operations. (f) Long-term indebtedness includes senior notes and subordinated indebtedness. (g) Matched book represents a short-term interest rate arbitrage collateralized primarily by U.S. government and agency securities. Several nationally recognized rating agencies consider "securities purchased under agreements to resell" ("reverse repos") a proxy for matched book assets. These rating agencies consider reverse repos to have a low risk profile, and when evaluating the Company's capital strength and financial ratios, exclude reverse repos in the calculation of total assets divided by total equity. Although there are other assets with similar risk characteristics on the Company's balance sheet, the exclusion of reverse repos from total assets in this calculation reflects the fact that these assets are matched against liabilities of a similar nature, and therefore require minimal amounts of capital support. Accordingly, the Company believes the ratio of total assets excluding matched book to total stockholders' equity to be a more meaningful measure of the Company's leverage. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Set forth on the following pages is Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1993. BUSINESS ENVIRONMENT The Company's principal business activities, investment banking and securities trading and sales are, by their nature, subject to volatility, primarily due to changes in interest and foreign exchange rates, global economic and political trends and industry competition. As a result, revenues and earnings may vary significantly from quarter to quarter and from year to year. In 1993, the Company's operating results were achieved in an environment of declining interest rates in the United States, mixed economic trends around the world and continued globalization of the capital markets. The general decline in interest rates in the United States, which began in 1990, continued in 1993 with interest rates declining to their lowest levels in more than 10 years. Investors, seeking higher returns, reduced their holdings of short-term fixed income securities in favor of longer term debt and equity securities in U.S. and non-U.S. markets. Corporate issuers took advantage of this environment and the pools of capital available for investment to restructure their balance sheets through the issuance of equity, repayment of debt and refinancing of debt at lower interest rates. These factors resulted in record levels of debt and equity issuances in 1993. In addition, though the U.S. economy grew slowly in 1993, and the economies of Europe and Japan continued to stagnate, many emerging market economies, particularly in Asia and Latin America, grew more rapidly. Increasing ease of cross-border capital movement, due to lessening of currency and investment restrictions, enhanced the ability of investors and issuers to participate in the international capital markets. RESULTS OF OPERATIONS During 1993, the Company completed the sales of three businesses: The Boston Company on May 21; Shearson on July 31; and SLHMC on August 31. In the Company's audited historical consolidated financial statements, the operating results of The Boston Company are accounted for as a discontinued operation while the operating results of Shearson and SLHMC are included in the Company's results from continuing operations through their respective sale dates. Because of the significant sale transactions completed during 1993, the Company's historical financial statements are not fully comparable for all years presented. To facilitate an understanding of the Company's results, the following discussion is segregated into three sections and provides financial tables that serve as the basis for the review of results. These sections are as follows: - Historical Results: the results of the Company's ongoing businesses; the results of Shearson and SLHMC through their respective sale dates; the loss on the sale of Shearson; the reserves for non-core businesses; the results of The Boston Company (accounted for as a discontinued operation); and the cumulative effect of changes in accounting principles. - The Lehman Businesses: the results of the ongoing businesses of the Company. - The Businesses Sold: the results of Shearson and SLHMC; the loss on the sale of Shearson; and the reserves for non-core businesses related to the sale of SLHMC. HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Net revenues decreased 4% to $5,218 million in 1993 from $5,426 million in 1992 due to the sale of Shearson and SLHMC, offset in part by a 25% increase in net revenues of the Lehman Businesses. Net revenues of $5,426 million in 1992 increased 11% over 1991 net revenues of $4,905 million with net revenues of the Lehman Businesses and the Businesses Sold increasing by 11% and 10%, respectively. Non-interest expenses decreased 8% to $5,191 million in 1993 from $5,673 million in 1992 due to the sale of Shearson and SLHMC and to a decrease in non-interest expenses of the Lehman Businesses. Non-interest expenses of $5,673 million in 1992 increased 19% over 1991 non-interest expenses of $4,755 million due primarily to $497 million of write-downs and reserves taken in 1992 and a 15% increase in compensation and benefits expenses related to the Businesses Sold. The Company reported a net loss of $102 million for the year ended December 31, 1993 compared to a net loss of $123 million in 1992 and net income of $207 million in 1991. Included in the 1993 net loss of $102 million was an after-tax loss on the sale of Shearson of $630 million ($535 million pre-tax) and an after-tax charge of $100 million ($152 million pre-tax) related to certain non-core businesses, including a $79 million ($120 million pre-tax) charge related to the sale of SLHMC and a $21 million ($32 million pre-tax) charge related to certain partnership syndication activities in which the Company is no longer actively engaged. The 1993 net loss also included income from discontinued operations of The Boston Company of $189 million, which included an after-tax gain of $165 million on the sale and after-tax operating earnings of $24 million. The 1992 net loss of $123 million included charges totaling $316 million ($497 million pre-tax) consisting of $59 million ($90 million pre-tax) of additional litigation reserves, a $107 million ($162 million pre-tax) write- down in the carrying value of certain real estate investments, and a $150 million ($245 million pre-tax) charge related to the Company's holdings of Computervision Corporation ("Computervision"). Also included in the 1992 results were income from discontinued operations of $77 million and a charge of $7 million related to the cumulative effect of the changes in accounting for non-pension postretirement benefits and income taxes. Net income of $207 million in 1991 included a $144 million (pre-tax and after-tax) write-off of the Company's investment in First Capital Holdings Corporation ("FCH"), a $32 million (pre-tax and after-tax) write-down of the Company's equity-related investment in DR Holdings Inc., the former parent company of Computervision, income from discontinued operations of $10 million, and a $122 million tax benefit on previously reported losses for which no financial statement benefit had been permitted. Included in the table below are the specific revenue and expense categories comprising the historical results as segregated between the Lehman Businesses and the Businesses Sold. The historical amounts for the Lehman Businesses do not include pro forma adjustments for the effects of the Distribution and, therefore, differ in some respects from the pro forma financial statements included in the Financial Statements. THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 Summary. For the Lehman Businesses, income from continuing operations before the cumulative effect of changes in accounting principles was $355 million in 1993 consisting of $376 million of income from the continuing businesses and a $21 million reserve ($32 million pre-tax) for certain non-core partnership syndication activities in which the Company is no longer actively engaged. The loss of $245 million in 1992 from the Lehman Businesses includes charges totaling $316 million ($497 million pre-tax), as described above in "Historical Results." Net Revenues. Net revenues increased 25% to $3,467 million in 1993 from $2,783 million in 1992. Revenues related to market making and principal transactions and investment banking were the primary sources of the increase. Net revenues increased both domestically and internationally with revenues associated with international products and services increasing 63% to $850 million in 1993 from $520 million in 1992. The Company estimates that approximately $300 million in 1993 revenues that were associated with domestic products and services resulted from relationships with international clients and customers. These international results reflect the Company's strategy to increase the global scope of its business activities. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities, as well as proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to- market gains and (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company utilizes various hedging strategies as it deems appropriate to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Market making and principal transactions revenues increased 47% to $1,644 million in 1993 from $1,122 million in 1992, reflecting greater activity and strong customer order flow across all business lines. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Market Making & Principal Transactions Revenues (in millions): Fixed income revenues increased 13% to $759 million in 1993 from $671 million in 1992. This increase was due principally to increased revenues from several products, particularly emerging markets, high yield and corporate debt instruments. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues increased 39% to $338 million in 1993 from $243 million in 1992, primarily as a result of higher revenues from the Company's proprietary trading activities. Derivative products revenues, which include revenues from fixed income derivative products and equity derivative products, increased 193% to $399 million in 1993 from $136 million in 1992. Fixed income derivative products revenues include net revenues from the trading and market making activities of the Company's fixed income derivative products business. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Fixed income derivative products revenues increased 197% to $318 million in 1993 from $107 million in 1992, representing 40% of the total increase in market making and principal transactions revenues. The increased revenues were primarily a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1993, the notional value of the Company's fixed income derivatives contracts increased to over $260 billion from approximately $105 billion at December 31, 1992. Notional amounts do not represent a quantification of the market or credit risk of the positions; rather, notional amounts represent the amounts used to calculate contractual cash flows to be exchanged and are generally not actually paid or received. During 1994, the Company will commence derivative trading and market making activities through Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary is expected to increase the Company's customer base and the volume of activity in its fixed income derivatives business and capture additional underwriting business. Equity derivative products revenues include net revenues from the trading and market making activities of the Company's equity derivative products business. Such revenues increased 179% to $81 million in 1993 from $29 million in 1992. The Company's equity derivatives business expanded during 1993 due to the Company's increased emphasis on equity derivative products and the Company's activity in the equities business generally. At December 31, 1993, the notional value of equity derivatives contracts was approximately $24 billion. Notional amounts for 1992 and 1991 were not material. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts, and energy and other commodity futures contracts. Revenues from these sources increased 106% to $148 million in 1993 from $72 million in 1992. Included in these results were foreign exchange revenues of $115 million and $62 million for 1993 and 1992, respectively, reflecting an increase of 85%. This increase was due primarily to increased customer-related and proprietary trading activities throughout 1993. Revenues from commodity trading activities increased 154% to $33 million in 1993 from $10 million in 1992, due primarily to increased customer-related trading activities throughout 1993. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1993 and 1992 were $230 billion and $104 billion, respectively. Investment Banking. Investment banking revenues increased 19% to $802 million in 1993 from $674 million in 1992. The 1993 results were driven primarily by a 40% increase in underwriting revenues to $523 million in 1993 from $373 million in 1992. Underwriting revenues increased as a result of significantly higher underwriting volumes in both domestic equity and fixed income products, with the increase in equity underwriting the primary component. Also included within these results were merchant banking revenues which decreased 10% to $105 million in 1993 from $117 million in 1992. Such revenues include net realized gains, net unrealized changes in the value of merchant banking investments and advisory fees. Commissions. Commission revenues increased 9% to $488 million in 1993 from $446 million in 1992, primarily as a result of higher volumes of customer trading of securities and commodities on exchanges. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 5% to $5,679 million in 1993 from $5,404 million in 1992. Net interest and dividend income decreased 5% to $454 million in 1993 from $476 million in 1992. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue is due to trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues increased 22% to $79 million in 1993 from $65 million in 1992. Asset management fees were the principal component of this increase. Asset management and related advisory fees increased 25% to $35 million in 1993 from $28 million in 1992, as assets under management increased substantially to over $12 billion in 1993 from $3 billion in 1992. Non-interest Expense. Compensation and benefits expense increased 18% to $1,825 million in 1993 from $1,551 million in 1992, reflecting higher compensation due to increases in revenues and profitability. However, compensation and benefits expense as a percentage of net revenues decreased to 52.6% in 1993 from 55.7% in 1992 due to improvements in productivity. Excluding compensation and benefits expense, non-interest expenses decreased 32% to $1,077 million in 1993 from $1,586 million in 1992. Included in the 1993 amount was a charge of $32 million ($21 million after-tax) related to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The 1992 results included a series of charges totaling $497 million ($316 million after-tax) which consisted of a charge of $90 million ($59 million after-tax) for additional litigation reserves, a $162 million ($107 million after-tax) write-down of the carrying value of certain real estate investments, and a $245 million ($150 million after-tax) charge related to the Company's holdings of Computervision. Excluding these charges, as well as compensation and benefits, non-interest expenses declined 4% to $1,045 million in 1993 from $1,089 million in 1992. This decrease was due primarily to lower levels of provisions for legal settlements and bad debts and reduced operating expenses. Distribution of Holdings Common Stock On January 24, 1994, American Express announced the Distribution. Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file the Registration Statement with the Commission with respect to the Distribution during the second quarter of 1994. Cost Reduction Effort. In August 1993, the Company announced an expense reduction program with the objective of reducing costs by $200 million on an annualized basis by the end of the first quarter of 1994. The Company's expense structure for the first half of 1993, adjusted for changes in the volume and mix of revenues as well as for additional costs due to external factors such as inflation or new legislation, is the basis against which these goals are being measured. As of March 31, 1994, the Company had taken the following actions which it believes will result in $200 million of cost reductions on an annualized basis: (i) reduced certain purchased costs by lowering the volume of goods and services purchased, renegotiating rates with vendors and strengthening internal compliance with established policies and procedures; (ii) consolidated certain administrative and support functions; (iii) strengthened compliance and control functions; and (iv) completed its annual review of personnel, the objective of which is to upgrade personnel and eliminate positions to improve the Company's overall productivity. During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $30 million pre-tax in the first quarter of 1994 as a result of these terminations. In addition to these actions, the Company has identified a variety of actions that are expected to reduce expenses further, such as (i) additional reductions in certain purchased expenses and (ii) the relocation in the summer of 1994 of certain administrative, operations and other support personnel to newly leased facilities in New Jersey. See "Properties." THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Summary. In 1992, the Company reported a loss from continuing operations before the cumulative effect of changes in accounting principles of $245 million compared to net income of $169 million in 1991. The 1992 results included charges of $316 million ($497 million pre-tax) as described above. Income of $169 million in 1991 included $313 million of income from the continuing core businesses, reduced by a charge of $144 million (pre-and after-tax) related to the write-off of the Company's investment in FCH. The 1991 income from the continuing core businesses also included a tax benefit of $122 million from the recognition of tax benefits under SFAS No. 96. Net Revenues. Net revenues increased 11% to $2,783 million in 1992 from $2,499 million in 1991. Investment banking revenues were the primary source of the improvement, increasing 44% to $674 million in 1992 from $468 million in 1991. Net revenues from domestic products and services accounted for most of the increase rising 14% to $2,263 million in 1992. Net revenues from international products and services increased 2% to $520 million in 1992. The Company estimates that approximately $100 million of 1992 net revenues associated with domestic products and services resulted from relationships with international clients and customers. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities and proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to-market gains (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company uses various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets as it deems appropriate. Market making and principal transactions revenues decreased 2% in 1992 to $1,122 million from $1,146 million in 1991. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Revenues from fixed income products increased 4% to $671 million in 1992 from $643 million in 1991, with money market products and government securities contributing most of the increase. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues decreased 28% to $243 million in 1992 from $338 million in 1991, primarily as a result of lower revenues from the Company's proprietary trading activities. Derivative products revenues, which include revenues from fixed income derivative products and equity derivative products increased 60% to $136 million in 1992 from $85 million in 1991. Fixed income derivative products revenues include net revenues from the trading and market making activities of the Company's fixed income derivatives business. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Fixed income derivative products revenues increased 84% to $107 million in 1992 from $58 million in 1991, primarily as a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1992, the notional value of the Company's fixed income derivatives contracts increased to approximately $105 billion from approximately $45 billion at December 31, 1991. Equity derivative products revenues increased 7% to $29 million in 1992 from $27 million for 1991. The notional value of the Company's equity derivatives contracts was not material at December 31, 1992 and 1991. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts and energy and other commodity futures contracts. Revenues from these sources decreased 10% to $72 million in 1992 from $80 million in 1991. Foreign exchange revenues increased 27% to $62 million in 1992 from $49 million in 1991, primarily due to an expansion of the Company's proprietary trading activities during 1992. Commodity trading revenues decreased to $10 million in 1992 from approximately $31 million in 1991. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1992 and 1991 were $104 billion and $60 billion, respectively. Investment Banking. Investment banking revenues increased 44% to $674 million in 1992 from $468 million in 1991. This increase was due to increased underwriting revenues and improved merchant banking results. Underwriting revenues increased 57% to $373 million in 1992 from $238 million in 1991, while merchant banking revenues increased 92% to $117 million in 1992 from $61 million in 1991. Merchant banking revenues include net realized gains, net unrealized changes in the value of the Company's merchant banking investments and advisory fees. Commissions. Commission revenues decreased 10% to $446 million in 1992 from $495 million in 1991. This decrease was due primarily to the strategic deemphasis of the Company's institutional futures sales activities in 1992. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 10% to $5,404 million in 1992 from $4,909 million in 1991. Net interest and dividend income increased 40% to $476 million in 1992 from $340 million in 1991. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue results from trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues increased 30% to $65 million in 1992 from $50 million in 1991. The growth in asset management fees was the primary source of this increase. Asset management and related advisory fees increased 33% to $28 million in 1992 from $21 million in 1991 due to an increase in assets under management. Non-interest Expense. Compensation and benefits expense increased 13% to $1,551 million in 1992 from $1,370 million in 1991. Compensation and benefits expense as a percent of net revenues was 55.7% in 1992 versus 54.8% in 1991, as a result of competitive pressures which caused compensation and benefits expense to increase at a faster rate than revenues. Excluding compensation and benefits, non-interest expenses increased 52% to $1,586 million in 1992 from $1,044 million in 1991. As previously discussed, 1992 results included a series of charges totaling $497 million while 1991 results included a charge of $144 million related to the write-off of the Company's investment in FCH. Excluding these charges, as well as compensation and benefits expense, other non-interest expenses increased 21% to $1,089 million in 1992 from $900 million in 1991. The increase in expenses was due primarily to higher provisions for legal settlements and bad debts as well as increased operating expenses related to the Company's investments in the expansion of its international, foreign exchange and derivatives businesses. THE LEHMAN BUSINESSES INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In 1993, the Lehman Businesses had an income tax provision of $210 million which consisted of a provision of $221 million for continuing businesses and a tax benefit of $11 million related to non-core business reserves. The effective tax rate for the continuing businesses was 37%, which is greater than the statutory U.S. federal income tax rate principally due to state and local income taxes partially offset by benefits attributable to income subject to preferential tax treatment and increased foreign profits. During the third quarter of 1993, the statutory U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $10 million from the impact of the federal rate change on the Company's net deferred tax assets. The Company's effective tax rate for continuing businesses is expected to increase slightly in 1994, subject to changes in the level and geographic mix of the Company's profits. The Company's net deferred tax assets decreased in 1993 to $265 million from $338 million in 1992. The decrease was primarily related to the utilization of net operating loss carryforwards ("NOLs") which resulted in cash savings to the Company. It is anticipated that the remaining deferred tax asset will be realized through future earnings. In addition, the Company had, as of December 31, 1993, approximately $175 million of tax NOLs available to offset future taxable income, the benefits of which have not yet been reflected in the financial statements. Although the benefit related to these NOLs does not currently meet the recognition criteria of SFAS No. 109, strategies are being implemented to increase the likelihood of realization. It is anticipated that approximately $35 million of these NOLs will be transferred to American Express in connection with the Distribution. In 1992, the Lehman Businesses had an income tax benefit of $109 million which consisted of a provision of $72 million from continuing businesses and a tax benefit of $181 million related to the special charges previously discussed. Excluding the tax benefit, the effective tax rate for the continuing businesses was 50%, which was higher than the statutory U.S. federal income tax rate primarily due to state and local taxes and the impact of certain non-deductible foreign losses. The effective rate on the benefit for special charges was 36%. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Previously, the Company accounted for income taxes in accordance with SFAS No. 96. As a result of the adoption, the Company recorded a $69 million increase in consolidated net income from the cumulative effect of this change in accounting principle, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E. F. Hutton Group Inc. The Company established a deferred tax asset of $327 million in the first quarter of 1992 related to tax benefits previously unrecorded under SFAS No. 96. The 1991 tax benefit of $84 million includes $122 million for the recognition of benefits on previously reported losses for which no financial statement benefit had been permitted. Excluding the recognition of these benefits, the 1991 effective tax rate was 45%, which was higher than the statutory U.S. federal income tax rate due primarily to state and local income taxes and the non-deductibility of goodwill amortization. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 This discussion is provided to analyze the operating results of the Businesses Sold. For purposes of this discussion, the amounts described as the Businesses Sold include the results of operations of Shearson and SLHMC, the loss on sale of Shearson and the reserve for non-core businesses related to the sale of SLHMC. All 1993 amounts for the Businesses Sold include results through their dates of sale and therefore reported results for 1993 are not fully comparable with prior years' results. Net revenues related to the Businesses Sold were $1,751 million in 1993 and $2,643 in 1992. Excluding the loss on the sale of Shearson and the reserve for non-core businesses related to SLHMC, non-interest expenses of the Businesses Sold were $1,634 million in 1993 and $2,536 million in 1992. Compensation and benefits expense were $1,164 million in 1993 and $1,759 million in 1992. The Businesses Sold recorded a net loss of $646 million in 1993 compared to net income of $52 million in 1992. The 1993 results include a loss on sale of Shearson of $630 million and a $79 million charge recorded in the first quarter as a reserve for non-core businesses in anticipation of the sale of SLHMC. The loss on the sale of Shearson included a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Excluding the $630 million after-tax loss on sale, Shearson's net income was $63 million in 1993 compared to $55 million in 1992. Excluding the $79 million after-tax charge discussed above, SLHMC operations were break-even in 1993 compared to a net loss of $3 million in 1992. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Net revenues related to the Businesses Sold increased 10% to $2,643 million in 1992 from $2,406 million in 1991, due primarily to increases in other revenues and commissions. The growth in other revenues was due to increases in investment advisory and custodial fees, reflecting growth in the Company's managed asset products. An increase in the volume of customer directed trading activity was the primary source of the increased level of commission revenues. Non-interest expenses of the Businesses Sold increased 8% to $2,536 million in 1992 from $2,341 million in 1991. Compensation and benefits increased 15% to $1,759 million in 1992 from $1,529 million in 1991, reflecting higher compensation due to increased revenues. Net income for the Businesses Sold increased 86% to $52 million in 1992 from $28 million in 1991. Shearson net income was $55 million in 1992 and $29 million in 1991. THE BUSINESSES SOLD INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The 1993 tax provision included $108 million for Businesses Sold included (i) expenses of $54 million related to the operating results of Shearson; (ii) an expense of $95 million from the sale of Shearson and (iii) a tax benefit of $41 million related to the $120 million reserve for non-core businesses recorded in anticipation of the sale of SLHMC. The provision related to the sale of Shearson primarily resulted from the write-off of $750 million of goodwill which was not deductible for tax purposes. For 1992 and 1991 the tax expense related principally to the Shearson operations. The effective tax rate for the Businesses Sold was 51% in 1992 and 57% in 1991, with the excess over the statutory U.S. federal income tax rate primarily resulting from state and local taxes and the non-deductibility of goodwill amortization. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, total assets were $80.5 billion, compared to $85.2 billion at December 31, 1992. The composition of the Company's assets changed significantly during 1993 due to the sales of The Boston Company, Shearson and SLHMC. The Company's asset base now consists primarily of cash and cash equivalents, and assets which can be sold within one year, including securities and other financial instruments owned, collateralized short-term agreements and receivables. At December 31, 1993, these assets comprised approximately 95% of the Company's balance sheet. Long-term assets consist primarily of other receivables, which include a $945 million interest-bearing receivable from American Express due in 1996, property, equipment and leasehold improvements, deferred expenses and other assets, and excess of cost over fair value of net assets acquired. Daily Funding Activities. The Company finances its short-term assets primarily on a secured basis through the use of securities sold under agreements to repurchase, securities loaned, securities and other financial instruments sold but not yet purchased and other collateralized liability structures. Repurchase agreements and other types of collateralized borrowings historically have been a more stable financing source under all market conditions. Because of their secured nature, these collateralized financing sources are less credit sensitive and also provide the Company access to lower cost funding. The Company uses short-term unsecured borrowing sources to fund short-term assets not financed on a secured basis. The Company's primary sources of short-term, unsecured general purpose funding include commercial paper and short-term debt, including master notes and bank borrowings under uncommitted lines of credit. Commercial paper and short-term debt outstanding totalled $11.2 billion at December 31, 1993, compared to $13.4 billion at December 31, 1992. Of these amounts, commercial paper outstanding totalled $2.6 billion at December 31, 1993, with an average maturity of 31 days, compared to $6.8 billion at December 31, 1992, with an average maturity of 22 days. The 1993 year-end balances reflected the repayment of commercial paper and short-term debt obligations with the proceeds from the sales of The Boston Company, Shearson and SLHMC. As of December 31, 1993, the Company had $1.6 billion of unused committed bank credit lines, provided by 35 banks, to support its commercial paper programs. To reduce liquidity risk, the Company carefully manages its commercial paper and master note maturities to avoid large refinancings on any given day. In addition, the Company limits its exposure to any single commercial paper investor to avoid concentration risk. The Company's and LBI's access to short-term and long-term debt financing is highly dependent on their debt ratings. Holdings' current long-term/short-term senior debt ratings are as follows: S&P A/A-1; Moody's A3/P-2; IBCA A-/A1; and Thomson BankWatch --/ TBW-1. As of the Distribution Date, the Company expects to receive long-term/short-term debt ratings from Fitch Investor Services of A/F-1. LBI's long-term and short-term debt ratings are generally comparable to, or in certain instances higher, than those of Holdings. The Company's uncommitted lines of credit provide an additional source of short-term financing. As of December 31, 1993, the Company had in excess of $10.8 billion in uncommitted lines of credit, provided by 158 banks and institutional lenders, consisting of facilities that the Company has been advised are available but for which no contractual lending obligation exists. Long-term assets are financed with a combination of long-term debt and equity. The Company's long-term funding sources are unsecured senior notes and subordinated indebtedness. The Company maintains long-term debt in excess of its long-term assets to provide additional liquidity, which the Company uses to meet its short-term funding requirements and reduce its reliance on commercial paper and short-term debt. During 1993, the Company issued $4.2 billion in long-term debt, compared to $3.5 billion in 1992. In addition to refinancing long-term debt, these issuances strengthened the Company's capital base, which consists of long-term debt plus equity. The Company staggers the maturities of its long-term debt to minimize refunding risk. At December 31, 1993, the Company had long-term debt outstanding of $9.9 billion with an average life of 3.1 years, compared to $7.7 billion outstanding at December 31, 1992, with an average life of 3.8 years. For long-term debt with a maturity of greater than one year, the Company had $7.4 billion outstanding with an average life of 4.0 years at December 31, 1993, compared to $6.0 billion outstanding with an average life of 4.7 years at December 31, 1992. As of December 31, 1993, the Company had $3.2 billion available for issuance of debt securities under various shelf registrations. In July 1993, the Company initiated a $1 billion Euro medium-term note program, which is not registered under the Securities Act. As of December 31, 1993, $560 million of issuance availability remained under this program. The Company anticipates that 1994 long-term debt issuances will be below that of prior years due to the previously described changes in its asset composition and the pre-funding in 1993 of a portion of the Company's long-term debt maturing in 1994. The cash proceeds to the Company from the Offerings and the Preferred Stock Purchases, which will total approximately $1,193 million, will be used to reduce commercial paper and short-term debt and to pay related fees and expenses estimated to be $20 million. The Company enters into a variety of financial and derivative products agreements as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. These agreements are not part of the Company's trading portfolio of derivative products. The Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense or income related to these agreements on an accrual basis, including the amortization of premiums, over the life of the contracts. At December 31, 1993 and 1992, the Company had outstanding interest rate swap and cap agreements for the above purposes of approximately $4.5 billion and $3.8 billion, respectively. Included in these amounts were approximately $2.3 billion of interest rate swaps and caps, maturing in 1995 and 1997, which serve to reduce the Company's overall fixed rate debt to a lower fixed rate. Of the remaining interest rate swaps, the most significant serve to convert a portion of the Company's debt to either a fixed rate or a floating rate. The Company has matched substantially all of the maturities of its remaining interest rate swaps to the terms of its underlying borrowings. The $4.5 billion of notional amount of interest rate swap and cap agreements mature as follows: The effect of interest rate swap and cap agreements was to decrease interest expense by approximately $56 million, $57 million and $15 million in 1993, 1992 and 1991, respectively. At December 31, 1993, the unrecorded net loss on these agreements was approximately $5 million compared to a net unrecorded gain of $64 million at December 31, 1992. The Company has no deferred gains or losses related to terminated agreements. The Company expects to continue using interest rate swap and cap agreements to modify the effective interest cost associated with its long-term indebtedness. The $2.3 billion of interest rate swaps and caps described above, which reduce the Company's rate on its fixed rate debt to a lower fixed rate, will lower 1994 and 1995 interest expense by approximately $25 million and $15 million, respectively. The effect of the remaining interest rate swaps is dependent on the level of interest rates in the future. Liquidity Management. The maintenance of the liability structure and balance sheet liquidity as discussed above is achieved through the daily execution of the following financing policies: (i) match funding the Company's assets and liabilities; (ii) maximizing the use of collateralized borrowing sources; and (iii) diversifying and expanding borrowing sources. (i) The Company's first financing policy focuses on funding the Company's assets with liabilities which have maturities similar to the anticipated holding period of the assets to minimize refunding risk. The anticipated holding period of assets financed on an unsecured basis is determined by the expected time it would take to obtain financing for these assets on a collateralized basis. (ii) The Company's second financing policy is to maximize that portion of its balance sheet that is funded through collateralized borrowing sources, which include repurchase agreements, securities loaned, securities sold but not yet purchased and other collateralized liability structures. The Company currently funds over 60% of its assets on a collateralized basis. As discussed above, repurchase agreements and other types of collateralized borrowings historically have been a more reliable financing source under all market conditions. (iii) The Company's third financing policy is to diversify and expand its borrowing sources in an effort to maximize liquidity and reduce concentration risk. Through its institutional sales force, the Company seeks financing from a global investor base with the goal of broadening the availability of its funding sources. The Company accesses both the unsecured and collateralized debt markets through its operations in New York, London, Tokyo, Hong Kong, Frankfurt and Geneva. In addition to maintaining geographic diversification, the Company also utilizes a broad range of debt instruments, which it issues in varying maturities. Where the Company deems it to be appropriate, foreign currency denominated assets are financed with corresponding foreign currency denominated liabilities. The Company incorporates these policies in its liquidity contingency planning process, which is designed to enhance the availability of alternative sources of funding in a period of financial stress. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. The Company's liquidity contingency plan is based on an estimate of its ability to meet its funding requirements with collateralized financing. To help achieve this objective, the Company would rely on the additional liquidity created by its policy of issuing long-term debt in excess of long-term assets and its ability to pledge its unencumbered marketable securities as collateral to obtain financing rather than on a sale of these securities. The Company's liquidity contingency plan assumes no draw-down of committed bank credit lines. The plan's assumptions are continually reviewed and updated as the Company's asset/liability mix and liquidity requirements change. The Company believes that these policies, combined with the maintenance of sufficient capital levels, position the Company to meet its liquidity requirements in periods of financial stress. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES In addition to financial instruments recorded on the consolidated balance sheet, the Company enters into off-balance sheet financial instruments primarily consisting of derivative contracts and credit-related arrangements. Derivative products include futures, forwards, swaps, options, caps, collars, floors, swaptions, forward rate agreements, foreign exchange contracts and similar instruments. Derivative products are generally based on notional amounts, while credit-related arrangements are based upon contractual amounts. The notional values of these instruments are generally not recorded on the balance sheet. Off-balance-sheet treatment is generally considered appropriate when the exchange of the underlying asset or liability has not occurred or is not assured, or where the notional amounts are utilized solely as a basis for determining cash flows to be exchanged. Therefore, the notional amounts of these instruments do not reflect the Company's market or credit risk amount. The Company conducts its derivative activities through wholly owned subsidiaries. In late 1993, the Company established a new subsidiary, Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary, which is expected to commence activities during the third quarter of 1994, was established to increase the volume of the Company's derivatives business related to customer-driven derivative activities. The Company records derivatives from dealer-related and proprietary trading activities at market or fair value, with unrealized gains and losses recognized in the consolidated statement of operations as market making and principal transactions revenue. While the notional value of these instruments is not reflected in the consolidated balance sheet, the mark to market value of trading-related derivatives is reflected on a net basis in the December 31, 1993 and 1992 balance sheets as securities and other financial instruments owned or securities and other financial instruments sold but not yet purchased, as applicable. Derivative products, like all financial instruments, include various elements of risk which must be actively managed. General types of risk from derivative products include market risk, liquidity risk and credit risk. Market risk from derivatives results from the potential for changes in interest and foreign exchange rates and fluctuations in commodity or equity prices. The market risk for derivatives is similar to that of cash instruments. The Company may employ hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Liquidity risk from derivatives represents the cost to the Company of adjusting its positions in times of high volatility and financial stress. The liquidity of derivative products is highly related to the liquidity of the underlying cash instruments. As with on-balance sheet financial instruments, the Company's valuation policies for derivatives include consideration of liquidity factors. Credit risk from derivatives relates to the potential for a counterparty defaulting on its contractual agreement. The Company manages its counterparty credit risk through a process similar to its other trading-related activities. This process includes an evaluation of the counterparty's credit worthiness at the inception of the transaction, periodic review of credit standing and various credit enhancements in certain circumstances. In addition, the Company attempts to execute master netting agreements which provide for net settlement of contracts with the same counterparty in the event of cancellation or default when appropriate or when allowable under relevant law. For a discussion of the Company's policies and procedures regarding risk, see "Business -- Risk Management." Cash Flows. Cash and cash equivalents increased $692 million in 1993 to $1,333 million, as the net cash provided by investing activities exceeded the net cash used in operating and financing activities. In addition, cash and cash equivalents for discontinued operations increased $42 million in 1993. Net cash used in operating activities of $1,361 million included the loss from continuing operations adjusted for non-cash items of approximately $677 million for the year ended December 31, 1993. Net cash used in financing activities was $372 million in 1993. Net cash provided by investing activities of $2,467 million in 1993 included cash proceeds from the sales of The Boston Company, Shearson and SLHMC of $2,570 million. Cash and cash equivalents decreased $250 million in 1992 to $641 million, as the net cash used in operating activities exceeded the net cash provided by financing and investing activities. In addition, cash and cash equivalents for discontinued operations decreased $1,082 million and the effect of exchange rate changes on cash was an increase of $9 million. Net cash used in operating activities of $6,277 million included the loss from continuing operations adjusted for non-cash items of approximately $733 million for the year ended December 31, 1992. Net cash provided by financing and investing activities was $4,913 million and $23 million, respectively. Cash and cash equivalents decreased $299 million in 1991 to $891 million. In addition, cash and cash equivalents for discontinued operations increased $706 million and the effect of exchange rate changes on cash was an increase of $4 million. Net cash used in operating activities of $3,111 million included income from continuing operations adjusted for non-cash items of approximately $804 million for the year ended December 31, 1991. Net cash provided by financing and investing activities was $157 million and $3,357 million, respectively. SPECIFIC BUSINESS ACTIVITIES AND TRANSACTIONS The following sections include information on specific business activities of the Company which affect overall liquidity and capital resources: Merchant Banking Partnerships. At December 31, 1993, the Company's investment in merchant banking partnerships was $381 million, which included $168 million in one employee-related partnership in which the Company, as general partner, is entitled to a priority return. At December 31, 1993, the Company had commitments to make investments through merchant banking partnerships of approximately $120 million of which approximately $66 million expired in March 1994. The Company's policy is to carry its interests in merchant banking partnerships at fair value based upon the Company's assessment of the underlying investments. The Company's merchant banking investments, made primarily through the 1989 Partnerships (as defined under "Business"), are, consistent with the terms of the 1989 Partnerships, expected to be sold or otherwise monetized during the remaining term of the Partnerships. Westinghouse. In May 1993, the Company and Westinghouse Electric Corporation ("Westinghouse") entered into a partnership to facilitate the disposition of Westinghouse's commercial real estate portfolio valued at approximately $1.1 billion, which will be accomplished substantially by securitizations and asset sales. The Company invested approximately $154 million in the partnership, and also made collateralized loans to the partnership of $752 million. During the third quarter of 1993, Lennar Inc. was appointed portfolio servicer and purchased a 10% limited partnership interest from the Company and Westinghouse. At December 31, 1993, the carrying value of the Company's investment in the partnership was $154 million and the outstanding balance of the collateralized loan, including accrued interest, was $539 million. The remaining loan balance is expected to be repaid in 1994 through a combination of mortgage remittances, securitizations, asset sales and refinancings by third parties. High Yield Securities. The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade companies. For purposes of this discussion, high yield debt securities are defined as securities or loans to companies rated below BBB- by S&P and below Baa3 by Moody's, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. High yield debt securities are carried at market value and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Operations. The Company's portfolio of such securities at December 31, 1993 and 1992 included long positions with an aggregate market value of approximately $1 billion and $920 million, respectively, and short positions with an aggregate market value of approximately $75 million and $50 million, respectively. The portfolio may from time to time contain concentrated holdings of selected issues. The Company's two largest high yield positions were $179 million and $82 million at December 31, 1993 and $180 million and $123 million at December 31, 1992. Change in Facilities. In 1993, the Company agreed to lease approximately 392,000 square feet of office space located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The lease term will commence in August 1994 and provides for minimum rental payments of approximately $87 million over its 16-year term. Concurrently, the Company announced it would relocate certain administrative employees to five additional floors at 3 World Financial Center in New York, New York. These floors will be purchased from American Express for approximately $44 million, with the Company financing the purchase through the issuance of notes to American Express. In connection with the relocation to the Operations Center and the additional space at the World Financial Center, the Company anticipates incremental fixed asset additions of approximately $112 million which is expected to be funded from the issuance of long-term debt. The relocation is expected to be completed in the summer of 1994. Non-Core Activities and Investments. In March 1990, the Company discontinued the origination of partnerships (whose assets are primarily real estate) and investments in real estate. Currently, the Company acts as a general partner for approximately $4.2 billion of partnership investment capital and manages a real estate investment portfolio with an aggregate investment basis of approximately $322 million. The Company provided additional reserves for these activities of $32 million and $162 million in 1993 and 1992, respectively. At December 31, 1993 and 1992, the Company had remaining net exposure to these investments (defined as the remaining unreserved investment balance plus outstanding commitments and contingent liabilities under guarantees and credit enhancements) of $252 million and $329 million, respectively. In certain circumstances, the Company provides financial and other support and assistance to such investments to maintain investment values. Except as described above, there is no contractual requirement that the Company continue to provide this support. Although a decline in the real estate market or the economy in general or a change in the Company's disposition strategy could result in additional real estate reserves, the Company believes that it is adequately reserved. The Company holds $98 million of long-term subordinated indebtedness and equity securities of American Marketing Industries Holding Inc. ("AMI"). The subordinated debt, as amended, matures in 1997, and includes certain provisions which limit cash interest payments and provides for payment-in-kind securities above such cash interest payments. The AMI loan is current in payment in accordance with its terms. The Company has other equity, partnership and debt investments unrelated to its ongoing businesses. At December 31, 1993, the total carrying value of the AMI loan and these other investments was $229 million. Management's intention with regard to non-core assets is the prudent liquidation of these investments as and when possible. See "Business -- Non-Core Assets." Change of Fiscal Year On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. EFFECTS OF INFLATION Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company's expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company's financial position and results of operations in certain businesses. NEW ACCOUNTING PRONOUNCEMENTS Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The Financial Accounting Standards Board ("FASB") has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. In November 1992, the FASB issued Statement of Financial Standards ("SFAS") No. 112, "Employers Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company records substantially all its securities at market value. No adjustment is anticipated to be recorded as a result of this accounting pronouncement. RISK MANAGEMENT Risk management is an integral part of the Company's business. The Company has established extensive policies and procedures to identify, monitor, assess and manage risk effectively. For a discussion of these policies and procedures, see "Business -- Risk Management." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary financial information required by this Item and included in this Report are listed in the Index to Financial Statements and Schedules appearing on page and are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction J of Form 10-K, the information required by Item 10 is omitted. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction J of Form 10-K, the information required by Item 11 is omitted. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction J of Form 10-K, the information required by Item 12 is omitted. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction J of Form 10-K, the information required by Item 13 is omitted. PART IV ITEM 14. ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Index to Historical and Pro Forma Consolidated Financial Statements appearing on page. 2. Financial Statement Schedules: See Index to Historical and Pro Forma Consolidated Financial Statements appearing on page. 3. Exhibits - --------------- * Filed herewith. ** To be filed by amendment. SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LEHMAN BROTHERS HOLDINGS INC. (Registrant) March 31, 1994 By: /s/ THOMAS A. RUSSO ------------------------------------ Title: Attorney-in-Fact 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. INDEX TO HISTORICAL AND PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS Schedules other than those listed above are omitted since they are not required or are not applicable or the information is furnished elsewhere in the consolidated financial statements or the notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders of Lehman Brothers Holdings Inc. We have audited the accompanying consolidated balance sheet of Lehman Brothers Holdings Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 11 to the consolidated financial statements, in 1992 the Company changed its methods of accounting for postretirement benefits and income taxes. Ernst & Young New York, New York February 3, 1994, except for Note 2 as to which the date is March 28, 1994 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN MILLIONS, EXCEPT SHARE DATA) See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) (IN MILLIONS) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) (INCLUDING THE BOSTON COMPANY) Interest paid (net of amount capitalized) totaled $5,591 in 1993; $5,561 in 1992 and $5,535 in 1991. Income taxes (received) paid totaled $28 in 1993; $86 in 1992 and $(47) in 1991. SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITY During 1993, the Company completed the sale of The Boston Company, Shearson and SLHMC. The cash proceeds related to these sales have been separately reported in the above statement. Excluded from the statement are the individual balance sheet changes related to the net assets sold as well as the non cash proceeds received related to these sales. See notes 3, 4 and 5. See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation The consolidated financial statements include the accounts of Lehman Brothers Holdings Inc. (formerly Shearson Lehman Brothers Holdings Inc., "Holdings"), (Holdings together with its subsidiaries, the "Company" or "Lehman Brothers" unless the context otherwise requires) whose principal subsidiary is Lehman Brothers Inc. (formerly Shearson Lehman Brothers Inc., "LBI"), a registered broker-dealer. American Express Company ("American Express") owns 100% of Holdings' common stock, par value $.10 per share (the "Common Stock"), which represents approximately 93% of Holdings' voting stock. The remainder of Holdings' voting stock is owned by Nippon Life Insurance Company ("Nippon Life"). See Note 2. All material intercompany transactions and accounts have been eliminated. The Consolidated Statement of Operations includes the results of operations of Shearson and SLHMC, which were sold on July 31, 1993 and August 31, 1993, respectively. See Notes 4 and 5. The balance sheet accounts of the Company's foreign subsidiaries are translated using the exchange rates at the balance sheet date. Revenues and expenses are translated at average exchange rates during the year. The resulting translation adjustments, net of hedging gains or losses, are included in stockholders' equity. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Operations. The Company uses the trade date basis of accounting for recording principal transactions. Customer accounts reflect transactions on a settlement date basis. Certain amounts reflect reclassifications to conform to the current period's presentation. Discontinued Operations As described in Note 3, the Company completed the sale of The Boston Company, Inc. ("The Boston Company"), on May 21, 1993. The accompanying consolidated financial statements and notes to consolidated financial statements reflect The Boston Company as a discontinued operation. Securities and Other Financial Instruments Securities and other financial instruments owned and securities and other financial instruments sold but not yet purchased, including interest rate and currency swaps, caps, collars, floors, swaptions, forwards, options and similar instruments are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in market making and principal transactions in the Consolidated Statement of Operations. These amounts also include certain instruments with multiple characteristics whose principal repayment is contingent upon the performance of certain stocks, stock indexes or change in foreign exchange rates. Market value is generally based on listed market prices. If listed market prices are not available, market value is determined based on other relevant factors, including broker or dealer price quotations, and valuation pricing models which take into account time value and volatility factors underlying the financial instruments. In addition to trading and market making activities, the Company enters into a variety of financial instruments and derivative products as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. As an end user, the Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense/revenue related to these instruments on an accrual basis, including the amortization of premiums, over the life of the contracts. Other than in connection with its debt related hedging programs, the Company's other hedging activities are immaterial. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Repurchase and Resale Agreements Securities purchased under agreements to resell and Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell and to value the securities on a daily basis to protect the Company in the event of default by the counterparty. In addition, provisions are made to obtain additional collateral if the market value of the underlying assets is not sufficient to protect the Company. Securities and other financial instruments owned which are sold under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Operations. Securities purchased under agreements to resell and Securities sold under agreements to repurchase for which the resale/repurchase date corresponds to the maturity date of the underlying securities are accounted for as purchases and sales, respectively. At December 31, 1993, such resale and repurchase agreements aggregated $5.5 billion and $5.2 billion, respectively. Securities Borrowed and Loaned Securities borrowed and Securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company's policy to value the securities borrowed and loaned on a daily basis, and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". Prior to January 1, 1992, the Company accounted for income taxes under the provisions of SFAS No. 96. Fixed Assets and Intangibles Property and equipment is depreciated on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases. The Company capitalizes interest costs during construction and amortizes the interest costs based on the useful lives of the assets. Excess of cost over fair value of net assets acquired is amortized using the straight-line method over a period of 35 years. Statement of Cash Flows The Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business. 2. SUBSEQUENT EVENTS: The Distribution On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all the common stock of Holdings (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Establishment of Long-Term Incentive Plans Prior and subject to the Distribution, Holdings adopted the Lehman Brothers Holdings Inc. 1994 Management Ownership Plan (the "1994 Plan"), the Lehman Brothers Holdings Inc. 1994 Management Replacement Plan (the "Replacement Plan"), and the Employee Stock Purchase Plan (the "ESPP"). The 1994 Plan provides for the Compensation and Benefits Committee (the "Compensation Committee") of the Board of Directors to grant stock options, stock appreciation rights ("SARs"), restricted stock units ("RSUs"), restricted stock and performance related shares to eligible employees. In addition, the 1994 Plan provides for non-employee directors to receive annual RSUs representing $30,000 of Common Stock, which vests ratably over a three-year period. Stock options may be awarded as either incentive stock options or non-qualified options. The exercise price for any stock option shall not be less than the market price of Common Stock on the day of the grant. SARs may be awarded as a single award or in conjunction with a stock option. Vesting provisions for stock options and SARs are at the discretion of the Compensation Committee, but in no case may the term of the award exceed 10 years. The 1994 Plan also allows the Compensation Committee to grant restricted stock and performance shares to eligible employees, with vesting and performance objective terms at the discretion of the Compensation Committee. The 1994 Plan expires in ten years. A total of 16,500,000 shares of Common Stock may be subject to awards under the 1994 Plan and an additional 150,000 shares may be subject to RSUs to be issued to non-employee directors. No individual may receive options or SARs over the life of the plan attributable to more than 1,650,000 shares. The Replacement Plan allows the Compensation Committee to grant stock options and restricted stock awards to eligible employees. The primary purpose of the plan is to replace awards relating to American Express common shares granted to Company employees which will be cancelled as of the date of the Distribution. A maximum of 3,200,000 shares of Common Stock will be subject to awards under the Replacement Plan. The number and terms of awards currently outstanding to individuals, as well as the current stock prices of American Express and the Company, will determine the actual number of shares awarded under the Replacement Plan. Awards made under the Replacement Plan will generally contain the same vesting conditions that apply to the cancelled awards. The Compensation Committee adopted, effective June 1, 1994, or such later date as the Compensation Committee shall designate, and subject to the Distribution, the ESPP, under which 6,000,000 shares of Common Stock were reserved for issuance. The ESPP will allow employees to purchase Common Stock at a 15% discount to market value, with a maximum of $15,000 in annual aggregate purchases by any one individual. Change of Fiscal Year-End On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year-end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $30 million pre-tax in the first quarter of 1994 as a result of these terminations. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 3. SALE OF THE BOSTON COMPANY: On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between Lehman Brothers and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction") The Boston Company, which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten-year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million for the Mellon Transaction. In connection with the completion of the Mellon Transaction, the Company received a $300 million dividend from LBI. As a result of the Mellon Transaction, the Company has treated The Boston Company as a discontinued operation. Accordingly, the Company's financial statements segregate the net assets of The Boston Company as of December 31, 1992, and operating results of The Boston Company for the three years ended December 31, 1993. Presented below are the results of operations and the gain on disposal of The Boston Company included in income from discontinued operations (in millions): 4. SALE OF SHEARSON: On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation), ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participa- LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) tion Right payment in the first quarter of 1994. It is anticipated that all the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, the Company received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39 per share. In August 1993, American Express purchased such preferred stock and warrant from the LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Presented below are the results of operations and the loss on the sale of Shearson (in millions): Shearson operating results reflect allocated interest expense of $72 million, $102 million and $112 million for the years ended December 31, 1993, 1992 and 1991, respectively. 5. SALE OF SHEARSON LEHMAN HUTTON MORTGAGE CORPORATION: LBI completed the sale of its wholly-owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC") to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire debt of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC, which are included in the $152 million of pre-tax reserves for non-core businesses on the Consolidated Statement of Operations. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. 6. SECURITIES AND OTHER FINANCIAL INSTRUMENTS: Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased are summarized as follows (in millions): LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 7. CASH AND SECURITIES SEGREGATED AND ON DEPOSIT FOR REGULATORY AND OTHER PURPOSES: In addition to amounts presented in the accompanying Consolidated Balance Sheet as Cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $890 million and $341 million at December 31, 1993 and 1992, respectively, primarily collateralizing resale agreements, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of Securities and Exchange Commission Rule 15c3-3. 8. COMMERCIAL PAPER AND SHORT-TERM DEBT: Short-term debt consists primarily of bank loans, master notes and payables to banks. At December 31, 1993 and 1992, unused committed lines of credit totaled approximately $1.6 billion and $1.7 billion, respectively. The proceeds from these lines, if utilized, would be used primarily to repay commercial paper obligations. Commitment fees on the lines supporting the commercial paper program are 1/8 of 1% on the committed line. 9. SENIOR NOTES: LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) As of December 31, 1993 the Company had $4,367 million of U.S. dollar fixed rate senior notes outstanding. Contractual interest rates on these notes ranged from 3.69% to 12.20% as of December 31, 1993, with a contractual weighted average interest rate of 7.79%. The Company entered into interest rate swap contracts which effectively converted $253 million of its U.S. dollar fixed rate senior notes to floating rates based on the London Interbank Offered Rate ("LIBOR"). Excluding this $253 million, but including the effect of $552 million of U.S. dollar floating rate senior notes effectively converted to fixed rates through the use of interest rate swap contracts and $401 million of fixed rate basis swaps, the Company's U.S. dollar fixed rate senior notes outstanding had an effective weighted average interest rate of 7.84%. As of December 31, 1993, the Company had $3,020 million of U.S. dollar floating rate senior notes outstanding, including $192 million of U.S. dollar floating rate senior notes on which the interest and/or redemption values have been linked to movements in various indices. Excluding this $192 million, contractual rates on the Company's U.S. dollar floating rate senior notes ranged from 3.48% to 5.75%, with a contractual weighted average interest rate of 3.97%. The Company entered into interest rate swap contracts which effectively converted $552 million of its U.S. dollar floating rate senior notes to fixed rates. Excluding this $552 million, but including the effect of $253 million of U.S. dollar fixed rate senior notes converted to floating rates through the use of interest rate swap contracts and $811 million of floating rate basis swaps, the Company's U.S. dollar floating rate senior notes outstanding had an effective weighted average interest rate of 3.90%. As of December 31, 1993 the Company had the equivalent of $392 million of foreign currency denominated senior notes outstanding of which $107 million were fixed rate and $285 million were floating rate. Contractual interest rates on the Company's fixed rate foreign currency denominated senior notes ranged from 2.65% to 5.50% as of December 31, 1993, with a contractual weighted average interest rate of 4.43%. Contractual interest rates on the Company's floating rate foreign currency denominated senior notes ranged from 2.43% to 10.06% as of December 31, 1993, with a contractual weighted average interest rate of 3.51%. The Company entered into cross currency swap contracts which effectively converted a portion of its fixed and floating rate foreign currency denominated senior notes into U.S. dollar obligations. The Company's fixed and floating rate foreign currency senior notes not converted to U.S. dollar obligations, totaling $283 million, were used to finance foreign currency denominated assets. Of the Company's U.S. dollar fixed rate senior notes outstanding as of December 31, 1993, $158 million are repayable prior to maturity at the option of the holder. These obligations are reflected in the above table as $78 million, $25 million, and $55 million maturing in 1994, 1996 and 1997, respectively, rather than at their contractual maturities in 1998, 2003 and 2023, respectively. The holders of these notes have the option to redeem them at par value. The Company's interest in 3 World Financial Center is financed with U.S. dollar, fixed rate senior notes totaling $384 million as of December 31, 1993. Of this amount, $301 million is guaranteed by American Express with a portion of these notes being collateralized by certain mortgage obligations. The remaining $83 million of debt supporting the Company's interest in 3 World Financial Center was loaned to the Company by American Express, the recourse of which is limited to certain fixed assets. As of December 31, 1993, the Company had $3.2 billion available for issuance of debt securities under various shelf registrations. In July 1993, the Company initiated a $1.0 billion Euro medium-term note program which is not registered under the Securities Act of 1933. As of December 31, 1993, $560 million of issuance availability remained under this program. At December 31, 1993, the fair value of the Company's senior notes were approximately $8,037 million ($5,608 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approxi- LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) mately $258 million ($140 million in 1992). For purposes of this fair value calculation the carrying value of variable rate debt that reprices within a year and fixed rate debt which matures in less than six months approximates fair value. For the remaining portfolio, fair value was estimated using either quoted market prices or discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. Unrecognized net losses on interest rate swaps and other transactions used by the Company to manage its interest rate risk within the senior notes portfolio were $54 million and $13 million at December 31, 1993 and 1992, respectively. The unrecognized net losses on these transactions reflect the estimated amounts the Company would pay if the agreements were terminated as calculated based upon market rates as of December 31, 1993 and 1992, respectively. 10. SUBORDINATED INDEBTEDNESS: As of December 31, 1993, the Company had $1,577 million of fixed rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness ranged from 5.75% to 12.50% as of December 31, 1993, with an effective weighted average rate of 9.46%. The Company entered into interest rate swap contracts which effectively converted $425 million of this debt to floating rates based on the London Interbank Offered Rate (LIBOR). Exclusive of this $425 million, the Company utilized a series of fixed rate basis swaps totaling $1,949 million to lower the fixed rate of this portfolio to an effective weighted average interest rate of 7.82% as of December 31, 1993. As of December 31, 1993, the Company had $543 million of floating rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness are primarily based on LIBOR and ranged from 2.91% to 4.25% as of December 31, 1993, with an effective weighted average rate of 3.89%. Including the effect of the $425 million of fixed rate indebtedness swapped to floating rates at an effective weighted average rate of 3.58%, the effective weighted average rate of the Company's floating rate subordinated indebtedness was 3.75%. Of the Company's fixed rate subordinated indebtedness outstanding as of December 31, 1993, $160 million is repayable prior to maturity at the option of the holder. This obligation is reflected in the above table as maturing in 1996, the year in which the holder has the option to redeem the debt at par value, rather than its contractual maturity of 2003. Of the Company's floating rate subordinated indebtedness maturing in 1995, $150 million is redeemable, in whole or in part, at the option of the Company on each quarterly interest payment date from proceeds of previously designated equity securities issuances. As of December 31, 1993, $1,926 million of the total subordinated indebtedness outstanding was senior subordinated indebtedness. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) As of December 31, 1993 the fair value of the Company's subordinated indebtedness was approximately $2,265 million ($2,329 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approximately $145 million ($117 million in 1992). Unrecognized net gains on interest rate swaps and other transactions used by the Company to manage its interest rate risk on the debt was $49 million and $77 million at December 31, 1993 and 1992, respectively. 11. CHANGES IN ACCOUNTING PRINCIPLES: Accounting for Postretirement Benefits Effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for the Company's retiree health and other welfare benefit plans. This accounting pronouncement requires the current recognition of these benefits as expenses based upon actuarially determined projections of the benefits provided. The cumulative effect of adopting SFAS No. 106 reduced 1992 net income by $76 million (net of taxes of $52 million). Of this amount, $5 million (net of taxes of $3 million) related to discontinued operations. Prior to the adoption of this accounting principle, the Company recorded these benefits as they were paid. Accounting for Income Taxes The Financial Accounting Standards Board ("FASB") issued SFAS No. 109, "Accounting for Income Taxes," which superseded SFAS No. 96, the accounting standard that the Company had followed since 1987. The primary difference between this accounting standard and SFAS No. 96, lies in the manner in which income tax expense is determined. SFAS No. 96 provided for significantly more restrictive criteria prior to the recognition of deferred tax assets. Under the provisions of SFAS No. 109, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carryforwards, if, in the opinion of management, it is more likely than not that the tax benefit will be realized. A valuation allowance is recognized, as a reduction of the deferred tax asset, for that component of the net deferred tax asset which does not meet the more likely than not criterion for realization. The Company adopted SFAS No. 109 as of January 1, 1992 and recorded a $69 million increase in consolidated net income from the Cumulative effect of a change in accounting principle, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E.F. Hutton Group Inc. (now known as LB I Group Inc., "Hutton"). 12. PENSION PLANS: The Company sponsors several noncontributory defined benefit pension plans. The cost of pension benefits for eligible employees, measured by length of service, compensation and other factors, is currently being funded through trusts established under the plans. Funding of retirement costs for the applicable plans complies with the minimum funding requirements specified by the Employee Retirement Income Security Act of 1974, as amended, and other statutory requirements. Plan assets consist principally of equities and bonds. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Total expense related to pension benefits amounted to $24 million, $27 million and $31 million for the years ended December 31, 1993, 1992 and 1991, respectively, and consisted of the following components (in millions): The following table sets forth the funded status of the Company's defined benefit plans (in millions): The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation for the Company's plans ranged primarily from 7.25% to 7.5% and 8.25% to 9.5% in 1993 and 1992, respectively. The rate of increase in future compensation levels used ranged primarily from 5.5% to 7% and 6% to 8% in 1993 and 1992, respectively. The expected long-term rate of return on assets ranged primarily from 9% to 9.75% in 1993 and 9% to 10% in 1992. During 1993, the Company incurred a settlement and curtailment with respect to its domestic pension plan in relation to the Primerica Transaction. The net gain of approximately $26 million (pre-tax) was included in the loss on sale of Shearson. 13. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: The Company sponsors several defined benefit health care plans that provide health care, life insurance and other postretirement benefits to retired employees. The health care plans include participant contributions, deductibles, co-insurance provisions and service-related eligibility requirements. The Company funds the cost of these benefits as they are incurred. Net periodic postretirement benefit cost for the year ending December 31, 1992 and 1993 consisted of the following components (in millions): LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company previously accounted for the cost of these benefits by expensing the amount the Company paid. For the year ending December 31, 1991 $2.5 million was paid for such benefits. During 1993, the Company incurred a curtailment with respect to its postretirement plan, in relation to the Primerica Transaction. The net gain of approximately $56 million (pre-tax) was included in the loss on sale of Shearson. The following table sets forth the amount recognized in the Consolidated Balance Sheet for the Company's postretirement benefit plans (other than pension plans) at December 31, 1993 and 1992 (in millions): The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% in 1993 and 8.5% in 1992. The weighted average annual assumed health care cost trend rate is 13% for 1994 and is assumed to decrease at the rate of 1% per year to 7% in 2000 and remain at that level thereafter. An increase in the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $1.4 million. In November 1992, the FASB issued SFAS No. 112, "Employer's Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. 14. INCOME TAXES: The Company's taxable income is included in the consolidated U.S. federal income tax return of American Express and in combined state and local tax returns with other affiliates of American Express. The income tax provision is computed in accordance with the income tax allocation agreement between the Company and American Express. Under the agreement, the Company receives income tax benefits for net operating losses ("NOLs"), future tax deductions and foreign tax credits that are recognizable on a stand-alone basis, or a share, derived by formula, of such losses, deductions and credits that are recognizable on American Express' consolidated income tax return. Intercompany taxes are remitted to or from American Express when they are otherwise due to or from the relevant taxing authority. The balances due from American Express at December 31, 1993 and 1992 were $12 million and $117 million, respectively, and are included in other receivables in the accompanying Consolidated Balance Sheet. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The provision for (benefit from) income taxes from continuing operations consists of the following (in millions): During the third quarter of 1993, the statutory U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $10 million from the impact of the rate change on the Company's net deferred tax assets as of January 1, 1993. Income from continuing operations before taxes included $318 million, $1 million and $26 million that is subject to income taxes of foreign jurisdictions for 1993, 1992 and 1991, respectively. The income tax provision for (benefit from) differs from that computed by using the statutory federal income tax rate for the reasons shown below (in millions): Deferred income tax assets and liabilities result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements that will result in differences between income for tax purposes and income for consolidated financial statement purposes in future years. At December 31, 1993 and 1992, the Company's net deferred tax assets from continuing operations consisted of the following (in millions): LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993 and 1992, deferred tax assets consisted primarily of reserves not yet deducted for tax purposes of $517 million and $398 million, respectively, and tax return NOLs of $38 million and $256 million, respectively, and deferred compensation of $178 million and $149 million, respectively. At December 31, 1993 and 1992, deferred tax liabilities consisted primarily of unrealized trading and investment gains of $183 million and $224 million, respectively, and excess tax over financial depreciation of $68 million and $117 million, respectively. During 1993, the Company increased deferred tax assets by approximately $65 million related to transactions arising from the sale of The Boston Company. The net deferred tax asset is included in Deferred expenses and other assets in the accompanying Consolidated Balance Sheet. At December 31, 1993, the valuation allowance recorded against deferred tax assets from continuing operations was $149 million as compared to $209 million at December 31, 1992. The reduction in the valuation allowance was primarily attributable to 1993 utilization of tax return NOLs for which a valuation allowance was previously established. Of the $149 million valuation allowance at December 31, 1993, approximately $100 million will reduce goodwill if future circumstances permit recognition. For tax return purposes, the Company has approximately $175 million of NOL carryforwards, all of which are attributable to the 1988 acquisition of Hutton. Substantially all of the NOLs are scheduled to expire in the years 1999 through 2007. A portion of the valuation allowance discussed above relates to these NOLs. This amount includes approximately $35 million of NOLs which it is anticipated will be transferred to American Express in connection with the Distribution discussed in Note 2, the benefit of which had not been reflected in the financial statements. 15. PREFERRED STOCK: In 1987, Holdings issued to Nippon Life 13,000,000 shares of Cumulative Convertible Voting Preferred Stock, Series A ("Series A Preferred Stock"), for a cash purchase price of $508 million, as adjusted, or $39.10 per share. The holder of the Series A Preferred Stock is entitled to receive preferred dividends at an annual rate of 5%, payable quarterly before any dividends are paid to the holders of Common Stock. The Company has the right to redeem the shares of Series A Preferred Stock on any dividend payment date after June 15, 1994, in cumulative annual increments of 2,600,000 shares, subject to adjustment, and subject to restrictions on redemptions when dividends are in arrears. Such redemption will be at a price per share equal to $39.10 and is permitted only if there is a public market for the Common Stock and the average market price of shares of Common Stock exceeds the conversion price on the date notice of redemption is given. Each share of Series A Preferred Stock is convertible, at any time prior to the date of redemption, into one share of Common Stock, provided that at least 250,000 shares of Series A Preferred Stock (or such lesser number of such shares then outstanding) are converted each time. The conversion rate is subject to adjustment in certain events. In 1989, the Company issued to American Express Money Market Cumulative Preferred Stock ("Cumulative Preferred Stock"), with a liquidation preference of $250 million. The Cumulative Preferred Stock is pari passu with the Series A Preferred Stock as to dividends and as to distributions upon liquidation. The Cumulative Preferred Stock dividends are payable quarterly at an annual rate of 9% through the fifth anniversary of their issuance. After such time the dividend rate will generally be set by auction. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 16. COMMON STOCK: Changes in shares of Common Stock outstanding are as follows: The Company has reserved for issuance 13,000,000 shares of Common Stock for conversion of the Series A Preferred Stock. On August 10, 1990, the Company issued to Nippon Life a non-transferable common stock purchase warrant, pursuant to which Nippon Life may purchase 10,398,221 shares of Common Stock with an initial exercise price of $15 per share and an expiration date of April 15, 1996. Effective December 31, 1992, the Company sold 11,666,667 shares of Common Stock to American Express for $175 million. 17. EMPLOYEE STOCK OWNERSHIP PLAN: During 1993, Lehman Brothers established the Lehman Brothers Inc. Employee Ownership Plan (the "Employee Ownership Plan") pursuant to which certain key employees of the Company deferred a percentage of their 1993 salary and bonus for the purchase of certain Phantom Units of Holdings. Each Phantom Unit is comprised of a phantom equity interest representing a notional interest in a share of Common Stock ("Phantom Share") and the right to receive a certain amount in cash with respect to a Phantom Share ("Cash Right"). The number of Phantom Units which were available to each participant was determined by the Finance Committee. Up to 6,000,000 Phantom Shares were available for "purchase" through voluntary and mandatory deferrals of 1993 compensation. The price of each Phantom Unit was $10.00 per Phantom Share and $6.67 for each related Cash Right and was determined by the Finance Committee in July 1993 using an assumed capital structure of Holdings for purposes of the program and taking into account various factors, including market multiples for comparable companies, the absence of a public market for Holdings, vesting requirements, and the restrictions on transferability of the Phantom Units. In accordance with the terms of the Plan, Phantom Units will be converted to the Common Stock contemporaneously with the Distribution. See Note 2. The Phantom Units purchased through voluntary deferrals are immediately vested and non-forfeitable; however, there is a restriction on transferability of such Units. There is also a restriction on transferability of the Common Stock which employees will receive upon conversion of the Phantom Shares. Generally, such restriction will lapse ratably over a three year period. The Phantom Units purchased through mandatory deferrals apply to selected senior executives and vest in accordance with a schedule established by the Company's Finance Committee of its Board of Directors and, together with the Common Stock into which they convert, are also subject to transfer restrictions. The Company will recognize compensation expense in 1994 equal to (i) the increase in book value attributable to the Phantom Shares and (ii) the excess, if any, of the market value of the Common Stock on the Distribution Date issued pursuant to the Phantom Share conversion over the price paid by employees for the Phantom Shares. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 18. CAPITAL REQUIREMENTS: As registered broker-dealers, LBI and certain of its subsidiaries are subject to the Net Capital Rule (Rule 15c3-1, the "Rule") promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. monitor the application of the Rule by LBI and such subsidiaries, as the case may be. LBI and such subsidiaries compute net capital under the alternative method of the Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if net capital is less than 4% of aggregate debit balances or 6% of the funds required to be segregated pursuant to the Commodity Exchange Act (the "Commodity Act") and the regulations thereunder, if greater. A broker-dealer may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations thereunder, if greater. In addition, the Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations, thereunder, if greater. The Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Securities and Exchange Commission (the "Commission") when net capital after the withdrawal would be less than 25% of its securities positions haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Rule requires broker-dealers to notify the Commission and the appropriate self-regulatory organization two business days before the withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000 or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000 or 20% of excess net capital. Finally, the Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the firm or would jeopardize the broker-dealer's ability to pay its customers. At December 31, 1993, LBI's net capital aggregated $1,339 million and was $1,293 million in excess of minimum requirement. Also at December 31, 1993, Lehman Government Securities Inc., a wholly owned subsidiary of LBI, had net capital which aggregated $184 million and was $161 million in excess of minimum requirement. The Company is subject to other domestic and international regulatory requirements. As of December 31, 1993, the Company believes it is in material compliance with all such requirements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 19. COMMITMENTS AND CONTINGENCIES: The Company leases office space and equipment and has entered into ground leases with the City of New York or its agencies. Total rent expense for each of the years ended December 31, 1993, 1992 and 1991 was $201 million, $283 million and $269 million, respectively. Minimum future rental commitments under noncancellable operating leases (net of subleases of $679 million) are as follows (in millions): Certain leases on office space contain escalation clauses providing for additional rentals based upon maintenance, utility and tax increases. On October 13, 1993, the Company executed a 16 year lease at 101 Hudson Street in Jersey City, New Jersey. The lease, which commences in August 1994, obligates the Company to make minimum lease payments of approximately $87 million over its term. Amounts shown above include this commitment. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the opinions of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial position. Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, the Company enters into financial instrument transactions to conduct its trading activities, to satisfy the financial needs of its clients and to manage its own exposure to credit and market risks. Many of these financial instruments typically have off-balance-sheet risk resulting from their nature including the terms of settlement. These instruments can be broadly categorized as interest rate and currency swaps, caps, collars, floors, swaptions and similar instruments (collectively "Swap Products"), foreign currency products, equity related products, commitments and guarantees and certain other instruments. Market risk arises from the possibility that market changes, including interest and foreign exchange rate movements, may make financial instruments less valuable. Credit risk results from the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. The Company has extensive control procedures regarding the extent of the Company's transactions with specific counterparties, the manner in which transactions are settled and the ongoing assessment of counterparty creditworthiness. The notional or contract amounts disclosed below provide a measure of the Company's involvement in such instruments but are not indicative of potential loss. Management does not anticipate any material adverse effect to its financial position or results of operations as a result of its involvement in these instruments. In many cases, these financial instruments serve to reduce, rather than increase, market risk. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company enters into interest rate contracts as principal in its trading operations or as an integral part of its interest rate risk management. These contracts include Swap Products, financial future contracts and forward security contracts. The notional or contractual amounts of these instruments are set forth below (in millions): The majority of the Company's off-balance-sheet transactions are short-term in duration with a weighted average maturity of approximately 1.80 years as of December 31, 1993 and 1.64 years as of December 31, 1992. Presented below is a maturity schedule for the notional/contractual amounts outstanding for Swap Products and other off-balance-sheet instruments (in millions): At December 31, 1993, the replacement cost of contracts in a gain position not recorded on the Company's Consolidated Balance Sheet is as follows (in millions): As of December 31, 1993 and 1992, the Company was contingently liable for $1.9 billion of letters of credit primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges and other financial guarantees. As of December 31, 1993 and 1992, the Company had pledged or otherwise transferred securities, primarily fixed income, having a market value of $34.1 billion and $21.7 billion, respectively, as collateral for securities borrowed or otherwise received having a market value of $33.8 billion and $21.4 billion, respectively. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Securities sold but not yet purchased represent obligations of the Company to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater or less than the amount recorded. The Company's customer activities may expose it to off-balance-sheet credit risk. The Company may be required to purchase or sell financial instruments at prevailing market prices in the event of the failure of a customer to settle trades on their original terms, or in the event cash and securities in customer accounts are not sufficient to fully cover customer losses. The Company seeks to control the risks associated with customer activities through the use of systems and procedures for financial instruments with off-balance-sheet risk. Subsidiaries of the Company, as general partner, are contingently liable for the obligations of certain public and private limited partnerships organized as pooled investment funds or engaged primarily in real estate activities. In the opinion of the Company, contingent liabilities, if any, for the obligations of such partnerships will not in the aggregate have a material adverse effect on the Company's consolidated financial position or results of operations. Concentrations of Credit Risk As a major international securities firm, the Company is actively involved in securities underwriting, brokerage, distribution and trading. These and other related services are provided on a worldwide basis to a large and diversified group of clients and customers, including multinational corporations, governments, emerging growth companies, financial institutions and individual investors. A substantial portion of the Company's securities and commodities transactions is collateralized and is executed with and on behalf of commercial banks and other institutional investors, including other brokers and dealers. The Company's exposure to credit risk associated with the non-performance of these customers and counterparties in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile or illiquid trading markets which may impair the ability of customers and counterparties to satisfy their obligations to the Company. Securities and other financial instruments owned by the Company include U.S. government and agency securities and securities issued by non-U.S. governments (principally Japan, Germany, Great Britain and Canada) which, in the aggregate, represented 16.6% of the Company's total assets at December 31, 1993. In addition, substantially all of the collateral held by the Company for resale agreements or bonds borrowed, which together represented 37.8% of total assets at December 31, 1993, consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. In addition to these specific exposures, the Company's most significant concentration is financial institutions, which include other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of the Company's business. Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The Financial Accounting Standards Board has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. 20. FAIR VALUE OF FINANCIAL INSTRUMENTS: In 1992, the Company adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," which requires disclosure of the fair values of most on- and off-balance-sheet financial instruments for which it LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) is practicable to estimate that value. The scope of SFAS No. 107 excludes certain financial instruments, such as trade receivables and payables when the carrying value approximates the fair value, employee benefit obligations and all non-financial instruments, such as land, buildings and equipment and goodwill. The fair values of the financial instruments are estimates based upon current market conditions and perceived risks and require varying degrees of management judgment. For the majority of the Company's assets and liabilities which fall under the scope of SFAS No. 107, book value approximates fair value, with the exception of senior notes and subordinated indebtedness, which are discussed in Notes 9 and 10, respectively. 21. RELATED PARTY TRANSACTIONS: The Company has entered into various related party transactions with American Express. The Company shares certain facilities, primarily the World Financial Center, and administrative support with American Express for which the Company is charged based upon specific identification and allocation methods. The Company believes that amounts arising through related party transactions, including those allocated expenses referred to above, are reasonable and approximate the amount that would have been incurred if the Company operated as an unaffiliated entity. On June 28, 1991, LBI sold all the issued and outstanding stock (the "Stock") of its wholly owned subsidiary, the Balcor Company ("Balcor"), to National Express Company, Inc. ("NEC"), a wholly owned subsidiary of American Express. In connection therewith, the Company sold to American Express certain loans (the "Loans") made by the Company to Balcor and one of Balcor's wholly owned subsidiaries. Pursuant to the terms of the transaction, NEC and American Express purchased the Stock and the Loans at book value for $1.445 billion in a combination of $500 million cash and a $945 million promissory note which matures on June 28, 1996. 22. INTERNATIONAL OPERATIONS: Although the Company's business activities are highly integrated and constitute a single industry segment for the purposes of SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise," they can be broadly categorized into the three major geographic areas in which it conducts operations: North America, Europe and Asia Pacific. The Company manages its businesses with the goal of maximizing worldwide profitability by product line. Activities such as the global distribution of underwritings and the twenty-four hour risk management of trading positions render geographic profitability to be highly subjective as it is the result of numerous estimates and assumptions not normally performed by the Company for internal management reporting purposes. The amounts presented below provide a broad indication of each region's contribution to the consolidated results. The method of allocation is as follows: Gross and Net Revenues, if syndicate or trading related, have been distributed based upon the location where the primary or secondary position was fundamentally risk managed; if fee related, by the location of the senior coverage banker; if commission related, by the location of the salesman. Income (Loss) Before Taxes includes expenses both incurred within and allocated to the region. Identifiable Assets represent essentially those recorded in the legal entities in which the Company does business within the respective region. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 23. OTHER CHARGES: Reserves for Non-Core Businesses During the first quarter of 1993, the Company provided $152 million pre-tax ($100 million after-tax) of non-core business reserves. Of this amount, $32 million pre-tax ($21 million after-tax) relates to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The remaining $120 million pre-tax ($79 million after-tax) relates to reserves recorded in anticipation of the sale of SLHMC. Such sale was completed during the third quarter of 1993. Computervision Write-Down In June 1992, in connection with the recapitalization of Computervision Corporation ("Computervision") the Company and DR Holdings Inc. of Delaware agreed to restructure the Company's $500 million subordinated loan (the "Loan") to Computervision. On June 5, 1992, Computervision filed a Registration Statement on Form S-1 (the "Registration Statement") with respect to the initial public offering of its common stock (the "Computervision Stock"). On August 21, 1992, the initial public offering of the Computervision Stock, for which the LBI was lead underwriter, was completed at a price of $12 per share. The Company received $250 million and 6,200,000 shares of Computervision Stock as consideration for all notes held by it in connection with the Loan and, as a result, recognized a second quarter 1992 after-tax charge to earnings of $84 million ($137 million pre-tax) which reflected a reduction in the carrying value of the Loan. Following the initial public offering, LBI purchased and sold Computervision Stock in connection with its activities as a broker-dealer and underwriter, and on August 28, 1992, sold approximately 4,300,000 shares of Computervision Stock to Holdings thereby LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) increasing Holding's beneficial ownership of Computervision Stock to 22%. On September 30, 1992, Holdings recorded a third quarter 1992 after-tax charge to earnings of $66 million ($108 million pre-tax) which reflected the losses incurred in connection with the aforementioned trading activities, the number of shares of Computervision Stock owned by Holdings, the market value ($6.25 per share) of such Computervision Stock at the close of business on September 30, 1992 and the Company's valuation. First Capital Holdings Corp. Write-Off Until December 24, 1992, the Company owned approximately 28% of the outstanding common stock of First Capital Holdings Corp. ("FCH"), a financial services holding company which specialized primarily in annuities and other life insurance products, through two subsidiaries, First Capital Life Insurance Company ("First Capital Life") and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life"). In May 1991, First Capital Life and Fidelity Bankers Life were placed into conservatorship, and an order for bankruptcy relief was entered with respect to FCH by United States Bankruptcy Court for the Central District of California. As a result, FCH wrote off the net assets of First Capital Life and Fidelity Bankers Life, resulting in a significant deficit in FCH's shareholders' equity. In the second quarter of 1991, the Company recorded a charge to earnings of approximately $144 million (pre-tax and after-tax) related to its investment in FCH. 24. QUARTERLY INFORMATION (UNAUDITED): Quarterly results for the year ended December 31, 1993 were as follows (in millions): The results for the first quarter reflect a loss on the Primerica Transaction of $630 million ($535 million pre-tax) and reserves for non-core businesses of $100 million ($152 million pre-tax). LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Quarterly results for the year ended December 31, 1992 were as follows (in millions): The results for the fourth quarter reflect $59 million after-tax ($90 million pre-tax) of additional legal provisions and a $107 million after-tax ($162 million pre-tax) write-down in the carrying value of certain real estate investments. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED BALANCE SHEET UNAUDITED (IN MILLIONS) ASSETS See notes to pro forma financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED BALANCE SHEET UNAUDITED (IN MILLIONS, EXCEPT SHARE DATA) LIABILITIES AND STOCKHOLDERS' EQUITY See notes to pro forma financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS UNAUDITED (IN MILLIONS, EXCEPT PER SHARE DATA) See notes to pro forma financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS UNAUDITED (IN MILLIONS) See notes to pro forma financial statements. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO PRO FORMA FINANCIAL STATEMENTS BASIS OF REPORTING The following pro forma financial data has been prepared by the Company based on certain adjustments to the audited historical consolidated financial statements of the Company. The pro forma statement of operations reflects adjustments for the Concurrent Transactions and the sale during 1993 of The Boston Company, Shearson and SLHMC as if such transactions had occurred as of the beginning of the periods presented. These adjustments include (i) the elimination of revenues and expenses of Shearson and SLHMC, (ii) the elimination of the loss on the sale of Shearson and the reserves related to the sale of SLHMC, and (iii) a reduction in net interest expense to reflect the use of proceeds from the Concurrent Transactions and the sales of The Boston Company, Shearson and SLHMC to reduce commercial paper and short-term debt and senior notes. The pro forma balance sheet reflects adjustments for the Concurrent Transactions as if such transactions had occurred as of December 31, 1993. The pro forma financial data does not purport to present the financial position and results of operations of the Company had the Concurrent Transactions and the sale of The Boston Company, Shearson and SLHMC actually occurred as of such dates, nor is it necessarily indicative of results of operations that may be achieved in the future. It is anticipated that the Company will incur certain costs in connection with the Distribution that will be charged to operating expenses in the second quarter of 1994. In addition, the Company will recognize compensation expense in 1994 equal to (i) the increase in book value attributable to the Phantom Shares and (ii) the excess, if any, of the market value of the Common Stock on the Distribution Date issued pursuant to the Phantom Shares conversion over the price paid by employees for the Phantom Shares. PRO FORMA BALANCE SHEET ADJUSTMENTS: As the sales of The Boston Company, Shearson and SLHMC were consummated prior to December 31, 1993, the effects of these transactions are reflected in the historical December 31, 1993 balance sheet. Accordingly, no further adjustments relating to these transactions are necessary. The pro forma adjustments to the balance sheet give effect to the items described below: (a) Reflects the repayment of commercial paper and short-term debt with proceeds from the Distribution. (b) Reflects the conversion of Phantom Shares into Common Stock as part of the Distribution (the "Phantom Stock Conversion"). (c) Reflects the exchange of Money Market Cumulative Preferred Stock of Holdings (the "MMP") held by American Express for Common Stock as part of the Distribution (the "MMP Exchange"). (d) Reflects the purchases of preferred stock most significantly by American Express. (e) Reflects the purchases of Common Stock most significantly by American Express, the MMP Exchange and the Phantom Stock Conversion. PRO FORMA STATEMENT OF OPERATIONS ADJUSTMENTS: The pro forma adjustments to the statement of operations give effect to the items described below: (f) The elimination of revenues and expenses of Shearson and the loss on the sale of Shearson in 1993. Also eliminated is the income tax expense of $149 million and $57 million in 1993 and 1992, respectively, related to these items. (g) The elimination of revenues and expenses of SLHMC. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO PRO FORMA FINANCIAL STATEMENTS -- (CONTINUED) (h) Elimination of interest expense of approximately $52 million and $112 million in 1993 and 1992, respectively, resulting from the utilization of cash proceeds from the sales of The Boston Company, Shearson and SLHMC to reduce the Company's commercial paper, short-term debt and senior notes, offset by additional interest expense of $72 million and $102 million in 1993 and 1992, respectively, allocated to Shearson and SLHMC for the carrying costs of buildings, improvements and equipment and certain acquisition-related debt, which is not directly eliminated by the Primerica Transaction or the sale of SLHMC other than through the utilization of available sales proceeds. (i) Reduced interest expense of approximately $42 million in both 1993 and 1992 resulting from the utilization of the cash proceeds to the Company from the Offerings and the Preferred Stock Purchases. (j) The elimination of the reserves related to the sale of SLHMC and the related income tax benefit of $41 million. (k) Adjustments (h) and (i) above, tax effected at an assumed rate of 40%. (l) Elimination of the dividend on the MMP, partially offset by the addition of an assumed dividend of 8 1/2% on $200 million of preferred stock. It is also anticipated that the Company will issue additional preferred stock on which no dividend would have been payable for 1992 and 1993 because such preferred stock is expected to pay a participation of 50% of the Company's net income in excess of $400 million per year (with a cap of $50 million per year for the eight years following the Distribution). SCHEDULE II LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 See notes to Schedule II on page SCHEDULE II LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES -- (CONTINUED) FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES -- (CONTINUED) FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES -- (CONTINUED) FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO PAGE OF SCHEDULE II (1) The Executive Stock Loan Program provides low interest demand loans, on an unsecured basis, to assist key employees in acquiring common stock through open market purchases. Loans under this program bear interest at the lower of the prime lending rate minus 2% or 11%. Such loans are payable on demand and mature on December 31, 1996. (2) Note is payable by March 1994. Interest accrues at the Company's margin rate. (3) Notes are payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (4) Note is payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (5) Notes are payable February 1995 vs. bonus. Interest accrues at the Company's margin rate. (6) Note is payable by payroll deductions of 10% of gross commissions up to $50,000 and all net commissions over $50,000, plus deferred compensation and investment banking fees. Interest accrues at the Company's margin rate. (7) Note is payable by monthly payments of $1,000 plus 50% of any net bonus payable February 1994. Interest accrues at the Company's margin rate. (8) Note is payable February 1994 vs. bonus. Note is noninterest bearing. (9) Other includes employees who transferred to Smith Barney on July 31, 1993. In connection with this transfer Smith Barney paid the Company $25,775,013 for loans related to these individuals. The balance in other also represents loans to individuals who terminated employment and are outstanding at December 31, 1993. (10) It is anticipated that American Express will purchase the loans of Mr. Collins and Mr. Hamerling as part of the Distribution. SCHEDULE III LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (PARENT COMPANY ONLY) (IN MILLIONS EXCEPT SHARE DATA) ASSETS See notes to condensed financial information of Registrant. SCHEDULE III LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF OPERATIONS (PARENT COMPANY ONLY) (IN MILLIONS) See notes to condensed financial information of Registrant. SCHEDULE III LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (PARENT COMPANY ONLY) (IN MILLIONS) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) Interest paid (net of amount capitalized) totaled $1,105 in 1993, $543 in 1992 and $642 in 1991. Income taxes paid (received) totaled $28 in 1993, $86 in 1992 and $(47) in 1991. SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITY Holdings' noncash investing and financing activity for all periods presented was insignificant. See notes to condensed financial information of Registrant. SCHEDULE III LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT 1. SENIOR NOTES: As of December 31, 1993 Holdings had $3,648 million of U.S. dollar fixed rate senior notes outstanding. Contractual interest rates on these notes ranged from 3.69% to 10.80% as of December 31, 1993, with a contractual weighted average interest rate of 7.45%. Holdings entered into interest rate swap contracts which effectively converted $243 million of its U.S. dollar fixed rate senior notes to floating rates based on the London Interbank Offered Rate ("LIBOR"). Excluding this $243 million, but including the effect of $542 million of U.S. dollar floating rate senior notes effectively converted to fixed rates through the use of interest rate swap contracts and $60 million of fixed rate basis swaps, Holdings' U.S. dollar fixed rate senior notes outstanding had an effective weighted average interest rate of 7.65%. As of December 31, 1993, Holdings had $2,439 million of U.S. dollar floating rate senior notes outstanding, including $192 million of U.S. dollar floating rate senior notes on which the interest and/or redemption values have been linked to movements in various indices. Excluding this $192 million, contractual rates on Holdings' U.S. dollar floating rate senior notes ranged from 3.48% to 4.53% with a contractual weighted average interest rate of 3.84%. Holdings entered into interest rate swap contracts which effectively converted $542 million of its U.S. dollar floating rate senior notes to fixed rates. Excluding this $542 million, but including the effect of $243 million of U.S. dollar fixed rate senior notes converted to floating rates through the use of interest rate swap contracts and $599 million of floating rate basis swaps, Holdings' U.S. dollar floating rate senior notes outstanding had an effective weighted average interest rate of 3.85%. As of December 31, 1993 Holdings had the equivalent of $194 million of foreign currency denominated senior notes outstanding, of which $45 million were fixed rate and $149 million were floating rate. The contractual interest rate on Holdings' fixed rate foreign currency denominated senior notes was 5.50% as of December 31, 1993. Contractual interest rates on Holdings' floating rate foreign currency denominated senior notes ranged from 2.62% to 10.06% as of December 31, 1993, with a contractual weighted average interest rate of 3.04%. Holdings entered into cross currency swap contracts which effectively converted a portion of its fixed and floating rate foreign currency denominated senior notes into U.S. dollar obligations. Holdings' floating rate foreign currency senior notes not converted to U.S. dollar obligations, totaling $164 million, were used to finance foreign currency denominated assets. SCHEDULE III LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT Of Holdings' U.S. dollar fixed rate senior notes outstanding as of December 31, 1993, $80 million are repayable prior to maturity at the option of the holder. These obligations are reflected in the above table as $25 million and $55 million maturing in 1996 and 1997, respectively, rather than at their contractual maturities in 2003 and 2023, respectively. The holders of these notes have the option to redeem them at par value. As of December 31, 1993, the fair value of Holdings' senior notes were approximately $6,513 million ($4,635 million in 1992) which exceeds the aggregate carrying value of the notes outstanding by approximately $232 million ($95 million in 1992). For purposes of this fair value calculation the carrying value of variable rate debt that reprices within a year and fixed rate debt which matures in less than six months approximates fair value. For the remaining portfolio, fair value was estimated using either quoted market prices or discounted cash flow analyses based on Holdings' current borrowing rates for similar types of borrowing arrangements. Unrecognized net losses on interest rate swaps and other transactions used by Holdings to manage its interest rate risk within the senior notes portfolio were $57 million and $20 million at December 31, 1993 and 1992, respectively. The unrecognized net losses on these transactions reflect the estimated amounts the Company would pay if the agreements were terminated as calculated based upon market rates as of December 31, 1993 and 1992, respectively. 2. SUBORDINATED INDEBTEDNESS: Subordinated indebtedness at December 31, 1993 consists of $150 million Capital Notes due 1995 (the "Notes"), with interest based on an index of LIBOR. The contractual interest rate on this debt was 4.25% as of December 31, 1993. The Notes are redeemable, in whole or in part, at the option of Holdings on each quarterly interest payment date from proceeds of previously designated equity securities issuances. 3. DIVIDENDS: Dividends and capital distributions declared to Holdings by its subsidiaries and affiliates were $587 million in 1993, $228 million in 1992 and $87 million in 1991. SCHEDULE IX LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS DECEMBER 31, 1993 Information pertaining to aggregate short-term borrowings during each of the three years in the period ended December 31, 1993 was as follows (dollars in billions): - --------------- (1) The maximum amount outstanding was based on month end balances. (2) The average borrowings were computed using the monthly amounts outstanding. (3) Interest rates were determined by dividing the actual interest expense for the year by the average monthly amounts outstanding. EXHIBIT INDEX - --------------- * Filed herewith. ** To be filed by amendment.	36,683	243,950
753308_1993.txt	753308_1993	1993	753308	Item 1. Business FPL GROUP, INC. FPL Group, incorporated under the laws of Florida in 1984, is a public utility holding company (as defined in the Holding Company Act) that is engaged, through its subsidiaries, in utility and non-utility operations. FPL Group is exempt from substantially all of the provisions of the Holding Company Act on the basis that FPL Group's and FPL's businesses are predominantly intrastate in character and carried on substantially in a single state, in which both are incorporated. FPL Group, together with its subsidiaries, employs approximately 12,400 persons. Utility operations are conducted through FPL, which is engaged in the generation, transmission, distribution and sale of electric energy. Non- utility operations are conducted through FPL Group Capital and its subsidiaries and consist mainly of investments in non-utility energy projects and agricultural operations. UTILITY OPERATIONS General. FPL, a wholly-owned subsidiary of FPL Group, supplies electric service throughout most of the east and lower west coasts of Florida. This service territory contains 27,650 square miles with a population of approximately 6.5 million. During 1993, FPL served approximately 3.4 million customer accounts. Operating revenues amounted to approximately $5.2 billion, of which about 56% was derived from residential customers, 37% from commercial customers, 4% from industrial customers and 3% from other sources. FPL provided approximately 98% of FPL Group's operating revenues in each of the years 1991 through 1993. Regulation. The retail operations of FPL represent approximately 98% of operating revenues and are regulated by the FPSC, which has jurisdiction over retail rates, service territory, issuances of securities, planning, siting and construction of facilities and other matters. FPL is also subject to regulation by the FERC in various respects, including the acquisition and disposition of certain facilities, interchange and transmission services and wholesale purchases and sales of electric energy. FPL is subject to the jurisdiction of the NRC with respect to its nuclear power plants. NRC regulations govern the granting of licenses for the construction and operation of nuclear power plants and subject such power plants to continuing review and regulation. Federal, state and local environmental laws and regulations cover air and water quality, land use, power plant and transmission line siting, electric and magnetic fields from power lines and substations, noise and aesthetics, solid waste and other environmental matters. Compliance with these laws and regulations increases the cost of electric service by requiring, among other things, changes in the design and operation of existing facilities and changes or delays in the location, design, construction and operation of new facilities. FPL estimates that capital expenditures for improvements needed to comply with environmental laws and regulations will be approximately $10 million to $30 million annually for the years 1994 through 1998. These amounts are included in FPL's projected capital expenditures set forth in Item 1. Capital Expenditures. FPL holds franchises with varying expiration dates to provide electric service in various municipalities and seven counties in Florida. FPL considers its franchises to be adequate for the conduct of its business. Retail Ratemaking. The underlying concept of utility ratemaking is to set rates at a level that allows the utility to collect total revenues (revenue requirements) equal to its cost of providing service, including a reasonable return on invested capital. To accomplish this, the FPSC uses various ratemaking mechanisms. The basic costs of providing electric service, other than fuel and certain other costs, are recovered through base rates, which are designed to recover the costs of constructing, operating and maintaining the utility system. These costs include operations and maintenance expenses, depreciation and taxes, as well as a rate of return on FPL's investment in assets used and useful in providing electric service (rate base). The rate of return on rate base approximates FPL's weighted cost of capital, which includes its costs for debt and preferred stock and an allowed ROE. Base rates are determined in rate proceedings which occur at irregular intervals at the initiative of FPL, the FPSC or a substantially affected party. Fuel costs are recovered through levelized monthly charges established pursuant to the fuel clause. These charges, which are calculated semi- annually, are based on estimated costs of fuel and estimated customer usage for the ensuing six-month period, plus or minus a true-up adjustment to reflect the variance of actual costs and usage from the estimates used in setting the fuel adjustment charges for prior periods. Capacity payments to other utilities and generators for purchased power are recovered primarily through the capacity clause. Costs associated with implementing energy conservation programs are recovered through rates established pursuant to the conservation clause. Certain other non-fuel costs and the accelerated recovery of the costs of certain projects that displace oil-fired generation are recovered through the oil-backout clause. Beginning in April 1994, costs of complying with new federal, state and local environmental regulations will be recovered through the environmental compliance cost recovery clause. In the past such costs would have been recoverable through base rates. The FPSC has the power to disallow recovery of costs which it considers excessive or imprudently incurred. Such costs may include operations and maintenance expenses, the cost of replacing power lost when fossil and nuclear units are unavailable and costs associated with the construction or acquisition of new facilities. Also, the FPSC does not provide any assurance that the allowed ROE will be achieved. System Capability and Load. FPL's resources for serving load as of January 1, 1994 consist of 16,708 mw of firm electric power generated by FPL-owned facilities (see Item 2. Item 2. Properties FPL Group and its subsidiaries maintain properties which are adequate for their operations. The operating properties of FPL constitute approximately 98% of FPL Group's gross investment in property at December 31, 1993. Generating Facilities. As of December 31, 1993, FPL had the following generating facilities: Transmission and Distribution. FPL owns and operates 451 substations with a total capacity of 100,054,470 kva. Electric transmission and distribution lines owned and in service as of December 31, 1993 are as follows: (1) Includes approximately 80 miles owned jointly with the JEA. Character of Ownership. Substantially all of FPL's properties are subject to the lien of its mortgage, which secures debt securities issued by FPL. The principal properties of FPL are held by it in fee and are free from other encumbrances, subject to minor exceptions, none of which is of such a nature as to substantially impair the usefulness to FPL of such properties. Some of the electric lines are located on land not owned in fee but are covered by necessary consents of governmental authorities or rights obtained from owners of private property. Item 3. Item 3. Legal Proceedings In October 1988, Union Carbide Corporation, the corporate predecessor of Praxair, Inc. (Praxair), filed suit against FPL and Florida Power Corporation (Florida Power) in the United States District Court for the Middle District of Florida. Praxair requested that Florida Power sell power to its facility located within FPL's service territory, and that FPL transport the power to the facility. Florida Power and FPL denied the request as being inconsistent with Florida law and public policy. The FPSC has issued a declaratory statement that FPL's denial of Praxair's request was proper and ordered FPL not to wheel power under such circumstances. The suit alleges that through a territorial agreement, FPL and Florida Power have conspired to eliminate competition for the sale of electric power to retail customers, thereby unreasonably restraining trade and commerce in violation of federal antitrust laws as contained in Section 1 of the Sherman Antitrust Act (Sherman Act). The suit seeks an award of three times Praxair's alleged damages in an unspecified amount based on alleged higher prices paid for electricity and product sales lost by Praxair. Cross motions for summary judgment were denied. Both parties are appealing the denials. In November 1988, TEC Cogeneration, Inc., its affiliate Thermo Electron Corporation, RRD Corp. and its affiliate Rolls Royce Inc. filed suit in the United States District Court for the Southern District of Florida against FPL Group and its subsidiaries, FPL and ESI, on behalf of South Florida Cogeneration Associates (SFCA), a joint venture which since 1986 has operated a cogeneration facility for Metropolitan Dade County within FPL's service territory in Miami, Florida. The suit alleges that the defendants have engaged in anti-competitive conduct intended to prevent and defeat competition from cogenerators within FPL's service territory and from SFCA's Metropolitan Dade County facility in particular. It alleges that the defendants' actions constitute monopolization and attempts to monopolize in violation of Section 2 of the Sherman Act; conspiracy in restraint of trade in violation of Section 1 of the Sherman Act; unlawful discrimination in prices, services or facilities in violation of Section 2 of the Clayton Act; and intentional interference with SFCA's contractual relationship with Metropolitan Dade County in violation of Florida law. The suit seeks damages in excess of $100 million, to be trebled under the Sherman and Clayton Acts, as well as compensatory and punitive damages under Florida law, and injunctive relief. A motion for summary judgment by FPL Group, FPL and ESI has been denied. In November 1989, Johnson Enterprises of Jacksonville, Inc. (Johnson Enterprises) filed suit in the United States District Court for the Middle District of Florida against FPL Group, FPL Group Capital and Telesat, a subsidiary of FPL Group Capital. The suit, which arises out of a cable television facilities installation agreement between Johnson Enterprises and Telesat, alleges breach of contract, fraud and violations of racketeering statutes. The suit seeks compensatory damages in excess of $24 million, treble damages under racketeering activity statutes, punitive damages and attorneys' fees, as well as the revocation of Telesat's corporate charter and cable television franchises. FPL Group believes that it and its subsidiaries have meritorious defenses to all of the litigation described above and is vigorously defending these suits. Accordingly, the liabilities, if any, arising from this litigation are not anticipated to have a material adverse effect on FPL Group's financial statements. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Common Stock Data. FPL Group's common stock is traded on the New York Stock Exchange. The high and low sales prices for the common stock of FPL Group as reported in the consolidated transaction reporting system of the New York Stock Exchange for each quarter during the past two years are as follows: Approximate Number of Stockholders. As of the close of business on February 28, 1994, there were 85,688 holders of record of FPL Group's common stock. Dividends. Quarterly dividends have been paid on common stock of FPL Group during the past two years in the following amounts: The amount and timing of dividends payable on common stock are within the sole discretion of FPL Group's Board of Directors. The increases in the annual dividend rates shown in the table above should not be viewed as indicating a trend for the future. As a practical matter, the ability of FPL Group to pay dividends on its common stock is dependent upon dividends paid to it by its subsidiaries, primarily FPL. Given FPL's current financial condition, there are no restrictions in effect that currently limit FPL's ability to pay dividends to FPL Group. See Management's Discussion - Financial Covenants. Item 6. Item 6. Selected Financial Data Certain amounts included in prior years' selected financial data were reclassified to conform to current year's presentation. (1) Reduced by after-tax effect of cost reduction program or restructuring charge. See Note 4. (2) Reduced by charges related to the write-down of businesses to be discontinued. See Note 5. (3) Reduced by charges related to the disposition of Colonial Penn. See Note 6. (4) Includes unbilled sales. (5) The winter season generally represents November and December of the prior year and January through March of the current year. (6) Includes unbilled and deferred cost recovery clause revenues. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations For the three periods presented, net income benefitted from increased energy sales, primarily from customer growth, and the effects of cost control measures. Charges associated with a cost reduction program in 1993 and a corporate restructuring in 1991 reduced net income in those years. In addition, 1992 net income was adversely affected by Hurricane Andrew. In the following discussion, all comparisons are with the corresponding items in the prior year. Operating Income - Approximately 98% of FPL Group's operating revenue is derived from the electric utility operations of FPL. FPL's retail operations are regulated by the FPSC. Energy sales to retail customers, which represent over 96% of total energy sales, increased 4.0%, 0.1% and 3.3% in 1993, 1992 and 1991, respectively. Retail customer growth for those years was 2.1%, 1.7% and 2.1%, respectively. Revenues from base rates, which represented 61%, 57% and 56% of total operating revenues for 1993, 1992 and 1991, respectively, increased for the three years presented due to higher energy sales. Revenues derived from cost recovery clauses (including fuel) and franchise fees comprise substantially all of the remaining portion of operating revenues. These revenues represent a pass-through of costs and do not significantly affect net income. With increasing competition in the utility industry, FPL is continuing its efforts to reduce its operating and capital costs and avoid filing for rate increases, the traditional response to increased rate base and cost pressures. In connection with these efforts, a major cost reduction program was implemented during 1993, resulting in a $138 million pretax charge. The charge consisted primarily of severance pay and employee retirement benefits related to a workforce reduction of approximately 1,700 positions. Approximately 45% of the charge relates to retirement benefits. Substantially all of the balance represents severance costs, of which about $60 million remains to be paid in 1994. In addition, substantial reductions were reflected in FPL's 1994-98 capital expenditure forecast, including a $210 million reduction from the previous capital expenditure forecast for 1994. The majority of the reductions in the 1994-97 period reflect a decrease in transmission and distribution expenditures through more efficient use of existing plant and more cost effective designs for new facilities. In 1991, FPL implemented a corporate restructuring that eliminated approximately 1,400 FPL positions and about 900 contractor positions. See Note 4. Other operations and maintenance expenses reflect cost savings from the 1991 restructuring, partially offset by the effects of an increasing customer base, changes in prices and operating activities, as well as the implementation of two new accounting standards relating to postretirement and postemployment benefits. See Note 3. As a result of FPL's recent cost reduction measures, other operations and maintenance expense is expected to decline in 1994, despite projected sales growth, additional generating units in service and two additional nuclear refueling outages. Higher utility plant balances, reflecting facilities added to meet customer growth, resulted in increased depreciation expense in each of the last three years. FPL filed new depreciation studies with the FPSC in December 1993. Changes in depreciation rates, when adopted, will be retroactive to January 1994 and, together with increases in utility plant, will increase depreciation expense in 1994. In addition, FPL is scheduled to file updated nuclear decommissioning studies with the FPSC in December 1994. Changes, if any, in the accrual for nuclear decommissioning costs will be effective January 1995. See Note 1. Non-Operating Income and Deductions - Allowance for funds used during construction (AFUDC) increased in 1993 and 1992 due to higher construction activity in the generation area. In future periods AFUDC is expected to decrease because the repowered Lauderdale units were placed in service in the second quarter of 1993, the Martin units are scheduled to be in service by June 1994 and no new generating capacity is under construction. Despite the obligation to fund growth in electric plant, interest and preferred dividends were relatively flat over the three-year period due to refunding approximately $3.3 billion of debt and preferred stock with lower rate instruments. The income contribution from other-net increased in 1993 mainly due to improved equity in earnings of partnerships and joint ventures associated with ESI Energy, Inc. (ESI) and its non-utility energy projects. This increase was largely offset by premiums paid to redeem high cost debt of FPL Group Capital Inc (FPL Group Capital). Premiums paid on the redemption of FPL debt are amortized over the remaining life of the respective debt securities, consistent with the ratemaking treatment. See Note 1. Effective January 1, 1993, the corporate federal income tax rate increased from 34% to 35%. The rate change increased income tax expense by approximately $11 million, including $4 million resulting from the adjustment of the deferred income tax balances of the non-utility subsidiaries. Pending Accounting Changes - In November 1993, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 93-6, "Employers' Accounting for Employee Stock Ownership Plans." If adopted, SOP 93-6 would significantly change the manner in which FPL Group recognizes compensation expense associated with the matching contributions to its thrift plans. Based on preliminary estimates, adoption of the statement would reduce net income by approximately $20 million but would increase earnings per share by $0.04 in 1994, since shares held by the trust for the thrift plans that have not been allocated to employees would not be considered outstanding for purposes of computing earnings per share. FPL Group is not required to adopt the accounting guidance in this pronouncement and is evaluating whether to adopt it. Liquidity and Capital Resources Capital Requirements and Resources - FPL Group's primary capital requirements consist of expenditures under FPL's construction program. FPL's capital expenditures for the period 1994-98, including AFUDC, are expected to be $3.7 billion, including $879 million in 1994. Internally generated funds are expected to fund an increasing percentage of capital expenditures. The balance will be provided primarily through the issuance of FPL long-term debt, preferred stock and commercial paper. FPL Group Capital and ESI have committed to invest approximately $3.2 million in, and lend approximately $4.2 million to, partnerships and joint ventures entered into through ESI, all of which are expected to be funded in 1994. Additionally, FPL Group Capital and its subsidiaries, primarily ESI, have guaranteed up to approximately $89.2 million of lease obligations, debt service payments and other payments subject to certain contingencies. Debt maturities and minimum sinking fund requirements will require cash outflows of approximately $809 million through 1998, including $280 million in 1994. See Note 10. Bank lines of credit currently available to FPL Group and its subsidiaries aggregate $950 million. Financial Covenants - FPL Group's charter does not limit the dividends that may be paid on its common stock; however, FPL's charter and mortgage contain provisions which, under certain conditions, restrict the payment of dividends and other distributions to FPL Group. Given FPL's current financial condition and level of earnings, these restrictions do not currently limit FPL's ability to pay dividends to FPL Group. FPL's charter limits the amount of unsecured debt and FPL's mortgage limits the amount of secured debt FPL can issue. At December 31, 1993, the charter and mortgage provisions would allow issuance of approximately $1.3 billion of additional unsecured debt and $5.5 billion of additional first mortgage bonds, respectively. The amount of additional first mortgage bonds that are permitted to be issued will increase as the amount of unfunded property additions increases. FPL's charter also prohibits the issuance of preferred stock unless the preferred stock coverage ratio, as prescribed, is at least 1.5; for the 12 months ended December 31, 1993 it was 2.24. FPL Group Capital, under a financial covenant in connection with a bank loan, is required to maintain a minimum level of consolidated net worth. At December 31, 1993, the required level was $100 million and actual consolidated net worth of FPL Group Capital was $333 million. Item 8. Item 8. Financial Statements and Supplementary Data INDEPENDENT AUDITORS' REPORT FPL GROUP, INC.: We have audited the consolidated financial statements of FPL Group, Inc. and its subsidiaries, listed in the accompanying index as Item 14(a)1 of this Annual Report (Form 10-K) to the Securities and Exchange Commission for the year ended December 31, 1993. Our audits also comprehended the financial statement schedules of FPL Group, Inc. and its subsidiaries, listed in the accompanying index as Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of FPL Group, Inc. and its subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 2 and 3 to the consolidated financial statements, FPL Group, Inc. and its subsidiaries changed their method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. DELOITTE & TOUCHE Certified Public Accountants Miami, Florida February 11, 1994 FPL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS (Thousands of dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS CAPITALIZATION AND LIABILITIES (Thousands of dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Thousands of Dollars) (1) Represents the effect on cash flows from operating activities of the net amounts deferred or recovered under the fuel and purchased power, oil-backout, energy conservation, capacity and environmental cost recovery clauses. (2) Excludes allowance for other funds used during construction. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 1. Summary of Significant Accounting and Reporting Policies Basis of Presentation - The consolidated financial statements include the accounts of FPL Group, Inc. (FPL Group) and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts included in prior years' consolidated financial statements have been reclassified to conform to the current year's presentation. Regulation - The principal operating company of FPL Group is Florida Power & Light Company (FPL), a utility subject to regulation by the Florida Public Service Commission (FPSC) and the Federal Energy Regulatory Commission (FERC). As a result of such regulation, FPL follows the accounting practices set forth in Statement of Financial Accounting Standard (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." Revenues and Rates - FPL's retail and wholesale utility rate schedules are approved by the FPSC and the FERC, respectively. FPL records the estimated amount of base revenues for energy delivered to customers but not billed. Such unbilled revenues are included in receivables - customers and amounted to approximately $112 million and $120 million at December 31, 1993 and 1992, respectively. Revenues include amounts resulting from cost recovery clauses, which are designed to permit full recovery of certain costs and provide a return on certain assets utilized by these programs, and franchise fees. Such revenues represent a pass-through of costs and include substantially all fuel, purchased power and interchange expenses, conservation-related expenses, revenue taxes and franchise fees. Revenues from cost recovery clauses are recorded when billed; FPL achieves matching of costs and related revenues by deferring the net under or over recovery. Electric Utility Plant, Depreciation and Amortization - The cost of additions to units of utility property is added to electric utility plant. The cost of units of property retired, less net salvage, is charged to accumulated depreciation. Maintenance and repairs of property as well as replacements and renewals of items determined to be less than units of property are charged to operating expenses - other operations and maintenance of utility plant. Depreciation of utility property is provided primarily on a straight-line average remaining life basis. Depreciation studies are performed at least every four years for substantially all utility property. The weighted annual composite depreciation rate was approximately 3.9%, 3.5% and 3.8% for the years 1993, 1992 and 1991, respectively. These rates exclude decommissioning expense and certain accelerated depreciation under cost recovery clauses. All depreciation methods and rates are approved by the FPSC. Nuclear fuel costs, including a charge for spent nuclear fuel disposal, is accrued in fuel expense on a unit of production method. Substantially all electric utility plant is subject to the lien of the Mortgage and Deed of Trust, as supplemented, securing FPL's first mortgage bonds. Allowance for Funds Used During Construction (AFUDC) - FPL recognizes AFUDC as a noncash item which represents the allowed cost of capital used to finance a portion of FPL's construction work in progress. AFUDC is capitalized as an additional cost of utility plant and is recorded as an addition to income. The capitalization rate used in computing AFUDC was 8.67% from January 1993 through June 1993, 8.26% from July 1993 through December 1993, 8.61% in 1992 and 8.46% in 1991. FPL allocates total AFUDC between borrowed funds and other funds. The portion of AFUDC attributable to short and long-term borrowed funds amounted to $31 million, $27 million and $17 million for the years ended December 31, 1993, 1992 and 1991, respectively. Nuclear Decommissioning - FPL accrues nuclear decommissioning costs over the expected service life of each plant. Nuclear decommissioning studies are performed at least every five years for FPL's four nuclear units. A provision for nuclear decommissioning of $38 million for each of the years 1993, 1992 and 1991 is included in depreciation expense. The accumulated provision for nuclear decommissioning totaled $445 million and $390 million at December 31, 1993 and 1992, respectively, and is included in accumulated depreciation. Amounts equal to decommissioning expense are deposited in either qualified funds on a pretax basis or in a non-qualified fund on a net of tax basis. Fund earnings, net of taxes, are reinvested in the funds. Both fund earnings and the charge resulting from reinvestment of the earnings are included in other income - net. The related income tax effects are included in deferred taxes. The decommissioning reserve funds, the predominant component of the utility special use funds, may be used only for the payment of the cost of decommissioning FPL's nuclear units. Securities held in the funds consist primarily of tax-exempt obligations and are carried at cost. See Note 11. The most recent decommissioning studies assume prompt dismantlement for the Turkey Point nuclear units commencing in the year 2005 and for St. Lucie Unit No. 2 commencing in 2021. St. Lucie Unit No. 1 will be mothballed in 2016 until St. Lucie Unit No. 2 is ready for dismantlement. FPL's portion of the cost of decommissioning these units, including dismantlement and reclamation, expressed in 1993 dollars, is currently estimated to aggregate $935 million. Storm and Property Insurance Reserve Fund - The storm and property insurance reserve fund provides coverage toward storm damage costs and possible retrospective premium assessments stemming from a nuclear incident under the various insurance programs covering FPL's nuclear generating plants. The storm and property insurance reserve represents amounts accumulated to date net of expenditures for storm damages. The related income tax effects are included in accumulated deferred income taxes. Securities held in the fund consist primarily of tax-exempt obligations and are carried at cost. In 1992, $21 million of the storm fund was used for storm damage costs associated with Hurricane Andrew. See Note 11. Investments in Partnerships and Joint Ventures - The majority of investments in partnerships and joint ventures are accounted for under the equity method. The cost method is used when FPL Group has virtually no ability to influence the operating or financial decisions of the investee. Securities Transactions - Marketable securities are held by a consolidated limited partnership and are accounted for at market value. Partnership assets are managed by an independent investment advisor. Earnings on the investments are included in other - net in the consolidated statements of income. Included in other current liabilities at December 31, 1993 are approximately $94 million of securities sold, but not yet purchased. These obligations are carried at their market value and create off-balance sheet market risk to the extent that the market value of the underlying securities (U.S. Treasury Notes) subsequently increases. Cash Equivalents - Cash equivalents consist of short-term, highly liquid investments with original maturities of three months or less. The carrying amount of these investments approximates their market value. Retirement of Long-Term Debt - The excess of FPL's reacquisition cost over the book value of long-term debt is deferred and amortized to expense ratably over the remaining life of the original issue, which is consistent with its treatment in the ratemaking process. FPL Group Capital Inc (FPL Group Capital) expenses this cost in the period incurred. Rate Matters - Deferred litigation items of FPL at December 31, 1993 and 1992, represent costs approved by the FPSC for recovery over five years commencing with the effective date of new base rates to be established in the next general rate proceeding. Income Taxes - Deferred income taxes are provided on all significant temporary differences between the financial statement and tax bases of assets and liabilities. Investment tax credits are used to reduce current federal income taxes and, in the case of FPL, are deferred and amortized to income over the approximate lives of the related property. 2. Income Taxes In 1993, FPL Group adopted SFAS No. 109, "Accounting for Income Taxes," which requires the use of the liability method in accounting for income taxes. Under the liability method, the tax effect of temporary differences between the financial statement and tax bases of assets and liabilities are reported as deferred taxes measured at current tax rates. At FPL, the principal effect of adopting SFAS No. 109 was the reclassification of the revenue equivalent of deferred taxes in excess of the amount required to be reported as a liability under SFAS No. 109 from accumulated deferred income taxes to a newly-established deferred regulatory credit - income taxes. This amount will be amortized over the estimated lives of the assets or liabilities which resulted in the initial recognition of the deferred tax amount. Adoption of this standard had no effect on results of operations. The net result of amortizing the deferred regulatory credit and the related deferred taxes established under SFAS No. 109 is to yield comparable amounts to those included in the tax provision under accounting rules applicable to prior periods. The components of income taxes are as follows: A reconciliation between income tax expense and the expected income tax expense at the applicable statutory rates is as follows: The income tax effects of discontinued operations in 1991 differ from the effects computed at statutory rates primarily due to FPL Group's assessment of loss disallowance rules and limitations on the ability to utilize capital loss benefits. FPL Group plans to challenge the loss disallowance rules. Based on the uncertainties associated with the ultimate outcome of this challenge and recognition of offsetting capital gains, a valuation allowance was recorded to fully offset the effect of establishing a deferred tax asset of approximately $170 million under SFAS No. 109 for the tax benefits of the capital loss carryforward. The income tax effects of temporary differences giving rise to FPL Group's consolidated deferred income tax assets and liabilities after adoption of SFAS No. 109 are as follows: 3. Employee Retirement Benefits Pension Benefits - Substantially all employees of FPL Group and its subsidiaries are covered by a noncontributory defined benefit pension plan. Plan benefits are generally based on employees' years of service and compensation during the last years of employment. Participants are vested after five years of service. Plan assets consist primarily of bonds, common stocks and short-term investments. For 1993, 1992 and 1991 the components of pension cost, a portion of which has been capitalized, are as follows: Prior to 1993, an adjustment was made to reflect in the results of operations FPL's pension cost calculated under the actuarial cost method used for utility ratemaking purposes. In 1993, FPL adopted consistent pension measurements for ratemaking and financial reporting. The accumulated regulatory adjustment is being amortized to income over five years. At December 31, 1993 and 1992, the cumulative amount of this regulatory adjustment included in other liabilities was approximately $16 million and $20 million, respectively. During 1992, the method used for valuing plan assets in the calculation of pension cost was changed from fair value to a calculated market-related value. The new method was adopted to reduce the volatility in annual pension expense that results from short-term fluctuations in the securities markets. The cumulative effect of the change was to reduce prepaid pension costs and the related accumulated regulatory adjustment by approximately $37 million, with no effect on earnings. During 1993, the effect of a prior plan amendment that changed the manner in which benefits accrue was recognized and included as part of prior service cost to be amortized over the remaining service life of the employees. FPL Group funds the pension cost calculated under the entry age normal level percentage of pay actuarial cost method, provided that this amount satisfies the Employee Retirement Income Security Act minimum funding standards and is not greater than the maximum tax deductible amount for the year. No contributions to the plan were required for 1993, 1992 or 1991. A reconciliation of the funded status of the plan to the amounts recognized in the Consolidated Balance Sheets is presented below: (1) Includes $37 million effect of changing to calculated market-related method of valuing plan assets. As of December 31, 1993 and 1992, the weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0% and 6.0%, respectively. The assumed rate of increase in future compensation levels at those respective dates was 5.5% and 6.0%. The expected long-term rate of return on plan assets used in determining pension cost was 7.75% for 1993 and 7.0% for 1992 and 1991. Other Postretirement Benefits - FPL Group and its subsidiaries have defined benefit postretirement plans for health care and life insurance benefits that cover substantially all employees. Eligibility for health care benefits is based upon age plus years of service at retirement. The plans are contributory, and contain cost-sharing features such as deductibles and coinsurance. FPL Group has capped company contributions for postretirement health care at a defined level which, depending on actual claims experience, may be reached by the year 2000. Generally, life insurance benefits for retirees are capped at $50,000. FPL Group's policy is to fund postretirement benefits in amounts determined at the discretion of management. Benefit payments in 1993 and 1992 totaled $13 million and $12 million, respectively, and were paid out of existing plan assets. In 1993, FPL Group adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." For the year ended December 31, 1993, the components of net periodic postretirement benefit cost, a portion of which has been capitalized, are as follows: A reconciliation of the funded status of the plan to the amounts recognized in the Consolidated Balance Sheets is presented below: The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) for 1993 is 10.5% for retirees under age 65 and 6.5% for retirees over age 65. These rates are assumed to decrease gradually to 6.0% by the year 2000, which is when it is anticipated that benefit costs will reach the defined level at which company contributions will be capped. The cap on FPL Group's contributions mitigates the potential significant increase in costs resulting from an increase in the health care cost trend rate. Increasing the assumed health care cost trend rate by one percentage point would increase the plan's accumulated postretirement benefit obligation as of December 31, 1993 by $8 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost of the plan for 1993 by approximately $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993. The expected long-term rate of return on plan assets was 7.75% at December 31, 1993. Postemployment Benefits - In 1993, FPL Group adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires a change from recognizing expenses when paid to recording the benefits as the liability is incurred. Implementation of this pronouncement did not have a material effect on FPL Group's results of operations. 4. Cost Reduction Program and Restructuring Charge In 1993, FPL implemented a major cost reduction program, which resulted in a $138 million charge and reduced net income by approximately $85 million. The program consisted primarily of a Voluntary Retirement Plan (VRP) and a Special Severance Plan (SSP). The VRP was offered to all employees who were at least 54 years of age and had at least 10 years of service. The plan, among other things, added five years to age and service for the determination of plan benefits to be received by eligible employees. Approximately 700 employees, or 75% of those eligible, elected to retire under this program. The impact on pension cost resulting from the two programs as determined under the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," was approximately $34 million. The impact on postretirement benefits as determined under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" was approximately $29 million. These amounts are included as part of the total charge of $138 million. See Note 3. In 1991, FPL recorded a $90 million restructuring charge in connection with a company-wide restructuring which reduced net income by $56 million. The charge included severance pay for departing employees, as well as relocation and facility modification expenditures. 5. Businesses to be Discontinued In 1990, FPL Group decided to sell or otherwise dispose of the real estate, cable television, environmental remediation and utility-related services businesses. In 1991, the environmental remediation and utility-related services businesses were sold with no significant impact on net income. During 1993, FPL Group sold or otherwise liquidated certain cable television and real estate assets, including cable television operating systems, interests in three cable television joint ventures and real estate rental properties. FPL Group's remaining developed real estate properties are under contract for sale. This pending sale, if closed, and the currently estimated result of disposing of the balance of FPL Group's cable television and real estate assets are not expected to have a significant adverse effect on net income. 6. Discontinued Operations In 1991, Colonial Penn Group, Inc. (Colonial Penn) was sold, resulting in a $135 million after-tax loss. The sale did not include Bay Loan and Investment Bank (Bay Loan), a former Colonial Penn subsidiary, which is winding down its operations and will be dissolved. The principal business of Bay Loan was investing in loans secured by real estate using funds provided from the issuance of insured certificates of deposit. Bay Loan ceased investing in new loans in 1990 and is in the process of effecting an orderly liquidation. The date when such liquidation will be completed cannot be predicted with certainty because it is dependent on the timing of loan prepayments and asset sales. FPL Group has no legal obligation and has no intention to contribute additional equity to Bay Loan. The investment in Bay Loan was written off in 1990; the orderly liquidation of its operations is not expected to have an adverse effect on FPL Group's future operating results. Colonial Penn and Bay Loan have been accounted for as discontinued operations. Operating revenues of Bay Loan were $16.3 million and $21.4 million for 1993 and 1992, respectively. Combined operating revenues of Colonial Penn (through date of closing) and Bay Loan were $714.1 million for 1991. Bay Loan reported operating income of $5.1 million in 1993 and operating losses of $5.9 million and $8.5 million in 1992 and 1991, respectively. The losses incurred subsequent to the measurement date (date on which Bay Loan was initially classified as discontinued operations) had no effect on FPL Group's results of operations as such losses had been provided for in the loss on disposal of discontinued operations in 1991. The remaining assets of Bay Loan consist primarily of loans secured by real estate and real estate owned as a result of foreclosures. Most of Bay Loan's loan customers and the real estate securing their loans are located in the northeast United States. The remaining liabilities of Bay Loan consist primarily of FDIC-insured certificates of deposit, which will be settled with funds generated from loan repayments and the sale of Bay Loan assets. Total assets and liabilities of Bay Loan at December 31, 1993 were $149.3 million and $129.7 million, respectively. Total assets and liabilities of Bay Loan at December 31, 1992 were $194.9 million and $180.4 million, respectively. The carrying amounts of assets and liabilities at December 31, 1993 and 1992, approximate the estimated fair values of the financial instruments of Bay Loan. 7. Leases In 1991, FPL expanded its nuclear fuel lease program to include all four of its nuclear units. In connection with this expansion, FPL sold to a non-affiliated lessor and leased back approximately $220 million of nuclear fuel held in reactors of these units, as well as nuclear fuel in various stages of enrichment. The fuel was sold at book value. Nuclear fuel payments, which are based on energy production and are charged to fuel expense, were $122 million, $120 million and $81 million for the years ended December 31, 1993, 1992 and 1991, respectively. Included in these payments was an interest component of $11 million, $13 million and $9 million in 1993, 1992 and 1991, respectively. Under certain circumstances of lease termination, FPL is required to purchase all nuclear fuel in whatever form at a purchase price designed to allow the lessor to recover its net investment cost in the fuel, which totaled $226 million at December 31, 1993. For ratemaking purposes, the leases encompassed within this lease arrangement are classified as operating leases. For financial reporting purposes, the capital lease obligation is recorded at the amount due in the event of lease termination. In 1992, FPL entered into a noncancelable capital lease arrangement for an office building whose net book value at December 31, 1993 and 1992 was approximately $46 million and $48 million, respectively. The present value of future minimum lease payments at December 31, 1993 totaled $49 million. Future minimum annual lease payments under this lease arrangement, which expires in 2016, are estimated to be $4 million. Excluding these leases, the amount of assets and capitalized lease obligations for other capital leases is not material. FPL Group, through its subsidiaries, leases automotive, computer, office and other equipment through rental agreements with various terms and expiration dates. Rental expense totaled $33 million, $55 million and $51 million for 1993, 1992 and 1991, respectively. Minimum annual rental commitments for noncancelable operating leases are $22 million for 1994, $19 million for 1995, $13 million for 1996, $7 million for 1997, $6 million for 1998 and $15 million thereafter. 8. Jointly-Owned Electric Utility Plant FPL owns approximately 85% of the St. Lucie Nuclear Unit No. 2, 20% of the St. Johns River Power Park (SJRPP) units and coal terminal and a 49% undivided interest in Scherer Unit No. 4. FPL expects to purchase an additional 27% undivided ownership interest in Scherer Unit No. 4 in two stages through 1995. At December 31, 1993, FPL's investment in St. Lucie Unit No. 2 was $768 million, net of accumulated depreciation of $397 million; the investment in the SJRPP units and coal terminal was $221 million, net of accumulated depreciation of $110 million; the investment in Scherer Unit No. 4 was $296 million, net of accumulated depreciation of $54 million. FPL is responsible for its share of the operating costs, as well as providing its own financing. At December 31, 1993, there was no significant balance of construction work in progress on these facilities. 9. Common Shareholders' Equity The changes in common shareholders' equity accounts are as follows: Common Stock Dividend Restrictions - FPL Group's Charter does not limit the dividends that may be paid on its common stock. As a practical matter, the ability of FPL Group to pay dividends on its common stock is dependent upon dividends paid to it by its subsidiaries, primarily FPL. FPL's charter and mortgage contain provisions that, under certain conditions, restrict the payment of dividends and other distributions to FPL Group. Given FPL's current financial condition and level of earnings, these restrictions do not currently limit FPL's ability to pay dividends to FPL Group. Employee Stock Ownership Plan - The employee thrift plans of FPL Group and FPL include a leveraged Employee Stock Ownership Plan feature. Shares of common stock held by the Trust for the Thrift Plans (Trust) are used to provide all or a portion of the employers' matching contributions. In 1990, the Trust borrowed the funds from FPL Group Capital, at an interest rate of 9.69% to purchase the shares and is repaying the loan with dividends received on the shares along with cash contributions from the employers. Reducing stockholders' equity at December 31, 1993 is approximately $317 million of unearned compensation related to unallocated shares of common stock held by the Trust. The unallocated shares are considered outstanding for purposes of computing earnings per share. Dividends paid aggregated approximately $30 million in all years. In November 1993, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued SOP 93-6, "Employers' Accounting for Employee Stock Ownership Plans." If adopted, SOP 93-6 would significantly change the manner in which FPL Group recognizes compensation expense associated with the matching contributions to its thrift plans. Based on preliminary estimates, adoption of the standard would reduce net income by approximately $20 million but would increase earnings per share by $0.04 in 1994, since shares held by the Trust which have not yet been allocated to employees would not be considered outstanding for purposes of computing earnings per share. FPL Group is not required to adopt the accounting guidance in this pronouncement and is evaluating whether or not to adopt it. Long-Term Incentive Plan - FPL Group has a long-term incentive plan under which an aggregate of 4 million shares may be awarded to officers and key employees of FPL Group and its subsidiaries. At December 31, 1993, 3,304,739 shares were available for future awards. Total compensation charged against earnings under the incentive plan, and the effect on earnings per share, were not material in any year. The changes in share awards under the incentive plan are as follows: (1) Payment of performance shares is based on the market price of FPL Group's common stock when the related performance goal is achieved. (2) Shares of restricted stock were issued at market value at the date of the grant. (3) All outstanding options are exercisable at $30 7/8. Stock appreciation rights in an equivalent amount have been granted in conjunction with the options referred to above. No awards of incentive stock options have been granted as of December 31, 1993. Other - FPL Group has reserved 17 million shares of common stock for issuance under the Dividend Reinvestment and Common Share Purchase Plan and Employee Benefit Plans. At December 31, 1993, 9 million of the shares reserved for these plans had been issued. Each share of common stock has been granted a Preferred Share Purchase Right, which is exercisable in the event of certain attempted business combinations. The Rights will cause substantial dilution to a person or group attempting to acquire FPL Group on terms not approved by the FPL Group Board of Directors. 10. Preferred Stock and Long-Term Debt Preferred Stock (1)(2) (1) FPL Group's charter authorizes the issuance of 100 million shares of serial preferred stock, $.01 par value. None of these shares are outstanding. (2) FPL's charter authorizes the issuance of 5 million shares of subordinated preferred stock, no par value. No shares of subordinated preferred stock are outstanding. In 1993, FPL issued 1,900,000 shares of $100 par value preferred stock. In 1992, FPL issued 5,000,000 shares of $2.00 No Par Value, Series A, preferred stock. There were no issuances of preferred stock in 1991. (3) Not redeemable prior to 2003. (4) Minimum annual sinking fund requirements on preferred stock are approximately $2 million for each of the years 1994 and 1995 and $4 million for each of the years 1996, 1997 and 1998. In the event that FPL should be in arrears on its sinking fund obligations, FPL may not pay dividends on common stock. (5) Entitled to a sinking fund to retire a minimum of 15,000 shares and a maximum of 30,000 shares annually from 1994 through 2026 at $100 per share plus accrued dividends. FPL redeemed and retired 15,000 shares in 1992, satisfying the 1993 minimum annual sinking fund requirement. (6) Entitled to a sinking fund to retire a minimum of 25,000 shares and a maximum of 50,000 shares annually from 1996 through 2015 at $100 per share plus accrued dividends. Long-Term Debt (1)(2) (1) Minimum annual maturities and sinking fund requirements of long-term debt are approximately $278 million for 1994, $82 million for 1995, $101 million for 1996, $151 million for 1997 and $181 million for 1998. (2) Available lines of credit aggregated approximately $950 million at December 31, 1993, all of which were based on firm commitments. (3) Excludes approximately $46 million principal amount of bonds removed from the balance sheet in December 1993 as a result of an in-substance defeasance. Such bonds were redeemed in January 1994 with funds previously placed in an irrevocable trust. 11. Fair Value of Financial Instruments The following estimates of the fair value of financial instruments have been made using available market information and other valuation methodologies. However, the use of different market assumptions or methods of valuation could result in different estimated fair values. (1) Based on quoted market prices for these or similar issues. (2) Includes current maturities. 12. Commitments and Contingencies Capital Commitments - FPL has made certain commitments in connection with its projected capital expenditures. These expenditures, for the construction or acquisition of additional facilities and equipment to meet customer demand, are estimated to be $3.7 billion, including AFUDC, for the years 1994 through 1998. FPL Group Capital and ESI Energy, Inc. (ESI), have committed to invest $3 million in, and lend approximately $4 million to, partnerships and joint ventures entered into through ESI, all of which are expected to be funded in 1994. Additionally, FPL Group Capital and its subsidiaries, primarily ESI, have guaranteed up to approximately $89 million of lease obligations, debt service payments and other payments subject to certain contingencies. FPL Group, through a consolidated limited partnership, has entered into forward commitments at December 31, 1993 to purchase $100 million of mortgage-backed securities on various dates through February 1994 at specified prices. The market value of these securities totaled $100 million at December 31, 1993. Additionally, the partnership had entered into forward commitments to sell short $87 million of U.S. Treasury Notes on various dates in January 1994 at specified prices. At December 31, 1993, the market value of those securities totaled $89 million. Insurance - Liability for accidents at nuclear power plants is governed by the Price-Anderson Act, which limits the liability of nuclear reactor owners to the amount of the insurance available from private sources and under an industry retrospective payment plan. In accordance with this Act, FPL maintains $200 million of private liability insurance, which is the maximum obtainable, and participates in a secondary financial protection system under which it is subject to retrospective assessments of up to $317 million per incident at any nuclear utility reactor in the United States, payable at a rate not to exceed $40 million per incident per year. FPL participates in insurance pools and other arrangements that provide $2.75 billion of limited insurance coverage for property damage, decontamination and premature decommissioning risks at its nuclear plants. The proceeds from such insurance, however, must first be used for reactor stabilization and site decontamination before they can be used for plant repair. FPL also participates in an insurance program that provides limited coverage for replacement power costs if a plant is out of service because of an accident. In the event of an accident at one of FPL's or another participating insured's nuclear plant, FPL could be assessed up to $58 million in retrospective premiums, and in the event of a subsequent accident at such nuclear plants during the policy period, the maximum assessment is $72 million under the programs in effect at December 31, 1993. This contingent liability would be partially offset by a portion of FPL's storm and property insurance reserve (storm fund), which totaled $82 million at that date. In the event of a catastrophic loss at one of FPL's nuclear plants, the amount of insurance available may not be adequate to cover property damage and other expenses incurred. Uninsured losses, to the extent not recovered through rates, would be borne by FPL and could have a material adverse effect on FPL Group's and FPL's financial condition. In 1993, FPL replaced its transmission and distribution (T&D) property insurance coverage with a self-insurance program due to the high cost and limited coverage available from third-party insurers. Costs incurred under the self-insurance program will be charged against FPL's storm fund. Recovery of any losses in excess of the storm fund from ratepayers will require the approval of the FPSC. FPL's available lines of credit include $300 million to provide additional liquidity in the event of a T&D property loss. Contracts - FPL has take-or-pay contracts with the Jacksonville Electric Authority (JEA) for 374 megawatts (mw) through 2023 and with the subsidiaries of the Southern Company to purchase 1,406 mw of power through May 1994, and declining amounts thereafter through mid-2010. FPL also has various firm pay-for-performance contracts to purchase 1,031 mw from certain cogenerators and small power producers (qualifying facilities) with expiration dates ranging from 2002 through 2026. These contracts provide for capacity and energy payments. Capacity payments for the pay-for-performance contracts are subject to the qualifying facilities meeting certain contract obligations. Energy payments are based on the actual power taken under these contracts. The required capacity payments through 1998 under these contracts are estimated to be as follows: FPL's capacity and energy charges under these contracts for 1993, 1992 and 1991 were as follows: (1) Recovered through base rates and the capacity cost recovery clause (capacity clause). (2) Recovered through the capacity clause. (3) Recovered through the fuel and purchased power cost recovery clause. (4) Recoverable through base rates. FPL has take-or-pay contracts for the supply and transportation of natural gas under which it is required to make payments estimated to be $280 million for 1994, $380 million for 1995 and $390 million for each of the years 1996, 1997 and 1998. Total payments made under these contracts were $270 million, $269 million and $221 million for 1993, 1992 and 1991, respectively. Litigation - Union Carbide Corporation sued FPL and Florida Power Corporation alleging that, through a territorial agreement approved by the FPSC, they conspired to eliminate competition in violation of federal antitrust laws. Praxair, Inc., an entity that was formerly a unit of Union Carbide, has been substituted as the plaintiff. The suit seeks treble damages of an unspecified amount based on alleged higher prices paid for electricity and product sales lost. Cross motions for summary judgement were denied. Both parties are appealing the denials. A suit brought by the partners in a cogeneration project located in Dade County, Florida, alleges that FPL Group, FPL and ESI have engaged in anti-competitive conduct intended to eliminate competition from cogenerators generally, and from their facility in particular, in violation of federal antitrust laws and have wrongfully interfered with the cogeneration project's contractual relationship with Metropolitan Dade County. The suit seeks damages in excess of $100 million, before trebling under antitrust law, plus other unspecified compensatory and punitive damages. A motion for summary judgment by FPL Group, FPL and ESI has been denied. A former cable installation contractor for Telesat Cablevision, Inc. (an indirect subsidiary of FPL Group) has sued FPL Group, FPL Group Capital and Telesat for breach of contract, fraud and violation of racketeering statutes. The suit seeks compensatory damages in excess of $24 million, treble damages under racketeering activity statutes, punitive damages and attorneys' fees, as well as the revocation of Telesat's corporate charter and cable television franchises. FPL Group believes that it and its subsidiaries have meritorious defenses to all of the litigation described above and is vigorously defending these suits. Accordingly, the liabilities, if any, arising from this litigation are not anticipated to have a material adverse effect on FPL Group's financial statements. 13. Quarterly Data (Unaudited) Condensed consolidated quarterly financial information for 1993 and 1992 is as follows: (1) In the opinion of FPL Group, all adjustments, which consist of normal recurring accruals necessary to present a fair statement of such amounts for such periods, have been made. Results of operations for an interim period may not give a true indication of results for the calendar year. (2) Charge resulting from cost reduction program reduced operating income by $138 million, net income by $85 million and earnings per share by $0.45. See Note 4. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required by this Item will be included in FPL Group's Definitive Proxy Statement which will be filed with the SEC in connection with the 1994 Annual Meeting of Shareholders (FPL Group's Proxy Statement) and is incorporated herein by reference, or is included in Part I under Executive Officers of the Registrant. Item 11. Item 11. Executive Compensation The information required by this Item will be included in FPL Group's Proxy Statement and is incorporated herein by reference, provided that the Compensation Committee Report and Performance Graphs which are contained in FPL Group's Proxy Statement shall not be deemed to be incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item will be included in FPL Group's Proxy Statement and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this Item will be included in FPL Group's Proxy Statement and is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements Page(s) Independent Auditors' Report 15 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 16 Consolidated Balance Sheets at December 31, 1993 and 1992 17-18 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 19 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991 20-35 2. Financial Statement Schedules(1) Schedule V Property, Plant and Equipment 39-40 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 41-42 Schedule IX Short-Term Borrowings 43 Schedule X Supplementary Income Statement Information 44 (1) All other schedules are omitted as not applicable or not required. 3. Exhibits including those Incorporated by Reference Exhibit Number Description 3(i) Restated Articles of Incorporation of FPL Group dated December 31, 1984, as amended through December 17, 1990 (filed as Exhibit 4(a) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 3(ii) Bylaws of FPL Group dated November 15, 1993 4(a) Rights Agreement, dated as of June 16, 1986, between FPL Group, Inc. and the First National Bank of Boston (filed as Exhibit 4(e) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 4(b) Mortgage and Deed of Trust dated as of January 1, 1944, and Ninety-four Supplements thereto between FPL and Bankers Trust Company and The Florida National Bank of Jacksonville (now First Union National Bank of Florida), Trustees (as of September 2, 1992, the sole trustee is Bankers Trust Company) (filed as Exhibit B-3, File No. 2-4845; Exhibit 7(a), File No. 2-7126; Exhibit 7(a), File No. 2-7523; Exhibit 7(a), File No. 2-7990; Exhibit 7(a), File No. 2-9217; Exhibit 4(a)-5, File No. 2-10093; Exhibit 4(c), File No. 2-11491; Exhibit 4(b)-1, File No. 2-12900; Exhibit 4(b)-1, File No. 2-13255; Exhibit 4(b)-1, File No. 2-13705; Exhibit 4(b)-1, File No. 2-13925; Exhibit 4(b)-1, File No. 2-15088; Exhibit 4(b)-1, File No. 2-15677; Exhibit 4(b)-1, File No. 2-20501; Exhibit 4(b)-1, File No. 2-22104; Exhibit 2(c), File No. 2-23142; Exhibit 2(c), File No. 2-24195; Exhibit 4(b)-1, File No. 2-25677; Exhibit 2(c), File No. 2-27612; Exhibit 2(c), File No. 2-29001; Exhibit 2(c), File No. 2-30542; Exhibit 2(c), File No. 2-33038; Exhibit 2(c), File No. 2-37679; Exhibit 2(c), File No. 2-39006; Exhibit 2(c), File No. 2-41312; Exhibit 2(c), File No. 2-44234; Exhibit 2(c), File No. 2-46502; Exhibit 2(c), File No. 2-48679; Exhibit 2(c), File No. 2-49726; Exhibit 2(c), File No. 2-50712; Exhibit 2(c), File No. 2-52826; Exhibit 2(c), File No. 2-53272; Exhibit 2(c), File No. 2-54242; Exhibit 2(c), File No. 2-56228; Exhibits 2(c) and 2(d), File No. 2-60413; Exhibits 2(c) and 2(d), File No. 2-65701; Exhibit 2(c), File No. 2-66524; Exhibit 2(c), File No. 2-67239; Exhibit 4(c), File No. 2-69716; Exhibit 4(c), File No. 2-70767; Exhibit 4(b), File No. 2-71542; Exhibit 4(b), File No. 2-73799; Exhibits 4(c), 4(d) and 4(e), File No. 2-75762; Exhibit 4(c), File No. 2-77629; Exhibit 4(c), File No. 2-79557; Exhibit 99(a) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669; Exhibit 99(a) to Post-Effective Amendment No. 1 to Form S-3, File No. 33-46076); and Exhibit 4(b) to Form 10-K dated March 21, 1994, File No. 1-3545). 10(a) Supplemental Executive Retirement Plan, as amended and restated (filed as Exhibit 99(b) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(b) Benefit Restoration Plan of FPL Group and affiliates, as amended and restated (filed as Exhibit 99(c) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(c) FPL Group Amended and Restated Supplemental Executive Retirement Plan for J. L. Broadhead (filed as Exhibit 99(d) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(d) Employment Agreement between FPL Group and D. P. Coyle dated June 12, 1989 (filed as Exhibit 99(e) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(e) Employment Agreement between FPL and Stephen E. Frank dated July 31, 1990 (filed as Exhibit 99(f) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(f) Employment Agreement between FPL and Jerome H. Goldberg dated August 9, 1989 (filed as Exhibit 99(g) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(g) FPL Group Long-Term Incentive Plan of 1985, as amended (filed as Exhibit 99(h) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(h) Director and Executive Compensation Deferral Plan of FPL, as amended (filed as Exhibit 99(i) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(i) Employment Agreement between FPL Group and James L. Broadhead dated February 13, 1989 (filed as Exhibit 99(j) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669) 10(j) Employment Agreement between FPL Group and James L. Broadhead dated as of December 13, 21 Subsidiaries of the Registrant 23 Independent Auditors' Consent * Incorporated herein by reference (b) Reports on Form 8-K (1) A Current Report on Form 8-K dated October 22, 1993 was filed October 22, 1993 reporting one event under Item 5. Other Events. SCHEDULE V FPL GROUP, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT SCHEDULE V FPL GROUP, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (Concluded) SCHEDULE VI FPL GROUP, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI FPL GROUP, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Concluded) (1) Depreciation of transportation equipment is charged to various accounts based on the use of such equipment. Amortization of nuclear fuel assemblies is charged to fuel, purchased power and interchange expense. (2) This reserve is maintained for all depreciable property. The amount in the retirements column is net of removal costs and salvage. (3) Includes fossil decommissioning reserves of $102 million, $92 million and $83 million at December 31, 1993, 1992 and 1991, respectively. SCHEDULE IX FPL GROUP, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (1) Represents the maximum amount outstanding at any month end. (2) Computed by dividing the sum of the daily ending balances by the number of days in the year. (3) Computation is based upon the principal amounts weighted by the number of days outstanding. SCHEDULE X FPL GROUP, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (1) (1) Other information required by Article 5, Schedule X - Supplementary Income Statement Information is shown in the Consolidated Financial Statements or notes thereto, or is not presented as such amounts are less than 1% of total revenues. SIGNATURES Pursuant to the requirements of Section 13 or 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. Date: March 21, 1994 FPL Group, Inc. By JAMES L. BROADHEAD James L. Broadhead (Chairman of the Board, President and Chief Executive Officer, Principal Executive Officer and Director) 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 date indicated. Signature Title Date PAUL J. EVANSON Principal Financial Officer Paul J. Evanson (Vice President, Finance and Chief Financial Officer) K. MICHAEL DAVIS Principal Accounting Officer K. Michael Davis (Controller and Chief Accounting Officer) March 21, 1994 H. JESSE ARNELLE H. Jesse Arnelle ROBERT M. BEALL, II Directors Robert M. Beall, II DAVID BLUMBERG David Blumberg Signature Title Date J. HYATT BROWN J. Hyatt Brown MARSHALL M. CRISER Marshall M. Criser JEAN MCARTHUR DAVIS Jean McArthur Davis BEVERLY F. DOLAN Beverly F. Dolan Directors March 21, 1994 WILLARD D. DOVER Willard D. Dover ALFONSO FANJUL Alfonso Fanjul STEPHEN E. FRANK Stephen E. Frank DREW LEWIS Drew Lewis FREDERIC V. MALEK Frederic V. Malek PAUL R. TREGURTHA Paul R. Tregurtha	11,264	73,035
716302_1993.txt	716302_1993	1993	716302	ITEM 1. BUSINESS General - ------- As of February 28, 1994, Care Enterprises, Inc. ("Care" or "the Company") operated and managed 52 nursing and rehabilitation, developmentally disabled and retirement centers in California, Ohio, West Virginia and New Mexico, and home health agencies at 14 locations in California and Ohio. The nursing and rehabilitation centers provide skilled nursing, subacute, custodial care and rehabilitative services to patients that do not require acute care hospitalization and the home health operations provide skilled nursing care, rehabilitative and homemaker services to patients outside the institutional setting. Care also has a 26% interest in a pharmacy partnership which provides products and services to California nursing and other institutional facilities, including nursing facilities operated by Care. Recent Development - ------------------ In December, 1993, Care entered into an Agreement and Plan of Merger with Regency Health Services, Inc. ("Regency"), a Delaware corporation, substantially all of whose business operations are conducted in California, pursuant to which Care would merge with a newly-formed, wholly-owned subsidiary of Regency, and shareholders of Care would receive 0.71 shares of Regency common stock for each share of Care. A Special Shareholders Meeting to vote on the merger is scheduled for April 4, 1994 at 11:00 A.M. at the Sheraton Hotel, Newport Beach, California. Definitive proxy information concerning the meeting was mailed to all shareholders of record as of the close of business on March 3, 1994, the record date fixed by Care's Board of Directors. In connection with the execution of the Agreement and Plan of Merger, holders of a majority of Care's outstanding shares agreed with Regency to vote in favor of the proposed merger. Under Delaware law, the affirmative vote of a majority of the outstanding shares is required to approve the merger. No dissenters' rights are available to shareholders of Care in connection with the merger. Care's Board of Directors has recommended that shareholders vote to approve the merger. Recent History - -------------- In 1992 Care initiated a long range strategic business plan under which Care undertakes to provide a continuum of quality care through delivery of specialized medical services from inpatient to in home settings. Care believes there is an inherent synergy that exists between its home health agencies and nursing and rehabilitation centers. By taking advantage of that unique continuum within one company, Care offers an attractive product to the market, particularly in the managed care arena. It currently has ten specialized clinical units in various stages of development at its nursing and rehabilitation centers. These units include ventilator and other complex medical care such as IV therapies, complex infections, pulmonary care, diabetic management, chemotherapy, treatment of AIDS patients and wound care. Care has increased its focus on physical, speech and occupational rehabilitative therapies, which continue to be a strong source of revenue, growing approximately from $26,600,000 in 1991 to $30,900,000 in 1992 and $34,800,000 in 1993. Care now has 16 outpatient therapy units licensed. Revenue from Care's high acuity specialized clinical programs was approximately 27% of total revenue in 1992 and approximately 32% for 1993. Care's home health operations have been extensively involved in program development. New services such as neonatal care, prenatal care and gero- psychiatric care and expanded infusion therapy services, ventilator care and care to AIDS patients were highlights in 1993. Continued development of a wide base of high acuity services and an integrated approach to the market with its nursing and rehabilitation and home care services make clear Care's direction for the future. Long-term Care Operations - ------------------------- Care's nursing and rehabilitation centers provide nursing care and rehabilitative services to persons who do not require the services of an acute care hospital. Each facility is operated by a licensed administrator and a director of nursing services, who are assisted on a part-time contract basis by a physician who acts as a medical director. The services provided at Care's nursing and rehabilitation centers include 24-hour nursing care by registered nurses and licensed practical nurses, room, board, housekeeping and laundry services, dietary planning, the provision of medical supplies and prescription drugs, and the provision for rehabilitative and other ancillary services including speech, occupational, physical and respiratory therapies and contract laboratory and x-ray services. In support of the health care operations, Care maintains executive and regional administrative centers which provide supervisory, administrative and consulting services. Each regional office is staffed by a regional administrator and support personnel specializing in nursing care, rehabilitation and dietary programs, medical bookkeeping and maintenance. Care's executive offices provide centralized management and support services including operations support, marketing, planning and development, human resources, accounting, reimbursement and financial services, cash management, data processing, legal support, risk management, quality control, centralized purchasing, education, training and consulting support services in the area of rehabilitative care. Care's profitability and cash flows are affected by many factors, including (i) the licensed bed capacity of its nursing facilities; (ii) the extent to which that bed capacity is occupied; (iii) the extent of rehabilitative and other ancillary services provided by Care at its skilled nursing facilities; (iv) the mix of private, Medicare and Medicaid patients; (v) the mix and volume of services provided by Care's home health agencies; (vi) the cost reimbursement rates paid by Medicare and Medicaid (see "Health Care Reimbursement Programs"); and (vii) labor and employee benefits and facility maintenance expense. Care, as well as many of its competitors, is affected by many factors that are indigenous to the long-term care industry, including (i) medical reimbursement levels, (ii) increased regulatory control and scrutiny as a result of the implementation of the Omnibus Budget Reconciliation Act of 1987 ("OBRA"); and (iii) alternatives to the institutional long-term care setting, (i.e., home health agencies, residential care facilities and acute hospital based nursing facility distinct parts). These alternatives have increased competition for employees resulting in an escalation in wages, and have also impacted competition for patient census. Facilities are now accepting patients with greater medical needs in order to maximize census and revenue. Care's specialized clinical units are designed to meet the needs of these high acuity patients and further enhance ancillary and routine revenues. The table below shows the number of Care's nursing and rehabilitation centers and licensed beds at year end, average occupancy rates and annual revenues by source during each of the last five years. (1) Data excludes a 248 bed facility which is being managed by Care under a management agreement. Home Health Operations - ---------------------- Care Home Health Services, Inc., a wholly-owned subsidiary of Care, has provided home care services throughout California and Southern Ohio since 1983 and has grown steadily in revenue and visits in every year since its founding. Through two divisions, Care Home Health and Care At Home, patients at home receive technical medical support such as infusion and ventilator care and respite services such as assistance with personal hygiene, cooking and cleaning. Home Health management resides in free-standing offices from where clinical staff is dispatched. One additional office was opened in 1993 for a total of 14 locations as of December 31, 1993. The 1993 revenue mix was approximately 70% Medicare, 17% private, 11% Medicaid and 2% managed care. Home health revenues increased approximately 39% from $14,700,000 in 1992 to $20,500,000 in 1993. The home care industry has experienced growth in the last decade due to the benefits to patients, physicians, hospitals and payors. Patients enjoy the increased comfort of home and the control of the schedule of nursing visits and therapies. They welcome earlier discharge from hospitals and significantly lower costs than hospitalization. Physicians use home care because it helps minimize distress calls to the doctor and provides ongoing communication regarding the patients' progress. Hospitals refer patients to home care to decrease lengths of stay, thereby reducing costs for services that are reimbursed to them by diagnosis versus time in the hospital. Payors support home care for cost savings and for the reduction in re- hospitalizations achieved by home care nurses recognizing clinical problems earlier and preventing misunderstandings on therapies. Internal factors supporting continued growth of Care Home Health Services, Inc. include the steady referral base from Care facilities and the market appeal of a company that provides a continuum of care from inpatient to outpatient rehabilitation to home care. Care Home Health Services, Inc. is well positioned due to its established longevity in this relatively adolescent industry. Care Home Health Services, Inc. is state licensed in California (not required in Ohio), Medicare and Medicaid certified in California and Ohio and accredited in California and Ohio by the independent Joint Commission on the Accreditation of Healthcare Organizations ("JCAHO"). Care Combined Operations - ------------------------ The table below sets forth the approximate percentage of Care's revenues from each of the following sources: Health Care Reimbursement Programs - --------------------------------- All but one of the nursing facilities and all of the home health agencies operated by Care are certified for participation in Medicare and all of the facilities and home health agencies operated by Care are Medicaid certified. Payments under the Medicare program received by Care are currently sufficient to cover all of the operating and fixed costs allocable to Medicare patients. Payments received by Care under Medicaid programs currently cover a substantial portion, but not all, of the operating and fixed costs of furnishing services to Medicaid patients. There is no assurance that payments under these programs will remain at levels comparable to present levels or will, in the future, be sufficient to cover the operating and fixed costs allocable to patients participating in such programs. Care has made a strategic commitment and has pledged resources to provide managed care organization members with services ranging from subacute care to home health care. The scope of care which Care offers along with the talents of new staff sets Care apart from its competitors in the market. Contracts have been negotiated with managed care organizations, such as health maintenance organizations ("HMO's"), preferred provider organizations ("PPO's") and independent provider associations ("IPA's"), including major medical groups, for care to their members. Numerous contracts have also been entered into with hospice providers and with the Veterans Administration for care to eligible veterans. The last audit of Care with respect to Medicare and Medicaid payments was for the year ended December 31, 1991. Care believes that its reserves for potential adjustments related to fiscal years 1992 and 1993 are adequate and that any future adjustments proposed by these agencies will not have a material effect on the consolidated financial position or liquidity of Care. Managed care is playing a larger role in the industry, with HMO's, PPO's, IPA's and insurance companies creating relationships with long-term care companies and home health agencies. Managed care reimbursement is predicated on different levels of services. Care has made a strategic commitment to develop new payor sources in this growing area. Regulations - ----------- Care's nursing and rehabilitation and home health operations are subject to extensive federal and state regulatory, licensing and inspection requirements. These requirements relate to, among other things, the adequacy of physical buildings and equipment, the qualifications of administrative personnel and nursing staff, the quality of nursing care provided and continuing compliance with the laws and regulations applicable to the operations of the facilities. OBRA contains provisions related to nursing care which are more stringent than those effective prior to its enactment. Care has implemented the provisions of OBRA applicable to its business through the support of its Corporate Professional Services Department, which includes quality improvement programs. In addition, before the acquisition of any existing nursing facility can be consummated, approval of the local state health care licensing authority must be obtained, together with certification for participation in its respective Medicaid and Medicare programs. The nursing and rehabilitation facilities and home health agencies operated by Care are licensed and certified by various governmental agencies. Care's Corporate Professional Services Department sets standards for patient care, provides training and education, assists in development of specialized clinical units, investigates patient complaints, reviews citations or deficiency notices issued by regulatory agencies, consults with facility management and conducts periodic site inspections to ensure that quality care is provided and deficiencies are corrected. Peer reviews are also conducted by teams, whose members are employees of Care's nursing and rehabilitation facilities, to ensure that Care's standards of quality are upheld. In the ordinary course of business, Care, like others in the long-term care industry, receives statements of deficiency for failure to comply with various federal and state regulatory requirements. Fines may be assessed and regulatory authorities have the ability to delicense or decertify facilities operated by any nursing care operator at which there has been failure to comply with the various regulatory requirements. Care believes that its present reserves for potential fines and decertification actions are adequate and that any future actions will not have a material effect on the consolidated financial position of Care. Competition - ----------- Care's approach to revenue enhancement is based on the philosophy that its facilities must strategically identify the needs of the local market and develop programs to meet those needs through a diversification of medical services in order to meet the challenge of a more competitive market. Care is developing specialized clinical units in its facilities to enhance its reputation as a high-end provider. Care has historically emphasized rehabilitation programs (physical, speech and occupational therapies) and has recently expanded its inpatient programs and is developing new outpatient therapy units. Currently, 31% of Care's facilities have outpatient therapy units. Care's specialized clinical units address hospice care, AIDS, wound care, pulmonary and respiratory, ventilator units, Alzheimers units and others currently in development. Care's infusion therapy programs have shown substantial growth in 1993. Increased revenue from these programs comes primarily through the Medicare program and managed care providers. Competition from home health agencies has been partially offset by the continued development of Care's home health operations and the recognition that Care's facilities can operate in conjunction with the home health agencies in their local communities. Employees - --------- At February 28, 1994, Care had approximately 5,900 full-time and part-time employees, of whom approximately 4,850 were employed at Care's nursing and rehabilitation facilities, approximately 900 at its home health agencies, and approximately 150 at its administrative, regional and corporate offices. Approximately 1,100 of the employees were covered by eight collective bargaining agreements. Care believes that its relations with its employees in general and the eight collective bargaining units remain very good. Tax Audits - ---------- An Internal Revenue Service audit of the Care federal income tax returns for the years 1987 through 1990 and the Care federal payroll tax returns for the year 1990 is presently pending, which raises issues concerning the amount of the net operating loss claimed by Care and certain other issues. Although it is not possible to predict with certainty the outcome of the audit, in the opinion of Care management, adequate provision for the audit has been made and the audit is not expected to have a material adverse effect on Care's financial position. Insurance - --------- Care maintains general and professional liability insurance for its operations, subject to a self-insurance retention, in amounts which it believes to be adequate. Property insurance is maintained to protect against all perils, including earthquake and flood, subject to deductibles. For workers' compensation, Care is self-insured in California and Ohio and purchases insurance for this risk in West Virginia and New Mexico. The cost of insurance is based on market conditions, claims history and number and type of company operations. As these factors vary, the cost of insurance can vary. To secure its obligations to pay benefits under its self-insured workers' compensation programs, Care has caused various surety bonds and letters of credit to be issued. Health Care Reform - ------------------ On October 27, 1993, President Clinton submitted to the United States Congress his proposed Health Security Act. As proposed by the Clinton Administration, the Health Security Act would guarantee comprehensive health care coverage for all Americans regardless of health or employment status. The Health Security Act would reduce certain Medicare and Medicaid programs, and permit greater flexibility in the administration of Medicaid. Changes in reimbursement levels under Medicare or Medicaid and changes in applicable government regulations could significantly affect the Company's results of operations. Several U.S. Senators and Representatives have submitted bills that could approach the reform of the United States healthcare system in different ways. In addition to federal initiatives, California, where the Company conducts a substantial portion of its business, has already enacted various healthcare reform measures that are expected to have an effect on the business of the Company. The Company is not able to predict whether the Health Security Act or any of such other healthcare legislation will be enacted and implemented or the precise effects of any such legislation. Management of the Company believes that health services organizations with specialized and diverse services, such as Care, are likely to be well positioned under any of the proposed legislative reforms. Recent Financing - ---------------- On December 30, 1993, Care entered into a note agreement with a number of institutional purchasers pursuant to which it issued $30,000,000 of its 8.10% Senior Secured Notes due December 15, 2000 (the "Notes"). The Notes have an average maturity of five years and provide for semi-annual interest payments commencing January 15, 1994. Principal payments of $6,000,000 are due annually commencing January 15, 1997. The Notes are secured by mortgages on 11 of Care's facilities. Proceeds from the financing were used to retire $18,851,000 of existing indebtedness, to pay the $495,000 remaining balance of a capitalized lease obligation and purchase the related facility, and to pay $1,848,000 of certain other costs and expenses. Net proceeds from the financing totalled $8,806,000, which, combined with the resulting reduction in current maturities of long-term debt, has created a working capital surplus of $5,769,000 at December 31, 1993. On March 3, 1994, Care entered into an $8,000,000 letter of credit facility with the Bank of America secured by Care's accounts and notes receivable and the shares of Care's subsidiary, Healthcare Network, which is a partner in the pharmacy partnership. These letters of credit are used by Care in connection with its self-insured workers' compensation programs in California and Ohio. ITEM 2. ITEM 2. PROPERTIES As of February 28, 1994, Care operated and managed 52 nursing and rehabilitation, developmentally disabled and retirement centers in California, Ohio, West Virginia and New Mexico, and home health agencies in 14 locations in California and Ohio through its subsidiary, Care Home Health Services, Inc. Long-Term Care - -------------- The following table sets forth information regarding the nursing and rehabilitation centers owned or leased by Care as of February 28, 1994: In addition, a 248-bed facility is being managed by the Company under a management agreement and, effective January 1, 1994, Care assumed the operation of a 64-bed residential facility in Pasadena, California. During 1993 Care exercised options to purchase three previously leased nursing facilities with a total of 278 beds. Home Health - ----------- Care's subsidiary, Care Home Health Services, Inc., leases facilities occupying approximately 33,000 square feet for its 14 home health locations. General Lease Information - ------------------------- Care leases a 52,000 square foot facility for its corporate offices in Tustin, California and 7,400 square feet at two regional offices in Suisun, California and Worthington, Ohio. Substantially all of the leases for its operating units require Care to pay all taxes, insurance and maintenance costs. The leases expire at various dates (inclusive of renewal periods) to October 2010. Care has options to purchase five of the leased facilities. See Note 7 to the Consolidated Financial Statements for additional information regarding facility leases. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceedings other than ordinary routine litigation incidental to its business. See Note 7 to the Consolidated Financial Statements for additional information regarding legal proceedings. ITEM 4. ITEM 4. RESULTS OF VOTES OF SECURITY HOLDERS None. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED MATTERS Care's capital structure consists of one class of common stock ("Common Stock") issued effective December 31, 1990, in accordance with the Joint Plan of Reorganization (the "Plan"). The previous two classes of common stock, Class A Common Stock and Class B Common Stock (collectively known as "Old Common Stock"), were retired in accordance with the Plan. Holders of Common Stock do not have pre-emptive rights or other rights to subscribe for additional shares. The Common Stock is not subject to conversion or redemption and is fully paid and non-assessable. Price of Common Stock - --------------------- The Common Stock commenced trading over-the-counter on January 7, 1991 and is being quoted on the National Market System of the National Association of Securities Dealers Automated Quotation System ("NASDAQ NMS") under the symbol CREI. The last reported sales price per share for the Common Stock as of March 22, 1994 was $13.00. As of March 22, 1994 Care had approximately 1,100 holders of record. Dividends and Dividends Policy - ------------------------------ Dividends were not paid on the Old Common Stock shares during 1989 and 1990. Covenants in the Company's loan agreement with its secured lenders prohibit the payment of cash dividends on the Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The summary consolidated financial information set forth below should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K. (a) The pre-reorganization periods are not comparable with 1991, 1992 and 1993 due to the effects of the implementation of "Fresh-Start Reporting" resulting from the Company's emergence from Chapter 11 reorganization. (b) Represents an extraordinary gain from discharge of debt in connection with the reorganization proceedings. (c) Per share amounts are not meaningful due to Chapter 11 reorganization. (d) Includes charges related to Care's Share Appreciation Rights Plan of $2,157,000, $323,000, and $293,000 for 1993, 1992 and 1991, respectively. (e) The December 31, 1990 balance sheet was restated to record the Plan of Reorganization and reflect "Fresh-Start Reporting." Accordingly, the Company's financial position at December 31, 1990 and subsequent thereto is not comparable to prior periods. (f) Average occupancy is calculated based on all facilities operated during the respective years and is not necessarily representative of occupancy for facilities operated at year end. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition, Capital Resources and Liquidity - ---------------------------------------------------- During most of 1993 Care relied on operations to meet its liquidity needs. Cash provided by operations totalling $10,570,000 for the year was used to make principal payments of $9,338,000 on long-term debt, including payments of $7,180,000 on the Term Notes. Cash used in investing activities totalled $5,074,000, including routine capital expenditures of $3,884,000 and payments of an additional $1,542,000 to exercise options to purchase two previously leased facilities, offset slightly by collections on notes receivable. On December 30, 1993 Care sold $30,000,000 of its 8.1% Senior Secured Notes to a number of institutional investors in a private transaction. The notes have an average maturity of five years and provide for semiannual interest payments, with annual principal payments of $6,000,000 commencing in January, 1997. The proceeds of the notes were used to pay $18,851,000 of existing debt, including the remaining balance of $11,569,000 on the Term Notes. An additional $495,000 was used to pay the outstanding balance of a capitalized lease obligation and purchase the related facility. Proceeds of the borrowing were also used to pay costs and expenses of the issuance of the notes totalling $1,139,000, and $709,000 was used to establish cash escrows with a title company pending the resolution of certain title and debt payoff related issues and to pay certain other costs. The $8,806,000 net cash proceeds from the sale of the Senior Secured Notes, combined with the reduction in current maturities of long-term debt, has created a working capital surplus of $5,769,000 at December 31, 1993, including cash of $12,985,000. Management believes the Company's liquidity, including cash provided by operating activities, is adequate to finance planned 1994 capital expenditures of approximately $5,000,000 and other known operating needs. In March 1994 Care entered into an $8,000,000 letter of credit facility with the Bank of America to replace $6,238,000 letters of credit previously issued by another bank to be used in connection with its self-insured workers' compensation programs in California and Ohio. The new letter of credit facility will allow Care to further improve liquidity by substituting an additional $1,762,000 in letters of credit for cash collateral currently held by certain regulatory agencies. Accordingly, these deposits have been included in receivables in the Company's balance sheet as of December 31, 1993. Comparison of operating results 1993 to 1992 - -------------------------------------------- Revenues for the year ended December 31, 1993 increased by $8,306,000 compared to 1992. The change consisted of increases of $16,180,000 for nursing and rehabilitation centers and $5,832,000 for home health, offset by a decrease of $13,706,000 for operations discontinued in 1992. The increase in nursing and rehabilitation center revenues is attributable to several factors. Medicare revenues increased by $11,849,000 due to the continued growth of therapy, subacute, and other specialized clinical services and a 13% increase in Medicare utilization. Medicaid revenues increased by $3,642,000 primarily due to rate increases, offset slightly by lower Medicaid utilization. Home health revenues increased due to the development of new clinical services and increased visits resulting from marketing efforts. The increase in salaries and employee benefits is the result of wage rate increases, increased labor hours and the resulting increase in payroll-related costs for nursing and rehabilitation centers and home health, partially offset by a decrease of $7,153,000 related to operations discontinued in 1992. The increase in labor hours is primarily the result of growth of the home health business. Share appreciation rights ("SARs") expense increased $1,834,000 due to the increase in the market price of shares of Care's Common Stock from $2.75 per share at December 31, 1992 to $9.625 per share at December 31, 1993. Depending on the future performance of Care's Common Stock, Care may incur substantial additional charges related to the SARs in future periods, through December 1995, which will aggregate approximately $333,000 for each one dollar increase in the market price of Care's Common Stock. Supplies and other expenses consist of food, routine supplies, costs related to therapy services, utilities, maintenance and other general and administrative expenses. The increase in supplies and other expenses is primarily the result of higher therapy-related costs in the nursing and rehabilitation centers and home health due to Care's increased provision of those services, offset by a decrease of $2,588,000 related to operations discontinued in 1992. The increased emphasis on the provision of therapy services also resulted in an increase in the cost for contract therapists, which accounts for most of the increase in purchased services and professional fees. Other costs and expenses increased due to the imposition of a health care provider tax in West Virginia. The decrease in interest expense is primarily due to the lower outstanding debt balances. The outstanding debt balances were increased on December 30, 1993 and interest expense for 1994 is expected to be substantially higher than for 1993. Lease and rent expense and depreciation decreased due to the discontinuance of certain operations in 1992. Comparison of operating results 1992 to 1991 - -------------------------------------------- During 1992 revenues increased by $6,372,000, consisting of increases of $11,976,000 for nursing and rehabilitation centers and $3,010,000 for home health partially offset by a $8,614,000 decrease for pharmacies. The decrease in pharmacy revenues resulted from the contribution of the pharmacies to an unconsolidated partnership on April 1, 1992. The increase in nursing and rehabilitation center revenues is attributable to several factors. The fastest growing revenue source was occupational, speech, and physical therapies which increased by approximately $4,300,000. Medicare and Medicaid revenues increased by $2,553,000 and $6,212,000, respectively, due primarily to rate increases. Medicaid revenues for 1992 include approximately $865,000 of favorable rate increases related to 1990 and favorable cost report settlements of $381,000. Medicare revenues for 1992 and 1991 include favorable settlements on prior years' cost reports of $670,000 and $743,000, respectively. The increase in salaries and employee benefits of $2,990,000 is primarily the result of wage rate increases, increased labor hours, and increases in the cost of vacation and other employee benefits provided by the Company totalling $6,724,000. This was offset by a reduction of $3,069,000 for pharmacies and a $665,000 decrease in the provision for workers' compensation insurance resulting from favorable loss experience on prior years' claims. The increase in wage rates was primarily due to nursing salaries which, unlike other staff salaries, are being driven upwards by increased market competition. The increase in labor hours is the result of enforcement of OBRA regulations, increased acuity levels of patients in the nursing and rehabilitation centers and increases in home health due to growth in that business. Supplies and other costs and expenses consist of food, routine supplies, costs relating to therapy services, utilities, maintenance and other general and administrative expenses. The decrease in supplies and other expenses was the result of decreased pharmacy cost of sales, offset by higher therapy-related costs in the nursing and rehabilitation centers due to Care's increased provision of therapy services and inflation. Care's increased emphasis on the provision of therapy services, as discussed above, resulted in an increase in the cost for contract therapists, which accounts for most of the increase in purchased services. The professional fee reduction was the result of the discontinuance of the services of certain management consultants. The decrease in the provision for doubtful accounts and losses is the result of an increased provision in 1991 for losses on mortgage notes receivable offset by a reduced provision in 1992 resulting from substantial recoveries of accounts previously written off as uncollectible. Lease and rent expense decreased due to the contribution of the pharmacies to a partnership, offset by an increase in rent under a short-term lease of a formerly owned facility. Depreciation expense decreased due to the disposal of two nursing and rehabilitation centers in 1991, combined with the elimination of the expense related to assets contributed to the pharmacy partnership. Interest expense declined due to lower interest rates on variable rate debt and a decrease in outstanding debt balances of approximately $7,700,000 during 1992. Additional financial data for fiscal 1992 - ----------------------------------------- In 1992, Care recognized a gain of $1,007,000 on a nursing facility disposal which occurred in 1991. The gain represents the difference between the book value of the nursing facility assets which were acquired in 1991 by a bank in a non-judicial foreclosure and management's estimate of the value of the assets surrendered. Care reduced its reserve for losses on discontinuance of certain operations by $461,000 and reduced its reserve for fees and expenses in connection with Chapter 11 proceedings by $75,000. Impact of Inflation - ------------------- Care's principal costs are salaries and wages (and related employee benefit costs) and payments to third parties for services rendered, all of which are generally sensitive to inflation. A principal source of Care's revenues is derived from the Medi-Cal program which is not a cost reimbursement type program. Adjustments to Medi-Cal reimbursement rates are typically made only on an annual basis and such adjustments may not be sufficient to fully cover all inflationary cost increases. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Report of Independent Auditors 18 Consolidated Balance Sheets as of December 31, 1993 and 1992 19 Consolidated Statements of Operations, Years Ended December 31, 1993, 1992 and 1991 20 Consolidated Statements of Shareholders' Equity, Years Ended December 31, 1993, 1992 and 1991 21 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 22 Notes to Consolidated Financial Statements 24 Report of Independent Auditors Shareholders and Board of Directors Care Enterprises, Inc. We have audited the accompanying consolidated balance sheets of Care Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Care Enterprises, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes. ERNST & YOUNG Orange County, California March 10, 1994 CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except number of shares and par values) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) See Independent Auditors' Report and Notes to Consolidated Financial Statements. CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands, except facility data) (Continued) In 1992 Care contributed the net assets of five pharmacies and four distribution centers having a net book value of $1,400,000 to a partnership formed with another long-term provider. During 1991 Care disposed of two facilities, one of which the Company continued to operate under a short term lease agreement through November 1992. See Independent Auditors' Report and Notes to Consolidated Financial Statements NOTE 1 - MERGER AGREEMENT - ------------------------- On December 20, 1993, Care Enterprises, Inc. ("Care" or "the Company") and Regency Health Services, Inc., a Delaware corporation ("Regency"), entered into an Agreement and Plan of Merger (the "Merger Agreement"). Regency currently operates 43 long-term care facilities with 4,215 beds and one pharmacy, all located in California. Pursuant to the Merger Agreement, Care will be merged with and into Regency with Regency as the surviving corporation (the "Merger") and each share of Care's Common Stock will be converted into 0.71 shares of Regency's Common Stock, par value $0.01 per share in a tax-free transaction. The Company anticipates that the Merger will be accounted for as a pooling of interests. The Merger has been approved by the Board of Directors of both companies and its completion is subject to, among other things, the approval of regulatory agencies and the shareholders of each of Care and Regency. In connection with the Merger Agreement, shareholders holding a majority of Care's Common Stock and shareholders holding approximately 22% of Regency's Common Stock have agreed to vote in favor of the Merger under certain circumstances. Care anticipates that the Merger will be consummated in the second calendar quarter of 1994. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------- Nature of Business - ------------------ Care provides skilled and intermediate nursing, rehabilitative services, subacute and other specialized medical services. Services are provided in the Company's owned, leased or managed nursing and rehabilitation facilities located in California, Ohio, West Virginia and New Mexico. Care, through its wholly-owned subsidiary Care Home Health Services, Inc., provides patients at home with technical medical support such as infusion therapy and ventilator care, and respite services such as assistance with personal hygiene, cooking and cleaning. Principles of Consolidation - --------------------------- The consolidated financial statements include the accounts of Care and its wholly-owned subsidiaries. All material intercompany balances have been eliminated. Reclassifications - ----------------- The Company has reclassified the presentation of certain prior year information to conform with the current year presentation. Cash - ---- Cash consists of cash balances held in banks and petty cash funds. The cash balance at December 31, 1993 includes $6,238,000 temporarily placed with Wells Fargo Bank to collateralize letters of credit issued in conjunction with Care's self-insured workers' compensation programs. An agreement in principle was reached in December 1993, and a definitive agreement was signed in March 1994 with the Bank of America to provide an $8,000,000 letter of credit facility (Note 7) and new letters of credit were obtained to secure the workers' compensation obligations. At December 31, 1993 and 1992 the Company held personal funds in trust for patients approximating $425,000 and $400,000, respectively, which are not reflected on the accompanying balance sheets. Supplies Inventory - ------------------ Supplies inventory is stated at the lower of cost or market using the first- in, first-out method. Property and Equipment - ---------------------- Property and equipment owned by the Company at the time of its emergence from bankruptcy on December 31, 1990 was adjusted to its then current fair market value. All other property and equipment is stated at cost. Depreciation and amortization is provided on the straight-line method over the following estimated useful lives or, if applicable, over the terms of the leases. Buildings 20 to 40 years Leasehold interests and improvements 7 to 30 years Equipment 5 to 10 years Assets under capitalized leases 10 to 25 years Betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed. The cost and accumulated depreciation applicable to assets retired are removed from the accounts and any gain or loss on disposition is recognized in income. Health Care Revenues and Reimbursement Programs - ----------------------------------------------- Long-term care facilities receive payments for services to certain patients under Medicare and state Medicaid programs and from the Veterans Administration. Revenues are recorded at the estimated net realizable amounts from patients and third party payors in the period in which the service is provided. Approximately 83% (1993), 82% (1992), and 83% (1991) of total revenue was derived from federal and state medical assistance programs. Revenues under these programs are based in part on cost reimbursement principles which govern reimbursement of current year costs. These revenues and costs are subject to audit and, in the opinion of management, adequate provision has been made for any adjustments that may result from such audits. Differences between estimated provisions and final settlements are reflected in operations in the year finalized. Approximately 75% (1993) and 78% (1992) of the Company's accounts receivable were related to federal and state medical assistance programs including approximately 26% (1993) and 33% (1992) related to the California Medicaid program. Interest Expense - ---------------- Interest expense is reflected net of $712,000, $752,000 and $1,280,000 of interest income for the years ending December 31, 1993, 1992 and 1991, respectively. Income Taxes - ------------ During 1991, the Company accounted for income taxes under the provisions of Statement of Financial Accounting Standards No. 96 ("SFAS 96"). Effective December 31, 1992, the Company adopted (on a cumulative basis from January 1, 1992) the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes" (Note 3). In accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), SFAS 96 and SFAS 109 tax benefits recognized in periods subsequent to bankruptcy reorganization, resulting from utilization of pre-reorganization financial reporting Net Operating Losses ("financial reporting NOL"), are recorded by the Company as direct additions to additional capital with a corresponding charge in lieu of taxes included in the provision for income taxes in the Statement of Operations. Income Per Share - ---------------- Income per share for 1993, 1992 and 1991 has been computed on the basis of the weighted average shares of Common Stock outstanding plus, for 1993, common equivalent shares arising from dilutive stock options, using the treasury stock method. For 1992, common equivalent shares arising from dilutive stock options have been excluded from the determination of income per share due to immateriality. No such options were outstanding during 1991. For the computation of fully diluted income per share for 1991, shares issued in November 1991 for the conversion of the $3,000,000 secured convertible exchangeable notes are included in the weighted average shares outstanding from the beginning of 1991 and, accordingly, net income for 1991 has not been reduced by interest expense on the notes. The weighted average number of common and common equivalent shares outstanding for the calculation of primary income per share was 13,312,000 in 1993, 11,667,000 in 1992, and 9,294,000 in 1991. The weighted average number of shares used to compute income per share, assuming full dilution, was 13,388,000 in 1993, 11,667,000 in 1992, and 11,635,000 in 1991. All common shares issued pursuant to the Plan of Reorganization have been treated as outstanding as of December 31, 1990. The income per share calculation does not include the shares reserved for issuance in connection with the Company's Share Appreciation Rights Plan (Note 8), which provides for settlement of the rights in cash or stock. The Company's Board of Directors does not presently plan to issue any shares in settlement of the rights. Workers' Compensation Self-Insurance - ------------------------------------ The Company maintains self-insurance programs for workers' compensation in California and Ohio. The self-insurance liability under these programs is based on claims filed and estimates of claims incurred but not reported. The self-insurance liability is discounted at a rate of 10%, which management believes to be its appropriate market rate of interest based on its current financial circumstances. Professional Liability Insurance - -------------------------------- The Company maintains approximately $30,000,000 of professional liability insurance covering substantially all of its operations on a claims-made basis, with a $10,000 deductible for operations in the states of New Mexico and West Virginia and a $250,000 self-insurance retention for all other locations. The estimated amount payable for claims, including unasserted claims, under the Company's self-insurance retention is recorded as a liability, without discounting. NOTE 3 - INCOME TAXES - --------------------- During 1991, the Company accounted for income taxes under the provisions of SFAS 96. Effective December 31, 1992, the Company adopted (on a cumulative basis from January 1, 1992) the provisions of SFAS 109, which mandates the liability method of accounting for deferred income taxes and permits the recognition of net deferred tax assets subject to an ongoing assessment of realizability. The change in accounting for income taxes did not have a material effect on the Company's financial statements. For federal tax return purposes, Care Enterprises, Inc. files a consolidated tax return with its subsidiaries. As of December 31, 1993, the Company had claimed a federal net operating loss carryforward for tax purposes ("Tax NOL") of approximately $93,200,000 and credit carryforwards of approximately $4,021,000. However, when the Company's Plan of Reorganization was confirmed, an ownership change as defined in Internal Revenue Code ("IRC") Section 382 occurred. As a result, use of Tax NOL and credit carryforwards accumulated on or before April 20, 1990 ("pre-confirmation") may be subject to an annual limitation of approximately $300,000. Tax losses and credits generated after April 20, 1990 ("post-confirmation") are not subject to the above limitation. Because a portion of the Company's Tax NOL was generated as early as 1985, it will begin to expire in the year 2000. Considering the annual limitation, it is currently estimated that as of December 31, 1993, a maximum of $3,300,000 of Tax NOL in the aggregate will be available for use prior to expiration. Management is pursuing the possibility that the Company may qualify for the special provisions of IRC Section 382(l)(5), which could reduce the aggregate Tax NOL and credit carryforwards available but would not limit their annual use. Should circumstances permit the Company to qualify for this section of the IRC, a significant portion of the pre-confirmation Tax NOL and credit carryforwards could become available for use. However, the Merger (discussed in Note 1) may also result in a limitation on the use of the Company's post- confirmation Tax NOL and credit carryforwards and, if Section 382(l)(5) applies, pre-confirmation Tax NOL and carryforwards. The Internal Revenue Service ("IRS") is examining the Company's income tax returns for the years 1987 through 1990. Management believes that the outcome of this examination will not have a material impact on the financial position or liquidity of the Company, although it may reduce the Tax NOL. In March 1994 the IRS issued final regulations relating to net operating losses, and specifically relating to the determination of eligibility for the use of Section 382(l)(5). Based on the new regulations, management believes the Company will qualify for use of this section. After applying its provisions, the amount of Tax NOL would be approximately $53,000,000, usable without annual limitation, before the effect of any audit adjustments. Deferred income tax assets and liabilities originate from differences between accounting principles and procedures used for book and tax purposes, principally related to depreciation, contingencies and legal settlements, workers' compensation, share appreciation rights, bankruptcy costs and fees, doubtful accounts and reserves for losses on discontinuance of certain operations. The provision for income taxes consists of the following: A reconciliation of the federal statutory income tax rate with the Company's effective tax rate follows: The tax effect of the temporary differences giving rise to the Company's deferred tax assets and liabilities are shown on the following table: NOTE 4 - PROPERTY AND EQUIPMENT - ------------------------------- A summary of property and equipment follows: NOTE 5 - DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS - -------------------------------------------------- Other assets consist of deposits (primarily related to the Company's self- insured workers' compensation plans and facility leases), debt service reserves related to the Industrial Development Bonds, a 26% interest in a pharmacy partnership, deferred charges and other. Accrued liabilities consist of the following (in thousands): NOTE 6 - LONG-TERM DEBT AND CREDIT FACILITIES - --------------------------------------------- Long-term debt consists of the following: The repayment of the remaining balances of the Term Notes and the working capital loan and the reduction of the outstanding balances of IDB's, mortgage notes payable, and capitalized lease obligations was primarily accomplished with the proceeds of the Senior Secured Notes, as discussed below. The aggregate maturities of long-term debt and capitalized lease obligations for the ensuing five years and thereafter are as follows (in thousands): On December 30, 1993, Care entered into a Note Agreement with a number of institutional purchasers pursuant to which it issued $30,000,000 of its 8.10% Senior Secured Notes due December 15, 2000 ("Notes"). The Notes have an average maturity of five years and provide for interest payments on each of January 15 and July 15, commencing January 15, 1994. Principal payments of $6,000,000 are due annually commencing on January 15, 1997, with the final payment due on maturity. The Notes are secured by mortgages on eleven nursing facilities having an aggregate carrying value of $30,374,000. The Notes contain covenants which require the maintenance of certain financial ratios and levels of tangible net worth, restrict the incurrence of new debt, and limit the payment of dividends on Care's Common Stock. The proceeds of the Notes were used to pay $18,851,000 of existing debt, including the remaining balance of $11,569,000 on the Term Notes, the $1,000,000 working capital loan from a shareholder, and $6,282,000 in other debt. An additional $495,000 was used to pay the outstanding balance of a capitalized lease obligation and purchase the related facility. Proceeds of the borrowing were also used to pay costs and expenses of the issuance of the notes totalling $1,139,000, and $709,000 was used to establish cash escrows with a title company pending the resolution of certain title and debt payoff related issues and to pay certain other costs. Each of the mortgage notes and IDBs is secured by a first deed of trust on the related facility. One of the IDBs requires the maintenance of debt service reserve funds and all of the IDBs contain affirmative and negative covenants and reporting requirements. NOTE 7 - COMMITMENTS AND CONTINGENCIES - -------------------------------------- Letters of Credit - ----------------- The Company is contingently liable under letters of credit principally related to deposit requirements on its self-insured workers' compensation plans. State regulations require the maintenance of deposits at specified percentages of estimated future claim payments which can be satisfied through a combination of cash deposits, surety bonds and letters of credit. The total amount of letters of credit outstanding at December 31, 1993 and 1992 were $6,238,000 and $6,250,000, respectively. An agreement in principle was reached in December 1993, and a definitive agreement was signed in March 1994 with the Bank of America to provide an $8,000,000 letter of credit facility secured by Care's accounts and notes receivable and the shares of Care's subsidiary, Healthcare Network, which is a partner in the pharmacy partnership. Leases - ------ The Company leases certain facilities and offices under cancelable and noncancelable agreements expiring at various dates through October 2010. The leases are generally triple-net leases and provide for the Company's payment of property taxes, insurance and repairs. Certain leases contain renewal options and rent escalation clauses. Rent escalation clauses require either fixed increases or increases tied to the Consumer Price Index. Five leases include purchase options at fixed or market prices at various dates. Three leases include put options in the year 2000 at 100% of fair market value. Rent and lease expenses aggregated $6,897,000 for 1993, $7,682,000 for 1992, and $7,785,000 for 1991. Future minimum lease payments (in thousands) for operating leases at December 31, 1993 are as follows: Guarantees of Leases - -------------------- The Company is contingently liable for certain operating leases assumed by the purchasers of the Company's leasehold interests in facilities. The Company is not aware of any failure on the part of these purchasers to meet the terms of their obligations, and does not anticipate any expenditures to be incurred in connection with its guarantees. If a default were to occur, the Company generally would be able to assume operations of the facility and use the net revenues thereof to defray the Company's expenditures on these guarantees. The following is a schedule of future minimum lease payments (in thousands) for the operating leases for which the Company is contingently liable: Litigation - ---------- The Company is also subject to various claims and lawsuits which arise in the normal course of business. In the opinion of management, adequate provision has been made and such claims or actions are not expected to have a material adverse effect on the Company's financial position. NOTE 8 - CAPITAL STRUCTURE - -------------------------- The Company has authorized capital stock of 26,000,000 shares consisting of 1,000,000 shares of Series A Preferred Stock, $1.00 par value per share, and 25,000,000 shares of Common Stock, $.01 par value per share. Preferred Stock - --------------- The Preferred Stock, none of which has been issued, has certain preferences upon liquidation or redemption and has voting rights similar to the Common Stock. Common Stock - ------------ On December 21, 1992, the Company sold 1,633,000 shares of Common Stock to affiliates of Smith Management Company and Foothill Group, Inc., its two largest shareholders for $4,000,000 (Note 9). In 1992, Care retired 46,000 shares of Common Stock which had been acquired by the Company through settlement of certain claims. Stock Option Plan - ----------------- In 1992, the Board of Directors and the shareholders of the Company approved a stock option plan providing for the grant of options to employees and certain consultants to purchase an aggregate of 550,000 shares of the Company's Common Stock. Under this plan, full-time employees are eligible to receive grants of either incentive stock options structured to qualify under Section 422 of the IRC of 1986, or nonqualified stock options which are not intended to meet the requirements of the IRC. Consultants and certain eligible directors may be granted only nonqualified stock options. The options vest over a four year period and have an exercise price equal to the market price of the Company's common stock on the date of grant. Outstanding options expire on various dates through December 15, 1998. Stock option activity (in shares): Share Appreciation Rights Plan - ------------------------------ In January 1991, Care's Board of Directors adopted a Share Appreciation Rights Plan (the "SAR Plan") which provided for the award of 1,000,000 units to certain key executives. The SAR Plan was amended by the Board of Directors and shareholders in May 1992. The SAR Plan provides that upon award, 25% of the units vest on each of the first four anniversaries of the award date and vested units must be exercised before the fifth anniversary of the award. Upon exercise, the awardee is entitled to receive in cash or stock, at the Company's option, the difference between the base value awarded and the market value on the date units are exercised. As indicated below, of the 900,000 units which were awarded in 1991 at the base price of $1 per unit, 36,000 were exercised, 531,000 were forfeited and 333,000 remain outstanding, of which 166,500 are vested as of December 31, 1993. The Board of Directors has decided not to award additional rights under the SAR Plan. During 1993, 1992 and 1991, the Company accrued $2,157,000, $323,000 and $293,000, respectively, in benefits associated with this plan and 450,000 shares of Common Stock have been reserved for possible issuance in settlement of the appreciation due awardees. Share appreciation rights activity (in units): NOTE 9 - RELATED PARTY TRANSACTIONS - ------------------------------------ Smith Management Company and its affiliated companies ("Smith") and Foothill Capital Corporation, Foothill Group, Inc. and affiliates ("Foothill") are significant shareholders of the Company. In January 1992, Foothill acquired from Wells Fargo Bank, N.A. a 50% interest in the Company's Term Note obligation. Their portion of the Term Notes amounted to $9,375,000 at December 31, 1992. As part of the transaction, Foothill also acquired a contingent letter of credit obligation with a principal amount of $4,316,000. The remaining balance of the Term Notes was paid on December 30, 1993. In December, 1992, the Company sold 1,633,000 shares of Common Stock to Smith and Foothill for $4,000,000. In connection with this transaction, Smith and Foothill have registration rights whereby they can join the Company in a registration if the Company chooses to register other shares of its Common Stock with the Securities and Exchange Commission. In 1990 and 1991 the Company sold $3,000,000 in secured convertible exchangeable notes to Smith and Foothill. The notes, which had a maturity date of December 31, 1993, bore interest at a rate approximating the Citibank, N.A. prime rate plus 1% payable quarterly, were secured by two of the Company's nursing facilities. The notes were convertible at any time, at the option of the holder, into shares of Preferred Stock or Common Stock and would automatically convert into shares of Common Stock upon the occurrence of certain events. On November 14, 1991, the requirements for automatic conversion were met and the notes were converted into 2,679,000 shares of Common Stock. The holders of these shares have registration rights whereby they can request, at the Company's expense, that the Common Stock issued be registered with the Securities and Exchange Commission. Foothill also provided the Company with a $1,000,000 revolving credit working capital facility which was terminated, and the outstanding balance paid, in December 1993. In April 1991, the Company engaged Smith to assist in the development and implementation of a program which would improve the Company's liquidity. Under this agreement, the Company paid Smith an aggregate of $218,000 for 1992 and $100,000 for 1991. This agreement expired on December 31, 1992. The Company has a 26% interest in the pharmacy partnership formed in April 1992. The partnership continues to provide products and services to the nursing and rehabilitation centers operated by the Company. For 1993 and 1992 these purchases totalled approximately $5,900,000 and $4,200,000, respectively. NOTE 10 - DISPOSAL OF FACILITY - ------------------------------ In 1992, Care recognized a gain of $1,007,000 on a nursing facility disposal which occurred in 1991. The gain represents the difference between the book value of the nursing facility assets which were acquired in 1991 by a bank in a non-judicial foreclosure and management's estimate of the value of the assets surrendered. NOTE 11 - RETIREMENT SAVINGS PLAN - --------------------------------- Effective January 1, 1992, the Company began accepting the entry of new participants and began accepting participant contributions to the Care Enterprises, Inc. Retirement Savings Plan, which is a qualified cash or deferred arrangement under Section 401(k) of the Internal Revenue Code. All employees with at least one year of employment who have attained the age of 21 are eligible to participate. Participants may contribute, on a pretax basis, up to 15% of their earnings to the plan (subject to certain limitations), for which the Company matches 15% of the first 3% of contributions for persons with less than three years of service and 25% of the first 5% for all others. The Company's contributions are subject to a four-year vesting period. Matching contributions made by the Company for 1993 and 1992 were $186,000 and $155,000, respectively. NOTE 12 - QUARTERLY FINANCIAL DATA - ---------------------------------- During the fourth quarter of 1993 the Company recorded a charge of $1,694,000 for compensation payable under the Share Appreciation Rights Plan. This charge is the result of an increase in the market price of Care's Common Stock from $4.00 per share at September 30, 1993 to $9.625 at December 31, 1993. During the fourth quarter of 1992 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $461,000, the reversal of reserves for expenses and fees resulting from Chapter 11 proceedings of $75,000 and recognized a gain on the sale of a facility disposed of in 1991 of $1,007,000. During the second quarter of 1991 Care disposed of one facility and recognized a loss of $653,000 that was charged against reserves for losses on discontinuance of certain operations. During the third quarter of 1991 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $882,000. During the fourth quarter of 1991 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $374,000 and reversal of reserves for expenses and fees resulting from Chapter 11 proceedings of $464,000. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT John W. Adams, 50, has been Chairman of the Board of Directors since May 1990 and was Chief Executive Officer of the Company from September 1991 through December 1993. He has been President of Smith Management Company, a New York- based investment firm since January 1984. Mr. Adams served as Co-Chairman of the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 to December 1990. From 1975 to 1983, Mr. Adams was a partner with the law firm of Dillon, Bitar and Luther in New Jersey. Corley R. Barnes, 42, has been a director of the Company since May 1990. He is a private investor and a financial consultant to various publicly and privately held companies, including certain companies in the health care industry. Mr. Barnes served on the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 through December 1990. Laraine K. Beck, 43, has been a director of the Company since May 1990. Since December 1992, Ms. Beck has been the Senior Credit Manager at Rykoff/Sexton, a food service distribution company based in Los Angeles, California. Prior to joining Rykoff, Ms. Beck was the Regional Credit Manager of Kraft Food Service, a food production and distribution company from 1978 to 1992 and served as Co-Chairman of the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 through December 1990. From 1975 to 1978, Ms. Beck was employed as Credit Manager of White Motor Credit, a truck manufacturing company, located in Dallas, Texas. Robert G. Coo, 52, has been a director of the Company since January 1991. Also since January 1991, Mr. Coo has been Vice President, Chief Financial Officer and Secretary of Pengo Industries, Inc., the parent company of two manufacturing companies - Pengo Corporation and Goex, Inc. From 1987 to 1990, Mr. Coo was Vice President, Finance and Secretary of Renewable Resource Systems, Inc., a privately owned, diversified venture capital company. Mr. Coo has been a director of First National Bank, whose headquarters are located in San Diego, California, since October 1993. Mr. Coo is the brother-in-law of Mr. Adams. John F. Nickoll, 59, has been a director of the Company since November 1991. Since 1970, he has been Vice Chairman, Co-Chief Executive Officer, Chief Operating Officer and President of The Foothill Group, Inc. and Chairman and Chief Executive Officer of Foothill Capital Corporation, a subsidiary of The Foothill Group. Mr. Nickoll is also a director of Carson Pirie Scott & Co., Inc.; a director of CIM-High Yield Securities, Inc., a closed-end investment company; and a director of American Healthcare Management, Inc., an owner and manager of acute care hospitals. Arthur J. Pasmas, 59, has been a director of Care since December 1993, when he was elected to fill the vacancy created by the death of a board member. Since 1987, Mr. Pasmas has served as a Vice President of Smith Management Company. Prior thereto, he was founder, President, and Chief Executive Officer of Energy Management Corporation (acquired by Smith Management Company in 1987). He presently serves as Chairman of the Board of Pengo Industries, Inc. and of Goex International, Inc., and is a director of Liberty National Bank, Austin, Texas. Richard K. Matros, 40, has been a director of the Company since November 1991, President and Chief Operating Officer of the Company since September 1991 and Chief Executive Officer of the Company since January 1994. Prior to September 1991, Mr. Matros was Executive Vice President, Operations of the Company from March 1988. Before joining the Company, Mr. Matros served as Vice President of Operations, from 1985 to 1987, and Regional Administrator, from 1983 to 1985, for Beverly Enterprises, the nation's largest long-term care company. He has over 17 years of experience in the long-term care industry and is President-elect of the California Association of Health Facilities. Gary L. Massimino, 57, was appointed Chief Financial Officer of the Company in March 1990 and Executive Vice President in September 1991. For the previous eight years, Mr. Massimino was a financial consultant to companies in the health care, real estate and entertainment industries in various specialized financial projects. He has also served as Chief Financial Officer, Treasurer and a Director of Flagg Industries, Inc., a major California-based operator of nursing homes and real estate ventures. Barbara A. Garner, 39, was appointed Vice President of Professional Services in January 1988. Ms. Garner has been an Administrator and Southern Division Quality Assurance Coordinator since joining Care in 1983. From 1978 to 1983, she held nursing and administrator responsibilities with National Health Enterprises and Hillhaven; both companies are providers of skilled nursing care. Janet M. Turner, 62, was appointed Vice President of Nursing and Rehabilitation Centers in July 1992. Prior to her appointment, Ms. Turner was the Company's Director of Operations from September 1991 to June 1992 and a Regional Administrator from 1983 to 1988 and again from 1989 to 1991. From 1988 through 1989, Ms. Turner served as a Regional Administrator for ARA Living Centers, a nationwide long-term care company based in Houston, Texas. Ms. Turner joined Care Enterprises in 1983 in conjunction with the Company's acquisition of Casa Blanca Convalescent Homes, Inc., a long-term care company for which she was then Vice President of Operations for Northern California. She has over 25 years experience in the long-term care industry including serving as a statewide Officer for the California Association of Health Facilities from 1976 through 1980. Steven C. Ronilo, 44, was appointed Vice President of Human Resources in March 1990. Prior to his appointment, from 1984 to 1990, Mr. Ronilo was the Corporate Director of Industrial Relations for Beverly Enterprises, Inc., the nation's largest long-term care company. Prior to joining Beverly Enterprises, Mr. Ronilo held a variety of positions in upper management specializing in labor relations, employee relations and industrial relations for various manufacturing companies. Mr. Ronilo has over 21 years experience in the field of human resources, including personnel development and administration and union negotiation. One report to the Securities and Exchange Commission on Form 5, due February 14, 1994, was filed on March 21, 1994 by Janet M. Turner. The report covered one transaction in December, 1993. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (1) The Company has no restricted stock awards outstanding. (2) The Company has no long term incentive payout plans. (3) All compensation is reported in columns c, d, & e. (4) SARs granted January 1, 1991. (5) Options granted April 9, 1992. (6) Options granted February 26, 1993. (7) Includes $26,000, $23,000, and $14,000 in Director's fees for 1993, 1992, and 1991, respectively. (8) Includes $9,688 of compensation resulting from December 20, 1993 exercise of nonqualified stock options. Options/Stock Appreciation Rights (SAR) Grants in Last Fiscal Year ------------------------------------------------------------------ Aggregated Option/SAR Exercises in Fiscal Year ended December 31, 1993 and - -------------------------------------------------------------------------- December 31, 1993 Option/SAR Value ---------------------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL SHAREHOLDERS The following table sets forth certain information, as of March 22, 1994, with respect to all those known by the Company to be the beneficial owners of more than 5% of its outstanding Common Stock, each director who owns shares of Common Stock, and all directors and executive officers of the Company as a group. Except as otherwise indicated, the address of each individual director is in care of the Company at 2742 Dow Avenue, Tustin, California, 92680. (1) Common Stock consists of 13,243,168 shares issued and outstanding as of March 22, 1994. (2) According to reports filed with the Securities and Exchange Commission and Company records, the aggregate number of shares reported for the Smith Group is beneficially owned by a group comprised of SOLVation Inc., d/b/a/ Smith Management Company, Randall D. Smith, Gary M. Smith, Energy Management Corporation, Woodstead Associates, L.P., The Durian Trust and SEGA Associates, L.P. (3) According to the most recent reports filed with the Commission and Care records, the aggregate number of shares reported for The Foothill Group was 3,161,729 and includes shares beneficially owned by The Foothill Group, Inc., a Delaware corporation, The Foothill Fund, a California limited partnership, Foothill Capital Corporation, a California corporation, Foothill Partners L.P., a Delaware Limited Partnership, as well as 35,803 shares owned directly by John F. Nickoll. On March 3, 1994, The Foothill Fund distributed 1,663,857 shares of Care Common Stock in connection with the liquidation of the partnership following the expiration of the partnership term. Of such amount, 1,928 shares were distributed to John F. Nickoll and 108,161 shares were distributed to The Foothill Group. (4) Mr. Adams is the sole general partner of SEGA Associates, L.P. and accordingly has voting control and beneficial ownership of 64,175 shares of Care Common Stock held by SEGA Associates, L.P. Mr. Adams is also the President of Smith Management Company and indirectly owns 4.2% of Smith Management Company. (5) Mr. Coo is the brother-in-law of John W. Adams. (6) John F. Nickoll is the President, Co-Chief Executive Officer and a Director of The Foothill Group, Inc. (7) Richard K. Matros is President and Chief Executive Officer of the Company. Beneficial ownership includes 31,250 shares that could be purchased within 60 days of March 22, 1994 upon exercise of stock options, but does not include SARs. (8) Arthur J. Pasmas is Vice President of Smith Management Company. (9) Includes 64,500 shares that could be purchased within 60 days of March 22, 1994 upon exercise of stock options, including 31,250 shares that could be purchased by Mr. Matros, and 22,000 shares that could be purchased by Mr. Massimino. Does not include SARs. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Smith Management Company and its affiliated companies ("Smith") and Foothill Capital Corporation ("Foothill Capital"), Foothill Group, Inc. and its affiliates ("Foothill") are significant shareholders of Care. John W. Adams, Chairman of the Board of Directors of Care (and, until January 1994, Care's Chief Executive Officer), is President of Smith Management Company. Arthur J. Pasmas, a director of Care, is also employed by Smith. Mr. Adams received a fee for services as chief executive officer of Care at the rate of $50,000 per annum until December 31, 1992 and at the rate of $100,000 per annum for fiscal year 1993. John F. Nickoll, a director of Care, is President and Co-Chief Executive Officer and a director of The Foothill Group, Inc. In December 1990 and January 1991, Care issued to Smith and Foothill an aggregate of $3,000,000 of Convertible Exchangeable Notes. These notes were converted by their terms into 2,679,000 shares of Common Stock in November 1991. In April 1991, Care engaged Smith to assist in the development and implementation of a program that would improve Care's liquidity. Under this agreement, Care paid Smith an aggregate of $218,000 for 1992 and $100,000 for 1991. This agreement expired on December 31, 1992. In December 1992, Care sold 1,633,000 shares of Common Stock to Smith and Foothill Capital for $4,000,000. In connection with this transaction, Smith and Foothill Capital have registration rights whereby they can join Care in a registration if Care chooses to register other shares of Common Stock with the Commission. In January 1992, Foothill Capital purchased from Wells Fargo Bank, N.A. a Term Note obligation of Care, which had a principal amount of $13,212,722 and which was scheduled to mature on April 20, 1995, and accrued interest at the rate of Prime plus 2%. As part of the Term Note purchase, Foothill Capital also acquired a standby letter of credit obligation of Care with a principal amount of $4,316,000. The Term Note obligation was repaid in full by Care on December 30, 1993. In March 1993, Care obtained a commitment for a $3,500,000 increase in its working capital facility provided by Foothill Capital. This facility was secured by certain of Care's nursing and rehabilitation centers and certain accounts receivable, and was to bear interest at a rate of Prime plus 3%. The facility was terminated and the collateral released on December 30, 1993. Until December 30, 1993, Care had a $1,000,000 working capital facility made available by Foothill Capital. This facility bore interest at a rate approximating Citibank N.A.'s prime rate plus 3%, payable quarterly, and was secured by one of Care's properties. This facility was terminated, all outstanding indebtedness was retired and the collateral was released on December 30, 1993. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8K (a) Set forth below is a list of Financial Statements and Financial Statement Schedules filed as part of this Report: AND FINANCIAL STATEMENT SCHEDULES 1. Financial Statements: Page ---- Report of Independent Auditors 18 Consolidated Balance Sheets at December 31, 1993 and 1992 19 Consolidated Statements of Operations, Years Ended December 31, 1993, 1992 and 1991 20 Consolidated Statements of Shareholders' Equity, Years Ended December 31, 1993, 1992 and 1991 21 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 22 Notes to Consolidated Financial Statements 24 2. Financial Statement Schedules: Schedule IV - Indebtedness of and to related parties - not current 55 Schedule V - Property and equipment 56 Schedule VI - Accumulated depreciation and amortization 57 Schedule VIII - Valuation and qualifying accounts 58 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits: Reference is made to the Exhibit Index which is filed as part of this annual report. (b) Reports on Form 8-K: The Company filed the following reports on Form 8-K during the quarter ended December 31, 1993: Date Item Reported - ------------------------ -------------------------- December 20, 1993 Merger Agreement with Regency Health Services, Inc. December 30, 1993 Sale of Senior Secured Notes SIGNATURES Pursuant to the requirements of Section 13 or 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. CARE ENTERPRISES, INC. (Registrant) March 24, 1994 /S/ John W. Adams - ---------------------- ------------------------------ Date John W. Adams Chairman of the Board March 24, 1994 /S/ Gary L. Massimino - ---------------------- ------------------------------ Date Gary L. Massimino Executive Vice President Chief Financial Officer SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on the date or dates indicated below, by the following persons on behalf of the registrant in the capacities indicated. CARE ENTERPRISES, INC. (Registrant) March 24, 1994 /S/ John W. Adams - ---------------------- ------------------------------ Date John W. Adams, Chairman March 24, 1994 /S/ Corley R. Barnes - ---------------------- ------------------------------ Date Corley R. Barnes, Director March 24, 1994 /S/ Laraine K. Beck - ---------------------- ------------------------------ Date Laraine K. Beck, Director March 24, 1994 /S/ Robert G. Coo - ---------------------- ------------------------------ Date Robert G. Coo, Director March 24, 1994 /S/ Richard K. Matros - ---------------------- ------------------------------ Date Richard K. Matros, Director March 24, 1994 /S/ John F. Nickoll - ---------------------- ------------------------------ Date John F. Nickoll, Director March 24, 1994 /S/ Arthur J. Pasmas - ---------------------- ------------------------------ Date Arthur J. Pasmas, Director INDEX TO EXHIBITS (ITEM 14(a) (3)) Sequential Exhibit Numbered Number Description Page - ---------- ------------------------------------------------ ------ 2.1 Debtors' and Official Creditors Committee's (A) Joint Plan of Reorganization. 2.2 Order confirming Debtors' and Creditors' (B) Committee's Joint Consolidated Plan of Reorganization. 2.5 Agreement and Plan of Merger, dated as of (M) December 20, 1993, between Regency Health Services, Inc. and Care Enterprises, Inc. 2.6 Amendment to Agreement and Plan of Merger, (O) dated as of January 7, 1994, between Regency Health Services, Inc. and Care Enterprises, Inc. 3.1 Restated Certificate of Incorporation of (C) Care Enterprises, Inc., a Delaware corporation. 3.2 Restated By-Laws of Care Enterprises, Inc. (C) 3.3 Certificate of Amendment of Restated (D) Certificate of Incorporation of Care Enterprises, Inc. 4.1 Form of Transfer Restriction Agreement (D) 4.2 Certificate of Designations, Preferences (D) and Relative, Participating, Optional or Other Special Rights of Series A Convertible Preferred Stock of CARE ENTERPRISES, INC. 4.3 1992 Stock Option Plan of the Registrant. (F) 4.4 Form of Incentive Stock Option Agreement for (G) Employees of the Registrant. 4.5 Form of Nonqualified Stock Option Agreement for (H) Employees and Consultants of the Registrant. 4.6 Registrant's Share Appreciation Rights Plan, (I) as amended. 4.7 Form of Agreement Regarding Allocation of Units (J) Under Registrant's Share Appreciation Rights Plan. 10.14 Stock Purchase Agreement dated as of (K) December 15, 1992 between Care Enterprises, Inc., Foothill Group Inc., Foothill Partners and Energy Management Corporation 10.15 Partnership agreement dated April 1, 1992 between (L) Medisave Pharmacies, Inc. and HealthCare Network, Incorporated. 10.16 Voting Agreement, dated December 27, 1993 between (M) Care Enterprises, Inc. and certain shareholders of Regency Health Services, Inc. named therein. 10.17 Voting Agreement, dated December 27, 1993 between (M) Regency Health Services, Inc. and certain shareholders of Care Enterprises, Inc. named therein. 10.18 Note Agreement dated as of December 15, 1993 between (N) Care Enterprises, Inc. and the Purchasers named on Schedule I to the Note Agreement. 10.19 Indenture of Trust dated as of December 15, 1993 (N) between Care Enterprises, Inc. and State Street Bank and Trust Company of Connecticut, National Association, as Indenture Trustee. 10.20 Guaranty Agreement dated as of December 15, 1993 in (N) favor of Note Holders by certain subsidiaries of Care Enterprises, Inc. 10.21 Letter Agreement dated December 29, 1993 (N) between Wells Fargo Bank, National Association and Care Enterprises, Inc. 10.22 Form of Deeds of Trust relating to the 8.1% (O) Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 10.23 Form of Open-End Mortgage and Security Agreement (O) relating to the 8.1% Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 10.24 Agreement dated as of December 30, 1993 (O) between Care Enterprises, Inc. and the Purchasers of the 8.1% Senior Secured Notes. 10.25 Agreement dated July 1, 1993 between (O) Mabon Securities Corp. and Care Enterprises, Inc. to provide investment banking services. 10.26 Agreement dated November 15, 1993 between (O) Merrill Lynch & Co. and Care Enterprises, Inc. to provide advisory services. 10.27 Business loan agreement dated as of (O) March 1, 1994, between Care Enterprises, Inc. and Bank of America National Trust and Savings Association. 10.28 Third Amendment to Lease, dated as of (O) October 22, 1992, by and among certain lessors and Care Enterprises, West. 10.29 Amendment to Agreement of Lease re: (O) Calistoga Convalescent Hospital dated August 21, 1992 between certain lessors and Care Enterprises, West. 10.30 Employment Agreement dated January 1, 1993 (O) between Care Enterprises, Inc. and Richard K. Matros. 10.31 Employment Agreement dated January 1, 1993 (O) between Care Enterprises, Inc. and Gary L. Massimino. 10.32 Form of Deeds of Trust relating to the 8.1% (O) Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 21 Subsidiaries of Registrant. (O) 23 Consent of Ernst & Young (O) 99.2 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to John Hancock Life Insurance Company of America in the original principal amount of $1,000,000, dated December 30, 1993. 99.3 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to Mellon Bank, N.A., Trustee under Master Trust Agreement of NYNEX Corporation dated January 1, 1984 for Employee Pension Plans - NYNEX - John Hancock - Private Placement in the original principal amount of $2,000,000, dated December 30, 1993. 99.4 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to Anchor National Life Insurance Company in the original principal amount of $15,000,000, dated December 30, 1993. 99.5 8.10% Senior Secured Note from (O) Care Enterprises, Inc. to John Hancock Mutual Life Insurance Company in the original principal amount of $7,000,000, dated December 30, 1993. 99.6 8.10% Senior Secured Note from (O) Care Enterprises, Inc. to John Hancock Mutual Life Insurance Company in the original principal amount of $5,000,000, dated December 30, 1993. 99.7 Annual Report on Form 11-K for (E) Employee Retirement Savings Plan for the year ended December 31, 1992. (A) Incorporated by reference from Exhibit 28.1 to Care's Current Report on Form 8-K dated December 29, 1989. (B) Incorporated by reference from the same numbered exhibit to Care's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. (C) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K dated April 20, 1990. (D) Incorporated by reference from the same numbered exhibit to Care's 8-A filed on December 28, 1990. (E) Incorporated by reference. (F) Incorporated by reference from Exhibit 4.1 to Care's Registration Statement on Form S-8 dated March 16, 1992. (G) Incorporated by reference from Exhibit 4.2 to Care's Registration Statement on Form S-8 dated March 16, 1992. (H) Incorporated by reference from Exhibit 4.3 to Care's Registration Statement on Form S-8 dated March 16, 1992. (I) Incorporated by reference from Exhibit 4.4 to Care's Registration Statement on Form S-8 dated March 16, 1992. (J) Incorporated by reference from Exhibit 4.5 to Care's Registration Statement on Form S-8 dated March 16, 1992. (K) Incorporated by reference from Exhibit 10.1 to Care's Current Report on Form 8-K filed on December 22, 1992. (L) Incorporated by reference from the same numbered exhibit to Care's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (M) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K filed on December 20, 1993. (N) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K filed on December 30, 1993. (O) Filed with this report. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY AND EQUIPMENT (in thousands) (a) Reclassification of previously leased assets to owned assets. (b) Restoration of assets previously classified as held for sale. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION (in thousands) (a) Reclassification of previously leased assets to owned assets. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (in thousands)	13,583	90,372
25890_1993.txt	25890_1993	1993	25890	ITEM 1. BUSINESS GENERAL Crown Cork & Seal Company, Inc. (the "Company" and the "Registrant") is a multinational manufacturer of metal and plastic packaging, including cans, bottles, crowns and closures (metal and plastic) and machinery for filling, packaging and handling. The Company is an international packaging producer and, as such, benefits from, but is also exposed to, the fluctuations of world trade. The Company recognizes that it must constantly review operations worldwide to ensure that it maintains its competitive position. To achieve better productivity, the Company closed or reorganized 24 facilities across nine countries between 1991 and 1993. The Company continues to review all operations so that it can determine the appropriate number, size and location of plants, emphasizing service to customers and rate of return to investors. Financial information about the Company's operations in its two industry segments and within geographic areas is set forth in Part II of this Report on page 38 under the Notes to Consolidated Financial Statements entitled "Segment Information by Industry and Geographic Areas". The Company has grown substantially since December 1989 when it commenced a series of acquisitions that have more than doubled its sales. The Company believes that these acquisitions have enabled it to become a leader in North American markets, to better penetrate important international markets, to enhance product quality, to realize economies of scale and to improve its technical and developmental capabilities while preserving the Company's traditional focus on customer service. To further accommodate its expanded base of operations, in 1992, the Company organized into four divisions by adding Plastics to its previously established North American, International and Machinery Divisions. The Company, with its 1992 acquisition of CONSTAR International, Inc., now conducts business in two separate industry segments within the Packaging Industry, Metal and Plastic. Information about the Company's acquisitions over the past three years appears in Part II hereof on pages 25 and 26 under Note C of the Notes to the Consolidated Financial Statements. DISTRIBUTION The Company's products are manufactured in 84 plants within the United States and 74 plants outside the U.S., spanning over 40 countries and are sold through the Company's sales organization to the food, citrus, brewing, soft drink, oil, paint, toiletry, drug, antifreeze, chemical and pet food industries. For the period ended December 31, 1993 and years prior to 1992, no one customer accounted for more than 10 percent of the Company's net sales. In 1992, one customer accounted for approximately 10.6 percent of the Company's net sales. RESEARCH AND DEVELOPMENT Pursuant to the acquisition of Continental Can International in 1991, the Company acquired an international engineering group currently based at the Company's new Alsip Technical Center near Chicago. The technical center enables the Company to enhance its technical and engineering services worldwide both within the Company and to third parties. The Company's research and development expenditures of $23.3 million, $16.7 million and $16.1 million in 1993, 1992, and 1991, respectively, are expected to make a greater contribution to improving and expanding the Company's product lines in the future. Crown Cork & Seal Company, Inc. MATERIALS The Company continues to pursue strategies which enable it to source its raw materials with increasing effectiveness, and may consider vertical integration into the production of certain raw materials, such as PET resin, used in plastic bottle production, if it is advantageous to do so. ENVIRONMENTAL MATTERS The Company has a Corporate Environmental Protection Policy. Environmental considerations are among the criteria by which the Company evaluates projects, products, processes and purchases. The Company continues to reduce the amount of metals and resins used in the manufacture of steel, aluminum and plastic containers through its "lightweighting" program. The Company currently recycles nearly 100 percent of scrap steel, aluminum, plastic and copper used in the manufacturing process, and through its Nationwide Recyclers subsidiary, is directly involved in post-consumer aluminum and steel can recycling. The Company is involved in promoting the development of recycling systems through various activities, including membership in recycling organizations and ongoing research and development programs. Further discussion of the Company's environmental matters is contained in Part II, Item 7 "Management's Discussion and Analysis", of this Report on page 15. WORKING CAPITAL Information relating to the Company's liquidity and capital resources is set forth in Part II, Item 7, "Management's Discussion and Analysis of Operations and Financial Condition", of this Report on pages 13, 14 and 15. EMPLOYEES At December 31, 1993, the Company employed 21,254 people throughout the world. CHANGE IN THE BOARD OF DIRECTORS After 37 years of service, Frank N. Piasecki has decided not to stand for re-election to the Board of Directors. Mr. Piasecki was the longest serving board member in the Company's 102 year history. APPOINTMENT OF CORPORATE OFFICERS As the Company continues to reorganize its operations to assimilate its recent acquisitions, the Board of Directors of the Company has appointed Mr. Mark W. Hartman to the newly created position of Executive Vice President, Corporate Technologies. Mr. Hartman will lead an organization charged with unifying the Company's extensive Research, Development and Engineering talents worldwide in keeping with its commitment to pursue global technological excellence in packaging. Mr. John W. Conway, formerly Senior Vice President - International Division, was appointed Executive Vice President, President - International Division, a position previously held by Mr. Hartman. Mr. Conway came to the Company in 1991 with the Company's acquisition of Continental Can International. Crown Cork & Seal Company, Inc. METAL PACKAGING The Metal Packaging segment includes the North American, International and Machinery Divisions of the Company. This segment in 1993 accounted for approximately 81 percent of net sales and operating profits. This segment manufactures and markets steel and aluminum cans as well as composite cans, crowns (also known as bottle caps) and metal closures. Within the Machinery Division, the Company manufactures filling, packaging and handling machinery. All products are sold through the Company's sales organization to the food, brewing, citrus, soft drink, oil, paint, toiletry, drug, chemical and pet food industries. The Company believes that price, quality and customer service are the principal competitive factors affecting its business. Based upon sales, the Company believes that it is a leader in the markets for metal packaging in which it competes; however, the Company encounters competition from a number of companies offering similar products. The basic raw materials for this segment's products are tinplate and aluminum. These metals are supplied by the major mills in the countries within which the Company operates plants. Some plants in less-developed countries, which do not have local mills, obtain their metal from nearby more-developed countries. Sufficient quantities have been available in the past, however, there can be no assurances that sufficient quantities will be available in the future. The Company, based on net sales, is one of two leading producers of aluminum beverage cans within the United States. This sector of its business, while important to the Company, continues to contribute a decreasing proportion of consolidated net sales (30% in 1993 versus 42% in 1991) as other sectors develop and as lower aluminum costs have been passed on to customers. Beverage can prices in the United States have declined by more than has been reflected in lower aluminum costs. The Company is addressing this situation through ongoing non-metal cost reductions and restructuring of production processes. Beverage can capacity in North America is being redeployed in emerging markets and, to a lesser extent, also is being retrofitted to produce two-piece food cans. In April 1993, the Company acquired the Van Dorn Company. Van Dorn provides the Company with two piece (drawn) aluminum cans for processed foods and adds additional manufacturing capacity for metal, plastic and composite cans for the paint, chemical, automotive, food, pharmaceutical and household product industries. On January 27, 1994, the Company announced that it had agreed in principle to acquire the Container Division of Tri Valley Growers. With this pending acquisition, the Company seeks to continue to expand the food can business. In North America, based on net sales, the Company believes that, along with beverage cans, it is a market leader in the manufacture and sale of metal packaging to the processed foods, aerosol and other industries. The Company's customers include leading producers of soft drinks, beer, juice, food and aerosol products. During 1992, the Company closed three Canadian plants and instituted other restructuring actions in Canada due to the unfavorable market conditions there. The Company remains confident that the Canadian economy will recover and become a better market for its products in the future. In 1993, the Company's Canadian operation reflected improvement. The Company intends over the next several years to continue to reduce the number of manufacturing lines used in North America to produce beverage cans in favor of fewer, but faster and more efficient lines. Additional restructuring also will be directed toward other products, particularly those involving U. S. non-beverage metal operations. Crown Cork & Seal Company, Inc. Outside North America, the Company's metal packaging products consist of metal crowns and closures as well as metal cans for food, beverage and aerosol customers. Europe is the most significant crown market for the Company with returnable bottles being a dominant form of beverage packaging in the region. In 1993, the Company commenced production of aerosol cans at a new facility near Amsterdam, the Netherlands and two-piece beverage cans at plants in Argentina and the United Arab Emirates. Construction of new two-piece beverage can lines at jointly-owned facilities is presently underway in Shanghai, China and Amman, Jordan. In addition to the Company's North American beverage can capacity, the Company had an additional 7 billion units of capacity in markets such as Hong Kong, China, Argentina, United Arab Emirates(UAE), Korea, Saudi Arabia and Venezuela. UAE, Korea, Saudi Arabia and Venezuela represent jointly-owned operations. This action continues to support the Company's current philosophy that the use of business partners in many overseas locations presents another cost-effective means of entering these new markets. International margins have been sustained as a result of actions commenced in 1992. Further restructuring occurred during 1993 with the closure of certain operations in France and the Netherlands. The Machinery division, representing approximately 2 percent of consolidated net sales, reported increased sales in 1993 but due to competitive factors, the Company has downsized its operations in Belgium and the United States. This downsizing will continue to reduce operating costs while improving efficiencies. PLASTIC PACKAGING The Plastics segment manufactures plastic containers and closures. The Company with its 1992 acquisition of CONSTAR International and the 1993 acquisition of the remaining 56 percent of CONSTAR'S affiliate in Europe, Wellstar, has enabled itself to offer a wider product range to its worldwide customers. The segment also includes plastic closure operations in Virginia and Switzerland. Metal Packaging plants in Belgium, Germany, Italy, Spain, Portugal, Argentina and the United Arab Emirates also manufacture plastic packaging, closures and bottles. With the acquisitions of CONSTAR and Wellstar, the Plastics segment has grown considerably and now represents almost 20 percent of the Company's net sales as compared to approximately 2 percent in 1991. The Company is actively integrating these operations into its organization by installing its cost systems and controls. CONSTAR and Wellstar manufacture plastic containers for the beverage, food, household, chemical and other industries. Wellstar is a leading European manufacturer of polyethylene terephthalate (P.E.T.) preforms and bottles, including P.E.T. returnable bottles. This acquisition strengthens the Company's plastics marketing base within Europe. Plastic containers continued to increase their share of the Packaging market during 1993. The principal raw materials used in the manufacture of plastic containers and closures are various types of resins which are purchased from several commercial sources. Resins, which are petrochemical derivatives, are presently available in quantities adequate for the Company's needs. Typically, the Company identifies market opportunities by working cooperatively with customers and implementing commercially successful programs. The Company will capitalize on both the conversions to plastic from other forms of packaging and the new markets through its technical expertise, quality reputation and customer service. Logistically, CONSTAR plant sites are strategically located and sized properly. Capital expenditures for Plastic Packaging was approximately 44 percent of total capital expenditures for the Company in 1993 as compared to approximately 5 percent in 1991. The Company has made a commitment to service global customers with plastic containers. Crown Cork & Seal Company, Inc. ITEM 2. ITEM 2. PROPERTIES The Company's manufacturing and support facilities are designed according to the requirements of the products to be manufactured, and the type of construction varies from plant to plant. In the design of each facility, particular emphasis is placed on quality assurance in the finished products, safety in the operations, and avoidance or abatement of pollution. The Company maintains its own engineering staff, which aids in achieving close integration of research, design, construction and manufacturing functions and facilitates the construction of plants which will be best suited to their special purposes. Warehouse and delivery facilities are provided at each of the manufacturing locations, however, the Company does lease outside warehouses at some locations. The plants of the Company and its subsidiaries are owned, with the exception of those that have the word "leased", in brackets, after the location name. Joint Ventures are indicated by the initials JV, in brackets, after the location name. Crown Cork & Seal Company, Inc. * Plastic Packaging manufactured within Metal Packaging locations Some metal manufacturing locations are supported by locations that provide art work for cans and crowns, coil shearing, coil coating, research, product development and engineering. The support locations within the United States are located in Alsip, IL, Baltimore, MD, Fairless Hills, PA (Leased), Massilon, OH, Plymouth, FL and Toledo, OH; and outside the United States in Aracaju, Brazil, Rotterdam, Holland and Santafe de Bogata, Colombia. Crown Cork & Seal Company, Inc. The Company manufactures bottle and can filling machinery and parts at locations within the United States in Baltimore, MD and Titusville, FL; outside the United States in Londerzeel, Belgium and San Luis Potosi, Mexico. The Company also operates two machinery overhaul locations within the United States in Bartow, FL and Philadelphia, PA. The Company has three machine shop locations which manufacture tool and die parts used within its own manufacturing locations and also sells to customers in the packaging industry. The locations are within the United States, with two in Philadelphia, PA., and one in Wissota, WI. The Company is directly involved in post-consumer aluminum and steel can recycling through its subsidiary, Nationwide Recyclers, Inc., located in Polkton, NC. Commencing June 1994, this site will recycle post-consumer plastic packaging. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In management's opinion, there are no pending claims or litigation, the adverse determination of which would have a material adverse effect on the consolidated financial position of the Company. The Company has been identified by the Environmental Protection Agency as a potentially responsible party (along with others, in most cases) at a number of sites. Information on this is presented in Part I, Item 1, entitled "Business" appearing on page 2 of this Report and in Part II Item 7, entitled "Management Discussion and Analysis of Financial Condition and Results of Operation" appearing on page 15 of this Report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Crown Cork & Seal Company, Inc. ITEM 4a. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning the principal executive officers of the Company, including their ages and positions as of December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock is listed on the New York Stock Exchange. On March 18, 1994, there were 6,163 registered shareholders of the Registrant's Common Stock. The market price with respect to the Registrant's Common Stock is set forth on page 37 as Note R of the Notes to Consolidated Financial Statements entitled "Quarterly Data (unaudited)". Crown Cork & Seal Company, Inc. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (in millions, except per share, employee, shareholder and statistical data) Management's discussion and analysis should be read in conjunction with the financial statements and the notes thereto. Share data for prior years have been restated for the 3 for 1 common stock split declared in 1992. RESULTS OF OPERATIONS NET INCOME AND EARNINGS PER SHARE BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES Net income before cumulative effect of accounting changes for 1993 was a record $180.9, an increase of 16.4% compared with $155.4 for 1992. Net income for 1991 was $128.1. Net income for 1992 and 1991 represents increases of 21.3% and 19.6%, respectively, over the preceding year. Earnings per share before cumulative effect of accounting changes for 1993 was a record $2.08 per share, an increase of 16.2% compared with $1.79 per share for 1992. Earnings per share for 1991 was $1.48 per share. Earnings per share for 1992 and 1991 represents increases of 20.9% and 19.4%, respectively, over the preceding year. The sum of per share earnings by quarter does not equal earnings per share for the year ended December 31, 1993, due to the effect of shares issued during 1993. SALES Net sales during 1993 were $4,162.6, an increase of $381.9 or 10.1% versus 1992 net sales of $3,780.7. Net sales during 1991 were $3,807.4. Domestic sales increased by $430.9 or 17.9% in 1993 versus 1992, while 1992 domestic net sales decreased $53.6 or 2.2% versus 1991. Domestic net sales in 1991 increased 38.3% over 1990. The increase in 1993 domestic net sales primarily reflects (i) a full year sales of CONSTAR, $600 in 1993 versus approximately $100 in 1992 for two months from the date of acquisition, (ii) $130 from the acquisition of Van Dorn and (iii) increased sales unit volume in aerosol and composite cans; offset by (i) lower raw material costs which were passed on to customers in the form of reduced selling prices and (ii) continued competitive pricing in the North America beverage can market. The decrease in 1992 domestic net sales was primarily a result of lower material costs passed on as reduced selling prices to customers offset partially by the addition of CONSTAR sales of $100 for two months. The increase in 1991 net sales was primarily due to the Company's acquisitions as described in Note C to the Consolidated Financial Statements. International sales decreased $49 or 3.6% in 1993 versus 1992, which compares to increases of 2.0% and 4.0% in 1992 and 1991 over the respective preceding years. The decrease in international net sales reflects (i) $100 due to the continued strengthening of the U.S. dollar against most currencies in which the Company's affiliates operate and (ii) the continuing recession in Europe; offset partially by the acquisition of Wellstar Holding B.V. which contributed $85 from the date of acquisition. International sales unit volumes for plastic closures, beverage cans, food cans and aerosol cans improved in 1993, while crown volumes declined. COST OF PRODUCTS SOLD Cost of products sold, excluding depreciation and amortization for 1993 was $3,474.0, an 8.7% increase from the $3,197.4 in 1992. This increase follows a 2.8% decrease and a 24.6% increase in 1992 and 1991, respectively. The increase in 1993 cost of products sold primarily reflects increased sales levels as noted above offset by lower raw material costs and continuing company-wide cost containment programs. The 1992 decrease was primarily due to lower material costs while the 1991 increase reflects higher sales level of the Company's products. Crown Cork & Seal Company, Inc. As a percent of net sales, cost of products sold was 83.5% in 1993 as compared to 84.6% in 1992 and 86.4% in 1991. SELLING AND ADMINISTRATIVE Selling and administrative expenses for 1993 were $126.6, an increase of 12.9% over 1992. This increase compares to increases of 6.4% for 1992 and 22.3% for 1991. Selling and administrative expenses have increased in recent years as a result of businesses acquired. As a percent of net sales, selling and administrative expenses were 3.0% in 1993 and 1992, and 2.8% in 1991. OPERATING INCOME The Company views operating income as the measure of its performance before interest costs and other non-operating expenses. Operating income of $378.7 in 1993 was $58.7, or 18.3% greater than in 1992. Operating income was $320.0 in 1992, an increase of 17.6% over 1991, and $272.0 in 1991, an increase of 17.1% versus 1990. Operating income as a percent of net sales was 9.1% in 1993 as compared to 8.5% in 1992 and 7.1% in 1991. Operating profit in the Company's U.S. operations was 10.2% of net sales in 1993 versus 10.5% and 6.9% in 1992 and 1991, respectively. Productivity improvement, research and development and continuing programs to contain and reduce cost have all contributed to retain and increase domestic margins in 1993 and 1992 despite competitive pricing pressures. European operating profit increased to 5.7% of net sales in 1993 from 4.9% in 1992. The higher operating profit margins reflect the benefits associated with the Company's continuing efforts to restructure its European operations in response to the changing economic environment in the region. Operating profit in North and Central America (other than the United States) at $23.3 in 1993 was 5.0% of net sales as compared to 1.8% in 1992. These increased results are a result of (i) costs associated with closing three Canadian plants in 1992 and (ii) better market conditions and demand in 1993 compared to 1992 in Canada; offset by lower unit sales in most product lines in Mexico. The Company is pleased with the signs of improvement in its Canadian operations, a result of several restructuring actions taken in 1992 and 1991 and is poised to take the necessary steps to compete in the changing economic environment in Mexico. NET INTEREST EXPENSE/INCOME Net interest expense was $79.7 in 1993, an increase of $15.8 when compared to 1992 net interest of $63.9. Net interest expense was $66.6 in 1991. The increase in 1993 net interest expense is due primarily to bank borrowings necessary to finance the CONSTAR acquisition, offset by lower interest rates and the repayment of a $100 note in June 1993 which carried an interest rate of 9.17%. The decrease in 1992 net interest expense was due to declining interest rates and the repayment, in June 1992, of a $100 note which had an interest rate of 9.13%. The increase in 1991 net interest expense was due to bank borrowings necessary to fund 1991 and 1990 acquisitions. Specific information regarding acquisitions is found in Note C to the Consolidated Financial Statements, while information specific to company financing is presented in the Liquidity and Capital Resources section of this discussion and Notes I and L to the Consolidated Financial Statements. TAXES ON INCOME The effective tax rates on income were 34.8%, 39.7% and 40.1% in 1993, 1992 and 1991, respectively. The lower effective rate for 1993 was primarily a result of lower effective tax rates in non-U.S. operations compared to 1992. The higher effective tax rates versus the U.S. statutory rate in 1992 and 1991 are primarily due to the effect of different tax rates in non-U.S. operations and the increase in non-deductible amortization of goodwill and other intangibles, as a result of recent acquisitions. Crown Cork & Seal Company, Inc. EQUITY IN EARNINGS OF AFFILIATES, NET OF MINORITY INTERESTS Equity in earnings of affiliates was $5.0, $6.3 and $6.2 for 1993, 1992 and 1991, respectively. The decrease in equity earnings in 1993 is primarily a result of the Company selling 30% of its interest in its joint venture in Saudi Arabia. Minority interests were $6.5, $4.6 and $3.1 in 1993, 1992 and 1991, respectively. The increases in minority interests relate to (i) more favorable results in the Company's 50.1% interest in a Hong Kong joint venture, (ii) the commencement of production and sales in the Company's 50% interest in Dubai, United Arab Emirates and (iii) the late 1992 sale by the Company of 50% of its South African affiliate and 30% of certain other African businesses to form a joint venture partnership with another South African packaging company. During 1993 the Company's CONSTAR International subsidiary acquired the remaining 56% of Wellstar Holding, B.V. The Company, beginning in 1993, consolidates this wholly-owned subsidiary. With the acquisition of Continental Can International Corporation, Inc. (CCIC) in 1991, the Company acquired minority interests in joint ventures in the Middle East, Korea and South America. Additionally, the Company acquired a 50.1% ownership interest in a joint venture in Hong Kong. As a result of these ownership interests, the Company now has sources of income and cash flow from non-consolidated affiliates and additional liabilities of minority partners. Due to the acquisition of CCIC, the Company has entered many new markets. These new markets provide excellent future growth potential for the Company's products and services while at the same time introducing the Company to viable business partners. The Company believes that the use of business partners in many overseas locations presents another cost-effective means of entering new markets. The Company has presented earnings from equity affiliates, net of minority interests (the components of which can be found in Notes F and P to the Consolidated Financial Statements), as a separate component of net income. Management believes that presenting such earnings as a component of pre-tax income would distort the Company's effective tax rate, and as such, has presented equity earnings after the provision for income taxes. INDUSTRY SEGMENT PERFORMANCE This section presents individual segment results for the last three years. The after-tax charge of $81.8 or $.96 per share related to adoption of SFAS 106, SFAS 109 and SFAS 112 in 1993 is included as an after tax charge in the Metal Packaging segment of $83.7 or $.98 per share and an after-tax credit in the Plastic Packaging segment of $1.9 or $.02 per share, and is excluded in making comparisons of 1993 results with prior years. Net sales for the Metal Packaging segment in 1993 were $3,367.0, down $206.1 or 5.8% compared to 1992 net sales of $3,573.1. Net sales during 1991 were $3,733.0. Sales in the segment have declined in recent years primarily as a result of lower raw material costs which have been passed on to customers in the form of reduced selling prices. Metal Packaging 1993 operating income was $308.5 or 9.2% of net sales compared to $296.4 in 1992 which was 8.3% of net sales. Operating income in 1991 was $261.4 or 7.0% of net sales. The increase in operating income reflects the successful integration of acquisitions made since 1989. Despite competitive price pressures and costs associated with restructuring efforts in North America and Europe, the Company has streamlined its organizational structure and improved efficiency to achieve significant cost reductions and increase operating profits. Net sales for the Plastic Packaging segment in 1993 increased $588.0 or 283.2% to $795.6 in 1993 from $207.6 in 1992. Net sales for 1992 increased $133.2 or 179.0% against 1991 net sales of $74.4. The increase in 1993 is primarily a result of the Company's October 1992 acquisition of CONSTAR International Inc. ("CONSTAR") and the acquisition during 1993 of the remaining 56% interest in Wellstar Holding B.V. Crown Cork & Seal Company, Inc. ("Wellstar") by CONSTAR. The full year sales of CONSTAR contributed approximately $600 in 1993 compared to two months sales in 1992 of approximately $100. Wellstar from the date of acquisition contributed net sales of $85 in 1993. Plastic Packaging 1993 operating income was 8.8% of net sales at $70.2 compared to 11.4% or $23.6 in 1992. Operating income in 1991 was $10.6 or 14.2% of net sales. Increased competition, product sales mix and the recession in Europe have contributed to decreased margins. ACCOUNTING CHANGES The Company, as required, adopted SFAS 106 and SFAS 109 on January 1, 1993. Additionally, during the fourth quarter, the Company adopted SFAS 112 retroactive to January 1, 1993. The after-tax effect of these accounting changes was a one-time charge to 1993 earnings of $81.8 or $.96 per share, with an incremental charge to 1993 earnings of $2.5 or $.03 per share. These accounting changes are more fully described in Note B to the Consolidated Financial Statements. Adoption of the above three statements did not and will not have any cash flow impact on the Company. FINANCIAL POSITION LIQUIDITY AND CAPITAL RESOURCES The Company's financial position remains strong. Cash and cash equivalents totaled $54.2 at December 31, 1993, compared to $26.9 and $20.2 at December 31, 1992 and 1991, respectively. The Company had working capital of $43.8 at December 31, 1993. The Company's primary sources of cash in 1993 consisted of (i) funds provided from operations, $352.5; (ii) proceeds from short-term debt borrowings, $136.5; (iii) proceeds from sale of businesses, $83.6; and, (iv) proceeds from long-term debt borrowings, $548.3. The Company's primary uses of cash in 1993 consisted of (i) payments on long-term debt, $715.0; (ii) acquisition of and investments in businesses, $66.2; (iii) capital expenditures, $271.3 and (iv) repurchases of common stock, $86.5. The Company funds its working capital requirements on a short-term basis primarily through issuances of commercial paper. The commercial paper program is supported by revolving bank credit agreements with several banks with equal maturities on December 12, 1994 and December 20, 1995. Maximum borrowing capacity under the agreements is $550. There are no borrowings currently outstanding under these agreements. There was $324.0 and $154.0 in commercial paper outstanding at December 31, 1993 and 1992, respectively. In January 1993, the Company filed with the Securities and Exchange Commission a shelf registration statement for the possible offering and sale of up to $600 aggregate principal amount of debt securities of the Company. On April 7, 1993 the Company sold $500 of public debt securities in three maturity tranches through Salomon Brothers Inc. and The First Boston Corporation. The notes and debentures were issued pursuant to the shelf registration of debt securities and are rated Baa1 by Moody's Investors Service and BBB+ by Standard & Poor's Corporation. The three tranches include $100 of 5.875% notes due 1998, priced at par; $200 of 6.75% notes due 2003, priced at 99.625% to yield 6.80%; and $200 of 8% debentures due 2023, priced at 99.625% to yield 8.03%. Net proceeds from the issues were used to repay the bank facility which financed the acquisition of CONSTAR International in October 1992. The Company has $100 remaining on the shelf registration. The Company has, when considered appropriate, hedged its currency exposures on its foreign denominated debt through various agreements with lending institutions. The Company also utilizes a corporate "netting" system which enables resources and liabilities to be pooled and then netted, thereby mitigating the exposure. During 1993, the Company acquired businesses for approximately $222, following acquisitions in 1992 and 1991 of $539 and $235, respectively. The details of such acquisitions are discussed in Note C to the Crown Cork & Seal Company, Inc. Consolidated Financial Statements. The Company has established reserves to restructure acquired companies. At December 31, 1993 and 1992, these reserves totaled $105.2 and $94.9, respectively, and have been allocated to the purchase price of acquired companies. These reserves relate primarily with the costs associated with Company plans to combine acquired company operations with existing operations such as, severance costs, plant consolidations and lease terminations. The Company estimates that 1994 cash expenditures related to its restructuring efforts will approximate $54.3 and cash expenditures for the three years ended December 31, 1996, will approximate $90. Cash expenditures for restructuring efforts were $81, $30 and $18 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company's ratio of total debt (net of cash and cash equivalents) to total capitalization was 50.1%, 52.1% and 40.5% at December 31, 1993, 1992 and 1991, respectively. Total capitalization is defined by the Company as total debt, minority interests and shareholders' equity. The increase in the Company's total debt in recent years is due to businesses acquired since December 29, 1989. As of December 31, 1993, $101.9 of long-term debt matures within one year. During the year the Company repaid $100 private placement debt which carried an interest rate of 9.17%. Additionally, the Company's Canadian subsidiary repaid CDN $100 private placement debt, partially with funds received from a property settlement and the balance with a capital increase from the parent Company. Management believes that, in addition to current financial resources (cash and cash equivalents and the Company's commercial paper program), adequate capital resources are available to satisfy the Company's investment programs. Such sources of capital would include, but not be limited to, bank borrowings. Management believes that the Company's cash flow is sufficient to maintain its current operations. CAPITAL EXPENDITURES Capital expenditures in 1993 amounted to $271.3 as compared with $150.6 in 1992. During the past five years capital expenditures totaled $730.7. Expenditures in the North American Division totaled $93 with major spending for beverage end conversion in Dayton, Ohio, a new technical center and aerosol plant in Alsip, Illinois and 2-piece food cans in Owatonna, Minnesota. Additional projects to convert beverage can and end lines in other plants to a smaller diameter began in 1993. Investments of $83 were made in the International Division. The Company constructed new plants and installed both beverage can and plastic cap production lines in Dubai, United Arab Emirates and Argentina. The Company is currently constructing a beverage can plant in Shanghai, China. Additionally, the Company constructed a new aerosol plant near Amsterdam, The Netherlands to service a major customer's centralized European filling plant. Expansion of existing plastic cap production in Italy and Germany, as well as the installation of single-serve PET equipment in Portugal have diversified the International Division from primarily metal packaging to include plastic products. With the acquisition of CONSTAR in October 1992, the Company made a commitment to service global customers with plastic containers. The Company continued this commitment with spending of $94 in 1993 within the Plastics Division. Major spending included capacity expansion of existing products and installation of several single-serve PET lines in the United States. New single-serve PET preform and bottle lines were also installed in CONSTAR's subsidiaries in England, Holland and Hungary. The Company expects its capital expenditures in 1994 to approximate $400. The Company plans to continue capital expenditure programs designed to take advantage of technological developments which enhance productivity and contain cost as well as those that provide growth opportunities. Capital expenditures, exclusive of potential acquisitions, during the five year period 1994 through 1998 are expected to approximate $1,500. Cash flow from operating activities will provide the principal support for Crown Cork & Seal Company, Inc. these expenditures; however, depending upon the Company's evaluation of growth opportunities and other existing market conditions, external financing may be required from time to time. ENVIRONMENTAL MATTERS The Company has adopted a Corporate Environmental Protection Policy. The implementation of this Policy is a primary management objective and the responsibility of each employee of the Company. The Company is committed to the protection of human health and the environment, and is operating within the increasingly complex laws and regulations of federal, state, and local environmental agencies or is taking action aimed at assuring compliance with such laws and regulations. Environmental considerations are among the criteria by which the Company evaluates projects, products, processes and purchases and, accordingly, does not expect compliance with these laws and regulations to have a material effect on the Company's competitive position, financial condition, results of operations or capital expenditures. The Company is dedicated to a long-term environmental protection program and has initiated and implemented many pollution prevention programs with the emphasis on source reduction. The Company continues to reduce the amount of metals and plastics used in the manufacture of steel, aluminum and plastic containers through a "lightweighting" program. The Company not only recycles nearly 100 percent of scrap aluminum, steel, plastic and copper used in the manufacturing process, but through its Nationwide Recyclers subsidiary is directly involved in post-consumer aluminum and steel can recycling. Nationwide Recyclers, in 1994, will also be directly involved in post-consumer plastics recycling. Additionally, the Company has already exceeded the Environmental Protection Agency's (EPA) 1995 goals for its 33/50 program which calls for companies, voluntarily, to reduce toxic air emissions by 33% by the end of 1992 and by 50% by the end of 1995, compared to the base year of 1988. The Company, at the end of 1993, had achieved a more than 64% reduction in the releases of such emissions for all U.S. facilities. The cost to accomplish this reduction did not materially affect operating results. Many of the Company's programs for pollution prevention lower operating costs and improve operating efficiencies. The Company has been identified by the EPA as a potentially responsible party (along with others, in most cases) at a number of sites. Estimated remedial expenses for active projects are recognized in accordance with generally accepted accounting principles governing probability and the ability to reasonably estimate future costs. Actual expenditures for remediation were $2.2 during 1993 and $1.7 in 1992. The Company's balance sheet reflects a net accrual for future expenditures to remediate known sites of $11.3 at December 31, 1993 and 1992, respectively. Gross remediation liabilities were estimated at $30.7 and $33.3 at December 31, 1993 and 1992, respectively. Indemnification received from the sellers of acquired companies and the Company's insurance carriers was estimated at $19.4 and $22.0 at December 31, 1993 and 1992, respectively. Environmental exposures are difficult to assess for numerous reasons, including the identification of new sites, advances in technology, changes in environmental laws and regulations and their application, the scarcity of reliable data pertaining to identified sites, the difficulty in assessing the involvement of the financial capability of other potentially responsible parties and the time periods (sometimes lengthy) over which site remediation occurs. It is possible that some of these matters (the outcome of which are subject to various uncertainties) may be decided unfavorably against the Company. It is, however, the opinion of Company management after consulting with counsel, that any unfavorable decision will not have a material adverse effect on the Company's financial position. COMMON STOCK AND OTHER SHAREHOLDERS' EQUITY Shareholders' equity was $1,251.8 at December 31, 1993, as compared with $1,143.6 at December 31, 1992. The increase in 1993 equity represents the retention of $99.1 of earnings in the business (net of $81.8 of accounting changes as more fully described in Note B to the Consolidated Financial Statements), the issuance of 3,631,624 common shares for the acquisition of Van Dorn Company and the issuance of 1,415,711 common shares for various stock purchase and savings plans offset by the effect of 2,580,982 common shares repurchased, $46.3 minimum pension liability adjustment as more fully described in Note Crown Cork & Seal Company, Inc. N to the Consolidated Financial Statements and equity adjustments for currency translation in non-U.S. subsidiaries of $29.3. The book value of each share of common stock at December 31, 1993, was $14.09, as compared to $13.24 at December 31, 1992. In 1993, the return on average shareholders' equity before cumulative effect of accounting changes was 14.6% as compared with 13.9% in 1992. The Company purchased 2,536,330 shares of its common stock from CCL Industries Inc. ("CCL") on January 7, 1993 for approximately $84.8. The Company and CCL had agreed to the share repurchase in August of 1992 at a then agreed purchase price of $33.00 per share, plus an adjustment computed at a rate of 3.5% per annum. The January 7, 1993 settlement was funded by cash flow from operations, borrowings and cash received from CCL of approximately $21. The cash received from CCL related to the settlement of guarantees made by CCL to the Company regarding the value of certain properties in connection with the Company's 1989 acquisition of Continental Can Canada Inc. The Company issued to CCL a total of 7,608,993 shares in the 1989 acquisition of Continental Can Canada Inc. The purchase of common stock from CCL was made pursuant to the Company's right of first refusal to purchase common stock offered for sale by CCL. After giving effect to the repurchase transaction, CCL held 2,536,331 shares or approximately 2.9% of the Company's shares then outstanding following the January 7, 1993 settlement date. In August 1992, the Company repurchased 1,500,000 shares from the Connelly Foundation for approximately $50.1 or approximately $33.38 per share. The purchase of shares from the Connelly Foundation was funded by cash flow from operations of $25 and an interest bearing note, at 3.5%, of approximately $25.1. The Company settled the note in December 1992 with cash flow from operations. At December 31, 1993, the Connelly Foundation held 8,554,700 shares of the Company's common stock which represented approximately 10% of the 88,814,533 shares then outstanding. The Board of Directors has approved resolutions authorizing the Company to repurchase shares of its common stock to meet the requirements for the Company's various stock purchase and savings plans. The Company acquired 2,580,982, 1,747,774, and 2,735,898 shares of common stock in 1993, 1992, and 1991 for $86.5, $61.4, and $69.1, respectively. These purchases included the purchases of stock held by the Connelly Foundation in 1992 and by CCL in 1993 and 1991. The Company has traditionally not paid dividends and does not anticipate paying dividends in the foreseeable future. At December 31, 1993 common shareholders of record numbered 6,168 compared with 4,193 at the end of 1992. INFLATION General inflation has not had a significant impact on the Company over the past three years due to strong cash flow from operations. The Company continues to maximize cash flow through programs designed for cost containment, productivity improvements and capital spending. Management does not expect inflation to have a significant impact on the results of operations or financial condition in the foreseeable future. Crown Cork & Seal Company, Inc. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Report of Independent Accountants 18 Consolidated Statements of Income 19 Consolidated Balance Sheets 20 Consolidated Statements of Cash Flows 21 Consolidated Statements of Shareholders' Equity 22 Notes to Consolidated Financial Statements 23 Financial Statement Schedules Schedule V - Property, Plant and Equipment 40 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 41 Schedule VIII - Valuation and Qualifying Accounts 42 Schedule X - Supplementary Income Statement Information 44 Crown Cork & Seal Company, Inc. Report of Independent Accountants To the Shareholders and Board of Directors of Crown Cork & Seal Company, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Crown Cork & Seal Company, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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 our audits provide a reasonable basis for the opinion expressed above. As discussed in Note B, the Company changed its methods of accounting for income taxes, postretirement benefits and postemployment benefits in 1993. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 March 14, 1994 Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF INCOME (in millions, except per share amounts) The accompanying notes are an integral part of these financial statements. Earnings per average common share for 1991 has been restated to reflect the 3 for 1 common stock split to shareholders of record as of May 12, 1992. Crown Cork & Seal Company, Inc. CONSOLIDATED BALANCE SHEETS (in millions, except share data) The accompanying notes are an integral part of these financial statements. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) The accompanying notes are an integral part of these financial statements. Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in millions, except share data) The accompanying notes are an integral part of these financial statements. Share data for prior years has not been restated for the 3 for 1 common stock split declared in 1992. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in millions, except per share, employee, shareholder and statistical data) (share data for years prior to 1992 have been restated for the 3 for 1 common stock split declared in 1992) A. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Crown Cork & Seal Company, Inc. and its wholly-owned and majority-owned subsidiary companies. All significant intercompany accounts and transactions are eliminated in consolidation. Investments in joint ventures and other companies in which Crown does not have control, but has the ability to exercise significant influence over operating and financial policies (generally greater than 20% ownership) are accounted for by the equity method. Other investments are carried at cost. Foreign Currency Translation For non-U.S. subsidiaries which operate in a local currency environment, assets and liabilities are translated into U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates prevailing during the year. Translation adjustments for these subsidiaries are accumulated in a separate component of Shareholders' Equity. For non-U.S. subsidiaries which operate in U.S. dollars (functional currency) or whose economic environment is highly-inflationary, local currency inventories and plant and other property are translated into U.S. dollars at approximate rates prevailing when acquired; all other assets and liabilities are translated at year-end exchange rates. Inventories charged to cost of sales and depreciation are remeasured at historical rates; all other income and expense items are translated at average exchange rates prevailing during the year. Gains and losses which result from remeasurement are included in earnings. Cash and Cash Equivalents Cash equivalents represent investments with maturities of three months or less from the time of purchase, and are carried at cost which approximates fair value because of the short maturity of those instruments. Inventory Valuation Inventories are carried at the lower of cost or market, with cost for all domestic metal and plastic container, crown and closure inventories determined under the last-in, first-out (LIFO) method. Machinery Division and non-U.S. inventories are principally determined under the average cost method. Goodwill Goodwill, representing the excess of the cost over the net tangible and identifiable intangible assets of acquired businesses, is stated on the basis of cost and is amortized, principally on a straight-line basis, over the estimated future periods to be benefitted (primarily 40 years). Accumulated amortization amounted to $62.7 and $35.1 at December 31, 1993 and 1992, respectively. Property, Plant and Equipment Property, plant and equipment (PP&E) is carried at cost and includes expenditures for new facilities and those costs which substantially increase the useful lives of existing PP&E. Maintenance, repairs and minor renewals are expensed as incurred. When properties are retired or otherwise disposed, the related costs and accumulated depreciation are eliminated from the respective accounts and profit or loss on disposition is reflected in income. Costs assigned to PP&E of acquired businesses are based on estimated fair value at the date of acquisition. Depreciation and amortization are provided on a straight-line basis for financial reporting and an accelerated basis for tax purposes. The useful lives range between 40 years for buildings and 5 years for vehicles. Crown Cork & Seal Company, Inc. Off-Balance Sheet Risk and Financial Instruments The Company enters into forward exchange contracts, primarily in European currencies, to hedge certain foreign currency transactions for periods consistent with the terms of the underlying transactions. At December 31, 1993, the Company had contracts to purchase approximately $37 and to sell approximately $23 in foreign currency. Based on year-end exchange rates and the maturity dates of the various contracts, the estimated aggregate contract value approximates the fair value of these items at December 31, 1993. Treasury Stock Treasury stock is reported at par value and constructively retired. The excess of fair value over par value is first charged to paid-in capital, if any, and then to retained earnings. Research and Development Research, development and engineering expenditures which amounted to $23.3, $16.7 and $16.1 in 1993, 1992 and 1991, respectively, are expensed as incurred. Earnings Per Share Earnings per share amounts are computed based on the weighted average number of shares actually outstanding during the period plus the shares that would be outstanding assuming the exercise of dilutive stock options, which are considered to be common stock equivalents. The number of equivalent shares that would be issued from the exercise of stock options is computed using the treasury stock method. Reclassifications Certain reclassifications of prior years' data have been made to improve comparability. B. Accounting Changes Effective January 1, 1993, the Company adopted, as required, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes." In the fourth quarter of 1993, effective January 1, 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The incremental after-tax effect of these accounting changes was a non-cash charge to 1993 earnings of $2.5 or $.03 per share. SFAS No. 106 requires employers to recognize the costs and obligations for postretirement benefits other than pensions over the employees' service lives. Previously, such costs were generally recognized as an expense when paid. The cumulative effect of implementing SFAS No. 106 as of January 1, 1993 resulted in a non-cash after-tax charge to net income of $89.2 or $1.03 per share. SFAS No. 109 establishes new accounting and reporting standards for income taxes and requires adopting the liability method, which replaces the deferred method required by Accounting Principles Board Opinion (APB) No. 11. The cumulative effect of implementing SFAS No. 109 as of January 1, 1993 resulted in a non-cash increase to net income of $23.5 or $.27 per share. SFAS No. 112 requires employers to accrue the costs and obligations of postemployment benefits (severance, disability, and related life insurance and health care benefits) to be paid to inactive or former employees. Prior to adoption, the Company had recognized expense for the cost of these benefits either on an accrual or on an "as paid" basis, depending on the plan. The cumulative effect of implementing SFAS No. 112 resulted in a non-cash after-tax charge to net income of $16.1 or $.18 per share as of January 1, 1993. Crown Cork & Seal Company, Inc. C. Acquisitions On April 16, 1993, the Company's acquisition of the Van Dorn Company was completed through the issuance of 3,631,624 shares of the Company's common stock valued at approximately $140, and the payment in cash of approximately $37. The cash portion was financed through cash from operations. Van Dorn's Plastic Machinery Division was then sold on April 20, 1993 for approximately $81 in cash to an affiliate of Mannesmann Demag, AG. During 1993, the Company through its affiliate, CONSTAR International, also acquired, in separate transactions, Wellman, Inc.'s 50% interest in Wellstar Acquisition, B.V., for consideration of approximately $33 in cash, and the minority interest in Wellstar Acquisition's affiliate, Wellstar Holding, B.V. The Company now owns 100% of Wellstar Holding. During 1992, the Company acquired the outstanding stock of Constar International, Inc. (CONSTAR) for approximately $519 in cash, which was financed through bank borrowings. Additionally, during 1992, the Company acquired in separate transactions with an aggregate cost of approximately $20, the stock of a tooling and machine overhaul company in Wisconsin, the assets of a coil coating facility in Ohio and the assets of a crown manufacturer in Texas. The cost of these acquisitions was financed through cash from operations. In 1991, the Company acquired all of the outstanding stock of Continental Can International Corporation, Inc. (Continental International) from Continental Can Europe, Inc. for $125 in cash of which $94 was financed through bank borrowings. Included in this acquisition were a wholly-owned subsidiary in Mexico, a majority-owned subsidiary in Hong Kong and minority interests in joint ventures in the Middle East, Asia and South America. During 1991, the Company also acquired, in separate transactions with an aggregate cost of approximately $110, the stock of machinery operations in Florida and the Philadelphia area, the stock of a can manufacturer in Orlando, Florida, the assets of a beverage closure business in Virginia and the assets of a can manufacturer in Canada. The cost of these acquisitions was funded through the issuance of 469,800 shares of the Company's common stock valued at approximately $13 and cash of approximately $97. The cash portion was financed through bank borrowings of approximately $85 and cash from operations of approximately $12. For financial reporting purposes, all of the acquisitions above were treated as purchases. An excess purchase price of approximately $632 has been determined, based upon the fair values of assets acquired and liabilities assumed in connection with the above acquisitions. A final allocation of the purchase price for 1993 acquisitions will be determined during 1994 when appraisals and other studies, particularly relating to restructuring costs, are completed. The operating results of each acquisition are included in consolidated net income from the date of acquisition. The following represents the unaudited pro forma results of operations as if the above noted business combinations had occurred at the beginning of the respective year in which the companies were acquired as well as at the beginning of the immediately preceding year: The pro forma operating results include each company's results of operations for the indicated years with increased depreciation and amortization on property, plant and equipment along with other relevant adjustments to reflect fair market value. Interest expense on the acquisition borrowings has also been included. Crown Cork & Seal Company, Inc. The pro forma information given above does not purport to be indicative of the results that actually would have been obtained if the operations were combined during the periods presented, and is not intended to be a projection of future results or trends. D. Receivables E. Inventories Approximately 57% and 53% of worldwide inventories at December 31, 1993 and 1992, respectively, were stated on the last-in, first-out (LIFO) method of inventory valuation. Had average cost (which approximates replacement cost) been applied to such inventories at December 31, 1993 and 1992, total inventories would have been $26.8 and $37.6 higher, respectively. F. Investments In January 1993, the Company sold 30% of its joint venture interest located in Saudi Arabia. During 1993, Constar International, a wholly-owned subsidiary, invested $9.9 in new joint ventures, primarily in Mexico and Turkey. In October 1992, the Company acquired all the outstanding stock of Constar International. With this acquisition the Company acquired a direct voting interest in Wellstar Acquisition, B.V. (Wellstar), a Dutch joint venture. During 1993, the Company acquired the remaining interest in Wellstar and has consolidated its results since acquiring a majority interest. Crown Cork & Seal Company, Inc. During 1992, the Company determined that it had operational and financial control over its joint venture investment located in China. Accordingly, the Company has consolidated the financial results of this joint venture in 1992. The effect on the Company's financial position is not significant. There was no effect on consolidated 1992 net income and prior periods have not been restated for this change in reporting entity. G. Property, Plant and Equipment H. Consolidated Non-U.S. Subsidiaries The condensed financial statements of the majority-owned non-U.S. subsidiaries are as follows: Net income from consolidated non-U.S. subsidiaries in 1992 reflects the Company's continuing efforts to restructure its businesses in Europe and Canada. Foreign exchange losses emanate primarily from the Company's holdings in Latin America. In 1991, the functional currency for the Company's affiliates in Mexico was changed to the local currency in accordance with the provisions of SFAS No. 52. On May 16, 1991, the Company acquired all the outstanding stock of Continental Can International Corporation. With this acquisition, the Company acquired a wholly-owned subsidiary in Mexico and a majority-owned affiliate in Hong Kong. The results of operations from the date of acquisition and the financial position are consolidated herein. Crown Cork & Seal Company, Inc. Combined net assets of non-U.S. subsidiaries reflected in the Consolidated Balance Sheets are: I. Short-Term Debt Domestic and Canadian operations' working capital requirements are funded on a short-term basis through the issuance of commercial paper. Short-term funds for certain international operations are obtained through bank overdrafts and short-term notes payable. The weighted average interest rates for the years ending December 31, 1993, 1992 and 1991 were determined using the average rate for each month. The Company has additional unused lines of credit amounting to $550 available under formal borrowing arrangements with various banks. Crown Cork & Seal Company, Inc. J. Accounts Payable and Accrued Liabilities Cash payments for interest were $82.2 in 1993, $78.4 in 1992 and $87.3 in 1991. K. Other Non-Current Liabilities Recognition of tax benefits associated with postretirement benefits resulted in a decrease of $190.4 in the deferred tax liability. Crown Cork & Seal Company, Inc. L. Long-Term Debt The aggregate maturities on all long-term debt are $101.9, $150.1, $128.5, $67.1 and $117.1 for each of the years ending December 31,1994 through 1998, respectively. Crown Cork & Seal Company, Inc. Proceeds from the shelf registration filed in January 1993 were used to repay the $525 term loan. The Company has $100 remaining on the shelf registration. The carrying value of total debt as of December 31, 1993 and 1992 does not differ materially from its estimated market value. M. Stock Options All amounts below have been adjusted to reflect the 3 for 1 stock split to shareholders of record as of May 12, 1992. In accordance with the Incentive Stock Option Plan adopted in December 1983, options to purchase 7,200,000 Common Shares have been granted to officers and key employees. Options were granted at market value on the date of grant and are exercisable beginning one year from date of grant and terminate up to ten years from date of grant. In accordance with the non-qualified Stock Option Plan for senior executives, adopted in July 1984, options to purchase 1,980,000 Common Shares have been granted. Options were granted at market value on the date of grant and are exercisable beginning two years from date of grant and terminate five years from date of grant. In accordance with the 1990 Stock-Based Incentive Compensation Plan adopted in December 1990, options to purchase 6,000,000 common shares can be granted to officers and key employees. Options were granted at market value on the date of grant and are exercisable beginning one to two years from date of grant and terminate up to ten years from date of grant. On April 25, 1991, the shareholders Crown Cork & Seal Company, Inc. approved the proposal to amend the 1990 Stock-Based Incentive Compensation Plan to increase the number of shares available for awards by 1,500,000 to an aggregate of 6,000,000 shares. N. Pensions and Other Retirement Benefits Pensions The Company sponsors various pension plans, covering substantially all U.S., Canadian and some non-U.S. and non-Canadian employees and participates in certain multi-employer pension plans. The company-sponsored plans are currently funded. The benefits for these plans are based primarily on years of service and the employees' remuneration near retirement. Contributions to multi-employer plans in which the Company and its non-U.S. and non-Canadian subsidiaries participate are determined in accordance with the provisions of negotiated labor contracts or applicable local regulations. Plan assets of company-sponsored plans of $1,253.4 consist principally of common stocks, including $241.3 of the Company's common stock. Pension income amounted to $18.6 (including expense of $5.7 for non-company sponsored plans) in 1993, income of $4.8 (including expense of $6.0 for non-company sponsored plans) in 1992 and expense of $14.8 (including expense of $3.8 for non-company sponsored plans) in 1991. Pension cost for non-U.S. and non-Canadian plans in 1993, 1992 and 1991 was determined under statutory accounting principles which are not considered materially different from U.S. generally accepted accounting principles. The 1993, 1992 and 1991 components of pension cost for company-sponsored plans were as follows: Crown Cork & Seal Company, Inc. The funded status of company-sponsored plans, including the assets and liabilities assumed in connection with acquisitions, at December 31, 1993 and 1992 was as follows: In addition to total pension (income) cost shown above, accrued pension cost includes $36.1 and $10.5 related to plan curtailments resulting from plant closings in 1992 and 1991, respectively, the effects of which were allocated to the purchase price of acquired companies. The Company recognized a minimum pension liability for underfunded plans. The minimum liability is equal to the excess of the accumulated benefit obligation over plan assets. A corresponding amount is recognized as either an intangible asset, to the extent of previously unrecognized prior service cost and previously unrecognized transition obligation, or a reduction of shareholders' equity. The Company had recorded additional liabilities of $84.8 and $12.2 as of December 31, 1993 and 1992, respectively. An intangible asset of $1.5 and a shareholders' equity reduction, net of income taxes, of $46.3 was recorded as of December 31, 1993. The additional liability recognized at December 31, 1992 was allocated to the purchase price of acquired companies. The weighted average actuarial assumptions for the Company's pension plans are as follows: Other Postretirement Benefit Plans The Company and certain subsidiaries sponsor unfunded plans to provide health care and life insurance benefits to pensioners and survivors. Generally, the medical plans pay a stated percentage of medical expenses reduced by deductibles and other coverages. Life insurance benefits are generally provided by Crown Cork & Seal Company, Inc. insurance contracts. The Company reserves the right, subject to existing agreements, to change, modify or discontinue the plans. Health care claims and life insurance benefits paid totaled $41.6 in 1993, $35.2 in 1992 and $25.1 in 1991. The health care accumulated postretirement benefit obligation was determined using a health care cost trend rate of 12.5% decreasing to 7% over fifteen years. The assumed long-term rate of compensation increase used for life insurance was 5%. The discount rate used was 7.1%. Changing the assumed health care cost trend rate by one percentage point in each year would change the accumulated postretirement benefit obligation by $50.0 and the postretirement net benefit cost by $4.1. Employee Savings Plan The Company, commencing in 1991, sponsors a Savings Investment Plan which covers all domestic salaried employees who are 21 years of age with one or more years of service. The Company matches with equivalent value of Company stock, up to 1.5% of a participant's compensation. The Company's 1993, 1992 and 1991 contributions were approximately $.9, $.9 and $.6, respectively. O. Income Taxes In August 1993, a new income tax law was enacted which increased the maximum corporate income tax rate from 34 percent to 35 percent. The impact on deferred tax assets and liabilities from this change was not significant. Pretax income before cumulative effect of accounting changes for the years ended December 31 was taxed under the following jurisdictions: Crown Cork & Seal Company, Inc. The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax income as a result of the following differences: The Company paid federal, state, local and foreign (net) income taxes of $11.7 for 1993, $38.7 for 1992 and $70.1 for 1991. The components of deferred tax assets and liabilities at December 31, 1993 follow: Other non-current assets includes $20.6 of deferred tax assets. Crown Cork & Seal Company, Inc. Approximately $37.2 of deferred tax assets relating to net operating losses and tax basis differences were available in various foreign tax jurisdictions at December 31, 1993, expiring in the following years: 1994 $ .1 1995 .3 1996 .2 1997 2.9 1998 4.6 1999 1.6 2000 2.2 2001 1.3 Unlimited 24.0 ----- Total 37.2 Portion applicable to minority interests (4.0) ----- Net future benefit available $ 33.2 ===== The Company believes that it is more likely than not that $3.8 of these benefits will be realized by offsetting existing taxable temporary differences that will reverse within the carryforward period. An additional $2.1 is expected to be realized by achieving future profitable operations based on actions taken by the Company. No net benefit has been recorded for the remaining items. Future recognition of these carryforwards will be made either when the benefit is realized or when it has been determined that it is more likely than not that the benefit will be realized against future earnings. No other tax operating loss or credit carryforwards exist for which the Company has recognized a net financial benefit. The cumulative amount of the Company's share of undistributed earnings of non-U.S. subsidiaries for which no deferred taxes have been provided was $401.2, $385.2 and $419.1 as of December 31, 1993, 1992 and 1991, respectively. Management has no plans to distribute such earnings in the foreseeable future. P. Minority Interests During 1993, the Company formed jointly-owned subsidiaries in China. During 1992, the Company formed jointly-owned subsidiaries in the United Arab Emirates (Dubai) and South Africa. Crown Cork & Seal Company, Inc. Q. Leases Minimum rental commitments under all noncancelable operating leases, primarily real estate, in effect at December 31,1993 are: Years ending December 31 1994 $ 21.7 1995 17.8 1996 12.7 1997 10.2 1998 9.4 Thereafter 11.7 ------ Total minimum payments 83.5 Less: Total minimum sublease rentals (6.5) ------ Net minimum rental commitments $ 77.0 Operating lease rental expense (net of sublease rental income of $1.0 in 1993, 1992 and 1991) was $21.9 in 1993, $10.2 in 1992 and $7.9 in 1991. R. Quarterly Data (unaudited) The closing price of the Company's common stock at December 31, 1993 and 1992 was $41.88 and $39.88, respectively. Crown Cork & Seal Company, Inc. Restatement of previously reported 1993 quarterly data to reflect accounting changes resulted in an increase in the net loss of $16.1 and an increase in the net loss per share of $.18 for the first quarter of 1993. The restatement does not have a material effect on net income for the second and third quarters of 1993. S. Segment Information by Industry and Geographic Area A. Industry Segment (1) Transfers between Geographic Areas are not material. (2) Within "Metal Packaging and Other" is the Company's machinery operation which along with other non-metal packaging domestic affiliates are not significant individually or in the aggregate so as to be reported as a separate segment. Crown Cork & Seal Company, Inc. (3) Operating profit for 1992 in Europe and North and Central America includes charges made during the year relating to the Company's continuing efforts to restructure its businesses in these regions. (4) The following reconciles operating profit to pre-tax income: * Includes interest income and expense along with other corporate income and expense items, such as exchange gains and losses and goodwill amortization. (5) The following reconciles identifiable assets to total assets: * Included in identifiable assets for 1993 is: (a) "United States," $96, relating to the acquisition of the Van Dorn Company. (b) "Europe," $42, relating to the acquisition of the remaining interest in CONSTAR International's affiliate, Wellstar Acquisition, B.V. and its affiliate Wellstar Holdings, B.V. Included in identifiable assets for 1992 is $525, relating to the acquisition of Constar International. * Included in identifiable assets for 1991 is: (a) "United States," $150.1, relating to the acquisition of Continental Can International Corporation and other domestic companies as outlined in Note C to the financial statements. (b) "North America," $61.4, relating to the acquisition of Continental Can International's affiliate in Mexico. (c) "Other Non-U.S.," $40.1, relating to the acquisition of Continental Can International's affiliate in Hong Kong. (6) For the year ended December 31, 1993 and prior to 1992, no one customer accounted for more than 10% of the Company's net sales. For 1992, one customer accounted for approximately 10.6% of the Company's net sales. Included in "Other Non-U.S." are affiliates in South America, Africa, Asia and the Middle East. Figures for the United States are not comparable due to the late 1992 acquisition of Constar International and the April 1993 acquisition of the Van Dorn Company. Figures for Europe are not comparable due to the 1993 acquisitions of Wellman's interest in Wellstar Acquisition, B.V. and the minority interest in Wellstar Acquisition's affiliate, Wellstar Holding, B.V. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (in millions) For the Year Ended December 31, 1993 (in millions) For the Year Ended December 31, 1992 (in millions) For the Year Ended December 31, 1991 Note: The lives assigned to plant and equipment for depreciation purposes are: Buildings and Facilities 12 to 40 years Machinery and Equipment 5 to 14 years Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VI - ACCUMULATED DEPRECIATION OF PLANT AND EQUIPMENT (in millions) For the Year Ended December 31, 1993 (in millions) For the Year Ended December 31, 1992 (in millions) For the Year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES 1 OF 2 (In millions) For the year Ended December 31, 1993 (In millions) For the year Ended December 31, 1992 (In millions) For the year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES 2 OF 2 (In millions) For the year Ended December 31, 1993 (In millions) For the year Ended December 31, 1992 (In millions) For the year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In millions) For the year ended December 31, 1993 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $170.6 Depreciation of plant and equipment $161.3 Taxes, other than income (excluding payroll taxes) $ 54.7 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $151.9 Depreciation of plant and equipment $124.8 Taxes, other than income (excluding payroll taxes) $ 39.2 * (In millions) For the year ended December 31, 1991 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $154.9 Depreciation of plant and equipment $117.8 Taxes, other than income (excluding payroll taxes) $ 33.7 * * Amounts have been restated to exclude payroll taxes so as to be consistent with the requirements of Item 601 Under Regulation S-K. Crown Cork & Seal Company, Inc. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by this Item, Directors and Executive Officers of the Registrant (except for the information regarding executive officers called for by Item 401 of Regulation S-K which is included in Part I, Item 4a of this Report on page 8 under the heading "Executive Officers of the Registrant") is set forth on pages 3, 4 and 5 of the Company's 1994 definitive Proxy Statement in the section entitled "Election of Directors" and on page 13 in the section entitled "Section 16 Requirements" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth on pages 6 through 12 of the Company's 1994 definitive Proxy Statement in the section entitled "Executive Compensation" is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is set forth on pages 2 through 5 of the Company's 1994 definitive Proxy Statement in the sections entitled "Proxy Statement Meeting, April 28, 1994" and "Election of Directors" and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is set forth on pages 3, 4 and 5 of the Company's 1994 definitive Proxy Statement in the section entitled "Election of Directors" and is incorporated herein by reference Crown Cork & Seal Company, Inc. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a) The following documents are filed as part of this report: (1) All Financial Statements: Crown Cork & Seal Company, Inc. and Subsidiaries (see Part II pages 19 through 39 of this Report). (2) Financial Statement Schedules: Schedule Number V. - Property, Plant and Equipment (see page 40 of this Report). VI.- Accumulated Depreciation and Amortization of Property, Plant and Equipment (see page 41 of this Report). VIII.- Valuation and Qualifying Accounts and Reserves (see pages 42 and 43 of this Report). IX.- Short-term Borrowings (see page 28 of this Report). X. - Supplementary Income Statement Information (see page 44 of this Report). All other schedules have been omitted because they are not applicable or the required information is included in Financial Statements or Notes thereto. (3) Exhibits 3.1 Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on March 9, 1993 (Registration No. 33-59286)). 3.2 By-laws of the Registrant (incorporated by reference to Exhibit 3(b) of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-2227)). 4.1 Form of the Company's 5-7/8% Note Due 1998 (incorporated by reference to Exhibit 22 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.2 Form of the Company's 6-3/4% Note Due 2003 (incorporated by reference to Exhibit 23 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.3 Form of the Company's 8% Debenture Due 2023 (incorporated by reference to Exhibit 24 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.4 Officers' Certificate of the Company (incorporated by reference to Exhibit 4.3 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (File No. 1-2227)). 4.5 Indenture dated as of April 1, 1993 between the Company and Chemical Bank, as Trustee (incorporated by reference to Exhibit 26 of the Registrant's Current Report on Form 8-K dated April 12, 1993 (File No 1-2227)). Crown Cork & Seal Company, Inc. 4.6 Terms Agreement dated March 31, 1993 (incorporated by reference to Exhibit 27 of the Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). Other long-term agreements of the Registrant are not filed pursuant to Item 601(b)(4)(iii)(A) of regulation S-K, and the Registrant agrees to furnish copies of such agreements to the Securities and Exchange Commission upon its request. 10.1 Crown Cork & Seal Company, Inc. Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (No. 1-2227)). 10.2 1990 Stock-Based Incentive Compensation Plan (incorporated by reference to Exhibit 10.2 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-2227)). 10.3 Crown Cork & Seal Company, Inc. Restricted Stock Plan for Non- Employee Directors. (incorporated by the reference to Exhibit 10.3 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-2227)). 10.4 Crown Cork & Seal Company, Inc. 1984 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 28 of Registrant's Registration Statement on Form S-8 (No. 33-06261)). 10.5 Crown Cork & Seal Company, Inc. Retirement Thrift Plan (incorporated by reference to Exhibit 4.3 of the Registrant's Registration Statement on Form S-8 (No. 33-50369)). 10.6 Crown Cork & Seal Company, Inc. Stock Purchase Plan (incorporated by reference to Exhibit 4.3 of the Registrant's Registration Statement on Form S-8, filed March 16, 1994 (No. 33-52699)). Exhibits 10.1 through 10.6, inclusive, are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of this Report. 21. Subsidiaries of Registrant. 23. Consent of Independent Accountants. b) Reports on Form 8-K There were no reports on Form 8-K by the Registrant during the fourth quarter of calendar year 1993. Crown Cork & Seal Company, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 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. Crown Cork & Seal Company, Inc. ------------------------------- Registrant Date March 30, 1994 By: /s/ Timothy J. Donahue ---------------------------- Timothy J. Donahue Financial Controller 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:	12,904	83,935
85961_1993.txt	85961_1993	1993	85961	ITEM 1. BUSINESS General Ryder System, Inc. ("the Company") was incorporated in Florida in 1955. Through its subsidiaries, the Company engages primarily in the following businesses: 1) full service leasing and short-term rental of trucks, tractors and trailers; 2) dedicated logistics services; 3) public transit management and student transportation; and 4) transportation by truck of automobiles and light trucks. On December 7, 1993, the Company spun off its Aviall, Inc. aviation services subsidiary to the Company's shareholders. After the Aviall, Inc. spin-off, the Company's main operating segments are Vehicle Leasing & Services and Automotive Carriers. General Motors Corporation ("GM") is the largest single customer of the Company, accounting for approximately 11%, 12%, and 13% of consolidated revenue of the Company in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company and its subsidiaries had a fleet of 168,278 vehicles and 37,949 employees.(1) Segment Information Financial information about industry segments is incorporated by reference from the table "Selected Financial and Operational Data" on page 29, and "Notes to Consolidated Financial Statements - Segment Information" on page 42, of the Ryder System, Inc. 1993 Annual Report to Shareholders. Vehicle Leasing & Services The Vehicle Leasing & Services Division, comprising Ryder Truck Rental, Inc. ("RTR"), Ryder Dedicated Logistics, Inc., and various other companies, engages in a variety of highway transportation services including full service truck leasing, dedicated logistics services, commercial and consumer truck rental, truck maintenance, student transportation and public transit management, operations and maintenance. As of December 31, 1993, the Vehicle Leasing & Services Division had 158,374 vehicles and 32,257 employees, excluding reimbursed public transit and leased personnel. Full service truck leasing was provided to 11,180 customers (ranging from small companies to large national enterprises), with a fleet of 78,544 vehicles (including 7,592 vehicles leased to affiliates), through 914 locations in 48 states and 8 Canadian provinces. Under full service leases, RTR (as Ryder Commercial Leasing & Services) provides customers with the vehicles, maintenance, supplies and equipment necessary for operation, while the customers furnish drivers and dispatch and exercise control over the vehicles. A fleet of 67,016 vehicles, ranging from heavy-duty tractors and trailers to light trucks, is available for short-term rental from over 4,650 Division locations and independent dealers in 48 states and Canada. Short-term truck rental, which tends to be seasonal, is used by commercial customers to supplement their fleets during peak business seasons. Additionally, RTR (as Ryder Consumer Truck Rental) serves the short-term consumer truck rental market, which also tends to be seasonal and is principally used by consumers for moving household goods. At December 31, 1993, RTR was servicing 27,067 vehicles (including 7,611 vehicles of affiliates) under Ryder Programmed Maintenance, which provides essentially the same maintenance services for customer-owned vehicles as are provided through full service truck leasing. ________________________ (1) In addition, certain subsidiaries of the Company manage the operating personnel of local transit authorities. In such situations, the entire cost of compensation and benefits for such personnel is passed through to the transit authority, which reimburses the Company's subsidiaries. Additionally, certain subsidiaries of the Company obtain drivers under driver leasing agreements for some of their operations. Through Ryder Dedicated Logistics ("RDL"), the Division offers customer-tailored industrial and consumer product distribution and logistics services from 440 locations in the U.S. and Canada. Services include varying combinations of logistics system design, provision of vehicles and equipment, maintenance, provision of drivers, warehouse management, transportation management and information systems support. Logistics systems range from metropolitan shuttles to interstate long-haul operations, and from just-in-time assembly plant service to factory-to-warehouse-to-retail facility service. These services are employed in the automotive industry (RDL specializes in inbound and aftermarket parts delivery for customers such as GM (including Saturn), Chrysler Corporation ("Chrysler"), Toyota Motor Manufacturing USA Inc. ("Toyota"), Ford Motor Company and auto parts retailers), and in the paper and paper packaging, chemical, electronic and office equipment, news, food and beverage, housing, general retail and other industries. The Division has historically disposed of its used and surplus revenue earning equipment at prices in excess of book value. The Division reported gains on the sale of revenue earning equipment (reported as reductions in depreciation expense) of approximately 16%, 12% and 5% of the Division's earnings before interest and taxes in 1993, 1992 and 1991, respectively. The extent to which the Division may consistently continue to realize gains on disposal of its revenue earning equipment is dependent upon various factors including the general state of the used vehicle market, the condition and utilization of the Division's fleet and depreciation policies with respect to its vehicles. During 1993, the Division continued to expand its presence in the public transportation management, operations and maintenance and student transportation markets through internal growth. The Division now manages or operates 88 public transit systems with 4,860 vehicles in 28 states, operates 7,140 school buses in 19 states, maintains about 16,000 public transit or fleet vehicles in 15 states and provides public transportation management consulting services. International In the first quarter of 1993 the Company established an International Division to develop and implement a strategy for growth in international markets of the Company's highway transportation services business and to manage operations of the Company's highway transportation services outside the United States and Canada. The Company's previously existing lease, rental, maintenance and logistics operations in the United Kingdom and Germany have become a part of the new International Division. As of December 31, 1993, the International Division had 6,997 vehicles, 1,697 employees, and provided service through 65 locations in the United Kingdom, Germany and Poland. (For financial reporting purposes, the International Division's results are included with those of the Vehicle Leasing & Services Division). Automotive Carriers The Company's Automotive Carrier Division transports new automobiles and trucks to dealers and to and from distribution points throughout the United States and several Canadian provinces for GM, Chrysler, Toyota, Honda and most other automobile and light truck manufacturers. GM remains the Division's largest customer, accounting for 54%, 57% and 63% of the Division's revenue in 1993, 1992 and 1991, respectively. The GM carriage contracts are typically subject to cancellation upon 30 days' notice by either party. The business is primarily dependent on the level of North American production, importation and sales by GM and various other manufacturers. Consequently, the business is adversely affected by any significant reductions in or prolonged curtailments of production by customers because of market conditions, strikes or otherwise. As of December 31, 1993, the Automotive Carrier Division had 4,636 auto transport vehicles, 5,294 employees (exclusive of leased drivers), and provided service through 89 locations in 37 states and 2 Canadian provinces. Most of the Division's employees are covered by an industry-wide collective bargaining agreement, the term of which ends in May 1995. Competition The Vehicle Leasing & Services Division's customers may finance lease or purchase their own vehicles and provide maintenance services for themselves substantially similar to those offered by the Division, or purchase such services from others, or obtain transportation services from other common or contract carriers. The Division also competes with other companies conducting nationwide truck leasing, rental or bus operations, a large number of regional truck leasing companies with multiple branches, many smaller companies operating primarily on a local basis but frequently with nationwide service and maintenance capabilities due to participation in cooperative programs and membership in various associations, and both local and nationwide common and contract carriers. Competition in the truck leasing business is based on a number of factors which include price, equipment, maintenance and geographical coverage. The Division also competes, to an extent, with a number of trailer and vehicle manufacturers who have entered the field of trailer and vehicle leasing, extended warranty maintenance, rental and other forms of transportation services. The carriage and dedicated logistics operations of the Vehicle Leasing & Services Division and the Automotive Carrier Division are subject to potential competition in most of the regions they serve from railroads and motor carriers providing similar services, and from customers insofar as they may own or lease equipment and provide the services for themselves. A growing number of U.S. school districts now have the option of contracting with private operators for student transportation services. In areas where private contractors are utilized, the market is fragmented and competitive. Even where private operators are being utilized, school districts still may have the option of performing student transportation services themselves. Public transit agencies generally have the option of contracting with private operators for public transportation services or providing such services themselves. The market for most types of public transportation services is fragmented and competitive. In the United Kingdom, both truck leasing and dedicated logistics are well developed and competitive markets, similar to those in the U.S. and Canada. Value-added differentiation of the Company's service offerings continues to be the Company's strategy in those markets. With the recent developments in Mexico relating to the passage of the North American Free Trade Agreement, Germany's continued integration into the European Community and Poland's transformation to a market economy, the Company's ability to provide services in these new markets is only now emerging. It is anticipated, however, that competition with the Company's services in these emerging markets will develop. Other Developments and Further Information Many Federal, state and local laws designed to protect the environment, and similar laws in some foreign jurisdictions, have varying degrees of impact on the way the Company and its subsidiaries conduct their business operations, primarily with regard to their use, storage and disposal of petroleum products. Compliance with these laws and with the Company's environmental protection policies involves the expenditure of considerable amounts of money and management expects that such expenditures will increase in the near-term. Based on information presently available, management believes that the ultimate disposition of such matters, although potentially material to the Company's results of operations in any one year, will not have a material adverse effect on the Company's financial condition or liquidity. For further discussion concerning the business of the registrant and its subsidiaries see the information referenced under Items 7 and 8 of this report. Executive Officers of the Registrant All of the executive officers of the Company were elected or re-elected to their present offices either at or subsequent to the meeting of the Board of Directors held on May 7, 1993, in conjunction with the Company's 1993 Annual Meeting on the same date. They all hold such offices, at the discretion of the Board of Directors, until their removal, replacement or retirement. M. Anthony Burns has been Chairman of the Board since May 1985, Chief Executive Officer since January 1983 and President and a director since December 1979. Wendell R. Beard has been Executive Vice President - Office of the Chairman since March 1991. Mr. Beard served as Senior Vice President - Office of the Chairman from August 1989 to March 1991 and as Vice President - Office of the Chairman from May 1987 to August 1989. Mr. Beard was Group Director - Corporate Affairs from July 1985 to April 1987 and Group Director - Development from March 1984 to June 1985. C. Robert Campbell has been Executive Vice President - Human Resources and Administration since March 1991. Mr. Campbell served as Executive Vice President - Finance of the Vehicle Leasing & Services Division from October 1981 to March 1991. Dwight D. Denny has been President - Ryder Commercial Leasing & Services since December 1992, and was Executive Vice President and General Manager - Commercial Leasing & Services of Ryder Truck Rental, Inc. from June 1991 until December 1992. Mr. Denny served Ryder Truck Rental, Inc. as Senior Vice President and General Manager - Eastern Area from March 1991 to June 1991 and Senior Vice President - Central Area from December 1990 to March 1991. Mr. Denny previously served Ryder Truck Rental, Inc. as Region Vice President in Tennessee from July 1985 to December 1990. R. Ray Goode has been Senior Vice President - Public Affairs since November 1993 and was President and Chief Executive Officer of We Will Rebuild from September 1992 to November 1993. He was Managing Partner of Goode, Olcott, Knight & Associates from April 1989 to September 1992, and served successively as Vice President, President and Chairman and Chief Executive Officer of The Babcock Company (a subsidiary of Weyerhaeuser Company) from 1976 to 1989. Mr. Goode served as County Manager for Metropolitan Dade County, Florida from 1970 to 1976. James B. Griffin has been President - Ryder Automotive Carrier Group Inc. since February 1993, and was Vice President and General Manager - Mid-South Region of Ryder Truck Rental, Inc. from December 1990 to February 1993. Mr. Griffin previously served Ryder Truck Rental, Inc. as Region Vice President in Syracuse, New York from April 1988 to December 1990. James M. Herron has been Senior Executive Vice President since July 1989 and General Counsel since April 1973. Mr. Herron was also Secretary from February 1983 through February 1986. Edwin A. Huston has been Senior Executive Vice President - Finance and Chief Financial Officer since January 1987. Mr. Huston was Executive Vice President - - Finance from December 1979 to January 1987. Larry S. Mulkey has been President - Ryder Dedicated Logistics, Inc. (formerly Ryder Distribution Resources, Inc.), a business unit of the Vehicle Leasing & Services Division, since November 1990. Mr. Mulkey was Senior Vice President and General Manager - Central Area of Ryder Truck Rental, Inc., from January 1986 to November 1990 and was Senior Vice President and General Manager - Eastern Area of Ryder Truck Rental, Inc., from August 1985 to January 1986. Gerald R. Riordan has been President - Ryder Consumer Truck Rental since December 1992, and was Senior Vice President and General Manager - Consumer Rental of Ryder Truck Rental, Inc., from June 1991 until December 1992. Mr. Riordan served Ryder Truck Rental, Inc. as Senior Vice President - Rental and Quality from December 1990 to June 1991, Vice President of Quality from January 1988 to December 1990 and Vice President of Rental from January 1983 to January 1988. Anthony G. Tegnelia has been Senior Vice President since March 1991 and Controller since August 1988. He is the Company's principal accounting officer. Mr. Tegnelia was Vice President - Corporate Systems from November 1986 to August 1988. Mr. Tegnelia served as Executive Vice President - Finance of the Company's former Freight System Division from September 1985 to October 1986, and Senior Vice President - Finance of Ryder Distribution System (now Ryder Dedicated Logistics, Inc.) from March 1984 to August 1985. Randall E. West has been Senior Vice President and General Manager of the International Division since December 1993, and was Vice President and General Manager - Southwest Region of Ryder Truck Rental, Inc. (Ryder Commercial Leasing & Services) from September 1991 to December 1993. Mr. West previously served Ryder Truck Rental, Inc. as Region Vice President at New Orleans from November 1988 to September 1991. ITEM 2. ITEM 2. PROPERTIES The Company's property consists primarily of vehicles, vehicle maintenance and repair facilities and other real estate and improvements. Information regarding vehicles is included in Item 1, which is incorporated herein by reference. The Vehicle Leasing & Services Division has 1,613 locations in the United States; 428 of these facilities are owned and the remainder are leased. Such locations generally include a garage, a repair shop and office space. The International Division has 65 locations in the United Kingdom, Germany and Poland; 15 of these facilities are owned and the remainder are leased. Such locations generally include a rental office, a repair shop and administrative office space. The Automotive Carrier Division has 81 operating locations in 37 states throughout the United States and 8 operating locations in Canada; 29 locations are owned and the remainder are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in various claims, law suits, and administrative actions arising in the course of their businesses. Some involve claims for substantial amounts of money and/or claims for punitive damages. While any proceeding or litigation has an element of uncertainty, management believes that the disposition of such matters, in the aggregate, will not have a material impact on the consolidated financial condition, results of operation or liquidity of the Company and its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by Item 5 is incorporated by reference from page 43 ("Common Stock Data") of the Ryder System, Inc. 1993 Annual Report to Shareholders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is incorporated by reference from pages 44 and 45 of the Ryder System, Inc. 1993 Annual Report to Shareholders. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by Item 7 is incorporated by reference from pages 24 through 28 of the Ryder System, Inc. 1993 Annual Report to Shareholders. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is incorporated by reference from pages 31 through 42 and page 43 ("Quarterly Data") of the Ryder System, Inc. 1993 Annual Report to Shareholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No Form 8-K was filed by the Company in the 24 months prior to December 31, 1993, reporting (i) a change of accountants or (ii) a disagreement on matters of accounting principles, accounting practices or financial statement disclosure matters. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 regarding directors is incorporated by reference from pages (4 through 9) of the Ryder System, Inc. 1994 Proxy Statement. The information required by Item 10 regarding executive officers is set out in Item 1 of Part I of this Form 10-K Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference from pages (20 through 23) of the Ryder System, Inc. 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated by reference from pages (16 and 17) of the Ryder System, Inc. 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated by reference from page (10) of the Ryder System, Inc. 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements for Ryder System, Inc. and Consolidated Subsidiaries: Items A through E are incorporated by reference from pages 30 through 42 of the Ryder System, Inc. 1993 Annual Report to Shareholders. A) Consolidated Statements of Earnings for years ended December 31, 1993, 1992 and 1991. B) Consolidated Balance Sheets for December 31, 1993 and 1992. C) Consolidated Statements of Cash Flows for years ended December 31, 1993, 1992 and 1991. D) Notes to Consolidated Financial Statements. E) Independent Auditors' Report. 2. Financial Statement Schedules of Ryder System, Inc. and Consolidated Subsidiaries (filed herewith unless otherwise indicated): A) Schedule II: Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties. B) Schedule V: Property and Equipment. C) Schedule VI: Accumulated Depreciation of Property and Equipment. D) Schedule VII: Guarantees of Securities of Other Issuers. E) Schedule X: Supplementary Income Statement Information. F) Independent Auditors' Report. All other schedules and statements are omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto. Supplementary Financial Information consisting of selected quarterly financial data is incorporated by reference from page 43 of the Ryder System, Inc. 1993 Annual Report to Shareholders. 3. Exhibits: The following exhibits are filed with this report or, where indicated, incorporated by reference (Forms 10-K, 10-Q and 8-K referenced herein have been filed under the Commission's file No. 1-4364). The Company will provide a copy of the exhibits filed with this report at a nominal charge to those parties requesting them. EXHIBIT INDEX (b) Reports on Form 8-K: A Report on Form 8-K dated December 8, 1993, was filed by the Company with respect to the distribution to its shareholders of the stock of Aviall, Inc. The report also included pro forma consolidated condensed financial information for the Company, after giving effect to the spin-off of Aviall, Inc. (c) Executive Compensation Plans and Arrangements: Please refer to the description of Exhibits 10.1 through 10.19(b) set forth under Item 14(a)3 of this report for a listing of all executive compensation plans and arrangements filed with this report pursuant to Item 601(b)(10) of Regulation S-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. 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. Schedule II RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Years ended December 31, 1993, 1992 and 1991 (1) The receivable includes accrued interest (at an average rate of 9.2% per annum) of $72,601 at December 31, 1993. The entire principal amount of $383,316 was due prior to December 31, 1993. Schedule V RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Property and Equipment Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) SCHEDULE V, PAGE 2 RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Property and Equipment, Continued (Thousands of Dollars) Notes: (1) Other changes include property and equipment of businesses acquired as follows: 1991-$7,584 and 1992-$17,173. The balance comprises adjustments relating to foreign currency translation and transfers (a) to and from non-operating property and equipment and (b) to and from fixed asset classifications. (2) Reconciliation of 1993 property and equipment additions on Schedule V with the consolidated statement of cash flows is as follows: Method and depreciable lives as to Ryder System, Inc. and consolidated subsidiaries: Provision for depreciation and amortization on substantially all depreciable assets is computed using the straight-line method over the following estimated useful asset lives: Schedule VI RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Accumulated Depreciation of Property and Equipment Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Schedule VII RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Guarantees of securities of other issuers (Thousands of dollars) Schedule X RYDER SYSTEM, INC. AND CONSOLIDATED SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 (Thousands of dollars) INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Shareholders Ryder System, Inc.: Under date of February 7, 1994, we reported on the consolidated balance sheets of Ryder System, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Part IV Item 14a(2). These financial statement schedules are the responsibility of the Company's mangement. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG PEAT MARWICK Miami, Florida February 7, 1994	4,002	26,666
77320_1993.txt	77320_1993	1993	77320	ITEM 1. BUSINESS AND ITEM 2. ITEM 3. LEGAL PROCEEDINGS. (a) TAX DISPUTE. Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Tax Dispute" and Note 8 of Notes to Consolidated Financial Statements for information regarding a letter and examination report received from the District Director of the Internal Revenue Service in January 1994 that proposes a tax deficiency based on an audit of Pennzoil's 1988 federal income tax return. (b) CURTAILMENT DAMAGE ACTIONS. Reference is made to Note 8 of Notes to Consolidated Financial Statements for information regarding a lawsuit in which Pennzoil has been joined as a defendant for damages allegedly caused by curtailment of deliveries of gas by United Gas Pipe Line Company, a former Pennzoil subsidiary, to its customers. (c) EATON V. PENNZOIL COMPANY. In December 1992, two former employees of Pennzoil filed a purported class action suit in the United States District Court for the Southern District of Texas, Galveston Division. The suit alleges that one of Pennzoil's deferred compensation plans had been improperly administered because of the absence of an adjustment under the plan for a significant event occurring in 1988 in determining the value of awards under the plan maturing in 1988 and 1990. The plaintiffs allege breach of contract, common law fraud and breach of fiduciary duty and seek compensatory and consequential damages of $40.0 million and punitive damages of $400.0 million. Pennzoil believes that the plan was administered properly and that the lawsuit is without merit. In October 1993, the court granted Pennzoil's motion for summary judgment. The plaintiffs have appealed. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted during the fourth quarter of 1993 to a vote of security holders. ITEM S-K 401(B). EXECUTIVE OFFICERS OF THE REGISTRANT. (a) Set forth below are the names and ages of the executive officers of Pennzoil (at March 4, 1994). Positions, unless otherwise specified, are with Pennzoil. DAVID P. ALDERSON, II (44) Group Vice President -- Finance and Treasurer CLYDE W. BEAHM (56) Group Vice President -- Franchise Operations LINDA F. CONDIT (46) Corporate Secretary JOHN L. DAVIS (46) Group Vice President -- Sulphur THOMAS M. HAMILTON (50) Group Vice President -- Oil and Gas TERRY HEMEYER (55) Group Vice President -- Administration J. HUGH LIEDTKE (72)(1) Chairman of the Board MARK A. MALINSKI (38) Group Vice President -- Accounting and Controller JAMES L. PATE (58)(1) President and Chief Executive Officer WILLIAM M. ROBB (49) Group Vice President -- Products Manufacturing JAMES W. SHADDIX (47) General Counsel WILLIAM E. WELCHER (61) Group Vice President -- Products Marketing - --------------- (1) Director of Pennzoil and member of Executive Committee. (b) Officers are appointed annually to serve for the ensuing year or until their successors have been appointed. Officers listed above have held their present offices for at least the past five years except for those named below, who have had the business experience indicated during that period. Positions, unless specified otherwise, are with Pennzoil. DAVID P. ALDERSON, II -- Group Vice President -- Finance since February 1992 and Treasurer since August 1989. Senior Vice President -- Finance from March 1990 to February 1992. Assistant Treasurer prior thereto. CLYDE W. BEAHM -- Group Vice President -- Franchise Operations since July 1992. Executive Vice President -- Franchise Operations from February 1992 to July 1992. Senior Vice President -- Franchise Operations from May 1991 to February 1992. Vice President -- Quick Lube Operations from November 1989 to May 1991. Assistant Vice President -- Wholesale Market Development of Western Auto Supply Company's wholesale supply division prior thereto. LINDA F. CONDIT -- Corporate Secretary since March 1990. Director -- Treasury Operations prior thereto. JOHN L. DAVIS -- Group Vice President -- Sulphur since June 1991. Senior Vice President -- Pennzoil Sulphur Company from June 1990 to June 1991. Vice President -- Legal of Pennzoil Sulphur Company prior thereto. THOMAS M. HAMILTON -- Group Vice President -- Oil and Gas since December 1991. Chief Executive -- Frontier and International Operating Company of BP Exploration from September 1989 to June 1991. General Manager -- East Asia, Australia and Latin America of BP Exploration prior thereto. TERRY HEMEYER -- Group Vice President -- Administration since February 1992. Senior Vice President -- Administration from March 1990 to February 1992. Vice President -- Public Affairs prior thereto. MARK A. MALINSKI -- Group Vice President -- Accounting since February 1992 and Controller since March 1990. Senior Vice President -- Accounting from March 1990 to February 1992. Corporate Secretary prior thereto. JAMES L. PATE -- President and Chief Executive Officer since March 1990. Chief Operating Officer from February to March 1990 and Executive Vice President from July 1989 to March 1990. Senior Vice President -- Finance and Treasurer prior thereto. WILLIAM M. ROBB -- Group Vice President -- Products Manufacturing since October 1992. Executive Vice President -- Manufacturing of Pennzoil Products Company prior thereto. JAMES W. SHADDIX -- General Counsel since March 1990. Assistant General Counsel prior thereto. WILLIAM E. WELCHER -- Group Vice President -- Products Marketing since October 1992. Executive Vice President -- Marketing of Pennzoil Products Company prior thereto. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The following table shows high and low sales prices for the common stock of Pennzoil as reported on the New York Stock Exchange (consolidated transactions reporting system), the principal market in which the common stock is traded and dividends paid per share for the calendar quarters indicated. The common stock is also listed for trading on the Pacific Stock Exchange, as well as the Toronto, London and Swiss stock exchanges. Pennzoil has paid quarterly dividends for 70 consecutive years. As of December 31, 1993, Pennzoil had 20,590 record holders of its common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table contains selected financial data for the five years indicated. - --------------- (1) Reference is made to Note 11 of Notes to Consolidated Financial Statements. (2) Reference is made to Note 3 of Notes to Consolidated Financial Statements. (3) Reference is made to Notes 2 and 6 of Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Reference is made to Industry Segment Financial Information included in Item 1, Business and Item 2, Properties and the Consolidated Financial Statements beginning on page for additional information. RESULTS OF OPERATIONS Net income for 1993 was $141.9 million, or $3.36 per share, compared with net income of $128.2 million, or $3.16 per share, for 1992 and $21.0 million, or $.52 per share, for 1991. In November 1993, Pennzoil sold 8,158,582 shares of Chevron Corporation ("Chevron") common stock in a block trade on the New York Stock Exchange ("NYSE") for a net price of $88.38 per share. The sale resulted in a net realized gain of $137.0 million ($171.6 million before tax), or $3.25 per share. Reference is made to "-- Capital Resources and Liquidity" for additional information. In September 1993, Pennzoil called for redemption an aggregate of $292.5 million principal amount of indebtedness. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $13.7 million ($21.1 million before tax), or $.33 per share, in the third quarter of 1993. Reference is made to "-- Capital Resources and Liquidity" for additional information. In August 1993, the Omnibus Budget Reconciliation Act of 1993 was enacted, establishing a new 35% corporate income tax rate effective January 1, 1993. As a result of the increase in the marginal income tax rate and other tax law changes, Pennzoil recorded a one-time, non-cash charge of approximately $16 million, or $.38 per share, in the third quarter of 1993 to adjust its deferred income tax liabilities and assets for the effect of the change in income tax rates. In June 1993, Pennzoil called for redemption $96.1 million principal amount of indebtedness (which redemption occurred in July 1993). The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $4.7 million ($7.2 million before tax), or $.12 per share, in the second quarter of 1993. Reference is made to "-- Capital Resources and Liquidity" for additional information. In December 1992, Pennzoil announced its decision to change its method of accounting for income taxes by adopting the new requirements of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective as of January 1, 1992. As a result, Pennzoil recognized an increase to net income of $119.1 million in 1992. Of this amount, $115.7 million, or $2.85 per share, is reported as the one-time cumulative effect on prior year results. The remaining $3.4 million, or $.08 per share, reflects the impact of adoption of this standard on 1992 income from continuing operations. In December 1992, Pennzoil sold in initial public offerings all its shares of capital stock of Purolator Products Company ("Purolator"). Pennzoil recorded a net gain on the disposition of Purolator of $1.5 million, or $.04 per share, in the fourth quarter of 1992. Reference is made to "-- Discontinued Operations" and Note 11 of Notes to Consolidated Financial Statements for additional information. In December 1992, Pennzoil called for redemption $272.9 million principal amount of indebtedness (which redemption occurred in February 1993). As of December 31, 1992, this indebtedness was defeased by placing funds required for the redemption with the trustee for the indebtedness. As a result, the funds deposited with the trustee for the redemption of the debentures and the principal amount of the indebtedness are not reflected in Pennzoil's consolidated balance sheet at December 31, 1992. The premiums and related unamortized discount and debt issue costs relating to this redemption resulted in an extraordinary charge of $16.6 million ($25.2 million before tax), or $.41 per share, in the fourth quarter of 1992. Reference is made to "-- Capital Resources and Liquidity" for additional information. In December 1991, Pennzoil announced its decision to change its method of accounting for postretirement benefit costs other than pensions by adopting the new requirements of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective as of January 1, 1991. As a result, Pennzoil recorded a charge of $49.0 million (including $11.4 million related to Purolator), or $1.21 per share, in the first quarter of 1991 to reflect the cumulative effect of the change in accounting principle for periods prior to 1991. In addition to the cumulative effect, Pennzoil's 1991 postretirement health care and life insurance costs increased $1.7 million, or $.04 per share, as a result of adopting the new standard. Net income for 1991 was increased by adjustments of approximately $27.6 million, or $.68 per share, required to reclassify Purolator from a discontinued operation to a continuing operation as a result of Pennzoil's 1991 decision to retain Purolator. Reference is made to Note 11 of Notes to Consolidated Financial Statements for additional information. Investment and other income for 1993 primarily represents a gain on the sale of 8,158,582 shares of Chevron common stock and dividend income from Pennzoil's investment in Chevron common stock. Investment and other income for 1992 and 1991 primarily represents dividend income from Pennzoil's investment in Chevron common stock. From 1989 through 1991, Pennzoil acquired 32,944,100 shares of common stock of Chevron. As of December 31, 1993, Pennzoil beneficially owned 9,035,518 shares of Chevron common stock, which is classified as non-current marketable securities and other investments in the accompanying consolidated balance sheet. Reference is made to "-- Capital Resources and Liquidity" for additional information. OIL AND GAS Operating income for the oil and gas segment was $159.2 million, compared with operating income of $134.7 million in 1992 and $48.6 million in 1991, reflecting the inclusion of a full year of results of Pennzoil Petroleum Company ("Pennzoil Petroleum"). Gas and liquids volume increases along with higher gas prices and gains on asset sales were primarily responsible for the increase in operating income. These increases were partially offset by lower crude oil prices, generally higher expenses associated with the higher level of activity within the oil and gas segment and higher exploration expenses described below. In October 1992, Pennzoil completed a transaction with Chevron, pursuant to which Pennzoil exchanged 15,750,000 shares of Chevron common stock held by Pennzoil for all the capital stock of Pennzoil Petroleum, which owns Gulf of Mexico, Gulf Coast, Permian Basin and other domestic oil and gas producing properties. The exchange of stock has been accounted for using the purchase method of accounting, and Pennzoil Petroleum's results of operations subsequent to October 30, 1992 have been included in Pennzoil's oil and gas segment results. Reference is made to Note 10 of Notes to Consolidated Financial Statements for additional information. During the four-month period between the "effective date" and the closing date of the transaction, Chevron continued operation of the Pennzoil Petroleum oil and gas properties and, immediately prior to closing, contributed $57.4 million in cash to Pennzoil Petroleum (for the benefit of Pennzoil), representing the cash flow from Pennzoil Petroleum's operations during this four-month period, less production costs, provisions for taxes and approximately $11 million of nonrecurring closing adjustments. As a result of an audit completed during 1993, Chevron contributed an additional $9.9 million in cash to Pennzoil Petroleum, representing an adjustment to the initial $57.4 million cash contribution made by Chevron to Pennzoil Petroleum prior to closing. This additional contribution from Chevron was accounted for as an adjustment to the original purchase price of Pennzoil Petroleum. Natural gas produced for sale in 1993 was 649,399 Mcf per day, compared with 447,561 Mcf per day and 400,960 Mcf per day in 1992 and 1991, respectively. Natural gas prices averaged $2.04 per Mcf in 1993 compared to $1.81 per Mcf in 1992 and $1.54 per Mcf in 1991. Liquids volumes in 1993 were 64,273 barrels per day, compared to 39,462 and 30,897 barrels per day in 1992 and 1991, respectively. The average liquids price received in 1993 dropped to $14.90 per barrel compared with $16.95 per barrel in 1992 and $18.30 per barrel in 1991. The results of operations from Pennzoil's oil and gas segment are subject to volatility resulting from changes in crude oil and natural gas prices. Pennzoil has used in the past, and may use in the future, a limited price risk management strategy to provide protection against temporary declines in domestic natural gas prices. To date, these price risk management activities have encompassed no more than 3% of Pennzoil's total annual natural gas production. During 1993, Pennzoil recorded $34.9 million in gains on sales of assets, primarily oil and gas producing properties. Proceeds from these asset sales were $87.5 million. These properties were categorized as noncore properties as a part of Pennzoil's continuing assessment of its domestic oil and gas properties, which commenced early in 1992. These properties, while constituting a significant number of fields, were, as a whole, immaterial to Pennzoil. Management estimates that Pennzoil's proved reserves at December 31, 1993 were reduced by approximately 13.7 million barrels of proved oil equivalents, or less than 3% of Pennzoil's proved reserves, as a result of these sales. Pennzoil intends to continue disposal of noncore properties during 1994, with the proceeds from these sales intended for reinvestment in or reallocation to Pennzoil's core properties. Expenses associated with exploration activities in 1993 increased to $70.7 million compared with $11.7 million in 1992 and $47.3 million in 1991. This increase was due to a $46.9 million charge for impairments of unproved offshore property costs, primarily in the Mobile Bay area, and an increase in geological and geophysical expenses of $12.9 million over 1992 associated with an increase in Pennzoil's domestic exploration and development activity and the continuing assessment of its domestic oil and gas properties. In the early stages of this assessment, Pennzoil curtailed domestic exploration activity and, as a result, reduced its 1992 capital budget related to both exploration and development activity and geological and geophysical expenses. As this assessment has progressed, more exploration and development activity has occurred in and around core areas. As a result, both domestic capital expenditures and geological and geophysical expenses for 1993 have more than doubled from the previous year as new opportunities were evaluated and exploration and development programs were implemented. Depreciation, depletion and amortization expense in 1993 included a charge of $17.7 million to increase an impairment reserve originally established in 1988 related to Pennzoil's net investment in offshore California producing properties. Generally lower offshore California oil price forecasts in the fourth quarter, led management to determine that an additional impairment was necessary. Internationally, Pennzoil in 1992 announced agreements for the exclusive right to negotiate with the Azerbaijan Republic and the State Oil Company of the Azerbaijan Republic ("SOCAR") to develop the Guneshli Field offshore Azerbaijan in the southern portion of the Caspian Sea. In May 1993, the Azeri government announced its intention to jointly develop, under a unified development plan, three fields (the Guneshli, Chirag and Azeri Fields) then under negotiation with western oil companies. In October 1993, the group of eight western oil companies, including Pennzoil, entered into an Area of Mutual Interest ("AMI") agreement that reaffirmed the equity distribution among the companies set out in a Declaration of Unitization previously signed by the western oil companies and SOCAR and established the basis for the companies' development of the three-field unit. Subsequently, during October 1993, the Azeri government elected to withdraw the Guneshli Field from the unit to be developed by the western oil companies and develop the Guneshli Field on its own. Under the terms of the AMI agreement, Pennzoil and Ramco Energy Ltd. of Scotland will have a 17% working interest in any development of the three fields by the western oil companies party to the AMI agreement, including the current two-field unit composed of the Chirag and Azeri Fields. Also in Azerbaijan, Pennzoil continued work on a comprehensive gas gathering and compression system during 1993. This project is designed to capture, compress and transport to shore approximately 150 million cubic feet per day of gas presently being vented from the Guneshli Field. The gas utilization project accounted for approximately $98 million of the $361 million in capital expenditures for the oil and gas segment in 1993. Pennzoil has signed a gas utilization agreement with SOCAR that provides for recovery of Pennzoil's costs incurred in connection with the gas utilization project by payment in hard currency or oil or petroleum products or by a credit against a signature bonus for the first exploration, exploitation and/or development contract entered into between Pennzoil and SOCAR in Azerbaijan. The gas utilization project should be completed during the first quarter of 1994. Pennzoil's total investment related to its Azerbaijan activities, including the gas utilization project, was $116 million as of December 31, 1993. Capital expenditures for the oil and gas segment in 1993 were $360.5 million compared to $93.8 million in 1992, excluding expenditures related to Pennzoil's acquisition of Pennzoil Petroleum, and $177.9 million in 1991. Total capital expenditures for this segment in 1994 are estimated to be $223.9 million, net of expected recoveries from the gas utilization project in Azerbaijan. Reference is made to "-- Capital Resources and Liquidity" for additional information. MOTOR OIL & AUTOMOTIVE PRODUCTS Operating income in 1993 for this segment was $90.0 million, compared with $77.9 million in 1992 and $108.3 million in 1991. Higher income in the marketing division in 1993 resulted primarily from higher domestic motor oil margins, which increased by approximately 6% due to lower crude oil prices in 1993. Domestic motor oil volumes were about even with 1992 but 4% higher than 1991 (lower 1991 volumes were the result of a recessionary decrease in total market demand). Domestic motor oil margin gains in 1993 were partially offset by higher advertising and selling expenditures. International motor oil and other lubricating product volumes increased 25% when compared to 1992 and 51% when compared to 1991. The revenue increases resulting from the higher international motor oil volumes were partially offset by higher selling and depreciation expenses. Higher income in the manufacturing division in 1993 was the result of higher refining and specialty product margins. Higher refining margins were due to higher fuels and other light product margins and higher base oil margins, all resulting from lower crude prices. Total processed volume at the refineries of 59,222 barrels per day was 767 barrels per day higher than 1992 but 2,683 barrels per day lower than 1991. The lower volumes in 1993 and 1992 were primarily due to major maintenance turnarounds. Higher refinery operating and maintenance expenses slightly offset the increased margin. Income from the specialty products Penreco division was up 47% in 1993 due to higher volumes and margins coupled with a division-wide focus on reducing operating expenses. The profitability of Pennzoil's refineries is directly affected by the supply and price of the grade and quality of crude oil purchased or otherwise obtained for refinery throughput. Because of shortages in the supply of crude oil meeting the unique grade and quality requirements for each of Pennzoil's refineries, and possible declining refinery margins resulting from such shortages, Pennzoil continually considers and evaluates crude oil supply arrangements for each of its refineries and the corresponding impact on the operating profitability of the affected refineries. In response to these crude oil supply shortages, Pennzoil is evaluating, among other things, the feasibility of increasing production from nearby fields and the possible reduction or consolidation of refinery operations. The magnitude and timing of crude oil supply shortages, and the resultant impact on Pennzoil's operating results and business operations, cannot be predicted with accuracy. Capital expenditures for the motor oil and automotive products segment were $71.5 million in 1993, $35.8 million in 1992 and $32.3 million in 1991. The 1993 expenditures included $26.6 million for a diesel desulphurization and dewaxing project at the Atlas Processing Company ("Atlas") refinery in Shreveport, Louisiana, required to meet the new standards of the Clean Air Act. Also included were expenditures of $6.3 million for a feasibility study for a state-of-the-art base oil plant to be built as a joint venture and $4.8 million for the acquisition of property, plant and equipment of a blending plant in Spain (acquired in the first quarter of 1993). Total capital expenditures for this segment in 1994 are estimated to be $59.1 million. FRANCHISE OPERATIONS The operating loss from franchise operations during 1993 was $17.6 million, compared with an operating loss of $13.4 million in 1992 and an operating loss of $7.8 million in 1991. Operating results for 1993 include a charge of $10.0 million for estimated costs associated with centers that Jiffy Lube International, Inc. ("Jiffy Lube") has decided to eliminate. Jiffy Lube has determined that these centers are not viable as company-operated centers and has been unsuccessful in subleasing many of these centers for alternative uses. This provision for estimated costs takes into consideration the present value of future lease obligations related to operating leases (less estimated sublease rental revenue of existing subleases) and the estimated fair value of land, buildings, leaseholds and leasehold improvements. Additionally, 1993 results include approximately $12.7 million for the settlement of certain litigation, estimated environmental costs and write-downs of other individually insignificant investments to reflect Jiffy Lube's estimate of the net realizability of those investments. The decline in operating results in 1992 as compared to 1991 was due in part to increased selling, general and administrative expenses incurred in connection with the settlement of certain litigation ($6.8 million in 1992 compared to $1.1 million in 1991) and increased start-up expenses incurred in association with the development and installation of a new point-of-sale system ($2.6 million in 1992 compared to $1.1 million in 1991). As of December 31, 1993, Jiffy Lube operated 410 service centers, of which 19 are currently held for resale. Systemwide service center sales reported to Jiffy Lube for the year ended December 31, 1993 increased $39 million, or approximately 8%, to $539 million, compared with the prior year and increased $64 million, or approximately 13%, compared with 1991. Average ticket prices increased to $33.60 for the year ended December 31, 1993, compared with $33.23 and $32.15 for the years ended December 31, 1992 and 1991, respectively. During the year ended December 31, 1993, Jiffy Lube acquired 70 centers with estimated values of $15.8 million and real estate with estimated values of $.9 million in exchange for cash of $12.2 million, forgiveness of amounts due Jiffy Lube of $.9 million, liabilities assumed of $.5 million, debt assumed of $.4 million and real estate valued at $1.6 million. During the year ended December 31, 1992, Jiffy Lube acquired 104 service centers with estimated values of $29.7 million in exchange for cash of $16.7 million, forgiveness of amounts due Jiffy Lube of $2.8 million, liabilities assumed of $8.7 million and debt issued of $1.5 million. During the year ended December 31, 1991, Jiffy Lube acquired 106 service centers with estimated values of $31.9 million in exchange for cash of $13.3 million, forgiveness of amounts due Jiffy Lube of $6.3 million, liabilities assumed of $11.5 million and debt issued of $6.5 million. Capital expenditures for the franchise operations segment were $21.7 million in 1993, compared to $25.8 million and $4.9 million in 1992 and 1991, respectively. Capital expenditures for 1994 are estimated to be approximately $14.5 million. SULPHUR The operating loss from this segment was $20.8 million in 1993, down from $1.0 million of operating income earned in 1992 and from $42.7 million of operating income reported in 1991. The decrease in operating income in the sulphur segment during 1993 was primarily attributable to reduced sales volumes and sharply lower prices received for sulphur during 1993. The average Green Markets Tampa Recovered Contract Price range for sulphur in 1993 had a mid-point of $64.00 per long ton, which was approximately 26% below the 1992 mid-point and 44% below the mid-point in 1991. A downturn related to aggressive pricing by Canadian and U.S. recovered sulphur producers began in mid-1991, with average mid-point prices falling by $77.00 per ton from a weekly high of $131.00 in June 1991 to a weekly low of $54.00 in December 1993. During 1993, sulphur sales volumes were 1.1 million long tons, a decrease of approximately 37% and 46% from 1992 and 1991 levels, respectively, due to reduced market share resulting from lower priced imports from Canada and increased recovered production domestically. Consumption of sulphur in North America was also estimated to be down one million tons due to lower phosphate exports. Sales volume commitments from certain Pennzoil customers have also been reduced or eliminated, including the elimination of commitments in the second half of 1992 from a customer accounting for approximately 10% of annual sulphur sales. In October 1993, Pennzoil announced intended capital expenditures of approximately $7.4 million to modify the process of heating recycled mine water for reinjection into the production zone at the Culberson mine and the replacement of inefficient steam turbines with a gas-fired turbine. The modification resulted in a one-time charge of approximately $3.6 million for the write-off of obsolete property, plant and equipment. In addition, Pennzoil Sulphur Company began a work force reduction program in 1993, which resulted in a fourth quarter charge of $3.2 million. Annual expense savings at current production rates as a result of these actions are estimated at $12 million. Pennzoil announced a voluntary workforce reduction for the sulphur segment effective in September 1992 and an involuntary workforce reduction program at two locations in October 1992. These measures resulted in one-time charges of $1.3 million and $1.1 million, respectively, and estimated cost reductions of $2.2 million and $3.2 million annually. So long as sulphur prices and volumes remain at current levels, operating results in the sulphur segment will continue to be adversely affected, and the sulphur segment will likely generate an operating loss. The magnitude and timing of the actual effect on operating results of any future sulphur price fluctuation cannot be accurately predicted. A significant portion of Pennzoil's sulphur sales is made to United States phosphate fertilizer producers who sell in both domestic and foreign agricultural markets. Domestic agricultural markets typically peak during spring and fall planting seasons, which are in the first and third quarters of the year. Foreign markets are also cyclical, but seasonal variations among individual foreign countries tend to offset each other. Capital expenditures for the sulphur segment were $2.3 million in 1993, compared with $2.9 million and $7.0 million in 1992 and 1991, respectively. Total capital expenditures for this segment in 1994 have been budgeted at $6.2 million. OTHER Other operating income for 1993 was $253.7 million, compared to $88.2 million in 1992 and $127.8 million in 1991. The higher level of other income in 1993 was primarily due to the gains on the sales of shares of Chevron common stock of $171.6 million and Pogo Producing Company common stock of $10.5 million. Dividend income on the Chevron common stock was $60.2 million for 1993, $95.7 million for 1992 and $107.0 million for 1991. Other revenues, net of related expenses, are included in the consolidated statement of income under "Investment and Other Income, Net" which consists of the following: Substantially all interest and dividend income is from marketable securities and other cash investments. INTEREST CHARGES, NET During 1993, Pennzoil's interest charges, net of interest capitalized, decreased $45.1 million over 1992 levels. This decrease is primarily due to a decrease in the average amount of debt outstanding and lower average interest rates during 1993 compared to 1992. In addition, interest expense for 1991 includes $3.7 million in interest payments related to federal income tax paid on a portion of the $3.0 billion settlement received by Pennzoil from Texaco, Inc. ("Texaco") in 1988 in settlement of certain litigation. Reference is made to "-- Capital Resources and Liquidity -- Investment in Chevron Corporation" for additional information. DISCONTINUED OPERATIONS In early 1990, Pennzoil decided to sell or otherwise dispose of Purolator. In connection with this decision, Pennzoil recorded a 1989 fourth quarter write-down of $125.0 million to reflect the estimated loss to be incurred from the then anticipated sale or other disposition of Purolator's filtration products operations, including estimated future costs and operating results from the segment until the date of disposition. In August 1991, Pennzoil concluded that, because of Purolator's improved performance, the intrinsic value of Purolator could be more effectively realized by retaining Purolator. Accordingly, Pennzoil reclassified Purolator's net assets and results of operations for all periods as part of continuing operations. As a result of Pennzoil's decision to retain Purolator, the remaining reserve of $115.7 million for the estimated loss on the disposition of Purolator originally established in the fourth quarter of 1989 was reversed. Concurrent with the reversal of the reserve, Pennzoil recorded, during the third quarter of 1991, a provision of $108.0 million ($88.0 million after tax) to reflect losses due to asset impairment and other identified liabilities related to Purolator. In October 1992, as a result of Pennzoil's conclusion that disposal of Purolator's filtration products operations would enhance Pennzoil's efforts to focus on its strategic businesses and to reduce indebtedness, Purolator filed a registration statement pursuant to which Pennzoil offered to the public all shares of Purolator stock held by Pennzoil. Accordingly, Purolator's net assets and results of operations for all periods have been reclassified as discontinued operations for financial reporting purposes. In December 1992, Pennzoil sold in initial public offerings all its shares of capital stock of Purolator. The total amount received by Pennzoil, prior to the payment of expenses, from the net proceeds of the offerings and the repayment of indebtedness by Purolator was $206.0 million. Pennzoil also expects to receive a tax refund of approximately $23 million as a result of the transaction. Pennzoil recorded a net gain on the disposition of Purolator stock of $1.5 million, or $.04 per share, in the fourth quarter of 1992. Reference is made to "-- Capital Resources and Liquidity -- Environmental Matters" and Note 8 of Notes to Consolidated Financial Statements for information concerning an environmental indemnification agreement between Pennzoil and Purolator entered into in connection with Pennzoil's disposition of Purolator. CAPITAL RESOURCES AND LIQUIDITY CASH FLOW. Pennzoil had cash and cash equivalents and current marketable securities and other investments of $946.6 million and $20.7 million at December 31, 1993 and 1992, respectively. Cash flow generated from operations, net proceeds from the sale of 8.2 million shares of Chevron common stock and proceeds from the sale of assets totaled approximately $1.1 billion. These funds were primarily used for the payment of cash dividends ($126.2 million) and for capital expenditures ($475.0 million). INVESTMENT IN CHEVRON CORPORATION. As of December 31, 1993, Pennzoil beneficially owned 9,035,518 shares of Chevron common stock. From 1989 through 1991, Pennzoil acquired 32,944,100 shares of Chevron common stock at an average cost of $67.36 per share with approximately $2.2 billion of the net proceeds from the Texaco settlement. In anticipation of not reinvesting in excess of $2.2 billion of the original $3.0 billion of proceeds from the Texaco settlement in property that is similar or related in service or use to the property involuntarily converted by Texaco, Pennzoil paid $13.2 million in federal income tax and $3.7 million in related interest in 1991 in addition to payments of $120.4 million in federal income tax and $17.6 million in related interest made during 1990. The interest payments are included in interest expense for 1991 and 1990, respectively. Provision for the income tax was previously made when the proceeds from the Texaco settlement were received in 1988. Reference is made to Note 8 of Notes to Consolidated Financial Statements for additional information. In April 1991, Chevron increased the amount of quarterly dividends paid to holders of its common stock from $.775 per share to $.825 per share, and, in January 1993, Chevron announced an increase in the amount of quarterly dividends paid to holders of its common stock from $.825 per share to $.875 per share. In January 1994, Chevron announced an increase in the amount of quarterly dividends paid to holders of its common stock from $.875 per share to $.925 per share. At March 4, 1994, the closing price for Chevron common stock on the NYSE was $88.25 per share. In October 1992, Pennzoil completed a transaction with Chevron, pursuant to which Pennzoil exchanged 15,750,000 shares of Chevron common stock held by Pennzoil for all capital stock of Pennzoil Petroleum, which owns Gulf of Mexico, Gulf Coast, Permian Basin and other domestic oil and gas producing properties. The exchange of stock has been accounted for using the purchase method of accounting, and Pennzoil Petroleum's results subsequent to October 30, 1992 are included in Pennzoil's oil and gas segment results. In November 1993, Pennzoil sold 8,158,582 shares of Chevron common stock in a block trade on the NYSE for a price of $89.00 per share before commissions ($88.38 per share net of commissions). The sale resulted in a net gain of $137.0 million ($171.6 million before tax), or $3.25 per share. The tax liability resulting from the sale of shares of Chevron common stock has been reduced by $25.5 million as a result of the utilization of a net operating loss carryforward. Realization of the net operating loss carryforward resulted in the reversal of a valuation allowance related to the deferred tax asset. Reference is made to Note 2 of Notes to Consolidated Financial Statements for additional information. EXCHANGEABLE DEBENTURES. In 1993, Pennzoil completed public offerings of $402.5 million principal amount of its 6 1/2% Exchangeable Senior Debentures due January 15, 2003 (the "6 1/2% Debentures") and $500.0 million principal amount of its 4 3/4% Exchangeable Senior Debentures due October 1, 2003 (the "4 3/4% Debentures"). The 6 1/2% Debentures and the 4 3/4% Debentures are exchangeable at the option of the holders thereof at any time prior to maturity, unless previously redeemed, for shares of Chevron common stock owned by Pennzoil at exchange rates of 11.887 shares and 8.502 shares, respectively, per $1,000 principal amount of the 6 1/2% Debentures and the 4 3/4% Debentures (the equivalent of $84 1/8 per share and $117 5/8 per share, respectively), subject to adjustment in certain events. In lieu of delivering certificates representing shares of Chevron common stock in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures, Pennzoil may, at its option, pay to any holder surrendering the 6 1/2% Debentures and the 4 3/4% Debentures an amount in cash equal to the market price of the shares for which the 6 1/2% Debentures and the 4 3/4% Debentures are exchangeable. Pennzoil has deposited 9,035,518 shares of Chevron common stock deliverable in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures with exchange agents. Under the instruments governing the 6 1/2% Debentures and the 4 3/4% Debentures, Pennzoil may not pledge, mortgage, hypothecate or grant a security interest in, or permit any mortgage, pledge, security interest or other lien upon, the shares of Chevron common stock deposited with exchange agents and deliverable in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures. Pennzoil may at any time obtain from the exchange agents or otherwise authorize or direct the exchange agents to release all or part of the 9,035,518 shares of Chevron common stock deposited with the exchange agents. However, in the event Pennzoil obtains or otherwise releases any shares of Chevron common stock subject to exchange, each holder of a 6 1/2% Debenture or a 4 3/4% Debenture will generally have the right, at such holder's option, to require Pennzoil to repurchase all or a portion of such holder's debentures at a premium. From the proceeds from the sale in January 1993 of the 6 1/2% Debentures, Pennzoil in March 1993 redeemed $223.4 million principal amount of indebtedness (including $80.1 million of Pennzoil's 12 1/8% and 12 1/4% debentures due 2007, $100.0 million of Pennzoil's 9 1/8% notes due 1996 and $43.3 million of Pennzoil's 9% debentures due 2001). The call premiums and related unamortized net premiums and debt issue costs relating to the redemption of these series of indebtedness resulted in a charge of $1.4 million, net of tax, or $.02 per share, for the first quarter of 1993. Also with such proceeds, approximately $23.3 million of additional indebtedness has been retired, repaid or repurchased in 1993 and $100.0 million principal amount of Pennzoil's 9% notes was retired upon maturity in May 1993. From the proceeds from the sale of the 4 3/4% Debentures, Pennzoil in October 1993 reduced its borrowings outstanding under its unsecured revolving credit facility. ASSESSMENT OF OIL AND GAS PROPERTIES. Pennzoil is continuing its assessment of its domestic oil and gas properties commenced in early 1992. This assessment has resulted in, and is expected to continue to result in, the categorization of Pennzoil's oil and gas properties into core and noncore producing areas and core and noncore producing fields within core areas. In the early stages of this assessment, Pennzoil curtailed domestic exploration and development activity and, as a result, reduced its 1992 capital expenditures for domestic exploration and development by approximately one-half, excluding expenditures related to Pennzoil's acquisition of Pennzoil Petroleum. This ongoing assessment now includes the properties added in October 1992 as a result of the acquisition of Pennzoil Petroleum, which has created additional core areas and enhanced other core areas. With respect to properties to date categorized as noncore, Pennzoil sought to dispose of certain of these properties during 1992, and Pennzoil responded to inquiries from third parties with respect to other of these properties. As a result, Pennzoil disposed of approximately $35 million of these noncore properties and fields during 1992. No significant gain or loss was realized as a result of these dispositions. Pennzoil began 1993 with interests in approximately 800 producing fields owning small working interests and/or insignificant reserves in the majority of these fields. The successful first step in an asset highgrading program resulted in the disposal of approximately 300 of these fields representing less than 3% of the total value of Pennzoil's proved oil and gas reserves. Pennzoil realized gains of $34.9 million from these asset sales on total proceeds of $87.5 million. In addition, four asset swaps were finalized during 1993 to increase working interests in core Gulf of Mexico fields. Pennzoil intends to continue disposal of noncore properties during 1994 with the proceeds from these sales intended for reinvestment in or reallocation to Pennzoil's core properties. CREDIT FACILITIES. In August 1993, Pennzoil entered into an amended and restated credit facility with a group of banks that provides for up to $600.0 million of unsecured revolving credit borrowings through August 19, 1994, with any outstanding borrowings on such date being converted into a term credit facility terminating on September 1, 1995. A facility fee of .15% per annum is payable on the aggregate amount of the banks' commitments. This amended and restated credit facility replaces and supersedes the previous revolving credit facilities of Pennzoil and Pennzoil Exploration and Production Company. Borrowings under the facility totaled $195.0 million and $200.0 million at December 31, 1993 and March 1, 1994, respectively. During 1993, Pennzoil's Board of Directors increased the limit on the aggregate amount of commercial paper that Pennzoil may issue under its domestic commercial paper program and/or its Euro-commercial paper program from $150.0 million to $250.0 million. Borrowings under Pennzoil's commercial paper facilities totaled $249.4 million and $247.1 million at December 31, 1993 and March 1, 1994, respectively. Pennzoil has several short-term variable-rate credit arrangements with certain banks. Pennzoil's Board of Directors has limited borrowings under these credit arrangements to $200.0 million. Outstanding borrowings totaled $183.6 million at December 31, 1993 and $193.9 million at March 1, 1994. None of the banks has any obligation to continue to extend credit after the maturities of outstanding borrowings or to extend the maturities of any borrowings under these credit arrangements. OTHER REDEMPTIONS OF INDEBTEDNESS. In December 1992, Pennzoil called for redemption $272.9 million principal amount of indebtedness (including $250.0 million of Pennzoil's 10 5/8% debentures due 2018 and $22.9 million of Pennzoil's 10% debentures due 2011), using proceeds from the disposition of Purolator, from the disposition of certain oil and gas properties and from cash contributed by Chevron to Pennzoil Petroleum for the benefit of Pennzoil. The redemptions were completed in February 1993. As of December 31, 1992, this indebtedness was defeased by placing funds required for the redemption with the trustee for the indebtedness. As a result, the funds deposited with the trustee for the redemption of the debentures and the principal amount of the indebtedness are not reflected in Pennzoil's consolidated balance sheet at December 31, 1992. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $16.6 million ($25.2 million before tax), or $.41 per share, in the fourth quarter of 1992. In June 1993, Pennzoil called for redemption $96.1 million principal amount of indebtedness (including $66.1 million of Pennzoil's 10% debentures due 2011 and $30.0 million of Pennzoil's 10 1/8% debentures due 2011). The redemptions were completed in July 1993. The funds used for these redemptions were obtained from (i) the cash proceeds from the completed sale of a subsidiary holding Pennzoil's Indonesian gold properties in January 1993, (ii) the cash proceeds from the sale in March 1993 of common stock of Pogo Producing Company held by Pennzoil and (iii) the cash payments received from Chevron from and as a result of the net cash flows from operations of the oil and gas properties of Pennzoil Petroleum through March 31, 1993. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $4.7 million, net of tax, or $.12 per share, in the second quarter of 1993. In September 1993, Pennzoil called for redemption $292.5 million principal amount of indebtedness (including $120.0 million of Pennzoil's 10 1/8% debentures due 2011, $111.0 million of Pennzoil's 10% debentures due 2011 and $61.5 million of Pennzoil's 9% debentures due 2017). The redemptions were completed in November 1993. The funds used for these redemptions were primarily obtained from the net proceeds from the sale in September 1993 of 5,000,000 shares of Pennzoil common stock. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $13.7 million, net of tax, or $.33 per share, in the third quarter of 1993. In November 1993, Pennzoil redeemed $24.0 million principal amount of indebtedness (including $21.3 million of Pennzoil's 8 3/8% and 8 5/8% debentures due 1996 and $2.7 million of Pennzoil's 8 3/4% debentures due 2001). No significant gain or loss resulted from these early retirements. TAX DISPUTE. In January 1994, Pennzoil received a letter and examination report from the District Director of the Internal Revenue Service ("IRS") that proposes a tax deficiency based on an audit of Pennzoil's 1988 federal income tax return. The examination report proposes two principal adjustments with which Pennzoil disagrees. The first adjustment challenges Pennzoil's position under Section 1033 of the Internal Revenue Code that (i) at least $2.2 billion of the $3.0 billion cash payment received from Texaco in 1988 in settlement of certain litigation was realized as a result of the involuntary conversion of property and (ii) the shares of Chevron common stock purchased with $2.2 billion of the net Texaco settlement proceeds were similar or related in service or use to the property converted by Texaco. Although these issues have not been resolved, Pennzoil believes that its position is sound, and it intends to contest the proposed adjustment in court unless an acceptable settlement is reached. The proposed tax deficiency relating to this proposed adjustment is $550.9 million, net of available offsets. Pennzoil estimates that the additional after-tax interest on this proposed deficiency would be approximately $234.3 million as of December 31, 1993. If Pennzoil's position is not sustained by the courts, Pennzoil would be required to pay the assessed taxes, plus the accrued interest. Pennzoil's consolidated financial statements do not include an accrual for the interest that would be due in such event. The second adjustment proposed by the IRS would permanently capitalize, rather than allow Pennzoil to deduct, approximately $366 million incurred by Pennzoil in 1988 and earlier years for litigation and related expenses in connection with the Texaco settlement, even if it were determined that the entire $3.0 billion is includable in Pennzoil's 1988 taxable income. Pennzoil believes that this proposed adjustment is irrational and capricious and will not be sustained in court. The proposed tax deficiency relating to the disallowance of deductions is $124.6 million, and the estimated additional after-tax interest on this proposed deficiency would be approximately $46.7 million as of December 31, 1993. If the deductions for legal and related expenses were ultimately disallowed, Pennzoil would be required to pay the assessed taxes, plus the accrued interest. Pennzoil's consolidated financial statements do not include an accrual for the taxes that would be assessed as a result of the proposed disallowance of deductions or the related interest that would be due in such event. Pennzoil has formally protested the IRS' proposed tax deficiency in writing within the required 30-day time period. The issue has been forwarded to the IRS Appeals Office, which is empowered to settle disputes with taxpayers, taking into account the hazards of litigation. If Pennzoil and the IRS Appeals Office are unable to reach a negotiated resolution of these tax issues, the IRS would forward a letter requiring Pennzoil to pay the assessed taxes, plus the accrued interest, within 90 days, unless Pennzoil files a petition with the United States Tax Court. If Pennzoil were to choose to file suit in the Tax Court, Pennzoil would not pay any taxes unless and until the Tax Court rendered a judgment against Pennzoil, but interest would continue to accrue on any taxes ultimately determined to be due. Alternatively, Pennzoil would be entitled to choose to pay the assessed taxes, plus the accrued interest, and file a claim for a refund in either the United States Court of Claims or the United States District Court for the Southern District of Texas. Paying the assessed taxes would halt the accrual of interest on any taxes finally determined to be owing by Pennzoil. In such event, any refund to Pennzoil would include a refund by the IRS of the prior interest paid by Pennzoil, as well as a payment by the IRS of additional interest accrued on the assessed taxes previously paid by Pennzoil. If litigation is necessary, a case of this kind would normally take several years in the absence of a settlement, which could occur at any stage in the process. Pennzoil had cash and cash equivalents and current marketable securities and other investments of $946.6 million at December 31, 1993 and approximately $850 million at March 1, 1994. As a result of these available liquid assets and Pennzoil's available credit facilities, Pennzoil believes that it has the financial flexibility to deal with any eventuality that may occur in connection with the dispute with the IRS, including the possibility of paying the taxes assessed, plus the accrued interest, and suing for a refund if Pennzoil is not able to resolve the disputed matters through discussions with the IRS. Deferred income taxes originally resulted from the timing difference in the recognition of the settlement income for tax and financial reporting purposes under the deferred method of accounting for income taxes and not from the accrual of a contingency reserve for taxes due in the event Pennzoil's tax reporting position ultimately were determined to be incorrect. Under the liability method of accounting for income taxes adopted by Pennzoil in December 1992, since the excess of the financial reporting basis over the tax basis of Pennzoil's investment in Pennzoil Petroleum is not expected to result in a future income tax liability, deferred income taxes attributable to the 15,750,000 shares of Chevron common stock exchanged for the stock of Pennzoil Petroleum have been reflected as a reduction of the cost of Pennzoil's investment in Pennzoil Petroleum. Deferred income taxes remain related to the 9,035,518 shares of Chevron common stock currently owned by Pennzoil. Resolution of the tax dispute could result in an increase in the carrying cost of Pennzoil's investment in Pennzoil Petroleum and, therefore, an increase in future depreciation, depletion and amortization expense. CAPITAL EXPENDITURES. Total capital expenditures for 1993 were $485.1 million, including $11.4 million of interest capitalized, representing an increase of $322.5 million from comparable 1992 capital expenditure levels. The table below summarizes the current 1994 capital budget by segment compared with 1993 and 1992 capital expenditures, excluding expenditures related to Pennzoil's acquisition of Pennzoil Petroleum in 1992. The capital budget is reassessed from time to time, and could, for example, be adjusted to reflect changes in oil and gas prices and other economic factors. - --------------- (1) The 1994 capital expenditures for this segment are net of expected recoveries from the gas utilization project in Azerbaijan. Pennzoil currently expects to generate funds for its budgeted 1994 capital expenditures from cash flows from operations, borrowings under its revolving credit facility, available cash, proceeds from future debt issuances or a combination of some or all of the foregoing. ENVIRONMENTAL MATTERS. Pennzoil continues to make capital and operating expenditures relating to the environment, including expenditures associated with the compliance with increasing federal, state and local environmental regulations. As they continue to evolve, environmental protection laws are expected to have an increasing impact on Pennzoil's operations. In connection with pollution abatement efforts related to current operations, Pennzoil made capital expenditures of approximately $35 million in 1993. The 1993 expenditures included $26.6 million for a diesel desulphurization and dewaxing project at the Atlas refinery in Shreveport, Louisiana, which was required to meet the new regulations promulgated under the federal Clean Air Act. Capital expenditures in connection with pollution abatement are expected to be approximately $18 million in 1994. Pennzoil's recurring operating expenditures relating to environmental compliance activities are not material. Pennzoil is subject to certain laws and regulations relating to environmental remediation activities associated with past operations, such as the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA"), the Resource Conservation and Recovery Act and similar state statutes. In response to liabilities associated with these activities, accruals have been established when reasonable estimates are possible. Such accruals primarily include estimated costs associated with remediation. Pennzoil has not used discounting in determining its accrued liabilities for environmental remediation, and no claims for possible recovery from third party insurers or other parties related to environmental costs have been recognized in Pennzoil's consolidated financial statements. Pennzoil adjusts the accruals when new remediation responsibilities are discovered and probable costs become estimable, or when current remediation estimates must be adjusted to reflect new information. Pennzoil's assessment of the potential impact of these environmental laws is subject to uncertainty due to the difficult process of estimating and refining remediation costs that are subject to ongoing and evolving change. Initial estimates of remediation costs reflect a broad-based analysis of site conditions and potential environmental and human health impacts derived from preliminary site investigations (including soil and water analysis, migration pathways, and potential risk). Later changes to initial estimates may be based on additional site investigations, completion of feasibility studies (comparing and selecting from among various remediation methods and technologies) and risk assessments (determining the degree of current and future risk to the environment and human health, based on current scientific and regulatory criteria) and finally the actual implementation of the remediation plan. This process occurs over relatively long periods of time and is sequential, highly influenced by regulatory and community approval processes and subject to ongoing development of remediation technologies. Pennzoil's assessment analysis takes into account the state of the process each site is in at the time of estimation, the degree of uncertainty surrounding the estimates for each phase of remediation and other site specific factors. In connection with Pennzoil's disposition of Purolator, Pennzoil and Purolator entered into an indemnification agreement pursuant to which Pennzoil has agreed to reimburse Purolator for costs and expenses of certain environmental remediation relating to a plant operated by Purolator in Elmira Heights, New York, and certain environmental remediation, if any, relating to one other site located near the Elmira facility and a landfill site located in Metamora, Michigan. The indemnification provided by Pennzoil applies to all remediation required by Purolator under CERCLA that has been identified at the Elmira facility in the Environmental Protection Agency's September 1992 Record of Decision with respect to the Elmira facility, but does not extend to certain additional environmental expenditures relating to the Elmira facility or other sites for which Purolator is or may be held responsible. Pennzoil had a reserve of $16.3 million and $17.7 million recorded with respect to its obligations under its indemnification agreement with Purolator as of December 31, 1993 and 1992, respectively. Certain of Pennzoil's subsidiaries are involved in matters in which it has been alleged that such subsidiaries are potentially responsible parties ("PRPs") under CERCLA or similar state legislation with respect to various waste disposal areas owned or operated by third parties. In addition, certain of Pennzoil's subsidiaries are involved in other environmental remediation activities, including the removal, inspection and replacement, as necessary, of underground storage tanks. As of December 31, 1993 and 1992, Pennzoil's consolidated balance sheet included accrued liabilities for environmental remediation of $33.1 million and $34.2 million, respectively, which amounts include reserves with respect to Pennzoil's obligations under its indemnification agreement with Purolator referred to in the previous paragraph. Of these reserves, $4.8 million and $4.9 million is reflected on the consolidated balance sheet as other current liabilities as of December 31, 1993 and 1992, respectively, and $28.3 million and $29.3 million is reflected as other liabilities as of December 31, 1993 and 1992, respectively. Pennzoil does not currently believe there is a reasonable possibility of incurring additional material amounts in excess of the current accruals recognized for such environmental remediation activities. With respect to the sites in which Pennzoil subsidiaries are PRPs, Pennzoil's conclusion is based in large part on (i) the availability of defenses to liability, including the availability of the "petroleum exclusion" under CERCLA and similar state laws, and/or (ii) Pennzoil's current belief that its share of wastes at a particular site is or will be less than the threshold deemed by the Environmental Protection Agency or recognized by the relevant group of PRPs as being de minimis (and as a result Pennzoil's monetary exposure is not expected to be material). OTHER MATTERS. Pennzoil does not currently consider the impact of inflation to be significant in the businesses in which Pennzoil operates. Reference is made to Notes 1 and 6 of Notes to Consolidated Financial Statements for a discussion of the impact that recently issued accounting standards are expected to have on Pennzoil's consolidated financial statements, when adopted. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Pennzoil, together with the report thereon of Arthur Andersen & Co. dated March 4, 1994 and the supplementary financial data specified by Item 302 of Regulation S-K, are set forth on pages through hereof. (See Item 14 for Index.) ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information appearing under the captions "Nominees," "Directors with Terms Expiring in 1995 and 1996" and "Compliance with Section 16(a) of the Exchange Act" set forth within the section entitled "Election of Directors" in Pennzoil's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. See also Item S-K 401(b) appearing in Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information appearing under the captions "Director Remuneration," "Executive Compensation" and "Compensation Committee Interlocks and Insider Participation" set forth within the section entitled "Election of Directors" in Pennzoil's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing under the caption "Security Ownership of Directors and Officers" set forth within the section entitled "Election of Directors" and under the caption "Security Ownership of Certain Shareholders" set forth within the section entitled "Additional Information" in Pennzoil's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions Concerning Continuing Directors" and "Certain Transactions Concerning Retiring Directors" set forth within the section entitled "Election of Directors" and under the caption "Security Ownership of Certain Shareholders" set forth within the section entitled "Additional Information" in Pennzoil's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (A)(1) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The supplementary financial data specified by Item 302 of Regulation S-K are included in the Supplemental Financial and Statistical Information -- Unaudited beginning on page. (A)(2) FINANCIAL STATEMENT SCHEDULES. Other schedules of Pennzoil and its subsidiaries are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements or notes thereto. (A)(3) EXHIBITS. - --------------- * Incorporated by reference. + Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to the requirements of Item 14(c) of Form 10-K. (B) REPORTS ON FORM 8-K. During the fourth quarter of 1993, Pennzoil filed a Current Report on Form 8-K with the SEC dated as of November 26, 1993 to report the completion of the sale of 8,158,582 shares of the common stock of Chevron. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 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. PENNZOIL COMPANY By: JAMES L. PATE ---------------------------------- (JAMES L. PATE, PRESIDENT AND CHIEF EXECUTIVE OFFICER) Date: March 11, 1994 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. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Pennzoil Company: We have audited the accompanying consolidated balance sheet of Pennzoil Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pennzoil Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 8 to the Consolidated Financial Statements, in January 1994, the Company received a letter and examination report from the District Director of the Internal Revenue Service ("IRS") that proposes a tax deficiency based on an audit of the Company's 1988 federal income tax return. The proposed tax deficiency relates primarily to the Company's tax reporting position with regard to the receipt of $3.0 billion in 1988 in settlement of certain litigation. Deferred income taxes were provided in the Consolidated Financial Statements in 1988 in connection with the Company's receipt of the $3.0 billion settlement; however, no accrual has been made for interest on the proposed tax deficiency. The Company has filed a protest with the IRS asserting the Company's disagreement with the examination report; however, the ultimate outcome of this matter is not presently determinable. As discussed in Note 2 to the Consolidated Financial Statements, as of January 1, 1992, the Company changed its method of accounting for income taxes. Also, as discussed in Note 6 to the Consolidated Financial Statements, as of January 1, 1991, the Company changed its method of accounting for postretirement benefit costs other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The financial statement schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Houston, Texas March 4, 1994 [THIS PAGE INTENTIONALLY LEFT BLANK] PENNZOIL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME See Notes to Consolidated Financial Statements. PENNZOIL COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET ASSETS See Notes to Consolidated Financial Statements. PENNZOIL COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET LIABILITIES AND SHAREHOLDERS' EQUITY See Notes to Consolidated Financial Statements. PENNZOIL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY See Notes to Consolidated Financial Statements. PENNZOIL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See Notes to Consolidated Financial Statements. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- Principles of Consolidation -- The accompanying consolidated financial statements include all majority-owned subsidiaries of Pennzoil Company ("Pennzoil"). All significant intercompany accounts and transactions have been eliminated. Certain prior period items have been reclassified in the Consolidated Financial Statements in order to conform with the current year presentation. The results of operations of Pennzoil Petroleum Company ("Pennzoil Petroleum") have been included in Pennzoil's consolidated financial statements subsequent to October 30, 1992 (see Note 10). Marketable Securities and Other Investments -- At December 31, 1993, marketable securities and other investments included in current assets were comprised of domestic commercial paper, Federal National Mortgage Association notes, a certificate of deposit and treasury bills. Marketable securities and other investments are carried at the lower of aggregate cost or market value, as shown below. As of December 31, 1993 and 1992, Pennzoil beneficially owned 9,035,518 shares and 17,194,100 shares, respectively, of the common stock of Chevron Corporation ("Chevron"). At March 4, 1994, the closing price for Chevron common stock on the New York Stock Exchange was $88.25 per share. Realized gains on Pennzoil's remaining investment in Chevron common stock could be limited as a result of the issuance of Pennzoil's 6 1/2% Exchangeable Senior Debentures due January 15, 2003 (the "6 1/2% Debentures") and 4 3/4% Exchangeable Senior Debentures due October 1, 2003 (the "4 3/4% Debentures"), all of which are exchangeable at the option of the holders thereof for shares of Chevron common stock owned by Pennzoil. Reference is made to Note 3 for additional information. In November 1993, Pennzoil sold 8,158,582 shares of Chevron common stock in a block trade on the New York Stock Exchange for a price of $89.00 per share before commissions ($88.38 per share net of commissions). The sale resulted in a net realized gain of $137.0 million ($171.6 million before tax), or $3.25 per share. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The cost of the securities sold is based on the average cost of each security held at the time of sale. Other income effects from marketable securities and other investments are discussed under the caption "Investment and Other Income, Net" below. In May 1993, the Financial Accounting Standards Board ("FASB") issued a new standard on accounting for certain investments in debt and equity securities. This standard requires that, except for debt securities classified as "held-to-maturity securities," investments in debt and equity securities must be reported at fair value. As a result of the standard, Pennzoil's remaining investment in Chevron common stock will be reported at fair value, with unrealized gains or losses excluded from earnings and reported as a separate component of shareholders' equity. Adoption of the standard by Pennzoil is required effective January 1, 1994. Based on December 31, 1993 fair values, adoption of the standard would increase shareholders' equity by approximately $107 million. Investment and Other Income, Net -- Other revenues, net of related expenses, are included in investment and other income, net, and consist of the following: Substantially all interest and dividend income is from marketable securities and other cash investments. Receivables -- Current receivables include trade accounts and notes receivable and are net of allowances for doubtful accounts of $10.0 million in 1993 and $10.1 million in 1992. Long-term receivables consist of notes receivable and are net of allowances for doubtful accounts of $4.2 million in 1993 and $8.2 million in 1992. At December 31, 1993 and 1992, current receivables included notes receivable of $12.6 million and $13.0 million, respectively. Other assets included long-term notes receivable of $44.7 million and $31.8 million at December 31, 1993 and 1992, respectively. In May 1993, the FASB issued a new standard on accounting by creditors for impairment of loans. This standard requires certain impaired loans to be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Adoption of the standard by Pennzoil is required no later than the first quarter of 1995, although earlier implementation is permitted. Pennzoil currently expects to adopt the standard effective January 1, 1995. Based on a preliminary review, Pennzoil does not expect that adoption of the standard will have a material effect on its financial condition or results of operations. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Inventories -- A majority of inventories are reported at cost using the last-in, first-out ("LIFO") method, which is lower than market. Substantially all other inventories are reported at cost using the first-in, first-out method. Inventories valued on the LIFO method totaled $131.2 million at December 31, 1993 and $134.3 million at December 31, 1992. The current cost of LIFO inventories was approximately $178.8 million and $207.9 million at December 31, 1993 and 1992, respectively. Oil and Gas Producing Activities and Depreciation, Depletion and Amortization -- Pennzoil follows the successful efforts method of accounting for oil and gas operations. Under the successful efforts method, lease acquisition costs are capitalized. Significant unproved properties are reviewed periodically on a property-by-property basis to determine if there has been impairment of the carrying value, with any such impairment charged currently to exploration expense. All other unproved properties are generally aggregated and a portion of such costs estimated to be nonproductive, based on historical experience, is amortized on an average holding period basis. Exploratory drilling costs are capitalized pending determination of proved reserves. If proved reserves are not discovered, the exploratory drilling costs are expensed. Other exploration costs are also expensed. All development costs are capitalized. Provision for depreciation, depletion and amortization is determined on a field-by-field basis using the unit-of-production method. Estimated costs of future dismantlement and abandonment of wells and production platforms, net of salvage values, are accrued as part of depreciation, depletion and amortization expense using the unit-of-production method; actual costs are charged to accumulated depreciation, depletion and amortization. The carrying amounts of proven properties are reviewed periodically and an impairment reserve is provided as conditions warrant. Pennzoil follows the sales method of accounting for natural gas imbalances. Under the sales method, revenue is recognized on all production delivered by Pennzoil to its purchasers, regardless of Pennzoil's ownership interest in the respective property. At December 31, 1993, Pennzoil's gas imbalance reflects a net underproduced position of 17 billion cubic feet of gas. The company expects to recover this imbalance from its co-owners through future production or alternative arrangements. Sulphur properties are generally depreciated and depleted on the unit-of-production method, except assets having an estimated life less than the estimated life of the mineral deposits, which are depreciated on the straight-line method. All other properties are depreciated on straight-line or accelerated methods in amounts calculated to allocate the cost of properties over their estimated useful lives. Environmental Expenditures -- Environmental expenditures are expensed or capitalized in accordance with generally accepted accounting principles. Liabilities for these expenditures are recorded when it is probable that obligations have been incurred and the amounts can be reasonably estimated. Intangible Assets -- Substantially all intangible assets, included in other assets in the accompanying consolidated balance sheet, relate to goodwill recognized in business combinations accounted for as purchases. Goodwill included in other assets in the accompanying consolidated balance sheet was $86.2 million at December 31, 1993 and $82.3 million at December 31, 1992, net of accumulated amortization of $17.2 million and $11.2 million, respectively. Goodwill is being amortized on a straight-line basis over periods ranging from 20 to 40 years. Amortization expense recorded during 1993 and 1992 was $8.1 million and $5.2 million, respectively. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Cash Flow Information -- For purposes of the consolidated statement of cash flows, all highly liquid investments purchased with a maturity of three months or less are considered to be cash equivalents. The effect of changes in foreign exchange rates on cash balances has been immaterial. Cash used in operating activities includes cash payments for interest (net of amounts capitalized) of $183.6 million, $228.9 million and $246.8 million in 1993, 1992 and 1991, respectively. Interest capitalized for 1993, 1992 and 1991 was $11.4 million, $8.7 million and $10.4 million, respectively. Income taxes paid, net of refunds, during 1993, 1992 and 1991 were $5.5 million, $2.2 million and $13.7 million, respectively. Changes in operating assets and liabilities, net of effects from the purchases of equity interests in certain businesses acquired, consist of the following: Earnings Per Share -- Earnings per share are computed based on the weighted average shares of common stock outstanding. The average shares used in earnings per share computations for the years 1993, 1992 and 1991 were 42,187,739, 40,582,451 and 40,346,652, respectively. Foreign Operations -- Consolidated income (loss) from continuing operations before income tax includes losses from foreign operations of $17.3 million, $21.7 million and $10.0 million in 1993, 1992 and 1991, respectively. (2) INCOME TAXES -- Accounting for Income Taxes -- In December 1992, Pennzoil announced its decision to change its method of accounting for income taxes by adopting the new requirements of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective as of January 1, 1992. Previous 1992 interim period results were restated as a result of the adoption. Prior year financial statements have not been restated to reflect the new accounting method. As a result of adopting SFAS No. 109, Pennzoil recognized a cumulative, one-time benefit from the change in accounting principle for periods prior to 1992 of $115.7 million, or $2.85 per share, as of the first quarter of 1992. In addition to the cumulative effect, income from continuing operations for the year ended December 31, 1992, increased $3.4 million ($4.5 million before tax), or $.08 per share, associated with adopting the new standard. SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Prior to adoption of SFAS No. 109, deferred income taxes resulted from timing differences in the recognition of revenue and expense for tax and financial purposes. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Federal, State and Foreign -- Federal, state and foreign income tax expense (benefit) for continuing operations consists of the following: Reference is made to Note 3 for information regarding the tax benefit applicable to the extraordinary loss on the early retirement of debt. In addition, reference is made to Note 6 for information regarding the deferred tax benefit applicable to the cumulative effect of the change in accounting for postretirement benefit costs other than pensions. Pennzoil's net deferred tax liability is as follows: Temporary differences and carryforwards which gave rise to significant portions of deferred tax assets and liabilities are as follows: PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Prior to adopting SFAS No. 109, the sources of timing differences resulting from the recognition of revenue and expense for tax and financial reporting purposes and the tax effect of each were as follows: The principal items accounting for the difference in income taxes on income from continuing operations computed at the federal statutory rate and as recorded are as follows: In August 1993, the Omnibus Budget Reconciliation Act of 1993 was enacted, establishing a new 35% corporate income tax rate effective January 1, 1993. As a result of the increase in the marginal income tax rate and other tax law changes, Pennzoil recorded a one-time, non-cash charge of approximately $16 million, or $.38 per share, in the third quarter of 1993 to adjust its deferred income tax liabilities and assets for the effect of the change in income tax rates. The tax liability resulting from the November 1993 sale of 8,158,582 shares of Chevron common stock was reduced by $25.5 million as a result of the utilization of a net operating loss carryforward (see Note 1). Realization of the net operating loss carryforward resulted in the reversal of a valuation allowance related to the deferred tax asset. As of December 31, 1993, Pennzoil had a United States net operating loss carryforward of approximately $133 million, which is available to reduce future regular income taxes payable. Additionally, for purposes of determining alternative minimum tax, an approximately $7 million net operating loss is available to offset future alternative minimum taxable income. Utilization of these regular and alternative minimum tax net operating losses, to the extent generated in separate return years, is limited based on the separate taxable PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) income of the subsidiary, or its successor, generating the loss. If not used, these carryovers will expire in the years 1998 to 2004. In addition, Pennzoil has approximately $195 million of alternative minimum tax credits indefinitely available to reduce future regular tax liability to the extent it exceeds the related alternative minimum tax otherwise due. All net operating loss and credit carryover amounts are subject to examination by the tax authorities. Reference is made to Note 8 for information regarding a letter and examination report received from the District Director of the Internal Revenue Service ("IRS") in January 1994 that proposes a tax deficiency based on an audit of Pennzoil's 1988 federal income tax return. (3) DEBT -- Long-term debt outstanding was as follows: In August 1993, Pennzoil entered into an amended and restated credit facility with a group of banks that provides for up to $600.0 million of unsecured revolving credit borrowings through August 19, 1994, with any outstanding borrowings on such date being converted into a term credit facility terminating on September 1, 1995. A facility fee of .15% per annum is payable on the aggregate amount of the banks' commitments. This amended and restated credit facility replaces and supersedes the previous revolving credit facilities of Pennzoil and Pennzoil Exploration and Production Company ("PEPCO"), a wholly owned subsidiary of Pennzoil. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Borrowings under the facility totaled $195.0 million at December 31, 1993. The average interest rate applicable to amounts outstanding under this facility and the previous revolving credit facilities of Pennzoil and PEPCO was 3.59% during 1993. Prior to August 1993, PEPCO had a revolving credit facility with a group of banks to provide for unsecured borrowings. A commitment fee of .20% per annum was payable on the average daily unborrowed amount under the facility. Outstanding borrowings under this facility totaled $72.1 million at December 31, 1992. The average interest rate applicable to amounts outstanding under this facility was 4.10% during 1992. Also prior to August 1993, Pennzoil had a $500.0 million revolving credit facility with a group of banks to provide for unsecured revolving credit borrowings. A commitment fee of .15% per annum was payable on the average daily unborrowed amount under the facility. Outstanding borrowings under this facility totaled $207.7 million at December 31, 1992. The average interest rate applicable to amounts outstanding under this facility was 4.15% during 1992. Pennzoil's Board of Directors has increased the limit on the aggregate amount of commercial paper that Pennzoil may issue under its domestic commercial paper program and/or its Euro-commercial paper program from $150.0 million to $250.0 million. Borrowings under Pennzoil's commercial paper facilities totaled $249.4 million and $147.3 million at December 31, 1993 and 1992, respectively, and are included in notes payable in the accompanying consolidated balance sheet. The average interest rates applicable to outstanding commercial paper were 3.26% and 3.81% during 1993 and 1992, respectively. Pennzoil has several short-term variable-rate credit arrangements with certain banks. Pennzoil's Board of Directors has limited borrowings under these credit arrangements to $200.0 million. Outstanding borrowings totaled $183.6 million and $192.1 million at December 31, 1993 and 1992, respectively, and are included in notes payable in the accompanying consolidated balance sheet. The average interest rates applicable to amounts outstanding under these arrangements were 3.35% and 3.87% during 1993 and 1992, respectively. None of the banks has any obligation to continue to extend credit after the maturities of outstanding borrowings or to extend the maturities of any borrowings under these credit arrangements. In December 1992, Pennzoil called for redemption $272.9 million principal amount of indebtedness (including $250.0 million of Pennzoil's 10 5/8% debentures due 2018 and $22.9 million of Pennzoil's 10% debentures due 2011), using proceeds from the disposition of Purolator Products Company ("Purolator"), from the disposition of certain oil and gas properties and from cash contributed by Chevron to Pennzoil Petroleum for the benefit of Pennzoil. The redemptions were completed in February 1993. As of December 31, 1992, this indebtedness was defeased by placing funds required for the redemption with the trustee for the indebtedness. As a result, the funds deposited with the trustee for the redemption of the debentures and the principal amount of the indebtedness are not reflected in Pennzoil's consolidated balance sheet at December 31, 1992. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $16.6 million ($25.2 million before tax), or $.41 per share, in the fourth quarter of 1992. In 1993, Pennzoil completed public offerings of $402.5 million of the 6 1/2% Debentures and $500.0 million of the 4 3/4% Debentures. The 6 1/2% Debentures and the 4 3/4% Debentures are exchangeable at the option of the holders thereof at any time prior to maturity, unless previously redeemed, for shares of Chevron common stock owned by Pennzoil at exchange rates of 11.887 shares and 8.502 shares, respectively, per $1,000 principal amount of the 6 1/2% Debentures and the 4 3/4% Debentures (the equivalent of $84 1/8 per share and $117 5/8 per share, respectively), subject to adjustment in certain events. In lieu of delivering certificates representing shares of Chevron common stock in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures, Pennzoil may, at its option, pay to any holder surrendering the 6 1/2% Debentures and the 4 3/4% Debentures an amount in cash equal to the market price of the shares for which the 6 1/2% Debentures and the 4 3/4% Debentures are PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) exchangeable. Pennzoil has deposited 9,035,518 shares of Chevron common stock deliverable in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures with exchange agents. Under the instruments governing the 6 1/2% Debentures and the 4 3/4% Debentures, Pennzoil may not pledge, mortgage, hypothecate or grant a security interest in, or permit any mortgage, pledge, security interest or other lien upon, the shares of Chevron common stock deposited with exchange agents and deliverable in exchange for the 6 1/2% Debentures and the 4 3/4% Debentures. Pennzoil may at any time obtain from the exchange agents or otherwise authorize or direct the exchange agents to release all or part of the 9,035,518 shares of Chevron common stock deposited with the exchange agents. However, in the event Pennzoil obtains or otherwise releases any shares of Chevron common stock subject to exchange, each holder of a 6 1/2% Debenture or a 4 3/4% Debenture will generally have the right, at such holder's option, to require Pennzoil to repurchase all or a portion of such holder's debentures at a premium. In March 1993, using proceeds from the sale of the 6 1/2% Debentures, Pennzoil redeemed $223.4 million principal amount of indebtedness (including $80.1 million of Pennzoil's 12 1/8% and 12 1/4% debentures due 2007, $100.0 million of Pennzoil's 9 1/8% notes due 1996 and $43.3 million of Pennzoil's 9% debentures due 2001). The call premiums and related unamortized net premiums and debt issue costs relating to the redemption of these series of indebtedness resulted in a charge of $1.4 million, net of tax, or $.02 per share, for the first quarter of 1993. Also with such proceeds, approximately $23.3 million of additional indebtedness has been retired, repaid or repurchased in 1993 and $100.0 million principal amount of Pennzoil's 9% notes was retired upon maturity in May 1993. In June 1993, Pennzoil called for redemption $96.1 million principal amount of indebtedness (including $66.1 million of Pennzoil's 10% debentures due 2011 and $30.0 million of Pennzoil's 10 1/8% debentures due 2011). The redemptions were completed in July 1993. The funds used for these redemptions were obtained from (i) the cash proceeds from the completed sale of a subsidiary holding Pennzoil's Indonesian gold properties in January 1993, (ii) the cash proceeds from the sale in March 1993 of common stock of Pogo Producing Company held by Pennzoil and (iii) the cash payments received from Chevron from and as a result of the net cash flows from operations of the oil and gas properties of Pennzoil Petroleum through March 31, 1993. The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $4.7 million ($7.2 million before tax), or $.12 per share, in the second quarter of 1993. In September 1993, Pennzoil called for redemption $292.5 million principal amount of indebtedness (including $120.0 million of Pennzoil's 10 1/8% debentures due 2011, $111.0 million of Pennzoil's 10% debentures due 2011 and $61.5 million of Pennzoil's 9% debentures due 2017). The redemptions were completed in November 1993. The funds used for these redemptions were obtained primarily from the net proceeds from the sale in September 1993 of 5,000,000 shares of Pennzoil common stock (see Note 7). The premiums and related unamortized discount and debt issue costs relating to these redemptions resulted in an extraordinary charge of $13.7 million ($21.1 million before tax), or $.33 per share, in the third quarter of 1993. In October 1993, using $350.0 million of the proceeds from the sale of the 4 3/4% Debentures, Pennzoil reduced its borrowings outstanding under its unsecured revolving credit facility. Also from such proceeds, Pennzoil redeemed $24.0 million principal amount of indebtedness in November 1993 (including $21.3 million of Pennzoil's 8 3/8% and 8 5/8% debentures due 1996 and $2.7 million of Pennzoil's 8 3/4% debentures due 2001). No significant gain or loss resulted from these early retirements. In May 1993, Jiffy Lube International, Inc. ("Jiffy Lube"), a wholly owned subsidiary of Pennzoil, repurchased at face value $20.0 million of its unsecured promissory notes which were originally issued in connection with Jiffy Lube's debt restructuring in January 1990 (see Note 10). Also issued in connection with Jiffy Lube's debt restructuring was a series of unsecured non-interest bearing promissory notes maturing over PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) seven years in the aggregate principal amount of approximately $15.1 million at December 31, 1993 (with a present value of approximately $11.5 million at December 31, 1993), the payment of which is contingent upon the future profitability of Jiffy Lube. Jiffy Lube also has $18.8 million in outstanding mortgages on certain real estate and buildings with interest rates ranging from 6.3% to 11.0% and maturing through 2012. The book value of the collateral securing these mortgages was $19.7 million at December 31, 1993. At December 31, 1993, amounts due within one year for Jiffy Lube include $17.4 million of the long-term mortgage debt described above that is in default as a result of the violation of certain covenants and cross-default provisions applicable to such debt. As a result, the applicable lenders could declare these obligations to be in default and exercise certain rights and remedies, including accelerating the maturity of the obligations so that they become immediately due and payable subject, in some cases, to certain notice periods and provisions allowing the curing of the defaults. Although these obligations are in technical default, Jiffy Lube has paid all principal and interest on such obligations when due. At December 31, 1993, sinking fund obligations and maturities of long-term debt for the years ending December 31, 1994 to 1998 were $19.6 million, $200.6 million, $5.4 million, $6.0 million and $1.7 million, respectively. Such maturities include $3.5 million, $3.5 million and $4.6 million for the years ending December 31, 1995 to 1997, respectively, related to Jiffy Lube's non-interest bearing promissory notes, the payment of which is contingent upon the future profitability of Jiffy Lube. These maturities of long-term debt include $17.4 million of Jiffy Lube's long-term debt in technical default classified as due within one year as discussed above. (4) FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK -- Financial Instruments with Off-Balance-Sheet Risk -- Pennzoil is a party to various financial instruments with off-balance-sheet risk as part of its normal course of business, including financial guarantees and contractual commitments to extend financial guarantees, credit and other assistance to customers, franchisees and other third parties. These financial instruments involve, to varying degrees, elements of credit risk which are not recognized in Pennzoil's consolidated balance sheet. In addition, in connection with Pennzoil's disposition of Purolator, Pennzoil entered into an agreement with certain banks to provide contingent credit support for a Purolator credit facility and an agreement with a government agency with respect to guarantees of benefits under certain of Purolator's employee benefit plans. The financial guarantees primarily relate to debt and lease obligation guarantees with expiration dates of up to twenty years issued to third parties to guarantee the performance of customers and franchisees in the fast lube industry. Commitments to extend credit are also provided to fast lube industry participants to finance equipment purchases, working capital needs and, in some cases, the acquisition of land and construction of improvements. Contractual commitments to extend credit and other assistance are in effect as long as certain conditions established in the respective contracts are met. Contractual commitments to extend financial guarantees are conditioned on the occurrence of specified events. The largest of these commitments is to provide a guarantee for letters of credit issued by third parties to meet the reinsurance requirements of Pennzoil's captive insurance subsidiary. This commitment has no stated maturity and is expected to vary in amount from year to year to meet the reinsurance requirements. Reserves established for reported and incurred but not reported insurance losses in the amount of $32.3 million and $30.7 million have been recognized in Pennzoil's consolidated balance sheet as of December 31, 1993 and 1992, respectively. The credit risk to Pennzoil is mitigated by the insurance subsidiary's portfolio of high-quality short-term investments used to collateralize the letter of credit. At December 31, 1993, the collateral was valued at approximately 137% of the credit risk. The credit support for the Purolator credit facility is contingent upon the occurrence of an acceleration of the debt under the facility after an event of default, but only if and to the extent Purolator has incurred certain PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) environmental expenses not covered by an indemnification agreement pursuant to which Pennzoil agreed to indemnify Purolator against necessary costs and expenses of certain environmental remediation activities currently required by the Environmental Protection Agency ("EPA") at specified Purolator sites (the indemnification is limited to remediation required solely as a result of contamination prior to the agreement) (see Note 8). In such event, Pennzoil would be required to pay to the banks an amount equal to the amount expended by Purolator for such unindemnified environmental expenses (in which case Purolator would become liable to Pennzoil for any such amount). The maximum amount of any such contingent payment is permanently reduced over time as the maximum amount available under the Purolator credit facility declines. As of December 31, 1993, the maximum amount of the contingent credit support was $23.1 million. In connection with Pennzoil's disposition of Purolator in December 1992, Pennzoil entered into an agreement with the Pension Benefit Guaranty Corporation ("PBGC"), pursuant to which Pennzoil agreed that, for up to five years, in the event of the termination of any or all the employee benefit plans of Purolator that are subject to Title IV of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and the inability of the PBGC in good faith to collect the amounts of any unfunded benefit liabilities under Purolator's plans from Purolator or any person controlling Purolator, Pennzoil would guarantee up to $7.0 million of such unfunded benefit liabilities. Following are the amounts related to Pennzoil's financial guarantees and contractual commitments to extend financial guarantees, credit and other assistance as of December 31, 1993 and 1992. Pennzoil's exposure to credit loss in the event of nonperformance by the other parties to these financial instruments is represented by the contractual or notional amounts. Decisions to extend financial guarantees and commitments and the amount of remuneration and collateral required are based on management's credit evaluation of the counterparties on a case-by-case basis. The collateral held varies but may include accounts receivable, inventory, equipment, real property, securities and personal assets. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Concentrations of Credit Risk -- Pennzoil extends credit to various companies in the oil and gas, motor oil and automotive products, fast lube and sulphur industries in the normal course of business. Within these industries, certain concentrations of credit risk exist. These concentrations of credit risk may be similarly affected by changes in economic or other conditions and may, accordingly, impact Pennzoil's overall credit risk. However, management believes that consolidated receivables are well diversified, thereby reducing potential credit risk to Pennzoil, and that allowances for doubtful accounts are adequate to absorb estimated losses as of December 31, 1993. Pennzoil's policies concerning collateral requirements and the types of collateral obtained for on-balance-sheet financial PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) instruments are the same as those described above under "Financial Instruments with Off-Balance-Sheet Risk." At December 31, 1993, receivables related to these group concentrations in the oil and gas, motor oil and automotive products, fast lube and sulphur industries were $182.8 million, $181.4 million, $36.9 million and $8.9 million, respectively, compared with $140.5 million, $184.5 million, $32.3 million and $20.3 million, respectively, at December 31, 1992. (5) FAIR VALUE OF FINANCIAL INSTRUMENTS -- The carrying amounts of Pennzoil's short-term financial instruments, including cash equivalents, current marketable securities and other investments, trade accounts receivable, trade accounts payable and notes payable, approximate their fair values based on the short maturities of those instruments and on quoted market prices, where such prices are available. The following table summarizes the carrying amounts and estimated fair values of Pennzoil's other financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instrument included above: Notes Receivable -- The estimated fair value of notes receivable is based on discounting future cash flows using estimated year-end interest rates at which similar loans have been made to borrowers with similar credit ratings for the same remaining maturities. Long-Term Investments -- The estimated fair value of long-term investments is based on quoted market prices at year end for those investments. Long-Term Debt -- The estimated fair value of Pennzoil's long-term debt is based on quoted market prices or, where such prices are not available, on estimated year-end interest rates of debt with the same remaining maturities and credit quality. Off-Balance-Sheet Financial Instruments -- The estimated fair value of certain financial guarantees written and commitments to extend financial guarantees is based on the estimated cost to Pennzoil to obtain third party letters of credit to relieve Pennzoil PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) of its obligations under such guarantees or, in the case of certain lease guarantees related to Jiffy Lube franchisees, the present value of expected future cash flows using a discount rate commensurate with the risks involved. Reference is made to Note 4 for further information regarding off-balance-sheet financial instruments. (6) BENEFIT PLANS -- Retirement Plans -- Substantially all employees are covered by non-contributory retirement plans which provide benefits based on the participants' years of service and compensation or stated amounts for each year of service. Annual contributions to the plans are made in accordance with the minimum funding provisions of ERISA where applicable, but not in excess of the maximum amount that can be deducted for federal income tax purposes. Net periodic pension cost for 1993, 1992 and 1991 included the following components: Actual return on plans' assets was $2.6 million, $6.2 million and $30.4 million in 1993, 1992 and 1991, respectively. Assumptions used were: PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table sets forth the plans' funded status and amounts recognized in the consolidated balance sheet: The plans' assets include equity securities, common trust funds and various debt securities. Unrecognized prior service cost is amortized on a straight-line basis over a period equal to the average of the expected future service of active employees expected to receive benefits under the respective plans. Postretirement Health Care and Life Insurance Benefits -- Pennzoil sponsors several unfunded defined benefit postretirement plans covering most salaried and hourly employees. The plans provide medical and life insurance benefits and are, depending on the type of plan, either contributory or non-contributory. The accounting for the health care plans anticipates future cost-sharing changes that are consistent with Pennzoil's expressed intent to increase, where possible, contributions from future retirees to a minimum of 30% of the total annual cost. Furthermore, Pennzoil's future contributions for both current and future retirees have been limited, where possible, to 200% of the average 1992 benefit cost. In December 1991, Pennzoil announced its decision to change its method of accounting for postretirement benefit costs other than pensions by adopting the new requirements of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective as of January 1, 1991. Previous 1991 PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) interim period results were restated as a result of adopting the new standard. Pennzoil recorded a charge of $49.0 million ($74.2 million before tax), or $1.21 per share, as of the first quarter of 1991 to reflect the cumulative effect of the change in accounting principle for periods prior to 1991. The first quarter charge included $11.4 million ($17.3 million before tax) related to the cumulative effect of the change in accounting principle associated with Purolator. In addition to the cumulative effect, Pennzoil's 1991 postretirement health care and life insurance costs increased $1.7 million ($2.6 million before tax), or $.04 per share, as a result of adopting the new standard. Net periodic postretirement benefit cost for 1993, 1992 and 1991 included the following components: The following table sets forth the plans' combined status reconciled with the amount included in the consolidated balance sheet at December 31, 1993 and 1992: For measurement purposes, an 11% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1994; the rate was assumed to decrease gradually to 7% through the year 2001 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. An increase in the assumed health care cost trend rates by 1% in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $3.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $.3 million. The weighted-average discount rates used in determining the accumulated postretirement benefit obligation as of December 31, 1993 and 1992 were 7.5% and 8.25%, respectively. Contribution Plans -- Pennzoil has defined contribution plans covering substantially all employees who have completed one year of service. Employee contributions of not less than 1% to not more than 6% of each covered employee's compensation are matched between 50% and 100% by Pennzoil. The cost of such company contributions totaled $9.4 million in 1993, $9.1 million in 1992 and $8.1 million in 1991. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Postemployment Benefits -- In November 1992, the FASB issued a new standard on accounting for postemployment benefits. This standard requires employers to recognize the obligation to provide postemployment benefits if the obligation is attributable to employees' services already rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable and the amounts can be reasonably estimated. If those four conditions are not met, the employer should recognize the obligation to provide postemployment benefits when it is probable that a liability has been incurred and the amount can be reasonably estimated. Adoption of the standard by Pennzoil is required effective January 1, 1994. The standard does not represent a significant change from Pennzoil's current policy of recognizing postemployment benefit costs. As such, adoption of the standard will not have a material effect on Pennzoil's financial condition or results of operations. (7) CAPITAL STOCK AND STOCK OPTIONS -- Pennzoil's Restated Certificate of Incorporation authorizes the issuance of up to 9,747,720 shares of preferred stock. None of these shares were issued or outstanding at December 31, 1993. Pennzoil's Restated Certificate of Incorporation authorizes the issuance of up to 27,862,924 shares of preference common stock. None of these shares were issued or outstanding at December 31, 1993. Dividend rights on any preference common stock are junior to the rights of any preferred stock and senior to the rights of Pennzoil's common stock. In September 1993, Pennzoil completed the sale, pursuant to underwritten public offerings, of 5,000,000 shares of its common stock at a price of $62.50 per share. As of December 31, 1993, 45,910,307 shares of Pennzoil common stock were issued and outstanding. The net proceeds from the sale of the shares of Pennzoil common stock offered, prior to the payment of expenses, totaled approximately $303.3 million. Primarily utilizing funds from such offerings, Pennzoil redeemed an aggregate of $292.5 million principal amount of Pennzoil's debentures (see Note 3). Pro forma earnings per share for the year ended December 31, 1993, assuming the stock offering and redemption of debentures had occurred at the beginning of 1993, was $3.43 per share. At December 31, 1993, Pennzoil had 2,694,418 shares of common stock reserved for issuance upon the exercise of stock options and the maturity of conditional stock awards. At December 31, 1993, Pennzoil had nonqualified and incentive stock option plans covering a total of 2,620,565 shares of common stock (compared to 2,673,848 shares at December 31, 1992), of which 605,140 shares were available for granting of options. Options granted under the plans have a maximum term of ten years and are exercisable under the terms of the respective option agreements at the market price of the common stock at the date of grant, subject to antidilution adjustments in certain circumstances. At December 31, 1993, expiration dates for the outstanding options ranged from March 1994 to December 2003 and the average exercise price per share was $63.55. Payment of the exercise price may be made in cash or in shares of common stock previously owned by the optionee, valued at the then-current market value. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Additional information with respect to the stock option plans is as follows: In 1993, 24,150 units of common stock were granted to selected employees under Pennzoil's conditional stock award programs. Awards under the programs are made in the form of units which entitle the recipient to receive, at the end of a specified period, subject to certain conditions of continued employment, a number of shares equal to the number of units granted. At December 31, 1993, units covering 73,853 shares were outstanding (compared to 50,033 shares at December 31, 1992). In 1992, 24,200 shares of common stock were distributed to selected employees upon maturity of awards granted under Pennzoil's conditional stock award programs. (8) COMMITMENTS AND CONTINGENCIES -- Tax Dispute -- In 1988, Pennzoil received $3.0 billion from Texaco Inc. ("Texaco") in settlement of all litigation between Pennzoil and Texaco arising out of Texaco's tortious interference with Pennzoil's contractual rights to purchase a minority interest in Getty Oil Company. From 1989 through 1991, Pennzoil acquired 32,944,100 shares of Chevron common stock with approximately $2.2 billion of the net Texaco settlement proceeds. For financial reporting purposes, Pennzoil reported an extraordinary gain of $1.656 billion (after expenses and estimated current and deferred taxes), or $42.62 per share, associated with the $3.0 billion in cash received from Texaco in April 1988. For federal income tax purposes, Pennzoil originally reported that it recognized no gain upon receipt of the $3.0 billion and obtained no tax basis in the Chevron shares. Pennzoil's reporting position was based on its belief that, under Section 1033 of the Internal Revenue Code, the $3.0 billion received from Texaco was an amount realized as a result of the involuntary conversion of property and that the Chevron shares were similar or related in service or use to the property converted by Texaco. During 1990 and 1991, Pennzoil recalculated its 1988 federal income tax liability to recognize approximately $800 million of income, being the excess of the $3.0 billion received over the amount expended to acquire Chevron shares. As a result of these adjustments, current taxes were increased, and deferred taxes were decreased, by $120.4 million in 1990 and $13.2 million in 1991. In addition, Pennzoil paid interest on such taxes of $17.6 million during 1990 and $3.7 million in 1991. In January 1994, Pennzoil received a letter and examination report from the District Director of the IRS that proposes a tax deficiency based on an audit of Pennzoil's 1988 federal income tax return. The examination report proposes two principal adjustments with which Pennzoil disagrees. The first adjustment challenges Pennzoil's position under Section 1033 of the Internal Revenue Code that (i) at least $2.2 billion of the $3.0 billion cash payment received from Texaco in 1988 in settlement of certain litigation was realized as a result of the involuntary conversion of property and (ii) the shares of Chevron common stock purchased with $2.2 billion of the net Texaco settlement proceeds were similar or related in service or use to the property converted by Texaco. Although these issues have not been resolved, Pennzoil PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) believes that its position is sound, and it intends to contest the proposed adjustment in court unless an acceptable settlement is reached. The proposed tax deficiency relating to this proposed adjustment is $550.9 million, net of available offsets. Pennzoil estimates that the additional after-tax interest on this proposed deficiency would be approximately $234.3 million as of December 31, 1993. If Pennzoil's position is not sustained by the courts, Pennzoil would be required to pay the assessed taxes, plus the accrued interest, and Pennzoil's tax basis in the shares of common stock of Chevron and Pennzoil Petroleum (see Note 10) would be Pennzoil's cost. Pennzoil's consolidated financial statements do not include an accrual for the interest that would be due in such event. The second adjustment proposed by the IRS would permanently capitalize, rather than allow Pennzoil to deduct, approximately $366 million incurred by Pennzoil in 1988 and earlier years for litigation and related expenses in connection with the Texaco settlement, even if it were determined that the entire $3.0 billion is includable in Pennzoil's 1988 taxable income. Pennzoil believes that this proposed adjustment is irrational and capricious and will not be sustained in court. The proposed tax deficiency relating to the disallowance of deductions is $124.6 million, and the estimated additional after-tax interest on this proposed deficiency would be approximately $46.7 million as of December 31, 1993. If the deductions for legal and related expenses were ultimately disallowed, Pennzoil would be required to pay the assessed taxes, plus the accrued interest. Pennzoil's consolidated financial statements do not include an accrual for the taxes that would be assessed as a result of the proposed disallowance of deductions or the related interest that would be due in such event. Pennzoil has formally protested the IRS' proposed tax deficiency in writing within the required 30-day time period. The issue has been forwarded to the IRS Appeals Office, which is empowered to settle disputes with taxpayers, taking into account the hazards of litigation. If Pennzoil and the IRS Appeals Office are unable to reach a negotiated resolution of these tax issues, the IRS would forward a letter requiring Pennzoil to pay the assessed taxes, plus the accrued interest, within 90 days, unless Pennzoil files a petition with the United States Tax Court. If Pennzoil were to choose to file suit in the Tax Court, Pennzoil would not pay any taxes unless and until the Tax Court rendered a judgment against Pennzoil, but interest would continue to accrue on any taxes ultimately determined to be due. Alternatively, Pennzoil would be entitled to choose to pay the assessed taxes, plus the accrued interest, and file a claim for a refund in either the United States Court of Claims or the United States District Court for the Southern District of Texas. Paying the assessed taxes would halt the accrual of interest on any taxes finally determined to be owing by Pennzoil. In such event, any refund to Pennzoil would include a refund by the IRS of the prior interest paid by Pennzoil, as well as a payment by the IRS of additional interest accrued on the assessed taxes previously paid by Pennzoil. If litigation is necessary, a case of this kind would normally take several years in the absence of a settlement, which could occur at any stage in the process. Pennzoil had cash and cash equivalents and current marketable securities and other investments of $946.6 million at December 31, 1993 and approximately $850 million at March 1, 1994. As a result of these available liquid assets and Pennzoil's available credit facilities, Pennzoil believes that it has the financial flexibility to deal with any eventuality that may occur in connection with the dispute with the IRS, including the possibility of paying the taxes assessed, plus the accrued interest, and suing for a refund if Pennzoil is not able to resolve the disputed matters through discussions with the IRS. Deferred income taxes originally resulted from the timing difference in the recognition of the settlement income for tax and financial reporting purposes under the deferred method of accounting for income taxes and not from the accrual of a contingency reserve for taxes due in the event Pennzoil's tax reporting position ultimately were determined to be incorrect. Under the liability method of accounting for income taxes adopted by Pennzoil in December 1992, since the excess of the financial reporting basis over the tax basis of Pennzoil's investment in Pennzoil Petroleum is not expected to result in a future income tax liability, deferred income taxes attributable to the 15,750,000 shares of Chevron common stock exchanged for the stock of Pennzoil PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Petroleum have been reflected as a reduction of the cost of Pennzoil's investment in Pennzoil Petroleum. Deferred income taxes remain related to the 9,035,518 shares of Chevron common stock currently owned by Pennzoil (see Note 10). Curtailment Litigation -- United Gas Pipe Line Company ("United"), a former subsidiary of Pennzoil, curtailed deliveries of natural gas to its customers in accordance with priorities contained in its tariffs during the 1970s and early 1980s. Several lawsuits filed by industrial and power plant "direct sale" customers for damages allegedly caused by curtailments were brought against United, and Pennzoil was joined as a defendant in five of these suits. The only remaining suit against United involving Pennzoil is an action filed in the United States District Court for the Southern District of Mississippi on November 14, 1974 by Mississippi Power Co. ("MPCo"), which alleges damages of approximately $44.7 million and seeks to have such damages trebled pursuant to federal antitrust laws. In related proceedings before the Federal Energy Regulatory Commission ("FERC"), MPCo has introduced evidence indicating that its claimed damages (before trebling) have increased to approximately $88.2 million. The judge in the MPCo case has referred certain issues to the FERC and stayed all proceedings pending action by the FERC. No action has been taken to remove the stay. Pennzoil believes that it has no liability for any action it has taken or omitted to take, that it can successfully defend itself in the action and that the final outcome of the case will not have a material adverse effect on its financial condition or results of operations. Eaton v. Pennzoil Company -- In December 1992, two former employees of Pennzoil filed a purported class action lawsuit in the United States District Court for the Southern District of Texas, Galveston Division. The suit alleges that one of Pennzoil's deferred compensation plans had been improperly administered because of the absence of an adjustment under the plan for a significant event occurring in 1988 in determining the value of awards under the plan maturing in 1988 and 1990. The plaintiffs allege breach of contract, common law fraud and breach of fiduciary duty and seek compensatory and consequential damages of $40.0 million and punitive damages of $400.0 million. Pennzoil believes that the plan was administered properly and the lawsuit is without merit. In October 1993, the court granted Pennzoil's motion for summary judgment. The plaintiffs have appealed. Pennzoil believes that the outcome of this suit will not have a material adverse effect on its financial condition or results of operations. Environmental Matters -- Pennzoil is subject to certain laws and regulations relating to environmental remediation activities associated with past operations, such as the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA"), the Resource Conservation and Recovery Act and similar state statutes. In response to liabilities associated with these activities, accruals have been established when reasonable estimates are possible. Such accruals primarily include estimated costs associated with remediation. Pennzoil has not used discounting in determining its accrued liabilities for environmental remediation, and no claims for possible recovery from third party insurers or other parties related to environmental costs have been recognized in Pennzoil's consolidated financial statements. Pennzoil adjusts the accruals when new remediation responsibilities are discovered and probable costs become estimable, or when current remediation estimates must be adjusted to reflect new information. In connection with Pennzoil's disposition of Purolator, Pennzoil and Purolator entered into an indemnification agreement pursuant to which Pennzoil has agreed to reimburse Purolator for costs and expenses of certain environmental remediation relating to a plant operated by Purolator in Elmira Heights, New York, and certain environmental remediation, if any, relating to one other site located near the Elmira facility and a PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) landfill site located in Metamora, Michigan. The indemnification provided by Pennzoil applies to all remediation required by Purolator under CERCLA that has been identified at the Elmira facility in the EPA's September 1992 Record of Decision with respect to the Elmira facility, but does not extend to certain additional environmental expenditures relating to the Elmira facility or other sites for which Purolator is or may be held responsible. Pennzoil had a reserve of $16.3 million and a $17.7 million recorded with respect to its obligations under its indemnification agreement with Purolator as of December 31, 1993 and 1992, respectively. Reference is made to Note 11 for additional information. Certain of Pennzoil's subsidiaries are involved in matters in which it has been alleged that such subsidiaries are potentially responsible parties ("PRPs") under CERCLA or similar state legislation with respect to various waste disposal areas owned or operated by third parties. In addition, certain of Pennzoil's subsidiaries are involved in other environmental remediation activities, including the removal, inspection and replacement, as necessary, of underground storage tanks. As of December 31, 1993 and 1992, Pennzoil's consolidated balance sheet included accrued liabilities for environmental remediation of $33.1 and $34.2 million, respectively, which amounts include reserves with respect to Pennzoil's obligations under its indemnification agreement with Purolator referred to in the previous paragraph. Of these reserves, $4.8 million and $4.9 million is reflected on the consolidated balance sheet as other current liabilities as of December 31, 1993 and 1992, respectively, and $28.3 million and $29.3 million is reflected as other liabilities as of December 31, 1993 and 1992, respectively. Pennzoil does not currently believe there is a reasonable possibility of incurring additional material amounts in excess of the current accruals recognized for such environmental remediation activities. With respect to the sites in which Pennzoil subsidiaries are PRPs, Pennzoil's conclusion is based in large part on (i) the availability of defenses to liability, including the availability of the "petroleum exclusion" under CERCLA and similar state laws, and/or (ii) Pennzoil's current belief that its share of wastes at a particular site is or will be less than the threshold deemed by the EPA or recognized by the relevant group of PRPs as being de minimis (and as a result Pennzoil's monetary exposure is not expected to be material). FTC Matters -- The Federal Trade Commission ("FTC") has inquired as to Pennzoil's reliance on the investment exemption of Section 7A(c)(9) and Rule 802.9 under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, in connection with Pennzoil's investment in common stock of other entities. Pennzoil has provided the requested information to the FTC and has cooperated with the FTC in response to the inquiry. Franchisee Litigation -- Certain current and former Jiffy Lube franchisees have brought suit against Jiffy Lube to challenge various matters relating to the franchisor-franchisee relationship. Certain of the suits have included allegations against Pennzoil and/or Pennzoil Products Company ("PPC"), a wholly owned subsidiary of Pennzoil, as well. These franchisee lawsuits generally contain allegations of, among other things, certain misrepresentations by Jiffy Lube in connection with the execution of franchise and licensing agreements, certain breaches of these agreements by Jiffy Lube and/or certain breaches of fiduciary duty by Jiffy Lube. In some cases, conflicts of interest or conspiracy between Jiffy Lube and Pennzoil are also alleged. Pennzoil believes that the allegations in these lawsuits stem primarily from previous uncertainties surrounding Jiffy Lube's financial condition, financial difficulties experienced by certain franchisees and franchisees' concerns relating to the adequacy of services provided by Jiffy Lube prior to Pennzoil's initial acquisition of Jiffy Lube stock in January 1990 (see Note 10). Jiffy Lube, Pennzoil and/or PPC, as the case may be, have each denied the material allegations against them and intend to defend these actions vigorously. Pennzoil does not believe that the final outcome of these cases will have a material adverse effect on its financial condition or results of operations. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) LEASES -- As Lessee -- Pennzoil leases various assets and office space with lease periods of 1 to 20 years. Additionally, Pennzoil's wholly owned subsidiary Jiffy Lube leases sites and equipment which are subleased to franchisees or used in the operation of automotive fast lubrication and fluid maintenance service centers operated by Jiffy Lube. The typical lease period for the service centers is 20 years with escalation clauses generally increasing the lease payments by 9% every third year, with some leases containing renewal options generally for periods of five years. These leases, excluding leases for land that are classified as operating leases, are accounted for as capital leases and are capitalized using interest rates appropriate at the inception of each lease. Certain operating and capital lease payments are contingent upon such factors as the consumer price index or the prime interest rate with any future changes reflected in income as accruable. The effects of these changes are not considered material. Total operating lease rental expenses for Pennzoil (exclusive of oil and gas lease rentals) were $59.6 million, $56.2 million and $49.7 million for 1993, 1992 and 1991, respectively. Non-current capital lease obligations are classified as other liabilities in the accompanying consolidated balance sheet. Future minimum commitments under noncancellable leasing arrangements as of December 31, 1993 are as follows: Assets recorded under capital lease obligations of $65.3 million and $20.2 million at December 31, 1993 are classified as property, plant and equipment and other assets, respectively, in the accompanying consolidated balance sheet. As Lessor -- Pennzoil, through its wholly owned subsidiary Jiffy Lube, owns or leases numerous service center sites which are leased or subleased to franchisees. Buildings owned or leased that meet the criteria for direct financing leases are carried at the gross investment in the lease less unearned income. Unearned income is recognized in such a manner as to produce a constant periodic rate of return on the net investment in the direct financing lease. Any buildings leased or subleased that do not meet the criteria for a direct financing lease and any land leased or subleased are accounted for as operating leases. The typical lease period is 20 years and some leases contain renewal options. The franchisee is responsible for the payment of property taxes, insurance and maintenance costs related to the leased property. The net investment in direct financing leases is classified as other assets in the accompanying consolidated balance sheet. PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Future minimum lease payment receivables under noncancellable leasing arrangements as of December 31, 1993 are as follows: (10) ACQUISITIONS -- Acquisition of Pennzoil Petroleum -- In October 1992, Pennzoil completed a transaction with Chevron, pursuant to which Pennzoil exchanged 15,750,000 shares of Chevron common stock held by Pennzoil for all the capital stock of Pennzoil Petroleum, which owns Gulf of Mexico, Gulf Coast, Permian Basin and other domestic oil and gas producing properties. The exchange of stock has been accounted for using the purchase method of accounting, and Pennzoil Petroleum's results of operations subsequent to October 30, 1992 have been included in Pennzoil's consolidated financial statements. The fair market value of the 15,750,000 shares of Chevron common stock exchanged for the capital stock of Pennzoil Petroleum approximated Pennzoil's historical book value for such shares of $1.06 billion. Accordingly, Pennzoil used the net book value of the Chevron shares exchanged for purposes of purchase accounting. Included in the assets of Pennzoil Petroleum at the time of the transfer to Pennzoil was $57.4 million in cash contributed by Chevron to Pennzoil Petroleum immediately prior to closing, representing the net cash flow from Pennzoil Petroleum's operations during the four-month period between the "effective date" and the closing date of the transaction, after reduction as a result of nonrecurring closing adjustments of approximately $11 million. As a result of an audit completed during 1993, Chevron contributed an additional $9.9 million in cash to Pennzoil Petroleum, representing an adjustment to the initial $57.4 million cash contribution made by Chevron to Pennzoil Petroleum prior to closing. This additional contribution from Chevron was accounted for as an adjustment to the original purchase price of Pennzoil Petroleum. The following unaudited pro forma information has been prepared assuming that the acquisition of Pennzoil Petroleum had occurred at the beginning of the periods presented. Permitted pro forma adjustments include only the effects of events directly attributable to a transaction that are factually supportable and expected to have a continuing impact. Pro forma adjustments reflecting anticipated "efficiencies" in operations resulting from a transaction are, under most circumstances, not permitted. As a result of the limitations imposed with regard to the types of permitted pro forma adjustments, Pennzoil believes that this PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) unaudited pro forma information is not indicative of future results of operations, nor the results of historical operations had the acquisition of Pennzoil Petroleum been consummated as of the assumed dates. Acquisition of Jiffy Lube -- On January 8, 1990, Jiffy Lube, Pennzoil and Jiffy Lube's senior unsecured creditors consummated a plan of debt restructuring for Jiffy Lube, which resulted in the restructuring and reduction of Jiffy Lube's senior unsecured debt and the acquisition by Pennzoil of 80% of the common stock of Jiffy Lube. In connection with the Jiffy Lube debt restructuring plan, Pennzoil paid $28.5 million in cash to or on behalf of Jiffy Lube and exchanged Pennzoil's $15.0 million principal amount of Jiffy Lube's 12% Convertible Subordinated Debenture (including accrued and unpaid interest) as consideration for the shares of Jiffy Lube common stock acquired. The acquisition was accounted for using the purchase method of accounting, and the results of operations of Jiffy Lube have been included in Pennzoil's consolidated statement of income subsequent to January 8, 1990. On August 5, 1991, a newly formed Pennzoil subsidiary commenced a tender offer to acquire all Jiffy Lube shares not already owned by Pennzoil at a price of $6.00 per share, or approximately $9.3 million in the aggregate. Pursuant to the tender offer, Pennzoil acquired additional Jiffy Lube common stock, as a result of which Pennzoil held directly or indirectly in excess of 93% of the outstanding Jiffy Lube common stock. A merger between Jiffy Lube and the newly formed Pennzoil subsidiary became effective as of October 17, 1991, pursuant to which each remaining Jiffy Lube share not owned by Pennzoil was converted into the right to receive $6.00 in cash. As a result of the merger, Jiffy Lube is now a wholly owned subsidiary of Pennzoil. (11) DISCONTINUED OPERATIONS -- Filtration Products Segment -- In early 1990, Pennzoil decided to sell or otherwise dispose of Purolator. In connection with this decision, Pennzoil recorded a 1989 fourth quarter write-down of $125.0 million to reflect the estimated loss to be incurred from the then anticipated sale or other disposition of Purolator's filtration products operations, including estimated future costs and operating results from the segment until the date of disposition. In August 1991, Pennzoil concluded that, because of Purolator's improved performance, the intrinsic value of Purolator could be more effectively realized by retaining Purolator. Accordingly, in the third quarter of 1991, Pennzoil reclassified Purolator's net assets and results of operations for all periods as part of continuing operations. As a result of Pennzoil's decision to retain Purolator, the remaining reserve of $115.7 million for the estimated loss on the disposition of Purolator originally established in the fourth quarter of 1989 was reversed. Concurrent with the reversal of the reserve, Pennzoil recorded a provision of $108.0 million ($88.0 million after tax) to reflect losses due to asset impairment and other identified liabilities PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) related to Purolator. The following is a summary of the write-downs and other charges provided during the three months ended September 30, 1991 (in millions): (a) Write-Down of Goodwill -- In connection with the August 1991 decision not to dispose of Purolator, Pennzoil assessed the potential for loss recognition resulting from asset impairment and concluded that a portion of Purolator's goodwill was permanently impaired. Accordingly, a write-down of approximately $48.0 million was recorded. (b) Reserve for Environmental Costs -- Purolator is involved in certain waste disposal areas in which it has been alleged that it is a potentially responsible party under CERCLA or similar state legislation. In connection therewith, charges totaling $30.0 million were recorded to reflect a reserve for estimated cleanup and compliance costs. (c) Adjustment to Postretirement Benefit Liability Established at Acquisition - -- In connection with Pennzoil's 1988 acquisition of Purolator, a liability was established in the purchase price allocation for vested postretirement benefit obligations attributable to a specific group of Purolator retirees. Based on revised actuarial estimates, Pennzoil concluded that the remaining liability established for these retirees was understated and recorded a charge against earnings of $16.5 million. As of December 31, 1991, the net assets of discontinued operations have been reduced by a liability of $43.9 million attributable to these vested postretirement benefit obligations. (d) Other Write-Downs and Charges -- Write-downs of other individually non-significant assets of approximately $10.0 million were recorded representing Pennzoil's estimate of the net realizability of those investments. In addition, other charges of approximately $3.5 million were recorded to reflect other identified liabilities. Public Offerings -- In October 1992, as a result of Pennzoil's conclusion that disposal of Purolator's filtration products operations would enhance Pennzoil's efforts to focus on its strategic businesses and to reduce indebtedness, Purolator filed a registration statement pursuant to which Pennzoil offered to the public all shares of Purolator stock held by Pennzoil. Accordingly, Purolator's net assets and results of operations for all periods have been reclassified as discontinued operations for financial reporting purposes. In December 1992, Pennzoil sold in initial public offerings all its shares of capital stock of Purolator. The total amount received by Pennzoil, prior to the payment of expenses, from the net proceeds of the offerings and the repayment of indebtedness by Purolator was $206.0 million. Pennzoil also expects to receive a tax refund of approximately $23 million as a result of the transaction. Pennzoil recorded a net gain on the disposition of Purolator stock of $1.5 million ($20.0 million before tax loss), or $.04 per share, in the fourth quarter of 1992. In connection with Pennzoil's disposition of Purolator, Pennzoil and Purolator entered into an indemnification agreement with respect to certain environmental matters (see Note 8). In addition, Pennzoil entered into an agreement with certain banks to provide contingent credit support for a Purolator credit facility and an PENNZOIL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) agreement with a government agency with respect to guarantees of benefits under certain of Purolator's employee benefit plans (see Note 4). Income from discontinued operations is as follows: (12) SEGMENT FINANCIAL INFORMATION -- Information with respect to revenues, operating income and other data by industry segment is presented in Item 1, Business and Item 2, Properties of this Annual Report on Form 10-K. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED QUARTERLY RESULTS(1) -- - --------------- (1) Reference is made to Notes 1, 2, 3 and 10 of Notes to Consolidated Financial Statements for information on items affecting quarterly results. (2) Operating income is defined as net revenues less costs and operating expenses. (3) The total of the 1993 quarterly earnings (loss) per share amounts presented does not equal the annual 1993 earnings per share amount primarily due to the issuance of 5 million shares of Pennzoil's common stock during September 1993. Reference is made to Note 7 of Notes to Consolidated Financial Statements for additional information. OIL AND GAS INFORMATION Estimated Quantities of Proved Oil and Gas Reserves Presented on the following page are Pennzoil's estimated net proved oil and gas reserves as of December 31, 1993, 1992 and 1991. Reserves in the United States are located onshore in all the main producing states (except Alaska) and offshore Alabama, California, Louisiana, Mississippi and Texas. Foreign reserves are located in Canada. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) The estimates of proved oil and gas reserves have been prepared by Ryder Scott Company Petroleum Engineers ("Ryder Scott") and are based on data supplied by Pennzoil. The reports of Ryder Scott, which include a description of the basis used in preparing the estimated reserves, are included as exhibits to Pennzoil's Annual Reports on Form 10-K for the respective years. Oil includes crude oil, condensate and natural gas liquids. PROVED OIL RESERVES (MILLIONS OF BARRELS) PROVED NATURAL GAS RESERVES (BILLIONS OF CUBIC FEET) - --------------- (1) Purchases of minerals in place for 1992 include proved developed and undeveloped reserves attributable to Pennzoil Petroleum as of the date of acquisition (October 30, 1992). (2) Purchases and sales of minerals in place for 1993 include 5 million barrels of oil and 91 billion cubic feet ("Bcf ") of natural gas and 4 million barrels of oil and 93 Bcf of natural gas, respectively, associated with asset swaps. (3) United States natural gas reserves for 1993, 1992 and 1991 exclude 162 Bcf, 124 Bcf and 129 Bcf, respectively, of carbon dioxide gas for sale or use in company operations. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) Capitalized Costs and Costs Incurred Relating to Oil and Gas Producing Activities The following table shows the aggregate capitalized costs related to oil and gas producing activities and related accumulated depreciation, depletion and amortization and valuation allowances. The following table shows costs incurred in oil and gas producing activities (whether charged to expense or capitalized). - --------------- (1) Costs incurred for unproved property acquisition include approximately $98 million related to the gas utilization project in Azerbaijan. Pennzoil has signed a gas utilization agreement with the State Oil Company of the Azerbaijan Republic ("SOCAR") that provides for recovery of Pennzoil's costs incurred in connection with the gas utilization project by payment in hard currency or oil or petroleum products or as a credit against a signature bonus for the first exploration, exploitation and/or development contract entered into between Pennzoil and SOCAR in Azerbaijan. Total costs incurred during 1993 include $114 million related to Pennzoil's Azerbaijan activities. (2) Costs incurred for property acquisitions in 1992 include $1,009 million attributable to the acquisition of Pennzoil Petroleum. See Note 10 of Notes to Consolidated Financial Statements for additional information. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) Results of Operations From Oil and Gas Producing Activities This information is similar to the disclosures set forth in the "Industry Segment Financial Information" set forth on pages 1 and 2 herein but differs in several respects as to the level of detail, geographic presentation and income taxes. Income taxes were determined by applying the applicable statutory rates to pretax income with adjustment for tax credits and other allowances. Income tax provisions involved certain allocations among geographic areas based on management's assessment of the principal factors giving rise to the tax obligation. - --------------- (1) Foreign technical support and other during 1993 includes approximately $7 million related to Pennzoil's Azerbaijan activities. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves (Standardized Measure) The Standardized Measure is determined on a basis which presumes that year-end economic and operating conditions will continue over the periods during which year-end proved reserves would be produced. Neither the effects of future inflation nor expected future changes in technology and operating practices have been considered. The Standardized Measure is determined as the excess of future cash inflows from proved reserves less future costs of producing and developing the reserves, future income taxes and a discount factor. Future cash inflows represent the revenues that would be received from production of year-end proved reserve quantities assuming the future production would be sold at year-end prices plus any fixed and determinable future escalations (but not escalations based on inflation) of natural gas prices provided by existing contracts. As a result of the continued volatility in oil and natural gas markets, future prices received from oil, condensate and natural gas sales may be higher or lower than current levels. Future production costs include the estimated expenditures related to production of the proved reserves plus any production taxes without consideration of inflation. Future development costs include the estimated costs of drilling development wells and installation of production facilities, plus the net costs associated with dismantlement and abandonment of wells and production platforms, assuming year-end costs continue without inflation. Future income taxes were determined by applying current legislated statutory rates to the excess of (a) future cash inflows, less future production and development costs, over (b) the tax basis in the properties involved plus existing net operating loss carryforwards. Tax credits are considered in the computation of future income tax expenses. The discount was determined by applying a discount rate of 10% per year to the annual future net cash flows. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) The Standardized Measure does not purport to be an estimate of the fair market value of Pennzoil's proved reserves. An estimate of fair market value would also take into account, among other things, the expected recovery of reserves in excess of proved reserves, anticipated changes in future prices and costs and a discount factor more representative of the time value of money and the risks inherent in producing oil and gas. In the opinion of Pennzoil's management, the estimated fair value of Pennzoil's oil and gas properties is in excess of the amounts set forth below. - --------------- (1) Includes future dismantlement and abandonment costs, net of salvage values. (2) Future income taxes before discount were $896 million (U.S.) and $35 million (foreign) and $1,004 million (U.S.) and $20 million (foreign) for 1993 and 1992, respectively. PENNZOIL COMPANY AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL AND STATISTICAL INFORMATION -- UNAUDITED (CONTINUED) OIL AND GAS INFORMATION (CONTINUED) Changes in the Standardized Measure The following table sets forth the principal elements of the changes in the Standardized Measure for the years presented. All amounts are reflected on a discounted basis. SULPHUR INFORMATION Reference is made to Item 1, Business and Item 2, Properties under the caption "Sulphur -- Reserves, Production and Sales Information" for disclosures relative to sulphur reserves, production and sales information. PENNZOIL COMPANY AND SUBSIDIARIES SCHEDULE I -- MARKETABLE SECURITIES AND OTHER INVESTMENTS AT DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Maturities for the various securities and investments were as of the dates of the original investments. S-1 PENNZOIL COMPANY AND SUBSIDIARIES SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Retirements or Sales includes dry hole costs charged to exploration expense of $4,256,000, $2,404,000 and $30,849,000 for 1993, 1992 and 1991, respectively. (2) During 1993, oil and gas property, plant and equipment has been reduced by $278,044,000 attributable to certain asset swap transactions. See Schedule VI for a corresponding reduction of oil and gas accumulated depreciation, depletion and amortization. (3) Additions to the oil and gas segment include $1,009,410,000 allocated to the oil and gas properties attributable to the acquisition of Pennzoil Petroleum in October 1992. S-2 PENNZOIL COMPANY AND SUBSIDIARIES SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION, AMORTIZATION AND VALUATION ALLOWANCES OF PROPERTY, PLANT AND EQUIPMENT =============================================================================== - --------------- (1) Additions charged to costs and expenses include impairments and abandonments charged to exploration expense. Impairments and abandonments for 1993, 1992 and 1991 were $46,884,000, $3,759,000 and $5,039,000, respectively. (2) During 1993, oil and gas accumulated depreciation, depletion and amortization has been reduced by $278,044,000 attributable to certain asset swap transactions. See Schedule V for a corresponding reduction of oil and gas property, plant and equipment. S-3 PENNZOIL COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Represents the weighted average interest rate in effect while the short-term borrowings were outstanding. (2) None of the banks has any obligation to continue to extend credit after the maturities of outstanding borrowings or to extend the maturities of any borrowings under these credit arrangements. S-4 PENNZOIL COMPANY AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-5 EXHIBIT INDEX - --------------- * Incorporated by reference. + Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to the requirements of Item 14(c) of Form 10-K.	23,348	154,878
741612_1993.txt	741612_1993	1993	741612	Item 1. Business. General Development of Business The Company And Its Subsidiaries TNP Enterprises, Inc. (Company) is a Texas corporation organized in February 1983. The Company owns all of the outstanding common stock of its three subsidiaries: Texas-New Mexico Power Company (Utility), its principal operating subsidiary; Bayport Cogeneration, Inc. (Bayport); and TNP Operating Company. The Company and the Utility are holding companies as defined in the Public Utility Holding Company Act but each is exempt from regulation as a "registered holding company" as defined in said act. All financial information presented herein or incorporated by reference is on a consolidated basis and all intercompany transactions and balances have been eliminated. Texas-New Mexico Power Company Texas-New Mexico Power Company is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity to customers within the States of Texas and New Mexico. The Utility is qualified to do business as a foreign corporation in the State of Arizona. Business conducted in Arizona is limited to ownership as tenant-in-common with two other electric utility corporations in a 345-KV electric transmission line which transmits electrical energy into New Mexico for sale to customers in New Mexico. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC Uniform System of Accounts. The Utility has two wholly owned subsidiaries, Texas Generating Company (TGC), organized in 1988, and Texas Generating Company II (TGC II), organized in 1991. TNP One Prior to 1990, the Utility purchased virtually all of its electric requirements, primarily from other utilities. In an effort to diversify its energy and fuel sources, the Utility contracted with a consortium consisting of Westinghouse Electric Corporation, Combustion Engineering, Inc. and H. B. Zachry Company to construct TNP One. TNP One is a two-unit lignite-fueled, circulating fluidized bed generating plant in Robertson County, Texas. Unit 1 and Unit 2 of TNP One together provide, on an annualized basis, approximately 30% of the Utility's electric capacity requirements in Texas. The Utility acquired Unit 1 on July 20, 1990, and Unit 2 on July 26, 1991, through TGC and TGC II, respectively. The Utility operates the two units and sells the output of TNP One to its Texas customers. Unit 1 began commercial operation on September 12, 1990, and Unit 2 on October 16, 1991. As of December 31, 1993, the costs of Unit 1 and Unit 2 were approximately $357 million and approximately $282.9 million, respectively. Portions of the costs were funded by the Utility, with the majority of the costs borrowed by TGC and TGC II under separate financing facilities for the two units, which are guaranteed by the Utility. TNP ENTERPRISES, INC. FORM 10-K Regulatory Proceedings The Utility has received rate orders from the PUCT placing the majority of the costs of each of the two units of TNP One in rate base. The Utility and other parties to the proceedings have appealed both orders. For a review of the history of the two rate proceedings and the pending judicial proceedings, see Item 3, "Legal Proceedings" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. See note 2 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for a discussion of the financings of the two units including, during 1993, substantial reduction of the TNP One construction indebtedness and extension of the payment schedule for the remaining balance of the construction debt. For a discussion of the effects of the construction and financing of TNP One on the Utility's financial condition, including the detrimental regulatory treatment received to date, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report to Shareholders for the year ended December 31, 1993. Business of Other Subsidiaries TNP Operating Company and Bayport are general purpose corporations organized under the Texas Business Corporation Act. Neither company was materially involved in any business activities during 1993. Financial Information About Industry Segments This information is incorporated by reference to page 37 of the Annual Report to Shareholders for the year ended December 31, 1993. It is not possible to attribute operating profit or loss and identifiable assets to each of the classes of customers listed on the page referred to in said Annual Report. Kilowatt-hour (KWH) sales in 1993 were assisted by more typical weather experienced in 1993 as compared to 1992. KWH sales declined in 1992 from 1991 due in part to milder than normal temperatures in the Utility's service area in Texas; however, revenues were approximately the same for the two years due primarily to an increase in the Utility's Texas customers' rates in 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report to Shareholders for the year ended December 31, 1993 for a discussion of the changes in operating revenues, including rate increases. Narrative Description of Business The Company is a holding company as defined in the Public Utility Holding Company Act of 1935, but is exempt from regulation as a "registered holding company" under the act except with respect to the acquisition of securities of other public utility companies. The Company's exemption is based upon the substantially intrastate character of the operations of the Utility, and the filing with the Securities and Exchange Commission (SEC) of an annual exemption statement pursuant to its Rule U-2. The Public Utility Holding Company Act authorizes the SEC to terminate an exemption which it determines to be detrimental to the public interest or to the interest of investors or consumers. Therefore, the extent to which the Company and its nonutility subsidiaries may expand or diversify and maintain the Company's exempt status is always subject to review by the SEC. The Company does not intend to take any action which will jeopardize its exempt status. TNP ENTERPRISES, INC. FORM 10-K The Company is not subject to regulation by the PUCT. The Company is not generally subject to regulation by the NMPSC; the NMPSC statutes do not regulate holding companies except under certain circumstances of consolidation, merger, or acquisition. Both of these agencies have regulatory authority under state laws over the activities of the Utility. The Utility, and not the Company, is also subject to the jurisdiction of the FERC, in certain respects, under the terms of the Federal Power Act. Narrative Description of Utility Business General The Utility purchases and generates electricity for sales to its customers wholly within the States of Texas and New Mexico. The Utility's purchases of electricity are primarily from other utilities and cogenerators (see "Sources of Energy" in this section). The Utility's current generation of electricity is from TNP One. The Utility owns and operates electric transmission and distribution facilities in 90 municipalities and adjacent rural areas in Texas and New Mexico. The areas served contain a population of approximately 616,000. The Utility's service is delivered to customers in four operating divisions in Texas and one operating division in New Mexico. The Utility's Southeast Division, on the Texas Gulf Coast, is adjacent to the Johnson Space Center and lies between the cities of Houston and Galveston. The economy is supported by the oil and petrochemical industries, agriculture and the general commercial activity of the Houston area. This division produced 49.5% of the total operating revenues in 1993. The Utility's Northern Division is based in Lewisville, just north of the Dallas-Fort Worth International Airport, and extends to include municipalities along the Red River and in the Texas Panhandle. This division serves a variety of commercial, agricultural and petroleum industry customers and produced 19.5% of the Utility's revenues in 1993. The economy of the Utility's New Mexico Division is primarily dependent upon mining and agriculture. Copper mines are the major industrial customers in the New Mexico Division. This division produced 16.8% of the total operating revenues in 1993. The Utility's Central Division includes municipalities and communities located to the south and west of Fort Worth. This area's economy is largely dependent on agriculture and to lesser degrees tourism and oil production. In far west Texas, between Midland and El Paso, the Utility's Western Division serves municipalities whose economies are primarily related to oil and gas production, agriculture and food processing. The Utility serves and intends to continue serving members of the public in all of its present service areas. The Utility will construct facilities as needed to meet increasing demand for its service. The Utility will also extend service beyond its present service territories to the extent permitted by law and the orders of regulatory commissions. For a description of the properties utilized to provide this service, see Item 2, "Properties." Operating Revenues Revenues contributed by the Utility's operating divisions in 1993, 1992 and 1991 and the corresponding percentages of total operating revenues are shown below: 1993 1992 1991 Operating Revenues Revenues Revenues Division (000's) %'s (000's) %'s (000's) %'s Central $39,460 8.3% $ 35,421 8.0% $ 34,625 7.8% Northern 92,265 19.5 83,626 18.9 84,227 19.1 Southeast 234,895 49.5 222,460 50.1 220,581 50.0 Western 28,084 5.9 27,193 6.1 27,487 6.2 New Mexico 79,538 16.8 75,127 16.9 74,423 16.9 Total $474,242 100.0% $443,827 100.0% $441,343 100.0% TNP ENTERPRISES, INC. FORM 10-K In 1993, 1992 and 1991, no single customer accounted for greater than 10% of operating revenues, although the Utility has two affiliated industrial customers in the New Mexico Division which, together, contributed between 8% and 10% of the Utility's revenues in each of these years. Sources of Energy Information on the "Sources of Energy" of the Utility is incorporated herein by reference to pages 4 and 5 of the Annual Report to Shareholders for the year ended December 31, 1993. Recovery of Purchased Power and Fuel Costs Purchased power cost recovery adjustment clauses in the Utility's rate schedules have been authorized by the regulatory authorities in Texas and New Mexico. A fixed fuel recovery factor in Texas has also been approved. Both are of substantial benefit to the Utility in efforts to recover timely and adequately these significant elements of operating expenses as described in note 1(g) to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. Franchises The Utility holds franchises from each of the 90 municipalities in which it renders electric service. On December 31, 1993, these franchises had expiration dates varying from 1994 to 2039, 86 having stated terms of 25 years or more and two having stated terms of 20 years and two having stated terms of 15 years. The Utility also holds certificates of public convenience and necessity from the PUCT covering all of the territories it serves in Texas. The Utility has been issued certificates for other areas after hearings before the PUCT. These certificates include terms which are customary in the public utility industry. In New Mexico, the Utility operates generally under the grandfather clause of that state's Public Utility Act which authorizes the continuance of existing service following the date of the adoption of such act. Seasonality of Business The Utility's business is seasonal in character. Summer weather causes increased use of air-conditioning equipment which produces higher revenues during the months of June, July, August and September. For the year ended December 31, 1993, approximately 40% of annual revenues were recorded in June, July, August and September, and 60% in the other eight months. Working Capital The Utility's major demands on working capital are (1) the monthly payments for purchased power costs from the Utility's suppliers, (2) monthly and semi-annual interest payments on long-term debt and (3) semi-monthly payments for the lignite fuel source for TNP One. The purchased power and fuel costs are eventually recovered through the Utility's customers' rates and the purchased power and fuel costs recovery adjustment clauses and fixed fuel factors, more fully described in note 1(g) to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. Unlike many other generating utilities, the Utility does not have the requirement of maintaining a large fuel inventory (lignite) due to the proximity of TNP One with the lignite mine site. The Utility sells customer receivables, as do many other utilities. The Utility sells its customer receivables to a nonaffiliated company on a nonrecourse basis. TNP ENTERPRISES, INC. FORM 10-K Competitive Conditions As a regulated public utility, the Utility operates with little direct competition throughout most of its service territory. Pursuant to the Texas Public Utility Regulatory Act, the PUCT has issued to all electric utilities in the State certificates of public convenience and necessity authorizing them to render elec- tric service. Rural electric cooperatives, investor-owned electric utilities and municipally owned electric utilities are all defined in such act as public utilities. In 72 of the 81 Texas municipalities served, the Utility has been the only electric utility issued a certificate to serve customers within the municipal limits. The Utility is also the only electric utility authorized to serve customers in some of the rural areas where it has electric facilities. In other rural areas served by the Utility, other electric utilities have also been authorized to serve customers; however, rural electric cooperatives may, under certain circumstances, become exempt from the PUCT's rate regulation. Where other electric utilities have also been certificated to serve customers within the same service area, the Utility may be subject to competition. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. In New Mexico, a utility subject to the jurisdiction of the NMPUC may not extend into territory served by another utility or into territory not contiguous to its service territory without a certificate of public convenience and necessity from the NMPUC. Investor-owned electric utilities and rural electric cooperatives are subject to the jurisdiction of the NMPUC. The Energy Policy Act of 1992, adopted in October 1992, significantly changed the U.S. energy policy, including the governing of the electric utility industry. Among the features of this act is the creation of Exempt Wholesale Generators and the authorization of the FERC to order, on a case-by-case basis, wholesale transmission access. It appears that these particular features will create competition for the generation and supply of electricity. Management continues to evaluate the effects of this act on the Utility. Although the act may not affect the Utility directly, the Utility believes that this increased competition will not have an unfavorable impact on it. Environmental Requirements Environmental requirements are not expected to materially affect capital outlays or materially affect the Utility directly. As the Utility's electric suppliers may be affected by environmental requirements and resulting costs, the rates charged by them to the Utility may be increased and thus the Utility will be affected indirectly. The Utility's facilities in Texas and New Mexico are regulated by federal and state environmental agencies. These agencies have jurisdiction over air emissions, water quality, wastewater discharges, solid wastes and hazardous substances. The Utility maintains continuous procedures to insure compliance with all applicable environmental laws, rules and regulations. Various Utility activities require permits, licenses, registrations and approvals from such agencies. The Utility has received all necessary authorizations for the construction and continued operation of its generation, transmission and distribution systems. TNP ENTERPRISES, INC. FORM 10-K TNP One's circulating fluidized bed technology produces "clean" emissions, without the addition of costly scrubbers. Unit 1 and Unit 2 meet the standards of the Clean Air Act of 1990. Under this act, an entity will be given an allotted number of allowances which permit emissions up to a specified level. The Utility believes the allowances received to be sufficient for the level of emissions to be created by TNP One. The construction costs for TNP One included approximately $89 million for environmental protection facilities. During 1993, 1992 and 1991, as an ongoing operation of air pollution abatement, including ash removal, TNP One incurred expenses of approximately $2.6 million, $2.7 million and $1.9 million, respectively. The Utility anticipates additional capital expenditures of $875,000 by 1995 for air emissions monitoring equipment for TNP One. The operations of the Utility are subject to a number of federal, state and local environmental laws and regulations, which govern the storage of motor fuels, including those regulating underground storage tanks. In September 1988, the Environmental Protection Agency (EPA) issued regulations that required all newly installed underground storage tanks be protected from corrosion, be equipped with devices to prevent spills and overfills, and have a leak detection method that meets certain minimum requirements. The effective commencement date for newly installed tanks was December 22, 1988. Underground storage tanks in place prior to December 22, 1988, must conform to the new standards by December 1998. The Utility currently estimates the cost over the next five years to bring its existing underground storage tanks into compliance with the EPA guidelines will be $100,000. The Utility also has the option of removing any existing underground storage tanks. During 1993, 1992, and 1991, the Utility incurred cleanup and testing costs on both leaking and nonleaking storage tanks of approximately $98,000, $89,000, and $84,000, respectively, in complying with these EPA regulations. A change in the regulations in the State of Texas permitted the Utility to collect in 1992 from the state environmental trust fund $65,000 of expenditures paid in prior years. Both states in which the Utility owns or operates underground storage tanks have state operated funds which reimburse the Utility for certain cleanup costs and liabilities incurred as a result of leaks in underground storage tanks. These funds, which essentially provide insurance coverage for certain environmental liabilities, are funded by taxes on underground storage tanks or on motor fuels purchased within each respective state. The funds require the Utility to pay deductibles of less than $5,000 per occurrence. During 1992, the Texas state environmental trust fund delayed reimbursement payments after September 30, 1992, of certain cleanup costs due to an increase in claims. Because the state and federal government have the right, by law, to levy additional fees on fuel purchases, the Utility believes these cleanup costs will ultimately be reimbursed. Employees The number of employees on December 31, 1993, was 1,051. TNP ENTERPRISES, INC. FORM 10-K Executive Officers of the Registrant Identification of Executive Officers Executive Officers of the Company Positions & Offices Held Period of with the Company Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock2 61 Interim President & Chief 0 1 Executive Officer and Director D. R. Barnard 61 Vice President & 4 8 Chief Financial Officer Vice President & 4 6 Treasurer M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 Executive Officers of the Utility Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock 61 Interim President & Chief 0 1 Executive Officer and Director Sector Vice President - 2 4 Operations Vice President - 11 1 Division Manager D. R. Barnard 61 Sector Vice President & 3 8 Chief Financial Officer Vice President & 1 0 Chief Financial Officer Vice President & 17 0 Treasurer J. V. Chambers, Jr. 44 Sector Vice President - 3 8 Revenue Production Vice President - Contracts 3 2 & Regulation 1, 2 See respective explanation appearing on the following page. TNP ENTERPRISES, INC. FORM 10-K Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months M. C. Davie 58 Vice President - Corporate 10 11 Affairs A. B. Davis 56 Vice President - Chief Engineer 1 8 Chief Engineer 1 4 Assistant Chief Engineer 0 1 Manager - Engineering 5 8 L.W. Dillon 39 Vice President - Operations 0 1 Division Manager 3 6 Division Engineering Manager 4 11 R. J. Wright 46 Vice President - 0 6 Corporate Services/Generation Vice President - Manager - Generation 4 8 M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 1 All officers are elected annually by the respective Board of Directors for a one-year term until the next annual meeting of the Board of Directors or until their successors shall be elected and qualified. The term of an officer elected at any other time by the Board also will run until the next succeeding annual meeting of the Board of Directors or until a successor shall be elected and qualified. 2 Retired as Sector Vice President of the Utility effective December 31, 1992; named Interim President & Chief Executive Officer effective November 9, 1993. With the exception of D. R. Spurlock, each of the above-named officers is a full-time employee of the Utility and has been for more than five years prior to the date of the filing of this Form 10-K. TNP ENTERPRISES, INC. FORM 10-K Item 2. Item 2. Properties. The Utility's electric properties served a total of 211,911 customers at year-end and consisted of the installations described in the following sections. (1) Electric generation, transmission and distribution facilities located in the State of Texas are as follows: (A) Central Division. Electric transmission and distribution sys- tems serving 25 municipalities and 18 unincorporated communities in 17 counties to the south and west of Fort Worth, Texas. The division is based at Clifton, Texas. (B) Northern Division. Electric transmission and distribution systems serving 36 municipalities and 19 unincorporated communities in 14 North Texas counties and 3 counties in the Texas Panhandle. The division is based at Lewisville, Texas. (C) Southeast Division. Electric transmission and distribution systems serving 14 municipalities and 2 unincorporated communities in 3 counties on the Texas Gulf Coast. The division is based at Texas City, Texas. (D) Western Division. Electric transmission and distribution sys- tems serving 6 municipalities and 1 unincorporated community in 5 counties in West Texas. The division is based at Pecos, Texas. (E) Robertson County, Texas. Two 150-megawatt lignite-fueled generating units (Unit 1 and Unit 2, collectively referred to as TNP One) using circulating fluidized bed technology. The Utility also has an 18-mile long transmission line to connect TNP One to a major transmission grid in Texas. (2) Electric generation, transmission and distribution facilities in the State of New Mexico serve 5 municipalities and 5 unincorporated communities in Grant and Hidalgo Counties, and 4 municipalities and 1 unincorporated community in Otero and Lincoln Counties. The New Mexico Division is based at Silver City, New Mexico. (3) The facilities owned by the Utility include those normally used in the electric utility business. The facilities are of sufficient capacity to adequately serve existing customers, and such facilities may be extended and expanded to serve future customer growth of the Utility in existing service areas. The Utility generally constructs its transmission and distribution facilities upon real property held pursuant to easements or public rights of way and not upon real property held in fee simple by the Utility. (4) All real and personal property of the Utility, with certain exceptions such as much of TNP One, is subject to the lien of the Indenture of Mortgage and Deed of Trust (Bond Indenture) under which the Utility's First Mortgage Bonds are issued. Certain exceptions are set forth in the Bond Indenture. The lenders in the Unit 2 financing facility and the holders of all secured debentures hold a second lien on all real and personal Texas property of the Utility. Holders of the Utility's Secured Debentures, due 1999 and Series A, Secured Debentures, due 2003 equally and ratably hold first liens on approximately 59% of Unit 1. The remaining amount of Unit 1 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. The lenders under the Unit 2 financing facility and the Utility's Secured Debentures, due 1999, equally and ratably hold first liens on approximately 74% of Unit 2. The remaining amount of Unit 2 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. Under certain conditions, upon repayment of portions of the loans or secured debentures under the financing facilities, the Utility may purchase undivided interests in Unit 1 or Unit 2 from TGC or TGC II, respectively, whereupon such undivided interests become subject to the first lien of the Utility's Bond Indenture. See note 2 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for additional information. TNP ENTERPRISES, INC. FORM 10-K Item 3. Item 3. Legal Proceedings. Appeals of Regulatory Orders The following summary discusses the Utility's most recent regulatory proceedings before the PUCT and the judicial appeals. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. More detailed discussions of the proceedings and related impacts are included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. PUCT Docket No. 9491 On April 11, 1990, the Utility filed a rate application, Docket No. 9491, with the PUCT for inclusion of the costs of Unit 1 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On February 7, 1991, the Utility received a final order which allowed $298.5 million of the costs of Unit 1 in rate base; however, the PUCT disallowed from rate base $39.5 million of the requested investment costs of $338 million for that unit. The PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request. The PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Nevertheless, the PUCT granted rate base treatment for Unit 2 in Docket No. 10200, as discussed below. On appeal by the Utility of the PUCT's order in Docket No. 9491, a State district court in Travis County, Texas, ruled that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." On appeal of the State district court's order by the Utility, the PUCT and certain of the intervenor cities (the Cities), a Third District Court of Appeals in Austin, Texas, rendered a judgment partially reversing the State district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 in the Utility's rate base and for the setting of rates to recover the costs of that unit. TNP ENTERPRISES, INC. FORM 10-K On March 18, 1993, the Utility received a final order which allowed $250.7 million of the Unit 2 costs in rate base; however, the PUCT disallowed from rate base $21.1 million associated with Unit 2 and $0.8 million additional costs requested for Unit 1. The PUCT also determined that $11.1 million of Unit 2 costs would be addressed in a future Texas rate application. The PUCT approved an increase in annualized revenues of approximately $19 million, or 53%, of the Utility's original $35.8 million rate request. The order in Docket No. 10200 also reflects application to the Utility of a new method for calculating the amount of Federal income tax expense allowed in cost of service, which significantly reduced the Utility's level of annualized revenue increase from $26 million to $19 million. The Docket No. 10200 rate order has been appealed to a Texas district court by the Utility and other parties. Because of the Court of Appeals judgment relating to the prudence of starting construction of Unit 2 (FF No. 84 in the docket No. 9491), the presiding judge in the Texas district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expenses, in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. The opposing parties are seeking a variety of relief to obtain lower rates and greater disallowances, including overturning the basis of the Utility's case as presented to the PUCT and sustaining the PUCT's adverse Federal income tax position without regard to any IRS ruling on the normalization issue. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other Legal Matters The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to a vote of security holders in the fourth quarter of 1993. PART II Item 5. Item 5. Market For The Registrant's Common Equity and Related Shareholder Matters. This information is incorporated by reference to "Common Stock Information" on page 38 of the Annual Report to Shareholders for the year ended December 31, 1993. For the years ended December 31, 1993 and 1992, the Company paid $17,344,000, and $13,780,000, respectively, in common dividends. Dividends were paid on a quarterly basis. Since most of the assets, liabilities and earnings capability of the Company are those of the Utility, the ability of the Company to pay dividends will be largely dependent upon the Utility's operations and the Utility's restrictions regarding payment of its dividends as discussed in notes 2 and 3 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. TNP ENTERPRISES 10-K Item 6. Item 6. Selected Consolidated Financial Data. This information is incorporated by reference to "Selected Annual Consolidated Financial Data" on page 36 of the Annual Report to Shareholders for the year ended December 31, 1993. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for discussion of material uncertainties which might cause the information incorporated by reference above not to be indicative of future financial condition or results of operations. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. This information is incorporated by reference to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 6 through 16 of the Annual Report to Shareholders for the year ended December 31, 1993. Item 8. Item 8. Financial Statements and Supplementary Data. This information is incorporated by reference to the appropriate sections on pages 17 through 35 of the Annual Report to Shareholders for the year ended December 31, 1993. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Identification of Directors and Directorships The information required by this item is incorporated by reference from "The Nominees and Continuing Directors" of the definitive Proxy Statement relating to the annual meeting of holders of common stock of the Company, pursuant to Regulation 14A, filed with the SEC and mailed on or about March 28, 1994 to the holders of common stock of the Company. Identification of Executive Officers The information required by this item with respect to executive officers is set forth in Item 1 of Part I of this Form 10-K under "Executive Officers of the Registrant, " pursuant to instruction 3 of paragraph (b) of Item 401 of Regulation S-K. Item 11. Item 11. Executive Compensation.* Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management.* Item 13. Item 13. Certain Relationships and Related Transactions.* * The information required by Items 11, 12, and 13 is incorporated by reference from the definitive Proxy Statement relating to the Annual Meeting of holders of common stock of the Company, pursuant to Regulation 14A, filed with the SEC and mailed on or about March 28, 1994 to the holders of common stock of the Company. TNP ENTERPRISES, INC. FORM 10-K PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Items Filed as Part of This Report Financial Statements and Supplementary Data The following information is incorporated by reference to pages 17 through 35 of the Annual Report to Shareholders for the year ended December 31, 1993: Independent Auditors' Report Consolidated Statements of Earnings, Three Years Ended December 31, Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Common Stock Equity and Redeemable Cumulative Preferred Stocks, Three Years Ended December 31, 1993 Consolidated Statements of Cash Flows, Three Years Ended December 31, Notes to Consolidated Financial Statements, December 31, 1993, 1992 and 1991 Selected Quarterly Consolidated Financial Data (Unaudited), Quarters ended March 31, June 30, September 30, and December 31, 1993 and 1992 Financial Statement Schedules Page Independent Auditors' Report. . . . . . . . . . . . . . 17 V - Utility Plant, Three Years Ended December 31, 1993 . . . . . 18 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993 . . . . . . . . . . . . . . 19 IX - Short-term Borrowings, Three Years Ended December 31, 1993 20 X - Supplementary Consolidated Earnings Statement Information, Three Years Ended December 31, 1993 . . . . . 21 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes contained in the Annual Report to Shareholders for the year ended December 31, 1993. Exhibits. See Exhibit Index, Pages 22 through 33. (b) Reports on Form 8-K None during the last quarter covered by this report. TNP ENTERPRISES, INC. FORM 10-K SIGNATURES Pursuant to the requirements of Section 13 or 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. (Registrant) TNP ENTERPRISES, INC. By /s/ D. R. Barnard D. R. Barnard, Vice President & Chief Financial Officer Date: March 22, 1994 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. Title Date By /s/ R. D. Woofter Chairman 3-22-94 R. D. Woofter By /s/ Dwight R. Spurlock Interim President & 3-22-94 D. R. Spurlock Chief Executive Officer By /s/ D. R. Barnard Vice President & 3-22-94 D. R. Barnard Chief Financial Officer By /s/ Monte W. Smith Treasurer (Principal 3-22-94 Monte W. Smith Accounting Officer) By /s/ R. Denny Alexander Director 3-22-94 R. Denny Alexander By /s/ Cass O. Edwards, II Director 3-22-94 Cass O. Edwards, II By /s/ John A. Fanning Director 3-22-94 John A. Fanning By /s/ Harris L. Kempner, Jr. Director 3-22-94 Harris L. Kempner, Jr. TNP ENTERPRISES, INC. FORM 10-K Index to Financial Statement Schedules Independent Auditors' Report Schedules: V - Utility Plant, Three Years Ended December 31, 1993 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993 IX - Short-term Borrowings, Three Years Ended December 31, 1993 X - Supplementary Consolidated Earnings Statement Information, Three Years Ended December 31, 1993 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. The consolidated balance sheets of the Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, common stock equity and redeemable cumulative preferred stocks, and cash flows for each of the years in the three-year period ended December 31, 1993, together with the related notes and the report of KPMG Peat Marwick, independent certified public accountants, all contained in the Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. TNP ENTERPRISES, INC. FORM 10-K Independent Auditors' Report The Shareholders and Board of Directors TNP Enterprises, Inc.: Under date of January 28, 1994, we reported on the consolidated balance sheets of TNP Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, common stock equity and redeemable cumulative preferred stocks, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The report includes an explanatory paragraph that states that uncertainties exist with respect to the outcome of certain regulatory matters as discussed in note 5 to the consolidated financial statements. The ultimate outcome of these matters cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the above consolidated financial statements and financial statement schedules. As discussed in note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As discussed in note 1(j), the Company also adopted the provisions of the Financial Accounting Standards Board's SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions in 1993. KPMG PEAT MARWICK Fort Worth, Texas January 28, 1994 TNP ENTERPRISES, INC. FORM 10-K Utility Plant Schedule V TNP ENTERPRISES, INC. FORM 10-K Accumulated Depreciation of Utility Plant Schedule VI Three Years Ended December 31, 1993 (In Thousands) TNP ENTERPRISES, INC. FORM 10-K Short-term Borrowings (1) Schedule IX Three Years Ended December 31, 1993 (Dollars in Thousands) TNP ENTERPRISES, INC. FORM 10-K Supplementary Consolidated Earnings Statement InformationSchedule X Three Years Ended December 31, 1993 (In Thousands) Charged to costs and expenses Item 1993 1992 1991 Taxes, other than payroll and income taxes: Gross receipts and street rentals $11,387 10,064 9,484 Property 14,132 14,272 10,302 Other 2,613 2,431 1,689 $28,132 26,767 21,475 TNP ENTERPRISES, INC. FORM 10-K EXHIBIT INDEX Exhibits filed herewith are denoted by "." The other exhibits have heretofore been filed with the Commission and are incorporated herein by reference. Exhibit No. Description 3(a) - Articles of Incorporation and Amendments through March 6, 1984 (Exhibit 3(a), File No. 2-89800). 3(b) - Amendment to Articles of Incorporation filed September 25, 1984. (Exhibit 3(b) to Form 10-K for the year ended December 31, 1987, File No. 1-8847). 3(c) - Amendment to Articles of Incorporation filed August 29, 1985 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1985, File No. 1-8847). 3(d) - Amendment to Articles of Incorporation filed June 2, 1986 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1986, File No. 1-8847). 3(e) - Amendment to Articles of Incorporation filed May 10, 1988 (Exhibit 3(e) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(f) - Amendment to Articles of Incorporation filed May 10, 1988 (Exhibit 3(f) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(g) - Amendment to Articles of Incorporation filed December 27, 1988 (Exhibit 3(g) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(h) - Bylaws of the Company, as amended February 18, 1992 (Exhibit 4(h), File No. 33-53918). 4(a) - Indenture of Mortgage and Deed of Trust of the Utility dated as of November 1, 1944 (Exhibit 2(d), File No. 2-61323). 4(b) - Seventh Supplemental Indenture dated as of May 1, 1963 (Exhibit 2(k), File No. 2-61323). 4(c) - Eighth Supplemental Indenture dated as of July 1, 1963 (Exhibit 2(1), File No. 2-61323). TNP ENTERPRISES, INC. FORM 10-K Exhibit Description No. 4(d) - Ninth Supplemental Indenture dated as of August 1, 1965 (Exhibit 2(m), File No. 2-61323). 4(e) - Tenth Supplemental Indenture dated as of May 1, 1966 (Exhibit 2(n), File No. 2-61323). 4(f) - Eleventh Supplemental Indenture dated as of October 1, 1969 (Exhibit 2(o), File No. 2-61323). 4(g) - Twelfth Supplemental Indenture dated as of May 1, 1971 (Exhibit 2(p), File No. 2-61323). 4(h) - Thirteenth Supplemental Indenture dated as of July 1, 1974 (Exhibit 2(q), File No. 2-61323). 4(i) - Fourteenth Supplemental Indenture dated as of March 1, 1975 (Exhibit 2(r), File No. 2-61323). 4(j) - Fifteenth Supplemental Indenture dated as of September 1, 1976 (Exhibit 2(e), File No. 2-57034). 4(k) - Sixteenth Supplemental Indenture dated as of November 1, 1981 (Exhibit 4(x), File No. 2-74332). 4(l) - Seventeenth Supplemental Indenture dated as of December 1, 1982 (Exhibit 4(cc), File No. 2-80407). 4(m) - Eighteenth Supplemental Indenture dated as of September 1, 1983 (Exhibit (a) to Form 10-Q of Texas-New Mexico Power Company for the quarter ended September 30, 1983, File No. 1-4756). 4(n) - Nineteenth Supplemental Indenture dated as of May 1, 1985 (Exhibit 4(v), File No. 2-97230). 4(o) - Twentieth Supplemental Indenture dated as of July 1, 1987 (Exhibit 4(o) to Form 10-K of Texas-New Mexico Power Company for the year ended December 31, 1987, File No. 2-97230). 4(p) - Twenty-First Supplemental Indenture dated as of July 1, 1989 (Exhibit 4(p) to Form 10-Q of Texas-New Mexico Power Company for the quarter ended June 30, 1989, File No. 2-97230). 4(q) - Twenty-Second Supplemental Indenture dated as of January 15, 1992 (Exhibit 4(q) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 4(r) - Twenty-Third Supplemental Indenture dated as of September 15, 1993 (Exhibit 4(r) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 4(s) - Indenture and Security Agreement for Secured Debentures dated as of January 15, 1992 (Exhibit 4(r) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 4(t) - Indenture and Security Agreement for Secured Debentures dated as of September 15, 1993 (Exhibit 4(t) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 4(u) - Rights Agreement and Form of Right Certificate, as amended, effective November 13, 1990 (Exhibit 2.1 to Form 8-A, File No. 1-8847). Material Contracts Relating to TNP One 10(a) - Fuel Supply Agreement, dated November 18, 1987, between Phillips Coal Company and the Utility (Exhibit 10(j) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(b) - Unit 1 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 1 Credit Agreement"), among the Utility, Texas Generating Company ("TGC"), the banks named therein as Banks (the "Unit 1 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 1 Banks (the "Unit 1 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of December 1, 1987 (Exhibit 10(c) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(b)1 - Participation Agreement, dated as of January 8, 1992, among the banks named therein as Banks, the parties named therein as Participants and the Unit 1 Agent (Exhibit 10(c)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(b)2 - Amendment No. 1, dated as of September 21, 1993, to the Unit 1 Credit Agreement (Exhibit 10(b)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(c) - Assignment and Security Agreement, dated as of January 8, 1992, among TGC and the Unit 1 Agent, for the benefit of the Secured Parties, as defined in the Unit 1 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of December 1, 1987 (Exhibit 10(d) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(d) - Assignment and Security Agreement, dated December 1, 1987, executed by the Utility in favor of the Unit 1 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(u) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(e) - Amended and Restated Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 1 Agent, amending and restating the Subordination Agreement among such parties dated as of December 1, 1987 (Exhibit 10(uu) to Form 10- K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(f) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of December 1, 1987, and executed by Project Funding Corporation ("PFC"), as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ee) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(f)1 - Supplemental Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), executed by TGC, as Mortgagor, on January 27, 1992, to be effective as of December 1, 1987, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(g)4) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)2 - First TGC Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)3 - Second TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)4 - Third TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)3) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)5 - Fourth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(f)5 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(f)6 - Fifth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(f)6 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(g) - Indemnity Agreement, made as of the 1st day of December, 1987, by Westinghouse, CE and Zachry, as Indemnitors, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ff) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(h) - Second Lien Mortgage and Deed of Trust (With Security Agreement) executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(jj) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(h)1 - Correction Second Lien Mortgage and Deed of Trust (with Security Agreement), dated as of December 1, 1987, executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(vv) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(h)2 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(i)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(h)3 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(h)3 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(i) - Agreement for Conveyance and Partial Release of Liens, made as of the 1st day of December, 1987, by PFC and the Unit 1 Agent for the benefit of the Utility (Exhibit 10(kk) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(j) - Inducement and Consent Agreement, dated as of June 15, 1988, between Phillips Coal Company, Kiewit Texas Mining Company, the Utility, Phillips Petroleum Company and Peter Kiewit Son's, Inc. (Exhibit 10(nn) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(k) - Assumption Agreement, dated as of October 1, 1988, executed by TGC, in favor of the Issuing Bank, as defined therein, the Unit 1 Banks, the Unit 1 Agent and the Depositary, as defined therein (Exhibit 10(ww) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(l) - Guaranty, dated as of October 1, 1988, executed by the Utility and given in respect of the TGC obligations under the Unit 1 Credit Agreement (Exhibit 10(xx) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(m) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGC, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated as of October 1, 1988 (Exhibit 10(n) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(n) - Operating Agreement, dated as of October 1, 1988, among the Utility and TGC (Exhibit 10(zz) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(o) - Unit 2 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 2 Credit Agreement"), among the Utility, Texas Generating Company II ("TGCII"), the banks named therein as Banks (the "Unit 2 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 2 Banks (the "Unit 2 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of October 1, 1988 (Exhibit 10(q) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(o)1 - Amendment No. 1, dated as of September 21, 1993, to the Unit 2 Credit Agreement (Exhibit 10(o)1 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(p) - Assignment and Security Agreement, dated as of January 8, 1992, among TGCII and the Unit 2 Agent, for the benefit of the Secured Parties, as defined in the Unit 2 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of October 1, 1988 (Exhibit 10(r) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(q) - Assignment and Security Agreement, dated as of October 1, 1988, executed by the Utility in favor of the Unit 2 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(jjj) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(r) - Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 2 Agent (Exhibit 10(mmm) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(s) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of October 1, 1988, and executed by Texas PFC, Inc., as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(uuu) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(s)1 - First TGCII Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)2 - Second TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)3 - Third TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)3) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)4 - Fourth TGCII Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(s)4 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(t) - Release and Waiver of Liens and Indemnity Agreement, made effective as of the 1st day of October, 1988, by a consortium composed of Westinghouse, CE, and Zachry (Exhibit 10(vvv) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(u) - Second Lien Mortgage and Deed of Trust (With Security Agreement), dated as of October 1, 1988, and executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(www) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(u)1 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(w)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(u)2 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(u)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(v) - Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among PFC, Texas PFC, Inc., the Utility, the Project Creditors, as defined therein, and the Collateral Agent, as defined therein (Exhibit 10(xxx) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(v)1 - Amendment #1, dated as of January 8, 1992, to the Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(x)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(v)2 - Amendment No. 2, dated as of September 21, 1993, to the Intercreditor and Nondisturbance Agreement among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(v)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(w) - Grant of Reciprocal Easements and Declaration of Covenants Running with the Land, dated as of the 1st day of October, 1988 between PFC and Texas PFC, Inc. (Exhibit 10(yyy) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(x) - Non-Partition Agreement, dated as of May 30, 1990, among the Utility, TGC and The Chase Manhattan Bank (National Association), as Agent for the Banks which are parties to the Unit 1 Credit Agreement (Exhibit 10(ss) to Form 10-K for the year ended December 31, 1990, File No. 1-8847). 10(y) - Assumption Agreement, dated July 26, 1991, to be effective as of May 31, 1991, by TGCII in favor of the Issuing Bank, the Unit 2 Banks, the Unit 2 Agent and the Depositary, as defined therein (Exhibit 10(kkk) to Amendment No. 1 to File No. 33-41903). 10(z) - Guaranty, dated July 26, 1991, to be effective as of May 31, 1991, by the Utility and given in respect of the TGCII obligations under the Unit 2 Credit Agreement (Exhibit 10(lll) to Amendment No. 1 to File No. 33-41903). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(aa) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGCII, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated July 26, 1991, to be effective as of May 31, 1991 (Exhibit 10(dd) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2- 97230). 10(aa)1 - Amendment No. 1 to the Unit 2 First Amended and Restated Facility Purchase Agreement, dated as of September 21, 1993, among the Utility, as the Purchaser, and TGCII, as the Seller (Exhibit 10(aa)1 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(bb) - Operating Agreement, dated July 26, 1991, to be effective as of May 31, 1991, between the Utility and TGCII (Exhibit 10(nnn) to Amendment No. 1 to File No. 33-41903). 10(cc) - Non-Partition Agreement, executed July 26, 1991, to be effective as of May 31, 1991, among the Utility, TGCII and The Chase Manhattan Bank (National Association) (Exhibit 10(ppp) to Amendment No. 1 to File No. 33-41903). Power Supply Contracts 10(dd) - Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 5(a), File No. 2-69353). 10(dd)1 - Amendment, dated January 4, 1989, to the Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 10(cccc) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(ee) - Contract dated May 1, 1986 between the Utility and Texas Electric Utilities Company, amended September 29, 1986, October 24, 1986 and February 21, 1987 (Exhibit 10(c) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ff) - Amended and Restated Agreement for Electric Service dated May 14, 1990 between the Utility and Texas Utilities Electric Company (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1990, File No. 1-8847). 10(ff)1 - Amendment, dated April 19, 1993, to Amended and Restated Agreement for Electric Service, dated May 14, 1990, As Amended between the Utility and Texas Utilities Electric Company (Exhibit 10(ii)1 to Form S-2 Registration Statement, filed on July 19, 1993, File No. 33-66232). 10(gg) - Contract dated June 11, 1984 between the Utility and Southwestern Public Service Company (Exhibit 10(d) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(hh) - Contract dated April 27, 1977 between the Utility and West Texas Utilities Company amended April 14, 1982, April 19, 1983, May 18, 1984 and October 21, 1985 (Exhibit 10(e) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ii) - Contract dated April 29, 1987 between the Utility and El Paso Electric Company (Exhibit 10(f) of Form 8 applicable to Form 10- K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(jj) - Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976 and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(g) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(jj)1 - Amendment, dated February 22, 1982, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(iiii) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2- 97230). 10(jj)2 - Amendment, dated February 8, 1988, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(jjjj) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2- 97230). 10(jj)3 - Amended and Restated Contract for Electric Service, dated April 29, 1988, between the Utility and Public Service Company of New Mexico (Exhibit 10(zz)3 to Amendment No. 1 to File No. 33-41903). 10(kk) - Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(h) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(kk)1 - Amendment, dated December 12, 1988, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(llll) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(kk)2 - Amendment, dated December 12, 1990, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company (Exhibit 19(t) to Form 10-K of the Utility for the year ended December 31, 1990, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(ll) - Contract dated August 31, 1983, between the Utility and Capitol Cogeneration Company, Ltd. (including letter agreement dated August 14, 1986) (Exhibit 10(i) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ll)1 - Agreement Substituting a Party, dated May 3, 1988, among Capitol Cogeneration Company, Ltd., Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(nnnn) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(ll)2 - Letter Agreements, dated May 30, 1990 and August 28, 1991, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)2 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(ll)3 - Notice of Extension Letter, dated August 31, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)3 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(ll)4 - Scheduling Agreement, dated September 15, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)4 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(mm) - Interconnection Agreement between the Utility and Plains Electric Generation and Transmission Cooperative, Inc. dated July 19, 1984 (Exhibit 10(j) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(nn) - Interchange Agreement between the Utility and El Paso Electric Company dated April 29, 1987 (Exhibit 10(l) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(oo) - DC Terminal Participation Agreement between the Utility and El Paso Electric Company dated December 8, 1981 amended April 29, 1987 (Exhibit 10(m) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). Employment Contracts 10(pp) - Texas-New Mexico Power Company Executive Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Sector Vice President and Chief Financial Officer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document) (Exhibit 10(pp) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(qq) - Texas-New Mexico Power Company Key Employee Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Assistant Treasurer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document) (Exhibit 10(qq) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(rr) - Agreement between James M. Tarpley and the Company and the Utility, effective January 1, 1994 (Exhibit 10(rr) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(ss) - Agreement between Dwight R. Spurlock and the Company and the Utility, effective November 9, 1993 (Exhibit 10(ss) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 13 - Annual Report to Shareholders for the year ended December 31, 1993. 21 - Subsidiaries of the Registrant. 23 - Independent Auditors' Consent - KPMG Peat Marwick. TNP ENTERPRISES, INC. FORM 10-K	11,915	73,788
54291_1993.txt	54291_1993	1993	54291	ITEM 1. BUSINESS Industry Overview Primary aluminum is produced by the refining of bauxite (the major aluminum-bearing ore) into alumina (the intermediate material) and the reduction of alumina into primary aluminum. Approximately two pounds of bauxite are required to produce one pound of alumina, and approximately two pounds of alumina are required to produce one pound of primary aluminum. Aluminum s valuable physical properties include its light weight, corrosion resistance, thermal and electrical conductivity, and high tensile strength. Demand The packaging and transportation industries are the principal consumers of aluminum in the United States, Japan, and Western Europe. In the packaging industry, which accounted for approximately 22% of consumption in 1992, aluminum s recyclability and weight advantages have enabled it to gain market share from steel and glass, primarily in the beverage container area. The aluminum packaging market in the United States, Japan, and Western Europe grew at a rate of approximately 4.0% per year during the period 1982-1992, and total United States aluminum beverage can shipments increased at a rate of approximately 2.5% in 1993, 1.5% in 1992, and 3.9% in 1991. Nearly all beer cans and approximately 95% of the soft drink cans manufactured for the United States market are made of aluminum. Despite the flat demand currently being experienced in the can stock market, growth in the packaging area is generally expected to continue in the 1990s due to general population increase and to further penetration of the beverage can market in Western Europe and Japan, where aluminum cans are a substantially lower percentage of the total beverage container market than in the United States. In the transportation industry, which accounted for approximately 28% of aluminum consumption in the United States, Japan, and Western Europe in 1992, automotive manufacturers use aluminum instead of steel or copper for an increasing number of components, including radiators, wheels, and engines, in order to meet more stringent environmental and fuel efficiency requirements through vehicle weight reduction. Management believes that sales of aluminum to the transportation industry have considerable growth potential due to projected increases in the use of aluminum in automobiles. According to industry sources, aluminum content in United States automobiles nearly doubled in the last 15 years to an average of 191 pounds per vehicle and the amount of aluminum consumed in the manufacture of Japanese automobiles more than doubled from 1983 to 1990. Management believes that the use of aluminum in automobiles in the United States and Japan will approximately double between 1991 and 2006. Supply As of year-end 1993, Western world aluminum capacity from 109 smelting facilities was approximately 16.4 million tons* per year. Net exports of aluminum from the Commonwealth of Independent States (the "C.I.S.") increased substantially from 1990 levels during the period from 1991 through 1993 and have contributed to a significant increase in London Metal Exchange stocks of primary aluminum. - -------------------- * All references to tons in this Report refer to metric tons of 2,204.6 pounds. - 1 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) Based upon information currently available, Kaiser Aluminum & Chemical Corporation (the "Company") believes that only moderate additions will be made during 1994-1995 to Western world alumina and primary aluminum production capacity; however, due to the decline of primary aluminum prices since January 1, 1991, and other factors, curtailments or permanent shutdowns have been announced, to management's knowledge, with respect to approximately three million tons of primary aluminum production capacity. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Trends." The increases in alumina capacity during 1994-1995 will come from incremental expansions of existing refineries and not from new plants, which generally require a four to five-year design, engineering, and construction period. Recent Industry Trends The aluminum industry has been cyclical and market prices of alumina and primary aluminum have been volatile from time to time. During 1989, tight supply conditions for alumina and strong demand for primary aluminum resulted in unusually high spot prices for alumina. During 1990, a moderate surplus of alumina supply developed due to new alumina production from two facilities restarted in prior years (including the Company s Alpart refinery) and increased production at other refineries. Furthermore, curtailments of primary aluminum production in response to declining ingot prices have increased the surplus of alumina supply. Since 1990, spot prices of alumina have declined substantially due to these factors and slow economic growth in major aluminum consuming countries. Contract prices for deliveries of alumina in 1993 were in a lower range than the ranges applicable during the past several years. As a result of these factors and the continuing expansion of existing alumina refineries during 1992-1993, the current surplus of alumina is expected to continue. During 1989 and 1990, primary aluminum smelters throughout the world operated at near capacity levels. This factor, combined with increased production from smelter capacity additions during 1989 and 1990, resulted in a reduction of the market price of primary aluminum from 1988 peak prices. Additions to smelter capacity in 1991, 1992, and 1993, continued high operating rates in the Western world, and slow economic growth in major aluminum consuming countries, as well as exports from the C.I.S. have contributed to an oversupply of primary aluminum and a significant increase in primary aluminum inventories in the world. If Western world production and exports from the C.I.S. continue at current levels, primary aluminum inventory levels are expected to increase further in 1994. The foregoing factors have contributed to a significant reduction in the market price of primary aluminum, and may continue to adversely affect the market price of primary aluminum in the future. The average price of primary aluminum was at historic lows in real terms for the year ended 1993. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Trends." Government officials from the European Union, the United States, Canada, Norway, Australia, and the Russian Federation met in a multilateral conference in January 1994 to discuss the current excess global supply of primary aluminum. All participants have ratified as a trade agreement the resulting Memorandum which provides, in part, for (i) a reduction in Russian Federation primary aluminum production by 300,000 tons per year within three months of the date of ratification of the Memorandum and an additional 200,000 tons within the following three months, (ii) improved availability of comprehensive data on Russian aluminum production, and (iii) certain assistance to the Russian aluminum industry. A Russian Federation Trade Ministry official has publicly stated that the output reduction would remain in effect for 18 months to two years, provided that other worldwide production cutbacks occur, existing trade restrictions on aluminum are eliminated, and no new trade restrictions on aluminum are imposed. The Memorandum does not require specific levels of production cutbacks by other producing nations. The Memorandum was finalized at a second meeting of the participants held at the end of February 1994. - 2 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) The Company General The Company is a direct subsidiary of Kaiser Aluminum Corporation ("Kaiser") and is an indirect subsidiary of MAXXAM Inc. ("MAXXAM"). The Company operates in all principal aspects of the aluminum industry the mining of bauxite, the refining of bauxite into alumina, the production of primary aluminum from alumina, and the manufacture of fabricated (including semi-fabricated) aluminum products. In addition to the production utilized by the Company in its operations, the Company sells significant amounts of alumina and primary aluminum in the domestic and international markets. In 1993, the Company produced approximately 2,826,600 tons of alumina, of which approximately 71% was sold to third parties, and produced 436,200 tons of primary aluminum, of which approximately 56% was sold to third parties. The Company is also a major domestic supplier of fabricated aluminum products. In 1993, the Company shipped approximately 373,200 tons of fabricated aluminum products to third parties, which accounted for approximately 6% of the total tonnage of United States domestic shipments in 1993. A majority of the Company's fabricated products are used by customers as components in the manufacture and assembly of finished end-use products. The following table sets forth total shipments and intracompany transfers of the Company's alumina, primary aluminum, and fabricated aluminum operations: Business Strategy The Company has made significant changes in the mix of products sold to customers by disposing of selected assets, restarting and increasing its percentage ownership interest in the Alumina Partners of Jamaica ("Alpart") alumina refinery, and increasing production of alumina at Gramercy, Louisiana, and Queensland Alumina Limited ("QAL") in Australia. The percentage of the Company's alumina production sold to third parties increased from approximately 35% in 1987 to approximately 71% in 1993, and the percentage of its primary aluminum production sold to third parties increased from approximately 20% in 1987 to approximately 56% in 1993. The Company has concentrated its fabricated products operations on the beverage container market (which historically has been recession-resistant); high value-added, heat-treated sheet and plate products for the aerospace industry; hubs, wheels and other products for the truck, trailer and shipping container industry; parts for air bag canisters and other automotive components; and distributor markets for a variety of semifabricated aluminum products. Since January 1, - 3 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) 1989, the Company has constructed four new fabrication facilities and has modernized and expanded others, with the objective of reducing manufacturing costs and expanding sales in selected product markets in which the Company has production expertise, high-quality capability, and geographic and other competitive advantages. The Company has taken steps to control and reduce costs, improve the efficiency and increase the capacity of its alumina and primary aluminum production and fabricating operations, modernize its facilities, and streamline and decentralize its management structure to reduce corporate overhead and shift decision-making and accountability to its business units. In October 1993, the Company announced that it is restructuring its flat-rolled products operation at its Trentwood plant in Spokane, Washington, to reduce that facility's annual operating costs. This effort is in response to overcapacity in the aluminum rolling industry, flat demand in the U. S. can stock market, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. The Trentwood restructuring is expected to result in annual cost savings of at least $50.0 million after it has been fully implemented (which is expected to occur by the end of 1995). See "- Production Operations - Fabricated Products - Flat-Rolled Products." Primary aluminum production at the Company's Mead and Tacoma smelters was curtailed in 1993 because of a power reduction imposed by the Bonneville Power Administration (the "BPA") which reduced the operating rates for those smelters. See "- Primary Aluminum Products". Furthermore, the Company announced on February 24, 1994, that it will curtail approximately 9.3% of its annual production capacity currently available from its primary aluminum smelters. The Company has also attempted to lessen its exposure to possible future declines in the market prices of alumina and primary aluminum by entering into fixed and variable rate power and fuel supply contracts, and a labor contract with the United Steelworkers of America (the "USWA") which provides for semi- variable compensation with respect to approximately 73% of the Company's domestic hourly work force. See "- Production Operations" and " Employees." Sensitivity to Prices and Hedging Programs The Company's earnings are sensitive to changes in the prices of alumina, primary aluminum, and fabricated aluminum products, and also depend to a significant degree upon the volume and mix of all products sold by the Company. Through its variable cost structures, forward sales, and hedging programs, the Company has attempted to mitigate its exposure to possible further declines in the market prices of alumina and primary aluminum while retaining the ability to participate in favorable pricing environments that may materialize. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Trends Sensitivity to Prices and Hedging Programs." Production Operations The Company's operations are conducted through the Company s decentralized business units which compete throughout the aluminum industry. o The Alumina Business Unit, which mines bauxite and obtains additional bauxite tonnage under long-term contracts, produced approximately 8% of Western world alumina in 1993. During 1993, the Company utilized approximately 82% of its bauxite production at its alumina refineries and the remainder was either sold to third - 4 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) parties or tolled into alumina by a third party. In addition, during 1993 the Company utilized approximately 29% of its alumina for internal purposes and sold the remainder to third parties. The Company's share of total Western world alumina capacity was 8% in 1993. o The Primary Aluminum Products Business Unit operates two domestic smelters wholly owned by the Company and two foreign smelters in which the Company holds significant ownership interests. In 1993, the Company utilized approximately 44% of its primary aluminum for internal purposes and sold the remainder to third parties. The Company's share of total Western world primary aluminum capacity was 3% in 1993. o Fabricated products are manufactured by three Business Units Flat-Rolled Products, Extruded Products (including rod and bar), and Forgings which manufacture a variety of fabricated products (including body, lid, and tab stock for beverage containers, sheet and plate products, screw machine stock, redraw rod, forging stock, truck wheels and hubs, air bag canisters, and other forgings and extruded products) and operate plants located in principal marketing areas of the United States and Canada. Substantially all of the primary aluminum utilized in the Company's fabricated products operations is obtained internally, with the balance of the metal utilized in its fabricated products operations obtained from scrap metal purchases. In 1993, the Company shipped approximately 373,200 tons of fabricated aluminum products to third parties, which accounted for approximately 6% of the total tonnage of United States domestic fabricated shipments for such year. Alumina -------- The following table lists the Company's bauxite mining and alumina refining facilities as of December 31, 1993: Bauxite mined in Jamaica by Kaiser Jamaica Bauxite Company ("KJBC") is refined into alumina at the Company's plant at Gramercy, Louisiana, or is sold to third parties. In 1979, the Government of Jamaica granted the Company a mining lease - 5 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) for the mining of bauxite sufficient to supply the Company s then-existing Louisiana alumina refineries at their annual capacities of 1,656,000 tons per year until January 31, 2020. Alumina from the Gramercy plant is sold to third parties. The Company has entered into a series of medium-term contracts for the supply of natural gas to the Gramercy plant. The price of such gas varies based upon certain spot natural gas prices, with floor and ceiling prices applicable to approximately one-half of the delivered gas. The Company has, however, established a fixed price for a portion of the delivered gas through a hedging program. Alpart holds bauxite reserves and owns an alumina plant located in Jamaica. The Company has a 65% interest in Alpart and Hydro Aluminium a.s ("Hydro") owns the remaining 35% interest. The Company has management responsibility for the facility on a fee basis. The Company and Hydro have agreed to be responsible for their proportionate shares of Alpart's costs and expenses. Alpart began a program of modernization and expansion of its facilities in 1991. As a part of that program, the capacity of the Alpart alumina refinery has been increased to 1,450,000 tons per year as of December 31, 1992. In 1981, the Government of Jamaica granted Alpart a mining lease covering bauxite reserves sufficient to operate the Alpart plant until December 31, 2019. In connection with the expansion program, the Alpart partners have entered into an agreement with the Government of Jamaica designed to assure that sufficient reserves of bauxite will be available to Alpart to operate its refinery, as it has been expanded and as it may be expanded through the year 2024 (to a capacity of 2,000,000 tons per year). In mid-1990, Alpart entered into a five-year agreement for the supply of substantially all of its fuel oil, the refinery s primary energy source. In February 1992, the term of this agreement was extended to 1996 and the quantity of fuel oil to be supplied was increased. The price for 80% of the initial quantity remains fixed at a price which prevailed in the fourth quarter of 1989; the price for 80% of the increased quantity is fixed at a negotiated price; and the price for the balance of the initial and increased quantities was based upon certain spot fuel oil prices plus transportation costs. Alpart has purchased all of the quantities of fuel oil which could be purchased based upon certain spot fuel oil prices under both the initial and extended agreements. The Company holds a 28.3% interest in QAL, which owns the largest and one of the most efficient alumina refineries in the world, located in Queensland, Australia. QAL refines bauxite into alumina, essentially on a cost basis, for the account of its stockholders pursuant to long-term tolling contracts. The stockholders, including the Company, purchase bauxite from another QAL stockholder pursuant to long-term supply contracts. The Company has contracted to take approximately 751,000 tons per year of capacity or pay standby charges. The Company is unconditionally obligated to pay amounts calculated to service its share ($73.6 million at December 31, 1993) of certain debt of QAL, as well as other QAL costs and expenses, including bauxite shipping costs. QAL's annual production capacity is approximately 3,300,000 tons, of which approximately 934,000 tons are availableto the Company. The Company's principal customers for bauxite and alumina consistof large and small domestic and international aluminum producers that purchase bauxite and reduction-grade alumina for use in their internal refining and smelting operations and trading intermediaries who resell raw materials to end-users. In 1993, the Company sold all of its bauxite to one customer, and sold alumina to 13 customers, the largest and top five of which accounted for approximately 22% and 79% of such sales, respectively. Among alumina producers, the Company believes it is now the world's second largest seller of alumina to third parties. The Company's strategy is to sell a substantial portion of the bauxite and alumina available to it in excess of its internal refining and smelting requirements pursuant to forward sales contracts. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Trends - Sensitivity to Prices and Hedging Programs". Marketing and sales efforts are conducted by executives of the Alumina Business Unit and the Company. - 6 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) Primary Aluminum Products - ------------------------- The following table lists the Company's primary aluminum smelting facilities as of December 31, 1993: The Company owns two smelters located at Mead and Tacoma, Washington, where alumina is processed into primary aluminum. The Mead facility uses pre-bake technology and produces primary aluminum, almost all of which is used at the Company's Trentwood fabricating facility and the balance of which is sold to third parties. The Tacoma plant uses Soderberg technology and produces primary aluminum and high-grade, continuous-cast, redraw rod, which currently commands a premium price in excess of the price of primary aluminum. Both smelters have achieved significant production efficiencies in recent years through retrofit technology, cost controls, and semi-variable wage and power contracts, leading to increases in production volume and enhancing their ability to compete with newer smelters. At the Mead plant, the Company has converted to welded anode assemblies to increase energy efficiency, reduced the number of anodes used in the smelting process, changed from pencil to liquid pitch to produce carbon anodes which achieved environmental and operating savings, and engaged in efforts to increase production through the use of improved, higher-efficiency reduction cells. Electrical power represents an important production cost for the Company at its Mead and Tacoma smelters. The electricity supply contracts between the BPA and the Company expire in 2001. The electricity contracts between the BPA and its direct service industry customers (which consist of 15 energy intensive companies, principally aluminum producers, including the Company) permit the BPA to interrupt up to 25% of the amount of power which it normally supplies to such customers. Both the Mead and Tacoma plants operated at approximately full rated capacity during 1991-1992, but operated at less than rated capacity throughout 1993. As a result of drought conditions, in January 1993 the BPA reduced the amount of power it normally supplies to its direct service industry customers. In response to such reduction, the Company removed three reduction potlines from production (two at the Mead smelter and one at the Tacoma smelter) and purchased substitute power in the first quarter of 1993 at increased costs. Despite the temporary availability of such power through July 1993, the Company operated its Mead and Tacoma smelters at the reduced operating rates introduced in January 1993, and operated its Trentwood fabrication facility without any curtailment of its production. The Company currently anticipates that in 1994, the Company will operate the Mead and Tacoma smelters at rates which do not exceed the current operating rates of 75% of full capacity for such smelters. The BPA has recently notified its direct service industry customers that it intends to restore full power through July 31, 1994. - 7 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) Through June 1996, the Company pays for power on a basis which varies, within certain limits, with the market price of primary aluminum, and thereafter the Company will pay for power at variable rates to be negotiated. During 1993, the Company paid for power under its power supply contract with the BPA at the floor rate. Effective October 1, 1993, an increase in the base rate the BPA charges to its direct service industry customers for electricity was adopted which will increase the Company s production costs at the Mead and Tacoma smelters by approximately $15.0 million per year (approximately $9.1 million per year based on the Company's current operating rate of approximately 75% of full capacity). The rate increase generally is expected to remain in effect for two years. In the event that the BPA's revenues fall below certain levels prior to April 1994, the BPA may impose up to a 10% surcharge on the base rate it charges to its direct service industry customers, effective during the period from October 1994 through October 1995 (which would increase the Company's production costs at the Mead and Tacoma smelters by approximately $9.1 million per year based on the Company s current operating rate of approximately 75% of full capacity). In addition, in order to comply with certain federal laws and regulations applicable to endangered fish species, the BPA may be required in the future to reduce its power generation and to purchase substitute power (at greater expense) from other sources. The Company manages, and holds a 90% interest in, the Volta Aluminum Limited ("Valco") aluminum smelter in Ghana. The Valco smelter uses pre-bake technology and processes alumina supplied by the Company and the other participant into primary aluminum under long-term tolling contracts which provide for proportionate payments by the participants in amounts intended to pay not less than all of Valco's operating and financing costs. The Company s share of the primary aluminum is sold to third parties. Power for the Valco smelter is supplied under an agreement which expires in 1997, subject to Valco's right to extend the agreement for 20 years. The agreement indexes the price of two-thirds of the contract quantity to the market price of primary aluminum and fixes the price for the remainder. The agreement also provides for a review and adjustment of the base power rate and the price index every five years. The Valco smelter restarted production early in 1985 after being closed for more than two years due to lack of rainfall and the resultant hydroelectricity shortage. The Company believes that there has been sufficient rainfall and water storage such that an adequate supply of electricity for the Valco plant at its current operating rate is probable for at least one year. The Company has a 49% interest in the Anglesey Aluminium Limited ("Anglesey") aluminum smelter and port facility at Holyhead, Wales. The Anglesey smelter uses pre-bake technology. The Company supplies 49% of Anglesey's alumina requirements and purchases 49% of Anglesey's aluminum output. The Company sells its share of Anglesey's output to third parties. Power for the Anglesey aluminum smelter is supplied under an agreement which expires in 2001. The Company has developed and installed proprietary retrofit technology in all of its smelters. This technology which includes the redesign of the cathodes and anodes that conduct electricity through reduction cells, improved "feed" systems that add alumina to the cells, and a computerized system that controls energy flow in the cells enhances the Company's ability to compete more effectively with the industry's newer smelters. The Company is actively engaged in efforts to license this technology and sell technical and managerial assistance to other producers worldwide, and may participate in joint ventures or similar business partnerships which employ the Company's technical and managerial knowledge. Pursuant to various arrangements, the Company's technology has been installed in aluminum smelters located in West Virginia, Ohio, Missouri, Kentucky, Sweden, Germany, India, Australia, New Zealand, Ghana, the C.I.S., and the United Kingdom. See " Research and Development". The Company's principal primary aluminum customers consist of large trading intermediaries and metal brokers, who resell primary aluminum to fabricated product manufacturers, and large and small international aluminum fabricators. In 1993, the Company sold the approximately 56% of its primary aluminum production not utilized for internal purposes to approximately 50 customers, the largest and top five of which accounted for approximately 44% and 64% of such sales, respectively. Marketing and sales efforts are conducted by a small staff located at the business unit's headquarters in - 8 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) Pleasanton, California, and by senior executives of the Company who participate in the structuring of major sales transactions. A majority of the business unit's sales are based upon long-term relationships with metal merchants and end-users. Fabricated Products ------------------- The Company manufactures and markets fabricated aluminum products for the packaging, transportation, construction, and consumer durables markets in the United States and abroad. Sales in these markets are made directly and through distributors to a large number of customers, both domestic and foreign. In 1993, seven domestic beverage container manufacturers constituted the leading customers for the Company's fabricated products and accounted for approximately 19% of the Company's sales revenue. The Company's fabricated products compete with those of numerous domestic and foreign producers and with products made with steel, copper, glass, plastic, and other materials. Product quality, price, and availability are the principal competitive factors in the market for fabricated aluminum products. The Company has refocused its fabricated products operations to concentrate on selected products in which the Company has production expertise, high quality capability, and geographic and other competitive advantages. Flat-Rolled Products The Flat-Rolled Products Business Unit, the largest of the Company's fabricated products businesses, operates the Trentwood sheet and plate mill at Spokane, Washington. The Trentwood facility is the Company's largest fabricating plant and accounted for substantially more than one- half of the Company's 1993 fabricated products shipments. The business unit supplies the beverage container market (producing body, lid, and tab stock), the aerospace market, and the tooling plate, heat-treated alloy and common alloy coil markets, both directly and through distributors. The Company announced in October 1993 that it is restructuring its flat-rolled products operation at its Trentwood plant to reduce that facility's annual operating costs. This effort is in response to overcapacity in the aluminum rolling industry, flat demand in the U.S. can stock market, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. The Trentwood restructuring is expected to result in annual cost savings of at least $50.0 million after it has been fully implemented (which is expected to occur by the end of 1995). In connection with the restructuring, Trentwood completed an organizational streamlining that included a reduction of approximately 80 salaried employees. In addition, the Company has reached an agreement with the USWA that will reduce the total number of hourly employees at Trentwood by approximately 300 employees, or about 25%, by the end of 1995. The agreement with the USWA also includes a commitment by the Company to spend up to $50.0 million of capital at Trentwood over three years, provided that goals on cost reduction and profitability are met or exceeded. The Company's flat-rolled products are sold primarily to beverage container manufacturers located in the western United States where the Company has a transportation advantage. Quality of products for the beverage container industry, timeliness of delivery, and price are the primary bases on which the Company competes. The Company believes that the Company's capital improvements at Trentwood have enhanced the quality of the Company's products for the beverage container industry and the capacity and efficiency of the Company's manufacturing operations. The Company believes that it is one of the highest quality producers of aluminum beverage can stock in the world. In 1993, the Flat-Rolled Products Business Unit had 22 foreign and domestic can stock customers, the majority of which were beverage can manufacturers (including seven of the eight major domestic beverage can manufacturers) and the balance of which were brewers. The largest and top five of such customers accounted for approximately 25% and 56%, respectively, of the business unit's sales revenue. In 1993, the business unit shipped products to over 200 customers in the aerospace, transportation, and industrial ("ATI") markets, most of which were distributors who sell - 9 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) to a variety of industrial end-users. The top five customers in the ATI markets for flat-rolled products accounted for approximately 10% of the business unit's sales revenue. The marketing staff for the Flat-Rolled Products Business Unit is headquartered in Pleasanton, California, and is also located at the Trentwood facility. Sales are made directly to customers (including distributors) from ten sales offices located throughout the United States. International customers are served by a sales office in the Netherlands and by independent sales agents in Asia and Latin America. See also "MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Trends - Sensitivity to Prices and Hedging Programs - - Aluminum Processing" for a discussion of demand for fabricated products in the aerospace market. Extruded Products The Extruded Products Business Unit is headquartered in Dallas, Texas, and operates soft-alloy extrusion facilities in Los Angeles, California; Santa Fe Springs, California; Sherman, Texas; and London, Ontario, Canada; a cathodic protection business located in Tulsa, Oklahoma, that also extrudes both aluminum and magnesium; and rod and bar facilities in Newark, Ohio, and Jackson, Tennessee, which produce screw machine stock, redraw rod, forging stock, and billet. Each of the soft-alloy extrusion facilities has fabricating capabilities and provides finishing services. The Extruded Products Business Unit's major markets are in the transportation industry, to which it provides extruded shapes for automobiles, trucks, trailers, cabs, and shipping containers, and distribution, durable goods, defense, building and construction, ordnance, and electrical markets. In 1993, the Extruded Products Business Unit had over 900 customers for its products, the largest and top five of which accounted for approximately 6% and 19%, respectively, of its sales revenue. Sales are made directly from plants as well as marketing locations across the United States. Forgings The Forgings Business Unit operates forging facilities at Erie, Pennsylvania; Oxnard, California; and Greenwood, South Carolina; and a machine shop at Greenwood, South Carolina. The Forgings Business Unit is one of the largest producers of aluminum forgings in the United States and is a major supplier of high-quality forged parts to customers in the automotive, commercial vehicle, and ordnance markets. The high strength-to- weight properties of forged aluminum make it particularly well suited for automotive applications. The Forgings Business Unit entered the castings business by purchasing the assets of Winters Industries, which supplies cast aluminum engine manifolds to the automobile, truck, and marine markets. The casting production facilities include two foundries and a machining facility in Ohio. The Company has recently implemented a plan to discontinue its castings operations at these facilities. See "MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Aluminum Processing". In 1993, the Forgings Business Unit had over 500 customers for its products, the largest and top five of which accounted for approximately 20% and 57%, respectively, of the Forgings Business Unit's sales revenue. The Forgings Business Unit's headquarters is located in Erie, Pennsylvania, and additional sales, marketing, and engineering groups are located in the midwestern and western United States. Competition Aluminum products compete in many markets with steel, copper, glass, plastic, and numerous other materials. Within the aluminum business, the Company competes with both domestic and foreign producers of bauxite, alumina, and primary aluminum, and with domestic and foreign fabricators. The Company's principal competitors in the sale of alumina include Alcoa of Australia Ltd., Billiton International Metals B.V., Clarendon Ltd., and Pechiney S.A. In addition to the foregoing, the Company competes with most aluminum producers in the production of primary aluminum. Many of the Company's competitors have greater financial resources than the Company. In addition, the C.I.S. has been supplying large quantities of primary aluminum to the Western world. - 10 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) Primary aluminum and, to some degree, alumina are commodities with generally standard qualities, and competition in the sale of these commodities is based primarily upon price, quality, and availability. The Company believes that, assuming the current relationship between worldwide supply and demand for alumina and primary aluminum does not change materially, the loss of any one of its customers, including intermediaries, would not have a material adverse effect on its business or operations. The Company also competes with a wide range of domestic and international fabricators in the sale of fabricated aluminum products. Competition in the sale of fabricated products is based upon quality, availability, price, and service, including delivery performance. The Company concentrates its fabricating operations on selected products in which the Company has production expertise, high quality capability, and geographic and other competitive advantages. Research and Development The Company conducts research and development activities principally at three facilities dedicated to that purpose the Center for Technology ("CFT") in Pleasanton, California; the Primary Aluminum Products Division Technology Center ("DTC") adjacent to the Mead smelter in Washington; and the Alumina Development Laboratory ("ADL") at the Gramercy, Louisiana refinery. Net expenditures for Company-sponsored research and development activities were $18.5 million in 1993, $13.5 million in 1992, and $11.4 million in 1991. The Company's research staff totaled 160 at December 31, 1993. The Company estimates that research and development net expenditures will be in the range of approximately $17 - $19 million in 1994. CFT concentrates its research and development efforts on flat- rolled products while providing specialized services to the Company's other business units. Its activities include development of can stock products and aircraft sheet and plate products, and process improvements directed at efficiency and quality. In can stock, CFT works to optimize the product s metallurgy, surface characteristics, coatings, and lubrication. CFT also offers research and development, technical services, and selected proprietary technology for license or sale to third parties. CFT provided technology and technical assistance to Samyang Metal Co. Ltd. in building an aluminum rolling mill in Yongju, Korea. CFT also is engaged in cooperative research and development projects with Furukawa Electric Co., Ltd., Pechiney Rhenalu, and Kawasaki Steel Corporation of Japan, with respect to the ground transportation market. DTC maintains specialized laboratories and a miniature carbon plant where experiments with new anode and cathode technology are performed. DTC supports the Company's primary aluminum smelters, concentrating on the development of cost-effective technical innovations and equipment and process improvements. Energy savings of approximately 10% have been achieved at smelters utilizing proprietary DTC developed technologies (which are employed in both retrofit and new construction applications), such as improved cathode and anode design and insulation, modified electrolyte chemistry, distributive microprocessor control, and modified cell magnetics. Other proprietary DTC retrofit technologies, such as redesigned reduction cells, have helped the Company's older smelters achieve competitiveness with more recently constructed facilities. The Company is actively engaged in efforts to license this technology and sell technical and managerial assistance to other producers worldwide. Pursuant to various arrangements, the Company's technology has been installed in aluminum smelters located in West Virginia, Ohio, Missouri, Kentucky, Sweden, Germany, India, Australia, New Zealand, Ghana, and the United Kingdom. The Company has entered into agreements with respect to the Krasnoyarsk smelter located in Russia pursuant to which it has licensed certain of its technology for use in such facility and agreed to provide purchasing services in obtaining western- sourced technology and equipment to be used in such facility. These agreements were entered into in November 1990, and the services under them are expected to be completed in 1994. In addition, the Company has entered into - 11 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) agreements with respect to the Nadvoitsy smelter located in Russia and the Korba smelter of the Bharat Aluminum Co. Ltd., located in India, pursuant to which the Company has licensed certain of its technology for use in such facilities. The agreements relating to the Nadvoitsy and Korba smelters were entered into in 1993, and the services under such agreements are expected to be completed in 1995 and 1994, respectively. ADL has developed technologies which have improved alumina refinery efficiency. These include a high capacity thickener process used in the separation of alumina from bauxite slurry, plant conversion designs that enable alumina refineries to convert from the production of fine alumina to the preferred coarser "sandy" alumina, technology that enables refineries to process different qualities of bauxite, and computer-aided instrumentation systems to improve process efficiencies and energy use in alumina refineries. The Company is actively pursuing the licensing of alumina refinery technology worldwide. The Company's technology is in use in alumina refineries in the Americas, Australia, India, and Europe. The Company's technology sales and revenue from technical assistance to third parties were $12.8 million in 1993, $14.1 million in 1992, and $10.9 million in 1991. Employees During 1993, the Company employed an average of approximately 10,220 persons, compared with an average of approximately 10,130 employees in 1992, and approximately 9,970 employees in 1991. At December 31, 1993, the Company's work force was approximately 10,029, including a domestic work force of approximately 5,930, of whom approximately 4,150 were paid at an hourly rate. Most hourly paid domestic employees are covered by collective bargaining agreements with various labor unions. Approximately 73% of such employees are covered by a master agreement (the "Labor Contract") with the USWA which expires on October 31, 1994. The Labor Contract covers the Company's plants in Spokane (Trentwood), Mead, and Tacoma, Washington; Gramercy, Louisiana; and Newark, Ohio. The Labor Contract provides for floor level wages at all covered plants. In addition, for workers covered by the Labor Contract at the Mead and Newark plants, for any quarterly period when the average Midwest U.S. transaction price of primary aluminum is $.54 per pound or above, a bonus payment is made. The amount of the quarterly bonus payment changes incrementally with each full cent change in the price of primary aluminum between $.54 per pound and $.61 per pound, remains constant when the price is $.61 or more per pound but is below $.74 per pound, changes incrementally again with each full cent change in the price between $.74 per pound and $.81 per pound, and remains at the ceiling when the price is $.81 per pound or more. Workers covered by the Labor Contract at the Trentwood, Tacoma, and Gramercy plants may receive quarterly bonus payments based on various indices of productivity, efficiency, and other aspects of specific plant performance, as well as, in certain cases, the price of alumina or primary aluminum. The particular quarterly bonus variable compensation formula currently applicable at each plant will remain applicable for the remainder of the contract term. Pursuant to the Labor Contract, base wage rates were raised $.50 per hour in 1990 and were raised an additional $.50 per hour effective November 1, 1993. Each of the employees covered by the Labor Contract has received $2,000 in lump-sum signing and special bonuses. In addition, in the first quarter of 1991 the Company acquired up to $4,000 of preference stock held in the stock bonus plan for the benefit of approximately 80% of the employees covered by the Labor Contract, and in February 1994 acquired an additional $2,000 of such preference stock held in the stock bonus plan for the benefit of substantially the same employees. In the first quarter of 1991, the Company also acquired up to $4,000 of preference stock which had been held for the benefit of each of certain - 12 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) salaried employees, and in February 1994 acquired an additional $2,000 of such preference stock held in the stock bonus plan for the benefit of substantially the same employees. The February 1994 acquisitions of preference stock were in the aggregate amount of $5.4 million. The Company considers its employee relations to be satisfactory. Environmental Matters The Company is subject to a wide variety of international, state, and local environmental laws and regulations ("Environmental Laws") which continue to be adopted and amended. The Environmental Laws regulate, among other things, air and water emissions and discharges; the generation, storage, treatment, transportation, and disposal of solid and hazardous waste; the release of hazardous or toxic substances, pollutants and contaminants into the environment; and, in certain instances, the environmental condition of industrial property prior to transfer or sale. In addition, the Company is subject to various federal, state, and local workplace health and safety laws and regulations ("Health Laws"). From time to time, the Company is subject, with respect to its current and former operations, to fines or penalties assessed for alleged breaches of the Environmental and Health Laws and to claims and litigation brought by federal, state or local agencies and by private parties seeking remedial or other enforcement action under the Environmental and Health Laws or damages related to alleged injuries to health or to the environment, including claims with respect to certain waste disposal sites and the remediation of sites presently or formerly operated by the Company. See " LEGAL PROCEEDINGS." The Company is currently subject to a number of lawsuits under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments and Reauthorization Act of 1986 ("CERCLA"). The Company, along with several other entities, has been named as a Potentially Responsible Party ("PRP") for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA and, in certain instances, may be exposed to joint and several liability for those costs or damages to natural resources. The Company's Mead, Washington facility has been listed on the National Priorities List under CERCLA. In addition, in connection with certain of its asset sales, the Company has indemnified the purchasers of assets with respect to certain liabilities (and associated expenses) resulting from acts or omissions arising prior to such dispositions, including environmental liabilities. While the ultimate extent of the Company's liability for pending or potential fines, penalties, remedial costs, claims, and litigation relating to environmental and health and safety matters cannot be determined at this time and, in light of evolving case law relating to insurance coverage for environmental claims, management is unable to determine definitively the extent of such coverage, management currently believes that the resolution of these matters (even without giving effect to potential insurance recovery) should not have a material adverse effect on the Company's consolidated financial position or results of operations. Environmental capital spending was $12.6 million in 1993, $13.1 million in 1992, and $11.2 million in 1991. Annual operating costs for pollution control, not including corporate overhead or depreciation, were approximately $22.4 million in 1993, $21.6 million in 1992, and $17.8 million in 1991. Legislative, regulatory, and economic uncertainties make it difficult to project future spending for these purposes. However, the Company currently anticipates that in the 1994-1995 period, environmental capital spending will be within the range of approximately $7 $20.0 million per year, and operating costs for pollution control will be within the range of $20.0 - $22.0 million per year. These expenditures will be made to assure compliance with applicable Environmental Laws and are expected to include, among other things, additional "red mud" disposal facilities and improved levees at the Gramercy, Louisiana refinery (which are being financed by the industrial revenue bonds); bath crushing improvements, baking furnace modernization, and - 13 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 1. BUSINESS (continued) improved calcining controls at the Mead, Washington facility; new and continuing environmental projects at the Trentwood, Washington facility; and environmental projects required under the Clean Air Act Amendments of 1990. In addition, $7.2 million in cash expenditures in 1993, $9.6 million in 1992, and $14.0 million in 1991 were charged to previously established reserves relating to environmental cost. Approximately $7.0 million is expected to be charged to such reserves in 1994. Note 10 of the Notes to the Consolidated Financial Statements contained in the Company's 1993 Annual Report to Shareholders (the "Annual Report") is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES The locations and general character of the principal plants, mines, and other materially important physical properties relating to the Company's operations are described in "ITEM 1. BUSINESS," and those descriptions are incorporated herein by reference. The Company owns in fee or leases all the real estate and facilities used in connection with its business. Plants and equipment and other facilities are generally in good condition and suitable for their intended uses, subject to changing environmental requirements. Although the Company's domestic aluminum smelters and alumina facility were initially designed early in the Company's history, they have been modified frequently over the years to incorporate technological advances in order to improve efficiency, increase capacity, and achieve energy savings. The Company believes that its domestic plants are cost competitive on an international basis. Due to the Company s variable cost structure, the plants operating costs are relatively lower in periods of low primary aluminum prices and relatively higher in periods of high primary aluminum prices. The Company's obligations under the Credit Agreement entered into on February 17, 1994, which replaced the Company's prior credit agreement, are secured by, among other things, mortgages on the Company's major domestic plants (other than the Gramercy alumina plant). See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Financial Condition and Capital Spending." ITEM 3. ITEM 3. LEGAL PROCEEDINGS Aberdeen Pesticide Dumps Site Matter The Aberdeen Pesticide Dumps Site, listed on the Superfund National Priorities List, is composed of five separate sites around the town of Aberdeen, North Carolina. These sites (collectively, the "Sites") include the Farm Chemicals Site, Twin Sites, Fairway Six Site, McIver Dump Site and the Route 211 Site. The Sites are of concern to the United States Environmental Protection Agency (the "EPA") because of their past use as either pesticide formulation facilities or pesticide disposal areas from approximately the mid 1930s through the late 1980s. The United States originally filed a cost recovery complaint (as amended, the "Complaint") in the United States District Court for the Middle District of North Carolina, Rockingham Division, No. C-89-231-R, against five defendants on March 31, 1989, and subsequently amended its complaint to add another ten defendants on February 6, 1991, and another four defendants on August 1, 1991. The Company was not a named defendant in the Complaint. The Complaint seeks reimbursement for past and future response costs and a determination of liability of the defendants - 14 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 3. LEGAL PROCEEDINGS (continued) under Section 107 of CERCLA. On or about October 2, 1991, the Company, along with approximately 17 other parties, was served with third party complaints from four of the defendants named in the Complaint (the "Third Party Plaintiffs") alleging claims arising under various theories of contribution and indemnity. On October 22, 1992, the United States filed a motion for leave to file an amended complaint naming the Company as a first party defendant in its cost recovery action. On February 16, 1993, the court granted that motion. The EPA has performed a Remedial Investigation/Feasibility Study and issued a Record of Decision ("ROD") dated September 30, 1991, for the Sites. The major remedy selected for the five Sites in the ROD consisted of excavation of contaminated soil, treatment of the contaminated soil at a single location utilizing thermal treatment, and placement of the treated material back into the areas of excavation. The estimated cost of such remedy for the five Sites is approximately $32 million. Other possible remedies described in the ROD included on-site incineration and on-site ash disposal at an estimated cost of approximately $53 million, and off-site incineration and disposal at an estimated cost of approximately $222 million. The Company understands that the EPA is also investigating contamination of groundwater at the Sites. The EPA has stated that it has incurred past costs at the Sites in the range of $7.5 - $8 million as of February 9, 1993, and alleges that response costs will continue to be incurred in the future. On May 20, 1993, the EPA issued three unilateral Administrative Orders under Section 106(a) of CERCLA ordering the respondents, including the Company, to perform the remedial design and remedial action described in the ROD for the Farm Chemicals Site (EPA Docket No. 93-13-C), Twin Sites (EPA Docket No. 93-14-C) and Fairway Six Site (EPA Docket No. 93-15-C). The estimated cost as set forth in the ROD for the remedial action at the three Sites is approximately $27 million. In addition to the Company, respondents named in the Administrative Orders for all three Sites include J.M. Taylor, Grower Service Corporation, E.I. DuPont de Nemours & Co., Olin Corporation, UCI Holdings, Inc., PPG Industries, Inc., and Union Carbide Corporation. Ciba-Geigy Corporation, Hercules, Inc., Mobil Oil Corporation, Shell Oil Company, The Boots Company (USA), Inc., Nor-Am Chemical Co., George D. Anderson, Farm Chemicals, Inc., Partners In The Pits, Ltd., Dan F. Maples, Pits Management Corp., Maples Golf Construction, Inc., Yadco of Pinehurst, Inc., and Robert Trent Jones are named as Respondents for one or two of the Sites. The Company has entered into an Agreement in Principle with certain of the respondents to participate jointly in responding to the Administrative Orders, to share costs incurred on an interim basis, and to seek to reach a final allocation of costs through agreement or to allow such final allocation and determination of liability to be made by the United States District Court. A definitive PRP Participation Agreement is currently awaiting execution by the group. By letter dated July 6, 1993, the Company has notified the EPA of its ongoing participation with such group of respondents which, as a group, are intending to comply with the Administrative Orders to the extent consistent with applicable law. By letters dated December 30, 1993, the EPA notified the Company of its potential liability for, and requested that the Company, along with certain other companies, undertake or agree to finance, groundwater remediation at certain of the Sites. With respect to the Farm Chemicals and Twin Sites, in addition to the Company, the EPA issued such letters to J.M. Taylor, Grower Services Corporation, Farm Chemicals, Inc., E.I. DuPont de Nemours and Company, Olin Corporation, UCI Holdings, Inc., Union Carbide Corporation, Miles, Inc., Mobil Oil Corporation, Shell Oil Company, Hercules, Inc., The Boots Company (USA), Inc., Nor- Am Chemical Company, and Ciba-Geigy Corporation. With respect to the Fairway Six Site, in addition to the Company, the EPA issued such letters to J.M. Taylor, G.D. Anderson, Grower Service Corporation, Partners in Pits, Dan Maples, Pits Management Corporation, Maples Golf Construction, Inc., Yadco of Pinehurst Inc., Robert Trent Jones, E.I. DuPont de Nemours and Company, Olin Corporation, UCI Holdings, Inc., Union Carbide Corporation, Miles, Inc., Ciba-Geigy Corporation, and Hercules, Inc. The ROD- selected remedy for the groundwater remediation selected by the EPA includes extraction, on site treatment by coagulation, flocculation, - 15 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 3. LEGAL PROCEEDINGS (continued) precipitation, air stripping, GAC absorption, and discharge on site for the Farm Chemicals/Twin Sites and extraction, on-site treatment by GAC absorption and discharge on-site for the Fairway Six Site. The EPA has estimated the total present worth cost, including 30 years of operation and maintenance, at $11,849,757. The Company, along with other notified parties, plans to meet with representatives of the EPA to discuss whether an agreement to perform this remediation is possible. Based upon the information presently available to it, the Company is unable to determine whether the Company has any liability with respect to any of the Sites or, if there is any liability, the amount thereof. Two government witnesses have testified that the Company acquired pesticide products from the operator of the formulation site over a two to three year period. The Company has been unable to confirm the accuracy of this testimony. United States of America v. Kaiser Aluminum & Chemical Corporation On February 8, 1989, a civil action was filed by the United States Department of Justice at the request of the EPA against the Company in the United States District Court for the Eastern District of Washington, Case No. C-89-106-CLQ. The complaint alleged that emissions from certain stacks at the Company s Trentwood facility in Spokane, Washington intermittently violated the opacity standard contained in the Washington State Implementation Plan ("SIP"), approved by the EPA under the federal Clean Air Act. The complaint sought injunctive relief, including an order that the Company take all necessary action to achieve compliance with the Washington SIP opacity limit and the assessment of civil penalties of not more than $25,000 per day. In the course of the litigation, questions arose as to whether the observers who recorded the alleged exceedances were qualified under the Washington SIP to read opacity. In July 1990, the Company and the Department of Justice agreed to a voluntary dismissal of the action. At that time, however, the EPA had arranged for increased surveillance of the Trentwood facility by consultants and the EPA's personnel. From May 1990 through May 1991, these observers recorded approximately 130 alleged exceedances of the SIP opacity rule. Justice Department representatives have stated their intent to file a second lawsuit against the Company based on the opacity observations recorded during that period. The second lawsuit has not yet been filed. Instead, the Company has entered into negotiations with the EPA to resolve the claims against the Company through a consent decree. Although the EPA and the Company have made substantial progress in negotiating the terms of the consent decree, key issues remain to be resolved. Anticipated elements of any settlement would include a commitment by the Company to improve the emission control equipment at the Trentwood facility and a civil penalty assessment against the Company, in an amount to be determined. At this time, the Company cannot predict the likelihood that the EPA and the Company will reach an agreement upon the terms of a consent decree. In the event that the negotiations are not successful the matter likely would be resolved in federal court. Catellus Development Corporation v. Kaiser Aluminum & Chemical Corporation and James L. Ferry & Son, Inc. On January 7, 1991, the City of Richmond, et al. (the "Plaintiffs") filed a Second Amended Complaint for Damages and Declaratory Relief against the United States of America, the United States Maritime Administration and Santa Fe Land Corporation (now known as Catellus Development Corporation ("Catellus")) (collectively, the "Defendants") alleging, among other things, that the Defendants caused or allowed hazardous substances, pollutants, contaminants, debris, and other solid wastes to be discharged, deposited, disposed of or released on certain property located in Richmond, California (the "Property") formerly owned by Catellus and leased to (i) the Company for the purpose of - 16 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 3. LEGAL PROCEEDINGS (continued) shipbuilding activities conducted by the Company on behalf of the United States during World War II, and (ii) subsequent tenants thereafter. Plaintiffs allege, among other things, that (i) the Defendants are jointly and severally liable for response costs and natural resources damages under CERCLA, (ii) Defendant United States of America is liable on grounds of negligence for damages under the Federal Tort Claims Act, and (iii) Defendant Catellus is strictly liable on grounds of negligence for such discharge, deposit, disposal or release. Certain of the Plaintiffs have alleged that they had incurred or expect to incur costs and damages in the amount of approximately $49 million, in the aggregate. On or about September 23, 1992, the Plaintiffs filed a Third Amended Complaint, alleging, among other things, that (i) the Defendants are jointly and severally liable for response costs, declaratory relief, and natural resources damages under CERCLA; (ii) Defendant United States of America is liable on grounds of negligence, continuing trespass and continuing nuisance for damages under the Federal Tort Claims Act; (iii) Defendant Catellus is strictly liable on grounds of continuing nuisance, continuing trespass, and negligence for such discharge, deposit, disposal or release; (iv) Catellus is liable to indemnify Plaintiffs; and (v) Catellus is liable for fraudulent concealment of the alleged contamination. On February 20, 1991, Catellus filed a third party complaint (the "Third Party Complaint") against the Company and James L. Ferry & Son, Inc. ("Ferry") in the United States District Court for the Northern District of California, Case No. C-89-2935 DLJ. The Third Party Complaint was served on the Company as of April 12, 1991. The Third Party Complaint alleges that, if the allegations of the Plaintiffs are true, then the Company and Ferry (which is alleged to have performed certain excavation activities on the Property and, as a result thereof, to have released contaminants on the Property and to have arranged for the transportation, treatment, and disposal of such contaminants) are liable for Catellus response costs and damages under CERCLA and damages under other theories of negligence and nuisance and, in the case of the Company, waste. Catellus seeks (i) contribution from the Company and Ferry, jointly and severally, for its costs and damages pursuant to CERCLA; (ii) indemnity from the Company and Ferry for any liability or judgment imposed upon it; (iii) indemnity from the Company and Ferry for reasonable attorneys fees and costs incurred by it; (iv) damages for the injury to its interest in the Property; and (v) treble damages from the Company pursuant to California Code of Civil Procedure Section 732. On June 4, 1991, Catellus served on the Company a first amended third party complaint which alleges, in addition to the allegations of the Third Party Complaint, that the Company and/or a predecessor in interest to the Company is also liable for Catellus damages, if any, on the basis of alleged contractual indemnities contained in certain former leases of the Property. The Third Party Complaint was amended on or about October 26, 1992. The amended Third Party Complaint alleges that, if the allegations of the Plaintiffs are true, then the Company and Ferry are liable for (i) Catellus response costs and natural resources damage under CERCLA; (ii) damages under theories of negligence, trespass and nuisance; (iii) indemnity (equitable and contractual); and (iv) attorneys fees under California Code of Civil Procedure Section 1021.6. By letter dated October 26, 1992, counsel for certain underwriters at Lloyd's London and certain London Market insurance companies ("London Insurers") advised that the London Insurers agreed to reimburse the Company for defense expenses in the third party action filed by Catellus, subject to a full reservation of rights. The Plaintiffs filed a motion for leave to file a Third Amended Complaint which would have added the Company as a first party defendant. This motion was denied. On October 26, 1992, the Plaintiffs served a separate Complaint against the Company for damages and declaratory relief. The claims asserted by the Plaintiffs are for (i) recovery of costs, natural resources damages, and declaratory relief under CERCLA; (ii) damages for injury to the Property arising from negligence; - 17 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 3. LEGAL PROCEEDINGS (continued) (iii) damages under a theory of strict liability; (iv) continuing nuisance and continuing trespass; (v) equitable indemnity; (vi) response costs incurred by the Richmond Redevelopment Agency under California Health & Safety Code Section 33459.4; and (vii) declaratory relief on the state claims. This matter has been tendered to the London Insurers. Picketville Road Landfill Matter On July 1, 1991, the EPA served on the Company and 13 other PRPs a Unilateral Administrative Order For Remedial Design and Remedial Action (the "Order") at the Picketville Road Landfill site in Jacksonville, Florida. The EPA seeks remedial design and remedial action pursuant to CERCLA from some, but apparently not all, PRPs based upon a Record of Decision outlining remedial cleanup measures to be undertaken at the site adopted by the EPA on September 28, 1990. The site was operated as a municipal and industrial waste landfill from 1968 to 1977 by the City of Jacksonville. The Company was first notified by the EPA on January 17, 1991, that wastes from one of the Company's plants may have been transported to and deposited in the site. In its Record of Decision, the EPA estimated that the total capital, operations, and maintenance costs of its elected remedy for the site would be approximately $9.9 million. In addition, the EPA has reserved the right to seek recovery of its costs incurred relating to the Order, including, but not limited to, reimbursement of the EPA's cost of response. Through negotiations with the EPA and other PRPs, the Company has reached an agreement with such PRPs under which the Company will fund $146,700 of the cost of the remedial action (unless remedial costs exceed $19 million in which event the settlement agreement will be re- opened). The implementation of the foregoing agreement is subject to continuing discussions among the EPA, the other PRPs, and the Company. Asbestos-related Litigation The Company is a defendant in a number of lawsuits in which the plaintiffs allege that certain of their injuries were caused by exposure to asbestos during, and as a result of, their employment with the Company or to products containing asbestos produced or sold by the Company. The lawsuits generally relate to products the Company has not manufactured for at least 15 years. The number of such lawsuits instituted against the Company increased substantially in 1993 and management believes the number of such lawsuits will continue to increase at a greater annualized rate than in prior years. For additional information see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Financial Condition and Capital Spending - Asbestos Contingencies." Various other lawsuits and claims are pending against the Company. Management believes that resolution of the lawsuits and claims made against the Company, including matters discussed above, will not have a material adverse effect on the Company's consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders of the Company during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no established public trading market for the Company's common stock, which is held solely by Kaiser. Page 64 of this Report, and the information in Note 10 of the Notes to Consolidated Financial Statements under the heading "Dividends on Common Stock" at page 54 of this Report, are incorporated herein by reference. - 18 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- The Indentures and the 1994 Credit Agreement (Exhibits 4.1 through 4.4 to this Report) contain restrictions on the ability of the Company to pay dividends on or make distributions on account of the Company's common stock and restrictions on the ability of the Company's subsidiaries to transfer funds to the Company in the form of cash dividends, loans or advances. Exhibits 4.1 through 4.4 to this Report; Note 6 of the Notes to Consolidated Financial Statements at pages 40-43 of this Report; and the information under the heading "Financial Condition and Capital Spending--Capital Structure" at pages 23-25 of this Report, are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the Company is incorporated herein by reference to the table at page 3 of this Report; to the table at page 20 of this Report; to the discussion under the heading "Results of Operations" at page 21 of this Report; to Note 1 of the Notes to Consolidated Financial Statements at pages 36-38 of this Report; and to pages 62-63 of this Report. - 19 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Kaiser Aluminum & Chemical Corporation ("KACC" or the "Company"), operates in two business segments: bauxite and alumina, and aluminum processing. Intracompany shipments and sales are excluded from the information set forth below. (1) All references to tons refer to metric tons of 2,204.6 pounds. (2) Includes net sales of bauxite. (3) Includes the portion of net sales attributable to minority interests in consolidated subsidiaries. - 20 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES ---------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Results of Operations The Company's operating results are sensitive to changes in prices of alumina, primary aluminum, and fabricated aluminum products, and also depend to a significant degree upon the volume and mix of all products sold. The previous table provides selected operational and financial information on a consolidated basis with respect to the Company for the years ended December 31, 1993, 1992, and 1991. As an integrated aluminum producer, the Company uses a portion of its bauxite, alumina, and primary aluminum production for additional processing at certain of its other facilities. Net Sales Bauxite and Alumina - Revenue from net sales of bauxite and alumina to third parties was $423.4 million in 1993, compared with $466.5 million in 1992 and $550.8 million in 1991. Revenue from alumina decreased 13% to $338.2 million in 1993 from $390.8 million in 1992 because of lower average realized prices. Revenue from alumina decreased 16% to $390.8 million in 1992 from $466.5 million in 1991 as significantly lower average realized prices more than offset a 3% increase in alumina shipments, which was principally attributable to increased production at all three of the Company's refineries. The remainder of the segment's sales revenues were from sales of bauxite, which remained about the same throughout the three years, and the portion of sales of alumina attributable to the minority interest in Alumina Partners of Jamaica ("Alpart"). Aluminum Processing -- Revenue from net sales to third parties for the aluminum processing segment was $1,295.7 million in 1993, compared with $1,442.6 million in 1992 and $1,450.0 million in 1991. The bulk of the segment's sales represents the Company's primary aluminum and fabricated aluminum products, with the remainder attributable to the portion of sales of primary aluminum related to the minority interest in Volta Aluminium Company Limited. Revenue from primary aluminum decreased 41% to $301.7 million in 1993 from $515.0 million in 1992 because of lower shipments and lower average realized prices. Shipments of primary aluminum to third parties were approximately 39% of total aluminum products shipments in 1993, compared with approximately 51% in 1992. Revenue from primary aluminum decreased 4% to $515.0 million in 1992 from $538.5 million in 1991, as an 8% decrease in average realized prices more than offset a 4% increase in primary aluminum shipments. Shipments of primary aluminum to third parties were approximately 51% of total aluminum products shipments in 1992, compared with approximately 52% in 1991. Revenue from fabricated aluminum products increased 7% to $981.4 million in 1993 from $913.7 million in 1992, principally due to increased shipments of most fabricated aluminum products, partially offset, to a lesser extent, by a decrease in average realized prices of most of these products. Revenue from fabricated aluminum products increased 2% to $913.7 million in 1992 from $898.9 million in 1991, primarily because lower average realized prices were more than offset by a 9% increase in shipments of fabricated aluminum products. - 21 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Operating Income (Loss) The Company had an operating loss of $123.1 million in 1993, compared with income of $90.2 million in 1992 and $215.8 million in 1991. In the fourth quarter of 1993, the Company recorded a pre-tax charge of approximately $35.8 million related to the restructuring charges (see Note 3 of the Notes to Consolidated Financial Statements) and a pre- tax charge of $19.4 million ($29.0 million in the fourth quarter of 1992) because of a reduction in the carrying value of its inventories caused principally by prevailing lower prices for alumina, primary aluminum, and fabricated products. Bauxite and Alumina -- This segment's operating loss in 1993 was $4.5 million, compared with income of $62.6 million in 1992 and $150.0 million in 1991. In 1993 compared with 1992, operating income was adversely affected principally due to a decrease in average realized prices for alumina, which more than offset above-market prices for virtually all of its excess alumina sold forward in prior periods under long-term contracts. In 1992 compared to 1991, operating income was adversely affected by a decrease in average realized prices for alumina, which more than offset higher alumina shipments and above- market prices for significant quantities of alumina sold forward in prior periods under long-term contracts. Aluminum Processing -- This segment's operating loss was $46.3 million in 1993, compared with income of $104.9 million in 1992. This decrease was caused principally by reduced shipments and lower average realized prices of primary aluminum products which more than offset increased shipments of fabricated products. In 1993, KACC implemented a restructuring plan for its flat-rolled products operation at its Trentwood plant in response to overcapacity in the aluminum rolling industry, flat demand in the U.S. can stock market, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. Additionally, KACC implemented a plan to discontinue its casting operations, which include three facilities located in Ohio. This entire restructuring is expected to be completed by the end of 1995 and will affect approximately 670 employees. The pre-tax charge for this restructuring of $35.8 million includes $25.2 million for pension, severance, and other termination benefits; $4.7 million for a writedown of the casting facilities to net realizable value; $3.3 million for estimated 1994 casting operating losses until the date of closure or sale; and $2.6 million for various other items. The Trentwood restructuring is expected to result in annual cost savings of at least $50.0 million after it has been fully implemented. Other contributing factors were lower production at the Company's smelters in the Pacific Northwest in 1993 as a result of the removal of three reduction potlines from production at those smelters in January 1993 in response to the Bonneville Power Administration's (the "BPA") reduction during the first quarter of 1993 of the amount of power it normally provides to the Company, and the increased cost of substitute power in such quarter. In 1993, the Company's average realized price from sales of primary aluminum was approximately $.56 per pound, compared to the average Midwest United States transaction price of approximately $.54 per pound during such period. In both 1993 and 1992, the Company realized above-market prices for significant quantities of primary aluminum sold forward in prior periods under long-term contracts. Operating income for the aluminum processing segment was $104.9 million in 1992, a decrease of 30% from $150.2 million in 1991. Operating income in 1992 was adversely affected by a decrease in average realized prices for primary aluminum and most fabricated aluminum products, partially offset by increased shipments. In both 1992 and 1991, the Company realized above-market prices for significant quantities of primary aluminum sold forward in prior periods under long-term contracts. - 22 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Corporate -- Corporate operating expenses of $72.3 million, $77.3 million, and $84.4 million in 1993, 1992, and 1991, respectively, represented corporate general and administrative expenses which were not allocated to segments. Income (Loss) Before Extraordinary Loss and Cumulative Effect of Changes in Accounting Principles Loss before extraordinary loss and cumulative effect of changes in accounting principles in 1993 was $117.6 million, compared with income of $29.6 million in 1992. This decrease resulted from the lower operating income previously described and approximately $10.8 million of other pre-tax charges, principally related to establishing additional litigation and environmental reserves. Other income remained about the same in 1992 and 1991, as approximately $14.0 million of income for non-recurring adjustments to previously recorded liabilities and reserves in the fourth quarter of 1992 approximately equaled the receipt of a $12.0 million fee in the first quarter of 1991 from the Company's minority partner in Alpart in consideration for the execution of an expansion agreement for the Alpart alumina refinery. Income before extraordinary loss and cumulative effect of changes in accounting principles in 1992 was $29.6 million, a decrease of 76% from $124.7 million in 1991. This decrease resulted from the lower operating income previously described, partially offset by an increase in other income principally due to approximately $14.0 million of income for non-recurring adjustments to previously recorded liabilities and reserves in the fourth quarter of 1992. Net Income (Loss) The Company reported a net loss of $647.3 million in 1993, compared with net income of $29.6 million in 1992 and $124.7 million in 1991. The principal reasons for the earnings decline in 1993 compared with 1992 were the cumulative effect of changes in accounting principles of $507.9 million related to the adoption of Statements of Financial Accounting Standards No. 106, 112, and 109 (see Note 1 of the Notes to Consolidated Financial Statements), the extraordinary loss on early extinguishment of debt of $21.8 million, and the operating losses described above. The principal reason for the earnings decline in 1992 compared with 1991 was the decrease in average realized prices for alumina, primary aluminum, and most fabricated products, partially offset by an increase in shipments of such products. Financial Condition and Capital Spending Capital Structure On February 17, 1994, the Company and its parent, Kaiser Aluminum Corporation ("Kaiser"), entered into a credit agreement with BankAmerica Business Credit, Inc. (as agent for itself and other lenders), the Bank of America National Trust and Savings Association, and certain other lenders (the "1994 Credit Agreement"). The 1994 Credit Agreement replaced the credit agreement entered into in December 1989 by the Company and Kaiser with a syndicate of commercial banks and other financial institutions (as amended, the "1989 Credit Agreement") and consists of a $250.0 million five-year secured, revolving line of credit, scheduled to mature in 1999. The Company is able to borrow under the facility by means of revolving credit advances and letters of credit (up to $125.0 million) in an aggregate amount equal to the lesser of $250.0 million or a borrowing base relating to eligible - 23 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES ------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) accounts receivable plus eligible inventory. The Company will record a pre-tax extraordinary loss of approximately $8.3 million in the first quarter of 1994, consisting primarily of the write-off of unamortized deferred financing costs related to the 1989 Credit Agreement. As of February 24, 1994, the amount outstanding under the 1994 Credit Agreement was $67.4 million of letters of credit. The 1994 Credit Agreement is unconditionally guaranteed by the all significant subsidiaries of KACC which were guarantors of KACC's obligations under the 1989 Credit Agreement and by Kaiser. Loans under the 1994 Credit Agreement bear interest at a rate per annum, at KACC's election, equal to (i) a Reference Rate (as defined) plus 1-1/2 % or (ii) LIBO Rate (Reserve Adjusted) plus 3-1/4%. After June 30, 1995, the interest rate margins applicable to borrowings under the 1994 Credit Agreement may be reduced by up to 1 % (non-cumulatively), based upon a financial test, determined quarterly. The 1994 Credit Agreement requires KACC to maintain certain financial covenants and places restrictions on the Company's and KACC's ability to, among other things, incur debt and liens, make investments, pay common stock dividends, undertake transactions with affiliates, make capital expenditures, and enter into unrelated lines of business. The 1994 Credit Agreement is secured by, among other things, (i) mortgages on KACC's major domestic plants (excluding the Gramercy plant); (ii) subject to certain exceptions, liens on the accounts receivable, inventory, equipment, domestic patents and trademarks, and substantially all other personal property of KACC and certain of its subsidiaries; (iii) a pledge of all the stock of KACC owned by Kaiser; and (iv) pledges of all of the stock of a number of KACC's wholly owned domestic subsidiaries, pledges of a portion of the stock of certain foreign subsidiaries, and pledges of a portion of the stock of certain partially owned foreign affiliates. On February 17, 1994, Kaiser consummated the public offering of 8,000,000 shares of its 8.255% PRIDES, Convertible Preferred Stock (the "PRIDES"). The net proceeds from the sale of the shares of PRIDES were approximately $90.6 million. Kaiser used such net proceeds to make a non-interest bearing loan to KACC in a principal amount equal to $30.0 million (the aggregate dividends scheduled to accrue on the shares of PRIDES from the issuance date until December 31, 1997, the date on which the outstanding PRIDES will be mandatorily converted into shares of Kaiser's common stock), evidenced by an intercompany note, and used the balance of such net proceeds to make a capital contribution to KACC in the amount of approximately $60.6 million. In connection with the PRIDES offering, Kaiser granted the underwriters an over allotment option for up to 1,200,000 of such shares. Concurrent with the offering of the PRIDES, on February 17, 1994, KACC issued $225.0 million of its 9-7/8% Senior Notes due 2002 (the "Senior Notes"). The net proceeds of the offering of the Senior Notes were used to reduce outstanding borrowings under the Revolving Credit Facility of the 1989 Credit Agreement immediately prior to the effectiveness of the 1994 Credit Agreement and for working capital and general corporate purposes. The offering of the PRIDES, the concurrent issuance of the Senior Notes, and the replacement of the 1989 Credit Agreement are the final steps of a comprehensive refinancing plan which the Company and Kaiser began in January 1993 which extended the maturities of the Company's outstanding indebtedness, enhanced its liquidity, and raised new equity capital. - 24 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) At December 31, 1993, the Company's total consolidated indebtedness was $729.4 million, compared to $795.8 million at December 31, 1992. As of December 31, 1992, the Company's long-term indebtedness consisted principally of $321.7 million aggregate amount of the 14- 1/4% Senior Subordinated Notes due 1995 (the "14-1/4% Notes") and the 1989 Credit Agreement. KACC refinanced the 14-1/4% Notes through the issuance in February 1993 of $400.0 million aggregate principal amount of the 12-3/4% Senior Subordinated Notes due 2003 (the "12-3/4% Notes"). The net proceeds from the sale of the 12-3/4% Notes were used to retire $321.7 million aggregate principal amount of, and pay premiums on, the 14-1/4% Notes, to prepay $18.0 million of the term loan under the 1989 Credit Agreement, and to reduce outstanding borrowings under the Revolving Credit Facility of the 1989 Credit Agreement. These transactions resulted in a pre-tax extraordinary loss of approximately $33.0 million in the first quarter of 1993 ($21.8 million after taxes), consisting primarily of the write-off of unamortized discount and deferred financing costs related to the 14-1/4% Notes and the payment of premiums on the 14-1/4% Notes. The obligations of KACC with respect to the Senior Notes and the 12-3/4% Notes are guaranteed, jointly and severally, by certain subsidiaries of KACC. The indentures governing the Senior Notes and the 12-3/4% Notes and the 1994 Credit Agreement restricts, among other things, Kaiser's and KACC's ability, to incur debt, undertake transactions with affiliates, and pay dividends. To increase its equity capital, Kaiser consummated a public offering of its $.65 Depositary Shares in June 1993, each representing one- tenth of a share of Series A Mandatory Conversion Premium Dividend Preferred Stock (the "Series A Shares") pursuant to which it realized net cash proceeds of approximately $119.3 million. In connection with the offering of the $.65 Depositary Shares, Kaiser made a non-interest bearing loan to KACC in the principal amount of $37.8 million (the aggregate dividends scheduled to accrue on the Series A Shares from the issuance date until the date on which the outstanding Series A Shares mandatorily convert into shares of Kaiser's common stock). The loan is evidenced by an intercompany note which matures on June 29, 1996, and is payable in quarterly installments. As of December 31, 1993, the aggregate principal amount of such intercompany note was $31.5 million. Cash from Operations Cash provided by operations was $25.3 million in 1993, compared with $28.0 million in 1992 and $143.7 million in 1991. The decrease in 1992 compared with 1991 was primarily because of the decline in net income and a $66.3 million decrease in previously withdrawn equity resulting from the excess of current market value over the premiums paid in certain option contracts. Capital Expenditures The Company's capital expenditures of approximately $300.2 million (of which $42.6 million was funded by the Company's minority partners in certain foreign joint ventures) during the three years ended December 31, 1993, were made primarily to improve production efficiency, reduce operating costs, expand capacity at existing facilities, and construct new facilities. Total consolidated capital expenditures were $67.7 million in 1993, compared with $114.4 million in 1992 and $118.1 million in 1991 (of which $9.4, $17.1, and $16.1 million were funded by the minority partners in certain foreign joint ventures in 1993, 1992, and 1991, respectively). Total consolidated capital expenditures (of which approximately 5% is expected to be funded by the minority partners in certain foreign joint ventures) are expected to be in the range of $50.0 to $75.0 million per year in the years 1994-1996. - 25 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES ----------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Debt Service and Capital Expenditure Requirements The Company expects that it will be able to satisfy its debt service and capital expenditure requirements through at least December 31, 1995, from cash flows generated by operations and, to the extent necessary, from borrowings under the 1994 Credit Agreement. Dividends and Distributions The declaration and payment of dividends by the Company and Kaiser on their shares of common stock is subject to certain covenants contained in the 1994 Credit Agreement and, in the case of the Company, the Senior Note Indenture and the 12-3/4% Note Indenture. The 1994 Credit Agreement does not permit the Company or Kaiser to pay any dividends on their common stock. The declaration and payment of dividends by Kaiser on the shares of the Series A Shares and the PRIDES is expressly permitted by the terms of the 1994 Credit Agreement to the extent Kaiser receives payments on the intercompany notes or certain other permitted distributions from the Company. Other Obligations In December 1992, KACC entered into an installment sale agreement (the "Sale Agreement") with the Parish of St. James, Louisiana (the "Louisiana Parish"), pursuant to which the Louisiana Parish issued $20.0 million aggregate principal amount of its 7-3/4% Bonds due August 1, 2022 (the "Bonds"), to finance the construction of certain solid waste disposal facilities at KACC's Gramercy plant. The proceeds from the sale of the Bonds were deposited into a construction fund and may be withdrawn, from time to time, pursuant to the terms of the Sale Agreement and the Bond indenture. At December 31, 1993, $10.8 million remained in the construction fund. The Sale Agreement requires KACC to make payments to the Louisiana Parish in installments due on the dates and in the amounts required to permit the Louisiana Parish to satisfy all of its payment obligations under the Bonds. The Company has historically participated in various raw material joint ventures outside the United States. At December 31, 1993, the Company was unconditionally obligated for $73.6 million of indebtedness of one such joint venture affiliate. Environmental Contingencies The Company and Kaiser are subject to a wide variety of environmental laws and regulations and to fines or penalties assessed for alleged breaches of the environmental laws and to claims and litigation based upon such laws. KACC is currently subject to a number of lawsuits under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments Reauthorization Act of 1986 ("CERCLA"), and, along with certain other entities, has been named as a potentially responsible party for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA. Based upon KACC's evaluation of these and other environmental matters, KACC has established environmental accruals primarily related to potential solid waste disposal and soil and groundwater remediation matters. The following table presents the changes in such accruals, which are primarily included in Long-term liabilities, for the years ended December 31, 1993, 1992, and 1991: - 26 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) These environmental accruals represent KACC's estimate of costs reasonably expected to be incurred based upon presently enacted laws and regulations, currently available facts, existing technology, and KACC's assessment of the likely remediation action to be taken. KACC expects that these remediation actions will be taken over the next several years and estimates that expenditures to be charged to the environmental accrual will be approximately $4.0 to $8.0 million for the years 1994 through 1998 and an aggregate of approximately $12.8 million thereafter. As additional facts are developed and definitive remediation plans and necessary regulatory approvals for implementation of remediation are established, or alternative technologies are developed, changes in these and other factors may result in actual costs exceeding the current environmental accruals by amounts which cannot presently be estimated. While uncertainties are inherent in the ultimate outcome of these matters and it is impossible to presently determine the actual costs that ultimately may be incurred, management believes that the resolution of such uncertainties should not have a material adverse effect upon the Company's consolidated financial position or results of operations. Asbestos Contingencies KACC is a defendant in a number of lawsuits in which the plaintiffs allege that certain of their injuries were caused by exposure to asbestos during, and as a result of, their employment with KACC or to products containing asbestos produced or sold by KACC. The lawsuits generally relate to products KACC has not manufactured for at least 15 years. At year-end 1993, the number of such lawsuits pending was approximately 23,400 (approximately 11,400 of which were received in 1993). The number of such lawsuits instituted against KACC increased substantially in 1993, and management believes the number of such lawsuits will continue at approximately the same rate for the next few years. In connection with such litigation, during 1993, 1992, and 1991, KACC made cash payments for settlement and other related costs of $7.0, $7.1, and $6.1 million, respectively. Based upon prior experience, KACC estimates annual future cash payments in connection with such litigation of approximately $8.0 to $13.0 million for the years 1994 through 1998, and an aggregate of approximately $88.4 million thereafter through 2006. Based upon past experience and reasonably anticipated future activity, KACC has established an accrual for estimated asbestos-related costs for claims filed and estimated to be filed and settled through 2006. The Company does not presently believe there is a reasonable basis for estimating such costs beyond 2006 and, accordingly, no accrual has been recorded for such costs which may be incurred. This accrual was calculated based upon the current and anticipated number of asbestos-related claims, the prior timing and amounts of asbestos-related payments, the current state of case law related to asbestos claims, the advice of counsel, and the anticipated effects of inflation and discounting at an estimated risk- free rate (5.25% at December 31, 1993). Accordingly, an accrual of $102.8 million for asbestos-related expenditures is included primarily in Long-term liabilities at December 31, 1993. The aggregate amount of the undiscounted liability at December 31, 1993, of $141.5 million, before considerations for insurance recoveries, reflects an increase of $56.6 million from the prior year, resulting primarily from an increase in claims filed during 1993 and the Company's belief that the number of such lawsuits will continue at approximately the same rate for the next few years. - 27 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The Company believes that KACC has insurance coverage available to recover a substantial portion of its asbestos-related costs. While claims for recovery from one of KACC's insurance carriers are currently subject to pending litigation and other carriers have raised certain defenses, the Company believes, based upon prior insurance- related recoveries in respect of asbestos-related claims, existing insurance policies, and the advice of counsel, that substantial recoveries from the insurance carriers are probable. Accordingly, estimated insurance recoveries of $94.0 million determined on the same basis as the asbestos-related cost accrual are recorded primarily in Other assets as of December 31, 1993. Based upon the factors discussed in the two preceding paragraphs, management currently believes that there is no more than a remote possibility (under generally accepted accounting principles) that the Company's asbestos-related costs net of related insurance recoveries exceed those accrued as of December 31, 1993, and, accordingly, that the resolution of such uncertainties and the incurrence of such net costs should not have a material adverse effect upon the Company's consolidated financial position or results of operations. Income Tax Matters Tax Attribute Carryforwards At December 31, 1993, the Company had certain tax attribute carryforwards which may be utilized, subject to certain limitations, to reduce future income tax liabilities. See Note 7 of the Notes to Consolidated Financial Statements for a discussion of the effects upon the Company's tax attribute carryforwards and carrybacks resulting from the offering of Kaiser's $.65 Depositary Shares in June 1993. Deferred Income Tax Assets As discussed in Note 7 of the Notes to Consolidated Financial Statements, the Company's net deferred income tax assets as of December 31, 1993, were $206.3 million. Approximately $82.3 million of these net deferred income tax assets relate to the benefit of loss and credit carryforwards, net of valuation allowances. The Company evaluated all appropriate factors to determine the proper valuation allowances for these carryforwards, including any limitations concerning their use and the year the carryforwards expire, as well as the levels of taxable income necessary for utilization. For example, full valuation allowances were provided for certain credit carryforwards that expire in the near term. With regard to future levels of income, the Company believes, based on the cyclical nature of its business, its history of prior operating earnings, and its expectations for future years, that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. The remaining portion of the Company's net deferred income tax assets at December 31, 1993, is approximately $124.0 million. A principal component of this amount is the tax benefit associated with the accrual for postretirement benefits other than pensions. The future tax deductions with respect to the turnaround of this accrual will occur over a 30- to 40-year period. If such deductions create or increase a net operating loss in any one year, the Company has the ability to carry forward such loss for 15 taxable years. For these reasons, the Company believes a long-term view of profitability is appropriate and has concluded that this net deferred income tax asset will more likely than not be realized despite the recent decline in profitability. - 28 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES --------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Trends Exports from the Commonwealth of Independent States ("C.I.S."), additions to smelter capacities during the past several years, continued high operating rates, and other factors have contributed to a significant increase in primary aluminum inventories in the Western world. If Western world production and exports from the C.I.S. continue at current levels, primary aluminum inventory levels will increase further in 1994. The foregoing factors, among others, have contributed to a significant reduction in the market price of primary aluminum, and may continue to adversely affect the market price of primary aluminum in the future. Government officials from the European Union, the United States of America, Canada, Norway, Australia, and the Russian Federation met in a multilateral conference in January 1994 to discuss the current excess global supply of primary aluminum. All six participating governments have ratified as a trade agreement the resulting Memorandum which provides, in part, for (i) a reduction in Russian Federation primary aluminum production by 300,000 tons per year within three months of ratification of the Memorandum and an additional 200,000 tons within the following three months, (ii) improved availability of comprehensive data on Russian aluminum production, and (iii) certain assistance to the Russian aluminum industry. A Russian Federation Trade Ministry official has publicly stated that the output reduction would remain in effect for 18 months to two years, provided that other worldwide production cutbacks occur, existing trade restrictions on aluminum are eliminated, and no new trade restrictions on aluminum are imposed. The Memorandum does not require specific levels of production cutbacks by other producing nations. There can be no assurance that the implementation of the Memorandum will adequately address the current oversupply of primary aluminum. If the Company's average realized sales prices in 1994 for substantial quantities of its primary aluminum and alumina were based on the current market price of primary aluminum, the Company would continue to sustain net losses in 1994, which would be expected to approximate the loss in 1993 ($81.5 million) before extraordinary loss and cumulative effect of changes in accounting principles, restructuring charges, reduction in the carrying value of inventories, and additions to litigation and environmental reserves as described in Notes 1 and 3 of the Notes to Consolidated Financial Statements. Effective October 1, 1993, an increase in the base rate the BPA charges to its direct service industry customers for electricity was adopted, which will increase the Company's production costs at the Mead and Tacoma smelters by approximately $15.0 million per year (approximately $11.3 million per year, based on the current operating rate of approximately 75% of full capacity). The rate increase is generally expected to remain in effect for two years. Sensitivity to Prices and Hedging Programs The Company's earnings are sensitive to changes in the prices of alumina, primary aluminum, and fabricated aluminum products, and also depend to a significant degree upon the volume and mix of all products sold. Consequently, the Company has developed strategies to mitigate its exposure to possible further declines in the market prices of alumina and primary aluminum while retaining the ability to participate in favorable pricing environments that may materialize. - 29 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES -------------------------------------------------------------------- ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Alumina -- The Company has sold forward substantially all of the alumina available to it in excess of its projected internal smelting requirements for 1994, and a substantial portion of such excess alumina for 1995. Approximately 95% of 1994 sales and virtually all of 1995 sales were made at prices indexed to future prices of primary aluminum. Approximately 75% of 1994 sales were made at prices indexed to future prices of primary aluminum, but with minimum prices that exceed the Company's estimated cash production costs. The remainder of 1994 sales were made either at fixed prices that exceed the Company's estimated cash production costs, or are subject to prices indexed to future prices of primary aluminum but without minimum prices. Approximately 85% of 1995 sales were made at prices indexed to future prices of primary aluminum, but with minimum prices that exceed the Company's estimated cash production costs. Aluminum Processing -- As of the date of this report, the Company has sold forward at fixed prices approximately 75% of its primary aluminum in excess of its projected internal fabrication requirements in 1994 and approximately 55% of such surplus in 1995 at fixed prices that exceed the current market price of primary aluminum. Hedging programs already in place would allow the Company to participate in higher market prices, should they materialize, for approximately 40% of the Company's excess primary aluminum sold forward in 1994, and 100% of the Company's excess primary aluminum sold forward in 1995. In response to the low price of primary aluminum caused by the current surplus, a number of companies have closed smelting facilities. In addition, in response to certain power reductions undertaken by the BPA in the Pacific Northwest, a number of companies (including the Company) have curtailed or shut down production capacities at their smelter facilities in the Pacific Northwest. Furthermore, after continued assessment of its production levels in light of market prices, industry inventory levels, production costs, and user demand, on February 25, 1994, the Company announced that in April 1994 it will curtail approximately 9.3% of its primary aluminum current annual production capacity. Fabricated aluminum prices, which vary considerably among products, are heavily influenced by changes in the price of primary aluminum and generally lag behind primary aluminum prices for periods of up to six months. A significant portion of the Company's fabricated product shipments consist of body, lid, and tab stock for the beverage container market. The Company may not be able to receive increases in primary aluminum prices from its can stock customers as promptly as in the recent past because of competition from other aluminum producers and because of excess supply in the industry. The Company also ships fabricated products to customers in the aerospace market. Aluminum demand in the aerospace market is decreasing as a result of the structural contraction of the defense industry caused by the end of the Cold War. In addition, the commercial aerospace market is experiencing a cyclical downturn in business due to the recent economic recessions in the United States, Canada, Australia, and the United Kingdom, and slow economic growth in other countries. - 30 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------------- ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page ---- Report of Independent Public Accountants.. . . 32 Consolidated Balance Sheets . .. . .. . .. . . 33 Statements of Consolidated Income. .. . .. . . 34 Statements of Consolidated Cash Flows.. .. . . 35 Notes to Consolidated Financial Statements . . 36 Five-Year Financial Data .. . .. . .. . .. . . 62 Quarterly Financial Data .. . .. . .. . .. . . 64 Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties. . . . . 65 Schedule V - Consolidated Property, Plant, and Equipment. . . 66 Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Consolidated Property, Plant, and Equipment. . . 67 Schedule IX - Consolidated Short- Term Borrowings. . . . . 68 Schedule X - Supplementary Consolidated Income Statement Information. . . . . 69 All other schedules are inapplicable or the required information is included in the Consolidated Financial Statements or the Notes thereto. - 31 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------------- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and the Board of Directors of Kaiser Aluminum & Chemical Corporation: We have audited the accompanying consolidated balance sheets of Kaiser Aluminum & Chemical Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kaiser Aluminum & Chemical Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission s rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. As explained in Note 1 of the Notes to Consolidated Financial Statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions, postemployment benefits, and income taxes. ARTHUR ANDERSEN & CO. San Francisco, California February 24, 1994 - 32 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES CONSOLIDATED BALANCE SHEETS --------------------------------------------------------------------- The accompanying notes to consolidated financial statements are an integral part of these statements. - 33 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES STATEMENTS OF CONSOLIDATED INCOME (LOSS) ---------------------------------------------------------------------- The accompanying notes to consolidated financial statements are an integral part of these statements. - 34 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES STATEMENTS OF CONSOLIDATED CASH FLOWS --------------------------------------------------------------------- The accompanying notes to consolidated financial statements are an integral part of these statements. - 35 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -------------------------------------------------------------------- (In millions of dollars, except share amounts) -------------------------------------------------------------------- 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the statements of Kaiser Aluminum & Chemical Corporation ("KACC" or the "Company") and its majority owned subsidiaries. Investments in 50%-or-less-owned entities are accounted for primarily by the equity method. Intercompany balances and transactions are eliminated. The Company is a wholly owned subsidiary of Kaiser Aluminum Corporation ("Kaiser") which is a subsidiary of MAXXAM Inc. ("MAXXAM"). Certain reclassifications of prior-year information were made to conform to the current presentation. Changes in Accounting Principles The Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), as of January 1, 1993. The costs of postretirement benefits other than pensions and postemployment benefits are now accrued over the period employees provide services to the date of their full eligibility for such benefits. Previously, such costs were expensed as actual claims were incurred. The cumulative effect of the changes in accounting principles for the adoption of SFAS 106 and SFAS 112 were recorded as charges to results of operations of $497.7 and $7.3, net of related income taxes of $234.2 and $3.5, respectively. The new accounting standards had no effect on the Company's cash outlays for postretirement or postemployment benefits, nor did these one-time charges affect the Company's compliance with its existing debt covenants. The Company reserves the right, subject to applicable collective bargaining agreements and applicable legal requirements, to amend or terminate these benefits. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), as of January 1, 1993. The adoption of SFAS 109 changes the Company's method of accounting for income taxes to an asset and liability approach from the deferral method prescribed by Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" ("APB 11"). The asset and liability approach requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Under this method, deferred income tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. The cumulative effect of the change in accounting principle reduced the Company's results of operations by $2.9. Cash and Cash Equivalents The Company considers only those short-term, highly liquid investments with original maturities of 90 days or less to be cash equivalents. Inventories Substantially all product inventories are stated at last-in, first-out ("LIFO") cost, not in excess of market. Replacement cost is not in excess of LIFO cost. Other inventories, principally operating supplies and repair and maintenance parts, are stated at the lower of average cost or market. Inventory costs consist of material, labor, and manufacturing overhead, including depreciation. Inventories consist of the following: - 36 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) -------------------------------------------------------------------- (In millions of dollars, except share amounts) -------------------------------------------------------------------- The Company recorded pre-tax charges of approximately $19.4 in 1993 and $29.0 in 1992 because of a reduction in the carrying values of its inventories caused principally by prevailing lower prices for alumina, primary aluminum, and fabricated products. The 1992 amount includes a LIFO inventory liquidation of $10.2. Depreciation Depreciation is computed principally by the straight-line method at rates based upon the estimated useful lives of the various classes of assets. The principal estimated useful lives by class of assets are: --------------------------------------------------------------------- Land improvements 8 to 25 years Buildings 15 to 45 years Machinery and equipment 10 to 22 years Other Income Other income in 1993 includes approximately $10.8 of pre-tax charges related principally to establishing additional litigation and environmental reserves in the fourth quarter. Other income in 1992 includes approximately $14.0 of pre-tax income for non-recurring adjustments to previously recorded liabilities and reserves in the fourth quarter. Included in interest and other income in 1991 is the receipt of a $12.0 fee in the first quarter from the Company's minority partner in consideration for the execution of an expansion agreement for the Alumina Partners of Jamaica ("Alpart") alumina refinery. The agreement provides for a program of expansion and modernization of Alpart at the existing ownership interest of 65% for KACC and 35% for KACC's minority partner. The prior expansion agreement provided for expansion rights of 75% for KACC and 25% for KACC's minority partner. Futures Contracts and Options The Company periodically enters into forward foreign exchange, commodity futures, and commodity and currency option contracts, which are primarily accounted for as hedges of its revenues and costs. The gains and losses on these contracts are reflected in earnings concurrently with the hedged revenues or costs. The cash flows from these contracts are classified in a manner consistent with the underlying nature of the transactions. At December 31, 1993, the net fair market value of the Company's position in these contracts was not material. Deferred Financing Costs Costs incurred to obtain debt financing are deferred and amortized over the estimated term of the related borrowing. Foreign Currency The Company uses the United States dollar as the functional currency for its foreign operations. - 37 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) -------------------------------------------------------------------- (In millions of dollars, except share amounts) ---------------------------------------------------------------------- Fair Value of Financial Instruments Unless otherwise disclosed, the carrying amount of all financial instruments is a reasonable estimate of fair value. 2. Pro Forma Financial Information On February 17, 1994, Kaiser completed an equity offering of preferred stock (see Note 10), and KACC completed a refinancing which included the issuance of $225.0 of Senior Notes and the signing of the 1994 Credit Agreement (see Note 6). The following unaudited pro forma information reflects the effects of these transactions as if they had occurred on December 31, 1993. ---------------------------------------------------------------------- Current assets $ 844.4 Non-current assets 1,799.6 Current liabilities 473.5 Long-term debt 755.7 Stockholders' equity 54.5 3. Restructuring of Operations In 1993, KACC implemented a restructuring plan for its flat-rolled products operation at its Trentwood plant in response to overcapacity in the aluminum rolling industry, flat demand in the U.S. can stock market, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. Additionally, KACC implemented a plan to discontinue its casting operations, which include three facilities located in Ohio. This entire restructuring is expected to be completed by the end of 1995 and will affect approximately 670 employees. The pre-tax charge for this restructuring of $35.8 includes $25.2 for pension, severance, and other termination benefits; $4.7 for a write-down of the casting facilities to net realizable value; $3.3 for estimated 1994 casting operating losses until the date of closure or sale; and $2.6 for various other items. 4. Investments In and Advances To Unconsolidated Affiliates Summary combined financial information is provided below for unconsolidated aluminum investments, most of which supply and process raw materials. The investees are Queensland Alumina Limited ("QAL") (28.3% owned), Anglesey Aluminium Limited ("Anglesey") (49.0% owned), and Kaiser Jamaica Bauxite Company (49.0% owned). The equity in earnings (losses) before income taxes of such operations are treated as a reduction (increase) in cost of products sold. At December 31, 1993 and 1992, KACC's net receivables from these affiliates were not material. - 38 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) ------------------------------------------------------------------------ (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Summary of Combined Financial Position The Company's equity in losses differs from the summary net income (loss) due to various percentage ownerships in the entities and equity method accounting adjustments. At December 31, 1993, KACC's investment in its unconsolidated affiliates exceeded its equity in their net assets by approximately $80.7. The Company is amortizing this amount over a 12-year period, which results in an annual amortization charge of approximately $11.9. The Company and its affiliates have interrelated operations. The Company provides some of its affiliates with services such as financing, management, and engineering. Significant activities with affiliates include the acquisition and processing of bauxite, alumina, and primary aluminum. Purchases from these affiliates were $206.6, $219.4, and $238.7 in the years ended December 31, 1993, 1992, and 1991, respectively. No dividends were received from investees in the three years ended December 31, 1993. See Note 7 for the impact of the adoption of SFAS 109 in 1993. - 39 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- 5. Property, Plant, and Equipment The major classes of property, plant, and equipment are as follows: See Note 7 for the impact of the adoption of SFAS 109 in 1993. 6. Long-Term Debt Long-term debt and its maturity schedule are as follows: 1994 Credit Agreement On February 17, 1994, the Company and Kaiser entered into a credit agreement with BankAmerica Business Credit, Inc. (as agent for itself and other lenders), Bank of America National Trust and Savings Association, and certain other lenders (the "1994 Credit Agreement"). The 1994 Credit Agreement replaced the 1989 Credit Agreement (as defined below) and consists of a $250.0 five-year secured, revolving line of credit, scheduled to mature in 1999. The Company - 40 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- is able to borrow under the facility by means of revolving credit advances and letters of credit (up to $125.0) in an aggregate amount equal to the lesser of $250.0 or a borrowing base relating to eligible accounts receivable plus eligible inventory. The Company will record a pre-tax extraordinary loss of approximately $8.3 in the first quarter of 1994, consisting primarily of the write-off of unamortized deferred financing costs related to the 1989 Credit Agreement. As of February 24, 1994, the amount outstanding under the 1994 Credit Agreement was $67.4 of letters of credit. The 1994 Credit Agreement is unconditionally guaranteed by Kaiser and by all significant subsidiaries of KACC which were guarantors of KACC's obligations under the 1989 Credit Agreement. Loans under the 1994 Credit Agreement bear interest at a rate per annum, at KACC's election, equal to (i) a Reference Rate (as defined) plus 1-1/2% or (ii) LIBO Rate (Reserve Adjusted) plus 3-1/4%. After June 30, 1995, the interest rate margins applicable to borrowings under the 1994 Credit Agreement may be reduced by up to 1-1/2% (non-cumulatively), based upon a financial test, determined quarterly. The 1994 Credit Agreement requires the Company to maintain certain financial covenants and places restrictions on the Company's and Kaiser's ability to, among other things, incur debt and liens, make investments, pay common stock dividends, undertake transactions with affiliates, make capital expenditures, and enter into unrelated lines of business. The 1994 Credit Agreement is secured by, among other things, (i) mortgages on KACC's major domestic plants (excluding the Gramercy plant); (ii) subject to certain exceptions, liens on the accounts receivable, inventory, equipment, domestic patents and trademarks, and substantially all other personal property of KACC and certain of its subsidiaries; (iii) a pledge of all the stock of KACC owned by Kaiser; and (iv) pledges of all of the stock of a number of KACC's wholly owned domestic subsidiaries, pledges of a portion of the stock of certain foreign subsidiaries, and pledges of a portion of the stock of certain partially owned foreign affiliates. The 1989 Credit Agreement The Company and Kaiser entered into a credit agreement with a syndicate of commercial banks and other financial institutions. This agreement was composed of a Revolving Credit Facility, a five-year Term Loan, and certain other agreements (as amended, the "1989 Credit Agreement"). The obligations of KACC in respect of the credit facilities were guaranteed by Kaiser, and by a number of wholly owned subsidiaries of KACC. The Revolving Credit Facility under the 1989 Credit Agreement provided for loans not to exceed the lesser of $350.0 or a borrowing base relating to the amount of eligible accounts receivable and eligible inventory of KACC and certain of its subsidiaries. Up to $50.0 of availability under the Revolving Credit Facility could have been used for letters of credit. As of December 31, 1993, $113.6 of borrowing capacity was unused under the Revolving Credit Facility of the 1989 Credit Agreement (of which $12.8 could also have been used for letters of credit). The five-year Term Loan component of the 1989 Credit Agreement, which was originally to be repaid in ten equal semi-annual installments commencing May 31, 1990, was prepaid in June 1993. Senior Notes Concurrent with the offering by Kaiser of its 8.255% PRIDES, Convertible Preferred Stock (the "PRIDES") on February 17, 1994 (see Note 9), KACC issued $225.0 of its 9-7/8% Senior Notes due 2002 (the "Senior Notes"). The net proceeds of the offering of the Senior Notes were used to reduce outstanding borrowings under the Revolving Credit Facility of the 1989 Credit Agreement immediately prior to the effectiveness of the 1994 Credit Agreement and for working capital and general corporate purposes. - 41 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Senior Subordinated Notes On February 1, 1993, KACC issued $400.0 of 12-3/4% Senior Subordinated Notes due 2003 (the "12-3/4% Notes"). The net proceeds from the sale of the 12-3/4% Notes were used to retire the 14-1/4% Senior Subordinated Notes due 1995 (the "14-1/4% Notes"), to prepay $18.0 of the Term Loan, and to reduce outstanding borrowings under the Revolving Credit Facility. These transactions resulted in a pre-tax extraordinary loss of approximately $33.0 in the first quarter of 1993, consisting primarily of the write-off of unamortized discount and deferred financing costs related to the 14-1/4% Notes and the payment of premiums on the 14-1/4% Notes. The obligations of KACC with respect to the Senior Notes and the 12-3/4% Notes are guaranteed, jointly and severally, by certain subsidiaries of KACC. The indentures governing the Senior Notes and the 12-3/4% Notes restrict, among other things, KACC's ability to incur debt, undertake transactions with affiliates, and pay dividends. Gramercy Revenue Bonds In December 1992, KACC entered into an installment sale agreement (the "Sale Agreement") with the Parish of St. James, Louisiana (the "Louisiana Parish"), pursuant to which the Louisiana Parish issued $20.0 aggregate principal amount of its 7-3/4% Bonds due August 1, 2022 (the "Bonds") to finance the construction of certain solid waste disposal facilities at KACC's Gramercy plant. The proceeds from the sale of the Bonds were deposited into a construction fund and may be withdrawn, from time to time, pursuant to the terms of the Sale Agreement and the Bond indenture. At December 31, 1993, $10.8 remained in the construction fund. The Sale Agreement requires KACC to make payments to the Louisiana Parish in installments due on the dates and in the amounts required to permit the Louisiana Parish to satisfy all of its payment obligations under the Bonds. Alpart CARIFA Loan In December 1991, Alpart entered into a loan agreement with the Caribbean Basin Projects Financing Authority ("CARIFA") under which CARIFA loaned Alpart the proceeds from the issuance of CARIFA's industrial revenue bonds. The terms of the loan parallel the bonds' repayment terms. The $38.0 aggregate principal amount of Series A bonds matures on June 1, 2008. The Series A bonds bear interest at a floating rate of 87% of the applicable LIBID Rate (LIBOR less 1/8 of 1%) on $37.5 of the principal amount (2.9% at December 31, 1993) with the remaining $.5 bearing interest at a fixed rate of 6.35%. The $22.0 aggregate principal amount of Series B bonds matures on June 1, 2007, and bears interest at a fixed rate of 8.25%. Proceeds from the sale of the bonds were used by Alpart to refinance interim loans from the partners in Alpart, to pay eligible project costs for the expansion and modernization of its alumina refinery and related port and bauxite mining facilities, and to pay certain costs of issuance. Under the terms of the loan agreement, Alpart must remain a qualified recipient for Caribbean Basin Initiative funds as defined in applicable laws. Alpart has agreed to indemnify bondholders of CARIFA for certain tax payments that could result from events, as defined, that adversely affect the tax treatment of the interest income on the bonds. Alpart's obligations under the loan agreement are secured by a $64.2 letter of credit guaranteed by the partners in Alpart (of which $22.5 is guaranteed by the Company's minority partner in Alpart). Capitalized Interest Interest capitalized in 1993, 1992, and 1991 was $3.4, $4.4, and $4.2, respectively. - 42 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Fair Value Disclosure The fair value of the Company's long-term debt was approximately $734.1 and $806.8 at December 31, 1993 and 1992, respectively. For 1993, the fair value of the 12-3/4% Notes was estimated using the market value of such notes, or $401.0. For 1992, the estimated fair value of the 14-1/4% Notes was the amount used to retire the 14-1/4% Notes in February 1993, or $347.8. The fair value of all other long-term debt is based upon discounting the future cash flows using the current rate for debt of similar maturities and terms. 7. Income Taxes The adoption of SFAS 109 as of January 1, 1993, as discussed in Note 1, required the Company to restate certain assets and liabilities to their pre-tax amounts from their net-of-tax amounts originally recorded in connection with the acquisition by MAXXAM in October 1988. The restatement of the assigned values with respect to certain assets and liabilities recorded as a result of the acquisition and the recomputation of deferred income tax liabilities under SFAS 109 resulted in: (i) an increase of $144.6 in the net carrying value of property, plant, and equipment; (ii) an increase of $47.8 in investments in and advances to unconsolidated affiliates; (iii) an increase of $126.7 in deferred income tax liabilities (a substantial portion of which has been netted against deferred income tax assets on the Consolidated Balance Sheet); (iv) a decrease of $2.5 in other assets; (v) an increase of $56.0 in long-term liabilities; and (vi) an increase of $10.1 in other liabilities. As a result of restating the assets and liabilities, as described above, the loss before income taxes, minority interests, extraordinary loss, and cumulative effect of changes in accounting principles for the year ended December 31, 1993, was increased by $9.3. Concurrent with the adoption of SFAS 109, the Company implemented changes in its accounting method for postretirement benefits and postemployment benefits pursuant to SFAS 106 and SFAS 112 (see Notes 1 and 8). The pre-tax cumulative effect of changes in accounting principles relating to SFAS 106 and SFAS 112 was a charge of $742.7. These accounting principles changes resulted in the recognition of deferred income tax assets of $237.7, net of valuation allowances. Income (loss) before income taxes, minority interests, extraordinary loss, and cumulative effect of changes in accounting principles by geographic area is as follows: - 43 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- The credit (provision) for income taxes on income (loss) before income taxes, minority interests, extraordinary loss, and cumulative effect of changes in accounting principles consists of: The Omnibus Budget Reconciliation Act of 1993 (the "Act"), enacted on August 10, 1993, retroactively increased the maximum federal statutory income tax rate from 34% to 35% for periods beginning on or after January 1, 1993. The 1993 federal deferred credit for income taxes of $68.6 includes $29.1 for the benefit of operating loss carryforwards generated in 1993 and includes a $3.4 benefit for increasing net deferred income tax assets (liabilities) as of the date of enactment of the Act due to the increase in the federal statutory income tax rate. The deferred credit for income taxes for the years ended December 31, 1992 and 1991, as computed under APB 11, results from the following timing differences: A reconciliation between the credit (provision) for income taxes and the amount computed by applying the federal statutory income tax rate to income (loss) before income taxes, minority interests, extraordinary loss, and cumulative effect of changes in accounting principles is as follows: - 44 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- - 45 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- The valuation allowances listed above relate primarily to loss and credit carryforwards and postretirement benefits other than pensions. As of December 31, 1993, approximately $82.3 of the net deferred income tax assets listed above relate to the benefit of loss and credit carryforwards, net of valuation allowances. The Company evaluated all appropriate factors to determine the proper valuation allowances for these carryforwards, including any limitations concerning their use and the year the carryforwards expire, as well as the levels of taxable income necessary for utilization. For example, full valuation allowances were provided for certain credit carryforwards that expire in the near term. With regard to future levels of income, the Company believes, based on the cyclical nature of its business, its history of prior operating earnings, and its expectations for future years, that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. The remaining portion of the Company's net deferred income tax assets at December 31, 1993, is approximately $124.0. A principal component of this amount is the tax benefit associated with the accrual for postretirement benefits other than pensions. The future tax deductions with respect to the turnaround of this accrual will occur over a 30- to 40-year period. If such deductions create or increase a net operating loss in any one year, the Company has the ability to carry forward such loss for 15 taxable years. For these reasons, the Company believes a long-term view of profitability is appropriate and has concluded that this net deferred income tax asset will more likely than not be realized despite the recent decline in profitability. Certain of the deferred income tax assets and liabilities listed above are included on the Consolidated Balance Sheet in the captions entitled Receivables, Prepaid expenses and other current assets, Other accrued liabilities, and Long-term liabilities. The Company and its subsidiaries (collectively, the "KACC Subgroup") were included in the consolidated federal income tax returns of MAXXAM for the period from October 28, 1988, through December 31, 1992. The taxable income and loss and tax credits for the KACC Subgroup for the period January 1, 1993, through June 30, 1993, will be included in the 1993 MAXXAM consolidated federal income tax return. As a consequence of the issuance of the Depositary Shares on June 30, 1993, as discussed in Note 10, the KACC Subgroup is no longer included in the consolidated federal income tax return of MAXXAM. The KACC Subgroup has become a member of a new consolidated return group of which Kaiser is the common parent corporation (the "New Kaiser Tax Group"). The New Kaiser Tax Group will file a consolidated federal income tax return for taxable periods beginning on or after July 1, 1993. The tax allocation agreement between the Company and MAXXAM (the "KACC Tax Allocation Agreement"), discussed below, terminated pursuant to its terms, effective for taxable periods beginning after June 30, 1993. Any unused federal income tax attribute carryforwards under the terms of the KACC Tax Allocation Agreement were eliminated and are not available to offset federal income tax liabilities of the KACC Subgroup for taxable periods beginning on or after July 1, 1993. Upon the filing of MAXXAM's 1993 consolidated federal income tax return, the tax attribute carryforwards of the MAXXAM consolidated return group as of December 31, 1993, will be apportioned in part to Kaiser and the KACC Subgroup, based upon the provisions of the relevant consolidated return regulations. It is estimated that the benefit of such tax attribute carryforwards apportioned to the KACC Subgroup will approximate or exceed the benefit of tax attribute carryforwards eliminated under the KACC Tax Allocation Agreement. To the extent the KACC Subgroup generates unused tax losses or tax credits for periods beginning on or after July 1, 1993, such amounts will not be available to obtain refunds of amounts paid by the Company to MAXXAM for periods ending on or before June 30, 1993, pursuant to the KACC Tax Allocation Agreement. The Company and MAXXAM entered into the KACC Tax Allocation Agreement, which became effective as of October 28, 1988. Under the terms of the KACC Tax Allocation Agreement, MAXXAM computed the federal income - 46 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- tax liability for the KACC Subgroup as if the KACC Subgroup were a separate affiliated group of corporations which was never connected with MAXXAM. The provisions of the KACC Tax Allocation Agreement will continue to govern for periods ended prior to July 1, 1993. Therefore, payments or refunds may still be required by or payable to the Company under the terms of the KACC Tax Allocation Agreement for periods ended prior to July 1, 1993, due to the final resolution of audits, amended returns, and related matters with respect to such periods. However, the 1994 Credit Agreement prohibits the payment by the Company to MAXXAM of any amounts due under the KACC Tax Allocation Agreement, except for certain payments that are required as a result of audits and only to the extent of any amounts paid after February 17, 1994, by MAXXAM to the Company under the KACC Tax Allocation Agreement. As of December 31, 1993, MAXXAM owed the Company approximately $11.6 under the terms of the KACC Tax Allocation Agreement. On June 30, 1993, the Company and Kaiser entered into a tax allocation agreement (the "New KACC Tax Allocation Agreement"), effective for taxable periods beginning on or after July 1, 1993. The terms of the New KACC Tax Allocation Agreement are similar, in all material respects, to those of the KACC Tax Allocation Agreement except that the Company is liable to Kaiser. Income taxes are classified as either domestic or foreign, based on whether payment is made or due to the United States or a foreign country. Certain income classified as foreign is also subject to domestic income taxes. The following table presents the Company's tax attributes for federal income tax purposes under the terms of the New KACC Tax Allocation Agreement as of December 31, 1993. The amounts of such attributes may change based upon the final 1993 tax returns. The utilization of certain of these tax attributes are subject to limitations: - 48 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Assumptions used to value obligations at year-end and to determine the net periodic pension cost in the subsequent year are: Postretirement Benefits Other Than Pensions The Company adopted SFAS 106 to account for postretirement benefits other than pensions effective January 1, 1993 (see Note 1). The Company and its subsidiaries provide postretirement health care and life insurance benefits to retired employees. Substantially all employees may become eligible for those benefits if they reach retirement age while still working for the Company or its subsidiaries. These benefits are provided through contracts with various insurance carriers. The Company has not funded the liability for these benefits. The Company changed certain salaried retiree group insurance benefits effective January 1, 1994, to provide for additional cost-sharing features, such as reducing certain reimbursements and requiring future retiree contributions which will lower salaried retiree medical expenses. The Company's accrued postretirement benefit obligation is composed of the following: The 1994 annual assumed rates of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) are 9.5% and 8.0% for retirees under 65 and over 65, respectively, and are assumed to decrease gradually to 5.25% in 2006 and remain at that level thereafter. The health care cost trend rate has a significant effect on the amounts reported. A one-percentage-point increase in the assumed health care cost trend rate would increase the accumulated - 49 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - -------------------------------------------------------------------------- postretirement benefit obligation as of December 31, 1993, by approximately $96.0 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by approximately $9.5. The weighted average discount rate used to determine the accumulated postretirement benefit obligation at December 31, 1993, was 7.5%. Postemployment Benefits The Company adopted the new accounting standard on postemployment benefits effective January 1, 1993 (see Note 1). The Company provides certain benefits to former or inactive employees after employment but before retirement. Incentive Plans Effective January 1, 1989, the Company adopted an unfunded Long-Term Incentive Plan (the "LTIP") for certain key employees of the Company and its consolidated subsidiaries. All compensation vested as of December 31, 1992, under the LTIP, as amended in 1991 and 1992, has been paid to the participants in cash or common stock of Kaiser as of December 31, 1993. Under the LTIP, as amended, 764,092 shares of Kaiser's common stock were distributed to participants during 1993, which will generally vest at the rate of 25% per year. The Company will record the related expense of $6.5 over the four-year period ending December 31, 1996. Effective January 1, 1990, KACC adopted an unfunded Middle Management Long-Term Incentive Plan. KACC also has a supplemental savings and retirement plan for salaried employees under which the participants contribute a percentage of their base salaries. The Company's expense for the above plans was $5.3, $6.6, and $6.5 for the years ended December 31, 1993, 1992, and 1991, respectively. 9. Redeemable Preference Stock In March 1985, KACC entered into a three-year agreement with the United Steelworkers of America (USWA) whereby shares of a new series of "Cumulative (1985 Series A) Preference Stock" would be issued to an employee stock ownership plan in exchange for certain elements of wages and benefits. Concurrently, a similar plan was established for certain nonbargaining employees which provided for the issuance of "Cumulative (1985 Series B) Preference Stock." Series A Stock and Series B Stock ("Series A and B Stock") each have a par value of $1 per share and a liquidation and redemption value of $50 per share plus accrued dividends, if any. For financial reporting purposes, Series A and B Stock were recorded at fair market value when issued, based on independent appraisals, with a corresponding charge to compensation cost. Carrying values have been increased each year to recognize accretion of redemption values and, in certain years, there have been other increases for reasons described below. Issuances and redemptions of Series A and B Stock are shown below. - 50 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- No additional Series A or B Stock will be issued based on compensation earned in 1992 or subsequent years. While held by the plan trustee, Series B Stock is entitled to cumulative annual dividends, when and as declared by the Board of Directors, payable in stock or in cash at the option of KACC on or after March 1, 1991, in respect to years commencing January 1, 1990, based on a formula tied to KACC's income before tax from aluminum operations. When distributed to plan participants (generally upon separation from KACC), the Series A and B Stock are entitled to an annual cash dividend of $5 per share, payable quarterly, when and as declared by the Board of Directors. Redemption fund agreements require KACC to make annual payments by March 31 each year based on a formula tied to consolidated net income until the redemption funds are sufficient to redeem all Series A and B Stock. On an annual basis, the minimum payment is $4.3 and the maximum payment is $7.3. In March 1992 and 1993, KACC contributed $7.0 and $4.3 for the years 1991 and 1992, respectively, and will contribute $4.3 in March 1994 for 1993. Under the USWA labor contract effective November 1, 1990, KACC was obligated to offer to purchase up to 80 shares of Series A Stock from each active participant in 1991 at a price equal to its redemption value of $50 per share. KACC also agreed to offer to purchase up to an additional 40 shares from each participant in 1994. The employees may elect to receive their shares, accept cash, or place the proceeds into KACC's 401(k) savings plan. Under separate action, KACC also offered to purchase 80 shares of Series B Stock from active participants in 1991 and 40 shares in 1994. Under the provisions of these contracts, in February 1994, KACC purchased $4.6 and $.8 of the Series A and B Stock, respectively. The Series A and B Stock is distributed in the event of death, retirement, or in other specified circumstances. KACC may also redeem such stock at $50 per share plus accrued dividends, if any. At the option of the plan participant, the trustee shall redeem stock distributed from the plans at redemption value to the extent funds are available in the redemption fund. Under the Tax Reform Act of 1986, at the option of the plan participant, KACC must purchase distributed shares earned after December 31, 1985, at redemption value on a five- year installment basis, with interest at market rates. The obligation of KACC to make such installment payments must be secured. The Series A and B Stock is entitled to the same voting rights as KACC common stock and to certain additional voting rights under certain circumstances, including the right to elect, along with other KACC preference stockholders, two directors whenever accrued dividends have not been paid on two annual dividend payment dates, or when accrued dividends in an amount equivalent to six full quarterly dividends are in arrears. The Series A and B Stock restricts the ability of KACC to redeem or pay dividends on common stock if KACC is in default on any dividends payable on the Series A and B Stock. - 51 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- 10. Stockholders' Equity Changes in stockholders' equity were: - 52 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Preference Stock KACC Cumulative Convertible Preference Stock, $100 par value ("$100 Preference Stock"), restricts acquisition of junior stock and payment of dividends. At December 31, 1993, such provisions were less restrictive as to the payment of cash dividends than the 1989 Credit Agreement provisions. KACC has the option to redeem the $100 Preference Stocks at par value plus accrued dividends. KACC does not intend to issue any additional shares of the $100 Preference Stocks. The 4-1/8% and 4-3/4% (1957 Series, 1959 Series, and 1966 Series) $100 Preference Stock can be exchanged for per share cash amounts of $69.30, $77.84, $78.38, and $76.46, respectively. KACC records the $100 Preference Stock at their exchange amounts for financial statement presentation and the Company includes such amounts in minority interests. The outstanding shares of KACC preference stock were: Additional Capital Series A Convertible -- On June 30, 1993, Kaiser issued 17,250,000 of its $.65 Depositary Shares (the "Depositary Shares"), each representing one-tenth of a share of Series A Mandatory Conversion Premium Dividend Preferred Stock (the "Series A Shares"). In connection with the issuance of the Depositary Shares, MAXXAM Group Inc. ("MGI"), a wholly owned subsidiary of MAXXAM, exchanged a $15.0 promissory note of KACC (the "MAXXAM Note") for an additional 2,132,950 Depositary Shares. The net cash proceeds from the sale of Depositary Shares were approximately $119.3. Kaiser used approximately $37.8 of such net proceeds to make a non-interest bearing loan to KACC evidenced by an intercompany note, which matures on June 29, 1996, and is payable in quarterly installments. The intercompany note is designed to provide sufficient funds to Kaiser to enable it to make dividend payments on the Series A Shares until June 30, 1996, the date on which the outstanding Series A Shares are mandatorily converted into shares of Kaiser's common stock. Kaiser used approximately $81.5 of such net proceeds and the MAXXAM Note to make a capital contribution to KACC. KACC used approximately $13.7 of the funds it received from Kaiser to prepay the remaining balance of the Term Loan under the 1989 Credit Agreement and $105.6 of such funds to reduce outstanding borrowings under the Revolving Credit Facility of the 1989 Credit Agreement. - 53 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- PRIDES Convertible -- On February 17, 1994, Kaiser consummated the public offering of 8,000,000 shares of the PRIDES. The net proceeds from the sale of the shares of PRIDES were approximately $90.6. Kaiser used such net proceeds to make a non-interest bearing loan to KACC in a principal amount equal to $30.0 (the aggregate dividends scheduled to accrue on the shares of PRIDES from the issuance date until December 31, 1997, the date on which the outstanding PRIDES are mandatorily converted into shares of Kaiser's common stock), evidenced by an intercompany note, and used the balance of such net proceeds to make a capital contribution to KACC in the amount of approximately $60.6. Note Receivable from Parent The Note Receivable from Parent bears interest at a fixed rate of 6- 5/8% per annum. No interest or principal payments are due until December 21, 2000, after which interest and principal will be payable over a 15-year term pursuant to a predetermined schedule. Accrued interest is accounted for as additional contributed capital. Dividends on Common Stock The Company paid quarterly cash dividends on common stock of $50.0, $37.3, $2.9, and $2.8, respectively, in 1991. The Company paid cash dividends on common stock of $2.9 in each quarter of 1992. As required under the 1989 Credit Agreement, on December 15, 1992, KACC issued a Pay-in-Kind Note (the "PIK Note") to a subsidiary of MAXXAM, in the principal amount of $2.5, representing the entire amount of the dividend received by such subsidiary in respect of the shares of Kaiser's common stock which it owned. The PIK Note bears interest, compounded semiannually, at a rate equal to 12% per annum, and is due and payable, together with accrued interest thereon, on June 30, 1995. The indentures governing the Senior Notes and the 12-3/4% Notes and the 1994 Credit Agreement restrict, among other things, the Company's ability to incur debt, undertake transactions with affiliates, and pay dividends. Under the most restrictive of these covenants, the Company is not currently permitted to pay dividends on its common stock. Stock Incentive Plan In 1993, Kaiser adopted the Kaiser 1993 Omnibus Stock Incentive Plan. A total of 2,500,000 shares of Kaiser common stock are reserved for awards or for payment of rights granted under the Plan. Six Company executives have received grants of 764,092 shares under the LTIP for benefits generally earned but not vested as of December 31, 1992 (see Note 8). In 1993, the stockholders approved the award of 584,300 shares as nonqualified stock options to members of management other than those participating in the LTIP. These options will generally vest at the rate of 20% per year over the next five years, commencing May 18, 1994. The exercise price of these shares is $7.25 per share, the quoted market price at the date of grant. 11. Commitments and Contingencies Commitments The Company has financial commitments, including purchase agreements, tolling arrangements, forward foreign exchange contracts, forward sales contracts, letters of credit, and guarantees. - 54 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Purchase agreements and tolling arrangements include agreements to supply alumina to Anglesey and to purchase aluminum from that company. Similarly, KACC has long-term agreements for the purchase and tolling of bauxite into alumina in Australia by QAL. These obligations expire in 2008. Under the agreements, KACC is unconditionally obligated to pay its proportional share of debt, operating costs, and certain other costs of QAL. The aggregate minimum amount of required future principal payments at December 31, 1993, is $73.6, due in 1997. The KACC share of payments, including operating costs and certain other expenses under the agreement, was $86.7, $99.2, and $107.6 for the years ended December 31, 1993, 1992, and 1991, respectively. Minimum rental commitments under operating leases at December 31, 1993, are as follows: years ending December 31, 1994 -- $24.3; 1995 - - $23.2; 1996 -- $22.3; 1997 -- $21.8; 1998 -- $23.4; thereafter -- $243.2. The future minimum rentals receivable under noncancelable subleases was $90.7 at December 31, 1993. Rental expenses were $29.0, $26.2, and $23.3 for the years ended December 31, 1993, 1992, and 1991, respectively. Environmental Contingencies KACC is subject to a wide variety of environmental laws and regulations and to fines or penalties assessed for alleged breaches of the environmental laws and to claims and litigation based upon such laws. KACC is currently subject to a number of lawsuits under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments Reauthorization Act of 1986 ("CERCLA"), and, along with certain other entities, has been named as a potentially responsible party for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA. Based upon the Company's evaluation of these and other environmental matters, the Company has established environmental accruals primarily related to potential solid waste disposal and soil and groundwater remediation matters. The following table presents the changes in such accruals, which are primarily included in Long-term liabilities, for the years ended December 31, 1993, 1992, and 1991: These environmental accruals represent the Company's estimate of costs reasonably expected to be incurred based upon presently enacted laws and regulations, currently available facts, existing technology, and the Company's assessment of the likely remediation action to be taken. The Company expects that these remediation actions will be taken over the next several years and estimates that expenditures to be charged to the environmental accrual will be approximately $4.0 to $8.0 for the years 1994 through 1998 and an aggregate of approximately $12.8 thereafter. - 55 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- As additional facts are developed and definitive remediation plans and necessary regulatory approvals for implementation of remediation are established, or alternative technologies are developed, changes in these and other factors may result in actual costs exceeding the current environmental accruals by amounts which cannot presently be estimated. While uncertainties are inherent in the ultimate outcome of these matters and it is impossible to presently determine the actual costs that ultimately may be incurred, management believes that the resolution of such uncertainties should not have a material adverse effect upon the Company's consolidated financial position or results of operations. Asbestos Contingencies KACC is a defendant in a number of lawsuits in which the plaintiffs allege that certain of their injuries were caused by exposure to asbestos during, and as a result of, their employment with KACC or to products containing asbestos produced or sold by KACC. The lawsuits generally relate to products KACC has not manufactured for at least 15 years. At year-end 1993, the number of such lawsuits pending was approximately 23,400 (approximately 11,400 of which were received in 1993). The number of such lawsuits instituted against KACC increased substantially in 1993, and management believes the number of such lawsuits will continue at approximately the same rate for the next few years. In connection with such litigation, during 1993, 1992, and 1991, KACC made cash payments for settlement and other related costs of $7.0, $7.1, and $6.1, respectively. Based upon prior experience, the Company estimates annual future cash payments in connection with such litigation of approximately $8.0 to $13.0 for the years 1994 through 1998, and an aggregate of approximately $88.4 thereafter through 2006. Based upon past experience and reasonably anticipated future activity, the Company has established an accrual for estimated asbestos-related costs for claims filed and estimated to be filed and settled through 2006. The Company does not presently believe there is a reasonable basis for estimating such costs beyond 2006 and, accordingly, no accrual has been recorded for such costs which may be incurred. This accrual was calculated based upon the current and anticipated number of asbestos-related claims, the prior timing and amounts of asbestos- related payments, the current state of case law related to asbestos claims, the advice of counsel, and the anticipated effects of inflation and discounting at an estimated risk-free rate (5.25% at December 31, 1993). Accordingly, an accrual of $102.8 for asbestos- related expenditures is included primarily in Long-term liabilities at December 31, 1993. The aggregate amount of the undiscounted liability at December 31, 1993, of $141.5, before considerations for insurance recoveries, reflects an increase of $56.6 from the prior year, resulting primarily from an increase in claims filed during 1993 and the Company's belief that the number of such lawsuits will continue at approximately the same rate for the next few years. The Company believes that it has insurance coverage available to recover a substantial portion of its asbestos-related costs. While claims for recovery from one of the Company's insurance carriers are currently subject to pending litigation and other carriers have raised certain defenses, the Company believes, based upon prior insurance- related recoveries in respect of asbestos-related claims, existing insurance policies, and the advice of counsel, that substantial recoveries from the insurance carriers are probable. Accordingly, estimated insurance recoveries of $94.0, determined on the same basis as the asbestos-related cost accrual, are recorded primarily in Other assets as of December 31, 1993. Based upon the factors discussed in the two preceding paragraphs, management currently believes that there is no more than a remote possibility (under generally accepted accounting principles) that the Company's asbestos-related costs net of related insurance recoveries exceed those accrued as of December 31, 1993, and, accordingly, that the resolution of such uncertainties and the incurrence of such net costs should not have a material adverse effect upon the Company s consolidated financial position or results of operations. - 56 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Other Contingencies The Company is involved in various other claims, lawsuits, and other proceedings relating to a wide variety of matters. While uncertainties are inherent in the ultimate outcome of such matters and it is impossible to determine the actual costs that ultimately may be incurred, management believes that the resolution of such uncertainties and the incurrence of such costs should not have a material adverse effect upon the Company's consolidated financial position or results of operations. 12. Segment and Geographical Area Information Sales and transfers among geographic areas are made on a basis intended to reflect the market value of products. The aggregate foreign currency gain included in determining net income was $4.9, $12.0, and $1.2 for the years ended December 31, 1993, 1992, and 1991, respectively. There were no sales of more than 10% of total revenue to a single customer for the year ended December 31, 1993. Sales to a single customer were $135.3 and $155.9 of bauxite and alumina and $144.9 and $160.9 of aluminum processing for the years ended December 31, 1992 and 1991, respectively. Export sales were less than 10% of total revenue during the years ended December 31, 1993, 1992, and 1991. - 57 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - -------------------------------------------------------------------------- (In millions of dollars, except share amounts) - -------------------------------------------------------------------------- Financial information by industry segment at December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, is as follows: - 58 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Geographical area information relative to operations is summarized as follows: 13. Subsidiary Guarantors Kaiser Alumina Australia Corporation ("KAAC"), Kaiser Finance Corporation ("KFC"), Kaiser Jamaica Corporation ("KJC"), and Alpart Jamaica Inc. ("AJI") (collectively referred to as the "Subsidiary Guarantors") are domestic wholly owned (directly or indirectly) subsidiaries of the Company that have provided subordinated guarantees of the 12-3/4% Notes and joint and several guarantees of the 1989 Credit Agreement (see Note 6). KAAC, KJC, and AJI are wholly owned subsidiaries, which serve as holding companies for the Company's investments in Alpart, KFC, and QAL. KFC is a wholly owned subsidiary of KAAC, whose principal business is making loans to the Company and its subsidiaries. Summary of combined financial information for the Subsidiary Guarantors as of December 31, 1993 and 1992, is as follows. - 59 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Summary of Combined Financial Position - 60 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - ------------------------------------------------------------------------- (In millions of dollars, except share amounts) - ------------------------------------------------------------------------- Notes to Summary of Combined Financial Information for the Subsidiary Guarantors Income Taxes -- The Subsidiary Guarantors were included in the consolidated federal income tax return of MAXXAM for the period from October 28, 1988, through December 31, 1992. The Subsidiary Guarantors' taxable income (loss) for the period from January 1, 1993, through June 30, 1993, will be included in the 1993 consolidated federal income tax return of MAXXAM. Effective July 1, 1993, the Subsidiary Guarantors became members of the consolidated federal income tax return group of which Kaiser is the common parent corporation. The taxable income (loss) of the Subsidiary Guarantors for the period from July 1, 1993, through December 31, 1993 (and for subsequent taxable periods) will be included in the consolidated federal income tax return of Kaiser. The (credit) provision for income taxes is computed as if each Subsidiary Guarantor filed returns on a separate company basis. Effective January 1, 1993, the Subsidiary Guarantors adopted SFAS 109, which required the restatement of certain assets and liabilities to their pre-tax amounts from their net-of-tax amounts originally recorded in connection with the acquisition by MAXXAM in October 1988. The restatement of the assigned values with respect to certain assets and liabilities recorded as a result of the acquisition and the recomputation of deferred income tax liabilities under SFAS 109 resulted in: (i) an increase of $13.5 in the net carrying value of property, plant, and equipment; (ii) an increase of $25.4 in investments in and advances to unconsolidated affiliates; and (iii) an increase of $50.2 in net deferred income tax liabilities. The net deferred income tax liabilities relate primarily to financial reporting basis in excess of tax basis with respect to investments in and advances to unconsolidated affiliates and property, plant, and equipment, offset, in part, by the benefit of loss and credit carryforwards. The cumulative effect of the change in accounting principle, as of January 1, 1993, reduced the Subsidiary Guarantors' results of operations by $11.3. Included in Other assets and Other long-term liabilities at December 31, 1993, are $25.0 and $54.2 of deferred income tax assets and liabilities, respectively. Receivables and Payables -- At December 31, 1993, receivables from and payables to KACC and affiliates include $635.8 and $237.3 of interest bearing loans, respectively. The similar amounts at December 31, 1992 were $592.2 and $242.2. Inventory Valuation -- Inventories are stated at first-in, first-out (FIFO) cost, not in excess of market. Investments -- At December 31, 1993, KAAC held a 28.3% interest in QAL. This investment is accounted for by the equity method. The equity in QAL's income (loss) before income taxes of $(2.5) and $1.8 in 1993 and 1992, respectively, is included in the Company's cost of products sold. Capital Contribution -- In 1993, the Company converted $200.0 and $25.0 of its receivables from KJC and AJI, respectively, into capital contributions to these companies. These amounts are included in Stockholders' equity as of December 31, 1993. Foreign Currency -- The functional currency of the Subsidiary Guarantors is the United States dollar, and accordingly, translation gains included in net income (loss) were $5.6, $27.3, and $5.3 for the years ended December 31, 1993, 1992, and 1991, respectively. - 61 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES FIVE-YEAR FINANCIAL DATA ---------------------------------------------------------------------- - 62 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES FIVE-YEAR FINANCIAL DATA ---------------------------------------------------------------------- STATEMENTS OF CONSOLIDATED INCOME (LOSS) - 63- KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - 65 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE V ---------------------------------------------------------------------- - 66 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE VI ----------------------------------------------------------------------- - 67 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES (1) Based on outstanding borrowings at the end of each month. (2) Based on outstanding borrowings and weighted average interest rates at the end of each month. (3) Short-term bank borrowings are made available on an uncommitted basis and no fee is charged. Maturities generally range from one to ten days with no formal provisions for the extension of maturities. Interest rates are based upon short-term prevailing rates. - 68 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE X ---------------------------------------------------------------------- SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION (1) (In millions of dollars) - 69 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART I I I Information required under Part III (Items 10, 11, 12, and 13) has been omitted from this Report since the Company intends to file with the Securities and Exchange Commission, not later than 120 days after the close of its fiscal year, a definitive proxy statement pursuant to Regulation 14A which involves the election of directors. PART I V ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Index to Financial Statements and Schedules 1. Financial Statements Page -------------------- ---- Report of Independent Public Accountants .. . . 32 Consolidated Balance Sheets. . .. . .. . .. . . 33 Statements of Consolidated Income.. .. . .. . . 34 Statements of Consolidated Cash Flows. . .. . . 35 Notes to Consolidated Financial Statements. . . 36 Five-Year Financial Data. .. . .. . .. . .. . . 62 Quarterly Financial Data. .. . .. . .. . .. . . 64 2. Financial Statement Schedules Page ---- Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties . . . . . 65 Schedule V - Consolidated Property, Plant, and Equipment . . . 66 Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Consolidated Property, Plant, and Equipment . . . 67 Schedule IX - Consolidated Short- Term Borrowings . . . . . 68 Schedule X - Supplementary Consolidated Income Statement Information. . . 69 All other schedules are inapplicable or the required information is included in the Consolidated Financial Statements or the Notes thereto. - 70 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (continued) 3. Exhibits --------- Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 73), which index is incorporated herein by reference. (b) Reports on Form 8-K No report on Form 8-K was filed by the Company during the quarter ended December 31, 1993. (c) Exhibits Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 73), which index is incorporated herein by reference. - 71 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- SIGNATURES Pursuant to the requirements of Section 13 or 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. KAISER ALUMINUM & CHEMICAL CORPORATION George T. Haymaker, Jr. Date: March 30, 1994 By - ------------------------------------ George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. George T. Haymaker, Jr. Date: March 30, 1994 - -------------------------------------- George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer (Principal Executive Officer) John T. La Duc Date: March 30, 1994 - -------------------------------------- John T. La Duc Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) Charlie Alongi Date: March 30, 1994 - -------------------------------------- Charlie Alongi Controller (Principal Accounting Officer) Robert J. Cruikshank Date: March 30, 1994 - -------------------------------------- Robert J. Cruikshank Director Charles E. Hurwitz Date: March 30, 1994 - -------------------------------------- Charles E. Hurwitz Director Ezra G. Levin Date: March 30, 1994 - -------------------------------------- Ezra G. Levin Director Robert Marcus Date: March 30, 1994 - ------------------------------------- Robert Marcus Director Paul D. Rusen Date: March 30, 1994 - -------------------------------------- Paul D. Rusen Director - 72 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- INDEX OF EXHIBITS Exhibit Number Description - ------ ----------- 3.1 Restated Certificate of Incorporation of Kaiser Aluminum & Chemical Corporation ("KACC"), dated July 25, 1989 (incorporated by reference to Exhibit 3.1 to the Registration Statement on Form S-1, dated August 25, 1989, filed by KACC, Registration No. 33-30645). 3.2 Certificate of Retirement of KACC, dated February 7, 1990 (incorporated by reference to Exhibit 3.2 to Form 10-K for the period ended December 31, 1989, filed by KACC, File No. 1-3605). 3.3 By-laws of KACC, dated November 30, 1988 (incorporated by reference to Exhibit (3)(c) to Form 10-K for the period ended December 31, 1988, filed by KACC, File No. 1-3605). 4.1 Indenture, dated as of February 1, 1993, among KACC, as Issuer, Kaiser Alumina Australia Corporation, Alpart Jamaica Inc., and Kaiser Jamaica Corporation, as Subsidiary Guarantors, and The First National Bank of Boston, as Trustee, regarding KACC's 12-3/4% Senior Subordinated Notes Due 2003 (incorporated to Form 10-K for the period ended December 31, 1992, filed by KACC, File No. 1-3605). 4.2 First Supplemental Indenture, dated as of May 1, 1993 (incorporated by reference to Exhibit 4.2 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 4.3 Indenture, dated as of February 17, 1994, among KACC, as Issuer, Kaiser Alumina Australia Corporation, Alpart Jamaica Inc., Kaiser Jamaica Corporation, and Kaiser Finance Corporation, as Subsidiary Guarantors, and First Trust National Association as Trustee, regarding KACC's 9-7/8% Senior Notes Due 2002 (incorporated by reference to Exhibit 4.3 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.4 Credit Agreement, dated as of February 17, 1994, among KACC, Kaiser Aluminum Corporation ("KAC"), the financial institutions a party thereto, BankAmerica Business Credit, Inc., as Agent, and certain financial institutions (incorporated by reference to Exhibit 4.4 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.5 Credit Agreement, dated as of December 13, 1989 (the "1989 Credit Agreement"), among KACC, KAC, the financial institutions a party thereto, Bank of America National Trust and Savings Association, as Agent, and Mellon Bank, N.A., as Collateral Agent (incorporated by reference to Exhibit 4.3 to Amendment No. 5 to the Registration Statement on Form S-1 dated December 13, 1989, filed by KACC, Registration No. 33-30645). 4.6 First Amendment to the 1989 Credit Agreement, dated as of April 17, 1990 (incorporated by reference to Exhibit 4.2 of the Report on Form 10-Q for the quarterly period ended September 30, 1990, of MAXXAM Inc. ("MAXXAM"), filed November 6, 1990, File No. 1-3924). 4.7 Second Amendment to the 1989 Credit Agreement, dated as of September 17, 1990 (incorporated by reference to Exhibit 4.3 of the Report on Form 10-Q for the quarterly period ended September 30, 1990, of MAXXAM, filed November 6, 1990, File No. 1-3924). - 73 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 4.8 Third Amendment to the 1989 Credit Agreement, dated as of December 7, 1990 (incorporated by reference to Exhibit 4.6 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 4.9 Fourth Amendment to the 1989 Credit Agreement, dated as of April 19, 1991 (incorporated by reference to Exhibit 4.1 of the Report on Form 10-Q for the quarterly period ended March 31, 1991, filed by KACC, File No. 1-3605). 4.10 Fifth Amendment to the 1989 Credit Agreement, dated as of March 13, 1992 (incorporated by reference to Exhibit 4.8 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 4.11 Seventh Amendment to the 1989 Credit Agreement, dated as of November 6, 1992 (incorporated by reference to Exhibit 4.10 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.12 Eighth Amendment to the 1989 Credit Agreement, dated as of January 7, 1993 (incorporated by reference to Exhibit 4.12 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.13 Ninth Amendment to 1989 Credit Agreement, dated as of May 19, 1993 including the form of Intercompany Note annexed as an Exhibit thereto (incorporated by reference to Exhibit 4.10 to Amendment No. 2 to the Registration Statement on Form S-1, dated June 22, 1993, filed by KACC, Registration No. 33-49555). 4.14 Tenth Amendment to 1989 Credit Agreement, dated as of July 23, 1993, (incorporated by reference to Exhibit 4.13 to the Registration Statement on Form S-3, dated August 26, 1993, filed by KACC, Registration No. 33-50097). 4.15 Eleventh Amendment to 1989 Credit Agreement, dated as of August 27, 1993, (incorporated by reference to Exhibit 4.13 to the Registration Statement on Form S-3, dated October 13, 1993, filed by KAC, Registration No. 33-50581). 4.16 Twelfth Amendment to 1989 Credit Agreement, dated as of December 20, 1993, (incorporated by reference to Exhibit 4.15 to Amendment No. 3 to the Registration Statement on Form S-2, dated February 8, 1994, filed by KACC, Registration No. 33-50097). 4.17 Certificate of Designation of Series A Mandatory Conversion Premium Dividend Preferred Stock of KAC, dated June 28, 1993 (incorporated by reference to Exhibit 4.3 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 4.18 Deposit Agreement between KAC and The First National Bank of Boston, dated as of June 30, 1993 (incorporated by reference to Exhibit 4.4 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). - 74 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 4.19 Intercompany Note between KACC and KAC (incorporated by reference to Exhibit 4.2 to Amendment No. 5 to the Registration Statement on Form S-1 dated December 13, 1989, filed by KACC, Registration No. 33-30645). 4.20 Senior Subordinated Intercompany Note between KACC and MAXXAM, dated January 14, 1993 (incorporated by reference to Exhibit 4.13 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.21 Certificate of Designation of KAC's 8.255% Preferred Redeemable Increased Dividend Equity Securities, dated February 17, 1994 (incorporated by reference to Exhibit 4.21 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.22 Senior Subordinated Intercompany Note between KACC and KAC dated February 15, 1994 (incorporated by reference to Exhibit 4.22 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.23 Senior Subordinated Intercompany Note between KACC and KAC dated March 17, 1994 (incorporated by reference to Exhibit 4.23 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.24 Senior Subordinated Intercompany Note between KACC and KAC dated June 30, 1993 (incorporated by reference to Exhibit 4.24 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). KACC has not filed certain long-term debt instruments not being registered with the Securities and Exchange Commission where the total amount of indebtedness authorized under any such instrument does not exceed 10% of the total assets of KACC and its subsidiaries on a consolidated basis. KACC agrees and undertakes to furnish a copy of any such instrument to the Securities and Exchange Commission upon its request. 10.1 Form of indemnification agreement with officers and directors (incorporated by reference to Exhibit (10)(b) to the Registration Statement of KAC on Form S-4, File No. 33-12836). 10.2 Tax Allocation Agreement between MAXXAM and KACC (incorporated by reference to Exhibit 10.21 to Amendment No. 6 to the Registration Statement on Form S-1, dated December 14, 1989, filed by KACC, Registration No. 33-30645). 10.3 Tax Allocation Agreement between KAC and MAXXAM (incorporated by reference to Exhibit 10.23 to Amendment No. 2 to the Registration Statement on Form S-1, dated June 11, 1991, filed by KAC, Registration No. 33-37895). 10.4 Tax Allocation Agreement, dated as of June 30, 1993, between KAC and KACC (incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 10.5 Amended and Restated Alumina Supply Agreement, dated as of October 11, 1989 (incorporated by reference to Exhibit 10.19 to Amendment No. 3 to the Registration Statement on Form S-1, dated November 14, 1989, filed by KACC, Registration No. 33-30645). 10.6 Assumption Agreement, dated as of October 28, 1988 (incorporated by reference to Exhibit HHH to the Final Amendment to the Schedule 13D of MAXXAM Group Inc. and others in respect of the Common Stock of KAC, par value $.33-1/3 per share). - 75 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.7 Agreement, dated as of June 30, 1993, between KAC and MAXXAM (incorporated by reference to Exhibit 10.2 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). Executive Compensation Plans and Arrangements --------------------------------------------- 10.8 KACC's Bonus Plan (incorporated by reference to Exhibit 10.25 to Amendment No. 6 to the Registration Statement on Form S-1, dated December 14, 1989, filed by KACC, Registration No. 33-30645). 10.9 KaiserTech Limited Long Term Incentive Plan, dated June 2, 1989 (incorporated by reference to Exhibit 10.14 to Form 10-K for the period ended December 31, 1989, filed by KACC, File No. 1-3605). 10.10 Amendment No. 2 to KaiserTech Limited Long Term Incentive Plan, dated as of December 18, 1991 (incorporated by reference to Exhibit 10.7 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.11 Amendment No. 3 to Kaiser Aluminum Long Term Incentive Plan, dated as of December 31, 1991 (incorporated by reference to Exhibit 10.8 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.12 Kaiser 1993 Omnibus Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 10.13 Kaiser Aluminum Middle Management Long-Term Incentive Plan, dated June 25, 1990, as amended (incorporated by reference to Exhibit 10.22 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 10.14 Employment Agreement, dated April 1, 1993, among KAC, KACC, and George T. Haymaker, Jr. (incorporated by reference to Exhibit 10.2 to the Report on Form 10-Q for the quarterly period ended March 31, 1993, filed by KAC, File No. 1-9447). 10.15 Employment Agreement, dated as of October 1, 1992, among KACC, KAC and A. Stephens Hutchcraft, Jr. (incorporated by reference to Exhibit 10.15 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 10.16 Severance Agreement, dated July 1, 1985, between KACC and A. Stephens Hutchcraft, Jr., as amended (incorporated by reference to Exhibit (10)(f) to Form 10-K for the period ended December 31, 1988, filed by KACC, File No. 1-3605). 10.17 Amendment, dated October 31, 1989, to the Severance Agreement of A. Stephens Hutchcraft, Jr. referenced in Exhibit 10.16 above (incorporated by reference to Exhibit 10.24 to Amendment No. 5 to the Registration Statement on Form S-1, dated December 13, 1989, filed by KACC, Registration No. 33-30645). - 76 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.18 Consulting Agreement, dated November 19, 1993 between KACC and A. Stephens Hutchcraft, Jr. (incorporated herein by reference to MAXXAM's Annual Report on Form 10-K for the period ended December 31, 1993, File No. 1-3924; the "MAXXAM 1993 Form 10-K"). 10.19 Employment Agreement, dated September 26, 1990, between KACC, MAXXAM and John T. La Duc (incorporated by reference to Exhibit 10.20 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 10.20 Employment Agreement, dated as of August 22, 1990, among KACC, MAXXAM and Robert W. Irelan (incorporated by reference to Exhibit 10.2 of the Report on Form 10-Q for the quarterly period ended March 31, 1991, filed by KACC, File No. 1-3605). 10.21 Promissory Note, dated October 4, 1990, by Robert W. Irelan and Barbara M. Irelan to KACC (incorporated by reference to Exhibit 10.54 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.22 Real Estate Lien Note, dated October 4, 1990, by Robert W. Irelan and Barbara M. Irelan to KACC and related Deed of Trust (incorporated by reference to Exhibit 10.55 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.23 Employment Agreement, dated as of March 8, 1990, between MAXXAM and Anthony R. Pierno (incorporated by reference to Exhibit 10.28 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.24 Promissory Note dated February 1, 1989, by Anthony R. Pierno and Beverly J. Pierno to MAXXAM (incorporated by reference to Exhibit 10.30 to Form 10-K for the period ended December 31, 1988, filed by MAXXAM, File No. 1-3924). 10.25 Promissory Note, dated July 19, 1990, by Anthony R. Pierno to MAXXAM (incorporated by reference to Exhibit 10.31 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.26 Commercial Guaranty, dated February 22, 1993, executed by MAXXAM in favor of Charter National Bank-Houston with respect to a loan from Charter National Bank- Houston to Anthony R. Pierno (incorporated by reference to Exhibit 10.27 to Form 10-K for the period ended December 31, 1992, filed by KAC, File No. 1-9447). 10.27 Commercial Guaranty, dated January 24, 1994, between MAXXAM and Charter National Bank-Houston, in respect of a loan from Charter National Bank-Houston to Anthony R. Pierno and a related letter agreement (incorporated herein by reference to the MAXXAM 1993 Form 10-K). - 77 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.28 Employment Agreement, dated as of March 8, 1990, between MAXXAM and Byron L. Wade (incorporated by reference to Exhibit 10.50 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.29 Promissory Note, dated July 20, 1993, between MAXXAM and Byron L. Wade (incorporated herein by reference to the MAXXAM 1993 Form 10-K). 10.30 Employment Agreement, dated as of July 1, 1991, by and among MAXXAM, KACC and Joseph A. Bonn (incorporated by reference to Exhibit 10.23 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.31 Agreement, dated December 20, 1991, between KAC and Joseph A. Bonn (incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q for the quarterly period ended March 31, 1992, filed by KACC, File No. 1-3605). 10.32 Employment Agreement, dated August 20, 1993, between KACC and Robert E. Cole (incorporated by reference to the MAXXAM 1993 Form 10-K). 21 Significant subsidiaries of KACC. - ----------------- Filed herewith. - 78 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit 21 SUBSIDIARIES Listed below are the principal subsidiaries of Kaiser Aluminum & Chemical Corporation and the jurisdiction of their incorporation or organization. Certain subsidiaries are omitted which, considered in the aggregate as a single subsidiary, would not constitute a significant subsidiary. Place of Incorporation Name or Organization ---- --------------- Alpart Jamaica Inc . .. . .. . .. . .. . .. Delaware Alumina Partners of Jamaica (partnership). Delaware Anglesey Aluminium Limited.. . .. . .. . . United Kingdom Kaiser Alumina Australia Corporation.. . . Delaware Kaiser Aluminium Europe (U.K.) Limited . .. United Kingdom Kaiser Aluminium International, Inc... . . Delaware Kaiser Aluminum & Chemical International N.V... . .. . .. . .. . .. Netherlands Antilles Kaiser Aluminum & Chemical of Canada Limited. Ontario Kaiser Aluminum Technical Services, Inc. .. California Kaiser Bauxite Company. . .. . .. . .. . .. Nevada Kaiser Center, Inc.. .. . .. . .. . .. . .. California Kaiser Center Properties (partnership) . .. California Kaiser Finance Corporation . . .. . .. . .. Delaware Kaiser Jamaica Bauxite Company (partnership) Jamaica Kaiser Jamaica Corporation.. . .. . .. . . Delaware Queensland Alumina Limited.. . .. . .. . . Queensland Strombus International Insurance Company, Ltd.. .. . .. . .. . .. . .. . .. . .. Bermuda Trochus Insurance Company, Ltd... . .. . . Bermuda Volta Aluminium Company Limited.. . .. . . Ghana - 79 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- PRODUCTION AND RESEARCH FACILITIES (100% owned unless otherwise noted) Alumina and Bauxite Fabricated Products Gramercy, Louisiana Flat Rolled Products Alumina Partners of Jamaica -------------------- (Alpart), Jamaica (65%) Trentwood, Washington Kaiser Jamaica Bauxite Company (KJBC), Jamaica (49%) Extruded Products Queensland Alumina Limited (QAL), ----------------- Australia (28.3%) including Rod and Bar Alumina Development Laboratory, --------------------- Gramercy, Louisiana Jackson, Tennessee Los Angeles, California Santa Fe Springs, Primary Products California Newark, Ohio Mead, Washington Sherman, Texas Tacoma, Washington Tulsa, Oklahoma Anglesey Aluminium Limited, Kaiser Aluminum & Wales (49%) Chemical of Canada Volta Aluminium Company Limited,London, Limited (Valco), Ontario, Canada Ghana (90%) Division Technology Center, Forgings Mead, Washington -------- Alliance, Ohio Canton, Ohio Center for Technology Erie, Pennsylvania Greenwood, South Pleasanton, California Carolina, Forge Greenwood, South Carolina, Machine Shop Oxnard, California - 80 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Executive Offices Directors 6177 Sunol Boulevard Charles E. Hurwitz Pleasanton, CA, 94566-7769 George T. Haymaker, Jr. 510/462-1122 Robert J. Cruikshank Ezra G. Levin Robert Marcus Paul D. Rusen Auditors Arthur Andersen & Co. Spear Street Tower Corporate Officers and One Market Plaza Business Unit Managers San Francisco, CA 94105-1019 George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer Charlie Alongi Controller Joseph A. Bonn Vice President, Planning and Administration Robert E. Cole Vice President, Government Affairs John E. Daniel Vice President, Primary Aluminum Products Richard B. Evans Vice President, Flat-Rolled Products Robert W. Irelan Vice President, Public Relations John T. La Duc Vice President and Chief Financial Officer James T. Owen Vice President, Extruded Products/Rod and Bar Joseph Peganoff Vice President, Forgings Anthony R. Pierno Vice President and General Counsel Geoffrey W. Smith Vice President, Alumina Kris S. Vasan Treasurer Byron L. Wade Vice President, Secretary and Deputy General Counsel Lawrence L. Watts Vice President, Alumina - 81 - ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Index to Financial Statements and Schedules 1. Financial Statements Page -------------------- ---- Report of Independent Public Accountants .. . . 32 Consolidated Balance Sheets. . .. . .. . .. . . 33 Statements of Consolidated Income.. .. . .. . . 34 Statements of Consolidated Cash Flows. . .. . . 35 Notes to Consolidated Financial Statements. . . 36 Five-Year Financial Data. .. . .. . .. . .. . . 62 Quarterly Financial Data. .. . .. . .. . .. . . 64 2. Financial Statement Schedules Page ---- Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties . . . . . 65 Schedule V - Consolidated Property, Plant, and Equipment . . . 66 Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Consolidated Property, Plant, and Equipment . . . 67 Schedule IX - Consolidated Short- Term Borrowings . . . . . 68 Schedule X - Supplementary Consolidated Income Statement Information. . . 69 All other schedules are inapplicable or the required information is included in the Consolidated Financial Statements or the Notes thereto. - 70 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (continued) 3. Exhibits --------- Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 73), which index is incorporated herein by reference. (b) Reports on Form 8-K No report on Form 8-K was filed by the Company during the quarter ended December 31, 1993. (c) Exhibits Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 73), which index is incorporated herein by reference. - 71 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- SIGNATURES Pursuant to the requirements of Section 13 or 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. KAISER ALUMINUM & CHEMICAL CORPORATION George T. Haymaker, Jr. Date: March 30, 1994 By - ------------------------------------ George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. George T. Haymaker, Jr. Date: March 30, 1994 - -------------------------------------- George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer (Principal Executive Officer) John T. La Duc Date: March 30, 1994 - -------------------------------------- John T. La Duc Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) Charlie Alongi Date: March 30, 1994 - -------------------------------------- Charlie Alongi Controller (Principal Accounting Officer) Robert J. Cruikshank Date: March 30, 1994 - -------------------------------------- Robert J. Cruikshank Director Charles E. Hurwitz Date: March 30, 1994 - -------------------------------------- Charles E. Hurwitz Director Ezra G. Levin Date: March 30, 1994 - -------------------------------------- Ezra G. Levin Director Robert Marcus Date: March 30, 1994 - ------------------------------------- Robert Marcus Director Paul D. Rusen Date: March 30, 1994 - -------------------------------------- Paul D. Rusen Director - 72 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- INDEX OF EXHIBITS Exhibit Number Description - ------ ----------- 3.1 Restated Certificate of Incorporation of Kaiser Aluminum & Chemical Corporation ("KACC"), dated July 25, 1989 (incorporated by reference to Exhibit 3.1 to the Registration Statement on Form S-1, dated August 25, 1989, filed by KACC, Registration No. 33-30645). 3.2 Certificate of Retirement of KACC, dated February 7, 1990 (incorporated by reference to Exhibit 3.2 to Form 10-K for the period ended December 31, 1989, filed by KACC, File No. 1-3605). 3.3 By-laws of KACC, dated November 30, 1988 (incorporated by reference to Exhibit (3)(c) to Form 10-K for the period ended December 31, 1988, filed by KACC, File No. 1-3605). 4.1 Indenture, dated as of February 1, 1993, among KACC, as Issuer, Kaiser Alumina Australia Corporation, Alpart Jamaica Inc., and Kaiser Jamaica Corporation, as Subsidiary Guarantors, and The First National Bank of Boston, as Trustee, regarding KACC's 12-3/4% Senior Subordinated Notes Due 2003 (incorporated to Form 10-K for the period ended December 31, 1992, filed by KACC, File No. 1-3605). 4.2 First Supplemental Indenture, dated as of May 1, 1993 (incorporated by reference to Exhibit 4.2 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 4.3 Indenture, dated as of February 17, 1994, among KACC, as Issuer, Kaiser Alumina Australia Corporation, Alpart Jamaica Inc., Kaiser Jamaica Corporation, and Kaiser Finance Corporation, as Subsidiary Guarantors, and First Trust National Association as Trustee, regarding KACC's 9-7/8% Senior Notes Due 2002 (incorporated by reference to Exhibit 4.3 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.4 Credit Agreement, dated as of February 17, 1994, among KACC, Kaiser Aluminum Corporation ("KAC"), the financial institutions a party thereto, BankAmerica Business Credit, Inc., as Agent, and certain financial institutions (incorporated by reference to Exhibit 4.4 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.5 Credit Agreement, dated as of December 13, 1989 (the "1989 Credit Agreement"), among KACC, KAC, the financial institutions a party thereto, Bank of America National Trust and Savings Association, as Agent, and Mellon Bank, N.A., as Collateral Agent (incorporated by reference to Exhibit 4.3 to Amendment No. 5 to the Registration Statement on Form S-1 dated December 13, 1989, filed by KACC, Registration No. 33-30645). 4.6 First Amendment to the 1989 Credit Agreement, dated as of April 17, 1990 (incorporated by reference to Exhibit 4.2 of the Report on Form 10-Q for the quarterly period ended September 30, 1990, of MAXXAM Inc. ("MAXXAM"), filed November 6, 1990, File No. 1-3924). 4.7 Second Amendment to the 1989 Credit Agreement, dated as of September 17, 1990 (incorporated by reference to Exhibit 4.3 of the Report on Form 10-Q for the quarterly period ended September 30, 1990, of MAXXAM, filed November 6, 1990, File No. 1-3924). - 73 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 4.8 Third Amendment to the 1989 Credit Agreement, dated as of December 7, 1990 (incorporated by reference to Exhibit 4.6 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 4.9 Fourth Amendment to the 1989 Credit Agreement, dated as of April 19, 1991 (incorporated by reference to Exhibit 4.1 of the Report on Form 10-Q for the quarterly period ended March 31, 1991, filed by KACC, File No. 1-3605). 4.10 Fifth Amendment to the 1989 Credit Agreement, dated as of March 13, 1992 (incorporated by reference to Exhibit 4.8 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 4.11 Seventh Amendment to the 1989 Credit Agreement, dated as of November 6, 1992 (incorporated by reference to Exhibit 4.10 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.12 Eighth Amendment to the 1989 Credit Agreement, dated as of January 7, 1993 (incorporated by reference to Exhibit 4.12 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.13 Ninth Amendment to 1989 Credit Agreement, dated as of May 19, 1993 including the form of Intercompany Note annexed as an Exhibit thereto (incorporated by reference to Exhibit 4.10 to Amendment No. 2 to the Registration Statement on Form S-1, dated June 22, 1993, filed by KACC, Registration No. 33-49555). 4.14 Tenth Amendment to 1989 Credit Agreement, dated as of July 23, 1993, (incorporated by reference to Exhibit 4.13 to the Registration Statement on Form S-3, dated August 26, 1993, filed by KACC, Registration No. 33-50097). 4.15 Eleventh Amendment to 1989 Credit Agreement, dated as of August 27, 1993, (incorporated by reference to Exhibit 4.13 to the Registration Statement on Form S-3, dated October 13, 1993, filed by KAC, Registration No. 33-50581). 4.16 Twelfth Amendment to 1989 Credit Agreement, dated as of December 20, 1993, (incorporated by reference to Exhibit 4.15 to Amendment No. 3 to the Registration Statement on Form S-2, dated February 8, 1994, filed by KACC, Registration No. 33-50097). 4.17 Certificate of Designation of Series A Mandatory Conversion Premium Dividend Preferred Stock of KAC, dated June 28, 1993 (incorporated by reference to Exhibit 4.3 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 4.18 Deposit Agreement between KAC and The First National Bank of Boston, dated as of June 30, 1993 (incorporated by reference to Exhibit 4.4 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). - 74 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 4.19 Intercompany Note between KACC and KAC (incorporated by reference to Exhibit 4.2 to Amendment No. 5 to the Registration Statement on Form S-1 dated December 13, 1989, filed by KACC, Registration No. 33-30645). 4.20 Senior Subordinated Intercompany Note between KACC and MAXXAM, dated January 14, 1993 (incorporated by reference to Exhibit 4.13 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 4.21 Certificate of Designation of KAC's 8.255% Preferred Redeemable Increased Dividend Equity Securities, dated February 17, 1994 (incorporated by reference to Exhibit 4.21 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.22 Senior Subordinated Intercompany Note between KACC and KAC dated February 15, 1994 (incorporated by reference to Exhibit 4.22 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.23 Senior Subordinated Intercompany Note between KACC and KAC dated March 17, 1994 (incorporated by reference to Exhibit 4.23 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). 4.24 Senior Subordinated Intercompany Note between KACC and KAC dated June 30, 1993 (incorporated by reference to Exhibit 4.24 to Form 10-K for the period ended December 31, 1993, filed by KAC, File No. 1-9447). KACC has not filed certain long-term debt instruments not being registered with the Securities and Exchange Commission where the total amount of indebtedness authorized under any such instrument does not exceed 10% of the total assets of KACC and its subsidiaries on a consolidated basis. KACC agrees and undertakes to furnish a copy of any such instrument to the Securities and Exchange Commission upon its request. 10.1 Form of indemnification agreement with officers and directors (incorporated by reference to Exhibit (10)(b) to the Registration Statement of KAC on Form S-4, File No. 33-12836). 10.2 Tax Allocation Agreement between MAXXAM and KACC (incorporated by reference to Exhibit 10.21 to Amendment No. 6 to the Registration Statement on Form S-1, dated December 14, 1989, filed by KACC, Registration No. 33-30645). 10.3 Tax Allocation Agreement between KAC and MAXXAM (incorporated by reference to Exhibit 10.23 to Amendment No. 2 to the Registration Statement on Form S-1, dated June 11, 1991, filed by KAC, Registration No. 33-37895). 10.4 Tax Allocation Agreement, dated as of June 30, 1993, between KAC and KACC (incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 10.5 Amended and Restated Alumina Supply Agreement, dated as of October 11, 1989 (incorporated by reference to Exhibit 10.19 to Amendment No. 3 to the Registration Statement on Form S-1, dated November 14, 1989, filed by KACC, Registration No. 33-30645). 10.6 Assumption Agreement, dated as of October 28, 1988 (incorporated by reference to Exhibit HHH to the Final Amendment to the Schedule 13D of MAXXAM Group Inc. and others in respect of the Common Stock of KAC, par value $.33-1/3 per share). - 75 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.7 Agreement, dated as of June 30, 1993, between KAC and MAXXAM (incorporated by reference to Exhibit 10.2 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). Executive Compensation Plans and Arrangements --------------------------------------------- 10.8 KACC's Bonus Plan (incorporated by reference to Exhibit 10.25 to Amendment No. 6 to the Registration Statement on Form S-1, dated December 14, 1989, filed by KACC, Registration No. 33-30645). 10.9 KaiserTech Limited Long Term Incentive Plan, dated June 2, 1989 (incorporated by reference to Exhibit 10.14 to Form 10-K for the period ended December 31, 1989, filed by KACC, File No. 1-3605). 10.10 Amendment No. 2 to KaiserTech Limited Long Term Incentive Plan, dated as of December 18, 1991 (incorporated by reference to Exhibit 10.7 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.11 Amendment No. 3 to Kaiser Aluminum Long Term Incentive Plan, dated as of December 31, 1991 (incorporated by reference to Exhibit 10.8 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.12 Kaiser 1993 Omnibus Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to the Report on Form 10-Q for the quarterly period ended June 30, 1993, filed by KACC, File No. 1-3605). 10.13 Kaiser Aluminum Middle Management Long-Term Incentive Plan, dated June 25, 1990, as amended (incorporated by reference to Exhibit 10.22 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 10.14 Employment Agreement, dated April 1, 1993, among KAC, KACC, and George T. Haymaker, Jr. (incorporated by reference to Exhibit 10.2 to the Report on Form 10-Q for the quarterly period ended March 31, 1993, filed by KAC, File No. 1-9447). 10.15 Employment Agreement, dated as of October 1, 1992, among KACC, KAC and A. Stephens Hutchcraft, Jr. (incorporated by reference to Exhibit 10.15 to Amendment No. 5 to the Registration Statement on Form S-2, dated January 22, 1993, filed by KACC, Registration No. 33-48260). 10.16 Severance Agreement, dated July 1, 1985, between KACC and A. Stephens Hutchcraft, Jr., as amended (incorporated by reference to Exhibit (10)(f) to Form 10-K for the period ended December 31, 1988, filed by KACC, File No. 1-3605). 10.17 Amendment, dated October 31, 1989, to the Severance Agreement of A. Stephens Hutchcraft, Jr. referenced in Exhibit 10.16 above (incorporated by reference to Exhibit 10.24 to Amendment No. 5 to the Registration Statement on Form S-1, dated December 13, 1989, filed by KACC, Registration No. 33-30645). - 76 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.18 Consulting Agreement, dated November 19, 1993 between KACC and A. Stephens Hutchcraft, Jr. (incorporated herein by reference to MAXXAM's Annual Report on Form 10-K for the period ended December 31, 1993, File No. 1-3924; the "MAXXAM 1993 Form 10-K"). 10.19 Employment Agreement, dated September 26, 1990, between KACC, MAXXAM and John T. La Duc (incorporated by reference to Exhibit 10.20 to Amendment No. 1 to the Registration Statement on Form S-1, dated February 13, 1991, filed by KAC, Registration No. 33-37895). 10.20 Employment Agreement, dated as of August 22, 1990, among KACC, MAXXAM and Robert W. Irelan (incorporated by reference to Exhibit 10.2 of the Report on Form 10-Q for the quarterly period ended March 31, 1991, filed by KACC, File No. 1-3605). 10.21 Promissory Note, dated October 4, 1990, by Robert W. Irelan and Barbara M. Irelan to KACC (incorporated by reference to Exhibit 10.54 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.22 Real Estate Lien Note, dated October 4, 1990, by Robert W. Irelan and Barbara M. Irelan to KACC and related Deed of Trust (incorporated by reference to Exhibit 10.55 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.23 Employment Agreement, dated as of March 8, 1990, between MAXXAM and Anthony R. Pierno (incorporated by reference to Exhibit 10.28 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.24 Promissory Note dated February 1, 1989, by Anthony R. Pierno and Beverly J. Pierno to MAXXAM (incorporated by reference to Exhibit 10.30 to Form 10-K for the period ended December 31, 1988, filed by MAXXAM, File No. 1-3924). 10.25 Promissory Note, dated July 19, 1990, by Anthony R. Pierno to MAXXAM (incorporated by reference to Exhibit 10.31 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.26 Commercial Guaranty, dated February 22, 1993, executed by MAXXAM in favor of Charter National Bank-Houston with respect to a loan from Charter National Bank- Houston to Anthony R. Pierno (incorporated by reference to Exhibit 10.27 to Form 10-K for the period ended December 31, 1992, filed by KAC, File No. 1-9447). 10.27 Commercial Guaranty, dated January 24, 1994, between MAXXAM and Charter National Bank-Houston, in respect of a loan from Charter National Bank-Houston to Anthony R. Pierno and a related letter agreement (incorporated herein by reference to the MAXXAM 1993 Form 10-K). - 77 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit Number Description - ------ ----------- 10.28 Employment Agreement, dated as of March 8, 1990, between MAXXAM and Byron L. Wade (incorporated by reference to Exhibit 10.50 to Form 10-K for the period ended December 31, 1990, filed by MAXXAM, File No. 1-3924). 10.29 Promissory Note, dated July 20, 1993, between MAXXAM and Byron L. Wade (incorporated herein by reference to the MAXXAM 1993 Form 10-K). 10.30 Employment Agreement, dated as of July 1, 1991, by and among MAXXAM, KACC and Joseph A. Bonn (incorporated by reference to Exhibit 10.23 to Form 10-K for the period ended December 31, 1991, filed by KACC, File No. 1-3605). 10.31 Agreement, dated December 20, 1991, between KAC and Joseph A. Bonn (incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q for the quarterly period ended March 31, 1992, filed by KACC, File No. 1-3605). 10.32 Employment Agreement, dated August 20, 1993, between KACC and Robert E. Cole (incorporated by reference to the MAXXAM 1993 Form 10-K). 21 Significant subsidiaries of KACC. - ----------------- Filed herewith. - 78 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Exhibit 21 SUBSIDIARIES Listed below are the principal subsidiaries of Kaiser Aluminum & Chemical Corporation and the jurisdiction of their incorporation or organization. Certain subsidiaries are omitted which, considered in the aggregate as a single subsidiary, would not constitute a significant subsidiary. Place of Incorporation Name or Organization ---- --------------- Alpart Jamaica Inc . .. . .. . .. . .. . .. Delaware Alumina Partners of Jamaica (partnership). Delaware Anglesey Aluminium Limited.. . .. . .. . . United Kingdom Kaiser Alumina Australia Corporation.. . . Delaware Kaiser Aluminium Europe (U.K.) Limited . .. United Kingdom Kaiser Aluminium International, Inc... . . Delaware Kaiser Aluminum & Chemical International N.V... . .. . .. . .. . .. Netherlands Antilles Kaiser Aluminum & Chemical of Canada Limited. Ontario Kaiser Aluminum Technical Services, Inc. .. California Kaiser Bauxite Company. . .. . .. . .. . .. Nevada Kaiser Center, Inc.. .. . .. . .. . .. . .. California Kaiser Center Properties (partnership) . .. California Kaiser Finance Corporation . . .. . .. . .. Delaware Kaiser Jamaica Bauxite Company (partnership) Jamaica Kaiser Jamaica Corporation.. . .. . .. . . Delaware Queensland Alumina Limited.. . .. . .. . . Queensland Strombus International Insurance Company, Ltd.. .. . .. . .. . .. . .. . .. . .. Bermuda Trochus Insurance Company, Ltd... . .. . . Bermuda Volta Aluminium Company Limited.. . .. . . Ghana - 79 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- PRODUCTION AND RESEARCH FACILITIES (100% owned unless otherwise noted) Alumina and Bauxite Fabricated Products Gramercy, Louisiana Flat Rolled Products Alumina Partners of Jamaica -------------------- (Alpart), Jamaica (65%) Trentwood, Washington Kaiser Jamaica Bauxite Company (KJBC), Jamaica (49%) Extruded Products Queensland Alumina Limited (QAL), ----------------- Australia (28.3%) including Rod and Bar Alumina Development Laboratory, --------------------- Gramercy, Louisiana Jackson, Tennessee Los Angeles, California Santa Fe Springs, Primary Products California Newark, Ohio Mead, Washington Sherman, Texas Tacoma, Washington Tulsa, Oklahoma Anglesey Aluminium Limited, Kaiser Aluminum & Wales (49%) Chemical of Canada Volta Aluminium Company Limited,London, Limited (Valco), Ontario, Canada Ghana (90%) Division Technology Center, Forgings Mead, Washington -------- Alliance, Ohio Canton, Ohio Center for Technology Erie, Pennsylvania Greenwood, South Pleasanton, California Carolina, Forge Greenwood, South Carolina, Machine Shop Oxnard, California - 80 - KAISER ALUMINUM & CHEMICAL CORPORATION AND SUBSIDIARY COMPANIES - --------------------------------------------------------------- Executive Offices Directors 6177 Sunol Boulevard Charles E. Hurwitz Pleasanton, CA, 94566-7769 George T. Haymaker, Jr. 510/462-1122 Robert J. Cruikshank Ezra G. Levin Robert Marcus Paul D. Rusen Auditors Arthur Andersen & Co. Spear Street Tower Corporate Officers and One Market Plaza Business Unit Managers San Francisco, CA 94105-1019 George T. Haymaker, Jr. Chairman of the Board and Chief Executive Officer Charlie Alongi Controller Joseph A. Bonn Vice President, Planning and Administration Robert E. Cole Vice President, Government Affairs John E. Daniel Vice President, Primary Aluminum Products Richard B. Evans Vice President, Flat-Rolled Products Robert W. Irelan Vice President, Public Relations John T. La Duc Vice President and Chief Financial Officer James T. Owen Vice President, Extruded Products/Rod and Bar Joseph Peganoff Vice President, Forgings Anthony R. Pierno Vice President and General Counsel Geoffrey W. Smith Vice President, Alumina Kris S. Vasan Treasurer Byron L. Wade Vice President, Secretary and Deputy General Counsel Lawrence L. Watts Vice President, Alumina - 81 -	33,978	227,661
728535_1993.txt	728535_1993	1993	728535	ITEM 1. BUSINESS GENERAL J.B. Hunt Transport Services, Inc. (Services) is a diversified transportation company focusing on the movement of full-load containerizable freight in North America. Services is an Arkansas holding company incorporated on August 10, 1961. Through its wholly-owned subsidiaries, Services operates as an irregular route, common motor carrier operating under the jurisdiction of the Interstate Commerce Commission (ICC) and various state regulatory agencies. References to "J.B. Hunt" or "the Company" are to Services and its wholly-owned subsidiaries. Utilizing its various operating authorities, the Company may transport any type of freight (except certain types of explosives) from any point in the continental United States to any other point in another state, over any route selected by the Company. The Company also has certain intrastate authorities, allowing it to pick-up and deliver within those states. The principal types of freight transported include foodstuffs, automotive parts, plastics and plastic products, general retail store merchandise, chemicals, paper and paper products, and manufacturing materials and supplies. The Company received Canadian authority in 1988 and 1989, which allowed general commodity service between certain Canadian provinces. Transportation services are also provided to and from all points in the continental United States to Quebec, British Columbia and Ontario. An agreement announced in March 1993 with Canada's largest railway, Canadian National, provides for expanded joint truck and rail service to Canada. J.B. Hunt has provided transportation services to and from Mexico since 1989 through interchange operations with various Mexican motor carriers. In May 1992 a joint venture with Transportacion Maritima Mexicana, the largest transportation company in Mexico, was announced. In 1990, the Company and the Atchison, Topeka and Santa Fe Railway Company (Santa Fe) initiated an intermodal operation with trailer-on-flatcar (TOFC) service. Since this initial agreement with Santa Fe, intermodal operations have been expanded to include nine railroads. The Company also provides double-stack container services which utilize a newly-designed container on a number of rail routes. Substantially all of the freight carried under these rail agreements is guaranteed space on trains and receives preferential loading and unloading at rail terminal facilities. The Company offers related full truckload transportation services such as regional, intrastate, flatbed, special (hazardous) commodities and dedicated equipment and logistics management services. Growth and expansion of these related businesses has been achieved through a combination of new internal service offerings and acquisitions. The new flatbed and special commodities operations were created in 1991. A company with Texas intrastate authority was acquired in 1991. A small hazardous waste carrier was acquired in 1992, and a new dedicated unit commenced operation in 1993. MARKETING AND OPERATIONS J.B. Hunt has targeted the service sensitive segment of the truckload dry van market rather than those segments that use price as their primary consideration. The truckload market has traditionally been a lower price, lower service market when compared to the less-than-truckload segment. The Company has opted to provide a premium service and charge compensating rates rather than compete primarily on the basis of price. The Company's business is well diversified and no one customer accounted for more than 6% of revenues during 1992 or 1993. Marketing efforts include significant focus on the diversified group of "Fortune 500" customers. A broad geographic dispersion and a good balance in the type of industries served allows J.B. Hunt some protection from major seasonal fluctuations. However, consistent with the truckload industry in general, freight is typically stronger in the second half of the year with peak months being August, September and October, In addition, demand for services is usually strong at the end of the first two quarters, (i.e. March and June). Revenue is also affected by bad weather and holidays, since revenue is directly related to available working days of shippers. The Company markets door-to-door truckload service through its nationwide marketing network. Services involving intermodal transportation mediums are billed by J.B. Hunt and all inquiries, claims and other customer contact is handled by the Company. PERSONNEL At December 31, 1993, J.B. Hunt employed 10,476 people including 7,531 drivers. The Company increased the rate of over-the-road driver compensation in late 1990 in order to attract and retain experienced drivers. The pay scale for certain local drivers was increased in January 1993. Both experienced and non-experienced drivers are trained in all phases of Company policies and operations as well as defensive driving, safety techniques and fuel efficient operations of equipment. During 1992 three distinct driving jobs (local, regional and over-the-road) were identified in order to get drivers home more frequently and provide quality service to intermodal and regional operations. Drivers receive additional incentive compensation based upon fuel economy and other operating performance criteria. Each operating unit measures the quality of on-time service provided to customers each day. This focus on quality has also generated internal operating efficiencies in a number of functional areas. None of the Company's drivers or other employees are represented by a collective bargaining unit. In the opinion of management, the Company's relationship with all of its employees is excellent. REVENUE EQUIPMENT At December 31, 1993, J.B. Hunt operated 6,775 tractors and 19,089 trailers/containers. The average age of the tractor fleet at year-end was less than two years. The trailer pool consisted primarily of 48-foot and 53-foot dry vans or containers. The number of 53-foot trailers/containers has been increased during the last few years in order to offer improved cost advantages to customers. In late 1992, J.B. Hunt announced the development of a new multi-purpose container which can be utilized for over-the-road truck transportation and provide double-stack capabilities for intermodal movements. The Company intends to convert a significant portion of its trailer fleet to these containers during the next few years. At December 31, 1993, there were approximately 7,600 containers in the fleet. The Company strictly enforces a periodic maintenance program based upon the specific type and use of a vehicle. This commitment to a quality maintenance program minimizes equipment downtime and enhances the trade-in value of all used equipment. The Company believes that modern, late-model, clean equipment differentiates service in the market place. COMPETITION J.B. Hunt is one of the two largest irregular route truckload carriers in the country. It competes primarily with other irregular route, short, intermediate and long-haul truckload common carriers. Less-than-truckload motor common carriers and private carriers generally provide competition to a lesser degree. Although any one of these may represent competition on a regional basis, there are a very limited number of companies that represent competition in all markets. The principal method of competition since deregulation of the industry has been through price reductions. Increasingly, shippers are looking for "core carriers" that can offer equipment availability, geographical coverage and technical expertise to handle a substantial part of their transportation needs. REGULATION The Company is a motor common carrier regulated by the ICC. The ICC generally governs activities such as authority to engage in motor carrier operations, accounting systems, certain mergers, consolidations, acquisitions, and periodic financial reporting. Motor carrier operations are subject to safety requirements prescribed by the United States Department of Transportation (DOT) governing interstate operation. Such matters as weight and dimensions of equipment and commercial driver's licensing are also subject to federal and state regulations. A new federal requirement that all drivers obtain a commercial driver's license became effective in April 1992. The federal Motor Carrier Act of 1980 was the start of a program to increase competition among motor carriers and limit the level of regulation in the industry (sometimes referred to as "deregulation"). The Motor Carrier Act of 1980 enables applicants to obtain ICC operating authority more easily and allows interstate motor carriers, such as the Company, to change their rates by a certain percentage per year without ICC approval. The new law also allowed for the removal of many route and commodity restrictions regarding the transportation of freight. As a result of the Motor Carrier Act of 1980, the Company was able to obtain unlimited authority to carry general commodities throughout the 48 contiguous states. ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters are in Lowell, Arkansas. A 150,000 square foot building was constructed and occupied in September 1990. The building is situated on a 127-acre tract of land. In addition, to the corporate headquarters, the Company owns a separate 62-acre tract in Lowell, Arkansas with four separate buildings totaling 21,000 square feet of office space and 90,000 square feet of maintenance and warehouse space. These buildings serve as the Lowell operations terminal, tractor and trailer maintenance facilities and additional administrative offices. A summary of the Company's principal facilities follows: The Company owns all of the above listed facilities except Chicago and Oklahoma City which are leased. In addition to the above facilities, the Company leases several small offices and/or trailer parking yards in various locations throughout the country. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a party to routine litigation incidental to its business, primarily involving claims for personal injury and property damage incurred in the transportation of freight. The Company maintains excess insurance above its self-insured levels which covers extraordinary liability resulting from such claims. Adverse results in one or more of these cases would not have a material adverse affect on the financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The 1993 Annual Meeting of stockholders was held on May 13, 1993. At that meeting, the following matters were submitted to a vote of security holders: 1. To elect nine (9) directors as recommended by the Board of Directors For Against Abstain --- ------- ------- Number of shares voted 32,070,726 0 60,585 Percentage of shares voted 99.81% -- .19% 2. To fix the number of Directors for the ensuing year at nine (9) For Against Abstain --- ------- ------- Number of shares voted 32,102,143 13,385 15,783 Percentage of shares voted 99.91% .04% .05% No matters were submitted during the fourth quarter of 1993 to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS PRICE RANGE OF COMMON STOCK The Company's common stock is traded in the over-the-counter market under the symbol "JBHT". The following table sets forth, for the calendar periods indicated, the range of high and low sales prices for the Company's common stock as reported by the National Association of Securities Dealers Automated Quotations National Market System ("NASDAQ"). The following quotations reflect a three-for-two stock split paid on March 13, 1992. On March 11, 1994, the high and low sales prices for the Company's common stock as reported by the NASDAQ were 24 3/4 and 24 1/4 respectively. As of March 11, 1994, the Company had 1,778 stockholders of record. DIVIDEND POLICY On January 13, 1994, the Board of Directors declared a quarterly dividend of $.05 per share, payable to shareholders of record on February 3, 1994. Although it is the present intention of the Board of Directors to continue quarterly dividends, payment of future dividends will depend upon the Company's financial condition, results of operations and other factors deemed relevant by the Board of Directors. The Company declared and paid cash dividends of $.20 per share in 1993 and $.20 per share in 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information set forth under the sections entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition", "Selected Financial Data", "Independent Auditors' Report", "Consolidated Statements of Earnings", "Consolidated Balance Sheets", "Consolidated Statements of Stockholders' Equity", "Consolidated Statements of Cash Flows", and "Notes to Consolidated Financial Statements", of the Company's 1993 Annual Report to Stockholders is hereby incorporated by reference for items 6, 7 and 8 above. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No reports on Form 8-K have been filed within the twenty-four months prior to December 31, 1993, involving a change of accountants or disagreements on accounting and financial disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under sections entitled "Proposal One Election of Directors", "Board Committees", "Executive Officers", "Voting Securities and Security Ownership of Management and Principal Stockholders", "Executive Compensation and Other Information", "1994 Performance Based Compensation" and "Proposal Two Ratification of Appointment of Auditors" of the Notice and Proxy Statement For Annual Stockholders' meeting is hereby incorporated by reference for items 10, 11 and 12 above. The Proxy Statement had not yet been mailed to stockholders and was not available as of March 31, 1994. It will be filed no later than April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as part of this report: (a) The following additional information for the years 1993, 1992 and 1991 is submitted herewith. Page references are to the consecutively numbered pages of this report on Form 10-K. Independent Auditors' Report . . . . . . . . . . . . . . . . . . 11 Schedule V - Property and Equipment - Years ended December 31, 1993, 1992, 1991. . . . . . . . . . . . . . . . . 12 Schedule VI - Accumulated Depreciation of Property and Equipment - Years ended December 31, 1993, 1992, 1991. . . . . . . . . . . 13 Schedule X - Supplementary Statement of Earnings Information - Years ended December 31, 1993, 1992, 1991. . . . . . . . . . . 14 (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits The response to this portion of ITEM 14 is submitted as a separate section of this report ("Exhibit Index"). SIGNATURES Pursuant to the requirements of Sections 13 or 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, in the City of Lowell, Arkansas, on the 25th day of March 1994. J.B. HUNT TRANSPORT SERVICES, INC. (Registrant) By: /s/ Kirk Thompson ------------------------------------------ Kirk Thompson President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ John A. Cooper, Jr. Member of the Board March 25, 1994 - ---------------------------- of Directors John A. Cooper, Jr. /s/ Fred K. Darragh, Jr. Member of the Board March 25, 1994 - ---------------------------- of Directors Fred K. Darragh, Jr. /s/ Wayne Garrison Member of the Board March 25, 1994 - ---------------------------- of Directors Wayne Garrison /s/ Gene George Member of the Board March 25, 1994 - --------------------------- of Directors Gene George /s/ Roy Grimsley Member of the Board March 25, 1994 - --------------------------- of Directors Roy Grimsley /s/ Bryan Hunt Member of the Board March 25, 1994 - --------------------------- of Directors (Vice Chairman) J. Bryan Hunt, Jr. /s/ J.B. Hunt Member of the Board March 25, 1994 - --------------------------- of Directors (Chairman) J.B. Hunt /s/ Johnelle Hunt Member of the Board March 25, 1994 - --------------------------- of Directors (Corporate Johnelle Hunt Secretary) /s/ Lloyd E. Peterson Member of the Board March 25, 1994 - --------------------------- of Directors Lloyd E. Peterson /s/ Kirk Thompson Member of the Board March 25, 1994 - --------------------------- of Directors (President and Kirk Thompson Chief Executive Officer) /s/ Jerry W. Walton Executive Vice President, March 25, 1994 - --------------------------- Finance and Chief Financial Jerry W. Walton Officer EXHIBIT INDEX Exhibit Number 3A The Company's Amended and Restated Articles of Incorporation dated May 19, 1988 (incorporated by reference from Exhibit 4A of the Company's S-8 Registration Statement filed April 16, 1991; Registration Statement Number 33-40028). 3B The Company's Bylaws as amended (incorporated by reference from Exhibit 3B of the Company's S-1 Registration Statement filed November 22, 1983; Registration Number 2-86684). 3C The Company's Amended Bylaws dated September 19, 1983 (incorporated by reference from Exhibit 3C of the Company's S-1 Registration Statement filed February 7, 1985; Registration Number 2-95714). 10A Material Contracts of the Company (incorporated by reference from Exhibits 10A-10N of the Company's S-1 Registration Statement; Registration Number 2-95714). 10B The Company has an Employee Stock Purchase Plan filed on Form S-8 on February 3, 1984 (Registration Number 2-93928), and a Management Incentive Plan filed on Form S-8 on April 16, 1991 (Registration Statement Number 33-40028). The Management Incentive Plan is incorporated herein by reference from Exhibit 4B of Registration Statement 33-40028. 13A Selected Financial Data 13B Management's Discussion and Analysis of Results of Operations and Financial Condition 13C Independent Auditor's Report 13D Financial Statements and Supplementary Data 22 Subsidiaries of J.B. Hunt Transport Services, Inc. * J.B. Hunt Transport, Inc., a Georgia corporation * L.A., Inc., an Arkansas corporation * J.B. Hunt Corp., a Delaware corporation * J.B. Hunt Special Commodities, Inc., an Arkansas corporation * Great Western Trucking Co., Inc., a Texas corporation * J.B. Hunt Logistics, Inc., an Arkansas corporation * Comercializadora Internacional De Cargo S.A. De C.V., a Mexican corporation * Hunt Mexicana, S.A. de C.V., a Mexican corporation 23 Consent of KPMG Peat Marwick INDEPENDENT AUDITORS' REPORT The Board of Directors J.B. Hunt Transport Services, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets of J.B. Hunt Transport Services, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick Little Rock, Arkansas February 11, 1994 Schedule V J.B. HUNT TRANSPORT SERVICES, INC. AND SUBSIDIARIES Property and Equipment Years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Schedule VI J.B. HUNT TRANSPORT SERVICES, INC. AND SUBSIDIARIES Accumulated Depreciation of Property and Equipment Years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Schedule X J.B. HUNT TRANSPORT SERVICES, INC. AND SUBSIDIARIES Supplementary Statements of Earnings Information Years ended December 31, 1993, 1992 and 1991 (Dollars in thousands)	3,177	21,022
719244_1993.txt	719244_1993	1993	719244	ITEM 1. BUSINESS All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, JMB Income Properties, Ltd. - X (the "Partnership"), is a limited partnership formed in 1983 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in improved income-producing commercial and residential real property. The Partnership sold $150,000,000 in limited partnership interests (the "Interests") commencing on June 29, 1983, pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2-83599). A total of 150,000 Interests were sold to the public at $1,000 per Interest and the holders of 150,000 Interests were admitted to the Partnership in fiscal 1984. The offering closed on November 1, 1983. No Limited Partner has made any additional capital contribution after such date. The Limited Partners of the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation, and sale and disposition of equity real estate investments. Such equity investments are held by fee title and/or through joint venture partnership interests. The Partnership's real estate investments are located throughout the nation and it has no real estate investments located outside of the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership agreement, the Partnership is required to terminate on or before October 31, 2033. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long- term investment where, due to current market conditions, it is impossible to forecast the expected holding period. At sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including, in certain areas, properties owned or advised by affiliates of the General Partners) in the respective vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in the table in Item 2 ITEM 2. PROPERTIES The Partnership owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of holders during fiscal years 1992 or 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 15,615 record holders of Interests of the Partnership. There is no public market for Interests and it is not anticipated that a public market for Interests will develop. Upon request, the Managing General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any other economic aspects of the transaction, will be subject to negotiation by the investor. Reference is made to Item 6 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On June 29, 1983, the Partnership commenced an offering of $150,000,000 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. All Interests were subscribed and issued between June 29, 1983 and November 1, 1983 pursuant to the public offering from which the Partnership received gross proceeds of $150,000,000. After deducting selling expenses and other offering costs, the Partnership had approximately $135,651,000 with which to make investments in income-producing commercial and residential real property, to pay legal fees and other costs (including acquisition fees) related to such investments and for working capital. A portion of such proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated venture had cash and cash equivalents of approximately $1,061,000. Such funds and short- term investments of approximately $3,190,000 are available for distributions to partners and for working capital requirements including tenant and capital improvements and any payments to the Animas Venture Partner should the property be disposed of as discussed below. The Partnership and its consolidated venture have currently budgeted in 1994 approximately $6,763,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures in 1994 is currently budgeted to be approximately $4,776,000. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through net cash generated by the Partnership's investment properties and through the sale of such investments. The Partnership's and its ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. In 1993, the Partnership completed an enhancement program at the Collin Creek Mall and the North Hills Mall. Also in 1993, the Partnership commenced an enhancement program (included in the budgeted amounts above) at the Pasadena Town Square with completion expected in 1994. In addition, over the next few years the Partnership will receive a reduced level of distributions from its 40 Broad Street and Royal Executive Park investments due to increased leasing costs and anticipated vacancy during releasing programs. These enhancement and releasing programs are expected to be paid for from the Partnership's investment properties' cash flow and the Partnership's cash on hand. Each of these programs is more fully discussed below. As a result of these programs, the Partnership reduced operating distributions effective as of the first quarter of 1993. As of December 31, 1993, the General Partners have continued to defer payment of certain of their distributions of net cash flow ($9,353,038 at December 31, 1993 or approximately $62 per interest) from the Partnership as required by the Partnership agreement as more fully described in Note 8. Overall cash flow returns at Broad Street for the next few years are expected to be lower than originally projected because a significant portion of the current tenants, who occupy approximately 20% of the building, are financial service companies whose leases expire between 1993 and 1994. In addition, a tenant, occupying approximately 37,000 square feet (approximately 15% of the building), did not renew its lease when it expired in September 1993. However, subtenants occupying approximately 21,000 square feet whose leases also expired in September 1993 have held over while Broad Street continues to negotiate leases with them. Furthermore, Broad Street has renewed and expanded another tenant, effective July 1, 1993, whose lease was scheduled to expire in December 1994. This tenant has expanded from approximately 18,000 square feet to approximately 35,000 square feet at a market effective rental rate which is lower than its previous lease. The Partnership will continue its aggressive leasing program; however, the downtown New York City market remains extremely competitive due to the significant amount of space available primarily resulting from the layoffs, cutbacks and consolidations by financial service companies and related businesses which dominated this market. In addition to competition for tenants in the downtown Manhattan market from other buildings in the area, there is increasing competition from less expensive alternatives to Manhattan. In order to enhance the building's competitive position in the marketplace, the joint venture partners have recently completed certain modest upgrades to the building's main lobby and elevators. Rental rates in the downtown market are currently at depressed levels and this can be expected to continue for the foreseeable future while the current vacant space is gradually absorbed. Little, if any, new construction is planned for downtown over the next few years and it is expected that the building will continue to be adversely affected by the lower than originally projected effective rental rates now achieved upon releasing of existing leases which expire over the next few years. Therefore, the JMB/Broad Street joint venture recorded a provision for value impairment at December 31, 1991 to reduce the net book value of 40 Broad Street to $30,000,000 due to the uncertainty of JMB/Broad Street joint venture's ability to recover the net carrying value of the investment property through future operations or sale. An additional provision for value impairment was recorded at December 31, 1992 to further reduce the net book value of the property to the then estimated valuation of $7,800,000. Reference is made to Note 3(d) for further discussion of the current status of this investment property. During 1991, the JMB/Broad Street joint venture was required to pay approximately $1,800,000 in transfer taxes (and related amounts) relating to the original acquisition of this investment property. See Note 3(d). In 1992 and 1993, the Partnership completed the renovation at the Collin Creek Mall's food court and main floor common area, added escalators at two locations, and upgraded the mall's interior and exterior signage. The total cost of these enhancement programs were approximately $4,400,000. In addition, in 1994, the Partnership will commence a parking lot repair project which will take five years to complete and cost approximately $1,300,000. The work scheduled to be incurred in 1994 has been included in the budgeted improvement costs described above. The total five-year project cost will be partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage note in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the Partnership will obtain a refinancing of the mortgage note which matures in July 1995. The Partnership continues to explore the replacement of a major tenant at the North Hills Mall which owns its own store, with another major tenant and/or adding another major tenant to the center. The major tenant, which is currently using only the first level of its two-story store, has expressed an interest in closing its store. In order to replace the major tenant with another and/or add another major tenant, the Partnership may need to commit substantial capital. Given the Partnership's current lack of substantial working capital, the Partnership may be unable to undertake the replacement and/or addition of the major tenant(s) without an outside source of capital. The Partnership is exploring its alternatives in this regard. However, there can be no assurance that such replacement and/or addition will ultimately occur. The Partnership has completed a mall enhancement program at the North Hills Mall which included the replacement of the floor in a portion of the mall, a food court remodel, and certain lighting improvements. The program cost was approximately $1,000,000. In addition, the Partnership is in the second year of a five year program to repair the property's roof and parking lot. The total cost of the repair is expected to be approximately $1,500,000. The work scheduled to be incurred in 1994 has been included in the budgeted improvement costs described above. The total five-year costs will be partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage loan on North Hills Mall in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the Partnership will obtain a refinancing of the mortgage note which matures in July 1995. In February 1994, the Partnership sold its sole remaining outparcel piece of land to an unaffiliated third party (see Note 10). The Partnership will retain the net sale proceeds in its working capital reserve. The Partnership continues to explore the possibility of adding another major department store to the Pasadena Town Square. In order to add another department store at this center, the Partnership may need to commit a substantial amount of capital. Given the Partnership's current lack of substantial working capital, the Partnership may be unable to undertake the addition of a department store without an alternative source of capital. The Partnership has commenced discussions with a major department store owner concerning the opening of a store at the property. There is no assurance that the addition of a department store will ultimately occur. In 1993, the Partnership commenced a minor mall enhancement program which includes a food court remodel. The program is expected to cost approximately $500,000 with completion during 1994. In addition, commencing in 1994 and continuing for the next four years, the Partnership is undertaking a program to repair the property's roof and parking lot. The total cost of the repair work is expected to be approximately $1,700,000. The work scheduled to be incurred in 1994 has been included in the budgeted improvement costs described above. The total five-year project cost will be partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage loan on Pasadena Town Square in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the Partnership will obtain a refinancing of the mortgage note which matures in January 1995. In 1991, the Partnership commenced an action against the venture partner seeking a declaration that the Animas joint venture partner had forfeited its interest in the joint venture, dissolution of the joint venture, and continuation of the joint venture's business by the Partnership. In addition, the joint venture partner, in turn, filed in February, 1991 a counterclaim lawsuit against the Partnership and the affiliated property manager alleging breaches of the joint venture agreement and mismanagement of the property. In April 1992, the Partnership and the joint venture partner settled their respective legal claims. Under the terms of the settlement, the unaffiliated venture partner has contributed approximately $404,000 to the joint venture and relinquished its approval rights in connection with the business affairs of the joint venture. The unaffiliated venture partner has retained certain approval rights in connection with a sale or refinancing of the property. The Partnership, in return, has agreed to pay the unaffiliated venture partner a certain settlement amount in connection with any disposition of the property. Such disposition payment, $300,000 at January 1, 1994, decreases annually on January 1 to a maximum of $92,000 in 1996 and thereafter. Under certain limited disposition events, the disposition payment amount can be further reduced or eliminated. In April 1992, the Partnership finalized a modification of the existing long-term mortgage note secured by the Animas Valley Mall. The Partnership, commencing with the January 1991 payment, has been paying debt service in accordance with the modification terms. Reference is made to Note 4(b) for further discussion of this matter. The Partnership commenced negotiations for refinancing the mortgage note upon its maturity in January 1994. Subsequent to the end of the year, the Partnership entered into a non-binding letter of intent to amend the loan agreement which would extend the loan maturity until March 1995 and lower the pay rate to 8% per annum. However, there are no assurances that such loan amendment will be finalized. In view of the competitive market conditions described above, and depending upon the outcome of the Partnership's negotiations with the lender, the Partnership may decide not to commit any significant additional amounts of capital to this property due to the fact that recovery of such amounts may be unlikely. As a result, the Partnership would no longer have an ownership interest in the property. In such event, the Partnership would recognize a gain for financial reporting and federal income tax reporting purposes without realizing any net proceeds. Also, the Partnership would be required to make a disposition payment as discussed above. In addition, due to the uncertainty of the Partnership's ability to recover the net carrying value of the Animas Valley Mall investment property the Partnership made, as of December 31, 1991 and as a matter of prudent accounting practice, a provision for value impairment of $6,344,908. As discussed in Note 3(b), such provision reduces the net carrying value of the investment property to the then outstanding balance of the related non-recourse financing. In December 1993, the Partnership sold an outparcel of land at the property (with a carrying cost of approximately $38,000) to an unaffiliated third party as described in Note 3(b). The Partnership will retain the net sale proceeds of approximately $188,000 as working capital. As anticipated, during the fourth quarter 1993, New York Telephone Company's lease (90,000 square feet) expired and it, along with certain of its subtenants, vacated the Royal Executive Park I building. MCI Realty Inc. (180,000 square feet), which had been subleasing a portion of the New York Telephone space, entered into a direct lease with the joint venture for 30,000 square feet. The lease term is coterminous with the remainder of its space and provides for an effective rental rate at market, which is substantially less that the rental rate paid previously by New York Telephone. The joint venture continues to actively market the remaining New York Telephone Company space to prospective tenants. As previously reported, MCI had approached the joint venture seeking a current rent reduction in return for a lease extension beyond its current lease expiration date of March 31, 1998 on its existing 180,000 square foot lease. The joint venture and MCI continue to negotiate the terms of a possible modification and extension. However, there can be no assurance that a modification or extension will be executed on economic terms acceptable to the venture. The Southern Westchester County office market (the competitive market for the building) is extremely competitive with a current vacancy rate of 19%. While office building development in this market is virtually at a standstill, significant improvement in the competitive market conditions is not expected for several years. These competitive market conditions have resulted in lower than originally anticipated effective rental rates that can be achieved and high releasing costs that will be incurred in conjunction with releasing space which expires. Consequently, the property cash flow will be significantly reduced as a result of the lease expiration and subsequent move-out of New York Telephone. In addition, the property cash flow will be adversely affected by the increased vacancy. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital including the reduction in regular quarterly distributions to partners as described above. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. RESULTS OF OPERATIONS The aggregate reduction in cash and cash equivalents and short-term investments, and related increase in buildings and improvements at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership's use of a portion of its funds on hand for capital improvement projects at certain of the Partnership's investment properties as discussed above. The decrease in rents and other receivables as of December 31, 1993 as compared to December 31, 1992 is primarily due to the 1993 collection of recoverable expenses related to 1992 at certain of the Partnership's investment properties. The increase in investments in unconsolidated ventures at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership's share of the operating income in 1993 of the 40 Broad Street Building versus its share of the operating loss in 1992. The operating loss was primarily due to the decision to establish a provision for value impairment at December 31, 1992. Reference is made to Note 3(d). The increase in accrued rents receivable at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership accruing prorated rental income at the Collin Creek Mall and the North Hills Mall. The increase in current portion of long-term debt and the corresponding decrease in long-term debt less current portion at December 31, 1993 as compared to December 31, 1992 is primarily due to the reclassification of the $27,000,000 mortgage note scheduled to mature January 1994 at the Animas Valley Mall investment property. However, the Partnership has a non-binding letter of intent to extend the mortgage note as discussed above and in Note 4(b). The increase in accrued interest at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership paying debt service commencing January 1991 at 10.25% per annum but accruing at 12.5% at the Animas Valley Mall investment property. See Note 4(b). The increase in rental income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily the result of increased occupancy at the Collin Creek Mall and the North Hills Mall. The decrease in rental income for 1992 as compared to 1991 is primarily the result of the Pylon Plaza Phase II office building being placed in receivership in August 1991 and the lender subsequently realizing upon their mortgage security in December 1991. Reference is made to Note 2(b). Interest income decreased in 1993 as compared to 1992 and 1992 as compared to 1991 primarily due to lower yields and a lower average balance held in interest-bearing U.S. Government obligations in the subsequent years. The increase in depreciation in 1993 as compared to 1992 is primarily due to the capital additions at the Collin Creek Mall. The decrease in depreciation in 1992 as compared to 1991 is primarily due to the lender realizing upon its security in the Pylon Plaza Phase II office building in early December 1991. Property operating expenses increased in 1993 as compared to 1992 and 1991 primarily due to higher repairs and maintenance expenses at certain of the Partnership's investment properties. The increase in Partnership's share of operations of unconsolidated ventures for 1993 as compared to 1992 and 1991 is primarily the result of the election to establish a provisions of $22,908,606 and $28,870,198 at December 31, 1992 and 1991 for value impairment in connection with the 40 Broad Street Building as discussed above. See Note 3(d). The increase in venture partner's share of consolidated venture's operations for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is the result of the failure of the venture partner, for the Animas Valley Mall joint venture, to fund its share of operating deficits incurred at the property. As a result of the settlement agreement (see Note 3(b)), additional losses have been allocated to the Partnership. The increase in venture partner's share of consolidated venture's operations during 1992 as compared to 1991 is primarily the result of the Partnership providing a provision for value impairment at December 31, 1991. The gain of $150,443 on disposition of investment property during 1993 is the result of the outparcel sale at the Animas Valley Mall as more fully described in Note 3(b). The gain of $73,311 on disposition of investment property during 1991 is the result of the lender realizing upon its security interest and taking title to Phase II of the Pylon Plaza investment property in December 1991 as more fully described in Note 2(b). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on operating results if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investments contain provisions which entitle the Partnership to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficit), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. JMB INCOME PROPERTIES, LTD. - X UNCONSOLIDATED VENTURES INDEX Independent Auditors' Report Combined Balance Sheets, December 31, 1993 and 1992 Combined Statements of Operations, years ended December 31, 1993, 1992 and 1991 Combined Statements of Partners' Capital Accounts, years ended December 31, 1993, 1992 and 1991 Combined Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Combined Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners JMB INCOME PROPERTIES, LTD. - X: We have audited the consolidated financial statements of JMB Income Properties, Ltd. - X (a limited partnership) and consolidated venture as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of JMB Income Properties, Ltd. - X and consolidated venture as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its venture, Animas Valley Mall Associates ("Animas") (note 3(b)). The effect of all transactions between the Partnership and its venture has been eliminated in the consolidated financial statements. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's venture interests in Royal Executive Park - I (Royal Executive Park) (note 3(c)) and JMB-40 Broad Street Associates ("Broad Street") (note 3(d)). Accordingly, the accompanying consolidated financial statements do not include the accounts of Royal Executive Park or of Broad Street. The Partnership records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the venture as described above. Such adjustments are not recorded on the records of the Partnership. The net effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net loss per limited partnership interest is based upon the number of limited partnership interests outstanding at the end of each period (150,005). Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. The Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Partnership's policy is to consider any such amounts held with original maturities of three months or less as cash equivalents. At December 31, 1993 and 1992 all the U.S. Government obligations were classified as short-term investments. Deferred loan fees are amortized over the term of the respective loan agreement. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues prorated rental income for the full period of occupancy on a straight-line basis. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the Partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership had acquired, either directly or through joint venture arrangements (note 3), interests in three office buildings and five shopping centers. Two properties have been sold or disposed of by the Partnership. All of the remaining properties owned at December 31, 1993 were operating. The cost of the investment properties represents the total cost to the Partnership or its consolidated venture plus miscellaneous acquisition costs. Depreciation on the consolidated investment properties has been provided over the estimated useful lives of the various components as follows: YEARS ----- Improvements--straight line. . . 30 Personal property--straight line 5 == JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The investment properties are pledged as security for the long-term debt, for which there is no recourse to the Partnership, as described in note 4. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. (b) Pylon Plaza During October 1983, the Partnership acquired two adjacent existing two-story office buildings (Phase I and Phase II) known as Pylon Plaza in Boca Raton, Florida. The purchase price for the office buildings was $5,750,000, of which $2,897,036 was paid in cash at closing with the balance represented by two existing non-recourse mortgage loans in the aggregate principal amount of $2,852,964. The lender on Phase I property realized upon its security and took title to the Phase I property in August, 1990. In early 1991, the Partnership commenced negotiations with the lender to modify the existing long-term mortgage note secured by Phase II of the Pylon Plaza Office Building. The property had been operating at a cash deficit and based upon analysis of current and anticipated future market conditions and the probability of large future cash deficits, the Partnership had decided not to fund any future deficits relating to the property. In connection with the modification discussion, monthly principal and interest payments for this mortgage note were not made for the period April 1991 through December 1991. Consequently, the lender commenced proceedings to realize upon its security, and under a court order, a receiver was appointed to manage the operations of the property effective August 8, 1991. The lender realized upon its security, and obtained title to the Phase II building in early December 1991. The Partnership no longer has any ownership interest in the property. The Partnership received no cash proceeds from the transfer of ownership interest; it however, recognized a gain on disposition of $71,311 for financial reporting purposes and a nominal loss on disposition of $85,580 for Federal income tax purposes in 1991. (c) Collin Creek Mall During October 1983, the Partnership acquired a two-level existing enclosed mall regional shopping center in Plano (Dallas), Texas. The Partnership's purchase price for the mall was $49,000,000, which was paid in cash at closing. In addition, the Partnership initially reserved an additional $1,754,000 for capital improvements, tenant improvements, lease-up expenses, financing fees and other expenditures. Also, in 1985, the Partnership obtained a permanent loan in the amount of $25,000,000 (note 4), secured by the property. In 1992 and 1993 the Partnership completed the renovation of the food court and main floor common area, added escalators at two locations and upgraded the mall's interior and exterior signage. The total cost of these enhancement programs was approximately $4,400,000. In addition, in 1994 the Partnership will commence a parking lot repair project which will take five years to complete and cost approximately $1,300,000. Such amount will be partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage note in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the Partnership will obtain a refinancing of the mortgage note which matures in July 1995. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (d) North Hills Mall During October 1983, the Partnership acquired an existing enclosed mall regional shopping center in North Richland Hills (Fort Worth), Texas. The Partnership's purchase price for the mall was $13,000,000 which was paid in cash at closing. In addition, the Partnership initially reserved an additional $465,000 for capital improvements, tenant improvements, lease-up expenses, financing fees and other expenditures. In 1985, the Partnership obtained a permanent loan in the amount of $8,000,000 (note 4), secured by the property. The Partnership's aggregate cash investment, including additional capital improvements and other expenditures, is approximately $14,690,000. Additionally, an affiliate of the General Partners of the Partnership obtained for the Partnership's benefit a right of first refusal from the seller to acquire two additional parcels of land (approximately 10-acres) adjacent to the shopping center. The Partnership continues to explore the replacement of a major tenant, which owns its own store, with another major tenant and/or adding another major tenant to the center. The major tenant, which is currently using only the first level of its two-story store, has expressed an interest in closing its store. In order to replace the major tenant with another and/or add another major tenant, the Partnership may need to commit substantial capital. Given the Partnership's current lack of substantial working capital, the Partnership may be unable to undertake the replacement or addition of the major tenant(s) without an outside source of capital. The Partnership is exploring its alternatives in this regard. The Partnership believes the replacement of the major tenant and/or addition of another major department store to this center would greatly enhance the position of this center within the North Richland Hills retail market. However, there can be no assurance that such replacement and/or addition will ultimately occur. The Partnership has completed a mall enhancement program which included the replacement of the floor in a portion of the mall, a food court remodel, and certain lighting improvements. The program cost approximately $1,000,000. In addition, the Partnership is in the second year of a five year program to repair the property's roof and parking lot. The total cost of the repair is expected to be approximately $1,500,000. Such amounts are partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage loan on the property in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the partnership will obtain a refinancing of the mortgage note which matures in July 1995. In February 1994, the Partnership sold its sole remaining outparcel piece of land to an unaffiliated third party. The Partnership will retain the net sale proceeds in its working capital reserve. (e) Pasadena Town Square Mall During October 1983, the Partnership acquired an existing enclosed mall regional shopping center in Pasadena (Houston), Texas. The Partnership's purchase price for the mall was $30,200,000 which was paid in cash at closing. In addition, the Partnership initially reserved an additional $1,081,000 for capital improvements, tenant improvements, lease-up expenses, financing fees and other expenditures. In 1985, the Partnership obtained a permanent loan in the amount of $15,150,000 (note 4), secured by the property. The Partnership's aggregate cash investment, including additional capital improvements and other expenditures, is approximately $16,131,000. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership continues to explore the possibility of adding another major department store to the Pasadena Town Square. In order to add another department store at this center, the Partnership may need to commit a substantial amount of capital. Given the Partnership's current lack of substantial working capital, the Partnership may be unable to undertake the addition of a department store without an alternative source of capital. The Partnership has commenced discussions with a major department store owner concerning the opening of a store at the property. There is no assurance that the addition of a department store will ultimately occur. In 1993, the Partnership commenced a minor mall enhancement program which includes a food court remodel. The program is expected to cost approximately $500,000 with completion during 1994. In addition, commencing in 1994 and continuing for the next four years, the Partnership is undertaking a program to repair the property's roof and parking lot. The total cost of the repair work is expected to be approximately $1,700,000. Such amount will be partially recoverable from tenants pursuant to provisions in their leases. The Partnership is currently seeking a refinancing of the mortgage loan on the property in order to obtain a lower interest rate and to provide additional funds to the Partnership. However, there is no assurance that the Partnership will obtain a refinancing of the mortgage note which matures in January 1995. (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to three operating joint venture agreements. Pursuant to such agreements, the Partnership made initial capital contributions of approximately $62,760,000 (before legal and other acquisition costs and its share of operating deficits as discussed below). Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, one shopping mall and two office buildings. The venture properties have been financed under various long-term debt arrangements as described in note 4. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill its financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. (b) Animas Valley Mall In October 1983, the Partnership acquired through a joint venture with the developer, an interest in a newly constructed enclosed mall regional shopping center in Farmington, New Mexico, known as the Animas Valley Mall. The Partnership contributed $9,000,000 in cash to the venture. Operating profits and losses are allocated to the Partnership and the joint venture partner according to their respective contributions to fund operating deficits with any remaining losses allocated to the Partnership. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership commenced an action against the venture partner seeking a declaration that the joint venture partner had forfeited its interest in the joint venture, dissolution of the joint venture, and continuation of the joint venture's business by the Partnership. In addition, the joint venture partner, in turn, filed in February, 1991 a counterclaim lawsuit against the Partnership and the affiliated property manager alleging breaches of the joint venture agreement and mismanagement of the property. In April 1992, the Partnership and the joint venture partner settled their respective legal claims. Under the terms of the settlement, the unaffiliated venture partner has contributed approximately $404,000 to the joint venture and relinquished its approval rights in connection with the business affairs of the joint venture. The unaffiliated venture partner has retained certain approval rights in connection with a sale or refinancing of the property. The Partnership, in return, has agreed to pay the unaffiliated venture partner a certain settlement amount in connection with the disposition of the property. Such disposition payment, $300,000 at January 1, 1994, decreases annually on January 1 to a maximum of $92,000 in 1996 and thereafter. Under certain limited disposition events, the disposition payment amount can be further reduced or eliminated. In April 1992, the Partnership had finalized a modification of the existing long-term mortgage note secured by the Animas Valley Mall. Under the terms of the modification, the joint venture, commencing with the January 1991 payment, was obligated to pay debt service of interest only installments at a rate of 10.25% per annum, through the original term of the note, with the deferred interest (2.25%) accruing at 12.5% and payable monthly to the extent of any excess cash flow (as defined) or upon the earlier of the sale of the property or maturity of the note in January 1994. The joint venture has paid debt service in 1991, 1992, 1993 and through February 1994 in accordance with these modified terms. In addition, under the terms of the modification, the joint venture was required to make monthly real estate tax escrow deposits. The Partnership continues to negotiate with the existing lender for a loan extension upon its maturity in January 1994. Subsequent to the end of the year, the Partnership entered into a non-binding letter of intent to amend the loan agreement which would extend the loan maturity until March 1995 and lower the pay rate to 8% per annum. There are no assurances that such loan amendment will be finalized. The Partnership has begun to remit debt service under the modified terms. However, there is no assurance that such loan amendment will be finalized. In view of the competitive market conditions described above, and depending upon the outcome of the Partnership's negotiations with the lender, the Partnership may decide not to commit any significant additional amounts of capital to this property due to the fact that recovery of such amounts may be unlikely. As a result, the Partnership would no longer have an ownership interest in the property. In such event, the Partnership would recognize a gain for financial reporting and federal income tax reporting purposes without realizing any net proceeds. Also, the Partnership would be required to make a disposition payment as discussed above. In December 1993, the Partnership sold an outparcel piece of land to an unaffiliated third party. The purchaser intends to build a bank on the site. The sale price for the outparcel was approximately $194,000 (before selling costs and prorations). The Partnership will retain the net sale proceeds in its working capital reserve. Due to the uncertainty of the Partnership's ability to recover the net carrying value of the Animas Valley Mall investment property, the Partnership made a provision at December 31, 1991 for value impairment of $6,344,908. Such provision reduced the net carrying value of the investment property to the then outstanding balance of the related non-recourse mortgage note. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The property is presently being managed under an agreement between the Partnership and an affiliate of the General Partners of the Partnership which provides for management fees calculated at 3% of fixed and percentage rent from the shopping center. (c) Royal Executive Park In December 1983, the Partnership acquired through a joint venture with the developer, an interest in a completed three-building office complex in Ryebrook, New York known as Royal Executive Park. The Partnership contributed the sum of $25,948,000 to the joint venture which was used to repay an interim construction loan secured by the property. The developer was obligated to contribute to the joint venture amounts required to complete construction including tenant improvements. The acquisition of the venture interest resulted in an excess of the Partnership's basis in the property over its proportionate share of the venture's assets of approximately $10,000,000. Such excess is being amortized over the remaining useful life of the Venture's property through an adjustment of the Partner- ship's share of the Venture's operations. Such amortization aggregated approximately $189,000, for 1993, 1992 and 1991, respectively. Annual cash flow is distributed 49.9% to the Partnership and 50.1% to the joint venture partner. However, since the joint venture partner did not receive $2,605,200 of cash flow for each of the initial five years, the joint venture partner will be entitled to receive such deficiency, up to $400,000 from annual cash flow, if any, available for distribution to the partners after the Partnership and the joint venture partners have received $2,594,800 and $2,605,200, respectively, per annum. Operating profits and losses are generally allocated to the joint venture partners in the same ratio that annual cash flow is distributed to the partners. The joint venture agreement further provides that proceeds from sale or refinancing of the complex will be distributed 49.9% to the Partnership and 50.1% to the joint venture partner. The complex is managed by an affiliate of the venture partner on a year-to-year basis for a management fee of 2% of collected revenues. Occupancy of this office building decreased to 78% from 97% in the previous year. As anticipated, during the fourth quarter New York Telephone Company's lease (90,000 square feet) expired and it, along with certain of its subtenants, vacated the building. MCI Realty Inc. (180,000 square feet), which had been subleasing a portion of the New York Telephone space, entered into a direct lease with the joint venture for 30,000 square feet. The lease term is coterminous with the remainder of its space and provides for an effective rental rate at market, which is substantially less that the rental rate paid previously by New York Telephone. The joint venture continues to actively market the remaining New York Telephone Company space to prospective tenants. As previously reported, MCI had approached the joint venture seeking a current rent reduction in return for a lease extension beyond its current lease expiration date of March 31, 1998 on its existing 180,000 square feet lease. The joint venture and MCI continue to negotiate the terms of a possible modification and extension. However, there can be no assurance that a modification or extension will be executed on economic terms acceptable to the venture. The Southern Westchester County office market (the competitive market for the building) is extremely competitive with a current vacancy rate of 19%. While office building development in this market is virtually at a standstill, significant improvement in the competitive market conditions is not expected for several years. The competitive market conditions have resulted in lower than originally anticipated effective rental rates that can be achieved and high releasing costs that will be incurred in conjunction with JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED releasing space which expires. Consequently, the property cash flow will be significantly reduced as a result of the lease expiration and subsequent move- out of New York Telephone. In addition, the property cash flow will be adversely affected by the increased vacancy. (d) Broad Street During December 1985, the Partnership acquired, through a joint venture partnership (the "Affiliated Joint Venture") with JMB Income Properties, Ltd.- XII (a partnership sponsored by the Managing General Partner of the Partnership) a 31.44% interest in an existing 24-story office building located at 40 Broad Street in New York, New York. The Affiliated Joint Venture's purchase price for the building was $65,100,000 (net of prorations and miscellaneous closing costs), of which the Partnership provided approximately $20,470,000, which was paid in cash at closing. Broad Street estimated at acquisition that it would pay up to approximately $1,050,000 from time to time for tenant improvements and other expenditures for the office building, the total of which was funded as of December 31, 1991. The Partnership will be allocated or distributed profits and losses, cash flow from operations and sale or refinancing proceeds in the ratio of its capital contributions to the Affiliated Joint Venture which is 31.44%. During 1991, Broad Street joint venture funded $1,797,828, of which the Partnership's share was $565,237, for an assessed transfer tax related to the original acquisition of the investment property and has been reflected in the investment in unconsolidated ventures in the accompanying consolidated financial statements. The downtown New York City market remains extremely competitive due to the significant amount of space available primarily resulting from the layoffs, cutbacks and consolidations by financial service companies and related businesses which dominated this market. Rental rates in the downtown market are currently at depressed levels and this can be expected to continue for the foreseeable future while the current vacant space is gradually absorbed. Little, if any, new construction is planned for downtown over the next few years and it is expected that the building will continue to be adversely affected by the lower than originally projected effective rental rates now achieved upon releasing of existing leases which expire over the next few years. Therefore, the JMB/Broad Street joint venture recorded a provision for value impairment at December 31, 1991 to reduce the net book value of 40 Broad Street to $30,000,000 due to the uncertainty of JMB/Broad Street joint venture's ability to recover the net carrying value of the investment property through future operations or sale. An additional provision for value impairment was recorded at December 31, 1992 to further reduce the net book value of the property to the then estimated valuation of $7,800,000. An affiliate of the General Partner currently manages the property for a fee calculated as 2% of the gross receipts of the property. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Five year maturities of long-term debt are summarized as follows: 1994. . . . . . . .$ 27,294,320 1995. . . . . . . . 46,800,991 1996. . . . . . . . -- 1997. . . . . . . . -- 1998. . . . . . . . -- ============= (b) Debt Modification In April 1992, the Partnership had finalized a modification of the existing long-term mortgage note secured by the Animas Valley Mall. Under the terms of the modification, the joint venture, commencing with the January 1991 payment, was obligated to pay debt service of interest only installments at a rate of 10.25% per annum, through the original term of the note, with the deferred interest (2.25%) accruing at 12.5% and payable monthly to the extent of any excess cash flow (as defined) or upon the earlier of the sale of the property or maturity of the note in January 1994. The joint venture has paid debt service in 1991, 1992, 1993 and through February 1994 in accordance with these modified terms. In addition, under the terms of the modification, the joint venture was required to make monthly real estate tax escrow deposits. The Partnership commenced negotiations with the existing lender for a loan extension upon its original maturity in January 1994. Subsequent to the end of the year, the Partnership entered into a non-binding letter of intent to amend the loan agreement which would extend the loan maturity until March 1995 and lower the pay rate to 8% per annum. However, there are no assurances that such loan amendment will be finalized. The Partnership has remitted debt service under the modified terms. However, there is no assurance that the Partnership will obtain a loan extension and modification of the mortgage note, see note 3(b). (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits or losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale or refinancing of investment properties are to be allocated to the General Partners to the greater of 1% of such profits or the amount of cash distributable to the General Partners from any such sale or refinancing (as described below). Losses from the sale or refinancing of investment properties are to be allocated 1% to the General Partners. The remaining sale or refinancing profits and losses will be allocated to the Limited Partners. An amendment to the Partnership Agreement, effective January 1, 1991, generally provides that notwithstanding any allocation contained in the Agreement, if at any time profits are realized by the Partnership, any current or anticipated event would cause the deficit balance in absolute amount in the Capital Account of the General Partners to be greater than their share of the Partnership's indebtedness (as defined) after such event, then the allocation of Profits to the General Partners shall be increased to the extent necessary to cause the deficit balance in the Capital Account of the General Partners to be no less than their respective shares of the Partnership's indebtedness after such event. In general, the effect of this amendment is to allow the deferral of the recognition of taxable gain to the Limited Partners. The General Partners are not required to make any capital contributions except under certain limited circumstances upon termination of the Partnership. Distributions of "cash flows" of the Partnership are allocated 90% to the Limited Partners and 10% to the General Partners. However, portions of such distributions to the General Partners are subordinated to the JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Limited Partners' receipt of a stipulated return on capital. Through December 31, 1993, a portion of the General Partners' distributions have been deferred (note 8). The Partnership Agreement provides that the General Partners shall receive as a distribution from the sale of a real property by the Partnership 3% of the selling price and any cumulative deferrals of their 10% distribution of disburseable cash, subject to certain limitations. Any remaining proceeds (net after expenses and retained working capital) will be distributed 85% to the Limited Partners and 15% to the General Partners. However, the Limited Partners shall receive 100% of such net sale proceeds until the Limited Partners (i) have received cash distributions of sale or refinancing proceeds in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership, and (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with sale or refinancing proceeds previously distributed, equal a 10% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by sale or refinancing proceeds previously distributed) commencing with the first fiscal quarter of 1984. Therefore, the General Partners have deferred certain sale proceeds ($241,080 or $1.60 per interest) from the Partnership. (6) MANAGEMENT AGREEMENTS - OTHER THAN VENTURES An affiliate of the General Partners managed the Pylon Plaza-Phase II office building for a fee equal to 5% of the gross rent of the building. This agreement was terminated in 1991 due to the lender realizing upon its security (note 2(b)). The North Hills Mall, Pasadena Town Square and Collin Creek Mall shopping centers are managed by an affiliate of the General Partners pursuant to management agreements which provide for leasing commissions and an annual fee based upon a percentage of rental income of the property, the aggregate of such commission and fee not to exceed 6% of the gross receipts of the property. (7) LEASES As Property Lessor At December 31, 1993, the Partnership and its consolidated venture's principal assets are four shopping centers. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the properties, excluding the cost of the land, is depreciated over the estimated useful lives. Leases with tenants range in term from one to thirty years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Minimum lease payments, including amounts representing executory costs (e.g. taxes, maintenance, insurance) and any related profit, to be received in the future under the operating leases are as follows: 1994. . . . . . . . . $ 14,723,228 1995. . . . . . . . . 13,912,354 1996. . . . . . . . . 12,620,460 1997. . . . . . . . . 11,459,214 1998. . . . . . . . . 10,139,341 Thereafter. . . . . . 43,111,250 ------------ Total. . . . . . $105,965,847 ============ Contingent rent (based on sales by property tenants) included in consolidated rental income was as follows for the years ended December 31, 1993, 1992 and 1991: 1991. . . . . . . . . $811,481 1992. . . . . . . . . 852,600 1993. . . . . . . . . 861,927 ========= (8) TRANSACTIONS WITH AFFILIATES Fees, commissions and other expenses required to be paid by the Partner- ship to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992, and 1991 are as follows: JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED The General Partners have deferred (in accordance with the Partnership agreement, see note 5) payment of certain of their distributions of net cash flow from the Partnership. The cumulative amount of such distributions aggregated $9,353,038 at December 31, 1993 (approximately $62 per interest). These amounts, together with the unpaid fees and expenses set forth in the chart above, do not bear interest and are expected to be paid in future periods in accordance with the Partnership agreement. (9) INVESTMENTS IN UNCONSOLIDATED VENTURES Summary financial information for Royal Executive Park and Broad Street (notes 3(c) and 3(d), respectively) as of and for the years ended December 31, 1993 and 1992 are as follows: 1993 1992 ------------ ------------ Current assets . . . . . . . . . . . $ 4,549,126 2,616,963 Current liabilities. . . . . . . . . (262,234) (377,884) ------------ ------------ Working capital . . . . . . . . 4,286,892 2,239,079 ------------ ------------ Investment property, net . . . . . . 28,448,677 28,154,702 Other assets, net. . . . . . . . . . 1,959,574 2,167,211 Other liabilities, net . . . . . . . (42,397) (42,397) Venture partners' equity . . . . . . (11,989,784) (10,319,764) ------------ ------------ Partners' capital . . . . . . . $ 22,662,962 22,198,831 ============ ============ Represented by: Invested capital. . . . . . . . $ 49,723,531 49,723,531 Cumulative cash distributions . (35,282,503) (33,340,812) Cumulative net earnings . . . . 8,221,934 5,816,112 ------------ ------------ $ 22,662,962 22,198,831 ============ ============ Total income . . . . . . . . . . . . $ 16,077,877 16,577,816 ============ ============ Expenses applicable to operations. . $ 10,052,562 10,481,968 ============ ============ Net earnings (loss). . . . . . . . . $ 6,025,315 (16,812,758) ============ ============ Also, for the year ended December 31, 1991, total income, expenses applicable to operations and net earnings were $17,182,290, $11,543,880 and ($23,779,437), respectively for the unconsolidated ventures listed above. (10) SUBSEQUENT EVENT - DISTRIBUTIONS In February 1994, the Partnership paid a distribution of $600,020 ($4.00 per Interest) to the Limited Partners. In February 1994, the Partnership sold its sole remaining outparcel piece of land at the North Hills Mall to an unaffiliated third party. The purchaser intends to build a restaurant on the site. The sale price for the outparcel was $700,000 (before selling costs and prorations). The Partnership will retain the net sale proceeds in its working capital reserve. The Partnership expects to record a gain for financial reporting and federal income tax purposes in 1994. SCHEDULE X JMB INCOME PROPERTIES, LTD. - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. $2,259,131 2,158,209 2,068,083 Depreciation . . . . . . 4,361,608 4,192,447 4,420,886 Taxes: Real estate. . . . . 2,707,616 2,729,116 2,361,147 Other. . . . . . . . 532 2,939 659 Advertising. . . . . . . 1,461,701 1,606,961 1,600,638 ========== ========= ========= INDEPENDENT AUDITORS' REPORT The Partners JMB INCOME PROPERTIES, LTD.-X: We have audited the combined financial statements of the Unconsolidated Ventures of JMB Income Properties, Ltd. - X (note 1) as listed in the accompanying index. In connection with our audits of the combined financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These combined financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these combined financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the combined financial position of the Unconsolidated Ventures of JMB Income Properties, Ltd. - X as of December 31, 1993 and 1992, and the combined results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 JMB INCOME PROPERTIES, LTD. - X Unconsolidated Ventures NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying combined financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. They include the accounts of the unconsolidated ventures in which JMB Income Properties, Ltd. - X ("JMB Income-X") owns a direct interest. The entities ("Combined Ventures") included in the combined financial statements are as follows: DATE ACQUIRED -------- 1. Royal Executive Park - I (a) 12/16/83 2. JMB-40 Broad Street Associates (a) 12/31/85 (a) Represents the unconsolidated venture in which JMB Income-X owns a direct ownership interest. Statement of Financial Accounting Standards No. 95 requires the Combined Ventures to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classification specified in the pronouncement. Combined Ventures record amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Combined Ventures' policy is to consider any such amounts held with original maturities of three months or less as cash equivalents. At December 31, 1993 and 1992 all the U.S. Government obligations were classified as short-term investments. The records of Combined Ventures are maintained on the accrual basis of accounting as adjusted for federal income tax reporting purposes. The accompanying combined financial statements have been prepared from such records after making appropriate adjustments to present the Combined Ventures' accounts in accordance with generally accepted accounting principles. Such adjustments are not recorded on the records of the Combined Ventures. Deferred expenses are comprised of deferred leasing costs which are amortized using the straight-line method over the terms of the related leases. Depreciation on the investment properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Management fees and reimbursements for out-of-pocket expenses payable to an affiliate of JMB Income-X were approximately $149,000 at December 31, 1993, $163,000 in 1992 and $176,000 in 1991. JMB INCOME PROPERTIES, LTD. - X UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONCLUDED Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues rental income for the full period of occupancy on a straight-line basis. Certain amounts in the 1992 and 1991 combined financial statements have been reclassified to conform with the 1993 presentation. No provision for state or federal income taxes has been made as the liability for such taxes is that of the venture partners rather than the ventures. (2) VENTURE AGREEMENTS A description of the venture agreements is contained in Note 3 of Notes to Consolidated Financial Statements of JMB Income-X for the year ended December 31, 1993. Such note is incorporated herein by reference. (3) LEASES As Property Lessor At December 31, 1993, the properties in the combined group consisted of two office buildings. The ventures have determined that all leases relating to the properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to fifteen years and provide for fixed minimum rent and partial to full reimbursement of operating costs. Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit to be received in the future under the above operating leases are as follows: 1994. . . . . . . $10,126,907 1995. . . . . . . 10,389,745 1996. . . . . . . 9,889,245 1997. . . . . . . 9,242,082 1998. . . . . . . 5,279,163 Thereafter. . . . 17,526,920 ----------- $62,454,062 =========== SCHEDULE X JMB INCOME PROPERTIES, LTD. - X UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Depreciation . . . . . . $ 1,536,729 1,737,426 2,628,867 Repairs and maintenance. 1,699,779 1,701,643 1,510,532 Taxes Real Estate. . . . . . 3,599,140 3,917,127 3,947,162 Other. . . . . . . . . 16,185 16,490 10,045 =========== ========== ========== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of or disagreements with, auditors during fiscal year 1992 and 1993. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Managing General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware corporation. JMB has responsibility for all aspects of the Partnership's operations, subject to the requirement that sales of real property must be approved by the Associate General Partner of the Partnership, Income Associates-X, L.P., an Illinois limited partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. Various relationships of the Partnership to the Managing General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 12-16 of the Prospectus, which description is hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1989 on Form 10-K (File No. 33-4107) dated March 28, 1990. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows at December 31, 1993: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/17/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve one-year terms until the annual meeting of the Managing General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Managing General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"),JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-XI ("JMB Income-XI"), JMB Income Properties, Ltd.-XII ("JMB Income-XII"), and JMB Income Properties Ltd.-XIII ("JMB Income-XIII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II") and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners of certain partnerships which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-XI, JMB Income-XII, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Managing General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Master degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President and Director of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 44) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 42) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Partnership has no officers or directors. The General Partners of the Partnership are entitled to receive a share of cash distributions, when and as cash distributions are made to the Limited Partners, and a share of profits or losses as described under the caption "Compensation and Fees" at pages 8-12, "Cash Distributions" at pages 57-59, "Allocation of Profits or Losses for Tax Purposes" at page 59 and "Cash Distributions; Allocations of Profits and Losses" at pages A-7 to A-11 of the Partnership Agreement included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12432) for December 31, 1992 on Form 10-K (File No. 0-12432) dated March 19, 1993. Reference is also made to Notes 5 and 8 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991 cash distributions of $0, $0 and $250,000 were paid, respectively to the General Partners. Affiliates of the Managing General Partner provided property management services to the Partnership for the North Hills Mall in North Richland Hills, Texas, the Pasadena Town Square shopping center in Pasadena, Texas, the Collin Creek Mall in Plano, Texas, beginning in fiscal 1985 for the Animas Valley Mall in Farmington, New Mexico and beginning in fiscal 1986 through the date of disposition, December 9, 1991, for the Pylon Plaza Office Building-Phase I and II in Boca Raton, Florida. Fees are calculated at 3% of fixed and percentage rents from Animas Valley Mall, 5% of gross rents from Pylon Plaza, and 4% of fixed and percentage rents from North Hills Mall, Pasadena Town Square and Collin Creek Mall, respectively. In 1993, such affiliate earned property management and leasing fees amounting to $667,066, of which all was paid as of December 31, 1993. As set forth in the Prospectus of the Partnership, the Managing General Partner must negotiate such agreements on terms no less favorable to the Partnership than those customarily charged for similar services in the relevant geographical area (but in no event at rates greater than 6% of the gross receipts from a property), and such agreements must be terminable by either party thereto, without penalty, upon 60 days' notice. JMB Insurance Agency, Inc., an affiliate of the Managing General Partner, earned and received insurance brokerage commissions in 1993 aggregating $83,329 in connection with the provision of insurance coverage for certain of the real property investments of the Partnership. Such commissions are at rates set by insurance companies for the classes of coverage provided. The General Partners of the Partnership or their affiliates may be reimbursed for their direct expenses or out-of-pocket expenses and salaries relating to the administration of the partnership and operation of the Partnership's real property investments. In 1993, the Managing General Partner incurred such out-of-pocket expenses and salaries in the amount of $100,924 of which $100,051 was unpaid at December 31, 1993. The Partnership is permitted to engaged in various transactions involving affiliates of the Managing General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8-12, "Conflicts of Interest" at pages 12-16 and "Rights, Powers and Duties of General Partners" at pages A-17 to A-20 of the Partnership Agreement included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A and 3-B to the Partnership's Report for December 31, 1989 on Form 10-K (File No. 33-4107) dated March 28, 1990. The relationship of the Managing General Partner (and its directors and officers) to its affiliates is set forth above in Item 10 and Exhibit 21 hereto. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements and Supplementary Data (See Index to Financial Statements filed with this annual report) 2. Exhibits. 3-A.* The Prospectus of the Partnership dated June 29, 1983 as supplemented September 12, 1983 and October 21, 1983, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Copies of pages 8-12, 57-59 and A-7 to A-11 are hereby incorporated herein by reference. 3-B.* Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference. 4-A.* Document relating to the mortgage loan secured by the Collin Creek Mall in Plano, Texas is hereby incorporated herein by reference. 4-B.* Document relating to the mortgage loan secured by the Pasadena Town Square shopping center in Pasadena, Texas is hereby incorporated herein by reference. 4-C.* Modification document relating to the mortgage loan secured by the Animas Valley Mall in Farmington, New Mexico is hereby incorporated herein by reference. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the 40 Broad Street office building in New York, New York are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12432) dated December 31, 1985. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Royal Executive Park office complex in Ryebrook, New York are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12432) dated December 30, 1983. 10-C. Acquisition documents relating to the purchase by the Partnership of the Collin Creek Mall in Plano, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-D. Acquisition documents relating to the purchase by the Partnership of the North Hills Mall in North Richland Hills, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post- Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-E. Acquisition documents relating to the purchase by the Partnership of the Pasadena Town Square shopping center in Pasadena, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-F. Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the Animas Valley Mall in Farmington, New Mexico are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-G. Sale documents relating to the outparcel sale at the Animas Valley Mall in Farmington, New Mexico a copy of which is filed herewith. 21. List of Subsidiaries. 24. Powers of Attorney. ___________ * Previously filed as Exhibits 3-A, 3-B, 4-A, 4-B and 4-C, respectively, to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12432) dated March 19, 1993. Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No Reports on Form 8-K have been filed since the beginning of the last quarter of the period covered by this report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - X By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 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. By: JMB Realty Corporation JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE Page ------------ ---- 3-A. Pages 8-12, 57-59 and A-7 to A-11 of the Prospectus of the Partnership dated June 29, 1983, as supplemented September 12, 1983 and October 21, 1983 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan documents related to Collin Creek Mall Yes 4-B. Mortgage loan documents related to Pasadena Town Square shopping center Yes 4-C. Mortgage loan modification documents related to Animas Valley Mall Yes 10-A. Acquisition documents related to the 40 Broad Street office building Yes 10-B. Acquisition documents related to the Royal Executive Park office complex Yes 10-C. Acquisition documents related to the Collins Creek Mall Yes 10-D. Acquisition documents related to the North Hills Mall Yes 10-E. Acquisition documents related to the Pasadena Town Square shopping center Yes 10-F. Acquisition documents related to the Animas Valley Mall Yes 10-G. Sale documents related to the Animas Valley Mall No 21. List of Subsidiaries No 24. Powers of Attorney No ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements and Supplementary Data (See Index to Financial Statements filed with this annual report) 2. Exhibits. 3-A. The Prospectus of the Partnership dated June 29, 1983 as supplemented September 12, 1983 and October 21, 1983, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Copies of pages 8-12, 57-59 and A-7 to A-11 are hereby incorporated herein by reference. 3-B.* Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference. 4-A.* Document relating to the mortgage loan secured by the Collin Creek Mall in Plano, Texas is hereby incorporated herein by reference. 4-B.* Document relating to the mortgage loan secured by the Pasadena Town Square shopping center in Pasadena, Texas is hereby incorporated herein by reference. 4-C.* Modification document relating to the mortgage loan secured by the Animas Valley Mall in Farmington, New Mexico is hereby incorporated herein by reference. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the 40 Broad Street office building in New York, New York are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12432) dated December 31, 1985. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Royal Executive Park office complex in Ryebrook, New York are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12432) dated December 30, 1983. 10-C. Acquisition documents relating to the purchase by the Partnership of the Collin Creek Mall in Plano, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-D. Acquisition documents relating to the purchase by the Partnership of the North Hills Mall in North Richland Hills, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post- Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-E. Acquisition documents relating to the purchase by the Partnership of the Pasadena Town Square shopping center in Pasadena, Texas are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-F. Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the Animas Valley Mall in Farmington, New Mexico are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-83599) dated June 29, 1983. 10-G. Sale documents relating to the outparcel sale at the Animas Valley Mall in Farmington, New Mexico a copy of which is filed herewith. 21. List of Subsidiaries. 24. Powers of Attorney. ___________ * Previously filed as Exhibits 3-A, 3-B, 4-A, 4-B and 4-C, respectively, to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12432) dated March 19, 1993. Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No Reports on Form 8-K have been filed since the beginning of the last quarter of the period covered by this report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - X By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 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. By: JMB Realty Corporation JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE Page ------------ ---- 3-A. Pages 8-12, 57-59 and A-7 to A-11 of the Prospectus of the Partnership dated June 29, 1983, as supplemented September 12, 1983 and October 21, 1983 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan documents related to Collin Creek Mall Yes 4-B. Mortgage loan documents related to Pasadena Town Square shopping center Yes 4-C. Mortgage loan modification documents related to Animas Valley Mall Yes 10-A. Acquisition documents related to the 40 Broad Street office building Yes 10-B. Acquisition documents related to the Royal Executive Park office complex Yes 10-C. Acquisition documents related to the Collins Creek Mall Yes 10-D. Acquisition documents related to the North Hills Mall Yes 10-E. Acquisition documents related to the Pasadena Town Square shopping center Yes 10-F. Acquisition documents related to the Animas Valley Mall Yes 10-G. Sale documents related to the Animas Valley Mall No 21. List of Subsidiaries No 24. Powers of Attorney No	15,614	101,108
351936_1993.txt	351936_1993	1993	351936	ITEM 1. Business Xerox Credit Corporation, a Delaware corporation (together with its subsidiaries herein called "the Company" unless the context otherwise requires), was organized on June 23, 1980. All of the Company's outstanding capital stock is owned by Xerox Financial Services, Inc. (XFSI), a holding company, which is wholly-owned by Xerox Corporation (Xerox Corporation together with its subsidiaries are herein called "Xerox" unless the context otherwise requires). The Company is engaged in financing long-term accounts receivable arising out of equipment sales by Xerox to its Document Processing customers throughout the United States. Contract terms on these accounts receivable range primarily from two to five years. The Company discontinued its real-estate development and related real- estate financing businesses in the first quarter of 1990. In the fourth quarter of 1990, the Company discontinued its third-party financing and leasing businesses. See Note 2 to the Consolidated Financial Statements for further information regarding the Company's discontinued operations. Xerox is a global company serving the worldwide Document Processing markets. Xerox' Document Processing activities encompass developing, manufacturing, marketing, servicing and financing a complete range of document processing products and services designed to make offices around the world more productive. These products and systems are marketed in over 130 countries by a direct sales force and a network of agents, dealers and distributors. The financing of Xerox equipment is generally carried out by the Company in the United States and internationally by several foreign financing subsidiaries. In December 1993, Xerox announced a worldwide restructuring program aimed at improving its productivity and significantly lowering its cost base. The ongoing operations of the Company are unaffected by this decision. (2) ITEM 2. ITEM 2. Properties The Company does not directly own any facilities in order to carry on its principal business. Its principal executive offices in Stamford, Connecticut comprise approximately 25,000 square feet of office space. In addition, the Company leases approximately 1,200 square feet of office space at various domestic and international locations, the majority of which are used by the Company's discontinued operations. These facilities are deemed adequate by management. ITEM 3. ITEM 3. Legal Proceedings None. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders Not Required. PART II ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters This item is inapplicable to Registrant, which is a wholly-owned subsidiary of Xerox. ITEM 6. ITEM 6. Selected Financial Data Not Required. (3) ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Continuing Operations Contracts receivable income represents income earned under an agreement with Xerox by which the Company purchases long-term accounts receivable associated with Xerox' sold equipment. These receivables arose from Xerox equipment being sold under installment sales and sales-type leases. In 1993, the Company purchased receivables from Xerox totaling $1,848 million compared to $1,964 million in 1992. Earned income from contracts receivable decreased in 1993 to $376 million from $389 million in 1992. The decreases in earned income is the result of lower purchases of contracts receivable in 1993 compared to 1992 due to weak United States sales early in 1993 because of reorganization of the Xerox United States Customer Operations sales force, as well as lower interest income earned on Xerox contracts receivable resulting from declining interest rates. Earned income from contracts receivable increased in 1992 to $389 million from $380 million in 1991. The increase reflected the growth of Xerox equipment sales financed through the Company in 1992 compared to 1991. In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase, which is intended to protect against future losses. Should any additional allowances be required, Xerox is required to provide such funding. The resultant effect is to relieve the Company of any exposure with regard to write-offs associated with the contracts receivable purchased from Xerox. Interest expense was $209 million in 1993 compared to $212 million in 1992, a decrease of $3 million. The 1993 decrease resulted from lower interest rates partially offset with increased borrowings required to fund the Companys additional investment in contracts receivable. The $212 million of interest expense in 1992 was an increase of $12 million from the 1991 interest expense of $200 million. The 1992 increase in interest expense reflected increased borrowings required to fund the additional investment in contracts receivable. The Company intends to continue to match its contracts receivable and indebtedness to maintain the relationship between interest income and interest expense. Operating and administrative expenses were $13 million for 1993, a decrease of $6 million from 1992. The decrease was due primarily to operating efficiencies associated with the administration of contracts receivable purchased from Xerox. Operating and administrative expenses increased to $19 million in 1992 compared to $16 million in 1991. This increase was due primarily to additional administrative costs associated with the increase in the volume of Xerox contracts receivable financed in 1992 compared to 1991. The effective income tax rate for 1993 was 40.9 percent as compared with 39.9 percent and 40.2 percent for 1992 and 1991, respectively. The increase in the effective tax rates in 1993 compared to 1992 and 1991 is due primarily to the 1993 increase in the corporate federal income tax rates from 34 percent to 35 percent retroactive to January 1, 1993. (4) Discontinued Operations Since their discontinuance in 1990, the Company has made substantial progress in disengaging from the real-estate and third-party financing businesses. During the three years ended December 31, 1993, the Company received net cash proceeds of $2,089 million from the sale of discontinued business units and assets, from several asset securitizations and from run-off collection activities. The amounts received were consistent with the Company's estimates in the disposal plan and were primarily used to reduce the Company's short-term indebtedness. At December 31, 1993, the Company remains contingently liable for approximately $126 million under recourse provisions associated with the securitization transactions. Since a portion of the remaining assets ($120 million) represents passive lease receivables, many with long-duration contractual maturities and unique tax attributes, the Company expects that the wind-down of the portfolio will be significantly slower in 1994 and future years, compared with 1993 and prior years. The Company believes that the liquidation of the remaining assets will not result in a net loss. Additional information regarding discontinued operations is included in Note 2 to the Consolidated Financial Statements. (5) Capital Resources and Liquidity The Company's principal sources of funds are cash from the collection of Xerox contracts receivable and borrowings. At December 31, 1993 the Company and Xerox have joint access to three revolving credit agreements totaling $3 billion with various banks, which expire from 1994 to 1998. The interest on amounts borrowed under these facilities is at rates based, at the borrower's option, on spreads above certain reference rates such as LIBOR and Federal funds rates. Net cash used in operating activities was $48 million in 1993 compared with $23 million of cash used in 1992. The 1993 increase in cash used by operating activities is mainly attributable to the reduction in accounts payable and accrued liabilities due to timing of payments. Net cash used in operating activities was $23 million in 1992 compared with $161 million of cash provided by operating activities in 1991. The 1992 decrease in cash provided by operating activities is mainly attributable to the reduction in deferred income taxes payable which declined as a result of the Company's adoption of Statement of Financial Accounting Standards (SFAS) No. 109- "Accounting for Income Taxes" and sales of certain discontinued operation's assets. Net cash provided by investing activities was $21 million in 1993 compared to $58 million of cash used in investing activities in 1992. The increase in cash provided by investing activities was the result of higher net collections from the Company's investment in contracts receivable in 1993, which was partially offset by lower net collections from discontinued operations. Net cash provided by investing activities during 1992 decreased $815 million from $757 million of cash provided by investing activities during 1991. The decrease resulted from lower net collections from the sale and run off activity of discontinued assets. Net cash provided by financing activities was $26 million in 1993 compared to $79 million in 1992. The decrease in cash provided was the result of increased principal payments on the Company's long- term debt. Net cash provided by financing activities was $79 million during 1992, compared with $926 million of cash used in financing activities during 1991. The proceeds from the 1991 sales and asset securitizations of the third-party financing and leasing assets enabled the Company to reduce the short-term indebtedness of the Company more in 1991 than in 1992, and pay higher dividends in 1991 than in 1992. (6) The Company believes that cash provided by continuing operations, cash available under its commercial paper program supported by its credit facilities, and its readily available access to the capital markets are more than sufficient for its funding needs. During 1994, new borrowing associated with the financing of customer purchases of Xerox equipment will continue. The timing, principal amount and form of new short- and long-term financing will be determined based upon the Company's need for financing and prevailing debt market conditions. The Company intends to continue to match its contracts receivable and indebtedness to maintain the relationship between investment income and interest expense. To assist in managing its interest rate exposure, the Company has entered into a number of interest rate swap agreements. In general, the Company's objective is to hedge its variable-rate debt by paying fixed rates under the swap agreements while receiving variable-rate based payments in return. The Company has also entered into swap agreements that convert both fixed-and non-commercial paper based variable-rate interest payments into payments that are indexed to commercial paper rates. During 1993, the Company entered into third-party interest rate swap agreements, which effectively converted $750 million of variable-rate debt into fixed-rate debt. These agreements mature at various dates through 1997 and resulted in a weighted average fixed-rate of 4.52 percent at December 31,1993. The Company also entered into third-party interest rate swap agreements, during 1993 which effectively converted $425 million of variable-rate debt into variable-rate debt that is indexed to the commercial paper rates. These agreements mature at various dates through 1997. As of December 31, 1993 the Company's overall debt-to-equity ratio was 6.5 to 1. The Company declared aggregate dividends of $59 million, $85 million and $230 million during 1993, 1992 and 1991, respectively. The Company intends to maintain a debt-to-equity ratio of approximately 6.5 to 1 over time. Pursuant to a Support Agreement between the Company and Xerox, Xerox has also agreed to retain ownership of 100 percent of the voting capital stock of the Company and to make periodic payments to the extent necessary to ensure that the Company's annual pre-tax earnings available for fixed charges equal at least 1.25 times the Company's fixed charges. (7) ITEM 8. ITEM 8. Financial Statements and Supplementary Data The financial statements of the Company and its consolidated subsidiaries and the notes thereto, the financial statement schedules, and the report thereon of KPMG Peat Marwick, independent auditors, are set forth on pages 10 through 30 hereof. The other financial statements and schedules required herein are filed as "Financial Statement Schedules" pursuant to Item 14 of this report on Form 10-K. ITEM 9. ITEM 9. Disagreements on Accounting and Financial Disclosure Not Applicable. ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant Not Required. ITEM 11. ITEM 11. Executive Compensation Not Required. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Not Required. ITEM 13. ITEM 13. Certain Relationships and Related Transactions Not Required. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) and (2) The financial statements and the financial statement schedules and the report of independent auditors thereon filed herewith are listed or otherwise included in the attachment hereto. (3) The exhibits filed herewith are set forth on the Exhibit Index included herein. (b) A Current Report on Form 8-K dated December 8, 1993 reporting Item 5 "Other Events" was filed during the last quarter of the period covered by this Report. (8) SIGNATURE Pursuant to the requirements of Section 13 or 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. (REGISTRANT) XEROX CREDIT CORPORATION BY (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer (DATE) March 18, 1994 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 date indicated. (NAME AND TITLE) David Roe, President and Chief Executive Officer and Director (Principal Executive Officer) (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer (Principal Financial Officer) (NAME AND TITLE) Paul G. Ryan, Controller (Principal Accounting Officer) (NAME AND TITLE) Donald R. Altieri, Director (NAME AND TITLE) David R. McLellan, Director (NAME AND TITLE) Stuart B. Ross, Director By Power of Attorney (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer Attorney-in-Fact (DATE) March 18, 1994 (9) SIGNATURE Report of Independent Auditors The Board of Directors Xerox Credit Corporation: We have audited the consolidated financial statements of Xerox Credit Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Xerox Credit Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 1 and 6 to the consolidated financial statements, the Company changed its method of accounting for income taxes and its method of accounting for postretirement benefits other than pensions in 1992. KPMG PEAT MARWICK Stamford, Connecticut January 31, 1994 (10) XEROX CREDIT CORPORATION INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Financial Statements: Consolidated statements of income for each of the years in the three-year period ended December 31, 1993 Consolidated balance sheets at December 31, 1993 and 1992 Consolidated statements of shareholder's equity for each of the years in the three-year period ended December 31, 1993 Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993 Notes to consolidated financial statements Schedules: II Amounts receivable from related parties and underwriters, promoters and employees other than related parties VIII Valuation and qualifying accounts IX Short-term borrowings All other schedules are omitted as they are not applicable or the information required is included in the consolidated financial statements or notes thereto. (11) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Earned Income: Contracts receivable $ 376 $ 389 $ 380 Expenses: Interest 209 212 200 Operating and administrative 13 19 16 Total expenses 222 231 216 Income before income taxes 154 158 164 Provision for income taxes 63 63 66 Net income $ 91 $ 95 $ 98 See notes to consolidated financial statements. (12) XEROX CREDIT CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Millions) ASSETS 1993 1992 Cash and cash equivalents $ 1 $ 2 Investments: Contracts receivable 4,148 4,006 Notes receivable - Xerox and affiliates 58 57 Investments in Xerox affiliates, at equity 74 - Unearned income (437) (520) Allowance for losses (153) (139) Total investments 3,690 3,404 Net assets of discontinued operations 357 650 Other assets 2 3 Total assets $4,050 $4,059 LIABILITIES, DEFERRED INCOME TAXES AND SHAREHOLDER'S EQUITY Liabilities: Notes payable within one year: Commercial paper $1,653 $1,257 Xerox Corporation - 78 Current portion of notes payable after one year 554 709 Notes payable after one year 1,079 1,145 Notes payable after one year-Xerox and affiliates 75 - Due to Xerox Corporation, net 54 39 Accounts payable and accrued liabilities 74 105 Liabilities of business transferred 17 78 Total liabilities 3,506 3,411 Deferred income taxes 38 174 Shareholder's Equity: Common stock, no par value, 2,000 shares authorized, issued, and outstanding 23 23 Additional paid-in capital 145 145 Retained earnings 337 305 Cumulative translation adjustment 1 1 Total shareholder's equity 506 474 Total liabilities, deferred income taxes and shareholder's equity $4,050 $4,059 See notes to consolidated financial statements. (13) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additional Cumulative Common Paid-In Retained Translation Stock Capital Earnings Adjustment Total Balance at December 31, 1990 $ 23 $ 138 $ 427 $ 2 $ 590 Net Income 98 98 Dividends (230) (230) XFSI Capital Contribution 7 7 Translation adjustment (1) (1) Balance at December 31, 1991 23 145 295 1 464 Net Income 95 95 Dividends* (85) (85) Balance at December 31, 1992 23 145 305 1 474 Net Income 91 91 Dividends (59) (59) Balance at December 31, 1993 $ 23 $ 145 $ 337 $ 1 $ 506 * Includes a non-cash dividend of $25 million. See notes to consolidated financial statements. (14) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Cash Flows from Operating Activities Net income $ 91 $ 95 $ 98 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of discount on long-term debt - 2 32 (Decrease) increase in deferred income taxes (136) (149) 21 Other, net (3) 29 10 Net cash (used in) provided by operating activities (48) (23) 161 Cash Flows from Investing Activities Purchases of investments (1,848) (1,964) (1,784) Proceeds from investments 1,637 1,426 1,164 Net collections from discontinued operations 232 480 1,377 Net cash provided by (used in) investing activities 21 (58) 757 Cash Flows from Financing Activities Increase in short-term debt, net 305 382 269 Proceeds from long-term debt 475 406 216 Principal payments of long-term debt (695) (649) (1,188) Dividends (59) (60) (230) Capital contribution - - 7 Net cash provided by (used in) financing activities 26 79 (926) Decrease in cash and cash equivalents (1) (2) (8) Cash and cash equivalents, beginning of year 2 4 12 Cash and cash equivalents, end of year $ 1 $ 2 $ 4 See notes to consolidated financial statements. (15) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Xerox Credit Corporation (the Company) and its subsidiaries. The Company is a wholly-owned subsidiary of Xerox Financial Services, Inc. (XFSI), which is in turn wholly-owned by Xerox Corporation (Xerox). All significant transactions between the Company and its subsidiaries have been eliminated. Recognition of Earned Income The Company utilizes the finance method for the recognition of earned income associated with contracts receivable. Under this method, the difference between the amount of gross contract receivable and the cost of the contract is recorded as unearned income. The unearned income is amortized to income over the term of the transaction under an effective yield method. Cash and Cash Equivalents All highly liquid investments of the Company, with a maturity of three months or less at date of purchase, are considered to be cash equivalents. Allowance for Losses In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase which is intended to protect against future losses. Should any additional allowances be required, Xerox is required to provide such funding. The resultant effect is to relieve the Company of any exposure with regard to write-offs associated with the contracts receivable purchased from Xerox. (16) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Charge Off of Delinquent Receivables The Company's policy with respect to the charge-off of delinquent receivables to the reserve is that such receivables are to be charged off as soon as it becomes apparent that the collection of the receivables through normal means is unlikely. The policy contemplates that delinquent receivables will be charged off before the aging of such delinquent receivables reaches 180 days. New Accounting Pronouncements Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 109- "Accounting for Income Taxes." The effect of adopting SFAS No. 109 has no impact on income and shareholder's equity for continuing operations in 1992. A tax benefit of $87 million was recorded to discontinued operations and represents the cumulative tax benefits associated with the discontinued real-estate operations that were not previously recorded. Also, effective January 1, 1992, the Company adopted SFAS No. 106- "Employees' Accounting for Postretirement Benefits other than Pensions," which changes the method of recording other postretirement benefit costs from a cash basis to the accrual basis. The cumulative effect of adopting SFAS No. 106 on the Company was immaterial. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112- "Employers' Accounting for Postemployment Benefits." SFAS No. 112 requires accrual accounting for employee benefits that are paid after the termination of active employment but prior to retirement. The Company is required to adopt SFAS No. 112 beginning in 1994. the adoption of SFAS No. 112 is not expected to have a significant impact on the Company since the applicable benefits are either routinely accrued or are types of benefits not currently offered by the Company. (17) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (2) Discontinued Operations The Company has made substantial progress in disengaging from the real-estate and third-party financing businesses that were discontinued in 1990. During the three years ended December 31, 1993, the Company received aggregate net cash proceeds of $2,089 million ($232 million in 1993, $480 million in 1992 and $1,377 million in 1991) from the sale of individual assets or of business units, from several asset securitizations and from run-off collection activities. The amounts received were consistent with the Company's estimates in the disposal plan and were used primarily to repay short-term indebtedness. At December 31, 1993, the Company remains contingently liable for $126 million under recourse provisions associated with the securitization transactions. In addition, the Company has issued certain guarantees with respect to obligations and debt of one operation sold, Highline Financial Services, Inc. As a result of the guarantees, liabilities in the amount of $17 million are included in the Company's balance sheet at December 31, 1993, under the caption "Liabilities of business transferred." Because the Company has full recourse to the underlying assets associated with the guarantees, $17 million of assets remain on the Company's December 31, 1993 balance sheet, under the caption "Net assets of discontinued operations." These liabilities and assets will decrease proportionately with the collection of the underlying receivables, which have a remaining life of approximately 12 months. During 1991 and 1992, incremental tax benefits of $22 million and $122 million, respectively, were realized by the Company related to the writeoff of its real estate businesses in 1990. Rather than recording these tax benefits in net income, the Company increased before-tax reserves related to the discontinued businesses. Management believed this prudent in view of weak market conditions and continuing uncertainties in the domestic real-estate and credit markets. Approximately $120 million (34 percent) of the remaining assets represent passive lease receivables, many with long-duration contractual maturities and unique tax attributes. Accordingly, the Company expects that the wind-down of the portfolio will be slower during 1994 and in future years, compared with prior years. The Company believes that the liquidation of the remaining assets will not result in a net loss. Short-and long-term debt represents debt included in the Company's consolidated balance sheets that has been assigned to the discontinued businesses in accordance with historical methodologies. Proceeds from disposition of these businesses, along with their results of operations during the phase-out period, are expected to be used to repay such consolidated indebtedness. (18) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Summarized information of discontinued operations for the three years ended December 31, 1993 follows: 1993 1992 1991 (In Millions) Summary of Operations Loss before income taxes $ - $ (122) $ (22) Income tax benefit - 122 * 22 Net income (loss) from $ - $ - $ - discontinued operations Balance Sheet Data Gross finance receivables $ 202 $ 515 $ 1,014 Unearned income (53) (87) (134) Other assets 208 222 359 Investment in discontinued operations, net $ 357 $ 650 $ 1,239 Allocated short- and long-term debt $ 244 $ 400 $ 709 * Includes $87 million resulting from the cumulative effect of adopting statement of Financial Accounting Standards No. 109- "Accounting for Income Taxes," effective January 1, 1992. Contractual maturities of the gross finance receivables at December 31, 1993 follow (in millions): 1994-$60; 1995-$17; 1996-$20; 1997-$25; 1998; $13; 1999 and thereafter-$67. (19) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (3) Investments Contracts receivable represent purchases of long-term trade accounts receivable from Xerox. These receivables arose from Xerox equipment being sold under installment sales and sales-type leases. Contract terms on these receivables range primarily from two to five years and are generally collateralized by a security interest in the underlying assets. The Company purchased receivables from Xerox totaling $1,848 million in 1993, $1,964 million in 1992, and $1,784 million in 1991. The Company was charged $11 million in 1993, $10 million in 1992, and $9 million in 1991 by Xerox for administrative costs associated with the contracts receivable purchased from Xerox. Under SFAS No. 107- "Disclosures about Fair Values of Financial Instruments," the Company is not required to determine the fair value of these receivables. Management believes that any revaluation of the contracts receivable would result in a fair value significantly in excess of the carrying value of these receivables. During 1990, the Company sold, with limited recourse, $750 million of Xerox contracts receivable in two asset securitizations. At December 31, 1993, $40 million of these receivables remain outstanding. For the securitization transactions, the Company or one of its subsidiaries acts as collection agent for the accounts and remits the principal collected plus a floating rate of interest to the purchasers on a monthly basis. The scheduled maturities of contracts receivable at December 31, 1993 are as follows (in millions): 1994-$1,663; 1995-$1,205; 1996-$781; 1997-$365; 1998-$127; 1999 and thereafter- $7. Experience has shown that a portion of these contracts receivable will be prepaid prior to maturity. Accordingly, the preceding schedule of contractual maturities should not be considered a forecast of future cash collections. Included in notes receivable from Xerox and affiliates are receivables from related parties payable on demand at various interest rates. For additional information relating to these amounts, see Schedule II- Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties. In September 1993, the Company acquired 873,550 shares of common stock of Xerox Financial Services Life Insurance Company ("XFSLIC"), a subsidiary of XFSI, representing approximately 26 percent of total common stock outstanding, from a Xerox affiliate. In connection with the purchase of the XFSLIC common stock, the Company issued a $75 million adjustable rate promissory note due 1998, with an initial interest rate of 6 percent. The XFSLIC investment is accounted for on the equity method and is recorded at Xerox' historical cost because all parties involved are part of the Xerox group. Xerox intends to dispose of its investment in XFSLIC and the Company is expected to receive book value upon ultimate disposition of this investment. (20) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (4) Lines of Credit, Interest Rate Swaps and Notes Payable- Xerox Corporation At December 31, 1993 the Company and Xerox had joint access to three revolving credit agreements totaling $3.0 billion with groups of banks, which expire from 1994 to 1998. These agreements are unused and are available to back the issuance of commercial paper. At December 31, 1993, Xerox' domestic operations had borrowed approximately $2.4 billion of commercial paper backed by these agreements of which approximately $1.7 billion is related to the Company. The Company routinely enters into interest rate swap agreements in the management of interest rate exposure. An interest rate swap is an agreement to exchange interest rate payment streams based on a notional principal amount. In general, the Company's objective is to hedge its variable-rate debt by paying fixed rates under the swap agreements and receiving variable-rate payments in return. These swap agreements effectively convert an amount (equal to the notional amount) of underlying variable-rate debt into fixed-rate debt. The net interest rate differentials that will be paid or received are recorded currently as adjustments to interest expense. The counterparties to these swap agreements are typically major commercial banks. At December 31, 1993 and 1992, there were outstanding swap agreements which effectively converted $2,200 million and $1,850 million, respectively, of short- and long-term variable-rate debt into fixed-rate debt. These swap agreements mature at various dates through 1999 and result in weighted- average fixed rates of 5.39 percent and 6.17 percent at December 31, 1993 and 1992, respectively. During 1993, the Company also entered into interest rate swap agreements which effectively converted $425 million of short- and long- term variable-rate debt into variable-rate debt that is indexed to the commercial paper rates. These agreements mature at various dates through 1997. In addition, at December 31, 1993 and 1992, the Company had an agreement which effectively converted $100 million of fixed-rate debt, with a weighted average fixed-rate of 8.97 percent, into variable-rate debt that is indexed to the commercial paper rates. At December 31, 1993, the Company's swap agreements had an aggregate net fair value of $35 million, based on quotes from banks, which represents the estimated net amount the Company would be required to pay to terminate all the agreements as of December 31, 1993. The Company has no present plans to terminate any of these agreements prior to their scheduled maturities. Because the $35 million represents a theoretical liability of the Company, there was no significant credit risk in the event of a counterparty default. Notes payable- Xerox Corporation is an intercompany payable with Xerox relating to the purchase of long-term trade accounts receivables. These amounts are settled periodically throughout the year. (21) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (5) Notes Payable After One Year A summary of notes payable at December 31, 1993 and 1992 follows: 1993 1992 (In Millions) 8.75% Notes due 1993 $ - $ 200 8.20% Notes due 1993 - 20 10.00% Notes due 1993 - 125 9.25% Notes due 1993 - 200 9.125% Notes due 1993 - 100 9.58% Notes due 1993 - 14 9.50% Notes due 1994 100 100 9.76% Notes due 1994 14 14 4.119% Notes due 1994 50 50 Floating Rate Notes due 1994 (a) 275 - 5.375% Notes due 1995 150 150 3.75 % Notes due 1995 50 - Floating Rate Notes due 1995 (a) 50 - 8.75% Notes due 1995 150 150 6.25% Notes due 1996 200 200 Floating rate Notes due 1996 (a) 50 - 4.80% Notes due 1997 50 - 8.00% Notes due 1999 (b) 100 100 10.00% Notes due 1999 150 150 10.125% Notes due 1999 (c) 150 150 Floating Rate Notes due 2048 (d) 61 62 Other Notes due 1993 - 50 Other Notes due 1994 - 1997 34 21 Subtotal $ 1,634 $ 1,856 Less unamortized discount (1) (2) Less current portion of notes payable after one year (554) (709) Total Notes Payable After one Year $ 1,079 $ 1,145 (a) The notes carry interest rates which are based primarily on spreads above certain reference rates such as U.S. Treasury Bill, LIBOR and Federal funds rates. (b) The notes are redeemable on or after March 1, 1994, at the option of the Company, in whole or in part, at a premium plus accrued interest. (c) The notes are redeemable on or after April 15, 1996, at the option of the Company, in whole or in part, at their principal amount plus accrued interest. (22) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (d) The notes mature August 15, 2048 and are repayable at the option of the noteholders beginning August 15, 1991 and annually thereafter. On August 15, 1993 and 1991, $1 million and $2 million of these notes were repaid, respectively. The outstanding notes are classified as notes payable after one year, since the Company has the ability to refinance them on a long-term basis, if required. The interest rate is indexed to rates on commercial paper placed for issuers whose commercial paper rating is "AA" or the equivalent as reported in Federal Reserve Statistical Release H.15 (519), which at year-end was 3.34 percent. Principal payments on notes payable for the next five years are: $554 million in 1994; $400 million in 1995; $415 million in 1996; $54 million in 1997; $0 million in 1998; and $211 million thereafter. Certain of the Company's debt agreements allow it to redeem outstanding debt, usually at par, prior to scheduled maturity. Outstanding debt issues with these call features are classified on the balance sheet and in the preceding five-year maturity table in accordance with management's current expectations. The actual decision as to early redemption will be made at the time the early redemption option becomes exercisable and will be based on economic and business conditions then in existence. Interest payments on notes payable for 1993, 1992 and 1991 were $148 million, $166 million, and $237 million, respectively. Interest payments on commercial paper for 1993, 1992 and 1991 were $48 million, $40 million and $55 million, respectively. The weighted-average commercial paper interest rates for 1993, 1992 and 1991 were 3.3 percent, 3.9 percent and 6.1 percent, respectively. At December 31, 1993, $1,634 million of notes payable remains out- standing, substantially all of which are subject to the requirements of SFAS No. 107- "Disclosures about Fair Values of Financial Instruments." The fair value of the Company's notes payable at December 31, 1993 was $1,698 million, which was estimated based on quoted market prices for these or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. The difference between the fair value and the carrying value represents the theoretical net premium the Company would have to pay to retire all notes payable at December 31, 1993. The Company has no plans to retire its notes payable after one year prior to their call or final maturity dates. The original issue discount and other expenses associated with the debt offerings are amortized over the term of the related issue. (23) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (6) Income Taxes "SFAS No. 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 (APB No. 11) to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109 the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1992, the Company prospectively adopted SFAS No. 109. The cumulative effect of that change was immaterial and had no impact on income from continuing operations. A tax benefit of $87 million was recorded in 1992 to discontinued operations, which represented the cumulative tax benefits associated with the discontinued real-estate operations that were not previously recorded. Pursuant to the deferred method under APB No. 11, which was applied in 1991 and prior years, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable to the year of the calculation. Under APB No. 11, deferred taxes were not adjusted for subsequent changes in tax rates. Income taxes are provided at statutory rates based on income before income taxes exclusive of the amortization of investment tax credits and earnings not subject to Federal taxation. Substantially all of the Company's operations are included in Xerox' consolidated income tax returns. In connection with these consolidated returns, the Company paid Xerox $136 million, $15 million, and $41 million in 1993, 1992 and 1991, respectively. The Company paid $1 million in 1993, 1992 and 1991, to taxing authorities for Company operations not included in Xerox' consolidated tax returns. (24) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The components of income from continuing operations before taxes and the provision for income taxes are as follows: 1993 1992 1991 (In Millions) Income from continuing operations before income taxes: $ 154 $ 158 $ 164 Federal income taxes Current $ 50 $ 52 $ 57 Deferred (1) (3) (7) State income taxes Current 14 15 18 Deferred - (1) (2) Total provision for income taxes $ 63 $ 63 $ 66 Deferred income taxes for 1993, 1992, and 1991 result from differences between financial and tax reporting in the timing of the recognition of income on securitized assets. In addition, deferred income taxes for 1991 included differences due to the timing of interest expense recognized on the Company's $250 million Zero Coupon Notes which were redeemed during 1992. A reconciliation of the effective tax rate from the U.S. Federal statutory tax rate follows: 1993 1992 1991 U.S. Federal statutory rate 35.0% 34.0% 34.0% Tax exempt interest income - - (0.4) State income taxes, net of Federal income tax benefit 5.9 5.9 6.6 Effective tax rate 40.9% 39.9% 40.2% (25) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The tax effects of temporary differences that give rise to significant portions of deferred taxes at December 31, 1993 follows: 1993 1992 Tax effect of future tax deductions: Discontinued real-estate tax benefit $ 42 $ 47 Tax effect on future taxable income: Discontinued leverage leases and other (77) (219) Continuing operations- asset securitizations (3) (2) Total deferred taxes, net $ (38) $(174) Total net deferred tax liabilities included in the Company's balance sheets at December 31, 1991 was $323 million. The 1993 reduction in deferred income taxes payable is the result of sales of certain discontinued operations assets. The Company believes that it is more likely than not that the deferred tax assets will be realized in the ordinary course of operations based on scheduling of deferred tax liabilities and income from operating activities. (7) Xerox Corporation Support Agreement The terms of a Support Agreement with Xerox provide that the Company will receive income maintenance payments, to the extent necessary, so that the Company's earnings shall not be less than 1.25 times its fixed charges. For purposes of this calculation, both earnings and fixed charges are as defined in Section 1404 (formerly Section 81(2)) of the New York Insurance Law. In addition, the agreement requires that Xerox retain 100 percent ownership of the Company's voting capital stock. (26) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (8) Quarterly Results of Operations (Unaudited) A summary of interim financial information follows: First Second Third Fourth Quarter Quarter Quarter Quarter Total (In Millions) Earned income $ 102 $ 93 $ 87 $ 94 $ 376 Interest expense 56 53 52 48 209 Operating and administrative expenses 4 2 4 3 13 Income taxes 17 15 13 18 63 77 70 69 69 285 Net income $ 25 $ 23 $ 18 $ 25 $ 91 Earned income $ 99 $ 98 $ 96 $ 96 $ 389 Interest expense 54 52 53 53 212 Operating and administrative expenses 5 4 5 5 19 Income taxes 16 17 15 15 63 75 73 73 73 294 Net income from continuing operations 24 25 23 23 95 Income (loss) from discontinued operations* 122 - - (122) - Net income (loss) $ 146 $ 25 $ 23 $ (99) $ 95 * 1992 first quarter includes $87 million benefit resulting from the cumulative effect of adopting SFAS No. 109. (27) SCHEDULE II XEROX CREDIT CORPORATION Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties Years Ended December 31, 1993, 1992 and 1991 (In Millions) Balance at Balance End of Period Beginning Amounts of Period Additions Collected Current Not Current Name of Debtor Xerox Financial Services, Inc. (A) $ 50 $ 3 $ 3 $ 50 $ - Xerox Financial Services, Inc. - 6 - 6 - CBC Funding Corporation 7 - 5 2 - $ 57 $ 9 $ 8 $ 58 $ - Van Kampen Merritt, Inc. (A) $ 50 $ 3 $ 3 $ 50 $ - CBC Funding Corporation 26 - 19 7 - $ 76 $ 3 $ 22 $ 57 $ - Van Kampen Merritt, Inc. (A) $ 51 $ 3 $ 4 $ 50 $ - CBC Funding Corporation - 33 7 - 26 Crum and Forster, Inc. 6 6 12 - - Xerox Finance N.V. 9 - 9 - - $ 66 $ 42 $ 32 $ 50 $ 26 (A) During February 1993, this note was assumed by XFSI. The note bears interest at the commercial paper rate plus 1.0 percent annually. (28) SCHEDULE VIII XEROX CREDIT CORPORATION Valuation and Qualifying Accounts Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Retained Balance at to at at Beginning Costs Time End of and of of Period Expenses Purchase Deductions Period (A) (B) Allowance for losses- continuing operations $ 139 $ - $ 63 $ 49 $ 153 Allowance for losses- continuing operations $ 108 $ - $ 75 $ 44 $ 139 Allowance for losses- continuing operations $ 127 $ - $ 36 $ 55 $ 108 (A) In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase which is intended to protect against future losses. Should any additional allowances be required, Xerox is required under the Operating Agreement to provide such funding. For the period covered by this Schedule, no additional funding was required or provided. (B) Amounts written off, net of recoveries. (29) SCHEDULE IX XEROX CREDIT CORPORATION Short-Term Borrowings Years Ended December 31, 1993, 1992 and 1991 (In Millions) Maximum Weighted Amount Weighted Balance Average Outstanding Average At End Interest At Any Average Interest Of Period Rate Month-End Balance Rate (A) (B) Commercial Paper $ 1,653 3.3% $ 1,653 $ 1,478 3.3% Commercial Paper $ 1,257 3.8% $ 1,283 $ 1,026 3.9% Commercial Paper $ 906 4.9% $ 1,246 $ 898 6.1% (A) Average Commercial Paper outstanding during the period is computed by dividing the daily outstanding balances by the number of days commercial paper was outstanding. (B) The weighted average interest rate during the period is computed by dividing the interest charged for the period by the weighted average amount outstanding during the period. (30) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (3) (a) Certificate of Incorporation of Registrant filed with the Secretary of State of Delaware on June 23, 1980. Incorporated by reference to Exhibit 3(a) to Registration Statement No. 2-71503. (b) By-Laws of Registrant, as amended through July 15, 1991. Incorporated by reference to Exhibit 3(b) to Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. (4) (a) Indenture dated as of February 1, 1987 between Registrant and Continental Illinois National Bank and Trust Company of Chicago relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-12160. (b) Indenture dated as of October 1, 1987 between Registrant and The Bank of New York relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-18258. (c) Indenture dated as of March 1, 1988 between Registrant and The First National Bank of Chicago relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of July 1, 1988. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-20640 and to Exhibit 4(a)(2) to Registrant's Current Report on Form 8-K dated July 13, 1988. (31) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (d) Indenture dated as of March 1, 1989 between Registrant and Citibank, N.A. relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of October 1, 1989. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-27525 and to Exhibit 4(a)(2) to Registration Statement No. 33-31367. (e) Indenture dated as of October 1, 1989 between Registrant and Chemical Bank (as successor by merger to Manufacturers Hanover Trust Company) relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-31366. (f) Indenture dated as of August 1, 1991, as supplemented by the First Supplemental Indenture dated as of December 31, 1991, between the Registrant and Bank of Montreal Trust Company relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by the Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-39838. (g) Indenture dated as of October 1, 1991 between Registrant and Citibank, N.A. relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by the Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of May 1, 1992. Incorporated by reference to Exhibit 4(a)(1) and 4(a)(2) to Registration Statement No. 33-43470. (32) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (h) Instruments with respect to long-term debt where the total amount of securities authorized thereunder does not exceed ten percent of the total assets of Registrant and its subsidiaries on a consolidated basis have not been filed. Registrant agrees to furnish the Commission a copy of each such instrument upon request. (10) (a) Amended and Restated Operating Agreement originally made and entered into as of November 1, 1980, amended and restated as of December 31, 1992 between Registrant and Xerox Corporation ("Xerox"). Incorporated by reference to Exhibit 10(a) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. (b) Support Agreement dated as of November 1, 1980 between Registrant and Xerox. Incorporated by reference to Exhibit 10(b) to Registration Statement No. 2-71503. (c) Tax Allocation Agreement dated as of January 1, 1981 between Registrant and Xerox. Incorporated by reference to Exhibit 10(c) to Registration Statement No. 2-71503. (12) (a) Computation of Registrant's Ratio of Earnings to Fixed Charges. See Page 34 of this Report on Form 10-K. (b) Computation of Xerox' Ratio of Earnings to Fixed Charges. See Page 35 of this Report on Form 10-K. (23) Consent of KPMG Peat Marwick. See Page 37 of this Report on Form 10-K. (24) Power of Attorney. See Page 38 of this Report on Form 10-K. (33)	8,257	52,721
36068_1993.txt	36068_1993	1993	36068	ITEM 3: LEGAL PROCEEDINGS Note 17 to the Consolidated Financial Statements, included in this Report under Item 8, is hereby incorporated in this Item 3 by reference. ITEM 4: ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 1993. PART II ITEM 5: ITEM 5: MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Corporation's Common Stock is traded on the national over-the-counter market (NASDAQ symbol: FATN), and is quoted on the National Market System of the National Association of Securities Dealers Automated Quotation System (the "National Market System"). At the close of business on February 10, 1994, there were approximately 9,590 holders of record of the Corporation's common stock. The following table sets out the quarterly high and low sales prices of the Corporation's common stock. The dividends declared during each quarter for the last two years are also shown. In the first quarter of 1994, the Corporation declared a dividend of $.21 per share, an increase of 40%. See SUPERVISION AND REGULATION, Payment of Dividends. See also, notes 9 and 17 to the Corporation's Consolidated Financial Statements, included in this Report under Item 8, which are incorporated herein by reference. ITEM 6: ITEM 6: SELECTED FINANCIAL DATA The table "Selected Financial Data" on page 17 hereof is incorporated in this Item 6 by reference. ITEM 7: ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OVERVIEW The following is management's discussion and analysis of the Corporation's results of operations and financial condition for 1993. The purpose of this discussion, including the accompanying tables, is to provide additional insight into the Corporation's consolidated financial statements and accompanying notes. It should be read in conjunction with such consolidated financial statements and notes and other data included herein. To the extent that this discussion includes assessments of future financial performance or trends, the assessments are based on information known at the date this discussion was prepared. Results for 1993 included several significant accomplishments which are highlighted as follows and are discussed in more detail in the sections which follow. - Net income was $101.8 million in 1993, a 143% increase from $42.0 million in 1992. On a per share basis, net income in 1993 increased to $3.93 from $1.74 in 1992. The primary factors contributing to increased earnings include: - Net interest income on a taxable equivalent basis increased to $271.5 million in 1993, an increase of 6% from $255.8 million in 1992 due to a $286.1 million (5%) increase in average earning assets and a slightly improved net interest margin (4.39% in 1993 versus 4.34% in 1992). The net interest margin improved primarily as a result of a more rapid decline in average rates paid on interest-bearing liabilities (down 77 basis points) as compared to the decline in the average yield of earning assets (down 64 basis points). - The pace of credit quality improvement accelerated in 1993, which resulted in a reduction in the allowance for possible loan losses. Nonperforming assets declined 54% to $40.5 million at December 31, 1993, as compared with $89.0 million at December 31, 1992. Net charge-offs decreased 84% to $6.3 million in 1993 versus $38.4 million in 1992. During 1993, the Corporation had a $42.0 million negative provision for loan losses, down $80.5 million from the $38.5 million provision in 1992. During the third quarter of 1993, management reviewed the Corporation's allowance for possible loan loss methodology. This review resulted in certain refinements to the methodology which will assist management in continuously arriving at an appropriate level for the allowance for possible loan losses on a quarterly basis. The revised methodology was used by the Corporation during third and fourth quarters of 1993. - Non-interest income increased $11.5 million (15%) to $90.1 million in 1993 from $78.6 million in 1992, primarily due to increased fee income resulting from new products and services introduced in 1993. Approximately $6.1 million of the increase resulted from additional investment services income earned on expanded investment services in 1993. - The Corporation was successful in controlling non-interest expense during 1993. Non-interest expense totalled $240.3 million in 1993, a $7.9 million or 3% increase from $232.4 million in 1992. The Corporation's non-interest expenses for 1993 include a $10.0 million charitable contribution to First American Foundation, a not-for-profit private foundation formed in 1993 to facilitate the Corporation's charitable contributions. Exclusive of the contribution, non-interest expense decreased $2.1 million or 1%. The operating efficiency ratio, which represents the ratio of operating expenses to taxable equivalent net interest income plus non-interest income, improved to 63.7% in 1993 (exclusive of the Foundation contribution) from 69.5% in 1992. - Adjusted to exclude negative provisions for loan losses of $44 million recorded by the Corporation in the last three quarters of the year, the $10 million Foundation contribution, and the cumulative effect of accounting changes, earnings per share would have equaled $3.08 for 1993, a 77% increase over 1992. - Two key measures of profitability, return on average assets (ROA) and return on average equity (ROE), increased in 1993. The ROA increased to 1.50% in 1993 from .65% in 1992. The ROE increased in 1993 to 19.90% from 10.03% in 1992. Excluding the effect of the Foundation contribution and the negative provisions for loan losses, the Corporation's ROA and ROE were 1.17% and 15.58%, respectively, for 1993. - The average equity to assets ratio was 7.52% for the year ended December 31, 1993, compared with 6.47% one year earlier. The Corporation's total risk-based capital ratio was 13.16% at December 31, 1993, compared with 11.76% at the end of the prior year. - Dividends paid amounted to $.55 per share for 1993 as compared to $.20 per share in 1992. The Board of Directors voted to increase the quarterly cash dividend from $.10 per share to $.15 per share during second quarter 1993. Subsequently, the quarterly dividend was increased to $.21 per share in January 1994. The increased dividend was the result of the Corporation's continued improvement in financial performance. - As a result of improvements in asset quality, operating processes, and earnings, FANB's agreement with the Office of the Comptroller of the Currency was terminated in second quarter 1993. - The Corporation consummated its acquisition of all of the outstanding shares of First American National Bank of Kentucky ("FANBKY"), formerly known as First Federal Savings and Loan Association of Bowling Green, a $219 million national bank headquartered in Bowling Green, Kentucky, for $27.5 million. FANBKY operates three branches in Warren and Simpson counties in southern Kentucky. The transaction was accounted for as a purchase; thus, the Corporation's financial results include the financial results of FANBKY only from the date of acquisition (October 1, 1993). - The Corporation signed a definitive stock purchase agreement to acquire Fidelity Crossville Corporation ("FCC"), the parent company of First Fidelity Savings Bank, F.S.B. ("First Fidelity") located in Crossville, Tennessee for $6.5 million. First Fidelity, with approximately $50 million in total assets at December 31, 1993, has offices in Crossville and Fairfield Glade. The acquisition is expected to be completed in the first half of 1994, subject to various conditions, including regulatory approval. - The Corporation filed a shelf registration statement with the Securities and Exchange Commission to issue up to $100 million of subordinated debt securities. An initial $50 million of subordinated debt was issued during second quarter 1993. - The Corporation's average total assets increased $340.2 million or 5% to $6.81 billion in 1993. Average loans grew $188.6 million (5%) to $3.87 billion in 1993, with growth in both commercial and consumer loans. Total assets at December 31, 1993, amounted to $7.19 billion, as compared to $6.72 billion at December 31, 1992, an increase of $472.0 million or 7%. - The Corporation adopted four new Statements of Financial Accounting Standards (SFAS) during 1993: SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions"; SFAS No. 109, "Accounting for Income Taxes"; SFAS No. 112, "Employers' Accounting for Postemployment Benefits"; and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." On a net basis, there was essentially no initial impact to 1993 net income ($84,000 after tax expense) from the adoption of these accounting standards. Shareholders' equity increased approximately $22.0 million, after tax, as a result of adopting these accounting standards. Table 1 presents selected financial data for the Corporation for the past five years. A more detailed discussion and analysis of the 1993 results of operations and financial condition is contained in subsequent sections. TABLE 1: SELECTED FINANCIAL DATA: 1989-1993 * Adjusted to a taxable equivalent basis based on the statutory Federal income tax rates, adjusted for applicable state income taxes net of the related Federal tax benefit. ** Ratio of operating expenses to taxable equivalent net interest income plus non-interest income. For 1993, calculation excludes the $10 million Foundation contribution. N/A - Information not considered meaningful. NET INCOME (LOSS) PER SHARE: (Graph) RETURN ON AVERAGE EQUITY (Graph) RETURN ON AVERAGE ASSETS (Graph) RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income, which is the Corporation's primary source of income, was $271.5 million in 1993 on a taxable equivalent basis, compared with $255.8 million in 1992, an increase of $15.7 million or 6%. Net interest income is the difference between total interest income earned on earning assets and total interest expense incurred on interest-bearing liabilities. Total interest income, total interest expense and net interest income are all impacted by fluctuations in the volume and mix of earning assets and interest-bearing liabilities and the corresponding interest yields and costs. Changes in the level of nonperforming assets, together with interest lost and recovered on those assets, also impact net interest income. The following table provides a recap of net interest income to assist in discussing the increase in 1993 net interest income from 1992. Throughout this discussion, tax-exempt interest income has been adjusted to a fully taxable equivalent basis (TEB) in order to be comparable to interest income which is subject to Federal income tax. This adjustment has been calculated using a Federal income tax rate of 35% in 1993 and 34% in 1992, adjusted for applicable non-deductible interest expense (for tax purposes) to purchase or carry tax-exempt obligations. TABLE 2: RATE-VOLUME RECAP * Amounts are adjusted to a fully taxable equivalent basis, based on the statutory Federal income tax rates, adjusted for applicable state income taxes net of the related Federal tax benefit. The effect of volume changes is computed by multiplying the change in volume for each item by the prior year rate. The effect of rate changes is computed by multiplying the change in rate by the prior year volume. Rate/volume changes are computed by multiplying the change in volume by the change in rate and are included in the effect on income of rate changes. Total interest income on earning assets was $430.9 million in 1993 compared with $448.7 million in 1992. The $17.8 million or 4% decrease in total interest income was due primarily to lower average yields on earnings assets, which was partially offset by a higher level of earning assets in 1993 over 1992. The average rate earned on earning assets was 6.97% in 1993 compared with 7.61% in 1992, a decline of 64 basis points. The Corporation's lower average yield earned on earning assets in 1993 resulted primarily from a lower interest rate environment in 1993 from prior years. The average national prime lending rate and other longer-term market indices significantly impact market rates charged on loans. During periods of declining national rates, the Corporation's yield on loans will decline. The decline will not be precisely of the same magnitude or will not occur at the same time as declines in national indices, since a portion of the Corporation's earning assets do not reprice immediately upon a change in national rates. The decline in the Corporation's yield on earning assets generally reflects declines in national rates, such as the average national prime lending rate (6.00% in 1993, 6.25% in 1992, and 8.46% in 1991). The impact of the change in average yields on earning assets was to reduce total interest income in 1993 by $39.6 million. Average earning assets in 1993 were $6.18 billion, an increase of $286.1 million or 5% from $5.90 billion in 1992. The increase in earning assets added $21.8 million to total interest income, partially offsetting the decline due to reduced yields. Interest earned on earning assets does not include interest income which would have been recognized on nonperforming loans if such loans were performing. The amount of interest not recognized on nonperforming loans approximated $1.1 million in 1993 compared with $3.7 million in 1992. Earning asset yields would have been 2 and 6 basis points higher in 1993 and 1992, respectively, if all loans had been performing. Net interest spreads and margins would also have been higher by approximately the same number of basis points. Total interest expense on interest-bearing liabilities in 1993 was $159.4 million, a $33.5 million or 17% decline from $192.9 million in 1992. This decline was due to lower average rates paid on interest-bearing funds as a result of the lower interest rate environment, which was partially offset by increased volumes of interest-bearing liabilities. The average cost of interest-bearing funds in 1993 was 3.14% as compared with 3.91% in 1992, a decline of 77 basis points. Changes in rates paid on the Corporation's interest-bearing liabilities are primarily impacted by changes in national market indices such as the Federal funds rate, London Interbank Offered Rate (LIBOR), and other longer-term indices. Like the average yield earned on earning assets, the average rate paid on interest-bearing liabilities tends to follow changes in national rate indices. For example, the decline in the Corporation's average rate paid on interest-bearing liabilities reflects declines in the average national Federal funds rate (3.02% in 1993, 3.52% in 1992, and 5.69% in 1991). Competitive factors also impact changes in rates earned on earning assets and rates paid on interest-bearing liabilities. During the first six months of 1993, loan demand was relatively slow in the banking industry, resulting in little need to increase funding requirements. As deposit growth increased, the banking industry was able to reduce rates paid on deposits relative to market indices. In 1993, the average rate paid on interest-bearing deposits was only 14 basis points higher than the average national Federal funds rate (3.16% deposit rate versus 3.02% average national Federal funds rate), compared with 47 basis points higher in 1992 (3.99% deposit rate versus 3.52% average national Federal funds rate). The decline in average rates paid on interest-bearing liabilities reduced interest expense in 1993 from 1992 by $39.1 million. The impact of the increase in average interest-bearing liabilities ($5.07 billion in 1993 versus $4.93 billion in 1992) was to increase interest expense $5.6 million. Net interest income increased as a result of the increase in the volume of earning assets and a higher net interest spread, which is the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. During 1993, the Corporation's net interest spread increased 13 basis points to 3.83% from 3.70% in 1992. The higher net interest spread was achieved through reductions in interest-bearing liability costs (primarily deposits), which declined more rapidly than yields on earning assets (primarily loans and securities). Also contributing to the Corporation's increased net interest spread in 1993 was a reduction in the level of nonperforming loans and a more favorable mix of funding sources. The volume of non-interest-bearing deposits and lower-cost savings and NOW accounts increased, while the volume of relatively higher-cost certificates of deposit declined. Changes in net interest spreads for different financial institutions generally vary based on the mix of earning assets and interest-bearing liabilities, as well as the timing of repricings of various longer-term earning assets and interest-bearing liabilities. As the Corporation's net interest spread widened, the net interest margin, which is net interest income expressed as a percentage of average earning assets, increased to 4.39% in 1993 from 4.34% in 1992, an improvement of 5 basis points. The net interest spread and margin were also aided by First American's interest sensitivity position, which enabled the Corporation to benefit from a declining interest rate environment in 1993. As a result, the Corporation had a higher volume of interest-bearing liabilities repricing in the lower interest rate environment than earning assets repricing. (See "Asset/Liability Management and Liquidity" section.) INTEREST INCOME, INTEREST EXPENSE AND NET INTEREST INCOME (Graph) AVERAGE YIELDS/RATES PAID (Graph) Based on current projections, management anticipates that the net interest margin may decline in 1994. However, net interest income is expected to increase due to an increase in the level of earning assets in 1994, as loan growth, which increased during the last six months of 1993, is expected to continue. Management continues to concentrate on improving the mix of earning assets, increasing the ratio of earning assets to total assets, and managing interest rate sensitivity. Various techniques are used to assist in managing of the Corporation's interest rate sensitivity, including off-balance-sheet hedging strategies. Unforeseen changes in the interest rate environment (such as narrowing of the difference between the average national prime lending rate and the average national Federal funds rate), increased levels of competition for loans and deposits among financial institutions, or other factors could adversely affect management's plan to increase net interest income in 1994. TABLE 3: CONSOLIDATED AVERAGE BALANCES, TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES * Loan fees and amortization of net deferred loan fees (costs), which are considered an integral part of the lending function and are included in rates and related interest categories, amounted to $2.2 million in 1993, $(.8) million in 1992, and $(2.7) million in 1991. Yields/rates and income/expense amounts are presented on a fully taxable equivalent basis based on the statutory Federal income tax rates adjusted for applicable state income taxes net of the related Federal tax benefit; related interest income includes taxable equivalent adjustments of $4.0 million in 1993, $4.2 million in 1992, and $6.6 million in 1991. Non-accrual and restructured loans are included in average loans and average earning assets. Consequently, yields on these items are lower than they would have been if these loans had earned at their contractual rate of interest. PROVISION FOR LOAN LOSSES The provision for loan losses represents a charge (credit) to earnings necessary, after loan charge-offs and recoveries, to maintain the allowance for possible loan losses at an appropriate level which is adequate to absorb estimated losses inherent in the loan portfolio. The level of the allowance for possible loan losses is determined on a quarterly basis using procedures which include: (1) an evaluation of individual criticized and classified credits as determined by internal reviews, of other significant credits, and of non-criticized/classified commercial and commercial real estate credits, to determine estimates of loss probability; (2) an evaluation of various consumer loan categories to determine an estimation of loss on such loans based primarily on historical loss experience of the category; (3) a review of unfunded commitments; and (4) an assessment of various other factors, such as changes in credit concentrations, loan mix, and economic conditions which may not be specifically quantified in the loan analysis process. During third quarter 1993, management reviewed the Corporation's allowance for possible loan loss methodology, resulting in refinements to such methodology which will assist management in continuously arriving at an appropriate level for the allowance for possible loan losses on a quarterly basis. Determining the appropriate level of the allowance and the amount of the provision for loan losses involves uncertainties and matters of judgment and therefore cannot be determined with precision. The allowance for possible loan losses consists of an allocated portion and an unallocated, or general, portion. The allocated portion is maintained to cover estimated losses applicable to specific segments of the loan portfolio. The unallocated portion is maintained to absorb losses which probably exist as of the evaluation date but are not identified by the more objective processes used for the allocated portion of the allowance for loan losses due to risk of error or imprecision. While the total allowance consists of an allocated portion and an unallocated portion, these terms are primarily used to describe a process. Both portions of the allowance are available to provide for inherent loss in the entire portfolio. Table 4 includes the allocation of the allowance for possible loan losses between the various loan portfolios and the unallocated portion of the allowance for each of the past five years. Based on the reviews of the appropriateness of the allowance throughout 1993, as described above, determinations were made that the allowance for possible loan losses should be reduced. Accordingly, reductions were effected by negative provisions for loan losses of $44.0 million recorded by the Corporation in the last three quarters of the year. As a result, the provision for loan losses amounted to a negative $42.0 million for 1993, compared to a $38.5 million charge for 1992. The primary factor leading to the negative provisions for loan losses in 1993 was the Corporation's continued improvement in asset quality. Nonperforming loans totalled $21.7 million at December 31, 1993, a 64% decrease from $60.3 million at year-end 1992. A further indication of continued asset quality improvement is the reduced level of net loan charge-offs. Net charge-offs were $6.3 million in 1993, a decline of $32.1 million or 84% from $38.4 million in 1992. This decrease resulted primarily from a $20.5 million decline in commercial loan net charge-offs, combined with a $7.4 million decline in consumer loan net charge-offs. The ratio of net charge-offs to average loans was .16% in 1993 compared with 1.04% in 1992. Net charge-offs are likely to be higher in 1994 than in 1993, as the level of recoveries experienced in 1993 is not expected to continue in 1994. Management currently does not anticipate that the provision for possible loan losses will be significant, if any, in 1994. The allowance for possible loan losses amounted to $134.1 million at December 31, 1993, compared with $181.1 million at December 31, 1992. The allowance for possible loan losses represented 3.09% and 4.90% of net loans at December 31, 1993 and 1992, respectively. Table 4 presents a recap of the activity in the allowance for possible loan losses for the past five years. A more detailed discussion of nonperforming assets is presented under the caption, "Asset Quality." TABLE 4: ALLOWANCE FOR POSSIBLE LOAN LOSSES Allowance amounts for commercial and real estate loans for 1989 are for specific loans. During this year, the unallocated/general reserve was not allocated to individual loan categories. NON-INTEREST INCOME Non-interest income in 1993 was $90.1 million, an increase of $11.5 million or 15% from $78.6 million in 1992. Non- interest income, excluding net securities losses ($2.0 million in 1993 and $3.0 million in 1992) and gain on sale of branch office ($607,000 in 1992), totalled $92.2 million for 1993, an increase of $11.2 million (14%) from $81.0 million in 1992. The increase from 1992 is primarily attributable to increases in service charges on deposit accounts and increases in investment services income. Service charges on deposit accounts, which consist primarily of analysis fees and other deposit account charges, amounted to $39.2 million in 1993, a $2.3 million or 6% increase from $36.9 million in 1992. This increase is partially due to higher volumes of deposit accounts in 1993, combined with additional fees generated from ValueFirst Checking, a new deposit product introduced in late 1992. Investment services income totalled $7.7 million for the year ended December 31, 1993, an increase of $6.1 million from the prior year amount of $1.6 million. This increase is primarily due to increased revenues generated in 1993 from executing annuities, mutual funds, and other investment product transactions for customers. Commissions and fees on fiduciary activities totalled $15.3 million in 1993, an increase of $.6 million (4%), due to increased customer activity in estates and personal and corporate trusts. Other increases in non-interest income occurred in merchant discount fees, which represents income earned from credit card receipts collected by merchants and discounted at First American (increase of $.5 million), trading account revenue, which represents net gains or losses and commissions on securities trading activities (up $.1 million), and other income (up $1.6 million). Management currently expects non-interest income to continue to increase in 1994, as developing new fee income opportunities is one of management's primary objectives over the next several years. NON-INTEREST EXPENSE Non-interest expense was $240.3 million in 1993, an increase of $7.9 million or 3% from $232.4 million in 1992. As previously mentioned, the First American Foundation was incorporated in 1993 and received a $10.0 million charitable contribution from the Corporation in the fourth quarter. The Corporation's 1993 contribution of $10.0 million is included in non-interest expense. Exclusive of this charitable contribution, non-interest expenses decreased $2.1 million or 1%. Salaries and employee benefits increased $8.1 million to $117.3 million for the year ended December 31, 1993, compared with $109.2 million in 1992. Salaries and employee benefits represented 49% of total non-interest expense for 1993, as compared to 47% for the prior year. Salaries expense increased $5.2 million in 1993, reflecting additional employees, merit increases and additional incentive compensation. The number of full-time equivalent employees increased to 3,138 at year-end 1993 as compared to 3,075 in 1992, primarily as a result of the acquisition of FANBKY in fourth quarter 1993, which had 54 employees at year-end. Incentive compensation increased $2.7 million or 65% as a result of higher corporate and individual performances and a higher volume of investment services product sales. Employee benefits expense increased $2.9 million or 15% during 1993. A primary factor contributing to the employee benefit increase is $1.7 million of additional corporate matching contributions to the Corporation's savings/thrift plan ("FIRST Plan") in 1993 ($2.9 million in 1993 versus $1.2 million in 1992). During 1993, the Corporation matched participating employees' qualifying contributions by 100%, as compared to 50% in 1992, as a result of improved corporate performance and the achievement of the highest level of contribution criteria. Exclusive of personnel-related expenses, non-interest expense decreased $.2 million from 1992. Net foreclosed properties expense decreased $13.1 million in 1993 ($2.5 million of net foreclosed properties income in 1993 versus net foreclosed properties expense of $10.6 million in 1992). The Corporation recorded net gains on disposals of foreclosed properties and in-substance foreclosures amounting to $3.8 million in 1993, as compared to net losses on disposals of $7.6 million in 1992. Operating costs associated with foreclosed properties declined, as the level of foreclosed properties decreased. Also, other decreases in non-interest expenses occurred in supplies expense (down $.8 million), communication expense (down $.1 million) and other expenses (down $.8 million). These decreases are partially offset by the $10.0 million contribution to First American Foundation in 1993. Other increases in non-interest expense occurred in equipment expense (increase of $1.9 million) and net occupancy expense (increase of $1.1 million), primarily related to branch automation and personal computer network upgrades; FDIC insurance expense (increase of $1.1 million), due to an increase in the FDIC assessment rate and increased deposit volumes in 1993; and systems and processing expense (increase of $.5 million) due to a higher volume of business. Certain software programming functions which were contracted with an outside vendor during 1993 are expected to be performed internally during 1994. As a result, systems and processing expense would decline and various other categories of non-interest expense, such as salaries and employee benefits, would increase during 1994. The operating efficiency ratio, which represents the ratio of operating expenses to taxable equivalent net interest income plus non-interest income, improved to 63.7% in 1993 (exclusive of the Foundation contribution expense) from 69.5% in 1992. Management continues to emphasize expense control as a means to improve efficiency and profitability. TABLE 6: NON-INTEREST EXPENSE Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires that the cost of postretirement benefits other than pensions be recognized on an accrual basis as employees perform services to earn such benefits. Like most companies, the Corporation previously expensed such postretirement benefits, which include retiree medical and death benefits, on a pay-as-you-go basis. The Corporation recognized the transition obligation related to this item during first quarter 1993 as a cumulative effect of a change in accounting principle, resulting in a one-time non-cash charge of $17.5 million before taxes, or $11.6 million after taxes. This charge represents the discounted present value of expected future retiree medical and death benefits attributed to employees' service rendered prior to 1993. The additional cost for these benefits on an annual basis is approximately $.6 million more than the pay-as-you-go cost. Effective December 31, 1993, the Corporation adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires employers to recognize a liability for postemployment benefits under certain circumstances. The Corporation's short-term and long-term disability benefits, survivor income benefits, and certain other benefits are governed by this statement. The Corporation recognized this item during fourth quarter 1993 as a cumulative effect of a change in accounting principle, resulting in a one-time non-cash charge of $2.0 million before taxes ($1.3 million after taxes). The annual impact of the Corporation's adoption of SFAS No. 112 in future years is not expected to be significant to First American's consolidated financial condition or results of operations. INCOME TAXES The Corporation's income tax expense was $57.4 million in 1993, an increase of $39.9 million from 1992 income tax expense of $17.5 million. The major factor resulting in the increase was the Corporation's higher taxable income. Net deferred tax asset balances carried on the consolidated balance sheets amounted to $38.2 million at December 31, 1993, and $47.3 million at December 31, 1992. The extent to which deferred tax assets may continue to be recognized in the future is discussed below. Effective January 1, 1993, the Corporation adopted SFAS No. 109, "Accounting for Income Taxes," which requires a change from the deferred method (an income statement approach) of accounting for income taxes as required by Accounting Principles Bulletin No. 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets or liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Additionally, the effect on deferred taxes of future changes in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance, if necessary, to an amount that more likely than not will be realized. The cumulative effect of the initial adoption of SFAS No. 109 was to increase net income by $12.8 million or $.50 per share in the first quarter of 1993. The statement was applied without restating prior years' consolidated financial statements. SFAS No. 109 requires that the tax benefit of deductible temporary differences be recorded as an asset to the extent that management estimates that such assets "more likely than not" will be realized. In accordance with SFAS No. 109, the realization of tax benefits of deductible temporary differences is based, in part, on whether the Corporation has sufficient taxable income within the carryback period and management's expectation of taxable income in the carryforward period permitted by the tax law to allow for utilization of the deductible amounts. As of January 1, 1993, the Corporation had net deductible temporary differences of $165.5 million. For Federal tax purposes, taxable income in the carryback and estimates of taxable income in the carryforward periods were expected to be sufficient to utilize this amount; however, for state tax purposes, Tennessee law does not permit carrybacks and thus a valuation allowance of $3.9 million at January 1, 1993, was established to address management's estimate of the deductible temporary differences which did not meet the realization criteria. The net change in the total valuation allowance for the twelve months ended December 31, 1993, was a net decrease of $2.6 million, composed of an increase related to the adoption of SFAS No. 106 of $1.1 million, an increase related to the adoption of SFAS No. 112 of $.1 million, and a decrease of $3.8 million related to continuing operations. The valuation allowance at December 31, 1993, was $1.3 million. During third quarter 1993, the Omnibus Budget Reconciliation Act of 1993 was signed into law. The new law includes an increase in the Federal corporate income tax rate from 34% to 35% effective January 1, 1993. The impact of the rate change as of the enactment date was an increase in current tax expense of $.5 million and a decrease in deferred tax expense of $1.7 million (as a result of the effect on deferred tax assets), resulting in a net tax reduction of $1.2 million, which was included in income tax expense in the third quarter. The increased Federal income tax rate of 35% from 34% applied to 1993 operations (income before income tax expense and cumulative effect of changes in accounting principles) resulted in an additional $1.5 million of income tax expense. For additional information on income taxes of the Corporation and the status of Internal Revenue Service examinations, see note 13 to the consolidated financial statements. FINANCIAL CONDITION BALANCE SHEET SUMMARY At December 31, 1993, the Corporation's total assets were $7.19 billion, a 7% increase ($472.0 million) from $6.72 billion at year-end 1992. Total securities were up $62.9 million (3%) to $2.05 billion at December 31, 1993, from $1.99 billion at December 31, 1992. Loans, net of unearned discount and net deferred loan fees, increased $640.8 million (17%) to $4.34 billion at December 31, 1993, from $3.70 billion at December 31, 1992, due to increased loan demand and the acquisition of FANBKY ($166.9 million of loans at December 31, 1993). Other earning assets (primarily Federal funds sold and securities purchased under agreements to resell, time deposits with other banks and trading account securities) decreased $61.3 million. Total deposits increased $168.7 million (3%) to $5.69 billion at December 31, 1993, from $5.52 billion a year earlier, primarily due to additional deposits from the acquisition of FANBKY ($184.3 million of deposits at December 31, 1993). Approximately $5.36 billion or 94% of total deposits were core deposits, which are defined as total deposits excluding certificates of deposit $100,000 and over and foreign deposits. This represents a $205.0 million increase in core deposits in 1993 from year-end 1992, with the largest growth in demand deposits (up $106.3 million), NOW accounts (up $77.5 million) and money market accounts (up $55.8 million). Short-term borrowings, which include Federal funds purchased and securities sold under agreements to repurchase and other short-term borrowings, increased $148.2 million or 24% and long-term debt increased $49.0 million as a result of the Corporation's $50.0 million subordinated note offering. A detailed discussion of capital, assets, and liabilities follows. CAPITAL POSITION Shareholders' equity amounted to $581.7 million or 8.09% of total assets at December 31, 1993, which is an increase of $113.4 million or 24% from the year-end 1992 balance of $468.3 million or 6.97% of total assets. This increase primarily reflects the Corporation's 1993 earnings retention of $87.5 million. Also, the issuance of approximately 191,000 shares of common stock in connection with the Corporation's employee benefit plans increased equity $3.4 million. Additionally, effective December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." As a result, unrealized gains and losses on securities available for sale are recorded as a separate component of shareholders' equity, net of tax. At December 31, 1993, total net unrealized appreciation on securities available for sale amounted to $36.1 million, resulting in an increase in equity of $22.0 million, net of taxes. There was no impact on the Corporation's consolidated net income as a result of the adoption of SFAS No. 115. The Corporation's total risk-based capital ratio, a regulatory ratio which is discussed below, increased 140 basis points to 13.16% at December 31, 1993, as compared to 11.76% at year-end 1992. The increase was partially attributable to the issuance of $50 million of subordinated debt (a component of total risk-based capital) in second quarter 1993 and to increases in common shareholders' equity. The Corporation's capital position and ratios for the past five years are presented in Table 7. AVERAGE EQUITY TO AVERAGE ASSETS (Graph) The Federal Reserve Board and the OCC risk-based capital guidelines and regulations for bank holding companies and national banks require minimum levels of capital based upon applying various risk ratings to defined categories of assets and to certain off- balance-sheet items. Under the risk-based capital requirements, total capital consists of Tier I capital (essentially realized common equity less intangible assets) and Tier II capital (essentially qualifying long-term debt and a portion of the allowance for possible loan losses). Assets by type, or category, are assigned risk-weights of 0% to 100%, depending on regulatory assigned levels of credit risk associated with such assets. Off-balance-sheet items are considered in the calculation of risk-adjusted assets through conversion factors established by regulators. These items are assigned the same risk-weighting as on-balance-sheet items and are included in total risk-adjusted assets. At December 31, 1993, these regulations required bank holding companies and national banks to maintain certain minimum capital ratios. As summarized in Table 8, the Corporation's ratios exceed the current regulatory minimum requirements. The Tier I, total risk-based capital, and leverage ratios for FANB were 10.28%, 11.55%, and 7.25%, respectively, at December 31, 1993. For FANBKY, these ratios were 18.66%, 19.89%, and 9.32%, respectively. All risk-based capital ratios are computed using realized equity (total shareholders' equity less net unrealized gains on securities available for sale, net of tax) and exclude the 7 5/8% debentures scheduled for redemption January 31, 1994 (see "Other Borrowed Funds" section). All of these ratios are above the current regulatory minimum requirements. TABLE 7: CAPITAL ANALYSIS DATA (Balance sheet items represented by averages unless indicated otherwise) Risk-based capital ratios are computed using realized equity (total shareholders' equity less net unrealized gains on securities available for sale, net of tax) and exclude the 7 5/8% debentures scheduled for redemption January 31, 1994. N/A - Not available, as regulatory guidelines were introduced in 1990. TABLE 8: RISK-BASED CAPITAL * Risk-based capital ratios are computed using realized equity (total shareholders' equity less net unrealized gains on securities available for sale, net of tax) and exclude the 7 5/8% debentures scheduled for redemption January 31, 1994. ASSET/LIABILITY MANAGEMENT AND LIQUIDITY The function of asset/liability management is to manage the mix of various balance sheet lending and funding factors which could result in interest rate risk exposure to the Corporation. Through this process, the Corporation seeks to maximize net interest income within liquidity, capital and interest rate risk constraints established by management. Asset/liability management is overseen by the Corporation's asset/liability committee, which is comprised of senior executives of the Corporation. The committee reviews the Corporation's balance sheet, net interest income performance, and forecasts of net interest income under alternative simulated interest rate environments in order to identify issues, risks, and opportunities relative to balance sheet and margin strategies. Additionally, the committee formulates related policies and guidelines and monitors ongoing compliance with these policies and guidelines. Interest rate sensitivity management focuses on monitoring the earnings risk associated with changes in the external interest rate environment and the resulting impact on the Corporation. Through the use of an earnings simulation model, the asset/liability committee evaluates the impact of various possible interest rate scenarios on net interest income and identifies strategies for achieving the optimum mix of assets and liabilities to achieve the goals of stability and growth in earnings. The Corporation's objective is that net income will not be impacted more than 5% from results simulated for the interest rate environment that the Corporation considers most likely, assuming that interest rates do not vary more than 150 basis points from the most likely scenario within the next twelve months. One measurement of interest rate risk is the volume of assets and liabilities subject to repricing over a series of future time periods. Table 9 presents the Corporation's interest rate sensitivity at both year-end 1993 and 1992 and reflects that the Corporation is positioned more favorably for a lower interest rate environment than for a higher interest rate environment. The Corporation's ratio of net risk-sensitive assets or liabilities to earning assets was a cumulative net liability of 15.6% over a one-year repricing period (1992 cumulative one-year repricing amount was a cumulative 16.6%). This means that the amount of liabilities repricing in 1994 in excess of the amount of assets repricing in 1994, net of related off-balance-sheet hedging activities, was 15.6% of all earning assets at year-end 1993. For interest rate sensitivity purposes, the Corporation classifies savings, NOW, and money market deposits, which in aggregate amount to $2.66 billion or 41% of earning assets, as immediately rate-sensitive since none of these deposits carry contractual rate guarantees or early withdrawal penalties. Management believes that rates paid on these deposits will not rise or fall in tandem with or to the extent that external interest rates rise or fall. Based on the current interest rate sensitivity position, management believes it is meeting its objectives of interest rate sensitivity management. The Corporation utilizes off-balance-sheet ("derivative") products in managing its interest rate sensitivity. Derivatives reduce the Corporation's vulnerability to changes in the interest rate environment. All off-balance-sheet hedging vehicles bear a correlation to an asset or liability or to a group of assets or liabilities on the balance sheet. By using derivative products such as interest rate swaps and futures contracts, the derivative product offsets fluctuations in net interest income from the otherwise unhedged position. In other words, if net interest income from the otherwise unhedged position changes (increases or decreases) by a given amount, the derivative product should result in close to the opposite result, making the combined amount (otherwise unhedged position impact plus the derivative product position impact) essentially unchanged. Included within net interest income for 1993 is a derivative product net expense of $8.3 million ($.8 million for 1992). Derivative products have enabled the Corporation to improve its balance between interest sensitive assets and interest sensitive liabilities by reducing interest rate risk, while continuing to meet lending and deposit needs of its customers. Credit risk exposure due to off-balance-sheet hedging is closely monitored, and counterparts to these contracts are selected on the basis of their credit worthiness, as well as their market-making ability. The Corporation does not use derivative products for speculative purposes. Derivatives that the Corporation utilizes include interest rate swaps, interest rate floors, futures contracts and basis swaps. Interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts. Interest rate floors represent obligations by counterparts whereby the Corporation receives payment when the underlying rate index falls below a stipulated level. The Corporation pays a fee for interest rate floors. Futures contracts are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery at a specified future date of a specified financial instrument, at a specified price or yield. Basis swaps represent interest rate contracts which are based on different market interest rate indices and are a protection against adverse changes in the shape ("steepness" or "flatness") of the interest rate yield curve. In conjunction with managing interest rate sensitivity, at December 31, 1993, the Corporation was the fixed-rate payor on $900 million of interest rate swaps, of which $450 million mature within one year and $450 million mature thereafter. Through these swaps, the Corporation receives variable payments based on the then current three-month LIBOR rate. The Corporation also had a $300 million short position of Eurodollar futures contracts at December 31, 1993, which in aggregate essentially simulated a $100 million one-year interest rate swap. At December 31, 1992, the Corporation was the fixed rate payor on $550 million of interest rate swaps, of which $100 million matured in 1993 ($450 million beyond 1993), and was receiving payments on a $200 million interest rate floor (purchased in 1991) which matured in 1993. Amounts for interest rate swaps and floors as presented in Table 9 represent the net effect of the swaps and the floor in each future time period. TABLE 9: INTEREST RATE SENSITIVITY ANALYSIS Each column includes earning assets and interest-bearing liabilities that are estimated to mature or reprice within the respective time frame. All floating rate balance sheet items are included as "within one month" regardless of maturity. Non-earning assets (cash and due from banks, premises and equipment, foreclosed properties, and other assets), non-interest-bearing liabilities (demand deposits and other liabilities) and shareholders' equity are considered to be non interest sensitive for purposes of this presentation and thus are not included in the above table. In the table, all NOW, money market, and savings accounts are reflected as interest sensitive within one month. NOW accounts, savings, and certain money market accounts are not totally interest sensitive in all interest rate environments. If NOW and regular savings accounts were not considered interest sensitive, the one year cumulative net asset interest sensitive gap position and percent of earning assets would be $201.0 million and 3.07%, respectively, for 1993 as compared to a net asset interest sensitive gap position of $129.4 million and 2.20%, respectively, for 1992. Liquidity management consists of maintaining sufficient cash levels (including the ability to access markets to raise additional cash) to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, money market instruments, and securities that mature within one year. At December 31, 1993, the carrying value of First American's liquid assets amounted to $883.7 million or 13% of earning assets, which compares with $1.64 billion or 28% at December 31, 1992. Additionally, the Corporation has securities available for sale maturing after one year which can be sold to meet liquidity needs. The carrying value of securities available for sale which mature after one year increased to $1.25 billion at December 31, 1993, from $439.6 million at December 31, 1992, as the Corporation had more securities classified as securities available for sale at year-end 1993 than at year-end 1992. Liquidity is reinforced by maintaining a relatively stable funding base, which is achieved by diversifying funding sources, extending the contractual maturity of liabilities, and limiting corporate reliance on volatile short-term purchased funds. The Corporation's policy is to fund earning assets to the maximum extent possible with core deposits, which provide the Corporation with a sizable source of relatively stable and low-cost funds. Core deposits were $5.36 billion or 94% of total deposits at December 31, 1993, compared with $5.16 billion or 93% at December 31, 1992. In order to provide additional liquidity and flexibility, the Corporation issued $50 million of subordinated debentures in second quarter 1993 under a $100 million shelf registration statement. Additionally, the Corporation has a $50 million revolving credit agreement expiring March 31, 1994. The Corporation had no borrowings outstanding under this agreement at December 31, 1993, or during the year ended December 31, 1993. Management believes the Corporation has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. ASSET QUALITY Nonperforming assets of the Corporation, which include non-accrual and restructured loans and foreclosed properties, showed significant improvement during 1993. Nonperforming assets were $40.5 million at December 31, 1993, a $48.5 million or 54% decline from $89.0 million at December 31, 1992. The 1993 decline in nonperforming assets follows a 1992 decrease of $53.2 million or 37% from $142.2 million at December 31, 1991, resulting in a two-year decline in nonperforming assets of $101.7 million. The ratio of nonperforming assets to total loans and foreclosed properties was .93% at December 31, 1993, compared with 2.39% a year earlier. The 1993 decrease is primarily the result of a $32.1 million decline in commercial non-accrual loans combined with a $9.8 million decrease in foreclosed properties. The improvement in asset quality resulted from the continuation of the Corporation's efforts to improve overall asset quality, to collect the full balance due on nonperforming assets, and to reduce the level of loans criticized or classified by the Corporation's internal loan grading and review process. During the past two years the Corporation has, among other things, reviewed and taken measures to strengthen lending, credit review, and credit administration procedures, including problem loan identification, insider lending procedures, non-accrual loan policies, the real estate appraisal process, credit concentration policy and procedures, and loan loss methodology. Nonperforming loans represent $21.7 million or 53% of nonperforming assets at December 31, 1993, compared with $60.3 million or 68% at year-end 1992. Table 10 summarizes changes in nonperforming assets for each of the past five years and presents the composition of the nonperforming asset balance at the end of each year. In addition, the accompanying graph reflects the level of nonperforming assets at the end of each of the last five years. TABLE 10: NONPERFORMING ASSET ACTIVITY NONPERFORMING ASSETS GRAPH Other potential problem loans consist of loans that are currently not considered nonperforming but where information about possible credit problems has caused the Corporation to have doubts as to the ability of the borrowers to comply fully with present repayment terms. At December 31, 1993, loans totalling approximately $75.1 million, while not considered nonperforming loans, were classified in the Corporation's internal loan grading system as substandard or worse, compared with $133.6 million of such loans at December 31, 1992. Depending on the economy and other factors, these loans and others which may not be presently identified could become future nonperforming assets. The following table recaps loans, foreclosed properties, and nonperforming assets by asset category. TABLE 11: LOANS, FORECLOSED PROPERTIES, AND NONPERFORMING ASSETS LOANS Loans represent the Corporation's largest component of earning assets and, accordingly, are the Corporation's primary source of income. Total outstanding loans averaged $3.87 billion during 1993, compared with $3.68 billion in 1992. During 1993, average loans increased 5% or $188.7 million, which is primarily attributable to increased loan demand resulting from lower interest rates in 1993 and from the acquisition of FANBKY. A trend of consecutive quarterly increases in average loans emerged during 1993 and gained momentum during the last half of the year. Average loans grew $328.2 million during fourth quarter 1993, of which $164.4 million was due to the FANBKY acquisition. Exclusive of loan growth attributable to the FANBKY acquisition, average loans grew 17% on an annualized basis during the fourth quarter of 1993. Management currently expects loan growth to continue during 1994, although not necessarily at the same rate experienced during the last quarter of 1993. The Corporation's loan portfolio is essentially composed of three major categories: commercial, consumer, and commercial real estate loans, each of which is further discussed below. Table 12 presents the loan portfolio by category for the past five years and Table 13 presents the maturities of loans outstanding at December 31, 1993, exclusive of consumer loans. Exclusive of consumer loans, loans due after one year with predetermined interest rates amounted to $614.3 million at December 31, 1993, and loans due after one year with floating or adjustable rates amounted to $549.9 million at December 31, 1993. TABLE 12: LOAN CATEGORIES TABLE 13: MATURITIES OF LOANS, EXCLUSIVE OF CONSUMER LOANS Commercial loans increased $211.7 million (12%) to $1.95 billion at December 31, 1993, from $1.74 billion at December 31, 1992, as a result of additional loan demand, primarily in the fourth quarter of 1993. At December 31, 1993 and 1992, commercial loans represented 45% and 47% of total loans, respectively. Consumer loans, which consist of consumer amortizing mortgages and other consumer loans, totalled $1.99 billion at December 31, 1993, as compared with $1.54 billion at December 31, 1992, an increase of $448.0 million or 29%. The fourth quarter 1993 acquisition of FANKBY added $166.7 million of consumer loans at December 31, 1993. The growth in consumer loans accounted for 71% of the total loan growth for the year. Consumer amortizing mortgages increased $373.9 million (58%) in 1993 as a result of the FANBKY acquisition, additional residential mortgage lending demand, and nationwide refinancing of residential mortgages resulting primarily from the lower interest rate environment for such mortgages. Other consumer loans increased $74.1 million or 8% in 1993, primarily due to an increase in installment loan demand. Consumer loans were 46% of total loans at December 31, 1993, compared with 41% at year-end 1992. Commercial real estate loans, which include real estate construction and real estate commercial mortgages, totalled $409.4 million at December 31, 1993, compared with $435.9 million at year-end 1992, a decrease of $26.5 million or 6%. This decline in commercial real estate loans reflects reduced loan demand and selective loan underwriting. Commercial real estate loans represented 9% of total loans at December 31, 1993, compared with 12% at December 31, 1992. Essentially all of the Corporation's loans are to borrowers residing in or doing business in Tennessee and adjacent states. The Corporation seeks to exercise prudent risk management in lending, including diversification by loan category and by industry segment, as well as by identification of credit risks. The Corporation's lending activities are performed by relationship managers organized by broad industry classification. The Corporation's ten largest outstanding loan relationships at December 31, 1993, amounted to $225.7 million compared to $177.0 million at year-end 1992. The increase from 1992 is primarily due to higher utilization of credit commitments. At December 31, 1993, the Corporation had no loans classified as highly leveraged transactions, as defined by banking regulations. Additionally, the Corporation had essentially no international loans outstanding at December 31, 1993. Concentrations of credits (both funded and unfunded) by major Standard Industrial Classification codes for 1993 and 1992 are presented in note 4 to the consolidated financial statements. Also, note 16 to the consolidated financial statements discusses off-balance-sheet loan commitments and risks. SECURITIES/MONEY MARKET INSTRUMENTS The Corporation's securities portfolio amounted to $2.05 billion at December 31, 1993, compared to $1.99 billion at December 31, 1992. Effective December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires investments in equity securities that have a readily determinable fair value and investments in debt securities to be classified into three categories, as follows: held to maturity debt securities, which are reported at amortized cost; trading securities, which are reported at fair value with unrealized gains and losses included in earnings; and securities available for sale, which are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of tax, as a separate component of shareholders' equity. In conjunction with the adoption of this standard on December 31, 1993, the Corporation reclassified $368.6 million of securities to the available for sale classification from the former investment, now held to maturity, category. At December 31, 1993, the securities portfolio consisted of $657.8 million of securities held to maturity (at amortized cost) and $1,393.0 million of securities available for sale (at market value). Unrealized net appreciation on the total securities available for sale portfolio amounted to $36.1 million at December 31, 1993, resulting in an increase in equity of $22.0 million, net of taxes. There was no impact on the Corporation's consolidated net income as a result of the adoption of SFAS No. 115. Securities available for sale and money market instruments (time deposits with other banks, Federal funds sold and securities purchased under agreements to resell, and trading account securities) are managed to provide liquidity, to balance interest rate risk, and to produce interest income. Management of the securities portfolio and money market instruments allows for diversification of interest income, diversification of credit risk, and satisfaction of legal and other pledging requirements. The portfolio is managed so that marketable securities or money market instruments mature periodically to enable the Corporation to satisfy potential customer needs for banking services. Purchases of securities (and sales from the securities available for sale portfolio) are made after taking into consideration previously determined corporate objectives, as well as the Corporation's ability to meet customer demands on a current basis. COMPOSITION OF SECURITIES AND MONEY MARKET INSTRUMENTS GRAPH Average securities and money market instruments amounted to $2.31 billion during 1993, an increase of $97.4 million or 4% from the 1992 average. Average securities increased $324.2 million (18%) to $2.12 billion in 1993 from $1.80 billion in 1992. Average money market instruments decreased $226.8 million (54%) to $191.5 million in 1993 from $418.3 million in 1992. Money market instruments yielded 3.26% in 1993, a decline of 52 basis points from 3.78% in 1992, reflecting the generally lower interest rate environment. The average yield for the total securities portfolio was 6.48% in 1993 compared with 7.42% in 1992. The average estimated maturity of the total securities portfolio was 4.9 years at December 31, 1993 (4.4 years for securities held to maturity portfolio and 5.1 years for securities available for sale portfolio), compared with 3.2 years at year-end 1992 (3.2 years for securities held to maturity portfolio and 3.3 years for securities available for sale portfolio). The expected maturity for government and corporate securities is the stated maturity, and the expected maturity for mortgage-backed securities is based on current estimates of average maturities. The following table presents the estimated average maturity and weighted average yields for securities held to maturity and securities available for sale at December 31, 1993. TABLE 14: SECURITY PORTFOLIO ANALYSIS * Yields presented on a taxable equivalent basis, based on the statutory Federal income tax rate, adjusted for applicable State income taxes net of the related Federal tax benefit. Included in U.S. Treasury and other U.S. Government agencies and corporations were mortgage-backed securities with carrying values totalling $1,497.2 million at December 31, 1993, compared with $1,203.0 million at December 31, 1992. All of these mortgage-backed securities were issued or guaranteed by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Corporation (Freddie Mac). Also included in other debt securities were mortgage-backed securities with carrying values of $22.6 million at December 31, 1993, compared with $35.5 million at December 31, 1992. On December 31, 1993, mortgage-backed security holdings included $139.1 million Ginnie Mae adjustable-rate mortgage pass-through securities ($88.8 million at December 31, 1992) and $289.5 million floating rate mortgage-backed securities (none at December 31, 1992). At both dates, essentially all other mortgage-backed securities consisted of Planned Amortization Class (PAC) collateralized mortgage obligations (CMOs), which were purchased because of their high credit quality and relatively certain average lives. At December 31, 1993, the estimated market value of the total securities portfolio exceeded amortized cost by $49.0 million (total unrealized gains of $50.9 million less total unrealized losses of $1.9 million). Approximately $36.1 million of net unrealized appreciation at December 31, 1993, is attributable to the securities available for sale portfolio, and in accordance with SFAS No. 115 is reflected in the carrying value of such securities. At December 31, 1992, the estimated market value of the total securities portfolio exceeded carrying value by $41.0 million (total unrealized gains of $43.1 million less total unrealized losses of $2.1 million). See note 3 to the consolidated financial statements for details of unrealized gross gains and losses for the securities held to maturity portfolio and the securities available for sale portfolio. At year-end 1993, approximately $2.1 million of the Corporation's securities were unrated, and none were below investment grade. During 1993, the Corporation made securities purchases totalling $2.05 billion, of which $461.3 million were for the securities held to maturity portfolio and $1,593.4 million were for the securities available for sale portfolio. Securities purchases were directed toward replacing maturing securities and utilizing excess corporate liquidity so as to improve net interest income. The Corporation made aggregate sales of $858.6 million, all of which were from the available for sale portfolio. Such sales resulted in a $2.0 million net realized loss in 1993 ($1.7 million gains less $3.7 million losses) compared with a net realized loss of $3.0 million in 1992 ($3.3 million gains less $6.3 million losses). Security sales were made in order to better structure the portfolio for future profitability and liquidity. See note 3 to the consolidated financial statements for a detail of realized gross gains and losses by category of securities. DEPOSITS Total deposits, which are the Corporation's largest source of funding, amounted to $5.69 billion at December 31, 1993, compared with $5.52 billion at December 31, 1992, an increase of $168.7 million or 3%. First American's core deposit base, which represents total deposits excluding certificates of deposit $100,000 and over and foreign deposits, totalled $5.36 billion or 94% of total deposits at December 31, 1993, as compared with $5.16 billion or 93% of total deposits at the end of the prior year. Core deposits provide a stable, low-cost source of funds for the Corporation. A primary factor contributing to the deposit growth was the fourth quarter 1993 acquisition of FANBKY, which had $184.3 million of core deposits at December 31, 1993. Increases in 1993 versus 1992 occurred in non-interest-bearing demand deposits of $106.3 million (9%), NOW accounts of $77.5 million (11%), money market accounts of $55.8 million (4%), and regular savings of $33.0 million (8%). These increases were partially offset by a $52.6 million (4%) decline in certificates of deposit under $100,000, as lower interest rates became less attractive to customers. The average rate paid on total interest-bearing deposits was 3.16% for 1993, 83 basis points lower than the average rate in 1992, reflecting the lower interest rate environment in 1993 and the change in deposit mix toward more liquid accounts. OTHER BORROWED FUNDS In addition to deposits, other sources of funding utilized by the Corporation include short-term borrowings and long-term debt. Total short-term borrowings include Federal funds purchased from correspondent banks, securities sold under agreements to repurchase (repurchase agreements), and other short-term borrowings, principally funds due to the U.S. Treasury Department in tax and loan accounts. Federal funds purchased and securities sold under repurchase agreements increased $75.9 million or 13% to $664.8 million at December 31, 1993. The net funds purchased position (Federal funds purchased and repurchase agreements less Federal funds sold and securities purchased under agreements to resell) at year-end 1993 was $520.0 million, up from $493.5 million at year-end 1992. The average rate paid on Federal funds purchased and securities sold under repurchase agreements for 1993 was 2.64%, 50 basis points less than the 3.14% average rate paid in 1992. Other short-term borrowings amounted to $91.9 million at December 31, 1993, compared with $19.6 million at December 31, 1992. The increase from year-end 1992 is primarily due to a higher U.S. Treasury tax and loan balance outstanding. The average rate paid on other short-term borrowings was 3.19% in 1993, a decrease of 63 basis points from 3.82% in 1992. At December 31, 1993 and 1992, long-term debt totalled $65.9 million and $16.9 million, respectively. During first quarter, the Corporation filed a shelf registration statement with the Securities and Exchange Commission to issue $100 million of subordinated debt securities. The Corporation issued $50 million of subordinated notes under the shelf registration statement during second quarter 1993. The notes mature in 2003 and bear interest at a face amount of 6.875%, payable semi-annually. The notes were sold at a discount, resulting in an effective interest rate of 6.965%. The Corporation used a portion of the proceeds ($27.5 million) from the subordinated notes issued for the acquisition of FANBKY. The balance of such proceeds is available for other acquisitions and for general corporate purposes. Notification has been given to holders of the Corporation's 7 5/8% debentures, due 2002, that the Corporation will redeem these debentures on January 31, 1994, at a price of 101.22%. At December 31, 1993, there were approximately $13.6 million of these debentures outstanding. The average rate paid on long-term borrowings was 7.48% in 1993 compared to 7.69% in 1992. The long-term debt to equity ratio was 11.34% at December 31, 1993, compared to 3.61% at December 31, 1992, which is reflective of the additional debt issued during 1993. TABLE 16: CONSOLIDATED QUARTERLY AVERAGE BALANCE SHEETS AND TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES Rates and income/expense amounts are presented on a fully taxable equivalent basis based on the statutory Federal income tax rates. Loan fees considered an integral part of the lending function are included in rates and related interest categories. TABLE 16: CONSOLIDATED QUARTERLY AVERAGE BALANCE SHEETS AND TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES Rates and income/expense amounts are presented on a fully taxable equivalent basis based on the statutory Federal income tax rates. Loan fees considered an integral part of the lending function are included in rates and related interest categories. TABLE 17: QUARTERLY FINANCIAL DATA Adjusted to a taxable equivalent basis based on the statutory Federal income tax rates, adjusted for applicable state income taxes net of the related Federal tax benefit. Calculated based on income before cumulative effect of changes in accounting principles. EARNINGS PERFORMANCE FOR 1992 VERSUS 1991 The previous discussion has concentrated on the Corporation's 1993 results of operations and financial condition. The following discussion recaps the Corporation's results of operations for 1992 compared to 1991. Net income for 1992 was $42.0 million or $1.74 per share as compared with $16.9 million or $.73 per share for 1991. The earnings improvement was primarily attributable to higher taxable equivalent basis net interest income ($255.8 million in 1992 compared to $223.1 million in 1991) and a lower loan loss provision ($38.5 million in 1992 versus $51.6 million in 1991). Net interest income (computed on a taxable equivalent basis) in 1992 was $255.8 million, an increase of $32.7 million or 15% from 1991. This increase was primarily due to an increase in the volume of earning assets and a higher net interest spread. Average earning assets increased 4% to $5.90 billion in 1992 from $5.65 billion in 1991, while the net interest spread on earning assets increased 58 basis points to 3.70%. The net interest margin increased to 4.34% in 1992 from 3.95% in 1991. The net interest spread and margin improvements in 1992 generally reflect a lower and more favorable interest rate environment for the Corporation. During 1992, the Corporation had a higher volume of interest-bearing liabilities repricing at a lower interest rate than earning assets repricing; thus, net interest income benefited from declining interest rates. The 1992 provision for loan losses was $38.5 million, a decrease of $13.1 million (25%) from the 1991 provision of $51.6 million. The lower provision for loan losses resulted primarily from improved asset quality as evidenced by a $29.2 million decrease in nonperforming loans ($60.3 million at December 31, 1992, versus $89.5 million at year-end 1991) and a $22.1 million decline in net charge-offs ($38.4 million in 1992 versus $60.5 million in 1991). Total non-interest income in 1992 was $78.6 million compared with $84.7 million in 1991. Exclusive of the gain on sales of branch offices and gains and losses on the sale of securities ($3.0 million net loss in 1992 and $3.7 million net gain in 1991), non-interest income increased $3.3 million or 4% to $81.0 million in 1992 from $77.7 million in 1991. This increase resulted primarily from higher service charge income on deposit accounts and higher commissions and fees on fiduciary activities. Total non-interest expense in 1992 was $232.4 million as compared with $225.9 million in 1991. During 1992, salaries and employee benefits declined $.7 million from 1991, reflective of a 2% decrease in the number of full-time equivalent employees since December 31, 1991. The impact of the decline in the number of employees was partially offset by merit increases and by a $1.9 million charge associated with an early retirement program involving six officers of the Corporation. Non-personnel related expense for 1992 increased $7.2 million or 6% from 1991. This increase was primarily due to increases in systems and processing expense ($6.7 million increase) and "other expenses" ($4.3 million increase), partially offset by a decline in foreclosed properties expense ($3.2 million decrease). The Corporation's income tax expense was $17.5 million in 1992, an increase of $10.7 million over the 1991 income tax expense of $6.8 million. The major factor for the increase was the Corporation's higher taxable income, along with a reduction in the proportionate amount of tax-exempt revenue in 1992 as compared with 1991. TABLE 18: RATE-VOLUME RECAP - 1992 FROM 1991 Amounts are adjusted to a fully taxable equivalent basis, based on the statutory Federal income tax rate, adjusted for applicable state income taxes net of the related Federal tax benefit. The effect of volume changes is computed by multiplying the change in volume for each item by the prior year rate. The effect of rate changes is computed by multiplying the change in rate by the prior year volume. Rate/volume changes are computed by multiplying the change in volume by the change in rate and are included in the effect on income of rate changes. ITEM 8: ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and schedule listed in Item 14(a)(1) and (2) are included in this Report beginning on Page 68 and are incorporated in this Item 8 by reference. The table "Quarterly Financial Data" on page 54 hereof, "Consolidated Year-End Balance Sheets" on page 105 hereof, and "Consolidated Average Balance Sheets and Taxable Equivalent Income/Expense and Yields/Rates" on pages 101-104 hereof are incorporated in this Item 8 by reference. ITEM 9: ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10: ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Executive Officers of the Registrant The following is a list of the Corporation's executive officers, their ages and their positions and offices during the last five years (listed alphabetically). Officer Age Business Experience - Past 5 years - ------- --- ---------------------------------- James C. Armistead, Jr. 46 Since June 1992, Mr. Armistead has served as Executive Vice President-Middle Market/Corporate Banking of FANB. From August 1991 until June 1992 he served as a Senior Vice President of FANB. From 1984 until April 1991 he served as Senior Executive Vice President and head of the banking division of Metropolitan Federal Savings and Loan Association in Nashville, which in 1991 changed its name to Metropolitan Federal Bank, F.S.B. ("Metropolitan"). In April 1991, Metropolitan was declared insolvent by the Office of Thrift Supervision ("OTS") and placed in receivership with the Resolution Trust Corporation appointed as receiver. The assets of Metropolitan were transferred to Metropolitan Federal Savings and Loan Association, F.A., a new thrift institution created by the OTS. From April 1991 until August 1991 Mr. Armistead was an officer of Metropolitan Federal Savings and Loan Association, F.A. Dennis C. Bottorff 49 Mr. Bottorff serves as President and Chief Executive Officer of the Corporation and as Chief Executive Officer of FANB. From November 1991 until January, 1994, Mr. Bottorff also served as President of FANB. From September 1990 until November 1991, he was President and Chief Operating Officer of C&S/Sovran Corporation. From April 1989 until September 1990, he was President of Sovran Financial Corp., from November 1987 until April 1989, he was Vice Chairman of Sovran Financial Corp. and from April 1988 until September 1990 he was Chief Operating Officer of Sovran Financial Corp. John W. Boyle, Jr. 53 Mr. Boyle is President, Corporate Bank of FANB and has served in such capacity since January 1992. From 1990 to January 1992, he was group executive vice president of C&S/Sovran Corporation, U.S. Banking Group. From 1984 to 1990, he was Executive Vice President, National/ Corporate Banking for Sovran Bank, N.A., Richmond, Virginia. R. Booth Chapman 53 Since September 1991 Mr. Chapman has served as Executive Vice President - Independent Loan Review of FANB. From December 1990 to September 1991, he was Senior Vice President, Corporate Special Assets, for C&S/Sovran Corporation. From 1985 to 1990, he was Senior Vice President and Manager of Real Estate Lending of Middle Tennessee for Sovran Bank of Tennessee. Emery F. Hill 50 Mr. Hill is Executive Vice President - Operations and Technology of FANB and has served in this position since March 1992. From 1981 through 1990 he served in a similar position with Sovran Bank of Tennessee and also served as Group Executive Officer of Information Management with C&S/Sovran Corporation from 1990 to September 1991 and with NationsBank from September 1991 until March 1992. Dennis J. Hooks 37 Mr. Hooks is Executive Vice President - Marketing of FANB and has served in this position since April 1992. From July 1987 until April 1992, he was Director of Marketing of First Tennessee National Bank. Rufus B. King 48 Mr. King is Executive Vice President and Chief Credit Officer of FANB and has served in such position since July 1989. From April 1987 until July 1989 he served as Vice Chairman of FANB - Knoxville, Tennessee. John W. Logan 51 Mr. Logan is Executive Vice President - Investment Division of FANB. From August 1987 until 1991 Mr. Logan was Executive Vice President of First American Corporation. Robert A. McCabe, Jr. 43 Mr. McCabe is President - First American Enterprises and Vice Chairman of the Board of Directors of the Corporation and FANB. From January 1992 until January 1994, he served as President, General Banking of FANB. From March 1991 until January 1992 he served as President, Corporate Banking of FANB. From April 1987 until March 1991, Mr. McCabe served as President and Chief Operating Officer of FANB - Knoxville, Tennessee Robert E. McNeilly, Jr. 61 Mr. McNeilly is President of FATC, and has served in this position since January 1992. From 1986 through 1991 he served as Chairman of the Board of Directors of FANB-Nashville. Dale W. Polley 44 Mr. Polley serves as Vice Chairman of the Board of Directors and Principal Financial Officer of the Corporation and FANB and also serves as President of FANB. From December 1991 until January 1994, he served as Vice Chairman and Chief Administrative Officer of the Corporation and FANB and since November 1992, also served as Principal Financial Officer of the Corporation and FANB. From 1990 until December 1991, he was group executive vice president and treasurer of C&S/Sovran Corporation. From 1988 until 1990, he was Senior Executive Vice President, Chief Financial Officer and Treasurer of Sovran Financial Corp. Martin E. Simmons 54 Mr. Simmons is Executive Vice President - Administration, Secretary and General Counsel of the Corporation and FANB. From August 1992 until January 1994, he served as Executive Vice President, Secretary and General Counsel of the Corporation and FANB. From 1973 to August 1992, Mr. Simmons was a partner with the Nashville law firm of Dearborn & Ewing and served as Chairman of the firm's management committee from 1988 through 1991 and during previous periods. John W. Smithwick 50 Mr. Smithwick is Executive Vice President - Human Resources of FANB and has served in such capacity since 1986. The additional information required by Item 405 of Regulation S-K is contained in the Corporation's Notice of 1994 Annual Meeting of Shareholders and Proxy Statement (the "1994 Proxy Statement") filed with the Securities and Exchange Commission within 120 days of the Corporation's year-end pursuant to Regulation 14A. Such information appears in the sections entitled "Election of Directors" and "Reports of Beneficial Ownership" in the 1994 Proxy Statement and is incorporated herein by reference. ITEM 11: ITEM 11: EXECUTIVE COMPENSATION This information appears in the sections entitled "Executive Compensation", "Human Resources Committee Interlocks and Insider Participation", "Compensation of Directors" and "Retirement Plans" in the 1994 Proxy Statement, and is incorporated herein by reference. ITEM 12: ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information appears in the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the 1994 Proxy Statement, and is incorporated herein by reference. ITEM 13: ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information appears in the sections entitled "Certain Transactions" and "Human Resources Committee Interlocks and Insider Participation" in the 1994 Proxy Statement, and is incorporated herein by reference. PART IV ITEM 14: ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. Financial Statements The Report of KPMG Peat Marwick, Independent Certified Public Accountants Consolidated Income Statements of First American Corporation and Subsidiaries for the three years ended December 31, 1993, 1992, and 1991 Consolidated Balance Sheets of First American Corporation and Subsidiaries at December 31, 1993 and 1992 Consolidated Statements of Changes in Shareholders' Equity of First American Corporation and Subsidiaries for the three years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows of First American Corporation and Subsidiaries for the three years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules All schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or the notes thereto. The following reports and consents are submitted herewith: Accountants' Consent by KPMG Peat Marwick. Exhibit 23 3. Exhibits Exhibit Number Description ------- ----------- 3.1 Restated Charter (previously filed as Exhibit 1 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). 3.2 By-Laws of the Corporation currently in effect (previously filed as Exhibit 3.2 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 The Corporation agrees to provide the SEC, upon request, copies of instruments defining the rights of holders of long-term debt of the Corporation, and all of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed with the SEC. 4.2 Rights Agreement, dated December 14, 1988, between First American Corporation and First American Trust Company, N.A. (previously filed as Exhibit 1 to a Current Report on Form 8-K dated December 14, 1988, and incorporated herein by reference). 4.3(a) Indenture, dated as of December 15, 1972, between First Amtenn Corporation and the Chase Manhattan Bank, National Association, as Trustee (previously filed as Exhibit 4(b) to Registration Statement No. 2-46447 and incorporated herein by reference). 4.3(b) Indenture, dated as of April 22, 1993, between First American Corporation and Chemical Bank, as Trustee (previously filed as Exhibit 4.1 to Registration Statement No. 33-59844 and incorporated herein by reference). 4.3(c) Supplemental Indenture, dated as of April 22, 1993, between First American Corporation and Chemical Bank, as Trustee (previously filed as Exhibit 4.2 to Registration Statement No. 33-59844 and incorporated herein by reference). 10.3(a) First American STAR Award Plan (previously filed as Exhibit 10.03(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1986 and incorporated herein by reference). 10.3(b) First American Corporation 1991 Employee Stock Incentive Plan (previously filed as part of the Corporation's Notice of Annual Meeting and Proxy Statement dated March 18, 1991 for the annual meeting of shareholders held April 18, 1991 and incorporated herein by reference). 10.3(c) 1993 Non-Employee Director Stock Option Plan (previously filed as part of the corporation's Notice of Annual Meeting and Proxy Statement dated March 18, 1993 for the annual meeting of shareholders held April 15, 1993 and incorporated herein by reference). 10.3(d) Consulting Agreement (previously filed as Exhibit 10.3(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) with James F. Smith dated January 1, 1993. 10.3(e) First American Corporation 1992 Executive Early Retirement Program (previously filed as Exhibit 10.4(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.3(f) First American Corporation Director's Deferred Compensation Plan (previously filed as Exhibit 19.1 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.3(g) First American Corporation Supplemental Executive Retirement Program dated as of January 1, 1989 (previously filed as Exhibit 19.2 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.3(h) Form of Deferred Compensation Agreement approved by the Human Resources Committee of the Board of Directors of the Corporation on December 16, 1993 and entered into by the Corporation and John Boyle and Dennis Bottorff, included on page 110 hereof. 11 Calculation of earnings per share is included in note 1 to the consolidated financial statements, contained herein under Item 8 on page 57 and incorporated herein by reference. 13 First American Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993. Such report, except for the portions included herein, is furnished for the information of the Securities and Exchange Commission and is not "filed" as part of this Report. 21 List of Subsidiaries included on page 119 hereof. 23 Consent of KPMG Peat Marwick, independent accountants included on page 121 hereof. Upon written or oral request, a copy of the above exhibits will be furnished at cost. (b) No reports on Form 8-K were filed during the last quarter of 1993. INDEPENDENT AUDITOR'S REPORT. The Board of Directors and Shareholders First American Corporation We have audited the accompanying consolidated balance sheets of First American Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First American Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in note 14 to the consolidated financial statements, the Corporation adopted in 1993 the provisions of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 109, Accounting for Income Taxes; No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; No. 112, Employers' Accounting for Postemployment Benefits; and No. 115, Accounting for Certain Investments in Debt and Equity Securities. KPMG Peat Marwick /s/ KPMG Peat Marwick Nashville, Tennessee --------------------- January 21, 1994 See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements of First American Corporation have been prepared in conformity with generally accepted accounting principles including general practices of the banking industry. Certain prior year amounts have been reclassified to conform with current year presentation. The following is a summary of the more significant accounting policies of the Corporation. CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, including its principal subsidiary First American National Bank, as well as First American National Bank of Kentucky and First American Trust Company, N.A. All significant intercompany accounts and transactions have been eliminated in consolidation. SECURITIES Effective December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires investments in equity securities that have a readily determinable fair value and investments in debt securities to be classified into three categories, as follows: held to maturity debt securities, trading securities, and securities available for sale. Under SFAS No. 115, classification of a debt security as held to maturity is based on the Corporation's positive intent and ability to hold such security to maturity. Securities held to maturity are stated at cost adjusted for amortization of premiums and accretion of discounts, unless there is a decline in value which is considered to be other than temporary, in which case the cost basis of such security is written down to market and the amount of the write-down is included in earnings. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading account securities, which are valued at market with unrealized gains and losses included in earnings. Interest rate futures contracts which provide for hedging of trading account securities are also valued at market. Gains or losses on sales and adjustments to market value of trading account securities are included in non-interest income in the consolidated income statements. Securities classified as available for sale, which are reported at market value with unrealized gains and losses excluded from earnings and reported, net of tax, in a separate component of shareholders' equity, include all securities not classified as trading account securities or securities held to maturity. These include securities used as part of the Corporation's asset/liability strategy which may be sold in response to changes in interest rates, prepayment risk, the need or desire to increase capital, and other similar factors. Gains or losses on sale of securities available for sale are recognized at the time of sale, based upon specific identification of the security sold, and are included in non-interest income in the consolidated income statements. FINANCIAL INSTRUMENTS The Corporation enters into interest rate swap and basis swap transactions in connection with its asset/liability management program in managing interest rate exposure. The impact of interest rate swaps and basis swaps is accrued based on expected settlement payments and is recorded as an adjustment to interest income and expense over the life of the related agreements. The Corporation also enters into interest rate swap agreements with customers desiring protection from possible adverse future fluctuations in interest rates. As an intermediary, the Corporation maintains a portfolio of generally matched offsetting swap agreements. At inception of the swap agreements, the portion of the compensation related to credit risk and ongoing servicing, if any, is deferred and taken into income over the term of the swap agreements. The Corporation also enters into interest rate caps, floors, options, and forward and futures contracts for its asset/liability management program and for its trading activities. Realized and unrealized gains and losses on such instruments which are designated as effective hedges of interest rate exposure are deferred and recognized as interest income or interest expense over the covered periods or lives of the hedged assets or liabilities. Such instruments used in trading activities are carried at market value, and realized and unrealized gains and losses are included in trading account revenue in the consolidated income statements. LOANS Loans are stated at the principal amount outstanding. Unearned discount, deferred loan fees net of loan acquisition costs, and the allowance for possible loan losses are shown as reductions of loans. Loan origination and commitment fees and certain loan related costs are being deferred and the net amount amortized as an adjustment of the related loan's yield over the contractual life of the related loan. Unearned discount represents the unamortized amount of finance charges, principally related to certain installment loans. Interest income on loans is generally computed on the outstanding loan balance. Interest income on installment loans which have unearned discount is recognized primarily by the sum-of-the-month's digits method. Interest income is generally accrued on all loans. Commercial loans are placed on non-accrual status when doubt as to timely collection of principal or interest exists, or when principal or interest is past due 90 days or more unless such loans are well-secured and in the process of collection. The decision to place a loan on non-accrual status is based on an evaluation of the borrower's financial condition, collateral, liquidation value, and other factors that affect the borrower's ability to pay. Generally, at the time a loan is placed on a non-accrual status, all interest accrued and uncollected on the loan in the current fiscal year is reversed from income, and all interest accrued and uncollected from the prior year is charged off against the allowance for possible loan losses. Thereafter, interest on non-accrual loans is recognized in interest income only to the extent that cash is received and future collection of principal is not in doubt. If the collectibility of outstanding principal is doubtful, such interest received is applied as a reduction of principal. A non-accrual loan may be restored to an accruing status when principal and interest are no longer past due and unpaid and future collection of principal and interest on a timely basis is not in doubt. Generally, consumer loans on which interest or principal is past due more than 120 days are charged off. ALLOWANCE FOR POSSIBLE LOAN LOSSES The provision for loan losses represents a charge (credit) to earnings necessary, after loan charge-offs and recoveries, to maintain the allowance for possible loan losses at an appropriate level which is adequate to absorb estimated losses inherent in the loan portfolio. Such estimated losses arise primarily from the loan portfolio but may also be derived from other sources, including commitments to extend credit and standby letters of credit. The level of the allowance for possible loan losses is determined on a quarterly basis using procedures which include: (1) an evaluation of individual criticized and classified credits as determined by internal reviews, of other significant credits, and of non-criticized/classified commercial and commercial real estate credits, to determine estimates of loss probability; (2) an evaluation of various consumer loan categories to determine an estimation of loss on such loans based primarily on historical loss experience of the category; (3) a review of unfunded commitments; and (4) an assessment of various other factors, such as changes in credit concentrations, loan mix, and economic conditions which may not be specifically quantified in the loan analysis process. The allowance for possible loan losses consists of an allocated portion and an unallocated, or general, portion. The allocated portion is maintained to cover estimated losses applicable to specific segments of the loan portfolio. The unallocated portion is maintained to absorb losses which probably exist as of the evaluation date but are not identified by the more objective processes used for the allocated portion of the allowance for loan losses due to risk of error or imprecision. While the total allowance consists of an allocated portion and an unallocated portion, these terms are primarily used to describe a process. Both portions of the allowance are available to provide for inherent loss in the entire portfolio. The allowance for possible loan losses is increased (decreased) by provisions for loan losses charged (credited) to expense and is reduced (increased) by loans charged off net of recoveries on loans previously charged off. The provision for loan losses is based on management's determination of the amount of the allowance necessary to provide for estimated loan losses based on its evaluation of the loan portfolio. Determining the appropriate level of the allowance and the amount of the provision for loan losses involves uncertainties and matters of judgment and therefore cannot be determined with precision. FORECLOSED PROPERTIES Foreclosed properties include property acquired through foreclosure and in-substance foreclosures. In-substance foreclosed properties are those properties where the borrower retains title but has little or no remaining equity in the property considering its fair value; where repayment can only be expected to come from the operation or sale of the property; and where the borrower has effectively abandoned control of the property or it is doubtful that the borrower will be able to rebuild equity in the property. Foreclosed properties are valued at the lower of cost or fair value minus estimated costs to sell. The fair value of the assets is the amount that the Corporation could reasonably expect to receive for them in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. Cost includes loan principal, accrued interest, foreclosure expense, and expenditures for subsequent improvements. The excess of cost over fair value minus estimated costs to sell at the time of foreclosure is charged to the allowance for possible loan losses. Provisions for subsequent declines in fair value minus estimated costs to sell are included in foreclosed properties expense. DEPRECIATION AND AMORTIZATION Premises and equipment is stated at cost less accumulated depreciation and amortization, which is computed principally on the straight-line method based on the estimated useful lives of the respective assets. For bank acquisitions accounted for as purchases, the net assets of the banks have been adjusted to their fair values as of the respective acquisition dates. The value of deposit rights and the excess of the purchase price of subsidiaries over net assets acquired are being amortized on a straight-line basis over periods ranging from ten to twenty years. Deposit rights and the excess of the purchase price of subsidiaries over net assets acquired, net of amounts amortized, are included in other assets in the consolidated balance sheets. EMPLOYEE BENEFIT PLANS The Corporation provides a variety of benefit plans to eligible employees. Retirement plan expense is accrued each year, and plan funding represents at least the minimum amount required by the Employee Retirement Income Security Act of 1974, as amended. Differences between expense and funded amounts are carried in other assets or other liabilities. Beginning in 1993, the Corporation recognizes postretirement benefits other than pensions on an accrual basis, and effective December 31, 1993, other postemployment benefits are also recognized on an accrual basis. The Corporation also makes contributions to an employee thrift and profit-sharing plan based on employee contributions and profitability levels of the Corporation. INCOME TAXES The Corporation files a consolidated Federal income tax return, except for its credit life insurance subsidiary, which files a separate return. Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," which requires a change from the deferred method of accounting under Accounting Principles Bulletin No. 11 to the asset and liability method of accounting for income taxes. Under SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets are reduced by a valuation allowance, if necessary, to an amount that more likely than not will be realized. EARNINGS (LOSS) PER COMMON SHARE Earnings (loss) per common share amounts are computed by dividing net income (loss) by the weighted average number of common shares outstanding during each year. ESTIMATED FAIR VALUES Estimates of the fair value of financial instruments are presented within the notes to the consolidated financial statements. Fair value estimates are made at a point in time, based on relevant market information and information about the financial instrument. Such estimates involve uncertainties and matters of judgment and therefore cannot be determined with precision. The more significant assumptions used in preparing the Corporation's fair value estimates are set forth below. For cash and due from banks, time deposits with other banks, and Federal funds sold and securities purchased under agreements to resell, fair value is estimated to approximate the carrying amount since such instruments mature within 90 days or less and do not present unanticipated credit concerns. The fair value of trading account securities is based on quoted market prices or dealer quotes. Fair values for securities are based on quoted market prices or dealer quotes, if available; however, if a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. For most loans, fair value is estimated by discounting estimated future cash flows using the current rates at which similar loans would be made to borrowers with similar credit risk and for similar remaining maturities. For certain homogeneous categories of loans, such as residential mortgages, fair value is estimated using quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. Under SFAS No. 107, the fair value of deposits with no stated maturity, such as demand deposits, NOW accounts, money market accounts, and regular savings accounts, is equal to the amount payable on demand at the reporting date. The fair value of certificates of deposit and other fixed maturity time deposits is estimated using the rates currently offered for deposits of similar remaining maturities. For foreign deposits, the carrying amount is considered a reasonable estimate of fair value due to the frequency with which rates for such deposits are adjusted to a market rate. For short-term borrowings, fair value is estimated to equal the carrying amount since these instruments have a relatively short maturity. Rates for long-term debt with similar terms and remaining maturities are used to estimate fair value of the Corporation's long-term debt. The fair value of commitments to extend credit is estimated based on unamortized deferred loan fees and costs. The estimated fair value of the Corporation's outstanding interest rate floor contracts is based on dealer quotes. The estimated fair value of the Corporation's outstanding interest rate and basis swaps is based on estimated costs to settle the obligations with the counterparts at the reporting date. NOTE 2: CASH AND DUE FROM BANKS The Corporation's bank subsidiaries are required to maintain reserves, in the form of cash and balances with the Federal Reserve Bank, against its deposit liabilities. Approximately $171.8 million and $145.5 million of the cash and due from banks balance at December 31, 1993 and 1992, respectively, represented reserves maintained in order to meet Federal Reserve requirements. NOTE 3: SECURITIES SECURITIES HELD TO MATURITY The amortized cost, gross unrealized gains, gross unrealized losses, and approximate market values of securities held to maturity at December 31, 1993 and 1992, are presented in the following table: Included in U.S. Treasury and other U.S. Government agencies and corporations securities held to maturity were agency-issued mortgage-backed securities amounting to $480.5 million ($492.3 million market value) at December 31, 1993, and $943.7 million ($959.8 million market value) at December 31, 1992. Mortgage-backed securities included in other debt securities amounted to $6.9 million ($7.2 million market value) at December 31, 1993, and $35.5 million ($37.3 million market value) at December 31, 1992. SECURITIES AVAILABLE FOR SALE The amortized cost, gross unrealized gains, gross unrealized losses, and approximate market values of securities available for sale at December 31, 1993 and 1992, are presented in the following table: Included in U.S. Treasury and other U.S. Government agencies and corporations securities available for sale were agency-issued mortgage-backed securities amounting to $992.7 million ($1,016.8 million market value) at December 31, 1993, and $259.3 million ($270.8 million market value) at December 31, 1992. Effective December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires investments in equity securities that have a readily determinable fair value and investments in debt securities to be classified into three categories, as follows: held to maturity debt securities, trading securities, and available for sale securities. In conjunction with the adoption of SFAS No. 115 on December 31, 1993, the Corporation reclassified $368.6 million of securities to the available for sale classification from the former investment, now held to maturity, category. At that date, unrealized appreciation on total securities available for sale amounted to $36.1 million, resulting in an increase in shareholders' equity of $22.0 million, net of taxes. There was no impact on the Corporation's consolidated net income as a result of the adoption of SFAS No. 115. Net realized gains (losses) from the sale of securities available for sale for the years ended December 31, 1993, 1992, and 1991, amounted to $(2,028,000), $(2,974,000), and $3,654,000, respectively. Gross realized gains and losses on such sales were as follows: TOTAL SECURITIES The amortized cost and approximate market values of debt securities at December 31, 1993, by average estimated maturity are shown below. The expected maturity for governmental and corporate securities is the stated maturity, and the expected maturity for mortgage-backed securities and other asset-backed securities is based on current estimates of average maturities. At December 31, 1993 and 1992, the Corporation held securities with amortized cost amounting to $503.7 million and $528.5 million, respectively, which were issued or guaranteed by the Federal National Mortgage Association and $856.1 million and $597.6 million, respectively, which were issued or guaranteed by the Federal Home Loan Mortgage Corporation. Securities carried in the consolidated balance sheets at approximately $1,310.0 million and $909.1 million at December 31, 1993 and 1992, respectively, were pledged to secure public and trust deposits and for other purposes as required or permitted by law. NOTE 4: LOANS AND ALLOWANCE FOR POSSIBLE LOAN LOSSES The Corporation's bank subsidiaries make commercial, consumer, and real estate loans to its customers, located principally within the Corporation's primary market, which consists of Tennessee and selected portions of adjacent states. Although the bank subsidiaries have a diversified loan portfolio, a substantial portion of their debtors' ability to honor their contracts is dependent upon economic conditions in the Corporation's primary market. Loans are either secured or unsecured based on the type of loan and the financial condition of the borrower. The loans are generally expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrower; however, the Corporation is exposed to risk of loss on loans due to the borrower's difficulties, which may arise from any number of factors including problems within the respective industry or economic conditions, including those within the Corporation's primary market. Directors and executive officers (and their associates, including companies in which they hold ten percent or more ownership) of the Corporation and its significant subsidiary, First American National Bank, had loans outstanding with the Corporation and its subsidiaries of $17,124,000 and $9,277,000 at December 31, 1993 and 1992, respectively. During 1993, $701,791,000 of new loans or advances on existing loans were made to such related persons, repayments from such persons totalled $693,872,000, and other reductions for loans which are no longer related were $72,000. The Corporation believes that such loans were made on substantially the same terms, including interest and collateral, as those prevailing at the time for comparable transactions with other borrowers and did not involve more than the normal risk of collectibility or present other unfavorable features at the time such loans were made. The following table is a summary of loans to customers as classified by Standard Industrial Classification (SIC) codes as of December 31, 1993 and 1992. SIC codes are governed by the borrower's type of business, and since balance sheet classifications are governed by the anticipated source of repayment, there are classification differences between the following table and the accompanying consolidated balance sheets. Consumer loans include amortizing mortgages, installment loans, single payment loans, and open end loans and are made for varying purposes. At year-end 1993 and 1992, outstanding consumer installment automobile loans, net of unearned discount and net deferred loan fees, were $623.7 million and $532.0 million, respectively, and consumer amortizing mortgage loans amounted to $1,015.9 million and $642.0 million, respectively. The estimated fair value of total loans, net of unearned discount and net deferred loan fees, outstanding at December 31, 1993 and 1992, was $4,295.0 million and $3,649.1 million, respectively. The estimated fair value of loans includes credit risk considerations. At year-end 1993 and 1992, the carrying value of loans, net of unearned discount and net deferred loan fees, was $4,340.1 million and $3,699.3 million, respectively. At December 31, 1993 and 1992, loans on a non-accrual status amounted to $21.7 million and $59.9 million, respectively. Interest income not recognized on non-accrual loans was approximately $1.1 million in 1993, $3.6 million in 1992, and $8.3 million in 1991. Interest income recognized on a cash basis on non-accrual loans was $1.2 million, $1.0 million, and $1.1 million for the same respective periods. Restructured loans amounted to approximately $.5 million at December 31, 1992, and $2.2 million at December 31, 1991 (none at December 31, 1993). Restructured loans had little effect on interest income during 1993, 1992, or 1991. Transactions in the allowance for possible loan losses were as follows: Net charge-offs (recoveries) by major loan categories were as follows: During May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which must be adopted on a prospective basis by January 1995. SFAS No. 114 requires that impaired loans be measured at the present value of expected future cash flows discounted at the loan's effective interest rate, at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. At this time, the Corporation is evaluating when and how it will adopt SFAS No. 114, as well as the possible financial impact of this statement to the Corporation. NOTE 5: PREMISES AND EQUIPMENT AND LEASE COMMITMENTS Premises and equipment is summarized as follows: Depreciation and amortization expense of premises and equipment for 1993, 1992, and 1991 was $13,831,000, $12,310,000, and $13,259,000, respectively. Non-cancelable minimum operating lease commitments for real property amount to $7,850,000 for 1994; $7,607,000 for 1995; $7,393,000 for 1996; $6,982,000 for 1997; $6,464,000 for 1998; and $41,510,000 thereafter. In the normal course of business, management expects that leases will be renewed or replaced by other leases. Rent expense, net of rental income on bank premises, for 1993, 1992, and 1991 was $3,522,000, $4,126,000, and $5,187,000, respectively. Rental income on bank premises for 1993, 1992, and 1991 was $3,959,000, $3,809,000, and $3,722,000, respectively. The Corporation also has a data processing outsourcing agreement expiring in 2001 that has an annual base expense of $12 million. Total annual fees can vary with cost of living adjustments and changes in services provided by the vendor, which services depend upon the Corporation's volume of business and system needs. The related expense is included in systems and processing expense in the consolidated income statements. NOTE 6: INTANGIBLE ASSETS Total intangible assets representing deposit rights and excess of purchase price of subsidiaries over net assets acquired amounted to $25,963,000 and $20,040,000 at December 31, 1993 and 1992, respectively, and are included in other assets on the consolidated balance sheets (see note 11). Approximately $6,998,000 of the intangible asset balance at December 31, 1993, is available for future tax deductibility as a core deposit intangible. Amortization expense of intangible assets was $2,546,000, $2,382,000, and $2,743,000 in 1993, 1992, and 1991, respectively. NOTE 7: DEPOSITS As the Corporation's average contractual rates on its outstanding time deposits are estimated to be higher than rates currently offered for comparable new time deposits, the Corporation's estimated fair value of total deposits ($5,699.1 million) exceeds the carrying amount of total deposits ($5,690.6 million) by $8.5 million at December 31, 1993. At year- end 1992, the estimated fair value of total deposits was $5,528.1 million compared with a carrying amount of $5,521.8 million. NOTE 8: SHORT-TERM BORROWINGS Short-term borrowings are issued on normal banking terms and consisted of the following: At December 31, 1993, Federal funds purchased and securities sold under agreements to repurchase included $55.0 million of Federal funds purchased due within five months. Other short-term borrowings is essentially composed of U.S. Treasury tax and loan accounts. The carrying amount of short-term borrowings approximates fair value due to the short maturity of these financial instruments. The following table presents information regarding Federal funds purchased and securities sold under agreements to repurchase. NOTE 9: LONG-TERM DEBT Long-term debt consisted of the following: During first quarter 1993, the Corporation filed a shelf registration statement with the Securities and Exchange Commission to issue $100 million of subordinated debt securities. The Corporation issued $50 million of subordinated notes under the shelf registration statement during second quarter 1993. The notes are non-callable. The 7 5/8% debentures amounted to $13.6 million at December 31, 1993, from the original issuance amount of $25,000,000 under an indenture dated December 15, 1972. These debentures will be redeemed at 101.22% of the principal amount, effective January 31, 1994. The Corporation owns a parking garage which was financed through an Industrial Revenue Bond due April 1, 1997. Indebtedness at December 31, 1993 and 1992, totalled $1,420,000 and $1,735,000, respectively. Sinking fund requirements of this debt amount to $330,000 for 1994; $345,000 for 1995; $365,000 for 1996; and $380,000 for 1997. The interest rate on these bonds is 5.9% for the remaining life of the bonds. At December 31, 1993, the Corporation had outstanding advances from the Federal Home Loan Bank of $1,150,000 maturing September 28, 2007, at an interest rate of 3.891%. On December 31, 1993, the Corporation had a revolving credit agreement with three banks which provided for loans of up to $50 million. Under the terms of the revolving credit agreement, which expires in March 1994, the Corporation pays a fee for the availability of these funds. Interest to be paid on outstanding balances will be computed based on the prime interest rate of the lending banks, Eurodollar rates, or adjusted certificate of deposit rates, as selected by the Corporation. The Corporation had no revolving credit borrowings outstanding at December 31, 1993 or 1992. The terms of these agreements provide, among other things, for restrictions on payment of cash dividends and purchases, redemptions, and retirement of capital shares. Under the Corporation's most restrictive debt covenant, approximately $155.7 million of retained earnings was available to pay dividends as of December 31, 1993. The estimated fair value of long-term debt outstanding at December 31, 1993 and 1992, was $66.5 million and $16.7 million, respectively, as compared with carrying value of $65.9 million and $16.9 million, respectively. The differences reflect that the Corporation's contractual rates on its existing long-term debt outstanding are slightly higher (lower for 1992) than rates estimated to be currently offered for comparable new long-term debt. NOTE 10: EMPLOYEE BENEFITS RETIREMENT PLAN The Corporation and its subsidiaries participate in a non-contributory retirement plan with death and disability benefits covering substantially all employees with one or more years of service. The benefits are based on years of service and average monthly earnings of a participant for the 60 consecutive months which produce the highest average earnings. The following table sets forth the plan's funded status and amounts recognized in the Corporation's consolidated balance sheets at December 31, 1993 and 1992: Net pension expense included the following components: The following table presents assumptions used in determining the actuarial present value of the projected benefit obligation for the pension plan: SUPPLEMENTAL RETIREMENT PLAN The Corporation has a supplemental retirement plan which provides supplemental retirement benefits to certain executives of the Corporation. This plan became effective on January 1, 1989, and the expense was $82,000 in 1993, $707,000 in 1992, and $213,000 in 1991. The higher level of expense in 1992 was due to early retirements. Benefit payments from the plan are made from general assets of the Corporation. The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation in 1993 were 7.5% and 4.5%, respectively, and in 1992 were 8.0% and 5.0%, respectively. OTHER POSTRETIREMENT BENEFITS In addition to pension benefits, the Corporation and its subsidiaries have defined postretirement benefit plans that provide medical insurance and death benefits for retirees and eligible dependents. Because the death benefit plan is not significant, it is combined with the health care plan for disclosure purposes. Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires the cost of postretirement benefits other than pensions to be recognized on an accrual basis as employees perform services to earn such benefits. The Corporation's previous practice, like most companies, was to expense such costs on a pay-as-you-go basis. The Corporation recognized this change during 1993 as a cumulative effect of a change in accounting principle, resulting in a one-time non-cash charge of $17.5 million before taxes ($11.6 million after taxes). This charge represents the discounted present value of expected future retiree medical and death benefits attributed to employees' service rendered prior to 1993. See note 14. The status of the plans at December 31, 1993, was as follows: The components of net periodic expense for postretirement benefits in 1993 were as follows: The Corporation continues to fund medical and death benefit costs principally on a pay-as-you-go basis. Postretirement benefit expense for 1992 and 1991, which were recorded on a cash basis, have not been restated and were $.6 million and $.7 million, respectively. For measurement purposes, a 10.75% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1994, declining gradually to 5.5% per year by 2011 and remaining at that level thereafter. The discount rate used to determine the accumulated postretirement benefit obligation was 7.5%, and the assumed long-term rate of compensation increase was 4.5%. The health care cost trend rate assumption has a significant effect on the accumulated postretirement benefit obligation and net periodic benefit costs. A 1% increase in the trend rate for health care costs would have increased the accumulated postretirement benefit obligation by $1.7 million as of December 31, 1993, and the net periodic expense (service cost and interest cost) would have increased by $138,000 for 1993. POSTEMPLOYMENT BENEFITS Effective December 31, 1993, the Corporation adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires employers to recognize a liability for postemployment benefits under certain circumstances. The Corporation's short-term and long-term disability benefits, survivor income benefits, and certain other benefits are governed by this statement. The Corporation recognized this item during fourth quarter 1993 as a cumulative effect of a change in accounting principle, resulting in a one-time non-cash charge of $2.0 million before taxes ($1.3 million after taxes). Prior to this date, postemployment benefit expenses were recognized on a pay-as-you-go basis. See note 14. OTHER EMPLOYEE BENEFITS The Corporation has executive incentive compensation plans covering certain officers and other key employees of the Corporation. The plans provide for incentives based on the attainment of annual and long-term performance goals. Executive incentive compensation plans also include stock option programs, which provide for the granting of incentive stock options and non- statutory options to key employees. Additionally, the Corporation has a stock option plan for non-employee directors. As of December 31, 1993, the Corporation had approximately 1.8 million shares of common stock reserved for issuance under these plans. During 1991 through 1993, the Corporation has issued 86,200 shares of restricted common stock to certain executive officers. The restrictions lapse within 15 years; however, if certain performance criteria are met, restrictions will lapse earlier. The amount recorded for the restricted stock issued is based on the market value of the Corporation's common stock on the award dates and is shown as deferred compensation in the consolidated statements of changes in shareholders' equity. Such compensation expense is recognized over a 3- to 15-year period. Stock options granted under option programs have been at 85% to 100% of the market price on the day of grant. Each stock option is for one share of common stock. Some options are exercisable immediately, while some options are exercisable over a period of time and may be exercisable earlier if certain performance criteria are met. All options expire within a ten-year period from the date of grant. The market price of the Corporation's stock was $32.00 at December 31, 1993. The following table presents a summary of stock option and restricted stock activity: The Corporation has a combination savings thrift and profit-sharing plan ("FIRST Plan") available to substantially all full-time employees. In connection with the plan, 1,350,000 shares of the Corporation's common stock have been reserved for issuance. At year-end 1993, 580,000 of these shares had been issued. The plan is funded by employee and employer contributions. The Corporation's annual contribution to the plan is based upon the amount of basic contributions of participants, participants' compensation, and the achievement of certain corporate performance standards and may be made in the form of cash or the Corporation's common stock with a market value equal to the cash contribution amount. During 1993, 1992, and 1991, 94,193 shares, 3,538 shares, and 172,557 shares, respectively, were purchased in the open market for the FIRST Plan. During 1992, 62,961 shares were issued by the Corporation in connection with the FIRST Plan (none in 1993 or 1991). Total plan expense in 1993, 1992, and 1991 was $2,919,000, $1,203,000, and $551,000, respectively. During 1993, 1992, and 1991, the Corporation matched participating employees' qualifying contributions by 100%, 50%, and 25%, respectively. NOTE 11: ACQUISITIONS AND SALES On October 1, 1993, the Corporation acquired all of the outstanding shares of First American National Bank of Kentucky (FANBKY), formerly known as First Federal Savings and Loan Association of Bowling Green, a $219.0 million national bank headquartered in Bowling Green, Kentucky, for $27.5 million. This transaction was accounted for as a purchase. All financial data after the acquisition date has been adjusted to reflect the purchase and, consistent with the purchase method of accounting, the results of operations of FANBKY are included in the Corporation's consolidated income statement beginning October 1, 1993. Total fair value of net assets of FANBKY on the acquisition date was approximately $19,051,000. The excess of the purchase price over the fair value of the net assets acquired was $8,449,000 at the acquisition date and is being amortized over 10 years. Net interest income and net income of FANBKY for the year ended December 31, 1992, were $8,325,000 and $2,541,000, respectively, and for the first nine months of 1993 were $5,156,000 and $1,837,000, respectively. FANBKY operates three branches in Warren and Simpson Counties in southern Kentucky. During fourth quarter 1993, the Corporation signed a definitive stock purchase agreement for the Corporation to acquire Fidelity Crossville Corporation (FCC), the parent company of First Fidelity Savings Bank, F. S. B. (First Fidelity) located in Crossville, Tennessee for $6.5 million. First Fidelity, with approximately $50 million in total assets at December 31, 1993, has offices in Crossville and Fairfield Glade. The acquisition of FCC and the merger of First Fidelity into First American National Bank are expected to be completed in the first half of 1994, subject to various conditions, including regulatory approval. The transaction will be accounted for as a purchase. The Corporation consummated the sale of one branch office in 1992, with deposits of approximately $11.3 million at the date of sale, and three branch offices in 1991, with deposits aggregating approximately $54.8 million at the respective dates of sale. These transactions resulted in a 1992 pre-tax gain of approximately $.6 million and a 1991 aggregate pre-tax gain of approximately $3.4 million. NOTE 12: FIRST AMERICAN FOUNDATION The Corporation's non-interest expenses for 1993 include a $10.0 million charitable contribution to First American Foundation, a not-for-profit private foundation formed in 1993 to facilitate the Corporation's charitable contributions. NOTE 13: INCOME TAXES Effective January 1, 1993, the Corporation prospectively adopted Statement of Financial Accounting Standards (SFAS) No. 109, which requires a change from the deferred method (an income statement approach) of accounting for income taxes under Accounting Principles Bulletin No. 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The cumulative effect of the adoption of SFAS No. 109 was a $12.8 million benefit. See note 14. SFAS No. 109 requires that the tax benefit of deductible temporary differences be recorded as an asset to the extent that management assesses the utilization of such temporary differences to be "more likely than not." In accordance with SFAS No. 109, the realization of tax benefits of deductible temporary differences depends on whether the Corporation has sufficient taxable income within the carryback and carryforward period permitted by the tax law to allow for utilization of the deductible amounts. As of January 1, 1993, the Corporation had net deductible temporary differences of $165.5 million. For Federal tax purposes, taxable income in the carryback and estimates of taxable income in the carryforward periods were expected to be sufficient to utilize this amount; however, for state purposes Tennessee law does not permit carrybacks and thus a valuation allowance was established for the portion of the net deductible temporary differences that was not expected to be realized within a twelve-month carryforward period, which is the period over which management believes is prudent to make projections of taxable income for such purposes. Based on projections of Tennessee 1993 taxable income at the beginning of 1993, a valuation allowance of $3,942,000 was established (as of January 1, 1993). The net change in the total valuation allowance for the year ended December 31, 1993, was a net decrease of $2,596,000; consisting of an increase related to the adoption of SFAS No. 106 (accounting for postretirement benefits) of $1,050,000, an increase related to the adoption of SFAS No. 112 (accounting for postemployment benefits) of $120,000, and a decrease of $3,766,000 related to continuing operations. The valuation allowance for deferred tax assets as of December 31, 1993, was $1,346,000. The components of income tax expense (benefit) are as follows: In addition to amounts in the above table, the Corporation provided taxes relating to the adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". In accordance with SFAS No. 115, there were $36,088,000 of unrealized gains on securities available for sale being credited directly to shareholder's equity. The tax effect applicable to the unrealized gain was $14,039,000 (composed of $11,873,000 Federal tax and $2,166,000 state tax). Total income tax expense (benefit) includes the effect of related tax expense (benefit) on security transactions amounting to $(789,000) in 1993, $(1,129,000) in 1992, and $731,000 in 1991. The following table presents a reconciliation of the provision for income taxes as shown in the consolidated income statements with that which would be computed by applying the statutory Federal income tax rates of 35% for 1993 and 34% for 1992 and 1991 to income (loss) before income taxes, including security transactions. The 1992 total income tax expense for financial reporting purposes included the benefit from utilization of tax credit carryforwards amounting to $5.6 million (general business credit carryforwards of $4.9 million and alternative minimum tax credits of $.7 million). The current portion of income tax expense is based on tax return computations, essentially regular tax (imposed at 35% on taxable income in 1993 and 34% on taxable income in 1992 and 1991) adjusted for alternative minimum taxes, if any. Current Federal income tax expense includes the utilization of alternative minimum tax credits amounting to $3,401,000 in 1992 and $381,000 in 1991. Accumulated deferred taxes aggregated net assets of $38,249,000 at December 31, 1993, and $47,303,000 at December 31, 1992, and are included in other assets on the consolidated balance sheets. Management believes that it is more likely than not that the deferred tax assets, net of the valuation allowance, will be realized. The tax effects of temporary differences that give rise to the significant portions of deferred tax assets and deferred tax liabilities at December 31, 1993, are as follows: Income tax expense from operations for 1993 includes deferred taxes of $11,088,000. Included in this amount is a $3,766,000 benefit applicable to a decrease in the valuation allowance and a $1,781,000 benefit applicable to a change in the Federal income tax rate from 34% in 1992 to 35% in 1993. The tax effects of timing differences that give rise to significant portions of deferred tax expense (benefit) for the years ended December 31, 1992, and December 31, 1991, are as follows: During 1993, the Corporation and the Internal Revenue Service (IRS) reached a settlement agreement of the IRS's examination of the Corporation's 1987 and 1988 consolidated Federal income tax returns. The results of this settlement have been previously reflected in the Corporation's consolidated financial statements. The IRS is currently examining the 1989 and 1990 consolidated Federal income tax returns of First American Corporation and subsidiaries. No material unrecorded tax liability is expected to result from the current examination. NOTE 14: CHANGES IN ACCOUNTING PRINCIPLES The cumulative effect of changes in accounting principles reflected in the 1993 consolidated income statement relates to the Corporation's 1993 adoption of Statements of Financial Accounting Standards (SFAS), as follows: SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and No. 112, "Employers' Accounting for Postemployment Benefits," are discussed in note 10 (employee benefits), and SFAS No. 109, "Accounting for Income Taxes," is addressed in note 13 (income taxes). See note 3 for a discussion regarding the impact to the 1993 consolidated financial statements resulting from the December 31, 1993, adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." NOTE 15: COMMON STOCK ISSUANCE On September 30, 1992, the Corporation completed an underwritten public offering of its common stock at $21.25 per share, resulting in the issuance of 2,012,500 shares. A $40.8 million addition to shareholders' equity in 1992 resulted from the offering. NOTE 16: OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS In the normal course of business, the Corporation is a party to financial transactions which have off-balance-sheet risk. Such transactions arise in meeting customers' financing needs and from the Corporation's activities in reducing its own exposure to fluctuations in interest rates. Off-balance-sheet items involving customers consist primarily of commitments to extend credit and letters of credit, which generally have fixed expiration dates. These instruments may involve, to varying degrees, elements of credit and interest rate risk. To evaluate credit risk, the Corporation uses the same credit policies in making commitments and conditional obligations on these instruments as it does for instruments reflected on the balance sheet. Collateral obtained, if any, varies but may include deposits held in financial institutions; U.S. Treasury securities or other marketable securities; income-producing commercial properties; accounts receivable; property, plant, and equipment; and inventory. The Corporation's exposure to credit risk under commitments to extend credit and letters of credit is the contractual (notional) amount of the instruments. Interest rate caps, floors, swap transactions, futures contracts, and forward contracts may have credit and interest rate risk significantly less than the contractual amount. Commitments to extend secured or unsecured credit are contractual agreements to lend money providing there is no violation of any condition. Commitments may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. At year-end 1993 and 1992, respectively, the Corporation had $1.3 billion and $1.1 billion of unfunded commitments to extend credit. Of these amounts, unfunded commitments for borrowers with loans on non-accrual status were $5.3 million at December 31, 1993, and $3.1 million at December 31, 1992. The fair value of commitments to extend credit is estimated based on unamortized deferred loan fees and costs, both of which amounted to $2.6 million and $.5 million of unearned income (a liability) at December 31, 1993 and 1992, respectively. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. As of December 31, 1993 and 1992, the Corporation had standby letters of credit issued amounting to approximately $135.4 million and $143.7 million, respectively. The Corporation also had commercial letters of credit of $56.1 million and $35.7 million at December 31, 1993 and 1992, respectively. Commercial letters of credit are conditional commitments issued by the Corporation to facilitate trade for corporate customers. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The fair value of letters of credit is estimated based on unamortized deferred fees and costs, both of which amounted to $.7 million and $.6 million of unearned income (a liability) at December 31, 1993 and 1992, respectively. The Corporation also makes certain loans with an interest rate cap or collar (a paired interest rate cap and floor) feature. On December 31, 1993 and 1992, respectively, $47.8 million and $82.8 million in commercial and real estate loans were subject to interest rate caps and $34.4 million and $58.0 million were subject to interest rate floors. Interest rate caps and floors written by the Corporation are interest rate contracts which enable customers to transfer, modify, or reduce their interest rate risk. The Corporation minimizes its exposure to market risk on these instruments by entering into offsetting interest rate contract positions that essentially counterbalance each other. Other than for loans, at December 31, 1993 and 1992, the Corporation had no outstanding interest rate cap or floor contracts written. At December 31, 1992, the Corporation held $200.0 million of interest rate floor contracts (none at year-end 1993), which were entered into to protect the Corporation from falling interest rates. If settled at December 31, 1992, the Corporation's outstanding interest rate floor contracts would have resulted in a $2.1 million pre-tax earnings benefit to the Corporation. Futures and forward contracts are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery at a specified future date of a specified instrument, at a specified price or yield. Risks arise from the possible inability of counterparts to meet the terms of their contracts and from movements in securities' values and interest rates. At December 31, 1993, the Corporation had $300.0 million of futures contracts outstanding (none at December 31, 1992), which were entered into to protect the Corporation's interest rate spread from rising interest rates. Of this amount, the Corporation had $100.0 million of three-month futures contracts which expire in December 1994, $100.0 million of three-month futures contracts which expire in March 1995, and $100.0 million of three-month futures contracts which expire in June 1995. The estimated fair value of the Corporation's outstanding futures contracts was immaterial at December 31, 1993. The Corporation contracts to buy and sell foreign exchange in order to meet the financing needs of its customers and to hedge its own exposure against market risk. At December 31, 1993 and 1992, the Corporation had $12.7 million and $18.9 million, respectively, of foreign exchange forward contracts, which is the sum of customers' contracts with the Corporation and the Corporation's offsetting contracts to minimize its exposure. The estimated fair value of the Corporation's foreign exchange forward contracts was immaterial at December 31, 1993 and 1992. Interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts. Entering into interest rate swap agreements involves not only the risk of dealing with counterparts and their ability to meet the terms of the contracts but also the interest rate risk associated with unmatched positions. At December 31, 1993, the contractual amount of the Corporation's interest rate swap contracts, which were for interest rate management purposes, was $900.0 million. Of this amount, the Corporation had $450.0 million of interest rate swaps which expire in 1994, $400.0 million which expire in 1995, and $50.0 million which expire in 1998. At December 31, 1992, the contractual amount of the Corporation's interest rate swap contracts was $550.0 million. If settled at December 31, 1993, the Corporation's outstanding interest rate swaps would require a $2.4 million expense (a payment) by the Corporation ($3.0 million expense if at December 31, 1992). Basis swaps represent interest rate contracts which are based on different market interest rate indices and are a protection against adverse changes in the shape ("steepness" or "flatness") of the interest rate yield curve. Entering into basis swap agreements involves not only the risk of dealing with counterparts and their ability to meet the terms of the contracts but also the interest rate risk associated with different indices. At December 31, 1993, the contractual amount of the Corporation's basis swap contracts was $200.0 million (none at year end 1992). The Corporation receives a floating rate based on 3-month LIBOR and pays a floating rate based on 5-year constant maturity Treasury rates. The settlement for the difference in the paying and receiving indices occurs every three months, and the indices are reset for the subsequent three-month period. These contracts expire in April 1995. If settled at December 31, 1993, the Corporation's outstanding basis swaps would require a $.6 million expense (a payment) by the Corporation. NOTE 17: LEGAL AND REGULATORY MATTERS In April 1993, written notice was received that the Office of the Comptroller of the Currency (OCC) terminated the supervisory agreement between the Corporation's principal bank subsidiary, First American National Bank (FANB), and the OCC. The formal agreement between the OCC and FANB was signed in September 1990. Under the agreement, FANB was required, among other things, to maintain minimum capital ratios, to review and to strengthen the bank's lending, credit review and credit administration procedures and to not pay dividends if the OCC objected. Also in April 1993, the Federal Reserve Bank of Atlanta advised the Corporation that it would no longer require its prior consent relating to dividend payments, repurchasing outstanding stock, and incurring additional debt. The extent to which dividends may be paid to the Corporation from its subsidiaries is governed by applicable laws and regulations. For the Corporation's national bank subsidiaries, the approval of the OCC is required if dividends declared in any year exceed net profits for that year (as defined under the National Bank Act) combined with the retained net profits of the two preceding years. In addition, under recently adopted OCC regulations, a national bank may not pay a dividend, make any other capital distribution, or pay management fees if such payment would cause it to fail to satisfy certain minimum capital requirements. In accordance with the most restrictive of these restrictions, at December 31, 1993, FANB and FANBKY had $123.4 million and $.4 million, respectively, available for distribution as dividends to the Corporation. For the trust company bank subsidiary, approximately $1.5 million was available for distribution as dividends to the Corporation as of December 31, 1993. The Corporation and seven other financial institutions are defendants in a class action lawsuit brought in the Circuit Court of Shelby County, Tennessee. The lawsuit alleges anti-trust, unconscionability, usury, and contract claims arising out of the defendants' returned check charges. The asserted plaintiff class consists of depositors who have been charged returned check or overdraft fees. The plaintiffs are requesting compensatory and punitive damages of $25 million against each defendant. The anti-trust, unconscionability, and usury claims were previously dismissed, and in December 1993 the Circuit Court granted the defendants' motion for summary judgment and dismissed the remaining claim. The plaintiffs have appealed. In addition, an antitrust lawsuit alleging a price fixing conspiracy has been filed against the Corporation and eight other financial institutions by the plaintiffs in the U.S. District Court for the Western District of Tennessee. The defendants have filed a motion for summary judgment in this action, which is pending. The Corporation believes these suits are without merit and, based upon information currently known and on advice of counsel, that they will not have a material adverse effect on the Corporation's consolidated financial statements. Also, there are from time to time other legal proceedings pending against the Corporation and its subsidiaries. In the opinion of management and counsel, liabilities, if any, arising from such proceedings presently pending would not have a material adverse effect on the consolidated financial statements of the Corporation. NOTE 18: PARENT COMPANY FINANCIAL INFORMATION Condensed financial information for First American Corporation (Parent Company only) was as follows: CONDENSED BALANCE SHEETS CONDENSED STATEMENTS OF CASH FLOWS CONSOLIDATED AVERAGE BALANCE SHEETS AND TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES * Loan fees and amortization of net deferred loan fees (costs), which are considered an integral part of the lending function and are included in rates and related interest categories, amounted to $2.2 million in 1993, $(.8) million in 1992, $(2.7) million in 1991, $(.3) million in 1990, $6.2 million in 1989, and $7.3 million in 1988. Yields/rates and income/expense amounts are presented on a fully taxable equivalent basis based on the statutory Federal income tax rates adjusted for applicable state income taxes net of the related Federal tax benefit; related interest income includes taxable equivalent adjustments of $4.0 million in 1993, $4.2 million in 1992, $6.6 million in 1991, $11.1 million in 1990, $15.5 million in 1989, and $17.8 million in 1988. Non-accrual and restructured loans are included in average loans and average earning assets. Consequently, yields on these items are lower than they would have been if these loans had earned at their contractual rate of interest. SIGNATURES Pursuant to the requirements of Section 13 or 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. FIRST AMERICAN CORPORATION (Registrant) BY:/s/ Dennis C. Bottorff -------------------------- DENNIS C. BOTTORFF, PRESIDENT AND CHIEF EXECUTIVE OFFICER Date: March 17, 1994 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. /s/ Dennis C. Bottorff /s/ Dale W. Polley - ------------------------------ --------------------------- Dennis C. Bottorff Dale W. Polley President and Chief Executive Vice Chairman, Director and Officer and Director Principal Financial Officer Dated: March 17, 1994 Dated: March 17, 1994 /s/ Marvin J. Vannatta, Jr. -------------------------- Marvin J. Vannatta, Jr. Senior Vice President, Controller and Principal Accounting Officer Dated: March 17, 1994 For purposes of EDGAR filing for 12/31/93 Form 10-K: APPENDIX TO ELECTRONIC FORMAT DOCUMENT Graph #1: In the Overview section of Management's Discussion and Analysis, this bar graph depicts the Corporation's net income(loss) per share for 1989 through 1993. For 1993, this graph also depicts the Corporation's 1993 earnings per share based on earnings exclusive of negative loan loss provisions in the last three quarters of 1993 and charitable contribution to First American Foundation in the fourth quarter of 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #2: In the Overview section of Management's Discussion and Analysis, this bar graph depicts the Corporation's return on average equity for 1989 through 1993. For 1993, this graph also depicts the Corporation's 1993 return on average equity based on earnings exclusive of negative loan loss provisions in the last three quarters of 1993 and charitable contribution to First American Foundation in the fourth quarter of 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #3: In the Overview section of Management's Discussion and Analysis, this bar graph depicts the Corporation's return on average assets for 1989 through 1993. For 1993, this graph also depicts the Corporation's 1993 return on average assets based on earnings exclusive of negative loan loss provisions in the last three quarters of 1993 and charitable contribution to First American Foundation in the fourth quarter of 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #4: In the Net Interest Income section of Management's Discussion and Analysis, this line graph depicts the Corporation's interest income (taxable equivalent basis), interest expense, and net interest income (taxable equivalent basis) for 1989 through 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #5: In the Net Interest Income section of Management's Discussion and Analysis, this line graph depicts the Corporation's average yield on earning assets (taxable equivalent basis), net interest margin, average national prime lending rate, and average rate paid as a percent of earning assets for 1989 through 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #6: In the Capital Position section of Management's Discussion and Analysis, this bar graph depicts the Corporation's average equity to average assets for 1989 through 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #7: In the Asset Quality section of Management's Discussion and Analysis, this line graph depicts the Corporation's nonperforming assets, nonperforming loans, and foreclosed properties at year-end 1989 through 1993. This graph appears in the paper format version of the document and not in this electronic filing. Graph #8: In the Securities/Money Market Instruments section of Management's Discussion and Analysis, this bar graph depicts the composition of the Corporation's securities and money market instruments at year-end 1989 through 1993. Categories depicted at each year-end include U.S. Treasury and other U.S. Government securities, obligations of states and political subdivisions, other securities, and money market instruments. This graph appears in the paper format version of the document and not in this electronic filing. EXHIBIT INDEX Number Name Page Exhibit 10.3(h) Salary Deferral Agreement 110 Exhibit 21 List of Subsidiaries 119 Exhibit 23 Accountants' Consent 121	23,773	157,224
93389_1993.txt	93389_1993	1993	93389	ITEM 1. BUSINESS - ----------------- (a) General Development of Business ------------------------------- Registrant manufactures replacement parts for automotive ignition systems, wires and cables, fuel system parts, temperature control systems, power steering parts and hydraulic brake systems parts, and distributes a general service line of automotive related items. In April 1993, the Company acquired, for approximately $9,000,000, substantially all of the general service line inventory and certain related other assets of APS, Inc., a national distributor of automotive parts, along with a ten-year agreement to supply this product line to APS, Inc. on an exclusive basis. The acquisition increased consolidated net sales by approximately $10,900,000 and decreased net earnings by approximately $1,500,000 in the same period primarily due to launch costs. As of January 1, 1994 the Company entered into a Joint Venture Agreement with Autoline Industries, Inc. for the remanufacture of calipers and other brake related items. The new venture, a general partnership named Eisline Manufacturing Company, will sell the products it remanufactures exclusively to the co-venturers under a long-term supply agreement with each. The Company's initial investment for fixed assets and working capital will be approximately $250,000. The remanufacturing operations of the venture will be located at the Company's Ontario, California facility. Replacement Parts Market. The size of the replacement parts market depends, in part, upon the average age and number of cars on the road and the number of miles driven per year. According to the Motor Vehicle Manufacturers Association and United States government sources, the average age of registered automobiles increased from 1988 through 1993 and this trend is projected to continue during the 1990's. (b) Financial Information about Industry Segments --------------------------------------------- Distribution of Sales. The table below shows the registrant's sales by product groups. [CAPTION] No class of products other than those listed in the chart on page 3 accounted for more than ten percent (10%) of total sales in any of such years. The business of the registrant is not dependent on any single customer. In the year ended December 31, 1993, the registrant's five largest customers accounted for approximately 28.1% of sales, or approximately one hundred and sixty-four million ($164,000,000) dollars. Ignition Parts. Replacement parts for automotive ignition and emission systems account for about 34% of the registrant's revenues. These parts include distributor caps and rotors, electronic ignition modules, voltage regulators, coils and switches. The registrant is a basic manufacturer of most of the ignition products it markets. These products cover a wide range of applications, from 30-year old vehicles to current models, both domestic and import, including passenger car, truck, farm, off-road and marine applications. Registrant's parts are sold under numerous brands and several levels of quality. The majority of the parts represent a level of quality equal to original equipment. The registrant also sells a premium line of parts that are better than original equipment and are priced proportionately higher. A lower priced line has been made available under the Modern Mechanic label. This line is marketed under other private labels as well. The shift from breaker-point ignition systems to electronic ignition systems started about 20 years ago, in response to pressures from the government and environmental groups to reduce national fuel consumption as well as the level of pollutants from auto exhausts. These systems enable the engine to burn fuel more completely, which improves fuel efficiency, while reducing the amounts of harmful substances in the exhaust gases. Electronic components comprise a portion of the registrant's total ignition sales. A major aspect of the program was the acquisition of the fixed assets, inventory and certain proprietary information of the Hybrid Products Division from Fairchild Semiconductor Corporation in 1986, which included a highly-automated electronics assembly plant in Hong Kong. This offshore facility is now producing electronic control modules and voltage regulators at costs that enable the registrant to compete effectively in the electronic parts replacement market. Since the designation of a separate emission control parts line in 1986, the registrant's sales of such parts as sensors, valves and solenoids have increased appreciably. The registrant is a basic manufacturer of throttle position sensors, air pump check valves, coolant temperature sensors, air charge temperature sensors and MAP sensors. New government emission laws are expected to increase automotive repair activity creating an increase in parts sales. In recent years, the registrant has significantly enhanced its position as a leading electronics manufacturer in the automotive aftermarket as demonstrated by the recent production of distributorless electronic control modules. The joint venture entered into in 1992 with Blue Streak Electronics, Inc., a rebuilder of engine management computers and MAF sensors, has positioned the registrant to take advantage of the fast growing remanufactured electronics market. Brake System Products. As of August 31, 1986, the registrant acquired the EIS Brake Parts Division from Parker-Hannifin Corporation. In the aftermarket, brake parts represent the single largest product group in a warehouse distributor's inventory. In the registrant's view, this product group could well surpass its ignition line as the largest single source of revenue. The division manufactures a full line of brake replacement parts and also markets many special tools and fluids used by mechanics who perform brake service. EIS has a long- established reputation in the industry for quality products and engineering excellence. Continued sales growth rates of the EIS division is based on several factors: EIS's respected name as a supplier of reliable products; the expanded opportunities for changeovers among registrant's existing customers of their five other product lines; and the fact that, at the time of acquisition, the division had a relatively small share of the market. Sales in 1993 represented approximately a 4% increase over 1992. EIS products account for approximately 28% of the registrant's revenues, making it the second largest producer of revenues for the registrant. A major factor for this increase has been the growth of private label business with Carquest, a major traditional aftermarket distributor. We anticipate that EIS's growth will be enhanced in 1994 and the future as a result of its entry into the retail and other markets. Wires and Cables. Wire and cable parts account for about 9% of the registrant's revenues. Products include ignition (spark plug) wires, battery cables and a wide range of electrical wire, terminals, connectors and tools for servicing an automobile's electrical system. A major part of this division's business is the sale of ignition wire sets. Since 1980, the registrant has made strong advances in the aftermarket, by developing and promoting a premium brand of ignition wires. Through a variety of marketing programs and advertising campaigns, the registrant was able to capitalize on the market's new awareness of the importance of quality. The registrant also manufactures a second line of wire and cable products, known as Modern Mechanic. In 1992, this line was expanded to include import coverage and was made available to all customers who now carry the Standard and GPS brands. Fuel System Parts. Fuel system parts account for about 8% of the registrant's revenues. The registrant manufactures and markets over 2,000 parts for the maintenance and repair of automotive fuel systems. These parts are sold under various brand names which include parts for traditional carburetors, feedback carburetors, fuel pumps, throttle body injection units and multi-port fuel injection systems. For several decades, the registrant's most important product was the carburetor rebuilding kit. Although these kits still represent a significant portion of the registrant's business, their sales have been declining gradually as car manufacturers change over to electronic fuel injection systems. Anticipating the eventual phase-out of carburetors, the registrant introduced in 1987 a line of fuel injection parts, including replacement fuel injectors. The injectors incorporate new disc-type design that makes them virtually immune to clogging, a known problem associated with O.E. injectors. Fuel injection parts are still a small segment of total fuel system business but rapid growth has developed over the last several years. In 1988 the registrant introduced its fuel pump product group. By offering a full line of mechanical and electrical fuel pumps to customers, the registrant will enhance its position as a central source of replacement parts for almost every part of today's and tomorrow's fuel systems. In 1993, the registrant continued to aggressively pursue the increase in parts marketed by its fuel pump product group. The registrant is expanding its activities in the fuel systems area to include the manufacturing of electronic fuel pumps. Temperature Control Systems & Power Steering Parts. The registrant markets a line of replacement parts for automotive temperature control systems (air conditioning and heating), under the brand name Four Seasons. Revenues from Four Seasons accounted for approximately 15% of the registrant's total sales. Federal regulation of CFC (fluorocarbon) refrigerants is revolutionizing the climate control industry. Legislation is gradually phasing out R-12 refrigerant (DuPont's Freon and other brands) completely. This is generating wide industry demand for refrigeration recycling equipment, retrofit kits, and for training in recycling and retrofit techniques. In the near future, vehicle air conditioners needing repair or recharge become candidates for retrofit to use the new R-134a refrigerant, at a cost of several hundred dollars per car. Installers are urgently seeking training and certification in the new technology, and the Company's Four Seasons division has taken the lead in providing these services. These major technological changes require many new parts, as well as new service equipment. As a result, our climate control division is enjoying excellent growth opportunities. Four Seasons also markets a full line of power steering products, which currently number over 1,500 parts including replacement hose assemblies and pumps. Champ Service Line Products. In 1993, Champ accounted for approximately 6% of the registrant's total sales. The division markets over 8,000 different automotive-related items, ranging from mirrors, window cranks and antennas to cleaning and polishing materials, specialty tools and maintenance supplies. Champ purchases products from a wide range of manufacturers and packages them under the Champ and Big A private brand label, enabling its customers to conveniently order items in many separate product groups from a single source. Ordering efficiency and effective shipping are considered key benefits for the registrant's customers, and continue to impact favorably on the Champ division's sales and continued prospects for growth. Early in 1993, Champ's flexibility was enhanced by the designation of its own management team and sales force. (c) Narrative Description of Business Sales and Distribution. The registrant sells its products throughout the United States and Canada under its proprietary brand names, to approximately 1,600 warehouse distributors, who distribute to approximately 27,000 jobber outlets. The jobbers sell the registrant's products primarily to professional mechanics, and secondarily to consumers who perform their own automobile repairs. The registrant has a direct field sales force of approximately 550 persons. The registrant generates demand for its products by directing the major portion of its sales effort to its customers' customers (i.e. jobbers and professional mechanics). In 1993 the registrant conducted approximately 4,000 instructional clinics, which teach mechanics how to diagnose and repair complex new electronic ignition systems, including computerized ignition and emission controls, automotive brake systems and temperature control systems. The registrant also publishes and sells related service manuals and video/cassettes and provides a free technical information bulletin service to registered mechanics. In addition, our Standard Plus Club, a professional service dealer network comprising approximately 12,000 members, offers technical and business development support and has a technical service telephone hotline. The registrant continued expansion into the retail market by selling its products to large retail chains. The registrant expects continued growth in the retail market in future years. Production and Engineering. The registrant engineers, tools and manufactures most of the components for its products, except for the Champ Service Line, many air conditioner, brake hydraulic, brake system, fuel system and certain commonly available small parts. It also performs its own plastic and rubber molding operations, extensive screw machining and power press operations, automated electronics assembly and a wide variety of other processes. The registrant has engineering departments staffed by 74 persons, approximately 69% of whom are graduate engineers. The departments perform product research and development and quality control and, wherever practical, design machinery for automation of the registrant's factories. As new models of automobiles, trucks, tractors, buses and other equipment are introduced, the registrant engineers and manufactures replacement parts for them. The registrant typically has a substantial lead time to engineer and manufacture new products. The registrant employs and trains tool and die makers needed in its manufacturing operations. Competition. Although the registrant is a leading independent manufacturer of automotive replacement parts and supplies, it faces substantial competition in all markets that it serves. A number of major manufacturers of replacement parts and supplies are divisions of companies having greater financial resources than those of the registrant. In addition, automobile manufacturers supply virtually every replacement part sold by the registrant. The competitive factors affecting the registrant's products are primarily product quality, customer service and price. The registrant's business requires that it maintain inventory levels satisfactory for the rapid delivery requirements of customers. Management believes that it is able to compete effectively and that its trademarks and trade names are well known and command respect in the industry and the marketplace. Backlog. Backlog is maintained at minimal levels by the registrant. The registrant fills orders, as received, from inventory and manufactures to maintain inventory levels. Supplies. The principal raw materials purchased by the registrant consist of brass, electronic components, fabricated copper (primarily in the form of magnet wire and insulated cable), ignition wire, stainless steel coils and rods, aluminum coils and rods, lead, rubber molding compound, thermo-set and thermo plastic molding powders, cast iron castings and friction lining materials. All of these materials are purchased in the open market and are available from a number of prime suppliers. Insurance. In 1988 and 1989 the registrant maintained basic liability coverage (general, product and automobile) of $1 million and umbrella liability coverage of $10 million. In 1990, 1991 and 1992 the umbrella coverage was increased to $20 million. In 1993 the umbrella coverage was increased to $50 million and remains at $50 million for 1994. Historically, the registrant has not experienced casualty losses in any year in excess of its coverage. Management has no reason to expect this experience to change, but can offer no assurances that liability losses in the future will not exceed the registrant's coverage. Employees. The registrant has approximately 3,450 employees in the United States, Canada, Puerto Rico and Hong Kong. Of these, approximately 1,500 are production employees. Long Island City, New York production employees are covered by a collective bargaining agreement with the United Auto Workers, which expires on October 1, 1995. Edwardsville, Kansas production employees are covered by a United Auto Workers contract that expires April 7, 1994. Berlin, Connecticut employees are covered by a collective bargaining agreement with the United Auto Workers, which expires on June 1, 1995. The registrant believes that its facilities are in favorable labor markets with ready access to adequate numbers of skilled and unskilled workers. In the opinion of management, employee relations have been good. There have been no significant strikes or work stoppages in the last five years. (d) Financial Information About Export Sales The registrant sells its general line of products primarily through Canada, Latin America, Europe and the Middle East. The table below shows the registrant's export sales for the last three years: (Dollars in thousands) Years Ended December 31, 1993 1992 1991 Canada $32,341 $29,083 $27,438 All Others 12,746 12,209 13,729 ------- ------- ------- Total $45,087 $41,292 $41,167 ------- ------- ------- ------- ------- ------- ITEM 2. ITEM 2. PROPERTIES - ------------------- The registrant maintains its executive offices and a manufacturing plant at 37-18 Northern Boulevard, Long Island City, NY. The table below describes the registrant's major (a) manufacturing and packaging properties and (b) warehousing properties. (For information with respect to rentals, see note 16 of Notes to Consolidated Financial Statements on page.). [CAPTION] -Continued- See Notes on page 11 [CAPTION] Product Key: A) Ignition B) Carburetor C) Wire & Cable D) Champ Service Line E) Temperature Control System Parts F) Friction - Brake Shoes & Pads G) Drums & Rotors H) Hydraulic Brake System Components I) Electronic Ignition J) Power Steering Parts See Notes on page 11 NOTES TO PROPERTY SCHEDULE: (1) Includes executive or division offices. (2) While owned by the registrant for accounting purposes, these properties were actually sold to local industrial development authorities and leased to the registrant under the terms of Industrial Revenue Bond ("IRB") financing agreements. Under those agreements,title to these properties passes to the registrant at maturity for little or no consideration. The rental payments made by the registrant equal the principal and interest due under each IRB. (3) Financed with a bond issue in 1982 for $1,750,000 maturing in 1997. (4) This property is owned subject to a mortgage held by the Massachusetts Mutual Life Insurance Company, in the original amount of $465,000, the final payment of which is due in 1995. (5) Financed with a bond issue in 1980 for $2,670,000 fully paid off in 1993 and a bond issue in 1984 for $2,000,000 maturing through 1999. (6) As of January 1, 1987, the registrant vacated this facility. It is now being leased by the registrant to a third party. (7) This property was purchased on January 5, 1988. (8) Financed with a bond issue in 1989 for $2,500,000 maturing through 1999. (9) The manufacturing operations of the Middletown facility have been consolidated with the existing manufacturing operations at the expanded Berlin, CT facility. This facility is presently being offered for sale. (10) Financed with a bond issue in 1990 for $1,800,000 maturing through 2000. (11) Under terms of the lease, the registrant has an option to purchase the property for $1,000 at the expiration of the lease. (12) The registrant uses this facility for chemical storage. (13) During 1993, the Gardena, CA and Rancho Cucamonga, CA facilities were consolidated into the new Ontario, California facility. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. - --------------------------------- Currently, there are no legal proceedings which management deems would have a material economic impact on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - ------------------------------------------------------------------- None PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND - ------------------------------------------------------------ RELATED STOCKHOLDER MATTERS. ---------------------------- The Company's stock is listed on the New York Stock Exchange. The number of Shareholders of record of Common stock on February 28, 1994 was approximately 1,100 including brokers who hold approximately 7,186,265 shares in street name. The quarterly market price and dividend information is presented in the following chart. Price Range of Common Stock and Dividends The Company's Common Stock is traded on the New York Stock Exchange under the symbol SMP. The following table shows the high and low sale prices on the composite tape of, and the dividend paid per share on, the Common Stock during the periods indicated. 1993 Quarter High Low Dividend 1992 Quarter High Low Dividend - -------------------------------------- -------------------------------------- 1st $17.38 $13.13 $.08 1st $12.25 $9.50 $.08 2nd 20.25 16.13 .08 2nd 13.25 10.38 .08 3rd 24.13 18.88 .08 3rd 13.50 11.50 .08 4th 26.88 21.00 .08 4th 13.63 11.38 .08 - -------------------------------------------------------------------------------- The Board of Directors will consider the payment of future dividends on the basis of earnings, capital requirements and the financial condition of the Company. The Company's loan agreements limit dividends and distributions by the Company. As of December 31, 1993, approximately $8,434,000 of retained earnings was available under those agreements for payment of cash dividends and purchase of capital stock. PART II (CONT'D) ------- ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - --------------------------------------- The following summary financial information has been extracted from the audited financial statements of the Company. [CAPTION] ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Liquidity and Capital Resources - During 1993, stockholders' equity increased $17,055,000 to $178,183,000 and working capital increased $13,336,000 to $204,232,000. Cash provided by operations in 1991 amounted to $50,573,000, primarily due to the decrease in inventories of $35,775,000. In 1992, cash provided by operations amounted to $31,550,000, primarily due to the $25,358,000 reduction in inventories. In 1993, cash provided by operations amounted to $20,105,000 primarily due to net income of $17,508,000. Cash used in investing activities in 1991 was $7,126,000 primarily due to capital expenditures partially offset by proceeds from sales of marketable securities. Cash used in investing activities, primarily due to capital expenditures, was $15,048,000 in 1992 and $11,899,000 in 1993. Cash used in financing activities, primarily due to repayment of debt and dividend payments, was $30,099,000 in 1991 and $23,519,000 in 1992. In December 1992, the Company secured $80,000,000 in long-term financing which was used to reduce short-term bank borrowings. Cash used in financing activities in 1993 was $12,879,000 which consisted primarily of repayments of debt and dividend payments. In 1993, cash provided by the exercise of employee stock options was almost entirely offset by the repurchase of treasury stock. The Company expects capital expenditures to be approximately $14,000,000 for new machinery and equipment. At December 31, 1993, the Company had unused lines of credit aggregating approximately $105,000,000 which will be used as a source of funding capital expenditures and working capital requirements. Comparison of 1993 to 1992 - Property, plant and equipment additions of $12,329,000 were primarily attributable to expenditures for new machinery and equipment. PART II (CONT'D) Short-term notes payable increased $5,100,000 primarily due to principal payments of long-term debt and capital expenditures. Long-term debt (current and non-current) decreased $16,010,000. In 1994, required long-term debt payments will be approximately $4,935,000. Net sales increased $47,298,000 or 8.8%. The sales increase was primarily attributable to increased sales at the Standard Division, Four Seasons Division and the Champ Service Line Division. The sales increase at the Champ Service Line Division was primarily due to the acquisition of substantially all of the General Service Line inventory and certain other related assets of APS, Inc. in the second quarter of 1993 (see Note 2). Excluding the sales resulting from the acquisition, revenues increased by 6.8% in 1993 compared to a year ago. Cost of goods sold increased $27,018,000 from $346,570,000 to $373,588,000. Cost of sales, as a percentage of net sales, decreased from 64.7% to 64.1%. The improvement was attributable to continuous cost reduction programs, and increased absorption of manufacturing overhead partially offset by the lower gross margins of the new product line acquired by the Champ Service Line Division. Selling, general and administrative expenses increased by 1.5% or $2,460,000. This increase was primarily due to costs to support the service line expansion, higher variable costs due to increased sales, higher administrative expenses, ongoing postretirement expenses and increased employee profit sharing contributions due to the higher level of earnings. This increase was partially offset by lower new customer acquisition costs. Restructuring charges of $2,781,000 were incurred in 1993 primarily due to the consolidation of the EIS Brake Parts operation within Connecticut and the rationalization of the Company's manufacturing operations involving the relocation of several product lines. Other income (expense), net increased $951,000 primarily due to income from Blue Streak Electronics, Inc., a decrease on the loss on sale of receivables and realized gains on investments sold. Interest expense was virtually unchanged versus the year earlier period. The interest expense reduction resulting from a lower level of borrowings was offset by an increase in the average maturity of borrowings resulting in a greater portion of borrowings with higher interest rates associated with such longer-term borrowings. Taxes based on earnings increased by $6,265,000 due to increased earnings and a higher effective tax rate. The higher effective tax rate in 1993 was primarily due to an increase in tax rates resulting from the Omnibus Budget Reconciliation Act of 1993 and lower United States tax exempt earnings of the Company's Puerto Rican operation relative to the Company's Domestic operations. Cumulative effect of changes in accounting for postretirement benefits and income taxes, net is the result of the Company adopting, as of January 1, 1993 two changes in accounting principles, Statement of Financial Accounting Standards (SFAS) No. 106 - "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 109 - "Accounting for Income Taxes". The aftertax charge for SFAS No. 106 of $6,135,000 (after an income tax benefit of $4,090,000), combined with the tax benefit for SFAS No. 109 of $5,045,000 reduced net earnings by $1,090,000. Comparison of 1992 to 1991 - Property, plant and equipment additions of $15,257,000 were attributable to new building construction in Connecticut and Texas and expenditures for new machinery and equipment. PART II (CONT'D) ------- Short-term notes payable to the banks decreased $82,200,000, primarily due to refinancing and inventory reductions, partially offset by principal payments of long-term debt and capital expenditures. Long-term debt (current and non-current) increased $61,218,000. This was attributable to the issuance of $80,000,000 in long-term financing partially offset by principal payments of $18,782,000. In 1993, required long-term debt payments will be approximately $15,348,000. Net sales increased $745,000 or 0.1%. Sales increases in the brake parts line were offset by sales decreases in temperature control systems, fuel systems and wire and cable. Ignition parts had a modest increase while Champ Service Line was flat. Cost of goods sold decreased $951,000, from $347,521,000 to $346,570,000. Cost of sales, as a percentage of net sales, decreased from 65.0% to 64.7%. The improvement was attributable to achieving strict cost controls and implementation of "Just in Time" manufacturing. Provisions for slow-moving and excess inventories negatively affected the cost of sales percentage in both 1992 and 1991. Selling, general and administrative expenses increased $3,774,000. This increase was primarily due to the provisions for bad debts, marketing programs and allowances, workmen's compensation expenses and plant consolidation expenses. Offsetting these increases were lower customer acquisition costs and cost reduction programs. Other income (expense) - net increased $221,000 primarily due to a reduction in loss on sale of receivables offset by lower returns on investments. Interest expense decreased $4,833,000 primarily due to lower interest rates on bank loans and a lower level of borrowings. Taxes based on earnings increased $765,000 due to higher earnings and a higher effective tax rate. Net income increased $2,211,000 from $6,667,000 to $8,878,000. Impact of Inflation - Although inflation is not a significant issue, the Company's management believes it will be able to continue to minimize any adverse effect of inflation on earnings. This will be achieved principally by cost reduction programs and, where competitive situations permit, selling price increases. Future Results of Operations - The Company expects to continue the inventory reduction program initiated in 1991. From December 1990 through December 1993 inventory has been reduced approximately $50 million. The company is facing increased price pressures in certain areas and has reduced prices in its Four Seasons Temperature Control, EIS Brake Parts and Champ Service Lines. These price reductions are expected to total approximately $7 million in 1994. Cost reduction programs are being implemented and are anticipated to offset most of the loss due to these price reductions. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ----------------------------------------------------------- INDEPENDENT AUDITORS' REPORT To the Board of Directors Standard Motor Products, Inc. We have audited the consolidated balance sheets of Standard Motor Products, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Standard Motor Products, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. New York, New York David Berdon & Co. February 25, 1994 Certified Public Accountants -F1- [CAPTION] See accompanying notes to consolidated financial statements. -F2- [CAPTION] See accompanying notes to consolidated financial statements. -F3- [CAPTION] See accompanying notes to consolidated financial statements. -F4- [CAPTION] See accompanying notes to consolidated financial statements. -F5- Standard Motor Products, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies Principles of Consolidation The Company is engaged in the manufacture and sale of automotive replacement parts. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries, all of which are wholly owned. As more fully described in Note 2, the Companys investment in an unconsolidated affiliate is accounted for on the equity method. All significant intercompany items have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. Marketable Securities Marketable securities are stated at the lower of cost or market values, determined by means of the first-in, first-out method. The valuation allowances for the excess of cost over market value was $13,000 at December 31, 1993. Inventories Inventories are stated at the lower of cost (determined by means of the first-in, first-out method) or market values. Property, Plant and Equipment These assets are recorded at cost and are depreciated over their respective useful lives using the straight-line method of depreciation. Stock Options In general, no accounting is made for options until they are exercised, at which time the difference between the option price and the par value of the capital stock issued or the cost of treasury stock issued is reflected in the capital in excess of par value account. Net Earnings Per Common and Common Equivalent Share Net earnings per common and common equivalent share are calculated using the daily weighted average number of common shares outstanding during each year and on the net additional number of shares which would be issuable upon the exercise of stock options, assuming that the Company used the proceeds received to purchase additional shares at market value. Shares held by the ESOP are considered outstanding and are included in the calculation to determine earnings per share. Income Taxes Deferred income taxes result from timing differences in methods of recording certain revenues and expenses for financial reporting and for income tax purposes (see Note 14). Customer Acquisition Costs Costs associated with the acquisition of new customer accounts are deferred and amortized over a twelve-month period. Foreign Currency Translation Accounts of foreign subsidiaries are measured using local currency as the functional currency. Assets and liabilities are translated into U.S. dollars at year end exchange rates and revenues and expenses are translated at average exchange rates during the year. The resulting translation adjustments are recorded in a separate component of stockholders equity. 2. Acquisitions The Company acquired, as of September 1, 1992, 50% ownership in Blue Streak Electronics, Inc. for approximately $360,000. Blue Streak Electronics, Inc., located in Concord, Canada, is a remanufacturer of automotive on-board computers, sensors and related parts. The investment is accounted for under the equity method. The accompanying consolidated Financial Statements include the investment in subsidiary at December 31, 1993 and 1992 of approximately $597,000 and $263,000, respectively in Other assets: Sundry. The gain of approximately $352,000 in 1993 and the loss of approximately $97,000 in 1992 attributed to this investment are included in Other income (expense), net. In April 1993, the Company acquired, for approximately $9,000,000, substantially all of the general service line inventory and certain other related assets of APS, Inc., a national distributor of automotive parts, along with a ten-year agreement to supply this product line to APS, Inc. on an exclusive basis. This acquisition has been accounted for as a purchase. The acquisition increased consolidated net sales by approximately $10,900,000 in 1993 and decreased net earnings by approximately $1,500,000 in the same period primarily due to launch costs. Subsequent to year end 1993, the Company entered into a Joint Venture Agreement for the remanufacture of calipers and other brake related items. The Companys initial investment was approximately $250,000. 3. Sale of Accounts Receivables On July 10, 1990, the Company entered into a three-year agreement whereby it can sell up to a $25,000,000 undivided interest in a designated pool of certain eligible accounts receivable. On July 8, 1993, the termination date on this agreement was extended to October 10, 1993. On December 20, 1993, the Company entered into a new three-year agreement with a different lending institution. At December 31, 1993, 1992 and 1991, net receivables amounting to $25,000,000 had been sold under these agreements. As collections reduce previously sold undivided fractional interest, new receivables are customarily sold up to the $25,000,000 level. At the expiration of the agreement, the Company and the purchaser share a proportionate risk of loss as the eligible pool of accounts receivable is liquidated (see Note 13). -F6- 4. Inventories (In thousands) December 31, --------------------- 1993 1992 ---------------------------------------------------------- Inventories consist of: Finished goods $103,886 $95,418 Work in process 18,249 19,123 Raw materials 42,015 38,657 ---------------------------------------------------------- Total inventory $164,150 $153,198 ---------------------------------------------------------- 5. Property, Plant and Equipment (In thousands) December 31, --------------------- 1993 1992 ---------------------------------------------------------- Property, plant and equipment consist of the following: Land and buildings $ 67,470 $ 67,045 Machinery and equipment 55,341 50,087 Tools, dies and auxiliary equipment 6,526 5,427 Furniture and fixtures 13,756 12,496 Leasehold improvements 4,622 4,714 Construction in progress 8,147 4,692 --------------------- 155,862 144,461 Less, accumulated depreciation and amortization 52,858 42,932 ---------------------------------------------------------- Total property, plant and equipment, net $103,004 $101,529 ---------------------------------------------------------- 6. Other Assets Sundry (In thousands) December 31, --------------------- 1993 1992 ---------------------------------------------------------- Other assets sundry consist of the following: Unamortized customer supply agreements $ 7,558 $3,142 Long-term investments 4,560 2,600 Equity in Blue Streak Electronics, Inc. 597 263 Pension assets 713 771 Deferred charges and other 465 674 ---------------------------------------------------------- Total other assets sundry $13,893 $7,450 ---------------------------------------------------------- 7. Notes Payable Banks The maximum amount of short-term bank borrowings outstanding at any month-end was $27,700,000 in 1993 and $105,800,000 in 1992, and averaged $16,958,000 and $96,100,000, respectively. The weighted average short-term interest rate was 3.99% for 1993 and 5.15% for 1992. At December 31, 1993, the Company had unused lines of credit aggregating approximately $105,000,000. As part of several of the loan arrangements, the Company has verbal agreements whereby it is expected to maintain compensating balances which amounted to $218,000 at December 31, 1993. The compensating balances are held under agreements which do not legally restrict the use of such funds and, therefore, the funds are not segregated on the face of the balance sheet. In lieu of maintaining these balances, the Company has paid fees of approximately $113,000, $132,000 and $107,000 in 1993, 1992 and 1991, respectively. 8. Long-Term Debt (In thousands) December 31, --------------------- 1993 1992 ----------------------------------------------------------------- Long-term debt consists of: 7.85% senior notes payable $ 65,000 $ 65,000 11.50%-12.00% senior notes payable 6,000 18,000 9.47% senior notes payable 30,000 30,000 6.01% senior notes payable 15,000 15,000 Credit Agreement 8,394 10,074 7.00%-13.00% purchase obligations 9,862 12,006 Floating rate purchase obligation 1,100 1,240 9.50% mortgage payable 93 139 ----------------------------------------------------------------- 135,449 151,459 Less current portion 4,935 15,348 ----------------------------------------------------------------- Total noncurrent portion of long-term debt $130,514 $136,111 ----------------------------------------------------------------- Under the terms of the $65,000,000 senior note agreement, the Company is required to repay the loan in seven equal annual installments beginning in 1996. Under the terms of the $6,000,000 senior note agreement, the Company is required to repay the remaining loan in three equal annual installments ending in 1996. An optional prepayment of $5,000,000 was made on March 1, 1993. Under the terms of the $30,000,000 senior note agreement, the Company is required to repay the loan in seven varying annual installments beginning in 1998. Subject to certain restrictions, the Company may make prepayments without premium beginning in 1998. Under the terms of the $15,000,000 senior note agreement, the Company is required to repay the loan in full in 1995. The Company also entered into an interest rate swap agreement. The swap agreement modifies the interest rate on the $15,000,000 senior note agreement, adjusted favorably or unfavorably for the spread between 5.66% and the 6-month reserve unadjusted London Interbank Offering Rate ("LIBOR"). The Credit Agreement matures in equal annual installments through 1998 and bears interest at the lower of 91% of prime rate, or 91% of the "LIBOR" plus 1.092%. The Company also entered into an interest rate swap agreement to reduce the impact of changes in interest rates on its Credit Agreement. The swap agreement modifies the interest rate on $7,762,500 of the Credit Agreement, adjusted favorably or unfavorably for the spread between 77.52% of the 3-month reserve unadjusted LIBOR and 7.69%. The proceeds of such note were loaned to the Companys Employee Stock Ownership Plan (ESOP) to purchase 1,000,000 shares of the Companys common stock to be distributed in accordance with the terms of the ESOP established in 1989 (see Note 11). The purchase obligations, due under agreements with municipalities, mature in annual installments through 2003, and are secured by properties having a net book value of approximately $23,513,000. An optional prepayment of $660,000 was made on November 1, 1993. -F7- The floating rate purchase obligation matures in annual installments through 1999, bears interest at sixty-five percent of prime, and is secured by property having a net book value of approximately $1,390,000. The mortgage payable is due in installments through 1995. Maturities of long-term debt during the five years ending December 31, 1998 are $4,935,000, $19,987,000, $14,262,000, $12,912,000, and $16,601,000 respectively. The loan agreements require the maintenance of a specified amount of working capital and limit, among other items, investments, leases, indebtedness and distributions for the payment of dividends and the acquisition of capital stock. Effective December 31, 1993, the Company had unrestricted retained earnings of $8,434,000. 9. Stockholders Equity The Company has authority to issue 500,000 shares of preferred stock, $20 par value, and the Board of Directors is vested with the authority to establish and designate series of preferred, to fix the number of shares therein and the variations in relative rights as between series. No such shares are outstanding at December 31, 1993. The Company announced on October 18, 1993 that the Board of Directors has authorized the repurchase by the Company of up to 325,000 shares of its common stock to be used to meet present and future requirements of its stock option program. As of December 31, 1993, 195,200 shares were repurchased at a cost of $4,524,000. 10. Stock Options Under the Companys stock option plans, options are exercisable in whole or in part anytime during the five years following the date of grant and while the holder is an employee of the Company. At December 31, 1993, 82,300 options were granted but have not yet been exercised. No additional shares of common stock were available under authorized stock option plans. The changes in outstanding options were as follows: ------------------------------------------------------------------- 1993 1992 1991 ------------------------------------------------------------------ Outstanding at beginning.. 437,700 441,600 491,865 Granted 32,000 72,000 22,000 Exercised (1993 $10.13 to $16.88, 1992 and 1991 $10.13) (378,650) (2,000) (2,000) Terminated and expired (8,750) (73,900) (70,265) ------------------------------------------------------------------ Outstanding at end 82,300 437,700 441,600 ------------------------------------------------------------------ Aggregate option price $1,337,688 $5,968,938 $6,330,538 ------------------------------------------------------------------ At a price range per share of: 1993 1992 1991 --------------------------------------------------------------------- Beginning $10.13 to $16.88 $10.13 to $17.56 $10.13 to $17.56 End $10.13 to $18.56 $10.13 to $16.88 $10.13 to $17.56 --------------------------------------------------------------------- 11. Employee Benefit Plans The Company has a defined benefit pension plan covering substantially all of the unionized employees of the EIS Brake Parts Division. The benefits are based on years of service. The Companys funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The following table sets forth the plans funded status and amounts recognized in the Companys statement of financial position at December 31, 1993 and 1992: (In thousands) December 31, --------------------- 1993 1992 --------------------------------------------------------------------- Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $9,474 ($9,011-1992) $(10,032) $(9,531) --------------------------------------------------------------------- Projected benefit obligation for service rendered to date $(10,032) $(9,805) Plan assets at fair value (primarily debt securities, commercial mortgages and listed stocks 8,738 8,095 --------------------------------------------------------------------- Plan assets (less than) projected benefit obligation (1,294) (1,710) Unrecognized net loss from past experience (different from that assumed and effects of changes in assumptions) 1,250 1,712 Unrecognized net obligation being recognized over 15 years 198 225 Adjustment required to recognize minimum liability (1,448) (1,663) --------------------------------------------------------------------- Accrued pension cost included in accrued expenses $(1,294) $(1,436) --------------------------------------------------------------------- Net pension cost for 1993 and 1992 included the following components: Service cost benefits earned during the period $ 248 $ 220 Interest cost on projected benefit obligation 613 590 Actual return on plan assets (960) (724) Net amortization and deferral 391 59 --------------------------------------------------------------------- Net periodic pension cost $ 292 $ 145 --------------------------------------------------------------------- Assumptions used in accounting for the pension plan at December 31, 1993 and 1992 were: Discount rates 6.5% 6.6% Expected long-term rate of return on assets 8.0% 8.5% --------------------------------------------------------------------- Pension expense for the year ended December 31, 1991 was $121,000. In addition, the Company participates in several multiemployer plans which provide defined benefits to substantially all unionized -F8- workers. The Multiemployer Pension Plan Amendments Act of 1980 imposes certain liabilities upon employers associated with multiemployer plans. The Company has not received information from the plans administrators to determine its share, if any, of unfunded vested benefits. The Company and certain of its subsidiaries also maintain various defined contribution plans providing retirement benefits for other eligible employees. The provisions for retirement expense in connection with the plans are as follows: Defined Multi- Contribution employer Plans and Other Plans -------------------------------------------------------------------------- Year-end December 31, 1993 $358,000 $4,760,000 1992 498,000 1,895,000 1991 478,000 1,729,000 -------------------------------------------------------------------------- In January 1989, the Company established an Employee Stock Ownership Plan (ESOP) and Trust for employees who are not covered by a collective bargaining agreement. The ESOP authorized the Trust to purchase up to 1,000,000 shares of the Companys common stock in the open market. In 1989, the Company entered into an agreement with a bank authorizing the Company to borrow up to $18,000,000 in connection with the ESOP. Under this agreement, the Company borrowed $16,729,000, payable in equal annual installments through 1998 (see Note 8), which was loaned on the same terms to the ESOP for the purchase of common stock. During 1989, the ESOP made open market purchases of 1,000,000 shares at an average cost of $16.78 per share. The ESOP allocated approximately 100,000 shares of common stock per annum to participants from 1989 through 1993. At December 31, 1993, the ESOP owned approximately 500,000 shares of common stock. Future company contributions plus dividends earned will be used to service the debt. Contributions to the ESOP are based on a predetermined formula which is primarily tied into dividends earned by the ESOP and loan repayments. The expense was calculated by subtracting dividend and interest income earned by the ESOP, which amounted to approximately $305,000, $313,000 and $319,000 for the years ended December 31, 1993, 1992 and 1991, respectively, from the principal repayment on the outstanding bank loan. Interest costs amounted to approximately $772,000, $756,000 and $1,149,000 for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 indebtedness of the ESOP to the Company in the amounts of $8,385,000 and $10,065,000, respectively, are shown as deductions from shareholders equity in the consolidated balance sheet. Federal income tax benefits of $124,000 in 1993, $123,000 in 1992 and $125,000 in 1991, resulting from the deductibility of certain dividends paid by the Company to the ESOP, were credited directly to capital in excess of par. The provision for expense in connection with the ESOP was approximately $1,380,000 in 1993, $1,387,000 in 1992 and $1,378,000 in 1991. 12. Postretirement Benefits Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions. Prior years financial statements have not been restated to apply the provisions of SFAS No. 106. The Company provides certain medical and dental care benefits to eligible retired employees. Approximately 2,200 employees and retirees are eligible under this plan. Salaried employees become eligible for retiree health care benefits after reaching age 65 if they retire at age 65 or older with at least 15 years of continuous service. EIS Brake Parts unionized employees become eligible after reaching age 65 if they retire at age 65 or older with at least 10 years of continuous service. Other unionized employees are covered under union health care plans. Generally, the health care plans pay a stated percentage of most health care expenses reduced for any deductible and payments made by government programs and other group coverage. The costs of providing most of these benefits has been shared with retirees since 1991. Retiree annual contributions will increase proportionally if the Companys health care payments increase. The plans are unfunded. SFAS No. 106 requires that the expected cost of these postretirement benefits be charged to expense during the years that the employees render services. SFAS No. 106 was adopted using the immediate recognition transition option; the accumulated postretirement benefit obligation of $10,225,000, and related deferred tax benefit of $4,090,000 (net of $6,135,000), has been included in cumulative effect of changes in accounting for postretirement benefits and income taxes, net in the statement of consolidated earnings. This new accounting method has no effect on the Companys cash outlays for retiree benefits. For measuring the expected postretirement benefit obligation, a 14 percent annual rate of increase in the per capita claims cost was assumed for 1993. This rate was assumed to decrease 1 percent per year to 7 percent in 2000, then 0.5 percent per year to 6 percent in 2002 and remain at that level thereafter. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 8 percent at January 1, 1993. The postretirement benefits expense, excluding the cumulative catch-up adjustment, was $1,472,000, $294,000 and $171,000 for 1993, 1992 and 1991, respectively. The 1993 figure includes approximately $800,000 interest charges. -F9- 13. Other Income (Expense), Net (In thousands) December 31, -------------------------------- 1993 1992 1991 ------------------------------------------------------------------ Other income (expense), net consists of: Interest and dividend income $1,648 $1,630 $2,024 Gains on investments in marketable securities 311 157 150 (Loss) on sale of accounts receivable (Note 3) (660) (997) (1,754) Income (loss) from Blue Streak Electronics, Inc. 352 (97) -- Other-net (3) 4 56 ------------------------------------------------------------------ Total other income (expense), net $1,648 $ 697 $ 476 ------------------------------------------------------------------ 14. Taxes Based on Earnings The effective tax rates for 1993, 1992 and 1991 were 30.6%, 17.9% and 15.0%, respectively, which vary from the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991. The difference is accounted for as follows: As a Percent of Earnings Before Taxes ------------------------------------------------------------------- 1993 1992 1991 ------------------------------------------------------------------- Statutory federal income tax rates 35.0% 34.0% 34.0% Increase (decrease) in tax rate resulting from: State and local income taxes, net of federal income tax benefit 5.5 1.5 1.6 (Tax-exempt income)/ non-deductible items-net 0.2 0.2 (12.9) Benefits of foreign taxes at lower than statutory federal rate (9.7) (16.8) (6.3) Other (0.4) (1.0) (1.4) ------------------------------------------------------------------- Effective tax rate 30.6% 17.9% 15.0% ------------------------------------------------------------------- The Company has not provided for federal income taxes on the undistributed income of its foreign subsidiaries because of the availability of foreign tax credits and/or the Companys intention to permanently reinvest such undistributed income. Cumulative undistributed earnings of foreign subsidiaries on which no United States income tax has been provided were $10,011,000 at the end of 1993, $7,181,000 at the end of 1992 and $5,734,000 at the end of 1991. Earnings of a subsidiary operating in Puerto Rico, amounting to approximately $7,285,000 (1992 $6,941,000; 1991 $5,906,000), which are not subject to United States income taxes, are partially exempt from Puerto Rican income taxes under a tax exemption grant expiring on December 31, 2002. The tax benefits of the exemption, reduced by a minimum tollgate tax instituted in 1993, amounted to $.22 per share in 1993 (1992 $.23; 1991 $.18). Income earned (losses) incurred by foreign subsidiaries not eliminated in consolidation amounted to approximately $453,000, ($29,000) and ($396,000) for the years ended December 31, 1993, 1992 and 1991. Foreign income taxes amounted to approximately $838,000, $697,000 and $363,000 for 1993, 1992 and 1991, respectively. These foreign income taxes relate primarily to manufacturing facilities whose operations are eliminated in consolidation. Deferred income tax expense results from timing differences in the recognition of income and expense for tax and financial reporting purposes. The sources and tax effects of these timing differences are presented below: (In thousands) December 31, -------------------------------- 1993 1992 1991 ------------------------------------------------------------------ Installment sales $ -- $ -- $(1,679) Allowance for doubtful accounts (28) (268) 299 Allowance for customer returns (1,252) (232) (483) Accrued salaries 61 332 (187) Restructuring charges (933) -- -- Promotional costs (722) (427) (120) Postretirement benefits (488) -- -- Inventory (2,070) (14) 62 Depreciation (118) 101 96 Other net 7 (68) 163 ------------------------------------------------------------------ Total deferred tax expense $ (5,543) $ (576) $(1,849) ------------------------------------------------------------------ Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. Prior years financial statements have not been restated to apply the provisions of SFAS No. 109. Under SFAS No. 109, deferred tax balances are stated at tax rates expected to be in effect when taxes are actually paid or recovered. The cumulative catch-up adjustment resulted in a deferred tax benefit of $5,045,000, which has been included in the statements of consolidated earnings as cumulative effect of changes in accounting for postretirement benefits and income taxes, net. The following is a summary of the components of the net deferred tax asset and liability accounts recognized in the accompanying consolidated balance sheets. (In thousands) December 31, ------------ --------------------------------------------------------------------- Differences between tax and book amounts: Deferred tax assets: Inventory $ 9,291 Allowance for customer returns 5,412 Postretirement benefits 4,581 Allowance for doubtful accounts 1,348 Accrued salaries 1,424 Restructuring charges 1,023 Other 408 --------------------------------------------------------------------- Total $23,487 --------------------------------------------------------------------- -F10- Deferred tax liabilities: Depreciation $ 8,093 Promotional costs 728 Other 831 --------------------------------------------------------------------- Total 9,652 --------------------------------------------------------------------- Net deferred tax asset $13,835 --------------------------------------------------------------------- 15. Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents The carrying amount approximates fair value because of the short maturity of those instruments. Long-term debt The fair value of the Corporations long-term debt is estimated based on the current rates offered to the Corporation for debt of the same remaining maturities. Interest rate swap agreements The fair value of interest rate swaps (used for hedging purposes) is the estimated amount that the Company would receive or pay to terminate the swap agreements at the reporting dates, taking into account current interest rates. The estimated fair values of the Corporations financial instruments are as follows: (In thousands) December 31, 1993 Carrying Fair Amount Value --------------------------------------------------------------------- Cash and cash equivalents $ 12,346 $ 12,346 Long-term debt (135,449) (151,587) Unrecognized financial instruments: Interest rate swaps: In a net receivable position -- 415 In a net payable position -- (1,146) --------------------------------------------------------------------- (In thousands) December 31, 1992 Carrying Fair Amount Value --------------------------------------------------------------------- Cash and cash equivalents $ 17,025 $ 17,025 Long-term debt (151,459) (154,940) Unrecognized financial instruments: Interest rate swaps: In a net receivable position -- 643 In a net payable position -- (1,328) --------------------------------------------------------------------- 16. Commitments Total rent expense for the three years ended December 31, 1993 was as follows: (In thousands) Real Total Estate Other --------------------------------------------------------------------- 1993 $5,544 $2,320 $3,224 1992 5,931 2,618 3,313 1991 6,837 3,217 3,620 At December 31, 1993, the Company is obligated to make minimum rental payments (exclusive of real estate taxes and certain other charges) through 2003, under operating leases for real estate, as follows: (In thousands) 1994 $ 1,734 1995 1,377 1996 1,178 1997 965 1998 853 Thereafter 3,900 --------------------------------------------------------------------- $10,007 --------------------------------------------------------------------- The Companys receivables are primarily from United States warehouse distributors in the automotive aftermarket industry. At December 31, 1993, the Company had letters of credit outstanding aggregating approximately $1,650,000. 17. Restructuring Charges During 1993, the company recorded a $2,781,000 provision for restructuring charges. Included in the restructuring plan are charges for the expected costs of facility consolidations, asset retirements, employee separations, relocations and related costs. 18. Quarterly Financial Data The following selected quarterly financial data have not been audited and, accordingly, the independent certified public accountants express no opinion thereon: Net Gross Net Per Sales Profit Earnings Share --------------------------------------------------------------------- (In thousands, except per share amounts) --------------------------------------------------------------------- 1993 Quarter: First $127,755 $ 45,684 $ 1,763 $ .13 Second 161,201 56,760 6,779 .51 Third 161,340 56,786 5,703 .43 Fourth 132,555 50,033 3,263 .25 --------------------------------------------------------------------- Total $582,851 $209,263 $17,508 $1.32 --------------------------------------------------------------------- 1992 Quarter: First $128,794 $ 46,250 $ 1,068 $ .08 Second 150,805 52,402 2,000 .15 Third 138,276 47,917 2,813 .22 Fourth 117,678 42,414 2,997 .23 --------------------------------------------------------------------- Total $535,553 $188,983 $ 8,878 $ .68 --------------------------------------------------------------------- Net earnings in the first quarter of 1993 were adversely impacted by $1,090,000 due to the net cumulative effect of changes in accounting for postretirement benefits and income taxes. The fourth quarter 1993 reflects an improved gross profit percentage, compared to the prior 1993 quarters, primarily due to favorable year-end inventory adjustments. The net earnings improvement in the fourth quarter 1993 as compared to the same quarter in 1992 was attributable to increased sales partially offset by restructuring charges and an increase in amortized customer acquisition costs. The fourth quarter 1992 reflects a slightly improved gross profit percentage, compared to the prior 1992 quarters, primarily due to favorable year-end inventory adjustments. -F11- INDEPENDENT AUDITOR'S REPORT To the Board of Directors and Stockholders Standard Motor Products, Inc. In connection with our audits of the consolidated financial statements of Standard Motor Products, Inc. and subsidiaries for the years ended December 31, 1993, 1992 and 1991, we have also audited the financial statement schedules listed in the accompanying index at Item 14(a) (2) for the years ending December 31, 1993, 1992 and 1991. Our audits of the financial statements were made for the purpose of forming an opinion on those statements taken as a whole. The financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These financial statements schedules have been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. DAVID BERDON & CO. New York, New York February 25, 1994 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. - -------------------------------------------------------------- None. PART III -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- -------------------------------------------------- Information relating to Directors and Executive Officers is set forth in the 1994 Annual Proxy Statement. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION AND TRANSACTIONS. - -------- ----------------------------------------- Information relating to Management Remuneration and Transactions is set forth in the 1994 Annual Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- ---------------------------------------------------------------- Information relating to Security Ownership of Certain Beneficial Owners and Management is set forth in the 1994 Annual Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ---------------------------------------------- Information relating to Certain Relationships and Related Transactions is set forth under "Certain Transactions" in the 1994 Annual Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON - ------------------------------------------------------------------- FORM 8-K. --------- 14.(a)Document List ------------- (a)(1) Among the responses to this Item 14(a) are the following financial statements. Report of Independent Certified Public Accountants Financial Statements: Consolidated Balance Sheets - December 31, 1993 and 1992 Statements of Consolidated Earnings - Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Changes in Stockholders' Equity- Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (a)(2) The following financial schedules for the years 1993, 1992 and 1991 are submitted herewith: Schedule Page -------- ---- V. Property, Plant and Equipment 24 VI. Accumulated Depreciation and 25 Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts 26 IX. Short-Term Borrowings 27 Selected Quarterly Financial Data, for the Years Ended December 31, 1993 and 1992, are included herein by reference to Part II, Item 8. All other schedules are omitted because they are not required, inapplicable or the information is included in the financial statements or notes thereto. (a)(3) Exhibits required by Item 601 of Securities and Exchange Commission Regulations S-K. (A) The following such exhibits are filed as a separate section of this report. (11)Computation of Weighted Average of Common and Common Equivalent shares Outstanding is included on Page 28. (22)List of Subsidiaries of Standard Motor Products, Inc. is included on Page 29. (B) The following such exhibits are incorporated herein by reference. (3) Restated Certificate of Incorporation, dated July 25, 1984, filed as an Exhibit of Registrant's quarterly report on Form 10-Q for the quarter ended September 30, 1984 is incorporated herein by reference. By-Laws filed as an Exhibit of Registrant's annual report on Form 10-K for the year ended December 31, 1986 is incorporated herein by reference. Restated Certificate of Incorporation, dated July 31, 1990, filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 is incorporated herein by reference. (4) Note Purchase Agreement of January 15, 1987 between the Registrant and the Travelers Insurance Company, the Great-West Life Assurance Company, the Franklin Life Insurance Company, the Franklin United Life Insurance Company, and Woodmen Accident and Life Company filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986 is incorporated herein by reference. Letter Agreement of January 25, 1989 amending the Note Agreement between the Registrant and the Travelers Insurance Company, the Great-West Life Assurance Company, the Franklin Life Insurance Company, the Franklin United Life Insurance Company, and Woodmen Accident and Life Company dated January 15, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 is incorporated herein by reference. Credit Agreement dated March 10, 1989 between the Registrant and Chemical Bank filed as an Exhibit of Registrant's Annual Report on Form 10- K for the year ended December 31, 1990 is incorporated herein by reference. Note Purchase Agreement dated October 15, 1989 between the Registrant and the American United Life Insurance Company, the General American Life Insurance Company, the Jefferson-Pilot Life Insurance Company, the Ohio National Life Insurance Company, the Crown Insurance Company, the Great-West Life Assurance Company, the Guarantee Mutual Life Company, the Security Mutual Life Insurance Company of Lincoln, Nebraska, and the Woodmen Accident and Life Company filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 is incorporated herein by reference. Letter Agreement of January 15, 1990 amending the Note Agreement between the Registrant and the Travelers Insurance Company dated January 15, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 is incorporated herein by reference. Letter Agreement of July 20, 1990 amending the Credit Agreement between the Registrant and Chemical Bank dated March 10, 1989 filed as an Exhibit of Registrant's Annual Report on Form 10- K for the year ended December 31, 1989 is incorporated herein by reference. Letter Agreement of September 30, 1990 amending the Note Agreement between the Registrant and the Travelers Insurance Company, the Great-West Life Assurance Company, The Franklin Life Insurance Company, The Franklin United Life Insurance Company and Woodmen Accident and Life Company January 15, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 is incorporated herein by reference. Letter Agreement of March 4, 1991 amending the Credit Agreement between the Registrant and Chemical Bank dated March 10, 1989 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 is incorporated herein by reference. Letter Agreement of December 20, 1991 amending the Credit Agreement between the Registrant and Chemical Bank dated March 10, 1989 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 is incorporated herein by reference. Letter Agreement of February 28, 1992 amending the Note Agreement between the Registrant and the Travelers Insurance Company, the Great-West Life Assurance Insurance Company, the Franklin Life Insurance Company, the Franklin United Life Insurance Comapany and the Woodmen Accident and Life Company dated January 15, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference. Letter Agreement of July 22, 1992 amending the Note Agreement between the Registrant and the Travelers Insurance Company, the Great-West Life Assurance Company, the Franklin Life Insurance Company, the Franklin United Life Insurance Company and Woodmen Accident and Life Company dated January 15, 1987 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference. Letter Agreement dated October 30, 1992 amending the Credit Agreement between the Registrant and Chemical Bank, assigned to NBD Bank, N.A. with amendment dated December 20, 1991, dated March 10, 1989 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference. Note Agreement of November 15, 1992 between the Registrant and Kemper Investors Life Insurance Company, Federal Kemper Life Assurance Company, Lumbermens Mutual Casualty Company, Fidelity Life Association, American Motorists Insurance Company, American Manufacturers Mutual Insurance Company, Allstate Life Insurance Company, Teachers Insurance & Annuity Association of America and Phoenix Home Life Mutual Insurance Company filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference. Note Agreement of November 15, 1992 between the Registrant and Principal Mutual Life Insurance Company and Principal National Life Insurance Company filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference. (5) Employee Stock Ownership Plan and Trust dated January 1, 1989 filed as an Exhibit of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 is incorporated herein by reference. (C) The following exhibits have been included in the filing made with the SEC and are available upon request. Letter Agreement dated December 27, 1993 amending the Credit Agreement between the Registrant and Chemical Bank, assigned to NBD Bank, N.A. with amendment dated December 20, 1991, dated March 10, 1989 is included as Exhibit A. 14(b) Reports on Form 8-K No reports on Form 8-K were required to be filed for the three months ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 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. STANDARD MOTOR PRODUCTS, INC. (Registrant) Lawrence I. Sills ----------------------------------------------- Lawrence I. Sills, President (Chief Operating Officer) Michael J. Bailey ----------------------------------------------- Michael J. Bailey, Vice President Finance, Chief Financial Officer David Kerner ----------------------------------------------- David Kerner, Treasurer Dated: New York, New York March 25, 1994 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: March 25, 1994 Lawrence I. Sills - -------------- ----------------------------------------------- (Dated) Lawrence I. Sills, President (Chief Operating Officer) March 25, 1994 Bernard Fife - -------------- ----------------------------------------------- (Dated) Bernard Fife Co-Chairman, Director March 25, 1994 Nathaniel L. Sills - -------------- ----------------------------------------------- (Dated) Nathaniel L. Sills Co-Chairman, Director March 25, 1994 Arlene R. Fife - -------------- ----------------------------------------------- (Dated) Arlene R. Fife, Director March 25, 1994 Ruth F. Sills - -------------- ----------------------------------------------- (Dated) Ruth F. Sills, Director [CAPTION] Estimated useful lives used in computing depreciation are as follows: Estimated Life Buildings and improvements 15 to 33-1/3 years Machinery and equipment 9-1/2 years Furniture and fixtures 8 years Tools, dies and auxiliary equipment3 to 8 years Leasehold improvements Lesser of 10 years or life of lease [CAPTION] [CAPTION] (a) Recoveries of accounts previously written off. (b) Uncollectible accounts charged against the reserve. [CAPTION] (a) Computed using the daily outstanding principal balance during the year. (b) Computed using the total interest expense from short-term borrowings and the average outstanding short-term borrowings during the year. [CAPTION] EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT AS OF FEBRUARY 28, 1994 Percent State or of Voting Country of Securities Name Incorporation Owned - ---- ------------- ---------- Blue Streak-Hygrade Motor Products Ltd. Canada 100(1) Marathon Auto Parts and Products, Inc. New York 100 Motortronics, Inc. New York 100 Reno Standard Incorporated Nevada 100 Stanric, Inc. Delaware 100 Mardevco Credit Corp. (2) New York 100 Standard Motor Products (Hong Kong) Limited Hong Kong 100 Industrial & Automotive Associates, Inc. California 100 All of the subsidiaries are included in the consolidated financial statements. - -------------------------------------------- (1) Except for directors' qualifying shares (2) Wholly owned subsidiary of Stanric, Inc. INDEX TO EXHIBITS PAGE Exhibit A - Letter Agreement dated December 27, 1993 31 - 37 amending the Credit Agreement between the Registrant and Chemical Bank assigned to NBD Bank, N.A. with amendment dated December 20, 1991, dated March 10, 1989. FIFTH AMENDMENT TO CREDIT AGREEMENT THIS FIFTH AMENDMENT TO CREDIT AGREEMENT, dated as of December 27, 1993 (this "Amendment") is among Standard Motor Products, Inc., a New York corporation (the "Borrower"), Stanric, Inc., Mardevco Credit Corp., Reno Standard Incorporated, Marathon Auto Parts & Products, Inc., Industrial and Automotive Associates, Inc., Motortronics, Inc., Standard Motor Products (Hong Kong) Ltd., Blue Streak-Hygrade Motor Products, LTD. (each of which is herein referred to as a "Guarantor" and collectively as the "Guarantors") and NBD Bank, N.A., a national banking association (the "Bank"). RECITALS WHEREAS, Chemical Bank, the Borrower and the Guarantors entered into a Credit Agreement dated as of March 10, 1989, as amended by a Conversion and Reaffirmation Agreement dated January 30, 1990, as amended by a First Amendment and Waiver Agreement dated July 20, 1990 and as amended by a Second Amendment and Waiver Agreement dated as of March 4, 1991 (as now and hereafter amended, the "Credit Agreement") pursuant to which Chemical Bank agreed to extend to the Borrower, under and subject to the conditions set forth therein, a credit facility of up to $18,000,000 (the "Credit Facility") for the purchase of approximately 1,000,000 shares of the Borrower's common stock, par value $2.00 per share, which stock is readily tradeable and is registered on the New York Stock Exchange (the Borrower's common stock is herein referred to as the "Employer's Securities" and the shares o Employer's Securities purchased by the Borrower with the proceeds of the Credit Facility are referred to herein as the "Shares"); and WHEREAS, pursuant to the terms of the Credit Agreement, the Borrower borrowed $15,111,733 (the "Credit Facility Borrowings") and on January 30, 1990, the Borrower, the Guarantors and Chemical Bank entered into a Conversion and Reaffirmation Agreement (the "Conversion and Reaffirmation Agreement") pursuant to which (1) the Credit Facility was terminated and (2) the Credit Facility Borrowings were converted into the Term Loan (as defined in the Credit Agreement), as evidenced by a Promissory Note (the "Term Note") dated January 30, 1990 in the original principal amount of the Credit Facility Borrowings; and WHEREAS, Chemical Bank and NBD Bank, N.A. entered into an Assignment Agreement dated as of December 20, 1991 wherein Chemical Bank assigned all of its right, title and interest in the Credit Agreement and all other documents executed in connection therewith to the Bank and the Bank assumed all of Chemical Bank's obligations under the Credit Agreement and all other documents executed in connection therewith; and WHEREAS, the Bank and the Borrower then entered into a Third Amendment to Credit Agreement dated as of December 20, 1991 and a Fourth Amendment to Credit Agreement dated as of October 30, 1992; WHEREAS, the Borrower has requested that the Bank waive certain provisions of the Credit Agreement to permit the Borrower to enter into an accounts receivable purchase transaction as evidenced by the Receivables Purchase Agreement (as herein defined) and the Bank is willing to do so strictly in accordance with the terms hereof. TERMS In consideration of the premises and of the mutual agreements herein contained, the parties agree as follows: ARTICLE I. AMENDMENTS. Upon fulfillment of the conditions set forth in Article IV hereof, the Credit Agreement shall be amended as follows: 1.1 Article I is hereby amended as follows: (a) The definition of "Event of Investment Ineligibility" shall be deleted in its entirety. (b) The definition of "Sale Agreement" shall be deleted in its entirety. (c) The following definitions shall be added in appropriate alphabetical order: "Liquidation Event" shall have the meaning assigned such term in the Receivables Purchase Agreement. "Receivables Purchase Agreement" shall mean the receivables purchase agreement dated as of December 20, 1993 between the Borrower as seller and initial servicer, Clipper Receivables Corporation, as purchaser, State Street Boston Capital Corporation, as administrator, and State Street Bank & Trust Company, as relationship bank, and all documents and agreements executed or delivered in connection therewith in each case as amended, supplemented, restated or otherwise modified from time to time. 1.2 Article VI shall be amended by adding a new Section 6.19 at the end thereof to read as follows: Section 6.19 Receivables Purchase Agreement. The Borrower shall not extend the date set forth in clause (c) of the definition of "Termination Date" contained in the Receivables Purchase Agreement. 1.3 Article VII is hereby amended by deleting clause (iv) contained in Section (f) therein and inserting the following in place thereof: "(iv) the occurrence and continuance of a Liquidation Event under the Receivables Purchase Agreement". ARTICLE II. CONSENT AND WAIVER. The Bank hereby consents to the execution, delivery and performance of the Receivables Purchase Agreement by the Borrower. Without limiting the foregoing consent, Sections 6.06, 6.07 and 6.09 of the Credit Agreement are hereby waived solely to the extent necessary to allow the Borrower to (a) sell an undivided interest in certain of its accounts receivable and related assets to Clipper Receivables Corporation for a total investment at any time outstanding of up to $25,000,000, plus earned discount on such investment, plus applicable loss, liquidation, yield, fee and other reserves, and plus all other fees, costs, expenses, indemnities and other amounts owing from time to time by the Borrower pursuant to the Receivables Purchase Agreement, (b) grant a security interest in the Borrower's retained undivided interest in such accounts receivable and related assets as security for all obligations of the Borrower under and pursuant to the Receivables Purchase Agreement, and (c) otherwise perform the Borrower's obligations under and pursuant to the Receivables Purchase Agreement. ARTICLE III. REPRESENTATIONS. The Borrower and the Guarantors represent and warrant to the Bank that: 3.1 (a) The execution, delivery and performance of this Amendment and all agreements and documents delivered pursuant hereto by Borrower have been duly authorized by all necessary corporate action and do not and will not require any consent or approval of its stockholders, violate any provision of any law, rule, regulation, order, writ, judgement, injunction, decree, determination or award presently in effect having applicability to it or of its Articles of Incorporation or By-Laws, or result in a breach of or constitute a default under any indenture or loan or credit agreement or any other agreement, lease or instrument to which Borrower is a party or by which it or its properties may be bound or affected; (b) no authorization, consent, approval, license, exemption of, or filing or registration with any court or governmental department, commission, board, bureau, agency or instrumentality, domestic or foreign, is or will be necessary to the valid execution, delivery or performance by Borrower of this Amendment and all agreements and documents delivered pursuant hereto; and (c) this Amendment and all agreements and documents delivered pursuant hereto by the Borrower are legal, valid and binding obligations of Borrower enforceable against it in accordance with the terms thereof. 3.2 The execution, delivery and performance of this Amendment by the Guarantors (a) does not and will not violate any provision of any law, rule, regulation, order, writ, judgement, injunction, decree, determination or award presently in effect having applicability to any Guarantor or result in a breach of or constitute a default under any indenture or loan or credit agreement or any other agreement, lease or instrument to which the Guarantor is party or by which the Guarantor or any of their properties may be bound or affected; (b) no authorization, consent, approval, license, exemption of or filing a registration with any court or governmental department, commission, board, bureau, agency or instrumentality, domestic or foreign, is or will be necessary to the valid execution, deliverr or performance by each of the Guarantors of this Amendment; (c) this Amendment is the legal, valid and binding obligations of each of the Guarantors enforceable against each in accordance with the terms thereof; and (d) the execution of this Amendment by each of the Guarantors has been duly authorized by all necessary corporate action. 3.3 The Borrower acknowledges and warrants that (i) the ESOP and the ESOT each is in compliance in operation with all applicable requirements of the Code and ERISA; and (ii) all amendments required to be made to the ESOT and the ESOP in order for the ESOP and ESOT to continue to constitute a qualified plan and trust under Section 401(a) of the Code have been made and duly adopted. 3.4 After giving effect to the amendments contained herein and effected pursuant hereto, the representations and warranties contained in Article III of the Credit Agreement are true and correct on and as of the effective date hereof with the same force and effect as if made on and as of such effective date. 3.5 No event of default (as defined in Article VII of the Credit Agreement) and no event which would become such event of default after the lapse of time or the giving of notice, or both, shall have occurred and be continuing or will exist under the Credit Agreement as the effective date hereof after giving effect to the amendments and waivers herein. ARTICLE IV. CONDITIONS OF EFFECTIVENESS. This Amendment shall not become effective until each of the following has been satisfied: 4.1 The Borrower shall have delivered, or caused to be delivered, to the Bank copies, certified as of the effective date hereof, of such documents evidencing necessary corporate action by the Borrower and the Guarantors with respect to this Amendment. 4.2 The Borrower and each of the Guarantors shall have executed this Amendment. 4.3 Approval by the Bank of the form and substance of the final draft of the Receivables Purchase Agreement. 4.4 Receipt by the Bank of a copy of the fully executed Receivables Purchase Agreement reflecting no material changes from the final draft thereof furnished to the Bank pursuant to Section 4.3 above. ARTICLE V. MISCELLANEOUS. 5.1 The terms used but not defined herein shall have the respective meanings ascribed thereto in the Credit Agreement. Except as expressly amended hereby, the Credit Agreement, the Term Note and all other related certificates, instruments and other documents, are hereby ratified and confirmed and shall remain in full force and effect. 5.2 This amendment shall be governed by and construed in accordance with the laws of the State of Michigan. 5.3 The Borrower agrees to pay and save the Bank harmless from liability for the payment of all costs and expenses arising in connection with this Amendment, including reasonable fees and expenses of Dickinson, Wright, Moon, Van Dusen and Freeman, counsel to the Bank, in connection with the preparation and review of this Amendment and all related documents. 5.4 This amendment may be executed in any number of counterparts, all of which taken together shall constitute one and the same instrument any of the parties hereto may execute this Amendment by assigning any such counterpart. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and delivered as of the 27th day of December, 1993. STANDARD MOTOR PRODUCTS, INC. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- STANRIC, INC. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- MARDEVCO CREDIT CORP. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- RENO STANDARD INCORPORATED By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- MARATHON AUTO PARTS & PRODUCTS, INC. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- INDUSTRIAL AND AUTOMOTIVE ASSOCIATES, INC. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- MOTORTRONICS, INC. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- STANDARD MOTOR PRODUCTS (HONG KONG) LTD. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- BLUE STREAK-HYGRADE MOTOR PRODUCTS, INC. LTD. By: Lawrence I. Sills -------------------------------------- Its: President --------------------------------- NBD BANK, N.A. By: Anna R. Hoffman -------------------------------------- Its: Vice President ---------------------------------	13,021	91,238
763901_1993.txt	763901_1993	1993	763901	ITEM 1 BUSINESS BANPONCE CORPORATION is a diversified, publicly owned bank holding company (NASDAQ symbol: BPOP), incorporated under the General Corporation Law of Puerto Rico in November 1984. It provides a wide variety of financial services through its principal subsidiaries: Banco Popular de Puerto Rico ("Banco Popular"), Vehicle Equipment Leasing Company, Inc. ("VELCO") and Popular International Bank, Inc. (PIB). BanPonce Corporation is subject to the provisions of the U.S. Bank Holding Company Act of 1956 (the "BHC Act") and, accordingly, subject to the supervision and regulation of the Board of Governors of the Federal Reserve System. BANCO POPULAR DE PUERTO RICO is a member of the Federal Reserve System and is also subject to the supervision of the Office of the Commissioner of Financial Institutions of the Commonwealth of Puerto Rico and the Superintendent of Banks of the State of New York. Deposits of Banco Popular are insured by the Federal Deposit Insurance Corporation. Banco Popular is the Corporation's full-service commercial banking subsidiary and Puerto Rico's largest banking institution, with $11.5 billion in assets, $8.5 billion in deposits, and a delivery system of 165 branches throughout Puerto Rico, 30 branches in New York City, one in Chicago, one in Los Angeles, 7 branches in the U.S. Virgin Islands and one in the British Virgin Islands. In addition, Banco Popular has two subsidiaries, POPULAR LEASING & RENTAL, INC., Puerto Rico's second largest vehicle leasing and daily rental company, and POPULAR CONSUMER SERVICES, INC., a small-loans company with 26 offices operating under the name of Best Finance. VELCO is a wholly owned subsidiary of BanPonce Corporation engaged in finance leasing and daily rental of motor vehicles to corporations and professionals. It is the leading leasing operation in Puerto Rico. PIB, incorporated under the Puerto Rico International Banking Center Act, owns all issued and outstanding stock of BANPONCE FINANCIAL CORP.("FINANCIAL"), a Delaware Corporation. SPRING FINANCIAL SERVICES, INC., also a Delaware Corporation and a wholly owned subsidiary of Financial, is a diversified consumer finance company engaged in the business of making personal and mortgage loans, and dealer finance through 58 offices located in 14 states. The Corporation took on its present form at the end of 1990 when Banco Popular, with assets of $5.9 billion, acquired the "old" BanPonce Corporation (including its main subsidiary bank, Banco de Ponce), with assets of $3.1 billion (the "Merger"). The name of BanPonce was used for the parent company, while the name of Banco Popular de Puerto Rico was used for the subsidiary bank. While Banco Popular had long been the leading bank in Puerto Rico, its acquisition of "old" BanPonce Corporation at year-end 1990 increased its assets by 50% and widened its market share as the Merger joined the institutions that held the first and third positions in many market segments. The Corporation is a legal entity separate and distinct from its subsidiaries. There are various legal limitations governing the extent to which the Corporation's banking subsidiaries may extend credit, pay dividends or otherwise supply funds to, or engage in transactions with, the Corporation or certain of its other subsidiaries. The rights of the Corporation to participate in any distribution of assets of any subsidiary upon its liquidation or reorganization or otherwise are subject to the prior claims of creditors of that subsidiary, except to the extent that the Corporation may itself be a creditor of that subsidiary and its claims are recognized. Claims on the Corporation's subsidiaries by creditors other than the Corporation include long-term debt and substantial obligations with respect to deposit liabilities, federal funds purchased, securities sold under repurchase agreements and commercial paper, as well as various other liabilities. The Corporation's business is described on pages 25 through 27 and pages 31 through 42 of the Business Review Section of the Annual Report to shareholders for the fiscal year ended December 31, 1993, which information is incorporated herein by reference, and in the following paragraphs. REGULATION AND SUPERVISION GENERAL The Corporation is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act. As a bank holding company, the Corporation's activities and those of its banking and nonbanking subsidiaries are limited to the business of banking and activities closely related or incidental to banking, and the Corporation may not directly or indirectly acquire the ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. Banco Popular is considered a foreign bank for purposes of the International Banking Act of 1978 (the "IBA"). Under the IBA and the BHC Act, the Corporation and Banco Popular are not permitted to operate a branch or agency, or acquire more than 5% of any class of the voting shares of, or substantially all the assets of, or control of an additional bank or bank holding company that is located outside of their "home state", except that (i) the Corporation may acquire control of a bank in a state if the laws of that state explicitly authorize a bank holding company from such bank holding company's home state to do so and (ii) Banco Popular may continue to operate a "grandfathered" branch or agency. The Commonwealth of Puerto Rico is not considered a state for purposes of these geographic limitations. Banco Popular has designated the state of New York as its home state. In addition, some states have laws prohibiting or restricting foreign banks from acquiring banks located in such states and treat Puerto Rico's banks and bank holding companies as foreign banks for such purposes. Banco Popular operates branches in Chicago and Los Angeles that are not grandfathered for purposes of the IBA. The Federal Reserve Board has required that Banco Popular conform their existence to the legal requirements set forth above. Banco Popular has petitioned the Federal Reserve Board for a period of four years from December 31, 1990 to conform these activities to the requirements of the IBA and to obtain the necessary approvals of Illinois and California regulatory authorities to maintain these two facilities. There can be no assurance that the Federal Reserve Board will grant Banco Popular's request or that Banco Popular will be able to obtain the regulatory approvals of California and Illinois authorities necessary to maintain these two facilities. Banco Popular is subject to supervision and examination by applicable federal, state and Puerto Rican banking agencies, including the Federal Reserve Board. Banco Popular is insured by, and therefore subject to the regulations of, the Federal Deposit Insurance Corporation (the "FDIC"), and to the requirements and restrictions under federal, state and Puerto Rican law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of Banco Popular. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. As a result of the enactment of the Financial Institutions Reform, Recovery and Enforcement Act on August 9, 1989, a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989, in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled depository institution in danger of default. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted on December 19, 1991. FDICIA substantially revises the depository institutions regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA established five capital tiers: "well capitalized", "adequately capitalized," "undercapitalized", "significantly undercapitalized", and "critically undercapitalized". A depository institution is considered "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject of any order or written directive to meet and maintain a specific capital level. An "adequately capitalized" depository institution is one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or, in the case of a bank with the highest examination rating, 3%). A depository institution is considered (A) "undercapitalized" if it does not meet any of the above definitions; (B) "significantly undercapitalized" if it has (i) a total risk-based capital ratio of less than 6%, (ii) a Tier 1 risk-based capital ratio of less than 3% and (iii) a leverage ratio of less than 3%; and (C) "critically undercapitalized" if it has a ratio of tangible equity to total assets less than or equal to 2%. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives a less than satisfactory examination rating in any one of the four rating categories. As of the date hereof, Banco Popular is considered "well-capitalized". FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee the capital plan, up to an amount equal to the lesser of five percent of the depository institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator. Under FDICIA, a depository institution that is not well capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rates in its market. Under FDICIA, the FDIC is permitted to provide financial assistance to an insured bank before appointment of a conservator or receiver only under limited circumstances. The FDIC's policy is that for such assistance to be provided, existing shareholders and debt holders must make substantial concessions. HOLDING COMPANY STRUCTURE Banco Popular is subject to restrictions under federal law that limit the transfer of funds by Banco Popular to the Corporation and its nonbanking subsidiaries, whether in the form of loans, other extensions of credit, investments or asset purchases. Such transfers by Banco Popular to the Corporation or any nonbanking subsidiary of the Corporation are limited in amount to 10% of Banco Popular's capital and surplus and, with respect to the Corporation and all nonbanking subsidiaries, to an aggregate of 20% of Banco Popular's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each such subsidiary bank. This support may be required at times when, absent such policy, the bank holding company might not otherwise provide such support. Any capital loans by a bank holding company to any of its subsidiary banks are subordinated in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. Because the Corporation is a holding company, its right to participate in the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors (including depositors in the case of bank subsidiaries) except to the extent that the Corporation itself is a creditor with recognized claims against the subsidiary. DIVIDEND RESTRICTIONS Various statutory provisions limit the amount of dividends Banco Popular can pay to the Corporation without regulatory approval. The principal source of cash flow for the Corporation is dividends from Banco Popular. As a member bank subject to the regulations of the Federal Reserve Board, Banco Popular must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared by the member bank in any calendar year would exceed the total of its net profits, as defined by the Federal Reserve Board, for that year, combined with its retained net profits for the preceding two years. In addition, a member bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts. For this purpose, bad debts are generally defined to include the principal amount of loans that are in arrears with respect to interest by six months or more unless such loans are fully secured and in the process of collection. Moreover, for purposes of this limitation, a member bank is not permitted to add the balance in its allowance for loan losses account to its undivided profits then on hand, however, it may net the sum of its bad debts as so defined against the balance in its allowance for loan losses account and deduct from undivided profits only bad debts as so defined in excess of that account. At December 31, 1993, Banco Popular could have declared a dividend of approximately $123,794,000 without the approval of the Federal Reserve Board. The payment of dividends by Banco Popular may also be affected by other regulatory requirements and policies, such as the maintenance of adequate capital. If, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in, or is about to engage in, an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. The Federal Reserve Board and the FDIC have issued policy statements that provide that insured bank and bank holding companies should generally pay dividends only out of current operating earnings. In addition, all insured depository institutions are subject to the capital-based limitations described under FDICIA. FDIC INSURANCE ASSESSMENTS Banco Popular is subject to FDIC deposit insurance assessments for the Bank Insurance Fund (the "BIF"). Pursuant to FDICIA, the FDIC has adopted a risk-based assessment system, under which the assessment rate for an insured depository institution varies according to the level of risk incurred in its activities. An institution's risk category is based partly upon whether the institution is well capitalized, adequately capitalized or less that adequately capitalized. Each insured depository institution is also assigned to one of the following "supervisory subgroups": "A", "B" or "C". Group "A" institutions are financially sound institutions with only a few minor weaknesses; Group "B" institutions are institutions that demonstrate weaknesses which, if not corrected, would result in significant deterioration; and Group "C" institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each BIF member institution is assigned an annual FDIC assessment rate varying between 0.23% and 0.31%. It remains possible that assessments may be raised to higher levels in the future. CAPITAL ADEQUACY The information in Table N, "Capital Adequacy Data", on page 19 of the Financial Review Section of the Corporation's Annual Report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. Under the guidelines the minimum ratio of qualifying total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. At least half of the total capital is to be comprised of stockholders' common equity, retained earnings, non-cumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock less goodwill ("Tier 1 Capital"). The remainder ("Tier 2 Capital") may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments, and a limited amount of loan and lease loss reserves. In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 Capital to quarterly average assets) guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies that meet certain specified criteria, including that they have the highest regulatory rating. All other bank holding companies are required to maintain a leverage ratio of 3% plus an additional cushion of at least 100 to 200 basis points. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier 1 leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage ratio is the ratio of a banking organization's Tier 1 Capital, less all intangibles, to total assets, less all intangibles. The Federal Reserve Board has not advised the Corporation of any specific minimum leverage ratio applicable to it. Effective for the periods ending on or after March 15, 1993, the Federal Reserve Board adopted regulations with respect to risk-based and leverage capital ratios that would require most intangibles, including core deposit intangibles, to be deducted from Tier 1 capital. The regulations, however, permit the inclusion of a limited amount of intangibles related to purchased mortgage servicing rights and purchased credit card relationships and includes a "grandfather" provision permitting the continued inclusion of certain existing intangibles. Banco Popular is subject to similar risk-based and leverage capital requirements adopted by the Federal Reserve Board. As of December 31, 1993, Banco Popular had a tier 1 capital ratio of 11.85%, a total capital ratio of 13.72% and a leverage ratio of 6.96%. Failure to meet capital guidelines could subject a bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC, and to certain restrictions on its business. Bank regulators continue to indicate their desire to raise capital requirements applicable to banking organizations beyond their current levels. However, management is unable to predict whether and when higher capital requirements would be imposed and, if so, at what levels and on what schedule. The following table reflects the capital position of the Corporation as of December 31, 1993 and December 31, 1992. The table below describes the components of the Corporations' Tier 1 and Tier 2 Capital. Puerto Rico Regulation As a commercial bank organized under the laws of the Commonwealth of Puerto Rico (the "Commonwealth"), Banco Popular is subject to supervision, examination and regulation by the Office of the Commissioner of Financial Institutions of the Commonwealth (the "Office of the Commissioner"), pursuant to the Puerto Rico Banking Act of 1933, as amended (the "Banking Law"). Section 27 of the Banking Law requires that at least ten percent (10%) of the yearly net income of the Bank be credited annually to a reserve fund. This apportionment shall be done every year until the reserve fund shall be equal to ten percent (10%) of the total deposits or the total paid-in capital, whichever is greater. At the end of its most recent fiscal year, the Bank had an adequate reserve fund established. Section 27 of the Banking Law also provides that when the expenditures of a bank are greater than the receipts, the excess of the former over the latter shall be charged against the undistributed profits of the bank, and the balance, if any, shall be charged against the reserve fund, as a reduction thereof. If there is no reserve fund sufficient to cover such balance in whole or in part, the outstanding amount shall be charged against the capital account and no dividend shall be declared until said capital has been restored to its original amount and the reserve fund to 20% of the original capital. Section 16 of the Banking Law requires every bank to maintain a legal reserve which shall not be less than 20% of its demand liabilities, except government deposits (federal, state and municipal) which are secured by actual collateral. However, if a bank becomes a member of the Federal Reserve System, the 20% legal reserve shall not be effective and the reserve requirements demanded by the Federal Reserve System shall be applicable. Pursuant to an order of the Board of Governors dated November 24, 1982, the Bank has been exempted from such reserve requirements with respect to deposits payable in Puerto Rico. Section 14 of the Banking Law authorizes the Bank to conduct certain financial and related activities directly or through subsidiaries, including finance leasing of personal property and operating a small loans company. Banco Popular engages in these activities through its wholly-owned subsidiaries, Popular Leasing & Rental, Inc. and Popular Consumer Services, Inc., respectively, both of which are organized and operate solely in Puerto Rico. Employees At December 31, 1993, the Corporation employed 7,439 persons. None of its employees are represented by a collective bargaining group. ITEM 2. ITEM 2. PROPERTIES As of December 31, 1993, the Bank owned (and wholly or partially occupied) approximately 65 branches and other facilities throughout the Commonwealth, 15 branches in New York, and a branch in Los Angeles. In addition, as of such date, the Bank leased properties for branch operations in approximately 105 locations in Puerto Rico, 15 locations in New York, 7 locations in the U.S Virgin Islands, one location in British Virgin Islands and one location in Chicago . The Corporation's management believes that each of its facilities is well-maintained and suitable for its purpose. The principal properties owned by the Bank for banking operations and other services are described below: Popular Center, the metropolitan area headquarters building, located at 209 Munoz Rivera Avenue, Hato Rey, Puerto Rico, a 20 story office building. Approximately 60% of the office space is leased to outside tenants. Hato Rey Center, a 23 story office structure located at 268 Munoz Rivera Avenue, Hato Rey, Puerto Rico. The office space is mostly rented to outside tenants. Cupey Center Complex, two buildings of three and two stories, respectively, located at Cupey, Rio Piedras, Puerto Rico. The computer center, operational and support services, and a recreational and training center for employees are some of the main activities conducted at these facilities. Stop 22 - Santurce building, a twelve story structure located in Santurce, Puerto Rico. A branch, the accounting department, the human resources division, the auditing department and the international division are the main activities conducted at this facility. San Juan building, a twelve story structure located at Old San Juan, Puerto Rico. The Bank occupies 50% of the basement, the entire ground floor, the mezzanine and the 10th floor. Most of the rest of the building is rented to outside tenants. Mortgage Loan Center, a seven story building located at 153 Ponce de Leon Avenue, Hato Rey, Puerto Rico, is fully occupied by the mortgage loans and mortgage servicing departments. Los Angeles building, a nine story structure located at 354 South Spring Street, Los Angeles, California in which office space is mostly rented to outside tenants. New York building, a nine story structure with two underground levels located at 7 West 51th Street, New York City, where approximately 54% of the office space is used for banking operations. The remaining space is rented or available for rent to outside tenants. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Corporation and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. Management is of the opinion that the aggregate liabilities, if any, arising from such actions would not have a material adverse effect in the financial position of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information contained under Table 0, "Stock Performance", on page 20, and under the captions "Common Stock" and "Dividends", on page 19 of the Financial Review Section of the Corporation's Annual Report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. Information concerning legal or regulatory restrictions on the payment of dividends by the Corporation and the Bank is contained under the caption "Regulation and Supervision" in Item 1 herein. In addition, the information contained in Notes 13 and 14 to the Consolidated Financial Statements describing various contractual restrictions on the payments of dividends by the Corporation and the Bank is incorporated herein by reference. The Corporation currently has outstanding Senior Notes due January 14, 1997 in the aggregate principal amount of $30,000,000 (the "1997 Senior Notes"). The 1997 Senior Notes contain various covenants, which, among others, restrict the payment of dividends. The 1997 Senior Notes prohibit the Corporation from paying dividends or making any other distributions with respect to the Corporation's Common Stock if such aggregate distribution exceeds $50,000,000 plus 50% of consolidated net income (or minus 100% of consolidated net loss), computed on a cumulative basis from January 1, 1992 to the date of payment of any such dividends or other distributions or if an event of default has occurred and is continuing. Banco Popular has outstanding $12,000,000 in subordinated notes due in June 28, 1996 (the "1996 Subordinated Notes") which contain certain restrictive covenants, including restrictions on the ability of Banco Popular to pay dividends to the Corporation. Pursuant to the covenants contained in the 1996 Subordinated Notes, Banco Popular may not pay dividends or other distribution on its common stock unless the sum of (i) 100% of its capital stock, (ii) its unimpaired reserve fund, and (iii) its undivided profits equals or exceeds the sum of (x) $80,000,000 and (y) the cumulative amount of all cash dividends or other distributions declared or paid after June 30, 1989. As of December 31, 1993, the sum of (i) the capital stock of Banco Popular, (ii) its unimpaired reserve fund, and (iii) its undivided profits was $759,260,753. Dividends and other distributions made with respect to the common stock since June 30, 1989 amounted to $82,937,419 for purposes of the 1996 Subordinated Notes. In addition, the 1996 Subordinated Notes provide that Banco Popular may not pay any dividend or other distributions on its common stock except out of undivided profits and only if, after giving effect to such distribution, the following conditions are satisfied: (i) funded debt (as defined in the agreements governing the 1996 Subordinated Notes) of Banco Popular would not exceed the sum of (a) 100% of its capital stock and (b) 50% of its reserve fund; (ii) undivided profits of Banco Popular would not be less than $1,000,000; (iii) certain amounts are transferred as required for redemption of the Subordinated Notes at maturity; and (iv) certain amounts are transferred as required for the redemption of other funded debt at maturity. As of December 31, 1993, funded debt of Banco Popular was approximately $91.5 million, and the sum of 100% of its capital stock and 50% of its reserve fund is $264,233,274. As of March 11, 1994, the Corporation had 5,306 stockholders of record, not including beneficial owners whose shares are held in record names of brokers or other nominees. The last sales price for the Corporation's Common Stock on such date, as quoted on the National Association of Securities Dealers Automated Quotation National Market System, was $31.875 per share. The Puerto Rico Income Tax Act of 1954, as amended, generally imposes a withholding tax on the amount of any dividends paid by corporations to individuals, whether residents of Puerto Rico or not, trusts, estates and special partnerships at a special 20% withholding tax rate. The rate of withholding is 25% if the recipient is a foreign corporation or partnership not engaged in trade or business within Puerto Rico. Prior to the first dividend distribution for the taxable year, individuals who are residents of Puerto Rico may elect to be taxed on the dividends at the regular rates, in which case the special 20% tax will not be withheld from such year's distributions. United States citizens who are non-residents of Puerto Rico may also make such an election, and will not be subject to Puerto Rico tax on dividends, if said individual's gross income from sources within Puerto Rico during the taxable year does not exceed $1,300 if single, or $3,000 if married. U.S. income tax law permits a credit against U.S. income tax liability, subject to certain limitations, for certain foreign income taxes paid or deemed paid with respect to such dividends. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information in Table C, "Selected Financial Data", for only the years 1993, 1992, 1991, 1990 and 1989, on pages 4 and 5 and the text under the caption "Earnings Analysis", on pages 3 and 6 of the Financial Review Section of the Annual Report to shareholders, is incorporated herein by reference, and in the following paragraphs. The Corporation's ratio of earnings to fixed charges on a consolidated basis for each of the last five years is as follows: For purposes of computing these consolidated ratios, earnings represent income before income taxes, plus fixed charges excluding capitalized interest. Fixed charges represent all interest expense (ratios are presented both excluding and including interest on deposits), the portion of net rental expense which is deemed representative of the interest factor, the amortization of debt issuance expense and capitalized interest. The Corporation's long term senior debt and preferred stock on a consolidated basis for each of the last five years ended December 31, is as follows: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations", on pages 2 through 26 of the Financial Review Section of the Annual Report to shareholders, is incorporated herein by reference. Table K, "Maturity Distribution of Earning Assets", on page 16 of the Financial Review Section of the Annual Report to shareholders, has been prepared on the basis of contractual maturities. The Corporation does not have a policy with respect to rolling over maturing loans but rolls over loans only on a case-by-case basis after review of such loans in accordance with the Corporation's lending criteria. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The report of the independent accountants, the Consolidated Financial Statements of the Corporation and its subsidiaries, together with the notes, on pages 27 through 47 of the Financial Review Section of the Annual Report to shareholders, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the captions "Shares Beneficially Owned by Directors, Nominees and Executive Officers of the Corporation", and "Board of Directors and Committees" on pages 3 through 8 and "Nominees for Election as Directors" on page 9 of the Corporation's definitive proxy statement filed with the Securities and Exchange Commission on March 18, 1994 (the "Proxy Statement"), and under the caption "Executive Officers", on pages 9 through 11 of the Proxy Statement, is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information under the caption "Executive Compensation Program", on pages 11 through 15 and under the caption "BanPonce Corporation Performance Graph" on page 16 of the Proxy Statement, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the captions "Principal Stockholders", on page 2 and under "Shares Beneficially Owned by Directors, Nominees and Officers of the Corporation", on pages 3 and 4 of the Proxy Statement, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Family Relationships" and "Other relationships and transactions", on page 11 of the Proxy Statement, is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K A.1 The following financial statements and reports included on pages 27 through 47 of the financial review section of the Corporation's Annual Report to Shareholders, have been incorporated herein by reference: Report of Independent Auditors. Consolidated Statements of Condition as of December 31, 1993 and 1992. Consolidated Statements of Income for each of the years in the three-year period ended December 31, 1993. Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1993. Consolidated Statements of Changes in Stockholders' Equity for each of the years in the three-year period ended December 31, 1993. Notes to Consolidated Financial Statements. A.2 Financial Statement Schedules: No schedules are presented because the information is not applicable or is included in the Consolidated Financial Statements described in A.1 above or in the notes thereto. A.3 Exhibits B. No report on Form 8-K was filed for the year ended December 31, 1993. (1) Incorporated by reference to Exhibit 4.1 of Registration Statement No. 33-39028. (1a)Incorporated by reference to exhibit 4.1 of the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (the "1990 Form 10-K"). (2) Incorporated by reference to Exhibit 4.3 of Registration Statement No. 33-39028. (2a) Incorporated by reference to Exhibit 4(c) to Registration Statement No. 33-41686. (2b) Incorporated by reference to Exhibit 2 on Form 8-K filed on October 8, 1991. (2c) Incorporated by reference to Exhibit 3 on Form 8-K filed on October 8, 1991. (3) Incorporated by reference to Exhibit 4.4 of Registration Statement No. 33-39028. (4) Incorporated by reference to Exhibit number 10.2 of Registration Statement No. 33-00497. (5) Incorporated by reference to Exhibit 10.3 of the 1991 Form 10-K. (6) Incorporated by reference to Exhibit 10.8 of the 1991 Form 10-K. (7) Incorporated by reference to Exhibit 10.9 of the 1991 Form 10-K. (8) Incorporated by reference to Exhibit 10.10 of the 1991 Form 10-K. (9) Incorporated by reference to Exhibit 10.12 of the 1991 Form 10-K. (10) Incorporated by reference to Exhibit 10.13 of the 1991 Form 10-K. (11) Incorporated by reference to Exhibit 10.14 of the 1991 Form 10-K. (12) Incorporated by reference to Exhibit 10.19 of the 1991 Form 10-K. (13) Incorporated by reference to Exhibit 10.6 of the 1991 Form 10-K. (14) Incorporated by reference to Exhibit 10.14 of the 1992 Form 10-K. (15) Incorporated by reference to Exhibit 10.15 of the 1992 Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 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. BANPONCE CORPORATION (Registrant) By: /s/ Richard L. Carrion -------------------------------- Richard L. Carrion Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) By: /s/ David H. Chafey, Jr. -------------------------------- David H. Chafey, Jr. Executive Vice President (Principal Executive Officer) By: /s/ Orlando Berges -------------------------------- Orlando Berges Treasurer (Principal Accounting 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. EXHIBIT INDEX Exhibit No. DESCRIPTION (1) Incorporated by reference to Exhibit 4.1 of Registration Statement No. 33-39028. (1a)Incorporated by reference to exhibit 4.1 of the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (the "1990 Form 10-K"). (2) Incorporated by reference to Exhibit 4.3 of Registration Statement No. 33-39028. (2a) Incorporated by reference to Exhibit 4(c) to Registration Statement No. 33-41686. (2b) Incorporated by reference to Exhibit 2 on Form 8-K filed on October 8, 1991. (2c) Incorporated by reference to Exhibit 3 on Form 8-K filed on October 8, 1991. (3) Incorporated by reference to Exhibit 4.4 of Registration Statement No. 33-39028. (4) Incorporated by reference to Exhibit number 10.2 of Registration Statement No. 33-00497. (5) Incorporated by reference to Exhibit 10.3 of the 1991 Form 10-K. (6) Incorporated by reference to Exhibit 10.8 of the 1991 Form 10-K. (7) Incorporated by reference to Exhibit 10.9 of the 1991 Form 10-K. (8) Incorporated by reference to Exhibit 10.10 of the 1991 Form 10-K. (9) Incorporated by reference to Exhibit 10.12 of the 1991 Form 10-K. (10) Incorporated by reference to Exhibit 10.13 of the 1991 Form 10-K. (11) Incorporated by reference to Exhibit 10.14 of the 1991 Form 10-K. (12) Incorporated by reference to Exhibit 10.19 of the 1991 Form 10-K. (13) Incorporated by reference to Exhibit 10.6 of the 1991 Form 10-K. (14) Incorporated by reference to Exhibit 10.14 of the 1992 Form 10-K. (15) Incorporated by reference to Exhibit 10.15 of the 1992 Form 10-K.	6,382	40,784
75754_1993.txt	75754_1993	1993	75754	ITEM 1. BUSINESS In addition to the detailed information set forth below, incorporated herein by reference is the general business description information on Paine Webber Group Inc. ("PWG") and its operating subsidiaries (collectively the "Company"), under the caption "Management's Discussion and Analysis" on page 29 in the 1993 Annual Report to Stockholders. BROKERAGE TRANSACTIONS A portion of the Company's revenues are generated from commissions or fees earned as a broker for individual and institutional clients in the purchase and sale of corporate securities (listed and over-the-counter securities), mutual funds, insurance products, options, commodities and financial futures, and direct investments. The Company also earns commissions or fees for services provided in the areas of employee benefits, managed accounts and personal trusts. Securities transactions The Company holds memberships in all major securities exchanges in the United States in order to provide services to its brokerage clients in the purchase and sale of listed securities. A major portion of the Company's revenues is derived from commissions from individual and institutional clients on brokerage transactions in listed securities and in over-the-counter ("OTC") markets. The largest portion of the Company's commissions revenue (53%) is derived from brokerage transactions in listed securities. The Company also acts as broker for investors in the purchase and sale of U.S. government and municipal securities. The Company has established commission rates for brokerage transactions which vary with the size and complexity of the transaction and with the activity level of the client's account. Mutual funds The Company distributes shares of mutual funds for which it serves as investment advisor and sponsor as well as shares of funds sponsored by others. Income from the sale of mutual funds is derived from standard dealers' discounts, which are determined by terms of the selling agreement and the size of the transaction. In addition, the Company distributes shares of proprietary mutual funds for which it serves as investment advisor and administrator. Income from these proprietary mutual funds is also derived from management and distribution fees. Mutual funds include both taxable and tax-exempt funds and front-load, reverse- load, and level-load funds. Insurance Through subsidiaries, PaineWebber Incorporated ("PWI") acts as agent for several life insurance companies and sells deferred annuities and life insurance. Additionally, variable annuities are issued by PaineWebber Life Insurance Company. Managed accounts The Company acts in a consulting capacity to both individuals and institutions in the selection of professional money managers. Services provided in this consulting capacity may include client profiling, asset allocation, manager selection and performance measurement. Money managers recommended may be either affiliated with the Company or non affiliated managers. Compensation for services is in the form of commissions or established fees. Options The Company's options related services include the purchase and sale of options on behalf of clients, and the delivery and receipt of the underlying securities upon exercise of the options. In addition, the Company utilizes its securities research capabilities in the formulation of options strategies and recommendations for its clients. Commodities and financial futures The Company provides transaction services for clients in the purchase and sale of futures contracts, including metals, currencies, interest rates, stock indexes and agricultural products. Transactions in futures contracts are on margin and are subject to individual exchange regulations. The risk to the Company's clients in futures transactions, and the resulting credit risk to the Company, is greater than the risk in cash securities transactions, principally due to the low initial margin requirements relative to the nominal value of the actual futures contract. Additionally, commodities exchange regulations governing daily price movements can have the effect of precluding clients from taking actions to mitigate adverse market conditions. These factors may increase the Company's risk of loss on collections of amounts due from clients. However, net worth requirements and other credit standards for customer accounts are utilized to limit this exposure. Employee benefit plans PW Trust Company, a wholly owned subsidiary of PWG, offers and administers 401(K) plans for corporations and acts as trustee, custodian or investment manager of retirement assets for approximately 1,300 corporate retirement plans. Personal trust services The Company offers its clients a full range of domestic and international personal trust services, including self trustee and corporate trustee options. Investment choices are broad and flexible. The Company serves its international clients through a trust company located in Guernsey and through third party trustees, and may serve as corporate trustee for domestic clients in 22 states. Direct investments The Company originates and markets a select number of private placements and publicly registered limited partnerships. While market conditions have significantly reduced activities in this area, the Company's offerings include a publicly registered equipment leasing partnership and a tax-credit real estate trust. DEALER TRANSACTIONS The Company regularly makes a market in OTC securities and as a block positioner, acts as market-maker in certain listed securities, U.S. government and agency securities, investment-grade and high-yield corporate debt, and a full range of mortgage-backed securities. Equity The Company effects transactions in large blocks of securities, usually with institutional investors, generally involving 5,000 or more shares of listed stocks. Such transactions are handled on an agency basis to the extent possible, but the Company may take a long or short position as principal to the extent that no buyer or seller is immediately available. By engaging in block positioning, the Company places a portion of its capital at risk to facilitate transactions for clients. Where possible, the Company seeks to reduce such risks by hedging with option positions. Despite the risks involved in block positioning, the aggregate brokerage commissions generated by the Company's willingness to commit a portion of its capital in repositioning, including commissions on other orders from the same clients, justify such activities. The Company makes markets, buying and selling as principal, in common stocks, convertible preferred stocks, warrants and other securities traded on the Automated Quotation System of the National Association of Securities Dealers ("NASD") or in other OTC markets. The unlisted equity securities in which the Company makes markets are principally those in which there is substantial continuing client interest and include securities which the Company has underwritten. Fixed Income The Company provides clients access to a multitude of fixed income products including: U.S. government and agency securities; mortgage related securities including those issued through Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corp. ("FHLMC"); corporate investment-grade and high-yield bonds; and options and futures contracts on these products. The Company's capital can be at risk to the extent significant price fluctuations occur. This risk is lessened by hedging inventory positions. As a "primary dealer" in U.S. government securities, the Company actively participates in the distribution of United States treasury securities and reports its inventory positions and market transactions to the Federal Reserve Bank on a weekly basis. The Company takes positions in government and government agency securities to facilitate transactions for its clients on a principal basis. Profits or losses are recognized from fluctuations in the value of securities in which it maintains positions. Additionally, trading activities include the purchase of securities under agreements to resell at future dates (reverse repurchase agreements) and the sale of the same or similar securities under agreements to repurchase at future dates (repurchase agreements). Profits and losses on the repurchase transactions are recognized from interest rate differentials. The Company actively participates in the mortgage-backed securities markets through the purchase or sale of GNMA, FNMA, FHLMC, mortgage pass-through securities, Collateralized Mortgage Obligations ("CMOs") and other mortgage related securities, in order to meet client needs on a principal basis. As a means of financing its trading, the Company enters into repurchase agreements. The Company also structures and underwrites CMOs. Additionally, the Company serves as principal and financier in the purchase, sale, securitization and resale of first mortgage notes and the related servicing rights. The Company is an active participant in the corporate bond markets. Through the fixed income debt syndicate desk and institutional sales force, the Company distributes and markets new issuances of corporate debt securities. The corporate bond trading desk supports this effort as a dealer in the secondary markets by effecting transactions on behalf of clients or for the Company's own account. Revenues generated from these activities include underwriting fees on syndicate transactions and trading gains or losses. The Company also underwrites, makes markets, and facilitates trades for clients in the high-yield securities markets. High-yield securities refer to companies whose debt is rated as non-investment grade. The Company continually monitors its risk positions associated with high-yield debt securities and establishes limits with respect to overall market exposure, industry group and individual issuer. Municipal securities Through its municipal bond department, the Company is a dealer in both the primary and secondary markets, buying and selling securities for its own account and for clients. Revenues derived from all these activities include underwriting and management fees, selling concessions and trading profits. Derivatives The Company is engaged in activities, primarily on behalf of clients, in equity derivative products, including listed and OTC options, warrants, futures and underlying equity securities. The Company has also engaged in creating structured products, which are sold to retail and institutional clients, that are based on baskets of securities and currencies, primary foreign and domestic market indexes and other equity and debt-based products. The Company generally hedges positions taken in these structured products based on option and other valuation models. Through the institutional options and futures group, the Company engages in interest rate, stock index, commodity options and futures contract transactions in connection with the Company's principal trading activities. The various commodity markets are highly regulated and impose strict margin and other financial requirements on the Company and its clients. Transactions in futures contracts are conducted through regulated exchanges which clear and guarantee performance of counterparties, however, in the event that members of clearinghouses default on material obligations to such clearinghouses, the Company may have financial exposure. The Company is also subject to credit risk on derivatives not traded on formal exchanges. The Company's risk of credit loss is mitigated by adherence to formal credit control procedures which include approved customer and counterparty credit limits, periodic monitoring of customer and counterparty credit worthiness, and continuous assessment of market exposure. As a principal trader, the Company is exposed to market risk in the event of unfavorable changes in interest rates, foreign currency exchange rates or the market values of the securities underlying the instruments. The Company monitors its exposure to market risk through a variety of control procedures including a review of trading positions and hedging strategies, and establishing limits by the Risk Management Committee. INVESTMENT BANKING The Company is a leading manager of public offerings of corporate securities. In addition, the Company participates as an underwriter in syndicates of public offerings managed by others. Management of an underwriting account is generally more profitable than participation as a syndicate member since the managing underwriters receive a management fee and have more control over the allocation of securities available for distribution. The Company is invited to participate in many syndicates of negotiated public offerings managed by others. The Corporate Finance Group manages and underwrites public offerings of debt and equity securities, arranges private placements and provides financial advice in connection with mergers and acquisitions, divestitures and other corporate reorganizations and restructurings. Significant risks are involved in the underwriting of securities. Underwriting syndicates agree to purchase securities at a discount from the public offering price. If the securities are ultimately sold below the cost to the syndicate, an underwriter will experience losses on the securities which it has purchased. In addition, losses may be incurred on stabilization activities taken during such underwritings. The Company is an industry leader in the management of tax-exempt bond offerings. Through its Municipal Securities Group, the Company provides financial advice to, and raises capital for, issuers of municipal securities to finance the construction and maintenance of a broad range of public-related facilities, including healthcare, housing, education, public power, water and sewer, airports, highways and other public finance infrastructure needs. The group also provides a secondary market for these securities and develops and markets various derivative products. The Company, through certain subsidiaries, may participate as an equity investor or provide bridge financing in connection with specific transactions. The Company has substantially decreased these activities in response to a changed environment for this type of financing. ASSET MANAGEMENT Asset management activities are conducted principally by Mitchell Hutchins Asset Management Inc. ("MHAM") and Mitchell Hutchins Institutional Investors Inc., ("MHII"). MHAM and MHII provide investment advisory and portfolio management services to individuals and pension, endowment and mutual funds. Mutual funds, for which MHAM serves as an investment advisor, include both taxable and tax-exempt funds and front-load, reverse-load, and level-load funds. At December 31, 1993, total assets under management were $38.9 billion including approximately $25.6 billion of proprietary mutual funds sponsored by PWI. MARGIN LENDING Client securities transactions are executed on either a cash or margin basis. In a margin transaction, the Company extends credit to a client for the purchase of securities, using the securities purchased and/or other securities in the client's account as collateral for amounts loaned. The Company receives income from interest charged on such extensions of credit. Amounts loaned are limited by margin requirements which are subject to the Company's credit review and daily monitoring procedures and are generally more restrictive than the margin regulations of the Federal Reserve Board and other regulatory authorities. The Company may lend to other brokers or use as collateral a portion of the margin securities to the extent permitted by applicable margin regulations. The financing of margin purchases can be an important source of revenue to the Company since the interest rate paid by the client on funds loaned by the Company exceeds the Company's cost of short-term funds. The amount of the Company's gross interest revenues is affected not only by prevailing interest rates, but also by the volume of business conducted on a margin basis. To finance margin loans to clients, the Company utilizes both interest-bearing and non-interest-bearing funds generated from a variety of sources in the course of its operations, including bank loans, free credit balances in client accounts, sale of securities under agreements to repurchase, the lending of securities and sales of securities not yet purchased. No interest is paid on a substantial portion of clients' free credit balances. By permitting a client to purchase on margin, the Company takes the risk that market declines could reduce the value of the collateral below the principal amount loaned, plus accrued interest, before the collateral could be sold. RESEARCH Research provides investment advice to institutional and individual clients. More than 750 companies in 78 industry sectors and sub-sectors are covered by the division's analysts. In addition to fundamental company and industry research, the Company offers research products and services in the following areas: asset allocation, economics, fixed income and high yield issues, convertible and closed-end bond funds, country funds and derivatives. OTHER ACTIVITIES Portions of the Company's core business activities are conducted through PaineWebber International Inc. and its subsidiaries, which also function as an introducing broker-dealer to PWI for U.S. market products and are members of various international exchanges. PaineWebber Specialists Inc. ("PWSI") maintains trading posts on the Pacific, Boston and Cincinnati stock exchanges and an affiliation on the Chicago stock exchange. Specialists are responsible for executing transactions and maintaining an orderly market in certain securities. In this function, the specialist firm acts as an agent in executing orders entrusted to it and/or acts as a dealer. PWSI acts as a specialist for approximately 430 equity issues. Correspondent Services Corporation, a registered broker-dealer and a wholly owned subsidiary of PWI, provides execution and clearing services of securities for approximately 100 broker-dealers on a fully disclosed and omnibus basis. Incorporated herein by reference is the information set forth under the caption "Revenues" in the "Five Year Financial Summary" on page 54 in the 1993 Annual Report to Stockholders, which summarizes the major sources of consolidated revenues. REGULATION The securities and commodities industry is one of the nation's most extensively regulated industries. The Securities and Exchange Commission ("SEC") is responsible for carrying out the federal securities laws and serves as a supervisory body over all national securities exchanges and associations. The regulation of broker-dealers has to a large extent been delegated, by the federal securities laws, to self-regulatory organizations ("SROs"). These SROs include all the national securities and commodities exchanges, the NASD and the Municipal Securities Rulemaking Board. Subject to approval by the SEC and Commodity Futures Trading Commission ("CFTC"), these SROs adopt rules that govern the industry and conduct periodic examinations of the operations of certain subsidiaries of the Company. The New York Stock Exchange ("NYSE") has been designated by the SEC as the primary regulator of certain of the Company's subsidiaries including PWI and other broker-dealer subsidiaries. In addition, certain of these subsidiaries are subject to regulation of the laws of the 50 states, the District of Columbia, Puerto Rico and certain foreign countries in which they are registered to conduct securities, banking, insurance or commodities business. Broker-dealers are subject to regulations which cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping, and the conduct of directors, officers and employees. Violation of applicable regulations can result in the revocation of broker-dealer licenses, the imposition of censures or fines, and the suspension or expulsion of a firm, its officers or employees. As a registered broker-dealer and member firm of the NYSE, PWI is subject to the Net Capital Rule (Rule 15c3-1 under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), which also has been adopted through incorporation by reference in NYSE Rule 325. The Net Capital Rule, which specifies minimum net capital requirements for registered broker-dealers, is designed to measure the financial soundness and liquidity of broker-dealers. The Net Capital Rule, as defined, prohibits registered broker-dealers from making substantial distributions of capital by means of dividends or similar payments, or unsecured advances and loans to certain related persons, including stockholders, without giving at least two business days prior or post notification to the SEC. Pre-notification requirement applies to any proposed withdrawal of capital if the aggregate of such withdrawals, on a net basis, within any 30 calendar day period would exceed 30% of the broker-dealer's excess net capital, as defined. Post notification requirement applies if the aggregate of such withdrawals, on a net basis, would exceed 20% of the broker-dealer's excess net capital, as defined. The rule permits the SEC, by order to restrict, for up to 20 business days, withdrawing of equity capital or making unsecured advances or loans to related persons under certain limited circumstances. Finally, broker-dealers are prohibited from making any withdrawal of capital that would cause the broker-dealer's net capital to be less than 25% of the deductions from net worth required by the Net Capital Rule as to readily marketable securities ("haircuts"). Under the Market Reform Act of 1990, the SEC adopted regulations requiring registered broker-dealers to maintain, preserve and report certain information concerning the organizational structure, risk management policies and financial condition of any affiliate of the Company whose activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealer. Securities broker-dealers are also required to file with the SEC, specified information on a quarterly and annual basis. COMPETITION All aspects of the business of the Company are highly competitive. The Company competes directly with numerous other brokers and dealers, investment banking firms, insurance companies, investment companies, banks, commercial banks and other financial institutions. In recent years, competitive pressures from discount brokerage firms and commercial banks, increased investor sophistication and an increase in the variety of investment products have resulted, primarily through mergers and acquisitions, in the emergence of a few well capitalized national firms. The Company believes that the principal factors affecting competition in the securities industry are available capital, and the quality and prices of services and products offered. ITEM 2. ITEM 2. PROPERTIES The principal executive offices of the Company are located at 1285 Avenue of the Americas, New York, New York under a lease expiring March 31, 2000. The Company is currently leasing approximately 507,000 square feet at 1285 Avenue of the Americas comprising the offices of its investment banking, asset management, institutional sales and trading, and corporate headquarters staff, as well as two branch offices for retail investment executives. The Company leases approximately 900,000 square feet of space at Lincoln Harbor in Weehawken, New Jersey under leases expiring December 31, 2013. The Lincoln Harbor facility houses retail sales and marketing headquarters, systems, operations, administrative services, and finance and training divisions. At December 31, 1993, the Company maintained 281 offices worldwide under leases expiring between 1994 and 2014. In addition, the Company leases various furniture and equipment. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of proceedings concerning matters arising in connection with the conduct of its business. Certain actions, in which compensatory damages of $120 million or more appear to be sought, are described below. The Company is also involved in numerous proceedings in which compensatory damages of less than $120 million appear to be sought, or in which punitive or exemplary damages, together with the apparent compensatory damages alleged, appear to exceed $120 million. The Company had denied, or believes it has legitimate defenses and will deny, liability in all significant cases pending against it, including those described below, and intends to defend actively each such case. NORTHVIEW CORPORATION LITIGATION In March 1992, PaineWebber Incorporated ("PaineWebber") as well as other individuals and entities including, inter alia, the former officers and directors of Northview Corporation ("Northview"), Calmark Holding Corporation and Calmark Financial Corporation and its respective officers and directors, were named as defendants in a purported class action filed by Northview in the Superior Court of the State of California for the County of Los Angeles. The Complaint sought to set aside as fraudulent and illegal, certain transfers of funds and distributions of cash, and to recover damages allegedly caused by the defendants for breach of contract, impairment of capital, unjust enrichment, breach of fiduciary duty, gross negligence and looting of corporate assets. As to PaineWebber, Plaintiff alleged that in November 1987, Northview retained PaineWebber to render a fairness opinion respecting the fair market value of the common stock of Calmark Financial Corporation which Northview was to receive in exchange for issuing its own stock to Calmark Holding Corporation, the parent corporation of Calmark Financial Corporation. The Complaint asserted that PaineWebber issued a fairness opinion which allegedly overstated the value of Calmark Financial Corporation's assets, which enabled the transaction at issue in the form of a self tender and merger to go forward. Plaintiff contends that, as a result of PaineWebber's allegedly overstating the value of the assets of Calmark Financial Corporation, Northview's assets were improperly transferred to Calmark, whose principals depleted the assets subsequent to the merger. On March 16, 1990, Northview filed for protection under Chapter XI of the Bankruptcy Law. The Complaint sought damages in an amount to be proven at trial, the imposition of a constructive trust of at least $100 million, punitive damages, interest, costs and attorneys fees from all the defendants. The Complaint was amended three times before January 12, 1994. On February 8, 1994, Plaintiff filed a motion for leave to file a Fourth Amended Complaint, which motion was granted on March 15, 1994. The Fourth Amended Complaint adds a new cause of action for negligent misrepresentation against PaineWebber and claims for professional negligence and breach of fiduciary duty against the law firm of Troy & Gould and certain of its principals who acted as outside counsel to both Northview and Calmark in connection with their merger. Defendants have until April 15, 1994 to respond to the Fourth Amended Complaint. In the meantime, discovery is on- going. GENERAL DEVELOPMENT CORPORATION SECURITIES LITIGATION On or about June 10, 1991, PaineWebber Incorporated ("PaineWebber") was served with a "First Amended Complaint" in an action captioned Rolo v. City Investing Liquidating Trust, et al., Civ. Action 90-4420 (D.N.J., filed on or about May 13, 1991) (the "Rolo action") naming it and other entities and individuals as defendants. The First Amended Complaint alleges violations of: (1) one or more provisions of the Racketeer Influenced and Corrupt Organizations Act ("RICO"); (2) one or more provisions of the Securities Exchange Act of 1934; (3) one or more provisions of the Interstate Land Sales Full Disclosure Act; and (4) the common law, on behalf of all persons (excluding defendants) who purchased lots and/or houses from General Development Corporation ("GDC") or one of its affiliates and who are members of an association known as the North Port Out-of-State Lot Owners Association. The allegations in the First Amended Complaint which relate to PaineWebber are premised on claims that PaineWebber is responsible for misrepresentations and/or omissions of material facts in the prospectuses and other public documents filed in connection with, and after, the following: (1) the April 8, 1988 offering by GDC of the Bonds; and (2) a 1989 offering of Adjustable Rate General Development Residential Mortgage Pass-Through Certificates, Series 1989-A, for which PaineWebber served as underwriter. Plaintiffs contend that due to such alleged misrepresentations and/or omissions of material facts, PaineWebber knowingly enabled GDC to acquire additional financial resources for perpetuation of (and/or aided and abetted) an alleged scheme to defraud purchasers of GDC lots and/or houses. The First Amended Complaint requests certain declaratory relief, equitable relief, compensatory damages of not less than $500 million, punitive damages of not less than three times compensatory damages, treble damages with respect to the RICO count, pre-judgment and post-judgment interest on all sums awarded, and attorney's fees, costs, disbursement and expert witness fees. Served with the Rolo First Amended Complaint was a letter from Plaintiffs' counsel to all parties in the action stating that the Rolo court stayed the action on April 26, 1991. The letter further stated that "the time within which defendants must answer or otherwise respond is stayed pursuant to the Court's Order." The stay remained in effect until January 28, 1993, when Plaintiffs in Rolo filed a motion to dissolve the stay. On March 9, 1993, the Court granted Plaintiffs' motion and dissolved the stay of proceedings in the Rolo action. On or about March 31, 1993, PaineWebber filed a motion to dismiss Plaintiffs' First Amended Complaint for insufficient service of process. On May 11, 1993, the Court denied said motion. On May 28, 1993, PaineWebber, together with a majority of other defendants filed motions to dismiss Plaintiffs' First Amended Complaint on, inter alia, jurisdictional and statute of limitation grounds as well as challenging the adequacy of the pleadings. On December 27, 1993, the Court entered an order dismissing Plaintiffs' First Amended Complaint against PaineWebber and the majority of the other defendants. On January 10, 1994, Plaintiffs filed a notice of appeal to the United States Court of Appeals for the Third Circuit. ICN PHARMACEUTICALS LITIGATION Class actions were commenced against PaineWebber Incorporated ("PaineWebber") in 1986 in the United States District Court for the Southern District of New York, and in 1987 in the United States District Court for the Central District of California, alleging Rule 10b-5 and common law fraud claims based on purported misstatements in a market advisory concerning ICN Pharmaceuticals, Inc. and its antiviral drug, ribavirin. Virtually all those complaints also alleged various federal securities and common law claims against ICN, its subsidiaries and several of its officers and directors. The California actions were transferred to New York in 1987, and all the related actions were there consolidated under an amended consolidated complaint. In June 1991, the Court dismissed the complaint with leave to replead. After motion practice directed to the repleaded complaint and the conduct of pretrial discovery, PaineWebber and plaintiffs reached an agreement to settle the consolidated action for $6.5 million, conditioned on (a) the execution of stipulation of settlement, (b) certification of the class by the Court, and (c) entry of a final judgment (no longer subject to appeal), issued after notice to the class and the conduct of a fairness hearing (i) approving the settlement, (ii) dismissing the complaint with prejudice, and (iii) barring co-defendants from maintaining any claim against PaineWebber for contribution or indemnification. ARIZONA STATE CARPENTERS PENSION TRUST FUND, ET AL. V. MITCHELL HUTCHINS INSTITUTIONAL INVESTORS, ET AL. In April 1989, Mitchell Hutchins Institutional Investors Inc. ("MHII") was named as a defendant in a suit filed in the U.S. District Court, District of Arizona, Phoenix (No. CIV 89-0693) by four employee benefit plans. MHII has been a subsidiary of Mitchell Hutchins Asset Management Inc. ("MHAM") since February 1988, when it was acquired from Manufacturers Hanover Trust Company ("Manufacturers"). The current complaint alleges violation of the Employee Retirement Income Security Act ("ERISA") and other federal and state laws as to MHII and other defendants and seeks unspecified monetary damages and other relief. The allegations of the complaint which pertain to MHII involve certain real estate related investments made through a Phoenix branch office almost entirely while the firm was owned by Manufacturers. The Plaintiffs were investment advisory clients until December 31, 1988. Subsequent amendments added, among others, Manufacturers, MHAM, PaineWebber Incorporated and Paine Webber Group Inc. as defendants. The parties are engaged in discovery. Under the current scheduling order entered by the Court, discovery will continue into 1994 and a trial date has been set for the middle of 1995. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Executive Officers of the Registrant Incorporated herein by reference is the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 5, 1994 ("Proxy Statement") to be filed with the Commission not later than 120 days after the end of the fiscal year. Set forth below, in addition to information contained in the Proxy Statement, is certain information concerning the executive officers of PWG who do not also serve as directors of PWG: Regina A. Dolan, 39, is Vice President and Chief Financial Officer of PWG, a position she has held since February 3, 1994. Prior thereto, she was the principal financial and accounting officer of PWG from October 1992 to February 3, 1994. Ms. Dolan is also Senior Vice President and has been Chief Financial Officer of PWI since February 3, 1994. From October 1992 to February 3, 1994, she was Director of Finance and Controls of PWI. Prior to joining the Company, Ms. Dolan was with Ernst & Young from September 1975 to September 1992, where she rose to the position of Partner and served as Director of the firm's Securities Industry Practice. Lee Fensterstock, 45, is an Executive Vice President and Director of Institutional Sales and Trading of PWI. Mr. Fensterstock was Senior Vice President, Finance and Controls of PWI from 1988 to January 1991. Before joining PWI he was with Citibank for fifteen years where he held various positions in planning, financial control and business management. Theodore A. Levine, 49, is General Counsel, Vice President and Secretary of PWG, and is an Executive Vice President of PWI, positions he has held since June 15, 1993. Prior to joining the Company, Mr. Levine was a partner at the Washington D.C. - based law firm of Wilmer, Cutler and Pickering from February 1984 to June 1993. He was with the Securities and Exchange Commission from 1969 to 1984 where he rose to the position of Associate Director in the Division of Enforcement. Pierce R. Smith, 50, has been Treasurer of PWG since February 16, 1988, Executive Vice President and Treasurer of PWI since February 2, 1988 and was appointed Controller of PWI as of February 15, 1993. He was Senior Vice President and Treasurer of Norwest Corporation from August 1982 to December 1987. Executive Officers are elected annually to serve until their successors are elected and qualify or until they sooner die, retire, resign or are removed. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information set forth under the captions "Market for Common Stock" and "Common Stock Dividend History" in the 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information set forth under the caption "Financial Highlights" in the 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the caption "Management's Discussion and Analysis" in the 1993 Annual Report to Stockholders is incorporated herein by reference beginning on page 30 under the caption "Results of Operations". ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, schedules and supplementary financial information required by this item and included in this report or incorporated herein by reference are listed in the index appearing on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the age and principal occupation of each director is set forth under the caption "Information Concerning the Nominees and Directors" in the Proxy Statement and is incorporated herein by reference. Information concerning executive officers of the Registrant, who do not serve as directors, is given at the end of Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information concerning compensation of directors and executive officers of the Registrant is set forth under the captions "Compensation of Directors," "Executive Compensation," "Other Benefit Plans and Agreements" and "Certain Transactions and Arrangements" in the Proxy Statement and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITIES OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security ownership of executive officers, directors and certain beneficial owners is set forth under the caption "Security Ownership" in the Proxy Statement and is incorporated herein by reference. Solely for the purpose of calculating the aggregate market value of the voting stock held by non-affiliates of the Registrant as set forth on the cover of this report, it has been assumed that directors and executive officers of the Registrant are affiliates. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information related to certain transactions with directors of the Registrant is set forth under the captions "Certain Agreements with Directors" and "Certain Transactions and Arrangements" in the Proxy Statement and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. FINANCIAL STATEMENTS, FINANCIAL SCHEDULES, EXHIBITS AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: (1) & (2) The financial statements and schedules included in this report are incorporated herein by reference and are listed in the accompanying index to financial statements and financial statement schedules appearing on page. (3) The exhibits included in this report or incorporated herein by reference are listed in the accompanying index to exhibits appearing on page. The management contracts or compensatory plans and arrangements listed in the index to exhibits that are applicable to the executive officers named in the "Summary Compensation Table", appearing in Registrant's 1994 Proxy Statement, are set forth on pages and. (b) Reports on Form 8-K: The Company filed a Current Report on Form 8-K dated January 14, 1994 with the SEC relating to the issuance by the Company of 2,200,000 AMEX Hong Kong 30 Index Call Warrants expiring January 17, 1996 and 4,100,000 AMEX Hong Kong 30 Index Put Warrants expiring January 17, 1996. The item reported on such Current Report was "Item 5 - Other Events". The Company filed a Current Report on Form 8-K dated February 10, 1994 with the SEC relating to the Certificate of the Powers, Designations, Preferences and Rights relating to the Company's 6% Convertible Preferred Stock. The item reported on such Current Report was "Item 7 - Exhibits". SIGNATURES Pursuant to the requirements of Section 13 or 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 on March 25, 1994. PAINE WEBBER GROUP INC. (Registrant) BY: Donald B. Marron /s/ ____________________________________ Donald B. Marron Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 25, 1994. Donald B. Marron /s/ ____________________________________ Donald B. Marron Chairman of the Board, Chief Executive Officer and Director (principal executive officer) Regina A. Dolan /s/ ____________________________________ Regina A. Dolan Vice President, Chief Financial Officer T. Stanton Armour /s/ ____________________________________ T. Stanton Armour Director E. Garrett Bewkes, Jr. /s/ ____________________________________ E. Garrett Bewkes, Jr. Director John A. Bult /s/ ____________________________________ John A. Bult Director SIGNATURES ______________________________ Yozo Fujisawa Director Joseph J. Grano, Jr. /s/ ______________________________ Joseph J. Grano, Jr. Director Paul B. Guenther /s/ ____________________________________ Paul B. Guenther Director John E. Kilgore, Jr. /s/ ____________________________________ John E. Kilgore, Jr. Director Robert M. Loeffler /s/ ____________________________________ Robert M. Loeffler Director Edward Randall, III /s/ ____________________________________ Edward Randall, III Director Henry Rosovsky /s/ ____________________________________ Henry Rosovsky Director _______________________________ Kyosaku Sorimachi Director PAINE WEBBER GROUP INC. ITEMS 8, 14(A)(1) AND (2) AND 14(D) INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial Statements Incorporated herein by reference are the following financial statements included in the 1993 Annual Report to Stockholders. With the exception of the following financial statements and the information incorporated by reference on items 1, 5, 6 and 7, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this report. All other schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the respective financial statements or notes thereto. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAINE WEBBER GROUP INC. (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF INCOME (IN THOUSANDS OF DOLLARS) See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAINE WEBBER GROUP INC. (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF FINANCIAL CONDITION (IN THOUSANDS OF DOLLARS EXCEPT SHARE AND PER SHARE AMOUNTS) * Retroactively adjusted to reflect a three-for-two common stock split in the form of a 50% stock dividend effective March 10, 1994 to stockholders of record on February 17, 1994. See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAINE WEBBER GROUP INC. (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF CASH FLOWS (IN THOUSANDS OF DOLLARS) See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAINE WEBBER GROUP INC. (PARENT COMPANY ONLY) NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (IN THOUSANDS OF DOLLARS) GENERAL The condensed financial information of Paine Webber Group Inc. (Parent Company Only) should be read in conjunction with the consolidated financial statements of Paine Webber Group Inc. and the notes thereto incorporated by reference in this report. STATEMENT OF CASH FLOWS Interest payments for the years ended December 31, 1993, 1992 and 1991 approximated $122,073, $84,323 and $86,421, respectively. Income tax payments (consolidated) totalled $128,089, $96,941 and $26,983 for the years ended December 31, 1993, 1992 and 1991, respectively. COMMITMENTS AND CONTINGENCIES The Company has guaranteed certain of its subsidiaries' unsecured lines of credit and contractual obligations. SCHEDULE VIII PAINE WEBBER GROUP INC. VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS OF DOLLARS) (1) Amounts charged to expense. (2) Represents amounts written off against assets and recoveries. SCHEDULE IX PAINE WEBBER GROUP INC. SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) (1) The general terms of each category of aggregate short-term borrowings are contained in the Notes to Consolidated Financial Statements appearing in the 1993 Annual Report to Stockholders on pages 41 and 43 under the captions "Summary of Significant Accounting Policies" and "Short-Term Borrowings", respectively. (2) Computation is based upon the total aggregate month-end borrowings divided by the number of months in the period during which the borrowings were outstanding. (3) Computation is based upon the total aggregate interest cost for the year divided by the average borrowings outstanding during the year. (4) There were no Medium-Term Notes with maturities of nine months to one year outstanding during 1991. SCHEDULE X PAINE WEBBER GROUP INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) ITEM CHARGED TO COSTS AND EXPENSES - ---- ----------------------------- Advertising Costs: Year ended December 31, 1993 $40,419 Year ended December 31, 1992 $31,233 Year ended December 31, 1991 $28,274 PAINE WEBBER GROUP INC. INDEX TO EXHIBITS Item 14(c) A. The following Exhibits are filed herewith: 1 - Distribution Agreement dated November 30, 1993 between Registrant, PWI and The First Boston Corporation. 4.1 - Copy of form of certificate of common stock to reflect a new signatory. 4.2 - Third Supplemental Indenture dated as of November 30, 1993 between Registrant and Chemical Bank Delaware, as Trustee, relating to the Subordinated Debt Securities. 10.1 - Limited Partnership Agreement of PW Partners 1992 Dedicated L.P. dated as of September 2, 1992. 10.2 - Employment Agreement dated as of May 4, 1993 between Registrant, PWI and Theodore A. Levine. 10.3 - Restated and Amended Agreement of Lease, dated as of January 1, 1989, between The Equitable Life Assurance Society of the United States and Registrant relating to property located at 1285 Avenue of the Americas, New York, New York. 11 - Computation of Earnings per Common Share. 12.1 - Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends. 12.2 - Computation of Ratio of Earnings to Fixed Charges. 13 - 1993 Annual Report to Stockholders of Registrant. 21 - Subsidiaries of the Registrant. 23 - Consent of Independent Auditors. B. Pursuant to the General Rules and Regulations under the Securities Exchange Act of 1934, as amended, the following Exhibits previously filed with the Securities and Exchange Commission are incorporated by reference as Exhibits to this annual report: 3.1 - Restated Certificate of Incorporation of Registrant, as filed with the Office of the Secretary of State of the State of Delaware on May 4, 1987 (incorporated by reference to Registrant's Form 10-Q for the quarter ended March 31, 1987). 3.2 - Certificate of Amendment to the Restated Certificate of Incorporation of Registrant as filed with the Office of the Secretary of State of the State of Delaware on June 3, 1988 (incorporated by reference to Exhibit 3.2 of Registrant's Form 10-Q for the quarter ended June 30, 1988). 3.3 - Certificate of Powers, Designations, Preferences and Rights relating to Registrant's 7.5% Convertible Preferred Stock as filed with the Office of the Secretary of State of Delaware on January 16, 1992 (incorporated by reference to Exhibit 3.1 of Registrant's Form 10-K for the year ended December 31, 1991). 3.4 - Certificate of Powers, Designations, Preferences and Rights relating to Registrant's 7.5% Convertible Preferred Stock, Series B, as filed with the Office of the Secretary of State of Delaware on January 16, 1992 (incorporated by reference to Exhibit 3.2 to Registrant's Form 10-K for the year ended December 31, 1991). 3.5 - Certificate of Designation, Preference and Rights relating to Registrant's Cumulative Participating Convertible Voting Preferred Stock, Series A as filed with the Office of the Secretary of State of the State of Delaware on November 5, 1992 (incorporated by reference to Exhibit 3 of Registrant's Form 10-Q for the quarter ended September 30, 1992). 3.6 - By-laws of the Registrant as amended March 1, 1988 (incorporated by reference to Exhibit 3.1 of Registrant's Form 10-K for the year ended December 31, 1987). 3.7 - Certificate of Stock Designation (elimination) relating to Registrant's 7% Cumulative Convertible Exchangeable Voting Preferred Stock, Series A as filed with the office of the Secretary of State of the State of Delaware on November 5, 1992 (incorporated by reference to Exhibit 3.1 of Registrant's Form 10-K for the year ended December 31, 1992). 3.8 - Certificate of Powers, Designations, Preferences and Rights relating to the Company's 6% Convertible Preferred Stock as filed with the Office of the Secretary of State of the State of Delaware on February 8, 1994 (incorporated by reference to Exhibit 7.1 of Registrant's Form 8-K dated February 10, 1994). 4.3 - Indenture dated as of March 15, 1988 between Registrant and Chemical Bank (Delaware), as Trustee, relating to Registrant's Medium-Term Subordinated Notes, Series B and Series D (incorporated by reference to Exhibit 4.2b of Registrant's Registration Statement No. 33-29253 on Form S-3 filed with the SEC on June 14, 1989). 4.4 - Supplemental Indenture dated as of September 22, 1989, to the Indenture dated as of March 15, 1988, between Registrant and Chemical Bank Delaware, as Trustee, Relating to Subordinated Debt Securities (incorporated by reference to Exhibit 4.2d of Registrant's Form 8-K dated September 30, 1989). 4.5 - Supplemental Indenture dated as of March 22, 1991 between Registrant and Chemical Bank Delaware, as Trustee, relating to Subordinated Debt Securities (incorporated by reference to Exhibit 4.2f of Registrant's Registration Statement No. 33-39818 on Form S-3 filed with the SEC on April 5, 1991). 4.6 - Form of Debt Securities (Medium-Term Subordinated Note, Series B, Floating Rate) -- Additional alternate form providing for the payment of additional amounts in certain circumstances to United States aliens (incorporated by reference to Exhibit 4.1 of Registrant's Form 8-K dated December 20, 1989). 4.7 - Indenture dated as of March 15, 1988 between Registrant and Chemical Bank, as Trustee, relating to Registrant's Medium-Term Senior Notes, Series A and Series C (incorporated by reference to Exhibit 4.2a of Registrant's Registration Statement No. 33-39818 on Form S-3 filed with the SEC on April 5, 1991). 4.8 - Supplemental Indenture dated as of September 22, 1989, to the Indenture dated as of March 15, 1988 between Registrant and Chemical Bank, as Trustee, relating to Senior Debt Securities (incorporated by reference to Exhibit 4.2c of Registrant's Form 8-K dated September 30, 1989). 4.9 - Supplemental Indenture dated as of March 22, 1991 between Registrant and Chemical Bank, as Trustee, relating to Senior Debt Securities (incorporated by reference to Exhibit 4.2c of Registrant's Registration Statement No. 33- 39818 on Form S-3 filed with the SEC on April 5, 1991). 4.10 - Form of Debt Securities (9-1/4% Notes Due 2001) (incorporated by reference to Exhibit 4.1 of Registrant's Form 8-K dated December 17, 1991 filed with the SEC). 4.11 - Form of Debt Securities (9-5/8% Senior Note Due 1995) (incorporated by reference to Exhibit 4.1 of Registrant's Form 8-K dated April 25, 1991 filed with the SEC). 4.12 - Form of 8% Convertible Debenture Due 1998 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31, 1988). 4.13 - Form of 8% Convertible Debentures Due 2000 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31, 1991). 4.14 - Form of 6.5% Convertible Debenture Due 2002 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31, 1992). 4.15 - Form of Debt Securities (7% Notes Due 2000) (incorporated by Reference to Exhibit 4.2 of Registrant's Form 10-K for the year ended December 31, 1992). 4.16 - Form of Debt Securities (7-7/8% Notes Due 2003) (incorporated by reference to Exhibit 4.1f of Registrant's Form 8-K dated February 11, 1993). 4.17 - Form of Book-Entry Global Security relating to Stock Index Return Securities on the S&P MidCap 400 Index due June 2, 2000 (incorporated by reference to Exhibit 4.1g of Registrant's Form 8-K dated May 25, 1993). 4.18 - Warrant Agreement dated as of January 27, 1993 between Registrant, Citibank, N.A., as Warrant Agent and PaineWebber Incorporated as Determination Agent relating to the Registrant's U.S. Dollar Increase Warrants on the Major Market Currency Index (incorporated by Reference to Exhibit 4.3 of Registrant's Form 10-K for the year ended December 31, 1992). 4.19 - Warrant Agreement, dated as of November 2, 1993, among Registrant, Citibank, N.A. as Warrant Agent and PaineWebber Incorporated as Determination Agent, relating to the Registrant's 2,400,000 AMEX Hong Kong 30 Index Put Warrants Expiring October 27, 1995 (incorporated by reference to Exhibit 4.1 of Registrant's Form 8-K dated October 26, 1993). 4.20 - Warrant Agreement, dated as of November 2, 1993, among Registrant, Citibank, N.A. as Warrant Agent and PaineWebber Incorporated as Determination Agent, relating to Registrant's 2,600,000 AMEX Hong Kong 30 Index Call Warrants Expiring October 27, 1995 (incorporated by reference to Exhibit 4.2 of Registrant's Form 8-K dated October 26, 1993). 4.21 - Warrant Agreement, dated as of January 24, 1994, among Registrant, Citibank, N.A. as Warrant Agent and PaineWebber Incorporated as Determination Agent, relating to Registrant's 4,100,000 AMEX Hong Kong 30 Index Put Warrants Expiring January 17, 1996 (incorporated by reference to Exhibit 4.1 of Registrant's Form 8-K dated January 14, 1994). 4.22 - Warrant Agreement, dated as of January 24, 1994, among Registrant, Citibank, N.A. as Warrant Agent and PaineWebber Incorporated as Determination Agent, relating to Registrant's 2,200,000 AMEX Hong Kong 30 Index Call Warrants Expiring January 17, 1996 (incorporated by reference to Exhibit 4.2 of Registrant's Form 8-K dated January 14, 1994). 4.23 - Warrant Agreement dated as of March 16, 1994 among Registrant, Citibank, N.A., as Warrant Agent and PaineWebber Incorporated as Determination Agent relating to the Registrant's U.S. Dollar Increase Warrants on the Japanese Yen Expiring March 6, 1996 (incorporated by reference to Registrant's Amendment No.1 of Registration Statement No.33-53776 filed on Form 8-A/A dated March 17, 1994). 4.24 - Form of Registrant's Medium-Term Senior Note, Series A, Floating Rate Due March 15, 1994 (incorporated by reference to Exhibit 4.4 of Registrant's Form 10-K for the year ended December 31, 1990). 4.25 - Form of Registrant's Medium-Term Subordinated Note, Series B, Floating Rate Due December 20, 1994 (incorporated by reference to Exhibit 4.5 of Registrant's Form 10-K for the year ended December 31, 1990). The credit agreements listed below have not been registered under the Securities Act of 1933 or the Securities Exchange Act of 1934, nor does the long-term indebtedness that they represent exceed, in the aggregate, 10% of the total assets of Registrant and its subsidiaries on a consolidated basis. Consequently, these instruments have not been filed as an exhibit with this report, but copies will be furnished to the Securities and Exchange Commission upon request. Credit Agreement dated as of June 3, 1993 among Registrant, the Lenders named therein and Citibank, N.A. as Administrative Agent, relating to the $275 million credit facility. Credit Agreement dated as of March 25, 1992 among Registrant, the managers named therein and the First National Bank of Chicago, Administrative Agent, relating to the $225 million credit facility. 10.4 - Amended and Restricted Investment Agreement dated as of November 5, 1992 by and between Registrant and The Yasuda Mutual Life Insurance Company ("Yasuda") relating to the repurchase by Registrant of 1,685,394 shares of Registrant's 7% Cumulative Convertible Exchangeable Voting Preferred Stock, Series A ("7% Preferred Shares") and the replacement of the remaining 3,370,786 7% Preferred Shares for 7,758,632 shares of Registrant's Cumulative Participating Convertible Voting Preferred Stock, Series A (incorporated by reference to Exhibit 10 of Registrant's Form 10-Q for the quarter ended September 30, 1992). 10.5 - Employment Agreement dated as of January 2, 1987 between Registrant, PaineWebber Incorporated and Donald B. Marron (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the three months ended December 31, 1986). 10.6 - Employment Agreement dated as of January 2, 1987 between Registrant, PWI and Paul B. Guenther (incorporated by reference to Exhibit 10.10 of Registrant's Form 10-K for the three months ended December 31, 1986). 10.7 - Employment Agreement dated as of January 2, 1987 between Registrant, PWI and John A. Bult (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the fiscal year ended December 31, 1988). 10.8 - Registrant's Supplemental Employee's Retirement Plan For Certain Senior Officers dated August 4, 1988 (incorporated by reference to Exhibit 10.4 of Registrant's Form 10-K for the year ended December 31, 1988). 10.9 - Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and Donald B. Marron relating to the Supplemental Employees Retirement Plan (incorporated by reference to Exhibit 10.6 of Registrant's Form 10-K for the year ended December 31, 1988). 10.10 - Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and Paul B. Guenther relating to the Supplemental Employees Retirement Plan (incorporated by reference to Exhibit 10.8 of Registrant's Form 10-K for the year ended December 31, 1988). 10.11 - Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and John A. Bult relating to the Supplemental Employees Retirement Plan (incorporated by reference to Exhibit 10.9 of Registrant's Form 10-K for the year ended December 31, 1988). 10.12 - Agreement and Declaration of Trust for Supplemental Employees Retirement Plan dated as of January 1, 1990 between Registrant and Chase Manhattan Bank, N.A. as Trustee (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K for the year ended December 31, 1990). 10.13 - Form of Consulting Agreement dated as of February 21, 1989 between PWI and E. Garrett Bewkes, Jr. (incorporated by reference to Exhibit 10.10 of Registrant's Form 10-K for the year ended December 31, 1988). 10.14 - Registrant's 1980 Employee Stock Option Plan (incorporated by reference to Registrant's Registration Statement No. 2-78627 on Form S-8 filed with the SEC on June 30, 1982). 10.15 - Registrant's 1983 Stock Option Plan (incorporated by reference to Exhibit 4 of Registrant's Registration Statement No. 2-81554 on Form S-8 filed with the SEC on January 28, 1983). 10.16 - Registrant's 1984 Stock Award Plan (incorporated by reference to Exhibit 4(a) of Registrant's Registration Statement No. 2-92770 on Form S-8 filed with the SEC on August 15, 1984). 10.17 - Registrant's 1984 Stock Appreciation Rights Plan (incorporated by reference to Exhibit 4(a) of Registrant's Registration Statement No. 2-92770 on Form S-8 filed with the SEC on August 15, 1984). 10.18 - Registrant's Stock Award Plan (incorporated by reference to Exhibit 4 of Registrant's Registration Statement No. 33-22265 on Form S-8 Filed with the SEC on June 1, 1988). 10.19 - Registrant's 1986 Stock Award Plan (incorporated by reference to Registrant's Registration Statement No. 33-2959 on Form S-8 filed with the SEC on February 4, 1986). 10.20 - Registrant's 1990 Stock Award and Option Plan (incorporated by reference to Exhibit 10.1 of Registrant's Form 10- K for the year ended December 31, 1990). 10.21 - Registrant's Savings Investment Plan (incorporated by reference to Exhibit 4.1 to Registrant's Post-Effective Amendment No. 1 on Form S-8, No. 33-20240, filed with the SEC on October 31, 1990). 10.22 - Lease dated March 22, 1985 between Jacom Computer Services, Inc. and PWI (IBM 3084) (incorporated by reference to Exhibit 10.1 of Registrant's report on Form 10-K for fiscal year ended September 30, 1985). 10.23 - Lease dated June 21, 1983 between Paine, Webber, Jackson and Curtis Incorporated and Jacom Computer Services Inc. (IBM 3081) (incorporated by reference to Exhibit 10.5 of Registrant's Report on Form 10-K for fiscal year ending September 30, 1983). 10.24 - Lease dated April 9, 1986 between Unilease Computer Corporation and PWI (IBM 3090-200) (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the year ended December 31, 1987). 10.25 - Master Agreement between PWI and Quotron Systems Inc. dated February 11, 1991 (incorporated by reference to Exhibit 10.4 of Registrant's Form 10-K for the year ended December 31, 1990). 10.26 - Third-Party Master Lease Agreement between PWI and AT&T Systems Leasing Corporation dated as of October 21, 1991 (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K for the year ended December 31, 1991). 10.27 - Lease dated December 14, 1983 between Oliver Wendell Realty Trust and PaineWebber, Jackson & Curtis Incorporated relating to property located at 265 Franklin Street, Boston, Massachusetts (incorporated by reference to Exhibit 10.3 of Registrant's Report on Form 10-K for the fiscal year ended September 30, 1985). 10.28 - Lease dated May 17, 1985 between Rosehaugh Greycoat Estates Limited and PaineWebber International Inc. relating to property located at 1 Finsbury Avenue, London EC2M 2PA, England (incorporated by reference to Exhibit 10.4 of Registrant's Report on Form 10-K for the fiscal year ended September 30, 1985). 10.29 - Lease Agreement dated as of April 14, 1986, between PWI (as Tenant) and Hartz-PW Limited Partnership (as Landlord) relating to the Lincoln Harbor Project (Operations Center) located in Weehawken, New Jersey (incorporated by reference to Exhibit 10.1 of Registrant's Form 10-K for the fiscal year ended September 30, 1986). 10.30 - Lease Agreement dated as of April 14, 1986, between PWI (as Tenant) and Hartz-PW Limited Partnership (as Landlord) relating to the Lincoln Harbor Project (Data Processing Center) located in Weehawken, New Jersey (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the fiscal year ended September 30, 1986). 10.31 - Lease Agreement dated as of April 14, 1986, between PWI (as Tenant) and Hartz-PW Tower B Limited Partnership, as successor in interest to Hartz-PW Hotel Limited Partnership relating to the Lincoln Harbor Project (Hotel/Office Building) located in Weehawken, New Jersey (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K for the fiscal year ended September 30, 1986). 10.32 - Agreement of Limited Partnership of Hartz-PW Limited Partnership dated April 14, 1986 relating to the Lincoln Harbor Project located in Weehawken, New Jersey (incorporated by reference to Exhibit 10.3 of Registrant's 10-K for the year ended December 31, 1987). 10.33 - Ground lease between Hartz Mountain Industries and Hartz-PW Limited Partnership dated April 14, 1986 relating to the Operations Center at the Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.4 of Registrant's 10-K for the year ended December 31, 1987). 10.34 - Ground lease between Hartz Mountain Industries and Hartz-PW Limited Partnership dated April 14, 1986 relating to the Data Processing Center at Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.5 of Registrant's 10-K for the year ended December 31, 1987). 10.35 - Lease Acquisition Agreement between Hartz-PW Limited Partnership and PWI dated April 14, 1986 relating to the Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.6 of Registrant's 10-K for the year ended December 31, 1987). 10.36 - Transportation and Completion Agreement between Hartz-PW Limited Partnership and PWI dated April 14, 1986 relating to the Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.7 of Registrant's 10-K for the year ended December 31, 1987). 10.37 - Guarantee between Hartz Mountain Industries, as Guarantor, and PWI, as Beneficiary, dated April 14, 1986 relating to the Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.8 of Registrant's 10-K for the year ended December 31, 1987). 10.38 - General Partner Guarantee, between Hartz Mountain Industries, as Guarantor, and PWI, as Beneficiary, dated April 14, 1986 relating to the Lincoln Harbor Project in Weehawken, New Jersey (incorporated by reference to Exhibit 10.9 of Registrant's 10-K for the year ended December 31, 1987). 10.39 - Agreement of Limited Partnership of River-PW Hotel Limited Partnership relating to the Ramada Suites Hotel, Weehawken, New Jersey (incorporated by reference to Exhibit 10.4 of Registrant's Form 10-K for the year ended December 31, 1991). 10.40 - Hotel Rental Guarantee between PWI as Guarantor and River-PW Hotel Limited Partnership relating to the Ramada Suite Hotel, Weehawken, New Jersey (incorporated by reference to Exhibit 10.5 of Registrant's Form 10-K for the year ended December 31, 1991). 10.41 - First Amendment to Lease Agreement between 700 Louisiana Limited, successor to RBC Limited, and Rotan Mosle Inc., as of December 24, 1991 (incorporated by reference to Exhibit 10.6 of Registrant's Form 10-K for the year ended December 31, 1991). 10.42 - Joint Venture Agreement dated as of November 30, 1987 between Registrant and The Yasuda Mutual Life Insurance Company (incorporated by reference to Exhibit 10.1 of Registrant's Form 10-K for the year ended December 31, 1988). 10.43 - Lease dated as of September 27, 1988 between PWI and American National Bank & Trust Company of Chicago relating to property located at 181 West Madison Street, Chicago, Illinois (incorporated by reference to Exhibit 10.12 of Registrant's Form 10-K for the year ended December 31, 1988). 10.44 - Directors and Officers Liability and Corporation Reimbursement insurance policy with Fiduciary Liability Rider with National Union Fire Insurance Company (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the year ended December 31, 1990). 10.45 - Limited Partnership Agreement of PW Partners 1989 Dedicated L.P. dated as of December 1, 1989 (incorporated by reference to Exhibit 10.1 of Registrant's Form 10-K for the year ended December 31, 1992). 10.46 - Limited Partnership Agreement of PW Partners 1991 Dedicated L.P. dated as of October 7, 1991 (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the year ended December 31, 1992). 10.47 - Letter Agreement dated as of March 9, 1993 between Registrant and The Yasuda Mutual Life Insurance Company (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K for the year ended December 31, 1992). 10.48 - Form of License Agreement between Standard and Poor's Corporation and Registrant (incorporated by reference to Exhibit 10.1 of Registrant's Form 8-K dated June 1, 1993). C. Executive Compensation Plans and Arrangements o Employment Agreement dated as of January 2, 1987 between Registrant, PaineWebber Incorporated and Donald B. Marron (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the three months ended December 31, 1986). o Employment Agreement dated as of January 2, 1987 between Registrant, PWI and Paul B. Guenther (incorporated by reference to Exhibit 10.10 of Registrant's Form 10-K for the three months ended December 31, 1986). o Employment Agreement dated as of January 2, 1987 between Registrant, PWI and John A. Bult (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the fiscal year ended December 31, 1988). o Employment Agreement dated as of May 4, 1993 between Registrant, PWI and Theodore A. Levine (filed as Exhibit 10.2 to this Form 10-K for the year ended December 31, 1993). o Registrant's Supplemental Employee's Retirement Plan for Certain Senior Officers dated August 4, 1988 (incorporated by reference to Exhibit 10.4 of Registrant's Form 10-K for the year ended December 31, 1988). o Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and Donald B. Marron relating to the Supplemental Employees Retirement Plan (incorporated by reference to Exhibit 10.6 of Registrant's Form 10-K for the year ended December 31, 1988). o Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and Paul B. Guenther relating to the Supplemental Employees Retirement Plan (incorporated by reference Exhibit 10.8 of Registrant's Form 10-K for the year ended December 31, 1988). o Deferred Compensation Agreement dated as of August 29, 1988 between Registrant and John A. Bult relating to the Supplemental Employees Retirement Plan (incorporated by Exhibit 10.9 of Registrant's Form 10-K for the year ended December 31, 1988). o Agreement and Declaration of Trust for Supplemental Employees Retirement Plan dated as of January 1, 1990 between Registrant and Chase Manhattan Bank, N.A. as Trustee (incorporated by reference to Exhibit 10.3 of Registrant's Form 10-K for the year ended December 31, 1990). o Registrant's 1980 Employee Stock Option Plan (incorporated by reference to Registrant's Registration Statement No. 2-78627 on Form S-8 filed with the SEC on June 30, 1982). o Registrant's 1983 Stock Option Plan (incorporated by reference to Exhibit 4 of Registrant's Registration Statement No. 2-81554 on Form S-8 filed with the SEC on January 28, 1983). o Registrant's 1984 Stock Award Plan (incorporated by reference to Exhibit 4(a) of Registrant's Registration Statement No. 2-92770 on Form S-8 filed with the SEC on August 15, 1984). o Registrant's 1984 Stock Appreciation Rights Plan (incorporated by reference to Exhibit 4(a) of Registrant's Registration Statement No. 2-92770 on Form S-8 filed with the SEC on August 15, 1984). o Registrant's Stock Award Plan (incorporated by reference to Exhibit 4 of Registrant's Registration Statement No. 33-22265 on Form S-8 filed with the SEC on June 1, 1988). o Registrant's 1986 Stock Award Plan (incorporated by reference to Registrant's Registration Statement No. 33-2959 on Form S-8 filed with the SEC on February 4, 1986). o Registrant's 1990 Stock Award and Option Plan (incorporated by reference to Exhibit 10.1 of Registrant's Form 10-K for the year ended December 31, 1990). o Form of 8% Convertible Debenture Due 1998 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31,1988). o Form of 8% Convertible Debentures Due 2000 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31, 1991). o Form of 6.5% Convertible Debenture Due 2002 issued in connection with Registrant's Key Executive Equity Program (incorporated by reference to Exhibit 4.1 of Registrant's Form 10-K for the year ended December 31, 1992). o Limited Partnership Agreement of PW Partners 1989 Dedicated L.P. dated as of December 1, 1989 (incorporated by reference to Exhibit 10.1 of Registrant's Form 10-K for the year ended December 31, 1992). o Limited Partnership Agreement of PW Partners 1991 Dedicated L.P. dated as of October 7, 1991 (incorporated by reference to Exhibit 10.2 of Registrant's Form 10-K for the year ended December 31, 1992). o Limited Partnership Agreement of PW Partners 1992 Dedicated L.P. dated as of September 2, 1992 (filed as Exhibit 10.1 to this Form 10-K for the year ended December 31, 1993). PAINE WEBBER GROUP INC. INDEX TO EXHIBITS 1 - Distribution Agreement dated November 30, 1993 between Registrant, PWI and The First Boston Corporation. 4.1 - Copy of form of certificate of common stock to reflect a new signatory. 4.2 - Third Supplemental Indenture dated as of November 30, 1993 between Registrant and Chemical Bank Delaware, as Trustee, relating to the Subordinated Debt Securities. 10.1 - Limited Partnership Agreement of PW Partners 1992 Dedicated L.P. dated as of September 2, 1992. 10.2 - Employment Agreement dated as of May 4, 1993 between Registrant, PWI and Theodore A. Levine. 10.3 - Restated and Amended Agreement of Lease, dated as of January 1, 1989, between The Equitable Life Assurance Society of the United States and Registrant relating to property located at 1285 Avenue of the Americas, New York, New York. 11 - Computation of Earnings per Common Share. 12.1 - Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends. 12.2 - Computation of Ratio of Earnings to Fixed Charges. 13 - 1993 Annual Report to Stockholders of Registrant. 21 - Subsidiaries of the Registrant. 23 - Consent of Independent Auditors.	11,196	74,353
205520_1993.txt	205520_1993	1993	205520	Item 1. Business 6-32 Item 2. Item 2. Properties 6-32 Item 3. ITEM 3. Legal Proceedings In 1990, a verdict was rendered against the company's subsidiary, Philadelphia Newspapers, Inc., (PNI), publisher of The Philadelphia Inquirer and Philadelphia Daily News, in a libel action entitled Sprague v. Philadelphia Newspapers, Inc., for $2.5 million in compensatory damages and $31.5 million in punitive damages. Following entry of the judgment on Sept. 15, 1992, PNI, as required by statute, posted a bond equal to 120% of the amount of the verdict and appealed the judgment to the Pennsylvania Superior Court. PNI believes that substantial grounds exist for a decision by an appellate court to reverse the trial court and remand the case for a new trial. The Comprehensive Environmental Response, Compensation and Liability Act (Superfund) establishes a fund to clean up deposits and spills of hazardous substances. The Company has been identified by certain regulatory agencies as one of several potentially responsible parties in connection with the generation of allegedly hazardous substances which may have been disposed of or reclaimed by third-party contractors at sites in New Jersey, Maryland, South Carolina, North Carolina, Pennsylvania, and Kansas. The Company, certain other potentially responsible parties and the United States Environmental Protection Agency (EPA) have entered into consent orders relating to the sites in New Jersey, South Carolina and North Carolina providing for remedial investigations and feasibility studies or remediation to be performed. The Company does not anticipate that any liability arising from ultimate relief secured by regulatory agencies or other persons will have a material effect on the Company's business or financial condition. The Company is cooperating with the appropriate regulatory agencies with respect to compliance with environmental laws. ITEM 4. ITEM 4. Submission of matters to a vote of security holders None. PART II ITEM 5. ITEM 5. Market for registrant's common stock and related stockholder matters -------------------------------------------------------------------- KRI STOCK Knight-Ridder common stock is listed on the New York Stock Exchange and the Frankfurt Stock Exchange under the symbol KRI and on the Tokyo Stock Exchange with the designation 9491. The stock also is traded on exchanges in Philadel- phia, Chicago, Boston, San Francisco, Los Angeles and Cincinnati, as well as through the Intermarket Trading System. Options are traded in the Philadel- phia Exchange. ITEM 6. ITEM 6. Selected Financial Data ----------------------- ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations ------------------------- Knight-Ridder is an international information and communications company engaged in newspaper publishing, business news and information services, electronic retrieval services and news, graphics and photo services. In 1993, the gross revenue from these businesses was almost $2.5 billion. The company also is involved in other newspaper businesses, cable television and newsprint manufacturing through business arrangements, including joint ventures and partnerships. The charts at the end of this section illustrate the approximate relative percentages of the components of operating revenue and of operating costs as a percentage of revenue. Glossary of Newspaper Advertising Terms The following definitions may be helpful when reading the Discussion and Analysis of Operations. RETAIL - display advertising from local merchants, such as department and grocery stores, selling goods and services to the public. GENERAL - display advertising by national advertisers who promote products or brand names on a nationwide basis. CLASSIFIED - small, locally placed ads listed together and organized by category, such as real estate sales, employment opportunities and automobile sales and display-type advertisements in these categories. FULL-RUN - advertising appearing in all editions of a newspaper. PART-RUN - advertising appearing in select editions or zones of a newspaper's market. Part-run advertising is translated into full-run equivalent linage (referred to as factored) based on the ratio of the circulation in a particular zone to the total circulation of a newspaper. RUN-OF-PRESS (ROP) - all advertising printed on Knight-Ridder presses and appearing within a newspaper. PREPRINT - advertising supplements prepared by advertisers and inserted into a newspaper. NEWSPAPER revenue is derived principally from advertising and newspaper copy sales. Newspaper advertising currently accounts for 60% of consolidated revenue. This revenue comes from the three basic categories of advertising - retail, general and classified - discussed above. Newspaper advertising volume is categorized as either run-of-press (ROP) or preprint. Volume for ROP advertising is measured in terms of either full-run or part-run advertising linage and reported in six-column inches. A six-column inch consists of one inch of advertising in one column of a newspaper page when that page is divided into six columns of equal size. By using part-run advertising, advertisers can direct their messages to selected market segments. Circulation revenue results from the sale of newspapers. Circulation of daily and Sunday newspapers currently accounts for 19% of consolidated revenue. It is reported at the net wholesale price for newspapers delivered or sold by independent contractors and at the retail price for newspapers delivered or sold by employees. Other newspaper revenue comes from alternate delivery systems, commercial job printing, newsprint scrap sales, newspaper trucking services, book publishing, niche publications and other miscellaneous sources. BUSINESS INFORMATION SERVICES (BIS) revenue includes operations of Dialog, Knight-Ridder Financial and the Journal of Commerce. Dialog includes Dialog Information Services and Data-Star, a 1993 acquisition with Europe-based online operations. Dialog and Data-Star have more than 155,000 customers in over 100 countries and offer more than 450 databases. Subscribers are charged according to the amount of time they spend online and which databases they access. Knight-Ridder Financial products include real-time and archival information services focusing on global sovereign debt, foreign exchange, money markets and futures instruments. Information displayed on these products consists of news, quotations, charts and a variety of other analytical services. The group generates revenue from subscribers in more than 30 countries. The Journal of Commerce publishes The Journal of Commerce, a business daily newspaper that focuses on global trade and transportation issues, and several more-targeted periodicals. It also provides access to electronic databases on imports, exports and steamship tariffs. SUMMARY OF OPERATIONS: A summary of the company's operations, certain share data and other financial data for the past 11 years is provided in Item 6. Compound growth rates for the past five- and 10-year periods are also included, if applicable. A review of this summary and of the Supplemental Information section (Items 1 & 2) will provide a better understanding of the following discussion and analysis of operating results and of the financial statements as a whole. The Supplemental Information section contains financial data for the company's operations by line of business and includes discussions of the company's largest newspapers and information regarding the company's properties, technology and the raw materials used in operations. RESULTS OF OPERATIONS: 1993 vs. 1992 - Knight-Ridder, Inc., earnings per share was $2.68, up $.03, or 1.1%, from $2.65 per share before the cumulative effect of changes in accounting principles in 1992. Operating income increased 2.3% on a 5.2% increase in revenue in 1993. Operating income as a percentage of revenue was 11.6% compared with 12.0% in 1992. A 20.7% increase in net interest expense resulted from a reduction in capitalization of interest related to the Philadelphia plant. This was partially offset by higher earnings from our cable investment. NEWSPAPERS: The Newspaper Division's operating income increased $8.2 million, or 2.8%, to $298.8 million. The increase resulted from improved revenues that more than offset a 3.4% increase in the average price of newsprint, and increased costs due to the transition to the new plant in Philadelphia. Overall, newspaper advertising revenue increased by $37.5 million, or 2.6%, in 1993 on a full-run ROP linage increase of 1.3%. The following table summarizes the percentage change in revenue and full-run ROP linage from 1992. Percent Percent Gain Gain (Decline) (Decline) in Full-Run Advertising Category in Revenue ROP Linage - -------------------- ---------- ---------- Retail 1.0 (1.0) General (3.4) (7.8) Classified 7.0 5.3 Total 2.6 1.3 Retail advertising revenue improved $7.6 million, or 1.0%. A 1.9% increase in full-run average rates and an increase in part-run ROP revenue was partially offset by a 1.0% decrease in full-run ROP linage. General advertising revenue declined by $6.0 million, or 3.4%, from 1992 on a 7.8% decline in full-run ROP general linage, partially offset by an increase in preprint revenue. General advertising revenue did show year-over-year improvement in the fourth quarter of 1993. Classified revenue improved by $35.9 million, or 7.0%, on a 5.3% increase in full-run ROP volume. Circulation revenue increased $14.4 million, or 3.1%, despite a decline in average number of copies. Morning circulation declined 11,300 copies, or 0.4%, and afternoon circulation declined 11,800 copies, or 2.5%. Sunday circulation declined 14,300 copies, or 0.3%. Other newspaper revenue increased $16.8 million, or 42.2%, during 1993, primarily due to efforts to augment the revenue of our core newspaper business. BUSINESS INFORMATION SERVICES: In 1993, BIS contributed 17.9% of consolidated revenue, compared with 16.5% in 1992. Operating income was $23.4 million, up $1.3 million, or 6.1%, from 1992 on a 13.8% increase in revenue. About half of the revenue growth was due to the first-quarter acquisition of Data-Star. Excluding Data-Star revenue, BIS revenue was up 6.5% from the prior year. The graph at the end of this section illustrates the 22.4% compound growth rate for BIS revenue from 1983. EXPENSES: Labor and employee benefit costs were up $33.9 million, or 3.4%, with 141, or 0.7%, more employees resulting from expansion and acquisitions in the BIS division. The average wage per employee increased 3.9%. Included in 1992 results were $10.5 million in severance and buyout costs related to a Detroit joint operating agreement (JOA) labor settlement. Newsprint, ink and supplements cost increased by $18.2 million, or 5.8%, due to a 3.4% increase in both consumption and average newsprint prices from the prior year. Depreciation and amortization expense increased 10.6%, or $13.5 million, due to the completion of the new Philadelphia printing plant and BIS expansion. Other operating costs increased 8.1% from 1992 due partially to a $21.7 million increase in volume-related BIS royalty and exchange fee expenses. NON-OPERATING ITEMS: Net interest expense increased $6.7 million, or 20.7%, from 1992 as a result of the $14.6 million reduction in capitalized interest. This was partially offset by a reduction of interest expense reserves related to prior year tax audits and the call of $100.0 million of 8.0% notes, replaced by lower-rate commercial paper. Average interest rates on commercial paper decreased from 4.3% in 1992 to 3.2% in 1993. Other non-operating items improved to a $2.2 million loss, a $4.1 million improvement from 1992. Most of the improvement came from our cable investment, which this year contributed an additional $3.5 million to our pretax income. INCOME TAXES: The effective income tax rate for 1993 was 39.2%, up 0.1% from 39.1% in 1992. Income tax expense included the $5.1 million unfavorable effect of the retroactive and current impact of the tax rate change in the Omnibus Budget Reconciliation Act of 1993. It was mostly offset by favorable adjustments of tax reserves and deferred tax assets resulting from settlement of IRS audits of prior years and resolution of other state tax issues. RESULTS OF OPERATIONS: 1992 vs. 1991 - Knight-Ridder, Inc., earnings per share before the cumulative effect of changes in accounting principles was $2.65, up $.10, or 3.9%, from $2.55 per share in 1991. The company recorded a non-recurring net charge of $105.2 million ($1.91 per share) related to the adoption of Financial Accounting Standards (FAS) 106 (Postretirement Benefits Other Than Pensions) and FAS 109 (Accounting For Income Taxes). The cumulative effect of adoption of FAS 106, relating to postretirement benefits other than pensions, was an after-tax reduction in earnings of $131.0 million, or $2.37 per share. This represents the unrecognized net obligation based on plans in place at the beginning of 1992. The company chose to recognize this "transition" amount immediately, rather than prospectively. In the second quarter, the company announced medical plan changes effective Jan. 1, 1993, that placed a maximum annual dollar cap for medical premiums that the company would pay for most future non-union retirees. Additionally, coverage after the age of 65 was eliminated for most future non-union retirees. The result of this announced plan change was a reduction in the prior service cost, which will be amortized over future years. The full-year operating profit reduction resulting from the recurring additional costs related to FAS 106 was $6.6 million, or an after-tax $.07 reduction in earnings per share. The adoption of FAS 109, which relates to accounting for deferred income taxes, resulted in an increase to 1992 net income of $25.8 million, or almost $.47 per share. Operating income increased 14.5% on a 3.2% increase in revenue in 1992. Operating income as a percentage of revenue improved to 12.0% from 10.8% in 1991. Revenue gains and a decline in the cost of newsprint contributed positively to operating income. A decline in net interest expense and higher earnings from our cable investment helped to offset the decline in earnings from our newsprint manufacturing investments. NEWSPAPERS: The Newspaper Division's operating income increased $30.9 million, or 11.9%, to $290.5 million. The increase resulted from improved revenue and a decline in the cost of newsprint. Newspaper Division operating costs increased $9.3 million. Overall, newspaper advertising revenue increased by $14.5 million, or 1.0%, in 1992 on a full-run ROP linage decline of 1.5%. The following table summarizes the percentage change in revenue and full-run ROP linage from 1991. Percent Percent Gain Gain (Decline) (Decline) in Full-Run Advertising Category in Revenue ROP Linage - -------------------- ---------- ----------- Retail (0.1) (2.8) General 1.0 (7.9) Classified 2.7 1.1 Total 1.0 (1.5) Retail advertising revenue was down $520,000, or 0.1%. A 2.8% decline in volume was partially offset by a 1.5% increase in full-run average rates and an increase in preprint and part-run revenue. General advertising revenue increased by $1.8 million, or 1.0%, from 1991 on the strength of an 8.2% increase in rates and an increase in preprint and part-run revenue. General full-run ROP linage declined 7.9% from 1991. Classified revenue improved by $13.2 million, or 2.7%, on a 1.1% increase in full-run ROP volume and a 1.7% increase in full-run average rates. Circulation revenue increased $21.0 million, or 4.8%, due to a 6.4% increase in average rates. Morning circulation declined 26,400 copies, or 0.8%, and afternoon circulation declined 40,900 copies, or 7.9%. Sunday circulation declined 7,200 copies, or 0.2%. BUSINESS INFORMATION SERVICES: In 1992, BIS contributed 16.5% of consolidated revenue, compared with 15.7% in 1991. Operating income was $22.1 million, up $1.9 million, or 9.3%, from 1991 on an 8.8% increase in revenue. EXPENSES: Labor and employee benefit costs were up $47.9 million, or 5.1%, with 83, or 0.4%, fewer employees. The average wage per employee increased 5.2%. Included in 1992 results were $10.5 million in severance and buyout costs related to a Detroit JOA labor settlement in the first half of the year. Newsprint, ink and supplements cost declined by $63.0 million, or 16.6%, due to a 17.8% decrease in average newsprint prices from the prior year. Newsprint consumption was 0.1% less than 1991 as a result of shifting the printing of the Journal of Commerce to an outside company. Supplements cost decreased by $4.8 million, or 10.6%. Depreciation and amortization expense increased 3.4%, or $4.2 million, due to the start-up of the new Philadelphia printing plant and BIS expansion. Other operating costs increased 8.3% from 1991 due partially to an $11.8 million increase in volume-related BIS royalty and exchange fee expenses, and increased circulation promotion costs. Additionally, Knight-Ridder increased its level of contributions to help with the aftermath of Hurricane Andrew. NON-OPERATING ITEMS: Net interest expense declined $7.7 million, or 19.2%, from 1991 as a result of lower average debt balances and lower interest rates. Average interest rates on commercial paper decreased from 6.4% in 1991 to 4.3% in 1992. Other non-operating items decreased to a $6.2 million loss, a $13.6 million decline from 1991. The major reason for the decline was unfavorable results from our investments in newsprint manufacturing, which suffered from soft newsprint prices in 1992. Our cable investments performed well, but this was not enough to offset other non-operating losses. INCOME TAXES: The effective income tax rate for 1992 was 39.1%, up 1.9% from 1991's 37.2% as a result of the resolution of prior year tax issues. RESULTS OF OPERATIONS: 1991 vs. 1990 - Knight-Ridder, Inc., earnings per share from continuing operations for 1991 of $2.55 was down $.39, or 13.3%, from $2.94 per share in 1990. The serious impact of the recession and the effects of the war in the Middle East early in the year resulted in our first down year after 15 consecutive years of earnings per share growth, excluding the impact of gains from major asset sales. Operating income from continuing operations decreased 19.1% on a 2.9% decrease in revenue in 1991. Operating income as a percentage of revenue was 10.8%, compared with 12.9% in 1990. Gains in the Business Information Services Division and a decline in total newsprint expense contributed positively to operating income, but were not enough to offset the softness in advertising revenue. A decline in net interest expense and higher earnings from investments in cable and newsprint manufacturing also helped offset the decline in operating income. NEWSPAPERS: The Newspaper Division's operating income decreased $64.2 million, or 19.8%, to $259.6 million. The decrease resulted from the cyclical weakness in advertising revenue being experienced throughout the newspaper industry and other advertising media. Newspaper Division operating costs decreased 1.4%. Overall, newspaper advertising revenue declined by $127.3 million, or 8.2%, in 1991 on a full-run ROP linage decline of 9.4%. The following table summarizes the percentage changes in revenue and full-run ROP linage from 1990. Percent Percent Decline Decline in Full-Run Advertising Category in Revenue ROP Linage - -------------------- ---------- ----------- Retail (4.1) (8.6) General (6.8) (12.5) Classified (14.1) (10.0) Total (8.2) (9.4) Retail advertising revenue was down $32.8 million, or 4.1%. An 8.6% decline in volume was partially offset by a 2.7% increase in full-run average rates and an increase in preprint revenue. The retail linage decline reflected the weakened condition of the retail industry and the economy in general. General advertising revenue declined $12.6 million, or 6.8%, from 1990. The volume decrease of 12.5% was slightly offset by a 3.9% increase in full-run average rates and greater volume in preprints. The continued decline in full-run ROP volume reflected softness in airline, food and factory automotive advertising. Classified revenue declined $81.9 million, or 14.1%, on a 10.0% drop in full-run ROP volume and a 4.8% decrease in full-run average rates. Almost every market was affected, with the biggest losses coming in the employment category. Employment revenue was down 24.4% on a 30.7% volume decrease, with the biggest losses in San Jose and Philadelphia. Real estate revenue dropped 13.8% on a 12.9% decline in linage. Automotive revenue was down 6.3% on a 0.3% decrease in volume. Circulation revenue increased $35.8 million, or 8.9%, due to a 12.0% increase in average rates. Morning circulation declined 12,000 copies, or 0.4%. Afternoon circulation declined 115,000 copies, or 18.2%. Sunday circulation declined 26,000 copies, about the same percentage reduction experienced in weekday morning circulation. BUSINESS INFORMATION SERVICES: In 1991, BIS contributed 15.7% of consolidated revenue, compared with 14.3% in 1990. While the company reinvested significant profits in the development of this division, operating income was $20.2 million, up $3.0 million, or 17.3%, from 1990 on a 6.5% increase in revenue. Dialog and MoneyCenter accounted for most of the revenue increases as a result of increases in the number of customers served. EXPENSES: Labor and employee benefit costs were up $12.5 million, or 1.3%, with 3.5% fewer employees. The average wage per employee increased 3.5%. Additionally, 1991 includes $14.3 million of severance and early retirement costs incurred in the second half of the year by several newspapers, designed to streamline operations and further reduce costs in future years. Excluding these buyout costs from 1990 and 1991, total labor costs were almost flat and employee benefits increased $6.7 million, or 3.8%. Newsprint, ink and supplements cost decreased $22.4 million, or 5.6%, due to a 7.3% decrease in consumption partially offset by a 1.5% increase in average newsprint prices. The reduced consumption reflected the lower volume in advertising linage and circulation. Supplements cost decreased by $2.8 million, or 5.9%. Other operating costs decreased 0.2% from 1990 due to strong efforts to control costs. NON-OPERATING ITEMS: Net interest expense was $40.3 million in 1991, down $13.8 million, or 25.6%, from 1990. The decline was primarily a result of higher capitalized interest, which increased by $12.0 million as a result of the construction of the Philadelphia production plant. Lower average debt balances and lower interest rates also helped. In the last half of 1991, the proceeds from the sale of 3 million shares of new common stock were used to reduce debt. Average interest rates on commercial paper decreased from 8.3% in 1990 to 6.4% in 1991. Other non-operating income increased to $7.4 million from a $579,000 loss in 1990. This resulted from significant improvement in the earnings of our cable investments and reduced royalties paid to joint operating agreement participants in Miami and Fort Wayne. INCOME TAXES: The effective income tax rate for 1991 was 37.2%, down 2.2% from 1990's 39.4%, mostly as a result of the favorable resolution of several outstanding tax issues. Earlier Years 1990 was the first full year of operations after entering the joint operating agreement between the Detroit Free Press and The Detroit News (owned by Gannett Co., Inc.) creating the Detroit Newspaper Agency (DNA), now doing business as Detroit Newspapers. DNA performs the newspaper's production, sales and distribution functions, while the two papers maintain separate and independent newsrooms. This resulted in significantly improved bottom-line results from our Detroit operation. In October 1989, Knight-Ridder completed the sale of its eight television stations for an after-tax gain of $66.9 million, or $1.07 per share. In November 1989, the DNA was formed. Knight-Ridder purchased Dialog Information Services in mid-year 1988 for approximately $353.0 million, and an effective 7-1/2% interest in SCI Holdings, Inc. (parent of Storer Communication) in November 1988. Despite the $.13 per share dilutive impact of these acquisitions, the company's earnings per share from continuing operations increased 2.0% over 1987. In 1987, the company's newspaper operations received a boost from strong classified advertising and a full year of operations from the State-Record Company acquisition. The acquisition, however, cost the company approximately $.15 in earnings per share dilution. Excluding the State-Record newspapers, newspaper advertising revenue increased 4.9% on a 0.4% decline in full-run ROP linage. In 1986, Knight-Ridder acquired six daily newspapers in South Carolina and Mississippi. The company closed its Viewdata operation and sold the assets of TelAir Network, Inc. Newspaper advertising revenue increased 9.2% on a 0.5% gain in full-run ROP linage. Excluding the impact of a 46-day strike in Philadelphia in 1985, linage declined 1.2%. The volume decline was due to softness in Miami and various airline mergers. Consistent with the company's experience, newspaper advertising, particularly retail and classified, mirrored the general state of the economy from 1983 through 1985. In 1985, newspaper advertising revenue increased 2.9% on a 2.4% decline in full-run ROP linage. The linage decline resulted from the strike in Philadelphia and softness in Miami. Fueled by a strengthening economy in 1984, full-run advertising revenue was up 14.7% on a 4.6% increase in full-run linage. A Look Ahead The outlook for 1994 is more positive than it has been going into the last few years. Signs indicate a slow but steady improvement in the economy, and the company is well positioned to benefit from the economic upturn. The Newspaper Division is expected to have moderate revenue growth, with fairly stable newsprint pricing. We will benefit from a reduction in operating costs related to the transition to the new Philadelphia printing facility. The BIS Division, strengthened by recent acquisitions, is expected to continue its strong double-digit revenue growth and will continue its global expansion efforts. We expect to continue to benefit from lower interest rates, as higher-rate notes are called and mature, and are replaced by lower-rate commercial paper. At this time, we don't expect significant changes in our 1994 share of investee earnings from our equity investments. In early 1994, the company made several strategic moves that should strengthen our position in the future. The company acquired the assets of Technimetrics, which publishes information documenting the equity holdings of major global investment professionals. The company formed a joint venture with the Canadian electronic publishing operations of Southam, Inc., to produce a more efficient and focused operation for the Canadian marketplace. The company announced an agreement with Bell Atlantic Video Services to explore ways to deliver news, information and advertising for Bell Atlantic's Stargazer service. Recent Acquisitions/Investments 1993 - In March, the company purchased all of the outstanding stock of Data-Star, Europe's leading online information service. In December, the company purchased all of the outstanding shares of Equinet Pty. Ltd. and EFECOM. Equinet is an Australia-based provider of online business real-time and archival equity, option price and analytical information services. EFECOM is a Spanish financial news service now known as KRF/Iberia. The company also made strategic minority investments in Individual, Inc., and Personal Library Software, Inc. In December, the company acquired a 6.0% interest in US Order, which provides a network of interactive electronic services to consumers utilizing screen-based telephones and other front-end devices. Capital Spending Program The company's capital spending program includes normal replacements, productivity improvements, capacity increases, building construction, expansion and printing press equipment. Over the past three years, expenditures have totaled $337.4 million for these items. Construction of the 693,000-square-foot production facility in Philadelphia began in 1989. The $299.5 million plant became fully operational in 1993. Also included in capital expenditures is the San Jose press project completed during 1992 for $38.6 million and the Dialog mainframe computer equipment enhancements for $20.3 million. Financial Position and Liquidity 1993 vs. 1992 - During 1993 net cash provided by operating activities decreased 2.5% from 1992 to $330.0 million. Cash and short-term cash investments were $23.0 million at year end, down $74.1 million from the prior year. The decrease in cash and short-term cash investments was primarily due to the acquisition of Data-Star and Equinet, the repurchase of treasury shares and the prepayment of debt. During 1993, the company acquired 750,000 shares of its common stock in the open market for an aggregate price of $40.7 million. Approximately $100.0 million in notes payable, bearing 8.0% interest and maturing in 1996, were early retired in April 1993. Total debt at year-end 1993 was $109.2 million less than at year-end 1992. This resulted in an improved long-term-debt-to-equity ratio of 33.0% from 42.0% at the end of 1992 and an improved total-debt-to-total-capital ratio of 26.6% from 32.2%. Standard & Poor's and Moody's rate the company's commercial paper A1+ and P1 and long-term bonds AA- and A1, respectively. Average outstanding commercial paper during the year was $97.4 million with an average effective interest rate of 3.2%. At the end of 1993, commercial paper outstanding was $54.0 million and aggregate unused credit lines were approximately $446.0 million. Various libel actions, environmental and other legal proceedings that have arisen in the ordinary course of business are pending against the company and its subsidiaries. In the opinion of management, the ultimate liability to the company and its subsidiaries as a result of these actions and proceedings will not be material. 1992 vs. 1991 - During 1992, net cash provided by continuing operations was $338.5 million, an increase of $32.5 million from 1991 due to investee distributions being less than investee earnings and net changes in working capital. Cash and short-term cash investments of $97.1 million were $70.9 million more than the prior year. Net cash required for investing activities decreased $9.9 million, or 5.1%, from 1991 levels, due to completion of the Philadelphia plant. Total debt declined $46.6 million from 1991 levels. This resulted in an improved long-term-debt-to-equity ratio from 48.5% to 42.0% and total-debt-to-total-capital ratio from 34.6% to 32.2%. These ratios improved despite the FAS 106 and FAS 109 net cumulative charge of $105.2 million. Average outstanding commercial paper during the year was $54.6 million with an average effective interest rate of 4.3%. At the end of 1992, commercial paper outstanding was $62.3 million. 1991 vs. 1990 - During 1991, net cash provided by continuing operations was $305.9 million, a decline of $19.0 million from 1990. The 5.9% decrease was primarily due to a lower level of operating income. Cash and short-term cash investments of $26.2 million were flat with 1990. Net cash required for investing activities of $192.9 million was $85.3 million, or 30.7% less, due to reduced capital requirements for the new Philadelphia plant as it approached completion. Total debt declined $217.1 million from 1990 levels, due largely to the use of proceeds of approximately $147.0 million from the company's sale of 3 million shares of common stock in August. No treasury stock was purchased in 1991. This resulted in an improved long-term-debt-to-equity ratio from 89.8% to 48.5% and total-debt-to-total-capital ratio from 47.9% to 34.6%. During 1991 the company redeemed $160.0 million of 7-1/4% notes due in 1992 and $100.0 million of 7-7/8% notes due in 1993, and issued $160.0 million of new 8-1/2% notes, maturing in 25% increments from 1998 through 2001. Average outstanding commercial paper during the year was $250.0 million with an average effective interest rate of 6.4%. Commercial paper outstanding at the end of 1991 was $111.3 million. Effect of Changing Prices The Consumer Price Index, a widely used measure of the impact of changing prices, has increased only moderately in recent years, up between 3% and 6% each year since 1983. Historically, when inflation was at higher levels, the impact on the company's operating costs was not significant. Historical cost depreciation charges may not accurately reflect the economic cost of replacing capital assets, but depreciation expense represents less than 5% of total operating costs. Newsprint expense represents a significant percentage of total costs, but it is a relatively current cost as inventory levels normally fluctuate between a 30- and 45-day supply. Labor and other operating costs are, by their very nature, current costs. The principal effect of inflation on the company's operating results is to increase reported costs. Historically, the company has demonstrated the ability to raise sales prices to offset these cost increases. ITEM 8. ITEM 8. Financial statements and supplementary data ------------------------------------------- See Quarterly Operations in Item 5. Notes to Consolidated Financial Statements Summary of Significant Accounting Policies Note A A description of the company's business and the nature and scope of its operations are set forth on Items 1 & 2. Reading this information is recommended for a more complete understanding of the financial statements. The company reports on a fiscal year, ending the last Sunday in the calendar year. Results for 1993, 1992 and 1991 are for the 52 weeks ended Dec. 26, Dec. 27 and Dec. 29, respectively. The basis of consolidation is to include in the consolidated financial statements all the accounts of Knight-Ridder, Inc., and its more-than-50%-owned subsidiaries. All significant intercompany transactions and account balances have been eliminated in consolidation. The joint operating agency of Fort Wayne Newspapers, Inc., is the only subsidiary with a minority interest. The minority shareholder's interest in the net income of this subsidiary has been provided for as an expense ($5.2 million in 1993, $5.1 million in 1992 and $5.2 million in 1991) in the Consolidated Statement of Income in the caption "Other, net." The company is a 50% partner in the Detroit Newspaper Agency (DNA), a joint operating agency between Detroit Free Press, Inc., a wholly owned subsidiary of Knight-Ridder, Inc., and The Detroit News, Inc., a wholly owned subsidiary of Gannett Co., Inc. The Consolidated Statement of Income includes on a line-by-line basis the company's pro rata share of the revenue and expense generated by the operation of the agency. Investments in companies in which Knight-Ridder, Inc., has an equity interest of at least 20% but not more than 50% are accounted for under the equity method. Under this method, the company records its share of earnings as income and increases the investment by the equivalent amount. Dividends are recorded as a reduction in the investment. All other investments are recorded at the lower of cost or net realizable value, and the company recognizes income from such investments upon receipt of a dividend. The investment caption "Equity in unconsolidated companies and joint ventures" in the Consolidated Balance Sheet represents the company's equity in the net assets of the Detroit Newspaper Agency, the Seattle Times Company and subsidiaries, a company responsible for the sales and services of general, retail and classified advertising accounts for a group of newspapers, two newsprint mill partnerships, a cable television joint venture and a joint venture that offers full-service copies of original journal articles. The company owns 49-1/2% of the voting common stock and 65% of the non-voting common stock of the Seattle Times Company, owns 33-1/3% of the voting stock of Newspapers First, is a one-third partner in the Southeast Paper Manufacturing Co., owns a 13-1/2% equity share of Ponderay Newsprint Company, and jointly owns TKR Cable Company and TKR Cable Partners. Effective December 1992, after a restructuring, the company has a 15% interest in TCI/TKR Limited Partnership through TKR Cable Partners. Prior to December 1992, the company held a 7-1/2% interest in SCI Holdings, Inc., the holding company for Storer Communications, Inc. Dialog, a Knight-Ridder subsidiary, owns 33.78% of the voting stock and 100% of the non-voting stock of Article Express International, Inc. The investment amount at Dec. 26, 1993, includes $64.1 million representing the company's share of undistributed earnings (excluding the DNA) accumulated since the investment dates. The company's share of the earnings of the unconsolidated companies (except for the DNA) of $7.3 million in 1993, $3.9 million in 1992 and $14.5 million in 1991 is included in the caption "Other, net" in the Consolidated Statement of Income. The company also recorded its share of Ponderay Newsprint Company's operating losses ($7.4 million in 1993 and $6.5 million in 1992) in this caption. Dividends and cash distributions received from the unconsolidated companies and joint ventures (excluding the DNA) were $3.0 million in 1993, $2.8 million in 1992 and $8.1 million in 1991 and offset against the investment account. "Cash and short-term cash investments" includes currency and checks on hand, demand deposits at commercial banks, overnight repurchase agreements of government securities and investment-grade commercial paper with maturities of fewer than 90 days. Cash and short-term investments are recorded at cost. Due to the short-term nature of marketable securities, cost approximates market value. In 1994, the company will adopt Statement of Financial Accounting Standards (FAS) 115, Accounting for Certain Investments in Debt and Equity Securities, the impact of which is immaterial. "Inventories" are priced at the lower of cost ( first-in, first-out FIFO method), or market. Most of the inventory is newsprint, ink and other supplies used in printing newspapers. "Property, plant and equipment" is recorded at cost and the provision for depreciation for financial statement purposes is computed principally by the straight-line method over the estimated useful lives of the assets. The company capitalizes interest expense as part of the cost of major construction projects. "Excess of cost over net assets acquired" arises from the purchase of at least a 50% interest in a company for a price higher the fair market value of the net tangible assets. Intangible assets of this type arising from acquisitions accounted for as purchases and occurring subsequent to Oct. 31, 1970, totaled approximately $773.0 million at Dec. 26,1993. They are generally being amortized over a 40-year period on a straight-line basis, unless management has concluded a shorter term is more appropriate. If, in the opinion of management, an impairment in value occurs, based on the undiscounted cash flow method, any necessary additional write-downs will be charged to expense. "Deferred revenue" arises as a normal part of business from advance subscription payments for newspapers and business information services. Revenue is recognized in the period in which it is earned. "Short-term borrowings" represents the carrying amounts of commercial paper and other short-term borrowings that approximate fair value. "Long-term debt" represents the carrying amounts of debentures and notes payable. Fair values, disclosed in Note C, are estimated using discounted cash flow analyses based on the company's current incremental borrowing rates for similar types of borrowing arrangements. In 1992, the company adopted the FAS 106, Accounting For Postretirement Benefits Other Than Pensions, and FAS 109, Accounting For Income Taxes. The effects of adoption are described in Notes H and B, respectively. In 1994, the company will adopt FAS 112, Employers' Accounting for Postemployment Benefits. The impact on the consolidated financial statements will not be material. Earnings per share is computed by dividing net income by the weighted average number of common and common equivalent shares outstanding. Quarterly earnings per share may not add to the total for the year, since each quarter and the year are calculated separately based on average outstanding shares during the period. Certain amounts in 1992 and 1991 have been reclassified to conform to the 1993 presentation. Income Taxes Note B The company's income tax expense is determined under the provisions of Statement of Financial Accounting Standards 109, Accounting for Income Taxes, which was adopted in 1992. This accounting standard requires the use of the liability method in adjusting previously deferred taxes for changes in tax rates. The company chose to reflect the cumulative effect of adopting this standard as a change in accounting principle as of the beginning of 1992. The adoption resulted in a credit to earnings of $25.8 million. Prior years' financial statements were not restated. Substantially all of the company's earnings are subject to domestic taxation. With the exception of immaterial amounts of taxes withheld on trans-border receipts, no foreign income taxes have been imposed on reported earnings. In 1991, deferred tax expense resulted principally from the excess of tax depreciation over financial statement depreciation (including depreciation on assets of partnerships in which the company participates), the tax effect of which amounted to $8.8 million. Cash payments of income taxes for the years 1993, 1992 and 1991 were $82.7 million $60.2 million and $61.4 million, respectively. Payments in 1993 include the payment and settlement of prior year state and federal income tax examinations. At the end of fiscal years 1993 and 1992, the company's deferred tax assets totaled $135.8 million and $120.7 million, respectively, of which the most significant component was postretirement benefit plans, $87.2 million and $83.0 million, respectively (including amounts relating to partnerships in which the company participates). Other material components were: compens- ation and benefits accruals of $11.2 million in 1993 and $19.2 million in 1992, and state net operating loss carryovers, net of allowance, of $7.0 million in 1993. Management is satisfied that a substantial portion of the state net operating loss carryovers will be realized within the applicable carryover periods. Accordingly, the related valuation allowance was reduced to $4.0 million in 1993. At the end of fiscal years 1993 and 1992, deferred tax liabilities totaled $249.3 million and $204.1 million, respectively, of which the most significant component was depreciation and amortization (including depreciation and amortization deductions claimed by partnerships in which the company has an interest). The components of deferred taxes included in the Consolidated Balance Sheet are as follows (in thousands): Debt Note C Debt consisted of the following (in thousands): The following table presents (in thousands) the approximate annual maturities of long-term debt for the five years after 1993: The carrying amounts and fair values of debt as of Dec. 26, 1993, are as follows (in thousands): Unconsolidated Companies and Joint Ventures Note D Beginning in 1992, the company's investment in Ponderay Newsprint Company is reported in "Equity in unconsolidated companies and joint ventures" in the Consolidated Balance Sheet, and related amounts are included in the above table. In 1989, the Detroit Free Press and The Detroit News began operating under a joint operating agreement as the Detroit Newspaper Agency (DNA). Balance sheet amounts for the DNA at Dec. 26, 1993, Dec. 27, 1992, and Dec. 29, 1991, are included above and the net assets contributed to the DNA are included in "Equity in unconsolidated companies and joint ventures" in the Consolidated Balance Sheet. Capital Stock Note E In 1991, shareholders authorized 20.0 million shares of preferred stock for future issuance. Common stock authorized for issuance is 250.0 million shares at par value $.02-1/12 per share. The Employees Stock Purchase Plan provides for the sale of common stock to employees of the company and its subsidiaries at a price equal to 85% of the market value at the end of each purchase period. Participants under the plan received 278,251 shares in 1993, 240,022 shares in 1992 and 266,330 shares in 1991. The purchase price of shares issued in 1993 under this plan ranged between $46.59 and $50.89, and the market value on the purchase dates of such shares ranged from $54.81 to $59.88. The Employee Stock Option Plan provides for the issuance of non-qualified stock options and incentive stock options. Options are issued at prices not less than market value at date of grant and are exercisable when issued. There is no expiration date for the granting of options, but options must expire no later than 10 years from the date of grant. The option plan provides for the discretionary grant of stock appreciation rights (SARs) in tandem with previously granted options, which allow a holder to receive in cash, stock or combinations thereof the difference between the exercise price and the fair market value of the stock at date of exercise. The value of stock appreciation rights is charged to compensation expense. When options and stock appreciation rights are granted in tandem, the exercise of one cancels the exercise right of the other. Proceeds from the issuance of shares under these plans are included in shareholders' equity and do not affect income. The exercise price of the shares issued upon exercise of stock options in 1993 ranged between $24.63 and $58.63. In 1993, shareholders voted in favor of a proposal amending the Employee Stock Option Plan to make an additional 3.5 million shares of the company's common stock available for options. In addition, shareholders voted in favor of an amendment to make 1.5 million shares of common stock available for purchase under the Employees Stock Purchase Plan. At Dec. 26, 1993, shares of the company's authorized but unissued common stock were reserved for issuance as follows: Shares --------- Employee stock option plans 3,569,818 Employees stock purchase plan 1,741,089 --------- Total 5,310,907 ========= Since 1985, the company has purchased 21.2 million shares of its own stock for approximately $872.0 million. See Treasury Stock Purchases in Item 5. Each holder of a common share has been granted a right, under certain conditions, to purchase from the company one common share at a price of $200, subject to adjustment. The rights provide that in the event the company is a surviving corporation in a merger, each holder of a right will be entitled to receive common shares having a value equal to two times the exercise price of the right. In the event the company engages in a merger or other business combination transaction in which the company is not the surviving corporation, the rights agreement provides that proper provision shall be made so that each holder of a right will be entitled to receive common stock of the acquiring company having a value equal to two times the exercise price of the right. The rights agreement also provides that in the event any person acquires 20% or more of the company's outstanding common stock (other than pursuant to an offer for all outstanding stock that the board determines is fair and in the best interests of the company and stockholders), each right (other than rights held by the person who has acquired such 20% or larger block) will entitle its holder to purchase common stock of the company having a value equal to twice the exercise price of the right. No rights certificates will be distributed until 10 days following a public announcement that a person or group has acquired beneficial ownership of 20% or more of the company's outstanding common stock, or 10 days following the commencement of a tender offer or exchange offer for 20% or more of the company's outstanding stock. Until such time, the rights are evidenced by the common share certificates of the company. The rights are not exercisable until distributed and will expire on July 10, 1996, unless earlier redeemed. The company has the option to redeem the rights in whole, but not in part, at a price of $.05 per right. Retirement Plans Note F The company and its subsidiaries have several company-administered non-contributory defined benefit plans covering most non-union employees. These plans provide benefits that are based on the employees' compensation during various times before retirement. The funding policy for these plans is to contribute annually an amount that is intended to provide the projected benefit earned during the year for the covered employees. The company also contributes to certain union-administered, company-administered and jointly administered negotiated plans covering union employees. The funding policy for these plans is to make annual contributions in accordance with applicable agreements. The company also sponsors certain defined contribution plans established pursuant to Section 401(k) of the Internal Revenue Code. Subject to certain dollar limits, employees may contribute a percentage of their salaries to these plans, and the company will match a portion of the employees' contributions. A summary of the components of net periodic pension cost for the defined benefit plans (both company-administered non-negotiated and single-employer negotiated plans) is presented here, along with the total amounts charged to pension expense for multi-employer union plans, defined contribution plans and other agreements (in thousands): The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheet for the defined benefit plans (in thousands): Segment Information Note G The company is a diversified information and communications company with two principal business segments: Newspapers and Business Information Services. Financial data regarding the company's business segments are presented in Items 1 & 2 in the supplemental information. Operating revenue by industry segment includes sales to un- affiliated customers, as reported in the company's consolidated income statement. Operating income is operating revenue less operating expenses, including depreciation expense and amortization of intangibles. General corporate expenses are not allocated to the Newspaper or Business Information Services divisions. Equity in net income of unconsolidated companies and joint ventures, interest income, net interest expense, other non-operating income and expense items, as well as income taxes, have not been included in the amounts reflected as operating income by segment. Identifiable assets by segment are all assets employed in the individual operations of each business segment and excess of cost over net assets acquired associated with acquisitions in each segment. General corporate assets include cash and equivalents, other investments, net assets of unconsolidated companies and joint ventures (other than the Detroit Newspaper Agency, which is included in Newspaper Division assets), and property, plant and equipment used primarily for corporate purposes. Investments in unconsolidated companies and joint ventures are discussed in Notes A and D. Postretirement Benefits Other Than Pensions Note H The company and its subsidiaries have defined postretirement benefit plans that provide medical and life insurance for retirees and eligible dependents. Effective with the beginning of fiscal year 1992, the company implemented, on the immediate recognition basis, Statement of Financial Accounting Standards (FAS) 106, Accounting for Postretirement Benefits Other Than Pensions. This statement requires that the cost of these benefits, which are primarily for health care and life insurance, be recognized in the financial statements throughout the employees' active working careers. The company's previous practice was to expense these costs on a cash basis, principally after retirement. The cumulative effect of adopting FAS 106 on the immediate recognition basis, as of the beginning of 1992, was to reduce net income by $131.0 million (net of income taxes of $80.3 million), or $2.37 per share. The 1992 after-tax impact of FAS 106 (excluding the cumulative effect of adoption) was to reduce earnings by $4.0 million, or $.07 per share. This charge includes a previously unrecognized accumulated postretirement benefit obligation of $211.3 million, including $47.2 million related to the company's share of the Detroit Newspaper Agency (DNA). This obligation was based on plans in place at the beginning of 1992. The company valued the accumulated postretirement benefit obligation as of Dec. 26, 1993, and Dec. 27, 1992, using the following actuarial assumptions: Discount rate: 7.5% in 1993 and 8.5% in 1992 Return on plan assets: 8.5% in 1993 and 1992 Annual rate of increase in salaries: 4.5% in 1993 and 5.0% in 1992 Medical trend rate: 12.0% for 1994, reducing to 5.5% in 2001 and thereafter and 14.0% for 1993, reducing to 6.5% in 2001 and thereafter. In 1992, the company announced several changes to its retiree non-union benefit plans that established a maximum annual dollar cap for medical premiums the company would pay and eliminated coverage for future retirees after the age of 65. During 1993, many of the company's unions adopted similar changes to their retiree benefit plans. Most current retirees will keep their current plans. Proforma amounts for 1991 show that net income would have been reduced by approximately $8.4 million (approximately $.16 per share). The impact on 1992 and 1993 is substantially less due to the effect of the plan amendments described above. These plan amendments resulted in an unrecognized reduction in prior service cost, which is being amortized over future years. 1993 reflects a full year of amortization for the reduction in prior service cost. Acquisitions Note I On March 1, 1993, the company (through its wholly owned subsidiaries Knight-Ridder Business Information Services, Inc., and Dialog Information Services, Inc.) acquired all of the outstanding shares of Data-Star (composed of Radio Suisse and Data-Star Marketing) from Motor-Columbus and Peter Martin, respectively. Data-Star is Europe's leading online information service. On Dec. 2, 1993, the company acquired all of the outstanding shares of Equinet Pty. Ltd. Equinet is an Australia-based provider of online business real-time and archival equity, option price and analytical information services. The acquisitions were accounted for as purchases and, accordingly, the accompanying financial statements include their operations from the acquisition dates. The cost of acquisitions is included in the caption "Other items, net" in the "Cash Required For Investing Activities" section of the Consolidated Statement of Cash Flows. The effect on operations and proforma results of operations was not material. Commitments and Contingencies Note J At Dec. 26, 1993, the company had lease commitments currently estimated to aggregate approximately $84.1 million that expire from 1994 through 2051 as follows (in thousands): Payments under the lease contracts were $25.4 million in 1993, $25.2 million in 1992 and $24.1 million in 1991. Various libel actions, environmental and other legal proceedings that have arisen in the ordinary course of business are pending against the company and its subsidiaries. In 1990, a verdict was rendered against the company's subsidiary, Philadelphia Newspapers, Inc., (PNI), publisher of The Philadelphia Inquirer and Philadelphia Daily News, in a libel action entitled Sprague v. Philadelphia Newspapers, Inc., for $2.5 million in compensatory damages and $31.5 million in punitive damages. Following entry of the judgment on Sept. 15, 1992, PNI, as required by statute, posted a bond equal to 120% of the amount of the verdict and appealed the judgment to the Pennsylvania Superior Court. PNI believes that substantial grounds exist for a decision by an appellate court to reverse the trial court and remand the case for a new trial. In the opinion of management, the ultimate liability to the company and its subsidiaries as a result of this and other legal proceedings will not be material. Management's Responsibility for Financial Statements Shareholders: The consolidated financial statements and other financial information were prepared by management in conformity with generally accepted accounting principles applied on a consistent basis throughout the periods. The manner of presentation, the selection of accounting policies and the integrity of the financial information are the responsibility of management. Some of the amounts included in the financial statements are estimates based on management's best judgment of current conditions and circumstances. To fulfill its responsibilities, management has developed and continues to maintain a system of internal accounting controls. We believe the controls in use are adequate to provide reasonable assurance that assets are safeguarded from loss or unauthorized use, and that the financial records are reliable for preparing the financial statements and maintaining accountability for assets. These systems are augmented by written policies, organizational structures providing for division of responsibilities, qualified financial officers at each operating unit, careful selection and training of financial personnel and a program of internal audits. There are, however, inherent limitations in any control system, in that the cost of maintaining a control system should not exceed the benefits to be derived. The Audit Committee of the Board of Directors is composed of outside directors and meets periodically with management, internal auditors and independent auditors, both separately and together, to review and discuss the auditors' findings and other financial and accounting matters. Both the independent and internal auditors have free access to the committee. The consolidated financial statements have been audited by the company's independent auditors and their report is presented below. The independent auditors are elected each year at the annual shareholders meeting based on a recommendation by the Audit Committee and the Board of Directors. James K. Batten - -------------------- James K. Batten Chairman and Chief Executive Officer Ross Jones - -------------------- Ross Jones Senior Vice President/Finance and Chief Financial Officer Report of Independent Certified Public Accountants Shareholders Knight-Ridder, Inc. We have audited the consolidated balance sheet of Knight-Ridder, Inc., and subsidiaries as of Dec. 26, 1993, Dec. 27, 1992, and Dec. 29, 1991, and the related consolidated statements of income, cash flows and shareholders' equity for each of the three years then ended. Our audits also included the financial statement schedules listed in the Index at Item 14 (a). These financial statements and schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Knight-Ridder, Inc., and subsidiaries at Dec. 26, 1993, Dec. 27, 1992, and Dec. 29, 1991, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes B and H the consolidtaed financial statements, in 1992 the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ERNST & YOUNG Miami, Fla. Feb. 1, 1994 ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure. --------------------- Not Applicable PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant -------------------------------------------------- 1994 Proxy Statement page 2, "Election of Directors"; page 3, "Nominees for Election as Directors for Terms Ending 1997"; page 4, "Nominees for Election as Directors for Terms Ending 1995"; "Nominees for Election as Directors for Terms Ending 1996"; page 15, "Certain Transactions, Relationships and Reports of Certain Stock Transactions." Knight-Ridder's Executive Committee: James K. Batten, 58, chairman since 1989 and chief executive officer since 1988. Served as president 1982 to 1989; senior vice president 1980 to 1982; vice president/news 1975 to 1980; Charlotte Observer executive editor 1972 to 1975. Advanced Management Program, Harvard Business School, 1981; M.P.A., public affairs, Princeton University, 1962; B.S., chemistry/ biology, Davidson College, 1957. Alvah H. Chapman Jr., 72, chairman of the Executive Committee since 1984. Served as chairman of the board 1982 to 1989; chief executive officer 1976 to 1988; president 1973 to 1982; executive vice president 1967 to 1973; vice president 1966 to 1967; Miami Herald general manager 1962 to 1969. B.S., business administration, The Citadel, 1942. Mary Jean Connors, 41, vice president/human resources since 1989. Served as Philadelphia Newspapers, Inc., vice president/human resources 1988 to 1989; assistant to the senior vice president/ news for Knight-Ridder 1988; The Miami Herald assistant managing editor/ personnel 1985 to 1988; held various editing positions at The Miami Herald 1980 to 1985. B.A., English, Miami University in Oxford, Ohio, 1973. John C. Fontaine, 62, executive vice president since January 1994; senior vice president 1987 to 1993; general counsel 1980 to 1993. Formerly a partner with Hughes Hubbard & Reed. LL.B., Harvard Law School, 1956; B.A., political science, University of Michigan, 1953. Ross Jones, 51, senior vice president and chief financial officer since October 1993; vice president/finance since March 1993. Served as vice president and treasurer of Reader's Digest Association, Inc., 1985 to 1993 and in other positions there 1977 to 1985. Served as manager at Brown Brothers Harriman & Co. 1970 to 1977. M.B.A., finance, Columbia University Business School, 1970; B.A. in classics, Brown University, 1965. Bernard H. Ridder Jr., 77, former chairman of the board 1979 to 1982; former chairman of the Executive Committee 1976 to 1984; former vice chairman of the board 1974 to 1979. Served as president and chief executive officer of Ridder Publications, Inc., 1969 to 1974. B.A., history, Princeton University, 1938. P. Anthony Ridder, 53, president since 1989; president of Newspaper Division since 1986; chairman of the Operating Committee since 1985; board member since 1987. Served as publisher of the San Jose Mercury News 1977 to 1986; general manager 1975 to 1977; business manager 1969 to 1975. B.A., economics, University of Michigan, 1962. Other Officers: Marty Claus, 45, vice president/ news since 1993. Served as Detroit Free Press managing editor/business and features from 1987 to 1992; held various editing positions at the Free Press 1977 to 1987. Held various writing and editing positions at the San Bernardino (Calif.) Sun-Telegram 1970 to 1977. B.A., journalism, Michigan State University Honors College, 1970. Stephen D. Dempsey, 41, assistant vice president/information systems since February 1994. Served as director of information systems from 1990 to 1994; San Jose Mercury News information systems director from 1984 to 1990; various technical positions 1979 to 1984; Boulder Daily Camera, various programming and circulation positions, 1969 to 1979. B.A., history, University of Colorado, 1975. Gary R. Effren, 37, assistant vice president/assistant treasurer since December 1993. Served as assistant to the vice president/ finance and treasurer 1989 to 1993; director of corporate accounting 1986 to 1989; business manager of Viewdata Corp. of America 1984 to 1986; manager of financial reporting 1983 to 1984. M.B.A., University of Miami, 1989; B.S., accounting, Rider College, 1978. Virginia Dodge Fielder, 45, vice president/research since 1989. Served as vice president/news and circulation research 1986 to 1989. Served as director/news and circulation research 1981 to 1985; editorial research manager, Chicago Sun-Times 1979 to 1981; held various positions at Lexington Herald-Leader 1976 to 1979. Ph.D., mass communications, Indiana University, 1976; M.A., journalism, Indiana University, 1974; B.A., psychology, Transylvania University, 1970. Douglas C. Harris, 54, vice president and secretary since 1986. Served as vice president/personnel 1977 to 1985; director/personnel 1972 to 1977. Formerly with Peat, Marwick, Mitchell and Co. as director of college and special recruiting. Advanced Management Program, Harvard Business School, 1987; Ed.D., counseling and guidance, Indiana University, 1968; M.S., student personnel, Indiana University, 1964; B.S., business administration, Murray State University, 1961. W. H. (Gus) Harwell Jr., 64, senior vice president/operations since 1989. Served as group vice president/operations 1981 to 1989. Served as Tallahassee Democrat president and publisher 1978 to 1981; general manager 1973 to 1978; Boca Raton News publisher 1968 to 1973. B.J., community journalism, University of Missouri, 1951. Clark Hoyt, 51, vice president/news since August 1993. Served as chief of the Knight-Ridder Washington Bureau 1987 to 1993; news editor 1985 to 1987; managing editor, The Wichita Eagle, 1981 to 1985; various editing positions, Detroit Free Press, 1977 to 1981; various reporting positions, the Detroit Free Press and Washington Bureau. B.A., English literature, Columbia College, 1964. Ivan A. Jones, 51, assistant vice president/personnel research and development since 1986. Served as director/ personnel research and development 1977 to 1986; personnel consultant 1975 to 1977. Formerly with the consulting firm of Byron Harless, Reid & Associates 1973 to 1975. Ph.D., industrial psychology, Baylor University, 1969; M.A., psychology, Baylor University, 1967; B.A., psychology, University of Arizona, 1964. Polk Laffoon IV, 48, vice president/ corporate relations since March 1994. Served as assistant to the president 1992 to 1994; assistant circulation director/distribution, The Miami Herald, 1991 to 1992; executive assistant to the vice president/marketing 1989 to 1991; Living Today editor, 1987 to 1989. Served as director and vice president/ investor relations, Taft Broadcasting Co., 1982 to 1987. Held various writing and editing positions at the Detroit Free Press 1978 to 1982. M.B.A., marketing, Wharton School, 1970; B.A., English, Yale, 1967. Tally C. Liu, 43, vice president/finance and controller since October 1993; vice president and controller 1990 to 1993. Served as San Jose Mercury News vice president and chief financial officer 1987 to 1990; chief financial officer 1986 to 1987; controller 1983 to 1986; Boca Raton News controller 1980 to 1983; assistant controller 1978 to 1980. M.B.A., Florida Atlantic University, 1977; B.S., business administration, National Chen-Chi University, 1973; CPA. Mario R. Lopez, 54, assistant vice president/internal audit since July 1993. Served as partner at Deloitte & Touche 1978 to 1993 and in other positions there from 1964 to 1978. B.S., business administration, Saint Joseph's University, 1962, CPA. Larry D. Marbert, 40, vice president/ technology since February 1994. Served as Philadelphia Newspapers, Inc., senior vice president/operations 1991 to 1994; vice president/operations research and planning 1988 to 1991; vice president/production 1986 to 1988; Knight-Ridder director of production/Newspaper Division 1981 to 1986; various production positions, The Miami Herald, 1977 to 1981. M.S., management science, Auburn University, 1977; B.S., University of North Carolina, business administration, 1976. Jerry M. Marshall, 55, assistant vice president/financial services since 1986. Served as director of accounting administration 1984 to 1985; director of corporate accounting 1977 to 1984; manager of corporate accounting 1972 to 1977; internal auditor 1969 to 1972. B.S., accounting, Kent State University, 1963. Cristina Lagueruela Mendoza, 47, vice president/general counsel since 1993; vice president/associate general counsel 1992 to 1993; associate general counsel since 1990. Served as a partner in the Miami law firm of Murai, Wald, Biondo, Moreno & Mendoza, P.A., 1988 to 1990; associate 1984 to 1988. J.D., University of Miami Law School, 1982; M.A., political science, University of Miami, 1967; B.A., political science, Chatham College, 1966. Laurence D. Olmstead, 36, assistant vice president/ human resources/ diversity since December 1993. Served as special projects editor/metro staff of The New York Times 1993; city editor of the Detroit Free Press 1991 to 1993; held various editing and reporting positions 1980 to 1991. Attended George Washington University. Peter E. Pitz, 52, vice president/operations since February 1994. Served as vice president/technology 1989 to 1994; San Jose Mercury News vice president/operations 1987 to 1989; Detroit Free Press director of operations 1983 to 1987; Denver Post operations manager 1974 to 1983. M.B.A., Denver University, 1979; B.S., business administration, Northern Illinois University, 1963. David K. Ray, 52, president of Business Information Services Division since 1983; Knight-Ridder vice president since 1980. Formerly a vice president, LIN Broadcasting Co. M.B.A., University of Chicago, 1965; B.A., liberal arts, Colgate University, 1963. Stephen H. Sheriff, 47, assistant vice president/taxation since 1989. Served as director of taxation 1987 to 1989. Formerly with Federal Express as director of taxation. J.D., University of Miami School of Law, 1992; B.B.A., accounting, University of Georgia, 1971; CPA. Homer E. Taylor, 51, vice president/supply since 1987. Formerly vice president/manufacturing and supply with Scripps Howard. B.S., business, West Virginia Institute of Technology, 1973; A.S., electrical engineering, West Virginia Institute of Technology, 1970. Jerome S. Tilis, 51, vice president/marketing since 1987. Served as president of the Detroit Free Press 1985 to 1989; senior vice president of Philadelphia Newspapers, Inc., 1980 to 1985; vice president of advertising sales and marketing 1979 to 1980; advertising director 1977 to 1979. Advanced Management Program, Harvard Business School, 1984; B.S., chemistry, Hunter College, 1964. Knight-Ridder Board: The Knight-Ridder Board of Directors is composed of members who represent a wide cross-section of American business and journalism. The group includes highly experienced investment and commercial bankers, leaders of top American corporations, senior executives and retired executives of the company and members of the Knight and Ridder families. The group is the central governing body of the company. Eric Ridder, 75, publisher emeritus of The Journal of Commerce, a director since 1983; attended Harvard University. Jesse Hill Jr., 67, chairman and chief executive officer of Atlanta Life Insurance Co., a director since 1980; M.B.A., actuarial science, University of Michigan, 1949; B.S., mathematics and physics, Lincoln University, 1947. Barbara Knight Toomey, 56, experienced in management consulting, data retrieval and storage, resort management and library science, a director since 1989; B.A., geography and zoology, Boston University, 1959. James K. Batten, 58, chairman and chief executive officer, a director since 1981; Advanced Management Program, Harvard Business School, 1981; M.P.A., public affairs, Princeton University, 1962; B.S., chemistry/biology, Davidson College, 1957. Ben R. Morris, 71, former president of The State-Record Company, a director since 1986; B.S., textile engineering, North Carolina State University, 1948. Peter C. Goldmark Jr., 53, president of The Rockefeller Foundation, a director since 1990; B.A., government, Harvard College, 1962. Bernard H. Ridder Jr., 77, former chairman of the board and of the Executive Committee, a director since 1946; B.A., history, Princeton University, 1938. P. Anthony Ridder, 53, president of Knight-Ridder and of the Newspaper Division, a director since 1987; B.A., economics, University of Michigan, 1962. C. Peter McColough, 71, former chairman and CEO of Xerox Corp., a director since 1982; LL.B., law, Dalhousie University (Nova Scotia), 1947; M.B.A., Harvard University, 1949. Joan Ridder Challinor, 66, research associate at the National Museum of American History, Smithsonian Institution, a director since 1989; Ph.D., U.S. history, The American University in Washington, D.C., 1982; M.A., U.S. history/ancient history, The American University, 1974; B.A., history, The American University, 1971. Thomas L. Phillips, 69, retired chairman and chief executive officer of Raytheon Co., a director since 1983; M.S., electrical engineering, Virginia Polytechnic Institute, 1948; B.S., electrical engineering, Virginia Polytechnic, 1947. Barbara Barnes Hauptfuhrer, 65, director of several public companies, a Knight-Ridder director since 1979; B.A., sociology and economics, Wellesley College, 1949. William S. Lee, 64, chairman and president of Duke Power, a director since 1990; B.S., civil engineering, Princeton University, 1951. John L. Weinberg, 69, senior chairman of Goldman, Sachs & Co., a director since 1969; M.B.A., business administration, Harvard University, 1950; B.A., economics, Princeton University, 1948. Gonzalo F. Valdes-Fauli, 47, regional chief executive: Latin America of Barclays Bank PLC, a director since 1992; master's in international finance, Thunderbird Graduate School for International Management, 1970; B.S., economics, Spring Hill College, 1968. Alvah H. Chapman Jr., 72, chairman of the Executive Committee and former chairman of the board and chief executive officer, a director since 1962; B.S., business administration, The Citadel, 1942. 11. Executive Compensation ---------------------- 1994 Proxy Statement, pages 7 and 8, "Compensation Committee Interlocks and Insider Participation"; pages 8 through 10, "Executive Compensation;" page 11, "Senior Executive Compensation;" page 12, "Stock Options Granted;" pages 12 and 13, "Stock Options Exercised;" page 13, "Pension Benefits;" and page 15, "Compensation of Directors" 12. Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- 1994 Proxy Statement page 1, "Common Stock Outstanding and Principal Holders" and page 6, "Security Ownership of Management" See Note E in Item 8. 13. Certain Relationships and Related Transactions ---------------------------------------------- 1994 Proxy Statement page 15, "Certain Transactions, Relationships and Reports of Certain Stock Transactions" PART IV 14. Exhibits, Financial Statement Schedules, and Reports on Form ------------------------------------------------------------ 8-K. ---- (a) 1. The following consolidated financial statements of Knight-Ridder, Inc. and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 26, 1993, are included in Item 8: Consolidated Balance Sheet - December 26, 1993, December 27, 1992 and December 29, 1991 Consolidated Statement of Income - Years ended December 26, 1993, December 27, 1992 and December 29, 1991 Consolidated Statement of Cash Flows - Years ended December 26, 1993, December 27, 1992 and December 29, 1991 Consolidated Statement of Shareholders' Equity - Years ended December 26, 1993, December 27, 1992 and December 29, 1991 Notes to consolidated financial statements - December 26, 1993 2. The following consolidated financial statement schedules of Knight-Ridder, Inc. and subsidiaries are submitted as a separate section of this report. Schedule V - Property, plant and equipment Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment Schedule VIII - Valuation and qualifying accounts Schedule IX - Short-term borrowings Schedule X - Supplementary income statement information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, or are inapplicable, or have been shown in the consolidated financial statements or notes thereto, and therefore have been omitted from this section. 3. Exhibits Filed No. 3 - Articles of Incorporation and Bylaws are incorporated by reference to the Company's Form 10K, filed in March, 1981. No. 4 - Indenture, dated as of April 6, 1989, is incorporated by reference to the Company's Registration Statement on Form S-3, effective April 7, 1989. (No. 33-28010) No. 10 - 1993 Executive MBO Plan description is incorporated herein on pages 116 to 121. - Amendment to the Employee Stock Option Plan originally filed on May 6, 1980 is incorporated herein on pages 121-129 - Director's Pension Plan dated January 1, 1994 is filed herein on pages 129-131 - Executive Officer's Retirement Agreement dated July 19, 1993 is incorporated herein on pages 131-133 No. 11 - Statement re Computation of Per Share Earnings is filed herein on pages 133-135. No. 12 - Statement re Computation of Earnings to Fixed Charges Ratio From Continuing Operations is filed herein on page 135-136. No. 19 - Executive Officer's Consulting/Retirement Agreement dated September 20, 1989 is incorporated herein on pages 136-138 - Executive Officer's Retirement Agreement dated December 19, 1991 is incorporated herein on pages 139-142. No. 22 - Subsidiaries of the registrant is filed herein on pages 142-144. No. 24 - "Consent of Independent Certified Public Accountants" is filed herewith on page 145. No. 25 - "Powers of Attorney" for all members of the Board of Directors, are filed herein on pages 146-161. (b) Reports on Form 8-K None were filed during the fourth quarter of 1993. (c) Exhibits The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules The response to this portion of Item 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 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. KNIGHT-RIDDER, INC. Dated March 22, 1994 By James K. Batten - -------------------- ------------------------------- James K. Batten Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Dated March 22, 1994 James K. Batten - ---------------------- ------------------------------- James K. Batten Chairman of the Board and Chief Executive Officer Dated March 22, 1994 Ross Jones - ---------------------- ------------------------------- Ross Jones Chief Financial Officer and Senior Vice President/Finance Dated March 22, 1994 Tally C. Liu - ---------------------- ------------------------------- Tally C. Liu Vice President/Finance and Controller (Chief Accounting Officer) /s/ James K. Batten* -------------------------------- James K. Batten Director /s/ Alvah H. Chapman, Jr.* -------------------------------- Alvah H. Chapman, Jr. Director /s/ Joan Ridder Challinor * ------------------------------- Joan Ridder Challinor Director /s/ Peter C. Goldmark, Jr.* ------------------------------- Peter C. Goldmark, Jr. Director /s/ Barbara Barnes Hauptfuhrer* ------------------------------- Barbara Barnes Hauptfuhrer Director /s/ Jesse Hill, Jr.* ------------------------------- Jesse Hill, Jr. Director /s/ William S. Lee* ------------------------------- William S. Lee Director /s/ C. Peter McColough* ------------------------------- C. Peter McColough Director /s/ Ben R. Morris* ------------------------------- Ben R. Morris Director /s/ Thomas L. Phillips* ------------------------------- Thomas L. Phillips Director /s/ P. Anthony Ridder* ------------------------------- P. Anthony Ridder Director /s/ Bernard H. Ridder, Jr.* ------------------------------- Bernard H. Ridder, Jr. Director /s/ Eric Ridder* ------------------------------- Eric Ridder Director /s/ Barbara Knight Toomey * ------------------------------- Barbara Knight Toomey Director /s/ John L. Weinberg* ------------------------------- John L. Weinberg Director /s/Gonzalo F. Valdes-Fauli* ------------------------------- Gonzalo F. Valdes-Fauli Director Dated March 22, 1994 By Ross Jones - ---------------------- ---------------------------- Ross Jones Attorney-in-fact ANNUAL REPORT ON FORM 10-K ITEM 14 (a) (2), (c) and (d) SUPPLEMENTARY DATA CERTAIN EXHIBITS YEAR ENDED DECEMBER 26, 1993 KNIGHT-RIDDER, INC. AND SUBSIDIARIES MIAMI, FLORIDA SCHEDULE V SCHEDULE VIII SCHEDULE IX EXHIBIT 10 ---------- GENERAL DESCRIPTION 1993 EXECUTIVE MBO PLAN (DESCRIPTION) I. Program Overview Following is an outline of the KRI Executive MBO Program. A. Basic Performance Criteria This incentive MBO program is related directly to: 1. The growth of operating profit for the corporation or for individual operating units. 2. The meeting of budgeted profit levels. 3. The attainment of individual performance goals that will contribute to the long-range strength of KRI. B. Factors Affecting Design of the Program. 1. Survey Data - Annual compensation studies by Towers Perrin and by others provide up-to-date data on compensation levels. From these studies, reliable competitive averages (as well as maximums and minimums) on most of our major positions are established. 2. KRI Position Within Our Industry - We wish to achieve a position such that an average KRI executive's total compensation will be competitive with compensation of executives at comparable companies. This positioning is necessary to continue to attract and retain the type of executive we want. 3.Rewards Increase With Responsibility - In general, the practice in American industry is for higher award opportunities at the top of the organization, since these executives have greater influence on profitability and should have more at risk. C. Program Regulations 1. Effective Starting Date - January 1, 1993, for this revised program. 2. Maximum Limit - It is usual practice to establish a limit to the amount that can be paid out in an executive award program in a given year. An appropriate limiting formula for the Category I and II participants will be one half of one percent of beginning shareholder equity. 3. Eligibility - Participants in the KRI Executive MBO Program are in three basic categories as follows: (The Chairman/CEO, President and Executive Vice President are excluded from the program. Awards, if any, for incumbents in these three offices are at the sole discretion of the KRI Compensation Committee.) Category I - Included as participants are all corporate officers, and certain director - level corporate employees. Category II - Included are newspaper publishers and other unit operating heads who report directly to corporate officers. The President of Ft. Wayne News-Sentinel, the Chief of the Washington Bureau and the Editor of KRTN are included in this category. Category III - Includes top editors, general managers and all division directors. (Any employee in this category not currently in the program joined the program on January 1, 1989. Exceptions may be negotiated with the Division Presidents in cases of inequity). Category IV - Employees not included in Categories I,II or III of the MBO program who hold positions of sufficient scope and organizational impact to be deemed by senior management as appropriately included in the KRI Executive MBO program. D. Goals Individual performance goals are an integral part of the KRI Executive Compensation Program. 1. Each participant in this program is or will be committed to written, defined goals in a number of fields such as: editorial product improvement, customer service, increased readership and/or product usage, circulation improvement, advertising share, personnel development and training, pluralism, leadership, etc. 2. The individual performance goals are the manager's program of how the operating unit will be improved. They are then reviewed, adjusted and finally accepted as meaningful and attainable by the senior officer to ensure that the goals have a valid corporate purpose. In this way, these goals are established from the "bottom up" rather than imposed by top management. 3. Goals should not number more than 6 to 8 objectives. Each goal will be given a weight, based on its relative importance, on a scale of 1 to 100. The combined weight of all the goals must equal 100. At the end of each year an individual is evaluated on the percentage of each goal accomplished, with the total yielding an individual's performance factor. II Award Calculations The award will be determined by these factors: A. The salary of the individual participant. See Appendix A. B. Operating profit - This factor measures operating profit for the current year against the previous year on a scale running from 90% to 115 %. This represents 25% of the award potential. C. Budgeted performance - This factor measures operating profit performance against budgeted performance on a scale running from 90% to 105%. This represents the other 75% of award potential. D. Individual performance - This factor measures the individual performance against pre-established goals. EXHIBIT 10 KNIGHT-RIDDER, INC. ---------- EMPLOYEE STOCK OPTION PLAN (As amended through May 13, 1993) 1. PURPOSE The purpose of this Stock Option Plan (hereinafter referred to as the "Plan") is to attract and retain key employees of Knight-Ridder, Inc. (hereinafter referred to as the "Company") and its subsidiaries, by the grant of options and stock appreciation rights. "Subsidiaries" as used herein shall mean corporations (other than Knight- Ridder, Inc.) or partnerships in an unbroken chain of corporations and/or partnerships beginning with Knight-Ridder, Inc. if, at the time the granting of the option or stock appreciation right, each of the corporations and partnerships other than the last corporation or partnership in the unbroken chain owns stock possessing 50% or more of the total combined voting power of all classes of stock in a corporation in such chain or at least a 50% partnership in such chain. Except as provided in Paragraph 7, a "stock appreciation right" shall mean the right of a holder thereof to receive from the Company, upon surrender of the related option, an amount equal to (A) the excess of the fair market value of a share of common stock on the date the stock appreciation right is exercised over the option price provided for in the related option, multiplied by (B) the number of shares with respect to which such stock appreciation right shall have been exercised. The term "fair market value" of a share of common stock as of any date shall be the mean between the highest and lowest sales price of a share of common stock on the date in question as reported on the composite tape for issues listed on the New York Stock Exchange. If no transaction was reported on the composite tape in the common stock on such date, the prices used shall be the prices reported on the nearest day preceding the date in question. If the common stock is not then listed or admitted to trading on such Exchange, "fair market value" shall be the mean between the closing bid and asked prices on the date in question as furnished by any member firm of the New York Stock Exchange selected from time to time for that purpose by the Compensation Committee. 2. ADMINISTRATION OF THE PLAN The Plan shall be administered by a committee as appointed from time to time by the Board of Directors of the Company, which committee shall consist of not less than three (3) members of such Board of Directors, all of whom shall be disinterested persons. Said committee shall be called the "Compensation Committee." In administering the Plan, the Compensation Committee may adopt rules and regulations for carrying out the Plan. The interpretation and decision with regard to any question arising under the Plan made by the Committee shall, unless overruled or modified by the Board of Directors of the Company, be final and conclusive on all employees of the Company and its subsidiaries participating or eligible to participate in the Plan. A Committee member shall be a "disinterested person" only if such person is not, at the time such person exercises discretion in administering the Plan, eligible and has not at any time within one year prior thereto been eligible for selection as a person to whom stock may be allocated or to whom stock options or stock appreciation rights may be granted pursuant to the Plan or any other plan of the Company or any of its affiliates entitling the participants therein to acquire stock, stock options or stock appreciation rights of the Company or any of its affiliates. 3. STOCK The stock which may be issued and sold pursuant to the exercise of options or stock appreciation rights granted under the Plan may be authorized and unissued common stock or shares of common stock reacquired by the Company and held in treasury of a total number not exceeding 16,100,000 shares. The shares deliverable under the Plan shall be fully paid and non- assessable shares. Any shares, in respect of which an option is granted under the Plan which shall have for any reason expired or terminated, may be again allotted under the Plan. Any shares covered by options which have been canceled by reason of the exercise of related stock appreciation rights as provided in the immediately following paragraph or which are used to exercise other options or to satisfy tax withholding obligations shall not be available for other options under the Plan. The exercise of options with respect to which stock appreciation rights shall have been granted shall cause a corresponding cancellation of such stock appreciation rights, and the exercise of stock appreciation rights issued in respect of options shall cause a corresponding cancellation of such options. Each option and stock appreciation right granted under the Plan shall be subject to the requirement and condition that if the Board of Directors shall determine that the listing, registration or qualification upon any Securities Exchange under any state or federal law, or the approval or consent of any governmental body is necessary or desirable as a condition of granting such option or stock appreciation right, or the issue or purchase of any shares thereunder, then no such option or stock appreciation right may be exercised in whole or in part unless or until such listing, registration, qualification or approval has been obtained, free of any conditions which are not acceptable to the Board of Directors of the Company. 4. ELIGIBILITY Options and stock appreciation rights will be granted only to persons who are employees of the Company and its subsidiaries (including officers and directors except for persons acting as directors only). The Compensation Committee of the Board of Directors of the Company shall determine in its sole discretion the employees to be granted options, the number of shares subject to each option, the employees to be granted stock appreciation rights and the options with respect to which such stock appreciation rights shall be granted. 5. PRICE The purchase price under each option shall be determined by the Compensation Committee subject to approval by the Board of Directors of the Company, but such price shall not be less than one hundred percent (100%) of the fair market value of the stock at the time such option is granted. 6. THE PERIOD OF THE OPTION AND THE EXERCISE OF THE SAME Each option granted under the Plan shall expire no later than ten (10) years from the date such option is granted, but the Compensation Committee may prescribe a shorter period for any individual option or options. The shares subject to the option may be purchased from time to time during the option period, subject to any waiting period or vesting schedule the Compensation Committee may specify for any individual option or options. In order to exercise the option or any part thereof, the employee shall give notice in writing to the Company of his intention to purchase all or part of the shares subject to the option, and in said notice he shall set forth the number of shares as to which he desires to exercise such option, and shall pay for such shares at the time of exercise of such option. Such payment may be made in cash, through the delivery to the Company of shares of common stock of the Company with a value equal to the total option price, or through a combination of cash and shares, and any shares so delivered shall be valued at their fair market value on the date on which the option is exercised. Such payment may also be made through the delivery to the Company of all or part of the shares of common stock of the Company that are the subject of the option; provided that such option is not an incentive stock option, and such employee instructs Manufacturers Hanover Trust Company ("MHTC") to effect on the date of such exercise or as early as practicable thereafter the sale of such number of such shares "at the market" in a broker's transaction (within the meaning of Section 4(4) of the Securities Act of 1933, as amended), the proceeds of which shall be at least equal to the purchase price of such option, plus the amount of income tax required to be withheld by the Company plus transaction costs. In accordance with these instructions MHTC shall sell such shares, deliver to the Company the portion of the proceeds of such sale which equals the purchase price of such option plus the amount of income tax required to be withheld by the Company and remit the remaining sale proceeds (net of transaction costs) to such employee. Said employee shall set forth in said notice, if in the opinion of Counsel for the Company it is necessary or desirable, that it is his present intention to acquire said shares being purchased for investment and not with a view to, or for sale in connection with, any distribution thereof. Except as specified in Paragraph 10 below, no option may be exercised except by the Optionee personally while he is in the employ of the Company or its subsidiaries and shall have been so employed continuously since the granting of his option. No Optionee or his legal representative, legatees or distributees, as the case may be, shall be or have any of the rights and privileges of a shareholder of the Company by reason of such option unless and until certificates for shares are issued to him under the terms of the Plan. 7. THE PERIOD OF THE STOCK APPRECIATION RIGHT AND THE EXERCISE OF THE SAME A stock appreciation right granted under the Plan shall be exercisable during the period commencing on a date specified by the Compensation Committee and ending on the date on which the related option expires unless such option is earlier canceled or terminated, provided that such right may be exercised by an officer (as that term is defined in the Securities Exchange Act of 1934), a director or a beneficial owner of more than 10% of any class of the Company's equity securities only during any period beginning on the third business day following the release of a quarterly or annual summary statement of the Company's sales and earnings and ending on the twelfth business day following such date (a "ten-day window period"). Notwithstanding the preceding sentence, the Compensation Committee may provide for the grant of a stock appreciation right the exercise of which may occur outside of a ten-day window period but shall be limited to a sixty-day period following certain events specified by the Compensation Committee in the grant of such stock appreciation right. Moreover, notwithstanding the third subparagraph of Paragraph 1 above, the Compensation Committee may provide that such stock appreciation right shall be payable only in cash and that, in addition to payment of the amount otherwise due upon exercise of such stock appreciation right, the holder thereof shall receive (unless such stock appreciation right is in tandem with an incentive stock option, as defined in Section 422A(b) of the Internal Revenue Code of 1986, as amended), an amount equal to the excess of the highest price paid for a share of common stock in the open market or otherwise over the sixty-day period prior to exercise over the fair market value of a share of common stock on the date the stock appreciation right is exercised. In order to exercise the stock appreciation right or any part thereof, the employee shall give notice in writing to the Company of the intention to exercise such right, and in said notice the employee shall set forth the number of shares as to which such employee desires to exercise the stock appreciation right, provided that such right may not be exercised with respect to a number of shares in excess of the number for which such option could then be exercised. Except as specified in Paragraph 10 below, no stock appreciation right may be exercised except by the holder thereof personally while such holder is in the employ of the Company or its subsidiaries and shall have been so employed continuously since the granting of the stock appreciation right. No holder of a stock appreciation right or such holder's legal representatives, legatees or distributees, as the case may be, shall be or have any of the rights and privileges of a shareholder of the Company by reason of such stock appreciation right unless and until certificates for such shares are issued to such holder under the terms of the Plan. 8. NON-TRANSFERABILITY OF OPTION AND STOCK APPRECIATION RIGHT No option or stock appreciation right granted under the Plan to an employee shall be transferred by him otherwise than by Will or by the laws of Descent and Distribution, and such option or stock appreciation right shall be exercisable during his lifetime only by him. 9. TERMINATION OF EMPLOYMENT If an Optionee shall cease to be employed by the Company or one of its subsidiaries, as the case may be, for any reason other than death, disability or retirement pursuant to a retirement plan of the Company or one of its sub- sidiaries, any option and any stock appreciation right theretofore granted to him which has not been exercised shall forthwith cease and terminate. However, the Compensation Committee of the Board of Directors may provide in the grant of any option or stock appreciation right or in an amendment of such grant that in the event of any such termination of employment (except termination for cause by the Company or one of its subsidiaries), any option and any stock appreciation right theretofore granted to him which has not been exercised shall be exercisable only within three months after his termination, but in no event after the expiration of the stated term of said option or any such stock appreciation right. The Company or any of its subsidiaries shall have "cause" to terminate the Optionee's employment only on the basis of the Optionee's having been guilty of fraud, misappropriation, embezzlement or any other act or acts of dishonesty constituting a felony and resulting or intended to result directly or indirectly in a substantial gain or personal enrichment to the Optionee at the expense of the Company or any of its subsidiaries. Notwithstanding the foregoing, the Optionee shall not be deemed to have been terminated for cause unless and until there shall have been delivered to the Optionee a copy of a resolution (i) duly adopted by three-quarters (3/4) of the entire membership of the Compensation Committee of the Board of Directors, or of the Board of directors of the Company, at a meeting called and held for such purpose after reasonable notice to the Optionee and an opportunity for the Optionee, together with the Optionee's counsel, to be heard before such Committee or the Board of Directors of the Company, as the case may be, and (ii) finding that in the good faith opinion of such Committee or the Board of Directors of the Company, as the case may be, the Optionee was guilty of conduct described in the preceding sentence of this paragraph and specifying the particulars of such conduct in detail. 10. RETIREMENT OR DEATH OF OPTIONEE OR HOLDER OF STOCK APPRECIATION RIGHT In the event of the retirement of an Optionee pursuant to a retirement plan of the Company or one of its subsidiaries, as the case may be, the option and any stock appreciation right heretofore granted to him shall be exercisable during such period of time, not to exceed one (1) year after the date of such retirement with respect to incentive stock options, as defined in Section 422A(b) of the Internal Revenue Code of 1986, as amended, and not to exceed three (3) years after the date of such retirement with respect to all other stock options and stock appreciation rights, as the Compensation Committee shall specify in the option grant either at the time of grant or by amendment, but in no event after the expiration of the term of said option or any such stock appreciation right. In the event of the disability or death of an Optionee while in the employ of the Company or one of its subsidiaries, or during the post employment period referred to in the immediately preceding paragraph, the option hereto- fore granted to him shall be exercisable any time prior to the expiration of six (6) months after the date of such disability or death but in no event after the expiration of the term of said option. In the event of the disability or death of the holder of a stock appreciation right while in the employ of the Company or one of its subsidiaries, or during the post employment period referred to in the first paragraph of this Section 10, the stock appreciation right heretofore granted to him shall be exercisable any time prior to six (6) months after the date of such disability or death, but in no event after the expiration of the term of such stock appreciation right. Such option or stock appreciation right may only be exercised by the personal representative of such decedent or by the person or persons to whom such employee's rights under the option or stock appreciation right shall pass by such employee's Will or by the laws of Descent and Distribution of the state of such employee's domicile at the time of death, and then only as and to the extent that such employee was entitled to exercise the option or stock appreciation right on the date of death. 11. WRITTEN AGREEMENT Within a reasonable time after the date of grant of an option, an option and stock appreciation right or a stock appreciation right related to a previously granted option, a written agreement in a form approved by the Compensation Committee shall be duly executed and delivered to the Optionee. 12. ADJUSTMENT BY REASON OF RECAPITALIZATION, STOCK SPLITS STOCK DIVIDENDS, ETC. If, after the effective date of this Plan, there shall be any changes in the common stock structure of the Company by reason of the declaration of stock dividends, recapitalization resulting in stock split-ups, or combina- tions or exchanges of shares by reason of merger, consolidation, or by any other means, then the number of shares available for options and stock appreciation rights, the shares subject to any options and the number of shares available for and subject to stock appreciation rights shall be equitably and appropriately adjusted by the Board of Directors of the Company as in its sole and uncontrolled discretion shall seem just and reasonable in the light of all the circumstances pertaining thereto. 13. RIGHT TO TERMINATE EMPLOYMENT The plan shall not confer upon any employee any right with respect to being continued in the employ of the Company and its subsidiaries or interfere in any way with the right of the Company and its subsidiaries to terminate his employment at any time, nor shall it interfere in any way with the employee's right to terminate his employment. 14. WITHHOLDING AND OTHER TAXES The Company or one of its subsidiaries shall have the right to withhold from salary or otherwise or to cause an Optionee (or the executor or administrator of his estate or his distributee) to make payment of any Federal, State, local or foreign taxes required to be withheld with respect to any exercise of a stock option or a stock appreciation right. An Optionee may irrevocably elect to have the withholding tax obligation or, if the Compensation Committee so determines, any additional tax obligation with respect to any exercise of a stock option satisfied by (a) having the Company or one of its subsidiaries withhold shares otherwise deliverable to the Optionee with respect to the exercise of the stock option, or (b) delivering back to the Company shares received upon the exercise of the stock option or delivering other shares of common stock; that any such election shall be made either (i) during a "ten-day window period", or (ii) at least six months prior to the date income is recognized with respect to the exercise of a stock option. 15. AMENDMENT TO THE PLAN The Board of Directors shall have the right to amend, suspend or terminate the Plan at any time; provided, however, that no such action shall affect or in any way impair the rights of the holder of any option or stock appreciation right theretofore granted under the Plan; and provided further, that unless first duly approved by the common shareholders of the Company entitled to vote thereon at a meeting (which may be the annual meeting) duly called and held for such purpose, no amendment or change shall be made in the Plan (a) increasing the total number of shares which may be purchased or transferred upon exercise of options or stock appreciation rights under the Plan by all employees; (b) changing the minimum purchase price hereinbefore specified for the optioned shares; (c) changing the maximum option period; (d) increasing the amount that may be received upon exercise of a stock appreciation right; or (e) allowing a stock appreciation right to be exercised after the expiration date of the related option. 16. EFFECTIVE DATE OF THE PLAN The Plan shall be effective as of February 24, 1971. 17. SAVINGS CLAUSE Nothing included in this Plan by amendment shall revoke or alter the terms and provisions of the Plan as in effect prior to such amendment with respect to options granted under the Plan prior thereto. EXHIBIT 10 ---------- DIRECTOR'S PENSION PLAN Plan Provisions Effective Date January 1, 1994 Normal Retirement Date The first of the month following attainment of Age 65 Normal Annual Pension 100% of annual retainer fee (currently $26,000 per year) Termination Benefits After vesting an annuity payable for life starting at the later of age 65 or termination from the Board. Death Benefits None Preretirement Spouse's Death Benefits None Postretirement Spouse's Death Benefit None Disability Pension 50% of the Normal Annual Pension payable after 2 years of Credited Service. Increases by 10% per year for years of Credited Service over 5 years until it is 100% of the Normal Annual Pension. Credited Service does not accrue while on Disability. Early Retirement Benefit An unreduced accrued benefit is available upon attainment of age 65 and 5 years of Credited Service. Eligibility All Outside Members of the Board of Directors. An Outside Member is a board member who has never been employed by the Company or an affiliate of the Company. Credited Service One year of Credited Service is granted for each calender year in which a Board member is on the Board for at least four months and attends at least one Board Meeting. Benefit Accrual 10% of the Normal Retirement Benefit for each year of Credited Service. A maximum of 100% after 10 years. Vesting Vesting Service equals Credited Service. Benefits vest after 5 years of Vesting Service. Contributions None Forms of Payment Life Annuity only EXHIBIT 10 ---------- EXECUTIVE OFFICER'S RETIREMENT AGREEMENT July 19, 1993 Robert F. Singleton 8496 Old Cutler Road Coral Gables, FL. 33143 Dear Bob: This letter describes the conditions of your retirement agreement with Knight-Ridder, Inc. 1. Your current job, compensation and benefit arrangements will continue through September 30, 1993. 2. On September 30, 1993 you will retire as an officer and as a member of the Board Of Directors of Knight-Ridder, Inc. 3. Upon retirement, you will be paid for any accrued, but unused vacation time. You will also be paid a prorated bonus for 1993, based on the potential bonus, if any, you would have received had you not retired until the end of 1993. This bonus will be calculated on the basis of projected 1993 KRI performance computed on the basis of nine months actual, plus three months budget. 4. For a one-year period beginning October 1, 1993, you will serve as a consultant to the company, reporting to me, at an annual fee of $50,000. You will be available to Ross Jones the new CFO, and other officers of the company. You will continue to represent Knight-Ridder on the TKR Cable, TCI/TKR LP and Southeast Paper Manufacturing Company Management Committees during the period you serve Knight-Ridder as a consultant. 5. Effective October 1, 1993, you will receive an annual pension of $200,000 in the form of a 66 2/3% joint and survivor annuity (66 2/3% CA Option), comprising the following elements: SENN Plan $ 88,082 BRP Plan 41,105 Special Retirement Agreement 70,813 -------- Total Annual Benefit $200,000 ======== 6 Upon your retirement, you and your dependents will be covered under the Knight-Ridder medical and dental plans for retirees. Because you originally intended to retire under the medical plan for retirees that was effective prior to January 1, 1993, upon your retirement, you will be paid a one-time bonus of $86,806 representing the difference in present value costs to you of continuing coverage for you and your dependents under the new plan versus the old plan. 7. All normal travel and out-of pocket expenses incurred in carrying out your assignments for the company during the period October 1, 1993 through September 30, 1994, will be paid for by the company upon submission of expenses. 8. Outside directorships not in conflict with Knight-Ridder, Inc. will be cleared with me. 9. You may retain your personal computer and have free access to Dialog, Moneycenter and other agreed-upon KRI electronic services until March 20, 1995. Accepted by: Knight-Ridder, Inc. Robert F. Singleton James K. Batten - ----------------------- --------------------- Robert F. Singleton James K. Batten Date: July 19, 1993 Date: July 19, 1993 EXECUTIVE OFFICER'S CONSULTING/RETIREMENT AGREEMENT EXHIBIT 19 ---------- September 20, 1989 Mr. Alvah H. Chapman, Jr. 4255 Lake Road Miami, Florida 33137 Dear Alvah: This letter sets forth our agreement with respect to your services to Knight-Ridder following your retirement as an officer and employee of the Company on October 1st. You have agreed to continue to serve as a Director of the Company and as Chairman of its Executive Committee. I am also pleased that you have agreed to serve as a consultant to the company for the 12 months beginning October 1, 1989 and, thereafter, for such period as you, the Compensation Committee and I may agree. In consideration of your services as Chairman of the Executive Committee and as a consultant, the Company will pay you $150,000 annually. This agree- ment extends from October 1, 1989 through September 30, 1994. And as customary, you will be compensated as an outside director, including meeting fees for the Board and Board Committees (including the Executive Committee of the Company). We have calculated that you will be entitled to an aggregate annual pension benefit under the Knight-Ridder Retirement and Benefit Restoration Plans of $328,670. In addition, in recognition of your contribution to the Company and your future services to it, the Company has agreed to pay you an additional retirement benefit of $100,000 per year for your life, in equal monthly installments. Although I hope to be able to take full advantage of your broad range of experience and knowledge of the Company, it is understood between us that we will make only reasonable demands upon your time and will seek to schedule our requests for your counsel so as to accommodate your schedule of other activities in retirement. The specific matters on which we will need your help necessarily will change from time to time. I anticipate that you and I will talk at least quarterly about your then current list of consultative duties. At the outset we look forward to your continued participation in (a) our Detroit JOA undertaking and I hope you will be willing to serve on the DNA Management Committee for at least a year following implementation; (b) our ongoing shareholder relations projects (with particular attention to the founding families); and (c) the Miami property development project. I know that there will be a number of other key issues where your counsel will be invaluable. Our consulting relationship will preclude you from accepting consulting assignments and from other companies and from other profit-making activities, provided your other assignments and activities do not constitute a conflict of interest with Knight- Ridder. The Company will reimburse you, in accordance with its usual policies and procedures, for your travel and other out of pocket expenses incurred in connection with your Knight-Ridder consulting activities, your attending ANPA and other industry meetings as long as you are a Knight- Ridder director, and your activities as Chairman of the FIU Foundation, Vice Chairman of The Miami Coalition, and other civic activities which are of benefit to KRI over the next several years. In accordance with our historical practice, we will provide you as a former CEO of the Company with an office and a secretary as long as you want them. I am happy we will continue to work together. If I have accurately summarized our understanding, I'd appreciate your signing and returning the enclosed copy of this letter to me for the Company's files. Sincerely yours, Knight- Ridder, Inc. By: James K. Batten ----------------- J.K. Batten President & CEO Agreed: Alvah H. Chapman Jr. - -------------------- Alvah H. Chapman, Jr. (The initial agreement was for one year and has been renewed annually through September 30, 1994). EXECUTIVE OFFICER'S RETIREMENT AGREEMENT EXHIBIT 19 (John C. Fontaine) ---------- AGREEMENT THIS AGREEMENT made and entered into as of the 1st day of January, 1992, by and between John C. Fontaine (hereinafter referred to as "Mr. Fontaine") and Knight-Ridder, Inc. (hereinafter referred to as "KRI") WITNESSETH THAT: WHEREAS Mr. Fontaine will work approximately nine-tenths (90%) of his time for KRI, commencing January 1, 1992; and, WHEREAS KRI desires to provide Mr. Fontaine with an adequate pension benefit for his services; 1. KRI will pay to Mr. Fontaine an amount, payable in monthly installments, under this Agreement which, together with benefits earned under the Retirement Plan for Employees of Knight-Ridder, Inc. Corporate Division (the "Plan") will equal $135,000 annually if Mr. Fontaine retires at age 62 or $200,000 annually if Mr. Fontaine retires at age 65. These amounts are given on a life-only basis; they may be converted to any of the optional forms of benefit available under the Plan using the same conversion factors which would apply under the Plan. 2. In the event that the employment relationship ends prior to attainment of age 62 by Mr. Fontaine other than (a) by reason of Mr. Fontaine's death or disability or (b) following a change in the control of the company, a pension benefit commencing at age 65 will be payable. The amount of the benefit will be calculated by multiplying $200,000 by the ratio of years and completed months of service since August 1, 1987 to 9 years 3 months. In the event of retirement at or after age 62, a pension determined in the same manner will be payable commencing immediately (except that the benefit payable at age 62 will be $135,000). See Exhibits I and II. Amounts payable under optional payment forms are shown in Exhibit III. 3. In the event Mr. Fontaine's employment terminates by reason of his disability or following a change in the control of the company, he will be 100% vested immediately in the benefits provided under paragraph 2 above for retirement at age 65. In the event of Mr. Fontaine's death while employed by KRI, there shall be paid to his surviving spouse for her life 50% of the amount which would otherwise be payable to him under this paragraph in the event of his disability; no beneficiary other than his surviving spouse shall be entitled to any death benefit under this Agreement. Benefit payments under this paragraph will commence on the first of the month following the occurrence of any of the above-mentioned circumstances. For purposes of this Agreement: (a) a "change in the control of the company" will be deemed to have occurred if the company is a party to a merger in which it is not the surviving entity or pursuant to which the company's common stock is converted into other property or securities; or upon the approval of the liquidation or dissolution of the company; or upon the sale of all or substantially all the company's assets; or upon the acquisition by any person or group of 35% of the company's outstanding stock; or upon a change within any 13- month period in the composition of a majority of the company's Board of Directors; and (b) "disability" shall mean a physical or mental condition which prevents Mr. Fontaine from fully performing the duties of Senior Vice President and General Counsel as agreed to by him and the company for a period of 90 consecutive days. 4. This Agreement does not give Mr. Fontaine the right to be retained in the employ of KRI. Effective January 1, 1992, this Agreement supersedes the agreement between Mr. Fontaine and KRI concerning pension benefits dated October 16, 1989. 5. This Agreement does not give Mr. Fontaine other rights or benefits provided under the Plan except as set forth in paragraphs 1, 2 and 3 above. 6. Neither this Agreement nor any benefits that may be payable under this Agreement are assignable by Mr. Fontaine. None of Mr. Fontaine's rights under this Agreement shall be subject to any encumbrance or to the claims of his creditors. 7. This Agreement shall be governed and construed in accordance with the laws of the State of Florida. 8. Nothing contained in this Agreement shall be deemed to require KRI to make any payment to Mr. Fontaine or to any other person contrary to applicable law. 9. IN WITNESS WHEREOF, the parties hereto have hereunto set their hands to duplicates this 19th day of December, 1991. JOHN C. FONTAINE John C. Fontaine ---------------- KNIGHT-RIDDER, INC. By James K. Batten ------------------ James K. Batten Chairman & CEO Exhibit 22 SUBSIDIARIES OF THE REGISTRANT ---------- State/Country of Incorporation --------------- KNIGHT-RIDDER, INC. Aberdeen News Company Delaware The Beacon Journal Publishing Company Ohio Boca Raton News, Inc. Florida Boulder Publishing, Inc. Colorado The Bradenton Herald, Inc. Florida Circom Corporation Pennsylvania Detroit Free Press, Incorporated Michigan Detroit Newspaper Agency Michigan(partnership) Drinnon, Inc. Georgia Grand Forks Herald, Incorporated Delaware Journal of Commerce, Inc. Delaware Keynoter Publishing Company, Inc. Florida KR Newsprint Company Florida Southeast Paper Manufacturing Co. Georgia (partnership) Knight News Services, Inc. Michigan Knight-Ridder Tribune News Services District of Columbia (partnership) The Knight Publishing Co. Delaware Knight-Ridder Business Information Services, Inc. Delaware Knight-Ridder Financial, Inc. Delaware Commodity News Services (International), Inc. Delaware Knight-Ridder Financial Holding AEA Company, Inc. Delaware Knight-Ridder Financial AEA, Inc. Delaware Knight-Ridder Financial JM, Inc. Delaware Knight-Ridder Financial Japan, Inc. Delaware Knight-Ridder Financial Iberica, S.A. Spain Equinet Pty Ltd. Australia Equinet Information (NZ), Ltd. New Zealand Dialog Information Services, Inc. California Dialog Information Europe, Inc. California D-S Marketing UK, Ltd. United Kingdom D-S Marketing, Inc. Pennsylvania D-S Marketing, SARL France D-S Marketing, GMBH Germany Radio-Suisse Marketing AB Sweden Knight-Ridder Nova AG Switzerland Radio-Suisse Ltd. Switzerland Knight-Ridder Cablevision, Inc. Florida KRC Sub, Inc. Delaware SCI Cable Partners Colorado (partnership) TKR Cable Company Colorado (partnership) Knight-Ridder Investment Company Delaware Seattle Times Company Delaware KR Video, Inc. Delaware Lexington Herald-Leader Co. Kentucky The Macon Telegraph Publishing Company Georgia The Miami Herald Publishing Company - News Publishing Company Indiana Fort Wayne Newspapers, Inc. Indiana Fort Wayne Newspaper Agency Indiana (partnership) Newspapers First Delaware Nittany Printing and Publishing Company Pennsylvania Northwest Publications, Inc. Delaware Duluth News-Tribune - Saint Paul Pioneer Press - The Observer Transportation Company North Carolina Philadelphia Newspapers, Inc. Pennsylvania Portage Graphics Co. Ohio Post-Tribune Publishing, Inc. Indiana PressLink Corporation Delaware The R.W. Page Corporation Georgia Ridder Publications, Inc. Delaware KR Land Holding Corporation Delaware San Jose Mercury News, Inc. California Silicon Valley D.A.T.A., Inc. California The State-Record Holding Company Delaware The State-Record Company, Inc. South Carolina Gulf Publishing Company, Inc. Mississippi Newberry Publishing Company, Inc. South Carolina Sun Publishing Company, Inc. South Carolina Tallahassee Democrat, Inc. Florida Tribune Newsprint Company Utah Ponderay Newsprint Company Washington (partnership) Twin Cities Newspaper Service, Inc. Minnesota Twin Coast Newspapers, Inc. New York Long Beach Press-Telegram - P.T. Sales and Marketing, Inc. California VU/TEXT Information Services, Inc. Florida Wichita Eagle and Beacon Publishing Company, Inc. Kansas Exhibit 24 ---------- CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in Registration Statement No. 33-11021 on Form S-3 dated December 22, 1986, in Registration Statement No. 33-28010 on Form S-3 dated April 7, 1989, in Registration Statement No. 33-31747 on Form S-8 dated October 30, 1989 and in Registration Statement No. 33-69206 on Form S-8 dated May 18, 1993, and in the related Prospectuses of our report dated February 1, 1994, with respect to the consolidated financial statements and schedules of Knight-Ridder, Inc. included in this Annual Report (Form 10-K) for the year ended December 26, 1993. ERNST & YOUNG March 22, 1994 Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Gonzalo F. Valdes- Fauli Date: March 22, 1994 - ---------------------------- -------------------- Gonzalo F. Valdes-Fauli Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Bernard H. Ridder, Jr. Date: March 22, 1994 - --------------------------- -------------------- Bernard H. Ridder, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Barbara Barnes Hauptfuhrer Date: March 22, 1994 - ------------------------------- -------------------- Barbara Barnes Hauptfuhrer Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Alvah H. Chapman, Jr. Date: March 22, 1994 - ------------------------ -------------------- Alvah H. Chapman, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Peter C. Goldmark, Jr. Date: March 22, 1994 - ------------------------- -------------------- Peter C. Goldmark, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. William S. Lee Date: March 22, 1994 - ------------------ -------------------- William S. Lee Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. John L. Weinberg Date: March 22, 1994 - -------------------- -------------------- John L. Weinberg Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Ben R. Morris Date: March 22, 1994 - ----------------- -------------------- Ben R. Morris Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Eric Ridder Date: March 22, 1994 - --------------- -------------------- Eric Ridder Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. James K. Batten Date: March 22, 1994 - ------------------- -------------------- James K. Batten Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Joan Ridder Challinor Date: March 22, 1994 - ------------------------- -------------------- Joan Ridder Challinor Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Jesse Hill, Jr. Date: March 22, 1993 - ------------------- -------------------- Jesse Hill, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. C. Peter McColough Date: March 22, 1994 - ---------------------- -------------------- C. Peter McColough Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Thomas L. Phillips Date: March 22, 1994 - ----------------------- -------------------- Thomas L. Phillips Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. P. Anthony Ridder Date: March 22, 1994 - --------------------- -------------------- P. Anthony Ridder Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Barbara Knight Toomey Date: March 22, 1994 - ------------------------- --------------------- Barbara Knight Toomey ITEM 14 (a) (2), (c) and (d) SUPPLEMENTARY DATA CERTAIN EXHIBITS YEAR ENDED DECEMBER 26, 1993 KNIGHT-RIDDER, INC. AND SUBSIDIARIES MIAMI, FLORIDA SCHEDULE V SCHEDULE VIII SCHEDULE IX EXHIBIT 10 ---------- GENERAL DESCRIPTION 1993 EXECUTIVE MBO PLAN (DESCRIPTION) I. Program Overview Following is an outline of the KRI Executive MBO Program. A. Basic Performance Criteria This incentive MBO program is related directly to: 1. The growth of operating profit for the corporation or for individual operating units. 2. The meeting of budgeted profit levels. 3. The attainment of individual performance goals that will contribute to the long-range strength of KRI. B. Factors Affecting Design of the Program. 1. Survey Data - Annual compensation studies by Towers Perrin and by others provide up-to-date data on compensation levels. From these studies, reliable competitive averages (as well as maximums and minimums) on most of our major positions are established. 2. KRI Position Within Our Industry - We wish to achieve a position such that an average KRI executive's total compensation will be competitive with compensation of executives at comparable companies. This positioning is necessary to continue to attract and retain the type of executive we want. 3.Rewards Increase With Responsibility - In general, the practice in American industry is for higher award opportunities at the top of the organization, since these executives have greater influence on profitability and should have more at risk. C. Program Regulations 1. Effective Starting Date - January 1, 1993, for this revised program. 2. Maximum Limit - It is usual practice to establish a limit to the amount that can be paid out in an executive award program in a given year. An appropriate limiting formula for the Category I and II participants will be one half of one percent of beginning shareholder equity. 3. Eligibility - Participants in the KRI Executive MBO Program are in three basic categories as follows: (The Chairman/CEO, President and Executive Vice President are excluded from the program. Awards, if any, for incumbents in these three offices are at the sole discretion of the KRI Compensation Committee.) Category I - Included as participants are all corporate officers, and certain director - level corporate employees. Category II - Included are newspaper publishers and other unit operating heads who report directly to corporate officers. The President of Ft. Wayne News-Sentinel, the Chief of the Washington Bureau and the Editor of KRTN are included in this category. Category III - Includes top editors, general managers and all division directors. (Any employee in this category not currently in the program joined the program on January 1, 1989. Exceptions may be negotiated with the Division Presidents in cases of inequity). Category IV - Employees not included in Categories I,II or III of the MBO program who hold positions of sufficient scope and organizational impact to be deemed by senior management as appropriately included in the KRI Executive MBO program. D. Goals Individual performance goals are an integral part of the KRI Executive Compensation Program. 1. Each participant in this program is or will be committed to written, defined goals in a number of fields such as: editorial product improvement, customer service, increased readership and/or product usage, circulation improvement, advertising share, personnel development and training, pluralism, leadership, etc. 2. The individual performance goals are the manager's program of how the operating unit will be improved. They are then reviewed, adjusted and finally accepted as meaningful and attainable by the senior officer to ensure that the goals have a valid corporate purpose. In this way, these goals are established from the "bottom up" rather than imposed by top management. 3. Goals should not number more than 6 to 8 objectives. Each goal will be given a weight, based on its relative importance, on a scale of 1 to 100. The combined weight of all the goals must equal 100. At the end of each year an individual is evaluated on the percentage of each goal accomplished, with the total yielding an individual's performance factor. II Award Calculations The award will be determined by these factors: A. The salary of the individual participant. See Appendix A. B. Operating profit - This factor measures operating profit for the current year against the previous year on a scale running from 90% to 115 %. This represents 25% of the award potential. C. Budgeted performance - This factor measures operating profit performance against budgeted performance on a scale running from 90% to 105%. This represents the other 75% of award potential. D. Individual performance - This factor measures the individual performance against pre-established goals. EXHIBIT 10 KNIGHT-RIDDER, INC. ---------- EMPLOYEE STOCK OPTION PLAN (As amended through May 13, 1993) 1. PURPOSE The purpose of this Stock Option Plan (hereinafter referred to as the "Plan") is to attract and retain key employees of Knight-Ridder, Inc. (hereinafter referred to as the "Company") and its subsidiaries, by the grant of options and stock appreciation rights. "Subsidiaries" as used herein shall mean corporations (other than Knight- Ridder, Inc.) or partnerships in an unbroken chain of corporations and/or partnerships beginning with Knight-Ridder, Inc. if, at the time the granting of the option or stock appreciation right, each of the corporations and partnerships other than the last corporation or partnership in the unbroken chain owns stock possessing 50% or more of the total combined voting power of all classes of stock in a corporation in such chain or at least a 50% partnership in such chain. Except as provided in Paragraph 7, a "stock appreciation right" shall mean the right of a holder thereof to receive from the Company, upon surrender of the related option, an amount equal to (A) the excess of the fair market value of a share of common stock on the date the stock appreciation right is exercised over the option price provided for in the related option, multiplied by (B) the number of shares with respect to which such stock appreciation right shall have been exercised. The term "fair market value" of a share of common stock as of any date shall be the mean between the highest and lowest sales price of a share of common stock on the date in question as reported on the composite tape for issues listed on the New York Stock Exchange. If no transaction was reported on the composite tape in the common stock on such date, the prices used shall be the prices reported on the nearest day preceding the date in question. If the common stock is not then listed or admitted to trading on such Exchange, "fair market value" shall be the mean between the closing bid and asked prices on the date in question as furnished by any member firm of the New York Stock Exchange selected from time to time for that purpose by the Compensation Committee. 2. ADMINISTRATION OF THE PLAN The Plan shall be administered by a committee as appointed from time to time by the Board of Directors of the Company, which committee shall consist of not less than three (3) members of such Board of Directors, all of whom shall be disinterested persons. Said committee shall be called the "Compensation Committee." In administering the Plan, the Compensation Committee may adopt rules and regulations for carrying out the Plan. The interpretation and decision with regard to any question arising under the Plan made by the Committee shall, unless overruled or modified by the Board of Directors of the Company, be final and conclusive on all employees of the Company and its subsidiaries participating or eligible to participate in the Plan. A Committee member shall be a "disinterested person" only if such person is not, at the time such person exercises discretion in administering the Plan, eligible and has not at any time within one year prior thereto been eligible for selection as a person to whom stock may be allocated or to whom stock options or stock appreciation rights may be granted pursuant to the Plan or any other plan of the Company or any of its affiliates entitling the participants therein to acquire stock, stock options or stock appreciation rights of the Company or any of its affiliates. 3. STOCK The stock which may be issued and sold pursuant to the exercise of options or stock appreciation rights granted under the Plan may be authorized and unissued common stock or shares of common stock reacquired by the Company and held in treasury of a total number not exceeding 16,100,000 shares. The shares deliverable under the Plan shall be fully paid and non- assessable shares. Any shares, in respect of which an option is granted under the Plan which shall have for any reason expired or terminated, may be again allotted under the Plan. Any shares covered by options which have been canceled by reason of the exercise of related stock appreciation rights as provided in the immediately following paragraph or which are used to exercise other options or to satisfy tax withholding obligations shall not be available for other options under the Plan. The exercise of options with respect to which stock appreciation rights shall have been granted shall cause a corresponding cancellation of such stock appreciation rights, and the exercise of stock appreciation rights issued in respect of options shall cause a corresponding cancellation of such options. Each option and stock appreciation right granted under the Plan shall be subject to the requirement and condition that if the Board of Directors shall determine that the listing, registration or qualification upon any Securities Exchange under any state or federal law, or the approval or consent of any governmental body is necessary or desirable as a condition of granting such option or stock appreciation right, or the issue or purchase of any shares thereunder, then no such option or stock appreciation right may be exercised in whole or in part unless or until such listing, registration, qualification or approval has been obtained, free of any conditions which are not acceptable to the Board of Directors of the Company. 4. ELIGIBILITY Options and stock appreciation rights will be granted only to persons who are employees of the Company and its subsidiaries (including officers and directors except for persons acting as directors only). The Compensation Committee of the Board of Directors of the Company shall determine in its sole discretion the employees to be granted options, the number of shares subject to each option, the employees to be granted stock appreciation rights and the options with respect to which such stock appreciation rights shall be granted. 5. PRICE The purchase price under each option shall be determined by the Compensation Committee subject to approval by the Board of Directors of the Company, but such price shall not be less than one hundred percent (100%) of the fair market value of the stock at the time such option is granted. 6. THE PERIOD OF THE OPTION AND THE EXERCISE OF THE SAME Each option granted under the Plan shall expire no later than ten (10) years from the date such option is granted, but the Compensation Committee may prescribe a shorter period for any individual option or options. The shares subject to the option may be purchased from time to time during the option period, subject to any waiting period or vesting schedule the Compensation Committee may specify for any individual option or options. In order to exercise the option or any part thereof, the employee shall give notice in writing to the Company of his intention to purchase all or part of the shares subject to the option, and in said notice he shall set forth the number of shares as to which he desires to exercise such option, and shall pay for such shares at the time of exercise of such option. Such payment may be made in cash, through the delivery to the Company of shares of common stock of the Company with a value equal to the total option price, or through a combination of cash and shares, and any shares so delivered shall be valued at their fair market value on the date on which the option is exercised. Such payment may also be made through the delivery to the Company of all or part of the shares of common stock of the Company that are the subject of the option; provided that such option is not an incentive stock option, and such employee instructs Manufacturers Hanover Trust Company ("MHTC") to effect on the date of such exercise or as early as practicable thereafter the sale of such number of such shares "at the market" in a broker's transaction (within the meaning of Section 4(4) of the Securities Act of 1933, as amended), the proceeds of which shall be at least equal to the purchase price of such option, plus the amount of income tax required to be withheld by the Company plus transaction costs. In accordance with these instructions MHTC shall sell such shares, deliver to the Company the portion of the proceeds of such sale which equals the purchase price of such option plus the amount of income tax required to be withheld by the Company and remit the remaining sale proceeds (net of transaction costs) to such employee. Said employee shall set forth in said notice, if in the opinion of Counsel for the Company it is necessary or desirable, that it is his present intention to acquire said shares being purchased for investment and not with a view to, or for sale in connection with, any distribution thereof. Except as specified in Paragraph 10 below, no option may be exercised except by the Optionee personally while he is in the employ of the Company or its subsidiaries and shall have been so employed continuously since the granting of his option. No Optionee or his legal representative, legatees or distributees, as the case may be, shall be or have any of the rights and privileges of a shareholder of the Company by reason of such option unless and until certificates for shares are issued to him under the terms of the Plan. 7. THE PERIOD OF THE STOCK APPRECIATION RIGHT AND THE EXERCISE OF THE SAME A stock appreciation right granted under the Plan shall be exercisable during the period commencing on a date specified by the Compensation Committee and ending on the date on which the related option expires unless such option is earlier canceled or terminated, provided that such right may be exercised by an officer (as that term is defined in the Securities Exchange Act of 1934), a director or a beneficial owner of more than 10% of any class of the Company's equity securities only during any period beginning on the third business day following the release of a quarterly or annual summary statement of the Company's sales and earnings and ending on the twelfth business day following such date (a "ten-day window period"). Notwithstanding the preceding sentence, the Compensation Committee may provide for the grant of a stock appreciation right the exercise of which may occur outside of a ten-day window period but shall be limited to a sixty-day period following certain events specified by the Compensation Committee in the grant of such stock appreciation right. Moreover, notwithstanding the third subparagraph of Paragraph 1 above, the Compensation Committee may provide that such stock appreciation right shall be payable only in cash and that, in addition to payment of the amount otherwise due upon exercise of such stock appreciation right, the holder thereof shall receive (unless such stock appreciation right is in tandem with an incentive stock option, as defined in Section 422A(b) of the Internal Revenue Code of 1986, as amended), an amount equal to the excess of the highest price paid for a share of common stock in the open market or otherwise over the sixty-day period prior to exercise over the fair market value of a share of common stock on the date the stock appreciation right is exercised. In order to exercise the stock appreciation right or any part thereof, the employee shall give notice in writing to the Company of the intention to exercise such right, and in said notice the employee shall set forth the number of shares as to which such employee desires to exercise the stock appreciation right, provided that such right may not be exercised with respect to a number of shares in excess of the number for which such option could then be exercised. Except as specified in Paragraph 10 below, no stock appreciation right may be exercised except by the holder thereof personally while such holder is in the employ of the Company or its subsidiaries and shall have been so employed continuously since the granting of the stock appreciation right. No holder of a stock appreciation right or such holder's legal representatives, legatees or distributees, as the case may be, shall be or have any of the rights and privileges of a shareholder of the Company by reason of such stock appreciation right unless and until certificates for such shares are issued to such holder under the terms of the Plan. 8. NON-TRANSFERABILITY OF OPTION AND STOCK APPRECIATION RIGHT No option or stock appreciation right granted under the Plan to an employee shall be transferred by him otherwise than by Will or by the laws of Descent and Distribution, and such option or stock appreciation right shall be exercisable during his lifetime only by him. 9. TERMINATION OF EMPLOYMENT If an Optionee shall cease to be employed by the Company or one of its subsidiaries, as the case may be, for any reason other than death, disability or retirement pursuant to a retirement plan of the Company or one of its sub- sidiaries, any option and any stock appreciation right theretofore granted to him which has not been exercised shall forthwith cease and terminate. However, the Compensation Committee of the Board of Directors may provide in the grant of any option or stock appreciation right or in an amendment of such grant that in the event of any such termination of employment (except termination for cause by the Company or one of its subsidiaries), any option and any stock appreciation right theretofore granted to him which has not been exercised shall be exercisable only within three months after his termination, but in no event after the expiration of the stated term of said option or any such stock appreciation right. The Company or any of its subsidiaries shall have "cause" to terminate the Optionee's employment only on the basis of the Optionee's having been guilty of fraud, misappropriation, embezzlement or any other act or acts of dishonesty constituting a felony and resulting or intended to result directly or indirectly in a substantial gain or personal enrichment to the Optionee at the expense of the Company or any of its subsidiaries. Notwithstanding the foregoing, the Optionee shall not be deemed to have been terminated for cause unless and until there shall have been delivered to the Optionee a copy of a resolution (i) duly adopted by three-quarters (3/4) of the entire membership of the Compensation Committee of the Board of Directors, or of the Board of directors of the Company, at a meeting called and held for such purpose after reasonable notice to the Optionee and an opportunity for the Optionee, together with the Optionee's counsel, to be heard before such Committee or the Board of Directors of the Company, as the case may be, and (ii) finding that in the good faith opinion of such Committee or the Board of Directors of the Company, as the case may be, the Optionee was guilty of conduct described in the preceding sentence of this paragraph and specifying the particulars of such conduct in detail. 10. RETIREMENT OR DEATH OF OPTIONEE OR HOLDER OF STOCK APPRECIATION RIGHT In the event of the retirement of an Optionee pursuant to a retirement plan of the Company or one of its subsidiaries, as the case may be, the option and any stock appreciation right heretofore granted to him shall be exercisable during such period of time, not to exceed one (1) year after the date of such retirement with respect to incentive stock options, as defined in Section 422A(b) of the Internal Revenue Code of 1986, as amended, and not to exceed three (3) years after the date of such retirement with respect to all other stock options and stock appreciation rights, as the Compensation Committee shall specify in the option grant either at the time of grant or by amendment, but in no event after the expiration of the term of said option or any such stock appreciation right. In the event of the disability or death of an Optionee while in the employ of the Company or one of its subsidiaries, or during the post employment period referred to in the immediately preceding paragraph, the option hereto- fore granted to him shall be exercisable any time prior to the expiration of six (6) months after the date of such disability or death but in no event after the expiration of the term of said option. In the event of the disability or death of the holder of a stock appreciation right while in the employ of the Company or one of its subsidiaries, or during the post employment period referred to in the first paragraph of this Section 10, the stock appreciation right heretofore granted to him shall be exercisable any time prior to six (6) months after the date of such disability or death, but in no event after the expiration of the term of such stock appreciation right. Such option or stock appreciation right may only be exercised by the personal representative of such decedent or by the person or persons to whom such employee's rights under the option or stock appreciation right shall pass by such employee's Will or by the laws of Descent and Distribution of the state of such employee's domicile at the time of death, and then only as and to the extent that such employee was entitled to exercise the option or stock appreciation right on the date of death. 11. WRITTEN AGREEMENT Within a reasonable time after the date of grant of an option, an option and stock appreciation right or a stock appreciation right related to a previously granted option, a written agreement in a form approved by the Compensation Committee shall be duly executed and delivered to the Optionee. 12. ADJUSTMENT BY REASON OF RECAPITALIZATION, STOCK SPLITS STOCK DIVIDENDS, ETC. If, after the effective date of this Plan, there shall be any changes in the common stock structure of the Company by reason of the declaration of stock dividends, recapitalization resulting in stock split-ups, or combina- tions or exchanges of shares by reason of merger, consolidation, or by any other means, then the number of shares available for options and stock appreciation rights, the shares subject to any options and the number of shares available for and subject to stock appreciation rights shall be equitably and appropriately adjusted by the Board of Directors of the Company as in its sole and uncontrolled discretion shall seem just and reasonable in the light of all the circumstances pertaining thereto. 13. RIGHT TO TERMINATE EMPLOYMENT The plan shall not confer upon any employee any right with respect to being continued in the employ of the Company and its subsidiaries or interfere in any way with the right of the Company and its subsidiaries to terminate his employment at any time, nor shall it interfere in any way with the employee's right to terminate his employment. 14. WITHHOLDING AND OTHER TAXES The Company or one of its subsidiaries shall have the right to withhold from salary or otherwise or to cause an Optionee (or the executor or administrator of his estate or his distributee) to make payment of any Federal, State, local or foreign taxes required to be withheld with respect to any exercise of a stock option or a stock appreciation right. An Optionee may irrevocably elect to have the withholding tax obligation or, if the Compensation Committee so determines, any additional tax obligation with respect to any exercise of a stock option satisfied by (a) having the Company or one of its subsidiaries withhold shares otherwise deliverable to the Optionee with respect to the exercise of the stock option, or (b) delivering back to the Company shares received upon the exercise of the stock option or delivering other shares of common stock; that any such election shall be made either (i) during a "ten-day window period", or (ii) at least six months prior to the date income is recognized with respect to the exercise of a stock option. 15. AMENDMENT TO THE PLAN The Board of Directors shall have the right to amend, suspend or terminate the Plan at any time; provided, however, that no such action shall affect or in any way impair the rights of the holder of any option or stock appreciation right theretofore granted under the Plan; and provided further, that unless first duly approved by the common shareholders of the Company entitled to vote thereon at a meeting (which may be the annual meeting) duly called and held for such purpose, no amendment or change shall be made in the Plan (a) increasing the total number of shares which may be purchased or transferred upon exercise of options or stock appreciation rights under the Plan by all employees; (b) changing the minimum purchase price hereinbefore specified for the optioned shares; (c) changing the maximum option period; (d) increasing the amount that may be received upon exercise of a stock appreciation right; or (e) allowing a stock appreciation right to be exercised after the expiration date of the related option. 16. EFFECTIVE DATE OF THE PLAN The Plan shall be effective as of February 24, 1971. 17. SAVINGS CLAUSE Nothing included in this Plan by amendment shall revoke or alter the terms and provisions of the Plan as in effect prior to such amendment with respect to options granted under the Plan prior thereto. EXHIBIT 10 ---------- DIRECTOR'S PENSION PLAN Plan Provisions Effective Date January 1, 1994 Normal Retirement Date The first of the month following attainment of Age 65 Normal Annual Pension 100% of annual retainer fee (currently $26,000 per year) Termination Benefits After vesting an annuity payable for life starting at the later of age 65 or termination from the Board. Death Benefits None Preretirement Spouse's Death Benefits None Postretirement Spouse's Death Benefit None Disability Pension 50% of the Normal Annual Pension payable after 2 years of Credited Service. Increases by 10% per year for years of Credited Service over 5 years until it is 100% of the Normal Annual Pension. Credited Service does not accrue while on Disability. Early Retirement Benefit An unreduced accrued benefit is available upon attainment of age 65 and 5 years of Credited Service. Eligibility All Outside Members of the Board of Directors. An Outside Member is a board member who has never been employed by the Company or an affiliate of the Company. Credited Service One year of Credited Service is granted for each calender year in which a Board member is on the Board for at least four months and attends at least one Board Meeting. Benefit Accrual 10% of the Normal Retirement Benefit for each year of Credited Service. A maximum of 100% after 10 years. Vesting Vesting Service equals Credited Service. Benefits vest after 5 years of Vesting Service. Contributions None Forms of Payment Life Annuity only EXHIBIT 10 ---------- EXECUTIVE OFFICER'S RETIREMENT AGREEMENT July 19, 1993 Robert F. Singleton 8496 Old Cutler Road Coral Gables, FL. 33143 Dear Bob: This letter describes the conditions of your retirement agreement with Knight-Ridder, Inc. 1. Your current job, compensation and benefit arrangements will continue through September 30, 1993. 2. On September 30, 1993 you will retire as an officer and as a member of the Board Of Directors of Knight-Ridder, Inc. 3. Upon retirement, you will be paid for any accrued, but unused vacation time. You will also be paid a prorated bonus for 1993, based on the potential bonus, if any, you would have received had you not retired until the end of 1993. This bonus will be calculated on the basis of projected 1993 KRI performance computed on the basis of nine months actual, plus three months budget. 4. For a one-year period beginning October 1, 1993, you will serve as a consultant to the company, reporting to me, at an annual fee of $50,000. You will be available to Ross Jones the new CFO, and other officers of the company. You will continue to represent Knight-Ridder on the TKR Cable, TCI/TKR LP and Southeast Paper Manufacturing Company Management Committees during the period you serve Knight-Ridder as a consultant. 5. Effective October 1, 1993, you will receive an annual pension of $200,000 in the form of a 66 2/3% joint and survivor annuity (66 2/3% CA Option), comprising the following elements: SENN Plan $ 88,082 BRP Plan 41,105 Special Retirement Agreement 70,813 -------- Total Annual Benefit $200,000 ======== 6 Upon your retirement, you and your dependents will be covered under the Knight-Ridder medical and dental plans for retirees. Because you originally intended to retire under the medical plan for retirees that was effective prior to January 1, 1993, upon your retirement, you will be paid a one-time bonus of $86,806 representing the difference in present value costs to you of continuing coverage for you and your dependents under the new plan versus the old plan. 7. All normal travel and out-of pocket expenses incurred in carrying out your assignments for the company during the period October 1, 1993 through September 30, 1994, will be paid for by the company upon submission of expenses. 8. Outside directorships not in conflict with Knight-Ridder, Inc. will be cleared with me. 9. You may retain your personal computer and have free access to Dialog, Moneycenter and other agreed-upon KRI electronic services until March 20, 1995. Accepted by: Knight-Ridder, Inc. Robert F. Singleton James K. Batten - ----------------------- --------------------- Robert F. Singleton James K. Batten Date: July 19, 1993 Date: July 19, 1993 EXECUTIVE OFFICER'S CONSULTING/RETIREMENT AGREEMENT EXHIBIT 19 ---------- September 20, 1989 Mr. Alvah H. Chapman, Jr. 4255 Lake Road Miami, Florida 33137 Dear Alvah: This letter sets forth our agreement with respect to your services to Knight-Ridder following your retirement as an officer and employee of the Company on October 1st. You have agreed to continue to serve as a Director of the Company and as Chairman of its Executive Committee. I am also pleased that you have agreed to serve as a consultant to the company for the 12 months beginning October 1, 1989 and, thereafter, for such period as you, the Compensation Committee and I may agree. In consideration of your services as Chairman of the Executive Committee and as a consultant, the Company will pay you $150,000 annually. This agree- ment extends from October 1, 1989 through September 30, 1994. And as customary, you will be compensated as an outside director, including meeting fees for the Board and Board Committees (including the Executive Committee of the Company). We have calculated that you will be entitled to an aggregate annual pension benefit under the Knight-Ridder Retirement and Benefit Restoration Plans of $328,670. In addition, in recognition of your contribution to the Company and your future services to it, the Company has agreed to pay you an additional retirement benefit of $100,000 per year for your life, in equal monthly installments. Although I hope to be able to take full advantage of your broad range of experience and knowledge of the Company, it is understood between us that we will make only reasonable demands upon your time and will seek to schedule our requests for your counsel so as to accommodate your schedule of other activities in retirement. The specific matters on which we will need your help necessarily will change from time to time. I anticipate that you and I will talk at least quarterly about your then current list of consultative duties. At the outset we look forward to your continued participation in (a) our Detroit JOA undertaking and I hope you will be willing to serve on the DNA Management Committee for at least a year following implementation; (b) our ongoing shareholder relations projects (with particular attention to the founding families); and (c) the Miami property development project. I know that there will be a number of other key issues where your counsel will be invaluable. Our consulting relationship will preclude you from accepting consulting assignments and from other companies and from other profit-making activities, provided your other assignments and activities do not constitute a conflict of interest with Knight- Ridder. The Company will reimburse you, in accordance with its usual policies and procedures, for your travel and other out of pocket expenses incurred in connection with your Knight-Ridder consulting activities, your attending ANPA and other industry meetings as long as you are a Knight- Ridder director, and your activities as Chairman of the FIU Foundation, Vice Chairman of The Miami Coalition, and other civic activities which are of benefit to KRI over the next several years. In accordance with our historical practice, we will provide you as a former CEO of the Company with an office and a secretary as long as you want them. I am happy we will continue to work together. If I have accurately summarized our understanding, I'd appreciate your signing and returning the enclosed copy of this letter to me for the Company's files. Sincerely yours, Knight- Ridder, Inc. By: James K. Batten ----------------- J.K. Batten President & CEO Agreed: Alvah H. Chapman Jr. - -------------------- Alvah H. Chapman, Jr. (*The initial agreement was for one year and has been renewed annually through September 30, 1994). EXECUTIVE OFFICER'S RETIREMENT AGREEMENT EXHIBIT 19 (John C. Fontaine) ---------- AGREEMENT THIS AGREEMENT made and entered into as of the 1st day of January, 1992, by and between John C. Fontaine (hereinafter referred to as "Mr. Fontaine") and Knight-Ridder, Inc. (hereinafter referred to as "KRI") WITNESSETH THAT: WHEREAS Mr. Fontaine will work approximately nine-tenths (90%) of his time for KRI, commencing January 1, 1992; and, WHEREAS KRI desires to provide Mr. Fontaine with an adequate pension benefit for his services; 1. KRI will pay to Mr. Fontaine an amount, payable in monthly installments, under this Agreement which, together with benefits earned under the Retirement Plan for Employees of Knight-Ridder, Inc. Corporate Division (the "Plan") will equal $135,000 annually if Mr. Fontaine retires at age 62 or $200,000 annually if Mr. Fontaine retires at age 65. These amounts are given on a life-only basis; they may be converted to any of the optional forms of benefit available under the Plan using the same conversion factors which would apply under the Plan. 2. In the event that the employment relationship ends prior to attainment of age 62 by Mr. Fontaine other than (a) by reason of Mr. Fontaine's death or disability or (b) following a change in the control of the company, a pension benefit commencing at age 65 will be payable. The amount of the benefit will be calculated by multiplying $200,000 by the ratio of years and completed months of service since August 1, 1987 to 9 years 3 months. In the event of retirement at or after age 62, a pension determined in the same manner will be payable commencing immediately (except that the benefit payable at age 62 will be $135,000). See Exhibits I and II. Amounts payable under optional payment forms are shown in Exhibit III. 3. In the event Mr. Fontaine's employment terminates by reason of his disability or following a change in the control of the company, he will be 100% vested immediately in the benefits provided under paragraph 2 above for retirement at age 65. In the event of Mr. Fontaine's death while employed by KRI, there shall be paid to his surviving spouse for her life 50% of the amount which would otherwise be payable to him under this paragraph in the event of his disability; no beneficiary other than his surviving spouse shall be entitled to any death benefit under this Agreement. Benefit payments under this paragraph will commence on the first of the month following the occurrence of any of the above-mentioned circumstances. For purposes of this Agreement: (a) a "change in the control of the company" will be deemed to have occurred if the company is a party to a merger in which it is not the surviving entity or pursuant to which the company's common stock is converted into other property or securities; or upon the approval of the liquidation or dissolution of the company; or upon the sale of all or substantially all the company's assets; or upon the acquisition by any person or group of 35% of the company's outstanding stock; or upon a change within any 13- month period in the composition of a majority of the company's Board of Directors; and (b) "disability" shall mean a physical or mental condition which prevents Mr. Fontaine from fully performing the duties of Senior Vice President and General Counsel as agreed to by him and the company for a period of 90 consecutive days. 4. This Agreement does not give Mr. Fontaine the right to be retained in the employ of KRI. Effective January 1, 1992, this Agreement supersedes the agreement between Mr. Fontaine and KRI concerning pension benefits dated October 16, 1989. 5. This Agreement does not give Mr. Fontaine other rights or benefits provided under the Plan except as set forth in paragraphs 1, 2 and 3 above. 6. Neither this Agreement nor any benefits that may be payable under this Agreement are assignable by Mr. Fontaine. None of Mr. Fontaine's rights under this Agreement shall be subject to any encumbrance or to the claims of his creditors. 7. This Agreement shall be governed and construed in accordance with the laws of the State of Florida. 8. Nothing contained in this Agreement shall be deemed to require KRI to make any payment to Mr. Fontaine or to any other person contrary to applicable law. 9. IN WITNESS WHEREOF, the parties hereto have hereunto set their hands to duplicates this 19th day of December, 1991. JOHN C. FONTAINE John C. Fontaine ---------------- KNIGHT-RIDDER, INC. By James K. Batten ------------------ James K. Batten Chairman & CEO Exhibit 22 SUBSIDIARIES OF THE REGISTRANT ---------- State/Country of Incorporation --------------- KNIGHT-RIDDER, INC. Aberdeen News Company Delaware The Beacon Journal Publishing Company Ohio Boca Raton News, Inc. Florida Boulder Publishing, Inc. Colorado The Bradenton Herald, Inc. Florida Circom Corporation Pennsylvania Detroit Free Press, Incorporated Michigan Detroit Newspaper Agency Michigan(partnership) Drinnon, Inc. Georgia Grand Forks Herald, Incorporated Delaware Journal of Commerce, Inc. Delaware Keynoter Publishing Company, Inc. Florida KR Newsprint Company Florida Southeast Paper Manufacturing Co. Georgia (partnership) Knight News Services, Inc. Michigan Knight-Ridder Tribune News Services District of Columbia (partnership) The Knight Publishing Co. Delaware Knight-Ridder Business Information Services, Inc. Delaware Knight-Ridder Financial, Inc. Delaware Commodity News Services (International), Inc. Delaware Knight-Ridder Financial Holding AEA Company, Inc. Delaware Knight-Ridder Financial AEA, Inc. Delaware Knight-Ridder Financial JM, Inc. Delaware Knight-Ridder Financial Japan, Inc. Delaware Knight-Ridder Financial Iberica, S.A. Spain Equinet Pty Ltd. Australia Equinet Information (NZ), Ltd. New Zealand Dialog Information Services, Inc. California Dialog Information Europe, Inc. California D-S Marketing UK, Ltd. United Kingdom D-S Marketing, Inc. Pennsylvania D-S Marketing, SARL France D-S Marketing, GMBH Germany Radio-Suisse Marketing AB Sweden Knight-Ridder Nova AG Switzerland Radio-Suisse Ltd. Switzerland Knight-Ridder Cablevision, Inc. Florida KRC Sub, Inc. Delaware SCI Cable Partners Colorado (partnership) TKR Cable Company Colorado (partnership) Knight-Ridder Investment Company Delaware Seattle Times Company Delaware KR Video, Inc. Delaware Lexington Herald-Leader Co. Kentucky The Macon Telegraph Publishing Company Georgia The Miami Herald Publishing Company - News Publishing Company Indiana Fort Wayne Newspapers, Inc. Indiana Fort Wayne Newspaper Agency Indiana (partnership) Newspapers First Delaware Nittany Printing and Publishing Company Pennsylvania Northwest Publications, Inc. Delaware Duluth News-Tribune - Saint Paul Pioneer Press - The Observer Transportation Company North Carolina Philadelphia Newspapers, Inc. Pennsylvania Portage Graphics Co. Ohio Post-Tribune Publishing, Inc. Indiana PressLink Corporation Delaware The R.W. Page Corporation Georgia Ridder Publications, Inc. Delaware KR Land Holding Corporation Delaware San Jose Mercury News, Inc. California Silicon Valley D.A.T.A., Inc. California The State-Record Holding Company Delaware The State-Record Company, Inc. South Carolina Gulf Publishing Company, Inc. Mississippi Newberry Publishing Company, Inc. South Carolina Sun Publishing Company, Inc. South Carolina Tallahassee Democrat, Inc. Florida Tribune Newsprint Company Utah Ponderay Newsprint Company Washington (partnership) Twin Cities Newspaper Service, Inc. Minnesota Twin Coast Newspapers, Inc. New York Long Beach Press-Telegram - P.T. Sales and Marketing, Inc. California VU/TEXT Information Services, Inc. Florida Wichita Eagle and Beacon Publishing Company, Inc. Kansas Exhibit 24 ---------- CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in Registration Statement No. 33-11021 on Form S-3 dated December 22, 1986, in Registration Statement No. 33-28010 on Form S-3 dated April 7, 1989, in Registration Statement No. 33-31747 on Form S-8 dated October 30, 1989 and in Registration Statement No. 33-69206 on Form S-8 dated May 18, 1993, and in the related Prospectuses of our report dated February 1, 1994, with respect to the consolidated financial statements and schedules of Knight-Ridder, Inc. included in this Annual Report (Form 10-K) for the year ended December 26, 1993. ERNST & YOUNG March 22, 1994 Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Gonzalo F. Valdes- Fauli Date: March 22, 1994 - ---------------------------- -------------------- Gonzalo F. Valdes-Fauli Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Bernard H. Ridder, Jr. Date: March 22, 1994 - --------------------------- -------------------- Bernard H. Ridder, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Barbara Barnes Hauptfuhrer Date: March 22, 1994 - ------------------------------- -------------------- Barbara Barnes Hauptfuhrer Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Alvah H. Chapman, Jr. Date: March 22, 1994 - ------------------------ -------------------- Alvah H. Chapman, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Peter C. Goldmark, Jr. Date: March 22, 1994 - ------------------------- -------------------- Peter C. Goldmark, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. William S. Lee Date: March 22, 1994 - ------------------ -------------------- William S. Lee Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. John L. Weinberg Date: March 22, 1994 - -------------------- -------------------- John L. Weinberg Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Ben R. Morris Date: March 22, 1994 - ----------------- -------------------- Ben R. Morris Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Eric Ridder Date: March 22, 1994 - --------------- -------------------- Eric Ridder Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. James K. Batten Date: March 22, 1994 - ------------------- -------------------- James K. Batten Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Joan Ridder Challinor Date: March 22, 1994 - ------------------------- -------------------- Joan Ridder Challinor Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Jesse Hill, Jr. Date: March 22, 1993 - ------------------- -------------------- Jesse Hill, Jr. Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. C. Peter McColough Date: March 22, 1994 - ---------------------- -------------------- C. Peter McColough Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Thomas L. Phillips Date: March 22, 1994 - ----------------------- -------------------- Thomas L. Phillips Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. P. Anthony Ridder Date: March 22, 1994 - --------------------- -------------------- P. Anthony Ridder Exhibit 25 ---------- POWER OF ATTORNEY The undersigned member of the Board of Directors of Knight-Ridder, Inc. hereby constitutes and appoints John C. Fontaine, Ross Jones, and Tally C. Liu and each of them severally, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all Reports on Form 10-K (Annual Report pursuant to the Securities Exchange Act of 1934) and any amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Barbara Knight Toomey Date: March 22, 1994 - ------------------------- --------------------- Barbara Knight Toomey	32,583	206,260
92103_1993.txt	92103_1993	1993	92103	ITEM 1. BUSINESS Southern California Edison Company ("Edison") was incorporated under California law in 1909. Edison is a public utility primarily engaged in the business of supplying electric energy to a 50,000 square-mile area of central and southern California, excluding the City of Los Angeles and certain other cities. This area includes some 800 cities and communities and a population of nearly 11 million people. As of December 31, 1993, Edison had 16,487 full-time employees. During 1993, 37% of Edison's total operating revenue was derived from commercial customers, 36% from residential customers, 13% from industrial customers, 8% from public authorities, 4% from agricultural and other customers and 2% from resale customers. Edison comprises the major portion of the assets and revenues of SCEcorp, its parent holding company. REGULATION Edison's retail operations are subject to regulation by the California Public Utilities Commission ("CPUC"). The CPUC has the authority to regulate, among other things, retail rates, issuances of securities and accounting and depreciation practices. Edison's resale operations are subject to regulation by the Federal Energy Regulatory Commission ("FERC"). The FERC has the authority to regulate resale rates as well as other matters, including transmission service pricing, accounting and depreciation practices and licensing of hydroelectric projects. Edison is subject to the jurisdiction of the Nuclear Regulatory Commission ("NRC") with respect to its nuclear power plants. NRC regulations govern the granting of licenses for the construction and operation of nuclear power plants and subject those power plants to continuing review and regulation. The construction, planning and siting of Edison's power plants within California are subject to the jurisdiction of the California Energy Commission and the CPUC. Edison is subject to rules and regulations promulgated by the California Air Resources Board and local air pollution control districts with respect to the emission of pollutants into the atmosphere, the regulatory requirements of the California State Water Resources Control Board and regional boards with respect to the discharge of pollutants into waters of the state and the requirements of the California Department of Toxic Substances Control with respect to handling and disposal of hazardous materials and wastes. Edison is also subject to regulation by the U.S. Environmental Protection Agency ("EPA"), which administers certain federal statutes relating to environmental matters. Other federal, state and local laws and regulations relating to environmental protection, land use and water rights also impact Edison. The California Coastal Commission has continuing jurisdiction over the coastal permit for San Onofre Nuclear Generating Station ("San Onofre") Units 2 and 3. Although the units are operating, the permit remains open. This jurisdiction may continue for several years because it involves oversight on mitigation measures arising from the permit. The Department of Energy ("DOE") has regulatory authority over certain aspects of Edison's operations and business relating to energy conservation, solar energy development, power plant fuel use and disposal, coal conversion, public utility regulatory policy and natural gas pricing. RATE MATTERS CPUC Retail Ratemaking The rates for electricity provided by Edison to its retail customers comprise several major components established by the CPUC to compensate Edison for basic business and operational costs, fuel and purchased power costs, and the costs of adding major new facilities. Basic business and operational costs are recovered through base rates, which are determined in general rate case proceedings held before the CPUC every three years. During a general rate case, the CPUC critically reviews Edison's operations and general costs to provide service (excluding energy costs and, in certain instances, major plant additions). The CPUC then determines the revenue requirement to cover those costs, including items such as depreciation, taxes, cost of capital, operation, maintenance, and administrative and general expenses. The revenue requirement is forecasted on the basis of a specified test year. Following the revenue requirement phase of a general rate case, Edison and the CPUC proceed to a rate phase which allocates revenue requirements and establishes rate levels for customers. Base rates may be adjusted in the years between general rate case years through an attrition year allowance. The attrition year allowance is intended to allow Edison to recover, without lengthy hearings, specific uncontrollable cost changes in its base rate revenue requirement and thereby preserve Edison's opportunity to earn its authorized rate of return in the years that are not general rate case test years. In December 1993, Edison filed an application with the CPUC in which it proposed a performance-based ratemaking procedure for recovery of operation and maintenance ("O&M") expenses and capital-related costs. Such costs have traditionally been recovered through general rate cases, attrition proceedings, and cost of capital proceedings. Edison proposed that the CPUC authorize a base rate revenue indexing formula which would combine O&M and capital-related cost recovery. In addition, Edison proposed that the period between general rate cases be lengthened from three to six years. Cost of capital proceedings would occur only after significant changes in utility capital markets. Edison's fuel, purchased power and energy-related costs of providing electrical service are recovered through a balancing account mechanism called the Energy Cost Adjustment Clause ("ECAC"). Under the ECAC balancing account procedure, fuel, purchased power and energy-related revenues and costs are compared and the difference is recorded as either an undercollection or overcollection. The amount recorded in the balancing account is periodically amortized through rate changes which return overcollections to customers by reducing rates or collect undercollections from customers by increasing rates. The costs recorded in the ECAC balancing account are subject to review by the CPUC and allowed for rate recovery only to the extent they are found to be reasonable. Certain incentive provisions are included in the ECAC that can affect the amount of fuel and energy-related costs actually recovered. Edison is required to make an ECAC filing for each calendar year, and must also make a second filing for a mid-year adjustment if such filing would result in an ECAC rate change exceeding 5% of total annual revenue. For Edison's interest in the three units of the Palo Verde Nuclear Generating Station ("Palo Verde"), the CPUC authorized a 10-year rate phase-in plan which deferred $200,000,000 of investment-related revenue during the first four years of operations for each of the three units, commencing on their respective commercial operation dates. Revenue deferred for each unit under the plan for years one through four was $80,000,000, $60,000,000, $40,000,000 and $20,000,000, respectively. The deferrals and related interest are being recovered over the final six years of each unit's phase-in plan. The CPUC has also adopted a nuclear unit incentive procedure which provides for a sharing of additional energy costs or savings between Edison and its ratepayers when operation of any of the units of San Onofre or Palo Verde is outside a specified target capacity factor ("TCF") range. For San Onofre Units 2 and 3, and Palo Verde Units 1, 2 and 3 the TCF range is 55% to 80% of their rated capacity. The Electric Revenue Adjustment Mechanism ("ERAM") reflects the difference between the recorded level of base rate revenue and the authorized level of base rate revenue. This mechanism has been adopted by the CPUC primarily to minimize the effect on earnings of fluctuations in retail kilowatt-hour sales. General Rate Case ("GRC") In December 1991, the CPUC issued a decision on the revenue requirement phase of Edison's 1992 test year GRC application. The CPUC authorized a $72,000,000 or 1% increase in Edison's base rate revenues, effective January 20, 1992. The decision did not adopt Edison's request to capitalize, rather than expense, computer software development and research, development and demonstration ("RD&D") expenditures, but did allow Edison to file additional information regarding such capitalization. In April 1992, Edison filed supplemental testimony supporting its request to capitalize application software development costs, and proposed to decrease its authorized level of base rate revenues ("ALBRR") by $53,000,000 in 1993 and 1994. Edison and the CPUC's Division of Ratepayer Advocates ("DRA") entered into a settlement agreement to allow rate recovery of capitalized software expenditures in which Edison agreed to an additional $32,000,000 base rate revenue decrease. The CPUC approved the settlement agreement in November 1992, and authorized a $48,900,000 decrease to Edison's ALBRR effective January 1, 1993. The related base rate revenue decrease was included in Edison's January 15, 1993, consolidated revenue change. The CPUC also authorized a $12,900,000 increase to Edison's ALBRR effective January 1, 1994. The related base rate revenue increase was included in Edison's January 24, 1994, consolidated revenue change. In September 1992, Edison filed supplemental testimony supporting its request to capitalize RD&D expenditures. In the additional filing, Edison proposed to capitalize approximately $9,000,000 in RD&D project expenditures. The DRA's supplemental testimony alleged that Edison did not comply with a CPUC order regarding joint remote meter reading and recommended a $10,000,000 penalty for non-compliance. Additionally, the DRA proposed to disallow approximately $4,500,000 of capital costs associated with Edison's research on off-grid generation technology. The CPUC's decision is expected by the end of 1994. In December 1992, the CPUC approved an ALBRR increase of $110,000,000, effective January 1, 1993, for the 1993 attrition year allowance. The related base rate revenue increase was included in Edison's January 15, 1993 consolidated revenue change. In April 1993, the CPUC modified its decision (pursuant to a petition by Edison), and approved an ALBRR increase of $10,400,000 effective April 28, 1993. The related base rate revenue increase was included in Edison's January 24, 1994, consolidated revenue change. In December 1993, the CPUC approved an ALBRR increase of $97,200,000 effective January 1, 1994, for: (1) the 1994 attrition year allowance; (2) increased federal income taxes pursuant to the Revenue Reconciliation Act of 1993; and, (3) reduction in Edison's California property tax liability resulting from a settlement agreement with the California State Board of Equalization. Each year, the CPUC reviews the components of the cost of capital for all the California energy utilities in a generic cost of capital proceeding. On December 3, 1993, the CPUC issued a final decision resulting in a $108,000,000 reduction to Edison's ALBRR effective January 1, 1994. The decision also resulted in a reduction of Edison's overall rate of return from 9.94% to 9.17%, a reduction in return on common equity from 11.80% to 11.00%, and an increase to Edison's common equity capital ratio from 46.00% to 47.25% effective January 1, 1994. The related base rate revenue decrease was included in Edison's January 24, 1994, consolidated revenue change. In December 1993, Edison filed with the CPUC its 1995 GRC application. In its application, Edison requested an increase to the ALBRR of $117,000,000 above the expected year-end 1994 ALBRR level to become effective January 1, 1995. On March 14, 1994, the DRA issued a report which, based on Edison's preliminary review, recommended a $269,000,000 reduction to Edison's expected year-end 1994 authorized level of base rate revenue. Evidentiary hearings are expected to commence in April 1994, with a final CPUC decision anticipated in December 1994. In January 1994, the CPUC approved an ALBRR increase of $8,800,000 effective January 24, 1994, for base rate recovery of the permanent component of Edison's fuel oil inventory. The related base rate revenue increase was included in Edison's January 24, 1994, consolidated revenue change. In November 1993, the CPUC approved an ALBRR increase of: (1) $64,400,000 effective December 31, 1993; and (2) $63,100,000 effective January 1, 1994, to reflect cost recovery of employee post-retirement benefits other than pensions ("PBOP"). In addition, the CPUC approved an ALBRR reduction of $39,500,000 effective December 30, 1993, to reflect the removal of costs associated with Edison's 1992 PBOP contributions. The related base rate revenue reduction associated with the PBOP ALBRR changes was included in Edison's January 24, 1994, consolidated revenue change, less $16,000,000 of rate recovery deferred until 1995. Energy Cost Adjustment Clause In January 1992, the DRA issued a report on the reasonableness of Edison's non-standard, non-affiliate qualifying facilities ("QF") power purchase contracts included in Edison's 1989 and 1990 annual ECAC applications. With respect to both ECAC periods, the DRA asserted that Edison had incorrectly calculated firm capacity payments and bonus capacity payments to QFs by including certain energy deliveries which the DRA contended should be excluded or "truncated" from the calculation. The DRA recommended disallowances of $2,500,000, for the 1989 record period and $4,800,000 for the 1990 record period. On April 26, 1993, the DRA withdrew its January 1992 testimony pursuant to an Edison-DRA agreement to jointly petition the CPUC for clarification of the CPUC's intent regarding truncation and two other QF contract administration issues. Edison and the DRA filed their joint petition on April 23, 1993. On November 2, 1993, the CPUC voted to dismiss the joint petition on the basis that the issues presented were complex and could be developed more appropriately in an ECAC proceeding or through direct negotiations among the affected parties. Pursuant to the Edison-DRA agreement, a dismissal on this basis permits the DRA to renew its challenge to Edison's truncation practice beginning with the 1991 ECAC record period and thereafter in each subsequent ECAC record period. To date, the DRA has not recommended further disallowances attributable to the truncation issue. In March 1992, Edison and the DRA settled disputes relating to Edison's power purchases from the 13 non- utility generation facilities partially owned by Mission Energy. Pursuant to the settlements, Edison agreed not to enter into new power-purchase contracts with Mission Energy and to a one-time disallowance. On March 10, 1993, the CPUC issued a decision approving the settlement and authorizing a ratepayer refund of $250,000,000 over a two-year period beginning January 1, 1994. The decision also ordered an immediate adjustment to Edison's ECAC balancing account with interest accruing until the rate reduction takes effect. The $250,000,000 disallowance is fully reflected in Edison's financial statements. In October 1993, the DRA issued its report on QF reasonableness issues for the ECAC record period April 1990 through March 1991. In its report, the DRA recommended that the CPUC disallow $1,574,000 in power purchase expenses incurred as a result of purchases during the record period under a QF contract with Mojave Cogeneration Company, a nonutility generator. In its report, the DRA also alleged that in 1990 and 1991 Edison imprudently renegotiated Mojave Cogeneration Company's contract with Edison, resulting in higher ratepayer costs. The DRA further alleged that ratepayers may be harmed in the amount of $31,600,000 (present value) over the contract's twenty-year life. The DRA found the execution of five other QF contracts to be reasonable. Hearings will likely be held no earlier than the second half of 1994. The DRA issued four reports addressing Edison's non-QF reasonableness showing for the April 1, 1991 through March 31, 1992 period. The DRA recommended: 1) a disallowance of $2,205,000 of replacement power costs associated with extended outage duration or reduced power production at Edison's nuclear units, which was allegedly caused by human error; and 2) a reduction of $1,203,000 to Edison's proposed TCF reward for San Onofre Unit 3, based on excluding generation above the unit capacity rating. A January 25, 1994 ALJ proposed decision found three nuclear plant outages unreasonable, resulting in a potential $1,600,000 disallowance, but rejected the DRA's recommendations for reducing Edison's TCF reward. Edison filed comments on the proposed decision on February 14, 1994. The final CPUC decision is expected in March 1994. On May 28, 1993, Edison requested a $152,000,000 annual rate increase for service beginning January 1, 1994, for changes to the Energy Cost Adjustment Billing Factor, Electric Revenue Adjustment Balancing Accounts ("ERABF"), Low Income Surcharge and base rate levels. Edison also made a rate stabilization proposal which defers recovery of approximately $200,000,000 of 1994 fuel and purchased-power expenses until 1995. In July 1993, Edison updated its ECAC request to a $181,000,000 increase. The DRA proposed a $105,000,000 increase. In October 1993, Edison and the DRA stipulated to a proposed $164,688,000 ECAC revenue increase subject to adjustment for incorporating Edison's forecast December 31, 1993 balance in the ECAC, Low Income Ratepayer Assistance, and ERABF to reflect more recent recorded data. On January 19, 1994, the CPUC issued its decision which adopted a revenue increase of $274,600,000. When this revenue change is combined with other revenue changes which occurred on or before January 1, 1994, the total combined revenue change is $232,101,000. On May 28, 1993, Edison filed the non-QF portion of its Reasonableness of Operations Report, which included power purchases and exchanges and the operation of its hydro, coal, gas and nuclear resources for the period April 1, 1992 through March 31, 1993. In February 1994, the DRA recommended: (1) a $7,200,000 disallowance relating to fuel oil inventory management; and (2) a $5,000,000 disallowance for transmission loss revenues. Hearings on this matter are scheduled for October 1994. Edison filed its QF Reasonableness of Operations Report on September 1, 1993. It is presently unknown when the DRA will file testimony in the QF reasonableness phase. Palo Verde Outage Review In March 1989, Palo Verde Units 1 and 3 experienced automatic shutdowns. Since the resultant outages overlapped previously scheduled refueling outages, normal refueling, maintenance, inspection, surveillance, modification and testing activities were conducted at the units, as well as modifications to the plants required by the NRC. Unit 3 was restored to service on December 30, 1989, and Unit 1 was restored to service on July 5, 1990. In December 1989, the CPUC instituted an investigation into the outages pursuant to the California Public Utilities Code ("Code"). The Code requires the CPUC to institute an investigation when any portion of a utility's generating facilities has been out of service for nine consecutive months. The CPUC order required that the subsequent collection of rates associated with Palo Verde Units 1 and 3 be subject to refund pending review of the outages. In November 1991, the DRA issued a report recommending disallowances totaling more than $160,000,000 including a $63,000,000 disallowance for revenue collected during the outages (including interest). In September 1993, Edison and the DRA agreed to settle these disputes for $38,000,000 (including $29,000,000 for replacement power costs, $2,000,000 for capital projects and approximately $7,000,000 for interest), subject to CPUC approval. The settlement resolves all issues related to the 1989-1990 outages at Palo Verde. The effect of the settlement has been fully reflected in the financial statements. Edison expects a CPUC decision regarding the settlement in mid-1994. Mohave Order Instituting Investigation ("OII") In April 1986, the CPUC began investigating the 1985 rupture of a high pressure steam pipe at the Mohave Generating Station ("Mohave"). Edison is the plant operator and 56% owner. The CPUC's OII reviewed Edison's share of repair costs and replacement fuel and energy related costs associated with the outage. Edison incurred costs of approximately $90,000,000 (including interest) to repair damage from the accident and provide replacement power during the six-month outage. This total is net of Edison's recovery of expenses from the settlement of lawsuits with contractors and insurance. In May 1991, the DRA and its consultant issued reports alleging that Edison imprudently operated the Mohave plant and therefore contributed to the accident. As a result, the DRA recommended that all expenses incurred because of the accident be disallowed in rates. The DRA did not quantify its proposed disallowance. Edison believes that metallurgical and physical characteristics of a weld reduced the otherwise expected pipe life to the point of failure after 15 years of service. Edison filed testimony contesting the allegations in May 1992, in December 1992, and on March 1, 1993. In March 1994, the CPUC issued a decision finding that Edison acted unreasonably in failing to implement an inspection program. The CPUC decision ordered a second phase of this proceeding to quantify the disallowance. High Voltage Direct Current Expansion Project ("HVDCEP") The HVDCEP began operation in 1989. In October 1989, Edison filed a report with the CPUC requesting recovery of $72,600,000 in project costs. Subsequently, Edison and the DRA agreed on an accounting adjustment of $150,000, and a settlement agreement was filed. A February 3, 1993 CPUC decision upheld the settlement agreement allowing Edison recovery in rates of approximately $72,450,000. In its 1995 GRC, Edison is requesting rate recovery of an additional $7,000,000 associated with completion items and other HVDCEP related expenditures. The total amount of rate recovery for the HVDCEP that Edison will be allowed remains subject to further adjustment pending a final determination of the cost-effectiveness of the project in comparison with the power exchange agreement between Edison and the Los Angeles Department of Water and Power. FERC Resale Ratemaking Edison sells electricity to public power utilities (the cities of Anaheim, Azusa, Banning, Colton, Riverside and Vernon), Southern California Water Company and Arizona Public Service Company ("APS") under rates subject to FERC jurisdiction. In accordance with FERC procedures, resale rates are subject to refund with interest if subsequently disallowed. Edison believes any refunds from pending rate proceedings, would not materially affect its results of operations or financial position. FUEL SUPPLY Fuel and purchased-power costs amounted to approximately $3.29 billion in 1993, a 7% increase over 1992. Sources of energy and unit costs of fuel for 1989 through 1993 were as follows: _______________ (1) British Thermal Unit ("BTU") is the standard unit of measure for the heat content of fuels. One BTU is the amount of heat required to raise the temperature of one pound of water, at 39.1 degrees Fahrenheit, by one degree Fahrenheit. (2) There are no fuel costs associated with these categories. Indicates a source of less than 1% Average fuel costs, expressed in cents per kilowatt-hour, for the year ended December 31, 1993, were: oil, 7.996 cents; natural gas, 2.930 cents; nuclear, 0.537 cents; and coal, 1.226 cents. Natural Gas Supply Twelve of Edison's major steam electric generating units are designed to burn oil or natural gas as a primary boiler fuel. In 1990, Edison adopted an all-gas strategy to comply with air quality goals by eliminating burning oil in all but very extreme conditions. In August 1991, the CPUC adopted regulations which made Edison fully responsible for all gas procurement activities previously performed by local distribution companies for natural gas. To implement its all-gas strategy, Edison acquired a balanced portfolio of gas supply and transportation arrangements. Traditionally, natural gas needs in southern California were met from gas production in the southwest region of the country. To diversify its gas supply, Edison entered into four 15-year natural gas supply agreements with major producers in western Canada. These contracts, totaling 200,000,000 cubic feet per day, have market-sensitive pricing arrangements. This represents about 40% of Edison's current average annual supply needs. The rest of Edison's gas supply is acquired under short-term contracts from West Texas, New Mexico, and the Rocky Mountain region. Firm transportation arrangements provide the necessary long-term reliability for supply deliverability. To transport Canadian supplies, Edison contracted for 200,000,000 cubic feet per day of firm transportation arrangements on the Pacific Gas Transmission and Pacific Gas & Electric Expansion Project connecting southern California to the low-cost gas producing regions of western Canada. Edison has a 30-year commitment to this project, construction of which was completed in late 1993. In addition, Edison has a 15-year commitment to 200,000,000 cubic feet per day of firm transportation rights on El Paso Natural Gas' pipeline to transport Southwest U.S. gas supplies. Nuclear Fuel Supply Edison has contractual arrangements covering 100% of the projected nuclear fuel cycle requirements for San Onofre through the years indicated below: _______________ (1) Assumes the San Onofre participants meet their supply obligations in a timely manner. (2) Assumes full utilization of expanded on-site storage capacity and normal operation of the units, including interpool transfers and maintaining full-core reserve. To supplement existing spent fuel storage, a contingency plan is being developed to construct additional on-site storage capacity with initial operation scheduled for no later than 2002. The Nuclear Waste Policy Act of 1982 requires that the DOE provide for the disposal of utility spent nuclear fuel beginning in 1998. The DOE has stated that it is unlikely that it will be able to start accepting spent nuclear fuel at its permanent repository before 2010. Participants in Palo Verde have purchased uranium concentrates sufficient to meet projected requirements through 1997. Independent of arrangements made by other participants, Edison will furnish its share of uranium concentrates requirements through at least 1995 from existing contracts. Contracts to provide conversion services cover requirements through 1994. Enrichment and fabrication contracts will meet Palo Verde requirements through 1995 and 1997, respectively. Palo Verde on-site expanded spent fuel storage capacity will accommodate needs through 2005 for Units 1 and 2 and 2006 for Unit 3, while maintaining full-core reserve. ENVIRONMENTAL MATTERS Legislative and regulatory activities in the areas of air and water pollution, waste management, hazardous chemical use, noise abatement, land use, aesthetics and nuclear control continue to result in the imposition of numerous restrictions on Edison's operation of existing facilities, on the timing, cost, location, design, construction and operation by Edison of new facilities required to meet its future load requirements, and on the cost of mitigating the effect of past operations on the environment. These activities substantially affect future planning and will continue to require modifications of Edison's existing facilities and operating procedures. Edison is unable to predict the extent to which additional regulations may affect its operations and capital expenditure requirements. The Clean Air Act provides the statutory framework to implement a program for achieving national ambient air quality standards and provides for maintenance of air quality in areas exceeding such standards. The Clean Air Act was amended in 1990, giving the South Coast Air Quality Management District ("SCAQMD") 20 years to achieve all the federal air quality standards. The SCAQMD's Air Quality Management Plan ("AQMP"), adopted in 1991, demonstrates a commitment to attain federal air quality standards within 20 years. Consistent with the requirements of the AQMP and the Clean Air Act Amendments of 1990 ("CAAA"), the SCAQMD adopted rules to reduce emissions of oxides of nitrogen ("NOx") from combustion turbines, internal combustion engines, industrial coolers and utility boilers. On October 15, 1993, the SCAQMD adopted the Regional Clean Air Incentives Market ("RECLAIM") which replaces most of the previous rule requirements with a market mechanism for NOx emission trading (trading credits). RECLAIM will, however, still require Edison to reduce NOx emissions through retrofit or purchase of trading credits on all basin generation by over 86% by 2003. In Ventura County, a NOx rule was adopted requiring more than an 88% NOx reduction by June 1996 at all utility boilers. Edison's expected total cost to meet these requirements is approximately $330,000,000 of capital expenditures. The CAAA do not require any significant additional emissions control expenditures that are identifiable at this time. The amendments call for a five-year study of the sources and causes of regional haze in the southwestern U.S. The extent to which this study may require sulfur dioxide emissions reductions at the Mohave plant is not known. The acid rain provisions of the amended Clean Air Act also put an annual limit on sulfur dioxide emissions allowed from power plants. Edison will receive more sulfur dioxide allowances than it requires for its projected operations. The CAAA also require the EPA to carry out a three-year study of risk to public health from emissions of toxic air contaminants from power plants, and to regulate such emissions only if required. As a result of a petition by Mohave County in the State of Arizona, the Nevada Department of Environmental Protection ("NDEP") studied the impact of the plume from the Mohave plant on the Mohave area air quality. The regulatory outcome requires Edison to meet a new lower opacity limit in early 1994. The NDEP will review the opacity limit again in 1995 in conjunction with an ongoing tracer study being conducted by the EPA and evaluate potential impacts on visibility in the Grand Canyon from sulfur dioxide emissions. Until more definitive information on tracer study results are available, Edison expects to meet all the present regulations through improved operations at the plant. Regulations under the Clean Water Act require permits for the discharge of certain pollutants into waters of the United States. Under this act, the EPA issues effluent limitation guidelines, pretreatment standards and new source performance standards for the control of certain pollutants. Individual states may impose even more stringent limitations. In order to comply with guidelines and standards applicable to steam electric power plants, Edison incurs additional expenses and capital expenditures. Edison presently has discharge permits for all applicable facilities. The Safe Drinking Water and Toxic Enforcement Act prohibits the exposure to individuals of chemicals known to the State of California to cause cancer or reproductive harm and the discharge of such listed chemicals into potential sources of drinking water. Additional chemicals are continuously being put on the state's list, requiring constant monitoring by Edison. The State of California has adopted a policy discouraging the use of fresh water for plant cooling purposes at inland locations. Such a policy, when taken in conjunction with existing federal and state water quality regulations and coastal zone land use restrictions, could substantially increase the difficulty of siting new generating plants anywhere in California. Edison has identified 42 sites for which it is, or may be, responsible for remediation under environmental laws. Edison is participating in investigations and cleanups at a number of these sites and has recorded a $60,000,000 liability for its estimated minimum costs to clean up several sites. Additional costs may be incurred as progress is made in determining the magnitude of required remedial actions, as Edison's share of these costs in proportion to other responsible parties is determined and as additional investigations and cleanups are performed. The CPUC currently allows rate recovery of environmental-cleanup costs, subject to reasonableness reviews. Edison filed for a reasonableness review of costs incurred through 1991 at two hazardous substance sites. Hearings have been delayed due to a 1992 CPUC decision involving another California utility, which concluded that the current procedure may not be appropriate for these costs and requested interested parties to recommend alternatives. In November 1993, the major California utilities, the DRA and others filed a collaborative report recommending an incentive mechanism, which would require shareholders to fund 10% of cleanup costs. Shareholders would have the opportunity to recover these costs through insurance. Accordingly, Edison has recorded a regulatory asset which represents 90% of the estimated cleanup costs for sites covered by this proposed mechanism. The remaining sites' cleanup costs are expected to be immaterial and would be recovered through base rates. If approved by the CPUC, Edison would be allowed to recover 90% of cleanup costs incurred to date under the reasonableness review procedure ($11,000,000). A March 11, 1994 proposed decision issued by a CPUC ALJ accepted the collaborative report's recommendation. A final CPUC decision is expected in early 1994. Twenty of the 42 sites identified are former manufactured gas plant sites. Edison's cleanup responsibility for these sites is based on Edison's, or a predecessor company's, ownership or operation of the plants. These gas plants were operated for the production of gas prior to the widespread availability of natural gas. The EPA and the California Department of Toxic Substances Control have determined that specified constituents of the gas plant by-products are hazardous substances or hazardous wastes, and may require removal or other remedial action. The Resource Conservation and Recovery Act ("RCRA") provides the statutory authority for the EPA to implement a regulatory program for the safe treatment, recycling, storage and disposal of solid and hazardous wastes. There is an unresolved issue regarding the degree to which coal wastes should be regulated under RCRA. Increased regulation may result in an increase in expenses related to the operation of Mohave. The Toxic Substance Control Act and accompanying regulations govern the manufacturing, processing, distribution in commerce, use and disposal of polychlorinated biphenyls, a toxic substance used in certain electrical equipment ("PCB waste"). Current costs for disposal of PCB waste are immaterial. Edison's capitalized expenditures for environmental protection for the years 1969 through 1993 and its currently estimated capital expenditures for such purpose for the years 1994 through 1998 are as follows: These estimates include budgeted and forecasted plant expenditures responsive to currently effective legislation. Projected capital expenditures for environmental protection are subject to continuous review and periodic revisions because of escalation in engineering and construction costs, additions and deletions of planned facilities, changes in technology, evolving environmental regulatory requirements and other factors beyond Edison's control. Edison believes that costs incurred for these environmental purposes will be recognized by the CPUC and the FERC as reasonable and necessary costs of service for rate recovery purposes. ITEM 2. ITEM 2. PROPERTIES EXISTING GENERATING FACILITIES Edison owns and operates 12 oil- and gas-fueled electric generating plants, one diesel-fueled generating plant, 38 hydroelectric plants and an undivided 75.05% interest (1,614 MW net) in Units 2 and 3 at San Onofre. These plants are located in central and southern California. Palo Verde (15.8% Edison-owned, 579 MW net) is located near Phoenix, Arizona. Palo Verde Units 1, 2 and 3 started commercial operation on February 1, 1986, September 19, 1986, and January 20, 1988, respectively. Edison owns a 48% undivided interest (754 MW) in Units 4 and 5 at the Four Corners Generating Station ("Four Corners Project"), a coal-fueled steam electric generating plant in New Mexico. Palo Verde and the Four Corners Project are operated by other utilities. Edison operates and owns a 56% undivided interest (885 MW) in Mohave, which consists of two coal-fueled steam electric generating units in Clark County, Nevada. Edison receives an entitlement of 277 MW from the DOE's Hoover Dam Hydroelectric Project. At year-end 1993, the existing Edison-owned generating capacity (summer effective rating) was comprised of approximately 67% gas, 14% nuclear, 11% coal and 8% hydroelectric. San Onofre, the Four Corners Project, certain of Edison's substations and portions of its transmission, distribution and communication systems are located on lands of the United States or others under (with minor exceptions) licenses, permits, easements or leases or on public streets or highways pursuant to franchises. Certain of such documents obligate Edison, under specified circumstances and at its expense, to relocate transmission, distribution and communication facilities located on lands owned or controlled by federal, state or local governments. With certain exceptions, major and certain minor hydroelectric projects with related reservoirs, currently having an effective operating capacity of 1,154 MW and located in whole or in part on lands of the United States, are owned and operated by Edison under governmental licenses which expire at various times between 1994 and 2022. Such licenses impose numerous restrictions and obligations on Edison, including the right of the United States to acquire the project upon payment of specified compensation. When existing licenses expire, FERC has the authority to issue new licenses to third parties, but only if their license application is superior to Edison's and then only upon payment of specified compensation to Edison. Any new licenses issued to Edison are expected to be issued under terms and conditions less favorable than those of the expired licenses. Edison's applications for the relicensing of certain hydroelectric projects referred to above with an aggregate effective operating capacity of 89.0 MW are pending. Annual licenses issued for all Edison projects, whose licenses have expired and are undergoing relicensing, will be renewed until the new licenses are issued. In 1993, Edison's peak demand was 16,475 MW, set on September 9, 1993. The 1993 peak was 1,938 MW less than Edison's record peak demand of 18,413 MW that occurred on August 17, 1992. Total area system operating capacity of 20,606 MW was available to Edison at the time of the 1993 record peak. Substantially all of Edison's properties are subject to the lien of a trust indenture securing First and Refunding Mortgage Bonds ("Trust Indenture"), of which approximately $3.5 billion principal amount was outstanding at December 31, 1993. Such lien and Edison's title to its properties are subject to the terms of franchises, licenses, easements, leases, permits, contracts and other instruments under which properties are held or operated, certain statutes and governmental regulations, liens for taxes and assessments, and liens of the trustees under the Trust Indenture. In addition, such lien and Edison's title to its properties are subject to certain other liens, prior rights and other encumbrances, none of which, with minor or unsubstantial exceptions, affects Edison's right to use such properties in its business, unless the matters with respect to Edison's interest in the Four Corners Project and the related easement and lease referred to below may be so considered. Edison's rights in the Four Corners Project, which is located on land of The Navajo Tribe of Indians under an easement from the United States and a lease from The Navajo Tribe, may be subject to possible defects. These defects include possible conflicting grants or encumbrances not ascertainable because of the absence of, or inadequacies in, the applicable recording law and the record systems of the Bureau of Indian Affairs and The Navajo Tribe, the possible inability of Edison to resort to legal process to enforce its rights against The Navajo Tribe without Congressional consent, possible impairment or termination under certain circumstances of the easement and lease by The Navajo Tribe, Congress or the Secretary of the Interior and the possible invalidity of the Trust Indenture lien against Edison's interest in the easement, lease and improvements on the Four Corners Project. EL PASO ELECTRIC COMPANY ("EL PASO") BANKRUPTCY El Paso owns and leases a combined 15.8% interest in Palo Verde and owns a 7% interest in Units 4 and 5 of the Four Corners Project. In January 1992, El Paso filed a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Western District of Texas. Pursuant to an agreement among the Palo Verde participants and an agreement among the participants in Four Corners Units 4 and 5, each participant is required to fund its proportionate share of operation and maintenance, capital and fuel costs of Palo Verde and Four Corners Units 4 and 5, respectively. The participation agreements provide that if a participant fails to meet its payment obligation, each non-defaulting participant must pay its proportionate share of the payments owed by the defaulting participant. In February 1992, the bankruptcy court approved a stipulation between El Paso and APS, as the operating agent of Palo Verde, pursuant to which El Paso agreed to pay its proportionate share of all Palo Verde invoices delivered to El Paso after February 6, 1992. El Paso agreed to make these payments until such time, if ever, the bankruptcy court orders El Paso's rejection of the participation agreement governing the relations among the Palo Verde participants. The stipulation also specifies that approximately $9,200,000 of El Paso's Palo Verde payment obligations invoiced prior to February 7, 1992, are to be considered "pre- petition" general unsecured claims of the other Palo Verde participants. On August 27, 1993, El Paso filed with the bankruptcy court an Amended Plan of Reorganization and Disclosure Statement ("Amended Plan"). The Amended Plan, which is subject to numerous conditions, proposes a reorganization pursuant to which El Paso will become a wholly-owned subsidiary of Central and South West Corporation. The Amended Plan also proposes, among other things, (i) rejection of the El Paso leases and reacquisition by El Paso of the Palo Verde interests represented by the leases, and (ii) El Paso's assumption of the Four Corners Operating Agreement and the Arizona Nuclear Power Project Participation Agreement. On November 19, 1993, the bankruptcy court approved a Cure and Assumption Agreement among El Paso and the Palo Verde Participants, in which El Paso shall (i) assume the Participation Agreement on the date the Amended Plan becomes effective, and (ii) cure its pre-petition default on the date the court approves the Order Confirming El Paso's Amended Plan. On December 8, 1993, the bankruptcy court confirmed El Paso's Amended Plan. Effectiveness of the Amended Plan is still subject to approval by numerous state and federal agencies. El Paso estimates that it will take about 18 months to obtain all necessary regulatory approvals. CONSTRUCTION PROGRAM AND CAPITAL EXPENDITURES In April 1992, the CPUC decided how Edison and other California utilities will meet their resource needs through 2002. The CPUC ruled that Edison must obtain 624 MW of new generation through competitive bidding. The decision required that 175 MW be reserved for renewables, such as wind, hydro and geothermal. The competitive bid solicitation was issued in August 1993 and suspended in December 1993 due to the discovery of a bidding anomaly that raised prices above those allowed by the rules of the solicitation. After the suspension, Edison requested the solicitation be cancelled because current forecasts show that Edison has no need for additional generating capacity until at least 2005. From the solicitation results, Edison has estimated that the cost of these resources would be approximately $530,000,000 (present value in 1997 dollars). However, two events have occurred that should reduce Edison's cost exposure resulting from power purchases under this CPUC mandated process. First, on March 15, 1994, Edison and Kenetech Corporation, a potential winning bidder in Edison's solicitation, signed a memorandum of understanding for a wind resource power purchase. Contingent upon CPUC approval, Kenetech, under this proposed agreement, will provide lower cost resources than those potentially awarded through Edison's solicitation. Second, on March 16, 1994, the CPUC issued an interim decision that reduces Edison's solicitation by 25% and gives Edison authority to eliminate the added costs from the bidding anomaly. Although Edison will likely continue to request cancellation of the competitive solicitation, these two events reduce Edison's exposure. The exact amount of this reduction cannot be estimated until the methodology the CPUC intends for implementation of these changes is known. Cash required by Edison for its capital expenditures totaled $1,040,000,000 in 1993, $787,000,000 in 1992 and $964,000,000 in 1991. Construction expenditures for the 1994-1998 period are estimated as follows: Edison's construction program and related expenditures are continuously reviewed and periodically revised because of changes in estimated system load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of environmental, siting and other regulatory approvals, the scope of modifications required by regulatory agencies, the availability and costs of external sources of capital, the development of new technology and other factors beyond Edison's control. Since the completion of San Onofre Units 2 and 3 and Palo Verde Units 1, 2 and 3, construction work in progress has been significantly reduced. The reduction in construction work in progress caused allowance for funds used during construction ("AFUDC"), which does not represent current cash income, to decline accordingly. Pre-tax AFUDC represented 5.7% of earnings for 1993. In addition to cash required for construction expenditures for the next five years as discussed above, $1.3 billion is needed to meet requirements for long-term debt maturities, and sinking fund redemption requirements. The majority of these capital requirements are expected to be met by internally generated sources. Edison's estimates of cash available for operations for the five years through 1998 assume, among other things, the receipt of adequate and timely rate relief and the realization of its assumptions regarding cost increases, including the cost of capital. Edison's estimates and underlying assumptions are subject to continuous review and periodic revision. The timing, type and amount of all additional long-term financing are also influenced by market conditions, rate relief and other factors, including limitations imposed by Edison's Articles of Incorporation and Trust Indenture. NUCLEAR POWER MATTERS Although higher energy costs will be incurred for replacement generation during any periods the San Onofre and Palo Verde Units are not in operation, substantially all such costs will be included in future ECAC filings. Edison cannot predict what other effects, if any, legislative or regulatory actions may have upon it or upon the future operation of the San Onofre or Palo Verde Units or the extent of any additional costs it may incur as a result thereof, except for those that follow. San Onofre Unit 1 On November 30, 1992, Edison discontinued operation of San Onofre Unit 1. The CPUC approved an agreement between Edison and the DRA which allows Edison recovery of its investment of approximately $350,000,000 (after deferred taxes), including an 8.98% rate of return, by August 1996. The agreement does not affect Unit 1's decommissioning, scheduled to start in 2013. The estimated current-dollar decommissioning costs for Unit 1 have been recorded as a liability. San Onofre Units 2 and 3 In 1974, the California Coastal Commission, as a condition of the San Onofre Units 2 and 3 coastal permit, established a three-member Marine Review Committee ("MRC") to assess the marine environmental effects caused by the Units. In August 1989, the MRC issued its final report which alleged, in part, that San Onofre Units 2 and 3 caused adverse effects to several species of marine life and to the environment. Based on the MRC findings, the Coastal Commission in 1991 revised the coastal permit for Units 2 and 3 and required Edison to restore 150 acres of degraded wetlands, construct a 300-acre artificial kelp reef, and install fish behavioral barriers inside the Units' cooling water intake structure. Edison is currently in the process of planning and designing these projects, all of which must receive the approval of the Coastal Commission and state and federal resource and regulatory agencies. Current estimates place Edison's share of these capital costs at about $83,000,000 which is expected to be spent over the next 10 to 12 years. Palo Verde Nuclear Generating Station On March 14, 1993, APS, as operating agent, manually shut down Palo Verde Unit 2 as a result of a steam generator tube leak. Unit 2 remained shut down and began its scheduled refueling outage on March 19, 1993. An extensive inspection of the Palo Verde Unit 2 steam generators was performed prior to the unit's return to service on September 1, 1993. APS determined that intergranular attack/intergranular stress corrosion cracking was a major contributor to the tube leak. APS is continuing its evaluation of the effects of possible steam generator tube degradation in all three units (six steam generators) and has instituted several avenues of study and corrective action. Palo Verde Units 1, 2, and 3 will be operated at reduced power (85%) until the investigation and other associated activities are completed. APS expects to be able to return the units to full power after implementing corrective action. Nuclear Facility Decommissioning Edison's share of costs to decommission nuclear generation facilities is estimated to be $225,500,000 for San Onofre Unit 1; $280,900,000 for San Onofre Unit 2; $365,400,000 for San Onofre Unit 3; $50,200,000 for Palo Verde Unit 1; $49,800,000 for Palo Verde Unit 2; and $55,400,000 for Palo Verde Unit 3. These costs are all in 1993 dollars. Edison is currently collecting $104,255,000 annually in rates for its share of decommissioning costs for San Onofre Units 1, 2 and 3 and Palo Verde Units 1, 2 and 3. As of December 31, 1993, Edison's decommissioning trust funds totaled approximately $853,000,000 (market value). In accordance with the Energy Policy Act of 1992, Edison's recorded liability at December 31, 1993, of $72,300,000 represents its share of the estimated costs to decommission three federal nuclear enrichment facilities. This cost is based on San Onofre's and Palo Verde's past purchases of enrichment services and will be paid over 15 years. These costs are expected to be recovered through the ECAC procedure and from participants. Nuclear Facility Depreciation To reduce Edison nuclear facilities' capital cost effect on future customer rates, Edison has filed for a $75,000,000 per year accelerated recovery of its nuclear investments. To offset the increased cost recovery, Edison proposes to lengthen its recovery period for transmission and distribution assets. This proposal would have no significant effect on customer rates. The CPUC held hearings in October 1993 and Edison expects a decision in mid-1994. Nuclear Insurance Edison carries the maximum insurance coverage reasonably available to protect against losses from damage to its nuclear units and to provide some of its replacement energy costs in the unlikely event of an accident at any of its nuclear units. A description of this insurance is included in Note 10 of "Notes to Consolidated Financial Statements" incorporated herein. Although Edison believes an accident at its nuclear units is extremely unlikely, in the event of an accident, regardless of fault, Edison's insurance coverage might be inadequate to cover the losses to Edison. In addition, such an accident could result in NRC action to suspend operation of the damaged unit. Further, the NRC could suspend operation at Edison's undamaged nuclear units and the CPUC and FERC could deny rate recovery of related costs. Such an accident, therefore, could materially and adversely affect the operations and earnings of Edison. NUCLEAR WASTE POLICY ACT Under the Nuclear Waste Policy Act of 1982, Edison, acting as agent for the San Onofre participants, has entered into a contract with the DOE for disposal of spent nuclear fuel for San Onofre Units 1, 2 and 3. Under the terms of the contract, Edison is required to pay a quarterly fee of one mill per kilowatt hour to the DOE for net nuclear power generated and sold on and after April 7, 1983. During 1992, DOE implemented a refund process for overpayments to the Nuclear Waste Fund through credits against future quarterly payments. For generation prior to April 7, 1983, the contract required payment of a one-time fee equivalent to one mill per kilowatt hour, plus accrued interest. The obligation for this one-time fee was being discharged by equal quarterly payments. In October 1992 and 1993, DOE credits arising from overpayments to the Nuclear Waste Fund were also applied to this obligation. In October 1993, this obligation was paid in full. Expenses associated with the disposal of spent nuclear fuel are recovered through the ECAC procedure and from participants. COMPETITIVE ENVIRONMENT Under various acts of Congress, federal power projects have been constructed in California and neighboring states. Municipally owned utilities, cooperative utilities and other public bodies have certain preferences over investor-owned utilities in the purchase of electric power provided by federally funded power projects and, in addition, have certain preferences over investor-owned utilities in connection with the acquisition of licenses to build and/or operate hydroelectric power plants. Any energy which is or may be generated at these projects and transmitted for the account of such other utilities and public bodies over present or future government or utility-owned lines into the territory or markets served by Edison would result in a loss of sales by Edison. Under the laws of California, utility districts may include incorporated as well as unincorporated territory. Such districts, as well as municipalities, have the right to construct, purchase or condemn and operate electric facilities. In addition, when a city owning an electric system annexes adjacent unincorporated territory which Edison has previously served, Edison may experience a loss of customers. Edison's construction permits for San Onofre Units 2 and 3 contain certain conditions which require Edison (i) on timely notice, to permit privately or publicly owned utilities, including Edison's resale customers within or adjacent to Edison's service area, to participate on mutually agreeable terms in future nuclear units initiated by Edison, and (ii) to interconnect and coordinate reserves with, furnish emergency service to, sell bulk power to and purchase bulk power from, and provide certain transmission services for such utilities. Edison has also entered into agreements with certain of its resale customers which contemplate their possible participation in jointly owned generating projects initiated by Edison, and the integration of power sources acquired by each such customer, including the dispatching, reserve sharing, partial power-supply requirements and transmission service required in connection with such integrated operations. Pursuant to these agreements, two resale customers exercised an option to participate in Edison's ownership entitlement in San Onofre Units 2 and 3. Effective November 1977, Edison sold an undivided 3.45% interest in San Onofre Units 2 and 3 to these two resale customers for approximately $90,000,000. Effective September 1981, a further 1.5% interest in Units 2 and 3 was sold to one of these resale customers for approximately $50,000,000. In addition, since 1986, six of Edison's resale customers have acquired ownership interests in other generating sources and made purchases from other utilities in such amounts as to decrease Edison's revenues from resale cities from 4.4% to 1.6% of sales. This revenue loss has not had a substantial effect on Edison's business and opportunities. The Public Utility Regulatory Policies Act of 1978 ("PURPA") has fostered the entry of nonutility companies into the electric generation business. Under PURPA, nonutility power producers are allowed to construct QFs for the production of electricity from certain alternative or renewable energy resources, and utilities are required to purchase the electrical output of these QFs at prices set pursuant to state regulations and, in the future, pursuant to a CPUC-approved competitive bidding process. Edison is required by contracts and state regulation to continue to buy power generated by QFs, under long-term contracts negotiated earlier at prices that are most often higher than the power Edison can produce or purchase from other sources. Edison is presently managing contracts with QF developers to reduce ratepayer impacts and to more closely match Edison's needs with proposed development. Further, certain operators of QFs sell power they produce to large industrial and commercial customers of Edison from projects located on-site. Further loss of sales from such customers may be aggravated in the future as a result of attempts by these producers to gain access to a utility's transmission lines to sell power directly to retail customers now being served by that utility--an activity called "retail wheeling." Edison opposes any attempt to impose mandatory wheeling to Edison's retail customers. In late 1992, Congress passed the Energy Policy Act of 1992. This Act creates a new class of Exempt Wholesale Generators ("EWGs") who are exempt from the restrictions otherwise imposed on utilities under the Public Utility Holding Company Act. The effect of this exemption is to facilitate the development of more independent third-party generators potentially available to satisfy utilities' needs for increased power supplies. However, unlike purchases from QFs, utilities have no statutory obligation to purchase power from EWGs. Furthermore, EWGs are precluded from making direct sales to retail electricity customers. The Energy Policy Act also broadens the authority of the FERC to require a utility to transmit power produced by a wholesale producer to another utility. Municipal utilities are eligible applicants for such transmission service. However, the FERC is precluded from ordering a utility to transmit power from another entity directly to a retail customer. The authority of states to order such retail wheeling is unclear; but, to the extent such authority exists, it is explicitly preserved by the Energy Policy Act. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ANTITRUST MATTERS In 1983, a public power utility, the City of Vernon, filed a complaint against Edison in the United States District Court for the Central District of California, alleging violation of certain antitrust laws. The complaint alleged that Edison engaged in anticompetitive behavior by restricting access to Edison transmission facilities and foreclosing Vernon from purchasing bulk power supplies from other sources. Vernon also alleged that Edison unlawfully designed its resale rates and claimed damages of approximately $60,000,000 before trebling. Edison filed three motions for Summary Judgment and the District Court entered final judgment in favor of Edison in August 1990. In October 1990, Vernon appealed the District Court decision to the Ninth Circuit Court of Appeals. In February 1992, the Court of Appeals affirmed the District Court's rulings on all issues but one, involving injunctive relief only, and remanded that issue back to the District Court for consideration. In July 1992, Vernon filed a writ of certiorari to the U.S. Supreme Court which was denied. On July 13, 1993, Edison and Vernon settled the remaining issue regarding injunctive relief. The settlement is part of a broader settlement of regulatory issues that was approved by the FERC on October 27, 1993. On January 31, 1991, California Energy Company ("CEC") filed a lawsuit in United States District Court for the Northern District of California against SCEcorp, Edison, several nonutility subsidiaries, selected individuals, and Kidder, Peabody & Co. CEC alleged antitrust violations of the Sherman Act, conspiracy to interfere with contractual relations and common law unfair competition. CEC asked for treble damages (as proved at trial) for antitrust violations and compensatory and punitive damages for the pendent claims. Furthermore, CEC requested that SCEcorp divest itself of Mission Energy. On April 30, 1993, Edison and CEC reached a settlement which dismissed the lawsuit. Transphase Systems, Inc. filed a lawsuit on May 3, 1993, in the United States District Court for the Central District of California against Edison and San Diego Gas & Electric Company ("SDG&E"). The complaint alleged that Transphase was competitively disadvantaged because it could not directly access the demand side management funds Edison collects from its ratepayers to fund conservation and demand side management activities and that the utilities willfully acquired and maintain monopoly power in the energy conservation industry. The complaint sought $50,000,000 in damages before trebling. Edison filed a motion to dismiss the complaint on the grounds that it was without merit. The court granted Edison's motion on October 7, 1993, and denied plaintiffs the opportunity to replead the case. Plaintiffs have appealed to the Ninth Circuit Court of Appeals. ENVIRONMENTAL LITIGATION On November 8, 1990, an environmental organization and two individuals filed a lawsuit against Edison in United States Federal District Court for the Southern District of California. The lawsuit alleges Edison's operation of San Onofre Units 2 and 3 is in violation of its National Pollutant Discharge Elimination System permits. The basis for the allegations was a report prepared for the California Coastal Commission on the marine environmental effects of the generating station. The plaintiffs requested that the Court enjoin operation of Units 2 and 3, impose civil penalties, and order Edison to repair the alleged damage to the marine environment. After mediation by the court, the parties agreed on a settlement that includes: (i) $2,000,000 in wetlands research which will be undertaken by the Pacific Estuarine Research Laboratory at San Diego State University; (ii) $7,500,000 in additional wetland restoration within the San Dieguito River Valley; (iii) a $5,500,000, 10 year, Marine Education Program which will be based at Edison's Redondo Generating Station; and (iv) $1,400,000 in attorney's fees. The court approved the settlement on June 15, 1993. On September 23, 1993, the California Department of Toxic Substances Control ("DTSC") issued a Report of Violation to Edison, alleging various hazardous waste violations of the California Health & Safety Code at several Edison facilities. Edison is currently in settlement negotiations with DTSC regarding these alleged violations and tentatively has reached an agreement in principle for settlement in the amount of $1,900,000. SAN ONOFRE PERSONAL INJURY LITIGATION In 1993, a former NRC inspector who was assigned to San Onofre in 1985 and 1986 filed a lawsuit against Edison, SDG&E and a fuel rod manufacturer in Los Angeles County Superior Court, Central District. The case was subsequently transferred to the Federal District Court for the Southern District of California. The inspector claimed that exposure to radioactive materials at the plant caused her leukemia. Plant records showed that the inspector's exposure to radiation was well below NRC regulatory levels. Plaintiff nevertheless alleged that she was exposed to radioactive fuel particles, that this caused a radiation exposure above the NRC levels and that this exposure was a legal cause for her illness. Plaintiff sought compensatory and punitive damages. The defendants denied having liability for plaintiff's illness. A jury trial began on January 4, 1994. In closing arguments at the end of the trial, plaintiff's counsel requested damages between $4,000,000 and $4,500,000 for medical costs and economic losses and asked for three to five times that amount for pain and suffering compensatory damages. After deliberations, the jury reported that it was "hung" and could not reach a unanimous verdict on the threshold question of whether plaintiff was exposed to radiation levels above the NRC-defined levels. (A 7-2 majority of the jury had concluded that plaintiff's exposure did exceed these levels). Finding itself hung on the exposure question, the jury did not decide the other questions regarding causation, the amount of compensatory damages and whether Edison's conduct warranted punitive damages. If the jury had found that punitive damages should be assessed, the trial would have resumed to decide the amount of such damages. On February 8, 1994, the trial judge declared a mistrial because of the hung jury. The second trial was scheduled to begin on March 15, 1994. On March 14, 1994, the case was settled. The amount of the settlement payment will not have a material adverse effect on Edison's net income. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. Pursuant to Form 10-K's General Instruction ("General Instruction") G(3), the following information is included as an additional item in Part I: EXECUTIVE OFFICERS(1) OF THE REGISTRANT - --------------- (1) Effective March 1, 1993, Michael R. Peevey retired from his position as President of Edison, and Harry E. Morgan, Jr. retired from his position as Vice President of Edison and Site Manager of San Onofre. At December 31, 1993, Charles B. McCarthy, Jr. was Senior Vice President of Edison; however, effective January 1, 1994, Mr. McCarthy retired from this position. (2) Messrs. Bryson, Danner, Bushey and Stewart also hold the same positions with SCEcorp. Mr. Fohrer holds the office of Senior Vice President, Treasurer and Chief Financial Officer of SCEcorp. SCEcorp is the parent holding company of Edison. None of Edison's executive officers are related to each other by blood or marriage. As set forth in Article IV of Edison's Bylaws, the officers of Edison are chosen annually by and serve at the pleasure of Edison's Board of Directors and hold their respective offices until their resignation, removal, other disqualification from service, or until their respective successors are elected. All of the executive officers have been actively engaged in the business of Edison for more than five years except for Bryant C. Danner and Margaret H. Jordan. Those officers who have not held their present position for the past five years had the following business experience during that period: - ---------------- (1) Prior to leaving the law firm of Latham & Watkins, Mr. Danner was in the firm's environmental department. (2) As Vice President of the Kaiser Foundation Health Plan of Texas, Ms. Jordan was responsible for serving over 124,000 members in 10 multispecialty medical offices in the Dallas/Fort Worth area. (3) This entity is not a parent, subsidiary or other affiliate of Edison. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Certain information responding to Item 5 with respect to frequency and amount of cash dividends is included in Edison's Annual Report to Shareholders for the year ended December 31, 1993, ("Annual Report") under "Quarterly Financial Data" on page 6 and is incorporated by reference pursuant to General Instruction G(2). As a result of the formation of a holding company described above in Item 1, all of the issued and outstanding common stock of Edison is owned by SCEcorp and there is no market for such stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information responding to Item 6 is included in the Annual Report under "Selected Financial and Operating Data: 1989-1993" on page 1 and is incorporated herein by reference pursuant to General Instruction G(2). ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Information responding to Item 7 is included in the Annual Report under "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 2 through 6 and is incorporated herein by reference pursuant to General Instruction G(2). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Certain information responding to Item 8 is set forth after Item 14 in Part IV. Other information responding to Item 8 is included in the Annual Report on page 6 under "Quarterly Financial Data" and on pages 7 through 21 and is incorporated herein by reference pursuant to General Instruction G(2). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning executive officers of Edison is set forth in Part I in accordance with General Instruction G(3), pursuant to Instruction 3 to Item 401(b) of Regulation S-K. Other information responding to Item 10 is included in the Joint Proxy Statement ("Proxy Statement") filed with the Commission in connection with Edison's Annual Meeting of Shareholders to be held on April 21, 1994, under the heading "Election of Directors of SCEcorp and Edison," and is incorporated herein by reference pursuant to General Instruction G(3). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information responding to Item 11 is included in the Proxy Statement under the heading "Election of Directors of SCEcorp and Edison," and is incorporated herein by reference pursuant to General Instruction G(3). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information responding to Item 12 is included in the Proxy Statement under the headings "Election of Directors of SCEcorp and Edison," and "Stock Ownership of Certain Shareholders" and is incorporated herein by reference pursuant to General Instruction G(3). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information responding to Item 13 is included in the Proxy Statement under the heading "Election of Directors of SCEcorp and Edison," and is incorporated herein by reference pursuant to General Instruction G(3). PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS The following items contained in the 1993 Annual Report to Shareholders are incorporated by reference in this report. Management's Discussion and Analysis of Results of Operations and Financial Condition Consolidated Statements of Income -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Retained Earnings -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets -- December 31, 1993, and 1992 Consolidated Statements of Cash Flows -- Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Responsibility for Financial Reporting Report of Independent Public Accountants (2) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AND SCHEDULES SUPPLEMENTING FINANCIAL STATEMENTS The following documents may be found in this report at the indicated page numbers. Schedules I through XIII, except those referred to above, are omitted as not required or not applicable. (3) EXHIBITS See Exhibit Index on page 40 of this report. (B) REPORTS ON FORM 8-K October 5, 1993 Item 5: Other Events: Palo Verde Settlement December 20, 1993 Item 5: Other Events: Cost of Capital Financing Results REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Southern California Edison Company: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in the 1993 Annual Report to Shareholders of Southern California Edison Company, incorporated by reference in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our audits of the consolidated financial statements were made for the purpose of forming an opinion on those basic consolidated financial statements taken as a whole. The supplemental schedules listed in Part IV of this Form 10-K which are the responsibility of the Company's management are presented for purposes of complying with the Securities and Exchange Commission's rules and regulations, and are not part of the basic consolidated financial statements. These supplemental schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Los Angeles, California February 4, 1994 SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 _______________ (a) Reflects transfers to plant in service, which are net of additions to construction work in progress. (b) Reflects prior-year adjustments. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 _______________ (a) Reflects transfers to plant in service, which are net of additions to construction work in progress. (b) Reflects removal from service of nuclear generating plant under an agreement reached with the California Public Utilities Commission. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 _______________ (a) Reflects transfers to plant in service, which are net of additions to construction work in progress. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 _______________ (a) Includes removal costs related to facilities retired, damage claims and relocation costs collected from others, and various other adjustments of depreciation and amortization. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 _______________ (a) Includes removal costs related to facilities retired, damage claims and relocation costs collected from others, and various other adjustments of depreciation and amortization. (b) Reflects removal from service of nuclear generating plant under an agreement reached with the California Public Utilities Commission. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 _______________ (a) Includes removal costs related to facilities retired, damage claims and relocation costs collected from others, and various other adjustments of depreciation and amortization. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1993 ________________ (a) Accounts written off, net. (b) Represents final settlement with the California Public Utilities Commission's Division of Ratepayer Advocates regarding affiliated company power purchases. (c) Represents new estimate based on actual billings. (d) Represents amounts paid. (e) Primarily represents transfers from the acrued paid absense allowance account for required additions to the comprehensive disability plan accounts. (f) Includes pension payments to retired employees, amounts paid to active employees during periods of illness and the funding of certain pension benefits. (g) Amounts charge to operations that were not covered by insurance. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1992 _______________ (a) Accounts written off, net. (b) Represents reserve addition for the settlement with the California Public Utilities Commission's Division of Ratepayer Advocates regarding affiliated company power purchases. (c) Represents the amortization of the difference between the nominal value and the present value. (d) Represents the estimated long-term costs to be incurred and recovered through rates over 15 years; reclassified from account 253, other deferred credits. (e) Represents an additional estimated liability established for environmental cleanup costs expected to be incurred and recovered through rates in future years. (f) Amount reclassified to account 253. (g) Primarily represents transfers from the accrued paid absence allowance account for required additioins to the comprehensive disability plan accounts. (h) Includes pension payments to retired employees, amounts paid to active employees during periods of illness and the funding of certain pension benefits. (i) Amounts charged to operations that were not covered by insurance. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1991 _______________ (a) Accounts written off, net. (b) Represents a reserve addition for a proposed settlement with the California Public Utilities Commission's Division of Ratepayer Advocates regarding affiliated company power purchases. (c) Represents an estimated minimum liability established for environmental cleanup costs expected to be incurred and recovered through rates in future years. (d) Primarily represents transfers from the accrued paid absence allowance account for required additions to the comprehensive disability plan accounts. (e) Includes pension payments to retired employees, amounts paid to active employees during periods of illness and the funding of certain pension benefits. (f) Amounts charged to operations that were not covered by insurance. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 _______________ (a) Average amount outstanding during the period is computed by dividing the total of daily outstanding principal balances by 365. (b) Weighted-average interest rate during the period is computed by dividing the total interest expense by the average amount outstanding. (c) Under credit agreements with commercial banks which allow Edison to refinance short-term borrowings on a long-term basis, borrowings of $70,000,000 as of December 31, 1993, $63,000,000 as of December 31, 1992, and $151,000,000 as of December 31, 1991, have been reclassified as long-term debt on the Consolidated Balance Sheets in the 1993 Annual Report to reflect the anticipated timing of repayment of nuclear fuel indebtedness. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 _______________ Note: Depreciation and maintenance expenses appear on the Consolidated Statements of Income. Royalties paid and advertising costs included in Other Operating Expenses are less than 1% of total operating revenue. SOUTHERN CALIFORNIA EDISON COMPANY SCHEDULE XIII -- OTHER INVESTMENTS DECEMBER 31, 1993 (IN THOUSANDS) SIGNATURES Pursuant to the requirements of Section 13 or 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. SOUTHERN CALIFORNIA EDISON COMPANY By W. J. Scilacci ----------------------------- (W. J. Scilacci Assistant Treasurer) Date: March 17, 1994 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. By W. J. Scilacci --------------------------------- (W. J. Scilacci, Attorney-in-fact) EXHIBIT INDEX EXHIBIT INDEX EXHIBIT INDEX EXHIBIT INDEX EXHIBIT INDEX _______________ * Incorporated by reference pursuant to Rule 12b-32.	12,317	81,485
794447_1993.txt	794447_1993	1993	794447	Item 1. Business FPL Group Capital Inc (Company) holds the capital stock of the non-utility subsidiaries of FPL Group, Inc. (FPL Group) and provides most of their funding. The Company was incorporated in 1985 under the laws of Florida. All of its common stock is owned by FPL Group. FPL Group is the parent of Florida Power & Light Company (FPL) and is, therefore, a public utility holding company as defined in the Public Utility Holding Company Act of 1935, as amended (Holding Company Act). FPL Group, however, is exempt from substantially all of the provisions thereof on the basis that FPL Group's and FPL's businesses are predominantly intrastate in character and carried on substantially in a single state, in which both are incorporated. The Company's principal business activities consist of investments in non- utility energy projects and agricultural operations. Energy production from the Company's non-utility energy investments is generally higher during the third quarter due to increased energy demand and resource availability. The agricultural operations of the Company are seasonal, with the majority of the citrus harvest taking place between January and April. Seasonality is not material to the Company's other businesses. For information regarding the Company's business segments, see Note 14 to the Consolidated Financial Statements (Note 14). The Company is continuing its efforts to exit substantially all of its non-energy and non-agricultural business activities, including cable television and real estate. In 1991, the sale of Colonial Penn Group, Inc. (Colonial Penn), formerly the Company's largest subsidiary, was completed, as were the sales of the environmental remediation and utility-related services divisions. Bay Loan and Investment Bank (Bay Loan), a former subsidiary of Colonial Penn, is winding down its operations and is expected to be dissolved with no anticipated adverse effect on future operating results. Contracts for the sale of all of the directly-owned and operated cable television systems were recently terminated. All of the developed real estate properties are under contract for sale. The Company cannot estimate the likelihood of consummating this sale; however, if completed, this sale and the currently estimated result of disposing of the balance of the Company's cable television and real estate assets are not expected to have a significant adverse effect on net income. See Management's Discussion and Analysis of Financial Condition and Results of Operations (Management's Discussion) and Notes 4 and 5 for additional information regarding businesses to be discontinued and discontinued operations. The Company and its subsidiaries had approximately 400 employees at December 31, 1993. Non-Utility Energy The Company invests in non-utility energy projects through ESI Energy, Inc. (ESI). ESI provides equity capital, loans, transaction management and project structuring for non-utility energy projects. Federal and state legislation, including the Public Utility Regulatory Policies Act of 1978 (PURPA) and, more recently, the Energy Policy Act of 1992 (Energy Act), have increased opportunities for non-utility entities to develop and operate generating facilities. ESI develops and invests in non- utility energy projects and performs various management roles associated with certain projects. All of ESI's projects are structured to be exempt from the Holding Company Act. The passage of the Energy Act resulted in the creation of a class of exempt wholesale generators (EWGs) that are exempt from the Holding Company Act. An EWG can more readily enter the power generation market which may have the effect of increasing competition in the market to supply energy to utilities and large wholesale customers. To date, ESI has invested in one project that qualifies as an EWG. Substantially all other projects in which it invests are qualifying facilities under PURPA. In order to achieve qualifying facility status under PURPA, a project must meet certain requirements, including that the project not provide more than 50% of its financial benefits to a regulated electric utility or a public utility holding company. An electric generating project that is a qualifying facility enjoys certain advantages under PURPA, including certain exemptions from federal and state legislation and regulation. PURPA also requires electric utilities to purchase electric power generated by qualifying facilities at rates not to exceed the utility's avoided cost of generating that power. The Energy Act also increased the opportunity for participation in foreign power markets and provides certain tax benefits for future alternative energy projects. Currently, ESI is exploring investment opportunities in several international markets. As the non-utility energy industry has matured, ESI has faced increased competition in identifying investment opportunities which meet ESI's desired levels of risk and return. ESI participates in 27 non-utility energy projects primarily through non-controlling ownership interests in joint ventures or leveraged lease investments. ESI has become more actively involved in management and development related activities of the projects in which it invests. Projects in which ESI invests are subject to federal, state and local environmental laws and regulations. Compliance with these laws can require changes in design and operation of facilities and the securing of licenses, permits and approvals from authorities. To the extent that unforeseen costs necessary to comply with such regulations can not be passed through to utilities purchasing power from projects in which ESI invests, investment returns may be adversely affected. The projects in which ESI has invested are typically dependent upon one electric utility customer. Based on ESI's invested capital at December 31, 1993, the projects are concentrated in California (48%), Virginia (32%) and Pennsylvania (11%) and are safeguarded, to the extent possible, from unfavorable economic conditions in those regions by long-term contracts between each of the projects and the local electric utility. The terms of the contracts vary but generally include fixed capacity payments, provided the project meets certain performance minimums, and either fixed or variable energy payments. Fluctuating energy payments will affect each project differently; however, for most of ESI's projects, this is not considered to pose a significant risk because the prices paid to those projects for the energy they sell is directly, or indirectly, tied to the projects' cost of fuel. The projects in which ESI has equity investments or to which financing has been provided use a diversified mix of technologies to produce electricity. At December 31, 1993, the breakdown of the Company's investments in and loans to the projects was as follows: Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS The operations of the Company consist primarily of investments in non-utility energy projects through ESI and the agricultural operations of Turner. In the following discussion, all comparisons are with the corresponding items in the prior year. Overview - The improvement in income from continuing operations, before extraordinary loss, over the past two years was primarily due to a decrease in interest expense and an increase in equity in earnings of non-utility energy projects. The significant loss reported in 1991 resulted from the sale of the Company's major insurance subsidiary as part of FPL Group's strategy to focus on its energy-related businesses and to sell or otherwise dispose of certain of its non-energy subsidiaries. The Company is continuing its efforts to dispose of certain assets, including cable television and real estate, as well as the winding down of its financial services business. See Notes 4 and 5. In 1992, the Energy Act was passed resulting in the creation of a class of wholesale generators that are exempt from the Holding Company Act. The Energy Act is expected to increase competition in the wholesale power purchase market and also create business opportunities for ESI. In addition, the loosening of restrictions on exempt holding companies under the Holding Company Act is expected to allow ESI to more readily compete for opportunities to provide energy in foreign markets. 1993 compared to 1992 - Earnings from the agricultural operations declined in 1993 despite an increase in citrus production, primarily due to lower citrus prices. The citrus industry experienced a decline in prices during the year, largely as a result of increases in worldwide citrus production. Costs of goods sold increased overall as a result of increased citrus production. This increase was partially offset by a reduction in Turner's unit costs due to increased efficiencies in production and harvesting and as a result of grove maturation. Substantially all of Turner's 1994 orange crop is under contract at prices indexed to monthly FCOJ commodity futures prices. Turner's citrus production is expected to continue to increase as existing citrus groves mature. The sale of certain cable television operating systems during the year resulted in a reduction of service revenues and related costs of services. In addition, the Company sold or otherwise liquidated its interests in three cable television joint ventures. Contracts for the sale of all of the remaining directly-owned and operated cable television systems were recently terminated. The Company's remaining developed real estate properties are under contract for sale. The Company cannot estimate the likelihood of consummating this sale; however, if completed, this sale and the currently estimated result of disposing of the balance of the Company's cable television and real estate assets are not expected to have a significant adverse effect on net income, but future service revenues and related expenses would decrease accordingly. Increase in other operating revenues and other operating expenses was attributable to rental properties of Alandco that were sold at the end of 1993. The sale resulted in a $3.8 million loss included in other - net. The increase in other operating revenues was partially offset by a decline in leveraged leasing revenues. Such revenues fluctuate over the life of the lease based on a constant lease yield applied to an investment balance which changes based on scheduled cash flows. Also, other operating expenses increased due to additional costs incurred in connection with certain non- utility energy projects, including those under leveraged leases and a wholly-owned project. Equity in earnings from partnerships and joint venture investments increased approximately $9.1 million primarily due to earnings from non-utility energy projects because of the full year impact of certain project operations which began in 1992, principally a natural gas EWG project, and a substantial increase in production from certain wind projects resulting from improved wind conditions. This increase occurred despite a $7.1 million loss representing ESI's proportionate share of losses from two solar power plant investments. Interest expense decreased for the period as the Company refinanced higher cost debt at lower interest rates. The net loss for 1993 reflects an extraordinary loss of approximately $12.8 million, net of income tax benefits of $8.0 million, resulting from the early extinguishment of debt. See Note 9. The adoption in 1993 of new accounting standards relating to income taxes and postretirement benefits other than pensions did not have a material effect on the Company's results of operations. However, the standard relating to income taxes did require a $3.5 million adjustment to the Company's income tax expense for 1993 and accumulated deferred income tax balance to reflect the change in the federal income tax rate from 34% to 35%, effective January 1, 1993, resulting from the enactment of The Omnibus Budget Reconciliation Act of 1993 (OBRA). Other provisions of OBRA are not expected to have a material effect on the Company's results of operations. Also increasing tax expense in 1993 was the recording of tax audit-related accruals and adjustments of prior year taxes. See Notes 2 and 3 - Other Postretirement Benefits. 1992 compared to 1991 - The contribution from agricultural operations in 1992 remained relatively constant compared with 1991. Earnings reflected a significant increase in production volume resulting from the maturing of young trees, partially offset by a decline in citrus prices and an increase in costs of goods sold. The agricultural industry experienced declining citrus prices throughout 1992, with year-end prices at approximately fifty percent of prices at the beginning of the year. A significant portion of Turner's 1992 harvest was sold under contracts with specified floor prices, alleviating much of the effects of the decline in prices. The decrease in other operating revenues was due to a reduction in leveraged leasing revenues. ESI recorded a $5.8 million charge to other operating expenses in 1991 to recognize an impairment of certain leveraged lease investments which were being converted to investments in partnerships and joint ventures. The decrease in general and administrative expenses was due to reduced costs incurred at Telesat. Equity in earnings of partnerships and joint ventures increased due to the first full year of operations from certain projects and the absence of certain start-up costs experienced in 1991. The improvement in 1992 was partially offset by $8.9 million of losses representing ESI's proportionate share of losses from two solar power plant investments. A restructuring of the solar projects was completed in 1992 and included additional capital contributions by the partners to fund site repairs and modifications which were required to return the plants to operation. Following these modifications, the plants performed at a level sufficient to receive capacity payments under existing contracts. Interest expense decreased during the period due to lower interest rates and a reduction in the average amount of debt outstanding. In 1992, an extraordinary loss of $5.3 million, net of tax benefits of $3.2 million, was incurred as a result of the early extinguishment of debt. Adjustments of prior year taxes increased the effective tax rate for 1992. The income tax benefit in 1991 included the recognition of tax credits associated with new investments in non-utility energy projects. In 1991, the Company completed the sale of Colonial Penn, the Company's largest operating subsidiary, resulting in a $135.6 million after-tax loss. Bay Loan, formerly a subsidiary of Colonial Penn, is winding down its operations. Both of these entities are reported as discontinued operations. The Company does not anticipate that the winding down of Bay Loan's operations will adversely affect its future operating results. See Note 5. Tax benefits associated with the sale of Colonial Penn and a related charge recorded in 1991 reflect the Company's assessment of loss disallowance rules and the availability of offsetting capital gains. These rules limit the amount of loss from the sale of a subsidiary stock that can be deducted. The Company plans to challenge the loss disallowance rules. Approximately $170.0 million of tax benefits have not been recognized for financial reporting purposes pending the outcome of the challenge and realization of offsetting capital gains. See Note 2. LIQUIDITY AND CAPITAL RESOURCES Capital Requirements and Resources - The Company requires funds to service its debt, for general and administrative expenses, for investments in or advances to subsidiaries and for payments of dividends to FPL Group. As shown in the consolidated statements of cash flows, the Company has generated positive cash flow from its operating activities, but has relied, in the past, on equity contributions from FPL Group for a substantial portion of the funds needed for investments and retirement of long-term debt. Funds to meet these requirements in the future are expected to be provided through cash dividends from subsidiaries including proceeds from the sale of certain assets, proceeds from short or long-term borrowings and, if needed, through contributions from FPL Group. The Company and ESI have committed to invest approximately $3.2 million in, and lend approximately $4.2 million to, partnerships and joint ventures entered into through ESI, all of which are expected to be funded in 1994. Additionally, the Company and its subsidiaries, primarily ESI, have guaranteed up to approximately $89.2 million of lease obligations, debt service payments and other payments subject to certain contingencies. In 1992, the Company renegotiated the terms of a $100.0 million bank loan by extending the term to December 1994 and increasing the principal amount to $125.0 million. The interest rate varies based on certain short-term interest rate indices. Proceeds from the original bank borrowings were used to partially fund, in 1990, the Company's $360.0 million 9.69% loan for a term of 20 years to the Trust (ESOP Loan). The Trust intends to repay the ESOP Loan with dividends received on FPL Group common shares it holds, along with cash contributions from the participating employers. The amount of additional contributions required in the future is primarily dependent on the level of dividends paid by FPL Group. See Note 13. Debt maturities will require cash outflows of approximately $432.3 million through 1998, including $278.2 million in 1994. See Note 9. Current maturities of long-term debt at December 31, 1993 include $150.0 million of debentures called in December 1993. The debentures were redeemed in January 1994 using proceeds from short-term borrowings. An additional $125.0 million represents the Company's bank loan which is due December 1994, and is expected to be repaid with available cash, including proceeds from the sale of cable television and real estate assets, or to be extended. Bank lines of credit currently available to the Company and its subsidiaries aggregate $150.0 million. Financial Covenants - The Company, under a financial covenant in connection with its bank loan, is required to maintain a minimum level of consolidated net worth which is reduced as loan prepayments are made. At December 31, 1993, the required level was $100.0 million and actual consolidated net worth was approximately $332.5 million. See Note 10 - Debt Covenant. Under the terms of the Company's Indenture dated March 1, 1987 (Indenture) relating to the issuance of its debentures, the Company is subject to certain restrictions on the pledging of property to secure debt. The Indenture also requires the Company to maintain a support agreement entered into with FPL Group until such time as the credit rating on the debt securities outstanding under the Indenture would be the same or better, whether or not the support agreement was in effect. See Note 10 - Support Agreement. Item 8. Item 8. Financial Statements and Supplementary Data INDEPENDENT AUDITORS' REPORT FPL GROUP CAPITAL INC: We have audited the consolidated financial statements of FPL Group Capital Inc and its subsidiaries, listed in the accompanying index as Item 14(a)1 of this Annual Report (Form 10-K) to the Securities and Exchange Commission for the year ended December 31, 1993. Our audits also comprehended the financial statement schedules of FPL Group Capital Inc and its subsidiaries, listed in the accompanying index as Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of FPL Group Capital Inc and its subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 2 and 3 to the consolidated financial statements, FPL Group Capital Inc and its subsidiaries changed their method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. DELOITTE & TOUCHE Certified Public Accountants Miami, Florida February 11, 1994 FPL GROUP CAPITAL INC AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP CAPITAL INC AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP CAPITAL INC AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FPL GROUP CAPITAL INC AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 1. Summary of Significant Accounting and Reporting Policies Basis of Presentation - The consolidated financial statements include the accounts of FPL Group Capital Inc (Company) and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The Company is a wholly-owned subsidiary of FPL Group, Inc. (FPL Group) and is organized as a holding company with its operations consisting primarily of investments in non-utility energy projects through ESI Energy, Inc. (ESI) and the citrus operations of Turner Foods Corporation (Turner). Certain amounts included in prior years' consolidated financial statements have been reclassified to conform to the current year's presentation. Cash Equivalents - Cash equivalents consist of short-term, highly liquid investments with original maturities of three months or less. The carrying amount of these investments approximates their market value. Investments in Partnerships and Joint Ventures - The majority of the Company's investments in partnerships and joint ventures are accounted for under the equity method. The cost method is used when the Company has virtually no ability to influence the operating or financial decisions of the investee. Investments in Leveraged Leases - For leveraged leases, aggregate rentals receivable are reduced by the related principal and interest on nonrecourse debt (net rentals receivable). The difference between net rentals receivable and the cost of the asset, less estimated residual value at the end of the lease term, is recorded as unearned income. Earned income is recognized over the life of the lease at a constant rate of return on the positive net investment, which includes the effects of tax credits and deferred taxes. Revenue Recognition - The Company recognizes revenues as goods and services are delivered and exchanged for cash or claims to cash. Revenues associated with agricultural products sold under contract are recognized, as provided in the related contracts, at the higher of the market price or the contract floor price. Estimated agricultural revenues in excess of initial cash payments received are accrued. Revenues from consulting contracts and cable television services are recognized at stated prices as services are provided. Revenues from real estate sales are recorded when property is sold, provided that the collectibility of the sales price is assured and the Company does not have substantial continuing involvement with the property. Property, Plant and Equipment - Depreciation on property, plant and equipment is provided primarily on a straight-line basis over the estimated useful lives of the property, plant and equipment. The Company follows the policy of capitalizing interest as a component of the cost of property and certain structures under development. During 1993, 1992 and 1991 total interest of approximately $40.6 million, $51.4 million and $61.2 million was incurred, of which $0.6 million, $1.0 million and $2.6 million was capitalized, respectively, with the balance charged to operations. Income Taxes - Deferred income taxes are provided on all significant temporary differences between the financial statement and tax bases of assets and liabilities. Deferred income taxes on the balance sheet are net of recognized alternative minimum tax (AMT) credits. Investment tax credits (ITCs) are used to reduce current federal income taxes. The Company determines its income tax provision on the "separate return method." See Note 2. 2. Income Taxes The Company and its subsidiaries are included in consolidated income tax returns filed by FPL Group. FPL Group has entered into a tax allocation agreement (Tax Allocation Agreement) with certain of its affiliates, including the Company and its subsidiaries, whereby each affiliate is charged its share of the consolidated federal and state tax liability based on the affiliate's separate income tax computation. In addition, each affiliate is reimbursed currently for the benefit derived from losses, deductions and credits which are utilized in the consolidated income tax return filed by FPL Group. For 1992 and 1991, the Company was in an AMT position which reduced the income tax benefits utilized by FPL Group and paid to the Company under the Tax Allocation Agreement. The resulting AMT credits can be carried forward for an indefinite period of time. In 1993, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes," which requires the use of the liability method in accounting for income taxes. Under the liability method, the tax effect of temporary differences between the financial statement and tax bases of assets and liabilities are reported as deferred taxes measured at current tax rates. The standard did not affect accounting for deferred income taxes related to leveraged leases. Substantially all of the Company's operations have taken place while the federal corporate tax rate was 34%; consequently, adoption of SFAS No. 109 in the first quarter of 1993 did not have a significant effect on results of operations. However, upon enactment of the Omnibus Budget Reconciliation Act of 1993 which increased the federal corporate rate to 35%, the Company adjusted its income tax expense and accumulated deferred income tax balance by $3.5 million to reflect this change in the tax rate. The principal effect of adopting SFAS No. 109 was to establish a deferred tax asset of approximately $170.0 million for a capital loss carryforward which, if unrecognized, will expire in 1996. This carryforward may not be allowed because of loss disallowance rules adopted by the Internal Revenue Service which deny recognition for tax purposes of a significant portion of losses resulting from FPL Group's disposition of discontinued operations in a prior period. The Company plans to challenge the loss disallowance rules. Based on the uncertainties associated with the ultimate outcome of this challenge and recognition of offsetting capital gains, a valuation allowance was recorded to fully offset the effect of establishing this deferred tax asset under SFAS No. 109. The components of income taxes are as follows: A reconciliation between income tax expense (benefit) and the expected income tax expense (benefit) at the applicable statutory rates is as follows: The income tax effects of discontinued operations in 1991 differ from the effects computed at statutory rates primarily due to the Company's assessment of loss disallowance rules and limitations on the ability to utilize capital loss benefits. The income tax effects of temporary differences giving rise to the Company's consolidated deferred income tax assets and liabilities after adoption of SFAS No. 109 are as follows: Real estate and personal property taxes were approximately $1.5 million, $1.2 million and $1.4 million for 1993, 1992 and 1991, respectively, and are included in other operating expenses in the Consolidated Statements of Operations. 3. Employee Retirement Benefits Pension Benefits - Substantially all employees of the Company and its subsidiaries are covered by FPL Group's noncontributory defined benefit pension plan. Plan benefits are generally based on employees' years of service and compensation during the last years of employment. Participants are vested after five years of service. Plan assets consist primarily of bonds, common stocks and short-term investments. Any pension cost recognized by FPL Group is allocated to the Company on a pro rata basis. Amounts allocated to the Company for 1993, 1992 and 1991 were not material. For the same periods, no contributions to the pension plans were required. During 1992, the method used for valuing plan assets in the calculation of pension cost was changed from fair value to a calculated market-related value. The new method was adopted to reduce the volatility in annual pension expense that results from short-term fluctuations in the securities markets. This change did not have a significant effect on results of operations. In 1993, the pension plans of FPL Group and its subsidiary, Florida Power & Light Company (FPL) were combined. Accordingly, the 1992 amounts have been restated to present the position of the combined plans. As of December 31, 1993 and 1992, the fair market value of FPL Group plan assets was approximately $1,662.0 million and $1,549.3 million, respectively, the projected benefit obligation was $1,066.5 million and $1,119.4 million, respectively, and the prepaid pension cost was $2.8 million and $22.5 million, respectively. For the same periods, the unrecognized prior service cost was approximately $212.9 million and $79.6 million, respectively, unrecognized net gain was $548.7 million and $206.7 million, respectively, and the unrecognized net transition asset was $256.9 million and $280.3 million, respectively. During 1993, the effect of a prior plan amendment that changed the manner in which benefits accrue, was recognized and included as part of prior service cost to be amortized over the remaining service life of the employees. As of December 31, 1993 and 1992, the weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0% and 6.0%, respectively. The assumed rate of increase in future compensation levels at those respective dates was 5.5% and 6.0%. The expected long-term rate of return on plan assets used in determining pension cost was 7.75% for 1993 and 7.0% for 1992 and 1991. Other Postretirement Benefits - Substantially all employees of the Company are covered by FPL Group's defined benefit postretirement plans for health care and life insurance benefits. Costs associated with the plans are allocated to the Company on a pro rata basis. Eligibility for health care benefits is based upon age plus years of service at retirement. The plans are contributory, and contain cost-sharing features such as deductibles and coinsurance. FPL Group has capped company contributions for postretirement health care at a defined level which, depending on actual claims experience, may be reached by the year 2000. Generally, life insurance benefits for retirees are capped at $50,000. FPL Group's policy is to fund postretirement benefits in amounts determined at the discretion of management. In 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." Postretirement benefit cost allocated to the Company on a pro rata basis amounted to $0.3 million for 1993. As of December 31, 1993, the fair market value of the FPL Group plan assets was approximately $109.4 million, the accumulated postretirement benefit obligation was $253.0 million, the unrecognized net transition obligation was $66.2 million and unrecognized net loss amounted to $32.6 million. The accrued postretirement benefit cost at December 31, 1993 is $44.8 million, of which $0.3 million represents the portion allocated to the Company. The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) for 1993 is 10.5% for retirees under age 65 and 6.5% for retirees over age 65. These rates are assumed to decrease gradually to 6.0% by the year 2000, which is when it is anticipated that benefit costs will reach the defined level at which FPL Group's contributions will be capped. The cap on FPL Group's contributions mitigates the potential significant increase in costs resulting from an increase in the health care cost trend rate. Increasing the assumed health care cost trend rate by one percentage point would increase the plan's accumulated postretirement benefit obligation as of December 31, 1993 by $8 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost of the plan for 1993 by approximately $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993. The expected long-term rate of return on plan assets was 7.75% at December 31, 1993. 4. Businesses To Be Discontinued In 1990, the Company decided to sell or otherwise dispose of the real estate, cable television, environmental remediation and utility-related services businesses. In 1991, the environmental remediation and utility-related services businesses were sold with no significant impact on net income. During 1993, the Company sold or otherwise liquidated certain cable television and real estate assets, including cable television operating systems, interests in three cable television joint ventures and real estate rental properties. The Company's remaining developed real estate properties are under contract for sale. This pending sale, if closed, and the currently estimated result of disposing of the balance of the Company's cable television and real estate assets are not expected to have a significant adverse effect on net income. 5. Discontinued Operations In 1991, Colonial Penn Group, Inc. (Colonial Penn) was sold, resulting in a $135.6 million after-tax loss. The sale did not include Bay Loan and Investment Bank (Bay Loan), a former Colonial Penn subsidiary, which is winding down its operations and will be dissolved. The principal business of Bay Loan was investing in loans secured by real estate using funds provided from the issuance of insured certificates of deposit. Bay Loan ceased investing in new loans in 1990 and is in the process of effecting an orderly liquidation. The date when such liquidation will be completed cannot be predicted with certainty because it is dependent on the timing of loan prepayments and asset sales. The Company has no legal obligation and has no intention to contribute additional equity to Bay Loan. The investment in Bay Loan was written off in 1990; the orderly liquidation of its operations is not expected to have an adverse effect on the Company's future operating results. Colonial Penn and Bay Loan have been accounted for as discontinued operations. Operating revenues of Bay Loan were $16.3 million and $21.4 million for 1993 and 1992, respectively. Combined operating revenues of Colonial Penn (through date of closing) and Bay Loan were $714.1 million for 1991. Bay Loan reported operating income of $5.1 million in 1993 and operating losses of $5.9 million and $8.5 million in 1992 and 1991, respectively. The losses incurred subsequent to the measurement date (date on which Bay Loan was initially classified as discontinued operations) had no effect on the Company's results of operations as such losses had been provided for in the loss on disposal of discontinued operations in 1991. The remaining assets of Bay Loan consist primarily of loans secured by real estate and real estate owned as a result of foreclosures. Most of Bay Loan's loan customers and the real estate securing their loans are located in the northeast United States. The remaining liabilities of Bay Loan consist primarily of FDIC-insured certificates of deposit, which will be settled with funds generated from loan repayments and the sale of Bay Loan assets. Total assets and liabilities of Bay Loan at December 31, 1993 were $149.3 million and $129.7 million, respectively. Total assets and liabilities of Bay Loan at December 31, 1992 were $194.9 million and $180.4 million, respectively. The carrying amounts of assets and liabilities at December 31, 1993 and 1992, approximate the estimated fair values of the financial instruments of Bay Loan. 6. Investments in Partnerships and Joint Ventures ESI holds interests in partnerships and joint ventures which are engaged in non-utility energy production in various parts of the United States, including California, Virginia and Pennsylvania. ESI's ownership percentages in these partnerships and joint ventures vary throughout the terms of the investments. Its participation in the expected financial benefits, which range from 5% to 50% over the life of the projects, does not exceed the maximum allowed under the Public Utility Regulatory Policies Act of 1978 (PURPA). The projects utilize a diverse mix of technologies, including wind power, waste coal, natural gas, solar power, geothermal and waste-to-energy. The investments are accounted for under the equity method. The difference between ESI's initial investment and the underlying equity in net assets of the partnerships and joint ventures at the date the investments were entered into is amortized over the projects' estimated useful lives as an adjustment to equity in earnings of partnerships and joint ventures. As of December 31, 1993 and 1992, the unamortized balance was approximately $17.4 million. Summarized information from the financial statements of ESI's investments, which represent essentially all of the Company's investments in partnerships and joint ventures accounted for under the equity method, is as follows: In addition to those investments reflected above, the Company holds other investments in partnerships and joint ventures accounted for under the equity method which contributed losses of approximately $60 thousand, $36 thousand and $41 thousand in 1993, 1992 and 1991, respectively, to the Company's aggregate equity in earnings of partnerships and joint ventures. At December 31, 1993 and 1992, these investments totaled approximately $4.5 million and $4.1 million, respectively. 7. Investments in Leveraged Leases ESI is the lessor in several diversified leveraged lease agreements entered into from 1985 through 1990. At December 31, 1993, the leased properties have remaining lease terms ranging from 14 to 22 years. ESI has supplied equity in varying amounts up to 20% of the purchase prices. The remaining funds were supplied by other equity contributors and by third-party financing in the form of nonrecourse long-term debt and are secured by first liens on the property. At the end of the lease term, the property is turned back to the equity participants. In some instances, the agreements provide for the lessee to have the option to purchase the property at a fixed price or at fair market value. These are not considered to be bargain purchase options. The estimated residual values at the end of the leases range from 5% to 25% of cost. The components of the net investment in leveraged leases are as follows: ITCs related to leveraged leases recognized during the years ended December 31, 1993, 1992 and 1991 were approximately $0.4 million, $0.6 million and $0.5 million, respectively. Pretax income from leveraged leases totaled approximately $4.6 million, $7.0 million and $11.1 million for the years ended December 31, 1993, 1992 and 1991, respectively. Leveraged lease income, after-tax, totaled approximately $2.1 million, $6.2 million and $7.9 million for the same periods, respectively. 8. Property, Plant and Equipment Property, plant and equipment, at cost (or estimated net realizable value for property held by businesses to be discontinued), less accumulated depreciation is summarized as follows: 9. Debt Long-term debt is summarized as follows: In 1993 and 1992, the Company issued debentures totaling $125.0 million and $150.0 million, respectively, and redeemed debt totaling $115.0 million and $200.0 million, respectively. Early debt extinguishments resulted in net losses of $12.8 million and $5.3 million, respectively, and have been reflected in the Consolidated Statements of Operations as extraordinary losses. In December 1993, the Company issued a redemption notice for $150.0 million of its 8 7/8% Debentures. The debentures were redeemed in January 1994, using the proceeds from short-term borrowings. Under the terms of the Company's Indenture dated March 1, 1987 (Indenture) relating to the issuances of its debentures, the Company is subject to certain restrictions on the pledging of property to secure debt. Annual maturities of long-term debt for the years ended December 31, 1994 through 1998 are approximately $278.2 million, $2.4 million, $1.0 million, $150.6 million and $0.1 million, respectively. Available bank lines of credit for the Company aggregated $150.0 million at December 31, 1993, all of which are based on firm commitments. 10. Stockholder's Equity The changes in Stockholder's Equity accounts are as follows: Support Agreement - Under the terms of a support agreement between the Company and FPL Group (Support Agreement), FPL Group has agreed: to retain ownership of 100% of the voting stock of the Company; to ensure that the Company maintains a net worth of not less than $1.00; and to make sufficient liquid asset contributions to the Company to permit the Company to pay its debt and, subject to certain limitations, its other obligations as they become due. With respect to such other obligations, FPL Group, in any calendar year, shall not be required to make payments in excess of the lesser of 110% of the debt outstanding at the time such payment may be required or $25.0 million. The Support Agreement provides that it may be terminated by either the Company or FPL Group, only if two nationally recognized securities rating organizations confirm in writing that their ratings for the Company's outstanding debt would be the same or better, whether or not the Support Agreement was in effect. Debt Covenant - The Company, under a financial covenant in connection with a bank loan, may not permit its consolidated net worth at any time to fall below $100.0 million minus 50% of the aggregate amount of the loan which has been prepaid by the Company. At December 31, 1993, the required level of consolidated net worth under this provision was $100.0 million and actual consolidated net worth was $332.5 million. 11. Fair Value of Financial Instruments The following estimates of the fair value of financial instruments have been made using available market information and other valuation methodologies. However, the use of different market assumptions or methods of valuation could result in different estimated fair values. The Company's investment in cable joint ventures accounted for under the cost method totaled approximately $3.0 million and $21.1 million at December 31, 1993 and 1992, respectively. The fair value of these investments cannot be practicably estimated. The fair value of the Company's commitments and guarantees (see Note 12) is based on fees currently charged for similar arrangements. The fair value of such amounts was not material at December 31, 1993 and 1992. 12. Commitments and Contingencies Leases - Rental expense for the years ended December 31, 1993, 1992 and 1991 was approximately $1.5 million, $1.7 million and $1.6 million, respectively. Future minimum rental commitments for noncancellable leases for the years ended December 31, 1994 through 1998 and thereafter are approximately $0.9 million, $0.8 million, $0.8 million, $0.8 million, $0.6 million and $2.0 million, respectively. Litigation - A suit brought by the partners in a cogeneration project located in Dade County, Florida, alleges that ESI, FPL Group and FPL have engaged in anti-competitive conduct intended to eliminate competition from cogenerators generally, and from their facility in particular, in violation of federal antitrust laws and have wrongfully interfered with the cogeneration project's contractual relationship with Metropolitan Dade County. The suit seeks damages in excess of $100 million, before trebling under antitrust law, plus other unspecified compensatory and punitive damages. A motion for summary judgment by ESI, FPL Group and FPL has been denied. A former cable installation contractor for Telesat Cablevision, Inc. (Telesat) has sued the Company, FPL Group and Telesat for breach of contract, fraud and violation of racketeering statutes. The suit seeks compensatory damages in excess of $24 million, treble damages under racketeering activity statutes, punitive damages and attorneys' fees, as well as the revocation of Telesat's corporate charter and cable television franchises. The Company believes that it and its affiliates have meritorious defenses to all of the litigation described above and is vigorously defending these suits. Accordingly, the liabilities, if any, arising from this litigation are not anticipated to have a material adverse effect on the Company's financial position. Other - The Company and ESI have committed to invest approximately $3.2 million in, and lend approximately $4.2 million to, partnerships and joint ventures entered into through ESI, all of which are expected to be funded in 1994. Additionally, the Company and its subsidiaries, primarily ESI, have guaranteed up to approximately $89.2 million of lease obligations, debt service payments and other payments subject to certain contingencies. 13. Related Party Transactions FPL Group and FPL periodically provide, at cost, the services of certain executive officers, administrative and clerical personnel, and various equipment to the Company and its subsidiaries. Such direct services are charged to the Company and its subsidiaries primarily on the full cost method. In addition, certain indirect costs of FPL Group, not identifiable to a specific company, are allocated based on each subsidiary's equity, which in management's opinion is reasonable. Such direct and indirect costs for the three years ended December 31, 1993 represented an insignificant portion of total operating expenses. The related amounts due to affiliated companies at December 31, 1993 and 1992 were not material. Advances payable to FPL Group totaled $6.0 million at December 31, 1992 and were repaid during 1993. Receivables from affiliated companies result primarily from income tax benefits due from FPL Group in accordance with the Tax Allocation Agreement. During 1993, 1992 and 1991 FPL Group paid approximately $52.1 million, $58.6 million and $28.6 million, respectively, to the Company and its subsidiaries in connection with this agreement. In 1990, the Company loaned $360.0 million, bearing an interest rate of 9.69% for a term of 20 years, to the Trust for the Employee Thrift Plans of FPL Group and FPL (Trust). The noncurrent portion of the remaining loan balance is reflected in receivable from Employee Stock Ownership Plan Trust in the Consolidated Balance Sheets, with the current portion of approximately $3.0 million and $1.9 million included in other receivables at December 31, 1993 and 1992, respectively. The Trust used the loan proceeds to purchase approximately 12 million shares of FPL Group common stock at a price of $29 per share, the closing price on the New York Stock Exchange on December 19, 1990. The Trust is repaying the loan with dividends received on the shares it holds, along with certain cash contributions from the participating employers. 14. Business Segment Information Summarized financial information by industry segment is as follows: DOSWELL II LIMITED PARTNERSHIP Consolidated Financial Statements and Financial Statement Schedules for the Years Ended December 31, 1993 and 1992 and the Period October 4, 1991 (Date of Inception) to December 31, 1991 and Independent Auditors' Report INDEPENDENT AUDITORS' REPORT Doswell II Limited Partnership: We have audited the accompanying consolidated balance sheets of Doswell II Limited Partnership as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital (deficiency), and cash flows for the years ended December 31, 1993 and 1992 and the period October 4, 1991 (date of inception) to December 31, 1991. Our audits also included the related financial statement schedules. These financial statements and financial statement schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for the years ended December 31, 1993 and 1992 and the period October 4, 1991 (date of inception) to December 31, 1991 in conformity with generally accepted accounting principles. Also in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 7 to the consolidated financial statements, Doswell Limited Partnership is involved in litigation relating to the amount and manner of calculating one component of electricity sales. The ultimate outcome of the litigation cannot presently be determined. DELOITTE & TOUCHE Certified Public Accountants Los Angeles, California March 18, 1994 DOSWELL II LIMITED PARTNERSHIP CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 See notes to consolidated financial statements. DOSWELL II LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 See notes to consolidated financial statements. DOSWELL II LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIENCY) YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 See notes to consolidated financial statements. DOSWELL II LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 See notes to consolidated financial statements.(Continued) DOSWELL II LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 See notes to consolidated financial statements.(Concluded) DOSWELL II LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 1. GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING POLICIES General - Doswell II Limited Partnership (Doswell II LP) was formed to replace Doswell II, Inc. (Doswell II) as the sole limited partner of Doswell Limited Partnership (DLP). DLP was formed to develop, construct, own and operate a 665 megawatt independent power production facility (the Facility) in Hanover County, Virginia. The Facility generates electric power for sale to Virginia Electric and Power Company (Virginia Power) primarily by burning natural gas with oil as a backup fuel. Commercial operations commenced in May 1992. DLP Reorganization - On October 4, 1991, the ownership structure of DLP was reorganized (the Reorganization). Under the terms of the Reorganization, Diamond Energy, Inc. (DEI), a wholly owned subsidiary of Mitsubishi Corporation (Mitsubishi), sold all of the capital stock of Doswell I, Inc. (Doswell I), the general partner of DLP, to Diamond - Hanover, Inc. (DHI), also a wholly owned subsidiary of Mitsubishi and an affiliate of DEI; Doswell II, Inc. (Doswell II) was replaced by Doswell II LP as the sole limited partner of DLP; Doswell II LP's initial partners were Doswell II and Doswell III, Inc. (Doswell III), both wholly owned subsidiaries of DEI. Doswell III is the sole general partner of Doswell II LP. On December 6, 1991, ESI Doswell Limited Partnership (ESI Doswell LP), whose partners are both wholly owned subsidiaries of ESI Energy, Inc. (ESI), a wholly owned subsidiary of FPL Group Capital Inc (FPL), which is a wholly owned subsidiary of FPL Group, Inc., became a limited partner in Doswell II LP by assuming $25,500,000 of the $30,000,000 equity obligation required to convert DLP's construction loan to a term facility. On July 14, 1992, Doswell II LP sold a portion of its interest in DLP to North Anna Power Company (NAPC) and recognized a gain of $3,394,000. Doswell I is the general partner, and NAPC and Doswell II LP are the limited partners in DLP; and Doswell III is the general partner, and Doswell II and ESI Doswell LP are the limited partners in Doswell II LP. Under the terms of the Third Amended and Restated Articles of Limited Partnership of DLP, Doswell I is allocated one percent of all income, loss, tax deductions and cash distributions; allocations to Doswell II LP and NAPC are in varying ratios over time based upon the after-tax net present value of allocations to NAPC at the end of each prior calendar year. Under the terms of the Amended and Restated Agreement of Limited Partnership of Doswell II LP, Doswell III is allocated one percent of all income, loss, tax deductions and cash distributions; allocations to Doswell II and ESI Doswell LP are in varying ratios over time based upon the net present value of aggregate cash distributions to ESI Doswell LP at the end of each prior calendar year. The following is a summary of Doswell II LP's significant accounting policies: Principles of Consolidation - Doswell II LP's consolidated financial statements include the accounts of, and reflect Doswell I's and NAPC's minority interests in, DLP. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements. Cash Equivalents - Doswell II LP considers all highly liquid investments purchased within three months of their maturity to be cash equivalents. Restricted Cash and Cash Equivalents - Restricted cash and cash equivalents represent amounts, consisting primarily of debt service and operations and maintenance reserves, which are restricted as to their use. Inventories - Fuel inventories are stated at the lower of weighted average cost or market; spare parts inventories are stated at cost, determined by specific identification. Property, Plant and Equipment - Property, plant and equipment are stated at cost. Depreciation is generally provided using the straight-line method over estimated useful lives ranging from three to forty years. Interest of $9,209,079 was capitalized during 1992 prior to the commencement of commercial operations. Interest of $8,242,781 was capitalized during the period October 4, 1991 to December 31, 1991. Deferred Financing Costs - Loan origination and other financing costs have been capitalized and are being amortized over the lives of the term loan and subordinated debt. Accumulated amortization at December 31, 1993 and 1992 was $1,723,295 and $563,541, respectively. Deferred Preoperating Expenses - Start-up expenses, consisting primarily of fuel and labor costs net of start-up revenues, have been capitalized and are being amortized over five years. Accumulated amortization at December 31, 1993 and 1992 was $4,943,444 and $1,976,012, respectively. Other Assets - Costs associated with the acquisition of power purchase and operating agreements have been capitalized and are being amortized over the twenty-five year lives of the agreements. Organization costs are being amortized over five years. Accumulated amortization at December 31, 1993 and 1992 was $1,902,689 and $239,754, respectively. Income Taxes - Doswell II LP has no liability for income taxes. Income is taxed to the partners based on their allocated share of taxable income (loss). Therefore, no provision or liability for income taxes has been included in these financial statements. Fair Value of Financial Instruments - The carrying amount of cash and cash equivalents approximates fair value because of the short maturities of these instruments. DLP's notes payable and short-term debt approximate fair value because their interest rates are based upon variable reference rates. The fair value of DLP's interest rate swaps (used for hedging purposes) is the estimated amount DLP would have to pay to terminate the swap agreements taking into account current interest rates and the current creditworthiness of the swap counterparties. The estimated termination cost associated with the interest rate swaps at December 31, 1993 and 1992 is approximately $59,000,000 and $60,400,000, respectively. The carrying amount of the subordinated notes payable approximates fair value at December 31, 1993. Reclassifications - Certain reclassifications have been made to the 1992 and 1991 financial statements to conform with the 1993 presentation. 2. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following: 3. NOTES PAYABLE DLP entered into a Construction Loan and Term Facility dated June 4, 1990 with Credit Suisse (the Agreement). DLP also entered into an eighteen- year Subordinated Credit Agreement whereby the lender agreed to fund $40,000,000 to be used to repay a portion of the construction loan on the date the construction loan converted to a term facility. On April 30, 1993, DLP converted its construction loan into a $410,000,000, fifteen-year senior term loan by the partners' contribution of $30,000,000 of equity required to pay down the construction loan and the satisfaction of various other conditions. In addition, the $40,000,000 subordinated loan was funded on April 30, 1993, with the proceeds used to pay down an additional portion of the construction loan. DLP may select the interest rate for the senior term loan from three alternatives: two bank reference rates plus applicable margins or the London Interbank Offer Rate plus a margin. The interest rate on the subordinated debt is fixed at 12.79%. The subordinated loan will amortize over eighteen years. Obligations under the Agreement and the Subordinated Credit Agreement will mature as follows: The Agreement and the Subordinated Credit Agreement contain various restrictive covenants, including the maintenance of certain reserve accounts and debt coverage ratios. Failure to meet such covenants may result in penalties which include restrictions on distributable cash and increases in borrowing costs. Substantially all assets, rights, income and title of the Facility are pledged as collateral on the notes payable and the subordinated debt. DLP has entered into interest rate swap agreements to reduce the impact of changes in interest rates on its floating rate long-term debt. At December 31, 1993, DLP had four interest rate swap agreements outstanding with total notional principal amounts of $313,600,000. Those agreements effectively change DLP's interest rate exposure on a portion of the senior term loan through 2002 to an average all-in borrowing cost of 10.7 percent. DLP is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements. However, DLP does not anticipate nonperformance by the counterparties, all of whom are affiliated with Credit Suisse. 4. SHORT-TERM DEBT The Agreement also provides for a working capital loan commitment up to an aggregate maximum principal amount of $38,000,000 for natural gas and fuel oil purchased by DLP (the Working Capital Facility) which will remain available until 2007. Working capital loan repayments are tied to fuel inventory usage. Interest rate and period alternatives are similar to those for the senior term loan (see Note 3). 5. RELATED PARTY TRANSACTIONS Under the terms of a project service agreement, DLP paid DEI $330,000 and $220,000 during 1992 and the period October 4, 1991 to December 31, 1991, for project management services, which amounts have been capitalized. Under the terms of the Articles of Limited Partnership, DLP reimbursed Doswell I $56,135 and $39,032 during 1993 and 1992, respectively, for management expenses incurred. On December 6, 1991, FPL loaned $25,500,000 to Doswell II LP (the Partner Note Payable), which Doswell II LP loaned to DLP. The Partner Note Payable had an interest rate and period identical to the construction loan notes payable and was classified as long-term at December 31, 1992 as it had a mandatory conversion provision whereby it funded $25,500,000 of the $30,000,000 of equity required to convert DLP's construction loan to a term facility. On April 30, 1993, the Partner Note Payable was converted to equity in conjunction with the conversion of the construction loan to a term loan (see Note 3). Interest of $493,507 on the Partner Note Payable was capitalized during 1992 prior to commercial operations and $107,135 was capitalized during the period October 4, 1991 to December 31, 1991. During 1993 and 1992, interest expense of $362,954 and $849,845, respectively, on the Partner Note Payable was recognized subsequent to the commencement of commercial operations. DLP had also borrowed funds from Doswell I, which loans were subordinated to all other DLP debt (the Subordinated Affiliate Note Payable) and bore interest at prime plus two percent. Principal and interest were repaid in May 1993. Interest of $83,678 on the Subordinated Affiliate Note Payable has been capitalized, including $73,418 and $10,260 in 1992 and 1991, respectively. Interest expense of $83,397 and $122,143 on the Subordinated Affiliate Note Payable was recognized subsequent to the commencement of commercial operations during 1993 and 1992, respectively. Doswell II LP pays Doswell III $5,000 per month for general management services. 6. COMMITMENTS AND CONTINGENCIES DLP has entered into two long-term power purchase and operating agreements with Virginia Power for the sale of all electricity produced at the Facility for periods of twenty-five years each; long-term natural gas transportation and storage agreements with CNG Transportation Corporation for periods of fifteen years with options to extend for an additional five years; and a twenty-five year natural gas transportation agreement with Virginia Natural Gas. At December 31, 1993, letters of credit established as security for payments to be made under certain of these agreements total $14,075,000. DLP has entered into various contracts committing it to make substantial payments in the ordinary course of its business to certain vendors in connection with the operation of the Facility. 7. LITIGATION DLP and Virginia Power are involved in litigation related to the amount and manner of calculating one component of electricity sales. DLP has accrued an aggregate $5,940,000 through December 31, 1993 in accounts receivable-other and has recognized revenue of $3,200,000 and $2,740,000 during the years ended December 31, 1993 and 1992, respectively, which is less than the amount to which management believes it is entitled. The issues in dispute include a determination of Virginia Power's costs for certain elements of fuel transportation and whether the payments to DLP should be based upon all or only a portion of those costs. The ultimate outcome of this litigation cannot presently be determined. * * * * * * DOSWELL II LIMITED PARTNERSHIP SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES - NOT CURRENT FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 AND PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 DOSWELL II LIMITED PARTNERSHIP SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 AND THE PERIOD OCTOBER 4, 1991 (DATE OF INCEPTION) TO DECEMBER 31, 1991 DOSWELL II LIMITED PARTNERSHIP SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 SKY RIVER PARTNERSHIP REPORT AND FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Sky River Partnership In our opinion, the accompanying balance sheet and the related statements of operations, of changes in partners' capital and of cash flows present fairly, in all material respects, the financial position of Sky River Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Partnership's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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 the opinion expressed above. As further described in the notes to the financial statements, the Partnership has extensive transactions and relationships with its affiliates. Because of these relationships, it is possible that the terms of these transactions may not be the same as those that would result from transactions among wholly unrelated parties. PRICE WATERHOUSE Woodland Hills, California February 11, 1994 SKY RIVER PARTNERSHIP BALANCE SHEET See accompanying notes to financial statements. SKY RIVER PARTNERSHIP STATEMENT OF OPERATIONS See accompanying notes to financial statements. SKY RIVER PARTNERSHIP STATEMENT OF CHANGES IN PARTNERS' CAPITAL DECEMBER 31, 1993 See accompanying notes to financial statements. SKY RIVER PARTNERSHIP STATEMENT OF CASH FLOWS INCREASE (DECREASE) IN CASH See accompanying notes to financial statements. SKY RIVER PARTNERSHIP NOTES TO FINANCIAL STATEMENTS NOTE 1 - THE PARTNERSHIP: Sky River Partnership, a California general partnership (the "Partnership" or "Sky River"), was formed on June 7, 1990 to design, construct and operate a system of 342 Vestas model V27-225 KW wind turbine electric generators (the "Turbines"). The Turbines, together with a power transfer system, form an integrated power generating facility (the "Windsystem") near Tehachapi, California. Power generated by the Windsystem is sold to Southern California Edison ("SCE") under thirty-year power purchase agreements ("Power Purchase Contracts"). The Project became fully operational in November 1991. The general partners of the Partnership are Zond Sky River Development Corporation ("Zond SR"), a wholly owned subsidiary of Zond Systems, Inc. ("Zond"), and ESI Sky River Limited Partnership ("ESI SR"), an affiliate of ESI Energy Inc. ("ESI"). Zond is a developer and operator of commercial wind-powered electric generating facilities. ESI is a wholly owned subsidiary of the FPL Group, a major regional utility holding company. Under the terms of the Partnership Agreement, Zond SR acts as the managing partner. The Project was constructed for a total cost of $158,000,000. Under the Partnership Agreement, ESI SR and Zond SR earned $6,200,000 and $8,000,000, respectively, in net developers' fees as compensation for certain services provided in developing the Project. Upon conversion to term debt financing on December 18, 1991, ESI made a capital contribution of $21,000,000 in cash and provided subordinated financing of $15,000,000, the proceeds of which were used by the Partnership to pay construction loans (see Note 3). Zond contributed certain intangible assets, including Power Purchase Contracts and land easements. These contributions have not been assigned a value by the Partnership. The accompanying financial statements include substantial transactions with related parties. These transactions are further described in Notes 3 and 4. A summary of the major agreements entered into by the Partnership is set forth below: (1) Windsystem Construction Agreement During the construction period of the Windsystem, Zond provided construction, installation, engineering, project management and technical services to the Partnership. Zond received reimbursement of direct construction costs, comprised principally of subcontract labor, substation and transmission line equipment, and equipment rental, under a fixed price contract of $45,000,000. NOTE 1: (Continued) (2) Grant of Wind Park Easement and Easement Agreement Zond owns and holds leasehold rights to the land on which the Windsystem is located. Zond has granted the Partnership exclusive easement rights to the operating site. In return, the Partnership will pay Zond a quarterly easement royalty of 2% of gross operating proceeds arising from Windsystem operations. Easement royalties totalled $587,000, $407,000 and $115,000 for 1993, 1992 and 1991, respectively. (3) Windsystem Management Agreement The Partnership has contracted with Zond for the operation and management of the Windsystem (exclusive of the Turbines). The agreement also requires the performance of certain ancillary management services, including the monitoring and collection of Partnership revenues, insurance and warranty claims (see Note 4). (4) Partnership Agreement The Partnership agreement designates Zond SR as managing partner. In that capacity, Zond SR provides managerial services including administration and payment of all Partnership expenses (see Note 4). (5) Wind Turbine Generator Warranty and Maintenance Agreement The Partnership has contracted with Vestas Windsystems A/S ("Vestas"), the Danish manufacturer of the Turbines, to provide turbine maintenance and repair services. The agreement also requires Vestas to replace defective parts, correct design flaws and warrant specified levels of Turbine performance for a period of five years from the date the final turbine is placed in service (see Note 4). (6) SCE Power Purchase Contracts The Partnership sells the electric power provided by the turbines to SCE pursuant to three power purchase contracts which have a term of thirty years. During the initial ten years of the agreement, SCE purchases the power produced based upon forecasted annual marginal costs of energy and capacity (which range from $.0944 per kilowatt hour ("kwh") to $.1828 per kwh). Subsequent to the initial ten years, the agreements provide for energy and capacity payments based on SCE's variable avoided costs of providing capacity and producing energy. NOTE 1: (Continued) (7) Lease of Vestas V-39 Turbine In November 1991, the Partnership entered into an operating lease of a single V39-500 KW Turbine with Vestas Windsystems A/S ("Vestas"). The ten-year lease (commencing January 1992) is cancelable at the option of Vestas upon thirty days written notice. Quarterly lease payments represent 85% of the gross operating proceeds less insurance and taxes. Such lease costs totalled $154,000, $109,000 and $0 for 1993, 1992 and 1991, respectively. The Partnership's significant distributions and allocations are as follows: (1) Profits and losses will be allocated to ESI SR and Zond SR in the following manner: Period ESI SR ZSI SR Inception to December 31, 1990 99% 1% January 1, 1991 - December 31, 1999 85% 15% January 1, 2000 - December 31, 2009 60% 40% January 1, 2010 - December 31, 2020 40% 60% (2) Cash is distributable to partners to the extent not needed to make debt service payments, maintain a minimum operating cash balance, and to fund the debt service reserve as prescribed by the credit agreement. Distributions of cash will be made pursuant to decisions of a management committee composed of representatives of ESI SR and Zond SR. Distributions to each partner will be allocated as follows: Period ESI SR ZSI SR June 7, 1990 - December 31, 1995 86.5% 13.5% January 1, 1996 - December 31, 2006 60.0% 40.0% January 1, 2007 - December 31, 2010 50.0% 50.0% January 1, 2011 - December 31, 2020 40.0% 60.0% Generally, gains or losses, if any, upon the eventual liquidation of the Partnership are to be based on the relative value of each partner's tax basis capital account. No distributions were made prior to 1993. Cash distributions in 1993 totalled $6,486,000. During January 1994, cash distributions totalling $5,546,000 were made to the partners. NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES: Wind Energy Generating and Electrical Transfer System All costs, including interest of $5,301,000, incidental to the construction of the Windsystem have been capitalized. Additions to the Windsystem totalled $93,817,000 during 1991; there have been no additions to the Windsystem in 1992 and 1993. Depreciation is being charged using the straight-line method over the Windsystem's and electrical transfer system's estimated useful lives of twenty years, which commenced as turbines were placed in service by the Partnership. Depreciation expense totalled $6,812,000, $6,812,000 and $3,677,000 for 1993, 1992 and 1991, respectively. Accumulated depreciation totalled $17,301,000, $10,489,000 and $3,678,000 at December 31, 1993, 1992 and 1991, respectively. Electricity Sales Power generated by the Windsystem is recognized as income upon delivery of power to SCE at fixed prices as stipulated under the Power Purchase Contracts with SCE. Restricted Cash Certain cash accounts are subject to restrictions pursuant to the project financing agreement. Financial Instruments Financial instruments which potentially subject the Partnership to concentration of credit risk consist of temporary cash investments. The Partnership places its temporary cash investments in money market accounts with the financial institution to which the Partnership is indebted under its financing agreements (Note 3). Historically, the Partnership has not incurred any credit related losses. Investment in Sagebrush Line The Partnership accounts for its interests in the Sagebrush power transmission line (the "Sagebrush Line") using the equity method (Note 5). Income Taxes No provision for federal income taxes is necessary in the financial statements of the Partnership because, as a partnership, it is not subject to federal income tax and the tax effect of its activities accrues to the partners. Deferred Organizational Costs The Partnership deferred certain organizational costs and is amortizing these costs using the straight-line method over a five-year period. Amortization expense relating to deferred organizational costs totalled $200,000, $200,000 and $217,000 for 1993, 1992 and 1991, respectively. NOTE 2: (Continued) Deferred Debt Issue Costs The Partnership deferred certain debt issue costs, principally legal fees relating to the issuance of the construction loans and conversion to a term loan, and is amortizing these costs using the interest method over the twelve-year term of the loans (see Note 3). Amortization expense relating to deferred debt issue costs totalled $598,000, $436,000 and $468,000 for 1993, 1992 and 1991, respectively. Prepaid Insurance The Partnership is amortizing its prepaid insurance premiums using the straight-line method over the related policies' terms. NOTE 3 - PROJECT FINANCING: Construction and Term Loans In December 1990, the Partnership entered into a $158 million credit agreement (the "Agreement") with a group of banks which provided funding for the construction of the Windsystem in the form of a series of notes payable (the "Construction Loans"). The Construction Loans matured on the date of conversion to term financing. During the construction period, the Partnership entered into various interest rate swap transactions to hedge against changes in LIBOR. These transactions effectively fixed the interest rate at 6.56% from May 14, 1991 through November 29, 1991. The net effect of the hedge transactions is recorded as an adjustment to interest costs during the period. Upon maturity of the Construction Loans, ESI SR contributed $36,000,000 towards repayment of the Construction Loans, comprising $21,000,000 in a capital contribution (see Note 1) and $15,000,000 in subordinated debt as described below. The remaining balance of $122,000,000 was converted to a twelve-year term loan (the "Term Loan"). The Term Loan is payable in semi- annual installments, plus interest at LIBOR plus 1.875%. The Partnership may from time to time fix the interest rate for a period of time based upon the LIBOR rate at that time. The Partnership fixed the interest rate for the period from October 30, 1993 through January 31, 1994 at 5.3125%. The Term Loan is secured by the Partnership's assignment of all of its rights in all tangible property, as well as all agreements and contracts relating to the Windsystem, its operations, maintenance and management. The Partnership is required to remit an annual administration fee of $75,000 on the Term Loan. The Partnership must periodically submit operating and capital budgets to the lenders as a condition of the use of any operating cash. The fair value of the Term Loan is equivalent to the value carried in the financial statements due to the loan's variable LIBOR rate provisions. NOTE 3: (Continued) The Partnership is required to maintain a debt reserve account which is funded on each term facility repayment date to the extent the balance is less than projected debt service for the following six-month period, and only after cash is provided for working capital requirements. Deposits to this account are subject to funding of the Partnership's current operating cash requirements and a $750,000 working capital balance. The debt reserve account balance at December 31, 1993 and 1992 was $2,777,000 and $757,000, respectively. For the initial six term facility repayments, the maximum debt reserve contributions are prescribed by the credit agreement. Subject to working capital funding and the six month limitation, the balance would reach $7,500,000 by the sixth term facility repayment date. Thereafter, the maximum reserve balance will equal projected debt service for the six-month period following each term facility repayment date. The projected debt service reserve requirement is not expected to exceed approximately $11,000,000 in any six-month period. ESI Participation ESI has purchased a subordinated fractional interest in the Term Loan commitment of Credit Suisse in the amount of $20,000,000. Subordinated Debt At the date of conversion to the Term Loan, ESI purchased from the Project lenders $15,000,000 of the original Construction Loans and converted such debt into unsecured notes payable, which are subordinated to the Term Loan. Repayment is due semiannually, subject to the priority repayment of the Term Loan installments and availability of funds after operating expense and minimum balance requirements, as described above, have been met. Interest is payable on the outstanding balance at LIBOR plus 5%. In 1991, ESI received a $150,000 financing fee from the Partnership for its loan. Interest costs of approximately $1,290,000, $389,000 and $50,000 relative to this agreement were incurred in 1993, 1992 and 1991, respectively. The fair value of the subordinated loan is equivalent to the value carried in the financial statements due to the loan's variable LIBOR rate provisions. Future Maturities Future scheduled principal repayments under the project financing agreements are as follows: NOTE 4 - RELATED PARTY TRANSACTIONS: In addition to transactions and relationships described elsewhere in the footnotes to the financial statements, the Partnership has the following related party transactions and relationships: (1) Prior to finalization of the Agreement, the Partnership obtained interim financing from ESI. The borrowings from ESI consisted of two notes: one for $8,500,000 and the other for $12,000,000, each were unsecured and earned interest at an annual rate of 11.5%. At the time of the first advance (December 26, 1990) under the Agreement, ESI was repaid $18,212,000 of principal and $497,000 of accrued interest. All interest costs relating to this loan have been capitalized. The remaining note balance and accrued interest in the amount of $291,000 was paid in full during the construction phase of the project. (2) Zond SR and ESI SR were entitled to receive developers' fees of up to $10,000,000 and $7,000,000, respectively, as compensation for their services in developing the projects, subject to reduction due to construction overruns in accordance with a formula specified in the Partnership Agreement. Zond SR and ESI SR earned $8,000,000 and $6,200,000, respectively, in developers' fees from the project. (3) The Partnership has contracted with Vestas to maintain the Turbines during their first five years of operation (see Note 1). Under the terms of this agreement, the Partnership pays Vestas $4,500 per turbine per year, commencing on the date each turbine became operational. Of this amount, $2,700 is paid to Zond for maintenance services under a turbine maintenance subcontract. These amounts are adjusted annually for increases in the Consumer Price Index. The remainder is held in a reserve account by one of the Term Lenders described in Note 3 as a means of providing for future warranty costs of the Turbines. At the end of the five year warranty period, any funds in this account are to be distributed to the Partnership and Vestas in the ratio of 65% and 35%, respectively. As of December 31, 1993, the balance in the reserve account was $1,239,000. At the end of the warranty period, management believes Zond will assume responsibility for maintenance of the Turbines under a contract to be negotiated. (4) The Partnership has contracted with Zond to operate the Windsystem and perform certain ancillary management services. As compensation for these services, Zond receives $675 per turbine per year commencing in 1992; this amount will be revised each January to reflect changes in the Consumer Price Index. Management services totalled $246,000, $237,000 and $128,000 for 1993, 1992 and 1991, respectively. (5) The Partnership agreement designates Zond SR as managing partner. In that capacity, Zond SR provides managerial and administrative services in exchange for an annual fee of $250,000, adjusted annually for increases in the Consumer Price Index, in addition to reimbursement of direct expenses incurred. Such management fees totalled $266,000, $257,000 and $250,000 for 1993, 1992 and 1991, respectively. NOTE 5 - OTHER TRANSACTIONS: The Partnership acquired certain entities (the "Sagebrush Entities"), whose sole assets are ownership interests representing approximately 41% of the capacity in a high voltage transmission line (the "Sagebrush Line"). The Sagebrush Line delivers power produced by the Partnership's turbines to the SCE Grid. The purchase of these interests was initially financed through the issuance of a $10,200,000 note payable, which was paid in full from proceeds of the Construction Loan in 1991. Sky River assigned its interests in approximately 50% of its share of the Sagebrush Line to existing turbine owner groups located in Tehachapi, also managed by Zond. The existing turbine owner groups relinquished their access rights to a separate interconnect facility. In consideration for moving their interconnect point from those existing facilities to the Sagebrush Line, Sky River agreed to absorb all maintenance and operating costs of the Sagebrush Line in lieu of any liability by the other turbine owner groups. Such maintenance and operating costs totalled $279,000, $271,000 and $237,000 for 1993, 1992 and 1991, respectively. Upon the expiration or termination of the power purchase contracts held by the other turbine owner groups, the interests in the Sagebrush Entities revert to the Partnership. The Partnership interests in all of the Sagebrush Entities is accounted for using the equity method. NOTE 6 - SUPPLEMENTARY FINANCIAL DATA: The following amounts have been reported in the related income statement: Prepaid assets are comprised of the following items: SIGNATURES Pursuant to the requirements of Section 13 or 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. Date: March 21, 1994 FPL Group Capital Inc By JAMES L. BROADHEAD James L. Broadhead (President and Chief Executive Officer and Director) 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 date indicated. Signature Title Date PAUL J. EVANSON Principal Financial Officer Paul J. Evanson and Director (Vice President and Chief Financial Officer) K. MICHAEL DAVIS Principal Accounting March 21, 1994 K. Michael Davis Officer (Controller and Chief Accounting Officer) DILEK L. SAMIL Director Dilek L. Samil (Vice President, Treasurer and Assistant Secretary)	13,369	87,509
104867_1993.txt	104867_1993	1993	104867	ITEM 1. BUSINESS General Development of Business Washington National Corporation (WNC) was incorporated as a general business corporation under the Delaware General Corporation Law on February 26, 1968, for the initial purpose of becoming the parent company and sole stockholder of Washington National Insurance Company (WNIC), an Illinois insurance corporation dating back to 1911. WNC was organized in order to permit diversification into the broader field of financial services and is admitted to do business in Delaware, Indiana, and Illinois. Its executive offices are located at 300 Tower Parkway, Lincolnshire, Illinois 60069-3665. The primary operating companies of WNC are WNIC and United Presidential Life Insurance Company (UPI). As of December 31, 1993, WNC and its affiliates had 971 employees. In 1989, WNC and its affiliates completed a strategic plan and began restructuring their operations. The strategic plan called for the divestiture of the home service and direct response lines of business at WNIC and a subsidiary, Washington National Life Insurance Company of New York (WNNY). WNIC sold the direct response and home service product lines and WNNY in 1989, 1990, and 1991, respectively. The organization is now focused on four lines of business: individual health insurance, group employee benefits, disability insurance for educators (all underwritten by WNIC), and individual life insurance and annuities (underwritten by UPI). In the third quarter of 1993, WNC issued 2.1 million new shares of common stock in a public offering that raised $47.3 million. GENERAL DESCRIPTION OF THE BUSINESS OF THE INDUSTRY SEGMENTS WNC is an insurance holding company which, through WNIC and UPI, provides life, annuity, health, disability, and specialty insurance products to individuals and groups in carefully targeted markets. The business segments related to WNC's business are a life insurance and annuities segment, an individual health insurance segment, a group products segment, and a corporate and other segment. The corporate and other segment includes realized investment gains and losses, as well as the operations of divested lines of business and the gain or loss on the sales thereof. In addition, this segment includes the operations of WNC that do not specifically support one of the other segments. Further information about WNC's four business segments can be found in Item 8, under the caption "Note K - Segment Information." Washington National Insurance Company WNIC is a legal reserve stock life insurance company organized under the laws of Illinois in 1926 and is the successor to other companies dating back to 1911. WNIC's home office is located at 300 Tower Parkway, Lincolnshire, Illinois 60069-3665. WNIC is licensed to do business in all states of the United States (except New York) and the District of Columbia. WNIC underwrites individual health insurance, group employee benefits, and disability insurance for educators. As part of the corporate strategy plan, the decision was made to write life insurance and annuity business solely at UPI. Therefore, as of November 1989, WNIC ceased writing individual life insurance policies and annuities, except for home service life products, which WNIC ceased writing in March 1990; however, WNIC continues to administer existing life insurance and annuity business. WNIC's individual health line of business includes major medical and hospital-surgical policies. Group employee benefits consists of term life, major medical, disability income, and dental insurance policies. Disability insurance for educators generally is sponsored by school districts or educational associations for voluntary purchase by employees of public school systems. In 1993, 2% of WNIC's insurance premiums and other policy charges were derived from products in the life insurance and annuities segment. A total of 40% of WNIC's 1993 insurance premiums and other policy charges were derived from products in the individual health insurance segment. A total of 58% of WNIC's 1993 insurance premiums and other policy charges were derived from products in the group products segment, of which 16% and 84% were from life insurance and health insurance, respectively. Group health insurance premiums were 29%, 30%, and 35% of WNC's total revenues in 1993, 1992, and 1991, respectively. Texas, New Jersey, and Illinois account for approximately 33% of WNIC's annual premium revenue. Arizona, Louisiana, Florida, and Missouri also account for a significant portion of WNIC's premium revenue, with a combined 20% of the total premium revenue. WNIC's insurance products are primarily sold by salaried group insurance representatives and field marketing organizations. The sector of WNIC's field force that distributes group employee benefits and disability insurance for educators consists of 65 field representatives, including 12 managers, all of whom are salaried employees of WNIC. Their activities are supported by 110 other field employees. WNIC markets individual health products through brokers, who are employed by field marketing organizations under standard brokerage contracts. At December 31, 1993, WNIC had approximately 40,500 brokers employed by 66 field marketing organizations, who sell insurance for other companies as well as for WNIC. United Presidential Life Insurance Company UPI, an Indiana life insurance company, began business in 1965 and currently is licensed to do business in 45 states and the District of Columbia. UPI's parent company, United Presidential Corporation (UPC), was incorporated in 1961 as an Indiana corporation and, effective during the fourth quarter of 1993, is 71% owned by WNIC and 29% owned by WNC. Prior to fourth quarter 1993 UPC was owned 100% by WNIC. Both UPC and UPI have executive offices located at One Presidential Parkway, Kokomo, Indiana 46904-9006. UPI's primary business is the marketing and underwriting of individual life insurance and annuities. Its primary marketing focus is interest- sensitive products such as universal life insurance, excess-interest whole life insurance, and annuities. UPI's operating results are in the life insurance and annuities segment. California, Indiana, and Michigan account for approximately 29% of UPI's 1993 premiums and other charges. However, several other states make significant contributions to premiums and other charges, including Pennsylvania, Florida, Ohio, and Minnesota. Sales are made through approximately 8,000 insurance agents and brokers having an independent contractor relationship with UPI. Such persons may also be independent insurance brokers. UPI has no internal or captive sales force and accordingly, has negligible training, maintenance, or financing expenses. This marketing system facilitates sales force expansion without significant cost, provided that product lines remain competitive with those being offered by other companies. New Products of the Segments For the life insurance and annuities segment, UPI introduced in 1993 two new universal life insurance products to meet the demands and needs of the marketplace. In 1994, UPI will introduce a low premium permanent life insurance product and an update to its annuity portfolio of products. The individual health insurance segment introduced in 1993 new versions of its major-medical and in-hospital products. New products anticipated in 1994 are an individual disability product and a cancer insurance product. The group products segment introduced in 1993 a cancer insurance product and several enhancements for disability insurance for employees of employer-sponsored groups. New products anticipated in 1994 are long-term care insurance and further enhancements to disability insurance. Competitive Conditions of the Segments The insurance subsidiaries, along with other insurance companies with whom they are in competition, are subject to regulation and supervision by the supervisory agency in each jurisdiction in which they are licensed to do business, greatly affecting the competitive environment in which they operate. These supervisory agencies have broad administrative powers, including those relating to the granting and revocation of licenses to transact business, licensing of agents, approval of policy forms, establishing reserve requirements as well as the form and content of required financial statements, and conducting of periodic examinations. The companies must meet the standards and tests established by the National Association of Insurance Commissioners and, in particular, the investment laws and regulations of their states of incorporation. This regulation and supervision is primarily for the protection of policyowners and not stockholders. WNIC's individual health insurance line of business faces competition from approximately 45 companies. There are approximately 90 group employee benefits insurers and less than 30 insurers of disability insurance for educators in competition with WNIC's group products segment. UPI competes for the sale of life insurance and annuity products with approximately 300 U.S. life insurance companies, including stock and mutual companies. FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Neither WNC nor any affiliated company is licensed to do business outside of the United States. ITEM 2. ITEM 2. PROPERTIES WNC's home office building is in a five-story, 175,000 square-foot office building located at 300 Tower Parkway, Lincolnshire, Illinois. The building is leased from a joint venture partnership in which Washington National Development Company (WNDC), a subsidiary of WNIC, has a one-third interest. WNC first occupied the property in May, 1993 and WNIC signed a twenty-year lease to occupy the building. WNDC has a fifty percent interest in a joint venture partnership that owns a 22,000 square-foot data center in Vernon Hills, Illinois, that is leased and occupied solely by WNIC. WNIC first occupied the property in April, 1993 and signed a twenty-year lease. WNIC also owns a 335,000 square-foot office building in Evanston, Illinois. WNIC occupies approximately 7 percent of this building and leases the remainder to nonaffiliated commercial enterprises. At December 31, 1993, the outstanding balance on the mortgage loan secured by this property was $2,434,000. WNIC also occupies 28 field offices throughout the country, all of which are leased. UPI's home office is a 102,000 square-foot office building that UPI owns, and is located on a thirty-acre site in Kokomo, Indiana. ITEM 3. ITEM 3. LEGAL PROCEEDINGS WNC and certain affiliated companies have been named in various pending legal proceedings considered to be ordinary routine litigation incidental to the business of such companies. A number of other legal actions have been filed against WNC's subsidiaries which demand compensatory and punitive damages aggregating material dollar amounts. WNC believes that such suits are substantially without merit and that valid defenses exist. WNC's management is of the opinion that such litigation will not have a material effect on WNC's consolidated financial position. No proceedings, or group of proceedings presenting in large degree the same issues, exceed the materiality standard for disclosure contained in Instruction 2 to Item 103 of Regulation S-K. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers of WNC and a description of their business experience are set forth below. The business experience of the officers who have been affiliated with WNC less than five years is described in detail; the business experience of officers who have been affiliated with WNC five years or more focuses on only such experience during the last five years. Wade G. Brown Mr. Brown, age 56, joined WNIC as Executive Vice President and Chief Information Officer in June, 1993. From 1990 to 1993, Mr. Brown was a senior management consultant with CompuPros, Inc. Prior to that, Mr. Brown spent over seven years with Computer Language Research, Inc. where his last position was as Director of Information Services. Mr. Brown is a Director of UPI and WNIC and serves on WNIC's Executive and Finance Committees. Curt L. Fuhrmann Mr. Fuhrmann, age 47, President of WNIC's Health Division as of October, 1993, joined WNIC as President of the Individual Health Division in October, 1989. Between 1985 and 1989, Mr. Fuhrmann was President and Chief Executive Officer of Pyramid Life Insurance Company, a company with approximately $40 million in annual premiums. In these positions, Mr. Fuhrmann had total profit and loss responsibility for an individual health book of business. Mr. Fuhrmann is a Director of UPI and WNIC and serves on WNIC's Executive and Finance Committees. Kenneth A. Grubb Mr. Grubb, age 54, joined WNIC as President of the Education Division in June, 1992. From 1989 to 1992, Mr. Grubb was Director of the Louisville Service Center of Humana, Inc., a large publicly- held healthcare company, responsible for billing, claims, customer service, underwriting and staff support. Prior to joining Humana, Mr. Grubb spent nine years at Capital Holding Corporation where he served as head of the group insurance division among other responsibilities. Mr. Grubb is a Director of UPI and WNIC and serves on WNIC's Executive and Finance Committees. Robert W. Patin Mr. Patin, age 51, was elected Chairman of the Board and Chief Executive Officer of WNC and Chairman of the Executive and Nominating Committees in July, 1988. At that time, he also assumed the position of Chairman of the Board of WNIC and Chairman of its Executive Committee. Mr. Patin also serves on WNIC's Finance Committee. Mr. Patin was elected President of WNC and WNIC in May, 1990 and February, 1991, respectively. He also is a Director of certain affiliated companies of WNC, including UPC and UPI. James N. Plato Mr. Plato, age 45, was elected Chairman of the Board, President and Chief Executive Officer of UPC and its principal subsidiary, UPI, effective February 1, 1994. From January 1, 1993 through January, 1994, Mr. Plato served as President and Chief Operating Officer of UPC and UPI. From March, 1992 through December, 1992, Mr. Plato held the position of Executive Vice President and Chief Marketing Officer. Mr. Plato joined UPI in 1990 as its Senior Vice President and Chief Marketing Officer. From 1986 to 1990, Mr. Plato was Senior Vice President of Marketing for Reserve Life Insurance, Dallas, Texas. Mr. Plato is a Director of WNIC. Thomas Pontarelli Mr. Pontarelli, age 44, has been Executive Vice President of WNC and WNIC and head of the Staff Division of WNIC since 1989. Mr. Pontarelli started at WNIC in 1974 and was elected Vice President, General Counsel and Corporate Secretary of WNC in 1984. In 1985, Mr. Pontarelli was elected Senior Vice President, General Counsel and Corporate Secretary of WNC and Senior Vice President of WNIC. He currently serves on the Board of Directors of WNIC, UPC, and UPI and is a member of the Finance and Executive Committees of WNIC's Board of Directors. Thomas C. Scott Mr. Scott, age 47, has been Executive Vice President and Chief Financial Officer of WNC and Executive Vice President, Chief Financial Officer and Chief Actuary of WNIC and head of its Financial Division since 1989. Mr. Scott joined WNIC in 1974, served as Vice President at WNIC from 1983 to 1987, and as Senior Vice President of WNIC from 1987 to 1989. He currently serves on the Board of Directors of WNIC, UPC, and UPI and is a member of the Executive Committee and Chairman of the Finance Committee of WNIC's Board of Directors. Don L. Wilhelm Mr. Wilhelm, age 62, retired on December 31, 1993 as a Director of WNC, a position he has held since 1987, and as Chief Executive Officer of UPC and UPI, positions he has held since 1961 and 1965, respectively. On January 31, 1994, Mr. Wilhelm retired from the Board of UPC and UPI and from his position as Chairman of the Board. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS QUARTERLY INFORMATION (unaudited) Washington National Corporation and Subsidiaries The following table summarizes selected unaudited quarterly information for 1993 and 1992. Stock quotes were obtained from the National Quotation Bureau, Inc. As of March 10, 1994, WNC had approximately 9,200 Common and Preferred stockholders, including individual participants in security depository position listings. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Washington National Corporation (WNC or the Company) is an insurance holding company that, through its two principal operating subsidiaries, Washington National Insurance Company (WNIC) and United Presidential Life Insurance Company (UPI), provides life, annuity, health, disability, and specialty insurance products to individuals and groups in carefully targeted markets that the Company believes are underserved by other insurance carriers. In 1991, the Company completed a three-year corporate restructuring that narrowed its focus to three core businesses, improved its operating performance, and in management's view, positioned the Company for profitable expansion. The Company's three core businesses are: (i) life insurance and annuities: universal life insurance and other interest-sensitive life insurance and annuity products marketed to individuals and small businesses; (ii) group products: employee-paid disability and other specialty insurance products for teachers and other employers with 100 to 1,000 employees; and (iii) individual health: individual health insurance products, primarily major medical and hospital coverage for persons under the age of 65 without employer-sponsored insurance. The Company employs a decentralized operating structure and utilizes distinct distribution systems to access each of its targeted markets and to provide timely, individualized service to its customers. The Company emphasizes the sale of market-driven products, a profit-oriented rather than a volume-oriented approach to underwriting, tight expense controls, and a proactive approach to market and regulatory changes. The Company continually evaluates new products and markets in order to capitalize on potential opportunities and to anticipate and respond effectively to business and regulatory changes. Corporate Restructuring In 1988, the Company commenced a major restructuring effort to narrow its focus to three core businesses, reduced its work force by over two-thirds, and recruited new operating managers with many years of insurance industry experience. The Company decentralized decision-making and implemented performance-based management compensation in order to promote greater accountability at the operating business level. The Company also invested approximately $40 million in its operating businesses to improve computer systems, technical expertise, administrative facilities, and distribution systems. In addition, the Company implemented underwriting and pricing changes in its three core businesses to improve profitability, and upgraded the quality of its investment portfolio. Strategy The Company's current focus is on continuing the improvement in its operating performance, principally through a strategy of disciplined revenue growth in each of the three core businesses along with further reductions in expense ratios. The Company seeks to achieve revenue growth primarily by expanding its sale of existing and new products and services within targeted markets that are underserved by other insurance carriers. The Company anticipates that additional revenue growth may result from certain cross-marketing opportunities within its businesses and selected acquisitions of profitable blocks of business. Additionally, the Company believes that its life insurance and annuities business complements the Company's more cyclical health businesses, thereby providing greater stability to the Company's earnings base. The Company seeks to achieve reductions in its expense ratios through infrastructure improvements, ongoing work flow re-engineering, and revenue growth. The Company is closely monitoring developments concerning health care reform and is preparing strategic responses to different possible outcomes. In anticipation of health care reform, the Company's health businesses have begun to diversify into product areas that the Company believes are consistent with its targeted market focus and may be less affected, or unaffected, by health care reform. The Company's strategy regarding health care reform is discussed in more detail under the caption "Health Care Reform." Year Ended December 31, 1993 Compared to Year Ended December 31, 1992 Insurance Premiums and Policy Charges. Insurance premiums and policy charges increased $57.8 million, or 15.2%, from $381.0 million in 1992 to $438.8 million in 1993. The increase was primarily due to an increase in individual health insurance premiums of $52.3 million and group products premiums of $4.1 million resulting from an increased amount of business in force and rate increases for both segments and $23.2 million of premium revenues from an individual health reinsurance transaction entered into in the second quarter of 1993. See "Segment Information - Group Products" and "Segment Information - Individual Health," below. Net Investment Income. Net investment income decreased $3.4 million, or 1.8%, to $183.7 million in 1993 from $187.1 million in 1992. The decrease was due to a general decline in market interest rates which caused a decline in the Company's portfolio yield from 8.6% to 8.0%, offset in part by an increase in invested assets. Invested assets at December 31, 1993 increased $122.4 million from December 31, 1992, principally due to deposits on life insurance policies and annuity contracts exceeding withdrawals combined with proceeds from a secondary stock offering in the third quarter of 1993. Realized Investment Losses. Realized investment losses for 1993 were $0.4 million compared to $4.6 million in 1992. In 1993, realized gains of $7.8 million, $2.0 million, and $0.4 million on fixed maturity investments, mortgage loans on real estate, and equity securities, respectively, were offset by losses of $10.6 million on real estate investments. In 1992, realized gains of $5.6 million on fixed maturity investments were offset by losses of $4.9 million on mortgage loans on real estate, $3.6 million on real estate investments, and $1.7 million on equity securities. Insurance Benefits Paid or Provided. Insurance benefits paid or provided increased $10.6 million, or 2.6%, from $409.8 million in 1992 to $420.4 million in 1993. The increase was primarily due to increased individual health insurance benefits of $29.2 million resulting from an increase in the block of in force business and the reinsurance transaction referred to above. Partially offsetting this was a decline in life insurance and annuities benefits of $16.6 million resulting from a decrease in interest credited on interest-sensitive products, favorable mortality experience, and the annual review of benefits assumptions, discussed below in "Amortization of Deferred Insurance Costs." Insurance and General Expenses. Insurance and general expenses increased $24.4 million from $107.1 million in 1992 to $131.5 million in 1993. Included in 1993 are expenses of $6.9 million related to an individual health reinsurance transaction. See "Segment Information - Individual Health," below. Additionally, 1993 includes charges of $1.6 million related to re-engineering in the life insurance and annuities segment and $1.7 million for the combination of the individual health and employee benefits divisions. 1993 also includes move related costs, primarily due to the closing of the Company's previous headquarters. Amortization of Deferred Insurance Costs. Amortization of deferred insurance costs increased $10.8 million, or 39.9%, in 1993 to $37.9 million from $27.1 million in 1992. The change was primarily due to increased amortization of $3.5 million in the individual health insurance segment resulting from an increase in the block of in force business and $3.6 million due to the annual review of amortization assumptions in the life insurance and annuities segment, partially offset by the decrease in benefits, discussed above. Income Before Income Taxes and Changes in Accounting Principles. Income before income taxes and changes in accounting principles increased $12.3 million, or 46.7%, to $38.7 million in 1993 compared to $26.4 million in 1992. The increase was due primarily to improved operations in the Company's individual health and life insurance and annuities segments, offset in part by lower pretax income from the group products segment. Income Taxes. Income taxes increased $1.0 million to $10.5 million in 1993 compared to $9.5 million in 1992, primarily due to improved income from operations. Included in income taxes for 1993 is a tax credit of $3.2 million related to realized investment losses. Also in 1993, the Company's federal income tax rate increased from 34% to 35%, retroactive to January 1, 1993, due to legislation enacted in August, 1993. Changes in Accounting Principles (Net of Taxes). The Company recorded a one-time charge of $1.6 million after taxes effective the first quarter 1993 for the adoption of a new accounting standard on accounting for postemployment benefits. The adoption did not have a material impact on income before accounting changes. 1992 included a $22.8 million after-tax charge relating to the first quarter 1992 adoption of new accounting standards, related to postretirement benefits other than pensions and income taxes. Net Income (Loss). Net income for 1993 was $26.7 million compared to a net loss of $6.0 million in 1992. The improvement in net income resulted primarily from the charges in the first quarter of 1992 relating to the adoption of two new accounting standards described above and improved operations in the individual health and life insurance and annuities segments, partially offset by a decline in group products operating income and the charge relating to the new accounting standard in the first quarter of 1993. Segment Information Life Insurance and Annuities. Revenues for the life insurance and annuities segment, which is comprised of new business sold by UPI to individuals and small businesses and closed blocks of life insurance and annuities written by WNIC prior to 1990, were $229.0 million for 1993, down from $233.5 million in 1992. A decline in investment income of $5.8 million resulted from lower portfolio yield rates, offset in part by an increase in invested assets. A $1.5 million improvement in insurance revenues was primarily due to an increase in life insurance in force combined with higher policy charges at UPI, offset in part by a decline in insurance revenues on the closed blocks of business at WNIC. Pretax income for the life insurance and annuities segment increased 28.7% to $28.1 million in 1993 from $21.9 million in 1992. The increase was primarily due to improved interest rate spreads, as the interest credited on account balances was reduced more than the reduction in the yield on invested assets, and favorable mortality experience. Also contributing to the improvement was a charge of $2.8 million for anticipated guaranty fund assessments recorded in 1992 compared to $0.5 million in 1993. Partially offsetting these increases were charges in 1993 of $1.6 million to combine the Company's data centers, implement work flow re-engineering at UPI, and transfer the administration of WNIC's closed block of life insurance to UPI. Group Products. Revenues for the group products segment were $234.6 million in 1993 compared to $231.2 million in 1992, an increase of 1.5%. The increase was primarily due to an increase in the amount of business in force in the education product line resulting from sales in 1992 and 1993 and premium rate increases averaging 7% in the employee benefits product line. These increases were partially offset by a decline of approximately $6 million from the termination of a large group life insurance contract, with approximately $3 billion of life insurance in force, in the third quarter of 1993. The annual premiums and related benefits related to this contract were each approximately $11 million. The termination of this contract will not materially affect net income. Pretax income for the group products segment was $6.1 million in 1993 compared to $10.2 million in 1992. The decline was primarily due to higher medical claims, less favorable mortality experience, and increased operating expenses, including the receipt in the first quarter of 1992 of an expense refund of $1.8 million in connection with a withdrawal from a partnership. Also included in operating expenses in 1993 were charges of $1.7 million related to the combination of the individual health and employee benefits divisions. These increases were partially offset by favorable disability claims experience in 1993. Individual Health. Revenues for the individual health insurance segment increased 48.7% to $159.9 million in 1993 compared to $107.6 million in 1992. Revenues for this segment increased in part as a result of a reinsurance transaction that added a total of $23.2 million of premium revenue in 1993. In addition to the reinsurance transaction, the amount of business in force (based on the average number of policies in force) increased approximately 13% in 1993 compared to 1992 and premium rates increased an average of 7% in 1993. Sales of individual health policies declined in 1993 compared to 1992 in part due to a decision to maintain pricing margins in spite of increased pricing competition. The Company expects such increased pricing competition to continue in 1994. However, as a result of an expanded sales force from the reinsurance agreements described below, the Company expects new sales will increase in 1994. Pretax income for the individual health insurance segment was $5.4 million for 1993 compared to a loss of $3.2 million in 1992. The improvement was primarily due to a larger premium base over which to spread fixed operating expenses. Effective in the 1993 second quarter, the Company entered into a reinsurance agreement with The Harvest Life Insurance Company (Harvest Life) that provides that the Company will reinsure 100% of a block of major medical business issued by Harvest Life. Harvest Life will continue to administer this business for a period of at least three years. As part of the reinsurance agreement, Harvest Life has agreed to market the Company's major medical products in place of its own major medical products through Harvest Life's career agent sales force. Harvest Life agents sell to insureds in rural areas, primarily farming communities. In addition to $23.2 million of premium revenue and $0.2 million of other income recorded in 1993, insurance benefits of $15.5 million and insurance and general expenses of $6.9 million were attributable to the reinsurance agreement. In 1994, the Company entered into a reinsurance agreement with National Casualty Company, a subsidiary of Nationwide Corporation, whereby the Company will reinsure 50% of a block of individual major medical health insurance, effective January 1, 1994. The block had approximately $60 million of premium revenue in 1993. Beginning in 1994, the Company will administer the entire block of business for a fee paid by National Casualty. In addition, WNIC will market its products through the existing National Casualty Company sales force. The Company will carefully consider entering into additional, similar reinsurance transactions as they arise. Corporate and Other. The corporate and other segment includes realized investment gains and losses, the operations of non-insurance lines of business, and corporate expenses. For 1993, the pretax loss was $0.9 million compared to a loss of $2.5 million in 1992. The improvement was primarily due to the previously mentioned decrease in realized investment losses. Revenues for this segment are expected to increase slightly in 1994 due to investment income on a portion of the proceeds from the third quarter 1993 stock offering. Year Ended December 31, 1992 Compared to Year Ended December 31, 1991 Insurance Premiums and Policy Charges. Insurance premiums and policy charges decreased $5.8 million, or 1.5%, from $386.8 million in 1991 to $381.0 million in 1992. The decrease was primarily attributable to a $36.5 million decline in the group products segment's premiums which was primarily due to the termination and restructuring of certain group health contracts resulting from rate increases in 1991 and a decrease of $3.4 million of premiums and policy charges resulting from the 1991 sale of discontinued lines. These declines were offset in part by increases in individual health premiums and policy charges of $24.2 million due to an increase in the block of in force business from higher sales of and premium rate increases on individual health policies and by increased policy charges on life and annuity contracts of $9.8 million. Net Investment Income. Net investment income decreased $12.3 million, or 6.1%, from $199.4 million in 1991 to $187.1 million in 1992. The decrease was due to a lower average yield on invested assets in 1992, which decreased from 9.1% in 1991 to 8.6% in 1992, resulting from a general decline in interest rates combined with the Company's reinvestment of assets in higher quality, lower yielding securities. Realized Investment Losses. Realized investment losses decreased $15.0 million, or 76.5%, from $19.6 million in 1991 to $4.6 million in 1992. Results in 1992 included gains of $5.6 million on the sale of fixed maturity investments and losses on mortgage loans on real estate and real estate investments of $4.9 million and $3.6 million, respectively, combined with losses on equity securities of $1.7 million. Results in 1991 included a $10.0 million loss related to bonds backed by guaranteed investment contracts issued by Executive Life Insurance Company as well as losses on mortgages loans on real estate of $6.6 million and real estate investments of $3.2 million. Loss on Divestitures. The 1991 pretax net loss consisted of a $1.8 million loss on the sale of a subsidiary, partially offset by a gain on blocks of business sold by WNIC. See Note J to the Consolidated Financial Statements for further information. Insurance Benefits Paid or Provided. Insurance benefits paid or provided decreased $20.5 million, or 4.8%, from $430.3 million in 1991 to $409.8 million in 1992. The decrease was due to a $26.0 million decline in the group products segment's benefits resulting from the termination and restructuring of certain group health policies and a $7.5 million decline in benefits related to the 1991 sale of discontinued lines, offset in part by an $11.8 million rise in individual health benefits directly associated with the increased business in force discussed above. Insurance and General Expenses. Insurance and general expenses, including a $4.0 million gain from the reduction of postretirement benefits, decreased $19.9 million, or 15.7%, from $127.0 million in 1991 to $107.1 million in 1992. The decline resulted primarily from the elimination of $3.7 million of expense from the sale of discontinued lines and a $7.7 million planned decrease in operating expenses in the group products segment. Amortization of Deferred Insurance Costs. Amortization of deferred insurance costs increased $6.0 million, or 28.4%, from $21.1 million in 1991 to $27.1 million in 1992, due primarily to additional amortization resulting from the early recognition of investment income caused by the prepayment of certain mortgage-backed securities combined with the increase in the individual health block of business. Income (Loss) Before Income Taxes and Changes in Accounting Principles. Income (loss) before income taxes and changes in accounting principles increased $26.8 million from a pretax loss of $0.4 million in 1991 to pretax income of $26.4 million in 1992. The largest items contributing to the increase were the $10.6 million improvement in the individual health segment's pretax income and the $15.0 million decrease in realized investment losses. Income Taxes. Income taxes increased $6.9 million from $2.6 million in 1991 to $9.5 million in 1992 due primarily to the higher level of pretax income of $26.4 million in 1992, versus a pretax loss of $0.4 million in 1991. Changes in Accounting Principles (Net of Taxes). Effective January 1, 1992, the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS 109, "Accounting for Income Taxes." The cumulative effect of adopting these new accounting standards was a charge of $20.1 million and $2.7 million, respectively. Net Loss. Net loss increased $3.0 million from $3.0 million in 1991 to $6.0 million in 1992. The change was primarily as a result of the $22.8 million cumulative effect of changes in accounting principles described above, partially offset by the increase in income before such changes of $19.8 million. Segment Information Life Insurance and Annuities. Revenues for the life insurance and annuities segment were $233.5 million in 1992 compared to $227.1 million in 1991. The increase was primarily due to increased policy revenues and investment income at UPI, offset in part by declines in revenues in the closed blocks of business at WNIC. Pretax income for the life insurance and annuities segment decreased 8.9% to $21.9 million in 1992 compared to $24.0 million in 1991. The decline was primarily due to 1992 accruals for anticipated guaranty fund assessments of $2.8 million. Group Products. Revenues for the group products segment were $231.2 million in 1992 compared to $268.0 million in 1991. The decline was attributable to terminated cases and the conversion of several cost plus cases to a minimum premium basis. Pretax income for the group products segment declined 24.2% to $10.2 million in 1992 compared to $13.5 million in 1991. The decline was primarily due to a decline in premium revenues and an increase in the claims ratio for 1992. Individual Health. Revenues for the individual health insurance segment increased 30.5% to $107.6 million in 1992 compared to $82.4 million in 1991. Revenues for this segment primarily increased due to an increase in the amount of business in force and an increase in premium rates. Pretax loss for the individual health insurance segment declined $10.6 million to $3.2 million for 1992 compared to a loss of $13.8 million in 1991. The decline in the loss from 1991 was primarily due to a larger premium base over which to spread fixed operating expenses for this segment and an improved ratio of claims to premium revenues in 1992. Corporate and Other. The pretax loss for the corporate and other segment in 1992 was $2.5 million compared to a loss of $24.1 million in 1991. In 1992 realized investment losses were $4.6 million compared to losses of $19.6 million in 1991, which included losses of $10.0 million related to fixed maturity investments backed by guaranteed investment contracts. 1991 also included a loss of $1.2 million related to divestitures. Investment Portfolio The Company's investment portfolio is managed by an experienced staff of in- house investment professionals, primarily at WNIC, and outside investment advisors, primarily the investment management group at Scudder, Stevens & Clark, Inc. Investments are made pursuant to strategies and guidelines approved by the Finance Committee of the Company's Board of Directors. The Company selects investments that match the needs of the businesses that the assets support in the areas of yield, liquidity, asset quality, and duration. The Company pursues a conservative investment philosophy by balancing a variety of objectives, including high credit quality, liquidity, high current income, preservation of capital, and protection against market and interest rate risk. The Company's investment portfolio consists primarily of investment grade, publicly-traded fixed maturity investments and mortgage loans on real estate. All investments made by WNIC and UPI are governed by Illinois and Indiana insurance laws and regulations, respectively. At December 31, 1993, the Company had invested assets of $2.4 billion. The following table sets forth certain information about the Company's investment portfolio as of that date: Fixed Maturity Investments The carrying value of fixed maturity investments at December 31, 1993 was $1.8 billion, or 74.7% of the Company's invested assets. This amount increased from $1.6 billion, or 69.5% of the Company's invested assets at December 31, 1992 primarily due to the Company making new investments principally in investment grade fixed maturity securities. At December 31, 1993 and December 31, 1992, the fair value of the Company's fixed maturity investments exceeded the carrying value by $82.3 million and $56.9 million, respectively. The Company's policy for rating fixed maturity investments is to use the rating on such investments as determined by Standard & Poor's Company (S&P's) or Moody's Investor Service, Inc. (Moody's). If an investment has a split rating (i.e., different ratings from the two rating services) the Company categorizes the investment under the lower rating. For those investments that do not have a rating from either S&P's or Moody's, the Company categorizes those investments on ratings assigned by the National Association of Insurance Commissioners (NAIC), whose ratings are as follows: NAIC Class 1 is considered equivalent to a AAA/Aaa, AA/Aa, or A rating; NAIC Class 2, BBB/Baa; and NAIC Classes 3-6, BB/Ba and below. Fixed maturity investments that are not rated by S&P's or Moody's (unrated private placements), but instead rated with comparable NAIC ratings, comprise 0.4% of AAA-rated investments, 1.7% of AA-rated, 4.1% of A-rated, 23.2% of BBB-rated, and 50.2% of investments rated BB and lower at December 31, 1993. The composition of the Company's fixed maturity portfolio, based on S&P's and Moody's ratings at December 31, 1993, was as follows: The carrying value of the Company's high-yield investments (investments rated BB and lower) at December 31, 1993 was $94.0 million or 4.0% of the Company's invested assets compared to $108.3 million or 4.8% of invested assets at December 31, 1992. The fair value of this portfolio exceeded the carrying value by $6.2 million at December 31, 1993 and $6.1 million at December 31, 1992. The decline in the size of the high-yield portfolio in 1993 was primarily due to redemptions and sales, partially offset by downgrades. At December 31, 1993, 29.5% of the Company's invested assets were in mortgage-backed fixed maturity investments, including collateralized mortgage obligations (CMOs) and mortgage-backed pass-through securities. Mortgage-backed securities generally are collateralized by mortgages backed by the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), or the Federal Home Loan Mortgage Corporation (FHLMC), all of which are agencies of the U.S. Government. Only GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government. Agency mortgage-backed securities are considered to have a AAA credit rating. In some instances, the Company invests in non-agency mortgage-backed securities. At December 31, 1993, 89.1% of the Company's non-agency CMOs were rated AAA. The credit risk associated with non-agency mortgage-backed securities is generally greater than that of agency mortgage-backed securities. The following details the carrying value and fair value of the Company's mortgage-backed securities portfolio at December 31, 1993: Certain mortgage-backed securities are subject to significant prepayment risk. This is due to the fact that in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as individuals refinance higher-rate mortgages to take advantage of lower rates. As a result, holders of mortgage-backed securities may receive large prepayments on their investments that cannot be reinvested at interest rates comparable to the rates on the prepaid mortgages. Planned amortization class (PAC) and target amortization class (TAC) tranches, which together comprised 12.4% of the Company's invested assets at December 31, 1993, are designed to amortize in a manner that shifts the primary risk of prepayment of the underlying collateral to investors in other tranches of the CMO. The PAC and TAC instruments tend to be less sensitive to prepayment risk. Sequential classes, which comprised 1.5% of the Company's invested assets at December 31, 1993, may have prepayment characteristics similar to mortgage-backed pass-through securities. Support classes, which comprised 1.0% of the Company's invested assets at December 31, 1993, are the most sensitive to prepayment risk. Mortgage Loans and Real Estate The Company had investments in mortgage loans of $391.7 million at December 31, 1993 compared to $452.0 million at December 31, 1992. Investments in mortgage loans declined primarily due to prepayments and amortization of the mortgage loan portfolio. Of the outstanding loans at December 31, 1993, $3.7 million (net of allowances of $3.9 million), or 0.9%, were delinquent 60 days or more as to interest or principal. At December 31, 1993, the Company's insurance subsidiaries had a delinquent mortgage loan ratio (mortgage loans overdue 60 days or in foreclosure, before allowances, as compared to the total mortgage portfolio before allowances) of 1.1% compared to 2.2% at December 31, 1992. The industry average delinquent mortgage loan ratio for residential and commercial mortgages, as measured by the American Council of Life Insurance, was 4.5% at December 31, 1993. The following summarizes the additions and deductions to the Company's mortgage loan allowance: The Company actively manages its non-current investments through restructuring of mortgages and sales and leasing of foreclosed real estate in order to achieve the highest current return as well as to preserve capital. Restructured loans, where modifications of the terms of the mortgage loan have generally occurred and which are considered current investments, were $16.9 million at December 31, 1993 compared to $18.2 million at December 31, 1992. At December 31, 1993, the Company's mortgage loan portfolio included $6.9 million of mortgage loans, before allowances, overdue at least three months and on which no interest income was being accrued. The Company does not expect the non-current investments to have a material adverse effect on its liquidity or ability to hold its other investments to maturity. This is primarily due to the relatively small amount of these non-current investments as compared to total invested assets and to the total amount of high quality, liquid investments. The Company's mortgage loan portfolio at December 31, 1993 was diverse with respect to geographic distribution, principal repayment schedule dates, and property type as outlined below: The Company's real estate investments totaled $39.1 million (net of allowances of $8.6 million) at December 31, 1993 compared to $60.0 million (net of allowances of $14.2 million) at December 31, 1992. The change was primarily due to sales of real estate investments. At December 31, 1993, $14.6 million of real estate investments were acquired through mortgage loan foreclosure, compared to $20.2 million at year-end 1992. Current and expected conditions in many real estate markets are depressed, with high vacancy rates and flat or declining rental rates. Moreover, the availability of financing is currently restricted as banks, insurance companies, and other lenders have reduced their exposure to real estate loans. In such an environment, the number of defaults on mortgage loans would be expected to remain at higher than historical average levels as borrowers' cash flows are insufficient to cover expenses. Additionally, the ability to rent investment real estate at favorable rates diminishes and properties may become vacant. Equity Securities At December 31, 1993, $7.0 million or 0.3% of the Company's invested assets consisted of common stocks and common stock mutual funds, $3.5 million or 0.2% of invested assets consisted of nonredeemable preferred stocks, and $5.4 million or 0.2% of invested assets consisted of fixed maturity and money-market mutual funds. Nonredeemable preferred stocks, common stocks, and common stock mutual funds are carried on the Company's balance sheet at fair value. The Company does not anticipate any significant change in the size of its equity securities portfolio. Liquidity and Capital Resources Cash Flows During 1993, the Company's operating activities generated cash of $104.7 million compared to $93.3 million in 1992. The increase in cash provided by operations in 1993 primarily resulted from improved insurance operations in 1993 compared to 1992. Investing activities (principally purchases and sales of investments) used cash of $130.8 million in 1993 compared to $140.0 million in 1992, primarily for the purchase of fixed maturity investments in both periods. Financing activities provided cash of $27.1 million and $49.7 million, in 1993 and 1992, respectively. In 1993, $47.3 million of cash was provided by the sale of 2.1 million new shares of common stock and $18.1 million was provided by net receipts from universal life insurance and annuity policies. Partially offsetting these amounts in 1993 was the payment of $17.4 million of short-term notes payable, $9.5 million of mortgage and other notes payable, and $12.2 million of dividends to stockholders. In 1992, $46.0 million of cash was provided by net receipts from universal life insurance and annuity policies and net proceeds from debt, offset in part by $11.1 million of dividends to stockholders. The fair value of the Company's investment portfolio, primarily fixed maturity investments, is affected by changing interest rates. When interest rates rise, the fair value of the Company's fixed maturity investments declines. In addition, the value of the Company's policy liabilities decreases. In periods of declining interest rates, the fair value of the Company's fixed maturity investments increases, accompanied by an increase in the value of its policy liabilities. The Company estimates that a one percentage point increase in market interest rates would result in a decrease in the fair value of its fixed maturity investments of approximately 5 percent, and a one percentage point decrease in market interest rates would result in an increase in the fair value of its fixed maturity investments of approximately 5 percent. In addition, rising interest rates could result in increased surrenders of life insurance policies and annuities causing the Company to sell fixed maturity investments below cost. In order to minimize the need to sell fixed maturity investments below cost, the Company seeks to maintain sufficient levels of cash and short-term investments. The Company held cash and short-term investments of $85.7 million at December 31, 1993, compared to $60.2 million at December 31, 1992. The balance of cash and short-term investments plus cash inflow from premium revenues, investment income, and investment maturities is considered to be more than sufficient to meet the requirements of the Company and its subsidiaries. Stock Offering During the third quarter of 1993, the Company issued 2,133,000 shares of Common Stock in a secondary stock offering. The sale of the additional shares resulted in an increase in stockholders' equity of $47.3 million and a decrease in 1993 primary earnings of 4.3% or $.11 per share. See Note E for additional information. Dividends The Company's primary sources of funds to pay dividends to stockholders are investments held at the parent and dividends from WNIC. These dividends are subject to restrictions set forth by the Illinois Insurance Department. Illinois state regulations limit the amount of cash that can be withdrawn from WNIC to the greater of the previous year's statutory earnings or 10% of statutory capital and surplus. See Note E for further information. UPI is wholly owned by United Presidential Corporation, an insurance holding company which in turn is 71% owned by WNIC and 29% owned by WNC. UPI is not considered a source of funds for dividends to stockholders of the Company. Management expects UPI to pay no dividends in the foreseeable future in order to conserve capital at that subsidiary. Health Care Reform On September 22, 1993, President Clinton provided the outline of the Administration's proposal for health care reform and delivered to Congress a more detailed package of the proposal in mid-October. The proposal relies heavily on a federally guaranteed package of health care benefits and medical services, primarily through an employer-based program for working Americans. In addition, the Administration's outline provides for health care coverage for non-working Americans. The Administration's proposal could have the following effects on insurers: (i) partially or fully replace products sold by insurers; (ii) limit the ability of insurers to charge higher rates to or decline to cover, insureds who present greater risks; (iii) limit the ability of insurers to exclude coverage for pre- existing conditions; (iv) mandate the types of insurance benefits to be provided in certain instances; (v) impose insurance rate regulation or additional taxes on insurance premiums or benefits; or (vi) increase competition by expanding employee choice of insurance plans and by requiring the employee to bear the full cost increment for higher priced plans. In addition to the Administration's plan, a number of members of Congress have proposed alternative health care reform plans. These plans rely, in some instances, more on market-driven reform rather than on government mandated reform and several aspects of the Administration's proposal, such as universal coverage and employer mandates, are being challenged by these alternative plans. The Company has monitored and will continue to monitor all aspects of the developments surrounding this issue and is preparing strategic responses to its possible outcomes. The Company's health businesses have begun to diversify into product areas, such as supplemental insurance products and disability products, that the Company believes are consistent with its targeted market focus and may be less affected or unaffected by health care reform. Such products may not be a component of a mandated benefits package and may be supplementally purchased by consumers. Health care reform at the federal and state levels may have a material adverse effect on the Company's operating results and financial position, but it is not possible at this time to predict the nature and effects of health care reform or how soon its measures will be adopted and implemented. During the 1993 fourth quarter, the Company announced that it had combined its individual health division and employee benefits division at WNIC. The combination is designed to accelerate the Company's positioning for strategic business opportunities under health care reform. A.M. Best Ratings The ability of an insurance company to compete successfully depends, in part, on its financial strength, operating performance, and claims-paying ability as rated by A.M. Best and other rating agencies. The Company's insurance subsidiaries are each currently rated "A- (Excellent)" by A.M. Best, based on their 1992 statutory financial results and operating performance. A.M. Best's 15 categories of ratings for insurance companies currently range from "A++ (Superior)" to "F (In Liquidation)." According to A.M. Best, an "A" or "A-" rating is assigned to companies which, in A.M. Best's opinion, have achieved excellent overall performance when compared to the standards of the life insurance industry and generally have demonstrated a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company's statutory financial and operating performance, A.M. Best reviews the company's statutory profitability, leverage, and liquidity, as well as the company's spread of risk, quality and appropriateness of its reinsurance program, quality and diversification of assets, the adequacy of its policy reserves and surplus, capital structure, and the experience and competency of its management. A.M. Best ratings are based upon factors of concern to policyholders, agents, and intermediaries and are not directed toward the protection of investors. In June 1993, the Company was advised by A.M. Best that, after review of the 1992 statutory financial results and operating performance, both WNIC and UPI were assigned ratings of "A- (Excellent)," an adjustment from their previous ratings of "A (Excellent)." Many of the Company's competitors have A.M. Best ratings of "A-" or lower, and the Company believes that its A.M. Best ratings are adequate to enable its insurance subsidiaries to compete successfully. In communicating its most recent rating, A.M. Best advised WNIC that, if current trends persist, further rating adjustments may be required. The Company believes that the trends referred to by A.M. Best are (i) a decline in WNIC's statutory capital and surplus and (ii) increased net statutory operating losses on certain health insurance products of WNIC as calculated using statutory accounting practices. WNIC's statutory operating income in recent years has been adversely affected by the payment of first year commissions on new sales of certain health insurance products and investments in infrastructure improvements. The Company believes that as renewal business increases as a percentage of total revenues, statutory operating income for these products will improve. For 1993, statutory net operating income improved to $19.9 million from $5.8 million in 1992, and net income improved to $11.0 million from $36 thousand in 1992. Statutory capital and surplus increased $9.2 million, or 5.1%, to $188.3 million in 1993 versus a decrease of $9.1 million, or 4.8%, in 1992. Notwithstanding the foregoing, there can be no assurance that A.M. Best will maintain the ratings of the Company's insurance subsidiaries at their present levels. A rating downgrade at either WNIC or UPI could have a materially adverse effect on the ability of that subsidiary to write and retain business. Inflation and Changing Prices Inflation and changing prices are anticipated by the Company in the pricing of its insurance products. Significant components of health insurance benefits are the medical care inflation rate, policyholder utilization of medical services, and cost-shifting, which is the transfer of medical care provider expenses that are not covered by governmental plans and HMOs to private insurers. As a result of relatively stable general and medical care inflation rates in 1993, WNIC's health insurance pricing assumptions regarding these factors were essentially unchanged from the prior year. For the first quarter of 1994, these assumptions have also not changed materially. The effect of inflation on operating expenses has not been significant. However, if inflation increases significantly, operating expenses would be expected to increase. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note A Significant Accounting Policies and Practices Principles of Consolidation The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) and include the accounts and operations of Washington National Corporation and its subsidiaries (WNC or the Company). Significant intercompany transactions have been eliminated. Reclassifications Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform to the 1993 presentation. Investments Fixed Maturities. Fixed maturity investments are securities that mature more than one year after issuance. They include bonds, notes, and redeemable preferred stocks. All fixed maturities are intended to be used by WNC as part of its asset/liability matching strategy. Effective March 31, 1993, the Company reclassified its fixed maturity investments into investments that are "held for sale" and investments that are "held to maturity." Fixed maturity investments held to maturity generally are carried at amortized cost, less write-downs for other-than-temporary impairments. Fixed maturity investments that are held for sale are those securities that may be sold in response to unanticipated policy surrenders, policy loan demand, or infrequent transactions. These fixed maturity investments are carried, on an aggregate basis, at the lower of amortized cost, less write-downs for other-than- temporary impairments and an allowance for below-investment grade securities, or fair value. Unrealized losses in aggregate on fixed maturity investments held for sale would be recorded in stockholders' equity, net of applicable deferred income taxes. At December 31, 1993 and 1992, the fair value of all fixed maturity investments exceeded carrying value by $82,332,000 and $56,894,000, respectively. Equity Securities. Equity securities represent investments in mutual funds, nonredeemable preferred stocks, and common stocks. These securities are carried at fair value which is determined primarily through published quotes of trading values. Changes in the valuation allowance necessary to adjust the carrying amount of the equity securities for temporary changes in fair value are reported directly in stockholders' equity. Other-than-temporary declines below cost are recorded as realized losses. Mortgage Loans on Real Estate. Mortgage loans on real estate are carried at unpaid principal, less unearned discount and allowance for possible losses. An allowance for mortgage loan losses is established based on an evaluation of the mortgage loan portfolio, past credit loss experience, and current economic conditions. Real Estate Investments. Real estate investments are principally carried at cost, less allowances for depreciation and possible losses. Foreclosed real estate is considered held for sale and is recorded at the lower of current carrying value or fair value, less estimated costs of disposal. Other Long-term Investments. Other long-term investments consist principally of venture capital investments which are carried at cost, less other- than-temporary impairments. Short-term Investments. Short-term investments include commercial paper, variable demand notes, and money market funds, and are carried at cost. Investment Income. Interest on bonds, loans, and notes is recorded in income as earned. Income is adjusted for any amortization of premium or discount on these investments. Any excess cash flows arising from prepayments are booked as adjustments to the carrying value of the investment. Income on real estate and other long-term investments is recorded principally on a cash basis. Dividends are recorded as income on ex-dividend dates. Realized Gains or Losses. When an investment is sold, its selling price may be higher or lower than its carrying value. The difference between the selling price and the carrying value is recorded as a realized gain or loss, using the specific identification method. Investments that have declined in fair value below cost, and for which the decline is judged to be other-than-temporary, are written down to their estimated fair value. Write-downs and allowances for losses on mortgage loans and below-investment grade bonds are included in realized investment losses. Fair Value of Financial Instruments GAAP requires the disclosure of fair value information about certain financial instruments for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. The fair values are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in the immediate settlement of the instrument. As the fair value of all of WNC's assets and liabilities is not presented, the aggregate fair value of the amounts presented does not represent the underlying value of WNC. The carrying amounts reported in the balance sheets for cash, short-term investments, short-term borrowings, and accrued investment income approximate their fair values. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. Fair values for mortgage loans and policy loans are estimated using discounted cash flow analyses, based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. A pricing cap is put on mortgage loans that carry significant above-market interest rate yields to reflect the illiquid nature of the mortgage loans and the risk that such loans could be prepaid. Fair values for liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with similar maturities. The fair value of long-term debt is estimated using discounted cash flow analyses, based on current incremental borrowing rates for similar types of borrowing arrangements. Fair values for real estate development guarantees, to the extent practicable, are based on estimates of fees to guarantee similar developments. Fair values for lending commitments are based on the commitment fee of the loans in question. Depreciation Provisions for depreciation of real estate investments and home office properties are computed using primarily the straight-line method over the estimated useful lives. Accumulated depreciation on real estate investments at December 31, was $24,184,000 in 1993 and $10,834,000 in 1992. Accumulated depreciation on home office properties at December 31, was $1,122,000 and $13,495,000 in 1993 and 1992, respectively. In 1993, the Company's previous home office real estate and related accumulated depreciation were transferred to investment real estate. Insurance Premiums and Policy Charges Health insurance premiums are earned pro rata over the terms of the policies. For traditional life insurance products, premiums are recognized as revenues when due. Revenues for certain interest-sensitive products consist of charges earned and assessed against policy account balances during the period for the cost of insurance, policy initiation fees, policy administration expenses, and surrenders. Policy Liabilities Liabilities for future policy benefits for traditional life insurance products are determined using the present value of future net premiums, benefits and expenses, and the net level valuation method, based on estimates of future investment yield, mortality, and withdrawal rates, adjusted to provide for possible adverse deviation. Interest rate assumptions are graded and range from 4.5% to 7.5%. Withdrawal assumptions are based principally on experience and vary by issue age, type of coverage, and duration. Liabilities for future policy benefits of certain interest-sensitive products represent policy account balances before applicable surrender charges plus certain deferred policy initiation fees that are recognized as income over the term of the policies and a provision for the return of cost of insurance charges. Policy benefits and claims that are charged to expense include interest credited to policy account balances, benefit claims incurred in the period in excess of related policy account balances, and a provision for the return of cost of insurance charges. Credited interest rates for these products ranged from 3.0% to 7.5% at December 31, 1993. The liabilities for policy and contract claims are determined using case- basis evaluations and statistical analyses. These liabilities represent estimates of the ultimate expected cost of incurred claims and the related claim adjustment expenses. Any required revisions in these estimates are included in operations in the period when such adjustments become determinable. The carrying amounts, net of deferred insurance costs, for investment-type insurance contracts, principally included with future policy benefits of annuities were $1,226,238,000 and $1,197,340,000, at December 31, 1993 and 1992, respectively. The estimated fair values at December 31, 1993 and 1992 were $1,224,550,000 and $1,176,435,000, respectively. The fair values of liabilities under all insurance contracts are taken into consideration in WNC's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts. Deferred Insurance Costs Costs directly associated with the acquisition of new business are deferred and amortized. For traditional life insurance and health insurance products, costs are amortized over the premium-paying period of the products based on assumptions that are used in calculating policy benefit reserves. For certain interest-sensitive products, costs are generally amortized over the estimated lives of the products in relation to the present value of estimated gross profits from surrender charges and investment, mortality, and expense margins. The unamortized cost of purchased insurance in force is included in deferred insurance costs. Amortization is in relation to the present value of estimated gross profits over the estimated remaining life of the related insurance in force of 23 years, with interest rates ranging from 7.5% to 8.5%. The following summarizes the changes in the unamortized cost of purchased insurance in force for the years ended December 31: The estimated percentage of the December 31, 1993 balance to be amortized over the next five years is as follows: Goodwill The cost of purchased businesses in excess of net assets is reported as goodwill and amortized on a straight-line basis, generally over thirty-six years. Goodwill is evaluated based on the prospect for continued growth and the long-term nature of the insurance policies sold. The asset value is considered appropriate. Accumulated amortization of goodwill was $6,023,000 and $5,204,000 at December 31, 1993 and 1992, respectively. Separate Account Separate Account assets and liabilities are principally carried at fair value and represent funds that are separately administered for annuity contracts and for which the contract holders bear the investment risk. Investment income and realized gains and losses allocable to Separate Accounts generally accrue to the contract holders and are excluded from the Consolidated Statements of Operations. Income Taxes In 1992, WNC adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." The accounting policies of WNC result in deferred taxes being provided for significant temporary differences between financial statement and tax return bases, using the asset and liability method. These differences result primarily from policy reserves, insurance acquisition costs, and reserves for postretirement benefits. WNC and its subsidiaries file a consolidated life/nonlife federal income tax return. Reinsurance The insurance subsidiaries of WNC reinsure a portion of their life, annuity, and health risks with other insurance companies to minimize their exposure to loss. In particular, for the life insurance and annuity business, the Company's policy is to retain a maximum of $300,000 of life insurance exposure on any one individual ($400,000 with accidental death). For the group products business, the Company limits its paid-claim exposure in any one calendar year to $750,000 per claim for major medical coverage and $250,000 per claim for individual stop-loss. The Company retains a maximum of 50% of each employee benefits long-term disability claim, and limits its group term life exposure to $200,000 per life ($400,000 with accidental death). The Company's reinsurance for individual health claims is designed to protect the Company from an excessive amount of claims in excess of $250,000 on an individual claim basis. Substantially all of the reinsurance ceded by the Company is to entities rated "A" or better by A. M. Best, or to entities required to maintain assets in an independent trust fund whose fair value is sufficient to discharge the obligations of the reinsurer. To the extent that any reinsurance company is unable to meet its obligations under the agreements, WNC's insurance subsidiaries would remain liable. Amounts paid or deemed to have been paid for ceded reinsurance contracts are recorded as reinsurance recoverables. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies. Substantially all of the reinsurance assumed by the Company as of December 31, 1993 is on a 100% coinsurance basis and is accounted for in a manner similar to the direct business. New Accounting Standards In 1992, the FASB issued SFAS 112, "Employers' Accounting for Postemployment Benefits," which WNC adopted effective January 1, 1993. This standard requires employers to recognize the costs and obligations of all types of postemployment benefits provided to former or inactive employees, their beneficiaries, and covered dependents. Under the standard, vested benefits are to be accrued over the relevant service period rather than expensed as they are paid, as was the practice. For postemployment benefits that do not vest or accumulate, employers are to accrue a liability and recognize the expected cost when it is probable that a benefit obligation has been incurred and the amount is reasonably estimable. The adoption resulted in a one-time cumulative adjustment of $1,550,000, net of taxes of $834,000, relating to benefits previously recorded on a pay-as-you-go basis. The adoption of SFAS 112 did not have a material effect on 1993 pretax income and is not expected to have a material impact on future years' earnings. Effective January 1, 1993, WNC adopted SFAS 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The statement requires that reinsurance recoverables, including amounts related to claims incurred but not reported and prepaid reinsurance premiums, be reported as assets instead of net of the related liabilities. The adoption resulted in an increase in total assets and liabilities of $58,173,000 and $60,266,000 at December 31, 1993 and 1992, respectively. The adoption had no impact on net income or stockholders' equity. In June 1993, the FASB issued two new accounting standards. SFAS 114, "Accounting by Creditors for Impairment of a Loan," must be adopted by the Company by January 1, 1995. The standard will require the Company to measure an impaired loan at (i) the present value of expected future cash flows, discounting those cash flows at the loan's effective interest rate, (ii) the fair value of the collateral of an impaired collateral dependent loan, or (iii) an observable market price. The impairment is recognized by a valuation allowance which may be subsequently increased or decreased based on changes in the measurement criteria. The Company is in the process of determining the effect the new standard will have on net income and stockholders' equity but does not expect the effect to be material. The second standard, SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," which the Company must adopt prospectively effective January 1, 1994, requires the Company to segregate its fixed maturity portfolio into three separate classifications on the balance sheet: investments held to maturity, trading securities, and investments available for sale. Investments held to maturity will include only those fixed maturities that the Company has a positive intent and ability to hold to maturity. These securities will be carried at amortized cost less write- downs for other-than-temporary impairments. Trading securities will consist of those fixed maturity and equity securities held for short periods of time and will be carried on the balance sheet at fair value, with any change in value reported as a component of income. Investments available for sale will consist of those securities that do not meet the criteria of investments held to maturity or trading securities and will be carried on the balance sheet at fair value, with any change in value recognized as an unrealized gain or loss in stockholders' equity. If a decrease in value of fixed maturity investments is other than temporary, the loss is recognized immediately as a realized loss. In addition, stockholders' equity will be reduced by the estimated amortization of deferred insurance costs that the realization of the unrealized gains would produce. The adoption of this standard at January 1, 1994 will result in an increase in stockholders' equity of approximately $43,000,000. This is the result of changing the carrying value of the current held for sale fixed maturities to fair value, a reduction in deferred insurance costs of $19,000,000, and a related increase in deferred taxes of $14,000,000. There will not be an income statement effect for adoption as the Company does not have a trading portfolio. The Company foresees that this standard will result in added volatility to stockholders' equity as the standard does not permit a corresponding adjustment to the liabilities that these assets support. Note B Investments Gains and Losses and Income Realized investment gains (losses) for years ended December 31 are comprised of the following: Major categories of net investment income for the years ended December 31 are as follows: As of December 31, 1993, investments included real estate, mortgage loans, and fixed maturities with a carrying value of $22,158,000 which were non- income producing for the previous twelve months. Fixed Maturities A comparison of amortized cost to fair value of fixed maturity investments by category at December 31, 1993 and 1992 is as follows: The amortized cost and fair value of fixed maturities at December 31, 1993, by contractual maturity, are shown in the following table. Expected maturities differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Fixed maturities had an increase (decrease) in unrealized gains (the excess of fair value over amortized cost) of $25,438,000, $(4,245,000), and $88,953,000 in 1993, 1992, and 1991, respectively. At December 31, 1993, gross unrealized gains (losses) on investments in equity securities amounted to $386,000 and $(429,000), respectively. Other During 1993, 1992, and 1991, non-cash investing activities consisted of real estate acquired through foreclosure of mortgage loans which totaled $4,869,000, $14,302,000, and $3,829,000, respectively. The fair value of investments in mortgage loans was estimated to be $411,250,000 and $471,082,000 at December 31, 1993 and 1992, respectively. The fair value of policy loans was estimated to be $50,340,000 and $48,246,000 at December 31, 1993 and 1992, respectively. Note C Borrowings and Other Credit Arrangements Borrowings Borrowings of $2,434,000 at December 31, 1993 consist of a mortgage on investment real estate with an interest rate of 6.5% that matures in March 1998. Payments of $526,000, $562,000, $599,000, $613,000 and $134,000 will be required in 1994, 1995, 1996, 1997, and 1998, respectively. The property is pledged as collateral. Interest paid on borrowings by WNC was $1,673,000, $1,313,000, and $2,130,000 in 1993, 1992, and 1991, respectively. The fair value of WNC's mortgage and long-term notes payable at December 31, 1993 and 1992 was estimated to be $2,438,000 and $14,107,000, respectively. Credit Arrangements WNC has a line of credit arrangement for short-term borrowings with one bank amounting to $10,000,000, all of which was unused at December 31, 1993. The line of credit arrangement can be renewed annually, but credit can be withdrawn at the bank's option. In addition, WNC has three letters of credit available from one bank totaling $1,892,000 with varying terms and conditions. As of December 31, 1993, the entire amount was unused. Note D Income Taxes Effective January 1, 1992, WNC adopted SFAS 109, "Accounting for Income Taxes." Amounts prior to 1992 are presented under the previous accounting rules. The Omnibus Budget Reconciliation Act of 1993 changed WNC's prevailing federal income tax rate from 34% to 35% effective January 1, 1993. The application of the 35% tax rate to the December 31, 1992 deferred income tax liability balance resulted in a $38,000 increase in federal income tax expense for 1993. Components of WNC's deferred tax liabilities and assets at December 31 are as follows: The net deferred tax liabilities relate primarily to the future taxable temporary differences for deferred insurance costs. The net deferred tax assets relate primarily to the future deductible temporary differences for policy liabilities and liabilities for employee benefits items. The nature of WNC's deferred tax assets and liabilities is such that the general reversal pattern for these temporary differences should result in a full realization of WNC's deferred tax assets other than capital gain or loss items. The components of the provision for deferred income taxes for the year ended December 31, 1991 are as follows: At December 31, 1993, WNC had capital loss carryforwards for tax return purposes of $7,404,000 that expire in 1996. For financial reporting purposes, a valuation allowance of $14,903,000 has been recognized to offset the deferred tax assets related to those carryforwards, investment loss reserves, and other capital loss related deferred tax assets not expected to be realized. The valuation allowance was reduced by $3,272,000 and $500,000 in 1993 and 1992, respectively. The components of income tax expense for the years ended December 31 are as follows: The following reconciles the difference between the actual tax provision and the amounts obtained by applying the statutory federal income tax rate of 35% for 1993 and 34% for 1992 and 1991 to the income or loss before income taxes and cumulative effect of changes in accounting principles: At December 31, 1993, up to $19,851,000 (at a 35% tax rate) would be required for possible federal income taxes that might become due in future years, in whole or in part, if any portion of $56,717,000 of the insurance companies' gains from operations which accumulated under pre-1984 income tax laws, presently included in earned untaxed surplus and identified as tax "Policyholders' Surplus," becomes includable in taxable income. Also, distribution of amounts in excess of taxable "Shareholders' Surplus" ($221,591,000 at December 31, 1993) by the insurance companies under certain conditions may require payment of additional federal income taxes. However, WNC does not expect or intend that these taxable events will occur and, as such, the related deferred income taxes are not required to be provided. Federal income taxes paid by WNC were $4,100,000, $8,700,000, and $5,300,000 in 1993, 1992, and 1991, respectively. WNC has a nonlife net operating loss carryforward for tax purposes of $2,222,000 that will begin to expire in 2005. Note E Stockholders' Equity Convertible Preferred Stock WNC has 10,000,000 shares of $5 par value Preferred Stock authorized that is designated as $2.50 Convertible Preferred Stock. Each share is entitled to a cumulative annual dividend of $2.50, and a preference of $50 in the event of involuntary liquidation and $55 in the event of voluntary liquidation of WNC. Further, each share is convertible at any time into 1.875 shares of Common Stock at the option of the holder and is redeemable at $55 at the option of WNC. Each holder is entitled to one vote for each share held and, except as otherwise provided by law, the $2.50 Convertible Preferred Stock and the Common Stock vote together as one class. Stock Purchase Rights WNC has one outstanding Common Stock Purchase Right for each outstanding share of Common Stock. The Rights will become exercisable only if a person or group acquires 20% or more of WNC's Common Stock or announces a tender offer following which it would hold 30% or more of such Common Stock. If the Rights become exercisable, a holder will be entitled to buy from WNC one share of WNC Common Stock at a price of $100 per share. If, after the Rights become exercisable, WNC is acquired in a merger or other business combination or more than 50% of WNC's assets or earning power are sold, each Right will entitle its holder to buy that number of shares of Common Stock of the acquiring company having a market value of twice the exercise price of the Right. Alternatively, if a 20% WNC stockholder acquires WNC by means of a merger in which WNC and its Common Stock survive or that stockholder engages in self-dealing transactions with WNC, each Right not owned by the 20% holder would become exercisable for that number of shares of WNC Common Stock which have a market value of twice the exercise price of the Right. Until the Rights become exercisable, one additional Right will be distributed with each share of WNC Common Stock issued in the future. The Rights will expire in January 1997. The Rights may be redeemed by WNC at $.01 per Right prior to the time that 20% or more of WNC's Common Stock has been accumulated by a person or group or within ten days thereafter under certain circumstances. Common Stock WNC has 60,000,000 authorized shares of $5 par value Common Stock including treasury shares. In the third quarter of 1993, the Company completed a public offering of 2,133,000 newly issued shares for $23.75 per share. Capital contributions of $14,000,000 were made to a subsidiary out of the net proceeds. In addition, short-term indebtedness was reduced $11,000,000. The remainder is being used for other general corporate purposes. At December 31, 1993, 13,768,000 shares of WNC's Common Stock were reserved for future issuance. Of this amount 12,118,000 shares were reserved for future exercises of Purchase Rights, 271,000 shares were reserved for conversion of outstanding Convertible Preferred Stock, 1,344,000 shares were reserved for exercise of options to purchase Common Stock and for use in connection with the restricted stock grants, and 35,000 shares were reserved for issuance of Common Stock in connection with the dividend reinvestment plan. The annual dividend paid on WNC Common Stock in 1993, 1992, and 1991 was $1.08 per share. The number of shares used in computing primary earnings per share for 1993, 1992, and 1991 was 10,755,000, 9,989,000, and 9,980,000, respectively. These consisted of average shares outstanding plus the effect of dilutive stock options totalling 112,000 shares in 1993 and 97,000 shares in 1992. No effect was given to stock options in 1991 because the effect would have decreased the loss per share. The number of shares used in computing fully diluted earnings per share for 1993 was 11,026,000. This included average shares outstanding plus 383,000 shares of common stock equivalents consisting of dilutive stock options and the assumed conversion of preferred stock. Primary and fully diluted earnings per share were the same for 1992 and 1991 because the computation of fully diluted earnings per share resulted in a smaller loss per share. Statutory The statutory accounting practices prescribed for WNC's insurance subsidiaries by regulatory authorities differ from GAAP. The following reconciles statutory capital and surplus to GAAP stockholders' equity at December 31: The following reconciles statutory net income (loss) to GAAP net income (loss) for the years ended December 31: The net assets of WNC's insurance subsidiaries that are available for transfer to WNC generally are limited to the amounts by which such net assets, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. In addition, transfers in excess of certain amounts require approval of regulatory authorities. Retained earnings at December 31, 1993 includes $125,000,000 in excess of the statutory unassigned surplus of the insurance subsidiaries. Note F Stock Benefit Plan WNC has a stock benefit plan under which WNC's Compensation Committee may grant stock options, stock appreciation rights (SARs), and shares of restricted stock. The following summarizes the changes in the shares of Common Stock of WNC under the plan: Stock options granted from 1991 to 1993 ranged from $10.21 per share to $26.57 per share. Stock options exercised from 1991 to 1993 ranged from $10.21 per share to $21.70 per share. Exercise prices on stock options outstanding range from $10.21 to $27.29 per share. Shares of restricted stock may be granted either separately or in tandem with the grant of a stock option to key employees and others. These restricted shares are subject to certain terms and conditions defined in the plan. Options for 7,500 and 6,750 such shares were granted in 1992 and 1991, respectively. Note G Defined Benefit and Contribution Plans Retirement Plans Washington National Insurance Company (WNIC) and an indirect wholly-owned subsidiary, United Presidential Life Insurance Company (UPI), each have a defined benefit retirement plan covering substantially all employees who have met the prescribed requirements for participation. Both plans have been amended to terminate the accrual of future benefits. Benefits are based principally on years of service and compensation. Generally, the funding policies are to contribute annually amounts required by the Internal Revenue Code (IRC). Contributions are intended to provide benefits attributed to service to date. Effective January 1, 1991 for WNIC, and March 31, 1993 for UPI, the Company established two defined contribution retirement plans, a money-purchase retirement plan and a discretionary profit sharing plan. Neither plan allows employee contributions. These two plans, in addition to the contributory 401(k) plan, collectively represent the current retirement benefit program. The plans now cover substantially all WNIC and UPI employees who have met the prescribed requirements for participation. The contribution to the 401(k) plan matches employee contributions dollar for dollar up to a maximum of 3% of compensation. The contribution to the money- purchase retirement plan is 3% of each employee's compensation and an additional 3% of compensation in excess of the Social Security wage base. The contribution to the profit sharing plan is at the discretion of the insurance subsidiaries' Boards of Directors in consultation with the Board of Directors of WNC and is based on financial performance. WNC also has supplemental retirement plans under which benefits are paid equal to any amount by which benefits are reduced for any participant in the defined contribution or defined benefit retirement plans due to provisions of the IRC. The liabilities for the supplemental retirement plans at December 31, 1993 and 1992 were immaterial. The net pension expense for the defined contribution plans in 1993, 1992, and 1991 was $2,777,000, $2,110,000, and $1,866,000, respectively. A summary of the components of the net periodic pension expense for the defined benefit retirement plans follows: Net periodic pension expense for 1993 includes a $491,000 curtailment gain from the termination of the accumulation of benefits of UPI's defined benefit plan. The defined benefit retirement plans' funded status and amounts reported in WNC's consolidated balance sheets as of December 31 are as follows: The unrecognized transition gain in the preceeding schedule is the amount by which the plans' net assets exceeded the actuarial present value of projected benefit obligations as of January 1, 1985, net of amortization, the date on which current pension accounting standards were adopted. The transition gain is being amortized by credits to income over a fourteen- year period. In addition, the excess of actual investment and actuarial gains and losses realized over those expected are deferred and, when the cumulative deferred amounts exceed certain limits, will be amortized at a rate consistent with a fourteen-year amortization period. Costs created by plan amendments that are associated with prior employee service are also deferred and amortized over fourteen years. Accrued pension cost and the various net gains and losses not recognized in the consolidated financial statements are compared annually to the plans' funded status. The comparison is made using the plans' accumulated benefit obligations. When a deficiency exists, an adjustment is made for the amount of the deficiency to recognize a minimum liability. At December 31, 1993 and 1992, the pretax adjustment was $3,033,000 and $1,269,000, respectively. The liability and subsequent changes had no effect on net periodic pension expense and were reported directly in stockholders' equity. In determining the actuarial present value of the projected benefit obligation as of December 31, 1993 and 1992, the discount rate used was 6.7% and 6.9%, respectively. The rate of increase in compensation levels used in 1992 was 5% for the UPI plan. The expected rate of return on plan assets was 7.5% for 1993, 1992, and 1991. Assets of the defined benefit plans are invested principally in mutual funds, bonds, and stocks. Assets of the WNIC retirement plan include Common and Preferred Stock of WNC of $10,863,000 and $10,332,000, at fair value, at December 31, 1993 and 1992, respectively. Dividends of $492,000 were received on the WNC Common and Preferred Stock in 1993 and 1992. No shares were purchased or sold during 1993. Postretirement Benefits In addition to WNC's various retirement programs, WNIC provides certain health care and life insurance benefits to eligible retired employees. Employees generally have become eligible for these benefits after reaching age 55 with 20 years of service or after reaching age 65 with 10 years of service. Generally, the health plans pay a stated percentage of most medical expenses reduced for deductibles and any payments made by government programs or other group coverage. Retirees contribute to the plan according to a schedule which averages 16% of the benefits paid. Effective January 1, 1992, WNC adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Prior to December 1993, these benefits were unfunded. In December 1993, the Company contributed $1,100,000 to a Voluntary Employees' Beneficiary Association (VEBA) trust. The amount funded to the VEBA trust was based on the difference between the net periodic postretirement benefit expense and the retiree medical claims incurred during the period, subject to certain IRC limitations. Assets of the VEBA trust were invested in short-term variable demand notes at December 31, 1993. Effective December 31, 1992, the WNIC plan was changed to limit future eligibility. Active employees who were not at least age 50 as of December 31, 1992 and whose combination of age and years of service did not total at least 65 as of that date are not eligible for postretirement health insurance benefits and are only eligible for $10,000 of postretirement life insurance benefits. This curtailment resulted in a gain of $4,033,000 recorded as part of operations in the fourth quarter of 1992. The net periodic postretirement benefit expense includes the following components at December 31: Postretirement benefit expenses were recorded on a pay-as-you-go basis in 1991 and totaled $3,100,000. The following reconciles the plans' accumulated postretirement benefit obligation with amounts recognized in WNC's consolidated balance sheets at December 31: The health care cost trend rate used in 1993 and 1992 was 15% grading to 6% evenly over thirty years. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the trend rate by 1% per year would increase the accumulated postretirement benefit obligation by $2,825,000 at December 31, 1993 and the aggregate of the service and interest cost components of the net periodic postretirement benefit expense for 1993 by $200,000. Note H Reinsurance The effect of reinsurance on premiums and policy charges for the years ended December 31 was as follows: Reinsurance benefits ceded were $22,685,000, $22,516,000, and $17,372,000 in 1993, 1992, and 1991, respectively. As a result of past divestitures, the Company reinsures 100% of certain blocks of supplemental health insurance, life insurance, and annuity business with unaffiliated companies. At December 31, 1993, approximately 50% of WNC's total reinsurance recoverables were ceded to Combined Life Insurance Company of America and approximately 19% was ceded each to American Founders Life Insurance Company and UNUM Life Insurance Company. Of these three, two are related to divestitures. Also at December 31, 1993, 89% of reinsurance premiums assumed were from Harvest Life Insurance Company. The reinsurance agreement provides that the Company will reinsure a block of individual major medical business issued by Harvest Life on a 100% coinsurance basis. The Company also uses yearly renewable term reinsurance at UPI to maintain statutory profitability and other financial requirements at UPI while sustaining growth. At December 31, 1993, such reinsurance, net of related taxes had contributed $9,300,000 of statutory capital to UPI. These transactions do not materially impact the Company's GAAP financial statements. Note I Commitments and Contingencies Leases WNC has noncancelable operating leases primarily for office space and office equipment, the most significant of which relates to a twenty-year lease of WNIC's home office building with a related party as lessor. Future minimum lease payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year at December 31, 1993 are as follows: Rental expenses were $6,900,000, $2,871,000, and $3,039,000 in 1993, 1992, and 1991, respectively. Financial Commitments and Guarantees The Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments include commitments to extend credit, commitments to fund investments, standby purchase commitments, and financial guarantees related to various investments in real estate and joint ventures. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for the aforementioned commitments and guarantees is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. If funded, the commitments and guarantees would be collateralized by the related real estate investments. Commitments to extend credit are agreements to lend to an entity as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. An entity's credit worthiness is evaluated on a case-by-case basis and the amount of collateral obtained upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held would include the related real estate investment properties. At December 31, 1993 and 1992, commitments to extend credit were $6,425,000 and $11,049,000, respectively. These commitments principally expire by July 1994. Commitments to fund investments primarily for venture capital and fixed maturity investments amounted to $358,000 and $14,398,000 at December 31, 1993 and 1992, respectively. These commitments are on call and do not have a formal expiration date. Standby purchase commitments and financial guarantees are conditional commitments issued by the Company to guarantee the performance of an unrelated entity to a third party. These purchase commitments and guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and letters of credit, and expire in 1994, 1995, and 1996. The Company does not hold collateral for these conditional commitments; however, in the event of nonperformance by the entity, the Company would be entitled to the underlying collateral, principally commercial real estate properties. In addition, the Company is entitled to share in the appreciation of the collateral on the conditional commitments at the time of sale or refinancing. Management is not aware of any material losses on these conditional commitments. At December 31, 1993 and 1992, standby purchase commitments and guarantees were $24,323,000 and $34,126,000, respectively. The Company issued financial guarantees on two real estate investments and received $676,000 of consideration, principally in 1986. The estimated fair value at December 31, 1993 of these guarantees is less than $500,000. The Company also entered into financial guarantees that are integral and inseparable components of real estate and mortgage loan transactions. No consideration was received for these guarantees which relate primarily to the guarantee of debt repayment on three joint venture real estate investments. Accordingly, the fair value of these financial guarantees is zero. Litigation WNC and certain affiliated companies have been named in various pending legal proceedings considered to be ordinary routine litigation incidental to the business of such companies. A number of other legal actions have been filed against the Company that demand compensatory and punitive damages aggregating material dollar amounts. Management believes that such suits are substantially without merit and that valid defenses exist and are of the opinion that such litigation will not have a material effect on WNC's consolidated financial position. Health Care Reform See Item 7, "Management's Discussion And Analysis Of Financial Condition And Results Of Operations - Health Care Reform" for a discussion of health care reform and its possible effect on the Company's business. State Guaranty Funds Under insolvency or guaranty laws in most states in which the Company's insurance subsidiaries operate, insurers can be assessed for policyholder losses incurred by insolvent insurance companies. At present, most insolvency or guaranty laws provide for assessments based on the amount of insurance underwritten in a given jurisdiction. The Company's insurance subsidiaries paid $2,500,000, $1,800,000, and $2,000,000 in state guaranty fund assessments in 1993, 1992, and 1991, respectively and had accrued liabilities of $2,800,000 for future assessments at December 31, 1993 and 1992. Mandatory assessments can be partially recovered through a reduction in future premium taxes in some states. The Company's accounting policy with regard to payments to state guaranty funds is to treat as a deferred asset any such payments in those states where current law allows an offset against future premium taxes. At December 31, 1993 and 1992, other assets included $5,100,000 and $4,000,000 of deferred payments to state guaranty funds. Generally, this amount will be used to offset future premium tax payments over periods from five to ten years. In the event of a change in the law pertaining to prior tax offsets, such amounts might become unrecoverable. Note J Divestitures In the third quarter of 1991, WNC completed the sale of its New York-based life insurance subsidiary. A pretax loss of $16,000,000 was recorded on this sale in 1990. An additional pretax loss of $1,826,000 was recognized in the second quarter of 1991. At June 30, 1991, this subsidiary had assets, principally investments, of $200,000,000 and liabilities, principally policy liabilities, of $176,000,000. In the consolidated statement of operations for 1991, total revenues of $12,200,000 are attributable to this subsidiary. In the second and third quarters of 1991, WNIC sold blocks of universal life insurance and annuities for a pretax gain of $668,000. The gain is included in net loss on divestitures. The operations of these blocks of business are included in the life insurance and annuities segment. These blocks of business had policy-related assets, principally deferred insurance costs, of $13,000,000 and policy liabilities of $110,000,000. Note K Segment Information WNC has four business segments: life insurance and annuities; group products; individual health insurance; and corporate and other. The segments are based on WNC's insurance products. The corporate and other segment includes realized investment gains and losses, a curtailment gain in 1992 of $4,033,000 resulting from a change to WNIC's postretirement health benefits program, operations that do not specifically support one of the other segments, and the operations and the net loss on divestitures in 1991. See Note J for further information on divestitures. Assets not individually identifiable by segment are allocated based on the amount of segment liabilities. Depreciation expense and capital expenditures are not considered material. Revenues, income or loss before income taxes and cumulative effect of changes in accounting principles, and assets by segment for the years ended and as of December 31 are as follows: ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Descriptions of WNC's directors are contained in WNC's 1994 proxy under the caption "Election of Directors." Information regarding compliance with Section 16(a) of the Exchange Act is contained in WNC's 1994 proxy statement under that caption. Additionally, biographical descriptions of Wade G. Brown, Executive Vice President and Chief Information Officer; Curt L. Fuhrmann, President - WNIC Health Division; Kenneth A. Grubb, President - WNIC Education Division; R. W. Patin, Chairman of the Board and Chief Executive Officer, WNC and WNIC; James N. Plato, President and Chief Executive Officer, United Presidential Life Insurance Company; Thomas Pontarelli, Executive Vice President, Thomas C. Scott, Executive Vice President and Chief Financial Officer; and Don L. Wilhelm, former Chairman of the Board and Chief Executive Officer, United Presidential Life Insurance Company, are contained in Part I of this Report, pursuant to General Instruction G. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Executive compensation and transactions are contained in WNC's 1994 proxy statement under the caption, "Executive Compensation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT A description of security ownership of certain beneficial owners and management is contained in WNC's 1994 proxy statement under the caption, "Stock Ownership." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS A description of transactions with management is contained in WNC's 1994 proxy statement under the caption, "Transactions with Management." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)The following consolidated financial statements of WNC and subsidiaries included in the 1993 Annual Report to Stockholders are presented in Item 8: Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, Year Ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows, Year Ended December 31, 1993, 1992, and 1991 Consolidated Statements of Stockholders' Equity, Year Ended December 31, 1993, 1992 and 1991 Capital Stock Activity, Year Ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements Quarterly Information (a)(2)The financial schedules required by Item 14(d) are presented in a separate section of this report and are preceded by the Index to Financial Schedules. All other schedules pursuant to Regulation S-X are not submitted because they are not applicable, not required, or the required information is included in the consolidated financial statements, including the notes thereto. (a)(3)The exhibits filed with this Form 10-K are listed in the Exhibit Index located elsewhere herein. All management contracts and compensatory plans or arrangements set forth in such list are marked with a double asterisk (*). (b) WNC filed no reports on Form 8-K during the last quarter of the period covered by this report. (c) Included in 14(a)(3) above. (d) Included in 14(a)(2) above. Signatures Pursuant to the requirements of Section 13 or 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. WASHINGTON NATIONAL CORPORATION REGISTRANT Date: March 11, 1994 /c/ Robert W. Patin Robert W. Patin Chairman of the Board, President and Chief Executive Officer and Director 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 11, 1994 /c/ Frederick R. Blume Frederick R. Blume Director Date: March 11, 1994 /c/ Elaine R. Bond Elaine R. Bond Director Date: March 11, 1994 /c/ Ronald L. Bornhuetter Ronald L. Bornhuetter Director Date: March 11, 1994 /c/ Joan K. Cohen Joan K. Cohen Vice President, Controller and Treasurer Date: March 11, 1994 /c/ Lee A. Ellis Lee A. Ellis Director Date: March 11, 1994 /c/ John R. Haire John R. Haire Director Date: March 11, 1994 /c/ Stanley P. Hutchison Stanley P. Hutchison Director Date: March 11, 1994 /c/ George P. Kendall, Jr. George P. Kendall, Jr. Director Date: March 11, 1994 /c/ Frank L. Klapperich, Jr. Frank L. Klapperich, Jr. Director Date: March 11, 1994 /c/ Lee M. Mitchell Lee M. Mitchell Director Date: March 11, 1994 /c/ Robert W. Patin Robert W. Patin Chairman of the Board, President and Chief Executive Officer and Director Date: March 11, 1994 /c/ Rex Reade Rex Reade Director Date: March 11, 1994 /c/ Thomas C. Scott Thomas C. Scott Executive Vice President and Chief Financial Officer Date: March 11, 1994 /c/ Patricia Y. Tsien Patricia Y. Tsien Director INDEX TO FINANCIAL SCHEDULES WASHINGTON NATIONAL CORPORATION AND SUBSIDIARIES Schedules filed pursuant to Rule 7-05 of Regulation S-X: I. Summary of Investments - Other than Investments in Related Parties II. Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties III. Condensed Financial Information of Registrant V. Supplementary Insurance Information VI. Reinsurance VII. Guarantees of Securities of Other Issuers IX. Short-Term Borrowings EXHIBIT INDEX WASHINGTON NATIONAL CORPORATION AND SUBSIDIARIES EXHIBITS FILED PURSUANT TO ITEM 14(a)(3) Page Number 3.1 Certificate of Incorporation, as amended, on Form 10-K, for the year ended December 31, 1987 3.2 By-laws, as amended, on Form 10-K, for the year ended December 31, 1986 * 4 Rights agreement between WNC and The First National Bank of Chicago, on Form 8-K dated December 23, 1986 * 10.1 Employment agreements with R. W. Patin, T. Pontarelli, T. C. Scott, and C. L. Fuhrmann, on Form 10-K, for the year ended December 31, 1991 ** * 10.2 Employment agreements with K. A. Grubb and J. N. Plato, on Form 10-K, for the year ended December 31, 1992 ** * 10.3 Employment agreement with W. G. Brown on Form 10-Q, for the period ended September 30, 1993 ** * 10.4 Form of Indemnification Agreement between Registrant and each Director and Executive Officer of Registrant on Form 10-Q, for the period ended June 30, 1993 ** * 11 Computation of Earnings per Share see below 13 WNC's Annual Report to Stockholders for the year ended December 31, 1993, which is furnished for the information of the Commission and, except for those portions which are expressly incorporated by reference in this filing is not to be deemed "filed" as part of this filing * 21 Subsidiaries of WNC see below 23 Consent of Ernst & Young, Independent Auditors see below * Incorporated by reference. ** Management contract and compensatory plans or arrangements.	17,376	113,936
882240_1993.txt	882240_1993	1993	882240	ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2	12,726	88,298
770949_1993.txt	770949_1993	1993	770949	Item 1. Business. Reebok International Ltd., a Massachusetts corporation organized on July 26, 1979, engages primarily in the design and marketing of sports and fitness performance products, including footwear and apparel, as well as the design and marketing of footwear and apparel for non-athletic "casual" use. The Company recently realigned its management responsibilities to establish two major business groups: the Reebok Division, which is primarily responsible for the Company's REEBOK (R) brand, and the Specialty Business Group, which consists of REEBOK brand outdoor products, golf products and retail operations, along with the Company's other major brands and non-athletic products, including BOKS (TM) casual footwear and the Company's subsidiaries, AVIA Group International, Inc. ("Avia") and The Rockport Company, Inc. ("Rockport"). (Reebok International Ltd. is referred to herein, together with its subsidiaries, as "Reebok" or the "Company" unless the context requires otherwise.) During calendar year 1993, net income for the Company increased to $223.4 million, or $2.53 per share, from $114.8 million, or $1.24 per share, for the year ended December 31, 1992, while net sales decreased by 4.3%, from $3.023 billion to $2.894 billion. Net income in 1992 was affected by a restructuring plan adopted by the Company in such year which resulted in after-tax charges totaling $135.4 million in the fourth quarter of 1992 and by after-tax gains of $18.0 million from the sale of CML Group, Inc. ("CML") common stock. The restructuring plan contemplated, among other things, the sale by the Company of two of its subsidiaries, Boston Whaler, Inc. ("Boston Whaler") and Ellesse U.S.A., Inc. ("Ellesse"). The Boston Whaler sale was completed on July 30, 1993 and the Ellesse sale was completed on September 28, 1993. The aggregate proceeds from these sales were $42.5 million (subject to certain post-closing adjustments), which included a note receivable of $6 million, due in installments through December 31, 1999. In connection with such sales, additional after-tax charges totaling $7.0 million were taken in the third quarter of 1993, thus affecting net income in 1993. On February 15, 1994, the Company filed a Registration Statement with the Securities and Exchange Commission to register 3,450,000 shares of its Common Stock to be sold in an underwritten public offering by the Company's Chairman and Chief Executive Officer, Paul Fireman, and his wife, Phyllis Fireman (the "Selling Stockholders"). The Company intends to purchase, subject to approval by a Special Committee of the Board of Directors of the Company and the consummation of the public offering of shares by the Selling Stockholders, 1,000,000 shares of Common Stock from the Selling Stockholders at the same price per share as the public offering per share price, less the amount of all underwriting discounts. It is anticipated that the Company's repurchase of these shares of Common Stock (the "Company Stock Repurchase") will occur simultaneously with the consummation of the public offering of the shares of Common Stock by the Selling Stockholders. The Company intends to fund the Company Stock Repurchase with available cash and short-term borrowings. If the Company Stock Repurchase is consummated, the repurchased shares will be returned to the status of authorized and unissued capital stock of the Company. On July 13, 1993, the Company's Board of Directors authorized the repurchase of up to $200 million in Common Stock in open market or privately reported transactions. This was in addition to the $200 million share repurchase program adopted by the Company in July 1992. Under these programs, the Company has purchased 8,725,100 shares at an aggregate price of approximately $269.1 million through February 14, 1994, which leaves the Company with authority to repurchase up to $130.9 million in additional shares of Common Stock. If consummated, the Company Stock Repurchase will be treated as a repurchase under the Company's share repurchase program. The following is a discussion of the business of each of the Company's operating units. REEBOK DIVISION The Reebok Division is responsible for designing, producing and marketing sports and fitness footwear, apparel and accessories that combine the attributes of athletic performance along with style, including footwear for basketball, running, soccer, tennis, track and field, volleyball, football, baseball, aerobics, cross training and walking activities, as well as athletic apparel and accessories (including apparel and accessories sold under the REEBOK (R) brand, a line of basketball clothing and accessories sold under the ABOVE THE RIM (R) brand, and a line of performance apparel, with emphasis on running and cycling, sold under the TINLEY (R) brand). The Division also produces children's footwear sold under the REEBOK (R) brand and a collection of footwear, apparel and accessories for infants and toddlers sold under the WEEBOK (R) brand, which is designed to meet the special requirements of infants and toddlers and to provide functional and contemporary head-to-toe dressing. The Division has recently expanded its product scope through the development and marketing of related sports and fitness products, such as sports and fitness videos, programming and equipment. In addition, to enhance brand awareness and gain credibility for its technologies, the Company has adopted a strategic licensing program pursuant to which the Company's technologies and/or trademarks are licensed to third parties for sporting goods and related products. The Reebok Division has targeted as its primary customer base athletes and others who believe that technical and other performance features are the critical attributes of athletic footwear and apparel. As part of its commitment to offer leading athletic footwear technologies, the Division engages in product research, development and design ("RD&D") activities in the Company's Stoughton, Massachusetts headquarters and in its various Far East offices. TECHNOLOGY Reebok continued to place a strong emphasis on technology in 1993, highlighted by further development of THE PUMP (TM) inflatable technology, an integrated system of one or more inflatable chambers that are adjustable to help provide custom fit and support in footwear and other products, and its evolution to INSTAPUMP (TM) technology. INSTAPUMP technology is a new inflatable technology from Reebok which brings the features and benefits of THE PUMP technology to lightweight performance shoes through use of an INSTAPUMP inflator containing a carbon dioxide cartridge which is used to inflate the chambers instantly. The INSTAPUMP technology was tested in both running and tennis shoes, first at the 1992 Olympic Summer Games in Barcelona where running shoes with the INSTAPUMP technology were worn by several medal winners, then at the 1992 and 1993 U.S. Open where tennis shoes incorporating the INSTAPUMP technology were worn by both Michael Chang and Arantxa Sanchez-Vicario, and finally in 1993 where running shoes incorporating the INSTAPUMP technology were worn by Reebok athletes competing in the IAAF World Track & Field Championships in Stuttgart, Germany. Cleated shoes incorporating the INSTAPUMP technology were also worn by Reebok athletes in the 1994 Super Bowl. Running and tennis shoes incorporating the INSTAPUMP technology were available in test markets in Fall 1993 and running, basketball and tennis shoes incorporating the INSTAPUMP technology are expected to be available at retail in Spring 1994. In 1993, Reebok continued its emphasis on HEXALITE (R) technology and the exclusively licensed DYNAMIC CUSHIONING (R) technology. The HEXALITE technology, introduced by Reebok in 1989, is a lightweight, flexible, compressible and resilient honeycomb structure designed to provide lightweight cushioning as a midsole component. The DYNAMIC CUSHIONING technology utilizes compressible rearfoot and forefoot chambers formed in the outsole connected by an air transmission duct to provide cushioning. The Company also continued its emphasis on GRAPHLITE (R) technology, a lightweight, high strength composite material in the midsole and outsole used to create a lightweight shoe that does not sacrifice stability or strength. MARKETING AND PROMOTIONAL ACTIVITIES The Reebok Division devotes substantial resources to advertising its products to a variety of audiences through television, radio and print media. A substantial advertising program was pursued in 1993 with advertisements directed toward both the trade and the ultimate consumer of REEBOK products. The major advertising campaigns in 1993 included the SHAQ campaign featuring NBA Rookie of the Year, Shaquille O'Neal of the Orlando Magic, which was aimed at enhancing the Company's performance image in basketball and introducing its signature line of SHAQ (TM) basketball shoes and apparel, the PRESEASON (TM) campaign featuring Emmitt Smith of the Super Bowl Champion Dallas Cowboys and Frank Thomas of the Chicago White Sox, and the Planet Reebok campaign, the Company's first global marketing campaign, which provided a unifying theme for the Company's worldwide advertising. In a further effort to present a unified global image, in 1993 Reebok adopted a new Performance Logo which provides a single, easily recognizable symbol for REEBOK products around the world. The new Performance Logo appears on REEBOK athletic footwear and apparel and is now featured in all of the Company's advertising, promotional and marketing materials. Substantial and increased resources were devoted to promotional activities in 1993, including endorsement agreements with athletes, teams, leagues and sports federations, event sponsorships, in-store promotions and point-of-sale materials. Recently, the Division has made a strong strategic push in the sports market, gaining increased visibility on playing fields and sports arenas worldwide through endorsement arrangements with such athletes as Shaquille O'Neal, with whom Reebok introduced a major signature line of footwear, apparel and accessories featuring his distinctive logo. Other endorsements in basketball come from professional players such as Dominique Wilkins, Shawn Kemp, Dee Brown, Steve Smith and Muggsy Bogues. Tennis promotions included teaching programs for inner-city youth and endorsement contracts with well-known professionals including Michael Stich, Michael Chang, Arantxa Sanchez-Vicario and Malivai Washington. Reebok also signed an endorsement contract with Jimmy Connors to serve as the coach/spokesperson for Reebok's HARDCOURT tennis line beginning in 1994. Promotional efforts in running included endorsement contracts with such well-known runners as Arturo Barrios, Sandra Farmer-Patrick and Suzy Hamilton. To promote the sale of its cross training footwear, Reebok used endorsements by prominent athletes such as Emmitt Smith and Frank Thomas. To promote its new line of cleated baseball and football shoes, the Company signed endorsement contracts with several hundred Major League Baseball and National Football League players, including numerous players in the recent Super Bowl. In addition, in 1993 Reebok entered into an agreement with the National Football League to become one of only three official athletic footwear licensees of the NFL; under this agreement, up to ten players on each team during each game are permitted to wear REEBOK footwear displaying the Company's logos and Reebok has the right to use NFL uniforms and logos in its advertising and promotions. Reebok has also entered into an agreement with National Football League Properties which permitted it to place INSTAPUMP inflation stations on the sidelines during the 1994 Super Bowl and will allow it to do so for the 1995 Super Bowl. This agreement also provides for Reebok to be one of three league-wide sponsors of the World Football League, which will include six European football teams that will begin play in Spring 1995. In soccer, Reebok entered into endorsement contracts with Ryan Giggs of Manchester United and Dennis Bergkamp of Inter-Milan and the Dutch national team that will compete in the 1994 World Cup. The Division also continued its promotional efforts in the fitness area. Aerobic promotional activities in 1993 focused on the STEP REEBOK (R) Program, a step training workout that is performed on an adjustable platform, and endorsements by aerobics experts, such as Denise Austin and Gin Miller. In 1993 the Division introduced its CITY JAM(SM) program, a mix of aerobics, funk and dance, and sponsored CITY JAM events nationwide during the summer of 1993. In addition, in 1993 Reebok introduced the SLIDE REEBOK (TM) lateral motion training device which provides a lateral motion training workout and used decathlete Dave Johnson and figure skater Nancy Kerrigan to promote this product. The Company promoted fitness walking with an endorsement arrangement with Kathy Smith and promoted its BODYWALK(SM) program with an endorsement arrangement with Ellen Abbott. To gain further visibility for the REEBOK (R) brand, Reebok has entered into a number of sponsorships. In January 1993, Reebok entered into an agreement to become the official footwear and apparel sponsor of the Russian Olympic Committee and the approximately 25 individual associated Russian sport federations for 1993 through 1996. The Company also entered into agreements to become the official athletic footwear and activewear sponsor of the International Amateur Athletic Federation through 1995, the official sponsor, through 1995, of the International Ice Hockey Federation and the International Triathlon Union, and the official athletic footwear and apparel sponsor of the U.S. Gymnastics Federation. In addition, Reebok will be a worldwide sponsor of the 1994 Goodwill Games. U.S. OPERATIONS The Reebok Division's U.S. operations unit is responsible for all footwear and apparel products sold in the United States by the Division. Sales of footwear in the United States (including sales of REEBOK outdoor products, golf footwear products and BOKS (TM) footwear) totalled approximately $1.271 billion in 1993, compared to $1.455 billion in 1992. REEBOK brand apparel sales in the U.S. in 1993 totalled approximately $125.4 million, compared to approximately $77.1 million in 1992. (1992's amounts reflect a reclassification of $17.2 million from footwear to apparel for WEEBOK and golf apparel.) In the U.S., the Reebok Division uses an employee sales force for all of its product lines, with the exception of the WEEBOK product line and TINLEY apparel, which are serviced primarily by independent sales representatives. The U.S. national sales staff and locally based sales employees are supported by field service representatives employed by Reebok who travel to assist in retail merchandising efforts and provide information to consumers and retailers regarding the features of the Company's products. There are also a number of promotional personnel who coordinate events and promotions at a "grass roots" level to help enhance the image of the REEBOK (R) brand. The Division's U.S. distribution strategy emphasizes high-quality retailers and seeks to avoid lower-margin mass merchandisers and discount outlets. In 1993, the Company took affirmative steps to enhance its brand image and to maintain the quality of its distribution channels, including the adoption of a resale pricing policy for certain of its products sold in the U.S., effective as of January 1993. REEBOK (R) footwear is distributed primarily through specialty athletic retailers, sporting goods stores and department stores. Distribution of the Company's apparel line is predominantly through pro shops, health clubs and department, sporting goods and specialty stores. INTERNATIONAL OPERATIONS The Reebok Division's international sales are coordinated from headquarters located in London, England which opened in August, 1993 and which is where the Reebok Division's regional operations responsible for Western and Eastern Europe, the Middle East, Africa and India are also located. There are additional regional offices in Hong Kong, which is responsible for Far East operations, and in Santiago, Chile, which is responsible for Latin American operations. The Canadian operations of the Division are managed through a wholly owned subsidiary headquartered outside of Toronto, Canada. The Division markets REEBOK products internationally through wholly owned subsidiaries in Austria, Belgium, Canada, Chile, France, Germany, The Netherlands, Italy, Russia and the United Kingdom and majority owned subsidiaries in Japan and Spain. Acquisition of the Belgian distributor took place as of January 1994. REEBOK products are also marketed internationally through 32 independent distributors and joint ventures. The Company or its wholly owned U.K. subsidiary holds partial ownership interests in 11 of these international distributors, with its percentage of ownership ranging from 20 to 35 percent. Through this international distribution network products bearing the REEBOK brand are actively marketed internationally in approximately 140 countries and territories. The Division's International operations unit also has small design staffs which assist in the design of REEBOK footwear and apparel. During 1993, the contribution of the Division's International operations unit to overall sales of REEBOK products (including REEBOK outdoor products, golf products and the BOKS casual line) increased to $1.083 billion from $1.008 billion in 1992 due to Reebok's increased market share in a growing world market for athletic and casual footwear and apparel. These sales figures do not, however, reflect the full wholesale value of all REEBOK products sold outside the United States in 1993 because some of the Division's distributors are not subsidiaries and thus their sales to retailers are not included in the calculation of the Division's international sales. If the full wholesale value of all international sales of REEBOK products are included, total sales of REEBOK products outside the United States represented approximately $1.358 billion in wholesale value, consisting of approximately 33 million pairs of shoes totalling approximately $1.08 billion in wholesale value of footwear sold outside the United States in 1993 (compared with approximately 30 million pairs totalling approximately $1.058 billion in 1992) and approximately $278 million in wholesale value of REEBOK apparel sold outside the United States in 1993 (compared with approximately $250 million in 1992). SPECIALTY BUSINESS GROUP The Company established the Specialty Business Group to provide a focus for the Company's non-Reebok brands and non-athletic and outdoor products and to pursue more aggressively markets outside Reebok's primary focus. The Specialty Business Group includes the ROCKPORT (R) brand, the BOKS (TM) casual footwear line and the Company's REEBOK brand outdoor products, through which the Company is pursuing the growing casual and outdoor markets, as well as the Company's Avia subsidiary. The Group is also responsible for the Company's golf products and its retail operations. BOKS, OUTDOOR AND GOLF PRODUCTS The BOKS (TM) line of casual footwear combines the Company's athletic heritage with fashionable styling and a comfortable fit. It is designed to appeal to the younger generation and to compete in the non-athletic footwear market. The BOKS line is sold predominantly through department stores, shoe stores and specialty stores. BOKS footwear products are sold through an employee sales force, except for BOKS field accounts, which are serviced by independent sales representatives. To pursue the growing outdoor market, the Company has developed authentic outdoor performance footwear under the REEBOK brand to appeal to outdoor enthusiasts as well as to young people. The REEBOK outdoor line is distributed primarily through specialty athletic retailers and sporting goods stores and is sold through an employee sales force. The Company also produces golf footwear and apparel, which includes a REEBOK line of golf products and a collection of footwear and apparel marketed under the GREG NORMAN (TM) name and logo. Golf products are distributed principally at on-course pro-shops, golf specialty stores and certain department and sporting goods stores and are sold by independent sales representatives. ROCKPORT The Company's Rockport subsidiary, headquartered in Marlboro, Massachusetts, designs, develops and markets lightweight and comfortable casual, dress, outdoor performance and fitness walking shoes for men and women. Rockport has been a leader in the development of biomechanically designed shoes that are structured specifically for the walking motion of the foot. The ROCKPORT (R) line also includes outdoor and casual apparel. Net sales of ROCKPORT products increased by approximately $15.3 million in 1993, to $282.7 million from $267.4 million in 1992. In 1993, Rockport focused on consolidating its product lines as part of a focus on its brand marketing strategies. Rockport markets its products to authorized retailers throughout the United States through a combination of locally based employees and independent sales representatives, supervised by a national sales staff. In 1993, Rockport continued to expand its international market for footwear to include 23 locally based distributors marketing ROCKPORT (R) footwear in approximately 28 foreign countries and territories. A majority of the international distributors are either subsidiaries of the Company or joint venture partners or independent distributors which also sell REEBOK (R) brand products. Rockport distributes its products predominantly through selected higher-quality national and local shoe store chains, department stores, independent shoe stores, specialty clothing stores and outdoor outfitters, emphasizing retailers that provide substantial point-of-sale assistance and carry a full product line. Rockport also has a concept store at Quincy Market in Boston. Rockport has not pursued mass merchandisers or discount outlets for the distribution of its products. At the end of 1993, Rockport discontinued its resale pricing policy that had been in effect since October 1992 for certain of its products sold in the U.S. Traditionally, Rockport's marketing has emphasized the comfort and design of its footwear. Its marketing activities include advertising and public relations, sales training clinics, technical brochures and a variety of promotional activities at the retail level, as well as sponsorship of walking events and educational and medical programs on walking. Rockport's marketing efforts in 1993 focused on increasing consumer awareness of the ROCKPORT product line. AVIA Avia designs, develops and markets athletic footwear and apparel under the AVIA (R) brand. Net sales for Avia decreased from $136.2 million in 1992 to $131.0 million in 1993. In 1993, Avia continued eliminating marginal business lines in order to return to its roots as a pure performance brand. Avia also made major design changes to its footwear line to be more responsive to market demands. Avia has focused its marketing efforts and resources on consumers who seek performance products in the categories of aerobics, cross training and tennis in its fitness marketing group and basketball, outdoor, running and walking in its sports marketing group. In the United States, Avia's primary target market is the women's fitness segment of the market. In 1993, a leading consumer magazine ranked one of Avia's women's walking shoes as the best overall walking shoe on the market. In addition, Avia began distributing products designed for the outdoor market. Avia continues to use its FOM (TM) technology, introduced in 1992, which is designed to provide cushioning and increase comfort. Avia also continues to utilize its ARC (R) technology which was developed to enhance Avia's patented CANTILEVER (R) sole by improving cushioning and stability and, hence, the functionality of the footwear. Avia conducts ongoing research activities at its research, design and development facility in Beaverton, Oregon, the site of Avia's corporate headquarters. The Company believes that Avia's technical capabilities have been, and will continue to be, important to its success. Avia continued to focus on improving its business operations during 1993 by consolidating its staff, reducing costs and strengthening its financial management and marketing capabilities. Internationally, Avia distributes its products through wholly owned subsidiaries in Germany and the United Kingdom and a network of independent distributors. In 1993, Avia formed a joint venture with its Spanish distributor in this important and successful Avia market. In 1993, Avia also changed its distribution arrangement in Canada. Previously, Avia distributed its products in Canada through a wholly owed subsidiary of Reebok; Avia is now using an independent distributor in Canada. Avia's distribution arrangements with independent distributors cover approximately 30 other foreign countries and territories. Avia's principal retail accounts are specialty athletic footwear stores, general sporting goods stores, shoe stores and department stores. Avia seeks to ensure that its products are distributed only to those retailers that reflect the high quality and performance image of its footwear. Avia operates factory direct retail stores in Centralia, Washington, in Bend, Oregon and in Gonzales, Louisiana. Additional stores are planned for 1994. Avia believes that purchasers of its products are primarily active sports and fitness participants who value functionality and performance as key product features. Avia's marketing efforts include advertising on television, on radio and in print and other media, national and local retail and event promotions, point-of-purchase displays and product endorsements by leading athletes. Avia also widely distributes sample products and product literature to key sports and fitness participants, including coaches, instructors and prominent athletes. RETAIL STORES AND OTHER PROPERTIES The Company has REEBOK "concept" stores located in Boston, Massachusetts, in Santa Monica, California, and in New York City. In addition, the Company intends to open a REEBOK "concept" store in Atlanta, Georgia in Spring 1994. The Company envisions its concept stores as a model for innovative retailing of its products and as a potential proving ground for testing new products and marketing/merchandising techniques. The stores sell a wide selection of current, in-line REEBOK (R), WEEBOK (R), ABOVE THE RIM (R), TINLEY (R) and BOKS (TM) footwear and apparel. The Company opened a retail store in Moscow, Russia in Spring 1993 and expects to open a retail store in St. Petersburg, Russia in February 1994. In addition, the Company has a retail store in Del Mar, California which sells TINLEY apparel. The Company also operates approximately 30 factory direct stores which sell footwear, apparel and accessories bearing the REEBOK, WEEBOK, BOKS, ROCKPORT, AVIA, TINLEY and ABOVE THE RIM trademarks. The Company's policy is to locate and operate its retail outlets in such a way as to minimize disruption to its normal channels of distribution. Avia and Rockport also operate retail stores. See discussion of those companies above. In 1992, Reebok entered into a partnership to develop and build a Reebok sports and fitness complex in New York City. The sports and fitness club will feature a wide array of fitness equipment, facilities and services in a luxurious atmosphere. The club will utilize approximately 125,000 square feet and will occupy 5 floors of the new Lincoln Square project. A REEBOK (R) concept store will also be located in the building. The club is scheduled for completion in early 1995. LICENSING The Company has continued to expand its strategic trademark and technology licensing programs begun in 1991. These programs are designed to pursue opportunities for licensing the Company's trademarks, patents and other intellectual property to third parties for sporting goods and related products. The licensing programs are focused on enhancing the reputation of the Company's brand and technologies, advancing their growth and introducing them into selective new markets. The Company has pursued strategic alliances with licensees who Reebok believes are leaders and innovators in their product categories and who share Reebok's commitment to offering superior, innovative products. The Company believes that its licensing programs reinforce Reebok's reputation as a market leader. In 1993, CCM hockey skates using THE PUMP (TM) technology were introduced by Sport Maska, Inc., the Company's licensee, who also introduced two new models of CCM in-line skates with THE PUMP (TM) technology. Also in 1993, the Company's licensee, Bell Sports, expanded its line of bicycle helmets using THE PUMP (TM) technology to include a children's bicycle helmet. In March of 1993, ski gloves using THE PUMP (TM) technology were introduced by the Company's licensee, Grandoe International Corporation, and leather weight lifting belts using THE PUMP (TM) technology are being sold by the Company's licensee, Champion Glove Manufacturing Co., Inc. Rawlings Sporting Goods continued to offer their Defense Series baseball fielding gloves featuring THE PUMP (TM) technology. Pursuant to the Company's trademark licensing program, Champion Glove Manufacturing Co., Inc. established a separate division called Reebok Athletic Glove, which designs, manufactures and markets a full line of athletic gloves, including baseball batting gloves, football gloves, running gloves, racquetball gloves and weightlifting gloves, all featuring the REEBOK trademark and Reebok's Performance Logo. In 1993, the Company's licensees, Sun Sport Optics, Inc. and the Renaissance Group, completed the design of a collection of REEBOK sports performance sunglasses and protective eyewear that will be shipped to retail in early 1994. In 1993, the Company also licensed its REEBOK and BLACKTOP (R) trademarks to Sports by Design for basketballs and licensed the REEBOK trademark to Tighe Industries for a line of gymnastic apparel. MANUFACTURING Virtually all of the Company's products are produced by independent manufacturers, almost all of which are outside the United States, except that some of the Company's apparel and some of the component parts used in the Company's footwear are sourced in the United States. Each of the Company's operating units generally contracts with its manufacturers on a purchase order basis. All contract manufacturing is performed in accordance with detailed specifications furnished by the operating unit, subject to strict quality control standards, with a right to reject products that do not meet specifications. To date, the Company has not encountered any significant problem with product rejection or customer returns. The Company generally considers its relationships with its contract manufacturers to be good. FOOTWEAR AND APPAREL In 1993, the Company continued efforts to diversify its production sources for footwear, placing increased levels of production in Thailand, China and Indonesia. Indonesia, China, Thailand and South Korea were the Company's primary sources for such footwear, accounting for approximately 28%, 27%, 18%, and 10%, respectively, of the Company's total footwear production during 1993. The Company's largest manufacturer, which has several factory locations, accounted for approximately 13% of the Company's total footwear production in 1993. A wholly owned Hong Kong subsidiary of Reebok serves as buying agent for footwear produced for the Reebok Division's U.S. and International operations through a network of related parties in China, Indonesia, Thailand, Taiwan, Korea and the Philippines. The agent's functions include quality assurance, quality control and the inspection of finished goods prior to shipment by the manufacturer, facilitating the shipment of goods from foreign ports and arranging for the issuance of letters of credit, which are the primary means used to pay manufacturers for finished products. The Company's apparel group utilizes the services of independent buying agents to assist in the placement, inspection and shipment of apparel and accessories orders internationally. Production of apparel in the United States is through independent contractors which are retained and managed by the Company's apparel group. Avia utilizes the services of an independent buying agent to assist in the placement, inspection and shipment of footwear orders in South Korea. ROCKPORT products are produced by independent contractors which are retained and managed through country managers employed by Rockport. The remainder of the Company's order placement, quality control and inspection work abroad is handled by a combination of employees and independent contractors in the various countries in which its products are made. The principal materials used in the Company's footwear products are leather, nylon, rubber, ethylvinyl acetate and polyurethane. Most of these materials can be obtained from a number of sources, although a loss of supply could temporarily disrupt production. Some of the component parts for the Company's THE PUMP (TM) and INSTAPUMP (TM) technologies are obtained from a single source, at the Company's election, in order to protect the confidentiality of such technologies. The Company believes that such component parts could be obtained from other sources, if necessary. If, however, the source of supply for such component parts were changed, a temporary disruption to production could result. The principal materials used in the Company's apparel products are nylon, cotton, fleece and spandex. These materials can be obtained from a number of sources. The footwear products of the Company that are manufactured overseas and shipped to the United States for sale are subject to U.S. Customs duties. Duties on the footwear products imported by the Company range from 6% to 37.5% (plus a unit charge in some cases of approximately 90 cents), depending on whether the principal component is leather or some other material and on the construction. The Company and its subsidiaries are in discussions with the U.S. Customs Service and certain foreign customs services about customs duty for certain past importations. However, the Company does not expect to incur any material additional liability as a consequence of any such discussions. As with its international sales operations, the Company's footwear and apparel production operations are subject to the usual risks of doing business abroad, such as import duties, quotas and other threats to free trade, foreign currency fluctuations, labor unrest and political instability. See "TRADE POLICY" below. The Company believes that it has the ability to develop, over time, adequate substitute sources of supply for the products obtained from present foreign suppliers. If, however, events should prevent the Company from acquiring products from its suppliers in Indonesia, China or Thailand, or significantly increase the cost to the Company of such products, the Company's operations could be seriously disrupted until alternative suppliers were found, with a significant negative financial impact. TRADE POLICY For several years, imports from China to the U.S., including footwear, have been threatened with higher tariff rates, either through statutory action or intervention by the Executive Branch, due to concern over China's trade policies, human rights, and foreign weapons sales practices. Further debate on this subject is expected during 1994, specifically relating to China's most favored nation trade status. However, the Company expects that China's most favored nation status will be renewed as it has in each of the preceding years that this debate has occurred. Legislation designed to restrict imports of footwear and apparel has been introduced in the last several sessions of Congress, although it has not been enacted. No such legislation has yet been introduced in 1994. The European Union ("EU") recently announced import quotas on footwear from China. The effective date is expected to be sometime in the Spring of 1994. The effect of such quota scheme on Reebok is not expected to be significant because only a small portion of REEBOK footwear sold in the EU is produced in China and because Reebok has taken steps to prepare for imposition of such quotas. Moreover, the quota scheme provides an exemption for certain higher-priced special technology athletic footwear, which will be available for some REEBOK products. Although the quota scheme is not anticipated to have a significant effect on the Company as a whole, it is likely to have a temporary disruptive effect on certain product lines. The EU may also be asked to take other action to restrict imports of products from China or other countries. If any such restrictive action is taken, the Company could be affected adversely, but it does not believe that its products will be more severely restricted than those of its major competitors. PRINCIPAL PRODUCTS Sales of the following categories of products contributed more than 10% to the Company's total consolidated revenue in the years indicated: 1993, footwear (approximately 88%) and apparel (approximately 11%); 1992, footwear (approximately 89%); 1991, footwear (approximately 91%). TRADEMARKS AND OTHER PROPRIETARY RIGHTS The Company believes that its trademarks, especially the REEBOK, WEEBOK, THE PUMP, INSTAPUMP, BOKS, AVIA, ROCKPORT, TINLEY and ABOVE THE RIM trademarks, are of great value, and the Company is vigilant in protecting them from counterfeiting or infringement. Loss of the REEBOK, AVIA or ROCKPORT trademark rights could have a serious impact on the Company's business. The Company also believes that its technologies and designs are of great value and the Company is vigilant in procuring patents and enforcing its patents and other proprietary rights in the United States and in other countries. See Item 3. Legal Proceedings. WORKING CAPITAL ARRANGEMENTS The Company has various arrangements with numerous banks which provide an aggregate of approximately $700 million of uncommitted facilities, substantially all of which are available to the Company's foreign subsidiaries. Of this amount, $187 million is available for short-term borrowings and bank overdrafts, with the remainder available for letters of credit for inventory purchases. At December 31, 1993, approximately $304 million was outstanding for open letters of credit for inventory purchases, in addition to $23.9 million in notes payable to banks. The Company can also issue up to $125 million of commercial paper which is supported to the extent available by a portion of the $175 million revolving credit agreement, which expires in December 1994. As of December 31, 1993, the Company had no commercial paper obligations outstanding. Under a medium-term note program, the Company may also issue medium term notes or other senior debt securities in an aggregate principal amount up to $150 million under an Indenture dated September 15, 1988, as amended and restated by a First Supplemental Indenture dated January 22, 1993. In February 1993, the Company issued $20 million of medium term notes pursuant to the First Supplemental Indenture. SEASONALITY Sales by the Company of athletic and casual footwear tend to be seasonal in nature, with the strongest sales occurring in the third quarter. Apparel sales also generally vary during the course of the year, with the greatest demand occurring during the spring and fall seasons. SINGLE CUSTOMER Foot Locker, a specialty athletic chain of retail stores with various affiliates, is the largest customer of the Company, although it accounted for less than 10% of the Company's net sales in 1993. BACKLOG The Company's backlog of orders at December 31, 1993 (many of which are cancelable by the purchaser), totalled approximately $1.022 billion, compared to $904 million as of December 31, 1992. The Company expects that all of these orders will be shipped in 1994. The backlog position is not necessarily indicative of future sales because the ratio of future orders to "at once" shipments may vary from year to year. COMPETITION Competition in sports and fitness footwear and apparel sales is intense. Competitors include a number of sports and fitness footwear and apparel companies, such as Nike, Adidas and others. Competition is very strong in each of the sports and fitness footwear market segments, with new entrants and established companies providing challenges in every category. The casual footwear market into which the ROCKPORT (R) and BOKS (TM) product lines fall is also highly competitive. Some competitors are highly specialized, while others have varied product lines, and some maintain their own retail outlets. The Company believes that Rockport has a strong position in the walking shoe market. Competition in this area, however, has intensified as the activity of walking has grown in popularity and as athletic shoe companies have entered the market. The Company's other product lines also continue to confront strong competition. The Company's WEEBOK (R) line, for example, competes with such companies as Stride-Rite, Buster Brown, Toddler University and Osh Kosh. The REEBOK (R), TINLEY (TM) and ABOVE THE RIM (R) apparel lines compete with well-known brands such as Nike and Adidas. Rockport's DRESSPORTS (R) line and Signature Collection compete with leading makers of dress shoes. Competition in each of the markets for the Company's products is manifested in a variety of ways, including price, quality, brand image and ability to meet delivery commitments to retailers. The intensity of the competition faced by the various operating units of the Company and the rapid changes in technology and consumer preference that can occur in the footwear and apparel markets constitute significant risk factors in the Company's operations. EMPLOYEES As of December 31, 1993, the Company had approximately 4,700 employees in all operating units. None of these employees is represented by a labor union. The Company has never suffered a material interruption of business caused by labor disputes with employees. Management considers employee relations to be good. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS Financial information pertaining to the Company's foreign and domestic operations is set forth in note 14 to the Financial Statements included in Item 8 and presented as a separate section of this report. EXECUTIVE OFFICERS OF THE REGISTRANT The following information is submitted as to the executive officers of the Company: Officers hold office until the first meeting of the Board of Directors following the annual meeting of stockholders, or special meeting in lieu thereof, and thereafter until their respective successors are chosen and qualified. Paul B. Fireman is the founder of the Company and has served as its Chief Executive Officer since the Company's founding in 1979 and its Chairman of the Board since 1986. Mr. Fireman served as President of the Company from 1979 to 1987 and was appointed again to that position in 1989. Mr. Fireman has been a director since 1979. Paul R. Duncan was appointed Executive Vice President and Chief Financial Officer of the Company in February 1990. Mr. Duncan, who joined the Company in May 1985 as Senior Vice President and Chief Financial Officer, has been a director of the Company since March 1989. John H. Duerden was appointed Executive Vice President of the Company in February 1994, with responsibility for global distribution of the Reebok Division's products. He was elected a director of the Company in June 1991. Mr. Duerden was previously President of the Reebok International Operations group of the Reebok Division from September 1992 until January 1994. Prior to that, Mr. Duerden was President of the Reebok Division from February 1990 to September 1992 and President of the Reebok International Division from October 1988 to February 1990. Robert Meers became an Executive Vice President of the Company in February, 1994, with responsibility for the Company's newly formed Specialty Business Group which includes the Company's subsidiaries Rockport and Avia, BOKS casual footwear, REEBOK (R) brand outdoor products, golf products and retail operations. Mr. Meers has been a director of the Company since February, 1993. Previously, Mr. Meers was President, U.S. Operations of the Reebok Division from November 1990 to January 1993 and President, U.S. and Canadian Operations of the Reebok Division from January 1993 until January 1994. Mr. Meers was Senior Vice President, Sales and Marketing of the Company from July 1990 to November 1990. Mr. Meers served as Senior Vice President, Sales of The Rockport Company, Inc. from December 1988 to July 1990, after holding positions as Vice President and Senior Vice President of Sales and Marketing of the Company and Reebok U.S. Operations from 1984 to December 1988. Angel R. Martinez became an Executive Vice President of the Company in February 1994, with responsibility for the Company's global marketing. Prior to that, Mr. Martinez was President of the Fitness Division of the Company from September 1992 to January 1994 and prior to that he was Vice President for Business Development of the Company for several years. Roberto F. Muller was appointed Executive Vice President of the Company in February 1994, with responsibility for the Reebok athletic footwear and apparel product groups. He joined the Company in February 1992 as President of the Company's Sports Division. Prior to joining Reebok, Mr. Muller was President, Chief Executive Officer and founder of Phoenix Integrated, Inc., a footwear company. Kenneth I. Watchmaker was appointed Executive Vice President of the Company in February 1994, with responsibility for the Company's footwear manufacturing, research, design and development, information systems and financial controls and accounting. Prior to that, he was Executive Vice President, Operations and Finance, Reebok Division from July 1992, when he joined the Company. Prior to joining Reebok, Mr. Watchmaker was the partner in charge of audit services in the Boston office of Ernst & Young. John B. Douglas III became Senior Vice President and General Counsel of the Company, in February 1994. Prior to that, he had been Vice President and General Counsel of the Company since 1986. Item 2. Item 2. Properties. The Company leases most of the properties that are used in its business. Its corporate headquarters and the offices of the Reebok Division and its U.S. Operations are located in office facilities in Stoughton, Massachusetts. At its corporate headquarters the Company occupies under lease approximately 255,000 square feet of space. The Company signed a six-year lease in July 1989, with two three-year renewal options, for its principal facility at its corporate headquarters. This facility and two other leased premises at the Company's corporate headquarters are located approximately one mile from the Reebok Division's U.S. Operations group's principal warehouse and distribution center in Stoughton, which is owned by the Company and which contains approximately 450,000 total square feet of usable space. The Company also has a lease for approximately 400,000 square feet of space for use as a warehouse in Avon, Massachusetts with an initial term expiring on December 31, 1994, with three one-year renewal options. In 1993, Rockport purchased its corporate headquarters facility in Marlboro, Massachusetts, containing approximately 80,000 square feet of floor space at a purchase price of four million dollars ($4,000,000). In 1992, Rockport purchased approximately 140 acres of land in Lancaster, Massachusetts with the intention of constructing a distribution center on the land by 1995. Rockport has a lease for approximately 241,000 square feet of space for use as a warehouse in Leominster, Massachusetts which expires on December 31, 1995. Avia extended its lease of a 194,000 square foot distribution facility in Wilsonville, Oregon, which now expires in 1999. Avia also has a lease ending in 2003 for a 56,146 square foot facility in Beaverton, Oregon, where its corporate headquarters and research, design and development facility are located. In June 1993, the Company's wholly owned U.K. subsidiary, Reebok International Limited, entered into a fifteen-year lease for the corporate headquarters of the Company's International operations in Stockley Park, London. The lease is for approximately 37,000 square feet of usable space, with a renewal option for a term of up to fourteen years mandated by law. This lease is guaranteed by the Company. The Company's wholly owned Canadian distribution subsidiary, Avrecan International Inc., leases an approximately 145,000 square foot office/warehouse facility in Aurora, Ontario pursuant to a lease which expires in 1998. The Company and its subsidiaries own and lease other warehouses, offices, showrooms and retail and other facilities in the United States and in various foreign countries to meet their space requirements. The Company believes that these arrangements are satisfactory to meet its needs. Item 3. Item 3. Legal Proceedings. On February 5, 1993, a lawsuit was filed by Byron A. Donzis ("Donzis") against the Company and its then wholly owned subsidiary Ellesse U.S.A., Inc., entitled Byron A. Donzis v. Reebok International Ltd. et al., Civil Action No. 93-10260H in the United States District Court for the District of Massachusetts. A second related lawsuit, entitled Donzis Laboratories, Inc., et al. v. Reebok International Ltd. et al., Civil Action No. 93-11761H, was filed on August 10, 1993 in the United States District Court for the District of Massachusetts. These two cases have been consolidated. Both complaints allege, among other things, that the Company breached an agreement with Donzis and misappropriated trade secrets in connection with the development of the Company's THE PUMP (TM) technology and its procurement of U.S. Patent No. 5,158,767 for the basic THE PUMP (TM) technology. The Complaint requests a declaratory judgment stating that Donzis is the owner/inventor of U.S. Patent No. 5,158,767, an assignment of such patent rights to Donzis, injunctive relief, recovery of profits received by the Company, punitive damages, treble damages, costs and attorneys' fees. The Company intends to vigorously defend this lawsuit. The Company believes that the lawsuit is without merit, and further believes that it is unlikely that any subsequent outcome would have a material adverse effect on the financial condition of the Company. On July 1, 1993, a lawsuit was filed by Stutz Motor Car of America, Inc. ("Stutz") against the company, entitled Stutz Motor Car of America, Inc. v. Reebok International Ltd., Case Number BC074579 in the Central District of Los Angeles County Superior Court. The case was removed to the United States District Court for the Central District of California and was assigned Civil Action No. 93-4433LGB. The present complaint alleges, among other things, fraud, misappropriation and conversion, unfair competition, tortious interference with prospective economic advantage in connection with the development of the Company's THE PUMP (TM) technology. The complaint requests compensatory damages, punitive damages, costs and attorneys' fees. The Company intends to vigorously defend this lawsuit. The Company believes that the lawsuit is without merit, and further believes that it is unlikely that any subsequent outcome would have a material adverse effect on the financial condition of the Company. A lawsuit was filed against the Company on February 7, 1994 in California Superior Court (a class action entitled Marshall Verano v. Reebok International Ltd., Case No. 67348) challenging the Company's resale pricing practices in California under California state law and seeking unspecified damages, including treble damages, injunctive relief and costs. Reebok intends to vigorously defend this lawsuit and believes that it is unlikely that the outcome of the lawsuit would have a material adverse effect on the financial condition of the Company. Item 4. Item 4. Submission of Matters to a Vote of Securities Holders. Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's common stock is quoted on the New York Stock Exchange under the symbol RBK. The following table, derived from data supplied by the NYSE, sets forth the quarterly high and low sale prices during 1992 and 1993. The number of record holders of the Company's common stock at December 31, 1993 was 8,898. Information regarding dividends is set forth under the heading "Quarterly Results of Operations" in the Financial Statements included in Item 8 and presented as a separate section of this report. Item 6. Item 6. Selected Financial Data. Amounts in thousands, except per share data Amounts in thousands Financial data for 1993 include a restructuring charge ($7,037 after-tax) related to the sale of Ellesse U.S.A., Inc. and Boston Whaler, Inc. Financial data for 1992 includes restructuring charges ($135,439 after-tax) principally related to the write-down of the Company's subsidiary, Avia Group International, Inc., to estimated fair value and estimated losses from the planned sales of Ellesse U.S.A., Inc. and Boston Whaler, Inc., and after-tax gains of $17,967 from the sale of investments. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. OPERATING RESULTS Net sales for the year decreased by 4.3%, or $128.7 million, to $2.894 billion in 1993 from $3.023 billion in 1992. On a pro forma basis, excluding the 1992 results of operations of Boston Whaler and Ellesse (both of which were sold and are excluded from 1993 results), net sales for the year decreased by $49.6 million, or 1.7%. The Reebok Division's worldwide sales were $2.48 billion in 1993, a decrease of 2.3% from $2.54 billion in 1992. This decrease is due entirely to the Reebok Division's U.S. footwear sales which decreased 12.6% to $1.271 billion in 1993 from $1.455 billion in 1992, partially offset by an increase in U.S. apparel sales and international sales. The decline in the Reebok Division's U.S. footwear sales can be attributed mainly to volume decreases in the walking, basketball, aerobics and BOKS footwear categories, as well as the negative impact of the Company's Centennial resale pricing program, effective as of January 1, 1993, on sales volume of certain Reebok footwear products. 1992's sales levels for footwear and apparel reflect a reclassification of $17.2 million from footwear to apparel for Weebok and golf apparel. The Reebok Division's U.S. apparel sales increased by 62.6% to $125.4 million in 1993 from $77.1 million in 1992. The Reebok Division's International sales (including both footwear and apparel) were $1.083 billion in 1993, an increase of 7.5% from $1.008 billion in 1992, primarily due to improved sales in the United Kingdom, Germany, several smaller European countries, Canada and South America, and acquisition of a majority interest in the Company's Spanish distributor effective January 1, 1993. Changes in foreign exchange rates had a negative effect on the Reebok Division's International net sales of $65.1 million, or 6.5%. Rockport sales reached a record level of $282.7 million in 1993, a 5.7% increase from $267.4 million in 1992. This increase is due to an increase in the number of pairs of footwear shipped both in the U.S. and internationally. Avia sales decreased in 1993 by 3.8% to $131.0 million from $136.2 million in 1992. The decrease in net sales at Avia is due to declines in both domestic and international net sales. The decline in domestic net sales is mainly due to lower volume in the tennis and basketball categories, partially offset by volume increases in the walking and cross training categories. The decline in international net sales volume can be partly attributed to a change in the Canadian distribution from a wholly owned subsidiary to an independent distributor which changed the recording of Canadian sales from a wholesale basis to a royalty basis. International sales were also affected by a volume decrease in Avia's Germany subsidiary, offset by volume increases in sales to independent distributors. The decrease in other income is mainly due to the inclusion in 1992 of a non-recurring pre-tax gain of $29.6 million on the sale of CML common stock. The common stock was acquired from the exercise of warrants which were obtained as part of the Company's 1989 purchase of Boston Whaler. In addition, recognized losses on foreign exchange transactions in 1993 compared to recognized gains in 1992 reduced other income by $6.2 million. Gross margin increased as a percentage of sales from 40.1% in 1992 to 40.6% in 1993. This improvement is due entirely to the exclusion in 1993 of the operating results of businesses held for sale, which generally carried lower gross margins. This improvement was offset in part by lower margins in the Reebok Division's U.S. footwear operations, mainly because of higher markdowns. Selling expenses decreased as a percentage of sales from 18.3% in 1992 to 17.8% in 1993 due to lower advertising expenditures. This decrease was partially offset by increased endorsements and sports promotions in the Reebok Division. Selling expenses decreased in absolute dollar amounts in part due to the exclusion of businesses held for sale from 1993's financial results and lower advertising expenses. General and administrative expenses also decreased in absolute dollar amounts due to the exclusion of businesses held for sale from 1993's financial results. Included in 1992's financial results were selling and general and administrative expenses of $19.4 million and $8.8 million, respectively, from businesses held for sale. General and administrative expenses increased as a percentage of sales from 8.4% in 1992 to 8.8% in 1993 partly due to Reebok Division's International operations, which generally carry higher general and administrative costs, representing a larger proportion of sales volume and the fixed nature of many of the expenses classified as general and administrative costs. During 1993, the Company recorded an additional pre-tax restructuring charge of $8.5 million related to the sales of Boston Whaler and Ellesse, which were completed during the third quarter. This restructuring charge was in addition to the restructuring charges previously recorded in December 1992, when the Company announced its intention to sell these businesses. Amortization of intangibles decreased due to the write-down of the carrying value of Avia in the fourth quarter of 1992. Minority interest represents the minority shareholders' proportionate share of the net income of the Company's Japanese and Spanish subsidiaries. Minority interest increased in 1993 due in part to the acquisition of a 51% interest in Reebok's Spanish distributor as of January 1, 1993. Interest expense increased in 1993 due to the higher average borrowing levels throughout the year. Interest income increased due to interest received from the successful settlement of certain prior years' state tax matters. The effective tax rate for the twelve months ended December 31 decreased from 55.5% in 1992 to 38.5% in 1993. 1992's effective tax rate was abnormally high because of certain restructuring charges which are not deductible for tax purposes. The Company's 1993 tax rate is more in line with the Company's future expectations. The decrease in the tax rate in 1993 was also caused in part by a change in the geographic mix of worldwide income partially offset by an increase in the U.S. federal tax rate. The higher level of net income in 1993 as compared with 1992 was a result primarily of a restructuring plan adopted by the Company during December 1992 which resulted in after-tax charges totaling $135.4 million ($1.46 per share). Under the restructuring plan, the Company announced its intention to dispose of two subsidiaries, Boston Whaler and Ellesse, a write-down of the carrying value of its Avia subsidiary, and certain office relocation charges. The effect of the restructuring charge was reduced by the after-tax gain of $18.0 million ($.19 per share) on the sale of common stock of CML obtained as part of the Company's 1989 purchase of Boston Whaler. The Boston Whaler sale was completed on July 30, 1993 and the Ellesse sale was completed on September 28, 1993. In connection with the sales, the Company recorded an additional after-tax restructuring charge of $7.0 million in addition to the restructuring charge recorded in 1992. Income from operations (without the effect of the restructuring charge) for 1993 was $2.61 per share compared to $2.51 per share in 1992 (after excluding the effect of the restructuring charge and the gain on the sale of CML common stock). If the restructuring had taken place as of the beginning of 1992, income from operations in 1992 would have been about $.18 per share higher. Year-to-year earnings per share comparisons benefited from the share repurchase programs announced in July 1992 and July 1993. Weighted average common shares outstanding for the year ended December 31, 1993 were 88.3 million, compared to 92.7 million for the year ended December 31, 1992. Net sales for the year reached a record level of $3.023 billion, 10.5% above the level reported for 1991. Reebok U.S. footwear sales increased 10.2% to $1.472 billion. Reebok International sales reached $1.008 billion, an increase of 21.0%. These increases in sales are mainly due to an increase in the number of pairs shipped. The effect of changes in foreign exchange rates did not have a material impact on the change in net sales. Reebok U.S. apparel sales increased by 13.5% to $59.9 million. Rockport sales increased by 6.4% to $267.4 million. Avia sales decreased by 15.4% to $136.2 million. Ellesse sales declined by 45.7% to $34.2 million. Boston Whaler sales were $45.0 million, an 18.7% increase. Other income in 1992 includes a gain of $29.6 million ($18.0 million after-tax) on the sale of CML common stock. The common stock was acquired from the exercise of warrants which were obtained as part of the Company's 1989 purchase of Boston Whaler. The small improvement in gross margin percentage is the net result of several trends in 1992. Higher gross margins arose as a result of favorable overall foreign currency exchange rates and as a result of Avia and Ellesse sales, which carry lower gross margins, representing a smaller portion of the total business in 1992. These higher margins were largely offset by lower gross margins in Reebok U.S. footwear sales caused by a change in mix of products sold to items with lower margins. Selling expenses increased as a percentage of sales from 16.1% in 1991 to 18.3% in 1992 primarily due to increased advertising and marketing costs in the Reebok Division. General and administrative expenses increased slightly as a percentage of sales from 8.2% in 1991 to 8.4% in 1992 due mainly to increased distribution costs in the Reebok International Division. Interest income decreased in 1992 due to the lower interest rates on investments as well as lower average cash balances in 1992 resulting from the repayment of borrowings incurred in connection with the share repurchase from Pentland in 1991 and the use of cash for the Company's share repurchase program announced in July 1992. Interest expense decreased due to the lower debt levels, as well as the impact of lower borrowing rates in 1992. The effective tax rate for the twelve months ended December 31 increased from 39.8% in 1991 to 55.5% in 1992. This increase is caused by certain restructuring charges which are not deductible for tax purposes. The decrease in net income for the year resulted primarily from a restructuring plan recorded by the Company during December 1992 which resulted in non-recurring after-tax charges totaling $135.4 million ($1.46 per share). The plan includes offering for sale the Company's Boston Whaler, Inc. and Ellesse U.S.A., Inc. subsidiaries; a write-down of the carrying value of its Avia subsidiary; the planned consolidation of the Reebok performance apparel operation to San Diego, where it is being combined with the recently acquired operations of the ABOVE THE RIM and TINLEY apparel brands; and the move of the Reebok Division's International Operations group's headquarters to London from Bolton, England. The restructuring plan will permit the Company to focus its efforts and resources on building its core brands. The effect of the restructuring charges was reduced by the after-tax gain of $18.0 million ($.19 per share) on the sale of common stock of CML obtained as part of the Company's 1989 purchase of Boston Whaler. Income from operations (without the effect of the restructuring charge and the sale of CML common stock) for 1992 was $2.51 per share compared to $2.37 per share in 1991. Income from operations in 1992 includes about $.18 per share of losses from the operations of Boston Whaler, Ellesse U.S.A. and Avia which will not occur in future years because of the restructuring plan which was put in place in the fourth quarter of 1992. Net sales for the year increased by $575 million, or 26.6% above the level reported for 1990. Reebok U.S. footwear sales increased 14% to $1.336 billion. The increase is mainly due to an increase in the number of pairs shipped. Reebok International sales were $833 million, an increase of 75%. During the first quarter of 1991 the Company began performing certain activities previously contracted out to an independent third party, and consequently, began recording sales on footwear sold to independent Reebok distributors. In the past the profit only was recorded as royalty income. If this change had taken place on January 1, 1990, net sales in 1990 and 1991 would have increased by $142 million and $32 million, respectively. The increased sales also reflect $117 million in sales from Reebok Italia and Reebok Japan, both of which were acquired in 1991. On a pro forma basis, after adjustment for the acquisitions and the change described above, Reebok International sales increased 24%. The remaining increase in net sales is mainly due to an increase in the number of pairs shipped. The effect of changes in foreign exchange rates did not have a material impact on the change in net sales. Rockport sales increased by 8.5% to $251 million. Avia sales were $161 million, a 4% increase. Ellesse sales were $63 million, 34% above the 1990 level. Reebok U.S. apparel sales increased by 26% to $53 million. Boston Whaler sales were $38 million, a 2.5% increase over 1990. Cost of sales as a percentage of sales was 60.1% in 1991, as compared with 59.7% in 1990. The decrease in gross margin percentage is largely due to the change in recording net sales, as described above. On a pro forma basis, gross margin percentage actually improved 1.6% partly due to higher international margins resulting from favorable exchange rates on inventory purchases. General and administrative expenses decreased as a percentage of sales from 9.4% in 1990 to 8.2% in 1991. The change in recording net sales as described above accounted for .5% of the difference and .6% was caused by the change in bonus arrangement with the Company's chief executive officer. Interest income decreased due to the lower cash balances and interest expense increased due to the higher debt levels resulting from the treasury stock repurchase from Pentland Group plc ("Pentland") on April 8, 1991. BACKLOG The Company's backlog of customer orders at December 31, 1993 was up approximately 13% from the prior year. Reebok U.S. footwear order levels as of the same date were up 14.4% from the prior year. The backlog position is not necessarily indicative of future sales because the ratio of future orders to "at once" shipments may vary from year to year. LIQUIDITY AND SOURCES OF CAPITAL The Company's financial position remains strong. Working capital increased by $48.4 million at December 31, 1993 as compared to December 31, 1992, primarily due to increases in accounts receivable and inventory which were offset in part by increases in borrowings and a decrease in cash. The current ratio remained relatively constant at December 31, 1993 (2.84 to 1) as compared to December 31, 1992 (2.81 to 1). Accounts receivable increased from December 31,1992 by $39.3 million reflecting in part an increase in days sales outstanding attributable principally to the Company's International business, where sales terms tend to be longer, representing a larger relative share of sales volume. Inventory increased by $79.8 million from December 31, 1992 as a result of an increase in the footwear and apparel inventory levels in the Reebok Division. The footwear increase can mainly be attributed to three factors:(1) an effort to more evenly load factory orders to reduce factory costs and improve on-time delivery, (2) an increase in Spring 1994 future orders, and (3) lower than anticipated sales during the fourth quarter of 1993. The increase in Reebok apparel inventory is due primarily to the overall increase in the Company's apparel business. On July 13, 1993, the Board of Directors authorized the repurchase of up to $200 million in Reebok common stock in open market or privately- negotiated transactions. This authorization was in addition to the $200 million share repurchase program announced in July 1992. Since the start of the program in 1992, the Company has repurchased 8,572,200 shares at an average price of $30.82 per share through December 31, 1993; approximately $135.8 million is authorized for future purchases. During the twelve months ended December 31, 1993, cash and cash equivalents decreased by $26.0 million, and outstanding borrowings increased by $36.9 million, while $194.0 million of common stock was repurchased. Net cash provided by operating activities during 1993 was $142.5 million, compared to $187.6 million and $335.2 million for the years ended December 31, 1992 and 1991, respectively. Net cash provided by investing activities in 1993 included cash proceeds of $36.5 million received in connection with the sale of Boston Whaler and Ellesse. Cash generated from operations, together with the Company's financing sources, is expected to adequately finance all of the Company's current and planned cash requirements. EFFECTS OF CHANGING PRICES The Company has generally been able to adjust selling prices and control expenses in the environment of cost escalation that has existed in the recent past. Product purchases require relatively short lead times (4 - 6 months) and the Company sells a large part of its product for future delivery on similar lead times, which generally permits a matching of committed costs with committed revenues. The Company anticipates that this matching ability will continue. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this Item is submitted as a separate section of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information required by this Item with respect to the Registrant's directors is incorporated herein by reference from the definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 1994, which will be filed with the Securities Exchange Commission on or before March 30, 1994 (the "1994 Proxy Statement"), under the headings "Information with respect to Nominees", "Executive Compensation" and "Transactions with Management and Affiliates". Information called for by this Item with respect to the registrant's executive officers is set forth under "Executive Officers of Registrant" in Item 1 of this report. Item 11. Item 11. Executive Compensation. The information required by this Item is incorporated herein by reference from the 1994 Proxy Statement under the headings "Compensation of Directors", "Executive Compensation", "Employee Agreements" and "Compensation Committee Interlocks and Insider Participation". Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this Item is incorporated herein by reference from the 1994 Proxy Statement under the heading "Beneficial Ownership of Shares". Item 13. Item 13. Certain Relationships and Related Transactions. The information required by this Item is incorporated herein by reference from the 1994 Proxy Statement under the heading "Transactions with Management and Affiliates". PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1) and (2) List of Financial Statements and Financial Statement Schedules. 1. Financial Statements The following consolidated financial statements are included in Item 8 and presented as a separate section of this report: FORM 10-K 2. Financial Statement Schedules The following consolidated financial statement schedules of Reebok International Ltd. are included in Item 14(d) and presented as a separate section of this report: FORM 10-K All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a)3. Exhibits Listed below are all the Exhibits filed as part of this report. Certain Exhibits are incorporated by reference from documents previously filed by the Company with the Securities and Exchange Commission pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, as amended. Exhibit (3) Articles of incorporation and by-laws. 3.1 Restated Articles of Organization of the Company, as amended 1 3.2 By-laws, as amended 5, 7, 9 (4) Instruments defining the rights of security holders, including indentures. 4.1 Indenture, dated September 15, 1988, between Reebok International Ltd. and Citibank N.A., as Trustee 4 4.2 First Supplemental Indenture, dated as of January 22, 1993, between Reebok International Ltd. and Cititbank N.A., as Trustee 13 4.3 Common Stock Rights Agreement dated as of June 14, 1990 between the Company and The First National Bank of Boston, as Rights Agent, as amended 8, 10, 11 (10) Material Contracts. 10.1 Distributorship Agreement between Reebok International Limited and the Company 2 10.2 Trademark License Agreement between Reebok International Limited and the Company 2 10.3 Continuing Letter of Credit Agreement, dated August 1, 1989, between the Company and State Street Bank and Trust Company; and Letter Agreement between The Rockport Company, Inc. and Norwest Bank, Master Security Agreement for Irrevocable Documentary Letters of Credit and Guarantee of the Company, all dated August 1, 1989 7 10.4 First Amended and Restated Master Agreement between The Company and Security Pacific dated June 26, 1991 12 10.5 Credit Facility Agreement between Reebok International Limited and Citibank dated November 7, 1991 12 10.6 Lease Agreement dated March 1, 1988 between Reebok International Ltd. and North Stoughton Industrial Park Development Trust 5 10.7 Purchase and Sale Agreement between Reebok International Ltd. and Pentland Group plc dated March 8, 1991 9 10.8 Credit Agreement dated as of December 7, 1992, among the Company, the Lenders named therein, Credit Suisse as Agent and Credit Suisse First Boston Limited as Syndication Agent 13 10.9 Agreements with various banks in Hong Kong reflecting arrangements for letter of credit facilities 9 Management Contracts and Compensatory Plans. 10.10 Reebok International Ltd. 1985 Stock Option Plan, as amended 12 10.11 Reebok International Ltd. 1987 Stock Option Plan for Directors, as amended 13 10.12 Reebok International Ltd. 1987 Stock Bonus Plan 3 10.13 Reebok International Ltd. Excess Benefits Plan 9 10.14 Stock Option Agreement with Paul B. Fireman 9 10.15 Split-Dollar Life Insurance Agreement with Paul B. Fireman 12 10.16 Contingent Severance Agreement with Paul R. Duncan 7 10.17 Employment Agreement with John H. Duerden 12 10.18 Contingent Severance Agreement with John H. Duerden 7 10.19 Change of Control Agreement with John B. Douglas III 13 10.20 Employment Agreement with Kenneth Watchmaker 13 10.21 Change of Control Agreement with Kenneth Watchmaker 13 10.22 Supplemental Retirement Program for Kenneth Watchmaker 13 10.23 Deferred Cash Compensation Plan for Directors 13 10.24 Employment Agreement with Roberto Muller 10.25 Contingent Severance Agreement with Angel Martinez 10.26 Lease with Angel Martinez (11) Statement Re Computation of Per Share Earnings. (12) Statement Re Computation of Ratio of Earnings to Fixed Charges. (22) Subsidiaries. 22.1 List of Subsidiaries of the Company (23) Consents of experts and counsel. 23.1 The consent of Ernst & Young (b) Reports on Form 8-K. None. (c) Exhibits. The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules. The response to this portion of Item 14 is submitted as a separate section of this report. ______________________________________________ 1 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 30, 1987 and incorporated by reference herein. 2 Filed as an Exhibit to Registration Statement No. 2-98367 and incorporated by reference herein. 3 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 28, 1988 and incorporated by reference herein. 4 Filed as an Exhibit to Reebok International Ltd. Form 8-K filed on September 29, 1988 and incorporated by reference herein. 5 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 30, 1989 and incorporated by reference herein. 6 Filed as an Exhibit to Reebok International Ltd. Form 8-K filed on March 8, 1990 and incorporated by reference herein. 7 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 26, 1990 and incorporated by reference herein. 8 Filed as an Exhibit to Reebok International Ltd. Form 8-A filed on July 31, 1990 and incorporated by reference herein. 9 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 28, 1991 and incorporated by reference herein. 10 Filed as an Exhibit to Reebok International Ltd. Form 8 Amendment to Registration Statement on Form 8-A filed on April 4, 1991 and incorporated by reference herein. 11 Filed as an Exhibit to Reebok International Ltd. Form 8 Amendment to Registration Statement on Form 8-A filed on December 13, 1991 and incorporated by reference herein. 12 Filed as an Exhibit to Reebok International Ltd. Form 10-K dated March 27, 1992 and incorporated by reference herein. 13 Filed as an Exhibit to Reebok International Ltd. Form 10-k dated March 26, 1993 and incorporated by reference herein. SIGNATURES Pursuant to the requirements of Section 13 or 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. REEBOK INTERNATIONAL LTD. BY: /S/ PAUL R. DUNCAN ----------------------- Paul R. Duncan Executive Vice President and Chief Financial Officer Dated: February 15, 1994 Pursuant to the requirements of the Securities 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 date indicated. /S/ PAUL FIREMAN - ------------------- Paul Fireman Director, Chairman of the Board and President (Chief Executive Officer) /S/ PAUL R. DUNCAN - -------------------- Paul R. Duncan Executive Vice President and Chief Financial Officer (Chief Financial and Accounting Officer) Director /S/ JOHN H. DUERDEN - --------------------- John H. Duerden Executive Vice President Director /S/ ROBERT MEERS - ---------------------- Robert Meers Executive Vice President Director /S/ JILL E. BARAD - --------------------- Jill E. Barad Director /S/ DANIEL E. GILL - ----------------------- Daniel E. Gill Director /S/ BERTRAM M. LEE, SR. - ------------------------- Bertram M. Lee, Sr. Director /S/ RICHARD G. LESSER - ------------------------- Richard G. Lesser Director /S/ WILLIAM M. MARCUS - ------------------------- William M. Marcus Director /S/ GEOFFREY NUNES - ------------------------- Geoffrey Nunes Director /S/ JOHN A. QUELCH - ------------------------- John A. Quelch Director Dated: February 15, 1994 ITEMS 8, 14(C) AND (D) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES Report of Ernst & Young, Independent Auditors BOARD OF DIRECTORS AND STOCKHOLDERS REEBOK INTERNATIONAL LTD. STOUGHTON, MASSACHUSETTS We have audited the accompanying consolidated balance sheets of Reebok International Ltd. as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Reebok International Ltd. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /S/ ERNST & YOUNG Boston, Massachusetts February 1, 1994, except for the third paragraph of Note 16, as to which the date is February 7, 1994. REEBOK INTERNATIONAL LTD. Consolidated Balance Sheets Amounts in thousands, except share data The accompanying notes are an integral part of the consolidated financial statements. REEBOK INTERNATIONAL LTD. Consolidated Statements of Income Amounts in thousands, except per share data The accompanying notes are an integral part of the consolidated financial statements. REEBOK INTERNATIONAL LTD. Consolidated Statements of Stockholders' Equity Dollar amounts in thousands The accompanying notes are an integral part of the consolidated financial statements. REEBOK INTERNATIONAL LTD. Consolidated Statements of Cash Flows Amounts in thousands The accompanying notes are an integral part of the consolidated financial statements. REEBOK INTERNATIONAL LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Dollar amounts in thousands, except per share data 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS ACTIVITY The Company and its subsidiaries develop and market active lifestyle and performance products, including footwear and apparel, under various trademarks, including REEBOK, WEEBOK, THE PUMP, INSTAPUMP, BOKS, AVIA, ROCKPORT, TINLEY and ABOVE THE RIM. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and accounts are eliminated in consolidation. CASH EQUIVALENTS Cash equivalents are defined as highly liquid investments with maturities of three months or less at date of purchase. INVENTORY VALUATION Inventory, substantially all finished goods, is recorded at the lower of cost (first-in, first-out method) or market. PROPERTY AND EQUIPMENT AND DEPRECIATION Property and equipment are stated at cost. Depreciation is computed principally on the straight line method over the assets' estimated useful lives. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful lives of the assets. INTANGIBLES Excess purchase price over the fair value of assets acquired is amortized using the straight line method over periods ranging from 5 to 40 years. Other intangibles are amortized using the straight line method over periods ranging from 7 to 40 years. FOREIGN CURRENCY TRANSLATION Assets and liabilities of most of the Company's foreign subsidiaries are translated at current exchange rates. Revenues, costs and expenses are translated at the average exchange rates for the period. Translation adjustments resulting from changes in exchange rates are reported as a separate component of stockholders' equity. Other foreign currency transaction gains and losses are included in the determination of net income. For those foreign subsidiaries operating in a highly inflationary economy or having the U.S. dollar as their functional currency, net nonmonetary assets are translated at historical rates and net monetary assets are translated at current rates. Translation adjustments are included in the determination of net income. FORWARD CURRENCY EXCHANGE CONTRACTS Certain of the Company's foreign subsidiaries purchase merchandise in U.S. dollars. To reduce the impact of changes in the rate of exchange of the U.S. dollar against the various local currencies, the Company enters into forward currency exchange contracts. Realized and unrealized gains and losses on these contracts are included in net income except that gains and losses on contracts to hedge specific foreign currency commitments are deferred and accounted for as a part of the transaction. INCOME TAXES The Company accounts for income taxes in accordance with FASB Statement No. 109 "Accounting for Income Taxes" ("Statement 109"). Tax provisions and credits are recorded at statutory rates for taxable items included in the consolidated statements of income regardless of the period for which such items are reported for tax purposes. Deferred income taxes are recognized for temporary differences between financial statement and income tax bases of assets and liabilities for which income tax benefits will be realized in future years. NET INCOME PER COMMON SHARE Net income per common share is computed based on the weighted average number of common and common equivalent shares outstanding for the period. RECLASSIFICATION Certain amounts in prior years have been reclassified to conform to the 1993 presentation. 2. RESTRUCTURING CHARGES In December 1992, the Company's Board of Directors approved a restructuring plan which included offering for sale the Company's Boston Whaler, Inc. ("Boston Whaler") and Ellesse U.S.A., Inc. ("Ellesse") subsidiaries, a write-down of the carrying value of its Avia subsidiary, the planned consolidation and relocation of its performance apparel operation and certain other office relocations. In connection therewith, the Company recorded a $155,000 pre-tax restructuring charge in 1992 for estimated costs and losses to be incurred. The sale of Boston Whaler was completed on July 30, 1993 and the sale of Ellesse was completed on September 28, 1993. In connection with the sales, the Company recorded an additional pre-tax restructuring charge in 1993 of $8,500. 3. PROPERTY AND EQUIPMENT Property and equipment consist of the following: - ------------------------------------------------------------------------------- 4. INTANGIBLES Intangibles consist of the following: - ------------------------------------------------------------------------------ In connection with the Company's restructuring charge, as more fully described in Note 2, the carrying value of certain intangibles was reduced in 1992. 5. SHORT-TERM BORROWINGS The Company has various arrangements with numerous banks which provide an aggregate of approximately $700,000 of uncommitted facilities, substantially all of which are available to the Company's foreign subsidiaries. Of this amount, $187,000 is available for short-term borrowings and bank overdrafts, with the remainder available for letters of credit for inventory purchases. In addition to amounts reported as notes payable to banks, approximately $304,000 was outstanding for open letters of credit for inventory purchases at December 31, 1993. The Company can also issue up to $125,000 of commercial paper which is supported to the extent available by a portion of a $175,000 revolving credit arrangement which expires in December 1994. 6. LEASING ARRANGEMENTS The Company leases various offices, warehouses, retail store facilities as well as certain of its data processing and warehouse equipment under lease arrangements expiring between 1994 and 2008. Minimum annual rentals for the five years subsequent to December 31, 1993 and in the aggregate are as follows: ================================================================================ Total rent expense for all operating leases amounted to $23,868, $20,496 and $16,342 for the years ended December 31, 1993, 1992 and 1991, respectively. 7. LONG-TERM DEBT Long-term debt consists of the following: Maturities of long-term debt during the five-year period ending December 31, 1998 are $3,009 in 1994, $14,086 in 1995, $102 in 1996, $66 in 1997, and $119,629 in 1998. Land and buildings, having a net book value of $20,846 at December 31, 1993, are pledged as collateral for certain bank notes payable. 8. EMPLOYEE BENEFIT PLANS The Company sponsors defined contribution retirement plans covering substantially all of its domestic employees and certain employees of its foreign subsidiaries. Contributions are determined at the discretion of the Board of Directors. Aggregate contributions made by the Company to the plans and charged to operations in 1993, 1992 and 1991 were $11,833, $8,536 and $7,318, respectively. 9. STOCK PLANS The Company has various stock option plans which provide for the grant of options to purchase shares of the Company's common stock to key employees, other persons or entities who make significant contributions to the success of the Company, and eligible members of the Company's Board of Directors. Under the plan for Directors, the exercise price of any stock option granted may not be less than fair market value, the exercise period cannot exceed ten years from the date of grant and grants have an automatic vesting period of three years. The Board of Directors approved the 1994 Equity Incentive Plan on December 15, 1993, subject to shareholder approval. If this plan is adopted, it will replace three of the Company's existing stock option and stock bonus plans. Under the new Equity Incentive Plan, these options may be incentive stock options or "non-qualified options" under applicable provisions of the Internal Revenue Code. The exercise price of any stock option granted may not be less than fair market value at the date of grant except in certain limited circumstances. The exercise period cannot exceed ten years from the date of grant. The vesting schedule for options granted under the 1994 Equity Incentive Plan is determined by the Compensation Committee of the Board of Directors. The following schedule summarizes the changes in stock options during the three years ended December 31, 1993: =============================================================================== At December 31, 1993, options to purchase 2,485,340 shares of common stock were exercisable, and 5,785,355 options were available for future grants under the stock option plans. Options outstanding at December 31, 1993 include 814,600 shares granted under the 1994 Equity Incentive Plan, subject to shareholder approval. The Company has a stock bonus plan for issuance of common stock to key employees of the Company. Beneficial ownership vests over a period ranging from three to five years. These grants give rise to unearned compensation that is amortized over the applicable vesting periods. During the three years ended December 31, 1993, a total of 33,058 shares of common stock were approved for issuance and 2,168 shares of common stock were cancelled under this plan. In December 1993, 102,400 shares of common stock were approved for issuance under the 1994 Equity Incentive Plan, subject to shareholder approval. The Company has two employee stock purchase plans. Under the 1987 Employee Stock Purchase Plan eligible employees are granted options to purchase shares of the Company's common stock through voluntary payroll deductions during two option periods, running from January 1 to June 30 and from July 1 to December 31, at the lower of 85% of market value at the beginning or end of each period. The number of options granted to each employee under this plan is limited to a fair market value of $12.5 during each option period. On December 15, 1993 the Board of Directors approved an increase of 1,000,000 shares reserved for issuance under this plan, subject to shareholder approval. Under the 1992 Employee Stock Purchase Plan, for certain foreign based employees, eligible employees are granted options to purchase shares of the Company's common stock during two option periods, running from January 1 to June 30 and from July 1 to December 31, at the market price at the beginning of the period. The option becomes exercisable 90 days following the date of grant and expires on the last day of the option period. During 1993, 1992 and 1991, respectively, 149,977, 152,310, and 157,040 shares were issued pursuant to these plans. In June 1990, the Company adopted a shareholders' rights plan and declared a dividend distribution of one common stock purchase right ("Right") for each share of common stock outstanding. Each Right entitles the holder to purchase one share of the Company's common stock at a price of $60 per share, subject to adjustment. The Rights will be exercisable only if a person or group of affiliated or associated persons acquires beneficial ownership of 10% or more of the outstanding shares of the Company's common stock or commences a tender or exchange offer that would result in a person or group owning 10% or more of the outstanding common stock, or in the event that the Company is subsequently acquired in a merger or other business combination. When the Rights become exercisable, each holder would have the right to purchase, at the then-current exercise price, common stock of the surviving company having a market value of two times the exercise price of the Right. The Company can redeem the Rights at $.01 per Right at any time prior to expiration on June 14, 2000. At December 31, 1993, 14,384,638 shares of common stock were reserved for issuance under the Company's various stock plans (including the 1994 Equity Incentive Plan and the approved increase in shares reserved for issuance under the 1987 Employee Stock Purchase Plan) and 98,076,034 shares were reserved for issuance under the shareholders' rights plan. If the 1994 Equity Incentive Plan is approved, three of the Company's existing stock option and stock bonus plans will be terminated and thus the number of shares reserved for issuance under the Company's various stock plans will be 12,157,371 and 95,848,767 shares will be reserved for issuance under the shareholders' rights plan. 10. ACQUISITION OF COMMON STOCK On July 13, 1993, the Board of Directors authorized the repurchase of up to $200,000 in Reebok common stock in open market or privately-negotiated transactions. This authorization was in addition to the $200,000 share repurchase program adopted by the Company in July 1992. As of December 31, 1993, the Company had approximately $135,800 available for future repurchases of common stock under these programs. On April 8, 1991, the Company reacquired 36,210,902 shares of its common stock from Pentland Group plc. The purchase price consisted of $396,147 paid in cash and 11,750,000 shares of newly issued common stock of the Company. 11. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments: Cash and cash equivalents and notes payable to banks: the carrying amounts reported in the balance sheet approximate fair value. Long term-debt: the fair value of the Company's corporate bonds is estimated based on quoted market prices. The fair value of other long-term debt is estimated using discounted cash flow analyses, based on the Company's incremental borrowing rates for similar types of borrowing arrangements. Unrealized gains or losses on foreign currency exchange contracts: the fair value of the Company's foreign currency exchange contracts is estimated based on current foreign exchange rates. The carrying amounts and fair value of the Company's financial instruments at December 31, 1993 are as follows: 12. OTHER INCOME Other income in 1992 included a gain of $29,648 resulting from the sale of 1,161,403 shares of common stock of CML acquired upon the exercise of a warrant obtained as part of the October 1989 purchase of Boston Whaler. 13. INCOME TAXES The components of income before income taxes are as follows: The provision for income taxes consists of the following: ============================================================================= In 1992, deferred tax credits attributable to restructuring charges approximated $16,200. Undistributed earnings of the Company's foreign subsidiaries amounted to approximately $215,559, $161,421 and $113,812 at December 31, 1993, 1992 and 1991, respectively. Those earnings are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the various foreign countries. Determination of the amount of U.S. income tax liability that would be incurred is not practicable because of the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credits would be available to reduce some portion of any U.S. income tax liability. Withholding taxes of approximately $8,815 would be payable upon remittance of all previously unremitted earnings at December 31, 1993. Income taxes computed at the federal statutory rate differ from amounts provided as follows: =============================================================================== Effective January 1, 1993, the Company adopted Statement 109. Under Statement 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of Statement 109, income tax expense was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. As permitted by Statement 109, the Company has elected not to restate the financial statements of any prior years. The effect of the change on net income for 1993 was not material. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred taxes are attributable to the following temporary differences at December 31, 1993: - -------------------------------------------------------------------------------- 14. OPERATIONS BY GEOGRAPHIC AREA Sales to unaffiliated customers, net income and identifiable assets by geographic area are summarized below: ============================================================================== There are various differences between income before income taxes for domestic and foreign operations as shown in Note 13 and net income shown above. 15. MAJOR CUSTOMER One customer accounted for 11.3% of net sales for 1991. No customer accounted for 10% or more of the Company's net sales in 1993 or 1992. 16. CONTINGENCIES On February 5, 1993, a lawsuit was filed against the Company and its then wholly owned subsidiary Ellesse U.S.A., Inc., in the United States District Court for the District of Massachusetts. A second related lawsuit was filed on August 10, 1993 in the United States District Court for the District of Massachusetts. These two cases have been consolidated. Both complaints allege, among other things, that the Company breached an agreement with the plaintiff and misappropriated trade secrets in connection with the development of the Company's THE PUMP (TM) inflatable technology and its procurement of its patent for the basic THE PUMP technology. The complaint requests a declaratory judgment stating that the plaintiff is the owner/inventor of the Company's THE PUMP patent, an assignment of the Company's patent, recovery of the Company's profits and other substantial damages from the Company. On July 1, 1993, a lawsuit was filed against the Company in the Central District of Los Angeles County Superior Court and subsequently moved to the United States District Court for the District of California. The complaint alleges, among other things, fraud, misappropriation and conversion, unfair competition, tortious interference with prospective economic advantage in connection with the development of the Company's THE PUMP technology. The complaint requests compensatory damages, punitive damages, costs and attorneys' fees. On February 7, 1994, a lawsuit was filed against the Company in California Superior Court challenging the Company's resale pricing practices in California under California state law and seeking unspecified damages, including treble damages, injunctive relief and costs. The Company intends to vigorously defend these lawsuits and believes that these lawsuits are without merit, and further believes that it is unlikely any subsequent outcome would have a material adverse effect on the financial condition of the Company. Quarterly Results of Operations Amounts in thousands, except per share data =============================================================================== Net income for the third quarter of 1993 includes an after-tax restructuring charge of $7,037 ($.08 per share). Net income for the fourth quarter of 1992 includes the effects of restructuring charges, $135,439 after-tax ($1.46 per share) and after-tax gains of $17,967 ($.19 per share) from the sale of investments. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES REEBOK INTERNATIONAL LTD. (Amounts in thousands) (A) An officer of the Company has a 25% general partnership interest in Mad Engine. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS REEBOK INTERNATIONAL LTD. (Amounts in thousands) (a) Reserves acquired through business acquisitions (b) Uncollectible accounts written off, net of recoveries SCHEDULE IX - SHORT-TERM BORROWINGS REEBOK INTERNATIONAL LTD. (Dollar amounts in thousands) (A) End of the period (B) Month end balance averaged for period, except for commercial paper - daily balance averaged for period (C) Interest expense for the year as a % of average balance SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION REEBOK INTERNATIONAL LTD. (Amounts in thousands) Amounts for maintenance and repairs, depreciation and amortization of intangible assets, taxes, other than payroll and income taxes, and royalties are not presented as such amounts are less than 1% of total sales and revenue. EXHIBIT INDEX EXHIBIT INDEX EXHIBIT INDEX	15,985	104,966
25885_1993.txt	25885_1993	1993	25885	Item 1. BUSINESS General Crown Central Petroleum Corporation and subsidiaries (the Company) operates primarily in one business segment as an independent refiner and marketer of petroleum products, including petrochemical feedstocks. The Company owns and operates two refineries, one located near Houston, Texas with a rated capacity of 100,000 barrels per day and the other in Tyler, Texas with a rated capacity of 50,000 barrels per day. The Company operates 17 product terminals in strategic locations from Houston, Texas to Elizabeth, New Jersey and through the Midwestern United States. The Company markets finished petroleum products in 18 states and the District of Columbia. These marketing activities are focused primarily in the Mid-Atlantic, Southeastern and Midwestern United States. In 1989, the Company acquired all of the stock of La Gloria Oil and Gas Company (La Gloria). La Gloria's principal asset is the Tyler refinery. La Gloria also owns a truck rack terminal at the refinery, a wholesale terminal in Illinois, and a crude oil gathering system that serves the Tyler refinery. La Gloria leases three other terminal facilities in Arkansas and Indiana. The addition of La Gloria's crude processing capacity has afforded Crown certain improved economies of scale in purchasing raw materials, in product distribution and in marketing. Further, this volume increase directly reduces the per barrel cost of the Company's selling and administrative expenses. The Company's marketing strategy has concentrated on the development of high- volume, multi-pump service stations that are located principally in neighborhoods rather than on interstate highways. The Company believes that the stations are distinctive because of their attractive landscaping, high standards of cleanliness and service and 24 hours-a-day operation. The Company owns and operates two convenience store chains (Fast Fare and Zippy Mart). Through the marketing of both merchandise and gasoline, these units have complemented the Company's traditional retailing activities. Sales values of the principal classes of products sold by the Company during the last three years are included in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 7 of this report. At December 31, 1993, the Company employed 3,031 employees. The total number of employees decreased approximately 9% from year-end 1992, due primarily to reductions in marketing operations as a result of the closing or divestment of retail units which were not strategic to the Company's future and reductions due to the consolidation of certain Marketing field operations. Regulation Like other petroleum refiners and marketers, the Company's operations are subject to extensive and rapidly changing federal and state environmental regulations governing air emissions, wastewater discharges, underground storage tanks, and solid and hazardous waste management activities. The Company anticipates that substantial capital investments will be required in order to comply with federal, state and local provisions. A more detailed discussion of environmental matters is included in Note A and Note G of Notes to Consolidated Financial Statements on pages 18 and 25 of this report, and in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 6 through 11 of this report. Competitive Conditions The Company faces intense competition in all of the business areas in which it operates. Many of the Company's competitors are substantially larger, and the Company's sales volumes represent a small portion of the overall products sold in its marketing areas. Therefore, the Company's earnings are affected by the marketing and pricing policies of its competitors, as well as changes in raw material costs. The majority of the Company's total crude oil purchases are transacted on the spot market. The Company selectively enters into forward hedging and option contracts to minimize price fluctuations for a portion of its crude oil and refined products. The Company maintains business interruption insurance to protect itself against losses resulting from shutdowns to refinery operations for periods in excess of 25 days or $5 million resulting from fire, explosions and certain other insured casualties. La Gloria has entered into long-term finished product Exchange Agreements with Exxon, USA (Exxon) and Chevron, USA (Chevron). The primary term of the Exxon Agreement extends through December 1999, and requires the exchange of approximately 297,000 barrels per month. The Chevron Agreement has been extended through March 1999, and requires the exchange of approximately 256,000 barrels per month. Merchandise sales and operating revenues of the convenience stores are seasonal in nature, generally producing higher sales and net income in the summer months than at other times of the year. Gasoline sales, both at the Crown multi-pumps and convenience stores, are also somewhat seasonal in nature and, therefore, related revenues vary during the year. The seasonality does not, however, negatively impact the Company's overall ability to sell its refined products. Item 2. Item 2. PROPERTIES Houston Refining The Company owns and operates a 100,000 Barrel-Per-Day (BPD) refinery located on approximately 174 acres adjacent to the Houston Ship Channel in Houston, Texas. The Gulf Coast location offers an advantage because of its access by tankers, barges and pipelines for the receipt of feedstocks and the shipment of finished products. The facility has a crude unit with a 100,000 BPD atmospheric column and a 38,000 BPD vacuum tower. Major downstream units consist of a 52,000 BPD fluid catalytic cracking (FCC) unit, a 12,000 BPD delayed coker unit, two alkylation units with a combined capacity of 12,000 BPD of alkylate production, and two reformers with a combined capacity of 36,000 BPD. Other units include a 5,000 BPD isomerization unit, two depropanizer units that can produce 5,500 BPD of refinery grade propylene, a liquefied petroleum gas unit that removes about 1,000 BPD of liquids from the refinery fuel system and a methyl tertiary butyl ether (MTBE) unit which can produce about 1,500 BPD of MTBE for gasoline blending. A fully-depreciated petroleum coke calcining plant is also located at the site, but this unit has not been in operation during the last several years because of economic conditions and environmental restrictions. In 1993, the refinery ran at approximately 91% of rated crude unit capacity with a product yield that was approximately 54% gasoline (of which 17% was premium octane grades) and 32% distillates. In addition, propylene, propane, slurry oil, petroleum coke and sulphur were produced. The Company owns and operates storage facilities located on approximately 130 acres near its Houston plant which, together with tanks at the refinery site, provide the Company with a storage capacity of approximately 6.2 million barrels. In addition, the Company has a third-party agreement for the storage and handling of crude received from large ocean going vessels. The Company obtains a continuous supply of crude oil and other feedstocks from a variety of sources, including major producers, independent domestic producers, foreign national oil companies, trading companies, and other refiners. Most of the domestic crude processed by the Company, other than that from the Alaskan North Slope (ANS), is transported by pipeline. The Company's purchases of ANS and foreign crude oil are transported primarily by tankers under spot charters which are arranged by either the seller or by the Company. The Company is not obligated under any time-charter contracts. The Company owns an undivided interest in the Rancho Pipeline System, which connects with gathering and other trunk line systems serving producing fields in parts of West Texas and New Mexico. Tyler Refining The Tyler refinery is a high conversion refinery located on approximately 100 of the 529 acres owned by the Company in Tyler, Texas. The crude unit has a current capability of processing approximately 52,000 BPD, but could be expanded to run 60,000 BPD with certain enhancements to downstream units. The refinery processes light, sweet crude oils delivered by pipeline to the refinery: about 80% from local East Texas producers and 20% from other sources. In 1993, the refinery had a crude unit utilization rate of approximately 94% resulting in a product yield which was approximately 55% gasoline (of which 33% was premium octane grades) and 34% distillates. The other major process units at the refinery include a 16,000 BPD vacuum distillation unit, an 18,000 BPD FCC unit, a 6,000 BPD delayed coker unit, a 20,000 BPD naphtha hydrotreating unit, a 12,000 BPD distillate hydrotreating unit, two reforming units with a combined capacity of 16,000 BPD, a 5,000 BPD isomerization unit, and an alkylation unit with a capacity of 4,700 BPD. The hydrotreating units were significantly modified in 1993 enabling this plant to produce 100% of its distillate to meet the .05% sulphur requirements under the Clean Air Act. In addition to the major process units, the refinery includes a gas recovery unit, sulfur plant, tankage, boilers, instrument air and plant air systems, and an API separator. Most of the refined products are delivered via the refinery truck terminal, which is equipped for automated blending. The refinery connects to the Texas Eastern Product Pipeline System which extends into the upper Midwestern States. The major source of crude supply to the refinery is the McMurrey Pipe Line Company system. The McMurrey Pipe Line Company, a wholly-owned subsidiary of La Gloria, owns and operates a crude oil transmission and gathering system in Smith, Gregg, and Rusk counties in East Texas. Marketing While the Company retails and/or wholesales finished petroleum products in several states, the majority of its 1993 sales were concentrated in Alabama, Arkansas, Georgia, Illinois, Indiana, Maryland, New Jersey, North Carolina, South Carolina, Texas and Virginia. The Company owns or leases 17 terminals in 11 states and has exchange agreements with other terminals. The Company's terminals are supplied through a combination of pipelines and barge loading facilities. In addition to serving the Company's retail requirements, the terminals supply petroleum products to other refiner/marketers, jobbers and independent distributors. As discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 8 of this report, in the third quarter of 1993, a fire destroyed the loading rack at the Pasadena Texas terminal. The Company's gasoline products are marketed at retail through Crown branded multi-pump service stations. At December 31, 1993, there were 298 locations in operation of which 101 were leased to dealers and 197 were operated by the Company. Of the Company's 298 service stations, 111 contain Express Marts which sell a variety of convenience items in an area of approximately 800 square feet and 49 locations operate as traditional convenience stores bearing the Crown name. Fast Fare and Zippy Mart convenience stores are currently located in Alabama, Georgia, North Carolina and South Carolina. The stores average 2,200-2,400 square feet of floor space and generally operate 24 hours a day. They offer a variety of dairy and bakery products, beer, wine, soft drinks, and other convenience items. Many outlets include deli counters and carry-out fast food. The 78 operating Fast Fare and Zippy Mart convenience stores at December 31, 1993 included 53 fee locations, where Fast Fare owns the land, and 25 leased facilities. Petroleum products are marketed at 75 of these locations. Item 3. Item 3. LEGAL PROCEEDINGS The Company is involved in various matters of litigation, the ultimate determination of which, in the opinion of management, will not have a material adverse effect on the Company's financial position. The Company's legal proceedings are further discussed in Note G of Notes to Consolidated Financial Statements on page 25 of this report. In 1991, 1992 and 1993, the Texas Water Commission conducted routine solid waste investigations of the Company's Pasadena Refinery. The violations that have been alleged as a result of these inspections have been combined into a single enforcement action in which the Texas Natural Resource Conservation Commission (TNRCC) is currently seeking the imposition of approximately $139,000 in administrative penalties and various corrective measures. In 1992, the Texas Air Control Board conducted a State Implementation Plan inspection. The Company is currently negotiating with TNRCC concerning the appropriate disposition of the alleged violations cited as a result of this inspection. In May 1993, the United States Environmental Protection Agency (EPA) conducted an inspection at the Pasadena Refinery, and in February 1994, the Company received a Notice of Violation (NOV) related to this inspection. Many of the alleged violations in this NOV are included in the air matters currently under consideration by TNRCC. The Company is attempting to coordinate the resolution of these matters which are now before the two agencies. The Pasadena Refinery and many of the Company's other facilities are involved in a number of other environmental enforcement actions or are subject to agreements, orders or permits that require remedial activities. Environmental expenditures, including these matters, are discussed in the Liquidity and Capital Resources section of Management's Discussion and Analysis of Financial Conditions and Results of Operations on pages 9 through 11 of this report, and in Note G of Notes to Consolidated Financial Statements on page 25 of this report. These enforcement actions and remedial activities, in the opinion of management, are not expected to have a material adverse effect on the financial position of the Company. In addition, the Company has been named by the EPA and by several state environmental agencies as a potentially responsible party at various federal and state Superfund sites. The Company's exposure in these matters has either been resolved or is de minimis and is not expected to have a material adverse -- ------- effect on the financial position of the Company. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the last three months of the fiscal year covered by this report. (This space intentionally left blank) PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the American Stock Exchange under the ticker symbols CNP A and CNP B. Common Stock Market Prices and Cash Dividends 1993 1992 ----------------- -------------------------- Cash Sales Price Sales Price Dividend High Low High Low Declared -------- ------- ------- ------- -------- CLASS A COMMON STOCK First Quarter . . . $18 $13 3/4 $26 1/2 $22 1/2 $.10 Second Quarter . . . 16 7/8 14 1/2 24 1/8 20 3/8 .10 Third Quarter . . . 16 3/4 14 1/2 20 1/2 16 Fourth Quarter . . . 16 1/4 14 5/8 17 1/4 13 5/8 Yearly . . . . . . 18 13 3/4 26 1/2 13 5/8 .20 CLASS B COMMON STOCK First Quarter . . . $16 1/8 $12 $24 3/8 $21 3/8 $.10 Second Quarter . . . 14 3/4 12 5/8 21 7/8 19 .10 Third Quarter . . . 14 1/4 12 1/4 19 1/4 14 1/2 Fourth Quarter . . . 14 5/8 13 15 1/8 11 1/4 Yearly . . . . . . 16 1/8 12 24 3/8 11 1/4 .20 The Company's policy of paying regular quarterly cash dividends is dependent upon future earnings, capital requirements, overall financial condition and restrictions as described in Note C of Notes to Consolidated Financial Statements on pages 19 and 20 of this report. There were no cash dividends declared on common stock in 1993. The approximate number of shareholders of the Company's common stock, based on the number of record holders on December 31, 1993 was: Class A Common Stock . . 794 Class B Common Stock . . 953 Transfer Agent & Registrar Mellon Securities Transfer Services Ridgefield Park, New Jersey Item 6. Item 6. SELECTED FINANCIAL DATA The selected consolidated financial data for the Company set forth below for the five years ended December 31, 1993 should be read in conjunction with the Consolidated Financial Statements. The above financial information reflects the operations of La Gloria Oil and Gas Company since the effective date of the acquisition in the fourth quarter of 1989. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As discussed in Notes D and F of Notes to Consolidated Financial Statements on pages 21 and 24 of this report, Crown Central Petroleum Corporation and subsidiaries (the Company) adopted the provisions of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), and No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), effective January 1, 1992. The 1992 results include the $13,403,000 cumulative effect benefit of the adoption of SFAS 109 on prior years, and the $5,631,000 net of tax cumulative effect charge of applying SFAS 106. In 1993, the Company had a net loss of $4.3 million compared to a net loss before cumulative effect of changes in accounting principles of $13.3 million in 1992, and a net loss of $6 million in 1991. The Company's sales and operating revenues decreased 2.7% in 1993 compared to a 3.4% decrease in 1992. The Company's sales and operating revenues include all Federal and State Excise Taxes which totalled $296,228,000, $218,944,000, and $214,716,000 in 1993, 1992 and 1991, respectively. The 1993 decrease in sales and operating revenues was due to an 8.8% decrease in the average unit selling price of petroleum products and to decreases in merchandise sales of 19.9%, which were partially offset by a 2.1% increase in sales volumes and an increase in excise taxes as previously mentioned. The 1992 decrease was primarily attributable to a 6.6% decrease in the average unit selling price of petroleum products and a 12.5% decrease in merchandise sales, which were partially offset by a 3.4% increase in petroleum product sales volumes. The merchandise sales decreases resulted principally from the sale or closing throughout 1992 and 1993 of retail marketing outlets which were either not profitable or did not fit with the Company's strategic direction. The closing of these units resulted in increases in the average sales level per store in each of the last two years. There were 376, 435 and 524 retail units operating at the end of 1993, 1992 and 1991, respectively. Gasoline sales accounted for 56.4% of total 1993 revenues (excluding excise taxes), while distillates and merchandise sales represented 30.4% and 6.0%, respectively. This compares to a dollar mix from sales of 57.1% gasoline, 28.7% distillates and 6.9% merchandise in 1992; and 56.4% gasoline, 29.3% distillates and 7.6% merchandise in 1991. The following table depicts the sales values of the principal classes of products sold by the Company, which individually contributed more than ten percent of consolidated sales and operating revenues (excluding excise taxes) during the last three years: Sales of Principal Products millions of dollars 1993 1992 1991 ------ ------ -------- Gasoline $817.6 $900.1 $926.1 No. 2 Fuel & Diesel 369.7 379.9 384.5 Costs and operating expenses decreased 3.3% in 1993, after decreasing 3.4% in 1992. The 1993 decrease was attributable to a decrease in the average cost per barrel consumed of crude oil and feedstocks of $2.29 or 11.2%, which was partially offset by increases in volumes sold and excise taxes as previously mentioned. The 1992 decrease was due primarily to a decrease in the average cost per barrel consumed of $1.45 or 6.6% which was partially offset by higher sales volumes. The results of operations were affected by the Company's use of the last-in, first-out (LIFO) method to value inventory which results in a better matching of current revenues and costs. The impact of LIFO was to increase the Company's gross margins in 1993, 1992 and 1991 by $.48 per barrel ($27.7 million), $.10 per barrel ($5.8 million) and $.86 per barrel ($45.9 million), respectively. The 1992 LIFO impact is net of a $2.3 million gross margin decrease resulting from a liquidation of LIFO inventory quantities as discussed in Note B of Notes to Consolidated Financial Statements on page 19 of this report. Total refinery throughput was: 158,000 barrels per day (bpd) in 1993, yielding 86,000 bpd of gasoline (54.5%) and 52,000 bpd of distillates (32.6%); 154,000 barrels per day (bpd) in 1992, yielding 86,000 bpd of gasoline (56.2%) and 49,000 bpd of distillates (31.9%); and 147,000 bpd in 1991, yielding 78,000 bpd of gasoline (53.1%) and 47,300 bpd of distillates (32.2%). Refinery production was slightly impacted in 1993 by a scheduled maintenance turnaround in the second quarter at the Tyler refinery, while Refinery production was more dramatically reduced in 1992 by scheduled first quarter maintenance turnarounds at both the Houston and Tyler refineries. Due to poor refining margins late in the fourth quarter of 1993, the Company announced that it had reduced runs at its Pasadena Refinery by 20%. In 1991, overall refinery production and gasoline yields were reduced by the first quarter's scheduled turnaround and extensive modification of the Houston refinery's Fluid Catalytic Cracking Unit (FCCU), which is the primary gasoline facility. The Company's finished product requirements in excess of its refinery yields and existing inventory levels are acquired thru its exchange agreements or outright purchases. On September 28, 1993, a fire destroyed the Red Bluff truck loading rack located one mile from the Pasadena Refinery. Since the fire, the Company has supplied its terminal rack customers with refined products at nearby locations. However, due to its strategic location, the Company has experienced certain reductions in operating margins in selling the refined product formerly sold from the Pasadena Terminal rack at these alternative sites or in the bulk products market. Prior to the fire, refined products sold from the Pasadena Terminal rack approximated 4% of consolidated 1993 refined product sales volumes. The Company continues to evaluate its options, but has not made a final decision concerning the repairs to the facility. A majority of the Company's total crude oil and related raw material purchases are transacted on the spot market. The Company selectively enters into forward hedging and option contracts to minimize price fluctuations for a portion of its crude oil and refined products. Selling and administrative expenses decreased 10.8% in 1993 after decreasing 8.3% in 1992. The 1993 decrease resulted primarily from decreased store level and marketing administrative costs associated with the closing of retail outlets as previously discussed, and the consolidation of certain marketing field operations. The 1992 decrease is also attributable to reduced costs associated with the closing of retail outlets, and reductions resulting from the reorganization of the Company's administrative functions. At December 31, 1993, the Company operated 249 retail gasoline facilities and 127 convenience stores compared to 262 retail gasoline facilities and 173 convenience stores at December 31, 1992 and 275 retail gasoline facilities and 249 convenience stores at December 31, 1991. Despite the net reduction in 1993 of 59 operating units (13.6%) from the December 31, 1992 level, the Company experienced a 9.1% increase in total retail petroleum product margin dollars while total retail sales volumes decreased less than 1%. The Company believes its extensive retail unit analysis is now complete and that a minimal number of existing units will be closed in 1994. Selling and administrative expense costs in 1993 include $.7 million in reorganization and office closure costs, while reorganization costs of $.4 million and $1.1 million are included in selling and administrative expenses for 1992 and 1991, respectively. Operating costs and expenses in 1993, 1992 and 1991 include $8.7 million, $7.6 million and $15.7 million, respectively, related to environmental matters and retail units that have been closed. Operating costs and expenses in 1993 also include $1.8 million of accrued non-environmental casualty related costs. Operating costs and expenses in 1992 include a $1 million reserve for the write-off of excess refinery equipment and a $1.3 million write-off of refinery feasibility studies. Depreciation and amortization in 1993 was comparable to 1992, and is expected to remain consistent in 1994. Depreciation and amortization increased 24.5% in 1992 resulting from additional depreciation and amortization relating to the 1991 capital modification and turnaround at the Houston refinery which was completed in March 1991, as well as depreciation associated with other capital expenditures made in 1991 and amortization of the 1992 turnarounds. Additionally, $2.4 million of depreciation was recorded as a result of the step-up in basis of fixed assets as required by the adoption of SFAS 109, effective January 1, 1992. The loss of $2.3 million from sales and abandonments in 1993 relates primarily to the write-down of the Sulphur Unit at the Houston refinery. The loss of $1.3 million from sales of property plant and equipment in 1992 includes a $.9 million write-off of abandoned equipment related to the capital modification of the Houston refinery's FCCU. Interest and other income increased $1.4 million in 1993 and decreased $4.7 million in 1992. The 1992 decrease was due primarily to decreases in the average daily cash invested of $40.9 million and to decreases in average interest rates. Interest and other income in 1993 includes income of $.7 million from the Company's wholly-owned insurance subsidiaries compared to a loss of $1 million in 1992 and income of $.2 million in 1991. Non-operating gains in 1991 include a favorable $2.4 million litigation settlement related to the Houston refinery property tax assessments for the years 1986 to 1989 and a favorable $1.2 million insurance settlement. There were no material net non-operating gains or losses credited or charged to income in 1993 or 1992. Interest expense increased $.6 million in 1993 and decreased $1.1 million in 1992. The 1993 increase related to a decrease in capitalized interest as disclosed in Note C of Notes to Consolidated Financial Statements on page 20 of this report. The 1992 decrease was due to decreases in the average effective rate on cash borrowed reflecting the Company's positive results from its interest rate swap program. Increases in the average daily cash borrowed of $5.2 million in 1992 partially offset the decreased expense. As discussed in Note D of Notes to Consolidated Financial Statements on page 22 of this report, the passage of the Tax Act of 1993 increased the Company's federal statutory income tax rate from 34% to 35% effective January 1, 1993. The effect of the change in statutory rate was to increase the Company's 1993 income tax expense and increase the net loss by $2.3 million or $.23 per share. Liquidity and Capital Resources The Company's cash and cash equivalents were $3.5 million lower at year-end 1993 than at year-end 1992. The decrease was attributable to $40 million of net cash outflows from investment activities which was partially offset by cash provided by operating activities of $31.3 million and cash provided by financing activities of $5.2 million. The positive $31.3 million cash generated from operating activities in 1993 is net of an $11.2 million cash outflow relating to working capital, resulting primarily from decreases in crude oil and refined products payable and increases in the value of crude oil and finished products inventories, which was partially offset by net decreases in accounts receivable. Since the Company purchases much of its crude oil in bulk, crude oil payables fluctuate depending on when the cargo is received and when the related payment is made. Net cash outflows from investment activities in 1993 consisted principally of capital expenditures of $40.9 million (which includes $19.1 million related to the Marketing area and $19.5 million for refinery operations) and $4 million of refinery deferred turnaround costs. The total outflows from investment activities were partially offset by proceeds from the sale of property, plant and equipment of $5.6 million. Net cash provided by financing activities in 1993 relates primarily to the $5.5 million received from the purchase money lien as discussed in Note C of Notes to Consolidated Financial Statements on page 20 of this report. The ratio of current assets to current liabilities at December 31, 1993 was 1.29:1 compared to 1.22:1 at December 31, 1992. If FIFO values had been used for all inventories, assuming an incremental effective income tax rate of 38.5% at December 31, 1993 and 37.5% at December 31, 1992, the ratio of current assets to current liabilities would have been 1.36:1 at December 31, 1993 and 1992. Like other petroleum refiners and marketers, the Company's operations are subject to extensive and rapidly changing federal and state environmental regulations governing air emissions, waste water discharges, and solid and hazardous waste management activities. The Company's policy is to accrue environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and that the amount can be reasonably estimated. While it is often extremely difficult to reasonably quantify future environmental related expenditures, the Company anticipates that a substantial capital investment will be required over the next several years to comply with existing regulations. The Company had recorded a liability of approximately $16.8 million as of December 31, 1993 to cover the estimated costs of compliance with environmental regulations. Environmental liabilities are subject to considerable uncertainties which affect the Company's ability to estimate its ultimate cost of remediation efforts. These uncertainties include the exact nature and extent of the contamination at each site, the extent of required cleanup efforts, varying costs of alternative remediation strategies, changes in environmental remediation requirements, the number and financial strength of other potentially responsible parties at multi-party sites, and the identification of new environmental sites. As a result, charges to income for environmental liabilities could have a material effect on results of operations in a particular quarter or year as assessments and remediation efforts proceed or as new claims arise. However, management is not aware of any matters which would be expected to have a material adverse effect on the Company's consolidated financial position, cash flow or liquidity. Over the next two to three years, the Company estimates environmental expenditures at the Houston and Tyler refineries, of at least $4.9 million and $16.8 million, respectively. Of these expenditures, it is anticipated that $3.5 million for Houston and $15.8 million for Tyler will be of a capital nature, while $1.4 million and $1 million, respectively, will be related to previously accrued non-capital remediation efforts. At the Company's marketing facilities, environmental related expenditures (capital and non-capital) of at least $10.5 million are planned for 1994 and 1995, which includes $5.1 million previously accrued relating to site testing and inspections, site clean-up, and monitoring wells. In the fourth quarter of 1993, the distillate hydrotreater at the Tyler, Texas refinery, was completed at a cost of approximately $8.2 million. This unit, which is capable of processing 10,000 barrels per day, has operated near capacity since start up and enables Crown to meet the on road distillate sulphur standard as required by the Clean Air Act. Since 1991, the Company has incurred expenditures of approximately $20.4 million in connection with engineering and equipment acquisition which would enable the Houston refinery to manufacture low sulphur distillate. These expenditures are included in Property, Plant and Equipment on the Company's Balance Sheet at December 31, 1993. This project has been temporarily halted while the Company further studies the market economics of high sulphur versus low sulphur distillate and evaluates various options for this project. The Company estimates that, depending upon the specific design and capacity, additional expenditures in the range of $50 million to $80 million would be required to complete this project. If the Company decides to install this unit, long-term capital or alternative financing arrangements will be required. As discussed in Note C of Notes to Consolidated Condensed Financial Statements on page 20 of this report, effective as of May 10, 1993, the Company entered into a new three year Revolving Credit Facility. Management believes the new agreement will provide anticipated working capital requirements as well as support future growth opportunities. As a result of a strong balance sheet and overall favorable credit relationships, the Company has been able to maintain open lines of credit with its major suppliers. Under the Revolving Credit Agreement, the Company had outstanding as of January 31, 1994, irrevocable standby letters of credit in the principal amount of $25.7 million for purposes in the ordinary course of business. Unused commitments totaling $99.3 million under the Revolving Credit Agreement were available for future borrowings and issuance of letters of credit at January 31, 1994. As discussed in Note C of Notes to Consolidated Financial Statement, on page 20 of this report, effective December 1, 1993, the Company entered into a Purchase Money Lien (Money Lien) for the financing of certain service station and terminal equipment and office furnishings. On January 31, 1994, an additional $1 million was drawn on the Money Lien for terminal equipment resulting in a total of $6.5 million outstanding at January 31, 1994. The $60 million outstanding under the Company's Note Purchase Agreement requires seven annual repayments of $8.6 million beginning in January 1995. Under the terms of the existing credit facilities, the Company has various options available to either repay or refinance this debt including short-term borrowings, long-term borrowings, lease financing and structures such as the Purchase Money Lien previously discussed. In 1993, due to declining interest rates, the Company reduced the discount rate used to measure obligations for pension and postretirement benefits other than pensions. This change will increase the Company's 1994 net periodic pension cost, however, adjustments to other assumptions used in accounting for the Company's defined benefit plans will likely result in a minimal impact on the overall cost. The Company's management is involved in a continual process of evaluating growth opportunities in its core business as well as its capital resource alternatives. Total capital expenditures and deferred turnaround costs in 1994 are projected to approximate the 1993 expenditures of $44.9 million. The capital expenditures relate primarily to planned enhancements at the Company's refineries, marketing store level improvements and to company-wide environmental requirements. Management anticipates funding these 1994 expenditures principally through funds from operations and existing available cash. The Company places its temporary cash investments in high credit quality financial instruments which are in accordance with the covenants of the Company's financing agreements. These securities mature within ninety days, and, therefore, bear minimal risk. The Company has not experienced any losses on its investments. The Company faces intense competition in all of the business areas in which it operates. Many of the Company's competitors are substantially larger and Crown's sales volumes generally represent a small portion of the overall products sold in the Company's marketing areas. Therefore, the Company's earnings are affected by the marketing and pricing policies of its competitors, as well as changes in raw material costs. Merchandise sales and operating revenues from the Company's convenience stores are seasonal in nature, generally producing higher sales and net income in the summer months than at other times of the year. Gasoline sales, both at the Crown multi-pumps and convenience stores, are also somewhat seasonal in nature and, therefore, related revenues may vary during the year. The seasonality does not, however, negatively impact the Company's overall ability to sell its refined products. The Company maintains business interruption insurance to protect itself against losses resulting from shutdowns to refinery operations from fire, explosions and certain other insured casualties. Business interruption coverage begins for such losses at the greater of $5 million or shutdowns for periods in excess of 25 days. Effects of Inflation and Changing Prices The Company's consolidated financial statements are prepared on the historical cost method of accounting and, as a result, do not reflect changes in the dollar's purchasing power. Although the level of inflation continued to remain relatively low in recent years, the Company's results are still affected by the inflationary trend of earlier years. In the capital intensive industry in which the Company operates, the replacement costs for its properties would generally far exceed their historical costs. Accordingly, depreciation would be greater if it were based on current replacement costs. However, since replacement facilities would reflect technological improvements and changes in business strategies, such facilities would be expected to be more productive and versatile than existing facilities, thereby increasing profits and mitigating increased depreciation and operating costs. The Company's use of LIFO to value inventories understates the value of inventories on the Company's consolidated Balance Sheet as compared to the first-in, first-out (FIFO) method. In recent years, crude oil and refined petroleum product prices have been falling which has resulted in a net reduction in working capital requirements. If the prices increase in the future, the Company will expect a related increase in working capital needs. (This space intentionally left blank) Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS Crown Central Petroleum Corporation and Subsidiaries (Thousands of dollars) December 31 Assets 1993 1992 -------- -------- Current Assets Cash and cash equivalents . . . . . . . . . $ 52,021 $ 55,504 Accounts receivable, less allowance for doubtful accounts (1993--$1,760; 1992--$1,392) 91,413 112,920 Recoverable income taxes . . . . . . . . . 2,690 Inventories . . . . . . . . . . . . . . . . 86,811 73,454 Other current assets . . . . . . . . . . . 762 1,403 ---------- -------- Total Current Assets . . . . . . . . . . . 231,007 245,971 Investments and Deferred Charges . . . . . . 42,908 53,616 Property, Plant and Equipment Land . . . . . . . . . . . . . . . . . . . 44,433 45,251 Petroleum refineries . . . . . . . . . . . 428,567 409,832 Marketing facilities . . . . . . . . . . . 182,473 177,911 Pipelines and other equipment . . . . . . . 20,932 19,247 --------- --------- 676,405 652,241 Less allowance for depreciation . . . . . 294,142 276,491 --------- --------- . . . . Net Property, Plant and Equipment 382,263 375,750 ----------- ---------- $656,178 $675,337 ======== ======== See notes to consolidated financial statements CONSOLIDATED BALANCE SHEETS Crown Central Petroleum Corporation and Subsidiaries (Thousands of dollars) December 31 Liabilities and Stockholders' Equity 1993 1992 -------- -------- Current Liabilities Accounts payable: Crude oil and refined products . . . . . . $104,166 $134,416 Other . . . . . . . . . . . . . . . . . . 20,500 17,787 Accrued liabilities . . . . . . . . . . . . 50,145 48,522 Income taxes payable . . . . . . . . . . . 3,264 Current portion of long-term debt . . . . . 1,094 357 --------- --------- . . . . . . . . Total Current Liabilities 179,169 201,082 Long-Term Debt . . . . . . . . . . . . . . . 65,579 61,220 Deferred Income Taxes . . . . . . . . . . . . 81,217 81,588 Other Deferred Liabilities . . . . . . . . . 31,860 28,173 Common Stockholders' Equity Class A Common Stock--par value $5 per share: Authorized--8,500,000 shares; issued and outstanding shares-- 4,817,392 in 1993 and 1992 . . . . . . . . 24,087 24,087 Class B Common Stock--par value $5 per share: Authorized--6,500,000 shares; issued and outstanding shares-- 5,015,206 in 1993 and 1992 . . . . . . . . 25,076 25,076 Additional paid-in capital . . . . . . . . 91,870 91,870 Retained earnings . . . . . . . . . . . . . 157,320 162,241 ---------- -------- . . . . Total Common Stockholders' Equity 298,353 303,274 ----------- ----------- $656,178 $675,337 ======== ======== See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF OPERATIONS Crown Central Petroleum Corporation and Subsidiaries (thousands of dollars, except per share amounts) Year Ended December 31 1993 1992 1991 ---------- ----------- --------- Revenues Sales and operating revenues (including excise taxes of 1993--$296,228; 1992--$218,944; 1991--$214,716) $1,747,411 $1,795,259 $1,857,711 Operating Costs and Expenses Costs and operating expenses . . 1,604,696 1,659,796 1,718,066 Selling and administrative expenses 91,714 102,805 112,131 Depreciation and amortization . . 41,873 41,526 33,346 Sales of property, plant and equipment 2,331 1,264 (20) ---------- ---------- ---------- 1,740,614 1,805,391 1,863,523 ---------- ---------- ---------- Operating Income (Loss) . . . . . . 6,797 (10,132) (5,812) Interest and other income . . . . . 1,461 3 4,713 Non-operating gains . . . . . . . . 3,674 Interest expense . . . . . . . . . (7,451) (6,826) (7,908) ---------- ---------- ---------- Income (Loss) Before Income Taxes and Cumulative Effect of Changes in Accounting Principles 807 (16,955) (5,333) Income Tax Expense (Benefit) . . . 5,107 (3,677) 693 ---------- ----------- --------- (Loss) Before Cumulative Effect of Changes in Accounting Principles (4,300) (13,278) (6,026) Cumulative Effect to January 1, 1992 of Change in Accounting for Postretirement Benefits Other Than Pensions (Net of Tax Benefit of $3,308) (5,631) Cumulative Effect to January 1, 1992 of Change in Accounting for Income Taxes 13,403 ----------- ----------- ----------- Net (Loss) . . . . . . . . . . . . $ (4,300) $ (5,506) $ (6,026) =========== ========== ========= Net (Loss) Per Share: (Loss) Before Cumulative Effect of Changes in Accounting Principles $ (.44) $ (1.35) $ (.61) Cumulative Effect to January 1, 1992 of Change in Accounting for Postretirement Benefits Other Than Pensions . . (.57) Cumulative Effect to January 1, 1992 of Change in Accounting for Income Taxes 1.36 ------------ ---------- ------------ Net (Loss) Per Share . . . . . . . $ (.44) $ (.56) $ (.61) ========== =========== =========== See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCKHOLDERS' EQUITY Crown Central Petroleum Corporation and Subsidiaries (thousands of dollars, except per share amounts) See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CASH FLOWS Crown Central Petroleum Corporation and Subsidiaries (thousands of dollars) Year Ended December 31 1993 1992 1991 ---------- ----------- --------- Cash Flows From Operating Activities Net (loss) . . . . . . . . . . . . . . $ (4,300) $ (5,506) $ (6,026) Reconciling items from net (loss) to net cash provided by operating activities: Depreciation and amortization . . . 41,873 41,526 33,346 Loss (gain) on sales of property, plant and equipment . . . . . . . . . . . 2,331 1,264 (20) Equity (earnings) loss in unconsolidated subsidiaries (651) 1,028 (237) Deferred income taxes . . . . . . . (36) (841) 11,125 Other deferred items . . . . . . . . 830 715 5,608 Cumulative effect of changes in accounting principles (7,772) Changes in assets and liabilities Accounts receivable . . . . . . . . 21,507 (1,506) 50,001 Recoverable income taxes . . . . . . 2,690 6,742 (9,432) Inventories . . . . . . . . . . . . (13,357) 31,953 5,832 Other current assets . . . . . . . . 641 330 (1,130) Crude oil and refined products payable (30,250) (13,303) (76,562) Other accounts payable . . . . . . . 2,713 (2,555) 1,335 Accrued liabilities . . . . . . . . 1,623 876 (5,155) Income taxes payable . . . . . . . . 3,264 (8,156) --------- ---------- -------- Net Cash Provided by Operating Activities 28,878 52,951 529 -------- ---------- -------- Cash Flows From Investment Activities Capital expenditures . . . . . . . . (40,860) (38,003) (64,782) Contract settlement regarding acquisition of La Gloria Oil and Gas Company . . 8,000 Proceeds from sales of property, plant and equipment 5,515 4,072 4,619 Investment in subsidiaries . . . . . (4) (177) 742 Deferred turnaround maintenance and other (4,678) (19,675) (21,333) -------- -------- -------- Net Cash (Used in) Investment Activities (40,027) (45,783) (80,754) -------- -------- -------- Cash Flows From Financing Activities Net (repayments) borrowings on loan agreements (376) (27,339) 86,333 Proceeds from purchase money lien . . 5,472 Proceeds from interest rate swap terminations 2,403 Net repayments (issuances) of long-term notes receivable 167 (499) (2,637) Cash dividends . . . . . . . . . . . (1,967) (7,866) -------- ------- -------- Net Cash Provided by (Used in) Financing Activities . . . . . 7,666 (29,805) 75,830 -------- ------- -------- Net (Decrease) in Cash and Cash Equivalents (3,483) (22,637) (4,395) Cash and Cash Equivalents at Beginning of Year 55,504 78,141 82,536 -------- ------- -------- Cash and Cash Equivalents at End of Year $ 52,021 $ 55,504 $ 78,141 ======== ======== ======== Supplemental Disclosures of Cash Flow Information Cash paid during the year for: Interest (net of amount capitalized) $ 4,249 $ 5,610 $ 3,824 Income taxes . . . . . . . . . . . . 4,329 1,023 5,858 See notes to consolidated financial statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Crown Central Petroleum Corporation and Subsidiaries Note A--Description of Business and Summary of Accounting Policies Description of Business: Crown Central Petroleum Corporation and subsidiaries - ----------------------- (the Company) operates primarily in one business segment as an independent refiner and marketer of petroleum products, including petrochemical feedstocks. The Company operates two refineries, one located near Houston, Texas with a rated capacity of 100,000 barrels per day and another in Tyler, Texas with a rated capacity of 50,000 barrels per day. Its principal business is the wholesale and retail sale of its products in the Mid-Atlantic, Southeastern and Midwestern United States. Locot Corporation, a wholly-owned subsidiary of the Company, is the parent company of La Gloria Oil and Gas Company (La Gloria) which operates the Tyler refinery, a pipeline gathering system in Texas and product terminals located along the Texas Eastern Pipeline system. F Z Corporation, a wholly-owned subsidiary of the Company, is the parent company of two convenience store chains operating in seven states, retailing both merchandise and gasoline. The following summarizes the significant accounting policies and practices followed by the Company: Principles of Consolidation: The consolidated financial statements include the - --------------------------- accounts of Crown Central Petroleum Corporation and all significant majority- owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Due to immateriality, the Company's investment in Tongue, Brooks & Company, Inc. and Tiara Insurance Company, two wholly-owned insurance subsidiaries, are accounted for using the equity method. Cash and Cash Equivalents: Cash in excess of daily requirements is invested in - ------------------------- marketable securities with maturities of three months or less. Such investments are deemed to be cash equivalents for purposes of the statements of cash flows. The carrying amount reported in the balance sheet for cash and cash equivalents represents its fair value. Accounts Receivable: The majority of the Company's accounts receivable relate - ------------------- to sales of petroleum products to third parties operating in the petroleum industry. The carrying amount reported in the balance sheet for accounts receivable represents its fair value. Inventories: The Company's crude oil, refined products, and convenience store - ----------- merchandise and gasoline inventories are valued at the lower of cost (last-in, first-out) or market with the exception of crude oil inventory held for resale which is valued at the lower of cost (first-in, first-out) or market. Materials and supplies inventories are valued at cost. Incomplete exchanges of crude oil and refined products due the Company or owing to other companies are reflected in the inventory accounts. Property, Plant and Equipment: Property, plant and equipment is carried at - ----------------------------- cost. Costs assigned to property, plant and equipment of acquired businesses are based on estimated fair value at the date of acquisition. Depreciation and amortization of plant and equipment are primarily provided using the straight- line method over estimated useful lives. Construction in progress is recorded in property, plant and equipment. Expenditures which materially increase values, change capacities or extend useful lives are capitalized in property, plant and equipment. Routine maintenance, repairs and replacement costs are charged against current operations. At intervals of two or more years, the Company conducts a complete shutdown and inspection of significant units (turnaround) at its refineries to perform necessary repairs and replacements. Costs associated with these turnarounds are deferred and amortized over the period until the next planned turnaround. Upon sale or retirement, the costs and related accumulated depreciation or amortization are eliminated from the respective accounts and any resulting gain or loss is included in income. Environmental Costs: The Company conducts environmental assessments and - ------------------- remediation efforts at multiple locations, including operating facilities, and previously owned or operated facilities. The Company accrues environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and that the amount can be reasonably estimated. Costs are charged to expense if they relate to the remediation of existing conditions caused by past operations or if they are not expected to contribute to future operations. Estimated costs are recorded at undiscounted amounts based on experience and assessments, and are adjusted periodically as additional or new information is available. Sales and Operating Revenues: Sales and operating revenues include excise and - ---------------------------- other similar taxes. Resales of crude oil are recorded net of the related crude oil cost (first-in, first-out) in sales and operating revenues. Income Taxes: As discussed in Note D of Notes to Consolidated Financial - ------------ Statements, effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires a liability approach for measuring deferred taxes based on temporary differences between the financial statement and tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for years in which taxes are expected to be paid or recovered. In 1993 and 1992, deferred tax liabilities reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Interest Capitalization: Interest costs incurred during the construction and - ----------------------- preoperating stages of significant construction or development projects is capitalized and subsequently amortized by charges to earnings over the useful lives of the related assets. Amortization of Goodwill: The excess purchase price of acquisitions of - ------------------------ businesses over the estimated fair value of assets acquired is being amortized on a straight-line basis over 20 years. Forward and Option Contracts: The Company selectively enters into forward - ---------------------------- hedging and option contracts to minimize price fluctuations for a portion of its crude oil and refined products. All realized and unrealized gains and losses on such hedging and option contracts are deferred and recognized in the period when the hedged materials are sold. Cash flows from forward hedging and option contracts are classified as operating activities for purposes of the statements of cash flows. Non-operating Gains and Losses: Non-operating gains and losses include - ------------------------------ significant transactions that, in the judgement of management, are not directly related to normal current operations. Note B--Inventories Inventories consist of the following: December 31 1993 1992 -------- -------- (thousands of dollars) Crude oil . . . . . . . . . . . . . . $ 38,989 $ 40,897 Refined products . . . . . . . . . . 60,519 72,915 --------- --------- Total inventories at FIFO (approximates current costs) 99,508 113,812 LIFO allowance . . . . . . . . . . . (25,828) (53,298) --------- --------- Total crude oil and refined products 73,680 60,514 --------- --------- Merchandise inventory at FIFO (approximates current cost) 7,200 7,509 LIFO allowance . . . . . . . . . . . (2,387) (2,569) --------- --------- Total merchandise . . . . . . . . . 4,813 4,940 --------- --------- Materials and supplies inventory at FIFO 8,318 8,000 --------- --------- Total Inventory . . . . . . . . . . $ 86,811 $ 73,454 ======== ======== In 1992, inventory quantities were reduced. This reduction resulted in a liquidation of LIFO inventory quantities carried at higher costs prevailing in prior years as compared with the cost of 1992 purchases. As a result of this liquidation in 1992, the net (loss) increased $1,406,000 ($.14 per share). Note C--Long-Term Debt and Credit Arrangements Long-term debt consists of the following: December 31 1993 1992 -------- -------- (thousands of dollars) Unsecured 10.42% Senior Notes . . . . $60,000 $60,000 Purchase Money Lien . . . . . . . . . 5,472 Other obligations . . . . . . . . . . 1,201 1,577 ------- ------- 66,673 61,577 Less current portion . . . . . . . . 1,094 357 ------- ------- Long-Term Debt . . . . . . . . . . $65,579 $61,220 ======= ======= The aggregate maturities of long-term debt through 1998 are as follows (in thousands): 1994 - $1,094; 1995 - $9,694; 1996 - $9,730; 1997 - $9,798; 1998 - $9,849. The unsecured 10.42% Senior Notes dated January 3, 1991, as amended (Notes) limit the payment of cash dividends on common stocks and require the maintenance of various covenants including minimum working capital, minimum fixed charge coverage ratio, and minimum consolidated tangible net worth, all as defined. The principal will be repaid in seven equal annual installments commencing January 3, 1995. The Notes are repayable, at a premium, in whole or in part at any time at the option of the Company. As of December 31, 1993, the Company has entered into interest rate swap agreements to effectively convert $17,500,000 of its 10.42% Notes to variable interest rates with maturities ranging from 1996 to 1998. During 1993, the Company terminated certain interest rate swap agreements associated with its 10.42% Notes resulting in deferred gains of $1.9 million at December 31, 1993, which will be recognized as a reduction of interest expense over the remaining swap periods, which range from 1996 to 1997. As a result of its interest rate swap program, the Company's effective interest rate on the Notes for 1993 was reduced from approximately 10.5% to approximately 9.2% per annum. The Company is exposed to credit risk to the extent of nonperformance by the counterparties to the interest rate swap agreements; however, management considers the risk of default to be remote. Under the terms of the Unsecured Credit Agreement dated May 10, 1993, (Credit Agreement) nine banks have committed a maximum of $125,000,000 to the Company for cash borrowings and letters of credit. There is a limitation of $50,000,000 for cash borrowings under the agreement. The Credit Agreement, which expires May 10,1996, but contains a one year renewal option, allows for interest on outstanding borrowings to be computed under one of three methods based on the Base Rate, the London Interbank Offered Rate, or the Certificates of Deposit Rate (all as defined). The Credit Agreement limits the Company's borrowings outside the Agreement to a maximum of $90,000,000 in unsecured senior notes. The Credit Agreement limits indebtedness (as defined), cash dividends on common stocks and capital expenditures and requires the maintenance of various covenants including, but not limited to, minimum working capital, minimum consolidated tangible net worth, and a borrowing base, all as defined. Under the terms of the Notes and Credit Agreement, at December 31, 1993, the Company was limited to paying additional cash dividends of $9,833,000. At December 31, 1993, the Company was in compliance with all covenants and provisions of the Notes and Credit Agreement. The Company expects to continue to be in compliance with the covenants imposed by the Notes and Credit Agreement over the next twelve months. Meeting the covenants imposed by the Notes and Credit Agreement is dependent, among other things, upon the level of future earnings and the rate of capital spending. As of December 31, 1993, the Company had outstanding irrevocable standby letters of credit in the principal amount of $30,709,000 and an outstanding documentary letter of credit in the principal amount of $12,600,000 for normal operations. Unused commitments under the terms of the Credit Agreement totaling $81,691,000 were available for future borrowings (subject to the $50,000,000 limitation described above) and issuance of letters of credit at December 31, 1993. The Company pays an annual commitment fee on the unused portion of the credit line. Effective December 1, 1993, the Company entered into a Purchase Money Lien (Money Lien) for the financing of certain service station and terminal equipment and office furnishings. The effective rate for the Money Lien is 6.65%. Ninety percent of the principal is repayable in 60 monthly installments and a balloon payment of 10% of the principal is payable in January 1999. The Money Lien is secured by the service station equipment and office furnishings having a cost basis of $5,472,000. The Money Lien allows for a maximum drawdown of $6,500,000 by January 31, 1994 and it is the Company's intention to draw the remaining balance. The following interest costs were charged to pretax income: Year Ended December 31 1993 1992 1991 ---------- ----------- --------- (thousands of dollars) Total interest costs incurred . . . . . $ 7,712 $7,754 $8,190 Less: Capitalized interest . . . . . . 261 928 282 -------- ------- ------- Interest Expense $ 7,451 $6,826 $7,908 ======= ====== ====== The approximate fair value of the Company's Long-term Debt at December 31, 1993 was $65,929,000, which was estimated using a discounted cash flow analysis, based on the Company's assumed incremental borrowing rates for similar types of borrowing arrangements. The fair value at December 31, 1993 of the Company's interest rate swap agreements is estimated to be $207,000 which was estimated using a discounted cash flow analysis, based on current interest rates. Note D--Income Taxes As discussed in Note A of Notes to Consolidated Financial Statements, effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). The 1991 financial statements have not been restated for the effects of applying SFAS 109. The $13,403,000 cumulative effect benefit of applying SFAS 109 reduced the net loss for 1992. One of the requirements of SFAS 109 is that deferred taxes be recorded for the tax effects of differences between assigned values and the tax bases of assets acquired in purchase business acquisitions. Previously, under the provisions of Accounting Principles Board Opinion No. 11 "Accounting for Income Taxes", acquired assets were recorded net of such tax effects. The adoption of SFAS 109 in 1992 resulted in total increases in inventory and net property, plant and equipment of $38 million relating to the acquisitions of the Fast Fare and Zippy Mart convenience store chains and La Gloria Oil and Gas Company, with related increases in the liability for deferred income taxes. The write-up of net property, plant and equipment is depreciated over the remaining life of the related assets and such depreciation is offset by a credit to the deferred tax provision. The adoption of SFAS 109 resulted in a decrease of $2,335,000 in the 1993 income before income taxes and cumulative effect of changes in accounting principles and an increase of $2,388,000 in the 1992 loss before income taxes and cumulative effect of changes in accounting principles, respectively, due to increased depreciation expense for the write- up of property, plant and equipment. Significant components of the Company's deferred tax liabilities and assets are as follows: December 31 1993 1992 -------- -------- (thousands of dollars) Deferred tax liabilities: Depreciation and amortization . . . . . . $ (58,095) $ (59,015) Difference between book and tax basis of property, plant and equipment . . . . . (30,945) (32,499) Other . . . . . . . . . . . . . . . . . . (16,768) (10,012) -------- -------- Total deferred tax liabilities . . . . (105,808) (101,526) Deferred tax assets: Postretirement and pension obligations . 5,596 4,672 Environmental, litigation and other accruals 9,734 6,982 Tax credits, contribution and net operating loss carryover 379 1,893 Construction and inventory cost not currently deductible 1,436 1,344 Other . . . . . . . . . . . . . . . . . . 7,446 5,047 --------- --------- Total deferred tax assets . . . . . . . 24,591 19,938 --------- --------- Net deferred tax liabilities . . . . . $(81,217) $(81,588) ======== ======== No valuation allowance is considered necessary for the above deferred tax assets. The company has tax credit carryforwards of $109,269 which expire in the year 2005. Significant components of the income tax provision (benefit) for the years ended December 31 follows. With the passage of the Tax Act of 1993, the Company's federal statutory income tax rate increased from 34% to 35% effective January 1, 1993. The effect of the change in statutory rate was to increase the 1993 net (loss) for 1993 by $2,252,000 or $.23 per share. Liability Deferred Method Method --------------- ------------ 1993 1992 1991 ------------------------------- (thousands of dollars) Current: Federal . . . . . . . . . . . . . $ 5,278 $(3,230) $(4,103) State . . . . . . . . . . . . . . 1,779 872 (462) -------- ------- ------- Total Current . . . . . . . . . 7,057 (2,358) (4,565) Deferred: Federal . . . . . . . . . . . . . (3,642) (1,485) 5,278 State . . . . . . . . . . . . . . (560) 166 (20) -------- ------- ------- Total Deferred . . . . . . . . (4,202) (1,319) 5,258 Federal tax rate increase . . . . . 2,252 -------- ------- ------- Income Tax Expense (Benefit) . . $ 5,107 $(3,677) $ 693 ======= ======= ======= Current state tax provision includes franchise taxes of $1,275,000, $1,300,000 and $1,146,000 for the years 1993, 1992 and 1991, respectively. The components of the deferred income tax provision for the year ended December 31, 1991 is as follows: (thousands of dollars) Refinery turnaround costs . . . . . . . . $ 4,789 Difference between book and tax depreciation and amortization 4,342 Gain on disposal . . . . . . . . . . . . 588 State income taxes . . . . . . . . . . . (20) Litigation and accruals . . . . . . . . . (66) Difference between book and tax basis of property disposals (478) Effect of tax leases . . . . . . . . . . (1,427) Unrealized insurance proceeds . . . . . . (1,540) Other . . . . . . . . . . . . . . . . . . (930) ------- Deferred income tax provision . . . . . $ 5,258 ======= The following is a reconciliation of the statutory federal income tax rate to the actual effective income tax rate for the years ended December 31: Liability Deferred Method Method --------------- ------------ 1993 1992 1991 ------------------------------- (thousands of dollars) Income tax expense (benefit) calculated at the statutory federal income tax rate $ 282 $(5,765) $(1,813) Amortization of goodwill and purchase adjustments 330 321 1,927 State taxes (net of federal benefit) 798 685 291 Federal tax rate increase . . . . . 2,252 Other . . . . . . . . . . . . . . . 1,445 1,082 288 ------- ------- ------- Income Tax Expense (Benefit) . . $ 5,107 $(3,677) $ 693 ======= ======= ======= Note E--Capital Stock and Net Income Per Common Share Class A Common stockholders are entitled to one vote per share and have the right to elect all directors other than those to be elected by other classes of stock. Class B Common stockholders are entitled to one-tenth vote per share and have the right to elect two directors. Net (loss) per share for 1993, 1992 and 1991 is based upon the 9,832,598 common shares outstanding for all years. Note F--Employee Benefit Obligations In 1993, the Company merged its two defined benefit pension plans covering the majority of full-time employees into one plan. The Company also has several defined benefit plans covering only certain senior executives. Plan benefits are generally based on years of service and employees' average compensation. The Company's policy is to fund the pension plans in amounts which comply with contribution limits imposed by law. Plan assets consist principally of fixed income securities and stocks. Net periodic pension costs consisted of the following components: Year Ended December 31 1993 1992 1991 ---------- ----------- --------- (thousands of dollars) Service cost - benefit earned during the year $ 4,002 $ 3,672 $ 3,221 Interest cost on projected benefit obligations 6,326 5,895 5,595 Actual (return) loss on plan assets (11,738) (10,217) (10,626) Total amortization and deferral . . 5,324 4,875 6,376 -------- --------- ------ Net periodic pension costs . . . $ 3,914 $ 4,225 $ 4,566 ======== ======== ======= Assumptions used in the accounting for the defined benefit plans as of December 31 were: 1993 1992 1991 ----------------------- Weighted average discount rates . . 7.25% 8.25% 8.25% Rates of increase in compensation levels 4.00% 5.00% 5.00% Expected long-term rate of return on assets 9.50% 9.50% 9.50% The following table sets forth the funded status of the plans in which assets exceed accumulated benefits: December 31 1993 1992 -------- -------- (thousands of dollars) Actuarial present value of benefit obligations: Vested benefit obligation . . . . $68,817 $58,064 ------- ------- Accumulated benefit obligation . $71,552 $60,226 ------- ------- Projected benefit obligation . . $86,728 $73,863 Plan assets at fair value . . . . . 78,573 69,081 ------- ------- Projected benefit obligation (in excess of) plan assets (8,155) (4,782) Unrecognized net loss . . . . . . . 9,532 2,872 Prior service (benefit) cost not yet recognized in net periodic pension cost . . (1,081) 2,132 Unrecognized net (asset) at beginning of year, net of amortization (2,495) (2,762) ------- ------- Net pension liability . . . . . . . $(2,199) $(2,540) ======= ======= The following table sets forth the funded status of the plans in which accumulated benefits exceed assets: December 31 1993 1992 -------- -------- (thousands of dollars) Actuarial present value of benefit obligations: Vested benefit obligation . . . . $ 5,339 $ 4,146 ------- ------- Accumulated benefit obligation . $ 5,339 $ 4,154 ------- ------- Projected benefit obligation . . $ 5,376 $ 4,300 Plan assets at fair value . . . . . 0 0 -------- -------- Projected benefit obligation (in excess of) plan assets (5,376) (4,300) Unrecognized net loss . . . . . . . 1,224 335 Prior service (benefit) cost not yet recognized in net periodic pension cost . . (231) (248) Unrecognized net obligation at beginning of year, net of amortization 1,834 2,064 Adjustment required to recognize minimum liability (2,790) (2,004) ------- ------- Net pension liability . . . . . . . $(5,339) $(4,153) ======= ======= In addition to the defined benefit pension plan, the Company provides certain health care and life insurance benefits for eligible employees who retire from active service. The postretirement health care plan is contributory, with retiree contributions consisting of copayment of premiums and other cost sharing features such as deductibles and coinsurance. Beginning in 1998, the Company will "cap" the amount of premiums that it will contribute to the medical plans. Should costs exceed this cap, retiree premiums would increase to cover the additional cost. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106 "Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). SFAS 106 requires the accrual of the expected costs of providing these postretirement benefits during the years that the employee renders the necessary service. Prior year financial statements have not been restated for the effects of applying SFAS 106. The $5,631,000 cumulative effect charge of adoption of SFAS 106 on prior years (after reduction for the income tax benefit of $3,308,000) is included in the net loss for 1992. The adoption of SFAS 106 resulted in increases in the 1993 and 1992 loss before cumulative effect of changes in accounting principles of $167,000 ($.02 per share) and $300,000 ($.03 per share), respectively, and increases in the 1993 and 1992 net loss of $167,000 ($.02 per share) and $5,931,000 ($.60 per share), respectively. The following table sets forth the accrued postretirement benefit cost of these plans recognized in the Company's Balance Sheet: December 31 1993 1992 -------- -------- (thousands of dollars) Accumulated postretirement benefit obligation (APBO): Retirees . . . . . . . . . . . . $5,491 $6,076 Fully eligible active plan participants 1,460 1,419 Other active plan participants . 2,186 1,836 Unrecognized net loss (gain) . . 4 (109) Unrecognized prior service cost . 353 -------- ------- Accrued postretirement benefit cost $9,494 $9,222 ====== ====== The weighted average discount rate used in determining the APBO was 7.25% and 8.5% in 1993 and 1992, respectively. Net periodic postretirement benefit cost include the following components: Year Ended December 31 1993 1992 -------- -------- (thousands of dollars) Service cost . . . . . . . . . . . $161 $161 Interest cost on accumulated postretirement benefit obligation 765 756 ---- ---- Net periodic postretirement benefit cost $926 $917 ==== ==== For 1991, the expense for postretirement benefits, which was recorded on a pay- as-you-go basis and has not been restated, was approximately $631,000. The Company's policy is to fund postretirement costs on a pay-as-you-go basis as in prior years. A 13% increase in the cost of medical care was assumed for 1993. This medical trend rate is assumed to decrease 1% annually to 9% in 1997, and decrease to 0% thereafter as a result of the expense cap in 1998. The medical trend rate assumption affects the amounts reported. For example, a 1% increase in the medical trend rate would increase the APBO by $674,000, and the net periodic cost by $72,000 for 1993. In 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits" (SFAS 112). SFAS 112 requires the accrual of the expected costs of providing certain benefits after employment, but before retirement, such as health care continuation coverage. The adoption of SFAS 112 did not materially affect the 1993 net loss. Note G--Litigation and Contingencies The Company has been named as a defendant in various matters of litigation, some of which are for substantial amounts, and involve alleged personal injury and property damage from prolonged exposure to petroleum, petroleum related products and substances used at its refinery or in the petroleum refining process. The Company is a co-defendant with numerous other defendants in a number of these suits. The Company is vigorously defending these actions, however, the process of resolving these matters could take several years. The liability, if any, associated with these cases was either accrued in accordance with generally accepted accounting principles or was not determinable at December 31, 1993. The Company has consulted with counsel with respect to each such preceding or large claim which is pending or threatened. While litigation can contain a high degree of uncertainty and the risk of an unfavorable outcome, in the opinion of management, there is no reasonable basis to believe that the eventual outcome of any such matter or group of related matters will have a material adverse effect on the Company's consolidated financial position. The Company's income tax returns for the 1988 and 1989 fiscal years are currently under examination by the Internal Revenue Service. The Company's income tax returns for the 1984 to 1987 fiscal years have been examined by the Internal Revenue Service and a Revenue Agent's Report has been received. The Company has filed a written protest in response to certain proposed adjustments with the Office of Regional Director of Appeals relating to these proposed adjustments. In management's opinion, the ultimate disposition of the Report will not have a material adverse effect on the financial position or results of operations of the Company. Like other petroleum refiners and marketers, the Company's operations are subject to extensive and rapidly changing federal and state environmental regulations governing air emissions, waste water discharges, and solid and hazardous waste management activities. The Company's policy is to accrue environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and the amount can be reasonably estimated. While it is often extremely difficult to reasonably quantify future environmental related expenditures,the Company anticipates that a substantial capital investment will be required over the next several years to comply with existing regulations. The Company had recorded a liability of approximately $16.8 million as of December 31, 1993 relative to the estimated costs of compliance with environmental regulations. Environmental liabilities are subject to considerable uncertainties which affect the Company's ability to estimate its ultimate cost of remediation efforts. These uncertainties include the exact nature and extent of the contamination at each site, the extent of required cleanup efforts, varying costs of alternative remediation strategies, changes in environmental remediation requirements, the number and financial strength of other potentially responsible parties at multi-party sites, and the identification of new environmental sites. As a result, charges to income for environmental liabilities could have a material effect on results of operations in a particular quarter or year as assessments and remediation efforts proceed or as new claims arise. However, management is not aware of any matters which would be expected to have a material adverse effect on the Company's consolidated financial position, cash flow or liquidity. Note H--Noncancellable Lease Commitments The Company has noncancellable operating lease commitments for refinery equipment, service station and convenience store properties, autos, trucks, an airplane, office and other equipment. Lease terms range from 60 to 96 months for automotive and transportation equipment. Property leases typically have a five-year term with renewal options for additional periods. Certain other leases also carry renewal provisions. The Corporate Headquarters office building lease which commenced in 1993 has a lease term of 10 years. The airplane lease which commenced in 1992 has a lease term of 7 years. The majority of service station properties have a lease term of 20 years. The average lease term of convenience stores is approximately 12 years. Future minimum rental payments under noncancellable operating lease agreements as of December 31, 1993 are as follows (in thousands): 1994 . . . . . . . . . . . . . . $10,799 1995 . . . . . . . . . . . . . . 9,835 1996 . . . . . . . . . . . . . . 9,547 1997 . . . . . . . . . . . . . . 8,407 1998 . . . . . . . . . . . . . . 8,062 After 1998 . . . . . . . . . . . 48,644 ------- Total Minimum Rental Payments $95,294 ======= Rental expense for the years ended December 31, 1993, 1992 and 1991 was $14,620,000, $16,487,000 and $16,438,000, respectively. Note I--Investments and Deferred Charges Investments and deferred charges consist of the following: December 31 1993 1992 -------- -------- (thousands of dollars) Deferred turnarounds . . . . . . $15,844 $24,454 Goodwill . . . . . . . . . . . . 10,883 11,859 Investments in subsidiaries . . 6,601 5,976 Long-term notes receivable . . . 2,969 3,136 Intangible pension asset . . . . 1,834 2,004 Deferred financing costs . . . . 1,121 1,324 Deferred proceeds - tax exchanges 1,067 2,428 Other . . . . . . . . . . . . . 2,589 2,435 -------- -------- Investments and Deferred Charges $42,908 $53,616 ======= ======= Accumulated amortization of goodwill was $5,974,000 and $4,998,000 at December 31, 1993 and 1992, respectively. The fair value of the Company's long-term notes receivable at December 31, 1993 was $2,913,000, which was estimated using a discounted cash flow analysis, based on the assumed interest rates for similar types of arrangements. Note J--Non-Operating Gains Non-operating gains in 1991 consist of litigation and insurance settlements. There were no material net non-operating gains or losses which impacted income in 1993 and 1992. REPORT OF INDEPENDENT AUDITORS To the Stockholders Crown Central Petroleum Corporation We have audited the accompanying consolidated balance sheets of Crown Central Petroleum Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in common stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Crown Central Petroleum Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes D and F of the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. Ernst & Young Baltimore, Maryland February 24, 1994 (This page intentionally left blank) UNAUDITED QUARTERLY RESULTS OF OPERATIONS Crown Central Petroleum Corporation and Subsidiaries (thousands of dollars, except per share amounts) First Second Third Fourth Quarter Quarter Quarter Quarter Yearly ------- ------- ------- ------- ------ Sales and operating revenues $413,302 $447,777 $455,691 $430,641 $1,747,411 Gross profit . . . . . 26,623 33,799 33,977 48,316 142,715 Net (loss) income . . . (5,720) (2,266) (3,256) 6,942 (4,300) Net (loss) income per share (.58) (.23) (.33) .70 (.44) Sales and operating revenues $371,886 $458,546 $475,299 $489,528 $1,795,259 Gross profit . . . . 23,312 41,877 33,471 36,803 135,463 (Loss) income before cumulative effect of changes in accounting principles (6,570) 2,560 (3,754) (5,514) (13,278) Net income (loss) . . . . 1,202 2,560 (3,754) (5,514) (5,506) (Loss) income per share before cumulative effect of changes in accounting principles (.67) .26 (.38) (.56) (1.35) Net income (loss) per share .12 .26 (.38) (.56) (.56) Gross profit is defined as sales and operating revenues less costs and operating expenses (including applicable property and other operating taxes). Per share amounts are based upon the actual number of common shares outstanding each quarter. The net (loss) in the fourth quarter of 1992 was unfavorably impacted by $1,406,000 due to reductions in physical inventory (see Note B of Notes to Consolidated Financial Statements on page 19 of this report). Net (loss) in the fourth quarter of 1992 was unfavorably impacted by a pre-tax $1,264,000 write-off of refinery feasibility studies, a pre-tax $1,000,000 reserve for the write-off of excess refinery equipment and a pre-tax $893,000 write-off of abandoned equipment related to the capital modification of the Houston refinery's Fluid Catalytic Cracking Unit. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company has not filed a Form 8-K within the last twenty-four (24) months reporting a change of independent auditors or any disagreement with the independent auditors. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Following is a list of Crown Central Petroleum Corporation's executive officers, their ages and their positions and offices as of March 1, 1994: Henry A. Rosenberg, Jr. (64) Director since 1955 and Chairman of the Board and Chief Executive Officer since May 1975. Also a director of Signet Banking Corporation and USF&G Corporation. Charles L. Dunlap (50) Director and President and Chief Operating Officer since December 1991. Served as a Director and Executive Vice President of Pacific Resources, Inc. from 1985 until employment by the Company. Edward L. Rosenberg (38) Senior Vice President - Finance and Administration since December 1991; Vice President - Supply & Transportation from October 1990 to December 1991; Vice President - Corporate Development from August 1989 to October 1990; Assistant to the President from March 1988 to August 1989. Edward L. Rosenberg is the son of Henry A. Rosenberg, Jr., and the brother of Frank B. Rosenberg. Thomas L. Owsley (53) Vice President - Legal since April 1983. John E. Wheeler, Jr. (41) Vice President - Treasurer and Controller since December 1991; Vice President - Controller from March 1984 to December 1991. Randall M. Trembly (47) Vice President - Refining since December 1991; Vice President-Treasurer from October 1987 to December 1991. Paul J. Ebner (36) Vice President - Marketing Support Services since December 1991; General Manager - Marketing Support Services from November 1988 to December 1991. J. Michael Mims (44) Vice President - Human Resources since June 1992. Vice President - Internal Auditing and Consulting Services from December 1991 to June 1992; Director of Internal Auditing from September 1983 to December 1991. George R. Sutherland, Jr. (49) Vice President - Supply and Transportation since July 1992. Senior Vice President - Trading of Pacific Resources, Inc. from 1989 until employment by the Company; Vice President - Crude Oil and Product Supply for Pacific Resources, Inc. from 1986 to 1989. Frank B. Rosenberg (35) Vice President - Marketing since January 1993; Southern Marketing Division Manager from January 1992 to January 1993; Vice President - Wholesale Marketing - - La Gloria Oil and Gas Company from October 1990 to January 1992; Manager - Economics, Planning and Scheduling from October 1989 to October 1990; Manager - Refinery Sales from November 1988 to October 1989. Frank B. Rosenberg is the son of Henry A. Rosenberg, Jr. and the brother of Edward L. Rosenberg. Dolores B. Rawlings (56) Secretary since November 1990; Assistant to the Chairman and Assistant Secretary from April 1988 to November 1990. There have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any Director or Executive Officer during the past five years. The information required in this Item 10 regarding Directors of the Company and all persons nominated or chosen to become directors is hereby incorporated by reference to the definitive Proxy Statement which will be filed with the Commission pursuant to Regulation 14A on or about March 23, 1994. Item 11. Item 11. EXECUTIVE COMPENSATION The information required in this Item 11 regarding executive compensation is hereby incorporated by reference to the definitive Proxy Statement which will be filed with the Commission pursuant to Regulation 14A on or about March 23, 1994. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required in this Item 12 regarding security ownership of certain beneficial owners and management is hereby incorporated by reference to the definitive Proxy Statement which will be filed with the Commission pursuant to Regulation 14A on or about March 23, 1994. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required in this Item 13 regarding certain relationships and related transactions is hereby incorporated by reference to the definitive Proxy Statement which will be filed with the Commission pursuant to Regulation 14A on or about March 23, 1994. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) LIST OF FINANCIAL STATEMENTS The following Consolidated Financial Statements of Crown Central Petroleum Corporation and subsidiaries, are included in Item 8 on pages 12 through 27 of this report: - Consolidated Statements of Operations -- Years ended December 31, 1993, 1992 and 1991 - Consolidated Balance Sheets -- December 31, 1993 and 1992 - Consolidated Statements of Changes in Common Stockholders' Equity -- Years ended December 31, 1993, 1992 and 1991 - Consolidated Statements of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 - Notes to Consolidated Financial Statements -- December 31, 1993 (a) (2) LIST OF FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules of Crown Central Petroleum Corporation and its subsidiaries are included in item 14 (d) on pages 33 through 36 of this report: - Schedule I - Marketable Securities - Other Investments - Schedule V - Property, Plant and Equipment - Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - Schedule X - Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) (3) and (c) LIST OF EXHIBITS EXHIBIT NUMBER 3 Articles of Incorporation and By-Laws (a) Agreement of Consolidation as amended through August 28, 1988 (Articles of Incorporation) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1992, herein incorporated by reference. (b) By-Laws of Crown Central Petroleum Corporation as currently in effect to reflect amendment dated February 25, 1988 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1987, herein incorporated by reference. 4 Instruments Defining the Rights of Security Holders, Including Indentures (a) Credit Agreement dated as of May 10, 1993 between the Registrant and various banks was previously filed with the Registrant's Form 8-K dated May 19, 1993, herein incorporated by reference. Certain portions of the Agreement have been omitted because of their confidential nature, and have been filed separately with the Securities and Exchange Commission marked "Confidential Treatment". (b) Amendment dated December 20, 1993 to the Credit Agreement dated as of May 10, 1993 is filed with the Securities and Exchange Commission as part of this Annual Report on Form 10-K. (c) Note Purchase Agreement dated January 3, 1991 between the Registrant and a group of institutional lenders was previously filed with the Registrants Form 8-K dated January 3, 1991, herein incorporated by reference. (d) Amendment dated as of February 14, 1992 to the Note Purchase Agreement dated January 3, 1991 was previously filed with the Registrants Form 10-K for the year ended December 31, 1991 as Exhibit 19 (c), herein incorporated by reference. Certain portions of the Amendment have been omitted because of their confidential nature, and have been filed separately with the Securities and Exchange Commission marked "Confidential Treatment". (e) Amendment dated as of November 10, 1992 to the Note Purchase Agreement dated January 3, 1991 was previously filed with the Registrants Form 10-Q for the quarter ended September 30, 1992 as Exhibit 19 (d), herein incorporated by reference. 10 Material Contracts (a) Crown Central Petroleum Retirement Plan effective as of July 1, 1993, is filed with the Securities and Exchange Commission as part of this Annual Report on Form 10-K. (b) Supplemental Retirement Income Plan for Senior Executives - As amended through October 27, 1983 and all subsequent amendments through May 30, 1991 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1992 as Exhibit 10 (a) (3), herein incorporated by reference. (c) Employee Savings Plan (as in effect on April 1, 1984), and all subsequent amendments through December 19, 1991 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1992 as Exhibit 10 (a) (4), herein incorporated by reference. (d) Directors' Deferred Compensation Plan adopted on August 25, 1983 was previously filed with the Registrant's Form 10-Q for the quarter ended September 30, 1983 as Exhibit 19(b), herein incorporated by reference. (e) The Long-Term Performance Reward Plan as in effect for the seventh performance cycle (1991/1992/1993) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1990, as Exhibit 19(d), herein incorporated by reference. (f) The Long-Term Performance Reward Plan as in effect for the eighth performance cycle (1992/1993/1994) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1991, as Exhibit 19(e), herein incorporated by reference. (g) The Long-Term Performance Reward Plan as in effect for the ninth performance cycle (1993/1994/1995) was previously filed with the Registrant's Form 10-Q for the quarter ended March 31, 1993, as Exhibit 19(a), herein incorporated by reference. (h) The following documents were previously filed with the Registrant's Form 10-Q for the quarter ended March 31, 1993, as Exhibits 19(b) and (c), herein incorporated by reference: (1) Crown Central Petroleum Corporation Annual Incentive Plan as in effect for fiscal 1993. (2) La Gloria Oil and Gas Company Annual Incentive Plan as in effect for fiscal 1993. (i) The Employment Agreement between Charles L. Dunlap, President and Crown Central Petroleum Corporation, dated October 29, 1991 was previously filed with the Registrant's Form 10-Q for the quarter ended September 30, 1991 as Exhibit 19(a), herein incorporated by reference. 13 Annual Report to Security Holders, Form 10-Q or Quarterly Report to Security Holders (a) Shareholders' Letter dated February 28, 1994. (b) Financial Summary, Operating Summary and Key Financial Statistics. (c) Directors and Officers of the Company. (d) Corporate Information. 21 Subsidiaries of the Registrant Exhibit 21 is included on page 37 of this report. 23 Consent of Independent Auditors 24 Power of Attorney Exhibit 24 is included on page 38 of this report. 99 Form 11-K will be filed under cover of Form 10-KA on or about May 15, 1994. (b) REPORTS ON FORM 8-K There were no reports filed on Form 8-K for the three months ended December 31, 1993. NOTE: Certain exhibits listed on pages 31 and 32 of this report and filed with the Securities and Exchange Commission, have been omitted. Copies of such exhibits may be obtained from the Company upon written request, for a prepaid fee of 25 cents per page. (This page intentionally left blank) Item 14(d) Crown Central Petroleum Corporation and consolidated subsidiaries Schedule I - Marketable Securities - Other Investments December 31, 1993 (thousands of dollars) Number of Market Amount shares or value of units - of each issue principal issue at carried amount of Cost of balance on Name of Issuer and bonds each sheet balance Title of each issue and notes issue date sheet(1) - ------------------- --------- ------- ------- ------- Repurchase Agreements(2) $30,254 $30,254 $30,254 $30,254 Eurodollar Time Deposits: The Yasuda Trust & Banking Co., LTD. 10,000 10,000 10,000 10,000 Commercial Paper: John Hancock Capital Corporation 7,498 7,498 7,498 7,498 ------- ------- ------- ------- $47,752 $47,752 $47,752 $47,752 ======= ======= ======= ======= (1) Cash in excess of daily requirements is invested in marketable securities with maturities of three months or less. Such investments are deemed to be cash equivalents for purposes of the statement of cash flows, and are classified on the balance sheet with cash and cash equivalents of $52,021. (2) Repurchase Agreements are comprised of securities of the United States Government and its agencies. Item 14(d) Crown Central Petroleum Corporation and consolidated subsidiaries Schedule V - Property, Plant and Equipment (thousands of dollars) Balance Other at changes- Balance beginning add at of Additions Retire- (deduct) end of Classification A period at cost ments describe period - -------------- --------- --------- ---------------- ------- Year Ended December 31, 1993 Land $ 45,251 $ 1,616 $ 2,411 $ (23) B $ 44,433 Petroleum refineries: Houston 297,643 5,392 780 302,255 Tyler 112,189 14,123 126,312 -------- --------- ------- -------- 409,832 19,515 780 428,567 Marketing facilities: Convenience stores 52,147 4,682 6,326 (317) C,D 50,186 Service stations and other 125,764 12,841 6,639 321 B,D 132,287 -------- ------- ------- ------- -------- 177,911 17,523 12,965 4 182,473 Pipelines and other equipment 19,247 2,206 539 18 D 20,932 -------- ------- ------- ------- -------- $652,241 $40,860 $16,695 $ (1) $676,405 ======== ======= ======= ======= ======== Year Ended December 31, 1992 Land $ 46,301 $ 1,631 $ 2,681 $ 45,251 Petroleum refineries: Houston 275,589 22,947 893 297,643 Tyler 72,743 3,276 $36,170 E,F 112,189 -------- -------- ------- ------- -------- 348,332 26,223 893 36,170 409,832 Marketing facilities: Convenience stores 58,642 4,873 13,341 1,973 C,D,E 52,147 Service stations and other 123,657 3,717 2,352 742 D 125,764 -------- ------- ------- ------- -------- 182,299 8,590 15,693 2,715 177,911 Pipelines and other equipment 18,390 1,559 654 (48) D,E,F 19,247 -------- ------- ------- ------- -------- $595,322 $38,003 $19,921 $38,837 $652,241 ======== ======= ======= ======= ======== Year Ended December 31, 1991 Land $ 36,737 $11,578 $ 2,014 $ 46,301 Petroleum refineries: Houston 264,892 24,281 13,218 $ (366) F 275,589 Tyler 70,795 2,027 79 72,743 -------- ------- ------- ------- -------- 335,687 26,308 13,297 (366) 348,332 Marketing facilities: Convenience stores 45,940 14,455 11,018 9,265 D,G 58,642 Service stations and other 114,889 11,346 2,484 (94) D 123,657 -------- ------- ------- ------- -------- 160,829 25,801 13,502 9,171 182,299 Pipelines and other equipment 17,714 1,095 681 262 D,F 18,390 -------- ------- ------- ------- -------- $550,967 $64,782 $29,494 $ 9,067 $595,322 ======== ======= ======= ======= ======== A Reference is made to Note A of the Consolidated Financial Statements in the 1993 Annual Report to Stockholders for a description of the accounting policies for property, plant and equipment. B Includes reclassification between Land' and Marketing facilities'. C Includes purchase accounting adjustments in connection with the acquisition of Fast Fare and Zippy Mart. D Includes assets transferred between Marketing facilities' and Pipelines and other equipment', as well as Convenience stores' and Service stations and other'. E Includes increases related to the step-up in basis of assets due to the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", as described in Note D of Notes to Consolidated Financial Statements on page 21 of this report. F Includes reclassification between Petroleum refineries' and Pipelines and other equipment'. G Includes purchase accounting adjustments of $9,047 in connection with the 1983 acquisition of Fast Fare and Zippy Mart. Item 14(d) Crown Central Petroleum Corporation and consolidated subsidiaries Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment (thousands of dollars) Balance Additions Other at charged changes- Balance beginning to add at of costs and Retire- (deduct) end of Classification period expenses ments describe period - -------------- --------- --------- ------- -------- -------- Year Ended December 31, 1993 Petroleum refineries: Houston $150,356 $11,075 $ 768 $160,663 Tyler 14,351 6,444 20,795 -------- ------- ------- -------- 164,707 17,519 768 181,458 Marketing facilities: Convenience stores 25,703 3,294 5,096 $ 175 A,B 24,076 Service stations and other 72,120 8,097 6,098 (175) A 73,944 -------- ------- ------- ------ -------- 97,823 11,391 11,194 0 98,020 Pipelines and other equipment 13,961 1,154 456 5 A 14,664 -------- ------- ------- ------ -------- $276,491 $30,064 $12,418 $ 5 $294,142 ======== ======= ======= ====== ======== Year Ended December 31, 1992 Petroleum refineries: Houston $141,751 $ 9,002 $ 397 $150,356 Tyler 8,131 6,186 $ 34 C 14,351 -------- ------- ------- ------ -------- 149,882 15,188 397 34 164,707 Marketing facilities: Convenience stores 30,842 3,718 10,594 1,737 A,B 25,703 Service stations and other 65,599 7,742 1,719 498 A 72,120 -------- ------- ------- ------ -------- 96,441 11,460 12,313 2,235 97,823 Pipelines and other equipment 13,344 1,150 490 (43) A,C 13,961 -------- ------- ------- ------ -------- $259,667 $27,798 $13,200 $2,226 $276,491 ======== ======= ======= ====== ======== Year Ended December 31, 1991 Petroleum refineries: Houston $146,697 $ 8,437 $13,193 $ (190) C $141,751 Tyler 4,380 3,807 56 8,131 -------- ------- ------- ------ -------- 151,077 12,244 13,249 (190) 149,882 Marketing facilities: Convenience stores 27,247 3,561 8,964 8,998 A,D 30,842 Service stations and other 59,876 7,641 2,052 134 A 65,599 -------- ------- ------- ------ -------- 87,123 11,202 11,016 9,132 96,441 Pipelines and other equipment 12,599 1,135 557 167 A,C 13,344 -------- ------- ------- ------ -------- $250,799 $24,581 $24,822 $9,109 $259,667 ======== ======= ======= ====== ======== A Includes assets transferred between Marketing facilities' and Pipelines and other equipment', as well as Convenience stores' and Service stations and other'. B Includes purchase accounting adjustments in connection with the acquisition of Fast Fare and Zippy Mart. C Includes reclassification between Petroleum refineries' and Pipelines and other equipment'. D Includes purchase accounting adjustments of $9,047 in connection with the acquisition of Fast Fare and Zippy Mart. Item 14(d) Crown Central Petroleum Corporation and consolidated subsidiaries Schedule X - Supplementary Income Statement Information (thousands of dollars) Charged to Costs and Expenses Year ended December 31 ------------------------------- Item 1993 1992 1991 - ---- ------- -------------- 1. Maintenance and repairs $27,257 $32,322 $33,877 2. Depreciation and amortization (A) 41,873 41,526 33,346 (A) Includes Refinery Maintenance Turnaround Amortization Note: None of the other items called for on this statement exceed 1% of total sales and operating revenues as reported in the related income statements for any year. EXHIBIT 21 SUBSIDIARIES 1. Subsidiaries as of December 31, 1993, which are consolidated in the financial statements of the Registrant; each subsidiary is 100% owned and doing business under its own name. Nation or State Subsidiary of Incorporation Continental American Corporation Delaware Coronet Security Systems, Inc. Delaware Coronet Software, Inc. Delaware Crown Central Holding Corporation Maryland Crown Central International (U.K.), Limited United Kingdom Crown Central Pipe Line Company Texas Crown Gold, Inc. Maryland Crown Nigeria, Inc. Maryland Crown-Rancho Pipe Line Corporation Texas Crown Stations, Inc. Maryland Crowncen International N.V. Netherlands Antilles Fast Fare, Inc. Delaware F Z Corporation Maryland La Gloria Oil and Gas Company Delaware Locot, Inc. Maryland McMurrey Pipe Line Company Texas The Crown Oil and Gas Company Maryland 2. Subsidiaries as of December 31, 1993, which are included in the Consolidated Financial Statements of the Registrant on an equity basis; each subsidiary is 100% owned and doing business under its own name. Nation or State Subsidiary of Incorporation Tiara Insurance Company Vermont Tongue Brooks (Bermuda, Ltd.) Bermuda Tongue, Brooks & Company, Inc. Maryland Health Plan Administrators, Inc. Maryland EXHIBIT 24 POWER OF ATTORNEY We, the undersigned officers and directors of Crown Central Petroleum Corporation hereby severally constitute Henry A. Rosenberg, Jr., Charles L. Dunlap, Edward L. Rosenberg, John E. Wheeler, Jr. and Thomas L. Owsley, and each of them singly, our true and lawful attorneys with full power to them and each of them to sign for us in our names and in the capacities indicated below this Report on Form 10-K for the fiscal year ended December 31, 1993 pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934 and all amendments thereto. Signature Title Date - --------- ----- ----- Henry A. Rosenberg, Jr. Chairman of the Board and 2/24/94 Henry A. Rosenberg, Jr. Chief Executive Officer (Principal Executive Officer) C. L. Dunlap Director, President and 2/24/94 Charles L. Dunlap Chief Operating Officer Jack Africk Director 2/24/94 Jack Africk George L. Bunting, Jr. Director 2/24/94 George L. Bunting, Jr. Michael F. Dacey Director 2/24/94 Michael F. Dacey Robert M. Freeman Director 2/24/94 Robert M. Freeman Thomas M. Gibbons Director 2/24/94 Thomas M. Gibbons Patricia A. Goldman Director 2/28/94 Patricia A. Goldman William L. Jews Director 2/28/94 William L. Jews Malcolm McNair Director 2/24/94 Malcolm McNair Phillip W. Taff Director 2/24/94 Phillip W. Taff Bailey A. Thomas Director 2/24/94 Bailey A. Thomas Edward L. Rosenberg Senior Vice President-Finance 2/24/94 Edward L. Rosenberg and Administration (Principal Financial Officer) John E. Wheeler, Jr. Vice President - Treasurer and 2/24/94 John E. Wheeler, Jr. Controller (Principal Accounting Officer) SIGNATURES Pursuant to the requirements of Section 13 or 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. CROWN CENTRAL PETROLEUM CORPORATION By * -------------------------------- Henry A. Rosenberg, Jr. Chairman of the Board and Chief Executive Officer By * -------------------------------- Edward L. Rosenberg Senior Vice President - Finance and Administration By John E. Wheeler, Jr. -------------------------------- John E. Wheeler, Jr. Vice President - Treasurer and Controller Date: March 2, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 2, 1994 by the following persons on behalf of the registrant and in the capacities indicated: * * - ------------------------------------- ---------------------------------- Jack Africk, Director Patricia A. Goldman, Director * * - ------------------------------------- ---------------------------------- George L. Bunting, Jr., Director William L. Jews, Director * * - ------------------------------------- ---------------------------------- Michael F. Dacey, Director Malcolm McNair, Director * * - ------------------------------------- ---------------------------------- Charles L. Dunlap, Director Henry A. Rosenberg, Jr. Director President and Chief Operating Officer Chairman of the Board and Chief Executive Officer * * - ------------------------------------- ---------------------------------- Robert M. Freeman, Director Phillip W. Taff, Director * * - ------------------------------------- ---------------------------------- Thomas M. Gibbons, Director Bailey A. Thomas, Director *By Power of Attorney (John E. Wheeler, Jr.) EXHIBIT INDEX ------------- EXHIBIT - ------- 3 Articles of Incorporation and By-Laws (a) Agreement of Consolidation as amended through August 28, 1988 (Articles of Incorporation) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1992, herein incorporated by reference. (b) By-Laws of Crown Central Petroleum Corporation as currently in effect to reflect amendment dated February 25, 1988 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1987, herein incorporated by reference. 4 Instruments Defining the Rights of Security Holders, Including Indentures (a) Credit Agreement dated as of May 10, 1993 between the Registrant and various banks was previously filed with the Registrant's Form 8-K dated May 19, 1993, herein incorporated by reference. Certain portions of the Agreement have been omitted because of their confidential nature, and have been filed separately with the Securities and Exchange Commission marked "Confidential Treatment". (b) Amendment dated December 20, 1993 to the Credit Agreement dated as of May 10, 1993 is filed with the Securities and Exchange Commission as part of this Annual Report on Form 10-K. (c) Note Purchase Agreement dated January 3, 1991 between the Registrant and a group of institutional lenders was previously filed with the Registrants Form 8-K dated January 3, 1991, herein incorporated by reference. (d) Amendment dated as of February 14, 1992 to the Note Purchase Agreement dated January 3, 1991 was previously filed with the Registrants Form 10-K for the year ended December 31, 1991 as Exhibit 19 (c), herein incorporated by reference. Certain portions of the Amendment have been omitted because of their confidential nature, and have been filed separately with the Securities and Exchange Commission marked "Confidential Treatment". (e) Amendment dated as of November 10, 1992 to the Note Purchase Agreement dated January 3, 1991 was previously filed with the Registrants Form 10-Q for the quarter ended September 30, 1992 as Exhibit 19 (d), herein incorporated by reference. 10 Material Contracts (a) Crown Central Petroleum Retirement Plan effective as of July 1, 1993, is filed with the Securities and Exchange Commission as part of this Annual Report on Form 10-K. (b) Supplemental Retirement Income Plan for Senior Executives - As amended through October 27, 1983 and all subsequent amendments through May 30, 1991 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1992 as Exhibit 10 (a) (3), herein incorporated by reference. (c) Employee Savings Plan (as in effect on April 1, 1984), and all subsequent amendments through December 19, 1991 were previously filed with the Registrant's Form 10-K for the year ended December 31, 1992 as Exhibit 10 (a) (4), herein incorporated by reference. (d) Directors' Deferred Compensation Plan adopted on August 25, 1983 was previously filed with the Registrant's Form 10-Q for the quarter ended September 30, 1983 as Exhibit 19(b), herein incorporated by reference. (e) The Long-Term Performance Reward Plan as in effect for the seventh performance cycle (1991/1992/1993) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1990, as Exhibit 19(d), herein incorporated by reference. (f) The Long-Term Performance Reward Plan as in effect for the eighth performance cycle (1992/1993/1994) was previously filed with the Registrant's Form 10-K for the year ended December 31, 1991, as Exhibit 19(e), herein incorporated by reference. (g) The Long-Term Performance Reward Plan as in effect for the ninth performance cycle (1993/1994/1995) was previously filed with the Registrant's Form 10-Q for the quarter ended March 31, 1993, as Exhibit 19(a), herein incorporated by reference. (h) The following documents were previously filed with the Registrant's Form 10-Q for the quarter ended March 31, 1993, as Exhibits 19(b) and (c), herein incorporated by reference: (1) Crown Central Petroleum Corporation Annual Incentive Plan as in effect for fiscal 1993. (2) La Gloria Oil and Gas Company Annual Incentive Plan as in effect for fiscal 1993. (i) The Employment Agreement between Charles L. Dunlap, President and Crown Central Petroleum Corporation, dated October 29, 1991 was previously filed with the Registrant's Form 10-Q for the quarter ended September 30, 1991 as Exhibit 19(a), herein incorporated by reference. 13 Annual Report to Security Holders, Form 10-Q or Quarterly Report to Security Holders (a) Shareholders' Letter dated February 28, 1994. (b) Financial Summary, Operating Summary and Key Financial Statistics. (c) Directors and Officers of the Company. (d) Corporate Information. 21 Subsidiaries of the Registrant Exhibit 21 is included on page 37 of this report. 23 Consent of Independent Auditors 24 Power of Attorney Exhibit 24 is included on page 38 of this report. 99 Form 11-K will be filed under cover of Form 10-KA on or about May 15, 1994. (b) REPORTS ON FORM 8-K There were no reports filed on Form 8-K for the three months ended December 31, 1993.	17,580	111,879
89415_1993.txt	89415_1993	1993	89415	Item 1. Business. The Company, incorporated in Delaware in January 1969, and its subsidiaries provide computer-based information processing systems and associated services to the healthcare industry in North America and Europe. The Company's products are offered to hospitals of all types (urban, teaching, suburban, rural, specialty), proprietary hospital companies, and not-for-profit multihospital groups. The Company's products are also offered to healthcare organizations such as clinics, physician group practices, medical schools, public health departments and home healthcare organizations. These products include a full range of financial, patient management, clinical, and decision support software systems that use diverse computing and networking technologies, ranging from remote processing, to distributed processing systems, to onsite turnkey systems. The Company also provides professional services related to its information processing systems business, such as system installation, support, and education. Domestically, the Company markets its products and provides installation services and ongoing technical and educational support with a field staff working out of branch offices. At its Corporate Headquarters and Information Systems Center, the Company has a customer service staff, applications specialists, and communications and computer operations personnel who assist customers in their day-to-day use of the Company's products; and system designers and programmers who work to improve existing programs and develop additional data processing products. In Europe, the Company markets, installs, and supports its products through local offices in seven countries. The Company's primary markets are acute-care (short-stay) hospitals, generally with 100 or more beds, multientity healthcare corporations, physician groups, and other healthcare providers. In the United States, which has historically been the Company's most significant market, the Company currently has contracts with hospitals in 47 states, the District of Columbia and Puerto Rico. In 1981, the Company entered the healthcare information processing systems and services market in Europe. The Company currently has hospital contracts in the United Kingdom, Ireland, Holland, Germany, Spain, France, Italy, and Portugal. The Company is also currently negotiating customer contracts in three additional countries in Europe. For financial information by geographic area, refer to page 30 of the Company's 1993 Annual Report to Stockholders, Notes to Consolidated Financial Statements, Business Segment Information (Note 9), which is incorporated herein by reference. Although the number of stand-alone acute-care hospital beds has declined slightly in recent years, the demand for integrated information systems in the healthcare industry has grown due to the emergence of multientity healthcare organizations, increases in information required by the government and private insurers, additional medical services provided by healthcare organizations, and the needs related to health maintenance organizations and preferred provider organizations. In addition, cost containment pressures on healthcare providers require more sophisticated levels of information systems and services. Services and Systems Offered ---------------------------- The principal healthcare information systems and related services offered by the Company are: Healthcare Information Systems - ------------------------------ . Financial Systems, which consist of a full range of financial functions that include patient accounting (including billing and receivables), accounting and financial management, materials management, personnel, and property. . Patient Management Systems, which assist in the administration of patient care through specialized programs for various hospital departments, such as admissions, outpatient, utilization review, and medical records. . Clinical Systems, which automate many labor-intensive tasks performed in the nursing, radiology, laboratory, pharmacy, and other departments in the hospital. These systems also facilitate communications among departments. . Decision Support Systems, which provide access to a range of strategic information collected from the clinical, financial, and patient management systems. . Physician Information Systems, which provide information processing and administrative support to physician groups, clinics, and medical schools with features such as scheduling, electronic claims processing, automated billing and rebilling, and online collections system. . Ambulatory Systems, which provide an integrated network that share clinical and financial information between healthcare providers in non- acute care settings. Healthcare Data Exchange Services - which facilitates the sharing and --------------------------------- standardization of information, such as eligibility verifications, claims and remittance transmissions, throughout the healthcare industry. Professional Services - These services consist of a variety of activities --------------------- related to the Company's healthcare information processing systems, such as systems installation and support, software and network customization, information system planning and integration, business office consulting, facilities management, and customer education. The Company's hospital information systems and related services operate on computer systems that range from personal computers to minicomputers to mainframes. These systems are offered on computers operating at the customer's site, at the Company's Information Systems Center (i.e. remotely), or as part of a distributed network. Distributed network systems generally process the financial applications at the Company's Information Systems Center, while the patient management and clinical applications operate on computers located at the customer's site or at the Company's Information Systems Center. These systems are also offered with networking features that enable multientity healthcare organizations to process information for affiliated hospitals, physician groups and clinics. The service and system fees earned by the Company for the years ended December 31, 1993, 1992, and 1991 were $452,797,000, $421,620,000, and $390,626,000, respectively. The hardware at the customer sites associated with these services and systems, can be sold or leased to the Company's customers. Hardware sales for the years ended December 31, 1993, 1992, and 1991 were $48,486,000, $48,004,000, and $48,079,000, respectively. Customers --------- The Company's services and systems are provided to customers under various contractual agreements. These agreements may be structured as fixed-period contracts with terms generally ranging from one to seven years (and in certain circumstances customer contracts can have terms up to ten years) or perpetual license contracts. Fixed-period agreements produce recurring revenues over the term of each contract, in contrast to perpetual license agreements, under which most revenues are recognized over a much shorter period, which can range from a few months to two years. No single customer or organization accounted for 10% or more of the Company's total revenues during 1993. Revenues from individual customers will vary, depending on the number and type of the Company's services and systems that are used. Because of the high fixed costs of the Company's operations, the loss of any customer under a fixed-period contract would have the effect of reducing the Company's net income by a greater percentage than the percentage of total revenues lost. Presently, no more than one quarter of the Company's fixed-period contracts expire in any future year. Although the Company strives to retain its customers, not all of the Company's past contracts have been renewed, and there can be no assurance that existing customers will either renew their contracts or convert to another type of system offered by the Company upon the expiration of their current contract. Competition ----------- The Company experiences intense competition in the healthcare information systems and services market. Virtually all hospitals with more than 100 beds use some form of computer-based information processing. The Company has competition from a number of firms, and its competitors vary in size, in geographical coverage, and in scope and breadth of products and services offered. The Company considers itself to be a major supplier of information processing systems and services to healthcare organizations. Some of its competitors are divisions of major corporations. These corporations are considerably larger, financially stronger, and more diversified than the Company. Competition among those providing information processing systems and services to hospitals, physician groups, and other healthcare providers is based upon the breadth and reliability of the systems and services provided and, to the extent that the services are comparable, upon price. Research and Development ------------------------ The Company is continually investigating the feasibility of enhancing existing systems and developing new systems to meet the information processing needs of healthcare organizations. Profitability of newly-developed systems and services depends upon attainment of sufficient sales volumes and continuing improvement and efficiency of the systems. In addition to developing its own computer software, the Company uses computer software from third parties. Some of the Company's development efforts are directed towards modification of this software to enable it to meet more fully the Company's specifications. The Company expenses all research and non-capitalized development costs, which are primarily the costs incurred to establish the technological feasibility of internally produced computer software. These expenses are primarily for computer costs and salaries of personnel. These expenses amounted to $37,087,000 in 1993, $33,703,000 in 1992, and $33,639,000 in 1991. The Company capitalizes the cost of certain internally produced computer software and purchased software. Capitalization for internally produced software begins when a project reaches technological feasibility and ceases when the software is available for general release to customers. Internally produced computer software costs, net of accumulated amortization, were $29,222,000 and $25,986,000 as of December 31, 1993 and 1992, respectively. Amortization related to internally produced software amounted to $5,464,000 in 1993, $4,894,000 in 1992, and $4,026,000 in 1991. Purchased software, net of accumulated amortization, was $4,325,000 and $3,498,000 as of December 31, 1993 and 1992, respectively. Computer software is amortized over its expected useful life, which is generally five years. Personnel --------- As of December 31, 1993, the Company had a total of 4,015 full-time employees. Item 2. Item 2. Properties. The Company purchased 116 acres of land in Chester County, Pennsylvania in 1978. The Company has constructed three buildings on this site, namely, an information systems center (81,000 square feet) which was put into service in 1979, and two office buildings with an aggregate of 431,000 square feet, the first of which was placed in service in 1981 and the second of which was placed in service in 1983. These office buildings serve as the Company's corporate headquarters. The Company also leases office space near the Company's corporate headquarters, which is utilized by certain corporate-based operations. These facilities are adequate for existing operations. In 1986, the Company purchased additional land (241 acres) in Chester County, Pennsylvania for possible future expansion. The Company leases office space in most major metropolitan areas in the United States for marketing, installation, and support personnel. The Company also leases office space in various locations for its European operations. In addition, the Company acquired in 1993 an office building in Spain for its local operations. As of December 31, 1993, the Company's Information Systems Center, which is used primarily to process customer information, contains one 5995-6650 AMDAHL processor, one IBM 9021-942 processor, and one IBM 9021-900 processor, all of which were obtained under operating leases. The Company's Information Systems Center also includes related mainframe peripherals, and data communications equipment that has been purchased or obtained under leases. These leases are generally contracted on a month-to-month basis or under fixed-period agreements, with terms that range from one to five years. Item 3. Item 3. Legal Proceedings. In October, 1991, the Securities and Exchange Commission (SEC) sued the Company and certain of its officers in the United States District Court for the Eastern District of Pennsylvania, alleging, among other things, that during 1986 and 1987 the Company and the officers made untrue and/or misleading statements of material fact and violated certain reporting requirements of the SEC. In February, 1994, the SEC dropped from its lawsuit all claims against the Company (and certain claims against the officers). The SEC's lawsuit now alleges only that Mr. R. James Macaleer sold shares of the Company's common stock (or caused the sale of shares of the Company's common stock) in 1986 while in possession of material non-public information. The Company continues to believe that this suit against Mr. Macaleer is without merit and that the outcome of the suit will not have a material effect on the Company's financial position. Also in February 1994, in order to settle claims concerning the Company's 1986 10-K and first quarter 1987 10-Q, the Company agreed to the entry of an administrative cease-and-desist order (in an administrative proceeding) requiring that it comply with the SEC's reporting requirements in all future filings. The SEC's claims concerned the failure of the Company to include in its 10-K and 10-Q filings information which was previously disclosed in a press release. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Executive Officers of the Registrant Listed below are the name, age as of December 31, 1993, position(s) with the Company and principal occupation(s) for the past five years of each of the executive officers of the Company. Positions with Company and Principal Name Age Occupation(s) - Past Five Years ------------------ --- ------------------------------------ R. James Macaleer 59 Chairman of the Board and Chief Executive Officer of the Company since 1969. Marvin S. Cadwell 50 Executive Vice President of the Company since October 1993. Prior to this, Mr. Cadwell served as Senior Vice President, Managing Director and Chief Operating Officer of the Company's SMS Europe operations since March 1992; and Vice President, Managing Director and Chief Operating Officer of the Company's SMS Europe operations, September 1986 - March 1992. James C. Kelly 54 Secretary of the Company since June 1990. Prior to this, Mr. Kelly served as Executive Vice President, Treasurer and Secretary of the Company, May 1985 - June 1990. Francis W. Lavelle 44 Senior Vice President of the Company since December 1993. Prior to this, Mr. Lavelle served as Vice President of New Business Development, January 1991 - December 1993; and National Sales and Installation Manager of the Company's Laboratory Division, September 1988 - December 1990. Positions with Company and Principal Name Age Occupation(s) - Past Five Years ------------------- --- ------------------------------------ Marion G. Tomlin 54 Senior Vice President and General Manager of the Company's Turnkey Systems Division since January 1991. Prior to this, Mr. Tomlin served as Senior Vice President of the Installation and Support group of the Company's Hospital Systems Division, February 1988 - January 1991. Michael B. Costello 50 Vice President of Administration and Corporate Communications of the Company since January 1991. Prior to this, Mr. Costello served as Vice President of Administration of the Company, February 1990 - January 1991; and Vice President of Administration and Human Resources of the Company, May 1986 - February 1990. Terrence W. Kyle 43 Vice President of Finance, Treasurer and Assistant Secretary of the Company since June 1990. Prior to this, Mr. Kyle served as Vice President of Finance of the Company, May 1985 - June 1990. Edward J. Grady 41 Controller and Assistant Treasurer of the Company since February 1993. Prior to this, Mr. Grady served as Controller of the Company, May 1985 - February 1993. Bonnie L. Shuman 45 General Counsel and Assistant Secretary of the Company since June 1990. Prior to this, Ms. Shuman served as General Counsel of the Company, September 1985 - June 1990. - -------------------------------------------------------------------------------- In calculating the aggregate market value of voting stock held by non- affiliates as shown on the cover page of this Form 10-K Report, the Company has included all of its directors, and only its directors, as affiliates of the Company. This is not an admission by the Company that any or all of its directors are in fact affiliates. The aggregate market value of voting stock held by non-affiliates was computed by using the average bid and asked prices of the stock as of February 28, 1994. Part II The following information contained in the Company's Annual Report to Stockholders for the year ended December 31, 1993 is incorporated herein by reference: Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Page 19, Table II Item 6. Item 6. Selected Financial Data. Page 14, Summary of Consolidated Operations - "Revenues", "Net Income", and "Net Income Per Share" columns and related footnotes Page 17, Summary of Consolidated Financial Position - "Total Assets" and "Long-Term Obligations" columns and related footnote Page 19, Table I, "Cash Dividends Declared - Per Share" column Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Pages 14, 15, 16, 17, and 18, Management's Discussion and Analysis of Financial Condition and Results of Operations Page 15, Analysis of Changes in Consolidated Expenses Item 8. Item 8. Financial Statements and Supplementary Data. Page 19, Table III Pages 20 through 30 Page 31, Report of Independent Public Accountants Page 19, Table I, "Cash Dividends Declared - Per Share" column Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. Part III The following information contained in the Company's definitive Proxy Statement mailed to stockholders on or about March 25, 1994 is incorporated herein by reference: Item 10. Item 10. Directors and Executive Officers of the Registrant. Pages 2 and 3, section titled "Directors and Management": "Name of Beneficial Owner", the section titled "Directors", and "Director Since" columns Page 12, section titled "Compliance With Section 16(a) of the Exchange Act" (For information concerning the Company's Executive Officers see pages 7 and 8 hereof, section titled "Executive Officers of the Registrant") Item 11. Item 11. Executive Compensation. Pages 4 and 5, section titled "Election of Directors": the subsection titled "Compensation of Directors" Pages 5 through 10, section titled "Executive Compensation": the subsections titled "Compensation Committee Interlocks and Insider Participation", and "Compensation Summaries" Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Pages 1 through 3, section titled "Security Ownership": subsections titled "Principal Stockholders" and "Directors and Management": "Name of Beneficial Owner", "Common Stock Beneficially Owned", and "Percent of Class" columns and related footnotes Item 13. Item 13. Certain Relationships and Related Transactions. Page 2, section titled "Directors and Management": "Name of Beneficial Owner" column with respect to Raymond K. Denworth, Jr. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as part of this report: 1. The consolidated financial statements included on pages 20 through 31 in the Company's Annual Report to Stockholders for the year ended December 31, 1993, have been incorporated by reference in Part II, Item 8, of this Form 10-K Report: . Consolidated Balance Sheet as of December 31, 1993 and 1992 (pages 20 and 21) . Consolidated Statement of Income for the years ended December 31, 1993, 1992, and 1991 (page 22) . Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992, and 1991 (page 23) . Consolidated Statement of Stockholders' Investment for the years ended December 31, 1993, 1992, and 1991 (page 24) . Notes to Consolidated Financial Statements for the years ended December 31, 1993, 1992, and 1991 (pages 25 through 30) . Report of Independent Public Accountants (page 31) 2. The financial statement schedules included on page 19, Table I and Table III, in the Company's Annual Report to Stockholders for the year ended December 31, 1993, have been incorporated by reference in Part II, Item 8 of this Form 10-K: . Operating Ratios "Cash Dividends Declared - Per Share" column for the years ended December 31, 1993, 1992, and 1991 . Selected Quarterly Financial Data for the years ended December 31, 1993 and 1992 The following Financial Statement Schedules required by Article 5 of Regulation S-X are included in this report: . Report of Independent Public Accountants on Schedules . Schedule I - Marketable Securities - Other Security Investments . Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties . Schedule V - Property and Equipment . Schedule VI - Accumulated Depreciation and Amortization - Property and Equipment . Schedule VIII - Valuation and Qualifying Accounts . Schedule IX - Short-Term Borrowings . Schedule X - Supplementary Income Statement Information . Schedules omitted - the following schedules are omitted since they are not required, or not applicable: III, IV, VII, XI, XII, XIII and XIV 3. The following exhibits are included in this report: No. Description ---- ------------------------------------------------------------ (3) Articles of Incorporation and By-Laws - Certificate of Amendment of Certificate of Incorporation dated June 19, 1992 (filed as Exhibit (4) to the Company's Form 10-Q Report for the quarter ended June 30, 1992), By-laws as amended through January 29, 1992 (filed as Exhibit (3) to the Company's Form 10-K Report for the year ended December 31, 1991) (10) Material Contracts - Deferred compensation agreements:** R. James Macaleer (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1990)* James C. Kelly Previously filed as indicated and incorporated herein by reference. May be deemed a management contract or compensatory arrangement. No. Description ---- --------------------------------------------------------------- Performance bonus plans - 1993:* R. James Macaleer (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Graham O. King (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Marvin S. Cadwell (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Insurance agreements:** Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1989)* Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Employment agreements:** Marvin S. Cadwell (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Previously filed as indicated and incorporated herein by reference. May be deemed a management contract or compensatory arrangement. No. Description ---- -------------------------------------------------------------- Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1989) Graham O. King (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1989)* Separation agreements:** Jack L. Ernsberger Graham O. King Stock Option Plans: 1987 Non-Qualified Stock Option Plan for Non-Employee Directors 1991 Non-Qualified Stock Option Plan for Non-Employee Directors (filed as Exhibit B to the Company's Proxy Statement for the Annual Meeting of Stockholders held on May 1, 1991)* (13) Annual Report to Stockholders for the year ended December 31, 1993*** (21) Subsidiaries of the Registrant (23) Consent of Independent Public Accountants (b) No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. Previously filed as indicated and incorporated herein by reference. May be deemed a management contract or compensatory arrangement. *With the exception of the material specifically incorporated by reference in Part II of this Form 10-K, the Annual Report to Stockholders for the year ended December 31, 1993 is not to be deemed "filed" as part of this Form 10-K. Signatures Pursuant to the requirements of Section 13 or 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. SHARED MEDICAL SYSTEMS CORPORATION By: /S/ R. James Macaleer Date: March 29, 1994 ----------------------------------- -------------------- R. James Macaleer - Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: /S/ R. James Macaleer Date: March 29, 1994 ----------------------------------- -------------------- R. James Macaleer - Chairman of the Board and Chief Executive Officer By: /S/ Raymond K. Denworth, Jr. Date: March 29, 1994 ----------------------------------- -------------------- Raymond K. Denworth, Jr. - Director By: /S/ Frederick W. DeTurk Date: March 29, 1994 ----------------------------------- -------------------- Frederick W. DeTurk - Director By: /S/ Josh S. Weston Date: March 29, 1994 ------------------------------------ -------------------- Josh S. Weston - Director By: Date: ----------------------------------- -------------------- Harvey J. Wilson - Director By: /S/ Jeffrey S. Rubin Date: March 29, 1994 ----------------------------------- -------------------- Jeffrey S. Rubin - Director By: /S/ Terrence W. Kyle Date: March 29, 1994 ----------------------------------- -------------------- Terrence W. Kyle - Vice President of Finance, Treasurer and Assistant Secretary By: /S/ Edward J. Grady Date: March 29, 1994 ----------------------------------- -------------------- Edward J. Grady Controller and Assistant Treasurer REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Shared Medical Systems Corporation: We have audited in accordance with generally accepted auditing standards, the financial statements included in Shared Medical Systems Corporation's 1993 Annual Report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 7, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Arthur Andersen & Co. Philadelphia, Pennsylvania February 7, 1994 SCHEDULE I SHARED MEDICAL SYSTEMS CORPORATION MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 ----------------------------------------- (1) The amounts shown represent the amount included in the Company's consolidated balance sheet. SCHEDULE II (1) This amount represents a non-interest bearing, six year term loan to Marvin S. Cadwell which is secured by a mortgage on a principal residence. (2) This amount represents an unsecured, non-interest bearing receivable from Frederick L. Morefield which was due in installments through April 30, 1992. SCHEDULE V PAGE 2 OF 2 SHARED MEDICAL SYSTEMS CORPORATION PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 ----------------------------------------------------- FOOTNOTES: - --------- (1) Additions during 1993 are primarily for an office building for the Company's Spanish operations. Also included are improvements associated with the Corporate Headquarters and Information Systems Center building. Building additions during 1992 and 1991 are primarily for improvements associated with the Corporate Headquarters and Information Systems Center building. (2) During 1993, 1992, and 1991 the Company purchased minicomputers and terminals, most of which are leased to the Company's customers, at a total cost of $3,259,000, $3,562,000, and $8,088,000, respectively. The Company also acquired computer equipment for internal use, primarily in its Information Systems Center, at a total cost of $16,753,000 in 1993, $9,481,000 in 1992, and $8,880,000 in 1991. For 1993, 1992, and 1991, equipment additions referred to above include $7,089,000, $2,196,000, and $1,421,000, respectively, of equipment acquired under capital leases. The remaining additions were primarily for office equipment and data communications equipment for data transmission. (3) The amount included in Other Changes represents the effect of translation adjustments primarily for European property and equipment during 1993, 1992, and 1991. Property and Equipment Depreciation and Amortization Methods - ------------------------------------------------------------ Depreciation and amortization are provided using the straight-line method over the estimated useful lives. Depreciable lives for equipment range from two to fifteen years. Leased property under capital leases is depreciated over the initial term of the lease. The Company's buildings, not including equipment therein, are being depreciated using a 45-year life. SCHEDULE VI SHARED MEDICAL SYSTEMS CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION-PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 ---------------------------------------------------------------- (1) The amount included in Other Changes represents the effect of translation adjustments primarily for European accumulated depreciation for property and equipment during 1993, 1992, and 1991. SCHEDULE VIII SHARED MEDICAL SYSTEMS CORPORATION VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 ----------------------------------------------------- (1) Write-offs of uncollectible accounts. (2) Write-offs of fully-amortized computer software. SCHEDULE IX SHARED MEDICAL SYSTEMS CORPORATION SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 ----------------------------------------------------- Amounts borrowed under these lines of credit were primarily used to partially fund certain of the Company's European and domestic operations. (1) The weighted average interest rate during the period was calculated by dividing the annual interest expense by the related average amount outstanding during the period. SCHEDULE X SHARED MEDICAL SYSTEMS CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 ----------------------------------------------------- No amounts have been reflected for depreciation and amortization of preoperating costs and similar deferrals, taxes other than payroll and income taxes, royalties, or advertising costs, because there were none or the amounts were less than one percent of revenue during these years. Exhibit Index Sequential page where Exhibit No. Description can be found ---- --------------------------------------------- --------------- (3) Articles of Incorporation and By-Laws - Certificate of Amendment of Certificate of Incorporation dated June 19, 1992 (filed as Exhibit (4) to the Company's Form 10-Q Report for the quarter ended June 30, 1992), By-laws as amended through January 29, 1992 (filed as Exhibit (3) to the Company's Form 10-K Report for the year ended December 31, 1991)* (10) Material Contracts - Deferred compensation agreements:** R. James Macaleer (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1990)* James C. Kelly Page 28 Performance bonus plans - 1993:** R. James Macaleer (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Graham O. King (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Marvin S. Cadwell (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992)* Previously filed as indicated and incorporated herein by reference on sequentially numbered pages 12 through 14. May be deemed a management contract or compensatory arrangement. Sequential page where Exhibit No. Description can be found ---- --------------------------------------------- --------------- Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1992) Insurance agreements:** Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1989)* Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Employment agreements:** Marvin S. Cadwell (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Marion G. Tomlin (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Jack L. Ernsberger (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Graham O. King (filed as Exhibit (10) to the Company's Form 10-K Report for the year ended December 31, 1991)* Separation Agreements:** Jack L. Ernsberger Page 30 Graham O. King Page 34 Stock Option Plans: 1987 Non-Qualified Stock Option Plan for Non-Employee Directors Page 39 1991 Non-Qualified Stock Option Plan for Non-Employee Directors (filed as Exhibit B to the Company's Proxy Statement for the Annual Meeting of Stockholders held on May 1, 1991)* Previously filed as indicated and incorporated herein by reference on sequentially numbered pages 12 through 14. May be deemed a management contract or compensatory arrangement. Sequential page where Exhibit No. Description can be found ---- --------------------------------------------- --------------- (13) Annual Report to Stockholders for the year ended December 31, 1993 Page 50 (21) Subsidiaries of the Registrant Page 86 (23) Consent of Independent Public Accountants Page 87 *With the exception of the material specifically incorporated by reference in Part II of this Form 10-K, the Annual Report to Stockholders for the year ended December 31, 1993 is not to be deemed "filed" as part of this Form 10-K.	5,251	36,075
351145_1993.txt	351145_1993	1993	351145	ITEM 1. BUSINESS Intergraph Corporation was founded in 1969, and is organized as a Delaware corporation. Unless the context of this discussion dictates otherwise, references to the "Company" or "Intergraph" include Intergraph Corporation and subsidiaries. Intergraph's business is principally in one industry segment: interactive computer graphics systems. With an emphasis on technical disciplines, Intergraph systems combine graphics workstations, servers, and peripheral hardware with operating system and application-specific software programs authored by Intergraph and third party software developers to perform such functions as design, drafting, mapping, modeling, analysis, and documentation. These systems are developed, manufactured, sold, and serviced by the Company. Intergraph systems support the creation, analysis, display, output, and maintenance of virtually every type of design, drawing, map, and other graphic representation, while simultaneously providing capabilities to manage a database of non-graphic descriptive information associated with the graphics data. Systems hardware consists of: * Workstations and servers based on reduced instruction set computing (RISC) or Intel Corporation (Intel) microprocessors * A variety of Intergraph and third-party peripheral devices * Industry-standard networking Software includes applications for computer-aided design/computer- aided manufacturing/computer-aided engineering (CAD/CAM/CAE), mapping and geographic information systems, electronic publishing, technical information management, and database management. INTERGRAPH SYSTEMS Intergraph systems include hardware and application software developed by the Company and others. These products can be configured to address the needs of any size organization. The Company provides solutions which are integrated -- workstations, servers, peripherals, and software configured by the Company to work together and satisfy each customer's requirements. All Intergraph workstations and servers are currently based on the Company's microprocessor with a UNIX operating system or Intel microprocessors with the Windows/DOS or Windows NT operating system. The Company has historically manufactured workstations and servers based on its own microprocessor technology, and offered its software applications on the UNIX operating system, with only limited availability of its software applications on hardware platforms of other vendors. In late 1992, the Company announced its decision to port its technical software applications to Microsoft Corporation's new Windows NT operating system for high-end computing, and to make Windows NT available on Intergraph workstations. Microsoft's standard Windows system is widely accepted in the personal computing (PC) market. The effect of this decision is to expand the availability of the Company's workstations and software applications to Windows-based computing environments not previously addressed, including the availability of Intergraph software applications that will operate on selected hardware platforms of other manufacturers that use the Windows NT operating system. At the same time, the Company continues to develop and maintain products in the UNIX operating system environment, the foundation for its software applications before Windows NT, thereby offering existing and potential customers a choice of UNIX or Windows NT operating systems. In addition, the Company believes Intel's architecture has an important role in the technical computing market it serves and now offers a hardware platform for all its software applications based on Intel microprocessors under the Windows NT operating system. Limited shipments of Windows NT-based applications software began in the fourth quarter of 1993. Most of the Company's software applications are expected to be available on Windows NT during 1994. The Company began shipping new Intel-based workstations in third quarter 1993, and expects that Intel-based systems will represent the majority of its 1994 workstation shipments. In addition, the Company has ceased design of its own microprocessor and has entered into an agreement with Sun Microsystems Computer Corporation (Sun) that, among other things, provides for the Company's purchase from Sun beginning in the second half of 1995 of a microprocessor to be co-developed by the Company and Sun. The Company may choose to offer future products based on the Sun microprocessor. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for further discussion of the Sun agreement. The Company supports industry standards for operating systems, windowing, graphics, peripherals, and communication networks, allowing its systems to operate in computing environments with products from other vendors who support the same industry standards. Intergraph offers more than 1,200 interactive graphics application programs, including more than 700 developed by third parties. Systems currently sold by the Company are configured using a combination of the following: (1) Workstations manufactured by the Company that offer user- selectable main memory capacity and performance levels. This flexibility allows customers to match hardware capabilities with their production requirements. All Intergraph-manufactured workstations are based on its 32-bit RISC microprocessor or Intel microprocessors. Intergraph workstations are general-purpose computer systems that can run third-party application, data management, and data processing software packages. (2) RISC-based and Intel-based servers that function as plot, file, compute, and database nodes. The servers off-load these functions from standalone workstations and enable workstation users to share data and system resources in a distributed network. Intergraph's servers offer user-selectable configurations and performance levels. (3) Special-purpose peripherals, including scanners, scanner/plotters, photoplotters, electrostatic and pen plotters, color and monochrome hardcopy devices, magnetic and optical disk technology, a variety of disk and tape drives, alphanumeric terminals, screen image cameras, line printers, and other devices available from the Company, either manufactured in-house or as original equipment from third parties. (4) A broad range of UNIX application software and increasing numbers of applications based on Windows/DOS and Windows NT. See "Intergraph Applications Software" below. (5) MicroStation core graphics software from Bentley Systems, Inc., an Intergraph affiliate, for various operating systems and hardware platforms. (6) An open network architecture that ties Intergraph hardware and software products together and provides access to other systems and processes. PRODUCT TRANSITION The Company believes that offering a choice of UNIX and Windows NT operating systems and Intergraph and Intel hardware platforms will expand the market for its products. However, while the Company believes that Windows NT will become the dominant operating system in the markets it serves, other operating systems are available in the market, and several competitors of the Company also use UNIX or are adopting the Windows NT system for their product offerings. As in any product transition, the Company is unable to predict the precise effects of the transition on its revenues, margins, and profitability for 1994, but believes the transition may continue to adversely affect orders and revenues through the first half of 1994. See "Product Development" and "Competition" below. INTERGRAPH SYSTEMS SOFTWARE At the systems software level, Intergraph develops software to provide graphics and database management capabilities on Intergraph systems, advanced compilers for Intergraph systems, and utilities to enable interoperability with systems from other vendors. The graphics software foundation for many Intergraph UNIX-based software applications is MicroStation 32, a graphics software product owned by Bentley Systems, Inc., an Intergraph affiliate. MicroStation 32 provides fundamental graphics element creation, maintenance, and display functions. In addition to MicroStation 32 for Intergraph workstations, other versions of MicroStation are available on many hardware platforms from other vendors, including MicroStation PC for personal computers, MicroStation Mac for the Apple Macintosh, MicroStation Sun for Sun SPARCstations and MicroStation HP700 for the Hewlett-Packard HP700 workstation. A Japanese language version of MicroStation (release 4.0) runs on the NEC personal computer. MicroStation is compatible with Intergraph's original core graphics software, the Interactive Graphics Design System, which runs on Digital Equipment Corporation (DEC) VAX- based systems. Intergraph supports relational database management systems for attribute (non-graphic) data management on its own workstations and servers, as well as on systems from other vendors. Currently supported are Ingres, Oracle, Informix, DB2, Rdb, and SyBase. Intergraph's Relational Interface System (RIS) is a core product that provides database-independent access to data stored in supported databases. To facilitate the use of Intergraph systems with those from other vendors, the Company develops software for translating data into Intergraph formats, inputting large volumes of text into graphics and attribute files, and communicating with other computer systems. Additionally, Intergraph provides interfaces to various models of electrostatic and pen plotters (both online and offline), online typesetters, units producing computer output microfilm, and other output devices such as those used in the graphic arts industry. INTERGRAPH APPLICATIONS SOFTWARE Intergraph offers a broad suite of graphics and data management applications software. Architecture/engineering/construction (AEC), mapping and geographic information systems (GIS), and mechanical design, engineering, and manufacturing (MDEM) applications have dominated the product mix over the last three years, with no other single application representing more than 10% of systems revenue. The following is a brief description of the Company's major product application areas. Each product organization is led by a senior executive responsible for product development, marketing, training, support, and documentation. ARCHITECTURE/ENGINEERING/CONSTRUCTION. Intergraph's architectural, facility management, and engineering product line automates the project design and management process. With this software, users can develop and model building concepts, produce construction documents, and manage space and assets in a finished facility. The system serves the needs of architecture/engineering firms and corporate or governmental facility management offices. Included are capabilities for producing three-dimensional models of design concepts, architectural drawings, reports, engineering plans, and construction drawings (for example, heating, ventilation, and air conditioning; electrical; and plumbing). Packages are also offered for space planning and facility layout. Intergraph's civil engineering software includes capabilities for coordinate geometry and for structural, site, water resources, bridge, geotechnical and transportation engineering. Structural engineering software is used to create two- and three-dimensional structural models that serve as the basis for frame and finite element-based structural design and analysis of steel and concrete structures. For construction needs, the products support traditional drafting and report requirements. The Company's highway, rail, site, and hydraulic/hydrologic engineering products link traditional workflow activities from data collection to plan and profile production, to generation of construction drawings. The Company's plant design software addresses the needs of process and power plant design efforts. The Plant Design System (PDS) product supports piping and instrumentation diagram generation, electrical, structural, and other design aspects of a plant. Three- dimensional modeling capabilities are provided. The system performs interference-checking and provides reports, materials lists, and drawings. A supporting product provides "walk-throughs" of three- dimensional plant models. The electrical engineering products are used for engineering and analysis of power systems, panel layout, raceway design, and wiring diagram production. MAPPING AND GEOGRAPHIC INFORMATION SYSTEMS. Intergraph offers a range of GIS and mapping solutions to assist businesses, governments, and academic institutions in solving geography-based problems. Intergraph's GIS/mapping software tools address the entire life cycle of GIS/mapping projects from project and data management, through data collection and integration, spatial query and analysis, to output and map production. Intergraph's GIS/mapping solutions help companies address workflows in several major industries. These products support solutions for all levels of government including infrastructure management, planning, growth management, economic development, land information management, public safety and security, public works, redistricting, tactical and strategic defense applications (such as land-based command and control operations), and hydrographic systems. Transportation industry applications range from decision support activities such as policy, planning, and programming to the creation of operations systems that support such day-to-day tasks in transportation agencies. Utility companies utilize Intergraph's GIS/mapping products to develop cost-effective, efficient ways to automate management and analysis applications such as market analyses, environmental impact studies for siting, permitting, contaminant studies, and risk evaluation, long-range planning and forecasting, corridor evaluation and selection, and right-of-way analysis. Environmental and natural resource management applications include monitoring, evaluating and managing, conservation and remediation of the environment. Energy exploration and production products assist geoscientists in every phase of geological analysis related to energy exploration and production and mineral extraction. Intergraph also provides solutions for end-to-end digital map and chart publishing, digital image processing, orthophoto production, and digital photogrammetry. MECHANICAL DESIGN, ENGINEERING AND MANUFACTURING. For the mechanical design and manufacturing market, Intergraph offers software to automate the product development cycle from design through analysis, manufacturing, and documentation. Customers use the system to design mechanical parts and assemblies, defining complex parts with specialized sculptured surface and solid modeling software. Detailing, dimensioning, and drafting capabilities are included for the production of engineering drawings. Engineering software evaluates product designs for functional and structural integrity, predicting behavior under service or test conditions. Finite element modeling and analysis software evaluates designs by simulating stresses encountered in end use. Other products assist in optimizing material usage and cutting cycles for metalworking and fabrication. In addition, a data management system organizes shared product databases for coordination and management of product cycle phases. PRODUCT DEVELOPMENT The Company believes a strong commitment to ongoing product development is critical to success in the interactive computer graphics industry. Significant resources are devoted to development of Intergraph products, and the Company believes its product offerings are responsive to market and competitive demands. Product development expenditures include all costs related to designing new or improving existing equipment and software. During the year ended December 31, 1993, the Company spent $160.3 million (15.3% of revenues) for product development activities compared to $150.2 million (12.8% of revenues) in 1992, and $134.4 million (11.3% of revenues) in 1991. The interactive computer graphics industry is characterized by intense price and performance competition and short product cycles, which necessitate new product development on an ongoing basis. The future operating results of the Company, and of others in the industry, depend in large part on the ability to rapidly and continuously develop and deliver new hardware and software products that are competitively priced and offer enhanced performance. MANUFACTURING AND SOURCES OF SUPPLY The Company's primary manufacturing activities consist of the fabrication and testing of Company-designed electronic circuits and the assembly and testing of components and subassemblies manufactured by the Company and others. In January, 1994 the Company announced its decision to close its manufacturing facility located in Nijmegen, The Netherlands. The decision was made to take advantage of lower costs of production and distribution in the U.S., and to utilize existing capacity in the U.S. manufacturing operation. The facility will be closed in phases over the course of 1994, with all manufacturing and distribution activity transferred to the Company's U.S. manufacturing facility. European sales and support activity will continue to be provided by the Company's subsidiary operations located throughout Europe and by its European headquarters located in The Netherlands. The Company plans to sell or lease the Nijmegen facility. As described under "Intergraph Systems" above, the Company no longer designs its own microprocessor. The Company has agreements in place currently with Intel, and beginning in the second half of 1995, with Sun for provision of its microprocessor needs. The Company believes it has good relationships with Intel and Sun and is unaware of any reason that Intel or Sun might encounter difficulties in meeting the Company's microprocessor needs. An inability to obtain a sufficient supply of microprocessors from Intel and Sun would adversely affect the Company's results of operations. The Company is not dependent on any other sole source supplier of purchased parts, components, or peripherals used in the systems manufactured by the Company. The Company is not required to carry extraordinary amounts of inventory to meet customer demands or to ensure allotment of parts from its suppliers. SALES AND SUPPORT SALES. The Company's systems are sold by its direct sales force through sales offices in 52 countries worldwide. The efforts of the direct sales force are augmented by dealers, value-added-resellers, distributors, and system integrators. In general, the direct sales force is compensated on a combined base salary and commission basis. Sales quotas are established along with certain incentives for exceeding those quotas. Additional specific incentive programs may be established periodically. The Company's sales organization is organized along industry lines to focus on key industries (transportation, utilities, local government, defense, building, vehicle design, electronics, manufacturing, etc.). The Company believes this structure enables it to better meet the specialized needs of these industries. International markets, particularly Europe, continue to increase in importance to the industry and to the Company. The percentage of total Company revenues from customers outside the United States was 51% for the last two fiscal years. European customers represented 35% of total Company revenues in 1993 and 38% in 1992. There are currently wholly-owned sales and support subsidiaries of the Company located in every major European country. European subsidiaries are supported by service and technical assistance operations located in The Netherlands. Outside of Europe, Intergraph systems are sold and supported through a combination of subsidiaries and distributorships. At December 31, 1993, the Company had approximately 1,900 employees in Europe and 900 employees in other international locations. The Company's operations are subject to and may be adversely affected by a variety of risks inherent in doing business internationally, such as government policies or restrictions, currency exchange fluctuations, and other factors. See Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 1 and 9 of Notes to Consolidated Financial Statements contained in the Company's 1993 Annual Report, portions of which are incorporated herein by reference, for further discussion of the Company's international operations. CUSTOMER SUPPORT. The Company believes that a high level of customer support is important to the sale of interactive graphics systems. Customer support includes pre-installation guidance, education services, customer training, onsite installation, hardware preventive maintenance, repair service, software help desk and technical support services in addition to consultative professional services. The Company employs engineers and technical specialists to provide customer assistance, maintenance, and training. Maintenance and repair of systems are covered by standard warranties and by maintenance agreements to which substantially all users subscribe. U.S. GOVERNMENT BUSINESS Revenues from the United States government were $165.7 million in 1993 (16% of total revenue), $186.5 million in 1992 (16% of total revenue), and $172.3 million in 1991 (14% of total revenue). Approximately 40% of total federal government revenues are earned under long-term contracts. The Company believes it has a good relationship with the federal government. While it is fully anticipated that these contracts will remain in effect through their expiration, the contracts are subject to termination at the election of the government (with damages paid to the Company). Any loss of a significant government contract through termination or expiration without renewal or replacement would have an adverse impact on the results of operations of the Company. No other customer exceeds 10% of the total revenue of the Company. BACKLOG An order is entered into backlog only when the Company receives a firm purchase commitment from a customer. The Company's backlog of unfilled systems orders at December 31, 1993, was $232 million. At December 31, 1992, backlog was $275 million. Substantially all of the December 1993 backlog of orders is expected to be shipped during 1994. The Company does not consider its business to be seasonal, though typically fourth quarter orders and revenues exceed those of other quarters. The Company does not ordinarily provide return of merchandise or extended payment terms to its customers. COMPETITION The industry in which the Company competes continues to be characterized by price and performance competition. To compete successfully, the Company and others in the industry must continuously develop products with enhanced performance that can be offered at a competitive price. The Company, along with other companies in the industry, engages in the practice of price discounting to meet competitive industry conditions. Other important competitive factors include quality, reliability, and customer service, support, and training. Management of the Company believes that competition will remain intense. Competition in the interactive computer graphics industry varies among the different application areas. The Company considers its principal competitors in the interactive computer graphics market to be IBM, Computervision Corp., Hewlett-Packard Corp., DEC, Sun, Unigraphics (a division of Electronic Data Systems, Inc.), Silicon Graphics, Inc., and Mentor Graphics, Inc. In the personal computer-based graphics market, Intergraph competes with the products of Autodesk, Inc. and Computervision. Several companies with greater financial resources than the Company, including IBM, DEC, and Hewlett-Packard, are increasing their activities in the industry. The Company provides solutions which are integrated -- workstations, servers, peripherals, and software configured by the Company to work together and satisfy each customer's requirements. By delivering such integration, the Company believes it has an advantage over other vendors who provide only hardware or software, leaving system integration to the customer. In addition, the Company believes that its experience and extensive worldwide customer service and support infrastructure represent a competitive advantage. ENVIRONMENTAL AFFAIRS The Company's manufacturing facilities are subject to numerous laws and regulations designed to protect the environment, particularly from plant wastes and emissions. In the opinion of the Company, compliance with these laws and regulations has not had, and should not have, a material effect on the capital expenditures, earnings, or competitive position of the Company. LICENSES, COPYRIGHTS, TRADEMARKS, AND PATENTS The Company develops its own graphics, data management, and applications software as part of its continuing product development activities. The Company has standard license agreements with UNIX Systems Laboratories for use and distribution of the UNIX operating system, and with Microsoft Corporation for use and distribution of the Windows NT operating system. The license agreements are perpetual and allow the Company to sublicense the operating systems software upon payment of required sublicensing fees. In addition, the Company has an exclusive worldwide license agreement with Bentley Systems, Inc. (a 50%-owned affiliate of the Company) to market, use, distribute, and sublicense MicroStation software. See Item 3. Legal Proceedings for further details. The Company has an extensive program for the licensing of third- party application and general utility software for use on systems and workstations. The Company owns and maintains a number of registered patents and registered and unregistered copyrights, trademarks, and servicemarks. The patents and copyrights held by the Company are the principal means by which the Company preserves and protects the intellectual property rights embodied in the Company's hardware and software products. Similarly, trademark rights held by the Company are used to preserve and protect the goodwill represented by the Company's registered and unregistered trademarks, such as the federally registered trademark "Intergraph". As industry standards proliferate, there is a possibility that the patents of others may become a significant factor in the Company's business. Personal computer technology, for example, is widely available, and many companies, including Intergraph, are attempting to develop patent positions concerning technological improvements related to PCs and workstations. At present, it does not appear that Intergraph will be prevented from using the technology necessary to compete successfully since patented technology is typically available in the industry under royalty- bearing licenses or patent cross-licenses, or the technology can be purchased on the open market. Any increase in royalty payments or purchase costs would increase the Company's costs of manufacture, however, and it is possible, though not anticipated, that some key improvement necessary to compete successfully in some markets served by the Company may not be available. The Company is actively engaged in a program to protect by patents the technology it is developing. The Company believes its success depends less on its ability to obtain and defend copyrights, trademarks, and patents than on its ability to offer higher-performance products for specific solutions at competitive prices. EMPLOYEES At December 31, 1993, the Company had approximately 9,500 employees. Of these, approximately 2,800 were employed outside the United States. The Company's employees are not subject to collective bargaining agreements, and there have been no work stoppages due to labor difficulties. Management of the Company believes it has a good relationship with its employees. Total employment is approximately 800 less than at December 31, 1992. The reduction was achieved both through direct action by the Company and through normal attrition. See Management's Discussion and Analysis of Financial Condition and Results of Operations for further details. ITEM 2. ITEM 2. PROPERTIES The Company's corporate offices and primary manufacturing facility are located in Huntsville, Alabama. Manufacturing facilities located in Nijmegen, The Netherlands will be closed in 1994, as explained under "Manufacturing and Sources of Supply" above. Sales and support facilities are maintained throughout the world. The Company owns over 2,000,000 square feet of space in Huntsville that is utilized for manufacturing, product development, sales and administration. The Huntsville facilities also include over 500 acres of unoccupied land that can be used for future expansion. The Company maintains subsidiary company facilities and sales and support locations in major U.S. cities outside of Huntsville, primarily through operating leases. Outside the U.S., the Company owns approximately 500,000 square feet of space, primarily its Nijmegen manufacturing facility and European headquarters facility. Sales and support facilities are leased in most major international locations. The Company considers its facilities to be adequate for the immediate future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a 50% owner of Bentley Systems, Inc. (BSI). BSI granted Intergraph an exclusive worldwide license to distribute MicroStation, which is a basic software package utilized by many of Intergraph's software applications. BSI notified Intergraph on February 3, 1994, that in its opinion certain events have occurred under the terms of the license agreement which make the license nonexclusive, and as a result, BSI may compete with Intergraph in the distribution of MicroStation and in the development and distribution of additional software products. Intergraph disputes that the license agreement has changed, and pursuant to the license agreement, Intergraph has submitted the dispute to arbitration under the rules of the American Arbitration Association. Related lawsuits were filed in February 1994, among BSI, Intergraph, and the other 50% shareholders of BSI in the Court of Common Pleas, Chester County, Pennsylvania, the Circuit Court of Madison County, Alabama and the United States District Court for the Eastern District of Pennsylvania. The principal relief sought is a declaration of the rights of the parties under the license and related agreements. The Company has entered into negotiations which could result in settlement of this matter. See the discussion under Results of Operations set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's 1993 Annual Report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY Certain information with respect to the executive officers of the Company is set forth below. Officers serve at the discretion of the Board of Directors. James W. Meadlock is a founder of the Company, has served as Chairman of the Board of Directors since the Company's inception in 1969, and is Chief Executive Officer. Mr. Meadlock and Nancy B. Meadlock are husband and wife. Larry J. Laster joined the Company in June 1981. Since that time, he has held several managerial positions in the Company's Finance Department and Federal Systems Division. He was elected Vice President in December 1986, named Chief Financial Officer in February 1987, elected to the Board of Directors in April 1987, and is currently Executive Vice President. Mr. Laster is a certified public accountant. Nancy B. Meadlock is a founder of the Company and has been a Director since 1969, excluding the period from February 1970 to February 1972. Mrs. Meadlock served as Secretary for ten years, was elected Vice President in 1979, and is currently Executive Vice President and Director. She holds a master's degree in business administration. Mrs. Meadlock and James W. Meadlock are wife and husband. Robert E. Thurber is a founder of the Company and has been a Director since 1972. He is responsible for the development of applications software to support AEC, mapping/GIS and utilities disciplines. In June 1977, Mr. Thurber was elected Vice President and is currently Executive Vice President. Mr. Thurber holds a master's degree in engineering. Lawrence F. Ayers, Jr., joined the Company in September 1987 after 32 years in federal government mapping where he became the Civilian Director of the Defense Mapping Agency. He served as Vice President for International Federal Marketing until February 1993 and is currently Executive Vice President with responsibility for commercial mapping and utility products. Mr. Ayers holds a bachelors of science degree in civil engineering and a master's degree in public administration. Neil E. Keith joined the Company in December 1981. He was elected Vice President in September 1985 and is currently Executive Vice President. He has extensive experience in manufacturing management and is responsible for the Company's manufacturing operations worldwide. Stephen J. Phillips joined the Company as Vice President and General Counsel in November 1987 when Intergraph purchased the Advanced Processor Division of Fairchild Semiconductor, where Mr. Phillips was General Patent Counsel. He was elected Executive Vice President in August 1992. Mr. Phillips holds a master's degree in electrical engineering and a juris doctor in law. Maurice G. Romine joined the Company in October 1976 in a Federal Systems support role and has since held key positions in the Company responsible for sales, marketing, development and support of the Company's computer graphics systems. He was responsible for organizing and managing the Company's European operations starting in January 1979. He was elected Vice President of European Operations in 1983 where he served until July 1986, when he returned to the U.S. as Vice President of the Mapping and Energy software product center. He was elected Executive Vice President in January 1987. Mr. Romine reassumed responsibility for the European operations in January 1987 until October 1989. In November 1989 Mr. Romine was appointed as Executive Vice President of Corporate Marketing and later also given responsibility for the MicroStation software product center. Since October 1992, he has served as Executive Vice President of Corporate Operations. William E. Salter joined the Company in April 1973. Since that time, he has held several managerial positions in the Company's Federal Systems Division and has served as Manager of Marketing Communications. Dr. Salter was elected Vice President in August 1984 and is currently Executive Vice President with responsibility for the Company's Federal Systems Division. He holds a doctorate in electrical engineering. Tommy D. Steele joined the Company in June 1992 as Executive Vice President with responsibility for software systems, mechanical design and technical information management applications, and professional services. Mr. Steele came to Intergraph from IBM Corporation, where he was employed 28 1/2 years. At IBM, he worked on Apollo/Skylab/Saturn programs, the space shuttle, and a number of Department of Defense programs. In his last four years with IBM, he managed PC Operating Systems (OS/2, DOS, and AIX) for IBM. Herman E. Thomason joined the Company in 1985 and was involved in the development of the Company's federal government business. In 1991, he was elected Executive Vice President with responsibility for the Company's scanning and imaging hardware and software, as well as for the graphic arts and publishing products. He holds a doctorate in electrical engineering. John M. Thorington, Jr., joined the Company in August 1977 and was responsible for the design, development, and manufacture of many of the Company's hardware products. In May 1980, Dr. Thorington was elected Vice President, Graphics Engineering, and is currently Executive Vice President. He holds a doctorate in electrical engineering. Damian Walters joined the Company in 1984 as the Managing Director of Intergraph Australia, a subsidiary of the Company. In 1986, he established the Intergraph office in New Zealand and in 1987 established the Asia Pacific regional headquarters operation in Hong Kong. In 1991, Mr. Walters was elected Vice President. In 1994, he was elected Executive Vice President. Mr. Walters is currently responsible for the Company's Asia Pacific region. Allan B. Wilson joined the Company in 1980 and was responsible for the development of international operations outside of Europe and North America. He was elected Vice President in May 1982 and Executive Vice President in November 1982. Mr. Wilson is responsible for corporate marketing (including marketing communications) as well as office automation standards and support. He holds a master's degree in electrical engineering. Manfred Wittler joined the Company in 1989 as Vice President. In 1991, he was elected Executive Vice President and is currently responsible for sales and support for Europe and the Americas. From 1983 through 1989, Mr. Wittler served as Division Vice President for Data General Corporation in Europe. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The information appearing under "Dividend Policy" and "Price Range of Common Stock" on page 27 of the Intergraph Corporation 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the five years ended December 31, 1993, appearing under "Five-Year Financial Summary" on the inside front cover page of the Intergraph Corporation 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of financial condition and results of operations appearing on pages 8 to 12 of the Intergraph Corporation 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements appearing on pages 13 to 26 of the Intergraph Corporation 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information appearing under "Election of Directors" and "Board Committees and Attendance" on pages 4 to 5 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. Directors are elected for terms of one year at the annual meeting of the Company's shareholders. Information relating to the executive officers of the Company appearing under "Executive Officers of the Company" on pages 9 to 10 in this Form 10-K Annual Report is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under "Executive Compensation" on pages 5 to 12 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under "Common Stock Outstanding and Principal Shareholders" on pages 2 to 3 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under "Certain Relationships and Related Transactions" on page 5 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Page in Annual Report * -------- (a) 1) The following consolidated financial statements of Intergraph Corporation and subsidiaries and the report of independent auditors thereon are incorporated by reference from the Intergraph Corporation 1993 Annual Report to Shareholders: Consolidated Balance Sheets at December 31, 1993 and 1992 13 Consolidated Statements of Income for the three years ended December 31, 1993 14 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 15 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 16 Notes to Consolidated Financial Statements 17 - 26 Report of Independent Auditors 27 Page in Form 10-K --------- 2) Financial Statement Schedules: Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties for the three years ended December 31, 1993 17 Schedule V - Property, Plant, and Equipment for the three years ended December 31, 1993 18 Schedule VI - Accumulated Depreciation of Property, Plant, and Equipment for the three years ended December 31, 1993 19 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the three years ended December 31, 1993 20 Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 21 Schedule X - Supplementary Income Statement Information for the three years ended December 31, 1993 22 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of 20%- to 50%-owned companies have been omitted because the registrant's proportionate share of income before income taxes and total assets of the companies is less than 20% of the respective consolidated amounts, and the investments in and advances to the companies are less than 20% of consolidated total assets. * Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. 3) Exhibits Page in Number Description Form 10-K ------ ----------- --------- 3(a) Certificate of Incorporation, Bylaws, and Certificate of Merger. (1) 3(b) Amendment to Certificate of Incorporation. (2) 3(c) Restatement of Bylaws. (3) 4 Shareholder Rights Plan, dated August 25, 1993. (4) 10(a) 1990 Intergraph Corporation Employee Stock Option Plan. (5) 10(b) Intergraph Corporation 1992 Stock Option Plan. (6) 10(c) Employment contracts of Manfred Wittler, dated November 1, 1989 (7) and April 18, 1991. * 10(d) Loan program for executive officers of the Company. (7) 10(e) Employment contract of Howard G. Sachs, dated February 8, 1993. 10(f) Termination agreement with Howard G. Sachs, dated August 9, 1993. * 10(g) Consulting contract of Keith H. Schonrock, Jr., dated January 17, 1990. * 10(h) Agreement between Intergraph Corporation and Green Mountain, Inc., dated February 23, 1994. * 11 Computation of Earnings (Loss) Per Share 23 13 Portions of the Intergraph Corporation 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K Annual Report 21 Subsidiaries of the Company 24 23 Consent of Independent Auditors 25 - -------------------- (1) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1984, under the Securities Exchange Act of 1934, File No. 0-9722. (2) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987, under the Securities Exchange Act of 1934, File No. 0-9722. (3) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, under the Securities Exchange Act of 1934, File No. 0-9722. (4) Incorporated by reference to exhibits filed with the Company's Current Report on Form 8-K dated August 25, 1993, under the Securities Exchange Act of 1934, File No. 0-9722. (5) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, under the Securities Exchange Act of 1934, File No. 0-9722. (6) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, under the Securities Exchange Act of 1934, File No. 0-9722. (7) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, under the Securities Exchange Act of 1934, File No. 0-9722. * Denotes management contract or compensatory plan, contract or arrangement required to be filed as an Exhibit to this Form 10-K. - -------------------- (b) No reports on Form 8-K were filed during the fourth quarter of the fiscal year ended December 31, 1993. (c) Exhibits - the response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial statement schedules - the response to this portion of Item 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 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. INTERGRAPH CORPORATION By Larry J. Laster Date: March 18, 1994 -------------------------- Larry J. Laster Executive Vice President, Chief Financial Officer and Director 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 ---- James W. Meadlock - ---------------------- Chief Executive Officer and March 18, 1994 James W. Meadlock Chairman of the Board (Principal Executive Officer) Larry J. Laster - ---------------------- Executive Vice President, Chief March 18, 1994 Larry J. Laster Financial Officer and Director (Principal Financial Officer) Nancy B. Meadlock - ---------------------- Executive Vice President March 18, 1994 Nancy B. Meadlock and Director Robert E. Thurber - ---------------------- Executive Vice President March 18, 1994 Robert E. Thurber and Director Roland E. Brown - ---------------------- Director March 18, 1994 Roland E. Brown Keith H. Schonrock, Jr. - ---------------------- Director March 18, 1994 Keith H. Schonrock, Jr. James F. Taylor, Jr. - ---------------------- Director March 18, 1994 James F. Taylor, Jr. John W. Wilhoite - ---------------------- Vice President and Controller March 18, 1994 John W. Wilhoite (Principal Accounting Officer) INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE II ---- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (1) Amount represents an unsecured promissory note receivable from Mr. Meadlock, who is Chief Executive Officer of the Company. Interest is charged at the prime rate. The loan is due in full by the earlier to occur of the date of sale of any common stock of the Company by Mr. Meadlock or May 20, 1994. This loan was executed under the provisions of the Executive Officer Loan Program. (2) Amount represented an unsecured promissory note receivable from Mr. Meadlock. The note was paid in full in 1992. Interest was charged at a rate of prime plus 2%. (3) Amount represented a non-interest bearing note receivable from Mr. Epstein, who was a Vice President of the Company. The note was a housing bridge loan secured by a mortgage on real estate. The note was paid in full in 1991. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE V ---- PROPERTY, PLANT AND EQUIPMENT (In Thousands) (1) Additions to equipment, furniture and fixtures in each year consist primarily of computer hardware manufactured by the Company and used in product development. (2) Non-cash additions consist of additions to a building at a cost of $7,246 through a long-term debt transaction in 1991. (3) Other changes consist primarily of changes in the reported dollar amounts of fixed assets held by international subsidiaries as the result of changes in currency translation rates. (4) As a part of changes in the Company's product, sales and manufacturing strategies, the Company will eliminate certain operations in phases over the course of 1994. Included in property, plant and equipment is $13.3 million in net book value of assets related to these operations, consisting primarily of $10.6 million in net book value of land and buildings comprising the Company's Netherlands manufacturing facility. The net book value of that facility approximates market value. The Company will sell or lease the facility. Certain reclassifications have been made to the previously reported 1991 and 1992 balances to provide comparability with the current year presentation. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE VI ---- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) (1) Depreciation is provided using the straight-line method over the estimated useful lives of the assets. Asset lives range from three to thirty years. (2) Other changes consist primarily of changes in the reported dollar amounts of accumulated depreciation on fixed assets held by international subsidiaries as the result of changes in currency translation rates. (3) See Note 4 in Schedule V regarding operations to be eliminated. Certain reclassifications have been made to the previously reported 1991 and 1992 balances to provide comparability with the current year presentation. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE VIII ---- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (1) Uncollectible accounts written off, net of recoveries. (2) Obsolete inventory reduced to net realizable value. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE IX ---- SHORT-TERM BORROWINGS (1) Represents financing arranged on behalf of an international subsidiary with repayment guaranteed by the parent company. (2) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principal balances by 12. (3) The weighted average interest rate during the period was computed by dividing actual interest expense for the period by the weighted average amount outstanding during the period. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE X ---- SUPPLEMENTARY INCOME STATEMENT INFORMATION Column A Column B ----------------- -------------------- Charged to costs Item and expenses ----------------- -------------------- Amortization of intangible assets 1993 $20,072,000 1992 $12,800,000 1991 $ 9,168,000 Royalties 1993 $40,048,000 1992 $37,175,000 1991 $31,168,000 Advertising 1993 $10,609,000 1992 $10,800,000 1991 $11,826,000	7,389	51,190
736157_1993.txt	736157_1993	1993	736157	ITEM 1. BUSINESS Time Warner Inc. (the "Company") was incorporated in the State of Delaware in August 1983 and is the successor to a New York corporation originally organized in 1922. The Company changed its name from Time Incorporated following its acquisition of 59.3% of the common stock of Warner Communications Inc. ("WCI") in July 1989. WCI became a wholly owned subsidiary of the Company in January 1990 upon the completion of the merger of WCI and a subsidiary of the Company (the "Merger"). As used in this report, the terms "Registrant," the "Company" and "Time Warner" refer to Time Warner Inc. and its subsidiaries and divisions, and includes Time Warner Entertainment Company, L.P. ("TWE"), which conducts substantially all of the Entertainment businesses of the Company, unless the context otherwise requires. The Company is the largest media and entertainment company in the world. Its businesses are carried on in three principal groups: Publishing, Music and Entertainment. The Publishing group consists principally of the publication and distribution of magazines and books; the Music group consists principally of the production and distribution of recorded music and the ownership and administration of music copyrights; and the Entertainment group consists principally of the production and distribution of motion pictures and television programming, the distribution of videocassettes, the ownership and operation of retail stores and theme parks, the production and distribution of pay television and cable programming, and the operation of cable television systems. These businesses are conducted throughout the world through numerous wholly owned, and in certain cases less than wholly owned, subsidiaries and affiliates. TWE was formed as a Delaware limited partnership in February 1992 pursuant to an Agreement of Limited Partnership, dated as of October 29, 1991, as amended (the "TWE Partnership Agreement"), and has, since its capitalization on June 30, 1992 (the "TWE Capitalization"), owned and operated substantially all of the Entertainment group businesses, and certain other businesses, previously owned and operated by the Company. Upon the TWE Capitalization, certain wholly owned subsidiaries of the Company (the "TW Partners" or the "General Partners"), contributed such businesses, or assigned the net cash flow derived therefrom (or an amount equal to the net cash flow derived therefrom), to TWE and became general partners of TWE. Also upon the TWE Capitalization, wholly owned subsidiaries of ITOCHU Corporation (formerly C. Itoh & Co., Ltd.), a corporation organized under the laws of Japan ("ITOCHU"), and Toshiba Corporation, a corporation organized under the laws of Japan ("Toshiba"), collectively contributed $1 billion to TWE and became limited partners of TWE. On September 15, 1993, TWE consummated the transactions contemplated by the Admission Agreement, dated as of May 16, 1993, as amended (the "Admission Agreement"), between TWE and U S WEST, Inc., a Colorado corporation ("USW"). Pursuant to the Admission Agreement, a wholly owned subsidiary of USW made a capital contribution of $2.553 billion and became a limited partner of TWE (the "USW Transaction"). As a result of the USW Transaction, the TW Partners collectively own 63.27% pro rata priority capital and residual equity interests in TWE and wholly owned subsidiaries of ITOCHU, Toshiba and USW (the "Class A Partners" or the "Limited Partners") own pro rata priority capital and residual equity interests in TWE of 5.61%, 5.61% and 25.51%, respectively. Each of ITOCHU and Toshiba has the right to maintain its original 6.25% pro rata priority capital and residual equity interests by acquiring additional partnership interests. In addition, the TW Partners own priority capital interests senior and junior to the pro rata priority capital interests. The Admission Agreement provides that TWE will use its best efforts to upgrade a substantial portion of its cable systems to "Full Service Network(TM)" capacity over the next five years. As systems are designated for such upgrade and after any required approvals are obtained, USW and TWE will share joint control of those systems through a 50-50 management committee. The "Full Service Network" business is expected to include substantially all of TWE's cable systems, subject to obtaining necessary regulatory consents and approvals. See "Entertainment--Description of Certain Provisions of the TWE Partnership Agreement." I-1 For financial information about the Company's industry segments and operations in different geographical areas with respect to each of the years in the three-year period ended December 31, 1993, see Note 10, "Segment Information," to the Company's consolidated financial statements at pages through herein. The Company's Entertainment Group, consisting of the Company's interests in certain entertainment companies, principally TWE, was deconsolidated effective January 1, 1993 as a result of the USW Transaction. The TWE Partnership Agreement and the TWE credit agreement impose restrictions on the ability of TWE to make distributions to the Company and the TW Partners. See Note 1, "Summary of Significant Accounting Policies," and Note 2, "Entertainment Group," to the Company's consolidated financial statements at pages through herein. PUBLISHING The Company's wholly owned publishing division, Time Inc., publishes magazines and books and develops products for the multimedia and television markets. It conducts these activities through wholly owned subsidiaries, joint ventures, equity investments and partnerships. MAGAZINES General Time Inc. publishes TIME, PEOPLE, SPORTS ILLUSTRATED, FORTUNE, MONEY, LIFE, SPORTS ILLUSTRATED FOR KIDS and ENTERTAINMENT WEEKLY. In March 1994, Time Inc. announced the launch of IN STYLE, a monthly celebrity life style publication, which will have an initial rate base of 500,000. Time Publishing Ventures, Inc. ("TPV"), a subsidiary of Time Inc. Ventures ("TIV") and an indirect subsidiary of Time Inc., is responsible for international, regional and special interest publishing and development activities, including Southern Progress Corporation ("Southern Progress"), Sunset Publishing Corporation ("Sunset Publishing"), PARENTING, BABY TALK, HEALTH, HIPPOCRATES, MARTHA STEWART LIVING and WHO WEEKLY magazines and various joint ventures. In September 1993, a joint venture between a subsidiary of TPV and affiliates of Quincy Jones Entertainment Company began publication of VIBE, a magazine that covers rap, rhythm and blues, reggae and dance music, as well as politics and fashion. Southern Progress publishes SOUTHERN LIVING, PROGRESSIVE FARMER, SOUTHERN ACCENTS, COOKING LIGHT and TRAVEL GUIDE magazines. Time Inc., either directly or through subsidiaries, has equity interests in ASIAWEEK, ELLE JAPON, PRESIDENT, American Family Publishers, Time Distribution Services and Publishers Express. In 1993, Time Inc. sold its interest in WORKING WOMAN and WORKING MOTHER, and in March 1994, it sold its interest in the magazine, YAZHOU ZHOUKAN, but retained the right to reacquire 25% of the magazine in the future. TIV has management responsibility for most of the American Express Publishing Corporation's operations, including TRAVEL & LEISURE and FOOD & WINE magazines. TIV also operates an in-store advertising and demonstration business, Time Inc. In-Store Marketing. Each magazine published by the Company has an editorial staff under the general supervision of a managing editor and a business staff under the management of a president or publisher. Magazine manufacturing and distribution activities are generally managed by centralized staffs at Time Inc. Fulfillment activities for Time Inc.'s magazines are generally administered from a centralized facility in Tampa, Florida. I-2 PARENTING, SUNSET, BABY TALK, HEALTH, HIPPOCRATES, MARTHA STEWART LIVING and Time Inc.'s overseas operations employ independent fulfillment services and undertake their own manufacturing and distribution. Magazine publishing follows a seasonal pattern with revenues being generally higher in the second and fourth quarters and lower in the first and third quarters. The individual magazines of the Company are summarized below: TIME, a weekly magazine, summarizes the news and brings original interpretation and insight to the week's events. The domestic advertising rate base of TIME as of January 1994 was 4,000,000, which is unchanged from January 1993. TIME Asia, TIME Atlantic, TIME Canada, TIME Latin America and TIME South Pacific are weekly English-language editions of TIME which circulate outside the United States. These editions had an aggregate worldwide advertising rate base of 1,480,000 as of January 1994, compared to 1,510,000 in January 1993. SPORTS ILLUSTRATED is a weekly magazine which covers the activities of, and is designed to appeal to, spectators and participants in virtually all forms of recreation and competitive sports. In 1993, Time Canada Ltd. tested a Canadian version of the magazine which provides expanded coverage of Canada's teams and athletes. The advertising rate base as of January 1994 was 3,150,000, the same as in January 1993. SPORTS ILLUSTRATED FOR KIDS is a monthly sports-oriented magazine geared to children ages eight through 14. Its advertising rate base as of January 1994 was 900,000, compared to 800,000 in January 1993, including 250,000 copies distributed free to over 1,400 schools. PEOPLE, a weekly magazine, focuses on celebrities and other notable personalities. The advertising rate base as of January 1994 was 3,150,000, the same as in January 1993. ENTERTAINMENT WEEKLY is a weekly magazine which includes reviews and reports on television, movies, video, music and books. The advertising rate base as of January 1994 was 1,075,000, compared to 800,000 in January 1993 and 1,000,000 in February 1993. FORTUNE, a biweekly magazine, reports on worldwide economic and business developments. FORTUNE International, an overseas English-language edition, contains most of the articles in the domestic edition. The combined worldwide advertising rate base was 870,000 as of January 1994, which is unchanged from January 1993. MONEY is a monthly magazine which reports on personal finance. The advertising rate base as of January 1994 was 1,900,000, the same as in January 1993. LIFE is a monthly magazine which features photographic essays. The advertising rate base as of January 1994 was 1,500,000 as compared to 1,700,000 in January 1993. The rate base was reduced in May 1993 as the magazine sought to redefine its publishing niche for the 1990's. SOUTHERN LIVING is a monthly regional home, garden, food and travel magazine focused on the South with an advertising rate base of 2,300,000 as of January 1994, which is the same as in January 1993. PROGRESSIVE FARMER is a monthly regional farming magazine with an advertising rate base of 415,000 as of January 1994, compared to 425,000 in January 1993. SOUTHERN ACCENTS, published six times a year, features architecture, fine homes and gardens, arts and travel and is targeted to affluent Southerners. Its advertising rate base as of January 1994 was 250,000, which is unchanged from January 1993. I-3 COOKING LIGHT is published seven times a year and features health and fitness through active lifestyles and good nutrition. The advertising rate base as of January 1994 was 1,100,000, compared to 1,000,000 in January 1993. TRAVEL GUIDE, formerly TRAVEL SOUTH, is a seasonal, regional travel magazine focused on the South with an average circulation of 200,000 as of January 1994, the same as in January 1993. PARENTING is published ten times per year and is aimed at parents of children under the age of ten. The advertising rate base increased as of January 1994 to 925,000, compared to 875,000 in January 1993. SUNSET, The Magazine of Western Living, is a monthly regional magazine focused on lifestyles in the West. The advertising rate base increased to 1,400,000 in January 1994 compared to 1,375,000 in January 1993. HEALTH is a consumer health magazine published seven times a year, and HIPPOCRATES is published ten times a year. Although similar in editorial content, HEALTH is targeted at the consumer market, while HIPPOCRATES is a trade magazine targeted at physicians and carries primarily trade advertising. HEALTH had an advertising rate base of 900,000 in January 1994, the same as in January 1993. HIPPOCRATES had a controlled circulation of 125,000 primary care physicians in January 1994, the same as in January 1993. MARTHA STEWART LIVING presents Martha Stewart's personal perspective on entertaining, cooking, decorating and gardening. Published bimonthly in 1993, it will expand to eight issues in 1994. Its advertising rate base as of January 1994 was 725,000, compared to 575,000 in January 1993. In 1993, a TIV subsidiary developed a weekly one-half hour syndicated television show featuring Martha Stewart which began airing on broadcast television to a nationwide audience in September 1993. BABY TALK is a monthly magazine targeted at expectant and new mothers. Its rate base as of January 1994 was 1,125,000, the same as in January 1993. BABY TALK's ancillary publications are BABY ON THE WAY (published semi-annually) and BABY ON THE WAY BASICS (published annually). WHO WEEKLY is an Australian version of PEOPLE which focuses on celebrities and other notable personalities. The advertising rate base as of January 1994 was 200,000, compared to 180,000 in January 1993. VIBE was launched in September 1993 and covers rap, rhythm and blues, reggae and dance music, as well as politics and fashion. Four issues of VIBE were published in 1993 and it is expected that 10 issues will be published in 1994. The advertising rate base as of January 1994 was 200,000. Circulation The Company's publications are sold primarily by subscription. Subscription copies are delivered to subscribers through the mail. Subscriptions are sold by direct-mail solicitation, subscription sales agencies, television and telephone solicitation and insert cards in the Company's magazines and other publications. Single copies of magazines are sold through retail news dealers who are supplied in turn by regional wholesalers. Advertising Advertising carried in the Company's magazines is predominantly consumer advertising. Eleven of the Company's magazines have numerous regional and demographic editions which contain the same basic editorial material but permit advertisers to concentrate their advertising in specific markets. Through the use of selective binding and ink-jet technology, the Company creates special custom editions targeted towards specific groups. This allows the Company to deliver advertisers a more highly targeted audience by I-4 segmenting subscriber lists to identify those subscribers advertisers desire most, as well as providing the opportunity to personalize advertising messages. Paper and Printing Lightweight coated paper, which for certain magazines is recycled, constitutes a significant component of physical costs in the production of magazines. Time Inc. has contractual commitments to ensure an adequate supply of paper, but periodic shortages may occur in the event of strikes or other unexpected disruptions in the paper industry. During 1993, a year in which paper prices generally increased, Time Inc. purchased paper principally from four independent manufacturers, in each case under contracts that, for the most part, are either fixed-term or open-ended at prices determined on a market price or formula price basis. Printing and binding for the Company's magazines are accomplished primarily by major domestic and international printing concerns in 21 locations. Magazine printing contracts are either fixed-term or open-ended at fixed prices with, in some cases, adjustments based on certain criteria. BOOKS General The Company's book operations include Time Life Inc.; Book-of-the-Month Club Inc.; Time Warner Trade Publishing which operates Warner Books, Warner Publisher Services and Little, Brown and Company, each of which is a wholly owned subsidiary of Time Inc.; and the Oxmoor House and Sunset Books divisions of Southern Progress and Sunset Publishing, respectively. In 1993, the book operations distributed, in aggregate, approximately 142 million gross units. Time Life Inc. Time Life Inc. is composed of five divisions: Books, Music, Video and Television, Education, and International. Time Life Inc. is one of the nation's largest direct marketers of books, music and videos. The products are sold by direct response, including mail order, television and telephone, through retail, institutional and license channels, and by door-to-door independent distributors in some foreign markets. Editions of the books are currently sold in 22 languages worldwide and approximately 42% of Time Life Inc.'s revenues are generated outside the United States. In 1993, Time Life Inc. created Time Life Education, a division designed to enter the school and library market. Editorial material is created by in-house staffs as well as through outside book packagers. The most significant new product launched in 1993 was Time Life Music's new series "The Rolling Stone Collection: 25 Years of Essential Rock." Other 1993 best sellers included the series "Barney & Friends" at Time Life Video and Television. In 1993, Time Life began the development of two ten-hour television documentary series, "Lost Civilizations" and "The History of Rock 'n' Roll," each of which draw on Time Life's existing editorial resources. First-run television rights to "Lost Civilizations" have been pre-sold to one of the three major networks, and "The History of Rock 'n' Roll" is being co- produced with TWE's Telepictures Productions. Manufacturing for Time Life Books is done by several independent companies. Manufacturing contracts are entered into on a series rather than a single title basis and are fixed-price with provisions for cost of labor, material and specification adjustments. These contracts, subject to certain limitations, may be terminated by Time Life Inc. or the manufacturer. Time Life Inc.'s fulfillment activities, excluding international operations, are conducted from a centralized facility in Richmond, Virginia. Book-of-the-Month Club Book-of-the-Month Club operates seven book clubs and two continuity businesses with combined membership in excess of 3.1 million. Two of the clubs, Book-of-the-Month Club and Quality Paperback Book I-5 Club, are general interest clubs and the remaining clubs specialize in history, cooking and crafts, business, children's books and the books of a particular author. In addition, audio and video products are offered through the clubs. In 1993, Book-of-the-Month Club launched its businesses internationally in over 20 countries primarily in Europe and Asia. Book-of-the-Month Club buys the rights from publishers to manufacture and distribute books and then has them printed by independent printing concerns. Book-of-the-Month Club runs its own fulfillment and warehousing operations in Mechanicsburg, Pennsylvania. Time Warner Trade Publishing Warner Books Warner Books publishes hardcover, mass market and trade paperback books. Among the best selling hardcover books published in 1993 were Robert James Waller's "Slow Waltz in Cedar Bend," and Sandra Brown's "Where There's Smoke." Robert James Waller's "The Bridges of Madison County," published in 1992, was the number one selling hardcover title of 1993. Mass market paperback books published in 1993 included "The General's Daughter" by Nelson DeMille, "The Star Shines Down" by Sidney Sheldon, "Decked: A Regan Reilly Mystery" by Carol Higgins Clark, "Along Came a Spider" by James Patterson, "French Silk" by Sandra Brown, and "Double Cross" by Sam and Chuck Giancana. The major trade paperback book published by Warner Books in 1993 was: "Bottoms Up!" by Joyce L. Vedral, Ph.D. Little, Brown Little, Brown publishes general and children's trade books, legal and medical reference books and textbooks. Through its subsidiary, Little, Brown (U.K.), it also publishes general hardcover and mass market paperback books in the United Kingdom. Among the trade hardcover books published by Little, Brown in 1993 were "The Hope" by Herman Wouk and "The Best Cat Ever" by Cleveland Amory. The major trade paperback book published by Little, Brown in 1993 was "Revolution From Within" by Gloria Steinem. Little, Brown handles book distribution for itself and Warner Books. The marketing of trade books is primarily to retail stores and wholesalers throughout the United States, Canada and the United Kingdom. Law and medical textbooks are sold primarily to university retail stores. Professional reference books are sold to practitioners through retail stores and direct marketing. Through their combined U.S. and U.K. operations, Little, Brown and Warner Books have the ability to acquire English-language publishing rights for the distribution of hard and softcover books throughout the world. In July 1993, the trade publishing group and Warner Music Group's Atlantic Records formed a joint venture, Time Warner AudioBooks, to develop and market audio versions of books and other materials published by Warner Books, Little, Brown and other outside publishers. Oxmoor House and Leisure Arts Oxmoor House, the book publishing division of Southern Progress, markets how- to books on a wide variety of topics including food and crafts, as well as illustrated volumes on art and other subjects. Acquired in 1992 and integrated into Oxmoor House, Leisure Arts is a well-established publisher and distributor of instructional leaflets, continuity books series and magazines for the needlework and craft market. Sunset Books Sunset Books, the book publishing division of Sunset Publishing, markets books on topics such as building and decorating, cooking, gardening and landscaping, and travel. Sunset Books' unique marketing formula includes an extensive network of home repair and garden centers. I-6 OTHER PUBLISHING OPERATIONS Multimedia and Other Television Development Time Inc. is actively developing products for emerging technologies such as on-line computer networks, the Full Service Network, and the CD ROM market. These efforts include alliances with leading worldwide consumer on-line computer services to provide interactive entertainment and information to the home computer market, the development of an interactive news-on-demand service for the Full Service Network, as well as the creation of CD ROM versions of original and existing Time Inc. editorial products. Time Inc. has also undertaken development efforts in various television ventures, both in combination with other divisions of the Company and independently. The most significant of these activities is an entertainment news show, "Entertainment News Television," produced in conjunction with the Telepictures division of TWE, which will be a six-day-a-week program utilizing the editorial resources of Time Inc. to break exclusive stories. The first episode of this show is planned for the autumn of 1994. Time Inc. In-Store Marketing In June 1993, Time Inc. formed, as part of TIV, Time Inc. In-store Marketing, an umbrella organization to operate all of the company's in-store advertising and demonstration businesses, including Media One, Inc. ("Media One") and SmartDemo Inc. ("SmartDemo"). Media One's primary product is a two-sided backlit advertising display unit that is installed in supermarket checkout lanes. SmartDemo, an in-store demonstration, couponing, sampling and merchandising business, was acquired by TIV in June 1993. American Express Publishing In March 1993, Time Inc., through its TIV subsidiary, entered into an agreement to assume management responsibility for most of American Express Publishing Corporation's operations, including its core lifestyle magazines, TRAVEL & LEISURE and FOOD & WINE. Under the terms of the agreement, TIV receives a fee for managing these properties, as well as incentives for improving profitability. American Family Publishers Time Inc. is a 50% partner in American Family Publishers ("AFP"), a direct mail magazine subscription sales agency. AFP sells magazine subscriptions for approximately 200 major magazines in the United States, including many of the Company's publications. AFP sells primarily through two heavily promoted nationwide sweepstakes mailings conducted each year. Time Distribution Services Time Inc. owns approximately a 63% interest in Time Distribution Services ("TDS"), a joint venture with the New York Times Company. TDS markets and distributes magazines published by both companies, and also certain other publishers in the United States and Canada, through wholesalers to retail outlets such as newsstands and directly to supermarkets and drugstore chains. Warner Publisher Services Warner Publisher Services ("WPS") is a major distributor of magazines and paperback books sold through wholesalers in the United States and Canada. WPS is the sole national distributor for MAD magazine, the publications of DC Comics and certain publications owned by other publishers, including TEEN, VOGUE, WOMAN'S DAY, and the Dell Puzzle Books. WPS also distributes the paperback books published by Warner Books as well as the full paperback lines of the Berkley Group and St. Martin's Press/Tor Books. WPS is wholly owned by the Company. I-7 Publishers Express Time Inc. owns 25% of Publishers Express Inc., a corporation whose shareholders consist of eleven other publishers, printers, paper companies and direct mailers established to deliver second- and third-class mail and advertising material in competition with the U.S. Postal Service. As of January 1994, the corporation was delivering in 30 cities throughout the United States. POSTAL RATES Postal costs represent a significant operating expense for the Company's publishing activities. There were no general postal rate increases in 1993 and none will occur in 1994. A general increase of approximately 10% has been proposed for 1995 by the Postal Service. Some relatively small savings will be realized by the Company through the adoption by the Postal Board of Governors of a special discount for certain types of barcoded postal material. Publishing operations continue to minimize postal expense through the use of certain cost-saving measures, including the utilization of contract carriers to transport books and magazines to central postal centers. It has been the Company's practice in selling books and other products by mail to include a charge for postage and handling, which is adjusted from time to time to partially offset any increased postage or handling costs. COMPETITION The Company's magazine operations compete for sales with numerous other publishers and retailers, as well as other media. The general circulation magazine industry is highly competitive both within itself and with other advertising media which compete with the Company's magazines for audience and advertising revenue. The Company's book publishing operations compete for sales with numerous other publishers and retailers as well as other media. In addition, the acquisition of publication rights to important book titles is highly competitive, and Warner Books and Little, Brown compete with numerous other book publishers. WPS and TDS meet with direct competition from other distributors operating throughout the United States and Canada in the distribution of magazines and paperback books. MUSIC GENERAL The Company's music business, conducted under the umbrella name Warner Music Group ("WMG"), consists of a vertically integrated worldwide recorded music business and a worldwide music publishing business. The Company's domestic recorded music business is conducted principally through WCI's wholly owned subsidiaries Warner Bros. Records Inc. ("WBR"), Atlantic Recording Corporation ("Atlantic"), WEA Manufacturing Inc. ("WEA Mfg.") and Warner-Elektra-Atlantic Corporation ("WEA"), and a division of WCI, Elektra Entertainment ("Elektra"). Outside of the United States, the recorded music business is conducted in 72 countries through WEA International Inc. and a division of WCI, Warner Music International, and their subsidiaries and affiliates ("WMI"), as well as through non-affiliated licensees. The Company's music publishing business is conducted principally through wholly owned subsidiaries of WCI (collectively, "Warner/Chappell"). In 1993, approximately 52% of WMG's revenues were derived from sources outside of the United States. I-8 RECORDED MUSIC WMI, WBR, Atlantic and Elektra produce, sell and license compact discs, cassette tapes and music videos (in both videocassette and video laserdisc configurations) of the performances of recording artists under contract to them or for whose recordings they have acquired rights. WMG's recorded music and video product is marketed under various labels, including the proprietary labels "Warner Bros.," "Reprise," "Sire," "Tommy Boy," "Warner Nashville," "Elektra," "Asylum," "Nonesuch," "Atlantic," "AVision," "EastWest America," "Big Beat," "Atlantic Nashville," "WEA," "EastWest," "Teldec," "CGD," "Carrere," "Erato," "MMG," "DRO," "Telegram," "D-Day" and "Muser." In addition, WMG has entered into joint venture agreements pursuant to which WMG companies manufacture, distribute and market (both domestically and, in most cases, internationally) recordings owned by such joint ventures. The terms of such agreements vary widely, but each agreement typically provides the WMG record company with an equity interest and a profit participation in the venture, with financing furnished either solely by WMG or by both parties. Included among these arrangements are the labels "American Recordings," "Giant," "Interscope," "Maverick," "Quest" and "Rhino." WMG's record companies also acquire rights pursuant to agreements to manufacture and distribute certain recordings that are marketed under the licensor's proprietary label. Included among the labels distributed under such arrangements are "Slash," which is distributed by WBR; "Hollywood" and "Mute," which are distributed by Elektra; and "Beggars Banquet," "Delicious Vinyl" and "Matador," which are distributed by Atlantic. Recording artists are engaged under arrangements that generally provide that the artist is to receive a percentage of the suggested retail selling price of compact discs, cassette tapes and music videos sold. Most artists receive non- returnable advance payments against future royalties. Among the artists whose albums resulted in significant record sales for WMG's record companies during 1993 were: Eric Clapton, Rod Stewart, the artist formerly known as Prince, Neil Young, Silk, Metallica, 10,000 Maniacs, Stone Temple Pilots, 4 Non Blondes, John Michael Montgomery, Tracy Lawrence, Luis Miguel, Noriyuki Mikihara, Leandro e Leonardo and Mana. In 1994, WMG's record companies expect to release albums by the following artists: Madonna, R.E.M., Travis Tritt, Philip Glass, Motley Crue, Keith Sweat, Tori Amos, Stevie Nicks, Confederate Railroad, Clawfinger, Enya, Gilberto Gil and Inner Circle, among others. WEA Mfg. is engaged in the domestic manufacturing of audio and ROM compact discs, cassette tapes, vinyl records and videocassettes. WEA Mfg. conducts its operations from facilities situated in Olyphant, Pennsylvania and in the greater Los Angeles area. WMI also operates two plants in Germany that manufacture compact discs, cassette tapes and vinyl records for WMI's European affiliates and licensees and for WMI companies outside Europe, as well as for unrelated parties. Ivy Hill Corporation ("Ivy Hill") is engaged in the offset lithography and packaging business through facilities situated in four states. Ivy Hill is a major supplier of packaging to the recorded music industry (including WMG's record companies) and also supplies packaging for a wide variety of other consumer products. Warner Special Products produces, primarily for telemarketers, compilations of music for which it has obtained rights from WMG's recorded music companies as well as third parties. WMG's recorded music product is marketed and distributed in the continental United States by WEA, which supplies, directly or indirectly through sub- distributors and wholesalers, thousands of record stores, department stores, discount centers and other retail outlets across the country. Alternative Distribution Alliance, a music distribution company specializing in alternative rock music, with a focus on new artists, was formed in 1993 as a joint venture of Warner Music Group, its labels, Restless Records and Sub-Pop. I-9 In foreign markets, WMI produces, distributes, promotes and sells recordings of local artists and, in most cases, distributes the recordings of those artists for whom WMG's domestic recording companies have international rights. In certain countries, WMI licenses to non-affiliated parties rights to distribute recordings of WMG's labels. Warner Music Enterprises, a direct marketing company, entered into an agreement in 1993 with the BBC to launch the BBC Music Service, a subscription program specializing in classical music, announced the launch of New Country Music Service, another subscription service, in the first quarter of 1994 and announced the addition of a new rock music magazine to the existing Rock Video Monthly Service for the third quarter of 1994. Through partnerships with Sony Music Entertainment Inc., Time Warner owns a 50% interest in the music and video clubs of The Columbia House Company. The Columbia House Company, consisting of a U.S. partnership and a Canadian partnership, is the leading direct marketer of compact discs, cassette tapes and videocassettes in the United States and Canada. WCI owns a minority portion of Time Warner's 50% interest in the U.S. partnership and all of Time Warner's 50% interest in the Canadian partnership. WMG and Sony Music Entertainment are also partners in Music Sound Exchange, a direct marketing catalog launched in 1993 that is primarily geared to selling music and related product to consumers age 35 and over. A 1993 joint venture between WMG and Sony Software Corporation became an equity partner with TWE's Time Warner Cable in Music Choice, an audio programming service that delivers multiple channels of CD-quality stereo music via cable television. In Europe, where the service is known as Music Choice Europe, it is delivered via cable television and direct-to-home satellite. In December 1993, a joint venture among WMG, Sony, PolyGram, EMI and Hamburg radio executive Frank Otto, launched VIVA, a 24-hour German language music video channel carried on cable television in Germany. In January 1994, WMG, EMI, PolyGram, Sony and Ticketmaster announced plans to form a partnership that will operate an advertiser-supported, 24-hour music video channel to be offered as a basic cable television service in the United States and Puerto Rico. MUSIC PUBLISHING Time Warner's music publishing companies own or control the rights to over 900,000 standard and contemporary compositions, including numerous popular hits, folk songs and music from the stage and motion pictures. Certain works of the following artists, authors and composers are included in Warner/Chappell's catalogues: John Bettis, Michael Bolton, The Black Crowes, Phil Collins, Comden & Green, Dubin & Warren, Genesis, George and Ira Gershwin, Gin Blossoms, Victor Herbert, Michael Jackson, Elton John, Leiber & Stoller, Lerner & Lowe, Madonna, Henry Mancini, Johnny Mercer, George Michael, Midnight Oil, Cole Porter, the artist formerly known as Prince, R.E.M., Rodgers & Hart, Soul Asylum, Jule Styne, Bernie Taupin, Van Halen, John Williams and the foreign administration of the works of Irving Berlin. Warner/Chappell also administers the film music of Lucasfilm, Ltd., Viacom Enterprises, Samuel Goldwyn Productions, Famous Music (the music publishing division of Paramount Communications Inc.) outside the United States and Japan, and several other television and motion picture companies. Warner/Chappell's printed music division markets publications throughout the world containing the works of Alabama, Phil Collins, Bon Jovi, The Eagles, The Grateful Dead, Michael Jackson, Led Zeppelin, Madonna, John Mellencamp, the artist formerly known as Prince, Rush, Bob Seger and many others. Principal sources of revenues to Warner/Chappell are license fees for use of its music copyrights on radio and television, in motion pictures and in other public performances; royalties for use of its music copyrights on compact discs, cassette tapes, vinyl records, music videos and in commercials; and sales of published sheet I-10 music and song books for the home musician as well as the professional and school markets, including methods for teaching musical instruments. LEGISLATION The Audio Home Recording Act, enacted in 1992, establishes the right of individuals to copy pre-recorded music for private non-commercial use and grants to copyright owners, including music publishers and record companies, a royalty in connection with the sale of new digital audio recording equipment and blank digital audio recording media. The statute also requires manufacturers of digital audio recording equipment to utilize technology that would prevent subsequent copying from copied audio recordings. In 1993, Congress began considering bills to provide royalties to performers and producers of digitized music. The legislation is prompted by the improved reception and the potential for recording that digitization of broadcast, cable and other means of music distribution is expected to provide. Passage of this legislation could be favorable to WMG's interests. COMPETITION The recorded music business is highly competitive. The revenues and income of a company in the recording industry depend upon the public acceptance of the company's recording artists and the recordings released in a particular year. Although WMG is one of the largest recorded music companies in the world, its competitive position is dependent upon its continuing ability to attract and develop talent that can achieve a high degree of public acceptance. The recorded music business continues to be adversely affected by counterfeiting, piracy, parallel imports and, in particular, the home taping of recorded music. In addition, the recorded music business also meets with competition from other forms of entertainment, such as television, pre-recorded videocassettes and video games. Competition in the music publishing business is intense. Although WMG's music publishing business is the largest on a worldwide basis, it competes with every other music publishing company in acquiring musical compositions and in having them recorded and performed. ENTERTAINMENT The Company's Entertainment Group consists of TWE's Filmed Entertainment, Programming--HBO and Cable businesses, and also the Company's interests in certain other businesses. Each of the three principal businesses is operated as a separate division of TWE and, except as described below, in the same manner as it was operated by the Company at the time of the TWE Capitalization. See "--Description of Certain Provisions of the TWE Partnership Agreement-- Management and Operations of TWE." In order to ensure compliance with the Modification of Final Judgment entered on August 24, 1982 by the United States District Court for the District of Columbia applicable to USW and its affiliated enterprises, which may include TWE (the "Modification of Final Judgment"), prior to USW's investment in TWE, TWE distributed to the TW Partners certain assets, including the satellite receiving dishes and broadcast antennae used by TWE's cable division, the transponders and other transmission equipment used by TWE's cable television programming and filmed entertainment divisions and equity interests in certain programming entities (collectively, the "TW Service Partnership Assets"). Such partners then contributed such assets to newly formed sister partnerships in which the TW Partners and subsidiaries of ITOCHU and Toshiba are the partners (the "Time Warner Service Partnerships"). Upon the distribution of the TW Service Partnership Assets to the TW Partners, the TW Partners' junior priority capital interests were reduced by approximately $300 million. See "--Other Entertainment Group Assets--Time Warner Service Partnerships." Generally, the Modification of Final Judgment prohibits the seven Regional Bell Operating Companies ("RBOCs") including USW, and any of their "affiliated enterprises," which, as a result of the USW I-11 Transaction, may include TWE, from among other things, (i) providing long distance telecommunications services, which may include operating or providing long distance services using TVROs or satellites, or coaxial cable, fiber or microwave facilities, (ii) manufacturing or providing telecommunications equipment and (iii) manufacturing "customer premises equipment," which may include cable television converter or multimedia boxes. In addition, the Modification of Final Judgment may prohibit the RBOCs and their "affiliated enterprises" from holding certain financial interests in ventures that engage in the foregoing activities. Several bills that would alleviate many of the restrictions contained in the Modification of Final Judgment are under active consideration in the Congress. See "--Other Entertainment Group Assets--Time Warner Service Partnerships." FILMED ENTERTAINMENT DIVISION General TWE's principal operations in the fields of motion pictures and television are conducted by its Warner Bros. division ("WB"). The filmed entertainment business includes the production, financing and distribution of feature motion pictures, television series, made-for-television movies, mini-series for television, first-run syndication programming, and animated programming for theatrical and television exhibition; and the distribution of pre-recorded videocassettes and videodiscs. TWE also is engaged in product licensing and the ownership and operation of retail stores, movie theaters and theme parks. Feature motion pictures and television programs are produced at various locations throughout the world, including The Warner Bros. Studio in Burbank, California and The Warner Hollywood Studio in West Hollywood, California. For additional information, see Item 2 ITEM 2. PROPERTIES PUBLISHING, MUSIC AND CORPORATE The following table sets forth certain information as of December 31, 1993 with respect to the Company's principal properties (over 250,000 square feet in area) that are used primarily by its publishing and music divisions or occupied for corporate offices, all of which the Company considers adequate for its present needs, and all of which were substantially used by the Company or were leased to outside tenants: I-37 ENTERTAINMENT The following table sets forth certain information as of December 31, 1993 with respect to TWE's principal properties (over 125,000 square feet in area), all of which TWE considers adequate for its present needs, and all of which were substantially used by TWE or were leased to outside tenants. I-38 - -------- (a) Ten acres consist of various parcels adjoining The Warner Bros. Studio, with mixed commercial, office and residential uses. (b) 1,640 acres of which are undeveloped land available for expansion. (c) Excludes 8,817,000 sq. ft. of owned and 2,024,000 sq. ft. of leased properties used by the Cable division for headend, hub, and tower sites. (d) Includes 108,000 sq. ft. of office space occupied by Time Warner corporate staff who provide services to TWE pursuant to arrangements set forth in the TWE Partnership Agreement. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties, in the ordinary course of business, to litigations involving property, personal injury and contract claims. The amounts that the Company believes may be recoverable in these matters are either covered by insurance or are not material. In June 1989, a stockholder class action was filed in the Court of Chancery for the State of Delaware, in and for New Castle County ("Delaware Chancery Court"), entitled In re Time Incorporated Shareholder Litigation, Consol. Civ. Action No. 10670 (the "Time Warner Stockholder Litigation"), against the Company, its Board of Directors, WCI and the Company's financial advisors, Wasserstein Perella & Co., Inc. ("Wasserstein Perella") and Shearson Lehman Hutton Inc. ("Shearson Lehman"), in which plaintiffs seek, among other things, judgment declaring that the defendant directors breached their fiduciary duties by entering into the Share Exchange Agreement dated as of March 3, 1989, as amended, between the Company and WCI (the "Share Exchange Agreement") and the Agreement and Plan of Merger (as amended, the "Merger Agreement") among the Company, TW Sub Inc., then a wholly owned subsidiary of the Company, and WCI, as in effect on March 3, 1989, and that WCI, Shearson Lehman and Wasserstein Perella aided and I-39 abetted those breaches; an order requiring redemption of the Rights issued pursuant to the Company's Stockholder Rights Plan; and judgment rescinding consummation of the Share Exchange Agreement and enjoining the Company's acquisition of WCI pursuant to the tender offer (the "Tender Offer") pursuant to which the Company purchased 100 million shares of WCI common stock for $70 per share on July 24, 1989 and the Merger Agreement. Plaintiffs' motion preliminarily to enjoin the Tender Offer was denied in July 1989 and that decision was affirmed on appeal. In July 1993, the action was dismissed without prejudice and without the payment of any compensation to the plaintiffs by the defendants. Two other purported stockholder class actions, Greenberg v. Time, et al., and Northern Laminating, Inc. Retirement Fund v. Munro, et al., Index No. 12653-89, were filed in June 1989 in the Supreme Court of the State of New York, County of New York ("New York Supreme Court") and make substantially similar allegations against most of the same defendants, plus an alleged violation of New York antitrust law. Defendants have not yet been required to respond to the amended complaint in the Northern Laminating case. The Greenberg action had been consolidated with the Time Warner Stockholder Litigation, which was dismissed in July 1993. Also pending in the Delaware Chancery Court is another consolidated stockholder litigation, In re Warner Communications Inc. Shareholders Litigation, Consol. Civ. Action No. 10671 (the "Warner Stockholder Litigation"), commenced in 1989 against WCI, its Board of Directors and the Company, alleging that WCI's Board of Directors breached their fiduciary duties to WCI's stockholders, and the Company aided and abetted such alleged breach, by not ensuring that the securities distributed to WCI stockholders in the Merger contained certain protective covenants and redemption provisions. The amended complaint seeks, among other things, to enjoin the consummation of the Tender Offer and the Merger, or to rescind the Tender Offer and the Merger. The defendants have not yet been required to respond to the amended complaint. The action has been stayed pending resolution of the Berger action described below. Another 1989 purported stockholder class action, Berger, et al. v. Warner Communications Inc., et al., Index No. 91-3735, filed in the New York Supreme Court against WCI, certain of WCI's directors, the Company, Wasserstein Perella, Shearson Lehman and Lazard Freres & Co. ("Lazard") alleges, among other things, that WCI's directors and the Company breached their fiduciary duties to WCI's stockholders by structuring the Merger as a freezeout of WCI's minority stockholders, and by failing to ensure that the securities to be distributed to stockholders in the Merger would in fact trade at the value imputed to those securities, and that Wasserstein Perella, Shearson Lehman and Lazard aided and abetted those breaches of fiduciary duty. The complaint seeks, among other things, a declaratory judgment that defendants have breached their fiduciary duties, compensatory damages and a judgment declaring the Merger a nullity. On April 9, 1991, a court order effected defendants' stipulation to the certification of a plaintiff class consisting of those persons who held shares of WCI common stock on August 23, 1989 and before the effective date of the Merger, except defendants in this litigation and any person or entity related to or affiliated with any defendants. Argument on both sides' motions for partial summary judgment on plaintiffs' contract claim for additional interest of approximately $20 million in connection with the consideration paid in the merger transaction was heard on February 22, 1994. Another purported stockholder class action, Silverstein v. Warner Communications Inc., et al., Civ. Action No. 11285, was filed in 1989 in the Delaware Chancery Court against WCI, members of its Board of Directors and the Company. The complaint alleges, among other things, violations of fiduciary duties to WCI stockholders by allegedly "forcing out" WCI's stockholders upon consummation of the Merger at an unfair price without according them a meaningful vote or the right to an appraisal proceeding. The complaint seeks rescission or rescissory and other damages in an unspecified amount. In August 1991, the court signed a stipulation of the parties staying the Silverstein action and the Warner Stockholder Litigation pending resolution of the Berger action. The parties have agreed to dismiss this action without prejudice and without compensation to the plaintiffs or their attorneys. An order effectuating that agreement was approved by the court on March 28, 1994. I-40 Two class actions consolidated under the caption In re Time Warner Inc. Securities Litigation, Master Case No. 91 Civ. 4081, brought purportedly on behalf of holders of the Company's Common Stock, were filed in June 1991 in the United States District Court for the Southern District of New York against the Company and several of its directors. Plaintiffs allege that defendants issued materially false and misleading statements regarding possible strategic alliances and failed to disclose the Company's intention to make the Rights Offering Proposal of June 5, 1991, whereby each holder of the Company's Common Stock was granted a specific number of transferable subscription rights to purchase additional shares of the Company's Common Stock that could be exercised or sold under certain specified terms and conditions, in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and the state common law of fraud and negligent misrepresentation. Plaintiffs in both actions seek unspecified monetary damages. On May 29, 1992, the defendants' motion to dismiss these actions with prejudice was granted. On November 30, 1993, a panel of the United States Court of Appeals for the Second Circuit, with one judge dissenting, reversed the dismissal and remanded the case to the District Court for further proceedings. On January 24, 1994, defendants filed a petition for a writ of certiorari in the U.S. Supreme Court. Plaintiffs filed briefs in opposition to the petition and in support of a conditional cross-petition on or about February 23, 1994, and defendants have filed reply papers. On March 3, 1994, defendants also filed a motion for summary judgment in the District Court. The District Court has stayed all proceedings pending a determination by the Supreme Court on the certiorari petitions. Two identical lawsuits under the name of Ferne Glanzrock, Bernice Berger, Charles Elder and Arthur Schecter v. Steven J. Ross et al., that were filed in March 1992, in the New York Supreme Court and in the Delaware Chancery Court against the Company's Board of Directors relating to certain payments to the Company's former President and Co-Chief Executive Officer N.J. Nicholas Jr. in connection with his termination of employment were dismissed without prejudice by Court order on January 26, 1994 pursuant to a stipulation of the parties. On January 24, 1994, a purported class action entitled Dr. Arun Shingala v. Gerald M. Levin, et al., Civil Action No. 13356, was filed against the Company and its directors in the Court of Chancery of the State of Delaware, New Castle County, on behalf of all stockholders of the Company, other than defendants and their related or affiliated entities. The complaint alleges that the defendant directors acting on behalf of the Company have adopted a plan ("rights plan") to thwart any attempt to take over control of the Company which the defendants find unfavorable to their personal interests. Plaintiff contends that defendants' actions are in violation of their fiduciary duties and seeks a judgment rescinding the adoption of the rights plan and ordering the director defendants jointly and severally to account for all damages which reasonably flow from the actions and transactions alleged. In November 1992, TWE filed a federal lawsuit seeking to overturn major provisions of the 1992 Cable Act primarily on First Amendment grounds. The complaint, filed in the U.S. District Court for the District of Columbia against the FCC and the United States of America, challenges the provisions of the 1992 Cable Act relating to rate regulation, must carry, retransmission consent, terms of dealing by vertically integrated programmers, uniform pricing and operation of cable systems by municipal authorities, the number of subscribers that a cable operator could serve nationwide, free previews of certain premium channels and educational channel set-aside requirements for direct broadcast satellite service. In addition, the complaint seeks to overturn several parts of the 1984 Cable Act relating to public, educational and government access requirements and commercial leased channels. The complaint seeks injunctions against the enforcement or implementation of these provisions. Several other parties have also filed similar lawsuits and these actions have been at least partially consolidated with the action filed by TWE. Hearings on the plaintiffs' motions for summary judgment and the defendants' motions to dismiss or for summary judgment were held in March 1993. On April 8, 1993, in a 2-1 decision, the District Court upheld the constitutionality of the must carry provisions of the 1992 Cable Act. On May 3, 1993, TWE filed an appeal from this decision directly to the U.S. Supreme Court. The U.S. Supreme Court heard argument on that appeal in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality on First Amendment grounds of all the other challenged provisions except restrictions on the number of subscribers that a cable operator could serve I-41 nationwide, free pay TV previews and direct broadcast channel usage. TWE appealed this decision to the U.S. Court of Appeals for the D.C. Circuit on November 12, 1993. For a description of the 1984 Cable Act and the 1992 Cable Act, see Item 1 "Business--Cable Division--Regulation and Legislation." By letters dated July 15, 1993 and September 21, 1993 (the "Access Letters"), the Dallas Regional Office of the Federal Trade Commission (the "FTC") informed WEA that it is conducting a preliminary investigation to determine whether WEA is "unreasonably restricting the resale of previously-owned compact discs" and "unreasonably restricting the sale of new compact discs." The Access Letters allege that WEA's conduct may violate Section 5 of the Federal Trade Commission Act, but also say that neither the Access Letters nor the existence of the investigation "should be viewed as an accusation by the FTC or its staff of any wrongdoing by [WEA]." The Access Letters request that WEA voluntarily submit the documents and information requested therein. The FTC investigation also includes other major distributors of recorded music. WEA is cooperating with the investigation. On July 19, 1993, Wherehouse Entertainment, Inc., a California corporation engaged in the retail sale of music cassettes and compact discs ("CDs"), filed an action in the United States District Court for the Central District of California entitled Wherehouse Entertainment, Inc. v. CEMA Distribution, Sony Music Distribution, UNI Distribution Corporation and Warner Elektra Atlantic Corporation, No. 93-4253 SVW, alleging that, by implementing policies restricting the advertising allowances of customers that sell used CDs, the defendants have violated Section 1 of the Sherman Act, Sections 2(d) and 2(e) of the Robinson-Patman Act and Section 17200 of the California Business & Professions Code. Plaintiff sought injunctive relief, treble damages pursuant to Section 4 of the Clayton Act, attorneys' fees and costs of suit. On October 20, 1993, plaintiff and WEA settled this case on terms not material to the business of either WEA or WCI. Also in July 1993, two purported class actions against the same defendants in the Wherehouse litigation were filed in the United States District Court for the Northern District of Ohio and in the United States District Court for the Central District of California, containing substantially the same allegations and seeking substantially the same relief as the complaint in the Wherehouse case. Both class action suits have been settled by agreements that are currently before the courts for approval. In October 1993, a purported class action was filed in the United States District Court for the Northern District of Georgia entitled Samuel B. Moore, et al. v. American Federation of Television and Radio Artists, et al., No. 93- CV-2358. The action was brought by fifteen named music performers or representatives of deceased performers on behalf of an alleged class of performers who participated in the creation or production of phonograph recordings for one or more of the defendant recording companies. The named defendants include the American Federation of Television and Radio Artists ("AFTRA"), the AFTRA Health and Retirement Fund ("Fund"), each present trustee of the Fund and fifty named recording companies, including four WCI subsidiaries. The named defendant recording companies comprise substantially all of the domestic recording industry and the complaint seeks to establish a defendant class for purposes of the litigation. The complaint seeks recovery against the recording companies for, among other things, breach of contract, breach of fiduciary duty, fraud, embezzlement and RICO violations, all growing out of alleged failure by the recording companies to make proper contributions to the Fund pursuant to the Phono Code, which is negotiated by AFTRA and most of the domestic recording companies, and other alleged failures to meet the terms of the Phono Code and individual contracts. Plaintiffs seek from the defendant record companies substantial monetary damages, treble damages, attorneys' fees and costs and the imposition of a constructive trust over the master recordings created from recorded performances of the plaintiffs. In March 1994, plaintiffs filed an amended complaint. Plaintiffs also have filed a motion for a preliminary injunction against AFTRA and the Fund's trustees seeking, among other things, to enjoin the completion of audits of the amount of contributions to be made to the Fund and ongoing collective bargaining negotiations between AFTRA and the record companies, as well as the removal of the Fund's present trustees. The defendant record companies, along with AFTRA and the Fund, have filed papers in opposition to the motion for a preliminary injunction. The time for the record companies to respond to plaintiffs' amended complaint has not yet expired. I-42 The Company and its subsidiaries are also subject to industry investigations by certain government agencies and/or proceedings under the antitrust laws that have been filed by private parties in which, in some cases, other companies in the same or related industries are also defendants. The Company and its subsidiaries have denied or will deny liability in all of these actions. In all but a few similar past actions, the damages, if any, recovered from the Company or the amounts, if any, for which the actions were settled were small or nominal in relation to the damages sought; and it is the opinion of the management of the Company that any settlements or adverse judgments in the similar actions currently pending will not involve the payment of amounts or have other results that would have a material adverse effect on the financial condition of the Company. In addition, WCI and certain of its current and former directors are parties to lawsuits previously disclosed in WCI's annual reports or other filings which, among other things, challenge as excessive certain executive compensation arrangements between WCI and, among others, Steven J. Ross, formerly Chairman of the Board of WCI. The parties have executed a stipulation of settlement of these actions and on March 15, 1994 the New York Supreme Court approved a Notice of Proposed Settlement to be sent to shareholders and set May 13, 1994 as the date for the settlement hearing. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders Not Applicable. I-43 EXECUTIVE OFFICERS OF THE COMPANY Pursuant to General Instruction G (3), the information regarding the Company's executive officers required by Item 401(b) of Regulation S-K is hereby included in Part I of this report. The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age, as of February 28, 1994, of such officer: Set forth below are the positions held by each of the executive officers named above since March 1, 1989: Mr. Levin.................. Chairman of the Board of Directors, President and Chief Executive Officer since January 21, 1993. Prior to that he served as President and Co-Chief Executive Officer from February 20, 1992; Vice Chairman and Chief Operating Officer from May 1991; and Vice Chairman of the Board prior to that. Mr. Munro.................. Chairman of the Executive/Finance Committee of the Board of Directors since January 1993 (at which time the functions of the Executive Committee and the Finance Committee were merged), having served as Chairman of the Executive Committee since May 8, 1990. Prior to that, he was Co-Chairman of the Board and Co-Chief Executive Officer from July 1989 and he served as Chairman and Chief Executive Officer prior to that. Mr. Wasserman.............. Executive Vice President and Chief Financial Officer since January 10, 1990. Prior to that, he was a member of the Office of the President and Chief Financial Officer of WCI. Mr. Haje................... Executive Vice President and General Counsel since October 1, 1990. Prior to that, he was a member of the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. Mr. Boggs.................. Senior Vice President, Public Policy since November 19, 1992. Prior to that he served as Vice President of Public Affairs from January 1990 and Vice President of Public Affairs of WCI prior to that. Mr. Haas................... Senior Vice President and Controller since January 18, 1990. Prior to that, he served as Senior Vice President and Controller of WCI. Mr. Holmes................. Senior Vice President, Technology since January 21, 1993. Prior to that, he served as Senior Vice President from January 10, 1990 and as Senior Vice President of WCI prior to that. I-44 Mr. Hullin................. Senior Vice President, Communications and Public Affairs since February 7, 1991. Prior to that, he served as Senior Vice President, Corporate Affairs of SmithKline Beecham (diversified health care company) from July 1989 and as Vice President, Communications and Public Affairs prior to that. Mr. Lochner................ Senior Vice President since July 18, 1991. Prior to that, he was a Commissioner of the Securities and Exchange Commission from March 1990 to June 1991. Prior to his tenure with the SEC, Mr. Lochner served as Deputy General Counsel and Senior Vice President of Time Warner from January to March 1990 and General Counsel, Senior Vice President and Secretary prior to that. I-45 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market for the Company's Common Stock is the New York Stock Exchange. The Common Stock is also listed on the Pacific Stock Exchange and the London Stock Exchange. For quarterly price information with respect to the Company's Common Stock for the two years ended December 31, 1993, see "Quarterly Financial Information" at page herein, which information is incorporated herein by reference. The approximate number of holders of record of the Company's Common Stock as of March 1, 1994 was 23,000. For information on the frequency and amount of dividends paid with respect to the Company's Common Stock during the two years ended December 31, 1993, see "Quarterly Financial Information" at page herein, which information is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial information of the Company for the five years ended December 31, 1993 is set forth at pages and herein and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the caption "Management's Discussion and Analysis" at pages through herein is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and supplementary data of the Company and the report of independent auditors thereon set forth at pages through and herein are incorporated herein by reference. Quarterly Financial Information set forth at page herein is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. II-1 PART III ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information called for by PART III (Items 10, 11, 12 and 13) is incorporated by reference from the Company's definitive Proxy Statement to be filed in connection with its 1994 Annual Meeting of Stockholders pursuant to Regulation 14A, except that the information regarding the Company's executive officers called for by Item 401(b) of Regulation S-K has been included in PART I of this report and the information called for by Items 402(k) and 402(l) of Regulation S-K is not incorporated by reference. III-1 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1)-(2) Financial Statements and Schedules: (i) The list of consolidated financial statements and schedules set forth in the accompanying Index to Consolidated Financial Statements and Other Financial Information at page herein is incorporated herein by reference. Such consolidated financial statements and schedules are filed as part of this report. (ii) The financial statements and financial statement schedules of Paragon Communications and the report of independent accountants thereon, set forth at pages through in the 1993 Annual Report on Form 10-K of Time Warner Entertainment Company, L.P. (Reg. No. 33-53742) are incorporated herein by reference and are filed as an exhibit to this report. (3) Exhibits: The exhibits listed on the accompanying Exhibit Index are filed or incorporated by reference as part of this report and such Exhibit Index is incorporated herein by reference. Exhibits 10.1 through 10.20 listed on the accompanying Exhibit Index identify management contracts or compensatory plans or arrangements required to be filed as exhibits to this report, and such listing is incorporated herein by reference. (b) No reports on Form 8-K were filed by Time Warner during the quarter ended December 31, 1993. IV-1 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 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. Time Warner Inc. /s/ Bert W. Wasserman By ................................... BERT W. WASSERMAN EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Date: March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE /s/ Gerald M. Levin Director, Chairman of the March 30, 1994 ............................ Board, President and Chief (GERALD M. LEVIN) Executive Officer /s/ Bert W. Wasserman Executive Vice President and March 30, 1994 ............................ Chief Financial Officer (BERT W. WASSERMAN) (principal financial officer) /s/ David R. Haas Senior Vice President and March 30, 1994 ............................ Controller (principal (DAVID R. HAAS) accounting officer) Director March 30, 1994 ............................ (MERV ADELSON) * Director March 30, 1994 ............................ (LAWRENCE B. BUTTENWIESER) * Director March 30, 1994 ............................ (HUGH F. CULVERHOUSE) * Director March 30, 1994 ............................ (EDWARD S. FINKELSTEIN) * ............................ Director March 30, 1994 (BEVERLY SILLS GREENOUGH) IV-2 SIGNATURE TITLE DATE --------- ----- ---- * ............................. Director March 30, 1994 (CARLA A. HILLS) * ............................. Director March 30, 1994 (DAVID T. KEARNS) * ............................. Director March 30, 1994 (HENRY LUCE III) * ............................. Director March 30, 1994 (REUBEN MARK) * ............................. Director March 30, 1994 (J. RICHARD MUNRO) * ............................. Director March 30, 1994 (RICHARD D. PARSONS) * ............................. Director March 30, 1994 (DONALD S. PERKINS) * ............................. Director March 30, 1994 (RAYMOND S. TROUBH) * ............................. Director March 30, 1994 (FRANCIS T. VINCENT, JR.) /s/ David R. Haas By: ........................ ATTORNEY-IN-FACT IV-3 TIME WARNER INC. AND TIME WARNER ENTERTAINMENT COMPANY, L.P. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND OTHER FINANCIAL INFORMATION All other financial statements and schedules are omitted because the required information is not present, or is not present in amounts sufficient to require submission of the financial statements or schedules, or because the information required is included in the consolidated financial statements and notes thereto. TIME WARNER INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, (MILLIONS, EXCEPT PER SHARE AMOUNTS) - -------- (a)The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Note 1). (b)Time Warner issued $6.1 billion of long-term debt and used $.5 billion of cash and equivalents in 1993 in exchange for or to redeem preferred stock having an aggregate liquidation preference of $6.4 billion (Notes 5 and 7). See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF OPERATIONS YEARS ENDED DECEMBER 31, (MILLIONS, EXCEPT PER SHARE AMOUNTS) (d)Includes $70 million unusual charge for increase in deferred income tax liability as a result of new tax law. (e)Time Warner issued $6.1 billion of long-term debt and used $.5 billion of available cash and equivalents in 1993 in exchange for or to redeem preferred stock having an aggregate liquidation preference of $6.4 billion (Notes 5 and 7). See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, (MILLIONS) - -------- (a)The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Note 1). (b)Includes $70 million increase in deferred income tax liability as a result of new tax law and $57 million extraordinary loss on the retirement of debt. See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (MILLIONS, EXCEPT PER SHARE AMOUNTS) See accompanying notes. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION AND ACCOUNTING FOR INVESTMENTS IN AFFILIATED COMPANIES The consolidated financial statements include the accounts of Time Warner Inc. and its subsidiaries ("Time Warner"). Significant intercompany accounts and transactions are eliminated. Interests in consolidated subsidiaries not owned by Time Warner are eliminated from operating results and reflected in the balance sheet as minority interests. Investments in companies in which Time Warner has significant influence but less than controlling financial interest are stated at cost plus equity in the affiliates' undistributed earnings. The excess of cost over the underlying net equity of investments in affiliated companies is attributed to the underlying net assets based on their respective fair values and amortized over their respective economic lives. Time Warner Entertainment Group ("Entertainment Group"), consisting of Time Warner's interests in certain entertainment companies, principally Time Warner Entertainment Company, L.P. ("TWE"), was deconsolidated effective January 1, 1993 as a result of an agreement between TWE and U S WEST, Inc. ("USW") to co- manage TWE Cable's Full Service Networks(TM), subject to franchise and regulatory approvals, and certain other changes to the partnership agreement relating to the general governance of TWE (Note 2). The historical financial statements of Time Warner for periods prior to January 1, 1993 have not been changed; accordingly, they include TWE and other Entertainment Group interests on a consolidated basis. However, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation of the Entertainment Group also are presented under the caption "restated" to facilitate comparative analysis. The effect of changes in Time Warner's ownership interests resulting from the issuance of equity capital to third parties by consolidated subsidiaries or affiliates accounted for on the equity basis is included in income. Time Warner's $14 billion cost to acquire Warner Communications Inc. ("WCI") was allocated to the net assets acquired as of December 31, 1989 in accordance with the purchase method of accounting for business combinations. The acquisition was financed principally by $8.3 billion of long-term debt and $5.6 billion of Series C and Series D preferred stock, which was redeemed or exchanged for debt in 1993 (Notes 5 and 7). The effect of the four-for-one common stock split on September 10, 1992 has been reflected retroactively. REVENUES AND COSTS The unearned portion of paid subscriptions is deferred until magazines are delivered to subscribers. Upon each delivery, a proportionate share of the gross subscription price is included in revenues. Inventories of magazines, books, cassettes and compact discs are stated at the lower of cost or estimated realizable value. Cost is determined using first-in, first-out; last-in, first-out; and average cost methods. In accordance with industry practice, certain products are sold to customers with the right to return unsold items. Revenues from such sales represent gross sales less a provision for future returns. Returned goods included in inventory are valued at estimated realizable value but not in excess of cost. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is provided generally on the straight-line method over useful lives ranging up to twenty- five years for buildings and improvements and up to fifteen years for furniture, fixtures and equipment. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) INTANGIBLE ASSETS Intangible assets are amortized over periods up to forty years using the straight-line method. Amortization of the excess of cost over net assets acquired amounted to $148 million, $257 million ($142 million on a restated basis) and $246 million in 1993, 1992 and 1991, respectively, and amortization of music copyrights, artists' contracts and record catalogues amounted to $113 million in all years. Amortization of cable television franchises in 1992 and 1991, years in which the Entertainment Group was consolidated, amounted to $194 million and $171 million, respectively. Accumulated amortization of intangible assets at December 31, 1993 and 1992 amounted to $1.245 billion and $2.021 billion ($943 million on a restated basis), respectively. FOREIGN CURRENCY TRANSLATION The financial position and operating results of substantially all foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in retained earnings (accumulated deficit). Foreign currency transaction gains and losses, which have not been material, are included in operating results. INCOME TAXES Income taxes are provided in 1993 and 1992 using the liability method prescribed by Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes," which Time Warner adopted as of January 1, 1992. Income taxes provided in 1991 using the liability method prescribed by FASB Statement No. 96 were not restated. The effect of the change in accounting method was not material. Under the liability method, deferred income taxes reflect tax carryforwards and the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under enacted tax laws and rates. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. Realization of the net operating loss and investment tax credit carryforwards, which were acquired in acquisitions, are accounted for as a reduction of the excess of cost over net assets acquired. The principal operations of the Entertainment Group are conducted by partnerships. Income tax expense includes all income taxes related to Time Warner's allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the partnerships. FINANCIAL INSTRUMENTS Investments in unrestricted marketable equity securities not accounted for on the equity basis are stated at fair value. Unrealized appreciation is reported net-of-tax in a separate component of shareholders' equity in accordance with FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which Time Warner adopted as of December 31, 1993. Foreign exchange contracts are used to reduce exchange rate exposure on future cash flows and earnings denominated in foreign currencies. Contract gains and losses generally are included in income. Time Warner had contracts for the sale of $573 million of foreign currencies at fixed rates at December 31, 1993, primarily Japanese yen, German marks, Canadian dollars and French francs. The fair value of foreign exchange contracts approximates carrying value. Time Warner reimburses or is reimbursed by TWE for contract gains or losses related to TWE's exposure. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Interest rate swap agreements are used to reduce exposure to interest rate changes and to lower the overall costs of borrowing. The net amounts paid and received under open contracts are included in interest expense. At December 31, 1993, Time Warner had contracts to pay floating rates of interest (average rate of 3.7%) and receive fixed rates of interest (average rate of 5.4%) on $2.1 billion notional amount of indebtedness over an average remaining term of 4 years. The fair value of the Company's debt and related interest rate swap agreements will fluctuate with changes in the credit markets, including changes in the level of interest rates. At December 31, 1993, the fair value of Time Warner's long-term debt was estimated to exceed its carrying value by $530 million. The fair value of the related interest rate swap agreements was not material. Fair value is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. LOSS PER COMMON SHARE Loss per common share is based upon the net loss applicable to common shares after preferred dividend requirements and upon the weighted average of common shares outstanding during the period. The conversion of securities convertible into common stock and the exercise of stock options were not assumed in the calculations of loss per common share because the effect would have been antidilutive. 2.ENTERTAINMENT GROUP Time Warner's investment in and amounts due to and from the Entertainment Group at December 31, 1993 consists of the following (millions): TWE is a Delaware limited partnership that was capitalized on June 30, 1992 to own and operate substantially all of the Filmed Entertainment, Programming- HBO and Cable businesses previously owned by subsidiaries of Time Warner. At December 31, 1993, the Time Warner subsidiaries ("General Partners") held a 63.27% pro rata priority capital partnership interest in TWE in the initial capital amount of $3.5 billion, plus partnership income allocated thereto; a partnership capital interest senior to the pro rata priority capital interests ("General Partners' Senior Capital"), in the initial capital amount of $1.4 billion, plus partnership income allocated thereto; a partnership capital interest junior to pro rata priority capital interests ("General Partners' Junior Capital") in the initial capital amount of $2.7 billion, plus partnership income allocated thereto; and a 63.27% residual equity partnership interest. The limited partners, subsidiaries of USW, ITOCHU Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba"), held 25.51%, 5.61% and 5.61% pro rata priority capital partnership interests, respectively, in the initial capital amounts of $1.4 billion, $313 million and $313 million, respectively, plus partnership income allocated thereto; and residual equity partnership interests of 25.51%, 5.61% and 5.61%, respectively. General Partners' Senior Capital is required to be distributed no later than in three annual installments beginning July 1, 1997; earlier distributions may be made under certain circumstances. General Partners' Junior Capital may be increased if certain performance targets are achieved between 1992 and 2001. Prior to the admission of USW on September 15, 1993, the General Partners held 87.5% pro rata priority capital and residual equity partnership interests in TWE, and the General Partners' Junior Capital interest; and ITOCHU and Toshiba each held 6.25% pro rata priority capital and residual equity partnership interests. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At the initial capitalization of TWE, the General Partners contributed the assets and liabilities or the rights to the cash flow of substantially all of Time Warner's Filmed Entertainment, Programming-HBO and Cable businesses, and ITOCHU and Toshiba each contributed $500 million of cash. On September 15, 1993, USW contributed $1.532 billion of cash and a $1.021 billion 4.4% note ("USW Note") for its interests. USW has an option to increase its pro rata priority capital and residual equity interests to as much as 31.84%, depending on cable operating performance. The option is exercisable between January 1, 1999 and on or about May 31, 2005 at a maximum exercise price of $1.25 billion to $1.8 billion, depending on the year of exercise. Either USW or TWE may elect that the exercise price be paid with partnership interests rather than cash. Each of ITOCHU and Toshiba have options to increase their interests to as much as 6.25% in certain circumstances, payable in cash. Each General Partner has guaranteed a pro rata portion of $7 billion of TWE's debt and accrued interest at December 31, 1993, based on the relative fair value of the net assets each General Partner contributed to TWE. Such indebtedness is recourse to each General Partner only to the extent of its guarantee. In addition to their interests in TWE and the other Entertainment Group companies, the assets of the General Partners include the equivalent of 29.6 million common shares of Turner Broadcasting System, Inc., 12.1 million common shares of Hasbro, Inc., 43.7 million common shares of Time Warner, and substantially all the assets of Time Warner's music business. There are no restrictions on the ability of the General Partner guarantors to transfer assets, other than TWE assets, to parties that are not guarantors. The summarized financial information for the Entertainment Group set forth below reflects the consolidation of Six Flags Entertainment Corporation ("Six Flags") as of January 1, 1993 as a result of the increase in TWE's ownership from 50% to 100% in September 1993. The historical financial information for periods prior to such date has not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. TIME WARNER ENTERTAINMENT GROUP TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Pursuant to the TWE partnership agreement, partnership income, to the extent earned, is first allocated to the partners so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership were taxed as a corporation ("special tax allocations"), then to the priority capital interests, in order of priority, at rates of return ranging from 8% to 13.25% per annum, and finally to the residual equity interests. For the purpose of the foregoing allocations, partnership income is based on the fair value of assets contributed to the partnership, and differs from net income of TWE, which is based on the historical cost of contributed assets. Partnership losses generally are allocated first to eliminate prior allocations of partnership income to, and then to reduce the initial capital amounts of, the residual equity, General Partners' Junior Capital and pro rata priority capital interests, in that order, then to reduce General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce any special tax allocations. TWE reported net income of $198 million and $160 million in 1993 and 1992, respectively, no portion of which was allocated to the limited partners. Time Warner did not recognize a gain when TWE was capitalized. The excess of the General Partners' interest in the net assets of TWE over the net book value of their investment in TWE is being amortized to income over a twenty year period at the rate of $17 million per year prior to the admission of USW, and $72 million per year thereafter. The assets and cash flows of TWE are restricted by the TWE partnership and credit agreements and are unavailable for use by the partners except through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitations. At December 31, 1993, the General Partners had recorded $276 million of tax related distributions due from TWE, $108 million of which is receivable on or after July 1, 1994, and $271 million of stock option related distributions due from TWE, based on a closing price of $44.25, receivable when the options are exercised. In addition to the tax, stock option and General Partners' Senior Capital distributions, TWE may make other distributions, generally depending on excess cash and credit agreement limitations. The General Partners' full share of such distributions may be deferred if the limited partners do not receive certain threshold amounts by certain dates. TWE may loan Time Warner up to $1.1 billion, increasing up to $1.5 billion on July 1, 1995. Generally, TWE must be in compliance with its credit agreement at the time distributions and loans are made. In the normal course of conducting their businesses, Time Warner and its subsidiaries and affiliates have had various transactions with TWE and other Entertainment Group companies, generally on terms resulting from a negotiation between the affected units that in management's view results in reasonable allocations. Time Warner provides TWE with certain corporate support services for which it receives an annual fee of $60 million. Inventories of TWE at December 31, 1993 and 1992 include $821 million and $879 million, respectively, of unamortized cost of the WCI acquisition allocated to the film library, which is amortized on a straight-line basis over twenty years, $1.085 billion and $982 million, respectively, of the unamortized cost of completed films, more than 90% of which is expected to be amortized within three years after release under the TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) individual film-forecast method prescribed by FASB Statement No. 53, "Financial Reporting by Producers and Distributors of Motion Picture Films," $347 million and $285 million, respectively, of theatrical films and television programs in process, and $405 million and $457 million, respectively, of unamortized programming acquired or produced for pay cable television exhibition, which is allocated to availability periods and amortized as the programming is exhibited. On June 26, 1992, Time Warner acquired the 18.7% minority interest in American Television and Communications Corporation ("ATC") by issuing redeemable reset notes due August 15, 2002 (Note 5), valued at such date at $1.3 billion. The acquisition was accounted for by the purchase method of accounting. ATC subsequently contributed its cable assets to TWE. The Entertainment Group would have reported net income of $142 million and Time Warner would have reported net income of $47 million (a loss of $1.57 per common share after preferred dividends) in 1992 if the acquisition of the ATC minority interest had occurred at the beginning of that year. 3. OTHER INVESTMENTS Time Warner's other investments consist of: - -------- (1) Upon adoption of FASB Statement No. 115 at December 31, 1993, unrestricted marketable equity securities not accounted for on the equity basis are stated at fair value. The 1993 amount includes the market value of 12.058 million shares of common stock of Hasbro, Inc., which can be used, at Time Warner's option, to satisfy its obligations with respect to the zero coupon exchangeable notes due 2012 (Note 5). Investments in unrestricted marketable equity securities not accounted for on the equity basis were carried at a cost of $297 million and had a market value of $481 million at December 31, 1992. Companies accounted for on the equity basis other than TWE and its equity affiliates include Turner Broadcasting System, Inc. ("TBS") (19.4% owned); Cinamerica Theatres, L.P. (50% owned) and The Columbia House Company partnerships (50% owned) and other music joint ventures (generally 50% owned). Equity affiliates of TWE include Paragon Communications (50% owned), certain other cable system joint ventures (generally 50% owned) and Comedy Partners (50% owned). A summary of financial information of equity affiliates (100% basis) is set forth below. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The market value and cost of Time Warner's investment in TBS at December 31, 1993 was $1.484 billion and $493 million, respectively. The sale, transfer or other disposition of substantially all of the shares of TBS capital stock is restricted pursuant to shareholder agreements. The TBS securities also may be considered restricted securities under the Securities Act of 1933 and, if so, could only be sold pursuant to an effective registration statement or in a transaction exempt from the registration requirements of the Securities Act of 1933. 4.INVENTORIES Time Warner's current inventories consist of: 5.LONG-TERM DEBT Long-term debt consists of: - -------- (1) Classified as long-term because of the intent and ability to refinance under a long-term financing arrangement with TWE. Time Warner issued $6.126 billion of long-term debt and used $494 million of cash and equivalents in 1993 in connection with the redemption and exchange of preferred stock having an aggregate liquidation value of $6.368 billion (Note 7). TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The redeemable reset notes due August 15, 2002 do not pay interest prior to August 15, 1995, the first redemption date, at which time an interest rate will be set. The interest rate will be reset on August 15, 1998, the second redemption date. The notes are redeemable at par on each redemption date, payable in any combination of cash and debt securities, if Time Warner elects to redeem the notes, or in any combination of cash or equity or debt securities of Time Warner or any other entity, if the holders elect to have the notes redeemed. Unamortized discount was $229 million and $358 million at December 31, 1993 and 1992, respectively. The zero coupon notes do not pay interest until maturity. The zero coupon exchangeable notes due December 17, 2012 are exchangeable at any time by the holder into 7.301 shares of common stock of Hasbro, Inc. ("Hasbro shares") per $1,000 principal amount, subject to Time Warner's right to pay in whole or in part with cash instead of Hasbro shares. Time Warner can elect to redeem the notes any time after December 17, 1997, and holders can elect to have the notes redeemed prior thereto in the event of a change of control, at the issue price plus accrued interest. Holders also can elect to have the notes redeemed at the issue price plus accrued interest on December 17, 1997, 2002 and 2007, subject to Time Warner's right to pay in whole or in part with Hasbro shares instead of cash. Unamortized discount was $1.137 billion and $1.168 billion at December 31, 1993 and 1992, respectively. The zero coupon convertible notes due June 22, 2013 are convertible at any time by the holder into 7.759 shares of Time Warner common stock. Time Warner can elect to redeem the notes any time after June 22, 1998, and holders can elect to have the notes redeemed prior thereto in the event of a change in control, at the issue price plus accrued interest. Holders also can elect to have the notes redeemed at the issue price plus accrued interest on June 22, 1998, 2003 and 2008, subject to Time Warner's right to pay in whole or in part with Time Warner common stock instead of cash. Unamortized discount was $1.492 billion at December 31, 1993. $3.125 billion of 8.75% convertible subordinated debentures due January 10, 2015 were issued in exchange for Series C convertible preferred stock in April 1993 (Note 7). $900 million of such debentures were redeemed in July 1993. The $2.225 billion of 8.75% convertible subordinated debentures outstanding at December 31, 1993 are convertible into 46.6 million shares of Time Warner common stock at the rate of $47.73 principal amount of indebtedness per common share and are redeemable at any time, in whole or in part, at Time Warner's option, at 105.25% of par until January 9, 1995, decreasing ratably each year thereafter to 100% of par on January 10, 2000. An after-tax cost of $57 million was incurred in connection with the redemption of debt in 1993, principally the redemption of $900 million of 8.75% convertible subordinated debentures and $529 million of WCI senior and subordinated debentures. Each General Partner has guaranteed a pro rata portion of $7 billion of TWE's debt and accrued interest at December 31, 1993, as more fully described in Note 2. When TWE was consolidated with Time Warner at December 31, 1992, TWE's debt consisted of $5.507 billion borrowed under its credit agreement (4.5% interest rate), $447 million of commercial paper (4.3% interest rate), $600 million of 9.625% senior notes due 2002, $350 million of 8.875% senior notes due 2012 and $250 million of 10.15% senior notes due 2012. TWE's credit agreement contains certain restrictive covenants relating to, among other things, additional indebtedness; cash flow coverage and leverage ratios; and loans, advances, distributions or other cash payments or transfers of assets to Time Warner and its subsidiaries. Interest expense amounted to $698 million in 1993, $729 million ($287 million on a restated basis) in 1992 and $912 million in 1991. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Annual repayments of long-term debt for the five years subsequent to December 31, 1993 are: 1994-$375 million; 1995-$300 million; and 1998-$500 million. Such amounts exclude the aggregate repurchase or redemption prices of $1.801 billion in 1995, $656 million in 1997 and $1.151 billion in 1998 relating to the redeemable reset notes, zero coupon exchangeable notes and zero coupon convertible notes, respectively, in the years in which the holders of such debt may first exercise their redemption options. 6.INCOME TAXES Domestic and foreign pretax income (loss) are as follows: Current and deferred income taxes (tax benefits) provided are as follows: - -------- (1) Includes utilization of tax carryforwards of $136 million in 1993, $15 million in 1992 and $120 million in 1991. Excludes $14 million of current tax benefits resulting from the exercise of stock options in 1993, which were credited directly to paid-in-capital, and $6 million of current tax benefits resulting from the retirement of debt, which reduced the extraordinary loss. (2) Includes $70 million unusual charge in 1993 to increase deferred tax liability for increase in tax rate. (3) Includes foreign withholding taxes of $79 million in 1993, $57 million in 1992 and $43 million in 1991. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The differences between income taxes expected at the U.S. federal statutory income tax rate and income taxes provided are as set forth below. The relationship between income before income taxes and income tax expense is most affected by the amortization of excess cost over net assets acquired and certain other financial statement expenses that are not deductible for income tax purposes and by a $70 million unusual charge ($.19 per common share) in 1993 to adjust the deferred income tax liability for the increase in the U.S. federal statutory rate from 34% to 35% enacted into law during the year. U.S. income and foreign withholding taxes have not been recorded on permanently reinvested earnings of foreign subsidiaries aggregating approximately $575 million at December 31, 1993. Determination of the amount of unrecognized deferred U.S. income tax liability with respect to such earnings is not practicable. If such earnings are repatriated, additional U.S. income and foreign withholding taxes are expected to be offset by the accompanying foreign tax credits. U.S. federal tax carryforwards at December 31, 1993 consisted of $52 million of net operating losses that expire from 1997 to 2003, $267 million of investment tax credits that expire from 1996 to 2004, and $27 million of alternative minimum tax credits that have no expiration dates. The utilization of certain carryforwards is subject to limitations under U.S. federal income tax laws. Significant components of Time Warner's net deferred tax liabilities are as follows: TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 7. CAPITAL STOCK In 1993, Time Warner redeemed its Series D convertible preferred stock for cash and exchanged its Series C convertible preferred stock for 8.75% convertible subordinated debentures due January 10, 2015. The Series D redemption was financed principally by the proceeds from the issuance of long- term notes and debentures (Note 5). Pursuant to a shareholder rights plan adopted in January 1994, Time Warner distributed one right per common share which becomes exercisable in certain events involving the acquisition of 15% or more of Time Warner common stock. Upon the occurrence of such an event, each right entitles its holder to purchase for $150 the economic equivalent of common stock of Time Warner, or in certain circumstances, of the acquiror, worth twice as much. In connection with the plan, 4 million shares of preferred stock were reserved. The rights expire on January 20, 2004. Time Warner issued 137.9 million shares of common stock at $20 per share at the completion of its rights offering on August 5, 1991. Net proceeds of $2.558 billion, after expenses and a $70 million loan to the Time Warner Employee Stock Ownership Plan, were used to reduce credit agreement debt. If the rights offering had been completed on January 1, 1991, net loss for the year ended December 31, 1991 would have been reduced to $33 million, or $1.70 per common share after preferred dividends. At December 31, 1993, Time Warner had reserved 66.2 million shares of common stock for the conversion of the 8.75% convertible subordinated debentures, zero coupon convertible notes and other convertible securities, and 73 million shares for the exercise of outstanding options to purchase shares of common stock. There were 45.2 million shares of common stock in treasury at December 31, 1993, of which 43.7 million were held by subsidiaries who are the General Partners of TWE. At January 31, 1994, there were approximately 23,000 holders of record of Time Warner common stock. 8. STOCK OPTION PLANS Options to purchase Time Warner common stock under various stock option plans have been granted to employees of Time Warner and TWE, generally at fair market value at the date of grant. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant. A summary of stock option activity under all plans is as follows: For options granted to employees of TWE, Time Warner is reimbursed for the amount by which the market value of Time Warner common stock on the exercise date exceeds the exercise price, or the greater of the exercise price or $27.75 for options granted prior to the TWE capitalization. There were 26.8 million options held by employees of TWE at December 31, 1993, 18.5 million of which were exercisable (Note 2). There were 933,000 options exercised in 1992 at prices ranging from $8-$28 per share, 512,000 options exercised in 1991 at prices ranging from $6-$29 per share, and 50.1 million options exercisable and 5.1 million options available for grant at December 31, 1992. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. BENEFIT PLANS Time Warner and its subsidiaries have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Qualifying plans are funded in accordance with government pension and income tax regulations. Plan assets are invested in equity and fixed income securities. Pension expense included the following: The status of funded pension plans is as follows: Employees of Time Warner's operations in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Time Warner also has an employee stock ownership plan, 401(k) savings plans and profit sharing plans as to which the expense amounted to $46 million in 1993, $57 million ($41 million on a restated basis) in 1992 and $53 million in 1991. Contributions to the 401(k) plans are based upon a percentage of the employees' elected contributions. Contributions to the employee stock ownership plan are determined by management and approved by the Board of Directors. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 10.SEGMENT INFORMATION Information as to the operations of Time Warner and the Entertainment Group in different business segments is set forth below: - -------- (1) Includes a $60 million restructuring charge ($36 million after taxes). TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) - -------- (1) Depreciation and amortization includes all amortization relating to the acquisition of WCI in 1989, the acquisition of the ATC minority interest in 1992 and other business combinations accounted for by the purchase method. Information as to the assets and capital expenditures of Time Warner and its Entertainment Group is as follows: - -------- (1) At December 31, 1993 and December 31, 1992 on a restated basis, Entertainment Group assets represent Time Warner's investment in and amounts due to and from Entertainment Group. At December 31, 1992 and 1991 on an historical basis, Entertainment Group assets represent total assets of the Entertainment Group, less certain assets related to transactions with other Time Warner companies. (2) Consists principally of cash and investments. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Information as to Time Warner's operations in different geographical areas is as follows: - -------- (/1/) Includes Filmed Entertainment export revenues of $1.379 billion and $1.133 billion in 1992 and 1991, respectively. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 11.COMMITMENTS AND CONTINGENCIES Total rent expense amounted to $163 million in 1993, $258 million ($159 million on a restated basis) in 1992 and $236 million in 1991. The minimum rental commitments under noncancellable long-term operating leases are: 1994- $138 million; 1995-$125 million; 1996-$113 million; 1997-$104 million; 1998- $102 million and after 1998-$954 million. Minimum commitments and guarantees under certain licensing, artists and other agreements aggregated approximately $1.5 billion at December 31, 1993, which are payable principally over a seven-year period. Such amounts do not include the General Partner guarantees of approximately $7 billion of TWE debt. Pending legal proceedings are substantially limited to litigation incidental to the businesses of Time Warner and alleged damages in connection with class action lawsuits. In the opinion of counsel and management, the ultimate resolution of these matters will not have a material effect on the financial statements of Time Warner. 12.SUPPLEMENTAL INFORMATION Supplemental information with respect to cash flows is as follows: The noncash effects of the deconsolidation of the Entertainment Group are reflected in the differences between the historical and restated balance sheet amounts at December 31, 1992. Time Warner issued $3.125 billion of debentures in a noncash exchange for Series C preferred stock on April 1, 1993 (Note 5 and 7). The principal noncash effects of the acquisition of the ATC minority interest in 1992 were to increase investments by $156 million, cable television franchise costs by $865 million, excess of cost over net assets acquired by $410 million, deferred income taxes by $299 million and long-term debt by $1.312 billion, and to eliminate the ATC minority interest of $180 million. On a restated basis, the investments in and amounts due to and from Entertainment Group were increased $1.431 billion. Investment proceeds in 1992 on a restated basis include $875 million from the collection of a note receivable from TWE. Cash equivalents consist of commercial paper and other investments that are readily convertible into cash, and have original maturities of three months or less. Other current liabilities consist of: REPORT OF MANAGEMENT The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles, and necessarily include some amounts that are based on management's best estimates and judgments. Time Warner maintains a system of internal accounting controls designed to provide management with reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, and that transactions are executed in accordance with management's authorization and recorded properly. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the benefits derived and that the evaluation of those factors requires estimates and judgments by management. Further, because of inherent limitations in any system of internal accounting control, errors or irregularities may occur and not be detected. Nevertheless, management believes that a high level of internal control is maintained by Time Warner through the selection and training of qualified personnel, the establishment and communication of accounting and business policies, and its internal audit program. The Audit Committee of the Board of Directors, composed solely of directors who are not employees of Time Warner, meets periodically with management and with Time Warner's internal auditors and independent auditors to review matters relating to the quality of financial reporting and internal accounting control, and the nature, extent and results of their audits. Time Warner's internal auditors and independent auditors have free access to the Audit Committee. Gerald M. Levin Bert W. Wasserman Chairman and Executive Vice President and Chief Executive Officer Chief Financial Officer REPORT OF INDEPENDENT AUDITORS THE BOARD OF DIRECTORS AND SHAREHOLDERS TIME WARNER INC. We have audited the accompanying consolidated balance sheet of Time Warner Inc. ("Time Warner") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of Time Warner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Time Warner at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York February 4, 1994 TIME WARNER INC. SELECTED FINANCIAL INFORMATION The selected financial information for each of the five years in the period ended December 31, 1993 set forth below has been derived from and should be read in conjunction with the financial statements and other financial information presented elsewhere herein. The selected historical financial information for 1993 reflects the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The selected historical financial information for periods prior to such date have not been changed; however, selected financial information for 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. The selected historical financial information for 1993 reflects the issuance of $6.1 billion of long-term debt and the use of $.5 billion of cash and equivalents in 1993 for the exchange or redemption of preferred stock having an aggregate liquidation preference of $6.4 billion. The selected historical financial information for 1992 reflects the capitalization of TWE on June 30, 1992 and associated refinancings, and the acquisition of the 18.7% minority interest in American Television and Communications Corporation as of June 30, 1992, using the purchase method of accounting for business combinations. The selected historical financial information for 1989 reflects the acquisition of a 59.3% common stock interest in Warner Communications Inc. ("WCI") as of July 31, 1989, and the acquisition on January 10, 1990 of the remaining capital stock of WCI as of December 31, 1989, using the purchase method of accounting for business combinations. Per common share amounts and average common shares have been restated to give effect to the four-for-one common stock split that occurred on September 10, 1992. - -------- (a) The net loss for the year ended December 31, 1993 includes an extraordinary loss on the retirement of debt of $57 million ($.15 per common share) and an unusual charge of $70 million ($.19 per common share) from the effect of the new income tax law on Time Warner's deferred income tax liability. (b) The net loss for the year ended December 31, 1991 includes a $36 million after-tax charge ($.12 per common share) relating to the restructuring of the Publishing division. The net loss in 1989 includes an after-tax gain of $42 million ($.18 per common share) resulting primarily from the sale of 3.125 million shares of Columbia Pictures Entertainment, Inc. common stock and an after-tax loss of $120 million ($.51 per common share) from the sale of Scott, Foresman and Company. (c) In August 1991, Time Warner completed the sale of 137.9 million shares of common stock pursuant to a rights offering. Net proceeds of $2.558 billion from the rights offering were used to reduce indebtedness under Time Warner's bank credit agreement. If the rights offering had been completed at the beginning of 1991, net loss for the year would have been reduced to $33 million, or $1.70 per common share, and there would have been 369.3 million shares of common stock outstanding during the year. (d) After preferred dividend requirements. TIME WARNER INC. SELECTED FINANCIAL INFORMATION--(CONTINUED) TIME WARNER INC. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the heading "restated" to facilitate comparative analysis. (b) The net loss for the second quarter of 1993 includes an extraordinary loss on the retirement of debt of $35 million ($.09 per common share). The net loss for the third quarter of 1993 includes an extraordinary loss on the retirement of debt of $22 million ($.06 per common share) and an unusual charge of $70 million ($.19 per common share) due to the effect of the new income tax law on Time Warner's deferred income tax liability. (c) After preferred dividend requirements. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION There have been a series of transactions during 1993 and 1992 resulting from the restructuring of Time Warner's balance sheet that have affected the comparability of the financial statements, including the following (collectively, the "Time Warner Transactions"): . The USW Transaction: The admission of a subsidiary of USW as an additional limited partner of TWE on September 15, 1993, which resulted in the deconsolidation of the Entertainment Group effective as of January 1, 1993. The historical financial statements of Time Warner for periods prior to 1993 have not been changed; however, financial statements retroactively reflecting the deconsolidation for 1992 also have been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The Series C Exchange and Series D Redemption: The issuance of $3 billion of publicly held long-term debt early in 1993 and $.5 billion late in 1992 in connection with the redemption of $3.3 billion aggregate liquidation value of Series D preferred stock and the exchange of $3.1 billion aggregate liquidation value of Series C preferred stock for $3.1 billion aggregate principal amount of 8-3/4% convertible subordinated debentures. . The 8-3/4% Partial Redemption: The issuance of zero coupon convertible notes in 1993 at an aggregate issue price of $900 million and the use of the proceeds therefrom and available cash and equivalents to redeem $900 million aggregate principal amount of 8-3/4% convertible subordinated debentures. . The 1993 WCI Refinancings: The repurchase or redemption of all of WCI's outstanding senior and subordinated debentures in the aggregate principal amount of $570 million. The following transactions have affected the comparability of the financial statements of both the Entertainment Group and Time Warner (collectively, and together with the USW Transaction, the "Entertainment Group Transactions"): . The 1993 Six Flags Acquisition and Refinancing: The increase in TWE's ownership of Six Flags from 50% to 100% on September 17, 1993 and the retirement of outstanding debt and preferred stock of Six Flags and its subsidiaries, using Six Flags cash flow and $550 million of funds provided by TWE, which resulted in the consolidation of Six Flags effective as of January 1, 1993. The historical summarized financial information of the Entertainment Group for periods prior to January 1, 1993 has not been changed; however, summarized financial information retroactively reflecting the consolidation for 1992 also has been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The 1993 TWE Refinancings: The issuance of $2.6 billion of TWE debentures in 1993 to reduce indebtedness under the TWE credit agreement. . The TWE Capitalization and Refinancing: The initial capitalization of TWE on June 30, 1992 and associated refinancings, including the repayment of the Time Warner and ATC credit agreements with $5.9 billion borrowed under a new TWE credit agreement and $1 billion of capital contributions; and the issuance of $1.2 billion of senior notes to reduce bank debt. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) . The ATC Merger: The acquisition of the ATC minority interest on June 26, 1992, in exchange for Time Warner notes then valued at $1.3 billion. . The 1992 Six Flags Recapitalization: The issuance of $192 million aggregate principal amount of zero coupon notes by Six Flags in December 1992 to redeem or repurchase shares of common stock of Six Flags and its principal subsidiary. The impact of these transactions on the financial statements of Time Warner and the Entertainment Group is reflected on a pro forma basis in the discussion and analysis set forth below. RESULTS OF OPERATIONS 1993 VS. 1992 Time Warner had 1993 revenues of $6.581 billion, a loss of $94 million ($.56 per common share) before a one-time tax charge and an extraordinary loss, and a net loss of $221 million ($.90 per common share), compared to 1992 revenues of $13.070 billion ($6.309 billion on a restated basis) and net income of $86 million (a loss of $1.46 per common share after preferred dividends). The one- time tax charge of $70 million ($.19 per common share) resulted from the effect on the company's deferred income tax liability of the increase in the corporate income tax rate enacted in August 1993; the extraordinary loss of $57 million ($.15 per common share) resulted from the retirement of debt in 1993. The improvement in per share results in 1993 includes the after-tax benefits of replacing preferred stock with debt in the first quarter. Preferred dividends were $118 million in 1993, compared to $628 million in 1992. Only Series B preferred stock is outstanding at December 31, 1993, as to which the annual dividends on a financial statement basis are $13 million. On a pro forma basis, giving effect to the Time Warner Transactions and the Entertainment Group Transactions as if they had occurred at the beginning of the years, Time Warner would have reported a net loss of $160 million ($.46 per common share) in 1993 and $247 million ($.70 per common share) in 1992. The relationship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of excess cost over net assets acquired and certain other financial statement expenses that are not deductible for income tax purposes, and by the unusual tax charge in 1993. Time Warner's income tax expense includes all income taxes related to its equity in the pretax income of the Entertainment Group, including its equity in the income tax expense of TWE. The Entertainment Group had revenues of $7.963 billion, income of $217 million before a $10 million extraordinary loss on the retirement of debt, and net income of $207 million in 1993, compared to revenues of $6.761 billion ($7.251 billion on a restated basis) and net income of $173 million in 1992. On a pro forma basis, giving effect to the Entertainment Group Transactions as if they had occurred at the beginning of the year, the Entertainment Group would have reported net income of $207 million in 1993 compared to $23 million in 1992. Other factors affecting comparative operating results are discussed below on a business segment basis. That discussion includes, among other factors, an analysis of changes in the operating income of the business segments before depreciation and amortization ("EBITDA") in order to eliminate the effect on the operating performance of the music, filmed entertainment and cable businesses of significant amounts of purchase price amortization from the $14 billion acquisition of WCI in 1989, the $1.3 billion acquisition of the ATC minority interest in 1992 and other business combinations accounted for by the purchase method. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) EBITDA for Time Warner and the Entertainment Group in 1993 and 1992 was as follows: While many financial analysts consider EBITDA to be an important measure of comparative operating performance for the businesses of Time Warner and the Entertainment Group, it should be considered in addition to, but not as a substitute for, or superior to, operating income, net income, cash flow and other measures of financial performance reported in accordance with generally accepted accounting principles. TIME WARNER Publishing. Revenues increased to $3.270 billion compared to $3.123 billion in 1992. Operating income increased to $295 million from $254 million. Depreciation and amortization amounted to $77 million in 1993 and $74 million in 1992. EBITDA increased to $372 million from $328 million. Revenues benefited from increased magazine circulation revenues, higher book publishing revenues and the full year impact of the 1992 Leisure Arts acquisition. Magazine circulation revenues reflected higher overall subscription and newsstand sales, led by People, Time and Entertainment Weekly, as well as increases at American Family Publishers, the subscription agency. Despite a difficult market, advertising revenues were nearly flat. EBITDA increased as a result of the revenue gains and improved operating margins achieved through continued cost savings. Music. Revenues increased to $3.334 billion compared to $3.214 billion in 1992. Operating income increased to $296 million from $275 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $347 million in 1993 and $310 million in 1992. EBITDA increased to $643 million from $585 million. The revenue gains primarily reflected an increase in domestic recorded music sales and Warner/Chappell Music Publishing revenues. An increase in unit volume was achieved internationally, principally because of an increase in Pacific Rim sales. International dollar-denominated revenues did not increase, however, because of exchange rate fluctuations. Overall, revenues benefited from a broad range of popular releases from both new and established artists, increased unit sales of compact discs and higher average unit selling prices. The increase in EBITDA reflects the revenue gains and improved margins, offset in part by start-up costs for new business ventures. Interest and Other, Net. Interest and other, net, decreased to $718 million in 1993 compared to $882 million ($351 million on a restated basis) in 1992. Interest expense decreased to $698 million compared to $729 million ($287 million on a restated basis) in 1992. The decrease in interest and other, net, on an historical basis resulted primarily from the exclusion in 1993 of the expenses of the Entertainment Group, which was TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) deconsolidated in 1993, offset in part by an increase in interest expense from higher debt levels associated with the Series D Redemption and Series C Exchange. Other expenses, net, in 1993 included reductions in the carrying value of certain investments offset by investment-related income. Other expenses, net, in 1992 included an expense in connection with the settlement of senior management employment contracts, ATC minority interest expense and litigation-related costs. ENTERTAINMENT GROUP Filmed Entertainment. Revenues increased to $4.565 billion compared to $3.455 billion ($3.945 billion on a restated basis) in 1992. Operating income increased to $286 million from $213 million ($254 million on a restated basis). Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $263 million in 1993 and $197 million ($266 million on a restated basis) in 1992. EBITDA increased to $549 million from $410 million ($520 million on a restated basis). The increase in revenues, operating income and EBITDA on an historical basis resulted primarily from the inclusion in 1993 of the operating results of Six Flags, which previously had been accounted for using the equity method. Revenues at Warner Bros. increased during the period primarily due to increases in international theatrical, international syndication and domestic home video revenues, as well as increased revenues from retail operations. Record international revenues of $1.650 billion would have been greater but for unfavorable exchange rate fluctuations. Warner Bros. ranked number one at both the domestic and international box office in 1993, led by the success of The Fugitive and The Bodyguard. Revenues at Six Flags increased, benefiting from higher revenues per visitor. EBITDA benefited from the revenue gains. Programming--HBO. Revenues decreased to $1.441 billion compared to $1.444 billion in 1992. Operating income increased to $213 million from $201 million. Depreciation and amortization amounted to $17 million in 1993 and $14 million in 1992. EBITDA increased to $230 million from $215 million. The decrease in revenues reflects lower HBO Video sales, which in 1992 were favorably affected by a children's sell-thru title, offset in part by higher subscriber revenues, principally as a result of higher pay-TV rates at HBO and an increase in subscribers. EBITDA benefited primarily from improved results from new businesses, including Time Warner Sports and the Comedy Central joint venture. Cable. Revenues increased to $2.208 billion compared to $2.091 billion in 1992. Operating income increased to $406 million from $400 million. Depreciation and amortization, including amortization related to the purchase of WCI and the ATC Merger, amounted to $629 million in 1993 and $577 million in 1992. EBITDA increased to $1.035 billion from $977 million. Revenues increased principally as a result of growth in the number of cable subscribers and increases in advertising sales and pay-per-view. The increase in subscribers accounted for approximately three quarters of the revenue increase. EBITDA benefited from the revenue gains and increased income from cable joint ventures, but was negatively affected in the fourth quarter by cable rate regulation which went into effect on September 1, 1993. The negative effect of rate regulation is expected to continue into 1994 (see "Financial Condition and Liquidity" elsewhere herein). Interest and Other, Net. Interest and other, net, increased to $564 million in 1993 compared to $531 million ($569 million on a restated basis) in 1992. Interest expense increased to $580 million compared to $442 million ($491 million on a restated basis) in 1992. The increase in interest expense resulted primarily from the higher average debt levels attributable to the TWE capitalization, the higher interest cost of the TWE notes and debentures issued to refinance TWE bank debt, and the consolidation of Six Flags' interest expense in 1993. Other income, net, in 1993 included gains on the sale of certain assets partially offset by losses from and reductions in the carrying value of certain investments. Other expenses, net, on a restated basis in 1992 is principally attributable to losses on certain investments and litigation- related costs. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) 1992 VS. 1991 Time Warner had revenues of $13.070 billion, net income of $86 million and a $1.46 net loss per common share after preferred dividends in 1992, compared to revenues of $12.021 billion, a net loss of $99 million and a net loss of $2.40 per common share in 1991. The 1991 results include a $60 million restructuring charge in the Publishing division ($36 million after tax, or $.12 per common share). Per common share amounts for 1991 have been restated to give effect to the four-for-one common stock split that occurred on September 10, 1992. EBITDA for 1992 and 1991 on a historical consolidated basis was as follows: Publishing. Revenues increased to $3.123 billion compared to $3.021 billion in 1991. Operating income increased to $254 million from $174 million in 1991, which included the $60 million restructuring charge. Depreciation and amortization amounted to $74 million in 1992 and $72 million in 1991. EBITDA increased to $328 million from $246 million in 1991. Magazine revenues benefited from increases in both circulation and advertising revenues and the inclusion in 1992 of the revenues of Leisure Arts, a crafts publisher acquired in the third quarter of 1992. Circulation revenues reflected higher overall subscription and newsstand sales. The revenue growth was led by People, Entertainment Weekly and the regional and lifestyle magazines. Book revenues benefited from higher direct marketing sales at Time Life Inc. Excluding the restructuring charge in 1991, EBITDA improved in 1992 as a result of cost savings and the revenue gains. Music. Revenues increased to $3.214 billion compared to $2.960 billion in 1991. Operating income increased to $275 million from $256 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $310 million in 1992 and $304 million in 1991. EBITDA increased to $585 million from $560 million in 1991. Revenues benefited from increases in both international and domestic recorded music sales. The strong international revenue growth reflected Warner Music International's continued success with local artist development and the continued popularity of the domestic labels' artists outside the U.S. Overall, revenues benefited from a broad range of popular releases, increased unit sales of compact discs and higher average unit selling prices. Warner/Chappell Music Publishing revenues increased, reflecting the continued popularity of its large worldwide catalogue of music copyrights. The revenue gains and increased income from the Columbia House partnerships contributed to the increase in EBITDA. Filmed Entertainment. Revenues increased to $3.455 billion compared to $3.065 billion in 1991, and operating income increased to $213 million from $207 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $197 million in 1992 and $183 million in 1991. EBITDA increased to $410 million from $390 million in 1991. The revenue growth resulted primarily from increased worldwide theatrical revenues, which benefited from a number of very successful releases. Warner Bros. ranked number one in domestic box office. Revenues from international home video and syndication, sales to network television and retail operations also increased, while revenue from pay-television sales declined. The increase in EBITDA reflects the higher revenues, offset in part by lower margins. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) Programming--HBO. Revenues increased to $1.444 billion from $1.366 billion in 1991, while operating income rose to $201 million from $183 million. Depreciation and amortization amounted to $14 million in 1992 and $12 million in 1991. EBITDA increased to $215 million from $195 million in 1991. The revenue growth resulted from higher subscriber revenues and increased revenues from ancillary businesses, particularly from television production. The increase in subscriber revenues resulted from higher pay-TV rates at HBO and a slight increase in the number of subscribers. EBITDA benefited from the revenue gains, improved operating margins and a smaller loss from the Comedy Central joint venture, offset in part by expenses associated with the start-up of international pay-TV ventures. Cable. Revenues increased to $2.091 billion, compared to $1.935 billion in 1991, and operating income increased to $400 million from $334 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $577 million in 1992 and $538 million in 1991. EBITDA increased to $977 million from $872 million in 1991. Revenues increased as a result of growth in the number of cable customers and an increase in per subscriber revenue. The increase in subscribers accounted for approximately 40% of the revenue increase. EBITDA benefited from the revenue gains, continued cost containment and increased income from domestic cable joint ventures, partially offset by higher cable programming costs and expenses associated with the start-up of international cable ventures. Operating income also was affected by amortization related to the ATC Merger. Interest and Other, Net. Interest and other, net, decreased to $882 million in 1992 from $966 million in 1991. Interest expense decreased to $729 million in 1992 compared with $912 million in 1991. The decrease in interest expense, which is attributable to lower interest rates and lower average debt levels, was offset in part by increases in litigation-related costs and other expenses, including expenses in connection with the settlement of senior management employment contracts, and a decline in investment-related income. In August 1992, Time Warner and TWE settled the litigation brought by Viacom International, Inc. in 1989 against Time Warner, ATC and HBO. The settlement terminated with prejudice all claims and counterclaims raised in the litigation. The effects of the settlement were not material to Time Warner or TWE. FINANCIAL CONDITION AND LIQUIDITY DECEMBER 31, 1993 TIME WARNER Aided by favorable conditions in the credit markets, Time Warner continued to restructure its balance sheet and reduce its after-tax financing cost. The Series C Exchange, Series D Redemption and 8-3/4% Partial Redemption replaced $6.4 billion of Series C and Series D preferred stock having an average after- tax cost of 9.9% with $6.6 billion of long-term debt having an average after- tax cost of 5%, resulting in annual savings of $300 million. In addition, the new debt includes $1.4 billion of zero coupon exchangeable or convertible notes that require no periodic payments of interest, resulting in annual deferrals of $75 million. The deconsolidation of the Entertainment Group also had a significant effect on the balance sheet by eliminating nearly $16 billion of assets and over $7 billion of debt. Principally as a result of these factors, Time Warner had $9.4 billion of debt and $1.4 billion of equity at December 31, 1993, compared to $10.2 billion of debt and $8.2 billion of equity at December 31, 1992. Cash and equivalents were $200 million at December 31, 1993, compared to $942 million at December 31, 1992, resulting in debt-net-of-cash amounts of $9.2 billion and $9.3 billion at such dates. Substantially all of Time Warner's debt at December 31, 1993 consisted of long-term fixed-rate or zero coupon obligations, approximately $2 billion of which was effectively converted to a floating rate basis through the use of interest-rate swap agreements. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) Cash provided by Time Warner's operations amounted to $257 million in 1993, after $330 million of interest payments, $182 million of income taxes and working capital requirements. Cash flows used in investing activities in 1993, excluding investment proceeds, were $373 million. Of this amount, $198 million was for capital expenditures, principally in the Music division. Cash dividends of $125 million were paid on common and Series B preferred stock during 1993. On a pro forma basis, giving retroactive effect to the beginning of the year to the 1993 Time Warner Transactions, cash flow from operations would have been $183 million, after $402 million of interest payments, $179 million of income taxes and working capital requirements. Time Warner has no claim on the assets and cash flows of TWE except through the payment of certain fees and reimbursements, such as the $60 million annual charge for corporate services, and cash distributions to the General Partners, which are limited by the TWE partnership and credit agreements. Distributions from TWE of $20 million in 1993 are expected to increase to approximately $125 million in 1994, primarily because of tax-related distributions. TWE is permitted under its partnership and credit agreements to loan Time Warner up to $1.1 billion, increasing up to $1.5 billion on July 1, 1995. Time Warner has $375 million of debt maturing in 1994 that will be refinanced by borrowings from TWE under a long-term arrangement. Management believes that 1994 operating cash flow, cash and marketable securities and additional borrowing capacity are sufficient to meet Time Warner's liquidity needs without distributions and loans from TWE above those permitted by existing agreements. ENTERTAINMENT GROUP TWE continued its strategy of significantly lengthening debt maturities at attractive fixed rates. Over the past two years, TWE reduced variable rate debt by $3.8 billion with proceeds from the issuance of long-term notes and debentures having an after-tax cost to Time Warner of 5.1%. An additional $2.5 billion of capital was raised by the USW Transaction, $1 billion of which, presently in the form of the USW Note, has been earmarked for building cable Full Service Networks(TM) ("FSN"). The Six Flags acquisition culminated a series of transactions over a two-year period that resulted in it becoming a wholly-owned subsidiary of TWE. Six Flags was consolidated by TWE effective as of January 1, 1993. Primarily as a result of these transactions, the Entertainment Group had $7.1 billion of long-term debt at December 31, 1993, $1.5 billion of TWE General Partners' Senior Capital and $6 billion of TWE partners' capital (net of the $1 billion uncollected amount of the USW Note), compared to $7.2 billion of long-term debt ($7.7 billion restated for the Six Flags consolidation) and $6.4 billion of TWE partners' capital at December 31, 1992. Cash and equivalents were $1.3 billion at December 31, 1993, reducing the debt-net-of-cash amount to $5.8 billion. Cash and equivalents at December 31, 1992 were $47 million. Cash provided by the operations of the Entertainment Group in 1993 amounted to $1.276 billion, after $450 million of interest payments, $70 million of income taxes and working capital requirements. On a pro forma basis, giving retroactive effect to the beginning of 1993 to the Entertainment Group Transactions, cash flow from operations would have been $1.284 billion, after $473 million of interest payments, $70 million of income taxes and working capital requirements. Cash used in investing activities in 1993, excluding investment proceeds, amounted to $981 million. Of this amount, $613 million was spent on capital projects, including $352 million to upgrade cable systems and $244 million to expand international theaters and Warner Bros. Studio Stores, upgrade facilities at the Warner Bros. Studio and introduce new rides at Six Flags. The Entertainment Group continues to expand its core businesses through selective acquisitions and investments, which in 1993 resulted in payments of $368 million, including $136 million for the purchase of common and preferred stocks of Six Flags. The Milwaukee, Wisconsin cluster of cable systems was TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) augmented by the purchase of a cable system from Viacom Inc. Several other cable systems that did not fit into a cluster were disposed of in 1993 for approximately $100 million. Capital spending is expected to increase significantly in 1994, principally because of the plan to upgrade a significant percentage of cable systems to FSN capacity over the next five years at an estimated cost of $5 billion, which is about three times cable capital expenditures for the last five years. $1 billion of FSN capital expenditures will be funded by collections on the USW Note. TWE is permitted under its partnership and credit agreements to loan up to $1.1 billion to Time Warner. An additional $400 million of such loans are permitted beginning July 1, 1995. There was $1.3 billion of cash and equivalents and $2 billion of available credit under the TWE credit agreement at December 31, 1993. In early 1994, TWE filed a shelf registration statement with the Securities and Exchange Commission covering the issuance of up to $2 billion of debt securities. These securities may be issued from time to time on terms determined at the time of sale. Management believes that 1994 operating cash flow, cash and equivalents, the USW Note, and additional borrowing capacity are sufficient to meet the capital and liquidity needs of TWE, and to fund anticipated loans to Time Warner. On October 5, 1992, Congress enacted the 1992 Cable Act, which among other things reimposed rate regulation on most cable systems. The Federal Communications Commission ("FCC") froze rates in April 1993 for regulated cable services and associated equipment, other than for systems in which local franchising authorities regulate rates. The current expiration date of the freeze is May 15, 1994. On May 3, 1993, the FCC released rules implementing rate regulation, which required that rates for certain equipment be established based on a cost-of-service standard and rates for regulated cable services be established based on either a per-channel benchmark or a cost-of-service standard, at the election of the cable operator. TWE Cable elected to establish rates based on the per-channel benchmarks, which the FCC had set at 10% below the average level of rates prevailing nationwide in September of 1992. On February 22, 1994, the FCC announced the adoption of revised rules lowering the per-channel benchmarks from 10% to 17% below the average level of rates prevailing in September of 1992 and changing the factors cable operators must use to calculate the benchmarks applicable to their systems. The text of the new rules is expected to be released in late March, with an effective date of May 15. Under the May 1993 rules, revenues from sales of regulated equipment and services had been expected to decline by $90 to $100 million per year. That decline was expected to be partially offset by increases in revenues from other activities, including optional services, advertising sales and subscriber growth, which could not be quantified. It is not yet possible to estimate the effect of the new rules adopted in February 1994, although it is expected to be more adverse than the effect of the earlier rules. On November 5, 1992, TWE filed a lawsuit seeking to overturn major provisions of the 1992 Cable Act, primarily on First Amendment grounds. On April 8, 1993, a three-judge District Court upheld the constitutionality of the "must carry" provisions of the 1992 Cable Act. TWE's appeal from this decision was heard by the U.S. Supreme Court in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality of a majority of the other challenged provisions of the 1992 Cable Act. The Company and the federal defendants have appealed this decision to the U.S. Court of Appeals for the D.C. Circuit. Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of films for pay and basic cable, network and syndicated television exhibition amounted to $724 million at December 31, 1993 compared to $674 million at December 31, 1992 (including amounts relating to HBO of $178 million at December 31, 1993 and $161 million at December 31, 1992). The backlog excludes advertising barter contracts. The net impact of inflation on operations has not been significant in the past three years. TIME WARNER INC. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. TIME WARNER INC. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTES TO SCHEDULE II (1) Note pursuant to an employment agreement bearing interest at 6% per annum, payable quarterly, due December 31, 1994. Secured by a mortgage on real estate. (2) Note pursuant to an employment agreement bearing interest at 8% per annum, payable quarterly, until end of employment term at which time principal and interest are payable in 48 monthly installments, beginning on August 1, 1996. Secured by a mortgage on real estate. (3) Note in the amount of $950,000 bearing interest at 6% per annum payable on December 31, 1996. Note in the amount of $431,746 bearing interest at 7% per annum due on demand. (4) Note bearing interest at 10% per annum due December 31, 1994. (5) Non-interest bearing notes pursuant to an employment agreement due on demand. TIME WARNER INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. (b) Represents uncollectible receivables charged against reserve. (c) Represents returns or allowances applied against reserve. (d) The distribution of magazines not owned by Time Warner results in a receivable recorded at the sales price and a corresponding liability to the publisher recorded at the sales price less the distribution commission recognized by Time Warner as revenue. Therefore, it would be misleading to compare magazine revenues to the provision charged to the reserve for magazine returns that is deducted from accounts receivable without also considering the related offsetting activity in the reserve for magazine returns that is deducted from the liability due to the publishers. TIME WARNER INC. SCHEDULE X--SUPPLEMENTARY OPERATING STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED BALANCE SHEET DECEMBER 31, (MILLIONS) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Notes 1 and 2). See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF OPERATIONS YEARS ENDED DECEMBER 31, (MILLIONS) See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, (MILLIONS) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Notes 1 and 2). See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF PARTNERSHIP CAPITAL (MILLIONS) - -------- (a) Distributions in 1993 and 1992 included $252 million and $24 million, respectively, of tax-related distributions, $274 million and $17 million, respectively, of stock option distributions and in 1993 $13 million of distributions to the Time Warner Service Partnerships. In addition, General Partners' Junior Capital was reduced $95 million in 1993 for the distribution of the Time Warner Service Partnership Assets. A $12 million contribution was made by the General Partners in 1992 after the TWE Capitalization pursuant to the net worth adjustment provision of the partnership agreement. (Note 6.) See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Time Warner Entertainment Company, L.P., a Delaware limited partnership ("TWE"), was capitalized on June 30, 1992 (the "TWE Capitalization") to own and operate substantially all of the Filmed Entertainment, Programming-HBO and Cable businesses previously owned by subsidiaries of Time Warner Inc. ("Time Warner"). At December 31, 1993, the general partners of TWE, subsidiaries of Time Warner ("General Partners"), collectively held 63.27% pro rata priority capital and residual equity partnership interests in TWE, and certain priority capital interests senior and junior to the pro rata priority capital interests, which they received for the net assets, or the rights to cash flows, they contributed to the partnership at the TWE Capitalization; and the limited partners, subsidiaries of U S WEST, Inc. ("USW"), ITOCHU Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba"), held 25.51%, 5.61% and 5.61% pro rata priority capital and residual equity partnership interests, respectively. ITOCHU and Toshiba each contributed $500 million of cash at the TWE Capitalization for their limited partnership interests. USW contributed $1.532 billion of cash and a $1.021 billion 4.4% note ("USW Note") on September 15, 1993 for its limited partnership interests. Prior to the admission of USW, the General Partners held 87.5% pro rata priority capital and residual equity partnership interests, and a priority capital interest junior to the pro rata priority capital interests, and ITOCHU and Toshiba each held 6.25% pro rata priority capital and residual equity partnership interests (Note 6). In lieu of contributing certain assets (the "Beneficial Assets"), the General Partners assigned to TWE the net cash flow generated by such assets or agreed to pay an amount equal to the net cash flow generated by such assets. TWE has the right to receive from the General Partners, at the limited partners' option, an amount equal to the fair value of Beneficial Assets, net of associated liabilities, that have not been contributed to TWE by June 30, 1996, rather than continuing to receive the net cash flow, or an amount equal to the net cash flow, generated by the Beneficial Assets. The consolidated financial statements include the assets and liabilities of the businesses contributed by the General Partners, including the Beneficial Assets and associated liabilities, all at Time Warner's historical cost basis of accounting. Time Warner's $14 billion acquisition of Warner Communications Inc. ("WCI") as of December 31, 1989, and $1.3 billion acquisition of the minority interest in American Television and Communications Corporation ("ATC") on June 26, 1992 were accounted for by the purchase method of accounting. WCI subsequently contributed filmed entertainment and cable assets to TWE, and ATC subsequently contributed its cable assets. The financial statements of TWE reflect an allocable portion of Time Warner's cost to acquire WCI and the ATC minority interest in accordance with the pushdown method of accounting. BASIS OF CONSOLIDATION AND ACCOUNTING FOR INVESTMENTS IN AFFILIATED COMPANIES The consolidated financial statements include the accounts of TWE and its subsidiaries. Significant intercompany accounts and transactions are eliminated. Significant accounts and transactions between TWE and its partners and affiliates are disclosed as related party transactions (Note 11). Investments in companies in which TWE has significant influence but less than controlling financial interest are stated at cost plus equity in the affiliates' undistributed earnings. The excess of cost over the underlying net equity of investments in affiliated companies is attributed to the underlying net assets based on their respective fair values and amortized over their respective economic lives. Six Flags Entertainment Corporation ("Six Flags") was consolidated effective January 1, 1993 as a result of the increase of TWE's ownership in Six Flags from 50% to 100% on September 17, 1993 (Note 2). The historical financial statements for periods prior to such date have not been changed; however, financial TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) statements for the year ended December 31, 1992 retroactively reflecting the consolidation of Six Flags are presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. Certain other prior year amounts have been reclassified to conform to the 1993 presentation. REVENUES AND COSTS Feature films are produced or acquired for initial exhibition in theaters followed by distribution in the home video, pay cable, basic cable, broadcast network and syndicated television markets. Generally, distribution to the theatrical, home video and pay cable markets (the primary markets) is completed within eighteen months of initial release. Theatrical revenues are recognized as the films are exhibited. Home video revenues, less a provision for returns, are recognized when the home videos are sold. Revenues from cable and broadcast television distribution are recognized when the films are available to telecast. Television films and series are initially produced for the networks or first-run television syndication (the primary markets) and may be subsequently licensed to foreign or other domestic television markets. Revenues from television license agreements are recognized when the films or series are available to telecast, except for barter agreements where the recognition of revenue is deferred until the related advertisements are telecast. Inventories of theatrical and television product are stated at the lower of amortized cost or net realizable value. Cost includes direct production and acquisition costs, production overhead and capitalized interest. A portion of the cost to acquire WCI was allocated to its theatrical and television product as of December 31, 1989, including an allocation to product that had been exhibited at least once in all markets ("Library"). Individual films and series are amortized, and the related participations and residuals are accrued, based on the proportion that current revenues from the film or series bear to an estimate of total revenues anticipated from all markets. These estimates are revised periodically and losses, if any, are provided in full. WCI acquisition cost allocated to the Library is amortized on a straight-line basis over twenty years. Current film inventories include the unamortized cost of completed feature films allocated to the primary markets, television films and series in production pursuant to a contract of sale, film rights acquired for the home video market and advances pursuant to agreements to distribute third-party films in the primary markets. Noncurrent film inventories include the unamortized cost of completed theatrical and television films allocated to the secondary markets, theatrical films in production and WCI acquisition cost allocated to the Library. A significant portion of cable system and cable programming revenues are derived from subscriber fees, which are recorded as revenue in the period the service is provided. The right to exhibit feature films and other programming on pay cable services during one or more availability periods ("programming costs") generally is recorded when the programming is initially available for exhibition, and is allocated to the appropriate availability periods and amortized as the programming is exhibited. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Additions to cable property, plant and equipment generally include material, labor, overhead, interest and certain start-up costs incurred in developing new franchises. Depreciation is provided generally on the straight-line method over useful lives ranging up to twenty-five years for buildings and improvements and up to fifteen years for furniture, fixtures and cable television and other equipment. INTANGIBLE ASSETS Intangible assets are amortized over periods up to forty years using the straight-line method. Amortization of the excess of cost over net assets acquired amounted to $132 million in 1993, $115 million TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) ($124 million on a restated basis) in 1992 and $110 million in 1991, and amortization of cable television franchises amounted to $222 million, $194 million, and $171 million, respectively. Accumulated amortization of intangible assets at December 31, 1993 and 1992 amounted to $1.438 billion and $1.078 billion ($1.108 billion on a restated basis), respectively. FOREIGN CURRENCY TRANSLATION The financial position and operating results of substantially all of the foreign operations of TWE are consolidated using the local currency as the functional currency. Accordingly, local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in partners' capital. Foreign currency transaction gains and losses, which have not been material, are included in operating results. INCOME TAXES As a Delaware limited partnership, TWE is not subject to U.S. federal and state income taxation. However, certain of TWE's operations are conducted by subsidiary corporations that are subject to domestic or foreign taxation. Income taxes are provided on the income of such corporations using the liability method of accounting for income taxes prescribed by Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes." The consolidated financial statements for periods prior to the TWE Capitalization include, for comparative purposes, the income and withholding tax consequences of those TWE operations subject to domestic or foreign taxation, as determined on a stand-alone basis consistent with the liability method of accounting for income taxes. FINANCIAL INSTRUMENTS Foreign exchange contracts are used to reduce exchange rate exposure on future cash flows and earnings denominated in foreign currencies. Contract gains and losses are included in income. TWE is reimbursed by or reimburses Time Warner for Time Warner contract gains and losses related to TWE's exposure. At December 31, 1993, Time Warner had contracts for the sale of $226 million of foreign currencies at fixed rates related to TWE's exposure, primarily Japanese yen, German marks, Canadian dollars and French francs. The fair value of foreign exchange contracts approximates carrying value. TWE has used interest rate swap agreements to reduce its exposure to interest rate changes; however, there were no material amounts of contracts outstanding at December 31, 1993. The net amounts paid and received under the contracts are included in interest expense. The fair value of TWE's debt will fluctuate with changes in the credit markets, including changes in the level of interest rates. At December 31, 1993, the fair value of TWE's publicly-held long-term debt was estimated to exceed its carrying value by approximately $290 million. Fair value is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. 2.INVESTMENTS Investments accounted for on the equity basis include Paragon Communications (50% owned), certain other cable system joint ventures (generally 50% owned), Comedy Partners (50% owned), Six Flags (50% owned until 1993 when consolidated) and E! Entertainment Corporation (50% owned until distributed in 1993). These investments were carried at cost plus undistributed equity in the affiliates' earnings of $517 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) million at December 31, 1993 and $594 million ($562 million on a restated basis) at December 31, 1992. A summary of financial information of equity affiliates (100% basis) is set forth below: In September 1993, TWE provided Six Flags with $136 million to repurchase the 50% common stock interest held by other stockholders and preferred stock of certain subsidiaries. TWE also provided $414 million to finance the repurchase or retirement of all indebtedness of Six Flags and its subsidiaries, except for the zero coupon notes due 1999. As a result, TWE has consolidated Six Flags effective January 1, 1993. Certain investments included in the balance sheet at December 31, 1992 were among the Time Warner Service Partnership Assets distributed to the General Partners in 1993 (Note 6), including common and common equivalent stock of QVC Inc., which was carried at a cost of $28 million and had a market value of $142 million at December 31, 1992, and common and common equivalent stock of E! Entertainment Corporation, an equity affiliate. The remainder of TWE's investments, none of which are individually significant, were carried at cost. 3.INVENTORIES TWE's inventories consist of: Excluding the Library, the unamortized cost of completed films at December 31, 1993 amounted to $1.085 billion, more than 90% of which is expected to be amortized within three years after release. Excluding the effects of accounting for the acquisition of WCI, the total cost incurred in the production of theatrical and television films amounted to $1.784 billion in 1993, $1.652 billion in 1992 and $1.476 billion in 1991; and the total cost amortized amounted to $1.619 billion, $1.535 billion and $1.494 billion, respectively. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. LONG-TERM DEBT Long-term debt consists of: Each General Partner has guaranteed a pro rata portion of substantially all of TWE's debt and accrued interest thereon based on the relative fair value of the net assets each General Partner contributed to TWE (the "General Partner Guarantees"). Such indebtedness is recourse to each General Partner only to the extent of its guarantee. The indenture pursuant to which TWE's notes and debentures have been issued (the "Indenture") requires the unanimous consent of the holders of the notes and debentures to terminate the General Partner Guarantees prior to June 30, 1997, and the consent of a majority of such holders to effect a termination thereafter. There are no restrictions on the ability of the General Partner guarantors to transfer material assets, other than TWE assets, to parties who are not guarantors. As of December 31, 1993, the TWE credit agreement provided for up to $5.2 billion of borrowings and consisted of a $4.2 billion revolving credit facility with available credit reducing at June 30, 1995 and thereafter by $200 million per quarter through June 30, 1996, by $125 million per quarter from September 30, 1996 through September 30, 1999, and by $1.575 billion at final maturity on December 31, 1999; and a $986 million term loan with repayments of $66 million on June 30, 1995, $98 million per quarter beginning September 30, 1995 through March 31, 1996, $27 million per quarter beginning June 30, 1996 through June 30, 1999, $20 million on September 30, 1999 and a final repayment of $255 million on December 31, 1999. Unused credit is available for general business purposes and to support commercial paper borrowings. Outstanding borrowings under the credit agreement generally bear interest at LIBOR plus 7/8% per annum. The credit agreement contains covenants relating to, among other things, additional indebtedness; liens on assets; acquisitions and investments; cash flow coverage and leverage ratios; and loans, advances, distributions or other cash payments or transfers of assets to its partners or their affiliates. TWE is permitted under the credit agreement to loan Time Warner up to $1.1 billion, increasing to up to $1.5 billion at July 1, 1995 (Note 6). In connection with and immediately prior to the TWE Capitalization, indebtedness under the Time Warner and ATC credit agreements was assigned to and assumed by the General Partners. Immediately TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) thereafter and concurrently with the TWE Capitalization, such indebtedness was assigned to and assumed by TWE. Proceeds from a $5.9 billion initial borrowing under the TWE credit agreement, $1 billion of capital contributed to the partnership by ITOCHU and Toshiba and $250 million of other loan proceeds were used, directly or indirectly, to repay and terminate the credit agreements of Time Warner and ATC and to pay certain transaction costs. In addition, $850 million of 9 5/8% and 10.15% long-term notes issued by Time Warner in April 1992 were assigned to and assumed by TWE. An after-tax cost of $10 million was incurred by Six Flags in 1993 in connection with the retirement of its debt (Note 2). The Six Flags zero coupon senior notes due 1999 are guaranteed by TWE. Interest expense was $573 million in 1993, $436 million ($486 million on a restated basis) in 1992 and $479 million in 1991. Interest expense for all periods prior to the TWE Capitalization includes interest expense related to Time Warner's credit and interest rate swap agreements on a pushdown basis and interest expense on $875 million of loans due to WCI, which were repaid at the TWE Capitalization. Annual repayments of long-term debt for the five years subsequent to December 31, 1993 are: 1994-$0 million; 1995-$262 million; 1996-$179 million; 1997-$108 million and 1998-$372 million. 5. INCOME TAXES Domestic and foreign pretax income are as follows: As a partnership, TWE is not subject to U.S. federal, state or local income taxation (Note 1). Income taxes (benefits) of TWE and subsidiary corporations are as set forth below: - -------- (1) Includes utilization of $75 million of Six Flags tax carryforwards in 1993. (2) Includes foreign withholding taxes of $59 million in 1993, $34 million in 1992 and $19 million 1991. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) The financial statement basis of TWE's assets exceeds the corresponding tax basis by $10 billion at December 31, 1993, principally as a result of differences in accounting for depreciable and amortizable assets for financial statement and income tax purposes. At December 31, 1993, Six Flags had $100 million of net operating loss carryforwards that expire from 2004 to 2007, which are subject to limitations. 6. TWE PARTNERS' CAPITAL The TWE partnership agreement provides for special allocations of income, loss and distributions of partnership capital, including priority distributions in the event of liquidation. Pursuant to the partnership agreement as amended for the admission of USW on September 15, 1993, and assuming that no additional partnership interests are issued to new partners, the relative priority of initial partnership capital amounts and of partnership income and loss related thereto is as follows, from most to least senior: (1) partnership income, to the extent earned, allocated to the partners so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership was taxed as a corporation, reduced by prior distributions and allocations of partnership agreement losses ("special tax allocations"), (2) a senior capital interest in the initial capital amount of $1.4 billion, plus allocations of partnership income, to the extent earned, of up to 8% per annum, compounded quarterly, of the initial capital amount, reduced by prior distributions and allocations of partnership losses, allocated to the General Partners ("General Partners' Senior Capital"), (3) pro rata priority capital interests in the initial capital amounts of $3.5 billion allocated to the General Partners, $1.4 billion allocated to USW and $313 million allocated to each of ITOCHU and Toshiba, plus allocations of partnership income, to the extent earned, of up to 13% per annum (11% to the extent concurrently distributed), compounded quarterly, of the initial capital amounts, reduced by prior distributions and allocations of partnership losses, allocated to all the partners according to their residual equity partnership interests, (4) a junior capital interest in the initial capital amount of $2.7 billion, plus allocations of partnership income, to the extent earned, of up to 13.25% per annum (11.25% to the extent concurrently distributed), compounded quarterly, of the initial capital amount, reduced by prior distributions and allocations of partnership losses, allocated to the General Partners ("General Partners' Junior Capital") and (5) residual equity capital, plus allocations of partnership income, to the extent earned, reduced by prior distributions and allocations of partnership losses, allocated to all partners according to their residual partnership interests. To the extent partnership income is insufficient to satisfy all special allocations in a particular accounting period, the unearned portion is carried over until satisfied out of future partnership income. Partnership losses are allocated first to eliminate prior allocations of partnership income to, and then to reduce the initial capital amounts of, the residual equity, General Partners' Junior Capital and pro rata priority capital interests, in that order, then to reduce General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce special tax allocations. Partnership income first earned following a period of partnership losses will be allocated in reverse order so as to eliminate prior allocations of loss. For the purpose of the foregoing allocations, partnership income or loss is based on the fair value of the assets contributed to the partnership, and differs from net income of TWE, which is based on the historical cost of the contributed assets. General Partners' Senior Capital is required to be distributed no later than in three annual installments beginning July 1, 1997; earlier distributions may be made under certain circumstances ("Senior Capital Distributions"). General Partners' Junior Capital is subject to retroactive adjustment, based on TWE's operating performance over five-and ten-year periods, so as to result in an additional initial capital amount of up to $4 billion, plus allocations of partnership income, to the extent earned, of up to 13% per annum (11% per annum to the extent concurrently distributed), compounded quarterly, reduced by prior distributions and allocations of partnership losses. USW has an option to increase its pro rata priority capital and residual equity interests to as much as 31.84%, depending on cable operating performance. The option is exercisable between January 1, 1999 and on or about May 31, 2005 at a maximum exercise price ranging from $1.25 billion to $1.8 billion, depending TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) on the year of exercise. USW or TWE may elect that the exercise price be paid with partnership interests rather than cash. Prior to the exercise of the USW option, each of ITOCHU and Toshiba has the right to maintain its original 6.25% pro rata priority capital and residual equity interests by acquiring additional partnership interests at fair market value; thereafter, each would have the right to maintain the percentage of the pro rata priority capital and residual equity interests it held immediately prior to USW's exercise. Distributions and loans to the partners are subject to partnership and credit agreement limitations. Generally, TWE must be in compliance with the cash flow coverage and leverage ratios, restricted payment limitations and other credit agreement covenants in order to make such distributions or loans. Certain assets of TWE (the "Time Warner Service Partnership Assets") were distributed to the General Partners prior to the admission of USW in order to ensure compliance with the Modification of Final Judgment entered on August 24, 1982 by the United States District Court for the District of Columbia applicable to USW and its affiliated companies, which may include TWE. The distribution was recorded based on the $95 million historical cost of the Time Warner Service Partnership Assets. For purposes of the partnership agreement, the initial capital amount of General Partners' Junior Capital of $3 billion was reduced by approximately $300 million to give effect to such distributions. The General Partners contributed the Time Warner Service Partnership Assets to newly formed partnerships (the "Time Warner Service Partnerships") in which the General Partners and subsidiaries of ITOCHU and Toshiba are the partners. The Time Warner Service Partnerships have entered into service agreements that make certain Time Warner Service Partnership Assets and related services available to TWE (Note 11). TWE is required to make quarterly distributions of $12.5 million with respect to General Partners' Junior Capital through September 30, 1998 ("TWSP Distributions"). The General Partners are required to contribute such amounts to the Time Warner Service Partnerships. TWE reimburses Time Warner for the amount by which the market price on the exercise date of Time Warner common stock options or options to purchase Time Warner redeemable reset notes due 2002 granted to employees of TWE exceeds the exercise price or, with respect to options granted prior to the TWE Capitalization, the greater of the exercise price or the market price of such securities at the TWE Capitalization ("Stock Option Distributions"). TWE paid $20 million of Stock Option Distributions in 1993 for exercised options and had a liability of $271 million and $17 million at December 31, 1993 and 1992, respectively, for future Stock Option Distributions based on the unexercised options and the market prices at such dates of $44.25 and $29.25, respectively, per Time Warner common share and $908.75 and $807.50, respectively, per $1,000 principal amount of Time Warner redeemable reset note. Cash distributions are required to be made to the partners to permit them to pay income taxes at statutory rates based on their allocable taxable income from TWE ("Tax Distributions"), including any taxable income generated by the Beneficial Assets, subject to limitations referred to herein. The aggregate amount of such Tax Distributions is computed generally by reference to the taxes that TWE would have been required to pay if it were a corporation. Tax Distributions in the amount of $276 million and $24 million were payable to the General Partners at December 31, 1993 and 1992, respectively. Other than the Stock Option Distributions and TWSP Distributions, under the most restrictive limitations, no other cash distributions to partners are permitted prior to July 1, 1994, at which time the payment of a Tax Distribution, limited in amount, is permitted. Accordingly, a $108 million Tax Distribution is classified as a current liability at December 31, 1993. Additional Tax Distributions are permitted beginning July 1, 1995. In addition to Stock Option Distributions, Tax Distributions, Senior Capital Distributions and TWSP Distributions, quarterly cash distributions may be made to the partners to the extent of excess cash, as defined ("Excess Cash Distribution"). Assuming that no additional partnership interests are issued to new partners and that certain cash distribution thresholds are met, cash distributions other than Stock Option TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Distributions, Tax Distributions, Senior Capital Distributions and TWSP distributions will in the aggregate be made 63.27% to the General Partners and 36.73% to the limited partners prior to June 30, 1998; thereafter, the General Partners also will be entitled to additional distributions of General Partners' Junior Capital. If aggregate distributions made to the limited partners, generally from all sources, have not reached approximately $800 million by June 30, 1997, cash distributions to the General Partners with respect to the General Partners' pro rata priority and residual equity capital, other than Stock Option Distributions and Tax Distributions, will be deferred until such threshold is met. Similarly, if such aggregate distributions to the limited partners have not reached approximately $1.6 billion by June 30, 1998, cash distributions with respect to General Partners' Junior Capital, other than TWSP Distributions, will be deferred until such threshold is met. If any such deferral occurs, a portion of the corresponding partnership income allocations with respect to such deferred amounts will be made at a rate higher than otherwise would have been the case. If a division of TWE or a substantial portion thereof is sold, the net proceeds of such sale, less expenses and proceeds used to repay outstanding debt, will be required to be distributed with respect to the partners' partnership interests. Similar distributions are required to be made in the event of a financing or refinancing of debt. Subject to any limitations on the incurrence of additional debt contained in the TWE partnership and credit agreements, and the Indenture, TWE may borrow funds to make distributions. 7. STOCK OPTION PLANS Options to purchase Time Warner common stock under various stock option plans have been granted to employees of TWE, generally at fair market value at the date of grant. Generally, the options are exercisable over a three-year vesting period and expire ten years from the date of grant. A summary of stock option activity with respect to employees of TWE is as follows: TWE reimburses Time Warner for the use of Time Warner stock options on the basis described in Note 6. There were 129,000 options exercised by employees of TWE in 1992 at prices ranging from $8-$24 per share. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 8. BENEFIT PLANS TWE and its divisions have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Qualifying plans are funded in accordance with government pension and income tax regulations. Plan assets are invested in equity and fixed income securities. Pension expense included the following: Certain domestic employees of TWE participate in defined contribution multiemployer pension plans as to which the expense amounted to $19 million in 1993, $20 million in 1992 and $21 million in 1991. Employees in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Certain domestic employees also participate in Time Warner's 401(k) savings plans and profit sharing plans as to which the expense amounted to $20 million in 1993, $16 million in 1992 and $18 million in 1991. Contributions to the 401(k) plans are based upon a percentage of the employees' elected contributions. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. SEGMENT INFORMATION Information as to the operations of TWE in different business segments is as set forth below: - -------- (1) Depreciation and amortization includes amortization relating to the acquisitions of WCI in 1989 and the ATC minority interest in 1992 and to other business combinations accounted for by the purchase method. - -------- (1)Consists principally of cash, cash equivalents and other investments. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Information as to the capital expenditures of TWE is as follows: Substantially all operations outside of the United States support the export of domestic products. Approximately 60% of export revenues are from sales to European customers. 10. COMMITMENTS AND CONTINGENCIES Total rent expense amounted to $119 million in 1993, $99 million ($107 million on a restated basis) in 1992 and $83 million in 1991. The minimum rental commitments under noncancellable long-term operating leases are: 1994-- $100 million; 1995--$97 million; 1996--$90 million; 1997--$76 million; 1998-- $71 million and after 1998--$453 million. Minimum commitments and guarantees under certain programming, licensing, franchise and other agreements at December 31, 1993 aggregated approximately $3 billion, which are payable principally over a five-year period. Pending legal proceedings are substantially limited to litigation incidental to the businesses of TWE. In the opinion of counsel and management, the ultimate resolution of these matters will not have a material effect on the consolidated financial statements. 11. RELATED PARTY TRANSACTIONS In the normal course of conducting their businesses, TWE units have had various transactions with Time Warner units, generally on terms resulting from a negotiation among the affected parties that in management's view results in reasonable allocations. Employees of TWE participate in various Time Warner medical, stock option (Note 7) and other benefit plans (Note 8) for which TWE is charged its allocable share of plan expenses, including administrative costs. Time Warner's corporate group provides various other services to TWE. The Music division of WCI provides home videocassette distribution services to certain TWE operations, and certain TWE units have placed advertising in magazines published by Time Warner's Publishing division. TWE is required to pay a $130 million advisory fee to USW over a five-year period ending September 15, 1997 for USW's expertise in telecommunications, telephony and information technology, and its participation in the management and upgrade of the cable systems to Full Service Network(TM) capacity. Time Warner provides TWE with certain corporate support services for which Time Warner is paid $60 million per year, subject to adjustment for inflation beginning in 1995. The corporate services agreement runs through June 30, 1997, and may be extended by agreement of both parties. Management believes that the corporate services fee is representative of the cost of corporate services that would be necessary for the stand-alone operations of TWE. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) TWE has entered into service agreements with the Time Warner Service Partnerships for program signal delivery and transmission services, and TWE provides billing, collection and marketing services to the Time Warner Service Partnerships. TWE also has distribution and merchandising agreements with Time Warner Entertainment Japan Inc., a company owned by partners of TWE to conduct TWE's businesses in Japan. In addition to transactions with its partners, TWE has had transactions with Paragon Communications, L.P., Comedy Partners, L.P. and its other equity affiliates, and with Turner Broadcasting System, Inc., The Columbia House Company partnerships, Cinamerica Theatres, L.P. and other equity affiliates of Time Warner, generally with respect to sales of product in the ordinary course of business. Long-term debt and interest expense prior to the TWE Capitalization include the effects of the pushdown of a portion of the Time Warner credit agreement debt that was related to the WCI acquisition, based on the proportion that the fair value of the WCI contributed businesses acquired bore to the fair value of all of the WCI net assets acquired. Interest expense prior to the TWE Capitalization also reflects interest on $875 million of loans due to WCI, which were repaid at the TWE Capitalization, at a rate approximating the rate applicable to borrowings under the Time Warner credit agreement. 12. SUPPLEMENTAL INFORMATION Supplemental information with respect to cash flows is as follows: The noncash effects of the consolidation of Six Flags are reflected in the difference between the historical and restated balance sheet amounts at December 31, 1992. The noncash effect of the acquisition of the ATC minority interest was to increase investments--$156 million; cable television franchises--$865 million; excess of cost over net assets acquired--$410 million; and partners' capital--$1.431 billion. A noncash effect of the TWE Capitalization was the assumption by TWE of $2.545 billion of Time Warner debt in excess of the amount reflected as a liability prior to the TWE Capitalization. Cash equivalents consist of commercial paper and other investments that are readily convertible into cash, and have original maturities of three months or less. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Other current liabilities consist of: REPORT OF INDEPENDENT AUDITORS TO THE PARTNERS OF TIME WARNER ENTERTAINMENT COMPANY, L.P. We have audited the accompanying consolidated balance sheet of Time Warner Entertainment Company, L.P. ("TWE") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and partnership capital for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of TWE's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TWE at December 31, 1993 and 1992, and the consolidated results of its operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York February 4, 1994 TIME WARNER ENTERTAINMENT COMPANY, L.P. SELECTED FINANCIAL INFORMATION The selected financial information for each of the five years in the period ended December 31, 1993 set forth below has been derived from and should be read in conjunction with the consolidated financial statements and other financial information presented elsewhere herein. Capitalized terms are as defined and described in such consolidated financial statements, or elsewhere herein. The selected historical financial information for 1993 gives effect to the consolidation of Six Flags effective as of January 1, 1993, as a result of the 1993 Six Flags acquisition. The selected historical financial information for periods prior to such date has not been changed; however, selected financial information for 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. The selected historical financial information for 1993 gives effect to the USW Transaction as of September 15, 1993 and the 1993 TWE Refinancings, and for 1992 gives effect to the TWE Capitalization and Refinancing as of the dates such transactions were consummated and the ATC Merger as of June 30, 1992, using the purchase method of accounting and reflected in the consolidated financial statements of TWE under the pushdown method of accounting. The selected historical financial information for 1989 gives effect to the purchase by Time Warner of 59.3% of the WCI contributed businesses (as part of Time Warner's acquisition of 59.3% of WCI) as of July 31, 1989, and to the purchase by Time Warner of the 40.7% minority interest in the WCI contributed businesses (as part of Time Warner's acquisition on January 10, 1990 of the remaining capital stock of WCI) as of December 31, 1989, using the purchase method of accounting for business combinations and reflected in the consolidated financial statements of TWE under the pushdown method of accounting. TIME WARNER ENTERTAINMENT COMPANY, L.P. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the heading "restated" to facilitate comparative analysis. (b) Net income for each of the second and third quarters of 1993 includes an extraordinary loss on the retirement of debt of $2 million and $8 million, respectively. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following transactions that occurred in 1993 and 1992 have affected the comparability of the financial statements of TWE (collectively, the "TWE Transactions"): . The 1993 Six Flags Acquisition and Refinancing: The increase in TWE's ownership of Six Flags from 50% to 100% on September 17, 1993 and the retirement of outstanding debt and preferred stock of Six Flags and its subsidiaries, using Six Flags cash flow and $550 million of funds provided by TWE, which resulted in the consolidation of Six Flags effective as of January 1, 1993. The historical financial information prior to 1993 has not been changed; however, financial statements retroactively reflecting the consolidation of Six Flags for 1992 also have been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The USW Transaction: The admission of a subsidiary of USW as an additional limited partner of TWE on September 15, 1993 for a capital contribution of $2.553 billion, consisting of $1.532 billion in cash and the $1.021 billion USW Note, in exchange for 25.51% pro rata priority capital and residual equity interests. . The 1993 TWE Refinancings: The issuance of $2.6 billion of TWE debentures in 1993 to reduce indebtedness under the TWE credit agreement. . The TWE Capitalization and Refinancing: The initial capitalization of TWE on June 30, 1992 and associated refinancings, including the repayment of the Time Warner and ATC credit agreements with $5.9 billion borrowed under a new TWE credit agreement and $1 billion of capital contributions; and the issuance of $1.2 billion of senior notes to reduce bank debt. . The ATC Merger: Time Warner's acquisition of the ATC minority interest on June 26, 1992, in exchange for Time Warner notes then valued at $1.3 billion. . The 1992 Six Flags Recapitalization: The issuance of $192 million aggregate principal amount of zero coupon notes by Six Flags in December 1992 to redeem or repurchase shares of common stock of Six Flags and its principal subsidiary. The impact of these transactions on the financial statements of TWE is reflected on a pro forma basis in the discussion and analysis set forth below. RESULTS OF OPERATIONS 1993 VS. 1992 TWE had 1993 revenues of $7.946 billion, income of $208 million before an extraordinary loss of $10 million on the retirement of debt and net income of $198 million, compared to 1992 revenues of $6.761 billion ($7.251 billion on a restated basis) and net income of $160 million. On a pro forma basis, giving effect to the TWE Transactions as if such transactions had occurred at the beginning of the year, TWE would have reported net income of $198 million in 1993, compared to $208 million on an historical basis. On the same pro forma basis, TWE would have reported net income of $10 million in 1992, compared to net income of $160 million on an historical basis. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) As a U.S. partnership, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $64 million and $50 million ($53 million on a restated basis) in the years ended December 31, 1993 and 1992, respectively, have been provided in respect of the operations of TWE's domestic and foreign subsidiary corporations, including Six Flags in 1993. Other factors affecting comparative operating results are discussed below on a business segment basis. That discussion includes, among other factors, an analysis of changes in the operating income of the business segments before depreciation and amortization ("EBITDA"), because the operating income of certain businesses has been affected by significant amounts of purchase price amortization from Time Warner's $14 billion acquisition of WCI in 1989, the $1.3 billion acquisition of the ATC minority interest in 1992 and other business combinations accounted-for by the purchase method. EBITDA for 1993 and 1992 was as follows: While many financial analysts consider EBITDA to be an important measure of comparative operating performance for the businesses of TWE, it should be considered in addition to, but not as a substitute for, or superior to, operating income, net income, cash flow and other measures of financial performance reported in accordance with generally accepted accounting principles. Filmed Entertainment. Revenues increased to $4.557 billion compared to $3.455 billion ($3.945 billion on a restated basis) in 1992. Operating income increased to $263 million from $194 million ($235 million on a restated basis). Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $258 million in 1993 and $191 million ($260 million on a restated basis) in 1992. EBITDA increased to $521 million from $385 million ($495 million on a restated basis). The increase in revenues, operating income and EBITDA on an historical basis resulted primarily from the inclusion in 1993 of the operating results of Six Flags, which previously had been accounted for using the equity method. Revenues at Warner Bros. increased during the period primarily due to increases in international theatrical, international syndication and domestic home video revenues, as well as increased revenues from retail operations. Record international revenues of $1.650 billion would have been greater but for unfavorable exchange rate fluctuations. Warner Bros. ranked number one at both the domestic and international box office in 1993, led by the success of The Fugitive and The Bodyguard. Revenues at Six Flags increased, benefiting from higher revenues per visitor. EBITDA benefited from the above gains. Programming--HBO. Revenues decreased to $1.435 billion compared to $1.444 billion in 1992. Operating income increased to $213 million from $201 million. Depreciation and amortization amounted to $17 million in 1993 and $14 million in 1992. EBITDA increased to $230 million from $215 million. The decrease in revenues reflects lower HBO Video sales, which in 1992 were favorably affected by a children's sell-thru title, offset in part by higher subscriber revenues, principally as a result of higher pay-TV rates at TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) HBO and an increase in subscribers. EBITDA benefited primarily from improved results from new businesses, including Time Warner Sports and the Comedy Central joint venture. Cable. Revenues increased to $2.205 billion compared to $2.091 billion in 1992. Operating income increased to $407 million from $400 million. Depreciation and amortization, including amortization related to the purchase of WCI and the ATC Merger, amounted to $627 million in 1993 and $577 million in 1992. EBITDA increased to $1.034 billion from $977 million. Revenues increased principally as a result of growth in the number of cable subscribers and increases in advertising sales and pay-per-view. The increase in subscribers accounted for approximately three quarters of the revenue increase. EBITDA benefited from the revenue gains and increased income from cable joint ventures, but was negatively affected in the fourth quarter by cable rate regulation which went into effect on September 1, 1993. The negative effect of rate regulation is expected to continue into 1994 (see "Financial Condition and Liquidity" elsewhere herein). Interest and Other, Net. Interest and other, net, increased to $551 million in 1993 from $525 million ($563 million on a restated basis) in 1992. Interest expense increased to $573 million compared with $436 million ($486 million on a restated basis) in 1992. The increase in interest expense resulted primarily from the higher average debt levels attributable to the TWE Capitalization, the higher interest cost of the TWE notes and debentures issued to refinance TWE bank debt, and the consolidation of Six Flags' interest expense in 1993. Other income, net, in 1993 included gains on the sale of certain assets partially offset by reductions in the carrying value of certain investments. Other expenses, net, on a restated basis in 1992 is principally attributable to losses on certain investments and litigation-related costs. 1992 VS. 1991 TWE had revenues of $6.761 billion and net income of $160 million in 1992, compared to revenues of $6.068 billion and net income of $97 million in 1991. EBITDA for 1992 and 1991 on a historical basis was as follows: Filmed Entertainment. Revenues increased to $3.455 billion compared to $3.065 billion in 1991, and operating income decreased to $194 million from $195 million. Depreciation and amortization, including amortization related to Time Warner's purchase of WCI, amounted to $191 million in 1992 and $183 million in 1991. EBITDA increased to $385 million from $378 million in 1991. The revenue growth resulted primarily from increased worldwide theatrical revenues, which benefited from a number of very successful releases. Warner Bros. ranked number one in domestic box office. Revenues from international home video and syndication, sales to network television and retail operations also increased, while revenue from pay-television sales declined. The increase in EBITDA reflects the higher revenues, offset in part by lower margins. Programming--HBO. Revenues increased to $1.444 billion from $1.366 billion in 1991, while operating income rose to $201 million from $183 million. Depreciation and amortization amounted to $14 million in 1992 and $12 million in 1991. EBITDA increased to $215 million from $195 million in 1991. The revenue TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) growth resulted from higher subscriber revenues and increased revenues from ancillary businesses, particularly from television production. The increase in subscriber revenues resulted from higher pay-TV rates at HBO and a slight increase in the number of subscribers. EBITDA benefited from the revenue gains, improved operating margins and a smaller loss from the division's 50% investment in Comedy Central, offset in part by expenses associated with the start-up of international pay-TV ventures. Cable. Revenues increased to $2.091 billion, compared to $1.935 billion in 1991, and operating income increased to $400 million from $334 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $577 million in 1992 and $538 million in 1991. EBITDA increased to $977 million from $872 million in 1991. Revenues increased as a result of growth in the number of cable customers and an increase in per subscriber revenue. The increase in subscribers accounted for approximately 40% of the revenue increase. EBITDA benefited from the revenue gains, continued cost containment and increased income from domestic cable joint ventures, partially offset by higher cable programming costs and expenses associated with the start-up of international cable ventures. Operating income also was affected by amortization related to the ATC merger. Interest and Other, Net. Interest and other, net increased to $525 million in 1992 from $520 million in 1991. Interest expense decreased to $436 million in 1992 compared with $479 million in 1991. The decrease in interest expense, which is attributable to lower interest rates and lower average debt levels, was offset in part by increases in litigation-related costs and a decline in investment-related income. In August 1992, Time Warner and TWE settled the litigation brought by Viacom International, Inc. in 1989 against Time Warner, ATC and HBO. The settlement terminated with prejudice all claims and counterclaims raised in the litigation. The effects of the settlement were not material to TWE. FINANCIAL CONDITION AND LIQUIDITY DECEMBER 31, 1993 Aided by favorable conditions in the credit markets, TWE continued its strategy of significantly lengthening debt maturities at attractive fixed rates. Over the past two years, TWE reduced variable rate debt by $3.8 billion with proceeds from the issuance of long-term notes and debentures having an average fixed interest rate of 8.6%. An additional $2.5 billion of capital was raised by the USW Transaction, $1 billion of which, presently in the form of the USW Note, has been earmarked for building the Cable division's Full Service Networks(TM) ("FSN"). The Six Flags acquisition culminated a series of transactions over a two-year period that resulted in it becoming a wholly-owned subsidiary of TWE. Six Flags was consolidated effective as of January 1, 1993. Primarily as a result of these transactions, TWE had $7.1 billion of long-term debt at December 31, 1993, and $1.5 billion of General Partners' Senior Capital and $6 billion of partners' capital (net of the $1 billion uncollected portion of the USW Note), compared to $7.2 billion of long-term debt ($7.7 billion on a restated basis) and $6.4 billion of partners' capital at December 31, 1992. Cash and equivalents were $1.3 billion at December 31, 1993, reducing the debt- net-of-cash amount to $5.8 billion at such date. Cash and equivalents at December 31, 1992 were $47 million on a restated basis. Cash provided by the operations of TWE in 1993 amounted to $1.271 billion, after interest payments of $450 million, income taxes of $70 million and working capital requirements. On a pro forma basis, giving retroactive effect to the beginning of the year to the 1993 TWE Refinancings, the USW Transaction and the 1993 Six Flags Acquisition and Refinancings, cash flow from operations would have been $1.279 billion, after interest payments of $473 million, income taxes of $70 million and working capital requirements. Cash used in investing activities in 1993, excluding proceeds from investments, amounted to $960 million. Of this amount, $613 million was spent on capital projects, including $352 million by the Cable division to upgrade its cable systems and $244 million by the Filmed Entertainment division, principally to continue the expansion of international theaters and Warner Bros. Studio Stores, to upgrade facilities at the Warner Bros. Studio, and to introduce new rides at Six Flags. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) TWE continues to expand its core businesses through selective acquisitions and investments, which in 1993 resulted in payments of $347 million, including $136 million for the purchase of common and preferred stocks of Six Flags in connection with the 1993 Six Flags Acquisition and Refinancing. The Milwaukee, Wisconsin cluster of cable systems was augmented by the purchase of a cable system from Viacom Inc. Several other cable systems that did not fit into a cluster were disposed of in 1993 for approximately $100 million. Capital spending is expected to increase significantly in 1994, principally because of the plan to upgrade a significant percentage of cable systems to FSN capacity over the next five years at an estimated cost of $5 billion, which is about three times cable capital expenditures for the last five years. $1 billion of FSN capital expenditures will be funded by collections on the USW Note. TWE is permitted under its partnership and credit agreements to loan up to $1.1 billion to Time Warner. An additional $400 million of such loans are permitted beginning July 1, 1995. There was $1.3 billion of cash and equivalents and $2 billion of available credit under the TWE credit agreement at December 31, 1993. In early 1994, TWE filed a shelf registration statement with the Securities and Exchange Commission covering the issuance of up to $2 billion of debt securities. These securities may be issued from time to time on terms determined at the time of sale. Management believes that 1994 operating cash flow, cash and equivalents, the USW Note, and additional borrowing capacity are sufficient to meet the capital and liquidity needs of TWE, and to fund anticipated loans to Time Warner. On October 5, 1992, Congress enacted the 1992 Cable Act, which among other things reimposed rate regulation on most cable systems. The Federal Communications Commission ("FCC") froze rates in April 1993 for regulated cable services and associated equipment, other than for systems in which local franchising authorities regulate rates. The current expiration date of the freeze is May 15, 1994. On May 3, 1993, the FCC released rules implementing rate regulation, which required that rates for certain equipment be established based on a cost-of-service standard and rates for regulated cable services be established based on either a per-channel benchmark or a cost-of-service standard, at the election of the cable operator. The Cable division elected to establish rates based on the per-channel benchmarks, which the FCC had set at 10% below the average level of rates prevailing nationwide in September of 1992. On February 22, 1994, the FCC announced the adoption of revised rules setting the benchmarks at an average of 17% below the level of rates prevailing in September of 1992, compared with an average 10% rollback under the earlier rules published in May 1993. The text of the new rules is expected to be released in late March, with an effective date of May 15. Under the earlier rules, revenues from sales of regulated equipment and services were expected to decline $90 to $100 million per year. That decline was expected to be partially offset by increases in revenues from other activities, including optional services, advertising sales and subscriber growth that could not be quantified. It is not yet possible to estimate the effect of the new rules although it is expected to be more adverse than the effect of the earlier rules. On November 5, 1992, TWE filed a lawsuit seeking to overturn major provisions of the 1992 Cable Act, primarily on First Amendment grounds. On April 8, 1993, a three-judge District Court upheld the constitutionality of the "must carry" provisions of the 1992 Cable Act. TWE's appeal from this decision was heard by the U.S. Supreme Court in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality of a majority of the other challenged provisions of the 1992 Cable Act. The Company and the federal defendants have appealed this decision to the U.S. Court of Appeals for the D.C. Circuit. Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of films for pay and basic cable, network and syndicated television exhibition amounted to $724 million at December 31, 1993 compared to $674 million at December 31, 1992 (including amounts TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) relating to HBO of $178 million at December 31, 1993 and $161 million at December 31, 1992). The backlog excludes advertising barter contracts. The net impact of inflation on operations has not been significant in the past three years. TIME WARNER ENTERTAINMENT COMPANY, L.P. SUPPLEMENTARY INFORMATION SUMMARIZED FINANCIAL INFORMATION OF SIX FLAGS Six Flags was formed by a group of companies, including a subsidiary of Time Warner ("Enterprises") which owned 50% of Six Flags common stock, to effect the acquisition on December 29, 1991 of Six Flags Theme Parks Inc. ("1991 SF Acquisition"). Enterprises' interest in Six Flags was contributed to TWE at the TWE capitalization. In December 1992, Six Flags redeemed certain of its equity with $102 million of proceeds from the issuance of zero coupon senior notes due 1999 and $12 million of proceeds from the issuance of additional shares of Six Flags common stock ("1992 SF Recapitalization"). TWE continued to own 50% of the common stock of Six Flags following the 1992 SF Recapitalization, until September 17, 1993, when it provided Six Flags with $136 million to repurchase all the common stock held by the other stockholders and preferred stock of certain subsidiaries. TWE also provided $414 million to finance the repurchase or retirement of all the indebtedness of Six Flags and its subsidiaries, except for the zero coupon senior notes due 1999 ("1993 SF Acquisition and Refinancing"). As a result of the 1993 SF Acquisition and Refinancing, TWE has consolidated Six Flags effective January 1, 1993. Set forth below is summarized financial information of Six Flags for 1993 and 1992, and of the predecessor to Six Flags ("Predecessor Company") for 1991, the year preceding the 1991 SF Acquisition. SIX FLAGS ENTERTAINMENT CORPORATION - -------- (a)The 1993 SF Acquisition and Refinancing, certain transactions with respect to the 1992 SF Recapitalization, and the 1991 SF Acquisition were accounted for using the purchase method of accounting for business combinations. If the 1993 SF Acquisition and Refinancing had occurred at the beginning of the year, the 1993 income before extraordinary item would have been $7 million; if the 1992 SF Recapitalization had occurred at the beginning of the year, the 1992 net loss would have been $18 million; and if the 1991 SF Acquisition had occurred at the beginning of the year, the 1991 net loss would have been $17 million. (b)Six Flags entered into a sale and leaseback transaction with TWE with respect to certain of its wholly-owned theme parks. Sale proceeds of $301 million were used to repay indebtedness to TWE incurred in connection with the 1993 SF Acquisition and Refinancing. The 15-year leases have been accounted for as capital leases. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (1)Non-interest bearing note pursuant to an employment agreement for $1,000,000 due on demand. Additional loan pursuant to the agreement of $1,000,000 due December 31, 1994, bearing interest at 6%, payable quarterly. (2)Note pursuant to an employment agreement due on demand bearing interest at 6% per annum, payable annually. (3)Payment of $50,000 received in February 1994. Remaining balance of note due on January 1, 1995, bearing interest at 10% per annum. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) Represents uncollectible receivables charged against the reserve. (b) Represents returns or allowances applied against the reserve. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE X--SUPPLEMENTARY OPERATING STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a)The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. APPENDIX FOR GRAPHIC AND IMAGE MATERIAL DESCRIPTION OF OMITTED LOCATION OF GRAPHIC GRAPHIC OR IMAGE OR IMAGE IN TEXT - --------------------- ------------------- An organizational chart showing the Registrant's major business groups and its ownership interests therein. IFC - 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- EXHIBITS FILED WITH FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-8637 TIME WARNER INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX i ii iii - -------- Incorporated by reference. The Registrant hereby agrees to furnish to the Securities and Exchange Commission at its request copies of long-term debt instruments defining the rights of holders of the Registrant's outstanding long-term debt that are not required to be filed herewith. iv	33,383	220,027
101830_1993.txt	101830_1993	1993	101830	Item 1. Business THE CORPORATION Sprint Corporation (Sprint), incorporated in 1938 under the laws of Kansas, is a holding company. Sprint's principal subsidiaries provide local exchange, cellular/wireless and domestic and international long distance telecommunications services. Other subsidiaries are engaged in the wholesale distribution of telecommunications products and the publishing and marketing of white and yellow page telephone directories. Sprint, through its subsidiaries, owns Sprint Communications Company L.P. (the Limited Partnership), the principal entity comprising the long distance division. Through December 31, 1991, GTE Corporation (GTE) owned a 19.9 percent interest in the Limited Partnership. In March 1993, Sprint's merger with Centel Corporation (Centel) was consummated, increasing Sprint's local exchange operations and greatly expanding its cellular/wireless operations. LONG DISTANCE COMMUNICATIONS SERVICES The long distance division is the nation's third largest long distance telephone company, operating a nationwide all-digital long distance communications network utilizing state-of-the-art fiber-optic and electronic technology. The division provides domestic voice and data communications services across certain specified geographical boundaries, as well as international long distance communications services. Rates charged by the division for its services sold to the public are subject to different levels of state and federal regulation, but are generally not subject to rate-base regulation. The division had net operating revenues of $6.14 billion, $5.66 billion and $5.39 billion in 1993, 1992 and 1991, respectively. The 1982 Modification of Final Judgment (MFJ) entered into by American Telephone and Telegraph Company (AT&T) and the Department of Justice significantly affected the long distance communications market. The major aspects of the MFJ were (1) the divestiture of AT&T's local telephone operating companies (the Bell Operating Companies), (2) the creation of geographical areas called Local Access and Transport Areas (LATAs) within which the Bell Operating Companies and independent local exchange companies provide basic local and intra-LATA toll service, (3) the retention of long distance services by AT&T, and (4) the prohibition against the Bell Operating Companies providing inter- LATA services and information services, and manufacturing telecommunications equipment. The Bell Operating Companies and GTE local exchange companies were required by the MFJ and the GTE Consent Decree, respectively, to provide customers with access to all inter-LATA carriers' networks in a manner "equal in type, quality, and price" to that provided to AT&T (equal access). The independent local exchange companies were required by the Federal Communications Commission (FCC) to provide equal access from many of their central offices. AT&T dominates the long distance communications market and is expected to continue to dominate the market for some years into the future. MCI Communications Corporation (MCI) is the nation's second largest long distance telephone company. Sprint's long distance division competes with AT&T and MCI in all segments of the long distance communications market. Competition is based upon price and pricing plans, the types of services offered, customer service, and communications quality, reliability and availability. The opportunities for and cost of competition and, as a result, the structure of the long distance telecommunications industry are all subject to varying degrees of change by decisions of the executive, judicial and legislative branches of the federal government. The stated objective of these changes is to open the long distance market to new entrants and eventually replace regulation with competition where it best serves the public interest. Some of the major issues being addressed by the federal government to facilitate the transition to a competitive market include the full implementation of equal access (discussed above), equal charges per unit of traffic for access transport provided to long distance carriers (discussed below), lessened regulation of AT&T (including permitting individual customer offerings), and the modification of some or all of the line-of- business restrictions imposed on the Bell Operating Companies by the MFJ (also discussed below). Many of these same competitive issues are also being considered by a number of state regulators and legislators. In 1982, the FCC distinguished between carriers and found some (AT&T and the Local Exchange Carriers, or LECs) to be dominant, and others (primarily smaller competitive long distance companies) to be nondominant. The FCC found it was in the public interest to continue to regulate dominant carriers but, because of market forces, it was appropriate to significantly lessen the amount of regulation applied to nondominant domestic carriers; thus, for instance, nondominant carriers were allowed to choose not to file interstate tariffs. This policy of "permissive detariffing" for nondominant carriers was found by the U.S. Court of Appeals for the D.C. Circuit, in November 1992, to violate the requirement in the Communications Act that all carriers "shall" file tariffs. In response to the Court's decision, the FCC adopted rules streamlining tariff filings for nondominant carriers. The U.S. Supreme Court subsequently agreed to hear an appeal of the Circuit Court decision. In February 1993, AT&T filed lawsuits in federal District Court in Washington, D.C. against the Limited Partnership, MCI and WilTel, Inc. alleging unspecified damages for providing competitive service at rates not contained in tariffs filed with the FCC. In November 1993, the court granted Sprint's motion to dismiss AT&T's lawsuit; however, AT&T has appealed the decision to the D.C. Circuit Court. Although it is impossible to predict the outcome of these proceedings with certainty, Sprint believes that the Limited Partnership has at all times complied with applicable laws and regulations and that its rates are proper and enforceable. In 1989, the FCC replaced regulation of AT&T's rate of return with a system of price caps, giving AT&T increased pricing flexibility. In 1991, the FCC adopted partial "streamlined" regulation of certain competitive business services provided by AT&T. Specifically, the FCC removed these services (primarily WATS and private line) from price caps regulation, reduced the related tariff filing requirements and permitted contracts with individual customers if the terms are generally available to other business users. The FCC subsequently extended "streamlined" regulation to most 800 services provided by AT&T. Also in 1991, the FCC extended the provision of the MFJ requiring the Bell Operating Companies (and all other LECs) to apply "equal charges per unit of traffic" for access transport to all interexchange carriers, which otherwise would have expired, and instituted a comprehensive proceeding to determine new access transport rules. In October 1992, the FCC adopted a new rate structure and new pricing rules for LEC-provided switched transport. LECs filed new access transport tariffs with the FCC in September 1993, which contain rates that will purportedly reduce the costs of the largest interexchange carrier by less than 1 percent and increase the costs of the smaller interexchange carriers (including Sprint's long distance division) by less than 2 percent. The new rates went into effect on December 30, 1993. In 1991, a series of decisions by the U.S. District Court and Circuit Court of Appeals in Washington, D.C. resulted in the MFJ's restriction against participation by the Bell Operating Companies in information services being removed. Legislation has been introduced in Congress, however, to place some safeguards on the provision of those services. Legislation also has been introduced in both Houses of Congress in 1994 to substantially modify the restrictions in the MFJ. The bill in the U.S. House would require the Justice Department, instead of the District Court, to determine whether the provision of long distance service by the Bell Operating Companies would substantially harm competition, but there are significant exceptions to this rule. The bill in the U.S. Senate would require the FCC to determine that the Bell Operating Companies can provide competitive long distance service only after local telephone competition has diminished their monopoly power. The Clinton Administration has also indicated that it favors legislation which promotes local telephone competition and the national information infrastructure. Although federal legislation to modify the MFJ has been introduced several times in recent years but has not passed, there appears to be a greater likelihood that Congress will act during the Clinton Administration. LOCAL COMMUNICATIONS SERVICES The local division is comprised of rate-regulated local exchange operating companies which serve approximately 6.1 million access lines in 19 states. In addition to furnishing local exchange services, the division provides intra-LATA toll service and access by other carriers to Sprint's local exchange facilities. The division had net operating revenues of $4.13 billion, $3.86 billion and $3.75 billion in 1993, 1992 and 1991, respectively. Florida and North Carolina were the only jurisdictions in which 10 percent or more of the division's total 1993 net operating revenues were generated. The following table reflects major revenue categories as a percentage of the division's total net operating revenues: 1993 1992 1991 Local service 39.4% 39.0% 38.3% Network access 37.1 36.9 37.2 Toll service 12.2 12.6 13.0 Other 11.3 11.5 11.5 Total 100.0% 100.0% 100.0% AT&T, as the dominant long distance telephone company, is the division's largest customer for network access services. In 1993, 17.3 percent of the division's net operating revenues (6.3 percent of Sprint's consolidated net operating revenues) was derived from services provided to AT&T, primarily network access services, compared to 18.7 percent (6.9 percent of Sprint's consolidated net operating revenues) in 1992. While AT&T is a significant customer, Sprint does not believe the division's revenues are dependent upon AT&T, as customers' demand for inter- LATA long distance telephone service is not tied to any one long distance carrier. Historically, as the market share of AT&T's long distance competitors increases, the percent of revenues derived from network access services provided to AT&T decreases. Effective January 1, 1991, the FCC adopted a price caps regulatory format for the Bell Operating Companies and the GTE local exchange companies. Other LECs could volunteer to become subject to price caps regulation. Under price caps, prices for network access service must be adjusted annually to reflect industry average productivity gains (as specified by the FCC), inflation and certain allowed cost changes. Sprint elected to be subject to price caps regulation, and under the form of the plan adopted, Sprint's LECs generally have an opportunity to earn up to a 14.25 percent rate of return on investment. Some of Sprint's LECs have committed to produce higher than industry average productivity gains, and as a result have an opportunity to earn up to a 15.25 percent rate of return on investment. The LECs owned by Centel did not originally elect price caps, but as a result of the merger, these LECs adopted price caps effective July 1, 1993. Prior to price caps, under rate of return regulation, the Centel companies' authorized rate of return on investment was 11.25 percent, with the ability to earn 0.25 percent above the authorized return. The FCC is conducting a scheduled review of all aspects of the price caps plan; changes to the plan may be proposed by interested parties and the FCC may implement changes in 1995. Without further action by the FCC, the current price caps plan would expire in 1995 and would be replaced by rate of return regulation. The potential for more direct competition with Sprint's LECs is increasing. Many states, including most of the states in which Sprint's LECs operate, allow competitive entry into the intra-LATA long distance service market. State regulators are also increasingly confronted with requests to permit resale of local exchange services, with such resale now existing in a number of states in which Sprint's LECs operate, including Pennsylvania, Kansas, Illinois and Missouri. Illinois law also allows alternative telecommunications providers to obtain certificates of local exchange service authority in direct competition with existing LECs if certain showings are made to the satisfaction of the Illinois Commerce Commission. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing LECs to direct coin telephone competition. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier 1 (over $100 million annual operating revenues) LECs allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the D.C. Circuit. The extent and ultimate impact of competition for LECs will continue to depend, to a considerable degree, on FCC and state regulatory actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress. It is uncertain if any of the bills will be enacted. CELLULAR AND WIRELESS COMMUNICATIONS SERVICES The cellular and wireless division primarily consists of Sprint Cellular Company and its subsidiaries. In addition, Sprint's LECs hold FCC licenses for Rural Service Areas. For management and financial reporting purposes, these operations have been combined with Sprint Cellular Company's operations. Approximately 50 percent of Sprint's local communications services customers are located in areas served by the cellular and wireless division of Sprint. The division has operating control of 88 markets in 15 states and a minority interest in 64 markets. The division had net operating revenues of $464 million in 1993 and served more than 652,000 customers as of year end. In 1992 and 1991, the division had revenues of $322 million and $242 million, respectively. Prior to the November 1992 decision by the U.S. Court of Appeals for the D.C. Circuit rejecting permissive detariffing discussed above under "Long Distance Communications Services", cellular carriers had not filed tariffs with the FCC. In February 1993, resale of domestic interstate toll tariffs for Sprint's cellular and wireless operations were filed. The FCC, pursuant to authority conferred by the Revenue Reconciliation Act of 1993, has adopted rules to pre-empt all state regulation of commercial mobile radio services, including cellular, and to forbear from enforcing tariffing requirements with respect to commercial mobile radio services. The FCC licenses two carriers in each cellular market area and these carriers compete directly with each other to provide cellular service to end users and resellers. Each carrier is licensed to operate on frequencies set aside for its cellular operation. Licensees also encounter retail competition from resale carriers in their market. Sprint Cellular Company also sells cellular equipment in the competitive retail market. Competition is based on quality of service, price and product quality. The FCC has announced that it will award additional radio spectrum for the provision of personal communications services (PCS). The FCC is expected to auction spectrum licenses during 1994. The FCC expects that PCS will result in additional competition for existing cellular carriers. PRODUCT DISTRIBUTION AND DIRECTORY PUBLISHING North Supply Company (North Supply), a wholesale distributor of telecommunications, security and alarm, and electrical products, distributes products of more than 900 manufacturers to approximately 12,000 customers. Products range from basics, such as wire and cable, telephones and repair parts, to complete PBX systems and security and alarm equipment. North Supply also provides material management services to several of its affiliates and to several subsidiaries of the Regional Bell Holding Companies. The nature of competition in North Supply's markets demands a high level of customer service to succeed, as a number of competitors, including other national wholesale distributors, sell the same products. North Supply sells to telephone companies and other users of telecommunications products, including Sprint's local and long distance divisions, other local and long distance telephone companies, and companies with large private networks. Other North Supply customers include original equipment manufacturers, interconnect companies, security and alarm dealers and local, state and federal governments. Sales to affiliates represented 39.3 percent of North Supply's total sales in 1993 and 1992 and 36.5 percent in 1991. North Supply's net operating revenues were $677 million, $594 million and $569 million in 1993, 1992 and 1991, respectively. Sprint Publishing & Advertising publishes and markets white and yellow page telephone directories in certain of Sprint's local exchange territories, as well as in the greater metropolitan areas of Milwaukee, Wisconsin and Chicago, Illinois. The company publishes approximately 277 directories in 19 states with a circulation of 12.6 million copies. Sprint Publishing & Advertising's net operating revenues were $268 million, $257 million, and $245 million in 1993, 1992 and 1991, respectively. In addition, Centel Directory Company, another Sprint subsidiary, publishes and markets approximately 59 directories in 5 states with a circulation of 3.5 million copies through The CenDon Partnership, a general partnership between Centel Directory Company and The Reuben H. Donnelley Corporation. Revenues of Sprint Publishing & Advertising and The CenDon Partnership are principally derived from selling directory advertisements. The companies compete with publishers of telephone directories and others for advertising revenues. ENVIRONMENT Sprint's subsidiaries are involved in the remediation of certain sites, primarily relating to leakage from tanks used for the storage of gasoline for vehicles and diesel fuel for standby power generators. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect on the capital expenditures or earnings of Sprint or any of its subsidiaries, and future effects are not expected to be material. PATENTS, TRADEMARKS AND LICENSES Sprint and its subsidiaries own numerous patents, patent applications and trademarks in the United States and other countries. Sprint and its subsidiaries are also licensed under domestic and foreign patents owned by others. In the aggregate, these patents, patent applications, trademarks and licenses are of material importance to Sprint's businesses. EMPLOYEE RELATIONS As of December 31, 1993, Sprint and its subsidiaries had approximately 50,500 employees, of whom approximately 25 percent are members of unions. During 1993, Sprint and its subsidiaries had no material work stoppages caused by labor controversies. INFORMATION AS TO INDUSTRY SEGMENTS Sprint's net operating revenues from affiliates and non- affiliates, by segment, for the three years ended December 31, 1993, 1992 and 1991, are as follows (in millions): Net Operating Revenues 1993 1992 1991 Long Distance Communications Services Non-affiliates $ 6,088.4 $ 5,612.1 $ 5,344.2 Affiliates 50.8 46.1 43.4 6,139.2 5,658.2 5,387.6 Local Communications Services Non-affiliates 3,911.5 3,662.4 3,564.6 Affiliates 214.5 199.8 189.1 4,126.0 3,862.2 3,753.7 Cellular and Wireless Communications Services Non-affiliates 464.0 322.2 242.1 Product Distribution and Directory Publishing Non-affiliates 679.2 629.7 618.5 Affiliates 266.0 233.2 207.5 945.2 862.9 826.0 Subtotal 11,674.4 10,705.5 10,209.4 Intercompany revenues (306.6) (285.2) (276.1) Net operating revenues $ 11,367.8 $ 10,420.3 $ 9,933.3 For additional information as to industry segments of Sprint, refer to "Business Segment Information" within the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 2. Item 2. Properties The aggregate cost of Sprint's property, plant and equipment was $17.72 billion as of December 31, 1993, of which $11.23 billion relates to local communications services, $5.49 billion relates to long distance communications services and $570 million relates to cellular/wireless communications services. These properties consist primarily of land, buildings, digital fiber-optic network, switching equipment, cellular radio, microwave radio and cable and wire facilities and are in good operating condition. Certain switching equipment and several general office facilities are located on leased premises. The long distance division has been granted easements, rights-of-way and rights-of-occupancy, primarily by railroads and other private landowners, for its fiber-optic network. The properties of the product distribution and directory publishing businesses consist primarily of office and warehouse facilities to support the business units in the distribution of telecommunications products and publication of telephone directories. Sprint owns its corporate headquarters building and certain other property located in the greater Kansas City metropolitan area. Property, plant and equipment with an aggregate cost of approximately $10.36 billion is either pledged as security for first mortgage bonds and certain notes or is restricted for use as mortgaged property. Item 3. Item 3. Legal Proceedings In September 1993, a memorandum of agreement setting forth settlement terms was executed in connection with the class action lawsuit originally filed in 1990 by certain Sprint shareholders against Sprint and certain of its executive officers and directors in the United States District Court for the District of Kansas. An amended class action complaint was filed in January 1992 after dismissal without prejudice of the original complaint. The plaintiffs in the class action alleged violations of various federal securities laws and related state laws and, among other relief, sought unspecified compensatory damages. A related shareholders' derivative complaint was dismissed without prejudice by the same court in March 1993. Pursuant to the settlement, which includes settlement of the derivative claims, Sprint will pay $28.5 million. Sprint admits no wrongdoing, but settled the case to avoid the costs and uncertainties of further litigation and the disruption of business activities that would result from trial. Approximately 60 percent of the settlement will be recovered from Sprint's insurance carriers. The net settlement did not have a significant effect on Sprint's 1993 results of operations. The settlement agreement is subject to the approval of the court. Following announcement of the Sprint/Centel merger agreement in May 1992, a class action suit was filed by certain Centel shareholders against Centel and certain of its officers and directors. The suit was consolidated in the United States District Court for the Northern District of Illinois in July 1992. The complaint alleges violations of federal securities laws by failing to disclose pertinent information regarding the value of Centel common stock. The plaintiffs seek damages in an unspecified amount. Other suits arising in the ordinary course of business are pending against Sprint and its subsidiaries. Sprint cannot predict the ultimate outcome of these actions or the above- described litigation, but believes they will not result in a material effect on Sprint's consolidated financial statements. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders during the fourth quarter of 1993. Item 10(b). Executive Officers of the Registrant Office Name Age Chairman and Chief Executive Officer William T. Esrey (1) 54 President - Cellular and Wireless Communications Division Dennis E. Foster (2) 53 President - Long Distance Division Ronald T. LeMay (3) 48 President - Local Telecommunications Division D. Wayne Peterson (4) 58 Executive Vice President - Law and External Affairs J. Richard Devlin (5) 43 Executive Vice President - Chief Financial Officer Arthur B. Krause (6) 52 Senior Vice President - Financial Services and Taxes Gene M. Betts (7) 41 Senior Vice President - External Affairs John R. Hoffman (8) 48 Senior Vice President and Controller John P. Meyer (9) 43 Senior Vice President - Strategic Planning and Business Development Theodore H. Schell (10) 49 Senior Vice President - Quality Development and Public Relations Richard C. Smith,Jr.(11) 53 Senior Vice President - Treasurer M. Jeannine Strandjord (12) 48 Senior Vice President - Human Resources I. Benjamin Watson (13) 45 Vice President and Secretary Don A. Jensen (14) 58 (1)Mr. Esrey was elected Chairman in 1990. He was elected Chief Executive Officer and a member of the Board of Directors in 1985. In addition, he has served as Chief Executive Officer of the Limited Partnership since 1988. (2)Mr. Foster was elected President - Cellular and Wireless Communications Division in April 1993. Mr. Foster had served as Senior Vice President - Operations of a subsidiary of Sprint since 1992. From 1991 to 1992, he served as President of GTE Mobilnet in Atlanta, Georgia. Prior to that, he had served in various positions with GTE Corporation for more than five years. (3)Mr. LeMay was elected President - Long Distance Division in 1989. He had served as Executive Vice President - Corporate Affairs of Sprint since 1987. He was elected to the Board of Directors of Sprint in 1993. (4)Mr. Peterson was elected President - Local Telecommunications Division in August 1993. From 1980 to 1993, he served as President of Carolina Telephone and Telegraph Company, a subsidiary of Sprint. (5)Mr. Devlin was elected Executive Vice President - Law and External Affairs in 1989. He had served as Vice President and General Counsel - Telephone since 1987. (6)Mr. Krause was elected Executive Vice President - Chief Financial Officer in 1988. During 1990 and 1991, he also served as Chief Information Officer. (7)Mr. Betts was elected Senior Vice President - Financial Services and Taxes in 1990. He had served as Vice President - Taxes since 1988. (8)Mr. Hoffman was elected Senior Vice President - External Affairs in 1990. He had served in the same capacity at the Limited Partnership since 1986. (9)Mr. Meyer was elected Senior Vice President and Controller in April 1993. He had served as Vice President and Controller of Centel since 1989. From 1986 to 1989, he served as Controller of Centel. (10)Mr. Schell was elected Senior Vice President - Strategic Planning and Business Development of Sprint in 1990. He joined the Long Distance Division as Vice President - Strategic Planning in 1989. From 1983 to 1989, he served as President of RealCom Communications Corporation, an IBM subsidiary, whose principal business is telecommunications services. (11)Mr. Smith was elected Senior Vice President - Quality Development and Public Relations in 1991. He had served as President of the Limited Partnership's National Markets since 1989. From 1986 to 1989, he served as President of the Limited Partnership's National Accounts Division. (12)Ms. Strandjord was elected Senior Vice President - Treasurer in 1990. She had served as Vice President and Controller since 1986. (13)Mr. Watson was elected Senior Vice President - Human Resources in April 1993. Mr. Watson headed a transition team in connection with the Centel merger following announcement of the merger. He had served as Vice President - Finance and Administration of United Telephone - Eastern Group, an operating group of subsidiaries of Sprint, since 1990. From 1983 to 1990, he served as Vice President - Administration of the Midwest Group, an operating group of subsidiaries of Sprint. (14)Mr. Jensen was elected Vice President and Secretary in 1975. There are no known family relationships between any of the persons named above or between any such persons and any outside directors of Sprint. Officers are elected annually. Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Market Price Per Share 1993 1992 End of End of High Low Period High Low Period First Quarter 31 3/4 25 1/2 30 1/2 26 3/8 21 22 1/2 Second Quarter 35 3/8 29 1/2 35 1/8 25 20 3/4 21 3/4 Third Quarter 37 1/2 33 1/2 36 3/4 24 3/8 21 1/2 24 3/8 Fourth Quarter 40 1/4 31 3/8 34 3/4 26 3/4 23 3/8 25 1/2 As of March 1, 1994, there were approximately 105,000 record holders of Sprint's common stock. The principal trading market for Sprint's common stock is the New York Stock Exchange. The common stock is also traded on the Chicago and Pacific Stock Exchanges. Sprint has declared dividends of $0.25 per quarter during each of the years ended December 31, 1993 and 1992. Item 6. Item 6. Selected Financial Data For information required by Item 6, refer to the "Selected Financial Data" section of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations For information required by Item 7, refer to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 8. Item 8. Financial Statements and Supplementary Data For information required by Item 8, refer to the "Consolidated Financial Statements and Schedules" and "Quarterly Financial Data sections of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure As previously reported in Sprint's Current Report on Form 8-K dated April 23, 1993, following consummation of the merger with Centel, Arthur Andersen & Co. was replaced with Ernst & Young as auditors of Centel and its subsidiaries, effective April 23, 1993. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant Pursuant to Instruction G(3) to Form 10-K, the information relating to Directors of Sprint required by Item 10 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. For information pertaining to Executive Officers of Sprint, as required by Instruction 3 of Paragraph (b) of Item 401 of Regulation S-K, refer to the "Executive Officers of the Registrant" section of Part I of this report. Pursuant to Instruction G(3) to Form 10-K, the information relating to compliance with Section 16(a) required by Item 10 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 11. Item 11. Executive Compensation Pursuant to Instruction G(3) to Form 10-K, the information required by Item 11 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to Instruction G(3) to Form 10-K, the information required by Item 12 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 13. Item 13. Certain Relationships and Related Transactions Pursuant to Instruction G(3) to Form 10-K, the information required by Item 13 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. The consolidated financial statements of Sprint and supplementary financial information filed as part of this report are listed in the Index to Financial Statements, Financial Statement Schedules and Supplementary Data. 2. The consolidated financial statement schedules of Sprint filed as part of this report are listed in the Index to Financial Statements, Financial Statement Schedules and Supplementary Data. 3. The following exhibits are filed as part of this report: EXHIBITS (3) Articles of Incorporation and Bylaws: (a) Articles of Incorporation, as amended (filed as Exhibit 4 to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (b) Bylaws, as amended (filed as Exhibit 3(b) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (4) Instruments defining the Rights of Sprint's Equity Security Holders: (a) The rights of Sprint's equity security holders are defined in the Fifth, Sixth, Seventh and Eighth Articles of Sprint's Articles of Incorporation. See Exhibit 3(a). (b) Rights Agreement dated as of August 8, 1989, between Sprint Corporation (formerly United Telecommunications, Inc.) and United Missouri Bank, N.A. (formerly United Missouri Bank of Kansas City, N.A.), as Rights Agent (filed as Exhibit 2(b) to Sprint Corporation Registration Statement on Form 8- A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (c) Amendment and supplement dated June 4, 1992 to Rights Agreement dated as of August 8, 1989 (filed as Exhibit 2(c) to Amendment No. 1 on Form 8 dated June 8, 1992 to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (10) Material Agreements - Merger Agreement: (a) Agreement and Plan of Merger dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2 to Sprint Corporation Current Report on Form 8-K dated May 27, 1992 and incorporated herein by reference). (b) First Amendment dated as of February 19, 1993, to the Agreement and Plan of Merger, dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2b to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (10) Executive Compensation Plans and Arrangements: (c) 1978 Stock Option Plan, as amended (filed as Exhibit 19(a) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (d) 1981 Stock Option Plan, as amended (filed as Exhibit 19(b) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (e) 1985 Stock Option Plan, as amended (filed as Exhibit 19(c) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (f) 1990 Stock Option Plan, as amended. (g) 1990 Restricted Stock Plan, as amended (filed as Exhibit 99 to Sprint Corporation Registration Statement No. 33-50421 and incorporated herein by reference). (h) Long-Term Stock Incentive Program, as amended (filed as Exhibit 19(e) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (i) Restated Memorandum Agreements Respecting Supplemental Pension Benefits between Sprint Corporation (formerly United Telecommunications, Inc.) and two of its current and former executive officers (filed as Exhibit 10(i) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (j) Executive Long-Term Incentive Plan. (k) Executive Management Incentive Plan. (l) Long-Term Incentive Compensation Plan (filed as Exhibit 10(j) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (m) Short-Term Incentive Compensation Plan (filed as Exhibit 10(k) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (n) Retirement Plan for Directors, as amended (filed as Exhibit 28d to Registration Statement No. 33-28237, and incorporated herein by reference). (o) Key Management Benefit Plan, as amended. (p) Executive Deferred Compensation Plan, as amended (filed as Exhibit 19(f) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (q) Director's Deferred Fee Plan, as amended (filed as Exhibit 19(g) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (r) Supplemental Executive Retirement Plan (filed as Exhibit 10(q) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (s) Form of Contingency Employment Agreements between Sprint Corporation and certain of its executive officers (filed as Exhibit 10(r) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (t) Form of Indemnification Agreements between Sprint Corporation (formerly United Telecommunications, Inc.) and its Directors and Officers (filed as Exhibit 10(s) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). (u) Summary of Executive Benefits (filed as Exhibit 10(u) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). (v) Amended and Restated Centel Management Incentive Plan. (w) Amended and Restated Centel Stock Option Plan. (x) Agreements Regarding Special Compensation and Post Employment Restrictive Covenants between Sprint Corporation and three of its executive officers. (y) Amended and Restated Centel Matched Deferred Salary Plan. (z) Amended and Restated Centel Directors Deferred Compensation Plan. (aa) Amended and Restated Centel Director Stock Option Plan. (11) Computation of Earnings Per Common Share. (12) Computation of Ratio of Earnings to Fixed Charges. (21) Subsidiaries of Registrant. (23a) Consent of Ernst & Young. (23b) Consent of Arthur Andersen & Co. Sprint will furnish to the Securities and Exchange Commission, upon request, a copy of the instruments defining the rights of holders of its long-term debt and the long-term debt of its subsidiaries. The total amount of securities authorized under any of said instruments does not exceed 10 percent of the total assets of Sprint and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits are listed in Item 14(a). SIGNATURES Pursuant to the requirements of Section 13 or 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. SPRINT CORPORATION (Registrant) By /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer Date: March 14, 1994 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 indicated on the 14th day of March, 1994. /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer /s/ Arthur B. Krause Arthur B. Krause Executive Vice President - Chief Financial Officer /s/ John P. Meyer John P. Meyer Senior Vice President and Controller Principal Accounting Officer SIGNATURES SPRINT CORPORATION (Registrant) 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 indicated on the 14th day of March, 1994. /s/ DuBose Ausley /s/ Robert E. R. Huntley DuBose Ausley, Director Robert E. R. Huntley, Director /s/ Warren L. Batts /s/ George Hutton Jr. Warren L. Batts, Director George N. Hutton Jr., Director /s/ Ruth M. Davis /s/ Ronald T. LeMay Ruth M. Davis, Director Ronald T. LeMay, Director /s/ Joseph L. Dionne /s/ Linda K. Lorimer Joseph L. Dionne, Director Linda Koch Lorimer, Director /s/ W. T. Esrey /s/ C. Price William T. Esrey, Director Charles H. Price II, Director /s/ Donald J. Hall /s/ Frank E. Reed Donald J. Hall, Director Frank E. Reed, Director /s/ P. H. Henson /s/ Charles E. Rice Paul H. Henson, Director Charles E. Rice, Director /s/ Harold S. Hook /s/ Stewart Turley Harold S. Hook, Director Stewart Turley, Director INDEX TO FINANCIAL STATEMENTS, FINANCIAL Sprint Corporation STATEMENT SCHEDULES AND SUPPLEMENTARY DATA Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Financial Statements and Schedules: Management Report Report of Independent Auditors - Ernst & Young Report of Independent Auditors - Arthur Andersen & Co. Business Segment Information as of or for each of the three years ended December 31, 1993 Consolidated Statements of Income for each of the three years ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Consolidated Statements of Common Stock and Other Shareholders' Equity for each of the three years ended December 31, 1993 Notes to Consolidated Financial Statements Financial Statement Schedules for each of the three years ended December 31, 1993: V - Consolidated Property, Plant and Equipment VI - Consolidated Accumulated Depreciation VIII - Consolidated Valuation and Qualifying Accounts IX - Consolidated Short-term Borrowings X - Consolidated Supplementary Income Statement Information Certain financial statement schedules are omitted because the required information is not present, or because the information required is included in the consolidated financial statements and notes thereto. Quarterly Financial Data SELECTED FINANCIAL DATA Sprint Corporation As of or For the Years Ended December 31, 1993 1992 1991 1990 1989 (In Millions, Except Per Share Data) Results of Operations <1> Net operating revenues $ 11,367.8 $10,420.3 $9,933.3 $9,469.8 $8,557.6 Operating income <2> 1,250.6 1,213.4 1,185.6 1,045.3 1,076.7 Income from continuing operations <2>, <3>, <4> 480.6 496.1 472.7 351.1 353.0 Earnings per common share from continuing operations <2>, <3>, <4> 1.39 1.46 1.41 1.06 1.08 Dividends per common share 1.00 1.00 1.00 1.00 0.97 Financial Position <1> Total assets $14,148.9 $13,599.6 $13,929.8 $14,080.6 $13,092.7 Property, plant and equipment, net 10,314.8 10,219.9 10,310.5 10,295.2 9,700.9 Total debt (including short-term borrowings) 5,094.4 5,442.7 5,571.2 6,082.3 5,471.3 Redeemable preferred stock 38.6 40.2 56.6 60.0 63.5 Common stock and other shareholders' equity 3,918.3 3,971.6 3,671.9 3,353.5 3,151.5 <1>Effective March 9, 1993, Sprint Corporation (Sprint) consummated its merger with Centel Corporation (Centel). Because the merger has been accounted for as a pooling of interests, the accompanying data has been retroactively restated to include the results of operations and financial position of Centel. Dividends per common share for periods prior to the merger represent the amounts paid by Sprint. <2>During 1993, nonrecurring charges of $293 million were recorded related to (a) transaction costs associated with the merger with Centel and the expenses of integrating and restructuring the operations of the two companies and (b) a realignment and restructuring within the long distance division. Such charges reduced consolidated 1993 income from continuing operations by $193 million ($0.56 per share). During 1990, nonrecurring charges of $72 million were recorded related to the long distance division, which reduced consolidated 1990 income from continuing operations by $37 million ($0.11 per share). <3>During 1992 and 1991, gains were recognized related to the sales of certain local telephone and cellular properties, which increased consolidated 1992 income from continuing operations by $44 million ($0.13 per share) and consolidated 1991 income from continuing operations by $78 million ($0.23 per share). <4>During 1993, as a result of the enactment of the Revenue Reconciliation Act of 1993, Sprint was required to adjust its deferred income tax assets and liabilities to reflect the increased tax rate. Such adjustment reduced consolidated 1993 income from continuing operations by $13 million ($0.04 per share). MANAGEMENT'S DISCUSSION AND ANALYSIS OF Sprint Corporation FINANCIAL CONDITION AND RESULTS OF OPERATIONS Sprint/Centel Merger Effective March 9, 1993, Sprint Corporation (Sprint) consummated its merger with Centel Corporation (Centel), creating a diversified telecommunications enterprise with operations in long distance, local exchange and cellular/wireless communications services. The merger has been accounted for as a pooling of interests. Accordingly, the accompanying consolidated financial statements and information have been restated retroactively to include the results of operations, financial position and cash flows of Centel for all periods prior to consummation of the merger. Consolidated Results of Operations Each of Sprint's primary divisions -- long distance, local and cellular/wireless communications services -- generated record levels of net operating revenues and improved operating results in 1993. The long distance division generated a solid 8 percent growth in traffic volumes in 1993, the number of access lines served by the local division grew 5 percent, and the cellular/wireless division benefited from a strong 67 percent customer line growth rate. Cost controls and synergies resulting from the merger with Centel also contributed to the improved 1993 results. Consolidated results of operations in 1993, 1992 and 1991 were, however, affected by several nonrecurring items, as described in the next section. Highlights of consolidated results are as follows, excluding nonrecurring items as applicable: Consolidated net operating revenues grew 9 percent in 1993 to $11.37 billion, following a 5 percent increase in 1992. Income from continuing operations in 1993 was $687 million as compared to $452 million in 1992 and $395 million in 1991 -- which represents a compounded annual growth rate of 21 percent over the past three years. *Earnings per common share from continuing operations increased 50 percent in 1993 to $1.99 per share as compared to $1.33 per share in 1992. The following analysis of earnings per common share in 1993 and 1992 highlights the factors contributing to the improved results and the impact of nonrecurring items: 1993 1992 Prior year's earnings per common share from continuing operations (excluding nonrecurring items) $ 1.33 $ 1.18 Favorable (unfavorable) factors contributing to changes Divisional operating results 0.63 0.06 Interest expense 0.11 0.07 Other non-operating expense (0.03) 0.05 Effective income tax rate (0.02) (0.02) Change in weighted average common shares (0.03) (0.01) Current year's earnings per common share from continuing operations (excluding nonrecurring items) 1.99 1.33 Nonrecurring items Merger, integration and restructuring costs (0.56) Divestitures 0.13 1993 Tax law change (0.04) Discontinued operations (0.04) Extraordinary losses (0.08) (0.05) Accounting changes (1.12) 0.07 Total earnings per common share $ 0.15 $ 1.48 Nonrecurring Items Merger, Integration and Restructuring Costs - As a result of the merger with Centel, the operations of the merged companies continue to be integrated and restructured to achieve efficiencies which have begun to yield operational synergies and cost savings, particularly during the latter half of 1993. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges aggregating $259 million, which reduced 1993 income from continuing operations by $172 million ($0.50 per share). In addition, in 1993, Sprint initiated a realignment and restructuring of its long distance division, including the elimination of approximately 1,000 positions and the closure of two facilities. These actions are expected to improve market focus, lower costs and streamline operations within the division, and resulted in a nonrecurring charge of $34 million, which reduced 1993 income from continuing operations by $21 million ($0.06 per share). Divestitures - Divestitures of local telephone and cellular operations in 1992 and 1991 resulted in gains of $81 million and $114 million, respectively, which increased income from continuing operations by $44 million and $78 million, respectively. 1993 Tax Law Change - In August 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate to 35 percent from 34 percent. As a result, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate. The adjustment related to Sprint's nonregulated subsidiaries increased the income tax provision for 1993 by $13 million. Discontinued Operations and Extraordinary Losses - During 1993, Sprint incurred a loss from discontinued operations of $12 million, net of related income tax benefits. In 1993, 1992 and 1991, Sprint incurred extraordinary losses related to the early extinguishments of debt of $29 million, $16 million, and $2 million, respectively, net of related income tax benefits. Accounting Changes - Effective January 1, 1993, Sprint changed its method of accounting for postretirement and postemployment benefits by adopting Statement of Financial Accounting Standards (SFAS) No. 106 and No. 112 and effected another accounting change. The cumulative effect of these changes in accounting principles reduced 1993 net income by $384 million. Effective January 1, 1992, Sprint also changed its method of accounting for income taxes by adopting SFAS No. 109. The cumulative effect of this change in accounting principle increased 1992 net income by $23 million. Non-operating Items Interest expense in 1993 and 1992 decreased $59 million and $37 million, respectively, generally related to decreases in average levels of debt outstanding and lower interest rates. The components of other expense, net are as follows (in millions): 1993 1992 1991 Equity in earnings from cellular minority partnership investments $ 20.0 $ 12.8 $ 8.8 Minority interests (9.4) (6.1) (51.6) Write-down of assets held for sale (16.0) (15.0) Other, net (16.9) 3.3 7.2 Total other expense, net $ (22.3) $ (5.0) $ (35.6) The decline in 1992 minority interests reflects Sprint's acquisition of the remaining 19.9 percent minority interest in Sprint Communications Company L.P. (the Limited Partnership) effective January 1, 1992. Sprint's income tax provisions for 1993, 1992 and 1991 resulted in effective tax rates of 38 percent, 36 percent and 34 percent, respectively. See Note 4 of "Notes to Consolidated Financial Statements" for information regarding the differences which cause the effective income tax rates to vary from the statutory federal income tax rates. As of December 31, 1993, Sprint has recorded deferred income tax assets of $316 million related to postretirement benefits and other accruals, $260 million related to alternative minimum tax credit carryforwards, and $40 million (net of a $25 million valuation allowance) related to state operating loss carryforwards. Sprint's management has determined that it is more likely than not that these deferred income tax assets, net of the valuation allowance, will be realized based on current income tax laws and expectations of future taxable income stemming from ordinary operations or the reversal of existing deferred tax liabilities. Uncertainties surrounding income tax law changes, shifts in operations between state taxing jurisdictions, and future operating income levels may, however, affect the ultimate realization of all or some portion of these deferred income tax assets. The effects of inflation on Sprint's operations were not significant during 1993, 1992, or 1991. Segmental Results of Operations Long Distance Communications Services Sprint's long distance division provides domestic and international voice and data communications services. Rates charged by the division for its services are subject to different levels of state and federal regulation, but are generally not rate-base regulated. Net operating revenues increased 9 percent in 1993, following a 5 percent increase in 1992. Such increases were generally due to traffic volume growth of 8 percent and 6 percent, respectively. Average revenue per minute received from customers was relatively constant during 1993 but declined 3 percent during 1992, primarily due to the mix of products among markets and competitive influences. The increases in net operating revenues and traffic volumes in both 1993 and 1992 reflect ongoing growth in the business and international markets, coupled with rebounding growth in the residential market during 1993. Growth in the business market in 1993 was also enhanced by the arrival of "800 portability," whereby customers who wish to change long distance carriers may now do so while retaining their advertised "800" numbers. In addition, lower revenue adjustments, reflecting improvement in the collectibility of customer accounts receivable, resulted in increased net operating revenues in 1992. Future rates of growth in both net operating revenues and traffic volumes may be influenced by both domestic and international economic conditions and the division's ability to maintain market share and current price levels in the intensely competitive long distance marketplace. Interconnection costs increased $136 million and $118 million in 1993 and 1992, respectively. International interconnection costs increased due to increased traffic volumes, partially offset by price reductions and the conversion of international traffic from resale arrangements (traffic transported by other long distance carriers) to less costly direct access arrangements. Costs of connecting to networks domestically also increased primarily as a result of traffic volume growth, partially offset by reductions in interconnection rates paid to local exchange companies and by reduced costs related to the transition from switched to special access arrangements. Interconnection costs as a percentage of net operating revenues were 44 percent in 1993 as compared to 46 percent in both 1992 and 1991. Operations expense consists of costs related to operating and maintaining the long distance network; costs of providing various services such as operator services, public payphones, telecommunications services for the hearing impaired, and video teleconferencing; and costs of data systems sales. Operations expense increased $98 million in 1993 over 1992, partially due to a change in accounting whereby circuit activity costs are now being expensed when incurred (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Exclusive of the effect of this accounting change, operations expense increased approximately $63 million in 1993 and $43 million in 1992, primarily due to expanded service offerings, increased traffic volumes and increased salaries and related benefits. Selling, general and administrative (SG&A) expense increased $120 million and $92 million in 1993 and 1992, respectively, generally as a result of intensified sales and marketing efforts. During 1993, marketing efforts primarily directed towards "800 portability," The Most calling plan and the recently introduced "Be there now" campaign resulted in increased advertising and other marketing expenses, as well as increased commissions and salaries and related expenses. During 1992, the introduction of several new calling plans and calling card features also resulted in increases in such sales and marketing expenses. Despite the increases in the amount of SG&A expense in 1993 and 1992, such expenses as a percentage of net operating revenues remained constant when compared to 1991, at 25 percent. Depreciation and amortization in 1993 decreased from 1992, primarily due to the change in accounting for circuit activity costs, as described above. Depreciation and amortization in 1992 was consistent with the 1991 amount as the increased depreciation resulting from additions to property, plant and equipment was substantially offset by a decrease in amortization expense resulting from the full amortization in June 1991 of certain intangible assets related to the 1986 formation of the Limited Partnership. Local Communications Services The local division consists principally of Sprint's rate- regulated, local exchange telephone operations. The following table summarizes, by major category, the net operating revenues of the division (in millions): 1993 1992 1991 Net operating revenues Local service $ 1,624.3 $ 1,507.4 $ 1,436.4 Network access 1,530.4 1,425.8 1,398.5 Toll service 505.3 487.5 487.2 Other 466.0 441.5 431.6 Total $ 4,126.0 $ 3,862.2 $ 3,753.7 As described in Note 9 of "Notes to Consolidated Financial Statements," certain local telephone operations were divested during 1992 and 1991. The following comparisons and discussion exclude the effects of such divested operations. Net operating revenues increased 7 percent in 1993, following a 5 percent increase in 1992. Increased local service revenues reflect continued increases in the number of access lines served and growth in add-on services, such as custom calling features. The division experienced 4.8 percent growth in access lines during 1993, compared to 4.2 percent in 1992. Network access revenues, derived from interexchange long distance carriers' use of the local network to complete calls, increased during 1993 and 1992 as a result of increased traffic volumes and additional revenues resulting from the recognition of a portion of the merger, integration and restructuring costs for regulatory purposes in certain jurisdictions, partially offset by periodic reductions in network access rates charged. Toll service revenues, related to the provision of long distance services within specified geographical areas and the reselling of interexchange long distance services, increased 4 percent and 1 percent in 1993 and 1992, respectively. Such increase in 1993 primarily reflects the election of the division's Indiana operations to serve as the primary intralata toll carrier within its serving area, rather than providing network access to another carrier. Other revenues increased in 1993 and 1992 generally due to higher equipment sales. Plant operations expense includes network operations costs; repair and maintenance costs of property, plant and equipment; and other expenses associated with the cost of providing services. The 4 percent and 2 percent increases in such costs in 1993 and 1992, respectively, were primarily related to increases in the costs of providing services resulting from access line growth. Depreciation and amortization expense increased $14 million in 1993, following a $15 million increase in 1992. Exclusive of the effects of depreciation rate changes, special short-term amortizations and nonrecurring charges approved by state regulatory commissions, such increases were $17 million and $16 million, respectively, generally due to plant additions. Other operating expense increased $99 million and $122 million in 1993 and 1992, respectively. Such increases resulted primarily from higher sales and marketing expenses to promote new products and services; increases in systems development costs incurred to enhance the efficiency and capabilities of the division's billing processes; and increases in the cost of equipment sales. The increases in both plant operations and other operating expenses also reflect the impact of the increased postretirement benefits cost of approximately $38 million being recognized in 1993 as a result of the adoption of SFAS No. 106. Consistent with most local exchange carriers, the division accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation and amortization based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. Sprint's management believes that the division's operations meet the criteria for the continued application of the provisions of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the division no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, noncash charge. Cellular and Wireless Communications Services Sprint's cellular and wireless division consists of wholly- owned and majority-owned interests in 42 metropolitan service area (MSA) markets and 46 rural service area (RSA) markets. The company also owns minority interests in 31 MSA and 33 RSA markets. Equity in the earnings and losses of these minority investments is included in other expense, net in the consolidated statements of income. The increases in net operating revenues during 1993 and 1992 resulted principally from the growth in customer lines served, which increased 67 percent in 1993 and 52 percent in 1992. The effects of growth in customer lines served was partially offset by a decline in service revenue per customer line served, reflecting an industry-wide trend that has occurred as a result of increased general consumer market penetration. Costs of services and products declined to 33 percent of net operating revenue in 1993 from 37 percent in 1992 and 39 percent in 1991, generally reflecting economies gained from serving additional customer lines. The increases in selling, general and administrative expense for 1993 and 1992 resulted principally from increased commissions and customer service expenses, as well as increased advertising costs related to the growth in customer lines. Despite the increases in the amount of SG&A expense, such costs as a percentage of net operating revenues declined to 45 percent in 1993 from 48 percent in 1992 and 47 percent in 1991. Such improvement resulted primarily from an overall reduction in the unit cost of acquiring new customers and additional economies realized from providing service and support to a larger customer base. Depreciation and amortization increased during both 1993 and 1992 as additional investment in property, plant and equipment was required to meet the growth in customer lines. Product Distribution and Directory Publishing Sprint's product distribution and directory publishing businesses generated operating income of $64 million, $66 million and $62 million in 1993, 1992 and 1991, respectively. North Supply, a wholesale distributor of telecommunications products, had 1993 net operating revenues of $677 million, compared to $594 million in 1992 and $569 million in 1991. The increases primarily reflect additional nonaffiliated contracts and increased sales to the local division, partially as a result of sales during 1993 to the merged Centel telephone operations. Sprint Publishing & Advertising, a publisher and marketer of telephone directories, had net operating revenues of $268 million in 1993, compared with 1992 and 1991 net operating revenues of $257 million and $245 million, respectively. Liquidity and Capital Resources Cash Flows - Operating Activities Cash flows from operating activities, which are Sprint's primary source of liquidity, were $2.14 billion, $2.26 billion and $1.82 billion in 1993, 1992 and 1991, respectively. The 1992 operating cash flows include proceeds of $300 million from the sale of accounts receivable within the long distance division. Excluding these proceeds, the improvement in 1993 operating cash flows reflects better operating results, partially offset by expenditures related to merger, integration and restructuring actions of $155 million. Cash Flows - Investing Activities Sprint's investing activities used cash of $1.57 billion, $1.58 billion and $1.08 billion in 1993, 1992 and 1991, respectively. Capital expenditures, which represent Sprint's most significant investing activity, were $1.59 billion, $1.47 billion and $1.52 billion in 1993, 1992 and 1991, respectively (see "Business Segment Information" for the amounts incurred by each division). Long distance capital expenditures were incurred each year primarily to increase the network capacity and to enhance network capabilities for providing new products and services. Capital expenditures for the local division were made to accommodate access line growth, to continue the conversion to digital technologies, and to expand the division's capabilities for providing enhanced telecommunications services. The increases in 1993 and 1992 capital expenditures for the cellular and wireless division reflect the significant increases in the number of customer lines served during such years. Investing activities in 1992 also include $250 million paid in connection with Sprint's $530 million acquisition of the remaining 19.9 percent interest in the Limited Partnership and proceeds of $114 million from the sale of certain local telephone properties. Investing activities for 1991 include proceeds of $468 million from the divestitures of certain local telephone, cellular and other properties. Cash Flows - Financing Activities Sprint's financing activities used cash of $620 million, $681 million and $755 million in 1993, 1992 and 1991, respectively. Improved operating cash flows during each year, together with proceeds from the sale of additional accounts receivable in 1992 and from the various divestitures in 1992 and 1991, allowed Sprint to fund capital expenditures and dividends internally and to reduce total debt outstanding during each year. In addition, the $280 million note issued to the seller in connection with the acquisition of the remaining interest in the Limited Partnership was paid in 1992. During 1993 and 1992, a significant level of debt refinancing occurred in order to take advantage of lower interest rates. Accordingly, a majority of the proceeds from long-term borrowings in 1993 was used to finance the redemption prior to scheduled maturities of $1.24 billion of debt. During 1992, Sprint refinanced $720 million of long-term debt and borrowed $250 million to finance the payment related to the acquisition of the remaining 19.9 percent interest in the Limited Partnership. Sprint paid dividends to common and preferred shareholders of $347 million, $300 million and $296 million in 1993, 1992 and 1991, respectively. Sprint's indicated annual dividend rate on common stock is currently $1.00 per share. Financial Position, Liquidity and Capital Requirements As of December 31, 1993, Sprint's total capitalization aggregated $9.05 billion, consisting of long-term debt (including current maturities), redeemable preferred stock, and common stock and other shareholders' equity. Long-term debt (including current maturities) and short-term borrowings comprised 55 percent of total capitalization as of December 31, 1993, compared to 58 percent at year-end 1992 (as adjusted in both years on a proforma basis for the effects of changes in accounting principles). During 1994, Sprint anticipates funding estimated capital expenditures of $1.8 billion and dividends with cash flows from operating activities. Notes payable and commercial paper outstanding as of December 31, 1993 (classified as long-term debt) aggregated $756 million. During 1994, this entire balance will be replaced by the issuance of long-term debt or will continue to be refinanced under existing long-term credit facilities. Sprint expects its external cash requirements for 1994 to be approximately $800 million to $900 million, which is generally required to repay scheduled long-term debt maturities and reduce notes payable and commercial paper outstanding. A portion of such external cash requirements is expected to be generated from issuances of common stock through employee benefit plans and from the sale of certain investments. The method of financing the remaining external cash requirements will depend upon prevailing market conditions during the year. Sprint may also undertake additional debt refinancings during 1994 in order to take advantage of favorable interest rates. At year-end 1993, Sprint had the ability to borrow $803 million under a revolving credit agreement with a syndicate of domestic and international banks and other bank commitments. Other available financing sources include a Medium-Term Note program, under which Sprint may offer for sale up to $175 million of unsecured senior debt securities. Additionally, pursuant to shelf registration statements filed with the Securities and Exchange Commission, up to $1.2 billion of debt securities may be offered for sale. The aggregate amount of additional borrowings which can be incurred is ultimately limited by certain covenants contained in existing debt agreements. As of December 31, 1993, Sprint had borrowing capacity of approximately $2.8 billion under the most restrictive of its debt covenants. MANAGEMENT REPORT The management of Sprint Corporation has the responsibility for the integrity and objectivity of the information contained in this Annual Report. Management is responsible for the consistency of reporting such information and for ensuring that generally accepted accounting principles are used. In discharging this responsibility, management maintains a comprehensive system of internal controls and supports an extensive program of internal audits, has made organizational arrangements providing appropriate divisions of responsibility and has established communication programs aimed at assuring that its policies, procedures and codes of conduct are understood and practiced by its employees. The consolidated financial statements included in this Annual Report have been audited by Ernst & Young, independent auditors. Their audit was conducted in accordance with generally accepted auditing standards and their report is included herein. The responsibility of the Board of Directors for these financial statements is pursued primarily through its Audit Committee. The Audit Committee, composed entirely of directors who are not officers or employees of Sprint, meets periodically with the internal auditors and independent auditors, both with and without management present, to assure that their respective responsibilities are being fulfilled. The internal and independent auditors have full access to the Audit Committee to discuss auditing and financial reporting matters. /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer /s/ Arthur B. Krause Arthur B. Krause Executive Vice President - Chief Financial Officer REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Sprint Corporation We have audited the accompanying consolidated balance sheets of Sprint Corporation (Sprint) as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, and common stock and other shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index To Financial Statements, Financial Statement Schedules and Supplementary Data. These financial statements and schedules are the responsibility of the management of Sprint. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements or schedules of Centel Corporation, a wholly-owned subsidiary, as of December 31, 1992, or for each of the two years in the period ended December 31, 1992, which statements reflect total assets constituting 25% in 1992, and net income constituting approximately 9% in 1992 and 29% in 1991 of the related consolidated financial statement totals. Those statements and schedules were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Centel Corporation, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sprint Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, Sprint changed its method of accounting for postretirement benefits, postemployment benefits and circuit activity costs in 1993 and income taxes in 1992. ERNST & YOUNG Kansas City, Missouri February 2, 1994 REPORT OF INDEPENDENT AUDITORS To the Shareowners of Centel Corporation: We have audited the consolidated balance sheet of CENTEL CORPORATION (a Kansas corporation) AND SUBSIDIARIES as of December 31, 1992, and the related consolidated statements of income, common shareowners' investment and cash flows for each of the two years in the period ended December 31, 1992, prior to the pooling of interests with Sprint Corporation (and, therefore, are not presented herein) described in Note 2 to the consolidated financial statements of Sprint Corporation for the year ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Centel Corporation and Subsidiaries as of December 31, 1992, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. In connection with our audits, certain auditing procedures were applied to the following schedules which are required for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. Such schedules are not included herein: Schedule I - Marketable Securities Schedule V - Consolidated Plant, Property and Equipment Schedule VI - Consolidated Accumulated Depreciation Schedule VIII - Consolidated Allowance for Doubtful Accounts Schedule IX - Consolidated Short-Term Borrowings Schedule X - Consolidated Supplementary Income Statement Information In our opinion, the information contained in these schedules fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 3, 1993 BUSINESS SEGMENT INFORMATION Sprint Corporation As of or for the Years Ended December 31, 1993 1992 1991 (In Millions) Long Distance Communications Services <1> Net operating revenues $ 6,139.2 $ 5,658.2 $ 5,387.6 Operating expenses Interconnection 2,710.7 2,574.9 2,457.0 Operations 857.7 759.8 717.1 Selling, general and administrative 1,546.4 1,426.3 1,334.3 Depreciation and amortization 523.5 586.6 584.4 Total operating expenses <2>, <3> 5,638.3 5,347.6 5,092.8 Operating income $ 500.9 $ 310.6 $ 294.8 Capital expenditures $ 529.4 $ 468.1 $ 580.2 Identifiable assets as of December 31 $ 4,193.1 $ 4,232.0 $ 4,543.5 Local Communications Services <1> Net operating revenues $ 4,126.0 $ 3,862.2 $ 3,753.7 Operating expenses Plant operations 1,206.7 1,165.6 1,160.9 Depreciation and amortization 733.0 720.0 716.7 Other 1,232.5 1,137.0 1,036.5 Total operating expenses <2>, <4> 3,172.2 3,022.6 2,914.1 Operating income $ 953.8 $ 839.6 $ 839.6 Capital expenditures $ 845.3 $ 839.4 $ 802.4 Identifiable assets as of December 31 $ 7,604.0 $ 7,242.2 $ 7,099.6 Cellular and Wireless Communications Services <1> Net operating revenues $ 464.0 $ 322.2 $ 242.1 Operating expenses Cost of services and products 154.9 118.3 95.2 Selling, general and administrative 209.9 154.6 114.5 Depreciation and amortization 75.0 52.1 43.2 Total operating expenses <2> 439.8 325.0 252.9 Operating income (loss) $ 24.2 $ (2.8) $ (10.8) Capital expenditures $ 164.9 $ 123.8 $ 91.8 Identifiable assets as of December 31 $ 1,504.3 $ 1,489.4 $ 1,418.1 Product Distribution, Directory Publishing and Other <1> Net operating revenues $ 945.2 $ 862.9 $ 826.0 Operating income <2> $ 64.2 $ 66.0 $ 62.0 Depreciation and amortization $ 27.2 $ 32.8 $ 25.2 Capital expenditures $ 55.1 $ 34.9 $ 48.8 Identifiable assets as of December 31 $ 847.5 $ 636.0 $ 868.6 <1>Include net operating revenues and operating expenses eliminated in consolidation of $306.6 million, $285.2 million and $276.1 million for the years ended December 31, 1993, 1992 and 1991, respectively. <2>Exclude a nonrecurring charge of $259.0 million in 1993 related to the transaction costs associated with the merger with Centel and the estimated expenses of integrating and restructuring the operations of the two companies (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). Such charge was allocable as follows: Long Distance-$12.4 million; Local-$190.1 million; Cellular and Wireless-$3.2 million; Product Distribution and Directory Publishing-$2.5 million; and Other-$50.8 million. <3>Exclude a nonrecurring charge of $33.5 million in 1993 related to the realignment and restructuring of the long distance division (see Note 9 of "Notes to Consolidated Financial Statements" for additional information). <4>Includes increased postretirement benefits cost of approximately $38 million in 1993 related to the adoption of SFAS No. 106. Such cost for the other divisions was not significant. CONSOLIDATED STATEMENTS OF INCOME Sprint Corporation For the Years Ended December 31, 1993 1992 1991 (In Millions, Except Per Share Data) Net Operating Revenues $11,367.8 $10,420.3 $ 9,933.3 Operating Expenses Costs of services and products 5,736.1 5,325.5 5,091.0 Selling, general and administrative 2,729.9 2,489.9 2,287.2 Depreciation and amortization 1,358.7 1,391.5 1,369.5 Merger, integration and restructuring costs 292.5 Total operating expenses 10,117.2 9,206.9 8,747.7 Operating Income 1,250.6 1,213.4 1,185.6 Gain on divestiture of telephone and cellular properties 81.1 113.9 Interest expense (452.4) (511.1) (548.3) Other expense, net (22.3) (5.0) (35.6) Income from continuing operations before income taxes 775.9 778.4 715.6 Income tax provision (295.3) (282.3) (242.9) Income From Continuing Operations 480.6 496.1 472.7 Discontinued operations, net (12.3) 49.4 Extraordinary losses on early extinguishments of debt, net (29.2) (16.0) (1.9) Cumulative effect of changes in accounting principles, net (384.2) 22.7 Net income 54.9 502.8 520.2 Preferred stock dividends (2.8) (3.5) (4.1) Earnings applicable to common stock $ 52.1 $ 499.3 $ 516.1 Earnings Per Common Share Continuing operations $ 1.39 $ 1.46 $ 1.41 Discontinued operations (0.04) 0.15 Extraordinary item (0.08) (0.05) (0.01) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $ 0.15 $ 1.48 $ 1.55 Weighted average number of common shares 343.7 337.2 333.5 See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS Sprint Corporation As of December 31, 1993 1992 Assets (In Millions) Current assets Cash and equivalents $ 76.8 $ 128.8 Accounts receivable, net of allowance for doubtful accounts of $121.9 million ($118.0 million in 1992) 1,230.6 1,044.8 Investment in common stock 130.2 Inventories 182.3 172.1 Deferred income taxes 81.1 46.5 Prepaid expenses 120.7 102.5 Other 156.2 169.3 Total current assets 1,977.9 1,664.0 Investments in common stocks 173.1 209.0 Property, plant and equipment Long distance communications services 5,492.7 5,355.9 Local communications services 11,226.4 10,732.2 Cellular and wireless communications services 569.6 409.9 Other 433.7 405.2 17,722.4 16,903.2 Less accumulated depreciation 7,407.6 6,683.3 10,314.8 10,219.9 Cellular minority partnership investments 287.5 271.2 Excess of cost over net assets acquired 736.8 765.3 Other assets 658.8 470.2 $14,148.9 $13,599.6 Liabilities and Shareholders' Equity Current liabilities Current maturities of long-term debt $ 523.4 $ 386.6 Short-term borrowings 362.3 Accounts payable 925.4 755.4 Accrued interconnection costs 487.5 464.3 Accrued taxes 307.2 291.9 Other 825.1 716.8 Total current liabilities 3,068.6 2,977.3 Long-term debt 4,571.0 4,693.8 Deferred credits and other liabilities Deferred income taxes and investment tax credits 1,182.9 1,308.3 Postretirement and other benefit obligations 793.1 69.0 Other 576.4 539.4 2,552.4 1,916.7 Redeemable preferred stock 38.6 40.2 Common stock and other shareholders' equity Common stock, par value $2.50 per share, authorized-500.0 million shares 858.5 847.1 Capital in excess of par or stated value 827.4 717.5 Retained earnings 2,184.2 2,451.7 Other 48.2 (44.7) 3,918.3 3,971.6 $14,148.9 $13,599.6 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Sprint Corporation For the Years Ended December 31, 1993 1992 1991 (In Millions) Operating Activities Net income $ 54.9 $ 502.8 $ 520.2 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 1,358.7 1,391.5 1,369.5 Gain on divestiture of telephone and cellular properties (81.1) (113.9) Discontinued operations (5.9) (20.6) (43.9) Extraordinary losses on early extinguishments of debt 49.5 25.1 3.1 Cumulative effect of changes in accounting principles 384.2 (22.7) Deferred income taxes and investment tax credits (34.5) 3.0 (34.7) Changes in operating assets and liabilities Accounts receivable, net (185.8) 257.8 42.4 Inventories and other current assets (42.7) (13.9) 52.3 Accounts payable and accrued interconnection costs 196.4 165.8 (130.1) Accrued expenses and other current liabilities 160.5 (39.0) 98.5 Noncurrent assets and liabilities, net 135.1 152.3 7.0 Other, net 66.0 (59.5) 50.2 Net cash provided by operating activities 2,136.4 2,261.5 1,820.6 Investing Activities Capital expenditures (1,594.7) (1,466.2) (1,523.2) Acquisition of Limited Partnership minority interest (250.0) Proceeds from divestiture of telephone and cellular properties 114.0 148.3 Proceeds from sale of discontinued operations 320.0 Other, net 26.3 24.3 (24.5) Net cash used by investing activities (1,568.4) (1,577.9) (1,079.4) Financing Activities Proceeds from long-term debt 840.4 951.2 645.0 Retirements of long-term debt (1,589.0) (1,257.4) (744.3) Net increase (decrease) in notes payable and commercial paper 393.5 147.0 (468.3) Payment of note payable to minority partner (280.0) Proceeds from common stock issued 70.8 51.6 54.1 Proceeds from employees stock purchase installments, net 28.3 13.2 13.9 Dividends paid (347.1) (300.1) (295.8) Other, net (16.9) (6.2) 40.7 Net cash used by financing activities (620.0) (680.7) (754.7) Increase (Decrease) in Cash and Equivalents (52.0) 2.9 (13.5) Cash and Equivalents at Beginning of Year 128.8 125.9 139.4 Cash and Equivalents at End of Year $ 76.8 $ 128.8 $ 125.9 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF COMMON STOCK Sprint Corporation AND OTHER SHAREHOLDERS'EQUITY For the Years Ended December 31, 1993, 1992 and 1991 Capital in Excess of Par or Common Stated Retained Stock Value Earnings Other Total (In Millions) Balance as of January 1, 1991 (330.6 million shares issued and outstanding) $ 826.4 $ 554.0 $2,021.4 $ (48.3) $3,353.5 Net income 520.2 520.2 Common stock dividends (291.7) (291.7) Preferred stock dividends (4.1) (4.1) Employee stock purchase and other installments received, net 16.0 16.0 Common stock issued 10.0 85.6 (24.8) 70.8 Other, net 0.5 0.7 2.3 3.7 7.2 Balance as of December 31, 1991 (334.8 million shares issued and outstanding) 836.9 640.3 2,248.1 (53.4) 3,671.9 Net income 502.8 502.8 Common stock dividends (296.6) (296.6) Preferred stock dividends (3.5) (3.5) Employee stock purchase and other installments received, net 15.5 15.5 Common stock issued 9.9 73.7 (6.5) 77.1 Other, net 0.3 3.5 0.9 (0.3) 4.4 Balance as of December 31, 1992 (338.9 million shares issued and outstanding) 847.1 717.5 2,451.7 (44.7) 3,971.6 Net income 54.9 54.9 Common stock dividends (324.5) (324.5) Preferred stock dividends (2.8) (2.8) Employee stock purchase and other installments received, net 30.8 30.8 Common stock issued 11.0 98.4 (2.4) 107.0 Unrealized holding gains on investments in common stocks, net 64.8 64.8 Other, net 0.4 11.5 4.9 (0.3) 16.5 Balance as of December 31, 1993 (343.4 million shares issued and outstanding) $ 858.5 $ 827.4 $2,184.2 $ 48.2 $3,918.3 See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Sprint Corporation 1. Accounting Policies Basis of Consolidation The accompanying consolidated financial statements include the accounts of Sprint Corporation and its wholly-owned and majority- owned subsidiaries (Sprint), including Centel Corporation (Centel) and Sprint Communications Company L.P. (the Limited Partnership). Investments in less than 50 percent-owned cellular communications partnerships are accounted for using the equity method. During 1991, GTE Corporation (GTE) owned a 19.9 percent interest in the Limited Partnership. Effective January 1, 1992, Sprint acquired GTE's interest in exchange for a $250 million cash payment and a $280 million note which was paid in June 1992. In accordance with industry practice, revenues and related net income of non-regulated operations attributable to transactions with Sprint's rate-regulated telephone companies have not been eliminated in the accompanying consolidated financial statements. Intercompany revenues of such entities amounted to $225 million, $194 million and $164 million in 1993, 1992 and 1991, respectively. All other significant intercompany transactions have been eliminated. Classification of Operations The long distance communications services division provides domestic voice and data communications services across certain specified geographical boundaries, as well as international long distance communications services. Rates charged for such services sold to the public are subject to different levels of state and federal regulation, but are generally not subject to rate-base regulation. The local communications services division consists principally of the operations of Sprint's rate-regulated telephone companies. These operations provide local exchange services, access by telephone customers and other carriers to local exchange facilities and long distance services within specified geographical areas. The cellular and wireless communications services division consists of wholly-owned and majority-owned interests in partnerships and corporations operating cellular and wireless communications properties in various metropolitan and rural service area markets. The product distribution and directory publishing businesses include the wholesale distribution of telecommunications products and the publishing and marketing of white and yellow page telephone directories. Revenue Recognition Operating revenues for the long distance, local and cellular/wireless communications services divisions are recognized as communications services are rendered. Operating revenues for the long distance communications services division are recorded net of an estimate for uncollectible accounts. Operating revenues for Sprint's product distribution business are recognized upon delivery of products to customers. Regulated Operations Sprint's rate-regulated telephone companies account for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation," which requires the accounting recognition of the rate actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Cash and Equivalents Cash equivalents generally include highly liquid investments with original maturities of three months or less and are stated at cost, which approximates market value. As of December 31, 1993 and 1992, outstanding checks in excess of cash balances of $166 million and $151 million, respectively, are included in accounts payable. Investments in Common Stocks Effective December 31, 1993, Sprint changed its method of accounting for its portfolio of marketable equity securities by adopting SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, such investments in common stocks are classified as available for sale and reported at fair value (estimated based on quoted market prices) as of December 31, 1993 and at cost as of December 31, 1992. As of December 31, 1993, the cost of such investments is $202 million, with the gross unrealized holding gains of $101 million reflected as an addition to other shareholders' equity, net of related income taxes. As of December 31, 1992, the market value of such investments was $278 million. Inventories Inventories, consisting principally of those related to Sprint's product distribution business, are stated at the lower of cost (principally first-in, first-out method) or market. Property, Plant and Equipment Property, plant and equipment are recorded at cost. Generally, ordinary asset retirements and disposals are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. Effective January 1, 1993, Sprint's long distance communications services division changed its method of accounting for certain costs related to connecting new customers to its network. The change was made to conform Sprint's accounting to the predominant industry practice for such costs. Under the new method, such costs (which were previously capitalized) are being expensed when incurred. The resulting nonrecurring, noncash charge of $32 million ($0.09 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. The proforma impact of retroactive application of the change would not have been material to net income or earnings per share for 1992 or 1991, and the impact of the change on Sprint's 1993 operating expenses was not significant. Depreciation The cost of property, plant and equipment is depreciated generally on a straight-line basis over the estimated useful lives (such lives related to regulated property, plant and equipment are those prescribed by regulatory commissions). Depreciation rate changes, special short-term amortizations and nonrecurring charges approved by regulatory commissions for the rate-regulated telephone companies resulted in additional depreciation totaling $7 million, $46 million and $49 million in 1993, 1992 and 1991, respectively. After the related effects on revenues and income taxes, these items reduced income from continuing operations for 1993, 1992 and 1991 by approximately $4 million, $24 million and $25 million, respectively. Cellular Minority Partnership Investments Cellular minority partnership investments include the excess of the purchase price over the underlying book value of cellular communications partnerships of $203 million and $209 million as of December 31, 1993 and 1992, respectively. Such excess is being amortized on a straight-line basis over 40 years; accumulated amortization aggregated $29 million and $23 million as of December 31, 1993 and 1992, respectively. Excess of Cost over Net Assets Acquired The excess of the purchase price over the fair value of net assets acquired, principally related to cellular communications services properties, is being amortized on a straight-line basis over 40 years. Accumulated amortization aggregated $112 million and $88 million as of December 31, 1993 and 1992, respectively. Postretirement Benefits Effective January 1, 1993, Sprint changed or modified its method of accounting for certain postretirement benefits by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Sprint provides postretirement benefits (principally health care benefits) to certain retirees. SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits to employees and their dependents or beneficiaries during the years employees earn the benefits. During 1992 and 1991, the cost of providing postretirement benefits to Sprint's retirees was expensed as such costs were paid, while for Centel's employees and retirees, an accrual basis approach was utilized to recognize such costs. Upon adoption of the new standard, Sprint elected to immediately recognize its previously unrecorded obligation for postretirement benefits already earned by current retirees and employees (the transition obligation), a substantial portion of which related to its rate-regulated telephone companies. Pursuant to SFAS No. 71, regulatory assets associated with the recognition of the transition obligation were recorded in jurisdictions where the regulators have issued orders specific to Sprint permitting recognition of net postretirement benefits costs for ratemaking purposes, and providing for recovery of the transition obligation over a period of no longer than 20 years. As of December 31, 1993, such regulatory assets aggregated $83 million. In all other jurisdictions, regulatory assets associated with the recognition of the transition obligation were not recorded due to the uncertainties as to the timing and extent of recovery. The resulting nonrecurring, noncash charge of $341 million ($1.00 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. Net postretirement benefits cost for 1993 increased approximately $50 million as a result of adopting SFAS No. 106. Postemployment Benefits Effective January 1, 1993, Sprint adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Upon adoption, Sprint recognized certain previously unrecorded obligations for benefits being provided to former or inactive employees and their dependents, after employment but before retirement. Such postemployment benefits offered by Sprint include severance, disability and workers compensation benefits, including the continuation of other benefits such as health care and life insurance coverage. The resulting nonrecurring, noncash charge of $11 million ($0.03 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. Adoption of SFAS No. 112 had no significant impact on operating expenses in 1993. Income Taxes Effective January 1, 1992, Sprint changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires an asset and liability approach to accounting for income taxes and establishes less restrictive criteria for recognizing deferred income tax assets. Accordingly, Sprint adjusted its existing deferred income tax assets and liabilities to reflect current statutory income tax rates and previously unrecognized tax benefits related to federal and certain state net operating loss carryforwards. To the extent reductions of the rate-regulated telephone companies' deferred income tax liabilities will accrue to the benefit of its customers, such reductions were recorded as regulatory liabilities. The remaining net change in Sprint's deferred income tax assets and liabilities increased 1992 net income by $23 million ($0.07 per share) and is reflected in the consolidated statement of income as a cumulative effect of change in accounting principle. As allowed under SFAS No. 109, prior years' consolidated financial statements were not restated. During 1991, in accordance with Accounting Principles Board Opinion (APB) No. 11, deferred income taxes were provided for all differences in timing of reporting income and expenses for financial statement and income tax purposes, except for rate- regulated telephone companies' items that were not allowable by various regulatory commissions as expenses for rate-making purposes. Investment tax credits related to regulated telephone property, plant and equipment have been deferred and are being amortized over the estimated useful lives of the related assets. Interest Charged to Construction Regulatory commissions allow the rate-regulated telephone companies to capitalize an allowance for funds expended during construction. Amounts capitalized will be recovered over the service lives of the respective assets constructed as the resulting higher depreciation is recovered through increased revenues. Interest costs associated with the construction of capital assets for Sprint's other operations are capitalized in accordance with SFAS No. 34, "Capitalization of Interest Costs." Total interest amounts capitalized during 1993, 1992 and 1991, including an allowance for funds expended during construction, totaled $8 million, $11 million and $15 million, respectively. Earnings Per Share Earnings per common share amounts are based on the weighted average number of shares both outstanding and issuable assuming exercise of all dilutive options, as applicable. Reclassifications Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. Such reclassifications had no effect on the results of operations. 2. Sprint / Centel Merger Effective March 9, 1993, Sprint consummated its merger with Centel, a telecommunications company with local exchange and cellular/wireless communications services operations. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock, or approximately 119 million shares. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges of $259 million, which reduced 1993 income from continuing operations by $172 million ($0.50 per share). The merger has been accounted for as a pooling of interests. Accordingly, the accompanying consolidated financial statements have been retroactively restated for all periods presented to include the results of operations, financial position and cash flows of Centel. In addition, the accompanying consolidated financial statements reflect the elimination of significant, recurring intercompany transactions and certain adjustments to conform the accounting policies of the two companies. Operating results of the separate companies for periods prior to the merger are as follows (in millions): 1992 1991 Net operating revenues Sprint $ 9,230.4 $ 8,779.7 Centel 1,191.4 1,180.5 Eliminations and reclassifications (1.5) (26.9) Total $ 10,420.3 $ 9,933.3 Income from continuing operations Sprint $ 427.2 $ 367.5 Centel 83.8 112.3 Accounting conformity adjustments (14.9) (7.1) Total 496.1 472.7 Discontinued operations, net 49.4 Extraordinary losses on early extinguishments of debt, net (1992: Sprint - $6.5 million, Centel - $9.5 million; 1991: Centel - $1.9 million) (16.0) (1.9) Cumulative effect of change in accounting for income taxes 22.7 Net income (1992: Sprint - $457.1 million, Centel - $45.7 million; 1991: Sprint - $367.5 million, Centel - $152.7 million) $ 502.8 $ 520.2 3. Employee Benefit Plans Defined Benefit Pension Plan Substantially all Sprint employees are covered by a noncontributory defined benefit pension plan. For participants of the plan represented by collective bargaining units, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plan provides pension benefits based upon years of service and participants' compensation. Sprint's policy is to make contributions to the plan each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plan's assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. The components of the net pension credits and related weighted average assumptions are as follows (in millions): 1993 1992 1991 Service cost -- benefits earned during the period $ 58.2 $ 50.8 $ 47.8 Interest cost on projected benefit obligation 103.9 96.1 87.2 Actual return on plan assets (241.2) (89.5) (381.7) Net amortization and deferral 62.5 (64.7) 231.4 Net pension credit $ (16.6) $ (7.3) $ (15.3) Discount rate 8.0% 8.4% 8.6% Expected long-term rate of return on plan assets 9.5% 8.5% 8.5% Anticipated composite rate of future increases in compensation 5.5% 6.2% 7.3% In addition, Sprint recognized pension curtailment losses of $3 million in 1993 as a result of integration and restructuring actions (see Notes 2 and 9). The funded status and amounts recognized in the consolidated balance sheets for the plan, as of December 31, are as follows (in millions): 1993 1992 Actuarial present value of benefit obligations Vested benefit obligation $ (1,277.0) $ (1,043.6) Accumulated benefit obligation $ (1,462.7) $ (1,183.2) Projected benefit obligation $ (1,582.9) $ (1,321.2) Plan assets at fair value 2,029.0 1,862.4 Plan assets in excess of the projected benefit obligation 446.1 541.2 Unrecognized net gains (197.3) (215.1) Unrecognized prior service cost 88.1 23.0 Unamortized portion of transition asset (221.9) (247.3) Prepaid pension cost $ 115.0 $ 101.8 The projected benefit obligations as of December 31, 1993 and 1992 were determined using discount rates of 7.5 percent and 8.0 percent, respectively, and anticipated composite rates of future increases in compensation of 4.5 percent and 5.5 percent, respectively. Defined Contribution Plans Sprint sponsors defined contribution employee savings plans covering substantially all employees. Participants may contribute portions of their compensation to the plans. Contributions of participants represented by collective bargaining units are matched by Sprint based upon defined amounts as negotiated by the respective parties. Contributions of participants not covered by collective bargaining agreements are also matched by Sprint. For these participants, Sprint provides matching contributions in common stock equal to 50 percent of participants' contributions up to 6 percent of their compensation and may, at the discretion of the Board of Directors, provide additional matching contributions based upon the performance of Sprint's common stock in comparison to other telecommunications companies. Sprint's matching contributions (including cash contributions under the former Centel savings plans) aggregated $49 million, $40 million and $36 million in 1993, 1992 and 1991, respectively. Postretirement Benefits Sprint sponsors postretirement benefits (principally health care benefits) arrangements covering substantially all employees. Employees who retired before specified dates are eligible for these benefits at no cost or a reduced cost. Employees retiring after specified dates are eligible for these benefits on a shared cost basis. Sprint funds the accrued costs as benefits are paid. The components of the 1993 net postretirement benefits cost are as follows (in millions): Service cost -- benefits earned during the period $ 22.1 Interest on accumulated benefit obligation 56.5 Net postretirement benefits cost $ 78.6 For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent increase in the assumed trend rates would have increased the 1993 net postretirement benefits cost by approximately $14 million. The weighted average discount rate for 1993 was 8.0 percent. In addition, the Company recognized postretirement benefits curtailment losses of $11 million in 1993 as a result of integration and restructuring actions (see Notes 2 and 9). The cost of providing postretirement benefits was $28 million in 1992 and $29 million in 1991. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in millions): Accumulated postretirement benefits obligation Retirees $ 322.8 Active plan participants -- fully eligible 158.0 Active plan participants -- other 254.4 735.2 Unrecognized prior service benefit 6.8 Unrecognized net gains 38.9 Accrued postretirement benefits cost $ 780.9 The accumulated benefits obligation as of December 31, 1993 was determined using a discount rate of 7.5 percent. An annual health care trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rates would have increased the accumulated benefits obligation as of December 31, 1993 by approximately $98 million. 4. Income Taxes The components of the income tax provisions allocated to continuing operations are as follows (in millions): 1993 1992 1991 Current income tax provision Federal $ 275.6 $ 242.1 $ 232.9 State 54.2 37.2 44.7 Amortization of deferred investment tax credits (24.7) (31.3) (34.6) 305.1 248.0 243.0 Deferred income tax provision (benefit) Federal 16.4 9.5 (6.4) State (26.2) 24.8 6.3 (9.8) 34.3 (0.1) Total income tax provision $ 295.3 $ 282.3 $ 242.9 On August 10, 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to January 1, 1993. Accordingly, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate. The resulting adjustment related to Sprint's nonregulated subsidiaries increased the 1993 deferred income tax provision by $13 million ($0.04 per share). Adjustments to the net deferred income tax liabilities associated with the rate-regulated telephone companies were generally recorded as reductions to regulatory liabilities and, accordingly, had no immediate effect on Sprint's net income. The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in millions): 1993 1992 1991 Income tax provision at the statutory rate $ 271.6 $ 264.7 $ 243.3 Less investment tax credits included in income 24.7 31.3 34.6 Expected federal income tax provision after investment tax credits 246.9 233.4 208.7 Effect of State income taxes, net of federal income tax effect 18.2 40.9 33.7 Differences required to be flowed through by regulatory commissions 6.0 5.6 5.7 Reversal of rate differentials (13.0) (16.3) (23.7) Amortization of intangibles 8.8 8.6 8.3 Merger related costs 18.0 Other, net 10.4 10.1 10.2 Income tax provision, including investment tax credits $ 295.3 $ 282.3 $ 242.9 Effective income tax rate 38% 36% 34% The income tax provisions (benefits) allocated to other items are as follows (in millions): 1993 1992 1991 Discontinued operations $ (6.6) $ 15.3 Extraordinary losses on early extinguishments of debt (20.3) $ (9.1) (1.2) Cumulative effect of changes in accounting principles Postretirement benefits (216.7) Postemployment benefits (6.7) Circuit activity costs (21.5) Unrealized holding gains on investments in common stocks (recorded directly to shareholders' equity) 36.5 Stock ownership, purchase and options arrangements (recorded directly to shareholders' equity) (10.6) (6.0) (2.7) Effective with the adoption of SFAS No. 109 in 1992, deferred income taxes are provided for the temporary differences between the carrying amounts of Sprint's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, 1993 and 1992, along with the income tax effect of each, are as follows (in millions): 1993 Deferred 1992 Deferred Income Tax Income Tax Assets Liabilities Assets Liabilities Property, plant and equipment $ 1,564.0 $ 1,522.6 Postretirement and other benefits $ 281.1 $ 25.6 Alternative minimum tax credit carryforwards 259.7 311.6 Operating loss carryforwards 64.7 70.2 Integration and restructuring costs 35.0 Other, net 9.9 10.2 Subtotal 640.5 1,573.9 417.6 1,522.6 Less valuation allowance 24.5 30.2 Total $ 616.0 $ 1,573.9 $ 387.4 $ 1,522.6 During 1993 and 1992, the valuation allowance related to deferred income tax assets decreased $6 million and $5 million, respectively. During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, are as follows (in millions): Property, plant and equipment $ 86.5 Allowance for doubtful accounts 8.9 Deferred revenue (2.9) Expense accruals (9.0) Exchangeable debentures 7.0 Alternative minimum tax credit carryforwards (90.8) Investment tax credit carryforwards 5.9 Special partnership allocations 25.3 Sale of telephone properties (32.2) Other, net 1.2 Total $ (0.1) As of December 31, 1993, Sprint has available, for income tax purposes, $260 million of alternative minimum tax credit carryforwards to offset regular income tax payable in future years, and tax benefits of $65 million associated with state operating loss carryforwards. The loss carryforwards expire in varying amounts annually from 1994 through 2008. 5. Debt Long-term debt, as of December 31, is as follows (in millions): Maturing 1993 1992 Corporate Senior notes 9.75% 1993 $ 100.0 8.60% to 9.71% 1994 $ 225.0 225.0 9.45% 1995 50.0 50.0 10.45% 1996 200.0 200.0 9.88% 1997 120.0 160.0 9.19% to 9.60% 1998 43.0 43.0 8.13% to 9.80% 2000 to 2003 632.3 632.3 Debentures 9.25% 2022 200.0 200.0 Subordinated debentures 8.00% 2006 204.8 Notes payable and commercial paper, classified as long-term debt 1996 634.4 Other 11.88% 1999 4.5 5.6 Long Distance Communications Services Vendor financing agreements 6.99% to 10.18% 1994 to 2001 423.4 538.5 Note payable to GTE 5.30% 1993 72.8 Local Communications Services First mortgage bonds 4.63% to 9.00% 1994 to 1998 167.4 260.3 2.00% to 9.37% 1999 to 2003 541.1 487.1 4.00% to 8.75% 2004 to 2008 353.0 344.3 6.88% to 9.79% 2009 to 2013 80.0 32.6 8.77% to 8.78% 2014 to 2018 80.5 216.3 7.13% to 9.89% 2019 to 2023 343.1 268.9 Debentures and notes 4.50% to 9.61% 1994 to 2017 424.4 340.1 Notes payable and commercial paper, classified as long-term debt 1996 121.4 Other 2.00% to 19.45% 1994 to 2017 17.3 20.7 Other Senior notes 9.88% to 11.70% 1998 to 2000 277.1 281.0 Debentures 9.00% 2019 150.0 229.2 Other 8.59% to 13.00% 1995 to 1998 6.5 167.9 Subtotal 5,094.4 5,080.4 Less current maturities 523.4 386.6 Long-term debt $4,571.0 $4,693.8 Long-term debt maturities during each of the next five years are as follows (in millions): Amount 1994 $ 523.4 1995 216.8 1996 1,104.2 1997 100.7 1998 385.3 Property, plant and equipment with an aggregate cost of approximately $10.36 billion is either pledged as security for first mortgage bonds and certain notes or is restricted for use as mortgaged property. Notes payable and commercial paper outstanding and related weighted average interest rates, as of December 31, are as follows (in millions): 1993 1992 Bank notes, 3.55% weighted average interest rate $ 397.5 $ 206.3 Master Trust notes, 3.71% weighted average interest rate 250.0 80.0 Commercial paper, 3.29% weighted average interest rate 108.3 76.0 Total notes payable and commercial paper $ 755.8 $ 362.3 Notes payable and commercial paper outstanding as of December 31, 1993 are classified as long-term debt due to Sprint's intent to refinance such borrowings on a long-term basis and due to its demonstrated ability to do so pursuant to the $1.1 billion revolving credit agreement described below. Such borrowings as of December 31, 1992 were classified as short-term borrowings. The bank notes are renewable at various dates throughout the year. Sprint pays a fee to certain commercial banks to support current and future credit requirements based upon loan commitments. Lines of credit may be withdrawn by the banks if there is a material adverse change in Sprint's financial condition. Sprint has a Master Trust Note Agreement with the trust division of a bank to borrow funds on demand. Interest on such borrowings is at a rate that yields interest equivalent to the most favorable discount rate paid on 180-day commercial paper. As of December 31, 1993, Sprint had a total of $1.31 billion of credit arrangements, consisting of various bank commitments and a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks. At that date, Sprint had availability totaling $803 million under such arrangements. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. During 1993 and 1992, Sprint redeemed or called for redemption prior to scheduled maturities $1.34 billion and $720 million, respectively, of first mortgage bonds, senior notes and debentures. Excluding amounts deferred by the rate-regulated telephone companies as required by certain regulatory commissions, the prepayment penalties incurred in connection with early extinguishments of debt and the write-off of related debt issuance costs aggregated $29 million in 1993 and $16 million in 1992, net of related income tax benefits, and are reflected as extraordinary losses in the consolidated statements of income. In 1991, extraordinary losses of $2 million, net of related income tax benefits, were recorded related to the early extinguishment and defeasance of debt. 6. Redeemable Preferred Stock Sprint has 20 million authorized shares and subsidiaries have approximately 6 million authorized shares of preferred stock, including non-redeemable preferred stock. The redeemable preferred stock outstanding, as of December 31, is as follows (in millions): 1993 1992 Third series -- stated value $100 per share, shares - 208,000 in 1993 and 220,000 in 1992, non-participating, non-voting, cumulative 7.75% annual dividend rate $ 20.8 $ 22.0 Fifth series -- stated value $100,000 per share, shares - 95 in 1993 and 1992, voting, cumulative 6% annual dividend rate 9.5 9.5 Subsidiaries -- stated value ranging from $10 to $100 per share, shares - 380,055 in 1993 and 395,765 in 1992, annual dividend rates ranging from 4.7% to 5.4% 8.3 8.7 Total redeemable preferred stock $ 38.6 $ 40.2 Sprint's third series preferred stock is redeemed through a sinking fund at the rate of 12,000 shares, or $1.2 million per year, until 2008, at which time all remaining shares are to be redeemed. Sprint may redeem additional third series preferred shares at $102.55 per share during 1994, and at declining amounts in succeeding years. In the event of default, the holders of Sprint's third series redeemable preferred stock are entitled to elect a certain number of directors until all arrears in dividend and sinking fund payments have been paid. Sprint's fifth series preferred stock must be redeemed in full in 2003. If less than full dividends have been paid for four consecutive dividend periods or if the total amount of dividends in arrears exceeds an amount equal to the dividend payment for six dividend periods, the holders of the fifth series preferred stock are entitled to elect a majority of directors standing for election until all arrears in dividend payments have been paid. 7. Common Stock Common stock activity during 1993 and shares reserved for future grants under stock option plans or future issuances under various arrangements are as follows (in millions): Number of Shares 1993 Reserved as of Activity December 31, 1993 Employees Stock Purchase Plan 0.1 3.3 Employee savings plans 1.4 5.0 Automatic Dividend Reinvestment Plan 0.4 1.3 Officer and key employees' and Directors' stock options 2.2 12.2 Conversion of preferred stock and other 0.4 2.1 Total 4.5 23.9 As of December 31, 1993, elections to purchase 2.6 million of Sprint's common shares were outstanding under the 1992 offering of the Employees Stock Purchase Plan. The purchase price under the offering cannot exceed $19.66 per share, such price representing 85 percent of the average market price on the offering date, or fall below $12.00 per share. The 1992 offering terminates on June 30, 1994. Under various stock option plans, shares of common stock are reserved for issuance to officers, other key employees and outside directors. All options are granted at 100 percent of the market price at date of grant. Approximately 6 percent of all options outstanding as of December 31, 1993 provide for the granting of stock appreciation rights as an alternate method of settlement upon exercise. The stock appreciation rights feature allows the optionee to elect to receive any gain in the stock price on the underlying option directly from Sprint, either in stock or in cash or a combination of the two, in lieu of exercising the option by payment of the purchase price. A summary of stock option activity under the plans is as follows (in millions, except per share data): Per Share Number Exercise Aggregate of Price Exercise Shares Low High Amount Shares under option as of January 1, 1993 (5.5 million shares exercisable) 7.5 $ 9.44 $ 39.31 $ 170.2 Granted 1.6 27.50 38.44 50.3 Exercised Options without stock appreciation rights (2.1) 9.44 33.75 (41.0) Options with stock appreciation rights (0.3) 11.09 29.68 (5.5) Terminated and expired (0.1) 18.16 33.75 (3.2) Shares under option as of December 31, 1993 (4.5 million shares exercisable) 6.6 $ 9.44 $ 39.31 $ 170.8 During 1990, the Savings Plan Trust, an employee savings plan, acquired shares of common stock from Sprint in exchange for a $75 million promissory note payable to Sprint. The note bears an interest rate of 9 percent and is to be repaid from the common stock dividends received by the plan and the contributions made to the plan by Sprint in accordance with plan provisions. The remaining balance of the note receivable of $60 million as of December 31, 1993 is reflected as a reduction to other shareholders' equity. Under a Shareholder Rights plan, one-half of a Preferred Stock Purchase Right is attached to each share of common stock. Each Right, which is exercisable and detachable only upon the occurrence of certain takeover events, entitles shareholders to buy units consisting of one one-hundredth of a newly issued share of Preferred Stock-Fourth Series, Junior Participating at a price of $235 per unit or, in certain circumstances, common stock. Under certain circumstances, Rights beneficially owned by an acquiring person become null and void. Sprint's Preferred Stock- Fourth Series is without par value. It is voting, cumulative and accrues dividends equal generally to the greater of $10 per share or one hundred times the aggregate per share amount of all common stock dividends. No shares of Preferred Stock-Fourth Series were issued or outstanding at December 31, 1993. The Rights may be redeemed by Sprint at a price of one cent per Right and will expire on September 8, 1999. During 1993, 1992 and 1991, Sprint declared and paid annual dividends on common stock of $1.00 per share, and Centel declared pre-merger common stock dividends of $0.15, $0.90 and $0.89 per share, respectively. The most restrictive covenant applicable to dividends on common stock results from the $1.1 billion revolving credit agreement. Among other restrictions, this agreement requires Sprint to maintain specified levels of consolidated net worth, as defined. As a result of this requirement, $1.45 billion of Sprint's $2.18 billion consolidated retained earnings were effectively restricted from the payment of dividends as of December 31, 1993. The indentures and financing agreements of certain of Sprint's subsidiaries contain various provisions restricting the payment of cash dividends on subsidiary common stock held by Sprint. In connection with these restrictions, $749 million of the related subsidiaries' $1.79 billion total retained earnings is restricted as of December 31, 1993. The flow of cash in the form of advances from the subsidiaries to Sprint is generally not restricted. 8. Commitments and Contingencies Litigation, Claims and Assessments During 1993, an agreement for settlement was reached related to a class action complaint filed in January 1992 against Sprint and certain of its officers and directors, amending a complaint originally filed in 1990. The plaintiffs in the class action alleged violations of various federal securities laws and related state laws and, among other relief, sought unspecified compensatory damages. The settlement, which is subject to approval by the court, totaled $29 million, of which approximately 60 percent will be recovered from Sprint's insurance carriers. The net settlement did not have a significant effect on Sprint's 1993 results of operations. Following announcement of Sprint's merger with Centel, class action suits were filed against Centel and certain of its officers and directors in federal and state courts. The state suits have been dismissed, while the federal suits have been consolidated into a single action and seek damages for alleged violations of securities laws. These and various other suits arising in the ordinary course of business are pending against Sprint. Management cannot predict the ultimate outcome of these actions but believes they will not result in a material effect on Sprint's consolidated financial statements. Accounts Receivable Sold with Recourse Under an agreement available through January 1995, Sprint may sell on a continuous basis, with recourse, up to $600 million of undivided interests in a designated pool of its accounts receivable. Subsequent collections of receivables sold to investors are typically reinvested in the pool. On a quarterly basis, subject to the approval of the investors, Sprint may extend the agreement for an additional ninety days. During 1992, proceeds of $300 million were received under the arrangement. Receivables sold that remained uncollected as of December 31, 1993 and 1992 aggregated $600 million. Operating Leases Minimum rental commitments as of December 31, 1993 for all non- cancelable operating leases, consisting principally of leases for data processing equipment and real estate, are as follows (in millions): Amount 1994 $ 304.1 1995 251.4 1996 171.1 1997 100.6 1998 83.8 Thereafter 243.6 Gross rental expense aggregated $387 million, $385 million and $397 million in 1993, 1992 and 1991, respectively. The amount of rental commitments applicable to subleases, contingent rentals and executory costs is not significant. 9. Additional Financial Information Segment Information See "Business Segment Information." Realignment and Restructuring Charge During 1993, Sprint initiated a realignment and restructuring of its long distance communications services division, including the elimination of approximately 1,000 positions and the closure of two facilities. These actions are expected to improve market focus, lower costs and streamline operations within the division, and resulted in a nonrecurring charge of $34 million, which reduced income from continuing operations by $21 million ($0.06 per share). Divestiture of Telephone and Cellular Properties During 1992, the sale of Centel's local telephone operations in Ohio was completed, pursuant to a definitive agreement reached in November 1991. Proceeds from the sale aggregated $129 million, including $114 million of cash and $15 million of assumed debt; a gain of $44 million ($0.13 per share), net of related income taxes, was realized on the sale. During 1991, the sales of Centel's local telephone operations in Minnesota and Iowa were completed, pursuant to a definitive agreement reached in November 1990. Proceeds from the sales included $116 million in cash, 2,885,000 shares of Rochester Telephone Corporation common stock with a value of $84 million and ownership rights in various cellular franchises with a value of $28 million. Gains of $64 million ($0.19 per share), net of related income taxes, were realized on the sales. Also during 1991, 50 percent of Centel's interest in a cellular limited partnership was divested. Cash proceeds of $36 million were received, and a gain of $14 million ($0.04 per share), net of related income taxes, was realized on this divestiture. Discontinued Operations During 1991, pursuant to a definitive agreement reached in December 1990, the sale of Centel's electric operations was completed for $320 million in cash and $26 million of assumed liabilities. A gain of $37 million, net of related income taxes, was realized on the sale. Revenues related to discontinued operations were $178 million in 1991. Financial Instruments The carrying amounts and estimated fair values of Sprint's long-term debt, as of December 31, are as follows (in millions): 1993 1992 Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value Long-term debt Corporate $ 2,109.2 $ 2,377.2 $ 1,820.7 $ 1,957.3 Long distance communications services 423.4 447.8 611.3 656.7 Local communications services 2,128.2 2,342.5 1,970.3 2,032.3 Other 433.6 534.6 678.1 705.4 The fair values of Sprint's long-term debt are estimated based on quoted market prices for publicly-traded issues, and based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved for all other issues. The carrying values of Sprint's other financial instruments (principally cash equivalents, temporary investments, short-term borrowings, interest rate swap/cap agreements and foreign currency contracts) approximate fair value as of December 31, 1993 and 1992. Supplemental Cash Flows Information 1993 1992 1991 Cash paid for (in millions) Interest $ 453.6 $ 507.5 $ 568.7 Income taxes $ 292.4 $ 269.0 $ 244.8 During 1993, 1992 and 1991, Sprint contributed previously unissued shares of its common stock with market values of $39 million, $28 million and $25 million, respectively, to the employee savings plans. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,976.9 $ 367.0 $ 153.0 (101.5)<1> $ 4,089.4 Data communications equipment 301.9 54.5 11.4 (64.8)<2> 280.2 Administrative assets 864.5 81.1 30.8 (31.2)<2> 883.6 Construction-in- progress 212.6 26.8 0.1 239.5 Subtotal 5,355.9 529.4 195.2 (197.4) 5,492.7 LOCAL COMMUNICATIONS SERVICES Land and buildings 636.5 29.7 6.2 660.0 Other general support assets 624.7 75.1 58.2 (0.7) 640.9 Cable and wire facility assets 5,150.8 324.9 71.5 5,404.2 Central office assets 3,855.7 387.8 163.6 3.3 4,083.2 Information origination/ termination assets 333.6 51.1 49.1 (0.2) 335.4 Telephone plant under construction 130.9 (23.3) (4.9) 102.7 Subtotal 10,732.2 845.3 348.6 (2.5) 11,226.4 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 409.9 164.9 3.3 (1.9) 569.6 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 405.2 55.1 24.8 (1.8) 433.7 $ 16,903.2 $ 1,594.7 $ 571.9 $ (203.6) $ 17,722.4 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.7 percent in 1993. <1>Adjustment primarily represents reductions to plant due to a change in the method of accounting for certain costs related to connecting new customers to the network. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. <2>Adjustments primarily represent the contribution of plant to a joint venture. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,899.1 $ 356.8 $ 230.2 $ (48.8)<1><2> $ 3,976.9 Data communications equipment 243.9 51.2 3.7 10.5 <2> 301.9 Administrative assets 932.0 76.6 76.5 (67.6)<2> 864.5 Construction-in -progress 227.7 (16.5) 1.4 212.6 Subtotal 5,302.7 468.1 310.4 (104.5) 5,355.9 LOCAL COMMUNICATIONS SERVICES Land and buildings 598.7 53.5 15.3 (0.4) 636.5 Other general support assets 593.8 81.6 51.5 0.8 624.7 Cable and wire facility assets 4,959.2 292.9 101.2 (0.1) 5,150.8 Central office assets 3,688.3 377.2 210.4 0.6 3,855.7 Information origination/ termination assets 527.4 42.4 237.0 0.8 333.6 Telephone plant under construction 140.2 (8.2) (1.1) 130.9 Subtotal 10,507.6 839.4 615.4<3> 0.6 10,732.2 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 298.4 123.8 8.2 (4.1) 409.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 398.8 34.9 29.3 0.8 405.2 $ 16,507.5 $ 1,466.2 $ 963.3 $ (107.2) $ 16,903.2 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.6 percent in 1992. <1>Adjustment represents an adjustment pursuant to Accounting Principles Board Opinion No. 16 related to the acquisition of the remaining 19.9% of the Limited Partnership, partially offset by reclassifications of plant among categories. <2>Adjustments represent the reclassification of plant among categories. <3>Retirements include approximately $95 million related to the divestiture of Centel's local telephone operations in Ohio. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,619.1 $ 451.6 $ 137.5 $(34.1)<1> $ 3,899.1 Data communications equipment 178.4 54.0 3.3 14.8 <2> 243.9 Administrative assets 835.1 136.8 39.2 (0.7) 932.0 Construction-in -progress 289.9 (62.2) 227.7 Subtotal 4,922.5 580.2 180.0 (20.0) 5,302.7 LOCAL COMMUNICATIONS SERVICES Land and buildings 585.9 27.0 15.0 0.8 598.7 Other general support assets 564.8 75.7 49.4 2.7 593.8 Cable and wire facility assets 4,801.0 308.1 149.8 (0.1) 4,959.2 Central office assets 3,580.2 348.3 238.5 (1.7) 3,688.3 Information origination/ termination assets 708.7 33.1 215.0 0.6 527.4 Telephone plant under construction 131.4 10.2 0.1 (1.3) 140.2 Subtotal 10,372.0 802.4 667.8<3> 1.0 10,507.6 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 222.5 91.8 14.5 (1.4) 298.4 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 363.9 48.8 13.8 (0.1) 398.8 $ 15,880.9 $ 1,523.2 $ 876.1 $ (20.5) $ 16,507.5 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.3 percent in 1991. <1>Adjustment primarily represents the reclassification of plant between categories and to inventories. <2>Adjustment represents the reclassification of plant between categories. <3>Retirements include approximately $213 million related to the divestiture of Centel's local telephone operations in Minnesota and Iowa. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1993 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $1,258.4 $357.4 $105.4 $(62.6)<3> $1,447.8 Data communications equipment 169.5 37.7 9.2 (18.4)<4> 179.6 Administrative assets 507.2 122.7 30.7 (13.3)<4> 585.9 Subtotal 1,935.1 517.8 145.3 (94.3) 2,213.3 LOCAL COMMUNICATIONS SERVICES Buildings 180.1 22.0 6.2 (2.5) 193.4 Other general support assets 318.0 67.5 58.0 4.6 332.1 Cable and wire facility assets 2,172.8 301.1 71.5 (12.2) 2,390.2 Central office assets 1,572.9 307.6 165.1 6.5 1,721.9 Information origination/ termination assets 251.0 28.8 49.1 5.2 235.9 Subtotal 4,494.8 727.0 349.9 1.6 4,873.5 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 85.9 55.5 2.0 (1.5) 137.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 167.5 33.3 21.1 3.2 182.9 $6,683.3 $1,333.6<1> $518.3<2> $(91.0) $7,407.6 <1> Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,333.6 Amortization of intangibles 25.1 Depreciation and amortization included in consolidated statement of income $ 1,358.7 <2> Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 518.3 Net book value of long distance and cellular/wireless division retirements and other 53.6 Total Schedule V retirements $ 571.9 <3>Adjustment primarily represents reduction to accumulated depreciation due to a change in the method of accounting for certain costs related to connecting new customers to the network. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. <4>Adjustments primarily represent the contribution of plant to a joint venture. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1992 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $1,062.9 $385.6 $190.6 $0.5<3> $1,258.4 Data communications equipment 125.5 39.5 3.1 7.6<3> 169.5 Administrative assets 453.3 136.9 74.9 (8.1)<3> 507.2 Subtotal 1,641.7 562.0 268.6 1,935.1 LOCAL COMMUNICATIONS SERVICES Buildings 171.1 19.9 10.4 (0.5) 180.1 Other general support assets 300.9 61.8 49.3 4.6 318.0 Cable and wire facility assets 1,973.8 289.4 78.6 (11.8) 2,172.8 Central office assets 1,429.5 319.7 182.9 6.6 1,572.9 Information origination/ termination assets 458.0 26.5 236.7 3.2 251.0 Subtotal 4,333.3 717.3 557.9 2.1 4,494.8 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 60.6 32.8 2.9 (4.6) 85.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 161.4 30.4 24.3 167.5 $6,197.0 $1,342.5<1> $853.7<2> $(2.5) $6,683.3 <1>Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,342.5 Amortization of intangibles 49.0 Depreciation and amortization included in consolidated statement of income $ 1,391.5 <2>Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 853.7 Divestiture of local telephone operations 57.3 Net book value of long distance and cellular/wireless divisions retirements and other 52.3 Total Schedule V retirements $ 963.3 <3>Adjustments primarily represent reclassifications of plant among categories. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1991 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $810.9 $370.8 $118.8 $1,062.9 Data communications equipment 63.4 24.1 1.1 $39.1 125.5 Administrative assets 363.6 143.5 22.6 (31.2)<3> 453.3 Subtotal 1,237.9 538.4 142.5 7.9 1,641.7 LOCAL COMMUNICATIONS SERVICES Buildings 162.0 18.9 8.5 (1.3) 171.1 Other general support assets 270.5 67.5 42.1 5.0 300.9 Cable and wire facility assets 1,802.5 271.4 89.2 (10.9) 1,973.8 Central office assets 1,295.9 320.0 192.1 5.7 1,429.5 Information origination/ termination assets 631.1 36.2 213.2 3.9 458.0 Subtotal 4,162.0 714.0 545.1 2.4 4,333.3 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 42.0 24.7 4.8 (1.3) 60.6 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 143.8 27.9 12.1 1.8 161.4 $5,585.7 $1,305.0<1> $704.5<2> $10.8 $6,197.0 <1>Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,305.0 Amortization of intangibles 64.5 Depreciation and amortization included in consolidated statement of income $ 1,369.5 <2>Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 704.5 Divestiture of local telephone operations 122.7 Net book value of long distance and cellular/wireless divisions retirements and other 48.9 Total Schedule V retirements $ 876.1 <3>Adjustments primarily represent reclassifications of plant between categories. SPRINT CORPORATION SCHEDULE VIII -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Charged Balance beginning to to other Other end of of year income accounts deductions year Allowance for doubtful accounts $118.0 $271.5 $2.6 $(270.2)<1> $121.9 Valuation allowance - deferred income tax assets $30.2 $0.7 $(6.4) $24.5 Allowance for doubtful accounts $144.8 $267.6 $2.4 $(296.8)<1> $118.0 Valuation allowance - deferred income tax assets $35.4<2> $ (5.2) $30.2 Allowance for doubtful accounts $212.6 $371.2 $2.9 $(441.9)<1> $144.8 <1> Accounts written off, net of recoveries. <2> Valuation allowance established upon adoption of SFAS No. 109, "Accounting for Income Taxes." See Notes 1 and 4 of "Notes to Consolidated Financial Statements" for additional information. SPRINT CORPORATION SCHEDULE IX -- CONSOLIDATED SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 <1> 1992 1991 <1> Bank Commercial Bank Commercial Bank Commercial Notes Paper Notes Paper Notes Paper <2> <3> <2> <3> <2> <3> Balance at end of period $ 647.5 $108.3 $ 286.3 $76.0 $ 185.3 $30.0 Weighted average interest rate 3.61% 3.29% 3.92% 4.10% 5.25% 5.31% Average amount outstanding during the year $ 456.8 $80.3 $ 398.0 $37.5 $ 401.2 $52.5 Maximum amount outstanding during the year $ 722.0 $198.0 $ 486.4 $78.5 $ 749.0 $130.2 Weighted average interest rate during the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.70% 3.25% 4.17% 4.10% 6.73% 6.66% <1>As of December 31, 1993 and 1991, short-term borrowings were classified as long-term debt in the consolidated balance sheets due to Sprint's intent and demonstrated ability to refinance such borrowings on a long-term basis. <2>Bank notes are generally issued for terms ranging from overnight to 60 days. <3>Commercial paper is generally issued for periods ranging from overnight to 30 days. SPRINT CORPORATION SCHEDULE X -- CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Maintenance and repairs <1> $ 167.2 $ 174.1 $ 162.2 Taxes, other than payroll and income taxes: Property taxes $ 158.6 $ 148.2 $ 157.0 Gross receipts and other 77.9 76.8 60.7 $ 236.5 $ 225.0 $ 217.7 Advertising expense $ 317.2 $ 251.7 $ 192.6 <1>Amount represents maintenance and repairs for the long distance division, cellular and wireless division, and product distribution, directory publishing and other. For the local division, maintenance and repairs is the primary component of plant operations expense which totaled $1.21 billion, $1.17 billion and $1.16 billion in 1993, 1992 and 1991, respectively. QUARTERLY FINANCIAL DATA (Unaudited) First Quarter Second Quarter Third Quarter 1993 1992 1993 1992 1993 1992 (In Millions, Except Per Share Data) Net operating revenues $2,718.0 $2,501.0 $2,800.9 $2,568.2 $2,867.6 $2,631.2 Operating expenses Costs of services and products 1,381.9 1,272.5 1,408.9 1,307.2 1,435.1 1,350.8 Selling, general and administrative 641.8 594.5 675.9 625.0 690.8 609.7 Depreciation and amortization 337.2 334.3 338.0 352.4 338.5 356.8 Merger, integration and restructuring costs <1>,<2> 248.0 44.5 Total operating expenses 2,608.9 2,201.3 2,422.8 2,284.6 2,508.9 2,317.3 Operating income 109.1 299.7 378.1 283.6 358.7 313.9 Gain on divestiture of telephone properties <3> 81.1 Interest expense (117.9) (131.2) (113.0) (129.4) (114.2) (126.7) Other income (expense), net (0.7) (1.8) (8.1) 6.5 (11.4) 6.4 Income (loss) from continuing operations before income taxes (9.5) 166.7 257.0 241.8 233.1 193.6 Income tax provision <4> (1.8) (60.4) (91.9) (94.2) (96.4) (68.3) Income (loss) from continuing operations (11.3) 106.3 165.1 147.6 136.7 125.3 Discontinued operations, net (12.3) Extraordinary losses on early extinguishments of debt, net (5.2) (8.5) (14.5) (5.6) Cumulative effect of changes in accounting principles, net<5> (384.2) 22.7 Net income (loss) (413.0) 129.0 156.6 147.6 122.2 119.7 Preferred stock dividends (0.6) (1.0) (0.9) (0.9) (0.6) (0.9) Earnings (loss) applicable to common stock $(413.6) $128.0 $155.7 $146.7 $121.6 $118.8 Earnings (loss) per common share Continuing operations $(0.03) $0.31 $0.48 $0.44 $0.39 $0.37 Discontinued operations (0.04) Extraordinary item (0.02) (0.02) (0.04) (0.02) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $(1.21) $0.38 $0.46 $0.44 $0.35 $0.35 QUARTERLY Sprint Corporation FINANCIAL DATA (Unaudited) Fourth Quarter Total Year 1993 1992 1993 1992 Net operating revenues $2,981.3 $2,719.9 $11,367.8 $10,420.3 Operating expenses Costs of services and products 1,510.2 1,395.0 5,736.1 5,325.5 Selling, general and administrative 721.4 660.7 2,729.9 2,489.9 Depreciation and amortization 345.0 348.0 1,358.7 1,391.5 Merger, integration and restructuring costs <1>,<2> 292.5 Total operating expenses 2,576.6 2,403.7 10,117.2 9,206.9 Operating income 404.7 316.2 1,250.6 1,213.4 Gain on divestiture of telephone properties <3> 81.1 Interest expense (107.3) (123.8) (452.4) (511.1) Other income (expense), net (2.1) (16.1) (22.3) (5.0) Income (loss) from continuing operations before income taxes 295.3 176.3 775.9 778.4 Income tax provision <4> (105.2) (59.4) (295.3) (282.3) Income (loss) from continuing operations 190.1 116.9 480.6 496.1 Discontinued operations, net (12.3) Extraordinary losses on early extinguishments of debt, net (1.0) (10.4) (29.2) (16.0) Cumulative effect of changes in accounting principles, net <5> (384.2) 22.7 Net income (loss) 189.1 106.5 54.9 502.8 Preferred stock dividends (0.7) (0.7) (2.8) (3.5) Earnings (loss) applicable to common stock $188.4 $105.8 $52.1 $499.3 Earnings (loss) per common share Continuing operations $0.55 $0.34 $1.39 $1.46 Discontinued operations (0.04) Extraordinary item (0.03) (0.08) (0.05) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $0.55 $0.31 $0.15 $1.48 <1>During 1993, Sprint consummated its merger with Centel. The transaction costs associated with the merger and the expenses of integrating and restructuring the operations of the two companies resulted in nonrecurring charges in the first and third quarters of 1993. Such charges reduced net income by $165 million ($0.48 per share) and $7 million ($0.02 per share), respectively. See Note 2 of "Notes to Consolidated Financial Statements" for additional information. <2>During third quarter 1993, Sprint realigned and restructured its long distance communications services division, resulting in a nonrecurring charge which reduced net income by $21 million ($0.06 per share). See Note 9 of "Notes to Consolidated Financial Statements" for additional information. <3>During second quarter 1992, a gain of $44 million ($0.13 per share), net of related income taxes, was recognized related to the sale of certain of Centel's local telephone operations. See Note 9 of "Notes to Consolidated Financial Statements" for additional information. <4>During third quarter 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate to 35 percent from 34 percent. As a result, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate, resulting in a nonrecurring charge which reduced net income by $13 million ($0.04 per share). See Note 4 of "Notes to Consolidated Financial Statements" for additional information. <5>Effective January 1, 1993, Sprint changed its method of accounting for postretirement and postemployment benefits by adopting SFAS No. 106 and No. 112 and effected another accounting change. Effective January 1, 1992, Sprint changed its method of accounting for income taxes by adopting SFAS No. 109. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. EXHIBIT INDEX EXHIBIT NUMBER (3) Articles of Incorporation and Bylaws: (a) Articles of Incorporation, as amended (filed as Exhibit 4 to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (b) Bylaws, as amended (filed as Exhibit 3(b) to Sprint Corporation Annual Report on Form 10- K for the year ended December 31, 1991 and incorporated herein by reference). (4) Instruments defining the Rights of Sprint's Equity Security Holders: (a) The rights of Sprint's equity security holders are defined in the Fifth, Sixth, Seventh and Eighth Articles of Sprint's Articles of Incorporation. See Exhibit 3(a). (b) Rights Agreement dated as of August 8, 1989, between Sprint Corporation (formerly United Telecommunications, Inc.) and United Missouri Bank, N.A. (formerly United Missouri Bank of Kansas City, N.A.), as Rights Agent (filed as Exhibit 2(b) to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (c) Amendment and supplement dated June 4, 1992 to Rights Agreement dated as of August 8, 1989 (filed as Exhibit 2(c) to Amendment No. 1 on Form 8 dated June 8, 1992 to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (10) Material Agreements - Merger Agreement: (a) Agreement and Plan of Merger dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2 to Sprint Corporation Current Report on Form 8-K dated May 27, 1992 and incorporated herein by reference). (b) First Amendment dated as of February 19, 1993, to the Agreement and Plan of Merger, dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2b to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (10) Executive Compensation Plans and Arrangements: (c) 1978 Stock Option Plan, as amended (filed as Exhibit 19(a) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (d) 1981 Stock Option Plan, as amended (filed as Exhibit 19(b) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (e) 1985 Stock Option Plan, as amended (filed as Exhibit 19(c) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (f) 1990 Stock Option Plan, as amended. (g) 1990 Restricted Stock Plan, as amended (filed as Exhibit 99 to Sprint Corporation Registration Statement No. 33-50421 and incorporated herein by reference). (h) Long-Term Stock Incentive Program, as amended (filed as Exhibit 19(e) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (i) Restated Memorandum Agreements Respecting Supplemental Pension Benefits between Sprint Corporation (formerly United Telecommunications, Inc.) and two of its current and former executive officers (filed as Exhibit 10(i) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). (j) Executive Long-Term Incentive Plan. (k) Executive Management Incentive Plan. (l) Long-Term Incentive Compensation Plan (filed as Exhibit 10(j) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (m) Short-Term Incentive Compensation Plan (filed as Exhibit 10(k) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (n) Retirement Plan for Directors, as amended (filed as Exhibit 28d to Registration Statement No. 33-28237, and incorporated herein by reference). (o) Key Management Benefit Plan, as amended. (p) Executive Deferred Compensation Plan, as amended (filed as Exhibit 19(f) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (q) Director's Deferred Fee Plan, as amended (filed as Exhibit 19(g) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (r) Supplemental Executive Retirement Plan (filed as Exhibit 10(q) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (s) Form of Contingency Employment Agreements between Sprint Corporation and certain of its executive officers (filed as Exhibit 10(r) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (t) Form of Indemnification Agreements between Sprint Corporation (formerly United Telecommunications, Inc.) and its Directors and Officers (filed as Exhibit 10(s) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (u) Summary of Executive Benefits (filed as Exhibit 10(u) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (v) Amended and Restated Centel Management Incentive Plan. (w) Amended and Restated Centel Stock Option Plan. (x) Agreements Regarding Special Compensation and Post Employment Restrictive Covenants between Sprint Corporation and three of its executive officers. (y) Amended and Restated Centel Matched Deferred Salary Plan. (z) Amended and Restated Centel Directors Deferred Compensation Plan. (aa) Amended and Restated Centel Director Stock Option Plan. (11) Computation of Earnings Per Common Share. (12) Computation of Ratio of Earnings to Fixed Charges. (21) Subsidiaries of Registrant. (23a) Consent of Ernst & Young. (23b) Consent of Arthur Andersen & Co.	22,966	154,850
81362_1993.txt	81362_1993	1993	81362	ITEM 1. BUSINESS. -------- General Description - ------------------- Quaker develops, produces, and markets a broad range of formulated chemical specialty products for various heavy industrial, institutional, and manufacturing applications. Quaker's principal products include: (i) rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel); (ii) corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment); (iii) metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing); (iv) machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process); (v) forming compounds (used to facilitate the drawing and extrusion of metal products); (vi) paper production products (used as defoamers, release agents, softeners, debonders, and dispersants); (vii) hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment); (viii) products for the removal of hydrogen sulfide in various industrial applications. During 1993, Quaker developed programs to provide recycling and chemical management services. In 1994, Quaker entered into an agreement for the creation of a joint venture which is expected to enhance the Total Fluid Management (TFM) service capabilities of Quaker. An initial cash investment of approximately $3,000,000 has been made with additional investments expected based on the growth of the venture. Other specialty products and services are produced and marketed by Quaker's domestic subsidiaries. AC Products, Inc., Quaker Construction Products, Inc., QSC Products, Ltd., and Multi-Chemical Products, Inc. manufacture and/or sell sealants and coatings for aerospace, construction, and industrial use. Selby, Battersby & Co. manufactures and sells trowel-applied flooring systems which derive their specialty characteristics from the different resins used and the methods of their application. During the third quarter 1992, as part of a plan to exit from the petroleum production chemicals market, Quaker entered into an agreement to sell certain of its petroleum production chemical operations assets, the principal component of which is technology used in the removal of hydrogen sulfide and organic sulfides from liquid and gaseous streams, embodied in the SULFA-SCRUB(R) product series. This transaction was consummated in 1993. Quaker acquired in May 1993 a French producer of metalworking fluids at a price of approximately French Francs 53,000,000 (approximately US $10,700,000), to reinforce Quaker's existing metalworking operations in Europe. Substantially all of Quaker's sales worldwide are made directly through its own sales forces. Quaker salesmen visit the plants of customers regularly and through training and experience identify production needs which can be resolved or alleviated either by adapting Quaker's existing products or by new formulations developed in Quaker's laboratories. Salesmen may call upon Quaker's regional managers, product managers, and members of its laboratory staff for assistance in obtaining and setting up product tests and evaluating the results of such tests. In 1993, certain products were also sold in Canada, Korea, India, and Argentina by exclusive licensees under long-term royalty agreements. Generally, separate manufacturing facilities of a single customer are served by different salesmen. Competition - ----------- The chemical specialty industry is composed of a number of companies of similar size as well as companies larger and smaller than Quaker. Quaker cannot readily determine its precise position in the industry. Many competitors are in fewer and more specialized product classifications or provide different levels of technical services in terms of specific formulations for individual customers. Competition in the industry is based primarily on the ability to provide products which meet the needs of the customer and render technical services and laboratory assistance to customers and, to a lesser extent, on price. Major Customers - --------------- During 1993, Quaker's five largest customers (each composed of multiple subsidiaries or divisions with semi-autonomous purchasing authority) accounted for approximately 16% of its consolidated net sales with the largest of these customers accounting for approximately 4% of consolidated net sales. No one subsidiary or division of these five customers accounted for more than 3% of consolidated net sales. During the same period, approximately 46% of consolidated net sales were made to customers engaged in the manufacture of cold-rolled steel. Raw Materials - ------------- Quaker uses over 500 raw materials, including mineral oils, fats and fat derivatives, ethylene derivatives, solvents, surface active agents, chlorinated paraffinic compounds, and a wide variety of organic and inorganic compounds. In 1993, only one raw material accounted for as much as 11% of the total cost of Quaker's raw material purchases. Quaker has multiple sources of supply for most materials, and Management believes that the failure of any single supplier would not have a material adverse effect upon its business. Patents and Trademarks - ---------------------- Quaker has a limited number of patents and patent applications, including patents issued, applied for, or acquired in the United States and in various foreign countries, some of which may prove to be material to its business. Principal reliance is placed upon Quaker's proprietary formulae and the application of its skills and experience to meet customer needs. Quaker's products are identified by trademarks which are registered throughout its marketing area. Quaker makes little use of advertising but relies heavily upon its reputation in the markets which it serves. Research and Development -- Laboratories - ---------------------------------------- Quaker's research and development laboratories support its sales organization. Accordingly, the activities of Quaker's laboratory staff are directed primarily toward applied research and development since the nature of Quaker's business requires continuing modification and improvement of formulations to provide chemical specialties to satisfy customer requirements. Quaker maintains quality control laboratory facilities in each of its manufacturing locations. In addition, Quaker maintains in Conshohocken, Pennsylvania, laboratory facilities which are devoted primarily to applied research and development. Most of Quaker's affiliates also have research and development facilities. Although not as complete as the Conshohocken laboratories, these facilities are generally sufficient for the requirements of the customers being served. If problems are encountered which cannot be resolved by local research and development facilities, such problems are referred to the Conshohocken laboratory staff. Approximately 195 persons, of whom 98 have B.S. degrees and 44 have B.S. and advanced degrees, are employed in Quaker's laboratories. Number of Employees - ------------------- On December 31, 1993, Quaker had 1,006 full-time employees, of whom 369 were employed by the parent company, 548 were employed by its international subsidiaries and associates, and 89 were employed by all domestic subsidiaries. Product Classification - ---------------------- Incorporated by reference is the information concerning product classification by markets served appearing under the caption "Supplemental Financial Information" on page 27 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. International Activities - ------------------------ Incorporated by reference is the information concerning international activities appearing in Note 9 to Notes to Consolidated Financial Statements and under the caption "General" of the Operations section of Management's Discussion and Analysis of Financial Condition and Results of Operations which appear on pages 30 and 31, respectively, of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 2. ITEM 2. PROPERTIES. ---------- Quaker's principal facilities in the United States are located in Conshohocken, Pennsylvania and Detroit, Michigan. Quaker also owns a non-operating facility in Pomona, California. Quaker's international subsidiaries own facilities in Woodchester, England; Uithoorn, The Netherlands; Verona, Italy; Villeneuve, France; Santa Perpetua de Mogoda, Spain; and Seven Hills, N.S.W., Australia. Quaker Construction Products, Inc. has a manufacturing facility in Sapulpa, Oklahoma that also serves QSC Products, Ltd. and Selby, Battersby & Co. All of these facilities are owned mortgage free. Financing for the Corporate Technical Center in Conshohocken, Pennsylvania was arranged through the use of industrial revenue and development bonds with an outstanding balance at December 31, 1993 of $5,000,000. Quaker's aforementioned facilities consist of various manufacturing, administrative, warehouse, and laboratory buildings. Substantially all of the buildings are of fire-resistant construction and are equipped with sprinkler systems. All facilities are primarily of masonry and/or steel construction and are adequate and suitable for Quaker's present operations. The Company has a program to identify needed capital improvements which will be implemented as Management considers necessary or desirable. Most locations have various numbers of raw material storage tanks ranging from six to 63 having a capacity from 500 to 80,000 gallons each and processing or manufacturing vessels ranging in capacity from 50 to 12,000 gallons each. In order to facilitate compliance with applicable federal, state, and local statutes and regulations relating to occupational health and safety and protection of the environment, the Company has implemented a program of site assessment, currently directed primarily to facilities in the United States for the purpose of identifying capital expenditures or other actions that may be necessary to comply with such requirements. The program includes periodic inspections of each facility in the United States by Quaker and/or independent environmental experts, as well as ongoing inspections by on-site personnel. Such inspections are addressed to operational matters, record keeping, reporting requirements, and capital improvements. In 1993, capital expenditures directed solely or primarily to regulatory compliance amounted to approximately $1,000,000. Quaker's executive offices are located in a four-story building containing a total of approximately 47,000 square feet. A corporate technical center containing approximately 28,700 square feet houses the laboratory facility. Both of these facilities are adjacent to Quaker's manufacturing facility in Conshohocken. Multi-Chemical Products, Inc. has a ten-year lease on its facility in Fontana, California which expires in 2001. AC Products, Inc. has a ten-year lease on its facility in Placentia, California that expires in 1997. Quaker's Mexican associate (40% owned) owns a plant in Monterrey, Mexico. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. ----------------- The Company is a party to proceedings, cases, and requests for information from, and negotiations with, various claimants and federal and state agencies relating to various matters including environmental matters, none of which are expected to result in monetary sanctions in any amount or in awards that would have a material adverse effect on the Company's financial condition. Reference is made to Note 11 to Notes to Consolidated Financial Statements which appears on page 26 in the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this report, for information concerning pending asbestos-related cases against a subsidiary. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. --------------------------------------------------- No matters were submitted to a vote of security holders during the last quarter of the period covered by this Report. ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT. ------------------------------------ YEAR FIRST ELECTED AS AN EXECUTIVE NAME OFFICE (SINCE) AGE OFFICER ---- -------------- --- ------------ Peter A. Benoliel Chairman of the Board (1980) 62 1963 S. W. W. Lubsen President (1988) and Chief 50 1988 Executive Officer (1993) John E. Burrows, Jr. Vice President-North America 47 1990 (1992) Jose Luiz Bregolato Vice President-South America 48 1993 (1993) Ira R. Dolich Vice President-Quality and 58 1981 Training (1990) (Retired December 31, 1993) William G. Hamilton Corporate Treasurer (1985) 57 1985 (Retired December 31, 1993) Marcus C. J. Meijer Vice President-Europe (1990) 46 1990 Clifford E. Montgomery Vice President-Human Resources 46 1990 (1990) Karl H. Spaeth Vice President (1981) and 65 1972 Corporate Secretary (1972) Joseph F. Spanier Vice President (1990), 47 1985 Corporate Controller (1985), and Corporate Treasurer (1994) All of the Executive Officers with the exception of Mr. Bregolato, Mr. Meijer, Mr. Burrows, and Mr. Montgomery have served as an officer of the Registrant for more than the past five years. Prior to being elected Chief Executive Officer of the Registrant, Mr. Lubsen served as Managing Director of Quaker Chemical B.V., a position to which he was appointed in 1984, and President and Chief Operating Officer to which he was elected in 1988. Prior to his election as an officer of the Registrant, Mr. Bregolato served as Financial Consultant and Administrative Director of Fabrica Carioca de Catalisadores, S.A. to which he was appointed in 1985. Prior to his election as an officer of the Registrant, Mr. Meijer served as Managing Director of Quaker Chemical B.V. to which he was appointed in 1988. Prior to that, he served as President of a Brazilian subsidiary and subsequently as Commercial Director, Chemical Division of the Akzo N.V. group. Prior to his election as an officer of the Registrant, Mr. Burrows served as Division Manager, Marine Colloids Division of FMC Corporation, a position to which he was appointed in 1986. Prior to being elected Vice President-Human Resources, Mr. Montgomery served as Manager of Human Resources, General Electric's Worldwide Marketing and Product Management Organization, and, prior to that, he served as Director, Human Resources, GE Plastics Europe. Mr. Spanier was elected Treasurer effective January 1, 1994 on the retirement of Mr. Hamilton. There is no family relationship between any of the Registrant's Executive Officers. Each Officer is elected for a term of one year. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. ----------------------------------------- Incorporated by reference is the information appearing under the caption "Stock Market and Related Security Holder Matters" on page 28 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ----------------------- Incorporated by reference is the information appearing under the caption "Selected Financial Information" on page 29 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ------------------------------------------------- Incorporated by reference is the information appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 and 31 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ------------------------------------------- Incorporated by reference is the information appearing on pages 14 through 27 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. --------------------------------------------- None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. -------------------------------------------------- Incorporated by reference is the information beginning immediately following the caption "Election of Directors" to, but not including, the caption "Executive Compensation" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993 and the information appearing in Item 4(a) of this Report. Based on the Company's review of certain reports filed with the Securities and Exchange Commission pursuant to Section 16(a) of the Securities Exchange Act of 1934, as amended, and written representations of the Company's officers and directors, the Company believes that all of such reports were filed on a timely basis, except for one filing on Form 4 covering one transaction each for Mr. Benoliel and Mr. Delattre. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ---------------------- Incorporated by reference is the information beginning immediately following the caption "Executive Compensation" to, but not including, the caption "Compensation/Management Development Committee and Long-Term Performance Incentive Plan Committee Report on Executive Compensation" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ----------------------------------------------- Incorporated by reference is the information beginning immediately following the caption "Security Ownership of Certain Beneficial Owners and Management" to, but not including, the caption "Election of Directors" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ---------------------------------------------- No information is required to be provided in response to this Item 13. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. -------------------------------------------- (a) Exhibits and Financial Statement Schedules 1. FINANCIAL STATEMENTS The following is a list of the Financial State- ments which have been incorporated by reference from the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, as set forth in Item 8: Consolidated Statement of Operations Consolidated Statement of Cash Flows Consolidated Balance Sheet Notes to Consolidated Financial Statements Report of Independent Accountants 2. FINANCIAL STATEMENT SCHEDULES The following is a list of the Financial State- ment Schedules filed herewith, all of which should be read in conjunction with the financial statements listed in Item 14(a) 1, above: Report of Independent Accountants on Financial Statement Schedules Schedule V-Property, plant, and equipment Schedule VI-Accumulated depreciation of proper- ty, plant, and equipment Schedule VIII-Valuation and qualifying accounts Schedule IX-Short-term borrowings All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of 50% or less owned companies have been omitted because none of the companies meets the criteria requiring inclusion of such statements. 3. EXHIBITS (NUMBERED IN ACCORDANCE WITH ITEM 601 OF REGULATION S-K) 3(a)--Articles of Incorporation. Incorporated by reference to Exhibit 3(a) to Form 10-Q as filed by the Regis- trant for the Quarter ended March 31, 1987. 3(b)--By-Laws. Incorporated by reference to Exhibit 3(b) to Form 10-Q as filed by the Registrant for the Quarter ended March 31, 1987. 3(c)--Amendment to Section 3.13 of the By-Laws dated May 2, 1990 and Amendment to Sec- tion 8.1 of the By-Laws dated July 11, 1990. Incorporated by reference to Exhib- it 3(c) as filed by Registrant with Form 10-K for the year 1990. 4 --Shareholder Rights Plan. Incorporated by reference to Form 8-K as filed by the Registrant, February 20, 1990. 10(a)--Long-Term Performance Incentive Plan as approved May 5, 1993. 10(b)--Employment agreement by and between the Registrant and Peter A. Benoliel, as amended July 1, 1989. Incorporated by reference to Exhibit 10(b) as filed by Registrant with Form 10-K for the year 1989.* 10(c)--Employment agreement by and between the Registrant and S. W. W. Lubsen. Incor- porated by reference to Exhibit 10(c) as filed by Registrant with Form 10-K for the year 1989.* 10(d)--Restricted Stock and Cash Bonus Plan and Agreement by and between the Registrant and S. W. W. Lubsen. Incorporated by reference to Exhibit 10(d) as filed by Registrant with Form 10-K for the year 1989.* 10(e)--Employment agreement by and between Reg- istrant and John E. Burrows, Jr. Incor- porated by reference to Exhibit 10(h) as filed by Registrant with Form 10-K for the year 1990.* 10(f)--Employment agreement by and between Registrant and Clifford E. Montgomery. Incorporated by reference to Exhibit 10(i) as filed by Registrant with Form 10-K for the year 1990.* 10(g)--Employment agreement by and between Registrant and Joseph F. Spanier. Incor- porated by reference to Exhibit 10(g) as filed by Registrant with Form 10-K for the year 1992.* 10(h)--Documents constituting employment contract by and between Quaker Chemical Europe B.V. and M. C. J. Meijer.* 10(i)--Documents constituting retirement agreement by and between Registrant and Ira R. Dolich.* 13 --Portions of the 1993 Annual Report to Shareholders incorporated by reference. 21 --Subsidiaries and Affiliates of the Registrant. 23 --Consent of Independent Accountants. * A management contract or compensatory plan or arrange- ment required to be filed as an exhibit to this report. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Registrant during the last quarter of the period covered by this Report. (c) The exhibits required by Item 601 of Regulation S-K filed as part of this Report or incorporated herein by refer- ence are listed in subparagraph (a)(3) of this Item 14. (d) The financial statement schedules filed as part of this Report are listed in subparagraph (a)(2) of this Item 14. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 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. QUAKER CHEMICAL CORPORATION --------------------------- Registrant Date: March 30, 1994 By: S. W. W. LUBSEN -------------------------------- S. W. W. Lubsen President and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE CAPACITY DATE --------- -------- ---- PETER A. BENOLIEL - ------------------------------ Director March 30, 1994 Peter A. Benoliel, Chairman of the Board JOSEPH F. SPANIER - ------------------------------ Principal Financial March 30, 1994 Joseph F. Spanier, Vice and Accounting Officer President, Corporate Controller, and Corporate Treasurer SIGISMUNDUS W. W. LUBSEN - ------------------------------ Principal Executive March 30, 1994 Sigismundus W. W. Lubsen Officer and Director President and Chief Executive Officer - ------------------------------ Director Joseph B. Anderson, Jr. PATRICIA C. BARRON - ------------------------------ Director March 30, 1994 Patricia C. Barron WILLIAM L. BATCHELOR - ------------------------------ Director March 30, 1994 William L. Batchelor - ------------------------------ Director Lennox K. Black EDWIN J. DELATTRE - ------------------------------ Director March 30, 1994 Edwin J. Delattre FRANCIS J. DUNLEAVY - ------------------------------ Director March 30, 1994 Francis J. Dunleavy ROBERT P. HAUPTFUHRER - ------------------------------ Director March 30, 1994 Robert P. Hauptfuhrer FREDERICK HELDRING - ------------------------------ Director March 30, 1994 Frederick Heldring RONALD J. NAPLES - ------------------------------ Director March 30, 1994 Ronald J. Naples ALEX SATINSKY - ------------------------------ Director March 30, 1994 Alex Satinsky - ------------------------------ Director D. Robert Yarnall, Jr. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Board of Directors Quaker Chemical Corporation Our audits of the consolidated financial statements referred to in our report dated February 18, 1994 appearing on page 26 of the 1993 Annual Report to Shareholders of Quaker Chemical Corporation (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an examination of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 February 18, 1994 QUAKER CHEMICAL CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT ADDITIONS RETIREMENTS OTHER BALANCE AT BEGINNING AT OR CHANGES, ADD END OF CLASSIFICATION OF PERIOD COST SALES (DEDUCT)(1) PERIOD - --------------- ---------- --------- ----------- ------------ ---------- YEAR ENDED DECEMBER 31, 1993 Land........... $ 6,042,000 $ 144,000 $ (61,000) $ 315,000 $ 6,440,000 Buildings and improvements. 32,873,000 2,234,000 (1,261,000) 1,744,000 35,590,000 Machinery and equipment.... 57,306,000 6,174,000 (1,295,000) 881,000 63,066,000 Construction in progress.. 1,477,000 408,000 95,000 1,980,000 ----------- ----------- ----------- ----------- ------------ $97,698,000 $ 8,960,000 $(2,617,000) $ 3,035,000 $107,076,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1992 Land........... $ 3,169,000 $ 488,000 $ 2,385,000 $ 6,042,000 Buildings and improvements. 31,284,000 355,000 $ (6,000) 1,240,000 32,873,000 Machinery and equipment.... 52,474,000 6,257,000 (3,506,000) 2,081,000 57,306,000 Construction in progress.. 2,077,000 126,000 (726,000) 1,477,000 ----------- ----------- ----------- ----------- ------------ $89,004,000 $ 7,226,000 $(3,512,000) $ 4,980,000 $ 97,698,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1991 Land........... $ 3,152,000 $ (43,000) $ 60,000 $ 3,169,000 Buildings and improvements. 29,414,000 $ 332,000 (659,000) 2,197,000 31,284,000 Machinery and equipment.... 48,385,000 2,567,000 (2,048,000) 3,570,000 52,474,000 Construction in progress.. 2,746,000 5,521,000 (6,190,000) 2,077,000 ----------- ----------- ----------- ----------- ------------ $83,697,000 $ 8,420,000 $(2,750,000) $ (363,000) $ 89,004,000 =========== =========== =========== =========== ============ - --------------- (1) Represents primarily companies acquired and fluctuations resulting from the translation of foreign currencies in 1993 and 1992, and fluctuations resulting from the translation of foreign currencies in 1991. QUAKER CHEMICAL CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT ADDITIONS RETIREMENTS OTHER BALANCE AT BEGINNING AT OR CHANGES, ADD END OF CLASSIFICATION OF PERIOD COST SALES (DEDUCT)(1) PERIOD - --------------- ---------- --------- ----------- ------------ ---------- YEAR ENDED DECEMBER 31, 1993 Buildings and improvements. $12,144,000 $ 1,203,000 $ (560,000) $ (296,000) $ 12,491,000 Machinery and equipment.... 33,375,000 5,342,000 (578,000) (105,000) 38,034,000 ----------- ----------- ----------- ----------- ------------ $45,519,000 $ 6,545,000 $(1,138,000) $ (401,000) $ 50,525,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1992 Buildings and improvements. $11,105,000 $ 1,183,000 $ (6,000) $ (138,000) $ 12,144,000 Machinery and equipment.... 29,238,000 5,244,000 (1,864,000) 757,000 33,375,000 ----------- ----------- ----------- ----------- ------------ $40,343,000 $ 6,427,000 $(1,870,000) $ 619,000 $ 45,519,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1991 Buildings and improvements. $10,552,000 $ 1,012,000 $ (446,000) $ (13,000) $ 11,105,000 Machinery and equipment.... 26,829,000 4,176,000 (1,675,000) (92,000) 29,238,000 ----------- ----------- ----------- ----------- ------------ $37,381,000 $ 5,188,000 $(2,121,000) $ (105,000) $ 40,343,000 =========== =========== =========== =========== ============ - --------------- (1) Represents primarily companies acquired and fluctuations resulting from the translation of foreign currencies in 1993 and 1992, and fluctuations resulting from the translation of foreign currencies in 1991. QUAKER CHEMICAL CORPORATION AND SUBSIDIARIES -------------------------------------------- SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR DOUBTFUL ACCOUNTS ------------------------------- ADDITIONS ---------------------- CHARGED OR BALANCE AT CHARGED TO (CREDITED) BALANCE AT FOR THE YEAR BEGINNING TO TO OTHER END OF ENDED OF PERIOD INCOME ACCOUNTS DEDUCTIONS PERIOD - ------------ ---------- ---------- ---------- ---------- ---------- 1993 $ 834,000 $693,000 ($68,000)(1) $215,000 $1,244,000 1992 837,000 772,000 84,000 (2) 859,000 834,000 1991 1,101,000 358,000 (20,000)(1) 602,000 837,000 - ------------ (1) Represents primarily fluctuations resulting from the translation of foreign currencies. (2) Represents primarily additions due to companies acquired and fluctuations resulting from the translation of foreign currencies. QUAKER CHEMICAL CORPORATION AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS(1) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 WEIGHTED MAXIMUM AVERAGE AVERAGE CATEGORY OF BALANCE WEIGHTED AMOUNT OUT- AMOUNT OUT- INTEREST AGGREGAGE AT AVERAGE STANDING STANDING RATE SHORT-TERM END OF INTEREST DURING THE DURING THE DURING THE BORROWINGS PERIOD RATE PERIOD(2) PERIOD(2) PERIOD(3) - ---------- ------- -------- ----------- ----------- ---------- Bank loans: Parent and subsidiary companies.. $ 1,168,000 10.0% $ 3,168,000 $ 619,000 6.1% Bank loans: Parent and subsidiary companies.. 971,000 6.6% 21,264,000 10,042,000 6.0% Bank loans: Parent and subsidiary companies.. 14,500,000 7.0% 22,398,000 17,607,000 7.8% - ---------- (1) Short-term borrowings are principally short-term notes payable to banks and, in the case of certain subsidiary companies, various revolving lines of credit available to the subsidiary. Generally they may be renewed or extended beyond the maturity period as specified in the agreement. (2) Based on amounts outstanding at the end of each monthly accounting period. (3) The weighted average interest rate was calculated by dividing the interest expense for the period by the average amount outstanding during the period. EXHIBIT INDEX EXHIBIT NO. DESCRIPTION ----------- ----------- 10(a) Long-Term Performance Incentive Plan 10(h) Documents constituting employment contract by and between Quaker Chemical Europe B.V. and M. C. J. Meijer. 10(i) Documents constituting retirement agreement by and between Registrant and Ira R. Dolich. 13 Portions of the 1993 Annual Report to Shareholders Incorporated by Reference 21 Subsidiaries and Affiliates of the Registrant 23 Consent of Independent Accountants	4,516	32,295
7286_1993.txt	7286_1993	1993	7286	ITEM 1. BUSINESS THE COMPANY The Company was incorporated in 1920 under the laws of Arizona and is engaged principally in serving electricity in the State of Arizona. The principal executive offices of the Company are located at 400 North Fifth Street, Phoenix, Arizona 85004 (telephone 602-250-1000). The Company currently employs approximately 7,050 persons, which includes employees assigned to joint projects where the Company is project manager. The Company serves approximately 654,000 customers in an area that includes all or part of 11 of Arizona's 15 counties. During 1993, no single purchaser or user of energy accounted for more than 3% of total electric revenues. Pinnacle West owns all of the outstanding shares of the Company's common stock. Pursuant to a Pledge Agreement, dated as of January 31, 1990, between Pinnacle West and Citibank, N.A., as Collateral Agent (the "Pledge Agreement"), and as part of a restructuring of substantially all of its outstanding indebtedness, Pinnacle West granted certain of its lenders a security interest in all of the Company's outstanding common stock. Until the Collateral Agent and Pinnacle West receive notice of the occurrence and continuation of an Event of Default (as defined in the Pledge Agreement), Pinnacle West is entitled to exercise or refrain from exercising any and all voting and other consensual rights pertaining to the common stock. As to matters other than the election of directors, Pinnacle West agreed not to exercise or refrain from exercising any such rights if, in the Collateral Agent's judgment, such action would have a material adverse effect on the value of the common stock. After notice of an Event of Default, the Collateral Agent would have the right to vote the common stock. INDUSTRY AND COMPANY ISSUES The utility industry continues to experience a number of challenges. Depending on the circumstances of a particular utility, these may include (i) competition in general from numerous sources; (ii) effects of the National Energy Policy Act of 1992 (the "Energy Act"); (iii) difficulties in meeting government imposed environmental requirements; (iv) the necessity to make substantial capital outlays for transmission and distribution facilities; (v) uncertainty regarding projected electrical demand growth; (vi) controversies over electromagnetic fields; (vii) controversies over the safety and use of nuclear power; (viii) issues related to spent fuel and low level waste (see "Generating Fuel" below); and (ix) increasing costs of wages and materials. The impact on the Company of other utility industry problems is discussed in this Item under "Environmental Matters." Also see "Water Supply" in this Item with respect to certain problems specific to the Company and other utilities. COMPETITION Certain territory adjacent to or within areas served by the Company is served by other investor-owned utilities (notably Tucson Electric Power Company serving electricity in the Tucson area, Southwest Gas Corporation serving gas throughout the state, and Citizens Utilities Company serving electricity and gas in various locations throughout the state) and a number of cooperatives, municipalities, electrical districts, and similar types of governmental organizations (principally SRP serving electricity in various areas in and around Phoenix). The Company expects increased competition in the future, mostly with respect to large customers, from entities offering alternative sources of energy. In recent years, changing laws and governmental regulations, interest in self-generation, competition from nonregulated energy suppliers, and aggressive marketing from the gas industry are providing some utility customers with alternative sources to satisfy their energy needs. This may be increased as a result of the Energy Act which, among other things, removes certain previously existing barriers to entry into electric generation. The Energy Act also permits certain other parties to compete for resale customers currently served by a particular utility and to use that utility's transmission facilities in order to do so. The requirements with respect to implementation of the Energy Act have not yet been completely determined, so the Company cannot currently predict its impact on the Company's business and operations. In order to remain competitive in this changing environment, the Company has determined that it must be a cost-effective supplier, provide excellent service, and be knowledgeable about its customers' businesses. The Company is concentrating on several areas which are key to the success of this strategy, including effectively managing its operating and maintenance expenses; reinforcing the importance of customer needs among Company employees; and working with customers to evaluate, recommend, and provide services which will optimize their efficiency. CAPITAL STRUCTURE The capital structure of the Company (which, for this purpose, includes short-term borrowings and current maturities of long-term debt) as of December 31, 1993 is tabulated below. Amount Percentage ---------- ---------- (Thousands of Dollars) Long-Term Debt Less Current Maturities: First mortgage bonds................................ $1,729,070 Other............................................... 395,584 ---------- Total long-term debt less current maturities...... 2,124,654 50.7% ---------- Non-Redeemable Preferred Stock........................ 193,561 4.6 ---------- Redeemable Preferred Stock............................ 197,610 4.7 ---------- Common Stock Equity: Common stock, $2.50 par value, 100,000,000 shares authorized; 71,264,947 shares outstanding......... 178,162 Premiums and expenses............................... 1,037,681 Retained earnings................................... 307,098 ---------- Total common stock equity......................... 1,522,941 36.4 ---------- Total capitalization............................ 4,038,766 Current Maturities of Long-Term Debt.................. 3,179 .1 Short-Term Borrowings................................. 148,000 3.5 ---------- -------- Total........................................... $4,189,945 100.0% ========== ======== See Notes 3, 4, and 5 of Notes to Financial Statements in Item 8. On March 1, 1994 the Company redeemed all of the outstanding shares of its $8.80 Cumulative Preferred Stock, Series K ($100 par value), in the amount of $14.21 million. On March 2, 1994, the Company issued $100 million of its First Mortgage Bonds, 65/8% Series due 2004 and applied the net proceeds to the repayment of short-term debt that had been incurred for the redemption of preferred stock and for general corporate purposes. So long as any of the Company's first mortgage bonds are outstanding, the Company is required for each calendar year to deposit with the trustee under its Mortgage cash in a formularized amount related to net additions to the Company's mortgaged utility plant; however, the Company may satisfy all or any part of this "replacement fund" requirement by utilizing redeemed or retired bonds, net property additions, or property retirements. For 1993, the replacement fund requirement amounted to approximately $122 million. Many, though not all, of the bonds issued by the Company under the Mortgage are redeemable at their par value plus accrued interest with cash deposited by the Company in the replacement fund, subject in many cases to a period of time after the original issuance of the bonds during which they may not be so redeemed and/or to other restrictions on any such redemption. The cash deposited with the trustee by the Company in partial satisfaction of its 1993 replacement fund requirements will be used to redeem $60.264 million in aggregate principal amount of the Company's First Mortgage Bonds, 103/4% Series due 2019, at their principal amount plus accrued interest, on April 4, 1994. RATES STATE. The ACC has regulatory authority over the Company in matters relating to retail electric rates and the issuance of securities. See "Rate Case Settlement" in Note 2 of Notes to Financial Statements in Item 8 for a discussion of the December 1991 settlement of the Company's most recent retail rate case before the ACC. FEDERAL. The Company's rates for wholesale power sales and transmission services are subject to regulation by the FERC. During 1993, approximately 8% of the Company's electric operating revenues resulted from such sales and charges. For most wholesale transactions regulated by the FERC, a fuel adjustment clause results in monthly adjustments for changes in the actual cost of fuel for generation and in the fuel component of purchased power expense. ARIZONA CORPORATION COMMISSION PETITION On May 1, 1990, the ACC approved the filing of a petition with the SEC requesting the SEC to revoke or modify the exemption of Pinnacle West under the Public Utility Holding Company Act of 1935 (the "Holding Company Act"). Pinnacle West and its subsidiaries, including the Company, are currently exempt from registration under the Holding Company Act. The SEC has the power to terminate Pinnacle West's exemption upon thirty days notice to Pinnacle West if it determines that a question exists as to whether the exemption may be detrimental to the public interest or the interests of investors or consumers. In the event of the exercise of such power by the SEC, if Pinnacle West were to file an application with the SEC during such thirty day period requesting an exemption order, Pinnacle West's exemption would remain in place until the SEC ruled on such application. If Pinnacle West ultimately were to have its exemption modified, conditioned, or revoked, the Company could be subject to SEC regulation in many aspects of its business, including those relating to securities issuances, diversification, and transactions among affiliates. In a series of responses to the ACC's petition and subsequent ACC letters to the SEC, Pinnacle West has asked the SEC to refuse to take the action requested by the ACC. The Company cannot predict what action, if any, the SEC may take with respect to the ACC petition. The Company does not believe that the revocation or modification of the Pinnacle West exemption under the Holding Company Act, if acted on by the SEC, would have a material adverse effect on the operations or financial position of the Company. CONSTRUCTION PROGRAM Although its plans are subject to change, the Company does not presently intend to construct any new major baseload generating units for at least the next ten years. Utility construction expenditures for the years 1994 through 1996 are therefore expected to be primarily for expanding transmission and distribution capabilities to meet customer growth, upgrading existing facilities, and environmental purposes. Construction expenditures, including expenditures for environmental control facilities, for the years 1994 through 1996 have been estimated as follows: (MILLIONS OF DOLLARS) BY YEAR BY MAJOR FACILITIES - ---------------------------- ---------------------------------------------- 1994 $279 Electric generation $271 1995 302 Electric transmission 92 1996 293 Electric distribution 390 ---- General facilities 121 $874 ---- ==== $874 ==== The amounts for 1994 through 1996 include expenditures for nuclear fuel but exclude capitalized interest costs and capitalized property taxes. The Company conducts a continuing review of its construction program. This program and the above estimates are subject to periodic revisions based upon changes in assumptions as to system reliability, system load growth, rates of inflation, the availability and timing of environmental and other regulatory approvals, the availability and costs of outside sources of capital, and changes in project construction schedules. During the years 1991 through 1993, the Company incurred approximately $641 million in construction expenditures and approximately $31 million in additional capitalized items. ENVIRONMENTAL MATTERS Pursuant to the Clean Air Act, the EPA has adopted regulations, applicable to certain federally-protected areas, that address visibility impairment that can be reasonably attributed to specific sources. In September 1991, the EPA issued a final rule that would limit sulfur dioxide emissions at NGS. Compliance with the emission limitation becomes applicable to NGS Units 1, 2, and 3 in 1997, 1998, and 1999, respectively. SRP, the NGS operating agent, has estimated a capital cost of $530 million, most of which will be incurred from 1995 through 1998, and annual operations and maintenance costs of approximately $10 million per unit, for NGS to meet these requirements. The Company will be required to fund 14% of these expenditures. The Clean Air Act Amendments of 1990 (the "Amendments") became effective on November 15, 1990. The Amendments address, among other things, "acid rain," visibility in certain specified areas, toxic air pollutants, and the nonattainment of national ambient air quality standards. With respect to "acid rain," the Amendments establish a system of sulfur dioxide emissions "allowances." Each existing utility unit is granted a certain number of "allowances." On March 5, 1993, the EPA promulgated rules listing allowance allocations applicable to Company-owned plants, which allocations will begin in the year 2000. Based on those allocations, the Company will have sufficient allowances to permit continued operation of its plants at current levels without installing additional equipment. In addition, the Amendments require the EPA to set nitrogen oxides emissions limitations which would require certain plants to install additional pollution control equipment. On March 22, 1994, the EPA issued rules for nitrogen oxide emissions limitations which will require the Company to install additional pollution control equipment at Four Corners. In the year 2000 Four Corners must comply with either these or more stringent requirements which might be promulgated by the EPA. The EPA has until 1997 to set more stringent requirements. However, if Four Corners accelerates to 1997 compliance with these March 22 requirements, it can delay until 2008 compliance with any more stringent requirements which the EPA may set. The Company has not yet determined how it will proceed; however, the Company currently estimates the capital cost of complying by 1997 with the specified requirements will be approximately $16 million. With respect to protection of visibility in certain specified areas, the Amendments require the EPA to complete a study by November 1995 concerning visibility impairment in those areas and identification of sources contributing to such impairment. Interim findings of this study have indicated that any beneficial effect on visibility as a result of the Amendments would be offset by expected population and industry growth. The EPA has established a "Grand Canyon Visibility Transport Commission" to complete a study by November 1995 on visibility impairment in the "Golden Circle of National Parks" in the Colorado Plateau. NGS, Cholla, and Four Corners are located near the "Golden Circle of National Parks." Based on the recommendations of the Commission, the EPA may require additional emissions controls at various sources causing visibility impairment in the "Golden Circle of National Parks" and may limit economic development in several western states. The Company cannot currently estimate the capital expenditures, if any, which may be required as a result of the EPA studies and the Commission's recommendations. With respect to hazardous air pollutants emitted by electric utility steam generating units, the Amendments require two studies. First, there will be a study to be completed by November 1994 of potential impacts of mercury emissions from such units and various other sources on public health and on the environment, including available control technologies. Second, the EPA will complete a general study by November 1995 concerning the necessity of regulating such units under the Amendments. Due to the lack of historical data, and because the Company cannot speculate as to the ultimate requirements by the EPA, the Company cannot currently estimate the capital expenditures, if any, which may be required as a result of these studies. Certain aspects of the Amendments may require related expenditures by the Company, such as permit fees, none of which the Company expects to have a material impact on its financial position. GENERATING FUEL Coal, nuclear, gas, and other contributions to total net generation of electricity by the Company in 1993, 1992, and 1991, and the average cost to the Company of those fuels (in dollars per MWh), were as follows: Other includes oil and hydro generation. The Company believes that Cholla has sufficient reserves of low sulfur coal committed to that plant for the next six years, the term of the existing coal contract, and sufficient reserves of low sulfur coal available for use to continue operating it for its useful life. The Company also believes that Four Corners and NGS have sufficient reserves of low sulfur coal available for use by those plants to continue operating them for at least thirty years. The current sulfur content of coal being used at Four Corners, NGS, and Cholla is 0.8%, 0.6%, and 0.4%, respectively. In 1993, average prices paid for coal supplied from reserves dedicated under the existing contracts were relatively stable, although applicable contract clauses permit escalations under certain conditions. In addition, major price adjustments can occur from time to time as a result of contract renegotiation. NGS and Four Corners are located on the Navajo Reservation and held under easements granted by the federal government as well as leases from the Navajo Tribe. See "Properties" in Item 2. ITEM 2. PROPERTIES The Company's present generating facilities have an accredited capacity aggregating 4,022,410 kw, comprised as follows: Capacity(kw) ------------ Coal: Units 1, 2, and 3 at Four Corners, aggregating........... 560,000 15% owned Units 4 and 5 at Four Corners, representing.... 222,000 Units 1, 2, and 3 at Cholla Plant, aggregating........... 590,000 14% owned Units 1, 2, and 3 at the Navajo Plant, representing........................................... 315,000 ----------- 1,687,000 =========== Gas or Oil: Two steam units at Ocotillo, two steam units at Saguaro, and one steam unit at Yucca, aggregating............... 468,400(1) Eleven combustion turbine units, aggregating............. 500,600 Three combined cycle units, aggregating.................. 253,500 ----------- 1,222,500 =========== Nuclear: 29.1% owned or leased Units 1, 2, and 3 at Palo Verde, representing........................................... 1,108,710 =========== Other........................................................ 4,200 =========== - ---------- (1) West Phoenix steam units (96,300 kw) are currently mothballed. -------------- The Company's peak one-hour demand on its electric system was recorded on August 2, 1993 at 3,802,300 kw, compared to the 1992 peak of 3,796,400 kw recorded on August 17. Taking into account additional capacity then available to it under purchase power contracts as well as its own generating capacity, the Company's capability of meeting system demand on August 2, 1993, computed in accordance with accepted industry practices, amounted to 4,505,000 kw, for an installed reserve margin of 16.7%. The power actually available to the Company from its resources fluctuates from time to time due in part to planned outages and technical problems. The available capacity from sources actually operable at the time of the 1993 peak amounted to 4,099,500 kw, for a margin of 13.4%. NGS and Four Corners are located on land held under easements from the federal government and also under leases from the Navajo Tribe. The risk with respect to enforcement of these easements and leases is not deemed by the Company to be material. The Company is dependent, however, in some measure upon the willingness and ability of the Navajo Tribe to honor its commitments. Certain of the Company's transmission lines and almost all of its contracted coal sources are also located on Indian reservations. See "Generating Fuel" in Item 1. Operation of each of the three Palo Verde units requires an operating license from the NRC. Full power operating licenses for Units 1, 2, and 3 were issued by the NRC in June 1985, April 1986, and November 1987, respectively. The full power operating licenses, each valid for a period of approximately 40 years, authorize the Company, as operating agent for Palo Verde, to operate the three Palo Verde units at full power. On August 18, 1986 and December 19, 1986, the Company entered into a total of three sale and leaseback transactions under which it sold and leased back approximately 42% of its 29.1% ownership interest in Palo Verde Unit 2. The leases under each of the sale and leaseback transactions have initial lease terms expiring on December 31, 2015. Each of the leases also allows the Company to extend the term of the lease and/or to repurchase the leased Unit 2 interest under certain circumstances at fair market value. The leases in the aggregate require annual payments of approximately $40 million through 1999, approximately $46 million in 2000, and approximately $49 million through 2015 (see Note 7 of Notes to Financial Statements in Item 8). See "Water Supply" in Item 1 with respect to matters having possible impact on the operation of certain of the Company's power plants, including Palo Verde. The Company's construction plans are susceptible to changes in forecasts of future demand on its electric system and in its ability to finance its construction program. Although its plans are subject to change, the Company does not presently intend to construct any new major baseload generating units for at least the next ten years. Important factors affecting the Company's ability to delay the construction of new major generating units are continuing efforts to upgrade and improve the reliability of existing generating stations, system load diversity with other utilities, and continuing efforts in customer demand-side conservation and load management programs. In addition to that available from its own generating capacity, the Company purchases electricity from other utilities under various arrangements. One of the most important of these is a long-term contract with SRP which may be canceled by SRP on three years' notice and which requires SRP to make available, and the Company to pay for, certain amounts of electricity that are based in large part on customer demand within certain areas now served by the Company pursuant to a related territorial agreement. The Company believes that the prices payable by it under the contract are fair to both parties. The generating capacity available to the Company pursuant to the contract was 302,000 kw until May 1993, at which time the capacity increased to 304,000 kw. In 1993, the Company received approximately 840,000 MWh of energy under the contract and paid approximately $40 million for capacity availability and energy received. In September 1990, the Company and PacifiCorp entered into certain agreements relating principally to sales and purchases of electric power and electric utility assets, and in July 1991, after regulatory approvals, the Company sold Cholla 4 to PacifiCorp for approximately $230 million. As part of the transaction, PacifiCorp agreed to make a firm system sale to the Company for thirty years during the Company's summer peak season in the amount of 175 megawatts for the first five years, increasing thereafter, at the Company's option, up to a maximum amount equal to the rated capacity of Cholla 4. After the first five years, all or part of the sale may be converted to a one-for- one seasonal capacity exchange. PacifiCorp has the right to purchase from the Company up to 125 average megawatts of energy per year for thirty years. PacifiCorp and the Company also entered into a 100 megawatt one-for-one seasonal capacity exchange to be effective upon the latter of January 1, 1996 or the completion of certain new transmission projects. In addition, PacifiCorp agreed to pay the Company (i) $20 million upon commercial operation of 150 megawatts of peaking capacity constructed by the Company and (ii) $19 million in connection with the construction of transmission lines and upgrades that will afford PacifiCorp 150 megawatts of northbound transmission rights. In addition, PacifiCorp secured additional firm transmission capacity of 30 megawatts over the Company's system. In 1993, the Company received 401,475 MWh of energy from PacifiCorp under these transactions and paid approximately $19 million for capacity availability and the energy received, and PacifiCorp paid approximately $2.7 million for 144,171 MWh. See "El Paso Electric Company Bankruptcy" in Note 10 of Notes to Financial Statements in Item 8 for a discussion of the filing by EPEC of a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code. EPEC has a joint ownership interest with the Company and others in Palo Verde and Four Corners Units 4 and 5. See Notes 4 and 7 of Notes to Financial Statements in Item 8 with respect to property of the Company not held in fee or held subject to any major encumbrance. GRAPHIC - ------- MAP OF THE STATE OF ARIZONA SHOWING THE COMPANY'S SERVICE AREA, THE LOCATION OF ITS MAJOR POWER PLANTS AND PRINCIPAL TRANSMISSION LINES, AND THE LOCATION OF TRANSMISSION LINES OPERATED BY THE COMPANY FOR OTHERS. SEE APPENDIX FOR DETAILED DESCRIPTION. ITEM 3. ITEM 3. LEGAL PROCEEDINGS PROPERTY TAXES On June 29, 1990, a new Arizona state tax law was enacted, effective as of December 31, 1989, which adversely impacted the Company's earnings in tax years 1990 through 1993 by an aggregate amount of approximately $82 million, before income taxes. On December 20, 1990, the Palo Verde participants, including the Company, filed a lawsuit in the Arizona Tax Court, a division of the Maricopa County Superior Court, against the Arizona Department of Revenue, the Treasurer of the State of Arizona, and various Arizona counties, claiming, among other things, that portions of the new tax law are unconstitutional. (Arizona Public Service Company, et al. v. Apache County, et al., No. TX 90-01686 (Consol.), Maricopa County Superior Court). In December 1992, the court granted summary judgment to the taxing authorities, holding that the law is constitutional. The Company has appealed this decision to the Arizona Court of Appeals. The Company cannot currently predict the ultimate outcome of this matter. See "Water Supply" and "Palo Verde Nuclear Generating Station" in Item 1 and "El Paso Electric Company Bankruptcy" in Note 10 of Notes to Financial Statements in Item 8 in regard to pending or threatened litigation and other disputes. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report, through the solicitation of proxies or otherwise. SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT The Company's executive officers are as follows: AGE AT NAME MARCH 1, 1994 POSITION(S) AT MARCH 1, 1994 - ---- ------------- ---------------------------- Richard Snell 63 Chairman of the Board of Directors (1) O. Mark De Michele 59 President and Chief Executive Officer(1) Jaron B. Norberg 56 Executive Vice President and Chief Financial Officer(1) William F. Conway 63 Executive Vice President, Nuclear Shirley A. Richard 46 Executive Vice President, Customer Service, Marketing and Corporate Relations William J. Post 43 Senior Vice President, Planning, Information and Financial Services Jan H. Bennett 46 Vice President, Customer Service Jack E. Davis 47 Vice President, Generation and Transmission Armando B. Flores 50 Vice President, Human Resources James M. Levine 44 Vice President, Nuclear Production Richard W. MacLean 47 Vice President, Environmental, Health and Safety E. C. Simpson 45 Vice President, Nuclear Support Jack A. Bailey 40 Assistant Vice President, Nuclear Engineering and Projects William J. Hemelt 40 Controller Nancy C. Loftin 40 Secretary and Corporate Counsel Nancy E. Newquist 42 Treasurer - ---------- (1) Member of the Board of Directors. ---------------------------------------- The executive officers of the Company are elected no less often than annually and may be removed by the Board of Directors at any time. The terms served by the named officers in their current positions and the principal occupations (in addition to those stated in the table and exclusive of directorships) of such officers for the past five years have been as follows: Mr. Snell was elected to his present position as of February 1990. He was also elected Chairman of the Board, President, and Chief Executive Officer of Pinnacle West at that time. Previously, he was Chairman of the Board (1989- 1992) and Chief Executive Officer (1989-1990) of Aztar Corporation and Chairman of the Board, President, and Chief Executive Officer of Ramada Inc. (1981-1989). Mr. De Michele was elected President in September 1982 and became Chief Executive Officer as of January 1988. Mr. Norberg was elected to his present position in July 1986. Mr. Conway was elected to his present position in May 1989. Prior to that time he was Senior Vice President -- Nuclear of Florida Power & Light Company (1988-1989). Ms. Richard was elected to her present position in January 1989. Mr. Post was elected to his present position in June 1993. Prior to that time he was Vice President, Finance & Rates (since April 1987). Mr. Bennett was elected to his present position in May 1991. Prior to that time he was Director, Customer Service (September 1990 to May 1991), and Manager, State Region -- Customer Service (January 1988 to September 1990). Mr. Davis was elected to his present position in June 1993. Prior to that time he was Director, Transmission Systems (January 1993-June 1993); Director, Fossil Generation (June 1992-December 1992); Director, System Development and Power Operations (May 1990-May 1992); and Manager, Power Contracts (March 1979-May 1990). Mr. Flores was elected to his present position in December 1991. Prior to that time, he was Director -- Human Resources (1990 to 1991) and Manager -- Employment (1989 to 1990) of GENCORP, Propulsion Division, Aerojet Group. He had previously held the position of Vice President -- Human Resources, AMFAC (1985 to 1988). Mr. Levine was elected to his present position in September 1989. Prior to that time he was Executive Director, Operations Support, System Energy Resources, Inc. (June 1989-September 1989) and Executive Director, Nuclear Operations (January 1988-June 1989) of Arkansas Nuclear One, Arkansas Power and Light Company. Mr. MacLean was elected to his present position in December 1991. Prior to that time he held the following positions at General Electric (General Electric's Corporate Environmental Programs): Manager, EHS Resource Development (January to December 1991); and Manager, Environmental Protection (February 1986 to January 1991). Mr. Simpson was elected to his present position in February 1990. Prior to that time he was Director, Nuclear Operations Engineering and Projects (1988- 1990) at Florida Power Corporation. Mr. Bailey was elected to his present position in July 1993. Prior to that time he was Director, Nuclear Engineering (1991-1993) and Assistant Plant Manager (1989 to 1991) at Palo Verde. Mr. Bailey was Superintendent of Operations of Virginia Electric and Power Company from 1986 to 1989. Mr. Hemelt was elected to his present position in June 1993. Prior to that time he was Treasurer and Assistant Secretary. Ms. Loftin was elected Secretary in April 1987 and became Corporate Counsel in February 1989. Ms. Newquist was elected to her present position in June 1993. Prior to that time she was Assistant Treasurer (since October 1992). She is also Treasurer (since June 1990) and Vice President (since February 1994) of Pinnacle West. From May 1987 to June 1990, Ms. Newquist served as Pinnacle West's Director of Finance. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Company's common stock is wholly-owned by Pinnacle West and is not listed for trading on any stock exchange. As a result, there is no established public trading market for the Company's common stock. See "The Company" in Part I, Item 1 for information regarding the Pledge Agreement to which the common stock is subject. The chart below sets forth the dividends declared on the Company's common stock for each of the four quarters for 1993 and 1992. COMMON STOCK DIVIDENDS (THOUSANDS OF DOLLARS) ------------------------------------------------- Quarter 1993 1992 ------------------------------------------------- 1st Quarter $42,500 $42,500 2nd Quarter 42,500 42,500 3rd Quarter 42,500 42,500 4th Quarter 42,500 42,500 ------------------------------------------------- After payment or setting aside for payment of cumulative dividends and mandatory sinking fund requirements, where applicable, on all outstanding issues of preferred stock, the holders of common stock are entitled to dividends when and as declared out of funds legally available therefor. See Notes 3 and 4 of Notes to Financial Statements in Item 8 for restrictions on retained earnings available for the payment of dividends. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The Company's capital needs consist primarily of construction expenditures and required repayments or redemptions of long-term debt and preferred stock. The capital resources available to meet these requirements include funds provided by operations and external financings. Present construction plans exclude any major baseload generating plants for at least the next ten years. In general, most of the construction expenditures are for expanding transmission and distribution capabilities to meet customer growth, upgrading existing facilities, and environmental purposes. Construction expenditures are anticipated to be $279 million, $302 million, and $293 million for 1994, 1995, and 1996, respectively. These amounts include nuclear fuel expenditures, but exclude capitalized property taxes and capitalized interest costs. In the 1991 through 1993 period, the Company funded all of its capital expenditures (construction expenditures and capitalized property taxes) with internally generated funds, after the payment of dividends. For the period 1994 through 1996, the Company currently estimates that it will fund substantially all of its capital expenditures with internally generated funds, after the payment of dividends. During 1993, the Company redeemed or repurchased approximately $637 million of long-term debt and preferred stock, of which approximately $527 million was optional. Refunding obligations for preferred stock, long-term debt, a capitalized lease obligation, and certain anticipated early redemptions are expected to total approximately $187 million, $135 million, and $4 million for the years 1994, 1995, and 1996, respectively. The Company currently expects to issue in 1994 a total of approximately $125 million of long-term debt (primarily first mortgage bonds) and approximately $125 million of preferred stock. Of this, the Company issued on March 2, 1994, $100 million of its First Mortgage Bonds, 65/8% Series due 2004, and applied the net proceeds to the repayment of short-term debt that had been incurred for the redemption of preferred stock and for general corporate purposes. The Company expects that substantially all of the net proceeds of the balance of the securities to be issued during 1994 will be used for the retirement of outstanding debt and preferred stock. On March 1, 1994, the Company redeemed all of the outstanding shares of its $8.80 Cumulative Preferred Stock, Series K ($100 Par Value) in the amount of $14.21 million. As of April 4, 1994, the Company will be redeeming all $60.264 million of its outstanding First Mortgage Bonds, 103/4% Series due 2019. Provisions in the Company's mortgage bond indenture and articles of incorporation require certain coverage ratios to be met before the Company can issue additional first mortgage bonds or preferred stock. In addition, the mortgage bond indenture limits the amount of additional bonds which may be issued to a percentage of net property additions, to property previously pledged as security for certain bonds that have been redeemed or retired, and/ or to cash deposited with the mortgage bond trustee. After giving effect to the transactions described in the preceding paragraph, as of December 31, 1993, the Company estimates that the mortgage bond indenture and the articles of incorporation would have allowed it to issue up to approximately $1.20 billion and $986 million of additional first mortgage bonds and preferred stock, respectively. The ACC has authority over the Company with respect to the issuance of long-term debt and equity securities. Existing ACC orders allow the Company to have up to approximately $2.6 billion in long-term debt and approximately $501 million of preferred stock outstanding at any one time. Management does not expect any of the foregoing restrictions to limit the Company's ability to meet its capital requirements. As of December 31, 1993, the Company had credit commitments from various banks totalling approximately $302 million, which were available either to support the issuance of commercial paper or to be used as bank borrowings. Commercial paper borrowings totalling $148 million were outstanding at the end of 1993. OPERATING RESULTS 1993 Compared to 1992 Earnings in 1993 were $219.5 million compared to $214.3 million in 1992 for an increase of $5.2 million. The primary factor contributing to this increase was lower interest expense. Interest costs in 1993 were $18.3 million lower than 1992 due to the Company refinancing debt at lower rates, lower average debt balances, and lower interest rates on variable-rate debt. Partially offsetting the lower interest expense were increased taxes and higher operating expenses. Operating revenues were up $16.6 million in 1993 on sales volumes of 20.1 million MWh compared to 20.6 million MWh in 1992. Although revenues increased $45.3 million due to customer growth in the residential and business classes, these increases were largely offset by milder than normal weather and reduced interchange sales to other utilities. Fuel and purchased power costs increased $15.5 million in 1993 due to Palo Verde outages and reduced power operations (see Note 10 of Notes to Financial Statements). Partially offsetting the $15.5 million increase were other miscellaneous items resulting in a net increase of $13.3 million over 1992. These increases are reflected currently in earnings because the Company does not have a fuel adjustment clause as part of its retail rate structure. The net result of operating revenues less fuel and purchased power expense was an increase of $3.3 million comparing 1993 to 1992. Operations expense for 1993 increased $11.8 million over 1992 levels primarily due to the implementation of SFAS No. 106 and SFAS No. 112, which added $17.0 million to expense in 1993. Partially offsetting these factors were lower power plant operating costs, lower rent expense, and lower costs for an employee gainsharing plan. 1992 Compared to 1991 Earnings in 1992 were $214.3 million compared with a loss in 1991 of $256.1 million. This was primarily due to the after-tax write-offs of $407 million in 1991 resulting from a rate case settlement with the ACC (see "Rate Case Settlement" in Note 2 of Notes to Financial Statements). Excluding the effects of the write-offs, earnings increased by $63.4 million over 1991 earnings as a result of several factors, including higher revenues, lower interest costs, and lower operating expenses. Partially offsetting these factors were higher fuel and purchased power costs and higher maintenance expense. Operating revenues were up $154.4 million during 1992 on sales volumes of 20.6 million MWh compared to 20.0 million MWh in 1991. The volume increase of $48.6 million was largely due to customer growth in residential and business customer classes and increased sales due to more normal weather as compared to 1991. A price-related increase of $85.9 million was largely due to an increase in retail base rates effective December 6, 1991 and a higher average price for interchange sales to other utilities. Also contributing to the increase in 1992 was $19.9 million reversal of a non-cash refund obligation recorded in December, 1991 (see Note 2 of Notes to Financial Statements). Interest costs were $34.9 million lower in 1992 as compared to 1991 due to lower average debt balances resulting from the redemptions of outstanding debt in 1991 with proceeds from the sale of Cholla 4 and lower interest rates on both variable-rate debt and refinancings. Fuel expenses increased in 1992 over 1991 by $13.4 million as a result of increased generation due to increased retail and interchange sales, and increased gas prices. These increases were partially offset by lower prices for coal and uranium. The increase in the purchased power component of fuel expenses was due to favorable market prices. Operations expense was $15.3 million lower in 1992 as compared to 1991 primarily due to lower operating costs at Palo Verde, lower fossil plant overhaul costs, and other miscellaneous cost reductions. Partially offsetting these were an obligation recorded for an employee gainsharing plan and higher nuclear refueling outage costs. Other Income Net income reflects accounting practices required for regulated public utilities and represents a composite of cash and noncash items, including AFUDC, accretion income on Palo Verde Unit 3, and the reversal of a refund obligation related to the Palo Verde write-off, (see "Statement of Cash Flows" and Note 2 of Notes to Financial Statements). The Company recorded after-tax accretion income of $45.3 million, $40.7 million and $3.2 million in 1993, 1992 and 1991, respectively. The Company also recorded refund obligation reversals in electric operating revenues of $12.9 million after tax in each of the years 1993 and 1992, and $0.9 million in 1991. The Company will record the remaining after-tax accretion income and refund obligation reversal of $20.3 million and $5.6 million, respectively, by June 5, 1994. PALO VERDE NUCLEAR GENERATING STATION As the Company continues its investigation and analysis of the Palo Verde steam generators, certain corrective actions are being taken. These include chemical cleaning, operating the units at reduced temperatures, and for some periods, operating the units at 86% power. So long as three units are involved in mid-cycle outages and are operated at 86%, the Company will incur an average of approximately $2 million per month (before income taxes) for additional fuel and purchased power costs. See "Palo Verde Tube Cracks" in Note 10 of Notes to Financial Statements for a more detailed discussion. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page -------- Report of Management................................................... 20 Independent Auditors' Report........................................... 21 Statements of Income for each of the three years in the period ended December 31, 1993.................................................... 22 Balance Sheets -- December 31, 1993 and 1992........................... 23 Statements of Retained Earnings for each of the three years in the period ended December 31, 1993........................................ 25 Statements of Cash Flows for each of the three years in the period ended December 31, 1993...................................................... 26 Notes to Financial Statements............................................ 27 Financial Statement Schedules for each of the three years in the period ended December 31, 1993 Schedule V -- Property, Plant and Equipment.......................... 41 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment................................... 44 Schedule IX -- Short-Term Borrowings................................. 47 See Note 12 of Notes to Financial Statements for the selected quarterly financial data required to be presented in this Item. REPORT OF MANAGEMENT The primary responsibility for the integrity of the Company's financial information rests with management, which has prepared the accompanying financial statements and related information. Such information was prepared in accordance with generally accepted accounting principles appropriate in the circumstances, based on management's best estimates and judgments, and giving due consideration to materiality. These financial statements have been audited by independent auditors and their report is included. Management maintains and relies upon systems of internal accounting controls, which are periodically reviewed by both the Company's internal auditors and its independent auditors to test for compliance. Reports issued by the internal auditors are released to management, and such reports, or summaries thereof, are transmitted to the Audit Committee of the Board of Directors and the independent auditors on a timely basis. The Audit Committee, composed solely of outside directors, meets periodically with the internal auditors and independent auditors (as well as management) to review the work of each. The internal auditors and independent auditors have free access to the Audit Committee, without management present, to discuss the results of their audit work. Management believes that the Company's systems, policies and procedures provide reasonable assurance that operations are conducted in conformity with the law and with management's commitment to a high standard of business conduct. O. MARK DE MICHELE JARON B. NORBERG O. Mark De Michele Jaron B. Norberg President and Executive Vice President and Chief Executive Officer Chief Financial Officer INDEPENDENT AUDITORS' REPORT Arizona Public Service Company: We have audited the accompanying balance sheets of Arizona Public Service Company as of December 31, 1993 and 1992 and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth herein. As discussed in Note 8 to the Financial Statements, the Company changed its method of accounting for income taxes effective January 1, 1993 to conform with Statement of Financial Accounting Standards No. 109. Deloitte & Touche Phoenix, Arizona February 21, 1994 ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a. Accounting Records -- The accounting records are maintained in accordance with generally accepted accounting principles applicable to rate- regulated enterprises. The Company is regulated by the ACC and the FERC and the accompanying financial statements reflect the rate-making policies of these commissions. b. Common Stock -- All of the outstanding shares of common stock of the Company are owned by Pinnacle West. c. Cash and Cash Equivalents -- For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an initial maturity of three months or less to be cash equivalents. d. Utility Plant and Depreciation -- Utility plant represents the buildings, equipment and other facilities used to provide electric service. The cost of utility plant includes labor, materials, contract services, other related items and an allowance for funds used during construction. The cost of retired depreciable utility plant, plus costs of removal minus salvage realized, is charged to accumulated depreciation. Depreciation on utility property is recorded on a straight-line basis. The applicable ACC approved rates for 1991 through 1993 ranged from 0.84% to 15.00% which resulted in annual composite rates of 3.37%. e. Nuclear Decommissioning Costs -- In 1993, the Company recorded $6.5 million for decommissioning expense. Based on a more recent site-specific study to completely remove all facilities, the Company expects to record $11.4 million for decommissioning expense in 1994. The Company estimates it will cost approximately $2.1 billion ($407 million in 1993 dollars), over a thirteen year period beginning in 2023, to decommission its 29.1% interest in Palo Verde. Decommissioning costs are charged to expense over the respective unit's operating license term and included in the accumulated depreciation balance until Palo Verde is retired from service. As required by the ACC, the Company has established external trust accounts into which quarterly deposits are made for decommissioning. As of December 31, 1993, the Company has deposited a total of $35.0 million. The trust accounts are included in "Investments and Other Assets" on the Company's balance sheet and have accumulated, with interest, a $44.7 million balance at December 31, 1993. f. Revenues -- Revenues are recognized on the accrual basis and include estimated amounts for service rendered but unbilled at the end of each accounting period. g. Allowance for Funds Used During Construction -- AFUDC represents the cost of debt and equity funds used to finance construction of utility plant. Plant construction costs, including AFUDC, are recovered in authorized rates through related depreciation when completed projects are placed into commercial operation. AFUDC does not represent current cash earnings. AFUDC has been calculated using composite rates of 7.20% for 1993; 10.00% for 1992; and 10.15% for 1991. The Company compounds AFUDC semiannually and ceases to accrue AFUDC when construction is completed and the property is placed in service. h. Reacquired Debt Costs -- Gains and losses on reacquired debt are deferred and amortized over the remaining original life of the debt, consistent with ratemaking. i. Nuclear Fuel -- Nuclear fuel cost is amortized to fuel expense based on the relationship of the quantity of heat produced in the current period to the total quantity of heat expected to be produced over the remaining life of the fuel. Under Federal law, the DOE is responsible for the permanent disposal of spent nuclear fuel. The DOE assesses $.001 per kilowatt-hour of nuclear generation. This amount is charged to nuclear fuel expense and recovered through rates. j. Palo Verde Cost Deferrals -- As authorized by the ACC, the Company deferred operating costs (excluding fuel) and financing costs for Palo Verde Units 2 and 3 (including their share of facilities common to all units) from the commercial operation date (September 1986 and January 1988, respectively) until the date the units ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) were included in a rate order (April 1988 and December 1991, respectively). The deferrals are being amortized and recovered in rates over thirty-five year periods. k. Reclassification -- certain prior year balances have been reclassified to conform to the 1993 presentation. 2. REGULATORY MATTERS RATE CASE SETTLEMENT In December 1991, the Company and the ACC reached a settlement in a retail rate case that had been pending before the ACC since January 1990. The ACC authorized an annual net revenue increase of $66.5 million, or approximately 5.2%. In turn, the Company wrote off $577.1 million of costs associated with Palo Verde and recorded a refund obligation of $53.4 million. The after-tax impact of these adjustments reduced 1991 net income by $407 million. A discussion of the components of the disallowance follows. Prudence Audit The ACC closed its prudence audit of Palo Verde and the Company wrote off $142 million ($101.3 million after tax) of construction costs relating to Palo Verde Units 1, 2, and 3 and $13.3 million ($8.6 million after tax) of deferred costs relating to the prudence audit. Interim or Temporary Revenues The ACC removed the interim and temporary designation on $385 million of revenues collected by the Company from 1986 through 1991 that had been previously authorized for Palo Verde Units 1 and 2. The Company recorded a refund obligation to customers of $53.4 million ($32.3 million after tax) related to the Palo Verde write-off discussed above. The refund obligation has been used to reduce the amount of annual rate increase granted rather than require specific customer refunds and is being reversed over thirty months beginning December 1991. The after-tax refund obligation reversals recorded as electric operating revenue by the Company amounted to $0.9 million in 1991 and $12.9 million in each of the years 1992 and 1993 and will amount to $5.6 million after tax in 1994. Temporary Excess Capacity -- Palo Verde Unit 3 The ACC deemed a portion of Palo Verde Unit 3 to be excess capacity and, accordingly, did not recognize the related Unit 3 costs for ratemaking purposes. This action effectively disallows for thirty months a return on approximately $475 million of the Company's investment in Unit 3. The Company recognized a charge of $181.2 million ($109.5 million after tax), representing the present value of the lost cash flow and to that extent temporarily discounted the carrying value of Unit 3. In accordance with generally accepted accounting principles, the Company is recording over the thirty-month period accretion income on Unit 3 in the aggregate amount of the discount. The Company recorded after-tax accretion income of $3.2 million, $40.7 million, and $45.3 million in 1991, 1992, and 1993, respectively, and will record after-tax accretion income of $20.3 million in 1994. In December 1991, the Company stopped deferring Unit 3 costs and recorded a $240.6 million ($155.3 million after tax) write-off of Unit 3 cost deferrals due to Unit 3 being deemed excess capacity. At that time the Company began amortizing to expense and recovering in rates the remaining $320 million balance of deferrals over a thirty-five year period as approved by the ACC. Future Retail Rate Increase The Company agreed not to file a new rate application before December 1993 and the ACC agreed to expedite the processing of a future rate application. The Company and the ACC also agreed on an average unit sales price ceiling of 9.585 cents per kilowatt-hour in this future rate application, if filed prior to January 1, ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1995. The Company's 1993 average unit sales price was approximately 9 cents per kilowatt-hour. This ceiling may be adjusted for the effects of significant changes in laws, regulatory requirements, or the Company's cost of equity capital. Management believes that the unit sales price ceiling will not adversely impact the Company's future earnings and has not yet determined when a rate case may be filed. Dividend Payments The Company agreed to limit its annual common stock dividends to Pinnacle West to $170 million through December 1993. SALE OF CHOLLA UNIT 4 In July 1991, the Company sold Cholla 4 to PacifiCorp for approximately $230 million. The resulting after-tax gain of approximately $20 million was deferred and is being amortized as a reduction to operations expense over a four year period in accordance with an ACC order. The transaction also provides for transmission access and electrical energy sales and exchanges between the Company and PacifiCorp. If there were to be any arrearage in dividends on any of the Company's preferred stock or in the sinking fund requirements applicable to any of its redeemable preferred stock, the Company could not pay dividends on its common stock or acquire any shares thereof for consideration. The redemption requirements for the above issues for the next five years are: 1994, $65,775,000; 1995, $13,525,000; 1996, $13,525,000; 1997, $13,525,000; and 1998, $13,525,000. Aggregate annual payments due on long-term debt and for sinking fund requirements through 1998 are as follows: 1994, $3,179,000; 1995, $3,408,000; 1996, $3,512,000; 1997, $153,780,000; and 1998, $109,068,000. The Company had approximately $370 million of variable-rate long-term debt outstanding at December 31, 1993. Changes in interest rates would affect the costs associated with this debt. Substantially all utility plant (other than nuclear fuel, transportation equipment, and the combined cycle plant) is subject to the lien of the first mortgage bond indenture. The first mortgage bond indenture includes provisions which would restrict the payment of common stock dividends under certain conditions which did not exist at December 31, 1993. 5. LINES OF CREDIT APS had committed lines of credit with various banks of $302 million at December 31, 1993 and 1992 which were available either to support the issuance of commercial paper or to be used for bank borrowings. The commitment fees on these lines were 0.1875% per annum through April 29, 1992 and 0.25% thereafter through December 31, 1993. The Company had commercial paper borrowings outstanding of $148 million at December 31, 1993 and bank borrowings of $130 million at December 31, 1992. In 1992, the Company also had a $70 million letter of credit commercial paper program. Under this program, which expired in November, 1993, the Company had $65 million of borrowings outstanding at December 31, 1992. The commitment fees for this program were 0.30% per year. By Arizona statute, the Company's short-term borrowings cannot exceed 7% of total capitalization without the consent of the ACC. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. JOINTLY-OWNED FACILITIES At December 31, 1993, the Company owned interests in the following jointly-owned electric generating and transmission facilities. The Company's share of related operating and maintenance expenses is included in Operating Expenses. 7. LEASES In 1986, the Company entered into sale and leaseback transactions under which it sold approximately 42% of its share of Palo Verde Unit 2. The gain of approximately $140,220,000 has been deferred and is being amortized to operations expense over the original lease term. The leases are being accounted for as operating leases. The amounts paid each year approximate $40,134,000 through December 1999, $46,285,000 through December 2000 and $48,982,000 through December 2015. The leases include options to renew for two additional years and to purchase the property at fair market value at the end of the lease terms. Consistent with the ratemaking treatment, an amount equal to the annual lease payments is included in rent expense. A regulatory asset (totalling approximately $49 million at December 31, 1993) has been established for the difference between lease payments and rent expense calculated on a straight-line basis. Lease expense for 1993, 1992 and 1991 was $41,750,000, $45,838,000 and $45,633,000, respectively. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) The Company has a capital lease on a combined cycle plant which it sold and leased back. The lease requires semiannual payments of $2,582,000 through June 2001 and includes renewal and purchase options based on fair market value. This plant is included in plant in service at its original cost of $54,405,000; accumulated depreciation at December 31, 1993 was $37,315,000. In addition, the Company also leases certain land, buildings, equipment and miscellaneous other items through operating rental agreements with varying terms, provisions and expiration dates. Rent expense for 1993, 1992, and 1991 were approximately $11,096,000, $14,733,000 and $16,046,000, respectively. Annual future minimum rental commitments, excluding the Palo Verde and combined cycle leases, for the period 1994 through 1998 range between $11 million and $13 million. Total rental commitments after 1998 are estimated at $129 million. 8. INCOME TAXES The Company is included in the consolidated income tax returns of Pinnacle West. Income taxes are allocated to the Company based on its separate company taxable income or loss. Approximately $17.3 million of income taxes were payable to Pinnacle West at December 31, 1993. Investment tax credits were deferred and are being amortized to other income over the estimated life of the related assets as directed by the ACC. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, which requires the use of the liability method in accounting for income taxes. Upon adoption the Company recorded deferred income tax liabilities related to the equity component of AFUDC, the debt component of AFUDC recorded net of tax, and other temporary differences for which deferred income taxes had not been provided. Deferred income tax balances were also adjusted for changes in tax rates. The adoption of SFAS No. 109 had no material effect on net income but increased deferred income tax liabilities by $585.3 million at December 31, 1993. Historically the FERC and ACC have allowed revenues sufficient to pay for these deferred tax liabilities, and, in accordance with SFAS No. 109, a regulatory asset has been established in a corresponding amount. The components of income tax expense (benefit) are: Year Ended December 31, -------------------------------- 1993 1992 1991 --------- --------- ---------- (Thousands of Dollars) Current: Federal................................... $ 69,243 $ 80,921 $ 39,446 State..................................... 23,915 23,141 11,010 --------- --------- ---------- Total current........................... 93,158 104,062 50,456 --------- --------- ---------- Deferred: Depreciation -- net....................... 58,844 75,931 56,478 Palo Verde cost deferral.................. (5,015) (5,015) 46,004 Alternative minimum tax................... 13,661 7,732 (10,565) Disallowed Palo Verde costs (including ITC).................................... -- -- (202,416) Refund obligation......................... 8,454 8,454 (20,591) Palo Verde accretion income............... 29,618 26,668 2,099 Loss on reacquired debt................... 4,288 10,266 (1,032) Palo Verde start-up costs................. (1,335) (28,976) (1,337) Investment tax credit -- net.............. (6,948) (6,804) (11,117) Other -- net.............................. (5,818) (10,963) (2,729) --------- --------- ---------- Total deferred.......................... 95,749 77,293 (145,206) --------- --------- ---------- Total................................. $ 188,907 $ 181,355 $ (94,750) ========= ========= ========== ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) Total income tax expense (benefit) differed from the amount computed by multiplying income before income taxes by the statutory federal income tax rate due to the following: Year Ended December 31, -------------------------------- 1993 1992 1991 --------- --------- ---------- (Thousands of Dollars) Federal income tax expense (benefit) at statutory rate (35% in 1993, 34% in 1992 and 1991)................................. $ 153,753 $ 145,574 $(107,916) Increase (reductions) in tax expense resulting from: Tax under book depreciation............... 17,671 17,465 21,776 Palo Verde cost deferral.................. -- -- (4,063) Disallowed Palo Verde costs (including ITC).................................... -- -- 22,236 Investment tax credit amortization........ (6,922) (7,036) (11,117) State income tax -- net of federal income tax benefit............................. 27,005 27,036 (9,820) Other..................................... (2,600) (1,684) (5,846) --------- --------- ---------- Total................................. $ 188,907 $ 181,355 $ (94,750) ========= ========= ========== The components of the net deferred income tax liability at December 31, 1993, were as follows (in thousands of dollars): Deferred tax assets: Deferred gain on Palo Verde Unit 2 sale/leaseback.............. $ 66,754 Alternative minimum tax (can be carried forward indefinitely).. 35,514 Other.......................................................... 86,745 Valuation allowance............................................ (15,413) ----------- Total deferred tax assets.................................. 173,600 ----------- Deferred tax liabilities: Plant related.................................................. 751,520 Income taxes recoverable through future rates -- net........... 585,294 Palo Verde deferrals........................................... 158,424 Other.......................................................... 40,429 ----------- Total deferred tax liabilities............................. 1,535,667 ----------- Accumulated deferred income taxes -- net......................... $1,362,067 =========== ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 9. PENSION PLAN AND OTHER BENEFITS Pension Plan The Company has a defined benefit pension plan covering substantially all employees. Benefits are based on years of service and compensation using a final average pay plan benefit formula. The plan is funded on a current basis to the extent deductible under existing tax regulation. Plan assets consist primarily of domestic and international common stocks and bonds, and real estate. Pension cost, including administrative cost, for 1993, 1992 and 1991 was approximately $13,950,000, $14,022,000 and $10,590,000, respectively, of which approximately $6,516,000, $3,917,000 and $4,939,000, respectively, was charged to expense; the remainder was either capitalized as a component of construction costs or billed to owners of facilities for which the Company is operating agent. The components of net periodic pension costs are as follows (in thousands of dollars): A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet is presented below (in thousands of dollars): 1993 1992 --------- --------- Plan assets at fair value............................... $ 417,938 $ 388,790 --------- --------- Less actuarial present value of benefit obligation: Accumulated benefit obligation, including vested benefits of $347,603 and $286,588................. 372,364 307,003 Effect of projected future compensation increases... 127,388 105,027 --------- --------- Total projected benefit obligation.............. 499,752 412,030 --------- --------- Plan assets less than projected benefit obligation...... (81,814) (23,240) Plus: Unrecognized net loss from past experience different from that assumed..................... 51,361 8,288 Unrecognized prior service cost................... 14,717 15,733 Unrecognized net transition asset................. (39,242) (42,458) --------- --------- Accrued pension liability included in other deferred credits............................................... $ (54,978) $ (41,677) ========= ========= Principal actuarial assumptions used were: Discount rate....................................... 7.50% 8.25% Rate of increase in compensation levels............. 5.00% 5.00% Expected long-term rate of return on assets......... 9.50%(a) 9.50% (a) The Company will assume a 9% rate of return on plan assets for computing the net periodic pension cost in 1994. In addition to the defined benefit pension plan described above, the Company also sponsors two qualified defined contribution plans. Substantially all employees are eligible to participate in one or the other of these two ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) plans. Both plans provide for employee contributions and partial employer matching contributions after certain eligibility requirements are met. The cost of these plans for 1993, 1992 and 1991 was $6,283,000, $5,311,000 and $2,708,000, of which $3,006,000, $2,514,000 and $1,344,000 was charged to expense. Postretirement Plans The Company provides medical and life insurance benefits to its retired employees. Employees may become eligible for these retirement benefits based on years of service and age. The retiree medical insurance plan is contributory; the retiree life insurance plan is noncontributory. In accordance with the governing plan documents, the Company retains the right to change or eliminate these benefits. During 1993, the Company adopted SFAS No. 106, which requires that the cost of postretirement benefits be accrued during the years that the employees render service. Prior to 1993, the costs of retiree benefits were recognized as expense when claims were paid. This change had the effect of increasing 1993 retiree benefit costs from approximately $6 million to $34 million; the amount charged to expense increased from approximately $2 million to $17 million for an increase of $15 million, including the amortization (over 20 years) of the initial postretirement benefit obligation estimated at January 1, 1993 to be $183 million. Funding is based upon actuarially determined contributions that take into account the tax consequences. The components of the postretirement benefit costs for 1993 are as follows (in thousands of dollars): Service cost -- benefits earned during the period........... $ 9,510 Interest cost on accumulated benefit obligation............. 15,630 Net amortization and deferral............................... 9,146 ------------ Net periodic postretirement benefit cost.................... $ 34,286 ============ A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet is presented below (in thousands of dollars): Plan assets at fair value, funded at December 31, 1993........ $ 28,154 ------------ Less accumulated postretirement benefit obligation: Retirees.................................................. 49,296 Fully eligible plan participants.......................... 13,504 Other active plan participants............................ 137,113 ------------ Total accumulated postretirement benefit obligation... 199,913 ------------ Plan assets less than accumulated benefit obligation.......... (171,759) Plus: Unrecognized transition obligation...................... 173,773 Unrecognized net gain from past experience different from that assumed and from changes in assumptions..... (2,072) ------------ Accrued postretirement liability included in other deferred credits................................................... $ (58) ============ Principal actuarial assumptions used were: Discount rate............................................. 7.50% Initial health care cost trend rate -- under age 65....... 12.00% Initial health care cost trend rate -- age 65 and over.... 9.00% Ultimate health care cost trend rate (reached in the year 2003)........................... 5.50% Annual Salary increase for life insurance obligation...... 5.00% Assuming a one percent increase in the health care cost trend rate, the Company's 1993 cost of postretirement benefits other than pensions would increase by $6.8 million and the accumulated benefit obligation as of December 31, 1993 would increase by $40.6 million. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) In 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The new standard requires a change from a cash method to an accrual method in accounting for benefits (such as long-term disability) provided to former or inactive employees after employment but before retirement. The adoption of this new standard resulted in an increase in 1993 postemployment benefit costs of approximately $2 million. 10. COMMITMENTS AND CONTINGENCIES Nuclear Insurance The Palo Verde participants have insurance for public liability payments resulting from nuclear energy hazards to the full limit of liability under federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $200 million and the balance by an industrywide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program for each nuclear incident is approximately $79 million, subject to an annual limit of $10 million per incident. Based upon the Company's 29.1% interest in the three Palo Verde units, the Company's maximum potential assessment per incident is approximately $69 million, with an annual payment limitation of $8.73 million. The insureds under this liability insurance include the Palo Verde participants and "any other person or organization with respect to his legal responsibility for damage caused by the nuclear energy hazard." The Palo Verde participants maintain "all risk" (including nuclear hazards) insurance for property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $2.75 billion, a substantial portion of which must first be applied to stabilization and decontamination. The Company has also secured insurance against portions of any increased cost of generation or purchased power and business interruption resulting from a sudden and unforeseen outage of any of the three units. The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions. El Paso Electric Company Bankruptcy The other joint owners in the Palo Verde and Four Corners facilities (see Note 6) include El Paso Electric Company, which currently is operating under Chapter 11 of the Bankruptcy Code. A plan whereby EPEC would become a wholly- owned subsidiary of Central and South West Corporation would resolve certain issues to which the Company could be exposed by the bankruptcy, including EPEC allegations regarding the 1989-90 Palo Verde outages. The plan has been confirmed by the bankruptcy court, but cannot become fully effective until several additional or related approvals are obtained. If they are not obtained, the plan could be withdrawn or terminate, thereby reintroducing the Company's exposures. Palo Verde Tube Cracks Tube cracking in the Palo Verde steam generators adversely affected operations in 1993, and will continue to do so in 1994 and probably into 1995, because of the cost of replacement power and maintenance expense associated with unit outages and corrective actions required to deal with the issue. The operation of Palo Verde Unit 2 has been particularly affected by this issue. The Company has encountered axial tube cracking in the upper regions of the two steam generators in Unit 2. This form of tube degradation is uncommon in the industry and, in March 1993, led to a tube rupture and an outage of the unit that extended to September 1993, during which the unit was refueled. Unit 2 is currently completing a mid-cycle inspection outage which revealed further tube degradation. Unit 2 will have another mid-cycle inspection outage later in 1994. The steam generators of Units 1 and 3 were inspected late in 1993, but did not show signs of axial cracking in their upper regions. All three units have, however, experienced cracking in the bottom of the steam generators of the types which are common in the industry. Although its analysis is not yet completed, the Company believes that the axial cracking in Unit 2 is due to deposits on the tubes and to the relatively high temperatures at which all three units are now designed to ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) operate. The Company also believes that it can retard further tube degradation to acceptable levels by remedial actions which include chemically cleaning the generators and performing analyses and adjustments that will allow the units to be operated at lower temperatures without appreciably reducing their output. The temperature analyses should be concluded within the next several months. In the meantime, the lower temperatures will be achieved by operating the units at less than full power (86%). Chemical cleaning was performed during Unit 2's current mid-cycle outage, and will be performed in the next refueling outage of Unit 3 (which will begin shortly) and of Unit 1 (which is scheduled for March 1995). The Company has concluded that Unit 1 can be safely operated until the 1995 outage and has submitted its supporting analysis to the NRC, but a mid-cycle inspection later in 1994 is possible. As a result of these corrective actions, all three units should be returned to full power by mid-1995, and one or more of the units could be returned to full power during 1994. So long as the three units are involved in mid-cycle outages and are operated at 86%, the Company will incur additional fuel and purchased power costs averaging approximately $2 million per month (before income taxes). Because of schedule changes associated with the tube issues and other circumstances, it now appears that all three units will be down for refueling outages at various times during 1995. When significant cracks are detected during any outage, the affected tubes are taken out of service by plugging. That has occurred in a number of tubes in Unit 2, which is by far the most affected by cracking and plugging. The Company expects that this will slow considerably because of the foregoing remedial actions and that, while it may ultimately reach some limit on plugging, it can operate the present steam generators over a number of years. Litigation The Company is a party to various claims, legal actions, and complaints arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the operations or financial position of the Company. Construction Program Expenditures in 1994 for the Company's continuing construction program have been estimated at $279 million, excluding capitalized property taxes and capitalized interest. Fuel and Purchased Power Commitments The Company is a party to various fuel and purchased power contracts with terms expiring from 1994 through 2020 that include required purchase provisions. The Company estimates its contract requirements during 1994 to be approximately $136 million. However, this amount may vary significantly pursuant to certain provisions in such contracts which permit the Company to decrease its required purchases under certain circumstances. 11. SUPPLEMENTARY INCOME STATEMENT INFORMATION Other taxes charged to operations during each of the three years in the period ended December 31, 1993 are as follows: ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 12. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) ELECTRIC OPERATING OPERATING NET EARNINGS FOR QUARTER(a) REVENUES INCOME INCOME COMMON STOCK - ---------------- ------------ ------------ ------------ ---------------- (THOUSANDS OF DOLLARS) First $371,303 $ 79,441 $ 47,166 $ 39,277 Second 407,375 92,264 61,364 53,716 Third 524,483 132,639 102,911 95,617 Fourth 383,129 68,144 38,945 30,936 First $344,947 $ 70,867 $ 30,911 $ 22,587 Second 409,012 101,222 62,773 54,680 Third 516,960 138,947 108,158 100,048 Fourth 398,760 81,222 44,963 37,038 (a) The Company's operations are subject to seasonal fluctuations with variations occurring in energy usage by customers from season to season and from month to month within a season, primarily as a result of weather conditions. For this and other reasons, the results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. 13. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company estimates that the carrying amounts of its cash equivalents and commercial paper are reasonable estimates of their fair values at December 31, 1993 and 1992 due to their short maturities. The December 31, 1993 and 1992 fair values of debt and equity investments, determined by using quoted market values or by discounting cash flows at rates equal to its cost of capital, approximate their carrying amounts. On December 31, 1993 the carrying amount of long-term debt liabilities (excluding $30 million of capital lease obligations) was $2.098 billion and its estimated fair value was approximately $2.257 billion. On December 31, 1992 the carrying amount of long-term debt (excluding $32 million of capital lease obligations) was $2.115 billion and its estimated fair value was approximately $2.226 billion. The fair value estimates were determined by independent sources using quoted market rates where available. Where market prices were not available, the fair values were estimated by discounting future cash flows using rates available for debt of similar terms and remaining maturities. The carrying amounts of long-term debt bearing variable interest rates approximate their fair values at December 31, 1993 and 1992, respectively. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is hereby made to "Election of Directors" in the Company's Proxy Statement relating to the annual meeting of shareholders to be held on April 19, 1994 (the "1994 Proxy Statement") and to the Supplemental Item -- "Executive Officers of the Registrant" in Part I of this report. During 1993, Mr. Woods, a Director of the Company, transferred shares of the Company's $2.625 Series C Preferred Stock directly owned by him to a trust under which he is a beneficiary and a trustee. This transfer technically required Mr. Woods to file with the SEC an amended securities ownership report (reflecting his indirect, rather than direct, ownership of the shares) and a new ownership report in his capacity as trustee under the trust. These reports were filed, but not within the required timeframe. ITEM 11. EXECUTIVE COMPENSATION Reference is hereby made to the fourth paragraph under the heading "The Board and its Committees," and to "Executive Compensation," "Report of the Human Resources Committee," and "Performance Graphs" in the 1994 Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is hereby made to "Principal Holders of Voting Securities" and "Ownership of Pinnacle West Securities by Management" in the 1994 Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is hereby made to the last paragraph under the heading "The Board and its Committees" in the 1994 Proxy Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See the Index to Financial Statements and Financial Statement Schedules in Part II, Item 8 on page 19. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The Company's capital needs consist primarily of construction expenditures and required repayments or redemptions of long-term debt and preferred stock. The capital resources available to meet these requirements include funds provided by operations and external financings. Present construction plans exclude any major baseload generating plants for at least the next ten years. In general, most of the construction expenditures are for expanding transmission and distribution capabilities to meet customer growth, upgrading existing facilities, and environmental purposes. Construction expenditures are anticipated to be $279 million, $302 million, and $293 million for 1994, 1995, and 1996, respectively. These amounts include nuclear fuel expenditures, but exclude capitalized property taxes and capitalized interest costs. In the 1991 through 1993 period, the Company funded all of its capital expenditures (construction expenditures and capitalized property taxes) with internally generated funds, after the payment of dividends. For the period 1994 through 1996, the Company currently estimates that it will fund substantially all of its capital expenditures with internally generated funds, after the payment of dividends. During 1993, the Company redeemed or repurchased approximately $637 million of long-term debt and preferred stock, of which approximately $527 million was optional. Refunding obligations for preferred stock, long-term debt, a capitalized lease obligation, and certain anticipated early redemptions are expected to total approximately $187 million, $135 million, and $4 million for the years 1994, 1995, and 1996, respectively. The Company currently expects to issue in 1994 a total of approximately $125 million of long-term debt (primarily first mortgage bonds) and approximately $125 million of preferred stock. Of this, the Company issued on March 2, 1994, $100 million of its First Mortgage Bonds, 65/8% Series due 2004, and applied the net proceeds to the repayment of short-term debt that had been incurred for the redemption of preferred stock and for general corporate purposes. The Company expects that substantially all of the net proceeds of the balance of the securities to be issued during 1994 will be used for the retirement of outstanding debt and preferred stock. On March 1, 1994, the Company redeemed all of the outstanding shares of its $8.80 Cumulative Preferred Stock, Series K ($100 Par Value) in the amount of $14.21 million. As of April 4, 1994, the Company will be redeeming all $60.264 million of its outstanding First Mortgage Bonds, 103/4% Series due 2019. Provisions in the Company's mortgage bond indenture and articles of incorporation require certain coverage ratios to be met before the Company can issue additional first mortgage bonds or preferred stock. In addition, the mortgage bond indenture limits the amount of additional bonds which may be issued to a percentage of net property additions, to property previously pledged as security for certain bonds that have been redeemed or retired, and/ or to cash deposited with the mortgage bond trustee. After giving effect to the transactions described in the preceding paragraph, as of December 31, 1993, the Company estimates that the mortgage bond indenture and the articles of incorporation would have allowed it to issue up to approximately $1.20 billion and $986 million of additional first mortgage bonds and preferred stock, respectively. The ACC has authority over the Company with respect to the issuance of long-term debt and equity securities. Existing ACC orders allow the Company to have up to approximately $2.6 billion in long-term debt and approximately $501 million of preferred stock outstanding at any one time. Management does not expect any of the foregoing restrictions to limit the Company's ability to meet its capital requirements. As of December 31, 1993, the Company had credit commitments from various banks totalling approximately $302 million, which were available either to support the issuance of commercial paper or to be used as bank borrowings. Commercial paper borrowings totalling $148 million were outstanding at the end of 1993. OPERATING RESULTS 1993 Compared to 1992 Earnings in 1993 were $219.5 million compared to $214.3 million in 1992 for an increase of $5.2 million. The primary factor contributing to this increase was lower interest expense. Interest costs in 1993 were $18.3 million lower than 1992 due to the Company refinancing debt at lower rates, lower average debt balances, and lower interest rates on variable-rate debt. Partially offsetting the lower interest expense were increased taxes and higher operating expenses. Operating revenues were up $16.6 million in 1993 on sales volumes of 20.1 million MWh compared to 20.6 million MWh in 1992. Although revenues increased $45.3 million due to customer growth in the residential and business classes, these increases were largely offset by milder than normal weather and reduced interchange sales to other utilities. Fuel and purchased power costs increased $15.5 million in 1993 due to Palo Verde outages and reduced power operations (see Note 10 of Notes to Financial Statements). Partially offsetting the $15.5 million increase were other miscellaneous items resulting in a net increase of $13.3 million over 1992. These increases are reflected currently in earnings because the Company does not have a fuel adjustment clause as part of its retail rate structure. The net result of operating revenues less fuel and purchased power expense was an increase of $3.3 million comparing 1993 to 1992. Operations expense for 1993 increased $11.8 million over 1992 levels primarily due to the implementation of SFAS No. 106 and SFAS No. 112, which added $17.0 million to expense in 1993. Partially offsetting these factors were lower power plant operating costs, lower rent expense, and lower costs for an employee gainsharing plan. 1992 Compared to 1991 Earnings in 1992 were $214.3 million compared with a loss in 1991 of $256.1 million. This was primarily due to the after-tax write-offs of $407 million in 1991 resulting from a rate case settlement with the ACC (see "Rate Case Settlement" in Note 2 of Notes to Financial Statements). Excluding the effects of the write-offs, earnings increased by $63.4 million over 1991 earnings as a result of several factors, including higher revenues, lower interest costs, and lower operating expenses. Partially offsetting these factors were higher fuel and purchased power costs and higher maintenance expense. Operating revenues were up $154.4 million during 1992 on sales volumes of 20.6 million MWh compared to 20.0 million MWh in 1991. The volume increase of $48.6 million was largely due to customer growth in residential and business customer classes and increased sales due to more normal weather as compared to 1991. A price-related increase of $85.9 million was largely due to an increase in retail base rates effective December 6, 1991 and a higher average price for interchange sales to other utilities. Also contributing to the increase in 1992 was $19.9 million reversal of a non-cash refund obligation recorded in December, 1991 (see Note 2 of Notes to Financial Statements). Interest costs were $34.9 million lower in 1992 as compared to 1991 due to lower average debt balances resulting from the redemptions of outstanding debt in 1991 with proceeds from the sale of Cholla 4 and lower interest rates on both variable-rate debt and refinancings. Fuel expenses increased in 1992 over 1991 by $13.4 million as a result of increased generation due to increased retail and interchange sales, and increased gas prices. These increases were partially offset by lower prices for coal and uranium. The increase in the purchased power component of fuel expenses was due to favorable market prices. Operations expense was $15.3 million lower in 1992 as compared to 1991 primarily due to lower operating costs at Palo Verde, lower fossil plant overhaul costs, and other miscellaneous cost reductions. Partially offsetting these were an obligation recorded for an employee gainsharing plan and higher nuclear refueling outage costs. Other Income Net income reflects accounting practices required for regulated public utilities and represents a composite of cash and noncash items, including AFUDC, accretion income on Palo Verde Unit 3, and the reversal of a refund obligation related to the Palo Verde write-off, (see "Statement of Cash Flows" and Note 2 of Notes to Financial Statements). The Company recorded after-tax accretion income of $45.3 million, $40.7 million and $3.2 million in 1993, 1992 and 1991, respectively. The Company also recorded refund obligation reversals in electric operating revenues of $12.9 million after tax in each of the years 1993 and 1992, and $0.9 million in 1991. The Company will record the remaining after-tax accretion income and refund obligation reversal of $20.3 million and $5.6 million, respectively, by June 5, 1994. PALO VERDE NUCLEAR GENERATING STATION As the Company continues its investigation and analysis of the Palo Verde steam generators, certain corrective actions are being taken. These include chemical cleaning, operating the units at reduced temperatures, and for some periods, operating the units at 86% power. So long as three units are involved in mid-cycle outages and are operated at 86%, the Company will incur an average of approximately $2 million per month (before income taxes) for additional fuel and purchased power costs. See "Palo Verde Tube Cracks" in Note 10 of Notes to Financial Statements for a more detailed discussion. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page -------- Report of Management................................................... 20 Independent Auditors' Report........................................... 21 Statements of Income for each of the three years in the period ended December 31, 1993.................................................... 22 Balance Sheets -- December 31, 1993 and 1992........................... 23 Statements of Retained Earnings for each of the three years in the period ended December 31, 1993........................................ 25 Statements of Cash Flows for each of the three years in the period ended December 31, 1993...................................................... 26 Notes to Financial Statements............................................ 27 Financial Statement Schedules for each of the three years in the period ended December 31, 1993 Schedule V -- Property, Plant and Equipment.......................... 41 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment................................... 44 Schedule IX -- Short-Term Borrowings................................. 47 See Note 12 of Notes to Financial Statements for the selected quarterly financial data required to be presented in this Item. REPORT OF MANAGEMENT The primary responsibility for the integrity of the Company's financial information rests with management, which has prepared the accompanying financial statements and related information. Such information was prepared in accordance with generally accepted accounting principles appropriate in the circumstances, based on management's best estimates and judgments, and giving due consideration to materiality. These financial statements have been audited by independent auditors and their report is included. Management maintains and relies upon systems of internal accounting controls, which are periodically reviewed by both the Company's internal auditors and its independent auditors to test for compliance. Reports issued by the internal auditors are released to management, and such reports, or summaries thereof, are transmitted to the Audit Committee of the Board of Directors and the independent auditors on a timely basis. The Audit Committee, composed solely of outside directors, meets periodically with the internal auditors and independent auditors (as well as management) to review the work of each. The internal auditors and independent auditors have free access to the Audit Committee, without management present, to discuss the results of their audit work. Management believes that the Company's systems, policies and procedures provide reasonable assurance that operations are conducted in conformity with the law and with management's commitment to a high standard of business conduct. O. MARK DE MICHELE JARON B. NORBERG O. Mark De Michele Jaron B. Norberg President and Executive Vice President and Chief Executive Officer Chief Financial Officer INDEPENDENT AUDITORS' REPORT Arizona Public Service Company: We have audited the accompanying balance sheets of Arizona Public Service Company as of December 31, 1993 and 1992 and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth herein. As discussed in Note 8 to the Financial Statements, the Company changed its method of accounting for income taxes effective January 1, 1993 to conform with Statement of Financial Accounting Standards No. 109. Deloitte & Touche Phoenix, Arizona February 21, 1994 ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a. Accounting Records -- The accounting records are maintained in accordance with generally accepted accounting principles applicable to rate- regulated enterprises. The Company is regulated by the ACC and the FERC and the accompanying financial statements reflect the rate-making policies of these commissions. b. Common Stock -- All of the outstanding shares of common stock of the Company are owned by Pinnacle West. c. Cash and Cash Equivalents -- For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an initial maturity of three months or less to be cash equivalents. d. Utility Plant and Depreciation -- Utility plant represents the buildings, equipment and other facilities used to provide electric service. The cost of utility plant includes labor, materials, contract services, other related items and an allowance for funds used during construction. The cost of retired depreciable utility plant, plus costs of removal minus salvage realized, is charged to accumulated depreciation. Depreciation on utility property is recorded on a straight-line basis. The applicable ACC approved rates for 1991 through 1993 ranged from 0.84% to 15.00% which resulted in annual composite rates of 3.37%. e. Nuclear Decommissioning Costs -- In 1993, the Company recorded $6.5 million for decommissioning expense. Based on a more recent site-specific study to completely remove all facilities, the Company expects to record $11.4 million for decommissioning expense in 1994. The Company estimates it will cost approximately $2.1 billion ($407 million in 1993 dollars), over a thirteen year period beginning in 2023, to decommission its 29.1% interest in Palo Verde. Decommissioning costs are charged to expense over the respective unit's operating license term and included in the accumulated depreciation balance until Palo Verde is retired from service. As required by the ACC, the Company has established external trust accounts into which quarterly deposits are made for decommissioning. As of December 31, 1993, the Company has deposited a total of $35.0 million. The trust accounts are included in "Investments and Other Assets" on the Company's balance sheet and have accumulated, with interest, a $44.7 million balance at December 31, 1993. f. Revenues -- Revenues are recognized on the accrual basis and include estimated amounts for service rendered but unbilled at the end of each accounting period. g. Allowance for Funds Used During Construction -- AFUDC represents the cost of debt and equity funds used to finance construction of utility plant. Plant construction costs, including AFUDC, are recovered in authorized rates through related depreciation when completed projects are placed into commercial operation. AFUDC does not represent current cash earnings. AFUDC has been calculated using composite rates of 7.20% for 1993; 10.00% for 1992; and 10.15% for 1991. The Company compounds AFUDC semiannually and ceases to accrue AFUDC when construction is completed and the property is placed in service. h. Reacquired Debt Costs -- Gains and losses on reacquired debt are deferred and amortized over the remaining original life of the debt, consistent with ratemaking. i. Nuclear Fuel -- Nuclear fuel cost is amortized to fuel expense based on the relationship of the quantity of heat produced in the current period to the total quantity of heat expected to be produced over the remaining life of the fuel. Under Federal law, the DOE is responsible for the permanent disposal of spent nuclear fuel. The DOE assesses $.001 per kilowatt-hour of nuclear generation. This amount is charged to nuclear fuel expense and recovered through rates. j. Palo Verde Cost Deferrals -- As authorized by the ACC, the Company deferred operating costs (excluding fuel) and financing costs for Palo Verde Units 2 and 3 (including their share of facilities common to all units) from the commercial operation date (September 1986 and January 1988, respectively) until the date the units ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) were included in a rate order (April 1988 and December 1991, respectively). The deferrals are being amortized and recovered in rates over thirty-five year periods. k. Reclassification -- certain prior year balances have been reclassified to conform to the 1993 presentation. 2. REGULATORY MATTERS RATE CASE SETTLEMENT In December 1991, the Company and the ACC reached a settlement in a retail rate case that had been pending before the ACC since January 1990. The ACC authorized an annual net revenue increase of $66.5 million, or approximately 5.2%. In turn, the Company wrote off $577.1 million of costs associated with Palo Verde and recorded a refund obligation of $53.4 million. The after-tax impact of these adjustments reduced 1991 net income by $407 million. A discussion of the components of the disallowance follows. Prudence Audit The ACC closed its prudence audit of Palo Verde and the Company wrote off $142 million ($101.3 million after tax) of construction costs relating to Palo Verde Units 1, 2, and 3 and $13.3 million ($8.6 million after tax) of deferred costs relating to the prudence audit. Interim or Temporary Revenues The ACC removed the interim and temporary designation on $385 million of revenues collected by the Company from 1986 through 1991 that had been previously authorized for Palo Verde Units 1 and 2. The Company recorded a refund obligation to customers of $53.4 million ($32.3 million after tax) related to the Palo Verde write-off discussed above. The refund obligation has been used to reduce the amount of annual rate increase granted rather than require specific customer refunds and is being reversed over thirty months beginning December 1991. The after-tax refund obligation reversals recorded as electric operating revenue by the Company amounted to $0.9 million in 1991 and $12.9 million in each of the years 1992 and 1993 and will amount to $5.6 million after tax in 1994. Temporary Excess Capacity -- Palo Verde Unit 3 The ACC deemed a portion of Palo Verde Unit 3 to be excess capacity and, accordingly, did not recognize the related Unit 3 costs for ratemaking purposes. This action effectively disallows for thirty months a return on approximately $475 million of the Company's investment in Unit 3. The Company recognized a charge of $181.2 million ($109.5 million after tax), representing the present value of the lost cash flow and to that extent temporarily discounted the carrying value of Unit 3. In accordance with generally accepted accounting principles, the Company is recording over the thirty-month period accretion income on Unit 3 in the aggregate amount of the discount. The Company recorded after-tax accretion income of $3.2 million, $40.7 million, and $45.3 million in 1991, 1992, and 1993, respectively, and will record after-tax accretion income of $20.3 million in 1994. In December 1991, the Company stopped deferring Unit 3 costs and recorded a $240.6 million ($155.3 million after tax) write-off of Unit 3 cost deferrals due to Unit 3 being deemed excess capacity. At that time the Company began amortizing to expense and recovering in rates the remaining $320 million balance of deferrals over a thirty-five year period as approved by the ACC. Future Retail Rate Increase The Company agreed not to file a new rate application before December 1993 and the ACC agreed to expedite the processing of a future rate application. The Company and the ACC also agreed on an average unit sales price ceiling of 9.585 cents per kilowatt-hour in this future rate application, if filed prior to January 1, ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1995. The Company's 1993 average unit sales price was approximately 9 cents per kilowatt-hour. This ceiling may be adjusted for the effects of significant changes in laws, regulatory requirements, or the Company's cost of equity capital. Management believes that the unit sales price ceiling will not adversely impact the Company's future earnings and has not yet determined when a rate case may be filed. Dividend Payments The Company agreed to limit its annual common stock dividends to Pinnacle West to $170 million through December 1993. SALE OF CHOLLA UNIT 4 In July 1991, the Company sold Cholla 4 to PacifiCorp for approximately $230 million. The resulting after-tax gain of approximately $20 million was deferred and is being amortized as a reduction to operations expense over a four year period in accordance with an ACC order. The transaction also provides for transmission access and electrical energy sales and exchanges between the Company and PacifiCorp. If there were to be any arrearage in dividends on any of the Company's preferred stock or in the sinking fund requirements applicable to any of its redeemable preferred stock, the Company could not pay dividends on its common stock or acquire any shares thereof for consideration. The redemption requirements for the above issues for the next five years are: 1994, $65,775,000; 1995, $13,525,000; 1996, $13,525,000; 1997, $13,525,000; and 1998, $13,525,000. Aggregate annual payments due on long-term debt and for sinking fund requirements through 1998 are as follows: 1994, $3,179,000; 1995, $3,408,000; 1996, $3,512,000; 1997, $153,780,000; and 1998, $109,068,000. The Company had approximately $370 million of variable-rate long-term debt outstanding at December 31, 1993. Changes in interest rates would affect the costs associated with this debt. Substantially all utility plant (other than nuclear fuel, transportation equipment, and the combined cycle plant) is subject to the lien of the first mortgage bond indenture. The first mortgage bond indenture includes provisions which would restrict the payment of common stock dividends under certain conditions which did not exist at December 31, 1993. 5. LINES OF CREDIT APS had committed lines of credit with various banks of $302 million at December 31, 1993 and 1992 which were available either to support the issuance of commercial paper or to be used for bank borrowings. The commitment fees on these lines were 0.1875% per annum through April 29, 1992 and 0.25% thereafter through December 31, 1993. The Company had commercial paper borrowings outstanding of $148 million at December 31, 1993 and bank borrowings of $130 million at December 31, 1992. In 1992, the Company also had a $70 million letter of credit commercial paper program. Under this program, which expired in November, 1993, the Company had $65 million of borrowings outstanding at December 31, 1992. The commitment fees for this program were 0.30% per year. By Arizona statute, the Company's short-term borrowings cannot exceed 7% of total capitalization without the consent of the ACC. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. JOINTLY-OWNED FACILITIES At December 31, 1993, the Company owned interests in the following jointly-owned electric generating and transmission facilities. The Company's share of related operating and maintenance expenses is included in Operating Expenses. 7. LEASES In 1986, the Company entered into sale and leaseback transactions under which it sold approximately 42% of its share of Palo Verde Unit 2. The gain of approximately $140,220,000 has been deferred and is being amortized to operations expense over the original lease term. The leases are being accounted for as operating leases. The amounts paid each year approximate $40,134,000 through December 1999, $46,285,000 through December 2000 and $48,982,000 through December 2015. The leases include options to renew for two additional years and to purchase the property at fair market value at the end of the lease terms. Consistent with the ratemaking treatment, an amount equal to the annual lease payments is included in rent expense. A regulatory asset (totalling approximately $49 million at December 31, 1993) has been established for the difference between lease payments and rent expense calculated on a straight-line basis. Lease expense for 1993, 1992 and 1991 was $41,750,000, $45,838,000 and $45,633,000, respectively. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) The Company has a capital lease on a combined cycle plant which it sold and leased back. The lease requires semiannual payments of $2,582,000 through June 2001 and includes renewal and purchase options based on fair market value. This plant is included in plant in service at its original cost of $54,405,000; accumulated depreciation at December 31, 1993 was $37,315,000. In addition, the Company also leases certain land, buildings, equipment and miscellaneous other items through operating rental agreements with varying terms, provisions and expiration dates. Rent expense for 1993, 1992, and 1991 were approximately $11,096,000, $14,733,000 and $16,046,000, respectively. Annual future minimum rental commitments, excluding the Palo Verde and combined cycle leases, for the period 1994 through 1998 range between $11 million and $13 million. Total rental commitments after 1998 are estimated at $129 million. 8. INCOME TAXES The Company is included in the consolidated income tax returns of Pinnacle West. Income taxes are allocated to the Company based on its separate company taxable income or loss. Approximately $17.3 million of income taxes were payable to Pinnacle West at December 31, 1993. Investment tax credits were deferred and are being amortized to other income over the estimated life of the related assets as directed by the ACC. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, which requires the use of the liability method in accounting for income taxes. Upon adoption the Company recorded deferred income tax liabilities related to the equity component of AFUDC, the debt component of AFUDC recorded net of tax, and other temporary differences for which deferred income taxes had not been provided. Deferred income tax balances were also adjusted for changes in tax rates. The adoption of SFAS No. 109 had no material effect on net income but increased deferred income tax liabilities by $585.3 million at December 31, 1993. Historically the FERC and ACC have allowed revenues sufficient to pay for these deferred tax liabilities, and, in accordance with SFAS No. 109, a regulatory asset has been established in a corresponding amount. The components of income tax expense (benefit) are: Year Ended December 31, -------------------------------- 1993 1992 1991 --------- --------- ---------- (Thousands of Dollars) Current: Federal................................... $ 69,243 $ 80,921 $ 39,446 State..................................... 23,915 23,141 11,010 --------- --------- ---------- Total current........................... 93,158 104,062 50,456 --------- --------- ---------- Deferred: Depreciation -- net....................... 58,844 75,931 56,478 Palo Verde cost deferral.................. (5,015) (5,015) 46,004 Alternative minimum tax................... 13,661 7,732 (10,565) Disallowed Palo Verde costs (including ITC).................................... -- -- (202,416) Refund obligation......................... 8,454 8,454 (20,591) Palo Verde accretion income............... 29,618 26,668 2,099 Loss on reacquired debt................... 4,288 10,266 (1,032) Palo Verde start-up costs................. (1,335) (28,976) (1,337) Investment tax credit -- net.............. (6,948) (6,804) (11,117) Other -- net.............................. (5,818) (10,963) (2,729) --------- --------- ---------- Total deferred.......................... 95,749 77,293 (145,206) --------- --------- ---------- Total................................. $ 188,907 $ 181,355 $ (94,750) ========= ========= ========== ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) Total income tax expense (benefit) differed from the amount computed by multiplying income before income taxes by the statutory federal income tax rate due to the following: Year Ended December 31, -------------------------------- 1993 1992 1991 --------- --------- ---------- (Thousands of Dollars) Federal income tax expense (benefit) at statutory rate (35% in 1993, 34% in 1992 and 1991)................................. $ 153,753 $ 145,574 $(107,916) Increase (reductions) in tax expense resulting from: Tax under book depreciation............... 17,671 17,465 21,776 Palo Verde cost deferral.................. -- -- (4,063) Disallowed Palo Verde costs (including ITC).................................... -- -- 22,236 Investment tax credit amortization........ (6,922) (7,036) (11,117) State income tax -- net of federal income tax benefit............................. 27,005 27,036 (9,820) Other..................................... (2,600) (1,684) (5,846) --------- --------- ---------- Total................................. $ 188,907 $ 181,355 $ (94,750) ========= ========= ========== The components of the net deferred income tax liability at December 31, 1993, were as follows (in thousands of dollars): Deferred tax assets: Deferred gain on Palo Verde Unit 2 sale/leaseback.............. $ 66,754 Alternative minimum tax (can be carried forward indefinitely).. 35,514 Other.......................................................... 86,745 Valuation allowance............................................ (15,413) ----------- Total deferred tax assets.................................. 173,600 ----------- Deferred tax liabilities: Plant related.................................................. 751,520 Income taxes recoverable through future rates -- net........... 585,294 Palo Verde deferrals........................................... 158,424 Other.......................................................... 40,429 ----------- Total deferred tax liabilities............................. 1,535,667 ----------- Accumulated deferred income taxes -- net......................... $1,362,067 =========== ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 9. PENSION PLAN AND OTHER BENEFITS Pension Plan The Company has a defined benefit pension plan covering substantially all employees. Benefits are based on years of service and compensation using a final average pay plan benefit formula. The plan is funded on a current basis to the extent deductible under existing tax regulation. Plan assets consist primarily of domestic and international common stocks and bonds, and real estate. Pension cost, including administrative cost, for 1993, 1992 and 1991 was approximately $13,950,000, $14,022,000 and $10,590,000, respectively, of which approximately $6,516,000, $3,917,000 and $4,939,000, respectively, was charged to expense; the remainder was either capitalized as a component of construction costs or billed to owners of facilities for which the Company is operating agent. The components of net periodic pension costs are as follows (in thousands of dollars): A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet is presented below (in thousands of dollars): 1993 1992 --------- --------- Plan assets at fair value............................... $ 417,938 $ 388,790 --------- --------- Less actuarial present value of benefit obligation: Accumulated benefit obligation, including vested benefits of $347,603 and $286,588................. 372,364 307,003 Effect of projected future compensation increases... 127,388 105,027 --------- --------- Total projected benefit obligation.............. 499,752 412,030 --------- --------- Plan assets less than projected benefit obligation...... (81,814) (23,240) Plus: Unrecognized net loss from past experience different from that assumed..................... 51,361 8,288 Unrecognized prior service cost................... 14,717 15,733 Unrecognized net transition asset................. (39,242) (42,458) --------- --------- Accrued pension liability included in other deferred credits............................................... $ (54,978) $ (41,677) ========= ========= Principal actuarial assumptions used were: Discount rate....................................... 7.50% 8.25% Rate of increase in compensation levels............. 5.00% 5.00% Expected long-term rate of return on assets......... 9.50%(a) 9.50% (a) The Company will assume a 9% rate of return on plan assets for computing the net periodic pension cost in 1994. In addition to the defined benefit pension plan described above, the Company also sponsors two qualified defined contribution plans. Substantially all employees are eligible to participate in one or the other of these two ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) plans. Both plans provide for employee contributions and partial employer matching contributions after certain eligibility requirements are met. The cost of these plans for 1993, 1992 and 1991 was $6,283,000, $5,311,000 and $2,708,000, of which $3,006,000, $2,514,000 and $1,344,000 was charged to expense. Postretirement Plans The Company provides medical and life insurance benefits to its retired employees. Employees may become eligible for these retirement benefits based on years of service and age. The retiree medical insurance plan is contributory; the retiree life insurance plan is noncontributory. In accordance with the governing plan documents, the Company retains the right to change or eliminate these benefits. During 1993, the Company adopted SFAS No. 106, which requires that the cost of postretirement benefits be accrued during the years that the employees render service. Prior to 1993, the costs of retiree benefits were recognized as expense when claims were paid. This change had the effect of increasing 1993 retiree benefit costs from approximately $6 million to $34 million; the amount charged to expense increased from approximately $2 million to $17 million for an increase of $15 million, including the amortization (over 20 years) of the initial postretirement benefit obligation estimated at January 1, 1993 to be $183 million. Funding is based upon actuarially determined contributions that take into account the tax consequences. The components of the postretirement benefit costs for 1993 are as follows (in thousands of dollars): Service cost -- benefits earned during the period........... $ 9,510 Interest cost on accumulated benefit obligation............. 15,630 Net amortization and deferral............................... 9,146 ------------ Net periodic postretirement benefit cost.................... $ 34,286 ============ A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet is presented below (in thousands of dollars): Plan assets at fair value, funded at December 31, 1993........ $ 28,154 ------------ Less accumulated postretirement benefit obligation: Retirees.................................................. 49,296 Fully eligible plan participants.......................... 13,504 Other active plan participants............................ 137,113 ------------ Total accumulated postretirement benefit obligation... 199,913 ------------ Plan assets less than accumulated benefit obligation.......... (171,759) Plus: Unrecognized transition obligation...................... 173,773 Unrecognized net gain from past experience different from that assumed and from changes in assumptions..... (2,072) ------------ Accrued postretirement liability included in other deferred credits................................................... $ (58) ============ Principal actuarial assumptions used were: Discount rate............................................. 7.50% Initial health care cost trend rate -- under age 65....... 12.00% Initial health care cost trend rate -- age 65 and over.... 9.00% Ultimate health care cost trend rate (reached in the year 2003)........................... 5.50% Annual Salary increase for life insurance obligation...... 5.00% Assuming a one percent increase in the health care cost trend rate, the Company's 1993 cost of postretirement benefits other than pensions would increase by $6.8 million and the accumulated benefit obligation as of December 31, 1993 would increase by $40.6 million. ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) In 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The new standard requires a change from a cash method to an accrual method in accounting for benefits (such as long-term disability) provided to former or inactive employees after employment but before retirement. The adoption of this new standard resulted in an increase in 1993 postemployment benefit costs of approximately $2 million. 10. COMMITMENTS AND CONTINGENCIES Nuclear Insurance The Palo Verde participants have insurance for public liability payments resulting from nuclear energy hazards to the full limit of liability under federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $200 million and the balance by an industrywide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program for each nuclear incident is approximately $79 million, subject to an annual limit of $10 million per incident. Based upon the Company's 29.1% interest in the three Palo Verde units, the Company's maximum potential assessment per incident is approximately $69 million, with an annual payment limitation of $8.73 million. The insureds under this liability insurance include the Palo Verde participants and "any other person or organization with respect to his legal responsibility for damage caused by the nuclear energy hazard." The Palo Verde participants maintain "all risk" (including nuclear hazards) insurance for property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $2.75 billion, a substantial portion of which must first be applied to stabilization and decontamination. The Company has also secured insurance against portions of any increased cost of generation or purchased power and business interruption resulting from a sudden and unforeseen outage of any of the three units. The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions. El Paso Electric Company Bankruptcy The other joint owners in the Palo Verde and Four Corners facilities (see Note 6) include El Paso Electric Company, which currently is operating under Chapter 11 of the Bankruptcy Code. A plan whereby EPEC would become a wholly- owned subsidiary of Central and South West Corporation would resolve certain issues to which the Company could be exposed by the bankruptcy, including EPEC allegations regarding the 1989-90 Palo Verde outages. The plan has been confirmed by the bankruptcy court, but cannot become fully effective until several additional or related approvals are obtained. If they are not obtained, the plan could be withdrawn or terminate, thereby reintroducing the Company's exposures. Palo Verde Tube Cracks Tube cracking in the Palo Verde steam generators adversely affected operations in 1993, and will continue to do so in 1994 and probably into 1995, because of the cost of replacement power and maintenance expense associated with unit outages and corrective actions required to deal with the issue. The operation of Palo Verde Unit 2 has been particularly affected by this issue. The Company has encountered axial tube cracking in the upper regions of the two steam generators in Unit 2. This form of tube degradation is uncommon in the industry and, in March 1993, led to a tube rupture and an outage of the unit that extended to September 1993, during which the unit was refueled. Unit 2 is currently completing a mid-cycle inspection outage which revealed further tube degradation. Unit 2 will have another mid-cycle inspection outage later in 1994. The steam generators of Units 1 and 3 were inspected late in 1993, but did not show signs of axial cracking in their upper regions. All three units have, however, experienced cracking in the bottom of the steam generators of the types which are common in the industry. Although its analysis is not yet completed, the Company believes that the axial cracking in Unit 2 is due to deposits on the tubes and to the relatively high temperatures at which all three units are now designed to ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) operate. The Company also believes that it can retard further tube degradation to acceptable levels by remedial actions which include chemically cleaning the generators and performing analyses and adjustments that will allow the units to be operated at lower temperatures without appreciably reducing their output. The temperature analyses should be concluded within the next several months. In the meantime, the lower temperatures will be achieved by operating the units at less than full power (86%). Chemical cleaning was performed during Unit 2's current mid-cycle outage, and will be performed in the next refueling outage of Unit 3 (which will begin shortly) and of Unit 1 (which is scheduled for March 1995). The Company has concluded that Unit 1 can be safely operated until the 1995 outage and has submitted its supporting analysis to the NRC, but a mid-cycle inspection later in 1994 is possible. As a result of these corrective actions, all three units should be returned to full power by mid-1995, and one or more of the units could be returned to full power during 1994. So long as the three units are involved in mid-cycle outages and are operated at 86%, the Company will incur additional fuel and purchased power costs averaging approximately $2 million per month (before income taxes). Because of schedule changes associated with the tube issues and other circumstances, it now appears that all three units will be down for refueling outages at various times during 1995. When significant cracks are detected during any outage, the affected tubes are taken out of service by plugging. That has occurred in a number of tubes in Unit 2, which is by far the most affected by cracking and plugging. The Company expects that this will slow considerably because of the foregoing remedial actions and that, while it may ultimately reach some limit on plugging, it can operate the present steam generators over a number of years. Litigation The Company is a party to various claims, legal actions, and complaints arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the operations or financial position of the Company. Construction Program Expenditures in 1994 for the Company's continuing construction program have been estimated at $279 million, excluding capitalized property taxes and capitalized interest. Fuel and Purchased Power Commitments The Company is a party to various fuel and purchased power contracts with terms expiring from 1994 through 2020 that include required purchase provisions. The Company estimates its contract requirements during 1994 to be approximately $136 million. However, this amount may vary significantly pursuant to certain provisions in such contracts which permit the Company to decrease its required purchases under certain circumstances. 11. SUPPLEMENTARY INCOME STATEMENT INFORMATION Other taxes charged to operations during each of the three years in the period ended December 31, 1993 are as follows: ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIAL STATEMENTS (CONTINUED) 12. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) ELECTRIC OPERATING OPERATING NET EARNINGS FOR QUARTER(a) REVENUES INCOME INCOME COMMON STOCK - ---------------- ------------ ------------ ------------ ---------------- (THOUSANDS OF DOLLARS) First $371,303 $ 79,441 $ 47,166 $ 39,277 Second 407,375 92,264 61,364 53,716 Third 524,483 132,639 102,911 95,617 Fourth 383,129 68,144 38,945 30,936 First $344,947 $ 70,867 $ 30,911 $ 22,587 Second 409,012 101,222 62,773 54,680 Third 516,960 138,947 108,158 100,048 Fourth 398,760 81,222 44,963 37,038 (a) The Company's operations are subject to seasonal fluctuations with variations occurring in energy usage by customers from season to season and from month to month within a season, primarily as a result of weather conditions. For this and other reasons, the results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. 13. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company estimates that the carrying amounts of its cash equivalents and commercial paper are reasonable estimates of their fair values at December 31, 1993 and 1992 due to their short maturities. The December 31, 1993 and 1992 fair values of debt and equity investments, determined by using quoted market values or by discounting cash flows at rates equal to its cost of capital, approximate their carrying amounts. On December 31, 1993 the carrying amount of long-term debt liabilities (excluding $30 million of capital lease obligations) was $2.098 billion and its estimated fair value was approximately $2.257 billion. On December 31, 1992 the carrying amount of long-term debt (excluding $32 million of capital lease obligations) was $2.115 billion and its estimated fair value was approximately $2.226 billion. The fair value estimates were determined by independent sources using quoted market rates where available. Where market prices were not available, the fair values were estimated by discounting future cash flows using rates available for debt of similar terms and remaining maturities. The carrying amounts of long-term debt bearing variable interest rates approximate their fair values at December 31, 1993 and 1992, respectively. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is hereby made to "Election of Directors" in the Company's Proxy Statement relating to the annual meeting of shareholders to be held on April 19, 1994 (the "1994 Proxy Statement") and to the Supplemental Item -- "Executive Officers of the Registrant" in Part I of this report. During 1993, Mr. Woods, a Director of the Company, transferred shares of the Company's $2.625 Series C Preferred Stock directly owned by him to a trust under which he is a beneficiary and a trustee. This transfer technically required Mr. Woods to file with the SEC an amended securities ownership report (reflecting his indirect, rather than direct, ownership of the shares) and a new ownership report in his capacity as trustee under the trust. These reports were filed, but not within the required timeframe. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is hereby made to the fourth paragraph under the heading "The Board and its Committees," and to "Executive Compensation," "Report of the Human Resources Committee," and "Performance Graphs" in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is hereby made to "Principal Holders of Voting Securities" and "Ownership of Pinnacle West Securities by Management" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is hereby made to the last paragraph under the heading "The Board and its Committees" in the 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See the Index to Financial Statements and Financial Statement Schedules in Part II, Item 8 on page 19.	20,064	135,438
108721_1993.txt	108721_1993	1993	108721	ITEM 1. BUSINESS Wynn's International, Inc., through its subsidiaries, is engaged primarily in the automotive parts and accessories business and the petrochemical specialties business. The Company designs, produces and sells O-rings and other seals and molded rubber and thermoplastic products and automotive air conditioning systems, components and related parts. The Company also formulates, produces and sells petrochemical specialty products and automotive service equipment and distributes, primarily in southern California, locks and hardware products manufactured by others. O-rings and other molded rubber products are marketed under the trademark "Wynn's-Precision." Air conditioning units for the automotive aftermarket are marketed by the Company under the trademark "Frostemp(R)," and wholesale parts are marketed and installation centers are operated under the trademark "Maxair(R)." Petrochemical specialty products are marketed under various trademarks, including "Wynn's(R)," "Friction Proofing(R)," "X-Tend(R)," "Spit Fire(R)," "Classic(R)," "Mark X(R)" and "Du-All(TM)." The Company's executive offices are located at 500 North State College Boulevard, Suite 700, Orange, California 92668. Its telephone number is (714) 938-3700. The terms "Wynn's International, Inc.," "Wynn's," "Company" and "Registrant" herein refer to Wynn's International, Inc. and its subsidiaries unless the context indicates otherwise. FINANCIAL INFORMATION BY BUSINESS SEGMENT AND GEOGRAPHIC DATA The Company's operations are conducted in three industry segments: Automotive Parts and Accessories; Petrochemical Specialties; and Builders Hardware. Financial information relating to the Company's business segments for the five years ended December 31, 1993 is incorporated by reference from Note 15 of "Notes to Consolidated Financial Statements" on pages 29 through 31 of the Company's Annual Report to Stockholders for the year ended December 31, 1993 (the "1993 Annual Report"). AUTOMOTIVE PARTS AND ACCESSORIES The Automotive Parts and Accessories Division consists of Wynn's-Precision, Inc. ("Precision") and Wynn's Climate Systems, Inc. ("Wynn's Climate Systems"). During 1993, sales of the Automotive Parts and Accessories Division were $181,478,000 or 64% of the Company's total net sales as compared with $185,947,000 and 64% in 1992. The operating profit of this division in 1993 was $16,643,000, or 70% of the Company's total operating profit as compared with $15,265,000 and 68% in 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. See also "Other Factors Affecting the Business." WYNN'S-PRECISION, INC. (O-RINGS, SEALS AND MOLDED RUBBER AND THERMOPLASTIC PRODUCTS) PRODUCTS Precision and its affiliated companies manufacture and sell a variety of static and dynamic sealing products. The principal users of the Precision products are automotive manufacturers, heavy vehicle manufacturers, industrial component manufacturers, hydraulic and pneumatic cylinder manufacturers, aerospace and defense contractors and the oil service industry. The principal products of Precision are O-rings, rack and pinion and front wheel drive seals, composite gaskets, hydraulic cylinder seals and various engineered molded rubber and plastic parts. These products are made from synthetic elastomers and thermoplastic materials. DISTRIBUTION Precision sells its products primarily through a direct sales force to original equipment manufacturer ("OEM") customers. Precision also markets its products throughout the United States through independent distributors and through Company-operated regional service centers located in Rancho Cucamonga, California; Elgin, Illinois; Grand Rapids, Michigan; Golden Valley, Minnesota; Charlotte, North Carolina; Buffalo, New York; Dayton, Ohio; Bensalem, Pennsylvania; Indianapolis, Indiana; Fort Worth, Texas; and Lenexa, Kansas. Precision's Canadian operation distributes products principally through a direct sales force to OEM customers, through independent distributors and through Precision-operated service centers in Canada and England. PRODUCTION Precision's manufacturing facilities are located in Lebanon and Livingston, Tennessee; Tempe, Arizona; Lynchburg, Virginia; Houston, Texas; and Orillia, Ontario, Canada. In 1993, Precision closed its 5,000 square-foot leased manufacturing facility located in Alexandria, Scotland due to certain start-up problems. Precision's corporate headquarters are located at the site of its main manufacturing facility in Lebanon, Tennessee. Precision also operates its own tool production facility in Lebanon, Tennessee. Over the past several years, Precision has made significant investments in modern computerized production equipment and facilities. Precision has a facility in Lebanon, Tennessee dedicated exclusively to injection molding. Using internally generated funds, Precision plans to spend approximately $10 million for capital expenditures in 1994 to increase its production capacity. The principal raw materials used by Precision are elastomeric and thermoplastic materials. These raw materials generally have been available from numerous sources in sufficient quantities to meet Precision's requirements. Adequate supplies of raw materials were available in 1993 and are expected to continue to be available in 1994. WYNN'S CLIMATE SYSTEMS, INC. (AUTOMOTIVE AIR CONDITIONING PRODUCTS) Wynn's Climate Systems sells its products to OEM customers and to independent distributors who resell units principally to car dealers. Wynn's Climate Systems also distributes wholesale parts manufactured by others and sells refrigerant recovery and recycling machines. In addition, Wynn's Climate Systems operates installation centers in the Denver, Colorado area and in Colorado Springs, Colorado, Phoenix, Arizona and Mesa, Arizona that perform installation services for car dealers and retail customers. PRODUCTS Wynn's Climate Systems designs, engineers and produces automotive air conditioning systems for the OEM market and the automotive aftermarket. Systems are manufactured for many current year models of domestic and imported automobiles, trucks and vans. Wynn's Climate Systems also manufactures and sells units for a wide range of automobiles, trucks and vans from prior model years. In addition, Wynn's Climate Systems manufactures and sells a variety of air conditioning components, including condensers, evaporator coils and adapter kits, and distributes air conditioning components and accessories manufactured by others. Wynn's Climate Systems also manufactures and sells refrigerant recovery and recycling equipment. DISTRIBUTION The products of Wynn's Climate Systems are distributed in several different ways. First, Wynn's Climate Systems manufactures air conditioners for sale to OEM customers and their distributors and dealers. Sales to Mazda, the largest customer of Wynn's Climate Systems, were approximately $35.1 million in 1993 or approximately 28% less than in 1992. In 1993, Wynn's Climate Systems supplied air conditioning kits to Mazda principally for its 323 automobile and light trucks. As previously reported, in approximately April 1993, Mazda began purchasing light trucks from Ford in lieu of importing them from Japan. Wynn's Climate Systems also supplies certain components to Mazda's Flat Rock, Michigan facility. Mazda assembles its own air conditioning kits in the United States for the MX-6, 626 and Miata model automobiles and the MPV. Mazda has informed Wynn's Climate Systems that Mazda will assemble air conditioning kits for the 323 automobile commencing in model year 1995, but Wynn's Climate Systems will continue to supply air conditioning kits for the 323 automobile through model year 1994. In 1991, Wynn's Climate Systems began supplying front units for Land and Range Rover four-wheel drive vehicles. This supply arrangement with Rover terminated in February 1994. In early 1993, Wynn's Climate Systems began supplying a newly-designed rear air conditioning unit for certain Rover models. Wynn's Climate Systems also sells its products to Chrysler Corporation, which purchases products for its Dodge vans and Jeep vehicles and for export. Wynn's Climate Systems supplies units to the General Motors Truck and Bus Division. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Other Factors Affecting the Business." Second, Wynn's Climate Systems manufactures and sells products under the trademark "Frostemp(R)" in the United States and Canada to approximately 75 active independent distributors. Sales to independent distributors decreased approximately 8% in 1993 compared to 1992 due primarily to the impact on aftermarket sales of the continuing trend of increased factory installed air conditioning systems. See "Other Factors Affecting the Business." Wynn's Climate Systems also distributes component parts and accessories purchased from other manufacturers to independent distributors. Third, Wynn's Climate Systems manufactures and sells refrigerant recovery and recycling equipment to end users and to distributors. Wynn's Climate Systems offers a line of equipment that recovers and recycles R-12 and R-134a refrigerants used in automotive air conditioning systems. Finally, Wynn's Climate Systems manufactures and distributes parts and components to OEM customers and distributors. Wynn's Climate Systems also sells "Frostemp(R)" brand air conditioning systems and products manufactured by others through five company-operated service centers which perform installation services for dealers and sell directly to retail customers. PRODUCTION The manufacturing facilities of Wynn's Climate Systems are located in Fort Worth, Texas. Air conditioning kits are assembled and produced in a 210,000 square foot facility which also serves as the corporate headquarters of Wynn's Climate Systems. In 1993, Wynn's Climate Systems consolidated three satellite manufacturing facilities into the main facility. The production facilities of Wynn's Climate Systems include an environmental test and calibration chamber used for evaluating the performance of air conditioning units. The test chamber has computer controlled environmental test conditions and data collection and can handle both front-wheel and rear-wheel drive vehicles over a variety of simulated speeds, temperatures and levels of humidity. Wynn's Climate Systems manufactures condensers and evaporator coils, injection-molded and vacuum-formed plastic parts, adapter kits, steel brackets and hose and tube assemblies. Wynn's Climate Systems uses these components in the production of its air conditioning units and sells them to outside customers. Outside vendors supply certain finished components such as accumulators, receiver/dryers and compressors. An adequate supply of these materials is available at present and is expected to continue to be available for the foreseeable future. Wynn's Climate Systems generally experienced only modest price increases for raw materials in 1993. In 1993, Wynn's Climate Systems installed a technologically advanced nitrogen brazing oven, which will be used to produce high efficiency heat exchangers. Wynn's Climate Systems also acquired in 1993 equipment to enable it to produce high quality hose assemblies in house. This equipment was purchased in connection with the efforts of Wynn's Climate Systems to enhance its production and technological capabilities. PHASE-OUT OF R-12 REFRIGERANT Most automotive air conditioning systems manufactured by Wynn's Climate Systems and others prior to 1994 utilized R-12 as a refrigerant. R-12 is a chlorofluorocarbon ("CFC") which has been linked to the destruction of ozone molecules in the Earth's upper atmosphere. Under the Montreal Protocol, CFC production in the United States is being phased out and will cease after December 31, 1995. Wynn's Climate Systems has developed air conditioning systems which use R-134a refrigerant, a hydrofluorocarbon which is a permissible alternative to CFC refrigerants. Sales of R-134a systems are expected to increase as sales of traditional CFC systems are phased out. Wynn's Climate Systems also has begun the development of retrofit kits that will permit automotive air conditioning systems designed for R-12 use to be converted to use R-134a. R-134a is not compatible with an R-12-based system without certain necessary changes. Other optional changes will enhance the performance of R-134a in an R-12-based air conditioning system. The sales volume of these retrofit kits will depend upon the future availability and price of R-12 refrigerant. PETROCHEMICAL SPECIALTIES The Petrochemical Specialties Division consists of Wynn Oil Company and its subsidiaries ("Wynn Oil"). During 1993, net sales at Wynn Oil were $98,318,000 or 34% of the Company's total net sales as compared to $99,622,000 and 34% for 1992. The operating profit of the division during 1993 was $7,046,000, or 29% of the Company's total operating profit compared with $6,636,000 and 30% for 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. See also "Other Factors Affecting the Business." PRODUCTS The principal business of Wynn Oil is the production and marketing of a wide variety of petrochemical specialty car care products under the "Wynn's(R)" and "X-Tend(R)" trademarks. Wynn Oil's car care products are designed to provide preventive or corrective maintenance for automotive engines, transmissions, differentials, engine cooling systems and other automotive mechanical parts. Wynn Oil also manufactures industrial specialty chemical products, including forging compounds, lubricants, cutting fluids and multipurpose coolants for precision metal forming and machining operations. In addition, the Company sells the GM-approved and patented "Mark X(R)" power-flush machine which, when combined with proprietary cooling system products, flushes a vehicle's engine cooling system, removes contaminants from the used antifreeze and returns the rejuvenated antifreeze to the engine cooling system. Wynn Oil also sells the new GM-approved "Du-All(TM)" bulk antifreeze recycling machine which, when combined with proprietary cooling system products, drains the used antifreeze, removes contaminants from the antifreeze and rejuvenates the antifreeze for reuse. Wynn Oil also sells its Emission Control product, a patented organic fuel combustion catalyst for spark ignition and diesel engines which helps reduce exhaust emissions and improve fuel economy. Wynn Oil also produces and markets a line of automotive appearance products under the "Classic(R)" and "Wynn's Classic(R)" trademarks. Wynn Oil is a principal U.S. automotive distributor of AirSept(TM) odor-removing chemical spray, used principally in automotive air conditioning systems. Wynn Oil also markets the Wynn's Product Warranty(R) program, which, in general, are kits containing a specially formulated line of automotive additive products, accompanied by a special product warranty. The warranty kits are sold, through distributors and automobile dealers, primarily to purchasers of used automobiles. The Wynn's Product Warranty(R) program provides reimbursement of certain parts and labor expenses and, in some instances, the costs of towing and a rental car incurred by vehicle owners who used the special products to treat their vehicles in accordance with the terms and conditions of the warranty and who experience certain types of damage which the special products were designed to help prevent. See "Other Factors Affecting the Business." DISTRIBUTION Wynn Oil's car care products are sold in the United States and in approximately 80 foreign countries. See "Foreign Operations." Wynn Oil distributes its products through a wide range of distribution channels. Domestically, Wynn Oil distributes its products through independent distributors, warehouse distributors, mass merchandisers and chain stores. The Company also uses an internal sales force and manufacturers' representative organizations in the sale and distribution of its products. Foreign sales are made principally through wholly-owned subsidiaries, which sell either through an internal sales force or to independent distributors. The Company also engages in direct export sales to independent distributors, primarily in Asia and Latin America. See "Other Factors Affecting the Business." PRODUCTION Wynn Oil has manufacturing facilities in Azusa, California; St. Niklaas, Belgium; and Arganda del Rey, Spain. Other foreign subsidiaries either purchase products directly from the manufacturing facilities in the United States or Belgium or have the products manufactured locally by outside suppliers according to Wynn Oil's specifications and formulae. Several years ago, Wynn Oil transferred some of its production requirements to its foreign subsidiaries due to the strength of the United States dollar at that time and its impact on prices to Wynn Oil's foreign customers. With fluctuating foreign currency rates, Wynn Oil periodically reviews its production and sourcing locations. Wynn Oil utilizes a large number of chemicals in the production of its various petrochemical specialty products. Primary raw materials necessary for the production of these products, as well as the finished products, generally have been available from several sources. An adequate supply of materials was available in 1993 and is expected to continue to be available for the foreseeable future. BUILDERS HARDWARE The Builders Hardware Division consists of Robert Skeels & Company ("Skeels"), a wholesale distributor of builders hardware products, including locksets and locksmith supplies. During 1993, Skeels' net sales were $5,161,000 or 2% of the Company's total net sales as compared with $6,219,000 and 2% for 1992. The operating profit of this division during 1993 was $193,000, or 1% of the Company's total operating profit compared with $422,000 and 2% for 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. Skeels' main facility is located in Compton, California. In addition, Skeels also has leased satellite facilities located in Fullerton and Los Angeles, California. Skeels supplies approximately 35,000 items to retail hardware, locksmith and lumberyard outlets in southern California, Arizona, and Nevada. Skeels also sells directly to school districts, municipalities, industrial firms and building contractors. Skeels has been a distributor of Schlage lock products since 1931. Skeels also distributes other well-known brands such as Lawrence, Kwikset and Master. All of Skeels' distributorship arrangements generally are cancelable by the manufacturers without cause. Most of Skeels' sales are derived from replacement items used by industry, institutions and in-home remodeling and repair. OTHER FACTORS AFFECTING THE BUSINESS COMPETITION All phases of the Company's business have been and remain highly competitive. The Company's products and services compete with those of numerous companies, some of which have financial resources greater than those of the Company. Sales by the Automotive Parts and Accessories Division are in part related to the sales of vehicles by its OEM customers. Precision has a large number of competitors in the market for static and dynamic sealing products, some of which competitors are substantially larger than Precision. The markets in which Precision competes are also sensitive to changes in price. Requests for price reductions are not uncommon. Precision attempts to work with its customers to identify ways to lower costs and prices. Precision focuses on high technology, high quality sealing devices and has made significant investments in advanced equipment and other means to raise productivity. Precision's major focus is to be the low cost producer of superior quality products within its industry. Precision believes it must expand into additional areas of sealing technology in order to continue to be an effective competitor. In 1993, Precision invested approximately $4.4 million in new equipment and facilities to improve overall performance to its customers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Historically, the largest part of Wynn's Climate Systems' sales have been to OEM customers. Following the opening of its Flat Rock, Michigan facility, Mazda has gradually taken over production of its requirements for air conditioning kits in the United States. Sales to Mazda decreased approximately 28% in 1993 compared to 1992 due to the phase-out of the air conditioning supply agreement for light trucks and a decline in sales by Mazda of its 323 cars. The Company anticipates that commencing in the third quarter of 1994, Wynn's Climate Systems will no longer furnish 323 kits to Mazda, as Mazda has elected to assemble these kits at its Flat Rock, Michigan facility. Sales of kits for Mazda 323 cars were approximately $29.9 million in 1993. In 1993, Wynn's Climate Systems' sales to the Rover Group in the U.K were approximately $14.5 million, of which approximately $12.8 million was for units for the Range Rover and Discovery vehicles, pursuant to a supply agreement in effect through the end of model year 1993. In 1994, this customer began purchasing air conditioning systems for these vehicles from a foreign competitor of Wynn's Climate Systems. Although the expiration of this supply agreement is not expected to have a material adverse effect on the Company's consolidated results of operation in 1994, it is expected to cause a decline in the operating profit of Wynn's Climate Systems in 1994. Over time there has been a gradual increase in the number of air conditioning systems installed on the factory line. An increase in the number of factory-installed units reduces the size of the market for aftermarket sales. See "Wynn's Climate Systems, Inc." Competition with respect to the Company's petrochemical specialty products consists principally of other automotive aftermarket chemical and industrial fluid companies. Some major oil companies also market their own additive products through retail service stations, independent dealers and garages. Certain national retailers market private label brands of petrochemical specialty products. The Company's "Mark X(R)" power flush system and "Du-All(TM)" antifreeze recycling equipment and chemicals compete against other antifreeze recycling processes, some of which also have been approved by General Motors. The principal methods of competition vary by geographic locale and by the relative market share held by the Company compared to other competitors. Skeels continues to face intense price competition from numerous cash-and-carry discount retailers. Skeels also has observed some manufacturers selling directly to retailers to increase volume. Skeels' revenues declined 17% in 1993 compared to 1992 in part due to this competition. KEY CUSTOMERS Sales to Mazda constituted 42% of the total net sales of Wynn's Climate Systems and 12.3% of the total net sales of the Company in 1993. As noted above, sales to Mazda related to kits for the 323 model are expected to continue until the third quarter of 1994, when Mazda will take over production of kits for the 1995 model 323 automobile. Due to the previous actions taken by the Company to restructure the business of Wynn's Climate Systems and the relatively low margins associated with the Mazda business, the loss of Mazda as a key customer of the Company is not expected to have a material adverse effect on the consolidated results of operations of the Company. See "Wynn's Climate Systems, Inc." and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Sales to General Motors constituted approximately 9.2% of the total net sales of the Company in 1993. GOVERNMENT REGULATIONS The number of governmental rules and regulations affecting the Company's business and products continues to increase. Wynn Oil markets the Wynn's Product Warranty(R) program in approximately thirty-five states and two foreign countries. Questions have been raised by certain state insurance regulators as to whether the product warranty that accompanies the kit is in the nature of insurance. Wynn Oil attempts to resolve these questions to the satisfaction of each state insurance regulator. At times, it has elected to withdraw the Wynn's Product Warranty(R) from certain states. No assurance can be given that governmental regulations will not significantly affect the marketing of the Wynn's Product Warranty(R) in the United States or other countries in the future. ENVIRONMENTAL MATTERS The Company has used various substances in its past and present manufacturing operations which have been or may be deemed to be hazardous, and the extent of its potential liability, if any, under environmental statutes, rules, regulations and case law is unclear. Under the Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), a responsible party may be jointly liable for the entire cost of remediating contaminated property even if it contributed only a small portion of the total contamination. The nature of environmental investigation and cleanup activities creates difficulties in determining the impact of such activities on the Company's financial position. The effect of resolution of environmental matters on results of operation cannot be predicted due to the uncertainty concerning both the amount and timing of future expenditures and future results of operations. See Note 12 of "Notes to Consolidated Financial Statements" on page 28 of the 1993 Annual Report, which is hereby incorporated by reference. All potentially significant environmental matters presently known to the Company are described below. In January 1984, Wynn Oil received a letter from the United States Environmental Protection Agency (the "EPA") regarding an investigation of groundwater contamination in the San Gabriel Valley, California. The letter from the EPA requested Wynn Oil to furnish certain information relating to its manufacturing facility in Azusa, California (the "Azusa Facility"). Wynn Oil complied with the request. In March 1988, Wynn Oil received a letter from the EPA requesting additional information with respect to its Azusa Facility. Wynn Oil submitted its response at the end of May 1988. In July 1990, Wynn Oil received a general notice letter from the EPA stating that it may be a potentially responsible party ("PRP") with respect to the Azusa/Irwindale Study Area in the San Gabriel Valley, California Superfund Sites (the "AISA"). The EPA letter included an information request pursuant to Section 104(e) of CERCLA. The EPA letter stated that the EPA contemplated using the Special Notice procedures of Section 122(e) of CERCLA to formally negotiate the terms of a consent agreement with PRPs to conduct a Remedial Investigation/Feasibility Study for the AISA. Wynn Oil Company responded to the EPA information request within the specified time period. In September 1990, Wynn Oil received a letter from the EPA stating that it did not expect to send a Special Notice letter to Wynn Oil for the AISA, but that it still considered Wynn Oil, as well as a large number of other companies, to be PRPs for basinwide groundwater activities in the San Gabriel Valley. In May 1993, the EPA made available for public comment its Operable Unit Feasibility Study for the Baldwin Park Operable Unit ("BPOU") of the San Gabriel Valley Superfund Sites. The Azusa Facility is located within the BPOU. In its Operable Unit Feasibility Study for the BPOU, the EPA has proposed construction of extraction and treatment facilities with an estimated initial capital cost of $47 million and estimated annual operating and maintenance costs of $4 to $5 million. Wynn Oil has been cooperating with other companies located in the BPOU, as well as state and local government and water supply officials, who are working to develop a substantially less costly alternative which would accomplish the desired remedial goals. In March 1988, a representative of the Los Angeles County Department of Health Services (the "LADHS") inspected the Azusa Facility and observed oil-stained surface soils. Based on these observations, LADHS directed Wynn Oil to conduct a site assessment and implement remedial measures if contaminated soils were identified. In February 1989, Wynn Oil received a Subsurface Investigation Report from the consulting firm retained by Wynn Oil to perform the site assessment and submitted the report to the LADHS. In April 1989, regulatory jurisdiction over this matter was transferred from the LADHS to the California Regional Water Quality Control Board-Los Angeles Region (the "RWQCB"). Since October 1989, Wynn Oil and its consultants have been working with representatives of the RWQCB to conduct a comprehensive site assessment of the Azusa Facility. In January 1992, at the request of the EPA and the RWQCB, Wynn Oil agreed to expand the scope of its investigation of the Azusa Facility to include three soil gas monitoring wells and one groundwater monitoring well. The monitoring wells were installed in 1992, and the results of ongoing sampling have been reported to the RWQCB. In the summer of 1993, RWQCB requested Wynn Oil to install an upgradient groundwater monitoring well at the Azusa Facility. The RWQCB subsequently requested two other companies located upgradient of Wynn Oil to install downgradient soil gas and groundwater monitoring wells. Wynn Oil and one of these companies have entered into an agreement to share the cost of one groundwater and one soil gas monitoring well which will operate as an upgradient monitoring well for Wynn Oil and a downgradient monitoring well for the other company. In May 1989, Wynn's Climate Systems received notice that it had been identified as a generator of hazardous waste that had been shipped to the Chemical Recycling, Inc. ("CRI") site in Wylie, Texas (the "CRI Site") for treatment. CRI was engaged in the business of recycling and reclaiming spent solvents and other hazardous wastes at the CRI Site until it ceased operations in February 1989. Wynn's Climate Systems is one of approximately 100 hazardous waste generators who have been identified as potentially responsible parties for the CRI Site. A PRP Steering Committee (the "Committee") was formed to negotiate with the EPA on behalf of its members an agreement to take remedial measures voluntarily at the CRI Site. As of March 15, 1994, approximately 88 PRPs, including Wynn's Climate Systems, have agreed to participate in the Committee for the CRI Site. PRPs who have agreed to participate in the Committee have signed Consent Agreements with the EPA with respect to the CRI Site. Remediation efforts have begun at the CRI Site under the guidance of the Committee. As of March 15, 1994, Wynn's Climate Systems' proportionate share of the total volume of waste contributed to the CRI Site by Committee members was less than one percent (1%). In January 1991, Wynn's Climate Systems received a letter from the Texas Water Commission (the "TWC") that soil adjacent to one of its leased manufacturing facilities was contaminated with hazardous substances. The TWC directed Wynn's Climate Systems to determine the extent of such contamination and then take appropriate remedial measures. Wynn's Climate Systems retained environmental consultants to conduct soil sampling and otherwise comply with the directive of the TWC. Performance of this work was completed in late 1991. Wynn's Climate Systems submitted a copy of the report of its consultants to the TWC in January 1992. In 1994, Wynn's Climate Systems received a letter from the TWC requesting additional information. Wynn's Climate Systems is cooperating with the requests of the TWC. In January 1990, Precision received a letter from the EPA regarding the Saad Site in Nashville, Tennessee. The owner of the Saad Site engaged in reclamation and recycling activities at the Site, which resulted in soil and groundwater contamination. The letter stated that Precision may be a PRP for the Saad Site. The EPA subsequently requested Precision to furnish information about its involvement with the Saad Site. Precision has provided the information requested. Precision's records indicated that a predecessor entity sent wastes to the Saad Site in the mid-1970s. Based on that information, Precision joined the Saad Site Steering Committee as a Limited Member. In February 1992, the Company received a letter stating that the Allocation Committee had concluded that Precision should become a Full Member of the Steering Committee and thus share proportionately in the liability for the cleanup. Precision responded by letter that there was no legal basis to hold it responsible for the activities of the predecessor entity. As of March 15, 1994, the Allocation Committee has not responded to Precision's letter. In 1992, Precision identified an area at its Lebanon, Tennessee facility which contained oil stained soils. Precision retained outside environmental consultants to investigate the nature and extent of the contamination. The remedial investigation is underway and Precision intends to take any necessary remedial actions. In March 1992, an inactive subsidiary of the Company received a letter from the then lessee ("Lessee") of a parcel of real property in Compton, California formerly leased by this subsidiary. The letter stated that the Lessee had discovered soil contamination at the site and asserted that the Company's subsidiary may be liable for the cost of cleanup. The letter stated that the Lessee was investigating the nature and extent of the soil contamination. In July 1993, the Company received a letter from the owner of the real property stating that the owner had asserted a claim against the Lessee to pay the cost of remediation and that the owner may assert a claim against the Company. The Company has determined that the Lessee has filed for voluntary reorganization under the federal bankruptcy laws. The Company does not know the extent of the contamination or the estimated cost of cleanup at this site. FOREIGN CURRENCY FLUCTUATIONS In 1993, the United States dollar generally appreciated in value compared to 1992 in the currencies of most countries in which the Company does business. This appreciation caused sales and operating profit to be lower than what would have been reported if exchange rates had remained constant during 1993. In 1993, the Equity Adjustment from Foreign Currency Translation account on the Consolidated Balance Sheet declined by $2.1 million, which caused a corresponding reduction in Total Stockholders' Equity. See "Foreign Operations." PATENTS, TRADEMARKS AND LICENSE AGREEMENTS The Company holds a number of patents and trademarks which are used in the operation of its businesses. There is no known challenge to the Company's rights under any material patents or material trademarks. In 1989, Wynn Oil filed a lawsuit in the federal district court in Detroit, Michigan against another company and its principal stockholder for infringement of Wynn Oil's X- Tend(R) trademark. In February 1994, the court awarded Wynn Oil $2.0 million in damages. The court also indicated it would award prejudgment interest and attorneys' fees to Wynn Oil. Following the entry of a final judgment, the defendants are expected to appeal the trial court's decision. See "Legal Proceedings." SEASONALITY OF THE BUSINESS Although sales at the Company's divisions are somewhat seasonal, the consolidated results of operations generally do not reflect seasonality. RESEARCH AND DEVELOPMENT Wynn Oil maintains research and product performance centers in Azusa, California; St. Niklaas, Belgium; Paris, France; and Edenvale, South Africa. The main activities of the research staff are the development of new specialty chemicals and other products, improvement of existing products, including finding new applications for their use, evaluation of competitive products and performance of quality control procedures. Precision maintains research and engineering facilities in Lebanon, Tennessee; Lynchburg, Virginia; and Orillia, Ontario, Canada. Research and development is an important aspect of Precision's business as Precision has developed and continues to develop numerous specialized compounds to meet the specific needs of its various customers. Precision also has technical centers at its Lebanon, Tennessee, Lynchburg, Virginia, and Orillia, Ontario, Canada facilities to construct prototype products and to perform comprehensive testing of materials and products. Precision maintains extensive research, development and engineering facilities to provide outstanding service to its customers. FOREIGN OPERATIONS The following table shows sales to foreign customers for 1993, 1992 and 1991: Consolidated operating results are reported in United States dollars. Because the Company's foreign subsidiaries conduct operations in the currencies of the countries in which they are based, all financial statements of the foreign subsidiaries must be translated into United States dollars. As the value of the United States dollar increases or decreases relative to these foreign currencies, the United States dollar value of items on the financial statements of the foreign subsidiaries is reduced or increased, respectively. Therefore, changes in dollar sales of the foreign subsidiaries from year to year are not necessarily indicative of changes in actual sales recorded in local currency. See Note 4 and Note 15 of "Notes to Consolidated Financial Statements" on pages 25 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. The value of any foreign currency relative to the United States dollar is affected by a variety of factors. It is exceedingly difficult to predict what such value may be at any time in the future. Consequently, the ability of the Company to control the impact of foreign currency fluctuations is limited. A material portion of the Company's business is conducted outside the United States. Therefore, the Company's ability to continue such operations or maintain their profitability is to some extent subject to control and regulation by the United States government and foreign governments. EMPLOYEES At December 31, 1993, the Company had 1,978 employees. A majority of the production and maintenance employees at the Lebanon, Tennessee plant of Precision are represented by a local lodge of the International Association of Machinists and Aerospace Workers. The collective bargaining agreement for this facility will expire in April 1995. The production and maintenance employees at the Orillia, Ontario, Canada plant of Precision are represented by a local unit of the United Rubber, Cork, Linoleum and Plastic Workers of America. The collective bargaining agreement for the unit will expire in February 1997. A majority of the production and maintenance employees at the Lynchburg, Virginia plant of Dynamic Seals, Inc., an affiliate of Precision, are represented by a local of the International Chemical Workers Union. The collective bargaining agreement for this facility expires in February 1996. The Company considers its relations with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company, who are appointed annually, are as follows: The principal occupations of Mr. Carroll and Mr. Gibbons for the past five years have been their current respective positions with the Company. Prior to his employment with the Company in July 1989, Mr. Schlosser was Vice President-Finance of EECO Incorporated (electronic components) from August 1987 to June 1989 and Controller of Baker Hughes Incorporated and its predecessor, Baker International Corporation (oil field services and process technologies) from July 1984 to August 1987. There is no arrangement or understanding between any executive officer and any other person pursuant to which he was selected as an officer. There is no family relationship between any executive officers of the Company. ITEM 2. ITEM 2. PROPERTIES The following is a summary description of the Company's facilities, all of which the Company believes to be of adequate construction: The Company believes that all of its operating properties are adequately maintained, fully utilized and suitable for the purposes for which they are used. With respect to those leases expiring in 1994 and 1995, the Company believes it will be able to renew such leases on acceptable terms or find suitable, alternative facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Various claims and actions, considered normal to Registrant's business, have been asserted and are pending against Registrant and its subsidiaries. Registrant believes that such claims and actions should not have any material adverse effect upon the results of operations or the financial position of Registrant based on information presently known to Registrant. In February 1994, the United States District Court for the Eastern District of Michigan, Southern Division, in the case of Wynn Oil Company v. American Way Service Corporation and Thomas A. Warmus, Case No. 89-CV-71777-DT, awarded Wynn Oil the sum of $2,023,645 in damages in an action brought by Wynn Oil in 1989 asserting trademark infringement by the defendants. The trial court also indicated that it would award prejudgment interest and attorneys' fees to Wynn Oil upon application to the court. Wynn Oil is seeking prejudgment interest and attorneys' fees in an aggregate amount of between approximately $1.2 million and $1.5 million. Following the entry of a final judgment by the trial court, the defendants are expected to appeal the trial court's decision to the United States Court of Appeals for the Sixth Circuit. No portion of this judgment has been included in the results of operations of the Company and all of Registrant's costs relating to this case have been expensed as incurred. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information appearing under "Common Stock Price and Cash Dividends Per Share: 1993-1992" on page 13 of the 1993 Annual Report and "Number of Stockholders" and "Stock Exchange Listing" on page 33 of the 1993 Annual Report is hereby incorporated by reference. On February 7, 1994, the Board of Directors of Registrant declared a cash dividend of $0.11 per share payable March 31, 1994 to stockholders of record on March 14, 1994. Under a long-term loan agreement with an insurance company, Registrant's ability to pay dividends may be restricted under certain circumstances. At the present time, Registrant believes that these restrictions will not have an impact on the declaration of future dividends. It is expected that Registrant will continue to pay dividends in the future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from page 13 of the 1993 Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from the 1993 Annual Report, pages 14 through 17. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated financial statements of Registrant at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 (including unaudited supplementary data) and the report of independent auditors thereon are incorporated by reference from the 1993 Annual Report, pages 13 and 18 through 32. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing under "Election of Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on pages 4, 5 and 21 of Registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 11, 1994 ("Registrant's 1994 Proxy Statement") is hereby incorporated by reference. A list of executive officers of Registrant is provided in Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under "Compensation of Directors," "Compensation Committee Interlocks and Insider Participation" and "Executive Compensation" on pages 6 through 10 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. The Report of the Compensation Committee on pages 10 through 12 of Registrant's 1994 Proxy Statement shall not be deemed to be incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under "Security Ownership of Certain Beneficial Owners and Management" on pages 2 through 4 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under "Certain Relationships and Related Transactions" on page 21 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. See Index to Financial Statements and Financial Statement Schedules Covered By Report of Independent Auditors. 2. See Index to Financial Statements and Financial Statement Schedules Covered By Report of Independent Auditors. 3. See Index to Exhibits. (b) No Reports on Form 8-K were filed by Registrant during the last quarter of 1993. WYNN'S INTERNATIONAL, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. The consolidated financial statements listed in the above index, which are included in the 1993 Annual Report, are hereby incorporated by reference. With the exceptions of the pages listed in the above index and the items referred to in Items 1, 5, 6, 7 and 8, the 1993 Annual Report is not deemed to be filed as part of this report. WYNN'S INTERNATIONAL, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 ____________________ (1) Represents accounts written off against the reserve. WYNN'S INTERNATIONAL, INC. SCHEDULE IX - SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 Notes payable represent obligations payable under several credit agreements to various banks. Borrowings are arranged on an as-needed basis at various terms and at the banks' most advantageous prevailing rates (see Note 7 of "Notes to Consolidated Financial Statements" on page 26 of the 1993 Annual Report). The average amount outstanding during the year was computed by averaging the month-end balances during the year. The weighted average interest rate was computed by dividing interest expense by the average amount outstanding. In 1993, the majority of the average outstanding borrowings were incurred by foreign subsidiaries in countries with interest rates above prevailing rates in the United States. WYNN'S INTERNATIONAL, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 All other information has been omitted since the required information is not present in amounts sufficient to require inclusion in this schedule or because the information required is included in the consolidated financial statements, including the notes thereto. POWER OF ATTORNEY Each person whose signature appears below hereby authorizes each of James Carroll, Seymour A. Schlosser and Gregg M. Gibbons as attorney-in-fact to sign on his behalf, individually and in each capacity stated below, and to file all amendments and/or supplements to this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 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, on March 25, 1994. WYNN'S INTERNATIONAL, INC. By JAMES CARROLL ------------------------------------ James Carroll President Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date ---- March 25, 1994 By WESLEY E. BELLWOOD ------------------------------------ Wesley E. Bellwood Chairman of the Board March 25, 1994 By JAMES CARROLL ------------------------------------ James Carroll President Chief Executive Officer Director Date ---- March 25, 1994 By SEYMOUR A. SCHLOSSER ---------------------------------- Seymour A. Schlosser Vice President-Finance (Principal Financial and Accounting Officer) March 25, 1994 By BARTON BEEK ---------------------------------- Barton Beek Director March 25, 1994 By JOHN D. BORIE ---------------------------------- John D. Borie Director March 25, 1994 By BRYAN L. HERRMANN ---------------------------------- Bryan L. Herrmann Director March 25, 1994 By ROBERT H. HOOD, JR. ---------------------------------- Robert H. Hood, Jr. Director March 25, 1994 By RICHARD L. NELSON ---------------------------------- Richard L. Nelson Director March 25, 1994 By JAMES D. WOODS ---------------------------------- James D. Woods Director WYNN'S INTERNATIONAL, INC. INDEX TO EXHIBITS (Item 14(a))	7,490	50,539
728586_1993.txt	728586_1993	1993	728586	ITEM 1. BUSINESS GENERAL As used herein, "LBI" or the "Registrant" means Lehman Brothers Inc., a Delaware corporation incorporated on January 21, 1965. LBI and its subsidiaries are collectively referred to as "Lehman Brothers" or the "Company." LBI is a wholly owned subsidiary of Lehman Brothers Holdings Inc., a Delaware corporation, which (together with its subsidiaries, where appropriate) is referred to herein as "Holdings." American Express Company, a New York corporation ("American Express") owns 100 percent of the outstanding common stock of Holdings, par value $.10 per share (the "Holdings Common Stock"), which represents approximately 93% of Holdings' issued and outstanding voting stock. The remainder of Holdings' voting stock, the 5% Cumulative Convertible Voting Preferred Stock, Series A (the "Series A Preferred Stock") is owned by Nippon Life Insurance Company ("Nippon Life"). Assuming the exercise by Nippon Life of a warrant to purchase shares of Holdings Common Stock (the "Warrant"), American Express' ownership percentage of Holdings' voting stock would be 88 percent. The Company is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. The Company's executive offices are located at 3 World Financial Center, New York, New York 10285 and its telephone number is (212) 298-2000. Distribution of Holdings Common Stock On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all of Holdings Common Stock (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Change of Fiscal Year On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. The Primerica Transaction On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of its domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation) ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participation Right payment in the first quarter of 1994. It is anticipated that all of the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, LBI received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39.00 per share. In August 1993, American Express purchased such preferred stock and warrant from LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. The Mellon Transaction On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between LBI and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction"), The Boston Company, Inc. ("The Boston Company") which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50.00 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs for the Mellon Transaction and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million. Shearson Lehman Hutton Mortgage Corporation Transaction LBI completed the sale of its wholly owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC"), to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire indebtedness of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. The Company's worldwide headquarters in New York are complemented by offices in 19 additional locations in the United States, 11 in Europe and the Middle East, four in Latin and South America and three in the Asia Pacific region. Lehman Brothers also operates a commodities trading and sales operation in London. Holdings provides investment banking and capital markets services in Europe and Asia. The Company is engaged primarily in providing financial services. Other businesses in which the Company is engaged represent less than 10 percent of consolidated assets, revenues or pre-tax income. The Company's business includes capital raising for clients through securities underwriting and direct placements; corporate finance and strategic advisory services; merchant banking; securities sales and trading; asset management; research; and the trading of foreign exchange, derivative products and certain commodities. The Company acts as a market maker in all major equity and fixed income products in both the domestic and certain international markets. Lehman Brothers is a member of all principal securities and commodities exchanges in the United States, as well as the National Association of Securities Dealers, Inc. ("NASD"). Holdings holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt and Milan stock exchanges. Since 1990, Lehman Brothers has followed a "client/customer-driven" strategy. Under this strategy, Lehman Brothers concentrates on serving the needs of major issuing and advisory clients and investing customers worldwide to build an increasing "flow" of business that leverages the Company's capabilities and generates a majority of the Company's revenues and profits. Developing lead relationships with issuing clients and investing customers is a central premise of the Company's client/customer-driven strategy. Based on management's belief that each client and customer directs a majority of its financial transactions to a limited number of investment banks, Lehman Brothers' investment banking and sales professionals work together with global products and services professionals to identify and develop lead relationships with priority clients and customers worldwide. The Company believes that such relationships position Lehman Brothers to receive a substantial portion of its clients' and customers' financial business and lessen the volatility of revenues generally associated with the securities industry. Holdings' strategy, of which Lehman Brothers is an integral part, consists of the following four key elements: (1) Focused coverage of major issuing clients and institutional and high net worth individual investing customers. The Company's Investment Banking and Sales areas develop and maintain relationships with clients and customers to understand and meet their financial needs. Business volume generated through these relationships accounts for the majority of Lehman Brothers' business. (2) Comprehensive product and service capabilities. Lehman Brothers has built capabilities in major product and service categories to enable the Company to develop lead relationships with its clients and customers, meet their diverse needs and increase the Company's overall volume of business. Each of these product and service capabilities is provided to clients and customers by Investment Banking and Sales. (3) Global scope of business activities. Lehman Brothers pursues a global strategy in order to: (i) enhance the Company's product and service capabilities; (ii) position the Company to increase its flow of business as the international markets continue to expand; (iii) leverage the Company's infrastructure to benefit from economies of scale; and (iv) geographically diversify the Company's revenues. (4) Organizational structure that enables and encourages the Company's business units to act in a coordinated fashion as "One Firm." The Company is organized to provide the delivery of products and services through teams comprised of professionals with specialized expertise focused on meeting the financial objectives of the Company's clients and customers. Lehman Brothers also engages in activities such as arbitrage and proprietary trading that leverage the Company's expertise and infrastructure and provide attractive profit opportunities, but generally entail a higher degree of risk as the Company makes investments for its own account. FOCUSED CLIENT AND CUSTOMER COVERAGE Investment Banking Lehman Brothers is a leading underwriter of equity and equity-related securities in the equity capital markets and of taxable and tax-exempt fixed income securities denominated in U.S. dollars. The Company also engages in project and real estate financings around the world. According to Securities Data Company, Inc., Lehman Brothers was the third ranked underwriter of debt and equity securities in the United States in 1993. During 1993, Lehman Brothers lead managed 667 offerings of debt and equity securities in the United States with a total volume of $114.9 billion. Investment Banking professionals are responsible for developing and maintaining relationships with issuing clients, gaining a thorough understanding of their specific needs and bringing together the full resources of Lehman Brothers and Holdings to accomplish their financial objectives. Investment Banking is organized into industry and geographic coverage groups, enabling individual bankers to develop specific expertise in particular industries and markets. Industry coverage groups include consumer products, financial institutions, health care, industrial, media, merchandising, natural resources, real estate, technology, telecommunications, transportation and utilities. Where appropriate, professionals with specialized expertise in Strategic Advisory, Equities, Fixed Income, Foreign Exchange, Commodities, Derivatives and Project Finance are integrated into the client coverage teams. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, divestitures, leveraged transactions, takeover defenses, spin-offs, corporate reorganizations and recapitalizations, tender and exchange offers, privatizations, opinion letters and valuations. The Company's Strategic Advisory Group works closely with industry and geographic coverage investment bankers and product specialists around the world. As mergers and acquisitions activity has become increasingly global, Lehman Brothers has maintained its position as a leader in cross-border transactions. In 1993, Lehman Brothers was ranked third in terms of mergers and acquisitions transactions in the United States according to Securities Data Company, Inc. In 1993, the Company advised clients in the United States on transactions totaling $20.8 billion. Institutional Sales Institutional Sales serves the investing and liquidity needs of major institutional investors worldwide and provides the distribution mechanism for new issues and secondary market securities. Lehman Brothers maintains a network of sales professionals around the world. Institutional Sales focuses on the major institutional investors that constitute the major share of global buying power in the financial markets. Lehman Brothers' goal is to be considered one of the top three investment banks by such institutional investors. By serving the needs of these customers, the Company also gains insight into investor sentiment worldwide regarding new issues and secondary products and markets, which in turn benefits the Company's issuing clients. Institutional Sales is organized into four distinct sales forces specialized by the following product types: Equities, Fixed Income, Foreign Exchange/Commodities and Asset Management. Institutional Sales professionals work together to coordinate coverage of major institutional investors through customer teams. Depending on the size and investment objectives of the institutional investor, a customer team can be comprised of from two to five sales professionals, each specializing in a specific product. This approach positions Lehman Brothers to understand and to deliver the full resources of the Company to its customer base. High Net Worth and Middle Market Sales The Company's Financial Services Division serves the investment needs of high net worth individual investors and small and mid-sized institutions. This division has one of the largest sales forces of its kind among major investment banks, with over 500 investment representatives located in seven offices in the major financial centers of the United States and offices in major financial centers worldwide. The Company's investment representatives provide investing customers with ready access to Lehman Brothers' equity and fixed income research, execution capabilities and global product offerings. The Financial Services Division also enables the Company's issuing clients to access a diverse investor base throughout the world. The global network of investment representatives is supported by the Investor Services Group located in New York, London and Hong Kong. This group provides an integrated, global approach to transaction execution, marketing support, asset allocation strategies, and product development. The Investor Services Group also works closely with Lehman Brothers Global Asset Management to develop proprietary product offerings for investing customers. Through Lehman Brothers Bank (Switzerland) S.A. (the "Bank"), an affiliate of LBI, the Financial Services Division provides high net worth investors the traditional personalized services of a Swiss bank, combined with the global resources of a leading securities company. The Bank's services include deposit facilities, international investment products, multi-currency secured lending and global custodial services. COMPREHENSIVE PRODUCT AND SERVICE CAPABILITIES Lehman Brothers provides equity, fixed income, foreign exchange, commodities, asset management and merchant banking products and services to clients and customers. Each area is organized to meet more effectively the needs of clients and customers, and professionals are integrated into teams, supported by a dedicated administrative and operations staff, to provide the highest quality products and services. Equities Lehman Brothers combines professionals from the sales, trading, financing, derivatives and research areas of Equities, together with investment bankers, into teams to serve the financial needs of the Company's equity clients and customers. The integrated nature of the Company's operations and the equity expertise delivered through the Company's client and customer teams enable Lehman Brothers to structure and execute global equity transactions for clients worldwide. The Company is a leading underwriter of initial public and secondary offerings of equity and equity-related securities. Lehman Brothers also makes markets in these and other securities, and executes block trades on behalf of clients and customers. The Company also actively participates in assisting governments around the world in raising equity capital as part of their privatization programs. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed equity and equity-related securities offerings in the United States in 1993. During 1993, the Company lead managed 87 equity offerings in the United States totaling $8.6 billion. The Equities product group is responsible for the Company's equity operations and dollar and non-dollar equity and equity-related products. These products include listed and over-the-counter ("OTC") securities, American Depository Receipts, convertibles, options, warrants and derivatives. During 1993, Lehman Brothers made markets in the top 300 NASDAQ stocks as measured by volume. The Company also makes markets in major European large capitalization stocks. In addition, the Company's convertible securities trading professionals make markets in convertible debenture issues and convertible preferred stock issues. Derivative Products. Lehman Brothers, in conjunction with its affiliates, offers equity derivative capabilities across a wide spectrum of products and currencies, including listed options and futures, portfolio trading and similar products. In 1993, Lehman Brothers developed and marketed several innovative products designed to help investors establish or hedge positions in global markets and currencies. These included products such as certain call and put warrants that use major stock indices as a benchmark. In addition, Lehman Brothers lead managed the largest ever stand-alone U.S. corporate warrant issue in 1993. Equities Research. The Equities research department is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Equities research is to have in place high quality research analysts covering industry and geographic sectors that support the activities of the Company's clients and customers. The Equities research department is comprised of regional teams staffed by industry specialists, covering industry sectors and companies worldwide. During 1993, the Company expanded its global economics coverage and technical market analysis capabilities. Equity Finance. Lehman Brothers operates a comprehensive equity finance business to support the funding, sales and trading activities of the Company and its clients and customers. Margin lending for the purchase of equities and equity derivatives, securities lending and short sale facilitation are among the main functions of the equity finance group. This group also engages in a conduit business, whereby the Company seeks to earn a positive net spread on matched security borrowing and lending activities. Fixed Income Lehman Brothers actively participates in all major fixed income product areas. The Company combines professionals from the sales, trading, financing, derivatives and research areas of Fixed Income, together with investment bankers, into teams to serve the financial needs of the Company's clients and customers. The Company is a leading underwriter of new issues, and also makes markets in these and other fixed income securities. The Company's global presence facilitates client and customer transactions and provides liquidity in marketable fixed and floating rate debt securities. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed fixed income securities offerings in the United States in 1993. During 1993, the Company lead managed 580 offerings in the United States for a total of $106.3 billion of fixed income securities. Fixed Income products consist of government, sovereign and supranational agency obligations; money market products; corporate debt securities; mortgage and asset-backed securities; emerging market securities; municipal and tax-exempt securities; derivative products and research. In addition, the Company's central funding operation provides access to cost efficient debt financing sources, including repurchase agreements, for the Company and its clients and customers. Government and Agency Obligations. Lehman Brothers is one of the leading 39 primary dealers in U.S. Government securities, as designated by the Federal Reserve Bank of New York, and participates in the underwriting of, and maintains positions in, U.S. Treasury bills, notes and bonds, and securities of federal agencies. Money Market Products. Lehman Brothers is a global market leader in the origination and distribution of short-term debt obligations, including commercial paper, short-term notes, preferred stock and Money Market Preferred Stock(R). The Company is an appointed dealer for approximately 480 commercial paper programs on behalf of companies and government agencies. Corporate Debt Securities. Lehman Brothers is a leader in the underwriting and market making of fixed and floating dollar investment grade debt and trades approximately $1.5 billion of these securities on a daily basis. According to Securities Data Company, Inc., during 1993, Lehman Brothers ranked third in new issue domestic investment grade debt. The Company also underwrites and makes markets in non-investment grade debt securities and bank loans. Lehman Brothers trades in excess of $2.0 billion of high yield securities on a monthly basis. Mortgage and Asset-Backed Securities. The Company is a leading underwriter of and market maker in mortgage and asset-backed securities. The Company's trading activity in the secondary mortgage market exceeds $3.0 billion on a daily basis. Municipal and Tax-Exempt Securities. Lehman Brothers is a leading dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities, and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds. Lehman Brothers is also a leader in the structuring, underwriting and sale of tax-exempt and taxable securities and derivative products for city, state, not-for-profit and other public sector clients. The Company's Public Finance group advises state and local governments on the issuance of municipal securities, and works closely with the municipal sales and trading area to underwrite both negotiated and competitive short-and long-term offerings. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed municipal securities offerings in 1993 with a total volume of $29.3 billion. Derivative Products. The Company offers a broad range of derivative product services. Derivatives professionals are integrated into all of the Company's major fixed income product areas. In 1993, Lehman Brothers assisted over 1,000 clients and customers worldwide, in the execution of over 3,900 transactions aggregating approximately $265 billion (notional amount). In 1993, the Company introduced several new derivative products to meet the needs of both issuers and investors, including Step-Up Recovery Floating Rate Notes and Range Floaters. These innovative products are designed to offer issuers and investors the opportunity to diversify their investment and liability portfolios. In late 1993, Lehman Brothers incorporated Lehman Brothers Financial Products Inc. ("LBFP"), a separately capitalized triple-A rated derivatives subsidiary. Lehman Brothers established LBFP to increase the volume of its derivatives business and capture additional underwriting and trading business. It is expected that LBFP will commence its derivatives activities in the third quarter of 1994. Central Funding. The central funding unit engages in two major activities, matched book funding and secured financing. Matched book funding involves lending cash on a short-term basis to institutional customers collateralized by marketable securities, typically government or government agency securities. These arrangements are classified on the Company's balance sheet as "securities purchased under agreements to resell." The Company may also enter into short-term contractual agreements, referred to as "securities sold under agreements to repurchase," whereby securities are pledged as collateral in exchange for cash. The Company enters into these agreements in various currencies and seeks to generate profits from the difference between interest earned and interest paid. Central funding works with the Company's institutional sales force to identify customers that have cash to invest and/or securities to pledge to meet the financing and investment objectives of the Company and its customers. Central funding also coordinates with the Company's treasury area to provide collateralized financing for a large portion of the Company's securities and other financial instruments owned. Fixed Income Research. Fixed Income research at Lehman Brothers encompasses a broad range of research disciplines: quantitative, economic, strategic, credit, portfolio and market-specific analysis. Fixed Income research is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Fixed Income research is to have in place high quality research analysts covering industry, geographic and economic sectors that support the activities of the Company's clients and customers. Their expertise includes U.S. government and agency securities, corporate securities, high yield, asset and mortgage-backed securities and emerging market debt. Fixed Income research expanded its quantitative capabilities and its coverage of the commercial real estate market during 1993. Foreign Exchange According to a leading market research firm, Lehman Brothers is one of the top two global investment banks that trade foreign exchange for clients and customers. Through its foreign exchange operations, Lehman Brothers seeks to provide its clients and customers with superior trading execution, price protection and hedging strategies to manage volatility. The Company and its affiliates, through operations in New York, London, and Hong Kong, engage in trading activities in all major currencies and maintain a 24-hour foreign exchange market making capability for clients and customers worldwide. In 1993, Lehman Brothers enhanced its foreign exchange capabilities by becoming the first U.S. investment bank to join the Electronic Broking Service in Europe. In addition to the Company's traditional client/customer-driven foreign exchange activities, Lehman Brothers also trades foreign exchange for its own account. Commodities and Futures Lehman Brothers engages in commodities and futures trading in three business lines: market making in metals, exchange futures execution services, and managed futures. The Company seeks to provide clients and customers with innovative investment and hedging strategies to satisfy their investing and risk management objectives. In 1993, professionals from Commodities, Investment Banking and Equities worked together to structure and issue gold-denominated preferred stock, which was the first commodity-linked equity security to be listed on the New York Stock Exchange. Asset Management Lehman Brothers Global Asset Management ("LBGAM") provides discretionary and non-discretionary investment management services to institutional and high net worth investors worldwide. LBGAM's asset management philosophy combines fundamental research with quantitative techniques to identify investment opportunities that span the global equity, fixed income and currency markets. During 1993, LBGAM launched the Lehman Brothers Institutional Funds, a family of funds directed toward U.S. institutional investors, and expanded its managed futures funds for investors throughout the world. Merchant Banking Fund Management Since 1989, Holdings' principal method of making merchant banking investments has been through a series of partnerships (the "1989 Partnerships"), for which subsidiaries of Holdings act as general partner, and in some cases as a limited partner. Merchant banking activities have consisted principally of making equity and certain other investments in merger, acquisition, restructuring and leveraged capital transactions, including leveraged buyouts, either independently or in partnership with the Company's clients. Current merchant banking investments include both publicly traded and privately held companies diversified on a geographic and industry basis. The 1989 Partnerships have a 10-year life with capital available for investment for only the first five years, which period ended in March 1994. Accordingly, during the remaining life of the Partnerships, Holdings' merchant banking activities, with respect to investments made by the 1989 Partnerships, will be directed toward selling or otherwise monetizing such investments. Holdings is currently considering the establishment of a new merchant banking fund and participation in other merchant banking opportunities. Other Business Activities While Lehman Brothers concentrates on its client/customer-driven strategy, the Company also participates in business opportunities such as arbitrage and proprietary trading that leverage the Company's expertise, infrastructure and resources. These businesses may generate substantial revenues but generally entail a higher degree of risk as the Company trades for its own account. Arbitrage. Lehman Brothers engages in a variety of arbitrage activities. In traditional or "riskless" arbitrage, the Company seeks to benefit from temporary price discrepancies that occur when a security is traded in two or more markets, or when a convertible or derivative security is trading at a price disparate from its underlying security. The Company's "risk" arbitrage activities involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the extent that these anticipated transactions do not materialize in a manner consistent with the Company's expectations, the Company is subject to the risk that the value of these investments will decline in value. Lehman Brothers' arbitrage activities benefit from the Company's presence in the global capital markets, access to advanced information technology, in-depth market research, proprietary risk management tools and general experience in assessing rapidly changing market conditions. Proprietary Trading. Lehman Brothers engages in the trading of various securities, derivatives, currencies and commodities for its own account. The Company's proprietary trading activities bring together various research and trading disciplines allowing it to take market positions, which at times may be significant, consistent with the Company's expectations of future events (such as movements in the level of interest rates, changes in the shape of yield curves and changes in the value of currencies). The Company is subject to the risk that actual market events will be different from the Company's expectations, which may result in significant losses associated with such proprietary positions. The Company's proprietary trading activities are generally carried out in consultation with personnel from the relevant major product area (e.g., mortgages, derivatives and foreign exchange). ADMINISTRATION AND OPERATIONS The Company's administration and operations staff supports its businesses through the processing of certain securities and commodities transactions; receipt, identification and delivery of funds and securities; internal financial controls; safeguarding of customers' securities; and compliance with regulatory and legal requirements. In addition, this staff is responsible for information systems, communications, facilities, legal, internal audit, treasury, tax, accounting and other support functions. In response to the needs of certain of its domestic and international businesses, the Company has acquired sophisticated data processing and telecommunications equipment. The Company believes such acquisition was necessary to provide the high level of technological and analytical support required to process, settle and account for transactions in a worldwide marketplace. Automated systems also provide sophisticated decision support which enhances trading capability and the management of the Company's cash and collateral resources. There is considerable fluctuation within each year and from year to year in the volume of business that the Company must process, clear and settle. GLOBAL SCOPE OF BUSINESS ACTIVITIES Through its network of offices around the world, Lehman Brothers pursues a global strategy to meet more effectively the needs of clients and customers and to generate increased business volume for the Company. The Company's headquarters in New York provides support for and is closely linked to its regional offices. Because Lehman Brothers' global strategy is based on a unified team approach to serving the financial needs of its clients and customers, the Company's regional offices enable Investment Banking and Sales to develop more effectively relationships and deliver products and services to clients and customers whose businesses are located in a given area or who predominantly transact business in that region. Based on the growth in international business activities over the past several years and the continued development of a more integrated global financial economy, Lehman Brothers expects international business activities to continue to grow in the future. The Company believes that its global presence and operating strategy position it to continue to increase the Company's flow of business, and thereby continue to realize greater benefits from economies of scale. ORGANIZATION The organization and culture of Lehman Brothers represent the fourth element of the Company's overall strategy. This strategy requires close integration of investment bankers and sales professionals and product and service professionals to maximize the Company's effectiveness in developing client and customer relationships. To effect this strategy, Lehman Brothers is managed as an integrated global operation. Business planning and execution is coordinated between regional locations and product heads. The Company's 18-member Operating Committee is the principal governing body of Lehman Brothers, and is comprised of representatives from every major area of the organization, including the senior managers from the European and Asia Pacific regions. This structure promotes communication and cooperation, enabling Lehman Brothers to identify and address rapidly opportunities and issues on a global, firm-wide level. The Operating Committee facilitates management's ability to run the business as a whole, as opposed to managing the business units separately. This structure is reinforced with a culture and operating practices that promote integration through the implementation and communication of organizational values and principles consistent with the Company's "One Firm" philosophy. An example of one of these operating practices is the Company's approach to compensation, whereby employees are compensated to a significant extent on the overall performance of the Company and to a lesser extent on the performance of any individual business area. RISK MANAGEMENT Risk is an inherent part of all of Lehman Brothers' businesses and activities. The extent to which Lehman Brothers properly and effectively identifies, assesses, monitors and manages each of the various types of risks involved in its trading, brokerage and investment banking activities is critical to the success and profitability of the Company. The principal types of risk involved in Lehman Brothers' activities are market risks, credit or counterparty risks and transaction risks. Lehman Brothers has developed a control infrastructure to monitor and manage each type of risk on a global basis throughout the Company. Market Risk In its trading, market making and underwriting activities, Lehman Brothers is subject to risks relating to fluctuations in market prices and liquidity of specific securities, instruments and derivative products, as well as volatility in market conditions in general. The markets for these securities and products are affected by many factors, including the financial performance and prospects of specific companies and industries, domestic and international economic conditions (including inflation, interest and currency exchange rates and volatility), the availability of capital and credit, political events (including proposed and enacted legislation) and the perceptions of participants in these markets. Lehman Brothers has developed a multi-level approach for monitoring and managing its market risk. The base level control is at the trading desks where various risk management functions are performed, including daily mark to market by traders and on-going monitoring of inventory aging and pricing by trading desk managers, product area management and the independent risk managers for each product area. The next level of management of market risk occurs in the Trade Analysis department, which independently reviews the prices of the Company's trading positions and regularly monitors the aging of inventory positions. The final level of the risk management process is the Senior Risk Management Committee, which is composed of senior management from the various product areas and from credit, trade analysis and risk management. In addition, when appropriate, Lehman Brothers employs hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Credit or Counterparty Risks Lehman Brothers is exposed to credit risks in its trading activities from the possibility that a counterparty to a transaction could fail to perform under its contractual commitment, resulting in Lehman Brothers incurring losses in liquidating or covering its position in the open market. The responsibility for managing these credit risks rests with the Corporate Credit department. The department, which is organized along both industry and geographic lines, is independent from any of Lehman Brothers' product areas. Corporate Credit manages the Company's credit risks by establishing and monitoring counterparty limits, structuring and approving specific transactions, actively managing credit exposures and participating in the new product review process. In addition, Lehman Brothers, when appropriate, may require collateral from the counterparty to secure its obligations to the Company or seek some other form of credit enhancement (such as financial covenants, guarantees or letters of credit) to support the counterparty's contractual commitment. Transaction Risk In connection with its investment banking and product origination activities, Lehman Brothers is exposed to risks relating to the merits of proposed transactions. These risks involve not only the market and credit risks associated with underwriting securities and developing derivative products, but also potential liabilities under applicable securities and other laws which may result from Lehman Brothers' role in the transaction. Each proposed transaction involving the underwriting or placement of securities by Lehman Brothers is reviewed by the Company's Commitment Committee. The Commitment Committee is staffed by senior members of the Company with extensive experience in the securities industry. The principal function of the Commitment Committee is to determine whether Lehman Brothers should participate in a transaction in which the Company's capital and reputation will be at risk. Fairness opinions and valuation letters to be delivered by Lehman Brothers must be reviewed and approved by the Company's Fairness Opinion Committee, which is composed of senior investment bankers who provide an independent evaluation of the opinions and conclusions to be rendered to the Company's clients. In connection with its investment banking or merchant banking activities, the Company may from time to time make proprietary investments in securities that are not readily marketable. These investments primarily result from the Company's efforts to help clients achieve their financial and strategic objectives. Any such proposed investment which falls within established criteria with respect to the amount of capital invested, the anticipated holding period and the degree of liquidity of the securities must be reviewed and approved by the Company's Investment Committee, which is composed of senior investment bankers. The Investment Committee reviews in detail the proposed investment and applies relevant valuation methodologies to evaluate the risk of loss of capital compared to the anticipated returns from the investment and determine whether to proceed with the transaction. Lehman Brothers recently established a New Products and Business Committee (the "NPBC") for new products developed by Lehman Brothers or new businesses to be entered into by the Company. The NPBC will work in cooperation with the originators or sponsors of a new product or business to evaluate its feasibility, assess its potential risks and liabilities and analyze its costs and benefits. NON-CORE ASSETS Prior to 1990, the Company participated in a number of activities that are not central to its current business as an institutional investment banking firm. As a result of these activities, the Company carries on its balance sheet a number of relatively illiquid assets (the "Non-Core Assets"), including a number of individual real estate assets, limited partnership interests and a number of smaller investments. Subsequent to their purchase, the values of certain of these Non-Core Assets declined below the recorded values on the Company's balance sheet, which necessitated the write-down of the carrying values of these assets and corresponding charges to the Company's income statement. Certain of these activities have resulted in various legal proceedings. Since 1990, management has devoted substantial resources to reducing the Company's Non-Core Assets. Between December 31, 1990 and December 31, 1993, the Company's Non-Core Assets decreased from $1.1 billion in 1990 to approximately $79 million in 1993, with Non-Core Assets defined as carrying value plus contingent exposures net of reserves. Management's intention with regard to these Non-Core Assets is the prudent liquidation of these investments as and when possible. RELATIONSHIP WITH SMITH BARNEY On July 31, 1993, the Company completed the sale of Shearson which consisted of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name), substantially all of its asset management business, the operations and data processing functions that supported those business and certain related assets and liabilities. Securities Clearing, Data Services and General Services Agreements Pursuant to a clearing agreement (the "Clearing Agreement"), Smith Barney carries and clears, on a fully disclosed basis, all accounts introduced to it by Lehman Brothers, and performs all clearing and settlement functions for equities, municipal securities and corporate debt which were previously performed by Shearson. Lehman Brothers also conducts certain securities lending activities as agent for Smith Barney under the Clearing Agreement. Pursuant to Data Services and General Services Agreements, Smith Barney provides to the Company all of the same data processing and related services that it previously received from Shearson. Charges for services under these three agreements are generally calculated using the intercompany transfer pricing methodology in effect prior to the Primerica Transaction. These agreements expire on December 31, 1994, but may be extended for up to an additional six months upon payment by the Company of up to $5 million. The Company has been reviewing alternative clearing, data processing and other servicing arrangements to take effect after the expiration of its arrangements with Smith Barney. Certain Arrangements Revolving Cash Subordination Agreement. Holdings has agreed to lend to Smith Barney up to $150 million to cover capital charges in excess of $50 million incurred by Smith Barney as a result of carrying LBI's customer and proprietary positions (the "Lehman Capital Charges"). Holdings will lend additional amounts to Smith Barney in the event that the Lehman Capital Charges increase above $200 million. As of March 28, 1994, $150 million was outstanding. Under certain circumstances, Travelers is required to purchase all or part of Smith Barney's indebtedness to Holdings under the facility up to $250 million. Holdings is only required to fund in excess of $250 million under this facility if Travelers agrees to a corresponding increase in its purchase obligation; provided that, without such agreement, the Company may not engage in any activity which results in the Lehman Capital Charges exceeding $300 million. Revolving Credit Agreements. Pursuant to a Revolving Credit Agreement, Smith Barney may borrow funds from LBI secured by securities having a market value equal to not less than 130% of the aggregate unpaid principal amount borrowed for the purpose of funding customer margin debits carried by Smith Barney. As of March 28, 1994, there were no amounts outstanding under this facility. Pursuant to an Unsecured Revolving Credit Agreement, Holdings has agreed to advance funds to Smith Barney in order to finance, in part, certain of the cash demands of the securities lending activities conducted under the Clearing Agreement. As of March 28, 1994, $756 million was outstanding under this facility. These facilities will terminate upon the termination of the Clearing Agreement. Non-Solicitation. In connection with the Primerica Transaction, both LBI and Smith Barney agreed that they would refrain from soliciting each other's employees and certain customers for varying periods of time after July 31, 1993. The majority of the customer-related non-solicitation provisions have expired. Shearson Related Litigation. LBI and Smith Barney agreed to a division of litigation relating to Shearson pursuant to which, subject to certain exceptions, Smith Barney is liable for such litigations arising after April 11, 1993. With respect to matters arising on or before April 11, 1993, LBI transferred to Smith Barney a $50 million reserve. If such reserve is exhausted, the parties have agreed to share liability on the matters arising on or before April 11, 1993. LBI retained liability for regulatory matters. COMPETITION All aspects of the Company's business are highly competitive. The Company competes in domestic and international markets directly with numerous other brokers and dealers in securities and commodities, investment banking firms, investment advisors and certain commercial banks and, indirectly for investment funds, with insurance companies and others. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, several small and specialized securities firms have been successful in raising significant amounts of capital for their merger and acquisition activities and merchant banking investment vehicles and for their own accounts. These developments have increased competition from firms, many of whom have significantly greater equity capital than the Company. REGULATION The securities industry in the United States is subject to extensive regulation under both federal and state laws. LBI and certain other subsidiaries of Holdings are registered as broker-dealers and investment advisers with the Commission and as such are subject to regulation by the Commission and by self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the Commission as LBI's primary regulator, and the Municipal Securities Rulemaking Board. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. LBI is a registered broker-dealer in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico. The Commission, self-regulatory organizations and state securities commissions may conduct administrative proceedings, which may result in censure, fine, the issuance of cease-and-desist orders or suspension or expulsion of a broker-dealer or an investment adviser, its officers or employees. LBI is registered with the CFTC as a futures commission merchant and is subject to regulation as such by the CFTC and various domestic boards of trade and other commodity exchanges. The Company's U.S. commodity futures and options business is also regulated by the National Futures Association, a not-for-profit membership corporation which has been designated as a registered futures association by the CFTC. Holdings and the Company do business in the international fixed income, equity and commodity markets and undertakes investment banking activities through Holdings' subsidiaries. The U.K. Financial Services Act of 1986 (the "Financial Services Act") governs all aspects of the United Kingdom investment business, including regulatory capital, sales and trading practices, use and safekeeping of customer funds and securities, record keeping, margin practices and procedures, registration standards for individuals, periodic reporting and settlement procedures. Pursuant to the Financial Services Act, Holdings and the Company are subject to regulations administered by The Securities and Futures Authority Limited, a self regulatory organization of financial services companies (which regulates their equity, fixed income, commodities and investment banking activities) and the Bank of England (which regulates their wholesale money market, bullion and foreign exchange businesses). The Company anticipates regulation of the securities and commodities industries to increase at all levels and for compliance therewith to become more difficult. Monetary penalties and restrictions on business activities by regulators resulting from compliance deficiencies are also expected to become more severe. The Company believes that it is in material compliance with regulations described herein. CAPITAL REQUIREMENTS As registered broker-dealers LBI and Lehman Government Securities Inc. ("LGSI"), a wholly owned subsidiary of LBI, are subject to the Commission's net capital rule (Rule 15c3-1, the "Net Capital Rule") promulgated under the Exchange Act. The NYSE and the NASD monitor the application of the Net Capital Rule by LBI and LGSI, respectively. LBI and LGSI compute net capital under the alternative method of the Net Capital Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if its net capital is less than 4% of aggregate debit balances and may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances. In addition, the Net Capital Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances. The Net Capital Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Net Capital Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Commission when net capital after the withdrawal would be less than 25% of its securities position haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Net Capital Rule requires broker-dealers to notify the Commission and the appropriate self-regulatory organization two business days before a withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000, or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000, or 20% of excess net capital. Finally, the Net Capital Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the Company or would jeopardize the broker-dealer's ability to pay its customers. Certain of LBI's other subsidiaries are also subject to the Net Capital Rule. Compliance with the Net Capital Rule could limit those operations of LBI that require the intensive use of capital, such as underwriting and trading activities and the financing of customer account balances, and also could restrict the ability of Holdings to withdraw capital from LBI, which in turn could limit the ability of Holdings to pay dividends, repay debt and redeem or purchase shares of its outstanding capital stock. See Footnote 16 of Notes to Consolidated Financial Statements. EMPLOYEES As of December 31, 1993, the Company employed approximately 7,500 persons. The Company considers its relationship with its employees to be good. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters occupy approximately 915,000 square feet of space at 3 World Financial Center in New York, New York, which is owned by the Company as tenants-in-common with American Express and various other American Express subsidiaries. Holdings expects to relocate on or about August 1994, certain administrative personnel from 388 and 390 Greenwich Street to five floors in the World Financial Center which are currently occupied by subsidiaries of American Express. These five floors will result in total occupancy of approximately 1,147,000 square feet by Holdings and the Company. Holdings entered into a lease for approximately 392,000 square feet for offices located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The Operations Center will be used by systems, operations, and certain administrative personnel and contains certain back-up trading facilities. The lease term is approximately 16 years and is expected to commence in August 1994. Holdings and the Company occupy 14 floors at 388 and 390 Greenwich Street which they expect to vacate by July 31, 1994 and will relocate the personnel to the Operations Center and the World Financial Center. Most of the Company's other offices are located in leased premises, the leases for which expire at various dates through the year 2007. Facilities owned or occupied by the Company and its subsidiaries are believed to be adequate for the purposes for which they are currently used and are well maintained. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against the Company and others with respect to transactions in which the Company acted as an underwriter or financial advisor, actions arising out of the Company's activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms of which the Company is one. Although there can be no assurance as to the ultimate outcome, the Company has denied, or believes it has a meritorious defense and will deny, liability in all significant cases pending against it including the matters described below, and intends to defend vigorously each such case. Although there can be no assurance as to the ultimate outcome, based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on the business or consolidated financial condition of the Company. GENERAL ACQUISITION, INC. ET AL. V. GENCORP, INC. ET AL. V. WAGNER & BROWN, ET AL. AND SHEARSON LEHMAN BROTHERS INC. AND SHEARSON LEHMAN BROTHERS HOLDINGS INC. This litigation in the United States District Court for the Southern District of Ohio (the "Ohio Court") arose out of the Company's representation of Wagner & Brown and AFG Industries, Inc. ("AFG") in connection with their effort to acquire GenCorp, Inc. ("GenCorp") in March 1986. In response to the tender offer and the litigation commenced by Wagner & Brown and AFG on March 17, 1986, GenCorp amended its answer and counterclaims on April 2, 1986 to assert claims against LBI and Holdings. Only GenCorp's counterclaims against LBI remain pending. GenCorp asserted common law claims for breach of fiduciary duty, fraud, negligence and unjust enrichment against Lehman Brothers. The claims are based on prior contacts between LBI and GenCorp and LBI's subsequent role in advising and assisting Wagner & Brown and AFG with respect to the tender offer. GenCorp seeks $258 million in damages and the imposition of a constructive trust on the fees and profits the Company earned in the transaction. On or about October 2, 1992, the Ohio Court granted LBI's motion for summary judgment and dismissed GenCorp's claim for compensatory damages. GenCorp has appealed this decision to the United States Court of Appeals for the Sixth Circuit. No decision has been rendered. GenCorp's claim for disgorgement of the fees that LBI received has been stayed pending the appeal. BAMAODAH V. E.F. HUTTON & COMPANY INC. In April 1986, Ahmed and Saleh Bamaodah commenced an action against E.F. Hutton & Company Inc. ("EFH"), a subsidiary of The E.F. Hutton Group Inc. ("Hutton"), to recover all losses the Bamaodahs had incurred since May 1981 in the trading of commodity futures contracts in a nondiscretionary EFH trading account. The Dubai Civil Court ruled that the trading of commodity futures contracts constituted illegal gambling under Islamic law and that therefore the brokerage contract was void. In January 1987, a judgment was rendered against EFH in the amount of $48,656,000. On January 5, 1991, the Dubai Court of Appeals affirmed the judgment. On March 22, 1992, the Court of Cassation, Dubai's highest court, revoked and quashed the decision of the Court of Appeals and ordered that the case be remanded to the Court of Appeals for a further review. FDIC V. CHENG, ET AL. On or about February 16, 1990, the Federal Deposit Insurance Corporation (the "FDIC"), as manager of the Federal Savings and Loan Insurance Corporation ("FSLIC") Resolution Fund (the "FSLIC Resolution Fund"), which is the receiver of Guaranty Federal Savings and Loan Association ("Guaranty Federal"), filed a complaint in the U.S. District Court for the Northern District of Texas (the "Texas District Court") in an action entitled Federal Deposit Insurance Corporation v. Paul Sau-Ki Cheng, et al. On or about February 2, 1993, the FDIC served a Third Amended Complaint naming EFH, Holdings, LBI, four former EFH brokers, Drexel Burnham Lambert Inc. and a subsidiary of it (collectively "Drexel"), a former Drexel broker, Paul Sau-Ki Cheng and Simon Edward Heath, both former directors and co-chairmen of the board of directors of Guaranty Federal and certain other parties not affiliated with Lehman Brothers as defendants. On or about February 11, 1993, the Company filed its answer to the Third Amended Complaint, denying all material allegations and asserting several affirmative defenses. The FDIC's claims related to trading losses and other alleged damages suffered by Guaranty Federal, its creditors, stockholders and depositors, the FSLIC and the FSLIC Resolution Fund as a result of U.S. government bond trading by Cheng and Heath through EFH and Drexel, as well as alleged violations of the Commodities Exchange Act. As a result, the FDIC sought $129,980,000 in alleged actual damages against all defendants and $387.6 million in punitive damages against all defendants except EFH, Holdings and LBI. On October 25, 1993, the Company and the FDIC entered into a settlement agreement, and on November 16, 1993, the Texas District Court entered an order and dismissed all claims with prejudice. PAUL WILLIAMS AND BEVERLY KENNEDY, ET AL. V. BALCOR PENSION INVESTORS ET AL. In February 1990, a purported class action complaint was filed in the United States District Court for the Northern District of Illinois. The complaint names eight separate limited partnerships originated by The Balcor Company ("Balcor"), which was then a wholly owned subsidiary of LBI, known as the Balcor Pension Investors series. Also named as defendants were the general partner of each named limited partnership, Balcor, and Balcor Securities Co., LBI and American Express. The complaint which was amended on October 10, 1990 alleges that the named entities violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in connection with the offering of limited partnership interests. The complaint also alleges breach of fiduciary duty, fraud, negligence and violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO"). The complaint seeks compensatory damages and punitive damages. Defendants' Amended Counterclaim filed on September 19, 1990, asserts common law claims of fraud and breach of warranty against plaintiffs. Defendants seek to recover for the alleged damage to their reputation and business as well as their costs and attorneys fees in defending against the claims brought by plaintiffs. On November 29, 1990, W.B. Copeland, Trustee, Ploof Truck Lines, Inc. Profit Sharing Plan and Allan Hirschfield filed a class action counterclaim against defendants which is identical to the Amended Complaint seeking, among other things, leave to join this action as named plaintiffs. On September 8, 1993, the plaintiffs filed a Third Amended Complaint adding additional named plaintiffs and an amended motion for class certification which motions had previously been denied. No plaintiff class has yet been certified and no judicial determination has been made. No merits discovery has been conducted. RALPH MAJESKI, ET AL. V. BALCOR ENTERTAINMENT COMPANY, LTD. ET AL.; ROBERT ECKSTEIN, ET AL. V. BALCOR FILM INVESTORS, ET AL. These two actions were filed in United States District Court for the Eastern District of Wisconsin (the "Wisconsin District Court"). LBI is a defendant only in the Majeski case. Plaintiffs allege that the named defendants in the lawsuits violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests in Balcor Film Investors, a partnership of which a Balcor subsidiary is the general partner. The Majeski complaint also alleges, in general, breach of fiduciary duty, common law fraud, misrepresentation, breach of contract and a cause of action in the nature of a derivative action. On January 18, 1991, the Wisconsin District Court entered an order certifying a plaintiffs class of all persons who purchased or currently own interests in the Partnership which were purchased from January 8, 1985 through December 31, 1985. The Wisconsin District Court also consolidated the Eckstein and Majeski actions for the remainder of the pretrial proceedings and trial, but did not merge such actions. On March 11, 1992, the Wisconsin District Court granted defendants' motions to dismiss on statute of limitations grounds in both actions. In August 1993, the U.S. Court of Appeals for the Seventh Circuit (the "Court of Appeals") issued an opinion which reversed the order of the Wisconsin District Court and remanded the cases to such court for further proceedings. The defendants sought a writ of certiorari in the U.S. Supreme Court which was denied in January 1994. Upon remand to the Wisconsin District Court, plaintiffs filed a motion to amend the complaint to assert a RICO claim; defendants opposed this amendment, and the motion is pending. In addition, defendants have renewed their motions to dismiss. These motions are pending before the Wisconsin District Court. On or about March 8, 1993, the Majeski plaintiffs filed an action in the Circuit Court for Milwaukee County, Wisconsin. The allegations, including damages, in this complaint are essentially the same as in their federal court action, described above. Plaintiff's counsel has represented that this state court action will be dismissed. GLYNWILL INVESTMENT, LTD. V. SHEARSON LEHMAN BROTHERS INC. Glynwill Investment, Ltd. ("Glynwill"), a corporation chartered in Curacao, N.A., commenced an action against LBI "as successor in interest to E.F. Hutton & Co., Inc." in May of 1990 in the Supreme Court of the State of New York (the "New York Court"), alleging fraud and breach of contract on the part of E.F. Hutton & Co. Inc. in overcharging Glynwill for foreign exchange transactions executed for Glynwill. The New York Court, on LBI's motion to dismiss, held that the release signed by Glynwill after Glynwill's repayment of approximately one half of the $10 million unsecured debit created in Glynwill's account was not a general release encompassing the claims raised by Glynwill in this action and denied LBI's motion. Discovery is ongoing. SANFORD F. KAPLAN V. THE E.F. HUTTON GROUP INC., ET AL; CHRISTOPHER J. HARRIS V. THE E.F. HUTTON GROUP INC., ET AL. On or about December 30, 1987 and January 11, 1988, the Kaplan and Harris complaints were filed as purported class actions. The complaints in these two actions, brought in New York State Supreme Court (the "State Court") and the United States District Court for the Southern District of New York (the "District Court"), respectively, name as defendants Hutton, LBI and SLBP Acquisition Corp., and purport to be brought on behalf of classes of certain holders of nonvested employee stock options or equity grants awarded under Hutton's Equity Ownership Plan (the "Plan"). Plaintiffs alleged, among other things, that as a result of the execution of the Agreement and Plan of Merger between Hutton, SLBP Acquisition Corp. and LBI and the acquisition by LBI of a majority of the shares of Hutton, their stock options and equity grams vested. They sought compensatory damages, declaratory relief and, in the case of Kaplan, injunctive relief. Classes were certified in each action. On December 29, 1993, the District Court issued a final judgment and order approving a settlement and dismissing the Harris action. On January 13, 1993, the State Court issued a final judgment and order approving the settlement and dismissing the Kaplan case. ACTIONS RELATING TO FIRST CAPITAL HOLDINGS INC. FCH Derivative Actions. On or about March 29, 1991, two identical purported shareholder derivative actions were filed, entitled Mentch v. Weingarten, et al. and Isaacs v. Weingarten, et al. The complaints in these two actions, pending in the Superior Court of the State of California, County of Los Angeles, are filed allegedly on behalf of and naming as a nominal defendant FCH. Other defendants include Holdings, two former officers and directors of FCH, Robert Weingarten and Gerry Ginsberg, the four outside directors of FCH, Peter Cohen, Richard DeScherer, William L. Mack and Jerome H. Miller (collectively, the "Outside Directors"), and Michael Milken. The complaints allege generally breaches of fiduciary duty, gross corporate mismanagement and waste of assets in connection with FCH's purchase of non-rated bonds underwritten by Drexel Burnham Lambert Inc. and seek damages for losses suffered by FCH, punitive damages and attorneys' fees. The actions have been stayed pursuant to the bankruptcy of FCH. Concurrent with the bankruptcy filing of FCH and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company ("First Capital Life") and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life") (First Capital Life and Fidelity Bankers Life collectively, the "Insurance Subsidiaries"), a number of additional actions were instituted, naming one or more of Holdings, LBI and American Express as defendants (individually or collectively, as the case may be, the "American Express Defendants"). FCH Shareholder and Agent Actions. Three actions were commenced in the United States District Courts for the Southern District of New York and the Central District of California allegedly as class actions on behalf of the purchasers of FCH securities during certain specified periods, commencing no earlier than May 4, 1988 and ending no later than May 31, 1991 (the "Shareholder Class"). The complaints are captioned Larkin, et al. v. First Capital Holdings Corp., et al., amended on May 15, 1991 to add American Express as a defendant, Zachary v. American Express Company, et al., filed on May 20, 1991, and Morse v. Weingarten, et al., filed on June 13, 1991 (the "Shareholder Class Actions"). The complaints raise claims under the federal securities laws and allege that the defendants concealed adverse material information regarding the finances, financial condition and future prospects of FCH and made material misstatements regarding these matters. On July 1, 1991 an action was filed in the United States District Court for the Southern District of Ohio entitled Benndorf v. American Express Company, et al. The action is brought purportedly on behalf of three classes. The first class is similar to the Shareholder Class; the second consists of managing general agents and general agents who marketed various First Capital Life products from April 2, 1990 to the filing of the suit and to whom it is alleged misrepresentations were made concerning FCH (the "Agent Class"); and the third class consists of Agents who purchased common stock of FCH through the First Capital Life Non Qualified Stock Purchase Plan ("FSPP") and who have an interest in the Stock Purchase Account under the FSPP (the "FSPP Class"). The complaint raises claims similar to those asserted in the other Shareholder Class Actions, along with additional claims relating to the FSPP Class and the Agent Class alleging damages in marketing the products. In addition, on August 15, 1991, Kruthoffer v. American Express Company, et al. was filed in the United States District Court for the Eastern District of Kentucky, whose complaint is nearly identical to the Benndorf complaint (collectively the "Agent Class Actions"). On November 14, 1991, the Judicial Panel on Multidistrict Litigation issued an order transferring and coordinating for all pretrial purposes all related actions concerning the sale of FCH securities, including the Shareholder Class Action and Agent Class Actions, and any future filed "tag-along" actions, to Judge John G. Davies of the United States District Court for the Central District of California (the "California District Court"). The cases are captioned In Re: First Capital Holdings Corporation Financial Products Securities Litigation, MDL Docket No.-901 (the "MDL Action"). On January 18, 1993, an amended consolidated complaint (the "Third Amended Complaint") was filed on behalf of the Shareholder Class and the Agent Class. The Third Complaint names as defendants the American Express Defendants, Weingarten and his wife, Palomba Weingarten, Ginsberg, Philip A. Fitzpatrick (FCH's Chief Financial Officer), the Outside Directors and former FCH outside directors Jeffrey B. Lane and Robert Druskin (the "Former Outside Directors"), Fred Buck (President of First Capital Life) and Peat Marwick. The complaint raises claims under the federal securities law and the common law of fraud and negligence. On March 10, 1993, the American Express defendants answered the Third Amended Complaint, denying its material allegations. On March 11, 1993, the California District Court entered an order granting class certification to the Shareholder Class. The class consists of all persons, except defendants, who purchased FCH common stock, preferred stock and debentures during the period May 4, 1988 to and including May 10, 1991. It also issued an order denying class certification to the Agent Class. The FSPP Class action had been previously dropped by the plaintiffs. The American Express Shareholder Action. On or about May 20, 1991, a purported class action was filed on behalf of all shareholders of American Express who purchased American Express common shares during the period beginning August 16, 1990 to and including May 10, 1991. The case is captioned Steiner v. American Express Company, et al. and was commenced in the United States District Court for the Eastern District of New York. The defendants are Holdings, American Express, James D. Robinson, III, Howard L. Clark, Jr., Harvey Golub and Aldo Papone. The complaint alleges generally that the defendants failed to disclose material information in their possession with respect to FCH which artificially inflated the price of the common shares of American Express from August 16, 1990 to and including May 10, 1991 and that such nondisclosure allegedly caused damages to the purported shareholder class. The action has been transferred to California and is now part of the MDL Action. The defendants have answered the complaint, denying its material allegations. The Bankruptcy Court Action. In the FCH bankruptcy, pending in the United States Bankruptcy Court for the Central District of California (the "Bankruptcy Court"), on February 11, 1992, the Official Committee of Creditors Holding Unsecured Claims (the "Creditors' Committee") obtained permission from the Bankruptcy Court to file an action for and on behalf of FCH and the parent corporations of the Insurance Subsidiaries. On March 3, 1992, the Creditors' Committee initiated an adversary proceeding in the Bankruptcy Court, Case No. AD 92-01723, in which they assert claims for breach of fiduciary duty and waste of corporate assets against Holdings; fraudulent transfer against both Holdings and LBI; and breach of contract against LBI. Also named as defendants are the Outside Directors, the Former Outside Directors, Weingarten and Ginsberg. Holdings and LBI have answered this complaint, denying the material allegations. Fact discovery has been completed and the contract claim has been dropped by plaintiffs. No trial date has been set. The Virginia Commissioner of Insurance Action. On December 9, 1992, a complaint was filed in federal court in the Eastern District of Virginia by Steven Foster, the Virginia Commissioner of Insurance as Deputy Receiver of Fidelity Bankers Life. The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a former director of FCH and Fidelity Bankers Life, as defendants. The action was subsequently transferred to California to be part of the MDL Action. The Complaint alleges that Holdings acquiesced in and approved the continued mismanagement of Fidelity Bankers Life and that it participated in directing the investment of Fidelity Bankers Life assets. The complaint asserts claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleges violations of the Virginia Securities laws by Holdings. It allegedly seeks no less than $220 million in damages to Fidelity Bankers Life and its present and former policyholders and creditors and punitive damages. Holdings has answered the complaint, denying its material allegations. IN RE COMPUTERVISION CORPORATION SECURITIES LITIGATION In connection with public offerings of notes and common stock of Computervision, actions were commenced in federal district court in Massachusetts against Computervision, certain of its executive officers, the directors of Computervision, LBI, Donaldson, Lufkin & Jenrette Securities Corporation, The First Boston Corporation and Hambrecht & Quist Incorporated, Holdings and J.H. Whitney & Co. in the United States District Court for the District of Massachusetts (collectively the "Massachusetts Case"). These actions have been consolidated in a consolidated amended class action complaint which alleges in substance that the registration statement and prospectus used in connection with the offerings contained materially false and misleading statements and material omissions related to Computervision's anticipated operating results for 1992 and 1993. The plaintiffs purport to represent a class of individuals who purchased in the public offering or in the aftermarket. The complaint seeks damages for negligent misrepresentation and under Sections 11, 12 and 15 of the Securities Act. In addition, three suits were filed in the United States District Court for the Southern District of New York. The suits raise claims similar to those in the Massachusetts Case against the same defendants. The Judicial Panel on Multidistrict Litigation has ordered these cases consolidated with the Massachusetts Case. State Court Action. LBI was named as the sole defendant in a putative class action, Greenwald v. Lehman Brothers Inc., brought in New York State Supreme Court (the "State Court"). The complaint alleges in substance that LBI breached a fiduciary duty owed to its customers in selling them the common stock, senior notes and senior subordinated notes of Computervision during the class period, as defined in the complaint. The State Court dismissed the complaint. SIMS V. SHEARSON LEHMAN BROTHERS HUTTON INC. In March 1990, LBI was sued in the United States District Court for the Northern District of Texas (the "Texas District Court") on behalf of a purported class of all purchasers of limited partnership interests in a limited partnership offering called Kanland Associates. The partnership was sold by EFH in 1982 and raised approximately $20 million. In 1987, the partnership's property was lost in a foreclosure. On May 29, 1992, a second Amended Complaint was filed against LBI alleging claims under Section 10(b) of the Exchange Act, common law fraud, breach of fiduciary duty and RICO relating to disclosures made in connection with the sale of the partnership and alleged breaches of fiduciary duty subsequent to the foreclosure. On August 10, 1992, the Texas District Court issued an order certifying a class of all persons who purchased limited partnership interests in Kanland pursuant to the offering materials distributed by EFH. On November 29, 1993, the Texas District Court signed a final judgment and order approving the class action settlement agreed to by the parties, and dismissed the action with prejudice. CC&F MEDFORD III INVESTMENT COMPANY V. THE BOSTON COMPANY, INC. AND WELLINGTON-MEDFORD III PROPERTIES, INC. In September 1992, Wellington-Medford Properties, Inc. ("W-M III"), then a subsidiary of The Boston Company, Inc. and now a subsidiary of LBI, and The Boston Company, then a subsidiary of LBI, were sued in Superior Court of the Commonwealth of Massachusetts by a limited partner in a partnership (the "Partnership") of which W-M III is the general partner. The Partnership's principal asset is an office building which is leased to The Boston Company. Financing in the amount of $74 million provided to the Partnership by The Sanwa Bank, Ltd. ("Sanwa") is secured by the office building and the lease with The Boston Company. The financing matured in December 1992 and Sanwa has initiated a foreclosure process. The complaint alleges that W-M III has breached its obligation to secure successor financing in order to prevent The Boston Company from being required to pay increased rental pursuant to a rental formula in its lease. The complaint seeks damages in an unspecified amount and a declaration regarding The Boston Company's lease obligations and W-M III's obligations to secure successor financing. W-M III and The Boston Company have answered, denying the material allegations of the complaint. In April 1993, The Boston Company filed a third-party complaint against Sanwa seeking a declaration as to The Boston Company's obligations pursuant to its lease of the office building. Sanwa answered and asserted claims against The Boston Company and W-M III, including claims for treble damages based on alleged breaches of the construction loan agreement. In December 1993, the parties entered into a stay of proceedings for purposes of facilitating negotiations of a possible settlement. Those negotiations are ongoing but have not resulted in agreement. The stay has been extended and now expires on April 15, 1994, with trial scheduled to commence on or after May 16, 1994. EASTON & CO. V. MUTUAL BENEFIT LIFE INSURANCE CO., ET AL.; EASTON & CO. V. LEHMAN BROTHERS INC. LBI has been named as a defendant in two consolidated class action complaints pending in the United States District Court for the District of New Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life Insurance Co., et al. ("Easton I"), and Easton & Co. v. Lehman Brothers Inc. ("Easton II"). The plaintiff in both of these actions is Easton & Co., which is a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege federal securities law claims and pendent common law claims in connection with the sale of certain municipal bonds as to which Mutual Benefit Life Insurance Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is an insurance company which was placed in rehabilitation proceedings under the supervision of the New Jersey Insurance Department on or about July 16, 1991. In the Matter of the Rehabilitation of Mutual Benefit Life Insurance Company, (Sup. Ct. N.J. Mercer County.) Easton I was commenced on or about September 17, 1991. In addition to LBI, the defendants named in this complaint are MBLI, Henry E. Kates (MBLI's former Chief Executive Officer) and Ernst & Young (MBLI's accountants). The litigation is purportedly brought on behalf of a class consisting of all persons and entities who purchased DeKalb, Georgia Housing Authority Multi-Family Housing Revenue Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994 (the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds were issued) through July 16, 1991. LBI acted as underwriter for this bond issue, which was in the aggregate principal amount of $18.7 million. The complaint alleges that LBI violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and seeks damages in an unspecified amount or rescission. The complaint also alleges a common law negligent misrepresentation claim against LBI and the other defendants. Easton II was commenced on or about May 18, 1992, and names LBI as the only defendant. Plaintiff purports to bring this second lawsuit on behalf of a class composed of all persons who purchased "MBLI-backed Bonds" from LBI during the period April 19, 1991 through July 16, 1991. The complaint alleges that LBI violated Section 10(b) and Rule 10b-5, and seeks monetary damages in an unspecified amount, or rescission pursuant to Section 29(b) of the Exchange Act. The complaint also contains a common law claim of alleged breach of duty and negligence. On or about February 9, 1993, the New Jersey District Court granted plaintiffs' motion for class certification in Easton I. The parties have agreed to certification of a class in Easton II for purchases of certain fixed-rate MBLI-backed bonds during the class period. MAXWELL RELATED LITIGATION Certain of Holdings' subsidiaries are defendants in several lawsuits arising out of transactions entered into with the late Robert Maxwell or entities controlled by Maxwell interests. These actions are described below. Berlitz International Inc. v. Macmillan Inc. et al. This interpleader action was commenced in Supreme Court, New York County (the "Court") on or about January 2, 1992, by Berlitz International Inc. ("Berlitz") against Macmillan Inc. ("Macmillan"), Lehman Brothers Holdings PLC ("PLC"), Lehman Brothers International Limited (now known as Lehman Brothers International (Europe), "LBIE") and seven other named defendants. The interpleader complaint seeks a declaration of the rightful ownership of approximately 10.6 million shares of Berlitz common stock, including 1.9 million shares then registered in PLC's name, alleging that Macmillan claimed to be the beneficial owner of all 10.6 million shares, while the defendants did or might claim ownership to some or all of the shares. As a result of its bankruptcy filing, Macmillan sought to remove this case to the Bankruptcy Court for the Southern District of New York. LBIE and PLC have moved to remand the case back to the Court. MGN Pension Trustees Limited v. Invesco MIM Management Limited, Capel-Cure Myers Capital Management Limited and Lehman Brothers International Limited. This action was commenced by issuance of a writ in the High Court of Justice, London, England on or about June 5, 1992. It was alleged that LBIE knew or should have known that certain securities received by it as collateral on a stock loan account held by Bishopsgate Investment Management were in fact beneficially owned by the Mirror Group Pension Scheme ("MGPS") or by MGN Pension Trustees Limited (the trustee of MGPS). On this basis, the plaintiff sought a declaration that LBIE holds or held a portfolio of securities in constructive trust for plaintiff. According to the writ, LBIE sold certain of these securities for L32,024,918, and that LBIE still holds certain of these securities, allegedly worth approximately L1,604,240. The plaintiff sought return of the securities still held and the value of the securities liquidated in connection with the stock loan account. On January 31, 1994, the Company, along with the other defendants, settled the case. Macmillan, Inc. v. Bishopsgate Investment Trust, Shearson Lehman Brothers Holdings PLC et al. This action was commenced by issuance of a writ in the High Court of Justice in London, England on or about December 9, 1991. In this action, Macmillan sought a declaration that it is the legal and beneficial owner of approximately 10.6 million shares of Berlitz International Inc. common stock, including 1.9 million shares then registered. (The same shares that are at issue in the Berlitz case in New York discussed above.) After a trial, on December 10, 1993, the High Court of Justice handed down a judgment finding for the Company on all aspects of its defense and dismissing Macmillan's claims. Bishopsgate Investment Management Limited (in liquidation) v. Lehman Brothers International (Europe) and Lehman Brothers Holdings PLC. In August 1993, Bishopsgate Investment Management Limited ("BIM") served a Writ and Statement of Claim against Lehman Brothers International (Europe) ("LBIE") and PLC. The Statement of Claim alleges that LBIE and PLC knew or should have known that certain securities received by them, either for sale or as collateral in connection with BIM's stock loan activities, were in fact, beneficially owned by various pension funds associated with the Maxwell Group entities. BIM seeks recovery of any securities still held by LBIE and PLC or recovery of any proceeds from securities sold by them. The total value of the securities is alleged to be L100 million. BIM also commenced certain proceedings for summary disposition of its claims relating to certain of the securities with a value of approximately L30 million. On January 11, 1994, the parties agreed to a settlement of that portion of the claim relating to BIM's request for summary disposition with respect to certain securities. Under this agreement, two securities holdings were delivered to BIM. The Company continues to defend the balance of BIM's claim for recovery of other assets alleged to be worth approximately L70 million. The case is scheduled for trial in April 1995. MELLON BANK CORPORATION V. LEHMAN BROTHERS INC., ET AL. In September 1993, Mellon Bank filed a complaint in the U.S. District Court for the Western District of Pennsylvania against LBI and American Express. The complaint alleges that LBI, through the conduct of Smith Barney and Primerica, breached certain covenants contained in the Mellon Agreement. The covenants, which relate to the provision of custodial and administrative services to certain mutual funds, were assumed by Smith Barney in connection with the Primerica Transaction. In a separate action, Smith Barney and Primerica were also sued by Mellon Bank in connection therewith. By order dated January 26, 1994, the action against LBI and American Express was dismissed. WARREN D. CHISUM, ET AL. V. LEHMAN BROTHERS INC. ET AL. On February 28, 1994 a purported class action was filed in the United States District Court for the Northern District of Texas. The complaint names LBI and two former E. F. Hutton & Company Inc. employees as defendants. The complaint alleges that defendants violated Section 10b of the Exchange Act and RICO, breached their fiduciary duties and the limited partners' contract and committed fraud in connection with the origination, sale and operation of four EFH net lease real estate limited partnerships. Plaintiffs seek: (i) to certify a class of all persons who purchased limited partnership interests in the four partnerships at issue, (ii) damages in excess of $140 million plus interest or rescission, (iii) punitive damages and (iv) accounting and attorneys' fees. The Company believes it has several meritorious defenses and intends to vigorously defend this case. OTHER MATTERS In connection with the regulatory attention focused on the U.S. treasury market, LGSI received from the Commission and the U.S. Department of Justice, Antitrust Division, subpoenas and letters requesting information and testimony in connection with a review of the activities of various participants in the government securities market. LGSI has responded to the subpoenas and letters. The Company continues to cooperate and supply documents and testimony requested. As of the date hereof, the Company does not believe that the investigations will have a material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Pursuant to General Instruction J of Form 10-K, the information required by Item 4 is omitted. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the outstanding common stock of the Company is owned by Holdings. American Express owns 100 percent of the common stock of Holdings, representing approximately 93% of the issued and outstanding voting stock of Holdings. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Pursuant to General Instruction J of Form 10-K, the information required by Item 6 is omitted. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction J of Form 10-K, the information required by Item 7 is omitted. Set forth on the following pages is Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS ENVIRONMENT The Company's principal business activities, investment banking and securities trading and sales are, by their nature, subject to volatility, primarily due to changes in interest and foreign exchange rates, global economic and political trends and industry competition. As a result, revenues and earnings may vary significantly from quarter to quarter and from year to year. In 1993, the Company's operating results were achieved in an environment of declining interest rates in the United States, mixed economic trends around the world and continued globalization of the capital markets. The general decline in interest rates in the United States, which began in 1990, continued in 1993 with interest rates declining to their lowest levels in more than 10 years. Investors, seeking higher returns, reduced their holdings of short-term fixed income securities in favor of longer term debt and equity securities in U.S. and non-U.S. markets. Corporate issuers took advantage of this environment and the pools of capital available for investment to restructure their balance sheets through the issuance of equity, repayment of debt and refinancing of debt at lower interest rates. These factors resulted in record levels of debt and equity issuances in 1993. RESULTS OF OPERATIONS During 1993, the Company completed the sales of three businesses: The Boston Company on May 21; Shearson on July 31; and SLHMC on August 31. In the Company's audited historical consolidated financial statements, the operating results of The Boston Company are accounted for as a discontinued operation while the operating results of Shearson and SLHMC are included in the Company's results from continuing operations through their respective sale dates. Because of the significant sale transactions completed during 1993, the Company's historical financial statements are not fully comparable for all years presented. To facilitate an understanding of the Company's results, the following discussion is segregated into three sections and provides financial tables that serve as the basis for the review of results. These sections are as follows: - Historical Results: the results of the Company's ongoing businesses; the results of Shearson and SLHMC through their respective sale dates; the loss on the sale of Shearson; the reserves for non-core businesses; the results of The Boston Company (accounted for as a discontinued operation); and the cumulative effect of changes in accounting principles. - The Lehman Businesses: the results of the ongoing businesses of the Company. - The Businesses Sold: the results of Shearson and SLHMC; the loss on the sale of Shearson; and the reserves for non-core businesses related to the sale of SLHMC. HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Net revenues decreased 12% to $4,346 million in 1993 from $4,947 million in 1992 due to the sale of Shearson and SLHMC, offset in part by a 13% increase in net revenues of the Lehman Businesses. Net revenues of $4,947 million in 1992 increased 11% over 1991 net revenues of $4,457 million with net revenues of the Lehman Businesses and the Businesses Sold increasing by 12% and 10%, respectively. Non-interest expenses decreased 3% to $4,492 million in 1993 from $4,628 million in 1992 due to the sale of Shearson and SLHMC. Non-interest expenses of $4,628 million in 1992 increased 11% over 1991 non-interest expenses of $4,174 million due primarily to a 13% increase in compensation and benefits expense, (including a 15% increase in compensation and benefits expenses related to the Businesses Sold) and higher levels of provisions for legal settlements and bad debts. The Company reported a net loss of $259 million for the year ended December 31, 1993, compared to net income of $173 million in 1992 and net income of $160 million in 1991. Included in the 1993 net loss of $259 million was an after-tax loss on the sale of Shearson of $630 million ($535 million pre-tax) and an after-tax charge of $92 million ($141 million pre-tax) related to certain non-core businesses, including a $79 million ($120 million pre-tax) charge related to the sale of SLHMC and a $13 million ($21 million pre-tax) charge related to certain partnership syndication activities in which the Company is no longer actively engaged. The 1993 net loss also included income from discontinued operations of The Boston Company of $189 million, which included an after-tax gain of $165 million on the sale and after-tax operating earnings of $24 million. The 1992 net income of $173 million included a $22 million ($33 million pre-tax) write-down in the carrying value of certain real estate investments, income from discontinued operations of $77 million and a charge of $8 million related to the cumulative effect of the changes in accounting for non-pension postretirement benefits and income taxes. Net income of $160 million in 1991 included income from discontinued operations of $10 million and a $71 million tax benefit on previously reported losses for which no financial statement benefit had been permitted. Included in the table below are the specific revenue and expense categories comprising the historical results as segregated between the Lehman Businesses and the Businesses Sold. The historical amounts for the Lehman Businesses do not include pro forma adjustments for the effects of the Distribution. THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 Summary. For the Lehman Businesses, income from continuing operations increased 122% to $266 million in 1993 from $120 million in 1992. The 1993 results consisted of $279 million of income from the continuing businesses decreased by a $14 million reserve ($21 million pre-tax) for certain non-core partnership syndication activities in which the Company is no longer actively engaged. The 1992 results include a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments. Net Revenues. Net revenues increased 13% to $2,595 million in 1993 from $2,304 million in 1992. Revenues related to market making and principal transactions and investment banking were the primary sources of the increase. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities, as well as proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to- market gains and (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company utilizes various hedging strategies as it deems appropriate to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Market making and principal transactions revenues increased 13% to $1,053 million in 1993 from $934 million in 1992, reflecting greater activity and strong customer order flow across all business lines. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Market Making & Principal Transactions Revenues (in millions): Fixed income revenues decreased 20% to $462 million in 1993 from $580 million in 1992. This decrease was due principally to decreased revenues from mortgage-related securities and money market instruments. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues increased 28% to $288 million from $225 million in 1992, primarily as a result of higher revenues from the Company's proprietary trading activities. Derivative products revenues include net revenues primarily from the trading and market making activities of the Company's fixed income derivative products group. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Derivative products revenues increased 213% to $222 million in 1993 from $71 million in 1992. The increased revenues were primarily a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1993, the notional value of the Company's fixed income derivatives contracts increased to over $270 billion from approximately $110 billion at December 31, 1992. Notional amounts do not represent a quantification of the market or credit risk of the positions; rather, notional amounts represent the amounts used to calculate contractual cash flows to be exchanged and are generally not actually paid or received. During 1994, the Company will commence derivative trading and market making activities through Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary is expected to increase the Company's customer base and the volume of activity in its fixed income derivatives business and capture additional underwriting business. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts and other commodity futures contracts. Revenues from these sources increased 40% to $81 million in 1993 from $58 million in 1992. Included in these results were foreign exchange revenues of $70 million and $56 million for 1993 and 1992, respectively, reflecting an increase of 25%. This increase was due primarily to increased customer-related and proprietary trading activities throughout 1993. Revenues from commodity trading activities increased to $11 million in 1993 from approximately $2 million in 1992, due primarily to increased customer-related trading activities throughout 1993. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1993 and 1992 were $234 billion and $97 billion, respectively. Investment Banking. Investment banking revenues increased 24% to $624 million in 1993 from $502 million in 1992. The 1993 results were driven primarily by a 39% increase in underwriting revenues to $477 million in 1993 from $343 million in 1992. Underwriting revenues increased as a result of significantly higher underwriting volumes in both equity and fixed income products, with the increase in equity underwriting the primary component. Commissions. Commission revenues increased 7% to $437 million in 1993 from $410 million in 1992, primarily as a result of higher volumes of customer trading of securities and commodities on exchanges. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 3% to $4,868 million in 1993 from $4,717 million in 1992. Net interest and dividend income increased 6% to $426 million in 1993 from $401 million in 1992. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue is due to trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues decreased 4% to $55 million in 1993 from $57 million in 1992. Asset management and related advisory fees increased 15% to $23 million in 1993 from $20 million in 1992, offset by a decrease in certain other revenue sources. Non-interest Expense. Compensation and benefits expense increased 14% to $1,400 million in 1993 from $1,223 million in 1992, reflecting higher compensation due to increases in revenues and profitability. However, compensation and benefits expense as a percentage of net revenues increased only moderately to 54.0% in 1993 from 53.1% in 1992. Excluding compensation and benefits expense, non-interest expenses decreased 8% to $803 million in 1993 from $869 million in 1992. Included in the 1993 amount was a charge of $21 million ($14 million after-tax) related to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The 1992 results included a $33 million write down ($22 million after-tax) in the carrying value of certain real estate investments. Excluding these charges, as well as compensation and benefits, non-interest expenses declined 6% to $782 million in 1993 from $836 million in 1992. This decrease was due primarily to lower levels of provisions for legal settlements and bad debts and reduced operating expenses. Cost Reduction Effort. In August 1993, the Company announced an expense reduction program with the objective of reducing costs by $170 million on an annualized basis by the end of the first quarter of 1994. The Company's expense structure for the first half of 1993, adjusted for changes in the volume and mix of revenues as well as for additional costs due to external factors such as inflation or new legislation, is the basis against which these goals are being measured. As of March 31, 1994, the Company had taken the following actions which it believes will result in $170 million of cost reductions on an annualized basis: (i) reduced certain purchased costs by lowering the volume of goods and services purchased, renegotiating rates with vendors and strengthening internal compliance with established policies and procedures; (ii) consolidated certain administrative and support functions; (iii) strengthened compliance and control functions; and (iv) completed its annual review of personnel, the objective of which is to upgrade personnel and eliminate positions to improve the Company's overall productivity. During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. In addition to these actions, the Company has identified a variety of actions that are expected to reduce expenses further, such as (i) additional reductions in certain purchased expenses and (ii) the relocation in the summer of 1994 of certain administrative, operations and other support personnel to newly leased facilities in New Jersey. See "Properties." Distribution of Holdings Common Stock On January 24, 1994, American Express announced the Distribution. Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file the Registration Statement with the Commission with respect to the Distribution during the second quarter of 1994. THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Summary. For the Lehman Businesses, income from continuing operations decreased 37% to $120 million in 1992 from $190 million in 1991, primarily as a result of a higher effective tax rate in 1992 as compared to 1991, due to the recognition in 1991 of $71 million of tax benefits under Statement of Financial Accounting Standards ("SFAS") No. 96. The 1992 results reflect higher revenues in virtually all of the Company's major revenue categories and improved net interest margins resulting in a 12% increase in net revenues. Also contributing to the 1992 results was a 14% increase in non-interest expense primarily due to a 10% increase in compensation and benefits expense in line with the improved net revenues and a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments. Net Revenues. Net revenues increased 12% to $2,304 million in 1992 from $2,051 million in 1991. Investment banking revenues were the primary source of the improvement, increasing 42% to $502 million in 1992 from $354 million in 1991. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities and proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to-market gains and (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company uses various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets as it deems appropriate. Market making and principal transactions revenues increased 10% in 1992 to $934 million from $846 million in 1991. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Revenues from fixed income products increased 36% to $580 million in 1992 from $427 million in 1991, with mortgage-related securities and money market instruments contributing most of the increase. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues decreased 29% to $225 million in 1992 from $318 million in 1991, primarily as a result of lower revenues from the Company's proprietary trading activities. Derivative products revenues include net revenues primarily from the trading and market making activities of the Company's fixed income derivatives group. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Derivative products revenues increased 78% to $71 million in 1992 from $40 million in 1991, primarily as a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1992, the notional value of the Company's fixed income derivatives contracts increased to approximately $110 billion from approximately $45 billion at December 31, 1991. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts and other commodity futures contracts. Revenues from these sources decreased 5% to $58 million in 1992 from $61 million in 1991. Foreign exchange revenues increased 19% to $56 million in 1992 from $47 million in 1991, primarily due to an expansion of the Company's proprietary trading activities during 1992. Commodity trading revenues decreased to approximately $2 million in 1992 from approximately $14 million in 1991. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1992 and 1991 were $97 billion and $53 billion, respectively. Investment Banking. Investment banking revenues increased 42% to $502 million in 1992 from $354 million in 1991. This increase was due to a 61% increase in underwriting revenues to $343 million in 1992 from $213 million in 1991. Commissions. Commission revenues decreased 10% to $410 million in 1992 from $458 million in 1991. This decrease was due primarily to the strategic deemphasis of the Company's institutional futures sales activities in 1992. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 10% to $4,717 million in 1992 from $4,283 million in 1991. Net interest and dividend income increased 18% to $401 million in 1992 from $340 million in 1991. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue results from trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues increased 8% to $57 million in 1992 from $53 million in 1991. The growth in asset management fees was the primary source of this increase. Asset management and related advisory fees increased 33% to $20 million in 1992 from $15 million in 1991. Non-interest Expense. Compensation and benefits expense increased 10% to $1,223 million in 1992 from $1,114 million in 1991. Compensation and benefits expense as a percent of net revenues decreased to 53.1% in 1992 from 54.3% in 1991, due to improvements in productivity. Excluding compensation and benefits, non-interest expenses increased 21% to $869 million in 1992 from $719 million in 1991. As previously discussed, 1992 results included a $33 million write-down in the carrying value of certain real estate investments. Excluding this charge, as well as compensation and benefits expense, other non-interest expenses increased 16% to $836 million in 1992 from $719 million in 1991. The increase in expenses was due primarily to higher provisions for legal settlements and bad debts as well as increased operating expenses related to the Company's investments in the expansion of its foreign exchange and derivatives businesses. THE LEHMAN BUSINESSES INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In 1993, the Lehman Businesses had an income tax provision of $126 million which consisted of a provision of $133 million for continuing businesses and a tax benefit of $7 million related to non-core business reserves. The effective tax rate for the continuing businesses was 32%, which is less than the statutory U.S. federal income tax rate principally due to benefits attributable to income subject to preferential tax treatment partially offset by state and local income taxes. During the third quarter of 1993, the statutory U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $8 million from the impact of the federal rate change on the Company's net deferred tax assets. The Company's effective tax rate for continuing businesses is expected to increase slightly in 1994, subject to changes in the level and geographic mix of the Company's profits. The Company had a net deferred tax liability of $36 million in 1992 as compared to a net deferred tax asset of $148 million in 1991. The elimination of the net deferred tax asset was primarily related to the utilization of net operating loss carryforwards ("NOLs") which resulted in cash savings to the Company. In addition, the Company had, as of December 31, 1993, approximately $145 million of tax NOLs available to offset future taxable income, the benefits of which have not yet been reflected in the financial statements. Although the benefit related to these NOLs does not currently meet the recognition criteria of SFAS No. 109, strategies are being implemented to increase the likelihood of realization. It is anticipated that approximately $15 million of these NOLs will be transferred to American Express in connection with the Distribution. In 1992, the Lehman Businesses had an income tax provision of $92 million which consisted of a provision of $103 million from continuing businesses and a tax benefit of $11 million related to the $33 million write-down in certain real estate investments previously discussed. Excluding this tax benefit, the effective tax rate for the continuing businesses was 42%, which was higher than the statutory U.S. federal income tax rate primarily due to state and local taxes. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Previously, the Company accounted for income taxes in accordance with SFAS No. 96. As a result of the adoption, the Company recorded a $68 million increase in consolidated net income from the cumulative effect of this change in accounting principles, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E. F. Hutton Group Inc. The Company established a deferred tax asset of $326 million in the first quarter of 1992 related to tax benefits previously unrecorded under SFAS No. 96. The 1991 tax provision of $28 million includes $71 million for the recognition of benefits on previously reported losses for which no financial statement benefit had been permitted. Excluding the recognition of these benefits, the 1991 effective tax rate was 46%, which was higher than the statutory U.S. federal income tax rate due primarily to state and local income taxes and the non-deductibility of goodwill amortization. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 This discussion is provided to analyze the operating results of the Businesses Sold. For purposes of this discussion, the amounts described as the Businesses Sold include the results of operations of Shearson and SLHMC, the loss on sale of Shearson and the reserve for non-core businesses related to the sale of SLHMC. All 1993 amounts for the Businesses Sold include results through their dates of sale and therefore reported results for 1993 are not fully comparable with prior years' results. Net revenues related to the Businesses Sold were $1,751 million in 1993 and $2,643 in 1992. Excluding the loss on the sale of Shearson and the reserve for non-core businesses related to SLHMC, non-interest expenses of the Businesses Sold were $1,634 million in 1993 and $2,536 million in 1992. Compensation and benefits expense were $1,164 million in 1993 and $1,759 million in 1992. The Businesses Sold recorded a net loss of $646 million in 1993 compared to net income of $52 million in 1992. The 1993 results include a loss on sale of Shearson of $630 million and a $79 million charge recorded in the first quarter as a reserve for non-core businesses in anticipation of the sale of SLHMC. The loss on the sale of Shearson included a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Excluding the $630 million after-tax loss on sale, Shearson's net income was $63 million in 1993 compared to $55 million in 1992. Excluding the $79 million after-tax charge discussed above, SLHMC operations were break-even in 1993 compared to a net loss of $3 million in 1992. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Net revenues related to the Businesses Sold increased 10% to $2,643 million in 1992 from $2,406 million in 1991, due primarily to increases in other revenues and commissions. The growth in other revenues was due to increases in investment advisory and custodial fees, reflecting growth in the Company's managed asset products. An increase in the volume of customer directed trading activity was the primary source of the increased level of commission revenues. Non-interest expenses of the Businesses Sold increased 8% to $2,536 million in 1992 from $2,341 million in 1991. Compensation and benefits increased 15% to $1,759 million in 1992 from $1,529 million in 1991, reflecting higher compensation due to increased revenues. Net income for the Businesses Sold increased 86% to $52 million in 1992 from $28 million in 1991. Shearson net income was $55 million in 1992 and $29 million in 1991. THE BUSINESSES SOLD INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The 1993 tax provision of $108 million for Businesses Sold included (i) expenses of $54 million related to the operating results of Shearson; (ii) an expense of $95 million from the sale of Shearson and (iii) a tax benefit of $41 million related to the $120 million reserve for non-core businesses recorded in anticipation of the sale of SLHMC. The provision related to the sale of Shearson primarily resulted from the write-off of $750 million of goodwill which was not deductible for tax purposes. For 1992 and 1991 the tax expense related principally to the Shearson operations. The effective tax rate for the Businesses Sold was 51% in 1992 and 57% in 1991, with the excess over the statutory U.S. federal income tax rate primarily resulting from state and local taxes and the non-deductibility of goodwill amortization. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, total assets were $57.8 billion, compared to $74.0 billion at December 31, 1992. The composition of the Company's assets changed significantly during 1993 due to the sales of The Boston Company, Shearson and SLHMC. The Company's asset base now consists primarily of cash and cash equivalents, and assets which can be sold within one year, including securities and other financial instruments owned, collateralized short-term agreements and receivables. At December 31, 1993, these assets comprised approximately 97% of the Company's balance sheet. Long-term assets consist primarily of other receivables, property, equipment and leasehold improvements, deferred expenses and other assets, and excess of cost over fair value of net assets acquired. Daily Funding Activities. The Company finances its short-term assets primarily on a secured basis through the use of securities sold under agreements to repurchase, securities and other financial instruments sold but not yet purchased, advances from Holdings and other affiliates, securities loaned and other collateralized liability structures. Repurchase agreements and other types of collateralized borrowings historically have been a more stable financing source under all market conditions. Because of their secured nature, these collateralized financing sources are less credit sensitive and also provide the Company access to lower cost funding. The Company uses short-term unsecured borrowing sources to fund short-term assets not financed on a secured basis. The Company's primary sources of short-term, unsecured general purpose funding include commercial paper and short-term debt, including master notes and bank borrowings under uncommitted lines of credit. Commercial paper and short-term debt outstanding totalled $2.6 billion at December 31, 1993, compared to $6.6 billion at December 31, 1992. Of these amounts, commercial paper outstanding totalled $0.4 billion at December 31, 1993, with an average maturity of 14 days, compared to $3.2 billion at December 31, 1992, with an average maturity of 11 days. The 1993 year-end balances reflected the repayment of commercial paper and short-term debt obligations with the proceeds from the sales of The Boston Company, Shearson and SLHMC. To reduce liquidity risk, the Company carefully manages its commercial paper and master note maturities to avoid large refinancings on any given day. In addition, the Company limits its exposure to any single commercial paper investor to avoid concentration risk. LBI's access to short-term and long-term debt financing is highly dependent on its debt ratings. LBI's current long-term senior subordinated/short-term debt ratings are as follows: S&P A/A-1; Moody's A3/P-1 and IBCA -- /A1. As of the Distribution Date, LBI expects to receive a long-term senior debt rating of A and a short-term debt rating of from Fitch Investor Services. The Company's uncommitted lines of credit provide an additional source of short-term financing. As of December 31, 1993, the Company had $5.7 billion in uncommitted lines of credit, provided by 51 banks, consisting of facilities that the Company has been advised are available but for which no contractual lending obligation exists. Long-term assets are financed with a combination of long-term debt and equity. The Company issues subordinated indebtedness as an integral component of its regulatory capital base. The Company maintains long-term debt in excess of its long-term assets to provide additional liquidity, which the Company uses to meet its short-term funding requirements and reduce its reliance on commercial paper and short-term debt. During 1993, the Company issued $722 million in long-term debt, compared to $239 million in 1992. In addition to refinancing long-term debt, these issuances strengthened the Company's capital base, which consists of long-term debt plus equity. The Company staggers the maturities of its long-term debt to minimize refunding risk. At December 31, 1993, the Company had long-term debt outstanding of $3.7 billion with an average life of 2.6 years, compared to $4.4 billion outstanding at December 31, 1992, with an average life of 3.1 years. For long-term debt with a maturity of greater than one year, the Company had $2.4 billion outstanding with an average life of 3.7 years at December 31, 1993, compared to $3.5 billion outstanding with an average life of 3.7 years at December 31, 1992. The Company anticipates that 1994 long-term debt issuances will exceed those of 1993. The proceeds of these issuances primarily will be used to refinance long-term debt maturing in 1994 and to meet regulatory capital objectives. The Company enters into a variety of financial and derivative products agreements as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. These agreements are not part of the Company's trading portfolio of derivative products. The Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense or income related to these agreements on an accrual basis, including the amortization of premiums, over the life of the contracts. At December 31, 1993 and 1992, the Company had outstanding interest rate swap and cap agreements for the above purposes of approximately $2.7 billion and $2.9 billion, respectively. Included in these amounts were approximately $2.3 billion of interest rate swaps and caps, maturing in 1995 and 1997, which serve to reduce the Company's overall fixed rate debt to a lower fixed rate. Of the remaining interest rate swaps, the most significant serve to convert a portion of the Company's fixed rate debt to a floating rate. The Company has matched substantially all of the maturities of its remaining interest rate swaps to the terms of its underlying borrowings. The $2.7 billion of notional amount of interest rate swap and cap agreements mature as follows: The effect of interest rate swap and cap agreements was to decrease interest expense by approximately $54 million, $53 million and $15 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, the unrecorded net gain on these agreements was approximately $55 million and $84 million, respectively. The Company has no deferred gains or losses related to terminated agreements. The Company expects to continue using interest rate swap and cap agreements to modify the effective interest cost associated with its long-term indebtedness. The $2.3 billion of interest rate swaps and caps described above, which reduce the Company's rate on its fixed rate debt to a lower fixed rate, will lower 1994 and 1995 interest expense by approximately $25 million and $15 million, respectively. The effect of the remaining interest rate swaps is dependent on the level of interest rates in the future. Liquidity Management. The maintenance of the liability structure and balance sheet liquidity as discussed above is achieved through the daily execution of the following financing policies: (i) match funding the Company's assets and liabilities; (ii) maximizing the use of collateralized borrowing sources; and (iii) diversifying and expanding borrowing sources. (i) The Company's first financing policy focuses on funding the Company's assets with liabilities which have maturities similar to the anticipated holding period of the assets to minimize refunding risk. The anticipated holding period of assets financed on an unsecured basis is determined by the expected time it would take to obtain financing for these assets on a collateralized basis. (ii) The Company's second financing policy is to maximize that portion of its balance sheet that is funded through collateralized borrowing sources, which include repurchase agreements, securities loaned, securities sold but not yet purchased and other collateralized liability structures. The Company currently funds over 68% of its assets on a collateralized basis. As discussed above, repurchase agreements and other types of collateralized borrowings historically have been a more reliable financing source under all market conditions. (iii) The Company's third financing policy is to diversify and expand its borrowing sources in an effort to maximize liquidity and reduce concentration risk. Through its institutional sales force, the Company seeks financing from a global investor base with the goal of broadening the availability of its funding sources. The Company incorporates these policies in its liquidity contingency planning process, which is designed to enhance the availability of alternative sources of funding in a period of financial stress. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. The Company's liquidity contingency plan is based on an estimate of its ability to meet its funding requirements with collateralized financing. To help achieve this objective, the Company would rely on the additional liquidity created by its policy of issuing long-term debt in excess of long-term assets and its ability to pledge its unencumbered marketable securities as collateral to obtain financing rather than on a sale of these securities. The Company's liquidity contingency plan is continually reviewed and updated as the Company's asset/liability mix and liquidity requirements change. The Company believes that these policies, combined with the maintenance of sufficient capital levels, position the Company to meet its liquidity requirements in periods of financial stress. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES In addition to financial instruments recorded on the consolidated balance sheet, the Company enters into off-balance sheet financial instruments primarily consisting of derivative contracts and credit-related arrangements. Derivative products include futures, forwards, swaps, options, caps, collars, floors, swaptions, forward rate agreements, foreign exchange contracts and similar instruments. Derivative products are generally based on notional amounts, while credit-related arrangements are based upon contractual amounts. The notional values of these instruments are generally not recorded on the balance sheet. Off-balance-sheet treatment is generally considered appropriate when the exchange of the underlying asset or liability has not occurred or is not assured, or where the notional amounts are utilized solely as a basis for determining cash flows to be exchanged. Therefore, the notional amounts of these instruments do not reflect the Company's market or credit risk amount. The Company conducts its derivative activities through wholly owned subsidiaries. In late 1993, the Company established a new subsidiary, Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary, which is expected to commence activities during the third quarter of 1994, was established to increase the volume of the Company's derivatives business related to customer-driven derivative activities. The Company records derivatives from dealer-related and proprietary trading activities at market or fair value, with unrealized gains and losses, recognized in the consolidated statement of operations as market making and principal transactions revenue. While the notional value of these instruments is not reflected in the consolidated balance sheet, the mark to market value of trading-related derivatives is reflected on a net basis in the December 31, 1993 and 1992 balance sheets as securities and other financial instruments owned or securities and other financial instruments sold not yet purchased, as applicable. Derivative products, like all financial instruments, include various elements of risk which must be actively managed. General types of risk from derivative products include market risk, liquidity risk and credit risk. Market risk from derivatives results from the potential for changes in interest and foreign exchange rates and fluctuations in commodity or equity prices. The market risk for derivatives is similar to that of cash instruments. The Company may employ hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Liquidity risk from derivatives represents the cost to the Company of adjusting its positions in times of high volatility and financial stress. The liquidity of derivative products is highly related to the liquidity of the underlying cash instruments. As with on-balance sheet financial instruments, the Company's valuation policies for derivatives include consideration of liquidity factors. The Company incorporates these policies in its liquidity contingency planning process, which is designed to enhance the availability of alternative sources of funding in a period of financial stress. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. The Company's liquidity contingency plan is based on an estimate of its ability to meet its funding requirements with collateralized financing. To help achieve this objective, the Company would rely on the additional liquidity created by its policy of issuing long-term debt in excess of long-term assets and its ability to pledge its unencumbered marketable securities as collateral to obtain financing rather than on a sale of these securities. The Company's liquidity contingency plan is continually reviewed and updated as the Company's asset/liability mix and liquidity requirements change. The Company believes that these policies, combined with the maintenance of sufficient capital levels, position the Company to meet its liquidity requirements in periods of financial stress. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES In addition to financial instruments recorded on the consolidated balance sheet, the Company enters into off-balance sheet financial instruments primarily consisting of derivative contracts and credit-related arrangements. Derivative products include futures, forwards, swaps, options, caps, collars, floors, swaptions, forward rate agreements, foreign exchange contracts and similar instruments. Derivative products are generally based on notional amounts, while credit-related arrangements are based upon contractual amounts. The notional values of these instruments are generally not recorded on the balance sheet. Off-balance-sheet treatment is generally considered appropriate when the exchange of the underlying asset or liability has not occurred or is not assured, or where the notional amounts are utilized solely as a basis for determining cash flows to be exchanged. Therefore, the notional amounts of these instruments do not reflect the Company's market or credit risk amount. The Company conducts its derivative activities through wholly owned subsidiaries. In late 1993, the Company established a new subsidiary, Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary, which is expected to commence activities during the third quarter of 1994, was established to increase the volume of the Company's derivatives business related to customer-driven derivative activities. The Company records derivatives from dealer-related and proprietary trading activities at market or fair value, with unrealized gains and losses, recognized in the consolidated statement of operations as market making and principal transactions revenue. While the notional value of these instruments is not reflected in the consolidated balance sheet, the mark to market value of trading-related derivatives is reflected on a net basis in the December 31, 1993 and 1992 balance sheets as securities and other financial instruments owned or securities and other financial instruments sold not yet purchased, as applicable. Derivative products, like all financial instruments, include various elements of risk which must be actively managed. General types of risk from derivative products include market risk, liquidity risk and credit risk. Market risk from derivatives results from the potential for changes in interest and foreign exchange rates and fluctuations in commodity or equity prices. The market risk for derivatives is similar to that of cash instruments. The Company may employ hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Liquidity risk from derivatives represents the cost to the Company of adjusting its positions in times of high volatility and financial stress. The liquidity of derivative products is highly related to the liquidity of the underlying cash instruments. As with on-balance sheet financial instruments, the Company's valuation policies for derivatives include consideration of liquidity factors. Credit risk from derivatives relates to the potential for a counterparty defaulting on its contractual agreement. The Company manages its counterparty credit risk through a process similar to its other trading-related activities. This process includes an evaluation of the counterparty's credit worthiness at the inception of the transaction, periodic review of credit standing and various credit enhancements in certain circumstances. In addition, the Company attempts to execute master netting agreements which provide for net settlement of contracts with the same counterparty in the event of cancellation or default when appropriate or when allowable under relevant law. For a discussion of the Company's policies and procedures regarding risk, see "Business -- Risk Management." Cash Flows. Cash and cash equivalents increased $21 million in 1993 to $316 million, as the net cash provided by operating and investing activities exceeded the net cash used in financing activities. In addition, cash and cash equivalents for discontinued operations increased $42 million in 1993. Net cash provided by operating activities of $1,312 million included the loss from continuing operations adjusted for non-cash items of approximately $464 million for the year ended December 31, 1993. Net cash used in financing activities was $3,784 million in 1993. Net cash provided by investing activities of $2,535 million in 1993 included cash proceeds from the sales of The Boston Company, Shearson and SLHMC of $2,570 million. Cash and cash equivalents decreased $120 million in 1992 to $295 million, as the net cash used in operating and investing activities exceeded the net cash provided by financing activities. In addition, cash and cash equivalents for discontinued operations decreased $1,082 million. Net cash used in operating activities of $5,194 million included income from continuing operations adjusted for non-cash items of approximately $564 million for the year ended December 31, 1992. Net cash used in investing activities was $25 million in 1993. Net cash provided by financing activities was $4,017 million. Cash and cash equivalents decreased $388 million in 1991 to $415 million as the net cash provided by financing and investing activities was exceeded by net cash used and operating activities. In addition, cash and cash equivalents for discontinued operations increased $706 million. Net cash used in operating activities of $3,365 million included income from continuing operations adjusted for non-cash items of approximately $538 million for the year ended December 31, 1991. Net cash provided by financing and investing activities was $879 million and $2,804 million, respectively. SPECIFIC BUSINESS ACTIVITIES AND TRANSACTIONS The following sections include information on specific business activities of the Company which affect overall liquidity and capital resources: Westinghouse. In May 1993, the Company and Westinghouse Electric Corporation ("Westinghouse") entered into a partnership to facilitate the disposition of Westinghouse's commercial real estate portfolio valued at approximately $1.1 billion, which will be accomplished substantially by securitizations and asset sales. The Company invested approximately $154 million in the partnership, and also made collateralized loans to the partnership of $752 million. During the third quarter of 1993, Lennar Inc. was appointed portfolio servicer and purchased a 10% limited partnership interest from the Company and Westinghouse. At December 31, 1993, the carrying value of the Company's investment in the partnership was $154 million and the outstanding balance of the collateralized loan, including accrued interest, was $539 million. The remaining loan balance is expected to be repaid in 1994 through a combination of mortgage remittances, securitizations, asset sales and refinancings by third parties. High Yield Securities. The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade companies. For purposes of this discussion, high yield debt securities are defined as securities of or loans to companies rated below BBB- by S&P and below Baa3 by Moody's, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. High yield debt securities are carried at market value and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Operations. The Company's portfolio of such securities at December 31, 1993 and 1992 included long positions with an aggregate market value of approximately $661 million and $895 million, respectively, and short positions with an aggregate market value of approximately $75 million and $47 million, respectively. The portfolio may from time to time contain concentrated holdings of selected issues. The Company's two largest high yield positions were $61 million and $56 million at December 31, 1993 and $128 million and $123 million at December 31, 1992. Change in Facilities. In 1993, Holdings agreed to lease approximately 392,000 square feet of office space located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The lease term will commence in August 1994 and provides for minimum rental payments of approximately $87 million over its 16-year term. Concurrently, Holdings announced it would relocate certain administrative employees to five additional floors at 3 World Financial Center in New York, New York. These floors will be purchased by Holdings from American Express for approximately $44 million by Holdings. In connection with the relocation to the Operations Center and the additional space at the World Financial Center, Holdings anticipates incremental fixed asset additions of approximately $112 million. Upon commencement of the relocation, a substantial portion of the lease and depreciation charges will be allocated to the Company based upon the Parent's method of allocating certain intercompany charges. Non-Core Activities and Investments. In March 1990, the Company discontinued the origination of partnerships (whose assets are primarily real estate) and investments in real estate. Currently, the Company acts as a general partner for approximately $4.2 billion of partnership investment capital and manages a real estate investment portfolio with an aggregate investment basis of approximately $108 million. The Company provided additional reserves for these activities of $21 million and $33 million in 1993 and 1992, respectively. At December 31, 1993 and 1992, the Company had remaining net exposure to these investments (defined as the remaining unreserved investment balance plus outstanding commitments and contingent liabilities under guarantees and credit enhancements) of $71 million and $201 million, respectively. In certain circumstances, the Company provides financial and other support and assistance to such investments to maintain investment values. Except as described above, there is no contractual requirement that the Company continue to provide this support. Although a decline in the real estate market or the economy in general or a change in the Company's disposition strategy could result in additional real estate reserves, the Company believes that it is adequately reserved. CHANGE OF FISCAL YEAR On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year-end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. EFFECTS OF INFLATION Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company's expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company's financial position and results of operations in certain businesses. NEW ACCOUNTING PRONOUNCEMENTS Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The FASB has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. In November 1992, the FASB issued Statement of Financial Standards ("SFAS") No. 112, "Employers Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company records substantially all its securities at market value. No adjustment is anticipated to be recorded as a result of this accounting pronouncement. RISK MANAGEMENT Risk management is an integral part of the Company's business. The Company has established extensive policies and procedures to identify, monitor, assess and manage risk effectively. For a discussion of these policies and procedures, see "Business -- Risk Management." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary financial information required by this Item and included in this Report are listed in the Index to Financial Statements and Schedules appearing on page and are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction J of Form 10-K, the information required by Item 10 is omitted. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction J of Form 10-K, the information required by Item 11 is omitted. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction J of Form 10-K, the information required by Item 12 is omitted. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction J of Form 10-K, the information required by Item 13 is omitted. PART IV ITEM 14. ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Index to Consolidated Financial Statements and Schedules appearing on Page. 2. Financial Statement Schedules: See Index to Consolidated Financial Statements and Schedules appearing on Page. 3. Exhibits - --------------- * Filed herewith. SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LEHMAN BROTHERS INC. (Registrant) March 31, 1994 By: /s/ THOMAS A. RUSSO ------------------------------------ Title: Managing Director 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. LEHMAN BROTHERS INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Schedules other than those listed above are omitted since they are not required or are not applicable or the information is furnished elsewhere in the consolidated financial statements or the notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder of Lehman Brothers Inc. We have audited the accompanying consolidated balance sheet of Lehman Brothers Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Inc. and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 11 to the consolidated financial statements, in 1992 the Company changed its methods of accounting for postretirement benefits and income taxes. ERNST & YOUNG New York, New York February 3, 1994 except for Note 2, as to which the date is March 28, 1994 LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN MILLIONS) ASSETS See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET -- (CONTINUED) (IN MILLIONS, EXCEPT SHARE DATA) LIABILITIES AND STOCKHOLDER'S EQUITY See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY THREE YEAR PERIOD ENDED DECEMBER 31, 1993 (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) (IN MILLIONS) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) (INCLUDING THE BOSTON COMPANY) Interest paid (net of amount capitalized) totaled $4,796 in 1993, $5,047 in 1992 and $5,029 in 1991. Income taxes paid totaled $265 in 1993, $20 in 1992 and $13 in 1991. SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITY The Company completed three sale transactions during the current year, the sale of The Boston Company, Shearson and SLHMC. The cash proceeds related to these sales have been separately reported in the above statement. Excluded from the statement are the individual balance sheet changes related to the net assets sold as well as the noncash proceeds received related to these sales. See Notes 3, 4 and 5. See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation The consolidated financial statements include the accounts of Lehman Brothers Inc., a registered broker-dealer (formerly Shearson Lehman Brothers Inc., "LBI") and subsidiaries (LBI together with its subsidiaries, the "Company" unless the context otherwise requires). LBI is a wholly owned subsidiary of Lehman Brothers Holdings Inc. (formerly Shearson Lehman Brothers Holdings Inc., "Holdings"). American Express Company ("American Express") owns 100% of Holdings' common stock, which represents approximately 93% of Holdings' voting stock. The remainder of Holdings' voting stock is owned by Nippon Life Insurance Company ("Nippon Life"). See Note 2. All material intercompany transactions and accounts have been eliminated. The Consolidated Statement of Operations includes the results of operations of Shearson and SLHMC, which were sold on July 31, 1993 and August 31, 1993, respectively. See Notes 4 and 5. The balance sheet accounts of the Company's foreign subsidiaries are translated using the exchange rates at the balance sheet date. Revenues and expenses are translated at average exchange rates during the year. The resulting translation adjustments, net of hedging gains or losses are included in stockholder's equity. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Operations. The Company uses the trade date basis of accounting for recording principal transactions. Customer accounts reflect transactions on a settlement date basis. Certain amounts reflect reclassifications to conform to the current period's presentation. Discontinued Operations As described in Note 3, the Company completed the sale of The Boston Company, Inc. ("The Boston Company"), on May 21, 1993. The accompanying consolidated financial statements and notes to consolidated financial statements reflect The Boston Company as a discontinued operation. Securities and Other Financial Instruments Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased, including interest rate and currency swaps, caps, collars, floors, swaptions, forwards, options and similar instruments are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in market making and principal transactions in the Consolidated Statement of Operations. Market value is generally based on listed market prices. If listed market prices are not available, market value is determined based on other relevant factors, including broker or dealer price quotations, and valuation pricing models which take into account time value and volatility factors underlying the financial instruments. In addition to trading and market making activities, the Company enters into a variety of financial instruments and derivative products as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. As an end user, the Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense/revenue related to these instruments on an accrual basis, including the amortization of premiums, over the life of the contracts. Other than in connection with its debt related hedging programs, the Company's other hedging activities are immaterial. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Repurchase and Resale Agreements Securities purchased under agreements to resell and Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell and to value the securities on a daily basis to protect the Company in the event of default by the counterparty. In addition, provisions are made to obtain additional collateral if the market value of the underlying assets is not sufficient to protect the Company. Securities and other financial instruments owned which are sold under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Operations. Securities purchased under agreements to resell and Securities sold under agreements to repurchase for which the resale/repurchase date corresponds to the maturity date of the underlying securities are accounted for as purchases and sales, respectively. At December 31, 1993, such resale and repurchase agreements aggregated $5.5 billion and $5.2 billion. Securities Borrowed and Loaned Securities borrowed and Securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company's policy to value the securities borrowed and loaned on a daily basis, and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". Prior to January 1, 1992, the Company accounted for income taxes under the provisions of SFAS No. 96. Fixed Assets and Intangibles Property and equipment is depreciated on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases. The Company capitalizes interest costs during construction and amortizes the interest costs based on the useful lives of the assets. Excess of cost over fair value of net assets acquired is amortized using the straight-line method over a period of 35 years. Statement of Cash Flows The Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business. 2. SUBSEQUENT EVENTS: The Distribution On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all the Holdings Common Stock (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Change of Fiscal Year-End On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year-end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. 3. SALE OF THE BOSTON COMPANY: On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between the Company and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction") The Boston Company, which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten-year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million for the Mellon Transaction. In connection with the completion of the Mellon Transaction, the Company paid a $300 million dividend to Holdings. As a result of the Mellon Transaction, the Company has treated The Boston Company as a discontinued operation. Accordingly, the Company's financial statements segregate the net assets of The Boston Company, as of December 31, 1992, and operating results of The Boston Company for the three years ended December 31, 1993. Presented below are the results of operations and the gain on disposal of The Boston Company included in Income from discontinued operations (in millions): LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. SALE OF SHEARSON: On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation) ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participation Right payment in the first quarter of 1994. It is anticipated that all of the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, the Company received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39 per share. In August 1993, American Express purchased such preferred stock and warrant from LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Presented below are the results of operations and the loss on the sale of Shearson (in millions): Shearson operating results reflect allocated interest expense of $72 million, $102 million, and $112 million for the years ended December 31, 1993, 1992 and 1991, respectively. 5. SALE OF SHEARSON LEHMAN HUTTON MORTGAGE CORPORATION: The Company completed the sale of its wholly owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC") to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire debt of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC, which are included in the LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $141 million of pre-tax reserves for non-core businesses on the Consolidated Statement of Operations. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. 6. SECURITIES AND OTHER FINANCIAL INSTRUMENTS: Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased are summarized as follows (in millions): 7. CASH AND SECURITIES SEGREGATED AND ON DEPOSIT FOR REGULATORY AND OTHER PURPOSES: In addition to amounts presented in the accompanying Consolidated Balance Sheet as Cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $890 million and $341 million at December 31, 1993 and 1992, respectively, primarily collateralizing resale agreements, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of Commission Rule 15c3-3. 8. COMMERCIAL PAPER AND SHORT-TERM DEBT: Short-term debt consists primarily of bank loans, master notes and payables to banks. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. SENIOR NOTES: As of December 31, 1993 the Company had $490 million of fixed rate senior notes outstanding. Contractual interest rates on these notes ranged from 7.86% to 12.20% as of December 31, 1993, with a contractual weighted average interest rate of 10.60%. The Company utilized a series of fixed rate basis swaps totalling $341 million to lower this fixed rate to an effective weighted average interest rate of 9.61%. As of December 31, 1993 the Company had $163 million of floating rate senior notes outstanding. Contractual interest rates on these notes ranged from 3.87% to 4.43% as of December 31, 1993, with a contractual weighted average interest rate of 4.38%. Included in floating rate senior notes outstanding were $148 million of borrowings from a subsidiary of Holdings, the recourse of which is limited to certain fixed assets. Interest rates on these related party borrowings are based on the subsidiary's cost of funds. As of December 31, 1993, the effective weighted average interest rate on these related party borrowings was 4.43%. The Company's interest in 3 World Financial Center is financed with fixed rate senior notes totalling $384 million as of December 31, 1993. Of this amount, $301 million is guaranteed by American Express with a portion of these notes being collateralized by certain mortgage obligations. The remaining $83 million of debt supporting the Company's interest in 3 World Financial Center was loaned to the Company by American Express, the recourse of which is limited to certain fixed assets. During 1993, the Company utilized proceeds from the sale of Shearson to repay $570 million of sole recourse notes from a subsidiary of Holdings, which supported buildings and certain fixed assets sold to Travelers. Of the fixed rate senior notes maturing in 1996, $102 million are an obligation of a subsidiary of LBI and are guaranteed by Holdings. As of December 31, 1993, the fair value of the Company's senior notes was approximately $678 million ($1,335 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approximately $25 million ($58 million in 1992). For purposes of this fair value calculation, the carrying value of variable rate debt that reprices within a year and fixed rate debt which matures in less than six months approximates fair value. For the remaining portfolio, fair value was estimated using either quoted market prices or discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. Unrecognized gains on interest rate swaps and other transactions used by the Company to manage its interest rate risk within the senior notes portfolio were $6 million and $7 million as of December 31, 1993 and 1992, respectively. The unrecognized gains on these transactions reflect the estimated amounts the Company would receive if the agreements were terminated as calculated based upon market rates as of December 31, 1993 and 1992, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. SUBORDINATED INDEBTEDNESS: As of December 31, 1993, the Company had $2,660 million of fixed rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness ranged from 5.75% to 13.13% as of December 31, 1993, with an effective weighted average rate of 8.52%. The Company entered into interest rate swap contracts which effectively converted $425 million of this debt to floating rates based on the London Interbank Offered Rate "LIBOR". Exclusive of this $425 million, the Company utilized a series of fixed rate basis swaps totalling $1,949 million to lower the fixed rate of this portfolio to an effective weighted average interest rate of 7.45% as of December 31, 1993. As of December 31, 1993, the Company had $393 million of floating rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness are primarily based on LIBOR and ranged from 2.91% to 4.13% as of December 31, 1993, with an effective weighted average rate of 3.75%. Including the effect of the $425 million of fixed rate indebtedness swapped to floating rates at an effective weighted average rate of 3.58%, the effective weighted average rate of the Company's floating rate subordinated indebtedness was 3.66%. Of the Company's subordinated indebtedness outstanding as of December 31, 1993, $160 million is repayable prior to maturity at the option of the holder. This obligation is reflected in the above table as maturing in 1996, the year in which the holder has the option to redeem the debt at par value, rather than its contractual maturity of 2003. Subordinated borrowings from Holdings and subsidiaries of Holdings were $1,183 million as of December 31, 1993, all of which were at a fixed rate. Interest rates on these related party borrowings are based on Holdings', and subsidiaries of Holdings' cost of funds and ranged from 6.12% to 13.13% as of December 31, 1993, with an effective weighted average rate of 7.57%. Of this amount, $100 million (which is included in the $425 million swapped indebtedness discussed previously) was swapped to floating rates based on LIBOR, with an effective weighted average rate of 3.09%. Excluding this $100 million, the effective weighted average rate of related party borrowings was 7.07%. As of December 31, 1993, $2,211 million of the total subordinated indebtedness outstanding was senior subordinated indebtedness. As of December 31, 1993 the fair value of the Company's subordinated indebtedness was approximately $3,198 million ($3,212 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approximately $145 million ($117 million in 1992). Unrecognized gains on interest rate swaps and other transactions used by the Company to manage its interest rate risk on the debt was $49 million and $77 million at December 31, 1993 and 1992, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. CHANGE IN ACCOUNTING PRINCIPLES: Accounting for Postretirement Benefits Effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for the Company's retiree health and other welfare benefit plans. This accounting pronouncement requires the current recognition of these benefits as expenses based upon actuarially determined projections of the benefits provided. The cumulative effect of adopting SFAS No. 106 reduced 1992 net income by $76 million (net of taxes of $52 million). Of this amount, $5 million (net of taxes of $3 million) related to discontinued operations. Prior to the adoption of this accounting principle, the Company recorded these benefits as they were paid. Accounting for Income Taxes The Financial Accounting Standards Board ("FASB") issued SFAS No. 109, "Accounting for Income Taxes," which superseded SFAS No. 96, the accounting standard that the Company had followed since 1987. The primary difference between this accounting standard and SFAS No. 96, lies in the manner in which income tax expense is determined. SFAS No. 96 provided for significantly more restrictive criteria prior to the recognition of deferred tax assets. Under the provisions of SFAS No. 109, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carryforwards, if, in the opinion of management, it is more likely than not that the tax benefit will be realized. A valuation allowance is recognized, as a reduction of the deferred tax asset, for that component of the net deferred tax asset which does not meet the more likely than not criterion for realization. The Company adopted SFAS No. 109 as of January 1, 1992 and recorded a $68 million increase in consolidated net income from the Cumulative effect of a change in accounting principle, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E.F. Hutton Group Inc. (now known as LB I Group Inc., "Hutton"). 12. PENSION PLANS: The Company participates in several noncontributory defined benefit pension plans sponsored by Holdings. The cost of pension benefits for eligible employees, measured by length of service, compensation and other factors, is currently being funded through trusts established under the plans. Funding of retirement costs for the applicable plans complies with the minimum funding requirements specified by the Employee Retirement Income Security Act of 1974, as amended. Plan assets consist principally of equities and bonds. Total expense related to pension benefits amounted to $16 million, $23 million and $27 million for the years ended December 31, 1993, 1992 and 1991, respectively, and consisted of the following components (in millions): LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the funded status of the Company's defined benefit plans (in millions): The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation for the Company's plans was 7.25% for 1993 and 8.25% for 1992. The rate of increase in future compensation levels used was 5.5% and 6.0% for 1993 and 1992, respectively. The expected long-term rate of return on assets was 9.75% for 1993 and 1992. During 1993, the Company incurred a settlement and curtailment in relation to the Primerica Transaction. The net gain of approximately $26 million (pre-tax) is included in the loss on sale of Shearson. 13. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: The Company participates in several defined benefit health care plans sponsored by Holdings that provide health care, life insurance and other postretirement benefits to retired employees. The health care plans include participant contributions, deductibles, co-insurance provisions and service-related eligibility requirements. The Company funds the cost of these benefits as they are incurred. Net periodic postretirement benefit cost for the years ending December 31, 1993 and 1992 consisted of the following components (in millions): The Company previously accounted for the cost of these benefits by expensing the amount the Company paid. For the year ending December 31, 1991, $2.5 million was paid for such benefits. During 1993, the Company incurred a curtailment in relation to the Primerica Transaction. The net gain of approximately $56 million (pre-tax) is included in the loss on sale of Shearson. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the amount recognized in the Consolidated Balance Sheet for the Company's postretirement benefit plans (other than pension plans) at December 31, 1993 and 1992 (in millions): The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% in 1993 and 8.5% in 1992. The weighted average annual assumed health care cost trend rate is 13% in 1994 and is assumed to decrease at the rate of 1% per year to 7% in 2000 and remain at that level thereafter. An increase in the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $1.4 million. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. 14. INCOME TAXES: The Company's taxable income is included in the consolidated U.S. federal income tax return of American Express and in combined state and local tax returns with other affiliates of American Express. The income tax provision is computed in accordance with the income tax allocation agreement among Holdings, the Company and American Express. Under the agreement, the Company receives income tax benefits for net operating losses ("NOLs"), future tax deductions and foreign tax credits that are recognizable on a stand-alone basis, or a share, derived by formula, of such losses, deductions and credits that are recognizable on American Express' consolidated income tax return. Intercompany taxes are remitted to or from American Express when they are otherwise due to or from the relevant taxing authority. The balances due to Holdings at December 31, 1993 and 1992 were $180 million and $54 million, respectively, and are included in Accrued liabilities and other payables in the accompanying Consolidated Balance Sheet. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The provision (benefit) for income taxes from continuing operations consists of the following (in millions): During the third quarter of 1993, the U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $8 million from the impact of the rate change on the Company's net deferred tax assets as of January 1, 1993. Income from continuing operations before taxes included $41 million, $1 million and $11 million that is subject to income taxes of foreign jurisdictions for 1993, 1992 and 1991, respectively. The income tax provision differs from that computed by using the statutory federal income tax rate for the reasons shown below (in millions): Deferred income tax assets and liabilities result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements that will result in differences between income for tax purposes and income for consolidated financial statement purposes in future years. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993 and 1992, the Company's net deferred tax (liabilities) assets from continuing operations consisted of the following (in millions): At December 31, 1993 and 1992, deferred tax assets consisted primarily of reserves not yet deducted for tax purposes of $78 million and $144 million, respectively, and tax return NOLs of $38 million and $220 million, respectively. At December 31, 1993 and 1992, deferred tax liabilities consist primarily of unrealized trading and investment gains of $33 million and $44 million, respectively. During 1993, the Company increased deferred tax assets by approximately $65 million related to transactions arising from the sale of The Boston Company. In addition, in accordance with the tax sharing agreement with Holdings, the Company was reimbursed for $169 million and $99 million of net deferred tax assets in 1993 and 1992, respectively. The net deferred tax (liability) asset is included in Deferred expenses and other assets in the accompanying Consolidated Balance Sheet. At December 31, 1993, the valuation allowance recorded against deferred tax assets from continuing operations was $116 million as compared to $174 million at December 31, 1992. The reduction in the valuation allowance was primarily attributable to 1993 utilization of tax return NOLs for which a valuation allowance was previously established. Of the $116 million valuation allowance at December 31, 1993, approximately $100 million will reduce goodwill if future circumstances permit recognition. For tax return purposes, the Company has approximately $145 million of NOL carryforwards, all of which are attributable to the 1988 acquisition of Hutton. Substantially all of the NOLs are scheduled to expire in the years 1999 through 2007. A portion of the valuation allowance discussed above relates to these NOLs. It is anticipated that approximately $15 million of these NOLs will be transferred to American Express in connection with the Distribution discussed in Note 2, the benefit of which had not been reflected in the financial statements. 15. EMPLOYEE STOCK OWNERSHIP PLAN During 1993, Lehman Brothers established the Lehman Brothers Inc. Employee Ownership Plan (the "Employee Ownership Plan") pursuant to which certain key employees of Holdings deferred a percentage of their 1993 salary and bonus for the purchase of certain Phantom Units of Holdings. Each Phantom Unit is comprised of a phantom equity interest representing a notional interest in a share of common stock, $.10 par value per share ("Common Stock"), of Holdings ("Phantom Share") and the right to receive a certain amount in cash with respect to a Phantom Share ("Cash Right"). Phantom Shares were available for "purchase" through voluntary and mandatory deferrals of 1993 compensation. In accordance with the terms of the Plan, Phantom Units will be converted to the Common Stock contemporaneously with the effectiveness of the Distribution. See Note 2. The Company will recognize compensation expense in 1994 equal to (i) the increase in book value attributable to the Phantom Shares and (ii) the excess, if any, of the market value of the Common Stock on LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the Distribution Date issued pursuant to the Phantom Share conversion over the price paid by employees for the Phantom Shares. 16. CAPITAL REQUIREMENTS: As registered broker-dealers, LBI and certain of its subsidiaries are subject to the Net Capital Rule (Rule 15c3-1, the "Rule") promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. monitor the application of the Rule by LBI and such subsidiaries, as the case may be. LBI and such subsidiaries compute net capital under the alternative method of the Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if net capital is less than 4% of aggregate debit balances or 6% of the funds required to be segregated pursuant to the Commodity Exchange Act (the "Commodity Act") and the regulations thereunder, if greater. A broker-dealer may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations thereunder, if greater. In addition, the Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations, thereunder, if greater. The Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Commission when net capital after the withdrawal would be less than 25% of its securities positions haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Rule requires broker-dealers to notify the Commission and the appropriate self-regulatory organization two business days before the withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000 or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000 or 20% of excess net capital. Finally, the Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the firm or would jeopardize the broker-dealer's ability to pay its customers. At December 31, 1993, LBI's net capital aggregated $1,339 million and was $1,293 million in excess of minimum requirement. Also at December 31, 1993, Lehman Government Securities Inc., a wholly owned subsidiary of LBI, had net capital which aggregated $184 million and was $161 million in excess of minimum requirement. The Company is subject to other domestic and international regulatory requirements. As of December 31, 1993, the Company believes it is in material compliance with all such requirements. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 17. COMMITMENTS AND CONTINGENCIES: The Company leases office space and equipment and has entered into ground leases with the City of New York or its agencies. For each of the years ended December 31, 1993, 1992 and 1991, total rent expense was $163 million, $248 million and $246 million, respectively. Minimum future rental commitments under noncancellable operating leases (net of subleases of $660 million) are as follows (in millions): Certain leases on office space contain escalation clauses providing for additional rentals based upon maintenance, utility and tax increases. On October 13, 1993, Holdings executed a 16 year lease at 101 Hudson Street in Jersey City, New Jersey. The lease, which commences in August 1994, obligates Holdings to make minimum lease payments of approximately $87 million over its term. Upon commencement, a substantial portion of these lease payments will be allocated to the Company based upon Holdings' method for allocating certain intercompany charges. The lease commitment amounts presented above do not reflect these allocations which have yet to be finalized. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the opinions of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial statements. Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, the Company enters into financial instrument transactions to conduct its trading activities, to satisfy the financial needs of its clients and to manage its own exposure to credit and market risks. Many of these financial instruments typically have off-balance-sheet risk resulting from their nature including the terms of settlement. These instruments can be broadly categorized as interest rate and currency swaps, caps, collars, floors, swaptions and similar instruments (collectively "Swap Products"), foreign currency products, equity related products, commitments and guarantees and certain other instruments. Market risk arises from the possibility that market changes, including interest and foreign exchange rate movements, may make financial instruments less valuable. Credit risk results from the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. The Company has extensive control procedures regarding the extent of the Company's transactions with specific counterparties, the manner in which transactions are settled and the ongoing assessment of counterparty creditworthiness. The notional or contract amounts disclosed below provide a measure of the Company's involvement in such instruments but are not indicative of potential loss. Management does not anticipate any material adverse effect to its financial position or results of operations as a result of its involvement in these instruments. In many cases, these financial instruments serve to reduce, rather than increase, market risk. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company enters into interest rate contracts as principal in its trading operations or as an integral part of its interest rate risk management. These contracts include Swap Products, financial future contracts and forward security contracts. The notional or contractual amounts of these instruments are set forth below (in millions): The majority of the Company's off-balance-sheet transactions are short-term in duration with a weighted average maturity of approximately 1.83 years as of December 31, 1993 and 1.69 years as of December 31, 1992. Presented below is a maturity schedule for the notional/contractual amounts outstanding for Swap Products and other off-balance-sheet instruments (in millions): At December 31, 1993, the replacement cost of contracts in a gain position not recorded on the Company's Consolidated Balance Sheet is as follows (in millions): As of December 31, 1993 and 1992, the Company was contingently liable for $463 million and $822 million, respectively, of letters of credit primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges and other financial guarantees. As of December 31, 1993 and 1992, the Company had pledged or otherwise transferred securities, primarily fixed income, having a market value of $21.3 billion and $14.5 billion, respectively, as collateral for securities borrowed or otherwise received having a market value of $21.1 billion and $14.2 billion, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Securities sold but not yet purchased represent obligations of the Company to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater or less than the amount recorded. The Company's customer activities may expose it to off-balance-sheet credit risk. The Company may be required to purchase or sell financial instruments at prevailing market prices in the event of the failure of a customer to settle trades on their original terms, or in the event cash and securities in customer accounts are not sufficient to fully cover customer losses. The Company seeks to control the risks associated with customer activities through the use of systems and procedures for financial instruments with off-balance-sheet risk. Subsidiaries of the Company, as general partner, are contingently liable for the obligations of certain public and private limited partnerships organized as pooled investment funds or engaged primarily in real estate activities. In the opinion of the Company, contingent liabilities, if any, for the obligations of such partnerships will not in the aggregate have a material adverse effect on the Company's consolidated financial position or results of operations. Concentrations of Credit Risk As a major securities firm, the Company is actively involved in securities underwriting, distribution and trading. These and other related services are provided on a worldwide basis to a large and diversified group of clients and customers, including multinational corporations, governments, emerging growth companies, financial institutions and individual investors. A substantial portion of the Company's securities and commodities transactions is collateralized and is executed with and on behalf of commercial banks and other institutional investors, including other brokers and dealers. The Company's exposure to credit risk associated with the non-performance of these customers and counterparties in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile or illiquid trading markets which may impair the ability of customers and counterparties to satisfy their obligations to the Company. Securities and other financial instruments owned by the Company include U.S. government and agency securities and securities issued by U.S. governments which, in the aggregate, represented 18.9% of the Company's total assets at December 31, 1993. In addition, substantially all of the collateral held by the Company for resale agreements or bonds borrowed, which together represented 47.5% of total assets at December 31, 1993, consisted of securities issued by the U.S. government and federal agencies. In addition to these specific exposures, the Company's most significant concentration is financial institutions, which include other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of the Company's business. Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The FASB has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. 18. FAIR VALUE OF FINANCIAL INSTRUMENTS: In 1992, the Company adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," which requires disclosure of the fair values of most on- and off-balance-sheet financial instruments for which it is practicable to estimate that value. The scope of SFAS No. 107 excludes certain financial instruments, such LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) as trade receivables and payables when the carrying value approximates the fair value, employee benefit obligations and all non-financial instruments, such as land, buildings and equipment and goodwill. The fair values of the financial instruments are estimates based upon current market conditions and perceived risks and require varying degrees of management judgment. For the majority of the Company's assets and liabilities which fall under the scope of SFAS No. 107, book value approximates fair value, with the exception of senior notes and subordinated indebtedness. See Notes 9 and 10. 19. RELATED PARTY TRANSACTIONS: In the normal course of business, the Company engages in various securities trading, investment banking and financing activities with Holdings, American Express and many of their affiliates (the "Related Parties"). In addition, various charges, such as occupancy, administration and computer processing are allocated between the Related Parties, based upon specific identification and allocation methods. In addition, Holdings and other subsidiaries of Holdings raise money through short and long term funding in the capital markets, which it uses to fund the operations of certain of the Company's wholly owned subsidiaries. Advances from Holdings and other affiliates were $5,063 million and $4,523 million at December 31, 1993 and 1992, respectively. In connection therewith, advances from Holdings aggregating approximately $3.6 billion and $4.1 billion at December 31, 1993 and 1992, respectively, are generally payable on demand, and the average rate of interest charged, which is computed primarily based on Holdings' average daily cost of funds, was 3.6% and 4.1% for the years ended December 31, 1993 and 1992, respectively. Interest charges incurred during 1993, 1992 and 1991 from Holdings, including interest charges on subordinated and senior debt issued to Holdings, amounted to $227 million, $214 million and $273 million, respectively. In addition, the Company has advances from other affiliates of Holdings aggregating approximately $1.5 billion and $442 million, at December 31, 1993 and 1992, respectively, with various repayment terms. The Company also has notes and other receivables due from Holdings and other subsidiaries of Holdings aggregating approximately $1.6 billion and $1.1 billion at December 31, 1993 and 1992, respectively, with various repayment terms. In 1992, the Company issued one share of its common stock to Holdings for $100 million. During 1993, the Company issued an additional three shares of its common stock to Holdings for $430 million. A wholly owned subsidiary of the Company has outstanding 1,000 shares of its 9% Cumulative Preferred Stock, Series A (the "Preferred Stock"), which it issued for an aggregate purchase price of $750,000,000 to a wholly owned subsidiary of Holdings for $1,000 in cash and a promissory note of $749,999,000 bearing interest at a rate equal to the holder's cost of funds (the "Note"). Interest income for the years ended December 31, 1993, 1992 and 1991 includes $28 million, $36 million and $50 million, respectively, from the Note. The dividend requirement on the Preferred Stock, as reflected on the Company's Consolidated Statement of Operations was $68 million for each of the years ended December 31, 1993, 1992 and 1991. The Company believes that amounts arising through related party transactions, including those allocated expenses referred to above, are reasonable and approximate the amounts that would have been recorded if the Company operated as an unaffiliated entity. 20. OTHER CHARGES: During the first quarter of 1993, the Company provided $141 million pre-tax ($93 million after-tax) of non-core business reserves. Of this amount, $21 million pre-tax ($14 million after-tax) relates to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The remaining LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $120 million pre-tax ($79 million after-tax) relates to reserves recorded in anticipation of the sale of SLHMC. Such sale was completed during the third quarter of 1993. 21. QUARTERLY INFORMATION (UNAUDITED): Selected quarterly results for year ended December 31, 1993 were as follows (in millions): The results for the first quarter of 1993 reflect a loss on the Primerica Transaction of $630 million ($535 million pre-tax) and reserves for non-core businesses of $93 million ($141 million pre-tax). LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Quarterly results for year ended December 31, 1992 were as follows (in millions): The results for the fourth quarter reflect a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments, and $19 million after-tax ($29 million pre-tax) net revenues primarily from asset management fees, the basis for the calculation of which was revised during the quarter retroactive to January 1, 1992. SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 See notes to Schedule II on page SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO PAGE OF SCHEDULE II (1) Note is payable by March 1994. Interest accrues at the Company's margin rate. (2) Notes are payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (3) Note is payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (4) Notes are payable February 1995 vs. bonus. Interest accrues at the Company's margin rate. (5) Note is payable by payroll deductions of 10% of gross commissions up to $50,000 and all net commissions over $50,000, plus deferred compensation and investment banking fees. Interest accrues at the Company's margin rate. (6) Note is payable by monthly payments of $1,000 plus 50% of any net bonus payable February 1994. Interest accrues at the Company's margin rate. (7) Note is payable February 1994 vs. bonus. Note is noninterest bearing. (8) Other includes employees who transferred to Smith Barney on July 31, 1993. In connection with this transfer Smith Barney paid the Company $2,263,202 for loans related to these individuals. The balance in other also represents loans to individuals who terminated employment and are outstanding at December 31, 1993. SCHEDULE IX LEHMAN BROTHERS INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS Information pertaining to aggregate short-term borrowings during each of the three years in the period ended December 31, 1993 was as follows (dollars in billions): - --------------- (1) The maximum amount outstanding was based on month end balances. (2) The average borrowings were computed using the monthly amounts outstanding. (3) Interest rates were determined by dividing the actual interest expense for the year by the average monthly amounts outstanding. EXHIBIT INDEX - --------------- * Filed herewith.	31,234	208,317
96271_1993.txt	96271_1993	1993	96271	Item 1. BUSINESS. Tampa Electric Company (Tampa Electric or the company) was incorporated in Florida in 1899 and was reincorporated in 1949. As a result of restructuring in 1981, the company became a subsidiary of TECO Energy, Inc. (TECO Energy), a diversified energy-related holding company. The company is a public utility operating wholly within the state of Florida and is engaged in the generation, purchase, transmission, distribution and sale of electric energy. The retail territory served comprises an area of about 2,000 square miles in West Central Florida, including substantially all of Hillsborough County and parts of Polk, Pasco and Pinellas Counties and has an estimated population of over one million. The principal communities served are Tampa, Winter Haven, Plant City and Dade City. In addition, the company engages in wholesale sales to other utilities which consist of broker economy, requirements and other types of service of varying duration and priority. The company has three electric generating stations in or near Tampa and two electric generating stations located near Sebring, a city located in Highlands County in South Central Florida. The company at Dec. 31, 1993 had 3,215 employees, of which 1,295 were represented by the International Brotherhood of Electrical Workers (IBEW) and 382 by the Office and Professional Employees International Union. In 1993, approximately 44 percent of the company's total operating revenue was generated from residential sales, 29 percent from commercial sales, 10 percent from industrial sales and 17 percent from other sales including bulk power sales for resale. See the detail of revenue per customer class on page 20. No material part of the company's business is dependent upon a single customer or a few customers, the loss of any one or more of whom would have a materially adverse effect on the company, except that 8 customers in the phosphate industry accounted for 5 percent of operating revenues in 1993. The company's business is not a seasonal one, but winter peak loads are experienced due to fewer daylight hours and colder temperatures, and summer peak loads are experienced due to use of air conditioning and other cooling equipment. Regulation The retail operations of the company are regulated by the Florida Public Service Commission (FPSC), which has jurisdiction over retail rates, the quality of service, issuances of securities, planning, siting and construction of facilities, accounting and depreciation practices and other matters. The company is also subject to regulation by the Federal Energy Regulatory Commission (FERC) in various respects including wholesale power sales, certain wholesale power purchases, transmission services and accounting and depreciation practices. Federal, state and local environmental laws and regulations cover air quality, water quality, land use, power plant, substation and transmission line siting, noise and aesthetics, solid waste and other environmental matters. See Environmental Matters on pages 6 and 7. TECO Transport & Trade Corporation (TECO Transport) and TECO Coal Corporation (TECO Coal), subsidiaries of TECO Energy, sell coal transportation services and coal to the company and to third parties. The transactions between the company and these affiliates and the prices paid by the company are subject to regulation by the FPSC and FERC and any charges deemed to be imprudently incurred would not be allowed to be passed on to the company's customers. See Utility Regulation on pages 14 and 15. The company's retail business is substantially free from direct competition with other electric utilities, municipalities and public agencies. However, greater levels of competition, particularly in the wholesale business, are developing and may have some impact on the company. Retail Pricing The FPSC's pricing objective is to set rates at a level that allows the utility to collect total revenues (revenue requirements) equal to its cost of providing service, including a reasonable return on invested capital. The basic costs, other than fuel and purchased power, of providing electric service are recovered through base rates, which are designed to recover the costs of owning, operating and maintaining the utility system. These costs include operations and maintenance expenses, depreciation and taxes, as well as a return on the company's investment in assets used and useful in providing electric service (rate base). The rate of return on rate base is intended to approximate the company's weighted cost of capital, which includes its costs for debt and preferred stock, deferred income taxes at a zero cost rate and an allowed return on common equity. Base prices are determined in price setting hearings that occur at irregular intervals at the initiative of the company, the FPSC or other parties. Fuel and certain purchased power costs are recovered through levelized monthly charges established pursuant to the FPSC's fuel adjustment and cost recovery clauses. These charges, which are reset semi-annually in an FPSC hearing, are based on estimated costs of fuel and purchased power and estimated customer usage for the ensuing six-month period, with a true-up adjustment to reflect the variance of actual costs from the projected charges for prior periods. The FPSC may disallow recovery of any costs that it considers imprudently incurred. Certain non-fuel costs and the accelerated recovery of the costs of conversion from oil-fired to coal-fired generation at the company's Gannon Station are recovered through the FPSC's oil backout clause. Accelerated recovery of this project's costs is obtained through accelerated depreciation, which is permitted in an amount equal to two-thirds of the fuel savings of the project. The remaining one-third of the savings is realized on a current basis by customers through the fuel adjustment clause. Prior to Oct. 27, 1992, the company had assigned its right to the oil backout tariffs to the Gannon Project Trust, the owner of the conversion assets. On Oct. 27, 1992, pursuant to FPSC approval, the Gannon Project Trust was terminated and the Trust's net assets and debt were placed on the company's balance sheet. Amounts collected in periods subsequent to Oct. 27, 1992, under the oil backout tariff are included in the company's operating revenues and continue to have no effect on net income. See further discussion in Note A page 25. Fuel About 98 percent of the company's generation for 1993 was from its coal-fired units. The same level is anticipated for 1994. The company's average fuel cost per million BTU and average cost per ton of coal burned have been as follows: Average cost per million BTU: 1993 1992 1991 1990 1989 Coal $ 2.26 $ 2.23 $ 2.22 $ 2.11 $ 2.02 Oil $ 2.69 $ 2.76 $ 3.21 $ 5.21 $ 4.35 Gas $ 3.52 $ 2.43 $ 1.98 -- -- Composite $ 2.27 $ 2.24 $ 2.25 $ 2.14 $ 2.03 Average cost per ton of coal burned $54.55 $53.65 $53.87 $51.07 $49.30 The company's Gannon Station burns low-sulfur coal; Big Bend Station burns coal of a somewhat higher sulfur content; Hookers Point Station burns low-sulfur oil; Phillips Station burns oil of a somewhat higher sulfur content; and Dinner Lake Station, which was placed on long-term reserve standby in March 1994, burns natural gas and oil. Coal. The company burned approximately 6.6 million tons of coal during 1993 and estimates that its coal consumption will be 7 million tons for 1994. During 1993, the company purchased approximately 74 percent of its coal under long-term contracts with five suppliers and 26 percent of its coal in the spot market and under intermediate-term purchase agreements. About one-third of the company's 1993 coal requirements were supplied by TECO Coal. During December 1993, the average delivered cost of coal (including transportation) was $51.61 per ton, or $2.13 per million BTU. The company expects to obtain approximately 80 percent of its coal requirements in 1994 under long- term contracts with six suppliers, with the remaining 20 percent available either in the spot market or under intermediate-term purchase agreements. The company's long-term coal contracts provide for revisions in the base price to reflect changes in a wide range of cost factors and for suspension or reduction of deliveries if environmental regulations should prevent the company from burning the coal supplied, provided that a good faith effort has been made to continue burning such coal. The company estimates that about one-third of its 1994 coal requirements will be supplied by TECO Coal. For information concerning transactions with affiliated companies, see Related Party Transactions on page 32. In 1993, about 72 percent of the company's coal supply was deep-mined and approximately 28 percent was surface-mined. Federal surface-mining laws and regulations have not had any material adverse impact on the company's coal supply or results of its operations. The company, however, cannot predict the effect on the market price of coal of any future mining laws and regulations. Although there are reserves of surface-mineable coal dedicated by suppliers to the company's account, high quality coal reserves in Kentucky that can be economically surface-mined are being depleted and in the future more coal will be deep-mined. This trend will not necessarily result in a substantial increase in costs to the company. Oil. The company has a supply agreement through Aug. 31, 1994 for No. 2 fuel oil and a supply agreement through Aug. 31, 1994 for No. 6 fuel oil for its four combustion turbine units and Hookers Point Station at prices based on Gulf Coast Cargo spot prices. The company has a supply agreement through July 31, 1994 for No. 6 fuel oil for Phillips Station at a price based on Gulf Coast Cargo spot prices. The price for No. 2 fuel oil deliveries taken in December 1993 was $25.74 per barrel, or $4.44 per million BTU. The price for the higher sulfur No. 6 fuel oil deliveries taken in December 1993 was $12.33 per barrel, or $1.95 per million BTU. Gas. The company has supply agreements through Oct. 31, 2000 for natural gas for its Dinner Lake Station, was placed on long-term reserve standby. The price for natural gas deliveries taken in September 1993 was $3.51 per million cubic feet, or $3.51 per million BTU. There were no natural gas deliveries taken in the fourth quarter of 1993. Franchises The company holds franchises and other rights that, together with its charter powers, give it the right to carry on its retail business in the localities it serves. The franchises are irrevocable and are not subject to amendment without the consent of the company although, in certain events, they are subject to forfeiture. Florida municipalities are prohibited from granting any franchise for a term exceeding 30 years. If a franchise is not renewed by a municipality, the franchisee has the statutory right to require the municipality to purchase any and all property used in connection with the franchise at a valuation to be fixed by arbitration. In addition, all of the municipalities except for the cities of Tampa and Winter Haven have reserved the right to purchase the company's property used in the exercise of its franchise, if the franchise is not renewed. The company has franchise agreements with 13 incorporated municipalities within its retail service area. These agreements have various expiration dates starting in October 1994 and extending through September 2021, including the City of Tampa, which expires in August 2006 and the City of Oldsmar, which expires in October 1994. The company has no reason to believe that any of these franchises, including the Oldsmar franchise, will not be renewed. Franchise fees payable by the company, which totaled $18.8 million in 1993, are calculated using a formula based primarily on electric revenues. Utility operations in Hillsborough, Pasco, Pinellas and Polk Counties outside of incorporated municipalities are conducted in each case under one or more permits to use county rights-of-way granted by the county commissioners of such counties. There is no law limiting the time for which such permits may be granted by counties. There are no fixed expiration dates for the Hillsborough County and Pinellas County agreements. The agreements covering electric operations in Pasco and Polk counties expire in September 2033 and March 2005, respectively. Environmental Matters The company's operations are subject to county, state and federal environmental regulations. The Hillsborough County Environmental Protection Commission and the Florida Environmental Regulation Commission are responsible for promulgating environmental regulations and coordinating most of the environmental regulation functions performed by the various departments of state government. The Florida Department of Environmental Protection (FDEP) is responsible for the administration and enforcement of the state regulations. The U.S. Environmental Protection Agency (EPA) is the primary federal agency with environmental responsibility. The company has all required environmental permits. In addition, a monitoring program is in place to assure compliance with permit conditions. The company has been identified as one of numerous potentially responsible parties with respect to nine Superfund Sites. The company expects that its liability in connection with these sites will not be material. Expenditures. During the five years ended Dec. 31, 1993, the company spent $49.1 million on capital additions to meet environmental requirements, including $8 million for the Polk Power Station project. Environmental expenditures are estimated at $44 million for 1994 and $150 million in total for 1995-1998, including, respectively, $32 million and $106 million for the planned Polk Power Station. These totals exclude amounts required to comply with the 1990 amendments to the Clean Air Act. The FPSC has adopted an environmental cost recovery clause that the company believes would allow it to recover the cost of future significant environmental programs. The company plans to comply with the Phase I emission limitations in 1995 imposed by the Clean Air Act by using blends of lower-sulfur coal. The cost of compliance with Phase I is expected to increase prices less than 3 percent. There is little capital investment associated with fuel blending. In connection with its Phase I compliance plan, the company has entered into a long-term contract for the purchase of low-sulfur coal beginning in mid-1994. The company is also evaluating the use of purchased sulfur dioxide allowances as a minor component of its overall compliance strategy. If limited to today's technology, to comply with Phase II emission standards set for 2000, the company would likely have to add either one or two scrubbers. The aggregate effect of Phase I and Phase II compliance on the utility's price structure is estimated to be 5 percent or less. Item 2. Item 2. PROPERTIES. The company believes that its physical properties are adequate to carry on its business as currently conducted. The properties are generally subject to liens securing long-term debt. The company had five electric generating plants and four combustion turbine units with a total net generating capability at Dec. 31, 1993 of 3,309 megawatts (MWs), including Big Bend (1,687-MW capability for four coal units), Gannon (1,171-MW capability for six coal units), Hookers Point (212-MW capability for five oil units), Dinner Lake (11-MW capability for one natural gas unit), Phillips (34-MW capability for two diesel units) and four combustion turbine units located at Big Bend and Gannon stations (194 Mws). Capability as used herein represents the demonstrable dependable load carrying abilities of the generating units during peak periods as proven under actual operating conditions. Units at Hookers Point went into service from 1948 to 1955, at Gannon from 1957 to 1967, and at Big Bend from 1970 to 1985. In 1991, the company purchased two power plants (Dinner Lake and Phillips) from the Sebring Utilities Commission (Sebring). Dinner Lake and Phillips were placed in service by Sebring in 1966 and 1983, respectively. In March 1994, Dinner Lake Station was placed on long-term reserve standby. The company owns approximately 4,350 acres of mined-out land located in Polk County, Florida. This site will accommodate the planned Polk Unit One electric power plant and also the projected additional generating capacity that will be required in 2001 and beyond. Polk Unit One is discussed further under Capital Expenditures on pages 13 and 14. The company owns 179 substations having an aggregate transformer capacity of 15,208,000 KVA. The transmission system consists of approximately 1,182 pole miles of high voltage transmission lines, and the distribution system consists of 6,755 pole miles of overhead lines and 2,283 trench miles of underground lines. As of Dec. 31, 1993, there were 482,447 meters in service. All of the foregoing property is located within Florida. All plants and important fixed assets are held in fee except that title to some of the properties are subject to easements, leases, contracts, covenants and similar encumbrances and minor defects, of the nature common to properties of the size and character of those of the company. The company has easements for rights-of-way adequate for the maintenance and operation of most of its electrical transmission and distribution lines that are not constructed upon public highways, roads and streets. It has the power of eminent domain under Florida laws for the acquisition of any such rights-of-way for the operation of transmission and distribution lines. Transmission and distribution lines located in public ways are maintained under franchises or permits. The company has a long-term lease for the office building in downtown Tampa, Florida, that serves as its headquarters. Item 3. Item 3. LEGAL PROCEEDINGS. None. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted during the fourth quarter of 1993 to a vote of the company's security holders through the solicitation of proxies or otherwise. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the company's common stock is owned by TECO Energy, Inc., and hence there is no market for the stock. The company pays dividends substantially equal to its net income applicable to common stock to TECO Energy. Such dividends totaled $102.4 million for 1993 and $106.4 million for 1992. See Note C on page 27 for a description of restrictions on dividends on the company's common stock. Item 6. Item 6. SELECTED FINANCIAL DATA. (millions of dollars) Year ended Dec. 31, 1993 1992 1991 1990 1989 Operating revenues $1,041.3 $1,005.8 $ 987.5 $ 939.8 $ 934.6 Net income $ 106.6 $ 110.8 $ 107.4 $ 108.2 $ 109.7 Total assets $2,199.6 $2,108.3 $1,994.5 $1,918.8 $1,886.1 Long-term debt $ 611.1 $ 595.1 $ 513.7 $ 513.9 $ 514.5 Preferred stock- Redemption required -- -- -- -- $ 6.0 Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. EARNINGS SUMMARY Tampa Electric's net income for 1993 of $106.6 million was 4 percent lower than for 1992 due to a $10 million non-recurring coal settlement charge described in the Other Income (Expense) section. In 1992, net income grew 3 percent to $110.8 million from $107.4 million in 1991 due to higher non-fuel revenues from sales to other utilities, lower interest expense and a continued commitment to cost containment. OPERATING RESULTS Operating income was level in 1993 after increasing in 1992. Higher base revenues in 1993 associated with retail customer growth of 1.7 percent and a retail price increase were partially offset by higher operating expenses. The improvement in 1992 operating income resulted from increased sales to other utilities and retail customer growth, partially offset by higher operating expenses. Upon termination of the Gannon Project Trust on Oct. 27, 1992, the revenues and expenses associated with an oil backout cost recovery tariff were included in the financial statements. These revenues, which were exactly offset by associated expenses, amounted to $11.5 million in 1993 and $1.8 million in 1992. The Trust was established in 1983 to fund the conversion of Gannon Station Units One through Four from oil-fired to coal-fired generation. The Florida Public Service Commission (FPSC) approved a specific oil backout cost recovery tariff related to this project. 1993 Change 1992 Change 1991 (millions of dollars) Operating revenues $1,041.3 3.5% $1,005.7 1.8% $987.5 Operating expenses 887.2 4.1% 852.5 2.1% 835.3 Operating income $ 154.1 .5% $ 153.2 .7% $152.2 Operating Revenues Operating revenues rose in both 1993 and 1992 with retail customer growth of 1.7 percent and 1.5 percent, respectively, and higher sales to other utilities. Also contributing in 1993 was a $12- million price increase effective February 1993, as described in the Utility Regulation section. The economy in the company's service area continues to grow, although energy sales in all categories have been affected by the economic slowdown. Residential and commercial energy sales showed good growth in 1993, but total retail energy sales dropped due to lower sales to the phosphate industry. Retail energy sales are expected to rise with economic recovery and a return to customer growth in the 2 to 2.5 percent range. Energy sold to other utilities declined in 1993 because of milder weather and lower-priced oil generation available on other systems. Despite this decline, non-fuel revenues from sales to other utilities increased to $34 million in 1993 from $32.8 million in 1992 and $16.9 million in 1991. This growth resulted from shifting sales to higher margin, longer-term contracts and an aggressive sales effort in Florida's bulk power market. In January 1993, the company began selling under a 10-year contract the limited use of 145 MWs of capacity from its Big Bend Unit Four to TECO Power Services for resale to Seminole Electric Cooperative. In the past two years, the company has added several other smaller bulk power sales contracts. Three of these contracts together provide more than 35 MWs of capacity to the cities of Wauchula, Ft. Meade and St. Cloud, Florida; all will be in effect beyond the year 2012. 1993 Change 1992 Change 1991 Megawatt-hour sales (thousands) Residential 5,706 2.6% 5,560 1.0% 5,507 Commercial 4,432 2.3% 4,333 1.4% 4,274 Industrial 2,236 -14.8% 2,625 -1.6% 2,669 Other 1,073 3.8% 1,034 2.9% 1,005 Total retail 13,447 - .8% 13,552 .7% 13,455 Sales for resale 2,330 -14.0% 2,710 5.3% 2,574 Total energy sold 15,777 -3.0% 16,262 1.5% 16,029 Retail customers (average) 477,010 1.7% 468,997 1.5% 462,260 Operating Expenses Effective cost management and efficiency improvement continue to be principal objectives at Tampa Electric. Continued emphasis on cost containment limited growth in operating expenses in 1993 to 3.8 percent, excluding amounts recovered through FPSC-approved cost recovery clauses and $6.3 million related to changes in accounting for postemployment benefits. Certain fuel, purchased capacity, conservation and oil backout costs were fully recovered and had no impact on earnings. 1993 Change 1992 Change 1991 (millions of dollars) Fuel $363.2 -4.0% $378.2 -2.3% $387.3 Purchased power 39.0 98.0% 19.7 16.6% 16.9 Total fuel and purchased power 402.2 1.1% 397.9 -1.6% 404.2 Other operating expenses 157.7 9.8% 143.6 5.4% 136.2 Maintenance 71.4 4.2% 68.5 4.6% 65.5 Depreciation 111.9 9.6% 102.1 5.6% 96.7 Taxes, federal and state income 60.5 -2.1% 61.8 6.4% 58.1 Taxes, other than income 83.5 6.2% 78.6 5.4% 74.6 Total operating expenses 887.2 4.1% 852.5 2.1% 835.3 Less: recoverable fuel, purchased capacity, conservation and oil backout expenses 421.6 3.7% 406.4 -1.1% 410.9 Net operating expenses $465.6 4.4% $446.1 5.1% $424.4 Total fuel cost remained relatively stable for the last three years. Generation declined 3 percent in 1993 and average fuel price increased 2 percent. More energy was purchased in 1993 to meet peak demand and because of a three-month outage at a major generating unit. Substantially all fuel and purchased power expenses are recovered through the fuel adjustment and cost recovery clauses. Nearly all of the company's generation in the last three years has been from coal, and the fuel mix will continue to be substantially coal. Coal prices are expected to increase slightly during the next few years, but at a slower rate than either oil or gas prices. The increase in other operating expenses in 1993 included $6.3 million related to changes in accounting for postemployment benefits as described in the Accounting Standards section. Increases in the cost of medical coverage and other employee benefits and more regulatory activity also increased 1993 expenses. Maintenance expense was level in 1993 compared to 1992, excluding $2.5 million related to the addition of oil backout costs. The increase in 1992 came from the return to service of Hookers Point Station in December 1991 and from the generating units purchased from the City of Sebring in February 1991. Depreciation expense increased both years because of normal additions to plant and equipment and the acquisition of the Sebring generating units in February 1991. Depreciation expense included an additional $7 million in 1993 and $1.2 million in 1992 which relate to oil backout changes. Taxes other than income taxes were up each year mainly from higher gross receipts taxes, which are included in customers' bills, and from additional property taxes. NON-OPERATING ITEMS Other Income (Expense) In 1993, the company recorded as other expense a one-time $10- million pre-tax charge associated with an FPSC-approved settlement agreement between the company and the Office of Public Counsel (Public Counsel). The agreement is described in the Utility Regulation section. Interest Charges Interest charges were $42.3 million in 1993, level with 1992 and lower than 1991. Interest costs in 1993 were affected by lower interest rates and savings from the refinancings as discussed in the Financing Activity section, which offset higher debt balances. In 1992, the effects of lower interest rates offset higher average debt balances resulting in lower interest charges than in 1991. Income Taxes Effective Jan. 1, 1993, the federal corporate income tax rate increased from 34 percent to 35 percent. This rate increase lowered 1993 earnings by $1.7 million. ACCOUNTING STANDARDS Income Tax Accounting Effective Jan. 1, 1993, the company adopted Financial Accounting Standards (FAS) 109, Accounting for Income Taxes, which requires the use of the liability method in accounting for income taxes. The adoption of FAS 109 had no effect on net income or common equity, but did result in certain adjustments to accumulated deferred income taxes and the establishment of a corresponding regulatory tax liability reflecting the amount payable to customers through future rates. The FPSC adopted a rule for accounting for deferred income taxes under FAS 109 requiring that deferred tax adjustments and the related regulatory tax liability be treated the same as accumulated deferred income taxes had been treated in the past. Based on the FPSC rule, the company believes that there will not be any changes in the computation of income tax expense for rate making purposes and thus, no change in its revenue requirements or earnings due to the adoption of FAS 109. Postemployment Benefits The company adopted FAS 106, Accounting for Postretirement Benefits Other than Pensions, effective Jan. 1, 1993. The standard requires full cost accrual accounting that recognizes the cost of these benefits over the service lives of employees. Adopting the new standard resulted in estimating a previously unrecognized obligation covering prior years of $41 million. The company is amortizing this transition obligation on a straight-line basis over the average remaining service lives of active employees, approximately 20 years. Full cost accrual under FAS 106 exceeds cash basis expense by approximately $5 million annually. The new rates approved by the FPSC for the company for 1993 and 1994 reflect full cost accrual of postretirement benefits including transition cost amortization. CAPITAL EXPENDITURES Capital expenditures for 1993 of $206 million included $71 million for the construction of Polk Unit One, a 250-megawatt coal- gasification plant. The capital cost of the plant is estimated at about $440 million, net of $100 million in construction funding from the Department of Energy under its Clean Coal Technology Program. The FPSC granted the Certificate of Need in 1992 and groundbreaking is planned for mid-1994. In addition, the company spent $135 million for equipment and facilities to meet the company's growing customer base and for generating equipment improvements. The company estimates total capital expenditures for ongoing operations at $247 million in 1994 and $1 billion during the 1995-1998 period mainly for distribution facilities to meet customer growth and for construction of Polk Unit One. About $100 million is estimated to be spent on this project in 1994, $215 million in 1995 and the remainder in 1996. At the end of 1993, the company had outstanding commitments of about $150 million for the construction of Polk Unit One. Construction Requirements (millions of dollars) 1993 1994 Actual Estimated Production $ 99 $147 Transmission 16 23 Distribution 47 50 General 44 27 Total $206 $247 ENVIRONMENTAL COMPLIANCE The company is subject to various environmental regulations. The company has all of the environmental permits required by the regulations and has a monitoring program in place to assure compliance with permit conditions. The company believes that environmental liabilities are minimal. In addition, the FPSC has adopted an environmental cost recovery clause that the company believes would allow it to recover the cost of future significant environmental programs. The company plans to comply with the Phase I emission limitations in 1995 imposed by the Clean Air Act by using blends of lower-sulfur coal. The cost of compliance with Phase I is expected to increase prices less than 3 percent. There is little capital cost associated with fuel blending. In connection with its Phase I compliance plan, the company has entered into a long-term contract for the purchase of low-sulfur coal beginning in mid-1994. The company is also evaluating the use of purchased sulfur dioxide allowances as a minor component of its overall compliance strategy. If limited to today's technology, to comply with Phase II emission standards set for 2000, the company would likely have to add either one or two scrubbers. The aggregate effect of Phase I and Phase II compliance on the utility's price structure is currently estimated to be 5 percent or less. UTILITY REGULATION Price Increase The FPSC granted the company a $1.2 million permanent base revenue increase and a $10.3 million revenue increase primarily associated with recovery of purchased power capacity payments effective in early February 1993. An additional base revenue increase of $16 million was effective Jan. 1, 1994. The FPSC decision reflected overall allowed regulatory rates of return of 8.20 percent in 1993 and 8.34 percent in 1994, which included an allowed regulatory rate of return on common equity of 12 percent, the midpoint of a range of 11 percent to 13 percent. The FPSC approved $19 million of construction work in progress in rate base in 1993 and $55 million in 1994. Following a separate hearing in February 1994, the FPSC issued an order on March 25, 1994 that changed the company's authorized regulatory rate of return on common equity to an 11.35 percent midpoint and a range of 10.35 percent to 12.35 percent, while leaving in effect the rates it had previously established. In its order, the FPSC approved a $4-million annual accrual for the establishment of an unfunded storm damage reserve for transmission and distribution property and rejected Public Counsel's request that the 1994 rate increase be held subject to refund. Any party to the case has 30 days from the date of the order in which to file an appeal with the Florida Supreme Court. Coal Settlement In February 1993, the FPSC approved an agreement between the company and Public Counsel that resolved all issues relating to prices for coal purchased in the years 1990 through 1992 by the company from its affiliate, Gatliff Coal Company, a subsidiary of TECO Coal. Tampa Electric agreed to refund $10 million plus interest to its customers through the fuel adjustment clause over a 12-month period beginning April 1, 1993. In 1993, the company refunded $7.6 million to its customers. The agreement approved by the FPSC also established a new regulatory benchmark procedure for 1993 through 1999 with a new price effective Jan. 1, 1993 and annual adjustments based on the change in the Consumer Price Index. The new procedure is expected to avoid the disputes which have arisen over the calculation of the prior benchmark price. FINANCING ACTIVITY Tampa Electric's 1993 year-end capital structure was 44 percent debt, 53 percent common equity and 3 percent preferred stock. The company's objective is to maintain a capital structure over time that will support its current credit ratings. Credit Ratings/Senior Debt Duff & Phelps Moody's Standard & Poor's AA Aa1 AA The company repaid $48 million of first mortgage bonds due May 1, 1993 with internally generated funds and proceeds from short-term debt. In May 1993, the company sold $80 million of first mortgage bonds due in 2000 at a 5.75 percent interest rate and $75 million of first mortgage bonds due in 2003 at a 6.125 percent interest rate. These bonds were sold at a discount with yields to maturity of 5.83 percent for the 2000 series and 6.25 percent for the 2003 series. Proceeds were used in June 1993 to redeem four outstanding series of first mortgage bonds totaling $155 million. The average interest rate of the refunded bonds was 7.7 percent. In June 1993, the Hillsborough County Industrial Development Authority issued $20 million of Pollution Control Revenue Bonds for the benefit of the company to finance the cost of waste disposal facilities. The bonds bear interest at a floating rate set daily. At Dec. 31, 1993, $4.4 million remained on deposit with the trustee for future expenditures for qualified facilities. In July 1993, the company entered into a forward refunding arrangement for $85.95 million of outstanding Pollution Control Revenue Bonds. Under this arrangement, $85.95 million of new tax- exempt bonds due Dec. 1, 2034 will be issued in December 1994 at a 6.25 percent interest rate. The proceeds will be used to refund a currently outstanding 9.9 percent series when these bonds become callable in February 1995. For accounting and rate making purposes, from July 1993 the company recorded interest expense using a blended rate for the outstanding and refunding bonds and will continue to use this rate through the original maturity dates of the currently outstanding bonds. LIQUIDITY, CAPITAL RESOURCES The company met its cash needs during 1993 largely with internally generated funds and capital contributions from its parent, with the balance from debt. At Dec. 31, 1993, the company had bank credit lines of $140 million available. The company expects to meet its capital requirements for ongoing operations in 1994-1998 substantially from internally generated funds. The company anticipates some capital contributions from parent and debt financing, primarily in 1994 and 1995. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page No. Report of Independent Accountants 18 Balance Sheets, Dec. 31, 1993 and 1992 19 Statements of Income for the years ended Dec. 31, 1993, 1992 and 1991 20 Statements of Cash Flows for the years ended Dec. 31, 1993, 1992 and 1991 21 Statements of Retained Earnings for the years ended Dec. 31, 1993, 1992 and 1991 22 Statements of Capitalization, Dec. 31, 1993 and 1992 22-24 Notes to Financial Statements 25-32 Schedules: V - Property, Plant and Equipment for the years ended 33-35 Dec. 31, 1993, 1992 and 1991 VI - Accumulated Depreciation of Property, Plant and 36-38 Equipment for the years ended Dec. 31, 1993, 1992 and 1991 IX - Short-term Borrowings for the years ended 39 Dec. 31, 1993, 1992 and 1991 X - Supplementary Income Statement Information 40 for the years ended Dec. 31, 1993, 1992 and 1991 Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Tampa Electric Company, We have audited the financial statements and the financial statement schedules of Tampa Electric Company, (a wholly owned subsidiary of TECO Energy, Inc.) as listed in the index under Item 8 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tampa Electric Company as of Dec. 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended Dec. 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note A to the financial statements, effective Jan. 1, 1993 the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." COOPERS & LYBRAND Certified Public Accountants Tampa, Florida Jan. 17, 1994 BALANCE SHEETS (thousands of dollars) Assets Dec. 31, 1993 1992 PROPERTY, PLANT AND EQUIPMENT, AT ORIGINAL COST Utility plant in service $2,773,652 $2,699,290 Construction work in progress 151,311 76,920 2,924,963 2,776,210 Accumulated depreciation (1,052,979) (995,616) 1,871,984 1,780,594 Other property 201 181 1,872,185 1,780,775 CURRENT ASSETS Cash and cash equivalents 4,499 28,260 Short-term investments 216 1,934 Receivables, less allowance for uncollectibles 97,997 94,056 Inventories, at average cost Fuel 77,438 86,468 Materials and supplies 37,726 37,139 Prepayments 10,062 4,381 227,938 252,238 DEFERRED DEBITS Unamortized debt expense 25,718 16,182 Deferred fuel expense 13,721 3,703 Deferred income taxes 37,045 31,145 Other 22,961 24,231 99,445 75,261 $2,199,568 $2,108,274 Liabilities and Capital CAPITAL Common stock $ 664,631 $ 627,631 Retained earnings 182,939 182,273 847,570 809,904 Preferred stock, redemption not required 54,956 54,956 Long-term debt, less amount due within one year 611,082 595,067 1,513,608 1,459,927 CURRENT LIABILITIES Long-term debt due within one year 1,245 49,800 Notes payable 81,500 29,200 Accounts payable 87,791 79,125 Customer deposits 47,358 45,037 Interest accrued 10,522 11,571 Taxes accrued 6,151 4,030 234,567 218,763 DEFERRED CREDITS Deferred income taxes 292,573 337,722 Investment tax credits 66,033 70,946 Regulatory liability-tax related 61,973 -- Other 30,814 20,916 451,393 429,584 $2,199,568 $2,108,274 The accompanying notes are an integral part of the financial statements. STATEMENTS OF INCOME (thousands of dollars) Year ended Dec. 31, 1993 1992 1991 OPERATING REVENUES Residential $ 464,096 $ 444,961 $ 436,888 Commercial 298,281 287,422 280,973 Industrial-Phosphate 55,116 70,175 73,948 Industrial-Other 48,906 46,497 45,267 Sales for resale 76,055 72,957 65,980 Other 98,850 83,770 84,469 1,041,304 1,005,782 987,525 OPERATING EXPENSES Operation Fuel 363,250 378,234 387,359 Purchased power 38,961 19,671 16,882 Other 157,701 143,624 136,165 Maintenance 71,397 68,501 65,535 Depreciation 111,866 102,081 96,701 Taxes-Federal and state income 60,559 61,809 58,063 Taxes-Other than income 83,513 78,626 74,580 887,247 852,546 835,285 OPERATING INCOME 154,057 153,236 152,240 OTHER INCOME (EXPENSE) Allowance for other funds used during construction 1,585 -- -- Other income (expense), net (6,676) 186 (325) (5,091) 186 (325) Income before interest charges 148,966 153,422 151,915 INTEREST CHARGES Interest on long-term debt 39,281 36,896 36,483 Other interest 5,133 6,845 9,176 Allowance for borrowed funds used during construction (2,096) (1,104) (1,098) 42,318 42,637 44,561 NET INCOME 106,648 110,785 107,354 Preferred dividend requirements 3,568 3,567 3,568 BALANCE APPLICABLE TO COMMON STOCK $ 103,080 $ 107,218 $ 103,786 The accompanying notes are an integral part of the financial statements. STATEMENTS OF CASH FLOWS (thousands of dollars) Year ended Dec. 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES Net income $106,648 $110,785 $107,354 Adjustments to reconcile net income to net cash Depreciation 111,866 102,081 96,701 Deferred income taxes 10,793 6,087 11,760 Investment tax credits, net (4,913) (4,139) (4,969) Allowance for funds used during construction (3,681) (1,104) (1,098) Deferred fuel cost (10,018) 2,030 (3,358) Fuel cost settlement 10,000 -- -- Refund to customers (7,572) -- -- Receivables, less allowance for uncollectibles (3,941) 2,502 (719) Inventories 8,443 15,022 8,004 Taxes accrued 2,121 2,556 (3,561) Accounts payable 6,088 16,757 (5,837) Other (306) 5,528 1,050 225,528 258,105 205,327 CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (205,642) (156,307) (169,626) Allowance for funds used during construction 3,681 1,104 1,098 Short-term investments 1,718 (1,727) (24) (200,243) (156,930) (168,552) CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from contributed capital from parent 37,000 14,000 68,007 Proceeds from long-term debt 15,636 75,000 -- Repayment of long-term debt (48,000) (235) (643) Net increase (decrease) in short-term debt 52,300 (60,100) 9,000 Dividends (105,982) (109,947) (104,856) (49,046) (81,282) (28,492) Net increase (decrease) in cash and cash equivalents (23,761) 19,893 8,283 Cash and cash equivalents at beginning of year 28,260 8,367 84 Cash and cash equivalents at end of year $ 4,499 $ 28,260 $ 8,367 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the year for: Interest $ 43,540 $ 42,257 $ 46,113 Income taxes $ 51,426 $ 55,781 $ 55,185 The accompanying notes are an integral part of the financial statements. STATEMENTS OF RETAINED EARNINGS (thousands of dollars) Year ended Dec. 31, 1993 1992 1991 BALANCE, BEGINNING OF YEAR $182,273 $181,435 $178,937 Add-Net income 106,648 110,785 107,354 288,921 292,220 286,291 Deduct-Cash dividends on capital stock Preferred 3,568 3,567 3,568 Common 102,414 106,380 101,288 105,982 109,947 104,856 BALANCE, END OF YEAR $182,939 $182,273 $181,435 STATEMENTS OF CAPITALIZATION The accompanying notes are an integral part of the financial statements. STATEMENTS OF CAPITALIZATION (continued) At Dec. 31, 1993, preferred stock had a carrying amount of $55.0 million and an estimated fair market value of $49.8 million. The estimated fair market value of preferred stock was based on quoted market prices. (thousands of dollars) LONG-TERM DEBT OUTSTANDING AT DEC. 31, Due 1993 1992 First mortgage bonds (issuable in series) 4 1/2% 1993 $ -- $ 48,000 5 1/2% 1996 25,000 25,000 7 1/4% 1998 -- 30,000 7 1/4% 2001 -- 35,000 7 3/8% 2002 -- 40,000 8 1/2% 2004 -- 50,000 7 3/4% 2022 75,000 75,000 5 3/4% 2000 80,000 -- 6 1/8% 2003 75,000 -- Installment contracts payable(1) 5 3/4% 2007 24,920 24,920 7 7/8% Refunding bonds(2) 2021 25,000 25,000 8% Refunding bonds(2) 2022 100,000 100,000 9.9%(3) 2011-2014 85,950 85,950 Variable rate: 2.12% for 1993 and 2.55% for 1992(4) 2025 51,605 51,605 Variable rate: 2.12% for 1993 and 2.49% for 1992(4) 2018 54,200 54,200 Variable rate: 2.28% for 1993(4)(5) 2020 15,636-- Unamortized debt premium 16 192 612,327 644,867 Less amount due within one year(6) 1,245 49,800 TOTAL LONG-TERM DEBT $611,082 $595,067 Maturities and annual sinking fund requirements of long-term debt for the years 1995, 1996, 1997 and 1998 are $1.3 million, $26.0 million, $1.0 million, and $1.1 million, respectively. Of these amounts $1.0 million for 1995 and $0.8 million per year for 1996 through 1998 may be satisfied by the substitution of property in lieu of cash payments. Substantially all of the property, plant and equipment of the company is pledged as collateral. ___________________________ (1) Tax-exempt securities. (2) Proceeds of these bonds were used to refund bonds with interest rates of 11 5/8%-12 5/8%. For accounting purposes, interest expense has been recorded using blended rates of 8.28%-8.66% on the original and refunding bonds, consistent with regulatory treatment. (3) Under a financing arrangement entered into in July 1993, new tax- exempt bonds will be issued in December 1994 to refund this outstanding series when it becomes eligible for refunding. The new refunding series bears an interest rate of 6.25%. For accounting purposes, interest expense has been recorded using a blended rate of the outstanding and refunding bonds from July 1993 forward, consistent with regulatory treatment. (4) Composite year-end interest rate. (5) This amount is recorded net of $4.4 million on deposit with trustee. Composite year-end interest rate of 2.47% for 1993. (6) Of the amount due in 1994, $1.0 million may be satisfied by the substitution of property in lieu of cash payments. The accompanying notes are an integral part of the financial statements. STATEMENTS OF CAPITALIZATION (continued) At Dec. 31, 1993, total long-term debt had a carrying amount of $611.1 million and an estimated fair market value of $658 million. The estimated fair market value of long-term debt was based on quoted market prices for the same or similar issues, on the current rates offered for debt of the same remaining maturities, or for long-term issues with variable rates that approximate market rates, at carrying amounts. The carrying amount of long-term debt due within one year approximated fair market value because of the short maturity of these instruments. The company entered into an interest rate exchange agreement to reduce the cost of $100 million of fixed rate long-term debt. The debt has been refinanced but the exchange agreement will remain in effect until January 1996. The benefit derived from the exchange agreement could range up to $2.3 million depending on floating rate levels. The benefits of this agreement are at risk only in the event of nonperformance by the other party to this agreement or if the floating rate reaches 12.55%. The company does not anticipate nonperformance by the other party. The benefit of the interest rate exchange is used to reduce interest expense. The reduction was $2.3 million per year in 1993, 1992 and 1991. At Dec. 31, 1993, this interest rate exchange agreement had an estimated fair market value of $4.4 million. Estimated fair market value was based on the expected realizable value to the company if the agreement were terminated. The accompanying notes are an integral part of the financial statements. NOTES TO FINANCIAL STATEMENTS A. Summary of Significant Accounting Policies Basis of Accounting The company maintains its accounts in accordance with recognized policies prescribed or permitted by the Florida Public Service Commission (FPSC) and the Federal Energy Regulatory Commission (FERC). These policies conform with generally accepted accounting principles in all material respects. The impact of Financial Accounting Standard (FAS) No. 71, Accounting for the Effects of Certain Types of Regulation, has been minimal in the company's experience, but when cost recovery is ordered over a longer period than a fiscal year, costs are recognized in the period that the regulatory agency recognizes them in accordance with FAS 71. The company's retail and wholesale businesses are regulated by the FPSC and the FERC, respectively. Prices allowed by both agencies are generally based on recovery of prudent costs incurred plus a reasonable return on invested capital. Revenues and Fuel Costs Revenues include amounts resulting from cost recovery clauses which provide for monthly billing charges to reflect increases or decreases in fuel, purchased capacity, oil backout and conservation costs. These adjustment factors are based on costs projected by the company for a six-month period. Any over-recovery or under-recovery of costs plus an interest factor are refunded or billed to customers during the subsequent six-month period. Over-recoveries of costs are recorded as deferred credits and under-recoveries of costs are recorded as deferred debits. Certain other costs incurred by the company are allowed to be recovered from customers through prices approved in the regulatory process. These costs are recognized as the associated revenues are billed. The company accrues base revenues for services rendered but unbilled to provide a closer matching of revenues and expenses. On Oct. 27, 1992, pursuant to FPSC approval, the Gannon Project Trust was terminated and the Trust's net assets and debt were placed on the company's balance sheet. At that time, the net assets of the Trust totaled $54.2 million, which included $140.3 million of property, plant and equipment, $87.6 million of accumulated depreciation and $1.5 million of other assets and liabilities. Concurrently, the Hillsborough County Industrial Development Authority issued $54.2 million of variable-rate Pollution Control Revenue Refunding Bonds due May 15, 2018 for the benefit of Tampa Electric, the proceeds of which were used to redeem all of the outstanding debt of the Gannon Project Trust. The effect of this non-cash transaction has been netted to arrive at capital expenditures and proceeds from long-term debt in the Statements of Cash Flows. In February 1993, the FPSC approved an agreement between the company and the Office of Public Counsel that resolved all issues relating to prices for coal purchased in the years 1990 through 1992 by the company from its affiliate, Gatliff Coal, a subsidiary of TECO Coal. The company recognized a $10-million liability in February 1993 and agreed to return this amount plus interest during the 12-month period effective April 1, 1993. The $10 million charge related to this agreement is classified in "Other income (expense)" on the income statement. Depreciation The company provides for depreciation primarily by the straight- line method at annual rates that amortize the original cost, less net salvage, of depreciable property over its estimated service life. The provision for utility plant in service, expressed as a percentage of the original cost of depreciable property, was 4.2% for 1993, 1992 and 1991. The original cost of utility plant retired or otherwise disposed of and the cost of removal less salvage are charged to accumulated depreciation. Deferred Income Taxes Effective Jan. 1, 1993, the company adopted FAS 109, which changed the requirements for accounting for income taxes. Although FAS 109 retains the concept of comprehensive interperiod income tax allocation, it adopts the liability method in the measurement of deferred income taxes rather than the deferred method. Under the liability method, the temporary differences between the financial statement and tax bases of assets and liabilities are reported as deferred taxes measured at current tax rates. Since the company is a regulated enterprise and reflects the expected regulatory treatment, the adoption of FAS 109 resulted in certain adjustments to accumulated deferred income taxes and the establishment of a corresponding regulatory tax liability reflecting the amount payable to customers through future rates and had no effect on earnings. Investment Tax Credits Investment tax credits have been recorded as deferred credits and are being amortized to income tax expense over the service lives of the related property. Allowance for Funds Used During Construction (AFUDC) AFUDC is a non-cash credit to income with a corresponding charge to utility plant which represents the cost of borrowed funds and a reasonable return on other funds used for construction. The rate used to calculate AFUDC is revised periodically to reflect significant changes in the company's cost of capital. The rate was 7.70% for 1993 and 7.93% for 1992 and 1991. The base on which AFUDC is calculated excludes construction work in progress which has been included in rate base. Cash and Cash Equivalents Cash equivalents are all highly liquid debt instruments purchased with a maturity of three months or less. The carrying amount of cash equivalents approximated fair market value because of the short maturity of these instruments. Investments Short-term investments consist of various equity investments, stated at lower of aggregate cost or market. Income from short-term investments is recognized when realized, with the exception of net unrealized losses that are recognized currently in order to reflect these investments at the lower of cost or market. Net unrealized gains are not recognized until they are realized. Realized gains and losses are determined on the specific identification cost basis. The carrying amount of these investments approximated fair market value because of their short holding period. Reclassifications Certain 1992 and 1991 amounts were reclassified to conform with current year presentation. B. Common Stock The company is a wholly owned subsidiary of TECO Energy, Inc. Common Stock Issue Shares Amount Expense (thousands of dollars) Balance Dec. 31, 1990 10 $547,316 $1,692 Contributed capital from parent 68,007 -- Balance Dec. 31, 1991 10 615,323 1,692 Contributed capital from parent 14,000 -- Balance Dec. 31, 1992 10 629,323 1,692 Contributed capital from parent 37,000 -- Balance Dec. 31, 1993 10 $666,323 $1,692 C. Retained Earnings The company's Restated Articles of Incorporation and certain of the company's first mortgage bond issues contain provisions that limit the dividend payment on the company's common stock and the purchase or retirement of the company's capital stock. At Dec. 31, 1993, substantially all of the company's retained earnings were available for dividends on its common stock. D. Retirement Plan The company is a participant in the comprehensive retirement plan of TECO Energy, which has a non-contributory defined benefit retirement plan which covers substantially all employees. Benefits are based on employees' years of service and average final salary. TECO Energy's policy is to fund the plan within the guidelines set by ERISA for the minimum annual contribution and the maximum allowable as a tax deduction by the IRS. The company's share of pension expense was $1.1 million for 1993 and $1.8 million for 1992 and 1991. About 62 percent of plan assets were invested in common stocks and 38 percent in fixed income investments at Dec. 31, 1993. Components of net pension expense, reconciliation of the funded status and the accrued pension prepayment are presented below for TECO Energy consolidated. Components of net pension expense (thousands of dollars) 1993 1992 1991 Service cost (benefits earned during the period) $ 7,665 $ 7,347 $ 6,873 Interest cost on projected benefit obligations 15,052 14,063 12,695 Less: Return on plan assets Actual 30,495 25,896 39,216 Less net amortization of unrecognized transition asset and deferred return 10,284 7,696 22,730 Net return on assets 20,211 18,200 16,486 Net pension expense $ 2,506 $ 3,210 $ 3,082 Reconciliation of the funded status of the retirement plan and the accrued pension prepayment (thousands of dollars) Dec. 31, Dec. 31, 1993 1992 Fair market value of plan assets $254,253 $224,350 Projected benefit obligation (207,282) (177,378) Excess of plan assets over projected benefit obligation 46,971 46,972 Less unrecognized net gain from past experience different from that assumed 36,426 43,252 Less unrecognized prior service cost (8,858) (9,441) Less unrecognized net transition asset (being amortized over 19.5 years) 11,472 12,469 Accrued pension prepayment $ 7,931 $ 692 Accumulated benefit obligation (including vested benefits of $151,213 for 1993 and $124,133 for 1992) $169,212 $138,386 Assumptions used in determining actuarial valuations Discount rate to determine projected benefit obligation 7.75% 8.75% Rates of increase in compensation levels 3.3-5.3% 4.0-6.2% Plan asset growth rate through time 9% 9% E. Postretirement Benefit Plan The company currently provides certain postretirement health care benefits for substantially all employees retiring after age 55 meeting certain service requirements. The company contribution toward health care coverage for most employees retiring after Jan. 1, 1990 is limited to a defined dollar benefit based on years of service. Postretirement benefit levels are substantially unrelated to salary. The company reserves the right to terminate or modify the plan in whole or in part at any time. In 1993, the company adopted FAS 106 that requires postretirement benefits be recognized as earned by employees rather than recognized as paid. Prior to 1993, the cost of these benefits was recognized as benefits were paid and amounted to $2.2 million for eligible retirees in 1992 and $1.9 million for eligible retirees in 1991. Components of postretirement benefit cost (thousands of dollars) Service cost (benefits earned during the period) $1,207 Interest cost on projected benefit obligations 3,616 Amortization of transition obligation (straight line over 20 years) 2,063 Net periodic postretirement benefit expense $6,886 Reconciliation of the funded status of the postretirement benefit plan and the accrued liability (thousands of dollars) Dec. 31, Accumulated postretirement benefit obligation Active employees eligible to retire $ 8,324 Active employees not eligible to retire 18,232 Retirees and surviving spouses 20,699 47,255 Less unrecognized net loss from past experience 3,497 Less unrecognized transition obligation 39,199 Accrued postretirement liability $ 4,559 Assumptions used in determining actuarial valuation Discount rate to determine projected benefit obligation 7.75% The assumed health care cost trend rate for medical costs prior to age 65 was 12.0% in 1993 and decreases to 6.0% in 2002 and thereafter. The assumed health care cost trend rate for medical costs after age 65 was 8.5% in 1993 and decreases to 6.0% in 2002 and thereafter. A 1 percent increase in the medical trend rates would produce an 11 percent ($517,000) increase in the aggregate service and interest cost for 1993 and a 9 percent ($4.2 million) increase in the accumulated postretirement benefit obligation as of Dec. 31, 1993. F. Income Tax Expense The company is included in the filing of a consolidated Federal income tax return with its parent and affiliates. The company's income tax expense is based upon a separate return computation. Income tax expense consists of the following components: (thousands of dollars) Federal State Total Currently payable $ 43,616 $ 7,647 $ 51,263 Deferred 9,368 1,425 10,793 Amortization of investment tax credits (4,912) -- (4,912) Total income tax expense $ 48,072 $ 9,072 57,144 Included in other income, net (3,415) Included in operating expenses $ 60,559 Currently payable $ 50,851 $ 8,930 $ 59,781 Deferred 5,187 900 6,087 Investment tax credits (2) -- (2) Amortization of investment tax credits (4,138) -- (4,138) Total income tax expense $ 51,898 $ 9,830 61,728 Included in other income, net (81) Included in operating expenses $ 61,809 Currently payable $ 43,462 $ 7,444 $ 50,906 Deferred 9,734 2,026 11,760 Investment tax credits 5 - 5 Amortization of investment tax credits (4,973) - (4,973) Total income tax expense $ 48,228 $ 9,470 $ 57,698 Included in other income, net (365) Included in operating expenses $ 58,063 The company adopted FAS 109 as of Jan. 1, 1993 and elected not to restate the prior years financial statements. Deferred taxes result from temporary differences in the recognition of certain liabilities or assets for tax and financial reporting purposes. The principal components of the company's deferred tax assets and liabilities recognized in the balance sheet are as follows: Dec. 31, 1993 Deferred tax assets(1) Property related $ 25,766 Leases 5,306 Insurance reserve 2,485 Early capacity payments 2,565 Other 923 Total deferred income tax assets 37,045 Deferred income tax liabilities(1) Property related (285,291) Other (7,282) Total deferred income tax liabilities (292,573) Accumulated deferred income taxes $(255,528) _________________ (1) Certain property related assets and liabilities have been netted. Deferred tax expense results from timing differences in the recognition of certain expenses or revenues for tax and financial reporting purposes. The source of these differences and the tax effect of each for 1992 and 1991 are as follows: 1992 1991 Tax depreciation in excess of book depreciation $11,679 $13,125 (Over-recovery)/under-recovery of fuel costs (834) 1,302 Coal contract buyout (1,279) (5,323) Construction-related items capitalized for tax purposes (1,474) (1,378) Other (2,005) 4,034 $ 6,087 $11,760 The total income tax provisions differ from amounts computed by applying the federal statutory tax rate to income before income taxes for the following reasons: 1993 1992 1991 Net income $106,648 $110,785 $107,354 Total income tax provision 57,144 61,728 57,698 Income before income taxes $163,792 $172,513 $165,052 Income taxes on above at federal statutory rate (35% for 1993 and 34% for 1992 and 1991) $ 57,327 $ 58,654 $ 56,118 Increase (decrease) due to State income tax, net of federal income tax 5,921 6,515 6,270 Amortization of investment tax credits (4,912) (4,138) (4,973) Other (1,192) 697 283 Total income tax provision $ 57,144 $ 61,728 $ 57,698 Provision for income taxes as a percent of income before income taxes 34.9% 35.8% 35.0% G. Short-Term Debt Notes payable at Dec. 31, 1993 consisted exclusively of commercial paper. The carrying amount of notes payable approximated fair market value because of the short maturity of these instruments. Unused lines of credit at Dec. 31, 1993 were $140 million. Certain lines of credit require commitment fees of .15% on the unused balances. H. Related Party Transactions (thousands of dollars) Net transactions with affiliates are as follows: 1993 1992 1991 Fuel related $190,495 $190,085 $200,154 Administrative and general, net $ 14,510 $ 10,358 $ 8,733 Other, net $ -- $ -- $ 10 Amounts due from or to affiliates of the company at year-end are as follows: 1993 1992 Accounts receivable $ 1,720 $ 516 Accounts payable $ 20,693 $ 24,044 Accounts receivable and accounts payable were incurred in the ordinary course of business and do not bear interest. I. Commitments and Contingencies The company has made certain commitments in connection with its continuing capital improvements program. The company's capital expenditures are estimated to be $247 million for 1994 and $1 billion for 1995 through 1998 for equipment and facilities to meet customer growth and for construction of additional generating capacity to be placed in service in 1996. The company plans to build a 250-megawatt coal-gasification plant (Polk Unit One) with a capital cost of about $440 million, net of $100 million in construction funding from the Department of Energy under its Clean Coal Technology Program. Tampa Electric spent $71 million on this project in 1993 and expects to spend $100 million in 1994, $215 million in 1995 and the remainder in 1996. At the end of 1993, Tampa Electric had outstanding commitments of approximately $150 million for the construction of Polk Unit One. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION Year ended Dec. 31, (thousands of dollars) Column A Column B Charged to costs and expenses Item 1993 1992 1991 1. Maintenance and repairs $71,397 $68,501 $65,535 3. Taxes-Other than income taxes, are classified as follows: Real and personal property $31,664 $28,383 $28,002 State gross receipts 23,101 21,769 18,776 FICA 10,563 10,235 9,940 Local franchise 18,796 18,485 18,230 Other 1,536 1,828 1,631 85,660 80,700 76,579 Charged to utility tax expense 83,513 78,626 74,581 Charged to other accounts $ 2,147 $ 2,074 $ 1,998 __________________ The information called for in items 2, 4 and 5 of this schedule were charged to operating expenses and were not material. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. During the period from Jan. 1, 1992 to the date of this report, the company has not had and has not filed with the Commission a report as to any changes in or disagreements with accountants, accounting principles or practices, or financial statement disclosure. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (a) Information concerning Directors of Tampa Electric is as follows: Principal Occupation During Last Five Years and Director Name Age Other Directorships Held Since DuBose Ausley 56 Chairman, Macfarlane, Ausley, 1992 Ferguson & McMullen (attorneys), Tallahassee, Florida; formerly President, Ausley, McMullen, McGehee, Carothers & Proctor, P.A. (attorneys), Tallahassee, Florida; also a director Sprint Corporation and Capital City Bank Group Inc. Sara L. Baldwin 62 Private Investor; formerly 1980 Vice President, Baldwin and Sons, Inc. (insurance agency), Tampa, Florida Hugh L. Culbreath 72 Retired; Formerly Chairman of 1971 the Board of TECO Energy, Inc. and Tampa Electric Company James L. Ferman, Jr. 50 President, Ferman Motor Car 1985 Company, Inc. (automobile dealerships), Tampa, Florida Edward L. Flom 64 Retired; Formerly Chairman 1980 of the Board and Chief Executive Officer, Florida Steel Corporation (production and fabrication of steel products), Tampa, Florida; also a director of Outback Steakhouse, Inc. Henry R. Guild, Jr. 65 President and Director, Guild, 1980 Monrad & Oates, Inc. (private trustees and family investment advisers), Boston, Massachusetts Timothy L. Guzzle 57 Chairman of the Board, 1988 President and Chief Executive Officer, TECO Energy, Inc.; formerly Chief Operating Officer of TECO Energy, Inc.; also a director of NationsBank Corporation Charles H. Ross, Jr. 56 Executive Vice President 1987 Emeritus of Merrill Lynch & Co., Inc., New York, New York; also a director of Merrill Lynch Ready Assets Trust, Merrill Lynch Capital Fund, Inc. and Enhance Financial Services Group, Inc. Robert L. Ryan 50 Senior Vice President and 1991 Chief Financial Officer, Medtronic, Inc. (medical devices manufacturer), Minneapolis, Minnesota; formerly Vice President-Finance, Union Texas Petroleum Holdings, Inc. (independent oil and gas exploration and production), Houston, Texas; also a director of Riverwood International Corporation and Inter-Regional Financial Group, Inc. J. Thomas Touchton 55 Managing Partner, The 1987 Witt-Touchton Company (private investment partnership), Tampa, Florida; also a director of 19 Merrill Lynch-sponsored mutual funds John A. Urquhart 65 President, John A. Urquhart 1991 Associates (management consultants) Fairfield, Connecticut; formerly Senior Vice President, G. E. Industrial & Power Systems, General Electric Company; also a director of Enron Corp., Hubbell, Inc. and Aquarion Company James O. Welch, Jr. 62 Retired; formerly Vice Chairman, 1976 RJR Nabisco, Inc. and Chairman, Nabisco Brands, Inc.; also a director of Vanguard Group of Investment Companies The term of office of each director extends to and expires at the next annual meeting of shareholders, scheduled to be held on April 19, 1994, and until a successor is elected and qualified. At present, all the directors of the company are also directors of TECO Energy. (b) Information concerning the current executive officers of the company is as follows: Current Positions and Principal Occupations Name Age During Last Five Years Timothy L. Guzzle 57 Chairman of the Board and Chief Executive Officer, 1991 to date; also Chairman of the Board, President and Chief Executive Officer of TECO Energy, Inc. Girard F. Anderson 62 President and Chief Operating Officer; also Executive Vice President-Utility Operations of TECO Energy, Inc. William N. Cantrell 41 Vice President-Energy Resources Planning, 1991 to date; and prior thereto, Vice President-Regulatory Affairs. Lester L. Lefler 53 Vice President-Controller. Alan D. Oak 47 Vice President, Treasurer and Chief Financial Officer 1992 to date; and prior thereto Chief Financial Officer; also Senior Vice President-Finance, Treasurer and Chief Financial Officer of TECO Energy, Inc. William T. Snyder, Jr. 56 Vice President-Customer Services and Marketing. Keith S. Surgenor 46 Vice President-Human Resources; also Vice President-Human Resources of TECO Energy, Inc. Robert F. Tomczak 58 Vice President-Production, Operations and Maintenance. Harry I. Wilson 55 Vice President-Transmission and Distribution. There is no family relationship between any of the persons named in response to Item 10. The term of office of each officer extends to and expires at the meeting of the Board of Directors following the next annual meeting of shareholders, scheduled to be held on April 19, 1994, and until a successor is elected and qualified. Item 11. Item 11. EXECUTIVE COMPENSATION. The following tables set forth certain compensation information for the Chief Executive Officer of the company and each of the four other most highly compensated executive officers of the company. The share amounts reported below have been restated to reflect the two-for-one stock split on August 30, 1993. The Compensation Committee of the TECO Energy Board may award options to purchase common stock of TECO Energy and stock appreciation rights (SARs) to officers and key employees of TECO Energy and its subsidiaries, including the company. Information for 1993 with respect to stock options and stock appreciation rights granted or exercised by the executive officers named in the "Summary Compensation Table" is set forth in the following two tables. Aggregated Option/SAR Exercises In Last Fiscal Year and Fiscal Year-End Option/SAR Value Number of Shares Value of Underlying Unexercised Unexercised In-The-Money Options/SARs Options/SARs at Year-End at Year-End Number of Shares Acquired Value Exercisable/ Exercisable/ Name On Exercise Realized Unexercisable Unexercisable Timothy L. Guzzle 40,000 $357,500 120,000/0 $361,250/0 Girard F. Anderson 22,400 $183,400 72,000/0 $216,750/0 Alan D. Oak 16,000 $153,500 39,000/0 $117,406/0 Keith S. Surgenor 30,000 $267,250 54,000/0 $262,375/0 Robert F. Tomczak 5,000 $ 26,719 9,600/0 $ 18,906/0 Pension Table The following table shows estimated annual benefits payable under the company's pension plan arrangements for the named executive officers other than Mr. Guzzle. Years of Service Years of Service Final Three Final Three Years Average Years Average Earnings 15 20 or more Earnings 15 20 or more $100,000 $ 45,000 $ 60,000 $450,000 $202,500 $270,000 150,000 67,500 90,000 500,000 225,000 300,000 200,000 90,000 120,000 550,000 247,500 330,000 250,000 112,500 150,000 600,000 270,000 360,000 300,000 135,000 180,000 650,000 292,500 390,000 350,000 157,500 210,000 700,000 315,000 420,000 400,000 180,000 240,000 The annual benefits payable to each of the named executive officers are equal to a stated percentage of such officer's average earnings for the three years before his retirement multiplied by his number of years of service, up to a stated maximum. The amounts shown in the table are based on 3% of such earnings and a maximum of 20 years of service; the amounts payable to Mr. Guzzle are based on 6% of earnings and a maximum of 10 years of service. The earnings covered by the pension plan arrangements are the same as those reported as salary and bonus in the summary compensation table above. Years of service for the named executive officers are as follows: Mr. Guzzle (6 years); Mr. Anderson (34 years); Mr. Oak (20 years); Mr. Surgenor (5 years); and Mr. Tomczak (31 years). The pension benefit is computed as a straight-life annuity commencing at age 62 and is reduced by an officer's Social Security benefits. If Mr. Guzzle's employment is terminated by the Corporation without cause or by Mr. Guzzle for good reason (as such terms are defined in Mr. Guzzle's employment agreement referred to below), his age and service for purposes of determining benefits under the pension plan arrangements are increased by two years. Severance Agreements TECO Energy has severance agreements with 25 officers of TECO Energy and its subsidiaries, including the five executive officers named above, under which payments will be made under certain circumstances following a change in control of TECO Energy (as defined in the severance agreements). Each officer is required, subject to the terms of the severance agreements, to remain in the employ of TECO Energy or its subsidiaries for one year following a potential change in control (as defined) unless a change in control earlier occurs. The severance agreements provide that in the event employment is terminated by the company or TECO Energy without cause (as defined) or by the officer for good reason (as defined) following a certain change in control, TECO Energy will make a lump sum severance payment to the officer of two times (three times in the cases of Mr. Guzzle, Mr. Anderson, Mr. Oak and Mr. Surgenor) annual salary and bonus. Upon such termination, the severance agreements also provide for: (i) a cash payment equal to the additional retirement benefit which would have been earned under TECO Energy's retirement plans if employment had continued for two years (three years in the cases of Mr. Guzzle, Mr. Anderson, Mr. Oak and Mr. Surgenor) following the date of termination, and (ii) participation in the life, accident and health insurance plans of TECO Energy for such period except to the extent such benefits are provided by a subsequent employer. Any benefit payable to the officer in connection with a change in control or termination of employment will be reduced to the extent that such payment, together with any other compensation provided by TECO Energy, would not be deductible by TECO Energy, or by any other person making such payment, pursuant to Section 280G of the Internal Revenue Code of 1986. TECO Energy has an employment agreement with Mr. Guzzle providing that if his employment is terminated by TECO Energy without cause or by Mr. Guzzle for good reason, he will receive benefits similar to those provided under the severance agreements described above based upon a level of two times annual salary and bonus and a two-year benefit continuation period. Compensation of Directors Directors of TECO Energy and the company who are not officers are paid a combined annual retainer of $17,500 ($20,000 effective April 1, 1994) and a fee of $1,000 for attendance at each meeting of the Board of Directors and $500 ($600 for the Committee Chairman) for attendance at each meeting of a Committee of the Board. Directors may elect to defer these amounts with earnings credited at either the 90- day U.S. Treasury bill rate or a rate equal to the total return on TECO Energy's Common Stock. 1991 Director Stock Option Plan. TECO Energy has a Director Stock Option Plan in which all directors of the company and TECO Energy participate except Mr. Guzzle. The plan provides automatic annual grants of options to purchase shares of TECO Energy common stock to each non-employee director serving on the TECO Energy Board at the time of grant. The exercise price is the fair market value of the common stock on the date of grant, payable in whole or in part in cash or TECO Energy common stock. The plan provides for an initial grant of options for 10,000 shares of TECO Energy common stock for each new director following election to the Board and an annual grant of options for 2,000 shares for each continuing director. Annual grants are made on the first trading day of TECO Energy common stock after each annual meeting. The options are exercisable immediately and expire ten years after grant or earlier as provided in the plan following termination of service on the Board. Directors' Retirement Plan. All Directors who have completed 60 months of service as a Director of TECO Energy and who have not been employees of TECO Energy or any of its subsidiaries are eligible to participate in a Directors' Retirement Plan. Under this plan, a retired Director or his or her surviving spouse will receive a monthly retirement benefit equal to the monthly retainer last paid to such Director for services as a Director of TECO Energy or any of its subsidiaries. Such payments will continue for the lesser of the number of months the Director served as a Director or 120 months, but payments will in any event cease upon the death of the Director or, if the Director's spouse survives the Director, the death of the spouse. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. All outstanding shares of Tampa Electric's common stock are owned by TECO Energy. As of Jan. 31, 1994, none of the directors or executive officers of Tampa Electric or TECO Energy owned any shares of the preferred stock of Tampa Electric. The following table sets forth the shares of TECO Energy common stock beneficially owned as of Jan. 31, 1994 by directors and nominees, the executive officers named in the summary compensation table and Tampa Electric's directors and executive officers as a group. Except as otherwise noted, such persons have sole investment and voting power over the shares. The number of shares of TECO Energy's common stock beneficially owned by any director or executive officer or by all directors and executive officers as a group does not exceed 1% of such shares outstanding at Jan. 31, 1994. Name Shares (1) DuBose Ausley 15,886 Sara L. Baldwin 16,918(2) Hugh L. Culbreath 71,875(3) James L. Ferman, Jr. 21,740(4) Edward L. Flom 16,784(5) Henry R. Guild, Jr. 128,598(6) Timothy L. Guzzle 143,110(7)(8) Charles H. Ross, Jr. 32,000(9) Robert L. Ryan 16,000(10) J. Thomas Touchton 18,000(11) John A. Urquhart 15,150(12) James O. Welch, Jr. 22,600(13) Girard F. Anderson 103,809(7)(14) Alan D. Oak 67,938(7)(15) Keith S. Surgenor 63,736(7)(16) Robert F. Tomczak 24,846(7)(17) 20 directors and executive officers as a group (including those named above) 870,575(7)(18) __________________ (1) The amounts listed include the following shares that are subject to options granted under TECO Energy's stock option plans: Mr. Ausley, 12,000 shares; Mrs. Baldwin and Messrs. Culbreath, Ferman, Flom, Guild, Ross, Ryan, Touchton and Welch, 14,000 shares each; Mr. Urquhart, 11,200 shares; Mr. Guzzle, 120,000 shares; Mr. Anderson, 72,000 shares; Mr. Oak, 39,000 shares; Mr. Surgenor, 54,000 shares; Mr. Tomczak, 9,600 shares; and all directors and executive officers as a group, 528,600 shares. (2) Includes 350 shares held by a trust of which Mrs. Baldwin is a trustee. (3) Includes 8,000 shares owned by Mr. Culbreath s wife, as to which shares he disclaims any beneficial interest. (4) Includes 2,584 shares owned jointly by Mr. Ferman and his wife. Also includes 436 shares owned by Mr. Ferman s wife, as to which shares he disclaims any beneficial interest. (5) Includes 1,596 shares owned by Mr. Flom s wife, as to which shares he disclaims any beneficial interest. (6) Includes 108,598 shares held by trusts of which Mr. Guild is a trustee. Of these shares, 49,875 are held for the benefit of Mr. Culbreath and are also included in the number of shares beneficially owned by him. (7) The amounts listed include the following shares that are held by the benefit plans of TECO Energy for an officer's account: Mr. Guzzle, 1,110 shares; Mr. Anderson, 7,889 shares; Mr. Oak, 8,808 shares; Mr. Surgenor, 1,482 shares; Mr. Tomczak, 9,578 shares; and all directors and executive officers as a group, 55,517 shares. (8) Includes 20,000 shares owned by a Revocable Living Trust of which Mr. Guzzle is a trustee. (9) Includes 12,000 shares owned jointly by Mr. Ross and his wife. Also includes 6,000 shares owned by Mr. Ross' wife, as to which shares he disclaims any beneficial interest. (10) Includes 2,000 shares owned jointly by Mr. Ryan and his wife. (11) Includes 4,000 shares owned by a Revocable Living Trust of which Mr. Touchton is the sole trustee. (12) Includes 1,000 shares owned by Mr. Urquhart's wife, as to which shares he disclaims any beneficial interest. (13) Includes 2,000 shares owned by a charitable foundation of which Mr. Welch is a trustee. (14) Includes 800 shares owned by Mr. Anderson's wife, as to which shares he disclaims any beneficial interest. (15) Includes 20,130 shares owned jointly by Mr. Oak and his wife. (16) Includes 8,162 shares owned jointly by Mr. Surgenor and his wife. (17) Includes 324 shares owned jointly by Mr. Tomczak and his wife. (18) Includes a total of 54,800 shares owned jointly with spouses. Also includes a total of 17,832 shares owned by spouses, as to which shares beneficial interest is disclaimed. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. TECO Energy paid $842,755 for legal services rendered during 1993 by Ausley, McMullen, McGehee, Carothers & Proctor, P.A., of which Mr. Ausley served as the President. The above firm merged with another law firm effective Feb. 1, 1994, and Mr. Ausley is now Chairman of the successor, Macfarlane, Ausley, Ferguson & McMullen. In addition, reference is made to Note H on page 32. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial Statements - See index on page 17. 2. Financial Statement Schedules - See index on page 17. 3. Exhibits 3.1 Articles of Incorporation (Exhibit 3.1 to Registration Statement No. 2-70653). 3.2 Bylaws as amended on April 16, 1991 (Exhibit 3, Form 10-Q for quarter ended March 31, 1991 of Tampa Electric Company). 4.1 Indenture of Mortgage among Tampa Electric Company, State Street Trust Company and First Savings & Trust Company of Tampa, dated as of Aug. 1, 1946 (Exhibit 7-A to Registration Statement No. 2-6693). 4.2 Ninth Supplemental Indenture, dated as of April 1, 1966, to Exhibit 4.1 (Exhibit 4-k, Registration Statement No. 2-28417). 4.3 Thirteenth Supplemental Indenture, dated as of Jan. 1, 1974, to Exhibit 4.1 (Exhibit 2-g-l, Registration Statement No. 2-51204). 4.4 Sixteenth Supplemental Indenture, dated as of Oct. 30, 1992, to Exhibit 4.1 (Exhibit 7-A, Registration Statement No. 2-6693). 4.5 Eighteenth Supplemental Indenture, dated as of May 1, 1993, to Exhibit 4.1 (Exhibit 4.1, Form 10-Q for the quarter ended June 30, 1993). 4.6 Installment Purchase and Security Contract between the Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of March 1, 1972 (Exhibit 4.9, Form 10-K for 1986 of Tampa Electric Company). 4.7 First Supplemental Installment Purchase and Security Contract, dated as of Dec. 1, 1974 (Exhibit 4.10, Form 10-K for 1986 of Tampa Electric Company). 4.8 Third Supplemental Installment Purchase Contract, dated as of May 1, 1976 (Exhibit 4.12, Form 10-K for 1986 of Tampa Electric Company). 4.9 Installment Purchase Contract between the Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of Aug. 1, 1981 (Exhibit 4.13, Form 10-K for 1986 of Tampa Electric Company). 4.10 Amendment to Exhibit A of Installment Purchase Contract, dated as of April 7, 1983 (Exhibit 4.14, Form 10-K for 1989 of Tampa Electric Company). 4.11 Second Supplemental Installment Purchase Contract, dated as of June 1, 1983 (Exhibit 4.16, Form 10-K for 1985 of Tampa Electric Company). 4.12 Third Supplemental Installment Purchase Contract, dated as of Aug. 1, 1989 (Exhibit 4.16, Form 10-K for 1989 of Tampa Electric Company). 4.13 Installment Purchase Contract between the Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of Jan. 31, 1984 (Exhibit 4.16, Form 10-K for 1983 of Tampa Electric Company). 4.14 First Supplemental Installment Purchase Contract, dated as of Aug. 2, 1984 (Exhibit 4.17, Form 10-K for 1984 of Tampa Electric Company). 4.15 Second Supplemental Installment Purchase Contract, dated as of July 1, 1993 (Exhibit 4.3, Form 10-Q for the quarter ended June 30, 1993). 4.16 Loan and Trust Agreement among the Hillsborough County Industrial Development Authority, Tampa Electric Company and NCNB National Bank of Florida, dated as of Sept. 24, 1990 (Exhibit 4.1, Form 10-Q for the quarter ended Sept. 30, 1990 of Tampa Electric Company). 4.17 Loan and Trust Agreement, dated as of Oct. 26, 1992 among the Hillsborough County Industrial Development Authority, Tampa Electric Company and NationsBank of Florida, N.A., as trustee (Exhibit 4.2, Form 10-Q for the quarter ended Sept. 30, 1992 of Tampa Electric Company). 4.18 Loan and Trust Agreement, dated as of June 23, 1993, among the Hillsborough County Industrial Development Authority, Tampa Electric Company and NationsBank of Florida, N.A., as trustee (Exhibit 4.2, Form 10-Q for the quarter ended June 30, 1993 of Tampa Electric Company). 10.1 Agreement between Belcher Oil Company and Tampa Electric Company, dated as of Sept. 1, 1987 (Exhibit 10.4, Form 10-K for 1987 of Tampa Electric Company). 10.2 Settlement Agreement between Pyramid Mining, Inc., Pyramid Equipment, Inc. and Tampa Electric Company, dated as of Oct. 7, 1987 (Exhibit 10.5, Form 10-K for 1987 of Tampa Electric Company). 10.3 Coal Mining Lease Contract by and among Cal-Glo Coal, Inc. and Jack Stewart and Tom Gambrel consisting of Underground Coal Mining Lease Contract dated as of May 3, 1967; Assignment of Lease dated as of Feb. 13, 1969; Supplemental Coal Lease dated as of May 13, 1970; Sublease Agreement dated as of Oct. 18, 1972; Amendment to Lease dated as of Jan. 26, 1976; Amendment to Lease dated as of March 31, 1978; and Consent dated as of May 15, 1978 (Exhibit 10.12, Form 10-K for 1986 of Tampa Electric Company). 10.4 Lease and Agreement dated as of July 23, 1979 between Tampa Electric Company and Franklin Street Associates, Ltd. (Exhibit 10.13, Form 10-K for 1986 of Tampa Electric Company). 10.5 1980 Stock Option and Appreciation Rights Plan, as amended on July 18, 1989 (Exhibit 28.1, Form 10-Q for quarter ended June 30, 1989 of TECO Energy, Inc.). 10.6 Directors' Retirement Plan, dated as of Jan. 24, 1985 (Exhibit 10.23, Form 10-K for 1986 of Tampa Electric Company). 10.7 Supplemental Executive Retirement Plan, as amended on July 18, 1989 (Exhibit 10.14, Form 10-K for 1989 of Tampa Electric Company). 10.8 TECO Energy, Inc. Group Supplemental Executive Retirement Benefits Trust Agreement Amendment and Restatement, dated as of April 27, 1989 (Exhibit 10.15, Form 10-K for 1989 of Tampa Electric Company). 10.9 Annual Incentive Compensation Plan for Tampa Electric Company, as amended on April 27, 1989 (Exhibit 28.1, Form 10-Q for quarter ended March 31, 1989 of Tampa Electric Company). 10.10 TECO Energy, Inc. Group Supplemental Disability Income Plan, dated as of March 20, 1989 (Exhibit 10.19, Form 10-K for 1988 of Tampa Electric Company). 10.11 Forms of Severance Agreements between TECO Energy, Inc. and certain senior executives, dated as of various dates in 1989 (Exhibit 10.18, Form 10-K for 1989 of Tampa Electric Company). 10.12 TECO Energy, Inc. 1990 Equity Incentive Plan (Exhibit 10.1, Form 10-Q for the quarter ended March 31, 1990 of TECO Energy, Inc.). 10.13 TECO Energy, Inc. 1991 Director Stock Option Plan as amended on Jan. 21, 1992 (Exhibit 10.20, Form 10-K for 1991 of Tampa Electric Company). 10.14 Supplemental Executive Retirement Plan for T. L. Guzzle, as amended on July 20, 1993 (Exhibit 10.1, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.15 Terms of R. H. Kessel's Employment, dated as of Dec. 1, 1989 (Exhibit 10.20, Form 10-K for 1989 of TECO Energy, Inc.). 10.16 Supplemental Executive Retirement Plan for R. H. Kessel, dated as of Dec. 4, 1989 (Exhibit 10.16, Form 10-K for 1989 of TECO Energy, Inc.). 10.17 Supplemental Executive Retirement Plan for H.L. Culbreath, as amended on April 27, 1989 (Exhibit 10.14, Form 10-K for 1989 of TECO Energy, Inc.). 10.18 Supplemental Executive Retirement Plan for A.D. Oak, dated as of July 20, 1993 (Exhibit 10.2, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.19 Supplemental Executive Retirement Plan for K.S. Surgenor, dated as of July 20, 1993 (Exhibit 10.3, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.20 Terms of T.L. Guzzle's employment, dated as of July 20, 1993 (Exhibit 10, Form 10-Q for the quarter ended June 30, 1993 of Tampa Electric Company). 10.21 Supplemental Executive Retirement Plan for G.F. Anderson (Exhibit 10.4, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.22 TECO Energy, Inc. Group Supplemental Retirement Benefits Trust Agreement Amendment and Restatement, dated as of April 27, 1989 as amended by First Amendment to 1989 Restatement dated as of July 20, 1993 (Exhibit 10.5, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 12 Ratio of earnings to fixed charges. 23 Consent of Independent Accountants. 24.1 Power of Attorney. 24.2 Certified copy of resolution authorizing Power of Attorney. _____________ Indicates exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference. Exhibits filed with periodic reports of Tampa Electric Company and TECO Energy, Inc. were filed under Commission File Nos. 1-5007 and 1-8180, respectively. Executive Compensation Plans and Arrangements Exhibits 10.5 through 10.22 above are management contracts or compensatory plans or arrangements in which executive officers or directors of TECO Energy, Inc. and its subsidiaries participate. (b) The company filed no reports on Form 8-K during the last quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 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, in the city of Tampa and the state of Florida on the 28th day of March, 1994. TAMPA ELECTRIC COMPANY By T. L. GUZZLE* T. L. GUZZLE, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on March 28, 1994: Signature Title T. L. GUZZLE* Chairman of the Board, T. L. GUZZLE Director and Chief Executive Officer (Principal Executive Officer) A. D. OAK* Vice President, Treasurer A. D. OAK and Chief Financial Officer (Principal Financial Officer) /s/ L. L. LEFLER Vice President-Controller L. L. LEFLER C. D. AUSLEY* Director C. D. AUSLEY S. L. BALDWIN* Director S. L. BALDWIN H. L. CULBREATH* Director H. L. CULBREATH J. L. FERMAN, JR.* Director J. L. FERMAN, JR. E. L. FLOM* Director E. L. FLOM H. R. GUILD, JR.* Director H. R. GUILD, JR. C. H. ROSS, JR.* Director C. H. ROSS, JR. R. L. RYAN* Director R. L. RYAN J. T. TOUCHTON* Director J. T. TOUCHTON J. A. URQUHART* Director J. A. URQUHART J. O. WELCH, JR.* Director J. O. WELCH, JR. By: /s/ L. L. LEFLER L. L. LEFLER, Attorney-in-fact INDEX TO EXHIBITS Exhibit Page No. Description No. 3.1 Articles of Incorporation (Exhibit 3.1 to Registration Statement No. 2-70653). 3.2 Bylaws as amended on April 16, 1991 * (Exhibit 3, Form 10-Q for quarter ended March 31, 1991 of Tampa Electric Company). 4.1 Indenture of Mortgage among Tampa Electric * Company, State Street Trust Company and First Savings & Trust Company of Tampa, dated as of Aug. 1, 1946 (Exhibit 7-A to Registration Statement No. 2-6693). 4.2 Ninth Supplemental Indenture, dated as of * April 1, 1966, to Exhibit 4.1 (Exhibit 4-k, Registration Statement No. 2-28417). 4.3 Thirteenth Supplemental Indenture, dated as of * Jan. 1, 1974, to Exhibit 4.1 (Exhibit 2-g-l, Registration Statement No. 2-51204). 4.4 Sixteenth Supplemental Indenture, dated as of * Oct. 30, 1992, to Exhibit 4.1 (Exhibit 7-A, Registration Statement No. 2-6693). 4.5 Eighteenth Supplemental Indenture, dated as of May 1, * 1993, to Exhibit 4.1 (Exhibit 4.1, Form 10-Q for the quarter ended June 30, 1993). 4.6 Installment Purchase and Security Contract * between and the Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of March 1, 1972 (Exhibit 4.9, Form 10-K for 1986 of Tampa Electric Company). 4.7 First Supplemental Installment Purchase and * Security Contract, dated as of Dec. 1, 1974 (Exhibit 4.10, Form 10-K for 1986 of Tampa Electric Company). 4.8 Third Supplemental Installment Purchase Contract, * dated as of May 1, 1976 (Exhibit 4.12, Form 10-K for 1986 of Tampa Electric Company). 4.9 Installment Purchase Contract between the * Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of Aug. 1, 1981 (Exhibit 4.13, Form 10-K for 1986 of Tampa Electric Company). 4.10 Amendment to Exhibit A of Installment Purchase * Contract, dated as of April 7, 1983 (Exhibit 4.14, Form 10-K for 1989 of Tampa Electric Company). 4.11 Second Supplemental Installment Purchase Contract, * dated as of June 1, 1983 (Exhibit 4.16, Form 10-K for 1985 of Tampa Electric Company). 4.12 Third Supplemental Installment Purchase Contract, * dated as of Aug. 1, 1989 (Exhibit 4.16, Form 10-K for 1989 of Tampa Electric Company). 4.13 Installment Purchase Contract between the 61 Hillsborough County Industrial Development Authority and Tampa Electric Company, dated as of Jan. 31, 1984 (Exhibit 4.16, Form 10-K for 1983 of Tampa Electric Company). 4.14 First Supplemental Installment Purchase Contract, * dated as of Aug. 2, 1984 (Exhibit 4.17, Form 10-K for 1984 of Tampa Electric Company). 4.15 Second Supplemental Installment Purchase Contract, * dated as of July 1, 1993 (Exhibit 4.3, Form 10-Q for the quarter ended June 30, 1993). 4.16 Loan and Trust Agreement among the Hillsborough * County Industrial Development Authority, Tampa Electric Company and NCNB National Bank of Florida, dated as of Sept. 24, 1990 (Exhibit 4.1, Form 10-Q for the quarter ended Sept. 30, 1990 of Tampa Electric Company). 4.17 Loan and Trust Agreement, dated as of * Oct. 26, 1992 among the Hillsborough County Industrial Development Authority, Tampa Electric Company and NationsBank of Florida, N.A., as trustee (Exhibit 4.2, Form 10-Q for the quarter ended Sept. 30, 1992 of Tampa Electric Company). 4.18 Loan and Trust Agreement, dated as of June 23, * 1993, among the Hillsborough County Industrial Development Authority, Tampa Electric Company and NationsBank of Florida, N.A., as trustee (Exhibit 4.2, Form 10-Q for the quarter ended June 30, 1993 of Tampa Electric Company). 10.1 Agreement between Belcher Oil Company and * Tampa Electric Company, dated as of Sept. 1, 1987 (Exhibit 10.4, Form 10-K for 1987 of Tampa Electric Company). 10.2 Settlement Agreement between Pyramid Mining, Inc., * Pyramid Equipment, Inc. and Tampa Electric Company, dated as of Oct. 7, 1987 (Exhibit 10.5, Form 10-K for 1987 of Tampa Electric Company). 10.3 Coal Mining Lease Contract by and among * Cal-Glo Coal, Inc. and Jack Stewart and Tom Gambrel consisting of Underground Coal Mining Lease Contract dated as of May 3, 1967; Assignment of Lease dated as of Feb. 13, 1969; Supplemental Coal Lease dated as of May 13, 1970; Sublease Agreement dated as of Oct. 18, 1972; Amendment to Lease dated as of Jan. 26, 1976; Amendment to Lease dated as of March 31, 1978; and Consent dated as of May 15, 1978 (Exhibit 10.12, Form 10-K for 1986 of Tampa Electric Company). 10.4 Lease and Agreement dated as of July 23, 1979 * between Tampa Electric Company and Franklin Street Associates, Ltd. (Exhibit 10.13, Form 10-K for 1986 of Tampa Electric Company). 10.5 1980 Stock Option and Appreciation Rights Plan, * as amended on July 18, 1989 (Exhibit 28.1, Form 10-Q for quarter ended June 30, 1989 of TECO Energy, Inc.). 10.6 Directors' Retirement Plan, dated as of * Jan. 24, 1985 (Exhibit 10.23, Form 10-K for 1986 of Tampa Electric Company). 10.7 Supplemental Executive Retirement Plan, as amended * on July 18, 1989 (Exhibit 10.14, Form 10-K for 1989 of Tampa Electric Company). 10.8 TECO Energy, Inc. Group Supplemental Executive * Retirement Benefits Trust Agreement Amendment and Restatement, dated as of April 27, 1989 (Exhibit 10.15, Form 10-K for 1989 of Tampa Electric Company). 10.9 Annual Incentive Compensation Plan for Tampa * Electric Company, as amended on April 27, 1989 (Exhibit 28.1, Form 10-Q for quarter ended March 31, 1989 of Tampa Electric Company). 10.10 TECO Energy, Inc. Group Supplemental Disability * Income Plan, dated as of March 20, 1989 (Exhibit 10.19, Form 10-K for 1988 of Tampa Electric Company). 10.11 Forms of Severance Agreements between TECO Energy, Inc. * and certain senior executives, dated as of various dates in 1989 (Exhibit 10.18, Form 10-K for 1989 of Tampa Electric Company). 10.12 TECO Energy, Inc. 1990 Equity Incentive Plan * (Exhibit 10.1, Form 10-Q for the quarter ended March 31, 1990 of TECO Energy, Inc.). 10.13 TECO Energy, Inc. 1991 Director Stock Option Plan * as amended on Jan. 21, 1992 (Exhibit 10.20, Form 10-K for 1991 of Tampa Electric Company). 10.14 Supplemental Executive Retirement Plan for * T. L. Guzzle, as amended on July 20, 1993 (Exhibit 10.1, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.15 Terms of R. H. Kessel's Employment, dated as of * Dec. 1, 1989 (Exhibit 10.20, Form 10-K for 1989 of TECO Energy, Inc.). 10.16 Supplemental Executive Retirement Plan for * R. H. Kessel, dated as of Dec. 4, 1989 (Exhibit 10.16, Form 10-K for 1989 of TECO Energy, Inc.). 10.17 Supplemental Executive Retirement Plan for * H.L. Culbreath, as amended on April 27, 1989 (Exhibit 10.14, Form 10-K for 1989 of TECO Energy, Inc.). 10.18 Supplemental Executive Retirement Plan for * A.D. Oak, dated as of July 20, 1993 (Exhibit 10.2, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.19 Supplemental Executive Retirement Plan for * K.S. Surgenor, dated as of July 20, 1993 (Exhibit 10.3, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.20 Terms of T.L. Guzzle's employment, dated * as of July 20, 1993 (Exhibit 10, Form 10-Q for the quarter ended June 30, 1993 of Tampa Electric Company). 10.21 Supplemental Executive Retirement Plan for * G.F. Anderson (Exhibit 10.4, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 10.22 TECO Energy, Inc. Group Supplemental * Retirement Benefits Trust Agreement Amendment and Restatement, dated as of April 27, 1989 as amended by First Amendment to 1989 Restatement dated as of July 20, 1993 (Exhibit 10.5, Form 10-Q for the quarter ended Sept. 30, 1993 of Tampa Electric Company). 12 Ratio of earnings to fixed charges. 88 23 Consent of Independent Accountants. 89 24.1 Power of Attorney. 90 24.2 Certified copy of resolution authorizing Power 92 of Attorney. _____________ * Indicates exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference. Exhibits filed with periodic reports of Tampa Electric Company and TECO Energy, Inc. were filed under Commission File Nos. 1-5007 and 1-8180, respectively.	15,840	100,738
102420_1993.txt	102420_1993	1993	102420	Item 1. Item 3. Item 3. Legal Proceedings. In November 1981 the Company and certain of its subsidiaries filed a third amended complaint against a former registered representative and certain of his affiliated companies and individuals and against certain former officers of USLIFE Savings and Loan Association ("USLIFE Savings", a former subsidiary of the Company) for indemnification, injunctive relief and accounting (USLIFE Savings and Loan Association v. Louis Wilcox, et al., Superior Court of the State of California for the County of Riverside). In the complaint, the Company, its subsidiaries and USLIFE Savings sought to recover all damages and losses incurred by them as defendants in actions related to the activities of the aforementioned former registered representative as well as attorneys' fees and costs incurred in defending against such actions. In April 1984, defendant Louis M. Wilcox, a former officer of USLIFE Savings, filed a cross complaint in this action. Wilcox seeks special damages in the amount of not less than $15 thousand, general damages of $1 million, and punitive damages of $10 million. In 1986 Wilcox's causes of action for malicious prosecution and abuse of process were dismissed. In 1989 Wilcox voluntarily dismissed the remainder of his case and appealed the 1986 decision dismissing his causes of action for malicious prosecution and abuse of process. On appeal, the dismissal of the cause of action for abuse of process was reversed. The dismissal of the cause of action for malicious prosecution was upheld. Trial was scheduled to begin in June 1993. Pursuant to the Company's request, the case was bifurcated for trial. In July 1993 the trial court, after hearing evidence on the issue, without a jury, decided that the Company originally had probable cause to sue Wilcox. As this was dispositive of Wilcox's claim for malicious prosecution, the Court dismissed Wilcox's claims against the Company. A judgment in the Company's favor was entered in late 1993. Wilcox has appealed. In March 1992, All American Life Insurance Company ("All American") terminated the right of Doug Ruedlinger, Inc. (the "Managing General Agent" or "DRI") to sell college medical insurance on behalf of All American. All American had entered into an arrangement with the Managing General Agent for sales and the administration of student accident and health policies, embodied in an Exclusive Agency Agreement. In April 1992, All American terminated the Managing General Agent's Exclusive Agency Agreement. The Exclusive Agency Agreement was terminated as a result of the failure of the Managing General Agent to secure adequate reinsurance as required under that contract, and to meet other contractual obligations. Subsequent to the termination of the Exclusive Agency Agreement, the Managing General Agent ceased processing and paying claims under All American policies, and All American assumed these functions. The Managing General Agent then commenced arbitration proceedings against All American before the American Arbitration Association based upon the termination of the Exclusive Agency Agreement (the "Arbitration Proceeding"). All American then commenced an action against the Managing General Agent in the United States District Court for the District of Kansas (All American Life Insurance Co. v. Doug Ruedlinger, Inc. and First Benefits, Inc. ("FBI") (the "Kansas litigation") seeking a Temporary Restraining Order (which was granted), and damages for breach of contract and breach of fiduciary duty; All American also secured a preliminary injunction prohibiting the Managing General Agent from, among other things, collecting premiums, placing any insurance on behalf of All American, or in any way holding itself out as representing All American. All American subsequently filed an amended complaint adding corporations and individuals affiliated with the Managing General Agent as party defendants (the "Ruedlinger Defendants") and alleging claims ranging from civil RICO violations to a claim for common law fraud. The Managing General Agent's Errors and Omissions carrier, Transamerica Insurance Company ("Transamerica"), intervened in the Kansas litigation to deny coverage for the claims asserted against the Managing General Agent in the Arbitration Proceeding and the Kansas litigation, which allegedly fell under the coverage of Transamerica's Errors and Omissions Policy (the "Policy"). In March 1993, All American entered into an Assignment Agreement with Merchants National Bank ("Merchants" or, the "Bank") (the Managing General Agent's former bank). The Bank had asserted a security interest in premiums and reinsurance recoveries on the policies at issue, and had intervened in the Kansas litigation seeking to enforce these alleged security interests. Through the Assignment Agreement, All American purchased all of the Bank's right, title and interest in and to the Managing General Agent's assets, as well as the assets of its parent and affiliates, pursuant to certain loan documents executed by the Managing General Agent and its parent and affiliates. Pursuant to the terms of the Assignment Agreement, all claims asserted by All American and the Bank, against each other, were dismissed. By consent order dated May 25, 1993, the Kansas litigation was stayed by the Court. The Court in the Kansas litigation lifted the stay in that case solely to permit All American to file a second amended complaint in that action, which was identical to the prior pleading except that it set forth an additional claim against an affiliate of the Managing General Agent, Fund Insurance Company, Ltd. ("FICL"), based on a promissory note that was assigned to All American by the Bank under the Assignment Agreement. FICL is a Bermuda insurance company that was already a defendant in the Kansas litigation, and is owned by a Kansas corporation known as The Ruedlinger Company, Inc. Among the loan documents assigned to All American by the Bank pursuant to the Assignment Agreement was a written guaranty by Douglas O. Ruedlinger ("Ruedlinger"), guarantying the full indebtedness represented by the loan documents. Prior to the execution and delivery of the Assignment Agreement, the Bank had commenced an action against Ruedlinger in the Kansas State Court of Shawnee County, Merchants National Bank v. Douglas O. Ruedlinger, 92CV1432 based on that guaranty (the "Guaranty Action"). In April 1993, after the Assignment Agreement, All American was substituted as plaintiff in that action. All American then moved for summary judgment, and by Order and Judgment dated September 15, 1993, the Court awarded All American final judgment against Ruedlinger personally for an amount in excess of $2.4 million. Ruedlinger has filed an appeal of that judgment. The arbitration hearings between All American and the Managing General Agent, which began in October 1992, and which by January 1993 were substantially completed (the "Arbitration Proceeding"), were effectively stayed on January 19, 1993, when the Managing General Agent, and its captive third-party administration affiliate FBI, filed Chapter 11 reorganization bankruptcy petitions (the "DRI Bankruptcy Cases"). In April 1993, the Bankruptcy Court converted those bankruptcy reorganization proceedings to Chapter 7 liquidations and appointed a trustee to administer the debtors' estates (the "DRI Trustee"). All American moved in those bankruptcy proceedings to lift the stay imposed by the bankruptcy filings to permit the Arbitration Proceeding to be concluded, which motion was granted by the Court in August 1993. In December 1993, All American negotiated a settlement with the DRI Trustee and Transamerica in the DRI Bankruptcy Cases (the "DRI Bankruptcy Settlement"). Under the terms of that settlement, which was approved by the bankruptcy court at a hearing on December 16, 1993, and later by written order dated January 25, 1994, all claims asserted, or which could have been asserted against All American by DRI, FBI, the DRI Trustee and Transamerica were dismissed, with prejudice. In addition, the DRI Trustee consented to the entry of an award in the Arbitration Proceeding whereby: (i) the arbitrators would find in favor of All American on all of its claims, including a finding that the termination of DRI's Exclusive Agency Agreement was proper and for cause; (ii) finding against DRI on all of its claims; and (iii) further entering a monetary award in All American's favor against DRI and FBI in the sum of $17 million (the "General Claim"). Also in connection with the DRI Bankruptcy Settlement, Transamerica agreed to pay to All American the sum of $200 thousand to settle All American's claim under Transamerica's Policy. As consideration for this payment, All American agreed to subordinate its claims to all other allowed claims in the DRI Bankruptcy Cases, and to dismiss and release certain claims against DRI, FBI, and certain of the Ruedlinger Defendants. Expressly exempted from the release were claims against FICL, Ruedlinger in the Guaranty Action, Wheatland and various other entities under the Merchants loan documents, and various other entities controlled by Ruedlinger. On or about April 21, 1993, All American filed involuntary bankruptcy petitions under Chapter 7 against the Managing General Agent's parent corporation, Wheatland Group Holdings, Inc. ("Wheatland"), and five of its other wholly owned subsidiaries, which were also affiliates of the Managing General Agent. Each of the six alleged debtors moved to dismiss the involuntary bankruptcy petition filed against it, and All American opposed those motions. After a hearing before the Court on October 12, 1993, by Judgment dated October 25, 1993, the Bankruptcy Court denied the debtors' motions to dismiss, ruling that All American had properly filed the involuntary bankruptcy petitions against each of the six debtors. In November 1993, the Court entered orders for relief under Chapter 7 of the Bankruptcy Code against each of the involuntary debtors, and appointed a Trustee to administer their estates. In July 1993, the Judge in an action entitled Sheldon Whitehouse, as Receiver for United International Insurance Company ("UIIC") v. Douglas O. Ruedlinger, et al., pending in the United States District Court for the District of Kansas, 92-4255 (RDR), permitted the plaintiff-Receiver to amend his complaint to add All American as a defendant in that case, and to assert claims against All American for an accounting and for money damages, which complaint was served on All American. In that action it is alleged that over $300 thousand in UIIC premiums were used by FBI to pay All American insured's claims, and that UIIC's Receiver is entitled to a refund of those funds. All American intends to vigorously oppose that action. That action has also been stayed pursuant to a separate consent order issued by the Court. In August 1993, All American filed a claim in the UIIC receivership action in Rhode Island, in which All American claimed that $87 thousand of its premiums were used by FBI to pay claims of UIIC's insureds. The Receiver has taken no position with respect to this claim. In December 1993, All American settled all potential claims by or against the National Federation of State High School Associations (the "Federation"). The Federation was an insured under a student accident medical payment insurance policy placed by DRI. The policy provided excess insurance to the Federation over a 55% self-insured program for the Federation members. All American and the Federation were involved in a dispute as to when All American's coverage applied. All American contended that its coverage was excess to the self- insured program, and the Federation contended that All American's insurance obligation was primary coverage. The Federation also threatened to bring an action against All American claiming that, since June 1992, All American had collected certain premiums directly from Federation insureds and further alleging that part of those premiums were Federation member dues for the self- insured program. The Federation threatened to seek an accounting from All American, and to the extent that DRI was All American's Managing General Agent, the Federation stated that it would allege that All American was liable to it for over $1.5 million in Federation dues that were misappropriated by DRI. In July 1992, All American entered into a standstill agreement with the Federation, which provided that All American would advance claim payments to Federation insureds for all claims under both the self-insured program and All American's insurance policy, subject to the resolution of the coverage dispute. All American advanced over $750 thousand for such claim payments. In December 1993, All American settled all claims by and against the Federation whereby the Federation has agreed to pay $100 thousand to All American in installments. The Federation and All American have agreed to exchange general releases as part of this settlement. Starting in June 1991, and through April 1992, DRI filed several claims with reinsurers of All American's insurance under reinsurance treaties issued for the school years 1988-1989, 1989-1990, and 1990-1991. As of June 1992, the outstanding reinsurance claims filed by DRI totalled to approximately $3.5 million. After a preliminary audit of DRI conducted by the reinsurers in February 1992, the reinsurers informed DRI that they would not pay any further claims until a full audit was completed. Among the questions raised by the reinsurers at that audit were (i) whether DRI improperly included a 5% TPA fee as part of loss adjustment expense when filing the aggregate stop loss claims; (ii) whether the reinsurance treaties covered illness claims; and (iii) whether DRI's tack-on premiums should have been included in calculating the premium component of the stop loss policies' attachment point, and the reinsurance premiums. The reinsurers claim that all three procedures were improper. All American had demanded payment of these outstanding claims, which is currently the subject of negotiations between All American and the reinsurers. Certain of the reinsurers have settled with All American, which when completed, will represent payments to All American of over $230 thousand. Other reinsurers have indicated that they will demand the refund of sums previously paid by them to DRI on certain aggregate claims that the reinsurers contend were improper. All American submitted claims to the reinsurers for the 1991-1992 year of account totalling over $3 million on an excess of loss treaty in effect for this period. These reinsurers, which for the most part were different from the prior years' reinsurers, denied coverage for the vast majority of the claims submitted and refused to pay any claims without a thorough audit. All American has reached settlements with reinsurers possessing over 85% of the participation interests in this period's treaties by agreeing to rescind these treaties, which have resulted in premium refund payments to All American totalling over $900 thousand. All American is continuing to negotiate with the remaining few reinsurers. All American's likelihood of recovering significantly more of these reinsurance billings is currently uncertain. All American has taken a one-time, after-tax charge of $10.6 million to establish a reserve for amounts receivable from the Managing General Agent. Management is of the opinion that any additional losses that might be suffered will not have a material adverse impact on the consolidated Equity Capital of the Company. In April 1991, All American commenced a lawsuit against 11 subscribers to a reinsurance pool when the reinsurers failed to honor their obligations under the reinsurance agreement. Approximately $15.8 million of reinsured claims were in dispute. All American's complaint sought declaratory relief, and damages for breach of contract and the reinsurers' duty of good faith and fair dealing (All American Life Insurance Company, et al. v. Beneficial Life Insurance Company, et al., U.S. District Court for the District of New Jersey). All of the defendants in the All American action asserted counterclaims against All American based upon its alleged failure to properly administer the reinsured policies. Certain other common law claims were also asserted. A total of eight of the reinsurers commenced their own lawsuits against All American, among others, arising out of the same transactions. Seven of those brought an action entitled Mutual Benefit Life Insurance Company, et al. v. George G. Zimmerman, et al., in the U.S. District Court for the District of New Jersey. The Mutual Benefit complaint sought rescission of the reinsurance agreement, as well as compensatory and punitive damages, based upon asserted federal and New Jersey state RICO claims and other common law claims for relief. All of the defendants in the Mutual Benefit action also cross-claimed against each other for contribution or indemnification. An eighth reinsurer commenced a further lawsuit arising out of the same transactions, naming All American, among others, as a defendant (Security Benefit Life Insurance Company v. All American Life Insurance Company, et al, U.S. District Court for the District of New Jersey). The Security Benefit complaint sought only rescission of the reinsurance agreement and declaratory relief as against All American. Certain of the other defendants in the Security Benefit action asserted cross- claims against All American for contribution or indemnification. All of the lawsuits were consolidated in the United States District Court for the District of New Jersey, Newark Division. All American has now reached settlements with all of the reinsurers. All direct claims concerning All American in the Mutual Benefit and Security Benefit actions have been dismissed. The consolidated actions are currently in the discovery phase and no date for trial has been set. All American has moved to dismiss the remaining cross-claims for contribution or indemnity asserted against it, but that motion has not yet been decided by the Court. In June 1993 a purported class action (Hoban v. USLIFE Credit Life Insurance Company, All American Life Insurance Company and Security of America Life Insurance Company) was filed in the United States District Court for the Northern District of Illinois. An Amended Complaint was filed in October 1993. The Amended Complaint alleges that the defendant companies, all of which are subsidiaries of USLIFE Corporation, sold single premium credit life and credit disability insurance policies to second mortgage borrowers in several states. The Amended Complaint further alleges that some second mortgage loans were paid off early so that the insureds were legally entitled to refunds for unearned premiums. The suit seeks damages on behalf of those insureds who did not claim and therefore did not receive partial refunds of their premiums from the named defendants. The Amended Complaint also contains claims under the Federal RICO statute and the Illinois Consumer Fraud Act. Defendants filed a Motion to Dismiss the Amended Complaint for lack of federal jurisdiction, for failure to allege facts amounting to fraud, and for failure to allege facts amounting to a RICO violation. Plaintiff has filed a Motion to Certify the Class, which defendants opposed. Both motions are awaiting decision by the Court. At this point in time the outcome of these suits is not predictable. However, in the opinion of management, the ultimate resolution of these suits is not likely to have a material adverse affect on the consolidated Equity Capital of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. USLIFE's Common Stock is traded on the New York, Chicago (formerly Midwest), Pacific and London Stock Exchanges. Dividends for the years ended December 31, 1993 and 1992 have been declared and paid to Common Stockholders at the annual rates of $1.21 and $1.14 respectively (paid quarterly in 1993 and 1992). As of February 24, 1994 there were approximately 8,100 record holders of the Common Stock. The following table sets forth the high and low sales prices for the Common Stock as reported in the consolidated transaction system for each quarterly period during the years indicated. MARKET PRICE RANGES (low to high) 1993 1992 ____ ____ First quarter...... 36 1/8 - 42 5/8 28 1/8 - 31 7/8 Second quarter..... 35 3/4 - 41 1/2 28 3/8 - 34 3/8 Third quarter...... 39 3/4 - 43 7/8 31 1/8 - 35 Fourth quarter..... 36 1/2 - 45 3/4 29 3/8 - 38 1/4 Market prices have been adjusted as appropriate to reflect the three-for-two split of the Company's common stock in December 1992. See "Insurance Accounting" in Note 1 of Notes to Financial Statements and Management's Discussion and Analysis of "Liquidity" herein, for information concerning regulatory restrictions upon payment of dividends by the Life Insurance Subsidiaries to the Company. Item 8. Item 8. Financial Statements and Supplementary Data. See separate Index to Financial Statements and Financial Statement Schedules on page 44. See Note 15 of Notes to Financial Statements as to condensed quarterly results of operations. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. Item 10. Item 10. Directors and Executive Officers of the Registrant. Executive Officers of the Registrant The executive officers of USLIFE are listed below. The executive officers, after their initial election, are elected at USLIFE's annual Board of Directors meeting to serve, unless removed, until the next such annual meeting, scheduled for May 1994. (1) Served as Chairman since March 21, 1967. Had been President from November 11, 1966 to June 14, 1971 and resumed that position from October 15, 1974 to March 1, 1976, from January 24, 1984 to November 17, 1987, and from December 1, 1988 to May 18, 1993. All of USLIFE's executive officers devote their full time to the business of USLIFE or its subsidiaries. With the exception of Messrs. Dicke, Hohn, Schlomann, and Simpson, all of the executive officers of USLIFE have been employed by USLIFE or one of its subsidiaries or one of their predecessors for at least five years. Mr. Casper has served as President and Chief Operating Officer of USLIFE Corporation since May 1993. He also serves as President and Chief Executive Officer of USLIFE Equity Sales Corporation, and has been a Director since March 1990. Prior to assumption of his current position, Mr. Casper served as President and Chief Operating Officer of the life insurance division of USLIFE Corporation since October 1991 and as President of United States Life since at least January 1989. Mr. Henderson has served as Vice Chairman and Chief Financial Officer and a Director since at least January 1989. Mr. Ruisi has served as Vice Chairman and Chief Administrative Officer since May 1993 and has been a Director since November 1992. Previously, Mr. Ruisi served as Senior Executive Vice President-Administration since March 1990 and as Executive Vice President-Administration since at least January 1989. Mr. Bushey has served as Executive Vice President-Corporate Planning since at least January 1989. Mr. Dicke has served as Executive Vice President - Product Actuary since April 1992. Previously, he served as Vice President and Actuary for The Equitable Life Assurance Society since April 1991, and as Consultant and Actuary with Tillinghast, a Towers Perrin Company, from at least January 1989. Mr. Forte has served as Executive Vice President-General Counsel since at least January 1989. Mr. Gavrity has served as Executive Vice President- Financial Actuary since October 1991 and previously served as Executive Vice President - Chief Actuary since at least January 1989. Mr. Schlomann has served as Executive Vice President - Financial Operations since October 1993. He previously served as Senior Vice President and Controller with Frank B. Hall & Company, Inc., since at least January 1989. Mr. Hohn has served as Senior Vice President - Corporate Secretary and Counsel since May 1993. He previously served as Vice President - Corporate Secretary since April 1991. Prior to that date, he served as consultant to the Life Insurance Council of New York, a trade association of New York life insurance companies, since April 1990; and as an attorney in private practice since at least January 1989. Mr. Lynch has served as Senior Vice President-Controller since at least January 1989. Mr. McQueen has served as Senior Vice President-Financial Operations since at least January 1989. Mr. Chouinard, who has served as Senior Investment Officer of USLIFE since at least January 1989, also serves as President and Chief Executive Officer of Advisers and President and a Director of Income Fund. Mr. Auriemmo has served as Vice President and Treasurer since at least January 1989. Mr. Cargiulo has served as President and Chief Executive Officer of United States Life since May 1993. Previously, he served as President- Chief Operating Officer of United States Life since October 1991. Prior to that date, he served as Executive Vice President for individual underwriting and insurance services of that subsidiary since November 1990 and as Senior Vice President - Individual Insurance Services of United States Life since at least January 1989. Mr. Faulkner has served as President and Chief Executive Officer of USLIFE Real Estate Services Corporation since at least January 1989. Mr. Griffin has served as President and Chief Executive Officer of Old Line Life since at least January 1989. Mr. Hendricks has served as President and Chief Executive Officer of USLIFE Systems Corporation since at least January 1989 and as President and Chief Executive Officer of USLIFE Insurance Services Corporation since April 1991. Mr. Lee has served as President and Chief Executive Officer of USLIFE Credit Life since at least January 1989. Mr. Simpson has served as President of All American Life since April 1990 and as a Director since March 1990. He served as President of USLIFE from March 1990 to October 1991. Previously, Mr. Simpson served as President and Chief Operating Officer and a member of the board of directors of Transamerica Occidental Life Insurance Company since at least January 1989. Information regarding directors of the Registrant is incorporated by reference to USLIFE Corporation's definitive proxy statement to be filed within 120 days after the end of USLIFE's fiscal year ended December 31, 1993 for use in connection with the Annual Meeting of Shareholders to be held on May 17, 1994. Item ll. Executive Compensation. Information regarding executive compensation is incorporated by reference to USLIFE Corporation's definitive proxy statement to be filed within 120 days after the end of USLIFE's fiscal year ended December 31, 1993 for use in connection with the Annual Meeting of Shareholders to be held on May 17, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information regarding beneficial ownership of USLIFE's voting securities by directors, officers, and persons who, to the best knowledge of USLIFE, are known to be the beneficial owners of more than 5% of any class of USLIFE's voting securities as of March 31, 1994, is incorporated by reference to USLIFE Corporation's definitive proxy statement to be filed within 120 days after the end of USLIFE's fiscal year ended December 31, 1993 for use in connection with the Annual Meeting of Shareholders to be held on May 17, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. Information regarding certain relationships and related transactions is incorporated by reference to USLIFE Corporation's definitive proxy statement to be filed within 120 days after the end of USLIFE's fiscal year ended December 31, 1993 for use in connection with the Annual Meeting of Shareholders to be held on May 17, 1994. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1 and 2. Financial Statements and Financial Statement Schedules of USLIFE and Subsidiaries. See separate Index to Financial Statements and Financial Statement Schedules on page 44. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 33-40793 (filed June 23, 1991), 33-13999 (filed May 11, 1987) and 2-77278 (filed April 30, 1982): Insofar as indemnification for liabilities under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission 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 Act and will be governed by the final adjudication of such issue. (a) 3. Exhibits. 3 (i) - Restated Certificate of Incorporation, as amended, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 3 (ii) - By-laws, as amended, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1992. 4 (i) - See Exhibit 3(i). (ii) - Indenture dated as of October 1, 1982 (9.15% Notes due June 15, 1999, 6.75% Notes due January 15, 1998, and 6.375% Notes due June 15, 2000) incorporated herein by reference to USLIFE's Registration Statement No. 2-79559 on Form S-3. Agreements or instruments with respect to long-term debt which are not filed as exhibits hereto do not in total exceed 10% of USLIFE's consolidated total assets and USLIFE agrees to furnish a copy thereof to the Commission upon request. (iii) - Amended and Restated Rights Agreement, dated as of June 24, 1986 and amended and restated as of January 24, 1989, between USLIFE Corporation and Manufacturers Hanover Trust Company (predecessor to Chemical Bank), as Rights Agent, relating to Common Stock Purchase Rights issued by USLIFE on July 10, 1986, incorporated herein by reference to USLIFE's Current Report on Form 8-K dated January 24, 1989. 10 * (i) - 1981 Stock Option Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1981. * (ii) - Employment contract dated as of April 1, 1989 between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (iii) - First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989 between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (iv) - Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (v) - Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (vi) - Fourth Amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (vii) - Fifth Amendment dated as of February 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1992. * (viii) - Sixth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Gordon E. Crosby, Jr., incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (ix) - Employment contract dated as of April 1, 1989 between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (x) - First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989, between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (xi) - Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (xii) - Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (xiii) - Fourth Amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xiv) - Fifth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Greer F. Henderson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xv) - Employment contract dated as of April 1, 1989 between USLIFE Corporation and Wesley E. Forte, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (xvi) - First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989 between USLIFE Corporation and Wesley E. Forte, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (xvii) - Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Wesley E. Forte, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (xviii)- Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Wesley E. Forte. * (xix) - Fourth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Wesley E. Forte, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xx) - Employment contract dated as of April 1, 1989 between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (xxi) - First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989 between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (xxii) - Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (xxiii)- Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (xxiv) - Fourth Amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xxv) - Fifth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and John D. Gavrity, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xxvi) - Employment contract dated as of April 1, 1989 between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (xxvii)- First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989 between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (xxviii)- Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (xxix) - Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (xxx) - Fourth Amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xxxi) - Fifth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and Christopher S. Ruisi, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xxxii)- Employment contract dated as of April 1, 1989 between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * (xxxiii)- First Amendment dated as of May 1, 1989 to employment contract dated as of April 1, 1989 between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (xxxiv)- Second Amendment dated as of May 1, 1990 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. * (xxxv) - Third Amendment dated as of May 1, 1991 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (xxxvi)- Fourth Amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xxxvii)- Fifth Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1989, as amended, between USLIFE Corporation and A. Scott Bushey, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. (xxxviii)- Employment contract dated as of April 16, 1990 between USLIFE Corporation and William A. Simpson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990. (xxxix)- First Amendment dated as of May 1, 1991 to employment contract dated as of April 16, 1990 between USLIFE Corporation and William A. Simpson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. * (xl) - Second Amendment dated as of May 1, 1992 to employment contract dated as of April 16, 1990, as amended, between USLIFE Corporation and William A. Simpson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xli) - Third Amendment dated as of October 1, 1992 to employment contract dated as of April 16, 1990, as amended, between USLIFE Corporation and William A. Simpson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. * (xlii) - Third Amendment dated as of May 1, 1993 to employment contract dated as of April 16, 1990, as amended, between USLIFE Corporation and William A. Simpson, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xliii)- Employment contract dated as of April 1, 1991 between USLIFE Corporation and Robert J. Casper, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992. * (xliv) - First amendment dated as of May 1, 1992 to employment contract dated as of April 1, 1991 between USLIFE Corporation and Robert J. Casper, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. * (xlv) - Second Amendment dated as of October 1, 1992 to employment contract dated as of April 1, 1991, as amended, between USLIFE Corporation and Robert J. Casper, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. * (xlvi) - Second Amendment dated as of May 1, 1993 to employment contract dated as of April 1, 1991, as amended, between USLIFE Corporation and Robert J. Casper, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. * (xlvii)- 1978 Stock Option Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1980. * (xlviii)- Deferred Compensation Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1980. * (il) - Book Unit Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1980. (l) - Lease dated as of December 30, 1986 between The United States Life Insurance Company In the City of New York and RREEF USA Fund-III for the lease of a portion of 125 Maiden Lane, New York, New York, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1986. (li) - Amendment to Lease dated August 31, 1988 to Lease dated as of December 30, 1986 between The United States Life Insurance Company In the City of New York and RREEF USA Fund-III for the lease of a portion of 125 Maiden Lane, New York, New York, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1988. (lii) - Second Amendment to Lease dated November 16, 1988 to Lease dated as of December 30, 1986 between The United States Life Insurance Company In the City of New York and RREEF USA Fund-III for the lease of a portion of 125 Maiden Lane, New York, New York, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1988. (liii) - Lease dated May 21, 1987 between The United States Life Insurance Company In the City of New York and Commercial Realty & Resources Corp. for the lease of premises at the Jumping Brook Corporate Office Park in Neptune, New Jersey, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1988. (liv) - February 9, 1989 Amendment to Lease dated May 21, 1987 between The United States Life Insurance Company In the City of New York and Commercial Realty & Resources Corp. for the lease of premises at the Jumping Brook Corporate Office Park in Neptune, New Jersey, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1988. * (lv) - Retirement Plan for Outside Directors effective February 28, 1989, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1988. * (lvi) - USLIFE Corporation Restricted Stock Plan effective January 1, 1989, incorporated herein by reference to USLIFE's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. * (lvii) - Trust Agreement made as of September 25, 1990 among USLIFE Corporation, Manufacturers Hanover Trust Company (predecessor to Chemical Bank) and KPMG Peat Marwick (as independent contractor) establishing a trust to fund certain employment contracts, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1990. * (lviii)- Trust Agreement made as of September 25, 1990 among USLIFE Corporation, Manufacturers Hanover Trust Company (predecessor to Chemical Bank) and KPMG Peat Marwick (as independent contractor) establishing a trust to fund the USLIFE Corporation Supplemental Retirement Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1990. * (lix) - Trust Agreement made as of September 25, 1990 among USLIFE Corporation, Manufacturers Hanover Trust Company (predecessor to Chemical Bank) and KPMG Peat Marwick (as independent contractor) establishing a trust to fund the USLIFE Corporation Retirement Plan for Outside Directors, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1990. * (lx) - 1991 Stock Option Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1991. 12 - Computations of ratios of earnings to fixed charges. 21 - List of Subsidiaries. 23 - Consent of Independent Certified Public Accountants (see page 41). 99 (i) - Annual Report on Form 11-K of USLIFE Corporation Employee Savings and Investment Plan for the plan year ended December 31, 1993 (to be filed within 120 days of fiscal year end of Plan). 99 (ii) - Trust Agreement made as of December 6, 1990 among USLIFE Corporation, Manufacturers Hanover Trust Company (predecessor to Chemical Bank), and KPMG Peat Marwick (as independent contractor) establishing a trust to fund the USLIFE Corporation Retirement Plan, incorporated herein by reference to USLIFE's Annual Report on Form 10-K for the year ended December 31, 1990. * Indicates a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. No Current Report on Form 8-K has been filed for the last quarter of the fiscal year ended December 31, 1993. CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors and Shareholders USLIFE Corporation: We consent to the incorporation by reference in Registration Statements Nos. 33-18287, 33-8489, 33-58944, 33-29934, 33-17126, 33-67344 and 33-9159 on Form S-3 relative to Debt Securities, and common stock, respectively; the post effective amendment to Registration Statement No. 33-29934 on Form S-3 relative to Debt Securities; the post effective amendment to Registration Statement No. 33-9159 on Form S-3 relative to common stock; the post effective amendments to Registration Statement Nos. 2-93655 and 33-11019 on Form S-3 relative to the General Agents Incentive Compensation Plan; Registration Statement No. 33-45377 on Form S-3 relative to the United States Life Insurance Company Retirement Plan for General Agents and Producers; the post effective amendments to Registration Statement No. 33-17126 relative to Debt Securities; Registration Statement No. 33-40793 on Form S-3 relative to the 1991 Stock Option Plan; and the post effective amendment to Registration Statement Nos. 2-63159, 2-32606 and 2-77278 on Form S-8 relative to the Stock Option Plans and Registration Statement Nos. 2-75011 and 33-13999 on Form S-8 relative to the Employee Savings and Investment Plan of USLIFE Corporation of our report dated February 22, 1994, relating to the consolidated balance sheets of USLIFE Corporation and subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income, equity capital, and cash flows for each of the years in the three-year period ended December 31, 1993 which report appears in this December 31, 1993 Annual Report on Form 10-K of USLIFE Corporation. Our report refers to a change in accounting to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." /s/ KPMG Peat Marwick KPMG Peat Marwick March 22, 1994 345 Park Avenue New York, New York SIGNATURES Pursuant to the requirements of Section 13 or 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. USLIFE Corporation (Registrant) Dated: March 22, 1994 By: /s/ Gordon E. Crosby, Jr. _____________________________ (Gordon E. Crosby, Jr., Chairman of the Board and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. USLIFE CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page ____ Selected Financial Data for the five years ended December 31, 1993............................................... 2 Independent Auditors' Report...................................... 45 Consolidated balance sheets as of December 31, 1993 and 1992...... 46 Statements of consolidated income for the three years ended December 31, 1993............................................... 48 Statements of consolidated cash flows for the three years ended December 31, 1993............................................... 49 Statements of consolidated Equity Capital for the three years ended December 31, 1993................................... 50 Notes to financial statements..................................... 51 Schedule of the Registrant: (A) Schedule III - Condensed Financial Information of Registrant (incorporated in Note 14 of Notes to Financial Statements)................................... Schedules of the Registrant and Consolidated Subsidiaries: (A) Schedule I - Summary of investments-other than investments in related parties (incorporated in Note 11 of Notes to Financial Statements)............... (B) Schedule V - Supplementary insurance information (incorporated in Note 13 of Notes to Financial Statements)............................................. (C) Schedule VI - Reinsurance (incorporated in Note 10 of Notes to Financial Statements).......................... (D) Schedule IX - Short-term borrowings (incorporated in Note 2 of Notes to Financial Statements)................ INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders USLIFE Corporation: We have audited the accompanying consolidated balance sheets of USLIFE Corporation and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income, equity capital, and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of USLIFE Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 1 and 5 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions in 1992 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." /s/ KPMG Peat Marwick KPMG Peat Marwick February 22, 1994 345 Park Avenue New York, New York USLIFE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS Note 1. Significant Accounting Policies Changes in Accounting Principles Effective as of the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 113 ("SFAS 113"), entitled "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." SFAS 113 requires that assets and liabilities relating to reinsured contracts be reported on a gross basis rather than net of the impact of reinsurance as permitted under previous accounting standards. The Statement also establishes guidelines for determining whether risk is transferred under a reinsurance contract and requires reinsurance contracts which do not qualify under these guidelines to be accounted for as deposits. As a result of the adoption of SFAS 113, reinsurance receivables amounting to approximately $135 million are included in consolidated total assets at December 31, 1993, including approximately $118 million which would have been offset to various liability accounts under previous accounting standards. Other than the required gross presentation of reinsurance assets and liabilities, SFAS 113 did not have a material impact on the Company's reported financial position or results of operations. Financial statements of previous years were not restated as a result of the adoption of SFAS 113. See Note 10 of Notes to Financial Statements for further information regarding the Company's reinsurance contracts. Effective as of January 1, 1992, the Company implemented new accounting standards for non-pension postretirement benefits required by Statement of Financial Accounting Standards No. 106 ("SFAS 106"), entitled "Employers' Accounting for Postretirement Benefits Other Than Pensions" and recognized the initial liability required by SFAS 106 by means of a one-time charge to net income for "cumulative effect of accounting change." As required by SFAS 106, this charge, which amounted to $38.0 million or $1.67 per share, was retroactively recorded in the first quarter of 1992. See Note 5 of Notes to Financial Statements for further information regarding non-pension postretirement benefits. Also in 1992, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), entitled "Accounting for Income Taxes," and restated, as appropriate, the financial statements of previous years presented to retroactively give effect to the accounting standards required by SFAS 109. See Note 4 of Notes to Financial Statements for further information regarding Federal income taxes. Future Accounting Changes In November 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." Statement No. 112, which must be implemented in 1994, will require advance recognition of non-retirement benefits such as severance pay and health insurance continuation when certain conditions are met. The adoption of Statement No. 112 will not have a material impact on the Company's reported financial position or results of operations. In May 1993, FASB issued two additional Statements which will require the Company to adopt new accounting and reporting standards in preparation of future period financial statements. Statement No. 114, "Accounting by Creditors for Impairment of a Loan," must be adopted by calendar year enterprises no later than 1995 and will require a writedown to fair value, as defined by the Statement, for certain mortgage loans and similar investments where impairment results in a change in repayment terms. Based on current evaluation of the Company's investments that are covered by this Statement, it is not anticipated to have a material impact on the Company's reported financial position or results of operations. The Company has not yet determined the timing of its implementation of Statement No. 114. Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," will require most fixed maturity investments to be carried at market value commencing in 1994. It is currently anticipated that substantially all of the Company's fixed maturity investments will be included in a category established by the Statement that will require the securities to be valued at market, with changes in market value recognized through equity. In addition to application of appropriate tax effect, the impact on Equity Capital from this unrealized appreciation may also be subject to certain additional adjustments which have not yet been quantified by the Company. Market value of these securities exceeds adjusted cost by approximately $380 million at December 31, 1993. The Company will adopt Statement No. 115 in the first quarter of 1994. Adjustments to market value will be required each quarter following the implementation of Statement No. 115, resulting in both increases and decreases to Equity Capital. Basis of Consolidation The consolidated financial statements include the accounts of USLIFE and all of its subsidiaries (the "Company"). All subsidiaries are 100 percent owned. All material intercompany accounts and transactions have been eliminated. Segment Information The only reportable industry segment of the Company is "Life Insurance" and the related information is presented below: The caption "Other" above consists principally of investment income and capital gains attributable to Equity Capital. Investments in Securities The Company's investments in preferred stocks (other than redeemable preferred stocks) and common stocks ("Equity Securities") are carried at market value in the Consolidated Balance Sheets at December 31, 1993, 1992, and 1991 and related valuation allowances, "Net unrealized losses on marketable equity securities," in the amounts of $29 thousand, $165 thousand, and $13 thousand, respectively, are included in Equity Capital at those dates. Effective December 31, 1992, Fixed Maturity investments (including bonds and redeemable preferred stocks) which may be sold prior to maturity as a result of the Company's investment strategies are considered available for sale and carried at the lower of aggregate amortized cost or market value as of the balance sheet date. The Company's investment management policies include continual monitoring and evaluation of securities market conditions and circumstances relating to its investment holdings which may result in the selection of investments for sale prior to maturity. Securities may also be sold as part of the Company's asset/liability management strategy in response to changes in interest rates, resultant prepayment risk, and similar factors. The reclassification, as of December 31, 1992, of the Company's entire Fixed Maturity portfolio to the "available for sale" category did not affect reported net income, and this classification had no impact on Equity Capital at December 31, 1993 or 1992 as the aggregate market value of these securities exceeded their amortized cost at those dates. Valuation reserves are maintained for investments with a reduction in value determined to be other than temporary. The cost and market values of the Company's consolidated investments in Fixed Maturities and Equity Securities at December 31, 1993, 1992 and 1991 are presented below: At December 31, 1993, consolidated invested assets included approximately $221 million book value of less than investment grade corporate securities, based on ratings assigned by recognized rating agencies and insurance regulatory authorities. Such investments had an aggregate market value of approximately $232 million at December 31, 1993 and, based on book value, represent approximately 3.3% of consolidated total assets at that date. Approximately $28 million book value of these investments are classified as problem securities at that date and, of that amount, approximately $16 million represented securities in default at December 31, 1993. Also at December 31, 1993, the book value of mortgage loans included in consolidated total assets which were 60 days or more delinquent or in foreclosure was approximately $26 million, and the book value of property acquired through foreclosure of mortgage loans was approximately $25 million. Realized gains on the Company's consolidated investments in Fixed Maturities and Equity Securities for the three years ended December 31, 1993 are summarized as follows: Pre-tax realized gains shown above reflect provisions for valuation of certain investments with decline in value determined to be other than temporary. The cost of securities sold for purposes of determination of realized gains or losses included in net income is based on the specific identification method. Pre-tax realized gains on Fixed Maturities and Equity Securities are reconciled to consolidated realized gains (losses) on investments as follows: 1993 1992 1991 __________ __________ __________ (Amounts in Thousands) Realized gains (losses): Fixed Maturities.............. $ 46,891 $ 23,094 $ 10,950 Equity Securities............. 897 1,584 1,244 __________ __________ __________ 47,788 24,678 12,194 Real estate, mortgage loans, and other investments (a)... (39,272) (27,258) (14,115) __________ __________ __________ Total......................... $ 8,516 $ (2,580) $ (1,921) ========== ========== ========== (a) Reflects provisions for valuation to estimated net realizable value for certain investments. The amortized cost and estimated market values of the Company's consolidated investments in debt securities at December 31, 1993 and 1992 are as follows: The amortized cost and estimated market value of debt securities at December 31, 1993 and 1992, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties. Proceeds from disposals of investments in debt securities (excluding short term commercial paper) during 1993, 1992 and 1991 were $1.209 billion, $824.1 million, and $756.1 million, respectively. During 1993, gross gains of $57.9 million and gross losses of $11.0 million were realized on such disposals. During 1992, gross gains of $41.0 million and gross losses of $17.9 million were realized on such disposals. During 1991, gross gains of $26.3 million and gross losses of $15.4 million were realized on such disposals. Short term investments are carried at cost, which approximates market value. Other Investments Real estate is carried at the lower of depreciated cost or net realizable value. Depreciation is calculated on a straight line basis with useful lives varying based on the type of building. Policy loans and mortgages, other than those with a decline in value determined to be other than temporary, are stated at the aggregate of unpaid principal balances. Other long term investments are stated at the lower of cost or their estimated net realizable value. Insurance Accounting Amounts for the life insurance subsidiaries are reported to regulatory authorities on the basis of statutory accounting practices and have been presented herein in conformity with generally accepted accounting principles ("GAAP"). Regulatory after-tax income and after-tax income in accordance with GAAP of the life insurance subsidiaries for the three years ended December 31, 1993, and regulatory Equity Capital and Equity Capital in accordance with GAAP of such subsidiaries at December 31, 1993, 1992 and 1991 are as follows: ______ (a) Amounts shown exclude after-tax capital gains (losses) of $(1.3) million, $(15.5) million and $5.0 million on a regulatory basis and $7.1 million, $(1.4) million, and $(1.4) million on a GAAP basis in 1993, 1992 and 1991, respectively. GAAP income above also excludes an after-tax charge in 1992 of $21.5 million for "cumulative effect of accounting change" relating to the adoption of FASB Statement No. 106 which had no impact on 1992 regulatory net income. Both regulatory and GAAP after-tax income shown above for 1992 reflect a charge equivalent to $10.6 million on an after-tax basis relating to receivables from an Association Group Health marketing organization which declared bankruptcy. As a result of the appropriate adjustments, Equity Capital of the life insurance subsidiaries prepared in accordance with GAAP exceeds that which was prepared on a regulatory basis by $826.5 million, $779.0 million and $736.7 million, respectively, at December 31, 1993, 1992 and 1991. It should be noted that the dividend paying capability of the life insurance subsidiaries is generally limited by income before capital gains and losses and Equity Capital as reported on a regulatory basis. Notice to or approval by regulatory authorities is frequently required for dividends paid by insurance companies. Loans to or advances from the life insurance subsidiaries to the parent company may also be subject to regulatory approval requirements or limitations. At December 31, 1993, the portion of the aggregate $1.376 billion Equity Capital of the life insurance subsidiaries which was not available for transfer to the parent company by dividend, loan, or advance or available for such transfer only with approval of a third party ("Restricted Net Assets"), as a result of the aforementioned regulatory requirements, amounted to $1.308 billion. Cash dividends paid by all consolidated subsidiaries to the parent company totalled $61.2 million, $47.7 million and $58.2 million for the years ended December 31, 1993, 1992 and 1991, respectively. Additionally, during 1993, securities with market value of $21.6 million were transferred from a life insurance subsidiary to the parent company and subsequently contributed to another life insurance subsidiary in connection with the combination of the two subsidiaries' operations. In addition to the 1992 cash dividends, investment securities with market value of $26.3 million were transferred by dividend from a life insurance subsidiary to the parent company. Life Insurance Deferred Policy Acquisition Costs The costs of acquiring new business (principally commissions) and certain costs of issuing policies (such as medical examinations and inspection reports) and certain agency and marketing expenses, all of which vary with and are primarily related to the production of new business, have been deferred. For traditional life insurance policies, these costs are being amortized over the premium-paying periods of the related policies in proportion to the ratio of the annual premium revenue to the total anticipated premium revenue. Anticipated premium revenue was estimated using the same assumptions which were used for computing liabilities for future policy benefits. For universal life- type policies, these costs are being amortized over the lives of the policies in relation to the incidence of gross profits arising principally from investment, mortality and expense margins. Deferred policy acquisition costs are reviewed to determine that the unamortized portion of such costs does not exceed recoverable amounts, after considering anticipated investment income. Details with respect to consolidated deferred policy acquisition costs and premium income for life insurance and annuities and accident and health insurance for the three years ended December 31, 1993 are as follows: Future Policy Benefits Liabilities for future policy benefits relating to traditional life insurance policies have been computed by the net level premium method based on estimated future investment yield, mortality and termination experience. Interest rate assumptions for most non-interest sensitive life insurance have ranged from 2-1/2 to 3-1/2 percent on issues of 1959 and prior, to 5-1/2 to 5- 7/8 percent on issues of 1967 and subsequent years. (On certain products, the rate ranges as high as 8-3/4 percent.) Mortality has been calculated principally on an experience multiple applied to select and ultimate tables in common usage in the industry. Estimated terminations have been determined principally based on industry tables. Universal Life-Type and Investment Contracts Revenues for universal life insurance, other interest-sensitive life insurance, and investment contracts include policy charges for administration and cost of insurance, and surrender charges assessed against policyholder account balances during the period. Premiums received on these products are treated as policyholder deposits rather than revenues. The liability for policyholder account balances represents the accumulated amounts which accrue to the benefit of policyholders, and reflects interest credited at rates which are subject to periodic adjustment. Charges to expense relating to these policies and contracts include such interest credited as well as benefits during the period in excess of related policy account balances. Participating Policies Participating policies subject to profit limitations approximate 2.4 percent of the individual life insurance in force at December 31, 1993 and 6.5 percent of individual life insurance premium income in 1993. The major portion of earnings therefrom inures to the benefit of the participating policyholders and is not available to shareholders. Undistributed earnings payable to participating policyholders are included as a liability in the Consolidated Balance Sheets. All participating policies approximate 2.5 percent of the total individual life insurance in force at December 31, 1993 and 6.8 percent of individual life insurance premium income in 1993. The provisions for dividends to policyholders in the statements of consolidated income include dividends paid or payable on participating policies. Liability for Unpaid Claims The liability for unpaid claims and claim adjustment expenses is based on the estimated amount payable on claims reported prior to the balance sheet date which have not yet been settled, claims reported subsequent to the balance sheet date which have been incurred during the period then ended, and an estimate (based on prior experience) of incurred but unreported claims relating to such period. Liability for Guaranty Fund Assessments The Company's life insurance subsidiaries may be required, under the solvency or guaranty laws of the various states in which they are licensed, to pay assessments up to prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies. Certain states permit these assessments, or a portion thereof, to be recovered as an offset to future premium taxes. Assessments are recognized based on notification of liability by regulatory authorities, including provision for certain future amounts payable, and, when subject to credit against future premium taxes and judged to be recoverable, may be capitalized and amortized on a basis consistent with the credits to be realized under applicable state law. Other Assets Included in other assets is the unamortized portion of goodwill, representing the excess of cost over the value of net assets acquired in subsidiary acquisitions accounted for by the purchase method. Such amounts are being amortized by straight-line basis charges to income over forty year periods which began at the respective dates of acquisition of the acquired subsidiaries. Amortization of goodwill amounted to approximately $2 million for each of the three years ended December 31, 1993. Income Taxes Deferred income taxes arise as a result of applying enacted statutory tax rates to the temporary differences between the financial statement carrying value and the tax basis of assets and liabilities. Such differences result primarily from amounts capitalized for policy acquisition costs and calculated for future policy benefit liabilities. The Company and its subsidiaries file a consolidated Federal income tax return and have elected to include the life insurance and non-life insurance subsidiaries in the consolidated tax return. Taxes on income for life insurance and non-life insurance subsidiaries are recorded in the individual income accounts of the subsidiaries and are remitted to the Company on a separate return basis. The provision for taxes in the Statements of Consolidated Income for the three years ended December 31, 1993 represents the tax for all companies on a consolidated return basis. Income Per Share Income per share was computed by dividing the income applicable to common and common equivalent shares by the weighted average number of common and common equivalent shares outstanding during each year. The weighted average number of common and common equivalent shares was determined by using the average number of common shares outstanding during each year, net of reacquired (treasury) shares from the date of acquisition; by converting the shares of the Series A and Series B Preferred Stock to their equivalent common shares, and by calculating the number of shares issuable on exercise of those common stock options with exercise prices lower than the market price of the common stock, reduced by the number of shares assumed to have been purchased with the proceeds from the exercise of the options. Income before cumulative effect of accounting change and net income were adjusted to deduct the dividend requirements on Series C Preferred Stock for periods when that issue was outstanding. Fully diluted income per share is the same as income per share data indicated. The following table sets forth the computations of income per share for the three years ended December 31, 1993: Statement of Cash Flows For the years ended December 31, 1993, 1992 and 1991, respectively, interest paid (net of amounts capitalized) amounted to $32.6 million, $34.7 million, and $39.4 million, and Federal income taxes paid amounted to $60.7 million, $75.7 million and $71.4 million. The major portion of the disposals of fixed maturity investments relate to securities sold or redeemed prior to their maturity dates. The $1.154 billion disposals of Fixed Maturity investments by the Company for the year ended December 31, 1993 included approximately $928 million book value of securities which were called for redemption by the respective issuers prior to maturity. The $799 million disposals of Fixed Maturity investments in 1992 included approximately $497 million of such redemptions. Financial Instruments and Concentrations of Credit Risk The Company's investments in Fixed Maturities and Equity Securities are comprised of a diverse portfolio represented by approximately 600 issuers, with no issuer accounting for more than 1% of the Company's total investment in these securities, based on book value, at December 31, 1993. The Company's investment in mortgage loans at December 31, 1993 is characterized by a broad geographical distribution, with approximately 6% of total book value relating to the New England region of the United States, 16% from the middle-Atlantic states, 23% from the north-central states, 16% from the south-Atlantic states, 10% from the south-central states, 14% from the mountain states, and 15% from the Pacific states. Based on book value, approximately 40% of the Company's mortgage loans at that date are secured by office buildings, 24% by industrial / warehouse properties, 25% retail, 1% apartments, 3% one to four family residential, and the remainder secured by hotel / motel, medically oriented, or other specialty properties. The Company's reinsurance receivables and other recoverable amounts at December 31, 1993 relate to approximately 160 reinsurers. Two major United States insurance companies, rated "A" (excellent) and "A+" (superior) respectively by A. M. Best Company, a recognized insurance rating agency, each account for approximately 10% of the reinsurance receivable and recoverable amounts at that date. Other than these companies, no single reinsurer accounts for more than 6% of total reinsurance receivable and recoverable amounts at December 31, 1993. The Company monitors the financial condition of its reinsurers in order to minimize its exposure to loss from reinsurer insolvencies. As described in Note 9 of Notes to Financial Statements, a life insurance subsidiary has an outstanding standby commitment amounting to $6.8 million at December 31, 1993. The Life Insurance Subsidiaries historically have not provided permanent financing on the major portion of such commitments. In the ordinary course of investment operations, the Life Insurance Subsidiaries also may extend permanent financing commitments for investments in mortgage loans, with specified closing dates typically within 90 to 120 days after approval and interest rates and other terms (based on the credit policies utilized for investments in mortgage loans) determined at the commitment date. There were no material permanent financing commitments outstanding at December 31, 1993. Disclosures about Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of the indicated classes of financial instruments: Cash and Short-term Investments The carrying amounts of these assets approximate their fair value. Fixed Maturities and Equity Securities Fair values are based on quoted market prices or dealer quotes. Mortgage Loans The fair value of mortgage loans, other than those which are more than 60 days delinquent or in foreclosure, is estimated by discounting the expected future cash flows. The rates used for this purpose are the estimated current rates that would be applied to the loans in a purchase or sale transaction, on an aggregate or bulk basis grouped by maturity range, considering the creditworthiness of the borrowers and the general characteristics of the collateral. For purposes of this calculation, the fair value of loans with stated interest rates greater than the estimated applicable market rate was adjusted to reflect the impact of prepayment options or other contractual terms upon market value. For mortgage loans which are classified as delinquent or are in foreclosure, fair value is based on estimated net realizable value of the underlying collateral. Long-term Debt The fair value of the Company's long-term debt is estimated based on rates believed to be currently available to the Company for borrowings with terms similar to the remaining maturities of the outstanding debt. For outstanding debt securities with fixed interest rates in excess of current market rates, repayment on call dates prior to stated maturity was assumed for purposes of fair value estimation. The estimated fair values of the Company's financial instruments are as follows: In accordance with the requirements of Statement No. 107 of the Financial Accounting Standards Board, the financial instruments presented above exclude accounts relating to the Company's insurance contracts and certain other classes of assets and liabilities. The estimated fair values of the Company's policy loan assets and its policyholder account balance liabilities relating to investment contracts at December 31, 1993 and 1992 are not materially different from the respective carrying values at those dates. No material carrying value or fair value amounts are ascribed to the Company's outstanding standby commitments at December 31, 1993 and 1992. Note 2. Notes Payable Included in this item are short term borrowings against bank lines of credit or pursuant to certain bank revolving credit agreements, and other short term bank borrowings. The Company has lines of credit of $60.0 million with 7 banks and revolving short term credit agreements with two banks which provide term loan borrowing facilities up to a maximum of $100 million. The lines of credit provide for annual review and renewal at the option of each bank. The interest rates and terms of loans under the lines of credit and the revolving credit agreements are determined bilaterally on the date of borrowing. Although there are no formal requirements to maintain compensating balances, the Company has carried balances which generally approximate 5 to 10 percent of the lines. The following table sets forth summary information with respect to short term borrowings of the Company for the three years ended December 31, 1993. (a) The average amounts of short term borrowings were computed by determining the arithmetic average of months' end short term borrowings. (b) The weighted average interest rates were determined by dividing interest expense related to short term borrowings by the average amounts of such borrowings. Note 3. Long Term Debt At December 31, 1993 and 1992, consolidated long term debt consists of the following: The contractual maturities of the Company's long term debt are as follows: Parent Company and Consolidated _______________________________ December 31, December 31, 1993 1992 ____________ ____________ (Amounts in Thousands) 1994....................... $100,000 $150,000 1995....................... -- 49,917 1996....................... -- 99,522 1998....................... 149,739 -- 1999....................... 50,000 50,000 2000....................... 149,496 -- ________ ________ Total............... $449,235 $349,439 ======== ======== Current maturities of long term debt at December 31, 1993 is comprised of $100 million borrowings under a two-year credit agreement between the Company and the Bank of New York which commenced on May 15, 1992 and provides for term borrowings in segments of up to six months with interest indexed to the LIBOR borrowing rate or based on certain alternative interest rates at the option of the Company. USLIFE Corporation has the option to prepay amounts borrowed under the credit agreement, in whole or in part, and to reborrow loans thereunder provided the total amount of outstanding borrowings does not exceed $150 million. All borrowings under the credit agreement must mature no later than May 13, 1994. Long term debt at December 31, 1992 includes $150 million borrowings under this agreement. None of the debt issues of the Company or its subsidiaries are or have been in default. Note 4. Federal Income Taxes Federal income tax expense relating to operations of the Company for 1993, 1992 and 1991 is comprised of the following components: The Omnibus Budget Reconciliation Act of 1993, enacted in August 1993, increased the Federal corporate income tax rate from 34% to 35% retroactively to January 1, 1993. This rate increase resulted in additional tax expense for the first half of 1993 amounting to $666 thousand, and the effect of the tax rate change upon net deferred tax liabilities as required by Statement of Financial Accounting Standards No. 109 ("SFAS 109") was $1.322 million. In accordance with SFAS 109, the $1.988 million aggregate catch-up impact of the rate change was included in Federal income tax expense for the third quarter of 1993. The significant components of deferred income tax expense for the years ended December 31, 1993, 1992 and 1991 are as follows: Total tax expense differs from the amount computed by applying the Federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 to income before tax for the following reasons: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below: December 31 ______________________ 1993 1992 ____ ____ (Amounts in Thousands) Deferred Tax Assets: Future policy benefits.......................... $ 129,078 $ 116,176 Tax net operating loss carryforward............. 23,990 26,005 Capital gains and losses........................ 42,678 27,913 Capitalization of policy acquisition costs, net of amortization, for tax return purposes.. 45,089 32,661 Sale and leaseback transactions................. 2,617 3,390 Allowance for uncollectible receivables......... 2,489 2,833 Resisted claim liability........................ 1,691 1,944 Employee retirement benefits.................... 26,534 27,818 Unearned interest............................... 1,787 1,814 Accrual of interest payable..................... 2,138 513 Other........................................... 5,397 5,393 _________ _________ Total gross deferred tax assets................. 283,488 246,460 Total valuation allowance....................... (16,368) (15,900) _________ _________ Net deferred tax assets......................... 267,120 230,560 _________ _________ Deferred Tax Liabilities: Deferral of policy acquisition costs, net of amortization, for accounting purposes......... (259,674) (239,991) Basis differences between tax and accounting for joint ventures............................ (4,266) (4,906) Basis differences between tax and accounting for securities................................ (4,672) (4,301) Depreciation.................................... (5,759) (6,079) Prepaid expenses................................ (2,403) (2,052) Differences between tax and accounting for reinsurance............................... (6,596) (10,366) Other........................................... (9,055) (7,808) _________ _________ Total gross deferred tax liabilities............ (292,425) (275,503) _________ _________ Net deferred tax liability...................... $ (25,305) $ (44,943) ========= ========= The 1993 change in the above valuation allowance is due only to the change in the Federal income tax rate from 34% to 35%. Federal income tax returns have been examined and settled for all life insurance subsidiaries and their predecessors through 1980. The consolidated Federal income tax returns of the Company and non-life insurance subsidiaries have been examined and settled through 1980. The life-nonlife consolidated Federal income tax returns of the Company and all subsidiaries have been examined and settled for 1981 through 1985. The Company believes that its recorded income tax liabilities are adequate for all open years. Under the provisions of prior tax law applicable to life insurance companies, one half of the excess of the gain from operations of a life insurance company over its taxable investment income was not taxed but was set aside in a special "Policyholders' Surplus Account". Under provisions of the Tax Reform Act of 1984, this account is "frozen" as of December 31, 1983 and is subject to tax under conditions set forth pursuant to prior tax law. Policyholder Surplus may be taxable at the time of its distribution to the company's shareholders or under certain other specified conditions. The Company does not believe that any significant portion of the amount in this account will be taxed in the foreseeable future. However, should the balance at December 31, 1993 become taxable, the tax computed at present rates would be approximately $54.3 million. At December 31, 1993, the Company has nonlife net operating loss carryforwards for Federal income tax purposes of approximately $68.5 million which are available to offset future Federal taxable income, if any, through 2008. Note 5. Retirement Plans The Company and its subsidiaries have a qualified noncontributory defined benefit pension plan covering substantially all employees. Benefits are generally based on years of service, the employee's compensation during the last three years of employment, and an average of Social Security covered wage bases. It is the Company's policy to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Based on such standards, contributions amounting to $4.5 million, $4.2 million and $3.9 million were made for the years ended December 31, 1993, 1992 and 1991, respectively. Substantially all of the Plan assets are invested in the general investment account of a life insurance subsidiary of the Company through a deposit administration insurance contract. As a result of compensation and benefit limitations under Federal tax law applicable to the Company's qualified defined benefit pension plan, the "excess" portion of the pension benefits for certain employees is provided under an unfunded Supplemental Retirement Plan for which eligibility requirements and certain other provisions were modified during 1993. Additionally, the Company has an unfunded Retirement Plan for Outside Directors which provides pension benefits to non-employee Directors of USLIFE Corporation subject to specified eligibility requirements. Benefits are based on years of service and the annual retainer at time of retirement. Pension expense for all of the above pension plans amounted to $5.212 million, $4.774 million and $3.748 million in 1993, 1992 and 1991, respectively. The net periodic pension cost for these plans in 1993, 1992 and 1991 included the following components: The funded status is reconciled to accrued pension cost included in the Company's consolidated balance sheets as of December 31, 1993 and 1992 as follows: The unrecognized net asset relating to the qualified pension plan is being recognized over a 14 year period which began January 1, 1987. The unrecognized net loss and unrecognized prior service cost relating to the Company's pension plans are subject to amortization on a straight-line basis over the estimated average future service period of active employees expected to receive benefits under the plan. Assumptions used in the actuarial computations for the Company's pension plans were as follows: In addition to providing pension benefits, the Company and its subsidiaries provide certain health care and life insurance benefits to retired employees under a defined benefit plan. Employees may become eligible for these benefits if they have accumulated ten years of service and reach normal or early retirement age while working for the Company. The postretirement benefit plan contains cost-sharing features such as deductibles and coinsurance, and contributions of certain retirees are subject to annual adjustment. It is the Company's current policy to fund these benefits, which are provided through an insurance contract with a life insurance subsidiary of the Company, on a "pay as you go" basis. Effective as of January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Statement No. 106 requires that an employer's obligation for non-pension plan benefits provided after retirement be recognized by income statement charges during the service periods of eligible employees rather than on a cash basis as permitted by previously established accounting standards. The Company elected to recognize the initial obligation under the Statement, representing the present value of future benefits attributed to service already rendered by eligible employees as of January 1, 1992, by means of a one-time charge to net income for cumulative effect of the accounting change. This initial obligation, and the consequent charge, amounted to $57.6 million before applicable taxes. Excluding this one-time charge, the cost of non-pension postretirement benefits for 1992 was approximately $2 million. Postretirement benefit costs of approximately $2 million in 1991, which were recorded on a cash basis, have not been restated. During 1993, the Company's non-pension postretirement benefit program was modified in several respects, including the establishment of a maximum dollar cap on amounts to be paid by the Company for future increases in the cost of retiree health benefits. These plan amendments resulted in an unrecognized reduction in prior service cost, which is being amortized over the remaining average service period to full eligibility for benefits of the active participants. Excess gains or losses are being amortized over the average remaining service period to full eligibility for benefits of the active participants. The funded status of the non-pension postretirement benefit program as of December 31, 1993 and 1992 is reconciled to accrued postretirement benefit cost as follows: Net periodic postretirement benefit cost for 1993 included the following components: (Amounts in Thousands) Service cost - benefits earned during the year........ $1,068 Interest cost on accumulated postretirement benefit obligation.................................. 2,198 Net amortization and deferral......................... (1,162) ______ Net periodic postretirement benefit cost.............. $2,104 ====== The non-pension postretirement benefit cost for the year 1992 was comprised primarily of "interest cost." For measurement purposes, a 14 percent annual rate of increase in the per-capita cost of covered health benefits (ie., health care cost trend rate) was assumed for 1993; the rate was assumed to decrease gradually to 6 percent by the year 1997 and remain at that level thereafter. The assumed health care cost trend rate does not have a significant effect on the amounts reported in accordance with Statement No. 106 due to the maximum dollar cap adopted. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $94 thousand and the aggregate of the service and interest cost components of 1993 net periodic postretirement benefit cost by $7 thousand. The discount rate used in determining the accumulated postretirement benefit obligation was 7.5% at both December 31, 1993 and 1992. Note 6. Capital Stock Non-Redeemable Preferred Stocks The $4.50 Series A Convertible Preferred Stock ($1.00 par value; authorized and issued as of December 31, 1993, 4,815 shares; December 31, 1992, 5,627 shares; December 31, 1991, 6,420 shares) is carried at involuntary liquidating value of $100 per share in the financial statements; is entitled to cumulative annual dividends of $4.50 per share; may be redeemed in whole or in part at the option of the Company at $100 per share; and is convertible at any time into Common Stock at a conversion price which at December 31, 1993 was $12.49 per share (each share of Series A Stock valued at $100), subject to adjustment under a formula intended to protect against dilution in certain events. Holders are entitled to vote together with the Common Stock and Series B Convertible Preferred Stock as one class on the basis of one vote per share and to vote as a class upon the election of two directors during any period in which four quarterly dividends (whether or not consecutive) are in default. The $5.00 Series B Convertible Preferred Stock ($1.00 par value; authorized and issued as of December 31, 1993, 2,050 shares; December 31, 1992, 2,251 shares; December 31, 1991, 2,405 shares) is carried at involuntary liquidating value of $50 per share in the financial statements; is entitled to cumulative annual dividends of $5.00 per share; may be redeemed in whole or in part at the option of the Company at $100 per share; and is convertible at any time into Common Stock at a conversion price which at December 31, 1993 was $12.51 per share (each share of Series B Stock valued at $100), subject to adjustment under a formula intended to protect against dilution in certain events. Voting rights are the same as those of holders of Series A Stock. The Preferred Stock, undesignated ($1.00 par value; authorized as of December 31, 1993, 10,793,135 shares, issued none), may be issued by authorization of the Board of Directors without further approval of shareholders. The Board has broad powers to fix the terms of such issues subject to the limit that the aggregate of all amounts which may be paid to holders of all of the series of Preferred Stock upon the involuntary liquidation, dissolution or winding up of the Company cannot exceed $100 times the number of such shares plus accrued unpaid dividends. Common Stock The outstanding shares of Common Stock (par value $1.00 per share; authorized, as of December 31, 1993: 60,000,000 shares; December 31, 1992 and 1991: 40,000,000 shares; issued, including treasury shares, as of December 31, 1993, 38,308,823 shares; December 31, 1992, 38,255,975 shares; December 31, 1991, 38,117,150 shares) entitle each holder to one vote per share in the election of directors and on all other matters submitted to a vote of shareholders and to such dividends and distributions as may be declared by the Board of Directors out of funds legally available. At December 31, 1993, 54,948 shares of Common Stock were reserved for issuance upon conversion of Preferred Stock. The Company sponsors, through certain of its life insurance subsidiaries, savings plans for selected general agents and producers (the "Agents Plans") providing for distribution of Common shares to participants if specified qualification and vesting requirements are satisfied. As of December 31, 1993, participant interests relating to 5,797 Common shares had vested under the Agents Plans. On July 10, 1986 the Company issued, to shareholders of record on that date, one Common Stock Purchase Right (a "Right") for each share of Common Stock owned on that date. Until the Rights become exercisable they will be represented by the stock certificates for all outstanding Common Stock including newly issued shares. Upon the occurrence of certain events specified in a Rights Agreement dated as of June 24, 1986 and amended and restated as of January 24, 1989 between the Company and Manufacturers Hanover Trust Company (predecessor to Chemical Bank) as Rights Agent, the Rights will become exercisable, separate certificates representing the Rights will be issued, and each Right will entitle the holder to purchase one half of a share of the Common Stock for $50.00. Under certain circumstances specified in the Rights Agreement each Right will entitle the holder to purchase, for one half of its then market value, publicly traded common stock of any corporation which acquires the Company; each Right will also entitle the holder, with certain exceptions specified in the Rights Agreement, to purchase $150.00 worth of the Common Stock for $75.00. As of December 31, 1993 the Rights had not become exercisable. The Company also sponsors a Dividend Reinvestment and Stock Purchase Plan which enables holders of the Company's Common Stock to invest cash dividends and optional cash payments in additional shares of the Common Stock. In 1993, 1992 and 1991, respectively, 25,689, 29,523 and 34,430 shares of the Common Stock had been sold pursuant to the Dividend Reinvestment and Stock Purchase Plan. Treasury Stock At December 31, 1993, there were 15,650,354 shares of Common Stock held in treasury. During 1993, 65,666 Common shares were acquired, at an aggregate cost of $2.6 million, and 168,811 Common shares, with an aggregate cost of $3.2 million, were utilized for certain employee, director, and agent benefit plans and for the Dividend Reinvestment and Stock Purchase Plan of USLIFE Corporation. At December 31, 1992, treasury stock consisted of 15,753,499 Common shares. Note 7. Stock Options, Book Units and Restricted Stock Plan In May, 1991, the Company adopted a stock option plan (the "1991 Stock Option Plan") for key employees to replace the previous stock option plan under which options could no longer be granted. Under the 1991 Stock Option Plan, a maximum of 1,050,000 shares of the Company's common stock may be issued upon the exercise of stock options which may be granted pursuant to the Plan. The 1991 Stock Option Plan also provides for "Reload" options, which are automatically granted to a participant upon the exercise of an option if the participant uses previously owned shares to pay for the option shares. Reload options will be for the number of previously-owned shares delivered upon the employee's exercise of an option. Under the 1991 Stock Option Plan, the purchase price of shares subject to each option will be not less than 100% of their fair market value at the time of the grant of the option. No options may be granted under the 1991 Stock Option Plan after May 20, 2001. No option granted under the Company's stock option plans is exercisable in whole or in part in less than six months from the date of grant. Each option may be exercisable in one or more installments as provided therein. To the extent such options are not exercised, installments accumulate to the total granted and are exercisable in whole or in part at any time during the term of the option. This term shall be set forth in the option but in no event is an option exercisable, in whole or in part, after the expiration of ten years from the date of grant. The 1991 Stock Option Plan provides that in the event of a Change in Control (as defined in the Plan), all outstanding options granted under that Plan which have been held for at least six months from the date of grant shall become immediately exercisable. As of December 31, 1993, the Company had outstanding options to its employees (including officers) for purchase of shares of its Common Stock as follows: A summary of activity under all stock option plans for the three years ended December 31, 1993 is presented below: As of December 31, 1993, options for 530,483 common shares were exercisable under all stock option plans at $18.42 to $29.50 per share. At December 31, 1993, up to 1,585,445 common shares could be issued under the Company's stock option plans. Common shares may be issued under the Company's stock option plans from shares in treasury or authorized but unissued shares. In May, 1976 the Company adopted a Book Unit Plan for certain key employees. Under the terms of the plan, the Board of Directors may award, at its sole discretion, one or more units to employees it has selected to become participants in the plan. No more than 600,000 units shall be outstanding under the plan at any time. The value of a unit shall be the amount by which the book value per share, as of its award date, has been increased or decreased by (a) the sum of the increases or decreases in the book value per share of the Company's common stock plus (b) dividend equivalents for subsequent years up to and including its valuation date. Accordingly, approximately $2.1 million, $1.4 million, and $1.1 million were charged to expense in 1993, 1992, and 1991, respectively. A summary of units outstanding under the Book Unit Plan follows: In May, 1989, the Company adopted a Restricted Stock Plan for certain key employees. Under the terms of the Plan, a committee of the Board of Directors may award restricted shares of common stock of the Company, up to an aggregate maximum of 1,050,000 shares, to designated Participants. The shares, when awarded, are initially non-transferable and subject to forfeiture in the event that the Participant ceases to be an employee of USLIFE or any of its subsidiaries other than by reason of death, permanent disability, retirement, or certain other specified circumstances. These restrictions generally terminate with respect to 20% of the number of shares awarded on January 1 of each of the five calendar years following the year of award, at which time the appropriate number of unrestricted shares are distributed to the Participant. For certain awards, restrictions terminate with respect to one-third of the number of shares awarded on the first, second, and third anniversaries of the award date, with similar distribution. Upon award of shares under the Plan, deferred compensation equivalent to the market value of the shares on the award date is charged to Equity Capital. Such deferred compensation is subsequently amortized by means of charges to expense over the period during which the restrictions lapse. During 1993, a total of 18,356 shares were awarded under the Plan. During 1991, a total of 16,200 previously awarded shares were forfeited pursuant to the terms of the plan. As of December 31, 1993, there were 30,356 previously awarded shares outstanding under the Plan as to which the restrictions had not yet lapsed. Expense charges recognized in 1993, 1992 and 1991 relating to these awards amounted to approximately $2.1 million, $2.0 million, and $2.0 million, respectively. Note 8. Leases In December, 1986 a subsidiary of the Company sold its home office building located at 125 Maiden Lane, New York, New York, and leased back portions of the premises which are utilized as the subsidiary's principal executive offices as well as the headquarters of the Company and several other subsidiaries. A $16.9 million portion of the gain arising from the sale and leaseback transaction (net of related taxes) was deferred and is being amortized by credits to income in proportion to rental payments made in accordance with the lease commitments over a ten year period. Additionally, several subsidiaries lease office space at other locations generally for periods ranging from five to fifteen years, and certain subsidiaries utilize leased furniture and office equipment. Certain of the operating leases for office premises provide for renewal options for periods ranging from five to twenty years based on fair rental value at time of renewal, and further options relating to rental of additional office space. The minimum rental commitments for all such non-cancelable operating leases as of December 31, 1993 approximate $12.6 million in 1994, $12.4 million in 1995, $11.4 million in 1996, $6.6 million in 1997, $5.5 million in 1998, and a total of $18.4 million from 1999 to 2003. Total rental expense amounted to approximately $13.5 million, $12.4 million, and $12.0 million for the years ended December 31, 1993, 1992 and 1991, respectively. Note 9. Contingent Liabilities and Commitments A life insurance subsidiary has an outstanding standby commitment, representing a contingent obligation to replace certain borrowings in the event of default by unaffiliated borrowers, amounting to $6.8 million at December 31, 1993. The life insurance subsidiaries historically have not provided permanent financing on the major portion of such commitments. This commitment, which is not guaranteed by the parent company, will expire in 1994. The Company has outstanding Standby Letters of Credit with two banks representing contingent obligations to fund various trusts established in connection with certain employment contracts of management employees, the Company's Supplemental Retirement Plan, Retirement Plan for Outside Directors, and Retirement Plan, in the event of a Change in Control (as defined in the trust agreements), totalling $31 million. Additionally, in connection with the application by a life insurance subsidiary for an additional state license to transact business, USLIFE Corporation has agreed to guarantee that subsidiary's maintenance of the state's minimum capital and surplus requirements (amounting to $4.4 million at December 31, 1993) for a ten year period commencing at the effective date of such license. The Company and certain of its subsidiaries are involved in litigation, which originated in 1981, with a former officer of a former subsidiary of the Company. Allegations in the former officer's lawsuit include breach of the covenant of good faith and fair dealing, breach of fiduciary duty, infliction of emotional distress and malicious prosecution. Judgment was rendered in favor of the Company. That judgment is being appealed. No contingent loss has been accrued for this litigation because the amount of loss, if any, cannot be reasonably estimated, nor is it probable in the opinion of management that the ultimate outcome of this litigation will result in a liability to the Company or any of its subsidiaries. In April 1991, All American Life Insurance Company ("All American"), a life insurance subsidiary of the Company, commenced a lawsuit against 11 subscribers to a reinsurance pool when the reinsurers failed to honor their obligations under the reinsurance agreement. Certain of the reinsurers also filed their own lawsuits against All American. Approximately $15.8 million of reinsured claims were in dispute. All American reached settlements with the 11 reinsurers. There remain pending against All American certain cross claims for indemnification and contribution by a third party administrator and a reinsurance intermediary. In the opinion of management the ultimate resolution of this matter will not result in a material adverse financial impact upon the Company. In March 1992, All American terminated the right of a Managing General Agent to sell college medical insurance on behalf of All American as a result of the failure of the Managing General Agent to secure adequate reinsurance under the contract and meet other contractual obligations. All American is currently involved in litigation with this former Managing General Agent, who has declared bankruptcy, and All American has taken a charge of $10.6 million (after applicable taxes) to establish a reserve for amounts receivable from the Managing General Agent. No contingent loss has been accrued for this litigation because the amount of additional loss, if any, cannot be reasonably estimated, nor is it probable in the opinion of management that the ultimate outcome of this litigation will result in a liability to the Company or any of its subsidiaries. In June 1993, a purported class action was filed against three of the Company's subsidiaries alleging that the class members were entitled to premium refunds on policies of credit life and disability insurance purchased from the three subsidiaries. No contingent loss has been accrued for this litigation because the amount of loss, if any, cannot be reasonably estimated. In addition to the aforementioned legal proceedings, the Company and its subsidiaries are parties to various routine legal proceedings incidental to the conduct of their business. Based on currently available information, in the opinion of management it is not probable that the ultimate resolution of these suits will result in a material liability on the part of the Company. Note 10. Reinsurance The life insurance subsidiaries reinsure with other companies portions of the risks they underwrite and assume portions of risks on policies underwritten by other companies. The life insurance subsidiaries generally reinsure risks over $1.5 million as well as selected risks of lesser amounts. In this connection, $7.5 billion, representing 6 percent of total life insurance in force as of December 31, 1993, was ceded to other carriers. Reinsurance contracts do not relieve the Company from its obligations to policyholders, and the Company is contingently liable with respect to insurance ceded in the event any reinsurer is unable to meet the obligations which have been assumed. The Company's consolidated financial statements for 1993 reflect the adoption of Statement of Financial Accounting Standards No. 113 ("SFAS 113"), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." Pursuant to the standards of SFAS 113, amounts paid for or recoverable under reinsurance contracts, including amounts previously reported as a reduction of various liability accounts as permitted under previous accounting standards, are included in total assets as reinsurance receivable or recoverable amounts. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies. Financial statements of previous years were not restated as a result of the adoption of SFAS 113. The effect of reinsurance on premiums, other considerations, and benefits to policyholders and beneficiaries, is as follows: Year Ended December 31, 1993 _______________________ (Amounts in Thousands) Premiums, before reinsurance ceded......... $1,021,694 Premiums ceded............................. 77,388 __________ Net premiums............................... $ 944,306 ========== Other considerations, before reinsurance ceded................................... $166,477 Other considerations ceded................. 12,938 ________ Net other considerations................... $153,539 ======== Benefits to policyholders and beneficiaries, before reinsurance recoveries............ $794,640 Reinsurance recoveries..................... 57,309 ________ Benefits to policyholders and beneficiaries, net of reinsurance recoveries............ $737,331 ======== A summary of reinsurance activity for the three years ended December 31, 1993 is presented below: The estimated amounts of reinsurance recoverable on paid and unpaid claims included in the Consolidated Balance Sheets as of December 31, 1993 and 1992 are as follows: The amount included in the consolidated balance sheet at December 31, 1993 for "Other reinsurance recoverable" includes the estimated amounts recoverable on unpaid claims as indicated above as well as prepaid reinsurance premiums. For periods prior to 1993, these amounts were netted against the related insurance liabilities in accordance with previous accounting standards. Note 11. Investment Securities The investments of the Company at December 31, 1993 are summarized as follows: Based on book value, assets categorized as "non-income producing" for the 12 months ended December 31, 1993 included in fixed maturities, mortgage loans, real estate investment properties, and real estate acquired in satisfaction of debt amounted to $16.3 million, $13.5 million, $4.9 million and $8.9 million, respectively. Note 12. Net Investment Income The details of consolidated net investment income for the three years ended December 31, 1993 follow: Note 13. Supplementary Insurance Information Supplementary data relating to the life insurance industry segment of the Company for the three years ended December 31, 1993 is presented below. Year Ended December 31, 1991 ___________________________________ Non- Life Reportable Insurance Segments and Industry Consolidating Segment Adjustments Consolidated __________ _________ __________ Deferred policy acquisition costs........ $ 648,835 $ - $ 648,835 ========== ========= ========== Future policy benefits: Life........... $1,091,759 $ - $1,091,759 Accident and health........ 189,585 - 189,585 __________ _________ __________ Total......... $1,281,344 $ - $1,281,344 ========== ========= ========== Policyholder account balances for universal life-type and investment contracts....... $2,147,849 $ - $2,147,849 ========== ========= ========== Other policy claims and benefits payable......... $ 223,755 $ (6,675) $ 217,080 ========== ========= ========== Premium income: Life........... $ 409,096 $ (566) $ 408,530 Accident and health....... 436,978 (5,250) 431,728 __________ _________ __________ Total........ $ 846,074 $ (5,816) $ 840,258 ========== ========= ========== Other consider- ation.......... $ 129,109 $ - $ 129,109 ========== ========= ========== Net investment income......... $ 351,671 $ 9,905 $ 361,576 ========== ========= ========== Realized gains (losses)....... $ (2,235) $ 314 $ (1,921) ========== ========= ========== Benefits, claims, losses and settlement expenses........ $ 835,084 $ 190 $ 835,274 ========== ========= ========== Amortization of deferred policy acquisition costs........... $ 130,659 $ - $ 130,659 ========== ========= ========== Other operating expenses ...... $ 231,362 $ 74,592 $ 305,954 ========== ========= ========== Note 14. Condensed Financial Information of Parent Company Note 15. Condensed Quarterly Results of Operations (Unaudited) The quarterly results of consolidated operations for the two years ended December 31, 1993 are presented below (in thousands of dollars except per share amounts):	18,134	118,024
64079_1993.txt	64079_1993	1993	64079	Item 1. Business GENERAL - ------- MCI* is the second largest nationwide carrier of long- distance telecommunications services and provides a wide spectrum of domestic and international voice and data communications services. MCI's communications services include long-distance telephone service, record communications service and electronic messaging service. During each of the last three years, more than 90% of MCI's operating revenues, operating income and assets related to MCI's activities in the long-distance telecommunications industry. SERVICES - --------- MCI provides a broad range of domestic long-distance telecommunications services, including dial 1 access and dial access long-distance telephone service; voice and data services over software-defined virtual private networks; private line and switched access services; toll free or 800 services; and 900 services. MCI also provides a range of domestic data services and electronic messaging services and provides international long-distance telephone service, international record communications service, international data service and international electronic messaging service. These services are provided to residential, business, governmental and institutional customers. Domestic long-distance telecommunications services are marketed through MCI's Multinational Account unit and its Communications Services unit. The Multinational Account unit serves MCI's largest multinational business customers. The Communications Services unit is comprised of two sub-units: Business Markets - serving all United States based businesses, except for the largest multinational businesses, and Federal, state and local governments; and Consumer Markets - serving residential customers. - ----------------------- MCI conducts its business primarily through its subsidiaries. Unless the context otherwise requires, "MCI" or "company" means MCI Communications Corporation, a Delaware corporation organized in August 1968, and its subsidiaries on a consolidated basis. MCI is a registered service mark of MCI Communications Corporation. MCI has its principal executive offices at 1801 Pennsylvania Avenue, N.W., Washington, D.C. 20006 (telephone number (202) 872-1600). Page 2 of 62 Domestic data and electronic messaging services are marketed through MCI's Data Services Division, which was established in September 1993. This unit has responsibility for integrating the data services operations of BT North America Inc. which MCI acquired in January 1994 as part of the British Telecommunications plc ("BT") transaction described below under the caption "LONG-TERM STRATEGY" and in Note 2 of the Notes to Consolidated Financial Statements on pages 34 and 35 of this Annual Report on Form 10-K. International long-distance, record communications, data and electronic messaging services are marketed through MCI International, Inc., a wholly-owned subsidiary of MCI. MCI also markets its services domestically and internationally, to a lesser extent, through arrangements with third parties. SYSTEM - ------ Domestic long-distance telecommunications services are provided primarily over MCI's own coast-to-coast optical fiber and terrestrial digital microwave communications system and, to a lesser extent, over facilities leased from other common carriers. International communications services are provided by way of submarine cable systems in which MCI holds investment positions, satellites, facilities of other domestic and international carriers and through private line leased channels. MCI provides most of its customers access to its services through local interconnection facilities provided by local exchange telephone companies ("LECs") and, to a lesser extent, by competitive access providers ("CAPs") that carry telecommunications between MCI's operations centers and the premises of its customers. MCI provides customers that have very large volumes of communications with direct access between their facilities and MCI's facilities. Additionally, MCI expects in the future to provide, through its new subsidiary, MCI Metro, Inc. ("MCI Metro"), where permitted by law, local interconnection services to connect MCI's long-distance system to the premises of its business, governmental, institutional and residential customers located in major metropolitan areas. MCI's costs of furnishing the required local interconnection facilities are expected to be favorably impacted by actions taken by the Federal Communications Commission ("FCC") in 1991. The actions provide for the restructuring of LECs switched local transport access charges and allow long-distance carriers, such as MCI, to collocate facilities and equipment at the LECs offices for the purpose of providing special access to their customers. These actions are more fully discussed below under the caption "REGULATION". Page 3 of 62 MCI's continued expansion of its digital transmission and switching facilities and capabilities to meet the demands of its customers for additional and enhanced domestic and international services, to add redundancy to its network and to enhance network intelligence, requires a high level of capital expenditures. Capital expenditures were $1,733 million in 1993; $1,272 million in 1992; and $1,377 million in 1991. In 1994, MCI plans capital expenditures of between $2.5 billion and $3.0 billion to continue to introduce new services, develop its communications system and meet the goals of its long- term strategy. At December 31, 1993, MCI had approximately 36,000 full-time employees. LONG-TERM STRATEGY - ------------------ As part of its long-term strategic plan, MCI announced networkMCI. Under networkMCI, MCI plans to expand its network to create and deliver a wide variety of new branded services both domestically and internationally. An initial element of networkMCI will involve the implementation of high-speed Synchronous Optical Network ("SONET") technology throughout MCI's domestic network and on international routes across the Atlantic and Pacific to substantially increase carrying speeds of traffic on MCI's network. In addition to the implementation of SONET technology, MCI plans to increase its network switching capabilities through the implementation of Asynchronous Transfer Mode ("ATM") technology, a state-of-the-art switching technology that enables a wide range of data communication services and will permit the MCI network to be linked to interactive multimedia and wireless communications. In addition, networkMCI will also include the formation by MCI of a new subsidiary, MCI Metro. MCI Metro will construct fiber rings and local switching infrastructure in major markets in the U.S. to provide special and switched transport access for data, voice, video and enhanced telecommunications services to business, governmental and institutional customers at a lower cost than is now generally available and, over time, subject to regulatory constraints, to offer a full range of local exchange telecommunications services to business, government, institutional and residential customers. - ----------------------- * networkMCI is a service mark of MCI Communications Corporation. Page 4 of 62 Further, in February 1994, MCI entered into a letter agreement with Nextel Communications, Inc. ("Nextel") and Comcast Corporation which contemplates, as part of a strategic alliance between the companies and subject to the terms and conditions of definitive documentation, that MCI will invest approximately $1.3 billion in Nextel over the next three years for approximately a 17% equity interest. The letter agreement also contemplates that MCI will utilize Nextel as its principal provider of wireless telecommunications services and will offer to Nextel all business opportunities in respect of providing wireless telecommunications services and products. In addition, MCI will provide Nextel marketing and other services to support Nextel's sales of wireless telecommunications services and products. The development of strategic alliances to expand the use of MCI's services internationally is also a part of networkMCI. In August 1993, MCI entered into a definitive agreement with BT providing for the acquisition by BT of an approximate 20% equity interest in MCI for approximately $4.3 billion, the formation of a joint venture between BT and MCI to provide global enhanced and value-added telecommunications services, and the purchase by MCI of substantially all the assets of the U.S. operations of BT's data services subsidiary, BT North America, Inc. The joint venture, in which MCI will own a 24.9% equity interest, will provide global enhanced and value-added telecommunications services for which MCI will be the exclusive distributor in North, Central and South America, and BT will be the exclusive distributor in the rest of the world. MCI expects to invest approximately $250 million in this joint venture over the next five years. In January 1994, the company announced its intention to form a joint venture with Grupo Financiero Banamex-Accival ("Banacci"), Mexico's largest financial group, to provide competitive domestic and international long-distance telecommunications services in Mexico using MCI's technology. Subject to the grant of a concession from the government of Mexico, which is expected in August 1994, the joint venture will provide competitive switched telecommunication services commencing in August 1996. MCI will own a 45% equity interest in this joint venture. MCI will invest a total of $450 million in the joint venture over the next several years. Page 5 of 62 In 1992, MCI entered into a strategic alliance with Stentor, an alliance of major Canadian telephone companies, to develop a fully integrated intelligent network linking the United States and Canada. The combination of the alliance and the formation of the joint venture in Mexico will assist in the development of a fully integrated, seamless North American network capable of providing services with identical features to customers throughout the United States, Canada and Mexico. The consummation of the transactions with BT are subject to various conditions, including the receipt of regulatory approvals which have not yet been obtained. The transactions with each of Banacci and Nextel are subject to the execution of definitive agreements and the satisfaction of various other conditions, including the receipt of regulatory approvals which have not yet been obtained. MCI estimates that networkMCI will involve the investment by MCI and its associated venturers of a total of more than $20 billion through the end of the decade. COMPETITION - ----------- Competition in the long-distance telecommunications services market is intense, and MCI expects it to remain so for the foreseeable future. American Telephone and Telegraph Company ("AT&T") continues to be MCI's primary and most powerful competitor in the domestic and international long-distance telecommunications services market. AT&T is substantially larger than MCI and continues to compete vigorously with MCI. In general, MCI's long-distance telecommunications services are priced lower than the comparable services offered by AT&T. Although price is a significant factor in customer choice, innovation and quality of services, marketing strategy, customer service and other non-price factors are also important elements affecting competition. MCI also competes with Sprint Corporation and other facilities-based domestic communications common carriers and numerous resellers of long-distance telecommunications services. Under current FCC policy, almost any entity can freely enter the domestic long-distance telecommunications services market. Further, MCI also competes with the LEC that services the local access transport area ("LATA") where MCI is authorized to provide intra-LATA long-distance telecommunications services. MCI expects competition in this market to remain intense for the foreseeable future. Page 6 of 62 The seven Regional Bell Operating Companies (individually an "RBOC" and collectively the "RBOCs"), are presently prohibited by the 1982 AT&T divestiture decree from entering the interstate long-distance telecommunications services market. Nevertheless, they have attempted to obtain relief from this and other restrictions through petitions to the federal courts and supporting proposed legislation in Congress. The RBOC's have very substantial capital and other resources and long standing customer relationships and if they are permitted to offer interstate long-distance telecommunications services, they could be significant competitors in the interstate long-distance telecommunications services market. Furthermore, to the extent the RBOC's maintain a monopoly in their local exchange markets, they have the potential to subsidize any long-distance rates with profits from their monopoly business. Several bills have been introduced in Congress that would permit the RBOCS to provide interstate long-distance telecommunications services. Some of these bills would permit an RBOC to enter the interstate long-distance telecommunications services market only once the RBOC sells separately each element of the local exchange telecommunications services it provides and there is actual and demonstrable competition in its local exchange telecommunications services market. Another bill introduced in the House of Representatives would permit the RBOCs to provide intrastate long-distance telecommunications services subject to state regulatory approval; resell long-distance telecommunications services for calls that originate in a state that permits intraLATA toll competition; and provide interstate long-distance telecommunications services for calls within the RBOC's service region, subject to FCC and Department of Justice approval. This bill requires that the RBOCs demonstrate that their monopoly position in the local exchange telecommunications services market will not impede competition in the interstate long-distance telecommunications services market but does not require that there be competition in an RBOC's local exchange telecommunications services market before it will be permitted to provide or resell interstate long-distance telecommunications services. It is not possible to predict whether or when any of these legislative proposals will be enacted, or what they will finally provide if enacted. MCI is monitoring these bills closely and will vigorously oppose any legislation that does not provide for substantial competition in the local exchange telecommunications services markets before the RBOCs are allowed into the long-distance telecommunications services market. Page 7 of 62 The partial unbundling of the local exchange telecommunications services through the FCC's actions related to special access services and switched access services has created an opportunity for MCI, through MCI Metro, to compete with the LECs and the CAPs in providing these services. In addition, as the states open up additional local exchange telecommunications services to competition, MCI Metro will also compete with the LECs in the offering of these services. MCI expects that the LECs will compete vigorously with MCI Metro in the local exchange telecommunications services market. The LECs have substantial capital and other resources, long standing customer relationships and existing networks. In addition, the state regulatory agencies regulating the LECs may provide them with a greater degree of flexibility in pricing their services than is currently permitted. This greater flexibility will give the LECs the freedom to determine their rates within a certain range and to enter into individual contracts with customers. The company believes this flexibility and the LECs control of those aspects of the local exchange network that cannot be reproduced efficiently by a competitor present opportunities for the LECs to subsidize the prices of services which compete with MCI Metro's proposed services in an effort to stifle MCI Metro's competition. MCI Metro will also compete in the local exchange telecommunications services market with a number of CAPs, a few of which have existing local networks and significant financial resources. REGULATION - ---------- The FCC has extensive authority to regulate common carriers, including the power to review the rates charged by long-distance carriers and to establish policies that promote competition in the long-distance telecommunications services market. The FCC exercised this power by adopting a policy, effective on May 1, 1993, that requires long-distance carriers to permit customers to retain their current 800 numbers when they change long-distance carriers. In recognition of AT&T's dominance in the 800 services market, this policy also required AT&T to permit certain large businesses using AT&T's 800 service to cancel their long-term contracts for AT&T services within 90 days of May 1, 1993 if they desired to choose another long-distance carrier for those services. Page 8 of 62 In another effort to promote competition in the long-distance telecommunications services market, the FCC in 1991 adopted a two year transition plan to restructure switched transport access charges imposed on long-distance carriers by LECs. The plan will permit the LECs to base a portion of these switched access charges on a flat, non-usage sensitive rate basis. This provides both the LECs and CAPs the ability to compete for long-distance carriers' access business on a more equal basis while minimizing the adverse impact on long-distance competition. In September 1992, the FCC voted to require certain of the LECs, subject to certain exceptions, to offer long-distance carriers, such as MCI, CAPs and certain others, physical collocation in the LEC's offices at cost-based rates. The LECs have filed tariffs for both special and switched access interconnection. These rates have not yet gone into effect and are being reviewed by the FCC. Under these decisions by the FCC, MCI expects to expand the number of customers to which it can offer special and switched access services by being able to reach through interconnection virtually every business customer in its metropolitan service areas. MCI believes that these regulatory developments will have a positive impact on its costs for local interconnection facilities, although it is not possible to estimate what such impact will be and whether it will be significant. Rates of international communications carriers for traffic from the United States to foreign countries are subject to regulation by the FCC. Revenues derived from international services (with the exception of leased channel services) are generally collected by the originating carrier and divided with the terminating carriers by means of agreements that are subject to the approval of the FCC and the approval of the appropriate overseas agency. International communications facilities in the U.S. are also subject to the jurisdiction of the FCC, and the provision of service to a foreign country is subject to the approval of the FCC and the appropriate foreign governmental agencies. To the extent MCI provides intrastate local and long-distance telecommunications services, it is subject to state regulatory commissions which have extensive authority to regulate the provision of such services. Page 9 of 62 Item 2. Item 2. Properties. - ------------------- MCI leases portions of railroad, utility and other rights of way for its fiber optic transmission system. MCI also has numerous tower sites, generally in rural areas, to serve as repeater stations in its domestic microwave transmission system. Most of these sites are leased, although MCI does own many of those which are at an intersection of two or more routes of MCI's transmission system. Generally, MCI owns the buildings that serve as switch facilities for the transmission system. In metropolitan areas, MCI leases facilities to serve as operations facilities for its intercity and overseas transmissions systems. MCI also leases office space to serve as sales office and/or administrative facilities. Some of these facilities are located jointly with operations facilities. In addition, MCI owns its headquarters in Washington, D.C. and two buildings in a suburb of Washington, D.C., as well as administrative facilities in Richardson, Texas; Colorado Springs, Colorado; Piscataway, New Jersey; and Cedar Rapids, Iowa. Item 3. Item 3. Legal Proceedings. - --------------------------- Information regarding contingencies and legal proceedings is included in Note 10 of the Notes to Consolidated Financial Statements on pages 46 and 47 of this Annual Report on Form 10-K. In March 1994, the Court of Appeals for the District of Columbia Circuit upheld the United States District Court for the District of Columbia's dismissal of the action described in the last paragraph of Note 10. MCI has been informed that no further action will be taken by the plaintiffs in this matter. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------- None. Page 10 of 62 Item 10. Executive Officers of the Registrant.* - ----------------------------------------------- The executive officers of MCI are elected annually and serve at the pleasure of the board of directors. They are: Name Age* Position Bert C. Roberts, Jr. 51 Chairman of the Board, Chief Executive Officer, Director Richard T. Liebhaber 58 Chief Strategy and Technology Officer, Director Gerald H. Taylor 52 Executive Vice President and Group Executive, MCI Telecommunications Corporation Eugene Eidenberg 54 Executive Vice President and Group Executive Seth D. Blumenfeld 53 President, MCI International, Inc. Daniel E. Crawford 54 Executive Vice President, MCI Telecommunications Corporation Angela O. Dunlap 37 Executive Vice President, MCI Telecommunications Corporation Gary M. Parsons 43 Executive Vice President Timothy F. Price 40 Executive Vice President, MCI Telecommunications Corporation Douglas L. Maine 45 Senior Vice President and Chief Financial Officer Jack E. Reich 43 Senior Vice President, MCI Telecommunications Corporation John R. Worthington 63 Senior Vice President, General Counsel, Director Bradley E. Sparks 47 Vice President, Controller - -------------------- As of March 1, 1994 Page 11 of 62 Mr. Roberts has been Chairman of the Board of MCI since June 1992 and Chief Executive Officer of MCI since December 1991. He was President and Chief Operating Officer of MCI from October 1985 to June 1992 and President of MCI Telecommunications Corporation, the subsidiary of MCI providing long-distance telecommunications services, from May 1983 to June 1992. Mr. Roberts has been a director of MCI since 1985. Mr. Liebhaber has been Chief Strategy and Technology Officer and a director of MCI since June 1992. He was an Executive Vice President and Group Executive of MCI from May 1990 to June 1992. He was an Executive Vice President of MCI from December 1985 to May 1990. Mr. Taylor has been an Executive Vice President and Group Executive of MCI Telecommunications Corporation since September 1993. He was an Executive Vice President of MCI Telecommunications Corporation, serving as President, Consumer Markets, from November 1990 to August 1993. For more than five years prior thereto, Mr. Taylor was a Senior Vice President of MCI Telecommunications Corporation, serving, at separate times, as President of the Mid-Atlantic Division and the West Division. Mr. Eidenberg has been an Executive Vice President and Group Executive of MCI since September 1993, an Executive Vice President of MCI since January 1990 and an Executive Vice President of MCI Telecommunications Corporation since December 1989. From May 1987 to November 1989, he was President and Chief Executive Officer of Macrovision Corporation, a technology company. Mr. Blumenfeld has been President of MCI International, Inc., a subsidiary of MCI that provides and markets telecommunications services internationally, since September 1984. Mr. Crawford has been an Executive Vice President of MCI Telecommunications Corporation, serving as President, Network Services, since December 1990. For more than five years prior thereto, Mr. Crawford was a Senior Vice President of MCI Telecommunications Corporation, serving as President of the Southwest Division from July 1989 to December 1990. Ms. Dunlap has been an Executive Vice President of MCI Telecommunications Corporation, serving as President, Consumer Markets, since October 1993. She was a Senior Vice President, Consumer Markets, of MCI Telecommunications Corporation from April 1993 to October 1993 and Vice President of MCI Telecommunications Corporation from November 1990 to April 1993. For more than five years prior thereto, Ms. Dunlap was employed by MCI Telecommunications Corporation in various managerial positions. Page 12 of 62 Mr. Parsons has been an Executive Vice President of MCI since August 1993. He was a Senior Vice President of MCI Telecommunications Corporation from August 1990 to August 1993, serving as President of the Southern Division and as a Senior Vice President. From December 1988 to August 1990, he was an Executive Vice President of TelecomUSA, Inc., a domestic long- distance telecommunications company acquired by MCI in August 1990. Mr. Price has been an Executive Vice President of MCI Telecommunications Corporation, serving as President, Business Markets, since June 1993. He was a Senior Vice President of MCI Telecommunications Corporation from November 1990 to June 1993, serving as President, Business Services, from July 1992 to June 1993 and as Senior Vice President, Consumer Markets, from November 1990 to June 1992. For more than five years prior thereto, Mr. Price was a Vice President of MCI Telecommunications Corporation. Mr. Maine has been a Senior Vice President of MCI since September 1988. Mr. Maine has been Chief Financial Officer of MCI since February 1992, was Controller of MCI from June 1987 to April 1989 and was Senior Vice President of Finance from April 1989 to November 1990. He has been a Senior Vice President of MCI Telecommunications Corporation since September 1988, serving as President of the Southern Division from November 1990 to February 1992. Mr. Reich has been a Senior Vice President of MCI Telecommunications Corporation, serving as President, Multinational Accounts, since November 1993. For more than five years prior thereto he was a Vice President of MCI Telecommunications Corporation. Mr. Worthington has been General Counsel of MCI since 1971, a Senior Vice President of MCI since September 1979, and a director of MCI since 1968. Mr. Sparks has been a Vice President and Controller of MCI since September 1993 and was a Vice President and Treasurer of MCI from September 1988 to September 1993. PART II BEGINS ON THE NEXT PAGE Page 13 of 62 PART II Item 5. Item 5. Market for Registrant's Common Equity and Related - ----------------------------------------------------------------- Stockholder Matters. - ------------------- MCI Common Stock is traded on the National Association of Securities Dealers Automated Quotation ("NASDAQ") NMS. The table below sets forth the high and low sales prices of the Common Stock as reported by NASDAQ for the periods indicated. (Prices in the tables below have been adjusted for the two-for-one stock split effected in the form of a 100% stock dividend paid on July 9, 1993.) HIGH LOW -------- --------- 1st Quarter $23 $18 13/16 2nd Quarter 28 15/16 21 7/16 3rd Quarter 29 7/8 26 1/4 4th Quarter 29 5/8 24 1/8 HIGH LOW -------- --------- 1st Quarter $18 1/16 $14 3/4 2nd Quarter 17 3/8 14 3/4 3rd Quarter 18 1/8 15 3/8 4th Quarter 20 7/16 16 13/16 MCI paid cash dividends of $.025 (adjusted for the effect of the two-for-one stock split) per share of common stock in June and December 1992 and in July and December 1993. At March 25, 1994, there were 49,939 holders of record of MCI's Common Stock. Page 14 of 62 Item 6. Item 6. Selected Financial Data. - ---------------------------------- In August 1990, the company acquired all the outstanding shares of common stock of TelecomUSA. The acquisition was accounted for as a purchase and, accordingly the net assets and results of operations of TelecomUSA are included in the information above since the acquisition date. All per share amounts have been retroactively restated as a result of a two-for-one stock split in the form of a 100% stock dividend, paid on July 9, 1993. Page 15 of 62 Item 7. Item 7. Management's Discussion and Analysis of Financial - ---------------------------------------------------------- Condition and Results of Operations. - ------------------------------------ MANAGEMENT'S DISCUSSION AND ANALYSIS - OVERVIEW Earnings Summary Net income was $582 million, $609 million and $551 million, for the years ended December 31, 1993, 1992 and 1991, respectively. Net income for the year ended December 31, 1993 reflects a pre-tax charge of $150 million, recorded in the fourth quarter, primarily to recognize costs associated with the company's strategic realignment, streamlining of engineering and network operations facilities and relocation of certain operations to lower cost areas. These actions are necessary to better meet the challenging needs of the domestic market, to expand the company's role in global telecommunications and to pursue business opportunities in emerging technologies. Net income for 1993 also includes an extraordinary loss of $45 million, net of tax benefit, for losses on the early retirement of debt. Earnings per share for the year ended December 31, 1993, were $1.12 before the extraordinary loss and $1.04 after it, compared to $1.11 and $1.00, for the years ended December 31, 1992 and 1991, respectively. All earnings per share amounts have been restated as a result of a two-for-one stock split in the form of a 100% stock dividend paid on July 9, 1993. In 1993, the company continued to operate in a single industry segment, the long-distance telecommunications industry. More than 90% of its operating revenue and identifiable assets relate to its activities in this industry. British Telecommunications plc Investment In August 1993, the company and British Telecommunications plc (BT) entered into a definitive agreement providing for a total investment by BT of $4.3 billion in exchange for a new class of common stock giving BT a 20% voting interest in the company. In June 1993, BT purchased $830 million of newly issued shares of convertible preferred stock which will be exchanged for shares of the new class of common stock upon the receipt of the remaining $3.5 billion from BT. The company expects these transactions to be consummated later in 1994 (see Note 2 of the Notes to Consolidated Financial Statements). Page 16 of 62 The company and BT also entered into several other definitive agreements in August 1993, one of which provided for the formation of a joint venture to provide global enhanced and value-added telecommunications services. The company expects to invest approximately $250 million in this venture over the next five years. Another agreement provided for the company's purchase of substantially all of the operations of BT North America Inc. (BTNA), a data services provider. This transaction was completed on January 31, 1994 for a purchase price of $108 million. The company used proceeds from the issuance of commercial paper and cash from operations to fund this purchase. Competitive Strategy In January 1994, the company announced networkMCI, its long-term strategic vision. Initiatives relating to networkMCI will involve a variety of activities, including the expansion of the company's network to create and deliver a wide variety of new branded services. The company estimates that networkMCI will involve substantial investment through the end of the decade, a portion of which is expected to be provided through alliances with other companies. One of the announced networkMCI initiatives is the implementation of high-speed Synchronous Optical Network (SONET) technology throughout the company's domestic network and on international routes across the Atlantic and Pacific. In addition to the implementation of SONET technology, the company plans to increase its network switching capabilities through the implementation of Asychronous Transfer Mode (ATM) technology, which enables a wide range of data communications and wireless communications. The company also announced the creation of MCI Metro, a new subsidiary that will construct fiber rings and local switching infrastructure in major U.S. metropolitan markets over the next several years. This initiative is intended to make local access facilities available to long-distance telecommunications carriers at a reasonable cost and, subject to regulatory constraints, permit MCI Metro to compete in the local telecommunications services market. The total investment in MCI Metro will be approximately $2 billion over the next several years, a portion of which is expected to be provided by alliances with other companies. As part of its international long-term strategy, the company announced, in January 1994, its intention to form a joint venture with Grupo Financiero Banamex-Accival (Banacci) to provide competitive domestic and international long-distance telecommunications services in Mexico. The long-distance market in Mexico will be opened to competition beginning in 1996, with licenses expected to be awarded in late 1994. The joint venture Page 17 of 62 will be 55 percent owned by Banacci and 45 percent by the company. The company plans to make available certain technology to the joint venture in order to facilitate the completion of its integrated North American network. The total investment over the next several years is expected to approximate $450 million, of which $150 million will be made in 1994. The company expects to finance its cash requirements for the foregoing activities from operating cash flow, the proceeds from the BT investment and access to the capital markets. Since all of these investments are in the early stages of development, they will not have a significant impact on the company's results of operations in 1994. The company anticipates that these investments will have a more significant impact on future results of operations as they develop and mature. On February 28, 1994, the company announced another integral part of its networkMCI strategy: a strategic alliance with Nextel Communications, Inc. (Nextel) and Comcast Corporation (Comcast), to provide digital wireless personal communications services throughout the U.S. Subject to regulatory approval, the company plans to invest approximately $1.3 billion in Nextel over the next several years, which equates to approximately a 17 percent interest in Nextel. In addition to the cash investment, the company will bring its marketing expertise, distribution channels and intelligent network to the alliance. Comcast currently owns approximately 17 percent of Nextel and will contribute its expertise in operating cellular and cable systems. These services will be marketed by the company under the company's brand name. Under the terms of the agreement, the company will make an initial investment of $792 million to acquire 22 million shares of Nextel Class A common stock, which is expected to occur in mid-1994. The company has also committed to purchase another 15 million shares of Class A common stock over the next three years, at an average price of $38 per share, to bring its total investment to approximately $1.3 billion. As with other networkMCI initiatives, the company expects to fund this investment from operating cash flow, the proceeds from the remaining BT investment and access to the capital markets. Recent Accounting Pronouncements In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 112, Employers' Accounting for Postemployment Benefits, effective for fiscal years beginning after December 15, 1993. This standard establishes financial accounting and reporting standards for the estimated cost of benefits provided by an employer to former or Page 18 of 62 inactive employees after their employment, but before their retirement, such as continuation of medical coverage. It requires that if defined conditions are met, postemployment benefits must be estimated and accrued rather than recognized as an expense when paid. The adoption of this new standard, in the first quarter of 1994, will not have a material impact on the company's financial position or results of operations. In May 1993, the FASB issued SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, effective for fiscal years beginning after December 15, 1993. This standard establishes new accounting and reporting requirements for certain investments in debt and equity securities. Upon adoption of this new standard in the first quarter of 1994, there will not be a material impact on the company's financial position or results of operations. This standard will be applied to the company's planned investment in Nextel, which is expected to occur in mid-1994. In accordance with the provisions of SFAS 115, any holding gains and losses related to this investment will be excluded from earnings and reported as a net amount in a separate component of stockholders' equity until realized. This standard will also be applied to other applicable investments that may arise as a result of the use of the final proceeds from the BT transaction. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Revenue In 1993, the company's revenue grew 13%, primarily due to growth in traffic volume of 14%. In 1992 and 1991, the company's revenue increased 11% and 12%, respectively, and traffic volume increased 15% and 16%, respectively. The variance between revenue growth and traffic growth in each of the past three years generally reflects the impact of various product promotions and discounts, changes in the mix of products sold and migration of some business customers to lower-priced products. In 1993, this variance narrowed to one percent compared to four percent in each of 1992 and 1991, as a result of growth in international and data revenue, changes in the mix of products sold and increases in certain product prices. While international and data revenues are expected to continue to provide a positive impact on this variance in 1994, competitive pressures in the marketplace may have an unfavorable impact. The overall increase in revenue and traffic over the last three years reflects ongoing growth in all areas of the company's business. Page 19 of 62 Revenue growth from the consumer market is a result of the sustained growth of the company's Friends & Family* brand of products and growth in the international and multilingual markets. The company's initiatives in these areas have resulted in substantial growth in international calling volumes on a year-over-year basis. The company's 1-800-COLLECT* product, introduced in May 1993, also contributed to the revenue growth in the consumer market. In the business market, revenue and traffic grew in each of the last three years primarily as a result of the continued success of the company's virtual private network product, Vnet*. MCI's Vision and Preferred products also experienced growth in these periods and were enhanced by the company's introduction of its Proof Positive** service in 1993. Growth also resulted from 800 products, particularly in 1993 from the initial net gain in signed contracts following the FCC's 800 portability ruling. This ruling, which took effect in May 1993, enables customers to keep their existing 800 numbers when they change long-distance carriers. The company's various data products experienced significant growth in 1993. While data products are not currently a large part of the company's revenue, continued growth is expected due to the anticipated increases in demand for broadband services. Telecommunications expense The principal components of telecommunications expense are the cost of access facilities provided by local exchange carriers and other domestic service providers and the payments made to foreign telephone companies (international settlements) to complete calls made from the U.S. by the company's customers. Telecommunications expense increased 12% in 1993, 11% in 1992 and 15% in 1991, primarily due to growth in the company's domestic and international traffic partially offset by reductions in international settlement and domestic switched access rates, costs savings associated with the company's focus on optimizing network efficiencies and effective use of local exchange carrier term pricing plans. Sales, operations and general Including a 1993 realignment charge of $150 million, sales, operations and general expenses increased by 18% in 1993, 11% in 1992 and 21% in 1991. Excluding the realignment charge, sales, operations and general expenses increased 13% in 1993. These increases generally reflect the overall growth in the company's business. The company recorded the $150 million charge in the fourth quarter of 1993, primarily to recognize costs associated with the company's strategic realignment, streamlining of engineering and Page 20 of 62 network operations facilities and relocation of certain operations to lower cost areas. Also affecting the 1993 increase was the mid-year implementation of new products and services, such as 1-800-COLLECT and Proof Positive, and the increased sales and marketing efforts necessary to take advantage of opportunities provided by the introduction of 800 portability. The 21% increase in 1991 was also attributable to the full-year impact of the purchase of TelecomUSA in August 1990, which resulted in an increase in full-time employees and related compensation expenses. Increased expenses relating to marketing and customer service, as well as expanded use of local telephone companies for billing services, also contributed to the 1991 increase. Other Interest expense decreased in 1993 from the 1992 and 1991 levels. The decreases reflect the interest savings from the early retirement and redemptions of debt, as well as the decline in interest rates during 1993. As a result of the early retirement of debt, the company recorded a $45 million extraordinary loss, net of the applicable tax benefit. In August 1993, legislation was passed which changed various provisions of the federal income tax laws, including an increase in the statutory federal income tax rate for corporations from 34% to 35%, retroactively effective to January 1, 1993. As required by SFAS 109, Accounting for Income Taxes, which the company adopted in the first quarter of 1993, the company recognized the cumulative effect of the changes in the third quarter of 1993, the period of enactment. The primary component of this increase was the required adjustment to the company's net deferred income tax liability at December 31, 1992, to reflect the tax law changes. MANAGEMENT'S DISCUSSION AND ANALYSIS OF LIQUIDITY AND FINANCIAL CONDITION Current assets grew primarily from the increase in accounts receivable reflecting higher 1993 revenue. The adoption of SFAS 109, which resulted in the reporting of a current deferred tax asset, accounted for the remaining portion of the increase. This tax asset was previously reported as a component of the noncurrent deferred tax liability (see Note 7 of the Notes to Consolidated Financial Statements). These increases were partially offset by a decrease in cash, as additional cash was held at December 31, 1992, in anticipation of the April 1993 partial retirement of the company's 10% Subordinated Debentures due April 1, 2011 (10% Debentures). Page 21 of 62 The increase in current liabilities is due mainly to the growth in the company's ongoing business which led to an increase in the company's accounts payable and accrued telecommunications expense. The increase in accrued telecommunications expense resulted from the company's increased revenue, while the increase in accounts payable resulted from increased investment in the company's communications system. The $150 million realignment charge, taken in the fourth quarter of 1993, also increased other accrued liabilities. As discussed in Note 4 of the Notes to Consolidated Financial Statements, the company uses its $1.25 billion bank credit facility in conjunction with its commercial paper program to fund short-term fluctuations in working capital. At December 31, 1993, $239 million of commercial paper borrowings were outstanding and no amounts were outstanding under the credit facility. To ensure ready access to the financial markets, the company also has a shelf registration providing for the issuance of debt securities with a range of possible maturities and interest at fixed or variable rates. At December 31, 1993, the company had $950 million principal amount of debt securities available under this shelf registration. The change in the company's net communications system primarily reflects continued investment in its digital transmission and switching facilities to meet customers' demands for new services, for redundancy and for enhanced network intelligence. This increase was offset primarily by the impact of the 1993 depreciation charge. The company's investment in its communications system resulted in a significant increase in capacity circuit miles, and was funded with cash generated from operating activities and commercial paper and bank credit facility borrowings. Noncurrent liabilities decreased as a result of the company's refinancing of a major portion of its long-term debt in the first half of 1993. This was offset by an increase in the net deferred income tax liability arising from both the effect of implementing SFAS 109 and the deferred income tax provision for 1993. In January 1993, the company issued $200 million of 7 1/8% Senior Notes due January 2000 and $200 million of 8 1/4% Senior Debentures due January 2023. The proceeds were used primarily to repay credit facility and commercial paper borrowings. In March 1993, the company issued $240 million of 7 3/4% Senior Debentures due March 2024. The proceeds from this issuance, along with borrowings under the company's credit facility and commercial paper program, were used to redeem all $616 million, net of unamortized discounts, of the company's Zero-Coupon Subordinated Convertible Notes. Finally, in 1993, the company redeemed all $575 million principal amount of its 10% Debentures. Pursuant to the terms of the indenture, the Page 22 of 62 call price for these debentures was $1,080 per each $1,000 principal amount of debenture, plus accrued and unpaid interest. The company used cash segregated from operations and earnings during both the fourth quarter of 1992 and the first quarter of 1993 to retire $283 million principal amount of these debentures. The remaining redemption of $292 million principal amount was funded by the proceeds of the June 1993 issuance of preferred stock to BT for $830 million. The remaining portion of the preferred stock proceeds was used to repay credit facility and commercial paper borrowings and execute an early buyout of a construction lease. Stockholders' equity increased primarily as a result of the aforementioned issuance of preferred stock. Additionally, the change reflects the additions to retained earnings from net income for 1993 and common stock issued in connection with employee benefit plans, partially offset by purchases of treasury stock during the year. The company's ratio of debt to total debt plus equity has been reduced substantially, to 35% at December 31, 1993, from 54% at December 31, 1992, as a result of the debt restructuring and increase in stockholders' equity. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CASH FLOWS Cash from Operating Activities Cash flows from operating activities in 1993 reflect the overall increase in the company's business volume during the year. Cash receipts from customers increased approximately 12% in 1993, primarily from the 13% growth in revenue offset by the increase in accounts receivable during the year. Cash paid to suppliers and employees increased 12%, while operating expenses, less depreciation expense, increased approximately 14%. The difference relates primarily to the realignment charge of $150 million, which was a non-cash item. The cash outflow for the realignment charge will be reflected as a component of cash from operating activities. Cash Used for Investing Activities The increase in cash used for investing activities is a result of an increase in capital expenditures of approximately $460 million related primarily to increased network capacity, necessary to support the company's growth in business. In 1993, the company continued to expand and enhance its digital transmission and switching facilities to meet customers' demands for new services, redundancy and enhanced network intelligence. Significant additions in 1993 included the construction of several major interstate fiber routes and the completion of a new data center. The remainder of the increase relates to acquisitions and dispositions of minor business ventures during the year. Page 23 of 62 As a result of its networkMCI strategy, the company is planning capital expenditures of cash in the range of $2.5 to $3.0 billion in 1994. In management's opinion, the company's cash generated from operating activities, the remaining $3.5 billion of proceeds from BT and the company's ability to borrow will be sufficient to maintain an adequate level of funding to finance these expenditures, the investment in Nextel and other 1994 investments associated with networkMCI. Cash Used for Financing Activities Cash used for financing activities in 1993 reflects activities designed to position the company for future business expansion. As discussed in the Liquidity and Financial Condition section, the company refinanced or redeemed a significant portion of its long-term debt in the first half of 1993. In addition, the company had a net decrease in commercial paper and bank credit facility borrowings during 1993 and purchased more treasury stock than in 1992. The cash proceeds from the sale of preferred shares to BT and the impact of increased employee stock option exercises, reflecting the favorable performance of the company's stock during the year, partially offset the outflow of cash in 1993 as mentioned above. ITEM 8. ITEM 8. BEGINS ON THE NEXT PAGE - ---------------------------------- Friends & Family, 1-800-COLLECT and Vnet are registered service marks of MCI Communications Corporation. ** Proof Positive is a service mark of MCI Communications Corporation. Page 24 of 62 Item 8. Financial Statements and Supplementary Data. - ----------------------------------------------------- REPORT OF MANAGEMENT The management of the company is responsible for the financial information and representations contained in the financial statements, notes and all other sections of the annual report. The financial statements have been prepared in conformity with generally accepted accounting principles appropriate under the circumstances to reflect, in all material respects, the substance of events and transactions which have occurred. In preparing the financial statements, it is necessary that management make informed estimates and judgments based on currently available information in order to record the results of certain events and transactions. The company maintains a system of internal controls designed to enable management to meet its responsibility for reporting reliable financial information. The system is designed to provide reasonable assurance that assets are safeguarded and transactions are recorded and executed with management's authorization. Internal control systems are subject to inherent limitations due to the necessity to balance costs incurred with benefits provided. The company believes that the existing system of internal controls provides reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected in a timely manner. The board of directors pursues its oversight role for the financial statements through its audit committee, which is comprised solely of directors who are not officers or employees of the company. They are responsible for engaging, subject to stockholder approval, the independent accountants. The audit committee meets periodically with management and the independent accountants to review their activities in connection with financial reporting matters. The independent accountants have full and free access to meet with the audit committee, without management representatives present, to discuss the results of their examination and the adequacy and quality of internal controls and financial reporting. The report of our independent accountants, Price Waterhouse, appears herewith. Their audit of the financial statements includes a review of the company's system of internal controls and testing of records as required by generally accepted auditing standards. BRADLEY E. SPARKS - ----------------- Bradley E. Sparks Vice President and Controller January 26, 1994 Page 25 of 62 REPORT OF INDEPENDENT ACCOUNTANTS Price Waterhouse To the Board of Directors and Stockholders of MCI Communications Corporation In our opinion, the accompanying balance sheet and the related consolidated income statement, statements of cash flows and stockholders' equity present fairly, in all material respects, the financial position of MCI Communications Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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 the opinion expressed above. /s/PRICE WATERHOUSE - ------------------- PRICE WATERHOUSE January 26, 1994 Washington, D.C. Page 26 of 62 INCOME STATEMENT MCI Communications Corporation and Subsidiaries Year ended December 31, 1993 1992 1991 (In millions, except per share amounts) ---- ---- ---- Revenue Sales of communications services $11,921 $10,562 $9,491 ------- ------- ------ Operating expenses Telecommunications 6,373 5,684 5,112 Sales, operations and general 3,310 2,794 2,512 Depreciation 970 873 776 ------- ------- ------ Total operating expenses 10,653 9,351 8,400 ------- ------- ------ Income from operations 1,268 1,211 1,091 Interest expense (178) (218) (212) Other expense, net (45) (30) (31) ------- ------- ------ Income before income taxes and extraordinary item 1,045 963 848 Income tax provision 418 354 297 ------- ------- ------ Income before extraordinary item 627 609 551 Extraordinary loss on early debt retirements, less applicable tax benefit of $26 million 45 - - ------- ------- ------ Net income $ 582 $ 609 $ 551 ======= ======= ====== Dividends on preferred stock 1 20 29 ------- ------- ------ Earnings applicable to common stockholders $ 581 $ 589 $ 522 ======= ======= ====== Earnings per common and common equivalent shares Income before extraordinary item $ 1.12 $ 1.11 $ 1.00 Loss on early debt retirements (.08) - - ------- ------- ------ Total $ 1.04 $ 1.11 $ 1.00 ======= ======= ====== See accompanying Notes to Consolidated Financial Statements Page 27 of 62 BALANCE SHEET MCI Communications Corporation and Subsidiaries December 31, 1993 1992 (In millions) ---- ---- Assets Current assets Cash and cash equivalents $ 165 $ 232 Receivables, net of allowance for uncollectibles of $211 and $189 million 2,131 1,764 Deferred income taxes 116 - Other 189 185 ------- ------ Total current assets 2,601 2,181 ------- ------ Communications system System in service 8,563 7,723 Other property and equipment 2,172 1,924 ------- ------ Total communications system in service 10,735 9,647 ------- ------ Accumulated depreciation (4,297) (4,151) Construction in progress 883 669 ------- ------ Total communications system, net 7,321 6,165 ------- ------ Other assets Excess of cost over net assets acquired, net 1,093 1,111 Other assets and deferred charges, net 261 221 ------- ------ Total other assets 1,354 1,332 ------- ------ Total assets $11,276 $9,678 ======= ====== Page 28 of 62 Liabilities and stockholders' equity Current liabilities Accrued telecommunications expense $ 1,507 $1,175 Accounts payable 742 467 Long-term debt due within one year 215 215 Other accrued liabilities 737 607 ------- ------ Total current liabilities 3,201 2,464 ------- ------ Noncurrent liabilities Long-term debt 2,366 3,432 Deferred income taxes 927 558 Other 69 74 ------- ------ Total noncurrent liabilities 3,362 4,064 ------- ------ Stockholders' equity Series D convertible preferred stock, $.10 par value, authorized and outstanding 13,736 shares 1 - Common stock, $.10 par value, authorized 800 million shares, issued 592 and 296 million shares 60 30 Additional paid in capital 2,493 1,479 Retained earnings 2,785 2,231 Treasury stock at cost, 51 and 33 million shares (626) (590) ------- ------ Total stockholders' equity 4,713 3,150 ------- ------ Total liabilities and stockholders' equity $11,276 $9,678 ======= ====== See accompanying Notes to Consolidated Financial Statements Page 29 of 62 STATEMENT OF CASH FLOWS MCI Communications Corporation and Subsidiaries Year ended December 31, 1993 1992 1991 (In millions) ---- ---- ---- Operating activities Cash received from customers $11,546 $10,328 $9,362 Cash paid to suppliers and employees (9,097) (8,154) (7,597) Taxes paid (321) (292) (292) Interest paid (150) (156) (202) ------- ------- ------ Cash from operating activities 1,978 1,726 1,271 ------- ------- ------ Investing activities Cash outflow for communications system (1,733) (1,272) (1,377) Other, net (26) 11 1 ------- ------- ------ Cash used for investing activities (1,759) (1,261) (1,376) ------- ------- ------ Net cash flow before financing activities 219 465 (105) ------- ------- ------ Financing activities Issuance of Senior Notes and other debt 756 481 527 Retirement of Senior Notes and other debt (1,468) (218) (504) Commercial paper and bank credit facility activity, net (497) (69) (84) Issuance of preferred stock 830 - - Redemption of preferred stock - (400) - Purchase of treasury stock (198) (180) - Issuance of common stock for employee plans 319 168 79 Payment of dividends on common and preferred stock (28) (56) (55) ------- ------- ------ Cash used for financing activities (286) (274) (37) Net (decrease) increase in cash and cash equivalents (67) 191 (142) Cash and cash equivalents at beginning of year 232 41 183 ------- ------- ------ Cash and cash equivalents at end of year $ 165 $ 232 $ 41 ======= ======= ====== See accompanying Notes to Consolidated Financial Statements Page 30 of 62 STATEMENT OF STOCKHOLDERS' EQUITY MCI Communications Corporation and Subsidiaries See accompanying Notes to Consolidated Financial Statements Page 31 of 62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MCI Communications Corporation and Subsidiaries NOTE 1. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The financial statements include the consolidated accounts of MCI Communications Corporation and its majority-owned subsidiaries (collectively, the company). All significant intercompany transactions are eliminated in the financial statements. Investments in 20% to 50% owned companies are accounted for under the equity method. Other investments are recorded at cost. Revenue The company records as revenue the amount of communications services rendered, as measured by the minutes of traffic processed, after deducting an estimate of the traffic which will be neither billed nor collected. Communications System The investment in communications system is recorded at cost and includes material, interest, labor and overhead. The costs of construction and equipment are transferred to communications system in service as construction projects are completed and/or equipment is placed in service. Depreciation is recorded commencing with the first full month that the assets are in service and is provided using the straight-line method over their estimated useful lives. The company periodically reviews and adjusts the useful lives assigned to fixed assets to ensure that depreciation charges provide appropriate recovery of capital costs over the estimated physical and technological lives of the assets. Writedowns related to assets not yet retired are included in accumulated depreciation. The weighted average depreciable life of the assets comprising the communications system in service approximates 11 years. Other property and equipment includes buildings and administrative assets that are depreciated using lives of up to 35 years. Most of the company's communications system assets are depreciated under the group method. Under this method the cost of equipment retired in the ordinary course of business, less proceeds, is charged to accumulated depreciation. Maintenance and repairs are charged to expense as incurred. Excess of Cost Over Net Assets Acquired Excess of cost over net assets acquired consists of the excess of the cost to acquire subsidiaries over the estimated fair market value of the net assets acquired. These amounts are being amortized by the use of the straight-line method over lives ranging from 10 to 40 years. Accumulated amortization at December 31, 1993 and 1992 was $101 million and $70 million, respectively. Page 32 of 62 Other Assets and Deferred Charges Included in other assets and deferred charges are investments in nonconsolidated entities, right-of-way agreements with third parties, debt issuance costs and unamortized customer discounts. Right-of-way costs are amortized as the assets are placed in service, over the lesser of the remaining term of the agreements or 25 years. Debt issuance costs are amortized over the life of the applicable debt. Deferred customer discounts are amortized over the life of the specific contract to which the discount relates. Capital Leases Certain of the company's lease obligations meet the criteria of a capital lease. These obligations are recorded for financial reporting purposes at the present value of the future lease payments, including estimated bargain purchase options, discounted at the approximate interest rate implicit in each lease. Corresponding amounts are capitalized and depreciated over the estimated useful lives of the equipment, which are generally longer than the terms of the leases. Income Taxes The company files a consolidated federal income tax return on a March 31 fiscal year-end. Deferred income taxes are provided on transactions which are reported in the financial statements in different periods than for income tax purposes. Tax credits are recorded under the flow-through method of accounting. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes (see Note 7). SFAS 109 superseded a similar standard on income tax accounting, SFAS 96, which the company had been using as the basis for recording its income taxes. The adoption of SFAS 109 had no impact on the company's results of operations. Income tax benefits of tax deductions related to common stock transactions with the company's employee benefit plans are recorded directly to additional paid in capital. Earnings Per Share Earnings per share are computed on the basis of the weighted average number of shares of common stock outstanding during each year. These weighted average shares are adjusted for the effect of common stock equivalents arising from the assumed exercise of stock options and subordinated convertible debt, if dilutive, and the assumed conversion of the Series D preferred stock. The weighted average number of shares used in the per share computations for each of the years was: 562 million shares in 1993, 532 million shares in 1992 and 520 million shares in 1991. Fully diluted earnings per share are not materially different from primary earnings per share. Page 33 of 62 Cash and Cash Equivalents At December 31, 1993 and 1992, checks not yet presented for payment of $193 million and $163 million in excess of cash balances, respectively, are included in current liabilities. The company had sufficient funds available to cover these outstanding checks when they were presented for payment. Cash equivalents consist of short-term investments with original maturities of ninety days or less. The carrying amount reported in the accompanying balance sheet for cash equivalents approximates fair value due to the short-term maturity of these instruments. Reclassification Certain prior year information has been reclassified to conform to the current year presentation. NOTE 2. BRITISH TELECOMMUNICATIONS PLC AGREEMENTS On June 2, 1993, the company and British Telecommunications plc (BT and, collectively with the company, the Parties) entered into a letter of intent and, on August 4, 1993, entered into superseding definitive agreements, providing for, among other things, (a) the purchase by BT at closing of a number of shares of a new class of voting common stock (Class A Common Stock) of the company, to be authorized by stock- holders, for approximately $3.5 billion in cash, (b) the formation of an international joint venture between BT and the company to provide global enhanced and value-added telecommunications services and (c) several other transactions, including the January 31, 1994 purchase of substantially all of the operations of BT North America Inc. by the company for $108 million. On June 4, 1993, the company issued 13,736 shares of Series D nonvoting convertible preferred stock to BT at a purchase price of $60,400 per share, which, if converted on that date, would have equated to approximately 4.9% of the outstanding common stock of the company. Each share of the preferred stock is entitled to receive dividends equal to 2,000 times the dividends or other distributions, if any, declared on the company's common stock. Each share of preferred stock will automatically convert into 2,000 shares of the company's common stock, subject to certain anti-dilution protections, upon expiration or termination of the waiting period, including any extensions thereof, under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, (the HSR Act) applicable to the conversion of the preferred stock. Each share of the company's common stock so issuable will be exchanged for one share of Class A Common Stock upon consummation of the transactions contemplated by the definitive agreements. In addition, if the Parties have terminated the transactions contemplated by the definitive agreements, each share of the preferred stock will be convertible into 2,000 shares of the company's common stock, subject to the satisfaction of certain conditions. BT has agreed not to transfer the preferred stock or Page 34 of 62 common stock issuable upon conversion until June 1995 and thereafter may transfer such shares subject to compliance with the registration requirements of U.S. federal securities laws. Generally, any shares of preferred stock will automatically convert into common stock on transfer. The Class A Common Stock of the company to be issued to BT under the definitive agreements will be equivalent on a per share basis to the existing common stock of the company, except with respect to voting rights. BT's Class A shares will entitle it to proportionate representation on the company's board of directors, which currently equates to three seats. In addition to board representation, BT will be entitled to investor protections with respect to certain corporate actions of the company. Any shares of Class A Common Stock would automatically convert into common stock on transfer. The transactions are subject to a number of conditions, including the approval of the company's stockholders; required approvals by the European Commission, United Kingdom regulatory authorities and Federal Communications Commission; and the expiration of waiting periods under the HSR Act and Exon-Florio statute. The shares of Class A Common Stock issuable to BT upon conversion of the preferred stock and the shares of Class A Common Stock to be issued to BT under the definitive agreements, will represent approximately 20% of the company's outstanding common stock at that time. The blended purchase price of the Class A Common Stock is $32 per share. The Parties plan to invest approximately $1 billion in the joint venture over the next five years. At inception, BT will hold 75.1% of the new venture's equity, with the company holding the remaining 24.9%. Each of the Parties will be exclusive distributors, in their respective territories, for marketing the global services produced by the joint venture. NOTE 3. LEASE TRANSACTIONS The amounts included in the communications system financed by capital leases are: December 31, 1993 1992 (In millions) System in service $ 783 $ 986 Other property and equipment 16 6 ------ ------ 799 992 Accumulated depreciation (440) (589) ------ ------ $ 359 $ 403 ====== ====== Page 35 of 62 Leases not capitalized are primarily for land on which communications equipment is located and for administrative facilities, including office buildings, vehicles, certain data processing equipment and office equipment. Total rental expense for all operating leases was $227 million, $229 million and $192 million for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, the future aggregate minimum rental commitments for capital leases and noncancellable operating leases are: Year ended Capital Operating December 31, Leases Leases Total (In millions) ------- --------- ------ 1994 $ 139 $ 150 $ 289 1995 121 124 245 1996 103 101 204 1997 103 76 179 1998 50 57 107 thereafter 683 166 849 ------ ------ ------ Minimum lease payments 1,199 $ 674 $1,873 ====== ====== Amount representing interest (510) ------ Present value of future lease payments $ 689 ====== NOTE 4. LONG-TERM DEBT Long-term debt consists of: December 31, 1993 1992 (In millions) ---- ---- Senior Notes, with maturities ranging from February 1994 to August 2004, at a weighted average interest rate of 7.2% $1,095 $ 868 Capital lease obligations at a weighted average interest rate of 7.6% 689 732 Senior Debentures, with maturities of January 2023 and March 2024, at a weighted average interest rate of 8.0%, net of unamortized discount of $3 million 437 - Commercial paper and bank credit facility borrowings at a weighted average interest rate of 3.5% 239 736 Zero-Coupon Subordinated Convertible Notes due December 11, 2004, net of unamortized discount of $697 million - 608 Page 36 of 62 10% Subordinated Debentures due April 1, 2011, net of unamortized discount of $9 million - 566 Other debt at a weighted average interest rate of 3.2% 121 137 ------ ------ Total debt 2,581 3,647 Debt due within one year (215) (215) ------ ------ Total long-term debt $2,366 $3,432 ====== ====== Annual maturities of long-term debt for the five years after December 31, 1993 are as follows: $215 million in 1994; $107 million in 1995; $643 million in 1996; $119 million in 1997 and $88 million in 1998. Total interest costs were $239 million in 1993, $270 million in 1992 and $270 million in 1991, of which $61 million, $52 million and $58 million, respectively, were capitalized. At December 31, 1993, the estimated fair value of the company's long-term debt, excluding capital lease obligations, is as follows. This valuation represents either quoted market values, when available, or the company's estimate based upon market prices of comparable debt instruments. Estimated Carrying Fair Amount Value (In millions) -------- --------- Senior Notes $1,095 $1,159 Senior Debentures 437 462 Commercial paper and bank credit facility borrowings 239 239 Other debt 121 121 Senior Notes and Debentures During 1993, the company issued $760 million principal amount of Senior Notes and Debentures under the current and previous shelf registrations. The company also repaid $93 million principal amount of Senior Notes during 1993, leaving $1,535 million principal amount of Senior Notes and Debentures outstanding at December 31, 1993. On March 31, 1993, the company filed a $1 billion shelf registration after issuing all the debt securities available under the previous $750 million shelf registration. The current shelf registration renews the company's ability to issue debt securities with a range of possible maturities at either fixed or variable rates. At December 31, 1993, the company had $950 million of available borrowings under the current shelf registration. Page 37 of 62 Commercial Paper and Bank Credit Facility Borrowings At December 31, 1993, the company had a $1.25 billion bank credit facility which expires in June 1996. This credit facility supports the company's commercial paper program and, in conjunction with this program, is used to fund fluctuations in working capital and other general corporate requirements. During 1993, the company issued commercial paper and borrowed under this credit facility an aggregate of $4,906 million and repaid an aggregate of $5,403 million of credit facility and commercial paper borrowings, leaving $239 million of commercial paper outstanding and no amounts outstanding under the credit facility at December 31, 1993. Borrowings under the commercial paper program and credit facility are classified as noncurrent if the remaining term of the credit facility agreement exceeds one year and the unused commitment thereunder equals or exceeds the amount of commercial paper then outstanding. Retirements and Redemptions In March 1993, the company redeemed all $616 million, net of the unamortized discount, of its Zero-Coupon Subordinated Convertible Notes due December 11, 2004. The funds for this redemption came from the issuance of Senior Notes and Debentures and commercial paper and credit facility borrowings. In April and May 1993, the company redeemed a total of $283 million principal amount of its 10% Subordinated Debentures due April 1, 2011 (10% Debentures). These redemptions were funded from segregated cash generated by the company's operations and earnings during the fourth quarter of 1992 and the first quarter of 1993. In June 1993, the remaining $292 million principal amount of 10% Debentures were redeemed, funded with a portion of the proceeds from the sale of preferred stock to British Telecommunications plc (see Note 2). An extraordinary loss of $45 million, net of current income tax benefit of $26 million, was recorded for the 1993 redemptions. There were no redemptions or early retirements of debt in 1992. In 1991, the company retired its $250 million principal, 7.44% promissory note due October 23, 1996. The funds for this retirement came from the issuance of Senior Notes. The resulting gain on retirement was not significant. NOTE 5. STOCKHOLDERS' EQUITY Preferred Stock The company is authorized to issue 20 million shares of preferred stock at $.10 par value per share. The terms and conditions are determined by the board of directors at each issuance. Page 38 of 62 In June 1993, the company issued 13,736 shares of preferred stock, designated as Series D Convertible preferred stock, to BT for $830 million. Each share of preferred stock will automatically convert into 2,000 shares of the company's common stock, subject to certain conditions and is entitled to receive dividends equal to 2,000 times the dividends or other distributions, if any, declared on the company's common stock (see Note 2). The company paid a dividend of $100 per share on this convertible preferred stock in 1993. At December 31, 1991, the company had outstanding two million shares of preferred stock, designated as Increasing Rate Cumulative Preferred Stock, totalling $400 million, which had semiannual dividends of $7.35 per share. During September 1992, all two million outstanding shares were redeemed and retired for $400 million plus accrued and unpaid dividends. Common Stock On May 24, 1993, the company's board of directors declared a two-for-one stock split in the form of a 100% stock dividend, which was paid on July 9, 1993, to stockholders of record as of the close of business on June 11, 1993. The following have been adjusted for the effect of the common stock dividend: all per share amounts, current year treasury stock transactions, the December 31, 1993, treasury stock share balance and data as to common stock options and the employee stock purchase plan. In 1993, 1992 and 1991, the company paid dividends of $.05 per share on its common stock. NOTE 6. STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS Employee and Directors' Stock Option Plans The current Employee Stock Option Plan (the Plan) provides for the issuance of up to 76 million shares of common stock. On an annual basis, pursuant to the Plan, the board of directors may increase the maximum number of shares as of each January 1, by up to 5% of the number of shares of common stock outstanding at each such date. Options granted under the Plan are exercisable at such times and in such installments as determined by the compensation committee of the board of directors. Options granted under the Plan may not have an option price less than the fair market value of common stock on the date of the grant. Stock appreciation rights may be granted in combination with a stock option either at the time of the grant or anytime thereafter. No stock appreciation rights had been granted as of December 31, 1993. The compensation committee may also grant restricted stock awards and performance share awards, subject to such conditions, restrictions and requirements as the committee may determine in its sole discretion. As of December 31, 1993, there were approximately 510,000 restricted Page 39 of 62 shares issued. No performance share awards had been issued as of December 31, 1993. The compensation committee may grant both incentive stock options and non-qualified options under the Plan. All options granted in the last three years were non-qualified options. These non-qualified options expire after 10 years and are exercisable to the extent of 33% of the option shares after one year, 66% after two years and 100% after three years. Incentive stock options expire between five and 10 years after issuance and are exercisable to the extent of 33% of the option shares after one year, 66% after two years and 100% after three years. The Plan permits the holder of an option to pay the purchase price for stock option exercises by surrendering shares of common stock having a fair market value equal to, or greater than, the purchase price. The company also has a stock option plan for non-employee directors (the Directors' Plan) which provides for the issuance of up to one million shares of common stock. Under the Directors' Plan each non-employee director has been granted a five-year option to purchase up to 40,000 shares of common stock at the closing price on the date of grant. The options are exercisable after the first anniversary of the date of grant, in cumulative installments of 25% per year. Similar options will be granted automatically to all new board members who are not employees. Upon the fifth anniversary of the date of grant of options, the unexercised portion of the grant shall be canceled and a new option for 40,000 shares shall be granted automatically. Additional information with respect to stock options under these plans is: Option Amount Number ----------------------- of Shares Per Common Share Total --------- ---------------- ----- (In millions, except per common share amounts) Shares under option, December 31, 1990 30.0 $ 2.69-22.44 $394.7 Options granted 21.4 9.94-14.44 215.1 Options exercised (4.0) 2.69-12.88 (24.9) Options terminated (2.6) 2.69-19.57 (38.6) ---- ------------ ------ Shares under option, December 31, 1991 44.8 2.69-22.44 546.3 Options granted 17.0 15.82-17.38 269.7 Options exercised (9.0) 2.69-19.57 (85.2) Options terminated (2.8) 2.69-22.44 (39.9) ---- ------------ ------ Shares under option, December 31, 1992 50.0 3.25-22.44 690.9 Options granted 18.6 20.56-28.75 394.5 Options exercised (15.0) 3.25-22.44 (202.4) Options terminated (2.3) 9.38-28.75 (40.6) ---- ------------ ------ Shares under option, December 31, 1993 51.3 $ 3.44-28.75 $842.4 ==== ============ ====== Options exercisable, December 31, 1993 18.0 $ 3.44-22.44 $255.6 ==== ============ ====== Page 40 of 62 Shares available for future grant, December 31, 1993 12.5 ==== Employee Stock Purchase Plan Under the company's Employee Stock Purchase Plan (the ESPP Plan), 25 million shares of common stock are available for purchase by eligible employees of the company through payroll deductions of up to 15% of their eligible compensation. The purchase price is equal to the lesser of (a) 85% of the fair market value of the stock on the date it is purchased or (b) 85% of the fair market value of the stock on certain specified valuation dates. Common Stock Reserved At December 31, 1993, 70.8 million shares of the company's authorized common stock were reserved for the Employee and Directors' Stock Option Plans and the ESPP Plan. However, the company has opted to fund its obligation under these plans with treasury shares for the three-year period ended December 31, 1993. NOTE 7. INCOME TAXES The components of the total income tax provision are: Year ended December 31, 1993 1992 1991 (In millions) ---- ---- ---- Current Federal $148 $121 $ 80 State and local 17 20 14 ---- ---- ---- Current income tax provision 165 141 94 ---- ---- ---- Deferred Federal 227 193 181 State and local 26 20 22 ---- ---- ---- Deferred income tax provision 253 213 203 ---- ---- ---- Total income tax provision $418 $354 $297 ==== ==== ==== A reconciliation of the statutory federal income tax rate to the company's effective income tax rate is: Year ended December 31, 1993 1992 1991 ---- ---- ---- Statutory federal income tax rate 35% 34% 34% State and local income taxes, net of federal income tax effect 3 3 3 Nondeductible amortization 1 1 1 Adjustment of prior period estimates - (1) (3) Changes in federal tax laws 1 - - ---- ---- ---- Effective income tax rate 40% 37% 35% ==== ==== ==== Page 41 of 62 In 1993, 1992 and 1991 the company recorded a tax benefit of $36 million, $18 million and $17 million, respectively, to additional paid in capital for tax deductions related to common stock transactions with its employee benefit plans. At December 31, 1993 and 1992, the company's net deferred income tax liability is comprised of the following: 1993 1992 ---- ---- (In millions) Deferred income tax asset $ 338 $ 292 Deferred income tax liability (1,149) (850) ------- ----- Net deferred income tax liability $ (811) $(558) ======= ===== The components of these amounts are: Communications system $(1,097) $(831) Allowance for uncollectibles 20 50 Realignment expenses 56 - License fees 29 35 Customer discounts (43) (5) Alternative minimum and general business tax credits 116 83 Other, net 108 110 ------- ----- Net deferred income tax liability $ (811) $(558) ======= ===== The balance sheet presentation of deferred income taxes under SFAS 109 requires the company to separately disclose its current and long-term deferred tax balances on a different basis than that required by SFAS 96. Under SFAS 96, the company's current deferred tax balances were immaterial and, therefore, deferred taxes were presented as a single net liability in the 1992 balance sheet. The company has not recorded any valuation allowances against its deferred income tax assets, either upon adoption of SFAS 109 or during the year ended December 31, 1993. In August 1993, legislation was passed which changed various provisions of the federal income tax laws, including an increase in the statutory federal income tax rate for corporations from 34% to 35%, retroactively effective to January 1, 1993. The company's net deferred income tax liability was increased by approximately $13 million to reflect the impact of the tax law changes on the net deferred income tax liability as of December 31, 1992. At December 31, 1993, for federal income tax purposes, the company has available $35 million of net operating loss carryforwards, $35 million of Alternative Minimum Tax (AMT) net operating loss carryforwards, $83 Page 42 of 62 million of general business tax credit carryforwards expiring after the year 2000 and $180 million of AMT credit carryforwards which have no expiration date. At December 31, 1993 and 1992, there are no carryforwards for financial reporting purposes. NOTE 8. EMPLOYEE BENEFIT PLANS Pension Plans The company maintains a noncontributory defined benefit pension plan (MCI Plan) and a supplemental pension plan (Supplemental Plan). Western Union International, Inc. (WUI), a subsidiary of the company, also has a defined benefit plan (WUI Plan). Collectively, these plans cover substantially all full-time employees. The company's policy is to fund the MCI Plan and the WUI Plan in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974. The MCI Plan and the Supplemental Plan provide pension benefits that are based on the employee's compensation for each year of service prior to retirement. The WUI Plan provides pension benefits based on the employee's compensation for each year of service after 1990 and prior to retirement. Net pension expense includes: Year ended December 31, 1993 1992 1991 (In millions) ---- ---- ---- Service cost during the period $18 $15 $11 Interest cost on projected benefit obligation 14 12 10 Actual return on plan assets (36) (11) (28) Net amortization and deferral 22 (2) 18 --- --- --- Net pension expense $18 $14 $11 === === === The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation for the MCI Plan were 7.75% and 5%, respectively. The expected long-term rate of return on assets was 9%. The decrease in the funded status as of December 31, 1993 is a direct result of the decrease in the discount rate from the 8.5% rate used in 1992. Page 43 of 62 The MCI Plan pension obligation consists of: December 31, 1993 1992 (In millions) ---- ---- Plan assets at fair value, primarily listed stocks and U.S. bonds $110 $ 88 Projected benefit obligation for service rendered to date (164) (105) ---- ---- Funded status (54) (17) Unrecognized net results from past experience different from that assumed 25 2 Prior service cost not yet recognized in net periodic pension cost 17 11 Unrecognized net asset at January 1, 1986 being recognized over 16 years (4) (5) ---- ---- Total pension obligation $(16) $( 9) ==== ==== The actuarial present value of accumulated benefit obligations for the MCI Plan is $127 million and $82 million, including vested benefits of $111 million and $62 million, as of December 31, 1993 and 1992, respectively. The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation for the WUI Plan were 7.25% and 5%, respectively. The expected long-term rate of return on assets was 9%. The WUI Plan pension (obligation)/asset consists of: December 31, 1993 1992 (In millions) ---- ---- Plan assets at fair value, primarily listed stocks and U.S. bonds $ 78 $ 72 Projected benefit obligation for service rendered to date (60) (53) ---- ---- Funded status 18 19 Unrecognized net results from past experience different from that assumed (20) (15) Prior service cost not yet recognized in net periodic pension cost 1 1 Unrecognized net asset at January 1, 1986 being recognized over 17 years (2) (2) ---- ---- Total pension (obligation)/asset $ (3) $ 3 ==== ==== Page 44 of 62 The actuarial present value of accumulated benefit obligations is $59 million and $51 million, including vested benefits of $57 million and $50 million, as of December 31, 1993 and 1992, respectively. Employee Stock Ownership Plan and 401(k) Plans The company has combined employee stock ownership (ESOP) and 401(k) retirement savings plans (RSP) covering substantially all of its employees. The savings plans allow employees to contribute pre-tax income in accordance with the requirements of Internal Revenue Code Section 401(k). Participants vest in the company's matching contributions at a rate of 20% per year of service and are 100% vested in their elective contributions. In accordance with the terms of the ESOP, the company is entitled to make an annual contribution to the ESOP, either in cash or shares of the company's common stock, in amounts as determined by the board of directors. During 1993, the company announced an increase in the company's match on 401(k) contributions for plan years beginning in 1994 and that it would not make an ESOP contribution for 1993. In lieu of a 1993 ESOP contribution, the company will make a similarly-calculated contribution for all eligible employees into the 401(k) section of the plans during the first quarter of 1994. The company contributed 1,015,414 and 1,137,588 shares of its common stock to the ESOP for the plan years ended December 31, 1992 and 1991, respectively. The company also contributed 791,447, 904,796 and 916,132 shares of its common stock as the company's matching contribution to the RSP for the plan years ended December 31, 1993, 1992 and 1991, respectively. WUI sponsors a 401(k) savings plan for its collectively bargained employees (WUI 401(k)). The savings plan is intended to meet requirements of Internal Revenue Code Section 401(k). WUI 401(k) participants vest in the company's matching contributions at a rate of 20% per year of service and are 100% vested in their elective contributions. The company contributed 18,974, 27,486 and 28,550 shares of its common stock to the WUI 401(k) for the plan years ended December 31, 1993, 1992 and 1991, respectively. Postretirement and Postemployment Benefits Effective January 1, 1993, the company adopted SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS 106 requires that certain postretirement benefits, such as medical insurance coverage, be estimated and accrued over an employee's working years, rather than recognized as an expense when paid. Except for pensions, the company does not generally provide postretirement benefits to its employees. Accordingly, adoption of SFAS 106 did not have a material impact on the company's financial position or results of operations. The company elected to amortize the transition obligation for the covered employees on a straight-line basis over 20 years. Page 45 of 62 In November 1992, the Financial Accounting Standards Board issued SFAS 112, Employers' Accounting for Postemployment Benefits, effective for fiscal years beginning after December 15, 1993. This standard established financial accounting and reporting standards for the estimated cost of benefits provided by an employer to former or inactive employees after their employment, but before their retirement, such as continuation of medical coverage. It will require that if defined conditions are met, postemployment benefits be estimated and accrued rather than recognized as an expense when paid. The company intends to adopt this new standard in the first quarter of 1994. Adoption of this new standard will not have a material impact on the company's financial position or results of operations. NOTE 9. CASH FLOW INFORMATION The reconciliation of net income in the Income Statement to cash from operating activities in the Statement of Cash Flows is as follows: Year ended December 31, 1993 1992 1991 (In millions) ---- ---- ---- Net income $ 582 $ 609 $ 551 Adjustments to earnings: Depreciation and amortization 1,019 955 855 Deferred income tax provision 253 213 203 Net change in operating activity accounts other than cash and cash equivalents: Receivables (370) (155) (157) Accounts payable (68) (120) 128 Other operating activity accounts 562 224 (309) ------ ------ ------ Cash from operating activities $1,978 $1,726 $1,271 ====== ====== ====== NOTE 10. CONTINGENCIES The company is a party to a number of lawsuits and other proceedings arising out of the conduct of its business, including certain regulatory proceedings. While the ultimate results of lawsuits or other proceedings cannot be predicted with certainty, the company's management does not expect that these matters will have a material adverse effect on the consolidated financial position or results of operations of the company. In December 1992, the company petitioned the United States District Court for the District of Columbia for a declaratory ruling that certain patents of American Telephone & Telegraph Company (AT&T) were invalid or that AT&T should be barred from enforcing them against the company. AT&T counterclaimed that the company was violating certain additional patents. In May 1993, AT&T and Unitel Communications Inc., a Canadian corporation in which AT&T has an equity interest, filed a Page 46 of 62 companion suit in the federal court in Canada, alleging that the company and the Stentor Group of Canadian telephone companies (with which the company has an alliance) are infringing in Canada four of the patents at issue in the U.S. litigation. Although these actions are in their early stages, the company does not expect that either of these matters will have a material adverse effect on the consolidated financial position or results of operations of the company. In 1990, certain stockholders of the company filed an action in the United States District Court for the District of Columbia alleging that the company and three of its officers violated securities laws by making material misstatements of, or omitting to state, material facts relating to its financial condition and prospects. In May 1992, the District Court granted the company's Motion to Dismiss, but the plaintiffs have filed an appeal. The company will vigorously defend the District Court's dismissal of the action in the Court of Appeals for the District of Columbia Circuit. NOTE 11. SELECTED QUARTERLY INFORMATION (Unaudited) Three months ended Dec. 31, Sept. 30, June 30, Mar. 31, (In millions, except 1993 1993 1993 1993 per share amounts) -------- --------- -------- -------- Revenue $3,128 $3,054 $2,929 $2,810 Operating expenses: Telecommunications 1,659 1,636 1,573 1,505 Sales, operations and general 992 814 772 732 Depreciation 256 245 236 233 Income from operations 221 359 348 340 Income before extraordinary item 107 174 178 168 Net income 107 174 150 151 Earnings applicable to common stockholders 107 174 149 151 Earnings per common and common equivalent shares: Income before extraordinary item .18 .30 .32 .31 Loss on early debt retirements - - (.05) (.03) ------ ------ ------ ------ Total .18 .30 .27 .28 Weighted average number of shares of common stock and common stock equivalents outstanding 581 580 554 538 === === === === Page 47 of 62 Three months ended Dec. 31, Sept. 30, June 30, Mar. 31, (In millions, except 1992 1992 1992 1992 per share amounts) -------- --------- -------- -------- Revenue $2,761 $2,682 $2,606 $2,513 Operating expenses: Telecommunications 1,472 1,447 1,407 1,358 Sales, operations and general 740 703 687 664 Depreciation 228 223 214 208 Income from operations 321 309 298 283 Net income 160 159 149 141 Earnings applicable to common stockholders 160 154 141 134 Earnings per common share .30 .29 .26 .25 Weighted average number of shares of common stock and common stock equivalents outstanding 534 532 532 530 === === === === The three months ended December 31, 1993, includes a $150 million charge primarily associated with the company's strategic realignment, streamlining of engineering and network operations facilities and relocation of certain operations to lower cost areas. The three months ended September 30, 1993, includes the effect of the retroactive tax law change on the company's net income, which approximated $13 million. The three months ended December 31, 1992, includes revenue of $56 million, net of expenses, from the intelligent network licensing agreement with the Stentor companies of Canada and $47 million of restructuring charges largely associated with the realignment of the company's Business Markets organization. Since there are changes in the weighted average number of shares outstanding each quarter, the sum of earnings per share by quarter does not equal the earnings per share for the year. Item 9. Item 9. Change in and Disagreements with Accountants on - -------------------------------------------------------- Accounting and Financial Disclosure. - ------------------------------------ None. PART III BEGINS ON THE NEXT PAGE Page 48 of 62 PART III Item 10. Item 10. Directors and Executive Officers. - ------------------------------------------ Information with respect to executive officers of MCI is set forth in Part I of this Annual Report on Form 10-K. Information with respect to directors of MCI is incorporated herein by reference to the information under the captions "Election of Directors" and "Compliance with Section 16(a) of the Exchange Act" in MCI's Proxy Statement for its 1994 Annual Meeting of Stockholders (the "1994 Proxy Statement"). Item 11. Item 11. Executive Compensation. - -------------------------------- Information with respect to executive compensation is incorporated herein by reference to information under the captions "Board of Directors' Committees, Meetings and Fees", "Remuneration of Executive Officers", "Pension Plans", "Compensation Committee Report on Executive Compensation", "Compensation Committee Interlocks and Insider Participation" and "Five-Year Performance Comparison" in the 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and - ------------------------------------------------------------- Management. - ---------- Information with respect to security ownership is incorporated herein by reference to the information under the captions "Election of Directors" and "Security Ownership of Management and Certain Beneficial Owners" in the 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. - -------------------------------------------------------- Information with respect to certain relationships and related transactions is incorporated herein by reference to the information in the eighth paragraph under the caption "Certain Relationships and Related Transactions" in the 1994 Proxy Statement. PART IV BEGINS ON THE NEXT PAGE Page 49 of 62 PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on - ----------------------------------------------------------------- Form 8-K. - -------- (a) Documents filed as a part of this report. (1) Financial Statements: Report of Management Report of Independent Accountants Income Statement for the years ended December 31, 1993, 1992 and 1991 Balance Sheet at December 31, 1993 and 1992 Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Statement of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements The Financial Statements and Notes thereto appear under Item 8 to this Annual Report on Form 10-K. (2) Financial Statement Schedules: The following additional financial data should be read in conjunction with the Financial Statements and Notes thereto which appear under Item 8 to this Annual Report on Form 10-K. Schedules not included with this additional financial data have been omitted because they are not required or applicable or the required information is shown in the Financial Statements or Notes thereto. Report of Independent Accountants on Financial Statement Schedules Communications System (Schedule V) Accumulated Depreciation of Communications System (Schedule VI) Page 50 of 62 Valuation and Qualifying Accounts (Schedule VIII) Short-Term Borrowings (Schedule IX) Supplementary Income Statement Information (Schedule X) The Financial Statement Schedules are submitted as Exhibits 99(a)-(e) to this Annual Report on Form 10-K. (3) Exhibits. Executive compensation plans and arrangements required to be filed, and which have been filed, with the Commission pursuant to Item 14(c) of this Annual Report on Form 10-K are listed in this Annual Report on Form 10-K as Exhibits 10(a)-(g). Exhibit No. Description - ----------- ----------- 3 (a) Restated Certificate of Incorporation of MCI Communications Corporation filed on June 25, 1993. (Incorporated by reference to Exhibit 4(a) to the registrant's Post Effective Amendment No. 1 to Registration Statement on Form S-8, Reg. No. 33-35339.) (b) By-laws of registrant, as amended. (Incorporated by reference to Exhibit 3(b) to registrant's Form S-3, Reg. No. 33-49387.) 4 (a) Indenture, dated as of October 15, 1989, between registrant and Bankers Trust Company. (Incorporated by reference to Exhibit 4(c) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (b) Indenture dated as of October 15, 1989 between registrant and Bankers Trust Company. (Incorporated by reference to Exhibit 4(d) to registrant's Registration Statement of Form S-3, Reg. No. 33-31600.) (c) Indenture dated as of October 15, 1989 between registrant and Citibank, N.A. (Incorporated by reference to Exhibit 4(e) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) Page 51 of 62 (d) Form of Senior Fixed Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(b) to registrant's Current Report on Form 8-K dated October 24, 1990.) (e) Form of Senior Floating Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(a) to registrant's Current Report on Form 8-K dated October 24, 1990.) (f) Form of Subordinated Fixed Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(g) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (g) Form of Subordinated Floating Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(i) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (h) Form of 7-5/8% Senior Note due November 7, 1996. (Incorporated by reference to Exhibit 1(c) to registrant's Current Report on Form 8-K dated November 6, 1991.) (i) Form of 7-1/2% Senior Note due August 20, 2004. (Incorporated by reference to Exhibit 4 of registrant's Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1992.) (j) Form of 7-1/8% Senior Note due January 20, 2000. (Incorporated by reference to Exhibit 1(b) of registrant's Current Report on Form 8-K dated January 19, 1993.) (k) Form of 8-1/4% Senior Debenture due January 20, 2023. (Incorporated by reference to Exhibit 1(c) of registrant's Current Report on Form 8-K dated January 19, 1993.) (l) Form of 7-3/4% Senior Debenture due March 15, 2024. (Incorporated by reference to Exhibit 4(a) of registrant's Current Report on Form 8-K dated March 12, 1993.) (m) Form of 6-1/4% Senior Note due March 23, 1999. (Incorporated by reference to Exhibit 4(a) of registrant's Current Report on Form 8-K dated March 15, 1994.) Page 52 of 62 (n) Form of 7-3/4% Senior Debenture due March 23, 2025. (Incorporated by reference to Exhibit 4(b) of registrant's Current Report on Form 8-K dated March 15, 1994.) (o) Form of Senior Floating Rate Note due March 16, 1999. (Incorporated by reference to Exhibit 4(c) of registrant's Current Report on Form 8-K dated March 15, 1994.) 10 (a) 1979 Stock Option Plan of registrant, as amended and restated. (Incorporated by reference to Exhibit 10(a) to registrant's Annual Report on Form 10-K for the year ended December 31, 1988.) (b) Supplemental Retirement Plan for Employees of MCI Communications Corporation and Subsidiaries, as amended. (c) Description of Executive Life Insurance Plan for MCI Communications Corporation and Subsidiaries. (Incorporated by reference to "Remuneration of Officers" in registrant's Proxy Statement for its 1992 Annual Meeting of Stockholders.) (d) MCI Communications Corporation Executive Incentive Compensation Plan. (Incorporated by reference to Exhibit 10(d) to registrant's annual Report on Form 10-K for the Year Ended December 31, 1988.) (e) Form of Director Indemnification Agreement. (Incorporated by reference to Appendix B to registrant's Proxy Statement for its 1987 Annual Meeting of Stockholders.) (f) 1988 Directors' Stock Option Plan of registrant. (Incorporated by reference to Exhibit D to registrant's Proxy Statement for its 1989 Annual Meeting of Stockholders.) (g) Stock Option Plan of registrant. (Incorporated by reference to Exhibit C to registrant's Proxy Statement for its 1989 Annual Meeting of Stockholders.) Page 53 of 62 (h) $1,250,000,000 Revolving Credit Agreement dated as of June 8, 1992 among MCI Communications Corporation, Bank of America National Trust and Savings Association and twenty-nine banks party thereto. (Incorporated by reference to Exhibit 28 to registrant's Current Report on Form 8-K dated June 24, 1992, as amended July 9, 1992.) The First Amendment to Credit Agreement dated June 9, 1993 is filed with this Annual Report on Form 10- K. (i) Amended and Restated Investment Agreement dated as of January 31, 1994 between MCI Communications Corporation and British Telecommunications plc. (Incorporated by reference to Appendix I of registrant's Notice of Special Meeting of Stockholders and Proxy Statement dated February 4, 1994.) (j) Joint Venture Agreement dated as of August 4, 1993 between MCI Communications Corporation and BT Forty-Eight Company and MCI Ventures Corporation and Moorgate (Twelve) Limited. (Incorporated by reference to Exhibit 10 (b) of registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) (k) Letter Agreement dated February 27, 1994 by and between MCI Communications Corporation, Nextel Communications, Inc. and Comcast Corporation. (Incorporated by reference to Exhibit 10(a) of registrant's Current Report on Form 8-K dated March 9, 1994.) 11 Computation of Earnings per Common Share. 12 Computation of Ratio of Earnings to Fixed Charges. 21 Significant Subsidiaries of MCI Communications Corporation. 23 Consent of Independent Accountants. 99 (a) Communications System (Schedule V). (b) Accumulated Depreciation of Communications System (Schedule VI). (c) Valuation and Qualifying Accounts (Schedule VIII). Page 54 of 62 (d) Short-Term Borrowings (Schedule IX) (e) Supplementary Income Statement Information (Schedule X). (f) Capitalization Table. (b) Reports on Form 8-K. None. (c) Exhibits. See Item 14(a)(3) of this Annual Report on Form 10-K. (d) Financial Statement Schedules See Items 14(a)(2) and 14(a)(3) of this Annual Report on Form 10-K. Page 55 of 62 Report of Independent Accountants on Financial Statement Schedules To the Board of Directors MCI Communications Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 1994 appearing on page 26 of this Annual Report on Form 10-K also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Annual Report on Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/PRICE WATERHOUSE - ------------------------------ PRICE WATERHOUSE Washington, D.C. January 26, 1994 Page 56 of 62 SIGNATURE SIGNATURES Pursuant to the requirements of Section 13 or 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. MCI COMMUNICATIONS CORPORATION Bert C. Roberts, Jr. Dated: March 30, 1994 By: -------------------------- Bert C. Roberts, Jr. Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on March 30, 1994 on behalf of the registrant and in the capacities indicated. Signature Title Bert C. Roberts, Jr. - ----------------------------- Principal Executive Officer, Bert C. Roberts, Jr. Director Douglas L. Maine - ----------------------------- Principal Financial Officer Douglas L. Maine Bradley E. Sparks - ----------------------------- Principal Accounting Officer Bradley E. Sparks Clifford L. Alexander, Jr. - ----------------------------- Director Clifford L. Alexander, Jr. Judith Areen - ------------------------------ Director Judith Areen Page 57 of 62 Michael H. Bader - ----------------------------- Director Michael H. Bader Richard M. Jones - ----------------------------- Director Richard M. Jones Richard T. Liebhaber - ----------------------------- Director Richard T. Liebhaber - ----------------------------- Director Gordon S. Macklin C. B. Rogers, Jr. - ----------------------------- Director C. B. Rogers, Jr. Richard B. Sayford - ----------------------------- Director Richard B. Sayford Judith Whittaker - ----------------------------- Director Judith Whittaker John R. Worthington - ----------------------------- Director John R. Worthington Page 58 of 62 Exhibit Index --------------- Exhibit No. Description - ----------- ----------- 3 (a) Restated Certificate of Incorporation of MCI Communications Corporation filed on June 25, 1993. (Incorporated by reference to Exhibit 4(a) to the registrant's Post Effective Amendment No.1 to Registration Statement on Form S-8, Reg. No. 33-35339.) (b) By-laws of registrant, as amended. (Incorporated by reference to Exhibit 3(b) to registrant's Form S-3, Reg. No. 33-49387.) 4 (a) Indenture, dated as of October 15, 1989, between registrant and Bankers Trust Company. (Incorporated by reference to Exhibit 4(c) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (b) Indenture dated as of October 15, 1989 between registrant and Bankers Trust Company. (Incorporated by reference to Exhibit 4(d) to registrant's Registration Statement of Form S-3, Reg. No. 33-31600.) (c) Indenture dated as of October 15, 1989 between registrant and Citibank, N.A. (Incorporated by reference to Exhibit 4(e) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (d) Form of Senior Fixed Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(b) to registrant's Current Report on Form 8-K dated October 24, 1990.) (e) Form of Senior Floating Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(a) to registrant's Current Report on Form 8-K dated October 24, 1990.) (f) Form of Subordinated Fixed Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(g) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) Page 59 of 62 (g) Form of Subordinated Floating Rate Medium-Term Note. (Incorporated by reference to Exhibit 4(i) to registrant's Registration Statement on Form S-3, Reg. No. 33-31600.) (h) Form of 7-5/8% Senior Note due November 7, 1996. (Incorporated by reference to Exhibit 1(c) to registrant's Current Report on Form 8-K dated November 6, 1991.) (i) Form of 7-1/2% Senior Note due August 20, 2004. (Incorporated by reference to Exhibit 4 of registrant's Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1992.) (j) Form of 7-1/8% Senior Note due January 20, 2000. (Incorporated by reference to Exhibit 1(b) of registrant's Current Report on Form 8-K dated January 19, 1993.) (k) Form of 8-1/4% Senior Debenture due January 20, 2023. (Incorporated by reference to Exhibit 1(c) of registrant's Current Report on Form 8-K dated January 19, 1993.) (l) Form of 7-3/4% Senior Debenture due March 15, 2024. (Incorporated by reference to Exhibit 4(a) of registrant's Current Report on Form 8-K dated March 12, 1993.) (m) Form of 6-1/4% Senior Note due March 23, 1999. (Incorporated by reference to Exhibit 4(a) of registrant's Current Report on Form 8-K dated March 15, 1994.) (n) Form of 7-3/4% Senior Debenture due March 23, 2025. (Incorporated by reference to Exhibit 4(b) of registrant's Current Report on Form 8-K dated March 15, 1994.) (o) Form of Senior Floating Rate Note due March 16, 1999. (Incorporated by reference to Exhibit 4(c) of registrant's Current Report on Form 8-K dated March 15, 1994.) 10 (a) 1979 Stock Option Plan of registrant, as amended and restated. (Incorporated by reference to Exhibit 10(a) to registrant's Annual Report on Form 10-K for the year ended December 31, 1988.) Page 60 of 62 (b) Supplemental Retirement Plan for Employees of MCI Communications Corporation and subsidiaries, as amended. (c) Description of Executive Life Insurance Plan for MCI Communications Corporation and Subsidiaries. (Incorporated by reference to "Remuneration of Officers" in registrant's Proxy Statement for its 1992 Annual Meeting of Stockholders.) (d) MCI Communications Corporation Executive Incentive Compensation Plan. (Incorporated by reference to Exhibit 10(d) to registrant's annual Report on Form 10-K for the Year Ended December 31, 1988.) (e) Form of Director Indemnification Agreement. (Incorporated by reference to Appendix B to registrant's Proxy Statement for its 1987 Annual Meeting of Stockholders.) (f) 1988 Directors' Stock Option Plan of registrant. (Incorporated by reference to Exhibit D to registrant's Proxy Statement for its 1989 Annual Meeting of Stockholders.) (g) Stock Option Plan of registrant. (Incorporated by reference to Exhibit C to registrant's Proxy Statement for its 1989 Annual Meeting of Stockholders.) (h) $1,250,000,000 Revolving Credit Agreement dated as of June 8, 1992 among MCI Communications Corporation, Bank of America National Trust and Savings Association and twenty-nine banks party thereto. (Incorporation by reference to Exhibit 28 to registrant's Current Report on Form 8-K dated June 24, 1992, as amended July 9, 1992.) The First Amendment to Credit Agreement dated June 9, 1993 is filed with this Annual Report on Form 10-K. (i) Amended and Restated Investment Agreement dated as of January 31, 1994 between MCI Communications Corporation and British Telecommunications plc. (Incorporated by reference to Appendix I of registrant's Notice of Special Meeting of Stockholders and Proxy Statement dated February 4, 1994.) Page 61 of 62 (j) Joint Venture Agreement dated as of August 4, 1993 between MCI Communications Corporation and BT Forty-Eight Company and MCI Ventures Corporation and Moorgate (Twelve) Limited. (Incorporated by reference to Exhibit 10 (b) of registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) (k) Letter Agreement dated February 27, 1994 by and between MCI Communications Corporation, Nextel Communications, Inc. and Comcast Corporation. (Incorporated by reference to Exhibit 10(a) of registrant's Current Report on Form 8-K dated March 9, 1994.) 11 Computation of Earnings per Common share. 12 Computation of Ratio of Earnings to Fixed Charges. 21 Significant Subsidiaries of MCI Communications Corporation. 23 Consent of Independent Accountants. 99 (a) Communications System (Schedule V). (b) Accumulated Depreciation of Communications System (Schedule VI). (c) Valuation and Qualifying Accounts (Schedule VIII). (d) Short-Term Borrowings (Schedule IX) (e) Supplementary Income Statement Information (Schedule X). (f) Capitalization Table. Page 62 of 62	17,696	116,554
71675_1993.txt	71675_1993	1993	71675	Item 1. Business (a) General development of business New York State Electric & Gas Corporation (Company) was organized under the laws of the State of New York in 1852. The following general developments have occurred in the business of the Company since January 1, 1993: Rates and regulatory matters Rate Matters In September 1993, the Company reached a three-year electric and natural gas rate settlement agreement (Agreement) with the Public Service Commission of the State of New York (PSC). The new electric and natural gas rates became effective September 4, 1993. The allowed return on equity is 10.8% in year one, 11.4% in year two, and 11.4% (subject to an indexing mechanism) in year three. Shareholders will be allowed to keep 100% of any earnings in excess of the allowed return in year one. Shareholders and customers will share, on a 50%/50% basis, any earnings in excess of the allowed return in years two and three. The Agreement also includes a modified revenue decoupling mechanism (RDM) for electric sales. Rates are based on sales forecasts. Since actual sales may differ significantly from forecasted sales because of conservation efforts, unusual weather, or changing economic conditions, the revenue collected may be more or less than forecast. Subject to the caps described below, the modified RDM will let the Company adjust for most of the differences between forecasted and actual sales. For example, if revenues exceed the forecast for a given year, the excess would be passed back to customers in a future year. If revenues are below the forecast, customers would receive a surcharge in a future year. The Company will share excesses or shortfalls from most large commercial and industrial sales revenues on a 70%/30% (customer/stockholder) basis. Customer savings for production and transmission operating costs of $21 million will be imputed over three years, $7 million each year, whether or not they are realized. Incentives for customer service, production cost, and demand-side management (DSM) could increase the allowed return to 12.3% or decrease it to 9.95% in year one, increase it to 13.05% or decrease it to 10.4% in year two, and increase it to 13.25% or decrease it to 10.2% in year three. The electric and natural gas rate increases discussed below represent eleven months for year one and twelve months for years two and three. The estimated total electric price increases below include base rate increases allowed by the Agreement plus estimates of fuel and purchased power increases which will be collected through the Fuel Adjustment Clause (FAC). Actual fuel and purchased power costs could vary from estimates causing the estimated FAC and total electric price increases below to change. Base Rate Estimated FAC Total Electric (Dollar Amounts in Millions) Year 1 $60.5 4.4% $39.1 3.0% $99.6 7.4% Year 2 $70.3 4.8% $39.2 2.8% $109.5 7.6% Year 3 $57.4 3.6% $30.4 2.0% $87.8 5.6% The natural gas base rate increases allowed by the Agreement are $7.5 million, or 2.9%, $8.2 million, or 3.0%, and $7.2 million, or 2.5%, in years one, two, and three, respectively. They do not include changes in natural gas costs, which will be collected through the Gas Adjustment Clause. Natural gas costs can be expected to rise and fall with overall natural gas market conditions. Such fluctuations will affect the total natural gas price increases. The Agreement also provides for the stated electric and natural gas base rate increases to be adjusted up or down in the second and third years, as well as the year after the Agreement period (year four). These adjustments will depend on several factors, such as electric sales and incentive mechanisms. The Agreement provides that no cap would apply to any downward revision to base rates for electric and natural gas service. The electric base rate increases could be increased by up to 1.5% in years two and three and 1.6% in year four (the caps). The natural gas base rate increases could also be increased by up to 1% in year two and 1.2% in year three. The Agreement does not specify a cap for natural gas base rates for year four. Flexible, Negotiable Rate Tariffs A major challenge to the Company's Electric Business Unit is to retain and grow its industrial base. The competitive energy supply options currently available to the Company's industrial customers include self-generation, shifting production to plants in other locations, or relocation. During 1993, the Company received PSC approval for a flexible, negotiable rate tariff for some of its high-use industrial customers. Discounts negotiated in agreements under this tariff are not expected to have a material effect on the Company's 1994 earnings. Two agreements have been negotiated which eliminated threats of self-generation and relocation. The PSC currently has a generic proceeding to study the broad subject of flexible, competitive rates, and will establish guidelines for the Company and other New York State utilities during 1994. In November 1993, the Company filed with the PSC an additional flexible, negotiable rate tariff to address opportunities for new load. The proposed tariff is for large additions to load (at least 500 kilowatts [kw]) for new or existing industrial and some commercial customers. The tariff will assist the Company in attracting new customers whose location or expansion decisions are influenced by electricity costs. Smaller customers will be assisted by a concurrent proposal to increase the Company's existing economic development incentives by one cent per kilowatt-hour. The Company has proposed and will continue to propose revisions or additional tariffs to respond to the opportunities or risks that develop in a changing electric utility industry. Federal Energy Regulatory Commission (FERC) Order 636 A major challenge to the Company's Gas Business Unit is FERC Order 636, which became effective in November 1993, and requires interstate natural gas pipeline companies to offer customers unbundled or separate services equivalent to their former sales service. With the unbundling of services, primary responsibility for reliable natural gas supply will shift from interstate pipeline companies to local distribution companies, such as the Company. This should result in increased direct access to low cost natural gas supplies by local distribution companies and end users. One goal of FERC Order 636 is to provide equitable access to interstate pipeline capacity. FERC Order 636 will substantially restructure the interstate natural gas market and intensify competition within the natural gas industry. FERC Order 636 will allow the Company, subject to PSC approval, to restructure rates and provide multiple service options to its customers. In July 1993, certain interstate pipelines serving the Company began implementing restructured services in compliance with FERC Order 636. The remaining pipelines implemented restructured services by November 1993. As a result of these restructuring changes, pipelines have incurred and will continue to incur transition costs. These transition costs include those associated with restructuring existing natural gas supply contracts, the unrecovered natural gas cost that would otherwise have been billable to pipeline customers under previously existing rules, costs of assets needed to implement the order, and stranded investment costs. FERC Order 636 allows pipelines to recover all prudently incurred costs from their customers. The Company's liability for transition costs will be based on the pipelines' filings with FERC to recover transition costs. Only a few of those filings have been made. The Company recorded an estimated liability for transition costs of approximately $29 million. The Company also recorded a deferred asset for that amount since it is currently recovering transition costs from its customers through its gas adjustment clause and believes that such costs will continue to be recoverable from its customers. Diversification Diversification will play an important role in the Company's future. While the strength of the Company's core electric and natural gas businesses remains its focus, and while the Company will not compromise its financial integrity, it is actively evaluating a number of corporate development opportunities for investment to help augment future earnings and dividend growth. In April 1992, the PSC issued an order allowing the Company to invest up to 5% of its consolidated capitalization (approximately $175 million at December 31, 1993) in one or more subsidiaries that may engage or invest in energy-related or environmental services businesses and provide related services. In May 1993, NGE Enterprises, Inc. (NGE), a wholly-owned subsidiary of the Company, formed a computer software company, EnerSoft Corporation (EnerSoft), to produce and market software applications for natural gas utilities in the post-FERC Order 636 environment. This represents NGE's initial diversified investment. In October 1993, EnerSoft began a strategic alliance with the New York Mercantile Exchange to develop an information superhighway that will provide the natural gas industry with a single system for monitoring and trading natural gas and pipeline capacity in the North American market. NGE invested approximately $9 million in EnerSoft through February 1994. The Company and NGE plan to develop two natural gas storage projects. One of the projects, which will be regulated by the PSC, is expected to cost approximately $14 million and will be used to supplement the Company's natural gas supply. Construction of this project is scheduled to begin in 1994 and it is expected to be operating for the 1995-96 heating season. The other project, which will be regulated by the FERC, is an equal partnership between NGE and ANR Storage, Inc., and is expected to cost approximately $44 million in total. The entire capacity of this project will be marketed to local distribution companies and non-utility generator (NUG)s, as well as marketers, producers, and end users of natural gas. Construction of this project is scheduled to begin in 1995 and it is expected to be operating for the 1996-1997 heating season. Restructuring In the fourth quarter of 1993, the Company recorded a $26 million restructuring charge. The corporate restructuring will reorganize the way the Company delivers services to its electric and natural gas customers beginning in March 1994. The restructuring reduced 1993 earnings available for common stock by approximately $17.2 million or 25 cents per share. Included in this amount are $13.2 million for a voluntary early retirement program, $3.2 million for an involuntary severance program, and $.8 million for the elimination and closing of electric and natural gas operations facilities statewide. During 1994, the restructuring resulted in a work force reduction throughout the organization of approximately 600, the elimination of customer walk-in services at 28 satellite locations, and the closing of up to 10 electric and natural gas operations facilities statewide. The work force reduction was accomplished through a voluntary early retirement program (See Note 7 to the Consolidated Financial Statements on page 60) and an involuntary severance program. 384 employees accepted the early retirement program. (b) Financial information about industry segments See Note 11 to the Consolidated Financial Statements on page 72. (c) Narrative description of business (i) Principal business The Company's principal business is generating, purchasing, transmitting, and distributing electricity and purchasing, transporting, and distributing natural gas. The service territory, 99% of which is located outside the corporate limits of cities, is in the central, eastern, and western parts of the State of New York. The service territory has an area of approximately 19,500 square miles, and a population of 2,400,000. The larger cities in which the Company serves both electricity and natural gas are Binghamton, Elmira, Auburn, Geneva, Ithaca, and Lockport. The Company serves approximately 790,000 electric retail customers and 226,000 natural gas retail customers. Its service territory reflects a diversified economy, including high- tech firms, light industry, agriculture, colleges and universities, and recreational facilities. No customer accounts for 5% or more of either electric or natural gas revenues. For the years 1993, 1992, and 1991, 85%, 86%, and 88%, respectively, of operating revenue was derived from electric service and 15%, 14%, and 12%, respectively, was derived from natural gas service. The 1993-1994 winter peak load of 2,618,000 kw, was set on January 19, 1994. This is 21,000 kw more than the previous all time peak of 2,597,000 kw set during the 1989-1990 winter on December 21, 1989. Power supply capability to meet peak loads is currently 3,194,430 kw. This is composed of 2,656,700 kw of generating capacity (90% coal-fired, 7% nuclear, and 3% hydroelectric) and 848,730 kw of purchases offset by 311,000 kw of firm sales. The purchases are composed of 362,280 kw from NUGs and 486,450 kw from the New York Power Authority (NYPA). Most purchases from NYPA are hydroelectric power. In June 1989, New York City, the Counties of Westchester, Nassau, and Suffolk, and their respective municipal distribution agencies, commenced Article 78 proceedings in the Supreme Court of the State of New York (New York County) (Court) against NYPA to set aside NYPA's contracts expiring in the year 2007 with the Company and two other utilities for the post January 1, 1990 allocation of NYPA hydroelectric power. The Company has intervened in these proceedings to protect its contractual entitlement. In November 1990, the Court issued a decision granting various motions and dismissing the Article 78 proceedings. On December 29, 1992, the Appellate Division, First Department unanimously affirmed the decision. On October 12, 1993, the Court of Appeals of the State of New York rejected a motion for leave to appeal to that court. The Company has on line and under contract 362 megawatts (mw) of NUG power. In addition, another 240 mw of NUG power is under construction. The Company is required to make payments under these contracts only for the power it receives. During 1993, 1992, and 1991, the Company purchased approximately $138 million, $71 million, and $30 million, respectively, of NUG power. The Company estimates that it will purchase approximately $255 million, $291 million, and $335 million of NUG power for the years 1994, 1995, and 1996, respectively. Increases in NUG power purchase costs are expected to be a significant contributor to price increases over the next three years. As part of the Company's effort to meet competition and minimize future price increases associated with uneconomical power purchases from NUGs, it negotiated the termination of two cogeneration projects. This effort, along with the termination of NUG contracts due to developers' failures to meet contract obligations, will save customers nearly $1 billion over the terms of the contracts. The Company has also recently negotiated amendments with two NUGs whereby the Company may direct the NUGs to reduce their output or shut down for limited periods each year. During these periods, lower-cost generation will replace the NUG energy and result in additional customer savings. The Company is negotiating with other NUGs for similar amendments. As part of the Company's effort to reduce costs, one of two generating units at each of its Goudey and Greenidge Generating Stations will be placed on long-term cold standby. These actions are being taken because the abundance of power in the Northeast has driven down wholesale prices. These units will continue to be utilized to provide electrical system support. The Company has implemented a number of demand-side management (DSM) programs. As a result of its three-year rate settlement agreement (See Item 1(a)-Rates and regulatory matters - - Rate Matters), incentives earned for conducting efficient DSM programs were reduced from 15% to 5% of the net resource savings achieved by these DSM programs. For 1994, the Company expects to earn approximately $3 million in incentives as a result of these DSM programs. In 1993, the Company's customers saved approximately 282 million kilowatt-hours (kwh) on an annualized basis through the Company's DSM programs. The implementation of these programs cost $48 million in 1993 and will cost approximately $16 million in 1994 with estimated customer savings of 113 million kwh on an annualized basis. The Company has approximately $73 million and $44 million of deferred DSM program costs on the Consolidated Balance Sheets at December 31, 1993, and 1992, respectively. The two-year (1993-1994) DSM plan, which has received PSC approval, has been modified to improve cost-effectiveness and reduce rate impacts. On January 19, 1994, the Company experienced its 1993-1994 maximum peak daily sendout for natural gas of 431,756 dekatherms. This is 69,175 dekatherms greater than the 1991-1992 peak of 362,581 dekatherms set on January 16, 1992. The following table provides information on the Company's estimated sources and uses of funds for 1994-1996. This forecast is subject to periodic review and revision, and actual construction costs may vary because of revised load estimates, imposition of additional regulatory requirements, and the availability and cost of capital. 1994 1995 1996 Total ---- ---- ---- ----- Sources of funds (Millions) Internal funds $254 $265 $269 $788 Long-term financing Debt and stock proceeds 413 141 80 634 Debt proceeds held in trust 34 8 - 42 ---- ---- ---- ----- Net financing proceeds 447 149 80 676 Increase (decrease) in short-term debt (50) - - (50) Decrease (increase) in temporary cash investments 89 (69) (52) (32) ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== Uses of funds Construction Cash expenditures $202 $193 $193 $588 AFDC 8 7 7 22 ---- ---- ---- ------ Total construction 210 200 200 610 Retirement of securities and sinking fund obligations 501 108 63 672 Working capital and deferrals 29 37 34 100 ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== As shown in the preceding table, internal sources of funds represent 129% of construction expenditures for 1994-1996. Capital expenditures for 1994-1996 have been significantly reduced from previously forecasted levels. This represents one of many actions the Company is taking to address competition (See Item 1(c)(x)-Competitive conditions). Capital expenditures for 1994-1996 will be primarily for extension of service, necessary improvements at existing facilities, and compliance with the Clean Air Act Amendments of 1990 (See Item 1(c)(xii)- Environmental matters). The Company forecasts that its current reserve margin, coupled with more efficient use of energy and generation from NUGs, will eliminate the need for additional generating capacity until after the year 2005. (ii) New product or segment (See Item 1(a)-Diversification.) (iii) Sources and availability of raw materials Electric In 1993, approximately 90% of the Company's generation was coal-fired steam electric, 8% nuclear and 2% hydroelectric power. About 37% of the Company's steam electric generation in 1993 was supplied from its one-half share of the output from the Homer City Generating Station, which is owned in common with Pennsylvania Electric Company. An additional 34% was supplied from the Company's Kintigh Generating Station, and the remaining 29% was supplied from its other generating stations which are located in New York State. Coal Coal for the New York generating stations is obtained primarily from Pennsylvania and West Virginia. Of the 3.2 million tons of coal purchased for the New York generating stations in 1993, approximately 46% was purchased under contract and the balance on the open market. Coal purchased under contract is expected to be approximately 53% of the estimated 3.1 million tons to be purchased in 1994. The annual coal requirement for the Homer City Generating Station is approximately four million tons, the majority of which is obtained under long-term contracts. During 1993, approximately 52% of Homer City Generating Station coal was obtained under these contracts. The Company anticipates obtaining approximately 79% of the 1994 requirements under these contracts. The balance will be purchased under short-term contracts and, when necessary, on the open market. Nuclear During the fall of 1993, Niagara Mohawk Power Corporation (Niagara Mohawk), the operator of the Nine Mile Point nuclear generating unit No. 2 (NMP2), in which the Company has an 18% interest, completed the third refueling outage. The present core will support NMP2 operations to 1995. Enrichment services are under contract with the U.S. Department of Energy for 100% of the services through 1995 and 70% of the services from 1996 through 1998. Fuel fabrication services are under contract for the first seven reloads. Approximately 55% of the uranium and conversion requirements are under contract through 1998. Natural Gas As a result of FERC Order 636 (See Item 1(a)-Rates and regulatory matters - Federal Energy Regulatory Commission (FERC) Order 636), the Company undertook a major restructuring of its natural gas transportation, storage, and supply contracts. Bundled pipeline sales, gas and transportation contracts have been eliminated thereby giving the Company greater flexibility with respect to its supply of natural gas. The gas supply mix now includes long-term, short-term, and spot gas purchases transported on firm transportation contracts, as well as spot gas purchases transported on interruptible transportation contracts. During 1993, about 15% of the Company's natural gas supply was purchased on firm sales contracts from CNG Transmission and Columbia Gas Transmission. The remaining 85% was purchased from other suppliers, approximately 25% under long-term and short-term sales contracts and 60% on the monthly spot natural gas market to maximize natural gas cost savings. An additional benefit of FERC Order 636 is that the Company now has access to increased natural gas storage space enabling it to purchase natural gas supply when prices are favorable. (iv) Franchises The Company has, with minor exceptions, valid franchises from the municipalities in which it renders service to the public. In 1993, the Company obtained PSC authorizations for natural gas transmission and distribution service in the towns of Skaneateles, Stillwater, Starkey, and the town and village of Champlain. (v) Seasonal business Sales of electricity are highest during the winter months primarily due to space heating usage and fewer daylight hours. Sales of natural gas are highest during the winter months primarily due to space heating usage. (vi) Working capital items The Company has been granted, through the ratemaking process, an allowance for working capital to operate its ongoing electric and natural gas utility services. (vii) Single customer - Not applicable (viii) Backlog of orders - Not applicable (ix) Business subject to renegotiation - Not applicable (x) Competitive conditions (See Item 1(a)-Rates and regulatory matters - Flexible Negotiable Rate Tariffs; Federal Energy Regulatory Commission (FERC) Order 636; and Restructuring and Item 1(c)(i)-Principal business) The utility industry is rapidly changing and facing an increasingly competitive environment. Factors contributing to this competitive environment are: the National Energy Policy Act of 1992 (Energy Policy Act), which provides open access at the wholesale level to electric transmission service, and the FERC Order 636, which significantly affects the natural gas industry. In addition, the Company's response to the economic pressures on its electric industrial and other large use customers, high purchase costs of NUGs, rising health care costs, increasing taxes, weak economic conditions, conservation programs, and compliance with environmental laws and regulations are all factors that continue to place increased pressure on electric and natural gas prices. The Energy Policy Act, enacted in October 1992, is expected to result in major changes to the utility industry. Certain provisions of the Energy Policy Act amended the Public Utility Holding Company Act of 1935 (PUHCA). These amendments encourage greater competition in the supply market by establishing a new category of wholesale electric generators that are exempt from PUHCA regulation. The Energy Policy Act also enables the FERC to order utilities to provide open access to transmission systems for wholesale transactions, expanding opportunities for utilities and NUGs to enter new and existing wholesale markets. These developments serve to underscore the increasingly competitive environment for utilities. The Company's five-year strategic plan is designed to address the competitive, rapidly changing utility industry. The Company's objective is to remain competitive in its core businesses in the face of increased competition. One of the key strategies to meet competition is to improve customer value by becoming a low-cost provider of energy services in the Northeast. The Company has developed a more aggressive and accelerated set of strategies in response to the increased challenges of competition which are necessary to achieve the objectives outlined in the Company's five-year strategic plan. The following represent strategies being implemented: - Reduce forecasted 1994 capital expenditures by one-third, or approximately $100 million. Additional reductions will be made in 1995 and 1996. - Reduce operating and maintenance expenses by five percent in 1994 and again in 1995. By 1995, this will save about $40 million annually. During 1993, the Company reduced its work force by 200 through attrition. In addition, as part of the O&M reduction, the Company's work force was further reduced by about 600 through an early retirement opportunity program and involuntary severance. - Streamline the field organization to eliminate walk-in customer service at 28 locations, and to close up to 10 electric and natural gas operations facilities statewide. - Place two generating units on long-term cold standby. - Continue to reduce NUG costs. The Company's previous NUG contract terminations and renegotiations will save customers more than $1 billion over the terms of the contracts. - Continue to reduce capital costs. Since 1988 the Company has refinanced over $1.4 billion in securities, and reduced annual interest expense by more than $55 million. The PSC currently has a generic proceeding to study the broad subject of flexible, competitive rates, and will establish guidelines for the Company and other New York State utilities during 1994. Also in late 1993, the PSC instituted a proceeding to address issues associated with the restructuring of the emerging competitive natural gas market. The PSC intends to investigate services provided by New York State gas utilities after FERC Order 636 by the 1994-1995 heating season. Other forms of competition stem from both federal and state action. Natural gas at the wellhead is available to be purchased directly by end users from the producer at a delivered price which may be less than that of the local distributor. Delivery of such natural gas is by pipeline transportation. By law, the Company must provide transportation service so long as it is not an undue burden on the Company or its customers and the Company's ability to render adequate service to its customers is not impaired. The Company has developed, and its customers are using, various transportation tariff services. Transportation of natural gas in lieu of retail sales is not expected to have a material effect on the Company's 1994 earnings. From time to time, the price of fuel oil has allowed oil suppliers to compete with the Company's sale of natural gas to large natural gas customers. To meet the competition from oil, the Company has flexible sales and transportation rates for qualifying natural gas customers. The flexible rates provide the Company with greater opportunity for making available rate offerings and setting rates which more closely reflect the competitive needs of dual-fuel customers. This capability enhances the Company's ability to set multiple rates each month in a manner which maximizes margins. The Company is now utilizing and receiving benefits from the various flexible pricing options. These flexible rates are not expected to have a material effect on the Company's 1994 earnings and enable the Company to minimize threats of bypass. (xi) Research and development Expenditures on research and development in 1993, 1992, and 1991 amounted to $18.9 million, $14.6 million, and $14.8 million, respectively, principally for the Company's internal research programs and for contributions to research administered by the Electric Power Research Institute, the Empire State Electric Energy Research Corporation, the New York Gas Group, and the New York State Energy Research and Development Authority. These expenditures are designed to improve existing technologies and to develop new technologies for the production, distribution, and conservation of energy. (xii) Environmental matters (See Item 3 - Legal proceedings) The Company is subject to regulation by the federal government and by state and local governments in New York and Pennsylvania with respect to environmental matters and is also subject to the New York State Public Service Law requiring environmental approval and certification of proposed major transmission facilities. The Company continually assesses actions that may need to be taken to ensure compliance with changing environmental laws and regulations. Compliance programs will increase the cost of electric and natural gas service by requiring changes to the Company's operations and facilities. Historically, rate recovery has been authorized for the cost incurred for compliance with environmental laws and regulations. Capital additions to meet environmental requirements during the three years ended December 31, 1993 were approximately $143.0 million and are estimated to be $76.5 million for 1994, $51.4 million for 1995, and $40 million for 1996. Water quality The Company is required to comply with federal and state water quality statutes and regulations including the Clean Water Act (Water Act). The Water Act requires that generating stations be in compliance with federally issued National Pollutant Discharge Elimination System Permits (NPDES Permits) or state issued State Pollutant Discharge Elimination System Permits (SPDES Permits), which must reflect water quality considerations and application of the best available technology. The Company has SPDES Permits for its six coal-fired generating stations in New York and has applied for permit renewals for five of those stations. Permits for these five stations have either been renewed or are currently being negotiated with the State of New York, in which case the existing permits for those facilities remain in effect. The permit for the sixth station will not expire until the fall of 1994. The Company's Homer City Generating Station received a NPDES Permit, which expires in the fall of 1994, from the Pennsylvania Department of Environmental Resources (PaDER). Prior to the expiration of the two permits which expire in the fall of 1994, renewal applications will be submitted by the Company. Until these permits are renewed, these stations will operate under their existing permits. SPDES licensing renewal is currently being addressed by the New York State Department of Environmental Conservation (NYSDEC) for NMP2. In connection with the issuance of permits under the Water Act, the Company has conducted studies of the effects of its coal pile operations on groundwater quality at its Hickling, Jennison, Milliken, and Greenidge Stations. New York State groundwater standards are sometimes exceeded at certain locations at each of those stations and remedial action may be required. Jennison Station will require remedial action which is estimated to cost up to $1 million. The remedial action, if required, at Hickling, Milliken, and Greenidge Stations is estimated to cost $7.4 million. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Remedial action has already been performed at the Goudey Station and the Company is currently monitoring the groundwater quality at this station. Groundwater monitoring data for Kintigh Station does not indicate facility induced groundwater contamination. Groundwater studies have been initiated at the Homer City Station. Air quality The Company is required to comply with federal and state air quality statutes and regulations. All stations have the required federal or state operating permits. Stack tests and continuous emission monitoring indicate that the stations are generally in compliance with permit emission limitations, although occasional opacity exceedances occur. Efforts are underway to identify and eliminate the causes of opacity exceedances. The Clean Air Act Amendments of 1990 (1990 Amendments) will result in significant expenditures of approximately $178 million, on a present value basis, over a 25-year period, for all capital and operating and maintenance expenses related to the reduction of sulfur dioxide and nitrogen oxides at several of the Company's coal-fired generating stations, of which $51 million has been incurred as of December 31, 1993. The Company's current estimate is a significant reduction from its prior estimate, primarily due to the postponement of the construction of a flue gas desulfurization (FGD) system at its Homer City Generating Station. The Company plans to re-evaluate the need to construct an FGD system at the Homer City Generating Station in 1995, since its present strategy to bank Phase I emissions allowances for use during Phase II, as discussed below, will allow the Company to meet Phase II allowance requirements through the year 2005. The cost to comply with the sulfur dioxide and nitrogen oxide limitations includes the construction of an innovative FGD system and a nitrogen oxide reduction system expected to be completed in 1995 at the Company's Milliken Generating Station. The Company estimates that approximately a 1% electric rate increase will be required for the cost of reducing sulfur dioxide and nitrogen oxide emissions in both Phase I (begins January 1, 1995) and Phase II (begins January 1, 2000). As a result of the 1990 Amendments, the Company plans to reduce its annual sulfur dioxide emissions by an amount that will allow the Company to meet the sulfur dioxide levels established for the Company, which is approximately a 49% reduction from approximately 138,000 tons in 1989 to 71,000 tons by the year 2000. The cost of controlling toxic emissions under the 1990 Amendments, if required, cannot be estimated at this time. Regulations may be adopted at the state level which would limit toxic emissions even further, at an additional cost to the Company. The Company anticipates that the costs incurred to comply with the 1990 Amendments will be recoverable through rates based on previous rate recovery of required environmental costs. The 1990 Amendments require the U.S. Environmental Protection Agency (EPA) to allocate annual emissions allowances to each of the Company's coal-fired generating stations based on statutory emissions limits. An emissions allowance represents an authorization to emit, during or after a specified calendar year, one ton of sulfur dioxide. During Phase I, the Company estimates that it will have allowances in excess of the affected coal-fired generating stations' actual emissions. The Company's present strategy is to bank these allowances for use in later years. By using a banking strategy, it is estimated that Phase II allowance requirements will be met through the year 2005 by utilizing the allowances banked during Phase I, which includes the extension reserve allowances discussed below, together with the Company's Phase II annual emissions allowances. This strategy could be modified should market or business conditions change. In addition to the annual emissions allowances allocated to the Company by the EPA, the Company will receive a portion of the extension reserve allowances issued by the EPA to utilities electing to build scrubbers, as a result of the pooling agreement that it entered into with other utilities who were also eligible to receive some of these extension reserve allowances. Certain other environmental regulations limit the amount of particulate matter which may be emitted into the environment. The Company and Pennsylvania Electric Company may find it necessary either to upgrade or install additional equipment at the Homer City Generating Station in order to consistently meet the particulate emission requirements. Waste disposal The Company has received or applied for SPDES Permits, Solid Waste Disposal Facilities Permits, and applicable local permits for its active ash disposal sites for its New York generating stations. Groundwater standards have been exceeded in areas close to portions of the Milliken and Weber ash disposal sites. Corrective actions have been taken and studies are continuing to monitor the effectiveness of the corrective actions. The Company has received NPDES permits, a Solid Waste Disposal Permit, and applicable local permits for its active ash disposal site for the Homer City Generating Station and for the active refuse disposal site for the Homer City Coal Cleaning Plant. In September 1993, the Company completed its study of costs to comply with the new Pennsylvania residual waste regulations governing solid waste disposal over the next 30 years. As a result of existing and new solid waste disposal legislation and regulations in Pennsylvania, the Company will incur approximately $24 million, on a present value basis, of additional costs over the next 30 years, beginning in 1994, at the Homer City Generating Station. These costs will be incurred to install new equipment, modify or replace existing equipment, and improve the design of a proposed expansion of disposal facilities. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Due to existing and proposed legislation and regulations, and legal proceedings commenced by governmental bodies and others, the Company may also incur costs from the past disposal of hazardous substances produced during the Company's operations or those of its predecessors. The Company has been notified by the EPA and the NYSDEC that it is among the potentially responsible parties (PRPs) who may be liable to pay for costs incurred to remediate certain hazardous substances at seven waste sites, not including the Company's inactive gas manufacturing sites, which are discussed below. With respect to the seven sites, five sites are included in the New York State Registry of Inactive Hazardous Waste Sites (New York State Registry). Any liability may be joint and several for certain of these sites. The ultimate cost to remediate these sites will be dependent on such factors as the remedial action plan selected, the extent of site contamination, and the portion attributed to the Company. At December 31, 1993, the Company recorded a liability in the Consolidated Balance Sheets related to four of these seven waste sites of $1.8 million. The Company has notified the NYSDEC that it believes it has no responsibility at two sites and has already incurred expenditures related to the remediation at the remaining site. A deferred asset has also been recorded in the amount of $2.6 million, of which $.8 million relates to costs that have already been incurred. The Company believes it will recover these costs, since the PSC has allowed other utilities to recover these types of remediation costs and has allowed the Company to recover similar costs in rates, such as investigation and cleanup costs relating to inactive gas manufacturing sites. This $1.8 million estimate was derived by multiplying the total estimated cost to clean up a particular site by the related Company contribution factor. Estimates of the total cleanup costs were determined by using information related to a particular site, such as investigations performed to date at a site or from the data released by a regulatory agency. In addition, this estimate was based upon currently available facts, existing technology, and presently enacted laws and regulations. The contribution factor is calculated using either the Company's percentage share of the total PRPs named, which assumes all PRPs will contribute equally, or the Company's estimated percentage share of the total hazardous wastes disposed of at a particular site, or by using a 1% contribution factor for those sites at which it believes that it has contributed a minimal amount of hazardous wastes. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A number of the Company's inactive gas manufacturing sites have been listed in the New York State Registry. The Company has filed petitions to delist the majority of the sites. The Company's program to investigate and initiate remediation at its 38 known inactive gas manufacturing sites has been extended through the year 2000. Expenditures over this time period are estimated to be $25 million. This estimate was determined by using the Company's experience and knowledge related to these sites as a result of the investigation and remediation that the Company has performed to date. It is based upon currently available facts, existing technology, and presently enacted laws and regulations. This liability, to investigate and initiate remediation, as necessary, at the known inactive gas manufacturing sites is reflected in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992. The Company also has recorded a corresponding deferred asset, since it expects to recover such expenditures in rates, as the Company has previously been allowed by the PSC to recover such costs in rates. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A low level radioactive waste management and contingency plan that has been developed for NMP2 provides assurance that NMP2 is properly prepared to handle interim storage of low level radioactive waste until 1998. Niagara Mohawk has contracted with the U.S. Department of Energy (DOE) for disposal of high level radioactive waste (spent fuel) from NMP2. The Company is reimbursing Niagara Mohawk for its 18% share of the cost under the contract (currently approximately $1 per megawatt hour of net generation). The DOE's schedule for start of operations of their high level radioactive waste repository has slipped from 2003 to no sooner than 2010. The Company has been advised by Niagara Mohawk that the NMP2 Spent Fuel Storage Pool has a capacity for spent fuel that is adequate until 2014. If further DOE schedule slippage should occur, the recent development of pre-licensed dry storage facilities for use at any nuclear power plant extends the on-site storage capability for spent fuel at NMP2 beyond 2014. (xiii) Number of employees The Company had 4,746 employees as of December 31, 1993 (See Item 1(a)-Restructuring) (d) Financial information about foreign and domestic operations and export sales - Not applicable Item 2. Item 2. Properties The Company's electric system includes coal-fired, nuclear, hydroelectric, and internal combustion generating stations, substations, and transmission and distribution lines, all of which are located in the State of New York, except for the Homer City Generating Station and related facilities which are located in the Commonwealth of Pennsylvania. Generating facilities are: Name and location of station Generating capability (kw) Coal-fired Goudey * (Binghamton, N.Y.) 127,000 Greenidge * (Dresden, N.Y.) 162,000 Hickling (East Corning, N.Y.) 86,000 Jennison (Bainbridge, N.Y.) 72,000 Milliken (Lansing, N.Y.) 318,000 Kintigh (Somerset, N.Y.) 675,000 Homer City (Homer City, Pa.) 954,000 --------- Total coal-fired 2,394,000 Nuclear NMP2 (Oswego, N.Y.) 189,000* Hydroelectric (Various - 9 locations) 66,500 Internal combustion (Various - 2 locations) 7,200 --------- Total - all stations 2,656,700 ========= * In the spring and summer of 1994 the Company plans to place one unit at both Goudey and Greenidge on long-term cold standby. These units have a combined capability of 97 megawatts. Company's 50% share of the generating capability. Company's 18% share of the generating capability. The Company owns 446 substations having an aggregate transformer capacity of 12,634,177 Kilovolt-amperes. The transmission system consists of 4,774 circuit miles of line and the distribution system of 33,410 pole miles of overhead lines and 1,790 miles of underground lines. The Company's natural gas system consists of the distribution of natural gas through 452 miles of transmission pipelines (3-inch equivalent) and 5,360 miles of distribution pipelines (3-inch equivalent). Somerset Railroad Corporation (SRC), a wholly-owned subsidiary, owns a rail line consisting of 15 1/2 miles of track and related property rights in Lockport, Newfane, and Somerset, New York which is used to transport coal and other materials to the Kintigh Generating Station. The Company's first mortgage bond indenture constitutes a direct first mortgage lien on substantially all of the Company's properties. Substantially all of the properties of SRC, other than rolling stock, are subject to a lien of a mortgage and security agreement. Item 3. Item 3. Legal proceedings (See Item 1(a)-Rates and regulatory matters, 1(c)(i)-Principal business, (x)-Competitive conditions, and (xii)-Environmental matters) The Company is unable to predict the ultimate disposition of the matters referred to below in (c), (d), (e), (g), (h), (i), and (j). There is no clear precedent with the PSC for rate recovery of the types of costs referred to in these matters. However, since the PSC has previously allowed the Company to recover similar costs in rates, such as investigation and clean- up costs relating to coal tar sites, the Company expects to recover in rates any remediation costs that it may incur. Therefore, the Company believes that the ultimate disposition of the matters referred to below in (c), (d), (e), (g), (h), (i), and (j) will not have a material adverse effect on its results of operations or financial position. (a) On January 27, January 31, and February 15, 1984, and on June 29, 1987, numerous individual plaintiffs instituted lawsuits in the Supreme Court of the State of New York (Broome County) for personal injuries allegedly arising out of a transformer fire at the State Office Building in Binghamton, New York, in February 1981. Multiple defendants, including the Company, are named in the actions which seek an aggregate of $329 million in compensatory and exemplary damages. Because the transformers involved were not owned, installed, or serviced by the Company, the Company believes that these claims against the Company are without merit. (b) On January 15 and January 30, 1985, numerous individual plaintiffs instituted two lawsuits against the Company in the Supreme Court of the State of New York (Broome County) seeking a total of $70 million in compensatory damages, plus punitive damages in an unstated amount. These actions arise out of a spill of PCB-contaminated oil on the Company's property on February 1, 1982. One of the lawsuits alleges mental anguish as the basis for recovery. The other lawsuit does not specify the nature of the damages claimed, except for an alleged decrease in the value of one residential property in the vicinity of the spill and deprivation of plaintiffs' right to quiet enjoyment of their property. Because the spill was contained on the Company's property and was quickly removed, the Company believes that these claims are without merit. Plaintiffs' counsel terminated their representation of the plaintiffs in these actions in 1988. The Company has not been notified of a substitution of attorneys for any of the plaintiffs and there has been no activity in these lawsuits since February 1988. (c) By letter dated February 29, 1988, the NYSDEC notified the Company that it has been identified as a potentially responsible party for investigation and remediation of the disposal of hazardous wastes at the Lockport City Landfill Site (Lockport Site) in Lockport, New York. The Lockport Site is listed on the New York State Registry. Four other potentially responsible parties were identified in the NYSDEC letter. The Company has been offered an opportunity to conduct remediation or finance remediation costs at the Lockport Site, failing which the NYSDEC might remediate the Lockport Site itself and commence an action to recover its costs and damages. The Company believes that remediation costs at the Lockport Site might rise to $6 million. By letter dated May 2, 1988, the Company notified the NYSDEC that it declined to finance remediation costs because it believes that the NYSDEC had not demonstrated that a significant threat to public health or the environment exists at the Lockport Site. (d) By letter dated December 10, 1990, the NYSDEC notified the Company that it had been identified as a potentially responsible party for investigation and remediation of the disposal of hazardous wastes at the Schreck's scrapyard site (Schreck's Site) in the City of North Tonawanda, New York. The Schreck's Site is listed on the New York State Registry. Seven other potentially responsible parties were identified in the NYSDEC letter. On February 3, 1992, the NYSDEC again notified the Company that it had been identified as a potentially responsible party for investigation and remediation costs at the Schreck's Site, this time listing eight other potentially responsible parties. The Company has been offered an opportunity to conduct remediation or finance remediation costs at the Schreck's Site, failing which the NYSDEC might remediate the Schreck's Site itself and commence an action to recover its costs and damages. The NYSDEC currently estimates that remediation costs at the Schreck's Site will be $4.5 million. By letter dated April 1, 1992, the Company notified the NYSDEC that it believed it had no responsibility for the alleged contamination at the Schreck's Site, and it declined to conduct remediation or finance remediation costs. (e) By letter dated June 7, 1991, the NYSDEC notified the Company that it had been identified as a potentially responsible party at the Pfohl Brothers Landfill inactive hazardous waste disposal site (Pfohl Site) in Cheektowaga, New York. The Pfohl Site is listed on the New York State Registry. The NYSDEC offered the Company an opportunity to enter into negotiations with it to undertake the investigation and remediation of the Pfohl Site. The NYSDEC informed the Company that if it declined such negotiations, the NYSDEC would perform the necessary work at the Pfohl Site using the Hazardous Waste Remedial Fund and would seek recovery of its expenses from the Company. On July 3, 1991, the Company responded to the NYSDEC by declining to negotiate to undertake work at the Pfohl Site and noted that the NYSDEC had not shown any significant responsibility on the part of the Company for the situation at the Pfohl Site. The Company believes that remediation costs at the Pfohl Site will be $35 million to $55 million. By letter dated April 2, 1992, the NYSDEC again notified the Company that it had been identified as a potentially responsible party for the Pfohl Site and offered the Company an opportunity to conduct or finance the on-site remedial design and action. This notice letter was also sent to 19 other potentially responsible parties. Ten of these other named potentially responsible parties have agreed to perform the remedial work required by the NYSDEC. By letter dated June 1, 1992, the Company notified the NYSDEC that it declined to perform such remedial work because it believed that it was not a significant contributor to the Pfohl Site. (f) By complaint dated October 31, 1991, General Motors Corporation (GM) commenced a lawsuit against the Company in the U. S. District Court for the Western District of New York. GM alleges, among other claims, that the Company violated various federal antitrust laws in connection with billings for electric service provided by the Company at GM's Harrison Radiator Plant at Lockport, New York. GM's claims are for damages incurred and to be incurred. The Company estimates that GM is claiming approximately $8 million, after trebling. The Company believes that it has not violated the federal antitrust laws and that this lawsuit is without merit. On October 5, 1993, the Magistrate to whom the case had been referred issued a decision recommending that GM's complaint be dismissed. The District Judge responsible for the case, after reviewing GM's exceptions to the decision and the Company's reply, will decide whether to adopt the Magistrate's recommended decision. (g) By letter dated January 21, 1992, the NYSDEC notified the Company that it had been identified as a potentially responsible party at the Peter Cooper Corporation's Landfill Site (Peter Cooper Site) in the village of Gowanda, New York. Three other potentially responsible parties were identified in the NYSDEC letter. The NYSDEC letter also notified the Company that state surface water and groundwater standards had been exceeded at the Peter Cooper Site and offered the Company an opportunity to conduct or finance a remedial program. NYSDEC indicated that if the Company did not agree to enter into a consent order it would perform the necessary work itself or seek a court order requiring the Company to conduct the work. The Company believes that remediation costs at the Peter Cooper Site might rise to $16 million. By letter dated May 12, 1992, the Company notified the NYSDEC that it believed it had no responsibility for the alleged contamination at the Peter Cooper Site, and it declined to conduct remediation or finance remediation costs. (h) By letter dated April 20, 1992, the EPA notified the Company that it had been identified as a potentially responsible party at the Bern Metals Removal Site (Bern Metals Site) in Buffalo, New York. Four other potentially responsible parties have been identified by the EPA. The EPA has taken response actions at the Bern Metals Site, including investigation, excavation, and removal of drums and contaminated soil, and implementation of measures to prevent surface water run-off. The EPA has demanded that the Company reimburse the EPA Hazardous Substances Superfund $2 million in response costs incurred to date by the EPA, with interest accruing from the date of the demand. Future response or remedial costs which the EPA may incur at the Bern Metals Site are not covered by the EPA demand and the EPA has reserved its rights relating to any such costs. In addition to the foregoing, the NYSDEC, by letter dated July 21, 1992, notified the Company that it had been identified as a potentially responsible party at the Bern Metals Site, which the NYSDEC defined to include an adjacent property known as the Universal Iron & Metal Site (Bern Metals/Universal Iron Site). The Bern Metals/Universal Iron Site is listed on the New York State Registry. The NYSDEC has also identified eight other potentially responsible parties for the Bern Metals/Universal Iron Site. The NYSDEC has requested that the Company, and the eight other identified potentially responsible parties, enter into negotiations in which the Company and the other identified potentially responsible parties would agree to finance or conduct a Remedial Investigation and Feasibility Study (RI/FS) designed to determine what further remediation or removal actions may be appropriate for the Bern Metals/Universal Iron Site. The NYSDEC has provided no estimate of the cost of the response action it proposes. By letter dated December 3, 1992, the Company declined to negotiate with NYSDEC to finance or conduct an RI/FS for the Bern Metals/Universal Iron Site, because the Company believed it was only a very small contributor to the Bern Metals/Universal Iron Site. In addition, the Company believes that it does not have any connection with the Universal Iron & Metal Site. (i) By letter dated April 20, 1992, the EPA notified the Company that the EPA had reason to believe that the Company was a potentially responsible party for the Clinton-Bender Removal Site (Clinton-Bender Site) in Buffalo, New York. Four other potentially responsible parties have been identified by the EPA. Nine private residential lots and one commercial property at the Clinton-Bender Site are contaminated with lead, allegedly due to run-off from the adjacent Bern Metals Site. The EPA has requested that the Company perform the necessary removal work at the Clinton-Bender Site and the Company is doing so in conjunction with the four other identified potentially responsible parties. The total cost of the removal actions to be performed at the Clinton-Bender Site is estimated to be $3.1 million. On November 3, 1993, the Company was served with a summons and complaint filed on behalf of certain of the homeowners at the Clinton-Bender Site. Seven other defendants were named in the complaint, which was filed in the New York State Supreme Court, Erie County. The action has since been removed to the U.S. District Court for the Western District of New York (District Court). In their complaint, plaintiffs make general allegations that the defendants violated federal environmental laws without alleging facts in support of these allegations. Plaintiffs also allege personal injury, property damage, and fear of cancer which they claim were caused by the presence of hazardous substances on their property, allegedly resulting from the disposal of such substances by the defendants at the Bern Metals Site. Any liability incurred as a result of these claims may be joint and several. The plaintiffs ask for $30 million in direct damages from all defendants, as well as treble damages (for unspecified reasons) from all defendants, and an additional $10 million in punitive damages from each defendant. The Company and some of the other defendants in this matter have made a motion to the District Court for dismissal of all claims based upon the Clean Air Act, the Clean Water Act, and the Comprehensive Environmental Response, Compensation, and Liability Act, which are the only claims based upon federal causes of action. The Company believes that its position in this action is meritorious, and it will defend this case vigorously. (j) By letter dated February 12, 1993, NYSDEC notified the Company that it had been identified as a potentially responsible party for remediation of hazardous wastes at the Booth Oil Site (Booth Oil Site) in North Tonawanda, New York. The Booth Oil Site is listed on the New York State Registry. Twelve other potentially responsible parties were identified in the NYSDEC letter. Booth Oil Company is a waste oil re-refiner and recycler. The Company had sent waste oils to Booth Oil Company for disposal as had numerous other companies in the Buffalo area. According to NYSDEC, the Booth Oil Site is contaminated with PCBs, lead, and other substances. NYSDEC has requested that the Company and the other identified potentially responsible parties conduct remediation at the Booth Oil Site pursuant to an Order on Consent to be negotiated with NYSDEC. NYSDEC has estimated that the present value of costs for on-site treatment alternatives range from $12 million to $24 million. Item 4. Item 4. Submission of matters to a vote of security holders - Not applicable. * * * * * * * * * Executive officers of the Registrant Positions, offices and business experience - Name Age January 1989 to date James A. Carrigg 60 Chairman, President and Chief Execu- tive Officer, January 1991 to date; Chairman and Chief Executive Officer, to January 1991. Richard P. Fagan 53 Senior Vice President-Management Services Business Unit, April 1990 to date; Senior Vice President- Administration, March 1989 to April 1990; Senior Vice President to March 1989. Executive officers of the Registrant (Cont'd) Positions, offices and business experience - Name Age January 1989 to date Russell Fleming, Jr. 55 Senior Vice President-Gas Business Unit, October 1990 to date; Partner in Putnam, Hayes and Bartlett (economic and management consultants), New York, New York May 1989 to September 1990; Partner in Theodore Barry & Associates (management consultants), New York, NY to May 1989. Jack H. Roskoz 55 Senior Vice President-Electric Business Unit, April 1990 to date; Senior Vice President, March 1989 to April 1990; Senior Vice President-Administration to March 1989. John J. Bodkin 48 Vice President-Electric Transmission and Distribution, January 1991 to date; Manager-Power Supply, to January 1991. Gerald E. Putman 43 Vice President-Fuel Supply and Opera- tion Services, May 1993 to date; Vice- President-East Region Electric, Septem- ber 1992 to May 1993; Executive Assistant to the Chairman, President and Chief Executive Officer, January 1991 to September 1992; District Manager, Auburn, NY to January 1991. Sherwood J. Rafferty 46 Vice President and Treasurer, September 1990 to date; Treasurer, to September 1990. Vincent W. Rider 62 Vice President-Generation. Everett A. Robinson 50 Vice President and Controller, September 1990 to date; Controller, to September 1990. Irene M. Stillings 54 Vice President-Electric Marketing, January 1991 to date; Assistant Vice President-Consumer Services and Communications, February 1989 to January 1991; Assistant Vice President- Consumer Affairs, to February 1989. Ralph R. Tedesco 40 Vice President-Strategic Growth Business Unit, February 1994 to date; Executive Assistant to the Chairman, President and Chief Executive Officer, September 1992 to February 1994; Manager, Corporate Performance June 1991 to September 1992; Manager, Research and Development to June 1991. Executive officers of the Registrant (Cont'd) Positions, offices and business experience - Name Age January 1989 to date Denis E. Wickham 45 Vice President-Electric Resource Planning, January 1991 to date; Assistant to Senior Vice President, to January 1991. The Company has entered into an agreement with James A. Carrigg which provides for his employment as Chairman, President and Chief Executive Officer of the Company for a term ending on December 31, 1996, with automatic one-year extensions unless either he or the Company gives notice that the agreement is not to be extended. Each officer holds office for the term for which he or she is elected or appointed, and until his or her successor shall be elected and shall qualify. The term of office for each officer extends to and expires at the meeting of the Board of Directors following the next annual meeting of stockholders. PART II Item 5. Item 5. Market for Registrant's common stock and related stockholder matters See Note 13 to the Consolidated Financial Statements on page 73. Principal Sources of Electric and Natural Gas Revenues Item 7. Management's discussion and analysis of financial condition and results of operations Results of Operations 1993 1992 over over 1992 1991 1993 1992 1991 Change Change (Thousands, except Per Share Amounts) Operating revenues $1,800,149 $1,691,689 $1,555,815 6% 9% Earnings available for common stock $145,390 $162,973 $148,313 (11%) 10% Average shares outstanding 69,990 67,972 62,906 3% 8% Earnings per share $2.08 $2.40 $2.36 (13%) 2% Dividends per share $2.18 $2.14 $2.10 2% 2% In 1993, operating revenues increased $108 million, or 6%, compared to 1992. This increase is primarily because of increases in electric and natural gas rates that became effective in August 1992 and September 1993, which totaled $61 million, and the amounts billed to customers for higher costs of non-utility generation (NUG) power and natural gas totaling $51 million. In 1992, operating revenues rose $136 million, or 9%, compared to 1991. The amounts billed to customers for higher costs of NUG power of $41 million, and increases in electric and natural gas rates effective in February 1991 and August 1992, which totaled $40 million, were the primary reasons for this increase. In addition, higher electric and natural gas retail sales due to an increase in retail customers, colder weather, and the April 1991 acquisition of Columbia Gas of New York, Inc. (CNY) helped boost operating revenues by $51 million in 1992. Earnings per share decreased 32 cents, or 13%, in 1993 compared to 1992, while earnings per share increased 4 cents, or 2%, in 1992 compared to 1991. Both 1993 and 1992 had non- recurring items that lowered earnings per share. Earnings in 1993 were reduced by 25 cents per share as a result of a corporate restructuring that will reorganize the way the Company delivers services to its electric and natural gas customers beginning in March 1994. This restructuring resulted in a work force reduction throughout the organization of approximately 600, the elimination of customer walk-in services at 28 satellite locations, and the closing of up to 10 electric and natural gas operations facilities statewide. This is one of several actions the Company has taken to reduce future costs, enhance efficiencies in service to its customers, and be competitive in the rapidly changing utility industry (See Competitive Conditions). A six-month electric rate moratorium, which began in February 1992, limited 1992 earnings per share by 24 cents. Excluding the effect of these non-recurring items, earnings per share decreased 31 cents in 1993 compared to 1992, and increased 28 cents in 1992 compared to 1991. The 31 cent 1993 decrease in earnings per share was primarily due to lower electric retail sales prior to the effective date of the Company's modified revenue decoupling mechanism (See Regulatory Matters) and lower than anticipated natural gas sales, both resulting from the sluggish economy in the Company's service territory. Also, earnings per share decreased due to changes in the Company's allowed return on equity from 11.7% effective through July 1992, to 11.2% effective through July 1993, and then to 10.8% beginning in August 1993. In 1992, earnings per share were favorably affected by the growth in electric and natural gas retail sales primarily due to an increase in retail customers, colder weather, and the April 1991 acquisition of CNY. The Company's efforts to control costs also contributed to the increase in 1992 earnings per share. Average shares outstanding were 70 million in 1993, 68 million in 1992, and 63 million in 1991. Average shares outstanding increased 3% in 1993 compared to 1992 due to the issuance of 1.2 million shares of common stock through the Dividend Reinvestment and Stock Purchase Plan (DRP). In 1992, average shares outstanding increased 8% because of a public offering of 5 million shares of common stock in March 1992, and the issuance of 1 million shares of common stock through the DRP. Interest Expense Interest expense (before the reduction for allowance for borrowed funds used during construction) decreased by $10 million, or 6%, in 1993 and $8 million, or 5%, in 1992. Interest on long-term debt decreased in 1993 and 1992 mainly due to the refinancing of certain high-coupon long-term debt at lower interest rates, and lower interest rates on the Company's variable rate debt. In 1993 and 1992 interest expense also decreased due to a reduction in the interest rate on the commercial paper borrowings (See Financing Activities). Operating Results by Business Unit 1993 1992 over over 1992 1991 Electric 1993 1992 1991 Change Change (Thousands) Retail sales-kilowatt- hours(kwh) 13,088,175 13,294,466 13,107,115 (2%) 1% Operating revenues $1,527,362 $1,451,525 $1,367,936 5% 6% Operating expenses $1,250,000 $1,146,619 $1,056,969 9% 8% Electric retail sales decreased 2% in 1993 compared to 1992 as a result of the sluggish economy in the Company's service territory and in spite of a 1% increase of customers. In 1992, electric retail sales increased 1% compared to 1991 mainly due to colder but more normal weather and an increase in customers. The primary cause of the $76 million, or 5%, increase in electric operating revenues in 1993 was the increase in rates effective August 1992 and September 1993, which accounted for $53 million of the increase. Also contributing to this increase were higher costs of NUG power of $28 million, which were billed to customers. Electric operating revenues increased $84 million, or 6%, in 1992 compared to 1991. This increase reflects the increases in electric rates that became effective February 1991 and August 1992 and that increased revenues by $35 million. The revenue increase reflects higher NUG costs of $41 million and an increase in certain New York State gross receipts taxes of $12 million, both of which were billed to customers. Also, increased electric retail sales, due to colder weather and an increase in customers, boosted revenues by $9 million. Electric operating expenses increased $103 million, or 9%, in 1993 compared to 1992, and $90 million, or 8%, in 1992 compared to 1991. In 1993, electricity purchased from NUGs increased $67 million. Other operating expenses increased primarily due to an increase in postretirement benefit costs other than pensions of $7 million. In addition, electric operating expenses increased $21 million due to the corporate restructuring. These increases were partially offset by a decrease of $17 million in fuel used in electric generation, the result of lower generation and a decrease in the price of coal, and a decrease of $12 million in federal income taxes, the result of lower pre-tax book income. In 1992, electricity purchased increased primarily because of the amounts billed to customers for higher NUG costs, which totaled $41 million. Other operating expenses increased primarily because of higher demand-side management (DSM) program costs of $6 million. Federal income taxes increased $4 million resulting from higher pre-tax book income. Other taxes increased primarily because of an increase in certain New York State gross receipts taxes and property taxes of $16 million. These increases were partially offset by a decrease of $12 million in fuel used in electric generation, the result of lower generation and a decrease in the price of coal, and a decrease in maintenance expense of $7 million. 1993 1992 over over 1992 1991 Natural Gas 1993 1992 1991 Change Change (Thousands) Deliveries -dekatherms(dth) 58,046 56,366 42,404 3% 33% Retail sales-(dth) 39,345 39,357 29,874 - 32% Operating revenues $272,787 $240,164 $187,879 14% 28% Operating expenses $249,493 $221,307 $177,751 13% 25% Natural gas deliveries increased 3% in 1993 compared to 1992 while natural gas retail sales were flat. In 1992, natural gas deliveries and retail sales increased 33% and 32%, respectively, compared to 1991. The increase in deliveries in 1993 reflects an increase in the number of transportation customers. The 1992 increases in deliveries, as well as retail sales, are largely because of the April 1991 acquisition of CNY. Excluding CNY, natural gas retail sales increased 8% in 1992, primarily because of the colder but more normal weather. Natural gas operating revenues rose $33 million, or 14%, in 1993 compared to 1992, and $52 million, or 28%, in 1992 compared to 1991. In 1993, the increase was primarily due to higher costs of natural gas of $23 million, which were billed to customers, and the increases in rates in August 1992 and September 1993, which totalled $8 million. The 1992 revenue increases are principally the result of the acquisition of CNY, which added $35 million, and the increases in rates effective February 1991 and August 1992 amounting to $4 million. Also, the recovery of an increase in certain New York State gross receipts taxes, which were billed to customers, boosted 1992 revenues by $2 million. Natural gas operating expenses increased $28 million, or 13%, in 1993 compared to 1992. The increase in natural gas purchased was primarily due to higher costs of natural gas amounting to $12 million. Federal income taxes increased $3 million due to higher pre-tax book income. Natural gas operating expenses increased $5 million due to the corporate restructuring. Natural gas operating expenses increased $44 million, or 25%, in 1992 compared to 1991. Natural gas purchased increased $31 million due to an increase in the volume of natural gas purchased. This volume increase was primarily due to the CNY acquisition. Federal income taxes increased $4 million due to higher pre-tax book income. Other taxes increased primarily due to an increase of $3 million in certain New York State gross receipts taxes and $1 million in property taxes. Liquidity and Capital Resources Competitive Conditions The utility industry is rapidly changing and facing an increasingly competitive environment. Factors contributing to this competitive environment are: the National Energy Policy Act of 1992 (Energy Policy Act), which provides open access at the wholesale level to electric transmission service, and the FERC Order 636, which significantly affects the natural gas industry. In addition, the Company's response to the economic pressures on its electric industrial and other large use customers, high purchase costs of NUGs, rising health care costs, increasing taxes, weak economic conditions, conservation programs, and compliance with environmental laws and regulations are all factors that continue to place increased pressure on electric and natural gas prices. The Energy Policy Act, enacted in October 1992, is expected to result in major changes to the utility industry. Certain provisions of the Energy Policy Act amended the Public Utility Holding Company Act of 1935 (PUHCA). These amendments encourage greater competition in the supply market by establishing a new category of wholesale electric generators that are exempt from PUHCA regulation. The Energy Policy Act also enables the FERC to order utilities to provide open access to transmission systems for wholesale transactions, expanding opportunities for utilities and NUGs to enter new and existing wholesale markets. These developments serve to underscore the increasingly competitive environment for utilities. The Company's five-year strategic plan is designed to address the competitive, rapidly changing utility industry. The Company's objective is to remain competitive in its core businesses in the face of increased competition. One of the key strategies to meet competition is to improve customer value by becoming a low-cost provider of energy services in the Northeast. A major challenge to the Company's Electric Business Unit is to retain and grow its industrial base. The competitive energy supply options currently available to the Company's industrial customers include self-generation, shifting production to plants in other locations, or relocation. During 1993, the Company received PSC approval for a flexible, negotiable rate tariff for some of its high-use industrial customers. Discounts negotiated in agreements under this tariff are not expected to have a material effect on the Company's 1994 earnings. Two agreements have been negotiated which eliminated threats of self-generation and relocation. The PSC currently has a generic proceeding to study the broad subject of flexible, competitive rates, and will establish guidelines for the Company and other New York State utilities during 1994. Also in late 1993, the PSC instituted a proceeding to address issues associated with the restructuring of the emerging competitive natural gas market. The PSC intends to investigate services provided by New York State gas utilities after FERC Order 636 by the 1994-1995 heating season. In November 1993, the Company filed with the PSC an additional flexible, negotiable rate tariff to address opportunities for new load. The proposed tariff is for large additions to load (at least 500 kilowatts [kw]) for new or existing industrial and some commercial customers. The tariff will assist the Company in attracting new customers whose location or expansion decisions are influenced by electricity costs. Smaller customers will be assisted by a concurrent proposal to increase the Company's existing economic development incentives by one cent per kilowatt-hour. The Company has proposed and will continue to propose revisions or additional tariffs to respond to the opportunities or risks that develop in a changing electric utility industry. A major challenge to the Company's Gas Business Unit is FERC Order 636, which became effective in November 1993, and requires interstate natural gas pipeline companies to offer customers unbundled or separate services equivalent to their former sales service. With the unbundling of services, primary responsibility for reliable natural gas supply will shift from interstate pipeline companies to local distribution companies, such as the Company. This should result in increased direct access to low cost natural gas supplies by local distribution companies and end users. One goal of FERC Order 636 is to provide equitable access to interstate pipeline capacity. FERC Order 636 will substantially restructure the interstate natural gas market and intensify competition within the natural gas industry. FERC Order 636 will allow the Company, subject to PSC approval, to restructure rates and provide multiple service options to its customers. In July 1993, certain interstate pipelines serving the Company began implementing restructured services in compliance with FERC Order 636. The remaining pipelines implemented restructured services by November 1993. As a result of these restructuring changes, pipelines have incurred and will continue to incur transition costs. These transition costs include those associated with restructuring existing natural gas supply contracts, the unrecovered natural gas cost that would otherwise have been billable to pipeline customers under previously existing rules, costs of assets needed to implement the order, and stranded investment costs. FERC Order 636 allows pipelines to recover all prudently incurred costs from their customers. The Company's liability for transition costs will be based on the pipelines' filings with FERC to recover transition costs. Only a few of those filings have been made. The Company recorded an estimated liability for transition costs of approximately $29 million. The Company also recorded a deferred asset for that amount since it is currently recovering transition costs from its customers through its gas adjustment clause and believes that such costs will continue to be recoverable from its customers. The Company has developed a more aggressive and accelerated set of strategies in response to the increased challenges of competition which are necessary to achieve the objectives outlined in the Company's five-year strategic plan. The following represent strategies being implemented: - Reduce forecasted 1994 capital expenditures by one-third, or approximately $100 million. Additional reductions will be made in 1995 and 1996. - Reduce operating and maintenance expenses by five percent in 1994 and again in 1995. By 1995, this will save about $40 million annually. During 1993, the Company reduced its work force by 200 through attrition. In addition, as part of the O&M reduction, the Company's work force was further reduced by about 600 through an early retirement opportunity program and involuntary severance. - Streamline the field organization to eliminate walk-in customer service at 28 locations, and to close up to 10 electric and natural gas operations facilities statewide. - Place two generating units on long-term cold standby. - Continue to reduce NUG costs. The Company's previous NUG contract terminations and renegotiations will save customers more than $1 billion over the terms of the contracts. - Continue to reduce capital costs. Since 1988 the Company has refinanced over $1.4 billion in securities, and reduced annual interest expense by more than $55 million. The cost of the corporate restructuring was $26 million and was a one-time charge against the Company's 1993 earnings. The restructuring reduced 1993 earnings available for common stock by approximately $17.2 million or 25 cents per share. Included in this amount are $13.2 million for a voluntary early retirement program, $3.2 million for an involuntary severance program, and $.8 million for the elimination and closing of operations facilities. The Company expects to recoup the one-time charge from lower O&M costs in approximately one year. As part of the Company's effort to meet competition and minimize future price increases associated with uneconomical power purchases from NUGs, it negotiated the termination of two cogeneration projects. This effort, along with the termination of NUG contracts due to developers' failures to meet contract obligations, will save customers nearly $1 billion over the terms of the contracts. The Company has also recently negotiated amendments with two NUGs whereby the Company may direct the NUGs to reduce their output or shut down for limited periods each year. During these periods, lower-cost generation will replace the NUG energy and result in additional customer savings. The Company is negotiating with other NUGs for similar amendments. The Company has on line and under contract 362 megawatts (mw) of NUG power. In addition, another 240 mw of NUG power is under construction. The Company is required to make payments under these contracts only for the power it receives. During 1993, 1992, and 1991, the Company purchased approximately $138 million, $71 million, and $30 million, respectively, of NUG power. The Company estimates that it will purchase approximately $255 million, $291 million, and $335 million of NUG power for the years 1994, 1995, and 1996, respectively. Increases in NUG power purchase costs are expected to be a significant contributor to price increases over the next three years. Diversification Diversification will play an important role in the Company's future. While the strength of the Company's core electric and natural gas businesses remains its focus, and while the Company will not compromise its financial integrity, it is actively evaluating a number of corporate development opportunities for investment to help augment future earnings and dividend growth. In April 1992, the PSC issued an order allowing the Company to invest up to 5% of its consolidated capitalization (approximately $175 million at December 31, 1993) in one or more subsidiaries that may engage or invest in energy-related or environmental services businesses and provide related services. In May 1993, NGE Enterprises, Inc. (NGE), a wholly-owned subsidiary of the Company, formed a computer software company, EnerSoft Corporation (EnerSoft), to produce and market software applications for natural gas utilities in the post-FERC Order 636 environment. This represents NGE's initial diversified investment. In October 1993, EnerSoft began a strategic alliance with the New York Mercantile Exchange to develop an information superhighway that will provide the natural gas industry with a single system for monitoring and trading natural gas and pipeline capacity in the North American market. NGE invested approximately $9 million in EnerSoft through February 1994. The Company and NGE plan to develop two natural gas storage projects. One of the projects, which will be regulated by the PSC, is expected to cost approximately $14 million and will be used to supplement the Company's natural gas supply. Construction of this project is scheduled to begin in 1994 and it is expected to be operating for the 1995-96 heating season. The other project, which will be regulated by the FERC, is an equal partnership between NGE and ANR Storage, Inc., and is expected to cost approximately $44 million in total. The entire capacity of this project will be marketed to local distribution companies and NUGs, as well as marketers, producers, and end users of natural gas. Construction of this project is scheduled to begin in 1995 and it is expected to be operating for the 1996-1997 heating season. Financing Activities The Company believes that maintaining a high degree of financial integrity and flexibility is critical to success in an increasingly competitive environment. The Company intends to build on the financial improvements realized over the past several years with a goal of achieving a 50% common equity ratio. New money needs are expected to be minimal and excess cash generated from reduced construction expenditures will be used to further manage the Company's capital structure (See Investing Activities - estimated sources and uses of funds for 1994-1996). The PSC adopted a new, innovative approach in December 1993 when it issued an order to the Company that provides for advanced approval for financings during the Company's three-year rate settlement. That order includes authorization for refundings of first mortgage bonds, preferred stock, and tax-exempt pollution control notes, issuance of common stock through the Dividend Reinvestment and Stock Purchase Plan (DRP), and issuances of other securities as required. With this order, the Company has the flexibility to achieve its financial goals of further reducing financing costs and improving its financial health as market conditions allow. The common stock equity ratio remained stable during 1993. Issuance of shares under the DRP was offset by the issuance of $100 million of preferred stock and $70 million of tax-exempt pollution control notes in December 1993. The Company received $38.4 million from the issuance of 1.2 million shares of common stock through the DRP. Common stock dividends paid in 1993 increased 5% over 1992 reflecting the increase in common stock outstanding and an increase in the dividend paid from $2.14 to $2.18 per share. The Company's dividend payout ratio has been gradually rising over the past several years, primarily as a result of declining earnings. These weak earnings put additional pressure on an already high dividend payout ratio at a time when growing competition dictates that we consider a more moderate dividend policy. We must significantly improve earnings if we are to continue even modest annual dividend increases. The Company sold $25 million of 6.30% preferred stock, $50 million of Adjustable Rate Series B preferred stock, and $25 million of 7.40% preferred stock in December 1993. The net proceeds were used to redeem $25 million of 8.80% preferred stock and $45 million of Adjustable Rate Series A preferred stock in January 1994, and $25 million of 8.48% preferred stock in February 1994. Those refundings will save approximately $1.8 million annually. After those refundings, the capital structure will be 49.8% long-term debt, 7.1% preferred stock, and 43.1% common stock equity. In February 1993, the Company redeemed, at par, through a sinking fund provision in our mortgage, the remaining $22.5 million of 10 5/8% Series first mortgage bonds due 2018. In February 1993, the Company priced $100 million of 6.05% tax-exempt pollution control bonds, due 2034. Proceeds from the sale, which will be delivered in April 1994, will be used to redeem, at a premium, $60 million of 12% pollution control bonds, due 2014, and $40 million of 12.3% pollution control bonds, due 2014. The refunding of those bonds in 1994 will save approximately $5.3 million annually in interest costs. In April 1993, the Company sold $50 million of 7.55% Series first mortgage bonds due 2023. Net proceeds from the sale were used in connection with the redemption of $50 million of the 9 1/4% Series due 2016. The refunding of those bonds will save approximately $300,000 annually in interest costs. In July 1993, the Company sold $100 million of 7.45% Series first mortgage bonds due 2023. Net proceeds from the sale were used in connection with the redemption of $100 million of the 9% Series due 2017. The refunding of those bonds will save approximately $650,000 annually in interest costs. In November 1993, the Company redeemed $50 million of the 8 5/8% Series first mortgage bonds due 1996, at a premium. Proceeds for the redemption were provided by a borrowing under the Company's revolving credit agreement. The refunding of those bonds will save approximately $2 million annually in interest costs. In December 1993, $70 million of 5.70% tax-exempt pollution control notes, due 2028, were issued by a governmental authority on behalf of the Company. Proceeds from the sale will be used to finance a portion of the costs incurred in the construction of certain solid waste disposal and other related facilities at the Company's Milliken Generating Station. The Company has reduced its embedded cost of long-term debt to 7.2% at the end of 1993 from 9.2% in 1988. The Company has refinanced more than $1.2 billion in long-term debt since 1988, and reduced annual interest expense by more than $55 million. Unless interest rates fall further, however, it will be difficult to significantly improve from the 7.2% level. All opportunities continue to be pursued aggressively. In February 1994, the Company redeemed, at par, through a sinking fund provision in its mortgage, $23 million of 8 5/8% Series first mortgage bonds due 2007. In February 1994, $37.5 million of tax-exempt pollution control notes were issued by a governmental authority on behalf of the Company. The notes will have several interest rate options and have an initial rate of 2.4% through April 13, 1994. Proceeds from the sale will be used to redeem $37.5 million of annual adjustable rate pollution control notes, due 2015, in March 1994. The Company uses interim financing in the form of short-term unsecured notes, usually commercial paper, to finance certain refundings and construction expenditures and for other corporate purposes, thereby providing flexibility in the timing and amounts of long-term financings. There was $50.2 million of commercial paper outstanding at December 31, 1993, at a weighted average interest rate of 3.5%. The weighted average interest rate during 1993 was 3.4%. The Company also has a revolving credit agreement with certain banks that provides for borrowing up to $200 million to July 31, 1997. The Company had an outstanding $50 million loan under this agreement at December 31, 1993, at an interest rate of 4.06%. In June 1993, the Company's first mortgage bonds and unsecured pollution control notes were upgraded by Standard & Poor's (S&P). The investment rating agency stated that the higher ratings reflect expected continued improvements in the Company's financial condition as a result of the Company's three- year rate settlement, which was pending at the time of the upgrade, aggressive cost controls, and limited new money needs. S&P also noted that regulatory adjustment mechanisms, such as electric revenue decoupling and natural gas weather normalization, should add stability to earnings. In October 1993, S&P completed its review of the U.S. investor-owned utility industry and concluded that more stringent financial benchmarks were appropriate for electric utilities to counter increased competition and mounting business risk. As a result, it revised the rating outlook downward for about one- third of the utility industry, including the Company. However, the Company's ratings were not changed. Investing Activities The Company's 1993 capital expenditures for its core electric and natural gas businesses totaled approximately $245 million. Most of the expenditures were for the extension of service and for improvements at existing facilities. Capital expenditures for 1994-1996 have been significantly reduced from previously forecasted levels. This represents one of many actions the Company is taking to address competition (See Competitive Conditions). Capital expenditures for 1994-1996 will be primarily for extension of service, necessary improvements at existing facilities, and compliance with the Clean Air Act Amendments of 1990 (See Environmental Matters). The Company forecasts that its current reserve margin, coupled with more efficient use of energy (See Conservation Programs) and generation from NUGs, will eliminate the need for additional generating capacity until after the year 2005. As part of the Company's effort to reduce costs, one of two generating units at each of its Goudey and Greenidge Generating Stations will be placed on long-term cold standby. These actions are being taken because the abundance of power in the Northeast has driven down wholesale prices. These units will continue to be utilized to provide electrical system support. The following table provides information on the Company's estimated sources and uses of funds for 1994-1996. This forecast is subject to periodic review and revision, and actual construction costs may vary because of revised load estimates, imposition of additional regulatory requirements, and the availability and cost of capital. 1994 1995 1996 Total ---- ---- ---- ----- Sources of funds (Millions) Internal funds $254 $265 $269 $788 Long-term financing Debt and stock proceeds 413 141 80 634 Debt proceeds held in trust 34 8 - 42 ---- ---- ---- ----- Net financing proceeds 447 149 80 676 Increase (decrease) in short-term debt (50) - - (50) Decrease (increase) in temporary cash investments 89 (69) (52) (32) ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== Uses of funds Construction Cash expenditures $202 $193 $193 $588 AFDC 8 7 7 22 ---- ---- ---- ------ Total construction 210 200 200 610 Retirement of securities and sinking fund obligations 501 108 63 672 Working capital and deferrals 29 37 34 100 ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== As shown in the preceding table, internal sources of funds represent 129% of construction expenditures for 1994-1996. Conservation Programs The Company has implemented a number of demand-side management (DSM) programs. As a result of its three-year rate settlement agreement (See Regulatory Matters), incentives earned for conducting efficient DSM programs were reduced from 15% to 5% of the net resource savings achieved by these DSM programs. For 1994, the Company expects to earn approximately $3 million in incentives as a result of these DSM programs. In 1993, the Company's customers saved approximately 282 million kilowatt-hours (kwh) on an annualized basis through the Company's DSM programs. The implementation of these programs cost $48 million in 1993 and will cost approximately $16 million in 1994 with estimated customer savings of 113 million kwh on an annualized basis. The Company has approximately $73 million and $44 million of deferred DSM program costs on the Consolidated Balance Sheets at December 31, 1993, and 1992, respectively. The two-year (1993-1994) DSM plan, which has received PSC approval, has been modified to improve cost-effectiveness and reduce rate impacts. Environmental Matters The Company continually assesses actions that may need to be taken to ensure compliance with changing environmental laws and regulations. Compliance programs will increase the cost of electric and natural gas service by requiring changes to the Company's operations and facilities. Historically, rate recovery has been authorized for the cost incurred for compliance with environmental laws and regulations. Due to existing and proposed legislation and regulations, and legal proceedings commenced by governmental bodies and others, the Company may also incur costs from the past disposal of hazardous substances produced during the Company's operations or those of its predecessors. The Company has been notified by the EPA and the NYSDEC that it is among the potentially responsible parties (PRPs) who may be liable to pay for costs incurred to remediate certain hazardous substances at seven waste sites, not including the Company's inactive gas manufacturing sites, which are discussed below. With respect to the seven sites, five sites are included in the New York State Registry of Inactive Hazardous Waste Sites (New York State Registry). Any liability may be joint and several for certain of these sites. The ultimate cost to remediate these sites will be dependent on such factors as the remedial action plan selected, the extent of site contamination, and the portion attributed to the Company. At December 31, 1993, the Company recorded a liability in the Consolidated Balance Sheets related to four of these seven waste sites of $1.8 million. The Company has notified the NYSDEC that it believes it has no responsibility at two sites and has already incurred expenditures related to the remediation at the remaining site. A deferred asset has also been recorded in the amount of $2.6 million, of which $.8 million relates to costs that have already been incurred. The Company believes it will recover these costs, since the PSC has allowed other utilities to recover these types of remediation costs and has allowed the Company to recover similar costs in rates, such as investigation and cleanup costs relating to inactive gas manufacturing sites. This $1.8 million estimate was derived by multiplying the total estimated cost to clean up a particular site by the related Company contribution factor. Estimates of the total cleanup costs were determined by using information related to a particular site, such as investigations performed to date at a site or from the data released by a regulatory agency. In addition, this estimate was based upon currently available facts, existing technology, and presently enacted laws and regulations. The contribution factor is calculated using either the Company's percentage share of the total PRPs named, which assumes all PRPs will contribute equally, or the Company's estimated percentage share of the total hazardous wastes disposed of at a particular site, or by using a 1% contribution factor for those sites at which it believes that it has contributed a minimal amount of hazardous wastes. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A number of the Company's inactive gas manufacturing sites have been listed in the New York State Registry. The Company has filed petitions to delist the majority of the sites. The Company's program to investigate and initiate remediation at its 38 known inactive gas manufacturing sites has been extended through the year 2000. Expenditures over this time period are estimated to be $25 million. This estimate was determined by using the Company's experience and knowledge related to these sites as a result of the investigation and remediation that the Company has performed to date. It is based upon currently available facts, existing technology, and presently enacted laws and regulations. This liability, to investigate and initiate remediation, as necessary, at the known inactive gas manufacturing sites is reflected in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992. The Company also has recorded a corresponding deferred asset, since it expects to recover such expenditures in rates, as the Company has previously been allowed by the PSC to recover such costs in rates. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. The Clean Air Act Amendments of 1990 (1990 Amendments) will result in significant expenditures of approximately $178 million, on a present value basis, over a 25-year period, for all capital and operating and maintenance expenses related to the reduction of sulfur dioxide and nitrogen oxides at several of the Company's coal-fired generating stations, of which $51 million has been incurred as of December 31, 1993. The Company's current estimate is a significant reduction from its prior estimate, primarily due to the postponement of the construction of a flue gas desulfurization (FGD) system at its Homer City Generating Station. The Company plans to re-evaluate the need to construct an FGD system at the Homer City Generating Station in 1995, since its present strategy to bank Phase I emissions allowances for use during Phase II, as discussed below, will allow the Company to meet Phase II allowance requirements through the year 2005. The cost to comply with the sulfur dioxide and nitrogen oxide limitations includes the construction of an innovative FGD system and a nitrogen oxide reduction system expected to be completed in 1995 at the Company's Milliken Generating Station. The Company estimates that approximately a 1% electric rate increase will be required for the cost of reducing sulfur dioxide and nitrogen oxide emissions in both Phase I (begins January 1, 1995) and Phase II (begins January 1, 2000). As a result of the 1990 Amendments, the Company plans to reduce its annual sulfur dioxide emissions by an amount that will allow the Company to meet the sulfur dioxide levels established for the Company, which is approximately a 49% reduction from approximately 138,000 tons in 1989 to 71,000 tons by the year 2000. The cost of controlling toxic emissions under the 1990 Amendments, if required, cannot be estimated at this time. Regulations may be adopted at the state level which would limit toxic emissions even further, at an additional cost to the Company. The Company anticipates that the costs incurred to comply with the 1990 Amendments will be recoverable through rates based on previous rate recovery of required environmental costs. The 1990 Amendments require the U.S. Environmental Protection Agency (EPA) to allocate annual emissions allowances to each of the Company's coal-fired generating stations based on statutory emissions limits. An emissions allowance represents an authorization to emit, during or after a specified calendar year, one ton of sulfur dioxide. During Phase I, the Company estimates that it will have allowances in excess of the affected coal-fired generating stations' actual emissions. The Company's present strategy is to bank these allowances for use in later years. By using a banking strategy, it is estimated that Phase II allowance requirements will be met through the year 2005 by utilizing the allowances banked during Phase I, which includes the extension reserve allowances discussed below, together with the Company's Phase II annual emissions allowances. This strategy could be modified should market or business conditions change. In addition to the annual emissions allowances allocated to the Company by the EPA, the Company will receive a portion of the extension reserve allowances issued by the EPA to utilities electing to build scrubbers, as a result of the pooling agreement that it entered into with other utilities who were also eligible to receive some of these extension reserve allowances. As a result of existing and new solid waste disposal legislation and regulations in Pennsylvania, the Company will incur approximately $24 million, on a present value basis, of additional costs over the next 30 years, beginning in 1994, at the Homer City Generating Station. These costs will be incurred to install new equipment, modify or replace existing equipment, and improve the design of a proposed expansion of disposal facilities. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Regulatory Matters In September 1993, the Company reached a three-year electric and natural gas rate settlement agreement (Agreement) with the PSC. The new electric and natural gas rates became effective September 4, 1993. The allowed return on equity is 10.8% in year one, 11.4% in year two, and 11.4% (subject to an indexing mechanism) in year three. Shareholders will be allowed to keep 100% of any earnings in excess of the allowed return in year one. Shareholders and customers will share, on a 50%/50% basis, any earnings in excess of the allowed return in years two and three. The Agreement also includes a modified revenue decoupling mechanism (RDM) for electric sales. Rates are based on sales forecasts. Since actual sales may differ significantly from forecasted sales because of conservation efforts, unusual weather, or changing economic conditions, the revenue collected may be more or less than forecast. Subject to the caps described below, the modified RDM will let the Company adjust for most of the differences between forecasted and actual sales. For example, if revenues exceed the forecast for a given year, the excess would be passed back to customers in a future year. If revenues are below the forecast, customers would receive a surcharge in a future year. The Company will share excesses or shortfalls from most large commercial and industrial sales revenues on a 70%/30% (customer/stockholder) basis. Customer savings for production and transmission operating costs of $21 million will be imputed over three years, $7 million each year, whether or not they are realized. Incentives for customer service, production cost, and DSM could increase the allowed return to 12.3% or decrease it to 9.95% in year one, increase it to 13.05% or decrease it to 10.4% in year two, and increase it to 13.25% or decrease it to 10.2% in year three. The electric and natural gas rate increases discussed below represent eleven months for year one and twelve months for years two and three. The estimated total electric price increases below include base rate increases allowed by the Agreement plus estimates of fuel and purchased power increases which will be collected through the Fuel Adjustment Clause (FAC). Actual fuel and purchased power costs could vary from estimates causing the estimated FAC and total electric price increases below to change. Base Rate Estimated FAC Total Electric (Dollar Amounts in Millions) Year 1 $60.5 4.4% $39.1 3.0% $99.6 7.4% Year 2 $70.3 4.8% $39.2 2.8% $109.5 7.6% Year 3 $57.4 3.6% $30.4 2.0% $87.8 5.6% The natural gas base rate increases allowed by the Agreement are $7.5 million, or 2.9%, $8.2 million, or 3.0%, and $7.2 million, or 2.5%, in years one, two, and three, respectively. They do not include changes in natural gas costs, which will be collected through the Gas Adjustment Clause. Natural gas costs can be expected to rise and fall with overall natural gas market conditions. Such fluctuations will affect the total natural gas price increases. The Agreement also provides for the stated electric and natural gas base rate increases to be adjusted up or down in the second and third years, as well as the year after the Agreement period (year four). These adjustments will depend on several factors, such as electric sales and incentive mechanisms. The Agreement provides that no cap would apply to any downward revision to base rates for electric and natural gas service. The electric base rate increases could be increased by up to 1.5% in years two and three and 1.6% in year four (the caps). The natural gas base rate increases could also be increased by up to 1% in year two and 1.2% in year three. The Agreement does not specify a cap for natural gas base rates for year four. Item 8. Financial statements and supplementary data New York State Electric & Gas Corporation Consolidated Statements of Income Year Ended December 31 1993 1992 1991 - ---------------------------------------------------------------------------- (Thousands, except Per Share Amounts) Operating Revenues Electric . . . . . . . . . . . . . . . . $1,527,362 $1,451,525 $1,367,936 Natural gas. . . . . . . . . . . . . . . 272,787 240,164 187,879 ---------- ---------- ---------- Total Operating Revenues . . . . . . $1,800,149 1,691,689 1,555,815 ---------- ---------- ---------- Operating Expenses Fuel used in electric generation . . . . 245,283 262,531 274,877 Electricity purchased (Note 9) . . . . . 161,967 95,026 45,808 Natural gas purchased. . . . . . . . . . 141,635 126,815 99,528 Other operating expenses . . . . . . . . 349,177 318,680 279,364 Restructuring expenses (Notes 6 and 7) . 26,000 - - Maintenance. . . . . . . . . . . . . . . 111,757 102,500 110,131 Depreciation and amortization (Note 1) . 164,568 158,977 152,380 Federal income taxes (Notes 1 and 2) . . 94,144 102,456 94,447 Other taxes (Note 12). . . . . . . . . . 204,962 200,941 178,185 ---------- ---------- ---------- Total Operating Expenses . . . . . . . 1,499,493 1,367,926 1,234,720 ---------- ---------- ---------- Operating Income. . . . . . . . . . . . . 300,656 323,763 321,095 Other Income and Deductions . . . . . . . 6,471 12,036 6,076 ---------- ---------- ---------- Income Before Interest Charges. . . . . . 307,127 335,799 327,171 ---------- ---------- ---------- Interest Charges Interest on long-term debt . . . . . . . 134,330 145,822 151,649 Other interest . . . . . . . . . . . . . 11,120 9,566 11,877 Allowance for borrowed funds used during construction. . . . . . . . (4,351) (3,557) (4,998) ---------- ---------- ---------- Interest Charges - Net . . . . . . . . 141,099 151,831 158,528 ---------- ---------- ---------- Net Income. . . . . . . . . . . . . . . . 166,028 183,968 168,643 Preferred Stock Dividends . . . . . . . . 20,638 20,995 20,330 ---------- ---------- ---------- Earnings Available for Common Stock . . . $145,390 $162,973 $148,313 ========== ========== ========== Earnings Per Share. . . . . . . . . . . . $2.08 $2.40 $2.36 Average Shares Outstanding. . . . . . . . 69,990 67,972 62,906 The notes on pages 50 through 73 are an integral part of the financial statements. New York State Electric & Gas Corporation Consolidated Balance Sheets December 31 1993 1992 - ------------------------------------------------------------------------------- (Thousands) Assets Utility Plant, at Original Cost (Note 1) Electric (Note 8). . . . . . . . . . . . . . . . . . . $4,777,368 $4,573,444 Natural gas. . . . . . . . . . . . . . . . . . . . . . 381,389 352,059 Common . . . . . . . . . . . . . . . . . . . . . . . . 158,986 157,979 ---------- ---------- . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,317,743 5,083,482 Less accumulated depreciation. . . . . . . . . . . . . 1,541,456 1,427,793 ---------- ---------- Net Utility Plant in Service. . . . . . . . . . . . 3,776,287 3,655,689 Construction work in progress. . . . . . . . . . . . . 143,859 177,566 ---------- ---------- Total Utility Plant . . . . . . . . . . . . . . . . 3,920,146 3,833,255 Other Property and Investments, net . . . . . . . . . . 73,537 59,157 Current Assets Cash and cash equivalents (Notes 1 and 10) . . . . . . 4,264 3,968 Special deposits (Note 10) . . . . . . . . . . . . . . 145,335 96,432 Accounts receivable, net (Note 1). . . . . . . . . . . 181,586 171,683 Fuel, at average cost. . . . . . . . . . . . . . . . . 54,791 69,077 Materials and supplies, at average cost. . . . . . . . 48,910 50,637 Prepayments. . . . . . . . . . . . . . . . . . . . . . 30,092 37,897 Accumulated deferred federal income tax benefits (Notes 1 and 2). . . . . . . . . . . . - 1,182 ---------- ---------- Total Current Assets. . . . . . . . . . . . . . . . 464,978 430,876 Deferred Charges (Note 1) Unfunded future federal income taxes (Notes 1 and 2) . . . . . . . . . . . . . . . 380,056 393,720 Unamortized debt expense . . . . . . . . . . . . . . . 112,059 96,378 Demand-side management program costs . . . . . . . . . 73,113 44,049 Other. . . . . . . . . . . . . . . . . . . . . . . . . 252,127 220,481 ---------- ---------- Total Deferred Charges. . . . . . . . . . . . . . . 817,355 754,628 ---------- ---------- Total Assets. . . . . . . . . . . . . . . . . . . . $5,276,016 $5,077,916 ========== ========== The notes on pages 50 through 73 are an integral part of the financial statements. New York State Electric & Gas Corporation Consolidated Balance Sheets December 31 1993 1992 - ------------------------------------------------------------------------------ (Thousands) Capitalization and Liabilities Capitalization Common stock equity Common stock ($6.66 2/3 par value, 90,000,000 shares authorized and 70,595,985 and 69,439,397 shares issued and outstanding at December 31, 1993 and 1992, respectively) . . . . . . . . . . $470,640 $462,929 Capital in excess of par value. . . . . . . . . . 824,943 796,505 Retained earnings . . . . . . . . . . . . . . . . 320,114 327,040 ---------- ---------- Total common stock equity. . . . . . . . . . . . . . . 1,615,697 1,586,474 Preferred stock redeemable solely at the option of the Company (Note 4). . . . . . . . . . . . . . . . 140,500 160,500 Preferred stock subject to mandatory redemption requirements (Notes 4 and 10) . . . . . . . . . . . 125,000 106,900 Long-term debt (Notes 3 and 10). . . . . . . . . . . . 1,630,629 1,777,027 ---------- ---------- Total Capitalization. . . . . . . . . . . . . . . 3,511,826 3,630,901 Current Liabilities Current portion of long-term debt and preferred stock (Notes 3 and 4) . . . . . . . . . . . . . . . 332,709 115,659 Commercial paper (Notes 5 and 10). . . . . . . . . . . 50,200 64,100 Accounts payable and accrued liabilities . . . . . . . 111,481 95,996 Interest accrued (Note 10) . . . . . . . . . . . . . . 31,348 37,690 Accumulated deferred federal income taxes (Notes 1 and 2) . . . . . . . . . . . . . . . . . . 1,132 - Other. . . . . . . . . . . . . . . . . . . . . . . . . 89,443 65,073 ---------- ---------- Total Current Liabilities . . . . . . . . . . . . 616,313 378,518 Deferred Credits Accumulated deferred investment tax credits (Notes 1 and 2) . . . . . . . . . . . . . . . . . . 138,478 141,729 Excess deferred federal income taxes (Notes 1 and 2) . 36,378 58,188 Other. . . . . . . . . . . . . . . . . . . . . . . . . 149,620 107,160 ---------- ---------- Total Deferred Credits. . . . . . . . . . . . . . 324,476 307,077 Accumulated Deferred Federal Income Taxes (Notes 1 and 2) Unfunded future federal income taxes . . . . . . . . . 380,056 393,720 Other. . . . . . . . . . . . . . . . . . . . . . . . . 416,545 342,700 ---------- ---------- Total Accumulated Deferred Federal Income Taxes . . . . . . . . . . . . . . . . . . 796,601 736,420 Commitments and Contingencies (Note 9). . . . . . . . . 26,800 25,000 ---------- ---------- Total Capitalization and Liabilities. . . . . . . $5,276,016 $5,077,916 ========== ========== The notes on pages 50 through 73 are an integral part of the financial statements. Notes to Consolidated Financial Statements 1 Significant Accounting Policies Principles of consolidation The consolidated financial statements include the Company's wholly-owned subsidiaries, Somerset Railroad Corporation (SRC) and NGE Enterprises, Inc. (NGE). All significant intercompany balances and transactions are eliminated in consolidation. Utility plant The cost of repairs and minor replacements is charged to the appropriate operating expense accounts. The cost of renewals and betterments, including indirect cost, is capitalized. The original cost of utility plant retired or otherwise disposed of and the cost of removal less salvage are charged to accumulated depreciation. Depreciation and amortization Depreciation expense is determined using straight-line rates, based on the average service lives of groups of depreciable property in service. Depreciation accruals were equivalent to 3.4%, 3.3%, and 3.3%, of average depreciable property for 1993, 1992, and 1991, respectively. Depreciation expense includes the amortization of certain deferred charges authorized by the Public Service Commission of the State of New York (PSC). Revenue During 1993, 1992, and 1991, the Company recognized on the income statement approximately $12 million, $22 million, and $40 million, respectively, of electric and natural gas unbilled revenues that had been accrued on its balance sheet for energy provided but not yet billed to minimize the rate increases for these years in accordance with various PSC rate decisions. The July 1992 rate decision allowed the Company to recognize on its income statement, beginning in August 1992, electric and natural gas unbilled revenues on a full accrual basis. The Company recognizes as revenue incentives earned as the result of conducting efficient demand-side management (DSM) programs. The Company is collecting those incentives in rates within approximately one year after they are recognized. During 1993, 1992, and 1991, incentives earned were $16.4 million, $15.6 million, and $12.4 million, respectively. At December 31, 1993 and 1992, approximately $14.3 million and $9.8 million, respectively, of DSM incentives were accrued and included in accounts receivable. Accounts receivable The Company has an agreement that expires in November 1996 to sell, with limited recourse, undivided percentage interests in certain of its accounts receivable from customers. The agreement allows the Company to receive up to $152 million from the sale of such interests. At December 31, 1993 and 1992, accounts receivable on the Consolidated Balance Sheets is shown net of $152 million and $138 million, respectively, of interests in accounts receivable sold. All fees associated with the program are included in other income and deductions on the Consolidated Statements of Income and amounted to approximately $5.7 million, $6.5 million, and $9.3 million in 1993, 1992, and 1991, respectively. Accounts receivable on the Consolidated Balance Sheets is also shown net of an allowance for doubtful accounts of $4 million and $1.9 million at December 31, 1993 and 1992, respectively. Bad debt expense was $15.3 million, $11.5 million, and $10.7 million in 1993, 1992, and 1991, respectively. Federal income taxes The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, in January 1993. Since the Company had been accounting for income taxes under Statement of Financial Accounting Standards No. 96, Accounting for Income Taxes, there was no effect on the Consolidated Statements of Income as a result of adopting SFAS 109. However, SFAS 109 did require the Company's deferred tax balances to be reclassified on its Consolidated Balance Sheets. The Company files a consolidated federal income tax return with SRC and NGE. Deferred income taxes are provided on all temporary differences between financial statement basis and taxable income. Investment tax credits, which reduce federal income taxes currently payable, are deferred and amortized over the estimated lives of the applicable property. The effect of the alternative minimum tax, which increases federal income taxes currently payable and generates a tax credit available for future use, is deferred and amortized at such times as the tax credit is used on the Company's federal income tax return. Deferred charges The Company defers certain incurred expenses when authorized by the PSC. Those expenses will be recovered from customers in the future. Consolidated Statements of Cash Flows The Company considers all highly liquid investments with a maturity or put date of three months or less when acquired to be cash equivalents. These investments are included in cash and cash equivalents on the Consolidated Balance Sheets. Total income taxes paid were $27.3 million, $38.5 million, and $31.8 million for the years ended December 31, 1993, 1992, and 1991, respectively. Interest paid, net of amounts capitalized, was $138.2 million, $149.3 million, and $159.9 million for the years ended December 31, 1993, 1992, and 1991, respectively. The Company purchased all of the common stock of Columbia Gas of New York, Inc. in 1991. In conjunction with the acquisition, liabilities assumed were $24.9 million (fair value of assets acquired of $82 million less cash paid of $57.1 million). Reclassification Certain amounts have been reclassified on the consolidated financial statements to conform with the 1993 presentation. 2 Federal Income Taxes Year ended December 31 1993 1992 1991 (Thousands) Charged to operations Current $34,989 $37,237 $22,991 Deferred - net Accelerated depreciation 49,580 41,492 37,409 Unbilled revenues 5,073 160 13,644 Alternative minimum tax (AMT) credit (3,194) 2,123 5,557 Demand-side management 13,479 9,324 8,589 NUG termination agreement 4,760 6,800 - Nine Mile No. 2 litigation proceeds 4,756 (2,047) - Restructuring expenses (6,965) - - Transmission facility agreement(7,778) (1,172) (1,162) Miscellaneous (6,198) (3,491) (9,365) Investment tax credit (ITC) deferred 5,642 12,030 16,784 ------- -------- ------- 94,144 102,456 94,447 Included in other income Amortization of deferred ITC (8,892) (16,927) (11,297) Miscellaneous 498 3,747 (533) ------- -------- ------- Total $85,750 $89,276 $82,617 ======= ======== ======= The Company's effective tax rate differed from the statutory rate of 35% in 1993 and 34% in 1992 and 1991 due to the following: Year ended December 31 1993 1992 1991 (Thousands) Tax expense at statutory rate $88,684 $92,903 $85,428 Depreciation not normalized 16,984 16,697 16,051 ITC amortization (8,892) (16,927) (11,297) Research & Development (R&D) credit (5,139) - - Cost of removal (4,921) (4,079) (6,120) Other - net (966) 682 (1,445) ------- ------- ------ Total $85,750 $89,276 $82,617 ======= ======= ======= The Company's current and noncurrent deferred taxes, which net to a tax liability of approximately $936.2 million as of December 31, 1993, consisted of the following deferred tax assets and liabilities: Deferred Tax Deferred Tax Assets Liabilities (Thousands) Depreciation $ 698,939 Loss on reacquired debt 28,440 Regulatory Asset (SFAS 109) 149,636 Accumulated deferred ITC 91,006 Demand-side management 35,381 NUG contract settlement costs 15,163 Alternative minimum tax credit $ 19,953 Excess tax reserve 12,603 Nine Mile No. 2 disallowed plant 19,347 Contributions in aid of construction 20,913 Capitalized interest 8,690 Other 35,369 34,521 ----------- ------------ Total deferred taxes $116,875 $1,053,086 =========== ============ The Revenue Reconciliation Act (RRA) of 1993 was enacted on August 10, 1993. Among other things, RRA 1993 provided for an increase of 1% in the statutory corporate income tax rate and an extension of the R&D credit until June 30, 1995. In September 1993, the Company reached a three-year rate settlement agreement with the PSC (Agreement) which included a provision for the Company to petition to defer the effect of RRA 1993 until it is reflected in rates. The Company has deferred for collection from customers $.6 million representing additional 1993 federal income taxes resulting from RRA 1993. The Company has recorded unfunded future federal income taxes and a corresponding receivable from customers of approximately $381 million and $393 million as of December 31, 1993 and 1992, respectively, primarily representing the cumulative amount of federal income taxes on temporary depreciation differences, which were previously flowed through to customers. Those amounts, including the tax effect of the future revenue requirements, are being amortized over the life of the related depreciable assets concurrent with their recovery in rates. The Company has approximately $20 million of AMT credits which do not expire, and $5.1 million of R&D credits which expire beginning in 2005. 3 Long-Term Debt At December 31, 1993 and 1992, long-term debt was (Thousands): First mortgage bonds Amount Series Due 1993 1992 8 3/8% Aug. 15, 1994 $ 100,000 $100,000 8 5/8% June 1, 1996 - 50,000 5 5/8% Jan. 1, 1997 25,000 25,000 6 1/4% Sept. 1, 1997 25,000 25,000 6 1/2% Sept. 1, 1998 30,000 30,000 7 5/8% Nov. 1, 2001 50,000 50,000 6 3/4% Oct. 15, 2002 150,000 150,000 9 3/8% Jan. 1, 2006 - 3,000 7 1/4% June 1, 2006 12,000 12,000 6 7/8% Dec. 1, 2006 25,250 25,500 8 5/8% Nov. 1, 2007 60,000 60,000 9 1/4% Apr. 1, 2016 - 50,000 9% Mar. 1, 2017 - 100,000 10 5/8% Jan. 1, 2018 - 100,000 9 7/8% Feb. 1, 2020 100,000 100,000 9 7/8% May 1, 2020 100,000 100,000 9 7/8% Nov. 1, 2020 100,000 100,000 8 7/8% Nov. 1, 2021 150,000 150,000 8.30 % Dec. 15, 2022 100,000 100,000 7.55 % Apr. 1, 2023 50,000 - 7.45 % July 15, 2023 100,000 - --------- --------- Total first mortgage bonds 1,177,250 1,330,500 ========= ========= Pollution control notes Interest Maturity Interest Rate Letter of Credit Amount Rate Date Adjustment Date Expiration Date 1993 1992 12% May 1, 2014* - - 60,000 60,000 12.30% July 1, 2014* - - 40,000 40,000 2.80% Dec. 1, 2014 Dec. 1, 1994 Dec. 15, 1995 74,000 74,000 2.75% Mar. 1, 2015 Mar. 1, 1994 Mar. 15, 1995 37,500 37,500 2.50% Mar. 15, 2015 Mar. 15, 1994 Mar. 31, 1995 60,000 60,000 2.60% July 15, 2015 July 15, 1994 July 31, 1995 63,500 63,500 2.85% Oct. 15, 2015 Oct. 15, 1994 Oct. 31, 1995 30,000 30,000 2.75% Dec. 1, 2015 Dec. 1, 1994 Dec. 15, 1995 42,000 42,000 4.10% July 1, 2026 July 1, 1996 July 15, 1996 65,000 65,000 5.95% Dec. 1, 2027 - - 34,000 34,000 5.70% Dec. 1, 2028 - - 70,000 - ---------- ---------- Total pollution control notes 576,000 506,000 ========== ========== Revolving Credit Agreement Note due July 31, 1997 50,000 - Long-term notes due December 31, 1996 36,100 27,707 CNG Transmission Corp. Note due November 10, 1996 8,862 - Obligations under capital leases 30,902 38,804 Unamortized premium and discount on debt-net (10,776) (11,975) ---------- ---------- 1,868,338 1,891,036 Less: debt due within one year-included in current liabilities 237,709 114,009 ---------- ---------- Total $1,630,629 $1,777,027 ========== ========== * Will be refunded in 1994 with proceeds from the issuance of $100 million of 6.05% pollution control notes due 2034. At December 31, 1993, long-term debt and capital lease payments which will become due during the next five years are: 1994 1995 1996 1997 1998 (Thousands) $237,709 $12,552 $45,651 $102,196 $31,411 The Company's mortgage provides for a sinking and improvement fund. This provision requires the Company to make annual cash deposits with the Trustee equivalent to 1% of the principal amount of all bonds delivered and authenticated by the Trustee prior to January 1 of that year (excluding any bonds issued on the basis of the retirement of bonds). The Company satisfied this requirement in 1993 by depositing $22.5 million in cash which was used to redeem in February 1993, $22.5 million of 10 5/8% Series first mortgage bonds, due 2018. The Company satisfied this requirement in 1994 by depositing $23 million in cash which was used to redeem in February 1994, $23 million of 8 5/8% Series first mortgage bonds, due 2007. Mandatory annual cash sinking fund requirements are $600,000 beginning June 1, 2001, for the 7 1/4% Series and $250,000 on December 1 in each year 1994 to 1996, for the 6 7/8% Series. The amount increases to $500,000 and $750,000 on December 1, 1997 and December 1, 2002, respectively, for the 6 7/8% Series. The Company's first mortgage bond indenture constitutes a direct first mortgage lien on substantially all utility plant. Adjustable rate pollution control notes were issued to secure like amounts of tax-exempt adjustable rate pollution control revenue bonds (Revenue Bonds) issued by a governmental authority. The Revenue Bonds bear interest at the rate indicated through the date preceding the interest rate adjustment date. The pollution control notes bear interest at the same rate as the Revenue Bonds. On the interest rate adjustment date and annually thereafter (every three years thereafter in the case of the Revenue Bonds due July 1, 2026), the interest rate will be adjusted, not to exceed a rate of 15%, or at the option of the Company, subject to certain conditions, a fixed rate of interest, not to exceed 18%, may become effective. In the case of the Revenue Bonds due July 1, 2026, at the option of the Company, subject to certain conditions, a fixed rate of interest may become effective prior to the interest rate adjustment date or each third year thereafter. Bond owners may elect, subject to certain conditions, to have their Revenue Bonds purchased by the Trustee. The Company has irrevocable letters of credit which expire on the letter of credit expiration dates and which the Company anticipates being able to extend if the interest rate on the related Revenue Bonds is not converted to a fixed interest rate. Those letters of credit support certain payments required to be made on the Revenue Bonds. If the Company is unable to extend the letter of credit that is related to a particular series of Revenue Bonds, that series will have to be redeemed unless a fixed rate of interest becomes effective. Payments made under the letters of credit in connection with purchases of Revenue Bonds by the Trustee are repaid with the proceeds from the remarketing of the Revenue Bonds. To the extent the proceeds are not sufficient, the Company is required to reimburse the bank that issued the letter of credit. 4 Preferred Stock At December 31, 1993 and 1992, serial cumulative preferred stock was: Shares Par Value Authorized Per Redeemable and Amount Series Share Prior to Per Share Outstanding(1) 1993 1992 (Thousands) Redeemable solely at the option of the Company: 3.75% $100 $104.00 150,000 $ 15,000 $ 15,000 4 1/2%(1949) 100 103.75 40,000 4,000 4,000 4.15% 100 101.00 40,000 4,000 4,000 4.40% 100 102.00 75,000 7,500 7,500 4.15% (1954) 100 102.00 50,000 5,000 5,000 6.48% 100 102.00 300,000 30,000 30,000 8.80% (2) 100 102.00 250,000 25,000 25,000 8.48% (3) 25 25.70 1,000,000 25,000 25,000 7.40% (4) 25 12/1/98 26.85 1,000,000 25,000 - Thereafter 25.00 Adjustable Rate (5) 25 25.00 1,800,000 45,000 45,000 Adjustable Rate (6) 25 12/1/98 27.50 2,000,000 50,000 - Thereafter 25.00 ---------- ---------- 235,500 160,500 Less: preferred stock redemptions within one year - included in current liabilities 95,000 - ---------- ---------- Total $ 140,500 $ 160,500 ========== ========== Subject to mandatory redemption requirements: 9.00% (7) 100 - $ - $ 8,550 6.30% (8) 100 1/1/95 105.67 250,000 25,000 - 8.95% (9) 25 1/1/95 26.79 4,000,000 100,000 100,000 ---------- ---------- 125,000 108,550 Less: sinking fund requirements at par value - included in current liabilities - 1,650 ---------- ---------- Total $ 125,000 $ 106,900 ========== ========== At December 31, 1993, preferred stock redemptions and annual redeemable preferred stock sinking fund requirements for the next five years are: 1994 1995 1996 1997 1998 (Thousands) $95,000 $ - $ - $5,000 $5,000 (1) At December 31, 1993, and after giving effect to the redemptions referred to in (2), (3), and (5) below, there were 1,550,000 shares of $100 par value preferred stock, 3,800,000 shares of $25 par value preferred stock and 1,000,000 shares of $100 par value preference stock authorized but unissued. (2) Redeemed January 18, 1994. (3) Redeemed February 1, 1994. (4) The Company is restricted in its ability to redeem this Series prior to December 1, 1998. (5) The Adjustable Rate Serial Preferred Stock, Series A, was redeemed January 10, 1994. (6) The payment on the Adjustable Rate Serial Preferred Stock, Series B, for April 1, 1994, is at an annual rate of 5.12% and subsequent payments can vary from an annual rate of 4% to 10%, based on a formula included in the Company's Certificate of Incorporation. The Company is restricted in its ability to redeem this Series prior to December 1, 1998. (7) On October 1, 1993, 33,000 shares were redeemed at par. The remaining 52,500 shares were redeemed at $100.50 per share on October 13, 1993. For the years 1991 and 1992, 16,500 shares were redeemed and cancelled annually. (8) On January 1, in each year 2004 through 2008, the Company must redeem 12,500 shares at par, and on January 1, 2009, the Company must redeem the balance of the shares at par. This Series is redeemable at the option of the Company at $105.67 per share prior to January 1, 1995. The $105.67 price will be reduced annually by 63 cents for the years ending 1995 through 2002; thereafter, the redemption price is $100.00. The Company is restricted in its ability to redeem this Series prior to January 1, 2004. (9) On January 1, in each year 1997 through 2016, the Company must redeem 200,000 shares at par. This Series is redeemable at the option of the Company at $26.79 per share prior to January 1, 1995. The $26.79 price will be reduced annually by 15 cents for the years ending 1995 through 1999; by 14 cents for the year ending 2000; and by 15 cents for the years ending 2001 through 2005. The Company is restricted in its ability to redeem this Series prior to January 1, 1996. 5 Bank Loans and Other Borrowings The Company has a revolving credit agreement with certain banks which provides for borrowing up to $200 million to July 31, 1997. At the option of the Company, the interest rate on borrowings is related to the prime rate, the London Interbank Offered Rate (LIBOR) or the interest rate applicable to certain certificates of deposit. The agreement also provides for the payment of a commitment fee which can fluctuate from .15% to .375% depending upon the ratings of the Company's first mortgage bonds. The commitment fee at December 31, 1993 is .1875%. The Company had an outstanding loan of $50 million under the revolving credit agreement at December 31, 1993, at an interest rate of 4.06% under the LIBOR option, and did not have any outstanding loans under this agreement at December 31, 1992. The revolving credit agreement does not require compensating balances. In order to provide flexibility in the timing and amounts of long-term financings, the Company uses interim financing in the form of short-term unsecured notes, usually commercial paper, to finance certain refundings and construction expenditures, and for other corporate purposes. Information relative to short-term borrowings is as follows: Commercial Paper 1993 1992 1991 (Thousands) Ending balance $50,200 $64,100 $103,900 Maximum amount outstanding $95,400 $140,000 $111,000 Average amount outstanding (1) $56,300 $31,400 $66,700 Weighted average interest rate On ending balance 3.5% 4.0% 5.3% During the period (2) 3.4% 4.3% 6.2% (1) Calculated as the average of the sum of daily outstanding borrowings. (2) Calculated by dividing total interest expense by the average of the sum of daily outstanding borrowings. 6 Restructuring In the fourth quarter of 1993, the Company recorded a $26 million restructuring charge. The corporate restructuring will reorganize the way the Company delivers services to its electric and natural gas customers beginning in March 1994. The restructuring reduced 1993 earnings available for common stock by approximately $17.2 million or 25 cents per share. Included in this amount are $13.2 million for a voluntary early retirement program, $3.2 million for an involuntary severance program, and $.8 million for the elimination and closing of electric and natural gas operations facilities statewide. During 1994, the restructuring resulted in a work force reduction throughout the organization of approximately 600, the elimination of customer walk-in services at 28 satellite locations, and the closing of up to 10 electric and natural gas operations facilities statewide. The work force reduction was accomplished through a voluntary early retirement program (See Note 7 - Retirement Benefits) and an involuntary severance program. 384 employees accepted the early retirement program. 7 Retirement Benefits Pensions The Company has a noncontributory retirement annuity plan that covers substantially all employees. Benefits are based principally on the employee's length of service and compensation for the five highest paid years out of the last 10 years of service. It is the Company's policy to fund pension costs accrued each year to the extent deductible for federal income tax purposes. The net pension benefit for 1993, 1992, and 1991 totaled $5.7 million, $1.5 million, and $2.9 million, respectively. Effective January 1, 1993, the retirement benefit plans for hourly and salaried employees were combined into one plan. Combining the two plans did not affect benefit levels. Net pension benefit for 1993, 1992, and 1991 included the following components: 1993 1992 1991 (Thousands) Service cost: Benefits earned during the year $ 17,688 $ 15,387 $ 13,252 Interest cost on projected benefit obligation 40,710 35,253 32,096 Actual return on plan assets (77,129) (60,020) (111,749) Net amortization and deferral 12,989 7,844 63,487 ------- -------- -------- Net pension (benefit) $ (5,742) $ (1,536) $ (2,914) ======= ======== ======== The funded status of the plans at December 31, 1993 and 1992 were: 1993 1992 (Thousands) Actuarial present value of accumulated benefit obligation: Vested $390,716 $287,504 Nonvested 55,476 42,286 -------- -------- Total 446,192 329,790 ======== ======== Fair value of plan assets $753,292 $701,893 Actuarial present value of projected benefit obligation (608,216) (480,429) -------- -------- Plan assets in excess of projected benefit obligation 145,076 221,464 Unrecognized net transition asset (73,612) (80,850) Unrecognized net (gain) loss (83,709) (139,729) Unrecognized prior service cost 4,182 5,209 --------- -------- Net pension (liability) asset $(8,063) $ 6,094 ========= ======== Plan assets primarily consist of equity securities, corporate, U.S. agency, and Treasury bonds, and cash equivalents. The projected benefit obligation was measured using an assumed discount rate of 7% for 1993 and 7.75% for 1992 and 1991, and a long-term rate of increase in future compensation levels of 5% for 1993 and 6% for 1992 and 1991. The net pension benefit was measured using an expected long-term rate of return on plan assets of 8% in 1993 and 7.5% in 1992 and 1991. Early Retirement As part of the corporate restructuring that was announced in the fourth quarter of 1993 (See Note 6 - Restructuring), the Company offered a voluntary early retirement program from December 1, 1993, through January 21, 1994, to employees who were 55 years and older and who had at least 10 years of service with the Company. The program included two provisions: an unreduced pension benefit for those eligible employees who were under 60 years old, and a monthly supplemental payment to "bridge" employees to age 62 when they can begin collecting Social Security benefits. 384 employees accepted the early retirement opportunity. In 1993, the Company recorded a $19.9 million expense for the early retirement program. Postretirement Benefits Other Than Pensions The Company has postretirement benefit plans, such as a comprehensive health insurance plan and a prescription drug plan, that provide certain benefits for retired employees and their dependents. Substantially all of the Company's employees who retire under the Company's pension plan may become eligible for those benefits at retirement. At December 31, 1993, 1992, and 1991, 1,996, 1,905, and 1,866 retirees and their dependents, respectively, were covered under these plans. The postretirement benefit plans are unfunded as of December 31, 1993. However, the Company is examining the cost-effectiveness of certain funding alternatives. In January 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires that the Company accrue a liability for estimated future postretirement benefits during an employee's working career rather than recognize an expense when benefits are paid. At the time of adoption, the actuarially determined accumulated postretirement benefit obligation (APBO) was $206.6 million. The Company elected to recognize the APBO over 20 years. In September 1993, the PSC issued a Statement of Policy concerning the accounting and ratemaking treatment for pensions and postretirement benefits other than pensions (PSC Policy). The PSC Policy was effective January 1993, adopted SFAS 106 for accounting and ratemaking purposes, and complies with generally accepted accounting principles. Postretirement benefits cost other than pensions that was recognized on the income statement for the twelve months ended December 31, 1993, 1992, and 1991, was $11.4 million, $5 million, and $4.4 million, respectively. The amount for 1993 represents the portion of SFAS 106 costs that the Company has been allowed to collect from its customers. The amounts for the twelve months ended December 31, 1992 and 1991, represent the postretirement benefits cost as determined prior to the adoption of SFAS 106, when the cost was not recognized as an expense until the benefits were paid. The Company has deferred $10.1 million of SFAS 106 costs as of December 31, 1993. The Company expects to recover any deferred SFAS 106 amounts in accordance with the PSC Policy. The PSC Policy allows various rate mechanisms, including the use of excess pension fund assets, such as Internal Revenue Service Code of 1986 Section 420 transfers, to temper the effect of SFAS 106 on rates. In 1993, the Company transferred approximately $5 million of its excess pension plan assets to cover most of the cost of retirees' health care for that year. As a result of this transfer, the Company recognized a decrease in its deferred SFAS 106 asset. The estimated net postretirement benefits cost other than pensions for the 12 months ended December 31, 1993, includes the following components: (Thousands) Service cost: Benefits accumulated during the year $ 6,888 Interest cost on accumulated postretirement benefit obligation 16,304 Amortization of transition obligation over 20 years 10,330 Deferral for future recovery (22,095) --------- Net periodic postretirement benefits cost $ 11,427 ========== The status of the plans for postretirements benefits other than pensions, as reflected in the Company's Consolidated Balance Sheets at December 31, 1993, is as follows: (Thousands) Accumulated postretirement benefit obligation (APBO): Retired employees $ 69,947 Fully eligible active plan participants 36,454 Other active plan employees 107,708 ---------- Total APBO 214,109 ---------- Less unrecognized transition obligation 196,268 Less unrecognized net (gain) (10,233) ---------- Accrued postretirement liability $ 28,074 ========== A 12% annual rate of increase in the per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 5% by the year 2003. Increasing the assumed health care cost trend rates by 1% in each year would increase the APBO as of January 1, 1994, by $41.5 million and increase the aggregate of the service cost and interest cost components of the net postretirement benefits cost for 1994 by $4.6 million. A discount rate of 7% was used to determine the APBO. 8 Jointly-Owned Generating Stations Nine Mile Point Unit 2 The Company has an undivided 18% interest in the output and costs of the Nine Mile Point nuclear generating unit No. 2 (NMP2), which is being operated by Niagara Mohawk Power Corporation (Niagara Mohawk). Ownership of NMP2 is shared with Niagara Mohawk 41%, Long Island Lighting Company 18%, Rochester Gas and Electric Corporation 14%, and Central Hudson Gas & Electric Corporation 9%. The Company's share of the rated capability is 189,000 kilowatts. The Company's net utility plant investment, excluding nuclear fuel, was approximately $652 million and $660 million, at December 31, 1993 and 1992, respectively. The accumulated provision for depreciation was approximately $103 million and $90 million, at December 31, 1993 and 1992, respectively. The Company's share of operating expenses is included in the Consolidated Statements of Income. A low level radioactive waste management and contingency plan that has been developed for NMP2 provides assurance that NMP2 is properly prepared to handle interim storage of low level radioactive waste until 1998. Niagara Mohawk has contracted with the U.S. Department of Energy (DOE) for disposal of high level radioactive waste (spent fuel) from NMP2. The Company is reimbursing Niagara Mohawk for its 18% share of the cost under the contract (currently approximately $1 per megawatt hour of net generation). The DOE's schedule for start of operations of their high level radioactive waste repository has slipped from 2003 to no sooner than 2010. The Company has been advised by Niagara Mohawk that the NMP2 Spent Fuel Storage Pool has a capacity for spent fuel that is adequate until 2014. If further DOE schedule slippage should occur, the recent development of pre-licensed dry storage facilities for use at any nuclear power plant extends the on-site storage capability for spent fuel at NMP2 beyond 2014. Nuclear Insurance Niagara Mohawk maintains public liability and property insurance for NMP2. The Company reimburses Niagara Mohawk for its 18% share of those costs. The public liability limit for a nuclear incident is approximately $8.8 billion. Should losses stemming from a nuclear incident exceed the commercially available public liability insurance, each licensee of a nuclear facility would be liable for up to a maximum of $75.5 million per incident, payable at a rate not to exceed $10 million per year. The Company's maximum liability for its 18% interest in NMP2 would be approximately $13.6 million per incident. The $75.5 million assessment is subject to periodic inflation indexing and a 5% surcharge should funds prove insufficient to pay claims associated with a nuclear incident. The Price-Anderson Act also requires indemnification for precautionary evacuations whether or not a nuclear incident actually occurs. Niagara Mohawk maintains nuclear property insurance for NMP2 and is reimbursed by the Company for its 18% interest. Niagara Mohawk has procured property insurance aggregating approximately $2.7 billion through the Nuclear Insurance Pools and the Nuclear Electric Insurance Limited (NEIL). In addition, the Company has purchased NEIL insurance coverage for the extra expense incurred in purchasing replacement power during prolonged accidental outages. Under NEIL programs, should losses resulting from an incident at a member facility exceed the accumulated reserves of NEIL, each member, including the Company, would be liable for its share of the deficiency. The Company's maximum liability under the property damage and replacement power coverages is approximately $2.3 million. Nuclear Plant Decommissioning Costs In May 1993, the Nuclear Regulatory Commission (NRC) updated labor, energy, and burial cost factors for determining the minimum funding requirement for nuclear decommissioning. As a result, the Company's 18% share of the cost to decommission NMP2 is currently estimated to be $234 million in 2027, when decommissioning is expected to commence ($74 million in 1993 dollars). The Company's annual decommissioning allowance currently included in electric rates is approximately $1.6 million and is sufficient to recover the minimum funding requirement. The Company believes that any increase in decommissioning costs will ultimately be recovered in rates. The Company has established a Qualified Fund under applicable provisions of the federal tax law. The fund also complies with the NRC regulations which require the use of an external trust fund to provide funds to decommission the contaminated portion of NMP2. The balance in this fund was approximately $5.7 million and $3.9 million at December 31, 1993 and 1992, respectively, and is included in other property and investments on the Consolidated Balance Sheets. Homer City The Company has an undivided 50% interest in the output and costs of the Homer City Generating Station, which is comprised of three generating units. The station is owned with Pennsylvania Electric Company, which operates the facility. The Company's share of the rated capability is 954,000 kilowatts and its net utility plant investment was approximately $258 million and $251 million at December 31, 1993 and 1992, respectively. The accumulated provision for depreciation was approximately $159 million and $148 million, at December 31, 1993 and 1992, respectively. The Company's share of operating expenses is included in the Consolidated Statements of Income. 9 Commitments and Contingencies Capital Expenditures The Company has substantial commitments in connection with its construction program and estimates that capital expenditures for 1994, 1995, and 1996 will approximate $210 million, $200 million, and $200 million, respectively. These forecasted levels have been significantly reduced as the Company is taking action to address competition. The program is subject to periodic review and revision, and actual construction costs may vary because of revised load estimates, imposition of additional regulatory requirements, and the availability and cost of capital. Environmental Matters The Company continually assesses actions that may need to be taken to ensure compliance with changing environmental laws and regulations. Compliance programs will increase the cost of electric and natural gas service by requiring changes to the Company's operations and facilities. Historically, rate recovery has been authorized for the cost incurred for compliance with environmental laws and regulations. Due to existing and proposed legislation and regulations, and legal proceedings commenced by governmental bodies and others, the Company may also incur costs from the past disposal of hazardous substances produced during the Company's operations or those of its predecessors. The Company has been notified by the U. S. Environmental Protection Agency (EPA) and the New York State Department of Environmental Conservation (NYSDEC) that the Company is among the potentially responsible parties (PRPs) who may be liable to pay for costs incurred to remediate certain hazardous substances at seven waste sites, not including the Company's inactive gas manufacturing sites, which are discussed below. With respect to the seven sites, five sites are included in the New York State Registry of Inactive Hazardous Waste Sites (New York State Registry). Any liability may be joint and several for certain of these sites. The ultimate cost to remediate these sites will be dependent on such factors as the remedial action plan selected, the extent of site contamination, and the portion attributed to the Company. At December 31, 1993, the Company recorded a liability in the Consolidated Balance Sheets related to four of these seven sites of $1.8 million. The Company has notified the NYSDEC that it believes it has no responsibility at two sites and has already incurred expenditures related to the remediation at the remaining site. A deferred asset has also been recorded in the amount of $2.6 million, of which $.8 million relates to costs that have already been incurred. The Company believes it will recover these costs, since the PSC has allowed other utilities to recover these types of remediation costs and has allowed the Company to recover similar costs in rates, such as investigation and cleanup costs relating to inactive gas manufacturing sites. This $1.8 million estimate was derived by multiplying the total estimated cost to clean up a particular site by the related Company contribution factor. Estimates of the total cleanup costs were determined by using information related to a particular site, such as investigations performed to date at a site or from the data released by a regulatory agency. In addition, this estimate was based upon currently available facts, existing technology, and presently enacted laws and regulations. The contribution factor is calculated using either the Company's percentage share of the total PRPs named, which assumes all PRPs will contribute equally, or the Company's estimated percentage share of the total hazardous wastes disposed of at a particular site, or by using a 1% contribution factor for those sites at which it believes that it has contributed a minimal amount of hazardous wastes. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A number of the Company's inactive gas manufacturing sites have been listed in the New York State Registry. The Company has filed petitions to delist the majority of the sites. The Company's program to investigate and initiate remediation at its 38 known inactive gas manufacturing sites has been extended through the year 2000. Expenditures over this time period are estimated to be $25 million. This estimate was determined by using the Company's experience and knowledge related to these sites as a result of the investigation and remediation that the Company has performed to date. It is based upon currently available facts, existing technology, and presently enacted laws and regulations. This liability, to investigate and initiate remediation, as necessary, at the known inactive gas manufacturing sites, is reflected in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992. The Company also has recorded a corresponding deferred asset, since it expects to recover such expenditures in rates, as the Company has previously been allowed by the PSC to recover such costs in rates. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. The Clean Air Act Amendments of 1990 (1990 Amendments) will result in significant expenditures of approximately $178 million, on a present value basis, over a 25 year period, for all capital and operating and maintenance expenses related to the reduction of sulfur dioxide and nitrogen oxides at several of the Company's coal-fired generating stations of which $51 million has been incurred as of December 31, 1993. The Company's current estimate is a significant reduction from its prior estimate, primarily due to the postponement of the construction of a flue gas desulfurization (FGD) system at the Homer City Generating Station. The Company plans to reevaluate the need to construct an FGD system at the Homer City Generating Station in 1995, since its present strategy to bank Phase I emissions allowances for use during Phase II, as discussed below, will allow the Company to meet Phase II allowance requirements through the year 2005. The cost to comply with the sulfur dioxide and nitrogen oxide limitations includes the construction of an innovative FGD system and a nitrogen oxide reduction system expected to be completed in 1995 at the Company's Milliken Generating Station. The Company estimates that approximately a 1% electric rate increase will be required for the cost of reducing sulfur dioxide and nitrogen oxide emissions in both Phase I (begins January 1, 1995) and Phase II (begins January 1, 2000). As a result of the 1990 Amendments, the Company plans to reduce its annual sulfur dioxide emissions by an amount that will allow the Company to meet the sulfur dioxide levels established for the Company, which is approximately a 49% reduction from approximately 138,000 tons in 1989 to 71,000 tons by the year 2000. The cost of controlling toxic emissions under the 1990 Amendments, if required, cannot be estimated at this time. Regulations may be adopted at the state level which would limit toxic emissions even further, at an additional cost to the Company. The Company anticipates that the costs incurred to comply with the 1990 Amendments will be recoverable through rates based on previous rate recovery of required environmental costs. The 1990 Amendments require the EPA to allocate annual emissions allowances to each of the Company's coal-fired generating stations based on statutory emissions limits. An emissions allowance represents an authorization to emit, during or after a specified calendar year, one ton of sulfur dioxide. During Phase I, the Company estimates that it will have allowances in excess of the affected coal-fired generating stations' actual emissions. The Company's present strategy is to bank these allowances for use in later years. By using a banking strategy, it is estimated that Phase II allowance requirements will be met through the year 2005 by utilizing the allowances banked during Phase I, which includes the extension reserve allowances discussed below, together with the Company's Phase II annual emissions allowances. This strategy could be modified should market or business conditions change. In addition to the annual emissions allowances allocated to the Company by the EPA, the Company will receive a portion of the extension reserve allowances issued by the EPA to utilities electing to build scrubbers, as a result of the pooling agreement that it entered into with other utilities who were also eligible to receive some of these extension reserve allowances. As a result of existing and new solid waste disposal legislation and regulations in Pennsylvania, the Company will incur approximately $24 million, on a present value basis, of additional costs over the next 30 years, beginning in 1994, at the Homer City Generating Station. These costs will be incurred to install new equipment, modify or replace existing equipment, and improve the design of a proposed expansion of disposal facilities. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Long-term Power Purchase Contracts The Company has on line and under contract 362 megawatts (mw) of non-utility generation (NUG) power. In addition, another 240 mw of NUG power is under construction. The Company is required to make payments under these contracts only for the power it receives. During 1993, 1992, and 1991 the Company purchased approximately $138 million, $71 million, and $30 million, respectively, of NUG power. The Company estimates that it will purchase approximately $255 million, $291 million, and $335 million of NUG power for the years 1994, 1995, and 1996, respectively. Increases in NUG power purchase costs are expected to be a significant contributor to price increases over the next three years. As part of the Company's continuing effort to minimize future price increases associated with uneconomical power purchases from NUGs, the Company negotiated termination of agreements for the South Corning and Indeck-Kirkwood cogeneration projects. The PSC approved full recovery of the $11.5 million in termination costs for the Indeck-Kirkwood project in rates. The Company expects to recover the $34 million in termination costs for the South Corning project in rates because the PSC issued an order in 1993 allowing the Company to defer these costs and the Company has been allowed by the PSC to recover costs for the Indeck-Kirkwood project in rates. Coal Purchasing Contracts The Company has long-term contracts with nonaffiliated mining companies for the purchase of coal for the jointly-owned Homer City Generating Station. The contracts, which expire between 1994 and the end of the expected service life of the generating station, require the purchase of either fixed or minimum amounts of the station's coal requirements. The price of the coal under one of these contracts is based on recovery of production costs plus incentives. The remaining contracts are based on fixed price plus escalation provisions. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $66 million, $45 million, and $31 million for the years 1994, 1995, and 1996, respectively. In addition, the Company has a long-term contract for the purchase of coal for the Kintigh Generating Station. The contract, which expires in 1997, supplies the annual coal requirements of the station. One-third of the tonnage price is renegotiated annually to reflect market conditions. The delivered cost of coal purchased under this agreement is expected to be $56 million, $55 million, and $56 million for the years 1994, 1995, and 1996, respectively. 10 Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments at December 31, 1993 and 1992, were as follows: Carrying Amount Fair Value 1993 1992 1993 1992 (Thousands) First mortgage bonds $1,166,779 $1,318,845 $1,274,883 $1,388,990 Pollution control notes $575,695 $505,680 $581,928 $523,251 Preferred stock subject to mandatory redemption requirements $125,000 $108,550 $134,000 $119,031 The carrying amount for the following items approximates estimated fair value because of the short maturity of those instruments: cash and cash equivalents, commercial paper, and interest accrued. Special deposits include restricted funds that are set aside for preferred stock and long-term debt redemptions. Special deposits also include restricted funds that are used to finance a portion of the costs incurred in the construction of certain solid waste disposal and other related facilities. The carrying amount approximates fair value because the special deposits have been invested in securities with a short-term maturity. The carrying amount of the revolving credit agreement note approximates fair value because its pricing is based on short- term interest rates. The fair value of the Company's first mortgage bonds, pollution control notes, and preferred stock is estimated based on the quoted market prices for the same or similar issues of the same remaining maturities. 11 Industry Segment Information Certain information pertaining to the electric and natural gas operations of the Company is: 1993 1992 1991 Natural Natural Natural Electric Gas Electric Gas Electric Gas (Thousands) Operating Revenues $1,527,362 $272,787 $1,451,525 $240,164 $1,367,936 $187,879 Expenses $1,250,000 $249,493 $1,146,619 $221,307 $1,056,969 $177,751 Income $277,362 $23,294 $304,906 $18,857 $310,967 $10,128 Depreciation and amortization* $155,231 $9,337 $150,549 $8,428 $145,700 $6,680 Construction expenditures $208,576 $36,453 $210,185 $35,433 $210,127 $35,756 Identifiable assets** $4,615,963 $458,596 $4,540,724 $377,424 $4,515,237 $340,090 * Included in operating expenses. ** Assets used in both electric and natural gas operations not included above were $201,457, $159,768, and $69,509 at December 31, 1993, 1992, and 1991, respectively. They consist primarily of cash and cash equivalents, special deposits, and prepayments. 12 Supplementary Income Statement Information Charges for maintenance, repairs, and depreciation and amortization, are set forth in the Consolidated Statements of Income. Taxes, other than federal income taxes, are: 1993 1992 1991 (Thousands) Property $84,616 $81,640 $76,589 Franchise and gross receipts 92,810 92,153 76,721 Payroll 17,985 17,096 15,467 Miscellaneous 9,551 10,052 9,408 -------- -------- -------- Total Other Taxes $204,962 $200,941 $178,185 ======== ======== ======== 13 Quarterly Financial Information (Unaudited) Quarter ended March 31 June 30 Sept. 30 Dec. 31 (Thousands, Except Per Share Amounts) Operating revenues $522,383 $388,601 $396,410 $492,755 Operating income $109,893 $56,649 $66,108 $68,006 Net income $74,039 $21,500 $32,541 $37,948 (1) Earnings for common stock $68,838 $16,299 $27,340 $32,913 Earnings per share $.99 $.23 $.39 $.47 (1) Dividends per share $.54 $.54 $.55 $.55 Average shares outstanding 69,561 69,836 70,119 70,431 Common stock price* High $35.13 $36.50 $36.25 $35.50 Low $31.63 $32.13 $34.63 $28.75 Operating revenues $489,847 $401,934 $367,833 $432,075 Operating income $111,373 $82,755 $60,109 $69,526 Net income $76,416 $46,772 $26,581 $34,199 Earnings for common stock $71,167 $41,488 $21,320 $28,998 Earnings per share $1.10 (2) $.60 (2) $.31 (2) $.42 (2) Dividends per share $.53 $.53 $.54 $.54 Average shares outstanding 64,682 68,800 69,063 69,318 Common stock price* High $29.63 $29.38 $32.00 $32.75 Low $26.13 $26.75 $29.25 $30.38 (1) Fourth quarter 1993 results reflect the effects of restructuring expenses, which decreased net income and earnings for common stock by $17.2 million and decreased earnings per share by 24 cents. (2) Late in 1992, the Company began reflecting on its income statement the value of energy consumed but not yet billed. If the Company had been allowed by the PSC to include this unbilled revenue factor during all of 1992, quarterly earnings per share in 1992 would have been 94 cents, 39 cents, 38 cents, and 72 cents for the first, second, third, and fourth quarters, respectively. * The Company's common stock is listed on the New York Stock Exchange. The number of stockholders of record at December 31, 1993 was 58,990. Dividend Limitations: After dividends on all outstanding preferred stock have been paid, or declared, and funds set apart for their payment, the common stock is entitled to cash dividends as may be declared by the Board of Directors out of retained earnings accumulated since December 31, 1946. Common Stock dividends are limited if Common Stock Equity (45% at December 31, 1993) falls below 25% of total capitalization, as defined in the Company's Certificate of Incorporation. Dividends on common stock cannot be paid unless sinking fund requirements of the preferred stock are met. The Company has not been restricted in the payment of dividends on common stock by these provisions. Retained earnings accumulated since December 31, 1946, were approximately $320 million and $327 million as of December 31, 1993 and 1992, respectively. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors New York State Electric & Gas Corporation and Subsidiaries Ithaca, New York We have audited the consolidated financial statements and the financial statement schedules of New York State Electric & Gas Corporation and Subsidiaries listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of New York State Electric & Gas Corporation and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 7 to the consolidated financial statements, the Company and Subsidiaries changed its method of accounting for postretirement benefits other than pensions in 1993. COOPERS & LYBRAND New York, New York January 28, 1994 Item 9. Changes in and disagreements with accountants on accounting and financial disclosure - None PART III Item 10. Directors and executive officers of the Registrant Incorporated herein by reference to the information under the caption "Election of Directors" in the Company's Proxy Statement dated March 31, 1994. The information regarding executive officers is on pages 23-25 of this report. Item 11. Executive compensation Incorporated herein by reference to the information under the captions "Executive Compensation," "Employment and Change in Control Arrangements," "Directors' Compensation," "Compensation Committee Interlocks and Insider Participation," "Report of Executive Compensation and Succession Committee on Executive Compensation" and "Stock Performance Graph" in the Company's Proxy Statement dated March 31, 1994. Item 12. Security ownership of certain beneficial owners and management Incorporated herein by reference to the information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement dated March 31, 1994. Item 13. Certain relationships and related transactions Incorporated herein by reference to the information under the captions "Election of Directors" and "Employment and Change in Control Arrangements" in the Company's Proxy Statement dated March 31, 1994. PART IV Item 14. Exhibits, financial statement schedules, and reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial statements Included in Part II of this report: a) Consolidated Statements of Income for the three years ended December 31, 1993 b) Consolidated Balance Sheets as of December 31, 1993 and 1992 c) For the three years ended December 31, 1993: Consolidated Statements of Cash Flows Consolidated Statements of Changes in Common Stock Equity d) Notes to Consolidated Financial Statements e) Report of Independent Accountants 2. Financial statement schedules Included in Part II of this report: For the three years ended December 31, 1993: V. Property, Plant and Equipment VI. Accumulated Depreciation of Property, Plant and Equipment VIII. Allowance for Doubtful Accounts - Accounts Receivable Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the Consolidated Financial Statements or notes thereto. 3. Exhibits (a)(1) The following exhibits are delivered with this report: Exhibit No. 3-11 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 10, 1993. 3-12 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. 3-13 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. 3-15 - By-Laws of the Company as amended February 25, 1994. 10-14 - Coal Sales Agreement dated December 21, 1983 between New York State Electric & Gas Corporation and Consolidation Coal Company. (A) 10-21 - Retirement Plan for Directors Amendment No. 1. (A) 10-23 - Deferred Compensation Plan for Directors Amendment No. 1. (A) 10-32 - Supplemental Executive Retirement Plan Amendment No. 8. (A) 10-33 - Supplemental Executive Retirement Plan Amendment No. 9. (A) 10-35 - Annual Executive Incentive Compensation Plan Amendment No. 1. (A) 10-36 - Annual Executive Incentive Compensation Plan Amendment No. 2. (A) 10-41 - Performance Share Plan Amendment No. 4. (A) 10-43 - Performance Share Deferred Compensation Plan Amendment No. 1. (A) 10-46 - Employment Agreement for J. A. Carrigg. (A) 10-47 - Form of Severance Agreement for Senior Vice Presidents. (A) 10-48 - Form of Severance Agreement for Vice Presidents. 12 - Computation of Ratio of Earnings to Fixed Charges. 21 - Subsidiaries. 23 - Consent of Coopers & Lybrand to incorporation by reference into certain registration statements. 99-1 - Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees. 99-2 - Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees. (a)(2) The following exhibits are incorporated herein by reference: Exhibit No. Filed in As Exhibit No. 3-1 - Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on October 25, 1988 - Registration No. 33-50719 . . . 4-11 3-2 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 17, 1989 - Registration No. 33-50719 . . 4-12 3-3 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 22, 1990 - Registration No. 33-50719 . . . . . . . . . . . . . 4-13 3-4 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 31, 1990 - Registration No. 33-50719 . . 4-14 ______________________________ (A) Management contract or compensatory plan or arrangement. Exhibit No. Filed in As Exhibit No. 3-5 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on February 6, 1991 - Registration No. 33-50719 . . 4-15 3-6 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 15, 1991 - Registration No. 33-50719 . . 4-16 3-7 - Certificate of Merger of Columbia Gas of New York, Inc. into the Company filed in the Office of the Secretary of State of the State of New York on April 8, 1991 - Registration No. 33-50719 . . . . . . . . . . . . . . . . . . . 4-20 3-8 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 28, 1992 - Registration No. 33-50719 . . . . 4-17 3-9 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 20, 1992 - Registration No. 33-50719 . . . 4-18 3-10 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 14, 1993 Registration No. 33-50719 . . . . . . . . . . . . . . 4-19 3-14 - Certificates of the Secretary of the Company concern- ing consents dated March 20, 1957 and May 9, 1975 of holders of Serial Preferred Stock with respect to issuance of certain unsecured indebtedness - Registration No. 2-69988. . . . . . . . . . . . . . 4-7 4-1 - First Mortgage dated as of July 1, 1921 executed by the Company under its then name of "New York State Gas and Electric Corporation" to The Equitable Trust Company of New York, as Trustee (Chemical Bank is Successor Trustee) - Registration No. 33-4186 . . . 4-1 Supplemental Indentures to First Mortgage dated as of July 1, 1921: 4-2 - No. 37 - Registration No. 33-31297. . . . . . . . . 4-2 4-3 - No. 39 - Registration No. 33-31297. . . . . . . . . 4-3 4-4 - No. 43 - Registration No. 33-31297. . . . . . . . . 4-4 4-5 - No. 51 - Registration No. 2-59840 . . . . . . . . . 2-B(46) 4-6 - No. 68 - Registration No. 2-59840 . . . . . . . . . 2-B(63) 4-7 - No. 69 - Registration No. 2-59840 . . . . . . . . . 2-B(64) 4-8 - No. 71 - Registration No. 2-59840 . . . . . . . . . 2-B(66) 4-9 - No. 74 - Registration No. 2-59840 . . . . . . . . . 2-B(69) 4-10 - No. 75 - Registration No. 2-59840 . . . . . . . . . 2-B(70) 4-11 - No. 80 - Registration No. 2-59840 . . . . . . . . . 2-B(75) 4-12 - No. 81 - Registration No. 2-59840 . . . . . . . . . 2-B(76) 4-13 - No. 83 - Registration No. 2-65948 . . . . . . . . . 2-B(78) 4-14 - No. 99 - Registration No. 33-11303. . . . . . . . . 4-9 4-15 - No. 102- Registration No. 33-33838. . . . . . . . . 4-8 4-16 - No. 103- Registration No. 33-43458. . . . . . . . . 4-8 4-17 - No. 104- Registration No. 33-43458. . . . . . . . . 4-9 4-18 - No. 105- Registration No. 33-52040. . . . . . . . . 4-8 4-19 - No. 106- Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . 4-23 4-20 - No. 107- Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . 4-24 4-21 - No. 108- Registration No. 33-50719. . . . . . . . . 4-8 4-22 - No. 109- Registration No. 33-50719. . . . . . . . . 4-9 Contracts, amendments, and letter agreement with the Power Authority of the State of New York: 10-1 - Contract UD-4 dated July 28, 1975 (FitzPatrick Power) - Registration No. 2-59840 . . . . . . . . . 5-5 Exhibit No. Filed in As Exhibit No. 10-2 - Contract PS-2 dated March 28, 1973 (Blenheim- Gilboa) - Registration No. 2-59840. . . . . . . . . 5-6 10-3 - Letter Agreement dated February 3, 1982 relating to transmission services - Registration No. 2-82192. . 10-1 10-4 - Amendment dated December 21, 1989 to the Letter Agreement dated February 3, 1982 relating to trans- mission services - Company's 10-K for year ended December 31, 1989 - File No. 1-3103-2 . . . . . . 10-4 10-5 - Contract effective as of February 22, 1989 relating to the purchase of hydroelectric power - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . . . 10-5 10-6 - Transmission Agreement dated December 12, 1983, with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2 . . . . 10-6 10-7 - Amendment dated December 21, 1989 to the Transmission Agreement dated December 12, 1983 with respect to connection of the Company's Kintigh (Somerset) Gener- ating Station to the Niagara-Edic 345 kv transmission system - Company's 10-K for the year ended December 31, 1989 File No. 1-3103-2. . . . . . . . . . . . . 10-7 Coal Sales Agreements and Amendments between New York State Electric & Gas Corporation, Pennsylvania Electric Company and: 10-8 - Helvetia Coal Company - Agreement made as of December 22, 1966 - Registration No. 2-59840. . . . 5-11 10-9 - Helvetia Coal Company - Amendment made as of April 1, 1974 - Registration No. 2-55131. . . . . . 5-F(1)b 10-10 - Amendment dated as of March 15, 1989 to the Coal Sales Agreement made as of December 22, 1966 between New York State Electric & Gas Corporation, Penn- sylvania Electric Company and Helvetia Coal Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . 10-10 10-11 - Amendment dated as of July 25, 1990 to the Coal Sales Agreement made as of December 22, 1966 between New York State Electric & Gas Corporation, Penn- sylvania Electric Company and Helvetia Coal Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . 10-11 * * * * * * * * * * Exhibit No. Filed in As Exhibit No. 10-12 - New York Power Pool Agreement dated July 11, 1985 - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-7 10-13 - Transmission Agreement dated January 10, 1990 between New York State Electric & Gas Corporation and Niagara Mohawk Power Corporation, with respect to remote load and generation wheeling service for the Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-17 10-15 - Amendment No. 1 dated as of October 1, 1985 to the Coal Sales Agreement dated December 21, 1983 between the Company and Consolidation Coal Company - Company's 10-K for year ended December 31, 1986 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-11 10-16 - Amendment No. 2 dated as of August 28, 1986 to the Coal Sales Agreement dated December 21, 1983 between the Company and Consolidation Coal Company - Company's 10-K for year ended December 31, 1986 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-12 10-17 - Basic Agreement dated as of September 22, 1975 between New York State Electric & Gas Corporation and others concerning Nine Mile Point Nuclear Station, Unit No. 2 - Registration No. 2-54903. . . 5-0 10-18 - Nine Mile Point Nuclear Station Unit 2 Operating Agreement effective as of January 1, 1993 among New York State Electric & Gas Corporation and others - Company's 10-K for the year ended December 31, 1992 - File No. 1-3103-2 . . . . . . . 10-18 10-19 - Coal Hauling Agreement dated as of March 9, 1983 between Somerset Railroad Corporation and New York State Electric & Gas Corporation - Registration No. 2-82352. . . . . . . . . . . . . . 10 (A) 10-20 - Retirement Plan for Directors - Company's 10-K for the year ended December 31, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-26 (A) 10-22 - Form of Deferred Compensation Plan for Directors - Company's 10-K for year ended December 31, 1989 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-22 (A) 10-24 - Supplemental Executive Retirement Plan - Company's 10-Q for quarter ended September 30, 1984 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-19 (A) 10-25 - Supplemental Executive Retirement Plan Amendment No. 1 - Company's 10-Q for quarter ended March 31, 1985 - File No. 1-3103-2. . . . . . . . . 10-21 ______________________________ (A) Management contract or compensatory plan or arrangement. Exhibit No. Filed in As Exhibit No. (A) 10-26 - Supplemental Executive Retirement Plan Amendment No. 2 - Company's 10-K for year ended December 31, 1987 - File No. 1-3103-2. . . . . . . . . . . . 10-19 (A) 10-27 - Supplemental Executive Retirement Plan Amendment No. 3 - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . 10-24 (A) 10-28 - Supplemental Executive Retirement Plan Amendment No. 4 - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . . . . . . . . . . . . . 10-30 (A) 10-29 - Supplemental Executive Retirement Plan Amendment No. 5 - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . . . . . . . . . . . . . 10-31 (A) 10-30 - Supplemental Executive Retirement Plan Amendment No. 6 - Company's 10-Q for quarter ended March 31, 1991 - File No. 1-3103-2. . . . . . . . . . . . . . 10-37 (A) 10-31 - Supplemental Executive Retirement Plan Amendment No. 7 - Company's 10-Q for quarter ended June 30, 1992 - File No. 1-3103-2. . . . . . . . . . . . . . 10-44 (A) 10-34 - Annual Executive Incentive Compensation Plan. Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-30 (A) 10-37 - Performance Share Plan - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . 10-36 (A) 10-38 - Performance Share Plan Amendment No. 1 - Company's 10-Q for quarter ended March 31, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-38 (A) 10-39 - Performance Share Plan Amendment No. 2 - Company's 10-Q for quarter ended June 30, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-39 (A) 10-40 - Performance Share Plan Amendment No. 3 - Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . . . 10-34 (A) 10-42 - Performance Share Deferred Compensation Plan - Company's 10-K for year ended December 31, 1991 File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-40 (A) 10-44 - Employment Contract for A. E. Kintigh - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . 10-26 (A) 10-45 - Agreement with R. Fleming, Jr. - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . 10-34 The Company agrees to furnish to the Commission, upon request, a copy of the Revolving Credit Agreement dated as of July 31, 1992, between the Company, Chemical Bank, as Agent, and certain banks; a copy of the Participation Agreement dated as of February 1, 1984 between the Company and New York State Energy Research and Development Authority (NYSERDA) relating to Pollution Control Revenue Bonds; a copy of the Participation Agreements dated as of October 15, 1984, June 1, 1987 and December 1, 1988 between the Company and NYSERDA relating to Adjustable Rate Pollution Control Revenue Bonds (1984 Series A), (1987 Series A), and (1988 Series A), respectively; a copy of the Participation Agreements dated as of March 1, 1985, October 15, 1985, July 15, 1985 and December 1, 1985 between the Company and NYSERDA relating to Annual ______________________________ (A) Management contract or compensatory plan or arrangement. Tender Pollution Control Revenue Bonds (1985 Series A), (1985 Series B), (1985 Series C) and (1985 Series D), respectively; a copy of the Participation Agreements dated as of February 1, 1993 and February 1, 1994 between the Company and NYSERDA relating to Pollution Control Refunding Revenue Bonds (1994 Series A) and (1994 Series B) respectively; a copy of the Participation Agreement dated as of December 1, 1993 between the Company and NYSERDA relating to Solid Waste Disposal Revenue Bonds (1993 Series A); and a copy of the Credit Agreement dated as of March 9, 1983, as amended, between Somerset Railroad Corporation and Chemical Bank. The total amount of securities authorized under each of such agreements does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K A report on Form 8-K, dated November 29, 1993, was filed during the fourth quarter of 1993 to report certain information under Item 5, "Other Events." Signatures Pursuant to the requirements of Section 13 or 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. NEW YORK STATE ELECTRIC & GAS CORPORATION Date: March 11, 1994 By Everett A. Robinson Everett A. Robinson Vice President and Controller (Chief Accounting 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. PRINCIPAL EXECUTIVE OFFICER Date: March 11, 1994 By James A. Carrigg James A. Carrigg Chairman, President, Chief Executive Officer and Director PRINCIPAL FINANCIAL OFFICER Date: March 11, 1994 By Sherwood J. Rafferty Sherwood J. Rafferty Vice President and Treasurer PRINCIPAL ACCOUNTING OFFICER Date: March 11, 1994 By Everett A. Robinson Everett A. Robinson Vice President and Controller Signatures (Cont'd) Date: March 11, 1994 By Alison P. Casarett Alison P. Casarett Director Date: March 11, 1994 By Everett A. Gilmour Everett A. Gilmour Director Date: March 11, 1994 By Paul L. Gioia Paul L. Gioia Director Date: March 11, 1994 By John M. Keeler John M. Keeler Director Date: March 11, 1994 By Allen E. Kintigh Allen E. Kintigh Director Date: March 11, 1994 By Ben E. Lynch Ben E. Lynch Director Date: March 11, 1994 By Alton G. Marshall Alton G. Marshall Director Date: March 11, 1994 By David R. Newcomb David R. Newcomb Director Date: March 11, 1994 By Robert A. Plane Robert A. Plane Director Date: March 11, 1994 By C. William Stuart C. William Stuart Director EXHIBIT INDEX * 3-1 -- Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on October 25, 1988. * 3-2 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 17, 1989. * 3-3 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 22, 1990. * 3-4 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 31, 1990. * 3-5 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on February 6, 1991. * 3-6 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 15, 1991. * 3-7 -- Certificate of Merger of Columbia Gas of New York, Inc. into the Company filed in the Office of the Secretary of State of the State of New York on April 8, 1991. * 3-8 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 28, 1992. * 3-9 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 20, 1992. * 3-10 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 14, 1993. 3-11 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 10, 1993. 3-12 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) 3-13 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. * 3-14 -- Certificates of the Secretary of the Company concerning consents dated March 20, 1957 and May 9, 1975 of holders of Serial Preferred Stock with respect to issuance of certain unsecured indebtedness. 3-15 -- By-Laws of the Company as amended February 25, 1994. * 4-1 -- First Mortgage dated as of July 1, 1921 executed by the Company under its then name of "New York State Gas and Electric Corporation" to The Equitable Trust Company of New York, as Trustee (Chemical Bank is Successor Trustee). Supplemental Indentures to First Mortgage dated as of July 1, 1921: * 4-2 -- No. 37 * 4-9 -- No. 74 * 4-16 -- No. 103 * 4-3 -- No. 39 * 4-10 -- No. 75 * 4-17 -- No. 104 * 4-4 -- No. 43 * 4-11 -- No. 80 * 4-18 -- No. 105 * 4-5 -- No. 51 * 4-12 -- No. 81 * 4-19 -- No. 106 * 4-6 -- No. 68 * 4-13 -- No. 83 * 4-20 -- No. 107 * 4-7 -- No. 69 * 4-14 -- No. 99 * 4-21 -- No. 108 * 4-8 -- No. 71 * 4-15 -- No. 102 * 4-22 -- No. 109 Contracts, Amendments, and Letter Agreement with the Power Authority of the State of New York: * 10-1 -- Contract UD-4 dated July 28, 1975 (FitzPatrick Power). * 10-2 -- Contract PS-2 dated March 28, 1973 (Blenheim- Gilboa). * 10-3 -- Letter Agreement dated February 3, 1982 relating to transmission services. * 10-4 -- Amendment dated December 21, 1989 to the Letter Agreement dated February 3, 1982 relating to transmission services. * 10-5 -- Contract effective as of February 22, 1989 relating to the purchase of hydroelectric power. * 10-6 -- Transmission Agreement dated December 12, 1983, with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) * 10-7 -- Amendment dated December 21, 1989 to the Transmission Agreement dated December 12, 1983 with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system. * * * * * * * * * * Coal Sales Agreements and Amendments between New York State Electric & Gas Corporation, Pennsylvania Electric Company and: * 10-8 -- Helvetia Coal Company--Agreement made as of December 22, 1966. * 10-9 -- Helvetia Coal Company--Amendment made as of April 1, 1974. * 10-10 -- Helvetia Coal Company--Amendment made as of March 15, 1989. * 10-11 -- Helvetia Coal Company--Amendment made as of July 25, 1990. * * * * * * * * * * * 10-12 -- New York Power Pool Agreement dated July 11, 1985. * 10-13 -- Transmission Agreement dated January 10, 1990 between New York State Electric & Gas Corporation and Niagara Mohawk Power Corporation, with respect to remote load and generation wheeling service for the Company. * * * * * * * * * * Coal Sales Agreement and Amendments between New York State Electric & Gas Corporation and Consolidation Coal Company: 10-14 -- Agreement dated December 21, 1983. * 10-15 -- Amendment No. 1 dated as of October 1, 1985. * 10-16 -- Amendment No. 2 dated as of August 28, 1986. * * * * * * * * * * * 10-17 -- Basic Agreement dated as of September 22, 1975 between New York State Electric & Gas Corporation and others concerning Nine Mile Point Nuclear Station, Unit No. 2. * 10-18 -- Nine Mile Point Nuclear Station Unit 2 Operating Agreement effective as of January 1, 1993 among New York State Electric & Gas Corporation and others. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) * 10-19 -- Coal Hauling Agreement dated as of March 9, 1983 between Somerset Railroad Corporation and New York State Electric & Gas Corporation. (A)* 10-20 -- Retirement Plan for Directors. (A) 10-21 -- Retirement Plan for Directors Amendment No. 1 (A)* 10-22 -- Form of Deferred Compensation Plan for Directors. (A) 10-23 -- Deferred Compensation Plan for Directors Amendment No. 1. (A)* 10-24 -- Supplemental Executive Retirement Plan (A)* 10-25 -- Supplemental Executive Retirement Plan Amendment No. 1. (A)* 10-26 -- Supplemental Executive Retirement Plan Amendment No. 2. (A)* 10-27 -- Supplemental Executive Retirement Plan Amendment No. 3. (A)* 10-28 -- Supplemental Executive Retirement Plan Amendment No. 4. (A)* 10-29 -- Supplemental Executive Retirement Plan Amendment No. 5. (A)* 10-30 -- Supplemental Executive Retirement Plan Amendment No. 6. (A)* 10-31 -- Supplemental Executive Retirement Plan Amendment No. 7. (A) 10-32 -- Supplemental Executive Retirement Plan Amendment No. 8. (A) 10-33 -- Supplemental Executive Retirement Plan Amendment No. 9. (A)* 10-34 -- Annual Executive Incentive Compensation Plan. (A) 10-35 -- Annual Executive Incentive Compensation Plan Amendment No. 1. (A) 10-36 -- Annual Executive Incentive Compensation Plan Amendment No. 2. (A)* 10-37 -- Performance Share Plan. (A)* 10-38 -- Performance Share Plan Amendment No. 1. (A)* 10-39 -- Performance Share Plan Amendment No. 2. (A)* 10-40 -- Performance Share Plan Amendment No. 3 (A) 10-41 -- Performance Share Plan Amendment No. 4 (A)* 10-42 -- Performance Share Deferred Compensation Plan. (A) 10-43 -- Performance Share Deferred Compensation Plan Amendment No. 1 (A)* 10-44 -- Employment Contract for A. E. Kintigh. (A)* 10-45 -- Agreement with R. Fleming, Jr. (A) 10-46 -- Employment Agreement for J. A. Carrigg. (A) 10-47 -- Form of Severance Agreement for Senior Vice Presidents. (A) 10-48 -- Form of Severance Agreement for Vice Presidents. ___________________________________ (A) Management contract or compenstory plan or arrangement. * Incorporated by reference. EXHIBIT INDEX (Cont'd) 12 -- Computation of Ratio of Earnings to Fixed Charges. 21 -- Subsidiaries. 23 -- Consent of Coopers & Lybrand to incorporation by reference into certain registration statements. 99-1 -- Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees. 99-2 -- Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees. Item 7. Management's discussion and analysis of financial condition and results of operations Results of Operations 1993 1992 over over 1992 1991 1993 1992 1991 Change Change (Thousands, except Per Share Amounts) Operating revenues $1,800,149 $1,691,689 $1,555,815 6% 9% Earnings available for common stock $145,390 $162,973 $148,313 (11%) 10% Average shares outstanding 69,990 67,972 62,906 3% 8% Earnings per share $2.08 $2.40 $2.36 (13%) 2% Dividends per share $2.18 $2.14 $2.10 2% 2% In 1993, operating revenues increased $108 million, or 6%, compared to 1992. This increase is primarily because of increases in electric and natural gas rates that became effective in August 1992 and September 1993, which totaled $61 million, and the amounts billed to customers for higher costs of non-utility generation (NUG) power and natural gas totaling $51 million. In 1992, operating revenues rose $136 million, or 9%, compared to 1991. The amounts billed to customers for higher costs of NUG power of $41 million, and increases in electric and natural gas rates effective in February 1991 and August 1992, which totaled $40 million, were the primary reasons for this increase. In addition, higher electric and natural gas retail sales due to an increase in retail customers, colder weather, and the April 1991 acquisition of Columbia Gas of New York, Inc. (CNY) helped boost operating revenues by $51 million in 1992. Earnings per share decreased 32 cents, or 13%, in 1993 compared to 1992, while earnings per share increased 4 cents, or 2%, in 1992 compared to 1991. Both 1993 and 1992 had non- recurring items that lowered earnings per share. Earnings in 1993 were reduced by 25 cents per share as a result of a corporate restructuring that will reorganize the way the Company delivers services to its electric and natural gas customers beginning in March 1994. This restructuring resulted in a work force reduction throughout the organization of approximately 600, the elimination of customer walk-in services at 28 satellite locations, and the closing of up to 10 electric and natural gas operations facilities statewide. This is one of several actions the Company has taken to reduce future costs, enhance efficiencies in service to its customers, and be competitive in the rapidly changing utility industry (See Competitive Conditions). A six-month electric rate moratorium, which began in February 1992, limited 1992 earnings per share by 24 cents. Excluding the effect of these non-recurring items, earnings per share decreased 31 cents in 1993 compared to 1992, and increased 28 cents in 1992 compared to 1991. The 31 cent 1993 decrease in earnings per share was primarily due to lower electric retail sales prior to the effective date of the Company's modified revenue decoupling mechanism (See Regulatory Matters) and lower than anticipated natural gas sales, both resulting from the sluggish economy in the Company's service territory. Also, earnings per share decreased due to changes in the Company's allowed return on equity from 11.7% effective through July 1992, to 11.2% effective through July 1993, and then to 10.8% beginning in August 1993. In 1992, earnings per share were favorably affected by the growth in electric and natural gas retail sales primarily due to an increase in retail customers, colder weather, and the April 1991 acquisition of CNY. The Company's efforts to control costs also contributed to the increase in 1992 earnings per share. Average shares outstanding were 70 million in 1993, 68 million in 1992, and 63 million in 1991. Average shares outstanding increased 3% in 1993 compared to 1992 due to the issuance of 1.2 million shares of common stock through the Dividend Reinvestment and Stock Purchase Plan (DRP). In 1992, average shares outstanding increased 8% because of a public offering of 5 million shares of common stock in March 1992, and the issuance of 1 million shares of common stock through the DRP. Interest Expense Interest expense (before the reduction for allowance for borrowed funds used during construction) decreased by $10 million, or 6%, in 1993 and $8 million, or 5%, in 1992. Interest on long-term debt decreased in 1993 and 1992 mainly due to the refinancing of certain high-coupon long-term debt at lower interest rates, and lower interest rates on the Company's variable rate debt. In 1993 and 1992 interest expense also decreased due to a reduction in the interest rate on the commercial paper borrowings (See Financing Activities). Operating Results by Business Unit 1993 1992 over over 1992 1991 Electric 1993 1992 1991 Change Change (Thousands) Retail sales-kilowatt- hours(kwh) 13,088,175 13,294,466 13,107,115 (2%) 1% Operating revenues $1,527,362 $1,451,525 $1,367,936 5% 6% Operating expenses $1,250,000 $1,146,619 $1,056,969 9% 8% Electric retail sales decreased 2% in 1993 compared to 1992 as a result of the sluggish economy in the Company's service territory and in spite of a 1% increase of customers. In 1992, electric retail sales increased 1% compared to 1991 mainly due to colder but more normal weather and an increase in customers. The primary cause of the $76 million, or 5%, increase in electric operating revenues in 1993 was the increase in rates effective August 1992 and September 1993, which accounted for $53 million of the increase. Also contributing to this increase were higher costs of NUG power of $28 million, which were billed to customers. Electric operating revenues increased $84 million, or 6%, in 1992 compared to 1991. This increase reflects the increases in electric rates that became effective February 1991 and August 1992 and that increased revenues by $35 million. The revenue increase reflects higher NUG costs of $41 million and an increase in certain New York State gross receipts taxes of $12 million, both of which were billed to customers. Also, increased electric retail sales, due to colder weather and an increase in customers, boosted revenues by $9 million. Electric operating expenses increased $103 million, or 9%, in 1993 compared to 1992, and $90 million, or 8%, in 1992 compared to 1991. In 1993, electricity purchased from NUGs increased $67 million. Other operating expenses increased primarily due to an increase in postretirement benefit costs other than pensions of $7 million. In addition, electric operating expenses increased $21 million due to the corporate restructuring. These increases were partially offset by a decrease of $17 million in fuel used in electric generation, the result of lower generation and a decrease in the price of coal, and a decrease of $12 million in federal income taxes, the result of lower pre-tax book income. In 1992, electricity purchased increased primarily because of the amounts billed to customers for higher NUG costs, which totaled $41 million. Other operating expenses increased primarily because of higher demand-side management (DSM) program costs of $6 million. Federal income taxes increased $4 million resulting from higher pre-tax book income. Other taxes increased primarily because of an increase in certain New York State gross receipts taxes and property taxes of $16 million. These increases were partially offset by a decrease of $12 million in fuel used in electric generation, the result of lower generation and a decrease in the price of coal, and a decrease in maintenance expense of $7 million. 1993 1992 over over 1992 1991 Natural Gas 1993 1992 1991 Change Change (Thousands) Deliveries -dekatherms(dth) 58,046 56,366 42,404 3% 33% Retail sales-(dth) 39,345 39,357 29,874 - 32% Operating revenues $272,787 $240,164 $187,879 14% 28% Operating expenses $249,493 $221,307 $177,751 13% 25% Natural gas deliveries increased 3% in 1993 compared to 1992 while natural gas retail sales were flat. In 1992, natural gas deliveries and retail sales increased 33% and 32%, respectively, compared to 1991. The increase in deliveries in 1993 reflects an increase in the number of transportation customers. The 1992 increases in deliveries, as well as retail sales, are largely because of the April 1991 acquisition of CNY. Excluding CNY, natural gas retail sales increased 8% in 1992, primarily because of the colder but more normal weather. Natural gas operating revenues rose $33 million, or 14%, in 1993 compared to 1992, and $52 million, or 28%, in 1992 compared to 1991. In 1993, the increase was primarily due to higher costs of natural gas of $23 million, which were billed to customers, and the increases in rates in August 1992 and September 1993, which totalled $8 million. The 1992 revenue increases are principally the result of the acquisition of CNY, which added $35 million, and the increases in rates effective February 1991 and August 1992 amounting to $4 million. Also, the recovery of an increase in certain New York State gross receipts taxes, which were billed to customers, boosted 1992 revenues by $2 million. Natural gas operating expenses increased $28 million, or 13%, in 1993 compared to 1992. The increase in natural gas purchased was primarily due to higher costs of natural gas amounting to $12 million. Federal income taxes increased $3 million due to higher pre-tax book income. Natural gas operating expenses increased $5 million due to the corporate restructuring. Natural gas operating expenses increased $44 million, or 25%, in 1992 compared to 1991. Natural gas purchased increased $31 million due to an increase in the volume of natural gas purchased. This volume increase was primarily due to the CNY acquisition. Federal income taxes increased $4 million due to higher pre-tax book income. Other taxes increased primarily due to an increase of $3 million in certain New York State gross receipts taxes and $1 million in property taxes. Liquidity and Capital Resources Competitive Conditions The utility industry is rapidly changing and facing an increasingly competitive environment. Factors contributing to this competitive environment are: the National Energy Policy Act of 1992 (Energy Policy Act), which provides open access at the wholesale level to electric transmission service, and the FERC Order 636, which significantly affects the natural gas industry. In addition, the Company's response to the economic pressures on its electric industrial and other large use customers, high purchase costs of NUGs, rising health care costs, increasing taxes, weak economic conditions, conservation programs, and compliance with environmental laws and regulations are all factors that continue to place increased pressure on electric and natural gas prices. The Energy Policy Act, enacted in October 1992, is expected to result in major changes to the utility industry. Certain provisions of the Energy Policy Act amended the Public Utility Holding Company Act of 1935 (PUHCA). These amendments encourage greater competition in the supply market by establishing a new category of wholesale electric generators that are exempt from PUHCA regulation. The Energy Policy Act also enables the FERC to order utilities to provide open access to transmission systems for wholesale transactions, expanding opportunities for utilities and NUGs to enter new and existing wholesale markets. These developments serve to underscore the increasingly competitive environment for utilities. The Company's five-year strategic plan is designed to address the competitive, rapidly changing utility industry. The Company's objective is to remain competitive in its core businesses in the face of increased competition. One of the key strategies to meet competition is to improve customer value by becoming a low-cost provider of energy services in the Northeast. A major challenge to the Company's Electric Business Unit is to retain and grow its industrial base. The competitive energy supply options currently available to the Company's industrial customers include self-generation, shifting production to plants in other locations, or relocation. During 1993, the Company received PSC approval for a flexible, negotiable rate tariff for some of its high-use industrial customers. Discounts negotiated in agreements under this tariff are not expected to have a material effect on the Company's 1994 earnings. Two agreements have been negotiated which eliminated threats of self-generation and relocation. The PSC currently has a generic proceeding to study the broad subject of flexible, competitive rates, and will establish guidelines for the Company and other New York State utilities during 1994. Also in late 1993, the PSC instituted a proceeding to address issues associated with the restructuring of the emerging competitive natural gas market. The PSC intends to investigate services provided by New York State gas utilities after FERC Order 636 by the 1994-1995 heating season. In November 1993, the Company filed with the PSC an additional flexible, negotiable rate tariff to address opportunities for new load. The proposed tariff is for large additions to load (at least 500 kilowatts [kw]) for new or existing industrial and some commercial customers. The tariff will assist the Company in attracting new customers whose location or expansion decisions are influenced by electricity costs. Smaller customers will be assisted by a concurrent proposal to increase the Company's existing economic development incentives by one cent per kilowatt-hour. The Company has proposed and will continue to propose revisions or additional tariffs to respond to the opportunities or risks that develop in a changing electric utility industry. A major challenge to the Company's Gas Business Unit is FERC Order 636, which became effective in November 1993, and requires interstate natural gas pipeline companies to offer customers unbundled or separate services equivalent to their former sales service. With the unbundling of services, primary responsibility for reliable natural gas supply will shift from interstate pipeline companies to local distribution companies, such as the Company. This should result in increased direct access to low cost natural gas supplies by local distribution companies and end users. One goal of FERC Order 636 is to provide equitable access to interstate pipeline capacity. FERC Order 636 will substantially restructure the interstate natural gas market and intensify competition within the natural gas industry. FERC Order 636 will allow the Company, subject to PSC approval, to restructure rates and provide multiple service options to its customers. In July 1993, certain interstate pipelines serving the Company began implementing restructured services in compliance with FERC Order 636. The remaining pipelines implemented restructured services by November 1993. As a result of these restructuring changes, pipelines have incurred and will continue to incur transition costs. These transition costs include those associated with restructuring existing natural gas supply contracts, the unrecovered natural gas cost that would otherwise have been billable to pipeline customers under previously existing rules, costs of assets needed to implement the order, and stranded investment costs. FERC Order 636 allows pipelines to recover all prudently incurred costs from their customers. The Company's liability for transition costs will be based on the pipelines' filings with FERC to recover transition costs. Only a few of those filings have been made. The Company recorded an estimated liability for transition costs of approximately $29 million. The Company also recorded a deferred asset for that amount since it is currently recovering transition costs from its customers through its gas adjustment clause and believes that such costs will continue to be recoverable from its customers. The Company has developed a more aggressive and accelerated set of strategies in response to the increased challenges of competition which are necessary to achieve the objectives outlined in the Company's five-year strategic plan. The following represent strategies being implemented: - Reduce forecasted 1994 capital expenditures by one-third, or approximately $100 million. Additional reductions will be made in 1995 and 1996. - Reduce operating and maintenance expenses by five percent in 1994 and again in 1995. By 1995, this will save about $40 million annually. During 1993, the Company reduced its work force by 200 through attrition. In addition, as part of the O&M reduction, the Company's work force was further reduced by about 600 through an early retirement opportunity program and involuntary severance. - Streamline the field organization to eliminate walk-in customer service at 28 locations, and to close up to 10 electric and natural gas operations facilities statewide. - Place two generating units on long-term cold standby. - Continue to reduce NUG costs. The Company's previous NUG contract terminations and renegotiations will save customers more than $1 billion over the terms of the contracts. - Continue to reduce capital costs. Since 1988 the Company has refinanced over $1.4 billion in securities, and reduced annual interest expense by more than $55 million. The cost of the corporate restructuring was $26 million and was a one-time charge against the Company's 1993 earnings. The restructuring reduced 1993 earnings available for common stock by approximately $17.2 million or 25 cents per share. Included in this amount are $13.2 million for a voluntary early retirement program, $3.2 million for an involuntary severance program, and $.8 million for the elimination and closing of operations facilities. The Company expects to recoup the one-time charge from lower O&M costs in approximately one year. As part of the Company's effort to meet competition and minimize future price increases associated with uneconomical power purchases from NUGs, it negotiated the termination of two cogeneration projects. This effort, along with the termination of NUG contracts due to developers' failures to meet contract obligations, will save customers nearly $1 billion over the terms of the contracts. The Company has also recently negotiated amendments with two NUGs whereby the Company may direct the NUGs to reduce their output or shut down for limited periods each year. During these periods, lower-cost generation will replace the NUG energy and result in additional customer savings. The Company is negotiating with other NUGs for similar amendments. The Company has on line and under contract 362 megawatts (mw) of NUG power. In addition, another 240 mw of NUG power is under construction. The Company is required to make payments under these contracts only for the power it receives. During 1993, 1992, and 1991, the Company purchased approximately $138 million, $71 million, and $30 million, respectively, of NUG power. The Company estimates that it will purchase approximately $255 million, $291 million, and $335 million of NUG power for the years 1994, 1995, and 1996, respectively. Increases in NUG power purchase costs are expected to be a significant contributor to price increases over the next three years. Diversification Diversification will play an important role in the Company's future. While the strength of the Company's core electric and natural gas businesses remains its focus, and while the Company will not compromise its financial integrity, it is actively evaluating a number of corporate development opportunities for investment to help augment future earnings and dividend growth. In April 1992, the PSC issued an order allowing the Company to invest up to 5% of its consolidated capitalization (approximately $175 million at December 31, 1993) in one or more subsidiaries that may engage or invest in energy-related or environmental services businesses and provide related services. In May 1993, NGE Enterprises, Inc. (NGE), a wholly-owned subsidiary of the Company, formed a computer software company, EnerSoft Corporation (EnerSoft), to produce and market software applications for natural gas utilities in the post-FERC Order 636 environment. This represents NGE's initial diversified investment. In October 1993, EnerSoft began a strategic alliance with the New York Mercantile Exchange to develop an information superhighway that will provide the natural gas industry with a single system for monitoring and trading natural gas and pipeline capacity in the North American market. NGE invested approximately $9 million in EnerSoft through February 1994. The Company and NGE plan to develop two natural gas storage projects. One of the projects, which will be regulated by the PSC, is expected to cost approximately $14 million and will be used to supplement the Company's natural gas supply. Construction of this project is scheduled to begin in 1994 and it is expected to be operating for the 1995-96 heating season. The other project, which will be regulated by the FERC, is an equal partnership between NGE and ANR Storage, Inc., and is expected to cost approximately $44 million in total. The entire capacity of this project will be marketed to local distribution companies and NUGs, as well as marketers, producers, and end users of natural gas. Construction of this project is scheduled to begin in 1995 and it is expected to be operating for the 1996-1997 heating season. Financing Activities The Company believes that maintaining a high degree of financial integrity and flexibility is critical to success in an increasingly competitive environment. The Company intends to build on the financial improvements realized over the past several years with a goal of achieving a 50% common equity ratio. New money needs are expected to be minimal and excess cash generated from reduced construction expenditures will be used to further manage the Company's capital structure (See Investing Activities - estimated sources and uses of funds for 1994-1996). The PSC adopted a new, innovative approach in December 1993 when it issued an order to the Company that provides for advanced approval for financings during the Company's three-year rate settlement. That order includes authorization for refundings of first mortgage bonds, preferred stock, and tax-exempt pollution control notes, issuance of common stock through the Dividend Reinvestment and Stock Purchase Plan (DRP), and issuances of other securities as required. With this order, the Company has the flexibility to achieve its financial goals of further reducing financing costs and improving its financial health as market conditions allow. The common stock equity ratio remained stable during 1993. Issuance of shares under the DRP was offset by the issuance of $100 million of preferred stock and $70 million of tax-exempt pollution control notes in December 1993. The Company received $38.4 million from the issuance of 1.2 million shares of common stock through the DRP. Common stock dividends paid in 1993 increased 5% over 1992 reflecting the increase in common stock outstanding and an increase in the dividend paid from $2.14 to $2.18 per share. The Company's dividend payout ratio has been gradually rising over the past several years, primarily as a result of declining earnings. These weak earnings put additional pressure on an already high dividend payout ratio at a time when growing competition dictates that we consider a more moderate dividend policy. We must significantly improve earnings if we are to continue even modest annual dividend increases. The Company sold $25 million of 6.30% preferred stock, $50 million of Adjustable Rate Series B preferred stock, and $25 million of 7.40% preferred stock in December 1993. The net proceeds were used to redeem $25 million of 8.80% preferred stock and $45 million of Adjustable Rate Series A preferred stock in January 1994, and $25 million of 8.48% preferred stock in February 1994. Those refundings will save approximately $1.8 million annually. After those refundings, the capital structure will be 49.8% long-term debt, 7.1% preferred stock, and 43.1% common stock equity. In February 1993, the Company redeemed, at par, through a sinking fund provision in our mortgage, the remaining $22.5 million of 10 5/8% Series first mortgage bonds due 2018. In February 1993, the Company priced $100 million of 6.05% tax-exempt pollution control bonds, due 2034. Proceeds from the sale, which will be delivered in April 1994, will be used to redeem, at a premium, $60 million of 12% pollution control bonds, due 2014, and $40 million of 12.3% pollution control bonds, due 2014. The refunding of those bonds in 1994 will save approximately $5.3 million annually in interest costs. In April 1993, the Company sold $50 million of 7.55% Series first mortgage bonds due 2023. Net proceeds from the sale were used in connection with the redemption of $50 million of the 9 1/4% Series due 2016. The refunding of those bonds will save approximately $300,000 annually in interest costs. In July 1993, the Company sold $100 million of 7.45% Series first mortgage bonds due 2023. Net proceeds from the sale were used in connection with the redemption of $100 million of the 9% Series due 2017. The refunding of those bonds will save approximately $650,000 annually in interest costs. In November 1993, the Company redeemed $50 million of the 8 5/8% Series first mortgage bonds due 1996, at a premium. Proceeds for the redemption were provided by a borrowing under the Company's revolving credit agreement. The refunding of those bonds will save approximately $2 million annually in interest costs. In December 1993, $70 million of 5.70% tax-exempt pollution control notes, due 2028, were issued by a governmental authority on behalf of the Company. Proceeds from the sale will be used to finance a portion of the costs incurred in the construction of certain solid waste disposal and other related facilities at the Company's Milliken Generating Station. The Company has reduced its embedded cost of long-term debt to 7.2% at the end of 1993 from 9.2% in 1988. The Company has refinanced more than $1.2 billion in long-term debt since 1988, and reduced annual interest expense by more than $55 million. Unless interest rates fall further, however, it will be difficult to significantly improve from the 7.2% level. All opportunities continue to be pursued aggressively. In February 1994, the Company redeemed, at par, through a sinking fund provision in its mortgage, $23 million of 8 5/8% Series first mortgage bonds due 2007. In February 1994, $37.5 million of tax-exempt pollution control notes were issued by a governmental authority on behalf of the Company. The notes will have several interest rate options and have an initial rate of 2.4% through April 13, 1994. Proceeds from the sale will be used to redeem $37.5 million of annual adjustable rate pollution control notes, due 2015, in March 1994. The Company uses interim financing in the form of short-term unsecured notes, usually commercial paper, to finance certain refundings and construction expenditures and for other corporate purposes, thereby providing flexibility in the timing and amounts of long-term financings. There was $50.2 million of commercial paper outstanding at December 31, 1993, at a weighted average interest rate of 3.5%. The weighted average interest rate during 1993 was 3.4%. The Company also has a revolving credit agreement with certain banks that provides for borrowing up to $200 million to July 31, 1997. The Company had an outstanding $50 million loan under this agreement at December 31, 1993, at an interest rate of 4.06%. In June 1993, the Company's first mortgage bonds and unsecured pollution control notes were upgraded by Standard & Poor's (S&P). The investment rating agency stated that the higher ratings reflect expected continued improvements in the Company's financial condition as a result of the Company's three- year rate settlement, which was pending at the time of the upgrade, aggressive cost controls, and limited new money needs. S&P also noted that regulatory adjustment mechanisms, such as electric revenue decoupling and natural gas weather normalization, should add stability to earnings. In October 1993, S&P completed its review of the U.S. investor-owned utility industry and concluded that more stringent financial benchmarks were appropriate for electric utilities to counter increased competition and mounting business risk. As a result, it revised the rating outlook downward for about one- third of the utility industry, including the Company. However, the Company's ratings were not changed. Investing Activities The Company's 1993 capital expenditures for its core electric and natural gas businesses totaled approximately $245 million. Most of the expenditures were for the extension of service and for improvements at existing facilities. Capital expenditures for 1994-1996 have been significantly reduced from previously forecasted levels. This represents one of many actions the Company is taking to address competition (See Competitive Conditions). Capital expenditures for 1994-1996 will be primarily for extension of service, necessary improvements at existing facilities, and compliance with the Clean Air Act Amendments of 1990 (See Environmental Matters). The Company forecasts that its current reserve margin, coupled with more efficient use of energy (See Conservation Programs) and generation from NUGs, will eliminate the need for additional generating capacity until after the year 2005. As part of the Company's effort to reduce costs, one of two generating units at each of its Goudey and Greenidge Generating Stations will be placed on long-term cold standby. These actions are being taken because the abundance of power in the Northeast has driven down wholesale prices. These units will continue to be utilized to provide electrical system support. The following table provides information on the Company's estimated sources and uses of funds for 1994-1996. This forecast is subject to periodic review and revision, and actual construction costs may vary because of revised load estimates, imposition of additional regulatory requirements, and the availability and cost of capital. 1994 1995 1996 Total ---- ---- ---- ----- Sources of funds (Millions) Internal funds $254 $265 $269 $788 Long-term financing Debt and stock proceeds 413 141 80 634 Debt proceeds held in trust 34 8 - 42 ---- ---- ---- ----- Net financing proceeds 447 149 80 676 Increase (decrease) in short-term debt (50) - - (50) Decrease (increase) in temporary cash investments 89 (69) (52) (32) ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== Uses of funds Construction Cash expenditures $202 $193 $193 $588 AFDC 8 7 7 22 ---- ---- ---- ------ Total construction 210 200 200 610 Retirement of securities and sinking fund obligations 501 108 63 672 Working capital and deferrals 29 37 34 100 ---- ---- ---- ------ Total $740 $345 $297 $1,382 ==== ==== ==== ====== As shown in the preceding table, internal sources of funds represent 129% of construction expenditures for 1994-1996. Conservation Programs The Company has implemented a number of demand-side management (DSM) programs. As a result of its three-year rate settlement agreement (See Regulatory Matters), incentives earned for conducting efficient DSM programs were reduced from 15% to 5% of the net resource savings achieved by these DSM programs. For 1994, the Company expects to earn approximately $3 million in incentives as a result of these DSM programs. In 1993, the Company's customers saved approximately 282 million kilowatt-hours (kwh) on an annualized basis through the Company's DSM programs. The implementation of these programs cost $48 million in 1993 and will cost approximately $16 million in 1994 with estimated customer savings of 113 million kwh on an annualized basis. The Company has approximately $73 million and $44 million of deferred DSM program costs on the Consolidated Balance Sheets at December 31, 1993, and 1992, respectively. The two-year (1993-1994) DSM plan, which has received PSC approval, has been modified to improve cost-effectiveness and reduce rate impacts. Environmental Matters The Company continually assesses actions that may need to be taken to ensure compliance with changing environmental laws and regulations. Compliance programs will increase the cost of electric and natural gas service by requiring changes to the Company's operations and facilities. Historically, rate recovery has been authorized for the cost incurred for compliance with environmental laws and regulations. Due to existing and proposed legislation and regulations, and legal proceedings commenced by governmental bodies and others, the Company may also incur costs from the past disposal of hazardous substances produced during the Company's operations or those of its predecessors. The Company has been notified by the EPA and the NYSDEC that it is among the potentially responsible parties (PRPs) who may be liable to pay for costs incurred to remediate certain hazardous substances at seven waste sites, not including the Company's inactive gas manufacturing sites, which are discussed below. With respect to the seven sites, five sites are included in the New York State Registry of Inactive Hazardous Waste Sites (New York State Registry). Any liability may be joint and several for certain of these sites. The ultimate cost to remediate these sites will be dependent on such factors as the remedial action plan selected, the extent of site contamination, and the portion attributed to the Company. At December 31, 1993, the Company recorded a liability in the Consolidated Balance Sheets related to four of these seven waste sites of $1.8 million. The Company has notified the NYSDEC that it believes it has no responsibility at two sites and has already incurred expenditures related to the remediation at the remaining site. A deferred asset has also been recorded in the amount of $2.6 million, of which $.8 million relates to costs that have already been incurred. The Company believes it will recover these costs, since the PSC has allowed other utilities to recover these types of remediation costs and has allowed the Company to recover similar costs in rates, such as investigation and cleanup costs relating to inactive gas manufacturing sites. This $1.8 million estimate was derived by multiplying the total estimated cost to clean up a particular site by the related Company contribution factor. Estimates of the total cleanup costs were determined by using information related to a particular site, such as investigations performed to date at a site or from the data released by a regulatory agency. In addition, this estimate was based upon currently available facts, existing technology, and presently enacted laws and regulations. The contribution factor is calculated using either the Company's percentage share of the total PRPs named, which assumes all PRPs will contribute equally, or the Company's estimated percentage share of the total hazardous wastes disposed of at a particular site, or by using a 1% contribution factor for those sites at which it believes that it has contributed a minimal amount of hazardous wastes. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A number of the Company's inactive gas manufacturing sites have been listed in the New York State Registry. The Company has filed petitions to delist the majority of the sites. The Company's program to investigate and initiate remediation at its 38 known inactive gas manufacturing sites has been extended through the year 2000. Expenditures over this time period are estimated to be $25 million. This estimate was determined by using the Company's experience and knowledge related to these sites as a result of the investigation and remediation that the Company has performed to date. It is based upon currently available facts, existing technology, and presently enacted laws and regulations. This liability, to investigate and initiate remediation, as necessary, at the known inactive gas manufacturing sites is reflected in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992. The Company also has recorded a corresponding deferred asset, since it expects to recover such expenditures in rates, as the Company has previously been allowed by the PSC to recover such costs in rates. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. The Clean Air Act Amendments of 1990 (1990 Amendments) will result in significant expenditures of approximately $178 million, on a present value basis, over a 25-year period, for all capital and operating and maintenance expenses related to the reduction of sulfur dioxide and nitrogen oxides at several of the Company's coal-fired generating stations, of which $51 million has been incurred as of December 31, 1993. The Company's current estimate is a significant reduction from its prior estimate, primarily due to the postponement of the construction of a flue gas desulfurization (FGD) system at its Homer City Generating Station. The Company plans to re-evaluate the need to construct an FGD system at the Homer City Generating Station in 1995, since its present strategy to bank Phase I emissions allowances for use during Phase II, as discussed below, will allow the Company to meet Phase II allowance requirements through the year 2005. The cost to comply with the sulfur dioxide and nitrogen oxide limitations includes the construction of an innovative FGD system and a nitrogen oxide reduction system expected to be completed in 1995 at the Company's Milliken Generating Station. The Company estimates that approximately a 1% electric rate increase will be required for the cost of reducing sulfur dioxide and nitrogen oxide emissions in both Phase I (begins January 1, 1995) and Phase II (begins January 1, 2000). As a result of the 1990 Amendments, the Company plans to reduce its annual sulfur dioxide emissions by an amount that will allow the Company to meet the sulfur dioxide levels established for the Company, which is approximately a 49% reduction from approximately 138,000 tons in 1989 to 71,000 tons by the year 2000. The cost of controlling toxic emissions under the 1990 Amendments, if required, cannot be estimated at this time. Regulations may be adopted at the state level which would limit toxic emissions even further, at an additional cost to the Company. The Company anticipates that the costs incurred to comply with the 1990 Amendments will be recoverable through rates based on previous rate recovery of required environmental costs. The 1990 Amendments require the U.S. Environmental Protection Agency (EPA) to allocate annual emissions allowances to each of the Company's coal-fired generating stations based on statutory emissions limits. An emissions allowance represents an authorization to emit, during or after a specified calendar year, one ton of sulfur dioxide. During Phase I, the Company estimates that it will have allowances in excess of the affected coal-fired generating stations' actual emissions. The Company's present strategy is to bank these allowances for use in later years. By using a banking strategy, it is estimated that Phase II allowance requirements will be met through the year 2005 by utilizing the allowances banked during Phase I, which includes the extension reserve allowances discussed below, together with the Company's Phase II annual emissions allowances. This strategy could be modified should market or business conditions change. In addition to the annual emissions allowances allocated to the Company by the EPA, the Company will receive a portion of the extension reserve allowances issued by the EPA to utilities electing to build scrubbers, as a result of the pooling agreement that it entered into with other utilities who were also eligible to receive some of these extension reserve allowances. As a result of existing and new solid waste disposal legislation and regulations in Pennsylvania, the Company will incur approximately $24 million, on a present value basis, of additional costs over the next 30 years, beginning in 1994, at the Homer City Generating Station. These costs will be incurred to install new equipment, modify or replace existing equipment, and improve the design of a proposed expansion of disposal facilities. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Regulatory Matters In September 1993, the Company reached a three-year electric and natural gas rate settlement agreement (Agreement) with the PSC. The new electric and natural gas rates became effective September 4, 1993. The allowed return on equity is 10.8% in year one, 11.4% in year two, and 11.4% (subject to an indexing mechanism) in year three. Shareholders will be allowed to keep 100% of any earnings in excess of the allowed return in year one. Shareholders and customers will share, on a 50%/50% basis, any earnings in excess of the allowed return in years two and three. The Agreement also includes a modified revenue decoupling mechanism (RDM) for electric sales. Rates are based on sales forecasts. Since actual sales may differ significantly from forecasted sales because of conservation efforts, unusual weather, or changing economic conditions, the revenue collected may be more or less than forecast. Subject to the caps described below, the modified RDM will let the Company adjust for most of the differences between forecasted and actual sales. For example, if revenues exceed the forecast for a given year, the excess would be passed back to customers in a future year. If revenues are below the forecast, customers would receive a surcharge in a future year. The Company will share excesses or shortfalls from most large commercial and industrial sales revenues on a 70%/30% (customer/stockholder) basis. Customer savings for production and transmission operating costs of $21 million will be imputed over three years, $7 million each year, whether or not they are realized. Incentives for customer service, production cost, and DSM could increase the allowed return to 12.3% or decrease it to 9.95% in year one, increase it to 13.05% or decrease it to 10.4% in year two, and increase it to 13.25% or decrease it to 10.2% in year three. The electric and natural gas rate increases discussed below represent eleven months for year one and twelve months for years two and three. The estimated total electric price increases below include base rate increases allowed by the Agreement plus estimates of fuel and purchased power increases which will be collected through the Fuel Adjustment Clause (FAC). Actual fuel and purchased power costs could vary from estimates causing the estimated FAC and total electric price increases below to change. Base Rate Estimated FAC Total Electric (Dollar Amounts in Millions) Year 1 $60.5 4.4% $39.1 3.0% $99.6 7.4% Year 2 $70.3 4.8% $39.2 2.8% $109.5 7.6% Year 3 $57.4 3.6% $30.4 2.0% $87.8 5.6% The natural gas base rate increases allowed by the Agreement are $7.5 million, or 2.9%, $8.2 million, or 3.0%, and $7.2 million, or 2.5%, in years one, two, and three, respectively. They do not include changes in natural gas costs, which will be collected through the Gas Adjustment Clause. Natural gas costs can be expected to rise and fall with overall natural gas market conditions. Such fluctuations will affect the total natural gas price increases. The Agreement also provides for the stated electric and natural gas base rate increases to be adjusted up or down in the second and third years, as well as the year after the Agreement period (year four). These adjustments will depend on several factors, such as electric sales and incentive mechanisms. The Agreement provides that no cap would apply to any downward revision to base rates for electric and natural gas service. The electric base rate increases could be increased by up to 1.5% in years two and three and 1.6% in year four (the caps). The natural gas base rate increases could also be increased by up to 1% in year two and 1.2% in year three. The Agreement does not specify a cap for natural gas base rates for year four. Item 8. Item 8. Financial statements and supplementary data New York State Electric & Gas Corporation Consolidated Statements of Income Year Ended December 31 1993 1992 1991 - ---------------------------------------------------------------------------- (Thousands, except Per Share Amounts) Operating Revenues Electric . . . . . . . . . . . . . . . . $1,527,362 $1,451,525 $1,367,936 Natural gas. . . . . . . . . . . . . . . 272,787 240,164 187,879 ---------- ---------- ---------- Total Operating Revenues . . . . . . $1,800,149 1,691,689 1,555,815 ---------- ---------- ---------- Operating Expenses Fuel used in electric generation . . . . 245,283 262,531 274,877 Electricity purchased (Note 9) . . . . . 161,967 95,026 45,808 Natural gas purchased. . . . . . . . . . 141,635 126,815 99,528 Other operating expenses . . . . . . . . 349,177 318,680 279,364 Restructuring expenses (Notes 6 and 7) . 26,000 - - Maintenance. . . . . . . . . . . . . . . 111,757 102,500 110,131 Depreciation and amortization (Note 1) . 164,568 158,977 152,380 Federal income taxes (Notes 1 and 2) . . 94,144 102,456 94,447 Other taxes (Note 12). . . . . . . . . . 204,962 200,941 178,185 ---------- ---------- ---------- Total Operating Expenses . . . . . . . 1,499,493 1,367,926 1,234,720 ---------- ---------- ---------- Operating Income. . . . . . . . . . . . . 300,656 323,763 321,095 Other Income and Deductions . . . . . . . 6,471 12,036 6,076 ---------- ---------- ---------- Income Before Interest Charges. . . . . . 307,127 335,799 327,171 ---------- ---------- ---------- Interest Charges Interest on long-term debt . . . . . . . 134,330 145,822 151,649 Other interest . . . . . . . . . . . . . 11,120 9,566 11,877 Allowance for borrowed funds used during construction. . . . . . . . (4,351) (3,557) (4,998) ---------- ---------- ---------- Interest Charges - Net . . . . . . . . 141,099 151,831 158,528 ---------- ---------- ---------- Net Income. . . . . . . . . . . . . . . . 166,028 183,968 168,643 Preferred Stock Dividends . . . . . . . . 20,638 20,995 20,330 ---------- ---------- ---------- Earnings Available for Common Stock . . . $145,390 $162,973 $148,313 ========== ========== ========== Earnings Per Share. . . . . . . . . . . . $2.08 $2.40 $2.36 Average Shares Outstanding. . . . . . . . 69,990 67,972 62,906 The notes on pages 50 through 73 are an integral part of the financial statements. New York State Electric & Gas Corporation Consolidated Balance Sheets December 31 1993 1992 - ------------------------------------------------------------------------------- (Thousands) Assets Utility Plant, at Original Cost (Note 1) Electric (Note 8). . . . . . . . . . . . . . . . . . . $4,777,368 $4,573,444 Natural gas. . . . . . . . . . . . . . . . . . . . . . 381,389 352,059 Common . . . . . . . . . . . . . . . . . . . . . . . . 158,986 157,979 ---------- ---------- . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,317,743 5,083,482 Less accumulated depreciation. . . . . . . . . . . . . 1,541,456 1,427,793 ---------- ---------- Net Utility Plant in Service. . . . . . . . . . . . 3,776,287 3,655,689 Construction work in progress. . . . . . . . . . . . . 143,859 177,566 ---------- ---------- Total Utility Plant . . . . . . . . . . . . . . . . 3,920,146 3,833,255 Other Property and Investments, net . . . . . . . . . . 73,537 59,157 Current Assets Cash and cash equivalents (Notes 1 and 10) . . . . . . 4,264 3,968 Special deposits (Note 10) . . . . . . . . . . . . . . 145,335 96,432 Accounts receivable, net (Note 1). . . . . . . . . . . 181,586 171,683 Fuel, at average cost. . . . . . . . . . . . . . . . . 54,791 69,077 Materials and supplies, at average cost. . . . . . . . 48,910 50,637 Prepayments. . . . . . . . . . . . . . . . . . . . . . 30,092 37,897 Accumulated deferred federal income tax benefits (Notes 1 and 2). . . . . . . . . . . . - 1,182 ---------- ---------- Total Current Assets. . . . . . . . . . . . . . . . 464,978 430,876 Deferred Charges (Note 1) Unfunded future federal income taxes (Notes 1 and 2) . . . . . . . . . . . . . . . 380,056 393,720 Unamortized debt expense . . . . . . . . . . . . . . . 112,059 96,378 Demand-side management program costs . . . . . . . . . 73,113 44,049 Other. . . . . . . . . . . . . . . . . . . . . . . . . 252,127 220,481 ---------- ---------- Total Deferred Charges. . . . . . . . . . . . . . . 817,355 754,628 ---------- ---------- Total Assets. . . . . . . . . . . . . . . . . . . . $5,276,016 $5,077,916 ========== ========== The notes on pages 50 through 73 are an integral part of the financial statements. New York State Electric & Gas Corporation Consolidated Balance Sheets December 31 1993 1992 - ------------------------------------------------------------------------------ (Thousands) Capitalization and Liabilities Capitalization Common stock equity Common stock ($6.66 2/3 par value, 90,000,000 shares authorized and 70,595,985 and 69,439,397 shares issued and outstanding at December 31, 1993 and 1992, respectively) . . . . . . . . . . $470,640 $462,929 Capital in excess of par value. . . . . . . . . . 824,943 796,505 Retained earnings . . . . . . . . . . . . . . . . 320,114 327,040 ---------- ---------- Total common stock equity. . . . . . . . . . . . . . . 1,615,697 1,586,474 Preferred stock redeemable solely at the option of the Company (Note 4). . . . . . . . . . . . . . . . 140,500 160,500 Preferred stock subject to mandatory redemption requirements (Notes 4 and 10) . . . . . . . . . . . 125,000 106,900 Long-term debt (Notes 3 and 10). . . . . . . . . . . . 1,630,629 1,777,027 ---------- ---------- Total Capitalization. . . . . . . . . . . . . . . 3,511,826 3,630,901 Current Liabilities Current portion of long-term debt and preferred stock (Notes 3 and 4) . . . . . . . . . . . . . . . 332,709 115,659 Commercial paper (Notes 5 and 10). . . . . . . . . . . 50,200 64,100 Accounts payable and accrued liabilities . . . . . . . 111,481 95,996 Interest accrued (Note 10) . . . . . . . . . . . . . . 31,348 37,690 Accumulated deferred federal income taxes (Notes 1 and 2) . . . . . . . . . . . . . . . . . . 1,132 - Other. . . . . . . . . . . . . . . . . . . . . . . . . 89,443 65,073 ---------- ---------- Total Current Liabilities . . . . . . . . . . . . 616,313 378,518 Deferred Credits Accumulated deferred investment tax credits (Notes 1 and 2) . . . . . . . . . . . . . . . . . . 138,478 141,729 Excess deferred federal income taxes (Notes 1 and 2) . 36,378 58,188 Other. . . . . . . . . . . . . . . . . . . . . . . . . 149,620 107,160 ---------- ---------- Total Deferred Credits. . . . . . . . . . . . . . 324,476 307,077 Accumulated Deferred Federal Income Taxes (Notes 1 and 2) Unfunded future federal income taxes . . . . . . . . . 380,056 393,720 Other. . . . . . . . . . . . . . . . . . . . . . . . . 416,545 342,700 ---------- ---------- Total Accumulated Deferred Federal Income Taxes . . . . . . . . . . . . . . . . . . 796,601 736,420 Commitments and Contingencies (Note 9). . . . . . . . . 26,800 25,000 ---------- ---------- Total Capitalization and Liabilities. . . . . . . $5,276,016 $5,077,916 ========== ========== The notes on pages 50 through 73 are an integral part of the financial statements. Notes to Consolidated Financial Statements 1 Significant Accounting Policies Principles of consolidation The consolidated financial statements include the Company's wholly-owned subsidiaries, Somerset Railroad Corporation (SRC) and NGE Enterprises, Inc. (NGE). All significant intercompany balances and transactions are eliminated in consolidation. Utility plant The cost of repairs and minor replacements is charged to the appropriate operating expense accounts. The cost of renewals and betterments, including indirect cost, is capitalized. The original cost of utility plant retired or otherwise disposed of and the cost of removal less salvage are charged to accumulated depreciation. Depreciation and amortization Depreciation expense is determined using straight-line rates, based on the average service lives of groups of depreciable property in service. Depreciation accruals were equivalent to 3.4%, 3.3%, and 3.3%, of average depreciable property for 1993, 1992, and 1991, respectively. Depreciation expense includes the amortization of certain deferred charges authorized by the Public Service Commission of the State of New York (PSC). Revenue During 1993, 1992, and 1991, the Company recognized on the income statement approximately $12 million, $22 million, and $40 million, respectively, of electric and natural gas unbilled revenues that had been accrued on its balance sheet for energy provided but not yet billed to minimize the rate increases for these years in accordance with various PSC rate decisions. The July 1992 rate decision allowed the Company to recognize on its income statement, beginning in August 1992, electric and natural gas unbilled revenues on a full accrual basis. The Company recognizes as revenue incentives earned as the result of conducting efficient demand-side management (DSM) programs. The Company is collecting those incentives in rates within approximately one year after they are recognized. During 1993, 1992, and 1991, incentives earned were $16.4 million, $15.6 million, and $12.4 million, respectively. At December 31, 1993 and 1992, approximately $14.3 million and $9.8 million, respectively, of DSM incentives were accrued and included in accounts receivable. Accounts receivable The Company has an agreement that expires in November 1996 to sell, with limited recourse, undivided percentage interests in certain of its accounts receivable from customers. The agreement allows the Company to receive up to $152 million from the sale of such interests. At December 31, 1993 and 1992, accounts receivable on the Consolidated Balance Sheets is shown net of $152 million and $138 million, respectively, of interests in accounts receivable sold. All fees associated with the program are included in other income and deductions on the Consolidated Statements of Income and amounted to approximately $5.7 million, $6.5 million, and $9.3 million in 1993, 1992, and 1991, respectively. Accounts receivable on the Consolidated Balance Sheets is also shown net of an allowance for doubtful accounts of $4 million and $1.9 million at December 31, 1993 and 1992, respectively. Bad debt expense was $15.3 million, $11.5 million, and $10.7 million in 1993, 1992, and 1991, respectively. Federal income taxes The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, in January 1993. Since the Company had been accounting for income taxes under Statement of Financial Accounting Standards No. 96, Accounting for Income Taxes, there was no effect on the Consolidated Statements of Income as a result of adopting SFAS 109. However, SFAS 109 did require the Company's deferred tax balances to be reclassified on its Consolidated Balance Sheets. The Company files a consolidated federal income tax return with SRC and NGE. Deferred income taxes are provided on all temporary differences between financial statement basis and taxable income. Investment tax credits, which reduce federal income taxes currently payable, are deferred and amortized over the estimated lives of the applicable property. The effect of the alternative minimum tax, which increases federal income taxes currently payable and generates a tax credit available for future use, is deferred and amortized at such times as the tax credit is used on the Company's federal income tax return. Deferred charges The Company defers certain incurred expenses when authorized by the PSC. Those expenses will be recovered from customers in the future. Consolidated Statements of Cash Flows The Company considers all highly liquid investments with a maturity or put date of three months or less when acquired to be cash equivalents. These investments are included in cash and cash equivalents on the Consolidated Balance Sheets. Total income taxes paid were $27.3 million, $38.5 million, and $31.8 million for the years ended December 31, 1993, 1992, and 1991, respectively. Interest paid, net of amounts capitalized, was $138.2 million, $149.3 million, and $159.9 million for the years ended December 31, 1993, 1992, and 1991, respectively. The Company purchased all of the common stock of Columbia Gas of New York, Inc. in 1991. In conjunction with the acquisition, liabilities assumed were $24.9 million (fair value of assets acquired of $82 million less cash paid of $57.1 million). Reclassification Certain amounts have been reclassified on the consolidated financial statements to conform with the 1993 presentation. 2 Federal Income Taxes Year ended December 31 1993 1992 1991 (Thousands) Charged to operations Current $34,989 $37,237 $22,991 Deferred - net Accelerated depreciation 49,580 41,492 37,409 Unbilled revenues 5,073 160 13,644 Alternative minimum tax (AMT) credit (3,194) 2,123 5,557 Demand-side management 13,479 9,324 8,589 NUG termination agreement 4,760 6,800 - Nine Mile No. 2 litigation proceeds 4,756 (2,047) - Restructuring expenses (6,965) - - Transmission facility agreement(7,778) (1,172) (1,162) Miscellaneous (6,198) (3,491) (9,365) Investment tax credit (ITC) deferred 5,642 12,030 16,784 ------- -------- ------- 94,144 102,456 94,447 Included in other income Amortization of deferred ITC (8,892) (16,927) (11,297) Miscellaneous 498 3,747 (533) ------- -------- ------- Total $85,750 $89,276 $82,617 ======= ======== ======= The Company's effective tax rate differed from the statutory rate of 35% in 1993 and 34% in 1992 and 1991 due to the following: Year ended December 31 1993 1992 1991 (Thousands) Tax expense at statutory rate $88,684 $92,903 $85,428 Depreciation not normalized 16,984 16,697 16,051 ITC amortization (8,892) (16,927) (11,297) Research & Development (R&D) credit (5,139) - - Cost of removal (4,921) (4,079) (6,120) Other - net (966) 682 (1,445) ------- ------- ------ Total $85,750 $89,276 $82,617 ======= ======= ======= The Company's current and noncurrent deferred taxes, which net to a tax liability of approximately $936.2 million as of December 31, 1993, consisted of the following deferred tax assets and liabilities: Deferred Tax Deferred Tax Assets Liabilities (Thousands) Depreciation $ 698,939 Loss on reacquired debt 28,440 Regulatory Asset (SFAS 109) 149,636 Accumulated deferred ITC 91,006 Demand-side management 35,381 NUG contract settlement costs 15,163 Alternative minimum tax credit $ 19,953 Excess tax reserve 12,603 Nine Mile No. 2 disallowed plant 19,347 Contributions in aid of construction 20,913 Capitalized interest 8,690 Other 35,369 34,521 ----------- ------------ Total deferred taxes $116,875 $1,053,086 =========== ============ The Revenue Reconciliation Act (RRA) of 1993 was enacted on August 10, 1993. Among other things, RRA 1993 provided for an increase of 1% in the statutory corporate income tax rate and an extension of the R&D credit until June 30, 1995. In September 1993, the Company reached a three-year rate settlement agreement with the PSC (Agreement) which included a provision for the Company to petition to defer the effect of RRA 1993 until it is reflected in rates. The Company has deferred for collection from customers $.6 million representing additional 1993 federal income taxes resulting from RRA 1993. The Company has recorded unfunded future federal income taxes and a corresponding receivable from customers of approximately $381 million and $393 million as of December 31, 1993 and 1992, respectively, primarily representing the cumulative amount of federal income taxes on temporary depreciation differences, which were previously flowed through to customers. Those amounts, including the tax effect of the future revenue requirements, are being amortized over the life of the related depreciable assets concurrent with their recovery in rates. The Company has approximately $20 million of AMT credits which do not expire, and $5.1 million of R&D credits which expire beginning in 2005. 3 Long-Term Debt At December 31, 1993 and 1992, long-term debt was (Thousands): First mortgage bonds Amount Series Due 1993 1992 8 3/8% Aug. 15, 1994 $ 100,000 $100,000 8 5/8% June 1, 1996 - 50,000 5 5/8% Jan. 1, 1997 25,000 25,000 6 1/4% Sept. 1, 1997 25,000 25,000 6 1/2% Sept. 1, 1998 30,000 30,000 7 5/8% Nov. 1, 2001 50,000 50,000 6 3/4% Oct. 15, 2002 150,000 150,000 9 3/8% Jan. 1, 2006 - 3,000 7 1/4% June 1, 2006 12,000 12,000 6 7/8% Dec. 1, 2006 25,250 25,500 8 5/8% Nov. 1, 2007 60,000 60,000 9 1/4% Apr. 1, 2016 - 50,000 9% Mar. 1, 2017 - 100,000 10 5/8% Jan. 1, 2018 - 100,000 9 7/8% Feb. 1, 2020 100,000 100,000 9 7/8% May 1, 2020 100,000 100,000 9 7/8% Nov. 1, 2020 100,000 100,000 8 7/8% Nov. 1, 2021 150,000 150,000 8.30 % Dec. 15, 2022 100,000 100,000 7.55 % Apr. 1, 2023 50,000 - 7.45 % July 15, 2023 100,000 - --------- --------- Total first mortgage bonds 1,177,250 1,330,500 ========= ========= Pollution control notes Interest Maturity Interest Rate Letter of Credit Amount Rate Date Adjustment Date Expiration Date 1993 1992 12% May 1, 2014* - - 60,000 60,000 12.30% July 1, 2014* - - 40,000 40,000 2.80% Dec. 1, 2014 Dec. 1, 1994 Dec. 15, 1995 74,000 74,000 2.75% Mar. 1, 2015 Mar. 1, 1994 Mar. 15, 1995 37,500 37,500 2.50% Mar. 15, 2015 Mar. 15, 1994 Mar. 31, 1995 60,000 60,000 2.60% July 15, 2015 July 15, 1994 July 31, 1995 63,500 63,500 2.85% Oct. 15, 2015 Oct. 15, 1994 Oct. 31, 1995 30,000 30,000 2.75% Dec. 1, 2015 Dec. 1, 1994 Dec. 15, 1995 42,000 42,000 4.10% July 1, 2026 July 1, 1996 July 15, 1996 65,000 65,000 5.95% Dec. 1, 2027 - - 34,000 34,000 5.70% Dec. 1, 2028 - - 70,000 - ---------- ---------- Total pollution control notes 576,000 506,000 ========== ========== Revolving Credit Agreement Note due July 31, 1997 50,000 - Long-term notes due December 31, 1996 36,100 27,707 CNG Transmission Corp. Note due November 10, 1996 8,862 - Obligations under capital leases 30,902 38,804 Unamortized premium and discount on debt-net (10,776) (11,975) ---------- ---------- 1,868,338 1,891,036 Less: debt due within one year-included in current liabilities 237,709 114,009 ---------- ---------- Total $1,630,629 $1,777,027 ========== ========== * Will be refunded in 1994 with proceeds from the issuance of $100 million of 6.05% pollution control notes due 2034. At December 31, 1993, long-term debt and capital lease payments which will become due during the next five years are: 1994 1995 1996 1997 1998 (Thousands) $237,709 $12,552 $45,651 $102,196 $31,411 The Company's mortgage provides for a sinking and improvement fund. This provision requires the Company to make annual cash deposits with the Trustee equivalent to 1% of the principal amount of all bonds delivered and authenticated by the Trustee prior to January 1 of that year (excluding any bonds issued on the basis of the retirement of bonds). The Company satisfied this requirement in 1993 by depositing $22.5 million in cash which was used to redeem in February 1993, $22.5 million of 10 5/8% Series first mortgage bonds, due 2018. The Company satisfied this requirement in 1994 by depositing $23 million in cash which was used to redeem in February 1994, $23 million of 8 5/8% Series first mortgage bonds, due 2007. Mandatory annual cash sinking fund requirements are $600,000 beginning June 1, 2001, for the 7 1/4% Series and $250,000 on December 1 in each year 1994 to 1996, for the 6 7/8% Series. The amount increases to $500,000 and $750,000 on December 1, 1997 and December 1, 2002, respectively, for the 6 7/8% Series. The Company's first mortgage bond indenture constitutes a direct first mortgage lien on substantially all utility plant. Adjustable rate pollution control notes were issued to secure like amounts of tax-exempt adjustable rate pollution control revenue bonds (Revenue Bonds) issued by a governmental authority. The Revenue Bonds bear interest at the rate indicated through the date preceding the interest rate adjustment date. The pollution control notes bear interest at the same rate as the Revenue Bonds. On the interest rate adjustment date and annually thereafter (every three years thereafter in the case of the Revenue Bonds due July 1, 2026), the interest rate will be adjusted, not to exceed a rate of 15%, or at the option of the Company, subject to certain conditions, a fixed rate of interest, not to exceed 18%, may become effective. In the case of the Revenue Bonds due July 1, 2026, at the option of the Company, subject to certain conditions, a fixed rate of interest may become effective prior to the interest rate adjustment date or each third year thereafter. Bond owners may elect, subject to certain conditions, to have their Revenue Bonds purchased by the Trustee. The Company has irrevocable letters of credit which expire on the letter of credit expiration dates and which the Company anticipates being able to extend if the interest rate on the related Revenue Bonds is not converted to a fixed interest rate. Those letters of credit support certain payments required to be made on the Revenue Bonds. If the Company is unable to extend the letter of credit that is related to a particular series of Revenue Bonds, that series will have to be redeemed unless a fixed rate of interest becomes effective. Payments made under the letters of credit in connection with purchases of Revenue Bonds by the Trustee are repaid with the proceeds from the remarketing of the Revenue Bonds. To the extent the proceeds are not sufficient, the Company is required to reimburse the bank that issued the letter of credit. 4 Preferred Stock At December 31, 1993 and 1992, serial cumulative preferred stock was: Shares Par Value Authorized Per Redeemable and Amount Series Share Prior to Per Share Outstanding(1) 1993 1992 (Thousands) Redeemable solely at the option of the Company: 3.75% $100 $104.00 150,000 $ 15,000 $ 15,000 4 1/2%(1949) 100 103.75 40,000 4,000 4,000 4.15% 100 101.00 40,000 4,000 4,000 4.40% 100 102.00 75,000 7,500 7,500 4.15% (1954) 100 102.00 50,000 5,000 5,000 6.48% 100 102.00 300,000 30,000 30,000 8.80% (2) 100 102.00 250,000 25,000 25,000 8.48% (3) 25 25.70 1,000,000 25,000 25,000 7.40% (4) 25 12/1/98 26.85 1,000,000 25,000 - Thereafter 25.00 Adjustable Rate (5) 25 25.00 1,800,000 45,000 45,000 Adjustable Rate (6) 25 12/1/98 27.50 2,000,000 50,000 - Thereafter 25.00 ---------- ---------- 235,500 160,500 Less: preferred stock redemptions within one year - included in current liabilities 95,000 - ---------- ---------- Total $ 140,500 $ 160,500 ========== ========== Subject to mandatory redemption requirements: 9.00% (7) 100 - $ - $ 8,550 6.30% (8) 100 1/1/95 105.67 250,000 25,000 - 8.95% (9) 25 1/1/95 26.79 4,000,000 100,000 100,000 ---------- ---------- 125,000 108,550 Less: sinking fund requirements at par value - included in current liabilities - 1,650 ---------- ---------- Total $ 125,000 $ 106,900 ========== ========== At December 31, 1993, preferred stock redemptions and annual redeemable preferred stock sinking fund requirements for the next five years are: 1994 1995 1996 1997 1998 (Thousands) $95,000 $ - $ - $5,000 $5,000 (1) At December 31, 1993, and after giving effect to the redemptions referred to in (2), (3), and (5) below, there were 1,550,000 shares of $100 par value preferred stock, 3,800,000 shares of $25 par value preferred stock and 1,000,000 shares of $100 par value preference stock authorized but unissued. (2) Redeemed January 18, 1994. (3) Redeemed February 1, 1994. (4) The Company is restricted in its ability to redeem this Series prior to December 1, 1998. (5) The Adjustable Rate Serial Preferred Stock, Series A, was redeemed January 10, 1994. (6) The payment on the Adjustable Rate Serial Preferred Stock, Series B, for April 1, 1994, is at an annual rate of 5.12% and subsequent payments can vary from an annual rate of 4% to 10%, based on a formula included in the Company's Certificate of Incorporation. The Company is restricted in its ability to redeem this Series prior to December 1, 1998. (7) On October 1, 1993, 33,000 shares were redeemed at par. The remaining 52,500 shares were redeemed at $100.50 per share on October 13, 1993. For the years 1991 and 1992, 16,500 shares were redeemed and cancelled annually. (8) On January 1, in each year 2004 through 2008, the Company must redeem 12,500 shares at par, and on January 1, 2009, the Company must redeem the balance of the shares at par. This Series is redeemable at the option of the Company at $105.67 per share prior to January 1, 1995. The $105.67 price will be reduced annually by 63 cents for the years ending 1995 through 2002; thereafter, the redemption price is $100.00. The Company is restricted in its ability to redeem this Series prior to January 1, 2004. (9) On January 1, in each year 1997 through 2016, the Company must redeem 200,000 shares at par. This Series is redeemable at the option of the Company at $26.79 per share prior to January 1, 1995. The $26.79 price will be reduced annually by 15 cents for the years ending 1995 through 1999; by 14 cents for the year ending 2000; and by 15 cents for the years ending 2001 through 2005. The Company is restricted in its ability to redeem this Series prior to January 1, 1996. 5 Bank Loans and Other Borrowings The Company has a revolving credit agreement with certain banks which provides for borrowing up to $200 million to July 31, 1997. At the option of the Company, the interest rate on borrowings is related to the prime rate, the London Interbank Offered Rate (LIBOR) or the interest rate applicable to certain certificates of deposit. The agreement also provides for the payment of a commitment fee which can fluctuate from .15% to .375% depending upon the ratings of the Company's first mortgage bonds. The commitment fee at December 31, 1993 is .1875%. The Company had an outstanding loan of $50 million under the revolving credit agreement at December 31, 1993, at an interest rate of 4.06% under the LIBOR option, and did not have any outstanding loans under this agreement at December 31, 1992. The revolving credit agreement does not require compensating balances. In order to provide flexibility in the timing and amounts of long-term financings, the Company uses interim financing in the form of short-term unsecured notes, usually commercial paper, to finance certain refundings and construction expenditures, and for other corporate purposes. Information relative to short-term borrowings is as follows: Commercial Paper 1993 1992 1991 (Thousands) Ending balance $50,200 $64,100 $103,900 Maximum amount outstanding $95,400 $140,000 $111,000 Average amount outstanding (1) $56,300 $31,400 $66,700 Weighted average interest rate On ending balance 3.5% 4.0% 5.3% During the period (2) 3.4% 4.3% 6.2% (1) Calculated as the average of the sum of daily outstanding borrowings. (2) Calculated by dividing total interest expense by the average of the sum of daily outstanding borrowings. 6 Restructuring In the fourth quarter of 1993, the Company recorded a $26 million restructuring charge. The corporate restructuring will reorganize the way the Company delivers services to its electric and natural gas customers beginning in March 1994. The restructuring reduced 1993 earnings available for common stock by approximately $17.2 million or 25 cents per share. Included in this amount are $13.2 million for a voluntary early retirement program, $3.2 million for an involuntary severance program, and $.8 million for the elimination and closing of electric and natural gas operations facilities statewide. During 1994, the restructuring resulted in a work force reduction throughout the organization of approximately 600, the elimination of customer walk-in services at 28 satellite locations, and the closing of up to 10 electric and natural gas operations facilities statewide. The work force reduction was accomplished through a voluntary early retirement program (See Note 7 - Retirement Benefits) and an involuntary severance program. 384 employees accepted the early retirement program. 7 Retirement Benefits Pensions The Company has a noncontributory retirement annuity plan that covers substantially all employees. Benefits are based principally on the employee's length of service and compensation for the five highest paid years out of the last 10 years of service. It is the Company's policy to fund pension costs accrued each year to the extent deductible for federal income tax purposes. The net pension benefit for 1993, 1992, and 1991 totaled $5.7 million, $1.5 million, and $2.9 million, respectively. Effective January 1, 1993, the retirement benefit plans for hourly and salaried employees were combined into one plan. Combining the two plans did not affect benefit levels. Net pension benefit for 1993, 1992, and 1991 included the following components: 1993 1992 1991 (Thousands) Service cost: Benefits earned during the year $ 17,688 $ 15,387 $ 13,252 Interest cost on projected benefit obligation 40,710 35,253 32,096 Actual return on plan assets (77,129) (60,020) (111,749) Net amortization and deferral 12,989 7,844 63,487 ------- -------- -------- Net pension (benefit) $ (5,742) $ (1,536) $ (2,914) ======= ======== ======== The funded status of the plans at December 31, 1993 and 1992 were: 1993 1992 (Thousands) Actuarial present value of accumulated benefit obligation: Vested $390,716 $287,504 Nonvested 55,476 42,286 -------- -------- Total 446,192 329,790 ======== ======== Fair value of plan assets $753,292 $701,893 Actuarial present value of projected benefit obligation (608,216) (480,429) -------- -------- Plan assets in excess of projected benefit obligation 145,076 221,464 Unrecognized net transition asset (73,612) (80,850) Unrecognized net (gain) loss (83,709) (139,729) Unrecognized prior service cost 4,182 5,209 --------- -------- Net pension (liability) asset $(8,063) $ 6,094 ========= ======== Plan assets primarily consist of equity securities, corporate, U.S. agency, and Treasury bonds, and cash equivalents. The projected benefit obligation was measured using an assumed discount rate of 7% for 1993 and 7.75% for 1992 and 1991, and a long-term rate of increase in future compensation levels of 5% for 1993 and 6% for 1992 and 1991. The net pension benefit was measured using an expected long-term rate of return on plan assets of 8% in 1993 and 7.5% in 1992 and 1991. Early Retirement As part of the corporate restructuring that was announced in the fourth quarter of 1993 (See Note 6 - Restructuring), the Company offered a voluntary early retirement program from December 1, 1993, through January 21, 1994, to employees who were 55 years and older and who had at least 10 years of service with the Company. The program included two provisions: an unreduced pension benefit for those eligible employees who were under 60 years old, and a monthly supplemental payment to "bridge" employees to age 62 when they can begin collecting Social Security benefits. 384 employees accepted the early retirement opportunity. In 1993, the Company recorded a $19.9 million expense for the early retirement program. Postretirement Benefits Other Than Pensions The Company has postretirement benefit plans, such as a comprehensive health insurance plan and a prescription drug plan, that provide certain benefits for retired employees and their dependents. Substantially all of the Company's employees who retire under the Company's pension plan may become eligible for those benefits at retirement. At December 31, 1993, 1992, and 1991, 1,996, 1,905, and 1,866 retirees and their dependents, respectively, were covered under these plans. The postretirement benefit plans are unfunded as of December 31, 1993. However, the Company is examining the cost-effectiveness of certain funding alternatives. In January 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires that the Company accrue a liability for estimated future postretirement benefits during an employee's working career rather than recognize an expense when benefits are paid. At the time of adoption, the actuarially determined accumulated postretirement benefit obligation (APBO) was $206.6 million. The Company elected to recognize the APBO over 20 years. In September 1993, the PSC issued a Statement of Policy concerning the accounting and ratemaking treatment for pensions and postretirement benefits other than pensions (PSC Policy). The PSC Policy was effective January 1993, adopted SFAS 106 for accounting and ratemaking purposes, and complies with generally accepted accounting principles. Postretirement benefits cost other than pensions that was recognized on the income statement for the twelve months ended December 31, 1993, 1992, and 1991, was $11.4 million, $5 million, and $4.4 million, respectively. The amount for 1993 represents the portion of SFAS 106 costs that the Company has been allowed to collect from its customers. The amounts for the twelve months ended December 31, 1992 and 1991, represent the postretirement benefits cost as determined prior to the adoption of SFAS 106, when the cost was not recognized as an expense until the benefits were paid. The Company has deferred $10.1 million of SFAS 106 costs as of December 31, 1993. The Company expects to recover any deferred SFAS 106 amounts in accordance with the PSC Policy. The PSC Policy allows various rate mechanisms, including the use of excess pension fund assets, such as Internal Revenue Service Code of 1986 Section 420 transfers, to temper the effect of SFAS 106 on rates. In 1993, the Company transferred approximately $5 million of its excess pension plan assets to cover most of the cost of retirees' health care for that year. As a result of this transfer, the Company recognized a decrease in its deferred SFAS 106 asset. The estimated net postretirement benefits cost other than pensions for the 12 months ended December 31, 1993, includes the following components: (Thousands) Service cost: Benefits accumulated during the year $ 6,888 Interest cost on accumulated postretirement benefit obligation 16,304 Amortization of transition obligation over 20 years 10,330 Deferral for future recovery (22,095) --------- Net periodic postretirement benefits cost $ 11,427 ========== The status of the plans for postretirements benefits other than pensions, as reflected in the Company's Consolidated Balance Sheets at December 31, 1993, is as follows: (Thousands) Accumulated postretirement benefit obligation (APBO): Retired employees $ 69,947 Fully eligible active plan participants 36,454 Other active plan employees 107,708 ---------- Total APBO 214,109 ---------- Less unrecognized transition obligation 196,268 Less unrecognized net (gain) (10,233) ---------- Accrued postretirement liability $ 28,074 ========== A 12% annual rate of increase in the per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 5% by the year 2003. Increasing the assumed health care cost trend rates by 1% in each year would increase the APBO as of January 1, 1994, by $41.5 million and increase the aggregate of the service cost and interest cost components of the net postretirement benefits cost for 1994 by $4.6 million. A discount rate of 7% was used to determine the APBO. 8 Jointly-Owned Generating Stations Nine Mile Point Unit 2 The Company has an undivided 18% interest in the output and costs of the Nine Mile Point nuclear generating unit No. 2 (NMP2), which is being operated by Niagara Mohawk Power Corporation (Niagara Mohawk). Ownership of NMP2 is shared with Niagara Mohawk 41%, Long Island Lighting Company 18%, Rochester Gas and Electric Corporation 14%, and Central Hudson Gas & Electric Corporation 9%. The Company's share of the rated capability is 189,000 kilowatts. The Company's net utility plant investment, excluding nuclear fuel, was approximately $652 million and $660 million, at December 31, 1993 and 1992, respectively. The accumulated provision for depreciation was approximately $103 million and $90 million, at December 31, 1993 and 1992, respectively. The Company's share of operating expenses is included in the Consolidated Statements of Income. A low level radioactive waste management and contingency plan that has been developed for NMP2 provides assurance that NMP2 is properly prepared to handle interim storage of low level radioactive waste until 1998. Niagara Mohawk has contracted with the U.S. Department of Energy (DOE) for disposal of high level radioactive waste (spent fuel) from NMP2. The Company is reimbursing Niagara Mohawk for its 18% share of the cost under the contract (currently approximately $1 per megawatt hour of net generation). The DOE's schedule for start of operations of their high level radioactive waste repository has slipped from 2003 to no sooner than 2010. The Company has been advised by Niagara Mohawk that the NMP2 Spent Fuel Storage Pool has a capacity for spent fuel that is adequate until 2014. If further DOE schedule slippage should occur, the recent development of pre-licensed dry storage facilities for use at any nuclear power plant extends the on-site storage capability for spent fuel at NMP2 beyond 2014. Nuclear Insurance Niagara Mohawk maintains public liability and property insurance for NMP2. The Company reimburses Niagara Mohawk for its 18% share of those costs. The public liability limit for a nuclear incident is approximately $8.8 billion. Should losses stemming from a nuclear incident exceed the commercially available public liability insurance, each licensee of a nuclear facility would be liable for up to a maximum of $75.5 million per incident, payable at a rate not to exceed $10 million per year. The Company's maximum liability for its 18% interest in NMP2 would be approximately $13.6 million per incident. The $75.5 million assessment is subject to periodic inflation indexing and a 5% surcharge should funds prove insufficient to pay claims associated with a nuclear incident. The Price-Anderson Act also requires indemnification for precautionary evacuations whether or not a nuclear incident actually occurs. Niagara Mohawk maintains nuclear property insurance for NMP2 and is reimbursed by the Company for its 18% interest. Niagara Mohawk has procured property insurance aggregating approximately $2.7 billion through the Nuclear Insurance Pools and the Nuclear Electric Insurance Limited (NEIL). In addition, the Company has purchased NEIL insurance coverage for the extra expense incurred in purchasing replacement power during prolonged accidental outages. Under NEIL programs, should losses resulting from an incident at a member facility exceed the accumulated reserves of NEIL, each member, including the Company, would be liable for its share of the deficiency. The Company's maximum liability under the property damage and replacement power coverages is approximately $2.3 million. Nuclear Plant Decommissioning Costs In May 1993, the Nuclear Regulatory Commission (NRC) updated labor, energy, and burial cost factors for determining the minimum funding requirement for nuclear decommissioning. As a result, the Company's 18% share of the cost to decommission NMP2 is currently estimated to be $234 million in 2027, when decommissioning is expected to commence ($74 million in 1993 dollars). The Company's annual decommissioning allowance currently included in electric rates is approximately $1.6 million and is sufficient to recover the minimum funding requirement. The Company believes that any increase in decommissioning costs will ultimately be recovered in rates. The Company has established a Qualified Fund under applicable provisions of the federal tax law. The fund also complies with the NRC regulations which require the use of an external trust fund to provide funds to decommission the contaminated portion of NMP2. The balance in this fund was approximately $5.7 million and $3.9 million at December 31, 1993 and 1992, respectively, and is included in other property and investments on the Consolidated Balance Sheets. Homer City The Company has an undivided 50% interest in the output and costs of the Homer City Generating Station, which is comprised of three generating units. The station is owned with Pennsylvania Electric Company, which operates the facility. The Company's share of the rated capability is 954,000 kilowatts and its net utility plant investment was approximately $258 million and $251 million at December 31, 1993 and 1992, respectively. The accumulated provision for depreciation was approximately $159 million and $148 million, at December 31, 1993 and 1992, respectively. The Company's share of operating expenses is included in the Consolidated Statements of Income. 9 Commitments and Contingencies Capital Expenditures The Company has substantial commitments in connection with its construction program and estimates that capital expenditures for 1994, 1995, and 1996 will approximate $210 million, $200 million, and $200 million, respectively. These forecasted levels have been significantly reduced as the Company is taking action to address competition. The program is subject to periodic review and revision, and actual construction costs may vary because of revised load estimates, imposition of additional regulatory requirements, and the availability and cost of capital. Environmental Matters The Company continually assesses actions that may need to be taken to ensure compliance with changing environmental laws and regulations. Compliance programs will increase the cost of electric and natural gas service by requiring changes to the Company's operations and facilities. Historically, rate recovery has been authorized for the cost incurred for compliance with environmental laws and regulations. Due to existing and proposed legislation and regulations, and legal proceedings commenced by governmental bodies and others, the Company may also incur costs from the past disposal of hazardous substances produced during the Company's operations or those of its predecessors. The Company has been notified by the U. S. Environmental Protection Agency (EPA) and the New York State Department of Environmental Conservation (NYSDEC) that the Company is among the potentially responsible parties (PRPs) who may be liable to pay for costs incurred to remediate certain hazardous substances at seven waste sites, not including the Company's inactive gas manufacturing sites, which are discussed below. With respect to the seven sites, five sites are included in the New York State Registry of Inactive Hazardous Waste Sites (New York State Registry). Any liability may be joint and several for certain of these sites. The ultimate cost to remediate these sites will be dependent on such factors as the remedial action plan selected, the extent of site contamination, and the portion attributed to the Company. At December 31, 1993, the Company recorded a liability in the Consolidated Balance Sheets related to four of these seven sites of $1.8 million. The Company has notified the NYSDEC that it believes it has no responsibility at two sites and has already incurred expenditures related to the remediation at the remaining site. A deferred asset has also been recorded in the amount of $2.6 million, of which $.8 million relates to costs that have already been incurred. The Company believes it will recover these costs, since the PSC has allowed other utilities to recover these types of remediation costs and has allowed the Company to recover similar costs in rates, such as investigation and cleanup costs relating to inactive gas manufacturing sites. This $1.8 million estimate was derived by multiplying the total estimated cost to clean up a particular site by the related Company contribution factor. Estimates of the total cleanup costs were determined by using information related to a particular site, such as investigations performed to date at a site or from the data released by a regulatory agency. In addition, this estimate was based upon currently available facts, existing technology, and presently enacted laws and regulations. The contribution factor is calculated using either the Company's percentage share of the total PRPs named, which assumes all PRPs will contribute equally, or the Company's estimated percentage share of the total hazardous wastes disposed of at a particular site, or by using a 1% contribution factor for those sites at which it believes that it has contributed a minimal amount of hazardous wastes. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. A number of the Company's inactive gas manufacturing sites have been listed in the New York State Registry. The Company has filed petitions to delist the majority of the sites. The Company's program to investigate and initiate remediation at its 38 known inactive gas manufacturing sites has been extended through the year 2000. Expenditures over this time period are estimated to be $25 million. This estimate was determined by using the Company's experience and knowledge related to these sites as a result of the investigation and remediation that the Company has performed to date. It is based upon currently available facts, existing technology, and presently enacted laws and regulations. This liability, to investigate and initiate remediation, as necessary, at the known inactive gas manufacturing sites, is reflected in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992. The Company also has recorded a corresponding deferred asset, since it expects to recover such expenditures in rates, as the Company has previously been allowed by the PSC to recover such costs in rates. The Company has notified its former and current insurance carriers that it seeks to recover from them certain of these cleanup costs. However, the Company is unable to predict the amount of insurance recoveries, if any, that it may obtain. The Clean Air Act Amendments of 1990 (1990 Amendments) will result in significant expenditures of approximately $178 million, on a present value basis, over a 25 year period, for all capital and operating and maintenance expenses related to the reduction of sulfur dioxide and nitrogen oxides at several of the Company's coal-fired generating stations of which $51 million has been incurred as of December 31, 1993. The Company's current estimate is a significant reduction from its prior estimate, primarily due to the postponement of the construction of a flue gas desulfurization (FGD) system at the Homer City Generating Station. The Company plans to reevaluate the need to construct an FGD system at the Homer City Generating Station in 1995, since its present strategy to bank Phase I emissions allowances for use during Phase II, as discussed below, will allow the Company to meet Phase II allowance requirements through the year 2005. The cost to comply with the sulfur dioxide and nitrogen oxide limitations includes the construction of an innovative FGD system and a nitrogen oxide reduction system expected to be completed in 1995 at the Company's Milliken Generating Station. The Company estimates that approximately a 1% electric rate increase will be required for the cost of reducing sulfur dioxide and nitrogen oxide emissions in both Phase I (begins January 1, 1995) and Phase II (begins January 1, 2000). As a result of the 1990 Amendments, the Company plans to reduce its annual sulfur dioxide emissions by an amount that will allow the Company to meet the sulfur dioxide levels established for the Company, which is approximately a 49% reduction from approximately 138,000 tons in 1989 to 71,000 tons by the year 2000. The cost of controlling toxic emissions under the 1990 Amendments, if required, cannot be estimated at this time. Regulations may be adopted at the state level which would limit toxic emissions even further, at an additional cost to the Company. The Company anticipates that the costs incurred to comply with the 1990 Amendments will be recoverable through rates based on previous rate recovery of required environmental costs. The 1990 Amendments require the EPA to allocate annual emissions allowances to each of the Company's coal-fired generating stations based on statutory emissions limits. An emissions allowance represents an authorization to emit, during or after a specified calendar year, one ton of sulfur dioxide. During Phase I, the Company estimates that it will have allowances in excess of the affected coal-fired generating stations' actual emissions. The Company's present strategy is to bank these allowances for use in later years. By using a banking strategy, it is estimated that Phase II allowance requirements will be met through the year 2005 by utilizing the allowances banked during Phase I, which includes the extension reserve allowances discussed below, together with the Company's Phase II annual emissions allowances. This strategy could be modified should market or business conditions change. In addition to the annual emissions allowances allocated to the Company by the EPA, the Company will receive a portion of the extension reserve allowances issued by the EPA to utilities electing to build scrubbers, as a result of the pooling agreement that it entered into with other utilities who were also eligible to receive some of these extension reserve allowances. As a result of existing and new solid waste disposal legislation and regulations in Pennsylvania, the Company will incur approximately $24 million, on a present value basis, of additional costs over the next 30 years, beginning in 1994, at the Homer City Generating Station. These costs will be incurred to install new equipment, modify or replace existing equipment, and improve the design of a proposed expansion of disposal facilities. The Company expects to recover these expenditures in rates, since the Company has been allowed by the PSC to recover similar costs in rates, such as groundwater protection costs to meet permit conditions and regulatory requirements. Long-term Power Purchase Contracts The Company has on line and under contract 362 megawatts (mw) of non-utility generation (NUG) power. In addition, another 240 mw of NUG power is under construction. The Company is required to make payments under these contracts only for the power it receives. During 1993, 1992, and 1991 the Company purchased approximately $138 million, $71 million, and $30 million, respectively, of NUG power. The Company estimates that it will purchase approximately $255 million, $291 million, and $335 million of NUG power for the years 1994, 1995, and 1996, respectively. Increases in NUG power purchase costs are expected to be a significant contributor to price increases over the next three years. As part of the Company's continuing effort to minimize future price increases associated with uneconomical power purchases from NUGs, the Company negotiated termination of agreements for the South Corning and Indeck-Kirkwood cogeneration projects. The PSC approved full recovery of the $11.5 million in termination costs for the Indeck-Kirkwood project in rates. The Company expects to recover the $34 million in termination costs for the South Corning project in rates because the PSC issued an order in 1993 allowing the Company to defer these costs and the Company has been allowed by the PSC to recover costs for the Indeck-Kirkwood project in rates. Coal Purchasing Contracts The Company has long-term contracts with nonaffiliated mining companies for the purchase of coal for the jointly-owned Homer City Generating Station. The contracts, which expire between 1994 and the end of the expected service life of the generating station, require the purchase of either fixed or minimum amounts of the station's coal requirements. The price of the coal under one of these contracts is based on recovery of production costs plus incentives. The remaining contracts are based on fixed price plus escalation provisions. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $66 million, $45 million, and $31 million for the years 1994, 1995, and 1996, respectively. In addition, the Company has a long-term contract for the purchase of coal for the Kintigh Generating Station. The contract, which expires in 1997, supplies the annual coal requirements of the station. One-third of the tonnage price is renegotiated annually to reflect market conditions. The delivered cost of coal purchased under this agreement is expected to be $56 million, $55 million, and $56 million for the years 1994, 1995, and 1996, respectively. 10 Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments at December 31, 1993 and 1992, were as follows: Carrying Amount Fair Value 1993 1992 1993 1992 (Thousands) First mortgage bonds $1,166,779 $1,318,845 $1,274,883 $1,388,990 Pollution control notes $575,695 $505,680 $581,928 $523,251 Preferred stock subject to mandatory redemption requirements $125,000 $108,550 $134,000 $119,031 The carrying amount for the following items approximates estimated fair value because of the short maturity of those instruments: cash and cash equivalents, commercial paper, and interest accrued. Special deposits include restricted funds that are set aside for preferred stock and long-term debt redemptions. Special deposits also include restricted funds that are used to finance a portion of the costs incurred in the construction of certain solid waste disposal and other related facilities. The carrying amount approximates fair value because the special deposits have been invested in securities with a short-term maturity. The carrying amount of the revolving credit agreement note approximates fair value because its pricing is based on short- term interest rates. The fair value of the Company's first mortgage bonds, pollution control notes, and preferred stock is estimated based on the quoted market prices for the same or similar issues of the same remaining maturities. 11 Industry Segment Information Certain information pertaining to the electric and natural gas operations of the Company is: 1993 1992 1991 Natural Natural Natural Electric Gas Electric Gas Electric Gas (Thousands) Operating Revenues $1,527,362 $272,787 $1,451,525 $240,164 $1,367,936 $187,879 Expenses $1,250,000 $249,493 $1,146,619 $221,307 $1,056,969 $177,751 Income $277,362 $23,294 $304,906 $18,857 $310,967 $10,128 Depreciation and amortization* $155,231 $9,337 $150,549 $8,428 $145,700 $6,680 Construction expenditures $208,576 $36,453 $210,185 $35,433 $210,127 $35,756 Identifiable assets** $4,615,963 $458,596 $4,540,724 $377,424 $4,515,237 $340,090 * Included in operating expenses. ** Assets used in both electric and natural gas operations not included above were $201,457, $159,768, and $69,509 at December 31, 1993, 1992, and 1991, respectively. They consist primarily of cash and cash equivalents, special deposits, and prepayments. 12 Supplementary Income Statement Information Charges for maintenance, repairs, and depreciation and amortization, are set forth in the Consolidated Statements of Income. Taxes, other than federal income taxes, are: 1993 1992 1991 (Thousands) Property $84,616 $81,640 $76,589 Franchise and gross receipts 92,810 92,153 76,721 Payroll 17,985 17,096 15,467 Miscellaneous 9,551 10,052 9,408 -------- -------- -------- Total Other Taxes $204,962 $200,941 $178,185 ======== ======== ======== 13 Quarterly Financial Information (Unaudited) Quarter ended March 31 June 30 Sept. 30 Dec. 31 (Thousands, Except Per Share Amounts) Operating revenues $522,383 $388,601 $396,410 $492,755 Operating income $109,893 $56,649 $66,108 $68,006 Net income $74,039 $21,500 $32,541 $37,948 (1) Earnings for common stock $68,838 $16,299 $27,340 $32,913 Earnings per share $.99 $.23 $.39 $.47 (1) Dividends per share $.54 $.54 $.55 $.55 Average shares outstanding 69,561 69,836 70,119 70,431 Common stock price* High $35.13 $36.50 $36.25 $35.50 Low $31.63 $32.13 $34.63 $28.75 Operating revenues $489,847 $401,934 $367,833 $432,075 Operating income $111,373 $82,755 $60,109 $69,526 Net income $76,416 $46,772 $26,581 $34,199 Earnings for common stock $71,167 $41,488 $21,320 $28,998 Earnings per share $1.10 (2) $.60 (2) $.31 (2) $.42 (2) Dividends per share $.53 $.53 $.54 $.54 Average shares outstanding 64,682 68,800 69,063 69,318 Common stock price* High $29.63 $29.38 $32.00 $32.75 Low $26.13 $26.75 $29.25 $30.38 (1) Fourth quarter 1993 results reflect the effects of restructuring expenses, which decreased net income and earnings for common stock by $17.2 million and decreased earnings per share by 24 cents. (2) Late in 1992, the Company began reflecting on its income statement the value of energy consumed but not yet billed. If the Company had been allowed by the PSC to include this unbilled revenue factor during all of 1992, quarterly earnings per share in 1992 would have been 94 cents, 39 cents, 38 cents, and 72 cents for the first, second, third, and fourth quarters, respectively. * The Company's common stock is listed on the New York Stock Exchange. The number of stockholders of record at December 31, 1993 was 58,990. Dividend Limitations: After dividends on all outstanding preferred stock have been paid, or declared, and funds set apart for their payment, the common stock is entitled to cash dividends as may be declared by the Board of Directors out of retained earnings accumulated since December 31, 1946. Common Stock dividends are limited if Common Stock Equity (45% at December 31, 1993) falls below 25% of total capitalization, as defined in the Company's Certificate of Incorporation. Dividends on common stock cannot be paid unless sinking fund requirements of the preferred stock are met. The Company has not been restricted in the payment of dividends on common stock by these provisions. Retained earnings accumulated since December 31, 1946, were approximately $320 million and $327 million as of December 31, 1993 and 1992, respectively. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors New York State Electric & Gas Corporation and Subsidiaries Ithaca, New York We have audited the consolidated financial statements and the financial statement schedules of New York State Electric & Gas Corporation and Subsidiaries listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of New York State Electric & Gas Corporation and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 7 to the consolidated financial statements, the Company and Subsidiaries changed its method of accounting for postretirement benefits other than pensions in 1993. COOPERS & LYBRAND New York, New York January 28, 1994 Item 9. Item 9. Changes in and disagreements with accountants on accounting and financial disclosure - None PART III Item 10. Item 10. Directors and executive officers of the Registrant Incorporated herein by reference to the information under the caption "Election of Directors" in the Company's Proxy Statement dated March 31, 1994. The information regarding executive officers is on pages 23-25 of this report. Item 11. Item 11. Executive compensation Incorporated herein by reference to the information under the captions "Executive Compensation," "Employment and Change in Control Arrangements," "Directors' Compensation," "Compensation Committee Interlocks and Insider Participation," "Report of Executive Compensation and Succession Committee on Executive Compensation" and "Stock Performance Graph" in the Company's Proxy Statement dated March 31, 1994. Item 12. Item 12. Security ownership of certain beneficial owners and management Incorporated herein by reference to the information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement dated March 31, 1994. Item 13. Item 13. Certain relationships and related transactions Incorporated herein by reference to the information under the captions "Election of Directors" and "Employment and Change in Control Arrangements" in the Company's Proxy Statement dated March 31, 1994. PART IV Item 14. Item 14. Exhibits, financial statement schedules, and reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial statements Included in Part II of this report: a) Consolidated Statements of Income for the three years ended December 31, 1993 b) Consolidated Balance Sheets as of December 31, 1993 and 1992 c) For the three years ended December 31, 1993: Consolidated Statements of Cash Flows Consolidated Statements of Changes in Common Stock Equity d) Notes to Consolidated Financial Statements e) Report of Independent Accountants 2. Financial statement schedules Included in Part II of this report: For the three years ended December 31, 1993: V. Property, Plant and Equipment VI. Accumulated Depreciation of Property, Plant and Equipment VIII. Allowance for Doubtful Accounts - Accounts Receivable Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the Consolidated Financial Statements or notes thereto. 3. Exhibits (a)(1) The following exhibits are delivered with this report: Exhibit No. 3-11 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 10, 1993. 3-12 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. 3-13 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. 3-15 - By-Laws of the Company as amended February 25, 1994. 10-14 - Coal Sales Agreement dated December 21, 1983 between New York State Electric & Gas Corporation and Consolidation Coal Company. (A) 10-21 - Retirement Plan for Directors Amendment No. 1. (A) 10-23 - Deferred Compensation Plan for Directors Amendment No. 1. (A) 10-32 - Supplemental Executive Retirement Plan Amendment No. 8. (A) 10-33 - Supplemental Executive Retirement Plan Amendment No. 9. (A) 10-35 - Annual Executive Incentive Compensation Plan Amendment No. 1. (A) 10-36 - Annual Executive Incentive Compensation Plan Amendment No. 2. (A) 10-41 - Performance Share Plan Amendment No. 4. (A) 10-43 - Performance Share Deferred Compensation Plan Amendment No. 1. (A) 10-46 - Employment Agreement for J. A. Carrigg. (A) 10-47 - Form of Severance Agreement for Senior Vice Presidents. (A) 10-48 - Form of Severance Agreement for Vice Presidents. 12 - Computation of Ratio of Earnings to Fixed Charges. 21 - Subsidiaries. 23 - Consent of Coopers & Lybrand to incorporation by reference into certain registration statements. 99-1 - Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees. 99-2 - Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees. (a)(2) The following exhibits are incorporated herein by reference: Exhibit No. Filed in As Exhibit No. 3-1 - Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on October 25, 1988 - Registration No. 33-50719 . . . 4-11 3-2 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 17, 1989 - Registration No. 33-50719 . . 4-12 3-3 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 22, 1990 - Registration No. 33-50719 . . . . . . . . . . . . . 4-13 3-4 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 31, 1990 - Registration No. 33-50719 . . 4-14 ______________________________ (A) Management contract or compensatory plan or arrangement. Exhibit No. Filed in As Exhibit No. 3-5 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on February 6, 1991 - Registration No. 33-50719 . . 4-15 3-6 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 15, 1991 - Registration No. 33-50719 . . 4-16 3-7 - Certificate of Merger of Columbia Gas of New York, Inc. into the Company filed in the Office of the Secretary of State of the State of New York on April 8, 1991 - Registration No. 33-50719 . . . . . . . . . . . . . . . . . . . 4-20 3-8 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 28, 1992 - Registration No. 33-50719 . . . . 4-17 3-9 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 20, 1992 - Registration No. 33-50719 . . . 4-18 3-10 - Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 14, 1993 Registration No. 33-50719 . . . . . . . . . . . . . . 4-19 3-14 - Certificates of the Secretary of the Company concern- ing consents dated March 20, 1957 and May 9, 1975 of holders of Serial Preferred Stock with respect to issuance of certain unsecured indebtedness - Registration No. 2-69988. . . . . . . . . . . . . . 4-7 4-1 - First Mortgage dated as of July 1, 1921 executed by the Company under its then name of "New York State Gas and Electric Corporation" to The Equitable Trust Company of New York, as Trustee (Chemical Bank is Successor Trustee) - Registration No. 33-4186 . . . 4-1 Supplemental Indentures to First Mortgage dated as of July 1, 1921: 4-2 - No. 37 - Registration No. 33-31297. . . . . . . . . 4-2 4-3 - No. 39 - Registration No. 33-31297. . . . . . . . . 4-3 4-4 - No. 43 - Registration No. 33-31297. . . . . . . . . 4-4 4-5 - No. 51 - Registration No. 2-59840 . . . . . . . . . 2-B(46) 4-6 - No. 68 - Registration No. 2-59840 . . . . . . . . . 2-B(63) 4-7 - No. 69 - Registration No. 2-59840 . . . . . . . . . 2-B(64) 4-8 - No. 71 - Registration No. 2-59840 . . . . . . . . . 2-B(66) 4-9 - No. 74 - Registration No. 2-59840 . . . . . . . . . 2-B(69) 4-10 - No. 75 - Registration No. 2-59840 . . . . . . . . . 2-B(70) 4-11 - No. 80 - Registration No. 2-59840 . . . . . . . . . 2-B(75) 4-12 - No. 81 - Registration No. 2-59840 . . . . . . . . . 2-B(76) 4-13 - No. 83 - Registration No. 2-65948 . . . . . . . . . 2-B(78) 4-14 - No. 99 - Registration No. 33-11303. . . . . . . . . 4-9 4-15 - No. 102- Registration No. 33-33838. . . . . . . . . 4-8 4-16 - No. 103- Registration No. 33-43458. . . . . . . . . 4-8 4-17 - No. 104- Registration No. 33-43458. . . . . . . . . 4-9 4-18 - No. 105- Registration No. 33-52040. . . . . . . . . 4-8 4-19 - No. 106- Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . 4-23 4-20 - No. 107- Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . 4-24 4-21 - No. 108- Registration No. 33-50719. . . . . . . . . 4-8 4-22 - No. 109- Registration No. 33-50719. . . . . . . . . 4-9 Contracts, amendments, and letter agreement with the Power Authority of the State of New York: 10-1 - Contract UD-4 dated July 28, 1975 (FitzPatrick Power) - Registration No. 2-59840 . . . . . . . . . 5-5 Exhibit No. Filed in As Exhibit No. 10-2 - Contract PS-2 dated March 28, 1973 (Blenheim- Gilboa) - Registration No. 2-59840. . . . . . . . . 5-6 10-3 - Letter Agreement dated February 3, 1982 relating to transmission services - Registration No. 2-82192. . 10-1 10-4 - Amendment dated December 21, 1989 to the Letter Agreement dated February 3, 1982 relating to trans- mission services - Company's 10-K for year ended December 31, 1989 - File No. 1-3103-2 . . . . . . 10-4 10-5 - Contract effective as of February 22, 1989 relating to the purchase of hydroelectric power - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . . . 10-5 10-6 - Transmission Agreement dated December 12, 1983, with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2 . . . . 10-6 10-7 - Amendment dated December 21, 1989 to the Transmission Agreement dated December 12, 1983 with respect to connection of the Company's Kintigh (Somerset) Gener- ating Station to the Niagara-Edic 345 kv transmission system - Company's 10-K for the year ended December 31, 1989 File No. 1-3103-2. . . . . . . . . . . . . 10-7 Coal Sales Agreements and Amendments between New York State Electric & Gas Corporation, Pennsylvania Electric Company and: 10-8 - Helvetia Coal Company - Agreement made as of December 22, 1966 - Registration No. 2-59840. . . . 5-11 10-9 - Helvetia Coal Company - Amendment made as of April 1, 1974 - Registration No. 2-55131. . . . . . 5-F(1)b 10-10 - Amendment dated as of March 15, 1989 to the Coal Sales Agreement made as of December 22, 1966 between New York State Electric & Gas Corporation, Penn- sylvania Electric Company and Helvetia Coal Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . 10-10 10-11 - Amendment dated as of July 25, 1990 to the Coal Sales Agreement made as of December 22, 1966 between New York State Electric & Gas Corporation, Penn- sylvania Electric Company and Helvetia Coal Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . 10-11 * * * * * * * * * * Exhibit No. Filed in As Exhibit No. 10-12 - New York Power Pool Agreement dated July 11, 1985 - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-7 10-13 - Transmission Agreement dated January 10, 1990 between New York State Electric & Gas Corporation and Niagara Mohawk Power Corporation, with respect to remote load and generation wheeling service for the Company - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-17 10-15 - Amendment No. 1 dated as of October 1, 1985 to the Coal Sales Agreement dated December 21, 1983 between the Company and Consolidation Coal Company - Company's 10-K for year ended December 31, 1986 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-11 10-16 - Amendment No. 2 dated as of August 28, 1986 to the Coal Sales Agreement dated December 21, 1983 between the Company and Consolidation Coal Company - Company's 10-K for year ended December 31, 1986 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-12 10-17 - Basic Agreement dated as of September 22, 1975 between New York State Electric & Gas Corporation and others concerning Nine Mile Point Nuclear Station, Unit No. 2 - Registration No. 2-54903. . . 5-0 10-18 - Nine Mile Point Nuclear Station Unit 2 Operating Agreement effective as of January 1, 1993 among New York State Electric & Gas Corporation and others - Company's 10-K for the year ended December 31, 1992 - File No. 1-3103-2 . . . . . . . 10-18 10-19 - Coal Hauling Agreement dated as of March 9, 1983 between Somerset Railroad Corporation and New York State Electric & Gas Corporation - Registration No. 2-82352. . . . . . . . . . . . . . 10 (A) 10-20 - Retirement Plan for Directors - Company's 10-K for the year ended December 31, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-26 (A) 10-22 - Form of Deferred Compensation Plan for Directors - Company's 10-K for year ended December 31, 1989 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-22 (A) 10-24 - Supplemental Executive Retirement Plan - Company's 10-Q for quarter ended September 30, 1984 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-19 (A) 10-25 - Supplemental Executive Retirement Plan Amendment No. 1 - Company's 10-Q for quarter ended March 31, 1985 - File No. 1-3103-2. . . . . . . . . 10-21 ______________________________ (A) Management contract or compensatory plan or arrangement. Exhibit No. Filed in As Exhibit No. (A) 10-26 - Supplemental Executive Retirement Plan Amendment No. 2 - Company's 10-K for year ended December 31, 1987 - File No. 1-3103-2. . . . . . . . . . . . 10-19 (A) 10-27 - Supplemental Executive Retirement Plan Amendment No. 3 - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . 10-24 (A) 10-28 - Supplemental Executive Retirement Plan Amendment No. 4 - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . . . . . . . . . . . . . 10-30 (A) 10-29 - Supplemental Executive Retirement Plan Amendment No. 5 - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . . . . . . . . . . . . . 10-31 (A) 10-30 - Supplemental Executive Retirement Plan Amendment No. 6 - Company's 10-Q for quarter ended March 31, 1991 - File No. 1-3103-2. . . . . . . . . . . . . . 10-37 (A) 10-31 - Supplemental Executive Retirement Plan Amendment No. 7 - Company's 10-Q for quarter ended June 30, 1992 - File No. 1-3103-2. . . . . . . . . . . . . . 10-44 (A) 10-34 - Annual Executive Incentive Compensation Plan. Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-30 (A) 10-37 - Performance Share Plan - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2 . . . . 10-36 (A) 10-38 - Performance Share Plan Amendment No. 1 - Company's 10-Q for quarter ended March 31, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-38 (A) 10-39 - Performance Share Plan Amendment No. 2 - Company's 10-Q for quarter ended June 30, 1991 - File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-39 (A) 10-40 - Performance Share Plan Amendment No. 3 - Company's 10-K for year ended December 31, 1992 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . . . 10-34 (A) 10-42 - Performance Share Deferred Compensation Plan - Company's 10-K for year ended December 31, 1991 File No. 1-3103-2 . . . . . . . . . . . . . . . . . 10-40 (A) 10-44 - Employment Contract for A. E. Kintigh - Company's 10-K for year ended December 31, 1988 - File No. 1-3103-2. . . . . . . . . . . . . . . . . . . . 10-26 (A) 10-45 - Agreement with R. Fleming, Jr. - Company's 10-K for year ended December 31, 1990 - File No. 1-3103-2. . 10-34 The Company agrees to furnish to the Commission, upon request, a copy of the Revolving Credit Agreement dated as of July 31, 1992, between the Company, Chemical Bank, as Agent, and certain banks; a copy of the Participation Agreement dated as of February 1, 1984 between the Company and New York State Energy Research and Development Authority (NYSERDA) relating to Pollution Control Revenue Bonds; a copy of the Participation Agreements dated as of October 15, 1984, June 1, 1987 and December 1, 1988 between the Company and NYSERDA relating to Adjustable Rate Pollution Control Revenue Bonds (1984 Series A), (1987 Series A), and (1988 Series A), respectively; a copy of the Participation Agreements dated as of March 1, 1985, October 15, 1985, July 15, 1985 and December 1, 1985 between the Company and NYSERDA relating to Annual ______________________________ (A) Management contract or compensatory plan or arrangement. Tender Pollution Control Revenue Bonds (1985 Series A), (1985 Series B), (1985 Series C) and (1985 Series D), respectively; a copy of the Participation Agreements dated as of February 1, 1993 and February 1, 1994 between the Company and NYSERDA relating to Pollution Control Refunding Revenue Bonds (1994 Series A) and (1994 Series B) respectively; a copy of the Participation Agreement dated as of December 1, 1993 between the Company and NYSERDA relating to Solid Waste Disposal Revenue Bonds (1993 Series A); and a copy of the Credit Agreement dated as of March 9, 1983, as amended, between Somerset Railroad Corporation and Chemical Bank. The total amount of securities authorized under each of such agreements does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K A report on Form 8-K, dated November 29, 1993, was filed during the fourth quarter of 1993 to report certain information under Item 5, "Other Events." Signatures Pursuant to the requirements of Section 13 or 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. NEW YORK STATE ELECTRIC & GAS CORPORATION Date: March 11, 1994 By Everett A. Robinson Everett A. Robinson Vice President and Controller (Chief Accounting 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. PRINCIPAL EXECUTIVE OFFICER Date: March 11, 1994 By James A. Carrigg James A. Carrigg Chairman, President, Chief Executive Officer and Director PRINCIPAL FINANCIAL OFFICER Date: March 11, 1994 By Sherwood J. Rafferty Sherwood J. Rafferty Vice President and Treasurer PRINCIPAL ACCOUNTING OFFICER Date: March 11, 1994 By Everett A. Robinson Everett A. Robinson Vice President and Controller Signatures (Cont'd) Date: March 11, 1994 By Alison P. Casarett Alison P. Casarett Director Date: March 11, 1994 By Everett A. Gilmour Everett A. Gilmour Director Date: March 11, 1994 By Paul L. Gioia Paul L. Gioia Director Date: March 11, 1994 By John M. Keeler John M. Keeler Director Date: March 11, 1994 By Allen E. Kintigh Allen E. Kintigh Director Date: March 11, 1994 By Ben E. Lynch Ben E. Lynch Director Date: March 11, 1994 By Alton G. Marshall Alton G. Marshall Director Date: March 11, 1994 By David R. Newcomb David R. Newcomb Director Date: March 11, 1994 By Robert A. Plane Robert A. Plane Director Date: March 11, 1994 By C. William Stuart C. William Stuart Director EXHIBIT INDEX * 3-1 -- Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on October 25, 1988. * 3-2 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 17, 1989. * 3-3 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 22, 1990. * 3-4 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 31, 1990. * 3-5 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on February 6, 1991. * 3-6 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 15, 1991. * 3-7 -- Certificate of Merger of Columbia Gas of New York, Inc. into the Company filed in the Office of the Secretary of State of the State of New York on April 8, 1991. * 3-8 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on May 28, 1992. * 3-9 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 20, 1992. * 3-10 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on October 14, 1993. 3-11 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 10, 1993. 3-12 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) 3-13 -- Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on December 20, 1993. * 3-14 -- Certificates of the Secretary of the Company concerning consents dated March 20, 1957 and May 9, 1975 of holders of Serial Preferred Stock with respect to issuance of certain unsecured indebtedness. 3-15 -- By-Laws of the Company as amended February 25, 1994. * 4-1 -- First Mortgage dated as of July 1, 1921 executed by the Company under its then name of "New York State Gas and Electric Corporation" to The Equitable Trust Company of New York, as Trustee (Chemical Bank is Successor Trustee). Supplemental Indentures to First Mortgage dated as of July 1, 1921: * 4-2 -- No. 37 * 4-9 -- No. 74 * 4-16 -- No. 103 * 4-3 -- No. 39 * 4-10 -- No. 75 * 4-17 -- No. 104 * 4-4 -- No. 43 * 4-11 -- No. 80 * 4-18 -- No. 105 * 4-5 -- No. 51 * 4-12 -- No. 81 * 4-19 -- No. 106 * 4-6 -- No. 68 * 4-13 -- No. 83 * 4-20 -- No. 107 * 4-7 -- No. 69 * 4-14 -- No. 99 * 4-21 -- No. 108 * 4-8 -- No. 71 * 4-15 -- No. 102 * 4-22 -- No. 109 Contracts, Amendments, and Letter Agreement with the Power Authority of the State of New York: * 10-1 -- Contract UD-4 dated July 28, 1975 (FitzPatrick Power). * 10-2 -- Contract PS-2 dated March 28, 1973 (Blenheim- Gilboa). * 10-3 -- Letter Agreement dated February 3, 1982 relating to transmission services. * 10-4 -- Amendment dated December 21, 1989 to the Letter Agreement dated February 3, 1982 relating to transmission services. * 10-5 -- Contract effective as of February 22, 1989 relating to the purchase of hydroelectric power. * 10-6 -- Transmission Agreement dated December 12, 1983, with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) * 10-7 -- Amendment dated December 21, 1989 to the Transmission Agreement dated December 12, 1983 with respect to connection of the Company's Kintigh (Somerset) Generating Station to the Niagara-Edic 345 kv transmission system. * * * * * * * * * * Coal Sales Agreements and Amendments between New York State Electric & Gas Corporation, Pennsylvania Electric Company and: * 10-8 -- Helvetia Coal Company--Agreement made as of December 22, 1966. * 10-9 -- Helvetia Coal Company--Amendment made as of April 1, 1974. * 10-10 -- Helvetia Coal Company--Amendment made as of March 15, 1989. * 10-11 -- Helvetia Coal Company--Amendment made as of July 25, 1990. * * * * * * * * * * * 10-12 -- New York Power Pool Agreement dated July 11, 1985. * 10-13 -- Transmission Agreement dated January 10, 1990 between New York State Electric & Gas Corporation and Niagara Mohawk Power Corporation, with respect to remote load and generation wheeling service for the Company. * * * * * * * * * * Coal Sales Agreement and Amendments between New York State Electric & Gas Corporation and Consolidation Coal Company: 10-14 -- Agreement dated December 21, 1983. * 10-15 -- Amendment No. 1 dated as of October 1, 1985. * 10-16 -- Amendment No. 2 dated as of August 28, 1986. * * * * * * * * * * * 10-17 -- Basic Agreement dated as of September 22, 1975 between New York State Electric & Gas Corporation and others concerning Nine Mile Point Nuclear Station, Unit No. 2. * 10-18 -- Nine Mile Point Nuclear Station Unit 2 Operating Agreement effective as of January 1, 1993 among New York State Electric & Gas Corporation and others. ___________________________________ * Incorporated by reference. EXHIBIT INDEX (Cont'd) * 10-19 -- Coal Hauling Agreement dated as of March 9, 1983 between Somerset Railroad Corporation and New York State Electric & Gas Corporation. (A)* 10-20 -- Retirement Plan for Directors. (A) 10-21 -- Retirement Plan for Directors Amendment No. 1 (A)* 10-22 -- Form of Deferred Compensation Plan for Directors. (A) 10-23 -- Deferred Compensation Plan for Directors Amendment No. 1. (A)* 10-24 -- Supplemental Executive Retirement Plan (A)* 10-25 -- Supplemental Executive Retirement Plan Amendment No. 1. (A)* 10-26 -- Supplemental Executive Retirement Plan Amendment No. 2. (A)* 10-27 -- Supplemental Executive Retirement Plan Amendment No. 3. (A)* 10-28 -- Supplemental Executive Retirement Plan Amendment No. 4. (A)* 10-29 -- Supplemental Executive Retirement Plan Amendment No. 5. (A)* 10-30 -- Supplemental Executive Retirement Plan Amendment No. 6. (A)* 10-31 -- Supplemental Executive Retirement Plan Amendment No. 7. (A) 10-32 -- Supplemental Executive Retirement Plan Amendment No. 8. (A) 10-33 -- Supplemental Executive Retirement Plan Amendment No. 9. (A)* 10-34 -- Annual Executive Incentive Compensation Plan. (A) 10-35 -- Annual Executive Incentive Compensation Plan Amendment No. 1. (A) 10-36 -- Annual Executive Incentive Compensation Plan Amendment No. 2. (A)* 10-37 -- Performance Share Plan. (A)* 10-38 -- Performance Share Plan Amendment No. 1. (A)* 10-39 -- Performance Share Plan Amendment No. 2. (A)* 10-40 -- Performance Share Plan Amendment No. 3 (A) 10-41 -- Performance Share Plan Amendment No. 4 (A)* 10-42 -- Performance Share Deferred Compensation Plan. (A) 10-43 -- Performance Share Deferred Compensation Plan Amendment No. 1 (A)* 10-44 -- Employment Contract for A. E. Kintigh. (A)* 10-45 -- Agreement with R. Fleming, Jr. (A) 10-46 -- Employment Agreement for J. A. Carrigg. (A) 10-47 -- Form of Severance Agreement for Senior Vice Presidents. (A) 10-48 -- Form of Severance Agreement for Vice Presidents. ___________________________________ (A) Management contract or compenstory plan or arrangement. * Incorporated by reference. EXHIBIT INDEX (Cont'd) 12 -- Computation of Ratio of Earnings to Fixed Charges. 21 -- Subsidiaries. 23 -- Consent of Coopers & Lybrand to incorporation by reference into certain registration statements. 99-1 -- Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees. 99-2 -- Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees.	53,829	329,876

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